Transfer Pricing

Comparable Uncontrolled Price (CUP) Method

Transfer Pricing

Comparable Uncontrolled Price (CUP) Method

1. Introduction:

The Comparable Uncontrolled Price (CUP) method is widely regarded as one of the most direct and reliable methods for determining the Arm's Length Price (ALP) in international transfer pricing. This method involves comparing the price charged in a controlled transaction between associated enterprises to the price charged for a similar transaction between unrelated parties under comparable circumstances. It ensures that transactions between related entities are priced fairly as if they were conducted between independent parties in an open market.

2. Key Features of CUP Method:

The CUP method has certain unique features that make it a preferred choice in many situations. It focuses heavily on finding a high degree of similarity between the products, services, or transactions being compared. Below are some key characteristics of this method:

It requires a very close similarity between the products or services involved in the controlled and uncontrolled transactions. Even small differences may require careful adjustments to maintain comparability.

Minor differences between controlled and uncontrolled transactions can be adjusted using reliable data, ensuring that the results of the comparison are accurate and meaningful.

CUP is considered the most reliable method when identical or nearly identical transactions exist between unrelated parties, as it directly reflects the conditions prevailing in an open market.

3. Transactional Methods Overview:

Transfer pricing regulations allow for multiple transactional methods to determine the arm’s length price. Each method is selected based on the nature of the transaction and the availability of data. Below are the three primary transactional methods:

CUP (Comparable Uncontrolled Price Method): This is the most direct and reliable method. It compares the price of goods or services in controlled transactions with the price of similar goods or services in uncontrolled transactions. Close similarity of products is crucial for the CUP method to work effectively.

RPM (Resale Price Method): This method is used primarily for distributors. It tests whether the distributor's gross margins are consistent with industry norms, focusing on the similarity of functions rather than the physical product itself.

CPM (Cost Plus Method): Used for manufacturing activities, this method involves analyzing direct and indirect production costs and adding an appropriate markup to determine the arm's length price.

4. Internal vs External CUP:

The CUP method can be applied using either internal or external data sources. Internal CUP involves comparing the prices charged within the same group but with unrelated entities, making it highly reliable since it relates directly to the company’s own data. External CUP, on the other hand, uses data from entirely unrelated parties, such as market databases or government publications. Internal CUP is generally preferred, as it provides more accurate and verifiable benchmarks.

5. Steps for Applying CUP Method:

The following systematic steps should be followed when applying the CUP method to determine the arm’s length price. Each step must be carefully documented to ensure transparency and compliance with regulatory requirements:

(i) Identify comparable uncontrolled transactions or prices that are similar to the controlled transaction being tested. The closer the similarity, the more reliable the results will be.

(ii) Make necessary adjustments to account for differences between the controlled and uncontrolled transactions. These differences could include geographic location, contractual terms, or volume of goods and services involved.

(iii) The adjusted price of the comparable transaction is treated as the arm's length price for the controlled transaction.

(iv) Compare the adjusted price with the price actually charged in the controlled transaction to identify variances.

(v) If a difference exists, adjust the controlled transaction price to bring it in line with the arm's length price.

6. Comparability Factors:

Several factors can influence the reliability of the CUP method. These factors must be evaluated carefully to ensure accurate results. The primary factors are listed below:

(i) Similarity of product: The products or services involved must be identical or nearly identical. Even minor differences can significantly affect pricing and require precise adjustments.

(ii) Contractual terms: Differences in terms such as credit periods, delivery responsibilities, or warranty conditions may impact pricing and need to be factored into the comparison.

(iii) Geographic and economic conditions: Prices may vary depending on the region where the transaction occurs or economic conditions in different markets. Adjustments should be made to reflect these differences.

7. Types of Differences in Transactions:

While comparing controlled and uncontrolled transactions, differences often arise. These differences are categorized as follows:

(i) No Difference: When there are no differences between the controlled and uncontrolled transactions, the CUP method is the most direct and reliable for determining the arm's length price.

(ii) Minor Differences: Small differences that can be reasonably and accurately adjusted using reliable data. These adjustments ensure that the final comparison remains meaningful.

(iii) Material Differences: Significant differences that cannot be accurately adjusted. In such cases, the CUP method may not be appropriate as it would not yield reliable results.

8. Sources of Data for CUP:

Accurate and reliable data are critical for applying the CUP method. Data can be sourced from both internal and external channels:

(i) Internal sources: These include the company’s own books of accounts, agreements, and records of transactions with unrelated parties. Internal CUP data are generally more reliable as they are specific to the entity’s operations.

(ii) External sources: Publicly available data, such as stock exchange rates, trade directories, government publications, and commodity exchange prices. While external data provide broader benchmarks, they may require careful validation.

9. Application Examples:

The following examples illustrate the practical application of the CUP method in real-world scenarios:

(i) UK Company ABC Ltd sold personal computers to both related and unrelated parties. Since the products and terms were nearly identical, the CUP method was applied successfully to compare prices after making minor adjustments.

(ii) A UK company with valuable trademarks could not apply the CUP method because the trademark value was included in controlled transactions but absent in uncontrolled ones, leading to incomparable conditions.

(iii) UK Company X Ltd sold manufacturing machinery components to related and unrelated entities. Adjustments were made for modifications required in controlled transactions, enabling effective use of the CUP method.

10. Case Study – Malaysian Bank:

A Malaysian bank with branches in India applied the CUP method to benchmark interest rates and foreign exchange transactions. The bank compared its rates with publicly available benchmarks like LIBOR and Reuters data to determine if its transactions were consistent with the arm's length principle. By using accurate market data, the bank ensured compliance and avoided disputes with tax authorities.

11. Case Laws on CUP methods:

(i) Ciba India Ltd. v. DDIT (IT) [2013] 38 taxmann.com 189 (Mumbai - Trib.): Ciba India Ltd. entered into a technology transfer agreement with its Swiss parent company, Ciba Specialty Chemicals Inc., for an exclusive license to use technology for manufacturing certain products. As per RBI approval, royalty was payable at 4% of domestic and export sales. The assessee, in its Transfer Pricing (TP) report, applied the Comparable Uncontrolled Price (CUP) Method to benchmark the royalty payment. However, the Transfer Pricing Officer (TPO) rejected CUP and adopted Transactional Net Margin Method (TNMM), determining the royalty value as nil. The ITAT noted that in a subsequent assessment year, on identical facts, the Dispute Resolution Panel (DRP) had accepted CUP as the most appropriate method for benchmarking royalty payments. Since no distinguishing facts were presented for the current year, the Tribunal held that CUP should be consistently applied, directing the Assessing Officer to re-examine and make adjustments based on CUP. Held in favour of the assessee.

(ii) Bharti Airtel Ltd. v. ACIT [2014] 43 taxmann.com 50 (Delhi - Trib.) : Bharti Airtel provided only the Indian domestic leg of international calls under bilateral arrangements with many overseas operators, including AE Singtel. To benchmark the price for carriage/termination services, the assessee used internal CUP, comparing AE rates with rates charged to ~30 non-AEs worldwide. The TPO rejected all but one comparable, insisting comparables must be from the same or nearest geographic market, and made an ALP upward adjustment. The Tribunal held geography per se is irrelevant for CUP unless it leads to materially different market conditions (Rule 10B). Here, Bharti’s service was the same India-segment activity regardless of the call’s origin; the TPO showed no market-condition differences between AE and non-AE transactions. Therefore, the assessee’s multiple internal CUPs were valid, and the exclusion based only on location lacked a legal basis. The ALP adjustment was deleted, affirming CUP as the most appropriate method for the service pricing.

(iii) Indian Additives Ltd. v. ACIT [2011] 15 taxmann.com 37 (Chennai): Indian Additives Ltd., a joint venture between COCL (USA) and CPCL (India), imported raw materials and finished goods from its AEs in Singapore and France. For raw materials worth ₹13.55 crores, the assessee used the Comparable Uncontrolled Price (CUP) method, citing specific comparable prices for two items—Dodecyl Phenol and Zinc Di Thio Phosphates—from unrelated parties. Since the AE prices were lower than market prices, no adjustment was made. The TPO rejected CUP without proper reasons and instead applied Transactional Net Margin Method (TNMM), using financials of a small company, IIP, whose turnover (₹14 lakhs) and operations were vastly different from the assessee (turnover ₹120 crores). The ITAT held that CUP was correctly applied as it relied on direct comparable uncontrolled transactions, fulfilling Section 92C and Rule 10B. TNMM was wrongly used because IIP was not functionally or economically comparable, having no excise duty or major manufacturing costs. Thus, the CUP-based valuation for raw materials was upheld, and the TPO’s adjustment of ₹1.22 crores was deleted.

(iv) Hughes Systique India (P.) Ltd. v. DCIT [2014] 50 taxmann.com 25 (Delhi - Trib.): Hughes Systique India, engaged in software development services, provided services to its AEs. In its Transfer Pricing (TP) study, the assessee adopted Comparable Uncontrolled Price (CUP) method as the Most Appropriate Method (MAM), with internal TNMM as a corroborative method. The TPO rejected CUP and applied external TNMM, selecting new comparables and making additions to the ALP. The DRP upheld the TPO’s approach. The Tribunal observed that in earlier years (AYs 2007-08 and 2008-09), it had already held that internal CUP should be applied first, and only if CUP was found inapplicable, TNMM could be used. As there was no change in facts or circumstances, the Tribunal followed its earlier decision and set aside the ALP adjustment. The matter was remanded to the TPO to reassess using CUP, with directions for the assessee to provide complete details for proper comparison. This confirmed CUP as the preferred method for benchmarking software development services.

(v) Nihilent Technologies (P.) Ltd. v. DCIT [2014] 50 taxmann.com 144 (Pune - Trib.): Nihilent Technologies, engaged in software development and consultancy services, rendered services to its Associated Enterprise (AE), Nedcor Bank of South Africa. The assessee adopted the Comparable Uncontrolled Price (CUP) method for benchmarking, claiming that the rates charged to AE were equal to or higher than rates charged to unrelated parties, such as Microsoft, and also higher than rates charged by other service providers like Zensar to the same AE. The TPO rejected CUP and applied Transactional Net Margin Method (TNMM) using external comparables, The ITAT observed that direct evidence of comparable transactions existed, including invoices showing that the assessee charged higher rates to its AE than to third parties. Citing Rule 10B and OECD guidelines, the Tribunal held that when such direct comparables are available, CUP is the most direct and reliable method, and TNMM, being a method of last resort, cannot override CUP. The Tribunal therefore upheld CUP as the most appropriate method, deleted the TNMM-based adjustment, and directed acceptance of the assessee’s ALP determination.

(vi) Apollo Health Street Ltd. v. DCIT [2014] 48 taxmann.com 111 (Hyderabad - Trib.) Apollo Health Street Ltd., a global healthcare BPO company, provided a corporate guarantee to its U.S. subsidiary for securing a loan from Barclays Capital and Bank of India, New York. The company did not charge any guarantee fee and did not report this as an international transaction. The TPO treated the guarantee as an international transaction, assumed the subsidiary’s credit rating had improved from BBB- to A+, and applied a 4.12% rate based on the difference between the domestic bond yield and U.S. loan rate, making an ALP adjustment of ₹30.92 crore. The assessee argued that the TPO’s approach was arbitrary and that internal CUP, based on a similar bank guarantee given by Andhra Bank at 0.92%, should have been applied. The ITAT held that the TPO failed to analyze the AE’s creditworthiness and wrongly compared domestic bond yields with U.S. loans, which was inappropriate. Following the Glenmark Pharmaceuticals ruling, the Tribunal stated that CUP is the most appropriate method for benchmarking corporate guarantees. The matter was remanded to the TPO to re-evaluate using proper CUP analysis and consider the assessee’s internal CUP evidence.

(vii) Consider following case laws also for studying CUP method.

i. Glenmark Pharmaceutical Ltd. vs. Addl. CIT. [2014] 62 SOT 79/43 taxmann.com 191 (Mum. - Trib.)

ii. L.G. Electronics India (P.) Ltd. vs. ACIT [2013] 29 taxmann.com 300 (Delhi - Trib.) (SB)

iii. Serdia Pharmaceuticals (India) (P.) Ltd. vs. ACIT [2011] 44 SOT 391 (Mum.)

iv. Iljin Automotive (P.) Ltd. vs. ACIT [2011] 16 taxmann.com 225 (Chennai)

v. Kodak Polychrome Graphics (I) (P.) Ltd. vs. Add. CIT, [2013] 36 taxmann. com 42 (Mumbai - Trib.)

vi. Gharda Chemicals Ltd. vs. Dy. CIT, [2010] 35 SOT 406 (MUM.)

vii. DCIT v. Vodafone India Services (P.) Ltd. [2011] 12 taxmann.com 412 (Mum.)

viii. ACIT v. Tara Ultimo (P.) Ltd. [2011] 13 taxmann.com 184 (Mum.)

ix. ACIT v. Genesys International Corpn. Ltd. [2012] 26 taxmann.com 102 (Mum.)