Introduction
Transfer Pricing (TP) is a crucial concept in the realm of international taxation and corporate finance, aimed at determining the prices at which goods, services, and intangible assets are exchanged between affiliated entities within a multinational corporation (MNC). It has emerged as a significant area of concern for tax authorities and multinational enterprises alike, as it directly impacts tax liabilities, profitability, and financial reporting accuracy. Understanding TP is essential for businesses operating across borders to navigate compliance requirements and optimize their tax positions while ensuring fairness and transparency in global economic transactions.
Why TP Matters:
The practice of TP gained prominence primarily due to the increasing globalization of businesses and the rise of multinational corporations. As companies expanded their operations globally, they often set up subsidiaries, affiliates, or branches in various countries. Intercompany transactions became commonplace, involving the transfer of goods, services, and intellectual property across borders. However, these transactions presented challenges for tax authorities, as they created opportunities for tax avoidance and profit shifting by manipulating prices charged between related entities.
In response to these concerns, governments around the world introduced TP regulations to ensure that multinational enterprises accurately reflect the economic substance of their transactions and pay their fair share of taxes in each jurisdiction where they operate. TP rules aim to prevent tax evasion, ensure tax revenues are properly allocated among countries, and promote a level playing field for both multinational corporations and domestic businesses.
When TP Was Introduced:
The origins of TP can be traced back to the early 20th century when multinational corporations began to expand their operations globally. However, the formalization of TP rules and guidelines occurred primarily in the latter half of the 20th century as international trade and cross-border investments surged.
One significant milestone in the development of TP regulations was the establishment of the Organisation for Economic Co-operation and Development (OECD) in 1961. The OECD, representing a coalition of developed countries, recognized the need for international standards to address TP issues and prevent double taxation. In 1979, the OECD released its first set of TP guidelines, providing a framework for determining arm’s length prices in intercompany transactions.
Since then, TP regulations have continued to evolve globally, with many countries enacting their own legislation and adopting the OECD guidelines as a basis for their TP rules. The increased focus on TP compliance and enforcement has led to a complex and dynamic landscape, requiring multinational enterprises to navigate intricate rules and documentation requirements to mitigate the risk of tax disputes and penalties.
Section 92: Computation of income from international transaction having regard to arm’s length price
The concept of Arm’s Length Price (ALP) is fundamental in determining the financial aspects of international transactions involving Associated Enterprises (AE) or Specified Domestic Transactions (SDT). All income, expenditure, interest, allocation of costs, or expenses related to such transactions must be computed with reference to the ALP.
However, it’s important to note that TP provisions do not apply if the ALP determined leads to a reduction in income or an increase in losses. This exemption is critical to ensure that the application of ALP does not inadvertently result in adverse financial consequences for the involved parties.
Income to be Computed having regard to ALP:
The ALP represents the price that would be agreed upon in a transaction between unrelated parties conducted under uncontrolled conditions. ALP determination involves selecting the most appropriate method (MAM) from the prescribed methods.
Several factors guide the selection of the MAM:
- The nature and classification of the International Transaction and Specified Domestic Transaction (SDT).
- The characteristics of the Associated Enterprises (AEs), including the functions performed, assets employed, and risks assumed (FAR).
- The availability, scope, and reliability of the data necessary for applying the method.
- The degree of comparability between the International Transaction/SDT and uncontrolled transactions.
- The feasibility of making reliable and accurate adjustments to account for differences between the International Transaction/SDT and comparable uncontrolled transactions (CUT).
- The nature, extent, and reliability of assumptions required in applying a particular method.
Who are AE’s?
As per section 92A of the Income Tax Act, 1961 (the Act), for sections 92, 2B, 92C, 92D, 92E, and 92F the term associated enterprises in relation to another enterprise shall mean, an enterprise-
i. Which participates either directly or indirectly or through one or more intermediaries in the control or management or capital of the other enterprise.
ii. In respect of one or more persons that participate either directly or indirectly or through one or more intermediaries in the control or management or capital are the same persons that participate either directly or indirectly or through one or more intermediaries in the control or management or capital of the other enterprise.
For sub-section (1), two enterprises will be deemed to be associated enterprises if any time during the previous year at any time-
i. One enterprise holds directly or indirectly, shareholding carrying not less than 26% of the voting power in another enterprise.
ii. Any individual or an enterprise holds directly or indirectly not less than 26% of the voting power in each of such enterprises.
iii. Any loan advanced from one enterprise to the other company constitutes not less than 51% of the book value of the total assets of the other enterprise.
iv. The guarantee of one enterprise is not less than 10% of the overall borrowings of the other enterprise.
v. More than half of the board of directors or the governing board, or the executive members or directors are appointed by the other enterprise.
vi. One enterprise has a dependency in terms of know-how, patents, trademarks, rights or any other business or commercial rights or any data, documentation, drawing or specification relating to any such patent, invention, model or design for manufacturing or processing of goods, and the other enterprise holds the rights to such patents.
vii. 90% or more of the raw materials or consumables are supplied by the other enterprise or by persons specified by the other enterprise, and the prices and other conditions relating to supply are influenced by such other enterprises.
viii. The goods or articles required by one enterprise are supplied by another enterprise, and the prices and other several conditions relating to supply are influenced by such other enterprises.
ix. Where one enterprise is controlled by an individual and the other enterprise is also in control of the same individual or his relative jointly.
x. Where one enterprise is controlled by an undivided Hindu 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.
xi. Where one enterprise is a firm, association of persons or body of individuals, the other enterprise holds not less than 10% interest in such a firm, an association of persons or body of individuals.
xii. There exists between the two enterprises, any relationship of mutual interest, as may be prescribed.
What is an International Transaction?
According to Section 92B of the Act, an international transaction refers to a transaction involving two or more AE’s, with at least one being a non-resident entity.
However, in scenarios where both AEs are non-resident entities, TP provisions are applicable only if the income of at least one of the AEs is taxable in India under the provisions of the Act.
A deemed international transaction occurs when a transaction involving an enterprise and a party other than an associated enterprise is treated as if it took place between two associated enterprises. This situation arises when there exists a prior agreement related to the transaction between the other party and the associated enterprise, or when the terms of the transaction are essentially determined between the other party and the associated enterprise.
In the context of the Act, an international transaction is defined as a transaction between two or more associated enterprises, where either or both of them are non-residents. Such transactions encompass the transfer of tangible or intangible property, provision of services, lending or borrowing of money, or any other transaction affecting the profits, income, losses, or assets of the enterprises involved. This definition also extends to any mutual agreement or arrangement for the allocation, apportionment, or contribution to costs or expenses incurred in connection with a benefit, service, or facility provided or to be provided to one or more of the associated enterprises.
Specified Domestic Transaction
SDT in the context of Income Tax refers to certain transactions that occur within India between related parties or associated enterprises. These transactions are governed by transfer pricing regulations to ensure that income and expenses arising from them are accounted for fairly and at arm’s length prices, which means they are transacted at market value as if they were between unrelated parties.
The Finance Act of 2012 introduced SDT under Chapter X of the Act, to mitigate the risk of profit shifting and tax evasion through related party transactions within India. Section 92BA of the Act lists the types of transactions that are considered SDT’s. These include:
- Transactions referred to in Section 80A, such as inter-unit transfers of goods or services.
- Business transacted between the assessee and other persons as referred to in sub-section (10) of Section 80-IA.
- Transactions referred to in any other section under Chapter VI-A or Section 10AA, to which provisions of sub-section (8) or sub-section (10) of Section 80-IA are applicable.
- Any business transacted between the persons referred to in sub-section (6) of Section 115BAB.
- Any other transaction as may be prescribed, where the aggregate of such transactions exceeds a sum of twenty crore rupees in the previous year.
The intent behind these regulations is to provide objectivity in determining income and the reasonableness of expenditure in domestic related party transactions, and to create a legally enforceable obligation on the assessee to maintain proper documentation.
Methods For Computing Alp [Section 92C]
1. Comparable Uncontrolled Price (CUP) Method: This method is employed when there are comparable transactions between unrelated parties that can be used as a benchmark for determining the ALP.
2. Resale Price Method (RPM): The RPM is utilized when an item acquired from an AE is subsequently resold to an unrelated party. The ALP is determined by applying an appropriate resale price margin to the resale price.
3. Cost Plus Method (CPM): This method is commonly used when semi-finished goods are sold to Associated Enterprises. It involves adding an appropriate markup to the cost incurred by the seller to arrive at the ALP.
4. Profit Split Method (PSM): The PSM is applied in situations involving the transfer of unique intangibles or in cases with multiple international transactions or specified domestic transactions. It involves splitting the combined profits of the associated enterprises in a manner that reflects each entity’s contribution to the overall value creation.
5. Transactional Net Margin Method (TNMM): The TNMM computes the net profit margin earned by the enterprise from international transactions or specified domestic transactions with associated enterprises, taking into account the costs incurred, sales effected, or assets employed. This method compares the net profit margin of the tested party with that of comparable independent enterprises to determine the ALP.
6. Other Method (as per Rule 10AB): This encompasses any method that considers the price charged or paid for the same or similar uncontrolled transactions with or between non-associated enterprises under similar circumstances. This method is applied when none of the above methods are appropriate or when reliable data is not available for applying the prescribed methods.
Section 92C(2): ALP if more than 1 price arrived.
ALP should be computed only by using the most appropriate method. However, where the most appropriate method results in more than I price, ALP shall be as per range concept, if prescribed conditions are satisfied, or by applying Arithmetic Mean in any other case.
How to apply Range Concept?
- The dataset values will be arranged in ascending order.
- If the actual transaction price falls within the 35th and 65th percentiles of the dataset, that value will be accepted as the Arm’s Length Price.
- If the transfer price does not fall within the above range, then the median of the dataset will be taken as the Arm’s Length Price.
When is range concept not applicable [Rule 10CA(7)]
Where the most appropriate method is PSM or any Other Method or the dataset has less than 6 entries, the ALP shall be the arithmetical mean of all the values included in the dataset.
Note: If the difference between the ALP and the transaction price does not exceed 3% of the transaction price (1% in the case of wholesale trading), the transaction price will be considered the ALP. In such cases, no TP adjustment will be made on account of ALP.
However, if the difference exceeds 3% (or 1% in wholesale trading), the entire difference will be added to the total income as a TP adjustment.
Section 92CE: Secondary Adjustment
“Primary adjustment” refers to the determination of the transfer price in accordance with the ALP that leads to an increase in total income or a reduction in the loss of the assessee.
“Secondary adjustment” involves making adjustments in the books of the assessee and its AE to ensure that the actual allocation of profits between the assessee and its AE aligns with the transfer price determined as a result of the primary adjustment. This ensures consistency between cash accounts and the actual profits of the assessee, thereby rectifying any imbalances.
Applicability:
Assessee shall be required to carry out secondary adjustment where the primary adjustment to transfer price:
- Has been made suo motu by the assessee in his return of income
- Made by AO during assessment & same has been accepted by assessee
- Is determined by an APA entered into by the assessee on or after 1.4.2017
- Is made as per the safe harbour rules
- Is arising as a result of resolution of an assessment by way of MAP under an agreement entered into u/s 90 or 90A for avoidance of double taxation.
Repatriation of excess money by AE
If the primary adjustment leads to an increase in the income or a reduction in the loss of the assessee, any excess amount or part thereof held by its Associated Enterprise (AE) should be repatriated to India within the specified time limit.
The time period for the repatriation of money in transfer pricing provisions, specifically under the secondary adjustment rule in India, is 90 days from the relevant date. This period applies to the repatriation of excess money, which is the difference between the ALP determined in the primary adjustment and the price at which the international transaction has actually taken place. If the excess money is not repatriated within this time frame, it is deemed to be an advance made by the assessee to the associated enterprise, and interest on such advance is computed as the income of the assessee.
Alternative option
Alternatively, instead of repatriating the excess money into India, the assessee has the option to pay additional income tax at a rate of 18%, along with a mandatory surcharge of 12%, and a Health and Education Cess (H&EC) of 4% on such excess money or part thereof.
Upon payment of this additional income tax, the assessee will no longer be required to make a secondary adjustment, and interest will be computed from the date of payment of such tax. The additional income tax paid shall be treated as the final payment of tax in respect of the excess money not repatriated.
It’s important to note that the excess money on which additional income tax has been paid will not be allowed as a deduction under any other provisions of the Act, and no credit will be allowed to the assessee or any other person for the additional income tax paid.
Conclusion
In conclusion, transfer pricing plays a critical role in the taxation of multinational corporations, influencing their tax liabilities, profitability, and compliance obligations. Introduced in response to the challenges posed by cross-border transactions, transfer pricing regulations aim to ensure that related-party transactions are conducted at arm’s length prices, reflecting the fair market value of goods, services, and intangible assets. Understanding the principles and implications of transfer pricing is essential for businesses operating in a globalized economy to manage their tax risks effectively and maintain compliance with regulatory requirements across jurisdictions.
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