Chapter II

Introduction

The development of the practice of transfer pricing and promulgation of laws to check abuses emanating from wide adherence to such practices owe their origin to the desire of taxpayers to avoid or minimize the impact of taxes on incomes profits and gains. Such a desire, which is common in all taxpayers irrespective of the countries to which they belong, has led to the designing of increasingly sophisticated methods of tax avoidance for transactions having international ramifications through transfer pricing techniques. Tax evasion/avoidance methods have led to imbalances in tax realizations in different tax regimes world over. The right allocation of profits from cross border transactions for taxation between various jurisdictions has been a matter of constant anxiety and debate between revenue authorities of various countries. The desire to share tax revenues to the optimum by different jurisdictions has posed many problems, which have become further complicated by technological advancements and new ways of doing business. The conflicting interests of developed and developing countries have added new dimensions to the continuing debate on such issues. The steps taken in the past to tackle such issues has been to incorporate in the Double Taxation Avoidance Agreements (DTAAs) stipulations regarding “ Arm’s Length Principle” In other words, the transactions between the parent company and branches, subsidiaries and associates should be charged at prevailing market prices. Where there was no tax treaty, the tax laws of respective countries contained appropriate provisions to deal with the problem. For example, section 92 of the Income Tax Act, 1961 in India gave Income Tax Officer the power to determine the reasonable amount of profit accruing or arising in India if it appeared to him that a resident has transferred his Indian source income to a closely connected non-resident by collusive invoicing or other arrangements in the course of business transacted between them. Where tax rates are different between the countries there is strong incentive to shift income to a lower tax country and deductions to a higher tax country so that overall tax effect is minimized. No Government can afford multinational enterprises to manipulate transactions amongst their affiliates in this way to avoid or minimize taxes in the state where these are rightfully collectible causing substantial loss of much needed revenue for the welfare of its people.

With the rapid advancement of trade and commerce and new economic policy having been introduced in 1991 in India, leading to liberalization of trade policies, removal of economic controls and restrictions and coming in of MNCs in a big way, section 92 for checking the abuses of transfer pricing proved inadequate. Therefore, while presenting the budget for the year 2001-02, the Finance Minister decided to make elaborate provisions concerning transferring pricing. He, in para 176 of the budget speech said “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”.Hence, by the Finance Act, 2001 sections 92 of the I.T. Act,1961 was substituted by section 92 to 92F w.e.f. 1.4.2002.

The need for regulating prices in international or transactional transactions arises because of varied reasons. There have been various commonly used devices to avoid taxation or to bring down its incidence. Tax evasion or avoidance is frequently indulged in by foreign multinational enterprises/companies who take advantage of the position that their books are being maintained at their head office and are therefore not available for examination by the assessing officers of the country where their subsidiaries branches, affiliates etc. are working. This often creates problems in investigation work when enquiries about assessments in host countries are being made. Past experience shows that foreign multinational enterprises avoid tax payments in other countries by indulging, inter alia, in the following practices:

-price manipulation;

-inflation of interest and rent ;

-duplicate payments for management charges; -payments for non-existent services;

-collusive agreements to shift income source; -disguising royalties as management charges; -allocation of expenses not connected with business; -disproportionate allocation of head office expenditure; -disguised dividends through loans.

The broad technique of a multinational corporation to evade proper taxes or to reduce its overall tax burden is to transfer its income from a country of high tax incidence to a tax heaven country or to a low tax jurisdiction. Sometimes, the transfer of income from one country to another is also done to circumvent foreign exchange regulations. The transfer of income is effected through one or more of the above methods. The manipulated channeling of income distorts equitable allocation of income and adversely affects the tax collections and foreign exchange position. Developing countries like India can ill afford such a drain on their tax and foreign exchange resources.

Many multinational enterprises resort to the practice of collusive invoicing to sell or transfer products or services to their marketing branches subsidiaries or associates at prices based not at the market rates but at rates decided by themselves. In such situations, prices are manipulated through transfer pricing in such transactions to the detriment of the host country. It is not easy to determine the comparable market price for goods and services in the case of many foreign enterprises. Firstly, the price in the domestic market may not be comparable with the price in the export market as both these markets are insulated by tariffs. Secondly, the market price in one foreign country may not be comparable with the price in another foreign country and companies charge prices on the basis of what each market can bear. Thirdly, the goods produced by many of these corporations are marketed under their trademarks and a company may claim that its product is different from that of a rival and therefore there can be no basis for comparison. Lastly, information as to how much profit is made on the sale of the transformed goods may not be available when assessing the reasonableness of the allocation of the income to the transferor. However, in spite of such limitations, the fair market price of goods may be determined by one or more of the following methods:

(a)  Comparing the transfer price with prevailing market prices, after making suitable adjustments for quality, quantity, time of sale, and other relevant factors:

(b) In the case of purchase by a marketing concern, applying an appropriate mark up factor downwards to the resale price to outside parties, namely the price at which the goods are sold by that enterprise to non-associate third parties.

(c) In the case of a manufacturing or buying concern, estimating a reasonable mark up on the cost and adding it to the cost;

(d)  Comparing the price with the value taken for the goods by the customs authorities for purposes of the levy and collection of customs duties;

(e)   Comparing the price with the value taken for the purposes of insurance.

Transfer pricing law/regulations are made to ensure that the forgoing exercises take a legal shape and expose the attempts to dupe the Revenue Authorities of the country affected.

Chapter II
Transfer pricing-the concept

No exhaustive and compact definition of the phrase ‘transfer pricing’ is possible nor has it been attempted in the legislations in the countries that have tried to find solutions to this menace. When transfers by way of sales exchange, etc. are made between two independent entities unconnected with each other as normal business deals, there can hardly be any scope of alleging any malpractice or hidden motives in price fixation. Market forces determine the prices in such situations which would certainly be ‘transfer prices’ but devoid of any objectionable feature in it. Transfer price in such a situation will represent the value of goods of services between independently operating units-may be between the same group. However, it is not in this sense that this discussion on transfer pricing is concerned. Transfer pricing in the present context refers to prices of transactions between associated enterprises which may take place under conditions differing from those taking place between independent enterprises. It refers to the value attached to transfers of goods, services and technology between related entities, which have not been fairly arrived at. It can also refer to the value attached to transfers between unrelated parties which are controlled by a common entity. The essence of transfer pricing is that it is not set by an independent transferor and transferee in arm’s length negotiations. It is within the discretion of a single enterprise.Transfer prices are widely used in multinational organizations, which typically involve a parent company domiciled in one country and a number of subsidiary companies operating in other countries. When multinational firms conduct business within their group , the concept of market pricing or arm’s length pricing has generally no relevance. Income or deduction is arbitrarily shifted.

Thus the effect of transfer pricing is to pass on some or all profit by a parent or controlling enterprise to its subservient or subsidiary undertaking to produce lesser taxable incomes or even less in the case of parent or controlling enterprise. It can work in the opposite direction also. if the subsidiary or the controlled unit is based in a high tax jurisdiction and the controlling or the parent company is based in a jurisdiction where the tax rates are low or it is a tax heaven in the sense that no tax is charged in that jurisdiction, profit of such undertaking can be increased by siphoning profits from high tax jurisdictions to low tax jurisdictions. For example X is a high tax country where Enterprise A is functioning. It has a 100 per cent subsidiary in Y country which is a tax heaven. A would sell its products say to B in Y country at a very low margin of profit. B may then sell the same product to C at arm’s length price(explained subsequently) and the resultant inflated price would be subject to no tax in Y country which has no laws to tax income thus A‘s financial position would increase consequent to B (its 100% subsidiary) earning more profit with a paying only nominal tax in a high taxed country.

Transfer pricing provisions in tax laws are thus, intended to counter the underpayment of tax, including tax deduction at source, by pricing the transactions on the bases of what independent parties acting freely and independently would do in normal business deals.

In para 5 of the UK Regulations Finance act, 1998, the aforesaid phenomenon has been described as “advantage in relation to United Kingdom taxation”. Its advantage arises wherever but for these provisions, the effect of making or imposing the actual provision, instead of the arm’s length provision, would be either that a smaller amount (which may be nil) would be taken for tax purpose to be the amount of that person’s profits for any chargeable period; or, a larger amount (or, if there would not otherwise have been losses, any amount of more than nil) would be taken for tax purposes to be the amount for any chargeable period of any losses of a person. In Germany, such an advantage arises in the case of a related person if he agrees on the terms and conditions of a business relationship, to exert influence on the taxpayer based on considerations outside that business relationship, or is personally interested in the earning of the relevant income by the other enterprise. This advantage had to be eliminated by applying arm’s length principle.

To sum up, transfer pricing relates to transactions in goods services between related parties. The main object is to avoid or lessen tax burden by withdrawing profits from is high tax jurisdictions. It involves transfer between the enterprises under the same control and management of goods, merchandise, commodities, stocks of raw materials, finished goods or services at prices which are dictated by the market forces but controlled by other considerations for the reasons aforesaid.

Besides tax evasion/avoidance, transfer pricing technique is used for other reasons also to gain advantage of exchange control regulations and economic and political domination.

Factors other than the tax considerations are outlined as below in OECD Transfer Pricing guidelines:-

“1.4 Factors other than the tax considerations may distort the conditions of commercial and financial relations established between associated enterprises. For example, such enterprises may be subject to conflicting governmental pressures ( in the domestic as well as foreign country) relating to customs valuations, anti-dumping duties, and exchange or price controls. In addition, transfer price distortions may be caused by the cashflow requirements of enterprises within the MNE group. An MNE group that is publicity held may feel pressure from shareholders to show high profitability at the parent company level, particularly if shareholder reporting is not undertaken on a consolidated basis. All of these factors may affect transfer prices and the amount of profits, accruing to associated enterprises within the MNE group.”

However, whatever be the motive in ‘transfer pricing’ the tax loss is the ultimate consequence for a country where it would have accrued, had the transaction been at arm’s length.

Illustrating the concept of Transfer pricing by a Supreme Courts decision

In Mazagaon Dock Ltd. v. CIT (1958) 34 ITR 368 the concept of transfer pricing was considered by the Supreme Court with reference to section 42 of the Indian Income Tax Act 1922, when the law relating to transfer pricing was in its rudimentary stage. In this case, the appellant company which carried on business as marine engineers and ship repairers was resident and ordinarily resident for the purpose of Income Tax Act. To non­resident British companies engaged in the business of plying ships beneficially owned the entire share capital of the appellant company which repaired the ships of the non-resident companies at cost and charged no profits. The question before the Supreme Court was whether having regard to the course of dealings between the non resident companies and the appellant-company it could be said of the former that they carried on business with the latter within the meaning of section 42(2). It was observed that section 42 spoke not of the non-residents carrying on business in the abstract but of their carrying on business with the resident, and, in that context, it must include all activities between them having a relationship to their business. According to the court, the words where a person not resident in the taxable territories carries on business with a person resident’ in section 42(2) aforesaid were held to mean that a non-resident should be held to carry on business with a resident if the dealings between them formed concerted and organized activities of a business character. Hence the apex court, rejecting contentions of the appellant company held that profits, if any foregone, must be taxed separately. The court expressed the view that the fact that the dealings were such as to yield no profit was immaterial.

Chapter III

Indian Law concerning Transfer Pricing Historical background

Section 42(2) in the Income tax act 1922 dealt with the situation concerning “Transfer pricing”. On the enactment of the Income tax Act 1961, the provisions of Section 42(2) were incorporated in this Act in the form of Section 92 with minor verbal changes to bring out the purport of the section more clearly.

Section 92 was backed by Rules 10 & 11 in the IT Rules 1962.

Conditions to be satisfied for applicability of Section 92

For invoking Section 92, certain requisite conditions had to exist. These were:

(i)  The business was transacted between a resident and non-resident.

(ii)   There was a close connection between the two

(iii)      On the account, the course of business was so arranged that the business produces either no profit or less than normal profit to the resident.

If the conditions at (i) to (iii) were found to exist, the Assessing Officer under the Act was empowered:

–     to determine the amount of profits, which may reasonably be deemed to have been derived from such business; and

–             to include such amount in the total income of the resident.

Rules 10 & 11 (supra) provided the methodology for working out the normal profit to be included in the income of the resident assessee in the circumstances mentioned earlier. The normal profit could be calculated:

(i)  at such percentage of the turnover so accruing or arising as the Assessing Officer may consider to be reasonable, or

(ii)  On any amount which bears the same proportion to the total profits and gains of the business of such person, as the receipts so accruing or arising bear to the total receipts of the business, or

(iii)   In such other manner as the Assessing Officer may deem suitable.

The Law as laid down by the Finance Act 2001

As mentioned earlier, Section 92 in the IT Act 1961 was substituted by 8 sections in the IT Act numbered 92, 92A,92B, 92C,92CA,92D, 92E & 92F dealing with various aspects concerning transfer pricing. Texts of these provisions have been given in Annexure A. The contents of these provisions concerning transfer pricing were explained in the Explanatory Memorandum to the Finance Act 2001. These are intended to “curb tax avoidance by abuse of transfer pricing”. The provisions were later explained in more detail in circular No. 14 dated 20th November explaining the provisions relating to Finance Act 2003. A clear and detailed idea about the Government objects to be achieved through the new provisions and about their implementation can be had from the CBDT’s circular. Hence the relevant portion from this circular is reproduced hereinafter.

Extracts from the CBDT’s Circular No. 14 dated 20.11.2001 containing Explanatory Notes on the provisions relating to Finance Act, 2001 (paragraphs 55 to 55.23)

New Legislation to curb tax avoidance by abuse of transfer pricing.

The increasing participation of multinational group in economic activities in the country has given rise to new and complex issues emerging from transactions entered in to between two or more enterprises belonging to the same multinational group. The profits derived by such enterprises carrying on business in India can be controlled by the multinational group, by manipulating the prices charge and paid in such intra group transactions, thereby, leading to erosion of tax revenues.

Under the existing Section 92 of the income tax Act, which was the only section dealing specifically with cross border transactions, an adjustment could be made to the profits of a resident arising from a business carried on between the resident and a non­resident ,if it appeared to the Assessing Officer that owing to the close connection between them, the course of business was so arranged so as to produce less than expected profits to the resident. Rules 11 prescribed under the section provided a method of estimation of reasonable profits in such cases. However, this provision was of a general nature and limited in scope, it did not allow adjustment of income in the case of non­residents. It referred to a “close connection” which was undefined and vague. It provided for adjustment of profits rather than adjustment of prices, and the rule prescribed for estimating profits was not scientific. It also did not apply to individual transactions such as payment of royalty, etc., which are not part of a regular business carried on between a resident and a non-resident. There were also no detailed rules prescribing the documentation required to be maintained.

With a view to provide a detailed statutory framework which can lead to computation of reasonable, fair and equitable profits and tax in India, in the case of such multinational enterprises, the Act has substituted section 92 with a new section, and has introduced new sections 92A to 92F in the Income-tax Act, relating to computation of income from an international transactions having regard to the arm’s length price, meaning of associated enterprise, meaning of international transaction, computation of arm’s length price, maintenance of information and documents by persons entering in to international transactions, furnishing of a report from an accountant by persons entering in to international transactions and definitions of certain expressions occurring in the said sections.

The substituted section 92 provides that income arising from an international transaction between associates enterprises shall be computed having regard to the arm’s length price. Any expense or outgoing in an international transaction is also to be computed having regard to the arm’s length price. Thus in the case of a manufacture, for example, the provisions will apply to exports made to the associated enterprises as also to imports from the same or any other associated enterprise. The provisions is also applicable in a case where the international transaction comprises only an outgoing from the Indian assessee.

The new section further provides that the cost or expenses allocated or apportioned between two or more associated enterprises under a mutual agreement or arrangement shall be at arm’s length price. Examples of such transactions could be where one associated enterprise carries out centralized functions which also benefit one or more other associated enterprises, or two or more associated enterprises agree to carry out a joint activity, such as research and development, for their mutual benefit.

The new provisions are intended to ensure that profits taxable in India are not understated (or losses are not overstated) by declaring lower receipts or higher outgoings than those which would have been declared by persons entering in to similar transactions with unrelated parties in the same or similar circumstances. The basic intention underlying the new transfer pricing regulations is to prevent shifting out of profits by manipulating prices charges or paid in international transactions, thereby eroding the country’s tax base. The new section 92 is therefore, not intended to be applied in cases where the adoption of the arm’s length price determined under the regulations would result in a decrease in the overall tax incidence in India in respect of the parties involved in the international transaction.

The substituted new Sections 92A and 92B provide meanings of the expression “associated enterprise” and “international transaction” with reference to which the income is to computed under the new section 92. While sub-section(1) of Section 92A gives a general definition of associated enterprises, based on the concept of participation in a management, control or capital, sub section (2) specifies the circumstances under which the two enterprises shall be deemed to be associated enterprises.

Section 92B provides a broad definition of international transaction, which is to read with the definition of transaction given in Section 92F. An international transaction is essentially a cross border transaction between associated enterprises in any sort of property, whether tangible or intangible, or in the provision of services, lending of money etc. At least one of the parties to the transaction must be a non-resident. The definition also covers a transaction between two non-residents, where for example, one of them has permanent establishment whose income is taxable in India.

Sub-section (2) of Section 92B extends the scope of the definition of international transaction by providing that a transaction entered in to with an unrelated person shall be deemed to be a transaction with the associated enterprise, if there exists a prior agreement in relation to the transaction between such other person shall be the associated enterprise, or the terms of the relevant transaction are determined by the associated enterprise. An illustration of such a transaction could be where the assessee, being an enterprise resident in India, exports goods to an unrelated person abroad, and there is a separate arrangements or agreement between the unrelated person and an associated enterprise which influences the price at which the goods are exported. In such a case the transaction with the unrelated enterprise will also be subject to transfer pricing regulations.

The new Section 92C provides that the arm’s length price in relation to an international transaction shall be determined by (a) comparable uncontrolled price method; or (b) resale price method; or (c) cost plus method; or (d) profits split method; or (e) transactional net margin method; or (f) any other method which may be prescribed by the Board. For the present, no additional method has been prescribed by the Board.

One of the five specified methods shall be the most appropriate method in respect of a particular international transaction, and shall be applied for computation of arm’s length price in the manner specified by the rules. Rules 10A to 10E , which have been separately notified, vide S.S. 808(E) dated 21.08.2001 inter alia, provide for the factors which are to be considered in selecting the most appropriate method.The major considerations in this regard have been specified to be the availability, coverage and reliability of data necessary for application of the method, the extent and reliability of data necessary for application of the method, the extent and reliability of assumptions required to be made and the degree of comparability existing between the international transaction and the uncontrolled transaction. The rules also lay down in detail the manner in which the methods are to be applied in determining the arm’s length price.

Applying the most appropriate method to different sets of comparable data can possibly result in computation of more that one arm’s length price. With a view to avoid unnecessary disputes, the proviso to Section 92C (2) provides that in such a case the arithmetic mean of prices shall be adopted as the arm’s length prices. In the normal course, if the different sets of comparable data are equally reliable there may not be any significant divergence between the various arm’s length prices determined.

Under the new provisions the primary onus is on the taxpayer to determine an arm’s length price in accordance with the rules, and to substantiate the same with the prescribed documentation. Where such onus is discharged by the assessee and the data use for determining the arm’s length price is reliable and correct, there can be no intervention by the Assessing Officer. This is made clear by sub-section (3) of section 92C which provides that the Assessing officer may intervene only if he is, on the basis of material or information or document in his possession, of the opinion that the price charged in the international transaction had not been determined in accordance with sub­sections (1) and (2), or information and documents relating to the international transaction have not been kept and maintained by the assesses in accordance with the provisions contained in sub-section (1) of section 92D and the rules made there under; or the information or data used in computation of the arm’s length price is not reliable or correct; or the assessee has failed to furnish, within the specified time, any information or document which he was required to furnish by a notice issued under sub-section (3) of section 92D. If any one of the such circumstances exists, the Assessing Officer may reject the price adopted by the assessee and determine the arm’s length price in accordance with same rules. However, an opportunity has to be given to the assessee before determining such price. Thereafter, as provided in sub-section (4) of section 92C, the Assessing officer may compute the total income on the basis the arm’s length price so determined by him.

The first proviso to section 92C (4) recognizes the commercial reality that even when a transfer pricing adjustments is made under that sub-section, the amount represented by the adjustments would not actually have been received in India or would have actually gone out of the country. Therefore, it has been provided that no deductions under section 10A or 10B or under Chapter VIA shall be allowed in respect of the amount of adjustments.

The second proviso to section 92C (4) refers to a case where the amount involved in the international transaction has already been remitted abroad after deducting tax at source and subsequently, in the assessment of the resident payer, an adjustment is made to the transfer price involved and thereby, the expenditure represented by the amount so remitted is partly disallowed. Under the Income tax Act, a non-resident in receipt of income from which tax has been deducted at source has the option of filing a return of income in respect of the relevant income. In such cases, a non-resident could claim a refund of a part of the tax deducted at source, on the ground that an arm’s length price has been adopted by the Assessing Officer in the case of the resident and the same price should be considered in determining the taxable income of the non-resident. However, the adopting of the arm’s length price in such cases would not alter the commercial reality that the entire amount claimed earlier would have actually been received by the entity located abroad. It has therefore been made clear in the second proviso that income of one associated enterprise shall not be recomputed merely by reason of an adjustment made in the case of the other associated enterprise on determination of arms length price by the Assessing Officer.

The new section 92D provides that every person who has undertaken an international transaction shall keep and maintain such information and documents as may be specified by rules made by the Board. The Board may also specify by rules the period for which the information and documents are required to be retained. The documentation required to be maintained has been prescribed under rule 10D. Such documentation includes background information on the commercial environment in which the transaction has been entered in to, and information regarding the international transaction entered in to, the analysis carried out to select the most appropriate method and to identify comparable transactions, and the actual working out of the arm’s length price of the transaction. The documentation should be available with assessee by the specified date defined in section 92F and should be retained for a period of 8 years. During the course of any proceedings under the Act, an Assessing Officer or Commissioner (Appeals) may require any person who has undertaken an international transaction to furnish any of the information and documents specified under the rules within a period of thirty days from the date of receipt of a notice issued in this regard, and such period may be extended by a further period not exceeding thirty days.

The new section 92E provides that every person who has entered into an international transaction during a previous year shall obtain a report from accountant and furnish such report on or before the specified date in the prescribed form and manner. Rule 10E and Form No. 3CEB have been notified in this regard.The accountant’s report only requires furnishing of factual information relating to the international transaction entered into, the arm’s length price determined by the assessee and the method applied in such determination. It also requires an opinion as to whether the prescribed documentation has been maintained.

The new section 92F defines the expression “accountant”, “arm’s length price”, enterprise”, “specified date” and “transaction” used in sections 92,92A, 92B,92C, 92D and 92E. The definition of enterprise is broad and includes a permanent establishment, even though a PE is not a separate legal entity. Consequently, transactions between a foreign enterprise and its PE, for example, between the head office abroad and a branch in India, are also subject to these transfer pricing regulations. Also the regulation 33 would apply to transactions between a foreign enterprise. The term permanent establishment has not been defined in the provisions but its meaning may be understood with reference to the tax treaties entered in to by India.

With a view to ensure that multinational enterprises comply with the requirements of the new regulations, the Act has also amended section 271 and inserted new sections 271AA, 271BA and 271G in the Income-tax Act, so as to provide for penalty to be levied in cases of non-compliance with procedural requirements, and in cases of understatement of profits through fraud or willful negligence.

The new Explanation 7 to sub-section (1) of Section 271 provides that where in the case of an asessee who has entered in to an international transaction, any amount is added or disallowed in computing the total income under sub-sections (1) and (2) of Section 92, then, the amount so added or disallowed shall be deemed to represent income in respect of which particulars have been concealed or inaccurate particulars have been furnished. However, no penalty under section 27 1(1) (c) shall be levied where the assessee proves to the satisfaction of the Assessing Officer or the Commissioner (Appeals) that the price charged or paid in such transaction has been determined in accordance with Section 92C in good faith and with due diligence.

The new section 271AA provides that if any person who has entered into an international transaction fails to keep and maintain any such information and documents as specified under section 92D, the Assessing Officer or Commissioner (Appeals) may direct that such person shall pay, by way of penalty, a sum equal to two percent of the value of the international transaction entered into by such person.

The new section 271BA provides that if any person fails to furnish a report from an accountant as required by section 92E, the Assessing Officer may direct that such person shall pay by way of penalty, a sum of one lakh rupees.

The new section 271 G provides that if any person who has entered into an international transaction fails to furnish any information or documents as required under sub-section (3) of Section 92D, the Assessing Officer or the commissioner (Appeals) may direct that such person shall pay, by way of penalty, a sum equal to two percent of the value of the international transaction.

The Act has also amended section 273B to provide that the above mentioned penalties under sections 271AA, 271BA and 271G shall not be imposable if the assessee proves that there was reasonable cause for such failures.

These amendments will take effect from 1st April, 2002 and will accordingly apply to the assessment year 2002-03 and subsequent years.

The circular reproduced above explains the various aspects of the law relating to transfer pricing as also in regard to penalties which could be imposed for non­compliance. However, some major concepts which underline the basis of new law are being elaborated further hereinafter. The Penalties portion would be discussed in a separate chapter.

International Transaction

The concept of ‘international transaction’ is important because the law relating to ‘transfer pricing’ applies only in the context of such transactions. ‘International transaction’ has been defined in section 92B. In defining it both words “ means” and “shall include” have been used. Thus the definition is both explanatory and inclusive namely expansionary. The explanatory part is quite wide in the sense that it defines it to mean a transaction between two or more associated enterprise, either or both of whom are non-residents, in the nature of purchase, sale or lease of tangible or intangible property; or provision of services, or lending or borrowing money or any other transaction having bearing on the profits, income, losses or assets of such enterprises. This definition is quite wide and would cover in its sweep all commercial dealings having an impact on the profits and losses between the associated enterprises where both are or either is non-resident (s). The inclusive or expansionary part, inter alia, covers mutual agreements or arrangements between the associated enterprises for the allocation or appropriation of any cost or expense contributed or incurred or to be incurred in the context of a benefit, service of facility provided or to be provided to any one or more enterprise.

Sub-section (2) extends the meaning of international transaction further. Some transactions between the two associated enterprises have been specifically defined to mean international transactions; some arrangements , though are not of the nature of transaction but are deemed so to be; while some others not being between them but are also so deemed. Thus sub-section (2) deems the preordained arrangements between an enterprise and a person other than an associated enterprise and the associated enterprise. The term ‘transaction’ is defined to cover arrangements, understandings and mutual practices whether or not they are intended to be legally enforceable. It encompasses transactions for which no price has been set that would not have taken place between the third parties.

“Transaction” in the context of the phrase ‘International transaction’ generally implies an act of transacting or conducting any business between two or more persons, negotiations, agreement or several acts or agreements between parties concerning business deals spread over globally. “Transaction” as defined in section 92F(v) includes an arrangement, understanding or action in concert whether or not it is formal or in writing or it is intended to be enforceable by legal proceedings.

Associated Enterprises

The concept of ‘Associated Enterprises’ as could by seen from earlier discussion is important in the context of ‘transfer pricing’ legislation. In common parlance the expression “enterprise” means an economic activity carried on by a person, capable of producing profits, an activity which is exercised in an independent manner, consisting of well defined actions, and, having economic character. According to section 92A, this phrase has relevance in the context of sections 92,92B,92C,92D and 92E. ‘Enterprise’ has been, or is proposed to be engaged in the following activity or business which is carried on, irrespective of whether done directly or through one or more of its units or divisions or subsidiaries and irrespective of whether such unit or division or subsidiary is located at the same or at the different place,. The activities mentioned relate to :

. the production, storage, supply, distribution or control of articles or goods, or

. know-how, patent, copyrights, trademarks, licenses, franchises or any other business or commercial rights of similar nature, or

. any data, documentation, drawing, or specification relating to any patent, invention, model, design, secret formula or process, of which the other enterprise is the owner or in respect of which the other enterprise has the exclusive rights, or

. the provision of services of any kind, or

. Engaged in investment, or providing loan or

. Engaged in the business of acquiring, holding, underwriting, or dealing with shares, debentures, or other securities of any other body corporate.

Associated Enterprises are those which are owned and controlled by the persons having same or common interest. The control could be direct or indirect, or through intermediaries. Sub-section (2) of section 92A mentions the circumstances when the control is exercisable through it may not have been exercised in fact. Sub-section (2) mentions the situations when two enterprises shall be deemed to be associated enterprises, if at any time during the previous year, these are found to be in situations mentioned in sub-clauses (a) to (m) of section (2). These sub-clauses are not being reproduced here as these can be seen from section 92A given in Annexure A. The focus in these clauses is broadly on three situations of management control and capital contribution.

Arm’s length principle/Arm’s length price

The concept of Arm’s length principle is not new in the context of income tax administration/legislation. It is generally incorporated tax treaties(Double Tax Avoidance Agreements). This principle was first incorporated in Article VI of the league of Nations Draft Convention on allocation of profits and property of International Enterprises in 1936. It is similar to Article 9 of the 1963 of OECD and UN model Convection of tax treaties should be put in to practice was issued in 1979 as the Report of the OECD committee on Fiscal Affairs on “Transfer Pricing & Multinational Enterprises” from their control.The underlying principle in Arm’s length dealing is to put controlled and uncontrolled enterprises at par to see whether the apportionment of income between related enterprises are economically reasonable. Under the arm’s length principle, controlled or associated taxkpayers are expected to realize from their controlled transaction, the results that would have been realized if uncontrolled taxpayers had been engaged in the same transactions under the same circumstances. It covers instances of under or over invoicing of goods or services in trans-border transactions between related parties.

Arm’s length price

Section 92C deals with the issue relating to computation of Arm’s length price and specifies the methods considered most appropriate for the determination of such prices. Broadly stated, Arm’s Length price as per section 92F is the price applied (or proposed to be applied) When two unrelated persons enter into a transaction in uncontrolled conditions. Persons are said to be unrelated, if they are not associated or deemed to be associated enterprises according to section 92A. Conditions which are not controlled or suppressed or moulded for achievement of a pre-determined results are said to be uncontrolled conditions. If a buyer is related to a seller, or where prices are governed by the Government policy then transaction is said to be taking place under controlled conditions.

Hence to constitute arm’s length price:

a. the price should be applied or proposed to be applied in a transaction;
b. the transaction is between unrelated persons; and

c. the transaction is taking place in uncontrolled conditions.

Methods considered most appropriate for determining, whether a price is arm’s length price or not mentioned in section 92C are:

  1. Comparable uncontrolled price method (CUP)
  2. Resale price method;
  3. Cost plus method;
  4. Profit split method;
  5. Transactional net margin method; (TNM)
  6. Such other method as may be prescribed by the Board.

Any of the above methods can be selected for determining the arm’s length price Rule 10C of the IT Rules has prescribed the guidelines for selecting the most appropriate method. It provides:

10C. Most appropriate method.

(1)  For the purposes of sub-section (1) of section 92C, the most appropriate method shall be the method which is best suited to the facts and circumstances of each particular international transaction, and which provides the most reliable measure of an arm’s length price in relation to the international transaction.

(2)  In selecting the most appropriate method as specified in sub-rule(1), the following factors shall be taken in to account, namely:-

(a)      the nature and class of the international transaction;

(b)   the class or classes of associated enterprises entering in to the transaction and the functions performed by them taking in to account assets employed or to be employed and risks assumed by such enterprises;

Methods for determining Arm’s length price

These methods are very briefly described as under:

(a) Comparable uncontrolled Price Method (CUP)

Under ‘CUP’ method, price charged for property or services transferred in a controlled transaction is compared to price charged in a comparable uncontrolled transaction. The sources of information for this could be (i) Internal Company data (ii) Company price list (iii) Website information (iv) trade directories (v) Government publications etc. The exercises involved in pursing this method would be (i) to identify prices charged or paid in a comparable uncontrolled transaction and (ii) to adjust such price to account for material difference which would affect the price in open market. However, this exercise will have to be done very carefully keeping in view the (i) “contract terms” (ii) the quantity of product, (iii) level of market (iv) geographical markets scene (v) intangibles associated with the sales and (vi) alternatives available to buyers and sellers.

The adjustments made on the basis mentioned earlier would lead to the determination of arm’s length price. For detailed understanding of this method Rule 10B (1)(a) of the IT Rules 1962 need to be referred to.

(b) Resale price method

Under this method:

a. the price at which property purchased or services obtained by the enterprise from an associated enterprise is resold or are provided to an unrelated enterprise, is identified;
b. such resale price is reduced by the amount of a normal gross profit margin accruing to the enterprise or to an unrelated enterprise from the purchase and resale of the same or similar property or from obtaining and providing the same or Similar services, in a comparable uncontrolled transaction, or a number of such transactions;
c. the price so arrived at is further reduced by the expenses incurred by the enterprise in connection with the purchase of property or obtaining of services;
d. the price so arrived at is adjusted to take in to account the functional and other differences including differences in accounting practices, if any, between the international transaction and the comparable uncontrolled transactions, or between the enterprises entering into such transactions, which could materially affect the amount of gross profit margin in the open market;

e. The adjusted price arrived at under (d) (supra) is taken to be an arm’s length price in respect of the purchase of the property or obtaining of the services by the enterprise from the associated enterprise.

Rule 10B (1) (b) of IT Rule 1962, is relevant in this context.

(c) Cost plus Method (CPM)

This method begins with the cost incurred by the supplier of property or services in a controlled transaction. An appropriate mark up is then added to this cost, in the light of functions performed and market conditions. The price arrived at after adding the cost plus mark up to these costs may be regarded as an arm’s length price of controlled transactions. Rule 1 0B (1) (c) provides the steps to compute the arm’s length price according to cost plus method.

(d)Profit split method

Under this method, the arm’s length price is determined through a division of the consolidated profits of the ‘associated enterprises’. The commonly applied method in this regard are contribution analysis and residual analysis. The method is applicable in cases involving multiple transactions which are so interrealated that they cannot be evaluated separately. The steps involved in applying this method are:

. Determine combined profits of the associated enterprises.

. Evaluate relative contributions of each enterprise towards earning of profits based on functions performed, assets employed and risks assumed.

. Split combined profits in proportion to relative economic contributions.

. The profit thus apportioned is taken in to account to arrive at the arm’s length price.

Rule 10B(1)(d) provides steps for determination of the arm’s length price under profit split method.

(e) Transnational net margin method (TNM)

The transactional net margin method examines the net profit margin that a taxpayer realizes from a transaction with an associated enterprise. The net margin is calculated with reference to appropriate base say costs, sales and assets etc. The net margin of the taxpayer from the controlled transaction is determined by reference to the margins earned in comparable uncontrolled transactions for establishing arm’s length price. The comparability of the transaction under this method is judged with reference to following:-

.   Specific characteristics of the property or services

. Functions performed

.   Contractual terms

. Market conditions

Rule 1 0B (1) (e) prescribes the steps for determination of arm’s length price according to this method.

(f)            Residuary Method and Mean of the Arm’s Length prices

Sub-section (1) of section 92C stipulates that in addition to the aforesaid five methods, the computation of the arm’s length price shall be made in accordance with such other method as may be prescribed by the Board, however, no such residuary method was prescribed in the notification dated 21.08.2001 defining the five methods enumerated in section 92 C( 1).

Sub-section (2) of section 92C envisages that the most appropriate method referred to in sub-section (1) shall be applied, for determination of arm’s length price, in the manner as may be prescribed. The proviso to the subsection before its amendment by the Finance Act, 2002, stipulated that where more than one price may be determined by the most appropriate method, the arm’s length price shall be taken to be the mean of such prices. The Finance Act, 2002, amended the proviso as per which in a case where more than one price is determined by the most appropriate method, the arm’s length price shall be taken to be:-

. the arithmetical mean of such prices, or

. at the option of the assessee,

. a price which may vary from the arithmetical mean,

. by an amount not exceeding five percent of such arithmetical mean.

A.O. Sresiduary powers for determining the Arm’s length price (sub-section (3) of section 92C)

Sub-section (3) of section 92C of the IT Act gives power to the Assessing Officer to determine arm’s length price in relation to an international transaction in accordance with sub-sections (1) & (2) of section 92C on the basis of material or information available with him if he notice the situations mentioned in sub-clauses (a) to (d) of sub­section (3). The situations when resort to sub-section (3) can be taken by the AO can be seen in sub-section (3) of section 92C in the Annexure ‘A’ when an Arm’s length price has been determined, sub-section (4) of section 92C provides that the AO may compute the total income of the assessee keeping in view the requirements mentioned in the two proviso to section 92C (4).

Other relevant aspects

(A)  Reference to Transfer pricing officer (Section 92CA)

Where any person, being the assessee, has entered in to an international transaction in any previous year, and the Assessing Officer considered it necessary or expedient so to do he may with the previous approval of the commissioner, refer the computation of the arm’s length price in relation to the said international transaction under section 92C to the Transfer Pricing Officer. After such a reference is made, the procedure specified in sub-sections (2) to (7) as mentioned will have to follow (See Annexure A ). For the purposes of this section, “Transfer Pricing Officer” means a Joint Commissioner or Deputy Commissioner or Assistant Commissioner authorized by the Board to perform all or any of the functions of an Assessing Officer specified in sections 92C and 92D in respect of any person or class of persons.

(B)  Report from an Accountant (Sections 92E)

Every person who has entered into an international transaction during a previous year shall obtain a report from an accountant and furnish such report on or before the specified date in the prescribed form duly signed and verified in the prescribed manner by such accountant and setting forth such particulars as may be prescribed. The word ‘accountant’ is to have the same meaning as given in Explanation below sub-section (2) of section 288. This has been defined in this Explanation as under:

“Explanation-In this section, “accountant” means a chartered accountant within the meaning of the Chartered Accountants Act, 1949, and includes, in relation to any state any person who by virtue of the provisions of sub-section (2) of section 226 of the Companies Act, 1956 (1 of 1956), is entitled to be appointed to act as an auditor of companies registered in that state.”

This report to be furnished in form No. 3CEB as prescribed under Rule 10E of the IT Rules 1962.

(C)  Notice to the assessees

Transfer Pricing Officer shall serve a notice to the assessee requiring him to produce (or cause to be produce) on a specified date any evidence which the assessee may rely in support of the computation made by him of the arm’s length price in relation to the international transaction. However, Assessing Officer referring the case to the Transfer Pricing Officer is not required to provide any reasons or basis for referring the case to the assessee.

(D) Documentation (Section 92D)

This section provides for maintenance, keeping of information and documents by persons entering in to International transactions as may be prescribed. Rule 10D (1) of the IT Rules prescribes the documents of primary and secondary nature that are to be maintained in the context of transfer pricing law. Broadly the information and documents that are required to be maintained are:

  1. a description of the ownership structure of the assessee enterprise with details of shares or other interest held by other enterprises.
  2. A profile of the multinational group of which the assessee enterprise is a part along with the same, address, legal status and country of tax residence of each of the enterprises comprised in the group with whom international transactions have been entered in to by the assessee and ownership linkages among them;
  3. a broad description of the business of the assessee and the industry in which the assessee operates, and of the business of the associated enterprises with whom the assessee has transacted;
  4. the nature and terms (including prices) of international transactions entered into with each associated enterprise, details of property transferred or services provided and the quantum and the value of each such transaction or class of such transaction;
  5. a description of the functions performed, risks assumed and assets employed or to be employed by the assessee and by the associated enterprises involved in the international transaction;
  6. a record of the economic and market analysis, forecasts, budgets, or any other financial estimates prepared by the assessee for the business as a whole and for each division of product separately, which may have a bearing on the international transactions entered into by the assessee;
  7. a record of uncontrolled transactions taken into account for analyzing their comparability with the international transactions entered into, including a record of the nature, terms and conditions relating to any uncontrolled transaction with third parties which may be of relevance to the pricing of the international transactions;
  8. a record of the analysis performed to evaluate comparability of uncontrolled transactions with the relevant international transaction;
  9. a description of the methods considered for determining the arm’s length price in relation to each international transaction or class of transaction, the method selected as the most appropriate method along with explanations as to why such method was so selected, and how such method was applied in each case;
  10. a record of the actual working carried out for determining the arm’s length price, including details of the comparable data and financial information used in applying the most appropriate method, and adjustments, if any, which were made to account for differences between the international transaction and the comparable uncontrolled transactions, or between the enterprises entering into such transactions;
  11. the assumptions, policies and price negotiations, if any, which have critically affected the determination of the arm’s length price;
  12. details of the adjustments, if any, made to transfer prices to align them with arm’s length prices determined under these rules and consequent adjustment made to the total income for tax purposes;
  13. any other information, data or document, including information or data relating to the associated enterprise, which may be relevant determination of the arm’s length price.

The information of the above nature is expected to be available by the due date of submission of return of income. These documents may not be maintained where the value of international transactions entered into by the asses see does not exceed rupees one crore Rule 10D (2). However, as per the proviso to Rule 10D(2), the assessee shall be required to substantiate, on the basis of material available with him, that income arising from international transactions entered into by him has been computed in accordance with arm’s length principle. Sub-rule (5) of rule 10D provides that the information and documents specified in sub-rules (1) and (2) of this rule shall be kept and maintained for a period of eight years from the end of the relevant assessment year

(E) Furnishing of information about international transactions

The Assessing Officer of Commissioner (Appeals) may in the course of any proceeding under this Act require any person who has entered into an international transaction to furnish any information or document in respect thereof, during continuation of any proceeding under Income-tax Act at the relevant time.

Chapter IV

Penalties

Penalty is a civil liability in the form of a monetary sanction in consequences of contravention of law by omission or commission. The objective of penalty provisions is to provide disincentives for non-compliance by making non-compliance more costly than compliance. This is to increase the cost of evasion.

The provisions for penalties relating to transfer pricing fall into two categories. One relates to the understatement of income chargeable to tax resulting from international transactions not being at arm’s length price and the other relates to the failure to keep or maintain or furnish the prescribed documents or to furnish the prescribed reports.

The two categories of penalties are briefly mentioned hereinafter

(A)  Penalty provision relating to understatement of profits [Explanation 7 to Section 271 of the IT Act]

The assessee who has entered into an international transaction would be deemed to have concealed particulars of his income or furnished inaccurate particulars of such income in respect of the amount added or disallowed in computing his total income under section 92C(4), unless he proves to the satisfaction of the Assessing Officer or the Commissioner (Appeals), as the case may be, that the price charged or paid in such transaction was computed in accordance with the provisions contained in section 92C and in the manner prescribed under that section, in good faith and with due diligence. An Explanation 7 in section 271 (1) has been inserted into this regard.

The Assessing officer or the Commissioner (Appeals), as the case may be, may direct that the defaulting person shall pay by way of penalty in addition to any tax payable by him, a sum which shall not be less than, but which shall not exceed three times, the amount of tax sought to have been evaded by reason of the concealment of particulars of his income or the furnishing of inaccurate particulars of such income.

(B)  Penalty Provisions for Procedural defaults [Section 271AA, 271BA and 271G]

The above mentioned three Sections deal with penalties where there had been defaults/non-compliances with regard to provisions concerning procedures prescribed in the context of transfer pricing.

Penalties for non-compliances of procedural requirements concerning the transfer pricing provisions can be imposed in regard to failing to :

1.  Keep and maintain information and documents as required under section 92D(1),for the period as may be prescribed under section 92D (2).

2. Furnish in the course of any proceeding under the Act when required to be done under section 92D(3), of any information or document in respect of the international transaction within thirty days of the receipt of the notice which could be extended for another thirty days.

3. Furnish a report after having obtained from an account, on or before the specified date in the prescribed form duly signed and verified in the prescribed manner by a Chartered accountant as required under section 92E.

For 1 and 2 above, the amount of penalty will be equal to two percent of the value of international transaction and for 3, one hundred thousand rupees. The Assessing Officer or the Commissioner (Appeals), as the case may be, may direct that the defaulting person shall pay the sum, by way of penalty. The above penalty cannot be imposed if the assessee proves that there was a reasonable cause for such failures (Section 273B).

Annexures

Annexure A- Provisions in the Income tax Act 1961 Concerning Transfer Pricing Sections 92 to 92 F

Annexure B- Rules Concerning Transfer Pricing Rules 10A to 10E of the IT Rules 1962

Annexure C- Copy of Form No 3CEB in which the report of the Accountant is to be furnished in terms section 92E of the IT Act, 1961 and Rule 10E of the IT Rules, 1962.

Annexure A

Computation of income from international transaction having regard to arm’s length price.

(1) Any income arising from an international transaction shall be computed having regard to the arm’s length price.

Explanation. – For the removal of doubts, it is hereby clarified that the allowances for any expense or interest arising from an international transaction shall also be determined having regard to the arm’s length price.

(2)   Where in an international transaction, two or more associated enterprises enter into a mutual agreement or arrangement for the allocation or apportionment of, or any contribution to, any cost or expense incurred or to be incurred in connection with a benefit, service or facility provided to any one or more of such enterprises, the cost or expense allocated or apportioned to, or, as the case may be, contributed by, any such enterprise shall be determined having regard to the arm’s length price of such benefit, service or facility as the case may be.

(3) The provisions of this section shall not apply in a case where the computation of income under sub-section (1) or the determination of the allowance for any expense or interest under that sub-section , or the determination of any cost or expense allocated or apportioned, or, as the case may be, contributed under sub-section (2), has the effect of reducing the income chargeable to tax or increasing the loss, as the case may be,computed on the basis of entries made in the books of account in respect of the previous year in which the international transaction was entered in to.

Meaning of associated enterprise.

(1) For the purposes of this section and sections 92, 92B, 92C, 92D, 92E and 92F, “ associated enterprise”, in relation to another enterprise, means an enterprise-

(a)      Which participates, directly or indirectly, or through one or more intermediaries, in the management or control or capital of the other enterprise; or

(b)   in respect of which one or more persons who participate, directly or indirectly, or through one or more intermediaries, in its management or 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.

(2) For the purposes of sub-section (1), two enterprises shall be deemed to be associated enterprises if, at any time during the previous year,

(a) one enterprise holds, directly or indirectly, shares carrying not less than twenty-six percent of the voting power in the other enterprise; or

(b) any person or enterprise holds, directly or indirectly, shares carrying not less than twenty-six percent of the voting power in each of such enterprises; or

(c) a loan advanced by one enterprise to the other enterprise constitutes not less than fifty-one percent of the book value of the total assets of the other enterprise:or

(d) one enterprise guarantees not less than ten percent of the total borrowing of the other enterprise ;or

(e) more than half of the board of directors or members of the governing board, or one or more executive directors or executive members of the governing board of one enterprise, are appointed by the other enterprise;or

(f)   more than half of the directors or members of the governing board, or one or more of the executive directors or members of the governing board, of each of the two enterprises are appointed by the same person or persons; or

(g) the manufacture or processing of goods or articles or business carried out by one enterprise is wholly dependent on the use of know-how, patents, copyrights, trade-marks, licences, franchises or any other business, or commercial rights of similar nature, or any data, documentation, drawing or specification relating to any patent, invention, model, design, secret formula or process of which the other enterprise is the owner or in respect of which the other enterprise has exclusive right;

(h) ninety percent or more of the raw materials and consumables required for the manufacture or processing of goods or articles carried out by one enterprise, are supplied by the other enterprise, or by persons specified by the other enterprise, and the prices and other conditions relating to the supply are influenced by such other enterprise; or

(i)   the goods or articles manufactured or processed by one enterprise, are sold to theother enterprise or to persons specified by the other enterprise, and the prices and other conditions relating thereto are influenced by such other enterprise; or

(j)   Where one enterprise is controlled by an individual, the other enterprise is also controlled by such individual or his relative or jointly by such individual and relative of such individual;or

(k) Where one enterprise is controlled by a Hindu undivided family, the other enterprise is controlled by a member of such Hindu undivided family or by a relative of a member of such Hindu undivided family or jointly by such member and his relative; or

(l)   Where one enterprise is a firm, association of persons or body of individuals, the other enterprise holds not less than ten percent interest in such firm, association of persons or body of individuals; or

(m) there exists between the two enterprises, any relationship of mutual interest, as may be prescribed.

Meaning of international transaction

(1)   For the purpose of this section and sections 92, 92C 92D and 92E “international transaction” means a transaction between two or more associated enterprises, either or both of whom are non-residents, in the nature of purchase, sale or lease of tangible or intangible property, or provision of services, or lending or borrowing money, or any other transaction having a bearing on the profits, income,losses or assets of such enterprises and shall include a mutual agreement or arrangement between two or more associated enterprises for the allocation or apportionment of, or any contribution to, any cost or expense incurred or to be incurred in connection with a benefit, service or facility provided or to be provided or to be provided to any one or more of such enterprises.

(2)   A transaction entered into by an enterprise with a person other than an associated enterprise shall, for the purposes of sub-section (1), be deemed to be a transaction entered into between two associated enterprises, if there exists a prior agreement in relation to the relevant transaction between such other person and the associated enterprise, or the terms of the relevant transaction are determined in substance between such other person and the associated enterprise.

Computation of arm’s length price

(1) The arm’s length price in relation to an international transaction shall be determined by any of the following methods, being the most appropriate method, having regard to the nature of transaction or class of transaction or class of associated persons or function performed by such persons or such other relevant factors as the Board may prescribe, namely:-

(a)      comparable uncontrolled price method;

(b)      resale price method;

(c)      cost plus method;

(d)      profit split method;

(e)      transactional net margin method;

(f)        such other method as may be prescribed by the Board.

(2)The most appropriate method referred to in sub-section (1) shall be applied, for determination of arm’s length price, in the manner as may be prescribed. Provided that where more than one price is determined by the most appropriate method, the arm’s length price shall be taken to be the arithmetical mean of such prices, or, at the option of the asses see, a price which may vary from the arithmetical mean by an amount not exceeding five percent of such arithmetical mean.

(3)Where during the course of any proceeding for the assessment of income, the Assessing Officer is, on the basis of material or information or document in his possession, of the opinion that—-

(a)      the price charged or paid in international transaction has not been determined in accordance with sub-sections (1) and (2); or

(b)   any information and document relating to an international transaction have not been kept and maintained by the assessee in accordance with the provisions contained in sub-section (1) of Section 92D and the rules made in this behalf; or

(c)      the information or data used in computation of the arm’s length price is not reliable or correct; or

(d)   the assessee has failed to furnish, within the specified time, any information or document which he was required to furnish by a notice issued under sub­section (3) of Section 92D, the Assessing Officer may proceed to determine the arm’s length price in relation to the said international transaction in accordance with sub-sections (1) and (2), on the basis of such material or information or document available with him:-

Provided that an opportunity shall be given by the Assessing Officer by serving a notice calling upon the assessee to show cause, on a date and time to be specified in the notice, why the arm’s length price should not be so determined on the basis of material or information or document in the possession of the Assessing Officer.

(4)Where an arm’s length price is determined by the Assessing Officer under sub section (3), the Assessing Officer may compute the total income of the assessee having regard to the arm’s length price so determined:

Provided that no deduction under Section 10A or Section 10B or under Chapter VI-A shall be allowed in respect of the amount of income by which the total income of the assessee is enhanced after computation of income under this sub­section:

Provided further that where the total income of an associated enterprises is computed under this sub-section on determination of the arm’s length price paid to another associated enterprise from which tax has been deducted or was deductible under the provisions of chapter XVIIB, the income of the other associated enterprise shall not be recomputed by reason of such determination of arm’s length price in the case of the first mentioned enterprise.

Reference to Transfer Pricing Officer

(1) where any person, being the assessee, has entered into an international transaction in any previous year, and the Assessing Officer considers it necessary or expedient so to do, he may, with the previous approval of the Commissioner, refer the computation of the arm’s length price in relation to the said international transaction under section 92C to the Transfer Pricing Officer.

(2) Where a reference is made under sub-section (1), the Transfer Pricing Officer shall serve a notice on the assessee requiring him to produce or cause to be produced on a date to be specified therein., any evidence on which the assessee may rely in support of the computation made by him of the arm’s length price in relation to the international transaction referred to in sub-section (1).

(3) On the date specified in the notice under sub-section (2), or as soon thereafter as may be, after hearing such evidence as the assessee may produce, including any information or documents referred to in sub­section (3) of section 92D and after considering such evidence as the Transfer Pricing Officer may require on any specified points and after taking into account all relevant materials which he has gathered, the Transfer Pricing Officer shall, by order in writing, determine the arm’s length price in relation to the international transaction in accordance with sub-section (3) of Section 92C and send a copy of his order to the Assessing Officer and to the assessee.

(4) On receipt of the order under sub-section (3), the Assessing Officer shall proceed to compute the total income of the assessee under sub­section (4) of section 92C having regard to the arm’s length price determined under sub-section (3) by the Transfer Pricing Officer.

(5) With a view to rectifying any mistake apparent from the record, the Transfer Pricing officer may amend any order passed by him under sub-Section (3), and the provisions of section 154 shall, so far as may be, apply accordingly.

(6) Where any amendment is made by the Transfer Pricing Officer under sub-section (5), he shall send a copy of his order to the Assessing officer who shall thereafter proceed to amend the order of assessment in conformity with such order of the Transfer Pricing Officer.

(7) The Transfer Pricing Officer may, for the purposes of determining the arm’s length price under this Section, exercise all or any of the powers specified in clauses (a) to (d) of sub-section (1) of Section 131 or sub­section (6) of Section 133.

Explanation- For the purposes of this section. ‘Transfer Pricing Officer “ means a Joint Commissioner or Deputy Commissioner or Assistant. Commissioner authorised by the Board to perform all or any of the functions of an Assessing Officer specified in sections 92C and 92D in respect of any person or class of persons.

Maintenance and keeping of information and document by persons entering into an international transaction.

(1)      Every person who has entered in to an international transaction shall keep and maintain such information and document in respect thereof, as may be prescribed.

(2)      Without prejudice to the provisions contained in sub-section (1), the Board may prescribe the period for which the information and document shall be kept and maintained under that sub-section.

(3) The Assessing officer or the Commissioner (Appeals) may, in the course of any proceeding under this Act, require any person who has entered in to an international transaction to furnish any information or document in respect thereof, as may be prescribed under sub-section (1), within a period of thirty days from the date of receipt of a notice issued in this regard:

Provided that the Assessing Officer or the Commissioner (Appeals) may, on an application made by such person, extend the period of thirty days by a further period not exceeding thirty days.

Report from an accountant to be furnished by persons entering in to international transaction.

Every person who has entered in to an international transaction during a previous year shall obtain a report from an accountant and furnish such report on or before the specified date in the prescribed form duly signed and verified in the prescribed manner by such accountant and setting forth such particulars as may by prescribed.

Definitions of certain terms relevant to computation of arm’s length price, etc. In Sections 92, 92A, 92B, 92C, 92D, and 92E, unless the context otherwise requires:-

i. “accountant” shall have the same meaning as in the Explanation below sub-section (2) of section 288;
ii. “arm’s length price” means a price which is applied or proposed to be applied in a transaction between persons other than associated enterprises, in uncontrolled conditions.

iii. “enterprise” means a persons (including a permanent establishment of such person) who is, or has been, or is proposed to be, engaged in any activity, relating to the production, storage, supply, distribution, acquisition or control of articles or goods, or know-how, patents,copyrights, trade-marks, licences, franchises or any other business or commercial rights of similar nature, or any data, documentation, drawing or specification relating to any patent, invention, model, design, secret formula or process, of which the other enterprise is the owner or in respect of which the other enterprise has exclusive rights, or the provision of services of any kind, or in carrying out any work in pursuance of a contract, or in investment, or providing loan or in the business of acquiring, holding, underwriting or deals with shares, debentures or other securities of any other body corporate, whether such activity of business is carried on, directly or through one or more of its units or divisions or subsidiaries, or whether such unit or division or subsidiary is located at the same place where the enterprise is located or at a different place or places;

(iiia) “permanent establishment” referred to in clause (iii), includes a fixed place of business through which the business of the enterprise is wholly or partly carried on;

iv. “specified date” shall have the same meaning as assigned to “due date” in Explanation 2 below sub-section (1) of Section 139;
v. “transaction” includes an arrangement, understanding or action in concert,-

(A)  whether or not such arrangement, understanding or action is formal or in writing; or

(B)  whether or not such arrangement, understanding or action is intended to be enforceable by legal proceeding.

Annexure B

Meaning of expressions used in computation of arm’s length price:-

For the purposes of this rule and rules 10B to 10E;-

(a)      “uncontrolled transaction” means a transaction between enterprises other than associated enterprises, whether resident or non-resident;

(b)      “Property” includes goods, articles or things, and intangible property;

(c)      “services” include financial services;

(d)      “transaction” includes a number of closely linked transaction.

Determination of arm’s length price under Section 92C.

(i) For the purposes of sub-section (2) of Section 92C, the arm’s length price in relation to an international transaction shall be determined by any of the following methods, being the most appropriate method, in the following manner, namely:-

(a) comparable uncontrolled price method, by which, –

(i) the price charged or paid for property transferred or services provided in a comparable uncontrolled transaction, or a number of such transactions, is identified;

(ii) such price is adjusted to account for differences, if any, between the international transaction and the comparable uncontrolled transactions or between the enterprises entering in to such transactions, which could materially affect the price in the open market;

(iii) the adjusted price arrived at under sub-clause (ii) is taken to be an arm’s length price in respect of the property transferred or services provided in the international transaction;

(b)   resale price method, by which,-

(i) the price at which property purchased or services obtained by the enterprise for an associated enterprise is resold or are provided to an unrelated enterprise, is identified;

(ii)Such resale price is reduced by the amount of a normal gross profit margin accruing to the enterprise or to an unrelated enterprise from the purchase and resale of the same or similar property or from obtaining and providing the same or similar property or from obtaining and providing the same or similar services, in a comparable uncontrolled transaction, or a number of such transactions;

(iii)the price so arrived at is further reduced by the expenses incurred by the enterprise in connection with the purchase of property or obtaining of services;

(iv)       the price so arrived at is adjusted to take in to account the functional and other differences, including differences in accounting practices, if any, between the international transaction and the comparable uncontrolled transactions, or between the enterprises entering in to such transactions, which could materially affect the amount of gross profit margin in the open market;

(v) the adjusted price arrived at under sub-clause (iv) is taken to be an arm’s length price in respect of the purchase of the property or obtaining of the services by the enterprise from the associated enterprise;

(c) cost plus method, by which:-

(i)                  the direct and indirect costs of production incurred by the enterprise in respect of property transferred or services provided to an associated enterprise, are determined:-

(ii)                the amount of a normal gross profit mark-up to such costs (computed according to the same accounting norms) arising from the transfer or provision of the same or similar property or services by the enterprise, or by an unrelated enterprise, in a comparable uncontrolled transaction, or a number of such transactions, is determined;

(iii)               the normal gross profit mark-up referred to in sub-clause (ii) is adjusted to take into account the functional and the comparable uncontrolled transaction and the comparable uncontrolled transactions, or between the enterprises entering in to such transactions, which could materially affect such profit mark-up in the open market;

(iv)              the costs referred to in sub-clause (i) are increased by the adjusted profit mark-up arrived at under sub-clause (iii);

(v)        the sum so arrived at is taken to be an arm’s length price in relation to the supply of the property or provision of services by the enterprise;

(d) profit split method, which may be applicable mainly in international transactions involving transfer of unique intangibles or in multiple international transactions which are so interrelated that they can not be evaluated separately for the purpose of determining the arm’s length price of any one transaction, by which :-

(i)         the combined net profit of the associated enterprises arising from the international transaction in which they are engaged, is determined.

(ii)        the relative contribution made by each of the associated enterprises to the earning of such combined net profit, is then evaluated on the basis of the functions performed, assets employed or to be employed and risks assumed by each enterprise and on the basis of reliable external market data which indicates how such contribution would be evaluated by unrelated enterprises performing comparable functions in similar circumstances.

(iii)               the combined net profit is then split amongst the enterprising in proportion to their relative contributions, as evaluated under sub-clause (ii);

(iv)              the profit thus apportioned to the assessee is taken in to account to arrive at an arm’s length price in relation to the international transaction.

Provided that the combined net profit referred to in sub-clause

(i) may, in the first instance, be partially allocated to each enterprise so as to provide it with a basic return appropriate for the type of international transaction in which it is engaged, with reference to market returns achieved for similar types of transactions by independent enterprises, and thereafter, the residual net profit remaining after such allocation may be split amongst the enterprises in proportion to their relative contribution in the manner specified under sub-clauses (ii) and iii), and in such a case the aggregate of the net profit allocated to the enterprise in the first instance together with the residual net profit apportioned to that enterprise on the basis of its relative shall be taken to be the net profit arising to that enterprise from the international transaction;

(e) transactional net margin method, by which:-

(i)               the net profit margin realised by the enterprise from an international transaction entered into with an associated enterprise is computed in relation to costs incurred or sales effected or assets employed or to be employed by the enterprise or having regard to any other relevant base;

(ii)                the net margin realised by the enterprise or by an unrelated enterprise from a comparable uncontrolled transaction or a number of such transactions is computed having regard to the same base;

(iii)            the net profit margin referred to in sub-clause (ii) arising in comparable uncontrolled transactions is adjusted to take into account the differences, if any, between the international transaction and the comparable uncontrolled transactions, or between the enterprises entering into such transactions, which could materially affect the amount of net profit margin in the open market;

(iv)              the net profit margin realised by the enterprise and referred to in sub-clause (i) is established to be the same as the net profit margin referred to in sub-clause (iii);

(v)                    the net profit margin thus established is then taken into account to arrive at an arm’s length price in relation to the international transaction.

(2) For the purposes of sub-rule (1), the comparability of an international transaction with an uncontrolled transaction shall be judged with reference to the following namely:-

(a)    the specific characteristics of the property transferred or services provided in either transation;

(b)   the functions performed, taking into account assets employed or to be employed and the risks assumed, by the respective parties to the transactions;

(c)    the contractual terms (whether or not such terms are formal or in writing) of the transactions which lay down explicitly or implicitly how the responsibilities, risks and benefits are to be divided between the respective parties to the transactions;

(d) conditions prevailing in the markets in which the respective parties to the transactions operate, including the geographical location and size of the markets, the laws and Government orders in force, costs of labour and capital in the markets, overall economic development and level of competition and whether the markets are wholesale or retail.

(3) An uncontrolled transaction shall be comparable to an international transaction if:-

(i)   none of the differences, if any, between the transactions being compared, or between the enterprises entering in to such transactions are likely to materially affect the price or cost charged or paid in, or the profit arising from, such transactions in the open market; or

(ii)    reasonably accurate adjustments can be made to eliminate the material effects of such differences.

(4) The data to be used in analysing the comparability of an uncontrolled transaction with an international transaction shall be the data relating to the financial year in which the international transaction has been entered in to:

Provided that data relating to a period not being more than two years prior to such financial year may also be considered if such data reveals facts which could have an influence on the determination of transfer prices in relation to the transactions being compared.

Most appropriate method.

( 1) For the purposes of sub-section (10 of Section 92C, the most appropriate method shall be the method which is best suited to the facts and circumstances of each particular international transaction, and which provides the most reliable measure of an arm’s length price in relation to the international transaction.

(2) In selecting the most appropriate method as specified in sub-rule (1) the following factors shall be taken into account, namely:-

(a)                the nature and class of the international transaction;

(b)               the class or classes of associated enterprises entering in to the transaction and the functions performed by them taking into account assets employed or to be employed and risks assumed by such enterprises;

(c)                the availability, coverage and reliability of data necessary for application of the method;

(d)               the degree of comparability existing between the international transaction and the uncontrolled transaction and between the enterprises entering into such transactions;

(e)                the extent to which reliable and accurate adjustments can be made to account for differences, if any, between the international transaction and the comparable uncontrolled transaction or between the enterprises entering into such transactions;

(f)                 the nature, extent and reliability of assumptions required to be made in application of a method.

Information and documents to be kept and maintained under Section 92D.

(1) Every person who has entered into an international transaction shall keep and maintain the following information and documents, namely:-

(a)    a description of the ownership structure of the assessee enterprise with details of shares or other ownership interest held therein by other enterprises;

(b)   a profile of the multionational group of which the assessee enterprise is a part along with the name, address, legal status and country of tax residence of each of the enterprises comprised in the group with whom international transactions have been entered into by the assessee, and ownership linkages among them;

(c)    a broad description of the business of the assessee and the industry in which the assessee operates, and of the business of the associated enterprises with whom the assessee has trasacted;

(d)      the nature and terms (including prices) of international transactions entered into with each associated enterprise, details of property transferred or services provided and the quantum and the value of each such transaction or class of such transaction;

(e)    a description of the functions performed, risks assumed and assets employed or to be employed by the assessee and by the associated enterprises involved in the international transaction;

(f)   a record of the economic and market analyses, forecasts, budgets or any other financial estimates prepared by the assessee for the business as a whole and for each division or product separately, which may have a bearing on the international transactions entered in to by the assessee;

(g)    a record of uncontrolled transactions taken into account for analysing their comparability with the international transactions entered into, including a record of the nature, terms and conditions relating to any uncontrolled transaction with third parties which may be of relevance to the pricing of the international transactions;

(h)    a record of the analysis performed to evaluate comparability of uncontrolled transactions with the relevant international transaction;

(i)   a description of the methods considered for determining the arm’s length price in relation to each international transaction or class of transaction, the method selected as the most appropriate method along with explanations as to why such method was so selected, and how such method was applied in each case;

(j)   a record of the actual working carried out for determining the arm’s length price, including details of the comparable data and financial information used in applying the most appropriate method, and adjustments, if any, which were made to account for differences between the international transaction and the comparable uncontrolled transactions, or between the enterprises entering into such transactions;

(k)   the assumptions, policies and price negotiations, if any, which have critically affected the determination of the arm’s length price;

(l)   details of the adjustments, if any, made to transfer prices to align them with arm’s length prices determined under these rules and consequent adjustment made to the total income for tax purposes;

(m) any other information, data or document, including information or data relating to the associated enterprise, which may be relevant for determination of the arm’s length price.

(2)   Nothing contained in sub-rule (1) shall apply in a case where the aggregate value, as recorded in the books of account, of international transactions entered into by the assessee does not exceed one crore rupees:

Provided that the assessee shall be required to substantiate, on the basis of material available with him, that income arising from international transactions entered into by him has been computed in accordance with Section 92.

(3)   The information specified in sub-rule (1) shall be supported by authentic documents, which may include the following:

(a)    official publications, reports, studies and data bases from the Government of the country of residence of the associated enterprise, or of any other country;

(b)   report of market research studies carried out and technical publications brought out by institutions of national or international repute;

(c)    price publications including stock exchange and commodity market quotations;

(d)   published accounts and financial statements relating to the business affairs of the associated enterprise;

(e)    agreements and contracts entered in to with associated enterprises or with unrelated enterprises in respect of transactions similar to the international transactions;

(f)     letters and other correspondence documenting any terms negotiated between the assessee and the associated enterprise;

(g) documents normally issued in connection with various transactions under the accounting practices followed.

(4)   The information and documents specified under sub-rules (1) and (2), should, as far as possible, be contemporaneous and should exist latest by the specified date referred to in clause (iv) of Section 92F.

Provided that where an international transaction continues to have effect over more than one previous year, fresh documentation need not be maintained separately in respect of each previous year, unless there is any significant change in the nature or terms of the international transaction, in the assumptions made, or in any other factor which could influence the transfer price, and in case of such significant change, fresh documentation as may be necessary under sub-rules (1) and (2) shall be maintained bringing out the impact of the change on the pricing of the international transaction.

(5)   The information and documents specified in sub-rules (1) and (2) shall be kept and maintained for a period of eight years from the end of the relevant assessment year.

Report from an accountant to be furnished under Section 92E.

The report from an accountant required to be furnished under section 92E by every person who has entered into an international transaction during a previous year shall be in Form No. 3CEB and be verified in the manner indicated therein.

Written By – T. N. Pandey

Source- Income Tax Department

This publication should not be construed as an exhaustive statement of the Law. In case of doubt, reference should always be made to the relevant provisions of the Income Tax Act 1961 and the Income Tax Rules 1962 and the Wealth Tax Act 1957 and Wealth Tax Rules 1957, and, wherever necessary Notifications issued from time to time.

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0 responses to “Transfer Pricing Concept & The Law in India”

  1. kiran says:

    excellent article.

    for transfer pricing studies, use our qualitative services

  2. K.S.KUMAR says:

    One of the Indian Company while adopting transfer-pricing concept under cost plus mark up method exporting their services, which are taxable in India, to their A.E. While arriving the cost they have included service tax paid on input services  plus markup and raised invoice accordingly. Later they received export proceeds from their A.E. In the meantime, the Indian Company has filed ST3 Returns to the excise authorities and shown the credit availed on the input services and later filed Refund Claim under Rule 5 of Cenvat Credit Rules, 2004 read with Notification No.5/2009-CE stating that they are unable to utilise the credit since no domestic sale of services. Can the company is entitled for refund when the said credit was absorbed in their cost plus mark up. PL GIVEN UR COMMENT PLEASE TO MY EMAIL ID.

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