Basics of Transfer Pricing

A presentation regarding the multifarious regulations in accordance

with the subject matter of Transfer Pricing juxtapositioned in the
Indian Scenario…

Kumar Kartikeya Prakash

5th Year

Symbiosis Law School, Pune

Transfer Pricing
 Transfer pricing (“TP”) is the act of pricing of

goods and services or intangibles when the

same is given for use or consumption to a Transfer pricing
is
related party (e.g. Subsidiary or associated
an Art not a
enterprises)
precise Science.
 TP is a tact for MNCs to evade tax liabilities

and park their profits in low tax rate

jurisdictions and therefore, increase the
overall profit of the organization. Aztec Software and
Technology Service Ltd. vs.
ACIT
Transfer Pricing
 TP can be of either market based i.e.

equivalent to what is being charged in the Transfer

outside market for similar goods, or non Pricing is a
market based. process not
 TP is generally understood as Transfer Pricing the product
Manipulation (“TPM”) where non market in itself.
based pricing strategies are used for fixing
price for inter corporate cross broader
transactions.
 TPM are discouraged by Governments with

the helps of various regulations.

TP Regulations:

Laws in US Global Scenario Indian Perspective

S. 262 of the Recommendations of

OECD Guidelines of
Revenue Act, Expert Group, set up in
1995
1921. Nov 1999

Finance Act, 2001 and

S. 45 of the Revenue OECD Guidelines of amendment of S. 92-92F of IT
Act, 1928 2009 Act, 1961 and Rule 10A-10E
of IT Rules, 1962

Proposed Changes in
S. 482 of Internal Chapter I-III of OECD Direct Tax Code
Revenue Code Guidelines, 2009 (Proposed)
Pre-2001 Scenario in India:
Some basic provisions were existed under Income Tax, Custom and Excise
Legislations such as:

1. Sec. 40A(2) of Income Tax Act 3. The definition of “related parties”

(“IT Act”), 1961 provides for
deduction of excessive or
unreasonable sum paid to a
related parties.
was borrowed from Companies Act,
1956 and MRTP Act,1969.
4. The former S.92 of the same Act

2. Some other provisions as 10A, allows recomputation of profits from

80IA of IT Act, 1961 provides for
adjustment of profits of a unit
entitled to a tax holiday, arising
due to ‘close connection’ with the
taxpayer.
a transaction between resident and
non-resident having ‘close
connection’ which is lesser than
ordinary profits.
Pre 2001 Scenario in India:
5. S. 93 laid down the tax liability of transactions between resident and non-
resident for the purpose of avoiding tax.
6. Rule 10 and 11 of Income Tax Rules, 1962 provides for computation of
taxable income of a non-resident when it is difficult to ascertain.
Shortcomings:
7. The term ‘Close Connection’ was not defined.
8. No detailed methodology was provided for computation of ‘ordinary profit’
out of a transaction.
9. Any adjustment of account due to recomputation of income made by
Revenue authorities was labeled on resident company only.
10. Having surrounded by ambiguity, they were seldom invoked by the revenue
authorities.
TP Regulations in India:
 Transfer Pricing Rules are applicable to all the enterprises that enter into an

‘International Transaction’ with an ‘Associated Enterprises (“AE”)’.

 It even embraces to the transactions involving a mere book entry having no

apparent financial impact.

 The ultimate aim is to arrive at the comparable price as available to any unrelated

party in open market conditions.

 Based on the Article 9 of OECD model convention, the Government of India

also enacted laws effective from Financial Year 2001- 2002 by which rules have
been framed to determine income arising from an international transaction or the
cost of transaction between associated enterprises to be computed on the basis of
Arm’s Length Principle.
International Transaction:
Sec. 92B
 Transaction between two or more Associated Enterprises (“AE”) of which

either or both of whom are non-residents.

 Transactions (It almost covers every type of transaction a company can

enter into): [read along with sec 92F(v) of IT Act, 1961]

 Purchase, sale or lease of tangible or intangible property

 Provision of services

 Lending or borrowing of money

 Any other transaction having a bearing on the profits, income, losses or

asset
 Mutual cost sharing agreement
Deemed International
Transaction: Sec. 92B(2)
 Transaction entered by AE with a person other than AE, be deemed to be

between two AEs, if prior agreement exists in relation to the relevant

transaction between such other Person and AE / terms of relevant transaction
are determined in substance between such other person and AE. [Under DTC-
‘C’ has to be a non- resident company.]
Parent Company
AE1 Prior Agreement / Determination
of Terms

Indian Subsidiary
Third Party (‘C’)
AE2 Purchase of Goods
 Associated Enterprise: Sec. 92A
 The word “enterprise” has got a wide and extensive definition under section

92F(iii).
 An “associated enterprise” relationship would be deemed to exist, inter-alia, in
cases of:
1. (a) Where an enterprise participates directly or indirectly, in the management or
control or capital of the other enterprise. [section 92A(1)] ‘or’
(b) when the persons in-charge of management or control or capital of two or
more enterprises are the same persons. [section 92A(1)] ‘and’
2. Fulfillment of any condition mentioned under section 92A(2).

Upcoming ‘Direct Tax Code (“DTC”)’ has omitted the sub-clause 1 of section
92A.
Arm’s Length Pricing: Sec. 92C
 The ‘arm’s length principle’ of transfer pricing states that the amount charge by

one related party to other must be same as if the party is not related. An arm’s
length price of that transaction would be uncontrolled price.

 Methods prescribed under sec 92C:

1. Comparable Uncontrolled Price Method (“CUP”),

2. Resale Price Method (“RPM”),
3. Cost Plus method (“CPM”), “No order can be passed for adjustments
by TPO without following any of the
4. Profit Split Method (“PSM”), methods prescribed under the sec 92C.”
- Nimbus Communications Ltd. v. ACIT
5. Transactional Net Margin Method (“TNMM”) and
6. Any other prescribed by CBDT (However, no method has yet been
prescribed).
Comparable Uncontrolled Price
Method (“CUP”): Internal
USCO Sell
s
for I monit
NR o
10,0 r
00

r
Indian related
ito
on
company
Indian unrelated
m
ls

company
l
Se

A B
Warranty at a
standard rate of
INR 1,000 p.a.
Sale warranty Sale

Customers Customers

“Cardinal principle of TP- Treat like with like & eliminate differences with
suitable adjustments.” - ACIT v. T Two International Pvt. Ltd.
Comparable Uncontrolled Price Method
(“CUP”): External
Independent US
US Company
Company (third
(AE1)
party)

International Price at which the transaction is

International
transaction completed between independent
transaction
parties will be external CUP.

Indian Independent Indian

Subsidiary AE2 Company
Resale Price Method
(“RPM”): Final retail price in
India
Rs.
5,000

US Software A Less: margin earned by Rs. 500

development co. comparable distributors

Transfer pricing using Rs.

RPM 4500

Related Indian
distributor co. B C
Comparable
independent distributor
Retail price
of software INR 5000 Earns margin of 10%

End Costumer End Costumer

Cost Plus Method (“CPM”):
 Based on cost plus comparable mark up calculation-

Parent USCo
car manufacturer

A company
INCo. X comparable
Assembly plant
to INCo.

Assuming Indian company’s cost is

Rs. 100, transfer price under cost plus
Earns 20% on costs
method would be Rs. 120 for its assembly plant
 Profit Split Method (“PSM”):

US intangible
holding co. A

Provides tangibles Pays value To determine the arm’s length price

and intangibles & Royalty for such fees and royalty to be paid by B

Related A Company
manufacturing B D
comparable to B
Indian Co.

Sells its Sells its production

production

Related marketing E A company

company
C
comparable to C

Customer
Transactional Net Margin Method
(“TNMM”):
 Compares net profit margins derived TNMM differs from RPM and
CPM to the extent that it
from the operations of uncontrolled
involves a comparison of
parties and associated enterprise on
margins at the net profit level
similar operations.
as against the gross profit level
 The net profit margin realized by AE
prescribed under RPM and
is computed in relation to costs
CPM.
incurred, sales effected or assets
employed.
“TNMM requires comparison of ‘net profit
margins’ not of ‘operating profit margins.”
– Addl.CIT v. Tej Diam
Most Appropriate Method (“MAM”):
Rule 10C(2)
Factors determining MAM

 Nature and class of international transaction

 Class of associated enterprises and FAR analysis

 Availability, coverage and reliability of data

 Degree of comparability
“If proper FAR analysis is carried out
 Extent and reliability of then the TPO can not reject the
comparable summarily without
economic adjustments
assigning any cogent reason.”
 Nature, extent and reliability

of assumptions ACIT vs. M/s. Toshiba India Pvt.

Ltd.
Computation of ALP: Sec. 92C
Burden of Proof:
 The primary responsibility is on the taxpayer to determine Arm’s Length Price

in accordance with the Transfer Pricing Regulation.

 Intervention by the Tax officer depends upon the reliability and correctness of

data undertaken for determination of ALP. [Para 4.13-4.16 of OECD

Guidelines 2009]
Computation:
 Where more than one prices are determined through most appropriate method

then [Section 92C(2)]-

ALP = Arithmetic mean (AM) of such prices ‘or’

ALP = +/- 5% of ALP determined (only in marginal
cases not as a routine process)
Functional Comparability:
Comparability shall be judged on following parameters mentioned under
Rule 10B (2):

1. The specific characteristics “It has to be shown that analysis

carried out is “judicial” and is
2. FAR analysis
done after taking into account all
3. The contractual Terms
relevant facts and circumstances of
4. Conditions prevailing in the market.
the case. The TPO can carry out a
“Tribunal upheld the validity of selection of
fresh economic search only if the
foreign comparable companies provided, data
comparables drawn by the taxpayer
pertaining to those companies must be
are insufficient or have any other
available in Public domain.” – Ranbaxy
deficiency.” -
Labs (Delhi ITAT) and Development
Mentor Graphics (P) Ltd.
Consultant (Kolkata ITAT).
(Delhi ITAT)
Adjustments: Rule 10B(3)
 An uncontrolled transaction shall be comparable to an international transaction if

there are no differences that materially affect price/cost charged or profit margin
in the open market and reasonably accurate adjustments can be made for
enhancing comparability.
 Under Indian Law, adjustment is permitted only to comparables not to the tested

party and scarcity of data on comparables is a challenge.

Case Laws:
 “The Tribunal recognized that differences in business models and higher cost incurred

during the start-up phase calls for economic adjustments.” – Skoda Auto India Pvt Ltd

(Pune ITAT)
 “Adjustment needs to be made for, (a) difference in risk profile, (b) difference in working

capital position, and (c) difference in accounting policies.” – Philips Software Centre

Pvt Ltd. (Bangalore ITAT)

 Reference to Transfer
Pricing Officer: Sec. 92CA
 Transfer pricing Officers (“TPOs”) designated by CBDT, have authority over

assessment of cross-border transactions.

 It is mandatory for Assessing Officer to refer all cross border transactions of

INR 150 million or above to the TPOs.

 The TPO on the basis of materials or information or documents in his

possession may determine the arm’s length price, after providing the assessee
an opportunity of being heard.
 TPO’s role would be limited to determination of arm’s length price in relation

to international transactions, which would be binding on the assessing officer.

 Documentation Requirements:
Sec. 92D and Rule 10D
 Documentation requirement content in sub-rule (1) of Rule 10D can be

summarized as below:
CLAUSES OF DOCUMENTATION REQUIREMENTS
RULE 10D(1)

Clauses (a), (b), (c) Group Overview :

and (d)
Description of ownership structure and interest,
profile of multinational group of which the
enterprises are the part, broad description of
business and broad description of international
transactions.
Sec. 92D and Rule 10D

CLAUSES OF DOCUMENTATION REQUIREMENTS

RULE 10D(1)
Clause (c)
Industry Scenario :
Information/documents regarding industry in which the
enterprise operates.
Clause (e)
Functional Analysis :
Description of functions performed, risk assumed and assets
employed by the enterprise and the associated enterprise.
[Quark Systems Ltd. ITAT Chandigarh- “Stress on ‘critical
importance’ of conducting FAR and Filters must be based on cogent
reasoning not on unsound assumptions.”]
Documentation Requirements:
Sec. 92D and Rule 10D

CLAUSES OF DOCUMENTATION REQUIREMENTS

RULE 10D(1)

Clauses (f), (g), (h), Economic Analysis :

(i), (j), (k), (l) and (m) Application of the most appropriate method to
establish arm’s length price – selection of the most
appropriate method, workings of arm’s length
price, analysis performed for comparability and
adjustments, etc.
Documentary Requirements: Accountant’s Report:
Sec. 92D and Rule 10D Sec 92E
 In the course of proceedings under the  A report from a Chartered
Act, requirement to furnish Accountant in Form 3CEB is to be
information or documents within a furnished along with the return of
period of thirty days from the date of income before the specified date,
receipt of a notice or an extended i.e., 30th September of the relevant
period not exceeding thirty days. assessment year in case of a
 No maintenance of prescribed company and 31st July of the
documentation where international relevant assessment year in case of
transaction does not exceed INR10 other assessee. [Rule 10E] [Under
million. DTC- Report to be filed by TPO and
filed before 31st August.]
Penal Provisions:
Section Default Quantum

S.271AA Failure to keep and maintain 2% of the value of each international

any such information or transaction entered into.
documents as required in the [Vertex Customers Services Delhi
proposed sub-section(1) or sub- ITAT- “No penalty proceeding when
section (2) of section 92D computation of TP is done in accordance
with law, in good faith and with due
diligence.”]

S. 271BA Failure to furnish a report from Rs. 1,00,000

an accountant as required in
section 92E
Penal Provisions:
Section Default Quantum

S.271G Failure to furnish any information 2% of the value of each

within a period of 30 days from the international transactions for
date of receipt of notice in this regard each such failure. [Cargill
as required by the AO or CIT(A) in India Pvt. Ltd. v. DCIT-
the course of any proceedings in the “Notices under sec 92D(3) to the
act as per sub-section(3) of section taxpayer must be issued on
‘specific points’ for furnishing
92D of the Act.
information.”]

Sec. 271 Penalty for concealment 100% - 300% of the tax

(1) (c) evaded.
Direct Tax Code:
 Proposed Changes in:

1. Definition of Associated Enterprises.

2. Meaning of International Transaction and Deemed International
Transaction.
3. Transfer Pricing Assessment.
4. Safe Harbour Rules.
5. Advance Pricing Guidelines.
6. Penalty Provisions.
7. Anti- Avoidance Measures.
8. Dispute Resolution Panel.
The Bringing Home the Bacon
Approach:
Planning

Active Defense:
Prior Defense:
Audit, Appeals or
Documentation
Litigation Reports

Selection of MAP

Economic and Functional Analysis

Financial Analysis of Analysis of comparable

Taxpayer entities: uncontrolled transaction:
Functions and
Adjustments Internal or External

FAR Analysis (Functions performed, assets utilized and risk undertaken)

 k You
Than