The expression “transfer pricing” generally refers to prices of transactions between two enterprises for supply of goods or services. Transfer prices between related/ associated enterprises are generally more controlled than being determined by market forces. When such associated enterprises belong to different countries, the tax revenues of the countries are impacted due to transfer prices.
Suppose a company A purchases goods for € 100 and sells it to its associated company B in another country for € 200, who in turn sells in the open market for € 400. If A had sold it directly in the latter country, it would have made a profit of € 300. But by routing it through B, it restricted the profit to € 100, permitting B to appropriate the balance. The transaction between A and B is arranged and not governed by market forces. The profit of € 200 is, thereby, shifted to the country of B. The goods is transferred on a price (transfer price) which is arbitrary or dictated (€ 200), but not on the market price (€ 400).
To protect interests of the revenue, the Indian Income Tax Act, 1961 (“the Act”) has vide its chapter X framed certain provisions. The basic principle enunciated through such provisions is to consider “arm’s length price” for international transactions.
“International transaction” is a transaction between two or more associated enterprises, either or both of whom are non-residents in the following nature:
- Sale or purchase of goods or services, or
- Lending or borrowing of money, or
- Arrangement for allocation of cost, or
- Any other transaction having a bearing on income or assets of the enterprise
“Associated enterprises” are those, where one enterprise participates directly or indirectly in the management or control or capital of another, or are under common control of a third party
Arm’s length price:
The Act states that arm’s length price shall be determined by any of the methods, being the most appropriate method:
- comparable uncontrolled price method – wherein price charged for goods or services in a comparable uncontrolled transactions is taken as the basis and adjusted for functional differences between the transaction in consideration and the comparable reference transaction.
- resale price method – Where goods or services are first transacted between two associated enterprises, and then they are subject to resale with a third unrelated enterprise, the resale price adjusted for normal profits for the enterprise selling, is considered to be the arm’s length price
- cost plus method – the direct and indirect costs of production are increased by normal gross profits. Normal gross profits are to be referred to from a comparable uncontrolled transaction and adjusted for functional differences.
- profit split method – where there are transfers of unique intangibles or there are multiple international transactions which are interrelated and cannot be separately evaluated for determining arm’s length price, the combined net profit arising out of international transactions to all associated enterprises are split between each enterprise based on relative contributions made by each enterprise in terms of risks assumed, resources deployed etc.,
- transactional net margin method – the net profit margin in a comparable uncontrolled transaction is taken as a reference to arrive at the arm’s length price
- such other method as may be prescribed by the Central Board of Direct Taxes
Most appropriate method – the Board has prescribed various factors to be taken into account while determining the most appropriate method
The Income Tax Act empowers the Income Tax Assessing officer to make a reference to the Transfer Pricing Officer (TP Officer), who shall assess the arm’s length price for international transactions entered into by an enterprise. Generally such references are made where the value of international transaction exceeds Rs.2 crores per annum (235k €). If the TP Officer is not satisfied that the price considered is arm’s length price, he is empowered to make an order determining the arm’s length price.
Documents and records to be maintained for International Transactions if exceeds Rs. 1 Crore:
Where value of international transaction exceeds Rs.1crore per annum (118k €), the rules have prescribed information and documents to be kept and maintained, such as:
- Ownership structure of the enterprise and detailed profile of all enterprises belonging to the multinational group to which the enterprise belongs to, and nature of ownership linkages between them
- Broad description of business of the enterprise and the business of associated enterprise with which there are international transactions
- Nature and terms of international transactions, and description of functions performed, risks assumed by each of the enterprise involved
- Record of economic and market analysis for the division or product and having bearing on international transactions
- Record of uncontrolled transactions taken for reference in arriving at the arm’s length price and related workings and basis for adjustments therein
- Description of methods considered in determining arm’s length price and justification for the most appropriate method considered
Safe harbours as an alternative:
The Government has recently notified safe harbour rules, wherein the transfer price declared by taxpayers shall be accepted (means no disputes would be raised) by the tax authorities provided that the margins are:
- Atleast 20% in case of provision of software development services and IT enabled services
- Atleast 30% in case of provision of contract research and development services.
Definitions of services are in the annexure for reference.
Margin would mean the profits over all operating expenses (including depreciation and amortisation)
Taking the route of safe harbours would mean more funds (in excess of operating expenses) will be available in the Indian company because of such margins. Therefore this route is not advisable where companies don’t intend to build funds in India.
Consequences of non-compliance with transfer pricing provisions:
- Penalty for failure to keep and maintain documents and records prescribed for international transactions – 2% of value of international transactions
- Penalty for failure to furnish information or document required to be maintained for international transactions, when required by the Income tax assessing officer – 2% of value of international transactions for each such failure
- In case the Income Tax authorities are not able to recover any dues from the Company, every person who was a director at any time during relevant year for income tax, will be jointly and severally liable for payment of such dues, unless he proves that the non-recovery cannot be attributed to any gross neglect, misfeasance or breach of duty on his part in relation to the affairs of the company