WIRC INTENSIVE COURSE ON TRANSFER PRICING

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1 1 WIRC INTENSIVE COURSE ON TRANSFER PRICING (From to ) I. INTRODUCTION What is Transfer Pricing? OVERVIEW OF TRANSFER PRICING By Nilesh Patel; Ex-IRS Officer, CPA(USA) Ph: OECD defines Transfer Prices as the prices at which an enterprise transfers physical (tangible) goods and intangibles, or provides services, or lends money to associated enterprises. Transfer Pricing is the process of setting the transfer prices. Transfer prices can be set (transfer price setting) at the time the transfer to the associated enterprises happens i.e. at the time of the transaction between two associated enterprises. And the transfer prices can be tested (transfer price testing) at the end of the accounting period. Why is transfer pricing relevant? Growth of MNCs Increasing volume of transactions within a MNC group Intra-firm transactions (i.e. transactions within a MNC group) form around 60% of international trade Such transactions may not be governed entirely by market forces, but by common interests of the business entities of a MNC group In a transaction between two unrelated, or uncontrolled, or independent parties, the price is fixed by negotiation Transfer prices, set within a MNC, may differ from the price that may be determined in a similar transaction between two unrelated parties under similar circumstances Transfer prices may be set with an intention to avoid or minimize taxation by shifting profits from a high tax country to a low tax country Transfer pricing can be considered as a management tool for determining the profitability of various business entities of the group. It can be used to allocate revenues, costs and resources of the group to different entities of the group efficiently. It can also be a performance measurement tool of the management of the different entities within a group. 1 OVERVIEW OF TRANSFER PRICING By Nilesh Patel: Ex-IRS Officer, CPA(USA)

2 2 Factors which influence Transfer Pricing: Differences in taxability, and tax rates, among countries Need to transfer capital or funds between business entities of the same group located in different countries Need to overcome restrictions on repatriation of profits Need to mitigate foreign exchange risk a MNC group may want to hold its assets in a particular foreign currency Remuneration of managers of different business entities of a group, if such managers are remunerated on basis of profits of the respective entities/divisions managed by them Transfer Pricing and International Taxation: Article 7 of the OECD Model Convention on Income and on Capital (which is the basis of Article 7 of DTAAs entered into by India with various countries) deals with attribution of profits to a permanent establishment (PE). That article reads as under:..where an enterprise of a Contracting State carries on business in the other Contracting State through a permanent establishment situated therein, there shall in each Contracting State be attributed to that permanent establishment the profits which it might be expected to make if it were a distinct and separate enterprise engaged in the same or similar activities under the same or similar conditions and dealing wholly independently with the enterprise of which it is a permanent establishment. The above Article lays down the following principles: Though a PE is an integral part of the enterprise of which it is a PE, the profits attributable to the PE have to be determined by treating the PE and the enterprise as distinct and separate enterprises. The profits attributable to the PE have to be determined by assuming that the PE deals with the enterprise in a wholly independent manner. The concept of determination of profits on basis of transactions between independent enterprises under similar conditions and circumstances is known as the Arm s Length Principle. Article 9 of the OECD Model Convention on Income and Capital (which is the basis of Article 9 of DTAAs entered into by India with various countries) provides for a tool to identify intra-group transactions. It also lays down the procedure for enforcing the application of the Arm s Length Principle. That article reads as under : 1. Where a) An enterprise of a Contracting State participates directly or indirectly in the management, control of an enterprise of the other Contracting State, or 2 OVERVIEW OF TRANSFER PRICING By Nilesh Patel: Ex-IRS Officer, CPA(USA)

3 3 b) The same person participates directly or indirectly in the management, control or capital of an enterprise of a Contracting State and an enterprise of the other Contracting State, and in either case conditions are made or imposed between the two enterprises in the commercial or financial relations which differ from those which would be made between independent enterprises, then any profit which would, but for those conditions, have accrued to one of the enterprises, but, by reason of those conditions, have not so accrued, may be included in the profits of that enterprise and taxed accordingly. 2. Where. a Contracting State includes in the profits of an enterprise of that State- and taxes accordingly- profits on which an enterprise of the other Contracting State has been charged to tax in that other State and the profits so included are profits which would have accrued to the enterprise of the first-mentioned State if the conditions made between the two enterprises had been those which would have been made between independent enterprises, then that other State shall make an appropriate adjustment to the amount of the tax charged therein on those profits. In determining such adjustment, due regard shall be had to the other provisions of this Convention and the competent authorities of the Contracting State shall if necessary consult each other. The above two provisions (Article 7 and Article 9) show the integration of transfer pricing with international taxation. By seeking to adjust profits with reference to the conditions which would have prevailed between independent/uncontrolled enterprises in comparable transactions and comparable circumstances, the arm s length principle treats the members of a MNC group as operating as separate entities rather than as inseparable parts of a single integrated business. The Arm s Length Principle: When independent parties transact with each other the price of goods transferred or services provided as well as the conditions of transfer are determined by market forces. When associated enterprises transact with each other the price of goods transferred or services provided as well as the conditions of transfer may not be affected by external market forces in the same way. A transaction between two associated or related or controlled parties must be priced in the manner it would be if they were unrelated or uncontrolled or independent parties. Application of arm s length principle involves a comparison of prices and conditions in a controlled transaction (between associated enterprises) with the prices and conditions in an uncontrolled transaction (between independent enterprises). 3 OVERVIEW OF TRANSFER PRICING By Nilesh Patel: Ex-IRS Officer, CPA(USA)

4 4 In practice, arm s length price is nothing but the market price. Development of the Arm s Length Principle: In 1933, the Fiscal Affairs Committee of the League of Nations approved a Draft Convention on the Allocation of Business Profits between States for the purposes of Taxation, which contained the following paragraph: The fiscal authorities of the Contracting States shall when necessary. rectify the accounts produced, notably to correct errors or omissions or to establish the prices or remuneration entered in the books at the value which would prevail between independent persons dealing at arm s length. The abovementioned paragraph led to Article 9 of OECD Model Convention on Income and Capital OCED published three Reports relating to Transfer Pricing: Transfer Pricing and Multinational Enterprises (1979) Transfer Pricing and Multinational Enterprises, Three Taxation Issues (1984) Thin Capitalization (1987) OCED brought out its Transfer Pricing Guidelines, 1995 The countries who are members of OECD (India is not a member of OECD, but has been given the status of an observer) adopted the arm s length principle Revised OCED Transfer Pricing Guidelines came out in July 2010 Global Formulary Apportionment a suggested alternative to Arm s Length Principle: Global Formulary Apportionment method is sometimes suggested as an alternative to Arm s Length Principle. Global Formulary Apportionment is often referred to as a unitary approach because it treats all members (located in various countries) of an affiliated group as one large global corporation for purposes of determining the allocation of income among countries. Global Formulary Apportionment aggregates the taxable income of a group of corporations (located in various countries) together as earned by a unitary enterprise. And then the aggregate taxable income of the group is apportioned to the various jurisdictions based on an internationally accepted formula using a weighted average. Global Formulary Apportionment suggests taxing MNCs on their worldwide income by allocating income to a particular jurisdiction using a formula derived from a combination of sales, costs and assets located within that jurisdiction. The goal is to achieve the same result as the arm s length principle Both methods attempt to allocate the correct amount of income to a particular 4 OVERVIEW OF TRANSFER PRICING By Nilesh Patel: Ex-IRS Officer, CPA(USA)

5 5 jurisdiction, and prevent double taxation and price manipulation. Some experts think that Global Formulary Apportionment provides a better alternative because the results would not depend on the organization of the corporate group, as the existence of separate subsidiaries in foreign jurisdictions would be ignored. Arm s Length Principle (ALP) vs. Global Formulary Apportionment: Difficulties in applying ALP: Need to find transactions between independent parties which can be compared to the controlled transaction between related parties. There may be transactions within a MNC group which may not be found between independent enterprises. Treating the member of a MNC group as separate independent entities leads to inappropriate allocation of the benefits of economics of scale and ignores the synergy between the entities. Difficulties in applying Global Formulary Apportionment: All countries must agree on the same formula, and if that does not happen, income earned by multinationals may be subject to double taxation While international implementation of a single formula is superior from a tax policy perspective, actual implementation requires cooperation from all governments around the world Determining which of the subsidiaries and branches of a MNC group should make up the global taxable entity Determining global profits accurately Setting up the formula (based on a combination of sales, costs and assets) for allocation of global profits acceptable to all countries in which the MNC operates Pre-determined formula may be arbitrary and may not reflect the market conditions The possibility of manipulation of the components of the formula, e.g. shifting of mobile assets from high tax jurisdiction to low tax jurisdiction; under-valuation of assets located in a high tax jurisdiction etc. The geographical differences are not taken into account because of consolidation of income Advantages of ALP: ALP provides parity of tax treatment for members of a MNC group and independent enterprises. Since ALP puts associated and independent enterprises on more equal footing for tax purposes, it avoids the creation of tax advantages or disadvantages that would otherwise distort the relative competiveness of the two types of enterprises. By removing tax considerations from economic decisions, ALP promotes international trade and investment. 5 OVERVIEW OF TRANSFER PRICING By Nilesh Patel: Ex-IRS Officer, CPA(USA)

6 6 ALP provides closest approximation of the workings of a free market. ALP has been accepted as the uniform international standard for pricing controlled transactions for a long time. II. BRIEF HISTORY OF INDIAN TRANSFER PRICING (TP) REGULATIONS Introduction of TP Regulations in Income Tax Act, 1961 and related amendments: Comprehensive TP Regulations were introduced by the Finance Act, 2001 Prior to introduction of detailed provisions, concept similar to transfer pricing was applied in a limited manner under the erstwhile section 92 of the I.T. Act, Sections 40A (2) (b), 10A, 10B, 80 HH, 80I, 80IA and 80IB also contain provisions to check manipulation of profits in transactions between related parties, but these provisions apply only in certain specified circumstances and are limited in their scope. Even before independence, transfer pricing was an issue because of the need to apportion income between British India and erstwhile States which were not part of British India. Following cases through light on this: i) Anglo-French Textile Company Limited v CIT(1954) 25 ITR 27 (SC) ii) CIT v Ahmedbhai Umarbhai & Co. (1950) 18ITR 472 (SC) iii) Abdul Aziz Sahib, 7 ITR 674 (Madras) Comprehensive TP Regulations (substituted section 92 and new sections 92A to 92F; Rules 10A to 10E) were introduced by Finance Act, 2001 w.e.f. 1 April The purpose of TP Regulations has been explained in Circular No: 14/2001 containing explanatory notes on provisions of the Finance Act, The said Circular explained that the earlier provisions were of a general nature and limited in scope, and that detailed TP Regulations were introduced to address the shortcomings in the then existing legislative framework. The explanatory memorandum of Finance Bill, 2001 clarifies that the legislative intention behind the TP Regulations is to prevent shifting of profits by manipulation of transfer prices. Explanatory memorandum of Finance Bill, 2002 explains the amendments made by Finance Act, 2002 in sections 92, 92A, 92C and 92F of the IT Act, 1961 w.r.e.f. 1 April 2001 Circular No. 12 of 2001 dated conveyed the decision of CBDT on the following matters: (i) If the transfer price is upto 5% less or upto 5% more than ALP determined by the Assessing Officer (AO) then no adjustment should be made by the AO; and (ii) where an international transaction is under scrutiny, the AO can invoke section 92C (3) only under the circumstances mentioned in 6 OVERVIEW OF TRANSFER PRICING By Nilesh Patel: Ex-IRS Officer, CPA(USA)

7 7 clauses (a) to (d) of that section, and in all other cases, the value of international transaction should be accepted without further scrutiny. Instruction No.3 of 2003 dated is on the issue of reference by AO to TPO, the role of TPO, and the role of AO after receipt of ALP from TPO. Explanatory Circular No.3 of 2008 dated on provisions of Finance Act, 2007 clarifies the following matters: (i) extension of time limit for making assessment when a reference is made by the AO to the TPO, and (ii) the ALP determined by the TPO would be binding on the AO. Finance Act 2009: (i) CBDT is empowered to formulate safe harbor rules section 92CB inserted [w.e.f ]; (ii) Sec. 92C amended [w.e.f ] to provide that : (a) ALP shall be arithmetic mean of prices if more than one price is determined by the most appropriate method, and (b) if variation between ALP and assessee s transfer price does not exceed 5% of transfer price, the assessee s price shall be deemed to be at arm s length; and (iii) mechanism of Dispute Resolution Panel introduced u/s 144C [w.e.f ]. Finance Act, 2011: (i) Due date for filing return in case of companies covered by TP Regulations extended to 30 November [w.e.f ], (ii) TPO empowered to determine ALP of any international transaction not referred to him by the AO [ w.e.f ], (iii) TPO can do survey u/s133a [w.e.f ], and (iv) Proviso to Sec. 92C (2) amended [w.e.f ] - if the variation between ALP (arithmetical mean of more than one price) and actual transfer price of the international transaction does not exceed such % (as notified by the Government) of the actual transfer price, then such transfer price shall be deemed to be at ALP. Changes in Direct Tax Code 2010: Additional criteria for Associated Enterprises- Provision of services (directly or indirectly) to another enterprise or to a person specified by such enterprise, if the amount payable and other terms relating thereto are influenced by such other enterprise; if any of the enterprises to the transaction is, or are, situated in any specific or distinct location as may be prescribed; Introduction of Advance Pricing Agreements regime TP Report to be submitted directly to the TPO instead of the AO III. LEGISLATIVE FRAMEWORK Overview of the relevant provisions of Income-Tax Act, 1961: Section 92: Computation of income from international transaction (i) Income from international transaction shall be computed having regard to arm s length price [Sec. 92 (1)] 7 OVERVIEW OF TRANSFER PRICING By Nilesh Patel: Ex-IRS Officer, CPA(USA)

8 8 (ii) Allowance for any expense or interest arising from an international transaction shall also be determined having regard to arm s length price [ Explanation to Sec. 92(1)] (iii) Allocation of cost or expense in a Cost Sharing Arrangement or Cost Contribution Arrangement shall be done having regard to arm s length price [Sec. 92(2)] (iv) TP Regulations will not apply where adoption of ALP will result in either reduction of taxable income or increase in loss [Sec. 92(3)] Section 92A: Meaning of Associated Enterprise and Deemed Associated Enterprises Section 92B: Meaning of International Transaction and Deemed International Transaction Section 92C: Computation of Arm s Length Price(ALP) i) Methods to determine ALP [Sec.92C (1)] ii) Most Appropriate Method (MAM) to be applied for determination of ALP [Sec. 92C (2)] iii) Where more than one price is determined by MAM, the ALP shall be arithmetical mean of such prices [ First Proviso to Sec. 92C(2)] iv) Variation between ALP and actual transfer price up to 5% ( w.e.f such % as may be notified by Govt.) of transfer price is acceptable [Second Proviso to Sec. 92C (2)] v) The AO may determine ALP in accordance with Sec. 92C (1) and (2) on basis of material or information or document available with him if, on basis of material or information or document in his possession, the AO is of the opinion that: (a) price charged or paid in an international transaction has not been determined as per Sec. 92C (1) and (2); or (b) any information and documents relating to an international transaction have not been kept and maintained as per Sec. 92D (1) and Rule 10D; or (c) the data used in computing ALP is unreliable or incorrect; or (d) the assessee has not furnished within specified time any information or document which he was required to furnish by a notice u/s 92D (3) [Sec. 92C (3)] vi) AO must give opportunity to the assessee to show cause why ALP should not be determined on the basis of material or information or document in possession of the AO [Proviso to Sec. 92C (3)] vii) AO may compute total income having regard to ALP determined by him u/s 92C (3) [Sec. 92C (4)] viii) No deduction u/s 10A or 10B or under Chapter VI-A shall be allowed in respect of the amount by which the total income is enhanced after 8 OVERVIEW OF TRANSFER PRICING By Nilesh Patel: Ex-IRS Officer, CPA(USA)

9 9 ix) computation of income under this sub-section [First Proviso to Sec. 92C (4)] In case of I-Gate Global Solutions Limited v ACIT (2007) 112 TTJ 1002 (ITAI Bangalore) it has been held that, where assessee had itself made adjustment to the transfer price, it would not be a case of enhancement of income, due to determination of ALP by the AO, and therefore, exemption u/s 10A would be available. Where total income of an enterprise is computed under Sec. 92 C (4) on determination of ALP, paid to AE, from which tax has been deducted or was deductible, the income of the AE shall not be recomputed by reason of such determination of ALP in case of first mentioned enterprise[second Proviso to Sec. 92C (4)] Section 92CA: Reference to TPO i) Where the AO considers it necessary and expedient he may, with the prior approval of the CIT, refer the computation of ALP in relation to an international transaction to the TPO [Sec. 92CA (1)] Vide Instruction No.3 of 2003 dated the CBDT directed the AO to pick up those cases for scrutiny where aggregate value of international transactions exceeded Rs. 5 Crores (increased to Rs. 15 Crores by CBDT from FY ) and refer those cases to the TPO. In the case of Sony India P. Limited v. CBDT [2007] 288 ITR 52, the Delhi High Court upheld the constitutionality of the said Instruction, and held that the creation of TPO and reference to TPO is constitutional. In that case it was also held that the AO can refer even those cases to the TPO where the value of international transaction is less than the prescribed limit (Rs. 15 Crores) for mandatory reference. ii) Where reference is made by the AO, TPO shall serve notice on the assessee for production of evidence in support of computation of ALP by the assessee [Sec. 92CA (2)] iii) Where any international transaction, other than an international transaction referred by the AO, comes to the notice of the TPO, he may determine the ALP of such other international transaction [ Sec. 92CA(2A) inserted w.e.f ] iv) TPO shall determine ALP after hearing the evidence produced by the assessee, including any information or documents u/s 92D (3), and after considering such evidence as TPO may require on specified points and after taking into account all relevant materials which the TPO has gathered [Sec.92CA (3)] v) TPO shall send a copy of his order to the AO [Sec.92CA (3)] 9 OVERVIEW OF TRANSFER PRICING By Nilesh Patel: Ex-IRS Officer, CPA(USA)

10 10 vi) TPO may pass his order u/s 92CA(3) at any time before 60 days prior to the time barring date for passing the assessment or re-assessment order Sec.92CA (3A)] vii) On receipt of order of TPO u/s 92CA (3), the AO shall compute the total income of the assessee under Sec. 92C (4) having regard to the ALP determined by TPO [Sec. 92CA (4)] viii) The TPO may rectify any mistake apparent from the record in the order passed by him u/s 92CA (3); provisions of Sec. 154 shall apply [Sec. 92CA (5)] ix) Where any rectification is done by the TPO, he shall send copy of his rectification order to the AO, who shall amend the assessment order [Sec. 92CA (6)] x) For determining ALP, the TPO may exercise all or any of the powers u/s 131(1) or 133(6) or 133A [Sec. 92CA (7)] Section 92CB: Power of Board to make Safe Harbour Rules Safe Harbour means circumstances in which the income-tax authorities shall accept the transfer price declared by the assessee (Explanation to Sec. 92CB) So far the CBDT has not made any Safe Harbour Rules Section 92D: Maintenance and keeping of information and documents by persons entering into an international transaction i) Every person who has entered into an international transaction shall keep and maintain information and documents prescribed under Rule 10D [Sec. 92D (1)] ii) The board may prescribe the period for which the information and documents shall be kept and maintained [Sec. 92D (2)] iii) The AO or CIT(Appeals) may require any person mentioned in Sec. 92D (1) to furnish any information or document prescribed under Rule 10D, within 30 days of notice [Sec. 92D (3)] iv) On application by such person, the AO or CIT (A) may extend the period of 30 days by a further period not exceeding 30 days [Proviso to Sec. 92D (3)] Section 92E: Persons entering into international transaction must furnish report from an Accountant Every person who has entered into an international transaction shall obtain a report from an accountant and furnish such report on or before the specified date, in form 3CEB. The report shall set forth particulars prescribed in Rule 10E [Sec. 92E] Section 92F: Definitions of Accountant, ALP, Enterprise, Permanent Establishment, Specified Date and Transaction [Sec. 92F (i) to (v)] 10 OVERVIEW OF TRANSFER PRICING By Nilesh Patel: Ex-IRS Officer, CPA(USA)

11 11 Overview of the Relevant Rules of Income Tax Rules, 1962: Rule 10A: Definition of - Uncontrolled transaction, Property, Services and Transaction [Rule 10A (a) to (d)] Rule 10B: Determination of ALP u/s 92C ALP shall be determined by the most appropriate method out of the five methods i.e. CUP, RPM, CPM, PSM or TNMM [ Rule 10B(1) (a) to (e)] Criteria for judging the comparability of an international transaction with an uncontrolled transaction [Rule 10B (2) (a) to (d)] An uncontrolled transaction shall be comparable to an international transaction: if there are no material differences between the two transactions, or if reasonably accurate adjustments can be made to eliminate the material effects of such differences [Rule 10B (3)] To analyze comparability of an uncontrolled transaction with an international transaction, the data relating to the financial year in which the international transaction has been entered into should be used [Rule 10B (4)] However, data relating to two years prior to such financial year may also be considered if such data reveals facts which could have an influence on determination of transfer prices in relation to the transactions being compared. [Proviso to Rule 10B (4)] Rule 10C: Most Appropriate Method The most appropriate method shall be the method best suited to the facts and circumstances of each particular international transaction, and which provides the most reliable measure of an ALP of the international transaction [Rule 10C (1)] Factors to be taken into account in selecting the most appropriate method [Rule 10C(2)] Rule 10D: Information and documents to be kept and maintained under Sec. 92D Information and documents prescribed under clauses (a) to (m) of Rule 10D (1) must be maintained The prescribed information and documents may not be maintained in a case where the aggregate value, as recorded in the books of account, of international transactions does not exceed Rs. 1 Crore. However, even in such cases the assessee shall be required to substantiate, on the basis of material available with him, that income from international transactions entered into by him, has been computed in accordance with Sec. 92 [Rule 10D (2)] 11 OVERVIEW OF TRANSFER PRICING By Nilesh Patel: Ex-IRS Officer, CPA(USA)

12 12 The information specified in Rule 10D (1) shall be supported by authentic documents, which may include documents listed in clauses (a) to (g) [Rule 10D (3)] The information and documents specified under Rule 10D (1) and (2) should, as far as possible, be contemporaneous and should exist latest by the specified date mentioned in Sec. 92 F (iv) i.e. due date for filing the return of income [Rule 10D (4)] Fresh documentation need not be maintained separately for each previous year, if an international transaction continues to have effect over more than one previous year, unless there is any significant change in the nature or terms of the international transaction, in the assumptions made, or in any other factor which could influence the transfer price [Proviso to Rule 10D (4)] The specified information and documents shall be kept and maintained for 8 years from the end of the assessment year [Rule 10 D (5)] Rule 10E: Report from an accountant required to be furnished under section 92 E shall be in form 3CEB [Rule 10E] Steps in determination of ALP under Indian Transfer Pricing Regulation: Identification of Associated Enterprises and International Transactions Ascertaining whether an enterprise has entered into an International Transaction with an Associated Enterprise (one of the two enterprises must be a nonresident). Carrying out a Functions, Assets and Risks (FAR) analysis Categorization (based on FAR analysis) of the Associated Enterprises involved in the international transaction into appropriate functional units, e.g. full-fledged manufacturer, toll manufacturer, contract manufacturer, normal risk bearing distributor, limited risk bearing distributor, service provider etc. Selecting the tested party the AE with simpler functional profile Searching for uncontrolled/independent comparable transactions or enterprises Identification of comparable transactions or enterprises -identify and compare specific characteristics of the controlled transaction, or enterprise, and the uncontrolled transaction or enterprise Establishing comparability by identifying the differences between the potential comparables, and making adjustment for material differences Choosing the Most Appropriate Method out of five specified methods: CUP, RPM, CPM, PSM and TNMM Determine the ALP by applying the MAM 12 OVERVIEW OF TRANSFER PRICING By Nilesh Patel: Ex-IRS Officer, CPA(USA)

13 13 Relevant Penalty Provisions: Sec. 271 (1) (c): Concealment of income or furnishing inaccurate particulars of income Sec. 271 AA: Failure to keep and maintain information required by Sec. 92 D (1) and (2) - penalty equal to 2% of value of each international transaction Sec. 271 BA: Failure to furnish report under section 92 E; penalty of Rs. 1 lakh Sec. 271 G: Failure to furnish information or documents u/s 92D (3) - the AO or CIT (A) may levy penalty equal to 2% of the value of international transaction for each failure Sec. 272A (1): Omission to attend or produce books of accounts or documents u/s 131(1) - penalty of Rs. 10,000 for each such default Sec. 272A (2): Failure to furnish in due time any particulars u/s 133; penalty of Rs. 100 for every day during which the default continues. IV. MECHANISM FOR RESOLUTION OF DISPUTES Appeal: Appeal can be filed before CIT(Appeals) against the assessment order (passed by the AO after incorporating the adverse order of TPO) The adverse order of CIT(Appeals) can be appealed against before ITAT Dispute Resolution Panel: Section 144C inserted w.e.f provides for reference to Dispute Resolution Panel (DRP) comprising of three Commissioners/Directors of Income Tax In transfer pricing cases, the AO shall forward draft of the proposed assessment order to the assessee On receipt of the draft order, the eligible assessee shall, within thirty days of the receipt by him of the draft order: (a) file his acceptance of the variations to the Assessing Officer; or (b) file his objections, if any, to such variation with, (i) (ii) the Dispute Resolution Panel; and the Assessing Officer On receiving objections of the assessee, the DRP may confirm, reduce or enhance the adjustments variations proposed in the draft order, and issue such directions (within 9 months), as it thinks fit, for the guidance of the Assessing Officer to enable him to complete the assessment Appeal can be filed to ITAT against the directions of DRP 13 OVERVIEW OF TRANSFER PRICING By Nilesh Patel: Ex-IRS Officer, CPA(USA)

14 14 If the assessee intimates the AO of acceptance of adjustment or does not file any objection within thirty days, the AO will complete the assessment on basis of the draft order in such case the assessee can file appeal before CIT(Appeals) Mutual Agreement Procedure (MAP): MAP is a dispute resolution mechanism under the Double Taxation Avoidance Agreements (DTAAs) entered into by India with various countries it flows from Article 25 of the OECD Model Convention ( which is like a Model DTAA) If tax authorities of one country make an upward adjustment to the transfer price of an AE, then there should be a corresponding downward adjustment in the case of the other AE in the other country- otherwise there will be double taxation MAP is used where a taxpayer group faces the risk of double taxation Competent authorities of two concerned countries enter into negotiations the Competent Authority for India is Joint Secretary, Foreign Tax Division, CBDT MAP is not mandatory- competent authorities of the two countries may or may not come to an agreement MAP may continue simultaneously along with Appeal proceedings Advance Pricing Agreement (APA): APA is a binding agreement between a taxpayer and the Government for determination of ALP of specified transactions APA is entered into between a taxpayer and the Government, before the international transaction is undertaken by the taxpayer, and is valid for the next 3 to 5 years APA provides a non-adversarial resolution of transfer pricing disputes Complex transfer pricing issues can be resolved in a spirit of co-operation between the taxpayer and the Government in advance Authority of Advance Rulings (AAR) does not admit issues which involve determination of ALP (please see comments on the next page) and MAP is not mandatory. Hence, APA regime is desirable. APA regime can provide certainty in Transfer Pricing APA regime has been successful in countries which have adopted it Taxpayer can fine tune the transfer pricing method and analysis during negotiations with Government. No detailed documentation required for years (up to 5 years) covered by the APA- only annual report to show that terms and conditions of APA have been complied with. Unilateral, Bilateral and Multilateral APAs: Unilateral APA binds only the country of the taxpayer s residence, Bilateral APAs bind the two countries of the two AEs 14 OVERVIEW OF TRANSFER PRICING By Nilesh Patel: Ex-IRS Officer, CPA(USA)

15 15 (which enter into an international transaction), and Multilateral APAs bind more than two countries where various AEs are located DTC, 2010 provides for unilateral APAs- section 118 of DTC, It can be time consuming and costly because negotiations will happen in CBDT Safe Harbour Rules CBDT is empowered to formulate safe harbor rules under Section 92CB inserted w.e.f However, so far no such rules have been formulated by the CBDT Advance Ruling from AAR not available on Transfer Pricing issues Authority of Advance Rulings (AAR) does not admit issues which involve determination of fair market value of any property [Clause (ii) of Proviso to Section 245R (2)] In case of Instrumentation Corporation, In Re (AAR) [2005] 272 ITR 499, the AAR declined to entertain the question requiring determination of ALP in a case where loan was given without charging interest. Likewise, in case of Morgan Stanley & Co. 284 ITR 260, the AAR declined to rule on an appropriate method for determination of ALP on the ground that the ruling will involve determination of fair market value of the property, which is outside the purview of the Authority V. ADMINISTRATIVE SETUP 15 OVERVIEW OF TRANSFER PRICING By Nilesh Patel: Ex-IRS Officer, CPA(USA)

16 16 VI. COMPARISON BETWEEN INDIAN AND OECD TP REGULATIONS A broad comparison between Indian TPR and OECD Guidelines is given as under: Concept Indian Regulations OECD Guidelines Associated Enterprises Very broad Restricted to controlled entities Comparable range Multiple year data Allows a specified % range on average results of comparables Only allows data for current year and earlier 2 years under limited circumstances Allows for range of comparable data Permitted Foreign comparables Restricted in practice Permitted Priority of methods Most appropriate method rule Preference for traditional transaction methods Use of unspecified Not specified Permitted method Documentation Stringent Prudent business management principles Intra-group services No specified guidelines Exhaustive guidelines Cost sharing rules Not specified Addressed as cost contribution arrangements Intangibles Self adjustment Penalty for substantial/gross valuation mis-statements Negotiated settlement mechanism Advance pricing agreement Absence of definition and guidelines Permitted but no formal guidelines Not specified. However penal provision u/s 271(1)(c) is applicable. Not available Not available now. DTC proposes unilateral APA. Clearly defined and described Recommended No penalty for reasonable efforts and good faith Recommended Recommended It may be pointed out that in the following cases, the OECD Transfer Pricing Guidelines have been referred to and relied upon to resolve the transfer pricing disputes: a. Aztec Software & Technology Services Limited, 107 ITD 141 (Special Bench of ITAT, Bangalore) b. Mentor Graphics (Noida) Private Limited, 109 ITD 101 (ITAT, Delhi) c. E-Gain Communication Private Limited, 118 ITD 243 (ITAT, Pune) 16 OVERVIEW OF TRANSFER PRICING By Nilesh Patel: Ex-IRS Officer, CPA(USA)

17 17 d. Schefenacker Motherson Ltd., 123 TTJ 509 (ITAT, Delhi) e. Philips Software, 26 SOT 226, (ITAT, Bangalore) f. MSS India, 32 SOT 132 (ITAT, Pune) VII. ASSOCIATED ENTERPRISE The term associated enterprise is defined in section 92A of the Act. According to sub-section (1), an enterprise which participates directly or indirectly or through one or more intermediaries, in the management or control or capital of the other enterprise shall be regarded as an associated enterprise. This can be understood as follows: Situation 1 - Direct Participation: Situation 2 - Participation through Intermediary: In both the situations depicted above, A and B will be associated enterprises. Similarly, an enterprise in respect of which one or more persons, who participate in its management or control or capital, directly or indirectly, or through one or more intermediaries, are the same persons who participate in a similar manner in the management or control or capital of the other enterprise shall be regarded as an associated enterprise. This proposition can be understood by the following diagrammatic depiction: 17 OVERVIEW OF TRANSFER PRICING By Nilesh Patel: Ex-IRS Officer, CPA(USA)

18 18 In the above situation, C and D are associated enterprises by virtue of participation of A in the management or capital or control of both C and D. In the following example, A and B, jointly and simultaneously, participate in the management, capital and control of both C and D. Consequently, C and D will be construed as associated enterprises. The Finance Act, 2002 has amended sub-section (2) of section 92A to the effect that for the purposes of sub-section (1), two enterprises shall be deemed to be associated enterprises if, at any time during the previous year any of the conditions mentioned in clauses (a) to (m) are satisfied. 18 OVERVIEW OF TRANSFER PRICING By Nilesh Patel: Ex-IRS Officer, CPA(USA)

19 19 The provisions of sub-section (2) of section 92A supplements the definition of associated enterprise given in sub-section (1) by enlisting various situations under which two enterprises shall be deemed to be associated enterprises. Each of these situations specified in clauses (a) to (m) of sub-section (2) of section 92A will be discussed below with appropriate illustration. It may be noted that for the purposes of these clauses, two enterprises would be associated enterprises if the conditions stipulated therein are fulfilled at any time during the previous year. However, transactions entered into by an enterprise before becoming an AE and after ceasing to be an AE would not be covered. In other words, the relationship of AE must subsist at the time of entering into an international transaction. In clauses (c) to (m) the words directly or indirectly have not been used which indicates the intention of the legislature that indirect control is not envisaged in these clauses. Therefore, direct relationship between two enterprises is relevant for the purposes of clauses (c) to (m) in order to determine whether they are associated enterprises. The various criteria laid down in clauses (a) to (m) of section 92A(2) are explained below One enterprise holds, directly or indirectly, shares carrying not less than twenty-six per cent of the voting power in the other enterprise [Section 92A(2)(a)] Two enterprises shall be associated enterprises based on the shareholding of one enterprise in the other if the investing enterprise holds shares carrying not less than twenty-six per cent of the voting power in the other enterprise. Holding for this purpose includes indirect holding too. (A, I and B are associated enterprises) 19 OVERVIEW OF TRANSFER PRICING By Nilesh Patel: Ex-IRS Officer, CPA(USA)

20 20 As the terms used in section 92A (2)(a) are shares and voting power, it is apparent that this clause applies only to those cases where the investee enterprise is a company. This is further supported by the fact that clause (j) refers to individuals, clause (k) to Hindu undivided families and clause (l) to firms, association of persons and body of individuals. Any person or enterprise holds, directly or indirectly, shares carrying not less than twenty-six per cent of the voting power in each of such enterprises [Section 92A(2)(b)] Under this clause, two enterprises are deemed associated enterprises, even though one enterprise may not hold any shares in the other enterprise. This clause comes into play when one person or enterprise simultaneously holds shares carrying not less than twenty-six per cent voting power in each such enterprise. For example, if A of USA holds 26% voting power in B Ltd. of Germany and also in C Ltd. of India, then B Ltd. and C Ltd. shall be deemed to be associated enterprises. For this clause too, shareholding may be direct or indirect holding. A loan advanced by one enterprise to the other enterprise constitutes not less than fifty-one per cent of the book value of the total assets of the other enterprise [Section 92A(2)(c)] Where the lender enterprise s loans to the borrower enterprise constitute more than 51% of the book value of the total assets of the borrowing enterprise, then both the lender and the borrower enterprises would be treated as associated enterprises One enterprise guarantees not less than ten per cent of the total borrowings of the other enterprise [Section 92A(2)(d)] Where the guarantor enterprise guarantees 10% or more of the total borrowing of the enterprise seeking guarantee, then they would become associated enterprises More than half of the board of directors or members of the governing board, or one or more executive directors or executive members of the governing board of one enterprise, are appointed by the other enterprise [Section 92A(2)(e)] 20 OVERVIEW OF TRANSFER PRICING By Nilesh Patel: Ex-IRS Officer, CPA(USA)

21 21 Where one enterprise has appointed (a) more than one-half of the board of directors or members of the governing board; or (b) one or more executive directors or executive members of that board in another enterprise the two enterprises shall be deemed to be associated enterprises This clause refers to board of directors and governing board. As per section 2(6) of the Companies Act, 1956, the term board of directors would refer to the board of directors of a company The term governing board, correspondingly, would refer to a body or council that has the executive authority to manage the affairs of the enterprise to which it relates The enterprises referred to in this clause could be artificial juridical non-corporate bodies. For the purposes of this clause, the appointment of even one person to the post of executive director or executive member would make the enterprises associated enterprises More than half of the directors or members of the governing board, or one or more executive directors or executive members of the governing board of each of the two enterprises are appointed by the same person or persons [Section 92A(2)(f)] Clause (f) is an extension of the principle laid down in clause (e). This clause is applicable where the same person has (a) appointed more than one-half of the board of directors or members of the governing board; or (b) appointed one or more executive directors or executive members of the governing board of two or more enterprises For example, the appointment of seven out of twelve members of board of directors of B Ltd. and six out of ten members of the board of directors of C Ltd. is controlled and has been made by A Ltd. By virtue of clause (f), B Ltd. and C Ltd. are associated enterprises Further, if the appointment of the executive director of B Ltd. and six out of ten members of the board of directors of C Ltd. has been made by A Ltd., then B Ltd. and C Ltd. shall be regarded as associated enterprises The manufacture or processing of goods or articles or business carried out by one enterprise is wholly dependent on the use of know-how, patents, copyrights, trade-marks, licences, franchises or any other business or commercial rights of similar nature, or any data, documentation, drawing or specification relating to any patent, invention, model, design, secret formula or process, of which the other enterprise is the owner or in respect of which the other enterprise has exclusive rights [Section 92A(2)(g)] Two enterprises are deemed to be associated, if one is wholly dependent on the other for the use of know-how, patents, copyrights etc. for the manufacture or processing of goods or articles or business carried on by such enterprise 21 OVERVIEW OF TRANSFER PRICING By Nilesh Patel: Ex-IRS Officer, CPA(USA)

22 22 Such know-how, patents, copyrights etc. must be either owned by the other enterprise or the exclusive rights thereto must vest with the other enterprise If an Indian enterprise is wholly dependent on the licence granted by a nonresident enterprise for manufacture or processing of goods or articles or business carried out by the Indian enterprise both enterprises shall be deemed to be associated enterprises Ninety per cent or more of the raw materials and consumables required for the manufacture or processing of goods or articles carried out by one enterprise, are supplied by the other enterprise or by persons specified by the other enterprise, and the prices and other conditions relating to the supply are influenced by such other enterprise [Section 92A(2)(h)] A and B are AEs There are two situations dealt with in this clause and they are as follows: (i) 90% or more of the raw materials and consumables required for manufacturing or processing of goods or articles are supplied by the other enterprise, or (ii) 90% or more of the raw materials and consumables required for manufacturing or processing of goods or articles are supplied by persons specified by the other enterprise, and the prices and other conditions relating to supply (by the specified person) are influenced by the other enterprise. Since this clause relates to manufacture or processing of goods, it is important to note that the 90% criteria should be applied exclusively to raw materials and consumables used for manufacturing and processing only. The goods or articles manufactured or processed by one enterprise, are sold to the other enterprise or to persons specified by the other enterprise, and the 22 OVERVIEW OF TRANSFER PRICING By Nilesh Patel: Ex-IRS Officer, CPA(USA)

23 23 prices and other conditions relating thereto are influenced by such other enterprise [Section 92A(2)(i)] Where the goods or articles manufactured and processed by one enterprise, (say, enterprise A) are sold (i) to another enterprise (say, enterprise B), or (ii) sold to another enterprise (say, enterprise C) specified by enterprise B, and the prices and other conditions relating thereto are influenced by enterprise B, then enterprises A and B shall be associated enterprises. A and B are AEs While in clause (h), a minimum criterion of 90% has been mentioned, no such quantification has been done in clause (i). This clause covers only sale of goods manufactured or processed and not the sale of traded goods. Where one enterprise is controlled by an individual, the other enterprise is also controlled by such individual or his relative or jointly by such individual and relative of such individual [Section 92A(2)(j)] This clause deals with a situation where one enterprise is controlled by an individual and the other enterprise is also controlled by (i) such individuals; or (ii) his relative; or (iii) jointly by such individual and his relative, then both the enterprises shall be deemed as associated enterprises. 23 OVERVIEW OF TRANSFER PRICING By Nilesh Patel: Ex-IRS Officer, CPA(USA)

24 24 The word control can be interpreted to mean that the individual along with his relatives has the power to make crucial decisions regarding the management and running of the two enterprises. The term relative is defined under section 2(41) of the Act as follows: relative, in relation to an individual, means the husband, wife, brother or sister or any lineal ascendant or descendant of that individual Where one enterprise is controlled by a Hindu undivided family, the other enterprise is controlled by a member of such Hindu undivided family, or by a relative of a member of such Hindu undivided family, or jointly by such member and his relative [Section 92A(2)(k)] This clause envisages control of the two enterprises by the same Hindu Undivided Family and includes control by - (i) a member of the Hindu undivided family, or (ii) by a relative of a member of such Hindu undivided family, or (iii) jointly by such member and his relatives. 24 OVERVIEW OF TRANSFER PRICING By Nilesh Patel: Ex-IRS Officer, CPA(USA)

25 25 Where one enterprise is a firm, association of persons or body of individuals, the other enterprise holds not less than ten per cent interest in such firm, association or body of individuals [Section 92A(2)(l)] This clause seeks to cover non-corporate bodies like partnership firms, association of persons and body of individuals. Sub-clause (v) of clause (31) of section 2 of the Act defines the term person to include these entities. In case of partnership firm or association of persons or body of individuals, the other enterprise must hold not less than 10% interest in such firm, association of persons or body of individuals to be regarded as an associated enterprise. There exists between the two enterprises, any relationship of mutual interest, as may be prescribed [Section 92A(2)(m)] This residuary clause enables the CBDT to widen the scope by adding any relationship of mutual interest from time to time that will make any two enterprises as associated enterprises. However, no such relationship of mutual interest has yet been prescribed. It may be mentioned that the term enterprise is defined under clause (iii) of section 92F of the Act. Under that provision, enterprise means a person (including a permanent establishment of such person) who is, or has been, or is proposed to be, engaged in any activity, relating to the production, storage, supply, distribution, acquisition or control of articles or goods, or know-how, patents, copyrights, trade-marks, licences, franchises or any other business or commercial rights of similar nature, or any data, documentation, drawing or specification relating to any patent, invention, model, design, secret formula or process, of which the other enterprise is the owner or in respect of which the other enterprise has exclusive rights, or the provisions of services of any kind, or in carrying out any work in pursuance of a contract, or in investment, or providing loan or in the business of acquiring, holding, underwriting or dealing with shares, debentures or other securities of any other body corporate, whether such activity or business is carried on, directly or through one or more of its units or divisions or subsidiaries, or whether such unit or division or subsidiary is located at the same place where the enterprises is located or at a different place or places. While the term is defined to mean a person engaged in the past, present or in the future in any activity relating to tangibles, intangibles, facilities or services with widest possible modes, forms or pattern of operation, it also includes a permanent establishment of such person. AE under DTAA : Where two enterprises become AEs by virtue of criteria u/s 92A, an interesting issue is under debate as to whether, by relying on Article 9 of 25 OVERVIEW OF TRANSFER PRICING By Nilesh Patel: Ex-IRS Officer, CPA(USA)

26 26 the relevant DTAA dealing with AE (similar to Article 9 of OECD Model Convention), it is possible to argue that such enterprises may not be treated as AEs if, by application of Article 9 of the relevant DTAA, they do not become AEs The concept of AE under the I. T. Act, 1961 is wider than the definition of related party relationship as contemplated under Accounting Standard 18 (AS 18) VIII. INTERNATIONAL TRANSACTION AND DEEMED INTERNATIONAL TRANSACTION Definition: Before proceeding to analyse the expression international transaction, it would be useful to take note of the definition of the term transaction. The term transaction has been defined in clause (v) of section 92F as under:- (v) transaction includes an arrangement, understanding or action in concert: (i) whether or not such arrangement, understanding or action is formal or in writing; or (ii) whether or not such arrangement, understanding or action is intended to be enforceable by legal proceedings This definition is an inclusive definition and therefore wider in its scope. As per this definition, a transaction includes any arrangement, understanding or action, whether formal or informal, whether oral or in writing, whether legally enforceable or not. Section 92B defines an international transaction in the following manner: For the purposes of this section and sections 92, 92C, 92D and 92E, international transaction means a transaction between two or more associated enterprises, either or both of whom are non-residents, in the nature of purchase, sale or lease of tangible or intangible property, or provision of services, or lending or borrowing money or any other transaction having a bearing on the profits, income, losses or assets of such enterprises and shall include a mutual agreement or arrangement between two or more associated enterprises for the allocation or apportionment of, or any contribution to, any cost or expense incurred or to be incurred in connection with a benefit, service, facility provided or to be provided to any one or more such enterprises - [ Section 92B(1)] A transaction entered into by an enterprise with a person other than an associated enterprise shall, for the purposes of subsection (1), be deemed to be a transaction entered into between two associated enterprises, if there exists a prior arrangement in relation to the relevant transaction between such other person and the associated enterprise; or the terms of the relevant transaction are determined in substance between such other person and the associated enterprise [Section 92B(2)] 26 OVERVIEW OF TRANSFER PRICING By Nilesh Patel: Ex-IRS Officer, CPA(USA)

27 27 From the above, it can be seen that sub-section (1) of section 92B defines the term international transaction in an exhaustive manner; and sub-section (2) of section 92B deems a transaction entered into between two enterprises in certain situations, as an international transaction between associated enterprises. The definition of international transaction under the transfer pricing regulations is very wide and in its scope it includes transaction in the nature of : (i) purchase, sale, or lease of tangible or intangible property; or (ii) provision of services; or (iii) lending or borrowing of money; or (iv) any other transaction having a bearing on the profits, income, losses or assets of such enterprises It shall also include a mutual agreement or arrangement between two or more associated enterprises for the allocation or apportionment of, or any contribution to, any cost or expense incurred or to be incurred in connection with a benefit, service, facility provided or to be provided to any one or more such enterprises. A continuing debit balance is not itself an international transaction (as defined under section 92B of the Income-tax Act, 1961) but is the result of international transactions - Patni Computer System v. DCIT [ITA No 426 & 1131/PN/06 (Assessment Year and )] and Nimbus Communications Limited v. ACIT [2010-TII-21-ITAT-MUM-TP] Any transaction between an enterprise and a person other than an associated enterprise will be deemed to be a transaction with an associated enterprise as per sub-section (2) of section 92B under certain situations. This deeming provision is intended to cover cases where an independent third party can be interposed by two associated enterprises to remain out of the transfer pricing provisions of the Act. According to sub-section (2) of section 92B, a transaction between an enterprise and an unrelated person shall be deemed to be a transaction between associated enterprises if in relation to that transaction - (i) there exists a prior agreement between such other person and the associated enterprise; or (ii) the terms of the relevant transaction are determined in substance between such unrelated person and the associated enterprise. For example, enterprise A of India and enterprise B of UK are associated enterprises. Enterprise C of Singapore is not an associated enterprise of enterprise A. Enterprise B and enterprise C enter into an agreement for determining the terms of transactions between enterprise A and enterprise C. The transaction which may be entered into by enterprise A and enterprise C, which is governed by such an agreement existing between B and C, shall be deemed to be a transaction between two associated enterprises. 27 OVERVIEW OF TRANSFER PRICING By Nilesh Patel: Ex-IRS Officer, CPA(USA)

28 28 The concept of deemed international transaction is illustrated below: Tangible and intangible property: 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. Commercial intangibles include patents, know-how, designs and models that are used for the production of goods or for the provision of services, as well as intangible rights that are themselves business assets transferred to customers or used in the operation of business (e.g. computer software). Marketing intangibles are a special type of commercial intangibles. Trademarks and trade names that aid in the commercial exploitation of a product or service, customer lists, distribution channels, and unique names, symbols, or pictures that have an important promotional value for the product concerned. Services, finances and costs etc.: Provision of services refers to trade related services like intellectual property rights and trade related investments. According to the OECD guidelines, there are two main issues while analysing intra-group services: (i) whether an intra-group service that should be charged for has been provided; and (ii) what the charge should be in accordance with the arm s length principle The basis to decide whether a service has been provided is set out in the guidelines as whether an independent enterprise in comparable circumstances would have been willing to pay for the activity if performed for it by an independent enterprise or would have performed the activity in-house for itself. If the activity is not one for which the independent enterprise would have been 28 OVERVIEW OF TRANSFER PRICING By Nilesh Patel: Ex-IRS Officer, CPA(USA)

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