An analysis into the use of Comparable Uncontrolled Pricing (cup) as the most appropriate method for arms’ length transaction

Dr. R. Kanthakrishnan* & §M.S. Vasan

 

INTRODUCTION:

An Uncontrolled price is the price agreed between the unrelated parties for the transfer of goods or services. If this uncontrolled price is comparable with the price charged for transfer of goods or services between the Associated Enterprises, then that price is Comparable Uncontrolled Price (CUP). This is the most direct method for the determination of the Arms’ length price.

SCOPE OF THE STUDY:

The Present study covers the situation under which the CUP method can be applied Vs. other methods of studies. The same has been emphasized by illustrative examples and the case laws adjudicated by the different courts of law. The study does not cover the advantages of using the other methods of computing the arms length pricing, its applicability by the industry and the acceptability by the Transfer Pricing Officers. 

 OBJECTIVES OF THE STUDY:

·        To understand the salient features of a CUP method 

·        To analysis the circumstances and conditions under which the CUP can be applied as a method to test the arms’ length transaction between the controlled enterprises

·        An insight of various judicial pronouncements , under the different situations where CUP can be used or reference is made to the CUP , to be used as the most direct method  

There is no gainsaying that the CUP is the most appropriate method for determining the arm’s length price. However, in practice, it is very difficult to find a CUP. Therefore, this article attempts to collate practical nuances to arrive at a meaningful understanding of the use of CUP method in determining the Arms’ length transaction.

METHODS OF CUP:

CUP can be either

a)      Internal CUP or

b)      External CUP

Internal CUP is available, when the tax payer enters into a similar transaction with unrelated parties, as is done with a related party as well. This is considered a very good comparable, as the functions performed, processes involved, risks undertaken  and assets employed are all easily comparable – more so, on “an apple to apple basis”. 

The tax payer or any other Associated Enterprise of the group buys or sells similar goods, in similar quantities and under similar terms from / to an independent enterprise in a similar market can be treated as internal CUP. 

CUP method can be internally comparable , if an enterprise does have a similar product manufactured and sold to a third party as well as transfer the same type of product to associated enterprises. This is very much accepted globally by the Transfer Pricing Officials, as there is a minimal adjustment to be made for the geographic conditions, volume Off-take, patent and distribution networks.

On the other hand, the e1xternal CUP is available if a transaction between two independent enterprises takes place under comparable conditions involving comparable goods or services. An independent enterprise buys or sells a particular product, in similar quantities and under similar terms from / to another independent enterprise in a similar market. 

CHART I

COMPARISON OF TRANSACTION

 

Chart I explains the comparability of the transactions between two parties who are related to each other when compared to an unrelated party.

 

APPLICABILITY OF THE CUP METHOD:

Though Comparable Uncontrolled Price appears simple in concept, it is very difficult to apply it  in practice. The CUP is believed to be the most reliable / best method, if one could identify and map it. 

Few examples, where the CUP can be applied without much difficulty are:

1)      Interest payment on a loan

2)      Royalty payment

3)      Software development where products are often licensed to a third party

4)      Price charged for homogeneous items like traded goods

WHAT THE INCOME TAX ACT, 1961 STATES ABOUT CUP:

Rule 10B (1)(a) , Indian Income Tax Rules, 1962 states that :

Comparable Uncontrolled Price is the price charged for property or services transferred in a uncontrolled transaction or for such uncontrolled transactions. This price identified is compared with  international transaction of the enterprise.

Such price identified is adjusted for any differences between the uncontrolled transaction and the international transaction of the enterprise.

The adjusted price arrived at, is taken to be the “arms length price” for the property or services provided in the international  transaction.

Rule 10C of the Indian Income Tax Rules, 1962 states that :

In selecting a most appropriate method , the following factors shall be taken into account namely,

a)      The nature and class of the international transaction

b)      The class or classes of Associated Enterprises entering into the transaction and the functions performed by them taking into account assets employed or to be employed and risks assumed by such enterprises

c)      The availability, coverage and reliability of data necessary for application of the method

d)      The degree of comparability existing between the international transaction and the uncontrolled transaction and between the enterprises entering into such transactions

e)      The extent to which reliable and accurate adjustments can be made to account for differences, if any, between the international transaction and the comparables uncontrolled transactions or between the enterprises entering into such transactions

f)        The nature, the extent and the reliability of assumptions required to be made in the application of a method.

 

OECD VIEW ON CUP METHOD:

The OECD Model on traditional transaction methods, while referring to the CUP method, clearly states that it is very difficult to find a transaction between independent enterprises that is similar enough to a controlled transaction such that no differences have a material effect on price.  A minor difference in the property transferred in the controlled and uncontrolled transaction could materially affect the price even though the nature of the business activities undertaken may be sufficiently similar to generate the same overall profit margin.

The arms’ length principle follow the approach of treating the Associate Enterprises (AE) within an MNE group as a separate entity and not as inseparable part of a single unified business.    These will AEs a status of independent entity when comparing the controlled and uncontrolled transactions.

When the test of comparability is done, one should not forget that independent enterprises , when evaluating the terms of a potential transaction, will clearly compare the relevant economic benefits derived  between the options realistically available to them. The Tax administration should also take these differences into account when establishing whether there is comparability between the situations being compared and what adjustments may be necessary to achieve comparability.

 

 

Company A manufactures Micro Wave Ovens and sells to unrelated distributor Company C and to its subsidiary Company B. Micro wave Ovens  sold to B and C are identical and there is no material differences – A to B and A to C , then the CUP is the most reliable (best) method. 

The CUP method is a particularly reliable method where an independent enterprise sells the same product as is sold between two associated enterprises.  However, the following need to be inquired:

a)      Type, quality and quantity sold by an independent enterprise Vs. two associated enterprises

b)      Production / Distribution chain , branded Vs. unbranded – whether premium commanded or requires a discount in the open market

c)      Geographic market in which the transaction takes place

d)      Intangible property associated with the sale

e)      Foreign currency risks

The comparability consideration and adjustment for volume, level of market , geographic market or trademark and the like, has to be considered before arriving at a CUP. In particular, the similarity of products generally will have the greatest effect on comparability under this method. The results derived from CUP method will be a more reliable measure of an arm’s length result.  There may be no differences between the controlled and uncontrolled transactions or a minor differences with definite and reasonably ascertainable effects on price for which appropriate adjustments are made. If such an exact comparable is not available, the CUP method may still be used based on an “inexact comparable” , but the reliability of analysis as a measure of arms’ length results will be reduced.

In case a taxpayer has only one international transaction, say a Business Development Commission @ 5% is payable on revenues to its Associated Enterprise. Application of a Transaction Net Margin Method will be a futile exercise, as it compares the net margins of comparable companies with that of the Taxpayer, being a tested party. Given that it is only a small piece in the entire gamut of revenues earned and expenses incurred to arrive at the net margins, the Profit Level Indicator analysis may not be a right approach to test the arms’ length transaction of the tax payer. In this situation, the CUP can be an appropriate method, wherein the Business Development Commission paid by comparable companies be benchmarked with that of the taxpayers’. Alternatively, the Associated Enterprise can be considered as a tested party and the comparables in that country can be considered on a cost plus method to justify the arms length pricing of the international transaction.  

 

ILLUSTRATIVE EXAMPLES WITH CASE LAWS:

Assume that a taxpayer sells 1000 tonnes of a product for US$80 per tonne to an associated enterprise in its MNE group, and at the same time sells 500 tonnes of the same product for US$100 per tonne to an independent enterprise. This case requires an evaluation of whether the different volumes should result in an adjustment of the transfer price. The relevant market should be researched by analyzing transactions in similar products to determine typical volume discounts.

“Eli Lilly and Company  Vs. Commissioner – 84 TC 996 (1985)” , the Tax Court rejected the CUP method because the adjustment could not be made on account of differences arising due to credit terms, supply of raw material, packaging, product quality and patent. If there are many adjustments to be made to the uncontrolled sales in comparison with the controlled sales, then the CUP method cannot be termed reliable and reasonable to be an arms length price for transfer pricing evaluation.  

U.S. Regulation 1.482-3(b)(5) provides that when the CUP method is to be applied on the basis of the public data, it should be a widely and routinely used data. The data should have been used for setting up prices for controlled transactions in the same way, as it is being used for uncontrolled transactions.

 In the case of “Intervet India Private Ltd., Vs. ACIT , Mumbai – (2010) TII – 12- ITAT-MUM-TP”, the following facts have been brought out clearly for the use of a CUP method :

A reasonably accurate adjustment has to be made for

·        The elimination of material factors such as the price , the cost or profit arising from a transaction with an associated enterprise Vs. unrelated party

·        Volume Off-take discounts, credit period and forex risks has to be adjusted for

·        Economic and market conditions in which the Associated Enterprise functions Vs. unrelated party – sale to a wholesale agent Vs. the final user has to be considered and adjusted for

 In  VVF Limited Vs. DCIT – (ITANo.673 –MUM – 08), it was held by the ITAT that the transaction of lending money by the assessee by way of interest free foreign currency loan to its foreign subsidiaries, should be compared with a company lending in foreign currency to unrelated party. It was observed that the ICICI Bank had advanced foreign currency loan to the assessee at LIBOR plus 3%. This can be taken as an “internal CUP” as the credit rating of subsidiary merges with the credit rating of the Parent. The comparison of interest should not be benchmarked with the Cash Credit @14% given to the Assessee.  

In another case, DCIT Vs. M/s 3 Global Services Private Limited (ITA No.1812/MUM/2009), Mumbai the ITAT held that per hour billing rate published by the NASSCOM for a specific business segment as an “external CUP” in determining the arms’ length price.

The Assessee operates in the voice-based customer care sub-segment of IT-enabled services industry. The assessee rendered services to its associated enterprise and the selected CUP method as the Most Appropriate Method to justify the arm’s length price of its international transactions. The assessee applied the CUP method , relying on the hourly rate of the ”customer care” published by the NASSCOM and a report prepared by the Batliwala & Karani Securities (India) Pvt. Ltd.,- an equity research company.

The Transfer Pricing Officer rejected the CUP method selected by the Assessee and chose Transaction Net Margin Method (TNMM) as the Most Appropriate Method selecting five companies operating in various segments – such as KPO, Content Development, Data Conversion, Software and the like, These segments are totally different from the Voice Based Customer Support Services performed by the Assessee. On appeal, the CIT ( Appeals) agreed to Assessee’s contention and rejected the TNMM method proposed by the TPO stating that the comparables selected do not belong to the Voice Based BPO services.

The Revenue went on appeal to the ITAT. The ITAT categorically stated that per hour rate of a specific sub-segment of the ITES industry can be considered as the CUP provided the assessee applying such rate belongs to such sub-segment. Further, companies operating in different segment of the industry cannot be selected as comparable for applying the TNMM.  

Let us take an example, of an Indian company  exporting  a particular component to its Associated Enterprise  for which there is no comparable transaction available and no other company in the industry does sell those components.

In order to justify the arms length pricing of such a specific transaction, the Indian company can submit the Cost Sheet certified by a Cost Accountant and justify the Export Price. It can defend the profit margins earned on sale of component to its AE with that of its profit margins earned on sale of the total unit.  This can be termed as an “internal CUP”.

In the case of National Semiconductor Corp Vs. Commissioner (67 TCM (CCH)2849 (1994)(US Tax Court), it was held that It is equally important to determine the adjustments to account for the differences in price of controlled and uncontrolled transactions.  This case lays down the conditions that should exist to apply the CUP method. 

1)      The Uncontrolled price is comparable to the controlled price if the physical property and circumstances involved in the uncontrolled transactions are identical or nearly identical to the controlled transactions that any differences have no effect on price or such differences can be reflected by a reasonable number of adjustments to the price of the uncontrolled transactions

2)      Adjustments can be made only where such differences have a definite and reasonably ascertainable effect on the price

3)      Under the CUP method, the comparables should be drawn from the transactions that are comparable from the economic and business perspective

4)      In an arm’s length pricing situation , subsidiary cannot make high profits, when the Parent incur huge losses, which may not be the case of a transaction between the unrelated parties, who might lose the business itself, instead of incurring such large losses.    

CUP, IN COMPARISON WITH OTHER METHODS OF EVALUATION FOR COMPARABILITY:

As part of the process of selecting the most appropriate transfer pricing method and applying it, the comparability analysis always aims at finding the most reliable comparables. Thus, where it is possible to determine that some uncontrolled transactions have a lesser degree of comparability than others, they should be eliminated. When performing comparability analysis , due care should be given to

a)       the determination of the available sources of information on external comparables , taking into account their relative reliability

b)      Identification of potential comparables, determining the key characteristics to be met by any uncontrolled transaction in order to be regarded a potential comparable, and

c)      The selection of the most appropriate method , determining the relevant financial indicator.

The scope of the adjustments has to be widened. All the submissions regarding the disparity between the two transactions should be considered and suitable adjustment is to be made before finalizing the arms length price under the CUP method.

Steps (a) to (c) should be repeatedly carried out until a satisfactory conclusion is reached.  The available sources of information for examination may influence the selection of the transfer pricing method.  In case the tax payer is not able to find information on comparable transactions and make reasonably accurate adjustment, the taxpayer might have to select another transfer pricing method and repeat the process of comparability analysis.  A relatively better methods - other less direct methods, can throw a fair degree of accuracy when comparing the transaction with associated enterprise with that of the unrelated parties to achieve comparability.

Practical considerations dictate a more flexible approach to enable the CUP method to be used and to be supplemented as necessary by the other appropriate methods. All the chosen methods should be evaluated according to their relative accuracy. Every effort should be made to adjust the data so that it may be used appropriately in a CUP method.  Where differences exist between the controlled and uncontrolled transactions or between the enterprises undertaking those transactions, it may be difficult to determine reasonably accurate adjustment to eliminate the effect on price.

The CUP method can be applied when the comparable transaction is identical or nearly similar to the controlled transaction.  There should not be such material differences as cannot be reasonably adjusted. The CUP can be applied when an adjustment can be easily made. For example, if controlled and uncontrolled sales are similar except for the fact that the controlled sale price is a CIF price and uncontrolled sales are made at the FOB factory. The difference in terms of transportation and insurance are generally definite and reasonably certain adjustment can be made to apply a CUP, as comparable.

Even the Canadian Customs and Revenue Agency (CCRA) mandated Comparable Uncontrolled Price (CUP) method as the topmost method in the hierarchy of transfer pricing methods. The CUP focuses directly on the price of products sold or transferred. However, since the CUP method requires both functional and product comparability, it is not always possible to find similar transactions that could be used as comparable arm's length transactions. Other methods may be used in case where there is not enough information in respect of the comparable transactions, or if it is not possible to adjust for all the material differences between the tested and the comparable transactions.

Also, the CUP method loses its reliability if a reasonably accurate adjustment cannot be made , due to the non- availability of data from the independent enterprises or the open market / commodity market for the above mentioned items.

 

CONCLUSION:

The CUP can be used predominantly, where the comparable uncontrolled data are available in the public domain and the prices are set reasonably accurately over a multiple years of data. 

 To conclude, the CUP is a very reliable method to apply, from a transfer pricing officer’s perspective, but for getting convinced for the adjustments made or to be made. In today’s world, each enterprise has its own way of doing business. It becomes extremely difficult to arrive at an apple to apple situation for an international transaction and defend the pricing, before the Transfer Pricing Officer. 

 

REFERENCES :

1)      Transfer Pricing Law and Practice – CCH Publication, 2007 edition

2)      Tax Strategies – May 31, 2004 – Volume 8, Number 10,’ Using Regression Analysis in the Transfer Pricing Process

3)      Cole & Partners –Article on ‘What is Transfer Pricing -http://www.transferpricing.ca/docum.htm

4)      OECD – Transfer Pricing Guidelines for Multinational Enterprises and Tax Administration – amended on 22nd July, 2010 – Chapter I to III and Chapter IX

 

 



* Associate Professor, Department of Commerce, Madurai Kamaraj University, Madurai – 625 020. 

§ Associate Vice-President (Finance), Sutherland, Chennai – 600 042.