Transcript PROFITS METHOD – PROFIT SPLIT METHOD (‘PSM’)

NATIONAL CONFERENCE ON DIRECT TAXES
DOMESTIC TRANSFER PRICING
– EMERGING ISSUES
NEERAJ K. JAIN
VAISH ASSOCIATES ADVOCATES
Contents

Introduction of Domestic Transfer Pricing

Specified Domestic Transactions

Specified domestic transaction in terms of Section 40A

Specified domestic transaction in terms of Section
80IA/IB/IC/ID/ID/10AA

Case Studies

Concept of Arms Length Price

Compliance and Penalties
2
INTRODUCTION
3
INTRODUCTION

Application of Transfer Pricing provisions was earlier
limited to “International Transactions”- to prevent
shifting of profits MNEs from one jurisdiction to other.

TP provisions contained in Chapter-X- self contained code provide mechanism for determining ALP.

Although determination of arm’s length price is enshrined in
various sections, viz., 40A(2), 80-A, 80-IA, etc., between related
domestic parties, no rules or methods was prescribed for such
determination.

4
INTRODUCTION

An obiter dicta by the Supreme Court in the case of
CIT Vs. Glaxo SmithKline Asia (P) Ltd. 236 CTR
113(SC) is the genesis for introduction of Domestic
TP , applying chapter X to specified domestic
transactions (SDT).

In that case:
- SLP against order by DHC in a writ petition by
the Revenue on a stay order by the ITAT .
- payment of allocated cost by GSKAP to GSKCH.
5
INTRODUCTION
 The
SC noted that In the case of domestic
transactions, the under-invoicing of sales
and
over invoicing of expenses ordinarily will be
revenue neutral in nature, except in two
circumstances having tax arbitrage:
[i] If one of the related Companies is loss making
and the other is profit making and profit is shifted
to the loss making concern; or
[ii] If there are different rates
6
INTRODUCTION
 The
SC observed that :
(i) To get over this situation, the matter needs to be examined by
Central Board of Direct Taxes CBDT.
(ii) The law can be amended to comply with Rule 10 D in respect
of domestic related party transactions.
(iii) The AO could be empowered to make adjustment to the value
of transactions based on TP methods.
 Based on the feedback from the Solicitor General appearing in
that case the SC noted “We are informed that the matter has been
examined by CBDT and it is of the view that amendments would
be required to the provisions of the Act if such Transfer Pricing
Regulations are required to be applied to domestic transactions
between related parties under Section 40A(2) of the Act.”
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INTRODUCTION
The purpose
transaction-

8
of
introduction
of
specified
domestic

To
prescribe
mechanism
to
determine
reasonableness of expenditure or income in related
party transactions having regard to arm’s length
principle.

To provide objectivity and avoid tax arbitrage

To provide legally enforceable obligation by shift
onus on taxpayer to maintain proper documentation
INTRODUCTION

Section 92BA was introduced in chapter X for applying,
Transfer Pricing regulation to specified domestic related
party transactions, for computation of allowance of
expenditure or interest or allocation of any cost or income
for the purpose of section 40A(2), 80A ,80-IA, 10AA, etc.
by Finance Act, 2012.

The Transfer Pricing provision for domestic transaction
exists in many countries, e.g., US. UK. China, Indonesia,
Netherlands with exceptions like Australia, Japan, etc.

However,such provisions are generally made applicable in
situations where there is perceptible risk of tax evasion.
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INTRODUCTION

Countries like UK provide mechanism of set off to other
party in case Transfer Pricing adjustment results in
double taxation.

No corresponding adjustment in Indian TP regulation
10
SPECIFIED DOMESTIC TRANSACTIONS
11
SPECIFIED DOMESTIC TRANSACTIONS

Specified domestic transactions are defined in section
92BA any of the following transactions, not being an
international transaction, namely:—
(i) any expenditure for which payment made or to be made
to a person covered u/s 40(A)(2)(b)
(ii) any transfer of goods and services between eligible
units and non eligible unit of two associate of an
undertaking- 80(IA)(8)
(iii) Any business transaction with entities having close
connection – 80 (IA)(10)
(iv) Any transaction referred in sections 80A ,80-IA, 10AA,
etc. to which sub sections(8) /(10) of section 80(IA)
applies.
(iv) Any other transaction as may be specified.
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SPECIFIED DOMESTIC TRANSACTIONS

Scope of TP provision extended to also include
Specified Domestic Transactions:

Expenditure for which payment is made or to be
made to domestic related parties:

Tax Holiday / Deductions claimed by the assessee
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
Transfer of goods or services between various
businesses of same assessee

More than ordinary profits derived from
transactions with closely connected persons
SPECIFIED DOMESTIC TRANSACTIONS

Sub-section (2A) inserted in section 92 providing that
“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”.

Determination of arm’s length price of each of the
specified domestic transaction would have to be made
qua the respective provisions ,eg. 40A(2), 10AA, 80A,
80IA, etc.
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SPECIFIED DOMESTIC TRANSACTIONS

In respect of Specified Domestic Transaction, an
allowance for an expenditure or allocation of any cost or
expense or income shall be computed as per ALP and
however, no computation shall be made which result in
reducing income or increasing loss. Sec 92(2A) or 92(3)
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SPECIFIED DOMESTIC TRANSACTIONS

Domestic Transfer Pricing is applicable only where value
of Specified Domestic Transactions crosses 5 Crs

While computing the aggregate value of transactions:

Value of the International transactions to be excluded

Value of transactions between 2 units of the same
company to be covered (when undertaken with a tax
holiday unit)

Inter-company transactions to be covered (when
undertaken with a company having a tax holiday unit)
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SPECIFIED DOMESTIC TRANSACTIONS
Aggregate Value of
transaction below INR 5
Cr
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Aggregate Value of SDT
above INR 5 Cr
Subject to existing
tax laws
Subject to Domestic
Transfer
Pricing regulations
Fair Market Valueinitial onus on the
AO
Arms Length Priceinitial onus on the
Assessee
CONCEPT OF ALP
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CONCEPT OF ARMS LENGTH PRICE

Arm’s length price means a price which is applied or proposed
to be applied in a transaction in uncontrolled conditions between
persons other than AEs [Section 92F(ii)].
Independent
enterprise
Related Party
Domestic Transactions




Resident
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Goods
Services
Intangibles
Loans
Resident
CONCEPT OF ARMS LENGTH PRICE

Arm’s length price is determined using the most appropriate
method (Sec 92C):
Methods
Comparable
Uncontrolled
Price Method
Cost
Method
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Applicability
Price of identical good/services
sold/purchased between two
unrelated parties or between
related party and third party is
available
Comparability
‘Price’
of
transactions.
the
Direct method – strict
comparability required
Plus Where there is transfer of semi ‘Gross profit margin’ on
finished goods between related direct/indirect cost of
parties or in case of services
production/service
CONCEPT OF ARMS LENGTH PRICE
Methods
Applicability
Comparability
Resale Price Where an enterprise purchases
Method
goods or services from a related
party and sells them to unrelated
parties without value addition
Profit
Split In case of transfer of unique
Method
intangibles or in multiple interrelated transactions which cannot
be evaluated separately
‘Gross profit margin’
of company reselling
products/services to
unrelated parties.
‘Split profits’ between
parties
to
transactions
based
on
economic
parameters.
Transactional Residual method. Applies where ‘Net Profit Margin’
Net
Margin reliable comparable data with broad (Operating Profit) of
Method
functional similarity is available
‘Tested Party’
Other
Where the price which would be
Method (Rule charged for similar transaction
10AB)
between
unrelated
parties
is
available ()
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Price
charged
vs.
price
would
be
charged - valuation
reports,
stock
or
commodity
indices
independent
price
quotations , etc.
FMV vs. ALP
Particulars
FMV
ALP
Definition
The price which goods or
services would have fetched
or cost in the open market
A price which is applied
in a transaction in
uncontrolled conditions
Computation
mechanism
No specific mechanism
provided in law
Most appropriate
method out of six
prescribed methods
Transaction value
Any market pricing point can
be treated as fair market
value
Arithmetic mean of
comparable prices
treated as ALP (except
CUP)
Sample size
One comparable may be
sufficient to establish fair
market value
Requires bigger sample
size for establishing
arms length (except
CUP)
Deviation
No deviation permitted from
FMV
Deviation of +/- 3%
permitted
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SECTION 40A
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APPLICABILITY OF SECTION 40A

Expenditure – Payment to related parties listed in Section
40A(2)(b)

The disallowance under section 40A(2) of the Act only after a
finding is recorded by the assessing officer that the
expenditure was excessive or unreasonable having regard to
(i) the tax market value of goods or services; (ii) the legitimate
business needs; (iii) benefit derived by or accruing to the
assessee.

The onus was on the assessing officer to find out the fair
market value of goods and services and to bring on record
comparable instances – onus now shifted on the assessee
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APPLICABILITY OF SECTION 40A

The Central Board of Direct Taxes vide Circular No.6-P
dated 6.7.1968 elaborated the scope of section 40A(2) of
the Act in the following terms:
“The Income-tax Officer is expected to exercise his
judgment in a reasonable and fair manner. It should be
borne in mind that the provision is meant 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.”

The Courts in a string of decisions have held section
40A(2) inapplicable on account of revenue neutrality.
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APPLICABILITY OF SECTION 40A

The Supreme Court in the case of CIT vs.
GlaxoSmithKline
Asia
Pvt.
Ltd.
(SLP
No.
18121/25007), while examining the issue of
application of section 40A(2) held that “no inference
is called for as the entire exercise is revenue neutral
exercise”.

TP provisions don’t provide for a corosponding
adjustment
-w.r.t.
the
specified
domestic
transaction, revenue neutrality no longer a relevant
consideration.
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APPLICABILITY OF SECTION 40A
Common









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transactions:
Buying of goods or semi - finished goods
Procurement of Services
Job work charges
Interest or royalty payments
Salary, Training & Marketing
Director’s Remuneration
Group Charges or sharing of costs
Rent
For 40A (2) , only expenditure is to be
benchmarked qua the payer
APPLICABILITY OF SECTION 40A
Payer
Receiver of Payment
Individual
• Relative of individual [S 40A(2)(b)(i)]
Company
/ Firm
• Director of company or relative of the director
• Partner or his relative[S 40A(2)(b)(ii)]
AoP/HUF
• Member of AoP/HUF or his relative [S 40A(2)(b)(ii)]
Any
Individual
• Payment to any individual who has substantial interest or
his relative [S 40A(2)(b)(iii)]
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SECTION 40A(2)(b)
Director or any relative of Director – Section 40A(2)(b)(ii)
Relative: in relation to an individual, means the husband, wife,
brother or sister or any lineal ascendant or descendant of that
individual
Mr. A
Mr. B
Director/Part
ner
XYZ
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Mr. C
SECTION 40A(2)(b)
To an individual who has substantial interest in the
business of XYZ Ltd or relative of such individual - Section
40A(2)(b)(iii)
Mr. A
Mr. B
Substantial
interest >
20%
XYZ
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Mr. C
SECTION 40A(2)(b)
To a Company having substantial interest in the business
of XYZ Ltd. or Director of such company or any relative of
Director – Section 40A(2)(b)(iv)
Mr. B
A Ltd.
XYZ
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Mr. C
SECTION 40A(2)(b)
Any other Company carrying on business in which
the first mentioned company has substantial interest
– Section 40A(2)(b)(iv)
Substantial
interest > 20%
B Ltd.
A Ltd.
C Ltd.
Substantial
interest > 20%
XYZ
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Substantial
interest > 20%
SECTION 40A(2)(b)
To a company of which director has substantial interest in
the business of XYZ Ltd. or any other director of such
company or relative of director – Section 40A(2)(b)(v)
Mr. B
Director
A Ltd.
Substantial
interest >
20%
XYZ
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Mr. C
Director
Relative
Mr. D
SECTION 40A(2)(b)
To a company in which XYZ Ltd. has substantial interest
in the business of the company – Section 40A(2)(b)(vi)
XYZ Ltd
Substantial
interest > 20%
B Ltd
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SECTION 40A(2)(b)
Any director or relative of a director of XYZ Ltd having
substantial interest in that person – Section 40A(2)(b)(vi)
Substantial
Interest > 20%
A Ltd
Mr. C
Relative
Director
XYZ
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Mr. B
Substantial
Interest > 20%
D Ltd
SECTION 40A(2)(b) - Issues

Whether Transfer Pricing provisions apply to any expenditure paid to
a person specified in section 40A(2b), whether claimed as deduction
or not?

Whether it include capital expenditure?

Judicial precedents - capital expenditure eligible for depreciation are
not covered under section 40A(2)- depreciation is not a deduction but
an allowance.

ICAI Guidance Note- SDT provisions are applicable to expenditures
which are capital in nature and ranking for 100% deduction under
provisions such as section 35(2AB), 35 or 35AD .
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SECTION 40A(2)(b) - Issues

Whether indirect shareholding is covered?

Revised ICAI Guidance Note - consideration of only direct
shareholding and emphasis on the real owner of the shares rather than
the nominal owner.

Whether shareholding of individual directors can be aggregated for
determining substantial interest? -No

Whether discounts given to related parties covered? - No
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EXAMPLES
Transaction
Rent paid
Interest on loan
Benchmarking
CUP method can be applied by comparing rent
for similar property
Chartered Engineers certificate or fair market
value - other method
Interest rates charged by Indian banks – SBI
base rate
Purchase of goods
CUP data wherever applicable,
RPM/TNMM may also be applied
Commission or brokerage
CUP/TNMM may be applied. Difficult to find
comparable uncontrolled transaction.
Royalty
CUP or TNMM may be applied. Difficult to find
comparable uncontrolled transaction – data
bases may be referred
Fees for professional services or CUP or TNMM may be applied. Difficult to find
fees for technical services or comparable uncontrolled transaction.
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management
services.
EXAMPLES
Transaction
Remuneration
director,
management
personnel
Benchmarking
to Option 1:
key • Ceilings provided in Companies Act, Listing
agreement norms, Shareholder and Board of Director
resolutions, Remuneration Committee approvals
Limitation:
• Not applicable to private limited companies
• Upper ceilings can be challenged by Revenue
Delhi High Court in the case of CIT vs. India Thermit
Corporation - commission paid to the Managing
Director/Director in accordance with the provisions of
the Companies Act , cannot be challenged by the revenue
authorities.
Rule 10B(2)(d) – laws and Government order in force – to
be taken into account for applying Transfer Pricing
method.- ITAT decisions in the context of royalty.
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EXAMPLES
Transaction
Remuneration
director,
management
personnel
Benchmarking
Option 2:
to • Remuneration to director may be compared with
key
remuneration paid by comparable companies.
Limitation:
• Could be unreliable and difficult to obtain
• May lead to cherry-picking
Option 3:
• Peer review
Limitation:
• Availability of reliable data may be a constraint
Option 4:
• Salary drawn elsewhere, simultaneously or previously
Limitation:
• Generally not available for promoter directors
40
EXAMPLES
Transaction
Remuneration
director,
management
personnel
Benchmarking
to Option 5:
key • Comparison of ratio of Director’s remuneration to
Total Cost (or Sales) with similar ratio for comparable
companies
Limitation:
• No emphasis on individual capabilities of a Director
• Limited comparable information on databases
• Requires high degree of comparability with selected
companies
• No known correlation between remuneration and sales
/ cost of a company
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EXAMPLES
Transaction
Remuneration
director,
management
personnel
Benchmarking
to Option 6:
key • Subsumed under overall net profit based approach
(TNMM)
Limitation:
• Cannot be applied for loss making companies
• Approach likely to be challenged by Revenue
Option 7:
• Qualitative analysis of educational qualifications, work
experience, etc.
Limitation:
• Can only be used for corroborative analysis
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SECTION 80IA/IB/IC/ID/ID/10AA
43
SECTION 10AA/80IA/80IB/80IC/80ID
SECTION
NATURE OF UNDERTAKING
10AA
Undertakings having a Special Economic Zone unit
80IA
80IB
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Undertakings engaged in
•Developing, operating and maintaining, developing and operating
and maintaining infrastructure facilities
•Generation/ transmission or distribution of power
•Reconstruction/ revival of power generating plants
Undertakings located/ engaged in
•Industrially backward districts as notified;
•Scientific research & development
•Refining of mineral oil/ commercial production of natural gas
•Operating cold chain facility for agricultural produce
•Processing, preservation and packing of meat/ meat products or
poultry/ marine/ dairy products
•Operating and maintaining a hospital of specified capacity
SECTION 10AA/80IA/80IB/80IC/80ID
SECTION
80IC
80ID
45
NATURE OF UNDERTAKING
Undertaking located in notified Centre/ Parks/ Areas in
•Sikkim
•Himachal Pradesh/ Uttaranchal
•North- Eastern states
Undertaking engaged in business of hotel/ convention centre in
specified areas/ districts
SECTION 80IA(8)
A Ltd.
46
Unit A
Telecom Business
Unit B
Manufacturing
Business
80IA-Eligible Unit
Taxable Unit
SECTION 80IA(10)
47
A Ltd.
Infrastructure
Business
B Ltd.
Trading Business
80IA-Eligible Unit
Taxable Unit
SAMPLE TRANSACTION AND ISSUES
Transaction
Benchmarking
Allocation of corporate Imperative to use appropriate allocation keys
costs and overheads for • Use of ad hoc allocation keys may be
computation of tax
questioned
holiday
Transfer of semifinished goods between
domestic units and tax
holiday units
Valuation of transfers between business units
• Excise law provides valuation based on
market price followed by 110% of cost of
production based on Cost Accounting
Standard 4 (CAS-4)
Capital transactions
including transfer of
machinery, technology,
etc.
As per Foreign Trade Policy/ SEZ Regulations,
transfer of used capital assets to be carried
out at Written Down Value arrived at after
provision of depreciation at prescribed rates .
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SECTION 80IA(8) & (10) - ISSUES

Issues in claiming corresponding credit when both units
are eligible for tax holiday.

Whether current year losses required to be set off
against future tax holiday profits?

The term “Close Connection“ not defined and subject to
litigation

Whether the term “more than ordinary profit” can be
equated with ALP?

Burden of proving the ‘close connection’ between the
assessee and the other party is on TPO?
49
CLOSE CONNECTION
Particulars
Substantial
interest
- section
40A(2)(b)
Associated
enterprise
- section
92A(2)
Related party
as per AS – 18
as issued by
ICAI
>= 20%
>= 26%
>50%
Direct or indirect
Holding covered
No (with
exception)
Both
Both
Directors covered
covered
covered
Key managerial
personnel
covered
Not covered
Supplying
more than
90%
Specifically
excluded
Voting power
Key suppliers
covered
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CASE STUDIES
51
CASE STUDY 1
100%
INDIA
OUTSIDE
INDIA
IT Enabled Services
B Ltd.
Royalty Payment
ITES
C Ltd.
25%
-Distribution of
Pharma products
D Ltd.
-Mfg of Raw material
-10AA Eligible Company
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A Ltd.
-Brand owner
Manufacturer
of
Pharma
Products
25%
Supply of raw material
CASE STUDY 2
Interest Free Loan
B Ltd.
- Foreign Company
OUTSIDE
INDIA
A Ltd.
- Indian Company
-Non Eligible Company
Interest Free Loan
INDIA
C Ltd.
- Indian Company
-Non Eligible Company
D Ltd.
Interest Free Loan
- Indian Company
-10AA Eligible Company
E Ltd.
-Loan @ 18% Interest
-ALP 11%
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- Indian Company
-10AA Eligible Company
CASE STUDY 3
A Ltd. Head
Office
Unit - 1
Rs.1200
per hour
-Insurance
business
-SEZ
-Back
office
support/ITES
-10AA eligible
Unit - 3
Rs. 800 per
hour
Unit - 4
-Telecom
business
Infrastructure
business
Rs. 900 per
hour
Third
Party
54
Unit - 2
-Performs general
management functions
-Insurance
business
CASE STUDY 4
For the period of 01.04.2012 to 30.09.2012
R & D Services
100%
A Ltd.
B Ltd.
-Indian co.
-Software development
-SEZ 10AA benefit
-OP/OC 40% (TNMM)
Payment based on
cost + 20% to B Ltd.
-Foreign co.
Change in shareholding 01.10.2012 to 31.03.2013
(Close connection established)
A Ltd.
-Indian co.
-Software development
-SEZ 10AA benefit
-OP/OC 40% (TNMM)
-ALP 17%
55
25%
Payment based on
cost + 20% to B Ltd.
B Ltd.
-Foreign co.
COMPLIANCE AND PENALTIES
56
DOCUMENTATION
Current Compliance
Requirements
• Section 40A: Transactions
to Be reported in Tax
Audit Report in Form 3CD
• Section 80IA: Declaration
of profit to be made in CA
certificate in Form 10CCB
• Section 10AA: For claiming
tax deduction, CA
Certificate in Form 56F
needs to be filed
57
Additional Compliance
Requirements
• Maintaining
contemporaneous
documentation as
prescribed in Rule 10D
and justify transaction to
be at ALP
• Filing audit report in new
Form 3CEB
DOCUMENTATION REQUIREMENTS
Documentation
Requirement
NATURE
INFORMATION
Group overview
Entity Related
(a), (b), (c), (d)
Industry scenario
Entity Related
(c)
Functional analysis
Price Related
(e)
Terms of transaction
Price Related
(d), (g)
Economic Analysis
Price related
(f),(g),(h),(i),(j),(k),(l),(m)
Agreements
Transaction Related
(g)
Invoice
Transaction Related
(g)
58
OF Clause of Rule 10D
PENALTIES
Nature of Default
Failure
to
documentation
Nature of penalty
maintain 2% of the value of each international
transaction or specified domestic transaction
Failure to furnish documents
2% of the value of each international
transaction or specified domestic transaction
Failure to report a transaction in 2% of the value of each international
accountants report
transaction or specified domestic transaction
Maintaining
incorrect
documents
or
furnishing 2% of the value of each international
information
or transaction or specified domestic transaction
•It will be necessary to identify and map the transactions which will now be
covered under the expanded scope of transfer pricing regulations
•The taxpayers need to ensure that such identified transactions are
analyzed so as to comply with the Arm’s Length Principle based on the
application of the most appropriate method adequately supported by a
robust economic analysis
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OTHER ISSUES

APA provisions
Transactions.

Whether safe harbor rules would be applicable on SDT?- No

Whether DRP route would be applicable in case there is
addition only on account of SDT? - Yes.

The considerations for ALP introduced under the companies
Act:
- The method for determining ALP not provided, methods
under the IT Act could be applied.
- The transactions with related parties of income as well as
expense to be taken in account.
- The definition of related parties under the Companies Act to
be taken in to account.
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not
applicable
to
Specified
Domestic
SDT - Impact
Expenses
Transaction
within
company
Tax Holiday
Shift of
Approach
Compliance
Assessment
61
Expenses paid by domestic companies to related parties will
be challenged
Corresponding adjustment not permitted for disallowed
expenses; will lead to double taxation.
Company with multiple units and claiming tax holiday will
be questioned on inter unit transfers.
Authorities will attempt to reduce profitability of exempted
unit for reducing the quantum of deduction.
Companies declaring ‘More than ordinary Profits’ for tax
holiday units will loose excessive income-tax benefits.
Approach will shift from generic ‘Fair Market Value’ concept
of ‘Arm’s Length Price’.
Heavy compliance burden of maintaining:
- Transfer pricing documentation and
- Reporting of transactions (Form 3CEB)
Assessment / audit by specialized cell of TPO
Thank You
NEERAJ K. JAIN
PARTNER, VAISH ASSOCIATES ADVOCATES
62