Few Points on Rule 10 of Transfer Pricing.

In India a new transfer pricing regime has been introduced this year by the Finance Act 2001. Earlier a limited provision (Section 92) existed in the Income tax Act, which provided for making adjustment to the income of a resident taxpayer from a transaction with a non resident if the Assessing Officer was of the view that the income from such a transaction was understated in the hands of the resident due to the close connection between the two. No other rules or obligations about maintenance of documents about such

transaction existed under the old Section 92 which remained in the statute for a number of years though it was almost never invoked in practice. The Finance Act 2001 has substituted a new section 92 and inserted sections 92A to 92F and certain other provisions in the Income tax Act which provide the statutory backbone of the new transfer pricing law. The procedural rules under these sections have been inserted in the Income tax Rules, by Notification S.O 808 (E) dated 21 August, 2001. This article touches very briefly on the main substantive provisions and then provides a summary of the requirements relating to documentation under the Indian transfer pricing regulation.

The new transfer pricing regime requires compliance with the principle of arm's length price in cases involving an 'international transaction' between associated enterprises (Section 92). The term 'associated enterprise' is defined in Section 92A which provides 13 parameters to determine if the enterprises concerned would constitute 'associated enterprises'. Section 92B defines the term 'international transaction' as a transaction between two or more associated enterprises when either or both them are non resident. The transactions covered are transfer of tangibles, intangibles, services, lending and borrowing of capital and cost contribution agreements. Section 92 C lays down five methods for the determination of arm's length price. These are same as the transaction methods prescribed in the OECD guidelines viz. comparable uncontrolled price method, resale price method, cost plus method, profit split method and transaction net margin method. Section 92C also lays down the provisions relating to transfer pricing audit which may be triggered if the administration is of the opinion that the transfer price adopted does not reflect arm's length price, or if proper information or documents are not maintained. Provisions have also been made in respect of penalties for concealment of income by adopting non arm's length price, defaults relating to maintenance of prescribed information and documents and failure to furnish required information or documents during an audit or appellate proceedings.

The legal framework for maintenance of information and documentation by a taxpayer is provided in Section 92D which lays down that every person who enters into an international transaction with an associated enterprise shall maintain prescribed information and documents. The various types of information to be maintained in respect of an international transaction, the associated enterprise and the transfer pricing method used are prescribed in Rule 10D of the Income tax Rules, as under:

i. A description of the ownership structure of the enterprise and details of shares or other ownership interest held therein by other enterprises;

ii. A profile of the multinational group of which the taxpayer is a part and the name, address, legal status and country of tax residence of each of the enterprises comprised in the group with whom international transactions have been made by the taxpayer and the ownership linkages among them;

iii. A broad description of the business of the taxpayer and the industry in which it operates and the business of the associated enterprises;

iv. The nature, terms and prices of international transaction entered into with each associated enterprise, details of property transferred or services provided and the quantum and the value of each such transaction or class of such transaction;

v. A description of the functions performed, risks assumed and assets employed or to be employed by the taxpayer and by the associated enterprise involved in the international transaction;

vi. A record of the economic and market analyses, forecasts, budgets or any other financial estimates prepared by the taxpayer for its business as a whole or separately for each division or product which may have a bearing on the international transaction entered into by the taxpayer;

vii. A record of uncontrolled transactions taken into account for analysing their comparability with the international transaction entered into, including a record of the nature, terms sand conditions relating to any uncontrolled transaction with third parties which may be of relevant to the pricing of the internationals transactions;

viii. A record of the analysis performed to evaluate comparability of uncontrolled transactions with the relevant international transaction;

ix. A description of the methods considered for determining the arm's length price in relation to each international transaction or class of transaction, the method selected as the most appropriate method along with explanations as to why such method was so selected, and how such method was applied in each case;

x. A record of the actual working carried out for determining the arm's length price, including details of the comparable data and financial information used in applying the most appropriate method and adjustments, if any, which were made to account for differences between the international transaction and the comparable uncontrolled transactions or between the enterprises entering into such transaction;

xi. The assumptions, policies and price negotiations if any which have critically affected the determination of the arm's length price ;

xii. Details of the adjustments, if any made to the transfer price to align it with arm's length price determined under these rules and consequent adjustment made to the total income for tax purposes;

xiii. Any other information data or document including information or data relating to the associated enterprise which may be relevant for determination of the arm's length price.

Rule 10D also prescribes that the above information is to be supported by authentic documents which may include the following:

i. Official publications, reports, studies and data bases of the government of the country of residence of the associated enterprise or of any other country;

ii. Reports of market research studies carried out and technical publications of institutions of national or international repute;

iii. Publications relating to prices including stock exchange and commodity market quotations;

iv. Published accounts and financial statements relating to the business of the associated enterprises;

v. Agreements and contracts entered into with associated enterprises or with unrelated enterprises in respect of transaction similar to the international transactions;

vi. Letters and other correspondence documenting terms negotiated between the taxpayer and associated enterprise;

vi. Documents normally issued in connection with various transaction under the accounting practices followed.

It is noteworthy that the information and documentation requirements referred to above are linked to the burden of proof laid on the taxpayer to prove that the transfer price adopted is in accordance with the arm's length principle. One of the conditions to be fulfilled for discharging this burden by the taxpayer is maintenance of prescribed information and documents in respect of an international transaction entered into with a associated enterprise. A default in maintaining information and documents in accordance with the rules is one of the conditions which may trigger a transfer pricing audit under Section 92C(3). Any default in respect of the documentation requirement may also attract penalty of a sum equal to two percent of the value of the international transaction (Sec 271AA).

There is no reference in the provisions included either in the Income tax Act or the Income tax Rules about any requirement to submit the prescribed information and documents at the stage of initial compliance in the form of submission of report under section 92E. All that Section 92E requires is that the concerned taxpayer shall obtain a report from an Accountant in the prescribed form (Form 3CEB) and submit the report by the specified date. Form 3CEB contains a certificate from the Accountant that in his opinion proper information and documents as prescribed have been maintained by the taxpayer. It does not require their submission along with the report.

While there is no requirement for their submission along with the report, Rule 10D requires that the information and document maintained should be contemporaneous as far as possible and should exist latest by the specified date for filing the report under section 92E. Section 92D also provides that information and documentation may be requisitioned by the Assessing Officer or the Appellate Commissioner on a notice of thirty days which period may be extended by another period of 30 days.

Although the law has prescribed no monetary limit in respect of international transaction covered by the transfer pricing requirements, an exception is provided in para 2 of Rule 10D in respect of the information and document requirement in respect of transactions not exceeding INR 10 million. It is provided that the above requirement will not apply to such transactions. However the concerned taxpayer may be required to substantiate on the basis of available material that the income arising from the international transaction is computed in accordance with the arm's length rule.

The prescribed information and documents are required to be maintained for a period of eight years. Rule 10D absolves a taxpayer entering into a international transaction which continues to have effect over more than one year from maintaining separate set of documents for each year. However separate documents are required for each year if there is any significant change in the terms and conditions of the international transaction which have a bearing on the transfer price.

Methods for determination of arm’s length price.

The methods for determination of arm’s length price are explained in the subsequent paragraphs:

Comparable uncontrolled price method (CUP) - The OECD Guidelines define CUP method as ‘a transfer pricing method that compares the price for property or services transferred in a controlled transaction to the price charged for property or services transferred in a comparable uncontrolled transaction in comparable circumstances.’

A CUP may be determined mainly in any one of the following two ways:

§ if the enterprise sells (or buys) the same product under same circumstances to [or from] an unrelated third party, that price can be used as a CUP.

§ if a transaction is undertaken either by the company with a third party or by two unrelated parties and there are some differences in the product traded, or in the circumstances of the transaction, and adjustments can be made to the price to take account of these differences, then the adjusted price can be used as a CUP.

As per Article 2.7 of the said Guidelines an uncontrolled transaction is comparable for purposes of the CUP method if one of the two conditions are met:

§ none of the differences (if any) between the transactions being compared or between the enterprises undertaking those transactions could materially affect the price in the open market.

§ reasonably accurate adjustments can be made to eliminate the material effects of such differences.

In applying the CUP method, all the facts and circumstances that are likely to affect the price must be considered. The market location, the volume of transactions, the risks involved, the warranty and payment terms, the market conditions, etc., may have an implication on the price of the product. Adjustments are made to the uncontrolled price to negate the effect of the differences in facts and circumstances, to arrive at the CUP.

Examples

          (A)     USCO, a US company, sells computer monitors to its Indian subsidiary (ICO) for resale. USCO also sells computer monitors to other computer resellers (say, CMI) in India on identical terms. In case USCO sells the monitors to CMI for Rs. 10,000, the CUP price for the computer monitors being sold by USCO to ICO would also be Rs. 10,000.

          (B)     Suppose, in the aforesaid illustration, the terms are different for warranty:

                   The warranty in case of sale of monitors by ICO is handled by ICO. However, for sale of monitors by CMI, USCO is responsible for the warranty for 3 months. Suppose, USCO and ICO offer extended warranty at a standard rate of Rs. 1,000 per annum. In such a case, if USCO sells the monitors to CMI for Rs. 10,000, the arm’s length price for the computer monitors being sold by USCO to ICO would be:

	Rs.
Third party sale price	10,000
Less : Value of 3 months warranty [Rs. 1,000/12 × 3]	250
CUP	9,750

6.5-2 Resale price method (RPM) - The OECD Guidelines define RPM as follows:

“A transfer pricing method based on the price at which a product that has been purchased from an associated enterprise is resold to an independent enterprise. The resale price is reduced by the resale price margin. What is left after subtracting the resale price margin can be regarded, after adjustment for other costs associated with the purchase of the product (e.g., custom duties), as an arm’s length price of the original transfer of property between the associated enterprises.”

For the above purposes, the OECD’s Guidelines define Resale Price Margin as

“a margin representing the amount out of which a reseller would seek to cover its selling and other operating expenses and, in the light of the functions performed (taking into account assets used and risks assumed), make an appropriate profit.”

The Guidelines further provide that “the resale price margin of the reseller in the controlled transaction may be determined by reference to the resale price margin that the same reseller earns on items purchased and sold in comparable uncontrolled transactions. Also, the resale price margin earned by an independent enterprise in comparable uncontrolled transactions may serve as a guide.” (para 2.15 of the Guidelines)

The resale price method is ordinarily used when the reseller has not added substantial value by either physically altering the property or using its intangible property before resale.

Example

ICO is a distributor of software developed by its parent company in the US. The end customer price (or retail price) of the software is Rs. 5,000. Assuming comparable independent distributors in India earn margins of 10%, the arm’s length transfer price would be as follows:

	Rs.
Final Retail Price in India	5,000
Less : Margin earned by comparable distributors	500
Transfer Price using RPM	4,500

6.5-3 Cost Plus method - The OECD Guidelines define cost plus method as follows:

“A transfer pricing method using the costs incurred by the supplier of property (or services) in a controlled transaction. An appropriate cost plus mark up is added to this cost, to make an appropriate profit in light of the functions performed (taking into account assets used and risks assumed) and the market conditions. What is arrived at after adding the cost plus mark up to the above costs may be regarded as an arm’s length price of the original controlled transaction.”

For this purpose, the OECD’s Guidelines define cost plus mark up as

“A mark up that is measured by reference to margins computed after the direct and indirect costs incurred by a supplier of property or services in a transaction.”

The Guidelines further provide that

§ the cost plus mark up of the supplier in the controlled transaction should ideally be established by reference to the cost plus mark up that the same supplier earns in comparable uncontrolled transaction. In addition, the cost plus mark up that would have been earned in comparable transactions by an independent enterprise may serve as a guide. (para 2.33 of the Guidelines)

§ an uncontrolled transaction is comparable to a controlled transaction (that is, it is a comparable uncontrolled transaction) for purposes of the cost plus method if one of the two conditions is met:

      (a)      none of the differences (if any) between the transactions being compared or between the enterprises undertaking those transactions materially affect the cost plus mark up in the open market; or

      (b)      reasonably accurate adjustments can be made to eliminate the material effects of such differences. (para 2.34 of the OECD Guidelines)

Example

ICO, an Indian company is a wholly owned subsidiary of USCO, a US car manufacturer. ICO has an assembly plant. It supplies no capital, automotive knowledge and takes no risk. Based on an analysis of the financial statements of comparable companies, it is determined that similar assembly businesses earn 20% on costs. Applying this margin to the costs of ICO, one can arrive at the arm’s length transfer price. Assuming that ICO’s cost is Rs. 100, the transfer price under cost plus method would then be Rs. 120.

6.5-4 Profit split method (PSM) - The OECD Guidelines define PSM as follows:

“A transactional profit method that identifies the combined profit to be split for the associated enterprises from a controlled transaction (or controlled transactions that is appropriate to aggregate) and then splits those profits between the associated enterprises based upon an economically valid basis that approximates the division of profit that would have been anticipated and reflected in an agreement made at arm’s length.”

Example

Assumptions

A, is a US intangible holding company that provides patents to a related manufacturing company B, in India. B, sells its entire production to a related marketing company C. There are no significant marketing intangibles (trade marks, etc.).

Methodology

In order to determine the arm’s length price for royalty to be paid by B in respect of patents provided by A, the following methodology will have to be adopted:

          (a)      A set of companies that are comparable to B are found.

          (b)      On the basis of the profits of such companies, the optimum profits that should be earned by B are determined.

          (c)      Thereafter, a set of marketing companies that are comparable to C are identified.

          (d)      On the basis of profits of comparable companies, the optimum profits for C are determined.

          (e)      The entire actual profits of the group that is, profits of A, B and C are then aggregated.

          (f)      From such aggregate profits, the optimum profits attributable to activities of Company B and Company C as determined in (b) & (d) above are deducted.

          (g)      The balance profits give the value of intangibles held by A and would indicate the optimum level of royalty to be paid by B.

6.5-5 Transactional Net Margin Method (TNMM) - The Guidelines define TNMM as:

“A transactional profit method that examines the net profit margin relative to an appropriate base (e.g., costs, sales, assets) that a taxpayer realises from a controlled transaction (or transactions that it is appropriate to aggregate).”

The Guidelines further provide that the net margin of the taxpayer from the controlled transaction (or transactions that are appropriate to aggregate) should ideally be established by reference to the net margin that the same taxpayer earns in comparable uncontrolled transactions. Where this is not possible, the net margin that would have been earned in comparable transactions by an independent enterprise may serve as a guide. A functional analysis of the associated enterprise and, in the latter case, the independent enterprise is required to determine whether the transactions are comparable and what adjustments may be necessary to obtain reliable results. (para 3.26 of OECD Guidelines)

Choice of appropriate transfer pricing method

6.6-1 For tangible property - The Guidelines provide that where it is possible to locate comparable uncontrolled transactions, the CUP method is the most direct and reliable way to apply the arm’s length principle. Consequently, in such cases the CUP method is preferable over all other methods. (para 2.7 of OECD Guidelines)

6.6-2 Services - The method to be used to determine arm’s length transfer pricing for intra-group services should be determined according to the prescribed guidelines. Often, the application of these guidelines will lead to use of the CUP or cost plus method for pricing intra-group services. A CUP method is likely to be used where there is a comparable service provided between independent enterprises in the recipient’s market, or by the associated enterprise providing the services to an independent enterprise in comparable circumstances. For example, this might be the case where accounting, auditing, legal, or computer services are being provided. A cost plus method would likely to be appropriate in the absence of a CUP where the nature of the activities involved, assets used, and risks assumed are comparable to those undertaken by independent enterprises. (para 7.31 of OECD Guidelines)

6.6-3 For intangible property - In establishing arm’s length pricing in the case of a sale or licence of intangible property, it is possible to use the CUP method where the same owner has transferred or licensed comparable intangible property under comparable circumstances to independent enterprises. If the aforesaid enterprise sub-licenses the property to third parties, it may also be possible to use some form of resale price method to analyse the terms of the controlled transaction. (para 6.23 of OECD Guidelines)

In the sale of goods incorporating intangible property, it may also be possible to use the CUP or resale price method. (para 6.24 of OECD Guidelines)

In cases involving highly valuable intangible property, it may be difficult to find comparable uncontrolled transactions. It, therefore may be difficult to apply the traditional transaction methods and the transactional net margin method, particularly where both parties to the transaction own valuable intangible property or unique assets used in the transaction that distinguish the transaction from those of potential competitors. In such cases the profit split method may be relevant although there may be practical problems in its application. (para 6.26 of OECD Guidelines)

Definition in section 92F(ii)

6.7 Irrespective of which method is ascertained/identified as the most appropriate method, while applying the said method for determination of the arm’s length price, the definition of arm’s length price under section 92F(ii) should always be kept in mind. Hence, the cardinal principle which can never be lost sight of is, that the objective is to determine ‘a price which is applied in a transaction between persons other than associated enterprises, in uncontrolled conditions.’ Hence, whatever be the method being applied, the effort/objective/attempt should be to arrive at a price which independent enterprises in uncontrolled conditions would have transacted at.