The Transfer Pricing Regulations and Rules (hereinafter the TP Law) have been finalized by the Indian revenue authorities. However, various aspects of the TP Law need to be clarified in detail, so that the taxpayer can follow the new transfer pricing regime with clarity and certainty.
Applicability
The TP Regulations were introduced by the Finance Act 2001, vide sections 92 to 92F of the Income Tax Act 1961 (the Act), and apply for the fiscal year April 1 2001 to March 31 2002 and onwards. The Act states that all international transactions between associated enterprises, ie related parties, must be documented and benchmarked, to show that the international transactions have taken place at arm's length. However, the detailed rules regarding documentation, application of various methods etc, was only notified on August 21 2001. Further, the rules state that documentation should be maintained on a contemporaneous basis.
The dichotomy relating to the documentation requirements for international transactions entered into before the framing of the final rules has been clarified, by way of a circular from the revenue authorities, which states: "Where an assessee has failed to maintain the prescribed information or documents in respect of transactions entered into during the period 1st April, 2001 to 31st August, 2001, then non-maintenance of such information or documentation, should not result in an adverse price adjustment for such affected transactions, nor is the levy of penalty necessitated."
Though the above circular embodies the spirit of fairness, in that the taxpayer should not suffer due to delays in finalizing the TP Rules, it has not addressed the main question ? ie that the taxpayer would still have to demonstrate that the international transactions entered into with its associated enterprises during the above period are at arm's length. The revenue authorities thus need to clarify explicitly the manner in which the taxpayer should justify the international transactions, without adhering to the strict documentation requirements. This will provide firmness of interpretation and avoid ambiguity.
Aggregation/grouping of transactions
The various pricing methods that are detailed in the TP Law have not set forth in specific terms the principle of aggregating and grouping transactions entered into by the single entity with its associated enterprises.
The OECD Guidelines, the US Regulations and general international transfer pricing rules all recognize that, in practice, an entity would be involved in a vast array of international transactions with its associated enterprises. These international transactions may involve numerous products or transactions for the same product, services performed etc. Hence, in such circumstances, it would be permissible to apply the appropriate pricing methods to the overall results of the product lines, or similar functions performed for similar products, eg resale of electronic goods, or to the entity as a whole, or other significant groupings as may be appropriate. Thus, in most cases, grouping or aggregating transactions for the purposes of a transfer pricing analysis is the norm followed by most countries. It would, therefore, be necessary for the Indian revenue authorities to issue guidelines on this matter, and also explain the principle of grouping or aggregation of transactions by way of examples under the various prescribed methods. Further, such clarification should also address the issue of aggregating transactions relating to separate entities, where the transactions involve related products or services, and aggregation would provide the most reliable means of determining the arm's-length consideration.
Arm's-length range
The TP Law provides that the controlled international transactions have to be compared to the arm's-length price determined by the taxpayer. Where the application of the most appropriate method results in more than one price, then the arithmetical mean of such prices is to be taken as the arm's-length price.
Transfer pricing is not an exact science, it is the application of a scientific methodology for arriving at an arm's-length price to the controlled transactions of a taxpayer. The arm's-length transaction, as defined in Indian law, being an exact price, would lead to a great burden on the taxpayer, as a reasonable range of prices would be unacceptable to the Indian revenue authorities.
The OECD, the US Regulations and other transfer pricing regulations provide for the use of a range of prices when the application of the most appropriate method or methods produces a range of figures all of which are relatively equally reliable. Further, when the controlled transactions are within the arm's-length range, they provide that no adjustment should be made.
A recent circular issued by the Indian revenue authorities tries to mitigate this hardship, by providing a range of plus or minus 5% of the arm's-length price as being acceptable. However, this does not mitigate the hardship, as the plus or minus 5% is benchmarked to the arm's-length price, which is an exact price, and hence the purpose is defeated. Thus, it would be expedient for the revenue authorities to clarify this, and bring within the TP Law the concept of an arm's-length range of prices, which is the international norm.
Services
Establishing transfer pricing methodologies for related party services has become a dynamic and complex area of international tax. With the advent of e-commerce, the concept of a global village has been introduced in today's world of international trade and commerce. Thus, the array of services provided in a multinational group has gone beyond the traditional areas of management functions, and encompasses a varied mix of activities such as IT-related activities, global dealing room activities, call centres, back office services etc. It is against this background that the Indian TP Law should clarify the issues discussed next.
Chargeability
All intra group services rendered within multinational groups may not be strictly chargeable activities. The OECD Guidelines recognize this principle: "an intra-group service justifying a pricing charge is rendered if the activity provides a group member with ?economic or commercial value to enhance its commercial position'."
The law should therefore contain a set of guidelines to determine whether the service is chargeable. If chargeable, is it so integral to the business of the taxpayer as to justify a mark-up? The test essentially is whether an independent company in comparable circumstances would have been willing to pay for the activity or would have performed the activity in-house. Reference may be made to the US Regulations that list four circumstances in which the provision of services is deemed to be an "integral part" of the business activity of a controlled group:
the renderer or the recipient engages in the trade or business of providing similar services to unrelated parties;
the provision of services to one or more related parties is one of the "principal activities" of the renderer;
the renderer is "peculiarly capable" of rendering the services and the services comprise a principal element in the operations of the recipient; and
the recipient has the benefit of receiving a "substantial amount" of services from related parties.
Further guidance can also be taken from the OECD Guidelines, which state that those activities undertaken by the parent company or a regional holding company solely because of its ownership interest in one or more other group members, ie in its capacity as a shareholder, do not justify a charge to the recipient companies.
Specific guidance
India is being looked upon internationally as an outsourcing centre for fulfilling the IT and IT-related needs of multinationals operating on a global basis. The ability of India to leverage its huge human resource pool, especially its IT and English language skills, is enormous. Indeed, a NASSCOM McKinsey Study? states that the global IT-enabled services opportunity is likely to grow to $142 billion by 2008. Further, India could build a $17 billion industry by 2008, given its very strong value proposition (skilled labour, long-term economics, position on learning curve). India has experienced the setting up by various multinationals of dedicated back office centres and should witness further growth in the future.
Thus, to keep this industry alive and create certainty in the environment, the Indian revenue authorities should consider issuing specific guidelines for specialized services regarding the methodology to be applied for arriving at an arm's-length price, etc. This would avoid litigation, remove uncertainty and encourage foreign direct investment in this large growth sector of the economy.
Intangibles
The TP Law states that for international transactions involving a transfer of unique intangibles, the profit-split method may be applied. The Indian revenue authorities should clarify by way of exhaustive examples how other methods should also be applied for the transfer of unique intangibles. Thus the Indian revenue authorities would have to clarify many issues relating to a transfer of intangibles: these are discussed next.
Definition
The TP Law should firstly try to focus its attention on trying to define the broad categories of property that would be covered by the definition of intangibles. The Indian revenue authorities can determine the scope of the definition requirements by drawing on the OECD Guidelines and the US Internal Revenue Service's definition in their Transfer Pricing Regulations. Generally, the definition encompasses the following:
patents, inventions, formulae, processes, designs, patterns or know-how;
copyrights and literary, musical or artistic compositions;
trademarks, trade names or brand names;
franchises, licences or contracts;
methods, programmes, systems, procedures, campaigns, surveys, studies, forecasts, estimates, customer lists or technical data; and
any other similar item that derives its value from its intellectual content rather than its physical attributes.
The definition would help the taxpayer to understand the scope of the property transferred.
Methodology
As pointed out above, the TP Law only prescribes the profit-split methodology for determining the arm's-length price for the transfer of intangibles. However, other methods are equally applicable and they should also be set out and explained by the Indian revenue authorities. The other methods stated in the OECD Guidelines and US Transfer Pricing Regulations are:
comparable uncontrolled transaction method (CUT) ? relies on a reference to an uncontrolled transaction to establish an arm's-length royalty rate. For an uncontrolled transaction to be comparable to the tested transaction, the intangibles being compared must be used in connection with similar products or processes within the same general industry or market. Further, the two intangibles being compared should have a similar profit potential;
transactional net margin methods (TNMM) ? when adequate comparables cannot be identified, the TNMM may be applied, however it may not give the best results, as the identification of adequate uncontrolled comparables may be difficult; and
economic return method (ERM) ? when benchmarking is not adequate by the application of the earlier methods, then the Indian revenue authorities may consider prescribing the ERM as an acceptable method for benchmarking the transfer of intangibles. Under this methodology, the economic returns expected by the transferor or the transferee, discounted to reflect both the time value of money and the cost of bearing risks inherent in the business activities under review, are considered. This method is based on the general economic principle that the transferor and the transferee will each seek to recover their costs related to the development or use of the intangibles plus an operating profit, in return for capital invested and risks assumed.
Cost contribution/sharing arrangements
The TP Law has not specified any methods for determining the arm's-length allocation/charge in the case of a cost contribution or cost sharing arrangement. With the globalization of research and development activities, and in view of the fact that foreign direct investors will try to leverage the availability of cheaper human resource Indian skills, it would be prudent for the Indian revenue authorities to bring out detailed guidelines to bring certainty in this matter.
Competent authority procedure
The Indian revenue authorities will have to frame guidelines to activate competent authority procedures, as India is now part of the global transfer pricing regime. This is a must, because the companies operating from countries that are global trading partners of India as well as Indian companies will have recourse to the mutual agreement procedure available under double taxation avoidance agreements signed with India.
Secrecy
To safeguard the highly sensitive and confidential nature of the data made available to them by taxpayers, the Indian revenue authorities should provide for safeguards to maintain the secrecy of such sensitive data. The adoption of such a measure will build confidence in the international community. Such measures are to be found in the US, under section 6103 of the Internal Revenue Code, and further, the taxpayer may supplement protection from disclosure by contractual agreements with the IRS and through protective orders (or conditional enforcement orders) issued by the courts.
The above are some of the important issues that the Indian revenue authorities would do well to focus on, so that the Indian TP Law and its administration may be a model for other countries to follow, based on the important principles of certainty, clarity and taxpayer-friendly measures. Further, the Indian regime should be flexible enough to adapt to and assimilate the changing international environment.
