Domestic Transfer Pricing Critical Challenges

1. Domestic Transfer Pricing Critical Challenges Dhinal Shah Chartered Accountant

2. Domestic Transfer Pricing Provisions

3. Domestic Transfer Pricing provisions • Specified domestic transactions (not being an international transaction) between associated enterprises will be subject to transfer pricing compliances at par with the norms applicable to international transactions. [S. 92A(2)]. • In respect of specified domestic transactions, allowance for an expenditure or for allocation of cost or any income shall be computed as per ALP, provided the determination is not likely to result in reduction of income chargeable to tax or result in increase of the loss. [S. 92(2A) and 92(3)] • MAT liability will continue to be as per books.

4. Domestic Transfer Pricing provisions • Specified domestic transaction (SDT) means. • any expenditure in favor of a person referred to in clause (b) of sub-section (2) of section 40A; • any transaction referred to in section 80A; • any transfer of goods or services referred in S. 80-IA (8); • any business transacted as referred in S. 80-IA(10); • any transaction, referred to in any other section under Chapter VI-A or section 10AA, to which provisions of sub-section (8) or sub-section (10) of section 80-IA are applicable or • any other transaction as may be prescribed, and where the aggregate of such transactions entered into by the assessee in the previous year exceeds a sum of five crore rupees. • The limit of INR 5 Cr. applies to aggregate of all transactions and may be amalgam of certain receipts and certain payments. • Section 40A(2) amended to cover companies which are under control of a related person.

5. Domestic Transfer Pricing provisions • S. 92BA(i) merely covers the transaction resulting in an expense of a revenue nature which is allowable in the computation of income. • 92BA(iii) refers to “transfer of goods or services”. There is no reference to “transaction” There may not be two different entities involved. Parenthesis does still suggest “transaction”. • S. 80IA(8) refers to reckoning of market value. The ALP may not match with market value. For transactions < 5 Cr., market value concept still applies. • Unlike in case of “international transactions”, certain transactions or arrangements which may give rise to notional taxation are not covered. For example, provisioning of guarantee, use of trademark, use of market intangibles, interest free loan, services rendered for less than ALP. • Provisions of 92C (ALP computation), 92D (document maintenance), 92E (accountant report furnishing) will apply. • + 3% tolerance limit gets applied as part of ALP computation. • 92CC (APA), are not made applicable.

6. Concept of Transfer Pricing • Difference between ‘PRICE’ & ‘TRANSFER PRICE’ • Price Transactions between two unrelated parties • Transfer Pricing Pricing of domestic transactions between two related parties • Due to special relationship between related parties, transfer price may be different than the price that would have been agreed between unrelated parties • A price between unrelated parties is known as the “arm’s length” price

7. Concept of Transfer Pricing Independent entity Related Party • Domestic transactions • Goods • Services • Intangibles • Loans Resident Resident Arm’s length price Transfer price

8. Transfer Pricing Methods • All related party transactions (domestic transactions between related parties) have to • be carried out at arm’s length • Arm’s length price is required to be determined by applying the ‘most appropriate’ method out of : • Comparable Uncontrolled Price Method (‘CUP’) • Resale Price Method (‘RPM’) • Cost Plus Method (‘CPM’) • Profit Split Method (‘PSM’) • Transactional Net Margin Method (‘TNMM’) • Any other method that takes into account prices charged or would have been charged under similar circumstances and facts – Rule 10AB

9. Prescribed Transfer Pricing Methods Traditional Transaction Methods Transactional Profit Methods Residuary Method Cost Plus Method CUP* Profit Split Method Any Other Method Resale Price Method TNMM** • Traditional methods generally preferred over transactional profit methods • Legal view is to follow order as they appear in the Act • Residuary method to be adopted in cases where it can be demonstrated that the method satisfies arm’s length test. ** Transactional Net Margin Method * Comparable Uncontrolled Price Method

10. Comparables • All methods require comparables • Transfer price is set/ defended using data from comparable transactions • Comparable transaction should be independent and similar to tested transactions • Factors for judging comparability (Rule 10C(2)): • nature of transactions undertaken (i.e. type of good, service etc.) • company functions • risks assumed • contractual terms (i.e. similar credit terms) • economic and market conditions

11. Points to be noted • SDT : Significant Transactions which may be impacted • Transfer of goods between related domestic companies eligible for tax holiday and others. • Inter-transfer of goods / services between tax holiday eligible business / units and other businesses / units of the taxpayer in India • Interest, corporate guarantee receipt /payment, cash pooling and related funding transactions between related parties in India Related party under 40 A (2)(b) – Threshold for substantial interest is 20% as against 26% in case of Associated enterprises

12. Domestic Transfer Pricing provisions – Penal consequences • There is likely concealment penalty exposure under section 271(1)(c) w.r.t. variation of income • Explanation 7 to section 271(1)(C) amended to include specified domestic transaction • Non compliance with transfer pricing provisions involve penal consequences. (S. 271AA). • Failure to keep and maintain documentation. • Failure to report transactions • Maintain incorrect documentation. • Furnish incorrect documentation. • Failure to furnish information triggers 2% of Tr. Value as penalty [S. 271(G)].

13. Critical Challenges

14. Benchmarking of Managerial Remuneration • Section 40A(2)(b) includes remuneration paid to the management. • Benchmarking of management remuneration in itself is challenge. • There are no uncontrolled comparable transactions are available owing to the fact that management remuneration in all cases is a related party transaction. • Salary of directors is determined by the management based on several factors viz qualifications, experience which are individual traits and varies from company to company. • Certain judicial precedents have accepted the view that if the managerial remuneration is within the limits prescribed in the Companies Act, 1956, the same is a reasonable expenditure under section 40A(2)(b).

15. Allocation of common expenses • Deduction under section 80IA is available to eligible units • As per section 80 IA(5), profits of eligible units are to be computed as if the eligible units are the only source of income. • The common expenses incurred by the Head Offices are considered as an expense of the eligible units . • Therefore the expenses of head office which may control the business of the eligible unit must be apportioned to arrive at the eligible profit. • It has been noted that in many cases, the revenue officials contend that the allocation of common expenditure done by the taxpayer is flawed.

16. Allocation of common expenses • Revenue has regularly contended that taxpayer has allocated more expenses to a non-tax incentive unit and fewer expenses to a tax-incentive unit. • This act of the taxpayer is aimed at decreasing the income which is subject to incidence of tax • It is desirable if some guidance could be provided on the manner in which the common expenditure should be allocated between various units of the taxpayer. • Absence of necessary guidelines to allocate the expenditure has resulted into lack of achieving consistency in allocation of expenditure and increase in litigations.

17. Meaning of ‘Close Connection’ • Section 80-IA(8) covers business transactions undertaken by a taxpayer claiming tax holiday with other entities having ‘close connection’ with the taxpayer. • The term ‘close connection’ has not been expressly defined in the Act. • For this reference could be drawn from other provisions of the Act to define ‘close connection’ as under: • ‘Substantial interest’ as defined under section 40A(2)(b); • ‘Associated Enterprises’ as defined under section 92A(2); and • ‘Related party’ defined as per Accounting Standard – 18 issued by ICAI • It is desirable if some guidance could be provided on the manner in which the common expenditure should be allocated between various units of the taxpayer.

18. Ordinary Profits v. Arm’s Length Profits • Section 80-IA (10): Where the Revenue authorities believe that the tax holiday undertaking produces more than ordinary profits due to a close connection with any person, only a reasonable level of profits will be eligible for the tax holiday benefit. • For domestic transfer pricing, ordinary profits for tax holiday units would need to be determined having regard to the arm’s length principle and the transfer pricing methods. • If price based method (say, the Comparable Uncontrolled Price method) has been applied to benchmark the transaction between and a person closely connected with it, the derived profits may be considered as ordinary profits, in view of absence of horizon of the comparables margin.

19. Ordinary Profits v. Arm’s Length Profits – Cont’d… • Where arm’s length price is benchmarked using profit based methods (such as net margins of comparable companies), a question arises as to whether tax holiday benefits will be denied when the tested party has earned profits in excess of ALP i.e. higher than the arithmetic mean operating margin of comparables. • There needs to be a clarification to define and indentify ‘more than ordinary profits’, especially where the legislation contemplates profits and not merely ordinary ‘profit’. • For domestic transfer pricing, ordinary profits for tax holiday units would need to be determined having regard to the arm’s length principle and the transfer pricing methods.

20. Some other issues and challenges • Section 40A(2)(b) • Whether indirect shareholding is covered for considering transactions under section 40A(2)(b)? • Whether shareholding of individual Directors can be aggregated for determining substantial interest? • Whether each member is a relative in case of Association of Persons (‘AOP’)? • Section 80IA(8) & 80IA(10) • Issues in claiming corresponding credit when both units are eligible for tax holiday • Whether the term “more than ordinary profit” can be equated with ALP? • Common • Grandfathering of long term contracts / agreements? • Whether Capital account transactions are covered under the scope of specified domestic transactions?

21. Filing form 3ceb • CBDT has issued a notification dated 10 June 2013 notifying the rules and certificate for reporting specified domestic transactions • The existing rules have been amended to include specified domestic transactions • Further Form 3CEB has been amended to include Part C which contains reporting of specified domestic transactions undertaken by the assessee • Accordingly every assessee who has entered into specified domestic transactions will now have to obtain the auditors report in Form 3CEB and file the same with the Income Tax Department • The amended rules comes into effect from 1 April 2013

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