Defending Loss making companies

APPROACH FOR DEFENDING TRANSFER PRICES OF LOSSMAKING COMPANIES

While preparing TP documentation, in instances where companies have incurred losses during the financial year, defending transfer prices using profitability analysis could prove challenging. In such situations, we have noticed cases where taxpayers resort to adopting CUP/Other Method to determine the arm’s length price, as against net profit ratios using Transactional Net Margin Method (TNMM). However in majority of the cases, they are not backed by robust supportings to approve the application of CUP/Other method, & the defence in the TP documentation is done referencing prevailing industry rates. Such adhoc basis would not stand the test of time during TP assessments.

Even in loss making situations it is still possible to adopt TNMM to defend your transfer price, if these losses were incurred due to genuine business reasons, the impact of which could be quantified in the form of suitable economic adjustments.

The Indian regulations, OECD guidelines, judicial pronouncements recognise the need to undertake economic adjustments to enhance comparability between tested party & uncontrolled transactions. Few adjustments which can be performed under TNMM are:

1. Capacity utilisation adjustment – It is performed to neutralize the impact of under absorption of a company’s fixed costs vis-a-vis comparables, in years where company has not operated at the optimal installed capacity. Currently there is no statutory requirement to publish capacity details in financials, hence obtaining capacity details would pose difficulties. However there are alternative approaches such as industry capacity, depreciation adjustment/Fixed cost adjustment or Breakeven point analysis
2. Working capital adjustment – It factors time value of money where there are differences in working capital levels between the tested party & comparables
3. Forex adjustment – In light of rupee depreciating heavily against foreign currencies, a forex fluctuation adjustment would be appropriate to substantiate dip in margins, in cases the tested party has significant imports in comparison with comparables. This is different from forex loss resulting on account of translation exposure appearing in the financials
4. Customs duty adjustment – This eliminates impact of higher customs duty incurred by the taxpayer while importing goods vis-à-vis comparables who might predominantly make local purchases

However one needs to bear in mind that any adjustment which can be claimed depends on the functional, asset and risk (FAR)profile & characterisation of the tax payer. Hence these cannot be randomly applied without it being in coherence to the FAR profile.