Over the past decade, taxpayers in sectors like information technology, infrastructure, and refining have faced significant challenges in claiming profit-linked tax incentives provided for them. Issues such as calculation of the exemption, whether the activity is eligible, and various others have been aggressively litigated by the revenue authorities, with relief available only at Tribunals and High Courts.

Amendments to the Finance Act 2012 require tax-holiday units to comply with transfer pricing documentation for transactions with other businesses of the taxpayer and closely connected persons. The question is whether the amendments impact the principles laid down by the courts.

Provisions deny benefits to ‘more than ordinary’ profits generated by the tax-holiday unit. In the past, tax authorities have applied this by comparing the unit’s profits (say cost plus 50 per cent) with comparables arrived at during transfer pricing proceedings (say cost plus 30 per cent) and denied tax holiday for excess profits (20 per cent), without appreciating underlying commercial reasons.

Tribunal rulings

Two recent Tribunal rulings have reversed the authorities’ approach, and held that ‘more than ordinary profits’ is different from an arm’s length price, and authorities do not have an arbitrary power to fix the profits of the taxpayer unless they can prove that the taxpayer has arranged its business in such a manner that would produce ‘more than ordinary profits’. The Act provides that ‘more than ordinary’ profits need to be determined with reference to the arm’s length price, and authorities need to heedguidance provided by the Tribunal before seeking to continue their past approach.

Provisions also require transactions by tax-holiday units with other businesses of the taxpayer or closely connected persons to be at market prices. In another recent ruling of the Ahmedabad Tribunal, important principles for applying this provision were laid down.

The assessee, engaged in manufacturing and trading of pharmaceuticals goods, claimed tax holiday on profits from sale of goods manufactured at a unit in Himachal Pradesh.

Actual transfer

The revenue authorities, however, held that the aforesaid unit carried out only manufacturing and was entitled to profits attributable only to manufacturing and not profits from exploiting the brand and marketing network. The revenue authorities created a notional transfer of goods from the manufacturing unit to the marketing division in the head office.

The Tribunal reversed this and held that to compute a price for transfer of goods from a unit to the other businesses of the taxpayer, an ‘actual’ transfer is required. The Tribunal also held that where the sale from the unit enjoying tax holiday is the only source of income, the profit should consider the sale price of goods and costs attributable to such sale (including allocation of head office costs).

Basic transfer-pricing principles were always relevant for tax holiday units’ transactions with other businesses and closely connected persons, since the underlying principle is that profits should be based on commercial activities uninfluenced by related party dealings.

The above rulings provide useful guidance on the underlying commercial principles for the formal application of transfer pricing requirements with effect from April 1. To that extent, the amendments do not necessarily change the rules of the game, but are laid down with a view to ensure robust transfer pricing documentation and its review by transfer pricing officers.

Principles of the above rulings would need to be followed going forward in consonance with the transfer pricing rules. One cannot overemphasise the need for authorities to consider the overall tax-holiday framework when applying formal transfer-pricing requirements to ensure a rational approach, and avoid protracted litigation for taxpayers.

Sanjay Tolia is Partner, Transfer Pricing, Price Waterhouse & Co. With inputs from Darpan Mehta, Associate Director.

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