The Indian Transfer Pricing Regulations came into force in 2001 with the transfer pricing audits effectively beginning from 2003. The Central Board of Taxes in India introduced a special cell of trained officers which is responsible for all transfer pricing audits. Over the past four years, there has been a significant increase in the number of transfer pricing audit officers (TPOs). The TPOs in this short time have clearly been successful in positioning India’s transfer pricing administration as an aggressive one.
The Indian process of selecting cases for a transfer pricing audit is procedural and apparently does not deal with the qualitative aspects of the case. The Board of Taxes has, vide an instruction, notified that should the value of its transaction exceeds $1.25 million (now stands revised at $3.75 million) the case should be compulsorily audited. This process has led to a large number of cases having selected, which does not leave the TPOs with adequate time to scrutinise the case.
In the past couple of years, the TPOs have made significant adjustments. The fact pattern of adjustments indicates that one in every four cases picked-up for audit, is adjusted.
The typical scenarios which would attract the attention of the TPOs for a transfer pricing audit would be:
Consistent losses of the taxpayer attributable to inter-company transactions;
Significant changes in the profitability of the taxpayer and its associated enterprises;
Unjustifiably large payment of management charges not passing the ‘benefit test’;
Losses incurred by routine distributors; and
Low mark-ups for services.
It is important that a taxpayer regularly monitors and regulates its transfer prices to survive a transfer pricing audit in India. Some of the key aspects which could help a company survive a transfer pricing audit process are discussed as under:
Strong and robust transfer pricing documentation
The Indian transfer pricing regulations mandate a taxpayer entering into international transactions with its overseas affiliates, to maintain specified transfer pricing documentation and information, on a contemporaneous basis. The list of prescribed documentation in India is an exhaustive one with details relating to the profile of the group, the industry in which the taxpayer operates, a description of the functional profile of the taxpayer, etc. The documentation maintained by the taxpayer must also include a detailed economic analysis which would be the basis to conclude that the taxpayer’s transactions are at arm’s length. The economic analysis is the critical part of a transfer pricing documentation which would be the basis of defending the transfer pricing policy of a taxpayer.
It also becomes imperative for a taxpayer to regularly update the information and documentation so that the true and accurate business reality of the taxpayer is reflected in the documentation, including their future business plans, strategies and market positioning.
Due recognition of the economic circumstances
Several MNEs (‘multi-national enterprises’) set their inter-company transfer pricing policies for India, based on their existing policies as prevalent in other countries. Some of the MNEs are guilty of periodically not reviewing such pricing policies.
Typically, the MNEs should fix their global transfer prices based on a global economic comparability analyses. In doing this exercise, it becomes important that a taxpayer takes note of the prevailing economic conditions in the country of operation, before the transfer prices are fixed. One should bear in mind that global pricing policies may be implemented; however they should be tuned to suit the local transfer pricing environment.
It is also crucial for a taxpayer to not deviate from global policies for pricing of goods and services unless the pricing is not feasible from a business perspective. Further, all reasons for any deviations must be clearly documented and recorded as the same may support the taxpayer during the audit process.
Establishing control of the audit process
Just as important is the need for robust documentation, it is equally important for a taxpayer to identify and document its defence strategy clearly. The Indian transfer pricing audit process may become tedious and lengthy at times; however it is crucial for the taxpayer to take control of the audit process. To take control of the situation, the taxpayer must take a firm stance and must clearly put his case forward to the TPO. When a taxpayer provides timely and appropriate responses to the TPO with a clear focus on (i) the business reality and (ii) the economic analysis, the former can really take control of the audit process. Further, the taxpayer must deploy the right resources for a transfer pricing audit, which can drive the audit in the right direction.
A clear approach in a transfer pricing audit is very important because the Indian TPOs tend to categorise taxpayers under certain classifications (e.g. IT service providers, contract manufacturers, routine distributors, etc.). Thus there is a need for highlighting the factual peculiarities of the taxpayer’s case and distinguishing oneself from others.
It is worthwhile to mention that the Indian transfer pricing regulations do not provide for a process of negotiation with the taxpayers. Under the Indian scenario, when a transfer pricing audit is completed, an order is passed either accepting or rejecting the arm’s length price of the taxpayer. The adjustment made by the TPO becomes final and the income tax officer shall proceed to raise a tax demand on that basis. The transfer pricing order, per se, is not an appealable order but the assessment order by the income tax officer based on which a tax demand has been raised is an appealable order.
Some other key challenges faced during Indian transfer pricing audits
Multiple year data vis-à-vis Single-year data: The Indian transfer pricing regulations specifically provide for use for ‘single year’ data in a comparability analysis, unless use of ‘multiple year’ data would really influence the arm’s length price. Even though the OECD guidelines support the use of multiple year data, the TPOs in India do not seem to generally accept the same.
Lack of comparable companies in databases: The Indian taxpayers as well as the TPOs use two databases to conduct their comparability analyses. However these databases have certain limitations in culling out reliable and accurate data. Further, benchmarking transactions such as ‘marketing services’, ‘management services’, etc., become a challenge as the databases do not provide substantial information about comparable companies.
Group’s income position: The Indian TPOs do not generally prefer to take note of the group revenue and profitability position before concluding an audit. As a result, the Indian service provider is expected to make substantial net profit margins for its services, even though the parent holding company may be making losses while selling the services in its home country.
Finality to an audit: Unlike the US, where the APA guidelines are applicable, the Indian tax regime has been structured in a manner, wherein if a TPO inadvertently misses to audit a taxpayer’s case, he can go back and reopen the case. In other words, when a TPO makes an adjustment to the transfer prices of a taxpayer in say, year 3, he may go back and revise the taxpayer’s prices for year 1 and 2, after obtaining the Commissioner’s approval.
In this case, if a taxpayer follows clear processes of establishing its arm’s length price based on strong documentation and economic analysis, it would become a challenging task for the TPO to prove otherwise.
