The Hindu Business Line : Arms of entanglement

TALKING of taxes, it has been said: "The trick is to stop thinking of it as `your' money." Assessees to whom Sections 92-92F of the Income-Tax Act — transfer pricing in its popular form — apply must certainly be agreeing with the above quote. Reports state that there have been additions galore on the transfer pricing front with the actual reasons for the additions being hazy.

The classic formula — getting a study of comparative companies in the same industry and pegging the rate after accounting for risk factors specific to the company — does not seem to be a success in many cases.

The buoyancy in the economy has not assisted much with rates such as cost plus 12 per cent also being questioned as erroneous in many cases. The most affected appear to have been the software companies wherein taxes along with penalties have been issued liberally.

Transfer pricing rules made their entry in the UK through Schedule 28AA of the Taxes Act, 1988 emphasising the arm's length principle. After 16 years, the Finance Act, 2004 has proposed that the transfer pricing rules should also apply to intra-UK transactions instead of being restricted to cross-border transactions with effect from April 1, 2004.

The provisions require an uplift of the taxable profits of a UK enterprise if they have been understated as a result of it having made an overpayment to, or received an underpayment from, a related party. The payment is considered `over' or `under' if it is greater than or less than the hypothetical price that would have been paid had the parties been unrelated — the arm's length price.

The popular opinion in the UK is that the legislation has been deliberately worded to ensure that almost any interaction is caught. Taxpayers must, therefore, consider not only transactions that they have recognised as being transactions but in fact anything from which one of the parties has derived a benefit from the other party for which they would have expected the other party to make a payment if that other party had not been related to them.

For example, if Company A and Company B are related parties, Company A should be charging Company B for things such as i) use of A's offices; ii) the time A's finance staff spend looking after B's accounts; iii) interest on a long dormant inter-account balance; iv) use of A's brand name; and v) guaranteeing B's bank loans. It would appear that the only transactions that would not apply would be plain-vanilla share capital investments and the payments of dividends thereon.

It is popularly felt that the transfer pricing rules apply to companies and partnerships. However, the rules as drafted in the UK would appear to apply to other legal persons such as individuals and trusts if they are related to a company or partnership.

For instance, an individual who owns a company would be hit by the provisions in relation to the transactions between him and the company.

Two companies could be said to be interrelated if one controls the other — control arising if voting power of more than 50 per cent rests with a person or a group of persons.

A popular example given is that if X owns 30 per cent of a company and his father, wife and a family trust 10 per cent each, there would be no doubt that X controls the company since his aggregate holding would tot up to 60 per cent.

However, in what is considered to be a good move, small companies in the UK go out of the scope of the tax. Small is defined to mean: Enterprise having less than 250 employees; turnover not be more than 50 million euros; assets not be more than 43 million euros.

As in India, the transfer pricing rules in the UK provide for stiff penalties. The latest provisions propose a suspension of the penalties on transfer pricing for a period of two years but only for failure to keep proper records.

Taxpayers who cannot show that they gave appropriate consideration to these rules remain exposed to negligence penalties of up to 100 per cent of any tax adjustment.

Transfer pricing rules in India appear to have got entangled in the "arm's length price" and the resultant penalties. However the "5 per cent band" given should keep companies safe from being visited with the penalty provisions. It would appear to be a matter of time before the small company exemption rule is introduced in India also.

(The author is a Hyderabad-based chartered accountant.)

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