TRANSFER PRICING: AN IMPORTANT CONCEPT IN INTERNATIONAL TAXATION

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1 TRANSFER PRICING: AN IMPORTANT CONCEPT IN INTERNATIONAL TAXATION - BY ADITI DANI SYNOPSIS: The purpose of this article is to examine the concept of transfer pricing in the context of global trade and commerce. With travel and communication becoming a non-issue, it became easier to have control and management over enterprises situated in various jurisdictions. Different jurisdictions however, entailed different tax implications, some with very high implications. In a bid to shift profits to low tax jurisdictions and avoid paying high taxes, these associated entities developed a practice of transacting with one another and manipulating the transfer price of the transactions. Of course, not all such transactions were carried out with a view to avoid tax, nevertheless the practice created a need to check whether the transaction is taking place at a fair price, so that taxes on such prices are duly paid in the governing jurisdictions. The article then examines the various ways in which transfer pricing is abused by enterprises. The article lists several methods adopted by the enterprises whereby tax incidence is sought to be reduced. The article then goes on to discuss the arm s length principle. The arm s length principle lays down how to determine what is a fair price, on the basis of prevailing economic principles governing the valuation of the article sold or service rendered. Lastly, the article discusses the current transfer pricing legislation in India and the critical issues which need to be addressed.

2 INTRODUCTION: The rate of growth of International Trade has been catalyzed to a great extent by the emergence and proliferation of Multinational Corporations. The MNCs establish a number of subsidiaries and affiliates all over the world primarily for distribution of their goods and services or for the local manufacture of goods. Prima facie the institution of such subsidiaries globally appears to be a bad management decision due to the huge investment involved for the MNCs in establishing such subsidiaries. This is so as the MNCs could instead have had exclusive dealers or manufacturers locally based in these countries to avoid the huge capital outflow in setting up new subsidiaries. However, under this scenario the MNCs would not be able to accrue the benefits from the abuse of Transfer Pricing which far outweighs the capital and revenue expenditure incurred in establishing operating these subsidiaries. TRANSFER PRICING: WHAT IT IS A large organization, often a Multi-National Enterprise, which is the primal user of Transfer Pricing, consists of several divisions. Each of these divisions are managed and run by a separate workforce that has the discretion to run the division in accordance with its own ratiocinations. The central management faces the arduous task of evaluating the performance of each of these divisions. To face this difficulty it calculates each division s contribution to the total profit made by the enterprise. This is done by setting a price at which the goods/services/knowhow, be they at the final or intermediate stage, are churned out by the division in consideration. This calculated price makes up what is known as transfer prices. Transfer Pricing is thus referred to as the price at which one part of a multi-dimensional organisation (mostly a Multinational Enterprise), provides goods, services or know how to another part of it. This other part part of the organization may be simply another division of it e.g. the marketing division of the enterprise when the goods are sold from the production division or it can simply be a foreign branch or subsidiary of the parent enterprise. This other part of the company, which becomes relevant for the purpose of Transfer Pricing in a globalized scenario, is usually located in another country. THE ILLEGITIMACY OF TRANSFER PRICING: Most of the International Trade being carried out, in the world today, is controlled by Multinational Corporations (MNCs). To state the precise facts, about 70% of the International Trade is carried within the MNCs. 1 The major portion of this trade is in the form of intra-group exchange of goods and services i.e. trade between several divisions of the enterprise. It is important to know that if the prices charged for such intra- group transactions do not reflect market prices like those negotiated between independent enterprises they stand illegitimate. This is because this pricing for the transfer of goods and services are manipulated by the management of the enterprise primarily to avoid paying taxes. What the management therefore does, in its act of illegitimacy is to shift profit from a country with a high tax rate to a country with a low tax rate or even to countries having tax incentives for certain specified economic activities. 1 Garrett D. Brown, Protecting Workers Health and Safety in the Globalizing Economy through International Trade Treaties, International Journal of Occupational And Environmental Health, Pg , Vol 11/No 2, Apr-Jun 2005

3 What ought to be noted here is that usage of this practice of shifting goods / services etc. by the MNC to one of its subsidiary foes not bring down the overall profitability of the MNC, since it is the overall profit of the individual companies within the group that is sifted from one to another. Infact the MNC registers better profits as it, in effect pays lesser taxes. It ought to be reiterated that such a practice of Transfer Pricing does not stand illegal unless and until it is curbed by legislation in this regard. However they do in any case stand illegitimate. This is so, as although a Multinational Corporation stands avoided of its obligation to pay taxes, the Government does not in any case stand disposed of its obligations like those of ensuring peace, providing security, health, sanitation, education and other facilities. To meet these obligations the Government imposes taxes like Corporation and Income Tax. Now when the MNCs and other economic firms avoid paying taxes, the brunt of taxes is shifted to the citizens. Therefore what happens in effect is that the citizens land up paying more taxes, the Governments expenses are met and the multinational s profits are on the rise. In a different parlance, the MNCs gauge their profits from the citizen s money being paid as taxes to meet the government expenses. To explain this practice of Transfer Pricing an illustration is cited. Let there be an individual firm A situated in country X, which sells it goods at a price lower than that prevalent in the global scenario to one of its subsidiaries B located in another country. Now the profit that firm A makes by selling its goods at a visibly reduced price, stands lower since the sale is carried out at a low price. Thus as a result of low profits, the tax paid by the company also stands concurrently reduced. The subsidiary firm B then resells the goods in the international market at a competitive price making up for the loss of profits incurred by firm A. Also with this arrangement, the tax paid by B, located in another country stands much lesser than the tax that would have been paid in effect had the sale been negotiated by A in its country having a higher rate of taxation. Thus with lesser taxes paid in conclusion by the corporation consisting of firm A and B, by such an arrangement, the multinational registers greater savings. Such an arrangement however stands illegitimate. It stands illegal if country X, seeks to curb such a practice by its legislation, as it stands deprived of the taxes which remain payable to it. It ought to be mentioned here that such an arrangement does not only involve the transfer of profits. There also exist illegitimate arrangements regarding transfer or beneficial sharing of the various costs of marketing, administration, R&D etc. between the numerous subsidiaries of a Multinational Enterprise so as to avoid paying taxes to an exuberant scale in a certain country. WAYS OF ABUSING TRANSFER PRICING: International tax experts have devised several ways of transfer pricing with the aim of reducing the overall tax burden. Some of the ways for doing this are as follows: (1) Tax Haven: Tax havens play an important role in influencing the location of subsidiary companies. This is so as the goods and services are invoiced to the subsidiaries located in low tax regimes at a very low price so as to leave them with high profits, which ultimately go untaxed in tax havens. (2) Unexplained Corporations: Unexplained corporations in the organizations, which do not have any valid functions, are used as a vehicle for tax avoidance through tax pricing. (3) Profit and Loss Account: The Research and Development expenditure is artificially and arbitrarily distributed among group companies to avoid taxes; excessive payments

4 for patents and trademarks and royalties are made to a group company because the group company is situated in a tax haven. These payments are not in accordance with the Arm s Length principle. Excessive payments made by an affiliate or subsidiary to the parent company for Head Office Administrative support. They contain hidden profits which are not assessed in the country of the parent company. (4) Intangible Property: The intangible property developed and owned by the entity in a low tax jurisdiction receives license fees from affiliates situated in high tax jurisdiction. (5) False Invoicing: This practice by the OECD Committee on Fiscal Affairs (1976), as a transaction intended to evade tax by putting taxable objects outside the reach of national tax authourities by means of both under and over invoicing of imports and exports, often by the same company. (6) Routing of Transaction: A company purchases a product that is made in one country, from another country, and resells it in another country. For ex. a company purchases a product from Argentina that is made in Britain and resells it in USA. Such a routing is done with a purpose of taking advantage of transfer price. (7) Paper Companies: Paper companies do not have any real office, employee or warehouse. They are founded in tax havens. Profits are diverted to these companies by transactions of paper. (8) Sale of Business: Herein a subsidiary company is formulated. In the case of CIT v. Assam Consolidated Tea Estates Ltd, 2 the assessee was a non resident company incorporated UK and had been carrying on business in India by running tea estates. Another subsidiary company to the assessee was incorporated in the UK. Now an agreement was entered between the said subsidiary and the assessee and in pursuance of such an agreement the assessee transferred and conveyed to the subsidiary the business in India and the subsidiary company issued to the assessee certain shares and redeemable unsecured loan stock under an instrument as consideration for the said sale. The question was whether the aforesaid interest payable on the unsecured redeemable loan stock was assessable u/s 9(1)(i) of the Act. The Calcutta High Court held that the assessee was not carrying on any business in India whatsoever. Though previously the assessee owned and ran the business but the same was transferred to the subsidiary and not by the assessee which was an entity separate and distinct from the subsidiary. Even otherwise, there was no continuity of any business of the assessee in the hands of the subsidiary, had been established. The interest on the loan stock was, therefore, held as not accruing or arising in India from any business connection in India. (9) Interest v. Dividend: If a subsidiary in one country is founded by a parent company in another, the group will pay less tax in total if the former transfers its profits to the latter in the form of interest, which is deductible from taxable profits rather than as a non deductible dividend. 10) Splitting of Transactions: The transactions may be split into a series of such transactions so that each may be looked upon as an independent source of income, though in substance the entire series is nothing but constitutes one composite 2 [1987] 167 ITR 215 (Cal)

5 transaction. By fragmenting the transaction, income is also fragmented so as to appear to be arising from different jurisdictions. THE ARMS LENGTH PRINCIPLE: As a result of such illegitimate transfers depriving countries of huge amounts, which they would have otherwise received as taxes, the international community brought out what is known as the Arm s Length Principle into being. The underlying concept of this principle is that the pricing of goods, services or costs that are transferred or shared, as the case may be, should be equivalent or at Arm s length to the price prevailing in an open, competitive market rather than at a price which is determined solely by tax considerations. In other words, the pricing of intragroups transactions within a Multinational Enterprise, operating from two or more countries, should be the same that would have been applied on unrelated parties in similar transactions, under similar circumstances in the open market. Transfer pricing rules in tax laws, therefore are intended to counter the underpayment of tax. The Arm s length principle was first incorporated in the tax treaties concluded by the USA, the UK and France in 1920s and 1930s. This principle was later formulated in Article VI of the League of Nations Draft Convention on the Allocation of Profits and Property of International Enterprises in This Article is similar to Article 9 of the 1963 OECD Draft Convention as also Article 9 of the Present OECD 4 and UN 5 Models of Tax Convention. THE INDIAN SCENARIO: TRANSFER PRICING ILLEGAL. The Finance Act 2001 introduced the detailed Transfer Pricing Regulations (T.P.R.) in India with effect from 1 st April 2001 corresponding to the assessment year The rules for transfer pricing have been notified on August 21, The sections and rules under the Income Tax Act, that deal with Transfer Pricing Regulations are sections 92 to 92F and rules 10A to 10E and sections 271(1)(c), 271AA,271BA and 271G. The Indian Law on this subject states that the any income arising from an international transaction 6 shall be calculated in accordance with the Arms-Length Principle. 7 In addition to this, if any cost or expense is allocated or apportioned between two or more associated 3 Prof Dr. John JA Burke, Re-Thinking First Principles of Transfer Pricing Rules, Virginia Tax Review 2011 (Also available at: 4 OECD Model Tax Convention UN Model Tax Convention Defined u/s 92C of the Income Tax Act, 1961 [hereinafter referred to as the IT Act] International transaction is defined to mean a transaction between two or more associated enterprises of which either both or anyone is a non-resident, in the nature of: (1) Purchase, sale or lease of tangible property or intangible property; or (2)Provision of services: or (3) Landing or borrowing of money: or (4) Any transaction having a bearing on the profits, income, losses or assets. (5)Mutual agreement or arrangement between two or more associated enterprises for the allocation or apportionment of any contribution, cost or expense. 7 Section 92(1), IT Act.

6 enterprises, 8 it is to be done at arm s length prices. 9 It ought to be mentioned here that if resort be made to the arm s length principle and the income on which tax is due to be paid stands reduced then the tax payable would not be calculated in accordance with the Arm s Length Principle. 10 COMPUTATION OF THE ARM S LENGTH PRICE: Section 92C of the IT Act deals with the computation of the Arm s Length Price. The methods recognized to arrive at arm s length price are based on the OECD Guidelines: a. Comparable uncontrolled price method (CUP): The CUP method compares the price charged for property or services transferred in a controlled transaction (A transaction between known entities or associated enterprises ) to the price charged for property or services transferred in a comparable uncontrolled transaction (i.e. a transaction between independent entities) in comparable circumstances. CUP method is the most direct and reliable way to apply the arm s length principle and hence the same is preferable over all other methods wherever it is possible to locate comparable uncontrolled transactions. b. Resale price method (RPM). The resale price method begins with the price at which a product that has been purchased from an AE is resold to an independent enterprise. For example, company A has sold a product to an associated company B at Rs The company B has resold the same to an unrelated party X at a price of Rs In order to arrive at arm s length price between A and B the price charged by B to X would be scrutinized. If reasonable profits in hands of B are presumed at Rs. 600, arm s length price between A and B will be Rs. 1400( ). There may be further adjustments due to customs duty, etc. The factors to be considered in this method are level of costs, value addition at each stage, time-frame of resale, computation of gross margin, etc. c. Cost plus method (CPM): In Cost Plus Method, first the cost incurred by the supplier of property (mainly service) is determined. An appropriate cost plus mark-up is then added to the cost, to arrive at an appropriate profit in the light of the functions performed and market conditions. The resultant figure is the arm s length price. So essentially, CPM involves comparability of gross margins earned by suppliers in uncontrolled transactions. This method is useful for sale of semi-finished goods, rendering of services, etc. d. Profit split method (PSM): This method is applicable where transactions are so interrelated that they cannot be evaluated separately for the purpose of determining arm s 8 Defined u/s 92 A of the Income Tax Act, The basic criterion to determine associated enterprises is the participation in management, control or capital (ownership) of one enterprise by another enterprise. The participation may be direct or indirect or through one or more intermediaries. Thus to investigate whether two enterprises are associated one is permitted to go to any layer of management, control or ownership in order to find out association. For e.g. If enterprise B is managed, controlled or owned either directly or through an intermediary, then Enterprise B is said to be an AE of enterprise A. If Mr. A and Mr. B control both Ent. A and Ent. B then both Ent. A and Ent. B are associated enterprises. 9 Section 92(2), Income Tax Act, Section 92(3), Income Tax Act, 1961

7 length price of any one transaction. The profit-split method first identifies the profit to be split for the associated enterprises. Then the profit so determined is split between the associated enterprises on the basis of functions performed, assets employed or to be employed and risks assumed by each enterprise. Such contribution is valued to the extent possible by any available reliable external data. e. Transactional net margin method (TNM) : In case of this method, the net profit margin realized by the enterprise from an international transaction entered into with an associated enterprise is computed in relation to costs incurred or sales effected or assets employed or to be employed in the enterprise or having regard to any other relevant base. Such net margin then, may be compared with comparable uncontrolled transaction, which the tax-payer has entered into with unrelated enterprise (internal comparison). If this is not possible, net margin that would have been earned in comparable transactions by an independent enterprise may be compared (external comparison). Thus, TNMM operates in a manner similar to cost plus and resale price methods. The section also provides any other method may also be prescribed by the Board if none of the above five methods are found to be suitable to arrive at arm s length price. Sub-section (2) provides that where more than one price may be determined by the most appropriate method, the arm s length price shall be taken to be the arithmetical mean of such prices. This is a unique concept in India. Rule 10B explains in detail methods prescribed above. The Indian provisions as regards to the computation of the arms length price as per the most appropriate method are in line with the international guidelines and laws of various countries. Rule 10C provides that the most appropriate method shall be the method which is best suited to the facts and circumstances of each particular international transaction, and which provides the most reliable measure of an arm s length price in relation to the international transaction. 11 CRUCIAL ISSUES TO BE ADDRESSED Some crucial issues which remain unaddressed in the Income Tax Act include the following: The definition of associated enterprises has many glitches like it includes multinational enterprises supplying technology to users world-wide as associated enterprises. The transfer of technology, in this case, could be by way of transfer of know-how, patents, copyrights trademarks, licenses, franchises or any other business or commercial rights 11 Rule 10C provides that the most appropriate method shall be selected having regard to the following, namely:- a) The nature and class of the international transaction; b) The class or classes of associated enterprises entering into the transaction and the functions performed by them; c) The availability, coverage and reliability of data necessary for application of the method; d) The degree of comparability existing between the international transaction and the uncontrolled transaction and between the enterprises entering into such transactions; e) The extent to which reliable and accurate adjustments can be made to account for differences, if any, between the transactions being compared and the enterprises entering into such transactions; f) The nature, extent and reliability of assumptions required to be made in application of a method.

8 of similar nature. Also, the definition excludes technology for services e.g. software from its scope. The definition of international transaction is very wide and goes far beyond the scope of transfer pricing. The provision requiring determination of arm s length price at an average of the price determined by the most appropriate method is unique to India only and is not consistent with the global practice. The provisions (S 92CA) give a lot of power to the Transfer Pricing Officer (TPO) for determination of arm s length price. The entire procedure for reference to TPO is lengthy and time consuming. The provisions are silent about the recourse to the Advance Pricing Agreements (APA).Through an APA, a taxpayer establishes its transfer pricing policy prospectively through an agreement negotiated with one or more revenue authorities. In India, the Authority for Advance Rulings (AAR) under Section 245 Q deals with among other things, transactions involving non-residents and notified resident applicants. Bringing in transfer pricing under the purview of advance rulings will result in eliminating uncertainties and enhancing the predictability of tax treatment in international transactions. The provisions are silent about the reference to the Double Taxation Avoidance Agreements (DTAA). The issue here is that where the agreements contain the specific anti-avoidance rules, would they override the general provisions of sections 92 to 92F. What would be the implication of the proposed provisions on the other associate laws is not clear. For example, what are the implications under the Customs Laws where there are variations in the prices of the goods imported/exported. CONCLUSION: The regulations made by the Indian Government on Transfer Pricing were much needed in a globalized world. However there remain certain issues which deserve attention by the Central Board of Direct Taxes as has been pointed above. From the tax administration point of view it would be better to move from the costly and time consuming dispute settlement mechanism to the APA mechanism as suggested above. The APA program has proven to enhance fiscal management operations for all the parties since each would be in a better position to predict their costs and expenses including the tax liabilities. A little willingness and flexibility on the part of the Indian government and the CBDT can go a long way in resolving inter-company pricing.