Type of transactions covered
Type of transactions covered
Section 92B of the Act read with it Explanation inserted in Finance Act 2012 defines the term ‘international transaction’ to mean a transaction between two (or more) associated enterprises involving the sale, purchase or lease of tangible or intangible property; provision of services; cost-sharing arrangements; lending/borrowing of money; or any other transaction having a bearing on the profits, income, losses or assets of such enterprises. It specifically cover certain transactions/ arrangements such as purchase, sale, transfer, lease or use of intangible property, provision of guarantees, deferred payments or receivables, business restructuring or reorganisation etc.
- The associated enterprises could be either two non-residents or a resident and a non-resident; furthermore, a permanent establishment (PE) of a foreign enterprise also qualifies as an associated enterprise. 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 5 crore:
- Any expenditure with respect to which deduction is claimed while computing profits and gains of business or profession.
- Any transaction related to businesses eligible for profit-linked tax incentives, for example, infrastructure facilities (Section 80-IA) and SEZ units (section 10AA).
- Any other transactions as may be specified.
Associated enterprises/ Related parties
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:
- Direct/indirect holding of 26% or more voting power in an enterprise by the other enterprise or in both the enterprises by the same person.
- Advancement of a loan, by an enterprise, that constitutes 51% or more of the total book value of the assets of the borrowing enterprise.
- Guarantee by an enterprise for 10% or more of total borrowings of the other enterprise.
- Appointment by an enterprise of more than 50% of the board of directors or one or more executive directors of the other enterprise or the appointment of specified directorships of both enterprises by the same person.
- Complete dependence of an enterprise (in carrying on its business) on the intellectual property licensed to it by the other enterprise.
- Substantial purchase of raw material/sale of manufactured goods by an enterprise from/to the other enterprise at prices and conditions influenced by the latter.
- The existence of any prescribed relationship of mutual interest.
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. Also, as per Section 94A of the Act, if a taxpayer enters into a transaction in which one party is a person located in a notified jurisdictional area, then all the parties to the transaction shall be deemed to be AEs, and any transaction with such party(ies) shall be deemed to be an international transaction.
For the purpose of specified domestic transactions, Related Parties (RPs) have been defined under section 40A(2)(b)
Where the assessee is an individual any relative of the assessee.
- Where the assessee is a company, any director of the firm, association of persons or company, partner of the Hindu undivided family firm, of member if the association or family, or family, or any relative of such director, partner or member.
- Any individual who has a substantial interest in the business or profession of the assessee, or any relative of such individual.
- A company, firm, association of persons or Hindu undivided family having a substantial interest in the business or profession of the assessee or any director, partner or member of such company, firm, association or family, or any relative of such director, partner or member.
- A company, firm, association of persons or Hindu undivided family of which a director, partner or member, as the case may be, has a substantial interest in the business or profession of the assessee; or any director, partner or member of such company, firm, association or family or any relative of such director, partner or member.
- Any person who carries on a business or profession- where the assessee being an individual, or any relative of such assessee, has a substantial interest in the business or profession of that person or where the assessee being a company, firm, association of persons or Hindu undivided family, or any director of such company, partner of such firm or member of the association or family, or any relative of such director, partner or member, has a substantial interest in the business or profession of that person.
- A substantial interest in a business or profession is deemed if,
(a) in a case where the business or profession is carried on by a company, such person is, at any time during the previous year, the beneficial owner of shares (not being shares entitled to a fixed rate of dividend whether with or without a right to participate in profits) carrying not less than twenty per cent of the voting power; and
(b) in any other case, such person is, at any time during the previous year, beneficially entitled to not less than twenty per cent of the profits of such business or profession.
The Arm’s-length Principle and Pricing Methodologies
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:
- Comparable uncontrolled price (CUP) method.
- Resale price method (RPM).
- Cost plus method (CPM).
- Profit split method (PSM).
- Transactional net margin method (TNMM).
- Such other methods as may be prescribed.
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.
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. Some flexibility has been extended to taxpayers by allowing a range benefit which would be notified by the Government, not exceeding 3% & in case of wholsale tradin it is restricted to 1%. 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.
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 with RPs. 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:
1. The first part of the rule lists mandatory documents/ information that a taxpayer must maintain. The extensive list under this part includes information on ownership structure of the taxpayer, group profile, business overview of the taxpayer and AEs/RPs, prescribed details (nature, terms, quantity, value, etc.) of international transactions or specified domestic transactions and relevant financial forecasts/estimates of the taxpayer. The rule also requires the taxpayer to document a comprehensive transfer pricing study. The requirement in this respect includes documentation of functions performed, risks assumed, assets employed, details (nature, terms and conditions) of relevant uncontrolled transactions, comparability analysis, benchmarking studies, assumptions, policies, details of adjustments and explanations as to the selection of the most appropriate transfer pricing method.
2. 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.
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. 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.
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) and in the prescribed Form 3CEB. 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 rescribed particulars.
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.
A taxpayer that is aggrieved by an order passed by the AO may appeal to the Commissioner of Income Tax, also called the Appellate Commissioner, within 30 days of the date of receipt of the scrutiny assessment order. The office of the Appellate Commissioner is a type of quasi-judicial authority, where the taxpayers make representations in support of their claims to rebut the order passed by the AO. The
decision of the appellate commissioner is reflected in an appellate order. An alternative dispute resolution mechanism has been instituted by the Finance Act (2009) to facilitate expeditious resolution of disputes in all cases involving transfer pricing and foreign company taxation. It has introduced the concept of draft assessment orders, which would be issued by the AO pertaining to the order of the TPO that is prejudicial to the taxpayer. In cases involving foreign companies or companies suffering transfer pricing adjustments, the AO is required to forward a draft assessment order to the taxpayer which would ordinarily include the order of the TPO. A dispute resolution panel (DRP), comprising a collegium of three Commissioners of Income Tax, is constituted to which the taxpayer would have recourse on receiving the draft assessment order from the AO.
At this stage, the taxpayer has two choices: It could either accept the draft order as it is, or seek to refer the matter to the DRP. The taxpayer has to communicate its decision to the AO within 30 days of the receipt of the draft order. If the order is accepted by the taxpayer as it is, the draft would be finalised by the AO and served to the taxpayer. If the matter is referred to the DRP, the panel would have nine months from the time of referral to decide the matter taking into consideration the draft order of the AO, the order of the TPO and the taxpayer’s objections and evidence. The draft assessment order would be finalised after the DRP has rendered its decision to the AO. If the taxpayer does not communicate its decision to refer the draft order to the DRP within 30 days, the AO would finalise the assessment order without modification of the draft assessment order.
However, an order of the AO that is based on the direction of the DRP would be appealable directly to the Income Tax Appellate Tribunal (Appellate Tribunal). All orders passed by the AO before 30 June 2012 pursuant to the directions of the DRP were binding on Revenue. However, with respect to objections filed on or after 1 July 2012, the Revenue can appeal against the direction passed by the DRP. It is also clarified that the taxpayer would have to decide whether to opt for the dispute resolution mechanism based on the draft assessment order or file an appeal in the normal course with the appellate commissioner against the assessment order. Thus, the order of the AO can be agitated before the appellate commissioner in the ordinary course (i.e. if it is not referred to the DRP).
Taxpayers that still feel aggrieved by the order of the appellate commissioner or, as the case may be, the order of the AO passed in conformity with the directions of the DRP have the right to appeal to the Appellate Tribunal, thereafter to the jurisdictional High Court, and finally to the Supreme Court. A similar right to appeal also rests with the Revenue, in cases where objections before the DRP have been filed on or after 1
Additional tax and penalties
The following stringent penalties have been prescribed for noncompliance with the
provisions of the transfer pricing code:
- For failure to maintain the prescribed information/document: 2% of
- For failure to furnish information/documents during audit: 2% of
- For failure to disclose any transaction in Accountant’s report: 2% of
- For adjustment to taxpayer’s income: 100% to 300% of the total tax on the
- For failure to furnish an accountant’s report: INR 100,000.
Further, taxable income enhanced as a result of transfer pricing adjustments does not
qualify for various tax concessions/holidays prescribed by the Act.
Advance pricing agreements
The Indian authorities have introduced unilateral, bilateral and multilateral APAs with effect from 1 July 2012. There are no monetary or other conditions prescribed under the Indian APA rules for a taxpayer to be eligible for applying for an APA. However, the APA mechanism is not available for specified domestic transactions. The validity of an APA (once entered into) shall not exceed five consecutive years and shall be binding on the taxpayer as well as the Revenue authorities in respect of the international transactions for which the APA is sought. APA fees would range between INR 1 million to 2 million, based on the value of international transactions. There are four phases in an APA which is in line with global practice, as follows:
- Pre filing phase: The process of an APA would start with a pre-filing consultation meeting. This meeting will be held to determine the scope of the agreement, understand the transfer pricing issues involved and to determine the suitability of the international transaction for the agreement. No fee is to be paid in this phase.
- Formal submission phase: After the pre- filing meeting, if the taxpayer is desirous of applying for an APA, an application in the prescribed format would be required to be made containing specified information. The APA filing fee is payable at this stage. In the application, the taxpayer must describe critical assumptions. Critical assumptions refer to a set of taxpayer related facts and macroeconomic criteria (such as industry, business, economic conditions, etc.), the continued existence of which are material to support the position concluded under an APA. A material change in any of the critical assumptions may result in revision of the APA or even termination in extreme circumstances.
- Negotiation phase: Once the application is accepted, the APA team shall hold meetings with the applicant and undertake necessary inquiries relating to the case. Post the discussion and inquiries, the APA team shall prepare a draft report which shall be provided to the Competent Authority in India (for unilateral/multilateral APA) or the Director General of Income Tax (International Tax and Transfer Pricing) (for Unilateral APA).
- Finalisation phase involves exchange of comments on draft APA, finalisation of the APA, and giving effect to the initial years covered under the APA term that have already elapsed.
Use and availability of comparables’ information
Taxpayers are required to maintain information on comparables as part of their transfer pricing documentation to demonstrate that the pricing policy complies with the arm’s-length principle. Comparable information is a crucial element for defending transfer pricing in India. Indian revenue officials have indicated that, to the extent possible, Indian comparables should be used. Use of foreign comparables is generally not acceptable, unless the tested party is located overseas. In some cases, the TPOs have exercised their power to obtain private information from other taxpayers and used it against the taxpayer undergoing an audit.
The tax authorities use a couple of electronic databases giving detailed financial and descriptive information for companies. It is also possible to obtain information about Indian public companies from the Registrar of Companies upon payment of statutory fees.