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Introduction to Transfer Pricing

Nageswara Rao Jammigumpula 
on 07 December 2019

LinkedIn


Objective: In our recent discussions, we had come across that many of the business people and few of the professionals were not aware/familiar with the TP provisions and the related compliances. This document is intended to provide basic knowledge of the same.

Introduction to Transfer Pricing

1. What is Transfer Pricing?

  • "Transfer Price" - In general, refers to price agreed between two parties for transfer of goods or services and technology.
  • "Transfer Pricing" - In general, refers to price agreed between related parties for transfer of goods, services and technology. It also refers to price agreedbetween unrelated parties for transfers which are controlled by a common entity.
  • Price in the case of a transaction between unrelated parties is determined by market forces. However, between related parties (i.e. associated enterprises), price may be determined by internal factors.
  • There is a general belief that multi-national corporations have employed creative transfer pricing approaches for transfer of goods, services, funds, intangibles, etc to minimize their global tax outflows.
  • Thus, the effect of transfer pricing is that lower profit or excessive loss in high tax rate countries and higher profit or minimal loss in low tax rate countries. The result is revenue loss to the country and also a drain on foreign exchange services.

2. When the TP regulations were introduced in India?

  • Considering the increase in the volume of cross-border transactions, in order to ensure no shifting of profits from India and to get itsfair share of tax, India introduced Transfer Pricing regulations for the first time in the year 2001 and amending from time to time.
  • The regulations are broadly based on the Organisation for Economic Co-operation and Development (OECD) Guidelines and describe:
  1. Various transfer pricing methods
  2. Impose extensive annual transfer pricing documentation requirements and
  3. Contain harsh penal provisions for noncompliance.

3. Who are Associated Enterprises (AEs)?

AEs - In general, direct/indirect participation in the management, control or capital of an enterprise by another enterprise [OR] same person in both the enterprises.

Certain specific parameters have been laid down based on which two enterprises would be deemed as AEs. These parameters include:

  • Direct/indirect holding of 26% or more voting power in an enterprise by another enterprise or in both the enterprises by the same person
  • Loan given by an enterprise to another and such loan equals to or more than 51% of the book value of the total assets of the borrower
  • Guarantee by an enterprise for 10% or more of total borrowings of the other enterprise
  • More than 50% of board of directors/members of the governing body [OR] 1 or more executive directors or executive members of the governing body of an enterprise are appointed by another enterprise or in both the enterprises by the same person
  • Complete dependence of an enterprise in carrying on its business on the intellectual property licensed to it by the other enterprise
  • Purchase of 90% or more of raw materials/consumables by one enterprise from other enterprise or persons specified by other enterprise at prices and conditions influenced by other enterprise
  • Sale of manufactured/processed goods by one enterprise to other enterprise or to persons specified by other enterprise at prices and conditions influenced by other enterprise
  • One enterprise is controlled by an individual and other enterprise is controlled by such individual or his relative or jointly
  • Any relationship of mutual interest as may be prescribed

4. What all types of transactions covered under TP?

 

Inter-national Transaction: Inter-national transaction means

 
  • a transaction between two (or more) AEs and
  • At least one of them must be a non-resident

Enterprise

Following transactions with AEs covered under inter-national transactions:

  1. Purchase/sale/transfer/lease/use of Tangible Propertyincluding building, transportation vehicle, machinery, equipment, tools, plant, furniture, commodity or any other article, product or thing
  1. Purchase, sale, transfer, lease or use of intangible property, including the transfer of ownership or the provision of use of rights regarding land use, copyrights, patents, trademarks, licenses, franchises, 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
  1. Capital financing, including 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
  1. Provision of services, including provision of market research, market development, marketing management, administration, technical service, repairs, design, consultation, agency, scientific research, legal or accounting service
  1. a transaction of business restructuring (i.e. operational change or organizational change) or re-organisation, whether or not it impacts on the profit, income, losses or assets of such enterprises at the time of the transaction or at any future date
  1. Cost-sharing agreement or arrangement

Business restructuring - Could be:

  • Cross border reorganization of the commercial or financial relations between AEs including the termination or substantial renegotiation of existing arrangements, relationship with third parties (e.g. suppliers, sub-contractors, customers) _As per OECD guidelines.
  • In the form of operational change (in function, asset and risk profile of the entity) or organizational change (in ownership structure/management of the entity)

Examples

  • Conversion of full-fledged manufacturer into a contract manufacturer
  • Conversion of a full-fledged distributor into a low risk distributor
  • Merger of two AEs to form a single entity
  • Demerger of a business unit of an enterprise with an AE

ii. Deemed Inter-national transaction

  • A transaction with a person other than an AE shall be deemed to be an international transaction with AE, if:
  1. There exists a prior agreement between such other person and AE OR
  2. The essential terms are determined by such other person and AE relevant to the above referred transaction.
  • Where either or both of AEs are non-residents, whether or not such other person is a non-resident

iii. Specified domestic transaction (SDT)

  • SDT - Following transactions with certain related domestic parties, only if the aggregate value of such transactions exceeds Rs.20 crore during the financial year:
  1. Any expenditure with respect to which deduction is claimed while computing profits and gains of business or profession (e. deductions u/s 80C to 80U)
  2. Any transaction related to business eligible for profit-linked tax incentives, for example, infrastructure facilities (Sec 80-IA) and SEZ units (Sec 10AA)
  • Any other transaction as may be specified
  • If the aggregate value does not exceed Rs.20 crore, those transactions does not amount to SDT and TP provisions will not be applicable.

5. What is arm's length price (ALP)?

ALP - means a price which is agreed or proposed to be agreed in a transaction between persons other than associated enterprises, in uncontrolled conditions (i.e. open market).

Accordingly, ALP demonstrates that the price that should have been charged between related parties, if those parties were not related to each other.

6. Types of methods prescribed for computation of ALP?

  1. Comparable Uncontrolled Price (CUP) Method
  2. Resale Price Method (RPM)
  3. Cost Plus Method (CPM)
  4. Profit Split Method (PSM)
  5. Transactional Net Margin Method (TNMM)
  6. Any Other Method

7. What type of information and documents to be maintained?

Shall keep and maintain the following information and documents in respect of 'international transaction' or 'SDT':

i. Enterprise-wise documents:

a) Ownership structure of the enterprise (i.e. 'assessee) including details of shares held by other enterprises_ Shareholding Structure.

b) Profile of the multinational group in which assessee is a part including name, address, legal status and country of tax residence of all the enterprises with whom assessee entered into international transaction and relationship among them_ Group Overview.

c) Broad description of the business of assessee, associated enterprises and the industry in which assessee operates_ Business and Industry Overview.

ii. Transaction-specific documents:

d) Details of transactions entered with each related party_ International transaction/SDT:

  • Nature and terms (including price agreed) of each transaction
  • Details of property (i.e. goods, machinery, royalty etc..) transferred or services provided
  • Quantity and value of each transaction

e. Functions performed, risks assumed and assets employed by both the parties_ FAR Analysis.

f. Economic and market analysis, forecasts, budgets or any other financial estimates prepared by the assessee for the business as a whole and for each division or product separately (i.e. Segment) _Economic Analysis/Selection of Tested Party.

g. Record of similar transactions entered with unrelated parties_ Uncontrolled Transactions (i.e. transactions with third parties).

h. Analysis to check whether transaction with unrelated party can be compared with international transaction_ Comparable uncontrolled transaction.

iii. Computation related documents:

i) Selection of most appropriate method (MAM):

  • Description of methods considered for computing arm's length price (ALP)
  • Method selected as MAM along with explanations - why such method was selected
  • And how such method applied in each case

j) Workings for computing ALP, including details of comparable data and financial information used in applying the MAM and adjustments, if any_ ALP Computation.

k) Assumptions, policies and price negotiations, if any, which have critically affected the computation of ALP.

l) Details of adjustments, if any, made to transfer prices (i.e. price agreed) to align with ALP computed and consequent adjustment made to total income for tax purposes.

m) Any other information/data/document which may be relevant for computing ALP.

8. Who has to maintain prescribed information and documents?

  • Every person who has entered into an international transaction and aggregate value of such transactions exceeds Rs.1 crore during the financial year.
  • In case the aggregate value of such transactions does not exceed Rs.1 crore, it is not mandatory to maintain the aforesaid information and documents. However, it is the responsibility of enterprise to prove that transactions with AEs are at Arm's length (computed as per the TP provisions)on the basis of material or information available with them.
  • Every person who has entered into a specified domestic transaction during the financial year.

9. Who has to obtain and furnish a report in Form No.3CEB?

Every person who has entered into an 'international transaction' or 'SDT' during the financial year shall obtain a report in Form 3CEB and furnish on or before the due date of filing of income tax return (i.e. 30th November).

10. What are the penal provisions for non-compliance with TP provisions?

 

Sl.no

Non-compliance/Default

Nature of penalty

1

Failure to maintain TP documentation

2% of value of each transaction

2

Failure to report a transaction in Form No.3CEB report

3

Maintaining or furnishing incorrect information or documents

4

Failure to furnish Report in Form No.3CEB

Rs.1,00,000

5

Penalty for under reporting of income

50% of tax payable on such under reported income

6

Penalty for under reporting of income on account of misreporting

200% of tax payable on such under reported income

7

In case of a transfer pricing adjustment, in the absence of good faith and due diligence by the taxpayer in applying the provisions and maintaining adequate documentation

100-300% of the tax on the adjusted amount

However, penalty for concealment of income shall not be levied if the taxpayer demonstrates that the price charged or paid has been determined in 'good faith' and with 'due diligence'. Further remaining penalty provisions also do not apply in case the taxpayer proves that there was 'reasonable cause' for failure to comply.

We will be covering the following topics in our upcoming articles:

  1. Master File (Form No.3CEAA (Part-A & B) and 3CEAB)
  2. Country-by-Country Report (CbC Report - Form No.3CEAC, 3CEAD & 3CEAE)
  3. Secondary adjustments
  4. Advance Pricing Agreement (APA)
  5. Use of Multi-year data
  6. Range concept
  7. Other related topics

Thank you for the patient reading. Hope this document has added value to your knowledge.

Disclaimer: This document had been written to provide updates under Income Tax in a simple manner. The author shall not be responsible for any of the decision made based on the contents of this document.


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Category Income Tax
Other Articles by - Nageswara Rao Jammigumpula 




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