Specified Domestic Transactions Coverage and Analysis S P Singh August 2012
Introduction The Finance Act 2012, extends the scope of Transfer Pricing provision to Specified Domestic Transactions ( SDT ) Transfer Pricing was earlier limited to International Transactions Genesis lie with Supreme Court s suggestion in Glaxo Smithkline Asia case, since certain provisions of the Act refer to FMV, which is not as well defined as determining ALP The Specified Domestic Transactions include the following: Expenditure for which payment is made or to be made to domestic related parties-40a 2(b) payment Tax Holiday/ Deductions claimed by the taxpayer u/s 80A(6)/80IA(8) or 80IA(10), where; Transfer of goods or services between various businesses of same taxpayer More than ordinary profits derived from transactions with closely connected persons; and No impact on the basic provisions of the above sections 2 Transfer Pricing provisions to apply if the aggregate value exceeds Five Crores
Specified Domestic Transactions what it includes? Clauses any expenditure in respect of which payment has been made or is to be made to a person referred to in clause (b) of sub-section (2) of section 40A any transaction referred to in section 80A any transfer of goods or services referred to in sub-section (8) of section 80-IA any business transacted between the assessee and other person as referred to in sub-section (10) of section 80-IA any transaction, referred to in any other section under Chapter VI-A or section 10AA (Taxpayers operating in Special Economic Zones), to which provisions of sub-section (8) or sub-section (10) of section 80-IA are applicable Explanation Payment made or to be made for expenditure incurred with domestic related parties Expenditure/ payments only covered Any transfer of goods / services between various undertakings or units of the assessee More than ordinary profits derived from closely connected persons for claiming deduction to be brought down to reasonable profits Covers both the above provisions on: Inter-undertaking transfer and more than ordinary profits earned by tax holiday / exempt unit any other transaction as may be prescribed to be prescribed by CBDT Excludes transactions which qualify as International Transactions 3
Expenditure under 40A2(b) Expenditure by Company Payment made to Director or any relative of the Director of the Company To an individual, company, firm, AOP or HUF having substantial interest in the business or profession of the Company To an individual, director, partner, member or family or to any of the relative of such director, partner or member of the Company, Firm, AOP or HUF having substantial interest in the business or profession of the Company Type of expenses Purchase of goods; and Services (e.g. Professional services, Salary, Bonus, ESOPs) or facilities (e.g. rent) Purchase of goods; and Services (e.g. Professional services) or facilities (e.g. rent) Purchase of goods; and Services (e.g. Professional services) or facilities (e.g. rent) Payment to any company, firm, AOP or HUF of which a director has a substantial interest in the business or profession of the company Payment to company having substantial interest or to any other company carrying on business or profession in which the first mentioned company has substantial interest (common shareholding, sister concerns, etc.) Purchase of goods; and Services (e.g. Professional services) or facilities (e.g. rent) Purchase of goods; Services (e.g. professional services, management cross charge) and facilities (e.g. rent) Section 40A(2) covers relationships based on Substantial Interest 4
Illustration Expenditure u/s 40A Transactions covered? A 20% 20% A & B A & C Yes Yes B C A & D A & E No No 20% 20% D E B & C Yes* D & E No * Post Budget 2012 amendment under section 40A Requirement to justify that expenditure not excessive or unreasonable and meets the arm s length criteria 5
Transactions covered u/s 80A Section 80A applies to deductions to be made in computing total income under Chapter VI-A. 80A(6) has been amended by Finance Act 2012 to provide that in case of SDT, the market value shall be computed at Arm s Length Price The provisions apply only to inter-unit transfer of goods and services, where one unit being the eligible unit. It does not cover transactions of eligible unit with third parties. The provisions envisage the determination of profits and gains of the eligible unit for calculation of deduction, and may not have an impact on the Gross Taxable Income of the taxpayer. 6 No deduction under chapter VI-A, where Arm s Length Price determined by the TPO is different from the market value
Transactions covered u/s 80-IA(8) Where any goods or services of the eligible business are transferred to any other business carried on by the assessee, or vice versa, and the consideration for such transfer is not at market value, then the profits and gains of eligible business shall be computed at the market value New explanation - For the purposes of this sub-section, market value, in relation to any goods or services, means (i) the price that such goods or services would ordinarily fetch in the open market; or (ii) the arm's length price as defined in clause (ii) of section 92F, where the transfer of such goods or services is a specified domestic transaction referred to in section 92BA. Similar (overlap) to section 80A the provisions apply only to inter-unit transfer of goods and services, where one unit being the eligible unit. 7 No deduction under chapter VI-A, where Arm s Length Price determined by the TPO is different from the market value
Transactions covered u/s 80-IA(10) Where it appears to the Assessing Officer that, owing to the close connection between the assessee carrying on the eligible business and any other person, the course of business between them is so arranged that the business transacted between them produces to the assessee more than the ordinary profits, the Assessing Officer shall, take the amount of profits as may be reasonably deemed to have been derived therefrom. New insert - Provided that in case the aforesaid arrangement involves a specified domestic transaction, the amount of profits from such transaction shall be determined having regard to arm's length price. Section 80-IA(10) refers to the course of business, which may have a wider meaning than business or a transactions, and may intend including the circumstances surrounding the transactions. The ALP analyses the transaction more holistically and best represents such situations. 8 Close connection not defined, will pose a challenge at the time of filing Form 3CEB
Illustration Tax holiday undertakings Transactions covered? A D B & C C & D Yes No B Tax holiday undertaking C DTA undertaking B & D Yes, if D is closely connected to A At-least one transacting unit has to be an eligible unit under chapter VI-A or section 10AA 9
Other sections to which s 80-IA(8) & 80-IA(10) apply The provisions include any transaction, referred to in any other section under Chapter VI-A or section 10AA (Taxpayers operating in Special Economic Zones), to which provisions of sub-section (8) or sub-section (10) of section 80- IA are applicable The other sections under chapter VI-A, include: 80-IAB Undertakings engaged in SEZ development 80-IB Industrial undertakings 80-IC Industrial undertakings or enterprises in special category states 80-ID Undertakings engaged in Hotels and convention centers in specified area 80-IE Undertakings in North-Eastern states Sub-section (7) of section 35AD provides that the provisions contained in sub-section (6) of section 80A and the provisions of subsections (7) and (10) of section 80-IA shall, so far as may be, apply to this section in respect of goods or services or assets held for the purposes of the specified business. However, section 35AD does not fall within chapter VI-A, hence the above provisions does not apply 10
SDT Different Facets SDT provisions not restricted to domestic parties, may apply to non-residents: Payments to non-resident directors SDT provisions inadvertently increases the scope of Transfer Pricing for international transactions: Payments made to a foreign party having substantial interest (20% interest in shareholding/ profits), which earlier was not covered due to 26% threshold, would now be covered, though within the SDT provisions Notional Income The provisions of section 92B would give rise to determining of ALP for notional transactions (provision of guarantee where no fee charged) The provisions of SDT contained in section 92BA does not expand the coverage of section 40A(2)(b) to include notional income. Similarly, the AO cannot increase the ordinary profits of eligible units under chapter VI-A Corresponding Adjustments The provisions of section 92C(4) equally apply to SDT, and prohibit consequential adjustments in the hands of the other party. 11
SDT Different Facets contd. Chapter VI-A/ Sec 10AA deductions Where the TPO determines that the payments made u/s 40A(2)(b) to a related party by a chapter VI-A unit is excessive, and increases the income of the chapter VI-A unit, whether an enhanced deduction is allowed to the chapter VI-A unit. The answer may be No, due to the provisions of sec 92C(4), which prohibits deduction, due to adjustments made in the total income. Transactions between two eligible units Where the TPO makes an adjustment to any payments made by one eligible unit to another, due to which the eligible income of one unit is reduced, no corresponding increase in deduction under chapter VI-A/ sec 10AA will be allowed to the other unit due to the provisions of sec 92C(4). Though, there will not be any difference to the gross total income of the enterprise. APA coverage APA coverage is not available to the transactions covered under SDT. Capital Expenditure Payments made to a related party in the nature of capital expenditure, may be covered under SDT provisions, as depreciation will have an impact on the taxable income of the taxpayer. 12
Impact Analysis Particulars Compliance Requirement Expenses Companies enjoying tax holiday Assessment Penalty Impact The taxpayers will now have to maintain the mandatory transfer pricing documentation for specified domestic related party transactions by specified timeline. Taxpayers will have to file Form 3CEB along with their tax return Expenses paid by domestic parties to related parties will be questioned in audit cases Need for benchmarking burden on taxpayer Corresponding adjustment not permitted for disallowed expenses which will lead to double taxation Owing to close connection, companies declaring More than ordinary Profits for tax holiday units will lose excessive income-tax benefits Inter undertaking transfers would be covered Close connection not defined Assessment of specified domestic transaction would be done by TPOs and not AOs. Stringent Penalty - For failure to report a transaction in accountants report a penalty of 2% of the value of transaction 13
Old vs. Proposed Fair Market Value Arm s Length Price The price which goods or services would have fetched or cost in the open market No method prescribed for computing fair market value No documentation required to be maintained Other than reporting in tax audit report, no statutory compliance Assessment done by the Assessing Officer A price which is applied in a transaction in uncontrolled conditions Most appropriate method out of the five methods Contemporaneous documentation required to be maintained Accountant s report signed by a Chartered Accountant to be filed Assessment done by the Transfer Pricing Officer 14
What documentation would be required? Entity Related Price Related Transaction Related Profile of Industry Profile of group Profile of related parties Transaction terms Functional Analysis (functions, assets and risks) Economic Analysis (method selection, comparable benchmarking) Forecasts, budgets, estimates Agreements Invoices Pricing related correspondence (letters, e-mails, fax, etc.) 15
Conclusion Now the Transfer pricing will not be limited to just the large groups any more. Many mid-sized groups, partnership firms, Hindu Undivided Families ( HUFs ) and even individuals in smaller cities will now have to adhere to the TP rules. This amendment will largely increase the compliance burden for taxpayers having substantial domestic related party transactions. 16
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