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Monday, 08 May 2017 12:51

Transfer Pricing Method - Whether Disallowing Claim of Taxpayer by following CUP Legitimate? - Is there a CUP?

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Transfer Pricing - CUP Method Analysis Transfer Pricing - CUP Method Analysis

The recent practice of the Indian revenue authorities (hereinafter “IRA”) have been notoriously disallowing the claim of the taxpayer towards payment made for intragroup services, royalty and management fee. The ideology adopted by the IRA has been by rejecting the transfer pricing approach applied by the taxpayer in its study to benchmark the impugned transactions and substituting it with ‘CUP’ and thereby reducing the arm’s length price (hereinafter “ALP”) of the transaction as NIL.

The intragroup service forms a definite charge in recent times wherein specific roles are being assigned to various entities across the value chain. In this scenario, the group participants have to rely on the expertise of these entities towards certain services like accounting, book keeping, human resource, finance, payroll, management, etc. More so, the decentralization of routine activities lets a group participant to focus on its core operation without worrying about the performance of the routine functions, while the centralised functions such as brand ownership helps in managing intangibles.

The concept of centralization and decentralization has been part of economics for centuries and has been reiterated by authors time and again. In their bestseller, “In Search of Excellence”, Tom Peters and Robert Waterman took a similar line: “Excellent companies,” they said, “are both centralised and decentralised.” Alfred Chandler said much the same in “Strategy and Structure”, arguing that strategy and responsibility for head office should be centralised, while day-to-day operations should be left to decentralised units.

The IRA has been arguing that if the services are available locally, there is no need for the taxpayer to look out for alternative from within the group, terming this approach as ‘duplication of services’. In addition, the IRA has been judging the payments for intragroup service in consonance with the need test, benefit test, rendition test and as a part of shareholders activity, causing serious hardship for the taxpayer by challenging the commercial wisdom. Moreover, the IRA has linked this approach to shifting of profits from India to offshore location thereby depriving the country of its fair share of revenue.

Here it is pertinent to note that the IRA does not have an authority to disallow the expense claimed by the taxpayer. The powers enshrined under Section 92CA of the Income Tax Act, 1961 authorise the IRA to compute the ALP of a given international transaction or a specified domestic transaction as in accordance with the methods prescribed under Section 92C read with Rule 10B, and in case of a deviation of price adopted by the taxpayer from the ALP, thus computed, to provide for an appropriate upward adjustment as the difference in the ALP. The section does not address the power of the IRA to question the commercial wisdom or the sanctity of such transactions. This view has also been upheld by the tax courts most famously by the Supreme Court in the case of Sassoon J. David & Co. Pvt. Ltd. vs. CIT, (1979) 118 ITR 261 (SC), wherein it was viewed that it is not necessary for the assessee to show that any legitimate expenditure incurred by him was also incurred out of necessity. It is also not necessary for the assessee to show that any expenditure incurred by him for the purpose of business carried on by him has actually resulted in profit or income either in the same year or in any of the subsequent years. The only condition is that the expenditure should have been incurred “wholly and exclusively” for the purpose of business and nothing more.

The view of the apex court was followed recently by the Delhi High Court in the case of CIT vs. EKL Appliances Ltd. [2012] 345 ITR 241, wherein the High Court observed as under:

“22. Even Rule 10B(1)(a) does not authorise disallowance of any expenditure on the ground that it was not necessary or prudent for the assessee to have incurred the same or that in the view of the Revenue the expenditure was unremunerative or that in view of the continued losses suffered by the assessee in his business, he could have fared better had he not incurred such expenditure. These are irrelevant considerations for the purpose of Rule 10B. Whether or not to enter into the transaction is for the assessee to decide. The quantum of expenditure can no doubt be examined by the TPO as per law but in judging the allowability thereof as business expenditure, he has no authority to disallow the entire expenditure or a part thereof on the ground that the assessee has suffered continuous losses. The financial health of assessee can never be a criterion to judge allowability of an expense; there is certainly no authority for that. What the TPO has done in the present case is to hold that the assessee ought not to have entered into the agreement to pay royalty/ brand fee, because it has been suffering losses continuously. So long as the expenditure or payment has been demonstrated to have been incurred or laid out for the purposes of business, it is no concern of the TPO to disallow the same on any extraneous reasoning. As provided in the OECD guidelines, he is expected to examine the international transaction as he actually finds the same and then make suitable adjustment but a wholesale disallowance of the expenditure, particularly on the grounds which have been given by the TPO is not contemplated or authorised.”

Transfer Pricing

However, it is not the legal position that is mystifying but the approach followed by the IRA that has caused the transfer pricing laureates to rethink their beliefs. According to the IRA, no sane businessmen shall incur such cost without conducting a cost benefit analysis of entering into such a transaction and therefore applying ‘CUP’ as the most appropriate method the ALP of such transactions is reduced to NIL.

The abovementioned approach of the IRA raises serious question on the application of the CUP.

According to the transfer pricing guidelines issued by the Organisation for Economic Cooperation and Development (“OECD”), the CUP method compares the price charged for property or services transferred in a controlled transaction to the price charged for property or services transferred in a comparable uncontrolled transaction in comparable circumstances. If there is any difference between the two prices, this may indicate that the conditions of the commercial and financial relations of the associated enterprises are not arm's length, and that the price in the uncontrolled transaction may need to be substituted for the price in the controlled transaction. In a nutshell, for the application of CUP there has to be a comparable uncontrolled transaction (“CUT”). A similar inference can be found in Rule 10B(1)(a)(i) of the Income Tax Rules, 1962 according to which under a CUP method “the price charged or paid for property transferred or services provided in a comparable uncontrolled transaction, or a number of such transactions, is identified”. Therefore, mandating the identification CUT as an essential prerequisite.

However, the practices of the IRA have failed to fulfill this basic tenet of applying the CUP, thereby making the entire assessment infructuous.

The IRA being a governing body is expected to challenge the transfer pricing methodology adopted by the taxpayer. However, a biased approach to dismiss the approach of the taxpayer by going beyond the basic principles puts transfer pricing in a bad light.

However, from some reason, the tax courts have refrained from taking this view while addressing the concern of the taxpayer.

Cases Referred to

1. Sassoon J. David & Co. Pvt. Ltd. vs. CIT, (1979) 118 ITR 261 (SC)

2. CIT vs. EKL Appliances Ltd. [2012] 345 ITR 241

Disclaimer: Views expressed are strictly personal. The content of this document are solely for informational purpose. It doesn’t constitute professional advice or recommendation. The Author does not accept any liabilities for any loss or damage of any kind arising out of information in this article and for any actions taken in reliance thereon. The readers are requested to consult their Tax Consultant before implementing.

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Read 5341 times Last modified on Wednesday, 10 May 2017 15:58
CA Rohan Pandey

Rohan Pandey, chartered accountant, is an avid transfer pricing and international tax writer and is having over 5 years of experience in the field.

This email address is being protected from spambots. You need JavaScript enabled to view it.


  • Comment Link Laura Thursday, 28 June 2018 16:19 posted by Laura

    Very interesting case analysis, I really enjoyed reading that. I was wondering if, perhaps, some other transfer pricing methods could be used. After some time on Google, I found this article ( Are these insights valuable? Should I refer to them during my analysis? Many thanks!

  • Comment Link Prachi Dwivedi Monday, 08 May 2017 18:19 posted by Prachi Dwivedi

    Really Good, !!

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