OVERVIEW
Transfer pricing is a mechanism that ensures that related-party transactions between associated enterprises are carried out at arm's length and not for the purpose of tax evasion. The Indian government introduced transfer pricing regulations in 2001 under the Income Tax Act, 1961, to align the prices of cross-border transactions between related parties with those of transactions between unrelated parties. The objective of these regulations is to prevent the shifting of profits from India to other countries through related-party transactions, thereby ensuring that the Indian government collects the appropriate tax revenue.
The regulations require companies to maintain detailed documentation of the transactions with their associated enterprises, including financial information, agreements, and any other relevant information. The Income Tax Department has the power to scrutinize these transactions and adjust the income of the companies if the transactions are not conducted at arm's length. The regulations also provide for various methods for determining the arm's length price of transactions, and courts and tribunals have upheld the importance of these regulations in preventing tax evasion.
LEGAL PROVISIONS OF TRANSFER PRICING UNDER IT ACT
Section 92 of the Income Tax Act deals with the concept of transfer pricing. It applies to all transactions between associated enterprises, i.e., enterprises that have a direct or indirect interest in each other, including subsidiaries, joint ventures, and other related entities. The section requires that all such transactions be conducted at arm's length, i.e., the price charged for the transaction should be similar to the price that would have been charged in a similar transaction between unrelated parties.
DEFINITION OF ASSOCIATED ENTERPRISES
Section 92A of the Income Tax Act defines the term "associated enterprises" to include companies that are under the same management or control, or have a common interest or business. It also includes a person who participates directly or indirectly in the management, control, or capital of the enterprise.
METHODS FOR DETERMINING ARM'S LENGTH PRICE
Section 92C of the Income Tax Act provides for various methods for determining the arm's length price of a transaction between associated enterprises. These methods include:
I. THE COMPARABLE UNCONTROLLED PRICE (CUP)
This method is one of the five methods prescribed under Section 92C of the Income Tax Act for determining the arm's length price of a transaction between associated enterprises. This method involves comparing the price charged in a controlled transaction with the price charged in a similar uncontrolled transaction between unrelated parties. If the prices are comparable, then the price charged in the controlled transaction is considered to be at arm's length.
To apply the CUP method, the following conditions must be met:
a) The transaction being tested must be identical or similar to the uncontrolled transaction.
b) The price charged in the uncontrolled transaction must be known and can be compared with the price charged in the controlled transaction.
c) The terms and conditions of the two transactions must be similar.
The CUP method is considered to be the most direct method for determining the arm's length price as it involves comparing actual prices charged in similar transactions between unrelated parties. However, it may not always be possible to find an identical or similar uncontrolled transaction.
Relevant case law:
1.In the case M/s. Sesa Goa Ltd. v. DCIT (2019), the taxpayer used the CUP method to determine the arm's length price of iron ore exports to its associated enterprise. The taxpayer identified a comparable uncontrolled transaction involving the sale of iron ore to an unrelated party at a similar price. However, the tax authorities rejected the taxpayer's use of the CUP method on the grounds that the taxpayer did not provide sufficient evidence to establish the comparability of the transactions. The tribunal upheld the taxpayer's use of the CUP method and allowed the taxpayer's claim for a deduction of the export profits. The tribunal held that the taxpayer had provided sufficient evidence to establish the comparability of the transactions.
II. THE RESALE PRICE METHOD (RPM)
It is a transfer pricing method that determines the price charged by a reseller to an unrelated customer and applies a suitable gross margin to arrive at an arm's length price. Under this method, the price charged by the associated enterprise to an unrelated customer is compared to the resale price charged by the reseller to an unrelated customer. The gross margin earned by the reseller is then used as a basis for determining the arm's length price of the controlled transaction.
For example, suppose a company in India sells a product to its associated enterprise in the US at a price of Rs. 100 per unit. The associated enterprise then resells the product to an unrelated customer in the US at a price of Rs. 150 per unit. If the reseller's gross margin is 20%, then the arm's length price of the controlled transaction would be Rs. 120 per unit (i.e., Rs. 150 - 20% of Rs. 150).
Relevant case laws:
1.Glaxo Smithkline Pharmaceuticals Ltd. v. DCIT ITAT No. 2453(2016) - In this case, the taxpayer used the RPM to determine the arm's length price of the sale of finished goods to its associated enterprise. The taxpayer applied a gross margin of 51% to the resale price charged by the associated enterprise to unrelated customers. However, the tax authorities rejected the taxpayer's use of the RPM on the grounds that the taxpayer did not provide sufficient evidence to establish the comparability of the transactions. The tribunal upheld the tax authorities' decision and disallowed the taxpayer's claim for a deduction of the profits.
2.Sony India Pvt. Ltd. v. DCIT ITAT No. 871/del/(2018) - In this case, the taxpayer used the RPM to determine the arm's length price of the sale of finished goods to its associated enterprise. The taxpayer applied a gross margin of 6% to the resale price charged by the associated enterprise to unrelated customers. The tax authorities disputed the taxpayer's use of the RPM and proposed an alternative method based on a benchmarking analysis. However, the tribunal upheld the taxpayer's use of the RPM and allowed the taxpayer's claim for a deduction of the profits. The tribunal held that the taxpayer had provided sufficient evidence to establish the comparability of the transactions and the suitability of the gross margin.
III. THE COST PLUS METHOD (CPM)
It is a transfer pricing method that adds a suitable markup to the cost of production or services to arrive at an arm's length price. Under this method, the cost incurred by the associated enterprise in providing the goods or services is determined, and an appropriate markup is added to arrive at the arm's length price. The markup should be determined based on factors such as the functions performed, risks assumed, and assets employed by the associated enterprise.
For example, suppose a company in India provides services to its associated enterprise in the US at a cost of Rs. 1,000,000. If the appropriate markup is 15%, then the arm's length price of the controlled transaction would be Rs. 1,150,000 (i.e., Rs. 1,000,000 + 15% of Rs. 1,000,000).
Relevant case law:
1.Bharat Forge Co. Ltd. v. ACIT ITAT No. 805/Pun/(2017): In this case, the taxpayer used the CPM to determine the arm's length price of the goods supplied to its associated enterprise. The taxpayer applied a markup of 10% to the cost of production. However, the tax authorities disputed the taxpayer's use of the CPM and proposed an alternative method based on a comparable uncontrolled price analysis. The tribunal held that the taxpayer's use of the CPM was appropriate and allowed the taxpayer's claim for a deduction of the profits.
IV. THE TRANSACTIONAL NET MARGIN METHOD (TNMM)
The TNMM compares the net profit margin earned by the taxpayer in a controlled transaction with the net profit margin earned by comparable uncontrolled transactions. The net profit margin is usually expressed as a ratio of operating profits to sales or operating expenses. The TNMM requires the identification of comparable that are similar in terms of functions performed, risks assumed, and assets employed by the taxpayer and the comparable uncontrolled enterprises.
Relevant case laws :
1.M/s. Mando India Limited v. DCIT (NO.1) (2019) 442 ITR (Mad) (HC): In this case, the taxpayer used the TNMM to determine the arm's length price of the services provided to its associated enterprise. The taxpayer compared its net profit margin with the net profit margin of comparable uncontrolled enterprises. However, the tax authorities disputed the taxpayer's use of the TNMM and proposed an alternative method based on a comparable uncontrolled price analysis. The Court held that the taxpayer's use of the TNMM was appropriate and allowed the taxpayer's claim for a deduction of the profits.
2.Mindtree Ltd. v. ACIT (2020) 427 ITR 338/193 DTR 289 (Karn)(HC): In this case, the taxpayer used the TNMM to determine the arm's length price of the services provided to its associated enterprise. The taxpayer compared its net profit margin with the net profit margin of comparable uncontrolled enterprises. However, the tax authorities disputed the taxpayer's use of the TNMM and proposed an alternative method based on a transactional profit split method analysis. The Court held that the taxpayer's use of the TNMM was appropriate and allowed the taxpayer's claim for a deduction of the profits.
V. THE PROFIT SPLIT METHOD (PSM)
It is a transfer pricing method that is used to determine the arm's length price of a controlled transaction. This method divides the profit from the controlled transaction between the associated enterprises in a manner that is consistent with the contribution made by each enterprise. The PSM is generally used when the contribution of each associated enterprise cannot be separately identified using other transfer pricing methods.
Under the PSM, the profit from the controlled transaction is divided into two parts: the routine profit and the non-routine profit. The routine profit is the profit that would have been earned by an independent enterprise engaged in a comparable transaction. The non-routine profit is the profit that is attributable to the unique contributions of the associated enterprises, such as intangibles, technology, or specialized services.
The division of profit between the associated enterprises is based on the relative value of their contributions to the controlled transaction. The contribution of each enterprise is evaluated based on the functions performed, risks assumed, and assets employed. The PSM requires a detailed analysis of the economic and commercial circumstances of the controlled transaction and the functions performed by each associated enterprise.
Relevant case laws:
1.In The case of SKF Boilers and Driers Pvt. Ltd. v. DCIT WP- 18680 (2013) decided by the Madras High Court involved a dispute over the arm's length nature of the prices charged by the taxpayer to its associated enterprise for the supply of components and materials. The taxpayer used the Profit Split Method (PSM) to determine the arm's length price and allocate the profits between the two enterprises based on the contribution made by each enterprise. The tax authorities rejected the taxpayer's use of the PSM and proposed an alternative method. The Madras High Court held that the PSM was a valid transfer pricing method and the taxpayer had provided sufficient evidence to establish its suitability and comparability.
PENALTIES FOR NON-COMPLIANCE
Section 271AA of the Income Tax Act provides for penalties for non-compliance with transfer pricing regulations. The penalty may be levied at a rate of 2% of the value of the transaction if the taxpayer fails to maintain documentation, and at a rate of 100% to 300% of the tax adjustment if the taxpayer has provided inaccurate information or failed to disclose material information.
CONCLUSION
Transfer pricing is a crucial aspect of international taxation, and it aims to ensure that the prices charged in controlled transactions between associated enterprises are at arm's length. The Indian Income Tax Act has provisions for transfer pricing, which require taxpayers to maintain transfer pricing documentation and apply transfer pricing methods to determine the arm's length pricing of their controlled transactions. The commonly used transfer pricing methods are the comparable uncontrolled price method, resale price method, cost-plus method, and profit split method. Taxpayers must ensure that they comply with the transfer pricing provisions of the Income Tax Act and maintain proper documentation to support their transfer pricing analysis.
In conclusion, transfer pricing is a complex area of taxation that requires careful consideration and documentation. The Indian Income Tax Act has provisions for transfer pricing that require taxpayers to determine the arm's length pricing of their controlled transactions with associated enterprises. Taxpayers must ensure that they apply the appropriate transfer pricing method and maintain contemporaneous transfer pricing documentation to support their analysis. Failure to comply with the transfer pricing provisions may result in penalties, so it is crucial for taxpayers to seek professional advice and ensure that they are in compliance with the law.
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