Transfer pricing is a common practice in multinational companies, where transactions take place between two or more entities belonging to the same group or company. Such transactions involve the transfer of goods, services, or intellectual property, and it is essential to ensure that they are conducted at arm’s length, i.e., at a fair market price. To prevent the manipulation of transfer pricing to reduce taxable income, the Indian government has implemented Transfer Pricing Audit under Section 92E of the Income Tax Act, 1961.
The primary objective of Section 92E is to ensure that the transfer pricing policies adopted by companies do not result in the erosion of the Indian tax base. As per the Act, any entity involved in an international transaction or specified domestic transaction must maintain proper documentation to support the prices adopted in such transactions. The transfer pricing audit is conducted by the tax authorities to determine the accuracy of the prices charged or paid by the parties involved in such transactions.
The transfer pricing audit is conducted in three phases:
1. Documentation and Compliance Audit:
Documentation and compliance audit is the first phase of the transfer pricing audit process under Section 92E of the Income Tax Act, 1961. In this phase, the tax authorities examine the documentation maintained by the entity involved in the international transaction or specified domestic transaction to ensure that it meets the compliance requirements under Section 92E. The objective of this phase is to determine whether the entity has maintained accurate and reliable documentation to support the prices charged or paid in the transactions.
The following are the key components of the documentation and compliance audit phase:
Documentation Requirements: The entity should maintain proper documentation to support the prices charged or paid in the international transactions or specified domestic transactions. The documentation should include details of the nature and terms of the transaction, the pricing methodology adopted, and the economic analysis supporting the prices charged or paid.
Timeliness of Documentation: The documentation should be prepared contemporaneously with the transactions and maintained for a minimum of eight years from the end of the relevant financial year.
Accuracy and Completeness of Documentation: The documentation should be accurate, complete, and reliable to support the prices charged or paid in the international transactions or specified domestic transactions.
Compliance with Rules and Regulations: The documentation should comply with the rules and regulations prescribed by the Income Tax Act, 1961, and other relevant laws and regulations.
Penalties for Non-Compliance: Non-compliance with the documentation requirements can lead to penalties under Section 271AA of the Income Tax Act, 1961.
The tax authorities may request the entity to provide additional information or clarification during the documentation and compliance audit phase. If the documentation is found to be inadequate or non-compliant, the tax authorities may proceed to the functional and risk analysis phase to determine the appropriate transfer price for the transaction.
The documentation and compliance audit is a crucial phase of the transfer pricing audit process under Section 92E of the Income Tax Act, 1961. The entity involved in the international transaction or specified domestic transaction must maintain accurate, complete, and reliable documentation to support the prices charged or paid. Non-compliance with the documentation requirements can lead to penalties, and therefore, it is essential to ensure compliance with the applicable rules and regulations.
2. Functional and Risk Analysis:
The functional and risk analysis is the second phase of the transfer pricing audit process under Section 92E of the Income Tax Act, 1961. In this phase, the tax authorities analyze the functions performed, assets employed, and risks assumed by the entities involved in the international transaction or specified domestic transaction. The objective of this phase is to determine the appropriate transfer price for the transaction based on an analysis of the economic substance of the transaction.
The following are the key components of the functional and risk analysis phase:
Functional Analysis: The tax authorities examine the functions performed by the entities involved in the transaction, including the managerial, operational, and strategic functions. The functional analysis considers the contribution made by each entity in generating the profits from the transaction.
Risk Analysis: The tax authorities examine the risks assumed by the entities involved in the transaction, including market, credit, and operational risks. The risk analysis considers the nature and magnitude of the risks assumed by each entity and their impact on the profitability of the transaction.
Comparable Uncontrolled Price (CUP) Method: The tax authorities may use the CUP method to determine the arm’s length price for the transaction. The CUP method compares the price charged or paid in the transaction with the price charged or paid in a comparable transaction between unrelated parties.
Resale Price Method (RPM): The tax authorities may use the RPM to determine the arm’s length price for the transaction. The RPM compares the gross profit margin earned by the reseller in the transaction with the gross profit margin earned by a comparable reseller in a similar transaction with unrelated parties.
Cost Plus Method: The tax authorities may use the cost-plus method to determine the arm’s length price for the transaction. The cost-plus method adds a markup to the cost incurred by the supplier in providing the goods or services to the recipient.
Profit Split Method: The tax authorities may use the profit split method to determine the arm’s length price for the transaction. The profit split method allocates the profits earned from the transaction between the entities involved based on their respective contributions to the transaction.
The functional and risk analysis is a critical phase of the transfer pricing audit process under Section 92E of the Income Tax Act, 1961. The tax authorities analyze the functions performed, assets employed, and risks assumed by the entities involved in the transaction to determine the appropriate transfer price for the transaction. It is essential for entities involved in international transactions or specified domestic transactions to maintain accurate and reliable documentation to support the prices charged or paid in the transactions. Failure to do so can lead to penalties and transfer pricing disputes.
3. Price Determination and Adjustment:
Price determination and adjustment is the final phase of the transfer pricing audit process under Section 92E of the Income Tax Act, 1961. In this phase, the tax authorities determine the arm’s length price for the international transaction or specified domestic transaction based on the functional and risk analysis conducted in the previous phase. The objective of this phase is to make adjustments to the prices charged or paid in the transaction to ensure compliance with the arm’s length principle.
The following are the key components of the price determination and adjustment phase:
Arm’s Length Price: The tax authorities determine the arm’s length price for the transaction based on the functional and risk analysis conducted in the previous phase. The arm’s length price represents the price that unrelated parties would have charged or paid for a similar transaction under similar circumstances.
Primary Adjustments: The tax authorities make primary adjustments to the prices charged or paid in the transaction to ensure compliance with the arm’s length principle. Primary adjustments include an increase or decrease in the prices charged or paid to match the arm’s length price.
Secondary Adjustments: The tax authorities make secondary adjustments to the prices charged or paid in the transaction to account for the actual flow of funds between the entities involved. Secondary adjustments include a transfer of profits between the entities involved in the transaction.
Mutual Agreement Procedure (MAP): If the entity is not satisfied with the adjustments made by the tax authorities, they can initiate a Mutual Agreement Procedure (MAP) to resolve the dispute. The MAP provides a mechanism for the competent authorities of the countries involved in the transaction to resolve the dispute through negotiations.
Penalties for Non-Compliance: Non-compliance with the transfer pricing regulations can lead to penalties under Section 271AA of the Income Tax Act, 1961.
The price determination and adjustment is the final phase of the transfer pricing audit process under Section 92E of the Income Tax Act, 1961. The tax authorities determine the arm’s length price for the transaction based on the functional and risk analysis conducted in the previous phase and make adjustments to the prices charged or paid in the transaction to ensure compliance with the arm’s length principle. It is essential for entities involved in international transactions or specified domestic transactions to maintain accurate and reliable documentation to support the prices charged or paid in the transactions. Compliance with the transfer pricing regulations can help avoid penalties and transfer pricing disputes.
DOCUMENTATION
Under Section 92E of the Income Tax Act, 1961, entities involved in international transactions or specified domestic transactions are required to maintain proper documentation to support the prices charged or paid in such transactions. The following are the documents that need to be maintained for transfer pricing audit:
1. Master File: A master file contains information about the global business operations of the company, including its organizational structure, business strategies, and transfer pricing policies.
2. Local File: A local file contains information about the specific transaction between the related parties. It includes details of the nature and terms of the transaction, pricing methodology adopted, and economic analysis supporting the prices charged or paid.
3. Country-by-Country Report: A country-by-country report provides a high-level overview of the global business operations of the company, including the revenues, profits, taxes paid, and employees in each jurisdiction where the company operates.
4. Transfer Pricing Study: A transfer pricing study is a detailed analysis of the specific transaction between the related parties. It includes an analysis of the functions performed, assets employed, and risks assumed by the parties involved, as well as an economic analysis supporting the prices charged or paid.
5. Annual Accounts: Annual accounts contain financial statements of the entity involved in the transaction. These statements should be prepared in accordance with the accounting standards prescribed by the Institute of Chartered Accountants of India.
6. Tax Return: The tax return filed by the entity should contain details of the international transactions or specified domestic transactions entered into during the relevant financial year.
7. Board Resolutions and Agreements: Board resolutions and agreements related to the international transactions or specified domestic transactions should be maintained to support the pricing adopted in such transactions.
It is essential to maintain these documents for a minimum of eight years from the end of the relevant financial year. The documentation should be accurate, complete, and reliable to support the prices charged or paid in the international transactions or specified domestic transactions. Non-maintenance of proper documentation can lead to transfer pricing disputes and penalties. Therefore, entities involved in such transactions must ensure compliance with the documentation requirements under Section 92E of the Income Tax Act, 1961.
In conclusion, the transfer pricing audit is a complex process that requires the expertise of professionals in accounting, economics, and taxation. It is important for companies to engage in proactive planning to avoid transfer pricing disputes and ensure that their transfer pricing policies are in compliance with the applicable laws and regulations.
Transfer Pricing Audit under Section 92E of the Income Tax Act, 1961, is a crucial tool for the Indian government to prevent the manipulation of transfer pricing by companies. It ensures that the transactions between related parties are conducted at arm’s length, and the Indian tax base is not eroded. Companies must maintain proper documentation and engage in proactive planning to avoid transfer pricing disputes and ensure compliance with the applicable laws and regulations.
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