Vol. 11 Issue 5.4 May 29, 2015

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CBDT issues draft scheme on the use of “Multiple year data” and

“Range Concept” for the computation of arm’s length price

In order to align Transfer Pricing regulations in India with the international

practices, the Hon Finance Minister had, at the time of presenting the Finance bill

(No 2) for 2014, announced to introduce the arm’s length range concept for cases

where adequate number of comparables are available. The impact of the said

range concept would be that it would provide a range of Arm’s Length Price

(“ALP”) or margin for assessing the compliance of the related party transactions

with the Indian transfer pricing regulations. The current practice of computing the

ALP in the Indian transfer pricing regulation is to use an arithmetic mean where

more than one comparable price is identified. The use of arithmetic mean concept

produces only one arm’s length price which is prone to being influenced by the

outlier comparables (ie very high margin or very low margin comparable) and has

accordingly been the one of the significant causes for high amount litigation in the

transfer pricing domain in India.

Further, it was also announced that use of multiple year data would be permitted

for undertaking comparability analysis as against the current practise of allowing

the use of multiple year data only if certain conditions, which are difficult to

evidence, are met. The use of multiple year data is expected to factor the cyclical

effect of the industry, and accordingly would help in keeping the ALP more

appropriately aligned to the economic circumstances prevailing in the industry.

Based on these statements of the Finance Minister, the necessary legislative

amendments were made in the Income tax Act, 1961 (“the Act”) to facilitate the

said change in the manner of computation of the ALP and the power was given to

the Central Board of Direct Taxes (“CBDT”) to specify the manner in which the

said concepts are to implemented in computing the ALP.

The CBDT has now, on May 21, 2015, issued a draft scheme of the proposed rule

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Suchint Majmudar

(“Draft Rule”) laying out the manner in which ALP is required to be computed, for

international transaction and specified domestic transactions, using the Range

concept and the Multiple year data. Specifically, in the said Draft Rule, the CBDT

has addressed the conditions applicable, and the mechanism for the use of

Multiple Year data and the Range concept for the purposes of computing the ALP.

The CBDT has invited comments and suggestions on the said Draft Rule which

can submitted by May 31, 2015.

A summary of the said conditions, and mechanism as proposed in the Draft

Rule, and our observation in relation to the same are as under:

1. Conditions and mechanism for use of multiple year data

Conditions

The multiple year data can be applied only in cases where the ALP is

determined using Transaction Net Margin Method (“TNMM”), Resale Price

Method (“RPM”) or Cost Plus Method (“CPLM”); and

Further, use of multiple year data is mandatorily required where the ALP is

determined using the above mentioned methods.

Mechanism

The multiple year data should comprise of three years including the year in

which the transaction took place (hereinafter referred to as “data for current

year”);

In case of non availability of data for all the three years for any of the

following reasons, data for two out of the three years can be used;

- Data for current year of the comparable companies is not available in the

databases at the time of filing of return of income;

- The comparable company fails a quantitative filter in any one of the three

years; and

- The comparable company has commenced operation only in the last two

years or it have closed down its operations during the current year.

Mukesh Butani, New Delhi

+91 11 3066 3010

mukesh.butani@bmrlegal.in

Rajeev Dimri, New Delhi +91 124 669 5050 rajeev.dimri@bmradvisors.com

Gokul Chaudhri, New Delhi

+91 124 669 5040

gokul.chaudhri@bmradvisors.com

Bobby Parikh, Mumbai

+91 22 6135 7010

bobby.parikh@bmradvisors.com

Sriram Seshadri, Chennai

+91 44 4298 7000

sriram.seshadri@bmrlegal.in

Amit Jain, Pune +91 20 668 19010 amit.jain@bmradvisors.com

Hussain Sunelwala

In cases where the current year data of the comparables are not available on

the databases at the time of filing of returns of income, the Draft Rule permit

that the same can be updated at the time of transfer pricing audit by both the

tax payer and the department if it becomes available at the time of audit.

BMR observation

Multiple Year data is mandatorily required to be used where the tax payer

uses TNMM, RPM, or CPLM method, and no discretion is available to the tax

payer in this regard;

Multiple Year data cannot be used where CUP method, profit split method

(residual profit split method), or method prescribed in Rule 10AB (“the Other

Method”) is selected for the purpose of determining the ALP;

As per the Act, the said Draft Rule only needs to be referred when more than

one ALP is determined, therefore Multiple year data cannot be used where

only one comparable is selected for the purpose of determining the ALP;

The Draft Rule require that, when using multiple year data, the quantitative

filter for selection of comparable companies shall be applied for each of the

three years, and only if the data for atleast two out of three years qualifies the

comparability test, the said company can be selected as a comparable;

When using multiple year data, in case a comparable company’s data is

available only for one year out of three years, or the data for comparable

company qualifies the quantitative filter only for one year out of three years

then the said company cannot be selected as a comparable. This is

irrespective of the fact that it may be the current year in respect of which the

data is available for a comparable company, and which qualifies the relevant

filter;

The Draft Rule while speaking on multiple year data does not provide the

methodology on how the arm’s length margin is required to be computed

using the said multiple year data. Guidance is however available on this,

when the Draft Rule discusses the Range concept, wherein the Draft Rule

provides that weighted average of the three years (or two years) of the

comparable company should be used for the purpose of determining the

margin earned by each comparable company;

The Draft Rule at its introduction refers to allowing the use of multiple year

data for undertaking comparability analysis, therefore leaving a doubt if the

intention of the CBDT is to allow use of multiple year data only for

undertaking comparability analysis or for computing the ALP. The latter is

likely to be the intention of the CBDT; and

Further, it is not clear, if the multiple year data could still be used for cases

which are not covered under the Draft Rules (ie for example: cases where

single comparable is available, or cases where Residual PSM is applied as a

method), however which satisfies the condition of the existing Rule 10B of the

Income tax Rules, 1962 which permits the use of multiple year data subject to

certain conditions.

2. Conditions and mechanism for use of Range concept

Conditions:

The Range concept can only be applied in cases where the ALP is

determined using TNMM, RPM or CPLM; and

The said Range concept is required to be applied in cases where 9 or more

entities are selected as comparable to the tested party.

Mechanism

Weighted average of 3 year data (or at least 2 year data in certain cases) of a

comparable company is required to be used to construct the data set;

For the purpose of computation of the weighted average, Numerator and

denominator of the chosen profit level indicator is required to be aggregated

for all the years for each comparable company;

Data points between 40th and 60th percentile will be treated as the arm’s

length range; and

If the margin earned by the tax payer is within the said range, the transaction

of the taxpayer with related party will be treated to be at arm’s length; and

In cases where the margins earned by the tax payer is not within the 40 – 60

percentile range, the median of the range identified will be treated as the

ALP, and the transfer pricing adjustment will be made accordingly.

BMR observation

The use of range concept is mandatory in case where CPLM, RPM or TNMM

is selected as the most appropriate method and where atleast 9 comparables

are selected for the purpose of determining the ALP;

Range concept cannot be used where CUP method, or profit split method

(residual profit split method), or other method is selected for the purpose of

determining the ALP;

For the purpose of selecting the comparable companies, three years data (or

atleast at least 2 year data) is required to be evaluated and used; and

The Draft Rule does not provide mechanism for the computation of 40

percentile to 60 percentile. There can be inclusive and exclusive ways of

calculating the percentiles.

3. Use of arithmetic mean for cases where Range concept cannot be

applied

For cases where the conditions for use of Range concept is not satisfied,

arithmetic mean concept will continue to apply.

BMR Comments

The Draft Rule will be applicable for transaction undertaken

during the Financial Year 2014-15 and onwards. Based on the

scheme proposed in the Draft Rule, the process of

determination of ALP will change as follows:

Proposed process of determining the ALP

- The Draft scheme issued by CBDT is a welcome step, as it

provides much needed guidance for calculating the ALP and

should contribute towards reducing the transfer pricing litigation in

India. The draft scheme however in its current form contains

certain ambiguities and may need some refinement. For example,

the following glaring aspects could be noted from the Draft Rule

which could lead to litigation or uncertainty:

- The Draft Rule proposes to use range between 40 percentile to 60

percentile which is different from the globally accepted inter-

quartile range of 25 percentile to 75 percentile. The 40 percentile

to 60 percentile band would provide a very narrow arm’s length

range, which is likely to get swayed easily by adding or removing

high or low margin comparable company data;

- The Draft Rule allows the use of Range concept only when 9 or

more comparables are available, and proposes to apply the

arithmetic mean concept where the number of comparables are

less than 9. This condition could lead to uncertainity and litigation.

For instance: in case during the transfer pricing audit the tax

authorities add one more comparable to the set of the taxpayer

who had selected 8 comparable companies, then the entire method

of computing the ALP would change. The taxpayer would have

calculated ALP by using the arithmetic mean as it had set of

comparables which was less than 9. Now post addition of one

more comparable by the tax department the method of computing

the ALP would shift to the range concept. The above situation

could be vice versa also; and

- Further, allowing the use of current year data available which

becomes available subsequently at the time of transfer pricing

audit will lead to uncertainties for the tax payers.

The publication of the Draft Rules by the CBDT for public comments

reflects well on the intention of the Government to follow an inclusive

and a transparent approach.

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