S.C. Mishra
Chief Commissioner of Income Tax (Retd.)
sureshcmishra2015@gmail.com
Sh.S.C. Mishra is a Chief Commissioner of Income Tax (Retd.). He had authored two books, namely, ‘Transfer Pricing Manual’ published by Law Publishing House in 2001 and ‘Transfer Pricing in India’ published by Wolters Kluwer in 2016 (First edition) and 2019(Second edition).
| Executive Summary
A substantial volume of global trade comprises transactions between related enterprises within groups of multinational enterprises (MNEs). The transactions between such related or associated enterprises may take place under conditions different from those taking place between independent enterprises. Transfer pricing is a term used for pricing of such cross-border, intra-group transactions in goods, intangibles or services including financial services. The prices of such transactions between associated enterprises should, however, for tax purposes be in conformity with those which would be charged between independent enterprises, usually, referred to as arm’s length pricing. Arm’s length simply means ‘at a distance, not on familiar or friendly terms’. Arm’s length pricing is an international standard that compares the transfer prices charged between associated enterprises with the prices carried out between independent entities. Arm’s length transaction is one negotiated by related parties, each acting in its own interest and it is the basis for a fair market value determination. Arm’s length pricing has been defined in Article 7 of the OECD Guidelines on Transfer Pricing in the permanent establishment context and in Article 9 in the associated enterprise context. |
Introduction
A substantial volume of global trade comprises transactions between related enterprises within groups of multinational enterprises (MNEs). The transactions between such related or associated enterprises may take place under conditions different from those taking place between independent enterprises. Transfer pricing is a term used for pricing of such cross-border, intra-group transactions in goods, intangibles or services including financial services. The prices of such transactions between associated enterprises should, however, for tax purposes be in conformity with those which would be charged between independent enterprises, usually, referred to as arm’s length pricing. Arm’s length simply means ‘at a distance, not on familiar or friendly terms’. Arm’s length pricing is an international standard that compares the transfer prices charged between associated enterprises with the prices carried out between independent entities. Arm’s length transaction is one negotiated by related parties, each acting in its own interest and it is the basis for a fair market value determination. Arm’s length pricing has been defined in Article 7 of the OECD Guidelines on Transfer Pricing in the permanent establishment context and in Article 9 in the associated enterprise context.
Object of Transfer Pricing Regulations
In India, transfer pricing regulations date back to 1939 which were adopted in the 1961 Act. In view of the increasing participation of MNEs in the economic life of India, particularly, after the liberalisation of the Indian economy in 1991, a need was felt to provide a detailed statutory framework which can lead to a reasonable, fair and equitable profit allocation and tax to India. Accordingly, sections 92 to 92F were introduced with effect from 01.04.2002 along with rules 10A to 10E notified on 21.08.2002. These provisions covered the meaning of the terms ‘international transaction’ and ‘associated enterprises’ besides providing methods for computation of arm’s length price and documentation requirements. The provisions also created an authority named as Transfer Pricing Officer for the specialised role of determining arm’s length price after the assessing officer has made a reference of an international transaction to the above authority. This process was completed after extensive consultations and feedback from all the stakeholders.
The basic intention underlying these transfer pricing regulations was to prevent shifting out of profits from India by manipulating prices charged in international transactions, thereby eroding the country’s tax base.
Associated Enterprise
This concept adopted from the OECD guidelines was primarily based on the participation, directly or indirectly, or through one or more intermediaries, in the management or control or capital of the other enterprise. The deeming provision extended the meaning to control of the other enterprise through shareholding or voting right or by advancing loan or providing guarantee or the use of know-how patents, trademark etc., or the manufacturing being wholly dependent or by being a major supplier of raw materials or consumables or being in a position to influence the pricing or other such influences. It is the reality of control rather than the form or mode of its exercise that is decisive in the presumption of control.
International Transaction
It means a transaction between two or more associated enterprises, either or both of whom are non-residents by way of transfer of tangible or intangible property or advancing of loans or providing services having a bearing on income or assets. Certain specified domestic transactions prone to price manipulations were also included. The scope of the term ‘international transactions’ was expanded by providing a clarificatory amendment to include various modes of transactions, particularly, relating to intangible property, capital financing, provision of technical, managerial or consultancy services and business restructuring.
Arm’s Length Methods
In conformity with the OECD guidelines, the methods provided are direct and indirect. The direct methods are the comparable uncontrolled price method, the resale price method and the cost plus method. These direct methods compare the prices or the normal gross profit margins or the normal gross profit mark-ups respectively. The indirect methods are the profit split method that splits the combined net profit and the transactional net margin method that compares the net profit margin or the operating profit relating to an appropriate base such as cost, sales or assets. In India, in most of the cases, the transactional net margin method is applied followed by the resale price method and cost plus method. The profit split method is applied in very few cases. There is also a residuary method as may be prescribed by the CBDT.
Most Appropriate Method
The most appropriate method is selected having regard to the nature of transaction, the method that provides the most reliable measure of an arm’s length price in relation to the international transaction and the functions performed taking into account assets employed and risks assumed. The function performed may relate to market or product development or procurement or inventory management or quality control or selling and marketing. The assets employed may be tangible like product distribution activity or computer systems or general office facilities or intangible including trademarks, patents, know-how etc. The risks assumed include those relative to the market, product liability, credit, inventory obsolescence, foreign currency, R&D, financing and country/regional risks.
Besides the above, the selection of the most appropriate method depends upon the degree of comparability between the international transaction and that of the selected comparables. Another factor is the availability and reliability of data and assumptions necessary or application of the method along with the extent to which reliable and accurate adjustment can be made to account for the differences with the comparable transaction.
Arm’s Length Range
Since transfer pricing is not an exact science, quite often, the application of the most appropriate method produces a range of figure all of which are equally reliable. In India, the earlier mode based on arithmetical mean has been substituted partly by the arm’s length range applicable only where the resale price method or the cost plus method or the transactional net margin method is being applied. The application is based on the dataset consisting of six or more entries and the arm’s length range beginning from the 35th percentile of the dataset and ending on 65th percentile. The range concept is not applicable where methods other than these are being applied.
Comparability
For determining the arm’s length price by the most appropriate method, comparability is at the heart of the matter. The factors for comparability are the specific characteristics of the property transferred or services provided in the transaction under review and comparable transaction, the functions performed, taking into account assets employed, the risks assumed by the respective parties to the transactions and the contractual terms and conditions prevailing in the relevant markets. The other factors are geographical location and size of the market, the laws and Government orders in force, cost of labour and capital in the respective markets, overall economic development and level of competition and whether the markets are wholesale or retail. In India, the adjustments for differences between comparable transaction and the transaction under review that could materially affect the prices, the gross profit margin or profit mark-up or net profit has proved to be the most litigation prone area.
Special Considerations for certain transactions
For transactions involving transfer of intangible property, provision of intra-group services, intra-group financing, cost contribution arrangements and business restructuring, there are special considerations.
In the transactions involving transfer of intangible property, the critical aspects to be considered are the identification of the specific intangibles, its legal and beneficial ownership, the contribution of each enterprise to their development, enhancement, maintenance, protection and exploitation in addition to the manner in which it contributes to the creation of value. In India, there have been a large number of disputes relating to the arm’s length compensation to be made to the Indian enterprise for its contribution to the advertisement, marketing and promotion expenses enhancing the value of the foreign brand.
The compensation for contract research and manufacturing services provided by the Indian enterprise to its overseas parent or associate has been another litigation prone area. In transfer pricing analysis, the initial factor is whether services have, in fact, been rendered and if so, what is the economic or commercial value of such services and, finally, whether the amount of service charge conforms to arm’s length standard.
The emerging markets like China and India are becoming sources of foreign investments. The factors for determining arm’s length interest rate for such investments are the principal amount, the duration of the loan, the security involved, the credit standing of the borrower and the interest rate prevailing at the situs of the lender for comparable loans between unrelated parties.
In cases of cost contribution arrangements, in any allocation of interest or cost or expense between the participants, arm’s length standard has to be applied. This is to be done after determining the participants, the expected benefits to each participant from the arrangement and the value of its contribution.
There have been cases of intentional profit shifting through restructuring by shifting of functions, assets and risks within the enterprises belonging to MNE groups. In transfer pricing analysis, it has to be seen whether the conduct of the enterprises conforms to the contractual allocation of risks and whether they are at arm’s length. The actual transaction undertaken including role of contractual terms and the economic substance of the transaction have to be examined.
Safe Harbour Rules
India, like Australia and Mexico, has adopted safe harbour rules that are consistent with arm’s length standard. These rules were introduced in 2013 and were liberalised in 2017. They are intended to reduce the administrative burden of Revenue by exempting low-value adding intra-group services from audit for simplified compliance and to provide certainty. The assessees eligible for opting these rules are those engaged in providing software development services or IT-enabled services or knowledge process outsourcing services with insignificant risks to the non-resident associated enterprise. Assessees engaged in contract research and development services relating to manufacture and export of core auto components apart from generic pharmaceutical drugs and those who have made intra-groups loans or provided corporate guarantee may also opt for safe harbour subject to specified conditions.
Burden of Proof
It is mandated that a taxpayer while furnishing the return of income shall compute any income or expense rising from international transaction having regard to the arm’s length price. He has to establish this by maintaining the prescribed documents. Thus, the primary onus is on the taxpayer to determine an arm’s length price and to substantiate the same with prescribed documentation. The underlying logic for this burden is that he being a party to the transaction, he has full knowledge of the same and the profits earned by him. In case of failure on the part of taxpayer to establish that the declared price conforms to arm’s length standard, it is for the tax authority to determine such price. In case an arm’s length price declared by the assessee is rejected, the burden shifts to the tax authority to re-compute the price as per the rules.
Documentation
The documentation requirement is guided by the burden of proof. The documentation requirements are intended to ensure that taxpayers give appropriate consideration in establishing prices of transactions with associated enterprises. Secondly, to provide tax administration with the information necessary to conduct an informed transfer pricing risk assessment. Finally, to provide tax administration with useful information to be employed in conducting a thorough audit.
In keeping with India’s commitment to implement the recommendation of BEPS Action 13 report on documentation and country-by-country reporting, enabling amendments were introduced in 2016. Pursuant to these amendments, as per notification dated 31.10.2017, the rules and forms thereunder were introduced. Accordingly, India adopted a three- tiered approach by envisaging a master file, a local file and a country-by-country report. This, in fact, is a landmark development and fulfils a long felt need of the tax administrations particularly, of the developing countries for access to the required information for transfer pricing analysis.
The master file is to be furnished by a constituent entity of an international group having consolidated group revenue exceeding 500 crore rupees and the aggregate value of international transaction exceeding 50 crore rupees. The master file provides a blueprint of the international group with the information in respect of ownership structure and the nature of businesses. The next item is the important drivers of profit of such businesses, particularly, overall strategy of the international group for the development, ownership and exploitation of intangible property, including location of principal research and development facilities and their management besides all the important intangible property owned by the group. It includes a brief description of important service arrangements made among members of the international group, details about transfer pricing policy or allocating service costs and determining prices paid for services. The next is the details about intra-group funding including central financing functions.
In contrast to the master file providing a blueprint of the MNE group, the local file provides more detailed information relating to the specific intercompany transactions supplementing the master file. The local file provides the local organisation chart and each material category of international transactions in which the entity is involved.
The country-by-country report is to be furnished by a parent entity or an alternate reporting entity or any other constituent entity resident in India. It furnishes location-wise indicators of economic activities like the revenue from transactions with unrelated and related parties, the profit (loss) before income tax, income tax accrued and paid on cash basis, stated capital, accumulated earnings, number of employees and tangible assets other than cash. It also provides the main business activities and particulars of R&D and intangibles, services and financial services by each constituent entity.
Penalties
The object of penalty provisions is to provide a disincentive against non-compliance of taxation laws and to encourage compliance. Hence, penalties have been stipulated for failure to keep and maintain the required documents, for failure to furnish the prescribed report from an accountant as also for concealing the particulars of income or furnishing inaccurate particulars thereof. The defence against penalty is existence of reasonable cause or taxpayer’s good faith and due diligence.
Dispute Resolution Mechanisms
An early finalisation of tax liability is a prerequisite for any effective tax system enabling early collection of revenues legally due. The dispute resolution mechanisms applicable to the taxes on income relating to cross-border transactions comprise domestic mechanisms and the mutual agreement procedures under the tax treaties. The domestic mechanism consists of appeals and judicial reviews. The mutual agreement procedure to resolve the issues arising under the tax treaties is the other limb of the mechanism. It is for the taxpayer to choose the forum which will be the most effective, depending upon the facts and circumstances of his case.
The first appellate authority is the CIT(A). However, any person in whose case there is variation in the income or loss returned as per the order proposed by the assessing officer, on the basis of the computation by the TPO of the arm’s length price as also a foreign company, the draft of the order of assessment which is prejudicial to the interest of the assessee and the variation is not acceptable to the taxpayer, he can file his objections to the Dispute Resolution Panels (DRP) based in Delhi and Mumbai. This Panel comprises three Commissioners who are its full time members. The powers of the DRP are coterminous with those of the assessing officer. The DRP is empowered to issue such directions as he thinks fit after considering the draft order, the objections by the assessee and the evidence furnished or collected. An order passed by an assessing officer pursuant to the directions of the DRP is appealable before the Tribunal which is the final fact finding authority. An appeal lies to the High Court from any order of Tribunal involving a substantial question of law. An appeal is provided to the Supreme Court from any judgement of High Court subject to certificate of fitness by the High Court certifying that the case involves a substantial question of law of general importance. India has developed a sophisticated body of case laws.
Article 25 of Model Double Taxation Convention provides an alternative mechanism in the form of Mutual Agreement Procedure (MAP) irrespective of the remedies
provided by the domestic law of the respective States. It is the responsibility of tax administrations who are parties to tax Conventions to ensure that the taxpayers are not subjected to double taxation, do not avail of unintended double non-taxation and are not subjected to taxation not in accordance with the provisions of a tax Convention. MAP is intended to resolve disputes in respect of these issues. A large number of cases under MAP are in the context of transfer pricing problems and the issue of the existence of PE.
Advance Pricing Agreement (APA) is an arrangement in respect of certain specified transactions that determines in advance for a specified period, the appropriate criteria for determining the arm’s length price of an international transaction or specifies the manner in which such price is to be determined. This is a dispute prevention mechanism. The main purpose of an APA is to supplement traditional administrative, judicial and treaty mechanisms for resolving transfer pricing issues in an environment of co-operative and non-adversarial negotiation for resolution of transfer pricing issues.
There are three types of APAs, namely, unilateral, bilateral and multilateral. This process is initiated with pre-filing consultation followed by furnishing of an APA application, due diligence, analysis of the terms of application by the APA team, negotiation between the competent authorities in the cases of bilateral or multilateral APA, acceptance or rejection of an APA application, entering into APA, its implementation, filing of annual compliance report by the taxpayer and compliance audit by the tax authorities concerned. This may result on renewal, revocation, revision or cancellation of the APA.
Capacity Building
The negotiation of APAs and the analysis of the country-by-country reporting are critical for the capacity building of Revenue by having access to the required information for transfer pricing analysis. This will address the problem of asymmetry of information between the taxpayer and the tax administration contributing to reduction in tax disputes.
Source- CBDT Taxalogue Magazine Jul – Oct 19 | Volume 1 | Issue 1
