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The most important facet of transfer pricing provisions is to derive an accurate Arms Length
Price (ALP) for the International Transactions. This ALP can be determined by using the
methods specified under TP provisions which require identification of comparables.
Comparables belong to varied economic conditions and must be facing different set of
challenges. Therefore, while comparing a company (herein after referred to as a tested party) to
that of similar companies (herein after referred to as comparables), it is necessary to undertake
Comparability Adjustments in order to arrive at a refined search.

Many clouds surround the concept of comparability adjustments. Hence, one needs to identify
and have a clear understanding of this important concept. Chapters I and III of the OECD
Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (TPG)
contain extensive guidance on comparability analyses for transfer pricing purposes. Revised
Guidance (approved by the Council of the OECD on 22 July 2010) on comparability
adjustments is found in the Annex to Chapter III of the TPG.

There exists a misconception that the concept of comparability adjustments is intertwined with
Transfer Pricing Adjustments, which is not true. Comparability adjustments are made to
comparables in uncontrolled transactions inorder to eliminate any material difference between
them and controlled transactions whereas transfer pricing adjustments are those which are made
after comparing the transaction price of international transactions to the ALP determined
subject to a condition that there exists a difference which is more than the allowable limit under
TP provisions.

Rule 10B of Income Tax Rules, 1962 which deals with determination of arms length price under
section 92C permits such Comparability adjustments. There is no other provision or rule under
Income Tax Act or Rules backing such adjustments. However, the judiciary in India has upheld
the use of OECD Transfer Pricing Guidelines for computing working capital adjustments.

As per Rule 10B of Income Tax Rules, 1962 (3)

An uncontrolled transaction shall be comparable to an international transaction if

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
reasonably accurate adjustments can be made to eliminate the material effects of such differences.

According to the United Nations Transfer Pricing (UNTP) Manual, comparability adjustments
can be divided into the following three broad categories:

Accounting adjustments
Balance sheet/working capital adjustments
Other adjustments

The most important amongst them is Balance sheet /Working Capital Adjustments
Balance sheet adjustments are intended to account for different levels of inventories, receivables,
payables, interest rates etc. The most common balance sheet adjustments made to reflect
different levels of accounts receivable, account payable and inventory are known as working
capital adjustments. As mentioned by the OECD, comparability adjustments should not be
performed on a routine or mandatory basis but rather on a case by case basis depending on the
facts and circumstances.

Economic rationale

Working capital of a business is the capital used in its day-to-day trading operations. Working capital is affected
by numerous business incidences.

It is very common for tested party and each of the potential comparables to differ materially in
the amount of working capital (inventory, accounts receivables and payable).Such differences
are mainly caused due to differences in the terms of purchase and sale, levels of inventory etc.
For example: If the business advances a trade credit of (say) 60 days, its cash gets locked up for 60 days and
reduces the working capital. It will have to borrow from open market to meet its working capital requirement,
and hence incur expenses. Similarly, if it avails of trade credit of 60 days, it has surplus cash at its disposal. It
will need to borrow less money to fund operational requirements. Hence, working capital position affects the
additional cost incurred by a business by way of interest on borrowing from the open market.

Working capital adjustments seeks to adjust for the differences in time value of money between
tested parties and potential comparables with an assumption that differences should be
reflected in profits

Working capital adjustment has a strong rationale in economic theory. It facilitates to increase
the comparability between the tested party and comparables working in an industry which is
competitive. Working capital adjustment can work out to be positive or negative. A positive
working capital adjustment (WCA) will tend to reduce the arms length PLI while a negative
WCA will tend to increase the arms length PLI. Whether WCA is positive or negative should
not ideally matter, for its an adjustment to increase comparability. However, these adjustments
should be done only if such adjustments can be reasonably made and they improve comparability

The process of calculating working capital adjustments is as under:

Identify differences in the levels of working capital. Generally, trade receivables, inventory and
trade payables are the three accounts considered. The transactional net margin method is applied
relative to an appropriate base, for example, costs, sales or assets. So, if the appropriate base is
sales, then any differences in working capital levels should be measured relative to sales.
Calculate a value for differences in levels of working capital between the tested party and the
comparable relative to the appropriate base and reflecting the time value of money by use of an
appropriate interest rate.
Adjust the result to reflect differences in levels of working capital. The following example adjusts
the comparables result to reflect the tested partys levels of working capital. Alternative
calculations are to adjust the tested partys results to reflect the comparables levels of working
capital or to adjust both the tested party and the comparables results to reflect zero working
A practical example of calculating working capital adjustment is given below: -

Generally, a question arises while making working capital adjustments as to at what point in time
are the Receivables, Inventory and Payables compared between the Tested Party. In the above
example, their levels are compared on the last day of the financial year. This may not be
appropriate if it does not portray representative levels of working capital over the year. In such
cases averages can be used to carry out working capital adjustments.

Another major issue in working capital adjustments involves the selection of appropriate interest
rate. The rate or rates of interest should be determined with reference to rate (s) of interest
applicable to a commercial enterprise operating in the same market as a tested party. In cases of
tested partys working capital being negative (that is Payables > Receivables + Inventory) a
different rate is applicable. In the above example, same rate of interest is assumed to be the same
for both the parties.

Judicial Pronouncements

1. Dy.CIT v. BMC Software India Pvt Ltd.

In this case, the assessee was engaged in rendering software development services.
The assessee received advances from its group entities against services to be performed.
The tribunal allowed the benefit of working Capital Adjustment to assessee after taking into
account advances so received from customers.
2. Philips Software Centre (P.) Ltd. v. ACIT

In this case the ITAT approved comparability adjustments being made to eliminate differences
on account of different functions, assets and risks, and specifically for differences in risk profile,
working capital and accounting policies.
On the other hand, if the differences between the companies or transactions are so material that
it is not possible to perform a reasonably accurate adjustment, then the comparables should
be rejected.

3. Mentor Graphics (ibid) and Egain Communication (P.) Ltd. v. Income-tax Officer

It was held in this case that a working capital adjustment should not be performed in a particular
case if its effect would be very marginal.

4. John Deere India Pvt Ltd v. Assistant Commissioner of Income Tax

In this case it was held that working capital is a factor which influences the price in the open
market and therefore requisite adjustment on account of working capital has to be made while
determining arms length operating margin of comparables.

A remaining difficulty is the subjective question of determining what a reasonably

accurate comparability adjustment is addressed in the following judicial

5. Sony India (P.) Ltd. v. Deputy Commissioner of Income-tax

ITAT upheld an overall flat adjustment of 20 per cent proposed by the Transfer Pricing Officer
for differences in intangible ownership and risks assumed in the controlled transaction and
comparables as being fair and reasonable

6. CIT v. Philips Software Centre Pvt. Ltd. (contrary to the above case)

In this case, the High Court of India examined whether the Tribunal was correct in allowing a
flat comparability adjustment of 11.72% (6.46% working capital adjustment +5.25% risk
ignoring all important issues like the quality of adjustment data, purpose and reliability of the
adjustment performed to be considered before making adjustment on account of capital and
risk, found this contrary to Rule 10B(3)(ii)1 which provides for only reasonably accurate
adjustment, and accordingly stayed the operation of judgement of ITAT.

Rule 10 (3)- 3) An uncontrolled transaction shall be comparable to an international transaction [or a
specified domestic 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;
(ii) Reasonably accurate adjustments can be made to eliminate the material effects of such
7. NITT DATA India Enterprise Application Services Pvt Ltd v. Assistant commissioner of
Income Tax

It was held in this case that revenue authorities were not justified in making negative working
capital adjustment in the course of transfer pricing adjustments.
The reason for such an order passes was that the assessee did not pay interest on working capital
loans and did not bear any working capital risk.
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About CA. Sudha G. Bhushan :

Sudha is qualified Chartered Accountant and a Company Secretary with more
than a decade of experience in the Foreign Exchange Management Act, RBI,
Transfer pricing and International taxation matters. She is a noted speaker and
Her articles are regularly published in the Journals of several institutes and at
various other forums and has authored the following books:
Practical aspects of FDI in India published by Institute of Company
secretaries of India
Due Diligence under Foreign Exchange Management Act, 1999 published by CCH.
Comprehensive Guide to Foreign Exchange Management in two volumes published by
Practical Guide to Foreign Exchange Management published by CCH, a Walter Kluwers
Handbook on FEMA, Publication of Institute of Chartered Accountants of India

A scholar throughout her life she has been awarded many awards and recognitions including
Women Empowerment through CA Profession by Northern India Regional Council (NIRC) of
Institute of Chartered Accountants of India (ICAI). Backed by experience in International firms she
has extensive experience of handling international transactions. She advises corporate as well as
government authorities in lot of intricate transactions. Rendering tax and regulatory advisory
services, she has overseen and played a crucial role in the execution of complex international
transactions involving issues revolving around tax, repatriation, minimization of tax exposure,
Foreign Investment (Inbound and outbound) etc.
She is on the Board of many esteemed listed companies as Independent director. She is member of
Committee of International Taxation of WIRC, ICAI, Member of Editorial Committee of WIRC of
ICAI and Committee of women empowerment of ICAI.

She can be contacted at sudha@taxpertpro.com || 09769033172