At Arm’s Length – A Perspective of the Transfer Pricing Regulations in
The rapid globalization of the Indian economy has seen the entry of the multinationals into
Developed countries like US and the
The Indian TP regulations are broadly based on the OECD[1] Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (OECD Guidelines), though in certain respects they maintain their own flavour. The Revenue Authorities are giving greater importance to the conduct of TP Audits and specialized TP Officers and TP Cells have been set up for the conduct of the same. The threshold limit for the compulsory scrutiny of international transactions between associated enterprises (AE’s), which was hitherto INR 5 crore in aggregate, has been increased by the Finance Ministry to INR 15 crore.
General Issues being faced by the Indian Tax Payer
The Indian TP law is still in a nascent stage and needs to evolve. There are practical problems arising out of the application of the transfer pricing regulations and these need to be given a re-look. The issues facing the Indian Tax payer have been outlined as under:
Selection in the Method:
The Indian TP regulations do not advocate the use of any hierarchy in the method selection but advocate the use of “Most Appropriate Method”. This is akin to the concept of the best method rule found in the
- Comparable Uncontrolled Price (CUP) Method
- Resale Price Method (RPM)
- Cost Plus Method (CPM)
- Profit
- Transactional Net Margin Method (TNMM)
- such other method as may be prescribed (no method has been prescribed till date)
Empirically it has been seen that TNMM has been the most commonly used method for documentation by the tax payers and also by the TPO’s for audits. The TPOs have been insisting normally on testing each transaction and using the TNMM benchmarking as a smell-test to check the adequacy of the overall profitability. Accordingly, from a transfer-pricing risk perspective, taxpayers need to demonstrate compliance at a transactional level as well as at an overall profitability level.
Usage of Secret Comparables:
The TPOs have been exercising their powers available to them (Section 92CA (7) read with Section 133 (6) of the Income Tax Act, 1961) and obtaining data of Comparable Companies, which is not available to the taxpayer in public domain and using the data during the TP audits.
Single Year Financial Data:
As per the Indian Regulations, the data to be used in analyzing the comparability of an uncontrolled transaction with an international transaction shall be the data relating to the financial year in which the international transaction has been entered into. In reality current year data, as stated in the Indian Regulations is unrealistic if we have to use ‘external’ comparables derived from the databases of independent companies. Current year company accounts may not have been filed and entered on the database before the comparable company has filed their accounts with regulatory authorities. Further, quarterly financial data, where available, would be in an abridged form and may be unaudited, which may distort comparability.
In order to overcome the difficulty, relying on the proviso to Rule 10B (4) of the Income Tax Rules, 1962, tax payers have been considering data relating to a period not being more than two years prior to such financial year if such data reveals facts, which could have an influence on the determination of the transfer price in relation to the transactions being compared.
However, TPOs continue to insist on benchmarking tested party results with margins of comparable companies computed using single- year financial data relating to the same fiscal year, that is, data that might have not been available to the taxpayer at the time of completing the documentation.
Arm’s
The Indian TP regulations do not recognize the arm’s-length range concept; what is prescribed is a somewhat narrow “arithmetical mean”, that is, a simple average, with a +/- 5% variation permitted. Commonly adopted statistical measures such as “median” or “inter quartile range” are also not recognized.
The Income-Tax Act specifies that where more than one price is determined by the most appropriate method (MAM), the arm's length price (ALP) shall be taken to be the arithmetic mean (AM) of such prices, or, at the option of the assessee, a price which may vary from the AM by an amount not exceeding 5 per cent of such AM.
The concept of determining the ALP by AM in the Indian regulations needs review. The +/- 5 per cent variation should be replaced with an inter-quartile range prevalent in other countries. Use of AM of uncontrolled prices is not a good statistical measure, as it is affected by the presence of extremely large or small prices.
However, median is a good measure of central tendency and used by some matured TP jurisdictions such as the
The transfer pricing rules could be modified to permit the use of internationally accepted statistical methods such as the median and inter-quartile range for measurement of arm's length price.
Issues in the application of the (+/-) 5 % safe-harbor Provisions:
The TPOs have denied the taxpayers the benefit of (+/-) 5 % Safe harbor available to them when there is a single arm’s length price, by a literal interpretation of the provisions of the Income Tax Act,1961 ( referred to hereinafter as the “Act”).
The proviso to Section 92C (2) of the Act reads as “where more than one price is determined by the most appropriate method, the arm’s length price shall be taken to be the arithmetical mean of such prices, or, at the option of the assessee, a price which may vary from the arithmetical mean by an amount not exceeding five per cent of such arithmetical mean”
“Substance” over “Form” of the legal agreements:
The TPOs have been giving importance to the “substance” of the legal agreements that have been entered into by the taxpayer as against the legal form. The TPOs have been laying emphasis on the internal correspondence that has been gone through between the related parties prior to and post the entering of a contractual agreement/internal transaction.
Approvals from other Government Departments:
TPOs are not giving cognizance during TP audits, to the approvals obtained from other specific government departments (FIPB / SIA / RBI / SEBI etc.) from which approval has been obtained even when the taxpayer has complied with the relevant policy guideline. This has been more so in the case of transactions involving payments for royalty for the use of brand name or technology and transactions involving payment of interest on External Commercial Borrowings.
The Revenue authorities should take a more reasonable view and its prudent that they come up with a Circular, that where the payment is in accordance with a specific Government approval or is within the limits prescribed by relevant guidelines laid down by any Government body (FIPB / SIA / RBI / SEBI etc.[2]), it should be considered compliant with the arm’s length principle.
It’s but normal that, if a transaction has been given a go ahead by one arm of the Government, or is completely compliant with the policy guideline laid down by it, the same should be acceptable to another arm of the Government. Admittedly the FIPB/SIA/RBI looks at the transactions from a foreign exchange perspective, however in doing so they also examine the economic substance and commercial need for these transactions and hence specific approvals / compliance with relevant guidelines is a strong indication that the transaction is on an arm’s length basis. This view also finds support in the Rules as well as the OECD Guidelines.
Use of the overseas “tested party” and overseas comparables- Issues
When a TNMM analysis is undertaken in the benchmarking of an international transaction with an overseas entity, the simpler of the taxpayers is selected as the “tested party”. The “tested party “is the participant in the controlled transaction whose profit attributable to the controlled transaction can be verified using the most reliable data and requiring the fewest and most reliable adjustments, that is, the taxpayer with the least amount of risk associated with its operations and without valuable intangibles or unique assets that may distinguish it from potential uncontrolled comparable companies.
The TPOs have been refusing to accept the overseas entity as the tested party even when it is the simpler of the entities to benchmark. This might be probably due to the lack of availability of foreign databases for benchmarking the overseas entity. Also, in certain industries, despite the lack of availability of data in public domain of comparables, use of overseas comparables is not accepted.
Advance pricing agreements:
The Indian TP regulations have not included provisions for advance pricing agreements (APA) so far. There are no provisions enabling the taxpayers to agree pricing policies with the tax authorities in advance. The advance pricing agreements have been in vogue in countries such as the
Further, there are no specific provisions in the TP legislation to ensure secrecy of strategic pricing and other information provided by taxpayers to tax authorities. As the information would be of strategic importance, in the absence of adequate safeguards in the code to ensure secrecy of such information, taxpayers would be hesitant to provide detailed information to the tax authorities.
Thin Capitalization
At present there exist no norms dealing specifically with thin capitalization and there exist no set debt-equity ratios.
Cross charges
The TPOs have been undertaking a rigorous inquiry of the benefits that are actually received by the Indian taxpayer whenever the overseas group company makes an allocation of the common costs that it incurs. Substantial proof and evidence is being sought by the TPOs for the cross charges made.
Tax holiday units and transfer pricing adjustment:
The Income Tax Act, 1961 contains specific provision in the TP regulations that deny the tax holiday unit, the benefit of a tax holiday when a TP adjustment. This needs a re-look.
At present the tax payers have initiated the procedure of appeal and quite a few of the issues are to be addressed by the appellate authorities. These contentious issues would take a while before they are addressed to by relevant legislative amendments/ administrative clarifications/judicial decisions. It would be some years before a clear picture emerges and the tax payers have to wait for the same.
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