CA Abhishek Jain
Formal Transfer pricing regulation has been present in India for more than twelve years. Section 92 of the income tax act, 1961 warrants that international transactions between the associated enterprises shall be computed having regard to the Arm’s Length Price (ALP). However, since inception the transfer pricing regulation does not explicitly provide the manner of treating the difference between the income actually earned and income determined as per the Arm’s Length Price ( i.e. Secondary Transfer Pricing adjustments) arising subsequently after computation of arm’s length price. Due to this ambiguity there has been a sharp increase in disputes in Transfer Pricing audits especially during the recently concluded eight cycle of TP audits.
One of the issues was in case of PMP Auto Components Pvt. Ltd. [TS 263 ITAT 2014 (Mum) TP]. In the relevant case the taxpayer, during the year under consideration has infused additional capital in its overseas subsidiary company and such additional infusion of capital was made at par value based on the valuation report obtained from an independent valuer. However, the TPO considered the arm’s length price of the shares at Nil as TPO found that value of shares as on closing date which is the nearest date of the transaction, was negative. Accordingly, TPO has made the transfer pricing adjustment (this is termed as ‘primary adjustment’). Further, the TPO has treated the amount invested in the capital of the overseas subsidiary as interest free loan given to the subsidiary company as the book value of shares as on the closing date is negative and such amount invested in equity capital was still lying with said subsidiary company. Therefore, the TPO has made an adjustment on account of notional interest taking 15% as arm’s length interest rate on the so called interest free loan transaction (this is termed as ‘secondary adjustment’). While the DRP has confirmed the primary adjustment made by the TPO, it has directed the TPO / AO to delete the secondary adjustment on the ground that same is not allowed under the Transfer Pricing provisions of the Act. Regarding the primary adjustments, the Mumbai ITAT held that valuation of shares should be based on the future earnings under DCF method especially given the fact that such investment is long term in nature and taxpayer is the sole shareholder. The Mumbai ITAT also concurred with the order of the DRP in deleting the secondary adjustment, since such secondary adjustment is not permitted under the transfer pricing provisions of the Act. Thus, in the instant case, the primary adjustment on account of investment in equity capital of the subsidiary is characterized by the TPO as interest free loan and the secondary adjustment is made by way of charging notional interest on the value of so called interest free loan which is nothing but value of the additional capital.
Looking at this approach of the TPO, it is clearly that as to how the ‘secondary adjustment’ works. The concept of characterizing the main transfer pricing adjustment and again subjecting it to tax consequences is generally regarded as ‘secondary adjustment’. This kind of adjustment is really a surprise to the taxpayers since it leads to double taxation on the same transaction.
Para 4.66 of OECD transfer pricing guidelines deals with the secondary transfer pricing adjustments.
The OECD transfer pricing guidelines defines the secondary transfer pricing adjustments as follows
An adjustment that arises from imposing a tax on secondary transaction.
A constructive transaction that some countries will assert under their domestic legislation after having proposed a primary adjustment in order to make the actual allocation of profits consistent with the primary adjustment. Secondary transactions may take the form of constructive dividends, constructive equity distribution or constructive loans.
From the definition it is clear that secondary adjustments will be made only in case the primary adjustments has been made. Now, the definition of primary adjustments is as follows:-
An adjustment that a tax administration in a first jurisdiction makes to a company’s taxable profits as a result of applying the arm’s length principle to a transactions involving an associated enterprise in second tax jurisdiction
Globally countries approach this situation either by treating the amount as deemed dividend, or capital contribution or a loan on which notional interest is then charged. Presently, only the United Kingdom has proposed the adoption of constructive loan approach (although this was in consultation stage till August 2016 – with no finality reached so far). European Union suggests a constructive dividend approach or constructive capital contribution approach to its member states. South Africa, USA, Spain, Korea follow the deemed dividend approach.
India has proposed to follow the constructive loan approach.
Finance Bill, 2017 has introduced the concept of secondary adjustments by way of insertion of section 92CE to the income tax Act.
Since the court had ordered the decisions in the favor of the assesses in the absence of any statutory backing to the secondary transfer pricing adjustments made by the tax authority therefore, Section 92CE has been introduced to provide the statutory backing for making secondary adjustments.
“Primary adjustment means the determination of the transfer price in accordance with the arm’s length principle, which increases the total income of the Assessee or reduces the loss”
“Secondary adjustments mean an adjustment in the books of accounts of the assessee and its associated enterprise to reflect that the actual allocation of profits between the assessee and its associated enterprise are consistent with the transfer price determined as a result of primary adjustment, thereby removing the imbalance between cash account and actual profit of the assessee”
“Excess Money means the difference arm’s length price determined and the price at which the international transactions has taken place”
(a) Every taxpayer shall be required to carry out a secondary adjustment in case a primary adjustment to transfer price has been made
(b) The excess money available with the AE consequent to the primary adjustment, if not repatriated to India within the prescribed time, shall be deemed to be an advance made by the taxpayer, requiring imputation of interest income, as may be prescribed.
(c) These provisions, however, would not apply in case
i. The amount of primary adjustment does not exceed INR 10 million; and
ii. The primary adjustment is made in relation to any FY prior to 1 April 2016
(d) This change will be effective from 1 April 2018 and will apply for AY 2018-19 and onwards
1. Whether the provisions of the Section 92CE are applicable retrospectively or prospectively:-
On one hand the section 92CE reads as it is proposed to be made applicable to the primary adjustments made from the AY 2018-19. This means that the secondary transfer pricing adjustments could relate to preceding AY if the primary adjustment is made the assessee sou moto or accepted by the Assessee in the pending proceedings.
However, the application of the section 92CE is restricted to primary adjustments made in respect of the assessment year commencing on or after the April, 2016, which means that secondary transfer pricing adjustments would not be applicable in respect of financial year 2015-16 or before.
Further the use of expression “and” used in the provision means that both the conditions (i.e. the primary adjustments does not exceeds Rs 1 crore and the primary adjustments relates to AY commencing on or before April, 2016) must be satisfied if the secondary transfer pricing adjustments has not be made applicable. This has further raised the issue of whether the secondary transfer pricing would be applicable to prior periods also.
For e.g. If the primary adjustments relates to AY 2011-12 but exceeds Rs 1 crores then it means that provisions of sec 92CE providing for the secondary adjustments will be applicable.
2. Timing of making the secondary adjustments
The section does not prescribe the timing of making the secondary adjustments in the books of accounts in case the Assesse appeal against the primary adjustments or accepts the primary adjustments at the later point in time after assessment or adverse ruling at the appellate stage.
Further, the section is silent about manner of dealing with the situation in case the partial relief is provided by the appellate authorities in case of appeal by the assesse against the primary adjustments.
3. Computation of Interest in case the amount of advance is not repatriated into India.
The excess money available with the AE consequent to the primary adjustment, if not repatriated to India within the prescribed time, shall be deemed to be an advance made by the taxpayer, requiring imputation of interest income, as may be prescribed. However there may be issues as to what will be arm’s length ate of interest which has to be taken for computation purposes.
Further, the section does not prescribe the any clarification on the time period for the computation of interest in case the assesse appeal against the primary adjustments or accepts the primary adjustments at the later point in time after assessment or adverse ruling at the appellate stage.
This section 92CE which is proposed to be introduced to make secondary adjustments, in its present form leaves many important issues unclarified. Further, there seems to be some ambiguity involved even with respect to its applicability for AYs commencing before April 1, 2016.
Even though that the pricing policies of Multinational companies are decided at the group level, each company in the group would be independent to make its business decisions. In such a case, there may be many practical issues involved with respect to repatriating the money from Associated Enterprises in accordance with the ALP in India. Further, in case of a non-repatriation, the secondary adjustment would be a permanent adjustment and the interest would be charged on a continuing basis. At some stage, the interest might very well exceed the primary adjustment itself. Therefore, it would be recommended that the CBDT provides a set of detailed clarifications to address all the issues involved, and the proposed Section in its present form is modified to provide greater flexibilities to the companies in the manner of effecting the secondary adjustment. Given the lack of clarity, this section would lead to more litigation