Indian transfer pricing legislation requires comparing the controlled transaction with uncontrolled transaction to verify the arm’s length character of the controlled transaction. The comparability between the controlled and uncontrolled transaction is the key factor for determining the arm’s length price. Comparability requires comparing the controlled transaction with uncontrolled transaction performing similar functions, employing similar assets and assuming similar risks. Comparability can be conducted on the basis of price or margin depending upon the choice of method. The Indian legislature has laid down in section 92C of the Income-tax Act, 1961; methods for determination of arm’s length price. These are:-
- Comparable Uncontrolled Price Method
- Resale Price Method
- Cost Plus Method
- Profit Split Method
- Transactional Net Margin Method and
- Any Other Method
In comparability, benchmarking is conducted considering various factors. Benchmarking is the process of scientifically driving the arm’s length price based on comparable financial data from recognized industrial databases using objective filters of selection. Benchmarking is a tool for determining the arm’s length price where following methods are used:–
- Cost Plus Method (“CPM”)
- Resale Price Method (“RPM”) and
- Transactional Net Margin Method (“TNMM”)
Benchmarking under transfer pricing in India is conducted using well recognized softwares such as ProwessTM and CapitalinePlus. In benchmarking; a profit level indicator (“PLI”) is computed. PLI for the purpose of benchmarking through TNMM could be:-
- Net margin ratio
- Operating margin ratio
- Return of capital employed and
- Return on operating assets
Concept of Tested party
There are atleast two parties to an international transaction or specified domestic transaction. Comparability for determining the arm’s length price can be either from taxpayer’s perspective or associated enterprise’s perspective. As per OECD guidelines; tested party should be the party who is least complex and whose comparable data can easily be found. In most of the cases; taxpayer is treated as a tested party since it becomes difficult to get all the detailed information of associated enterprise. Although the Indian Transfer pricing provisions have not specified any guidelines on choice of tested party. For the purpose of choice of tested party; OECD guidelines are referred.
Process of benchmarking
- Identification of the tested party: First step is to identify the tested party whose financials are tested to conduct the comparability analysis.
- Choice of PLI :- Next step is choose a suitable profit level indicator
- Run a search:- Run a search on databases such as CapitalinePlus and ProwessTM
- Application of filters: – There are two types of filters such as qualitative and quantitative. Both are applied to find out the comparables
- Determination of arm’s length price:- Margin of selected comparables are computed and the same is compared with the margin earned by the taxpayer.