india's domestic transfer pricing

Domestic Transfer Pricing

Feb 16, 2013New Delhi, India

By: CA Gaurav Garg

Topic

• Applicability – SDT

• Compliance

• Arm’s Length Principle

• Documentation

• TP Methods

JGarg Economic Advisors

Applicability – SDT…

• The Finance Act 2012 extended the scope of Transfer Pricing provision to ‘Specified Domestic Transactions (‘SDT’)

• The SDT would include the following:

• Expenditure for which payment is made or to be made to domestic related parties-40A 2(b) payment

• Tax Holiday/ Deductions claimed by the taxpayer, where;• Transfer of goods or services between various

businesses of same taxpayer

• More than ordinary profits derived from transactions with closely connected persons

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Transfer Pricing provisions to apply to the ‘Specified Domestic Transactions’ if the aggregate value exceeds five crores

..Applicability – SDT..

• 92BA. For the purposes of this section and sections 92, 92C, 92D and 92E, "specified domestic transaction" in case of an assessee means any of the following transactions, not being an international transaction, namely:—

(i) any expenditure in respect of which payment has been made or is to be made to a person referred to in section 40A(2)(b) –

4JGarg Economic Advisors


• Section 40A(1)– Applicability restricted to the computation of income under the head

“Profits and gains of business or profession”

• Section 40A(2)– Applicable on expenditure in respect of which payment has been made

or it to be made

– Expenditure in respect of goods, services or facilities

• Q & A– Interest free loan given to related party

– Corporate guarantee without any charge

– Goods sold at lower value

– Capital expenditure



(ii) any transaction referred to in section 80A

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Undertaking/ unit / enterprise / eligible

businessAny other business

Assessee

Goods/ Services



(iii) any transfer of goods or services referred to in sub-section (8) of section 80-IA

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Undertaking/ unit / enterprise / eligible

businessAny other business

Assessee

Goods/ Services



(iv) any business transacted between the assessee and other person as referred to in sub-section (10) of section 80-IA

8

Eligible business with more than ordinary

profits

AssesseeIndependent tax

payer

Close Connection

Any other reason



(v) any transaction, referred to in any other section under Chapter VI-A or section 10AA, to which provisions of sub-section (8) or sub-section (10) of section 80-IA are applicable; – 10AA - Special provisions in respect of newly established Units in Special

Economic Zones.

– 80IAB - Deductions in respect of profits and gains by an undertaking or enterprise engaged in development of Special Economic Zone.

– 80IB - Deduction in respect of profits and gains from certain industrial undertakings other than infrastructure development undertakings.

– 80 IC - Special provisions in respect of certain undertakings or enterprises in certain special category States

– 80ID - Deduction in respect of profits and gains from business of hotels and convention centers in specified area.

– 80IE - Special provisions in respect of certain undertakings in North-Eastern States



(vi) any other transaction as may be prescribed

and where the aggregate of such transactions entered into by the assessee in the previous year exceeds a sum of five crore rupees.


Compliance…

• Taxpayer must compute the arm’s length price of SDT as per the methods prescribed under section 92C.

• Burden of proof is on the taxpayer to establish the arm’s length price and to maintain related documents.

• Must obtain a report under Form 3CEB (or any other as prescribed) from a Chartered Accountant and file it before tax authorities within due date of filing of return of income.

• For assessment year 2011-12 and onwards, due date would be 30November.

• Tax payer must submit the transfer pricing document to the tax authorities, within 30 days of the receipt of notice from the department.


…Compliance

• Penalties– Non maintenance of documents, fail to report transaction, maintain or

furnishes an incorrect information or document – 2% of the value of SDT – Section 271AA

– Non filing of Form 3CEB – Rs.100,000/ - Section 271BA

– Failure to furnish information or document to tax authorities – 2% of the value of SDT – Section 271G


• Prices set for transactions between group entities

• should,

• for tax purposes,

• be derived from

• prices which would have been applied by unrelated parties

• in similar transactions under similar conditions in the open market.

JGarg Economic Advisors 13

Arm’s Length Principle…

TP Documentation…

• Refer section 92D of the Act read with Rule 10D of the Rules

Types of Documents

Enterprise - wiseTransaction

specificComputation

related


…TP Documentation…

• Enterprise-wise documents– Ownership structure of the taxpayer– Profile of the Group– Name of Associated Enterprises, address,, legal status, country of

tax residence, ownership linkage and business – Business of the taxpayer, description of industry



• Transaction-specific documents– Description of transaction– Functional Asset & Risk Analysis– Industry / market condition, forecasts/ budget, financial estimates– Uncontrolled transactions and comparability analysis



• Computation – related documents– Most appropriate method– Computation of arm’s length price– Assumptions, policies and price negotiation– Transfer pricing adjustment



• Section 92 D of the Act read with Rule 10E of the Rules

– Should be prepared on contemporaneous basis

– Should be kept and maintained for 8 years from the end of the relevant assessment year

– No fresh documentation required for continuing transactions unless there is some significant change which can have impact on pricing


Sufficiency

Reasonableness

Accuracy

Contemporaneous

Regulation

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Flow Chart

Business Transaction

Computation of Arm’s Length Price

EnvironmentComparable Transaction

Method

Form 3CEB

Documentation


OECD Guidelines

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Transfer Pricing Methods

TP Methods

Indian Regulations

CUP Methods

Resale Price Method

Cost Plus Method

Profit Split Method

Transactional Net Margin Method

CUP Methods

Resale Price Method

Cost Plus Method

Profit Split Method

Transactional Net Margin Method


• In general– Comparable Uncontrolled Price (“CUP”) Method compare prices– Resale Price Method (“RPM”) compares gross margins– Cost Plus Method (“CPM” compares profit mark-ups on costs– Profit Split Method (“PSM”) refers to the (total) profits from

transactions and splits them among the parties based on the level of contribution

– Transactional Net Margin Method (“TNMM”) analyses net profit in relation to an appropriate base, such as costs, sales or assets

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..TP Methods..


• CUP Method– Most direct way of determining an ALP– It compares the price charged for goods or services transferred in

SDT to the price charged for property or services transferred in a comparable uncontrolled transaction.

– Price is adjusted to account for differences, if any, between the SDT and the comparable uncontrolled transactions or between the enterprises entering into such transactions, which could materially affect the price in the open market.

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TP Methods – CUP…


Types of comparison– Internal comparison– External comparison

Internal Comparison

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..TP Methods – CUP..

Seller (RP)

Buyer (RP)

Seller

SDT

Uncontrolled Transaction


Internal Comparison

External Comparable

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..TP Methods – CUP..

Seller (RP)

Buyer (RP)

Buyer

SDT


Seller (RP)

Seller

Buyer (RP)

Buyer

SDT



• Comparability– The comparability of property transferred in SDT and an

uncontrolled transaction is most decisive for the application.– Intended purpose of use, branding or customer perception and

preference would impact applicability.– Market comparability is another important factor to be considered.– Contractual term including quantity of property sold or acquired,

volume discounts, applicable currency, marketing, advertising, after sale support, duration of contract, terms of delivery, terms of payment etc can not be ignored.

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…TP Methods – CUP


CUP – Case Study 1


A Ltd.

AB India Ltd.

XY India Ltd.

200 customers

210 customers

• FAR

28



FAR A Ltd & AB India Ltd. A Ltd. & XY India Ltd.

F.1. Procurement A Ltd. A Ltd.

F.2. Packaging A Ltd A Ltd

F.3. Marketing AB India Ltd. XY India Ltd.

F.4. Sales to final customer

AB India Ltd. XY India Ltd.

F.5. After sales support AB India Ltd. XY India Ltd.

A.1. Warehouse A Ltd. A Ltd.

A.2. Logistics AB Ltd. XY India

A.3. Brand A Ltd. A Ltd.

A.4. Distribution network AB Ltd. XY India

• FAR

29



FAR A Ltd & AB India Ltd. A Ltd. & XY India Ltd.

A.5. Customer list AB Ltd. XY India

R.1. Product risk A Ltd A Ltd

R.2. Product service risk AB India Ltd. XY India Ltd.

R.3. Credit risk AB India Ltd. XY India Ltd.

R.4. Product obsolescence risk

AB India Ltd. XY India Ltd.

• Other information

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Transaction Detail A Ltd & AB India Ltd. A Ltd. & XY India Ltd.

Product Cotton Shirts of same fabric and brand

Cotton Shirts of same fabric and brand

Payment terms 30 days 30 days

Delivery terms FOB C&F

Market in which A Ltd operates

Wholesale Wholesale

Market in which AB India & XY India operates

Retail Retail

Conditions prevailing in the market

Same Same

• Conclusion– Transaction between A Ltd. & AB Ltd. (‘Controlled transaction’) and A Ltd. & XY

India Ltd (‘Uncontrolled transaction’) are comparable.

– However, difference for adjustments in delivery terms need to be carry out.

– Hence, CUP is the most appropriate method.

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• Steps to follow – Identify controlled transaction

– Identify uncontrolled transaction

– Is price data or data for calculating profit margin available for each transaction?

– Are the physical characteristics of inventories and nature of services involved in controlled transactions and uncontrolled transaction are same or similar?

– Is market level same – retail, wholesaler, OEM, secondary etc.?

– Do the transactions differ in volume or timing?

– Are there any differences in the terms of trade, payment terms, conditions for returns, or conditions regarding contract renewal?

– Are there any differences in the functions of the seller or buyer (e.g. in terms of R&D, marketing, and after-sales service)?

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• Steps to follow – Are there any differences in the terms of trade, payment terms, conditions for

returns, or conditions regarding contract renewal?

– Are there any differences in the functions of the seller or buyer (e.g. in terms of R&D, marketing, and after-sales service)?

– Are intangible properties used by the seller or buyer in transactions?

– Are there any differences in terms of business strategy (e.g., policy toward market development and penetration) or timing of market entry?

– Are there any differences in government regulation (e.g. price regulation), market size, or competition, etc. affecting prices and profit margins?

– Are there any special circumstances dictating that transactions may not reasonably be regarded as comparable (e.g. bankruptcy situations)?

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• Resale Price Method (‘RPM’)– The resale price method measures an arm's length price by

subtracting the appropriate gross profit from the applicable resale price for the property involved in the controlled transaction under review.

– The price is adjusted to take into account the functional and other differences, including differences in accounting practices, if any, between the SDT and the comparable uncontrolled transactions, or between the enterprises entering into such transactions, which could materially affect the amount of gross profit margin in the open market.

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TP Methods – RPM…


RPM – Case Study 2


A Ltd. AB India Ltd.Third party customers

- AB India Ltd. is a distributor of product A in India.-AB India does not engage in unique or original advertising or sales promotion activities, and makes no use of its own trademarks or other such properties in its distribution activities.- No internal comparable available- Financial data in respect of distributor of comparable product available

• FAR

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FAR A Ltd & AB India Ltd.

Comparable 1 Comparable 2

F.1. Procurement from

A Ltd. Third party Third party

F.2. Packaging A Ltd Third party Third party

F.3. Marketing AB India Ltd.(2 % of sales)

Comparable 1(3% of sales)

Comparable 2(25% of sales)

F.4. Sales to final customer

AB India Ltd. Comparable 1 Comparable 2

F.5. After sales support


• FAR

37





A.1. Warehouse A Ltd. Third party Comparable 2

A.2. Logistics AB India Ltd. Comparable 1 Comparable 2

A.3. Brand A Ltd. Third party Comparable 2

A.4. Distribution network


A.5. Customer list AB India Ltd. Comparable 1 Comparable 2

• FAR

38





R.1. Product risk A Ltd Third party Comparable 2

R.2. Productservice risk


R.3. Credit risk AB India Ltd. Comparable 1 Comparable 2

R.4. Product obsolescence risk


• Conclusion– Transaction between A Ltd. & AB Ltd. (‘Controlled transaction’) and

Comparable 1 transactions are comparable.

– Though Comparable 2 is distributor but cannot be considered comparable on account of different FAR, for which it might be tough to carry out reasonable adjustments.

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• Applicability– Reseller should not make any material alterations to the product

traded.

• Comparability– Product comparability not very important, however better the

product comparability better would be the results– More functions and asset, higher risk would require higher gross

margin– Accounting variations should be taken care– Other factors like geographical differences, volume, high operating

cost may effect comparison

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…TP Methods – RPM


• Cost Plus Method (‘CPM’)– The cost plus method tests whether a profit mark-up charged in a

SDT is at arm’s length by reference to the mark-up charged in uncontrolled transactions.

– Transfer pricing is calculated by adding a mark-up, earned in uncontrolled transactions, to a direct and indirect cost of production/ services relating to SDT.

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TP Methods – CPM…


Example

SDT


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..TP Methods – CPM..

Seller (RP)

Buyer (RP)

Buyer

100 + 20

100 + 25


CPM – Case Study 3


AB India Ltd. A Ltd.Distributors &

Agents

-AB India Ltd is a manufacturer - A India Ltd. is a distributor of product “A100” manufactured by AB India Ltd.-A Ltd. also procures another product “A200” from third party contract manufacturer and distributes the same- A India ltd owns all intangibles

Third party manufacturer

• FAR

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FAR Controlled Transaction Uncontrolled Transaction

F.1. Designing & conceptualization

A Ltd. A Ltd.

F.2. Raw material procurement & manufacturing

AB India Ltd. Third party manufacturer

F.3. Marketing & sales A Ltd A Ltd.

F.4. Distribution A Ltd. A Ltd.

• FAR

45




A.1. Manufacturing facility

AB India Ltd Third party

A.2. Warehouse A Ltd. A Ltd.

A.3. Trade mark & brand name

A Ltd. A Ltd.

A.4. Design A Ltd. A Ltd.

A.5. Customer list A Ltd. A Ltd.

A.6. Distribution network

A Ltd. A Ltd.

• FAR

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R.1. Product risk A Ltd A Ltd

R.2. Market risk A Ltd A Ltd

R.3. Capacity risk AB India Ltd. Third party

R.4. Credit risk A Ltd. A Ltd.

• Conclusion– AB India Ltd. being simpler entity should be considered as the ‘tested party’

– As financial data would be available for the tested party and third party, gross margin earned by the third party would be considered as arm’s length mark-up

– If tested party would be earning less, it can be concluded that the transaction is at arm’s length.

– However, if financial data for third party contract manufacturer is not available, it may be tough to apply CPM.

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• Applicability– CPM is useful in case of long-term buy-and-supply agreements,

pricing of semi-finished goods, toll or contract manufacturing, services of purchasing agents, contract research etc.

• Comparability– Product comparability not very important, however better the

product comparability better would be the results– More functions and asset, higher risk would require higher gross

margin– Accounting variations should be taken care– Other factors like geographical differences, volume, high operating

cost may effect comparison

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...TP Methods - CPM


• Profit Split Method (‘PSM’)– This method aims to determine what division of total profits

independent enterprise would expect in relation to the relevant transactions.

– The profits should be split on an economically valid basis that reflects the functions and risks of each of the parties.

– In order to apply this method, it is necessary to identify the total profit arising from the related party transactions and split that profit between the parties according to their respective contributions.

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TP Methods – PSM…


• Applicability– In certain very complex trading relationships involving very

interrelated transactions, it is sometimes genuinely difficult to evaluate those transactions on a separate basis.

Approaches– There are two approaches to this method;

• Total profits split, and

• Residual profit split

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..TP Methods – PSM..


• Total Profit Split– Total profits from the controlled transactions made by all the

enterprises involved in earning those profits are split between those enterprises based on the relative value of the functions that each carries out.

Residual Profit Split– Total profit of the overall trade made by the associated enterprises

is considered. – Firstly, each participant is allocated sufficient profit to provide it

with a basic return appropriate to the functions carried out.– Secondly, any profit (or loss) left after the allocation of basic

returns would be split as appropriate between the parties – based on an analysis of how this residual would have been split between third parties.

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..TP Methods – PSM


• Transactional Net Margin Method (‘TNMM’)– The TNMM examines the net profit margin relative to an

appropriate base that a tax payer realizes from SDT vis-à-vis comparable uncontrolled transactions.

– Thus, the TNMM operates in a manner similar to the cost plus and resale price methods.

– The TNMM is based on the economic theory that returns earned by an enterprise operating under similar conditions, in the same market and industry, tend to become more equal after some time.

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TP Methods – TNMM…


• Applicability– If other methods are not applicable

• Procedure– Selection of Tested Party– Data – Current year vs. Multiple year– Aggregation of transaction– Identification of comparables– Profit level indicator

• Operating Margin = OP/Sales X 100• Net Cost Plus = OP/ Total Operating Expenses X 100• Berry Ratio = GP/ Operating Expenses• Return on Asset = OP/ Operating Asset X 100

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… TP Methods – TNMM


Any Questions?


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india's domestic transfer pricing

Economy & Finance

value of sdt section

section 40a1 applicability

jgarg economic advisors13

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domestic transactions

provisions of subsection

respect of goods

special economic zones