Convergence – Divergence? The Evolving Relationship Between Direct and Indirect Taxes in India – Related Party Transactions
In Part 1, the author of the article has dealt with aspects of revenue recognition, in Part 2, the author of the article has dealt with the contours of inventories, in Part 3, the author has discussed aspects of revenue expenditure and in Part 4, the author has discussed Capex aspects by discussing Convergence-Divergence? In this article, author is discussing The Evolving Relationship Between Direct and Indirect Taxes in India” vis-à-vis Related Party Transactions.
Financial statements are considered a reflection and barometer of business enterprises’ performance. They ensure compliance with complex legal frameworks, including Generally Accepted Accounting Principles (GAAP), Accounting Standards (AS), Indian Accounting Standards (Ind AS), Auditing Standards (Statements of Auditing), and Direct and Indirect Tax Laws, while leveraging modern technological advancements. All financial statements are prepared following various allied laws, such as Corporate Laws, Customs Acts, Contract Acts, Sale of Goods Acts, Factories and Establishment Acts, Stamp Duty Laws, Evidence Laws, Digital Laws, the Prevention of Money Laundering Act, the Benami Property Act, the Legal Metrology Act, FEMA, Local Laws, and others.
Various stakeholders utilise financial statements to derive valuable insights regarding enterprise value and intrinsic value and key financial metrics such as EBITDA, ROC, ROCE, CAGR, PEG, NCF, margin trends, ratio analysis, PE ratio, dividend yield, and other indicators. These metrics are often compared with industry peers to assess the company’s financial health and performance. Tax authorities also conduct similar analyses to evaluate the disclosures in audited financial statements. While listed companies publish their financial statements publicly, unlisted and closely held companies do not. With technological advancements, financial data and records reported under statutory and regulatory frameworks are now seamlessly shared among tax authorities. This enables them to review and examine potential revenue leakages in real-time—at speed comparable to light.
In this article, the author explores key aspects of Direct and Indirect Taxes under the Income Tax Act 1961, and the Goods and Services Tax (GST) Act 2017, respectively. These tax laws are fundamentally applicable to every enterprise, depending on its size, volume, and the nature of its business activities. When analysing the application of direct and indirect tax laws, they can be metaphorically compared to the **two poles—North and South—**, raising the question of whether they share any similarities or are entirely distinct. The core issue to examine is whether a meaningful comparison exists between Direct Tax Laws, which have evolved and stabilised over nearly a century, and Indirect Tax Laws, which remain in a nascent stage of development, having been in effect for just about seven years. The implementation of each tax law has significant ramifications on working capital management and the overall regulatory taxation framework. This becomes particularly crucial in an era where regulatory authorities are leveraging data-sharing mechanisms and digital reporting systems, ensuring that all stakeholders remain duty-bound to comply with evolving tax regulations.
In this article, the author has attempted to explore complementary or completely opposing perspectives by examining aspects such as revenue recognition of revenues and expenditures, inventories, capital expenditures (Capex), and related party transactions.
All readers would agree that conducting business within India or internationally has become akin to solving a jigsaw puzzle of multiple regulatory compliances. This means that before executing any transaction, one must carefully evaluate all applicable regulations to arrive at a validated conclusion for the execution of economic business transactions. With the continuous growth of trade, commerce, and industry, regulatory compliance requirements are expected to increase multifold, further emphasising the need for meticulous adherence to legal and financial frameworks.
The article has been crafted to discuss broadly Direct and Indirect Tax Regime provisions with a broad framework:
1. Revenue Recognitions – Revenues – Toplines
2. Inventories
3. Revenue Recognitions – Expenditure
4. Capex
5. Related Party Transactions
5. Related Party Transactions
Direct Taxes – Broad Framework
Related-party transactions (RPTs) refer to transactions between a company and its related entities such as subsidiaries, associates, joint ventures, substantial shareholders, executives, directors and their relatives, or entities owned or controlled by its executives, directors, and their families. RPTs are widespread and are part of every business group activity. The concept of RPTs is age-old and prevalent since, under varied statutes within India and outside India. Every revenue authority across the globe would like to monitor and examine RPTs to ensure there are no revenue leakages by organising a manner whereby revenue loses its pie of the cake out of such transactions. Regulatory Authorities keep expanding the disclosures related to RPTs in a structured manner via SAAR, GAAR, Accounting Standards, Ind AS, Directors Reporting and Tax Audit reporting, etc. The crux and essence of monitoring RPTs is to ensure transparency, corporate governance, and execution of the transactions at arm’s length. Taxpayers must maintain robust documentation and provide well-supported evidence to justify assertions and statements related to RPT transactions.
Under ITA, reporting of transactions under section 40A(2)(b), disclosures in the tax audit report u/s 44AB, Domestic & International Transfer Pricing form u/s 92CE, master file reporting in Form 3CEAA u/s 92D, benchmarking studies, GAAR provisions u/s 95 and CbCR reporting in Form 3CEAD u/s 286, etc., are some of the examples of monitoring data points captured relating to RPTs. RPTs are monitored using RMS (Risk Management Strategies) and technology-developed algorithms to flag significant variations compared to others in the same business segments using various parameters. For scrutiny, the verification of revenue returns is selected based on predefined algorithms.
Indirect Taxes – Broad Framework
Distinct Persons
A distinct person is specified under explanation 1 to section 8 of the IGST Act, which defines the distinct person as follows:
Explanation 1. —For the purposes of this Act, where a person has, —
i. an establishment in India and any other establishment outside India;
ii. an establishment in a State or Union territory and any other establishment outside that State or Union territory; or
iii. an establishment in a State or Union territory and any other establishment registered within that State or Union territory,
then such establishments shall be treated as establishments of distinct persons.
Thus, transactions executed between distinct persons are subject to GST levy either as intra-state supplies under section 8 or inter-state supplies under section 7 of the IGST Act, 2017.
Schedule I transactions
Regarding Schedule I-specified transactions, the taxpayer is supposed to determine deemed consideration and discharge GST levies as applicable, considering the nature and facts of the transactions.
Further, such deemed consideration under schedule I must be reported in the appropriate GST returns by depositing GST levies as applicable.
Specified Transactions under schedule I are as follows:
1. Permanent transfer or disposal of business assets where input tax credit has been availed on such assets.
2. Supply of goods or services or both between related persons or between distinct persons as specified in Section 25 when made in the course or furtherance of business:
Provided that gifts not exceeding fifty thousand rupees in value in a financial year by an employer to an employee shall not be treated as supply of goods or services or both.
3. Supply of goods—
a. by a principal to his agent where the agent undertakes to supply such goods on behalf of the principal; or
b. by an agent to his principal where the agent undertakes to receive such goods on behalf of the principal.
4. Import of services by a person from a related person or from any of his other establishments outside India in the course or furtherance of business
The valuation provisions under Proviso 2 to Rule 28(1) are reproduced below:
Provided further that where the recipient is eligible for full input tax credit, the value declared in the invoice shall be deemed to be the open market value of the goods or services.
Given the above background concerning RPTs, let us try to examine the implications of Direct Taxes and Indirect Taxes on illustrative relevant RPTs (excluding transactions involving Secondment of Employees, use of Brand name and IPR as they are discussed by other authors in the separate articles) in the tabular format:
| Description | Direct Tax Regime | Indirect Tax Regime |
| Scope | Section 40A(2)(a) provides as under:
Where the assessee incurs any expenditure in respect of which payment has been or is to be made to any person referred to in clause (b) of this subsection, and the Assessing Officer is of the opinion that such expenditure is excessive or unreasonable having regard to the fair market value of the goods, services or facilities for which the payment is made or the legitimate needs of the business or profession of the assessee or the benefit derived by or accruing to him therefrom, so much of the expenditure as is so considered by him to be excessive or unreasonable shall not be allowed as a deduction : Provided that for an assessment year commencing on or before the 1st day of April 2016 no disallowance, on account of any expenditure being excessive or unreasonable having regard to the fair market value, shall be made in respect of a specified domestic transaction referred to in section 92BA if such transaction is at arm’s length price as defined in clause (ii) of section 92F. Thus, if transactions are carried out at arm’s length prices, then no disallowance is attracted u/s 40(A)(2)(a) |
Suppose transactions between RPTs are executed at arm’s length prices, aligned to the provisions of Section 15 and the rules thereunder.
In that case, no technical challenges arise unless such transactions are structured in violation of Sections 73, 74, or 74A to evade taxes.
|
| Persons Covered | 1. where the assessee is an individual, any relative of the assessee;
2. where the assessee is a company, firm, association of persons or Hindu undivided family, any director of the company, partner of the firm, or member of the association or family, or any relative of such director, partner or member; 3. any individual who has a substantial interest in the business or profession of the assessee, or any relative of such individual; 4. a company, firm, association of persons or Hindu undivided family having a substantial interest in the business or profession of the assessee or any director, partner or member of such company, firm, association or family, or any relative of such director, partner or member or any other company carrying on business or profession in which the first mentioned company has substantial interest 5. a company, firm, association of persons or Hindu undivided family of which a director, partner or member, as the case may be, has a substantial interest in the business or profession of the assessee; or any director, partner or member of such company, firm, association or family or any relative of such director, partner or member; 6. any person who carries on a business or profession— a. where the assessee being an individual, or any relative of such assessee, has a substantial interest in the business or profession of that person; or b. where the assessee being a company, firm, association of persons or Hindu undivided family, or any director of such company, partner of such firm or member of the association or family, or any relative of such director, partner or member, has a substantial interest in the business or profession of that person. Explanation. —For the purposes of this sub-section, a person shall be deemed to have a substantial interest in a business or profession, if,— a. in a case where the business or profession is carried on by a company, such person is, at any time during the previous year, the beneficial owner of shares (not being shares entitled to a fixed rate of dividend whether with or without a right to participate in profits) carrying not less than twenty per cent of the voting power; and b. in any other case, such person is, at any time during the previous year, beneficially entitled to not less than twenty per cent of the profits of such business or profession |
All the persons specified under 40A(2)(b) of the ITA (previous column)
plus persons specified under schedule I of CGST Act, 2017 viz. 1. Distinct persons as defined under explanation 1 to section 8, 2. Principal and Agent and vice versa, 3. transaction between employer and employee and 4. import of services from the related persons from establishments outside India. To conclude, scope of RPTs under GST is much wider as compared to scope specified under Direct Tax regime. |
| Intercompany Billings | Suppose transactions are executed among related parties at arm’s length prices, supported by corroborated assertions with substantial documentation and justification. In that case, the taxpayer is expected to report such transactions as follows:
1. Appropriate disclosures in the financial statements and Notes to accounts; 2. Disclosures in the Tax Audit Report u/s 40A(2)(b) of the ITA with nature of relationships in TAR; 3. Filing of Domestic and International transfer pricing report in Form 3CEB; 4. Filing of CbCR compliance; 5. Preparation of Transfer pricing Study reports to justify the prices adopted for executing RPTs after due processes; 6. Filing DPT- 03 & MSME-1 under Companies Act, 2013 7. Maintenance of register of related parties’ contracts and arrangements under the Companies Act, 2013; 8. Disclosure of stake holding in the capital structure of the company; 9. Maintenance of Minutes and resolutions relating to RPTs; 10. Non-participation of related persons by way of participation in RPTs during the voting; 11. Proper legal compliance of RPTs; 12. Any other compliances that validate assertions made for such transactions. Care should be taken to avoid any secondary adjustment u/s 92CE of the Act by maintaining requisite documentation and justification. Under the Direct Tax Regime, intercompany billings are quite usual but the concept of Input Service Distributor is missing. Readers should note that all invoices that are billed as intercompany billings and have a common PAN number will get nullified on consolidation of the financial statements as per the method of accounting followed by the enterprise.
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Disclosure in the financial statements, notes to accounts and Tax audit reports under allied laws would suffice. There is no specific disclosure required relating to RPTs in the indirect tax regime per se.
Unique concepts under Indirect Tax Regime: Input Service Distributor defined u/s 2(61) as “Input Service Distributor” means an office of the supplier of goods or services or both which receives tax invoices towards the receipt of input services, including invoices in respect of services liable to tax under sub-section (3) or sub-section (4) of Section 9 for or on behalf of distinct persons referred to in section 25, and liable to distribute the input tax credit in respect of such invoices in the manner provided in section 20; Invoices raised using Input Service Distributor as per Sections 20 to 21 need to be complied with as per the provisions of the Act and Rules notified from time to time. RTP as ISD distributor needs to file GST Returns in GST FORM 6 as per time limits specified under the Act i.e. 13th of the succeeding month. Further, ISD registration if applicable is compulsory w.e.f April 1, 2025, unless extended further by the Official Notification by the CBIC. Cross Charge The term cross charge is not defined under the GST Act and Rules as per my understanding. In common parlance, it refers to intercompany billings done between two units of the same unit being distinct persons as defined under Explanation 1 to Section 8. For Cross Charge invoices, invoices are issued as per the provisions of Section 31 of the CGST Act, 2017 and all returns are filed as per the provisions of the Act and Rules framed thereunder. Invoices should be issued following arms’ length prices referred to as transaction values or values adopted following the provisions of Section 15 and Rules framed thereunder. Unit raising the invoice will do all applicable compliance required under the Act and Rules framed thereunder. |
| Corporate Guarantees | Transactions between Holding companies and subsidiaries are pretty standard, especially holding companies providing hand-holding support to subsidiaries to establish their businesses in the region where they are established.
Under the Direct tax regime, established jurisprudence exists, whereby compensation @ 0.5% is accepted as adequate consideration to be termed an arms’ length price u/s 92C of the ITA. Taxpayers are duty-bound to file TP reports in Form 3CEB u/s 92E. |
Recently, CBIC issued circular no 204/16/2023 dated 27.10.2023, which interalia stated that in all such cases of supply of services by a holding company to a subsidiary company in the form of corporate guarantee to a bank/financial institution, the taxable value shall henceforth be determined as per provisions of rule 28(2) irrespective of whether full ITC is available to the recipient of services or not.
Consequently, Notification NO 12/2024 – Central tax dated 10.07.2024 has been amended retrospectively. Additionally. Circular No 225/19/2024 dated 11.07.2024 is also issued qua valuation of Corporate Guarantee interalia clarified that: a. for corporate guarantee issued or renewed before 26.10.2023, the valuation would be determined based on rule 28 as it existed at that time b. in cases where full ITC is available to the recipient, the value declared on the invoice shall be deemed to be the value of supply of the said service. The circulars and notifications will mitigate the litigation arising out of the issuance of corporate guarantees by holding companies to subsidiary companies. Food for Thought: If the transaction of a corporate guarantee constitutes a transaction of money, and it does not qualify as a supply under Section 7, why is there an obligation to pay the deemed value of GST levies on such corporate guarantee consideration? |
Readers, please note that I have attempted to explain certain Related Party Transactions to highlight the distinction between both regimes. However, numerous other transactions may need to be considered and validated to fully decipher the implications under either law. Therefore, the above tabulations should not be regarded as exhaustive in understanding the convergence.
Conclusion:
Readers of this article should keep in mind probable future developments which are envisaged as under:
- Expansion of data reporting under the Direct Tax and Indirect Tax regimes especially if we examine the definition of computer systems as provided under the new Income Tax Bill 2025 which is reproduced below;
- Clause 261 (e) states “computer system” means computers, computer systems, computer networks, computer resources, communication devices, digital or electronic data storage devices, used on stand-alone mode or part of a computer system, linked through a network, or utilised through intermediaries for information creation or processing or storage or exchange, and includes the remote server or cloud server or virtual digital space;
- Whether such change would mean the integration of evidence law, digital data protection laws, digital data sharing and extended by the invasion of privacy of the taxpayers (Food for thought)
- KYC (Know your customer) requirements;
- Digital Trail Monitoring and the significance of electronic evidence;
- Increase in data points applicable to E-Invoicing requirements & mandatory e-invoicing for B2C transactions;
- Geo Tagging and Mapping of Place of Business & movement of supply to plug leakage of revenues;
- Implementation of Unique Identification Markings for implementing the Track and Trace Mechanism.
- Mandatory Bio-metric authentication for registrations, additional or change in place of Business;
- Data locking of values reported in the returns filed under GST Returns;
- Synchronization of data across allied laws vis-à-vis direct tax and indirect tax regime;
- Deep dive to verify the inputs and output analysis using the nexus theory mapped to HSN and SAC Classifications;
- Advanced AI, ML and RMS tools to plug out revenue leakages etc.
In this article, the author has sought to restrict discussions to the broad areas specified while being fully aware that there could be many more aspects that can be discussed and engaged for the discussions. Given the fast-evolving nature of laws and their underlying regulations, the statements made herein may undergo significant changes due to amendments, notifications, or circulars issued after the article’s publication. The author urges all readers to validate the assertions and statements by corroborating them with the latest legal precedents before drawing any conclusions or relying on this document. Any suggestions for improving the content of the article are welcome with folded hands. Further, my views are personal and based on my limited understanding of the subject. My views shall not be considered explicit/implicit opinions. They are not binding on me as an organisation established for the benefit of all indirect professionals based in and outside India.
With this article, the author has concluded all 5 parts from the perspective of Convergence–Divergence. The Evolving Relationship Between Direct and Indirect Taxes in India.
Happy reading to all.
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