In this article, Ambika Kajal discusses Transfer Pricing Disputes in Offshore Jurisdictions.
Transfer Pricing
The price set for a transaction within a business group (controlled transactions), i.e., between the parent company and an affiliate or between related entities within the industry group, is known as the transfer price. Transfer pricing is the most important tax dispute faced by MNCs (UNCTAD 1999). ”The problem addressed by the transfer pricing rules is the absence of market friction in transactions between controlled persons and the resulting need to verify prices in such transactions for income tax purposes and, if necessary, to adjust for that absence” (Rosenbloom 2005).
Transfer pricing is termed as the pricing of the intermediate products or services supplied by one or more related units to other entities within the same company group.
The transaction value of a good or service between related enterprises may not always reflect market values. Transfer pricing refers to the distortion between transaction values and market values (OECD 2008).
Associated Enterprise
Associated Enterprises has been described in Section 92A of the Income Tax Act. The primary criteria to determine an AE is the participation in management, control or capital (ownership) of one enterprise by another whereby the participation may be direct or indirect or through one or more intermediaries, control over the entity may be direct or indirect.
International Transaction
International Transaction has been described in Section 92B of Income Tax Act. International Transaction” means a transaction between two or more associated enterprises (AE), either or both of whom are non-residents, in the nature of lease, purchase or sale, etc., of tangible or intangible asset, or provision of services, or lending or borrowing money, or any other related transaction having an impact on the profits, income, losses or assets of such enterprises,
It shall include an arrangement or mutual agreement between two or more associated enterprises (AE) for the allocation of, or any contribution to, any cost or expense incurred or to be incurred in connection with a benefit, service or facility provided or to be provided to any one or more of such enterprises.[1]
Arm Length Principle
This valuation principle applies to commercial and financial transactions between related companies. It says that transactions should be valued as if they had been carried out between unrelated parties, each acting in his own best interest. It is a condition that the parties to a transaction are independent and on an equal footing.[2] This definition is provided in OECD, 2006, Annual Report on the OECD Guidelines for Multinational Enterprises: Conducting Business in Weak Governance Zones, OECD, Paris.
TRANSFER PRICING – METHODS
Section 92C of Income Tax Act states the methods which are to be used in the computation of Arm’s Length Price.
Rule 10C of the Indian Income Tax Rules (1962)
While selecting the appropriate method, Assessee is to give regard to the nature of transaction or series of a transaction, or
The class/classes of Associated Enterprises (AE) entering into the transaction and the functions performed by them taking into account the tangible or intangible assets employed or to be employed and risks (losses) assumed by such enterprises, or
The availability, reliability of data required for application of the method and other relevant factors as the Board may prescribe.
Methods are
- Comparable Uncontrolled Price Method (CUP)
- Resale Price Method (RPM)
- Cost Plus Method (CPM)
- Profit Split Method (PSM)
- Transactional Net Margin Method (TNMM)
- Any other methodology prescribed by the board.
TRANSFER PRICING DEFINED IN INDIAN LEGISLATION
The Finance Act 2001 came up with a critical introduction with effect from Assessment Year of 2002-2003, relating to detailed Transfer Pricing regulations (Section 92 to 92F of the Income Tax Act, 1961).
(CBDT) Central Board of Direct Taxes has introduced some rules (Rule 10A to 10E) which related to Transfer Pricing
Applicability
Some conditions need to be fulfilled for applicability
- Firstly, There must be an international transaction.
- Secondly, such international transaction must be between two or more associated enterprises, either or both of whom are non-residents.
Documentation
Return
13 Different types of documents are to be maintained. These are-
(1) Enterprise-wise documents
- Detailed description of the enterprise,
- Defining relationship with other associated enterprises,
- Nature of business carried out.
(2) Transaction-specific documents
- Substantial information regarding each transaction,
- Description of the functions performed by each party,
- Assets employed and risks assumed by each party involved in the transaction,
- Economic & Market Analysis etc.
(3) Computation related documents
- Describe in details the method considered for calculation,
- Actual working assumptions, concerning policies, etc.,
- Adjustment made to transfer price,
- Any other relevant data, documents relied upon for determination of arm’s Length price, etc.
A report from a Chartered Accountant in the prescribed form giving details of transactions is required to be submitted within a specific time limit.
PROVISIONS RELATED TO TRANSFER PRICING IN DIFFERENT COUNTRIES
USA
Legal Position
Internal Revenue Services, Internal Revenue Code 482, 6038A, 6038C, 6062(e)-(n)
Pricing Method Allowed
Best Method among CUP, Resale Price, Cost Plus, CPM, Profit Split
Documentation
Return
- A tax payer is required to maintain extensive contemporaneous documentation.
- Returns in Forms 5471 and 5472 have to be filed.
Penalty
20% and 40% penalty for underpayment of tax is levied.
United Kingdom
Legal Position
Schedule 28AA mentioned in the Income and Corporation Taxes Act, 1988 and Section 12B of the Taxes Management Act 1970 guide transfer pricing in the UK. Inland Revenue Department manages the affairs. Guidance Notes in Inland Revenue Tax Bulletin 37 & 38 have also been published in public.
Applicability
It relates to transactions made between a UK body corporate and another body corporate, partnership or unit trust under common control, in a transaction or some transactions. Where the parties are not under common control, Schedule 28AA may still apply as between a Joint Stock Company and one or both of two 40% shareholders.
Pricing Method Allowed
Most reasonable methods like CUP, Resale Price, Cost Plus, Profit Split, TNMM is used for computation. Preference is given to Transaction based method over profit-based method.
Documentation
Return
Contemporaneous documentation is needed. The tax payer should keep all such records as may be required for the sole purpose of helping him to make and deliver a correct and complete tax return. The absence of it is tantamount to negligence, exposing the tax payer to substantial penalties.
Apart from Annual Return showing compliance with any APA, no other return is required to be submitted.
Penalty
Up to 100% of any additional tax due as a result of transfer pricing adjustment where the tax payer is negligent.
LEGAL PROCEDURE FOR TRANSFER PRICING DISPUTES SETTLEMENT
- The Central Board Of Direct Taxes published certain guidelines in 2015 to the income tax authorities in link with the Transfer pricing regulations.
- After the permission of the commissioner is granted, the assessing officer has the power to refer any transaction (whether international or domestic) in the previous year to the transfer pricing officer (TPO), to calculate the arm’s length price of such the transaction.
- After examining the evidence and taking into account all relevant data at his disposal, the TPO shall pass an order concerning the arm’s length principle (ALP) in the domestic or international transaction in question.
- On receipt of the statement from transfer pricing officer, the AO (assessing officer) computes the total income of the assessee after taking into consideration the ALP so determined by the transfer pricing and prepares a draft order which is sent to the assessee.
- Now the assessee has to either obey or objection to the draft order within 30 days of having received the draft order of the assessing officer.
- Following the receipt of the reply(acceptance or rejection) of the assessee, the AO passes a final order within 30 days.
- Subsequently, appeals against the AO order can be made in the appellate forums beginning with the hierarchy of Commissioner of Income Tax (Appeals) [CIT(A)], then Income Tax Appellate Tribunal (ITAT), ultimately High Court and Supreme Court, the guardian.
Dispute Resolution Panel
During earlier times, if the assessee wanted to object the assessment order, he had the only one option to approach the Commissioner of Income Tax Appeal.
After the establishment of Dispute Resolution Panel (DRP), the assessee has an additional option to approach DRP against the Draft Order issued. Finance Act introduced DRP mechanism, in 2009, as an alternative option to first appellate authority (Commissioner of Income-tax (Appeals) [CIT(A)]).
The purpose of introduction of mechanism was speedy disposal of pending disputes and to promote the growth of foreign investment. It has collegium consisting of three Commissioners of Income-tax constituted by the CBDT for meeting the purpose.
After receiving the objections from assessee, the DRP conducts hearings and passes a direction to the AO within nine months who, in turn, pass the final order within one month as per the directions of the DRP.
If an assessee is not satisfied or contented with the order of DRP, he can then appeal to the appellate authorities like the income tax appellate tribunal -ITAT, High Court and Supreme Court.
Case analysis on
Bharti Airtel Limited vs. ACIT (ITAT Delhi)
ISSUE: Whether a transaction about corporate guarantee which does not result in any profits, incomes, losses of the enterprise can come under the ambit of an ‘international transaction’ u/s 92B(1) and is subject to transfer pricing?
Bharati airtel issued a corporate guarantee to Deutsche Bank in place of its associated enterprise (AE), Bharti Airtel (Lanka). The guarantee was for repayment of the working capital facility. The assessee claimed that since it didn’t bear any cost on the issuance of such guarantee, and such guarantee was given as a part of the shareholder activity. Therefore, no transfer pricing adjustment can be made.
The TPO gave the view that as the enterprise had benefited, the ALP has to be calculated with the help of CUP method at a commission income of 2.68% plus a markup of 200 bp. The DRP upheld this by relying heavily on the retrospective amendment to s. 92B which specifically included guarantees in the definition of “international transaction.” Assessee appealed to the Tribunal which HELD:
(i) An assessee company extends assistance to the AE, which does not cost anything to the parent company. Also, particularly for which the company would not have been able to realize money by giving it to some other entity during the regular business, such assistance does not lead to any fluctuation of its profits, income, losses. Therefore, it is not covered by the definition of international transaction u/s 92B (1).
VODAFONE CASE (INDIA) (Call options case)
The case revolved around the sale of the call centre business of Vodafone, to Hutchison. Whereas, the tax agencies demanded capital gain tax for the said transaction.
In this transfer pricing case, Vodafone contended in the Bombay High Court that the Income Tax Department had no jurisdiction because the said transaction was not an international transaction and thus, did not attract any tax.
JUDGEMENT: The High Court gave judgment in favour of Vodafone company. The court reversed the decision of the tax tribunal that the recasting of the framework agreement between the taxpayer and Indian business partners was to be treated as a transfer of call options by the assessee to its Parent entity or unit merely because the latter was a confirming party.
Vodafone India Services (P) Ltd. v Union of India (issues of shares case)
The facts of Case – Vodafone India issued equity share to Vodafone Holding (Outside India) at a premium, and the same is mentioned in 3CEB in tax audit report.
JUDGEMENT: The Bombay High Court gave judgement in favor of Vodafone in accord with the petitioner’s submissions and held that issue of shares to holding company is a capital receipt and does not come under the ambit of the word ‘income’ under the act.
Maruti Suzuki Ltd v Commissioner of Income Tax [2016]
HELD: Delhi High Court stated that AMP expenses incurred cannot be framed and categorized as an international transaction under the Indian transfer pricing rules and regulations, unless the revenue can establish that the AMP spend was dictated by the foreign associated enterprise, for and on its behalf. The High Court rejected the submission of the revenue department that the mere fact of incurring AMP expenses should be considered as an inference of the existence of an international transaction.
First Blue Home Finance Ltd. v. ACIT
HELD: If an international transaction of capital nature doesn’t lead to the generation of any income itself, but the resultant transaction has an impact on the income of the taxpayer. And, if is not at arm’s length, it would invoke the provisions of chapter X and will have to satisfy the provisions of Chapter X of the Income Tax Act. If provisions are not satisfied, it will attract penalty concerning transfer pricing.
ESSAR GROUP CASE (INDIA – 2014)
ISSUE: Whether the transfer pricing provisions apply to the issue of shares.
HELD: The court held that the provisions do not apply to the issuance of shares. Vodafone case relied heavily for judgment.
Shell case (Royal Dutch Shell Group) (INDIA)
CONTENTION OF SHELL COMPANY: Equity infusion by a foreign parent company into an Indian subsidiary or enterprise cannot be taxed under the head of ” income ”.
Shell India also objected that the transfer pricing decision of tax authorities had its basis on an incorrect interpretation of the tax rules and regulations and was bad in law because the international transaction was a capital receipt on which income tax cannot be implicated.
JUDGEMENT: The Bombay High Court decided in favor of Shell India. It supplemented the principle that no income tax liability can be put on a foreign parent company’s funding of a local subsidiary through the issue of shares.
The honourable court set aside the transfer pricing adjustment of ₹17,920 crore.
The High Court rulings of VODAFONE and SHELL rest the tax controversy around capital infusion by foreign parents into their Indian enterprises.
TRANSFER PRICING DISPUTES IN OTHER COUNTRIES
All cases of foreign courts give us a glimpse of how law concerning a legal topic is applied whether strictly or liberally. These judgments have persuasive values for Indian courts. The example of a few landmark cases are given below:
AMAZON CASE (USA) (Transferring of intangibles and other issues)
FACTS
Amazon US transferred the following intangible assets: software and other technology needed to operate Amazon’s European websites, marketing intangibles, such as trademarks, trade names, and domain names and customer lists and other information concerning the Amazon’s European customers.
The Luxembourg subsidiary or enterprise made buy-in payments to Amazon of millions over seven years in exchange for the use of the intangibles. The subsidiary was also told to make annual cost-sharing payments for compensating Amazon. The amount was utilized for ongoing intangible developmental costs.
To determine the buy-in amount, Amazon preferred the comparable uncontrolled transaction (CUT) method for valuing each group separately.
The IRS contended that the buy-in payment was not arm’s length. Tax agency applied a DCF methodology to the expected cash flows from the European business to arrive at its valuation.
JUDGEMENT
Amazon.com Inc won a US Tax Court case, fending off IRS transfer pricing adjustments relating to a cost-sharing agreement (CSA) buy-in payment. The transfer pricing adjustments would have substantially increased the amazon’s taxable income by more than a billion in 2005 and 2006.
Following the similar ratio dictated in the case of Veritas Software Corp. v. Commissioner, 133 T.C. 297.
Taking the Side of Amazon, the Tax Court rejected the IRS’s recalculation, terming it as arbitrary, and unreasonable. The court said that the CUT method, used by Amazon, was the best method to calculate the CSA buy-in payment.
EATON CORPORATION & SUBSIDIARIES V. COMMISSIONER, (T.C.) (2017)
HELD
US tax court held that IRS, revenue department abused its discretion in cancelling two unilateral Advanced Pricing Agreements (APAs) between Eaton Us subsidiaries and foreign subsidiaries. APAs were related to intangible assets etc.
The court was of the view that APA revocation or cancellation must be rare. It must be the last step taken. APA is a nonadversarial method against the traditional one. It aims at reaching peaceful consensus regarding the proposed set of transactions. It gives time to the parties to meticulously set the terms and conditions in abidance of law. Only 11 APA has been revoked from 1995 till 2015.
The importance of APA must be realized in solving complex pricing transfers. APA must be encouraged as an alternative to solve possible transfer pricing disputes. IRS must not abuse its discretion. Also, Court held that APA cannot be reviewed by Law of Contract principles.
CHEVRON CASE (AUSTRALIA TAKING A STRICTER VIEW REGARDING INTER COMPANY LOANS)
A credit facility, established in 2003, Chevron’s unit in Australia paid an interest of 9 % to another subsidiary that put to use the group’s investment grade credit rating to take a loan in the US at 1.2%. This led to hefty profits for the subsidiary of A$1.1bn between 2004 to 2008, which were not taxed in both the countries (Australia or the US).
The Australian Tax Office argued that the terms and conditions of this loan allowed Chevron to claim excessive interest deductions which led to a reduction in its tax bill in Australia.
JUDGEMENT: Chevron lost the landmark case, and Federal Court ruled in favour of the Australian Taxation Offices. The tax agency had claimed that the US energy group owed A$340m ($256m) in tax, penalties, and interest, as a result of an inter-company loan to finance a massive gas project off the coast of Western Australia.
The Chevron litigation amplifies an intensifying crackdown on corporate tax avoidance.
CHANGES BROUGHT TO ENSURE REDUCTION IN NUMBER OF TRANSFER PRICING DISPUTES
India has introduced new rules that aim to provide certainty to multinationals further and reducing transfer pricing litigation.
(CBDT) Central Board of Direct Taxes revamped the rules called the safe harbour rules, introduced in 2013, under which income tax authorities do not put up a question mark on the pricing of dealing between international multinational parent companies and a related party such as their subsidiaries.
Tax experts say changes are in line with the Multilateral Convention of Base Erosion and Profit Shifting (BEPS). India has taken up the principles for acceptability of management fee from BEPS Action 10, and even though India has not yet adopted the BEPS Action 10 report about low value added service charges, it has partly aligned itself to the report tabled by the Organisation for Economic Cooperation and Development.
ADVANTAGES OF THE SAID RULES
- To reduce transfer pricing disputes
- To provide certainty to taxpayers,
- Safe harbour margins with industry standards and
- To enlarge the scope of safe harbour transactions
ADVANCED PRICING AGREEMENT (SECTION 92CC)
APA programs are structured so that the taxpayers can willingly pre determine the possible TP disputes in an honorable and stable manner, as an optional means to the traditional assessment process preferred by tax authorities.
An APA supplements the taxpayers with greater confidence concerning their TP methods. The basic foundation laid down for APA is to support ethical resolution of transfer pricing issues before positions become well-established. APAs can be one-sided, two-sided, or bilateral.
As long as the taxpayer does not breach the terms and the conditions laid down in the APA, the concerned tax authorities do not scrutinize the enclosed transactions of the said agreement.
ADVANTAGES OF APA IN THE PRESENT SCENARIO
It is a profitable thing to acquire an APA. APAs provide better assurance on the transfer pricing method. As an effect, they provide some relaxation from the possibility of risk and APA assists the financial reporting of possible tax liabilities.
APAs also considerably lessen the incidences of double taxation and costs associated with audit defence and TP documentation preparation.
PENALTIES
The provisions related to the transfer pricing matters in the Income-tax Act, 1961 are mentioned hereunder :
The penalty for failure in keeping and maintaining the required information and document in respect of the ” international transaction”.
271AA: If any person does not keep and maintain any such concerned information and document as required by section 92D(Sub-section 1 or sub-section 2), he is liable to pay the penalty.
The Assessing Officer or the Appeals Commissioner may order the person who entered into the international transactions, to pay a sum equal to the 2% of the value of each such transaction.
The penalty for failure to furnish information or document under subsection 3 of section 92D.
271G: If a person who has taken part in an international transaction and fails to provide any such information or document concerning the said transaction, as required by sub-section (3) of section 92D, he has to pay a hefty penalty.
The Officer or the Appeals Commissioner may direct that such person shall pay a sum equal to 2 % of the value of the international transaction for each such failure of producing the document.
The penalty for not furnishing a report under section 92E :
271BA: If any person fails to present a report from a chartered accountant as mentioned in section 92E, the Assessing Officer may order that such person shall pay a sum of one lakh rupees.
Tax authorities can levy stringent penalties in India and taxpayer can avoid them by proper planning and also avoid greater tax risk.
CONCLUSION
Countries are signing agreements to come up with more uniform standards of transfer pricing. Transfer pricing is a way of avoiding tax which is practiced by most of the big companies. Transfer pricing needs more stringent rules and even stricter authorities to keep a check o companies inflating the bills and getting out of the clutches of the legal system.
[1] https://indiankanoon.org/doc/131072984/ (Last visited:30th August, 2017)
[2] https://stats.oecd.org/glossary/detail.asp?ID=7245 (Last Visited : 30th August, 2017)
