Domestic Transfer Pricing CPE Seminar on Domestic Transfer Pricing ICAI- Trichur 22nd June 2013 CA P.V.S.S Prasad pvsatya.prasad@gmail.com

Domestic transactions - Transfer Pricing Inspired by – Apex court ruling – Glaxo Smithkline (2010) 195 Taxman 35 (SC): we are of the view that certain provisions of the Act, like section 40A(2) and section 80-IA(10), need to be amended empowering the Assessing Officer to make adjustments to the income declared by the assessee having regard to the fair market value of the transactions between the related parties. The Assessing Officer may thereafter apply any of the generally accepted methods of determination of arm’s length price, including the methods provided under Transfer Pricing Regulations. However, in a number of matters, we find that, many a times, the Assessing Officer is constrained by non-maintenance of relevant documents by the taxpayers as, currently, there is no specific requirement for maintenance of documents or getting specific transfer pricing audit done by the taxpayers in respect of domestic transactions between the related parties. The suggestions which need consideration are whether the law should be amended to make it compulsory for the taxpayer to maintain books of account and other documents on the lines prescribed under rule 10D of the Income-tax Rules in respect of such domestic transactions and whether the taxpayer should obtain an audit report from his Chartered Accountant so that the taxpayer maintains proper documents and requisite books of account reflecting the transactions between related entities as at arm’s length price based on generally accepted methods specified under the Transfer Pricing Regulations”

Domestic transactions - Transfer Pricing May lead to economic double taxation Inline with some tax jurisdictions like Australia, Thailand , Denmark etc., Increase in compliance burden

Domestic transactions -Transfer Pricing New sub.sec (2A) to sec.92 “(2A) Any allowance for an expenditure or interest or allocation of any cost or expense or any income in relation to the specified domestic transaction shall be computed having regard to the arm’s length price.” w.e.f 1st Apr ‘13 Specified domestic transaction means “92BA. For the purposes of this section and sections 92, 92C, 92D and 92E, “specified domestic transaction” in case of an assessee means any of the following transactions, not being an international transaction, namely:—

Domestic transactions-Transfer Pricing Specified domestic transaction means : (i) any expenditure in respect of which payment has been made or is to be made to a person referred to in clause (b) of sub- section (2) of section 40A; (ii) any transaction referred to in section 80A; (iii) any transfer of goods or services referred to in sub-section (8) of section 80-IA; (iv) any business transacted between the assessee and other person as referred to in sub-section (10) of section 80-IA;

Domestic transactions-Transfer Pricing Specified domestic transaction means : (v) 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; or (vi) any other transaction as may be prescribed, and where the aggregate of such transactions entered into by the assessee in the previous year exceeds a sum of five crore rupees.” - w.e.f. 1st Apr 2013

Domestic transactions -Transfer Pricing S.10AA S.40A(2)(b) – FMV vs. ALP S.80A - Scope of deductions & FMV for inter business transfers S.80IA (8) – Eligible business Vs. Other business S. 80IA (10) - Eligible assessee Vs. Other person S.80IAB(3), 80IB(13),80IC (7), 80ID (5), 80IE (6)

Domestic transactions-Transfer Pricing S.92C – computation of ALP – methodologies- also apply to Spec. dom. transactions S.92CA (1)(2)&(3)- reference , service of notice & order to be made by TPO S.92D – documentation – maintenance & production S.92E – report from an accountant – may be a new form

Domestic transactions -Transfer Pricing Corresponding Amendments : S. 40A(2) – Proviso inserted to provide for ALP in cl(a) : “ Provided that no disallowance, on account of any expenditure being excessive or unreasonable having regard to the fair market value, shall be made in respect of a specified domestic transaction referred to in S.92BA, if such transaction is at arm’s length price as defined in cl.(ii) of S.92F” - FMV different from ALP? In cl.(b) (iv) , after the words “ or any relative of such director, partner or member” , the words “or any other company carrying on business or profession in which the first mentioned company has substantial interest” shall be inserted.

Domestic transactions -Transfer Pricing Corresponding Amendments : S. 80A – Cl (iii) to Explanation inserted : “in relation to any goods or services sold, supplied or acquired means the arm’s length price as defined in cl.(ii) of S.92F of such goods or services, if it is a specified domestic transaction referred to in S.92BA” is ALP synonymous with Market value ? S. 80-IA – Explanation substituted in Ss(8) : Market Value , in relation to any goods or services means – the price that such goods or services would ordinarily fetch in the open market: or the arm’s length price as defined in cl(ii) of S.92F, where the transfer of such goods or services is a specified domestic transaction referred to in S.92BA

Domestic transactions -Transfer Pricing Corresponding Amendments : In S.80 IA(10) - Proviso inserted : “Provided that in case the aforesaid arrangement involves a specified transaction referred to in S.92BA, the amount of profits from such transaction shall be determined having regard to arm’s length price as defined in clause (ii) of S. 92F” not clear whether ALP and FMV are the same .

Relationship can exists any time during the year Sec 40A (2)(b) – Related Party Relationship can exists any time during the year Sr.No Payer / assessee Payee (i) Individual Any relative [defined in sec. 2(41) to mean husband, wife, brother, sister, lineal ascendant or descendant] * Definition of Relative u/s 56(2) not relevant (ii) Company any director or relative of such director Firm (includes LLP) any partner or relative of such partner AOP any member or relative of such member HUF (iii) Any Assessee any individual having substantial interest in the assessee’s business or relative of such individual (iv) Any assessee a Company, Firm, AOP, HUF having substantial interest in the assessees business or any director, partner, member relative of such director, partner or member or (newly inserted) any other company carrying on business or profession in which the first mentioned company has substantial interest. X Ltd. (subsidiary co) A Ltd. (holding co) Y Ltd. (subsidiary co)

Type of transactions covered (illustrations for payments made by a Company) … Case 1 - Director or any relative of the Director of the taxpayer – Section 40A(2)(b)(ii) Case 2 - To an individual who has substantial interest in the business or profession of the taxpayer or relative of such individual – Section 40A(2)(b)(iii) Assessee (Taxpayer) Assessee (Taxpayer) Director Director Substantial interest >20% Relative Mr. A Mr. D Mr. C Mr. A Mr. D Mr. C Relative Relative Covered transactions Holding Structure

Type of transactions covered (illustrations for payments made by a Company) … Case 3 – To a Company having substantial interest in the business of the taxpayer or any director of such company or relative of the director – Section 40A(2)(b)(iv) Case 4 – Any other company carrying on business in which the first mentioned company has substantial interest – Section 40A(2)(b)(iv) Mr. D Assessee (Taxpayer) C Ltd Director Substantial interest >20% Assessee (Taxpayer) A Ltd Relative Substantial interest >20% Substantial interest >20% Mr. C Substantial interest >20% A Ltd B Ltd Covered transactions Holding Structure

Type of transactions covered (illustrations for payments made by a Company) … Case 5 – To a Company of which a director has a substantial interest in the business of the taxpayer or any director of such company or relative of the director – Section 40A(2)(b)(v) B Ltd Director Director Substantial interest >20% Assessee (Taxpayer) Mr. A Mr. C Relative Mr. D Covered transactions Holding Structure

Type of transactions covered (illustrations for payments made by a Company)… Case 6 – To a Company in which the taxpayer has substantial interest in the business of the company – Section 40A(2)(b)(vi)(B) Case 7 – Any director or relative of the director of taxpayer having substantial interest in that person– Section 40A(2)(b)(vi)(B) Assessee (Taxpayer) Substantial interest >20% A Ltd Mr C Director Substantial interest >20% Assessee (Taxpayer) Relative B Ltd Substantial interest >20% D Ltd Mr B Covered transactions Holding Structure

Tax burden, if transaction not at ALP X Ltd. (non-tax holiday) Disallowance of ` 20 to Y Ltd [40A(2)(b)] Y Ltd. Sale at ` 120 v/s ALP i.e. ` 100 X Ltd. (tax holiday) Y Ltd. (non-tax holiday) Sale at ` 120 v/s ALP i.e. ` 100 Double Adjustment Tax holiday on ` 20 not allowed to X Ltd – [80IA(10)] (more than ordinary profits) Disallowance of ` 20 to Y Ltd - [40A(2)(b)] X Ltd. (tax holiday) Y Ltd. (non-tax holiday) Sale at ` 80 v/s ALP i.e. ` 100 Inefficient pricing structure – reduced tax holiday benefit since sale price is lower than ALP

Section 80IA (8) & 80IA (10) – Deduction in respect of profits and gains from industrial undertaking or enterprise engaged in infrastructure development, etc. 80IA (8) 80IA (10) Inter-unit transaction of goods or services Business transacted with any person generates more than ordinary profits Owing to either close connection or any other reason Applicable where transfer is not at market value Applicable to tax holiday units earning more than ordinary profit Onus on tax payer Primary onus on taxpayer Onus on tax authorities as well No guidance on the meaning of close connection To align ordinary profits with arm’s length price. For example: OP/ TC of 30% considered to be at arm’s length by the TPO Under 801A(10) the AO states that the profits are more than ordinary Solution: Defend price or evaluate alternate methods (other then profit based) Impact of non-charging of services/ costs to tax holiday undertaking ALP of 5 comparable companies OP/TC Mark-up of the tax holiday entity OP/TC Arithmetic mean = 15% 30%

Tax holiday undertaking International TP Vs. Tax holiday profits Sec 10A(7) / 10B (7) Case laws - Visual Graphics Computing Services (India) Pvt. Ltd vs ACIT 2012) 52 SOT 172 (URO), Weston Knowledge Systems & Solutions (India) Pvt. Ltd. vs ITO (2012) 52 SOT 120 (Hyd)(URO) AO has no authority to reduce tax holiday claim once approved by TPO Whether same approach is possible when domestic TP is targeted in computing ordinary profits. Domestic TP supports the approach of AO in restricting ordinary profits?

Cost allocation Whether corporate group expenses to be allocated? Courts held that it need not be allocated Case laws - Wipro Information Technology vs DCIT (2004) 88 TTJ(Bang) 778 ; Zandu Pharmaceuticals Works Ltd, vs CIT (2013) 213 Taxman 207 Ponds India Ltd (ITA NO. 2047/Mad/88) Whether every cost allocation should have a mark up?

Transfer Pricing Process TP Assessment Identification of Intra Group Transactions Return Filing FAR Analysis Documentation Identification of Comparable Transactions Adjustments Establishing Comparability, Adjustment for Material Differences Selection of Most Appropriate Method Determination of A L P 21

Arm’s length price S. 92 F (ii) “arm’s length price” means a price which is applied or proposed to be applied in a transaction between persons other than associated enterprises, in uncontrolled conditions” 22

Traditional transaction methods Transactional profit methods Comparable Uncontrolled Price Method (CUP) Resale price method (RPM) Cost plus method (CPM) Transactional profit methods Profits split method (PSM) Transactional net margin method (TNMM) Other method 23

“Other Method” for determination of ALP New Rule 10AB inserted vide Notification No.18/2012 dated 23-05-2012 Refers to “price which has been charged or paid, or would have been charged or paid, for the same or similar uncontrolled transaction, with or between non-associated enterprises, under similar circumstances, considering all the relevant facts” 24

“Other Method” for determination of ALP New Rule 10AB inserted vide Notification No.18/2012 dated 23-05-2012 Refers to “price which has been charged or paid, or would have been charged or paid, for the same or similar uncontrolled transaction, with or between non-associated enterprises, under similar circumstances, considering all the relevant facts” 25

Objectives – Specified Domestic Transactions (SDT) When profit getting shifted from profit making unit to a loss making unit ; Profit shift from taxable unit to tax free unit ; SDT is not meant to cover revenue neutral transactions- lest it would result in economic double taxation

Domestic transactions -Transfer Pricing S.92CA (2A) , (2B) & (2C) apply only to international transactions and not to SDT Non-reference and non-reporting of SDTs are not covered by new Ss (2A) & (2B) APA mechanism proposed u/s 92CC & CD is not available for SDTs

Domestic transactions -Transfer Pricing If SDTs do not cross threshold INR 5 Crores, TP Documentation & Reporting not applicable ; however, original requirement to comply with market value concept of u/s 40A(2)(b) / 10AA/ 80A/ 80IA (8) & (10) still continues. ◊ then how is it a safe harbor?

Domestic transactions -Transfer Pricing Typical SDTs: Rent payments Intra- group transactions Financial transactions Managerial remuneration etc Corporate guarantee Equity contributions Reimbursement of expenses Commission paid and discount allowed

Domestic transactions -Transfer Pricing Expenditure incurred by a resident against non-resident – though not covered as AE , as ownership and control being less than 26% voting, but may be covered as SDT if voting power is ≥20%

Domestic transactions -Transfer Pricing AE Vs Related Party creates dichotomy Circular 6-P dated 6th July 1968 provides – no disallowance- where there is no attempt to evade taxes SDT covers only assessee spending u/s 40A(2)(b) and will not cover entity receiving payments

Domestic transactions -Transfer Pricing OECD TP guidelines apply to SDTs? Benefit of range available to SDTs TP adjustments for SDTs result in double taxation – in revenue neutral cases – hence corresponding adjustments warranted

Documentation Rule 10D is amended to cover SDTs – sub rule (2) applies only to international transactions Need based documentation good enough even for SDTs Should be contemporaneous and be in place by specified date Initial burden lies with the assessee 33

Section 271 –Penalty Implications Sr. No. Type of penalty Section Penalty quantified 1 a) Failure to maintain prescribed information/ documents 271AA 2% of transaction value (b) Failure to report any such transaction or (c) Furnish incorrect information 2 Failure to furnish information/ documents during assessment u/s 92D 271G 3 Adjustment to taxpayer’s income during assessment 271(1)(c) 100% to 300% of tax on adjustment amount 4 Failure to furnish accountant’s report u/s 92E 271BA INR 100,000

Issues Whether payment for capital expenditure Or expenditure capitalized is also covered ? Whether the provisions will apply in case the payer’s income is chargeable to tax under the head ‘Income from other sources’, because section 58(2) says –The provisions of section 40A shall, so far as may be, apply in computing the income chargeable under the head “Income from other sources” as they apply in computing the income chargeable under the head “Profits and gains of business or profession” ? Whether new provision applies to - Public Charitable Trust paying remuneration to related persons. Co-operative Societies Social Clubs having a business undertaking

Issues Transfer pricing provisions are not applicable in case where income is not chargeable to tax at all. Correlative adjustments - if excessive or unreasonable expenses are disallowed in the hands of tax payer at time of the assessment then corresponding adjustment to the income of the recipient will not be allowed in the hands of recipient of income. Hence, it would lead to double taxation in India.

Type of payments/ transactions Challenges Type of payments/ transactions Challenges Salary and Bonuses paid to the partners Remuneration paid to the Directors Transfer of land Joint Development agreements Project management fees Allocation of expenses between the same taxpayer having an eligible unit and non-eligible unit Definition of Related Party Benchmarking? Whether the limit as mentioned in section 40 (b) would be the ALP? Whether the limit as mentioned in Schedule XIII would be the ALP? Whether the rates mentioned in the ready reckoner be considered as ALP? Whether these allocation would be SDT – Sec 80-IA(10)? Directly v/s Indirectly  

New Rules & Forms Form 3 CEB enlarged – Part C inserted with respect to details of specified domestic transactions. Rule 10A – Expands AE definition when Sec.92A(1) & (2) doesn’t do so.

Action Awaited Clarifications in line with old circular 6-P (supra) Revenue neutral transactions – avoidance of double taxation – critical

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