Introduction
o
Basics about Transfer Pricing
o
Terms and abbreviations used
o
Objective of the Guidance note
o
Applicability of the Provisions
o
New developments like safe harbors & Advance
Pricing Agreement
Responsibility
of the Enterprises and Accountant
The
obligation of an enterprise to keep and maintain records and documents
vis-a-vis the duty of revenue authorities to verify about the compliance with
the arm’s length principle has been succinctly stated by the OECD in their Transfer Pricing Guidelines:
“Taxpayers should make reasonable
efforts at the time the transfer pricing is established to determine
whether the transfer pricing is appropriate for tax
purposes in accordance with the arm’s length principle. Tax administrations
should have the right to obtain the documentation prepared or referred to in this process as
means of verifying compliance with the arm’s length principle. However, the
extensiveness of this process should be determined in accordance with the same
prudent business management principles that
would govern the process of evaluating the business decision of a similar level
of complexity and importance. Moreover, the need for the documents should be
balanced by the costs and the administrative burdens, particularly where this
process suggests the creation of documents that would not other wise be prepared or
referred to in the absence of tax
considerations. Documentation requirements should not impose on tax
payers’ costs and burdens disproportionate to the circumstances, taxpayer
should nonetheless recognize that adequate record keeping practices and
production of documents facilitates examination and resolution of transfer pricing issues that arise”.
Associated Enterprises
Examples are
given of each point covered under the section 92A which is not given under the Income tax act, 1961.
International
Transaction
a. Tangible
Property defined in detailed manner
(Transfer pricing regulation
+OECD guidelines)
Tangible
property has an existence in physical form. Any property other than tangible
is intangible property. OECD guidelines include right to use industrial assets
such as patents, trademarks, names, designs or models as intangible properties.
It also includes literary and artistic property. OECD guidelines focus on
“business rights” associated with commercial activities including marketing
activities.
b. Intangible Property defined in detailed manner (Transfer pricing regulation +OECD guidelines)
o Marketing related – Trademark, trade names, brand names,
logos
o Technology related- Process patents, patents applications,
technical documentation such as laboratory notebooks ,
technical know-how
o artistic related intangible
assets, such as, literary
works and copyrights, musical compositions, copyrights, maps,
engravings
o data processing related
intangible assets, such as
proprietary computer software, software copyrights, automated databases,
and integrated circuit masks and masters
o engineering related intangible assets,
such as industrial design, product patents, trade
secrets, engineering drawing and schema-tics, blueprints, proprietary documentation
o customer related intangible assets, such as, customer lists,
customer contracts, customer relationship, open purchase orders
o contract related intangible assets,
such as, favorable supplier, contracts, license
agreements, franchise agreements, non-compete agreements
o human capital related intangible
assets, such as, trained and organized
workforce, employment agreements, union contracts;
o location related intangible assets, such as leasehold
interest, mineral exploration rights, easements, air rights, water rights
o goodwill related intangible assets,
such as, institutional goodwill, professional practice
goodwill, personal goodwill of professional, celebrity goodwill, general
business going concern value
o methods, programmes, systems, procedures,
campaigns, surveys, studies, forecasts, estimates, customer lists,
or technical data
o any other similar item that
derives its value from its intellectual
content rather than its
physical attributes
c. Service, finance cost etc
d. Cross
Border transactions with examples
Specified
Domestic Transactions
a. The threshold limit for SDT can be
computed either on net basis (i.e. without including indirect tax levies like service tax,
VAT, etc.) If the assessee is availing credit of those indirect taxes or on gross basis if the assessee
is not availing credit, depending upon the method of accounting regularly
followed. An useful reference may be made
to the paragraph relating to Sales, Turnover, Gross Receipts
under Guidance Note on Tax Audit u/s. 44AB issued by the Institute for the
purpose of determining the threshold limit.
b. The provisions of Section 40Aoperates only
on the expenditure side and
would not have any impact in the hands of the recipients of such payments. Thus
only the persons/entities incurring such expenditure would
be subject to SDT under this provision
and would be required to comply with
the relevant transfer pricing compliances
c. The persons/entities receiving such
income will not be subject to SDT under this provision and would not be
required to comply with the relevant transfer pricing compliances.
d. These provisions are applicable
to expenditures claimed as deduction under ‘income from other sources’ head on
account of specific direction in section 58(2) which states that provisions of
section 40A are also applicable for computation of taxable income under “income
from other sources”.
e.
Provisions of Section 40A are also applicable to the expenditures which
are capital in nature and fully claimed as a deduction under other
sections like Sec 35(2AB), 35 or 35AD) since
any expenditure is covered under the scope of sec 40A (2)(b). I.e. we have to comply with
theTransfer pricing provisions in
case Research and development. (Important to note that R&D is also covered
under OECD guidelines and United Nations Guidelines)
f. The
transactions included in the ambit of this section would include expenditure
transactions like (illustrative only):
• Expenditure on buying goods
• Expenditure on procurement
of services
• Expenditure on interest
payments
• Expenditure on salary,
training services, marketing expenses
• Expenditure on purchase of
tangible and intangible property
• Director’s remuneration,
commission, sitting fees
• Group charges
• Reimbursement expenditure
•
Guarantee fee expenditure
g.
Relationship chart is given to explain the persons who are covered under
section 40A.
h.
Transactions in other provisions to which section 80-IA (8)/ (10) apply
Specified domestic transactions as
defined in section 92BA also refer to any transaction, referred to in any other
section under Chapter VI-A or section 10AA, to which provisions of section
80-IA(8) and section 80-IA(10) are applicable.
The following profit linked
incentive provisions under Chapter VI-A are also governed by provisions of
section 80-IA(8) and section 80-IA(10) and hence will be subject to Domestic
TP:-
o
Section 80-IAB, Section 80-IB, Section 80-IC, Section 80-ID,
Section 80-IE
Arm’s
Length Price
a. The steps involved in the
determination of the arm’s length price can be summarized as follows:
(i)
Identification of the “international transaction” or specified domestic
transaction;
(ii)
Identification of an “uncontrolled transaction” – Rule 10A (a);
(iii)
Identification and comparison of specific characteristics embodied in
international transactions or specified domestic transactions and uncontrolled
transactions – Rule 10B (2);
(iv)
finding out whether uncontrolled
transactions and international transactions or
specified domestic transactions can be compared by reconciling/resolving differences,
if any – Rule 10B (3);
(v)
ascertaining the most appropriate method by applying the tests laid down – Rule
10C;
(vi)
determination of the arm’s length price by
applying the method chosen – Rule 10B (1)
b. The factors given under Rule 10C
are to be applied cumulatively in selecting the most appropriate method. The
reference therein to the terms ‘best suited’ and ‘most reliable measure’
indicates that the most appropriate method will have to be selected after a
meticulous appraisal of the facts and circumstances of the international
transaction or specified domestic transaction. Further, the selection of the
most appropriate method shall be for each particular international transaction
or specified domestic transaction. The term ‘transaction’ itself is defined in
rule 10A (d) to include a number of closely linked transactions. Therefore,
though the reference is to apply the most appropriate method to each particular
transaction, keeping in view, the definition of the term ‘transaction’, the
most appropriate method may be chosen for a group of closely linked
transactions. Two or more transactions can be said to be linked when these
transactions emanate from a common source being an order or a contract or an
agreement or an arrangement and the nature, characteristics and terms of these
transactions are substantially flowing from the said common source. For
example, a master purchase order is issued stating the various terms and
conditions and subsequently, individuals orders are released for specific quantities.
The various purchase transactions are closely linked transactions.
c. Examples are given where
variation of 3% in TP is explained.
d. The
following are some of the characteristics
to be assessed vis-Ã -vis the property transferred or service provided:
•
Quality of product/services;
•
Quantity and value of the transactions;
•
Presence of intangibles like brand name, trademarks etc.;
•
Material/physical features.
e. Analysis of functions performed like design & development of
product, manufacturing, warehousing, sales and distribution, technical
services, conceptualization and specification of services performed etc
f. Analysis of Assets employed like whether assets are owned
or leased, whether activity is capital or labour intensive Presence or absence
of intangibles
g. Analysis of Market Conditions like geographical location and size,
regulatory laws, govt orders, cost of labour, cost of capital, Nature of
Market, level of Competition
h. Examination of Important
contractual terms like
Terms of Delivery, FOB, CIF, terms of payment, discount, rebate, taxes etc
i. Analysis of Risk Assumed
|
Nature of risks
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Particulars
|
|
1.Financial risk
|
a.
Capital contribution
b.
Method of funding
c.
Funding of losses
d.
Bad debts
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|
2.Product risk
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a.
Design and development of product
b.
Up-gradation of product
c.
After Sales Service
d.
Risks associated with R & D
e.
Product liability risk f
.
Intellectual property risk if any
|
|
3.Market risk
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a. Development of market
including advertisement and product promotion etc.
b.
Business volume risk
c.
Assured sales risk
d. Fluctuations
in demand and prices.
e.
Credit and collection risk
|
j. It is important to note that the transactions entered
into by associated enterprises with unrelated party (“internal comparables”) would
provide more reliable and accurate data as compared to transactions by and
between third parties (“external comparables”). OECD’s Guidelines on Transfer Pricing
recognize the fact that external comparables are difficult to obtain and, also,
it may be incomplete and difficult to interpret. Hence for these reasons,
internal comparables are preferred to external comparables.
k. All above analysis given under
Rule 10 d – information and documents to be kept but examples are not mentioned
in income tax rule, examples covered by ICAI guidelines (above)
Methods
of Arm’s Length Price
a.
Comparable uncontrolled transaction Method
Price Charged in a comparable
uncontrolled transaction + Adjustment which could materially affect the
price in open market
OECD Guidelines
Typical transactions in which CUP
Method May be used
o
Transfer of Goods
o
Provision of Services
o
Intangibles
o
Interest on Loans
The OECD in its Transfer Pricing
Guidelines observes as under:
“The CUP method is a particularly
reliable method where an independent enterprise sells the same product as is
sold between two associated enterprises.”
“The CUP method compares the price charged
for property or services transferred in a controlled transaction to the price
charged for property or services transferred in a comparable uncontrolled
transaction in comparable circumstances. If there is any difference between the
two prices, this may indicate that the conditions of the commercial and
financial relations of the associated enterprises are not arm’s length, and
that the price in the uncontrolled transaction may need to be substituted for
the price in the controlled transaction.”
The steps involved in the
application of this method are:
(i) Identify
the price charged or paid
in comparable uncontrolled transactions;
(ii) The above
price should be adjusted for transaction
level the differences on the basis of functions
performed, assets used and risks taken (FAR) analysis and
enterprise level differences if any;
(iii)The adjusted price is the arm’s length price
b. Collective
Materiality and Open Market
Only
differences that would materially affect the price in the open market are
required to be adjusted. Two points may be noted. Firstly, materiality would have to be
judged in the light of various circumstances. If there are numerous adjustments,
which are individually not material but collectively material, the necessary
adjustments are required to be made.
Secondly,
the term ‘open market’, though
not defined, would mean a transaction between a knowledgeable and a willing
purchaser and a knowledgeable and willing seller where neither of them is
influenced or compelled to act in a particular manner.
Explanation to the section 80IA not
defined the term open market.
c. Resale
Price Method
Typical transactions where the
resale price method may be adopted are distribution of goods involving little
or no value addition
OECD guideline:-
An Appropriate resale price Margin
is easiest to determine where the reseller does not add substantially to the
value of the product.
It may be more difficult to use the
RSM to arrive at an arm’s length price where before re-sale the goods are
further processed or incorporated in more complicated product so that their
identity is lost or transformed.
A resale price margin is more
accurate where it is realized within a short time of the reseller’s purchase of
the goods. The more time that elapses between the original purchase and resale
the more likely it is that other factors – changes in the market, in rates of
exchange, in costs, etc. – will need to be taken into account in any
comparison.”
d. Cost plus Method
Cost plus Method includes Direct
plus indirect costs
Typical transactions in which Cost
plus Method May be used
o
Joint facility arrangements
o
Provision of Services
o
Transfer of Semi-finished goods
o
Long term buying & selling arrangements
The OECD in its Transfer Pricing
Guidelines states as follows:
“This method probably is most useful
where semi finished goods are sold between associated parties, where associated
parties have concluded joint facility agreements or long-term buy-and-supply
arrangements, or where the controlled transaction is the provision of
services.”
e. Profit
Split Method
Rule
10B(1) profit split method, which may be
applicable mainly in international transactions involving transfer of
unique intangibles or in multiple international transactions which are so inter- related that
they cannot be evaluated separately for the purpose of determining the arm’s
length price of any one transaction, by which…….
f. Transactional Net margin Method
Typical transactions where the
transactional net margin method may be adopted are:
(a)
Provision of services;
(b)
Distribution of finished products where resale price method cannot be applied;
(c)
Transfer of semi finished goods where cost plus method cannot be applied;
(d)
Transactions involving intangibles where profit split method cannot be applied
g. Other Method is used in case of International
Transactions.
|
Method
|
Comparability
|
Approach
|
Provider
|
Application
|
|
CUP
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Very
High
|
Price
Benchmarking
|
All
(Very
important for us )
|
Where
goods or service under consideration is sold widely among unrelated parties.
Transfer of Tangibles, Intangibles, Royalty, Loans
|
|
CPM
|
High
|
GP
based Price Benchmarking
|
Distributor/
Service
provider
|
Raw
materials or semi- finished goods are sold; where joint facility agreements
or long-term buy-and-supply arrangements, or the provision of services are
involved;
|
|
RPM
|
High
|
GP
based Price Benchmarking
|
Manufacturer
/ Service
Provider
|
It is
applied when a property purchased or services obtained from associated
enterprises are resold to unrelated parties.
|
|
PSM
|
Medium
|
NP
based Price Benchmarking
|
Manufacturer
/ Service
Provider
|
where
the transactions involve provision of integrated services by more than one
enterprise
|
|
TNMM
|
Medium
|
NP
based Price Benchmarking
|
Manufacturer
/ Service
Provider
|
Universally applied but used as a method of last resort, where RPM cannot be used.
|
|
Other
Method
(Rule
10AB)
|
New
method according to Situation but the applicability according to our
understanding in case of Director’s remuneration, cost allocations ,
allocations between group entities, Intangibles etc.
|
Documentation
and Verification
a. Following is the illustrative
checklist to carry out business analysis of the assessee:
(a)
year of establishment/incorporation;
(b)
Name and residence of the parent company (holding company);
(c)
details of the place/s (units) from where
services are rendered
(Including area occupied,
infrastructure, etc.);
(d)
Activity in brief (if there is more than one unit, details of activities in
each unit);
(e)
stake-holding of the parent company;
(f)
Legal environment of the industry;
(g)
Key value drivers of the industry;
(h) Major
players in the industry;
(i)
share of business in the industry;
(j)
Trends in profitability, turnover, market share etc.
b. A similar description of the
business of the associated enterprises with whom the assessee has
undertaken international transactions, is also
to be prepared by the assessee. The accountant shall verify if such
description is also maintained.
c. A record of the actual working
carried out for determining the arm’s length price, including
details of the comparable data and
financial information used in applying the most
appropriate method, and adjustments, if any, which were made to account
for differences between the international transaction and the comparable
uncontrolled transactions,
d. The regulations
require the assessee to
maintain information regarding the shareholding pattern
e. Ownership interest held by
enterprises in the assessee enterprise, directly or indirectly through
intermediaries, also needs to be maintained by the assessee.
f. Summarized global financials and
other details such as capital invested, assets employed, turnovers achieved,
incomes earned, profits made / losses incurred, etc.
g. Sometimes, the establishment of
ownership linkages between the assessee and other associated enterprises is a
problem for the reason that sufficient reportable information is not available.
In such cases, the assessee will have to provide only the information that is
available with him.
h. Remark of OECD: - “Tax
administrators further should
not require taxpayers to
produce documents that are not in the actual possession or control of the
taxpayer or otherwise reasonably available, e.g., information that cannot be
legally obtained, or that is not actually available to the taxpayer because it
is confidential to the taxpayer’s competitor or because it is unpublished and
cannot be obtained by normal enquiry or market data.”
i. The
assessee is not required to maintain this information in respect of other
associated enterprises i.e. enterprises that are not its group entities but are
deemed to be associated enterprises by virtue of provisions of clauses (c) to
(m) of section 92A(2).
|
Indian
Regulation Vs OECD Regulations
|
|
Concepts
|
Indian
Regulation
|
OECD
Regulation
|
|
Associated
Enterprises
|
Very
wide definition
|
Restricted
to controlled entities
|
|
Comparable
range
|
(FY
2013)Allows 3% range band on avg. results of comparables
|
Allows
for range of Comparable Data
|
|
Multiple
year data
|
Only
allows data for current year (and earlier 2 years under limited
circumstances)
|
Permitted
|
|
Foreign
comparables
|
Not
permitted in practice
|
Permitted
|
|
Priority
of methods
|
Most
appropriate method rule
|
Originally
preference for Traditional Methods
|
|
Use of
unspecified method
|
Now
specified
|
Permitted
|
|
Documentation
|
Stringent
|
Prudent
business principle
|
|
Intangibles
|
definition
vague and unclear No guidelines
|
Defined
& described but progress still not full achieved.
|
