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Introduction
Transfer pricing (TP) regulations have been at the forefront of corporate headlines over the last few years due to the increasing number of controversies resulting out of tax structuring by multinational companies (MNE). What makes the topic both contentious and interesting is that regulators view the various techniques applied to intercorporate transactions as purportedly planned with the intent of achieving benefits of comparable labor cost and tax advantage at the cost of a countries tax revenues.
The Indian Scenario
In India, TP Regulations were first introduced in 2001, as a measure against tax avoidance. The Indian TP Regulations are largely influenced by the said OECD TP Guidelines, but they are modified to specifically meet the needs of the Indian tax regime.
Similar to the OECD Guidelines and TP Regulations of several other countries, Indian TP Regulations prescribe methods to compute ‘Arm’s Length Price’ for an ‘International Transaction’ or a ‘Specified Domestic Transaction’ entered into by a taxpayer with its ‘Associated Enterprise’.
Section 92 of the Income tax Act, 1961 provides for the authority to an assessing officer to determine the profit which may be reasonably be deemed to have been derived from a transaction. This would be applicable where controlled Companies (associated enterprises) arrange the business between them is a way that either no profit is earned from such transaction or profit earned is lower than what would be expected in a transaction between uncontrolled Companies (un related entities).
Arm’s Length Price (ALP)
ALP has been defined to be the price, which is applied or is proposed to be applied in a transaction between persons other than Associated Enterprises, in uncontrolled conditions.
Associated Enterprises
Section 92A of the Income Tax Act, 1961 defines associated enterprise as, an enterprise which:
- Participates directly or indirectly, or through one or more intermediaries, in the management or control or capital of the other enterprise; or
- In respect of which one or more persons who participate, directly or indirectly, or through one or more intermediaries, in its management, control, or capital, are the same persons who participate, directly or indirectly, or through one or more intermediaries, in the management or control or capital of the other enterprise.
The Regulations further provide specific conditions and circumstances under which two entities are deemed to be Associated Enterprises.
Computation of ALP
The Indian TP Regulations require computation of ALP based on the prescribed TP methods. The Regulations have prescribed the following five methods for determination of ALP —
Price Based Methods
1. Comparable Uncontrolled Price Method (CUP) :
- Compare the prices charged for property or services for controlled transactions vs. uncontrolled transactions.
- The basic tenet is to compare close similarity in products, property or services that are involved
- Timing of the transactions are relevant where prices of the product fluctuate regularly
2. Cost Plus Method (CPM)
- CPM determines ALP by adding Gross Profit Margin (mark-up) earned in comparable transaction(s) / by comparable companies to the cost incurred by Tested Party under controlled transaction
3. Resale Price Method (RPM)
- RPM computes purchase price paid to related party based on its resale price to unrelated party
- RPM is typically useful to determine ALP of purchases made by the distributor (trader) from related party
Profit Based Methods
1. Profit Split Method (PSM):
- PSM determines arm’s length profit based on combined profits derived by related parties
2. Transactional Net Margin Method (TNMM).
- TNMM tests the net margins of the tested party as oppose to gross margins in case of RPM or CPM
The TP Regulations also provide for use of any other method, which takes into consideration a price charged in a similar transaction between unrelated parties in uncontrolled circumstances.
In cases where there is more than one price determined using the most appropriate from the above methods, ALP shall be taken to be at arithmetic mean of such prices. Where the transfer price differs from ALP, no TP adjustment is made where the arithmetic mean falls within the tolerance range of transfer price. Currently, the tolerance range available for wholesale traders is 1%, while that for other taxpayers is 3% of the value of International Transaction/ Specified Domestic Transaction.
Use of Range Concept
The Central Board of Direct Taxes (CBDT), the regulatory body responsible for tax administration in India, has also notified the concept of ‘arm’s length range’ for computation of ALP for transactions after April 1, 2014. Under this concept, data points lying within the 35th and the 65th percentile of a data set constructed using comparable data would constitute the arm’s length range. Accordingly, transfer price falling within the arm’s length range would be considered to be at arm’s length.
A minimum of six comparable entities are required for application of the range concept. In cases where the number of comparables in a data set is less than six, the arithmetic mean would continue to be considered as the ALP. Where the arithmetic mean is considered as the ALP, the benefit of a tolerance range continues to be available.
Use of Multiple Year Data
Originally, the TP Regulations did not provide for using data of years other than the year in which transactions were undertaken (except in certain specific cases). The CBDT has amended the Rules and now permitted use of ‘multiple year data’ while performing a benchmarking analysis. If certain conditions are satisfied, the taxpayer shall be permitted to use comparable data of 2 years preceding the relevant fiscal year along with that of the relevant fiscal “current” year.
Reporting needs
Taxpayers in India by law have an obligation to report compliance to the requirements under the act of entering into any international or specified domestic transaction. This is done by obtaining a certificate from an accountant that needs to be furnished before the due date of filing of income tax return.
The accountant is required to certify on two key points:
- The ALP computed by the tax payer is correct and in line with the regulations; and
- Appropriate documentation has been maintained by the tax payer, as per the regulatory requirements
This is reported along with specific details of the international / specified domestic transaction, how ALP has been determined, the value of the transaction etc.
Three tiered Documentation
Documentation is known to be one of the foremost requirements. The OECD has come up with a recommendation under Base Erosion and profit shifting (BEPS) action plan, which prescribes a three-tiered approach to maintenance of documentation. This requires the taxpayer to maintain:
1. A master file
2. A local file
3. A country by country report
The union budget of India for 2016 provided for a similar convergence with the OECD recommendation, and it is therefore now a mandate for Companies in India to align their documentation in line with the OECD recommendations, as listed above.
1. The master file is required to include global information about the multinational corporation group, including information on intangibles and financial activities, to be made available to the local regulations.
2. The local file must contain all relevant information for material intercompany transactions of the group entity, in each separate Country
3. Country-by-country report (CbCR) must contain details on income, earnings, taxes paid and measures of economic activities.
This is a game-changing move that increased the burden of compliance for MNEs, as they will now need to provide a lot more granular level information to the tax authorities, as compared to the past.
Adjustment to the Reported Income
The tax officer is bound to adjust the reported income of the taxpayer with the amount of adjustment proposed by the TPO. This would have an effect of increasing the assessed income or alternatively decreasing the assessed loss. Furthermore, the eligible deductions available to the taxpayer under section 80 could not be availed on the enhanced income. However, those taxpayers who are eligible for deductions under section 10A and 10B remain unaffected as these deductions remain available on the enhanced income.
Conclusion
With the speed at which globalization is affecting the business world and the way countries are competing with one another for foreign direct investments, it may be safe to conclude that the world of transfer pricing is only going to get more interesting by the day. It is quite apparent that the view of the regulators are also evolving, as there is a clear demonstration of intent to simplify the processes. However, only time will tell if they are able to keep pace with the dynamic changes in the business models and structures being formed with the advent of technology, free market economy and aggressive investment vehicles coming into play.
Author Bio
IMPROMPTU
On the first blush this write-up brings to one’s mind the decision of the itat in re. Cargill India (P) Ltd. (reported in 300 ITR (AT) 223,; and the article (Critique) published in (2008) 301 ITR (Journal) pg. 13. A proposition raised on the FIRST PRINCIPLES and discussed was, – whether TPR could be rightly invoked and applied to purchase transaction (entailing not income but expenditure) of an enterprise situate in iindia with a foreign enterprise.
The observatons in the paragraph under ‘Adjustment to the Reported Income’ prima facie provides enough ammunition as to provoke one to think again why the above mentioned proposition does not still desaerve to be reiterated and pursued; . and, what one knows, that has not been so far done in any other case. Any thoughts or information of value anyone in field practice has , to share ?