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1. Amongst the many enigmas that transfer pricing (TP) poses as a subject, the selection of an appropriate profit level indicator (PLI)has been an under played aspect. PLIs are ratios that measure the interplay between profits and costs incurred or resources employed. While adopting the Transactional Net Margin Method (TNMM), the most ubiquitous of the methods for TP analysis globally, selection of PLI along with the appropriate selection of tested party and comparables is of paramount importance. This article seeks to discuss the adoption of PLIs, specifically in the context of TNMM.
Sub-clause (i) and (ii) of Rule 10B(1)(e) of the Indian Income Tax Rules prescribe that while adopting TNMM, the 'net profit margin' realized by the enterprise from an international transaction is computed in relation to costs incurred or sales effected or assets employed by the enterprise or having regard to any other relevant base and the same base needs to be adopted in case of uncontrolled transactions for comparability purposes. Thus, the regulations have given the choice for selecting a suitable denominator, whereas the numerator needs to be 'net profit margin', though the same has not been defined in the regulations.
The OECD Guidelines1 (Para 2.77 to 2.102) provide reasonable guidance on the determination of the 'net profit margin' and adoption of varied denominators based on the functional and risk profile of the tested party. The Guidelines (Para 2.88) lay down the fundamental principle that the denominator should be reasonably independent from controlled transactions, otherwise there would be no objective starting point.
The selection of an appropriate PLI depends upon a number of factors, including the characterisation of the tested party, nature of industry, the type of comparables and the reliability of the comparable data. It is essential that the functions, assets and risks (FAR) profile of the tested party is aligned with the selection of PLI. The PLI denominator should, to the extent possible, capture the gamut of functions performed, risks assumed and assets deployed by the tested party. In line with the aforesaid principle, the adoption of the following PLI denominators is commonly seen: costs incurred in cases of contract manufacturers or captive service providers, sales effected in case of distributors, operating assets in cases of asset-intensive companies, etc.
As such, it has been seen that, on account of relatively reliable availability of information and wide acceptability, financial ratios based on operating profit to total operating costs or sales have emerged as the most popular PLIs. In many instances, the aforesaid PLIs are selected at the expense of not evaluating or adopting certain alternative PLIs which may prove to be more appropriate given the facts and circumstance of the case. Certain key alternative PLIs are discussed below:
Cash profit ratio
2. Cash profit ratio is derived by modifying the operating profit ratio through removal of depreciation and amortisation i.e. cash profits earned over an appropriate base such as total sales, costs, etc. This can be adopted in cases involving significant differences in capitalised asset base, where a separate adjustment may not be feasible to account for such differences.
Practically, this PLI can be suitably adopted in cases of:
The Delhi Income Tax Appellate Tribunal (ITAT) in the case of Schefenacker Motherson Ltd.2 accepted the adoption of cash profit ratio while explaining how this PLI is no different than making depreciation adjustment to an operating profit based PLI. Subsequently, principles supporting the adoption of cash profit ratio have been upheld by the ITAT in cases of Reuters India3, Amdocs Business Services4 and Qual Core5.
In the case of Sumi Motherson6, the Delhi ITAT ruled that Cash Profit Ratio is not a valid PLI as per strict interpretation of the Indian TP regulations requiring 'net profit margin' as the numerator for PLI, though at the same time upheld that the regulations do not preclude an appropriate adjustment to account for differences in depreciation between the tested party and the comparable companies. In this context, it is pertinent to note that the OECD Guidelines (Para 2.84) have observed that the decision whether or not to include items like depreciation or amortisation in the determination of the net profit indicator for applying TNMM will depend on a weighing of their expected effects on the appropriateness of the net profit indicator to the circumstances of the transaction and the reliability of comparison.
This PLI was not accepted by the ITAT in cases of Fiat India7 and Toyota Kirloskar Motors8, while taking into consideration the characterisation of the tested party and the nature of the business and concluding that for such asset intensive companies, it would be a difficult proposition to measure profitability without considering depreciation in its entirety. It is worth noting that in the aforesaid cases, the selection of entrepreneurs like Fiat India and Toyota Kirloskar Motors as tested party itself may be technically inappropriate. However, in light of the limitations on availability of data for transacting Group companies and the stringent requirement of law mandating testing of transactions in a certain manner, if such companies are eventually selected as tested party then adoption of alternate PLI like Cash PLI, which though questionable going by the strict interpretation of law, may be evaluated to account for material differences in tested party vis-à-vis comparables.
In light of the different views emanating from the judicial precedents, it would be critical to document strong economic rationale as to why depreciation, amortization and other non-cash items do not influence the tested party's performance. Such documentation would serve as the key to convince the tax authorities that cash profit ratio, in applicable cases, is the most appropriate PLI.
Return on assets or capital employed
3. Balance-sheet based PLI like return on assets or capital employed, can be an appropriate PLI in cases where assets rather than costs or sales are a better indicator of the value added by the tested party, e.g. in certain manufacturing or other asset intensive activities and in capital-intensive financial activities.
The ICAI Guidelines9 (Para 6.36) have provided that return (operating profit) on assets or capital employed can be typically used in case of a capital intensive set-ups where the tangible operating assets have a high correlation to profitability. Instances of the aforesaid can be companies engaged in leasing operations, owning and managing telecommunication towers, mining operations, etc.
A critical aspect while adopting balance-sheet based PLI is the correct valuation of operating assets. The OCED guidelines (Para 2.98) have prescribed that choice between book value, adjusted book value, market value and other possibly available options should be made with a view to finding the most reliable measure, taking account of the complexity of the transaction and the availability of reliable comparable data.
The Delhi High Court (HC) in the case Johnson Matthey10 has ruled that the reliability of return on capital employed as a PLI depends upon the extent to which the composition of assets/ capital deployed by the tested party and their valuation is similar to that of comparables.
Further, it should be noted that the ITAT in the case of Gold Star Jewellery11 and Dinurje Jewellery12 ruled that adoption of return on capital employed would not be appropriate in cases where the computation of separate capital employed or profitability in respect of transactions with AEs is not practical due to the integrated nature of the transactions with AEs and non-AEs.
Balance-sheet based ratios are considered to be relatively more accommodative of functional differences as opposed to financial ratios like operating margin and accordingly, where the operating assets play a greater role in generating operating profits and suitable comparable data is available, adoption of return on assets or capital employed canbe evaluated.
4. Berry Ratio, which is typically applied to test the results of certain type of distributors and agents, can be derived as gross profits to value adding expenses (VAE) or operating expenses, where the VAE or operating expenses, primarily comprise of selling and general administrative expenses incurred by the tested party, without taking into account the cost of goods dealt with by them. An offshoot of Berry Ratio is the PLI, namely operating profit (OP)/ VAE. Thus, if Berry Ratio for a taxpayer measures say 120%, then the resultant ratio of OP/VAE would be 20%. OP/ VAE can also be applicable in cases, where the cost denominator warrants exclusion of certain pass-through costs i.e. costs which are incidental to the primary business activity of a taxpayer and in respect of which the taxpayer neither performs any significant functions nor assumes any risks thereof and accordingly no return is warranted on such costs.
Berry Ratio has been discussed as a possible PLI in the OECD Guidelines and the United Nations Practical Manual on Transfer Pricing for Developing Countries. The OECD Guidelines (Para 2.101) lay down certain broad guidelines for the applicability of Berry Ratio in the case of distributors. In cognizance of the aforesaid and the US Court case of E.I. du Pont de Nemours & Co. v. United States: 608 F.2d 445, the Delhi HC in the case of Sumitomo Corporation13, a trading company, laid down certain succinct principles for appropriate adoption of berry ratio.The HC held that Berry Ratio would apply where:
The HC further held that Berry Ratio would not be an appropriate PLI where:
The above principles would prove to be the guiding factors in adoption of Berry Ratio or OP / VAE as PLI in the Indian context. In light of the aforesaid, it may be observed that in the case of limited risk distributors, the Berry Ratio could be an appropriate PLI to measure the arm's length return. However, in case of normal risk-taking distributors or entrepreneurial/ super distributors, Berry Ratio may not be appropriate since it would not capture the additional returns from undertaking enhanced functions. Even is such cases, Berry Ratio may be applied as a sanity check (not as a primary PLI), to ensure that such risk bearing entities, whose remuneration model and profit earning potential is inter-linked to the value of goods, have not earned exorbitant profits with reference to their operating costs.
It is pertinent to note that the adoption of Berry Ratio for 'sogo shosha' companies, has been upheld by the ITAT in the case of Mitsubishi Corporation14 and Mitsui & Co.15.
Though Berry Ratio has found increasing global acceptability in cases of certain distributors as discussed above, the suitability of this PLI can also be evaluated in cases where based on the functional profile of the taxpayer it is concluded that the taxpayer warrants a return only its VAE and certain costs are merely in nature of pass-through costs.
4. The above mentioned alternative PLIs may warrant a further exposition to grasp the finer nuances associated with their appropriate adoption. In addition, depending on the industry and the controlled transaction under review, it may be useful to look at other denominators where reliable comparable data may exist, such as, floor area, weight of products transported, number of employees, time, distance, etc.
At a fundamental level however, it is important for taxpayers to be cognizant of the alternative PLIs available, the factors determining their apt usage and the related documentation to be maintained. This would substantially contribute in taxpayers undertaking a more scientific and apposite comparability analysis for TP purposes.
In light of the varied views emerging from judicial precedents, litigation with lower level tax authorities cannot be ruled out in connection with adopting the alternative PLIs. It would be critical for the taxpayers to document strong economic and technical rationale while adopting them. Taxpayers can also approach alternate dispute resolution mechanisms like the Advance Pricing Agreement ('APA') programme to achieve certainty on its proposed TP analysis including selecting of appropriate PLI.
1. Organisation for Economic Cooperation and Development - Transfer Pricing Guidelines for Multinational Enterprises.
Schefenacker Motherson Ltd. v. ITO  12 TTJ 509 (Delhi).
Dy. CIT v. Reuters India (P.) Ltd.  150 ITD 458/ 33 taxmann.com 481 (Mum. - Trib.).
Amdocs Business Services (P.) Ltd. v. Dy. CIT  54 SOT 46 (URO)/26 taxmann.com 120 (Pune).
Qual Core Logic Ltd. v. Dy. CIT  52 SOT 574/22 taxmann.com 4 (Hyd.).
Dy. CIT v. Sumi Motherson Innovative Engg.  150 ITD 195/42 taxmann.com 242 (Delhi).
7. Fiat India (P.) Ltd. (IT Appeal No. 1848 (Mum) of 2009).
Toyota Kirloskar Motors (P.) Ltd. v. Asstt. CIT  28 taxmann.com 293 (Bang.).
9. Guidance Note (2016) on Report Under Section 92E of the Income Tax Act, 1961 issued by the Institute of Chartered Accountants of India.
Johnson Mathey India (P.) Ltd. v. Dy. CIT  63 taxmann.com 2/235 Taxman 590/ 380 ITR 43 (Delhi).
11. Goldstar Jewellery Design (P.) Ltd. v. ITO  144 ITD 99/36 taxmann.com 292 (Mum. - Trib.).
Dinurje Jewellery (P.) Ltd. v. ITO  51 taxmann.com 41 (Mum. - Trib.).
13. Sumitomo Corpn. India (P.) Ltd. v. CIT  71 taxmann.com 290/242 Taxman 260/387 ITR 611 (Delhi).
14. Mitsubishi Corpn. India (P.) Ltd. v. Dy. CIT  50 taxmann.com 379/ 67 SOT 83 (Delhi-Trib).
15. Mitsui & Co. India (P.) Ltd. v. Dy. CIT  64 taxmann.com 453 (Delhi-Trib)