Navigating Transfer Pricing Compliances: Methods And Frameworks Under Indian Tax Law

This article provides a detailed exploration of transfer pricing ('TP') compliance methods and frameworks as mandated under Indian tax law. Starting with an overview of TP regulations introduced in 2001, it delves into the procedural and strategic aspects that multinational enterprises must navigate to align with local and global tax standards. Key methodologies, compliance requirements, and the pivotal role of the arm's length principle are discussed to guide entities through the complexities of TP to ensure legal and financial conformity.

Introduction

TP regulations, introduced in 2001, aim to prevent the evasion of the Indian tax base, as enshrined in ss. 92 to 92F of Chapter X of the Income-tax Act, 1961 ('Act'). TP involves valuing intra-group, cross-border transactions within multinational enterprises ('MNEs'), applying to international transactions between associated entities, such as parent-subsidiary relationships and transactions between subsidiaries under common control. TP plays a pivotal role in MNEs' financial strategies, allowing profit optimization through strategic allocation of earnings across various subsidiaries, thereby optimizing global tax liabilities and mitigating tax discrepancy risks.

Compliance with TP regulations reduces the risk of disputes with tax authorities, which could lead to penalties, interest accruals, and reputational impairment. TP considerations are crucial for global market entry strategies, ensuring compliance with local tax jurisdictions and TP protocols, facilitating frictionless market entry, and avoiding tax-related obstacles. Internally, TP is a performance assessment tool, enabling MNEs to evaluate distinct business units' profitability and operational efficiency. It also ensures that MNEs derive commensurate value from their intellectual property assets while securing associated tax benefits.

Conceptual Framework of TP

The conceptual framework of TP is based on the arm's length principle ('ALP'), a globally recognized standard for evaluating intra-group transactions within MNEs. The ALP, outlined in s. 92A of the Act stipulates that transactions between associated enterprises ('AEs') should be conducted under terms and conditions comparable to those agreed upon by unrelated entities in similar transactions and circumstances. The ALP prevents TP manipulation, preventing AEs from engaging in artificial price-setting practices to shift profits to low-tax jurisdictions, thereby minimizing their tax liability. Adherence to the ALP ensures that transactions reflect economic realities and facilitate appropriate profit allocation among AEs.

The Organisation for Economic Co-operation and Development ('OECD') TP Guidelines provide a comprehensive framework for determining ALP, documenting TP policies, and resolving related disputes. MNEs must adhere to the ALP through rigorous TP analyses, meticulous documentation of pricing arrangements, and ensuring congruence with arm's length standards. Tax authorities may scrutinize TP arrangements and implement adjustments if transactions are deemed non-compliant with the ALP, potentially resulting in tax assessments and penalties. Though not an OECD member, India is a key partner country, actively participating in various OECD committees, workshops, and working groups. The bilateral relationship between the OECD and India fosters cooperation in addressing TP issues and promoting improved tax compliance to mitigate cross-border disputes.

Methods of TP

There are five methods, other than the residuary method, for TP purposes for MNEs and tax administration, defined under r. 10B(1)(d) of the Income-tax Rules, 1962 ('Rules'). R. 10B(2) of the Rules emphasizes the importance of considering functions, assets, and risks in the comparability analysis ('FAR analysis'). The FAR analysis is crucial in determining the appropriate TP method. Entities can choose the most appropriate method ('MAM') based on the nature of goods, activities, market conditions, and other comparables without a prescribed sequence for applying these methods.

1. Comparable Uncontrolled Price ('CUP')

This method compares the price charged in a controlled transaction with that charged in a comparable uncontrolled transaction. There are two types of CUP:

a) Internal CUP: Involves the taxpayer or another entity within the same group engaging in comparable uncontrolled transactions with independent entities.

b) External CUP: Evaluating the controlled transaction against a comparable uncontrolled transaction. Internal CUP is generally preferred over external CUP due to the higher reliability and accuracy of available data for analysis.

The CUP method's direct application to the ALP makes it effective for determining ALP, reflecting the 'open market' price in a controlled transaction. However, its stringent comparability criteria often lead to the rejection of potential comparables. In Bharti Airtel Ltd. v. ACIT¹, the Income-tax Appellant Tribunal ('ITAT') held that the market's geographical location is inconsequential in assessing the comparability of an uncontrolled transaction for the purpose of applying the CUP method unless the market conditions differ materially.

In Gharda Chemicals Ltd. v. DCIT², the ITAT preferred the internal CUP method over the external CUP method on the grounds of its superior ability to neutralize distinguishing factors that impede comparability, specifically local market conditions and economic circumstances unique to the taxpayer's operations. It was noted that by utilizing the assessee's own transactions with unrelated parties, the internal CUP method provides a more precise and contextually relevant comparison of prices in controlled and uncontrolled transactions. This decision emphasizes the importance of leveraging taxpayer-specific data when available, aligning with international TP principles, prioritizing comparability, and using the most reliable data.

2. Resale Price Method ('RPM')

This method focuses on the gross profit margin as a key indicator of ALP, comparing the margin earned by the tested party³ in a controlled transaction with that of comparable independent entities engaged in similar uncontrolled transactions. RPM is applicable when the reseller adds minimal value before resale and where reliable comparables for the resale transaction can be identified. There are two types:

a) Internal RPM: Compares the gross profit margin of the controlled transaction with a comparable uncontrolled transaction of the tested party.

b) External RPM: Compares the gross profit margin of the tested party in a controlled transaction with that earned by an independent third party in a comparable uncontrolled transaction.

RPM's primary advantage is its demand-driven approach, which is predicated on the resale price and reliability when demand is inelastic. In Gharda Chemicals Ltd.'s (supra) case, the ITAT held that RPM is applicable only where an Indian enterprise procures goods or services from its AE and not in the converse situation. The Tribunal rejected RPM's application where the Indian enterprise sells, rather than purchases, goods to its foreign AE. In L'Oreal India Pvt. Ltd. v. DCIT⁴, the ITAT held that in the absence of a prescribed hierarchy in method selection, RPM retains its status as the MAM in evaluating distribution and marketing activities where goods are procured from AE and subsequently sold to unrelated parties.

3. Cost Plus Method ('CPM')

This method determines the appropriate price for property or services supplied to an AE by augmenting the supplier's cost base with a suitable gross margin. CPM's simplicity and seamless integration with existing accounting systems facilitate straightforward invoicing and payment processing. However, its inherent simplicity may lead to inappropriate application in transactions involving valuable intangibles, potentially resulting in significant profit fluctuations for the related party distributor.

In Skaps Industries India (P.) Ltd v. DCIT⁵, the ITAT addressed the rejection of CPM employed by the assessee for benchmarking its international transactions in fabrics manufacturing and sales. The TP officer ('TPO') and CIT(A) had dismissed the CPM, citing its sensitivity to differences in accounting practices and the lack of readily available comparable gross profit margins. However, the Tribunal found that the TPO had failed to consider the assessee's specific manufacturing and sales activities adequately and erroneously omitted to base the gross profit margin solely on manufacturing costs. The ITAT noted that the TPO had not sufficiently considered appropriate comparables and necessary adjustments, such as bulk quantity discounts and customs duties. The Tribunal emphasized the critical oversight of the assessee's status as a 100% export-oriented unit and remanded the matter to the TPO for reassessment. This case underscores the importance of a nuanced application of CPM, considering the unique circumstances of each assessee and the specific nature of their international transactions.

4. Profit Split Method ('PSM')

This method allocates combined profits earned by related parties from transactions based on a predetermined, economically valid basis, replicating the profit division expected in an arm's length agreement. PSM ensures that the ALP is derived for both parties by reverse-engineering from overall profit to price. It involves analysing combined profits and splitting them based on the FAR analysis. This method benefits highly integrated transactions where traditional methods may not apply. PSM considers the shared nature of risks and contributions among AEs, aligning with ALP by facilitating fair profit distribution, provided that robust economic analysis clearly defines and substantiates the profit split basis. However, its practical application is complex, involving challenges in accurately determining profit shares and contributions.

In DQ Entertainment (International) Ltd. v. DCIT⁶, the ITAT addressed the issue of profit attribution ('PA') under PSM concerning intangible assets transferred to its AE. In this case, the Dispute Resolution Panel ('DRP') and assessing officer ('AO') proposed an adjustment of Rs. 2,84,73,482 as PA to the appellant company, arguing that revenue generated by the AE, DQ Ireland, as the absolute owner of intangible assets, justified such an adjustment. The assessee contended that intangible assets had been transferred at ALP in previous years, accepted by AO/TPO, and thus required no further adjustment. The ITAT referred to its earlier rulings in the appellant's case, determining that the sale of intellectual property to AE had been appropriately valued at arm's length in the year of sale and accordingly directed reconsideration in accordance with the principles of natural justice.

5. Transactional Net Margin Method ('TNMM')

This method determines profits from controlled transactions by comparing them with returns achieved by comparable independent enterprises. TNMM calculates the net profit margin relative to an appropriate base for controlled transactions, referencing the net profit margin of similar bases in uncontrolled transactions. Its primary advantage is its reliance on publicly available data on net profits of comparable independent enterprises, facilitating easier application and reduced sensitivity to minor product differences compared to CPM or RPM. However, its main drawback lies in the potential inadequacy of detailed public information, which may compromise true comparability by introducing the risk of reliance on insufficient data.

In DCIT v. Investurus Knowledge Solution (P.) Ltd.⁷ the ITAT upheld the CIT(A)'s decision, affirming that the international AE should be considered the tested party for TP regulations. This case involved an international transaction where the assessee, engaged in providing revenue cycle management services, applied TNMM. The assessee designated its international subsidiary as the tested party, using databases such as Standard & Poor's Compustat and merchant databases to identify comparable entities. The TPO had rejected the AE as the tested party, citing challenges in comparability analysis due to geographical differences, and the CIT(A) reversed the decision. The ITAT confirming the CIT(A)'s decision emphasized that the tested party should have the simplest functional analysis and least complexity, aligning with OECD guidelines.

Documentation Required for TP Compliance & Procedure

Under Indian TP Regulations, persons engaged in international transactions must maintain documentation. R.10D(2) of the Rules reiterates that if the aggregate value of transactions exceeds Rs. 1 crore, the assessee must keep prescribed information and documents. However, if the aggregate value does not exceed this threshold, the assessee is exempt from maintaining the specified information and documents listed in the rule.

Procedure in Case of Non-Compliance

Tax authorities conduct TP audits to ensure that MNEs comply with the ALP and domestic TP regulations. During audits, tax authorities meticulously scrutinize the taxpayer's TP documentation, inter-company agreements, and financial records to verify related-party transaction prices. This rigorous process requires comprehensive evidence to support TP methodologies. Authorities may adjust TP if found inconsistent with the arm's length standard, resulting in additional tax liabilities, interest charges, and penalties.

In India, entities engaged in international transactions with AEs must obtain a report in Form No. 3CEB from a Chartered Accountant and submit it by November 30th, coinciding with the IT filing deadline. Filing this form online has been mandatory since assessment year ('AY') 2013-14. Entities selected for scrutiny based on risk parameters may undergo TP audits, during which the tax authority or TPO may request TP documentation, which must be provided within 10 days of notice. The TPO can independently determine the ALP of the taxpayer's international transactions, and any discrepancy may result in primary adjustments, subjecting such difference between the TPO-determined price and the assessed determination to taxation in India.

Advance Pricing Agreements⁸ ('APAs') offer a proactive compliance mechanism, allowing taxpayers to obtain pre-approval from tax authorities on TP methods for specific transactions over a set period. Introduced in India on 01.07.2021, APAs can be unilateral, bilateral, and multilateral. While obtaining an APA can be time-consuming and costly, the benefits include compliance with TP rules and reduced audit risks. Indian APA rules impose no monetary or other conditions for eligibility, though APAs are not available for specified domestic transactions ('SDTs'). Valid for up to 5 consecutive years, APAs bind both the taxpayer and Revenue authorities concerning the covered international transactions.

The APA process comprises four phases:

• Pre-filing: A consultation meeting determines the agreement's scope and transaction suitability.
• Formal submission: The taxpayer submits an application with critical assumptions and pays the filing fee.
• Negotiation: Meetings and inquiries lead to a draft report by the APA team.
• Finalization: Comments are exchanged, the APA is finalized, and initial years under the APA term are addressed.

The taxpayer must prepare an annual compliance report ('ACR') for each APA year, detailing actual results and demonstrating compliance with APA terms. The ACR must be submitted within 30 days of the IT return due date or 90 days of entering the agreement, whichever is later.

Penalties for Non-Compliance

In case of failure to comply with the procedure prescribed above, the person shall be subject to the following penalties:

• S. 271(1)(c) of the Act: Addresses concealment or furnishing of inaccurate particulars of income. The penalty ranges from a minimum of the tax sought to be evaded to a maximum of thrice this amount, in addition to any applicable tax. This penalty may be imposed by the AO, CIT(A), or Principal CIT ('PCIT').
• S. 271AA of the Act: Pertains to failure to maintain or furnish information and documents as mandated by ss. 92D(1) and 92D(2) of the Act or reporting incorrect information. The penalty is set at 2% of the value of each international transaction, imposed by the AO or CIT(A).
• S. 271BA of the Act: Addresses failure to furnish an accountant's report as required by s. 92E of the Act. The penalty for non-compliance is a fixed sum of Rs. 1 lakh, imposed by the AO.
• S. 271G of the Act: Covers failure to furnish information or documents during a TP audit as required under s. 92D(3) of the Act. The penalty is equivalent to 2% of the value of each international transaction or SDT imposed by the AO/TPO or the CIT(A).

Role of TPO

Under s. 92CA(1) of the Act, if an assessee engages in an international transaction or SDT during any previous year, the AO may refer the case to the TPO to compute the ALP. This referral requires prior approval from the CIT or PCIT.

Upon receiving the referral, the TPO is required to issue a notice to the assessee. This notice mandates the production of any evidence that the assessee intends to rely upon to substantiate the computation of the ALP for the relevant international transactions or SDTs. The TPO's authority also extends to any transactions not reported in Form No. 3CEB that may come to light during the assessment proceedings under s. 92CA of the Act.

After reviewing the presented evidence and relevant factors, the TPO determines the ALP. The TPO must then formally communicate the determined ALP in writing to the AO and the assessee. Upon receipt of the TPO's order, the AO is obligated to compute the total income of the assessee in conformity with the ALP as determined by the TPO.

Conclusion

TP procedures and compliance mechanisms are essential for ensuring fair and accurate allocation of profits among AEs across jurisdictions. Adherence to TP regulations ensures compliance with international standards and mitigates the risk of disputes and financial penalties. MNEs must prioritize TP compliance to optimize their global tax liabilities, maintain their reputation, and support smooth market entry and expansion.

Non-compliance with TP documentation and reporting requirements can lead to significant financial penalties, substantially increasing the cost of doing business and impacting the profitability of MNEs. Moreover, non-compliance can damage reputation, as it may lead tax authorities to perceive the MNE as engaging in tax evasion or avoidance. This perception can negatively impact the entity's reputation and relationships with stakeholders, including investors, customers, and regulators. Therefore, businesses with cross-border transactions must understand and prioritize TP compliance to ensure their long-term sustainability and success.

Footnotes

1 (2014) (43 taxmann.com 50) (Delhi-Trib.) [2014] 64 SOT 50 (Delhi-Trib.) (URO)/[2014] 161 TTJ 283 (Delhi - Trib.)[11-03-2014].

2 [2010] 35SOT406 (MUM.)/[2010] 130 TTJ 556 (Mumbai)[30-11-2009].

3 The Tested Party is the entity for which RPM evaluates the price at which it sells a product to an unrelated customer, establishing an arm's length gross margin based on its functions, assets, and risks.

4 [2013] 34 taxmann.com 78 (Mumbai Tribunal).

5 [2024] 162 taxmann.com 675 (Ahmedabad - Trib.)[08-05-2024].

6 [2022] 141 taxmann.com 188 (Hyderabad - Trib.)[23-06-2022].

7 2022] 145 taxmann.com 514 (Mumbai - Trib.)[21-10-2022].

8 APAs are formal arrangements between a taxpayer and tax authorities that establish TP methodologies for cross-border transactions. These agreements provide certainty and ensure consistency in the allocation of profits across AEs by determining acceptable pricing methods in advance. The Institute of Company Secretaries of India (2016), Guide to Transfer Pricing, pp. 61–65.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.