Finance Bill 2012 has cast the transfer pricing net wide and deep. There is not only an increase in scope of transfer pricing regulations but also a qualitative tightening on enforcement with a slew of retrospective amendments
Detailed transfer pricing regulations were introduced in India by the Finance Act, 2001. While originally the regulations applied only to cross-border transactions, the Finance Bill 2012 recently has extended their scope to domestic transactions. Considering the widespread ramifications of ‘transfer pricing’ on the conduct of a multinational company’s affairs, and even on domestic related party transactions, post budget 2012, the need for a basic understanding of transfer pricing regulations cannot be overemphasized.
The concept of transfer pricing is inextricably linked with the ability of multinational enterprises to control prices in related party transactions, and thereby evade taxes by shifting profits to low taxjurisdictions. A multinational company can fix inter-company prices in a manner that maximizes profit in low tax jurisdiction and minimizes the same in a relatively high tax jurisdiction. In this manner a conglomerate can minimize its global tax burden by artificially shifting profits to low tax jurisdiction(s).
The term transfer pricing as such, is inherently neutral and refers to the valuation of goods or services exchanged between different divisions of the same organization. Thus, transfer pricing merely denotes a valuation exercise with nothing inherently suspect about it. The price at which two unrelated parties trade with each other is referred to as the ‘arm’s length price’. On the other hand, the price at which goods or services are supplied by one company to a related company is referred to as the transfer price. The transfer pricing of goods or services may be such that the transfer price coincides with the ‘arm’s length price’ or there is a significant deviation between the two calling for a correction. It is in the latter situation, that the transfer pricing regulations come into play to introduce the required adjustment
The Indian legal and regulatory landscape underwent a significant change in the mid to late nineties as India embarked on the economic reforms program. As the Indian economy was opened up to foreign investment and there was a quantum increase in cross-border transactions, an expert group was set up by the government to study global transfer pricing practices and examine the need for detailed legislation specifically dealing with transfer pricing. Based on the recommendations ofthe group, in 2001, India enacted new provisions in the Income-tax Act dealing specifically with transfer pricing.
Indian transfer pricing regulations are broadly in line with OECD Guidelines [Transfer Pricing Guidelines for Multinational Enterprises and Tax administrations (1995)]. To some extent, the regulations have been borrowed from legislations of China, Korea, Germany, Italy and Brazil (some aspects of US and UK regulations have also been considered).
Indian transfer pricing regulations apply to cross-border transactions between related parties. The regulations delineate specific situations in which two entities are deemed to be related (such as voting power in excess of 26 percent, substantial dependence on an enterprise for supply of raw materials, dependence on intellectual property sourced from an enterprise, etc). Thus, to determine whether two entities are related one is to examine whether or not they are covered by any one of the specific situations described in the regulations. Cross-border transactions between related parties are picked up for scrutiny based on the aggregate value of such transactions. Transactions exceeding an administratively specified threshold value of Rs. 150 million are referred to a specialized wing of tax officers (Transfer Pricing Officers) for detailed examination.
The Transfer Pricing Officer may employ any one of five methodologies, prescribed under the regulations [Comparable Uncontrolled Price (CUP) Method, Resale Price Method (RPM), Cost Plus Method (CPM), Profit Split Method (PSM) and Transactional Net Margin Method (TNMM)] for determining the arm’s length price.
Each of the prescribed methodologies relies on the principle of ‘comparability’. This entails identifying similar transactions and using their prices or profit margins as guiding posts. The most direct application of this principle is found in the use of CUP method that compares the transfer price with the price at which independent parties have undertaken a similar transaction. Thus, where a related party is being charged $ 500 for a good when the same is being sold for $ 1000 to third parties, the intra-corporate dealing immediately becomes suspect. In such a case, the taxpayer did better have cogent reasons for charging a lower price to the related party or else an adjustment is quite likely
“The onus is on the taxpayer to prove that the transfer price is justified. Towards this end, the taxpayer is required to maintain detailed documentation to support the finding in respect of the arm’s length price. In the absence of such documentation, the taxpayer may be subjected to penalty under the regulations (as high as 2 percent of the value of cross border transaction)”
The revenue authorities have been extremely aggressive while enforcing the transfer pricing regulations (to say the least). The adjustment curve has moved upwards with relentless momentum inducing a 100 percent growth in the adjustment quantum on a year on year basis. The adjustment value of $ 8.5 billion in fiscal year 2008 (for the seventh round of Transfer Pricing audit) has already made headlines.
There are several factors responsible for the sky high transfer pricing adjustments. Some factors are systemic and attributable to the inherent nature of Indian Transfer Pricing regulations requiring use of arithmetic mean for determining the arm’s length price and use of single year data (not available with taxpayers at the time of drawing up the Transfer Pricing documentation) for benchmarking prices. Similarly, absence of safe harbor rules and an APA mechanism (until recently) are other factors that have fuelled sky-high transfer pricing adjustments.
Finance Bill 2012 has caste the transfer pricing net wide and deep. There is not only an increase in scope of transfer pricing regulations but also a qualitative tightening on enforcement with a slew of retrospective amendments.
The biggest break-through has undoubtedly been the introduction of the much awaited Advance Pricing Agreement (‘APA’) mechanism in India. An APA is an arrangement wherein the taxpayer determines the transfer pricing methodology or price in agreement with the Revenue Department, in advance of the transaction. In this sense, APA is a pre-emptive mechanism and not really a tool for dispute resolution. The greatest benefit of an APA is the certainty it imparts to the transfer price determination process which will be accepted and respected by the Revenue Authorities for a definite time period.
Extension of transfer pricing provisions to specified domestic transactions increases the compliance burden on taxpayers. With FY 2012-13 being the first year of applicability of transfer pricing regulations to domestic transactions, corporates need to plan even domestic inter-company prices in advance to conform to the arm’s length standard by the year end.
For the first time ‘intangibles’ have been comprehensively defined in the Act and the definition of ‘international transaction’ broadened to cover contentious transactions like ‘guarantee’, working capital advances and ‘business restructuring. The definition of ‘intangibles’ also includes human capital/ workforce calling for a careful pricing analysis before workforce is transferred or re-located pursuant to a business re-structuring exercise. The proposed amendment makes Indian Transfer Pricing regulations amongst the few country regulations (similar to the US Transfer Pricing regulations) that consider ‘workforce’ as an intangible.
While above amendments aim to impart greater clarity their retrospective operation (in a number of cases retrospective effect dates back to 2001 when the detailed transfer pricing regulations were first issued) sullies the excitement. As precedents lose relevance and tax planning is rendered redundant, one questions the wisdom of retrospective amendments unsettling a decade old law and jurisprudence. Ironically, it is the same Finance Bill that also harps on certainty through introduction of APAs. Having said that one will also have to wait and watch how the retrospective amendments play out in Courts. Some, if not all, will surely be tested on the anvil of constitutionality.
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