Background
The taxpayer was engaged in manufacturing material-handling equipment (industrial cranes and other types of cranes) and had aggregated its international transactions using the Transactional Net Margin Method (TNMM). The taxpayer identified six comparable companies and compared its entity-level margin (11.70%) with the margin of the comparables (2.76%) using multiple-year data.
During the assessment proceedings, the Transfer Pricing Officer looked at the taxpayer’s “segment-wise profitability” for the manufacturing, trading, and servicing segments. Based on this position, an adjustment was made concerning the manufacturing segment (2.41%) with the current year margins of the comparables (7.18%) using current year data selected by the taxpayer.
The Transfer Pricing Officer also made an adjustment concerning the trading segment, by applying the Resale Price Method to the extent of the difference in the arithmetic mean of the gross profit margin of the sale of traded goods to third parties (33.62%) and gross profit margin from the sale of goods to associated enterprises / related entities (20.20%).
The Transfer Pricing Officer further:
- Denied the taxpayer the benefit of a working capital adjustment
- Rejected the benefit of application of the +/- 5% safe harbor
On administrative appeal, the Dispute Resolution Panel upheld the adjustment with respect to the manufacturing segment, but agreed with the taxpayer that the Resale Price Method was not an appropriate method to apply. The panel thus directed the Assessing Officer to make an adjustment by comparing net margins earned by the taxpayer from sales to third parties (17.74%) to the margin earned by the taxpayer from sales to related entities (4.65%).
Tribunal’s decision
On appeal to the tribunal, it was noted that the Dispute Resolution Panel had not considered the taxpayer’s claims concerning the working capital adjustment. Thus, two issues concerning working capital were considered by the tribunal:
- Whether “working capital” constitutes a difference, if any, between the international transactions and the comparable uncontrolled transactions, or between the enterprises entering into such transactions?
- Whether this difference could materially affect the amount of net profit margin of relevant transactions in the open market?
The tribunal concluded that “net working capital”—i.e., current assets (accounts receivables + inventory) minus current liabilities (accounts payable)—affects pricing and, therefore, affects net margins, and that as such, it constitutes the “difference.”
Because the difference in arm’s length operating margin of the comparables before and after making the adjustment for working capital was up to 3.77%, the tribunal concluded that it was “material” and must be eliminated. Thus, the tribunal held that the difference on account of the working capital adjustment for determining the arm’s length operating margin of the comparables must be allowed.
The tribunal also allowed the +/- 5% adjustment, finding that this adjustment must be allowed even in situations when the difference in value of international transactions and its arm’s length price is greater than 5%.
Finally, the tribunal concluded that the transfer pricing adjustment must be determined in relation to the taxpayer’s international transactions, and not with respect to its entire sales. Because the data for controlled and uncontrolled costs is available and undisputed, the tribunal found such data was sufficient to arrive at the proportionate sales as related to international transactions with the associated enterprises.
To read a January 2012 report on this case, prepared by the KPMG member firm in India: Adjustment on account of working capital to be allowed if the difference could materially affect the amount of net profit margin of relevant transactions in the open market