In 2001, India became the third developing country to introduce Transfer Pricing Regulations in its income-tax law, mainly to ensure that corporates do not shift profits from India to other countries, an act that could be perceived as tax avoidance. Accordingly, the Finance Act, 2001 introduced transfer pricing regulations building on the Organisation for Economic Co-operation and Development (OECD) Guidelines, which describes the various transfer pricing methods, transfer pricing documentation requirements and also contains the penal provisions for non-compliance.
What is Transfer Pricing?
When two related parties enter into any transaction, the price at which they undertake their transaction is called “transfer price”. Transfer pricing regulations require that this transfer price be at arm’s length (i.e. price at which third party dealing would take place). Let’s take an illustration to understand this further:
Party A (a tax-paying manufacturer), sells goods to B (a related party and distributor) at ₹100. Similarly, these goods are sold by A to C (a third party), also a distributor, at ₹95. In such a case, since the transfer price (₹100) is higher than the arm’s length price (₹95), this transaction would be at arm’s length.
In the above example, if the goods are sold to C at ₹110, since the transfer price (₹100) is lower than the arm’s length price (₹110), this transaction would not be at arm’s length.
Understanding the basics
The transfer pricing regulations prescribe that income arising from “international transactions” between “associated enterprises” should be computed having regard to the “arm’s length price”. Therefore, for applicability of transfer pricing regulations, the income needs to be chargeable to tax in India.
An international transaction could be a transaction between two or more associated enterprises involving a sale, a purchase or lease of tangible or intangible property, a provision of services, cost-sharing arrangements, lending or borrowing of money, or any other transaction that adds to the profits, income, losses or assets of an enterprise.
An associated enterprise is one that participates, directly or indirectly, in the management, control or capital of the other enterprise, in relation to another enterprise. The transfer pricing regulations also provide certain specific parameters for two enterprises to be considered associated enterprises.
The arm’s length price is the price that is applied, or proposed to be applied, to transactions between persons other than an associate enterprise in uncontrolled comparable conditions.
Additionally, effective financial year 2012-13, transfer pricing regulations were extended to transactions with certain related domestic parties, if the transaction value exceeds ₹200 million (₹20 crore). These transactions would primarily include expenditure with respect to deduction claimed while computing profit and gains of business or profession and businesses eligible for profit-linked tax incentive.
The transfer pricing regulations prescribe that the arm’s length price has to be determined based on any of the following methods:
~~ Comparable Uncontrolled Price method;
~~ Resale Price method;
~~ Cost Plus method;
~~ Profit Split method;
~~ Transactional Net Margin method; or
~~ Other method – as notified by the Central Board of Direct Taxes.
Transfer pricing documentation
Taxpayers whose aggregate value of international transactions exceeds ₹10 million (₹1 crore), and in case of domestic transactions exceed ₹200 million (₹20 crore), are required to maintain contemporaneous documentation to demonstrate that the transactions are at arm’s length.
One such document is an ‘Accountant’s Report’, which is a certificate issued by an independent accountant. It provides details of the taxpayers international and domestic transactions with its associated enterprises , and also details the method used to determine the arm’s length price and whether such transactions were at arm’s length or not. This report has to be furnished by the taxpayer within the due date of filing the income-tax return. In the case of non-compliance, stringent penalties are levied.
Transfer pricing litigation
Today, transfer pricing is among the most important international tax issues affecting corporates. In the last decade, India has witnessed a large number of transfer pricing adjustments, and most taxpayers are settling cases at a higher appellate level. Their main concern is the delayed redressal mechanism, which has been the cause for continued uncertainty.
Corporates are also increasingly adopting dispute resolution mechanisms such as a Mutual Agreement Procedure or Advance Pricing Arrangements. These mechanisms go a long way in reducing the litigation, and consequently provide taxpayers a sense of certainty.