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Background

  • Taking into account the increased participation of Multinational groups involved in economic activities in India, Transfer Pricing regulations were introduced in 2001 to ensure that fair and equitable proportion of profits and tax arising from cross border transactions between related entities are duly received in India. India today is experiencing an evolving transfer pricing regulation with issues relating to interpretation and effective implementation mechanism that have surfaced in the course of sustained transfer pricing audits. India now ranks among the top 50 countries that have enacted comprehensive Transfer Pricing regulations to protect the erosion of its tax base. Since its introduction in April 2001, the Indian transfer pricing regulations have come of age– both in terms of quality of audits as well as the revenue generated for the Indian Government. It is estimated1 that till date, the Directorate of Transfer Pricing has made adjustments of approximately INR 230 billion, which is a considerable achievement in a relatively small period of time – this being due to the focused efforts of the Indian Revenue Authorities on transfer pricing matters.
  • The Indian transfer pricing regulations are broadly based on the Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations.
  • Issued by Organization for Economic Co – Operation and Development (OECD Guidelines), albeit with some differences. The regulations prescribe detailed mandatory documentation requirements along with disclosure of international transactions and impose steep penalties for non – compliance.

Scope and Applicability

  • Section 92 of the Act provides that the price of any transaction between “associated enterprises”, either or both of whom are non resident for Indian income tax purposes, shall be computed having regard to the arm’s length price.
  • Two enterprises are considered to be “associated” if there is direct/indirect participation in the management or control or capital of an enterprise by another enterprise or by same persons in both the enterprises. Further, the Transfer Pricing regulations prescribe certain other conditions that could trigger an “associated enterprise” relationship. Significant conditions among these include:
    – Direct/indirect shareholding giving rise to 26 percent or more of voting power
    – Substantial purchase of raw materials/sale of manufactured goods by an enterprise from/to the other enterprise at prices and conditions influenced by latter
    – Authority to appoint more than 50 percent of the board of directors or one or more of the executive directors
    – Dependency in relation to intellectual property rights (know – how, patents, trademarks, copyrights, trademarks, licenses, franchises etc) owned by either party; and
    – Dependency relating to borrowings i.e. advancing of loans amounting to not less than 51 percent of total assets or provision of guarantee amounting to not less than 10 percent of the total borrowings.

Determination of arm’s length price
The Indian transfer pricing regulations require the arm’s length price in relation to an international transaction to be determined any one of the following methods, being the most appropriate method.
• Comparable uncontrolled price (CUP) method
• Resale price method (RPM)
• Cost plus method (CPLM)
• Profit split method (PSM)
• Transactional Net Margin Method (TNMM)

The regulations also permit the CBDT to prescribe any other method – however, no other method has been prescribed to date. Further, there is no hierarchy of methods prescribed.

The most appropriate method shall be the method which is best suited to the facts and circumstances of each particular
international transaction, and which provides the most reliable measure of an arm’s length price in relation to an international transaction. In a case where more than one price is determined by the most appropriate method, the arm’s length price shall be taken to be the arithmetical mean of such prices. Further the Transfer Pricing regulations also incorporate the option of a 5 percent variation in the arithmetic mean, in determining the arm’s length price. However, the recent amendment now restricts the adjustment only to those cases which fall within the +/- 5% variance range. Those cases falling outside the range shall no longer be eligible for the benefit as the option clause has now been omitted.

Compliance Requirements
The Transfer Pricing regulations have prescribed an illustrative list of information and supporting documents required to maintain by taxpayers entering into an international transaction. Currently, the mandatory documentation requirements are applicable only in cases where the aggregate value of the international transactions entered into by the taxpayer as recorded in the books of account exceed INR 10 million.
The information and documents specified, should, as far as possible, be contemporaneous and should exist latest by the specified date and should be maintained for a period of nine years from the end of the relevant financial year. The prescribed documentation include details of ownership structure, description of functions performed, risks undertaken and assets used by respective parties, discussion on the selection of most appropriate method and economic analysis resulting into determination of arm’s length price, etc.

In addition to maintaining the prescribed documentation, taxpayers are also required to obtain a certificate / report (detailing the particulars of international transactions) from an accountant and file the same with the Revenue Authorities on or before the specified date (currently the due date of filing the corporate tax return) in the prescribed from and manner.
The Act has prescribed penal provisions for default in compliance with the aforesaid transfer pricing regulations, which are summarized below.

Nature of Default Penalty prescribed
Failure to maintain prescribed
information/ documents
2 percent of value of international
transaction
Failure to furnish information/
documents during audit
2 percent of value of international
transaction
Adjustment to taxpayer’s income 100 percent to 300 percent of tax on
adjustment amount
Failure to furnish accountant’s report INR 100,000

Transfer Pricing Audits
Transfer pricing matters are dealt with by specialized Transfer Pricing Officers duly guided by Directors of International Taxation, being part of the Indian tax administration. In accordance with the internal administrative guidelines issued to the Revenue Authorities, all taxpayers reporting international transactions with associated enterprises exceeding INR 150 million are subject to a mandatory transfer pricing audit. In the course of a Transfer Pricing audit, in case any adjustments are made by the Revenue authorities to the taxable income reported, taxpayers cannot avail of any tax exemption to which they may be otherwise entitled to. Further, the penalties as stated above may also be levied.

RECENT DEVELOPMENTS
Safe Harbor Rules
The CBDT has been empowered to introduce Safe Harbor provisions aimed at minimizing disputes relating to transfer pricing matters. ‘Safe Harbor’ has been defined to mean ‘circumstances’ in which the Revenue authorities shall accept the transfer prices declared by the taxpayers – i.e. such taxpayers would not be subject to transfer pricing scrutiny. The primary objective seems to be reduction of judgmental errors in determination of transfer price
relating to international transactions. Safe harbor provisions are expected to offer three main benefits to taxpayers and tax administrators: i) compliance relief ii) administrative simplicity and iii) certainty.
Detailed rules to operationalize the safe harbor provisions are awaited and with the establishment of Committee constituted by CBDT, it is anticipated that the same shall be introduced soon.
Advance Pricing Agreements
Currently, the Indian transfer pricing provisions do not provide any facility for Advance Pricing Agreements (APAs), however this is proposed to be introduced in the DTC. An APA is a mechanism whereby a taxpayer enters into an agreement with the Revenue authorities on its transfer prices. If the taxpayer meets the criteria agreed in the APA, the taxpayer will not be subject to a transfer pricing adjustment and such an arrangement would remain valid for a period of five years. This would help in minimizing risk of a
transfer pricing adjustment; providing certainty through a negotiation process and avoiding tax risk by preventing double taxation.

Mutual Agreement Procedure
The taxpayers can choose Mutual Agreement Procedure (MAP) to resolve bilateral transfer pricing issues with certain foreign jurisdictions depending on the provisions in the relevant DTAAs.
The Revenue Authorities have issued notifications whereby subject to the satisfaction of certain conditions and depending on the relevant foreign jurisdiction, the taxpayers choosing the MAP process may not need to pay the tax demand until the closure of the MAP proceedings.
Judicial Guidance
Since the introduction of Transfer Pricing regulations in India, litigation on Transfer Pricing matters has consistently been on the increase. Five rounds of transfer pricing audits have been completed. Each year has seen a steep increase in the quantum of adjustments with the latest assessment year (AY 2006-07) resulting in an estimated INR100 billion adjustment for about estimated 800 cases(The Economic Times in an article “800 Cos. slapped with Rs. 10k cr. Transfer pricing demand” dated 11th December 2009.).
The numerous judicial precedents available on Transfer Pricing matters to date provide guidance on the interpretation and application of Indian transfer pricing laws. Though some of them may have varied interpretations on contentious issues, many of them acknowledge certain fundamental Transfer Pricing principles and in a way, have supported that the following are an integral part of an objective Transfer Pricing analysis.

  • Detailed FAR analysis for tested party and comparable companies is crucial – taxpayers must have robust documentation with sound FAR analysis and well developed economic analysis to justify their transfer prices.
  • International transactions should not be aggregated unless they are inextricably linked.
  • Greater need to build adequate “cost-benefit” documentation to substantiate management and technical fee payouts.
  • Least complex entity to be selected as the tested party.
  • Adjustments may be made to improve comparability between the results of taxpayer and the comparables.
  • Transfer Pricing provisions being specific in nature; override other general provisions as contained in the Act.
  • The business case and the economic environment of the taxpayer must be taken into account while testing the arm’s length criterion.

Transfer Pricing and Customs Valuation

There is a lack of consistency between customs valuation procedure and transfer pricing regulations under tax laws. Both departments work at divergent purposes in relation to the same transactions. Suitable methods for valuation of imported goods should be established which are acceptable to both customs law and the Indian transfer pricing regulations. Towards this end, the Indian Revenue Authorities set up a Joint Working Group, comprising of transfer pricing and customs officers. This initiative was undertaken by the Revenue Authorities in order to bring greater harmonization, coordination and communication between the two departments as regards valuation of imported goods.

While the transfer pricing compliance requirement and audits are stringent, there is good hope for the taxpayers that the objectivity witnessed through recent developments and in particular on the dispute resolution mechanism, is expected to overhaul for better the Indian transfer pricing administration.

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