The Hindu Business Line : Transfer pricing circular endures legal scrutiny

The Delhi High Court upholds CBDT's Instruction No. 3 of 2003 advising departmental officers to take up cases wherever the aggregate value of transfer-pricing transactions exceeds Rs 5 crore.

Multinational corporations set up base by incorporating a local subsidiary in a country where they seek to operate. Quite often the MNC transfers goods and services to its local subsidiary at a price not reflective of the market price or the arm's length price, as it is referred to generally in tax laws. In turn, the subsidiary is able to avoid, at least partly, payment of income-tax in the host country.

The term `transfer price' is not defined in the income-tax law. It means "that price which is arrived at when two associated or related enterprises deal with each other". The presence of MNCs in India and their ability to allocate profits in different jurisdictions by controlling prices in intra-group transactions has made the issue of transfer pricing a matter of serious concern.

CBDT Instruction

The Finance Act, 2001 introduced Sections 92 to 92F in Chapter X of the Income-Tax Act. These sections deal with computation of income from international transactions having regard to the arm's length price of international transactions. The Finance Act, 2002 brought in Section 92 CA, providing for reference by the assessing officer (AO) to the transfer pricing officer (TPO) wherever he considered it necessary or expedient to do so.

The TPO is generally a senior officer of the I-T Department. Reference to the TPO requires the approval of the Commissioner of Income-Tax.

Since these provisions were new, the Central Board of Direct Taxes (CBDT) issued Instruction No. 3 on May 20, 2003, advising departmental officers to take up cases wherever the aggregate value of international transactions exceeded Rs 5 crore. The AO, the Board instructed, should pick up such cases for scrutiny and make a reference to the TPO.

Sony India case

Sony India (P) Ltd, a wholly-owned subsidiary of Sony Corporation of Japan, is engaged in the manufacture and distribution of electronic goods. It imports from Japan and other sister concerns high-end products such as DVDs, handy-cams, play stations, projectors, and so on, for sale in India.

For the assessment year 2002-03, the Indian subsidiary filed a return declaring an income of Rs 8,67,46,730. The AO referred the question of determining the arm's length price in respect of international transactions entered into by Sony to the TPO.

The TPO heard the matter and passed an advice determining the arm's length price of the international transactions of exports made by the subsidiary to the Japanese holding company. He recommended that the AO enhance the total income of Sony India (P) Ltd by Rs 42,41,40,934. The AO, in turn, heard the company and passed an assessment determining the income at Rs 59,92,40,000.

Sony India (P) Ltd, filed a writ petition in the Delhi High Court pointing out that Instruction No. 3 of 2003 issued by the CBDT was outside the powers of the CBDT. It classified international transactions on the basis of arbitrary figures of Rs 5 crore and made it obligatory to refer such cases to the TPO. To this extent the discretion of the AO was taken away.

The Delhi High Court examined the issues involved in detail in Sony India (P) Ltd vs CBDT (2006 157 Taxman 125 Delhi). It took the view that Instruction No. 3 did not fetter the discretion of the AO to refer the matter of computation of arm's length price to the TPO. The AO can use the powers to refer the matters to the TPO whenever necessary and expedient, and this required the formation of an opinion by the AO of the need to make a such a reference. He has to, prima facie, form an opinion.

Abundant safeguard is provided in the statute by ensuring hearing by the TPO and the AO. The CBDT instruction does not come in the way of the exercise of the judicial power. It provides an objective intelligible criterion for classifying cases in the initial stages of the transfer pricing law.

A guideline

The instruction being contrary to the statute does not arise. It acts as a guideline to the AO in the exercise of the discretion conferred by statute on the AO. It ensures that such discretion will not be abused. Even transactions of the value of less than Rs 5 crore can be referred to the TPO if the facts warrant. The Instruction is aimed at enhancing the efficiency of the AO in the initial years of the operation of the TP law. The CBDT may periodically review the impact of the instruction on the functioning of the AO and can review such instruction from time to time. In due course a database of decisions by TPOs may be made available to the AOs so as to act as a useful guide in the determination of arm's length price.

The Delhi High Court went into the impact of the new law and upheld the validity of the CBDT circular. This is the first major ruling of any High Court on the operation of the TP law. An analysis of the judgment will provide vital clues to the interpretation of the TP law.

(The author is a former Chief Commissioner of Income-Tax.)

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