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DOMESTIC TRANSFER PRICING

CONTENTS Introduction to Transfer Pricing Transfer Pricing Litigation Statistics Introduction to Domestic Transfer Pricing Section 40A(2)(b), 80IA(8) & 80IA(10) Relationships, Issues & Challenges Case laws on DTP prior to introduction of detailed DTP Regulations Domestic Transfer Pricing - Compliances Information and Documentation Requirements Transfer Pricing Compliances and Penalties on Default Applicability of TP Regulations to Domestic TP transactions Domestic Transfer Pricing Case StudiesPage 2

INTRODUCTION TOTRANSFER PRICING

INTRODUCTION TO TRANSFER PRICING What is Transfer Pricing?OECD Guidelines defines “Transfer Prices” as “the prices at which an enterprisetransfers physical goods and intangibles or provide services to associatedenterprises”Thus, Transfer Pricing is a term used to refer to all inter company pricingarrangements between related enterprises Transfer Pricing provisions were introduced to prevent shifting of profits by MNCsfrom high tax rate jurisdiction to low tax rate jurisdictions to minimize tax cost atgroup levelPage 4

EVOLUTION OF TRANSFER PRICINGYearEvents Occurred1991Integration of Indian economy with Global economy leading toincreased cross border transactionsMarch 1999The Standing committee on Finance realized that existing taxprovisions (Section 92) may not be effective to curb TransferPricing abuse in IndiaNovember 1999CBDT constitutes an Expert Group on Transfer Pricing forsuggesting necessary amendments in the Act and regulatoryframeworkExpert Group submitted its report to CBDTJanuary 2001February 2001Page 5Finance Ministry introduces Chapter X to deal with transfer pricingissue with effect from AY 2002-03 (ie FY 2001-02)

TRANSFER PRICING REGULATIONS IN INDIA Any international transaction undertaken between associated enterprises wouldbe subject to transfer pricing regulations and the transfer price charged/paidshould be at arm’s length The term “international transaction” is widely defined to cover almost all kindsof transactions Associated Enterprise is also defined to cover direct or indirect shareholding ofmore than 26% or various other criterions by way of participation in themanagement or control Indian Transfer Pricing regulations are based on OECD Guidelines but with somemodificationsPage 6

APPLICABILITY OF TRANSFER PRICINGInternational Transaction purchase, sale, transfer, lease or use of tangible as well as Intangible property capital financing, including borrowings, lending, guarantees, deferred payments,etc arising during the course of business provision of services transaction of business restructuring or reorganization, irrespective of whether ithas bearing on the profit, income, losses or assets of such enterprises at the timeof the transaction or at any future datePage 7

APPLICABILITY OF TRANSFER PRICINGAssociated Enterprise which participated directly or indirectly, or through one or more intermediariesin Management or Control or Capital of the Other Enterprise in respect of which one or more persons participate directly or indirectly orthrough one or more intermediaries in Management or Control or Capital of twoenterprises Associated Enterprise also include Deemed Associated Enterprises like:-one enterprise has direct or indirect shareholding carrying not less than 26%voting power in the other enterprise-one person holds 26% or more of the voting power in two enterprises-OthersPage 8

APPLICABILITY OF TRANSFER PRICINGArm’s Length Price Arm’s length price means a price applied or proposed to be applied in a transactionbetween non Associated Enterprises in uncontrolled conditions Arm’s length price can be determined by any of the following methods:–––––– Comparable Uncontrolled Price MethodResale Price MethodCost Plus MethodProfit Split MethodTransactional Net Margin MethodOther Method as prescribed under Rule 10ABWhere arm’s length price is within 5% range of the transaction price, no adjustment iswarranted but if it is beyond 5% range, adjustment is required to be made to the transferprice and benefit of 5% is not available (5% range is applicable for A.Y.2012-13). ForA.Y.2013-14 onwards, tolerance range would be notified by the central government subjectto maximum 3%Page 9

TRANSFER PRICINGLITIGATION STATISTICS

TRANSFER PRICING LITIGATION STATISTICSNumber ofTransfer Pricingaudits completedNumber of casesadjustedPercentage ofadjustment 08-092,5891,33852%44,500For AssessmentYearPage 11AdjustmentAmount(INR Crores)

INTRODUCTION TO DOMESTICTRANSFER PRICING

GLAXO SMITHKLINE CASEDecision of the H’ble Supreme Court in the case of Glaxo Smithkline Asia (P) Ltd[236 CTR 113]The H’ble Supreme Court while deciding on the issue of section 40A(2) made some of theimportant observations as under: The present Transfer Pricing Regulations does not apply to domestic transactions In domestic transactions, under-invoicing and over-invoicing will be revenueneutral, except in two circumstances:i. where one of the related entities is loss making orii. where one of the related entities is liable to pay tax at a lower rate and theprofits are shifted to such entity The question of extending Transfer Pricing regulations to domestic transactionsrequire expeditious consideration by the tax authoritiesPage 13

GLAXO SMITHKLINE CASE The CBDT should examine whether Transfer Pricing Regulations be extended todomestic transactions by making amendments to the Act Law can be amended to mandate the taxpayer to comply with Rule 10D Assessing Officer can be empowered to make adjustments to value of thetransactions between the related parties based on methods of determination ofarm’s length priceBased on the above observations of the H’ble Supreme Court, the Finance Act, 2012has extended the applicability of the transfer pricing provisions for specifieddomestic related party transactionsPage 14

PURPOSE OF INTRODUCING DOMESTIC TRANSFER PRICINGIt was realized by the government that: Presently, there is no method prescribed to determine reasonableness ofexpenditure to re-compute the income in related party transactions There is need to provide objectivity in determination of income and determinationof reasonableness of expenditure in domestic related party transactions There is need to create legally enforceable obligation on assessee to maintainproper documentationBased on the above observations of the H’ble Supreme Court, the Finance Act, 2012has extended the applicability of the transfer pricing provisions for specified domesticrelated party transactionsPage 15

SPECIFIED DOMESTIC TRANSACTIONSSection 40A Expenditure paid or to be paid to related party as defined under section 40A(2)(b)Section 80IA Inter unit transfer of goods and services as referred to in section 80IA(8)Section 80IA Transaction between the tax payer and any other person owing to close connection asreferred to in section 80IA(10) where more than ordinary profits are earned by businessunit claiming tax holiday/deductionSection 10AA Some examples of Specified Domestic TransactionsAny transaction under Chapter VIA or Section 10AA to which the provisions of 80IA apply, ie:――Page 16inter-unit transfersmore than ordinary profits earned by tax holiday/ exemption unit

SPECIFIED DOMESTIC TRANSACTIONS – COMMON TRANSACTIONS Payment for purchase of semi-finished goods Transfer of machinery, technology, etc Sharing of common costs Job work charges Payment of interest /royalty charges Transfer of goods from one unit to another (in specific cases) examples of Specified Domestic TransactionsPayment made to keySomepersonnel/relatives Rent chargedPage 17

THRESHOLD LIMIT & COVERAGE Domestic Transfer Pricing is applicable only where value of Specified Domestic Transactions crosses5 Crs While computing the aggregate value of transactions:–Value of the International transactions to be excluded–Value of transactions between 2 units of the same company to be covered (when undertakenwith a tax holiday unit)–Inter-company transactions to be covered (when undertaken with a company having a taxholiday unit)–Transactions with a person having a close connection as mentioned in section 80IA(10) to becovered–Payment of expenses to related person defined under section 40A(2)(b) to be coveredPage 18Aggregate Value oftransaction below INR 5 CrAggregate Value of SDTabove INR 5 CrSubject to existing tax lawsSubject to Domestic TransferPricing regulations

DOMESTIC TRANSFER PRICINGSECTION 40A(2)(b), 80IA(8) &80IA(10) RELATIONSHIPS,ISSUES & CHALLENGES

TRANSACTIONS COVERED UNDER SECTION 40A(2)(b)Case-I: Director or any relative of Director – Section 40A(2)(b)(ii)Relative: in relation to an individual, means the husband, wife, brother or sister or any lineal ascendant ordescendant of that individualRelativeMr. AMr. BMr. CDirectors/Partner/MemberXYZCovered Transactions underDomestic Transfer PricingPage 20Cont

TRANSACTIONS COVERED UNDER SECTION 40A(2)(b)Case-II: To an individual who has substantial interest in the business of XYZ Ltd or relative ofsuch individual – Section 40A(2)(b)(iii)RelativeRelativeMr. AMr. BMr. CSubstantialinterest 20%XYZSubstantial Interest: The Beneficial owner of shares carrying notless than 20% of the voting power in the companyCovered Transactions underDomestic Transfer PricingPage 21Cont

TRANSACTIONS COVERED UNDER SECTION 40A(2)(b)Case-III: To a Company having substantial interest in the business of XYZ Ltd orDirector of such company or any relative of Director – Section 40A(2)(b)(iv)RelativeMr. BMr. CDirectorA LtdSubstantialinterest 20%XYZCovered Transactions underDomestic Transfer PricingPage 22Cont

TRANSACTIONS COVERED UNDER SECTION 40A(2)(b)Case-IV: Any other Company carrying on business in which the first mentioned company hassubstantial interest – Section 40A(2)(b)(iv)Substantialinterest 20%B LtdA LtdSubstantialinterest 20%C LtdSubstantialinterest 20%XYZCovered Transactions underDomestic Transfer PricingPage 23Cont

TRANSACTIONS COVERED UNDER SECTION 40A(2)(b)Case V - To a Company of which a director has substantial interest in the business ofXYZ Ltd or any other director of such company or relative of director - Section 40A(2)(b)(v)RelativeMr. BDirectorSubstantialinterest 20%Mr. CMr. DDirectorA LtdXYZCovered Transactions underDomestic Transfer PricingPage 24Cont

TRANSACTIONS COVERED UNDER SECTION 40A(2)(b)Case-VI: To a Company in which XYZ Ltd has substantial interest in the business of thecompany - Section 40A(2)(b)(vi)XYZ LtdSubstantialinterest 20%B LtdCovered Transactions underDomestic Transfer PricingPage 25Cont

TRANSACTIONS COVERED UNDER SECTION 40A(2)(b)Case-VII: Any director or relative of a director of XYZ Ltd having substantial interest in thatperson - Section 40A(2)(b)(vi)Substantialinterest 20%Mr. CRelativeA LtdMr. BSubstantialinterest 20%D LtdDirectorXYZCovered Transactions underDomestic Transfer PricingPage 26Back

TRANSACTIONS COVERED UNDER SECTION 40A(2)(b)b(iv)b(iii)Relative ofIndividualb(iii)Individual (A)holding 20%b(v)b(v)b(v)Companyin which Ais DirectorAOP in whichA is MemberFirm inwhich Ais PartnerHUF inwhich Ais MembersRelative ofotherDirectorsRelative ofotherMembersRelative ofotherPartnerRelative ofOtherMembersRelative ofDirectorsDirectorb(ii)Page 27b(v)b(vi)b(vi)Any entity inwhichrelativeholds 20%Any entity inwhichDirectorholds 20%Firmholding 20%AOPholding 20%HUFholding 20%PartnerMemberMemberRelative ofPartnerRelative ofPartnerRelative ofPartnerb(iv)b(iv)b(iv)Companyholding 20% (HCo)DirectorRelative ofDirectorb(ii)TaxpayerCompanyb(vi)Any entity inwhichTaxpayerholds 20%b(iv)Company inwhich HCoholds 20%

40A(2) ISSUES AND CHALLENGES Whether indirect shareholding is covered? Whether Capital expenditure or corresponding depreciation is covered? Whether shareholding of individual Directors can be aggregated fordetermining substantial interest? Director’s remuneration – Benchmarking Issues Corresponding credit for tax neutral entitiesPage 28

TRANSACTIONS COVERED UNDER SECTION 80IA(8)A LtdUnit ATelecom BusinessGoods and ServicesUnit BManufacturing Business80IA - Eligible UnitTaxable UnitTransfer at Rs 120Market Value of above goods/ services is Rs 100Thus, the ALP of the above transaction would be Rs 100Page 29

TRANSACTIONS COVERED UNDER SECTION 80IA(10)A LtdInfrastructure BusinessGoods and ServicesClose Connection80IA - Eligible UnitB LtdTrading BusinessTaxable UnitOperating Margin: 40% (Extraordinary Profits)Industry Average: 10%Thus, Arm’s length profit margin would be taken as 10%Page 30

80IA(8) & (10) – ISSUES AND CHALLENGES Issues in claiming corresponding credit when both units are eligible for taxholiday The term “Close Connection“ not defined and subject to litigation Whether the term “more than ordinary profit” can be equated with ALP? Whether Capital account transactions are covered?Page 31

DOMESTIC TRANSFER PRICINGCASE LAWS ON DTP PRIOR TOINTRODUCTION OF DETAILEDDTP REGULATIONS

IN THE CONTEXT OF SECTION 40A(2) KR Motilal v. CIT (1999) (240 ITR 810) (Mad)–The assessee engaged in the business of manufacture of three wheel cycles–Payment of remuneration and commission to brothers of the assessee for providingtechnical and supervisory services–The AO disallowed the same u/s 40A(2)–ITAT held that:Part of the remuneration / commission paid to brothers is excessive and unreasonableand thus to be disallowed u/s 40A(2) since: Page 33The assessee was unable to justify possession of technical qualifications / technicalskill by the brothers required to handle the jobUnable to produce supporting to substantiate the technical experience of brothers

IN THE CONTEXT OF SECTION 40A(2) Mangal Chand Tubes Pvt. Ltd. v. CIT (1994) 208 ITR 729 (Raj)–Payments to two directors for managing the operations for the same area–The AO disallowed part of the payments made to one of the director u/s 40A(2)–Rajasthan High Court upheld the AO’s order and held that:Page 34 The disallowance made by the AO is justified since one of the directors who waspermanently stationed in the same region (Delhi) was looking after the day to dayfunctions of the company and business needs of the company did not warrantpayments to another director The assessee was unable to justify commercial rationale of making payments to bothdirectors and how it benefited its operations Legitimate business needs of the company did not warrant incurrence of suchexpenditure

IN THE CONTEXT OF SECTION 80IA(8) Whether HO expenses are required to be allocated among units?–ACIT v. Asea Brown Boveri Ltd. (2007) 110 TTJ 502 (Mum)It was held that HO expenses are required to be allocated since HO is a cost centre whichis common to all the units. It does not exist for its own sake but its existence is relevantfor all the activities undertaken by various divisions, units and profit centre–Page 35Similarly, in the following cases, it was held that HO expenses are required to beallocated based on rationale allocation keys: CIT v. S T Micro Electronics Pvt. Ltd. (2011-TIOL-499-HC-DEL-IT) Wipro GE Medical Systems Ltd v. DCIT (2003) 81 TTJ 455 (Bang)

IN THE CONTEXT OF SECTION 80IA(10) M/s Tweezerman India Pvt Ltd Vs. Addl. CIT (2010-TII-45-ITAT-MAD-TP)–The assessee (Indian Company) engaged in manufacturing of tweezers and eligible for 10Bdeduction exported 100% to its US AE–TPO accepted the value of ITs at ALP and passed remark that Arm's length profit would beRs. 733.42 lacs as against Rs. 1,251 lacs reported by the assessee–AO invoked Section 10B(7) r.w.s.80IA(10) and reduced 10B deduction–ITAT deleted the addition and held that: Page 36Section 80IA(10) does not give an arbitrary power to the AO and the AO has tospecify as to why he feels that the profits of the assessee is shown at a higher figureFurther, AO has to show as to how he has computed the ordinary profits which theassessee might be expected to generateAO has blindly taken a calculation for determining the ordinary profits which theassessee had given before the TPO and admitted it to be erroneous

IN THE CONTEXT OF SECTION 80IA(10) M/s Visual Graphics Computing Services (India) Pvt. Ltd Vs. ACIT (2012-TII-55-ITAT-MAD-TP)–The assessee (Indian company), a subsidiary of US Company was engaged in preparingPowerPoint presentations and related software–The assessee provided finance and accounting services to its AEs and adopted TNMM asthe most appropriate method–TPO held that the international transactions of the assessee are above ALP and noadjustment is called for. However, the AO reduced the quantum of eligible deduction u/s10A to the extent of excess of price realised by the assessee over the ALP determined bythe TPO as per section 10A(7) read with section 80IA(10)–ITAT deleted the adjustment and held that:Page 37 TP regime is different from regular computation of income Section 10A belongs to that part of regular computation of income and it should becomputed independent of TP regulations and TP orders It is not permissible for the AO to work out section 10A deduction on the basis of ALPprofit generated out of the order of the TPO

DOMESTIC TRANSFER PRICINGCOMPLIANCES

COMPLIANCE REQUIREMENTS FOR DOMESTIC TRANSFER PRICINGCurrent ComplianceRequirements Section 40A: Transactions to bereported in Tax Audit Report inForm 3CD Section 80IA: Declaration ofprofit to be made in CACertificate in Form 10CCB Section 10AA: For claiming taxdeduction, CA Certificate in Form56F needs to be filedPage 39Additional ComplianceRequirements Maintaining ContemporaneousDocumentation as prescribed inRule 10D and prove thattransactions are at ALP byselecting the most appropriatemethod Filing audit report in Form 3CEB /any other Form may beprescribed

DOMESTIC TRANSFER PRICING – PROCESS FLOWDetermination of ALPVoluntaryAdjustments inReturn (if any)FAR AnalysisSelection of MostAppropriate MethodDocumentation,Return Filing andForm 3CEB FilingIdentification adjustment fordifferencesAssessment andAppellateProceedingsIdentification ofSpecified DomesticTransactionsPage 40

VARIOUS METHODS FOR DOMESTIC TRANSFER PRICINGMethodCUPRPMCPMPSMTNMMApplicabilityCUP method can be applied where reliable data of similar uncontrolled Pricestransaction between two unrelated parties or between related partyand third party is availableWhere an enterprise purchases goods or services from a related partyGross Profit Marginsand sells them to unrelated parties without adding any substantialvalue to the product or servicesWhere there is transfer of semi finished goods between related parties Gross Profit Margins/or in case of servicesDirect & Indirect Cost ofProduction / serviceIn case of transfer of unique intangibles or in multiple inter-relatedGenerally, operatingtransactions which cannot be evaluated separately for determining the Profit Marginsarm’s length priceWhen all other methods for determining ALP fails and reliablecomparable data with broad functional similarity is availableOther Method Where the price which would be charged for similar transactionas per Rule between unrelated parties is available (based on the valuation reports,genuine quotes available from independent parties, etc)10ABPage 41PLI to be comparedGenerally, operatingProfit MarginsSuch “would be Price”

INFORMATION & DOCUMENTATIONREQUIREMENTS

Page 43Transaction TermsFunctional, Asset andRisk (‘FAR’) AnalysisEconomic Analysis(selection of themost appropriatemethod,benchmarking anddetermining ALP)Transaction RelatedGroup Profile(incl. organizationstructure)Indian Entity Profile(incl. description oftransactions)Related Party Profile(incl. description oftransactions)Industry ProfilePrice RelatedEntity RelatedINF