TRANSFER PRICING

Definition:

Transfer pricing is a term used to describe all aspects of inter-company pricing arrangements between related business entities, including transfers of intellectual property; transfers of tangible goods; services and loans and other financing transactions.

TP can be either Market-based, or it can be non-market based.

There can be internal and external reasons for transfer pricing.

Applicability of transfer pricing provisions

The transfer pricing provisions are always applicable when the transactions are entered into with the associated enterprises and one holds larger voting power in the other; consequently, if there is a receipt of dividend by one enterprise from the other associated enterprise, which is chargeable to tax in India, then the application of the transfer pricing provisions should not be ruled out.

Definitions: -

Price:

“Price” by definition is the rate at which a product / service is sold by a seller to the buyer.

The legal definition of "price", in relation to the sale of any goods or to the performance of any services, includes every valuable consideration, whether direct or indirect, or deferred, and includes any consideration which in effect relates to the sale of any goods or to the performance of any services although ostensibly relating to any other matter or thing;

Market Price:

It is the Price, which is determined by the interaction of various forces in the market.

Transfer Price (TP):

Transfer Price is an ‘internal price’ which can be fixed by the management of an enterprise or group of enterprises for transfer of products and services intra enterprise/group/related parties who may be in a position have “undue influence” to intervene in the process of fixing the price.

Undue influence:

Parties who may be in a position to intervene in the process of fixing the transfer price, as above, may intervene in a manner so as to lead to an advantage or disadvantage to the transferor or transferee.

Such Intervention can be termed as undue influence on the price.

Tangible Transactions:

It refers to Transactions involving physical goods or services.

Intangible Transactions:

It refers to the transactions having intellectual content like inventions, patents, design, trademark, franchises, licenses, brand, know-how, etc.

Related parties:

In the context of a company, parties connected to the common through relation with directors and persons having substantial controlling interest in the company, companies under the same management and subsidiaries. In particular, in the context of a company it means an entity:

a) which participates, directly or indirectly, or through one or more intermediaries, in the management or control or capital of such company or vice versa; or

b) in respect of which one or more persons who participate, directly or indirectly, or through one or more intermediaries, in its management or control or capital of such company or vice versa.

An entity (which includes an individual, a Hindu Undivided Family, a partnership firm, an association of persons, a trust or a company) shall be deemed to be a related party in relation to a company if, at any time during the previous year:

a) The entity holds, directly or indirectly, shares carrying not less than 26% of the voting power in such company or vice versa: or

b) Any person or entity holds, directly or indirectly, shares carrying not less than 26% of the voting power in each of the entities: or

c) A long advanced by entity to company constitutes not less than 51% of the book value of the total assets of the company or vice versa: or

d) The entity guarantees not less than 51% of the total borrowings of the company or vice versa: or

e) More than half of the board of directors or members of the governing board, or one or more executive members of the governing board of the entity, are appointed by the company or vice versa: or

f) More than half of the directors or members of the governing board, or one or more of the executive directors or members of the governing board, of each of the entity and the company are appointed by the same person or persons: or

g) The manufacture or processing of goods or articles or business carried out by the entity is wholly dependent on the use of know how, patients, copyrights, trademarks, licenses, franchises or any other business or commercial rights of similar nature, or any data, documentation, drawing or specification relating to any patent, invention, model, design, secret formula or process, of which the company is the owner or in respect of which the company has exclusive eights or vice versa: or

h) 90% or more of the raw materials and consumables required for the manufacture or processing of goods or articles carried out by the entity, are supplied by the company, or by persons specified by the company, and the prices and other conditions relating to the supply are influenced by such company or vice versa: or

i) The goods or articles manufactured or processed by the entity, are sold/transferred to the company or to persons specified by the company, and the prices and other conditions relating thereto are influenced by such company or vice versa: or

j) Where the entity is controlled by an individual, the other company is also controlled by such individual or his relative or jointly by such individual and relative of such individual: or

k) Where an entity has the power to direct, by statute or agreement, the financial and operating policies of the company or vice versa:

l) There exists between two entities, any relationship of mutual interest as may be prescribed provided one of them is a company.

Differences in the definition of related party under AS-18 and AEs under IT Act.

As per AS-18, single customer/ supplier with whom an enterprise transacts a significant volume of business would not be related party merely by virtue of resulting economic dependence. This is in contrast to IT Act, wherein specific deeming provisions have been made to bring them within the ambit of TP regulations.

As per AS-18, a person having 20% of the voting power and power to direct the financial and operating policies of the enterprise would be considered as a related party. As against this, a person is deemed to be AE under the IT Act only if he has a minimum of 26% of voting power.

AS-18 requires disclosure of ’any other elements of related party transactions necessary for an understanding of the financial statements’. For e.g. transfer of a major asset at an amount materially different from that obtainable on normal commercial terms. However, issue is that AS-18 does not stipulate methodology to arrive at a price obtainable on ’normal commercial terms’.

Currently, we have different sets of definitions for related parties i.e. under AS-18, Customs Act, section 40A(2) and section 92A of IT Act. Related party transactions are evaluated by different persons at different points of time.

At the time of transacting, a company is expected to conduct TP analysis to arrive at arm’s length price and maintain contemporaneous documentation under IT Act. Customs authorities examine related party transaction at the time of import. Thereafter, the company has to abide by disclosure requirements under AS-18. Lastly, IT authorities would examine all international transactions with AEs.

Arms Length Price (ALP):

It means the price, which is applied in a transaction between persons other than related parties in uncontrolled conditions.

Methods of Computation of ALP

The following methods may be adopted for determination of Arm’s Length Price, having regard to the nature of transaction or class of transactions.

I. For Tangible Transactions.

1. Comparable Uncontrolled Price Method (CUP)
2. Resale Price Method
3. Cost Plus Method
4. Profit Split Method
5. Transactional Net Margin

II. For Intangible Transactions (Method described later).

COMPARABLE UNCONTROLLED PRICE METHOD

The price charged or paid in a comparable uncontrolled transaction or a number of such transactions shall be identified. Such prices shall be adjusted to account for differences, if any, between the related party transaction and the comparable uncontrolled transactions or between the enterprises entering into such transactions, which could materially affect the price in the open market.

The adjusted price shall be taken as arm’s length price.

RESALE PRICE METHOD

The price at which the goods purchased / service obtained from a related party is resold or is provided to an unrelated entity shall be identified. Such resale price shall be reduced by the amount of a normal gross profit margin accruing to the enterprise or to an unrelated enterprise from the purchase and resale of the same or similar goods or services in a comparable uncontrolled transaction or a number of such transactions. The price so arrived at shall be further reduced by the expenses incurred by the enterprise in connection with the purchase of goods or services. Such price shall be further adjusted to take into account the functional and other differences including differences in accounting practices, if any, between the related party transaction and the comparable uncontrolled transactions or between the enterprises entering into such transactions, which could materially affect the amount of gross profit margin in the open market. . The adjusted price shall be taken as arm’s length price in respect of goods purchased or services obtained from the related party.

COST PLUS METHOD

The total cost of production incurred by the enterprise in respect of goods transferred or services provided to a related party shall be determined. The amount of a normal gross profit mark-up to such costs arising from the transfer of same or similar goods or services by the enterprise or by an unrelated enterprise in a comparable uncontrolled transaction or a number of such transactions, shall be determined. The amount of a normal gross profit mark-up shall be adjusted to take into account the functional and other differences, if any, between the related party transaction and the comparable uncontrolled transactions or between the enterprises entering into such transactions, which could materially affect such profit mark-up in the open market. The total cost of production referred to above increased by the adjusted profit mark-up shall be taken as arm’s length price.

PROFIT SPLIT METHOD

The combined net profit of the related parties arising from a transaction in which they are engaged shall be determined. This combined net profit shall be partially allocated to each enterprise so as to provide it with a basic return appropriate for the type of transaction in which it is engaged with reference to market returns achieved for similar types transactions by independent enterprises. The residual net profit, thereafter, shall be split amongst the related parties in proportion to their relative contribution to the combined net profit. This relative contribution of the related parties shall be evaluated on the basis of function performed, assets employed or to be employed and risks assumed by each enterprise and on the basis of reliable market data which indicates how such contribution would be evaluated by unrelated enterprises performing comparable functions in similar circumstances. The combined net profit will then be split amongst the enterprises in proportion to their relative contributions. . The profit so apportioned shall be taken into account to arrive at an arm’s length price.

TRANSACTIONAL NET MARGIN METHOD

The net profit margin realized by the enterprise from a related party transaction shall be computed in relation to costs incurred or sales effected or assets employed or to be employed by the enterprise or having regard to any other relevant base. The net profit margin realized by the enterprise or by an unrelated enterprise from a comparable uncontrolled transaction or a number of such transactions, shall also be computed having regard to same base. This net profit margin shall be adjusted to take into account the differences, if any, between the related party transaction and the comparable uncontrolled transactions or between the enterprises entering into such transactions, which would materially affect such net profit margin in the open market. The cost of production referred to above increased by the adjusted profit mark-up shall be taken as arm’s length price.

TRANSFER PRICE FOR INTANGIBLES

Intangibles refer to the property having intellectual content like inventions, patents, design, trademark, franchises, licenses, brand, etc.

The intangibles are classified as:

Trade

Market

ALP for Intangibles:

The utility of the property is an important criterion while determining comparability of intangible properties. The following aspects should be given proper weight age while applying the Arm’s length principles.

Area of right

Export restriction

Nature of right (exclusive or non-exclusive)

Capital investment

New or special machinery

Start-up expenses/ development work required in the market

Possibility of sub-licensing

Licensee’s right for participation in further development of property by licensor.

Amendment according to Union budget 2009 –10

Clarifications as regards +/- 5% range

Budget 2009 Transfer pricing Existing provisions in relation to the arm’s With a view to resolving this controversy, it is length price range state that at the option of the proposed to amend the proviso to Section 92C taxpayer, the arm’s length price may be to provide if the arithmetical mean, so determined as a price which may vary from the determined, is within five per cent of the arithmetical mean by an amount not exceeding transfer price, then the transfer price shall be five per cent of such arithmetical mean. This treated as the arm's length price and no provision has been subject to conflicting adjustment is required to be made. This interpretation by the assessee and the Income amendment will take effect from 1st October, Tax Department. The assessee’s view is that 2009 and shall accordingly apply in relation to the arithmetical mean should be adjusted by 5 all cases in which proceedings are pending per cent to arrive at the arm's length price. before the Transfer Pricing Officer (TPO) on However, the department’s contention is that if or after such date. the variation between the transfer price and the arithmetical mean is more than 5 per cent of A new Section inserted to enable CBDT to the arithmetical mean, no allowance in the make Rules with respect to safe harbour arithmetical mean is required to be made. provisions. These rules would provide the circumstances in which the income tax authorities shall accept the transfer price declared by the assessee as an arm’s length transfer price.

Dispute Resolution Panel

Dispute Resolution Panel Key aspects to note are:

In order to improve tax administration and The DRP has to provide a conclusive view avoid prolonged uncertainty in tax related i.e. it may confirm, reduce or enhance the matters for foreign companies or transfer variations proposed in the draft order. The pricing matters, it is proposed to introduce an DRP is not authorized to merely set aside alternate dispute resolution mechanism which any proposed variation or issue any will facilitate expeditious resolution of disputes direction for further enquiry and passing of in a fast track basis with effect from the assessment order by the AO. 01.10.2009. Every direction issued by the DRP shall be binding on the Assessing Officer and the Prior to finalization of an adverse order, the same is appellable only with the Appellate assessing officer shall need to forward a draft Tribunal. of the proposed order of assessment (draft No direction shall be issued unless an order) to the above mentioned assessee, who opportunity of being heard is given to the may file his objections to the draft order with assessee and the AO on such directions the DRP. The DRP shall after due which are prejudicial to the interest of the consideration issue such directions, as it thinks assessee or the revenue, respectively. fit, for the guidance of the Assessing Officer to The DRP proceeding to be completed enable him to complete the assessment. The within 9 months from the end of the month law provides for the process, powers and time in which the draft order is forwarded to the frames for the dispute resolution, besides eligible assessee. enabling the CBDT to prescribe further rules The DRP shall have the same powers as are for its efficient functioning. vested in a Court under the Code of Civil Procedure, 1908 (5 of 1908);

Documentation:

Section 92D provides that the documentation has been prescribed under Rule 10D. The documentation should be available with the assessee by the specified date defined in section 92F and should be retained for a period of 8 years.

Further, Section 92E provides that every person who has entered into an international transaction during a previous year shall obtain a report from an accountant and furnish such report on or before the specified date in the prescribed form and manner. Rule 10E and form No. 3CEB have been notified in this regard.

Penalties:

Explanation 7 to sub-section (1) of section 271 provides that where in the case of an assessee who has entered into an international transaction any amount is added or disallowed in computing the total income under sub-sections (1) and (2) of section 92, then, the amount so added or disallowed shall be deemed to represent income in respect of which particulars have been concealed or inaccurate particulars have been furnished.

Section 271BA provides that if any person fails to furnish a report from an accountant as required by section 92E, the AO may levy a penalty of a sum of one lakh rupees.

Section 271G provides that if any person who has entered into an international transaction fails to furnish any information or documents as required under section 92D (3), the AO or CIT (A) may levy a penalty equal to 2% of the value of the international transaction.