Methods of computing Arm's Length Price

I dealt with the basic concept of transfer pricing in an earlier post. As promised (to myself), I will now deal with the methods of computing arm’s length price (ALP).

ALP, crudely, is the fair market value at which transactions take place in the open market. Section 92C names the methods and Rule 10B elaborates on their application. There are primarily 5 methods of ALP computation:

1. Comparable Uncontrolled Transaction Method - CUP Method

2. Cost Plus Method - CPM

3. Resale Price Method - RPM

4. Profit Split Method - PSM

5. Transactional Net Margin Method - TNMM

The most complicated of these (and probably the most popular) is TNMM, I think. PSM has hardly ever been used in Indian cases. CUP is the simplest and most preferred one.

In this post however, I have discussed only the first three methods. I shall discuss PSM and TNMM in the next post.

CUP METHOD:

Under CUP method, the transacting enterprise has to:

• Identify the price paid for goods or services provided in a (or a number of) comparable uncontrolled transaction(s).
• Adjust such price to account for differences, which could materially affect it in the open market, between:
• Transaction with AE and comparable uncontrolled transaction, or
• The enterprises entering into such transaction

Sale price in uncontrolled transaction: 100

Add (in proportion to better quality goods sold to AE): 25

ALP = 125

In the above scenario, the transaction between the TE and Unrelated Enterprise 2 would be an ‘internal comparable.’ The transaction between the two unrelated enterprises would be an ‘external comparable.’ This is true for all methods of ALP computation; transactions of the TE with third parties would be termed as internal comparables. It is to be noted that internal comparables are preferred over external comparables, since they provide a greater degree of comparability.

CUP Method is generally preferred in all situations, where suitable uncontrolled transactions are available. The uncontrolled transactions can be considered comparable in terms of the goods sold, services rendered, prices charged, qualitative and quantitative comparability, etc.

COST PLUS METHOD:

Under CPM, the transacting enterprise has to:

• Determine the costs of production (direct and indirect)
• Determine the normal gross profit mark-up on such costs, incurred by an unrelated enterprise
• Adjust this mark-up to account for functional or other differences that could materially affect it in the open market
• Add the adjusted profit mark-up to the costs of production.

ALP = 150 + 10 + 2 = 162

CPM is most suitable for:

• Sale of semi-finished goods
• Provision of services
• Long-term buy and supply arrangements

RESALE PRICE METHOD:

Under RPM, the transacting enterprise has to:

• Identify price at which goods / services obtained from AE are re-sold to unrelated enterprise
• Reduce such price by:
• normal GP margin accruing to assessee / unrelated enterprise from similar uncontrolled transaction
• expenses incurred by assessee for obtaining goods / services
• Adjust the price on account of functional differences that could materially affect it in the open market

Price of sale: 120

Less: 15 (normal GP margin)

          10 (freight charges)

Add:    5 (packaging expenses)

ALP = 100

RPM  is most suitable for:

• Chain of distribution of goods through an intermediate company
• Marketing operations

The Vodafone Controversy

The hottest issue of the tax world right now is the Vodafone case. There has already been enough discussion on the structure of the deal so I won't go into the details. Vodafone (Netherlands) paid 11 billion dollars to Hutch (Hong Kong), for purchasing Hutch’s wholly-owned subsidiary in Cayman Islands (HCI). HCI owned a company in Mauritius which directly and indirectly (through various companies) held a controlling stake of 67% in Hutchison Essar Ltd, India (HEL). By purchasing HCI, Vodafone acquired a controlling stake in HEL.

The Department cried foul and sought to tax Vodafone on the deal, conducted and concluded outside India. The Department’s claim rested on the fact that the underlying purpose of the transfer of HCI was to acquire Indian operations of HEL and therefore, such transfer had a sufficient nexus with India to attract tax. And we’re not talking peanuts here; the tax liability is 2 billion dollars.

The Bombay HC ruled against Vodafone and the case is currently in the Supreme Court. There has been enough debate on the applicability of section 9(1), whether there is ‘transfer’ of a ‘capital asset’ ‘situated in India.’ While it is true that Vodafone’s intention was to acquire Indian operations, the ultimate question that arises is, whether the IT Department can tax an ‘indirect’ transfer of a capital asset situated in India, effected through intermediary companies.

My take is, no they cannot do that until the DTC is introduced or the present Section 9 is amended. Section 9 of the IT Act says that income accruing or arising, directly or indirectly, through the transfer of a capital asset in India is liable to tax in the hands of the non-resident. It is section 5 of the DTC, however that lays down that such ‘transfer’ can be ‘direct or indirect.’ The DTC is not an amendment to the current Income Tax Act, but is a whole new legislation, which will repeal and replace the Act. In my view, bringing indirect transfers into the ambit of taxation is possible only after DTC comes into effect or after Section 9 is amended to that effect.

Moreover, other countries like China, Australia and Peru have specifically enacted provisions making indirect transfers taxable. Can India tax such transfers without a specific provision in place? Not unless there is clear tax evasion, in the garb of a colourable device (lawyers simply love to use this phrase). In my opinion, Vodafone has not evaded tax, it has merely structured an indirect transfer as a part of some creative tax planning, which is legal. In the glaring absence of a specific provision, it will be unfair to tax Vodafone.

The outcome of the case is keenly awaited by foreign investors and MNCs who are waiting for settlement of the issue before structuring any deals involving Indian assets/operations.