Transfer Pricing PDF

CHAPTER 24 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;  comprehend...

CHAPTER 24 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;  comprehend 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” and “specified domestic transaction”;  determine the arm’s length price using different methods prescribed under the income-tax law;  appreciate the meaning of safe harbour and rules for safe harbor incorporated in the income-tax law;  appreciate the benefits of entering into advance pricing agreements;  identify the cases where secondary adjustments have to be made;  pinpoint the responsibilities of a person entering into an international transaction to keep and maintain prescribed information and documents; © The Institute of Chartered Accountants of India  24.2 INTERNATIONAL TAXATION  identify the circumstances when the Assessing Officer can invoke the power to determine the arm’s length price;  comprehend and appreciate the country-by-country reporting requirements and related matters incorporated in the income-tax law in compliance with BEPS Action Plan 13;  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. © The Institute of Chartered Accountants of India  TRANSFER PRICING 24.3 24.1 INTRODUCTION In the present age of globalisation, Multinational Companies (MNCs) have branches/subsidiaries/divisions operating in more than one country. There is a possibility that two or more entities belonging to the same multinational group can fix up their prices for goods and services and allocate profits among the enterprises within the group in such a way that there may be either no profit or negligible profit in the jurisdiction which taxes such profits and substantial profit in the jurisdiction where the tax liability is minimum. This results in base erosion of the high tax jurisdiction by shifting the profits to the low tax jurisdiction, thereby minimizing the taxes. This may adversely affect a country's share of due revenue. The increasing participation of multinational groups in economic activities in India has given rise to new and complex issues emerging from transactions entered into between two or more enterprises belonging to the same multinational group. In order to curb such tax avoidance measures, Arm’s Length Principle (ALP) is used internationally to substitute the transfer price adopted by the MNCs to price the intra-group transfer of goods or provision of services. Generally, the arm’s length price refers to the price an unrelated enterprise would be willing to pay in comparable circumstances. The OECD guidelines define the “Transfer prices” as 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. 24.2 MEANING OF “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. The Arm’s Length Principle, in the context of taxation, is explained in the OECD Model Tax Convention as under: © The Institute of Chartered Accountants of India  24.4 INTERNATIONAL TAXATION “Where conditions are made or imposed between two associated enterprises in their commercial 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. 24.3 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 is needed to determine real 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 they 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 jurisdiction at a high price (which exceeds the market price) and to an entity in a low-tax jurisdiction or a tax haven at a low price (which is lower © The Institute of Chartered Accountants of India  TRANSFER PRICING 24.5 than the market price). This would result in extreme price distortion of goods and services in the international market. 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. 24.4 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 information regarding the comparable companies, their profit margins, the pricing charged by them in independent and comparable circumstances may be difficult to obtain. Further, the differences in the accounting of the data could result in difficulty as the reliable adjustments may not be possible to be made. 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 © The Institute of Chartered Accountants of India  24.6 INTERNATIONAL TAXATION a comparable market price for transactions involving intangibles because they are unique. The unique nature of these transactions creates a very wide price range. Administrative burden – Due to the subjectivity in selection of comparables and the methods, the application of arm’s length principle results in administrative burden for the tax administration as well as the taxpayers. 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. 24.5 THE INDIAN SCENARIO (1) Transfer pricing in relation to International Transactions Finance Act, 2001 has introduced Chapter X to the Income-tax Act, 1961 with a view to provide a statutory framework which can lead to computation of reasonable, fair and equitable profits and tax in India so as to curb the pricing strategies adopted by the MNCs resulting in base erosion and profit shifting. These provisions are contained in sections 92 to 92F of the Income-tax Act, 1961. Rules 10A to 10E have been inserted in the Income-tax Rules, 1962. 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. The following conditions must be satisfied in order to attract the special provisions of Chapter X relating to avoidance of tax: © The Institute of Chartered Accountants of India  TRANSFER PRICING 24.7 (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 (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 can 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. I. 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. © The Institute of Chartered Accountants of India  24.8 INTERNATIONAL TAXATION 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. It is, however, pertinent to note that the transfer pricing provisions would not be applicable if substitution of the ALP has the effect of reducing the income chargeable to tax or increasing the loss. The Assessing Officer will have wide powers to determine what is an arm’s length price for such transactions and make adjustments for computation of income. The keywords in section 92 are (i) associated enterprises, (ii) international transactions and (iii) arm’s length price. These terms are defined in sections 92A, 92B and 92C. II. Associated Enterprises [Section 92A]: Section 92A(1) defines the associated enterprises generally. Section 92A(2) provides 13 relationships between the enterprises which constitutes deemed associated enterprises. The term “associated enterprise” in relation to another enterprise is defined in section 92A(1). Associated enterprises are those which are owned or controlled by the same or common entity/ person. Associated Enterprises [Section 92A(1)] Condition Example (1) An enterprise which participates, directly Where A Ltd. directly participates in the or indirectly, or through one or more management of B Ltd. and B Ltd. directly intermediaries, in: participates in the management of C Ltd. In management of the other enterprise, or such situation, A Ltd. has direct participation in management of B Ltd. but has an indirect control of other enterprise, or participation in management of C Ltd. capital of other enterprise A B C In such scenario, both B Ltd. and C Ltd. would be associated enterprises of A Ltd. (2) If one or more persons participates, Mr. A directly has control in A Ltd. and B directly or indirectly, or through one or Ltd. In such a scenario, both A Ltd. & B Ltd. more intermediaries in: are associated enterprises since there is a © The Institute of Chartered Accountants of India  TRANSFER PRICING 24.9 management/control/capital of the common person i.e., Mr. A, who controls two different enterprises both entities A Ltd. & B Ltd. Then, those two enterprises are AEs. 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: Deemed Associated Enterprises [Section 92A(2)] Condition Situation Example Enterprise One enterprise holds A Ltd. holds 33% of Voting Power in B Ltd. and ownership 26% or more of the B Ltd. holds 80% Voting Power in C Ltd. voting power, directly or 33% 80% indirectly, in the other A B C enterprise. In above situation, A Ltd. holds 26% or more voting power in B Ltd., directly and in C Ltd. indirectly (i.e. through B Ltd.). Therefore, both B Ltd. & C Ltd. are deemed associated enterprises of A Ltd. Substantial Any person or enterprise Mr. A holds 40% of voting power in both X Ltd. voting power in holds 26% or more of and Y Ltd. where neither X Ltd. has any holding in two entities by the voting power, Y Ltd. nor Y Ltd. has any holding in X Ltd. common directly or indirectly, in person each of two different Mr. A enterprises. 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. Advancing of One enterprise advances Book Value of total assets of Y Ltd. is ` 100 crores. X substantial loan to the other enterprise Ltd. advances loan of ` 60 crores to Y Ltd. sum of money of an amount of 51% or In this case, X Ltd. advances loan of ` 60 crores more of the book value of to Y Ltd, which is 60% of the book value of total the total assets of other assets of Y Ltd. Hence, X Ltd. & Y Ltd. are enterprise deemed associated enterprises. © The Institute of Chartered Accountants of India  24.10 INTERNATIONAL TAXATION Guaranteeing One enterprise P Inc. has total loan of 1 million dollars from XYZ borrowings guarantees 10% or more Bank of America. Out of that, A Ltd., an Indian of the total borrowings company, guarantees 20% of total borrowings in of the other enterprise. case of any default made by P Inc. In such case, since A Ltd. guarantees 20% of total borrowings of P Inc., P Inc. and A Ltd. are deemed associated enterprises. Appointment of One enterprise appoints X Ltd. has 15 directors on its Board. Out of that, Y majority more than half of the Ltd. has appointed 8 directors. In such case, X directors of board of directors or Ltd. and Y Ltd. are deemed associated other members of the enterprises. enterprise governing board, or one or more executive directors or executive members of the governing board of other enterprise. Appointment of More than half of the Mr. A appointed 9 directors out of 15 directors of majority directors or members of X Ltd. and appointed 2 executive directors on the directors of two the governing board, or board of Y Ltd. In such case, since a common different one or more of the person i.e. Mr. A appointed more than half of the enterprises by executive directors or directors in X Ltd. and appointed 2 executive same person(s) members of the governing directors in Y Ltd., both X Ltd. and Y Ltd. are board of each of the two deemed associated enterprises. enterprises are appointed by the same person(s). Dependence on The manufacture or processing of goods or articles or business carried out intangibles by one enterprise is wholly dependent (i.e. 100%) on the know-how, w.r.t which patents, copyrights, trade-marks, licenses, franchises or any other business other or commercial rights of similar nature, or any data, documentation, drawing enterprise has or specification relating to any patent, invention, model, design, secret exclusive formula or process, of which the other entity is the owner or in respect of rights which the other enterprise has exclusive rights. Dependence on 90% or more of raw materials and consumables required for the raw material manufacture or processing of goods or articles carried out by one enterprise, supplied by are supplied by the other enterprise, or by persons specified by the other other enterprise, where the prices and other conditions relating to the supply are enterprise influenced by such other enterprise. Dependence on The goods or articles manufactured or processed by one enterprise, are sale 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 24.11 Control by Where one enterprise is Mr. A and Mr. B are relatives. Mr. A has control common controlled by an over X Ltd. and Mr. B has control over Y Ltd. individual individual, the other Therefore, both X Ltd. and Y Ltd. will be enterprise is also deemed associated enterprises. controlled by such individual or his relative or jointly by such individual and his relatives. Control by HUF Where one enterprise is or member controlled by a HUF and Member of thereof the other enterprise is HUF HUF/ Relative of controlled by a member member of of such HUF or by such HUF relative of a member of such HUF or jointly by Control Control such member and his relative. A Ltd. B Ltd. A Ltd & B Ltd are deemed associated enterprises Interest in a Where one enterprise is a firm, AOPs or BOls, the other enterprise holds 10% firm, AOPs or or more interest in firm/AOPs/BOIs. BOIs Mutual interest There exists b/w the two enterprises, any relationship of mutual interest, relationship as may be prescribed. 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, - 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 © The Institute of Chartered Accountants of India  24.12 INTERNATIONAL TAXATION 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. “Permanent establishment” includes a fixed place of business through which the business of the enterprise is wholly or partly carried on. III. Definition of International Transaction [Section 92B]  As per section 92B, 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.  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”), ♦ 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, © The Institute of Chartered Accountants of India  TRANSFER PRICING 24.13 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 1/6/2023 and Mr. B has entered into an agreement for sale of product X with C Inc., a non-resident entity, which holds 27% of the voting power in A Ltd., on 30/5/2023, 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 Agreement for sale of Product X entered into on product X entered into on 1/6/2023 30/5/2023 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 holds 26% or more of the voting power A Ltd.  The scope of “international transaction” shall include: Transactions Amplification of scope of terms used (1) Purchase, sale, transfer, lease Tangible property includes - or use of tangible property building, transportation vehicle, machinery, equipment, tools, plant, furniture, © The Institute of Chartered Accountants of India  24.14 INTERNATIONAL TAXATION commodity or any other article, product or thing; (2) Purchase, sale, transfer, lease “Use of certain rights” refer to – or use of intangible property, land use, including transfer of ownership or the provision of use of copyrights, patents, trademarks, licences, franchises, certain rights customer list, marketing channel, brand, commercial 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 24.15 (5) Business restructuring or All such transactions are included in the definition of reorganization entered into by “international transaction”, whether or not it has bearing an enterprise with an on the profit, income, losses or assets of such associated enterprise enterprises at the time of the transaction or at any future date.  The expression “intangible property” shall include: Type of Examples of each type of intangible asset 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 proprietary computer software processing 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 © The Institute of Chartered Accountants of India  24.16 INTERNATIONAL TAXATION customer contracts customer relationship open purchase orders (7) Contract favourable supplier contracts, licence agreements franchise agreements non-compete agreements (8) Human trained and organised work force capital 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.  Transaction: The word “transaction” has been defined in section 92F to include an arrangement, understanding or action in concert (i) whether or not such arrangement, understanding or action is formal or in writing; or (ii) whether or not such arrangement, understanding or action is intended to be enforceable by legal proceedings.” 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 © The Institute of Chartered Accountants of India  TRANSFER PRICING 24.17 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. It may be noted that one of the parties to the international transaction should be a non- resident. Therefore, transactions between a resident assessee (“A” Ltd.) and its foreign branches or between its two or more foreign branches will not be considered as international transactions. This is for the reason that when “A” Ltd. is a resident in India, all its foreign branches will be deemed to be resident in India and transactions between Head Office and branches or between branches inter se will be considered as transactions between residents. Even otherwise there can be no avoidance of income in the transactions between Indian Head Office and foreign branches. On the other hand, if an Indian branch of a foreign company (“B” Ltd.) is having a transaction with the Head Office, the same will be covered by the definition of international transaction between associated enterprises. This is because the Indian branch (permanent establishment of “B” Ltd.) will be liable to tax in India in respect of its Indian operations and, therefore, any transaction between the Indian branches of “B” Ltd. with its head office in foreign country or with any of the branches of “B” Ltd. outside India will be considered as an international transaction and it will have to establish that the transaction is at an arm’s length price. This will be the position even in respect of transactions between a parent company (“A” Ltd.) and its foreign subsidiary and, therefore, such transactions will have to comply with the provisions of transfer pricing regulations. IV. 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. It provides that the arm’s length price in relation to an international transaction would 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 CBDT may prescribe, namely - © The Institute of Chartered Accountants of India  24.18 INTERNATIONAL TAXATION (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 CBDT has prescribed that the other method for determination of arm’s length price in relation to an international transaction would 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 Methods Other 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  TRANSFER PRICING 24.19 (a) Comparable Uncontrolled Price Method Adjustment to account for differences between the international Under this method the The adjusted price as transaction and price charged or paid worked out under (b) comparable for property transferred will be considered as uncontrolled or services provided an arm’s length price in transactions or under any comparable respect of the property between the uncontrolled transferred or services enterprises entering transaction or provided in the into such transactions transactions should be international which could materially identifiable. transaction. affect the price in the open market can be made. 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: © The Institute of Chartered Accountants of India  24.20 INTERNATIONAL TAXATION Particulars No. ` Sale price charged by US Ltd. to CMI Ltd. 10,000 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. (b) Resale Price Method Under this method, the price at which property purchased or services obtained by the enterprise from an associated enterprise is resold or are provided to an unrelated enterprise should be identifiable. The following adjustments can be made to such resale price. - For normal gross profit margin - For expenses incurred in connection with the purchase of property or obtaining of services. - For functional and other differences, including differences in accounting practices which could materially affect the gross profit margin in the open market. The adjusted price as stated in (b) above will be considered as the arm’s length price in respect of the purchase of the property or obtaining of the services by the enterprise from the associated enterprise. ILLUSTRATION 2 Earth (P) Ltd., Calcutta is engaged in trading of electronic goods. It purchased goods from its associated enterprise Sun Pte. Ltd., Singapore, and also from unrelated party, Oceania Ltd., UK. For the F.Y.2023-24, the gross profit margin was 15% on the sale of goods of Sun Pte Ltd., © The Institute of Chartered Accountants of India  TRANSFER PRICING 24.21 whereas it was 20% in the case of Oceania Ltd. After-sales warranty of 6 months was provided by Sun Pte Ltd. whereas Oceania Ltd. gave after-sales warranty of 1 year. The cost of warranty may be taken as 2% of the sale price. The Sun Pte. Ltd.’s brand value is internationally known and the benefit of the brand value can be taken as 1% of sale price. During the F.Y.2023-24, it sold goods of Sun Pte Ltd. for ` 20 crores and of Oceania Ltd. for ` 15 crores. As regards transport cost of the goods purchased, there was no difference between related and unrelated party. Compute the ALP of the transaction between Earth (P) Ltd. and Sun Pte Ltd., Singapore by applying the Resale Price Method, considering the facts of the case. SOLUTION As per section 92B, the transactions entered into between Earth (P) Ltd., an Indian company, and Sun Pte. Ltd., Singapore, being associated enterprises, for purchase of electronic goods would be international transaction. Since Earth (P) Ltd. purchased similar electronic goods from Oceania Ltd., an unrelated entity, and sold the same to unrelated parties, this transaction can be considered as uncontrolled transaction and the gross profit margin of 20% earned on sale of such goods can be considered for the purpose of determining the arm’s length price of the transactions between Earth (P) Ltd. and Sun Pte. Ltd. However, functional adjustments need to be given effect to in arriving at the ALP. Computation of ALP of transaction between Earth (P) Ltd. and Sun Pte. Ltd. Particulars Amount (In `) Resale price of goods purchased from Sun Pte. Ltd. 20,00,00,000 Less: Profit margin with reference to uncontrolled transaction between Earth 4,00,00,000 (P) Ltd. and Oceania Ltd. (20% on sale) 16,00,00,000 Add: Adjustment for benefit of brand value of Sun Pte. Ltd. [Sun Pte. Ltd has 20,00,000 its brand value internationally. Therefore, adjustment of benefit of brand value has to be carried out to arrive at ALP (1% of sale price)] Less: Adjustment of cost of warranty [Sun Pte. Ltd. provides warranty for 6 months whereas unrelated party has provided warranty of 12 months. Therefore, adjustment for the cost of such warranty has to be carried out to arrive at arm’s length price (2% of sale price x 6/12)] (20,00,000) Arm’s length price 16,00,00,000 © The Institute of Chartered Accountants of India  24.22 INTERNATIONAL TAXATION (c) Cost Plus Method The amount of a normal gross profit Under this method, mark-up to such costs the direct and indirect arising from the The above normal Costs referred to in costs of production transfer or provision of gross profit mark-up (a) above should be incurred by the the same or similar can be adjusted to increased by the enterprise in respect property or services by take into account the adjusted profit mark- of property the enterprise, or by functional and other up as stated in (c) transferred or an unrelated differences which above and the price services provided to enterprise in could materially affect so arrived at will be an associated comparable such profit mark-up in considered as the enterprise should be uncontrolled the open market. arm’s length price. determined. transaction or transactions should be determined. ILLUSTRATION 3 ABC Ltd., Canada holds 35% shares in LMN Ltd., India. LMN Ltd. develops software and does both onsite and offsite consultancy services for the customers. LMN Ltd. during the year billed ABC Ltd. Canada for 120 man-hours at the rate of ` 1,800 per man hour. The total cost (direct and indirect) for executing this work amounted to ` 2,25,000. However, LMN Ltd. billed XYZ Ltd., India at the rate of ` 2,800 per man hour for the similar level of manpower and earned a Gross Profit of 50% on its cost. The transactions of LMN Ltd. with ABC Ltd. and XYZ Ltd. are comparable, subject to the following differences: While LMN Ltd. derives technology support from the ABC Ltd., there is no such support from XYZ Ltd. The value of technology support received from ABC Ltd. may be put at 18% of normal gross profits. As ABC Ltd. gives business in large volumes, LMN Ltd. offered to ABC Ltd., a quantity discount which may be valued at 10% of normal gross profits. In the case of rendering services to ABC Ltd., LMN Ltd. neither runs any risk nor incurs any marketing costs. On the other hand, in the case of services to XYZ Ltd., LMN Ltd. has to © The Institute of Chartered Accountants of India  TRANSFER PRICING 24.23 assume all the risk and costs associated with the marketing function which may be estimated at 12% of the normal gross profits. LMN Ltd. offered one month credit to ABC Ltd. The cost of providing such credit may be valued at 2% of the gross profits. No such credit was given to XYZ Ltd. Compute the Arm's Length Price along with income to be increased under the Cost Plus Method. SOLUTION LMN Ltd, an Indian company and ABC Ltd., a Canadian company, are deemed to associated enterprises as per section 92A(2), since ABC Ltd. holds shares carrying 35% of the voting power (i.e., not less than 26% of voting power) in LMN Ltd. Further, the transaction of developing software and providing consultancy services (both onsite and offsite) fall within the meaning of “international transaction” under section 92B. Hence, transfer pricing provisions would be attracted in this case. Computation of Arm’s Length Price as per Cost Plus Method Gross Profit mark-up on cost in case of XYZ Ltd. [an unrelated party] 50% Less: Adjustments for functional and other differences - Value of technology support [ABC Ltd. provides technology support, 9% but XYZ Ltd. does not provide such support. Therefore, value of technology support shall be adjusted] [18% of 50%, being gross profit] - Quantity discount to ABC Ltd. [Quantity discount is allowed to ABC 5% Ltd. as it gives business in large volumes, but the same is not provided to XYZ Ltd. Therefore, it shall be adjusted] [10% of 50%, being gross profit] - Risk and cost associated with marketing [LMN Ltd. has to bear all the 6% risk and costs associated with the marketing function in case of XYZ Ltd., while there is no such risk in case of services to ABC Ltd. Therefore, market risk and cost shall be adjusted] [12% of 50%, being gross profit] 20% 30% Add: Cost of credit to ABC Ltd. [LMN Ltd has provided credit of 1 month to ABC Ltd. but not to the unrelated party. Therefore, adjustment for the cost of such credit has to be carried out to arrive at the ALP] [(2% of 50%, being gross profit] 1% Arm’s length gross profit mark up to cost 31% © The Institute of Chartered Accountants of India  24.24 INTERNATIONAL TAXATION Cost incurred by LMN Ltd. for executing ABC Ltd.’s work 2,25,000 Add: Adjusted gross profit (` 2,25,000 x 31%) 69,750 Arm’s length billed value 2,94,750 Less: Actual Billed Income from ABC Ltd. (` 1800 x 120 man hours) 2,16,000 Total Income of LMN Ltd to be increased by 78,750 (d) 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. Under this method, combined net profit of the associated enterprises arising from the international transactions in which they are engaged is first determined. The relative contribution of each associated enterprise to the earning of such combined net profit is then evaluated on the basis of the functions performed, assets employed and risks assumed 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. The combined net profit is then split amongst the enterprises in proportion to their relative contributions. The profit thus apportioned to the assessee is taken into consideration to arrive at an arm’s length price in relation to the international transaction. In certain cases the combined net profit referred to in (b) above may, in the first instance, be partially allocated to each enterprise so as to provide it with a basic return appropriate for the type of international transaction in which it is engaged. This has to be determined with reference to market returns achieved for similar types of transactions by independent enterprises. Thereafter, the residual net profit remaining after such allocation may be split amongst the enterprises as stated in (c) and (d) above. In such a case the aggregate of net profit allocated in the first instance together with the residual profit apportioned should be considered for arriving at the arm’s length price of the international transaction. © The Institute of Chartered Accountants of India  TRANSFER PRICING 24.25 (e) Transactional Net Margin Method In this method, the net profit margin realised by the enterprise from an international transaction entered into with an associated enterprise is computed having regard to costs incurred or sales effected or assets employed or having regard to any other relevant base. The net profit margin realised by the enterprise or by an unrelated enterprise from a comparable uncontrolled transaction by applying the same base as in (a) above is computed. This profit margin is adjusted to take into account the differences which could materially affect the net profit margin in the open market having regard to international transaction and comparable uncontrolled transactions or having regard to the enterprise entering into such transactions. If the net profit margin realised by the enterprise as in (a) above is established to be the same as the net profit margin as in (b) above, then the same is taken into consideration to arrive at an arm’s length price in relation to the international transaction. ILLUSTRATION 4 Andes Inc. having its business in Malaysia has advanced a loan of MD 1,60,000 to Andes Ltd, India. Book value of total assets of Andes Ltd was ` 125 lakhs. Andes Ltd provides software backup support to Andes Inc. Andes Ltd has spent 50,000 man hours during the financial year 2023-24 for the services rendered to Andes Inc. The cost for Andes Ltd is MD 75/manhour. Andes Ltd has billed Andes Inc. at MD 90.75/manhour. Gama Ltd. in India which has a similar business model, provides software backup support to Olive Inc. in Penang, Malaysia. Gama Ltd.'s cost and operating profits are as hereunder: Particulars ` in lakhs Direct costs 600 Indirect costs 200 Operating profits 200 (1) Calculate Arm’s Length Price for the transaction between Andes Ltd. and Andes Inc. based on the above data of Gama Ltd. using the Transactional Net Margin Method. Assume 1 MD = ` 45. (2) Explain, if there is any adjustment to be made to the total income of Andes Ltd. Note: MD = Malaysia Dollars © The Institute of Chartered Accountants of India  24.26 INTERNATIONAL TAXATION SOLUTION Two enterprises are deemed to be associated enterprises where one enterprise advances loan constituting not less than 51% of the book value of the total assets of the other enterprise. In this case, since Andes Inc., a foreign company, has advanced loan to Andes Ltd., an Indian company, and such loan constitutes 57.6% [(` 45 x 1,60,000 x 100/1,25,00,000] of the book value of total assets of Andes Ltd., Andes Inc and Andes Ltd. are deemed to be associated enterprises. Since the transaction of provision of software backup support by Andes Ltd. to Andes Inc. is an international transaction between associated enterprises the provisions of transfer pricing would be attracted in this case. Determination of Operating Margin of transaction of provision of software backup support by Andes Ltd. to Andes Inc Particulars ` Billing per manhour [MD 90.75/hour x `45] 4,083.75 Cost per man hour [MD 75/hour x `45] 3,375.00 Operating profit per manhour 708.75 Operating profits to cost (%) [708.75 x 100/3375] = 21% Determination of Operating Margin of Comparable Uncontrolled transaction i.e., provision of software backup support. by Gama Ltd. to Olive Inc. Particulars ` in lakhs Direct Cost 600 Indirect Cost 200 Total cost 800 Operating profits 200 Operating profits to cost (%) [200 x 100/800] = 25% (1) Computation of Arm’s Length Price of provision of software backup support provided by Andes Ltd. to Andes Inc. by applying TNMM Particulars ` Cost for Andes Ltd. (per man hour) [MD 75 x ` 45/MD] 3,375.00 Add: Arm’s length operating profit margin as % of cost (25% of ` 3,375) 843.75 Arm’s length price (per manhour) in ` 4,218.75 Arm’s length price of total manhours spent by Andes Ltd. for providing software backup support to Andes Inc. [` 4,218.75 x 50,000 man hours] = ` 21,09,37,500 © The Institute of Chartered Accountants of India  TRANSFER PRICING 24.27 (2) Adjustment to be made to the total income of Andes Ltd. Particulars ` Arm’s length price of total manhours spent by Andes Ltd. for providing 21,09,37,500 software backup support to Andes Inc. Less: Amount actually billed [90.75 MD x ` 45/MD x 50,000 manhours] 20,41,87,500 Arm’s length adjustment to be made to the total income of Andes 67,50,000 Ltd. (f) Other Method as may be prescribed by the CBDT The Other method allows the use of ‘any method’ which takes into account (i) the price which has been charged or paid or (ii) would have been charged or paid for the same or similar uncontrolled transactions with or between non-associated enterprises, under similar circumstances. The various data which may possibly be used for comparability purposes under this method could be third party quotations, valuation reports, tender/Bid documents, documents relating to the negotiations, standard rate cards, commercial & economic business models; etc. © The Institute of Chartered Accountants of India  24.28 INTERNATIONAL TAXATION Methods for computing ALP [Section 92C] CUP Method Resale Price Cost Plus Profit Split Transactional Net Method(RPM) Method (CPM) Method (PSM) Margin Method (TNMM) This method is This method is This method is This method is Compute Net Profit applied where applied where generally applied where (NP) margin of the there are item obtained applied where there is transfer of enterprise from similar from AE is semi-finished unique intangibles International transaction(s) resold to goods are sold or in multiple Transaction with AE b/w unrelated party to AEs International having regard to cost unconnected Transaction incurred/sales effected/ parties assets employed Identify price Identify the Identify direct & Determine Compute the NP in a Resale Price indirect cost of combined NP of margin realised by comparable (RP) at which production the AEs arising out the enterprise or uncontrolled the item is incurred for of International unrelated enterprise transaction resold to property Transaction in a CUCT by (CUCT) unrelated party transferred or applying the same services base provided to AE Reduce the RP Determine Evaluate the Adjust NP margin by the normal normal GP relative realised from CUCT Gross Profit mark up to contribution of to a/c for differences (GP) margin on such costs by each enterprise to affecting NP margin CUCT & an unrelated the earning of in the OM expenditure enter in CUCT combined NP on incurred the basis of FAR (customs duty) w.r.t. purchase Adjust the Adjust the price Adjust the Split the combined Compare NP margin price for for functional & normal GP NP amongst the relative to material other differences mark-up for enterprise in costs/sales/assets of differences in materially functional and proportion to the AE with NP terms of affecting GP other market returns; & margin of contract, margin in open differences residual profits in uncontrolled party in credit, market (OM) materially proportion to their comparable transport etc. affecting GP relative transactions mark-up in OM contribution Adjusted price Adjusted price Total Costs ↑d ALP to be detd. Adjusted NP margin is ALP is ALP by adjusted on the basis of taken into A/c to mark up = ALP profit apportioned. arrive at ALP © The Institute of Chartered Accountants of India  TRANSFER PRICING 24.29 Determination of the most appropriate method: Rule 10C deals with the determination of most appropriate method. Under this Rule, the method which is best suited to the facts and circumstances and which provides the most reliable measure of an arm’s length price in relation to the international transaction will be considered to be the most appropriate method. For the purpose of selecting the most appropriate method, the following factors should be taken into account. (i) The nature and class of the international transaction; (ii) The class, or classes of associated enterprises entering into the transaction and the functions performed by them taking into account assets employed or to be employed and risks assumed by such enterprises; (iii) The availability, coverage and reliability of data necessary for application of the method; (iv) The degree of comparability existing between the international transaction and the uncontrolled transaction and between the enterprises entering into such transactions; (v) The extent to which reliable and accurate adjustments can be made to account for difference, if any, between the international transaction and the comparable uncontrolled transaction or between the enterprises entering into such transactions; (vi) The nature, extent and reliability of assumptions required to be made in application of a method. Manner of computation of Arm’s length price (Applicable for international transactions and specified domestic transactions undertaken on or after 1.4.2014) [Third proviso to section 92C(2)] In case of an international transaction or specified domestic transaction 1 undertaken on or after 1.4.2014, where more than one price is determined by the most appropriate method, the ALP would be computed in the prescribed manner specified in Rule 10CA. Computation of arm’s length price in certain cases [Rule 10CA] Determination of arm’s length price using one of the prescribed methods As per range concept, if prescribed conditions are The price thus Whether a Yes No satisfied (covered in later determined is the arm’s single price sections), length price is arrived at? (or) By applying Arithmetic Mean in any other case 1 discussed later in this Chapter © The Institute of Chartered Accountants of India  24.30 INTERNATIONAL TAXATION Rule 10CA(1) provides that where in respect of an international transaction or a specified domestic transaction, the application of the most appropriate method referred to in section 92C(1) results in determination of more than one price, then, the arm’s length price in respect of such international transaction or specified domestic transaction has to be computed on the basis of the dataset constructed by placing such prices in an ascending order as provided in Rule 10CA(2). Application of multiple year data for construction of dataset Multiple year data allowed only in cases where determination of ALP is done using TNMM, RPM or CPM Data to be used for analyzing the comparability of an uncontrolled transaction with an international transaction The data to be used for analyzing the comparability of an uncontrolled transaction with an international transaction should relate to the financial year (current year) in which the international transaction has been entered into. In case the most appropriate method for determination of ALP of a transaction entered into on or after 1.4.2014 is the resale price method or cost plus method or the transactional net margin method, then, the data to be used for analyzing the comparability of an uncontrolled transaction with an international transaction shall be – (a) the data relating to the current year; or (b) the data relating to the financial year immediately preceding the current year, if the data relating to the current year is not available at the time of furnishing the return of income by the assessee, for the assessment year relevant to the current year. However, where the data relating to the current year is subsequently available at the time of determination of arm’s length price of an international transaction during the course of any assessment proceeding for the assessment year relevant to the current year, then, such data shall be used for such determination irrespective of the fact that the data was not available at the time of furnishing the return of income of the relevant assessment year. For the data relating to the current year, where the comparable uncontrolled transaction has been identified and the enterprise undertaking the said uncontrolled transaction, [not being the enterprise undertaking the international transaction or the specified domestic transaction referred © The Institute of Chartered Accountants of India  TRANSFER PRICING 24.31 to in sub-rule (1)], has in either or both of the two financial years immediately preceding the current year undertaken the same or similar comparable uncontrolled transaction then,- (i) the most appropriate method used to determine the price of the comparable uncontrolled transaction undertaken in the aforesaid period and the price in respect of such uncontrolled transactions has to be determined; and (ii) the weighted average of the prices, computed in accordance with the manner provided in sub-rule (3), of the comparable uncontrolled transactions undertaken in the current year and in the aforesaid period preceding it has to be included in the dataset instead of the price referred to in sub-rule (1). Further, where the comparable uncontrolled transaction has been identified on the basis of the data relating to the financial year immediately preceding the current year and the enterprise undertaking the said uncontrolled transaction, [not being the enterprise undertaking the international transaction or the specified domestic transaction referred to in sub-rule (1)], has in the financial year immediately preceding the said financial year undertaken the same or similar comparable uncontrolled transaction then, - (i) the price in respect of such uncontrolled transaction shall be determined by applying the most appropriate method in a similar manner as it was applied to determine the price of the comparable uncontrolled transaction undertaken in the financial year immediately preceding the current year; and (ii) the weighted average of the prices, computed in accordance with the manner provided in sub-rule (3), of the comparable uncontrolled transactions undertaken in the aforesaid period of two years shall be included in the dataset instead of the price referred to in sub-rule (1). Also, in such cases, where the use of data relating to the current year for determination of ALP subsequently at the time of assessment establishes that,- (i) the enterprise has not undertaken same or similar uncontrolled transaction during the current year; or (ii) the uncontrolled transaction undertaken by an enterprise in the current year is not a comparable uncontrolled transaction, then, irrespective of the fact that such an enterprise had undertaken comparable uncontrolled transaction in the financial year immediately preceding the current year or the financial year immediately preceding such financial year, the price of comparable uncontrolled transaction or the © The Institute of Chartered Accountants of India  24.32 INTERNATIONAL TAXATION weighted average of the prices of the uncontrolled transactions, as the case may be, undertaken by such enterprise shall not be included in the dataset. Rule 10CA(3) provides that where an enterprise has undertaken comparable uncontrolled transactions in more than one financial year, then for the purposes of constructed the dataset, the weighted average of the prices of such transactions would be computed in the following manner, namely:- Method used to Manner of computation of weighted average of the prices determine the prices (i) The resale price By assigning weights to the quantum of sales which has been method considered for arriving at the respective prices (ii) The cost plus method By assigning weights to the quantum of costs which has been considered for arriving at the respective prices (iii) The transactional net By assigning weights to the quantum of costs incurred or margin method sales effected or assets employed or to be employed, or as the case may be, any other base which has been considered for arriving at the respective prices. Range Concept: Rule 10CA(4) provides that where the most appropriate method applied is – (i) a method other than the profit split method or a method prescribed by the CBDT under section 92C(1)(d)/(f); and (ii) the dataset constructed in accordance with sub-rule (2) consists of six or more entries, an arm’s length range beginning from the thirty-fifth percentile of the dataset and ending on the sixty-fifth percentile of the dataset would be constructed. If the price at which the international transaction or the specified domestic transaction has actually been undertaken is within the said range, then, the price at which such international transaction or the specified domestic transaction has actually been undertaken would be deemed to be the arm’s length price [Rule 10CA(5)]. If the price at which the international transaction or the specified domestic transaction has actually been undertaken is outside the said arm's length range, the arm’s length price shall be taken to be the median of the dataset [Rule 10CA(6)]. © The Institute of Chartered Accountants of India  TRANSFER PRICING 24.33 Most appropriate method selected is Comparable uncontrolled When to apply range price method, resale price method, cost plus method or concept? transactional net margin method and The dataset constructed has six or more entries. Arrange the values in the dataset in the ascending order. Where the actual transaction price falls within 35th and 65th percentile of the dataset, the value of transaction will be accepted How to apply? to be arm's length price. Where the transfer price does not fall within the above range, then median of dataset shall be taken as the Arm's Length price. Range concept not applicable: In a case where the provisions of Rule 10CA(4) are not applicable [i.e. most appropriate method is profit split method or any other method or the dataset has less than 6 entries], the arm's length price shall be the arithmetical mean of all the values included in the dataset. However, if the variation between the arm's length price so determined and price at which the international transaction or specified domestic transaction has actually been undertaken does not exceed such percentage not exceeding 3% of the latter, as may be notified by the Central Government in the Official Gazette in this behalf, the price at which the international transaction or specified domestic transaction has actually been undertaken shall be deemed to be the arm's length price [Rule 10CA(7)]. Meaning of certain terms [Rule 10CA(8)] Term Meaning (a) the thirty-fifth The lowest value in the dataset such that at least 35% of the values percentile of a included in the dataset are equal to or less than such value. dataset (having However, if the number of values that are equal to or less than the values arranged aforesaid value is a whole number, then, the thirty-fifth percentile in an ascending shall be the arithmetic mean of such value and the value order) immediately succeeding it in the dataset. (b) the sixth-fifth The lowest value in the dataset such that at least 65% of the values percentile of a included in the dataset are equal to or less than such value. dataset (having However, if the number of values that are equal to or less than the values arranged aforesaid value is a whole number, then, the sixty-fifth percentile in an ascending shall be the arithmetic mean of such value and the value order) immediately succeeding it in the dataset. (c) the median of The lowest value in the dataset such that at least 50% of the values the dataset included in the dataset are equal to or less than such value. (having values © The Institute of Chartered Accountants of India  24.34 INTERNATIONAL TAXATION arranged in an However, if the number of values that are equal to or less than the ascending order) aforesaid value is a whole number, then, the median shall be the arithmetic mean of such value and the value immediately succeeding it in the dataset. Comparability Analysis The comparability of the international transaction with an uncontrolled transaction is to be judged with reference to the following factors: (i) The specific characteristics of the property transferred or services provided in either transaction; (ii) The functions performed, taking into account assets employed or to be employed and the risks assumed, by the respective parties to the transactions; (iii) The contractual terms (whether or not such terms are formal or in writing) of the transactions which lay down explicitly or implicitly how the responsibilities, risks and benefits are to be divided between the respective parties to the transactions; (iv) Conditions prevailing in the markets in which the respective parties to the transactions operate, including the geographical location and size of the markets, the laws and Government orders in force, costs of labour and capital in the markets, overall economic development and level of competition and whether the markets are wholesale or retail. As per Rule 10B(3), an uncontrolled transaction should be considered comparable to the international controlled transaction only if there are no material differences (in terms of functions, assets and risks) between the transactions being compared or the enterprises entering into such transactions which would materially affect the prices or costs charged or paid in, or the profit arising from, such transactions in the open market. It, further, provides that in a case there are any such material differences, reasonably accurate adjustments should be made to eliminate such material differences in order to compare the controlled and the uncontrolled transactions. Comparable uncontrolled transactions could be of two types - Internal or external. Comparable uncontrolled transactions Internal External Comparables Comparables (a) Internal comparables: These are the comparable transactions between one of the parties to the controlled transaction, (taxpayer or the AE) and an independent third party. These © The Institute of Chartered Accountants of India  TRANSFER PRICING 24.35 comparables are considered a good measure of comparability as it is likely that the Functions, Assets, Risks analysis (FAR analysis) of the comparable transaction would be similar to that of the controlled transaction due to the involvement of a common entity to the said two transactions. Even though internal comparables may offer a higher degree of comparability, there is a need of rigorous scrutiny like in external comparables and suitable adjustments should be made, wherever necessary. (b) External comparables: These are the comparable transactions between two independent parties, neither of which is a party to the controlled transaction. Generally, the level of comparability offered in the external comparables is not as precise as internal comparables; however, this rule is not absolute. For instance, it may so happen that an entity offers a certain variation of its product exclusively to its AE and a slightly different variation to unrelated parties. In such a situation, preference should be given to external comparables involving the identical product and identical contractual terms than accepting the internal comparable. In the above example, Transaction between AE1 and AE2 are subject to transfer pricing. AE1 and AE2 are parties to a controlled transaction. Transaction #1 and #2 are internal uncontrolled transactions since it is entered by AEs with unrelated parties. Transaction #3 is external uncontrolled transactions since it is entered between unrelated parties. Process for identification and selection of external comparables: Wherever internal comparables are available, preference should be given to internal comparables in the process of determination of ALP. However, in the absence of the same, recourse has to be taken to search for external comparables. The transfer pricing legislation in India does not prescribe a particular process for selection of such comparables. However, various decisions of © The Institute of Chartered Accountants of India  24.36 INTERNATIONAL TAXATION the judicial authorities have provided guidance on how to carry out such process based on the data available in public domain. The major steps involved in the search process are discussed hereunder: A database is a domain where information (financial and non-financial) about companies is maintained in an organised manner so as to facilitate easy search for data and also for the application of the relevant filters. Some of the commonly used databases in India are as under: (a) Capitaline Plus/ Capitaline TP: It contains digital database of over 35,000 companies. It includes information of public, private, co-operative and joint sector companies, listed or otherwise. (b) Prowess: Prowess is a database of the financial performance of Indian companies. Audited Annual Reports of companies and information submitted to the MCA; and in the case of listed companies, company filings with stock exchanges and prices of securities listed on the major stock exchanges are the sources of the database. The database contains information on all listed companies and a larger set of unlisted companies. (c) ACE TP Database: ACE TP database contains information, both financial and non-financial of companies and sectors. It also contains information regarding equity and commodity and derivative markets. There are other available Indian and foreign databases also like Prowess Pro, Amadeus, Royalty Stat, Compustat Global, Osiris, ktmine, Oriana, Bloomberg etc. which can be referred. The application of the quantitative filters help in filtering the companies available in the database based on the similarity of the quantitative information between the tested party and the potential comparables. Some of the commonly used quantitative filters are: (a) Availability of financial data: The companies whose financial information for the relevant period (financial year of the controlled transaction or the preceding two years as the case may be) are not available in the public domain should not be considered in the comparability analysis. (b) Industry of the tested party: The appropriate industry head should be selected. For instance, if the tested party operates in the seed segment, it should be ensured that various industry heads which could include comparable companies should be chosen, i.e. seeds, agriculture etc. Therefore, while applying this filter, the parameters should be fairly broad. © The Institute of Chartered Accountants of India  TRANSFER PRICING 24.37 (c) Turnover filter: This is perhaps the most commonly used quantitative filter in the search process. This is for the reason that companies which are operating in the same range of turnover would have similar share in the market and thus are more likely to have somewhat similar margins. On the other hand, companies with extremely high or low turnover would not provide an effective base for comparison since their margins would not only reflect the efficiency of their business but also the scale of the operations. The range of the filter is very subjective and varies with the facts of each case. (d) Net worth filter: Net worth of a company can be used to determine the creditworthiness of the company. Negative net worth would indicate that the debts of the company have surpassed its assets. Therefore, a company with consistent negative net worth should be rejected in the comparability analysis since its margins would be adversely affected and it would ordinarily be difficult to quantify and adjust the effect of its negative worth on the margins. Companies with negative net worth are usually rejected in this filter. (e) Export filter: The parameter of ‘geographic location of market’ has lead to adoption of ‘export turnover filter’ whereby Transfer Pricing Officers (‘TPOs’) insist that if the taxpayer is an exporter then the comparables should also have export earnings of a certain degree. The export activity levels, by itself, cannot be a valid filter unless it is established that the market to which the exports are made are materially different from the domestic market. (f) Employee expense filter: The employee expense ratio helps to analyse the level of activities and intensity of employee dependence. (g) Related party transactions: As already discussed, a transaction between two related parties cannot be taken as a comparable uncontrolled transaction for the purpose of benchmarking a controlled transaction. This filter finds its application on the same principle, i.e., if a potential comparable has substantial related party transactions, it can be inferred that its margins are contaminated with transactions which are not entirely governed by the market forces and thus such a company should be rejected in the search process. (h) Consistently loss making companies: The companies which are incurring losses on a consistent basis cannot be considered as good comparables as their profitability is adversely impacted by factors which are not specific to the industry but to the entity. However, loss in just one year would not be indicative of any extra ordinary factors surrounding the company and therefore such a company should not be rejected on that count alone. © The Institute of Chartered Accountants of India  24.38 INTERNATIONAL TAXATION The entities remaining after the application of the quantitative filters are further narrowed down by applying the qualitative filters. Some of the commonly used qualitative filters are as under: (a) Product filter: Although the industry filter excludes the companies not operating in the same industry but at the same time there are entities producing a variety of products in the same industry and therefore in order to reach a precise measure of comparability, the list of companies should be further shortlisted to exclude the companies not dealing in the same/similar products as that of the tested party. For instance, for a tested party trading in seeds, the industry filter to be applied could be agri-trading. However, this filter might result in companies engaged in various types of agricultural products such as fertilizers, pesticides etc. In order to remedy this, product criteria would be applied to only select the companies engaged in trading of seeds in the agriculture industry. (b) Functional filter: The chosen companies must be further analyzed to select only those companies which are functionally similar to the tested party. The functions could be in the form of manufacturing of goods, rendering of services, trading in goods etc. Thus, the filter to be applied depends on the functions performed by the tested party to find transactions which are functionally similar. (c) Ownership (Government or private): Generally, entities in the private sector exist for generating profits. Government owned entities on the other hand, function to serve the society and are not necessarily driven by the profit motive. Accordingly, such companies should be included/ excluded based on their comparability analysis like the other private companies. V. Reference to Transfer Pricing Officer [Section 92CA]: This section provides for a procedure for reference to a Transfer Pricing Officer (TPO) of any issue relating to computation of arm’s length price in an international transaction. The procedure is as under - (1) The option to make reference to TPO is given to the Assessing Officer. Where the assessee has entered into an international transaction in any previous year and if Assessing Officer considers it necessary or expedient to do so, he may refer the computation of the arm’s length price in relation to the said international transaction to the TPO. This option is not, however, available to the assessee. © The Institute of Chartered Accountants of India  TRANSFER PRICING 24.39 (2) The Assessing Officer has to take the approval of the Principal Commissioner of Income-tax (PCIT)/Commissioner of Income-tax (CIT) before making such a reference. (3) Any Joint/Deputy/Assistant Commissioner of Income-tax, authorised by CBDT, can be appointed as TPO. (4) When such reference is made, TPO would serve a notice to the assessee requiring him to produce on a date specified in the notice, any evidence on which the assessee relied in support of the computation of arm’s length price made by him in relation to the international transaction. (5) The TPO can also determine the ALP of other international transactions identified subsequently in the course of proceedings before him as if such transaction is referred to the TPO by the Assessing Officer under section 92CA(1) [Sub-section (2A)]. (6) Where in respect of an international transaction, the assessee has not furnished the report under section 92E and such transaction comes to the notice of the TPO during the course of proceeding before him, the transfer pricing provisions shall apply as if such transaction is referred to the TPO by the Assessing Officer under section 92CA(1) [Sub-section (2B)]. (7) The TPO has to pass an order determining the arm’s length price af