Transfer Pricing – Concept, Methods, Coverage

Topic Covered in this page

Transfer Pricing

What is Transfer Pricing ?  Transfer Pricing is, arriving at of the price for goods and services, which are transacted between controlled legal entities (branches /companies) within an enterprise, whether in same or different countries, under the assumption that they were independent parties.

In other words, Transfer pricing  involves the following : –

  • There is /are transactions between controlled legal entities (branches /companies) within an enterprise;
  • Such controlled legal entities maybe in the same countries (in such a case domestic Transfer pricing provisions are applicable) or different countries
  • Transfer pricing involves arriving at of the price for goods and services
  • The prices arrived at by application of Transfer pricing , are under the assumption that the controlled legal entities are independent parties.

For example, if a parent company of a multinational group, sells goods to its  subsidiary company in other Country, the price of such transaction, would be covered under Transfer Pricing, and would need to be computed under the assumption that they were independent parties.

 

TRANSFER PRICE

In both the cases, discussed above, the USCO  has sold certain goods to the Indian Company or provided technical services to the Indian company.

The purpose of Indian Transfer pricing regulation in such a case would be to ensure that the deduction claimed by the Indian Company towards payment to the US company are at arm’s length.

Let us now look at some of the, COMMON BUSINESS TRANSACTIONS, BETWEEN GROUP COMPANIES WITHIN AN MNE WHICH MAY BE COVERED UNDER TRANSFER PRICING

  • Purchase or Sale Transactions or use of Property –
    • Purchase, sale or lease of tangible or intangible property; or
    • Use of intangible property like Brand, Trademark, royalty etc
  • Service Transactions – Availing or Provision of services (technical or non technical); or
  • Financing Transactions – Lending or borrowing money
  • Investment Transactions – Investment in Shares, Debentures (non convertible/ convertible)

In case of transfer pricing, it may be noted that the price which are actually charged in a transaction are same as the amount of money received or paid by two entities. The fact that the arm’s length price is different from  or the transaction price , does not necessarily mean that there has been any under invoicing for over invoicing by the parties. It merely means that for tax purposes, the tax has to be computed on a different amount as against the transaction price agreed between parties.

Let us now look at some examples to understand this concept : –

  1. Lease of tangible equipment

Facts : –

ICO India Private Limited (India) acquires equipment on lease from its group concern UK CO. International (UK) at a lease rental of USD 10,000 per month.

Analysis : –

This is a transaction of lease of tangible property. Thus, arm’s length price of such leasing transaction would be determined under transfer pricing provisions.

The deduction of expenses in the hands of the Indian company would be based on the arm’s length price of the lease rentals, which would be decided based on the Transfer Pricing provisions applicable in the relevant country.

  1. Lending and borrowing

ABC Ltd. (India) borrows USD 10,000 from its group concern, ABC International Ltd. (UK) at interest rate of 3% p.a.

Analysis : –

In this case, the transaction is of lending or borrowing of money.

Thus, arm’s length price of interest rate would be determined under transfer pricing provisions.

The deduction of interest  expenses in the hands of the Indian company would be based on the arm’s length price of the interest, which would be arrived at based on the Transfer Pricing provisions applicable in India.

 

Use of brand – Intangible Property

Maruti India  makes royalty payment to its group concern, Maruti Japan for use of Brand.

In this case, the transaction is of use an intangible asset.

Thus, arm’s length price of royalty payments would be determined under transfer pricing provisions.

TRANSFER PRICING IN INDIA [PRE-2001 ERA] – SECTION 92

The transfer pricing rules and regulations in India can be broadly covered under 2 time frames :-

  • The provision existing right to the amendments made by Finance Act 2001
  • The provisions after the amendments made by Finance Act 2001

Let us now look at the transfer pricing rules and regulations in India existing right to the amendments made by finance act 2001  : –

Prior to such amendments, Section 92 of the IT Act, 1961 was the only section dealing specifically with cross border taxation in case of MNEs. Section 92 was applicable when the following conditions were satisfied:

  • There was a business transaction between a resident and a non-resident;
  • There was a close connection between a resident and a non-resident;
  • Due to close connection, they arranged business in such a manner that there were either no profit / or less than normal profit to resident.

Where these conditions existed, the Assessing Officer was empowered to determine the reasonable amount of profits, that could have been derived from such business . In order to compute the amount of reasonable profits, AO was under an obligation to apply the provision and methodology provided under Rules 10 and 11 of the Income Tax Rules 1962. If such an application resulted in, difference between the amount reported by the company and the amount computed by the AO, the AO would consider such differences in arriving at the total income of the resident.

 

COMPUTATION OF NORMAL PROFIT AS PER THE PROVISIONS OF RULE 10

As per Rule 10 and 11, normal profit could be calculated :

  1. As such % of the turnover so accruing or arising as the AO may consider Thus, in these cases, the AO computed the profits, and not the arm’s length price;
  2. on any amount which bears the same proportion to the total profits and gains of   the business of such person, as the receipts so accruing or arising bear to the total receipts of the business:
    Total Profits   X Receipts related to business transaction with AE
                                             Total receipts
  3. in such other manner as the AO may deem suitable.

SHORTCOMINGS of the Method

  • The method provided for adjustment of profit Vs adjustment of prices. Since profits, are not necessary in every business transaction, this method, did not take into consideration the fact that they could be business losses as well.
  • No detailed rules for necessary documentation to substantiate basis of price between parties. In the absence of any specific guidelines, the assessment were more prone to be governed by the outlook of the respective assessing officer, as against standard International practices.
  • Since these rules were applicable in case of business  profits, and business demands a continuity of relationship  isolated transactions were outside Section 92
  • Transfer of services or intangibles were not covered within the scope of the above provisions
  • Transfer Pricing provisions did not provide for situations where a non-resident entered into a transaction with another non-resident.

EVOLUTION OF TRANSFER PRICING IN INDIA [PRE-2001 ERA] – REPLACEMENT OF EXISTING LAW

With a view to provide detailed statutory framework , which would address the issues discussed above, and curb tax avoidance by Multinational Enterprises, the detailed law dealing with Transfer Pricing was introduced by making the following changes to the existing law/incorporating new provisions : –

  • Substituting the then existing Section 92 , with new Section 92, Section 92A, Section 92B, Section 92C, Section 92CA, Section 92D, Section 92E and Section 92F; and
  • Detailed Circular No.14 explaining the Transfer Pricing provisions introduced as above .

ROLE OF OECD TP GUIDELINES IN INDIAN CONTEXT

While the indian Transfer pricing regulations are not completely aligned with OECD TP Guidelines , the OECD TP Guidelines have been referred to, and extensively considered by the Indian courts, in connection with rendering decisions under the Indian Transfer pricing provisions.

 

COMPUTATION OF INCOME HAVING REGARD TO THE ALP – SECTION 92 – APPLICABILITY OF ARM’S LENGTH PRINCIPLE

SECTION 92 of the IT Act,  provides which transaction would be covered within the scope of Indian Transfer pricing provisions. It also provide for the situation, when even though a particular transaction may be covered under the Indian Transfer pricing provision, it would be excluded where it results in loss of revenue to the Indian government.

According to the provision of section  of the IT Act, the following transaction would be covered under Transfer Pricing : –

COMPUTATION OF INCOME ARISING FROM INTERNATIONAL TRANSACTION

  • Any income arising from international transaction shall be computed on the basis of arm’s length price. For example, the following would be covered :-
  • Exports of goods by an Indian company, to its non-resident Associated Enterprise.
  • Service provided by an Indian company, to its non-resident Associated Enterprise.

ALLOWANCE OF AN EXPENSE/INTEREST UNDER INTERNATIONAL TRANSACTION

  • Any expense/ allowance for any interest, for computing income for international transaction shall also be computed on the basis of arm’s length price of such expense/interest.
  • Expense incurred by an Indian company, towards service received from foreign AE,
  • Import of goods by an Indian company, from its non-resident AE;
  • Interest on Loan /Debentures paid by an Indian company to its non-resident AE;
  • Payment of royalty by an Indian company to its non-resident AE

 

ALLOCATION OR APPORTIONAMENT OF COST OR EXPENSES UNDER A

MUTUAL AGREEMENT

The cost or expenses allocated or apportioned between Associated enterprises under a mutual agreement or arrangement shall be at arm’s length price. For example, if B Ltd., a foreign company and an Associated Enterprise of X Ltd. , an Indian company, carries out certain centralized functions like Human Resource, obtaining finance, IT services etc., for several group companies, including X Ltd., proposes to allocate a part of such cost to X Ltd., cost of such centralized functions allocated between X Ltd., Y and Z, shall be made, having regard to the arm’s length price of services obtained by each of these enterprises, using common basis, like time spent by common resource, etc. Any excess amount charged by B Ltd. Over and above the fair value of services obtained by X Ltd. Would not be allowed as a deduction to text Limited under the Indian Transfer pricing provisions.

 

CONTRIBUTION TO ANY COST, EXPENSES FOR OBTAINING BENEFIT/SERVICE

Any contribution to any cost, expenses, for obtaining any benefit/service/facility to AE shall also be computed on the basis of the ALP of such benefit/service/facility

Sometimes more than one foreign company, may agree to jointly develop an asset through research,  or set up some common facility whose benefit may be obtained by all the members who are contributing to the setting up of search facility.  In such a case, any contribution to any cost, expenses, for obtaining any benefit/service/facility by the Indian Company to its foreign associated Enterprise, shall be allowed on the basis of the ALP of such benefit/service/facility . If the payment made is disproportionate to the value of the benefit obtained by the Indian Company, such excess shall not be allowed as deduction for Indian tax purposes.

EXAMPLE: –

  • Associated enterprises A, B and C agreed to carry out a joint activity, such as research and development, for their mutual benefit.
  • In this case, cost allocation will be made amongst associated enterprises having regard to the arm’s length price.

COMPUTATION OF INCOME HAVING REGARD TO THE ALP – SECTION 92 – BASE EROSION CONCEPT

NON-APPLICABILITY OF ARM’S LENGTH PRINCIPLE

  • The transfer pricing provisions are intended to ensure that profits taxable in India are not understated (or losses are not overstated) by declaring lower receipts or higher outgoings (expenditure or other deductions) than those, which would have been declared by persons entering into similar transactions with unrelated parties in the same or similar circumstances.
  • The basic intention underlying the transfer pricing regulations is to prevent shifting of profits by manipulating prices charged by overseas entity or paid by Indian entity in international transactions, thereby eroding the country’s tax base.

However in certain cases, application of the transfer pricing provisions, main result in reduction of profits taxable in India , increase in the expenses, allowable as a deduction for Indian tax purposes. In such cases, transfer pricing provision are not be applied where the adoption of the arm’s length price would result in a decrease in the overall tax incidence in India in respect of the parties involved in the international transaction.

 

EXAMPLE: –

ABC Ltd. purchased goods at USD 200 per unit from its AE in USA. However, it was purchasing the same material at USD 250 per unit from independent third party located in USA. Evaluate whether the Arm’s Length Price (ALP) should be USD 200 or USD 250?

SOLUTION: –

In this case, arm’s length price would be USD 250 per unit , which would increase the purchasing cost of ABC Ltd. and consequently, reduce its taxable profits by USD 50 per unit.

Thus, transfer pricing provisions would not be applied in this case and the actual transaction price of USD 200 per unit will be considered as the arm’s length price for computation of income.

 

ASSOCIATED ENTERPRISES – SECTION 92A (1)

Transfer pricing provisions are applicable for international transaction between Associated enterprise.

Associated enterprise may be actual (covered specifically under the explicit provisions) or under certain circumstances may be deemed as associated Enterprises (applicable where the taxpayer tries to circumvent being covered under associated enterprise provisions, through use of third parties)

As per Section 92A (1) of the Act, the following would be covered within the definition of Associated enterprise : –

DIRECT OR INDIRECT PARTICIPATION IN MANAGEMENT, CONTROL OR CAPITAL OF ANOTHER ENTERPRISE BY AN ENTERPRISE

a).  An enterprise, which participates directly or indirectly,  or through one or more  intermediaries in:

  • Management of the other enterprise, or
  • Control of the other enterprise, or
  • Capital of the other enterprise.

Under this clause , the enterprise, which ITSELF participates directly or indirectly in the Management, control or capital of the other enterprise, is treated as an Associated Enterprise .

If you look at the under mentioned diagram, the following shall be AE’s : –

  • F1 participate directly in ICO is Figure 1 , thus in Figure 1, F1 and ICO are AE’s.

 

  • In Figure 2,
  • F1 participate indirectly in ICO in Figure 2, and therefore in Figure 2 also, F1 and ICO are AE’s.
  • FCO1 participate directly in FCO2 in Figure 2 , and thus FCo1 and FCO2 are AE’s .
  • Further, FCO2 participate directly in ICO in Figure 2, and therefore even they are AE’s

 

ASSOCIATED ENTERPRISES – SECTION 92A (1)

DIRECT OR INDIRECT PARTICIPATION IN MANAGEMENT, CONTROL OR CAPITAL OF ANOTHER ENTERPRISE JOINTLY BY ONE OR MORE ENTERPRISE

b).  If one or more persons, participates directly or indirectly, or through one or more intermediaries in: –

  • Management of the two different enterprises;
  • Control of two different enterprises;
  • Capital of two different enterprise.

Under this clause , where one or more person (participant), participate directly or indirectly in the Management, control or capital of the another enterprise, the participants, between themselves, would be treated as Associated Enterprise .

If you look at the under mentioned diagram, the following shall be AE’s from the perspective of ICO :

  • A participate indirectly in ICO for more than 26%, and thus A and ICO are AE’s .
  • B participate directly in ICO for more than 26%, and thus B and ICO are AE’s .

DEEMED ASSOCIATED ENTERPRISES – SECTION 92A (2)

READERS INFORMATION: –

The general application of definition of AE , discussed in Section 92A(1) may not be sufficient to cover all cases of tax manipulation by various Enterprise, and may leave scope for manipulation in such a manner, that the issue becomes debatable. For example, if an enterprise (A) participates to the extent of 2% in the capital of another enterprise (B), it may not result in an exercising influence on B so as to exercise control on transactions, and may therefore not qualify as an AE of B. However, if A is the only purchaser of goods produced by B, it may still be able to exercise control on prices of B.

In order to address this situation, the concept of deemed AE, is introduced in Section 92A (2).

Section 92A (2) provides two enterprises shall be deemed to be associated enterprises if, at any time during the previous year they satisfy any one or more of following 13 conditions . For identification of Associated enterprise, any of the aforesaid relationship should exist at any time during the previous year. It is not necessary that such relationship should exist throughout the year or atleast for some duration of time, before the relationship of Associated enterprise shall be deemed to exist.

Further, it may also be noted that once two entities fall under any of the following clauses, they shall be treated as AE’s even though they may not be covered u/s Section 92A (1) :-

Direct or Indirect voting power of  26% or more

(i) One enterprise (FCO) holds, directly or indirectly, shares carrying 26% or more of the voting power in the other enterprise (ICO).

Note : –

In this case, the entity which participates namely, FCO and the investee company (ICO), would be treated as associated Enterprises.

Since only Equity share carry voting rights, the participation is based on ownership of such equity shares. Generally preference shares do not carry any voting rights, and therefore even if an enterprise phone more than 26% preference shares in another Enterprise, the two will not be treated as associated Enterprises.

Example 1 : –

 

Facts:

  • FCO holds 26% Equity Shares in ICO (all equity shares carry equal voting rights) .

Issue:

  • Whether FCO and ICO will be deemed to be Associated enterprise?

Solution:

  • Since, FCO directly holds 26% voting rights in ICO, both the enterprise would be  deemed to be Associated enterprise.

Example 2 : –

Facts:

  • FCO holds 100% equity shares (all equity shares carry equal voting rights) in ICO 1.
  • ICO 1 holds 49% equity shares (all equity shares carry equal voting rights) in ICO 2.

Issue: Who all will be the Associated enterprises based on the above facts ?

Solution:

  • Since, FCO directly holds 100% voting rights in ICO 1, both FCO and ICO1 would be deemed to be Associated enterprise.
  • Since, ICO 1 directly holds 49% voting rights in ICO 2, both the enterprise are deemed to be Associated enterprise. However, the Transfer Pricing provision applicable between them would be Domestic Transfer Pricing provisions, and hence the threshold and conditions of Domestic Transfer Pricing provisions would need to be applied on transactions between them.
  •  FCO and ICO 2 will also be deemed to be the Associated enterprise because FCO indirectly holds more than 26% voting rights in ICO 2.

 

VOTING POWER/ OWNERSHIP > 26%

(ii)  Any person or enterprise holds, directly or indirectly (to be discussed), shares carrying 26% or more of the voting power in each of such enterprises.

Example : –

Consider the following diagram : –

 

 

In such a case,  the two investee company ICO1 and ICO2 ,  would also be treated as Associated Enterprises, between themselves.

Facts:

  • FCO holds 26% equity shares in ICO 1;
  • FCO also holds 26% shares in ICO 2.

Issue:

  • Who all will be the Associated enterprises?

Solution:

  • Since, FCO directly holds 26% voting rights in ICO 1, both the enterprise would be deemed to be the Associated enterprise.
  • Since, FCO directly holds 26% voting rights in ICO 2, both the enterprise would be deemed to be the Associated enterprise.
  • Since, common person FCO, holds 26% voting rights in each of the enterprise ICO 1 and ICO 2, hence ICO 1 and ICO 2 will also be deemed to be the Associated enterprise. However, the Transfer Pricing provision applicable between them would be Domestic Transfer Pricing provisions, and hence the threshold and conditions of Domestic Transfer Pricing provisions would need to be applied on transactions between them.

 

Example 2 : –

Consider the following diagram : –

 

Facts:

  • FCO holds 26% equity shares in ICO 1;
  • FCO also holds 100% shares in ICO 2;
  • ICO 2 holds 49% shares in ICO 3.

Issue:

  • Who all will be Associated enterprises, based on the given facts?

SOLUTION: –

  • FCO holds 26% voting rights in ICO 1, and hence both the companies would be  deemed to be Associated enterprise.
  • FCO holds 100% voting rights in ICO 2, and hence both the companies would be deemed to be Associated enterprise.
  • ICO 2 holds 49% shares in ICO 3, and hence both the companies would be   deemed to be Associated enterprise.
  • Since, common person FCO holds 26% and more voting rights in ICO 1 and ICO 2, hence ICO 1 and ICO 2 will also be deemed to be Associated enterprise as regards transactions between themselves .
  • FCO holds 100% voting rights in ICO 2,  and ICO 2 in turn holds 49% voting rights in ICO 3.  Hence, we can say that FCO indirectly holds more than 26% voting rights in ICO 3. Hence both FCO and ICO3 will be deemed to be Associated enterprise.
  • Since, FCO indirectly holds more than 26% voting rights in ICO 3 and FCO directly holds 26% voting rights in ICO 1, hence, ICO 1 and ICO 3 will be deemed to be Associated enterprise.

LOAN OF 51% OR MORE OF TOTAL BOOK VALUE OF ASSETS

(iii) Where loan advanced by one enterprise,  to the other enterprise constitutes 51% or more of the book value of the total assets of the other enterprise, the two enterprise would be deemed to be Associated Enterprises.

In such cases it is not necessary, that there should be a direct or indirect participation of 26% or more voting power by one enterprise into another Enterprise.

 

Consider the following  example : –

 

EXAMPLE 2: –

Facts : –

  • FCO holds 20% voting rights in ICO.
  • Balance sheet of ICO is as under:

Issue: –

Whether FCO and ICO will be deemed to be Associated enterprise ?

In the above case, what would be the answer, if the loan amount was 255 crores assuming other facts remain same?

SOLUTION: –

Since, FCO has advanced loan of 52% (260/500*100) % = 52%) of book value of total assets to ICO, FCO and ICO would be deemed to be the Associated enterprise.

Even if the loan amount was Rs. 255 crores, FCO would have advanced loan of 51% (255/500*100) % = 51%) of book value of total assets to ICO. Hence FCO and ICO would still be deemed to be the Associated enterprise.

EXAMPLE 3: –

In the above case, what would be the position, if the loan amount was 250 crores?  Other facts remain same.

SOLUTION: –

Since, FCO has advanced loan of less than 51% of book value (250/500*100)% = 50%) of total assets to ICO, FCO and ICO would not deemed to be the Associated enterprise.

 

GUARANTOR OF 10% or more BORROWINGS

(iv)    Where one enterprise (FCO) guarantees 10% or more of the total borrowings of the other enterprise (ICO), the two enterprise will be treated as associated Enterprises. In such cases it is not necessary, that there should be a direct or indirect participation of 26% or more voting power by one enterprise into another Enterprise.

Consider the following  example : –

Since, FCO has guaranteed borrowings of ICO of 20% (100/500*100) % = 20%) of ICO, FCO and ICO would be deemed to be the Associated enterprise.

In case the borrowings were Rs. 50 crores, FCO would have guaranteed borrowings of ICO of 10% or more (50/500*100) % = 10%) of ICO, FCO and ICO would be deemed to be the Associated enterprise.

In case the borrowings were Rs. 49 crores, FCO would have guaranteed borrowings of ICO of less than 10% (49/500*100) % = 9.8%) of ICO. Hence ,  FCO and ICO would not be deemed to be the Associated enterprise.

 

APPOINTMENT OF GOVERNING BOARD

(v) Where one enterprise appoints

  • More than half of the Board of Directors or members of the Governing Board, or
  • One or more Executive Directors of the Governing Board, or
  • One or more Executive Members of the Governing Board of one enterprise, are appointed by the other enterprise.

the two enterprise will be treated as associated Enterprises. In such cases it is not necessary, that there should be a direct or indirect participation of 26% or more voting power by one enterprise into another Enterprise.

 

 

EXAMPLE 1: –

In the following case, list out the Associated enterprises of ICO 1 : –

  • FCO 1 has made the appointment of 12 out of 20 Board of Directors of the Governing Board in ICO 1.
  • FCO 2 has made the appointment of Mr. B, as Executive Director of the Governing Board in ICO 1.
  • FCO 3 has made the appointment of Mr. C as an Executive Member of the Governing Board in ICO 1.

SOLUTION: –

  • Since, more than half of Board of Directors in Governing Board in ICO 1 have been appointed by FCO 1, FCO 1 and ICO 1 are deemed to be Associated enterprise.
  • Since, an Executive Director in the Governing Board has been appointed in ICO 1 by FCO 2, FCO 2 and ICO 1 are deemed to be Associated enterprise.
  • Since, an Executive Member in the Governing Board has been appointed in ICO 1 by FCO 3, FCO 3 and ICO 1 are deemed to be Associated enterprise.

EXAMPLE 2: –

  • FCO has the power to appoint three out of five directors of Governing Board of ICO. However, due to certain disputes it was able to appoint only one director during FY 2016-17.
  • Whether FCO and ICO are Associated enterprise ?

SOLUTION:

  • Since, FCO has made appointment of less than 50% of Board of Directors of the Governing Board of ICO, FCO and ICO would not be considered as Associated enterprise.

In such cases, it is the actual appointment which is the relevant for the purpose of ascertaining whether the two enterprise are Associated Enterprises. Merely because one person has the power to appoint more than half of the board of Directors would not make such person and the other company and associated Enterprise, unless such power has been exercised.

 

APPOINTMENT OF BOARD OF 2 DIFFERENT ENTERPRISES BY SAME PERSON

(vi) Where one or more person, have the power, to appoint

  • More than half of the Board of Directors or members of the Governing Board of each of the two enterprises, or
  • One or more Executive Directors of the Governing Board of each of the two enterprises, or
  • One or more Executive Members of the Governing Board of each of the two enterprises

  each of the two enterprise would be deemed to be associated Enterprise.  

In such cases it is not necessary, that there should be a direct or indirect participation of 26% or more voting power by one enterprise into another Enterprise.

EXAMPLE: –

FCO 1, (US Company) has made the following appointments in ICO, (Indian Company) and FCO (US Company):

(a) An Executive Director in both FCO and ICO; or

(b)8 out of 12, Directors on Board in FCO and 7 out of 13, Directors on Board in ICO.

Identify who all would be treated as AE’s in the transaction ?

SOLUTION: –

(a) An Executive Director has been appointed in FCO and ICO by FCO 1, hence, FCO 1 & FCO , and FCO 1 & ICO, are deemed to be the Associated enterprise as FCO1 has the power to appoint Executive Director in FCO and ICO .

(b) Since FCO 1, a common person has appointed more than half of Board of Directors of the Governing Board, both in FCO and ICO, FCO and ICO are Associated enterprise.

(c) Further, since more than half of Board of Directors in FCO and ICO have been appointed by FCO 1, hence, FCO 1 & FCO, and FCO 1 & ICO are deemed to be the Associated enterprise.

 

DEPENDENCE ON INTANGIBLES which are owned by , or under exclusive right of another enterprise

(vii)

  • Where the business of one enterprise , or manufacture or processing of goods or articles by one enterprise is wholly dependent on
  • the know-how, patents, copyrights, trade-marks, licenses, franchises, or any other business or commercial rights of similar nature, or
  • any data, documentation, drawing or specification relating to any patent, invention, model, design, secret formula or process.
  • of which the other enterprise is the owner, or
  • in respect of which the other enterprise has exclusive rights.

 

This clause intends to cover cases where the business of one Enterprise is significantly dependent upon, certain intangibles, which are either owned buy another Enterprise, for such other Enterprise has exclusive right over them. In such cases, given the dependence of the first mentioned Enterprise, it is assumed, that the owner of intangibles would be able to exercise significant influence on the business of the first mentioned enterprise and therefore affect the prices of the transaction.

Facts : –

  • ICO (India) manufactures Fizzy drinks by using patented formula owned by a FCO (USA).
  • The manufacture of Fizzy drink by ICO is wholly dependent on use of secret patented formula owned by a FCO

Issue:

  • Whether FCO and ICO will be deemed to be Associated enterprise?

Solution:

Both the enterprises will be deemed to be Associated enterprise u/s 92A(2)(vii) because the business of ICO is wholly dependent on the use of patent provided by FCO

DEPENDENCE ON RAW MATERIALS AND CONSUMABLE

(viii) Where 90% or more of raw materials and consumables, required for the manufacture or processing of goods or articles or carrying on of business carried out by one enterprise (ICO), are supplied by

  • the other enterprise (FCO), or
  • by persons specified by the other enterprise (FCO1), and the prices and other conditions relating to the supply are influenced by such other enterprise.

This clause intends to cover cases where the business of one Enterprise is significantly dependent raw material supplied by another Enterprise. In such cases, given the dependence of the first mentioned Enterprise, it is assumed, that the supplier of raw material would be able to exercise significant influence on the business of the first mentioned enterprise,  and therefore affect the prices of the transaction.

The comparison is to be made based on the value of raw material and consumables.

Facts:

  • ICO manufactures chairs, using plastic manufactured by FCO.
  • FCO sub-contracted the reshaping part of plastics to FCO 1.
  • FCO 1 reshapes the plastic purchased from FCO and on the instructions of FCO sells it to ICO.
  •  95% of the plastic consumed by ICO was supplied by FCO 1 out of total plastic consumed by it amounting Rs. 190 crores.
  • Prices and other conditions are decided by FCO in terms of contract between FCO and FCO 1.

Issue:

  • Who all will be deemed to be the Associated enterprise?

Solution:-

FCO and ICO would be treated as AE, as 90% or more of raw materials and consumables, required for the manufacture by ICO, are supplied by persons specified by the other enterprise (FCO1).

 

EXAMPLE 2: –

In the above case, what if the raw material supplied by FCO amounts to Rs. 170 crores out of total raw material consumed of Rs. 200 crores? Other facts remain same.

SOLUTION: –

Since, FCO has supplied less than 90% of the raw material required by ICO, FCO and ICO would not be deemed to be the Associated enterprise

EXAMPLE 3: –

In the above case, what if the raw material supplied by FCO amounts to Rs. 180 crores out of total raw material consumed of Rs. 200 crores? Other facts remain same.

SOLUTION: –

Since, FCO has supplied 90% of the raw material required by ICO, both would be deemed to be the Associated enterprise.

DEPENDENCE ON SALE

(ix) Where, the goods or articles manufactured or processed by one enterprise, are sold

  • to the other enterprise or
  • to persons specified by the other enterprise, and the prices and other conditions relating thereto are influenced by such other enterprise.

such enterprise would be deemed to be Associated Enterprises.

This clause intends to cover cases where the sale made by one Enterprise are so significantly made to another Enterprise, that without the buyer, the business of the first mentioned Enterprise would not exist. In such a case, it is assumed, that the buyer would be able to exercise significant influence on the business of the first mentioned enterprise,  and therefore affect the prices of the transaction.

 

Facts:

  • ICO is engaged in manufacturing of bikes in India.
  • It supplied all the bikes it made to FCO, a US Company.

Issue:

  • Whether FCO and ICO will be deemed to be Associated enterprise?

Solution:

  • Since ICO has supplied all the bikes manufactured by it to FCO, both FCO and ICO will be deemed to be Associated enterprise .

 

Facts:

  • FCO 1, a US Co. is engaged in the business of branding and trading of plastic bottles. FCO 1 uses the plastic bottles manufactured by FCO.
  • FCO sub-contracts the manufacturing of bottles to ICO.
  • ICO imports plastic from FCO, reshapes the plastic imported from FCO in bottles and on instructions of FCO, and sells it to FCO 1.
  • Price and other conditions of such sale are influenced by FCO.

Issue:

  • Whether FCO 1 and ICO will be deemed to be the Associated enterprise ?

 

Where, the goods or articles manufactured or processed by one enterprise (ICO), are sold to persons specified by the other enterprise (FCO) , and the prices and other conditions relating thereto are influenced by such other enterprise (FCO), such enterprise would be deemed to be Associated Enterprises.

SECTION 92a(2) – INDIVIDUAL AND RELATIVE CONTROL OVER DIFFERENT ENTERPRISE

(x) Where one enterprise is controlled by an individual, and the other enterprise is also controlled by

  • such individual, or
  • his relative, or
  • jointly by such individual and relative of such individual.

the two enterprises so controlled would also be deemed to be Associated Enterprises.

 

Facts:

  • Mr. A controls Indian company (ICO),
  • Foreign Company (FCO) is controlled by
    • A
    • Relative of Mr. A
    • Jointly by Mr. A and relative of Mr. A.

Issue:

  • Whether FCO & ICO will be deemed to be Associated enterprise ?

Solution:

  • Since, ICO is controlled by Mr. A  and FCO is also controlled by Mr. A, both FCO and ICO will be deemed to be the Associated enterprise.
  • Since, ICO is controlled by Mr. A  and FCO is also controlled by relative of Mr. A, , both FCO and ICO will be deemed to be the Associated enterprise.
  • Since, ICO is controlled by Mr. A  and FCO is Jointly by Mr. A and his relative, both FCO and ICO will be deemed to be the Associated enterprise.

SECTION 92a(2) – CONTROL BY HUF and members

(xi)  Where one enterprise is controlled by a Hindu Undivided Family (“HUF”), and

the other enterprise is controlled by

  • a member of such HUF, or
  • a relative of a member of such HUF, or
  • jointly by such member and his relative.

the two enterprises so controlled would also be deemed to be Associated Enterprises.

 

Facts : –

  • HUF controls X Ltd., and
  • Mr. A and Mr. B are the members of HUF.
  • Members of HUF control FCO.

Issue:

  •   Whether FCO & X Ltd. will be deemed to be Associated enterprise?

Solution:

  • Since, FCO is controlled by members of HUF and HUF controls X Ltd., hence, both FCO and X Ltd. will be deemed to be the Associated enterprise.

Facts:

  • HUF controls X Ltd., and
  • Mr. A and Mr. B are the members of HUF.
  • Relative of Mr. A/ Mr. B control FCO.

 

Issue:

  • Whether FCO & X Ltd. will be deemed to be Associated enterprise ?

Solution:

  • Since, FCO is controlled by relative of members of HUF , and HUF controls X Ltd., hence, both FCO and X Ltd. will be deemed to be the Associated enterprise.

SECTION 92a(2) – Enterprise HOLDING NOT LESS THAN 10% IN A FIRM

(xii) Where one enterprise is a

  • Firm,
  • Association of Persons (“AOP”), or
  • Body of Individuals (“BOI”),

and the other enterprise holds 10% or more interest in such Firm, AOP or BOI,

the two enterprises would also be deemed to be Associated Enterprises.

                         

 

Facts:

  • FCO holds 10% voting rights in a firm/ an association of persons or body of individuals, incorporated in India.

Issue:

  • Whether FCO and Firm/ AOP/ BOI will be deemed to be the Associated enterprise?

Solution:

  • Both the enterprise will be deemed to be Associated enterprise because FCO holds not less than 10% interest in the Firm/ AOP/ BOI.

SECTION 92a(2) – MUTUAL INTEREST RELATIONSHIP

(xiii) There exists between two enterprises, any relationship of mutual interest, as may be prescribed.

DEEMED ASSOCIATED ENTERPRISES – SECTION 92a(2)

NOTES: –

QUESTION AND ANSWERS ON ASSOCIATED ENTERPRISE

QUESTION 1: –

  • A Ltd.(India) holds 26% non-voting Preference shares in AB International (Mauritius).
  • Whether A Ltd. and AB International (Mauritius), would be Associated enterprise?

SOLUTION: –

A Ltd. and AB International are not AE. It may be noted that Preference shares do not carry any voting rights. Thus, A Ltd. does not hold shares carrying 26% voting rights in AB International and hence the two entities are not Associated Enterprises.

QUESTION 2 : –

  • D Ltd. (India) holds 100% Equity shares in V International (USA). Further, V International holds 100% Equity shares in Z International (UK).
  • Who all would be the Associated enterprises ?

SOLUTION : –

  • D Ltd. & V International are Associated enterprise, since D Ltd. owns > 26% voting rights in V International.
  • V International and Z International are Associated enterprise, since V International owns > 26% voting rights in Z International.
  • D Ltd. and Z International would also be Associated enterprise as D Ltd. indirectly holds more than 26% voting rights in Z International.

QUESTION 3: –

  • G Ltd. (India) holds 30% Equity shares in VZ Ltd. (India). It also holds 25% Equity shares in XZ International (UK).
  • Who all would be the Associated enterprises ?

SOLUTION: –

  • G Ltd. & VZ Ltd. are Associated enterprise, since G Ltd. owns > 26% voting rights in VZ Ltd.
  • VZ Ltd. and XZ International are not Associated enterprise as G Ltd. does not hold 26% voting rights in XZ International.

QUESTION 4: –

  • Y Ltd. (India) holds 30% Equity shares in R Ltd. (India) and 40% Equity shares in Z International (UK).
  • Who all would be the Associated enterprises?

SOLUTION: –

  • Y Ltd. & R Ltd. are Associated enterprise, since Y Ltd. owns > 26% voting rights in R Ltd.
  • Y Ltd. & Z International are Associated enterprise, since Y Ltd. owns > 26% voting rights in Z International.
  • R Ltd. and Z International are Associated enterprise as Y Ltd. holds more than 26% voting rights, in both the Companies.

QUESTION 5: –

  • X Ltd. (India) holds 10% Equity shares in Z International (Switzerland) as on April 1, 2016. It further acquired Equity shares in Z International so that its aggregate shareholding reached at 30% as on November 1, 2016.
  • Whether X Ltd. and Z International would be the Associated enterprise for FY 2016-17 ?

SOLUTION: –

  • X Ltd. and Z International are Associated enterprise for F.Y. 2016-17.
  • The condition of 26% voting right should exist at any time during the previous year.
  • Once that condition is satisfied, then both enterprises shall be deemed to be AE for the entire year.

QUESTION 6 : –

  • R Ltd. (India) holds 35% Equity shares in T International (Russia) as on April 30, 2016. However, its shareholding decreased to 20% as on December 1, 2016.
  • Whether R Ltd. and T International would be the Associated enterprise?

SOLUTION: –

  • R Ltd. and T International are Associated enterprise for F.Y. 2016-17.
  • The condition of 26% voting right should exist at any time during the previous year.
  • Once that condition is satisfied, then any subsequent reduction in shareholding in same year does not affect the status of Associated enterprise.

INTERNATIONAL TRANSACTION [SECTION 92B]

Transfer pricing provisions are applicable to determine the arm’s length price of international transaction and specified domestic transactions between Associated enterprises. Even though domestic transactions are covered, generally transfer pricing provisions are mostly considered in the context of international transaction.

Thus, it is essential to understand the meaning of international transaction, as if a transaction is not an international transaction, TP provision would not apply. However, to understand the definition of “International Transaction”, it is first important to understand the definition of “Transaction”.

DEFINITION OF TRANSACTION [SECTION 92F & RULE 10A(D)]

Sections 92F provides for an inclusive definition of transaction, thereby implying that if a particular transaction is not covered within this definition, it may still  amount to be a transaction for TP purpose. It defines as Transaction as under :

“Transaction” includes

  • an arrangement, understanding or action in concert,
  1. whether or not such arrangement, understanding or action is formal or in writing; or
  2. whether or not such arrangement, understanding or action is intended to be enforceable by legal proceeding.

For computation of arm’s length price under Rule 10A of the IT Rules, Rule 10A(d) defines a “Transaction” as including number of closely linked transactions.

 

EXAMPLES ON MEANING OF TRANSACTION

EXAMPLE 1: –

  • ICO Private Ltd. has a show room of home furnishings in New Delhi. Due to high demand of furniture during Diwali, ICO places an order for certain furniture and furnishings with FCO, the overseas parent of ICO. FCO agrees to supply the furniture to ICO on credit basis and agrees to formalize the arrangement after Diwali.
  • Would the transaction of sale of furnishing amount to a transaction ?

SOLUTION: –

  • To constitute a transaction, it is not mandatory to have a formal written agreement. Transaction” includes an arrangement, understanding or action in concert, whether or not such arrangement, understanding or action is formal or in writing. In view of this, transaction of sale of furnishing would amount to a transaction.

EXAMPLE 2: –

  • ICO manufactures shirts and trousers (in-house) for its showroom of readymade garments. FCO agrees to supply fine quality of fabric as demanded by ICO, on a no-return, full upfront payment basis, without any formal agreement. FCO supplied sub-standard quality of fabric due to which ICO suffered heavy losses.
  • Would the transaction of sale of fabric amount to a Transaction , even though there is no formal agreement between parties ?

SOLUTION: –

To constitute a transaction for Transfer Pricing purpose, it is not mandatory to have a formal written agreement, or any intention of the parties to legally enforce a transaction. However, to constitute a Transaction, there should be an arrangement, understanding or action between parties. In the present case, even though there was no formal agreement, there was an understanding between parties that FCO would supply fine quality of fabric as demanded by ICO.

  • In view of this, transaction of “sale of fabric” would amount to a transaction for transfer pricing purposes.

 

DEFINITION OF INTERNATIONAL TRANSACTION [Section 92B]

In order to constitute an International Transaction, a transaction should satisfy the following conditions : –

  • It should be a transaction as defined in Section 92F,
  • Transaction should be between two or more Associated enterprises.
  • Either or both of the parties to transaction should be non-residents.
  • Transaction should relate to any of the following :
    • Purchase, sale or lease of tangible or intangible property; or
    • Provision of services; or
    • Lending or borrowing money; or
    • Any other transaction having a bearing on the profits, income, losses or assets of the enterprises; or
    • Mutual agreements or arrangements between two AE for allocation or apportionment of, or any contribution to, any cost or expense incurred or to be incurred in connection with a benefit, service or facility provided or to be provided to any one or more of such enterprises.

CASE LAW – RECEIPT OF SECURITY PREMIUM BELOW MARKET VALUE IN RESPECT OF ISSUE OF SHARES – WHETHER AN INTERNATIONAL TRANSACTION ?

Vodafone India Services (P.) Ltd. v Union of India [2014] 50 taxmann.com 300 (Bombay)

Facts: –

  • Vodafone India (‘Assessee’) issued 2,89,224 shares [face value of Rs. 10 each] at a premium of Rs. 8,509 per share to its holding company. It had determined the fair market value of equity shares at Rs. 8,519 per share.
  • However, according to Assessing Officer and TPO, the assessee ought to have valued each equity share at Rs. 53,775. Accordingly, shortfall in premium to the extent of Rs. 45,256 per share (Rs 53,775 – Rs 8,519) resulted into total shortfall of receipts of Rs. 1308.91 crores.
  • Both the Assessing Officer and the TPO held that said amount of Rs. 1308.91 crores would be income of the assessee.

Held : –

  • The activity of issue of shares to Associated enterprise at a price below the fair market value does not give arise to any income.  There should be income arising from International Transaction for application of transfer pricing provisions.
  • Income will not   include capital receipts , unless such receipts are specifically specified to be covered as income .
  • The amounts received on issue of share including the premium is on capital account. Thus, receipt of security premium from associated enterprise below market value could not be considered as international transaction.
  • Thus, transfer pricing provision are not applicable on such transaction.

 

CBDT’s instruction No. 2/2015, dated 29-1-2015

CBDT had also accepted the aforesaid judgment of Bombay High Court that premium on issue of shares, was on capital account and does not give rise to any income. Thus, premium on issue of shares not liable to transfer pricing adjustment.

EXAMPLES ON INTERNATIONAL TRANSACTION

EXAMPLE 1 : –

  • A Ltd. (India), purchases raw material from its Associated enterprise AB Ltd. (India).
  • Would the transaction amount to an international transaction ?

SOLUTION : –

  • In order to be considered as international transaction, one of the party to the transaction should be non-resident.
  • In this case, neither A Ltd. nor AB Ltd. is non-resident. Thus, such transaction would not be considered as an international transaction.
  • Such transaction may be covered as “Specified Domestic Transaction” where one of the entity is claiming profit linked deductions, i.e., Section 80-IA, 80-IB, 10A, etc. or other conditions applicable on SDT are satisfied.

EXAMPLE 2 : –

  • D Ltd. (India) imports goods from E International (Switzerland). D Ltd holds 10% shares in E International.
  • Would the transaction amount to an international transaction?

SOLUTION : –

  • In order to be considered as international transaction, both parties should be Associated enterprise.
  • In this case, D Ltd. is holding less than 26% shares in E International. Thus, D Ltd. and E International are not Associated enterprise. Thus, such transaction of import would not be considered as an international transaction.

EXAMPLE 3 : –

  • C Ltd. (India) imports 10,000 units of goods from its Associated Enterprise C International (Germany) at USD 50 per unit. C Ltd. (India) imports 10,000 units of goods of same quality from independent third party in Germany at USD 50 per unit.
  • Whether the transaction is at arm’s length price ?
  • Would the transaction amount to an international transaction?

SOLUTION : –

  • In this case, the transaction of import from Associated enterprise is at arm’s length price as C Ltd. imports same quality of goods from third party at USD 50 per unit.
  • Transaction of import from Associated enterprise would be considered as an “international transaction” even if transaction of import is made at arm’s length price.

EXAMPLE 4 : –

  • V (India) is an Associated enterprise of V International (UK). It issued certain shares at Rs. 5,000 per share (face value of Rs. 10 each and a premium of Rs. 4,990 per share) to V International. The market value of per share determined by TPO was Rs. 10,000 per share.
  • Whether the receipt of premium at less than the FMV would be deemed as an international transaction ?

SOLUTION : –

  • Receipt of lower premium on issue of shares to an Associated enterprise, would not be considered as an international transaction as per the Ruling of Bombay High Court in case of Vodafone and CBDT’s instruction 2/2015, dated 29-1-2015.

 

DEEMED INTERNATIONAL TRANSACTION [SECTION 92B] (2)

In certain cases, to avoid applicability of TP provisions, AE’s may agree into a transaction, by adding an independent third party to a transaction, such that TP provisions would not apply, if the form of the transaction is considered . However, in substance, the terms and conditions relating to such transactions are decided by the associated Enterprise in such a manner, as if the transaction was between two associated Enterprises.  To deal with such cases the concept of deemed International transaction has been Incorporated.

A transaction entered into by an enterprise,  with a person other than an Associated enterprise (i.e., independent third party) shall be deemed to be a transaction entered into between two AEs, if :

  • there exists a prior agreement in relation to the relevant transaction between independent third party and the AE; or
  • the terms of the relevant transaction are determined in substance between independent third party and the AE.

Facts:

  • I Ltd. of India and S International of Singapore are AE.
  • I Ltd. and U International enters into an agreement for provision of services by U International (Non AE of I Ltd.).
  • Terms of agreement between I Ltd. and U International will be governed by prior agreement between S International and U.

 

Issue:

  • Whether the transaction between I Ltd. and U International would be deemed as an international transaction ?

 

EXAMPLE 2 : –

  • In the above example, if the nature and purpose of the transaction between I Ltd. and U International is entirely different from what was contemplated in the prior agreement between S and U Ltd., whether the transaction between I Ltd. and U International would be deemed as an international transaction ?

SOLUTION : –

  • Transaction between I Ltd. and U International cannot be deemed as international transaction in such a case, as the nature and purpose of relevant transaction is completely different from what was contemplated in the prior agreement between U Ltd. and S International.

 

Facts:

  • BB Ltd. and B Ltd. of India are AE. BB Ltd. entered into an agreement with C international (non AE) to determine the terms of provision of services between C International and B Ltd.
  • B Ltd. and C International enter into a service agreement for provision of services.

Issue:

  • Whether the transaction between B Ltd. and C International would be deemed as an international transaction ?

Solution:

  • For an international transaction, one of the AE should be non-resident. In this case neither B Ltd. nor BB Ltd. is non-resident. Hence, the transaction between B Ltd. and C International cannot be deemed as international transaction.

EXPLANATION TO SECTION 92B – INTERNATIONAL TRANSACTION

The definition of the term ‘international transaction’ also includes several other items including tangible/ intangible property.


 

 

Arms’ length principle

  • The ARM’s length principle is the fundamental principle within transfer pricing. The purpose of this principle is that if there is a transaction between two related parties (AE’s), the price of such transaction should be charged/ received, as the price that would have been charged/ received, if the transaction was between unrelated parties. The relation between the parties,  should not affect the price at which transaction is entered, i.e, there should be no discounts offered/premium charged, or other concessional treatments in the price, merely because the two parties are related.

DEFINITION OF ARM’S LENGTH PRICE [SECTION 92F]

Section 92F(ii) of the Income Tax Act, 1961 defines arm’s length price to mean a price –

  • Which is applied, or proposed to be applied in a transaction – This implies that the arm’s length price can be applied to an existing or a future transaction;
  • Transaction is between person other than AEs – The person should not be either : –
    • Associated enterprise
    • Deemed associated enterprises as per Section 92A;
  • Transaction is entered in uncontrolled conditions, i.e., the conditions under which the transaction has taken place, should not have been designed or suppressed in a manner, so that certain predetermined results are obtained.

Arm’s Length Price (“ALP”) provides a benchmark against which transactions between Associated Enterprise can be compared.

COMPUTATION OF ARM’S LENGTH PRICE [SECTION 92C]

There are various methods which are used for determination of the Arm’s Length Price (“ALP”) in relation to an international transaction. Each of these method can be applied to a particular set of transaction, based on their nature and facts.

As per Section 92C of the Income Tax Act, 1961, ALP shall be determined by any of the following methods  :

  •  TRADITIONAL TRANSACTION METHOD –
    • Comparable Uncontrolled Price Method (‘CUP’)
    • Resale Price Method (‘RPM’)
    • Cost Plus Method (‘CPM’)
  • TRANSACTIONAL PROFIT METHODS –
    • Profit Split Method (‘PSM’)
    • Transactional Net Margin Method (‘TNMM’)

 

ANY OTHER METHOD PRESCRIBED BY THE CENTRAL BOARD OF DIRECT TAXES – Rule 10AB

  • Other Method , can be considered as a method which takes into account the price which has been charged or paid, or would have been charged or paid, for the same or similar uncontrolled transaction, with or between non-associated enterprises, under similar circumstances, considering all the relevant facts.

COMPARABLE UNCONTROLLED PRICE (“CUP”) METHOD

WHEN CAN CUP METHOD BE APPLIED

Comparable UNCONTROLLED PRICE,  as the name suggests, compares the price in the transaction which is being evaluated for arm’s length, with the price charged /received between two unrelated parties for similar goods or services.

This can take place under two cases, i.e, where the transaction is between : –

  • the company and unrelated third party (Internal CUP) . In such cases, the concerned company buys, or sells similar goods or services in comparable transactions with unrelated enterprises; or
  • Two unrelated parties (External CUP) . In such cases, two Unrelated enterprises buy or sell similar goods or services, as is being done between the AE.

 

Facts:

  • ICO 1 sold unbranded Colombian coffee beans to ICO 2 (non AE).
  • ICO1 also sold unbranded Colombian coffee beans of similar type, quality and quantity to FCO.

Issue:

  • Identify the nature of transaction as
    1. Internal CUP ; and
    2. Controlled transaction.

Solution:

    • Transaction between ICO1 and FCO is a controlled transaction.
    • Transaction between ICO 1 and ICO 2 is an internal CUP.

Facts:

  • AE 1 sold unbranded Colombian coffee beans to AE 2.
  • AE 1 did not sell any unbranded Colombian beans to third party (Non-AE).
  • There is a sale of unbranded Colombian coffee beans of similar type, quality and volume between non-AE 1 non-AE 2.

Issue:

  • Identify the nature of transaction as External CUP and Controlled transaction ?

Solution:

  • Transaction between AE 1 and AE 2 is a controlled transaction.
  • Transaction between Non – AE 1 and Non AE 2  is termed as external CUP, since it’s a transaction between two external parties.

STEPS INVOLVED IN CUP METHOD – Assume examining transactions of X Ltd. for transfer pricing purpose

STEP 1 : – identifying prices of  comparable uncontrolled transaction/s

Identify prices charged from or paid to, on transfer of goods or services

in comparable uncontrolled transaction/s by X Ltd. Such transaction could be entered into by X Ltd. itself or between two unrelated enterprise.

STEP 2 : – Adjustments to uncontrolled Price

The price arrived at Step 1 should be adjusted for the following : –

a.  If there are any functional differences between the international transaction or the Specified Domestic Transaction (SDT) under review, and the comparable uncontrolled transactions , adjustment should be made for such functional differences . Functional differences could be for the following : –

a) Quality of product or service,

b) Contractual terms,

c) Credit terms (one entity allows a credit of 1 month and other allows credit of 6 months),

d) Transport terms – Free on Board, Cost, Insurance and Freight

e) Market level (wholesale, retail etc.));

b.  If there are any differences between the enterprises entering into such transactions, such as size of the entity (if one entity is market leader and other is a small startup in same segment), operating environment, which could materially affect the price in the open market, the price should be adjusted for such differences.

Such adjusted price will be the arm’s length price.

EXAMPLES ON CUP METHOD

EXAMPLE 1 : –

  • AE 1 sold unbranded Colombian coffee beans to AE 2 at Rs 5,00,000.  AE 1 sold unbranded Colombian coffee beans of similar type, quality and quantity to third party (Non-AE) at Rs 4,00,000.
  • Analyse the impact of transfer pricing provisions and ascertain the ALP?

SOLUTION: –

  • Price charged by AE 1 for sale of coffee beans from AE 2 is Rs. 5,00,000 and the price charged from Non-AE is Rs. 4,00,000.
  • Since, the price charged from AE 2,  Rs. 5,00,000 is more than the price charged from Non-AE Rs. 4,00,000, we cannot consider Rs 4,00,000 as ALP as it will reduce the taxable income of AE 1. This is due to the reason that TP provision cannot be applied to result in reduction in taxable income.

Hence, the ALP for sale of coffee beans by AE 1 to AE 2 shall be Rs. 5,00,000.

EXAMPLE 2 : –

  • AE 1 sold unbranded Colombian coffee beans to AE 2 at Rs 5,00,000.  AE 1 sold unbranded Colombian coffee beans of similar type, quality and quantity to third party (Non-AE) at Rs 6,00,000.
  • Analyse the impact of transfer pricing provisions and ascertain the ALP ?

SOLUTION : –

  • Price charged by AE 1 for sale of coffee beans from AE 2 is Rs. 5,00,000 and the price charged from Non-AE is Rs. 6,00,000.
  • Since, the price charged from Non-AE is Rs. 6,00,000, this would be an internal CUP . Since it is more than the price charged from AE 2 under controlled transaction, i.e. Rs. 5,00,000, the ALP would be Rs. 6,00,000.
  • Accordingly, by applying the TP provisions, Rs. 1,00,000 (6,00,000 – 5,00,000) would be added to the income of AE 1.

 

EXAMPLE 3 : –

  • AE 1 sold unbranded Colombian coffee beans to AE 2 at Rs 5,00,000.  AE 1 sold unbranded Colombian coffee beans of similar type, quality and quantity to third party (Non-AE) at Rs 5,50,000 (Internal CUP). Independent third party (i.e., Non-AE) sold unbranded Colombian coffee beans of similar type, quality and quantity to third party (Non-AE) at Rs 6,00,000. (External CUP).
  • Analyse the impact of transfer pricing provisions and ascertain ALP ?

SOLUTION : –

  • In the present case, ALP can be as under : –
    • Applying internal CUP, the price would be Rs 5,50,000
    • Applying external CUP, the price would be Rs 6,00,000
  • Where both internal and external CUP are available, Internal CUP should be preferred over External CUP for comparison of controlled transaction with uncontrolled transaction.
  • In this case, the ALP would be Rs 5,50,000, i.e., the price at which coffee beans were sold by AE 1 to Non-AE.
  • Hence, the income of AE 1 would be increased by Rs 50,000 (5,50,000 – 5,00,000).

EXAMPLE 4 : –

  • AE 1 sold unbranded Colombian coffee beans to AE 2 at Rs 5,00,000.  AE 3 sold unbranded Colombian coffee beans of similar type, quality and quantity to AE 4 at Rs 5,50,000. Independent third party (i.e., Non-AE) sold unbranded Colombian coffee beans of similar type, quality and quantity to third party (Non-AE) at Rs 6,00,000. (External CUP).
  • Analyse the impact of transfer pricing provisions on AE 1 and ascertain ALP ?

SOLUTION: –

  • Transactions between two AE’s are controlled transactions and such transactions cannot be considered as base for determining ALP.
  • In the given case, transactions between AE 1 & AE 2 amounting Rs. 5,00,000 and AE 3 & AE 4 amounting Rs. 5,50,000 are controlled transactions and hence should not be considered as comparables for the purpose of determining ALP.
  • Therefore, ALP would be Rs 6,00,000 in the case, i.e., the price at which coffee beans were sold between two Non-AE.
  • Hence, the income of AE 1 would be increased by Rs 1,00,000 (6,00,000 – 5,00,000).

 

EXAMPLE 5 : –

  • AE1 sold 1,000 bicycles to AE 2 at FOB price (Free on Board) of Rs 3,000 per bicycle.
  • AE 1 sold 10,000 bicycles to Non-AE at CIF price (Cost, Insurance and Freight) of Rs 6,000 per bicycle.
  • AE2 would bear the cost of insurance and freight of Rs 500 per bicycle.
  • As Non-AE placed order in large volumes, AE 1 offered quantity discount of Rs 200 per bicycle.
  • Sales were made to Non-AE at credit facility of three months whereas the sales to AE 2 have always been on cash basis.
  • The cost of credit may be taken as 1% per month.
  • Analyse the impact of transfer pricing provisions and ascertain the ALP ?

Solution: –

JUDICIAL RULINGS ON CUP METHOD

RESALE PRICE METHOD (“RPM”)

In the case of, resale price method, there are three parties to a transaction : –

  • Non-resident related enterprise – AE1
  • Resident importer and reseller – AE2
  • Resident Buyer – Non – AE1

 

Under the  resale price method, when a resident importer and reseller (AE2), and a related enterprise (AE1), enter into a transaction, and the purchaser or service recipient in that transaction (AE2) , resells the product/ provides services to an unrelated enterprise (Non – AE1), the ALP has to be calculated by deducting a “normal profit of the purchaser/recipient of services” from that resale price . The price so arrived at is deemed to be the arm’s length price applicable to the transaction between the related parties.

RPM compares the gross margins (i.e. gross profit over sales) earned in transactions between related and unrelated parties for determination of Arm’s length price.

NOTE : –

  • RPM is generally used in case where the tested party (AE2) purchases products or acquire services from related parties and sells the same to independent parties without adding substantial value to the product or services. For example in case of distribution function.

STEP 1 : –

Identify the Resale Price, i.e, the price at which property or services are resold or provided to an unrelated party

STEP 2 : –

Less :-  

Reduce Normal gross (not net) profit margin, which are derived BY THE ENTERPRISE from the resale price of such property or services in comparable uncontrolled transactions (internal comparable). (Normal Net profit margin should not be considered as we need to reduce only gross profit margin)

STEP 3 : –

Less :-  

Reduce any expenses incurred by the enterprise in connection with the purchase of goods /property,  or obtaining of services (For example, if customs duty borne by purchaser, the same should be reduced in Step 3).

STEP 4 : –

Add/Less:-

  • Impact of Functional and other differences, (including accounting practices) between international transaction (or SDT) and the comparable uncontrolled transactions,
  • Impact of differences, between the enterprises entering into such transactions, which could materially affect the amount of gross profit margin in the open market (Adjustments affecting only net profit margin should not be considered).

 

RESALE NORMAL GROSS PROFIT MARGIN

The resale normal gross profit margin (Step 2 above) is the margin which the enterprise would earn if it : –

  • Purchase similar product from an unrelated party; and
  • Resale of such product to another unrelated party.

The resale margin is the margin, which the reseller, would try to obtain to cover the cost of sales and other charges.

This comparable gross margin is determined by reference to either : –

  • the resale price margin earned by re-seller itself, in comparable uncontrolled transactions (internal comparable); or
  • the resale price margin earned by an independent enterprise in comparable uncontrolled transactions (external comparable).

INTERNAL COMPARABLE – RPM

 

EXTERNAL COMPARABLE – RPM – INTERNAL COMPARABLE

 

EXAMPLE – RPM – INTERNAL COMPARABLE

Facts:

  • AE 2 purchases bicycles from AE 1 at Rs. 4,50,000 and resold these bicycles to Non – AE 1 at Rs. 5,00,000.
  • AE 2 purchases bicycle from Non – AE 2 and resold the same to Non – AE 3. AE 2 earned gross profit margin of 20% on sales on such transaction.
  • There are no expenses in connection with purchase of bicycles and no functional or other differences which could affect the gross profit margin earned by AE 2 ?

Issue:

  • Compute Arms’ length price under Resale Price Method?

Solution : –

EXAMPLE – RPM – INTERNAL COMPARABLE

Facts:

  • AE 2 purchases bicycles from AE 1 at Rs. 4,50,000.
  • AE 2 resold these bicycles to Non – AE1 at Rs. 5,00,000.
  • AE 2 purchases bicycles from Non – AE 2 and resold the same to Non – AE 3. AE 2 earned gross profit margin of 20% on sales on such transaction.
  • AE 2 offers extended warranty of one-year to Non – AE 1. The estimated cost of extended warranty is Rs. 2,000.

Issue:

    • Compute Arms’ length price under Resale Price Method ?

Solution : –

 

 

Facts:

  • AE 2 purchases bicycles from AE 1 at Rs. 4,50,000. & resold these to Non – AE 1 at Rs. 5,00,000.
  • AE 2 purchases bicycles from Non – AE 2 and resold the same to Non – AE 3. AE 2 earned gross profit margin of 20% on sales on such transaction before any discount.
  • Differences in comparable transactions : –
      • AE 2 incurred freight of Rs. 20,000 on purchase from AE 1. However, no freight was incurred on purchases made from Non – AE 2.
      • Non – AE 1 purchased a larger order due to which it was given quantity discount by AE 2. Such quantity discount reduces the gross profit margin (as above) with Non – AE 1 by 3% on sales.

Issue:

    • Compute Arms’ length price under Resale Price Method ?

Solution : –

 

JUDICIAL RULINGS ON RPM

COST PLUS METHOD (“CPM”)

Under Cost plus method, the arm’ s length price is determined by adding appropriate gross profit margin , also known as the cost plus mark up, (considering the function performed, return on capital and risk assumed by an entity) to the AE’s cost of producing goods/ providing services.

 

In other words, ALP =

This method is most suitable in cases, where a manufacturer sells tangible goods to both related and unrelated parties.

 

As per the Organisation for Economic Co-operation and Development (OECD), CPM method is applicable when,

  • Semi-finished goods are sold between Associated Enterprises,
  • There are long term supply and purchase agreements between Associated Enterprises,
  • Provision of services between Associated Enterprises,
  • Agreements relating to contract manufacturing, between Associated Enterprises.

STEPS INVOLVED IN CPM

STEP 1 : – Direct and indirect costs of production

Determine the direct and indirect costs of production in a tested party transaction.

STEP 2 : – Determine normal gross profit mark-up to such costs

Determine the amount of a normal gross profit mark-up to such costs, arising from the transfer or provision of the same or similar goods or services : –

  1. by the enterprise itself, (i.e., transfer of similar goods or services by the enterprise – Internal comparable), or
  2. by an unrelated enterprise to another unrelated enterprise (i.e., transfer of similar goods or services between unrelated parties) – External comparable,

in a comparable uncontrolled transaction, or a number of such transactions.

STEP 3 : –

The normal gross profit mark-up determined above shall be adjusted to account for the functional and other differences.

STEP 4 : –

The costs referred to in Step 1, shall be increased by the adjusted profit mark-up calculated in Step 3 leads to arm’s length price.

 

JUDICIAL RULINGS ON THE SELECTION OF CPM

PROFIT BASED METHODS

When traditional methods of determining arm’s length price, are not found to be appropriate given the facts of the case, the profit based methods can be used to determine the arm’s length price.

Profit-based methods examine the profits,  that arise from particular transactions among Associated Enterprises, against profits derived by other independent enterprise, who may be involved in same or similar transaction.

The two profit-based transfer pricing methods, recognised by the TP legislation, are : –

  • Profit Split method (“PSM”) ;
  • Transactional net margin method (“TNMM”).

PROFIT SPLIT METHOD (“PSM”)

In case of a transaction between two related Enterprises, both the enterprise maybe earning certain profits or losses. Under the profit split method, the total operating profit earned by  the parties involved in the transaction is first ascertained. There after it is splitted, amongst the parties, based on the respective contributions.

PSM evaluates, if, the profits or loss, allocated to a particular entity, out of combined operating profit,of controlled transaction, is at arm’s length, considering their individual contribution in the overall profit or loss.

 

STEPS INVOLVED IN PSM

STEP 1 : – DETERMINE COMBINED NET PROFIT

Determine combined net profit of the AEs, arising from the controlled international transaction.

STEP 2 : –

Evaluate the relative contribution made by each AE, to the earning of such combined net profit.

STEP 3 : –

The combined net profit is then splitted amongst the enterprises in proportion to their relative contributions.

STEP 4 : –

The profit so apportioned to the tested party, is considered to arrive at an arm’s length price of the international transaction.

 

 

 

 

 

 

 

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