Having discussed the conceptual aspects of the Transfer pricing (TP) in the first part of this article titled “Understanding the Essence of Transfer Pricing” published in the last issue. In this issue, are attended to the technical aspects of the Transfer pricing.
To determine the exact price of the international transaction, a particular yardstick has to be used; this yard stick is arm’s length price (ALP). It means the price which is applied or proposed to be applied in a transaction between persons other than associated enterprises, in uncontrolled condition, Section 92F of Income Tax Act, 1961.
Simply, it is a price applied to the international transaction between two associated enterprises in such a way that both are treated as un-connected to each other. Thus, the transaction has to be priced as if the parties to the transaction are independent entities. In the case of Coca Cola India Inc. vs. Assistant Commissioner of Income Tax and rs,(2009)1CompLJ 460(P & H) it was held that ALP is nothing but a fair price which would have been normal price.
There are different modes of calculating arm’s length price, Section 92C of Income Tax, 1961 but out of which most appropriate method has to be used. R.10 of the Income Tax Rules 1962 provides list of guidelines to choose appropriate method.
In case of Serdia Pharmaceuticals (India) (P.) Ltd. v. ACIT, (2011) 44 SOT 391(Mum) it was held that ALP is to be determined on the basis of one of the specified methods but such a specified method must also be most appropriate method of determining the arm’s length price. This is best suited to the facts and circumstances of each particular international transaction, which provides the most reliable measure of an arm’s length price in relation to the international transaction. It is therefore, clear that the assesse must not only select a specified method of determining the arm’s length price but such a method must also be best suited to the facts of the case.
The assessee cannot simply pick up any of the specified method without discharging the onus of demonstrating that the method so selected is indeed most appropriate to the facts of the case.
According to Rule 10B (1) (a) of the Rules, there will be comparison of price charged in the controlled transaction and price charged in uncontrolled transaction. By comparing two transaction prices, ALP of the transaction in question can be determined.
Here controlled transaction means a transaction which takes place between enterprises and associated enterprises. In controlled transaction the price of the international transaction to be determined will be under control of the parties.
Un-controlled transaction is transaction which takes place between enterprises and an independent entity. In this type of transaction, the price to be charged will be left to the market to be determined.
In this method, after comparison between the two transactions, if price charged in the uncontrolled transaction is higher than the price charged in the controlled transaction, than the latter price will prevail for computing arm’s length price.
This method is dealt under Rule 10(1) (b) of the Rules, where there will be a comparison between the gross profit margin earned by the enterprise by purchasing the goods from the associated enterprises and selling the same goods without any value addition to the independent enterprises.
On comparing gross profit margin earned in respective transactions of buying the goods from the associated enterprises and transaction of reselling those goods without value addition to the independent buyer, ALP can be calculated. This method is applicable when there is a transfer of goods between associated enterprises before resale of the same to the independent party.
This method is dealt under Rule 10 (1) (c ) of the Rules. Here total cost of production incurred by the enterprise in respect of goods transferred or services provided to a related party shall be determined. According to other authors, CPM means considering something more than cost of production, Law of Transfer Pricing in India by D.P Mittal, 2009 Edition, Taxmann Publications, of a product, hence the word cost plus is used. Here some additional mark ups will be added to the cost price of the product or the service rendered. These marks up may be in the form of value of functions rendered, risk undertaken or the assets utilise. The value of the mark up added in the controlled transaction has to be compared with value of the mark up added in the uncontrolled transaction and by this arm’s length price for a particular international transaction can be calculated.
This is dealt under Rule10B (1)(d) of the rules. This method would normally be adopted in those transactions where integrated services are provided by more than one enterprise, or in the case multiple inter-related transactions, which cannot be separately evaluated.
The combined net profit of the related parties arising from a transaction, in which they are engaged, shall be determined. The residual net profit shall be split amongst the related parties in proportion to their relative contribution to the combined net profit. This relative contribution of the related parties shall be evaluated on the basis of the function performed, assets employed or to be employed and risks assumed by each enterprise. The reliable market data indicates how such contribution would be evaluated by unrelated enterprises performing comparable functions in similar circumstances. The combined net profit will then be split amongst the enterprises in proportion to their relative contributions. The profit so apportioned shall be taken into account to arrive at an arm’s length price.
Rule 10B(1) (e) of the Rules states about this method. In this method, net profit margin realised by the enterprise when transacting with associated enterprise is to be compared with the net profit margin earned by the same enterprises, when dealing with independent enterprise. On comparing net profit margin in both the transactions, arm’s length price of an international transaction in question can be calculated.
AO and TPO are the authorities mentioned under the Income Tax Act, 1961, (‘the Act’), for assessing the price of the international transaction to which arm’s length price is applicable S. 92CA of the Act.
Here the primary burden is on the assessee to prove that the price of the international transaction is in accordance with the ALP. In the case of Aztech Software and Technology Services Ltd vs. ACIT, it was held that when the primary responsibility is discharged by the taxpayer by conducting appropriate transfer pricing study, then responsibility shifts to revenue and the tax authorities are required to prove that the said comparables are not in fact comparables. Tax authorities cannot exclude the comparable cases given by the assessee as per their opinion or selection, (2007) 107 ITD 141.
In this regard, the question which arises is whether the taxing authorities can replace the method of calculation of arm’s length price by their own method. The answer may be in positive but which is conditional, because at the time making replacement by their own method AO or the TPO has to make sure that they are complying with the requirement under S. 92C of the Act and giving an opportunity of being heard to the party before making replacement is of utmost importance otherwise order of the authority will be considered invalid (2008) 26 SOT 226. (Bang.)
AO is the authority to compute the price of the international transaction where ALP is applicable, he is also having the discretion to refer the computation to TPO if he seems it necessary or expedient. In the case of Sony India (P) Ltd. v. CBDT, (2006) 157 Taxman 125 the court upheld the constitutional validity of CBDT Instruction No. 3 dated 20th May 2003 requiring compulsory reference to the TPO to determine ALP where the aggregate value of international transactions exceeds Rs.5 crore. When the assessment is referred to TPO by AO, the former will make reassessment of the price of the transaction according to arm’s length price, if he comes to the conclusion that the data used by theassessee discredits the computation and it is unreliable, incorrect or inappropriate. Before making any re-adjustment in the computation of the arm’s length price, he has to give an opportunity of being heard to the opposite party Maruti Suzuki v. ACIT (Delhi HC), 233 CTR 105.
Section 92D of the Act, provides the documentation requirement for the tax payer who has entered into an international transaction. Documentation is one the important parts in transfer pricing laws, since acts of fraud in international transaction to avoid tax burden are common regulation and prescribe a stringent documentation for determining whether pricing of the international transaction is in conformity with arm’s length price calculated for a given transaction.
The main object of documentation procedure is to assist the tax payer to determine whether the price of the transaction calculated by the parties to the transaction is in accordance with arm’s length price. It is the duty of the assessee to prove that pricing of the transaction is in conformity with arm’s length price by documents on which he relies. The burden of proof is on the assessee to prove that transfer price is in accordance with arm’s length price.
In the case of Aztec Software and Technology Service Ltd. vs. ACIT, (2007)162TAXMAN119(Bang.) the court held that the burden is on the assessee to select the most appropriate method (MAM). This decision of selecting MAM is to be substantiated by the assessee by an appropriate documentation besides substantiating as to why a particular method is considered best suited to the facts and circumstances of the international transaction and how it provides the most reliable result of the ALP.
Transfer pricing laws are one of the important milestone for the tax authorities to prevent tax evasion in the international transactions between associated enterprises, as the fixation of the price in such transaction is done by the parties to the transaction and no outside element is involved. For the convenience of the tax payers, legislation prescribes different methods for calculating price of the transaction and use of the particular method depends upon the type of the transaction entered into.
The tax evasion, especially in case of India, not only takes place in international transaction, but also takes place in domestic markets. Hence, it is recommended that transfer pricing laws will have to be made applicable to domestic transactions where maximum tax evasion is recorded. Thus, by implementing the TP model of USA, where transfer pricing laws are also applicable to domestic transaction, thereby preventing huge amounts of tax evasion.
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