[Editorial Note: Best Research Paper of 5th Nani Palkhivala Research Paper Competition for the year 2009]

Introduction

The genesis of the concept of transfer pricing lies in international transactions and cross border transactions. With the opening of the world markets and their economies, companies have sought to make their presence felt in more and more counties to gain global domination; and with technological advancement in the early 20th century it became easier for them to move funds, technology, labour across political and geographical boundaries. Thus, they expanded rapidly to open subsidiaries and affiliates resulting in emergence of Multinational Enterprises (MNEs) in those countries. An MNE is an enterprise wherein the parent company is in one country and its branches or subsidiaries are spread out in different countries having distinct and separate tax regimes.

This kind of structure resulted in a number of intra-group transactions which are governed by market and group driven forces. They are influenced by factors such as creation of economies of scale; cost sharing; manipulating taxable profits; and many more considerations. There are many considerations for shifting of profits which may result in loss of revenue to the country where the subsidiary or branch is situated and may cause tax disputes amongst states. In the twentieth century countries tackled tax related disputes arising out of ever growing cross border transactions by entering in to treaties to mitigate double taxation and aimed at promoting transnational trade and investment. Proliferation of MNE activities gave rise to multiplicity of situations where international tax disputes could arise, both between taxpayer and state; and between states themselves. Experience suggests that the MNEs structure their transactions depending on the market and group driven forces. In an article reported in Tax Analyst (2008)¹ Martin A. Sullivan pointed out that the US corporate tax revenues dropped by $ 17.4 billion in 2004 because US multinational corporations have enhanced their ability to shift profits out of the United States since 1999. He further emphasized that though there were treaties and agreements revenue collection was not effective and that it was becoming a global problem.

The shifting of profits by MNEs has created a requirement for stringent transfer pricing regulations all over the world. This paper seeks to discuss these regulations, compare them and identify those areas where a different approach or outlook is required; and provides certain suggestions as to how this may be achieved.

What is Transfer Pricing?

The Organisation for Economic Development and Cooperation (hereinafter referred to as the “OECD”) defines “transfer prices” as the “prices at which an enterprise transfers physical goods and intangibles or provide services to associated enterprises”.² The agreed price between two independent parties in a normal business transaction is normally driven by the market, where as the transfer price between two units of the same enterprise may reflect “group interest “more than market demand. When there is a differential in tax rates in different jurisdictions, firms may be tempted to shift profits to a lower tax regime and show higher expenditure in a higher regime. As mentioned earlier, tax may not be the only influencing factor. Other considerations for practicing transfer pricing may include flexibility in shifting funds/capital; ease in overcoming restriction on repatriation of profits and other value based restrictions; undercutting shares of local shareholders; pressure by shareholders of the parent company; achieve efficiency in production; etc.³

There is no doubt that any manipulation of the transfer price will ultimately affect adversely the tax base of either country. It is also apparent that any aggressive policy to counter manipulation of transfer pricing may affect inflow of funds from foreign countries. This thought may have delayed framing of comprehensive transfer pricing regulation in developing countries.

While international transactions of the MNEs have multiplied with the growth of cross border businesses, the tax authorities view transfer pricing as having potential to produce very large increase in revenue. In a presentation⁴ Mr. T. P. Ostwal has stated that in UK, for every $1 spent investigating transfer pricing cases, $120 was recovered in extra taxes; in Japan billions of Dollars have been recovered in extra taxes with individual cases exceeding $100 million; approximately 60% of international tax litigation worldwide pertains to transfer pricing; and in India, the press has reported that a demand of Rs.500 Crores pertaining to transfer pricing adjustments are pending after completion of assessments for the assessment year 2002-03. Today, transfer pricing has become single biggest taxation issue across the globe. And with the world gradually shrinking and becoming unified, long drawn out and expensive transfer pricing controversies can adversely affect global trade.

Global Formulary Apportionment Approach

Apart from TP there is one other method of preventing MNEs from diverting profits to a different jurisdiction, namely, the Global Formulary Apportionment (GFA) Method. Under this method the profits of all subsidiaries of an enterprise are consolidated and then they are apportioned to the subsidiaries or associated enterprises on the basis of a predetermined formula. The OECD describes this method as follows:

“A Global Formulary Apportionment Method would allocate the global profits of an MNE Group on a consolidated basis, among the Associated Enterprises in different countries, on the basis of a pre- determined and mechanistic formula. There would be three essential components to applying a global formulary apportionment method, namely, determining the unit to be taxed, that is, which of the subsidiaries and branches of an MNE group should comprise the globally taxable entity; accurately determining the global profits; and establishing the formula to be used to allocate the global profits of the unit. The formula would most likely be based on some combination of costs, assets, payroll and sales.”⁵

This method has certain disadvantages. Firstly, it is difficult to determine which unit should form part of the consolidated group. Secondly, ascertaining the global profits accurately may not possible. And lastly, determinations of a formula to allocate profit to various entities may cause confusion and conflict amongst the enterprises as well as the states where the profits are accruing and thereby become taxable. The end result is that, on one hand there is double taxation on certain profits, on the other certain profits may not be taxed properly.⁶ Therefore, the OECD Model as well as the U.N. Model have preferred the TP method in comparison to the GFA method. India, on the other hand has incorporated certain aspects of the GFA method.

OECD Guidelines

The contribution of OECD in the development of comprehensive transfer pricing legislation has been most noteworthy. The Guidelines issued by OECD has been the source document for drafting transfer pricing legislation as well as interpreting the legislation. Earlier landmark reports relating to transfer pricing coming from OECD are Transfer Pricing and Multinational Enterprise (1979), Three Taxation Issues (1984) and Thin Capitalization (1987).

Art. 9 of the OECD Guidelines, 1995 discusses the concept of TP and states that the transactions between AEs be taxed on the basis that they are at arm’s length. This approach seeks not only to secure appropriate tax base in each jurisdiction, it also aims at avoiding double taxation, thereby minimizing conflict between tax administrations and promoting international trade and investment.⁷

The article provides that the profits of the enterprise maybe re- written if, as a result of the special relationship between enterprises, the accounts do not show the true taxable profits arising in that state.⁸ This means that these guidelines will apply only when there is a “special relationship” between the enterprises. This relationship is defined under Art. 9 to mean any direct/indirect participation of, one enterprise in one Contracting State or the same persons, in the management, control or capital of another enterprise in another Contracting State.⁹ These enterprises are known as Associated Enterprises (AE). Further, it is provided that this article shall come into picture only when the true taxable profits arising in that state are not shown, that is, the price charged for the transactions between the AEs is not at arm’s length. The Arm’s Length Principle states that the any profits which would, but for the conditions made/ imposed between AEs, 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 be taxed accordingly.¹⁰ Based on this principle the Arm’s Length Price (ALP) is calculated. The Guidelines provide guidance for the application of this principle, which is listed below:

1. Comparability Analysis

2. Recognition of the Actual Transaction Undertaken

3. Evaluation of Separate and Combined Transactions

4. Use of an Arm’s Length Range

5. Use of Multiple Year Data

6. Losses

7. Effect of Governmental Policies

8. Intentional Set-offs

9. Use of Customs Valuations

10. Use of TP Methods

The OECD Guidelines enumerate the following methods for the calculation of ALP. The first three are categorized as Traditional Transaction Methods and the last two as Transactional Profit Methods. OECD prefers the former to the latter.

1. Comparable Uncontrolled Price Method (CUP)

It compares the price of property/services transferred in a controlled transaction to the price charged for property/ service transferred in a comparable uncontrolled transaction in comparable circumstances. This is the best method to be used where possible. But it very difficult to find a transaction so similar to the uncontrolled transaction, as even a slight difference in the product or enterprise or other contractual terms may materially affect the transaction.

2. Resale Price Method (RPM)

It uses the price at which a product is purchased from an AE and resold to an independent enterprise as the base and reduces from this the resale price margin, that, is, the profit margin plus the expenses of the reseller. The remainder, after adjustment for other costs is considered to be the ALP. Here the quality of data and assumptions is of utmost importance. If there is any material difference between the transactions, the ALP computation may be inaccurate.

3. Cost Plus Method (CPM)

It uses the costs incurred by the supplier of the product in a controlled transaction to which an appropriate cost plus mark up is added, to make an appropriate profit in light of the inputs to the production. The amount so arrived may be taken as the ALP.

4. Profit Split Method (PSM)

It identifies the combined profit to be split for the AEs from a controlled transaction and then splits those profits between the AEs based upon an economically valid basis that approximates the division of profits that would have been anticipated and reflected in an agreement made at arm’s length. As this method does not require similar or identical transactions it can be used in cases where such data is not available.

5. Transactional Net Margin Method (TNMM)

The net margin relative to an appropriate base that a taxpayer realizes from a controlled transaction is considered.

OECD Guidelines require that the enterprise must maintain adequate documentation regarding the computation of ALP. The enterprise should maintain an outline of the business and the organization, showing its connection with the MNE group. Further, a brief financial history of the enterprise should be given along with details of the transaction in question. Also the enterprise should show whether the TP method chosen by it is appropriate in the light of available comparable data.

Lastly, as per Paragraph 2 of Art. 9, in case using of ALP leads to double taxation, the state may make such adjustment so as to relieve the enterprise of this burden.

United States of America

In the US transfer pricing is governed by Sec. 482 of the Internal Revenue Code and regulations there under. The Tax Reforms Act of 1986 amended Sec. 482 to require that intercompany charges for use of intangible property should be commensurate with the income attributable to the use of the intangible. Subsequently, the final transfer pricing regulations were released on 1 July, 1994. Most of the reforms were based on a treasury study issued in 1986 that addressed the effectives of the then current transfer pricing regulations. In general the US regulation under Sec.482 provide taxpayers both with guidance and flexibility in determining and demonstrating arm’s length results for intercompany transactions. It further provides that the taxpayers through documentation should justify the adoption of their chosen methodology, and the manner in which data from unrelated transaction were employed to establish arm’s length results for inter-company transaction.

This section is applicable to both domestic and international transactions. The following transactions between related parties are covered by this provision:¹¹

1. Any loan or advance with no interest or interest which is not at arm’s length;

2. Performance of service without charge or charge not at arm’s length;

3. Leasing tangible/ intangible property without rent/ royalty or rent/ royalty not at arm’s length;

4. Sale of property for which no price is charged or isn’t at arm’s length; and

5. Cost sharing agreements.

The US regulations prescribe the use of the “best method” for the computation of ALP; out of the CUP method, RPM, PSM, CPM and the Comparable Price Method. While determining the “best method”, the degree of comparability and the availability and quality of data should be taken into consideration.

A brief look at certain significant judicial decisions gives an idea of the development of transfer pricing concepts in the USA. The general rule is that if there is a US allocation, foreign tax credit will not be creditable unless the tax payer attempts to seek a foreign correlative adjustment. However, in the case of Schering Corporation v. Commissioner¹², the tax court allowed a taxpayer to receive a foreign tax credit for Swiss tax, even though assistance of the competent authority was not sought. The court held that a tax payer could not be penalized for not seeking competent authority assistance where it was not clear whether a resolution could be obtained on that basis. In the DHL Corporation v. Commissioner¹³, the tax court in most part upheld a large IRS allocation of income between DHL and its foreign subsidiaries, and also imposed valuation penalties against the company for the misallocation. Another case where IRS allocation of income between a domestic corporation and its wholly owned subsidiaries was upheld is that of E1 Du Pont de Nemours v. US¹⁴. In the case of Xilinx Inc and Consolidated Subsidiaries v. Commissioner¹⁵ the United States Tax Court held that the IRS’s allocation was contrary to the arm’s length standard mandated by Sec. 1.482-1(b), Income Tax Regulations. The court ruled that if independent enterprise did not allocate the costs for certain items (in the instant case, the cost for employees stock options), it would be improper to allocate costs for the same between related parties in intra group transactions.

In July 2006, the treasury department and the IRS issued temporary and proposed regulations governing the provision of intra-group services. These regulations follow the pattern established for transfers of tangibles and intangible property by specifying methods that reference prices and margins earned through transactions with unrelated parties, or by reference to profits earned by parties performing comparable services for unrelated parties. In this context, it is appropriate to refer to the GlaxoSmithKline Plc.¹⁶ (hereinafter referred as “Glaxo”) tax court case. In September 2006, the IRS announced the resolution of the case, the largest tax dispute in the agency’s history wherein the parties reached a settlement under which Glaxo agreed to pay IRS approximately US$ 3.4 billion. According to the IRS claim, drugs marketed by the UK multinational Glaxo through a US affiliate derived their primary value from marketing efforts in the USA rather than from the R&D owned in UK. The IRS’s position was that the unique nature of the R&D may explain the success of the first drug of its kind; however, subsequent market entrants are successful primarily because of the marketing acumen of the USA affiliate. Consequently, the IRS asserted that the rate Glaxo’s affiliate was charging to its UK parents for marketing services was too low. Furthermore, it argued that the “embedded” marketing intangibles, trademarks, and trade names existed and were economically owned by the US affiliate. This approach by the IRS suggests a greater reliance on the PSM where high value can be attached to the marketing efforts.

The recent IRS pronouncements on out-bound transfer of tangibles, with emphasis on cost sharing along with complete revision of the regulation governing intercompany services are likely to increase litigation. The US has also broadened the issues that may be covered in APA to include attribution of profit to a permanent establishment, and certain sourcing issues, providing an MNE with an important alternative to a transfer pricing audit. US’s APA process has been a subject matter of a multi layered investigation by US Senate Finance Committee. Though no report was issued, some procedural changes have been made. In the US, the current issues of Transfer Pricing are as under¹⁷:

• Litigation appears to be used as a dispute resolution strategy,

• IRS emboldened by recent victories as such as XILINX and Textron and designation of Tier 1 issues limits authority for settlement.

United Kingdom

Transfer pricing is governed by ICTA88/SCH28AA, introduced in July 1999, and applies to a situation where there is a provision between two connected persons and one of them controls the other or both are controlled by third party. Here, the controlled must be a body corporate or a partnership whereas the controller may be an individual. Further, it may apply to a branch of a connected company. Under this legislation, the onus is on the taxpayer to incorporate the arm’s length principle in their self-assessment.

The provision itself requires that Sch.28AA be construed in accordance with the OECD Guidelines and wherever there is a conflict the Guidelines shall prevail¹⁸. The schedule is to be applied when both parties are enterprises, that is, they undertake a commercial or business-like activity. Small and Medium size companies are exempted from the basic TP rule except when the transaction is with a resident of a territory with whom UK does not have a tax treaty; where the enterprise elects to disapply the exemption; and where HMRC notifies an enterprise that basic TP rules shall have to be followed.

The rules apply to transactions such as purchase and sale of goods; provision of intra-group services; rent and hire charges; transfer of intangibles; cost contribution agreements; and provision of finance and other financial arrangements. Further, this legislation may be applied to a series of transactions than looking at one transaction in isolation.¹⁹ In addition, even transactions in a series involving third party also fall within the purview of this legislation.

The legislation provides that wherever the actual provision confers a potential advantage on one or both affected parties, an adjustment is to be made to the taxable profits of the tax-advantaged persons; calculated on the arm’s length principle. Moreover, an adjustment may be made only to increase the taxable profits or reduce a tax loss.²⁰ Here it may be added that the tax authorities may re-characterize the actual structure of the controlled transaction only exceptionally, where the issue is the sale of goods or provision of services.

From 1st April, 2004, interest deduction from connected party borrowing and loan guarantees was brought within the UK Transfer Pricing regime. In UK, transfer pricing rules require adjustments to a corporation tax computation where : a) provision is made on a transaction or a series of transactions between connected persons; b) provisions depart from the arms length standard; and c) UK tax advantage is conferred on one of the parties. Comparable arms length text introduced within FA 2004 is to apply to all intra-group transactions. And the transfer pricing rules are further extended to capture certain financing arrangements.

As regards the documentation requirements, they may be maintained in any form which the enterprise may wish to. Further, there is no requirement to furnish evidence of record to HMRC at the time of filing of returns. It is to be done only during an enquiry. But they must exist before filing returns. The requirements are guided by Chapter 5 of the Guidelines. The following documents are to be maintained by an enterprise:²¹

1. Primary Accounting Records;

2. Tax Adjustment Records;

3. Records of transactions with related parties; and

4. Evidence to demonstrate arm’s length result.

HMRC has been using a new transfer pricing risk assessment procedure since July 2008, including pre-return discussions wherein it opens an enquiry only where there is likelihood of collecting large amount of tax. It has mostly been concentrating on industries where intangibles are of great significance, such as pharmaceuticals and food and beverage²².

In DSG Retail Limited v. Revenue & Customs Commissioners²³, the first landmark case upholding the authority of Sch. 28AA, the transaction involving a third party was held to be within the purview of this legislation as it formed a “series of transactions”, as contemplated by Paragraph 1 of the schedule. Also, moving away from the OECD preference for traditional transactional methods, the Commissioners were in favour of using one of the transactional profit methods in this case.

Australia

The Australian transfer price laws aim at curbing underpayment of tax by treating related party international dealings to be at arm’s length. Related party international dealings include sale, purchase, finance or asset transactions to or from an Australian taxpayer and an overseas company or other overseas business entity or non-Australian resident person who is related to the taxpayer by common ownership or family ties. It covers goods, services and intangibles.²⁴ The TP laws are given under TR98/11, TR97/20 and TR94/14.

No method for computation of ALP is prescribed or preferred. Any internationally accepted method which projects a commercially realistic outcome, and is most appropriate must be used. And unlike India or OECD there are no considerations provided for selection of a method. Minimum documentation is required, only to enable reasonable assessment showing compliance with the arm’s length principle.

The documentation should record the transaction and demonstrate the method used. Further, a Sch.25A is to be filed by the related parties, which imposes obligations to disclose information regarding related party international dealings. Guidelines for filling this are set in TR IT 2514. Small businesses are exempted to quite an extent from TP rules. They only need to maintain basic documents in this regard.

A brief overview of transfer pricing laws in various Asian countries is given below.

Japan

The Special Taxation Measures Law (STML), enacted in 1986, remains the central transfer pricing legislation in Japan. Under STML 66-4, a transaction between a domestic or foreign corporation and a foreign related person not priced in accordance with the arms-length principle will be deemed to occur at an arms-length price for corporate tax purposes. Foreign related person includes any corporation related to the taxpayer directly or indirectly through 50% or more shareholdings, or through a substantial control relationship due to business, financial, or other dependence. Other key transfer pricing regulations include the STML Enforcement Order 39-12 and the STML Enforcement Regulations 22-10, respectively laying out detailed rules on foreign related persons and transfer pricing methods, and items to be reported on schedule 17(3). The STML Circular provides further guidance on control relationships, comparables, and transfer pricing methods. The Administrative Guidelines outline the various transfer pricing administrative procedures. The National Tax Agency (NTA) has also published 28 hypothetical illustrating the application of Japan’s transfer pricing rules. Generally Japan’s transfer pricing rules adhere to the OECD transfer pricing guidelines. The Administrative Guidelines expressly direct tax examiners to consider OECD guidelines during audits and assessments.²⁵

Like the OECD Guidelines, Japan prefers the traditional transaction methods to any other method. But it goes a step further by allowing the use of the PSM and TNMM only when the traditional methods are inapplicable.

Sch. 17(3) requires that the documents contained therein must be filed annually by the corporate taxpayers, unlike the UK laws which require only maintenance of the documents to be produced during enquiry.

Following the trend in many countries, the NTA has been increasingly focusing on intangible property transactions and intra-group services in its assessments. Rules relating to intra-group services were introduced in 2002 which were based on the OECD Guidelines, and detailed Rules on intangibles in 2006. Now, the examiners consider all intangible producing activities in determining economic ownership.

China

The Chinese State Administration of Taxation (SAT) issued its first decision on TP in 1998 in the case Guosshuifa (1998) 59, the “Tax Administration Rules and Procedures for Transactions between Associated Enterprises” which came to known as Ruling 59. It lays down the basis of selecting audit targets, conducting audits and applying TP methods and requires inter-company transactions and transactions between associated entities should be priced at arm’s length. It is largely based on the OECD Guidelines.

The Circular allows the tax bureau to make adjustments to the tax payable on companies who do not transact at arm’s length. The test of an Associated Entity is based on ownership and control. Like other countries, the AEs must account for all international transactions on arm’s length basis. These rules are applicable to tangibles, intangibles and intra-group services.

The rules do not prescribe any method but allow a flexible best method to be used. The CUP, CPM or a modified RPM (based on functions performed, assets used and risks assumed by reseller) are used. The other method used is the Profit-base method, based on the performance measures of a comparable company or industry.

Unlike other jurisdictions, a company wanting to provide services in China must register with the relevant authorities and every enterprise must determine its objective prior to setting up business.

Singapore

The TP Guidelines were issued by Inland Revenue Authority Singapore (IRAS) in February 2006. They are applicable to both local and cross-border transactions between a Singaporean taxpayer and its related party. Sec.53(2A) of the Singapore Income Tax Act endorses the arm’s length principle and calls for a reasonable effort by the taxpayer to demonstrate the computation of ALP.

Annex G to this Circular, lists (non-exhaustive) out the documents to be maintained, such as, details of the parties and the transaction; functional analysis of the parties; rationale for choosing the method for computation of ALP; and details of the comparable uncontrolled transaction.

In 2008 a TP Consultation Circular was issued to supplement the existing rules. And in 2009 an e-Tax Guide came out which allows some flexibility to vary from the arm’s length principle under certain circumstances to provide flexibility in compliance. Such a provision does not exist in the laws of any other country.

India

Conceptually the issue of transfer pricing existed in the pre-independence period mainly on the determination of income between British India and erstwhile state not forming part of British India. The apportionment of income was on the basis of functions and additions based on comparables. In Anglo- French Textile Co. Ltd. v. CIT²⁶ the Supreme Court held that there should be allocation of the income between the various business operations of the Assessee Company, demarcating the income arising in the taxable territory from the income arising outside the taxable territory. Enacted on these lines, Sec. 92 of the IT Act, 1961 was the only piece of legislation previously, which governed TP in India. This section provided for re-computation of the taxable profits of the resident if the tax authorities believed that an international transaction with a nonresident resulted in a less than ordinary profits for the resident owing to ‘close connection” between the two. In Mazagaon Dock Ltd.²⁷ two non-resident shipping companies were having an agreement with an Indian subsidiary engaged in the business of ship repairing. Under the agreement the resident Indian company was to recover the cost of repair of the ships from the non-resident companies without charging any profit. The SC upheld the applicability of the provisions of Sec. 42(2) of the Income Tax Act, 1922 (that is, Sec. 92 of the Income Tax Act, 1961) on the ground that the dealings between the parties formed concerted and organized activities of a business character and the non-resident companies carried out business with the resident companies. In this manner the concept of transfer pricing was applied under the Act in certain specified circumstances in a limited manner.

The Finance Act, 2001 replaced the existing Sec. 92 by introducing sub-sections 92A to 92 F in the Income Tax Act and relevant Secs. 10A to 10E in the Income Tax rules 1962, w.e.f. 1st April 2001, applicable to the relevant international transactions. These regulations together are known as the Transfer Pricing Regulations (TPR). Explaining the provisions of the Finance Act, 2001, circular number 14/2001 states that the TPR was introduced with a view to provide a detailed statutory framework which can lead to computation of reasonable, fair and equitable transfer price. The TPR was introduced to curb transfer pricing abuse.²⁸

The TPR provide that the income arising from “International Transactions” between “associated enterprise” should be computed having regard to the “arm’s length price”.

As per the Act, direct/ indirect participation, by one enterprise or by same persons, in the management, control or capital of another enterprise would make the two Associated Enterprises (AEs). Further, under Sec. 92F an enterprise includes a Permanent Establishment (PE). Moreover, Cl. 2 of the Sec. 92A prescribes certain specific conditions to be fulfilled in addition to this general condition:

1. Direct /indirect holding of 26% or more voting powers in an enterprise by the other enterprise or in both the enterprise by the same person;

2. Advancement of a loan, by an enterprise, that constitutes 51% or more of the total book value of the assets of the borrowing enterprise;

3. Guarantee by an enterprise for 10% or more of the borrowings of the other enterprise;

4. Appointment by an enterprise of more than 50% of the board of directors or one or more executive directors of an enterprise, or the appointment of specified directorships of both enterprises by the same person;

5. Complete dependence of an enterprise (in carrying on its business) on the intellectual property licensed to it by the other enterprise;

6. Substantial purchase of raw material/ sale of manufactured goods by n enterprise from/ to the other enterprise at prices and conditions influenced by the latter; and

7. The existence of any prescribed relationship of mutual interest (none prescribed to date).

The above conditions must exist at any time during the previous year. Cl. (1) of the section is subject to the conditions prescribed under Cl. (2). For an enterprise to qualify as en AE it must fulfill at least one condition mentioned under Cl. (2) and mere participation in the management, control or capital shall not make it an AE.²⁹ Therefore, any “international transaction”, between two enterprises which qualify the above conditions shall be deemed to fall within the purview of the TPR.

An “International Transaction” is a transaction between two or more associated enterprises involving sale, purchase or lease of tangible or intangible property, provision of services, cost sharing arrangements, lending/borrowing of money, or any other transaction having a bearing on the profits, losses or assets of such enterprise.³⁰ Further in certain cases, a transaction between an enterprise and a third party may be deemed to be a transaction between associated enterprises, if there exists a prior agreement in relation to such transaction between a third party and an associated enterprise or if the terms of such transactions are determined in substance between the third party and an associated enterprise. Accordingly, this rule, like the UK rule, claims to counter any move by tax payers to avoid the transfer pricing regulations by interposing third parties amongst group entities.

Transactions other than the sale or purchase of tangibles are also covered under the TPR. It is relatively more difficult to obtain comparable information from independent entities regarding them and hence, calculation of ALP may become difficult. Some of these transactions are listed below:

1. Subscription and Buy-back of Shares

2. Cost Contribution Agreements

3. Transfer of Intangibles

4. Transfer of existing Assets

5. Intra- group Services

Here, it may be appropriate to discuss the case of Morgan Stanley & Co.³¹ (hereinafter referred to as “M.S. & Co.”), where the Hon’ble Supreme Court examined whether M.S. & Co. had a permanent establishment (hereinafter referred to as “PE”) in India under the India-USA Tax Treaty as a consequence of the outsourcing of its back office operations to its captive BPO in India. The Supreme Court also examined the incidence of tax of M.S. & Co. if it is accepted that the taxpayer had a PE in India. After going through nature of transactions of M.S. & Co. the Hon’ble Supreme Court held that M.S. & Co. did not have a fixed place PE or an agency PE in India under the tax treaty as a consequence of the back office operations outsourced to its captive BPO. However with reference to the personnel of M.S. & Co. on long term deputation to the captive BPO, the Supreme Court held that as such personnel continued to be employees of M.S. & Co., having a lien on their jobs with M.S. & Co., the employees could result in M.S. & Co. having a service PE in India. As regards the profits attributable to the PE, the Court held that as the transfer pricing analysis of the captive BPO adequately reflected the functions performed and the risks assumed by it, no further profits would be attributable to the PE.

However, in the SET Satellite (Singapore)³², it was held by the ITAT that payment of Arm’s Length Remunerations to a dependant agent PE does not necessarily extinguish the tax liability of non-resident in India.

Further, in the case of Rolls Royce PLC³³, the Appellate Tribunal had rejected the argument that payment of Arm’s Length Remuneration to a PE extinguishes the tax liability of the non-resident in India, and has proceeded to attribute the profits of Rolls Royce PLC that can be said to accrue of arise directly or indirectly through the operations of its PE in India.

The term “Arm’s Length Price” is defined in Section 92F of the said Act to mean a price that is applied/ proposed to be applied to transactions between persons other than associated enterprises in uncontrolled conditions. The following methods have been prescribed by S. 92C of the Act for the determination of the arm’s length price:

1. Comparable uncontrolled price method (CUP)

2. Resale price method (RSM)

3. Cost Plus Method (CPM)

4. Profit Split Method (PSM)

5. Transactional Net Margin Method (TNMM)

6. Such other methods as may be prescribed (no additional method has yet been prescribed)

Under the Act no particular method has been accorded priority or preference. Contrary to the OECD Guidelines which prefer the traditional transaction methods, the TPR require the use of the “Most Appropriate Method (MAM)”. While the OECD guidelines, in exceptional circumstances, allow the use of more than one transfer pricing methods to demonstrate the arm’s length nature of an associated party transaction, the Indian Laws allow the use of only MAM. It is ultimately up to the taxpayer to select the method that provides “the best estimation of an arm’s length price” for that particular transaction based on the considerations provided by the TPR³⁴, namely:

1. The nature and class of the international transaction;

2. The class of AEs entering into the transaction and the functions performed by them taking into account assets employed or to be employed and risks assumed by such enterprises;

3. Availability, coverage and reliability of data necessary for application of the method. The data should be complete and accurate. Also the AE should attempt to compare data with independent enterprises instead of expert reports or industrial reports as internal comparables are more reliable than external comparables;

4. Degree of comparability existing between the international transaction and the uncontrolled transaction and between the enterprises entering into the transaction, and if there are any adjustments, they should be reasonable and accurate. Also, any assumptions required to be made should be reliable and documented.

Further, it is provided³⁵ that the where more than one price is determined by using the MAM, the ALP shall be taken to be the arithmetical mean of such prices, or at the option of the assessee, a price which may vary from the mean by an amount not exceeding 5% of such mean.

All details regarding the MAM should be documented and recorded for presentation before the Assessing Officer. Although, the Assessing Officer may use a different method for the calculation of the ALP he must state the reasons for doing so.³⁶ Therefore, documentation becomes extremely important in the calculation of the ALP. In Mentor Graphics (Noida) Pvt. Ltd. vs. DCIT³⁷ the Appellate Tribunal clarified that transfer pricing is not an exact science in which mathematical certainty is possible; and some approximations cannot be ruled out. The ITAT also observed that it needs to be prima facie shown that the transaction was properly examined; comparable prices were objectively fixed in a bonafide and honest manner as required by law.

Sec. 92D of the IT Act read with R. 10D(1) of the IT Rules lays down a list of documents that are to be maintained by the enterprise. These documents may be categorized³⁸ as:

1. Enterprise-wise documents – these documents relate to the ownership/shareholding structure of the assessee, a profile of the MNE the assessee is part of, broad description of the business of the assessee and its AEs, a broad analyses of the industry of which the assessee is part;

2. Transaction-specific documents – documents listing the international transactions between the assessee and AEs, a functional analysis of the assessee and the AEs, a record of financial estimates prepared for the business which may have bearing upon the transaction, a complete record of uncontrolled transactions and comparability analysis with the relevant international transaction;

3. Computation-related documents – a description of methods considered for computing ALP and the factors determining the MAM, a record of the actual workings, any assumptions, policies or price negotiations, details of any adjustments.

4. Any other information or data that may be relevant to the AE or to the computation of ALP.

Apart from these other documents such as official publications or reports made by the Government of the country of residence of the AE; market research studies and technical publications; price publications; published accounts and financial statements of the AEs; similar transactions with AEs or unrelated parties; correspondence between the AEs; and documents required as per the accounting practices followed.

The US also follows the best method Rule. The use of such rules may result in conflicts between countries which follow the OECD Guidelines as to the determination of the method to be used.

In the matter of Development Consultants Pvt. Limited³⁹, the ITAT approved that “the tested party” concept and the use of foreign benchmarking studies adopted by the taxpayer. The Tribunal affirmed that in order to select the most appropriate method for determining the Arm’s Length Price it is first necessary to select the tested party which will be least complex of the controlled taxpayers engaged in the transaction. The Appellate Tribunal further noted the concept of “tested party” referring to Section 1.482-5 of the US Transfer pricing regulations. Tested party refers to the AE on behalf of whom the international transaction is tested for computation of ALP.

There are certain other differences between the OECD Guidelines and the Indian TPR, as regards the computation of ALP. Firstly, the OECD guidelines provide guidance with respect to cost sharing arrangements and treatment of intangibles, but there is no clear guidance in these regards in the Indian regulations. Secondly, the OECD guidelines approve the concept of Arm’s Length Range, the Indian regulations go a step further and provide a specific range as the +/- 5% range from the mean of prices. Lastly, and importantly, R.10 of the Rules have been retained which provides that when the Assessing Officer is of the opinion that actual amount of income accruing or arising to a non resident can’t be definitely ascertained, one of the three methods (presumptive, proportionate or discretionary method) contained in the rule can be adopted. These methods are more in line with the GFA which the OECD has rejected.

Under the Indian Regulations, a study of third party is a necessity and it is not sufficient for the taxpayer to simply identify and document the pricing policies adopted. To avoid any adjustment, the taxpayer has to prove that such pricing policy is justified. Such a method would need preparation of documentation by the taxpayer which otherwise would not have been required.

By putting the onus on the taxpayer to maintain information relating to the international transaction, irrespective of the extent of such transaction, the taxpayer is burdened with elaborate documentation for each transaction requiring extensive resources. In contrast to this, countries like U.K. require documentation to be maintained on a best effort basis.

Chapter 5 of the OECD Guidelines provides guidance on the type of documentation and information that would be useful in determining the Arm’s Length Price. The OECD Guidelines recognize the fact that gathering information about foreign associated enterprises across jurisdiction and countries may be difficult for a taxpayer, especially when the taxpayer is a subsidiary of the foreign associated enterprises or is only a minority shareholder as he would not have control of the associated enterprise. The Indian Revenue Authorities however are not sensitive to such kind of difficulties faced by the taxpayer while doing the transfer pricing audits. The Indian Revenue Authorities also do not endorse the provision in the OECD Guidelines which state that taxpayers are not expected to prepare records every year with regard to the transfer pricing method selected and the reasons for selecting it. In the recently concluded discussion in the aforementioned Global Transfer Pricing Forum, experts felt that India has recognized the importance of transfer pricing by increasing internal capacity but India’s overall documentation requirements were onerous and only Indian compatible are accepted.

The major disputes on the rise in India were identified as under⁴⁰:

• Multiple year versus single year data;

• Selection of comparables’;

• Economic adjustments;

• Contemporaneous nature of documentation;

• Mean versus the inter-quartile range;

• Use of +/- 5% adjustments; and

• Preference of transaction specific approach.

Resolution of Transfer Pricing Disputes

Resolution of international tax disputes is one of today’s major concerns for business and Government. As the disputes have increased in number and complexity, there is a need for more effective procedure to resolve the disputes. In the area of transfer pricing, advance pricing agreements (APAs) are gradually getting wider acceptance. APAs are agreements between tax payers and tax administrations on transfer pricing methodology (TPM) to be applied to the apportionment of income, and other tax attributes among related parties. As per OECD Guidelines, it is an arrangement that determines, in advance of controlled transactions, an appropriate set of criteria for determination of TP for those transactions over a fixed period of time. An APA is formally initiated by a tax payer and requires negotiation between the tax payer, associated enterprises and tax administration. Japan’s NTA claims to have been the first to initiate APA programme in 1987 and United States followed suit in 1991. As of today, APA programme are also available in Canada, New Zealand, Australia, Mexico, Korea, Brazil, China, UK, France, the Netherlands and Germany. Increasingly, APAs are being used to resolve/ preempt TP issues.

An advantage to APA process over administrative/ judicial procedures is that it is more of a cooperative venture rather than an adversarial undertaking. The OECD guidelines provide for an option to extend the period of applicability of an APA and also for renegotiation after its expiry. Both the US and Australia allow the option to the tax payer to apply for APA renewal. Whereas in the UK there are provisions for both, renewal and where issues remain the same, APA can simply be amended and extended. Globally, there appears to be a moderate trend for both parent and subsidiary respondents to rely less on the competent authority process. This may be a result of the increased availability of APAs, and perhaps a general desire by tax payers to manage controversy risk prospectively as a means to achieving financial statement certainty. For companies who have used APAs, proportion that would be using them again is 78% in Australia, 75% in Japan, 100% in New Zealand, 100% in Argentina, 100% in Brazil, Belgium, US, 90% in the Netherlands and 88% in UK⁴¹.

In India, the Finance Ministry has introduced the concept of advance pricing arrangement (APA) in the Direct tax code which is likely to come into force from April, 2011. Recent introduction of safe harbor rules and dispute resolution panel coupled with the proposed APA regime are welcome moves to achieve faster dispute resolution mechanism which may bring about certainty for taxpayers.

An Overview of the Amendments made to the tpr under the Direct Tax Code Bill, 2009

The Direct Tax Code Bill, 2009 (hereinafter referred to as “DTC”) shall come into effect from 1st April, 2011. DTC has brought in many amendments to the existing laws of transfer pricing under the IT Act and Rules. Let us now examine the changes made by DTC in the field of Transfer Pricing.

Firstly, the definition of the term “Associated Enterprises” has been widened by decreasing the threshold limits prescribed under Sec. 92A(2) of the IT Act. The following amendments have been made to the existing definition:

1. The amount of shareholding prescribed under Sec. 92A(2)(a) has been reduced from 26% to 10%.

2. Now if a loan advanced by one enterprise to the other enterprise exceeds 26% (as compared to 51% under the IT Act) of the book value of total assets of the latter, then these enterprises would be termed AEs.

3. Appointment, by one enterprise, of more than 1/3rd of the directors or governing members of another enterprise would make them AEs. Earlier only appointment of more than half of the directors would have had this effect.

4. A supply of 2/3rd of the raw material by one enterprise to another would render them “Associated” within the meaning of the DTC, as compared the 90% limit prescribed under the IT Act.

Secondly, certain amendments have been made with regards to the Assessment of Transfer Pricing. Now the Accountant’s report is to be filed with the Transfer Pricing Officer (TPO) who will select the cases for scrutiny based on the risk management strategy developed by the CBDT. This selection must be communicated to the taxpayer within 2 months from the end of the financial year for which the report has been filed or information about the transaction has been received by the TPO. The TPO must send his report determining the ALP, to the Tax officer within ⁴² months of the financial year in which the transaction took place. Further, the Tax Officer shall compute the taxable income based on this report and pass the assessment order within 21 months from the end of the financial year or the 3 months from the date of receipt of the TPO’s report, whichever later. Also, in the existing laws the TPO is authorized to use any information in his possession to determine the ALP, thus, creating a bias against the taxpayer. Under the DTC he may do so only after a hearing of the taxpayer.

Thirdly, the concept of Advance Price Agreements (APA) has been introduced by the DTC. It defines an APA as an “agreement between a taxpayer and tax authorities for an upfront determination of the arm’s length price in relation to international transactions”. CBDT is authorized to enter into such agreements and it shall determine the mode of calculation of ALP. This shall be binding on both the parties as regards the transaction for which it is entered into. An APA may be in force for the time prescribed in it, but for a maximum of 5 consecutive financial years.

Finally, certain other provisions have been introduced under the DTC. These are enumerated as under:

1. Impermissible Avoidance Agreements – any agreement primarily for obtaining tax benefits, creating rights/ obligations contrary to the arm’s length principle.

2. Thin Capitalization –allows the re characterization of debt as equity and vice versa in case of Impermissible Avoidance Agreements.

3. Safe Harbour Rules – a Taxpayer may be relieved from complicated obligations under in the application of the arm’s length principle by providing circumstances where the Taxpayer could follow certain simple rules. These may be provided by CBDT.

4. 2% of the international transaction as penalty for non- maintenance of records and a penalty of INR 1,00,000 for not filing the Accountant’s report within the due date. Maximum penalty for both is INR 2,00,000.

5. The due date for filing the Accountant’s Report is 31st August of the following financial year.

Concluding Remarks & Suggestions

In the current environment of global recession, it is widely recognized that the ground realities have changed and will continue to change. The multinationals are trying to optimize their transfer pricing structure and are looking at the potential benefits of sharing losses, use of transfer pricing to repatriate cash effectively, taking advantage of depressed IP values and revising ways to achieve consistent treatment of restructuring cost42. In this scenario it is suggested that the tax administrations instead of competing for maximization of tax collection from transfer pricing issues, reach agreement on primary and corresponding adjustments. The OECD on its part should play a more pro active role and work with the tax administrations in the harmonization of transfer pricing adjustments with customs valuations. The OECD should prescribe a set of guidelines, like India, to determine the relation between two enterprises instead of the present wide of the AE. It is further suggested that APAs should be made available in more countries and this should be projected as the actual solution to transfer pricing issues as against protracted and high cost litigation currently resorted to by certain countries like the USA. The tax administrations should focus more on economic ownership and proper allocation and distribution of economic income. The tax administration should realize that profit shifting results from various demands of global business and not necessarily for the purpose of tax avoidance. The concept of arbitration may be considered in more countries for resolving transfer pricing issues. The relationship between the tax payer and the tax administration in different countries should be strengthened and the tax administration should be encouraged to understand the nature of the business of the tax payer. Under the Indian Laws, there are no separate methods or guidelines for application of the usual methods to transactions like CCA, transfer of intangibles and intra-group services. The OECD on the other hand, provides Guidelines for computing ALP in such cases. The selection of MAM may be made more ‘flexible’ on the lines of the Chinese TP regulations. Further, if the ALP arrived at by the MNE and the TPO do not match, the TPO may use his own method to compute ALP, which may create a bias against the MNE and it must be heard. Lastly, there is no guidance on practical application of TP rules in India. In this context, the rapid development of the Transfer Pricing regulations in India particularly, the positive direction given in the Direct Tax Code 2009 appears to be a leap in the right direction. The need of the hour is not an aggressive tax collection drive but a Transfer Pricing regime which takes into account, the best interests of business and Governments.

References

Books :

1. Bombay Chartered Accountants Society, Transfer Pricing Manual, Volumes 1 & 2, 2009 Edition

2. Bhutani, Mukesh, Transfer Pricing- An India Perspective, 2nd Edition, 2007 Lexis Nexis

3. Deloitte, CCH, Transfer Pricing Law and Practice in India, 2008 Edition, Wolters Kluwer (India) Pvt. Ltd.

4. PriceWater Coopers, International Transfer Pricing, 2009 Edition

5. Mittal, D.P., Taxmann’s Transfer Pricing in India, 2008 Edition, Taxmann

6. Dr. Singhania, Vinod K. & Dr. Singhania, Kapil, Taxmann’s Direct Taxes – Law and Practice, 37th Edition, 2008, Taxmann

Legislations :

1. Income Tax Act (India), 1963

2. Income Tax Rules, (India), 1962

3. New Tax Code (India)

4. OECD Guidelines Transfer Pricing for Multinational Enterprises and Tax Administrations, 1995

5. U.N. Model Tax Convention on Double Taxation

6. Inland Revenue Code (United States)

7. ICTA88/SCH28AA (United Kingdom)

8. Special Taxation Measures Law (Japan), 1986

9. Tax Administration Rules and Procedures for Transactions between Associated Enterprises (China), 1998

10. Income Tax Act (Singapore) and Transfer Pricing Guidelines, 2006

11. TR98/11, TR97/20 and TR94/14 (Australia)

Articles :

1. Agrawal, Mayank K., Transfer Pricing in India- a Beginner’s Perspective

2. Sullivan, Martin A., Economic Analysis: Extraordinary Profitability in Low-Tax Countries

3. Ostwal, T.P., Recent Transfer Pricing Controversies

4. Grand Thornton, Transfer Pricing in Japan

5. KPMG, India: Details of Transfer Pricing Proposals in the Direct Tax Code Bill, 2009

6. Ernst and Young, Direct Taxes Code Bill, 2009 – Key Amendments Relating to Transfer Pricing Provisions

7. Discussion in Annual Global Transfer Pricing Forum held by International Tax Review

8. Report from Arcotia Hatsidimitris (Head, IBFD International Tax Academy)

9. Ernst & Young, Global Transfer Pricing Survey, 2007-08

10. Introduction to Concepts and Risk Management

Websites :

1. www.incometaxindia.gov.in

2. www.oecd.org

3. www.un.org

4. www.upan.un.org

5. www.hmrc.gov.in

6. www.irs.gov

7. www.ato.gov.au

8. www.iras.gov.sg

9. www.iccwbo.org

10. www.deloitte.com

11. www.kpmg.com.sg

12. www.kpmg.co.uk

13. www.gthk.hk

14. www.transferpriscing.com

15. www.freshfields.com

16. www.manupatra.com

17. www.iimcal.ac.in

18. www.ey.com

19. us.kpmg.com

20. online2.ibfd.org

21. services.taxanalyst.com

22. www.bcasonline.org

23. www.usa-international-offshore-company-tax.com

1. Sullivan, Martin A., Economic Analysis: Extraordinary Profitability in Low-Tax Countries, available at http://services.taxanalyst.com.

2. Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, OECD, 1995

3. Deloitte, CCH, India, Transfer Pricing Law and Practice in India, 2008 Edition, Wolters Kluwer (India) Pvt. Ltd.

4. Ostwal, T.P, Practical Aspects and Recent Developments in Transfer Pricing, power point presentation
   dated 08-11-2006, http://www.bcasonline.org/webadmin/res_material/resfiles/43RecentTransferPricingControversies.pdf

5. Paragraph 3.59, OECD Guidelines, 1995 (2009)

6. Mittal, D.P., Taxmann’s Transfer Pricing in India, 2008 Edition

7. Preface to the OECD Guidelines, 1995

8. Commentary on OECD Guidelines, 1995 available on www.oecd.org/dataoecd/52/24/36221039.pdf

9. Art. 9(1), OECD Guidelines, 1995

10. Art. 9, OECD Guidelines, 1995

11. http://www.usa-international-offshore-company-tax.com/transfer_pricing.asp

12. 69 TC 579 (1978)

13. T.C. Memo 1998-461 (Dec.30, 1998)

14. 366 U.S. 316 (1961)

15. 125 T.C. No. 4, filed August 30, 2005

16. GlaxoSmithKline Holdings (America) Inc. v. Commissioner of the IRS (117 TC 1); settled in September 2006

17. Discussion in Annual Global Transfer Pricing Forum held by International Tax Review, available at http://online2.ibfd.org/data/tns/docs/html/tns_2009-09-23_fr_1.html

18. Paragraph 2, ITCA88/SCH28AA

19. http://www.hmrc.gov.uk/manuals/intmanual/INTM432050.htm

20. http://www.hmrc.gov.uk/manuals/intmanual/INTM432030.htm

21. http://www.hmrc.gov.uk/manuals/intmanual/INTM433030.htm

22. Recent Developments & Trends in Transfer Pricing by Murray Clayson and Danny Beeton available at http:// www.freshfields.com/publications/pdfs/2009/aug09/ClaysonBeeton.pdf

23. 2009 TC 00001

24. Introduction to Concepts and Risk Management available at http://www.ato.gov.au/content/downloads/LBI_35283_introduction_concepts_risks_assessment.pdf

25. Transfer Pricing in Japan by Grand Thornton, available at www.gthk.com.hk

26. (25 ITR 27)

27. (34 ITR 368)

28. Memorandum explaining the Finance Bill, 2001

29. Memorandum explaining Finance Act, 2002

30. Sec. 92B, IT Act, 1961

31. Morgan Stanley & Co. v. DIT (2007) 292 ITR 416 SC

32. SET Satellite (Singapore) v. DDIT [106 ITD 75 (Bombay)]

33. M/s Rolls Royce Plc v. DDIT [ITA Nos. 1496 to 1501/DEL of 2007]

34. R. 10C of the IT Rules, 1962

35. Sec. 92C(2) of the IT Act, 1961

36. BCAS, Transfer Pricing Manual, Vol.1, 2009 Edition, Pg.128; confirmed in Aztech Software & Technologies Services Ltd. v. ACIT [2007] 294 ITR (A.T.) 32 (Bang) (SB)

37. [2007] 109 ITD 101 (Delhi)

38. BCAS, Transfer Pricing Manual, Vol. 1, 2009 Edition, Pg. 76

39. Development Consultants Pvt. Ltd. v. DCIT [2008] 115 TTJ 577 (Kolkata)

40. Report from Arcotia Hatsidmitris, (Head, International Tax Academy), available at http://online2.ibfd.org

41. Ernst & Young, Global Transfer Pricing Survey, 2007-08

42. Discussion in Annual Global Transfer Pricing Forum held by International Tax Review, available at http://online2.ibfd.org/webadmin/res_material/resfiles/43-RecentTransferPricingControversies.pdf