Understanding Domestic Transfer Pricing Concept under India Income tax laws:

 

Widening of scope of Section 40A (2), Transfer Pricing regulations to apply to domestic transactions, (Applicable for the AY 2013-14)

 Under Section 40A(2) of Income Tax Act, 1961 in case of any transaction with a related party, the Assessing Officer can disallow the expenditure while computing income from business or profession  which in his opinion is excessive or unreasonable having regard to the:

 a. Fair market value of the goods,

b. Services or

c. Facilities

 for which expenditure has been incurred. There is NO mechanism to re-compute the income received from a related party, in case the Assessing Officer is of the opinion that such income is low considering the market value, since this section focuses on EXPENDITURE. In order to address this issue, the provisions of Transfer Pricing are being amended to extend the scope to ‘specified domestic transactions’ by amending Section 92 of the Act. Further specified domestic transactions have been defined in a new Section 92BA as following transactions where the aggregate of such transactions entered into by the assessee in a year exceed Rs.5 crore:

Section	Transaction covered
40A	Any payment made or to be made in respect of expenditure incurred to persons specified in section 40A (2) (b). i.e. related parties
IN CASE OF DEDUCTIONS IN RESPECT OF CERTAIN TAX HOLIDAYS
80A	Any transaction in relation to transfer of goods or services from eligible business (refer sec. 35AD) to non-eligible business, vice versa.
80IA(8)	Any business transaction in relation to transfer of any goods or services between units of the assessee i.e. inter units transfers.
80IA(10)	Any business transaction between the assessee (covered under 80IA) and his associated entities.
80-IB, 80-IC, 80ID, 80-IE AND 10AA	Any business transaction entered between the assessee who is eligible for 80-IB, 80-IC, 80ID & 10AA and associated entities or inter unit transfer between the eligible business of the assessee and his non- eligible business.
	Any other transactions as may be prescribed.

 Because of the above tax holidays deductions, there could be transaction between the related party which is been carried out to eliminate/reduce tax liability by shifting profits to tax holiday entities.

 It has been further provided by inserting a new subsection (2A) in Section 92 that any allowance or any expenditure or interest or allocation of any cost or expense or any income in relation to specified domestic transaction shall be computed having regards to arm’s length price, meaning thereby the specified domestic transaction will be tested applying arm’s length (ARM) principle.

 Accordingly corresponding amendment is been made in the procedural laws of transfer pricing to cover domestic transactions i.e.

 1.  Section 92C for computation of arm’s length price by the method prescribed,

2.  Section 92D maintenance and keeping of information and document,

3.  Section 92E obtaining report from Chartered Accountant in respect of specified domestic transactions,

4.  Section 92CA being reference to the Transfer Pricing Officer,

5.  Penal provisions of Section 271(1), Explanation 7 regarding concealment,

6.  Section 271AA penalty for failure to keep and maintain information and

7.  Section 271G penalty for failure to furnish information or document.

 Further the section 40A(2)(b)(ii)  scope of the related party is being expanded to cover cases of companies which have the same parent company by providing that “any other company carrying on business or profession in which the first mentioned company has substantial interests” shall be considered to be a related party.

 This compliance increases the compliance cost substantially which may be beyond the means of small taxpayer. In international transaction, the country looses tax through the transactions with associated enterprises located overseas. However in domestic transactions, the country does not loose tax even though the taxable transaction between two related parties are not at arm’s length, still there are no tax implications if the both such entities are in same tax bracket.

 It is a normal practice may be because of regulatory requirement or because of family set up or development and structuring of business over the period one entity related to other may be selling its products or providing services despite both such entities falling in same tax brackets and there being no net tax effect still there will be requirement on both these entities of maintaining and complying all complex transfer pricing regulations. The cost of such compliance will be too high as compared to nominal margin of profits.

 

The threshold of Rs.5 crore may not also be helpful as in manufacturing or trading of goods this is too little and the total margin earned in such transactions may not be sufficient to meet the cost of compliance.

Key Issues.

 

Interest paid to related parties – nexus with loans given

 

The approach to determine the fair market value of interest paid on loans taken from related parties in several cases has been that high interest paid to related parties cannot be disallowed if the nexus of  such related party loan with a low interest-bearing loan given by the taxpayer cannot be proved. Under the arm’s length principle, the stress is on the comparability of comparable interest rates, rather than on the nexus between loans taken and loans given by the taxpayer.

 

Payment made to key personnel(KMP) of assessee i.e. transaction with Director / CFO / CEO etc.  Including ESOP.

 

Many assessees are bound to face issues in justifying KMP payments, as this is subjective. The KMP payments of a particular company may not be comparable to a peer company, even if both are same size. The managerial personnel may differ in terms of qualification, experience, and so on.  One way of benchmarking this transaction may be to consider the replacement cost of the KMP — and the Human Resources department records may be helpful in this. In the case of ESOPs for key managerial personnel, the terms and conditions of issue to other employees and KMPs could act as a basis to justify the arm’s length principle.

 

Outsourcing by a Special Economic Zone (SEZ) unit to a non-SEZ unit of the taxpayer:

 

In this case, the rates charged by the non-SEZ unit to the SEZ unit can be compared with the rates charged to third-party customers; or the profit earned by the non-SEZ unit can be compared with the profit earned by the non-SEZ unit from services rendered to third-party customers; or the profit earned by the non-SEZ unit can be compared with the profit earned by third-party companies in rendering similar services using external databases. The development of intellectual property by the units may add to the complexity.

 

 

Sharing of premises and utilities with a related person:

SDT will be applicable to the person incurring expenditure in the form of payment for rent and utilities. The rent paid may be compared with the prevailing rent for a similar property in the area.   The rent and utilities may be benchmarked from the perspective of the receiving entity, if such data is available. The following transactions between related parties will also be examined under the arm’s length concept.

Management Fees.

-       Maintenance of cost and benefit analysis – to commensurate the cost with the benefits derived

-       Allocation key used should be based on the nature of services and benchmarking analysis for mark-up charged

-       Proper documentation of services received from related party

-       Possibility of treating  the services as duplicatory or shareholder or incidental services by revenue authorities

-       Selection of Tested party?

 

Others.

Ø  Government approvals u/s 295, 297 of Companies Act

Ø  Interest free loan to group companies.

Ø  Granting of corporate guarantee / performance guarantee.

Ø  If commercial transaction is at ALP but Debt overdue for long period would

      attracts transfer price interest.  

Ø  Purchase or sale of shares.  

Ø  Goods sold at lower value

Ø  Capital expenditure.

Ø  Use of Brand or trade mark.  

Ø  Reimbursement of expenses.

Ø  Unique In-tangibles Transaction

Ø  Business Promotion

Ø  Seconding employees.

Ø  Group Re-structuring.