Capacity utilization adjustment in transfer pricing – a mathematical fallacy or myth? - Part I

February 19,2018
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Rahul K Mitra (Partner, KPMG India)

Given that transfer pricing (TP) is not an exact science, taxpayers and Revenue Officers often end up spending lot of time in trying to make economic adjustments to the arms or financial results of either the taxpayers or comparable companies, in order to arrive at an optimal arm’s length price (ALP), since, as people tread on the path of comparability analyses, they find that different people have arms of varying lengths. If one makes an attempt to compare the characteristics of two diametrically opposite individuals like Sachin Tendulkar and Joel Garner; and then grapple with either trying to shorten the arms of Joel Garner or lengthen those of Sachin Tendulkar, in order to fallaciously obtain parity, then, to put it in the words of Gladstone, the attempt may either be a catastrophic disaster or disastrous catastrophe, depending upon whether the very attempt to select the said two stalwarts for comparison can be termed as a disaster or catastrophe in the first place, such that the subsequent exercise of making adjustments to their arms become a mere fallacy or meaningless exercise.

The type of economic adjustment, which has caught maximum amount of attention in India, is the one relating to capacity utilization. Taxpayers and Revenue Authorities, particularly taxpayers, have resorted to making such adjustment in order to moderate the profit margins of comparable companies on the ground that there exist significant disparity between the capacities utilized by the taxpayers and comparable companies chosen for determining ALP, generally under transactional net margin method (TNMM), which compares net profits of taxpayers and comparable companies. Tax Tribunals across the country have taken divergent stands in matters relating to granting or otherwise of adjustment on account of capacity utilization.

This article is aimed towards a dissertation on the entire concept of capacity utilization, which, very humbly stated, appears to be more of a mathematical fallacy, often being several leagues away from the very basics or fundamentals of TP. I shall address the issue as the article would unfold itself.

It is the golden rule of TP that attempt should be made to select comparable companies with characteristics as close to the “tested party” as possible, since it is always advisable to minimize the need or necessity of making economic adjustments for ironing out material differences between the comparable companies and the “tested party”, in order to achieve reliability in the overall exercise of comparability analysis.

Sometimes, resorting to economic adjustments, even after choosing the best available comparable companies, become inevitable. For example, making working capital adjustment in order to neutralize the impact on profit margins of the “tested party” and comparable companies, arising as a result of different levels of working capital, vis- -vis funds being locked, therein, is a very crucial and important economic adjustment to be carried out for determining the ALP. Similarly, needs may arise to make adjustments to profit margins, for comparable companies, which otherwise bear closest resemblances to the “tested party” as per comparable analysis carried out with most meticulous of precisions, having due regard to limitation of data available in databases, yet may differ with respect to some important attributes as compared to the “tested party”, e.g.


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