Conceptual Framework of Transfer Pricing
Introduction & Need:
Through the advent of the Globalization, multinational companies (MNCs) are prominently engaged in establishing their presence worldwide. They can enjoy the privileges of doing the trade practices with their related/connected parties in various parts of the globe as compared to the companies dealing with unrelated/unconnected parties. Today, MNCs face a real challenge in adopting the TP Methodologies to distribute their profits fairly among the companies in the group. On the other hand, jurisdictional tax authorities are enforcing the TP regulations and provisions to avoid the loss of respective tax revenue. Therefore, to have the fair division of taxable profits among different tax jurisdictions worldwide and to address the international double taxation issues there arose a need to introduce Transfer Pricing (the “TP”) principles & regulations.
The OECD Model Tax Convention of Income and Capital (OECD Model convention) focuses on the guidelines for taxing the MNCs through Double Tax Avoidance Agreements (DTAA Tax Treaties) between OECD members and OECD member and non-OECD member countries.
Terminologies in Transfer Pricing Principles:
- the price or consideration charged by,
- an enterprise transferring any physical goods or facilities or services or benefits
- to its associated enterprise or enterprises (the “AEs”)
- in a transaction.
- the mechanism
- to arrive at the transfer price
- for tax purposes
- charged between two or more AEs
- functioning in different countries in the globe.
- of a transaction between two or more AEs is the price/consideration
- that would have been charged or paid
- as if the comparable transaction had taken place
- between two or more unrelated enterprises
- under given commercial terms.
As per OECD Model Tax Convention:
“Where conditions are made or imposed between two associated enterprises in their commercial or financial relations which differ from those which would be made between independent enterprises, then any profits which would, but for those conditions, have accrued to one of the enterprises, but, by reason of those conditions, have not so accrued, may be included in the profits of that enterprise and taxed accordingly.”
In simple terms, Arm’s length principle aims at recalculating the taxable profits of the AEs where actual transfer prices or terms are compared with the arm’s length prices or terms.
As per the provisions of Section 92A of Income Tax Act, 1961 (the “Act”), AEs refer to following situations:
- where one enterprise participates, directly or indirectly, or through one or more intermediaries, in either management or control or capital of the other enterprise
- where one or more persons participate, directly or indirectly, or through one or more intermediaries, in either management or control or capital of two different enterprises
- two enterprises fall under any or more of the situations prescribed under the said section 92A(2) of the Act (Deemed Associated Enterprises)
As per the provisions of Section 92B of the Act international transaction means,
- a transaction between two or more AEs
- either or both of whom are non-residents and
- where such transaction is sale/purchase/lease of tangible/intangible property or provision of services or lending/borrowing money or having an impact on profits, income, losses or assets of the said enterprises or
- includes mutual agreement or arrangement for the allocation or apportionment of, or any contribution to, any cost or expense referred to in Section 92(2) of the Act.
Further, if a transaction is entered into by an enterprise with unrelated party,
- under prior agreement between unrelated party and the AE of the enterprise for the relevant transaction or,
- if the terms of the relevant transaction are determined in substance by the unrelated party and AE and
- either enterprise or the AE or both are non-residents
then, such transaction will be treated as deemed international transaction irrespective of the residential status of the unrelated party.
- As per the Section 92BA of the Act for an enterprise SDT means any of the following transaction, not being an international transaction, viz.,
- any transaction referred to in Section 80A of the Act, or
- any transfer of goods or services referred to in Section 80-IA(8) of the Act or
- any business transacted between the enterprise and other person referred to in Section 80-IA(10) of the Act or
- any transaction referred to in any other section under Chapter VI-A or Section 10AA of the Act, to which provisions of the sections 80-IA(8) or 80-IA(10) are applicable or
- any other prescribed transaction
- and where the aggregate of such transactions exceeds a sum of twenty crore rupees during the respective previous year.
Relevant provisions in connection with the Indian TP Regulations in Income Tax Act, 1961 and Rules framed accordingly:
Computation of ALP
Following are the prescribed methodologies used in determination of ALPs:
- Comparable Uncontrolled Price (CUP) Method:
- Compare transaction price
- Most direct method
- Can be used in all cases where comparable prices available
- Resale Price Method (RPM):
- Comparison of gross margins
- Mostly used in case of distributors without significant value add
- Cost Plus Method (CPM):
- Comparison of cost (direct and indirect) plus margins
- Mostly used in case of service providers or semi-finished goods
- Profit Split Method (PSM):
- Can be residual or contribution-based profit split. Used in cases involving creation of intangibles and complex inter-linked transactions
- Transactional Net Margin Method (TNMM):
- Comparison of net profit margins
- Most widely used
- Other Method as per Rule 10AB:
- Can use price which has been or would have been charged or paid
- E.g.: valuation certificates, quotations, etc.
Functions, Asset & Risk (FAR) Analysis
FAR Analysis is a method of finding and organizing facts about a business in terms of the functions performed, assets used (including intangible property) and risks assumed by such business to:
- identify how they are divided among the AEs; and
- assess the importance of each function in the overall value chain.
FAR analysis is the starting point in determining the arm’s length price. This is the most critical information for the purpose of comparability analysis and forms the base for selecting comparable companies/ transaction. Sources for conducting FAR analysis are agreements, interviews with client personnel, questionnaires, etc.)
Key points to FAR analysis and Approach
- Identify economically significant risks with specificity.
- Determine how specific, economically significant risks are contractually assumed by the associated enterprises under the terms of the transaction.
- Determine through a functional analysis how the associated enterprises that are parties to the transaction operate in relation to assumption and management of the specific, economically significant risks, and in particular which enterprise or enterprises perform control functions and risk mitigation functions, which enterprise or enterprises encounter upside or downside consequences of risk outcomes, and which enterprise or enterprises have the financial capacity to assume the risk.
- Steps 2-3 will have identified information relating to the assumption and management of risks in the controlled transaction. The next step is to interpret the information and determine whether the contractual assumption of risk is consistent with the conduct of the associated enterprises and other facts of the case by analysing (i) whether the associated enterprises follow the prescribed contractual terms and (ii) whether the party assuming risk, as analysed under (i), exercises control over the risk and has the financial capacity to assume the risk.
- Where the party assuming risk under steps 1-4(i) does not control the risk or does not have the financial capacity to assume the risk, apply the guidance on allocating risk.
- The actual transaction as accurately delineated by considering the evidence of all the economically relevant characteristics of the transaction as set out in the prescribed guidance, should then be priced taking into account the financial and other consequences of risk assumption, as appropriately allocated, and appropriately compensating risk management functions.
TP documentation and drafting
- Every person who has entered into an international transaction or specified domestic transaction (‘SDT’) shall keep and maintain such information and document in respect thereof, as may be prescribed.
- TP documentation to be submitted within 30 days from date of receipt of notice issued.
- 30 more days may be allowed on filing an application before Assessing Officer/ Commissioner (Appeals).
Rule 10D: (Form 3CEB)
- Elaborate list of documentation to be maintained by the assessee to substantiate that the international transactions has been undertaken in accordance with arm’s length principles.
- TP documentation may not be required to be maintained in case value of international transaction as recorded in the books of account does not exceed INR 1 crores.
Process of TP Documentation:
- Understanding of taxpayer’s business
- Analysis of international transactions, FAR and characterisation
- Selection of Tested Party
- Selection of Most Appropriate Method
- Identifying potential comparable companies
Sections in TP Report and corresponding Rule 10D requirements:
- Business Overview:
- Ownership structure of the assessee
- Profile of multinational group and each of the associated enterprise (AEs)
- Description of the business of the assessee and AEs
- Industry Overview:
- Description of the industry in which the assessee operates
- Overview of international transactions and Functional Analysis
- Details, quantum and the value of each transaction
- Nature and terms of international transactions
- Description of functions, assets and risks of the assessee and AEs
- Economic Analysis
- Record of uncontrolled transactions
- Record of economic and market analyses performed to evaluate comparability of uncontrolled transactions
- Description of the methods considered for determining the arm’s length price (ALP) – Selection of most appropriate method
- Record of determination of the ALP – comparable data and financial information used in analysis
- Critical assumptions, policies and price negotiations
- Details of the adjustments made to transfer prices, if any
Country by Country Reporting (CbCR) – Section 286 and Rule 10DB:
(Forms 3CEAC, 3CEAD, 3CEAE)
- CbCR is applicable to taxpayers having an annual consolidated group turnover of over INR 5,500 crore (750 million EUR as suggested in Action 13) in the immediately preceding financial year;
- CbCR is to be filed with the ultimate parent’s (or nominated entity’s) home tax authority
(to be shared via the automatic information exchange mechanism);
- Notification to be filed by constituent entities in form 3CEAC within 10 months from the end of the reporting accounting year;
- Every constituent entity in India, of an international group having parent entity that is not resident in India, shall provide information regarding the country or territory of residence of the parent of the international group to which it belongs. This information shall be furnished to the prescribed authority on or before the prescribed date;
an entity in India belonging to an international group shall be required to furnish CbC report to the prescribed authority if the parent entity of the group is resident:
- where the parent entity is not obligated to file the CbC report;
- in a country with which India does not have an arrangement for exchange of the CbC report; or
- such country is not exchanging information with India even though there is an agreement; and this fact has been intimated to the entity by the prescribed authority.
Master File Applicability- Rule 10DA
Group entities where:
- Revenue threshold – Consolidated Group revenue > than INR 500 Crores; and
- Transaction threshold:
- International transactions > INR 50 crores OR
- Intangibles related transactions > INR 10 Crores
- To be filed in Form No. 3CEAA;
- Due date of tax return;
- For multiple group entities, one entity to be designated and notified 30 days before the due date of filing the MF (Form 3CEAB);
- Constituent entities not fulfilling the thresholds to file certain general information – Form 3CEAA (Part A)