The Finance Bill 2012 extended transfer pricing provisions to ‘specified domestic transactions’ with effect from 2013-14. The memorandum explaining the provisions states that while section 40A/ Chapter VI-A of Income Tax Act, 1961 empowers the tax officer to re-compute the income of the related parties if the transactions are not at fair market value, there is, however, no specific method to determine the fair market value. Hence, taking a cue from the Supreme Court’s suggestions in the case of Glaxo Smithkline Asia, SDT provisions have been introduced.

The Supreme Court had observed that tax laws may have to be amended to bring domestic transactions between related parties within the ambit of Indian transfer pricing provisions. However, it also noted that in the case of domestic transactions, the under-invoicing of sales and over-invoicing of expenses will ordinarily be revenue-neutral in nature, except under two circumstances:

if one of the related companies is loss-making and the other is profit-making, and profit is shifted to the loss-making concern; and

if there are different rates for two related units (on account of different status, area-based incentives, nature of activity and so on) and if profit is diverted to the unit whose income is subject to a lower tax rate.

Interestingly, the I-T Act already contains provisions to curb claim of excess expenditure or re-compute income on transactions between related parties if it results in extraordinary profit in a tax-holiday enterprise/ unit. Section 40A(2) empowers the tax officer to disallow excess/ unreasonable expenses between related parties. Vide section 80-IA(8)/ 80-IA(10), the tax officer can re-compute the income of an eligible undertaking based on the fair market value if the transactions with related parties or other undertakings of the same entity are not based on market value. The scope of transfer pricing regulations has now been expanded to include SDT and it covers even revenue-neutral transactions. However, to provide relief to small enterprises, it will apply only to transactions that exceed Rs 5 crore in aggregated value during the year.

SDT, among other things, include payments to related persons and as specified in Section 40A(2)(b), and transactions/ transfers under section 80A, section 80-IA and section 10AA. The infrastructure sector, including power, which enjoys tax holiday under section 80-IA, will be governed by transfer pricing regulations from 2013-14.

Typically, due to the legal and commercial requirements in the infrastructure sector, a separate entity is formed for each project. In many cases, a separate entity is also formed for the operation and management services provided to group entities. The domestic transfer pricing provisions require such entities to charge arm’s length price for the support services provided to group entities.

Given the wide scope of the current domestic transfer pricing provisions, the manner and extent to which they will apply remain uncertain. The computation of arm’s length price is one such area of uncertainty. For instance, suppose a parent company or non-tax holiday unit cross-charges the tax-holiday company/ unit for goods or services at an arm’s length price of, say, Rs 115. If the tax officer puts it at Rs 110, the tax-holiday unit will suffer a disallowance of Rs 5 under section 40A(2) and excess profit of Rs 5 is offered to tax by the non-tax holiday entity. However, if the tax officer determines the arm’s length price at Rs 120, there will be adjustments in the tax-holiday unit due to excess profit of Rs 5 claimed under section 80-IA.

It would be extremely difficult for taxpayers to determine the correct/ exact arm’s length price to the satisfaction of the tax officer. Any arm’s length price above or below the taxpayer’s calculation would lead to needless litigation. As such, domestic transfer pricing provisions have come as a double-edged sword, especially for infrastructure and power sector companies. It would be pertinent for the Government to bring out a clarification on all such issues so that domestic transfer pricing provisions can achieve the purpose for which they were introduced.

Hemal Zobalia is Partner, KPMG

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