This article has been written by David Varghese Thomas, from Government Law College, Thiruvananthapuram.
Guest: Ashutosh Mohan Rastogi is the Co-founder of Amicus Advocates & Solicitors, a full-service Law firm, he heads the tax practice. The Firm is nine years old and is recognized as a Transfer Pricing and Tax leader by the Legal 500 multiple times. Mr. Ashutosh has got prior Big 4 experience before having started his firm in Amicus. He is an Economics graduate with a law degree and his masters from New York University.
Host:- Abhyuday Agarwal is the Co-founder and COO of LawSikho, iPleaders and Superlawyer.net. He has graduated from West Bengal National University of Juridical Sciences in the year 2011 and currently heads the content team and liaise with subject matter experts, look into online delivery of Lawsikho’s courses and relationships with technology vendors and university or industry collaborators. He also helps the companies and organizations to manage legal learning needs for their internal teams.
Can you give an Introduction about the firm and the practice?
Our firm was set up in the year 2011. At that time, it was a transfer pricing booking firm. I’ve had previous experience with the Big 4 in Transfer Pricing. 2011 is when I thought it was time to venture out as a practitioner in Tax and Transfer Pricing. We have provided Transfer Pricing advice ranging from policy setting to documentation and litigation right up to the apex court level to our clients. In the past year, we have won many awards and accolades for Transfer Pricing. We have been ranked consistently by Legal 500 as the Asia Pacific leading tax firm from 2014 to 2020. I have argued many matters at the Tax Tribunal and High Court. We have not lost a single case so far. Amicus is a law firm that is highly focused on learning and knowledge sharing.
- Transfer Price: price at which different divisions of a multidivisional organization transact with each other
- Transfer Pricing: pricing of inter-divisional transactions, particularly cross-border transactions
- Arm’s length price: price at which independent enterprises enter into a comparable transaction(s)
- Transfer Pricing Planning -Extane Concept: setting the price in advance of the transaction or before closing the books
- Transfer Pricing Compliance- Filing/Maintaining Forms or Documents on due dates usually after the transaction occurs.
Why do we have the transfer pricing regulations? What is the economic in context to the transfer pricing discipline as a whole?
Transfer Pricing has a direct nexus with the ability of multinational companies to shift profits across the globe. How and why that happens is because a global company has units or subsidiaries set up in different countries, and each of these other countries has different tax rates. Different Tax rates create the opportunity for Tax arbitrage. What that means is that a multinational company can move profits from a high tax jurisdiction to low tax jurisdiction.
Only by manipulating the product’s price, it may sell from a high tax jurisdiction to tax jurisdiction. It may merely inflate the price when it is purchasing from a low tax jurisdiction. This will shift a higher amount of profit in the low tax jurisdiction. And in that manner, it will be able to keep more profits in the low tax jurisdiction and lower profits in the high tax jurisdiction.
Now, from a country tax based perspective. No company would want to lose its share of profit just because a multinational company can fix price on its own, to check that Countries have introduced Transfer pricing regulations. The whole purpose of transfer pricing regulations is to set in place a mechanism whereby they will test the price of the latent party transaction. For that testing, they have prescribed various transfer pricing methods. They have specified various compliances, documentation. It is all backed with penalties. A company must comply with the transfer pricing regulations to ensure that it reports a fair share of profit in every country where there are transfer pricing regulations. So a multinational company through profit shifting seeks to minimize its Global tax cost. In contrast, transfer pricing regulations endeavour to prevent mispricing by companies and thereby protect the tax base.
Now, looking at the transfer pricing adjustment trend in India.
From the financial year 2001 onwards, the transfer pricing adjustment graph has been rising. You will see that in India in the year 2012, the transfer pricing adjustment had peaked to 11 billion dollars, now that is huge, and after that, it started declining. So you might just be wanting to know what happened in India that we had such colossal transfer pricing adjustments that India was known as a country with the most challenging tax administration to deal with. There was a word coined called Tax terrorism. That word especially gained currency when this huge adjustment was happening.
Why India faced such a significant adjustment?
A lot of reasons were inbuilt in the Indian transfer pricing regulations in that time we had a minimal way of determining the Arm’s length price when we use arithmetic means as a statistical measure. Tax authorities had a target driven mindset. They often followed the previous year’s approach. In India, the only use of single-year data was allowed during transfer pricing audits. The Tax department had a very harsh stance towards certain key sectors, such as the Information technology sector, where the department insisted that they must have 27 to 30 percent of operating profit margins and had a special comparable set to support that. Then they had a specific stance towards marketing intangibles, management services, guarantee fee. So the country saw a significant adjustment on these grounds. One crucial factor responsible for colossal transfer pricing addition earlier and which has now remedy is the reference criterion of the tax department for referring cases for transfer pricing scrutiny. More first, we had a monetary threshold. If the international transaction value is more than Rs 50 million, then you just refer the case to the transfer pricing officer for details. Later on, this value was revised to rupees 150 million, but even that did not help. Cases kept piling at before the transfer pricing officer and finally with the change of guard at the central level when the BJP had formed its government for the first time, in its tenure at that time they changed the reference criterion and instead of having a monetary threshold they converted it into an audit arrest based referral criterion wherein they would look at various factors. for example, if you are trading or transaction with a tax haven only then your case would be picked up for scrutiny. If suddenly, you start making significant clauses and had profits in the prior years, your case would be picked up for scrutiny.
It was a matter of concern for the government that the country witnessed a huge transfer pricing addition. It had become a matter of India’s reputation in the international arena and certainly not suitable for investment by multinational companies in India. To address this, some changes were introduced in the Transfer-pricing regulations.
The manner in which you determined the Arm’s-length price that was changed. Instead of arithmetic mean as a measure for determining arm’s length price, the regulation switched to use of the range concept. So we started using the 35th percentile top 65th percentile. Instead of using single year data for determining the arms-length price, the regulations now permitted the use of multiple years data. Further to nip the tax disputes in the bud, the government also introduced safe harbor rules and also the advanced pricing arrangement mechanism. Safe harbor and advanced pricing arrangement mechanisms are pre-emptive transfer pricing mechanisms whereby you can ensure that you will not have a formal dispute with the government because, in both these scenarios, you are seeking certainty in your transfer prices.
Role of OECD
OECD stands for Organization for Economic Cooperation and Development is an international organization whose mission is to promote policies to improve economic and social well-being. It comprises of 36 Member Countries as on date.
OECD has been actively helping shape the tax systems of the 21st century and it keeps promulgating useful guidance on tax and economics from time to time. Some of its recent guidance has been in the context of financial transactions, treaty shopping, and, very importantly, guidance on how the tax treaties need to be modified or approach in the COVID scenario.
OECD has been publishing its transfer pricing guidelines, which have been a reference point for transfer pricing lawmakers, practitioners, multinational companies worldwide. The first guidance was published in 1995 and since then, there have been updates on the transfer pricing guidance. In 2017, it came up with the latest version of the OECD guidelines, which is available now.
India is not a member of OECD but has been an observer since 1997. It does actively comment and partake in the discussion, but the OECD transfer pricing guidelines do not bound India since India is not a member. Therefore, you can not put forth OECD guidelines in the court of law and say that this is the law applied. Whereas in some of the OECD member countries, you can cite the OECD transfer guidelines if you want to make a particular point. OECD guidelines are essential in the Indian context because wherever the Indian transfer pricing regulations fall short on guidance, practitioners take guidance from OECD. Time and again, the courts have held that if Indian Transfer pricing regulations are silent on a particular issue, them OECD guidelines can be referred for assistance. In that sense, OECD guidance on transfer pricing remains very relevant in India as a gap filler.
Indian transfer pricing regulations
Introduced in 2001, to prevent India’s profit shifting and are applicable to cross-border transactions between related parties. In some cases, they are also applicable to domestically. The Indian transfer pricing regulations require taxpayers to set inter-company prices in line with arm’s length principle. The taxpayer must maintain adequate documentation to prove the arm’s length nature of inter-company transactions. The documentation should explain how you are conducting your business, the role and responsibility of your associated enterprise, and your application of transfer pricing method and the final determination of the arm’s length price. Non-compliance with the regulation or the law on the transfer pricing documentation can invite stringent penalties under law. Overseas jurisdictions also require compliance with arm’s length principle under their respective transfer pricing regulations. You need to keep in mind that when you plan your transfer price, you may set your price high, but you have to keep in mind that you should not put it so high that you have an issue in the overseas country.
Charging provision of Indian Transfer Pricing Regulations is given in section 92 of the Income Tax Act. As per section 92, ‘Any Income arising from an international transaction shall be computed having regard to the arm’s length price’. The two components of transfer pricing regulations are Income and International Transaction. An International Transaction is a transaction between two Associate Enterprises, of which at least one Associate Enterprise is a Non-Resident. Section 92(a)(2) talks about the 13 conditions that must be satisfied for two entities to be considered associates. In all of these 13 conditions, the commonality is that one associated enterprise has control over the other associated enterprise, or the same individual or entity controls both of them. It is that control element that makes possible the fixing of price or the shifting of profits if one entity has more than 26% voting power in the other company. For transfer pricing regulations, they are considered associates.
Domestic transfer pricing
Transfer pricing is applicable in a limited manner in the domestic context, the genesis of which was a Supreme Court decision in the case of GlaxoSmithKline wherein the court mentioned while considering section 40A(2) of the Income Tax Act that for International transactions we have a mechanism to determine transfer price. Still, we don’t have any such tool in case of a domestic latent party transaction. The court made an obiter reference while pronouncing the ruling that it would be useful if we also had such a mechanism.
After the Supreme Court ruling in finance bill 2012, transfer pricing regulations were also extended to certain domestic transactions technically referred to as the specified domestic transactions. When the domestic transfer pricing regulations were introduced in 2012 for the first time, their scope was vast. So not only were transactions covered between a tax holiday unit and a non-tax holiday unit, but transactions even between two tax-paying units were covered.
One might wonder, what is the point of bringing a domestic transaction within the transfer pricing net when both entities are in India? Both are profitable and are paying taxes in India. Even if both entities are related and I am not complying with the arm’s length price but with any other prices, whether I have a high profit or low profit in one of the taxpaying entities or the other, how does it matter? Since if I don’t pay tax in one or if I Pay low tax in one, I end up paying high tax in the other entity. Because it will be a zero-sum game when both entities are considered together, precisely, for this reason; eventually, the government in 2017 omitted those transactions which were not causing any tax arbitrariness. So section 40A(2)(b) of the income tax act was taken out of the transfer pricing net in the year 2017. Before that, Eventually, in 2015, they had increased the threshold for application of domestic transfer pricing from Rs 5 crore to Rs 50 crore. Domestic transfer pricing is applied only when a tax holiday unit is transacting with a non-tax holiday unit.
Arm’s length range and multiple year data
Previously, when we had the arithmetic mean even though you would have a comparable set. Your transfer price would be at a similar price. Still, the way the law was working was that it was too harsh and you would not want within the permissible range.
Let’s say you have five comparables and the pricing for the five comparables is plotted in the form of a graph. So your transfer price, which is the price at which you are transacting, is two, and when you take the arithmetic mean of all the different comparable values that come out to be three. The law as it was designed earlier was that your pricing would be considered to be at arm’s length if you would fall within the plus-minus five percent band around the arithmetic mean so in this scenario the arithmetic mean which comes out to be three it allows for a band of 2.85 to 3.15.
In 2014 the law was amended and we accepted the range concept but only partially. OECD says that a full range has to be applied (the range from the lowest figure in the comparable set to the highest figure). There can be other variants internationally; for example, the US only accepts the interquartile range as the arms-length range. In India, the field is from 35th percentile to 65th percentile, narrower than the Internationally accepted standard of the interquartile range. To apply the range concept, the number of similar entries should be at least 6.
Now the law permits taxpayers in India to use multiple layered data and what that means is once you have arrived on your comparable points. A to H in this example, you can compute the companies’ profit margins and you can take profit margins for over three years. For the latest financial year, if data is available, it’s perfect, and then you can take the weighted average of the profit margins. The advantage of taking the weighted average against considering only single-year data is that it leads to moderation in the image given below. Some of the companies in the financial year 2018-19 are having a sudden spurt in their margins so if you see the company B does phenomenally well in 2018-19 as a 40 percent margin.
Similarly, there is company G also, which is doing well. These are a few companies with higher margins; they might not necessarily be having such high margins in the previous years. So if you would look at the mean margin for the financial year 2018-19, It is 25.42, which is significantly higher, but when you consider their profitability in 3 years, you will get a moderation, and the mean margin weighted average is 19.37. So it will give you a more realistic picture. Unfortunately, when you are taking a weighted average of the comparables’ margin when you are determining the profitability of the taxpayer, for the taxpayer, we are still taking the single-year data, so if I was testing the profitability for 2018-19. I would take the only financial year 2018-19 results and push against the weighted average or the comparables with the prior three years data.
Transfer pricing planning in COVID environment.
In the current times, profitability, turnover, everything has gone for a toss. Sales are not happening, cash flow is not coming in, there is a liquidity crunch, and indeed, it raises a challenge for tax professionals, cash flow managers.
The challenge right now is that the economic environment in which you had determined your transfer price has changed dramatically, so if you had set certain markups for your various entities, you would be able to meet those markups. For example, let’s say you set up a back-office operation in India, and two years back, you set up a policy that will indemnify the manufacturer, the cost plus 10%. Suddenly, you realize that you have set this markup, but there is not enough money coming as you don’t know what to do and my bench cost is increasing, and domestic sales are also declining. So, in this scenario, how do you cope with this? Tax professionals now need to relook their transfer pricing policies because the environment has undergone a complete change.
As the year 2020 ends and financial results for companies are out, we will see a remarkable dip in the companies’ profitability this year compared to the previous years. So any pricing that you may have said based on the last years’ financial results will not hold good any longer. You have to do an interim review of your financial transactions and revisit the transfer pricing for them. Even the Advanced Pricing Arrangement mechanism (agreement with the government to set a price for a definite period) has to be revisited. When the company agreed with the government, it will pay this much amount of tax, keeping this much of profit. That was based on an assumption of a particular economic environment. Right now, the economic environment has almost crashed, at least it seems like that until things revive. So in this environment, whether a multinational company would consider the APA as valid or binding, or does the APA become invalid because, in the APA, there is a critical assumption of similarity or the continuity of economic conditions.
Measures which the government could take up to address the transfer pricing dilemma
Revise the Safe Harbour Norms, which they have set up. Safe Harbour Thresholds, even as on date in the form they are, taxpayers are criticizing that the profit markups they have stipulated as Safe Harbours are very high. Indeed, in the COVID environment, these markups are way too high. The government has to relook at the advanced pricing development mechanisms with the taxpayers.
The review criteria also for the selection of transfer pricing cases have to be looked at closely. You cannot just pick up a case now because the company is in a loss because you would find that there are so many companies all around, which would be earning more profit or maybe making losses. Suppose your selection criteria are as simple as the fact that the company was making profits earlier, and now suddenly it has started making a loss. In that case, there has to be a transfer pricing manipulation. No, that is not true. Your review criteria have to be a little more refined. Even in the transfer pricing audits, the Indian government must adopt a more pragmatic approach and not be too target driven.
Amending the Transfer Pricing Regulations, if done on time, can provide relief. So if you broaden the range concept and adopt the interquartile range, that is much needed, and perhaps the government may also have to relook at the multiple year data norm. Interestingly multiple year data norms in a COVID environment can create a problem for multinational companies. Rather than being of help and the reason for that is 2020 will be the first year in which we might see a sudden fall in the companies’ profitability and in case we still use multiple year data. That may take into account the previous two years as well, which may not be so bad. That will dilute the comparables’ core performance in the year 2020, whereas when it comes to the taxpayer, you would be only considering data for 2020.
These are just some recommendations as to what the government can possibly do to decrease the transfer pricing problem.
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