India Adopts Range Concept and Use of Multi-Year Data

By Dezan Shira & Associates
Editor: Tracie Frost

India recently made a significant move towards aligning transfer pricing practices with global norms.  The new rules, codified in October, introduced a “range concept” for determination of arm’s length pricing and “use of multiple year data” for performing comparability analysis in transfer pricing cases.   

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Background

Transfer pricing has been one of the most litigious areas for multinational companies doing business in India.  India introduced transfer pricing legislation in 2001 with the aim of preventing shifting of profits from India to other jurisdictions.  However, in practice, transfer pricing measures have been used for revenue generation.  The Tax Administration Reform Commission, in its May 2014 report, observed that transfer pricing officers are required to meet revenue targets from transfer pricing adjustments, a practice which is unheard of internationally.   “Accordingly,” the Commission found, “India has clocked by far the highest number of transfer pricing adjustments, demanding adjustments even for very small amounts… Taxpayers reported that they often succumb to such adjustments simply to carry on with business activity for, otherwise, they would have to allot or divert huge and unavailable financial and staff resources to such activities.”

In fact, the number of transfer pricing audits has almost doubled in the last five years.  Fiscal year 2011-2012 saw an 85 percent increase in adjustments over the previous fiscal year, and in fiscal year 2012-2013, adjustments reached 70 billion rupees (U.S. $1 billion).  Protests from foreign investors, combined with the May 2014 Tax Administration Reform Commission report and the outcomes of several high-profile transfer pricing cases before the Supreme Court, moved the government to begin significant reforms.  In 2012, the government instituted an advance pricing agreement mechanism wherein the taxpayer and revenue authorities agree on an appropriate transfer pricing methodology for a fixed set of transactions.  Additionally, in 2013, the Central Board of Direct Taxes introduced safe harbor provisions, providing minimum operating profit margins in relation to operating expenses a taxpayer is expected to earn for certain categories of international transactions. 

Global parity

Both of these reforms have improved the transfer pricing landscape.  Nevertheless, the biggest issue for multinational companies remains the non-alignment of Indian transfer pricing provisions with those of the global standards – in particular, the use of arithmetic mean and single year data.  In this latest reform, the Indian government confronts this issue as well.

The new rules, which are applicable for transactions undertaken after April 1, 2014, generally follow the draft rules that were issued for public comment on May 21, 2015, but they also make some significant changes. 

Use of multiple year data

 Under the previous regulations, taxpayers could only use the data of comparable companies during the current year, i.e., the year in which the intercompany transaction took place. If current data for a comparable company was unavailable, then that company could not be used in the comparable analysis.  This approach caused innumerable difficulties for taxpayers as a result of the practical difficulty of obtaining comparable data for the current financial year at the time of the preparation of the transfer pricing documentation.

In its transfer pricing guidelines, the Organization of Economic Co-operation and Development (OECD) recognizes that “In order to obtain a complete understanding of the facts and circumstances surrounding the controlled transaction, it generally might be useful to examine data from both the year under examination and prior years.”  Indeed, most countries with transfer pricing regulations allow for use of multiple year data.  With the new regulations, India brings its transfer pricing rules more into line with the international standard.

The amended rules provide that taxpayers may use data for the current financial year and/or data from the preceding financial year for the purpose of undertaking a benchmarking analysis if current year data is unavailable at the time of filing the tax return.

Multiple year data may only be used if the taxpayer has adopted the cost plus, resale price, or transactional net margin method for benchmarking the transaction and has considered more than one comparable.  If data for the current year is not available during the benchmarking analysis, it can be updated during the audit proceedings.

Arm’s length range

 Prior to the amendment, transfer pricing regulations required that the arm’s length price be calculated as the arithmetic mean of comparable prices. A tolerance band of plus or minus three percent of the taxpayer’s intercompany transaction price was allowed. This approach was problematic as the mean is easily distorted by outliers in the comparability analysis.  Further, availability of information and comparability defects severely limited taxpayers’ ability to compute an accurate arithmetic mean.

The OECD in its transfer pricing guidelines acknowledges that “differences in the figures that comprise the range may be caused by the fact that in general the application of the arm’s length principle only produces an approximation of conditions that would have been established between independent enterprises.” For this reason, most countries do apply or allow a range concept in computing arm’s length price.  With the revised rules, India joins the international standard.

Under the new law, application of a range is allowed when the taxpayer is using the cost plus, resale price, comparable uncontrolled price, or transactional net margin method.  The dataset must contain six or more comparable transactions, an improvement over the draft rules which called for nine or more comparable transactions.  The acceptable range is from the 35^th percentile of the data set (arranged in ascending order) to the 65^th percentile.  The draft regulations used the 40^th to the 60^th percentile, so the final rules are an improvement.  However, the range is still smaller than the interquartile range (25^th to 75^th) used by most countries, including the United States.

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Observations

The new guidance is expected to reduce transfer pricing disputes and make transfer pricing computations easier for taxpayers.  This is yet another signal that the Indian government is seeking to improve the regulatory environment for international businesses. 

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