1. INTRODUCTION TO TRANSFER PRICING:
In general, Transfer Pricing (TP) refers to determination of Arm’s Length Price (ALP) for transfer of goods, services and technology between Associated enterprises (generally referred as related parties) who are otherwise known as members of Multi National Entities (MNE) or between unrelated parties which are controlled by a common party.
The substratal rationale of the transfer pricing regulations is to ensure that the true income of an Assessee is brought to tax under the Act and there is no avoidance of tax by transfer of income from India to any other tax jurisdiction by virtue of the influence exercised by the associated enterprises.
It can even be observed from the Finance Minister’s speech at the time of introducing TP regulations vide Finance Act 2001:
“The presence of multinational enterprises in India and their ability to allocate profits in different jurisdictions by controlling prices in intra-group transactions has made the issue of transfer pricing a matter of serious concern. I had set up an Expert Group in November 1999 to examine the issues relating to transfer pricing. Their report has been received, proposing a detailed structure for transfer pricing legislation. Necessary legislative changes are being made in the Finance Bill based on these recommendations.”
Article 9 of the Organisation for Economic Cooperation and Development (OECD) Model Convention provides for the concept of the Arm’s Length Principle wherein the profits of Enterprises of MNE is based on transactions between the independent Enterprise under similar conditions and circumstances.
The aim of the provisions of Chapter X of the Act is to compute the income in relation to a controlled transaction between an Assessee and its associated enterprise having regard to Arm’s Length Principle which seeks to ensure that the variations in the transfer price between members of an MNE (the Controlled Transactions), which may be based on special relationship between the enterprises, are either eliminated or reduced to large extent.
The object of the exercise of determining ALP is to remove the effect of any influence on the prices or costs that may have been exerted on account of the international transactions being entered into between related parties. Thus it is clear that for the exercise of determining ALP to be reliable, it is necessary that the controlled transactions be compared with uncontrolled transactions which are similar in all material aspects.
2. APPLICABILITY OF REAL INCOME THEORY TO TRANSFER PRICING:
A Specific Anti-Avoidance Rule (“SAAR”) such as transfer pricing should only be applied sparingly and should not deviate from the ‘real income’ theory which provides that only actual profits and gains should be considered as income chargeable to tax. Tax authorities tend to exercise wide powers by using SAAR without carefully analysing the thin line between prevention of tax avoidance and violation of the real income theory.
Decision of the Hon’ble Delhi High Court in the case of Rampgreen Solutions Pvt. Ltd Vs. CIT (377 ITR 533) is the case in point. The relevant observations read as under;
“12. At the outset, it is necessary to bear in mind that the object and purpose of introducing provisions relating to transfer pricing adjustment in the Act. By virtue of Finance Act, 2001, Section 92 of the Act was substituted by Sections 92 to 92F of the Act with effect from 1 st April, 2002. Section 92 of the Act, as was in force prior to 1st April, 2002, enabled the AO to bring the correct profits to tax in relation to certain cross-border transactions. However, with a large number of multi-national companies establishing operations in India, either through their subsidiaries or through other related ventures, a need was felt to provide a statutory framework to ensure that there is no avoidance of tax by transfer of income from India to other tax jurisdictions. Circular no. 14 of 2001 issued by the CBDT indicates that the provisions of Section 92 to 92F of the Act were introduced “With a view to provide a detailed statutory framework which can lead to computation of reasonable, fair and equitable profits and tax in India”.
13. The heading of Chapter X also clearly indicates that it contains“special provisions relating to avoidance of tax”. The object of Chapter X of the Act is not to tax any notional income but to ensure that the real income is brought to tax under the Act. This has also been explained by a Division Bench of this Court in Sony Ericsson Mobile Communications India Pvt. Ltd. and Ors. v. Commissioner of Income Tax-III and Ors. 374 ITR 118 in the following words:-
“77. As a concept and principle Chapter X does not artificially broaden, expand or deviate from the concept of “real income”. “Real income”, as held by the Supreme Court in Poona Electricity Supply Company Limited versus CIT, :  57 ITR 521 (SC), means profits arrived at on commercial principles, subject to the provisions of the Act. Profits and gains should be true and correct profits and gains, neither under nor over stated. Arm’s length price seeks to correct distortion and shifting of profits to tax the actual income earned by a resident/domestic AE. The profit which would have accrued had arm’s length conditions prevailed is brought to tax. Misreporting, if any, on account of non-arm’s length conditions resulting in lower profits, is corrected.””
Further, Global Vantedge judgement (37 SOT 1) emphasizes the fact that total amount of transfer pricing adjustment cannot exceed the absolute amount of revenue realized by the associated enterprise from third parties, by the following Observations-
“The crux of the contention raised by the appellant is that in a revenue sharing arrangement between the entities, what may be questioned is the proportion of sharing between the entities and not the absolute amount of revenue itself which is the subject of sharing because that is beyond the control of either the appellant or its associated enterprise(s). I would agree with such a view because the Indian Transfer Pricing Regulations only require us to analyse the transactions between associated enterprises and not the transactions with third parties since extraneous factors cannot be controlled. Moreover, if an entity is unable to earn adequate profits on account of legitimate business exigencies and not due to manipulation of transactions undertaken by the associated enterprises, such entity cannot be penalised.”
3. REAL INCOME THEORY IMPACT ON TP ADJUSTMENTS ON ACCOUNT OF NOTIONAL INTEREST:
As per Apex Court judgment it is clear that real income theory principles squarely applies even with respect to transfer pricing cases. Undoubtedly it applies in the case of determining ALP for notional interest on outstanding receivables from Associated Enterprises.
In the case of Evonik Degussa India Pvt. Ltd., in ITA No. 7653/Mum/2011 Honourable Mumbai Tribunal’s observations with respect to real income theory on notional interest are as follows-
“Moreover, the T.P. adjustment cannot be made on hypothetical and notional basis until and unless there is some material on record that there has been under charging of real income. Thus, on the facts and circumstances of the case, we are of the opinion that addition an account of notional interest relating to alleged delayed payment in collection of receivables from the A.Es, is uncalled for on the facts of the present case and is, accordingly, deleted.”
It is also pertinent to mention that Courts have time and again held upon taxability of notional interest on outstanding receivables from Associated Enterprises, among those judgments some are in favour of Department and some are favourable to Assessee either by reckoning towards working capital adjustments or by comparing credit period of uncontrolled transaction or by looking into Assessee’s debt free status.
No-doubt that the above guidelines followed by Courts while issuing favourable judgments are in line with enquiring the undercharging of real income. Since as per Rule 10A(d) interest on outstanding receivables transaction should be clubbed with the principal sale transaction and if there is no adjustment in determining its Arm’s length price, practically there shall no undercharging of real income even with respect to notional interest on outstanding receivables from Associated Enterprises.
Thus based on precedents it can be concluded that tax authorities at-best cannot interfere with legitimate business transactions which have commercial objectives and offerings to tax are inline with real income principles.
It is pertinent to mention that arm’s length adjustment should be done sparingly and only in exceptional circumstances, where avoidance of tax is glaring, by setting transfer Prices for transactions between associated enterprises involving the transfer of property or services.
The standard for deciding transfer price, which was agreed internationally, was to compare them with those of independent firms, and this approach was called arm’s length principle or Separate Accounting (SA) principle. Based on this principle, the Organisation for Economic Co- operation and Development (OECD) published Transfer Pricing Guidelines in 1995 which approved Five transfer pricing methods (i.e, Comparable Uncontrolled price method, Resale price method, Cost-plus method, Transactional Net Margin method, Profit-split method) and most appropriate method among them needs to be opted by Assessee, this option to Assessee is in addition to Safe Harbour Rules, which specifies the margin to be offered.
However, many independent commentators have highlighted the shortcoming of arm’s length principle and argued for a shift away towards approaches which would treat MNCs in accordance with the economic reality that they operate as unitary firms. This approach is known as Unitary Taxation with Formula Apportionment (UT- FA).
Under the UT-FA approach, tax authorities would apportion the MNC’s global consolidated proit among the subsidiaries, based on factors which relect its real economic presence, such as number of employees, payroll, physical assets and sales. Each subsidiary will then pay taxes according to domestic tax regulations.