The expression “transfer pricing” generally refers to prices of transaction between associated enterprises which may take place under conditions differing from those taking place between independent enterprises. It refers to the value attached to transfers of goods, Services and technology between related entities located at different territories. It also refers to the value attached to transfers between unrelated parties which are controlled by a common entity. Or in other words, Profits accruing to the parent company can be increased by setting high transfer prices to siphon profits from subsidiaries domiciled in high tax countries and low transfer prices to move profits to subsidiaries located in low tax jurisdiction.
To restrict these kinds of the activities, finance Act, 1994 has introduced section 92A to 92F under the Income Tax Act, 1994 which is also known as “transfer pricing”. A separate code on transfer pricing under Sections 92 to 92F of the Indian Income Tax Act, 1961 (the Act) covers intra-group cross-border transactions which is applicable from 1 April 2001 and specified domestic transactions which is applicable from 1 April 2012. Since the introduction of the code, Transfer pricing has become the most important international tax issue affecting multinational enterprises operating in India. The regulations are broadly based on the Organisation for Economic Co-operation and Development (OECD) Guidelines and describe the various transfer pricing methods, Impose extensive annual transfer pricing documentation requirements and contain harsh penal provisions for noncompliance.
The Indian Transfer Pricing Code prescribes that income arising from international transactions or specified domestic transactions between associated enterprises should be computed having regard to the arm’s-length price. It has been clarified that any allowance for an expenditure or interest or allocation of any cost or expense arising from an international transaction or specified domestic transaction also shall be determined having regard to the arm’s-length price. The Act defines the terms ‘international transactions’, ‘specified domestic transactions’, ‘associated enterprises’ and ‘arm’s-length price’.
Domestic Transactions
Until financial year (FY) 2011-12, transfer pricing regulations were not applicable to domestic transactions. However, the Finance Act 2012 has extended the application of transfer pricing regulations to ‘specified domestic transactions’, being the following transactions with certain related domestic parties.
If the aggregate value of such transactions exceeds INR 20 crore:
Definition of Associated enterprises
The relationship of associated enterprises (AEs) is defined by Section 92A of the Act to cover direct/ indirect participation in the management, Control or capital of an enterprise by another enterprise. It also covers situations in which the same person (directly or indirectly) participates in the management, Control or capital of both the enterprises.
For the purposes of the above definition, Certain specific parameters have been laid down based on which two enterprises would be deemed as AEs. These parameters include :
Furthermore, in certain cases, a transaction between an enterprise and a third party may be deemed to be a transaction between AEs if there exists a prior agreement in relation to such transaction between the third party and an AE or if the terms of such transaction are determined in substance between the third party and an AE. Accordingly, This rule aims to counter any move by taxpayers to avoid the transfer pricing regulations by interposing third parties between group entities.
The arm’s-length principle and pricing methodologies
The term ‘arm’s-length price’ is defined by Section 92F of the Act to mean a price that is applied or is proposed to be applied to transactions between persons other than AEs in uncontrolled conditions. The following methods have been prescribed by Section 92C of the Act for the determination of the arm’s-length price:
In this regard, The Central Board of Direct Taxes has notified that the ‘other method’ for determination of the arm’s-length price in relation to an international transaction shall be any method which takes into account the price which has been charged or paid, or would have been charged or paid, for the same or similar uncontrolled transaction, with or between non-associated enterprises, under similar circumstances, considering all the relevant facts. The ‘other method’ shall apply to FY 2011-12 and subsequent years. However, For domestic transaction there is no “other method“ has been prescribed by CBDT so far which has resulted in difficulty in determination of Arm Length Price in various cases.
No particular method has been accorded a greater or lesser priority. The most appropriate method for a particular transaction would need to be determined having regard to the nature of the transaction, Class of transaction or associated persons and functions performed by such persons as well as other relevant factors.
The regulations require a taxpayer to determine an arm’s-length price for international transactions or specified domestic transactions. It further provides that where more than one arm’s-length price is determined by applying the most appropriate transfer pricing method, the arithmetic mean (average) of such prices shall be the arm’s-length price of the international transaction or specified domestic transactions. Accordingly, the Indian regulations do not recognise the concept of arm’s-length range but requires the determination of a single arm’s-length price.
However, some flexibility has been extended to taxpayers by allowing a range benefit which may be extended upto maximum 5%. Accordingly, if the variation between the arm’s-length price and the price at which the transaction has actually been undertaken does not exceed the specified range of the latter, the price at which the transaction has actually been undertaken shall be deemed to be the arm’s-length price. Therefore, the benefit of the range would be available only if the arm’s-length price falls within the specified range of the transfer price. This, in turn, would have the effect of disallowing the benefit to a taxpayer where variation between the arm’s-length price and transfer price of the taxpayer exceeds the specified range, leading to a transfer pricing adjustment even though the transfer price is only marginally outside the range benefit. The transfer pricing provisions will not apply if the arm’s-length price would result in a downward revision in the income chargeable to tax in India.
Documentation requirements
Taxpayers are required to maintain, on an annual basis, a set of extensive information and documents relating to international transactions undertaken with AEs or specified domestic transactions. Rule 10D of the Income Tax Rules, 1962 prescribes detailed information and documentation that has to be maintained by the taxpayer. Such requirements can broadly be divided into two parts.
The first part of the rule lists mandatory documents/ information that a taxpayer must maintain likewise, the second part of the rule requires that adequate documentation be maintained that substantiates the information/ analysis/ studies documented under the first part of the rule. The second part also contains a recommended list of such supporting documents, including government publications, reports, studies, technical publications/ market research studies undertaken by reputable institutions, price publications, relevant agreements, contracts, and correspondence.
Taxpayers having aggregate international transactions below the prescribed threshold of INR 10 million and specified domestic transactions below the threshold of INR 50 million are relieved from maintaining the prescribed documentation. However, even in these cases, it is imperative that the documentation maintained should be adequate to substantiate the arm’s-length price of the international transactions or specified domestic transactions.
All prescribed documents and information have to be contemporaneously maintained (to the extent possible) and must be in place by the due date of the tax return filing. Companies to whom transfer pricing regulations are applicable are currently required to file their tax returns on or before 30 November following the close of the relevant tax year. The prescribed documents must be maintained for a period of nine years from the end of the relevant tax year, and must be updated annually on an ongoing basis.
The documentation requirements are also applicable to foreign companies deriving income liable to Indian withholding tax.
Accountant’s report
It is mandatory for all taxpayers, Without exception, To obtain an independent accountant’s report in respect of all international transactions between associated enterprises or specified domestic transactions. The report has to be furnished by the due date of the tax return filing (i.e. on or before 30 November). The form of the report has been prescribed. The report requires the accountant to give an opinion on the proper maintenance of prescribed documents and information by the taxpayer. Furthermore, the accountant is required to certify the correctness of an extensive list of prescribed particulars.
In this context, It is important to note that entities enjoying a tax holiday in India still need to comply with transfer pricing provisions and would need to demonstrate that their international transactions have been carried out at arm’s length. In addition, such entities would not be entitled to a tax holiday on any upward adjustment made to their transfer prices in the course of an audit.
Burden of proof
The burden of proving the arm’s-length nature of a transaction primarily lies with the taxpayer. If the tax authorities, During audit proceedings on the basis of material, information or documents in their possession, Are of the opinion that the arm’s-length price was not applied to the transaction or that the taxpayer did not maintain/ produce adequate and correct documents/ information/ data, the total taxable income of the taxpayer may be recomputed after a hearing opportunity is granted to the taxpayer.