INSIGHT: Covid-19, Transfer Pricing and the Sixth Method

Economic analysis is a fundamental aspect of transfer pricing (TP) analysis and it is now, in the age of Covid-19, that the real test awaits taxpayers as well as revenue authorities (stakeholders). Until now, in most cases, the benchmarking exercise was treated as a mundane exercise by stakeholders, but now it is time for stakeholders to benchmark intra-group transactions differently.

This article explores the feasibility for stakeholders to diverge from the conventional benchmarking route and explore the relative unknown.

The compliance of the arm’s length price (ALP) principle is ensured through benchmarking intra-group transactions using the prescribed globally recognized methods.

The most appropriate method (MAM) among the prescribed methods is chosen to comply with the ALP principle. Usually, the MAM remains the same, year-on-year, if there is no change in the transaction(s) but, of course, there is no restriction on changing the MAM, as long as one can justify its selection.

Emergence of the Sixth Method

The Organization for Economic Co-operation and Development (OECD) and United Nations (UN), under their respective transfer pricing guidelines (TPG), primarily endorse five methods to benchmark intra-group transactions, as shown in the table below.

In view of the fact that transfer pricing is not an exact science, requiring an analysis to be molded in light of the facts and circumstances, the need for the sixth method has finally been recognized by policymakers. The sixth method has always been perceived to be a flexible avatar of the CUP method, but this is not true. This method has been enshrined in the domestic tax laws of numerous Latin American countries and, of course, India.

The advantages that the sixth method has over the other five methods include the following:

• flexible enough to allow stakeholders to leverage upon it based on unusual facts and circumstances;
• allows the stakeholders to not only compare it with an actual transaction but also with quotations, etc;
• gives due importance to the “relevant facts” as also acknowledged in the Indian transfer pricing legislation (discussed below).

These advantages could assist stakeholders to benchmark the intra-group transactions, especially in Covid-19 times, using the sixth method as the MAM, by giving due importance to the individual facts of each case.

Incorporation in the Indian Tax Statute

India notified the “Other Method,” in the form of Rule 10AB (Other method of determination of arm’s length price), as the sixth method for determination of ALP in 2012.

The relevant extracts of the above-mentioned notification are:

“Other method of determination of arm’s length price
10AB. For the purposes of clause (f) of sub-section (1) of section 92C, the other method for determination of the arms’ length price in relation to an international transaction shall be any method which takes into account the price which has been charged or paid, or would have been charged or paid, for the same or similar uncontrolled transaction, with or between non-associated enterprises, under similar circumstances, considering all the relevant facts.”
[Emphasis added]

Furthermore, there was an insertion of clause (f) in Rule 10B (Determination of arm’s length price under section 92C) of the Rules which reads "(f) Any other method as provided in rule 10AB.”

This additional method was introduced due to genuine hardships being faced by taxpayers in justifying the compliance of the ALP principle using the five originally prescribed methods. Such hardships, inter alia, included justifying the valuation methods adopted, quotations being used (where there was no actual third-party transaction to compare), use of standard rate cards in specific industries, etc.

How Can the Sixth Method be Leveraged?

Economic analysis going forward (particularly for calendar year 2020 or financial year 2020–21) will certainly be a challenge. Therefore, it is worth exploring the Sixth Method as the MAM for this particular period (and beyond).

The reasons to explore the Sixth Method are outlined below.

Preference of Single Year Data over Multiple Year Data

This year, given that the situation may be unusual for most industries, even the functionally comparable companies might be incurring losses. Hence, the use of multiple year data, which also considers the previous two years—which are not impacted by this ongoing pandemic—may not represent a true picture.

Hence, it is only logical to compare the tested party’s data with a single year data to benchmark the intra-group transactions during the ongoing calendar year (CY)/financial year (FY).

In the Indian context, applying the “range concept” (introduced vide Finance Act, 2014) for transactions entered on or after April 1, 2014 may not be effective, at least for FY 2020–21, since it requires multiple year data to be considered to average out the unusual impact, if any. Range concept (35th to 65th percentile) is only applicable in case of CUP, RPM, CPM and TNMM where the dataset includes minimum six entries [Sub-rule(4) of Rule 10CA (Computation of arm’s length price in certain cases) of Indian Income-tax Rules, 1962]).

Similarly, on the global front, where interquartile range (25th to 75th percentile) is applied, multiple year data may not be effective for the ongoing CY/FY, as may be applicable.

One may, of course, have an option to ensure (through cherry picking) that the data entries do not exceed the prescribed limit (five, in the case of India) and, thereby, apply the arithmetic mean and choose single year data, but this may run a risk of having the revenue authorities change the entire data set during the audit proceedings, and also increase the data entries so as to make it fall under the “range concept.”

Need for Qualitative Adjustments

The ongoing pandemic may not only have a quantitative impact, which can be easily measured from the financial statements, but may also have a qualitative impact which is hard to measure or, for that matter, even harder to identify. For example, there may be productivity impact on the human capital due to social distancing, impact due to illness of the employees, impact due to travel restrictions, etc. This method surely provides that flexibility to consider all the relevant facts.

Include Loss-incurring Companies

With the effects of this pandemic, it will be challenging to find the right set of comparables. Some may even be qualitatively comparable to the taxpayer but may be running into losses, like most of the taxpayers during this period. It could be risky to compare the loss-incurring entity (tested party) vis-à-vis loss-incurring comparables (either at gross or net level).

Of course, one may even select loss-making companies under the RPM/CPM/TNMM, but the sixth method does provide a little more flexibility, or ensures that the benchmarking is not carried out in a rigid and mechanical manner. Normally, loss-making comparables are rejected by the revenue authorities during the audit proceedings.

Conclusion

Considering that taxpayers are faced with unprecedented circumstances, one may argue that the sixth method could be the MAM in the present circumstances, subject to respective jurisdictions allowing the use of the same in their domestic tax laws.

It could be argued that the sixth method will bring us closer to the commercial reality and that is what the entire transfer pricing exercise is all about: so perhaps the sixth method could be the “Knight in Shining Armor” for multinational enterprises.

Karnik Gulati is a Tax and Regulatory Consultant at Coinmen Consultants LLP in India.

The author may be contacted at: cakarnikgulati@yahoo.com

The views are personal and the author disclaims any responsibility for any loss suffered by the reader in relying or by acting on this suggestion. Expert guidance, where required and user discretion is highly recommended.

Karnik Gulati is an Associate Member of the Institute of Chartered Accountants of India. He also holds Baccalaureate in Law (LL.B.) from India and Advanced Diploma in International Taxation (ADIT) from Chartered Institute of Taxation, London.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.