Transfer Pricing Mechanism in India

Introduction

Indian businesses are now reaching the global scale by setting up their subsidiaries and affiliates in multiple locations across the world. When a global multinational company sells products, services or technology between its related entities in different countries it is faced with major difficulties such as the transfer pricing. The term "Transfer Pricing," this is the process of how the internal prices within an organization are set.

This term "transfer pricing" means the value for the transfer of goods and services between related companies or the value attached to exchanging goods and services between related parties who exercise joint ownership or control. The 1961 Income Tax Act provides for the guidelines containing the provisions for transfer pricing and its application in India. India, however, in the case of 'international transactions' between related firms, as well as income produced from 'international transactions' between affiliated enterprises, has to follow the route of ‘arm’s-length pricing'. In order to be treated as reasonable, a transfer price (for cost or interest) should be determined with reference to the arm’s length price.

In 2001, provisions on transfer pricing as per the Indian Income-tax Act were amended.

Transfer Pricing Regime in India

Corporations that engage in international transactions with an affiliated firm must document those transactions using the required form and have them reviewed by a certified public accountant. IT Act[1] requires the retention of contemporaneous data on entities, prices, and transactions, respectively. After all the documentation has been received, the Assessing Officer will choose cases for further investigation and review.

The TPO is responsible for calculating the Arm's Length Price (ALP). The AO receives an order from the TPO, calculating the assessee's total income in accordance with the ALP before delivering the drafted order to the assessee. Within 30 days of receiving draught orders, assessors must either accept them or file objections with the Dispute Resolution Panel (DRP) for assessment and discussion. Alternatively, he has 30 days from the date of receipt of the final order to file an appeal with the Commissioner of Income Tax (CIT) (Appeals).

The Finance Act of 2012, on the other hand, made changes to Section 253(2A) of the Information Technology Act of 1984. If an objection is made after July 1, 2012, the Principal Commissioner or Commissioner of Internal Revenue may initiate an appeal with the Income Tax Appellate Tribunal against the DRP's decision (ITAT). When it comes to deciding on appeals, the Income Tax Act affords the two dispute resolution organisations varying amounts of time to do so. In accordance with Sections 250(6A) and 254, the CIT(A) or ITAT shall, to the extent practicable, respond to appeals within a reasonable time. An entire year has passed since the conclusion of the fiscal year in which an appeal for the CIT is filed has been completed. As a result, the ITAT has a four-year statute of limitations for filing an appeal. While this is true in general, Section 144(C)(12) requires that no directive be provided by the DRP after nine months have gone since it was sent to an eligible assessee in conjunction with the draught order as per law.

The Act therefore only applies to DRP, in spite of the fact that it has a date attached to it. The ITAT is the final and conclusive authority in this case. Any legal appeals are considered by the High Court, which then refers the case to the Supreme Court for consideration.

The Arm’s Length Principle

Different nations have vastly differing tax rates. Since countries with high tax rates have an incentive to relocate their money into countries with lower tax rates, multinational firms have an incentive to do so. Profit shifting is possible when a parent company gives financial or advisory services to its subsidiaries or a manufacturing branch distributes completed items to a distribution branch. A network may be used to offer services from one linked business to another. Consequently, the quantity of profit earned and the amount of tax paid at the end of the day are subject to the influence of multinational corporations. With this in mind, tax administrations (which are part of the OECD) have adopted the arm's length principle. In accordance with the legislation, all regulated transactions must be conducted at market prices.

Companies that are connected in some manner must agree to the same terms and conditions as non-related organizations for similar transactions while engaged in regulated activities so as to follow the arm's length principle. When the terms and circumstances are in line with this fundamental idea, it is said to be "at arm's length.".[2]

Methods of Transfer Pricing

CUP Method: Comparing the price paid in a regulated transaction to the price paid in an unregulated transaction between comparable independent parties under similar conditions is known as the "Comparable Uncontrolled Price (CUP) approach. A CUP can make use of comparable transactions that are both internal and external to the organisation.[3]

Transactional Net Margin Method: There are several ways to find out if a transaction is at arm's length. To establish whether or whether transactions involving related parties were carried out on an arm's length basis, it analyses the operating and net margin of different firms

Profit Split Method: There are instances when the transactions of a corporation are so intertwined that it is difficult to distinguish between them. In order to evaluate these types of regulated transactions, the Profit Split Method is employed as it calculates what proportion of earnings independent firms would have realized as a result of their participation.[4]

Other Method: Rule 10AB, a new rule, which is comparable to the CUP Method, has been added to compare the real price of an uncontrolled transaction with the price quoted in the transaction. Transactions involving a third party are permitted under the new rule. According to this guideline, the price that would have been charged or paid in an uncontrolled transaction should be utilised as a starting point. According to the OECD Guidelines, the alternative technique allows for some degree of flexibility in selecting between the five steps required for computing ALP, with the first step being the most straightforward.

Case Study: Engineering Analysis Centre of Excellence Ltd. vs CIT[5]

Factual Background

Courts in Karnataka and Delhi had two sets of appeals before the Supreme Court, which ruled on both sets in a two-day hearing on Monday. Supreme Court also put to rest the conflicting decisions of the Authority for Advance Rulings (AAR). A non-resident Indian corporation sells shrink-wrapped computer software to the Appellant, who is an Indian resident in the United States. Taxes were not deducted from payments to the corporation by the Appellant because of their nature. However, since the parties had agreed on a copyright for the right to use the software in consideration for royalties, it was found that tax should be deducted at source in line with Section 195 of the Act in this situation. An appeal to the Karnataka High Court by a variety of assessors was unsuccessful. the High Court upheld the appeal and found that the sale of computer software contained a right or interest in Copyright, which therefore generated royalty payments and necessitated a tax deduction at source under section 9(1)(vi) of India's Income Tax Act. Civil appeals were brought at the Supreme Court by the Appellant and others who felt they had been wronged.

Issue Before the Court

“The Supreme Court had to decide if an Indian resident making payments for software purchased from foreign software suppliers qualified as "royalty" under the terms of the DTAA and s 9(1)(vi) of the Income Tax Act, 1961. If yes, then was he compelled to deduct tax at source under Section 195 of the Act.

Judgement

Ø  Only those sections of the Act that are more favourable to the assessee may be enforced while the DTAA is in effect.

Ø  To be eligible for Tax Deduction at Source under Section 195 of the Act, a non-resident must be required to pay tax under Section 9's charging provision read with Section 4 of the Act, as well as the DTAA's Tax Treaty Agreement. There is no need to apply the PILCOM decision in this situation.

Ø  When a computer program is used for the purpose for which it was provided, or if it is used as a backup copy, it does not constitute infringement of copyright and does not constitute a transfer of copyright as defined in Sections 14b(ii) and 52(1)(aa).

Ø  It is important to read the EULAs as a whole in order to understand the full nature of the agreement. According to Tata Consulting, the sale of a physical thing with an integrated computer software qualifies as a licensed transaction.

Ø  It is impossible for the Act's Explanation 4 to apply retroactively. Because the Supreme Court agreed with the assesses in all four areas, they won.

Conclusion

Transfer pricing reforms have been beneficial, however there are still concerns that need to be dealt with. As a primary worry, more than one-third of all situations are comparable to those of an assessee in the past. As a result, the department and taxpayers are likely to get stuck in the same issues over and over again. The APAs were created solely for this purpose.  From the perspective of tax administration, switching from the expensive and time-consuming dispute resolution technique to the APA mechanism would be better. Since it allows everyone involved in financial management to more accurately predict their costs and spending, as well as their tax obligations, the APA programme has shown to be beneficial to all parties involved in financial management. Inter-company price disagreements can be resolved quickly and peacefully if the Indian government and the Central Board of Trade (CBDT) are willing to be flexible.

Further, for firms, understanding and following the regulations is much better to being subjected to the taxman's wrath and scrutiny. Therefore, transfer pricing should be a critical consideration in the development of a company's strategy and decision-making processes. Preventative efforts must be made to improve the performance of the company, limit legal risk, and lower the overall tax burden. This can be accomplished through merging and restructuring business units. If the organisation adheres to this strategy, it will reap both immediate and long-term rewards.

Suggestions

It takes time for a law to grow as institutions mature and precedents become more readily available. This is true of India's transfer pricing regulations. In terms of the length of cases, there has been some noticeable progress. The introduction of the DRP was also a factor in the reported decrease in length. Recurring conflicts over the same issues and low success rates for tax officials mean that the current system still needs to be reformed. It is necessary to promote in advance price agreements in order to reduce the related expenses.

The tax agency also has a shortage of expertise in the field of transfer pricing. As a time- and money-saving measure, a combination evaluation may be an appropriate option.

Suggestion in light of the Covid-19 pandemic

Covid-19 will force companies to reevaluate their transfer pricing practices. Agreements between businesses must be re-examined. It is expected that tax payers would take into account the influence on profit margins of limited-risk distributors, contract manufacturers, and contract R&D services providers. Despite the absence of administrative guidance, taxpayers may, however, renegotiate the terms of their APA.

[1] s92D, Income Tax Act, 1961.

[2] Abhishek Sharma, ‘Understanding Transfer Pricing Regulations in India’, (2021) Tax Guru, < https://taxguru.in/income-tax/understanding-transfer-pricing-regulations-india.html> as accessed 4th April 2022.

[3] ‘Comparable Uncontrolled Price Method for Transfer Pricing’, (2021) Au-Partners, < https://au-partners.com/en/blog/comparable-uncontrolled-price-method-for-transfer-pricing> as accessed 4th April 2022.

[4]‘The Profit Split Method with Example’, (2017) Transfer Pricing India, < https://transferpricingasia.com/2017/04/11/profit-split-method-with-example/> as accessed 4th April 2022.

[5] Engineering Analysis Centre of Excellence (P.) Ltd. v. CIT [2021] 125 taxmann 2 (SC).