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Domestic Transfer Pricing Begins Now
Finance Minister through Finance Bill 2012 proposed the provisions for Domestic Transfer Pricing in India. The real need for Domestic Transfer Pricing was expressed by Hon. Apex Court in the judgment of Glaxo Smith Klein Asia Pvt. Ltd. dated 26th October 2010. A three Judges’ bench headed by CJI S.H.Kapadia ruled in favour of assessee but suggested amendments for consideration by the Finance Ministry in certain provisions for empowering AO to apply any of the generally accepted methods of determination of arm’s length price, including the methods provided under the Transfer Pricing Regulations to domestic transactions between related parties.
As ruled by the Hon. Apex Court in the case of Glaxo smith Klein, in case of Domestic transactions, the under-invoicing of sales and over-invoicing of expenses ordinarily will be revenue neutral in nature, except in two circumstances having tax arbitrage:-
(1) If one of the related companies is loss making and the other is profit making and profit is shifted to the loss making concern; and
(2) If there are different rates for the two related units (on account of different status, area based incentives, nature of activity, etc.) and if profit is diverted towards the unit on the lower side of tax arbitrage.
The suggestion made in this ruling actually triggered the need for amendment in Indian Income Tax Law for Domestic TP.
Finance Bill 2012 proposed transfer pricing regulations to the transactions entered into by domestic related parties or by an undertaking with other undertakings of the same entity for the purpose of section 40A, Chapter VI-A and section 10AA. Domestic TP will be applicable if aggregate amount of all such domestic transactions exceed Rs.5 crores in a year. Thus it can be interpreted as if transactions with all the related parties during the year exceeds Rs.5 Crores then DTP will be applicable.
The said proposal has made it clear that when an undertaking is enjoying tax benefits as offered by Chapter VI-A or Section 10AA, then the transactions between such undertaking with the other undertaking of the same entity shall be at Arm’s Length Price.
Suppose, ABC Ltd. is a company having two separate Units viz. ‘Unit X’ which is in SEZ and ‘Unit Y’ which is not in SEZ. Unit X being the unit in SEZ, is enjoying Income Tax holiday. After introduction of Domestic TP, the transactions between Unit X and Unit Y will be tested with the Arm Length Pricing mechanism. Even before introduction of Domestic TP, section 80IA(8) or section 80IA(10) of Income Tax Act required such transfer at fair market value.
Thus companies with multiple units and claiming tax holiday will be questioned on inter-unit transactions. The Domestic TP is alarming for companies showing supernormal profits in the units enjoying tax holiday and having transactions with other units or undertakings of the same entity.
Section 40A(2)(b) specifies the related parties. As per section 40A(2)(a):
Where the assessee incurs any expenditure in respect of which payment has been or is to be made to any person referred to in section 40A(2)(b) and the Assessing Officer is of opinion that such expenditure is excessive or unreasonable having regard to the fair market value of the goods, services or facilities for which the payment is made or the legitimate needs of the business or profession of the assessee or the benefit derived by or accruing to him there from, so much of the expenditure as is so considered by him to be excessive or unreasonable shall not be allowed as a deduction.
Thus the transactions between related parties which are unreasonable as compared to fair market price are disallowed even before introduction of Domestic TP provisions. But in the absence of specific mechanism to determine the fair market price, the judgment on the reasonableness of the transfer price was as per the discretion of the assessee while carrying out the transaction and at the discretion of the Assessing Officer while completing the tax assessment. It resulted into litigation for many cases relating to transactions with related party. Now as per Domestic TP provisions, the transactions between two related parties shall be at ‘Arm’s Length Price’. The fair market price can be established using market evidence. Arm’s Length Price can be determined by use of methods prescribed under International Transfer Pricing.
The parties covered under 40A(2)(b) covers the relationship between holding and subsidiary company as per clause (iv) which says:
A company, firm, association of persons or Hindu Undivided Family having a substantial interest in the business or profession of the assessee or any director, partner or member of such company, firm, association of family, or any relative of such director, partner or member.
But the said provision does not cover the relationship between subsidiary companies having same holding company. To cover the said relationship as well, Finance Bill 2012 has amended the meaning of related persons to include companies having same holding company.
Provisions relating to maintenance of documentation, audit and other procedures and penalties as per International Transfer Pricing Regulations are applicable under Domestic TP provisions as well. Hence the assessee will have to maintain documentation of domestic transactions with related parties to substantiate that the said transactions are at Arm’s Length Price.
Finance Act 2012 has also introduced Advance Pricing Agreements (APAs). However the APAs are applicable only to International Transaction and hence not applicable to Domestic TP transactions.
Now assessee needs Domestic TP planning which may include cost analysis, pricing policy review, modification in transactions with related party in commercial sense, shareholding structure review etc.
At present, it appears that Domestic TP Regulations will help assessee to substantiate the transaction at Arm’s Length Price using prescribed methods and supporting documentation which was not the case using section 80IA(8), 80IA(10) in isolation at discretion of AO. The same time Tax Authorities can prevent misuse of tax holiday by entities showing supernormal profits as a result of transactions with related party.
CA Sagar Tilak