How to Tackle Penalty Notices in the Case of Transfer Pricing Adjustments

 A. Introduction: Section 270A of the Income Tax Act classifies variations in income into two categories: under-reporting and misreporting. Penalties for under-reported income are 50% of the tax payable, while for misreported income, they escalate to 200% of the tax base calculated on such income.

B. Under-Reporting in Transfer Pricing Adjustments: Under Section 270A(6), income additions based on the arm’s length price (ALP) determined by the Transfer Pricing Officer (TPO) do not qualify as under-reported income, provided that:

1. The assessee maintained the prescribed information and documentation under Section 92D.

2. The international transaction was duly declared under Chapter X of the Income Tax Act.

3. All material facts regarding the transaction were fully disclosed.

C. Tackling Penalty Notices for Under-Reported Income Due to TP Adjustments: In cases where a penalty notice is issued for under-reporting of income due to transfer pricing adjustments, the taxpayer can present the following arguments:

1. OECD Transfer Pricing Guidelines (Para 4.25): The OECD guidelines emphasize fairness in the administration of penalties in transfer pricing matters. Para 4.25 states: “...Owing to the nature of transfer pricing problems, care should be taken to ensure that the administration of a penalty system as applied in such cases is fair and not unduly onerous for taxpayers.”

2. Reasonable Effort to Comply (Para 4.28 of OECD Guidelines): Para 4.28 further states that penalties should not be imposed when taxpayers have made a reasonable, good-faith effort to determine transfer prices in line with the arm’s length principle: “... It would be unfair to impose sizable penalties on taxpayers that made a reasonable effort in good faith to set the terms of their transactions with associated enterprises in a manner consistent with the arm’s length principle.”

3. Compliance with Section 92D and Rule 10D: The taxpayer should demonstrate that they complied with the provisions of Section 92D and Rule 10D of the Income Tax Act. This includes maintaining robust and comprehensive transfer pricing documentation to justify the determination of the arm’s length price (ALP) for international transactions.

4. Thorough Analysis and Good Faith Efforts: The Transfer Pricing Report should reflect a thorough analysis and confirm compliance with Section 92C of the Income Tax Act. The taxpayer should highlight that:

   • The ALP was determined following prescribed rules.

   • The documentation was prepared in good faith and with due diligence.

5. No New Evidence or Inaccuracies: It is critical to establish that:

   • No new material evidence was discovered during the assessment or appellate proceedings.

   • All explanations provided were accurate and consistent with the facts.

   • At no stage were any explanations found to be false or misleading.

   This demonstrates that the taxpayer fully disclosed all relevant material facts, acted transparently, and did not have any malicious intent to evade taxes.

D. Conclusion: Penalty notices for under-reporting of income arising from transfer pricing adjustments can be effectively addressed by emphasizing compliance with the legal provisions, OECD guidelines, and demonstrating transparency and good-faith efforts. By presenting robust transfer pricing documentation and highlighting fair practices, taxpayers can build a strong defense to counter penalties under Section 270A.