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TRANSFER PRICING AUDIT

TRANSFER PRICING AUDIT

Transfer Pricing in India – Background & History

Since 1991, India's trade and foreign exchange policies have undergone liberalization, initiating an integration of its economy into the global marketplace. This shift has facilitated the cross-border movement of goods, services, funds, and even intangible assets. It resulted in a substantial influx of Foreign Direct Investment (FDI), accompanied by the relaxation of monetary controls and the removal of quantitative import barriers. As multinational enterprises (MNEs) have shown increasing interest in India, the nation's tax authorities have recognized the need to address transfer pricing matters. This is a consequence of the burgeoning economic interactions and transactions across borders. Notably, many Indian companies have evolved into significant global entities, engaging in substantial acquisitions and establishing subsidiaries in various tax jurisdictions around the world.

Introduction of Transfer Pricing Regulations in India

The Transfer Pricing Regulations (TPR) were introduced in India through the Finance Act of 2001. This involved substituting the existing Section 92 and introducing new sections 92A to 92F in the Income Tax Act, along with corresponding rules 10A to 10E in the Income Tax Rules, 1962. These regulations are applicable to international transactions entered into on or after April 1, 2001.

Before these detailed provisions, the concept of Transfer Pricing Laws in India was applied under specific circumstances and in a limited manner. The former Section 92 allowed tax authorities to recompute the taxable income of a resident if an international transaction with a non-resident resulted in less than ordinary profits due to a "close connection" between them.

The introduction of TPR aimed to establish a comprehensive statutory framework for calculating reasonable, fair, and equitable profits and taxes in cases involving multinational enterprises. It also introduced new sections 92A to 92F in the Act, covering aspects such as arm's length price, associated enterprise, international transaction, and related computations.

The legislative intent behind TPR is to prevent profit shifting by manipulating prices in international transactions, thus protecting India's tax base. The explanatory memorandum of the Finance Bill, 2001, highlights that TPR was introduced to curb transfer pricing abuse.

How to Transfer Pricing Audit in India

Over the past decade, India has emerged as a significant opportunity for global entrepreneurs seeking to establish successful businesses. Factors such as liberalization, a growing middle class, increased employment opportunities, and wage growth have contributed to India's attractiveness as a business destination. However, establishing a company in India involves navigating through a complex landscape of tax and legal considerations. One of the key tax regulations that requires careful attention is transfer pricing litigation.

To address the issue of foreign companies avoiding tax audits in India, a legislation named 'Transfer Pricing Regulation' has been introduced.

In a series of articles, Neeraj Bhagat & Company has delved into various facets of transfer pricing tax audits. The journey begins with gaining a comprehensive understanding of the transfer pricing rules in India.

The following are the important statutes of the law.

Every individual or entity engaged in an international transaction is required to maintain accurate and up-to-date records of each transaction as specified by the legislation. All income obtained through any international transaction must be assessed based on the arm's length price. Various methods are available to determine the arm's length price, depending on the transaction's nature, the entities involved, and other transaction characteristics. These methods are established by the Central Board of Direct Taxes, commonly known as the 'Board.' Examples of these methods include the resale price method, cost plus method, comparable uncontrolled price method, and transactional net margin method.

If multiple appropriate prices exist for a specific transaction, the arm's length price is calculated as the average of those prices.

At the conclusion of a financial year, individuals or groups engaged in international transactions must submit a report in Form 3CEB, guided by a Chartered Accountant. This report must be filed before filing the Income Tax return for the same period.

Failure to comply with these regulations may lead to penalties as determined by the Board.

TRANSFER PRICING FAQ’s

Q1. When do the transfer pricing outline regulations apply to a business?

A.Auditing Services When two or more associated companies enter into a mutual contract during an international transaction in order to apportion a particular cost incurred in relation with a benefit, service or facility offered by any one or all of the companies, such a cost shall be calculated considering the arm’s length price of the particular benefit, service, or facility, as applicable.

Q2.When can two companies be called as ‘associated enterprises?’

A.According to sections 92, 92A, 92B, 92C, 92D, 92E and 92F, a company can be termed as an associated enterprise with respect to the other under the following circumstances. –
If the respective company is involved directly or indirectly or with the help of one or more intermediaries in the management, control, or the capital of the other company. –
If any person/persons of the respective company who is/are involved directly or indirectly or with the help of one or more intermediaries in the management, control, or the capital of one company is/are involved directly or indirectly or with the help of one or more intermediaries in the management, control, or the capital of the other company.

Q3. What is meant by ‘International Transaction’ with regard to Transfer Pricing Outline?

A.An international Transaction is defined as any transaction between two or more associated companies situated in different countries in terms of a property that is tangible or intangible, a service offered by the company, or any form of lending of money, etc. It is compulsory that at least one of the participants involved in the transaction is a non-resident of India. However, a transaction that has been carried out by two non-resident Indians, where one of them possesses a permanent setup in India and whose income is taxable from India, such a type of transaction is also considered as ‘International Transaction.’

Q4. What are the different procedures to calculate the arm’s length price?

A.The various procedures to calculate the arm’s length price with respect to an international transaction are the following.

  • Transactional net margin procedure
  • Resale price procedure
  • Comparable uncontrolled price procedure
  • Cost plus procedure
  • Profit split procedure

There are various other procedures that are prescribed by the Central Board of Direct Taxes, generally known as the Board.

Q5. What all documents are required to be maintained by a company while executing an international transaction?

A.The following documents have to be maintained when a company is involved in an international transaction.

  • The details of the ownership of the person with respect to the company. These include the ownership structure, the details of the shares, and information on ownerships held by any other company on it.
  • A detailed profile of the foreign group to which the assessed company is associated with for the international transactions. The details such as name, address, country where tax returns are filed, and the legal status, etc., have to be furnished about the multinational group.
  • A detailed description of the business activities of both the assessed person and the associated group of companies with whom the former has been involved in international transaction.
  • The details of the international transaction, such as the nature of the transaction, details of the property or services transferred, the terms contained in the transaction, and the amount and value of each transaction.
  • The details of the functions carried out by such a transaction, the details of the risks involved and the value of the assets used or to be used by the assessed or the associated company that is involved in such a transaction.
  • The details of the records collected for the entire business or a particular division of the business during the period of the company’s business activity in which the foreign transaction has been involved. These include reports such as the estimates made on various market trends, forecasts about the market, budget analysis or any other such finance-related reports prepared by the company.
  • The details of the uncontrolled transactions, if any, that has taken place with a third party during the period of the international transaction. The nature and the terms and conditions of such transaction have to be mentioned as they play an important role in deciding the value of the international transaction.
  • The details of the analysis conducted in order to assess the impact of the uncontrolled transaction on the international transaction concerned.
  • The details of the various procedures considered and the one adopted in deciding the arm’s length price with respect to an international transaction. The details should also include the details on why the particular method was adopted and how it was implemented successfully in order to decide the arm’s length price.

Q6. Who is the authorized person to furnish the report under section 92E of the Transfer Pricing Regulation Act?

A.Any person who has involved in an international transaction in the previous year shall submit the report in Form 3CEB through a Chartered Accountant, duly verified by him, on or before the date prescribed by the authority, furnishing all the required details.

Appropriate method- Can there be more than one?

Q7.Does the expression “arithmetical mean” warrant the inference that there could be two prices where the most appropriate method is followed?

A. Since what is chosen is the “most appropriate method”, the concept of more than one appropriate price is a self-contradiction. But the proviso to section 92C(2) reads as under: “Provided that where more than one price may be determined by the most appropriate method, the arm’s length price shall be taken to be the arithmetical mean of such price.” The above proviso indicates that in the most appropriate method, which was chosen, there could be more than one price in which case the arithmetical mean will be taken. In other words, there could be more than one comparable and uncontrollable price, so that average could be adopted. Similarly, there could be more than one resale price or one cost plus price, so that the average can be adopted. The law does not, however contemplate more than one most appropriate method. Transfer pricing only when there is tax relevance

Q8. Is the transfer pricing to be certified even when the assesses is not liable to income tax?

A. An international transaction is one which takes place between a resident and a non resident or between two residents with a non resident associated concern as an intermediary. There is bound to be a tax impact for one or the other,so that transfer pricing become relevant , if not for the non- resident but atleast for the resident associate. Transfer pricing is bound to be relevant in such cases. It stands to reason, when the transfer pricing has no relevance at all for either party to the transaction, the rules would have no application, because the requirement of ascertainment of transfer pricing would not arise in such a case.

Associate concern –Duration of association

Q9. An Indian company becomes associate of a non -resident in the last quarter of the previous year. Do the transfer pricing rules apply for the year? If it does, does it apply for the quarter or whole of the year?

A. Transfer pricing rules relate to transactions. It is therefore reasonable to presume that the transaction covered in the last quarter of the previous year alone could be covered. There is possible view, that since it is an associate concern at any time during the year, all the transactions for the year are covered. The definition of “associated enterprise” in section 92A(2) would indicate, that an enterprise becomes an associate enterprise , if it becomes so “at any time during the previous year”. It would, therefore, mean that the associate enterprise is an associate enterprise for the whole year, so that the transaction for the period for which it was not associate enterprise may also be covered. This would, however, be a less plausible interpretation.

Related party transaction v Associated Enterprise

Q10. Indian Accounting Standard 24 issued by the Institute of Chartered Accountant of India relates to related party transactions. What is its relevance to the concept of associated enterprise under transfer pricing rules? How does it affect gifts?

A. Ind AS 24 would understand a related party transaction as a transfer of resources or obligation between related parties regardless of whether or not the price is charged. It would, therefore, appear that accounting standard 24 is even more plain and clear in comprehending a gift as one, which is covered by the transfer pricing rules, because a gift can be understood as transaction for which no price is charged.

The Indian Accounting Standard 24 is styled “Related party disclosures” .The objectives is to make available relevant information in the financial statements in respect of accounting periods commencing from 1.4.2001, since it has become mandatory from that date. It is not applicable for intra- group transactions but it is applicable for related parties not forming part of intra- group either . Direct inter-party relationship or indirectly through controlled enterprise may come in for disclosure in the context of transaction between them.

The concept of key management underlies the concept of control. Though key management is central to both the accounting standards and the transfer pricing rules, Ind AS 18 is more concerned with the disclosure of the transaction with a view to ensure transparency, and it is not concerned whether such transaction take place at arm’s length price, but only require information about such transactions to be disclosed. It is intended to help the user to appreciate the financial statements as to its operating results, its true financial position and net worth. It may help a person to understand the credit standing of the enterprise, resources by way of raw material or market, and such other information which may be relevant in judging the standing of the enterprise as a member or group of associated enterprise, since the normal reporting is one as an independent entity. Reports indicating common directors and the associated concerns would complete the required information for judging the standing of an enterprise.

DOMESTIC TRANSFER PRICING

Introduction

Starting from the fiscal year 2012-13, evaluations will necessitate the implementation of transfer pricing regulations for domestic transactions involving affiliated parties. Here is a summary of the most recent advancements within the realm of Domestic Transfer Pricing regulations:

  • Expanded Scope: The ambit of transfer pricing rules has been broadened to encompass transactions between domestic entities with connected relationships. This expansion moves beyond the previous focus solely on international transactions.
  • Threshold Applicability:The need to adhere to transfer pricing regulations within domestic transactions depends on the cumulative value of these transactions. The thresholds vary according to the nature of the transaction.
  • Documentary Requirements: Similar to international transactions, entities involved in domestic dealings with related parties must maintain comprehensive documentation that substantiates the conformity of these transactions with arm's length principles.
  • Methods and Comparables:The methodologies employed to evaluate international transactions, including the Comparable Uncontrolled Price (CUP) method and the Resale Price method, can also be used for domestic transactions. However, the selection of suitable comparables may differ.
  • Advance Pricing Agreements (APAs):Domestic transfer pricing regulations also offer the option to enter into Advance Pricing Agreements with tax authorities. These agreements provide assurance to taxpayers concerning transfer pricing methodologies.
  • Increased Scrutiny:The expansion of domestic transfer pricing regulations has amplified the attention from tax authorities. This underscores the significance of meticulous documentation and adherence to arm's length principles.

    • As India continues to refine its transfer pricing regulations, businesses engaged in domestic transactions with affiliated parties should remain informed about evolving rules and ensure compliance to prevent penalties and disputes.

    Specified Domestic Transactions

    Section 92BA outlines the definition of Specified Domestic Transactions to which various other provisions regarding transfer pricing are applicable. These encompass the following:

    a) Any expenditure for which payment has been made or is scheduled to be made to an individual mentioned in section 40A(2)(b);
    b) Any transaction stated in section 80A;
    c) Any transfer of goods or services mentioned in section 80IA(8);
    d) Any commercial dealing between the assessee and another individual as mentioned in section 80-IA(10);
    e) Any transaction indicated in any other section under Chapter VI-A or section 10AA, or the stipulations of sub-section (8) or sub-section (10) of section 80-IA are applicable;

    Any other transaction as specified by regulations, Provided that the collective value of such transactions undertaken by the assessee in the preceding fiscal year exceeds a total of two hundred million Indian rupees.

    Threshold exemption

    The Finance Act of 2012 initially defined the materiality threshold for the application of transfer pricing provisions to domestic transactions involving related parties at Rs. fifty million. This threshold was subsequently increased to Rs. 200 million starting from April 1, 2016. Consequently, if the combined value of specified domestic transactions remains below Rs. 200 million, there is no obligation to fulfill compliance requirements such as maintaining transfer pricing documentation or submitting accountants' reports. Nevertheless, it remains essential to consistently ensure that pricing adheres to market value principles and isn't influenced by the relationship between the related parties, in accordance with applicable sections.

    Consequential amendments

    Related party transactions

    Section 40A(2) refers to payments made to relatives and associates. The modified definition of related party under section 40A(2)(b) and the proviso read as under:

    “Provided that no disallowance, on account of any expenditure being excessive or unreasonable having regard to the fair market value, shall be made in respect of a specified is at arm’s length price as defined in clause (ii) of section 92F.

    (b) The persons referred to in clause (a) are the following, namely;-

    (i) where the assessee is any relative of the assessee;
    an individual

    (ii) (ii) where the assessee is a company, firm association of persons or Hindu undivided family any director of the company/partner of the firm, or member of association or family, or any relative of such director, partner or member;

    (iii) (iii) any individual who has a substantial interest in the business or profession of the assessee, or any relative of such individual;

    (iv) (iv) 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 or any other company carrying on business or profession in which the first mentioned company has substantial interest;

    (v) (v) 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;

    (vi) any person who carried on business or profession,-

    (A) 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

    (B) 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 ay relative of such director, partner or member, has a substantial interest in the business or profession of that person.

    Explanation– For the purposes of this sub-section, a person shall be deemed to have a substantial interest in a business or profession, 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, or 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”

    For the above purpose, the word “relative” is defined in section 2(41) to mean husband , wife, brother, sister, or any lineal ascendant or descendant of the individual.

    Where the assessee incurs any expenditure in respect of which payment has been or is to be made to certain persons, the Assessing Officer may disallow so much of the expenditure, which he considers excessive or unreasonable having regard to the fair market value of goods, services or facilities for which the payment is made,

    Transfer pricing rules have some similarity with the disallowance under section 40A(2) with respect to payments made in excess of the arm’s length price. The Tribunal in Aztec Software and Technology Services Ltd v. ACIT[2007] 294 ITR (AT)32 (BANG) [SB] held that Chapter X is a complete code in itself applicable in respect of transaction with a non- resident associate in excess of arm’s length price. Section 40A(2) covers excessive or unreasonable payment made to related parties.
    Section 40A(2) has been amended to the effect, that no disallowances would be made under this section in respect of specified domestic transactions, if such transactions are at arm’s length as defined under section 92F.The specified domestic transaction under section 92BA has been defined to mean “expenditure” and does not include income. There are also no clear answer in respect to managerial payments, so as to require a detailed analysis.