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'Tested Party': Should It Be Local Or Foreign?

Published on Tue, Aug 20,2013 | 22:00, Updated at Tue, Aug 20 at 22:00Source : 

By: SP Singh-Senior Director & Gaurav Bhutani-Manager, Deloitte Haskins & Sells

Transfer pricing regulations adopted by India is based upon the arm's length principle, which revolves around the concept that price or margin determined in a controlled transaction involving two associated enterprises should be compared to an uncontrolled transaction between two independent enterprises operating under similar circumstances. The process of identification of uncontrolled comparable and the arm’s length price known as "comparability analysis" consists of two steps, namely, functional analysis and economic analysis. Functional analysis is a process of finding and organizing facts about the transaction in terms of the functions, risks and assets in order to identify how these are divided between the parties involved in the transaction. The functional analysis (also called FAR analysis) consists of analysis of functions carried out, assets used and risks assumed by the enterprises involved in the international transaction. The analysis helps in characterizing the roles of the two entities involved in the transaction under examination. Economic analysis consists of selection of the 'most appropriate method', appropriate 'profit level indicator' and finally, determination of the arm's length price or margin. Except for Comparable Uncontrolled Price (CUP) Method, where price of the goods or services transacted is directly determined, under all other methods it is profit which is taken up for arriving at the arm's length price. In the methodologies requiring determination of profits, the entity whose profit margin is taken up for comparison is called "tested party". Identification of the tested party is crucial, as that determines selection of comparables, and thereby the arm's length price. Which entity, local or foreign, should be taken as the tested party, has been a matter of dispute in several cases in India. Recently, in the case of General Motors Ahmedabad bench of the Income Tax Appellate Tribunal ("ITAT") has addressed this issue in a comprehensive manner. This article analyses this decision and tries to draw some conclusions.

One of the reasons for continued controversy on "tested party" is that this term has not been defined in the Income-tax Act, 1961. However, Organisation for Economic Co-operation and Development in the Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations,(2010 Edition) ("OEDC TP Guidelines)[1] and UN Practical Manual on Transfer Pricing (UN Manual)[2] have dealt with this issue in a great detail. The OECD Guidelines defines 'tested party' as "the one to which a transfer pricing method can be applied in the most reliable manner and for which the most reliable comparable can be found, i.e. it will most often be the one that has the less complex functional analysis." UN Manual defines tested party in the similar manner. Based upon these definitions, one can infer that the "tested party" should have the following attributes:

• Least complex (amongst the parties to the transaction)

• Availability of reliable and accurate data for comparison

• Data available can be used with minimal adjustments

The UN Manual clarifies that the tested party can be local or foreign party. Further, that "if a taxpayer wishes to select the foreign associated enterprise as the tested party, it must ensure that the necessary relevant information about it and sufficient data on comparables is furnished to tax administration and vice versa in order for the latter to be able to verify the selection and application of the transfer pricing method".

In several cases, different benches of the ITAT have accepted the approach of selecting the "tested party", as envisaged by the OECD Guidelines and the UN Manual. As mentioned earlier, recently the Ahmedabad bench of the ITAT pronounced a judgment [3], wherein it was held that the entity with the least complex functions should be accepted as the "tested party". This would be irrespective of the fact whether the "tested party" is an Indian entity or a foreign entity. As per the ITAT, what needs to be seen is the complexity of functions and availability of reliable information.

The brief facts of the case are that General Motors India Pvt. Ltd. ("GMI") was engaged in manufacture and trading of automobiles and its parts. GMI used to imports finished vehicles kits (CKD kits) from its foreign entity for manufacturing cars and selling them in the Indian market.  It also purchased spare parts from foreign entity for resale in India. With regard to this international transaction relating to import of CKD kits, GMI characterized itself as an "entrepreneur", whereas the foreign entity was characterized as a "contract manufacturer" assuming limited risks. Hence, based on this, foreign entity was selected as the "tested party" and was benchmarked using foreign comparables companies.

This approach of GMI was challenged and rejected by the Transfer Pricing Officer (TPO) as well as Dispute Resolution Panel (DRP), inter alia, argued that GMI was lesser complex entity and that data for verifying foreign tested party and comparables were not available. The Ahmedabad ITAT after hearing both the parties pronounced its judgment in favor of GMI by concluding that a foreign entity can be selected as the tested party. The ITAT made several important observations. First, the entity to be selected as the "tested party" should be the least complex and not necessarily unique. Second, rejection of foreign entity as "tested party" on the ground that comparable companies selected doesn't fall within the ambit of the Income Tax Authorities' jurisdiction is not correct. Also, the contention that data would not be reliable or easily available was rejected, since the same was provided by GMI and was audited by an independent auditor. The ITAT referred to the UN Manual and the OECD Guidelines, which clearly supported the view that the least complex entity should be selected as the "tested party". The ITAT, also, highlighted conflicting stand taken by the authorities, wherein for determining the arm's length price of the royalty transaction the foreign entity was accepted as the "tested party".

The decision by the Ahmedabad ITAT highlights the fact that the selection of "tested party" should be based on a robust FAR analysis and that the enterprise performing least complex functions (but not unique) should be selected as the tested party. The ITAT accepted that reliable financial data (requiring minimum adjustments) should be available for the tested party as well as for the comparables. It is expected that this decision will settle the dispute regarding selection of the tested party. The message for taxpayers is that they should ensure that while maintaining TP documentation, all the requisite criteria are met and since the onus of selecting foreign entity as "tested party" would be on the taxpayer, proper records and documents to demonstrate the same should also be maintained.

[1]. Para number 3.9 of the OECD Guidelines

[2]. Para number of UN  Manual

[3]. In the case of General Motors India Private Limited vs. DCIT (ITA No. 3096/ Ahd./ 2010 and 3308/Ahd/2011) pertaining to Assessment Year 2006-07 and 2007-08


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