The Income Tax Act 1961(‘The Act’) as amended by Finance Act 2012 brought specified domestic related party transactions (SDT) within its fold with effect from FY 2012-13 vide section 93BA of the Act and admittedly as with any new legislation, there were very few early adopters. SDT provisions principally have impact in two ways, firstly the pricing of domestic transactions will need to comply with the arm’s length principle and secondly there shall be the compliance and documentation obligations for such specified domestic transaction as per the provisions of Section 92D and 92E of the Act read with Rule 10D and 10E.

Very recently, in the context of related party transactions, two regulatory changes have been promulgated which significantly underscore the need to be at ‘arm’s length’ – the Companies Act, 2013 and the clause 49 of the revised listing agreement notified by SEBI with effect from October 1, 2014. Further Reserve Bank of India has recently issued notification liberalizing and simplifying the entry and exit of foreign investor investing in unlisted Indian companies. The foreign investor would have the clarity on the potential exit price based on internationally accepted pricing methodology for valuation of equity instrument at the arm’s length price as certified by a Chartered Accountant or a SEBI registered Merchant Banker.

Boards have started directing their management to set up a more realistic review of the related party transactions amongst the group companies and other covered parties to navigate the complexities around related party transaction pricing documentation and compliance.

We summarize below some of the challenges experienced and learning we gathered in advising our clients last year in the context of SDT compliance for income-tax purposes.

Directorial remuneration:

Any Payments to directors including inter alia, remuneration, sitting fees, commission, perquisites, etc. are covered under SDT provisions, regardless of the nature of directorship. Payments to directors vary across companies and depend upon number of combination of factors. Each individual’s capabilities and contributions to a company’s profitability leading to enhancing shareholder value are unique. Therefore there are few difficulties in benchmarking the pay of top executives of the companies. However, the company still needs to comply with the Act by demonstrating that the payments to directors are at arm’s length.

A detail describing the key experience of the directors, their detailed career profile and linkage to the company’s operations during the year and future would comprise key documentation. The directorial remuneration can even be supported with the market surveys of compensation by leading Human Resource consulting firms that are often available categorized based on industry and also functional expertise. Further the other comparables includes the limit prescribed under the provisions of Companies Act.

Inter-corporate loans:

There is a varied practice followed by business houses in the context of inter-corporate loans. In a bid to provide financial support some companies does not charged any interest on such inter-corporate loans, while some may charge. In the other parts of the world such as the US, UK and Canada, complex financial analyses are undertaken to evaluate the credit rating of the borrower, security of the loan, repayment capability and a variety of the other factors in order to determine an arm’s length interest rate. In India, we continue to work with basic benchmark references, which may also accepted by the Revenue Authorities. One can substantiate that the interest rate charged is at arm’s length based on interest rate incurred by the company advancing the loan; (b) with reference to quotes obtained by the recipient company from banks for a loan of a similar tenure and security; or (c) interest rate ranges of banks for similar loans available in the public domain, in the order of reliability.

Leasing / sharing of premises, infrastructure and common costs among related party:

Very often, a promoter or a shareholder leases property owned or leased by him/her to the company in lieu of rent. The rent paid may be compared with the prevailing rent for a similar property in the area. The rent paid could be tested for arm’s length based on quotes for similar properties in the same location obtained by the payer specifically or based on publicly available quotes on a variety of popular websites.

In case of sharing of infrastructure, administration, management, and human resources, amongst related parties, expenses ought to be allocated in reasonable and scientific basis having key nexus with the actual usage and benefit to the transacting related parties (headcount ratio perhaps).

Some of the common cost allocation keys adopted by companies for shared costs are:

  • The costs relating to Finance, HR & Admin and IT – allocated based on the headcount ratio;
  • IT support charges – could be allocated based on usage of bandwidth by the entities involved;
  • Training or conference expenses – could be allocated based on ratio of participating employees of the respective entities;
  • Marketing expenditure – could be allocated in the ratio of revenue of the respective entities;

Inter-company sale of goods or services:

If an entity is selling similar goods or services to third party clients and related parties, the arm’s length benchmark prices or target profit margin is available to the company based on internal data and that is to be preferred under law as well (internal comparables). However, if any of these transactions are only undertaken for related parties and not with the third party clients, then a variety of transfer pricing methods are available and the most appropriate one is selected based on the nature and class of the transaction and availability of comparable data in the public domain. In the case of internal data, the comparable uncontrolled price (CUP) method or the cost plus method can be applied subject to making economic adjustments for material differences as most of the differences can be identified and mostly capable of quantification. The Transactional Net Margin Method (TNMM), which works with the net margin on a variety of appropriate base is generally chosen to be applied using external comparable data.

Conclusion:

Currently, while most of the companies gear up for their statutory audits, it would be more purposeful to integrate the transfer pricing review around the audit schedule as that helps the companies to proactively deal with potential non-arm’s length situations before the books are closed. Proactive transfer pricing planning from a holistic perspective is the only right way to maintain a fine balance amongst the tax requirements and corporate governance in India; and avoid unwanted penalties  A more holistic review will definitely add a lot more credibility and substance to the underlying transfer pricing policy put in place for the SDTs. Arm’s length transfer pricing planning, implementation and compliance is clearly a board room agenda and not just tax compliance relegated to the finance function.

(Raghav Gupta – Partner – Legal Quotient Consultants – T: +91-9899099030, E: raghavguptamail@gmail.com )

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0 responses to “An Year with Specified Domestic Transaction (Transfer pricing)”

  1. himanshu says:

    i dont think using bank interest rate for inter corporat loans is appropriate, using LIBOR rate is generally more prefered.

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