INCOME TAX RULES,PENALTIES,METHODS,DOCUMENTATION REQUIRED IN TRANSFER PRICING

RULES,PENALTIES,METHODS,DOCUMENTATION REQUIRED IN TRANSFER PRICING

Transfer pricing refers to the prices that related parties charge one another for goods and services passing between them.

The most common application of the Transfer pricing rules is the determination of the correct price for sales between subsidiaries of a multinational corporation. These prices can be used to shift profits to tax-favored countries, if in a transaction between a subsidiary in a high-tax countries and another in a low-tax country, the high-tax subsidiary charges a price below the “true” price, some of the group’s economic profit is shifted to the low-tax subsidiary. Obviously taxpayers would want to engage in this sort of behavior because it can significantly reduce their taxes. If there were no limitations on this behavior, the entire income of multinational corporations would be taxed at the lowest tax rate in the world to zero rate of taxation. Consequently, most countries have some set of tax rules that regulate the prices that related persons can charge one another.

From past experience it has been noticed that foreign multinational enterprises adopting following practices to avoid the tax payments: -

  • Manipulation of prices
  • Manually inflated rent and interest
  • Double payments for management charges or payment of unknown services and non-exist services.
  • Agreement for shift the sources of income etc.

So for stop this type of wrong practicing transfer pricing provisions are made by tax authorities.

Section 92 of income tax act deals with the rules of transfer pricing. Rules of section 92 are as follows:

Following conditions have been satisfied for applicability of section 92:

  1. Transaction will be done between a resident and non-resident.
  2. Connection between above two are very close.
  3. Business condition of resident person is that produce no profit or less than normal profit

If the conditions (i) & (iii) were satisfied, then Assessing Officer under the Act has power:

  • to determine the amount of profits, which is reasonably assume to have been derived from such business.
  •  to include such amount in the total income of the resident.

Documentation Requirements to be verified Rule 10D (1)

Following are the compulsory documentation required by law: -

  • Description of Ownership Structure (Step I)
  • Profile of Multinational Group (Step II)
  • Description of Business (Step II)
  • Nature & Terms of International Transactions (Step III) 
  • Description of Functions, Risks & Assets (Step IV)
  • Record of Economic & Market Analyses, if any (Step III & IV)
  • Record of Uncontrolled Transactions & Comparability analysis (Step V)
  • Description of Methods considered (Step VI)
  • Record of Actual working (Step VII)
  • Assumptions, policies, Price negotiations, if any. (Step II & IV)
  • Any other information, data or document.

Benchmarking Methodology

  • Methodology for comparing international transaction of a tested party to that of comparable transaction
  • Methods – CUP, RPM, CPM, PSM, TNMM

Choice of benchmarking methodology

  • Depends on availability of data
  • Depends on comparability of data
  • Depends on reliability of data
  • Depends on adjustability of data

Fair market value of goods can be determined by following methods: -

  • Compare the current market price of goods to the transfer price and make the adjustment in quality, quantity, time of sale and other factors.
  • Show the appropriate mark up of factors from resale price to outside parties, specially the price at which goods are sold to non-associate third parties.
  • In case of manufacturing concern, estimate reasonable profit of concern and added to the cost.
  • Compare the price of goods with price of goods set by custom authorities for the purpose of levy and collection duties imposed by custom authorities.
  • Compare the goods price with value decided by insurance companies.

Transfer Pricing Process: -

  • Gathering Background Information
  • Functional Analysis
  • Manage the Process
  • Benchmarking
  • Documentation
  • Chartered Accountant’s Report

Documentation requirements:

Factual and Functional Analysis: In transaction between related parties, compensation will reflect the functions that the parties perform taking into account risks assumed and assets used.

Description of the company and the group: Description about Outline of the business, Structure of the organization, Legal ownership within the MNE Group, Overview of financial key figures.

Industry analysis: it includes details about competitors, market and trends, added values, USPs.

Overview of intercompany transactions: Giving details of all transactions which is related to the companies.

Economic Analysis:

Selection of most appropriate method among all the following methods: -

Comparable Uncontrolled Price (CUP) METHOD: The CUP method evaluates the arm’s-length character of a controlled transaction by comparing the price and conditions to the price and conditions of similar transactions between the taxpayer and an unrelated party, or between two unrelated parties. this method is the most direct and reliable way to apply the arm’s-length principle and to determine the prices for the related party transactions.

Computation of Arm’s length price are as follows: -

  1. Compute the price to be charged or paid for transfer of property or provide the services in a comparable uncontrolled transaction.
  2. Such computed price is then adjusting to the account for functional differences between comparable uncontrolled transactions and international transactions. That will affect the price of open market
  3. That adjust price is Arm’s length price.

COST PLUS METHOD:  this method is used to test the activities of manufacturing entities by comparing gross profits to cost of sales. This method is less likely to be reliable if material differences exist between the controlled and uncontrolled transactions with respect to intangibles, cost structure, business experience, management efficiency, functions performed and products.

Computation of Arm’s length price are as follows: -

  1. Compute the direct and indirect costs of production for property transferred or service provided to associate enterprises.
  2. Compute the normal gross profit of such cost which will incur from transfer of goods and services to unrelated enterprises.
  3. Such computed profit is then adjusting to the account for functional differences between comparable uncontrolled transactions and international transactions. That will affect the profit of open market
  4. Cost that will be calculated above will be added in the adjusted profit.

RESALE PRICE METHOD: The resale price method is normally used to test gross profits earned by sales and distribution entities. This method compares gross profit relative to turnover of the tested party to gross margins earned by comparable third parties.

Computation of Arm’s length price are as follows: -

  1. Firstly, compute the price at which property purchased or services is obtained from associate enterprises sell it to unrelated enterprises.
  2. Resale price is reduced by normal G.P. accuring during purchase and resale of similar goods in a comparable uncontrolled transaction.
  3. Then reduce the all expenses incurred during purchase.
  4. Such computed price is then adjusting to the account for functional differences between comparable uncontrolled transactions and international transactions. That will affect the price of open market

PROFIT SPLIT METHOD: this method will eliminate the effect on profits of special conditions made or imposed in a controlled transaction by determining the division of profits that independent enterprises would have expected to realize from engaging in the transaction or transactions.

Computation of Arm’s length price are as follows: -

  1. Determine the net profit of associate enterprises that will arise from international transactions.
  2. Determine the relative contribution made by each of the associated enterprises for earning of combined profit.
  3. Divide that combined profit in proportion of their contributions.

TRANSACTIONAL NET MARGIN METHOD: This method compares the tested party’s net profitability on a controlled transaction to the net profit obtained by broadly similar uncontrolled companies on similar transactions.

Computation of Arm’s length price are as follows: -

  1. Determine the net margin earned from an international transaction.
  2. Determine the net profit margin earned by the enterprises or by an unrelated enterprises.
  3. Adjust the net profit margin computed above in step 2 for account of differences.
  4. Net profit margin will be same as calculated in step 1.

After selection of appropriate method apply the selected method in efficient manner.

Penalty: -

for Failing to submit CA Report

Entities entering into an international transaction are required to obtain a report from a chartered accountant. Failure to furnish a report from chartered accountant can attract a penalty of Rs. 1,00,000

for Not Maintaining Required Documents

As mentioned above, entities entering into international transactions are required to maintain certain documents as listed above. Failure to maintain such document or failure to report or furnishing incorrect information can attract a penalty of up to 2% of the value of each transaction, where noncompliance exists.

for Not giving Documents to tax authorities within time

Tax authorities may demand any related information or documents in the course of any proceeding, from any person who has entered into international transactions. The taxpayer must furnish such information or document within a period of 30 days from the date of receipt of a notice. Failure to furnish information can attract a penalty equal to 2% of the value of the specified transaction for each such failure.

Case law and judicial pronouncements: -

Analysis of tested party’s accounts – whether accounts are to be split vis-à-vis international transactions or profits of entity as a whole to be analyzed

Judicial pronouncement:

  • Maintenance of split financials warranted for justification of functionally different activities - use of whole entity approach not appropriate (Manufacturing and trading can’t be aggregated for benchmarking purposes – UCB India)
  • ALP of each class of international transactions to be considered separately unless the different classes of transactions are interlinked and cannot be evaluated separately (Development Consultants and Star India)

Documentation to be maintained for justifying arm’s length price

Judicial pronouncements:

UCB India

  • Documentation maintained to be the extent relevant Sufficient compliance with Rule 10D.
  • Documentation mentioned in all clauses of Rule 10D need not be maintained if not relevant
  • What needs to be seen is the substantial compliance by the taxpayer with regard to maintenance of documents (UCB India)

Cargill India

  • Documents and information to be kept and maintained as per Rule 10D
  • Voluminous, and all the sub-clauses attracted very rarely
  • Taxpayer and tax authorities are required to consider only relevant information and documents needed for determining ALP
  • Not possible to casually ask for information under all the clauses

Functional Analysis

 Judicial pronouncements:

  • Functional analysis of potential comparable companies should be taken into consideration and compared with that of the tested party (Aztec India, E-gain Communication, Skoda, UCB India)
  • In case of differences in the functional profiling of the comparable companies vis-à-vis the tested party adjustments should be made to the comparable companies (E-Gain, Sony India, Skoda Auto)
  • Selection of the tested party is important for the purpose of determining of the Most Appropriate Method. The selection of the tested party depends on the following:
  • Least complex of the entities i.e. entity performing simpler functions, assuming lesser risks, owning routine assets
  • Comparable data with regard to the entity is easily available (Development Consultants)
  • Foreign entity can be selected as the tested party if it’s the least complex entity
  • However comparable data in this regard need to be provided by the taxpayer (Ranbaxy India)

Selection of Method

 Judicial pronouncements: -

  • It is imperative for the department to reject the taxpayer’s analysis vis-à-vis the selection of the most appropriate method, before selecting any other method as the most appropriate method (MSS India)
  • Transaction based methods are to be preferred over profit based methods (The aforesaid observation is not in consonance with Indian TPR which does not provide any hierarchy amongst the methods)
  • Loss incurred by taxpayer does not lead to foregone conclusion that the taxpayer’s international transactions are not at arm’s length.
  • However, the taxpayer needs to demonstrate the reasons for the loss and will be required to justify based on documentation in this regard.
  • Status of the company vis-à-vis industry performance / economic slowdown
  • Business strategy – market penetration, diversification etc.
  • Start-up phase
  • Capacity utilization
  • Management inefficiency????
  • Government Policy

(Disclaimer:  The author is a Chartered Accountant and the Chief Gardener & Founder Director of Rajput Jain & Associates , a leading Tax & Investment Planning Advisory Service Provider. His blog can be found at http://carajput.com/blog/ For any query you can write to info@carajput.com  or call on 9555555480 Before making any decisions do consult your Professional / tax advisor. it hereby disclaims any and all liability to any person for any loss or damage that may be caused by any errors or omissions, whether such errors or omissions result from negligence, accident or any other cause. This blogs is not a source or a form of advertising or solicitation nor is it intended to be so. The contents of this website should not be construed as legal advice. For misrepresentation or interpretation of act or rules Author does not take any responsibility. Neither the author nor the firm accepts any liability for the loss or damage of any kind arising out of information in this document or for any action taken in reliance there on)

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