ANNEXURE B

 

TRANSFER PRICING:

 

Harmonization of Regulatory controls in India under the Customs and Income Tax laws

 

 

A.         Introduction:

 

            Transfer pricing is the mechanism adopted by multinational Enterprises for valuing the goods and services traded with their Subsidiaries or Associate Companies abroad so as to lower taxes and to maximize profits. The yardstick for acceptance of such transfer pricing is the “Arms Length Price” which should represent the price charged in comparable transactions between independent parties, where price is not influenced by the relationship or business interest between the parties in the transaction.

 

2.         The Transfer Pricing policies of several countries are based on the OECD (Organization of Economic Cooperation and Development) Guidelines on the subject, which broadly defines the controls between enterprises indulging in Transfer Pricing, the methods for determination of “arms length price” and the administration of Transfer Pricing Regulations.

 

3.         According to the OECD, the role of Multinational Enterprises (MNEs) in world trade has increased dramatically from the mid 70s. It is estimated that MNEs account for almost 60% of international trade and the intra group transactions involving Transfer Pricing cover more than 50% of this trade. By resorting to Transfer Pricing, business entities are in a position to shift the profits arising out of such transactions to more friendly tax jurisdictions, thereby reducing the total tax liability for the group as a whole.

 

4.         The chief method used by business entities to achieve the above objective is to adjust prices charged between their related concerns (Subsidiaries and associate enterprises) in such a manner that the higher taxing jurisdiction is left with none or miniscule profits to tax. These practices which result in erosion of revenues in high taxing jurisdictions. The regulatory and procedural controls to check these trends are broadly covered under the "Transfer Pricing" issues handled by tax administrations.

 

5.         Many countries like USA, UK, Germany, Australia, Canada and France have already laid down specific provisions in national laws and administrative procedures to regulate Transfer Pricing practices.  These are measures mainly based on the OEID guidelines to check the pricing pattern in international transactions between the related parties for ensuring the adherence to arm’s length price principle.

 

6.         During the last 15 years, India has been actively integrating itself within the global economy. In tandem, Indian companies, have started expanding rapidly into overseas markets in order to become multinational groups. Foreign MNEs are also expanding their investments in India. Effective laws and procedures, both for the Income Tax and Customs purposes, to regulate the "Transfer Pricing” thus assume importance in India today.

 

 

 

B.         Transfer Pricing  under I.T. Law.

 

 Relevant Provisions of I.T. Act

 

7.         In November 1999, The Central Board of Direct Taxes (CBDT) appointed a six member expert group to recommend changes in the provisions of the Income Tax Act, so that transfer pricing abuses in respect of cross border transactions are effectively curbed. Based on the report of the expert group, Income Tax Act was amended in the Finance Act, 2001, to incorporate suitable provisions in sections 92 to 92 F, and section 27 so as to regulate Transfer Pricing. These were broadly based on the OECD guidelines. Supplementary provisions in Income Tax Rules were incorporated to prescribe the procedures on Transfer Pricing controls.

 

8.         A summary of these legal provisions is given below:

Section	What it provides
92	Computation of Income from International transactions involving transfer pricing having regard to ''Arm’s length price''
92A	Meaning of ''Associated Enterprise''
92B	Meaning of ''International Transaction''
92C	Computation of ''Arm’s Length Price''
92CA	Reference to Transfer Pricing Officer
92D	Maintenance of Documents and Information
92E	Requirement of Audit Report
92F	Important Definitions.
271(1)(C)	Adjustment to income on account of Transfer Pricing Provisions to be regarded as concealed Income.
271AA	Penalty for failure to keep and maintain information and documents
271BA	Penalty for failure to furnish Audit Report
271G	Penalty for failure to furnish information or documents
Rules
10A	Meaning of expression used in computation of ''Arm’s Length Price''
10B	Determination of ''Arm’s Length Price’ under section 92C
10C	Most Appropriate Method
10D	Information and Documents to be kept and maintained under section 92D
10E	Report from an Accountant to be furnished under section 92E

 

 

 

9.         The new regulation requires that  "international transaction" between "associated enterprises" should be at an "arm's length price." International transaction is defined to mean a transaction between two (or more) associated enterprises that has a bearing on the profits, income, losses or assets of such enterprises. Associated Enterprises have been defined to cover those having direct/indirect participation in the management, control or capital of one enterprise by another enterprise. Participation in management and control is determined based on various factors including:

 

a) Direct/indirect holding of 26% or more voting power of an enterprise by the other enterprise or by a same person in both the enterprises, 

 

b) Advancing loan by an enterprise that constitutes 51% or more of total book value of assets of the borrowing enterprise,

 

c) Guaranteeing by an enterprise of 10% or more of total borrowings of the other enterprise,

 

d) Appointment by an enterprise of more than 50% of board of directors or one or more executive directors of an enterprise, or appointment of specified directorships of both enterprises by a same person,

 

e) Complete dependence of an enterprise (for carrying on its business) on the intellectual property licensed to it by the other enterprise,

 

f) Substantial purchase of raw material/ sale of manufactured goods by an enterprise to the other enterprise at prices and conditions influenced by the latter,

 

g) Existence of any prescribed relationship of mutual interest.

 

 

Arms Length Price

 

10.        Section 92 of the Income tax Act states that "Any income arising from an international transaction shall be computed having regard to the arm's length price".  “Arm's length price” is defined as a price, which is applied in a transaction between persons other than associated enterprises, in uncontrolled conditions.

 

11.        The legislation requires a taxpayer to determine the arm's length "price" for all international transactions using any one of the following five alternative methods:

 

a) Comparable uncontrolled price method (CUP)

b) Resale price method (RPM);

c) Cost plus method (CPM);

d) Profit split method (PSM);

e) Transactional net margin method  (TNMM);

 

Under CUP method, the Arm's Length Price would be the price charged in comparable transactions by/to non-associated parties. This method is generally applied when market prices from uncontrolled transactions can be used directly to set transfer prices.

 

Under the RPM, the Arm's Length Price is determined by deducting an appropriate discount for the activities of the reseller from the actual resale price. The appropriate discount is the gross margin, expressed as a percentage of net sales, earned by a reseller on the sale of property that is both purchased and resold in an uncontrolled transaction in the relevant market. The RPM is generally used where one of the affiliated parties performs 'routine' distribution functions.

 

Under the CPM, the Arm's Length Price is determined by adding an appropriate mark-up to cost of production. The CPM is generally used where one of the affiliated parties performs 'routine' manufacturing options. 'Routine' functions typically involve standard services that can be contracted out and that can be readily priced using comparables.

 

The PSM is based on the notion that profits earned on a given transaction should be equitably divided between the related parties involved in the transaction.

 

The TNMM is used to compare assessee’s net margins with other comparable companies. This method uses various 'profit level indicators' (such as return on costs or return on sales or return on capital employed etc) for comparisons.

 

12.        Selection of the most appropriate method would depend upon the degree of comparability between the international transactions and the uncontrolled transactions and between the enterprises entering into such transactions. As one travels from CUP method to TNMM, the comparability requirement reduces. The CUP method requires the strongest degree of comparison of relevant economic parameters since it deals directly with price. The RPM and CPM require strong functional similarity as compared to comparability. The TNMM deals with net margins and hence does not require a strong degree of comparability as net margins are generally less affected with small difference in products.

 

13.        The taxpayer has been given the flexibility to choose the most appropriate method as he deem fit among those prescribed, but the appropriate method for a particular transaction would be determined with regard to the nature of the transaction, class of associated persons, functions performed by such persons, or such other relevant factors. The Transfer Pricing officer (TPO) may re-determine the price independently by applying the above methods.  Where more than one arm's length price may be determined by applying the most appropriate TP method, the average of such prices shall be the arm's length price of the relevant international transaction.

 

 

Selection of the most appropriate method

 

14.        The selection of the tested party precedes the selection of the most appropriate method. Out of two associated enterprises, the tested party is generally the one, which is simpler of the two parties. For e.g., if the Indian company X merely acts as a distributor for its US associated enterprise Y, i.e. acts as a mere reseller and all manufacturing and trading activities are done by the said US company Y, it may be easier to test (compare) Indian company X with other distributors of similar products. This is also because Company Y may also own intangibles and it may be difficult to make adjustment for such intangibles. Once company X's results are at arm's length, as a corollary, company Y is automatically at arm’s length since after all transfer pricing is two sides of the same coin.

 

15.        The selection of the most appropriate method requires the taxpayer to analyze transfer prices under the method that provides the most reliable estimate of arm's length prices under the given circumstances. In practice, application of the best method rule requires a careful balance in which the taxpayer selects the appropriate pricing methods, taking into account the circumstances of the controlled transaction, the availability and quality of comparable transactions under each method, and the measures of comparable performance that can be used under those circumstances.

 

16.        In case the Assessing Officer believes (on the basis of material or information available) that the arm's length price has not been determined in the prescribed manner, or adequate and correct documents/ information/ data is not maintained/ produced, he may refer the computation of arm's length price to the Transfer Pricing Officer (TPO). After taking into account all relevant materials, and after giving reasonable opportunity to the assessee, the TPO will re-determine the arm's length price. The assessing officer computes the tax liability on the basis of the decision by TPO. In case of an adjustment to prices, the adjusted amount would not qualify for any export exemptions (under section 10A, 10B)/ deductions (section 80HHC, 80HHE etc.) prescribed by the Act.

 

Documentation:

 

17.        The taxpayer (assessee) has to maintain adequate supporting information and documents in respect of all international transactions between associated enterprises. The Transfer Pricing Rule 10D prescribe the information and documents to be kept and maintained under Section 92D by persons entering into international transactions. The information / documentation requirements prescribed are exhaustive. A synopsis of the requirements is given below:

 

* Description of ownership structure;

* Names and addresses of and relationships with all associated

   enterprises;

* Nature, terms, quantum and value of each international transaction;

* Business overview of the assessee, and description of business of

   associated enterprises;

* Record of any forecasts, budgets or any other financial estimates for 

   the business as a whole and for each division or product;

* Details of property/service involved;

* Description of functions performed, risks assumed, assets utilized;

* Commercial agreements of transactions with associated enterprises

   and third parties;

* Record of transactions considered for determining price of the

   international transaction;

* Data collected and analysis performed to evaluate comparability;

* Description of methods considered, selected and applied;

* Details of comparable data used in applying most appropriate

   method;

* Assumptions, policies, price negotiations, if any;

* Accounts of the associated enterprise potentially relevant to the 

   pricing and tax treatment accorded or likely to be accorded by

   overseas tax authorities;

* Any other information/data/document, as is relevant.

 

The above are primary documentation which shall be supported by certain supplementary documentation viz. Government publications, reports, technical publications, price publications, agreements and contracts, market research reports, correspondence between assessee and associated enterprise.

 

18.        The above-mentioned documentation should exist latest by the due date for filing of Income tax return by the assessee. Further, an accountant's report has to be obtained in the prescribed format in respect of all international transactions between associated enterprises.  If an international transaction is spread over a period of above one year, fresh documentation need not be maintained unless there is any significant deviation in the nature / terms of such international transaction. Primary and Support documentation should be maintained for eight years from the end of the relevant assessment year.

 

Penalties

 

19.        The following penalties have been prescribed for non compliance with the provisions of the transfer pricing code and would run cumulatively:

 

(i)    For failure to maintain prescribed information/ documents – 2%  

       of transaction value.

 

(ii)  For failure to furnish information/ documents before Revenue - 

      2% of transaction value

 

(iii) For adjustment to taxpayer's income - 100% to 300% of tax on

      adjusted amount

 

(iv) For failure to furnish accountant's report-INR 100,000.

 

 

C. Transfer Pricing under Customs Law.

 

Provisions of Customs Valuation Law and Transfer Pricing

 

20.        Article VII of the GATT and the WTO Agreement on Customs Valuation (ACV); do not refer explicitly to transfer pricing.  However, in the case of related party transactions the Agreement indirectly accepts the arm’s length principle. This is evident in respect of transfer of goods between related parties, where the transaction value of identical/similar goods provides the basis for Customs Valuation when the relationship is found to have influenced the price.  The Customs Valuation Rules, 1988 (CVR) also provide for deductive and computed value methods which are similar to RPM and CPM methods under the Transfer Pricing law.

 

21.        ACV Article 1.2 sets out a general principle that the transaction value shall be accepted provided that the relationship did not influence the price. To determine whether the relationship has influenced the price in any given controlled transaction, one has to compare such transaction with similar uncontrolled transaction. Thus, both customs and income tax valuation systems have chosen arm’s length standard as the principle that must govern the relations between related parties.          

 

22.        While the Income Tax authorities may seek to avoid diversion of profits to the exporting country by assessing lower transaction price on imports, the custom authorities as well as anti-dumping authorities would prefer to determine a higher transfer price to enhance customs revenue and anti-dumping duty. There could also be a case wherein a lower import value is declared to customs to pay less duty and a higher transaction price is indicated to income tax to minimize profits.

 

Comparison of Transfer Pricing Rules (notified under the Income Tax Act) and Customs Valuation Rules.

 

23.        The Customs Valuation Rules (CVR) deal with the valuation of tangible goods only while the transfer pricing rules cover international transactions involving both tangibles and intangibles. Both the taxes are however driven by diametrically opposite approaches to valuation in view of the conflicting interests involved for measuring the tax incident.

 

24.        The categories of associated enterprises in transfer pricing rules are much wider in their scope than those specified for related parties under CVR. In CVR the relationship is defined under Rule 2 and is deemed to exist broadly in terms of ownership control of equity/stock or other controls. The transfer pricing rules have a much broader coverage and treat parties as related even on the grounds of consumption of raw material, dependence of patent, technology etc. The definition of “associated enterprises” includes multinational enterprises supplying technology to users world wide as associated enterprise (related parties). The use of technology could be by way of transfer of know-how, patents, copyrights trademarks, licenses franchises or any other business or commercial rights of similar nature. The definition excludes technology for services e.g. software from its scope.

 

25.        Despite a relationship, the CVR permits the acceptance of declared price if the relationship did not influence the price. In cases where it is held as influencing the price, the importer has the option to demonstrate, with the help of test values, that the declared price is closer to the arms length price. In transfer pricing rules, the arm’s length price has to be determined by the application of any of the methods prescribed. Though the assessee can chose his own method for such a determination, the Assessing Officer, in the course of the assessment proceedings, can re-determine the arm’s length price if he is of the view that the prescribed information is not maintained/furnished or data used for computing such price is not reliable or not in accordance with the prescribed provisions. However, the tax authorities shall not make any adjustments to the arm’s length price adopted by the taxpayer if such price is up to 5% less or 5% more than such price determined by the Assessing Officer.

 

26.        Under the CVR, the custom officer has the discretion to entertain doubt about the genuineness of the declared price and initiate a proceeding to verify the price under Rule 10A. In such a situation the burden proof is shifted to the assesse (importer).  Though such a provision is missing in the transfer pricing rules, the burden of proof is always on the assessee and the tax office may determine the transfer price at its own discretion.

 

27.        The Income Tax Act provides for the application of the most appropriate method, whereas in CVR after the rejection of declared transfer price, the hierarchy of the Valuation methods must be followed strictly to re-determine the price for assessment.

 

28.        However, there are several common areas in both systems and efforts could be made at national level to coordinate the approaches. The first three valuation methods of the Income Tax Act, namely, (a) comparable uncontrolled price method; (b) resale price method; and (c) cost plus method are very similar to the identical/similar goods value method, deductive value method and computed value method under the Customs Valuation Rules.

 

 

D. Possible Approaches to Harmonize the Income Tax and Customs treatment of transfer pricing

 

29.        The transfer pricing rules under the Income Tax treat enterprises as related even on the grounds of consumption of raw materials, dependence on patents, technology etc. whereas, the concept of relationship under CVR is limited. This difference between the CVR and transfer pricing rules could lead to one department treating the same transactions as between related parties  and the other taking a contrary view. Thus, while customs may accept the declared price as at arm’s length, the tax authorities may not and may reduce the declared price. Harmonization of definition of related parties is a possible solution. However the definition of “related party” in Customs Valuation Rules (CVR) is based on the WTO definition in the ACV  and cannot be revised at national level. There are certain common areas where the definitions are similar and the coordination between the two departments could focus on these areas.

 

30.        In order to circumvent transfer pricing provisions, certain taxpayers structure international Transactions between group companies by involving a third party. In order to plug this loophole, Section 92B(2) in the lncome Tax Act was introduced. The Customs Valuation Rules could be amended to take care of this situation.

 

31.        Income Tax and Customs officials proceed independently to establish arm’s length valuations in related-party import transactions. This may lead to different results which may be far from reality. Legislative action and agency cooperation should create an environment in which the Income tax and Customs authorities can coordinate import valuations as a unified force. In USA, Section 1059A has been introduced to prevent a US importer from jeopardizing the government revenue by valuing merchandise inconsistently for customs and income tax purposes. Under section 1059A, importers are barred from declaring a transfer price that exceeds the value declared for Customs valuation purposes. In USA, the IRS and Customs have executed a document entitled “Working Arrangement for Mutual Assistance and Exchange of Information Between the U.S. Department of the Treasury U.S. Customs Service and the Internal Revenue Service Regarding International Compliance and Importation lssues “ (the “Mutual Assistance  Agreement” ) that is designed to facilitate communication and cooperation between the agencies. A similar legal basis could be introduced to harmonize the Income tax and Customs approaches in India also 

 

32.        The Documentation requirements under Income Tax Transfer Pricing Rule 10D are quite exhaustive. The documentation requirements under the Customs Act, (Valuation Rules) are however not specific. In case of an adjustment of import valuation by Customs or Income tax, the importer should be obliged to disclose such adjustments to the other department. As there is no such provision in the law as of now, suitable amendments could be made. Transfer pricing documentation including Cost Accountants certificate submitted to Income Tax Authorities could also be mandatory for submission to the Customs department handling special valuation (SVB) cases of related party transactions.

 

33.        For effective administration of transfer pricing policies, a very comprehensive Database is required.  There are several databases available with Income Tax and Customs departments, each of which provides information of a niche area. Some of the Databases/Information resources maintained by Customs Department are NIDB (National Import Database), Export Commodity Database (ECDB), Special Valuation Branch Database(SVB), Valuation instructions Valuation Alerts and the Valuation Bulletin. Similar databases will be available in the Income Tax department.  Sharing information contained in these databases would be beneficial to both the departments in taking considered decisions as Transfer Pricing questions. 

 

34.        Transfer Pricing under the Income Tax Act  is administered by the Directorate General of Transfer Pricing in the Income Tax Dept.  In the Customs Department, the Special Valuation Branch (SVB) presently functioning at major customs stations (Mumbai, Delhi, Chenna, Bangalore, Kolkata) examine the relationship based imports which include Transfer Pricing. For effective coordination between Customs & Income Tax Departments, it would be necessary to bring the SVBs under a single authority. Directorate General of Valuation which is handling all Customs valuation related matters is best suited or the purpose. This would also facilitate sharing of data bases maintained by the Customs Department and Income Tax Department. 

 

35.        Income Tax and Customs Departments may also exchange data regarding adjustments/revisions made during assessments for uniformity in approach. It is also desirable to have joint action plan in  important areas such as valuation rulings, documentation, and audit controls for effective coordination over the Transfer Pricing controls of Multinational Enterprises. These would also reduce transaction costs to the trade. Joint programme for training of officers on the Income Tax and Customs Laws relating to transfer pricing is also recommended.

 

36.        Finally, an institutional mechanism for harmonization and coordination of transfer pricing matters between Income Tax and Customs departments with adequate legal backing is desirable.

           

D.  Conclusion

 

37.        Transfer Pricing is an area, which is emerging as very important in the application of customs and income tax laws in India. This is on ascent with the opening of FDI and multifold increase in NME transactions. Effective coordination between the Customs and Income Tax Departments by necessary legal and administrative provisions are urgently needed to improve the efficiency of transfer pricing administration not only for ensuring the interest of revenue but also for facilitating the trade and FDI.

 

 

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