Transfer pricing (“TP”) is applicable both to goods and services and comes into play when these change hands in inter-company transactions in an international scenario. The concept of TP is provided under section 92 to 92 F of the Income Tax Act, 1961 (“ITA”). In India TP has been in news due lots of litigation arising on the subject but at the same time the scenario has changed substantially with introduction of Advance Pricing Agreements (“APA”), Safe Harbour Rules (“SHR”) and Dispute Resolution Panel (“DRP”). This article tries to bring in an understanding over the subject and also what are the developments on it in view of Instruction notification 15/2015 which has come into immediate effect and was issued by CBDT.
A. Understanding Transfer Pricing
Section 92 of the ITA is dealing with the income from International Transactions. Transfer Pricing regulations come into play for all the enterprises that enter into an international transactions with associated enterprises. It generally applies to all cross border transactions entered into between the enterprises.
Lets look at the illustration below.
The profit earned by Company A is Rs. 100 as compared to Rs. 200 earned by the Company B. By routing the profit through B, company B therefore, appropriates the balance profit and the price of goods sold is fixed on arbitrary basis and is not governed by market forces. Therefore, the TP may be arbitrary or dictated and not governed by market forces as shown above. It is basically the price or value of goods or services transferred between related units or even between unrelated parties but through a common entity. So, if the company B is in high tax jurisdiction, the transfer pricing can siphon off profits and if company B is in low tax jurisdiction, it can reflect the profits. To resolve this imbalance various tools have been introduced as the solution, which are discussed below.
B. Assessment of Tools to Tackle TP
1. Arms Length Principle
Prices set for international transactions for goods and services exchanged between group entities should for purposes of tax be derived from prices which would be applied for tax purposes in similar transactions or similar conditions in the open market. To resolve the issue of TP, Arms Length Principle is the concept. There are more than one method to compute the ALP, however the taxpayer can choose his method of ALP as per regulations. In terms of the ITA, the following falls within the ambit of ALP, the international transactions and specified domestic transaction between two or more associated enterprises. Under Companies Act, 2013 define Arm’s Length Transactions as the expression Arm’s Length Transaction to mean a transaction between two related parties that is conducted as if they were unrelated, so that there is no conflict of interest. Under Income Tax Act, 1961 Section 92F define Arm’s Length Price is the price applied (or proposed to be applied) when two unrelated persons enter into a transaction in uncontrolled conditions.
2. Safe Harbor Rules
The Finance (No. 2) Act 2009 introduced the provisions in the Income Tax Law that empowered the Central Board of Direct Taxes (CBDT) to issue transfer pricing-Safe Harbour Rules. On September 18, 2013, the CBDT issued the final SHR. So, in order to reduce TP audits and the law has been modified stating that ALP would be subject to SHRs. Section 92CB of the Income Tax Act, 1961 states that the circumstances under which CBDT will accept the TP of the assesse. The SHR are not arm’s length prices, but in the nature of presumptive taxation, which generally enthuse taxpayers to opt for the same, as a compromise for not having to be involved in prolonged litigation. As duly explained by different tax experts, safe harbor include a premium payable by taxpayers for avoiding disputes and protracted litigations. Any taxpayer who has entered into an eligible international transaction and who wishes to exercise the option to be governed by the safe harbour rules is required to file a specified form (Form 3CEFA). SHRs are applicable on both small and big corporations, without any cap on the transaction value. SHRs seems to be good alternative to APA for those companies who wants to avoid tax litigations.
3. Advance Pricing Agreements
The APA were introduced in the Income Tax Act, 1961 with effect from July 2012. These are agreements between taxpayers and tax authorities, defining the approach for determining the transfer pricing methodology for pricing the taxpayer’s international transactions for future years. An APA can be unilateral, multilateral or bilateral. APA brings in certainty with respect to taxpayer’s international transaction, removal of audit threat. The methodology is applied for certain period of time. The Ministry of Finance is streamlining SHR and APA, two mechanisms to determine the price of services rendered by a multinational to its subsidiary in India. Indian APA rules do not prescribe any conditions for applying for APA it covers any type of international transaction.
4. Dispute Resolution Panel
Alternative Dispute Resolution is most important dispute resolution mechanism even in international transaction market as well. The DRP constituted under the ITA is an an an alternative mechanism for resolving the disputes relating to Transfer Pricing. Section 144C of the ITA talks about Reference to Dispute Resolution Panel with a collegium comprising of three Commissioners of Income-tax constituted by the Board Central Board of Direct Taxes for this purpose. Section 144C comes into play when the Assessing Officer (AO) under the ITA proposes to make, any variation in the income or loss stated in the return filed by the assessee and such variation is prejudicial to the interest of the assessee and the AO forwards a draft of the proposed Assessment order to the assessee in order to invite his acceptance or objections to the same. This section was introduced in the ITA by the Finance Act, 2009 and came into effect from 1st October 2009. Prior to the formation of DRP the assessee had the option to approach the Commissioner of Income Tax Appeal CIT (A) against the assessment order, if the assessee wanted to raise objections against the Order. However, after the formation of DRP, the assessee has an additional option to approach DRP on the basis Draft Order issued by AO.
C. New Developments
The New Instruction guidelines issued by Central Board of Direct Taxes in the year 2015 has made following important developments:
1. Reference to Transfer Pricing Officer (TPO): The Assessing Officer has power to refer to computation of the international transaction to the TPO. Under such reference the computation is required to be done by the Assessing Officer. The following conditions needs to be satisfied before such reference can be made:
a. AO has to satisfy that the tax payer has entered into the international transaction with an associated enterprise, which can be gathered from Form 3CEB filed by the tax payer, an accountant’s report.
b. The merit of the transaction is not required to be evaluated by the AO at this stage.
There is requirement of satisfaction of AO arises if:
- Taxpayer has not filed the accountant’s report but international transaction has taken place.
- Incomplete declaration of the international transactions in accountant’s report.
- International transactions declared by the tax payer with qualifying remark that they do not affect the said transactions are not of the nature of international transactions.
However, in all the above opportunities, the AO must give the tax payer a proper hearing. Before making reference to the TPO, the AO has to seek permission of the Principal Commissioner or Commissioner under the Act. Additionally, the following too is important to mention.
- There will be no requirement of referring the international transaction to TPO on the ground that the same is above the certain limit.
- Where a case is selected for scrutiny on the basis of non-TP issues and the case involves the international transactions of AE’s, the case will not be referred to TPO irrespective of value of transactions. The only exception would be non-disclosure of international transaction in accountant’s report.
2. Role of Transfer Pricing Officer (TPO): The following role of TPO is outlined.
- It involves determination of ALP on reference being made by the AO for international transactions. If any other international transaction comes to the notice of any other transaction, then he is empowered to determine the ALP of the same. The ALP is pronounced vide speaking order after seeking the permission of the jurisdictional CIT.
- Compliance audit of the Advance Pricing Agreements (APA).
- Examine the safe harbor options of the tax payers
- The number of cases to be handled by the TPO would not be more than 50.
3. Role of AO after determination of the ALP: After determination of the ALP, the AO will compute the income keeping the ALP in mind.
4. Maintenance of Data base: CIT (TP) has to ensure that all the reference received by the TPO from AO are dealt expeditiously and the entire record of the same is maintained as per the format provided.
The applicability of the Instruction Note 15/2015 is from immediate effect.
The following points are important take aways based on discussions and developments:
- TP is one of the most important international tax issue facing multinational enterprises and Indian Courts. In 2015, itself according to online data, the number of cases handled in 2015 for TP is 531 with average time period of disposal of 2.5 years.
- The main objective of the TP is reduction of taxes and minimization of foreign exchange risks. Moreover, TP has become most litigated tax issue of recently and the country has highest litigation on the issue.
- SHRs are meant to give much needed respite to people from the tax litigation but needs better implementation to see results.
- India has signed with US and Japan agreements to resolve TP disputes.
- Mumbai High Court in 2014 has passed landmark judgments against Tax Authorities in TP in shell and Vodafone cases.
- New developments in October 2015 related to TP which came into effect immediately. It is a step to simplify TP calculations.