Related Party Transactions: AS 18 vs. Transfer Pricing in India

Introduction: Delving into the realm of Related Party Transactions, this article compares the perspectives of Accounting Standard 18 (AS 18) with the Transfer Pricing framework in India. Understanding the intricacies of control, influence, disclosure requirements, and the application of the arm’s length principle is crucial for businesses engaged in transactions with related parties.

Related party

As per AS 18- 

Related parties – Parties are considered connected if they are time during the reporting period can be one party controlling the other party or exercising significant influence over the other aspects of financial and/or operational decision-making.

Related parties involve not only parties within a similar group but also parties that have a connection of direct or indirect authority, involving power over the board of directors.

Related party transaction – the transfer of resources or liabilities between the parties, whether it is a chargeable activity or not.

As per AS 18 Control can be established through ownership, control of the board of directors, or a significant interest in voting power and the ability to direct operations and/or the financial systems of the enterprise.

Significant influence refers to participation in the operation and/or decision-making of an entity’s financial policies, without controlling such policies. A Subsidiary is an entity in which a reporting investment entity has significant influence but is not a subsidiary or joint venture.

A joint venture is a lawful agreement among two or more parties to carry out economic activities depending on joint management. Mutual governance refers to the shared agreement of authority to control financial policy and the conduct of economic activities for the common good.

KMP (Key management personnel) means those who have the authority and responsibility for planning, directing, and controlling the activities of the reporting enterprise.

When one company or person owns 20% or more of another company, they have what is called a “Considerable interest” in that company. This means that they can have a significant impact on how the company operates. There are many ways this can be done, such as speaking on important decisions or sharing important information.

If a person owns more than 20% of a company, they are considered to have significant influence over it. If they have less than 20%, it is assumed that they do not have a significant effect unless they can prove otherwise.

Companies often find business deals with parties with whom they are familiar or have a common interest. However, related-party transactions can cloud the business environment by limiting competition in the marketplace. In some cases, they must be approved by management consensus or a company’s board of directors to make sure that they are conflict-free.

Disclosure Requirement-

The following information must be revealed when needed:

– The name of the related party involved in the transaction

– The relationship between the parties

– The nature of the transaction

– The volume of the transaction

– Any additional information that may aid understanding

– The outstanding amounts of related parties

The reporting entity’s financial statements must reveal related party transactions, which may involve:

– Buy or sales of goods or services

– Buy or sales of finished or unfinished goods

– Buy or sales of fixed assets

– Equipping or receipt of services

– Agency displays

–  Lease or hire purchase agreements

-Transfer of (R&D) research and development

– License contracts

– Finance transactions, like loans or equity contributions

– Guarantees and collaterals

– Management agreements, including employee deputation.

Related Party under Transfer Pricing-

Transfer pricing-

Transfer pricing identifies goods and services prices that are exchanged among related parties, that are subsidiaries of a similar parent company. Transfer pricing is necessary for tax objectives, as it has an impact on the issuance of income and expenses between different administrations. Transfer pricing rules in India are form on the arm’s length principle, which means that the transaction price among related parties should be equivalent to the price of the same transaction among independent parties. Transfer pricing in India is managed by the Income Tax Act 1961, the Income Tax Rules, 1962, and various guidelines and circulars furnished through the Central Board of Direct Taxes (CBDT). The CBDT has also established various methods/techniques for ascertaining the arm’s length price. In India, Transfer pricing is based on documentation needs, detailing obligations, and audits through tax authorities.

How does Transfer pricing operate-

As per the Income Tax Chapter X, any international transaction entered into by an associated enterprise and any defined domestic transaction according to Section 92BA should be calculated as arm’s length value and should be reported in form 3CEB. 

Associated Enterprise-

You can Identify an Associated Enterprise with the help of these cases-

Case 1- Financial Control

• One party, directly or indirectly, has 26% or more shares of another party. OR
• One party advanced loan of 51% or more of the total borrowing of another party. OR
• One party guarantees 10% or more of the total borrowing of another party.

Conclusion-

In that case, Enterprises will be the Associated Enterprise.

Case 2- Operating Control

• One party has the power to appoint more than half of the board of directors. OR
• One party advanced loan of 51% or more of the total borrowing of another party. OR
• One party guarantees 10% or more of the total borrowing of another party.

Conclusion-

In that case, Enterprises will be the Associated Enterprise.

Case 3- Common Control

If One party, directly or indirectly, has 26% or more shares OR has the power to appoint more than half of the board of directors of another two parties.

Conclusion–

In that case, Enterprises will be the Associated Enterprise.

Special domestic transactions according to section 92BA-

• Any transaction covered by Part VI-A of the Income-tax Act as a deduction in terms of Sections 80C to 80U.
• Any transaction between the assessee and the person mentioned in Section 80IA or Section 10AA.

Comparison of Cases as per AS 18 and Transfer Pricing-

Arm’s Length principle-

The arm’s length concept is a business deal in which purchasers and vendors act separately without one party influencing the other. It is a key principle in international taxation that makes sure that transactions among related parties are managed at fair market prices. The principle focuses on preventing tax avoidance and making sure a level playing field for taxpayers.

The arm’s length concept depends on the thought that unrelated parties would conclude the terms and conditions of a transaction in a way that considers their relevant economic interests and risks. By appealing the arm’s length concept, The arm’s length price can be considered by various transfer pricing techniques as per section 92C (1) using the best applicable techniques suited to parties included in specific transactions.

Transfer Pricing Methodologies:

Section 92C (1) outlines diverse techniques for determining arm’s length prices, each serving specific contexts:

i. Comparable Uncontrolled Price (CUP) Technique: The CUP technique scrutinizes prices in a related party’s managed transaction against those in an unmanaged transaction among independent parties in identical circumstances. Ideal for similar or nearly similar property exchanges, it thrives when there’s substantial transaction equality and market comparability.

ii. Resale Price Technique: Evaluating the gross margin of a reseller in a related party’s managed transaction versus an independent reseller’s margin in unmanaged circumstances, this technique suits situations where the reseller acts as an intermediary. It calculates the arm’s length price by balancing gross profit margin and other expenses from resale value.

iii. Cost Plus Technique: This method contrasts the markup on costs incurred by a related party’s supplier with an equivalent supplier’s markup in an unmanaged transaction under similar conditions. Applicable when goods or services are standard and not highly customized or complex, this technique is chosen for transactions with minimal presumed risks.

iv. Profit Split Technique: Apportioning combined profits or losses from a related party’s controlled transaction among participants based on their contributions to value creation, the profit split technique is apt for highly integrated, interdependent scenarios involving shared significant risks and intangible assets.

v. Transactional Net Margin Technique (TNMM): TNMM compares the net profit margin of a related party’s tested party in a managed transaction with an equivalent party’s margin in an unmanaged transaction under comparable circumstances. Useful when comparability is crucial at the transaction level or when dealing with multiple associated transactions.

Meaning of a transfer pricing testimonial?

Transfer pricing testimonial is a set of documents that multinational corporations must arrange and submit to tax officials to indicate their intercompany transactions’ regularity with the arm’s length concept. The arm’s length concept expresses that the prices imposed by related parties for services, products, or intangible assets should be equivalent to those imposed by independent parties under the same situations. Transfer pricing testimonial supports multinational corporations to obey tax rules & regulations and reduce transfer pricing risks.

Explanation of Transfer Pricing Audit Applicability in India-

As per transfer pricing rules and regulations in India, every taxpayer who has come into an international transaction or a stated domestic transaction with a correlated enterprise must prepare proper documentation and detailed records to justify the arm’s length nature of such transactions. The taxpayer must also file a report in Form 3CEB with the income tax return, mentioning the information of such transactions and the techniques used to identify the arm’s length charges.

Conclusion-

Hence, Transfer pricing of products or services is concerned with the arm’s length concept of identifying the prices of products and services purchased and sold among related enterprises. The arm’s length concept states that related enterprises must fix the transfer price in line with the charge that is paid by an outsider for similar products or services.

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About the Author: The author is Ruchika Bhagat, FCA helping foreign companies in setting up and closing businesses in India and complying with various tax laws applicable to foreign companies while establishing a business in India. Neeraj Bhagat & Co. Chartered Accountants is a well-established Chartered Accountancy firm founded in the year 1997 with its head office in New Delhi.