India enacted transfer pricing rules in 2001, which require companies to conclude international transactions with associated enterprises at an arm’s length. The legislation is primarily targeted at large business groups who engage in base erosion and profit shifting to avoid paying corporate income tax in India. This article is the first of two that will provide an insight into some of the key compliance issues that surround India’s transfer pricing regime, which has, since its enactment in 2001, evolved and acquired new shapes.
The key transfer pricing legislation in India is contained in Chapter X of the Income Tax Act (IT Act), 1961. In addition, the Central Board of Direct Taxes (CBDT) issues circulars and notifications as well as specific guidance known as Taxpayer Information Series, which, together with rulings of tax tribunals and courts, comprise Indian transfer pricing rules. These are given effect to by specialists working under the CBDT’s supervision, including the Directorate of International Taxation and Transfer Pricing, Transfer Pricing Officers (TPO), and Assessing Officers (AO).
In interpreting domestic transfer pricing rules, courts in India rely on guidance published by the Organization for Economic Cooperation and Development, such as commentaries on specific transfer pricing provisions contained in model double tax avoidance conventions and the transfer pricing guidelines for multinational enterprises and tax administration. However, the domestic legislative framework takes precedence over the OECD guidance.
Concept of “arm’s length price”, “international transaction” and “associated enterprises”
Section 92 of the IT Act requires international or specified domestic transactions carried out between associated enterprises to reflect arm’s length pricing – that is, the price that would have been paid if such transactions were made between independent third parties at general market value.
For the purpose of the IT Act, “international transaction” means a transaction between two or more associated enterprises and includes purchase, sale or lease of tangible or intangible property, provision of services, or lending or borrowing money, or any other transaction that has a bearing on the profits, income, losses or assets of the enterprise.
“Associated enterprise” means, in relation to another enterprise, an enterprise that participates, directly or indirectly, in the management, control or capital of the other enterprise. The IT Act also sets out a certain shareholding participation threshold under which two or more enterprises are deemed to be associated with each other.
Methods for calculating arm’s length price
The rules state that the arm’s length price must be established using five specific transfer pricing methods. These methods – which largely mirror those outlined in the OECD guidance – include comparable uncontrolled price, resale price, cost plus, profit split, and transactional net margin methods. Additionally, the CBDT prescribes other appropriate methods to establish the arm’s length price so long as they are in conformity with the OECD guidelines.
Transfer pricing documentation and penalties
An enterprise entering into an international transaction with an associate enterprise must maintain transfer pricing documentation, the requirements of which are set out in Section 92D of the IT Act and Rule 10D of the Income Tax Rules. The rules require enterprises to submit details of international transactions in Form 3CEB, which is appended to the tax return. Any supplementary documentation must be produced before the tax authority upon request.
Transfer pricing documentation is pivotal in defending the enterprise’s own transfer pricing treatment and avoiding transfer pricing penalties. A penalty is applicable where the enterprise has failed to file Form 3CEB, or where the enterprise fails to submit all necessary details of international transactions and associated enterprises, and where submitted, the details provide an inaccurate account of particulars of income.
Transfer pricing audit, adjustments and appeal
In India, the principal approach in selecting cases for transfer pricing audit is “risk-based”, which is carried out through the Computer Aided Selection System (electronic software). CASS plays an important role in selecting cases for transfer pricing audit as large taxpayers (with annual income of more than INR 10 lakhs, approximately US $15,750) submit electronic returns. Paper returns, however, escape such an extensive selection process.
Taxpayers who have recorded international transactions worth more than INR 15 crores (approximately US $2.4 mil) in a given year are subject to mandatory scrutiny. In 2014, a government-appointed Tax Administration Reform Commission recommended doing away with mandatory scrutiny for lack of adequate infrastructure, hinting that the CBDT fails to pursue other “appropriate” cases in its pursuit for cases under mandatory scrutiny.
The tax authority is entitled to make transfer pricing adjustments to the enterprise’s total income in calculating the arm’s length price. The tax adjustment is subject to penalties, which is calculated based on the increase in the total taxable income or a decrease in the amount of allowances following such an adjustment.
An enterprise disputing the tax authority’s adjustment may file an appeal against assessment orders according to the provisions set out under Sections 246 to 262 of Chapter XX of the IT Act. An appeal first lies with the Commissioner of Income Tax (CIT Appeals), and must be made within 30 days from the date of assessment order. Alternatively, Section 144C of the IT Act provides for an optional Dispute Resolution Panel (DRP) to speedily adjudicate disputes relating to international transactions, including transfer pricing.
An appeal further lies with the Income Tax Appellate Tribunal within 60 days from the date of the order of the CIT Appeals or the DRP. Thereafter, appeal lies with the respective High Court and finally with the Supreme Court. The limitation period prescribed for appeals is fixed and may only be varied at the discretion of the adjudicating authority and subject to presentation of satisfactory evidence justifying the delay.
Advance pricing agreements
In 2012, the Government introduced an advance pricing agreement (APA) regime with a view to reducing transfer pricing litigation. An APA is an agreement between the tax authority and the taxpayer to determine, in advance, the arm’s length price in relation to an international transaction. Under Section 92CC of the IT Act, the CBDT is empowered to enter into an advance pricing agreement with any person, determining the arm’s length price or specifying the manner in which the arm’s length price is to be determined, in relation to an international transaction to be entered into by that person.
An APA can be of three kinds: unilateral, and bilateral or multilateral APAs involving foreign tax authorities. Once entered, an APA is usually binding and valid for five years, but may be declared void on grounds of fraud or misrepresentation of facts. Primarily, an APA is entered into with the following four objectives:
- Increases tax certainty, as arm’s length pricing is pre-determined;
- Avoids double-taxation, as a bilateral or multilateral APA binds a foreign tax authority;
- Reduces compliance costs, as audit risks are eliminated; and
- Easy transfer pricing documentation.
To strengthen the administrative set up of APA to expedite disposal of applications, Budget 2014 introduced a “Roll Back” provision in the APA scheme, which implies that an APA entered for future transactions may be applied to international transactions undertaken in the previous four years in specified circumstances.
Mutual agreement procedure
In addition to APAs, countries usually agree a mutual agreement procedure (MAP) at the time of concluding double tax avoidance agreements (DTAAs). The procedure is usually contained in Article 25 of the DTAA, which requires two contracting countries to endeavour to amicably resolve tax disputes (by way of arbitration) that arise from the DTAA. As part of its work on base erosion and profit shifting (analysis to be included in part 2 of this article), the OECD is seeking to set out a uniform framework on MAP for countries to apply. However, at the recently concluded meeting of the Group of Twenty (G-20) nations in Australia, India’s representation expressed reservations on introducing a mandatory arbitration clause in tax treaties.
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