The Simplest Understanding To Transfer Pricing Compliance In India

This article is intended to provide a simple understanding of transfer pricing (TP) provisions in India to those who have not yet been exposed to TP compliance in India. This may be due to various reasons such as meeting the threshold of international transactions with group companies for the first time, setting up new business in India to act as a captive service/goods provider to group companies, etc. Readers who have been complying with TP requirements in India would already be aware of most of the contents covered in this article.

Before we discuss the methods, forms, and documentation that are applicable because of TP, let's first understand why TP provisions were enacted in India. In the year 2001, TP provisions were enacted in the provisions of the Income Tax Act, 1961 ('the Act') through Chapter X i.e., 'Special Provisions relating to avoidance of tax'. The said provisions were enacted to ensure that the transactions (i.e., international cross-border transactions and specified domestic transactions) between group companies in and outside India, are conducted on arm's length prices ('ALP') to prevent profit shifting and tax avoidance.

It is important to understand that the TP provisions do not provide the exact mathematics of any particular transaction between the related parties. The TP provisions guide what should be an ALP for a particular transaction. Hence, in the tax community, it is mentioned that 'Transfer Pricing is not an Exact Science'.

The Provisions of the Act

The TP provisions are mentioned in Section 92 to 92F of the Act. The said provisions predominantly define the terms 'international transactions', 'specified domestic transactions', 'associated enterprises', and 'arm's length price'.

Types of transactions

Section 92B of the Act defines 'International transaction'. International transactions broadly include –

• purchase, sale, or lease of physical or intangible property; or
• provision of services; or
• borrowing or lending money, or any other transaction having a bearing on the profits, losses, income, or assets of such businesses, and
• shall involve a joint agreement or arrangement between two or more associated enterprises for the allotment or apportionment of, or any contribution to, any cost or expense suffered or to be incurred in connection with a benefit, facility, or service provided or to be provided to anyone or more of such enterprises.

Further, Section 92B(2) of the Act provides for an are interesting deeming provision.which provides that a transaction between two independent companies may be deemed to be a transaction between associated or related enterprises (AEs) if there exists a prior agreement in relation to such transaction between the third party and an AE or if the terms of such transaction are determined in substance between the third party and an AE.

It's important to note that wherever there is an international transaction (of the nature specified above), then irrespective of the threshold, the transfer pricing provisions get triggered.

Let's understand the deeming provisions with an example. ABC Limited is an Indian company with a holding company in the USA i.e., ABC LLC. ABC LLC has a customer in the US, say XYZ LLC. Now if ABC Limited supplies goods to XYZ LLC, on terms and conditions as have been agreed between XYZ LLC and ABC LLC, then even the supplies by ABC Limited to XYZ LLC shall be considered to be an international transaction. Since the terms being decided by the holding company in this case for the transaction with the non-associated enterprise, therefore, the transaction between ABC Limited and XYZ Limited shall be deemed to be an international transaction.

Associated enterprises

Section 92A of the act defines 'Associated enterprise'. The said definition covers direct/ indirect participation in the management, control, or capital of an enterprise by another enterprise. It also covers situations in which the same person (directly or indirectly) participates in the management, control, or capital of both enterprises. Further, the said section provides a detailed list of instances where the parties shall be associated enterprises.

Computing arm-length price

Once the type of transaction has been identified and the relationship between the parties is defined, the main step i.e., determining arm-length price comes into the picture. The methods prescribed in Section 92C of the Act are as under –

• Comparable uncontrolled price (CUP) method.

CUP stands for Comparable and Uncontrolled Price. Under this method, the price charged or paid for services provided in compared with comparable and uncontrolled transactions with that charged to an associated enterprise. Hence, the similarity of goods or services will generally be the most important factor under this method. The said method can be applied where associated enterprises buy or sell the same goods or services in comparable transactions with unrelated parties as are being done between the associated enterprises.

• Resale price method (RPM).

RPM or the Resale Price Method applies in a resale situation, where the goods or services purchased from an associated enterprise is resold to an independent third party in which the reseller has not added substantial value to the products or services.

Generally, in this method, gross margins earned by a company undertaking related party transaction is compared with gross margins from unrelated party transactions or that of independent companies. For application of this method, comparability of goods or services is not needed to be as strict as in case of application of CUP method.

• Cost plus method (CPM).

This method is generally employed in cases involving the manufacture, assembly or production of tangible products or services that are sold/provided to related parties. CPM compares the normal gross profit markup on costs (both direct and indirect) earned by a manufacturer/service provider to the gross profit markup earned by uncontrolled manufacturers/service providers.

• Profit split method (PSM).

PSM or the Profit split method is typically applicable in international transactions involving the transfer of unique intangibles or in multiple international transactions which are so interrelated that they cannot be evaluated separately for the purpose of determining the arm's length price of any one transaction. The PSM is therefore appropriate for integrated transactions with more than one enterprise.

• Transactional net margin method (TNMM).

TNMM or Transactional net margin method compares the net profit margin earned from an international transaction with an associated enterprises to net margins earned from transactions undertaken between unrelated parties. This method is most widely used, it is not necessarily the best method to apply due to inherent limitations on calculations of net margins. However, this method gets widely used due to lack of good quality data needed for application of other methods.

• Such other methods as may be prescribed.

Any other method is applied when any other method mentioned above could not be applied due to any reason such as uniqueness of transaction, lack of comparable data etc. Any other 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.

While selecting the method for benchmarking a particular transaction, the following points should be kept in mind –

• The taxpayer cannot say that none of the methods can be applied to benchmark a transaction and therefore, it should be absolved of the statutory duty of determining ALP.
• All the methods cannot be rejected arbitrarily and the taxpayer resorts to TNMM or any other method.
• The TNMM method is not residuary.
• It's the responsibility of the taxpayer to prove that the method selected is the most appropriate method.
• The income tax department may select any other method apart from the method selected by the taxpayer.
• Internal data is preferred over the external data. For example, in the case of the CPM, there is a segment for transactions with related parties and unrelated parties, then this segmental information shall be a better benchmark than the external search.
• The functional and risk analysis (FAR) of the particular transaction should be explained in depth. The same shall be vital for determining the independence or dependence of the AE on the transaction. Also, this helps to identify the method to be deployed for benchmarking a particular transaction.

Compliances under TP provisions

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.