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Transfer pricing -- Preserving the golden egg-laying goose

R.Parthasarathy

THE FINANCE Bill 2001-02 has introduced detailed provisions for transfer pricing legislation based on the recommendations of an expert committee set up by the Government to examine the issue in the light of prevailing international practices.

This is a relatively new subject for the income-tax authorities, although Section 92 of the Income-Tax Act empowers the assessing officer to determine the taxable profits of the resident company, if, as a result of close connection between a resident and non-resident company, the course of business is so arranged that it shows no or less than ordinary profits with the resident company. Section 92, which addresses the issue of transfer pricing has remained unchanged since the 1922 Act. However, the conce pt of transfer is determined by the `arm's length transaction' principle, whereby the monetary compensation is supposed to have taken place without special consideration as among related parties. It is usually the basis of determining the fairness of the transaction and the financial arrangement.

The principle of the `arm's length' transaction, however, finds mention in Section 9(1)(i) dealing with business connection, and Section 80IA dealing with close connection between two entities and `more than ordinary profits'. Section 93 also deals with the avoidance of I-T by transactions resulting in the transfer of income to non-residents. But these are provisions in the Act dealing with specific situations of limited nature and cannot take the place of comprehensive regulations to deal with a whole gamut of transfer pricing activities.

International taxation

With globalisation, the subject assumes great significance and urgency if India does not want to lose its share of revenue from international transactions covering not only goods and services, but also intangibles such as brands, patents, trademarks and the capital gains on them. International taxation, in particular of MNCs, is becoming a specialised field. Last year, the I-T Department raised fresh tax demands on the MNCs, mainly telecom majors, for Rs 1,114 crore. On transfer pricing the demand raise d was nearly Rs 5 crore.

For instance, the transfer pricing issue came up in the case of the medical equipment company, Picker India Ltd, British Telecom's Indian branch and Bentley Venture One LLC. In the case of Picker India Ltd, a subsidiary of Picker International, the Depar tment found that the commission received by the Indian entity was not on the basis of the arm's length principle. Also, the gross profit on the goods purchased from the parent company was about 50 per cent less than the gross profit on goods purchased fr om third parties. Moreover, it was found that BT Worldwide was not showing any income from BT Plc for services rendered in India.

BT Worldwide revised the return and paid about Rs 1 crore as tax, based on a cost plus formula. It was subsequently found that the `arm's length' principle was not adopted. Bentley Venture One LLC also fell in a similar category. These cases illustrate t he occurrence of transfer pricing cases with significant revenue implications.

At the same time, as a developing country, India should administer the transfer pricing mechanism with fairness and based on facts, without the subjective interpretations that might discourage foreign investors. This test becomes crucial since the field is relatively new for tax administration in India. Proper training of officers and exposure to the way the provision is administered in developed countries, which have more experience, are essential. International accounting and legal firms have consider able experience in this subject by virtue of their practice in different tax jurisdictions. Indian tax law firms too have to acquire expertise in this field.

New regulations

Transfer pricing means the value or price of goods and services, tangible and intangible properties, arrived at between, or, by two taxable entities being related parties or closely-held companies in the course of their inter se transactions involving tr ansfer of such goods or rendering of services across different tax jurisdictions worldwide where the ``related entities'' may be located. The accounting and allocation of costs may be so manipulated as to shift the profit and tax base of the host country such that it might confer undue benefit to the non-resident associate, to the detriment of the host country's revenue.

Historically, MNCs conducted their operations through self-sufficient subsidiaries. With increasing interlinkages in global manufacturing, outsourcing and marketing, the MNCs look at possibilities of optimising their global profits. Transfer pricing prov isions, while not interfering with such business arrangements, are there to ensure that the legitimate revenue share of the host nation is not eroded. Thus, these provisions need to be administered with care and fairness.

Section 92 of the IT Act has been amplified to include any conceivable arrangement or transaction between a local and a foreign company for the latter to be considered an ``associated enterprise''. The definition encompasses control over the management o f the enterprise, the shareholding in the enterprise by the other enterprise not being less than 26 per cent of voting power, loans extended being not less than 51 per cent of the book value of the total assets of the other enterprise, 90 per cent or mor e of the raw material and consumables required for manufacture being supplied by the other enterprise, goods manufactured by one enterprise sold to the other, more than half the members of the board of one enterprise appointed by the other enterprise, an d so on.

Similarly, what constitutes an international transaction has also been widely defined to cover both financial and physical transactions of all conceivable type. Having defined the scope extensively, the relevant Section proceeds to lay down the methodolo gies.

The `arm's length' price in relation to an international transaction shall be determined by any of the following methods: Being the most appropriate method, having regard to the nature of transaction, class of transaction, class of associated persons, fu nctions performed by such persons, or such other relevant factors as the board may prescribe, including:

Comparable uncontrolled price method (CUP): Under this method, the arm's length price for the associated party transaction is assumed to be equal to the price charged in a comparable transaction with a non-associated person.

Resale price method: The resale price starts with the price at which a product or service is sold to an independent third party by a related enterprise which is the seller. This price is reduced by the gross profit margin taking into account the relevant costs and expenses of the seller and also reasonable profit in the light of functions performed and the risks involved.

Cost plus method: Under this method, the arm's length price is determined as being equal to the cost of producing the goods plus a benchmark gross mark-up.

Profit split method: This requires the allocation of the global profits earned on any transaction between each of the associated parties to the transaction concerned.

Transaction net margin method: This method examines the net profit margin vis-a-vis the costs, sales or assets that a tax-payer realises from a transaction with a related party, or such other method as may be prescribed by the board.

Whatever be the method, the idea is to determine the arm's length price that will help arrive at a fair taxable income of the assessee.

Documentation

The important thing is the elaborate documentation and record that need to be maintained by the enterprise and the powers enjoyed by the assessing officer to call for such document or data, relevant in his judgment, to determine the genuineness of the c laim of the assessee of arm's length transaction and the tax liability that will accrue. Specific time schedules have been prescribed for submission of records and documentation which invariably have to be certified by an accountant. Thus, the burden of proof through providing credible and authentic documentation reflecting on the transaction under scrutiny rests entirely with the assessee. Penalties for non-compliance or understatement of incomes are stiff. A fact to be noted is that the documentation maintenance and compliance cost on the part of the assessee will be fairly significant.

The influence of the Customs valuations on transfer pricing is also to be considered. The data of the Customs authorities can be useful as they relate to the situation at the time of importation, whereas officials of direct tax administration usually are able to evaluate a situation much later. Moreover, in regard to Customs, the tax-payer may have interests that may not be consistent with the direct tax requirement. For Customs purposes, he may be keen to show lower price, whereas for I-T purposes he m ay be interested to show higher price for the same goods. Therefore, coordination between the two departments becomes essential. The experience of French law may be useful, in as much as different prices cannot be used for tax and financial reporting.

In transfer pricing, several methods are prescribed since no one approach can be suitable for all situations, and it is also not possible to provide specific rules to cover every case. Suo motu adjustments by the tax authorities unsupported by hard facts will only complicate the case and lead to litigation. Penalties are meant to deter non-compliance and, as such, should not be excessive. The assessee must be given reasonable opportunity to prove his bona fide. These are basic principles in any scheme o f taxation and how far they will be observed can be seen only after an initial period of application of the provisions.

Advance pricing agreements

One of the ways that will facilitate certainty in tax liability is through advance pricing agreements. APA is an agreement between tax-payer and the tax administration for a specified number of years mentioning the criteria for determining transfer price s for future transactions between related enterprises. While concluding an APA, comparability with open-market conditions, and assumptions vis-a-vis future events may play a role. APA finds a place in the transfer pricing provisions of the American and B ritish tax laws. The APA may be retroactively revoked in fraud or malfeasance, cancelled in the event of misrepresentation, mistake/omission of fact or lack of good faith compliance and revised if the critical assumptions change. It is not clear why our regulations are silent on APA.

APAs may be bilateral, unilateral or even multilateral. Bilateral or multilateral APAs may cover conditions in more than one country and thus might confer greater credibility and universality of application. One must, however, guard against over allocati ng profits to any one country where the APA has been arrived at depending on the tax shelter or relief. In Germany, unilateral APAs of foreign tax authorities are not accepted by the German revenue department without an audit in accordance with German ta x standards. The intention is apparently to ensure that such imbalances do not occur.

OECD has issued guidelines on transfer pricing methods and practices which might be useful as a reference source. The US has one of the strictest transfer pricing regulations although over several years they have also learnt through experience. Well-docu mented transfer pricing administrative practices may be available with international tax audit firms and the Amsterdam-based International Fiscal Documentation Centre.

As earlier noted, India is still in the early stage of attracting FDI. While China is able to get $40 billion of FDI annually, India is still at the threshold of actual flows being around $2-3 billion annually. While transfer pricing is a necessary tax p rovision to get our share of revenue from international transactions, it should be administered with sensitivity so as not to kill the goose that lays the golden egg!

(The author is a New Delhi-based management and financial consultant.)