Presentation on Specific Domestic Transactions CA Hiren D. ShahAhmedabad Email: email@example.com
Introduction • TP was earlier limited to ‘International Transactions’ • The Finance Act 2012, extends the scope of TP provision to ‘Specified Domestic Transactions’ between related parties w.e.f. 1 April 2012 • The SC in the case of CIT vsGlaxoSmithkline Asia Pvt Ltd [2010-195Taxman 35 (SC)] recommended introduction of domestic TP provisions • SDT previously reported/certified but onus on revenue authorities • Obligation now on taxpayer to report/ document and substantiate the arm’s length nature of such transactions • Shift from generic FMV concept to focused ALP concept • These new provisions would have ramifications across industries which benefit from the said preferential tax policies such as SEZ units, infrastructure developers or operators, telecom services, industrial park developers, power generation or transmission etc. Apart from this, business conglomerates having significant intra-group dealing would be largely impacted
ALP FMV Implication post - budget 2012 for SDT Six methods prescribed for computing ALP No method prescribed for computing FMV Contemporaneous documentation required to be maintained No documentation required to be maintained Accountant’s report signed by a CA to be filed Other than reporting in tax audit report, no statutory compliance Assessment done by the TPO Assessment done by the AO
Intent of Indian TP Regulations (International transactions) Shifting of Profits India Overseas Associated Enterprise (AE Co.) Indian Co. Tax @ 32.45% Tax @ lower rate approx 10% Shifting of Losses Tax Saving for the Group – Loss to Indian revenue
Intent of Indian TP Regulations… (Domestic transactions) India India Shifting of expenses/losses Indian Co. Tax Holiday undertaking Related Enterprise in Domestic Tariff Area (DTA) Tax Exemption Tax @32.45% Shifting of income/profits Tax Saving for the Group – Loss to Indian revenue
Intent of Domestic TP–Domestic Tariff Area (DTA) Scenario 1 Scenario 2 Particulars Co.A Co.B Particulars Co.A Co.B Taxed in India @ 33% 33% Taxed in India @ 33% 33% Sales to RP 150 - Sales to RP 100 - Other Income 200 400 Other Income 200 400 Purchases from RP - 100 150 Purchases from RP - Other Expenses 400 200 Other Expenses 400 200 Profit/Loss (50) 50 Profit/Loss (100) 100 Tax - 17 Tax - 33 Total Tax for the Total Tax for the 33 17 Group Group By shifting of expenses from a loss making company to a profit making company, the group could reduce its tax liability by 16.
Intent of Domestic TP–DTA & Tax Holiday Unit Scenario 1 Scenario 2 Particulars Power DTA Particulars Power DTA Taxed in India@ 0% 33% Taxed in India@ 0% 33% Sales to RP 225 - Sales to RP 150 - Other Income 300 600 Other Income 300 600 150 225 Purchases from RP - Purchases from RP - Other Expenses 300 300 Other Expenses 300 300 Profit/Loss 225 75 Profit/Loss 150 150 Tax - 25 Tax - 50 Total Tax for the Total Tax for the 25 50 Group Group By shifting of expenses from a tax holiday unit(Power ) to a unit in the Domestic Tariff Area, the group could reduce its tax liability by 25. To avoid such cases, Domestic TP was introduced.
What is Specified Domestic Transaction? Explanation Payment made or to be made for expenditure incurred with domestic related parties Aggregate transaction value exceed INR 50 million in a financial year Expenditure incurred between related parties defined u/s 40A(2)(b) Section 80IA(8) – Any transfer of goods/services between various undertakings or units of the assessee. Transfer at market value. Onus on tax payer. Section 80IA(10) – More than ordinary profits derived from closely connected persons for claiming deduction to be brought down to reasonable profits. Primary onus on tax payer. Onus on tax authorities as well • Undertaking to which profit linked deductions are provided, covering: • Inter-Unit transfer of goods and services – 80 IA (8) & • Transactions between entities having close connection and generating more than ordinary profits – 80 IA (10) 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
CONCEPT OF ARM’S LENGTH PRICE (ALP) • Concept of ALP applicable for determining taxable income arising from international transaction introduced in 2001, now extended to SDTs • ALP defined to mean a price which is applied or proposed to be applied in a transaction between persons other than AEs, in uncontrolled conditions • Comparability and FAR fundamental to the concept of ALP • Comparison of conditions in a controlled transactions with conditions in transactions between uncontrolled enterprises • Compensation usually reflects functions performed (taking into account assets used and risks assumed) • ALP concept usually relevant for transactions between “separate enterprises”; may need to be applied by analogy to SDT involving inter-unit transfer of goods/ services
What is Arm’s Length Pricing? • “Arm’s length price” means a price which is applied or proposed to be applied in a transaction in uncontrolled conditions • Arm’s Length price is determined using the Most Appropriate Method : • If more than one comparable price is obtained using above methods, then the arm’s length price would be ‘Arithmetic Mean’ of comparable prices • Deviation of plus / minus three percent is permitted from arm’s length price
Fair Market Value vs. Arm’s Length Price • Domestic Transfer Pricing usher shift from generic ‘Fair Market Value’ concept to Arm’s Length Pricing
Methods for Determination of ALP • Price applied in a transaction between independent enterprises in uncontrolled conditions • To be determined by applying the Most Appropriate Method, being one of the following five methods • Comparable Uncontrolled Price (CUP) Method • Resale Price Method (RPM) • Cost Plus Method (CPM) • Any other method • Profit Split Method (PSM) • Transactional Net Margin Method (TNMM) • In case, more than one price is determined by MAM: • Apply Arithmetic mean • Range of + 3% of the arithmetic mean Traditional transaction methods Transactional profit methods
Comparable Uncontrolled Price Method: • Comparison of price charged to a related party with the price charged to independent third parties or price charged between two independent parties under similar circumstances. Resale Price Method (‘RPM’): • This method is generally used in the case of distributor or re-seller model with reference to gross profit earned from such transactions.
Cost Plus Method: • CPM is used for examining transactions comprising provision of services or manufacturing activities with reference to gross profit earned from such transactions. Profit Split Method (‘PSM’): • It is used where transaction involves intangibles or transaction is complex. In the Indian context, the use of this method is very limited.
Transactional Net Margin Method (‘TNMM’): • The method examines net profit margin relative to an appropriate base that a taxpayer realises from a transaction with related party. This method is widely used and the most preferred method. Any other Method: • It can be any method which can help in determining the arm’s length price (ALP) of the transaction.
KEY PROVISIONS OF SDT • S. 40A(2) • S. 80A(6) • S. 80IA(8) • S. 80IA (10)
Legislature intention behind insertion of Section 40A(2) • To check evasion of tax through excessive or unreasonable payments to relatives and associate concerns and should not be applied in a manner which will cause hardship in bona fide cases. • AO is expected to exercise his judgment in a reasonable and fair manner
Reasonableness of expenses to be judges having regards to • Fair market value of the goods, services or facilities for which the payment is made, or • The legitimate needs of the business or Profession • The benefit derived by or accruing to the assesse from the expenditure • The above view is expressed by Hon’ble Guj High Court in the case of Coronation Flour Mills vs. Asst. CIT [ 2009] 314 ITR 1
Type of transactions covered (illustrations for payments made by a Company) … 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) Case 1 - Director or any relative of the Director of the taxpayer – Section 40A(2)(b)(ii) 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 4 – Any other company carrying on business in which the first mentioned company has substantial interest – Section 40A(2)(b)(iv) 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) Assessee (Taxpayer) C Ltd Mr. D Director Substantial interest >20% Relative Assessee (Taxpayer) Substantial interest >20% Substantial interest >20% A Ltd Substantial interest >20% A Ltd B Ltd Mr. C 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) Substantial interest >20% Assessee (Taxpayer) Mr C A Ltd Director Assessee (Taxpayer) Substantial interest >20% Relative B Ltd Substantial interest >20% Mr B D Ltd Covered transactions Holding Structure
Domestic TP may even apply to cross border transactions • Generally, Domestic TP covers domestic transactions. However it does not indicate that a SDT should not be a cross border transaction. • It does not also mean that both parties should necessarily be residents. • Example: Payment to a non-resident director covered u/s 40A(2)
Categories of assessee not covered u/s 40A(2) • Person indirectly related circular No. 61 dated July, 6 1968 • Body of Individuals • Co-operative Societies • Trust
Expenditure • Scope of section is restricted only to disallowance of any expenditure incurred. • 40A(2) cannot be applied in a case where no expenses have been claimed as a deduction by the assessee. • It does not embark upon measuring the reasonableness of income earned by the assessee for the related party transaction in the nature of income not covered. (sale at a lower price or trade discount)
Notional Income • International TP gives tax authorities authority to impute notional income while it is not possible in case of domestic TP. • Domestic TP may best lead to disallowance of excessive expenditure as only expenditure is covered by section 40A(2) of the Act. • Only certain capital expenditure covered (fully claimed as deduction)
Tax burden, if transaction not at ALP Y Ltd. (non-tax holiday) X Ltd. (non-tax holiday) Disallowance of ` 20 to Y Ltd [40A(2)(b)] 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 ` 120 v/s ALP i.e. ` 100 Inefficient pricing structure – reduced tax holiday benefit since sale price is lower than ALP X Ltd. (tax holiday) Y Ltd. (non-tax holiday) Sale at ` 80 v/s ALP i.e. ` 100
S.80A(6) & S.80 IA(8) • SDT provisions apply to business transactions/ transfers referred to in section 80A, 80IA(8), 80IA(10), 10AA, Chapter VI-A provisions Section 80A(6) and Section 80IA(8) require adjustment to tax holiday profits where • Goods and services of eligible business are transferred to any other business carried on by the same taxpayer and vice versa • Consideration for such transfer as recorded in the accounts of eligible business does not correspond to market value of such goods/ services • In such cases, tax authorities/ taxpayer required to re-compute tax holiday claim by reference to ALP of such goods/ services
Overlap between 80A(6) and 80IA(8) not of much consequence • Is in the nature of notional adjustments for determining profits eligible for tax holiday • Applies to all tax holiday claims under Chapter VI-A/ Section 10AA • Onus on tax payer to establish that goods and services transferred at market value.
Other Sections under Chapter VI-A......to which s. 80-IA(8) or (10) are applicable
Section 80IA (8) & 80IA (10) – Deduction in respect of profits and gains from industrial undertaking or enterprise engaged in infrastructure development, etc. • 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
Close connection • The language used in Section 80IA (10) states that “owing to the close connection ……………. the course of business is so arranged”. • However, the ‘close connection’ used in Section 80 IA(10) has not been defined in the Act. • Hence, for the purpose of this section, close connection is only a method of ascertaining as to whether there is any arrangement made by the assessee for inflating the eligible profits. • But one cannot presume the existence of close connection or possibility of arrangement for earning more than ordinary profits. • UnlikeSection 40A(2)(b), 92A, even though the scope of Section 80IA (10) has been left wide and open to cover any transaction, as long as the AO cannot substantiate that the course of business has been so ‘arranged’, owing to whatever reasons, Section 80 IA (10) can not be invoked.
Close connection? Particulars AS-18 40A(2)(b) 92A(2) Voting Power >50% >=20% >=26% Direct or indirect Both Direct Both holding Directors Key Managerial Directors Not covered Personnel Key Suppliers Specifically excluded Not covered More than 90% supplies
Key differences in the provisions relating to Domestic TP and International TP
Types of Transactions covered: • International TP inter alia covers both income and expenditure transactions while Domestic TP covers transactions of expenditure only ie transactions covered u/s 40A(2). • As regards other transactions falling under sections 80A(6)/ 80-IA(8)/ 80-IA(10)/ 10AA of the Act specified for Domestic TP purposes, both expense or profit from transactions are covered.
Shareholding criteria for applicability of TP Provisions • International TP provisions prescribe a shareholding criteria of 26% for applicability of TP while under Domestic TP a beneficial owner of shares carrying not less than 20% of voting power or beneficially entitled to share not less than 20% of profits shall be treated as a person covered u/s 40A(2). • Indirect shareholding is covered under International TP while clarity is not there in this regard in case of Domestic TP.
Most Likely effected Industries.. • Industries operating in SEZs • Infrastructure Developers • Infrastructure Operator • Telecom Services • Industrial Park Developers • Power Generations or Transmission
Most Likely Transactions under Scanner of SDT • Interest free Loans to Group Companies Sub section 8 of Section 80IA • Granting of Corporate Guarantees/ Performance Guarantees by Parent Company to its subsidiaries Sub section 8 of Section 80IA • Intra-group purchase/ sell/ service transactions Sub section 8 of Section 80IA • Payment made to key personnel e.g. transaction with Directors/CFO/CEO etc.. Section 40A(2)(b) • Payment made to key personnel of Group Companies. Section 40A(2)(b) • Payment made to relative of key personnel of the assessee/group companies. Section 40A(2)(b)
Critical Issues…….. • Provisions applicable only to expenditure where payment is made or to be made • Does this include capital expenditure? – Section 40A(2)(b) • Does this include transactions without consideration? – Section 80IA(8) & 80IA(10) • Does threshold apply to the amount recorded in the Books of Account or Amount determine as per ALP? • Wide coverage and goes beyond the related parties covered under AS-18 • Whether Government approval u/s 295, 297 of the Companies Act would be relevant?
Critical Issues…….. • Applicability of OECD TP guidelines • Advance Pricing Arrangement • Benefit of range • Corresponding adjustment
Difficult to establish Transactions at ALP • Commission to relatives of the directors/ partners • Salary paid to the relatives of the directors/Partners • Remuneration to the directors • Extra Purchase Price and Interest foregone to relatives • Good sold at lower than market price if bona fide • Higher Purchase Price than rates prevailing in the market • Interest paid to sister concerns at rate higher than normal rates • Hire Charges of Machinery or Rent paid for use of Immovable property