Transfer Pricing in India: A Comprehensive overview with key case studies

Introduction

Transfer pricing refers to the pricing of goods and services traded between related parties, such as subsidiaries of the same multinational corporation. It is an important aspect of international business, as it can significantly impact a company's profitability and tax liability. In recent years, transfer pricing has come under scrutiny by governments worldwide, as it can be used as a means of tax avoidance or evasion.

In India, transfer pricing is regulated by the Income Tax Act 1961 and the rules prescribed thereunder. The Central Board of Direct Taxes (CBDT) is responsible for enforcing India's transfer pricing regulations.

Overview of transfer pricing in India

Indian transfer pricing regulations apply to transactions between related parties, whether they are residents in India or abroad. A "related party" includes associates, such as joint ventures and shareholders holding more than 26% of the voting power and members of the same group of companies.

Transfer pricing in India is governed by the "arm's length principle," which states that transactions between related parties should be conducted on terms comparable to those made between unrelated parties. This means that the price of a product or service should be the same as what it would be if it were traded between unrelated parties in a similar transaction under similar circumstances.

Transfer pricing methods in India

There are five main methods for determining the arm's length price of a transaction in India:

1. Comparable uncontrolled price method: This method involves comparing the price of the related party transaction with the price of a similar transaction between unrelated parties.
2. Resale price method: This method involves determining the markup that a reseller would add to the price of a product when reselling it to an unrelated party.
3. Cost plus method: This method involves adding a markup to the cost of producing a product or service to determine the arm's length price.
4. Profit split method: This method involves allocating the profit from a transaction between the related parties based on their contributions to the transaction.
5. Transactional net margin method: This method involves comparing the net profit margin of a related party transaction with the net profit margin of a similar transaction between unrelated parties.

Suitability of the method

The choice of transfer pricing method can have significant implications for a company's profitability and tax liability. It is important for taxpayers to carefully consider the suitability of each method for their specific transactions. Here is a brief overview of the suitability of each transfer pricing method:

1. Comparable uncontrolled price method: This method is suitable for transactions involving products or services that are readily available in the market and for which prices can be easily obtained from unrelated parties. For example, suppose Company A is a subsidiary of a multinational corporation and it purchases raw materials from an unrelated supplier. In that case, the comparable uncontrolled price method could be used to determine the arm's length price of the transaction.
2. Resale price method: This method is suitable for transactions in which one party resells a product or service to an unrelated party. The markup applied by the reseller can be used to determine the arm's length price of the transaction. For example, suppose Company A is a subsidiary of a multinational corporation, and it purchases finished goods from another subsidiary to resell to unrelated parties. In that case, the resale price method could be used to determine the arm's length price of the transaction.
3. Cost plus method: This method is suitable for transactions in which one party incurs costs to produce a product or service for another party. The markup applied to the production costs can be used to determine the arm's length price of the transaction. For example, suppose Company A is a subsidiary of a multinational corporation and it incurs costs to manufacture a product for another subsidiary. In that case, the cost-plus method could be used to determine the arm's length price of the transaction.
4. Profit split method: This method is suitable for transactions in which the parties make significant contributions to the profits of the transaction. The profits can be split based on the relative contributions of each party. For example, if Company A and Company B are both subsidiaries of a multinational corporation and they jointly develop a new product, the profit split method could be used to determine the arm's length price of the transaction.
5. Transactional net margin method: This method is suitable for transactions in which the net profit margin is a key driver of the price. The net profit margin of the related party transaction is compared to the net profit margin of a similar transaction between unrelated parties to determine the arm's length price. For example, if Company A is a subsidiary of a multinational corporation and it provides consulting services to another subsidiary, the transactional net margin method could be used to determine the arm's length price of the transaction.

The comparable uncontrolled price method in India is the most commonly used transfer pricing method. This method involves comparing the price of the related party transaction with that of a similar transaction between unrelated parties. It is generally considered the most reliable method for determining the arm's length price of a transaction, as it is based on prices that have been independently negotiated in the open market.

However, the choice of transfer pricing method will depend on the specific circumstances of the transaction. In some cases, other methods may be more appropriate, such as the resale price method, cost plus method, profit split method, or transactional net margin method. It is important for taxpayers to carefully consider the suitability of each method for their specific transactions.

Advance pricing agreements in India

An advance pricing agreement (APA) is a binding agreement between a taxpayer and the CBDT that sets out the transfer pricing method to be applied to a specific transaction or set of transactions in advance. APAs can be bilateral (between two countries) or multilateral (involving three or more countries).

In India, taxpayers can apply for an APA by submitting a request to the APA unit of the CBDT. The request must be made at least six months before the start of the financial year in which the transaction is proposed to be carried out. The APA unit will then review the request and, if accepted, negotiate with the taxpayer to finalize the terms of the APA.

Transfer pricing documentation in India

In India, transfer pricing documentation must be prepared in accordance with the rules prescribed under section 92D of the Income Tax Act, 1961. The documentation should include a report setting out the details of the related party transactions, the transfer pricing methods applied, and the comparables used to determine the arm's length price.

The transfer pricing documentation should also include a certificate, signed by a chartered accountant or a cost accountant, stating that the arm's length price has been determined in accordance with the provisions of the Act and the rules prescribed thereunder. The certificate should also state that the report and the documentation supporting the arm's length price have been prepared in accordance with the prescribed format.

The specific requirements and format for the transfer pricing documentation, including the certificate, are prescribed in Rule 10D of the Income Tax Rules, 1962. The documentation should be prepared in English or Hindi and filed with the tax authorities in the prescribed format along with the tax return.

It is important to note that the transfer pricing documentation must be prepared and filed with the tax authorities on an annual basis, regardless of whether or not there have been any related party transactions during the year. Failure to comply with the transfer pricing documentation requirements can result in penalties, including a penalty equal to 2% of the value of the transaction (up to a maximum of INR 1 crore) for each year of non-compliance.

Resources and Databases available to assist with transfer pricing

Several resources and databases are available in India to assist with transfer pricing analyses. These include:

1. The Indian Transfer Pricing Portal: This website maintained by the Central Board of Direct Taxes (CBDT) provides information on transfer pricing regulations and guidance in India. It includes guidance on transfer pricing methods, advance pricing agreements, transfer pricing documentation requirements, and access to relevant forms and instructions.
2. The Indian Transfer Pricing Handbook: This is a comprehensive guide to transfer pricing in India, published by the CBDT. It provides detailed information on the Indian transfer pricing regulations and guidance on applying the various transfer pricing methods.
3. The Indian Transfer Pricing Database: This is a database of transfer pricing comparables maintained by the CBDT. It includes financial data and other relevant information on Indian companies that can be used as comparables in transfer pricing analyses.
4. External databases: Several external databases can be used to gather comparable data for transfer pricing analyses in India. These include databases such as Bloomberg, Capital IQ, and Compustat.

It is important to note that using external databases is not mandatory in India, and taxpayers are free to use any other sources of comparable data that they consider reliable. However, the CBDT may challenge the comparables used in a transfer pricing analysis if it believes they differ from the market.

Recent Case Laws

PCIT v/s M/s Aegis Limited (Bombay High Court) ITA No. 1248 of 2016

In this case, the Bombay High Court considered the issue of whether the transfer pricing officer (TPO) has the authority to adjust the arm's length price of a transaction based on external comparables. The taxpayer, M/s Aegis Limited, argued that the TPO did not have the authority to consider external comparables, as the arm's length price of a transaction should be determined based on the comparables provided by the taxpayer.

The Bombay High Court rejected this argument and held that the TPO has the authority to consider external comparables in determining a transaction's arm's length price. The court noted that the arm's length principle requires that the price of a transaction between related parties should be the same as what it would be if it were being traded between unrelated parties in a similar transaction under similar circumstances. Therefore, the TPO has the authority to consider any relevant comparables, whether they are provided by the taxpayer or obtained from external sources, to determine the arm's length price of the transaction.

Hero Moto Corp Vs. DCIT, Delhi [2020] 117 taxmann.com 101 (Delhi - Trib.)

In this case, the Delhi Tribunal considered the issue of whether the cost plus method was the most appropriate transfer pricing method for determining the arm's length price of a transaction involving the procurement of raw materials by the taxpayer, Hero Moto Corp. The taxpayer argued that the cost-plus method was the most appropriate method, as it took into account the specific circumstances of the transaction and the taxpayer's contribution to the value of the raw materials.

The Delhi Tribunal agreed with the taxpayer and held that the cost-plus method was the most appropriate transfer pricing method in this case. The tribunal noted that the cost-plus method is generally considered a reliable method for determining the arm's length price of a transaction involving the procurement of raw materials, as it takes into account the costs incurred by the taxpayer in procuring the raw materials and the value added by the taxpayer through its manufacturing activities.

Instrumentarium Corporation Limited v. ADIT (Kolkata Tribunal) [2016] 71 taxmann.com 193 (Kolkata - Trib.) (SB)

In this case, the Kolkata Tribunal considered the issue of whether the taxpayer, Instrumentarium Corporation Limited, was eligible for the safe harbor rules, which guide the arm's length price of certain types of transactions, such as services and intangibles, based on benchmarking studies. The taxpayer argued that it was eligible for the safe harbor rules, as it provided technical support and maintenance services to its related party customers.

The Kolkata Tribunal agreed with the taxpayer and held that it was eligible for the safe harbor rules. The tribunal noted that the safe harbor rules are intended to provide certainty and reduce the compliance burden for taxpayers engaged in low-risk transactions, such as providing technical support and maintenance services. The tribunal also held that the taxpayer had provided sufficient evidence to demonstrate that its transactions fell within the scope of the safe harbor rules.

Adani Enterprise Ltd vs Additional Commissioner of Income Tax [2019] 111 taxmann.com 196 (Ahmedabad - Trib.)

In this case, the Ahmedabad Tribunal considered the issue of whether the taxpayer, Adani Enterprise Limited, was required to maintain transfer pricing documentation in respect of its related party transactions. The taxpayer argued that it was not required to maintain transfer pricing documentation as it had no related party transactions during the relevant tax year.

The Ahmedabad Tribunal rejected this argument and held that the taxpayer was required to maintain transfer pricing documentation, regardless of whether or not it had any related party transactions during the year. The tribunal noted that the transfer pricing documentation requirements are intended to provide the tax authorities with the information necessary to ensure that related party transactions are being conducted on arm's length terms. The tribunal also held that the taxpayer had failed to comply with the transfer pricing documentation requirements and imposed a penalty equal to 2% of the value of the transactions (up to a maximum of INR 1 crore) for each year of non-compliance.

Recent Government Measures

Over the past few years, the Indian government has taken several steps to strengthen its transfer pricing regulations and enforcement. Here is a timeline of some of the key events:

• 2010: The Indian government introduces the "arm's length range" concept, which allows for a certain degree of flexibility in determining the arm's length price of a transaction.
• 2012: The Indian government introduces the "advance pricing agreement" (APA) framework, which allows taxpayers to resolve transfer pricing disputes in advance through binding agreements with the tax authorities.
• 2014: The Indian government introduces the "safe harbor" rules, which provide guidance on the arm's length price of certain types of transactions, such as services and intangibles, based on benchmarking studies.
• 2016: The Indian government introduces the "secondary adjustments" provision, which allows the tax authorities to make adjustments to the profits of a taxpayer if the arm's length price of a related party transaction is not properly reflected in the taxpayer's financial statements.
• 2017: The Indian government introduces the "country-by-country" (CbC) reporting requirement, which requires multinational corporations to report certain information on their global operations, including transfer pricing, to the tax authorities.
• 2018: The Indian government introduces the "master file" and "local file" concepts, which require multinational corporations to maintain additional documentation on their global transfer pricing arrangements and the specific transfer pricing arrangements of their Indian operations, respectively.

Overall, these changes reflect the Indian government's efforts to align its transfer pricing regulations with international standards and to enhance its transfer pricing enforcement capabilities.

Conclusion

In conclusion, transfer pricing is an important aspect of international business that can significantly impact a company's profitability and tax liability. In India, transfer pricing is regulated by the Income Tax Act 1961 and the rules prescribed thereunder. It is governed by the arm's length principle, which states that transactions between related parties should be conducted on terms that are comparable to those that would be made between unrelated parties. Several methods are available for determining a transaction's arm's length price, including the comparable uncontrolled price method, resale price method, cost plus method, profit split method, and transactional net margin method. Advance pricing agreements (APAs) are also available in India to resolve transfer pricing disputes in advance. It is important for taxpayers to carefully consider the suitability of each transfer pricing method for their specific transactions and to maintain adequate documentation supporting the arm's length nature of their related party transactions. Non-compliance with transfer pricing regulations can result in penalties and disputes with the tax authorities.

The author is a Chartered Accountant and has an MBA from IIM Indore.