Transfer Pricing as of 18th Sept 2013 including the Safe Harbour Rules

Vikram Sankhala

The Law

The entire concept of Transfer Pricing revolves around the following Three Key Concepts

1. International Transaction (including Specified Domestic Transactions)

2. Associated Enterprise3. Arm’s Length Price

The Basic Principle of Transfer Pricing

• An international transaction between Associated entities needs to be at an Arm’s Length price.

So what do the Tax Authorities do

• They ask you to report all international transactions between Associated entities and to maintain support documentation to establish this.

• There is a threshold limit of the aggregate of such transactions being Rs 5 Crore.

• They also conduct Transfer Pricing Audits to scrutinize your documentation and the method you have adopted to establish this.

International Transfer Pricing provisions are covered under

• Section 92 to 92F in the Indian Income Tax Act, 1961;

• Rule 10A to Rule 10T of the Income Tax Rules; • Sections 271(1)(c), 271 AA, 271 BA and 271 G.

Relevant Provisions

• Computation of income from international transaction having regard to arm’s length price - Section 92 of the Income tax Act, 1961 (‘the Act’)

• Meaning of associated enterprises - Section 92A of the Act• Meaning of international transaction - Section 92B of the Act• Computation of arm’s length price - Section 92C of the Act• Reference to transfer pricing officer - Section 92CA of the Act• Power of Board to make safe harbour rules - Section 92CB of the

Act• Maintenance and keeping of information and document by person

entering into an international transaction - Section 92D of the Act

Relevant ProvisionsProvision Section of the IT Act

Report from an accountant to be furnished by person entering into international transaction

Section 92E of the Act

Definitions of various terms Section 92F of the Act

Penalty consequent to re-determination of arm’s length price

Explanation 7, Section 271(1)(c) of the Act

Penalty for failure to keep and maintain information and document in respect of international transaction

Section 271AA of the Act

Penalty for failure to furnish report under section 92E Section 271BA

Penalty for failure to furnish information or document under section 92D

Section 271G

Relevant ProvisionsProvision Section of the IT Rules

Meaning of certain expressions Rule 10A of the Income tax Rules, 1962 (‘the Rules’)

Determination of arm’s length price under section 92C Rule 10B of the Rules

Most appropriate method Rule 10C of the Rules

Information and documents to be kept and maintained under section 92D

Rule 10D of the Rules

Report from an accountant to be furnished under section 92E

Rule 10E of the Rules

Advance Pricing Agreements Rule 10F to 10S of the Rules

Safe Harbour Rules Rule 10T of the Rules

The Economics of Transfer Pricing

• Where tax rates are different between tax jurisdictions,

• there is a strong incentive to shift• income to a lower tax jurisdiction • and deductions to a higher tax jurisdiction• so that the overall Tax Rate is minimized.

What it means to the Jurisdiction

• As the aggregate tax payable by MNCs is reduced, tax authorities across the world incur significant losses.

• To guard against such losses, many countries have introduced transfer pricing legislation to govern the pricing of cross border transactions between related parties.

• India introduced rules and regulations on transfer pricing as of 2001 through sections 92A to 92F of the Indian Income tax Act, 1961 which guides computation of the transfer price and suggests detailed documentation procedures.

On Whom does TP Apply

• Transfer Pricing Regulations ("TPR") are applicable to the all enterprises that enter into an 'International Transaction' with an 'Associated Enterprise'.

• Therefore, generally it applies to all cross border transactions entered into between associated enterprises.

What is the Purpose

• The aim is to arrive at the comparable price as available to any unrelated party in open market conditions and is known as the Arm's Length Price ('ALP').

Associated Enterprises ('AEs')- How Identified?

• The basic criterion to determine an AE is the participation in management, control or capital (ownership) of one enterprise by another enterprise.

• The participation may be direct or indirect or through one or more intermediaries.

Participation in management

• Appointment of more than half of Board of Directors/ Board of Members/ one or more Executive Directors/ Executive Members by :

• ● - The other Enterprise• ● - The same person(s) in both the

enterprises.

Participation through Capital

Holding not less than 26% of the voting power directly or indirectly– - in the other enterprise– - in each of such enterprise

Participation through Control• Loan not less than 51% of Book value of Total Assets• Guarantee not less than 10% of Total borrowings• Use of Know how, patents, copy right, etc., of which other

enterprise is owner or has exclusive rights• Purchase of 90% or more Raw Materials and Consumables

for which prices and other conditions are influenced• Sale of goods manufactured or processed to other

enterprise or person specified by it for which prices and other conditions are influenced or Controlled by same person

• Apart from these, any relationship of mutual interest, as may be prescribed shall also be considered as Associated enterprise.

What is an InternationalTransaction?

• ‘International transaction’ means any of the following nature of• transactions between two or more “Associated enterprise” where,

either or both of whom are non-residents• ● (a) purchase,• ● (b) sale,• ● (c) lease of tangible or intangible property,• ● (d) provision of services,• ● (e) lending or borrowing money, or• ● (f) any other transaction having a bearing on the profits, income,• losses or assets of such enterprise.• ● (e) Mutual agreement between AEs for allocation/apportionment• of any cost, contribution or expense.

Deemed International Transaction [Sec 92B]

• Further section 92B provides that, where a transaction entered into by an enterprise with a person other than an associated enterprises and there exist a prior agreement in relation to the relevant transaction between such other person and associated enterprise, or the terms of the relevant transaction are determined in substance between such other person and the associated enterprises then such transaction shall also be treated as an international transaction.

Specified Domestic Transactions if the aggregate value exceeds Rs 5 Crores

• 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

SDT

• The amendment is in accordance with the suggestion made by the Supreme Court in case of Glaxo Smithkline Asia (P) Ltd.

Arms length price

• ‘Arms length price ‘ means a price which is applied or proposed to be applied in a transaction between persons other than associated enterprises, in uncontrolled conditions.

TP Methods

● (a) Comparable uncontrolled price method● (b) Resale price method● (c) Cost plus method● (d) Profit split method● (e) Transactional net margin method● (f) Such other method as may be prescribed

by the Board

Comparable uncontrolled pricemethod

● In this method, price charged in an uncontrolled deal between comparable entities is recognized and evaluated with the verified entity price to determine the Arm’s Length Principle.

● The CUP method offer the finest evidence of ALP.

• Comparable uncontrolled price method is relevant in case of

• ● transaction of loans,• ● royalties,• ● services,• ● transfer of tangibles.

Resale price method

● This method is used where the vendor addssimilarly little value to goods owned fromassociate enterprises. Here, Arm’s Length Priceis determined by reducing the relevant grossprofit mark-up from the sale price charged tofree entity.

● Resale price method is relevant in case of marketing operations of finished products more particularly in case of distribution of products not involving significant value addition.

● In this method the vendor adds comparatively small or no value to goods taken from associate enterprises.

Cost plus method

● In CP method first the cost incurred is determined.

● An appropriate cost plus mark up is thenadded to the cost to arrive at an appropriate

profit.● The resultant is the ALP

● Cost plus method is more relevant whereraw materials or semi finished products aresold.● Similarly, it can also be used where jointfacility agreements or long term buy andsupply arrangements or provisions ofservices are involved

Profit Split method

● PSM is used when transaction are inter relatedand is not possible to evaluate separately.● PSM first identifies the profit to be split for AE.The profit so determined is split between the AEon the basis of the function performed

● Profit split method is relevant where the transactions involved provision of integrated services by more than one enterprise.

● PSM method is used when associate enterprises are so combined that it turns into difficult to make transfer pricing analysis on transactional methods basis.

Transaction Net Margin Method

● Compares the net profit margin of a taxpayerarising from a non-arm's length transaction withthe net profit margins realized by arm's lengthparties from similar transactions; and● Examines the net profit margin relative to anappropriate base such as costs, sales orassets.

● Transactional net marginal method is used in most of the cases including transfer of semi finished goods, distribution of products where resale price method appears to be inappropriate and also in case involving provision of services.

Points

● Arithmetical mean of prices obtained by most appropriate method to be taken as Arm’s Length Price.

● Tolerance zone of 3 percent allowed at taxpayer’s option.

The obligations of an assesseehaving international transactions:

● (1) The income from the international transaction shouldbe computed as per arm’s length price● (2) Every person who has entered into an internationaltransaction shall keep and maintain such information anddocument in respect thereof and for such period, as maybe prescribed by the board and produce before the A.O orcommissioner (Appeals) as and when required in thecource of proceedings under Income Tax Act within aperiod of 30 days from the date of receipt of notice. (3) Theassessee entering into an international transaction is alsorequired to firnish an audit report in the form 3CEB by achartered accountant by 31st of October of relevant A.Ywhere the assessee is a company and by 31st day of julyin other cases.

DOCUMENTATION● The provisions contained in the TPR are exhaustive as far asthe maintenance of documentation is concerned.● This includes

– Enterprise wide information– Transaction Specific Information– Computation of the Arm’s Length Price.

● This also includes report of an accountant certifying that theALP has been determined in accordance with the TPR and thatprescribed documentation has been maintained.● This documentation should be retained for a minimum period

of 8 years.

● In case the value of the international transactionis below INR 10 million, it would be sufficient forthe taxpayer to maintain documentation andinformation which substantiates his claim for theALP adopted by him.● In effect, they need not maintain the prescribeddocumentation.

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

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

EFFECTS OF ADJUSTMENT TOTHE ALP

In case the ALP determined by the TPO indicatesunderstatement of income by the taxpayer,it could result into the following(a) Adjustment to reported income of the

taxpayer(b) Levy of penalty

Adjustment to the Reported Income

● The tax officer is bound to adjust the reported income of thetaxpayer with the amount of adjustment proposed by the TPO.● This would have an effect of increasing the assessed income oralternatively decreasing the assessed loss.● Furthermore, the eligible deductions available to the taxpayerunder section 80 could not be availed on the enhanced income.● However, those taxpayers who are eligible for deductions undersection 10A and 10B remain unaffected as these deductionsremain available on the enhanced income.

• Section 92 also provides that its provisions shall not apply where it has effect of reducing the income chargeable to tax or increasing the loss,

Penalties

(a) Penalty for Concealment of Income - 100 to 300 percent on tax evaded

(b) Failure to Maintain/Furnish Prescribed Documentation – 2 percent of the value of the international transaction

(c) Penalty for non-furnishing of accountants report – INR 100,000 (fixed)

● The above penalties can be avoided if the taxpayer proves that there was reasonable cause for such failures.

Time limit for passing orders

• The time limit for passing orders by the Assessing Officer where a reference is made to the TPO for determining the arm’s length price in an international transaction is 33 months from the end of the assessment year in which the income was first assessable

Latest Developments 2013

• In the new Circular No. 6 dated 29.06.2013, the CBDT has laid down guidelines for identifying Development Centres as a contract R&D service provider with insignificant risk for transfer pricing purposes.

The gist of these guidelines are:

1. Conceptualization and design of the product and providing the strategic direction and framework should be carried out by the foreign principal.

2. Funding for assets should be by the foreign principal and the foreign principal provides the remuneration to the Indian Development Centre for the work carried out by the latter.

3. Strategic Decisions should be taken by the foreign principal4. Direct Control and Supervision should be by the foreign principal5. The Indian Development Centre should not have economically significant

risks6. In the case of a foreign principal being located in a country/ territory (to

be notified in this behalf under section 94A of the Act as a low or no tax jurisdiction), it will be presumed that the foreign principal is not controlling the risk.

Income-tax (16th Amendment), Rules, 2013

Eligible Transactions:1. Software Development and ITES – 20/22%2. KPOs – 25%3. Interest on Intra group Loans – Base Rate of SBI + 150/300

Basis Points.4. Corporate Guarantees – 1.75/2% pa.5. Contract research related to Software Development – 30%6. Contract research related to Pharmaceuticals– 30%7. Manufacture and Export of Core Auto Components – 12%8. Manufacture and Export of Non Core Auto Components –

8.5%.

For identifying an Assessee with Insignificant Risk, the foreign principal must perform/provide:

1. Most of the economically significant functions2. Capital and funds and other economically

significant assets3. eligible assessee works under the direct

supervision4. eligible assessee does not assume or has no

economically significant realised risks5. eligible assessee has no ownership right, legal or

economic, on any intangible generated

Income-tax (16th Amendment), Rules, 2013

• The safe harbour rules shall be applicable for 5 assessment years beginning from and including assessment year 2013-14.

• AO can make reference to TPO within 2 Months of receipt of Form 3CEFA and the TPO has to pass an order within 2 Months of receipt of reference from AO on the validity of the option.

• The assessee can appeal against the order to the commissioner, who will be required to file an order within 2 Months of the appeal.

• Provisions relating to Documentation (sections 92D and 92E) will still apply.

• This option can be exercised by filing of Form 3CEFA which has been prescribed in the rules.

Income-tax (16th Amendment), Rules, 2013

• Shall not apply to transaction entered into with an associated enterprise located in any country or territory notified under section 94A or in a no tax or low tax country or territory.

Notification 41/2013

• Notification No. 41/2013/F. No. 142/42/2012 (10 June 2013) revises the rules applicable to the Accountant’s Report in Form No. 3CEB, to align those reporting requirements with the definition of international transactions and to extend transfer pricing provisions for certain specified domestic transactions. All international transactions and specified domestic transactions must be appropriately disclosed in Form No. 3CEB on or before the 30 November due date.

Notification No. 47/2013

• Applicable when international transaction with a party located in a “notified jurisdictional area.”

• Form No. 10FC to be filled.

Additional Documentation to be maintained vide Notification 47/2013

• (a) a description of the ownership structure of the specified person, including name and address of individuals or other entities, whether located in the notified jurisdictional area or outside, having directly or indirectly more than ten per cent, shareholding or ownership interests;

• (b) a profile of the multinational group of which the specified person is a part along with the name, address, legal status and country of tax residence of each of the enterprises comprised in the group with whom the assessee has entered into a transaction, and ownership linkage among them;

• (c) a broad description of the business of the specified person and the industry it operates in;

• (d) any other information, data or document, which may be relevant for the transaction with the specified person.

• India’s APA Guidance Booklet with FAQs addresses the procedures to be followed by taxpayers and the tax authorities before a taxpayer can enter into an APA.

Recent Important Rulings

Vodafone Case

• An Addition of Rs 8500 Crore was made by the TPO on account of two unreported international transactions.

• The two unreported transactions are the sale of the call centre business by the petitioner to Hutchison Whampoa Properties (India) Pvt. Ltd. and an alleged assignment of call options by the petitioner to Vodafone International Holdings B.V.

The Ruling

• The petition was dismissed on the Grounds that an alternate remedy is available before the petitioner.

• Vodafone had an alternate remedy of challenging the notices before the CIT (Appeals).

Advertising, Marketing and Promotion expenses.

• The Maruti Suzuki judgement was set aside by the Supreme court. The LG Case, the BMW Case and the Ford(India) Case are two important cases on this issue.

LG Electronics Case – Delhi ITAT (Special Bench)

• Transfer pricing adjustment in relation to advertisement, marketing and sales promotion expenses incurred?

• Whether the assessee should have earned a mark up from the Associated Enterprise in respect of AMP expenses alleged to have been incurred for and on behalf of the AE?”

Held

1. advertising, marketing and promotion (“AMP”) expenses incurred by a taxpayer constitute an “international transaction”.

2. The “Bright Line test” can be applied to determine whether Advertising, Marketing and Promotion expenses incurred by assessee are excessive and for the benefit of the brand owner

What is the bright line test

• The bright line test looks at the average advertising and promotional spend of comparable companies, with any expenditure above this potentially treated as either non-deductible or as creating a local marketing intangible.

• The test was laid down in a US court in the case of DHL incorporated and its subsidiary.

BMW Case

• It was held that no separate compensation is required for excessive advertisement, marketing and sales promotion (AMP) Expen diture as the same has been received by way of the premium profits earned by the taxpayer at the gross level as well as the net level vis-à-vis comparable companies.

Ford India Private Ltd. v. DCIT (ITA No. 2089/Mds/2011)

• The Chennai Bench of the Income-tax Appellate Tribunal applied a “bright-line test” with respect to the taxpayer’s “excessive” advertising, marketing, and brand promotion expenditure to uphold the transfer pricing adjustment, but concluded that companies using a foreign brand could not be considered comparable companies for purposes of applying the “bright-line test.”

Ariston Thermo India Ltd. v. DCIT

• Held that adjustments by the taxpayer due to under utilization of capacity could be made.

• The tribunal rejected the department’s contention that economic adjustments can only be made on the basis of comparables.

Micro Inks Ltd. v. ACIT

• The Ahmedabad Bench of the Income Tax Appellate Tribunal ruled that in applying the CUP method, an adjustment can be made under Rule 10B(1) “to account for differences …. which could materially affect the price in the open market”.. Micro Inks Ltd. v. ACIT [2013], Ahemedabad ITAT, Bench.

Hinduja Global Solutions Ltd. v. ACIT (ITA No. 254/Mum/2013)

• The Mumbai Bench of the Income-tax Appellate Tribunal held that, where the lending of money was in foreign currency to its AE the domestic prime lending rate would have no applicability and the interbank rate fixed should be taken as benchmark rate for international transactions.

• It, therefore held that LIBOR rate has to be adopted in the instant case

Vijai Electricals Ltd Vs ACIT

• The Hyderabad Bench of the Income-tax Appellate Tribunal held Transfer pricing provisions do not apply

• (i) to an investment in share capital of overseas companies and

• (ii) to transactions where no “income” has arisen

Redington (India) Ltd. v. ACIT (ITA No. 2164/Mds/2010)

• Prices are negotiated between parties according to quantity, value and other aspects which are determinant of market forces. For making a comparative study under CUP method also, what is required is a comparison with actual sale and purchase with unassociated enterprise or transaction between unassociated enterprises.

• It cannot solely be based on list prices, which at the best can be considered only as a reference point.

CIT v. Indo American Jewellery Ltd. (ITA No. 1053 of 2012)

• If the ALP in respect of an international transaction of `sale' is determined, then there can be no question of treating the non-receipt of interest in such sale transaction as a separate international transaction warranting any further adjustment.

Ascendas (India) Private Ltd. v. DCIT, (ITA NO. 1736/Mds/2011)

• The Chennai Bench of the Income-tax Appellate Tribunal held that the discounted-cash-flow method is preferable in determining the arm’s length price for the sales of shares.

Vodafone and Shell Transfer Pricing Issue

• Here the two companies had transferred shares to Associated entities at Book Value.

• The TPO made an adjustment valuing the shares as underpriced.

• The hearings before the court are in progress.

The END