Domestic Transfer Pricing

1. Domestic Transfer Pricing Dhinal Shah Chartered Accountant

2. Domestic Transfer Pricing Provisions

3. Domestic Transfer Pricing provisions • Specified domestic transactions (not being an international transaction) between associated enterprises will be subject to transfer pricing compliances at par with the norms applicable to international transactions. [S. 92A(2)]. • In respect of specified domestic transactions, allowance for an expenditure or for allocation of cost or any income shall be computed as per ALP, provided the determination is not likely to result in reduction of income chargeable to tax or result in increase of the loss. [S. 92(2A) and 92(3)] • MAT liability will continue to be as per books.

4. Domestic Transfer Pricing provisions • Specified domestic transaction (SDT) means. • any expenditure in favor of a person referred to in clause (b) of sub-section (2) of section 40A; • any transaction referred to in section 80A; • any transfer of goods or services referred in S. 80-IA (8); • any business transacted as referred in S. 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 or • 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. • The limit of INR 5 Cr. applies to aggregate of all transactions and may be amalgam of certain receipts and certain payments. • Section 40A(2) amended to cover companies which are under control of a related person.

5. Concept of Transfer Pricing • Difference between ‘PRICE’ & ‘TRANSFER PRICE’ • Price Transactions between two unrelated parties • Transfer Pricing Pricing of domestic transactions between two related parties • Due to special relationship between related parties, transfer price may be different than the price that would have been agreed between unrelated parties • A price between unrelated parties is known as the “arm’s length” price

6. Concept of Transfer Pricing Independent entity Related Party • Domestic transactions • Goods • Services • Intangibles • Loans Taxpayer Taxpayer Arm’s length price Transfer price

7. Points to be noted SDT : Significant Transactions which may be impacted • Transfer of goods between related domestic companies eligible for tax holiday and others. • Inter-transfer of goods / services between tax holiday eligible business / units and other businesses / units of the taxpayer in India • Interest, corporate guarantee receipt /payment, cash pooling and related funding transactions between related parties in India Related party under 40 A (2)(b) – Threshold for substantial interest is 20% as against 26% in case of Associated enterprises

8. Transfer Pricing Process Identification of Related Parties Identification of Transactions Subject to Transfer Pricing Determination of Arm’s Length Price (ALP) Benchmarking Analysis Documentation and Certification

9. Benchmarking Specified Domestic Transactions - Methods • Comparable Uncontrolled Price Method • comparison of charged related with price charged independent third price to a party to parties or price charged between two independent parties under similar circumstances • Resale Price Method • generally used in case of distributor/re-seller model with reference to gross profit earned from such transactions • Cost Plus Method • normally used for examining transaction comprising provision of services or manufacturing activities with reference to gross profit earned from such transactions • Profit Split Method • uses complex context where transaction involves intangibles or transaction is complex. In Indian context, the use of this method is very limited • Transactional Net Margin Method • examines net profit margin relative to an appropriate base that a taxpayer realizes from a transaction with related party. This method is widely used and most preferred method • Any other suitable method notified by the Board as per Rule 10AB. Method 1 Method 2 Method 3 Method 4 Method 5 Method 6

10. Domestic Transfer Pricing provisions – Penal consequences • There is likely concealment penalty exposure under section 271(1)(c) w.r.t. variation of income • Explanation 7 to section 271(1)(C) amended to include specified domestic transaction • Non compliance with transfer pricing provisions involve penal consequences. • (S. 271AA). • Failure to keep and maintain documentation. • Failure to report transactions • Maintain incorrect documentation. • Furnish incorrect documentation. • Failure to furnish information triggers 2% of Tr. Value as penalty [S. 271(G)].

11. Domestic Transfer Pricing - Methods

12. Transfer Pricing Methods • All related party transactions (domestic transactions between related parties) have to • be carried out at arm’s length • Arm’s length price is required to be determined by applying the ‘most appropriate’ method out of : • Comparable Uncontrolled Price Method (‘CUP’) • Resale Price Method (‘RPM’) • Cost Plus Method (‘CPM’) • Profit Split Method (‘PSM’) • Transactional Net Margin Method (‘TNMM’) • Any other method that takes into account prices charged or would have been charged under similar circumstances and facts – Rule 10AB

13. Prescribed Transfer Pricing Methods Traditional Transaction Methods Transactional Profit Methods Residuary Method Cost Plus Method CUP* Profit Split Method Any Other Method Resale Price Method TNMM** • Traditional methods generally preferred over transactional profit methods • Legal view is to follow order as they appear in the Act • Residuary method to be adopted in cases where it can be demonstrated that the method satisfies arm’s length test. ** Transactional Net Margin Method * Comparable Uncontrolled Price Method

14. Comparable Uncontrolled Price Method • Usually considered the most appropriate method for all transactions • Compares the price charged in a controlled transaction with the price in an uncontrolled transaction • Requires strict comparability in products, contractual terms, economic terms, etc

15. Comparable Uncontrolled Price Method Identification of price charged or paid in comparable transaction(s) Such price adjusted to account for differences if any between international transaction and uncontrolled transaction(s) Adjusted price arrived above taken to be arm’s length price

16. Comparable Uncontrolled Price Method Related party - Manufacturer B Manufacturer A Non-related party Non-related party A Non-related party B

17. Related Party Related Party S S S S XYZ TP TP ABC CUP CUP UP UP Comparable Uncontrolled Price Method

18. Resale Price Method • Compares the resale gross margin earned by associated enterprise with the resale gross margin earned by comparable independent distributors • An arms’ length gross margin should be sufficient for a reseller to cover its operating expenses and make an appropriate operating profit (in light of its functions and risks) • Preferred method for a distributor buying purely finished goods from a group company (if no CUP available) Related Distributor Manufacturer Unrelated Wholesalers Rs. 100 Rs.75

19. Resale Price Method Identification of resale price by tested party Resale price reduced by normal gross profit with reference to uncontrolled transaction(s) Such price reduced by expenses incurred (VAT, Local levies etc.) in purchase of the product/ services. This price may be adjusted to account for functional and other differences if any Adjusted price arrived above taken to be arm’s length price

20. Resale Price Method Transaction: Puchase of goods from related parties for resale to unrelated parties

21. Cost Plus Method • Compares the gross profit on costs the related party earns with the gross profit on costs earned by comparable independent companies • This method will have better applicability in cases which are covered under Specified Domestic Transaction on account of Sections 80IA(8) or 80IA(10) • Preferred method for: • manufacturer supplying semi-finished goods • company providing services Related Manufacturer B Manufacturer A Cost + 40%

22. Cost Plus Method Identification of direct and indirect costs of production incurred in tested party transactions Identification of normal gross profit with reference to uncontrolled transaction(s) Normal gross profit adjusted to account for functional and other differences if any Adjusted gross profit added to total costs identified in step 1 Sum arrived above is taken to be arm’s length price

23. Cost Plus Method Transaction: Sale of raw material and electronic components by XYZ to related parties

24. Profit Split Method • Appropriate for transactions which are not capable of being evaluated separately • Calculates the combined operating profit resulting from a whole inter-company transaction based on the relative value of each related party contribution to the operating profit • The contribution made by each party is determined on the basis of a division of functions performed, valued, if possible using external comparable data • Applicable for analysing tangible, intangible or services issues

25. Profit Split Method • Use where parties are so interdependent that it is not possible to identify closely comparable transactions • Based on expected rather than actual profits • Requires consolidated Profit & Loss numbers i.e. both parties • How would profits be split between related parties? • Relies heavily on the judgement of the profit splitter • Complex Method

26. Profit Split Method Determination of combined net profit of the related parties arising out of international transaction Evaluation of relative contributions by each enterprise on the basis of functions performed, risks assumed and assets employed Splitting of combined net profit amongst enterprises in proportion to their relative contributions Profit thus apportioned to the tested party is used to arrive at the arm’s length price

27. Transactional Net Margin Method • Examines net operating profit from transactions as a percentage of a certain base (can use different bases i.e. costs, turnover, etc) in respect of similar parties • Ideally, operating margin should be compared to operating margin earned by same enterprise on uncontrolled transaction • Can compare to “comparable transactions” between independent parties • Applicable for any type of transaction and often used to supplement analysis under other methods • Most frequently used method in India, due to lack of availability of comparable uncontrolled prices and gross margin data required for application of the comparable uncontrolled price method/ cost plus method/ resale price method

28. Transactional Net Margin Method\ Computation of net profit as a percentage of a certain base realised from the international transaction. Computation of net profit as a percentage of a certain base realised from the international transaction. Computation of net profit realised by the tested party or an unrelated enterprise in a comparable uncontrolled transaction Computation of net profit realised by the tested party or an unrelated enterprise in a comparable uncontrolled transaction Net profit from uncontrolled transaction adjusted to account for differences if any Net profit from uncontrolled transaction adjusted to account for differences if any The net profit thus established is taken into account to arrive at an arm’s length price for the international transaction

29. Any Other Method • Rule 10AB has been inserted by IT (Sixth Amdt.) Rules, 2012 w.r.e.f 1 April 2012 (effective for assessment year 2012-13 and subsequent years) • Any method that takes into account the price that has been charged or paid or would have been charged or paid, for the same or similar un controlled transaction, with or between non-associated enterprises, under similar circumstances considering all the facts, shall be regarded as one of the recognized methods for determining the arm’s length price

30. Comparables • All methods require comparables • Transfer price is set/ defended using data from comparable transactions • Comparable transaction should be independent and similar to tested transactions • Factors for judging comparability (Rule 10C(2)): • nature of transactions undertaken (i.e. type of good, service etc.) • company functions • risks assumed • contractual terms (i.e. similar credit terms) • economic and market conditions

31. Compliances

32. Filing form 3ceb • CBDT has issued a notification dated 10 June 2013 notifying the rules and certificate for reporting specified domestic transactions • The existing rules have been amended to include specified domestic transactions • Further Form 3CEB has been amended to include Part C which contains reporting of specified domestic transactions undertaken by the assessee • Accordingly every assessee who has entered into specified domestic transactions will now have to obtain the auditors report in Form 3CEB and file the same with the Income Tax Department • The amended rules comes into effect from 1 April 2013 • E-filing of Form 3CEB has been made mandatory from AY 2013-14

33. Annexures to Form 3CEB

34. Annexures to Form 3CEB (contd)…

35. Annexures to Form 3CEB (contd)… 35

36. Annexures to Form 3CEB (contd)… 36

37. Annexures to Form 3CEB (contd)… 37

38. Annexures to Form 3CEB (contd)… 38

39. TP Documentation • Legal requirement [Sec. 92D read with Rule 10D] • Helps taxpayer in discharge of “burden of proof” that transactions are at arm’s length • Captures relevant aspects of price determination mechanism in controlled transactions • Economically significant • Functions • Assets • Risk • Other relevant factors (such as ‘business strategies’, ‘special circumstances’, etc.) • Facilitate TP audit and evaluation by tax authorities • A good defense against TP litigation • Greater the complexity and unusualness of the case, more importance is attached to documentation. • Cost, time and efforts involved vis-à-vis likely benefits and importance need to be evaluated T.P.Ostwal & Associates 39

40. Rule 10D-Documentation Requirements Entity related Price related Transaction related -Profile of industry -Transaction terms -Agreements -Profile of group -Functional Analysis -Invoices -Profile of India entity ( function, assets and risks) -Pricing related correspondence -Profile of associated enterprises -Economic analysis (letters, emails etc) (method selection, comparable benchmarking) -Forecasts, budgets, estimates -Contemporaneous documentation requirement- Rule 10D Documentation to be retained for 8 years No specific documentation requirement if the value of international transaction / SDT * is less than one crore rupees * Section 92D refers to documentation as prescribed by Rule 10D, however there has not been corresponding amendment in Rule 10D with respect to providing relief from documentation requirement where value of SDT does not exceed 1 crore as is available in case of international transactions. However going by legislative intent such relief should also be available in case of SDT as well.

41. Critical Challenges

42. Benchmarking of Managerial Remuneration • Section 40A(2)(b) includes remuneration paid to the management. • Benchmarking of management remuneration in itself is challenge. • There are no uncontrolled comparable transactions are available owing to the fact that management remuneration in all cases is a related party transaction. • Salary of directors is determined by the management based on several factors viz qualifications, experience which are individual traits and varies from company to company. • Certain judicial precedents have accepted the view that if the managerial remuneration is within the limits prescribed in the Companies Act, 1956, the same is a reasonable expenditure under section 40A(2)(b).

43. Allocation of common expenses • Deduction under section 80IA is available to eligible units • As per section 80 IA(5), profits of eligible units are to be computed as if the eligible units are the only source of income. • The common expenses incurred by the Head Offices are considered as an expense of the eligible units . • Therefore the expenses of head office which may control the business of the eligible unit must be apportioned to arrive at the eligible profit. • It has been noted that in many cases, the revenue officials contend that the allocation of common expenditure done by the taxpayer is flawed.

44. Allocation of common expenses • Revenue has regularly contended that taxpayer has allocated more expenses to a non-tax incentive unit and fewer expenses to a tax-incentive unit. • This act of the taxpayer is aimed at decreasing the income which is subject to incidence of tax • It is desirable if some guidance could be provided on the manner in which the common expenditure should be allocated between various units of the taxpayer. • Absence of necessary guidelines to allocate the expenditure has resulted into lack of achieving consistency in allocation of expenditure and increase in litigations.

45. Meaning of ‘Close Connection’ • Section 80-IA(8) covers business transactions undertaken by a taxpayer claiming tax holiday with other entities having ‘close connection’ with the taxpayer. • The term ‘close connection’ has not been expressly defined in the Act. • For this reference could be drawn from other provisions of the Act to define ‘close connection’ as under: • ‘Substantial interest’ as defined under section 40A(2)(b); • ‘Associated Enterprises’ as defined under section 92A(2); and • ‘Related party’ defined as per Accounting Standard – 18 issued by ICAI • It is desirable if some guidance could be provided on the manner in which the common expenditure should be allocated between various units of the taxpayer.

46. Ordinary Profits v. Arm’s Length Profits • Section 80-IA (10): Where the Revenue authorities believe that the tax holiday undertaking produces more than ordinary profits due to a close connection with any person, only a reasonable level of profits will be eligible for the tax holiday benefit. • For domestic transfer pricing, ordinary profits for tax holiday units would need to be determined having regard to the arm’s length principle and the transfer pricing methods. • If price based method (say, the Comparable Uncontrolled Price method) has been applied to benchmark the transaction between and a person closely connected with it, the derived profits may be considered as ordinary profits, in view of absence of horizon of the comparables margin.

47. Ordinary Profits v. Arm’s Length Profits – Cont’d… • Where arm’s length price is benchmarked using profit based methods (such as net margins of comparable companies), a question arises as to whether tax holiday benefits will be denied when the tested party has earned profits in excess of ALP i.e. higher than the arithmetic mean operating margin of comparables. • There needs to be a clarification to define and indentify ‘more than ordinary profits’, especially where the legislation contemplates profits and not merely ordinary ‘profit’. • For domestic transfer pricing, ordinary profits for tax holiday units would need to be determined having regard to the arm’s length principle and the transfer pricing methods.

48. Some other issues and challenges • Section 40A(2)(b) • Whether indirect shareholding is covered for considering transactions under section 40A(2)(b)? • Whether shareholding of individual Directors can be aggregated for determining substantial interest? • Whether each member is a relative in case of Association of Persons (‘AOP’)? • Section 80IA(8) & 80IA(10) • Issues in claiming corresponding credit when both units are eligible for tax holiday • Whether the term “more than ordinary profit” can be equated with ALP? • Common • Grandfathering of long term contracts / agreements? • Whether Capital account transactions are covered under the scope of specified domestic transactions?

49. Case Studies

50. CASE STUDY 1 50