Global Tax Alert (News from Transfer Pricing) | 29 January 2014
India’s Delhi Tribunal rules on application of Profit Split Method
This Tax Alert summarizes a recent ruling1 of India's Delhi Income-Tax Appellate Tribunal (Tribunal) in the case of M/s. Net Freight (India) Private Limited (Taxpayer). The Taxpayer is a logistics service provider. The Taxpayer and its associated enterprises (AEs) have an arrangement of profit sharing on a 50% basis of all transactions of inbound and outbound shipments. The Taxpayer's transfer pricing documentation supported that the international transactions were arm's length using the Residual Profit Split Method (RPSM) as the most appropriate method (MAM).
During the course of audit proceedings, the Transfer Pricing Officer (TPO) rejected the RPSM adopted by the Taxpayer stating that sufficient information was not available to determine whether the arrangement of the profit sharing rate of 50% was appropriate or not. The TPO, instead, adopted Transactional Net Margin Method (TNMM) and tested the net operating margin of the Taxpayer at the entity level with third party comparable companies and made a transfer pricing adjustment.
The Tribunal rejected the application of TNMM at the entity level as adopted by the TPO. The Tribunal held that RPSM was the MAM in the case of the Taxpayer. Further, the Tribunal held that a two-step approach should be followed to allocate the profit between the AEs. At the first stage, the combined net profits are partially allocated to each enterprise so as to provide each with an appropriate routine return based on reliable external market data and the residual profits thereafter may be split on a scientific basis in accordance with the relative contribution of the AEs, which need not be benchmarked.
The Taxpayer is a logistics service provider offering a comprehensive portfolio of international, domestic and specialized freight handling services. The Taxpayer and its AEs mutually appoint each other as exclusive agents with respect to the transportation of shipments. For these services, the Taxpayer and its AEs have an arrangement of profit sharing on a 50% basis of all transactions of inbound and outbound shipments.
In its transfer pricing report for the FY 2003-04, the Taxpayer after undertaking a functional analysis adopted the RPSM as the MAM in order to determine the arm's length nature of the international transactions with its AEs.
During the course of audit proceedings, the TPO rejected the use of RPSM as the MAM on the basis that sufficient information was not available to determine whether the arrangement of the profit sharing rate of 50% was appropriate or not. The TPO instead adopted TNMM as the MAM and selected seven companies with a net operating margin of 7.17% compared to the net operating margin of 2.56% of the taxpayer. Since the net operating margin of the Taxpayer was less than that of the comparable companies, the TPO made a transfer pricing adjustment for the differential. The Taxpayer then appealed to the Commissioner of Income-tax (Appeals), the first-level appellate authority. The first appellate authority accepted the plea of the Taxpayer and deleted the transfer pricing adjustment. The Tax Authority then filed an appeal before the Tribunal, the second-level appellate authority.
Ruling of the Tribunal
The Tribunal observed that under Indian transfer pricing rules, the PSM is applicable mainly in international transactions: (a) involving transfer of unique intangibles; or (b) in multiple international transactions that are so interrelated they cannot be evaluated separately.
Under the transfer pricing rules, a taxpayer can adopt either contribution PSM, where the entire system profits are split among the various AEs who are parties to the transaction or RPSM, where each of the AEs who are parties to the transaction in question are first assigned basic returns for the routine functions performed by them, and thereafter the residual profits are split among the AEs.
Where RPSM is adopted, the Tribunal held that in the first stage the profits need to be split among the AEs on the basis of reliable external market data, which indicate how unrelated parties have split the profits in similar circumstances. At the first stage, benchmarking with reliable external market data is to be done. In this step, the combined net profits are partially allocated to each enterprise so as to provide it with an appropriate base return keeping in view the nature of the transaction. The residual profits may be split as per relative contribution of the AEs, which need not be benchmarked by external market or comparable data. However, a scientific methodology may be applied for allocating the residual profits.
Based on the facts of the case, the Tribunal upheld the use of RPSM as the MAM. However, the Tribunal held that the method had not been correctly applied as per law by the Taxpayer as no benchmarking had been done.2 The Tribunal rejected the application of TNMM at the entity level by the TPO, because it did not follow the legal requirement for a transaction level comparison.
Thus, the Tribunal set aside the issue for fresh adjudication, while giving the Taxpayer an opportunity to file a revised transfer pricing study with comparable data, in accordance with law.
Indian transfer pricing rules are based broadly on the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (OECD TPG). The OECD TPG discuss various approaches – contribution analysis and residual analysis - for splitting profits when the PSM is determined as the MAM. The 2010 revision to the OECD TPG appears to provide more opportunities for the frequent use of the PSM. The OECD in its 2010 revision gives examples of circumstances the OECD considers appropriate to use the PSM, such as where each of the parties contributes “unique intangibles” or where there are “highly integrated activities.” The revised OECD TPG also suggest that the PSM might in appropriate circumstances be considered even without comparable data. As per the 2010 revisions, in the absence of comparable data, the analysis can be based on relative value of functions performed. Further, there is recognition of the potential use of allocation keys while applying the PSM.
Taxpayers may need to review the nature of their international transactions to evaluate whether PSM may be regarded as the MAM taking into account the facts and circumstances of their case, especially in situations where there is insufficient comparable data or where AEs make “non-routine contributions” to the value chain.
2. It appears from the ruling that the Taxpayer had not benchmarked the returns while applying the first step of the RPSM.
For additional information with respect to this Alert, please contact the following:
Ernst & Young LLP (India), Bangalore
- • Rajendra Nayak
+91 80 4027 5454
Ernst & Young LLP (India), New Delhi
- • Vijay Iyer
+91 11 6623 324
EYG no. CM4133