In this blog post, Tresa Ajay, a student of National University of Advanced Legal Studies, Kochi, who is currently pursuing a Diploma in Entrepreneurship Administration and Business Laws from NUJS, Kolkata, discusses how arm’s length price compliance is demonstrated.
According to the Companies Act, 2013, an arm’s length transaction is defined as one conducted as though the transaction took place between two unrelated persons even though they are related so that no conflict of interest arises. Simply put, it is a transaction entered into as if entered with an unrelated party and so there is no interest. So, contracts with no interest cover the meaning of arm’s length transactions.
The Companies Act, 2013 specifies that any transaction entered into by related parties shall be treated as if they were made with unrelated parties. So in these instances, if a transaction takes place between unrelated parties, there should be no interest there.
Section 188 of the Companies Act states that a transaction will qualify as a related party transaction (RPT) if a company enters into any prescribed transaction with a related party. It must also be determined that the transaction is in the company’s ordinary course of business and is entered at an arm’s length. If otherwise, then the approval of the board of directors and shareholders is required. Section 188 of Companies Act 2013 is about Related Party Transactions applicable to both private and public limited companies. The Act only mentions arm’s length transaction and not pricing. We need to look into provisions of the Income Tax Act i.e. the domestic transfer pricing and international transfer pricing requirements to understand pricing requirements.
Section 92F of the Income Tax Act, 1961 mentions arm’s length price to be the price proposed or applied in a transaction between unrelated persons in uncontrolled conditions. Unrelated persons are defined in Section 92A of the same Act i.e. persons that are not associated or deemed to be of an associated enterprise. Uncontrolled conditions would be those that are not controlled or molded to achieve a predetermined result.
Section 92 is only applicable to residents whose income can be taxed under the Sections 5 and 9 of the Income Tax Act, 1961. Section 9 deals with income that is accrued from India and Section 5 deals with non-residents liable to pay tax on income that is received or believed to be received by him in India that arises during the previous year.
What are the main elements required to constitute arm’s length price?
To sum it up, firstly, the price needs to be applied, or there must be some proposition that it will be applied in the transaction. Secondly, the transaction must take place between two unrelated persons and thirdly it must take place under uncontrolled conditions.
Let us take an example to make it clearer. Suppose a bank in its normal course of business provides interest at 9% to its customers on a fixed deposit for two years but provides an interest of 9.25% to its employees. This might come off as a violation of the arm’s length principle.
Transfer pricing
As mentioned earlier, arm’s length price compliance comes into play in transfer pricing as well. So what is transfer pricing? This is a process by which Multi-National Corporations structure their business strategy in such a manner that they have subsidiary companies in tax havens to maximize profits. Such MNC’s declare fewer profits and adjust their international transactions to evade tax. This gives rise to the issue of transfer pricing. The provisions with regard to this were made very recently in India. Although Section 92 mentioned, it there were no rules which could help resolve the issue. The Finance Act, 2001 inserted Sections 92A to 92F with regard to this.
Again, let us take an example. A subsidiary company which manufactures goods is a resident in country A where the tax rate is 30%. It transfers these goods to its parent company in country B to trade where the tax rate is 20%. The company will then supply goods at a rate lower than the market price to increase profits. But the subsidiary company in country A will have lower profits and thus will be taxed less whereas in country B even though it generates high profits it will be taxed less due to the low tax rate. In short, the parent company sells the products manufactured at an inflated price to the subsidiary company to show less generation of profits and reduce tax imposition. The law however, requires you to sell the products at arm’s length price.
Section 92 states that any income, expenses, allowances or interest that arises from an international transaction needs to be computed at arm’s length. Also, any allowance for the expense or interest that arises should also be determined at arm’s length. This Section shall not apply to non-residents as their income cannot be taxed under Sections 5 and 9 of Income Tax Act, 1961 as mentioned earlier.
Also if two or more associated enterprises enter into an international transaction for any benefit, service or facility provided, apportioned or contributed by an enterprise then it shall be determined on an arm’s length basis. Thus not only income but any expense or cost is to be determined by arm’s length price. Associated enterprises which participate directly or indirectly or through intermediaries in the control or management of capital.
Sections 92, 92A to 92F will be applied only to international transactions where either or both are non-resident companies. They shall also be associated enterprises if in the previous year an enterprise or person holds, directly or indirectly, shares not less than 26% voting in that enterprise or if an enterprise loans another not less than 26% of the book value of the total assets of that enterprise or if not less than 10% of the total borrowings is guaranteed.
The RBI has also come out with guidelines that specify instances when arm’s length principle needs to be applied. It had mandated that share valuation by an Indian company to a foreign company must be by any internationally accepted method but on an arm’s length basis. This impacts how the valuer has to apply professional judgment and look it on a case by case basis and maybe look at methods as well. This will help Indian companies comply with transfer pricing regulations as well, as it emphasizes on arm’s length compliance.
Thus, according to the guidelines, various shares such as equity shares, preference shares or even debentures that are convertible of an unlisted company approved by FEMA regulations must be valued at a price not lower than the internationally accepted standard on an arm’s length basis for unlisted companies and SEBI (ICDR) Regulations for listed companies. In instances where a non-resident exists from investments in an Indian company, of equity instruments, the price must be arrived at according to internationally accepted standards determined on an arm’s length basis. The same shall be applicable for non-residents when they acquire shares from residents or when they are issued shares under the FDI policy
Methods for computing arm’s length price
There are various methods that are used to compute arm’s length price. Comparable Uncontrolled Price Method (CUP) where the price is adjusted so that there are no differences between the international transaction and the comparable uncontrolled transactions. This is used in case it is for a product or service i.e. to compare prices charged for property transferred or a service that is provided. The price at which the service or property obtained by an associated enterprise is resold to an unrelated one is identified and adjusted is called Resale Price Method. The Cost Plus Method is applied in cases where there are semi-finished goods which are sold between related parties or joint facility agreements etc. The Profit Split Method is mainly used in international transactions which deal with unique intangibles or in international transactions that are multiple in nature and so cannot be evaluated separately to determine arm’s length as they are interrelated. Transactional Net Margin Method first computes the net profit margin that was realized by an associated enterprise about certain factors like sales; costs incurred, assets utilized from an international transaction. Then the net profit margin of uncontrolled transactions is compared with the same earned by an associate enterprise to arrive at the arm’s length price.
According to Section 92C(1) of the Income Tax Act, the arm’s length price will be determined using the most appropriate method. The same method cannot be used if the enterprise is involved in various transactions with associated enterprises. This will be determined the case is specifically looking at the facts and circumstances of every situation.
In Serdia Pharmaceuticals (India) (P.) Ltd. V. CIT [2011] 44 SOT 391 (Mum), it was held that there is no priority of methods or order that needs to follow by the assessed as no method can be claimed to be more reliable than the other.
There is no single Indian Bare Act that defines Arm’s length price compliance in totality or explains how this compliance is demonstrated. There are various Acts though such as the Companies Act, 2013, the Income Tax Act, 1961 and the AS 18 that make a mention of it. It is together with these legislations, various circulars, and notifications from the concerned statutory bodies such as the RBI or SEBI along with customary practice that one can grasp what the principle states and how its compliance is demonstrated.
