Transfer Pricing

Posted by   Libin Babu   |   Categories :   Tranfer Pricing

Objective

Provisions relating to Transfer Pricing are brought in, to create a statutory framework for the computation of reasonable, fair and equitable profit and tax in India, so that the profits chargeable to tax in India do not get diverted elsewhere by altering the prices charged and paid in intra-group transactions, leading to erosion of Indian Tax Revenue.

Applicability

The provisions of Sec. 92 to 92F of the Income Tax Act are applicable when above concepts come into effect in a transaction. Consequences of these tax provisions require:

  • Computation of income/expenses having regard to the Arm’s length price. (Sec. 92(1))
  • Maintenance of prescribed documentation. (Sec.92D read with Rule 10D)
  • Obtaining of Accountant’s Report under Form 3CEB. (Sec. 92E)
  • To ensure compliance with the arm’s length principle, stringent penalties have been prescribed.

Concept

  • Transfer prices are the prices at which an enterprise transfers physical goods and intangible property or provides services to associated enterprises.
  • Two enterprises are “associated enterprises” if one of the enterprises participates directly or indirectly in the management, control or capital of the other or if both enterprises are under common control.
  • A price between unrelated parties is known as the “arm’s length” price.

International Transactions (Sec. 92B)

  1. Meaning
    1. Transaction between two or more Associated Enterprises.
    2. Either both or at least one of the Enterprises should be a Non-resident.
    3. Should be in the nature of-
      • Purchase, sale or lease of tangible or intangible property,
      • Provision of services,
      • Lending or borrowing of money,
      • Any other transaction having bearing on Profits/Income/Losses/Assets of such enterprises
    4. It includes a mutual agreement or arrangement between two or more Associated Enterprises for –
      • Allocation of, or
      • Apportionment of, or
      • Contribution to
       Any cost or expense in connection with a benefit, service or facility  provided or to be provided to on or more of such Enterprises.
  2. Deemed Transactions between Non-Associated Enterprises: A transaction by an enterprise with a person other than an Associated Enterprise shall be deemed to be an International transaction between two Associated Enterprises, if –
    1. There is a prior agreement in relation to the relevant transaction between such person and the Associated Enterprise, or,
    2. The terms of the relevant transaction are determined in substance between such other person and the Associated Enterprise.

    where the Enterprise or the Associated Enterprise or both of them are Non-Residents, irrespective of whether of such other person is a Non-resident or not.

Specified Domestic Transactions (Sec. 92BA)

Includes any of the following transactions, not being an International transaction, and where the aggregate of such transactions entered into by the Assessee in the previous year exceeds Rs. 20 crores –

  1. Any expenditure in respect of which payment has been made or is to be made to a person u/s 40A(2)(b),
  2. Any transaction referred in Sec. 80A,
  3. Any transfer of goods or services referred to in Sec.80IA(8),
  4. Any business transacted between the Assessee and other person as referred to in Sec.80IA(10),
  5. Any transaction, referred to in any other section under Chapter VI-A or Sec 10AA, to which provisions of Sec.80IA(8) or (10) is applicable, or
  6. Any other transaction as may be prescribed.

Associated Enterprise (Sec. 92A)

  1. One enterprise participates in management or control or capital of other enterprise.
  2. Management or control or capital of both enterprises vests in the same person.

Deemed Associated Enterprises

  1. Shareholding > 26% – (i) One enterprise holds in another Enterprise, (ii) Any person/enterprise holds in each of such enterprise.
  2. Loans > 51% of book value of Total assets,
  3. Guarantee > 10% of Total borrowings,
  4. Management Control,
  5. Control by same person,
  6. Know-how relationship,
  7. Purchase > 90% of RM and consumables,
  8. Sale relationship,
  9. Control through Relatives of Individual, Members of HUF, Firms, etc
  10. Mutual Interest.

Arm’s Length Price (ALP)

It is the price applied or proposed to be applied in a transaction between persons other than associated enterprises, in uncontrolled conditions. Determination of arm’s length prices using one of the prescribed methods arrive at a single price then it is termed as arm’s length price. Else arithmetic mean of such prices which varies from transfer price not exceeding 3% is the arm’s length price.

Prescribed methods to compute ALP

1. Comparable Uncontrolled Price

  • Identify price charged in comparable uncontrolled transaction;
  • Adjust for differences materially affecting the price;
  • The adjusted price is the ALP
Considerations to be kept in mind while making the comparison:
  • Availability and reliability of the comparable data
  • Degree of comparability of the comparable data
  • The extent to which reliable and accurate adjustments can be made to account for differences
    • Delivery terms – Ex-works, FOB, CIF;
    • Contractual terms – differences in credit period;
    • Volumes of sales – discount %;
    • Timing of transaction;
    • Geographical location; etc.
How it works

A Inc. Japan and AB Ltd, an Indian Company are Associated Enterprises. AB Ltd manufactures goods and sells them to A Inc. Japan and C Inc., a company based at Beijing. During the year AB Ltd supplied 50 units to A Inc. @ Rs. 3,000 per unit and 250 units to C Inc. @ Rs. 4,800 per unit. The transactions of AB Ltd with A Inc and C Inc are comparable subject to the following considerations-

  1. Sales to A Inc is on FOB basis, sales to C Inc are CIF basis. Freight and Insurance paid by A Inc for each unit is Rs. 700.
  2. Sales to C Inc are under a free warranty for two years whereas sales to A Inc are without any such warranty. The estimated cost of executing such warranty is Rs. 500.
  3. Since A Inc’s order was huge in volume, quantity discount of Rs 200 per unit was offered to it.

Computation of Arm’s Length Price sold to A Inc.

Particulars INR INR
Price per unit in a Comparable Uncontrolled Transaction 4,800
Less: Adj for differences
  a) Freight and Insurance 700
  b) Estimated Warranty costs 500
  c) Discount for voluminous purchase 200 (1,400)
Arm’s length Price for goods sold to A Inc 3,400

Resale price Method

  • Identify the third party selling price for products purchased from Group Companies
  • Reduce the comparable uncontrolled GP Margin in similar products
  • Reduce the expenses incurred for procuring products/services
  • Adjust for functional and other differences, if any
  • The adjusted price is the ALP
How it works
Particulars Amount (Rs)
Selling price to third party 100
Arm’s length gross margin for similar product 10
Cost of Goods Sold 90
Costs in relation to procurement (Duties, freight, insurance etc.) 20
Arm’s length price – ALP (A) 70
Price charged by the related party (B) 65

In the above case, since price charged by the related party is lower than the ALP, the transaction is concluded to meet arm’s length standards.

Cost Plus Method

  • Identify direct and indirect costs of production for goods
  • Add uncontrolled normal GP mark-up
  • Adjust for functional and other differences, if any
  • The adjusted price is the ALP
How it works
Particulars Amount(Rs)
Direct cost of production 100
Indirect cost of production 50
Total cost of production 150
Arm’s length gross margin for similar product (say 20%) 30
Arm’s Length Price – ALP (A) 180
Price charged to the related party (B) 185

In the above case, since price charged to the related party is higher than the ALP, the transaction is concluded to meet arm’s length standards.

Profit Split Method

  • Determine combined NP for Group from international transactions
  • Evaluate relative contribution by each of the AEs based on the functions performed, assets employed and risks assumed.
  • Split the combined NP amongst the AEs proportionate to relative contributions
  • The apportioned portion of the profit is taken to compute ALP

Typically applied when both sides to the controlled transaction own valuable intangible property. (Eg. Patents, Trademarks, Trade names, etc.)

Practical application of this method is very difficult, especially the valuation of intangible and the remuneration for the intangible owned by each entity is very important.

How it works

AB Inc of Canada has received an order from a leading UK based Hospital for development of a hi-tech medical equipment which will integrate the best of software and latest medical examination tool to meet varied requirements. The order was for 2,50,000 Euros.

To execute the order, AB Inc joined hands with its subsidiary CD Inc of USA and EF Inc, an Indian Company. CD Inc holds 40% of EF Inc.

AB Inc paid to CD Inc and EF Inc Euro 70,000 and Euro 80,000 respectively and kept the balance for itself.

In the entire transaction, a profit of Euro 50,000 is earned. EF Inc incurred a total cost of Euro 75,000 in execution of its work in the above contract.

The relative contribution of AB, CD and EF may be taken at 35%, 25% and 40% respectively.

(A) Share of each of the Associates in the Combined Net profit of 50,000 Euros
Share of EF Inc (Contribution of 40%*50,000) 20,000
Share of CD Inc (Contribution of 25%*50,000) 12,500
Share of AB Inc (Contribution of 35%*50,000) 17,500
(B) Computation of Incremental Total Income of EF Inc.
Total Cost to Bioinformatics India Ltd 75,000
Add: Share in the Profit to BIL 20,000
Revenue of EF Inc on the basis of Arm’s Length Price 95,000
Less: Revenue actually received by EF Inc 80,000
Increase in Total Income of EF Inc 15,000

Transactional Net Margin Method

  • Compute net margin for;
    • costs incurred
    • sales effected
    • assets employed or
    • any other relevant base
  • Compare net margin realised from comparable uncontrolled transaction
  • Adjust for functional and other differences, if any
  • The net margin is to be taken to compute ALP

If more than one price is determined by the most appropriate method, ALP in relation to an International Transaction or Specified Domestic Transaction undertaken on or after 01.04.2014, shall be computed in the prescribed manner as per Rule 10CA.

Safe Harbour Rule refers to circumstances in which the IT Authorities shall accept the Transfer Price declared by the Assessee. (Sec.92CB)

ALP in other cases

ALP with respect to Intangibles

General Rule: The following rules shall apply between Associated Enterprises.

Transferor: ALP= Price at which a Comparable Independent Enterprise would be willing to transfer the property.

Transferee: ALP= Price that a Comparable Independent Enterprise would be prepared to pay, depending on the value and usefulness of the intangible property to the Transferee in its business.

ALP with respect to Intra-Group Services

It covers any activity provided to Group member with economic or commercial value, to enhance its commercial position, except performing activity for itself in-house.

Determination of ALP:

This involves examination of the actual arrangement between Associated Enterprises in order to determine amount charged for services.

  • Direct charge method: It charges Associated Enterprises a set of price for specific services.
  • Indirect charge method: The cost can be allocated and apportioned where Intra-Group charges are readily identifiable.

Consequences of Non-Compliance with Regulations

Section Act/Omission Consequence
92C(3) Use of Price other than ALP
Non-maintenance of info/documents
Unreliable/Incorrect information
Failure to furnish documents required u/s 92D
Determination of ALP by Assessing officer after giving Show Cause Notice to Assessee
271(1)(c) Addition to Income/Disallowance consequent to determination of ALP by AO Concealment Penalty:
Minimum=100%
Maximum=300% of tax evaded
271AA Failure to maintain documents u/s 92D (1) or 92D (2), Failure to report such transactions, or maintain or furnishing any incorrect information or document. Penalty at 2% on the value of each international transaction/specified domestic transaction
271G Failure to furnish documents/ information required by AO/CIT(A) u/s 92D (3)/TPO
271BA Failure to file report in Form No. 3CEB on or before due date Penalty of Rs. 1 lakh
272A(2)(a) Failure to comply with a notice issued u/s 94(6) regarding furnishing of information relating to securities Rs. 100/day of default

Case Laws

  1. SECTION 92B
    TRANSFER PRICING – INTERNATIONAL TRANSACTION
    Interest: Where transaction was otherwise capable of generating income but because related parties decided not to charge or pay to each other, basic character and nature of transaction would not change, thus, transaction of extending credit period to AE was to be regarded as an international transaction even if it did not give rise to any income – [2016] 73 taxmann.com 70 (Bangalore – Trib.)
  2. SECTION 92C
    TRANSFER PRICING – COMPUTATION OF ARM’S LENGTH PRICE
    Comparables and Adjustments/Adjustments – Interest: Extending credit period for realization of sales to AE was a closely linked transaction with transaction of providing services to AE and, therefore, could not be treated as an individual and separate transaction of advance or loan for determination of ALP – [2016] 73 taxmann.com 70 (Bangalore – Trib.)
  3. SECTION 194C
    DEDUCTION OF TAX – CONTRACTORS/SUB-CONTRACTORS, PAYMENTS TO;
    Transportation of LPG: A person, who transported LPG for assessee-LPG dealer without any accountability to assessee, was a contractor/sub-contractor having TDS liability under section 194C – [2016] 73 taxmann.com 72 (Kerala)Film-negative printing: Taking out prints of final negative of film does not involve any technical or professional service; TDS would be deducted under section 194C – [2016] 73 taxmann.com 73 (Mumbai – Trib.)

    Warehousing charges : Issue as to whether TDS from warehouse charges was to be deducted under section 194C or 194-I being a debatable one, penalty could not be imposed upon assessee under section 271C – [2016] 73 taxmann.com 71 (Delhi)

  4. SECTION 226
    COLLECTION AND RECOVERY OF TAX – OTHER MODES OF RECOVERY
    Jurisdictional Court: Where branch office located at Chennai had deducted TDS but it was remitted to New Delhi Office and assessed in Income-tax Office at New Delhi, there was no cause of action that arose for filing writ petition at Chennai – [2016] 73 taxmann.com 58 (Madras)
  5. SECTION 249
    COMMISSIONER (APPEALS) – FORM OF APPEAL AND LIMITATION
    Stay of demand: Petitioner-bank could not escape from its liability to deposit entire tax liability before admission of its appeal before Commissioner (Appeals) when it did not come within ambit and scope of Instruction No. 1914 – [2016] 73 taxmann.com 55 (Karnataka)

March 15, 2017

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