By Smarak Swain, New Delhi
India’s Income Tax Appellate Tribunal recently set aside an order of the assessing authority in the case of GCO Technologies Centre Pvt Ltd (Case No. 6310/Mum/2014, dated 05.11.2020), in which the assessing authority had rejected a risk adjustment to the comparables’ margin under the transactional net margin method (TNMM).
GCO Technologies was a captive service provider of M/s. Global Conference Organizers B.V., Netherlands that was remunerated by the principal under a cost plus mark-up model.
The taxpayer had argued in front of the assessing authority that it did not take any market risk, being a captive entity. The comparables found by the assessing authority from public databases were of entrepreneurial companies that took on full market risk. The higher the risk, the higher the reward. Hence, the taxpayer claimed that a risk adjustment to the margins of comparable companies was warranted. The taxpayer had claimed an overall risk adjustment of 2% on the arm’s length price. The assessing authority rejected the taxpayer’s claim on the grounds that the risk adjustment had not been quantified by the taxpayer.
The Tribunal found merit in the taxpayer’s contention that its risk level was different from that of the comparables, and hence risk adjustment should be allowed. Accordingly, it directed the assessing authority to consider the taxpayer’s claim for benchmarking the international transactions under the TNMM. However, the Tribunal was silent on how to quantify the risk and compute the risk adjustment.
Comparability adjustments are mandated when a tested party is found to be markedly different from comparables upon an analysis of functions, assets, risks, and markets (FARM). A good comparable is one in which reasonably accurate adjustments can be made to eliminate the effect of differences in FARM between the tested party and the comparable.
However, risk adjustment is not frequently applied in transfer pricing practice internationally. One reason is that risk differences are difficult to ascertain with reasonable accuracy. Where the tested party is a captive cost centre (contract / toll manufacturer or a service provider) of an MNE group, it bears limited market risk. Entrepreneurial companies, which form part of the comparables’ set, usually bear full market risk.
However, where the tested party has a single customer or a couple of customers in the same MNE group, it takes up high non-diversification risk, while the comparables diversify their client basket to reduce this risk.
There are two types of risks a company faces – systematic risk and unsystematic risk. Market risk is a systematic risk, and is higher for a comparable than the tested party. Non-diversification risk is an unsystematic risk and is higher for the tested party. It is difficult to ascertain the unsystematic risk taken up by comparables merely from their annual report.
A second reason why risk adjustment is not frequently undertaken probably is that when considering a bunch of comparables, differences in the level of systematic and unsystematic risk even out, and there is no need to engage in complex quantification by making numerous assumptions.
Risk quantification
While in this case, the Tribunal was silent on means to quantify risk adjustment, in an earlier case, Motorola Solutions India Pvt Ltd, Case No. 5637/Del/2011, dtd 14.08.2014, the Tribunal weighed in on this issue.
In the Motorola case, the taxpayer had used the capital asset pricing model for risk adjustment. The assessing authority rejected this computation on several grounds. The tax authority claimed that the manner in which risk adjustment was calculated by the taxpayer was not followed in any country; that where the beta value of a comparable is not available, the beta is estimated on the basis of guideline companies on the stock market; and that beta of the tested party was assumed to be zero, whereas the beta would not be zero as return on capital fluctuates with changes in cost base in a cost plus model.
The Tribunal set aside the assessing authority’s decision and asked it to compute the risk adjustment under the capital asset pricing model by employing a technical expert.
Under a capital asset pricing model, a comparable’s weighted average cost of capital is calculated as:
Under a capital asset pricing model, a comparable’s weighted average cost of capital is calculated as:
WACC = WdCd(1-t) + WeCe
Where We = Weight of company’s equity to total finance = equity/(equity + debt)
Ce = RF + βc x RP + NDRc,
Where RF = risk free rate
βc = beta value of comparable
RM = risk premium
URc = premium for unsystematic risk
Difference in weighted average cost of capital of comparable at its risk level and at the risk level of tested party is:
Difference = [WdCd(1-t) +WeCe] – [WdCd(1-t) + WeCe’] = We (Ce – Ce’)
= We x (RF + βc x RP + URc – RF – βT x RP – URT)
= We x RP x (βc – bT) + We x (URc – URT)
This difference is applied to operating assets to find the risk adjustment for the specific comparable.
Now, there are two major shortcomings in this approach. First, the beta value of the tested party is often assumed as zero (βT = Ο), on the grounds that it takes up limited systematic risk. However, captive service providers and contract manufacturers still undertake operational and service delivery risks. Under the cost plus model, cost optimisation may lead to lower profits. Profits as a percentage of capital employed will differ with costs. Hence, the beta value in ‘limited risk’ entities would be low, but not zero.
Secondly, a comparable that has been operating in the market for quite some years and is outside the start-up phase may be assumed to be fully diversified and hence has UR = Ο.
Again, this is a broad assumption, required because it is difficult to determine the premium for unsystematic risk of comparable.
At the end of the day, even after making numerous assumptions and estimations, one cannot be sure if risk adjustment on comparables would yield positive or negative results.
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Smarak Swain — Views are personal.
Your presentation of the CAPM adjustment could be simplified in a couple of ways: (1) do this as a comparison of the unlevered betas; and (2) delete any reference to the alleged price of diversifiable risk. This issue could have been prominent in Westreco except for the fact that the IRS experts had a very confused presentation of the argument. The Indian cases could have had clearer presentations with the basic problem in both being that CAPM is about the return to assets not the return to total costs. So it is not surprising that the courts in each case gave little weight to arguments not clearly presented.
I see some valid comments on non-applicability of CAPM here. However, the fact that CAPM is on asset base and not cost base cannot cut water with courts, especially on concepts. The PLI for a particular comparable is OP/OC. The risk adjusted PLI is (OP – delta)/OC, where delta is the difference in profits at two different risk levels. Delta is calculated by applying difference in WACC on operating assets of the comparable. This way, the bases of CAPM and PLI don’t actually affect the applicability of CAPM – at least for the limited purpose of risk adjustment under TNMM.
Main challenge is in estimating the unsystematic risk of captive entities as well as comparables in public forums, in order to reasonably calculate wacc differences.
In the first case in above article, the tribunal did not even get into whether capm should be used or another method. What other methods are there? It did not get into this issue also. Revenue’s presentation was weak in the sense that they did not provide any metrics for unsystematic risk quantification, nor could they demonstrate that risk adjustment may increase the margins of comparable companies since the tested party takes up very high risk owing to having a single customer.