Chapter X of Income tax Act not applicable to non-AE transactions

Summary: Chapter X of the Income Tax Act mandates transfer pricing regulations for transactions with Associated Enterprises (AEs) to determine the arm’s length price (ALP). This applies when an entity exclusively deals with AEs, as it controls profit margins via intercompany agreements. However, for entities transacting with both AEs and non-AEs, Chapter X applies only to AE transactions. Non-AE transactions, conducted independently and without the same pricing control, are outside the purview of transfer pricing adjustments. Courts have clarified that any transfer pricing adjustment on non-AE profits contradicts the Act’s intent, reinforcing that ALP should be calculated only for AE transactions.

The regulations of Transfer Pricing (‘TP’) applies to entities engaged in international transactions with its Associated Enterprise (‘AE’), the ambit of Chapter X of Income tax Act (‘Act’) is to determine the arm’s length price (‘ALP’) of the transaction with related party.

When the entity transacts only with its related party, such as captive service provider which dependent on the AE in terms of business and generate revenue, the entire entity margins shall be considered to calculate ALP and apply TP provisions at entity level to benchmark the transaction. However, when an entity is engaged in AE and non-AE transaction to generate revenue, the provisions of Chapter X shall apply only to the transaction with AE and not to non-AE. The entity having both AE and non-AE revenue shall earn profit which shall be mixture of AE and non-AE markup over cost.

The entities when transacting exclusively with AEs shall have control over the profit margin, since they commit to charge their service at cost plus markup as per the intercompany agreement (‘agreement’). When the cost-plus markup is defined under agreement, such entity succeeds in recovering the consideration from AE as per the terms of the agreement and shall rarely suffer defaults. Whereas, when the entity deals with non-AE or third party, it shall not have control over the margin and recovery of the service fees, because of business difficulties, commercial arrangement or financial stress of customer and may even sell service at loss due to market demand.

Interplay between AE and non-AE transactions

When the entity engages with AE and non-AE, the margin of AE and non-AE gets mixed in entity level and such combined margin may not project favourable margins at entity level for benchmarking with the comparable companies and shall also not match the margin as agreed under the intercompany agreement. In such a situation, the entity profits become inappropriate to determine the ALP.

Segmentation of revenue in the books of accounts is not possible, since the entity is not required to perform segmental reporting as per accounting standards. However, to determine profits earned between AE and non-AE segments, segmentation is independently conducted to support the TP analysis. Whereas when the segmental revenue or profits are not bifurcated between AE and non-AE in the financials, revenue may contend to determine the ALP at entity level and impose TP adjustment on the entity profits.

Provisions of Income Tax Act, 1961 (‘Act’)

The company determines the ALP in relations to the international transaction with its AE, it shall compute ALP by applying most appropriate method in accordance with section 92C of the Act.

As per the provisions of the Sub section 3 of Section 92CA of the Act, the TPO shall determine the ALP in relation to international transaction in accordance with sub-section 3 of section 92C of the Act.

The Act under section 92C and 92CA clearly states that the ALP should be determined for international transaction and any deviation from the provisions of act shall make it contravene. The provisions of chapter X shall not apply to non-AE transactions.

Views of High Court and Tribunal

The TP adjustment is mandated only for international transaction with AE and not to independent transaction with third parties. The reason behind imposing TP is to scrutinise the ALP of the controlled transaction with AEs and to avoid profit shifting.  The avoidance of tax or profit shifting shall not arise in case of transaction with independent third party since the transactions are uncontrolled. When the revenue determines ALP on entity level, it indirectly imposes TP adjustment on non-AE transaction and this will result in increasing the profits earned from non-AE transaction as well[1], which is against the basic principles of transfer pricing and shall fall beyond the scope of Chapter X.[2] [3]

Illustration

The following illustration elucidates the issue of TP adjustments on non-AE transactions:

The Intragroup companies execute intercompany agreement for the transaction to be executed and shall charge the services provided at cost plus agreed markup, in the above illustration, AEs had agreed for Cost plus 17 per cent. With respect to non-AE transaction, they have no control over the cost and revenue earned, therefore the non-AE segment earned a profit margin of 4.5 per cent.

During the course of TP Assessment, the Transfer Pricing officer (‘TPO’) while carries out benchmarking analysis, shall consider entity’s profit to determine ALP. Since the cost of AE and non-AE transactions are combined at entity level, it resulted into profit margin of 14.75% and fails to meet the profit margin as per intercompany agreement.

The TP adjustment when imposed on the entity profit shall compel the company to accept the additions made on adjustment over non-AE segment as well and consequently non-AE revenue and cost gets adjusted, which defeats the fundamental merits of TP regulations. The TP adjustment inevitably requires the company to maintain margins of non-AE profit at ALP, which is inappropriate and contrary to the law.

Conclusion

Therefore, when the entity engages in transaction with AE and non-AE, the profit earned by such entity is a result of AE and non-AE transaction and in such case, segmentation of revenue and cost is imperative. Since, determination of ALP is mandated only to transaction with AE, the revenue should consider only transaction between entity and AEs and should not consider non-AE cost and revenue while calculating ALP[4].

[1] Thyssen Krupp Industries India (P.) Ltd. Vs. Assistant Commissioner of Income-tax, Central Circle – 3(3), [2012] 27 taxmann.com 334 (Mumbai – Trib.)

[2] Commissioner of Income-tax Vs. Thyssen Krupp Industries India (P.) Ltd., reported in [2016] 70 TAXMANN.COM 329 (Bombay),

[3] PR. COMMISSIONER OF INCOME TAX-2 Vs. M/S TT STEEL SERVICE INDIA PVT. LTD

[4] FIS Global Business Solutions India (P.) Ltd Vs. ACIT, [2024] 166 taxmann.com 28 (Delhi – Trib.)