When Is the Berry Ratio the Right Profit Level Indicator for a Limited Risk Contract Manufacturer in India?

By CA Mithilesh Reddy, Founder and CEO, and CA Rajesh Vaishnav, Partner, Steadfast Business Consulting LLP | Transfer Pricing

Introduction

A profit level indicator is a ratio that expresses the tested party’s return against some measure of what it does. The transactional net margin method does not prescribe one. It allows the return to be measured against costs, against sales, against assets, or against any other base that is relevant, and the choice of base is part of applying the method rather than a preliminary to it. Choosing the wrong base produces a comparison between two things that are not alike, however carefully the comparables are screened.

The base that matters here is operating expenses, and the ratio built on it is the Berry ratio. It is the wrong indicator far more often than it is the right one, and a case built on it fails where the functional analysis does not support it. It is not a way of improving a result. It is a conclusion that follows from a particular functional profile, and the profile has to be established first.

This note deals with the base to use where the tested party’s accounts are dominated by purchases it does not control. It covers what the Berry ratio measures and why that matters, the Indian legal authority permitting it and the limits that authority sets, the functional evidence that has to be established before the ratio can be defended, the recharacterisation argument the Revenue usually runs, and the classification reconciliation on which these cases are actually decided. The functional analysis that underpins all of it is dealt with separately in our note on FAR analysis for transfer pricing audit defence.

1. What the ratio measures and why that matters

The Berry ratio is gross profit divided by operating expenses. Expressed differently, it asks how much gross margin the business earns for each rupee it spends on running itself.

What makes it useful is what it leaves out. Cost of goods sold does not appear in the denominator. Where an entity buys components from an associated enterprise, assembles them and sells the output, and where it has no influence over what it pays for those components, the purchases are not a measure of anything the entity does. They are a number passing through its accounts. A cost plus margin computed on total cost treats that number as the base for the entity’s return, which means the return rises and falls with component prices the entity does not set.

Operating expenses, by contrast, are the entity’s own spending: its people, its premises, its plant running costs, its local functions. For a business whose contribution is assembly and local execution, those expenses are a reasonable proxy for the value it adds.

The OECD Transfer Pricing Guidelines describe the Berry ratio as appropriate in narrow circumstances, broadly where the value of the functions performed is proportional to operating expenses, the value of the functions is not materially affected by the value of the products distributed, and the taxpayer does not perform other significant functions that should be remunerated separately.

2. The Indian legal basis

Rule 10B(1)(e) of the Income-tax Rules, 1962 (now rule 79(1)(e) of the Income-tax Rules, 2026) sets out the transactional net margin method and permits the net profit margin realised to be computed “in relation to costs incurred or sales effected or assets employed or to be employed by the enterprise or having regard to any other relevant base”. The closing words are the statutory foundation.

The Delhi High Court settled the point in Sumitomo Corporation India (P.) Ltd. v. CIT, decided on 22 July 2016 in IT Appeal Nos. 381 and 382 of 2013, 702 of 2014 and 738 of 2015, by Muralidhar and Vibhu Bakhru JJ. The Court held that the words “any other relevant base” permit operating expenses to be used as the base, and that the transfer pricing officer’s view that only cost, sales or assets could be used was plainly erroneous.

The Court was equally clear about the limits, and a submission that quotes the first holding without the second is incomplete. The ratio suits what the Court described as stripped down distributors with no financial exposure or risk in the goods. It is unsuitable where the entity uses intangibles or substantial fixed assets, and it is unsuitable where the comparables’ product mix differs materially. The matter was remanded to the Tribunal.

The Delhi Bench had reached a consistent view in Mitsubishi Corporation India Pvt. Ltd. v. DCIT, pronounced on 21 October 2014. For a high volume, low risk trading model the Berry ratio was held appropriate, because comparables carried much higher inventory and inventory risk, which would distort a cost based or sales based margin. The Bench identified the suitable profile as pure trading with no processing, no significant trade or marketing intangibles and low inventory.

Read together, the two decisions give a workable test. The Berry ratio is available where the entity’s contribution is proportional to its operating expenses and is not proportional to the value of the goods flowing through it. Where the entity owns intangibles, carries meaningful inventory or market risk, or deploys substantial fixed assets, the ratio understates what it should be earning and the courts have said so.

3. The functional analysis that has to come first

The method follows the functional profile. Establishing that profile is the work, and it is done on evidence rather than assertion. For a limited risk contract manufacturer the following has to be demonstrated.

Procurement. Who selects the supplier, who negotiates the price, who bears the consequence of a price movement. Where the associated enterprise nominates the supplier and sets the transfer price, and the Indian entity has no ability to source elsewhere or to renegotiate, the purchases are pass through in substance as well as in form. The evidence is the supply agreement, the purchase orders, the pricing mechanism and any correspondence showing who decided.

Product and process design. Who owns the specification, who approves changes, who holds the technical know how. A contract manufacturer executes a specification it did not write.

Customers. Who holds the customer relationship, who negotiates the sale price, who carries the credit risk. In a global contracting arrangement the Indian entity often supplies to customers under terms agreed by the parent, and that should be visible in the contracts.

Inventory. Who bears obsolescence, who decides production volumes, who carries the risk of unsold stock. This is the single most probative risk indicator for a manufacturing entity and it is frequently glossed over.

Capacity and idle cost. Who bears the cost of underutilisation. An entity guaranteed a return on its operating expenses regardless of volume is not carrying volume risk.

Foreign exchange. Where purchases are denominated in foreign currency and sales in rupees, who carries the exposure.

The documentary sources are the inter company agreement, the board minutes, the delegation of authority, the insurance policies, the actual pattern of profitability across years, and the correspondence that shows who actually decided things. A limited risk characterisation contradicted by a pattern of volatile margins is not a limited risk characterisation.

4. The recharacterisation risk, and how it is met

The standard revenue position is that the entity is not a limited risk manufacturer at all but an entrepreneurial one, with the consequence that a total cost base is appropriate and that entrepreneurial comparables should be used. The two halves of that position have to be met separately.

On characterisation, the evidence set out above is the answer, and it has to be assembled from primary documents rather than from the transfer pricing report of the previous year.

On comparables, the principle is well established in a related context. In CIT v. UT Starcom Inc. (India Branch), pronounced on 25 September 2017, the Delhi High Court found no substantial question of law and dismissed the Revenue’s appeal against the Tribunal’s exclusion of large risk taking companies with significant intangibles and assets from the comparable set for a captive unit subject to limited risk. The reasoning, that functional similarity alone does not make such a company a valid comparable, is the Tribunal’s, affirmed on appeal. The reasoning transfers directly to manufacturing: a company that owns its products, carries its own market risk and funds its own development is not comparable to one that assembles to a specification for a guaranteed return.

5. A worked example

Assume, purely for illustration, an Indian processing enterprise whose total costs are dominated by purchases subject to pricing decisions made by an associated enterprise. Its own contribution is confined to identifiable operating functions. Whether those material purchases may be treated as pass-through for benchmarking depends on evidence that the Indian enterprise does not control supplier selection, purchasing risks or principal customer terms; the Berry ratio is not assumed merely from the size of purchases.

The mechanical problem. With a cost base of, say, 100 of which 88 is component purchases and 12 is operating expenses, a benchmark margin of five per cent on total cost demands a return of 5. The same entity earning a Berry ratio in the comparable range on its 12 of operating expenses earns something quite different. The two indicators are not measuring the same thing, and on these facts only one of them is measuring the entity’s actual contribution.

The analysis. Establish through the supply agreement and the purchase documentation that component sourcing and pricing are controlled by the associated enterprise. Establish through the customer contracts that the parent holds the relationship and negotiates price. Establish through the inventory and capacity arrangements who bears obsolescence and idle cost. Identify operating expenses as the value added base. Select comparables on the functional profile, excluding entities with their own products, intangibles or market risk. Compute the Berry ratio for the tested party and the comparable set on a consistent basis.

What decides it. Consistency of classification. The single most common reason a Berry ratio analysis fails is that operating expenses and cost of goods sold are classified one way in the tested party’s accounts and another way in the comparables’ published accounts. A comparable that includes factory overheads in cost of goods sold while the tested party books them as operating expenses produces a ratio that is not comparable to anything. The reclassification work has to be done, documented and disclosed.

6. The computation, in figures

The mechanics are easier to see with numbers. Take an Indian assembler with the following results for a year, in crore.

Line	Amount
Sales	1,000
Cost of goods sold, almost entirely components bought from associated enterprises	880
Gross profit	120
Operating expenses, being the entity’s own people, premises and plant running costs	100
Operating profit	20

On a total cost basis the operating margin is 20 on 980, a little over two per cent. If the transfer pricing officer benchmarks the entity against manufacturers earning five per cent on total cost, the required profit is 49 and the adjustment is 29.

On a Berry ratio basis the measure is gross profit over operating expenses, 120 over 100, or 1.20. If the comparable set of stripped down assemblers shows a Berry ratio range of 1.10 to 1.25, the entity sits inside the range and no adjustment arises.

The two indicators disagree because they are measuring different things. The total cost measure asks what return the entity earns on every rupee that passes through it, including 880 of components whose price it did not set. The Berry measure asks what return it earns on the 100 it actually spends running the business. Where the entity genuinely controls neither the supplier nor the price, only the second question is about the entity.

Two cautions on the arithmetic. First, the result is highly sensitive to where costs sit. Moving 30 of factory overhead from operating expenses into cost of goods sold changes the ratio from 1.20 to 1.29 and changes gross profit at the same time, which is why the classification reconciliation matters more than any other working in the file. Second, a Berry ratio below 1.0 means the entity’s gross profit does not cover its own operating costs, which is a loss and will require explanation whatever method is applied.

7. The conditions the OECD attaches

The OECD Transfer Pricing Guidelines treat the Berry ratio as appropriate only in narrow circumstances, and the three conditions they identify are worth testing explicitly in the file because an officer is likely to raise them.

1. The value of the functions performed is proportional to operating expenses. This is the central condition and it is the one the functional analysis has to establish. It fails where the entity’s contribution is driven by something other than its own spending, such as an intangible or a risk it bears.
2. The value of the functions performed is not materially affected by the value of the products distributed. This fails where the entity earns more simply because the goods passing through it are more valuable, which is characteristic of a distributor that carries price or inventory risk.
3. The taxpayer does not perform other significant functions that should be remunerated by another method. This fails where, alongside the assembly or distribution activity, the entity performs development, marketing or service functions that are not compensated through the same base.

Each condition should be addressed in the documentation by reference to evidence rather than assertion, and where one of them is doubtful the honest course is to say so and explain why the ratio is still the most reliable measure available, rather than to leave the officer to find the weakness.

8. Where a Berry ratio case fails

First, classification is inconsistent between the tested party and the comparables. This is the dominant failure and it is a data problem, not a legal one.

Second, the entity holds intangibles. Any marketing intangible, customer list, process know how or product right makes the ratio inappropriate on the Sumitomo reasoning, because the return on the intangible is not proportional to operating expenses.

Third, fixed assets are substantial. A manufacturer with a significant asset base is deploying capital that a Berry ratio ignores, and a return that compensates operating expenses but not capital is not arm’s length.

Fourth, the purchases are not genuinely pass through. Where the entity can source alternatively, negotiates its prices, or benefits from favourable purchasing, the characterisation collapses.

Fifth, the ratio is selected because of the answer it produces. Where the file shows a total cost analysis prepared first and a Berry analysis prepared after it gave an unfavourable result, the method selection is not credible.

Sixth, the method changes between years on unchanged facts. Consistency matters more than optimality. A change of method invites the question of what changed, and the answer has to be something in the business.

Seventh, the comparable set is too small. The ratio is sensitive, and a narrow set magnifies classification noise.

9. Documentation

A defensible file contains the following, and it is prepared before the return rather than after the notice.

1. A functional analysis evidenced from primary documents, covering procurement, design, customers, inventory, capacity and currency risk.
2. The inter company agreement, with the pricing mechanism and the risk allocation it records.
3. An explanation of why the purchases are pass through in substance, supported by the sourcing and pricing documentation.
4. The method selection analysis, showing why the transactional net margin method was chosen and why operating expenses is the relevant base under Rule 10B(1)(e), with Sumitomo cited for the legal availability of the base.
5. The comparable search, with the screens applied and the reasons for each rejection, including the rejection of entities with intangibles, significant assets or market risk.
6. The classification reconciliation, showing how each comparable’s published figures were adjusted to a consistent basis, and disclosing the adjustments made.
7. The computation for the tested party and the set, with the range and the tested party’s position in it.
8. A note on the alternative, showing what a total cost analysis would produce and why it is not appropriate on these facts, so that the officer’s likely approach has already been addressed.
9. The accountant’s report under section 172 of the 2025 Act (section 92E of the 1961 Act), which is furnished in Form No. 48 under rule 85 of the Income-tax Rules, 2026 (Form 3CEB for earlier years), with the transaction described consistently with the analysis.

10. The statutory framework in the 2025 Act

Transfer pricing now sits in Chapter X of the Income-tax Act, 2025, sections 161 to 177. The provisions most relevant here are section 163 (section 92B of the 1961 Act, the meaning of international transaction), section 165 (section 92C, determination of arm’s length price), section 166 (section 92CA, reference to the transfer pricing officer), section 171 (section 92D, documentation) and section 172 (section 92E, the accountant’s report).

Two changes are worth noting. Section 165 is now headed determination rather than computation of arm’s length price, and it provides for a tolerance band of up to three per cent as notified by the Central Government. Separately, the general anti avoidance rules have been moved out of the transfer pricing chapter into a standalone Chapter XI, sections 178 to 184.

For proceedings relating to earlier years, section 536 preserves the 1961 Act, so current assessments and appeals continue to be argued on the old numbering.

Practitioner’s perspective

The Berry ratio has a reputation in Indian practice as an aggressive position. That reputation is partly deserved, because it is often reached for when a total cost analysis produces an uncomfortable result. Used properly it is the opposite: it is the indicator that reflects economic reality for an entity whose accounts are dominated by numbers it does not control.

The legal question is settled. Sumitomo confirms that operating expenses can be the base under Rule 10B(1)(e), and the same decision sets out the limits. What remains contested in practice is almost always factual: whether the entity really is stripped down, whether the purchases really are pass through, and whether the comparables have been put on a consistent footing.

Two pieces of advice follow. Establish the functional profile from primary documents before choosing the method, and be prepared to abandon the ratio if the profile does not support it. And treat the classification reconciliation as the centre of the file rather than an annexure, because that is where these cases are actually won and lost.

Where the Berry ratio sits under the Income-tax Rules, 2026

For tax years beginning on or after 1 April 2026, the arm’s length price is determined under section 165 of the Income-tax Act, 2025, which replaces section 92C of the 1961 Act. The manner of applying each method is prescribed in rule 79 of the Income-tax Rules, 2026, which the CBDT notified on 20 March 2026 as the successor to Rule 10B. The transactional net margin method in rule 79(1)(e) still measures the net profit margin against costs, sales, assets employed or to be employed, or any other relevant base, so the legal footing for an operating expense base that Sumitomo recognised under Rule 10B(1)(e) carries over in the same words.

Rule 80 replaces Rule 10C and lists the factors for choosing the most appropriate method: the nature of the transaction, the functions, assets and risks of each enterprise, the availability and reliability of data, the degree of comparability, whether reliable adjustments can be made, and the reliability of the assumptions the method needs. A Berry ratio file should be organised against those factors, because that is how an officer or the Dispute Resolution Panel will test it.

Two points on safe harbour. The safe harbour table in rule 89 of the 2026 Rules covers manufacture and export of auto components among manufacturing activities, so a general contract manufacturer outside that category cannot rely on a prescribed margin and must benchmark. And a safe harbour election does not remove the need for documentation under section 171 and the accountant’s report under section 172.

Frequently asked questions

1. What is the Berry ratio?

Gross profit divided by operating expenses. It measures the return the business earns relative to its own operating spending, and it excludes cost of goods sold from the base.

2. Is the Berry ratio permitted under Indian transfer pricing rules?

Yes. Rule 10B(1)(e) permits the net profit margin to be computed in relation to costs incurred, sales, assets employed or any other relevant base. In Sumitomo Corporation India the Delhi High Court held that operating expenses can be that base and that confining the base to cost, sales or assets was plainly erroneous.

3. When is the Berry ratio appropriate?

Where the value of the functions performed is proportional to operating expenses and not to the value of the goods flowing through the entity, and where the entity does not own intangibles, deploy substantial fixed assets or carry meaningful inventory or market risk.

4. When is it inappropriate?

Where the entity owns intangibles or substantial fixed assets, where it carries inventory or market risk, or where the comparables’ product mix differs materially. The Delhi High Court identified each of these limits in Sumitomo.

5. Why exclude cost of goods sold from the base?

Because where the entity neither selects the supplier nor negotiates the price, the purchases measure nothing the entity does. Including them makes the entity’s return move with component prices it does not control.

6. What is the most common reason a Berry ratio analysis fails?

Inconsistent classification between the tested party and the comparables. Where a comparable books factory overheads in cost of goods sold and the tested party books them as operating expenses, the ratios are not comparable. The reconciliation has to be done and disclosed.

7. Can the method be changed from an earlier year?

It can, but the change has to be explained by something that changed in the business. A change of method on unchanged facts, particularly one that improves the result, undermines the credibility of the selection.

8. How should comparables be selected for a limited risk manufacturer?

On the functional profile, excluding entities that own their products, carry their own market risk or fund their own development. The reasoning in UT Starcom, that a large risk taking company with significant intangibles is not comparable to a limited risk captive, applies directly.

9. What evidence establishes that purchases are pass through?

The supply agreement, the purchase orders, the pricing mechanism, evidence of who nominates the supplier, and evidence that the entity cannot source elsewhere or renegotiate. Assertion in a transfer pricing report is not evidence.

10. Which provisions govern transfer pricing under the Income-tax Act, 2025?

Chapter X, sections 161 to 177. In particular section 163 (section 92B, the meaning of international transaction), section 165 (section 92C, determination of arm’s length price), section 166 (section 92CA, reference to the transfer pricing officer), section 171 (section 92D, documentation) and section 172 (section 92E, the accountant’s report). Section 536, the repeal and savings provision, preserves the 1961 Act for earlier years and pending proceedings.

11. Is the Berry ratio accepted by Indian courts and tribunals?

Its legal availability is accepted. The Delhi High Court in Sumitomo Corporation India (22 July 2016) held that operating expenses can be the ‘relevant base’ under Rule 10B(1)(e), and the Delhi Tribunal in Mitsubishi Corporation India (21 October 2014) accepted it for a high-volume, low-risk trading model. Acceptance in a given case depends on the functional profile, and both decisions concerned trading rather than manufacturing.

12. Can the Berry ratio be used for a contract manufacturer in India?

It can, where component purchases are pass-through costs the entity does not control, it owns no significant intangibles, carries no material inventory or market risk and deploys no substantial fixed assets. Those facts must be proved from the supply agreement, purchase records and customer contracts. If the entity owns plant or know-how, a total cost or asset-based indicator is likely to be more reliable.

13. Which rule replaces Rule 10B of the Income-tax Rules under the Income-tax Act, 2025?

Rule 79 of the Income-tax Rules, 2026 prescribes how the arm’s length price is determined under section 165, and rule 80 lists the factors for the most appropriate method. The accountant’s report under section 172 is in Form No. 48 under rule 85. Rule 10B, Rule 10C and Form 3CEB continue to apply to periods and proceedings governed by the 1961 Act.

Related reading from SBC

• Defending the Residual Profit Split Method in India When the TPO Proposes TNMM for an Intangible-Owning Entity
• A Trading Entity Is Not a Service Provider: How to Defend the Resale Price Method Against a TNMM Adjustment in India
• Contract R&D or Routine Software Development: How the Functional Profile Decides the Transfer Pricing Method in India
• More articles on the SBC blog

Disclaimer

This article is for general information and does not constitute professional advice. It reflects the law as understood at the date of publication and does not take account of later developments. Statutory references give the Income-tax Act, 2025 section with the Income-tax Act, 1961 section in brackets; section 536 preserves the 1961 Act for proceedings pending on 31 March 2026 and for earlier tax years. The selection of a profit level indicator depends on the functional profile established on the facts of each case. No reader should act on the basis of this article without taking advice on their own circumstances.