UNDERSTANDING TRANSFER PRICING WITH LATEST CASE LAWS:

UNDERSTANDING TRANSFER PRICING WITH LATEST CASE LAWS:

With the advent of MNCs(Multi National Concerns) trend has also been adopted by the MNCs to structure their investments and business strategy in such a way that profits are maximized in such jurisdictions where tax rates are low, which give rise to the emerging  problem of transfer pricing all over the world. Many countries have made laws to deal with the issue of transfer pricing. India has been a late enterant in making provisions under the Income Tax Act to tackle the issue of transfer pricing. Although there existed section 92 under Income tax Act 1961 but there were not relevant rules which could help tackle the issue of transfer pricing. Section 92A to 92F had been inserted to deal with transfer pricing by the Finance Act, 2001. Some views are expressed in this article as below explaining
provisions under the Income Tax Act 1961 dealing with transfer pricing. 

What is Transfer Pricing: Ussualy there is a tendancy among MNCs to adjust their international transactions in such a way that maximum profit arises in that country where the rate of tax is lowest and minimum profit arises in that country where the rate of tax is highest. This creates the problem of transfer pricing. Thus there may be chances that MNC  escape tax in those countries where the tax rate is more by adjusting their international transaction and declaring lesser profits in such country. This can be explained with an example: 

 Suppose a subsidiary company, resident in country A (which has a tax rate of, say, 30%) manufactures goods and transfers them to its parent company in country B (which has a tax rate of 20%) for trading. In order to increase the overall profits of the group company, it will seek to supply the goods at prices which are lower than the market price. So, in effect, the subsidiary company in country A will have lower profits and hence, a lower tax incidence whereas the parent company in country B is affected in the opposite manner higher profits due to low costs, but lower taxes because of the tax rate.

 Transfer pricing deals with the technique where parent companies sell goods and services to subsidiary entities at an inflated price to deliberately reduce profits and tax liability. The law requires that goods and services should be sold to subsidiary companies at arm's length price -- the price at which goods are traded between unconnected companies.  

In order to cover such tendencies of MNCs section 92A to 92F have been enacted  and section 271AA, 271BA and 271G have been incorporated and section 271 has been amended providing for penal provisions in this regard.

How the income from international transactions will be computed: As per section 92 any income from international transaction shall be computed as per arm’s length price. Any allowance of interest or expenses with respect to the above income shall also be computed having regard to arm’s length price.

Further where, in an international transaction, two or more associated enterprises enter into a mutual agreement for the allocation or apportionment of, or any contribution to, any cost or expense incurred or to be incurred in connection with a benefit, service or facility provided or to be provided or apportioned to or as the case may be, contributed by, any such enterprises shall be determined having regard to the arm’s length price of such benefit, service or facility, as the case may be.

In simple words it means that not only the income from an international transaction is to be computed as per arm’s length price but also any expense or cost to be incurred in an international transaction in conection with a benefit or service or facility to be provided will be computed as per arm’s length price.

Section 92 also provides that its provisions shall not apply where it has effect of reducing the income chargeable to tax or increasing the loss, as the case may be, computed on the basis of enteries made in the books of account in respect of the previous year in which the international transaction was entered into.

Now the question arises about the meaning of some of the concepts as mentioned above like International transactions, associated enterprises and arm’s length. These can be discussed as follows:

What is an International Transaction: To apply the provisions related to transfer pricing as contained u/s 92, 92A to 92F there must be an international transaction.

As per section 92B an international transaction means a transaction between two or more associated enterprises, either or both of whom are non-resident and such transaction is in the nature of purchase, sale or lease of tangible or intangible property or provision of services, or lending or borrowing money or any other transaction having a bearing on the profits, income, losses or assets of such associated enterprises.

International transaction shall also include a mutual agreement or arrangement between two or more associated enterprises for the allocation or apportionment of, or any contribution to, any cost or expense incurred or to be incurred in connection with a benefit, service or facility provided or to be provided to any of such associated enterprises.

Further section 92B provides that, where a transaction entered into by an enterprise with a person other than an associated enterprises and there exist a prior agreement in relation to the relevant transaction between such other person and associated enterprise, or the terms of the relevant transaction are determined in substance between such other person and the associated enterprises then such transaction shall also be treated as an international transaction.

What is associated Enterprises: To apply the provisions relating to transfer pricing there must also be associated enterprises. Which enterprises can be termed as associated enterprises can be known u/s 92B. As per section 92B(i) the associated enterprises in relation to another enterprise is:

(a)    which participates, directly or indirectly, or though one or more intermediateries, in the management or control or capital of other enterprise; or

(b)   in respect of which, one or more persons who participate directly or indirectly or through one or more intermediateres, in its management or control or capital, are the same persons who participate, directly or indirectly or through one or more intermediataries, in the management or control or capital of the other enterprise.

Two enterprises shall be deemed to be associated enterprises if, at any time during the previous year,-

(a)    One enterprise holds, directly or indirectly, shares carrying not less than 26 per-cent of the voting power in the other enterprise; or

(b)   Any person or enterprise holds, directly or indirectly, shares carrying not less than 26 per-cent of the voting power in each of such enterprises; or

(c)    A loan advanced by one enterprise to the other enterprise constitutes not less than 26 percent of the book value of the total assets of other enterprise; or

(d)   One enterprise guarantees not less than 10 per-cent of the total borrowings of the other enterprise; or

(e)    More than half of the board of directors or members of the governing board, or one or more of the executive directors or executive members of the governing board of one enterprise, are appointed by the other enterprise;

(f)     More than half of the board of directors or members of the governing board, or one or more of the executive directors or executive members of the governing board of each of the two enterprises  are appointed by the same person or persons; or

(g)    The manufacture or processing of goods or articles or business carried out by one enterprise is wholly dependent on the use of know-how, patents, copyrights, trademarks, licences, frenchises or any other business or commercial rights of similar nature, or any data, documentation, drawing or specification relating to any patent, invention, model, design, secret formula or process, of which the other enterprise is the owner or in respect of which the other enterprise is the owner or in respect of which the other enterprise has executive rights; or

(h)    90 per cent or more of the raw materials and consumables required for the manufacture or processing of goods or articles carried out by one enterprise, or by persons specified by the other enterprise, and the prices and other conditions relating to the supply are influenced by such other enterprise; or

(i)      the goods or articles manufactured or processed by one enterprise, are sold to the other enterprise or to persons specified by the other enterprise, and the prices and other conditions relating thereto are influenced by such other enterprise; or

(j)     where one enterprise is controlled by an individual, the other enterprise is also controlled by such individual or his relative or jointly by such individual and relative of such individual; or

(k)   where one enterprise is controlled by a Hindu undivided family, the other enterprise is also controlled by a member of such HUF or by a relative of a member of such HUF or jointly by such member and his relative; or

(l)      where one enterprise is a firm, association of persons or body of individuals, the other enterprise holds not less than 10 percent interest in such firm, association of person or body of individual.

(m)   There exists between the two enterprises, any relationship of mutual interest, as may be prescribed.

What is arm’s length price: As stated above the income from an international transaction is computed as per arm’s length price. Arm’s length price has been defined in section 92F(ii) as a price which is applied or proposed to be applied in a transaction between persons other than associated enterprises, in uncontrolled conditions.

The arm’s length principle suggests that the associated enterprises should be treated as independent enterprises and international transaction is considered at the market price.

As per section 92C the arm’s length price in relation to an international transaction shall be determined by any of the prescribed methods discussed as below:

Comparable Uncontrolled Prices method (CUP): Under this method, price charged in an uncontrolled transaction between comparable entities is identified and compared with the tested entity price (after making due adjustments in relation to terms and conditions and risk involved) to determine the ALP.

Cost Plus Method (CPM): Here, the total cost of production incurred by the enterprise in question in transferring goods and services to Associated Enterprises (AEs) is calculated and the total gross profit mark up used by comparable entities in similar transactions with independent enterprises is determined. The total gross mark-up arrived at is adjusted to take into account functional and other differences and is added to the costs calculated to determine ALP.

Resale Price Method (RPM): Under this method the price at which property or services in question are resold or provided to an unrelated enterprise is identified. Such resale price is reduced by the normal gross profit accruing to an enterprise in a comparable incontrolled transaction.

Profit Split Method (PSM): PSM is used when AEs transactions are so integrated that it becomes impossible to conduct a TP analysis on a transactional basis. First, the combined net profit incurring to related enterprises from a transaction is determined. Then, the combined net profit is allocated between related enterprises with reference to market returns achieved by independent entities in similar transactions. The relative contribution of related parties is then evaluated on the basis of assets employed, functions performed or to be performed and risk assumed.

Transactional Net Margin Method (TNMM): TNMM is normally adopted in cases of transfer of semi-finished goods, distribution of finished products (where resale price method (RPM) cannot be adequately applied) and transactions involving the provision of services. TNMM compares the net profit margin relative to an appropriate base (sales, assets or costs incurred) of the tested party with net profit margin of the independent enterprises in similar transactions after making adjustments

Any other method as may be prescribed by the Board

The most appropriate method of all the above methods should be applied in determining arm’s length price depending upon various factors like nature of transaction availability of information etc.

Where more than one price is determined by the most appropriate method, the arm’s length price shall be taken to be the airthmatical mean of such prices.

Actual price at which international transaction has been undertaken shall be accepted where the variation with the arm’s length price doesnot exceed 5 percent.

Section 92CB provides that w.r.ef asst. year 2009-10 Income tax authorities will accept the transfer price declared by the assessee provided they are in accordance with the Safe Harbour Rules to be notified by CBDT. safe Harbour means circumstances in which the income tax authorities shall accept the transfer price declared by the assessee.

When the assessing officer can determine arm’s length price: As per section 92C(3)

Where during the course of any proceeding for the assessment of income, the Assessing Officer is, on the basis of material or information or document in his possession, of the opinion that—

          (a)  the price charged or paid in an international transaction has not been determined in accordance with the prescribed manner; or

          (b)  any information and document relating to an international transaction have not been kept and maintained by the assessee in accordance with the provisions contained in sub-section (1) of section 92D and the rules made in this behalf; or

           (c)  the information or data used in computation of the arm’s length price is not reliable or correct; or

          (d)  the assessee has failed to furnish, within the specified time, any information or document which he was required to furnish by a notice issued under sub-section (3) of section 92D,

the Assessing Officer may proceed to determine the arm’s length price in relation to the said international transaction on the basis of the information or material available.

Procedure to be followed by the assessing officer while determining arm’s length price: Proviso to section 92C(3) provides that an opportunity shall be given by the Assessing Officer by serving a notice calling upon the assessee to show cause, on a date and time to be specified in the notice, why the arm’s length price should not be so determined on the basis of material or information or document in the possession of the Assessing Officer.

The Finance Act 2002 has inserted a new section 92CA according to which in case of international transaction, the A.O may refer the matter to Transfer Pricing officer, if he considers it necessary or expedient to do so, with the prior approval of commissioner, for the purpose of computing arm’s length price.

The following procedure will be followed by TPO while determining ALP:

(1) Where a reference is made to the TPO, the Transfer Pricing Officer shall serve a notice on the assessee requiring him to produce or cause to be produced on a date to be specified therein, any evidence on which the assessee may rely in support of the computation made by him of the arm’s length price in relation to the international transaction in question.

(2) On the date specified in the notice , or as soon thereafter as may be, after hearing such evidence as the assessee may produce, including any information or documents referred to in sub-section (3) of section 92D and after considering such evidence as the Transfer Pricing Officer may require on any specified points and after taking into account all relevant materials which he has gathered, the Transfer Pricing Officer shall, by order in writing, determine the arm’s length price in relation to the international transaction and send a copy of his order to the Assessing Officer and to the assessee.

(3) On receipt of the order under from TPO, the Assessing Officer shall proceed to compute the total income of the assessee  in conformity with the arm’s length price as so determined by the Transfer Pricing Officer.

The obligations of an assessee having international transactions: The obligation of an assessee having international transaction are as follows:

(1)   The income from the international transaction should be computed as per arm’s length price

(2)   Every person who has entered into an international transaction shall keep and maintain such information and document in respect thereof and for such period, as may be prescribed by the board and produce before the A.O or commissioner (Appeals) as and when required in the cource of proceedings under Income Tax Act within a period of 30 days from the date of receipt of notice.

(3)   The assessee entering into an international transaction is also required to firnish an audit report in the form 3CEB by a chartered accountant by 31st of October of relevant A.Y where the assessee is a company and by 31st day of july in other cases.

 Penal provisions: As per section 271AA if the required information and documents are not maintained, the A.O or CIT(A0 may impose a penalty of a sum equal to 2% of the value of such international transaction. Similar penalty is provided u/s 271G if the assessee fails to furnish the documents requisitioned by the A.O or CIT(a).

Section 271BA provides that if an assessee fails to furnish the report of Chatered accountant as required u/s 92E, the A.O may impose penalty of Rs 1 Lakh.

Explanation 7 to section 271(1)(c)  provides thatwhere in the case of an assessee who has entered into an international transaction defined in section 92B, any amount is added or disallowed in computing the total income under section 92C(4) then, the amount so added or disallowed shall, for the purpose of section 271(1)(c) , be deemed to represent the income in respect of which particulars have been concealed or inaccurate particulars have been furnished.

However the explanation doesnot apply where the assessee proves to the satisfaction of the A.O or the CIT that the price charged or paid in such transaction has been determined in accordance with section 92C in good faith and with due diligence.

As per section 273B no penalty will be levied u/s 271AA, 271BA, 271G where it is proved that there was a reasonable cause for the failure.

There are number of judgments coming everyday and below given summary of some of the important judgments during last one year.

01.  Data of the rate charged to unrelated parties should be available.

01. Transfer Pricing provisions are not attracted in the case of transfer of the shares of the company when due to DTAA provisions, capital gain on such shares are not taxable.

02. TNM method requires comparison of net profit margins realized by an enterprise from an international transaction and not comparison of operating margins of enterprises as a whole.

03. The assessee can appeal before DRP in case he is not satisfied with the order of TPO.

04. The comparison study must be done with same countries as different countries have different economic & political situation.

05.  In view of parameters prescribed in Rule 10B, bad debt written off cannot be a factor to determine arm’s length price of any international transaction.

06. RBI's Approval does not put a seal of approval on true character of a Transaction from perspective of transfer pricing regulation

07. Before passing the order, the TPO must provide personal hearing to the assessee.

08. Chapter X dealing with Transfer Pricing is constitutionally valid.

09. The TPO can change the process of determining the ALP on the ground that process selected was complex .

10.  Notional interest on interest-free loans can be assessed under transfer pricing law.

11. For determination of ALP under TNMM assessee was justified in taking profit level indicator of comparable companies as operating cash profits without taking into consideration, exclusion of depreciation was justified to eliminate difference in technology used, age of assets used in  production, differences in capacity utilization and different depreciation policies adopted by various companies.

12. Merely because a comparable is making loss, same cannot be excluded from the TP comparison .

13. TPO can reject the price computed by the assessee, if they found that data provided by assessee are unrealistic.

14.  Transfer Pricing TNMM must be applied to transaction margins and not to enterprise level margins. Adjustments must be confined to international transactions

15.  It is Mandatory for assessee to follow one of prescribed methods and demonstrate that International transactions entered into by it with an associated enterprise are at arms length price

16.  Where the supervisory activity of each project of the assessee company was for less than 75 days, the income from the supervision and installation of the plant cannot be treated as income of the PE

17. A reference made by AO to TOP on matters of ALP is not to be made in piece Meal Manner.

18. For determining the ALP of international transactions with AEs the TPO should work out the profit disclosed by the assessee on those receipts and compare the result with the comparables of independent cases, and in that exercise the domestic receipts are to be excluded for working out profit level indicator shown by the assessee in respect of the international transactions.

19. Data for comparison to be data relating to year in which international transaction entered into

20. Comparables of extreme cases both on higher side and lower side to be avoided. Foreign exchange fluctuations cannot be excluded. Income tax refund cannot be included. Donations to be included. Compensation for termination of agreement to purchase property to be excluded. Shifting from one process to another in selection process permissible.

21.  Overdue Debt Attracts Notional Interest / Assessee company having an AE in USA, entered into a product development services agreement and a professional services agreement, both separately, with its said AE. Assessing Officer made  reference under section 92C to TPO. TPO has accepted prices in respect of transaction entered into between assessee and its AE as ALP compatible. However, TPO noticed that an amount of Rs. 5.52 crores belonging to assessee was outstanding for more than six months. She opined that by parking this huge
amount at disposal of its AE, assessee was depriving funds otherwise available in its hands and adversely affecting its profitability. TPO has calculated interest on aforesaid amount and recommended Assessing Officer to add interest in assesses’s taxable income. Assessing Officer made additions. Tribunal upheld
the addition made by the Assessing Officer

22.  For transfer pricing analysis internal comparables are preferable over external comparables. While applying TNMM, only profits related to the transaction with AEs should be compared and not profits of the company as a whole.

23. Rule 10C requires the “most appropriate” method to be chosen from amongst those specified. The exercise of selecting the “most appropriate” method implies that the appropriateness of method is to be ranked in some order. Accordingly, it is open to the TPO to reject the TNMM and adopt the CUP method on the basis that the latter is “most appropriate” on the facts of the case.

24.  When an assessee company works in a risk mitigated environment. TPO cannot select extreme cases as comparable cost examine the ALP of the assessee under TNM methods

25. In case international transactions have demonstratively booted profits of a assessee, it is obvious that transaction are at Arm Length & no adjustment are called for in Operating Margin of Assessee

26.  A continuing debit balance per se, in account of associated enterprise does not amount to an international transaction under section 92B in respect of which ALP adjustment can be made

27. An assessee is not entitled to concession, as prescribed in provision to section 92 C(2) when only one price (ALP) has been determined by TPO under most appropriate method

28. Where only one price has been determined under “most appropriate method” for evaluation of ALP, the question of application of proviso to section 92C(2) does not arise, therefore, assessee was not entitled to the concession of 5 percent as prescribed in the said proviso.

29. Unless the functional profiles of assessee company are examined minutely and in detail, it is very difficult to say that the assessee is engaged in the business of software development as decided by TPO and not in the business of rendering support in respect of engineering designs and drawings as claimed by the assessee.

30. Payment received by the assessee company from its AE / parent company was in the nature of reimbursement of incentives paid to the employees of the assessee and it did not have any element of income and therefore, no adjustment could be made in the computation of ALP by notionally imputing a mark up on that amount, more so when no such adjustment has been made in the earlier or subsequent years wherein also similar incentives were paid and the facts were identical.

31. Choice of method of determination of ALP is not an unaffected choice on the part of the tax payer and this choice has to be exercised on the touch stone of principles governing selection of most appropriate method set out in section 92C(1). Where the Assessing Officer finds that selection of most appropriate method is not correct, he has the powers as well as corresponding duty to select the most appropriate method and compute the ALP by applying that method.

32. In case of assessee engaged in trading of goods without any value addition, resale price method is the most appropriate method for determining the ALP with respect to AE Transaction

33.  Lack of segmental reporting for reason that transaction with AES & non AES belong to same item of software related services cannot be made a basis for rejecting assessee method of computing ARMs Length price by way of internal comparison made between transaction with AES and unrelated parties

34. Additional evidence for TP study provided by assessee to be admitted

35. For Transfer pricing adjustment, assessee should take same class of transaction for comparing profit with comparables

36. Under Chapter X of the Income Tax Act, 1961, the determination of the arm’s length price of an international transaction has to be only at the transaction level or at a class of transactions. The law does not permit determination of the arm’s length price of international transactions, by comparing margins at entry level or by taking overall industry level averages.

37. Bad debts written off cannot be factor to determine the arm’s length price of any international transaction. The Transfer Pricing Officer had exceeded his limits in following a method not authorized under the Act or Rules.

38. The report of the TPO is not binding on the Assessing Officer. Assessing Officer can refer the matter to the TPO for determination ALP of an International taxation transaction or he may determine it on his own. AO can determine the price of imports of his own. New proviso to section 92C(2) came in to operation from asst year 2009-10 and therefore, did not apply to asst year 2003-04, further, where only one price is determined in the matter of ALP, the option of five percent under proviso to section 92C(2) is not available to the assessee.

39. Inclusion of non-operating income and non - exclusion of the non -operating expenses would definitely affect net margin of operating profits of comparable company

40. Sec 92C(2) specifies that adjustment of 5 percent is not applicable if a single price is determined by assessee

The above summary are based on the decisions of case laws on Transfer Pricing by various Tribunals & High Courts of India.  There may be cases where facts of one case is being similar to other case . In case you required the full facts of any of the above particular judgment, please mail me at mr_manish_ca@yahoo.com.