INTERNATIONAL TAXATION Study Material PDF

Final Course (Revised Scheme of Education and Training) Study Material Elective Paper 6C International Taxation...

Final Course (Revised Scheme of Education and Training) Study Material Elective Paper 6C International Taxation (Relevant for May, 2020 and November, 2020 examinations) BOARD OF STUDIES THE INSTITUTE OF CHARTERED ACCOUNTANTS OF INDIA © The Institute of Chartered Accountants of India This study material has been prepared by the faculty of the Board of Studies. The objective of the study material is to provide teaching material to the students to enable them to obtain knowledge in the subject. In case students need any clarifications or have any suggestions for further improvement of the material contained herein, they may write to the Director of Studies. All care has been taken to provide interpretations and discussions in a manner useful for the students. However, the study material has not been specifically discussed by the Council of the Institute or any of its Committees and the views expressed herein may not be taken to necessarily represent the views of the Council or any of its Committees. Permission of the Institute is essential for reproduction of any portion of this material. © The Institute of Chartered Accountants of India All rights reserved. No part of this book may be reproduced, stored in a retrieval system, or transmitted, in any form, or by any means, electronic, mechanical, photocopying, recording, or otherwise, without prior permission, in writing, from the publisher. Edition : September, 2019 Website : www.icai.org E-mail : [email protected] Committee/ : Board of Studies Department ISBN No. : Price : ` Published by : The Publication Department on behalf of The Institute of Chartered Accountants of India, ICAI Bhawan, Post Box No. 7100, Indraprastha Marg, New Delhi 110 002, India. Printed by : © The Institute of Chartered Accountants of India  iii BEFORE WE BEGIN … Revised Scheme of Education and Training: Bridging the competence gap The role of a chartered accountant is evolving continually to assume newer responsibilities in a dynamic environment. There has been a notable shift towards strategic decision making and entrepreneurial roles that add value beyond traditional accounting and auditing. The causative factors for the change include globalisation leading to increase in cross border transactions and consequent business complexities, significant developments in information and technology and financial scams underlining the need for a stringent regulatory set up. These factors necessitate an increase in the competence level of chartered accountants to bridge the gap between competence acquired and competence expected from stakeholders. Towards this end, the scheme of education and training is being continuously reviewed so that it is in sync with the requisites of the dynamic global business environment; the competence requirements are being stepped up to enable aspiring chartered accountants to acquire the requisite professional competence to take on new roles. In the Revised Scheme of Education and Training, the concept of electives has been introduced at the Final level in line with the school of thought that specialisation is the key to developing professionally competent chartered accountants. As per this school of thought, an emerging chartered accountant has to be geared up to assume new roles as consultants and advisors, necessitated on account of growing business complexities, dynamic changes in legislations and regulatory requirements and client expectations. Elective Paper on International Taxation: Paving way for specialization in this key concern area of businesses engaged in cross border transactions and tax administrations Consequent to borderless economies, it has become imperative that subjects which transcend borders be added in the curriculum, for instance, Global Financial Reporting Standards and International Taxation. In fact, globalisation, capital mobility and increased trade and services have resulted in the whole world virtually becoming one market and consequently, international taxation has become a key concern area both for business enterprises engaged in cross border transactions as well as for tax administrations of the concerned States. In a highly advanced IT enabled business scenario where an entity operates from many establishments spread throughout the globe, chartered accountants have to be well versed with the nuances of international taxation to be able to give an informed and correct advice and ensure compliance with tax laws. With this objective, International Taxation has been introduced as an elective paper in the Final Course. In fact, © The Institute of Chartered Accountants of India  iv the core paper on Direct Tax Laws and International Taxation [Paper 7] in the Final Course, in which there is a dedicated part on International Taxation for 30 marks, lays the foundation for further specialisation in the area of International Taxation by opting for the Elective Paper [Paper 6C] on International Taxation. Syllabus of International Taxation: Division into two parts The syllabus of this elective paper on International Taxation is divided into two parts: Part I comprises of “Taxation of International Transactions and Non-resident Taxation in India” covering Transfer Pricing provisions under the Income-tax Act, 1961, Non-resident Taxation, Double Taxation Relief, Advance Rulings as well as an Overview of the Law and Procedures under the Black Money (Undisclosed Foreign Income and Assets) and Imposition of Tax Act, 2015. Part II comprises of “Other aspects of International Taxation” covering Taxation of E- Commerce Transactions, Overview, Features, Application and Interpretation of Tax Treaties, Anti Avoidance Measures and Overview of Model Tax Conventions. Elective Paper on International Taxation: Building on the knowledge base of the Core Paper on Direct Taxes and International Taxation Part I of the syllabus of this paper comprises of five chapters and Part II comprises of four chapters. In this Study Material, the contents of Part I on Taxation of International Transactions and Non-resident Taxation in India are based on the provisions of income-tax law, as amended by the Finance (No. 2) Act, 2019. The relevant assessment year is A.Y.2020-21. Students may note that in the chapters comprised in Part I of the Syllabus of this Elective Paper, the special provisions relating to non-resident taxation, transfer pricing, double taxation relief and advance rulings under the Income-tax Act, 1961 are dealt with in detail in this Study Material. Also, certain general provisions of the Income-tax Act, 1961 which would apply in the same or modified form to non-residents have been discussed at some length. Since these general provisions and other general provisions of the income-tax law are dealt with in detail in the core paper on Direct Tax Laws and International Taxation [Final Paper 7], students are expected to integrate and apply the provisions of income-tax law (dealt with in Final Paper 7: Direct Tax Laws and International Taxation and in the Elective Paper 6C: International Taxation) in making computations and addressing relevant issues in case study based questions raised in the Elective Paper on International Taxation. Enhance your knowledge through the webpages on international taxation and non-resident taxation and relevant Acts and Rules available at the Income-tax Department website Along with the Study Material, students are also advised to read the relevant provisions of the Income-tax Act, 1961 [as amended by the Finance (No.2) Act, 2019], the updated edition of the Income-tax Rules, 1962, Black Money (Undisclosed Foreign Income and Assets) and Imposition of © The Institute of Chartered Accountants of India  v Tax Act, 2015 [As amended by the Finance (No.2) Act, 2019], the Black Money (Undisclosed Foreign Income and Assets) and Imposition of Tax Rules, 2015, Chapter VIII of the Finance Act, 2016 on Equalisation Levy and Equalisation Levy Rules, 2016 available at the website of the Income-tax Department, Government of India, www.incometaxindia.gov.in. It is desirable that the above Acts and Rules form part of a candidate’s reference material for open book in addition to the September, 2019 edition of the Study Material of Final Paper 6C International Taxation, the October, 2019 edition of the Study Material of Final Paper 7 Direct Tax Laws and International Taxation, the webhosted Statutory Update and Judicial Update and any other material/book/text which he may opt to take as reference material for open book examination. The double taxation avoidance agreements (DTAAs) entered into by India with different countries are available on this website, and it is important that students read and appreciate the different articles forming part of the DTAAs. Furthermore, the webpage on international taxation https://www.incometaxindia.gov.in/pages/international-taxation.aspx contains useful compilation on various topics relating to international taxation, like, advance ruling, transfer pricing, withholding tax, DTAAs etc and the webpage on non-resident taxation https:// www.incometaxindia.gov.in/ pages/ non-resident-specific-content.aspx details the specific provisions relating to non-residents. Students are advised to go through the contents of these webpages and enhance their knowledge on international taxation. This would help them to solve the case study based questions in a more effective manner. Students may note that case studies on international taxation are being hosted at the BoS Knowledge Portal on the Institute’s website www.icai.org from time to time. Happy Reading and Best Wishes! © The Institute of Chartered Accountants of India  vi ELECTIVE PAPER – 6 C: INTERNATIONAL TAXATION (One paper – Three hours – 100 Marks) Objective: To develop an understanding of the concepts, principles and provisions relevant to international taxation and acquire the ability to apply such knowledge to make computations and address issues in practical case scenarios. Content: Part I - Taxation of International Transactions and Non-resident Taxation in India 1. Transfer Pricing provisions under the Income-tax Act, 1961, including (i) Arm’s Length Price (ii) International Transactions (iii) Most Appropriate Method (iv) Functions, Assets and Risk Analysis (v) Documentation & Compliances (vi) Specific Reporting Regime in respect of Country by Country reporting and master file (vii) Advance Pricing Agreements 2 Other Provisions relating to taxation of international transactions and non-resident taxation under the Income-tax Act, 1961 (i) Non-resident Taxation (including Source Rule of Taxation) (ii) Double Taxation Relief (iii) Advance Rulings 3. Law and Procedures under the Black Money (Undisclosed Foreign Income and Assets) and Imposition of Tax Act, 2015 – An Overview. © The Institute of Chartered Accountants of India  vii Part II – Other aspects of International Taxation 1. Overview of Model Tax Conventions (i) OECD Model Tax Convention (ii) UN Model Tax Convention (iii) US Model Tax Convention ∗ 2. Tax treaties, Application and Interpretation (i) Features of Tax treaties (ii) Overview of Tax Information Exchange Agreements (iii) Commentaries and their importance (iv) Role of Vienna Convention in application and interpretation of tax treaties 3. Anti Avoidance Measures (i) Controlled Foreign Corporations (ii) Base Erosion and Profit Shifting (iii) Other Anti Avoidance Measures 4. Taxation of E-Commerce Transactions (i) Introduction (ii) Emerging issues (iii) Equalisation levy Note – If any new legislation(s) are enacted in place of an existing legislation(s), the syllabus will accordingly include the corresponding provisions of such new legislation(s) in the place of the existing legislation(s) with effect from the date to be notified by the Institute. Similarly, if any existing legislation(s) on direct tax laws ceases to be in force, the syllabus will accordingly exclude such legislation(s) with effect from the date to be notified by the Institute. The specific inclusions/ exclusions in any topic covered in the syllabus will be effected by way of Study Guideline every year, if required. Specific inclusions/ exclusions in a topic may also arise due to additions/ deletions made every year by the Annual Finance Act. ∗ Excluded from Syllabus by way of Study Guidelines © The Institute of Chartered Accountants of India  viii Contents CHAPTER 1 – TRANSFER PRICING Learning Outcomes........................................................................................................... 1.1 Contents: 1.1 Introduction............................................................................................................ 1.3 1.2 What is transfer pricing?.......................................................................................... 1.4 1.3 Meaning of the term “Arm’s Length Principle”.......................................................... 1.4 1.4 Significance of Arm’s Length Principle..................................................................... 1.5 1.5 Practical difficulties in application of ALP................................................................. 1.6 1.6 Evolution of transfer pricing in India......................................................................... 1.7 1.7 Computation of income from transaction with non-resident...................................... 1.10 1.8 Associated Enterprises.......................................................................................... 1.11 1.9 International transaction........................................................................................ 1.16 1.10 Specified Domestic Transactions........................................................................... 1.21 1.11 Computation of Arm’s Length Price........................................................................ 1.22 1.12 Functions, Assets and Risk (FAR) Analysis............................................................ 1.40 1.13 Concept of comparability adjustments.................................................................... 1.44 1.14 Documentation and compliances............................................................................ 1.46 1.15 Specific reporting requirements– Country by Country reporting............................... 1.56 1.16 Transfer pricing assessment................................................................................. 1.63 1.17 Transfer of income to non-residents....................................................................... 1.94 © The Institute of Chartered Accountants of India  ix 1.18 Introduction of specific anti avoidance measures in respect of transactions with persons located in notified jurisdictional area.................................................. 1.96 1.19 Limitation of interest deduction in certain cases...................................................... 1.98 CHAPTER 2 – NON RESIDENT TAXATION Learning Outcomes........................................................................................................... 2.1 Contents: 2.1 Introduction............................................................................................................ 2.3 2.2 Important definitions................................................................................................ 2.3 2.3 Charge of Income-tax.............................................................................................. 2.6 2.4 Residential status and scope of total income............................................................ 2.7 2.5 Exempt income of non-residents............................................................................ 2.48 2.6 Presumptive taxation for non-residents.................................................................. 2.56 2.7 Capital gains taxation for non-residents.................................................................. 2.67 2.8 Special provisions prescribed under Chapter XII-A................................................. 2.92 2.9 Determination of tax in certain special cases [Chapter XII]...................................... 2.98 2.10 Applicability of MAT on foreign companies........................................................... 2.108 2.11 Special provisions relating to conversion of Indian branch of a foreign bank into a subsidiary company [Chapter XII-BB]..................................... 2.110 2.12 Withholding tax provisions for non-residents......................................................... 2.113 2.13 Miscellaneous provisions..................................................................................... 2.130 CHAPTER 3 – DOUBLE TAXATION RELIEF Learning Outcomes........................................................................................................... 3.1 Contents: 3.1 Concept of Double Taxation Relief.......................................................................... 3.2 © The Institute of Chartered Accountants of India  x 3.2 Types of Relief....................................................................................................... 3.2 3.3 Double Taxation Relief provisions under the Income-tax Act, 1961............................ 3.3 3.4 Concept of Permanent Establishment.................................................................... 3.20 3.5 Taxation of Business Process Outsourcing Units in India....................................... 3.21 CHAPTER 4 – ADVANCE RULINGS Learning Outcomes........................................................................................................... 4.1 Contents: 4.1 Introduction............................................................................................................ 4.2 4.2 Definitions.............................................................................................................. 4.2 4.3 Authority for Advance Rulings.................................................................................. 4.4 4.4 Qualifications, terms and conditions of service of Chairman, Vice-chairman and members................................................................................... 4.5 4.5 Vacancies, etc., not to invalidate proceedings.......................................................... 4.7 4.6 Application for advance ruling.................................................................................. 4.7 4.7 Procedure on receipt of application.......................................................................... 4.9 4.8 Applicability of Advance Ruling.............................................................................. 4.11 4.9 Advance Ruling to be void in certain circumstances................................................ 4.12 4.10 Powers of the Authority......................................................................................... 4.13 4.11 Procedure of Authority........................................................................................... 4.13 CHAPTER 5 – OVERVIEW OF THE BLACK MONEY & IMPOSITION OF TAX LAW Learning Outcomes........................................................................................................... 5.1 Contents: 5.1 Introduction............................................................................................................ 5.2 5.2 Basis of charge [Chapter II]..................................................................................... 5.2 © The Institute of Chartered Accountants of India  xi 5.3 Tax Management [Chapter III]............................................................................... 5.12 5.4 Penalties [Chapter IV]........................................................................................... 5.28 5.5 Offences and prosecution [Chapter V]................................................................... 5.31 5.6 General provisions [Chapter VII]............................................................................ 5.36 CHAPTER 6 - TAXATION OF E-COMMERCE TRANSACTIONS Learning Outcomes.......................................................................................................... 6.1 Contents: 6.1 What is E-Commerce?............................................................................................ 6.2 6.2 Issues and problems in taxing E-Commerce transactions......................................... 6.2 6.3 Equalisation Levy: Genesis & Statutory provisions.................................................... 6.6 6.4 Business Connection constituted through significant economic presence................. 6.21 CHAPTER 7 – TAX TREATIES: OVERVIEW, FEATURES, APPLICATION & INTERPRETATION Learning Outcomes.......................................................................................................... 7.1 Contents: 7.1 Introduction............................................................................................................ 7.2 7.2 Double Taxation and Connecting Factors................................................................. 7.3 7.3 Tax Treaties – An Overview..................................................................................... 7.4 7.4 Features of Tax Treaties....................................................................................... 7.13 7.5 Application of Tax Treaties................................................................................... 7.20 7.6 Interpretation of Tax Treaties................................................................................ 7.22 7.7 Role of Vienna Convention in application and interpretation of Tax Treaties............. 7.32 © The Institute of Chartered Accountants of India  xii CHAPTER 8 - ANTI AVOIDANCE MEASURES Learning Outcomes.......................................................................................................... 8.1 Contents: 8.1 Controlled Foreign Corporations.............................................................................. 8.2 8.2 Base Erosion and Profit Shifting.............................................................................. 8.9 8.3 Other Anti-Avoidance Measures............................................................................ 8.56 CHAPTER 9 – OVERVIEW OF MODEL TAX CONVENTIONS Contents: 9.1 Introduction............................................................................................................ 9.2 9.2 Comparative analysis of some of the significant Articles of OECD and UN Model Conventions.......................................................................... 9.5 © The Institute of Chartered Accountants of India  1 TRANSFER PRICING LEARNING OUTCOMES After studying this chapter, you would be able to -  appreciate the need for incorporation of transfer pricing provisions in the Income-tax Act, 1961;  examine the meaning and significance of arm’s length principle and the practical difficulties in application of arm’s length principle;  appreciate the meaning and significance of the terms “associated enterprise”, “international transaction”;  analyze the functions performed, assets used and risks assumed to determine the arm’s length price of an international transaction;  determine the arm’s length price of an international transaction using the most appropriate method;  pinpoint the responsibilities of a person entering into an international transaction to keep and maintain prescribed information and documents;  examine the country-by-country reporting requirements and related matters incorporated in the income-tax law in compliance with BEPS Action Plan 13; © The Institute of Chartered Accountants of India  1.2 INTERNATIONAL TAXATION  identify the circumstances when the Assessing Officer can invoke the power to determine the arm’s length price;  identify the cases where secondary adjustments have to be made;  appreciate the mechanisms for dispute resolution in transfer pricing cases, including filing of objections before Dispute Resolution Panel, filing of appeal, adoption of safe harbour and entering into advance pricing agreements;  appreciate the specific anti-avoidance measures incorporated in the Income-tax Act, 1961 in respect of transactions with persons located in notified jurisdictional areas;  appreciate the provisions incorporated in the Income-tax Act, 1961 restricting interest deduction claimed by an entity in respect of borrowings from an associated enterprise in line with BEPS Action Plan 4;  integrate, analyse and apply the relevant provisions to make computations and address issues relating to transfer pricing. © The Institute of Chartered Accountants of India  TRANSFER PRICING 1.3 1.1 INTRODUCTION Transactions between related entities may have inherent advantage as compared to transactions between unrelated entities. Such advantage may be by means of price concessions, extended credit period, reduced interest rates, lower logistics expenses, etc. With the advent of globalization, multinational companies (MNCs) have established presence in all parts of the world and are conducting business seamlessly. They can enjoy the privileges of doing business with related parties whereas companies which deal with unrelated parties in an open market are not able to exploit such benefits. Therefore, in order to ensure safe and fair dealing among all companies and markets, the need to introduce regulations for transfer pricing was felt. In addition to price related benefits, MNCs may also bear in mind the goal of minimizing tax burden and maximizing profits but the two tax jurisdictions/countries also need to ensure that they are not losing their fair share of tax revenue in such cases. This has given rise to an internationally accepted practice that such ‘transfer pricing’ should be governed by the Arm’s Length Principle (ALP) and the transfer price should be the price applicable in case of a transaction of arm’s length. In other words, the transaction between associates should be priced in the same way as a transaction between independent enterprises. Today, transfer pricing is one of the most important issues faced by MNCs as they attempt to fairly distribute their profits amongst the companies within the group. While on the other hand, the tax authorities implement transfer pricing regulations and strengthen the enforcement in order to prevent a loss of revenue for each regime where these companies are incorporated. The net result of this dichotomy is that transfer pricing has become a major tax issue for the companies. The principles governing the taxation of MNCs are embodied in the OECD Model Tax Convention of Income and Capital (OECD Model Convention), which serves as the basis for the bilateral income-tax treaties between Organization of Economic Cooperation and Development (OECD) member countries and between OECD member and non-OECD member countries. According to these guidelines, “Transfer prices” are the prices at which an enterprise transfers physical goods and intangible property or provides services to associated enterprises. Two enterprises are “associated enterprises” if one of the enterprises participates directly or indirectly in the management, control or capital of the other or if both enterprises are under common control. Since international transfer pricing involves more than one tax jurisdiction, any adjustment to the transfer price in one jurisdiction requires a corresponding adjustment in the other jurisdiction. If a corresponding adjustment is not made, double taxation will result. © The Institute of Chartered Accountants of India  1.4 INTERNATIONAL TAXATION 1.2 WHAT IS TRANSFER PRICING? Transfer pricing as a concept traditionally began with the amount charged by one segment of an enterprise for a product or service that it supplied to another segment of the same enterprise. With the evolution of MNC concept, segments of the enterprise started spreading as independent entities operating in various parts of the globe. Accordingly, the term has evolved to mean price which is charged between two or more entities of a MNC [associated enterprises (AEs)] operating in different countries. For example, common business transactions between the AEs are in the nature of purchase and sale of assets, raw materials, finished goods and provision of services. Due to the lack of a natural conflict between the parties involved in commercial transactions in a group scenario, most MNCs, given their wide geographical presence, have a possibility to use their position to arrange business transaction to favourably exploit tax positions. By structuring transactions in a way which is most beneficial to the MNC from a tax perspective, the MNC is basically able to steer and manage where it books its profits and therefore also can influence actively the tax burden. This, the tax administrators believe is unjust. Thus, to protect each country’s fair share in an MNC’s total profit, the tax authorities have established principles under which it can be assumed that related parties deal with each other as if they were independent and this principle is called the arm’s length principle. Example: X Limited, a trader of goods, purchases and sells goods as below: Particulars Related parties Unrelated parties Purchases 8,00,000 5,00,000 Sales 10,00,000 10,00,000 Profits 2,00,000 5,00,000 By increasing the costs of purchases from related parties, X Ltd has reduced its taxable profits in said jurisdiction. 1.3 MEANING OF THE TERM “ARM’S LENGTH PRINCIPLE” The Arm’s Length Price (ALP) of a transaction between two associated enterprises is the price that would be paid if the transaction had taken place between two comparable independent and unrelated parties, where the consideration is only commercial. The Arm’s Length Principle, in the context of taxation, is explained in the OECD Model Tax Convention as under: “Where conditions are made or imposed between two associated enterprises in their commercial © The Institute of Chartered Accountants of India  TRANSFER PRICING 1.5 or financial relations which differ from those which would be made between independent enterprises, then any profits which would, but for those conditions, have accrued to one of the enterprises, but, by reason of those conditions, have not so accrued, may be included in the profits of that enterprise and taxed accordingly.” The OECD transfer pricing guidelines provides guidance on the application of the arm’s length principle in order to arrive at the proper transfer pricing range between associated enterprises. Market forces determine business relations between independent parties. The arm’s length principle seeks to adjust the profits between two associated enterprises by comparing the same as if the transaction is carried out between two independent enterprises. It treats each enterprise as a separate independent entity rather than as inseparable parts of a single unified business. 1.4 SIGNIFICANCE OF ARM’S LENGTH PRINCIPLE There are several reasons as to why the OECD member countries and other countries have adopted the arm’s length principle. Parity between MNCs and independent enterprises – A major reason is that the ALP provides broad parity of tax treatment for MNCs and independent enterprises. Since the ALP puts associated and independent enterprises on a more equal footing for tax purposes, it avoids the creation of tax advantages and disadvantages that would otherwise distort the relative competitive positions of these entities. The ALP, thus promotes the growth of international trade and investment by removing these tax considerations from economic decisions. Determines real taxable profits - The transfer price adopted by a multinational has a direct bearing on the proportional profit it derives in each country in which it operates. If inadequate or excessive consideration is paid for the transfer of goods, services or intangible property between the members of an MNC group, the income calculated for each of those members will be inconsistent with their relative economic contributions. An ‘arm’s length’ price – a price two independent firms operating at arm’s length would agree on – is needed to determine taxable profits earned in each country. The arm’s length doctrine permits the taxing authorities to rectify the accounts of the enterprise so as to reflect correctly the income that the establishment would have earned if it were an independent enterprise. Reduction of artificial price distortion - If the ALP is not followed, an MNC will sell goods/ provide services to a controlled entity in a high tax regime at a high price (which exceeds the market price) and to an entity in a low-tax regime or a tax haven at a low price (which is lower than the market price). This would result in extreme price distortion of goods and services in the international market. Minimization of double taxation – The ALP is an international concept and it represents the international norm. The potential for double taxation is minimized, since in international transfer pricing, adjustment to the transfer price in one tax jurisdiction requires a corresponding adjustment in the other tax jurisdiction. © The Institute of Chartered Accountants of India  1.6 INTERNATIONAL TAXATION Accurate measurement of economic contribution – The ALP provides accurate measurement of the fair market value of the economic contribution units of an MNC. The focus of the ALP is to ensure that the proper amount of income is attributed to where it is earned. This result in each unit of the MNC earning a return commensurate with its economic contribution and risk assumed. 1.5 PRACTICAL DIFFICULTIES IN APPLICATION OF ALP There are, however, certain practical difficulties in applying the ALP, which are described hereunder: True comparison difficult in certain cases – The commercial and financial conditions governing a transaction between independent enterprises are, by and large, never similar to those existing between associated enterprises. As a result, there cannot be a true comparison. The economies of scale and integration of various business activities of the associated enterprise may not be truly appreciated by arm’s length principle. Further, associated enterprises may enter into transactions which independent enterprises may not enter into, like say, licensing of valuable intangible or sharing the benefits of research. The owner of an intangible may be hesitant to enter into licensing arrangements with independent enterprises for fear of the value of the intangible being degraded. In contrast, he may be prepared to offer terms that are less restrictive to associated enterprises because the use of the intangible can be closely monitored. Further, there is no risk to the overall group’s profit from a transaction of this kind between members of an MNC group. In such situations, where independent enterprises seldom undertake transactions of the type entered into by associated enterprises, the ALP is difficult to apply because there is little or no direct evidence of what conditions would have been established by independent enterprises. Availability of data and reliability of available data – There may be difficulty in getting adequate and reliable information and data in order to apply arm’s length principle. The comparison of controlled and uncontrolled transactions between associated and independent enterprises usually requires a large quantum of data. Easily accessible information may be incomplete and difficult to interpret while the relevant and required information may be difficult to obtain due to geographical constraints or secrecy and confidentiality aspects. In other cases, information about an independent enterprise which could be relevant may not exist at all. Due to these difficulties, the tax administration and tax payers may have to exercise reason and judgment when applying the ALP. Absence of market price - There must be a reasonably reliable and comparable uncontrolled market price. The ALP does not meet this condition because of the nature of the market place. A market price is an outcome of unique negotiations. It may be possible to know the price range, but it is very difficult to know the actual market price unless a market transaction actually takes place. Absence of comparable market price for “intangible” transactions - The ALP reaches a comparable uncontrolled market price that is reasonably reliable for standard transactions where the price range is narrow and market price is certain. However, the ALP generally fails to achieve a comparable market price for transactions involving intangibles because they are unique. The unique nature of these transactions creates a very wide price range. © The Institute of Chartered Accountants of India  TRANSFER PRICING 1.7 Administrative burden - In certain cases, the arm’s length principle may result in an administrative burden for both the taxpayer and the tax administrations of evaluating significant numbers and types of cross-border transactions. Time lag - Although an associated enterprise normally establishes the conditions for a transaction at the time it is undertaken, at some point the enterprise may be required to demonstrate that these are consistent with the arm’s length principle. The tax administration may also have to engage in the verification process perhaps some years after the transactions have taken place. It may result in substantial cost being incurred by the tax payer and the tax administration. It is also difficult to appreciate the business realities which prevailed at the time when the transactions were entered into. This may lead to bias against the tax payer. In spite of the practical difficulties listed above, OECD member countries are of the view that the ALP does provide a sound basis to appreciate the transfer pricing between associated enterprises. It has so far provided acceptable solutions to both taxpayers and the tax administrations. The experience gained so far should be effectively used to remove the practical difficulties and improve the administration. 1.6 EVOLUTION OF TRANSFER PRICING IN INDIA Post the globalization/ liberalization in 1991, the enhanced presence of MNCs in India and their ability to allocate profits in different jurisdictions by controlling prices in intra-group transactions, made the issue of transfer pricing a matter of serious concern for the Indian exchequer. Just like their global counterparts, the Indian tax authorities presumed the ability/intention of the MNCs to resort to transfer pricing as tool to shift profits and thereby erode the Indian tax base. This presumption ultimately laid to the evolution of the transfer pricing regulations in India. Pre 2001 scenario: Prior to the introduction of comprehensive transfer pricing regulations by the Finance Act, 2001, certain basic provisions existed under the income-tax and the customs and excise legislation. While provisions like erstwhile Section 92 and Rule 10 did exist in law (which empowered the Assessing Officers to examine inter-company transactions of MNC group), however, given their restricted scope/ methodology, it was felt over a period of time that the same were not sufficient enough to prevent the erosion of the Indian tax base on account of inter-company transactions undertaken by MNC members. There was no detailed statute on transfer pricing. Further, the term “related parties” found mention under the company law and the anti-trust legislation. In Mazagaon Dock Ltd v. CIT, the concept of transfer pricing was considered by the Supreme Court with reference to section 42 of the Indian Income-tax Act, 1922, when the law relating to transfer pricing was in its rudimentary stage. The question before the Supreme Court was whether the transaction between the non-resident British companies and the Indian company were at arm’s length. If not, whether it is covered within the scope set out under section 42(2) of the Indian Income-tax Act, 1922. It was observed that section 42 states that it is not the question of the non- residents carrying on business in the abstract but of their carrying on business with the resident. The arrangement has to be looked into and decided on the taxability. © The Institute of Chartered Accountants of India  1.8 INTERNATIONAL TAXATION The Apex court rejected the contentions of the Indian company and held that profits, if any foregone, must be taxed. The court expressed the view that the fact, that the dealings were such as to yield no profit, was immaterial. Section 42(2) in the Indian Income-tax Act, 1922 dealt with the situation concerning ‘Transfer pricing’. On the enactment of the Income-tax Act, 1961 (the Act), the provisions of section 42(2) were incorporated in this Act in the form of section 92 with minor changes to bring out the purport of the section more clearly. Section 92 was backed by Rule 10 and 11 of the Income-tax Rules, 1962. For invoking section 92, certain requisite conditions had to exist. These were: (i) The business was transacted between a resident and a non-resident. (ii) There was a close connection between the two. (iii) On the account, the course of business was so arranged that the business produces either no profit or less than normal profit to the resident. If the conditions at (i) to (iii) were found to exist, the Assessing Officer was empowered under the Act to: determine the amount of profits, which may reasonably be deemed to have been derived from such business; and include such amount in the total income of the resident. Rules 10 and 11 provided the methodology for working out the normal profit to be included in the income of the resident assessee in the circumstances mentioned earlier. The normal profit could be calculated: (i) at such percentage of the turnover so accruing or arising as the Assessing Officer may consider to be reasonable, or (ii) 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, or (iii) in such other manner as the Assessing Officer may deem suitable. Section 92 as it existed prior to its amendment, was not sufficient to deal with complex cases of transfer pricing. Its primary shortcomings were: The section applied only to ‘businesses’ between a resident and a non-resident. Since business demands a continuity of relationship, isolated transactions were outside its purview. The section was not wide enough in its scope to cover cases of transfer of services or intangibles. The section was not applicable in the case where a non-resident entered into a transaction with another non-resident. Therefore, business transactions between a permanent © The Institute of Chartered Accountants of India  TRANSFER PRICING 1.9 establishment of a non-resident company and a non-resident were not covered. The section provided for adjustment of profits instead of adjustment of prices and the rules prescribed for estimating profits were not scientific. The concept of ‘close connection’ was not defined, leading to arbitrariness in applying the said provisions. No detailed rules for necessary documentation were prescribed to defend actions by the Revenue authorities. In March 1999, the Standing Committee on Finance realised that the existing transfer pricing policy framework may not be effective to curb transfer pricing abuse in India. In view of the above, the Central Board of Direct Taxes (CBDT) set up an Expert Group on Transfer Pricing in November, 1999 to determine whether any amendments were necessary in the Act and if so to suggest a regulatory framework for the same. The Group submitted its report in January, 2001 to the CBDT. The Ministry of Finance after considering the report introduced exhaustive legislative framework to deal with transfer pricing issues vide the Finance Act, 2001. Post 2001 scenario: The Finance Act, 2001 introduced Transfer Pricing Regulations for curbing tax avoidance and manipulation of intra-group transactions by abusing transfer pricing. Specifically, the memorandum to the Finance Act, 2001 stated that: “The increasing participation of multinational groups in economic activities in the country has given rise to new and complex issues emerging from transactions entered into between two or more enterprises belonging to the same multinational group. The profits derived by such enterprises carrying on business in India can be controlled by the multinational group, by manipulating the prices charged and paid in such intra-group transactions, thereby, leading to erosion of tax revenues. With a view to provide a statutory framework which can lead to computation of reasonable, fair and equitable profits and tax in India, in the case of such multinational enterprises, new provisions are proposed to be introduced in the Income-tax Act.” Accordingly, sections 92 to 92F had been included in Chapter X of the Income-tax Act, 1961, through the Finance Act, 2001, providing for a transfer pricing mechanism based on computation of income from cross-border transactions. The following conditions must be satisfied in order to attract the special provisions of Chapter X relating to avoidance of tax: (i) There must be an international transaction; (ii) Such international transaction should be between two or more associated enterprises either or both of whom are non-residents; (iii) Such international transaction should be in the nature of: (a) purchase, sale or lease of tangible or intangible property; or © The Institute of Chartered Accountants of India  1.10 INTERNATIONAL TAXATION (b) provision of service; or (c) lending or borrowing money; or (d) any other transaction having a bearing on the profits, income, losses or assets of such enterprise. (iv) Further, such transaction may also involve allocation or apportionment of, or any contribution to any cost or expenses incurred or to be incurred in connection with a benefit, service or facility provided or to be provided to any one or more of the associated enterprises on the basis of mutual agreement or arrangement between such associated enterprises. (v) Such international transaction must be done at arm’s length price and if such international transaction has been done at less than the arm’s length price, it shall require determination of income or apportionment of cost or expense on the basis of arm’s length price. (vi) The above adjustment should either result in an increase of income or decrease of loss returned by the assessee. In other words, the adjustment should not have the effect of reducing the income chargeable to tax or increasing the loss. The provisions of Chapter X apply to international transactions entered into with effect from 1st April, 2001. Rules 10A to 10E have been inserted in the Income-tax Rules, 1962 by a notification dated 21st August, 2001. These sections and rules of the Income-tax Act, 1961 and the Income-tax Rules, 1962 respectively, will affect all non-corporate and corporate assessees who have dealings with non- residents for import or export of goods, properties or services. In other words, price paid for import of goods, properties or services and price received for export of goods, properties or services will be subject to scrutiny by the Assessing Officer. Therefore, it is necessary to make a detailed study of these provisions. All assessees who have such dealings with non-residents will have to keep detailed records as prescribed under the Rules and will have to furnish audit report every year with the return of income about their international transactions. 1.7 COMPUTATION OF INCOME FROM TRANSACTION WITH NON-RESIDENT [SECTION 92] Section 92 provides that any income arising from an “international transaction” shall be computed having regard to “the arm’s length price”. For this purpose, the allowance for any expense or interest shall be determined on the basis of arm’s length price. The section further provides that in an international transaction between two or more ‘associated enterprises” when there is a mutual agreement or arrangement for the allocation or apportionment of, or any contribution to, any cost or expenses in connection with a benefit, service or facility provided to any one or more of such enterprises, the allocation of cost, expenses etc. shall be determined having regard to arm’s length price of such benefit, service or facility. Similarly, the price received for exports and amounts received for services rendered to associated enterprise will be determined on the basis of arm’s © The Institute of Chartered Accountants of India  TRANSFER PRICING 1.11 length price. It will be noticed that in the international transaction, the income or expense will have to be at arm’s length price, if the transaction is between associated enterprises. The objective of transfer pricing provisions is to protect the tax base of India and to ensure that due to inter-company transactions, there is no reduction in the taxable profits or the taxes paid by the Indian taxpayer. The reverse, however, does not hold true. Section 92(3) provides that the transfer pricing provisions contained in Section 92 shall not apply if the same has the effect of reducing the income chargeable to tax or increasing the loss of the assessee for the year under consideration. The same can be understood with the help of the following example: Example: Case Income as Income Expenses Expenses Profit/ Profit/ Has TP Will TP determined as per claimed by as per ALP Loss as Loss after resulted provisions by ALP assessee per applying in apply? assessee assessee TP reduction provisions of taxable income/ increase of losses? 1 100 150 70 70 30 80 No Yes 2 100 90 70 70 30 20 Yes No 3 100 90 110 110 (10) (20) Yes No 4 100 100 70 110 30 (10) Yes No 1.8 ASSOCIATED ENTERPRISES Associated enterprises are those which are owned or controlled by the same or common entity/ person. Section 92A of the Act defines the term ‘Associated Enterprises’ for the purpose of provisions relating to Transfer Pricing. As per Section 92A(1) of the Act, associated enterprise refers to: 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. © The Institute of Chartered Accountants of India  1.12 INTERNATIONAL TAXATION Enterprise which participates, directly or indirectly, or through one or more intermediaries, in Management of Control of the Capital of the the other OR other enterprise OR other enterprise enterprise Both Enterprises are Associated Enterprises Example: A Ltd. directly participates in management of B Ltd. A B Therefore, both A Ltd. & B Ltd. are associated enterprises. Now, consider a situation where A Ltd. directly participates in management of B Ltd. and B Ltd. directly participates in management of C Ltd. In such situation, A Ltd. has direct participation in management of B Ltd. but has an indirect participation in management of C Ltd. A B C Therefore, in such scenario, C Ltd. is also an associated enterprise of A Ltd. 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 enterprises Then, those two enterprises are associated enterprises. © The Institute of Chartered Accountants of India  TRANSFER PRICING 1.13 Example: Mr. A directly has control in A Ltd. and B Ltd. In such a scenario, both A Ltd. & B Ltd. are associated enterprises since they have a common person i.e. Mr. A, who controls both entities A Ltd. & B Ltd. Deemed Associated Enterprises Two enterprises are deemed to be associated enterprises if they fall under any one or more of the situations contained in section 92A(2). This section provides 13 such situations during which associated enterprise relationship is deemed to be established. Two enterprises are deemed to be associated enterprise if: (i) Enterprise ownership - One enterprise holds 26% or more of the voting power, directly or indirectly, in the other enterprise. Example: A Ltd. holds 33% of voting power in B Ltd. and B Ltd. holds 40% voting power in C Ltd. 33% 40% A B C In above situation, A Ltd. holds 33% of voting power in B Ltd. directly and 40% of voting power in C Ltd. indirectly (i.e. through B Ltd.). Therefore, both B Ltd. & C Ltd. are deemed associated enterprises of A Ltd. (ii) Voting power by common person - Any person or enterprise holds 26% or more of the voting power, directly or indirectly, in each of two different enterprises. Example: Mr. A holds 40% of voting power in both X Ltd. and Y Ltd. where neither X Ltd. has any holding in Y Ltd. nor Y Ltd. has any holding in X Ltd. Mr. A 40% 40% X Ltd. Y Ltd. In this situation, since Mr. A directly holds 40% of voting power in both X Ltd. and Y Ltd., X Ltd. & Y Ltd. will be deemed associated enterprises. (iii) Lender - One enterprise advances loan to the other enterprise of an amount of 51% or more of the book value of the total assets of such other enterprise. Example: Book value of total assets of Y Ltd. is ` 100 crores. X Ltd. advances loan of ` 60 crores to Y Ltd. © The Institute of Chartered Accountants of India  1.14 INTERNATIONAL TAXATION Since, in this case, X Ltd. advances loan of ` 60 Crores to Y Ltd, which is 60% of the book value of total assets of Y Ltd. Hence, X Ltd. & Y Ltd. are deemed associated enterprises. (iv) Guarantor - One enterprise guarantees 10% or more of the total borrowings of the other enterprise. Example: P Inc. has total loan of 1 million dollars from XYZ Bank of America. Out of that, A Ltd., an India company, guarantees 20% of total borrowings in case of any default made by P Inc. In such scenario, since, A Ltd. guarantees 20% of total borrowings of P Inc., P Inc. and A Ltd. are deemed associated enterprises. (v) Appointment of Board by other enterprise - One Enterprise appoints more than half of the board of directors or members of the governing board, or one or more executive directors or executive members of the governing board of another enterprise, or Example: X Ltd. has 15 directors on its Board. Out of that, Y Ltd. has appointed 8 directors. In such case, X Ltd. and Y Ltd. are deemed associated enterprises. (vi) Appointment of Board of two different enterprises by same person(s) - More than half of the directors or members of the governing board, or one or more of the executive directors or members of the governing board, of each of the two enterprises are appointed by the same person or persons. Example: Mr. A appointed 9 directors out of 15 directors of X Ltd. and appointed 2 executive directors on the board of Y Ltd. In such case, since a common person i.e. Mr. A appointed more than half of the directors in X Ltd. and appointed 2 executive directors in Y Ltd., both X Ltd. and Y Ltd. are deemed associated enterprises. (vii) Dependence on intangibles - The manufacture or processing of goods or articles or business carried out by one enterprise is wholly dependent (i.e. 100%) 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 entity is the owner or in respect of which the other enterprise has exclusive rights. (viii) Dependence on supply in manufacturing process - 90% or more of raw materials and consumables required for the manufacture or processing of goods or articles or business carried out by one enterprise, are supplied by the other enterprise, or by persons specified by the other enterprise, where the prices and other conditions relating to the supply are influenced by such other enterprise. (ix) Dependence on sale - 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. © The Institute of Chartered Accountants of India  TRANSFER PRICING 1.15 (x) Individual control - Where one enterprise is controlled by an individual, the other enterprise is also controlled by such individual or his relative or jointly by such individual and his relatives. Example: Mr. A and Mr. B are relatives. Mr. A has control over X Ltd. and Mr. B has control over Y Ltd. Therefore, both X Ltd. and Y Ltd. will be deemed associated enterprises. Relatives Mr. A Mr. B Control Control X Ltd. Y Ltd. X Ltd. & Y Ltd. are deemed to be associated enterprises (xi) Control by Hindu Undivided Family - Where one enterprise is controlled by a Hindu undivided family (HUF) and the other enterprise is controlled by a member of such HUF or by relative of a member of such HUF or jointly by such member and his relative Member of HUF/Relative HUF of member of such HUF Control Control A Ltd. A Ltd. & B Ltd. are associated enterprises B Ltd. (xii) Holding in a firm, association of persons or body of individuals – Where one enterprise is a firm, association of persons or body of individuals, the other enterprise holds 10% or more interest in firm/AOPs/BOIs. (xiii) Mutual interest relationship - There exists between the two enterprises, any relationship of mutual interest, as may be prescribed. Meaning of Enterprise: The term “enterprise” is defined in section 92F(iii) to mean a person (including its certain specified Permanent Establishment) who is, or has been, or is proposed to be, engaged in any activity, © The Institute of Chartered Accountants of India  1.16 INTERNATIONAL TAXATION relating to the production, storage, supply, distribution, acquisition or control of articles or goods, or know-how, patents, copy rights, trade-marks, licences, 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, or the provision of services of any kind, or in carrying out any work in pursuance of a contract, or in investment, or providing loan or in the business of acquiring, holding, underwriting or dealing with shares, debentures or other securities of any other body corporate, whether such activity or business is carried on, directly or through one or more of its units or divisions or subsidiaries, or whether such unit or division or subsidiary is located at the same place where the enterprise is located or at a different place or places. For this purpose, the term “Permanent establishment” is defined in section 92F(iiia) to include a fixed place of business through which the business of the enterprise is wholly or partly carried on. 1.9 INTERNATIONAL TRANSACTION (1) International transaction [Section 92B(1)] As per section 92B of the Act, an international transaction means: (i) a transaction between two or more associated enterprises, either or both of whom are non- residents; and (ii) transaction in the nature of: (a) sale/ purchase/ lease of tangible property; or (b) sale/ purchase/ lease of intangible property; or (c) provision of services; or (d) lending/ borrowing money; or (e) any other transaction having a bearing on profits, income, losses or assets of such enterprises; or (f) mutual agreement or arrangement between two or more associated enterprise for the 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. (2) Deemed international transaction [Section 92B(2)] Where, in respect of a transaction entered into by an enterprise with a person other than an associated enterprise (hereinafter referred to as “other person”), © The Institute of Chartered Accountants of India  TRANSFER PRICING 1.17 ♦ there exists a prior agreement in relation to the relevant transaction between the other person and the associated enterprise or, ♦ where the terms of the relevant transaction are determined in substance between such other person and the associated enterprise; and ♦ either the enterprise or the associated enterprise or both of them are non-residents, then such transaction entered into between the enterprise and the other person shall be deemed to be an international transaction entered into between two associated enterprises, whether or not such other person is a non-resident. Example: If A Ltd., an Indian company, has entered into an agreement for sale of product X to Mr. B, an unrelated party, on 1/6/2019 and Mr. B has entered into an agreement for sale of product X with C Inc., a non-resident entity, which is a specified foreign company in relation to A Ltd., on 30/5/2019, then, the transaction between A Ltd. and Mr. B shall be deemed to be an international transaction entered into between two associated enterprises, irrespective of whether or not Mr. B is a non- resident. Mr. B C Inc. A Ltd (Unrelated (Associated party) Enterprise of A Ltd.) Agreement for sale of Product Agreement for sale of product X entered into on 1/6/2019 X entered into on 30/5/2019 Transaction between A Ltd. and Mr. B is deemed to be an international transaction between associated enterprises, whether or not Mr. B is a non-resident. Note – C Inc. is deemed to be an associated enterprise of A Ltd. since it is a specified foreign company in relation to A Ltd., which means that A Ltd. holds 26% or more in the nominal value of the equity share capital of C Inc. © The Institute of Chartered Accountants of India  1.18 INTERNATIONAL TAXATION (3) The scope of “international transaction” shall include: Transactions Amplification of scope of terms used (1) Purchase, sale, transfer, Tangible property includes - lease or use of tangible building, property transportation vehicle, machinery, equipment, tools, plant, furniture, commodity or any other article, product or thing; (2) Purchase, sale, transfer, “Use of certain rights” refer to – lease or use of intangible land use, property, including copyrights, patents, trademarks, licences, franchises, transfer of ownership or the provision of use of customer list, marketing channel, brand, commercial certain rights secret, know-how, industrial property right, exterior design or practical and new design or any other business or commercial rights of similar nature. (3) Capital financing any type of long-term or short-term borrowing, lending or guarantee, purchase or sale of marketable securities or any type of advance, payments or deferred payment or receivable or any other debt arising during the course of business. (4) Provision of services provision of market research, market development, marketing management, administration, technical service, repairs, design, consultation, agency, scientific research, legal or accounting service. © The Institute of Chartered Accountants of India  TRANSFER PRICING 1.19 (5) Business restructuring or All such transactions are included in the definition of reorganization entered “international transaction”, whether or not it has bearing on into by an enterprise with the profit, income, losses or assets of such enterprises at an associated enterprise the time of the transaction or at any future date. (4) Further, the expression “intangible property” shall include Type of intangible asset Examples of each type of intangible asset in relation to (1) Marketing Trademarks trade names brand names logos (2) Technology Process patents patent applications technical documentation such as laboratory notebooks technical know-how (3) Artistic literary works and copyrights musical compositions copyrights maps engravings (4) Data processing proprietary computer software software copyrights automated databases integrated circuit masks and masters (5) Engineering industrial design product patents trade secrets engineering drawing and schematics blueprints proprietary documentation (6) Customer customer lists customer contracts customer relationship open purchase orders © The Institute of Chartered Accountants of India  1.20 INTERNATIONAL TAXATION (7) Contract favourable supplier contracts, licence agreements franchise agreements non-compete agreements (8) Human trained and organised work force employment agreements union contracts (9) Location leasehold interest mineral exploitation rights easements air rights water rights (10) Goodwill institutional goodwill professional practice goodwill personal goodwill of professional celebrity goodwill general business going concern value (11) methods, programmes, systems, procedures, campaigns, surveys, studies, forecasts, estimates, or technical data; (12) any other similar item that derives its value from its intellectual content rather than its physical attributes. (5) Meaning of Transaction As per section 92F(v) of the Act, “transaction” includes an arrangement, understanding or action in concert – (a) whether or not such arrangement, understanding or action is formal or in writing; or (b) whether or not such arrangement, understanding or action is intended to be enforceable by legal proceeding. Section 92F(v) provides an inclusive definition of the term “transaction”. Based on the reading of the section, it is evident that it is not necessary that for a transaction undertaken between two enterprises there needs to be a formal written agreement between them. It is only relevant whether a transaction has been entered into in substance. The section also negates the requirement as to the legal enforceability of agreement or understanding. © The Institute of Chartered Accountants of India  TRANSFER PRICING 1.21 1.10 SPECIFIED DOMESTIC TRANSACTIONS It is common knowledge that the under invoicing of sales and over invoicing of expenses is ordinarily revenue neutral in case of a domestic transaction. However, shifting of profits from a profit making entity to related entity which is into losses or from one group entity to another to take undue advantage of tax incentive (tax holiday or any other), can create unwarranted situation of significant revenue loss to the Government. To understand such situations in a greater detail, following examples can be referred to: Example 1: Profit shifting from a domestic tariff area (DTA) unit to a tax holiday unit Actual situation Particulars Tax Holiday Unit DTA Unit Tax Rate - 30% Income from related party transaction (‘RPT’) 100 - Other income 300 300 Expenses in relation to RPT - 100 Other expenses 200 50 Profit / (loss) 200 150 Tax 0 45 (i.e. 150 * 30%) Shifting of profits Particulars Tax Holiday Unit DTA Unit Tax Rate - 30% Income from related party transaction (‘RPT’) 250 - Other income 300 300 Expenses in relation to RPT - 250 Other expenses 200 50 Profit / (loss) 350 0 Tax 0 0 © The Institute of Chartered Accountants of India  1.22 INTERNATIONAL TAXATION Example 2: Profit shifting from a profit making entity to a related loss making concern. Actual situation Particulars ABC Ltd. XYZ Ltd. Tax Rate 30% 30% Income from related party transaction (‘RPT’) 100 - Other income 300 300 Expenses in relation to RPT - 100 Other expenses 700 50 Profit / (loss) (300) 150 Tax 0 45 (i.e. 150 * 30%) Tax planning to shift profits Particulars ABC Ltd. XYZ Ltd. Tax Rate 30% 30% Income from related party transaction (‘RPT’) 250 - Other income 300 300 Expenses in relation to RPT - 250 Other expenses 700 50 Profit / (loss) (150) 0 Tax 0 0 In order to provide objectivity in determination of income from domestic related party transactions and determination of reasonableness of expenditure between related domestic parties, the provisions of section 92 have been extended to include within its ambit the specified domestic transactions. The transfer pricing provisions and other related provisions pertaining to Specified Domestic Transaction are discussed in detail in “Chapter 1: Transfer pricing and other provisions to check avoidance of tax” of Module 4: Part II- International Taxation of Paper 7: Direct Tax Laws and International Taxation. 1.11 COMPUTATION OF ARM’S LENGTH PRICE (SECTION 92C) “Arm’s length price” is defined in section 92F(ii) to mean price which is applied or proposed to be applied in a transaction between persons other than associated enterprises in uncontrolled conditions. Section 92C deals with the method for determining arm’s length price and the factors which are to be considered for applicability or non-applicability of a particular method to a given situation. The factors as well as methods incorporated in this section are not exhaustive and the CBDT may prescribe further factors and methods. © The Institute of Chartered Accountants of India  TRANSFER PRICING 1.23 It provides that the arm’s length price in relation to an international transaction shall be determined by any of the following methods, being the most appropriate method, having regard to the nature of transaction or class of transaction or class of associated persons or functions performed by such persons or such other relevant factors as the Board may prescribe, namely - (a) comparable uncontrolled price method; (b) resale price method; (c) cost plus method; (d) profit split method; (e) transactional net margin method; (f) such other method as may be prescribed by the Board. Accordingly, the Board has prescribed that the other method for determination of arm’s length price in relation to an international transaction shall be any 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. [Rule 10AB] Transfer Pricing Methods Traditional Transaction Transactional Profit Other Methods Methods Methods Comparable Uncontrolled Price Profit Split Method Any other method as Method provided in Rule 10AB Resale Price Transactional Net Method Margin Method Cost Plus Method Section 92C(2) provides that the most appropriate method out of the above methods has to be applied for determination of arm’s length price, in the prescribed manner. Rule 10B(1) prescribed the manner to determine the arm’s length price under the five methods as stated in above diagram in respect of any goods, property or services purchased or sold under any international transaction. © The Institute of Chartered Accountants of India  1.24 INTERNATIONAL TAXATION (1) Comparable uncontrolled price method: A comparable uncontrolled price is the price agreed between unconnected parties for the transaction of goods or services under similar circumstances. Mechanism to determine CUP is as follows: (i) Identification of price charged or paid for property transferred or services provided under any comparable uncontrolled transaction(s). (ii) Such price is adjusted to account for differences, if any, between the international transaction and comparable uncontrolled transactions or between the enterprises entering into such transactions which could materially affect the price in the open market can be made. (iii) Adjusted price arrived above taken to be as arm’s length price in respect of the property transferred or services provided in the international transaction. Meaning of “Uncontrolled transaction”: Uncontrolled transaction means a transaction between enterprises other than associated enterprises, whether resident or non-resident. The comparable uncontrolled price method requires a high degree of comparability of products, services and functions and such comparability can be improved by carrying out necessary reasonable adjustments, in respect of differences arising on account of various factors such as quality of the product or service, contractual terms, credit terms, transport terms, level of the market (i.e. wholesale, retail, etc.), geographic market in which the transaction takes place, etc. A Comparable uncontrolled price can be determined as follows: © The Institute of Chartered Accountants of India  TRANSFER PRICING 1.25 Transaction between AE1 and AE2 are subject to transfer pricing. Transaction #1 and #2 are internal transaction since it is entered by AEs with unrelated parties and Transaction #3 is external transaction since it is entered between unrelated parties. Hence, controlled transaction need to be compared with either Transaction #1 (If AE1 is the tested party) or Transaction #2 (If AE2 is the tested party) or Transaction #3. In the given example, AE1 and AE2 are parties to a controlled transaction. Assume, AE1 provides back office support services to AE2 (i.e. engaged in manufacturing of goods). The functions performed, assets deployed and risk assumed for back office support services is less complex vis-à-vis the functions performed, assets deployed and risk assumed in manufacturing activities. Hence, AE1 must be selected as tested party which has least complex functional profile. Accordingly, controlled transaction need to be compared with Transaction #1 i.e., between unrelated party and AE1. ILLUSTRATION 1 US Ltd., a US company has a subsidiary, IND Ltd. in India. US Ltd. sells computer monitors to IND Ltd. for resale in India. US Ltd. also sells computer monitors to CMI Ltd., another computer reseller. It sells 50,000 computer monitors to IND. Ltd. at ` 11,000 per unit. The price fixed for CMI Ltd. is ` 10,000 per unit. The warranty in case of sale of monitors by IND Ltd. is handled by IND Ltd. However, for sale of monitors by CMI Ltd., US Ltd. is responsible for the warranty for 3 months. Both US Ltd. and IND Ltd. offer extended warranty at a standard rate of ` 1,000 per annum. On these facts, how is the assessment of IND Ltd. going to be affected? SOLUTION US Ltd., the foreign company and IND Ltd., the Indian company are associated enterprises since US Ltd. is the holding company of IND Ltd. US Ltd. sells computer monitors to IND Ltd. for resale in India. US Ltd. also sells identical computer monitors to CMI Ltd., which is not an associated enterprise. The price charged by US Ltd. for a similar product transferred in comparable uncontrolled transaction is, therefore, identifiable. Therefore, Comparable Uncontrolled Price (CUP) method for determining arm’s length price can be applied. While applying CUP method, the price in comparable uncontrolled transaction needs to be adjusted to account for difference, if any, between the international transaction (i.e. transaction between US Ltd. and IND Ltd.) and uncontrolled transaction (i.e. transaction between US Ltd. and CMI Ltd.) and the price so adjusted shall be the arm’s length price for the international transaction. For sale of monitors by CMI Ltd., US Ltd. is responsible for warranty for 3 months. The price charged by US Ltd. to CMI Ltd. includes the charge for warranty for 3 months. Hence arm's length price for computer monitors being sold by US Ltd. to IND Ltd. would be: Particulars No. ` Sale price charged by US Ltd. to CMI Ltd. 10,000 © The Institute of Chartered Accountants of India  1.26 INTERNATIONAL TAXATION Less: Cost of warranty included in the price charged to CMI Ltd. (` 1,000 x 3 /12) 250 Arm's length price 9,750 Actual price paid by IND Ltd. to US Ltd. 11,000 Difference per unit 1,250 No. of units supplied by US Ltd. to IND Ltd. 50,000 Addition required to be made in the computation of total income of IND Ltd. (` 1,250 × 50,000) 6,25,00,000 No deduction under chapter VI-A would be allowable in respect of the enhanced income of ` 6.25 crores. Note: It is assumed that IND Ltd. has not entered into an advance pricing agreement or opted to be subject to Safe Harbour Rules. (2) Resale price method The resale price method (RPM) is a method which compares the gross margins (i.e. gross profit over sales) earned in transactions between related and unrelated parties for the determination of the ALP. The RPM requires high level of functional comparability and is mainly applicable where the controlled party is a distributor. The RPM evaluates whether the amount charged in a controlled transaction is at arm’s length by reference to the gross margin realised in comparable uncontrolled transactions. RPM can be computed as follows: (i) Identification of resale price by tested party i.e., the price at which property purchased or services obtained by the enterprise from an associated enterprise is resold or provided to an unrelated enterprise. (ii) Resale price is reduced by normal gross profit margin with reference to uncontrolled transaction(s). (iii) Such price reduced by expenses incurred (customs duty etc.) in connection with purchase of the product/ services. (iv) This price may be adjusted to account for functional and other differences, if any, including differences in accounting practices which could materially affect the gross profit margin in the open market. (v) Adjusted price arrived above taken to be as arm’s length price RPM is generally used to test transactions involving distribution function, i.e. when the tested party purchases products/ acquires services from related party and resells the same to independent parties. The use of RPM is appropriate where the reseller does not add substantially to the value © The Institute of Chartered Accountants of India  TRANSFER PRICING 1.27 of the product/ services. Where the transactions are not comparable in all ways and the differences have a material effect on price, one has to make adjustments to eliminate the effect of those differences. For this purpose, consideration of operating expenses associated with functions performed and risks assumed may be necessary, because differences in functions performed are often reflected in operating expenses. Using RPM as the most appropriate method, ALP can be computed as follows: AE2 has purchased goods from AE1 and re-sold to independent enterprise at USD 100. A similar transaction is entered into by unrelated parties with resale price margin of USD 25. Thus, the arm’s length price arrived at is USD 75 (i.e. market value of goods at which AE2 should have purchased from AE1 (assuming no other costs for AE2 for simplicity purposes). (3) Cost plus method The Cost Plus Method (‘CPM’) determines an arm’s-length price by adding an appropriate gross profit margin to an associated entity’s costs of producing goods or services. The gross profit margin should reflect the functions performed by an entity and should include a return for capital used and risks assumed by the entity. Mechanism to compute ALP based on CPM is as follows: (i) Identification of direct and indirect costs of production incurred by the enterprise in respect of property transferred or services provided to an associated enterprise. (ii) Determination of amount of normal gross profit mark-up to such costs arising from the transfer or provision of the same or similar property or services by the enterprise or by an unrelated enterprise in comparable uncontrolled transaction or transactions. (iii) The normal gross profit mark-up determined above is adjusted to account for functional and © The Institute of Chartered Accountants of India  1.28 INTERNATIONAL TAXATION other differences, if any, which could materially affect such profit mark-up in the open market. (iv) Adjusted gross profit mark-up added to total costs identified in (i) above. (v) Sum arrived above is taken to be arm’s length price in relation to the supply of property or provision of services by the enterprise. This method probably is most useful where semi-finished goods are sold between related parties, where related parties have concluded joint facility agreements or long-term buy-and-supply arrangements, or where the controlled transaction is the provision of services. Using CPM as the most appropriate method, ALP can compute as follows: AE2 has purchased manufactured goods from AE1. A similar transaction is entered into by unrelated parties with gross profit margin of USD 250. Thus, the arm’s length price arrived at is USD 750 i.e. market value of goods at which AE2 should have purchased from AE1. If there are differences between the controlled and uncontrolled transactions that would affect the gross profit mark-up, adjustments should be made to the gross profit mark-up earned in the comparable uncontrolled transaction. For this purpose, consideration of the operating expenses associated with the functions performed and risks assumed may be necessary, because differences in functions performed are often reflected in operating expenses. (4) Profit split method This is a method which may be applicable mainly in international transactions involving transfer of unique intangibles or in multiple international transactions which are so inter-related that they cannot be evaluated separately for the purpose of determining the arm’s length price of any one transaction. The Profit Split Method (PSM) evaluates whether the allocation of the combined operating profit or loss attributable to one or more controlled transactions is at arm’s length with reference to the relative value of each controlled taxpayer’s contribution to that combined operating profit or loss. The combined operating profit or loss must be derived from the most prominently identifiable business activity of the controlled taxpayers for which data is available that includes the controlled transactions (relevant business activity). © The Institute of Chartered Accountants of India  TRANSFER PRICING 1.29 Profit split method, generally, is applied as per following steps: (i) Determination of combined net profit of the associated enterprises arising out of international transaction in which they are engaged. (ii) Evaluation of relative contributions by each enterprise to the earning of such combined net profit on the basis of functions performed, risks assumed and assets employed by each enterprise. This evaluation is to be made on the basis of reliable external market data which can indicate how such contribution would be evaluated by unrelated enterprises performing comparable functions in similar circumstances. (iii) Splitting of combined net profit amongst the enterprises in proportion to their relative contributions, as evaluated above. (iv) Profit thus apportioned to the assessee is taken into account to arrive at the arm’s length price in relation to the international transaction. Allocation of profits must be made in accordance with one of the following allocation methods: (a) Comparable profit split - Under this method, uncontrolled taxpayer’s percentage of the combined operating profit or loss is used to allocate the combined operating profit or loss of the relevant business activity. (b) Residual profit split - Following the two-step process: i. Allocate income to routine contributions ii. Allocate residual profit The following example explains the PSM: Net Profits from all Transactions (USD 100M) Minus functional/assets returns to each party based on market benchmarks (USD 70M) Residual Profit (USD 30M) Residual Profits split, based on Residual Profit Share for each party’s ownership of non- Residual Profit Share for Related Party X routine intangibles Related Party Y (example network reach, efficiency of sales and marketing team, etc.) © The Institute of Chartered Accountants of India  1.30 INTERNATIONAL TAXATION Suppose in the above example, Net profit margins from all transactions were USD 100M. Depending on the contribution of each AE, the net profit of USD 70M will be distributed to all AEs (i.e. Allocate income to routine contributions). Further, after the respective contribution is allocated specifically, the residual profit of USD 30M will be distributed among AEs based on various factors. Total profit for Related Party X: 1. Income for specific contribution (suppose 40% by X and 60% by Y) made by X: USD 28M (i.e. USD 70M x 40%) 2. Income as residual profit (i.e. 50:50) (allocated considering various factors): USD 15M (i.e. 30M x 50%) Total A