West Delhi Study Circle - D omestic Transfer Pricing

1. West Delhi Study Circle-Domestic Transfer Pricing By CA MANOJ KUMAR C/O MANOJ KUMAR MITTAL & CO. CHARTERED ACCOUTANTS Ph No. 9810764620

2. Finance Minister’s speech on the rational for introducing Transfer Pricing Regulations • “The presence of multinational enterprises in India and their ability to allocate profits in different jurisdictions by controlling prices in intra-group transactions has made the issue of transfer pricing a matter of serious concern. I had set up an Expert Group in November 1999 to examine the detailed structure for transfer pricing legislation. Necessary legislative changes are being made in the Finance Bill based on these recommendations.” Shri Yashwant Sinha Finance Minister Government of India • February 28, 2001

3. Relevant Provision of the Income Tax Act-Chapter X

5. Relevant Circular and notification-Circular NO. 6-P, Dated 6-7-1968 and circular NO. 4-P[LXXVI-65], dated 7-6-1968 • Circular No. 14 dated 20.11.2001 containing explanatory notes • Circular No. 2 dated 26.03.3013-Application of profit split method-withdrawn • Circular N0. 3 dated 26.03.2013-Condition relevant to identify development centre engaged in contract R& D service with insignificant risk • Notification No. 30 dated 15.04.2013 explaining tolerance limit • Circular No.6 dated 29.06.2013 amending circular no. 3 • For related Party, reference is to • 40A(2)(b)-Related Party • AS-18

6. Concept of Transfer Pricing • Difference between price and transfer Price • Price means the price at which transaction takes places between party • Transfer Pricing means the price at which the transaction takes places between two related enterprises. • Due to special relationship between related enterprises, the transfer price may be different from price for any transaction. • Arm’s Length Price(Sec 92F(ii))- It means a price which is applied or proposed to be applied in a transaction between persons other than associated enterprises, in uncontrolled conditions;

7. Transfer Pricing-History • Sec 42(2) of the Income Tax Act, 1922 • Where a person not resident or ordinary resident in the taxable territories carried on business with a person resident in the taxable territories, and it appears to the income tax officer that owing to the close connectionbetween such persons the course of business is so arranged that the business done by the resident produce to the resident either no profit or less than the ordinary profit which might be expected to arise in that business, the profit derived therefrom, or which may reasonably be deemed to have been derived therefrom shall be chargeable to income tax in the name of resident person who shall be deemed to be for all the purpose of this Act, the assessee in respect of such income tax. • It is substituted by section 92 in Income Tax Act 1961 which was further substituted by section 92 to 92F by the finance Act 2001.

8. Hon’ble SC in CIT vs. GlaxoSmithKline Asia(p) Ltd. (SLP 18121/2007) had observed • “The larger issue is whether Transfer Pricing Regulations • should be limited to cross-border transactions or whether the • Transfer Pricing Regulations to be extended to domestic • transactions. In domestic transactions, the under-invoicing of sales and over-invoicing of expenses ordinarily will be revenue neutral in nature, except in two circumstances having tax arbitrage such as where one of the related entities is i)loss making or (ii) liable to pay tax at a lower rate and the profits are shifted to such entity. • The CBDT should examine whether Transfer Pricing • Regulations can be applied to domestic transactions • between related parties u/s 40A(2) by making • amendments to the Act.

9. Transfer Pricing Arm’ Length Price Related Party Independent Party Domestic Transaction *Goods *Services *Intangibles *Loans Resident Resident

10. Domestic Transfer Pricing from 01.04.2013 • Specified Domestic Transaction (not being international transaction) will be subject to transfer pricing at par with the norms applicable to International transaction.(Sec 92(2) • In respect of Specified Domestic Transaction, an allowance for an expenditure or allocation of any cost or expense or income shall be computed as per ALP and however, no computation shall be made which result in reducing income or increasing loss. Sec 92(2A) or 92(3) • MAT liability will continue as per books.

11. Domestic Transfer pricing regulation Sec-92BA-Meaning of Specified Domestic Transaction-Scope of the section i) any expenditure for which payment made or to be made to a person covered u/s 40(A)(2)(b) ii) Any transfer of goods and services between eligible units and non eligible unit of two associate of an undertaking -(80)(IA)(8) iii) Any business transaction with entities having close Connection-80(IA)(10) iv) Any other transaction as may be specified.

12. Specified Domestic Transaction

16. The above provision will be applicable if the aggregate of such transaction exceeds Rs 5.00 Cr. • Whether notional income principle will be applicable for clause 80(IA)(8) or (10)-YES • A pays rent of Rs. 4 crores to B ltd and pays interest on loan of Rs, 1.5 crores to C, as the aggregate of transaction exceeds Rs. 5 Cr, it will be covered. • The aggregate is to be seen of the six limbs together and not only one limb

17. 92BA-Grand Summary

18. Fair Market Value vs. Arm’s Length Price

22. ►Relevant extracts of the Departmental Circular - Circular NO. 6-P,Dated 6-7-1968 and circular NO. 4-P[LXXVI-65], dated 7-6-1968 • Brief Background • ►It may be noted that the new provision is applicable to all categories of • expenditure incurred in businesses and professions, including expenditure on purchase of raw materials, stores or goods, salaries to employees and also other expenditure on professional services, or by way of brokerage, commission, interest, etc. • ► Where payment for any expenditure is found to have been made to a • relative or associate concern falling within the specified categories, it will • be necessary for the Income-tax Officer to scrutinize the reasonableness • of the expenditure with reference to the criteria mentioned in the section. • ► The Income-tax Officer is expected to exercise his judgment in a • reasonable and fair manner. It should be borne in mind that the provision • is meant to check evasion of tax through excessive or unreasonable • payments to relatives and associate concerns and should not be applied in • a manner which will cause hardship in bona fide cases.

23. Definition of Relatives-Sec 2(41) Relative means • -Husband • -Wife • Brother • Sister • Any lineal ascendant or descendent • Circular 6P of 1968

24. Case Study-1-Payment to director or relative of director of the company- 40A2b(ii) X ltd(assessee) C-Relative of director-Y Y-Director X LTD

26. Case Study-II-payment to person having substantial interest in the business or any relative of such perosn40 A 2b(iii) A Related Transaction Related Party X LTD A has substantial interest in X ltd X and A and X and Y are related person Y, relative of A

28. Case Study-III-payment to company, firm, HUF or AOP having substantial interest or any director , partner or member thereof or any relative of director , partner or member -40A2b(iv) • D ltd has substantial interest in X ltd • X and D, X and Y, X and C are related person. D Ltd X LTD Y, Director of D LTD C –Relative of Y

30. Illustration – Section 40A(2)(b)(iv) A B C D E A & B--------- A & C--------- A & D--------- A & E---------- B & C---------- D & E----------- Transactions covered ? *Post Budget 2012 amendment under section 40A

31. Case Study –IV-Payment to company, HUF, Firm or AOP of which director, partner or member has substantial interest in assessee or any other director, partner or member of such co. firm or AOP or relative of director, partner or member thereof -40A2bv A X Ltd A has substantial interest in X ltd X and A, X and Y, X and Z and X and C are related person Director in Y ltd C relative of Z Z director in Y ltd

33. Case Study V-Payment to a person in whom assessee or any relative of assessee has substantial interest-40Ab (vi)A A C - relative of A Y Ltd A is an assessee , C is relative of A C substantial interest in Y ltd A and Y, Y and C are related person.

34. Case Study VI-Payment to a person in whom the assessee being co.,firm, HUF or AOP has a substantial interest or any director, partner or member there of or any relative of them-40A2bvi B Y, Director of H Ltd X LTD H ltd X Ltd has substantial interest in H ltd X and H, X and Y, X and C are related person C relative of Y

36. Relative of director 4 Relative of partner 4 Relative of member 4 Relative of member 4 Relative of director 3 Relative of partner 3 Relative of member Relative of member 3 b(iv) b(v) b(v) b(v) b(v) b(iv) b(iv) b(iv) Other Directors 3 Other Partners 3 Other members 3 Other family members 3 Director 2 Partner 2 Member 2 Member 2 b(v) b(v) b(v) b(v) b(iv) b(iv) b(iv) b(iv) Company in which A is a Director 2 Firm in which A is a Partner 2 AOP in which A is a Member 2 HUF in which A is a Family Member 2 Company H holding SI in X 1 Firm holding SI in X 1 AOP holding SI in X 1 HUF holding SI in X 1 b(iv) b(iv) b(iv) b(iv) b (vi) b(iv) b(iii) b(v) Relative of A 2 Individual (A) holding SI in X 1 b(iii) Company in which H Co holds SI 2 Relative of A Director 2 Director 1 Company (X) b(ii) b(ii) b(vi) b(vi) b(vi) Person/Entity in which Relative holds SI 3 Person/Entity in which Relative holds SI 2 Person/Entity in which Relative holds SI 1 CA BALDEV RAJ GS-BVSS

37. Case Study • There is a company XYZ Ltd which has a three unit, one deals in production of sugar, another garments and one in generation of power. The power is supplied for the production of sugar and cloth. If any shortage comes in the production of power. The power is purchased from state Electricity Board. The power unit is tax free unit. • The power is purchased for production of cloth and sugar at Rs. 5 per unit. However, the rate of state electricity board is 4 per unit. Hence, the profit of power unit is being enhanced which is tax free and other unit is being reduced, • Similarly, there are certain common expenditure which as per accepted accounting principle should be divided into three unit but all the expenses are divided into cloth and sugar unit so as to reduce their profit.

38. XYZ Ltd Power Production Sugar Production Cloth Production

39. Tax Burden if transaction not at ALP

40. Close Connection • If we look at the precedents with reference to section 42(2) of Indian Income Tax Act, 1922, the close connection, to our opinion, refers to Business Connection. There are three ingredients of business connection:- • - There should be a systematic dealing between two units • - It should be for mutual benefit of both • - It should be of continuous nature. • Example Subsidiary company, Factory, Office etc.

41. Examples Of Close Connection • A ltd provides loan to B Ltd which is more than 50% of its total assets • The manufacture or processing of goods or articles or business carried on by the a assessee is wholly dependent on knowhow, trade mark or any kind of data, documentation provided by other enterprises. • A ltd supplies more than 90% of the raw material to B Ltd for its manufacturing operation. • 90% of the goods produced by A Ltd is sold to B Ltd and this is B ltd who determines the price of the goods.

42. What is the difference before and after SDT? • The basic difference between pre and post period of SDT is the method of calculation of price in relation to transaction between related parties. Earlier, it was to be calculated as per FMV and now as per the ALP. The transfer pricing provisions under section 92 of the Act does not impact operation of basic scope of the provision of section 40 (A)(2) or section 80A/80-IA(8) or 80-1A(10). It merely provides that the FMV as contemplated by any of the specified provision will need to be determined in accordance with arm’s length price as defined in section 92 F (ii) of the Act. • Apart from that the taxpayer is required to maintain the contemporaneous documents under section 92 D and furnish accountants report under section 92E of the Income Tax Act. • SDT previously reported/certified but onus on revenue authorities • Obligation now on taxpayer to establish transaction at Arm' length.

43. Economic Double Taxation • Non compliance with ALP would result in disallowance of expenditure in the hands of assessee but no corresponding adjustment will be allowed to the other party leading to economic double taxation. • However, in the case of international transfer pricing, there is a concept of corresponding adjustment under article 9(2) of the OECD MC/ UNMC which should be brought in DTP also.

44. Penalty

45. Assessment Timelines ► This amendment will take effect from 1st July,2012. ► The due date for completion of a TP assessments is extended by 3 months. ► The existing and the new extended period for completion of pending proceedings and subsequent proceedings under the provisions is given below :

46. Implication of GAAR on TP • As per the proposed GAAR provisions in Chapter X of the Income Tax Act ,An arrangement whose main purpose is to obtain a tax benefit and which also satisfies at least one of the four tests, can be declared as 'impermissible avoidance agreements'. • The four tests inter alia are: • The arrangement that creates rights and obligations, which are not normally created between parties dealing at arm's length; • It results in misuse or abuse of provisions of tax laws; • it lacks commercial substance or is deemed to lack commercial substance. • Is carried out in a manner , which is normally not employed for bonafide purpose. TP Implications will arise mainly if it satisfies any one of the following two tests : • The arrangement that creates rights and obligations, which are not normally created between parties dealing at arm's length • It lacks commercial substance

47. Compliance Requirements • Documentation for specified Domestic Transaction within the specified time limit • Benchmarking for the specified domestic Transaction-onus on the tax payer • Determining the arm’s length price following six method as provided in the Act • Adjustment in the price-No corresponding adjustment allowed to other party causing double taxation • Preparing TP report • Giving audit report in form 3CEB

48. International TP vs. Domestic TP • If transactions are covered under SDT provisions, disallowance u/s 40A(2)(a) may be made by the AO only when transactions are not at arm’s length. [Proviso to Sec 40A(2)(a)] • Software / databases generally used for searches- Prowess, Capitaline Plus

49. Probable Issues • Provisions applicable only to expenditure where payment is made or to be made • Does this include capital expenditure? • Does this include transactions without consideration? • Does threshold apply to the amount recorded in the Books of Account or Amount determined as per ALP? • Wide coverage and goes beyond the related parties covered under AS-18 • Whether Government approval u/s 295, 297 of the Companies Act would be relevant?

50. If aggregate of International and Domestic transaction exceeds INR 50 million, Do we need to demonstrate ALP for Domestic transaction which is otherwise below INR 50 million? • If aggregate of International and Domestic transaction exceeds INR 50 million, but the International Transactions are below INR 10 million, Do we need to maintain documents prescribe under Rule 10D? ( Reference Rule 10D(2) • Would claim of Depreciation comes under the ambit of Domestic Transfer Pricing?