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Introduction to Domestic Transfer Pricing

Introduction to Domestic Transfer Pricing. Naveen ND Gupta, CCM Delhi. What is Transfer Pricing?. TRANSFER PRICING REGULATIONS IN INDIA.

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Introduction to Domestic Transfer Pricing

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  1. Introduction to Domestic Transfer Pricing Naveen ND Gupta, CCM Delhi

  2. What is Transfer Pricing?

  3. TRANSFER PRICING REGULATIONS IN INDIA • Any international transaction undertaken between associated enterprises wouldbe subject to transfer pricing regulations and the transfer price charged/paidshould be at arm’s length • The term "international transaction" is widely defined to cover almost all kindsof transactions. • Associated Enterprise is also defined to cover direct or indirect shareholding ofmore than 26% or various other criterions by way of participation in themanagement or control. • Indian Transfer Pricing regulations are based on OECD Guidelines but with somemodifications.

  4. GLAXO SMITHKLINE CASE Decision of the H’ble Supreme Court in the case of Glaxo Smithkline Asia (P) Ltd [236 CTR 113] The H’ble Supreme Court while deciding on the issue of section 40A(2) made some of theimportant observations as under: • The present Transfer Pricing Regulations does not apply to domestic transactions • In domestic transactions, under-invoicing and over-invoicing will be revenue neutral, except in two circumstances • where one of the related entities is loss making or • where one of the related entities is liable to pay tax at a lower rate and the profits are shifted to such entity • The question of extending Transfer Pricing regulations to domestic transactions require expeditious consideration by the tax authorities

  5. GLAXO SMITHKLINE CASE • The CBDT should examine whether Transfer Pricing Regulations be extended to domestic transactions by making amendments to the Act • Law can be amended to mandate the taxpayer to comply with Rule 10D • Assessing Officer can be empowered to make adjustments to value of the transactions between the related parties based on methods of determination ofarm’s length price Based on the above observations of the H’ble Supreme Court, the Finance Act, 2012 has extended the applicability of the transfer pricing provisions for specifieddomestic related party transactions

  6. Genesis of Domestic TP regime Explanatory Memorandum to Finance Bill, 2012 “The application and extension of scope of transfer pricing regulations to domestic transactions would provide objectivity in determination of income from domestic related party transactions and determination of reasonableness of expenditure between related domestic parties. It will create legally enforceable obligation on assessees to maintain proper documentation. However, extending the transfer pricing requirements to all domestic transactions will lead to increase in compliance burden on all assessees’ which may not be desirable.” Applies to all entities including firms

  7. PURPOSE OF INTRODUCING DOMESTIC TRANSFER PRICING It was realized by the government that: • Presently, there is no method prescribed to determine reasonableness of expenditure to re-compute the income in related party transactions • There is need to provide objectivity in determination of income and determinationof reasonableness of expenditure in domestic related party transactions • There is need to create legally enforceable obligation on assessee to maintain proper documentation Based on the above observations of the H’ble Supreme Court, the Finance Act, 2012 has extended the applicability of the transfer pricing provisions for specified domesticrelated party transactions

  8. SPECIFIED DOMESTIC TRANSACTIONS (Sec. 92BA) Following Transactions, which are not INTERNATIONAL TRANSACTIONS Section 40A • Expenditure paid or to be paid to related party as defined under section 40A(2)(b) Section 80IA • Inter unit transfer of goods and services as referred to in section 80IA(8) Section 80IA • Transaction between the tax payer and any other person owing to close connection as referred to in section 80IA(10) where more than ordinary profits are earned by businessunit claiming tax holiday/deduction Section 10AA • Any transaction under Chapter VIA or Section 10AA to which the provisions of 80IA apply, ie: ― inter-unit transfers ― more than ordinary profits earned by tax holiday/ exemption unit Where aggregate of above transactions by assessee in previous year exceeds Rs. 5 crore.

  9. THRESHOLD LIMIT & COVERAGE • Domestic Transfer Pricing is applicable only where value of Specified Domestic Transactions crosses 5 Crs • While computing the aggregate value of transactions: - Value of the International transactions to be excluded - Value of transactions between 2 units of the same company to be covered (when undertaken with a tax holiday unit) - Inter-company transactions to be covered (when undertaken with a company having a tax holiday unit) - Transactions with a person having a close connection as mentioned in section 80IA(10) to be covered - Payment of expenses to related person defined under section 40A(2)(b) to be covered Aggregate Value of SDT above INR 5 Cr Aggregate Value of transaction below INR 5 Cr Subject to Domestic Transfer Pricing regulations Subject to existing tax laws

  10. DOMESTIC TRANFER PRICING CASE LAWS ON DTP PRIOR TO INTRODUCTION OF DETAILED DTP REGULATIONS

  11. IN THE CONTEXT OF SECTION 40A(2) • KR Motilal v. CIT (1999) (240 ITR 810) (Mad) - The assessee engaged in the business of manufacture of three wheel cycles - Payment of remuneration and commission to brothers of the assessee for providing technical and supervisory services - The AO disallowed the same u/s 40A(2) - ITAT held that Part of the remuneration / commission paid to brothers is excessive and unreasonableand thus to be disallowed u/s 40A(2) since: • The assessee was unable to justify possession of technical qualifications / technicalskill by the brothers required to handle the job • Unable to produce supporting to substantiate the technical experience of brothers

  12. IN THE CONTEXT OF SECTION 40A(2) • MangalChand Tubes Pvt. Ltd. v. CIT (1994) 208 ITR 729 (Raj) - Payments to two directors for managing the operations for the same area - The AO disallowed part of the payments made to one of the director u/s 40A(2) - Rajasthan High Court upheld the AO’s order and held that: • The disallowance made by the AO is justified since one of the directors who waspermanently stationed in the same region (Delhi) was looking after the day to dayfunctions of the company and business needs of the company did not warrantpayments to another director • The assessee was unable to justify commercial rationale of making payments to bothdirectors and how it benefited its operations • Legitimate business needs of the company did not warrant incurrence of suchexpenditure

  13. IN THE CONTEXT OF SECTION 80IA(10) • M/s Tweezerman India Pvt Ltd Vs. Addl. CIT (2010-TII-45-ITAT-MAD-TP) - The assessee (Indian Company) engaged in manufacturing of tweezers and eligible for 10B deduction exported 100% to its US AE - TPO accepted the value of ITs at ALP and passed remark that Arm's length profit would be Rs. 733.42 lacs as against Rs. 1,251 lacs reported by the assessee - AO invoked Section 10B(7) r.w.s.80IA(10) and reduced 10B deduction - ITAT deleted the addition and held that: • Section 80IA(10) does not give an arbitrary power to the AO and the AO has to specify as to why he feels that the profits of the assessee is shown at a higher figure • Further, AO has to show as to how he has computed the ordinary profits which theassessee might be expected to generate • AO has blindly taken a calculation for determining the ordinary profits which theassessee had given before the TPO and admitted it to be erroneous

  14. Objective of Domestic TP Payments to related parties u/s 40A(2)(b) Profit linked tax holiday units Other transactions to be notified Inter unit transactions Transactions with outsiders Discourage excessive payments to associates Should be in ALP Should not lead to shifting of excessive profits to qualifying unit

  15. SPECIFIED DOMESTIC TRANSACTIONS - COMMON TRANSACTIONS • Payment for purchase of semi-finished goods • Transfer of machinery, technology, etc • Sharing of common costs • Job work charges • Payment of interest /royalty charges • Transfer of goods from one unit to another (in specific cases) • Payment made to key personnel/relatives • ns • Rent charged

  16. Which tax payers are covered under Specified Domestic Transactions? Taxpayers claiming tax holidays are covered e.g.

  17. Substantial interest means: • In case where business is carried on by company, any person being the beneficial owner of shares carrying not less than 20% of the voting power; and • In any other case, such person being beneficially entitled to not less than 20% of the profits of such business. • Relative:- in relation to an individual, means the husband, wife, brother or sister or any lineal ascendant or descendant of that individual.

  18. DOMESTIC TRANSFER PRICING SECTION 40A(2)(b), 80IA(8) & 80IA(10) RELATIONSHIPS

  19. TRANSACTIONS COVERED UNDER SECTION 40A(2)(b) Case-I: Director or any relative of Director – Section 40A(2)(b)(ii) Relative: in relation to an individual, means the husband, wife, brother or sister or any lineal ascendant ordescendant of that individual Relative Mr. A Mr. B Mr. C Directors/ Partners/ Member XYZ Covered Transaction Under Domestic Transfer Pricing

  20. TRANSACTIONS COVERED UNDER SECTION 40A(2)(b) Case-II: To an individual who has substantial interest in the business of XYZ Ltd or relative of such individual - Section 40A(2)(b)(iii) Relative Relative Mr. A Mr. B Mr. C Substantial Interest 20% XYZ Substantial Interest: The Beneficial owner of shares carrying not less than 20% of the voting power in the company Covered Transactions under Domestic Transfer Pricing

  21. TRANSACTIONS COVERED UNDER SECTION 40A(2)(b) Case-III: To a Company having substantial interest in the business of XYZ Ltd or Director of such company or any relative of Director - Section 40A(2)(b)(iv) Relative Mr. B Mr. C Director A Ltd Substantial Interest > 20% XYZ Covered Transaction under Domestic transfer Pricing

  22. TRANSACTIONS COVERED UNDER SECTION 40A(2)(b) Case-IV: Any other Company carrying on business in which the first mentioned company has substantial interest - Section 40A(2)(b)(iv) Substantial Interest > 20% B Ltd Substantial Interest > 20% A Ltd C Ltd Substantial Interest > 20% XYZ Covered Transaction under Domestic transfer Pricing

  23. TRANSACTIONS COVERED UNDER SECTION 40A(2)(b) Case V - To a Company of which a director has substantial interest in the business of XYZ Ltd or any other director of such company or relative of director - Section 40A(2)(b)(v) Relative Mr. B Mr. C Mr. D Director Director A Ltd Substantial Interest > 20% XYZ Covered Transaction under Domestic transfer Pricing

  24. TRANSACTIONS COVERED UNDER SECTION 40A(2)(b) Case-VI: To a Company in which XYZ Ltd has substantial interest in the business of the company - Section 40A(2)(b)(vi) XYZ Ltd Substantial Interest > 20% B Ltd Covered Transaction under Domestic transfer Pricing

  25. TRANSACTIONS COVERED UNDER SECTION 40A(2)(b) Case-VII: Any director or relative of a director of XYZ Ltd having substantial interest in that person - Section 40A(2)(b)(vi) Mr. C Mr. B Relative Substantial Interest > 20% Substantial Interest > 20% A Ltd D Ltd Director XYZ Covered Transaction under Domestic transfer Pricing

  26. TRANSACTIONS COVERED UNDER SECTION 80IA(8) Goods & Services Transfer at Rs 120 Market Value of above goods/ services is Rs 100 Thus, the ALP of the above transaction would be Rs 100 A Ltd. Unit A Telecom Business Unit B Manufacturing Business 80IA - Eligible Unit Taxable Unit

  27. TRANSACTIONS COVERED UNDER SECTION 80IA(10) Goods and Services Close Connection 80IA - Eligible Unit Taxable Unit Operating Margin: 40% (Extraordinary Profits) Industry Average: 10% Thus, Arm’s length profit margin would be taken as 10% A Ltd Infrastructure Business B Ltd Trading Business

  28. Coverage of SDT • For A Co • Domestic TP not applicable transaction is of income receipt, 40A(2) not triggered • For B Co • Covered by S. 40A(2)(b) and hence SDT. But, payment is at < FMV, no TP adjustments required. • S. 80-IA(10) may still be invoked on the ground that arrangement leads to more than ordinary profits? Related Parties A Co B Co (WOS) Sale of goods at cost < FMV Tax Holiday Unit

  29. DOMESTIC TP NOT RESTRICTED TO TRANSACTION WITH RESIDENTS • S. 92BA excludes International Transaction from within its scope • Trigger for AE relationship different for International and Domestic TP • Illustrative examples where transactions with non-resident may be covered under Domestic TP • Remuneration paid by an Indian Company to a non-resident director • Remuneration paid by a FC having PE to non resident director • Payment by Indian Co to Foreign Co. where Foreign Co. holds 20 to <26% in Indian Co.

  30. No notional imputation of Income--------------------------------------------------- • Section 40A(2) covers transactions in the nature of ‘expenditure’ and not ‘income’. • Illustrative transactions not covered. • Grant of interest free loan to an associate • Corporate guarantee on behalf of subsidiaries. • Sale of goods at less than FMV • Allowing use of trade mark or know-how or common services by group entities at NIL or nominal charges • Gratis lease of machinery to associates • S. 40A(2) inapplicable if expense is lower • TP adjustment by AO w.e.t. S. 80A(6)/ S.80-IA(8)/ S. 80-IA(10) cannot lead to higher income of tax holiday qualifying unit. (ref. s. 92(3))

  31. Determining years of eligibility of incentive • Applicability of Domestic TP vis-à-vis commencement of ‘initial year’ • Provisions apply from year of effective claim • No choice available to Taxpayer (e.g. 80-IC, 80-IE etc.) • Choice available to Taxpayer (e.g. 80-IA, 80-IAB) • Provisions to apply in year of tax holiday – though, in loss

  32. Transfer Pricing and TDS • Case Study: • X Co. makes rent payment of INR 2 Lacs to Y Co (related party) • ALP is determined at INR 1.5 Lacs • X Co. Defaults in TDS compliance

  33. Consequences of TP adjustment--------------------------------------------------- • S. 40A(2)(b) disallowance leads to enhancement of income and consequential tax/interest levy • No consequential enhancement of s. 10AA/Chapter VI- deduction (First proviso to s. 92C(4)) • S.80A(6)/S.80-IA(8)/S.80-IA(10) adjustment leads to curtailment of tax holiday deduction leading to additional income and consequential tax, interest levy • No, co-relative adjustment in the hands of the recipient • Penal consequences

  34. Voluntary TP adjustment in ROI--------------------------------------------------- • Taxpayer is benefited by voluntary TP adjustment in Domestic TP if it is 40A(2)(b) transaction which impacts GTI and Taxpayer is eligible for S.10AA/ Chapter VI-A deduction (Refer illustration). • Where s. 10AA/Chapter VI-A deduction is not available and / or adjustment is to deductible profits, voluntary TP adjustment may lead to additional income but mitigates interest and concealment penalty.

  35. DOMESTIC TRANSFER PRICING COMPLIANCES

  36. COMPLIANCE REQUIREMENTS FOR DOMESTIC TRANSFER PRICING • Current Compliance Requirements • Section 40A:Transaction to be reported in Tax Audit Report in Form 3CD • Section 80IA: Declaration ofprofit to be made in CA Certificate in Form 10CCB • Section 10AA: For claiming taxdeduction, CA Certificate in Form 56F needs to be filed Additional ComplianceRequirements •Maintaining ContemporaneousDocumentation as prescribed in Rule 10D and prove thattransactions are at ALP by selecting the most appropriatemethod • Filing audit report in Form 3CEB /any other Form may be prescribed

  37. DOMESTIC TRANSFER PRICING - PROCESS FLOW Identification ofSpecified Domestic Transactions ALP Determination of ALP Voluntary Adjustments inReturn (if any) FAR Analysis Selection of MostAppropriate Method Documentation,Return Filing andForm 3CEB Filing Identification ofcomparable transactions EstablishingComparability,adjustment for differences Assessment andAppellate Proceedings

  38. INFORMATION & DOCUMENTATION REQUIREMENTS Group Profile(incl. organizationstructure) Indian Entity Profile(incl. description oftransactions) Related Party Profile(incl. description oftransactions) Industry Profile Agreements Invoices Pricing relatedcorrespondence letters, emails, etc) Internal presentation & business plan Brochure and Catalogues Management’saccounts & reports Transaction Terms Functional, Asset and Risk (‘FAR’) Analysis Economic Analysis (selection of the most appropriate method, benchmarking and determining ALP) Price Related Entity Related Transaction Related

  39. COMMON TRANSACTIONS DOCUMENTATION

  40. COMMON TRANSACTIONS DOCUMENTATION

  41. APPLICABILITY OF TRANSFER PRICINGArm’s Length Price • Arm’s length price means a price applied or proposed to be applied in a transaction between non Associated Enterprises in uncontrolled • Arm’s length price can be determined by any of the following methods(Sec. 92C): • Comparable Uncontrolled Price Method • Resale Price Method • Cost Plus Method • Profit Split Method • Transactional Net Margin Method • Other Method as prescribed under Rule 10AB • Where arms length price is within 5% range of the transaction price, no adjustment is warranted but if it is beyond 5% range, adjustment is required to be made to the transferprice and benefit of 5% is not available (5% range is applicable for A.Y.2012-13). ForA.Y.2013-14 onwards, tolerance range would be notified by the central government subjectto maximum 3%.

  42. VARIOUS METHODS FOR DOMESTIC TRANSFER PRICING

  43. Comparable Uncontrolled Price Method---------------------------------------------------- • Internal CUP Sale to related party B Manufacturer A Sale to non-related party C • External CUP (Unrelated Parties) Non-related party P Non-related party Q Adjustments permitted for volume discount, geographical differences, etc.

  44. Resale Price Method (RPM)--------------------------------------------------- • Compares the resale gross margin earned by AE, with gross margin of comparable independent distributors Group Manufacturer (Eligible Unit) Related Distributor (India) Unrelated Wholesalers INR 75 INR 100 • Comparable need not be in very same product • Software distributor compared with FMCG distributor

  45. Cost Plus Method (CPM) (C+)--------------------------------------------------- • Used predominantly when AE works for another AE as contract manufactures. Direct & Indirect Cost of Production / service + ALP = Comparable Margin • Typically applied to a contract manufacturer who: • Does not bear risk of marketing • Does not “normally” undertake high skill work • May apply to contract manufacture, BPO, call centre, software developers, etc.

  46. Profit Split Method (PSM)--------------------------------------------------- • Generally applicable in case of transaction involving • Transfer of unique intangibles OR • Multiple transactions which are interrelated not permitting separate evaluation • Split global profit according to contribution of each AE.

  47. Transactional Net Margin Method (TNMM)---------------------------------------------------------------- • Comparable Net profit adopted in relation to : • Costs incurred, or • Sales effected, or • Assets employed, or • Any other relevant base. (ef. PBDIT, gross margin, operating margin)

  48. FAR Analysis: Functions, Assets, Risk Functions: Analysis of critical functions performed in controlled environment with function performed in uncontrolled transactions that add value to transactions hence fetch higher returns. Some of important functions those are generally examine are: • Research and Development • Process engineering and designing work • Purchasing and materials management • Manufacturing, production or assembly work • Warehousing and inventory • Marketing and distribution • Development of software services • Business Process Management • Outsourcing nature of work

  49. FAR Analysis: Functions, Assets, Risk Assets: Analyzing assets employed in transaction in controlled environment by identifying the assets. • Type of assets • Capital • Tangibles • Intangibles • Analysis Factors • Extent of usage • Ownership pattern • Financed internally or externally • Age • Market Value • Location • Property rights protection available

  50. FAR Analysis: Functions, Assets, Risk Risk: Analysis involve identification of various risk assumed by each party in controlled transaction.

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