Overview of Transfer Pricing Regulations in India

CA Jinesh R. Bhagdev

J. B. Nagar CPE Study Circle

Contents

• Background• Identification of Associated Enterprises• Identification of International Transactions /

Specified Domestic Transactions• Functional, Assets and Risk Analysis• Methods and Selection of the Most

Appropriate Method

Background

Background

Any income arising to "AEs" from an "International Transaction" shall be computed having regard to "ALP"

PreconditionsTwo or more AEs;Enter into an international transaction

ConsequenceIncome (expenses) to be computed having regard to ALP

Identification of Associated Enterprises

Associated Enterprises

Means direct or indirect participation in management, control or capital:by one enterprise into another enterprise; orby the same person in both the enterprises

Equity holding, Control of Board of Directors / Appointment of one or more Executive Directors, mutual interest constitute AEs

Either or both of the AEs should be non-residents

COMPANY

A

(NR)

COMPANY

B

(Common) Participation in capital > = 26%

Loan > = 51% of book value of assets

Guarantee > = 10% of borrowings

Appointment > half of the directors

Dependence on know-how, patent etc

Supply of raw material > = 90%

Firm/AOP/BOI>=10% InterestExistence of Mutual Interest

Relationship at any time during the year sufficient to constitute AE

Associated Enterprises – Deeming Fiction

Identification of International Transactions

(Specified Domestic Transactions)

International TransactionsMeans "transaction" between two or more AEs:

Transaction between two or more AEs (atleast one of which will be non-resident) of purchase, sale or lease of tangible property and / or intangible property, provision of services, financing, cost sharing / cost contribution arrangements

OrAffecting profits, losses, income, assets or

liabilities of the enterprises

International Transactions Prominent Transactions now specifically included

Capital Financing including guaranteeAny type of advance payment or deferred paymentsReceivablesTransaction of business restructuring or reorganisation with the

AEIntangible Property – As clarified

Customer ListsCustomer ContractsCustomer RelationshipsHuman Capital Related intangibles assets, such as, trained and

organised work force, employment agreements, union contracts;

Prior arrangement relating to quantity and price of goods

India

Outside IndiaNon - AE

XYZ Inc. USA

ABC Ltd. India

AEs

Subsidiary

Sale of goods

Deemed InternationalTransaction

• Related prior agreement between XYZ Inc. and Non –AE• The terms of the transactions are determined in substance by XYZ Inc.

Deemed International Transaction – Section 92B(2)

Domestic Transaction under the ambit of Transfer Pricing Regulations

• Any expenditure in respect of which payment is made or is to be made to a person referred to in Section 40A(2)(b) of the IT Act;

• Any transaction that is referred to in Section 80A;

• Any transfer of goods or services referred to in Section 80-IA(8) i.e. applicable to companies operating as industrial undertaking or enterprises engaged in infrastructure development;

Domestic Transaction under the ambit of Transfer Pricing Regulations

• Any business transacted between the assessee and other person as referred to in section 80-IA(10);

• Any transaction, referred to in any other section under Chapter VI-A or section 10AA, to which provisions of sub-section (8) or sub-section (10) of section 80-IA are applicable;

• Any other transaction, as may be prescribed by the board.

Provided that the aggregate value of the transaction entered into by theassessee with its domestic AE exceeds Rs. 5 crore

• Most likely transactions under the scanner of the TP Authorities would be:• Interest Free Loans to group companies;• Granting of Corporate Guarantees / Performance

Guarantees by Parent Company to its subsidiaries;• Intra-group purchase / sell / service transactions;• Payment made to key personnel of the group companies;• Payment made to relatives of key personnel of the group

companies.

Domestic Transaction under the ambit of Transfer Pricing Regulations

Functional, Assets & Risk Analysis

Functional, Assets & Risk AnalysisFunctions Performed Assets Utilized Risks Assumed

Core Business Functions• Manufacturing• Trading• Services, etc.

Core Business Assets• Factory Shed• Office Building• Office Equipments• Computers

Business Risks• Market Risks• Product Risks• Employee Attrition Risk• Credit Risks• Foreign Exchange Risks

Management Functions• Strategic Decision Making (Market Penetration / Skimming Policy)• Accounting and Preparation of Financial Statements

Special Assets• Intangible Assets• Human Resource

Special Risks• Risk of Intangible Infringement• Legal Risks

It is important to note that FAR Analysis of each activity needs to be undertaken separately

FAR Analysis is the Heart of Transfer Pricing as on the basis of FAR Analysis, one has to select the comparable companies

• Based on the FAR Analysis, Tested Party needs to be identified.

• Based on the FAR Analysis, Each of the Party (parties to the transaction) needs to be Economically Characterized (E.g. Contract Manufacturer, Full-Fledged Manufacturer, Distributor, Full-Fledged Trader, Contract Service Provider, etc.)

Functional, Assets & Risk Analysis

Methods and Selection of Most Appropriate Method

Methodology in Computing ALPSection 92C lays the foundation

The ALP in relation to an international transaction shall be determined by applying one of the following methodTraditional Methods

CUP MethodRPMCPM

Profit Based MethodsPSMTNMM

Such other method as may be prescribed by the BoardOther method of determination of arm's length price

Traditional Methods

ComparisonParticulars CUP Method RPM CPM

Comparison Prices (direct comparison) Gross Profit Margin (gross profit over sales)

Gross Profit Mark-up on cost

When it can be applied

When there is no difference or the difference can be negated through reasonable adjustments

When there is direct re-sale by tax-payer to third party – without much value addition

When there is a sale of semi-finished goods amongst the associated enterprises

Example • When Product A is purchased from AE as well as third party•When product B is sold to AE as well as third party

•When goods are purchased from AE and sold to third party without value addition•As per Guidance Note issued by institute, RPM is not applicable when goods are purchased from third party and sold to AEs

• When Raw materials are purchased from third parties and sold to AEs for further processing

ComparisonParticulars CUP Method RPM CPM

Strengths •Most Direct Method•Easy to Apply•No Concept of Tested Party

•Minor Product Difference allowed•More closure functional comparability required

•Easy to apply•Suitable in case of transfer of semi-finished goods

Weakness •May be difficult to find comparable transaction•Difference in products not allowed

•Not applicable for further processing of goods•Lack of availability of gross profit margin of comparable companies

•Estimation of cost may be difficult•Cost may not be sole determinant for determination of mark-up•Lack of availability of gross profit margin of comparable companies

Profit Based Methods

ComparisonParticulars PSM TNMM

When it can be applied

When there are international transactions involving transfer of unique intangibles or there are multiple inter-related transactions which cannot be evaluated separately

When all other methods fail the application test (usually considered as the measure of last resort)

Strengths •Offers solution when both parties contribute unique intangibles;•The only method which adopts the two sided approach

•Requires Broad functional comparability;•Operating margins are less affected by transactional difference•Difference in functions performed are reflected in financial statements

Weakness •Difficult to apply in practice;•Difficult to estimate costs and revenues for all the entities;•Difficult to identify the operating expense associated with international transaction and AE’s other activities

•Requires information on uncontrolled transactions which may not be available at the time of entering into international transaction•Difficult for making reasonable adjustments like Working Capital Adjustments, Risk Assumed, etc

Background – Profit Based Method• Profit based methods are more appropriate in

situations where• Each of the parties make valuable and unique contribution in

relation to the controlled transaction or when the transactions are highly inter-linked; or

• Reliable data for application of traditional method is not available

• Traditional method cannot be applied to every possible situation;

• Mere difficulty in obtaining data for application of traditional methods should not be the sole criteria for adopting profit based methods in determining ALP

Other Method

• the other method for determination of the ALP in relation to an international transaction shall be • any method• which takes into account price charged / paid / would

be charged / payable• for same or similar uncontrolled transaction• with or between non-associated enterprises• under similar circumstances, considering all the

relevant facts

Background – Other Method

Most Appropriate Method• Indian TPR does not provide any hierarchy or priority for

selection of MAM

• MAM is that method which, under the facts and circumstances of the transaction under review, provides the most reliable measure of an arm’s length result

• Each method needs to be tested on merits depending on the nature of international transaction, availability of comparable data, extent to which reasonable and reliable adjustments can be made, etc.

Factors for Selection of MAMNature and class of international transactionThe class or classes of AEs entering into an international

transactionAvailability, coverage and reliability of data necessary for

application of MAMThe degree of comparability existing between the

international transaction and uncontrolled transactionExtent to which reliable and accurate adjustments can be

madeNature, extent and reliability of assumptions required to

be made in application of a method

Jinesh BhagdevJinesh R. Bhagdev & Co.Proprietor#3, Shyam Sadan, Opp. Sairaj Garden, 3rd Irani Wadi,Kandivli (West), Mumbai – 400 067IndiaEmail: jinesh@jbhagdev.comWebsite: www.jbhagdev.comContact No: 99209 22929

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