Transfer Pricing Study [bestcomputersprices.blogspot.com]

Transfer Pricing Study [bestcomputersprices.blogspot.com]

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Indian Transfer Pricing Laws

In an era of liberalization and globalization of trade and investment and the emergence of e-commerce, the perceptible results have been increase in the number of cross-border transactions, the complexity, speed and lack of transparency with which global business can be transacted. There is a general belief that multi-national corporations, in an effort to manage and minimize their global tax outflow, have employed creative transfer pricing approaches in the context of flow of goods, services, funds, intangibles etc.

When transactions are entered into between independent enterprises, the consideration therefore is determined by market forces. However, when associated enterprises deal with each other, it is possible that the commercial and financial aspects of transactions are not influenced by external market forces but are determined based on internal forces. In such a situation, when the transfer pricing agreed between the ass ociated enterprises does not reflect market forces and arm's length principle, the profit arising from the transactions, the consequent tax liabilities of the associated enterprises and the tax revenue of the host countries could be distorted.

The existence of different tax rates and rules in different countries offers a potential incentive to multinational enterprises to manipulate their transfer prices to recognize lower profit in countries with higher tax rate and vice versa. This can reduce the aggregate tax payable by multinational groups and increase the after tax returns available for distribution to shareholders.

In India, the Act had hitherto not dealt with this problem in a detailed manner. The erstwhile section 92 sought to determine the amount of profits which may reasonably be deemed to have been derived from a business carried on between a resident and a non-resident which, owing to the close connection between them is so arranged that it produced, to the resident, either no profits or less than the ordinary profits which might be expected to arise in that business.

The Finance Act ,2001 introduced transfer-pricing regulation (TPR) in India with effect from 1st April 2001 corresponding to the assessment year 2002-03.The section 92 to 92F and rule 10A to 10E and sections 271(1)(c),271 AA, 271 BA and 271 G. Certain amendments were made in Transfer Pricing regulations corresponding to assessment year 2003-04. The exercise of amendment is carried out to remove inconsistencies, administrative problem and inconvenience besides widening the tax base.

In line with the international income, the Finance Act, 2001 introduced transfer pricing provisions in the income Tax Act,1961 under chapter X and sections 92 to 92F. The new TP provisions deviate very little from the one by the Organization for Economic Co-operation and Development (OECD) in their report on Transfer pricing and Multinational Enterprises.

Sectio n 92 of Finance Act,2002 provides that any income arising from an international transaction or where the international transaction comprise of only an outgoing, the allowance for such expenses or interest arising from the international transaction shall be determined having regard to the arm's length price. The provisions, however, would not be applicable in a case where the application of arm's length price results in decrease in the overall tax incidence in India in respect of the parties involved in the international transaction.

The term "associated enterprise" is defined in section 92A of the act. According to sub-section (1), an enterprise which participates directly or indirectly or through one or more intermediaries, in the management or control or capital of the other enterprise shall be regarded as an associated enterprise.

Similarly, an enterprise in respect of which one or more persons who participate in management or control or capital, directly or i ndirectly through one or more intermediaries are the same persons who participate in a similar manner in the management or control or capital of the other enterprise shall be regarded as an associated enterprise.

ASSOCIATED ENTERPRISES

MANAGEMENT :- Appointment of more than half of the Board of directors/ Board of Members/ One or

more Executive Directors/ Executive Members by :

- The other enterprise

- The same person in both the enterprises.

CAPITAL :- Holding not less than 26% of the Voting power directly or indirectly

- In the other enterprise - In each of such enterprises.

CONTROL :- - Loan>= 51% of book value of total assets - Guarantees>= 10% of total borrowings - Use of know how, patents - Purchase of >= 90% of Raw Materials under controlled conditions - Control by same person - Sale to or under instruction or direction of the controlling party

International Transaction

T he term 'transaction' has been defined in clause (v) of section 92F as under:- "(v) Transaction includes an arrangement, understanding or action in concert ;

(i) Whether or not such arrangement, understanding or action is formal or in writing; or

(ii) Whether or not such arrangement, understanding or action is intended to be enforceable by legal

proceedings."

The definition is an inclusive definition and therefore wider in its scope. As per this definition, a transaction includes any arrangement, understanding or action, whether formal or informal, whether oral or in writing, whether legally enforceable or not.

The definition of international transaction under the transfer pricing regulation is very wide and in its scope it includes transaction in the nature of :

i. Purchase, sale or lease of tangible or intangible property; or ii. Provision of services; or iii. Lending or borrowing of money; or iv. Any other transaction ha ving a bearing on the profits, income, losses or assets of such enterprises.

It shall also include a mutual agreement or arrangement between two or more associated enterprises for the allocation or apportionment of, or any contribution to, any cost or expenses incurred or to be incurred in connection with a benefit, service, facility provided or to be provided to any one or more such enterprises.

Any transaction between an enterprise and a person other than an associated enterprise will be deemed to be a transaction with an associated enterprise as per sub-section (2) of section 92B under certain situations. This deeming provision is intended to cover cases where an independent third party can be interpreted by two associated enterprises to remain out of the transfer pricing provisions of the Act.

According to sub-section (2) of section 92B, a transaction between an enterprise and an unrelated person shall be deemed to be a transaction between associated en terprises if in relation to that transaction-

i. There exists a prior agreement between such other person and the associated enterprise; or ii. The terms of the relevant transaction are determined in substance between such unrelated person and the associated enterprise.

Difference between International and Cross Border Transaction:

For a transaction to be an international transaction, it should satisfy the following two conditions cumulatively:

a) It must be a transaction between two associated enterprises; and b) At least one of the two enterprises must be a non-resident.

A transaction is considered to be a cross border transaction if it originates in one country and get concluded in another country. A cross-border transaction may or may not be an international transaction within meaning of Chapter X of the Act. Similarly, a transaction which is not a cross-border transaction may still be an international transaction for the purpose of the said chapter if it falls within the ambit of the definition of "International transaction".

Arm's length price:

In commercial parlance, an arm's length price is the price at which independent enterprises deal with each other, where the conditions of their commercial and financial relations ordinarily are determined by market forces. Section 92F(ii) of the Act, however, defines the arm's length price as a price which is applied or proposed to be applied in a transaction between persons other than associated enterprises, in uncontrolled conditions.

The steps involved in the determination of the arm's length price can be summarized as follows:

i. Identification of the "international transaction"; ii. Identification of an "uncontrolled transaction"-Rule 10A(a); iii. Identification and comparison of specific characteristics embodied in international transactions and uncontrolled transactions - Rule 10B(2); iv. Finding out whether uncontroll ed transactions and international transactions can be compared by reconciling/resolving differences, if any- Rule 10B(3); v. Ascertaining the most appropriate method by applying the tests lay down- Rule 10C; vi. Determination of the arm's length price by applying the method chosen- Rule 10B (1).

Uncontrolled Transaction:

Rule 10A (a) defines an "uncontrolled transaction" to mean "a transaction between enterprises other than associated enterprises, whether resident or non-resident". In other words, these are "transactions between enterprises that are independent enterprises with respect to each other". An uncontrolled transaction can, therefore, be between:

A resident and a non-resident; or A resident and a resident; or A non-resident and a non-resident.

When an uncontrolled transaction has been entered into , it could be said that it has been contracted in an " uncontrolled condition".

Transfer Pricing Study in India

Metho ds of Computation of Arm's Length Price:

The various methods of computation of arm's length price are prescribed in Rule 10B. For this purpose certain term are defined in Rule 10A as under:

For the purposes of this rule and Rules 10B to 10E,-

a) 'Uncontrolled transaction' means a transaction between enterprises other than associated enterprises, whether resident or non-resident; b) 'Property' includes goods, articles or things, and intangible property; c) 'Service' includes financial services; d) 'Transaction' includes a number of closely linked transactions.

Rule 10B stipulates the methods of determination of arm's length price. For same explanation is given below:

Comparable Uncontrolled Price(CUP) Method:

The comparable uncontrolled price method is considered as one of the traditional method of determining the arm's length price.

The other traditional two methods are the Resale Price Method and the Cost Plus Method.

Typical transactions in respect of which the comparable uncontrolled price method may be adopted are:

a) Transfer of goods; b) Innovation of services; c) Intangibles; d) Loan, provision of finance.

The OECD in its Transfer Pricing Guidelines observes as under:

"This method is particularly good where an independent enterprises sells the same product or service as is sold between two associated enterprises".

" The uncontrolled transactions should reflect goods of a similar type, quality and quantity as those between the associated enterprises, and relate to transactions taking place at a similar time and stage in the production/distribution chain, with similar condition applying."

The steps involved in the application of this method are:

1. Identify the price charged or paid for property transferred or services provided in comparable uncontrolled

transaction or a number of such transactions;

2. Adjust such price t o account for the differences if any, between the international transaction and the

comparable uncontrolled transaction or between enterprises entering into such transaction which could

materially affect the price in the open market;

3. The adjusted price is taken to be the arm's length price;

4. The arm's length price is compared with the price changed in the international transaction;

5. If the price charged in the international transaction is lower than the arm's length price or the price paid in the

international transaction is higher than the arm's length price then an adjustment is to be made to the price

charged or paid in the international transaction by the amount of such variance.

The following points are to be noticed:

1. All adjustments in the course of applying this method are to be made to the price charged in the uncontrolled

transaction. The presence or absence of any specific features in the uncontr olled transaction as compared to

the international transaction need to be adjusted for. These features are to be evaluated in mathematical terms

or absolute numbers. This is a subjective process based on objective facts.

2. Only differences that would materially affect the price in the open market are required to be adjusted. The

term 'materiality' is not defined. Therefore, materiality would have to be judged in the light of various

circumstances attaching to transaction. However, if there are numerous adjustments, which individually

appear not material but collectively appears to be material, the same would require to be adjusted.

3. If there are number of uncontrolled transactions which are comparable, this method would have to applied to

a reasonable number of transactions. An adjustment will have to be made to the price charged or paid in such

uncontrolled transactions.

4. It would not be possible to select onl y one or few of the uncontrolled transactions for adjustment depending

on the convenience of the parties.

5. If after the adjustment to the uncontrolled transactions, a range of figures are available, an arithmetical

average of such range of figures will have to be arrived at and adopted as the arm's length price.

6. The adjusted price of the uncontrolled transaction will have to applied to the international transaction. The

total income offered for tax by the assesse's will have to be correspondingly adjusted.

7. The term ' open market', though not defined , would mean a transaction between a knowledgeable and a

willing purchaser and a knowledgeable and willing seller where neither of them is influenced or compelled

to act in particular manner.

8. It may be noted that averaging is permissible only if a range of arm's length price have been arrived at under

any one particular methods.

Resale Price Method(RPM):

Transaction where the resale price method may be adopted are distribution of finished products or other goods involving no or little value addition.

The OECD in its Transfer Pricing Guidelines has observed as under : "It is generally accepted amongst most tax authorities that the Resale Price method is applicable and preferable where the entity performs basic sales, marketing and distribution functions. (i.e. where there is a little or no value added by the reseller prior to the resale of goods required from related parties). The method is applicable even with differences in products, as long as the functions performed are similar. It is less useful where goods are further processed or incorporated into other products."

The steps involved in the application of the method are:

1. Identify the international transaction of purchase of property or services;

2. Identify the price at which such property or services are resold or provided to an unrela ted party;

3. Deduct the normal gross profit margin derived by the enterprise from the resale price of such property or

services. The normal gross profit margin is that margin which the enterprise would earn from purchase of the

similar product from an unrelated party and the resale of the same to another unrelated party.

4. Deduct also expenses incurred in connection with the purchase of goods from the price so arrived;

5. Adjust the prices so computed for the differences between the uncontrolled transaction and the international

transaction. These differences could be functional and other differences including differences in accounting

practices. Further these differences should be such as would materially affect the amount of gross profit

margin in the open market;

6. The adjusted price arrived at the arm's length price for the property purchased or service obtained;

7. Substitute the arm's length price for the p rice charged in the international transaction and make adjustments

to the income returned accordingly.

Note:- In steps (ii) and (iii) above only internal comparables are mentioned. An enterprise can also use external comparable and do the computation.

The following points are to be noticed:

1. The resale price method is to be adopted only when goods purchased from an associated enterprises are

resold to unrelated parties. For sales made to an associated enterprise, this method would be inapplicable. For

the sales made to an associated enterprise, the Comparable Uncontrolled Price Method or any other

appropriate method may be adopted. Thus two different methods may be applicable for transactions that

together may constitute an integral part of a business activity;

2. The gross profit margin to be reduced may be either- a) That which accrued to the enterprise from the sale of same or similar property in an uncontrolled transaction; or b) That which accrued to an unrelated enterprise from sale of same or similar property in an uncontrolled transaction.

3. The reference is to the gross profit margin derived from sale of same or similar property. The reference is

thus not to the overall gross profit margin but to the gross profit margin from individual transactions. It may

be difficult to identify and arrive at the gross profit margin from individual transactions;

4. One has to arrive at the normal gross profit margin. There may be situations where multiple normal gross

profit arise from comparable uncontrolled transactions. In such case, the correct procedure would be to apply

each of such gross profit margins on the international transaction and arrive at arm's length purchase price.

The arithmetical mean of purchase prices so arrived would be the arm's length price.

5. The rule contemplates the gross profit margin of either the transactio n entered into by the enterprise or of an

unrelated enterprise in uncontrolled transactions. If there is a variation in the gross profit margin of these

enterprise , the gross profit margin of the enterprise is to be preferred, being an internal comparable;

6. The expenses incurred by the enterprise in connection with the purchase of the property are to be further

reduced. The gross profit margin may have been arrived at after taking into account such expenses. The

purpose of this method is to arrive at the arm's length price of the purchases. In this method, this purchase

price is arrived at by beginning from the resale price and reducing there from the normal gross profit margin

as the first step. If the arm's length price of the purchase is arrived at by stopping at this step itself, the

resulting figure would be inclusive of the expenses incurred by the enterprise which have been taken into

account in arriving at the gross profit. It is therefore necessary to arrive at the correct arm's length price to

further reduce such expenses.

7. Adjustments have to be made also for accounting practices apart from functional and other differences. Some

of the differences in accounting practices may be because:

a) Sales and purchases have been accounted for inclusive of taxes or exclusive of taxes; b) Method of pricing the goods namely, FOB or CIF; c) Fluctuations in foreign exchange.

8. As a general rule, it is expected that the gross profit margin would increase with increased risks, functions

and assets.

Cost Plus Method (CPM):

Transactions where the cost plus method may be adopted are:

a) Provision of services; b) Joint facility arrangements; c) Transfer of semi finished goods; d) Long term buying and selling arrangements.

The OECD in its Transfer Pricing Guidelines states as follows:

"This method is particularl y useful where semi-finished goods are sold between associates, where there are long term buy and supply arrangements, or in the case of the provisions of the services or contract manufacturing, particularly where these are of a subsidiary or peripheral nature".

The steps involved in the application of this method are :

1. Determine the direct and indirect cost of production in respect of property transferred or service provided to an associated enterprises.

2. Identify a comparable uncontrolled transaction or a series of transactions with an unrelated party for same or similar property or service.

3. Determine gross profit mark-up in the comparable uncontrolled transaction.

4. Adjust the gross profit mark-up to account for functional and other differences between the international transaction and comparable uncontrolled transaction.

5. The direct and indirect cost of production in the international transaction is to be increased by such a djusted gross profit mark-up.

6. The resultant figure is the arm's length price;

7. The actual price charged in the international transaction is to be compared with the arm's length price and adjustment made to the income accordingly.

The following points are to be noticed:

1. In this method, the direct and indirect cost of production are to be identified. The term 'direct' or 'indirect' costs are however not defined. A reference may therefore be made to the industry practice as well as the pronouncements of the ICAI for an industry. Any deviation made by the enterprise as compared to the industry practice or the pronouncement of the ICAI will have to be justified.

2. In identifying and adopting the direct and indirect cost , the following factors would also have to be borne in mind:

a) Utilization of the plant; for example, if plant has been under utilized the method of adsorbing fixed costs may have to be suitably adjusted;

b) Meth od of absorbing costs; absorption costing method is normally to be preferred.

c) In abnormal situations, marginal-costing principles have to be applied; for example, substantial degree of under utilization of plant facilities. Thus incremental costing or marginal costing can be used as a basis if the transactions represent a disposal of marginal functions.

3. This method is to be adopted only in cases of supply of property or services to an associated enterprise.

This method is not to be applied when the enterprise is in receipt of property or services from an

associated enterprise.

4. Even under this method, the gross profit mark-up is to be adjusted for differences in accounting norms

adopted by enterprise.

5. In identifying the comparable, one should depend more upon the similarities of functions performed

and less on the product or service similarities.

Profit Split Method (PSM) :

Transactions where the profit-s plit method may be used are transactions involving:

a) Integrated services provided by more than one enterprise; b) Transfer of unique intangibles; c) Multiple inter-related transactions, which can not be separately evaluated.

The observation of the OECD , in its Transfer Pricing Guidelines, on this method are as follows:

" This method aims to determine what division of total profits independent enterprise would expect in relation to the relevant transactions. The profits should be split on an economically valid basis that reflects the functions and risk of each of the parties. In order to apply this method, it is necessary to identify the total profit arising from the related party transactions and split that profit between the parties according to their respective contributions."

The steps involved in the application of this method are to :

1. Determine the combined net profit of all associated enterprises engaged in the international transactions; 2. Evaluate relative contribution made by each of them with regards to: a) Function performed; b) Assets employed; c) Risk assumed; d) Reliable external market data indicating how such contribution would be evaluated.

3. Split the combined net profit in proportion to the relative net contribution. 4. The profit so apportioned is taken to arrive at arm's length price in relation to the international transaction.

A two-tier allocation may also be adopted as follows:

i. Partial allocation of the net profit to each enterprise so as to provide it with a basic return appropriate to the type of the international transaction entered into; ii. The remainder of the net profit to be allocated on the basis of the evaluation of the relative contribution made and iii. The total net profit from such a two-term allocation is taken to arrive at the arm's length price in relation to the international transaction.

The follo wing points are to be noticed :

1. It is the profit from a transaction with the associated enterprise that needs to be ascertained. If there are other transactions, which contribute to the profits, then the profits from transactions with associated enterprise may have to be arrived at on some approximation.

2. The rule itself provides an alternative method to arrive at the arm's length price being the two-tier profit split method;

3. If in either of the alternatives, a range of figures is available , the arithmetical mean of such figures may be adopted as the arm's length price. It may however not be possible to adopt the arithmetical mean of the two alternatives.

4. Under the two-tier split-method, the basic rate of return may have to be adopted having regard to the profits compared to the net worth of the enterprise. Such rate of return may not be uniform for all associated enterprises involved in the transaction.

5. This is the only method fo r which the Rule itself has prescribed the types of transaction to which it may be applicable.

6. Even though the computation proceeds with the profits from a transaction, the purpose is only to arrive at the arm's length price of a transaction. It is only by substituting the arm's length price for the price in the international transaction that an adjustment may be made to the income returned.

Transactional Net Margin Method (TNM) :

Transaction where the transactional net margin method may be used are:

a) Provision of services; b) Distribution of finished products where resale price method cannot be adequately applied; c) Transfer of semi finished goods.

The steps involved in the application of this method are:

1. Identify the net margin realized by the enterprise from an International Transaction. The net profit margin may be computed in relation to costs incurred or sales effected or assets employed or any other relevant base;

2. Identify the net profit margin from a comparable uncontrolled transaction or a number of such transactions having regard to the same base;

3. The net profit margin so identified is adjusted to take into account the differences if any between the international transaction and the comparable uncontrolled transaction. The difference should be those that could materially affect the net profit margin in the open market;

4. The adjusted net profit margin is taken into account to arrive at the arm's length price in relation to the international transaction.

The following points are to be noticed in the application of the transactional net margin method:

Difference bases of arriving at the net profit are recognized. The same basis of arriving at the net profit margin is to adopted year after year, unless circumstances justify an alternate base being adopted. This would ensure consistency and hence comparability would become meaningful;

Whichever base is selected in determining the net profit margin in an international transaction, the same basis is to be adopted for arriving at net profit margin in comparable uncontrolled transaction;

The net profit is not a derivative of the product/ service alone, but a derivative of various processes, namely, nature of market, cost practices, the price of intangibles etc. Hence it would be very essential that appropriate comparables are identified for this method.

Net profit , for example, can be influenced by a number of factors a few of which could be:

v Threat of new entrants v Management efficiency v Individual strategies v Cost of capital v Business Experience v Obsolescence due to change in demand/ technology v Method of depreciation

The selection of the comparable transaction therefore become very crucial, and consistency is critical;

The accounting treatment of expenses and depreciation is also critical factor in find ing a comparable. Unlike the preceding method, the rule does not explicitly provide for adjustment on account of differing accounting practices. Nevertheless, such differing practices would have to be factored in;

Some of the ratios that can be used for determining the arm's length price under the method are;

v Ratio of net profit before tax to sales v Ratio of net profit before interest & tax to sales v Ratio of cash profit to sales v Ratio of net profit before tax to shareholders' funds v Ratio of net profit before interest & tax to assets v Berry ratio - ratio of operating cost to operating revenue.

Most Appropriate Method:

1. For the purposes of sub-section (1) of section 92C, the most appropriate method shall be the method which is best

suited to the facts and circumstances of each particular international transaction, and which provides the most reliable

measure of an arm's length price in relation to the international transaction.

2. In selecting the most appropriate method as specified in sub-rule (1), the following factors shall be taken into account,

namely :-

v the nature and class of the international transaction ;

v the class or classes of associated enterprises entering into the transaction and the functions performed by them taking into account assets employed or to be employed and risks assumed by such enterprises;

v the availability, coverage and reliability of data necessary for application of the method; the degree of comparability existing between the international transaction and the uncontrolled transaction and between the enterprises entering into such transactions;

v the extent to which reliable and accurate adjustments can be made to account for differences, if any, between the

international transaction and the comparable uncontrolled transaction or between the enterprises entering into

such transactions;

< p>v the nature, extent and reliability of assumptions required to be made in application of a method. [Rule 10C]

Documentation: Section 92D provides that every person who has undertaken an international taxation shall keep and maintain such information and documents as specified by rules made by Board.

Further, Section 92E provides that every person who has entered into an international transaction during a previous year shall obtain a report from an accountant and furnish such report on or before the specified date in the prescribed form and manner.

More Transfer Pricing Study Issues

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Answer by DeMeNtoR
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