Turn to the turnover filter for transfer pricing

Is a company with a turnover of Rs 10 crore comparable to a company with turnover exceeding Rs 1,000 crore? In other words, is a company’s profitability influenced by its turnover? The answer is important from a transfer pricing perspective, as comparability is vital in determining whether prices charged in intra-group transactions are at arm’s length. Unfortunately, there is no clear answer. Tax tribunals have given conflicting decisions, and it has been referred to a Special Bench.

In order to find comparable companies, certain quantitative filters are applied to reject a large number of obviously different companies; the remainder are taken up for extensive examination. “Turnover filter” is commonly used, where the underlying logic is “economies of scale”. In simple terms, it means that efficiency of production increases as the number of goods produced increases. Alternatively, as a company grows and its production volume increases, there is a better chance to decrease production costs. Further, with increased size, companies develop expertise or intangibles which, in turn, further increase turnover.

The 18th-century philosopher and economist Adam Smith identified division of labour and specialisation as the two key means to achieving higher return on production — employees would not only be able to concentrate on a specific task but also, with time, improve the skills necessary for the job. There may be other reasons too for achieving economies of scale. However, this increase has limitations. After a point, due to various factors such as an increase in coordination costs, a plateau is reached and profitability may be reduced.

The Organisation for Economic Co-operation and Development’s transfer pricing guidelines for multinational enterprises and tax administrations finds the size criteria — in terms of sales, assets and employees — as one of the most commonly used quantitative criteria. It notes that “the size of the transaction in absolute value or in proportion to the activities of the parties might affect the relative competitive positions of the buyer and seller and therefore comparability”.

In other words, turnover could impact comparability and profit margins. Tax tribunals have divergent views on this filter. In fact, one tribunal has taken conflicting views in different cases. One view is that the turnover filter should not be applied as there is no correlation between turnover and profit potential. Another sees a direct nexus in view of the economies of scale and other factors, and the need for the filter in any scientific transfer pricing analysis. Even where the turnover filter is accepted, there is no clarity on the lower and upper ranges.

Given the conflicting views, the Delhi Income Tax Appellate Tribunal has set up a Special Bench to determine whether a turnover filter is needed in a comparability analysis to exclude companies. If yes, then what is the parameter for excluding high/ low turnover companies vis-à-vis the taxpayer. Also, is the turnover filter valid for service and distribution sectors, besides manufacturing.

There can be a strong case in favour of the turnover filter. Normally, growth in turnover occurs due to a corresponding growth in the factors responsible for the turnover. For example, a software service provider relies on two important factors — manpower and technology. Larger size implies that, over time, the company has successfully provided services to its clients and, therefore, developed a brand name, which puts it at advantage when seeking new work and premium rates. A stronger name also attracts talent. Finally, it can join an exclusive group of companies capable of servicing large engagements. The turnover filter matters, its application depends on the specific industry and the facts of the case. Making one determination for all industries and companies might be counterproductive. Whether turnover can affect profitability is not a question of law but of economics, and requires intensive analysis. However, a definite and considered decision by the Special Bench will provide certainty on the applicability of the turnover filter.

S.P. Singh is Senior Director and Neeta Punjabi is Manager, Deloitte Haskins & Sells

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