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Key Notes:


Transfer pricing relates to the pricing of transactions (such as transfer of goods, services, intangibles and funds) that take place within affiliate segments of a group company in different tax jurisdictions. Transfer pricing is typically used in situations where Multinational Enterprises (MNEs) seek to cut their tax base by artificially shifting the profits from higher tax jurisdictions to lower tax jurisdictions without a considerable change in business operations.



The use of Transfer Pricing (TP) tax strategies has recently attracted a high level of international attention, due in part to the rapid rise of multinational trade, the opening of several significant developing economies and transfer pricing’s increased impact on corporate income taxation. The lopsided distribution of economic resources between different countries is the basis of international trade. With increasing globalization, related party transactions between Multinational Enterprises (MNEs), which account for almost 60% of all international transactions, necessitated the concept of TP. TP is typically used in situations where MNEs seek to cut their tax base by artificially shifting the profits from higher tax jurisdictions to lower tax jurisdictions without a considerable change in business operations. The TP regime may even be manipulated by small organizations engaging in cross border transactions with affiliated entities. A less developed country is more likely to suffer due to TP manipulation than a developed country because of the lack of adequate resources and the inability to monitor transactions. The result is revenue loss and also a drain on foreign exchange reserves


The Concept:

TP relates to the pricing of transactions (such as transfer of goods, services, intangibles and funds) that take place within affiliate segments of a group company in different tax jurisdictions.

Suppose a company X (resident of country A which has a tax rate of, say, 40%) purchases goods for Rs.100/- and sells it to its associated company Y (resident of country B which has a tax rate of 20%) for Rs.200/-, who in turn sells in the open market for Rs.400/-. Had X sold it direct, it would have made a profit of 300 rupees that would have been taxed at 40%. But by routing it through Y, it restricted it to Rs.100/-, permitting Y to appropriate the balance to be taxed at 20% only. The transaction between X and Y is arranged and not governed by market forces. The profit of Rs.200/- is, thereby, shifted to the country B. The goods is transferred on a price (transfer price) which is arbitrary or dictated (Rs.200/-), but not on the market price (Rs.400/-) so, in effect, the company in country A will have lower profits and[therefore,] a lower tax incidence whereas the company in country B is affected in the opposite manner higher profits due to low costs, but lower taxes because of the tax rate – which illustrates the importance of TP from a taxation perspective. However, TP transactions can be much more complex than the example above and usually involve deliberations on inter related variables and the weighing of regulatory and other constraints.


Nowadays, tax revenue authorities have become more vigilant about TP issues as TP transactions form a considerable part of the tax base of all countries. Compared to other countries, India is a late entrant in the field of regulating TP. The Finance Act, 2001 introduced provisions regulating TP in the Income Tax Act, 1961 with effect from 1 April, 2001. Prior to this amendment, a limited provision regulating transfer pricing did exist in section 92 of the Act. However, this was very often not strictly complied with by businesses as there were no rules or guidance available regarding its implementation. However, the 2001 amendment, which defined associated enterprise and international transaction for the first time, has brought much needed clarity to the law. There is greater respect among businesses (including MNEs) for the expertise of the Indian tax authorities in handling the complexities involved in TP transactions.MNEs have to keep in mind multiple factors in deciding their TP strategies. Some of them are:

Tax Jurisdiction: Profit is a function of price. As a result, charging higher prices in a higher tax jurisdiction results in a low tax base and relatively higher profits in a lower tax jurisdiction.

Import Duties: Usually, low prices of commodities attract low import duties in countries where custom duties form a major part of tax revenues.

Thin Capitalization: MNEs also have the option of thinly capitalizing some of its constituent entities by making investments as loans instead of equity to avail tax benefits. This mechanism would usually involve a foreign affiliate of a group company making an investment in a domestic affiliate of the company in the form of loans. As a result, the company’s debt-equity ratio increases, i.e. it becomes thinly capitalized. Thin capitalization can be part of a larger TP strategy. MNEs make iniquitous use of this method to avail of tax benefits since interest on loans is deductible while calculating taxable income. In India, there is no formalized provision regulating thin capitalization under the law, but there are some related provisions regarding permissible debt in the Foreign Exchange Management Act, 1999 (FEMA), which act as alternative mechanisms to reduce such practices.

Others: Other methods include the exploitation of fluctuations in foreign exchange rates to derive maximum benefit. For instance, a company can reduce the expected currency devaluation risk by transferring funds to its affiliates in other countries and varying the cash flow requirements of the companies within MNEs. The MNE group may be pressurised by shareholders to show high profitability at the parent company level, particularly if financial reporting is not carried out on a consolidated basis.

Chapter X of the Income-tax Act, 1961 (“The Act”), comprising of sections 92 to 92F, which is titled, “special provisions relating to avoidance of tax” was inserted in the Act by the Finance Act, 2001 with effect from 1st April, 2002; i.e., from Assessment Year 2002-03 


The Scheme of Chapter X under Income act, 1961: Chapter X opens with Section 92 which provides that the income arising from “International Transactions” shall be calculated having regard to the Arms’ Length Price. The explanation to Section 92 clarifies that allowance for any expense or interest arising from an international transaction shall also be determined having regard to the ALP.


Associated Enterprises:

Section 92A defines as to which enterprises would, for the purposes of the provisions of Chapter X, come within the purview of an Associate Enterprise. Sub-section (1) of section 92A proceeds generally to define an Associated Enterprise as one, which is, directly or indirectly, managed and controlled by another. The specific with respect to the various modes by which control may be exerted by one enterprise on the other is provided in sub-section (2) of Section 92A. In the eventuality of an enterprise fulfilling any of the attributes provided in sub-clause (a) to clause (m), the two enterprises under subsection (2) of section 92A would be deemed to be Associated Enterprises.


Clause (iii) of section 92F of the Act defines the term “enterprise” to mean a person (including a permanent establishment of such person) who is, or is proposed to be, engaged in any of the specified activities. Clause (iiia) of the said section defines the term “permanent establishment” to include a fixed place of business through which the business of the enterprise is wholly or partly carried on. The definition of the term enterprise is exhaustive while that of the term permanent establishment is inclusive.


Section 92A (1) of the Act defines an associated enterprise in relation to another enterprise to be an enterprise which participates, directly or indirectly, or through one or more intermediaries in the management or control or capital of the other enterprise, or when a person participates, directly or indirectly, or through one or more intermediaries in the management or control or capital of both the enterprises.


Sub-section (2) of section 92A provides thirteen (13) specific instances where two enterprises would be deemed to be associated enterprises. Some instances are where one enterprise holds, directly or indirectly, shares carrying 26% of the voting power in the other enterprise, or an enterprise which holds, directly or indirectly, shares carrying 26% of the voting power in each of such enterprises, or where loan advanced by one enterprise to the other enterprise constitutes not less than 51% of the book value of the total assets of the other enterprise, etc. Two enterprises fulfilling the criteria in any one of the thirteen illustrations would be deemed to be associated enterprise for the purpose of sub-section (1). It is evident from the above that whereas sub-section (1) provides for a general management, control and capital criteria, sub-section (2) provides for thirteen specific instances to decide the relationship of association between two enterprises.


Sub-section (2) of section 92B deems a “transaction” between an enterprise and a non associated enterprise to be a transaction entered into between two associated enterprises if there exists a prior agreement in relation to the relevant transaction between such non associated enterprise and the associated enterprise or the terms of the relevant transaction are determined in substance between such non associate enterprise and the associated enterprise. The heading of section 92B suggests that it is dealing with “international transaction”, but sub-section (2) of the said section actually deals with the aspect of a transaction being regarded as entered into between two associated enterprises. The distinction between section 92A and section 92B(2) both of which deals with associated enterprises is that the former regards the enterprises as associated to each other if the specified conditions are fulfilled, while the latter deals with a situation where though the enterprises are non-associated enterprises a particular transaction is deemed to be a transaction between associated enterprises.


Transfer pricing provisions are applicable only with respect to international transactions.


Section 92B defines as to what would be construed as an “international transaction”. In order to appreciate the full width, amplitude of an “international transaction” the meaning of which is provided in section 92B one would have to in addition read the definition of “transaction” as given in section 92F(v).


Section 92B defines an “international transaction” to mean a transaction between two or more associated enterprises where at least one of them is a non-resident. This section includes transactions in the nature of -

Ø  Purchase, sale or lease of tangible or intangible property, or

Ø  Provision of services, or

Ø  Lending or borrowing money, or

Ø  Any other transaction having a bearing on the profits, income, losses or assets of such enterprises, or

Ø  Mutual cost sharing agreement.


It could be seen from above that the definition is an extremely wide one to include all types of transaction entered into by the parties. However, as the phrase (international transaction) itself suggests, transfer pricing provisions would apply to only those transactions in which at least one of the parties is a non-resident. When both the parties are residents then transfer pricing provisions would not apply.


A transaction has been defined in clause (v) of section 92F to include an arrangement, understanding or action in concert, whether or not such arrangement, understanding or action is formal or in writing; or whether or not such arrangement, understanding or action is intended to be enforceable by legal proceeding. This definition is inclusive and not exhaustive. Hence any agreement which falls within the general meaning of the term “transaction” may also be regarded as a transaction though not specifically covered by the said clause.


Sub-section (1) of section 92C provides that Arms’ Length Price (ALP) in relation to an “international transaction; could be determined by any of the methods provided in the said sub-section which is “most appropriate” having regard to the nature of transactions or class of transaction or class of associated persons or functions performed by such persons or such other relevant factors which may be prescribed by the Board. The methods provided being

Ø  Comparable uncontrolled price method;

Ø  Resale price method;

Ø  Cost plus method;

Ø  Profit split method;

Ø  Transactional net margin method and;

Ø  Such other method as may be prescribed by the board.

In determining the most appropriate method, regard is to be had to rules 10A and 10B of the Income Tax Rules, 1962 (in short the “Rules”).


The term “arm’s length price” is defined in clause (ii) of section 92F of the Act to mean a price which is applied or proposed to be applied in a transaction between persons other than associated enterprises, in uncontrolled transaction. Section 92C (1) provides that the ALP has to be determined following the most appropriate method.


Sub-rule (2) of rule 10C of the Rules further elucidates the factors which have to be taken into account for selecting the “most appropriate method” which is described in sub-rule (1) of the said rule as the method which is best suited to the facts and circumstances of each particular international transaction, and which provides the most reliable measure of an ALP in relation to an international transaction.

These factors are as under:

Ø  The nature and class of international transaction;

Ø  The class or classes of associated enterprise and the functions performed by them taking into account the assets employed and risks assumed;

Ø  The availability, coverage and reliability of the data;

Ø  Degree of comparability between the international transaction and comparable uncontrolled transaction and the extent to which reliable and accurate adjustment can be made for differences, if any, between the two; and

Ø  The nature, extent and reliability of the assumptions required to be made in application of the methods.


Presently, as stated above, five methods of computing the ALP are available under the Act. CBDT has not prescribed any other method for determination of ALP for which power has been provided to them under clause (f) of section 92C (1).

Rule 10B (1) provides the manner in which each of the aforesaid method is to be applied to arrive at the ALP. Each of the methods requires a comparison of the international transaction with an uncontrolled transaction.


Sub-rules (2) to (4) of rule 10B, deals with the manner in which such comparison is to be made and the data to be used for such comparison.


To counter TP manipulations, the Organization of Economic Cooperation & Development (OECD) introduced the Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations in 1995. These guidelines are respected worldwide and the Indian TP regime is primarily based on them, though with a few customized features. Under the TP regime, the transfer price has to be determined on the basis of the arms length principle and the price so determined is the Arms Length Price (ALP).

According to the arms length principle, there are two sets of methods for arriving at the ALP:


Transactional Methods

These methods emphasize each transaction specifically rather than considering the overall profit figure of related entities to arrive at the ALP. These are:


Comparable Uncontrolled Prices method (CUP): Under this method, price charged in an uncontrolled transaction between comparable entities is identified and compared with the tested entity price (after making due adjustments in relation to terms and conditions and risk involved) to determine the ALP.


Cost Plus Method (CPM): Here, the total cost of production incurred by the tested enterprise in transferring goods and services to Associated Enterprises (AEs) is calculated and the total gross profit mark up used by comparable entities in similar transactions with independent enterprises is determined. The total gross mark-up arrived at is adjusted to take into account functional and other differences to determine ALP.


Resale Price Method (RPM): This method is similar to CPM and is used where the seller adds relatively little or no value to products acquired from AEs. Here, ALP is determined by subtracting the appropriate gross profit mark-up from the sale price charged to an independent entity. The appropriate gross margin is determined by comparing the gross margin of comparable entities with the tested enterprise, after making necessary adjustments regarding functional and other differences.


Non Transactional Methods

In non transactional methods, related parties income figures are considered and adjusted according to their share. These are:

Profit Split Method (PSM): PSM is used when AEs transactions are so integrated that it becomes impossible to conduct a TP analysis on a transactional basis. First, the combined net profit incurring to related enterprises from a transaction is determined. Then, the combined net profit is allocated between related enterprises with reference to market returns achieved by independent entities in similar transactions. The relative contribution of related parties is then evaluated on the basis of assets employed, functions performed or to be performed and risk assumed.


Transactional Net Margin Method (TNMM): TNMM is normally adopted in cases of transfer of semi-finished goods, distribution of finished products (where resale price method (RPM) cannot be adequately applied) and transactions involving the provision of services. TNMM compares the net profit margin relative to an appropriate base (sales, assets or costs incurred) of the tested party with net profit margin of the independent enterprises in similar transactions after making adjustments regarding functional differences and risk involved.


Under the Indian TP regime, there is no hierarchy in terms of preferred methods of determining ALP. Indeed, as per section 92C (2) of the Income Tax 1961, the most appropriate method has to be applied for determining ALP in the manner prescribed under Rules 10 A to 10C notified vide S.O. 808 E dated 21.8.2001.

An example would be useful in understanding the procedure for calculating ALP. Let us suppose a subsidiary company A in India is importing manufactured goods from parent company B in France for the purpose of trading the goods in India. There is no public information available regarding prices charged by companies engaged in similar activities. To calculate ALP, we will have to select most appropriate method after taking into consideration the various aspects described below:


Finding Uncontrolled Comparable Data:

The first step would be to access databases like Prowess and Capitaline Plus, two commercial databases available in India which contain financial and non-financial information gathered from audited annual accounts, stock exchanges, company announcements, etc., of over 10,000 small and mid-sized companies. Let us suppose that to find comparable companies; a search for companies engaged in similar business is first run in Prowess which shows say 200 companies with comparable transactions.Then say the same procedure is followed in Capitaline Plus database from where we get 100 companies.We would now have to compare the results from the two electronic databases to exclude companies which form part of both searches and say we get 110 comparable companies.


These comparable companies would then be screened on a qualitative basis (for instance on the basis of the exclusion of sick units, related party transactions and functionally different units) and quantitative basis (for instance, transaction thresholds, turnover thresholds etc.) and say, finally we get 15 companies for comparison with company A.


Selection of Most Appropriate Method:


Cost plus Method (CPM): Since the CPM method is usually used where semi finished goods are transferred, it will not be applicable to our example.


Comparable Uncontrolled Prices Method (CUP): The CUP is not applicable as no public information is available regarding prices charged by independent companies in import of similar goods.


Resale Price Method (RPM): RPM is used where the seller adds relatively little or no value to products acquired from AEs. In the present case RPM may be taken as the most appropriate method as comparable data of similar transactions by independent entities is available.


Profit Split Method (PSM): This method is used when AEs transactions are so integrated that it becomes impossible to make TP analysis on transactional basis, which is not the case in our example.


Transactional Net Margin Method (TNMM): TNMM is normally adopted in the case of transfer of semi finished goods, distribution of finished products and where resale price method (RPM) cannot be adequately applied. However, since RPM can be more appropriately applied in this case, TNMM is also not appropriate.


Calculation of ALP: Now the most appropriate method, which is RPM in this case, is applied to calculate the ALP. Since data is available for 15 comparable companies, we would take arithmetic mean of prices of charged by such companies for similar goods and this arithmetic mean, or a price which differs from arithmetic mean by +5%, will be taken as the ALP for company A.


Significant Factors While Calculating ALP:


Risk Analysis: In India, tax authorities often err on the side of caution and transfer pricing officers (TPOs) have largely ignored the importance of risk in TP analysis in many cases. It is a fundamental principle of economics that enterprises which undertake low risk can expect only to yield low profits. This was also acknowledged by Delhi Income Tax Appellate Tribunal (ITAT) in its recent landmark decision of Mentor Graphics (Noida) Private Limited v. Dy. CIT ITA, NO. 1969/D/2006 which has revived the hopes of taxpayers. Mentor Graphics Private Limited (Noida) was engaged in the business of software development and rendering marketing systems services to its parent company, IKOS Systems Inc. in USA. It charged for its software development services by using TNMM as the most appropriate method and used Net Cost Profit (NCP) as the price level indicator to its US parent company (in this case, NCP of 6.99%). However, placing reliance on the TPOs order, the Assessing Officer accepted the revised NCP at 23.53% and accordingly made an adjustment of Rs.14.5 million to the company’s taxable income which was upheld by the Commissioner (Appeals). However, ITAT, in its decision, concluded that search conducted by the TPO had serious defects affecting the ALP and ruled that the decision was incorrect. Therefore the price disclosed by the assessee was considered as the ALP and the addition of Rs.14.5 million was rejected. ITAT emphasized that appropriate adjustments relating to functional, asset and risk differences are necessary while choosing comparable enterprises in TP analyses.


Use of secret data: In many developed countries, use of secret data while carrying out assessments is prohibited. However in India, this information may be used by tax authorities against tax payers.


Transactions involving intangibles: At present TP regulations have no specific provisions for transfer of intangibles and the five prescribed methods are often found inadequate to deal with TP issues relating to intangibles.




Advance Pricing Agreement (APA): In some jurisdictions, in order to resolve complex TP issues, taxpayers may agree with the appropriate tax authority that future transactions will be conducted at an agreed price which will be deemed as the ALP for those transactions. For instance, UK legislation provides that a UK business may agree the ALP with Her Majesty’s Revenue & Customs (HMRC) but it will run the risk of being assessed by foreign tax authorities relating to the method of calculation of the ALP. Bilateral or multilateral agreements, which eliminate risk of double taxation, are also in existence in certain other developed countries, but there is no provision for such agreements in India as of now. APA places a company in a better position by predicting costs and expenses including tax liabilities. It limits the prospect of potentially costly and time consuming examination of major TP issues that would arise in TP audit and also substantially reduces or eliminates the possibility of double taxation. By promulgation of the amendment regarding APA, government can reduce TP problems to a great extent.


Databases: In India, as mentioned earlier, two commercial databases (Prowess and Capitoline Plus) are available which contain financial information of about 10,000 public and private companies. However, these databases are not primarily designed for TP analyses. If these databases are made suitable for TP analysis in terms of improvement of search parameters, increase in the size of the databases etc., finding comparable transactions for determination of ALP would become much easier.

Risk differences: While the ruling laid in Mentor Graphics case (as discussed above) acknowledges the risk differences to be considered for TP analysis, no guidance has been provided on the correct approach for making risk adjustments. If appropriate guidance for making such adjustments is provided, key TP issues can be resolved.


A summarized overall review of the provisions of Transfer Pricing under Income Tax act, 1961 is as follows:

Ø  Under Section 92, an Assessing Officer is empowered to compute income from international transactions which involve transfer pricing provision having regard to ALP. The meaning of what would constitute an associated enterprise or an international transaction is provided in section 92A and 92B respectively. The manner of computation of ALP is set out in section 92C. The primary burden in regard to computation of ALP is that of the assessee, which the assessee is required to compute by resorting to the most appropriate method amongst those mentioned in sub-clause (a) to sub-clause (f) of subsection (1) of section 92C, having regard to the nature of transactions or the class of transaction or even class of associated persons or functions performed by such persons or such other relevant factor as may be prescribed by the Board. In this respect, regard is required to be had to the factors prescribed in Rule 10B. In the event the Assessing Officer has doubts with regard to the ALP determined by the assessee, having regard to the circumstances mentioned in sub-clause (a) to (d) of sub- section (3) of section 92C, the Assessing Officer can proceed to determine the ALP. However, while doing so, the Assessing Officer is statutorily required under the first (1st) proviso to section 92C, to give an opportunity to the assessee by issuing him a show cause notice with respect to the same.

Ø  In the event, the Assessing Officer considers it “necessary” or “expedient”; he is empowered under Section 92CA to make a reference to the Transfer Pricing Officer (TPO). The TPO under subsection (2) is required to serve notice on the assessee to produce or cause to be produced on a date specified, evidence which the assessee relies upon in support of computation made by him of the ALP in relation to the international transaction. Under sub-section (3) of Section 92CA, the TPO is required to pass an order in writing, determining the ALP in relation to the international transaction in accordance with the provisions of sub-section (3) of section 92C. An important caveat in this regard is that, while determining the ALP, he is statutorily required to hear such evidence as the assessee may produce including information or documents referred to under sub-section (3) of section 92D and such evidence as the TPO may require the assessee to furnish on specified points. The provisions of sub-section (3) of section 92CA make it clear that it is only upon consideration of all such material by way of information, documents or evidence that the TPO can proceed to determine the ALP.

Published by

Manikanta Raju CA,CWA,(CS)
Category Income Tax   Report

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