Economic adjustments under OECD guidelines:

The taxpayer has to critically argue for economic adjustments before the Transfer Pricing Officer (TPO) in Transfer Pricing (TP) assessments.  This is important as a common base has to be created for comparing transactions with comparable companies to determine whether or not the entity being assessed has entered into ‘Arms Length Price’ (ALP) in international transactions with an Associated Enterprise (AE).  Organization for Economic Co-operation and Development (OECD), in its revised version, has deliberated on several economic issues that contribute to adjustments while arriving at the ALP.  However, the Indian TP law, in its present outfit, has miles to go before it catches up with the international thinking and practice.
 
The adjustment considered by OECD in arriving at ALP, by comparing transactions with an uncontrolled price includes:

Indian thinking on economic adjustments:

Many arguments have been put forward by experts at various levels for seeking adjustments so as to make final comparisons with uncontrolled entities meaningful; and some of the oft repeated ones are listed below:

 
To be able to seek for such economic adjustment, the taxpayer has to demonstrate the knowledge of FAR in the industry and the documentation process has to quantify the extent of such adjustment with acceptable justification.  If the taxpayers can justifiably persuade the judicial authorities, it will pave the way for laying down precedents, as TP law is still in its infancy in India.  
 
The legislature and the executive have their own apprehensions to appreciate changes that are happening in the outside world, but the judiciary has always, in its wisdom, appreciated references to economic adjustments proposed by the taxpayer based on the international practice.  To understand the direction and the depth, there is a need to deliberate the concept through various judicial decisions of different Courts.
 
Economic adjustments of working capital support:

As accountants we understand the components of working capital and require no further elaboration.  While transacting with an AE, there are instances of extended support or service (which of course can be either way), may be in terms of extended credit period, discounted supplies, loans at discounted rates, etc.  This, therefore, is likely to have an impact on the functioning and bottom-lines of an enterprise.  If we are looking at ALP between AEs, obviously the extended support or service cannot be ignored. One of the AEs extending the support service may seek for some or the whole of such benefit as compensation elsewhere in other transactions with the other AE.  Hence, benefits derived in some transactions may be offset with others while dealing with the same AE.  Unless the taxpayer is able to demonstrate the impact of such adjustments, benefit passed on to the other AE in the international transaction is going to be challenged.  A computed demonstration, to bring home the facts, is an essential requirement in all TP assessments.  When such attempts are made it will go a long way not only before the tax authorities but also before the Appellate Authorities.  Even if the TP authority turns a blind eye to a computed submission that is mathematically factual and precise, judicial rulings in such circumstances are more likely to come in favour of the taxpayer.
 
Depending on the prevailing facts and circumstances of each case, adjustments have to be made to eliminate differences in funding for working capital.  This was clearly laid down in the decision of Mentor Graphics (Noida) Pvt. Ltd. v. DCIT, Circle 6(1), New Delhi [2007] 109 ITD 101 (Delhi). Wherein it was held that the final set of comparables may need to eliminate differences by making adjustments for the following:
 
a)Working capital (b) adjustment for risk and growth (c) adjustment of R&D expenses
 
In Philips Software Centre Pvt. Ltd. v. ACIT, Circle 12(2) [2008] 26 SOT 226 (Bang.), the Hon’ble ITAT approved comparability adjustments of effects in working capital and accounting policies to eliminate differences, apart from all other adjustments such as different functions, assets and risk profile of entities being compared. The Bangalore Tribunal allowed an adjustment equivalent to the difference between Prime Lending Rate (PLR) and the bank rate, to the margin of comparable companies.
 
The CIT (A) did not allow an adjustment for working capital citing that the same cannot be granted merely because such an adjustment has been allowed by the TPO for the succeeding assessment year. It was held that the CIT (A) has not addressed the merits of the case of the assessee as it was noted that the assessee being a captive contract service provider, rendering software development services to its associated enterprises, the payment cycle in the case of the assessee is shorter as against a considerable time lag in case of a third party service provider. In case of the comparables as approved by the CIT (A), the holding period for working capital is around 8 months as against that of the assessee of around 3 months. The learned Counsel submitted that considering the provisions of Rule 10B (1) (c)(iii)/(e)(iii), an adjustment on account of working capital difference is required to be made for an equitable comparison.  This was accepted by the ITAT and the representation of the taxpayer for such adjustment was accepted.
 
It has been held in Mentor Graphics (supra) that in Rule 10(B)(1)(e) of I.T. Rules providing for determination through TNMM, it is clearly-provided in clause (iii) the net profit margin referred to in sub-clause (ii) arising in comparable uncontrolled transactions is adjusted to take into account the difference if any. The regulations have force of law and notwithstanding OECD guidelines, the T.P.O. cannot refuse to consider specific characteristics of transaction, functions performed and assets employed as has been done in this case.
 
Adjustments under Indian TP Law:

The law on transfer pricing adequately provides for making adjustments between a controlled and comparable uncontrolled transaction. Rules governing comparability is provided in the Income-tax Rules, 1962, as follows:
 
“Rule 10 B (3)- An uncontrolled transaction shall be comparable to an international transaction if-
  
(i)none of the differences, if any, between the transactions being compared, or between the enterprises entering into such transactions are likely to materially affect the price or  cost charged or paid in, or the profit arising from, such transactions in the open market; or
(ii)reasonably accurate adjustments can be made to eliminate the material effect of such differences.”
 
Rule 10(B)(1)(e) provides for determination of ALP by the use of TNMM and further states that-
(iii)the net profit margin referred to in sub-clause (ii) arising in comparable uncontrolled transactions is adjusted to take into account the difference if any.
 
  
Contradicting views in judgements:

In the case of Aztech Software and Technology Services Ltd. v. Asst. CIT [2007] 107 ITD 141, it has been held that rarely one is able to locate an identical uncontrolled transaction and the ALP is determined by taking the result of a comparable transaction in comparable circumstances and by making suitable adjustments for the differences.  Hence, the taxpayer or his representative has to seriously work towards providing details of adjustment that are reliable and meticulous.  
 
However, in Wrigley India Pvt. Ltd. v. Addl. CIT [IT Appeal No. 5224 of 2010, (Delhi - Trib.), in spite of differences in FAR between exports to AEs and domestic sales, the tribunal went on to compare the two activities without making any adjustments, which was far from truth.  The facts relating to the two segments were entirely different as there were no risks such as market risks, contractual risks, credit risks and inventory risks when dealing with the AE, but the situation would be just the opposite while transacting in the domestic market.  In fact economic adjustments had to be made and if that was not possible, it should have been concluded that the two sets of transactions were not comparable at all. The point that becomes clear from this judicial decision is that it required proper representation to highlight that there was vast differences between the domestic and the export transactions with AEs, to such an extent that comparison between the two had to be undeniably overlooked.
 
Adjustment of market risk among comparables:

Market risk represents the price and volume that cannot be achieved by an enterprise, to go beyond the break-even sales level, to realize margin for its sustainability.  Obviously, all enterprises strive towards this objective.  This is an entrepreneurial spirit.  But take the case of captives, where no marketing efforts are made and they survive on the market strength of others and become surrogates to them. This brings in different risk profiles for the two entities.  A captive providing services to affiliates has no market risk and any comparison with an entrepreneurial entity, requires a calculated economic adjustment.  This has been appreciated by various tribunal decisions like in Sony India Pvt. Ltd. v. DCIT [ITA Nos. 1189 of 2005](Del.), Mentor Graphics (supra) and E-Gain Communications. v. ITO [2008] 23 SOT 385 Pune.
 
The Hyderabad Tribunal on the other hand in the case of Deloitte Consulting, has held that a responsibility was fixed by the AE to ensure that the performance of the work should be free of errors and that there should be proper documentation.  In view of this condition it was concluded by the Tribunal that the taxpayer was also bearing risks and therefore plea for market risk adjustment was not accepted.
 
It is important to understand that if risks can be quantified and the impact demonstrated before the authorities, it should make a perceptible difference.  This therefore calls for adequate documentation and proper presentation to strike in a significant logic before the tax administrators and the judiciary.  In fact, the captives are so set up that the quality aspects are taken care at the time of setting up the unit.  There is no additional responsibility or a requirement of assuming any additional risk like the entrepreneur without the affiliates.  If this aspect can get demonstrated through documentation, there would not have been any argument that the taxpayer was also bearing some amount of risk in international transactions with AEs.  Apart from documentation, the taxpayer has to precisely understand his FAR analysis vis-a-vis that of the AE and that of the chosen comparable.  It is only then that the submission for adjustments can be quantitatively and qualitatively argued.
 
It may be safely assumed that that to compare transactions between the party being tested and comparable uncontrolled transaction the transactions have to be first adjusted for differences, only then there can be a meaningful exercise.  Para 1.33 of the OECD guidelines prescribe that-“To be comparable means that none of the differences (if any) between the situations being compared could materially affect the condition being examined in the methodology (e.g. price or margin), or that reasonably accurate adjustments can be made to eliminate the effect of any such differences.”
 
Differences due to intangibles:

In the case of Sony India Pvt. Ltd. (supra) the Tribunal appreciated significant differences in the intangibles held, research and development costs incurred, risk factors and working capital.  An ad hoc adjustment of 20% was permitted without seeking for specific methods of establishing the differentials.
 
In E-Gain Communication Pvt. Ltd., (supra) the Pune ITAT was emphatic in allowing for adjustments even though the taxpayer had shown a margin of profit that was fully satisfying the ALP and that no further adjustment was required.  In the judgement the Tribunal stated as follows:
 
“We further agree with the contention of the Ld. Counsel for the taxpayer that the benefit of adjustment was required to be given in working the margin of profit of the taxpayer for not undertaking any risk in the transactions with its parent company.”
 
Both in the case of Agnity India Technologies Pvt. Ltd. v. ITO (ITA No. 3856) (Delhi)-2010 and SAP Labs India Pvt. Ltd. v. Asst. CIT [2010] 8 taxman.com 207 (Bang-ITAT), it was held that smaller companies cannot be compared with companies that have high risk profile although both of them have got similar businesses.  In SAP Labs case the Tribunal categorically declared thus-
 
“Therefore, it is to be seen that the assessee company, as such, working in Bangalore is having only a limited role in generating what is called a ‘commercial profit’ and, therefore, it cannot be compared with other leaders playing in the market.  It is also relevant to note that the assessee company is working in a risk-mitigated environment.  When this is the position, TPO/AO cannot select extreme cases as comparables to examine the ALP of the assessee company under TNMM method.”
 
Marketing intangibles in “Maruti” Suzuki’s case:

In “Maruti” Suzuki India Ltd. v. ACIT TPO, New Delhi [2010], the TPO has relied on the ‘bright line’ test of the U.S. DHL case insisting that Maruti should be compensated for non-routine advertising expenditure.  The same was quoted in its order by the Delhi High Court:
 
“Here the trial Judge espoused his “bright line” test which notes that, while every license or distributor is expected to spend a certain amount of cost to exploit the items of intangible property to which it is provided, it is when the investment crosses the ‘bright line’ of routine expenditure into the realm of non-routine that, economic ownership likely in the form of marketing intangible is created”.
 
An adjustment was made by the TPO to reign in this benefit flowing to the AE.  Elements of marketing intangible can include all costs that are incurred for developing and maintaining the value of a trademark.  It could include brand maintenance, customer lists, distribution channels, market information, using the logo as in Maruti’s case, etc.  Economic adjustments made by the TPO were rejected by the High Court on the grounds that the TPO had failed to identify and select the entities that were comparable with the turnover and income of Maruti.  This case is important from the point of view of understanding that the tax authorities can invoke methods of adjustments that are prevailing in the international scenario. It also gives us a peep into how the tax authorities view marketing intangibles for the purpose of making adjustments.  The Supreme Court has remanded the matter to the TPO directing him to follow the existing law while staying the orders of the Delhi High Court.
 
Adjustment of notional interest:

The Delhi Tribunal Bench in Perot Systems TSI Ltd. v. DCIT [2010] 37 SOT 358 (Delhi) has ruled that the non-payment of interest to an AE by the Indian taxpayer amounted to shifting of profits and the additions made by the TPO was upheld.  It taxpayer’s plea that it had not in fact received the payment and that notional interest should not be added was not accepted by the Tribunal and the appeal was dismissed against the taxpayer.
 
Adjustment of capacity utilization:

Any differences in capacity utilized by comparable entities have a bearing on the net margin of the transactions and also on the enterprise as a whole.  Idle capacities and lower capacities are tied with expenses that cannot be built into the price whether it is for a related party or an unrelated party.  This therefore requires adjusting fixed costs on a proportionate basis depending upon what capacities are used in comparison with the selected entity if capacity utilization differences exist.  Skoda Auto India Pvt. Ltd. v. Asst. CIT [2009] 30 SOT 319 (Pune), is a case in point that wherein it has been held that unusual high costs incurred by the entity during setting up have to be adjusted to increase comparability between entities.
 
In Global Vantedge Ltd. v. DCIT [2010] 001 ITR (Delhi Trib.), it has been held that expenses and costs require suitable adjustments for differences in capacity utilization when one is in the start-up phase and the other is fully established.  Again, the adjustment should be made to the figures of the comparable enterprise and not to the tested entity.
 
The other economic grounds for comparison:

There are many other adjustments that are to be made in order to make the comparisons more meaningful.  These have surfaced out on the basis of many assessments that have taken place so far.  Some of those economic grounds that have become a subject of discussion and practice are as tabled below:

If the above concepts have to be differentiated and used for economic adjustments in TP assessments, the taxpayer has to plan his documentation so well that it has to convince the verifying authorities that differences do exist and the submission of the taxpayer is genuine.
 
From the plethora of cases cited above it is clear that the tax authorities and the judiciary will expect that all adjustments have to be factual and verifiable.  If these conditions have to be fulfilled, the taxpayer has to justify that a difference exists, it is measurable and the methodology of identifying the difference has to be submitted.  An ad hoc adjustment or a rule of thumb may not be appreciated as the subject matures, with more practical issues coming to the fore.  Any adjustment that is required to be made should be so demonstrated that it is appealing to the human mind.  It is high time that the taxpayers and tax gatherers do not continue to play guessing games to protect their individual turfs, but efforts are made in laying down concrete methods of solving issues that emerge from time to time.  This has to be done both by the legislature and the executive to bring in certainty to transfer pricing, which is one of the factors for improving international trade.