Saturday 1 September 2012

An Introduction to Domestic Transfer Pricing.




First I thanks to all the readers who had supported me to achieve this milestone.



After the grand success of International Transfer pricing, through which huge transfer pricing orders slapped on companies with cross-border operations in the last financial year 2011-12,
Finance Minister has cast his net wider and deeper for the next one by including “Specified Domestic Transactions” in the purview of transfer pricing (TP). Out of 100+ amendments made by the Finance Act 2012 by overruling 100+ case decisions, the provisions related to Domestic Transfer Pricing seems to be the one which had been brought in the statute after considering instructions / suggestions of the Supreme Court. The other reason for implementing the same may be hidden in the statistics (given in succeeding paras).

Origin of Domestic Transfer Pricing (TP) law:

While dealing with the issue whether the assessee company and its service provider are related companies in terms of Section 40A (2), Hon’ble SC in CIT vs. GlaxoSmithKline Asia (P) Ltd. (SLP 18121/2007) had observed “The larger issue is whether Transfer Pricing Regulations should be limited to cross-border transactions or whether the Transfer Pricing Regulations be extended to domestic transactions. In domestic transactions, the under-invoicing of sales and over-invoicing of expenses ordinarily will be revenue neutral in nature, except in two circumstances having tax arbitrage such as where one of the related entities is (i) loss making or (ii) liable to pay tax at a lower rate and the profits are shifted to such entity. The CBDT should examine whether Transfer Pricing Regulations can be applied to domestic transactions between related parties u/s 40A(2) by making amendments to the Act. The AO can be empowered to make adjustments to the income declared by the assessee having regard to the fair market value of the transactions between the related parties and can apply any of the generally accepted methods of determination of arm’s length price, including the methods provided under Transfer Pricing Regulations.” SC further mentioned “Though the Court normally does not make recommendations or suggestions, in order to reduce litigation occurring in complicated matters, the question of extending Transfer Pricing regulations to domestic transactions require expeditious consideration by the Ministry of Finance and the CBDT may also consider issuing appropriate instructions in that  regard.” The above remarks of the SC had laid the foundation for Domestic Transfer Pricing (DTP) law in India, which was also affirmed in the memorandum explaining the Finance Bill 2012.

Interesting Statistics of Transfer Pricing (TP) regime in India:

For understanding the magnitude of the topic, it is important to refer interesting statistics of TP regime in India. TP provisions were introduced in India by the Finance Act 2001 (w.e.f. AY 2002-03). Since then 7 TP assessments had been concluded (AY 2002-03 to AY 2008-09). As per the available data, aggregate adjustments of INR 1,00,000 crore ($ 19 billion, approximately) had been made by the TPO in these seven years, out of which adjustments of INR 45,000 crore ($ 9 billion, approximately) had been made in AY 2008-09 alone. (Source: Business standard/ The Hindu-Business Line). Interestingly AY 2008-09 was one of the best years in terms of outbound Mergers & Acquisition (M & A) deals in India. According to Bloomberg data, Indian companies acquired assets abroad worth $ 19.6 billion in 302 deals. When I go through the statistics above, I wonder whether the record Transfer Pricing Adjustments were only an aggressive move on the part of an over enthusiastic department or justified in the wake of global norms? However, the various Tribunal /  High court orders pronounced in last 1-2 years have provided the answer wherein the magnitude of these adjustments has been significantly reduced.

Category of Transactions covered under Domestic Transfer Pricing net:

As per the newly-inserted section 92BA, “Specified Domestic Transaction” in case of an assessee means any of the following transactions (the aggregate of which exceeds ` 5 crore in previous year and which is not an international transaction), namely:—
(1) any expenditure incurred between related parties referred to in section 40A(2)(b);
(2) any transaction referred to in section 80A;
(3) any transfer of goods or services referred to in section 80-IA(8);
(4) any business transacted between the assessee and other person as referred to in section 80-IA(10);
(5) any transaction, referred to in any other section under Chapter VI-A or section 10AA, to which section 80-IA(8) or section 80-IA(10) are applicable;
or
(6) any other transaction as may be prescribed,

If a transaction is an international transaction, then the same will not be a Specified Domestic Transaction.

Aggregate of Transactions should exceed INR 5 crore:

TP provisions will not be applicable, if aggregate of transactions entered during the year does not exceeds INR 5 crore.For e.g. - Rent payment of INR 2.5 crore has been made to a sister concern and a remuneration of INR 1.5 crore paid to Managing Director. In this case the aggregate of transaction is below INR 5 crore; hence TP provisions will not be applicable. Suppose Rent of INR 4 crore is paid to sister concern and MD’s Remuneration is INR 1.5 crore. Here the aggregate value of transactions will exceed INR 5 crore and both transactions will become specified domestic transaction.

In the succeeding paras, different categories of transactions have been dealt in detail:
1. Any ‘Expenditure’ incurred between related parties referred to in section 40A(2)(b)
Section 40A override the other provisions of the act relating to computation of income under “Profit & Gains of Business or Profession”. As per sub section (2), any expenditure by way of payment to the persons [mentioned in sub clause (b)], is liable to be disallowed in computing business profit to the extent such expenditure is considered to be excessive or unreasonable having regard to fair market value of goods, services, facilities etc. However, no disallowance shall be made if the transaction (Specified Domestic Transaction) has been made at arm’s length price. Sub clause (b) of sub section (2) covers the various situations mentioned below wherein the two persons are related parties.
Illustration:
Payments by ABC Ltd to the following persons will be covered, if the relationship exists at any time during the previous year, where:

_ Any company in which ABC Ltd has 20% or more voting rights,
_ A company, XYZ Ltd, has 20% or more voting power in ABC Ltd,
_ A company in which above-mentioned XYZ Ltd has 20% or more voting power,
_ Any company of which a director has 20% or more voting rights in ABC Ltd,
_ Any company in which a director of ABC Ltd has 20% or more voting rights,
_ Any Director of ABC Ltd or XYZ Ltd and his/her relative,
_ Any Individual having 20% or more voting rights in ABC Ltd or any relative of such individual

Further, related party also includes a company having the same parent company. The following chart will explain the few scenarios:

AAA
XYZ
                                                           
ABC
 



BBB
PQR
                       
                                                           

Now, transactions between (i) ABC Ltd – XYZ Ltd, (ii) ABC Ltd – PQR Ltd & (iii) XYZ Ltd – PQR & (iv) ABC Ltd – AAA Ltd will fall under the mischief of section 40A (2). However, any transaction between (i) ABC Ltd – BBB Ltd &(iii) AAA Ltd – BBB Ltd will not come under 40A(2).

This clause covers only the “Expenditure” and not the income. Hence, it will not cover the cases when any person receives any income which is less than ALP. For e.g. - ABC Ltd gives an interest-free loan to its sister concern. The notional interest is not covered in this section and hence no addition can be made in the hands of the ABC Ltd.

Area of Uncertainty / clarification required:

a) Benchmarking requirement for Remuneration / other payments to Director / Chairman / KMP:
In case of a company, specified person as per sub clause (b) includes directors, key management personnel and their relatives. It will be very difficult for the companies / groups to benchmark the payment made to their directors / chairman. For e.g. - It will be a big challenge for RIL to justify the payments made to Mr. Ambani, as it is not possible to find a comparable instance and one cannot compare the above payment with those made by business groups like the ones owned by the Tatas or Birlas to their key management personnel.

Delhi High Court in a recent Judgement (CIT vs. India Thermit Corporation – ITA/350/2011) held that when commission paid to the Managing Director/Director was in accordance with the provisions of the Companies Act 1956; AO cannot make any disallowance on this account. Inspite of the same, this issue is litigation prone.

b) Payment for Expenditure made to Sister Concern / corresponding adjustments:
For e.g. - ABC Steel Ltd has paid rent of INR 6 crore to sister concern ABC Housing Ltd in F.Y. 2012-13. TPO disallow 50% of the rent payment by stating that it is unreasonable or excessive, and accordingly allows a deduction of INR 3 crore only to ABC Steel Ltd. There are no corresponding provisions in the act to adjust the income of ABC Housing Ltd i.e. inspite of disallowance, ABC Housing Ltd will be assessed at an income of INR 6 crore. This will result to double taxation.

c) Whether Depreciation will be covered?
Can depreciation be treated as expenditure for the purpose of this section? For e.g. - A Ltd purchases certain fixed assets from its sister concern Z Ltd for INR 1 crore, the ALP of which is INR 50 Lakh. Whether AO can disallow depreciation on INR 50 lakh, as the payment made for purchase of capital asset is not covered under section 40A (2)?

2. Any transaction referred to in section 80A;
Section 80A (6) refers to internal transactions between various units / undertakings of the assessee in respect of goods or services. This clause covers any transactions of goods or services and hence this transaction will be applicable to income as well as expenditure.

3. Transactions of Tax Holiday undertakings
a) Any transfer of goods or services referred to in section 80- IA(8)

b) Any business transacted between the assessee and other person as referred to in section 80-IA(10)

c) Any transaction, referred to in any other section under Chapter VI-A or section 10AA, to which section 80-IA(8) or section 80-IA(10) are applicable;

It is a common practice among companies / groups enjoying tax holiday period to park excess profits in tax-exempt units / businesses. To curb the same, the relevant clauses had been inserted in the domestic transfer pricing law. Now AO is empowered to make adjustments if it appears that ‘more than ordinary profits' were earned by tax exempt businesses/units owing to its ‘close connection' with transacting parties.

Section 80IA (8):

Section 80IA-(8) deals with the internal transactions with more than one undertaking / units of the assessee, out of which one or more undertaking is enjoying the tax holiday. Normally units enjoying tax holiday, charge more than the market value for goods or services used by non-eligible units. Due to this conduct, there is no effect on the health of the tax holiday unit as there are no taxes at all and the non-eligible unit gets higher deduction from taxable income. As per Section 80IA-(8), if the internal transfer of goods or services is not at market value, then profits or gains of transacting units shall be computed as if transfer, in either case, had been  made at market value of such goods or services. Onus is on the taxpayer to prove that the internal transfer is at ALP.

Section 80IA (10):

As per this clause, when due to close connection between assessee and ‘any other person’ or for any other reason, the eligible business of the assessee produces ‘more than the ordinary profit’, then for the purpose of deduction under this section, profit of the eligible business shall be determined by taking ALP of the transaction. Primary onus is on the taxpayer to prove that the internal transfer is at ALP. However, the department has to prove that the transaction is not at ALP.

Section 10AA:

As per this section, profits of the units located in SEZ, engaged in the manufacturing of any article or thing or providing any services, is exempt subject to conditions.

Non Allocation of Indirect Costs / Services to Tax Holiday Units:

Many a times indirect expenses / head office expenses / administrative expenses have not been charged to the undertaking enjoying tax holiday, due to which more than ordinary profits arise to the tax-holiday undertaking.

Illustration:

ABC Sugar Co Ltd is engaged the manufacturing of Sugar, having three divisions- Sugar, Power & Chemical. Power produced by power division is captively consumed in the sugar and chemical division. In case of any shortfall in power generation, the same will be purchased from the State Electricity Board (SEB). By-product of the sugar division is used in chemical division for producing
ethanol. Profits of the power division are exempt u/s 80-IA.

INR 5 / unit have been charged by Power Division to sugar & chemical divisions for consumption of electricity. However, SEB rate for industrial undertakings are INR 4/ unit. Due to this pricing, the profit of the power division, which is enjoying a tax holiday, gets inflated by INR 1/ unit. Further, taxable profits of sugar and chemical divisions get reduced due to overcharging by the power division.
There are certain administrative/ indirect expenditure which have been incurred by ABC Sugar Co Ltd. As per prudent accounting norms, entire expenditure should be allocated to the three divisions in a proper ratio. However, ABC Sugar Co Ltd had not allocated the indirect expenditures in the Power division, due to which profits of power division gets inflated and profits of Sugar & chemical
division get reduced. Domestic Transfer pricing law is introduced to curb these types of transactions.

4. Any other Transactions as may be prescribed:
Board (CBDT) had been given the power to notify any other transaction, which they feel it necessary, to include in the definition of “Specified Domestic Transaction.”

Area of Uncertainty / clarification required:

a) ‘Close Connection’ not defined

By applying arm's length principle, an imprecise concept of ‘more than ordinary profits' has suddenly started appearing. Section 80- IA(10) talks about ‘close connection’ between the assessee and the other person. However, the term has not been defined, which will lead to litigation.

b) ‘Corresponding Adjustments’

Normally DTAA provides that where any upward adjustment has been made in the hands of one entity, say an Indian Company, with respect to transaction with another company, say a British Company, then the corresponding downward adjustments should be made in the hands of
the British Company. This eliminates the double taxation. No corresponding provisions are incorporated in DTP law. c) ‘Indian Company having Domestic / International Transaction’ :
What happens when an Indian company is having both international transactions as well as domestic transactions? Whether the specified domestic transactions are required to be reported in the following scenarios:

a) When the value of aggregate of international transactions and specified domestic transactions is less than INR 5 crore.
b) When the value of aggregate of international transactions and specified domestic transactions is more than INR 5 crore, but value of specified domestic transactions is less than INR 5 crore.
What if, when the value of International transactions as well as value of Specified Domestic Transaction will be INR 3 crore each? Is the assessee required to report the same or to take an accountant’s report for the same? A clarification may be expected from CBDT on this issue.

‘Domestic Transfer Pricing (DTP)’ law not applicable, if original tax liability reduced’:

Section 92(3) provides that TP provisions will not apply when the same has effect of reducing the income chargeable for tax or enhancing the original losses. Hence, for expenditure recorded in the books for less than ALP or income recorded in the books for more than ALP, will be out of purview of DTP. The situation may be reversed when tax holiday unit will come in picture.
For e.g. – If an internal transfer from a tax holiday unit to a non-tax holiday unit has been made at INR 1,00,000 for which ALP is INR 200,000, then the provisions of DTP as well as TP will not be applicable and ALP will not substitute the original recorded transaction. If ALP of INR 200,000 will substitute the original price then it will result into additional exemption to tax holiday unit as well as additional deduction of expenditure to non tax holiday unit.

Documentation / Compliances:

As per section 92D, every person who has entered into Specified Domestic Transaction shall keep and maintain such information and documents in respect thereof, as prescribed in Rule 10D. Further, the assessee has to take an accountant’s report (Form 3CEB) duly signed and verified and is required to submit the same to the assessing officer on or before the due date of filing the return of income. Due care should be taken for physical submission of audit report with AO, as due to e-filing of IT return, one can miss the same.

Penalty Provisions for Non- compliances:

Penal provisions for non compliance of TP provisions are very harsh. Earlier there was no penalty when any transaction escaped from the Auditor’s Report in Form 3CEB. Section 271AA has been amended w.e.f. 01-07-2012, and now the AO may impose penalty @ 2% of the value of transaction. Further penalty @ 2% may be imposed on the assessee for non maintenance of Documents / non furnishing of Report. Thus, even if one forgets to disclose a transaction of INR 5
crore, which is the minimum threshold for reporting, the penalty is INR 10 lakh.

Preventive Measures:

TPO will put to use all lessons learnt from foreign firms over the past 10 years.  They know exactly where to attack. Questions will be raised on routing of transactions through multiple entities, and adjustment entries. Companies, who have the specified domestic transitions exceeding INR 5 crore, should be advised to validate their present business model and pricing methodology from a transfer pricing perspective, which will enable them to take corrective action, if any. A good understanding of the business of the assessee is a must for every consultant dealing in the Transfer Pricing arena.

Conclusion:

Transfer pricing will not be limited to large groups. Many mid-sized groups, partnership firms, HUFs and even individuals in smaller cities will now have to adhere to the TP rules. This will lead to an increase in the administrative and compliance burden for the taxpayer in respect of such transactions and a focused examination by the tax authorities. Certain expenses, transfer of goods and services between related parties, extraordinary profits and profits earned by SEZs / tax holiday units will now be liable for scrutiny by TPO’s. While the Advance Pricing Agreement (APA) regime has been introduced with respect to international transactions, the same benefit has not been extended for domestic transactions. One can pray that the extension of transfer pricing provisions to specified domestic transactions will not create the same level of
havoc as prevalent in current TP assessments. It would be pertinent for the Government to bring out a clarification on all such issues so that domestic transfer pricing provisions can achieve the purpose for which they were introduced.

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