Transfer Pricing on Specified Domestic Related Party Transactions

Applicability of Transfer pricing regulation on Specified Domestic Related Party Transactions

The Union budget 2012 (“UB”) has extended the gamut of transfer pricing regulation to domestic firms, with effect from 1st April, 2013. Therefore, transfer pricing regulation will be applicable to specified domestic transactions that these firms get into with their sister company from same group.
Transfer Pricing on Specified Domestic Related Party Transactions
Transfer Pricing Domestic Related Party Transactions
The Supreme Court in the case of CIT Vs Glaxo SmithKline Asia (P) Ltd, after examining the complications which arise in cases where fair market value is to be assigned to transactions between domestic related parties, has suggested that Ministry of Finance should consider appropriate provision to make Transfer Pricing regulations applicable to certain related party domestic transactions.
Thus UB 2012 empowers the tax officer to re-compute the income of the related parties if the transactions are not at fair market value, there is, however, no specific method to determine the fair market value. The transfer pricing provisions in respect of domestic transaction are applicable to transactions that will exceed threshold of Rs 5 crore.

How to Define Domestic Related Party?

The domestic related party will inter alia include a director, a relative of the director, a person having substantial interest in the taxpayer (carrying not less than 20% of the voting power) and fellow related parties where a single person has substantial interest in two taxpayers.

Specified Domestic Transactions defined

The following transactions with the aggregate value exceeding INR 50 million (US$ 1 million) are covered.
  • Expenditure for which payment is made or to be made to specified domestic related parties.
  • Transfer of goods or services to/from eligible business (tax holiday undertaking) from/to other business (non-tax holiday undertaking).
  • Business transactions between eligible business (tax holiday unit) and other person(s) producing more than ordinary profits owing to close connection.

Specified Domestic Transactions in a simplified language:

  • Any expenditure in respect of which payment is made or is to be made to a person referred to in Section 40A(2)(b) of the IT Act;
  • Any transaction that is referred to in Section 80A;
  • Any transfer of goods or services referred to in Section 80-IA(8) i.e. applicable to companies operating as industrial undertaking or enterprises engaged in infrastructure development;
  • Any business transacted between the assessee and other person as referred to in section 80-IA(10);
  • Any transaction, referred to in any other section under Chapter VI-A or section 10AA, to which provisions of sub-section (8) or sub-section (10) of section 80-IA are applicable;
  • Any other transaction, as may be prescribed by the board.

Provided that the aggregate value of the transaction entered into by the assessee with its domestic associated enterprise exceeds Rs. 5 crores.

Enactment:

Effective from April 1, 2013, if the aggregate value of “specified domestic transaction” exceeds INR 5 Crores (US$ 1 Million) in a year, Taxpayers will now have to:
  • Documentation: maintain mandatory documentation as required U/s 92 D read with rule 10 D
  • Compliance: file Form 3CEB along with their tax return. (Sec 92 E)
  • Methods: follow the five transfer pricing methods for determining arm’s length price. (Sec 92 C)
  • Scrutiny: Be subject to scrutiny by the TPO (Sec 92 CA)
  • Penal Provision: be subject to penal provisions as provided U/s 271AA, 271G, 271BA and 271(1)(c).
Also the finance bill expands the definition of related parties for purpose of section 40A to cover cases of companies which have the same parent company.

Purpose of Amendment

This amendment strives to do away with tax arbitrage abuse that stems from
  1. Differential tax rate

    When one of the entities to the transaction enjoys a tax stimulus (i.e. in case of entities in SEZ, Infrastructure sector, backward area etc.) parties are tempted to shift profit to the entity enjoying favored status.

  2. Presence of accumulated loss

    When one the party to the transaction have accumulated loss in their book, they might be tempted shift profit from profit making entity to the organization with accumulated loss in a bid to profiteer from reduced combined tax obligation

 

Methods for determining Arm’s Length Price

The Arm’s Length Price has to be determined applying any of the prescribed methods

Penal Consequences

A stringent penalty regime has been prescribed:
  • Failure to maintain documents – 2% of the value of the transaction
  • Failure to furnish documents – 2% of the value of the transaction
  • Failure to report a transaction in Accountant’s report – 2% of the value of the transaction
  • Maintaining or furnishing incorrect information or documents – 2% of the value of the transaction
  • Adjustment for incorrect pricing – 100% to 300% of the additional tax payable

Due date for filing the Accountant’s report and documentation

  • The Accountant’s report needs to be submitted with the tax authorities by the due date of filing annual return of income.
    At present, the due date is 30 November.
  • Documentation is not required to be submitted along with the Accountant’s report, but is to be in place by the due date. It it does need to be submitted during the course of the audit/assessment.

Burden:

  1. Increased compliance burden on all effected assessee: in terms of maintaining TP documentation, selecting the most appropriate method and being subject to scrutiny by the TPO.
  2. Increased administrative burden on revenue department: Indian revenue department, which is still grappling with developing adequate expertise to address international transaction, will now have to double up for domestic transaction as well. However with the avenue of increase in revenue in the eyesight, they would be least bothered about logistics.
  3. Impact on litigation: Although SC had suggested introduction of TP to the domestic turf in a bid to bring legislative clarity and reduce litigation. However, given the litigative record of Revenue department with respect to TP sphere one would have reasonable reason to doubt it
  4. Formulation of product pricing methods: Methods of arm length pricing along with TP concepts and considerations like risk -reward planning, benchmark driven pricing, supply chain re-engineering, location planning study, etc. would help in formulation of product pricing methods and also enable legitimate tax cost management (TCM) avenues.
  5. Robust TP Documentation: Assessee will also be subject to stringent penal provisions as provided U/s 271AA, 271G, 271BA and 271(1)(c). As a corollary, maintenance of robust TP documentation would be accorded paramount significance.

Conclusion

In order to avoid litigation at the future date, companies who have domestic transaction with its related parties equal to or more than Rs. 5 crore or companies whose present domestic transaction less than Rs. 5 crore but is likely to increase beyond Rs. 5 crore in the financial year 2013-14 are advised to validate their present business model and pricing methodology from a transfer pricing perspective which will enable them to take corrective actions, if necessary.

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