Transfer Pricing for CFOs / Tax Heads (Learning Byte 01)
When to use Cash Profit as a Profit Level Indicator?
Normally depreciation forms part of operating expenses for comparing profit ratios for arms length testing. However, there are situations wherein depreciation can be left out and cash profit be used for Transfer Pricing analysis. This can be when:
For example it is the first year of manufacturing operations and assesse's fixed cost is high along with capacity under utilization; and/ or
Different rates or methodologies are used for computing depreciation between assesses and comparable; and / or
Insufficient data is available to undertake meaningful depreciation/ capacity under utilization adjustment
Arms length results alter drastically with inclusion or exclusion of depreciation - Assesses is at arms length using cash profit but not if depreciation is included in operating cost.
Important to note that there should be some exceptional circumstances to warrant exclusion of depreciation such as first year of operations, higher depreciation rates etc that warrant exclusion. Merely higher quantum of depreciation in absolute or relative terms is not sufficient by itself.