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Using The Inter-Quartile Range!

Published on Thu, Jun 11,2015 | 20:27, Updated at Thu, Jun 11 at 20:45Source : Moneycontrol.com 

By: Rohan Phatarphekar, Partner & National Head Global Transfer Pricing Services, KPMG

Transfer pricing has been a major area of litigation between the tax department and taxpayers in recent times. While computing arm’s length price (ALP), availability of range as a standard deduction and use of single year vs multiple year data, have been two of the most litigious transfer pricing issues.
 
The finance minister announced in his budget speech in July 2014 that the "range" concept for determination of arm's length price would be introduced in the Indian transfer pricing regulations. It was also announced that use of multiple year data would be permitted for undertaking comparability analysis. The intent was to align Indian TP regulations with international leading practices. The Oraganisation for Economic Co-operation and Development (OECD) advocates the usage of Inter-Quartile Range (IQR) for determination of arm’s length price. The IQR is the range from the twenty-fifth to the seventy-fifth percentile of the results derived from the uncontrolled comparables. The concept of IQR has been adopted by majority of the countries having transfer pricing regulations including Austria, Australia, China, Denmark, Finland, France, Germany, Indonesia, Israel, Italy, Japan, Korea, Malaysia, Mexico, Netherlands, Poland, Portugal, Romania, Singapore, Spain, South Africa, Sweden, Taiwan, Thailand, United Kingdom and United States of America to name a few (based on information from IBFD Tax Research Platform on TP Regulations).
 
The CBDT issued the draft scheme of the proposed rules for computation of arm’s length price of international transactions or specified domestic transactions undertaken on or after April 1, 2014. Comments and suggestions from stakeholders and general public were sought until May 31, 2015 which is a very inclusive and transparent move from the government.
 
The draft recommendations provide that the data points between the fortieth and sixtieth percentile should be considered for the range. If the transfer price falls outside the range then the median of the range would be taken as arm’s length price and adjustment to transfer price shall be accordingly made. Use of the fortieth to sixtieth percentile will narrow the range, since it will exclude comparables with some deviations unlike in the case of IQR ie the twenty-fifth to the seventy-fifth percentile which is much broader.
 
The proposed draft rules provides for use of fortieth to sixtieth percentile and the use of multiple year data only in the cases where the most appropriate method is either Resale Price Method, Cost Plus Method or Transactional Net Margin Method. Clarity on the mode of computation of the range as well as extending the range concept and multiple year analysis to the other methods i.e. Comparable Uncontrolled Price and the Profit Split Method, is desirable.
Notably, as per the draft rules, the concept of “range” would only be available for a minimum of nine comparables. The arithmetic mean concept would continue to apply in cases where the number of comparables are less than nine. This may be a practical challenge as, in the Indian scenario, the number of comparables are generally on the lower side. Also, the threshold of nine comparables stands unexplained since statistically, for the computation of IQR, a minimum of four data points suffices.
 
In the future, at the time of Transfer Pricing audits, if the Transfer Pricing Officer (“TPO”) reduces the number of comparable companies to less than nine, there could be practical challenges around the use of the range vis-a-vis the arithmetic mean. Hence, the suggested option in case of lesser comparables would be to resort to the use of range as well as median for sake of consistency.
 
The impact of the use of the concept of range can be seen in the following illustration, prepared using indicative numbers from benchmarking analysis for some common transactions.

Benchmarking Sets No. of comparables Indicative Mean
(%)
Median (%) 40th Percentile (%) 60th Percentile (%)
Manufacturing of Medical Equipment 11 – 13 12 9 8 10
Distribution of Medical Device

5 – 7

5

5

Range may not be applicable if minimum

9 comparables are required

 

Distribution of Software

5 – 7

1 0.5

Range may not be applicable if minimum

9 comparables are required

 

Marketing and Business Support Services

5 – 7

10 8

Range may not be applicable if minimum

9 comparables are required

 

Software Development Services

12 – 14

14 14 14 17

Information Technology Enabled Services

7 – 9

13 16 8 18

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

It can be seen that in most of the sets, number of comparables are lower than nine. Therefore, the decision to use the range or arithmetic mean would become subjective based on acceptance or rejection of a couple of comparables. Further, the arithmetic mean of the comparables in general do not fall in the range of fortieth to sixtieth percentile.
 
Another important step towards reducing litigation is the use of multiple year data. The issue in TP litigation is the use of single year current data at the time of TP audits which was not available at the time of undertaking the TP compliance studies.
 
The proposed draft suggests that during the transfer pricing audit, if current year data is available, the same can be used by both the taxpayer and the department. This is against the requirement of contemporaneous documentation under the Indian TP regulations and needs to be relooked at.
 
While broadly, the concept of multiple year data and use of range are internationally accepted norms, certain modifications are required to move to completely adapt to global leading practices, including IQR. The perceived benefit of moving from the mean to a unique concept of fortieth to sixtieth percentile range concept may be a mirage rather than an advantage. Further, the economic analysis of the taxpayer could be robust allowing the use of IQR, median and multiple year to even out any abnormal pattern or cyclic phases. Also, guidance on mode of calculation of the percentiles and providing illustrations is recommended. It is pertinent to mention that if the rules and the guidance synchronise with globally accepted norms and practices it can help in reducing transfer pricing litigation, closing in on bilateral APAs, applications under Mutual Agreement Procedures and more importantly the overall confidence of the corporates, both in India and cross border may soar.

 
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