Clarify method for transfer pricing adjustments

Transfer pricing as a subject has been evolving since its introduction with the Finance Act, 2001.

An important aspect that has been referred to in many recent tribunal rulings is the need for economic adjustments for closer comparability between transactions entered into by the taxpayer with its group affiliates and the comparable analysis.

The guiding principle for comparability between an uncontrolled and controlled transaction is that reasonable accurate adjustments be made to eliminate the effect of any differences.
Indian transfer pricing regulations expressly require that adjustments to price/margins should be made (where appropriate) to enhance comparability, but they give limited guidance on the methodology to be adopted for comparability adjustments. Hence, guidance may be sought from OECD guidelines, US regulations and recent tribunal rulings.

Some possible scenarios where economic adjustments could be carried out for better comparability from a transfer pricing standpoint are given in the table.

Some jurisdictions, such as the US, expect or require that certain adjustments are made in all the transfer pricing analysis (for example, stock option adjustments and working capital adjustments are generally required in US advance pricing agreements). Furthermore, the US Internal Revenue Service has also published guidelines on how and why working capital adjustments may be performed.

Whether an economic adjustment falls under one of the above categories or not, it is important for taxpayers to be able to justify the application of an adjustment. Such justification would typically involve demonstrating the economic rationale relating to aspects such as market dynamics, risk differentials, variations in the working capital cycle and so on. Furthermore, the method of application needs to be supported by a sound basis in line with international principles. Strongly articulating the rationale along with appropriate documentation would enhance the possibility of such economic adjustments being favourably considered by the tax authorities.

With this in mind, the tax authorities do recognise the need for economic adjustments and tend to accept the basic ones like working capital adjustment at the level of the transfer pricing officer. However, adjustments pertaining to accounting and risk, which have certain economic assumptions, have been allowed at the tribunal level. Hence, the subject is still evolving; taxpayers should not be discouraged from considering such adjustments if their underlying analysis suggests that it is necessary to reach a materially more reliable level of comparability between their inter-company transactions and third party data.

To summarise, India is still at a nascent stage with respect to the application of economic adjustments. It would be prudent for Indian Regulations to take cues from advanced economies and provide definitive guidance on the computation of economic adjustments. This would also be relevant where APAs are expected and will allow discussions with tax authorities to bring certainty on such matters. However, it is currently wise for taxpayers to document the commercial rationale behind conducting any economic adjustment so that it supports the justification of a transaction at the time of assessment.

(Dhaivat Anjaria is executive director and Bhavik Timbadia manager, transfer pricing practice, PricewaterhouseCoopers. Views are personal.)