Overview of Transfer Pricing in India

By CA. Akshay Kenkre (Founder and Practice Lead, TransPrice Tax Advisors LLP, India)

Introduction

The Indian transfer pricing regulations were enacted via the Indian Finance Act 2001 by introducing  a separate code under Sections 92 to 92F of the Income- tax Act , 1961 (‘the Act’) read with Income- tax Rules, 1962 (‘the Rule’s) 10A to 10ETHD. The regulations are largely and principally based on OECD guidelines and describe the various transfer pricing methods, requirement for transfer pricing documentation, and contain penal provisions for non-compliance. The Indian regulations deal with intra-group transactions and is applicable from April 1, 2001.

Need for Transfer Pricing in India

With the emergence of era of liberalization and globalisation, there has been an increase in the number of cross-border transactions, complexity and speed with which global business could be transacted.

When transactions are entered into between independent enterprises, the consideration is determined by market forces. However, when associated enterprises deal with each other, there is a possibility that the commercial and financial aspects of the transactions may be influenced by factors other than market forces.

The existence of different tax rates and rules in different countries may give a chance to multinational enterprises to arrange their transfer prices to recognize lower profits in countries with higher taxes and vice versa. This may reduce the average tax payable by the multinational group and increases the after tax returns which in turn could be distributed to shareholders. In India ,earlier the Act had not dealt with this problem in a detailed manner. The Finance Act 2001 recognized this issue and introduced the provisions of Transfer Pricing in India to curb such practices.

The Indian Transfer Pricing Regulations prescribes that income arising from “international transactions” between “associated enterprises” should be computed having regard to the “arm’s length price”. It has been clarified that the allowance for any expense or interest arising from an international transaction shall also be determined having regard to the ALP.

 

The expressions “international transactions”, “specified domestic transaction” “associated enterprises” and “arm’s length price” have been explained hereunder:

International Transactions:

Section 92B of the Act defines the expression “International Transaction” to mean a transaction between two (or more) AEs involving sale, purchase, or lease of tangible or intangible property, provision of services, cost sharing arrangements, lending / borrowing of money, or any other transaction having a bearing on the profits, income, losses, or assets of such enterprises. The AEs could be either two non-residents or a resident and a non-resident.

Specified Domestic Transaction:

Until March 2012, Indian TP regulations were applicable only to international transactions entered into with associated enterprises. Considering the suggestions made by the Supreme Court in India in the case of Glaxo SmithKline Asia (P) Ltd., the application of transfer pricing regulations has been extended to specified domestic related party transactions as well.

As per Section 92BA of the Act, Specified Domestic Transaction essentially include transactions with undertakings to which profit linked deductions are provided covering inter-unit transfer of goods and services; and transactions between entities having close connection. Accordingly, the taxpayer would be required to undertake annual Transfer Pricing compliance in respect of the specified domestic transactions if the aggregate of such transactions exceeds INR 20 crores in a financial year.

Associated Enterprises:

The relationship of “Associated Enterprises” has been defined by Section 92A of the Act to cover direct / indirect participation in the management, control, or capital of an enterprise by another enterprise. It also covers situations where the same person (directly or indirectly) participates in the management, control, or capital of both the enterprises.

For the purpose of this definition, certain other specific parameters have been laid down, based on which two enterprises have been deemed to be AEs (In total 13 parameters, that have been summarised below). These include:

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

b. Advancing a loan by an enterprise that constitutes 51% or more of the total book value of the 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, existence of any prescribed relationship of mutual interest (none prescribed till date). Further, a Permanent Establishment (“PE”) of a foreign enterprise also qualifies as an AE. Accordingly, transactions between a foreign enterprise and its Indian PE are covered within the ambit of this code.

Arm’s Length Price:

Section 92F of the Act, defines Arm’s Length Price as the price that is applied or is proposed to be applied to transactions between persons other than AEs in uncontrolled conditions. Such price is determined by using the most appropriate method out of the following prescribed methods, The ‘Most Appropriate Method’ is that method which, under the facts and circumstances of the transaction under review, provides the most reliable measure of an arm’s length result:

1. Comparable Uncontrolled Price Method (CUP): The CUP compares the price charged for property or services transferred in Controlled Transaction to the price charged in Comparable Uncontrolled Transaction in comparable circumstances. When it is possible to identify comparable transactions , CUP is the most direct and reliable way to apply the Arm’s Length Principle. The CUP requires high degree of comparability of products and functions.

2. Resale Price Method (RPM): The price at which property purchased or services obtained by the enterprise from an AE is resold or are provided to an unrelated enterprise, is identified. Such resale price is reduced by the amount of a normal gross profit margin accruing to the enterprise or to an unrelated enterprise from the purchase and resale of the same or similar property or from obtaining and providing the same or similar services, in a comparable uncontrolled transaction, or a number of such transactions. The price so arrived at is further reduced by the expenses incurred by the enterprise in connection with the purchase of property or obtaining of services. The price so arrived at is adjusted to take into account the functional and other differences, including differences in accounting practices, if any, between the international transaction and the comparable uncontrolled transactions, or between the enterprises entering into such transactions, which could materially affect the amount of gross profit margin in the open market;

3. Cost Plus Method (CPM): The CPM determines Arm’s Length price by adding an appropriate mark-up to the costs. The CPM begins with the costs (direct as well as indirect) incurred by the supplier of property or services in a Controlled Transaction. An appropriate cost plus mark-up (being a Gross Margin) is then added to this cost so that the related suppler makes an appropriate profit in light of the functions performed and the market conditions. The amount thus arrived is treated as an Arm’s length Price for the original controlled transaction.

4. Transactional Net Margin Method (TNMM): The net profit margin realized by the enterprise from an international transaction entered into with an AE is computed in relation to costs incurred or sales effected or assets employed or to be employed by the enterprise or having regard to any other relevant base. The net profit margin realized by the enterprise or by an unrelated enterprise from a comparable uncontrolled transaction or a number of such transactions is computed having regard to the same base. The net profit margin referred to in sub-clause (ii) arising in comparable uncontrolled transactions is adjusted to take into account the differences, if any, between the international transaction and the comparable uncontrolled transactions, or between the enterprises entering into such transactions, which could materially affect the amount of net profit margin in the open market. The net profit margin realized by the enterprise and referred to in sub-clause (i) is established to be the same as the net profit margin referred to in sub-clause (iii) The net profit margin thus established is then taken into account to arrive at an ALP in relation to the international transaction.

5. Profit Split Method (PSM): The Indian Regulations define PSM, which may be applicable mainly in international transactions involving transfer of unique intangibles or in multiple international transactions which are so interrelated that they cannot be evaluated separately for the purpose of determining the ALP of any one transaction, as follows:

i. the combined net profit of the AEs arising from the international transaction in which they are engaged, is determined;

ii. the relative contribution made by each of the AEs to the earning of such combined net profit, is then evaluated on the basis of the functions performed, assets employed or to be employed and risks assumed by each enterprise and on the basis of reliable external market data which indicates how such contribution would be evaluated by unrelated enterprises performing comparable functions in similar circumstances; 

iii. the combined net profit is then split amongst the enterprises in proportion to their relative contributions, as evaluated under sub-clause (ii);

iv. the profit thus apportioned to the assessee is taken into account to arrive at an ALP in relation to the international transaction:

Provided that the combined net profit referred to in sub-clause (i) may, in the first instance, be partially allocated to each enterprise so as to provide it with a basic return appropriate for the type of international transaction in which it is engaged, with reference to market returns achieved for similar types of transactions by independent enterprises, and thereafter, the residual net profit remaining after such allocation may be split amongst the enterprises in proportion to their relative contribution in the manner specified under sub-clauses (ii) and (iii), and in such a case the aggregate of the net profit allocated to the enterprise in the first instance together with the residual net profit apportioned to that enterprise on the basis of its relative contribution shall be taken to be the net profit arising to that enterprise from the international transaction.

6. Other Method: For the purpose of computation of ALP, apart from the five methods described above, the CBDT has prescribed sixth method i.e. “Other method” for determination of ALP. The other method for determination of the ALP in relation to an international transaction shall be any method which takes into account the price which has been charged or paid, or would have been charged or paid, for the same or similar uncontrolled transaction, with or between non-associated enterprises, under similar circumstances, considering all the relevant facts.

The Regulations provide no priority of methods. Rather, the selection of the pricing method to be used to test the arm’s length character of a controlled transaction must be made under the ‘Most Appropriate Method Rule’. The ‘Most Appropriate Method’ is that method which, under the facts and circumstances of the transaction under review, provides the most reliable measure of an arm’s length result.

The Regulations require a taxpayer to determine an arm’s length “price” for all international transactions. It further provides that where more than one ALP may be determined by applying the most appropriate Transfer Pricing method, the arithmetic mean of such prices shall be the ALP of the international transaction. Accordingly, the Indian Regulation does not recognize the concept of “arm’s length range”, but requires the determination of a single arm’s length “price”. However, some flexibility has been given to taxpayers in case the arithmetic mean of uncontrolled prices falls within (+/-) 3% range around the actual transaction price.

In determining the reliability of a method, the two most important factors to be taken into account are

• the degree of comparability between the controlled and uncontrolled transactions; and
• The coverage and reliability of the available data. As per the Indian Regulations, other factors such as nature and class of international transactions, conditions prevailing in the markets, extent and reliability of adjustments that can be made, and extent and reliability of assumptions that may be required in applying the method, shall also be taken into account.

Range concept

As per the recent notification by the CBDT, range concept has been introduced to benchmark the transactions under consideration. The highlights of the new notification are as follows.

New rules applicable for transactions entered on or after 1 April 2014 or in short, since FY 2014-15:

• To determine Arm’s length price (ALP), data of current year in which the international transaction is entered, has to be considered.
• If such current year data is not available till the time of furnishing return of income, data relating to FY immediately preceding the current year to be considered.
• If data relating to current year is available at the time of assessment, then such data to be considered at the time of assessment.
• If similar uncontrolled conditions existed and similar transactions prevailed with the comparable companies in the earlier FY, then previous two FY data to be considered when current year information is available OR single preceding FY data to be considered when earlier year to current year information is considered. 
• All information considered above to be in uncontrolled conditions.
• Where more than one price is determined, the ALP would be weighted average considering multiple year data as mentioned above.
• Where more than or equal to six comparable are selected in a data set, an arm’s length range would be between the 35th and 65th percentile (considering data set in ascending order) 
• In case the international transaction falls outside such arm’s length range, the calculation of adjustment to be made from the 50th percentile.

Secondary Adjustment

The Indian Finance Act, 2017 introduced the secondary adjustment mechanism vide section 92CE in the Income-tax Act, 1961 (the Act). A secondary adjustment, which follows a primary adjustment (PA), seeks to reflect in the books of AEs such allocation of profits as is consistent with the transfer price determined in a primary adjustment. Secondary adjustments will be required in case of the following primary adjustments:

• Suo-moto adjustment offered by the taxpayer.
• Adjustment made by the Tax Officer (TO) and accepted by the taxpayer.
• Adjustment determined by an Advance Pricing Agreement (APA).
• Adjustment made as per Indian safe harbour rules.
• Adjustment arising as a result of a Mutual Agreement Procedure (MAP) resolution.

A primary adjustment is the difference between the transfer price determined based on the arm’s-length principle and the transfer price at which the transaction took place. This difference also represents the ‘excess money’ with the AE that is required to be repatriated to India. If such ‘excess money’ is not repatriated to India, it will be considered as an advance and interest will be computed thereon.

The time limit is 90 days for repatriation of excess money. In case the excess money is not repatriated within the time limit of 90 days, interest shall be computed—

• at the one-year marginal cost of fund lending rate of State Bank of India as on 1st of April of the relevant previous year plus three hundred twenty-five basis points in the cases where the international transaction is denominated in Indian rupee; or
• at six-month London Interbank Offered Rate as on 30th September of the relevant previous year plus, three hundred basis points in the cases where the international transaction is denominated in foreign currency.

The Indian Finance Act, 2019 introduced following amendments in the section 92CE of the Income-tax Act, 1961 (the Act):

1. where the amount of primary adjustment made to transfer price in any previous year does not exceed 1 crore, the clauses of sub-section (1) of Section 92CE of the Act are not applicable;
2. no refund of taxes paid, if any, by virtue of provisions of sub-section (1) of Section 92CE of the Act as they stood immediately before their amendment by the Finance (No. 2) Act, 2019 shall be claimed and allowed;
3. the excess money or part may be repatriated from any of the associated enterprises of the taxpayer which is not a resident in India.
4. the excess money or part thereof that has not been repatriated within the prescribed time, the taxpayer may, at his option, pay additional income-tax at the rate of eighteen per cent on such excess money or part thereof, as the case may be;
5. the tax on the excess money or part thereof so paid by the taxpayer under sub-section (2A) shall be treated as the final payment of tax in respect of the excess money or part thereof not repatriated and no further credit therefor shall be claimed by the taxpayer or by any other person in respect of the amount of tax so paid;
6. no deduction under any other provision of this Act shall be allowed to the taxpayer in respect of the amount on which tax has been paid in accordance with the provisions of sub-section (2A).
7. the additional income-tax referred to in sub-section (2A) paid by the taxpayer, the taxpayer shall not be required to make secondary adjustment under sub-section (1) and compute interest under sub-section (2) from the date of payment of such tax.

Advance pricing Agreements

With a view to address the large scale litigation in TP, the Government has introduced Advance Pricing Agreement (APA) in the Finance Act, 2012 with effect from July 1, 2012. An APA is an arrangement between the taxpayer and the tax authority made prior to actual transactions, with a view to solve potential taxation disputes in a cooperative manner. The taxpayer and tax authority mutually agree on the transfer pricing methodology to be applied over a certain future period of time.

An APA seeks to determine an appropriate set of criteria for the computation of the transfer price, which may include the TP method to be applied, characteristics of comparables to be used, adjustments to be made to the taxpayer’s results for a fair comparison with comparables, critical assumptions as to future events, etc. The Central Board of Direct Taxes (CBDT), with the approval of the central government, has been empowered to enter into an APA with any taxpayer undertaking international transactions to determine the arm’s length price or specifying the manner in which arm’s length price shall be determined.

The APA so entered shall be binding on the taxpayer and the tax authorities in respect of the transaction covered under the agreement. Such agreement shall be valid for a period not exceeding five years.

Safe harbour Rules

Following the best practices of International tax jurisdiction, the Indian Government introduced another dispute resolution mechanism in the form of Safe Harbour Rules(SHR) vide Finance Act 2009.

Section 92CB of the Income tax Act defines “Safe Harbour” as circumstances in which  the tax authority shall accept the transfer price declared by the taxpayer to be at arm’s length price. Rule 10TE of Income tax Rules, 1962 prescribes the relevant rates of Operating Margin to be maintained as Transfer Price.

Dispute Resolution Panel (DRP)

As per section 144C, the DRP under the Act is an alternate dispute resolution mechanism for resolving the disputes relating to Transfer Pricing. It is a collegium of three Commissioners of Income Tax constituted by CBDT. Section 144C comes into picture when the Assessing Officer proposes to make any variation in the income in the income or loss stated in the return filed by the assessee. An Assessee under section 144C refers to  Foreign company and/or any person in where the AO proposes to make any variation in the returned income or loss as a consequence of the order passed by the Transfer Pricing Officer under sub section (3) of  Section 92CA of the Act.

The DRP was formed with a view to provide  speedy and appropriate directions to the assessee at the first level of appeal itself. Thus, it has to complete the hearing and give its final directions within a period of 9 months. The directions given by the DRP are binding on the AO, however the said directions can be challenged before the Income Tax Appellate Tribunal, and then before HC, and Supreme Court

The Indian Finance Act, 2017 introduced the secondary adjustment mechanism vide section 92CE in the Act. A secondary adjustment, which follows a primary adjustment (PA), seeks to reflect in the books of AEs such allocation of profits as is consistent with the transfer price determined in a primary adjustment. Secondary adjustments will be required in case of the following primary adjustments:

• Suo-moto adjustment offered by the taxpayer.
• Adjustment made by the Tax Officer (TO) and accepted by the taxpayer.
• Adjustment determined by an Advance Pricing Agreement (APA).
• Adjustment made as per Indian safe harbour rules.
• Adjustment arising as a result of a Mutual Agreement Procedure (MAP) resolution.

A primary adjustment is the difference between the transfer price determined based on the arm’s-length principle and the transfer price at which the transaction took place. This difference also represents the ‘excess money’ with the AE that is required to be repatriated to India. If such ‘excess money’ is not repatriated to India, it will be considered as an advance and interest will be computed thereon.

The time limit is 90 days for repatriation of excess money. In case the excess money is not repatriated within the time limit of 90 days, interest shall be computed—

• at the one-year marginal cost of fund lending rate of State Bank of India as on 1st of April of the relevant previous year plus three hundred twenty-five basis points in the cases where the international transaction is denominated in Indian rupee; or
• at six-month London Interbank Offered Rate as on 30th September of the relevant previous year plus, three hundred basis points in the cases where the international transaction is denominated in foreign currency.

Thin Capitalisation

Section 94B has been inserted with effect from Assessment Year 2019-20 providing for limitation of deduction of interest in certain cases.

The Section applies if all the following conditions are satisfied:

1. There is an Indian company or a permanent establishment of a foreign company in India.
2. The specified entity is not engaged in business of banking or insurance.
3. The specified entity is a borrower.
4. The borrowing is in respect of any debt issued by a non-resident.
5. The non-resident lender is an associated enterprise of the specified entity or where the non-resident lender is not an associated enterprise, an associated enterprise of the specified entity has either provided an implicit or explicit guarantee to such lender or has deposited a corresponding and matching amount of funds with the lender.
6. The specified entity has incurred any expenditure by way of interest or of similar nature in respect of debt issued by a non-resident.
7. Such expenditure exceeds INR 1 Crore.
8. The Expenditure referred above is deductible in computing income chargeable under the head ‘Profits and Gains of Business of Profession’.

If the aforesaid conditions are satisfied, then:

a) Interest shall not be deductible in computation of income to the extent it arises from excess interest. For this purpose, excess interest means total interest paid or payable minus lower of:

• 30% of Earnings before interest, taxes, depreciation and amortization (EBITDA) of the specified entity; or
• Interest paid or payable to Associated Enterprise [Section 94B(2)]

b) Where for any Assessment Year the interest expenditure is not wholly deducted against income under the head ‘’Profits and Gains of Business or Profession’’, the interest to the extent it is not deducted shall be allowed as a deduction against the profits and gains of business or profession carried on by the specified entity and assessable for that year [Section 94B(4)]

c) The carried forward interest shall be allowable to the extent of maximum allowable interest expenditure under Section 94B(2)[Section 94B(4)]

d) The interest shall be carried forward for the maximum period of 8 assessment years immediately succeeding the assessment year for which the excess interest expenditure was first computed.

Documentation Requirements and Penal Provisions:

Documentation

Taxpayers are required to maintain the prescribed information and 3 – tier documentation as part of their transfer pricing documentation to demonstrate that the pricing policy complies with the arm’s length principle.

 BEPS Action plan 13 proposes the concept of  3- tier documentation which includes the following:

1. Master File (applicable for all companies in short form and in full form to companies about INR 500 crores with international transactions at INR 50 crores for tangible and INR 10 crores for intangible transactions)
2. Local File (applicable to all companies with international transactions)
3. Country-by-Country-Reporting (CbCR) (Applicability threshold at INR 6,400 crores)

Documentation should be kept and maintained for nine years from the end of the relevant tax year.

Comparable 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 FY in which the international transaction has been entered into. However, data relating to a period not being more than two years prior to such FY may also be considered if such data reveals facts which could have an influence on the determination of the transfer price in relation to the transactions being compared.

Accountant’s Report

It is mandatory to obtain an independent accountant’s report in respect of all international transactions between AEs and furnish the report within the due date of filing the income tax return. The form of the report has been prescribed. The report requires the accountant to give an opinion on the proper maintenance of prescribed documents and information by the taxpayer. Further, the accountant is required to certify the correctness of an extensive list of prescribed particulars.

The due date of furnishing Accountant’s Report has been amended to the date one month prior to the due date for furnishing the return on income under sub-section (1) of section 139 for the relevant assessment year.

Tax Penalties

The following penalties have been prescribed for default in compliance with the provisions of the transfer pricing code:

Sr. No.	Section	Nature of non-compliance	Penalty Amount
1	270A	Adjustment to taxpayer’s income on grounds of under-reporting and misreporting of income	50% of tax on unreported income and 200% of tax on misreported income
2	271AA	Failure to maintain prescribed information/ documents	2% of transaction value
3		Failure to furnish information/ documents during audit
4		Failure to report transactions
5	271BA	Failure to furnish accountant’s report	INR 100,000
6	271G	Failure to furnish prescribed information/ documents	2% of transaction value
7	271AA(2)	Failure to furnish Master File	INR 500,000