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.
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
|
“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
|
“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.
“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.
“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)
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)
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.
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