Export Turnover Filter - a parameter of comparing geographical location of markets?

October 25,2017
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Sumeet Khurana (Director Direct Tax, Lakshmikumaran & Sridharan Attorneys)

Background

“Comparability analysis” is at the heart of the application of the arm’s length principle[1]. One of the key economically relevant characteristic to be examined in the comparability analysis is the economic circumstances of the parties and of the market[2] in which the parties operate[3]. The reason being that Arm’s length prices may vary across different markets even for transactions involving the same property or services[4]. This parameter of ‘geographic location of market’ has lead to adoption of ‘export turnover filter’ whereby Transfer Pricing Officers (‘TPOs’) insist that if the taxpayer is an exporter then the comparable should also have export earnings of a certain degree. The Author through the present article seeks to explore the dimensions of this filter deciphering its rationale and scope in Indian context.

Fundamentals

It may be easily accepted that the price (or the profit embedded therein) of goods or services may be influenced by[5]:

  1. availability of local country infrastructure[6];
  2. the relative availability of a pool of trained or educated workers[7];
  3. proximity to profitable markets[8];
  4. the levels of supply in the market as a whole and in particular regions[9];
  5. Requirement of government license to operate and carry on business[10];
  6. costs of production and transportation (location savings) [11];
  7. the levels of demand in the market as a whole and in particular regions[12]; and
  8. consumer purchasing power[13].

Thus, the necessity of comparison of geographical location of markets cannot be overemphasized. A point to be highlighted here is that items (a) to (f) above certainly refer to geographical location of production / supplier while points (g) and (h) above are capable of being perceived as pertaining to geographical location of customer/sale. The issue that the Author seeks to examine is that which of the following geographical comparison needs to be considered:

Parties

Geography of production

Geography of customer / sale

Tested party

(A)

(C)

Potential comparable

(B)

(D)

Author proceeds on the footing that (A) and (B) necessarily need to be comparable in order to treat the potential comparable as a proper comparable to the tested party. This proposition is evident from OECD TP Guidelines (OECD TPG), UN Practical Manual for TP for Developing Countries as well as US IRS Regulations on TP. As noted above, OECD TPG seem to warrant comparability between (C) and (D) as well.

Before moving further, it will be important to consider the jurisprudence on this point.

In the case of GlaxoSmithKline[14] the Tax Court of Canada refused to treat the sale transaction to European market as comparable to taxpayer’s domestic sales within Canada holding as under:

“The European markets and the European transactions differed significantly from the Canadian market and the Canadian transactions and it is not possible to compensate for those differences.

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