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