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Implications of Transfer Pricing in India

Transfer Pricing is not an exact science, evaluation of transactions through which the process of determination is carried is an art where mathematical certainty is indeed not possible and some approximation cannot be ruled out, yet it has to be shown that analysis was ‘judicial’ and was done after taking into account all the relevant facts and circumstances of the case writes Madhu.S

Transfer Pricing denotes the price which is fixed for intra-group transactions. In simple words it is the price in which a product or service is transferred between related entities. For e.g. a company in United States having an Indian subsidiary transfers a product or service to its subsidiary for a fixed price determined by the parent U.S Company for sale in the open market in India. This is normally less than the actual market price at which the product or service is actually sold in the market. The Implications of Transfer pricing comes to light when such a pricing of products or services are done to evade tax. Transfer pricing has huge implications on the tax jurisdictions of various states especially when Double Taxation Avoidance Agreements (DTAA) are entered into by the states (such as Indo-Mauritius Free Trade Agreement).

Transfer Pricing is a mode by which Multinational Enterprises (MNE’s) makes huge profits by increasing the price of products or services in low tax jurisdictions and decreasing the price in high tax jurisdictions thereby shifting profits especially in a scenario wherein more than 60 percent of international trade is done intra-group (E&Y Survey). Transfer Pricing thus provides for huge loss to the public exchequer as they are prevented from taxing a product or service or on the other hand are prevented from realizing the real tax at which a product was to be taxed in a country. The theory of Transfer Pricing is based on the concept of ‘functions, risks and assets’.

It is at this juncture that we need a strict Transfer Pricing Regulation to prevent the Multinational Enterprises from evading tax and reaping huge profits left unaccounted. The Morgan Stanley Case (AAR No 61 of 2005) made huge waves in the economic and legal sector and brought out the concept of implications of Transfer Pricing in the forefront, though indirectly. The case assumed significance for it raised significant issues in the emerging BPO sector in India and the manner in which Transfer Pricing provisions were applicable. One of the groups of companies of Morgan Stanley & Co (MSCo), Morgan Stanley Advantage Services Private Limited (MSAS) incorporated in India provided certain support services to MSCo.  MSCo provided personnel to MSAS for stewardship activities and persons on deputation. The question arose was whether MSAS was a Permanent Establishment (PE) for tax purposes and whether profits attributed to the PE was within the purview of Transfer Pricing provisions. The AAR in the said ruling held unequivocally that as long as the PE deals on an Arms length basis with its associated enterprises, there cannot be any further attribution. It is in this context that the impact on IT Enabled services becomes a matter of concern. For the purpose of determining ALP, the Revenue authorities have to determine the price of services rendered by the PE to its head office or vice versa. Bringing BPO’s under the transfer pricing regime will have a considerable effect on the booming industry especially in the light of rupee appreciation, US Sub-prime crisis and changing political scenario.

Similarly, the Mentor Graphics Pvt Ltd (2007) 165 Taxman 28, also brought about the need of having a strict transfer pricing regime in India especially in era of booming of IT and ITeS. It was seen as victory for the corporate taxpayers as the Income Tax Appellate Tribunal (ITAT) rejected the tax authorities’ adjustments to the transfer pricing bill of mentor graphics. The recent decision of the Authority for Advanced Ruling (AAR) in In re Mustaq Ahmed ([2007] 293 ITR 0530) wherein the issue was relating to taxing of a non-resident in a case of tax avoidance and in another case of Vanenburg Group B.V In re ([2007] 289 ITR 0464), it was a question of determining whether transfer pricing provisions would be applicable to a Foreign Company holding 100 percent shares in Indian company in the transfer of shares to its foreign subsidiary abroad. The ruling went in favour of the assessee, throws light on the implication of Transfer Pricing in the present economic and legal scenario.

The Indian Transfer Pricing Regulation owes its existence to the Finance Act, 2001 which amended Section 92 of the Income Tax Act by bringing in sections 92A to F. It came into existence from the methods and principles set forth in the Organization for Economic Co-operation and Development’s Report on Transfer Pricing and Multinational Enterprises (OECD TP Report). Section 92 A of the Income Tax Act.1962 ( as Amended in 2001) provided for clarity in terms like International Transactions, Enterprise, Associated Enterprises etc which are essential for clothing various Multinational Enterprises( MNE) within the gamut of direct taxation. The amended Act also provided for the methods by which the ‘Arms Length Price’ (ALP) or the Price in which a related party has to transact has to be measured. ALP proposes that in an International Transaction the price at which unrelated or independent parties transact should be the price at which related entities transact. For e.g. where an American Company transacts with its Indian subsidiary, the price at which they shall transact would be the price at which a third party transacts with the Indian subsidiary in a similar transaction. It should be understood that there are 5 methods by which the ALP is determined, The Comparable Uncontrolled Method (CUP), Resale Price Method (RPM), Cost Plus Method (CPM), Profit Split Method (PSM) and the Transactional Net Margin Method (TNMM) (S.92C). The Act provides for the determination of ALP by Assessing Officer or Transfer Pricing Officer (TPO) in case of trade of value INR 150 Million or more.

The various areas wherein the concept of Transfer Pricing is seen reflected are the Central Excise Act, 1944 which speaks of Levying of excise duty for transactions between ‘related persons’ determined by value at which it sells a good to an unrelated party (Section 4 (3)(b)). The valuation rules under the Customs Act, 1962 recognizes the principle of ALP in dealing with Transfer Pricing. Under the Customs Rules, unless an exception applies, the ‘Assessable Value’ is the invoice value (i.e. ‘Transaction Value’ under Rule 4(2)). Transfer Pricing is Customs valuation under S.14 of the Act read with S.2(2) Customs Valuation (Determination of Prices of Imported Goods), Rules, 1988.  While provisions in the Companies Act, 1956 such as S.211 which deals with the form and content of Balance sheet and the profit and loss account requires the financial statements to provide the true and fair picture of the state of affairs of the company. Similar provisions relating to disclosure requirements and financial statements have indirect implication on Transfer Pricing. The Accounting Standards (AS-18) framed by the Institute of Charted Accountants in India (ICAI) deals with transactions between a reporting enterprise and its related parties. S.8 of Foreign Exchange Management Act (FEMA) provides for provisions relating ALP. Computation of transfer pricing using ALP has been done on related entities using these provisions.

The various provisions under Income Tax Act, 1961 (as amended by Finance Act, 2001) and Rules 10 A to 10 E effectively deals with Transfer Pricing in India. S.92 (1) provides that ‘any income arising from an international transaction shall be computed having regard to the Arm’s length price. An Associated Enterprise as per the Income Tax Act has to comply with a) Maintaining a prescribed Documentation and b) Obtain an Accountant’s Certificate. While the MNE is free to determine the Transfer Price, it is the duty of the Authorities to see that it is in Arm’s Length Price. Thus where the market prices are not reflected in prices set by related parties, the Tax authorities will have the power to adjust profits so that they represent an Arm’s length result. It is here where the issue of strict compliance comes into the picture.

The Transfer Pricing Officer (TPO) appointed under the Act should find the ‘most appropriate method’ (Rule 10 C(2) of Income Tax Rules, 1962) in determining ALP when none of the aforementioned methods does not apply, which is subject to the discretion of the Assessing or TP Officer as the case maybe. This proves to be negative as the TPO may not be efficient enough to determine the price in certain cases. In the recent case of Sony Pvt Ltd v. Central Board of Direct Taxes ([2007] 288 ITR 0052), evolved the question of reference in determining ALP to TPO.  The best way to comply with the TP Regulations would be to have a TP Study and determine the ALP thereby saving the procedural difficulties. But without adequate procedural requirements, such a study may not be fruitful in most cases. In addition to this the Indian tax regime has the shortcoming of realizing the importance of an Advance Pricing Agreement (APA) which would enable the taxpayer (MNE’s) and the tax authorities to save time and money. In the case of APA’s, the Taxpayer which in most cases would be the MNE’s and the Tax Authority would reach an Agreement with respect to the price at which a product or service shall be traded. In most cases it would the price in a uncontrolled transaction vis-à-vis a Controlled transaction (Associated entities).

The present Indian Tax regime suffers the lacunae of having provisions relating to safe harbours which are a simple set of rules which if satisfied by the tax payer would enable it to be relieved from certain regulatory obligations otherwise imposed by tax legislation. Similarly lack of comparables needed to determine ALP is another issue and can be redeemed with a reliable database (like Prowess and Capitaline).  But all these changes can be made only by a strict compliance of Transfer Pricing Regulation with regular updating of the technology in tune with the changing needs with a more reliable assessment of Transfer Pricing. In a country where there is a steep increase in financial transactions with large number of Merger & Acquisition’s (M&A’s) happening, there is a need to post an efficient, reliable and transparent Transfer Pricing with regards to the implications it can have on the International Trade. Though we can be proud of having a more reliable Transfer Pricing Provisions compared to other countries, the need to emerge as a stronghold of the International Trade, India has to reinvigorate its taxing procedures.

To end one should understand the concept of Transfer Pricing as held by the Commissioner of Income Tax (Appellate) in Aztech Computer case (Aztech Software & Technology Services Ltd. v. ACIT 249 ITR (AT) 32) that “Transfer Pricing is not an exact science, evaluation of transactions through which the process of determination is carried is an art where mathematical certainty is indeed not possible and some approximation cannot be ruled out, yet it has to be shown that analysis was ‘judicial’ and was done after taking into account all the relevant facts and circumstances of the case.”

MADHU.S is a 5th year B.A.LL.B (Hons) student of National University of Advanced Legal Studies, Kochi

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