In this article, Anirban Deep Ghosh who is currently pursuing M.A. IN BUSINESS LAWS, from NUJS, Kolkata, discusses TRANSFER PRICING IN INDIA.
Transfer pricing (TP) regulations have been at the forefront of corporate headlines over the last few years due to the increasing number of controversies resulting out of tax structuring by multinational companies (MNE). What makes the topic both contentious and interesting is that regulators view the various techniques applied to intercorporate transactions as purportedly planned with the intent of achieving benefits of comparable labor cost and tax advantage at the cost of a countries tax revenues.
An example of the problem
Suppose a UK resident company X purchases goods for 1,000 rupees and sells it to its associated Indian resident company Y for 2,000 rupees, who in turn sells in the market in India for Rs. 4,000. Had X sold it directly in India to an unrelated party, it would have made a profit of Rs. 3,000 on the transaction. However, by routing it through Y, it restricted it to 1,000 rupees, permitting Y to appropriate the remaining balance. The transaction between X and Y is intentionally arranged and not governed by market forces. Hence, the profit of 2,000 rupees is shifted to the country of Y instead of accruing in country X. The goods are transferred on a price (transfer price) which is arbitrary (Rs. 2,000) and not on the market price (Rs. 4,000). The UK tax authorities in particular may raise a question as to why X sold the goods to Y for lower profits 1. Sometimes, through books of accounts and records, these transactions are so manipulated that there is extra – earning of the parent company at the cost of some national treasuries. Transfer pricing has therefore become a global tax management technique. The organization structure taxes advantage of the business or part of it spread over different countries.
Off-course, there is two sides to an argument as taxpayers sometimes view this as a complicated process due to conflicting regulations across different countries that sometimes result in unreasonable demands by the regulators, that are hard to satisfy. While it is fair to say that no country should be deprived of its share of revenue, it is also important for companies to seek competitive advantage where the bottom line decides the fate of the business and its owners / investors.
In order to bring some balance to the expectations and best practices by various regulators, On June 27, 1995 the first draft of the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (“OECD Guidelines”) was published. These Guidelines originate from the OECD Report on Transfer Pricing and Multinational Enterprises that was first published in 1979. Since then, the OECD Guidelines have been evolving continuously and are updated to the current form2.
But what do these guidelines provide?
The OECD Guidelines provide guidance on the application of the “arm’s length principle” for the valuation, for tax purposes, of cross-border transactions between “associated enterprises”. In a global economy where MNEs play a significant role in the economy of various countries, governments need to ensure that the taxable profits of MNEs are not artificially shifted out of their jurisdiction. This is to ensure that the tax base reported by MNEs in their country reflects the economic activity undertaken therein. For taxpayers, it is important to limit the risks of economic double taxation that may result from a dispute between two countries on the determination of the arm’s-length price for their cross-border transactions with associated enterprises.
There are therefore two key objectives for Transfer Pricing regulation are:
- The transactional transfer and valuation is to be regulated that no country is deprived of its revenues to a reasonable extent
- The regulation has to allow flexibility enough to further the reasonable interest of the entire organization (MNE) of the parent subsidiary bodies in the aggregative sense.
The Indian Scenario
In India, TP Regulations were first introduced in 2001, as a measure against tax avoidance. The Indian TP Regulations are largely influenced by the said OECD TP Guidelines, but they are modified to specifically meet the needs of the Indian tax regime. Two basic principles applied are:
Allocation of reasonable profits
Similar to the OECD Guidelines and TP Regulations of several other countries, Indian TP Regulations prescribe methods to compute ‘Arm’s Length Price’ for an ‘International Transaction’ or a ‘Specified Domestic Transaction’ entered into by a taxpayer with its ‘Associated Enterprise’.
Section 92 of the Income tax Act, 1961 provides for the authority to an assessing officer to determine the profit which may be reasonably be deemed to have been derived from a transaction. This would be applicable where controlled Companies (associated enterprises) arrange the business between them is a way that either no profit is earned from such transaction or profit earned is lower than what would be expected in a transaction between uncontrolled Companies (un related entities).
In order to better understand the terms, the following definitions may be of use:
Arm’s Length Price (ALP)
ALP has been defined to be the price, which is applied or is proposed to be applied in a transaction between persons other than Associated Enterprises, in uncontrolled conditions.
Section 92A of the Income Tax Act, 1961 defines associated enterprise as, an enterprise which:
- Participates directly or indirectly, or through one or more intermediaries, in the management or control or capital of the other enterprise; or
- In respect of which one or more persons who participate, directly or indirectly, or through one or more intermediaries, in its management, control, or capital, are the same persons who participate, directly or indirectly, or through one or more intermediaries, in the management or control or capital of the other enterprise. 4
The Regulations further provide specific conditions and circumstances under which two entities are deemed to be Associated Enterprises.
Computation of ALP
The Indian TP Regulations require computation of ALP based on the prescribed TP methods. The Regulations have prescribed the following five methods for determination of ALP —
Price Based Methods
- Comparable Uncontrolled Price Method (CUP) :
- Compare the prices charged for property or services for controlled transactions vs. uncontrolled transactions.
- The basic tenet is to compare close similarity in products, property or services that are involved
- Timing of the transactions are relevant where prices of the product fluctuate regularly
- Cost Plus Method (CPM)
- CPM determines ALP by adding Gross Profit Margin (mark-up) earned in comparable transaction(s) / by comparable companies to the cost incurred by Tested Party under controlled transaction
- Resale Price Method (RPM)
- RPM computes purchase price paid to related party based on its resale price to unrelated party
- RPM is typically useful to determine ALP of purchases made by the distributor (trader) from related party 5
Profit Based Methods
- Profit Split Method (PSM):
- PSM determines arm’s length profit based on combined profits derived by related parties
- Transactional Net Margin Method (TNMM).
- TNMM tests the net margins of the tested party as oppose to gross margins in case of RPM or CPM 5
The TP Regulations also provide for use of any other method, which takes into consideration a price charged in a similar transaction between unrelated parties in uncontrolled circumstances.
In cases where there is more than one price determined using the most appropriate from the above methods, ALP shall be taken to be at arithmetic mean of such prices. Where the transfer price differs from ALP, no TP adjustment is made where the arithmetic mean falls within the tolerance range of transfer price. Currently, the tolerance range available for wholesale traders is 1%, while that for other taxpayers is 3% of the value of International Transaction/ Specified Domestic Transaction.
Use of Range Concept
The Central Board of Direct Taxes (CBDT), the regulatory body responsible for tax administration in India, has also notified the concept of ‘arm’s length range’ for computation of ALP for transactions after April 1, 2014. Under this concept, data points lying within the 35th and the 65th percentile of a data set constructed using comparable data would constitute the arm’s length range. Accordingly, transfer price falling within the arm’s length range would be considered to be at arm’s length.
A minimum of six comparable entities are required for application of the range concept. In cases where the number of comparables in a data set is less than six, the arithmetic mean would continue to be considered as the ALP. Where the arithmetic mean is considered as the ALP, the benefit of a tolerance range continues to be available. 4
Use of Multiple Year Data
Originally, the TP Regulations did not provide for using data of years other than the year in which transactions were undertaken (except in certain specific cases). The CBDT has amended the Rules and now permitted use of ‘multiple year data’ while performing a benchmarking analysis. If certain conditions are satisfied, the taxpayer shall be permitted to use comparable data of 2 years preceding the relevant fiscal year along with that of the relevant fiscal “current” year.
Prevention of tax Avoidance
Although Tax avoidance is not unlawful, tax evasion certainly is. Section 93 of the Income Tax Act provides for various methods to prevent avoidance of tax legally, which would otherwise be levible on an taxpayer. Some of the critical provisions are:
- Income in the hand of the non-resident if enjoyed by the resident on account of any transfer of assets, the income is deemed to have been earned by the resident
- Income originating due to transfer of asset to the non-resident, if results in the receipt of a capital sum by the resident, the income is deemed to be of the resident company itself.
Assuming that tax is levied on such deemed income in a year, the concern shall not be charged again on that income when it is subsequently realized. Section 93 shall not apply I the resident shows to the satisfaction of the assessing officer that:
- The avoidance of tax was not the purpose of the transaction
- The transfer was a bonafide commercial transaction
Taxpayers in India by law have an obligation to report compliance to the requirements under the act of entering into any international or specified domestic transaction. This is done by obtaining a certificate from an accountant that needs to be furnished before the due date of filing of income tax return.
The accountant is required to certify on two key points:
- The ALP computed by the tax payer is correct and in line with the regulations; and
- Appropriate documentation has been maintained by the tax payer, as per the regulatory requirements
This is reported along with specific details of the international / specified domestic transaction, how ALP has been determined, the value of the transaction etc. 4
Three tiered Documentation
Documentation is known to be one of the foremost requirements. The OECD has come up with a recommendation under Base Erosion and profit shifting (BEPS) action plan, which prescribes a three-tiered approach to maintenance of documentation. This requires the taxpayer to maintain:
- A master file
- A local file
- A country by country report
The union budget of India for 2016 provided for a similar convergence with the OECD recommendation, and it is therefore now a mandate for Companies in India to align their documentation in line with the OECD recommendations, as listed above.
- The master file is required to include global information about the multinational corporation group, including information on intangibles and financial activities, to be made available to the local regulations.
- The local file must contain all relevant information for material intercompany transactions of the group entity, in each separate Country
- Country-by-country report (CbCR) must contain details on income, earnings, taxes paid and measures of economic activities. 6
This is a game-changing move that increased the burden of compliance for MNEs, as they will now need to provide a lot more granular level information to the tax authorities, as compared to the past.
Penalties for Non-Compliance 7
The Income Tax Act, 1961 provides for various penalties under Alternate pricing scenarios.
Some of the critical provisions indicating Penalties are as follows, for the following violations
- Concealment of income or furnishing of inaccurate particulars of Income,
- Section 271(1)(c) provides for 100%-300% of tax sought to be evaded due to Transfer pricing adjustments
- Failure to maintain documentation prescribed under section 92D of the Act, report a transaction or maintaining / furnishing incorrect information
- Section 271AA provides for 2% penalty on the value of international transaction or specified domestic transaction
- Failure to furnish Accountant’s Report in Form 3CEB
- Section 271BA provides for Rs. 100,000 as penalty
- Failure to furnish Master file when called for by the Indian tax authorities
- Penalty of Rs. 500,000
- Providing inaccurate information in CbCR
- Penalty of Rs. 500,000
Transfer pricing disputes
While the initial years of transfer pricing regulations saw a slow rise of TP adjustments being proposed by the tax officers, soon the adjustment volumes increased considerably and reached an epic proportion of Rs. 70,000 crores by FY 2013. After a huge pushback from foreign investors, this number has come down but continues to generate a lot of heat for the taxpayers.
A recent study by Deloitte and TaxSutra for FY 14-15 3 reveal some interesting statistics around the trends of TP disputes:
- 50% of the cases selected for TP audit went through adjustments by tax officer
- 500+ court rulings with a distribution of:
- 4 by Supreme Court,
- 41 by High court,
- 486 by tribunals
- 45% of the cases relate to IT and ITES sector
- Delhi, Mumbai and Bangalore have the highest number of cases contributing to 69% of all cases in a year.
In this same report 3, it was further revealed that the most common causes of transfer pricing disputes were for the following:
- Selection of appropriate Comparables – 38%
- Computation of Profit Level indicator (PLI) – 13%
- Selection of the most appropriate method – 9%
- Intra group services and commercial expediency – 8%
Resolution by Government
In order to curb this problem, the Indian Government has responded with several measures in the recent years to address the increasing volume of TP litigation. Some of these measures so introduced are as follows 3:
- Issuance of internal guidance notes to Transfer Pricing Officers (TPOs) for consistent application of Tax Department’s views across India;
- Issuance of clarificatory circulars on critical TP matters;
- Introduction of safe-harbor guidelines;
- Introduction of range concept and allowing use of multiple years data;
- Dedicated DRP charge for commissioners;
- Introduction of APA (along with rollback provisions);
- Introduction of risk based approach for manual selection of TP cases instead of compulsory audit of cases selected based on criteria of threshold limit
Advanced Pricing Agreements (APAs)
Finance Act, 2012 introduced Advanced Pricing Agreement (APA) in India. The primary objective of APAs is to overcome the issues due to transfer pricing between related parties and bring tax certainty in international transactions. To avoid uncertainty, principle of arm’s-length price is used to decide what price should be charged by associated enterprises, that is, the price two unrelated parties / non-associated enterprises would charge under similar circumstances. Although there are various methods to determine ALP, yet, there is no scientific way to calculate an exact one, as explained in the earlier sections of this article. Further, the countries involved often take the benefit of a provision in the double taxation avoidance agreements called mutual agreement procedure (MAP). Competent authorities of India and the foreign Country would negotiate how much of total profit would be taxable in India and how much in the foreign country, to avoid double taxation.
However, as mutual agreement procedure (MAP) is a post-assessment process and may take considerable time, some countries have advance pricing agreement/arrangement scheme (APA scheme). Under this scheme, the two competent authorities from different countries will negotiate in advance to determine the ALP of the future international transaction. This helps in bringing tax certainty, reduce litigation expenses and avoid risk of double taxation.
APAs may be bilateral or unilateral. When the competent authorities of two countries negotiate in advance to determine the ALP of the future international transaction, it is called bilateral APA. However, if taxpayers intends to have tax certainty in just of the two countries, they would go for unilateral APA and it is generally done when there is no DTAA/DTAC between the two countries or that the taxpayer. 1
An APA can be executed for a maximum period of 5 consecutive years from the year in which such APA has been entered into. Recently, the APA rules were amended to provide for roll back of the APA to 4 years prior to the year in which the same was entered into. Therefore an APA can provide certainty to a taxpayer for up to 14 years (i.e., 4 years rollback + 5 years under APA + 5 years renewal) which takes the focus away from worries of aggressive taxation, to being able to think and concentrate on the business. This also enhances the overall environment of Foreign direct investments (FDI) favorably for India and avoids long audits and prohibitive litigation cost. However, taxpayers should evaluate their APA strategy in detail based on the nature of the international transaction, risk of TP adjustment, FAR analysis, corporate action plans, etc. Additionally, taxpayers should thoroughly understand the entire specified procedural requirements involved in the process as any lapse on their part may put the entire APA programme under jeopardy. 4
As at October 2016, more than 700 APA applications have been filed by taxpayers in India. Of this, 44 APAs were concluded since the beginning of April 2016 and taking the total concluded APAs to 108 since inception. 3
With the speed at which globalization is affecting the business world and the way countries are competing with one another for foreign direct investments, it may be safe to conclude that the world of transfer pricing is only going to get more interesting by the day. It is quite apparent that the view of the regulators are also evolving, as there is a clear demonstration of intent to simplify the processes. However, only time will tell if they are able to keep pace with the dynamic changes in the business models and structures being formed with the advent of technology, free market economy and aggressive investment vehicles coming into play.