Introduction
1. Transactions globally are increasingly between 'related persons' or 'associated enterprises'. Such transactions account for a significant component of global trade. Transactions between Multi National Enterprises ('MNE's) are estimated to account for about 60% of global trade as per the UNCTAD report of 1995.2 Post-liberalization of the Indian economy in 1991 and as a consequence of rapid globalization, there has been a significant inflow of Foreign Direct Investment (FDI) into India accompanied by a manifold increase in transactions between 'related persons' or 'associated enterprises'. Relevant to the levy and collection of direct and indirect taxes in India, the Transfer pricing regulations in the context of direct taxes and the Customs Valuation provisions in the context of indirect taxes have a bearing on such 'related person'/'associated enterprise' transactions, especially where an Indian entity and a foreign entity are involved. While the broader purpose of both the regulations in question is to arrive at an appropriate arm's length price/fair value for the levy of income-tax under the Income Tax Act, 1961 ('the IT Act') and customs duty under the Customs Act, 1962 ('the CA'), the higher the assessable value in India of goods imported the greater the customs duty which can be realized, and, lower the assessable import value, the greater will be the profit realization in India which can be subject to income-tax. Both, Transfer Pricing and Customs Valuation, significantly influence the level and quantum of taxes which the Central Government in the Indian context can collect.
Given this background, this article seeks to primarily discuss and analyze the following issues:
(i) Scope of the Customs Valuation and Transfer Pricing Regulations in India;
(ii) Similarities and differences between the two legislations;
(iii) International thought and practice on harmonization between Customs Valuation and Transfer Pricing; and
(iv) Harmonization of Customs Valuation and Transfer Pricing Regulations in the Indian context.
Customs valuation -scope of legislation in India
2. The levy of basic customs duty in India is in terms of section 12 of the CA. Section 14 of the CA, which deals with the valuation of goods, provides that the value of the imported goods and exported goods shall be the transaction value of such goods, that is, the price actually paid or payable for the goods when sold for export to India for delivery at the time and place of importation, or as the case may be, for export from India for delivery at the time and place of exportation, where the buyer and the seller of the goods are not related and price is the sole consideration for the sale, subject to such other conditions as specified in the Customs Valuation (Determination of Price of Imported Goods) Rules, 2007 (CVR, 2007) and the Customs Valuation (Determination of Price of Exported Goods) Rules, 2007 [CVR (Export), 2007]. The Indian Customs Valuation Rules are modelled on Article VII of the General Agreement on Trade and Tariffs (GATT). The CA and the CVR, 2007/CVR (Export), 2007 are concerned only with the importation of the goods into India and the exportation of goods outside India. They do not deal with service activities in any manner, except in certain limited instances where the value paid for certain services which are integrally connected with the imported goods is to be added back to the assessable value of the imported goods for customs purposes.3
Under the CVR, 2007, persons are deemed to be related in the circumstances set out in Rule 2(2) therein.4 In a situation, where the 'buyer' and 'seller' are related persons, the transaction value shall be accepted provided that the examination of the circumstances of the sale of the imported goods indicates that the relationship did not influence the price.5 In a sale between 'related persons', the transaction value shall be accepted, whenever the importer demonstrates that the declared value of the goods being valued, closely approximates to one of the following values ascertained at or about the same time:
(i) the transaction value of identical goods, or of similar goods, in sales to unrelated buyers in India;
(ii) the deductive value for identical goods or similar goods; and
(iii) the computed value for identical goods or similar goods.6
In this context it is also to be noted that the hierarchy of the methodologies7 to be adopted under the CVR, 2007 to arrive at the appropriate assessable value of the imported goods is as under:
(i) the transaction value of identical goods;
(ii) the transaction value of similar goods;
(iii) deductive value for identical goods or similar goods;
(iv) the computed value for identical goods or similar goods; and
(v) the residual method.
The CVR, 2007 which was introduced on 10th October, 2007 was preceded by the Customs Valuation Rules, 1988 which contained similar provisions. Section 14 of the CA was also amended w.e.f. 10th October, 2007.
Transactions involving import of goods between 'related persons' are normally investigated by a specialized institution referred to as the Special Valuation Branch (SVB). Most MNE's operating in India, who import goods, from 'related persons' as defined under Rule 2(2) of the CVR, 2007 and as per normal practice, the assessable value of such imports is subject to determination by the SVB. The SVBs are located only at four Custom Houses, i.e., at Chennai, Calcutta, Delhi and Mumbai and the investigation of imports is normally handled by the SVB which is most proximate to the head or corporate office of the importer, or as requested by the importer. There is no specific statutory provision under the CA to which the formation of SVB's can be traced, and the functions and the manner of working of the SVBs are only prescribed in Circulars issued by the Central Board of Excise and Customs ('CBEC').8
An order issued by the SVB as a matter of practice is followed by Customs authorities throughout India and an SVB Order is valid for a period of three years, post which the same is to be reviewed once again by the concerned SVB authority passing the Order.
Transfer pricing -scope of legislation
3. Transfer pricing in essence deals with the determination of price and other conditions as regards the transfer of goods, services and assets between affiliated companies situated in different tax jurisdictions. Transfer pricing influences the level and quantum of taxes which governments in different jurisdictions collect. The transfer price in cross border transactions constitutes the base value for determining the assessable value on which customs duty is payable as well as the level of taxable profits which an entity will make. Transfer pricing in essence determines the amount of income which each party earns and the amount of income-tax that is due, both in the country of export as well as the country of import.9 Revenue administrations world over are concerned with transfer pricing as it influences the level of both direct and indirect taxes. A higher transfer price reduces the income-tax liability whereas a lower transfer price reduces the customs duty liability.
Transfer pricing is grounded in Article 9 of the OECD and the UN Model Tax conventions which seeks to establish the arm's length principle. All cross-border commercial and financial transactions between 'associated enterprises' (goods, services, intangibles and financial transactions) are within the scope of transfer pricing. There are also transfer pricing issues for attributing profits to permanent establishments (i.e., between various parts of a single entity situated in different tax jurisdictions).10
In other words, the transactions between two related parties must be based on Arm's Length Principles ('ALP'). The term ALP itself is not a term specifically used in Article 9 but is well accepted by countries as encapsulating the principles taken in Article 9, with some differing interpretations as to what this means in practice. Consequently, the ALP is the accepted guideline at present in determining an acceptable "transfer price". The ALP is in itself not a new concept and has its origins in Contract law to arrange an equitable arrangement that will stand up to legal scrutiny, even though the parties involved may have shared interests.11
In the context of this article, it is of significance to note that transfer pricing also covers intangibles which are broadly divided into 'trade intangibles' and 'marketing intangibles'. Trade intangibles such as know-how relate to the production of goods and the provision of services, and are typically developed through research and development. Marketing intangibles refer to intangibles such as trade names, trade marks and client lists that aid in the commercial exploitation of a product or service. The concept of ALP often becomes difficult to apply to intangibles due to lack of suitable comparables. For example, Intellectual property gains its significance and value from its distinctiveness and uniqueness rather than from its similarity to other products.
In India, the transfer pricing provisions and guidelines are provided for in the IT Act and the rules thereunder. The IT Act was amended in the Finance Act, 2001, to incorporate suitable provisions in sections 92 to 92 F, so as to regulate Transfer Pricing. These were broadly based on the OECD guidelines. Supplementary provisions in the Income Tax Rules were incorporated to prescribe the procedures on Transfer Pricing controls.12
A summary of these legal provisions is given below:
| Section | What it provides |
| 92 | Computation of Income from International transactions involving transfer pricing having regard to ''Arm's length price'' |
| 92A | Meaning of ''Associated Enterprise'' |
| 92B | Meaning of ''International Transaction'' |
| 92C | Computation of ''Arm's Length Price'' |
| 92CA | Reference to Transfer Pricing Officer |
| 92CB | Power to make Safe Harbour Rules |
| 92D | Maintenance of Documents and Information |
| 92E | Requirement of Audit Report |
| 92F | Important Definitions. |
| 271(1)(C) | Adjustment to income on account of Transfer Pricing Provisions to be regarded as concealed Income. |
| 271AA | Penalty for failure to keep and maintain information and documents |
| 271BA | Penalty for failure to furnish Audit Report |
| 271G | Penalty for failure to furnish information or documents |
| Rules | |
| 10A | Meaning of expression used in computation of ''Arm's Length Price'' |
| 10B | Determination of ''Arm's Length Price' under section 92C |
| 10C | Most Appropriate Method |
| 10D | Information and Documents to be kept and maintained under section 92D |
| 10E | Report from an Accountant to be furnished under section 92E |
The transfer pricing regulations follow the ALP for determination of international transaction between associated enterprises. Section 92(1) provides that any income arising from an international transaction shall be computed having regard to ALP. A transaction is regarded to be made at ALP if it is between persons or entities which are not influenced by any special relationship. The ALP for an international transaction is determined by any of the following methods:
(i) Comparable uncontrolled price (CUP) method;
(i) Resale price method;
(iii) Cost plus method;
(iv) Profit split method; or
(v) Transactional net margin method (TNMM).
The concept of arithmetic mean is unique to the Indian Transfer Pricing regulations. The proviso to section 92C(2) provides that where more than one price is determined by the most appropriate method, the arm's length price shall be taken to be the arithimetical mean of such prices or, a price that may be taken to be the arithimetical mean of such prices or, a price that may vary from the arithimethical mean by an amount not exceeding 5 per cent of such arithimethical mean. However, the principle of averaging is not followed when different prices are obtained under different methods prescribed in law.13
As far as India is concerned domestic transactions are not covered by Transfer Pricing regulations enshrined in section 92 to 92F of the IT Act. The domestic related party transactions are dealt in section 40A(2) of the IT Act. Countries like the USA do not draw any distinctions between domestic and international transactions, and transfer pricing guidelines are equally applicable to both nature of transactions.
The essential concomitants of transfer pricing are that the:
(i) transaction in question should be between 'associated enterprises'; and
(ii) the transaction in question should be an 'international transaction'.
An international transaction is essentially a cross-border transaction between 'associated enterprises' in any sort of property, whether tangible or intangible, or in the provision of services or borrowing or lending of money, or any other transaction having a bearing on the profits, income, losses or assets of such enterprise, and shall include a mutual agreement or an arrangement between two or more associated enterprises for the allocation or apportionment of 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 one or more of such associated enterprises. The important condition is that either both or at least one party to the transaction must be a non-resident. The concept also applies to a transaction between two non-residents, where, for example, one of them has a permanent establishment whose income is taxable in India.
The Income Tax Rules14 contain exhaustive rules regarding the nature of information and documentation which are required to be maintained by the assessee including the following information:
• Ownership structure of the taxpayer's enterprise;
• Profile of the multinational group;
• Record of the economic market analysis;
• Broad description of the business of the assessee and the associated enterprises with whom the assessee has transacted;
• Details of property transferred or services and quantum, and value of each transaction;
• Description of functions performed; risks assumed, and assets employed in the international transaction;
• Details of the adjustments made to transfer prices to align them with arm's length price;
• Forecasts and budgets prepared by the taxpayer; and
• Record of uncontrolled transactions taken into account in analyzing the comparability of the international transactions entered into.
Similarities and differences between the two legislations
4. Customs duty is based on the event of importation and is assessed upon the filing of a bill of entry for home consumption, whereas transfer pricing assessments take place two to three years after the economic event has occurred. In India, while the transfer pricing guidelines are administered by the Central Board of Direct Taxes (CBDT), the CBEC administers the levy and collection of Customs duty and valuation of goods for the purposes of Customs. Both authorities, however, are administratively a part of the Department of Revenue, Ministry of Finance. It is noteworthy, that both direct and indirect taxes in India were commonly administered by the Central Board of Revenue until 1963, when the two separate board(s) - CBDT and CBEC were separately constituted under the Central Board of Revenue Act, 1963.
The essential distinctions between the scope and purpose of the Customs Valuation regulations and the Transfer Pricing guidelines are discussed below:
| Transfer pricing | Customs Valuation |
| Deals with goods, services, intangibles as well as other transactions like lending or borrowing of money, etc. |
Deals only with goods.
In certain specified cases, there are additions prescribed under the CVR, 2007 for the value of costs and services which are normally paid as a condition of sale of the imported goods, but such additions made are only to the value of goods.
The valuation of services is separately dealt with under the Finance Act, 1994 ('law relating to Service tax') and the rules framed thereunder, which is an altogether distinct legislation.
|
| The lesser the transfer price to India, the greater retention of profit in India and higher the net realization of direct taxes in India. | The higher the import price into India ('transfer price'), the greater the realization of customs duty ('import duty') in India. |
Treated as a direct tax; assessment of tax is for a financial period ('assessment year').
The adjustments are made at the "Aggregate Profit Level".
|
Treated as an indirect tax, normally re-imbursed by the buyer and customs duty is payable in the event of import into or export from India.
The adjustments are made at the individual transaction level.
|
| Applies only to international transactions between associated enterprises. | Applies in certain cases even to transactions between "unrelated parties" Example: case of undervaluation, addition for royalties, etc. |
| There is no statutory prescription of the priority of methods to be followed. | The hierarchy of methods to be followed is prescribed under the Customs Valuation Rules. |
| A deviation of 5% from the ALP is permissible. | No such deviation is permissible. |
| Extensive documentation requirements exist for transfer pricing, such as the requirement of an accountant's report in Form 3CEB which is issued after examination of the accounts and records of the assessee. | No such extensive documentation requirements exist under the Custom Valuation Rules. |
| Administered by the CBDT which functions under the aegis of the Ministry of Finance. | Administered by the CBEC which functions under the aegis of the Ministry of Finance. |
A summary of the transfer pricing methodology adopted in the Indian context and the approximately comparable methodology under the Indian Customs Valuation Rules is tabulated hereunder:
| Transfer pricing | Customs Valuation |
Comparable uncontrolled price method ('CUP').
The CUP method compares the price charged for a property or service in a controlled transaction to the price charged for a property or service in a comparable uncontrolled transaction in comparable circumstances.
|
Transaction value of identical goods/similar goods in sales to unrelated persons.
There is a hierarchical preference for the transaction value of identical goods under the Customs Valuation Rules in comparison to the transaction value of similar goods.
These rules in essence refer to comparison of price of goods which are alike in all respects or are commercially inter-changeable and are imported at the same commercial level, comparable quantities and at or about the same time as the goods.
|
Resale price method ('RPM').
The RPM is used to determine the price to be paid by a reseller for a product purchased from an associated enterprise and resold to an independent enterprise. The purchase price is set so that the margin earned by the re-seller is sufficient to allow it to cover its selling and operating expenses and retain its profit margin.
|
Deductive value.
From the resale price of the goods imported, similar goods or identical goods to unrelated buyers in India, the commission paid/profit and general expenses, costs of transportation, insurance, associated costs, customs and other taxes payable by reason of importation or sale of the goods in question are deducted to arrive at the deductive value.
|
Cost plus method ('CPM').
The CPM is used to determine the appropriate price to be charged by a supplier of property or services to its related purchaser. The same is arrived at by adding to the costs of the supplier, a gross margin, so that the supplier will make an adequate profit in light of market conditions for the functions he or she has performed.
|
Computed value.
This is in essence a cost plus method to compute the cost price of the supplier which will include an element of profit.
|
Profit split method ('PSM')
Transactional net margin method ('TNMM') or any other method as prescribed by CBDT
These methods seek to compare the level of profits that would have resulted from controlled transactions with the returns realized by the comparable independent enterprise.
|
Residual method.
Under this method, the value is determined by using reasonable means consistent with the principles and general provisions of the Valuation Rules and on the basis of data available in India.
|
International practice as well as harmonization between Customs Valuation and Transfer Pricing
5. Income Tax and Customs officials proceed independently to establish arm's length valuations in related-party import transactions. This may lead to different results which may be far from reality. Legislative action and agency cooperation should create an environment in which the Income-tax and Customs authorities can coordinate for import valuations as a unified force. In USA, section 1059A of the Internal Revenue Code has been introduced to prevent a U.S. importer from jeopardizing the government's revenue by valuing merchandise inconsistently for customs and income-tax purposes. Under section 1059A, importers are not permitted from declaring a transfer price that exceeds the value declared for Customs valuation purposes subject to certain exceptions.15
In USA, the IRS and Customs have executed a document entitled "Working Arrangement for Mutual Assistance and Exchange of Information Between the U.S. Department of the Treasury, U.S. Customs Service and the Internal Revenue Service Regarding International Compliance and Importation issues" (the 'Mutual Assistance Agreement') that is designed to facilitate communication and cooperation between the agencies.
It has for long been the concern of MNE's that it is difficult to satisfy the different and at times inconsistent requirements of the Customs and Transfer Pricing authorities. Attempting to balance the two tax regimes is a time and resource consuming hassle for MNEs and, consequently, results in more time being spent on tax planning/tax compliance, thereby adversely affecting the productivity of business. Their basic concern is that different rules and standards, as applied by the two departments, and the absence of coordinated efforts could also lead to double taxation that might create barriers to trade and investment.
The OECD and the World Customs Organization ('WCO') have jointly hosted two conferences on "Transfer Pricing and Customs Valuation" in 2006 and 2007, with a view to promote understanding and co-ordination between Customs and Transfer pricing authorities world over. At the conferences, it was noted that between customs valuation and transfer pricing, common features and similarities exist, but there are also significant divergences. Two schools of thought emerged at the end of the second conference on the future relationship between customs valuation methods and transfer pricing rules - One which thought that convergence of transfer pricing and customs was desirable and possible and the other which was more cautious. There was a general view on the necessity of finding a way out for improving consistency and certainty between transfer pricing and customs valuation. Some major recommendations which were put forth at the end of the conference were as under:
• Need to continuously encourage dialogue between customs administrations, tax authorities and the business community, possibly by establishing a mechanism for liaison.
• Comprehensive approach between customs administrations and tax authorities to facilitate better understanding between the two role-players.
• Explore the possibilities of a joint approach to audit, compliance and advanced pricing agreements as a means to enhance cooperation and coordination between customs administrations and tax authorities.16
The recent OECD Revision of Chapters I-III of the Transfer Pricing Guidelines, Review of Comparability and of profit methods17, inter alia, discusses the use of customs valuations methods in the context of transfer pricing and states that valuation methods for customs may not be aligned fully with the OECD's recognized transfer pricing principles. However, the customs valuation may be useful to tax administrations in evaluating the arm's length character of a controlled transaction transfer price and vice versa. In particular, customs officials may have contemporaneous information regarding the transaction that could be relevant for transfer pricing purposes, especially if prepared by the taxpayer, while tax authorities may have transfer pricing documentation which provides detailed information on the circumstances of the transaction.
The World Customs Organization18 has recently sought to provide guidance on the use of transfer pricing guidelines prepared in accordance with the OECD Guidelines, and provided by importers as a basis for examining the 'circumstances surrounding the sale' under Article 1.2(a) of the GATT Valuation Agreement.19 The commentary states on the one hand that the transfer pricing study submitted by an importer may be a good source of information, if it contains relevant information regarding the circumstances surrounding the sale; On the other hand, a transfer pricing study may not be relevant or adequate in examining the circumstances surrounding the sale because of the substantial and significant differences which exist between the methods prescribed in the GATT Valuation Agreement and that prescribed in the OECD Transfer Pricing Guidelines. Accordingly, the use of a transfer pricing study as a possible basis for examining the circumstances of the sale should be considered on a case by case basis. As a conclusion, any relevant information and documents provided by an importer may be utilized for examining the circumstances of the sale. A transfer pricing study could be one source of information.
Harmonization of Customs Valuation and Transfer Pricing Regulations in the Indian context
6. The benefits of a rational and consistent tax policy in promoting growth and long-term sustainability of businesses are well precedented. If India is to offer a more sustainable and holistic growth environment for business and industry, there arises an imminent need for a harmonized environment encompassing both regulations-Customs Valuation and Transfer Pricing. It would, therefore, be desirable to have a coordinated approach to valuation of imported goods in cases involving transfer pricing so that the same price is adopted for both purposes after necessary verification for authenticity. It is also not conceivable that in respect of the same goods there can be two ALP's under two different statutes.
A Joint Working Group (JWG) comprising of senior officers from Income Tax and Customs Departments was constituted to study the subject of Transfer Pricing (Price adjusted in Related Party Transactions) in the context of Income Tax and Customs laws and the substantive recommendations of the JWG which were made in May, 2007 are as under:
• Co-operation and co-ordination between the Customs and Income tax Departments on this issue is absolutely essential;
• Need to have separate training for officers of the Customs Department and Transfer Pricing Department;
• Nodal officers to be appointed at the four metros- Calcutta, Chennai, Delhi and Mumbai for the sharing of information.20
The Directorate of Valuation (under the CBEC), has also considered the issue of co-ordination between customs valuation and transfer pricing, and has also suggested the need for further discussions on the following issues:
• Legal and procedural changes for effective handling of transfer pricing on the customs side;
• Mechansim for co-ordination of transfer pricing work within the Customs Department; and
• Integration of SVB's and transfer pricing work.21
The Tax Departments in India have also expressed a need to harmonize the Income Tax Department and the Customs Department's approaches in India.
The trend which is emerging both globally and in India is a move towards harmonization of Customs and Transfer Pricing. In fact, in some nations and the European Union, the discussion is on convergence on Transfer pricing, Customs and VAT. In the context of customs valuation, the tax tribunal in India22 way back in 2005 itself has made references to the broad principles relating to the convergence of Customs Valuation and Transfer Pricing which now find place in WCO Commentary 23.1.
While the divergences between the interest of the authorities as well as the purposes of Customs Valuation regulations and Transfer Pricing guidelines have been the subject matter of much debate and discussion, it is only fair that the same goods are valued by the same standard under two or more statutes. Not only is such harmonization desirable but is also imminent.
Thus, in the view of the author, the relevant question in the Indian context is not "if such harmonization of customs and transfer pricing is possible" but rather is "when will such harmonization of customs and transfer pricing be made possible?".
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1. The author can be contacted at karthiksundaram@gmail.com.
2. UNCTAD World Investment Report - 1995.
3. See Rule 10 of the CVR, 2007.
4. (2) For the purpose of these rules, persons shall be deemed to be "related" only if -
(i) they are officers or directors of one another's businesses;
(ii) they are legally recognised partners in business;
(iii) they are employer and employee;
(iv) any person directly or indirectly owns, controls or holds five per cent or more of the outstanding voting stock or shares of both of them;
(v) one of them directly or indirectly controls the other;
(vi) both of them are directly or indirectly controlled by a third person;
(vii) together they directly or indirectly control a third person; or
(viii) they are members of the same family.
Explanation I. - The term "person" also includes legal persons.
Explanation II. - Persons who are associated in the business of one another in that one is the sole agent or sole distributor or sole concessionaire, howsoever described, of the other shall be deemed to be related for the purpose of these rules, if they fall within the criteria of this sub-rule.
5. Rule 3(3)(a) of the CVR, 2007.
6. Rule 3(3)(b) of the CVR, 2007.
7. Rule 3(4) of the CVR, 2007.
8. Circular 1/98-Cus., dated 1-1-1998 as modified by Circular No. 11/2001-Cus., dated 23-2-2001.
9. Transfer Pricing, Customs Duties and VAT Rules: Can We Bridge the Gap? - Lu Ping, World Customs Organisation and Caroline Silberztein, OECD Centre for Tax Policy and Administration.
10. Ibid.
11. Paper prepared by the UN Tax Committee's sub-committee on Practical Transfer Pricing Issues.
12. http://www.dov.gov.in/newsite3/TP_AGENDA.asp.
13. Transfer Pricing - Law, Procedure and Documentation - 2010, Fourth Edition.
14. See Rule 10D(1).
15. Please see Office of Chief Counsel, Internal Revenue Service, Memorandum No. 201043028 dated August 13, 2010.
16. http://www.oecd.org/dataoecd/42/3/42651203.pdf.
17. http://www.oecd.org/dataoecd/23/12/45763692.pdf, approved in July 2010.
18. Refer Commentary 23.1.
19. Corresponding Indian provision is Rule 3(3)(a) of the CVR, 2007.
20. Circular No. 20/2007-Cus. dated 8th May, 2007.
21. http://www.dov.gov.in/newsite3/TP_AGENDA.asp.
22. See Gemplus India (P.) Ltd. v. Commissioner of Customs 2005 (185) ELT 269 (Trib. - Bang.).
•DT - Secs. 92 to 92F.
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