Finance act 2012 has brought two landmark changes pushing us towards a comprehensive TP legislation. TP has been made applicable to domestic transactions and the much awaited Advance Pricing Agreement (APA) has been introduced. In the part I of this series we have tried to analyze proposed enactment relating domestic transfer pricing bringing out the purpose, impact and issues related with it.
Transfer pricing for “Specified Domestic Transaction”- An analysis
As quoted in the memorandum 1 to Finance bill 2012 “The Supreme Court in the case of CIT Vs. Glaxo SmithKline Asia (P) Ltd (2010)., in its order has, after examining the complications which arise in cases where fair market value is to be assigned to transactions between domestic related parties, suggested that Ministry of Finance should consider appropriate provisions in law to make transfer pricing regulations applicable to such related party domestic transactions.”
Taking a cue from above suggestion from honorable SC, Finance Bill 2012 has introduced TP regulation with regard to domestic transaction on following lines:
Effective from April 1, 2013, if the aggregate value of “specified domestic transaction” exceeds INR 50 million in a year, Taxpayers will now have to:
As per the proposed provisions, the following domestic transactions would be classified as “Specific Domestic Transaction” and shall be subject to TP regulation (Sec 92BA):
Also the finance bill expands the definition of related parties for purpose of section 40A to cover cases of companies which have the same parent company.
Doing away with Tax Arbitrage abuse:
This amendment strives to do away with tax arbitrage abuse that stems from
a) Differential tax rate: When one of the entities to the transaction enjoys a tax stimulus (i.e. in case of entities in SEZ, Infrastructure sector, backward area etc.) parties are tempted to shift profit to the entity enjoying favored status.
b) Presence of accumulated loss: When one the party to the transaction have accumulated loss in their book, they might be tempted shift profit from profit making entity to the organization with accumulated loss in a bid to profiteer from reduced combined tax obligation
Bringing in objectivity in the interpretation and governance:
ITA already has provisions insisting upon the said transactions to be transacted at Fair Market Value. However FMV is not defined which leaves a scope for subjectivity and conflict in interpretation. Thus introducing the ALP mechanism to the said transactions shall result in moving away from discretionary undefined situation to a situation that is better defined paving the path for objectivity and greater discipline in pricing by the industry and better governance from revenue administration.
SC through its suggestion, as cited above, has sought to achieve the end of reduced litigation by ushering in clarity and methodology in an undefined and subjective legislation.
C. Benefit & Burden:
Increased compliance burden on all effected assessee: in terms of maintaining TP documentation, selecting the most appropriate method and being subject to scrutiny by the TPO.
Increased administrative burden on revenue department: Indian revenue department, which is still grappling with developing adequate expertise to address international transaction, will now have to double up for domestic transaction as well. However with the avenue of increase in revenue in the eyesight, they would be least bothered about logistics.
Impact on litigation: Although SC had suggested introduction of TP to the domestic turf in a bid to bring legislative clarity and reduce litigation. However, given the litigative record of Revenue department with respect to TP sphere one would have reasonable reason to doubt it
Formulation of product pricing methods : Methods of arm length pricing alongwith TP concepts and considerations like risk -reward planning, benchmark driven pricing, supply chain re-engineering, location planning study, etc. would help in formulation of product pricing methods and also enable legitimate tax cost management (TCM) avenues.
Robust TP Documentation: Assessee will also be subject to stringent penal provisions as provided U/s 271AA, 271G, 271BA and 271(1)(c). As a corollary, maintenance of robust TP documentation would be accorded paramount significance.
Exclusion of entities, where there is no risk of tax erosion: TP provisions to domestic transactions are prevalent in most countries with certain exceptions like Japan, Australia etc. However in most of such jurisdictions there is a provision to exempt transaction, where there is no perceptible risk involved of tax erosion. There is no mention of such relief clause as yet. Such exclusionary provision would go a long way in reducing the compliance and administrative burden.
Managerial Remuneration of Director: On literal interpretation applying TP to Section 40 A would also include application ALP for determination of managerial remuneration of directors (directors being related party). How would one benchmark such transaction remains anybody’s guess.
Threshold holding for being considered a related party: Threshold holding under section 40A and under current international TP as enshrined in ITA is respectively 20 % and 26%. And in case of tax holiday unit, no such threshold is specified, rather a subjective phrase “Close Connection” has been used. A harmonization of definition in this regard shall bring more objectivity.
Will Domestic TP also include marketing intangibles, Corporate guarantee etc.: Experts opine that unless a payment is made and these items actually appear in the books of accounts they shall not be covered by domestic TP (International TP covers such transaction), however it would be wise to add that jury is still out on this issue.
Mechanism of set off / Instances of double taxation: In case department identifies a case of excessive cost or under invoicing of sales and resultantly makes adjustment enhancing the tax liability of the concerned assessee, there is no provision to provide corresponding benefit to the other party to the transaction. This might result in double taxation (Countries like UK provide a mechanism of set off to the other party in such circumstances). Also in international taxation, such cases are covered by the treaty which invariably has the provisions to arrest the instances of double taxation.
This brings one to wonder that –Wasn’t different set of rules warranted for domestic TP. There is still some time left before these rule comes into effect and one hopes that some of these issue will be resolved in due time.
In the part II of this series we have analyzed the proposed enactment relating Advance Pricing Agreement bringing out its benefits and issues. Also to add a broader perspective we have put forward a study of the integral features of APAs prevalent across the globe.
CA Rahul Kumar, Partner
AVA & Associates
About AVA – AVA & Associates is a Chartered Accountant firm with an experience of more than two decades in providing contemporary services to clients of varying nature, business line, size, scale and geography. AVA inter-alia specialize in to the discipline of accounting, taxation, audit & assurance, financial management and corporate law.