The long-expected detailed transfer pricing provisions introduced into the Indian Income Tax Act with effect from April 1 2001 have given rise to a good deal of activity amongst the Indian corporate community.
The provisions are largely in line with international norms and prescribe methodologies to be followed, documentation to be maintained and penalties to be levied, though in some respects they have their own peculiar flavour. The central theme of the provisions, as with most national regulations in this area of international tax, is the arm's-length principle, which requires charging an arm's-length price for all international transactions between associated enterprises. The provisions cast a wide net and apply to all multinational corporations with a presence in India as well as Indian companies with a presence overseas and all types of transactions between or among them.
The provisions require that income of associated enterprises from international transactions should be computed according to the arm's-length price.
Methodologies
The provisions have specifically defined certain terms for the sake of clarity regarding arm's-length price, associated enterprise, international transactions and many other relevant terms. These definitions are generally exhaustive covering most of the situations in which the term may apply.
The provisions prescribe five methods to arrive at the arm's-length price:
comparable uncontrolled price method (CUP);
resale price method (RPM);
cost plus method (CPLM);
profit split method (PSM); and
transactional net margin method (TNMM).
In addition to these five methods, the legislation permits the use of any other method as may be prescribed, though such a method is not yet prescribed.
The provisions require the taxpayer to select the most appropriate method and establish that the selected method is best suited to the facts and circumstances of the particular transaction and provides the most reliable measure of an arm's-length price.
When application of the most appropriate method produces more than one arm's-length price the taxpayer is required to use the arithmetic mean of such prices. In this respect the provisions also permit the taxpayer to target a range of plus or minus 5% of the arm's length-price, rather than targeting a single price.
Documentation
The documentation to be maintained by a taxpayer is mandatory and exhaustive. Every associated enterprise entering into an international transaction must maintain certain information and documents, all of which must be provided in the event of a request by the tax officer.
The documentation requirements cover two categories - primary and support. While the taxpayer must maintain the primary documentation, the support documentation requirements are optional and may be maintained by the taxpayer. The primary documentation mainly constitutes most of the aspects covered in a typical documentation study, and the support documentation includes external government publication and industry reports. The primary documentation would need to be in place by the due date for filing the income tax return at the latest and would have to be maintained for nine years from the end of the relevant year.
Fortunately, the provisions prescribe that a taxpayer need not maintain fresh information and documentation of a particular international transaction with its associates in the following years, unless there is any significant deviation in the nature or terms of the international transaction that may influence the transfer price. Nevertheless, the taxpayer would need to update the comparable set and financial data pertaining to the documentation study with the latest available financial information.
Typical to Indian provisions is the requirement for taxpayers to furnish an accountant's report along with the income tax return, certifying firstly, that the taxpayer has maintained all the prescribed information and documents and secondly, certain factual information about international transactions with associated enterprises.
Audit
Based on the material and information available, the tax officer, in the course of audit proceedings, has been empowered to determine the arm's-length price. This is in cases where:
the price is not in accordance with the provisions;
prescribed information or documentation is not maintained;
data used for computing the price is unreliable or incorrect; or
where requested information is not provided.
The provisions stipulate that in cases where certain profits, which are otherwise tax sheltered, are enhanced by application of the provisions, no tax exemption would be available on such enhanced profits.
Penalties
Probably the most striking feature of the Indian transfer pricing provisions is the prescription for significant penalties for specified defaults. Penalties can be levied if there is any addition or disallowance by the tax officer, failure to maintain documentation or failure to provide an accountant's report. The penalty may amount to between 100% and 300% of the amount of incremental tax in the case of additions or disallowances by the tax officer and as high as 2% of the value of the transaction in cases where the taxpayer has failed to maintain or furnish prescribed documentation. These penalties may not be levied in the following cases:
non-maintenance of documentation;
if the taxpayer can demonstrate reasonable cause for non-compliance; and
in cases of additions or disallowances, if the tax officer is satisfied that the arm's-length price has been computed as per the provisions in good faith and due diligence.
Issues
While the setting up of a comprehensive framework to determine profits from transactions between associated enterprises had been expected, the legislation introduced has given rise to some interesting issues.
The provisions require computation of income from international transactions having regard to arm's-length price only in cases wherein there is 'income arising from international transactions'. There is no clarification on what would be the position for non-income-generating transactions such as gifts of assets, transfers at cost and no mark-up being charged.
The provisions extend application of the arm's-length price to cost-sharing arrangements and intra-group services without dealing adequately with these concepts.
Conspicuous by its absence is the facility to obtain advance pricing agreements (APAs). Such provisions are expected to be introduced in the future.
Business reorganizations are not excluded from the scope of applicability of the transfer pricing provisions.
This being the initial period of application of the detailed transfer pricing provisions, the depth of the available databases is not yet tuned completely from a transfer pricing perspective. This poses certain problems in relation to finding closely comparable companies. Further, availability of latest financial information also poses a problem in updating the documentation studies. To add to the concern, the provisions stipulate that if the revenue authorities are satisfied that the data used in the analysis is not reliable, they are empowered to re-determine the arm's-length price.
While the detailed provisions apply with effect from April 1 2001, the discovery of non-arm's-length prices by the tax authorities in the first year of the new legislation may lead to adjustment in the audit of prior years in terms of the general anti-avoidance provisions. This could empower the tax authorities to reassess income; demand interest for delayed payment of tax and levy penalties.
The provisions require a taxpayer to arrive at the arm's-length price of the transactions under all methods. However, while applying the margin methods, working out the arm's-length price for the transactions would pose practical difficulties.
Though the provisions permit a buffer of 5% while benchmarking to the arm's-length price, there is insufficient clarity on the manner in which the 5% range should be worked out.
Since no other method is prescribed as yet, acceptance of treatment of certain special transactions such as capital transactions, interest-free loans remains to be seen.
It is expected that as the law and practice of transfer pricing evolves in India, the above issues will be suitably addressed.
Double tax avoidance treaties and domestic provisions
India has entered into several double tax avoidance treaties with countries around the world. Most of India's treaties follow the OECD model. The treaties recognize the arm's-length principle by providing that the profits of the related parties should be determined on an arm's-length basis and various tax concessions would only be granted with respect to arm's-length income. Most of India's treaties follow Article 9(1) of the OECD model which permits the taxing of profits that would have resulted had the related parties transacted on a basis governed by market forces. Many treaties also contain a provision equivalent to Article 9(2) of the OECD model, which provides for transfer pricing adjustments as a consequence of any transfer pricing adjustments made by the other contracting state.
The treaties enable the tax officer to apply the transfer pricing provisions contained in the Indian Income Tax Act and do not enlarge the scope of the provisions of the domestic tax law. In other words, the treaties by themselves do not impose any burden from an Indian transfer pricing perspective. However, since the treaties merely enable the tax officers of the respective contracting states to apply the transfer pricing provisions contained in the respective domestic laws, there is a potential for unfair advantage to a state that has a comparatively aggressive approach to transfer pricing in its domestic tax law compared to India.
Corresponding adjustments
A peculiarity of the Indian provisions is that they specifically reject certain types of corresponding adjustment. Consider a case where X India Ltd pays $100 as royalty to X Inc. The tax officer of X India Ltd makes an adjustment to this royalty after studying the transfer pricing implications and arrives at an arm's-length royalty of $80. Though the adjusted transfer price is $80, no corresponding downward adjustment will be permissible to the taxable income of X Inc. However, certain tax treaties (for example, Australia, Japan, Netherlands, the UK, and US) specifically provide for correlative adjustments so it may be possible to contend under those treaties that the income of X Inc should be reduced to $80.
Company law and transfer pricing
There are two mandatory accounting standards issued by the Institute of Chartered Accountants of India, which relate to specific disclosure norms for corporates applicable in specified situations. The first is accounting standard 17 (AS-17), which speaks of reporting separate segments of revenue separately and the second is accounting standard 18 (AS-18), which deals with related party disclosures.
AS 17 recognizes two criteria of segregated reporting - one on the basis of business segments and the other on the basis of geographical segments. Business segmentation requires specified taxpayers to report distinguishable components: a group of products or services subject to certain risks and returns that are distinguishable from the other group of products or services, on a segregated basis. Geographical segmentation is based on provision of products or services to different markets and economic environments. There may be situations wherein the classification on this basis may be different from the manner in which the set of functions have been analyzed in the documentation study for transfer pricing. The acceptability by the tax officers regarding such differential approaches adopted in case of corporate disclosure and for transfer pricing analysis is yet to be seen.
AS 18 aims to ensure disclosure in the financial statements relating to transactions with related parties. The required disclosure includes an indication of the volume of the transactions, amount of outstanding items and the pricing policies. The underlying intention of the standard is to enable a reader of the financial statements to form a view about the effects of related party relationships on the company. The definition of the term related party as in the standard is a little different from the term, associated enterprises, as defined in the transfer pricing provisions. Hence, there may arise certain circumstances wherein the disclosure based on the AS may not cover all the international transactions as purported to be covered by the transfer pricing provisions and vice-versa.
Exchange control regulations and transfer pricing
Under the prevailing foreign exchange regulations, to ensure that there is no under invoicing of merchandise exports, an exporter needs to file a declaration before the customs department showing the full export value of the goods and receive the foreign exchange corresponding to such value into India. Customs authorities recognize the value declared by the exporter.
To guard against over invoicing on imports, the central bank - the Reserve Bank of India - has directed authorized dealers to exercise due precautions when releasing foreign exchange for importers.
It may be noted that the Indian transfer pricing provisions acknowledge the impact of the Indian laws and government orders in force while establishing comparability of two enterprises. This calls for a harmonized reading of the transfer pricing provisions and the regulatory restrictions whilst arriving at the arm's-length price.
Customs laws and transfer pricing
The transfer pricing provisions are separate from the customs laws (laws regulating imports and exports). While the value determined under the transfer pricing provisions might have persuasive value for the purpose of customs laws or vice-versa, competing incentives of the two laws would present practical problems.
The road from here
With India increasingly integrating with the rest of the world economy, transfer pricing is an issue that will gain significant momentum. On the one hand, the revenue authorities will look to transfer pricing adjustments to boost revenue collection rather than wasting efforts on disallowing petty expenses. While on the other hand, corporates will spend more time harnessing the legitimate benefits that transfer pricing has to offer.
Transfer pricing related litigation could result in stimulating the perennial conflict between the revenue authorities and the taxpayer. Where the litigation may lead is for India to wait and see.
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