Transfer pricing

6 January 2011

International Tax Alert
News and views from Transfer Pricing

Mumbai Tribunal upholds TP adjustment that substituted taxpayer’s Transactional Net Margin Method with Comparable Uncontrolled Price Method
Executive summary
The Mumbai Income-tax Appellate Tribunal (Tribunal), in a ruling in the case of Serdia Pharmaceuticals (India) Private Limited (Taxpayer), has adjudicatedon certain transfer pricing (TP) issues with respect to determining the arm’s length price (ALP) for the import of generic drugs by the taxpayer from its associated enterprises (AE). The Tribunal rejected the Taxpayer’s analysis based on the Transactional Net Margin Method (TNMM) to test the arm’s length price of its international transactions. According to the Tribunal, the exercise of selectingthe most appropriate method implies that the appropriateness of a method is to be ranked in some order. Accordingly, it is open to the Tax Authority to reject the TNMM and adopt the Comparable Uncontrolled Price (CUP) method on the basis that the latter is most appropriate on the facts of the case. The Tribunal found that the CUP method is the most appropriate method to determine the arm’s lengthprice in the case of generic drug manufacturers so long as comparables are available. As the products imported are generic drugs and not patent protected, the CUP method
1 ITA Nos: 2469/Mum/06, 3032/Mum/07 and 2531/Mum/08.
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could be used. The Tribunal also observed that while innovators of drugs are allowed monopolistic pricing during the period when patents are in force so as to recoup theresearch and development (R&D) costs, once the patent period expires, the higher pricing of the drug vis-à-vis prices of generic drugs manufactured by competitors [Yffgl Z] bmklaÕ]\ gf l`] _jgmf\ g^ heavy R&D costs.

arithmetic mean of the operating margins of the comparable companies. Accordingly, the international transactions are at arm’s length. During the audit proceedings, the TaxAuthority, based on the inputs from the Taxpayer, collected information on the prices at which the APIs are purchased by other manufacturers of competing FDFs. The Tax Authority observed that the APIs purchased by the Taxpayer from its AEs are not unique items since other manufacturers are also purchasing the same APIs, though from different vendors. The Tax Authority thus rejected the TNMM applied by theTaxpayer and proceeded to compute the ALP on the basis of the CUP method. With respect to the CUP of one of the APIs, the Tax Authority held that the price paid to the AE was more than four times the ALP. For a CUP of another of the APIs, the Tax Authority held the price paid to the AE to be more than 2.5 times the ALP after allowing an adjustment for differences in quality norms and puritystandards. Being aggrieved by the Tax Authority’s order, the Taxpayer hj]^]jj]\ Yf Yhh]Yd Yl l`] Õjkl% d]n]d Yhh]ddYl] Yml`gjalq& L`] Õjkl appellate authority decided the matter in favor of the Revenue Authority. L`] LYphYq]j Õd]\ Yf Yhh]Yd Z]^gj] the Tribunal, the second-level appellate authority, against the gj\]j g^ l`] Õjkl%d]n]d Yhh]ddYl] authority.

Contentions of the Taxpayer
The Indian TPrules do not prescribe a hierarchy of methods for ascertaining the ALP. The right to choose the most appropriate method to determine the ALP rests with the taxpayer and unless the Tax Authority can demonstrate that the ALP so computed is not in accordance with the rules, the Tax Authority cannot reject the method chosen by the taxpayer. Developing a new drug entails huge costs and efforts and thatis the reason why original inventors need to charge higher prices for their products. It is thus submitted that the price at which a drug is sold by the enterprise that has invented the said drug cannot be compared with the price at which other enterprises manufacture and sell the same drug. The Indian TP rules prescribe strict comparability requirements for the use of CUP. The API manufactured...