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Domestic Transfer Pricing - Provisions, Concepts & Issues

Apurv Gandhi Nirav Poddar Neha Lala Karan Lala

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Apex Court Remarks… • Dispute regarding allocation of cross charges between assessee company and its

service provider for AY 2001-02

• Comments on the merits

“…..no interference is called for as the entire exercise is a revenue neutral exercise”

• Comments on “larger issue”

“ …, whether TP Regulations should be limited to cross-border transactions or whether the Transfer Pricing Regulations be extended to domestic transactions. In the case of domestic transactions, the under-invoicing of sales and over-invoicing of expenses ordinarily will be revenue neutral in nature, except in two circumstances having tax arbitrage—

(i)If one of the related Companies is loss making and the other is profit making and profit is shifted to the loss making concern; and

(ii)If there are different rates for two related units (on account of different status, area based incentives, nature of activity, etc.) and …”

Whether Tax Authorities will comply with the spirit of “revenue neurality”

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Position Pre & Post Finance Act, 2012 • Tax Authority empowered to disallow payments to “related parties” which are

“excessive” or “unreasonable” – Section 40A(2)(b)

• In cases of entities possessing tax holiday undertakings

AO empowered to determine profits based on FMV in inter unit transfer [80IA(8)]- Also empowered to re-compute eligible profit in case of arrangements with closely connected persons or otherwise [80IA(10)]

No specific methodology prescribed

No co-relative adjustment is permitted to give effect to consequences in hands of both parties.

• Transfer pricing provisions extended to “Specified Domestic Transactions (SDT)” w.e.f A.Y 2013 - 14

Seeks to create legally enforceable obligation on taxpayers to maintain proper documentation increasing compliance and administrative burden for ALL tax payers

SC decision in Glaxo Smithkline – Precursor to Domestic TP provisions

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Domestic transfer pricing provisions

Specified Domestic

Transactions

Section 80IA(8) • Inter-business transfer of

goods/ services of the tax payer claiming tax holiday; and

• The consideration for such transfer does not correspond to the market value of goods/ services transferred

Section 40A(2)(b) Payments for expenses incurred being excessive in nature made to specified related entities

Section 80IA(10) • Transfer of goods/

services from tax holiday unit to persons having close connections results in more than ordinary profits to tax payer; and

• The consideration for such transfer does not correspond to the market value of goods/ services transferred

Others •Transactions specified in chapter VI-A/ section 10AA to which section 80IA(8)/ 80IA(10) applies •Any other transactions as may be prescribed

Aggregate of above referred transaction to exceed Rs 5 crores

For entities not claiming any tax holiday – only section 40A(2)(b) applicable

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Computation of “aggregate value”

• What value – ALP or the actual price accounted?

• Where transactions referred to in definition cover both income as well as expenditure – Both the receipt as well as outflow from transactions would be aggregated

• Same transaction falling in more than one clause – To be considered twice?

• Evaluate exclusion of expenditure disallowed (say for TDS default)?

• Evaluate exclusion of expenditure of a disallowable nature?

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Domestic TP not restricted to transaction with residents

• Section 92BA excludes International Transaction from within its scope

• Trigger for AE relationship different for International & Domestic TP

• Illustrative examples where transactions with non-resident may be covered under Domestic TP Remuneration paid by an Indian company to a non-resident

director Remuneration paid by a FC having PE to non resident director Payment by Indian Co to Foreign Co. where Foreign Co. holds 20

to < 26% in Indian Co.

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Section 40A(2) – Payments to related parties • Applicable to taxpayers making the payment/incurring expenditure and

not to recipients of such income Sec 40A(2) generally covers relationship based on holding of ‘substantial

interest’. No correlative relief for recipient if payer subject to a TP adjustment

• Expenditure should be towards ‘goods’, ‘services’ or ‘facilities’

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Scope of s. 40A(2)(b)

• Domestic TP applies to expenditure for which payment is made or is to be made to a person referred to in s. 40A(2)(b)

Coverage is wide; conceptually different from AS-18 • Applies to transactions on or after 1 April 2012 • Applies to payments which results in “expenditure”

Arguably includes constructive payment Dividends/DDT not covered since not an expenditure Payment of loan or share capital is not an expenditure

• Payment should be to independent entity; Inter unit transaction of same taxpayer not covered

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No notional imputation of Income

• Section 40A(2) covers transactions in the nature of ‘expenditure‘ and not ‘income‘.

• Illustrative transactions not covered - Grant of interest free loan to an associate Corporate guarantee on behalf of subsidiaries Sale of goods at less than FMV Allowing use of trade mark or know-how or common services

by group entities at NIL or nominal charge Gratis lease of machinery to associates

• S. 40A(2) inapplicable if expense is lower – consequently no “notional” income in the hands of payee

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Section 40A(2)(b) Related entities/ persons (to the extent relevant)…

Clause no Provisions (i) Relatives of the individual taxpayer

(ii) Directors1 of the tax payer

(iii) Individual having substantial interest

(iv) - A Company having substantial interest in business of the tax payer or Directors1/ Partner1/ Member1 of such Company as the case may be

- Company having a Common Shareholding Company

(v) Company, a Director as the case may be of which is having substantial interest in business of the tax payer or any Director1 of such Company as the case may be

(vi) Any person in whose business the tax payer Company; or any Directors1 of such tax payer Company have a Substantial interest

Payments to :

A simplified version of explanation of Section 40A(2)(b) is enclosed as Annexure 1

1 Includes reference to relatives

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S. 40A(2)(b) – controversial transactions

• Inter-linking of S.40A(2)(a) and S.40A(2)(b) • Benchmarking of remuneration Remuneration to partners regulated by s.40(b) Directors remuneration regulated under Company Law

• Payment to related parties covered under non-business heads Interest payment to related party claimed as deduction u/s 57;

s.58 (2) extends s. 40(A)( 2) to Income from other sources Cost of capital asset acquired from related party? Payments for capital assets under business head - Depreciation

claimed u/s. 32?

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Transactions covered u/s 80A

Section Description

10AA Units in SEZ

10B Export of eligible articles

80IA Infrastructure Development etc

80 IAB Developer of SEZ

80 IB Industrial Undertaking

80 IC Industrial Undertaking or Enterprise in special category states

80 ID Hotels & Convention Centre's in specified area

80 IE Undertaking in North – Eastern states

80 JJA Collection & processing of bio-degradable waste

80JJAA Employment of new workmen

80 LA Offshore Banking units & International Financial Services Centre

80 P Co-operative Societies

• Reference in general to entire section 80A - On closer examination it is clear reference is merely to subsection (6)

• Sections which are covered by 80A(6) and hence subject to SDT

80A(6) not applicable to Section 10A and Section 10B due to sun-set clause In the said sections

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S.80A(6)/80-IA(8) coverage

• Contextually covers intra division transfers not being a transaction

• Overlapping provisions of section 80A(6) and 80IA(8) • Influences a case where taxpayer is entitled to deduction u/s.10A

/10AA/10B/10BA/Chapter VI-A in respect of a unit, where: Goods or services held for the purpose of eligible business are transferred

to “any other business”. Goods or services held for the purpose of “any other business” transferred

to eligible business, Consideration recorded in books does not correspond to “market value” of

such goods • Further it refers to valuation of such goods/ services at arms length

price u/s 92F(ii) if its is a SDT u/s 92BA

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S.80A(6)/80-IA(8) coverage

• Sec 80A(6) requires comparison of MV and value recorded “in the accounts of the unit/enterprise/eligible business” • Even if the threshold of Rs. 5 crore is not crossed ; such transaction

will have to be valued as per 80A(6) at FMV • Inter unit transfer between two non-eligible units has no TP

implications • Section requires “any other business” carried on by assessee and

dealings between businesses Restricted to goods and services of ‘marketable’ nature Restricted to transfer

• Application of sec 80 IA(8) to other provisions :- Sec 10AA(9), Sec 80 IAB(3), Sec 80 IC(7), 80 ID(5) and Sec 80 IE (6)

Whether sec 80A(6) can apply to increase the eligible profits?

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S.80A(6)/80IA(8) coverage Cont..

• Activities which are not carried on as business HO expenses including IT support, accounts, law compliance etc Use of corporate resources, including IPR HO finance out of capital or accumulated profits. Temporary use of funds

• Allocation of actual expenses and challenges around allocation keys Research cost, finance cost, HO overheads, sales promotion

• Provides for al “two-way” adjustment (both favorable as well as adverse) Restricted to core activity Supply of power by captive power unit to the manufacturing unit Supply of intermediate goods to the unit manufacturing FG

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Pre-requisite of ‘any other business’

Head Office (HO)

Treasury Operations

Eligible Unit 1 Eligible Unit 2

Non Eligible Unit

•Audit Fees

•Directors’ fees

•Payroll processing

•H.O. rent, etc.

• Typical H.O. expenses need fair and commercial allocation If not a super specialty/ commercial function no mark up needed

• Marketable services rendered by inter unit will need to be at ALP

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Applicability of Domestic TP – Inter Unit Transfer • Facts:

Both units of A Co are tax holiday qualifying units @ 100%

Power Unit transfers power to the Manufacturing Unit

• Issue: Whether application of Domestic

TP can result in adverse impact for taxpayers despite there being no potential for tax arbitrage between two units?

A Co

Power Unit (Tax Holiday 100%)

Manufacturing Unit (Tax

Holiday 100%)

Particulars Income GTI Deduction Total Income Unit

P Unit M

Unit P Unit M

As returned by the taxpayer

100 100 200 100 100 Nil

If AO enhances income of Unit P

120 80 200 120 (100?)

80 Nil (20?)

If AO reduces income of Unit P

80 120 200 80 120 (100?)

(20?)

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Inter unit transfers – Interplay of eligible and non-eligible unit

• Facts: Power unit is eligible for Tax holiday

deduction

Power unit transfers power to non-eligible Manufacturing unit at INR 100

• Issue: Will there be any adverse tax

implications if Domestic TP is invoked by the AO?

A Co

Power Unit (Tax Holiday 100%)

Non eligible Manufacturing

Unit

Particulars

Income GTI Deduction Total Income

Unit P

Unit M

Unit P

Unit M

As returned by the taxpayer

100 100 200 100

Nil 100

If AO enhances income of Unit P

120 80 200 100

Nil 100

If AO reduces income of Unit P

80 120 200 80 Nil 120

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Transaction covered under s.80-IA (10) • Needs to be a “transaction” with “other person” • Ingredients which trigger invocation of s. 80-IA(10). Assessee carrying on eligible (tax holiday) business If it appears to AO Owing to close connection or otherwise Course of business arranged Transaction produces more than ordinary profit in tax holiday unit

• No need to report transaction unless conditions for invocation established? Scope not restricted to goods or services Scope not restricted to S.40A(2) persons Scope not extended to inter-unit transfer

• Revenue > ALP does not per se imply existence of more than ordinary profits

Applicability to investment-linked tax incentives under Section 35AD?

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Sections 80IA(10) coverage

• Provisions of sec 80IA(10) are applicable to :- Sec 10AA(9) Sec 80IAB(3) Sec 80 IB(13) Sec 80 IC(7) Sec 80 ID( 5) Sec 80 IE(6)

• ‘Close Connection’ & ‘More than ordinary profits’ has not been defined. • A.O needs to substantiate and establish close connections between assessee

and the other parties. • Working of arms length price made by TPO can be taken as calculation for

determination of “ordinary profits”- NO • Whether capital receipt transaction would be relevant for purpose of sec

80IA(10) – No ; as the transaction should form part of ‘profits’ of eligible business.

• Purchase of depreciable asset would attract 80IA(10) provisions.

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Coverage of s. 80-IA(10)

A Co B Co

Tax Holiday Unit

• For A Co Domestic TP not

applicable-transaction is of income receipt, 40A(2) not triggered

• For B Co

Covered by s.40A(2)(b) and hence SDT. But, payment is at < FMV, no TP adjustments required.

S.80-IA(10) may still be invoked on the ground that arrangement leads to more than ordinary profits?

Related Parties

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Tax Burden, if transaction not at ALP – Interplay between 40A(2) & 80IA(10)

X Ltd. (non-tax holiday)

Y Ltd. (non-tax holiday Sale at 120 v/s

ALP i.e. 100

Disallowance of Rs. 20 to Y Ltd [40A(2)(b)] Double Effect Tax holiday on 20 not allowed to X Ltd – [80IA(10)] (more than ordinary profits) . Disallowance of 20 to Y Ltd. – [40A(2)(b)]

Inefficient pricing structure Reduced tax holiday benefit since sale price is lower than ALP

Sale at 120 v/s ALP i.e. 100

Sale at 80 v/s ALP i.e. 100

X Ltd. (tax

holiday)

Y Ltd. (non-tax holiday

X Ltd. (tax

holiday)

Y Ltd. (non-tax holiday

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Sec 80IA(8) vis-à-vis Sec 80IA(10)

Particulars 80IA (8) 80IA (10)

Extends Deals with internal transfer of goods & services

Deals with external transfers

Application Section is triggered when any internal transfer is undertaken

Section is triggered when AO forms an opinion that arrangement of the transaction is showing more than ordinary profits.

AO’s onus AO needs to just prove whether the recorded values of transfer is at “market value”

AO needs to prove the fact that the profits shown by eligible business is inflated as also the motive / intention of the assessee.

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Voluntary TP adjustment in ROI

• Taxpayer is benefited by voluntary TP adjustment in Domestic TP if it is 40A(2)(b) transaction which impacts GTI and Taxpayer is eligible for s. 10AA/Chapter VI-A deduction (Refer illustration).

• Where s. 10AA/Chapter VI-A deduction is not a available and/ or adjustment is to deductible profits, voluntary TP adjustment may lead to additional income but mitigates interest and concealment penalty

Taxpayer (Eligible

Unit)

Taxpayer Post Vol. TP

AO

Purchase from related party

100 80 80

GTI 200 (200 + 20) = 220

(200+20)=220

Less: Deduction u/s.10AA

200 220 200

Taxable income

Nil Nil 20

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Determination of Arm’s Length Price (ALP)

• ALP defined in Section 92F(ii)

• ALP is the price at which two unrelated parties would undertake a “similar transaction” in “similar circumstances”

• Deviation of ALP from actual price has consequences

• To determine if transfer price is ALP, find answers to following questions : Would the selling / provider firm agree on the price if it were

dealing with an unrelated firm?

Would the purchasing / availing firm agree to purchase or avail if it were dealing with an unrelated firm?

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Challenges around ALP exercise

• ALP determination is not an exact science

• ALP is an economic concept : FAR analysis the prime driver

Evaluate the comparable with similarity of FAR

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Permissible deviation range from ALP

Particulars w.e.f. 1.04.12

Transfer Price 100

ALP (Arithmetic Mean)

120

Permissible Range

Not exceeding + 3% of transaction value(97-103)

Tolerance limit for TP adjustment (Notified on April 15, 2013)

1% for wholesale traders 3% for other taxpayers

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Comparability: Key points • Selection of tested party is critical and precedes applicability of

methods

• Tested party is one in respect of which: Reliable comparable data is easily available

Least complex entity

Leads to fewest adjustments

• Onus of establishing ALP is on taxpayer

• Comparison should be with independent uncontrolled (unrelated party) transactions Enterprises with predominant AE business are generally

disqualified

In any case, transactions with other AEs do not qualify to be comparable

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Prescribed Benchmarking Methods

• Any other method prescribed by the Central Board of Direct Taxes

• Indian rules have no guidance on preference for any method • CUP is the most preferred method; TNMM is the most frequent method

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Most Appropriate Method Rule

• ALP to be determined by adopting the most appropriate method. (i.e. Best method Rule) The method best suited to the facts and circumstances of the

case

AND

Which provides most reliable measure of ALP

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Comparable Uncontrolled Price Method

• Preferred method, if available As applicable to product / service

• Requires high degree of comparability

• Parameters of non-comparison Geographical difference

Intangible

Market share

Bargaining strength

Quality segment of product / service

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Comparable Uncontrolled Price Method

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Resale Price Method (RPM)

• Apt for distributors involved in merely trading activities

• Compares the resale gross margin earned by AE, with gross margin of comparable independent distributors • Recommended if following conditions are fulfilled: Distribution of finished products involving no or little value addition Where the entity performs the basic sales and marketing functions Where the product is resold to an independent entity after being purchased from related party

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Cost Plus Method (CPM) ( C+)

• Used predominantly when AE works for another AE as contract manufacturer.

• Typically applied to a contract manufacturer who: Does not bear risk of marketing Does not normally undertake high skill work

• May apply to contract manufacture, BPO, call centre, software developer, etc.

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Transactional Net Margin Method (TNMM) • Resorted to as the residuary method

• Caution needs to be exercised as it is a double-edged sword

• Comparable Net profit adopted in relation to : Costs incurred, or

Sales effected, or

Assets employed; or

Any other relevant base. (eg. PBDIT, gross margin, operating margin)

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Profit Split Method (PSM)

• Generally applicable in case of transaction involving Use of unique intangibles

OR

Multiple transactions which are interrelated/high integration not permitting separate evaluation

• Split global profit according to contribution of each AE

• Avoids vice of unilateral entity level adjustment which may lead to overall distortion

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Unspecified method – Rule 10AB

• Other method – Rule 10AB For the purposes of clause (f) of sub-section (1) of section 92C,

the other method for determination of the arms' length price in relation to an international transaction or a specified domestic 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.”

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Documentation

• Maintenance as per Section 92D • Documentation to be contemporaneous • Due date for maintenance of TP documentation for FY 2012-13 is November 30, 2013

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ALP Benchmarking

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TP Audit process

• TPO provides opportunity of hearing if referred by A.O with approval of CIT • TPO order binding on A.O • A.O. prepares draft order

• Taxpayer has alternative remedy of DRP

• Taxpayer cannot avail APA or safe harbor

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Consequences of TP Adjustment

• S. 40A(2)(b) disallowances leads to enhancement of income and consequential tax / interest levy

• No consequential enhancement of s. 10AA / Chapter VI-A deduction (First proviso to s. 92C(4))

• S. 80A(6) / s. 80IA(8) / s. 80IA(10) adjustment leads to curtailment of tax holiday deduction leading to additional income and consequential tax, interest levy

• No co-relative adjustment in the hands of recipient

• Penal consequences

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• Adjustment related penalty not leviable where taxpayer has acted in ‘good faith’ and exercised ‘due diligence’

• TP documentation serves as a good basis to demonstrate good faith and due diligence

Section Trigger Quantum of penalty

271(1)(c) In case of an adjustment post assessment, if regarded as concealment of income

100-300% of the tax leviable on the amount of adjustments

271AA Failure to maintain TP documentation, failure to report the transaction, maintenance or furnishing of incorrect information/document

2% of the value of the transactions

271BA Failure to furnish Form 3CEB INR 100,000

271G Failure to furnish TP documentation with the tax officer

2% of the value of the transactions

Domestic TP – Penal provisions

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• Analyze SDT provisions and applicability thereof well in advance

• Analyze and document technical positions relating to scope/

coverage/ applicability of SDT

• Undertake impact assessment on current practices and policies

• Take corrective action as may be necessary

Reset inter company/inter unit pricing policies, wherever required

Properly document inter-company/ intra-company pricing policies

• Initiate steps for preparing SDT TP documentation

What taxpayers need to do

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Implication post – budget 2012 for SDT

FMV ALP

Contemporaneous documentation required to be

maintained

Six methods prescribed for computing FMV

Other than reporting in tax audit report, Form 56F and

10CCB no statutory compliance

No method prescribed for computing FMV

No documentation required to be maintained

Accountant’s report signed by a CA to be filed

Assessment done by the TPO Assessment done by the AO

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Challenges Sr. No.

Types of payments/transactions Challenges

1 Salary and Bonuses paid to the partners • Benchmarking

• Whether the limit as mentioned in section 40(b) would be the ALP?

2 Remuneration paid to the Directors • Benchmarking

• Whether the limit as mentioned in Schedule XIII would be the ALP?

3 Transfer of land • Whether the rates mentioned in the ready reckoner be considered as the ALP?

4 Joint Development Agreements • Benchmarking?

5 Project management fees • Benchmarking?

6 Allocation of expenses between the same taxpayer having an eligible unit and non- eligible unit

• Whether this allocation would be SDT –Sec 80-IA(10)?

7 Definition of Related Party • Directly v/s Indirectly?

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Clause (ii) Clause (iv)

Taxpayer Co

Director or relative of Director

Payment

Taxpayer Co Individual or relative of individual

Payment

> 20%

Taxpayer Co

Company Director or

their relatives

> 20%

XYZ Co

Taxpayer Co

LMN Co

> 20% > 20%

Payment

Payment

Payment

Clause (iii)

Annexure 1

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Clause (v) Clause (vi)

Company

Any other Director or their

relatives Taxpayer Co

Director

Payment

> 20%

Taxpayer Co

Any person

Director/ relative of Director

> 20% Payment > 20%

Annexure 1