Source: https://www.taxpertpro.com/blog/2018/03/22/working-capital-adjustments-transfer-pricing/
Timestamp: 2019-04-23 18:25:28+00:00

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Balance sheet adjustments are intended to account for different levels of inventories, receivables, payables, interest rates etc. The most common balance sheet adjustments made to reflect different levels of accounts receivable, account payable and inventory are known as working capital adjustments. As mentioned by the OECD, comparability adjustments should not be performed on a routine or mandatory basis but rather on a case by case basis depending on the facts and circumstances. Economic rationale Working capital of a business is the capital used in its day-to-day trading operations. Working capital is affected by numerous business incidences. It is very common for tested party and each of the potential comparables to differ materially in the amount of working capital (inventory, accounts receivables and payable).Such differences are mainly caused due to differences in the terms of purchase and sale, levels of inventory etc. For example: If the business advances a trade credit of (say) 60 days, its cash gets locked up for 60 days and reduces the working capital. It will have to borrow from open market to meet its working capital requirement, and hence incur expenses. Similarly, if it avails of trade credit of 60 days, it has surplus cash at its disposal. It will need to borrow less money to fund operational requirements. Hence, working capital position affects the additional cost incurred by a business by way of interest on borrowing from the open market. Working capital adjustments seeks to adjust for the differences in time value of money between tested parties and potential comparables with an assumption that differences should be reflected in profits Working capital adjustment has a strong rationale in economic theory. It facilitates to increase the comparability between the tested party and comparables working in an industry which is competitive. Working capital adjustment can work out to be positive or negative. A positive working capital adjustment (WCA) will tend to reduce the arm’s length PLI while a negative WCA will tend to increase the arm’s length PLI. Whether WCA is positive or negative should not ideally matter, for it’s an adjustment to increase comparability. However, these adjustments should be done only if such adjustments can be reasonably made and they improve comparability The process of calculating working capital adjustments is as under: • Identify differences in the levels of working capital. Generally, trade receivables, inventory and trade payables are the three accounts considered. The transactional net margin method is applied relative to an appropriate base, for example, costs, sales or assets. So, if the appropriate base is sales, then any differences in working capital levels should be measured relative to sales. • Calculate a value for differences in levels of working capital between the tested party and the comparable relative to the appropriate base and reflecting the time value of money by use of an appropriate interest rate. • Adjust the result to reflect differences in levels of working capital. The following example adjusts the comparable’s result to reflect the tested party’s levels of working capital. Alternative calculations are to adjust the tested party’s results to reflect the comparables levels of working capital or to adjust both the tested party and the comparable’s results to reflect “zero” working capital.
Observations Generally, a question arises while making working capital adjustments as to at what point in time are the Receivables, Inventory and Payables compared between the Tested Party. In the above example, their levels are compared on the last day of the financial year. This may not be appropriate if it does not portray representative levels of working capital over the year. In such cases averages can be used to carry out working capital adjustments. Another major issue in working capital adjustments involves the selection of appropriate interest rate. The rate or rates of interest should be determined with reference to rate (s) of interest applicable to a commercial enterprise operating in the same market as a tested party. In cases of tested party’s working capital being negative (that is Payables > Receivables + Inventory) a different rate is applicable. In the above example, same rate of interest is assumed to be the same for both the parties. Judicial Pronouncements 1. Dy.CIT v. BMC Software India Pvt Ltd.  In this case, the assessee was engaged in rendering software development services.  The assessee received advances from its group entities against services to be performed.  The tribunal allowed the benefit of working Capital Adjustment to assessee after taking into account advances so received from customers.
Philips Software Centre (P.) Ltd. v. ACIT  In this case the ITAT approved comparability adjustments being made to eliminate differences on account of different functions, assets and risks, and specifically for differences in risk profile, working capital and accounting policies.  On the other hand, if the differences between the companies or transactions are so material that it is not possible to perform a reasonably accurate adjustment, then the “comparables” should be rejected. 3. Mentor Graphics (ibid) and Egain Communication (P.) Ltd. v. Income-tax Officer  It was held in this case that a working capital adjustment should not be performed in a particular case if its effect would be very marginal. 4. John Deere India Pvt Ltd v. Assistant Commissioner of Income Tax  In this case it was held that working capital is a factor which influences the price in the open market and therefore requisite adjustment on account of working capital has to be made while determining arm’s length operating margin of comparables. A remaining difficulty is the subjective question of determining what a “reasonably accurate comparability adjustment” is addressed in the following judicial pronouncements. 5. Sony India (P.) Ltd. v. Deputy Commissioner of Income-tax  ITAT upheld an overall flat adjustment of 20 per cent proposed by the Transfer Pricing Officer for differences in intangible ownership and risks assumed in the controlled transaction and “comparables” as being “fair and reasonable” 6. CIT v. Philips Software Centre Pvt. Ltd. (contrary to the above case)  In this case, the High Court of India examined whether the Tribunal was correct in allowing a flat comparability adjustment of 11.72% (6.46% working capital adjustment +5.25% risk adjustment)  “ignoring all important issues like the quality of adjustment data, purpose and reliability of the adjustment performed to be considered before making adjustment on account of capital and risk”, found this contrary to Rule 10B(3)(ii)1 which provides for only reasonably accurate adjustment, and accordingly stayed the operation of judgement of ITAT. 1 Rule 10 (3)- 3) An uncontrolled transaction shall be comparable to an international transaction [or a specified domestic transaction] if: – (i) none of the differences, if any, between the transactions being compared, or between the enterprises entering into such transactions are likely to materially affect the price or cost charged or paid in, or the profit arising from, such transactions in the open market; (ii) Reasonably accurate adjustments can be made to eliminate the material effects of such differences.
NITT DATA India Enterprise Application Services Pvt Ltd v. Assistant commissioner of Income Tax  It was held in this case that revenue authorities were not justified in making negative working capital adjustment in the course of transfer pricing adjustments.  The reason for such an order passes was that the assessee did not pay interest on working capital loans and did not bear any working capital risk.

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