Transfer Pricing – A definitive guide

The increasing participation of multinational groups in economic activities in the country has given rise to new and complex issues emerging from transactions entered into between two or more enterprises belonging to the same multinational group. The profits derived by such enterprises carrying on business in India can be controlled by the multinational groups by manipulating the prices charged and paid in such intra-group; transactions, thereby, leading to erosion of tax revenues. With a view to provide a statutory framework which can lead to computation of reasonable, fair and equitable profits and tax in India, in the case of such multinational enterprises, the Legislature has enacted transfer pricing provisions in the Income-tax Act. These provisions provide a comprehensive code relating to computation of income from international transactions having regard to arm’s length price, meaning of associated enterprise, meaning of international transaction, determination of arm’s length price, keeping and maintaining of information and documents by persons entering into international transactions, furnishing of a report from an accountant by persons entering into such transactions and definitions of certain expressions occurring in the said sections.

Background, purpose and object of the Transfer Pricing provisions:

Chapter X of the Income-tax Act, 1961 (“The Act”), comprising of sections 92 to 92F, which is titled, “special provisions relating to avoidance of tax” was inserted in the Act by the Finance Act, 2001 with effect from 1st April, 2002; i.e., from assessment year 2002-03 (click here to see the statutory provisions).

The purpose and object of introduction of the provisions contained in Chapter X is to prevent an assessee from avoiding payment of tax by transferring income yielding assets to non-residents even while retaining the power to enjoy the fruits of such transactions i.e. the income so generated.

Transfer Pricing provisions under the 1922 Act:

Under the Income-tax Act, 1922 a somewhat similar provision appeared in the statute book being, section 42(2) which, broadly provided that where a non- resident carried out business with the person resident in the taxable territory and it appeared to the Assessing Officer that on account of a “close connection” between such persons the business was so arranged that the business conducted by the resident with the non-resident either yielded no profit or, less than ordinary profit, which may be expected to arise in that business then, the Assessing Officer was empowered to tax profits which were derived or which may reasonably be deemed to be derived from the business in the hands of a person resident in the taxable territory.

Relevant extracts of the Statement of Objects and Reasons in the speech of the Finance Minister while introducing the Finance Bill, 2001:

“The presence of multinational enterprises in India and their ability to allocate profits in different jurisdictions by controlling prices in intra-group transactions has made the issue of transfer pricing a matter of serious concerned, I had set up an Expert Group in November, 1999 to examine the issues relating to transfer pricing. Their report has been received, proposing a detailed structure for transfer pricing legislation. Necessary legislative changes are being made in the Finance Bill based on these recommendations.”

Relevant extracts of the Memorandum explaining the provisions of the Finance Bill:

“The increasing participation of multinational groups in economic activities in the country has given rise to new and complex issues emerging from transactions entered into between two or more enterprises belonging to the same multinational group. The profits derived by such enterprises carrying on business in India can be controlled by the multinational groups by manipulating the prices charged and paid in such intra-group; transactions, thereby, leading to erosion of tax revenues. With a view to provide a statutory framework which can lead to computation of reasonable, fair and equitable profits and tax in India, in the case of such multinational enterprises, new provisions are proposed to be introduced in the Income-tax Act. These provisions relating to computation of income from international transactions having regard to arm’s length price, meaning of associated enterprise, meaning of international transaction, determination of arm’s length price, keeping and maintaining of information and documents by persons entering into international transactions, furnishing of a report from an accountant by persons entering into such transactions and definitions of certain expressions occurring in the said sections.”

Relevant extract from the Statement of Objects and Reasons dealing with transfer pricing:

“It is proposed to substitute the said section by new sections 92, 92A, 92B, 92C, 92D, 92E and 92F relating to computation of income from international transactions having regard to the arm’s length price, meaning of associated enterprise, meaning of international transaction, computation of arm’s length price, maintenance of information and documents by persons entering into international transactions, furnishing of a report from an accountant by persons entering into international transaction and definitions of certain expressions occurring in the new sections. It is proposed to substitute section 92 by a new section to provide that any income arising from an international transaction shall be computed having regard to arm’s length price. It further provides that the cost of expenses shall be at arm’s length price. The proposed new sections 92A and 92B provide meaning of the expressions “associated enterprise” and “international transaction” with reference to which the income is to be computed under the new section 92. The proposed new section 92C provides for computation of arm’s length price. The section provides that the arm’s length price in relation to an international transaction shall be determined by (a) comparable uncontrolled price method; or (b) resale price method; or (c) cost plus method; or (d) profit split method; or (e) transactional net margin method; or (f) any other method which may be prescribed by the Central Board of Direct Taxes. One of these methods shall be the most appropriate method which shall be applied for computation of arm’s length price in the manner as may be specified by the rules to be made by the Central Board of Direct Taxes in this behalf. In a case where more than one price can be determined by the most appropriate method, in such case the arm’s length price shall be the arithmetical mean of such two or more prices. The new section further provides that where during the course of any proceeding for the assessment of income the Assessing Officer is, on the basis of material or information or document in his possession, of the opinion that the price charged in the international transaction has not been determined in accordance with sub-sections (1) and (2) or information and documents relating to the international transaction have not been kept and maintained by the assessee in accordance with the provisions contained in sub-section (1) of section 29D, and the rules made in this behalf or the information or data used in computation of the arms’ length price is not reliable or correct or the assessee has failed to furnish, within the specified time, any information or document which he was required to furnish by a notice issued under sub-section (3) of section 92D, the Assessing Officer may proceed to determine, after giving an opportunity of being heard to the assessee, the arm’s length price in relation to the said transaction in accordance with the sub-sections (1) and (2) of this section, on the basis of such material or information or documents available with him. The new section 92D seeks to provide that every person who has entered into an international transaction shall keep and maintain such information and documents as may be specified by rules by the Central Board of Direct Taxes. The Central Board of Direct Taxes may also specify by the rules the period for which the information and documents are required to be retained. During the course of any proceedings under the Act, an Assessing Officer or Commissioner (Appeals) may require any person who has entered into an international transaction to furnish any of the information and documents specified under the rules within a period of thirty days from the date of receipt of a notice issued in this regard, and such period may be extended by a further period not exceeding thirty days. The new section 92E seeks to provide that every person who has entered into an international transaction during a previous year shall obtain a report of an accountant and furnish such report on or before the specified date in the prescribed form and manner. The new section 92F defines the expressions “accountant”, “Arm’s length price”, “enterprise”, “specified date” and “transaction” used in the proposed new sections 92, 92A, 92B, 92C, 92D, 92E.”

CBDT Circular explaining the object of the Transfer Pricing provisions:

The scope and effect of the new set of provisions that find mention in Chapter X [i.e. sections 92 to 92F] was explained by the Central Board of Direct Taxes (“CBDT”) by its circular no. 14/2001 dated 12.12.2001 [2001 252 ITR (st.) 65]. Broadly, the Board explained that the reasons for insertion of the said Chapter was that with the increasing participation of multi-national groups in the economic activities in the country, it gave rise to “new” and “complex” issues whereby two or more enterprises of the same multi-national group would manipulate their prices in a manner which led to erosion of tax revenues. The raison d’ etre for substituting the existing section 92 of the Act is best explained in the following paragraphs of the said Circular no. 14/2001:

“55.2 Under the existing section 92 of the Income Tax Act, which was the only section dealing specifically with cross border transactions, an adjustment could be made to the profits of a resident arising from a business carried on between the resident and a non-resident, if it appeared to the Assessing Officer that owing to the close connection between them, the course of business was so arranged so as to produce less than expected profits to the resident. Rule 11 prescribed under the section provided a method of estimation of reasonable profits in such cases.

However, this provision was of a general nature and limited in scope. It did not allow adjustment of income in the case of non- residents. It referred to a “close connection” which was undefined and vague. It provided for adjustment of profits rather than adjustment of prices, and the rule prescribed for estimating profits was not scientific. It also did not apply to individual transactions such as payment of royalty, etc., which are not part of a regular business carried on between a resident and a non-resident. There were also no detailed rules prescribing the documentation required to be maintained.

55.3 With a view to provide a detailed statutory framework which can lead to computation of reasonable, fair and equitable profits and tax in India, in the case of such multi-national enterprises, the Act has substituted section 92 with a new section, and has introduced new Sections 92A to 92F in the Income Tax Act, relating to computation of income from an international transaction having regard to the arm’s length price, meaning of associated enterprise, meaning of international transaction, computation of arm’s length price, maintenance of information and documents by persons entering into international transactions, furnishing of a report from an accountant by persons entering into international transactions and definitions of certain expressions occurring in the said sections.”

Relevant extract from Circular No.12 dated 23.8.2001 issued by the CBDT:

“The aforesaid provisions have been enacted with a view to provide statutory framework which can lead to computation of reasonable, fair and equitable profit and tax in India so that the profits chargeable to tax in India do not get diverted elsewhere by altering the prices charged and paid in intra-group transactions leading to erosion of our tax revenues.”

The statutory scheme of the Transfer Pricing provisions:

The scheme of Chapter X is as follows.

Chapter X opens with Section 92 which provides that the income arising from “international transactions” shall be calculated having regard to the ALP. The explanation to Section 92 clarifies that allowance for any expense or interest arising from an international transaction shall also be determined having regard to the ALP.

Associated Enterprises

Section 92A defines as to which enterprises would, for the purposes of the provisions of Chapter X, come within the purview of an Associate Enterprise. Subsection (1) of section 92A proceeds generally to define an Associated Enterprise as one, which is, directly or indirectly, managed and controlled by another. The specifics with respect to the various modes by which control may be exerted by one enterprise on the other is provided in sub-section (2) of Section 92A. In the eventuality of an enterprise fulfilling any of the attributes provided in sub-clause (a) to clause (m), the two enterprises under sub-section (2) of section 92A would be deemed to be Associated Enterprises.

Clause (iii) of section 92F of the Act defines the term “enterprise” to mean a person (including a permanent establishment of such person) who is, or is proposed to be, engaged in any of the specified activities. Clause (iiia) of the said section defines the term “permanent establishment” to include a fixed place of business through which the business of the enterprise is wholly or partly carried on. The definition of the term enterprise is exhaustive while that of the term permanent establishment is inclusive.

Section 92A (1) of the Act defines an associated enterprise in relation to another enterprise to be an enterprise which participates, directly or indirectly, or through one or more intermediaries in the management or control or capital of the other enterprise, or when a person participates, directly or indirectly, or through one or more intermediaries in the management or control or capital of both the enterprises.

Sub-section (2) of section 92A provides thirteen (13) specific instances where two enterprises would be deemed to be associated enterprises. Some instances are where one enterprise holds, directly or indirectly, shares carrying 26% of the voting power in the other enterprise, or an enterprise which holds, directly or indirectly, shares carrying 26% of the voting power in each of such enterprises, or where loan advanced by one enterprise to the other enterprise constitutes not less than 51% of the book value of the total assets of the other enterprise, etc. Two enterprises fulfilling the criteria in any one of the thirteen illustrations would be deemed to be associated enterprise for the purpose of sub-section (1). It is evident from the above that whereas sub-section (1) provides for a general management, control and capital criteria, sub-section (2) provides for thirteen specific instances to decide the relationship of association between two enterprises.

An issue which arises under this sub-section is whether the 13 instances mentioned therein are exhaustive of the situations where there can be associated enterprises or they are merely illustrative of the forms of participation in management or control or capital contemplated in sub-section (1). If one goes by the memorandum explaining the Finance Act, 2002, wherein sub-section (2) was amended, then it would appear that unless any of the criteria mentioned in subsection (2) are satisfied, two enterprises would not be regarded as associated enterprise even though they fulfill the general criteria of participation in management or control or capital. However, this proposition cannot be said to be free from doubt and another view is also possible.

Sub-section (2) of section 92B deems a ‘transaction’ between an enterprise and a non associated enterprise to be a transaction entered into between two associated enterprises if there exists a prior agreement in relation to the relevant transaction between such non associated enterprise and the associated enterprise or the terms of the relevant transaction are determined in substance between such non associate enterprise and the associated enterprise. The heading of section 92B suggests that it is dealing with “international transaction”, but sub-section (2) of the said section actually deals with the aspect of a transaction being regarded as entered into between two associated enterprises. The distinction between section 92A and section 92B(2) both of which deals with associated enterprises is that the former regards the enterprises as associated to each other if the specified conditions are fulfilled, while the latter deals with a situation where though the enterprises are non-associated enterprises a particular transaction is deemed to be a transaction between associated enterprises.

Issue which arises for consideration is, would a transaction, which is deemed to be a transaction between associated enterprise under section 92B (2), be automatically regarded as international transaction or would it have to fulfill the requirement of at least one of the parties being a non-resident?

Let us consider an example, X an Indian resident company is an associated enterprise of Y a nonresident company. X enters into a transaction with Z an Indian resident and non associated enterprise. There exists a prior agreement between Y and Z in relation to the transaction between X and Z. In the above example both X and Z are non-associated enterprises but, under section 92B (2) of the Act the transaction would be regarded as a transaction between associated enterprise. The question which would then arise is whether under the deeming provisions of sub-section (2), can the transaction be regarded as an international transaction though both X and Z are Indian residents or the said sub-section would apply only in a case where at least one of the parties to the transaction is a non-resident. Further, as per sub-section (2) of section 92A of the Act, if the condition of association is satisfied anytime during the previous year, then they would be regarded as associated enterprise. In this view of the matter, the issue which arises is whether a transaction entered into between two enterprises which were non-associated at the time of entering into of the transaction, but, who became associated later during the year, would be covered under this chapter. Similar would be the case when the enterprises were associated at some point of time during the year, however at the time of entering into the transaction, they are no longer associated.

International Transaction

Transfer pricing provisions are applicable only with respect to international transactions.

Section 92B defines as to what would be construed as an “international transaction”. In order to appreciate the full width, amplitude of an “international transaction” the meaning of which is provided in section 92B one would have to in addition read the definition of “transaction” as given in section 92F(v).

Section 92B defines an “international transaction” to mean a transaction between two or more associated enterprises where at least one of them is a non-resident. This section includes transactions in the nature of

• purchase, sale or lease of tangible or intangible property, or
• provision of services, or
• lending or borrowing money, or
• any other transaction having a bearing on the profits, income, losses or assets of such enterprises, or
• mutual cost sharing agreement.

It could be seen from above that the definition is an extremely wide one to include all types of transaction entered into by the parties. However, as the phrase (international transaction) itself suggests, transfer pricing provisions would apply to only those transactions in which at least one of the parties is a non-resident. When both the parties are residents then transfer pricing provisions would not apply.

A transaction has been defined in clause (v) of section 92F to include an arrangement, understanding or action in concert, whether or not such arrangement, understanding or action is formal or in writing; or whether or not such arrangement, understanding or action is intended to be enforceable by legal proceeding. This definition is inclusive and not exhaustive. Hence any agreement which falls within the general meaning of the term ‘transaction’ may also be regarded as a transaction though not specifically covered by the said clause.

Arms’ Length Price (“ALP”):

Sub-section (1) of section 92C provides that ALP in relation to an “international transaction; could be determined by any of the methods provided in the said sub-section which is “most appropriate” having regard to the nature of transactions or class of transaction or class of associated persons or functions performed by such persons or such other relevant factors which may be prescribed by the Board. The methods provided being

(a) comparable uncontrolled price method;
(b) resale price method;
(c) cost plus method;
(d) profit split method;
(e) transactional net margin method and;
(f) such other method as may be prescribed by the Board.

In determining the most appropriate method, regard is to be had to rules 10A and 10B of the Income Tax Rules, 1962 (in short the “Rules”).

The term “arm’s length price” is defined in clause (ii) of section 92F of the Act to mean a price which is applied or proposed to be applied in a transaction between persons other than associated enterprises, in uncontrolled transaction. Section 92C (1) provides that the ALP has to be determined following the most appropriate method having regard to the

• nature of transaction, or

• class of transaction, or

• class of associated persons, or

• functions performed by such persons, or

• such other relevant factors as may be prescribed by the board.

Sub-rule (2) of rule 10C of the Rules further elucidates the factors which have to be taken into account for selecting the “most appropriate method” which is described in sub-rule (1) of the said rule as the method which is best suited to the facts and circumstances of each particular international transaction, and which provides the most reliable measure of an ALP in relation to an international transaction. These factors are as under:

1. The nature and class of international transaction;

2. The class or classes of associated enterprise and the functions performed by them taking into account the assets employed and risks assumed;

3. The availability, coverage and reliability of the data;

4. Degree of comparability between the international transaction and comparable uncontrolled transaction and the extent to which reliable and accurate adjustment can be made for differences, if any, between the two; and

5. The nature, extent and reliability of the assumptions required to be made in application of the methods.

The various methods for determination of ALP as prescribed under section 92C(1) of the Act are as follows:

(a) comparable uncontrolled price method;

(b) resale price method;

(c) cost plus method;

(d) profit split method;

(e) transactional net margin method;

(f) such other method as may be prescribed by the board.

Presently, as stated above, five methods of computing the ALP are available under the Act. CBDT has not prescribed any other method for determination of ALP for which power has been provided to them under clause (f) of section 92C (1).

Rule 10B (1) provides the manner in which each of the aforesaid method is to be applied to arrive at the ALP. Each of the methods requires a comparison of the international transaction with an uncontrolled transaction.

Sub-rules (2) to (4) of rule 10B, deals with the manner in which such comparison is to be made and the data to be used for such comparison. A brief note on each of the aforesaid methods as prescribed by the Act and the Rules for determination of ALP is as under:

(a) Comparable uncontrolled price method

For applying this method one has to first identify the price charged or paid for the property transferred or services provided in a comparable uncontrolled transaction, or a number of such transactions. Such price is to be further adjusted to account for differences, if any, between the international transaction and the comparable uncontrolled transaction or between the enterprises entering into such transactions which would materially affect the price in the open market. The price so arrived at would be the ALP.

(b) Resale price method

Under this method the price at which the property purchased from an AE is resold or the services obtained from an AE is provided to an unrelated enterprise is taken to be the base price. Such price is reduced by the normal gross profit margin which could be earned by an enterprise in the same or similar comparable uncontrolled transaction. This is further reduced by the expenses incurred by the enterprise in connection with the purchase of property or obtaining of services. The price so arrived at is adjusted to take into account the functional and other differences between the international transaction and the comparable uncontrolled transaction or between the enterprises entering into such transactions which could materially affect the amount of gross profit margin in the open market. This adjusted price is taken as the ALP.

(c) Cost plus method

In essence it is reverse of the resale price method. Here, first the direct and indirect costs of production incurred by the enterprise in respect of the property transferred or service provided to an associated enterprise is determined. To this a normal gross profit mark up in the same or similar comparable uncontrolled transaction by the enterprise or an unrelated enterprise is added. The price so arrived at is then adjusted to take into account the functional and other differences between the international transaction and comparable uncontrolled transaction or between the enterprises entering into such transactions which could materially affect the amount of gross profit margin in the open market to arrive at the ALP.

(d) Profit split method

Under this method, first the combined net profit of the associated enterprises arising from an international transaction in which they are engaged is determined. The net profit is then split among the enterprises on the basis of the relative contribution made by each of them, having regard to the functions performed, assets employed and risk assumed, and on the basis of reliable external market data which indicates how such contribution would be evaluated by unrelated enterprises performing comparable functions in similar circumstances. The ALP would then be calculated taking into account the profits so apportioned. It is also prescribed that the combined net profit, in the first instance, be partially allocated to each enterprise so as to provide it with a basic return appropriate for the type of international transaction and thereafter the residual net profit remaining after such allocation may be split amongst the enterprises in proportion to their relative contribution and in such a case the aggregate of the net profit allocated to the enterprise in the first instance together with the residual net profit apportioned to that enterprise on the basis of its relative contribution shall be taken to be the net profit arising to that enterprise from the international transaction. This method is generally applied to international transactions involving transfer of unique intangibles or in multiple international transactions which are so interrelated that they cannot be evaluated separately for the purposes of determining the ALP of any one transaction.

(e) Transactional net margin method

This is the method of last resort i.e. this method is to be applied only when no other method could be applied to a particular case.

Nevertheless, this is the most widely used method in transfer pricing analysis. Under this method, the net margin from the international transaction is computed in relation to cost incurred or sales effected or assets employed or any other base. Then the net margin realized by the enterprise or unrelated enterprise for a comparable uncontrolled transaction is calculated with respect to the same base, as adjusted to take into account the difference, if any, between the international transaction and comparable uncontrolled transaction or between the enterprises entering into such transactions which could materially affect the amount of gross profit margin in the open market. The net margin so arrived is then taken into account to arrive at the ALP.

Acceptable variation in arms’ length price

Instruction No. 3 of 2003 dated 20-5-2003 issued by the CBDT initially, and thereafter the proviso to section 92C (2) of the Act (as amended by Finance Act, 2002 with effect from 1st April, 2002), clarifies that if the price determined by the Assessing Officer is within the range of +/- 5% of the price so determined by the assessee, then the Assessing Officer would not make any addition. In view of the aforesaid instruction, the issue which arises for consideration is, in a case where the difference of the ALP and the price offered exceeds 5%, then whether the adjustment has to be made for the entire difference or whether the assessee can make a claim that there should be a discount of 5% allowed because if the price would have been within that limit, there would have been no adjustment.

This issue has been considered by the Bangalore Bench of the Tribunal in Philips Software vs. ACIT (ITAT Bangalore) and it has been held that the proviso to section 92 C (2) provides a standard deduction of 5% to the taxpayers at their option.

Adjustment is only for the Revenue’s benefit:

One important thing to be noted is that Assessing Officer would substitute the ALP so calculated for the assessee’s price only if it would benefit the revenue. Section 92(3) provides that if the applicability of the transfer pricing provision has the effect of reducing the income chargeable to tax or increasing the loss, as computed on the basis of entries made in the books of account in respect of the previous year in which the international transaction was entered into then the provisions would not apply. For example, if the ALP is less than the price for which the goods were actually sold, such that if the ALP is substituted for the actual price the income of the assessee would be less than what is offered to tax. In such situations the transfer pricing provisions would not apply.

Assessment Procedure:

Under section 92C (1) of the Act the prerogative to choose the most appropriate method for determining the ALP is with the assessee. Acceptance of the ALP arrived at by the assessee is the rule and its rejection an exception.

Section 92C (3) gives jurisdiction to the Assessing Officer to determine the ALP, if, in the course of the assessment proceedings he on the basis of material or information or document in his possession of the opinion that:

1. the price charged or paid in an international transaction has not been determined as per any of the specified methods or the assessee has not followed the most appropriate method in the manner prescribed by rule 10C; or

2. the assessee has not kept and maintained the information and documents relating to the international transaction in accordance with section 92D(1) of the Act and rule 10D of the Rules.

3. the information used in computing the ALP is not reliable or correct.

4. the assessee has failed to furnish within the specified time any information or document which he is required to furnish by a notice issued under section 92D (3).

The first proviso to sub-section (3) of section 92 clearly mandates that before the Assessing Officer proceeds to determine the ALP on the basis of the material or information or document available with him he shall give an opportunity by serving upon the assessee a show cause notice fixing thereby a date and time for the said purpose.

Under sub-section (4) of section 92C the Assessing Officer can proceed to compute the total income of the assessee only after the ALP has been determined by the Assessing Officer as per the provision of sub-section (3) of Section 92C.

Computation of ALP by the Transfer Pricing Officer

Section 92CA was inserted w.e.f. 1.6.2002. Under Section 92CA, the Assessing Officer is empowered to refer the computation of ALP, in relation to, an “international transaction” under Section 92C to the TPO, if he considers it “necessary” or “expedient” to do so with the prior approval of the Commissioner. It is only after a reference is made under sub-section (1) of section 92CA that the TPO enters the picture and gets a mandate to approach upon the assessee by issuing him a notice calling upon him to produce or cause to be produced on a date to be specified therein, any evidence on which the assessee may rely in support of the computation made by him of the ALP.

It is interesting to note that the reference is in respect of each individual transaction and not of the assessee. The effect is that, if during the course of the proceedings, the transfer pricing officer becomes aware of certain other international transactions which have not been specifically referred to him for determination of ALP, then he cannot determine the ALP of those transactions. Instead he would require a fresh reference in this regard from the Assessing Officer. This position is also clarified by Instruction 3 of 2003 dated 20-5-2003 issued by the CBDT.

Aforesaid Instruction 3 of 2003 also carries a direction from the CBDT that, whenever the aggregate value of the international transaction exceeds rupees five crores, the case should be picked up for scrutiny and a mandatory reference be made to the transfer pricing officer for determination of ALP. Constitutional validity of this direction has been upheld by the Delhi High Court in the case of Sony India Pvt. Ltd. vs. CBDT 288 ITR 52. On a practical note, it has also been the experience that although the provisions provides for the Assessing Officer to himself make a determination of the ALP, in almost all cases where there is a transfer pricing adjustment, it has always been after a reference has been made for the same to the Transfer Pricing Officer.

Sub-section (3) of Section 92CA provides that the TPO, by an order in writing, will determine the ALP in relation to an “international transaction” in accordance with subsection (3) of section 92C after hearing such evidence as the assessee may produce including any information or documents referred to in sub-section (3) of Section 92D and after considering such evidence as the TPO may require on any specified points, and after taking into account all relevant material which the TPO has gathered. The TPO is required to send a copy of the order, whereby a determination of ALP is made both to the Assessing Officer and the assessee. Sub-section (3A) of Section 92CA provides a time frame within which the TPO is required to pass an order under sub-section (3) of section 92CA.

Sub-section (3) of Section 92CA reads as follows:-

“On the date specified in the notice under sub-section (2), or as soon thereafter as may be, after hearing such evidence as the assessee may produce, including any information or documents referred to in subsection (3) of Section 92D and after considering such evidence as the Transfer Pricing Officer may require on any specified points and after taking into account all relevant materials which he has gathered, the Transfer Pricing Officer shall, by order in writing, determine the arm’s length price in relation to the international transaction in accordance with sub-section (3) of Section 92C and send a copy of his order to the Assessing Officer and to the assessee.”

Assessing Officer bound by the ALP determined by the TPO:

An important change has been brought about in sub-section (4) of section 92CA with the amendment carried out by virtue of Finance Act, 2007 w.e.f. 1.6.2007. Prior to the Finance Act, 2007, sub-section (4) of Section 92CA read as follows:-

“On receipt of the order under sub-section (3), the Assessing Officer shall proceed to compute the total income of the assessee under sub-section (4) of section 92C having regard to the arm’s length price determined under sub-section (3) by the Transfer Pricing Officer”

Sub-section 4A post amendment w.e.f. 1.6.2007

“On receipt of the order under sub-section (3), the Assessing Officer shall proceed to compute the total income of the assessee under sub-section (4) of section 92C in conformity with the arm’s length price as so determined by the Transfer Pricing Officer”

The essential difference is that prior to the amendment, the Assessing Officer on receipt of an order passed by the TPO under sub-section (3) of section 92CA, would proceed to compute the total income of the assessee under the provisions of sub-section (4) of 92C “having regard” to the ALP determined by the TPO. After the amendment, the Assessing Officer is required to compute the total income of the assessee under subsection (4) of section 92C in conformity with the ALP determined by the TPO. Thus, prior to the amendment, the Assessing Officer while computing the total income of the assessee, having regard to the ALP so determined by the TPO, was required to give a final opportunity to the assessee before computing the assessee’s total income.

This is clear from the language used in sub-section (4) of section 92CA prior to its amendment by virtue of Finance Act, 2007, as the determination by the TPO was not binding on the assessing officer. The Assessing Officer was empowered even at the stage of computation of total income to look into issues pertaining to determination of ALP by the TPO. {See Sony India P. Ltd vs. Central Board of Direct Taxes and Anr (2007) 288 ITR 52 (Del)}.

Hearing by the TPO is mandatory:

S. 92CA (3) imposes an obligation on the TPO to accord an oral hearing to the assessee. The fact that the assessee did not demand an oral hearing makes no difference. Further, the hearing has to be given before the order is passed.

In Moser Baer India Ltd vs. ACIT the Delhi High Court has mandated that the TPO should follow the procedure laid down:

(1) The show-cause notice issued by the TPO just prior to the determination of ALP should refer to the documents or material available with the AO in relation to the international transaction in issue. The show cause notice should also give an option to the assessee:-

(a) To inspect the material available with the AO as give the leeway to file further material or evidence if he so desires, and

(b) to seek a personal hearing in the matter.

Requirement relating to information and documents

Section 92D of the Act mandates that every person entering into an international transaction shall keep and maintain the prescribed information and documents. Sub-section (3) of Section 92D empowers the Assessing Officer or the Commissioner (Appeals) to request the assessee to furnish any information or document as may be sought within 30 days of being served with such a notice. This period of 30 days on an application being made is extendable by a further period not exceeding 30 days.

Rule 10D (1) of the Rules gives a detailed list of information to be maintained by such person. Such information should also be supported by authentic documents as prescribed in rule 10D (3). This information and documents should, as far as possible, be contemporaneous and should exist latest by the due date for furnishing the return of income prescribed under Explanation to section 139 (1) of the Act. Fresh documentation is not required to be made separately in respect of each of the previous years in a case where an international transaction continues to have effect over a period of more than one previous year unless there is significant change in the nature of terms of the international transaction, in the assumptions made, or in any other factor which could influence the transfer price. Under sub-rule (5) of the said rule this information and documents are required to be kept and maintained for a period of eight years from the end of the relevant assessment year. An assessee whose aggregate value of the international transactions as recorded in the books of account does not exceed one crore rupees is not required to maintain the above referred information and documents. However, he may be required to substantiate the basis on which he has computed the ALP under section 92 in the course of assessment proceedings.

Requirement relating to Auditor’s report

Section 92E of the Act requires that every person who has entered into an international transaction during a previous year shall obtain a report from an accountant. This report is required to be furnished on or before the due date prescribed for filing the return of income under Explanation 2 to section 139(1).

This report is to be obtained from a Chartered Accountant in Form 3CEB prescribed by rule 10E of the Rules.

Penalties in relation to the Transfer Pricing provisions

A necessary adjunct to chapter X of the Act, are certain provisions contained in Chapter XXI, which is, entitled “penalties imposable”. It is pertinent to note that with the insertion of chapter X in the Act, the legislature has also inserted the following provisions in Chapter XXI. Explanation 7 to Section 271 has been inserted which provides that any assessee who has entered into an international transaction as defined in section 92B, then, in the event of any amount being allowed or disallowed in the process of computation of total income of the assessee under sub-section (4) of section 92C, the amount, allowed or disallowed, will be deemed to represent the income, in respect of, which particulars have been concealed or inaccurate particulars have been furnished unless the assessee proves to the satisfaction of the Assessing Officer or the Commissioner(Appeals) or the Commissioner that the price charged or paid in such transaction was computed in accordance with the provisions contained in section 92C and the manner prescribed under that Section, in good faith and with due diligence. The sum and substance of the explanation is that it deems that any adjustment made in the ALP on account of transfer pricing provisions will be regarded as concealment of particulars of income or income or furnishing inaccurate particulars under Section 271(1)(c) unless the assessee is able to establish that the price charged or paid in respect of such an international transaction was not only in accordance with the provision of Section 92C and the manner prescribed in that Section, but also that, the assessee acted in good faith and with due diligence.

Apart from the above, penalties are also imposable under Section 271AA for failure to keep and maintain information and documents required under sub-section (1) or subsection (2) of Section 92D. The penalty prescribed is a sum equal to 2% of the value of each such international transaction entered into by such person.

Similarly, under Section 271BA, an Assessing Officer is entitled to impose a penalty equivalent to a sum of Rs. 1,00,000 in the event of failure on the part of the assessee to furnish an audit report in terms of section 92E. Lastly, under Section 271G, the Assessing Officer or the Commissioner of Appeals is entitled to impose penalty if the assessee fails to furnish any information or document as required in sub-section (3) of section 92D. Under this provision, the penalty imposable is, a sum equal to 2% of the value of the international transaction for the each such failure.

A summarized overall review of the provisions is as follows:

(a) Under Section 92, an Assessing Officer is empowered to compute income from international transactions which involve transfer pricing provision having regard to ALP. The meaning of what would constitute an associated enterprise or an international transaction is provided in section 92A and 92B respectively. The manner of computation of ALP is set out in section 92C. The primary burden in regard to computation of ALP is that of the assessee, which the assessee is required to compute by resorting to the most appropriate method amongst those mentioned in sub-clause (a) to sub-clause (f) of subsection (1) of section 92C, having regard to the nature of transactions or the class of transaction or even class of associated persons or functions performed by such persons or such other relevant factor as may be prescribed by the Board. In this respect, regard is required to be had to the factors prescribed in Rule 10B. In the event the Assessing Officer has doubts with regard to the ALP determined by the assessee, having regard to the circumstances mentioned in sub-clause (a) to (d) of sub- section (3) of section 92C, the Assessing Officer can proceed to determine the ALP. However, while doing so, the Assessing Officer is statutorily required under the first (1st) proviso to section 92C, to give an opportunity to the assessee by issuing him a show cause notice with respect to the same.

(b) In the event, the Assessing Officer considers it “necessary” or “expedient”, he is empowered under Section 92CA to make a reference to the TPO. The TPO under subsection (2) is required to serve notice on the assessee to produce or cause to be produced on a date specified, evidence which the assessee relies upon in support of computation made by him of the ALP in relation to the international transaction. Under sub-section (3) of Section 92CA, the TPO is required to pass an order in writing, determining the ALP in relation to the international transaction in accordance with the provisions of sub-section (3) of section 92C. An important caveat in this regard is that, while determining the ALP, he is statutorily required to hear such evidence as the assessee may produce including information or documents referred to under sub-section (3) of section 92D and such evidence as the TPO may require the assessee to furnish on specified points. The provisions of sub-section (3) of section 92CA make it clear that it is only upon consideration of all such material by way of information, documents or evidence that the TPO can proceed to determine the ALP.

Other provisions akin to Transfer Pricing:

Section 40A (2) of the Act dealing with disallowance of excessive or unreasonable expenditure is a category of transfer pricing tool given to the Assessing Officer. Section 40A (2) of the Act provides for disallowance of expenditure in respect of which payment has been or is to be made to any person specified in clause (b) of the said sub-section, where the Assessing Officer is of the opinion that such expenditure incurred is excessive or unreasonable having regard to the fair market value of the goods, services or facilities for which the payment is made or the legitimate needs of the business or profession of the assessee or the benefit derived by or accruing to him therefrom. This section also applies to transactions between residents and it is not a pre-condition that for application of this section one of the parties should be a non-resident as in the case of Chapter X of the Act.

Note: Large parts of this write-up are from the article “Transfer Pricing: An overview” by Nitesh Joshi & Madhur Agrawal, Advocates

Judgements / decisions / orders on transfer pricing:

Supreme Court:

(1) DIT vs. Morgan Stanley & CO (2007) 292 ITR 416 (SC)

Computation of profits attributable to the Permanent Establishment (“PE”)

The computation of income arising from international transactions has to be done keeping in mind the principle of arm’s length price. In the case of a service PE, the transactional net margin method is the most appropriate method as it apportions the total operating profit arising from the transaction on the basis of sales, costs, assets, etc. Once the transfer pricing analysis is undertaken, there is no further need to attribute profits to PE which is an associated enterprise and has been remunerated on an arm’s length basis taking into account all the risk-taking functions of the multinational enterprise. However, the situation would be different if transfer pricing analysis does not adequately reflect the functions and the risks assumed by the multinational enterprise in which case, there would be a need to further attribute profits to PE as regards those functions and risks not considered. The economic nexus is an important feature of profits attributable to the PE.

High Courts:

(1) Coca Cola India Inc vs. ACIT (P & H High Court)

(a) There is no lack of Legislative competence in enacting the transfer pricing provisions and making them applicable to foreign companies. The provisions seek to remedy the mischief of multinational companies of allocating profits in intra group transactions to outside jurisdiction resulting in tax evasion;

(b) The transfer pricing provisions are applicable to a well defined class which meets the test of intelligible differentia. It also meets the test of rational relationship to the object i.e. to determine the real income. There is no ambiguity or absurd consequence of application of Chapter X to persons who are subject to jurisdiction of taxing authorities in India;

(c) There is no requirement to establish transfer of profits outside India or evasion of tax before applying the transfer pricing provisions;

(d) The fact that under the FERA – RBI approval the assessee cannot charge more than particular price cannot control the arms’ length price;

(e) There is no requirement to give a hearing at the stage of making reference under Section 92 CA of the Act because the decision to make a reference does not visit the assessee with any civil consequence;

(2) Sony India vs. CBDT (2007) 288 ITR 52 (Del) {Note some parts of this judgement have been superceded by the amendment to s. 92CA (4) and (4A) by Finance Act, 2007 w.e.f. 1.6.2007

(1) The words ‘necessary and expedient’ posit the formation of an opinion by the AO of the need to make a reference to TPO—However, there is nothing in s. 92CA that requires the AO to first form a considered opinion in the manner indicated in s. 92C (3) before he can make a reference to the TPO. It will suffice if the AO forms a prima facie opinion that it is necessary and expedient to make such a reference.

(2) The AO has necessarily to give an opportunity to the assessee after receiving the report of the TPO before he finalises the assessment. The AO is not bound to accept the arm’s length price as determined by the TPO. He can always be persuaded by the assessee at that stage to reject the TPO’s report and proceed to determine the arm’s length price himself. Full effect can be given to the words ‘having regard to’ occurring in both ss. 92C (4) and 92CA (4) by preserving the power of the AO to determine the arm’s length price even after determination by the TPO.

Instruction No. 3 of 2003 are based on a correct interpretation of law. Though Instruction ‘picks out’ transactions of value in excess of Rs. 5 crores for automatic reference to TPO for determination of their arm’s length price and in that sense recognizes two classes of international transactions within the meaning of s. 92C, it does not violate Art. 14. The classification brought about by the Instruction is based on a straightforward recognizable basis and bears a nexus with the objective of expedient disposal of the assessment. Also, the impugned Instruction cannot be said to be ultra vires the Act only because the classification of international transactions envisaged by it is not contained in the Act itself. It serves to supplement the statutory provisions to achieve the objective and not override them. The Instructions are based on a correct understanding of the legal position and are consistent with s. 119. There is no question of CBDT supplanting the judicial discretion of the AO.

(3) Moser Baer India Ltd vs. ACIT (Delhi High Court)

Where the assessees challenged by writ petitions the orders passed by the Transfer Pricing Officer (“TPO”) determining the Arm’s Length Price (“ALP”) in relation to “International transactions” on the grounds that the said orders were passed without granting an oral hearing and without considering the documents and information filed by the assessees and without disclosing the information and documents obtained by the TPO which were used by him in the determination of the ALP, HELD, allowing the challenge:

(1) S. 92CA (3) imposes an obligation on the TPO to accord an oral hearing to the assessee. Even otherwise, an order entailing civil and penal consequences cannot be passed without a hearing.

(2) The fact that the assessee did not demand an oral hearing makes no difference. It is the constitutional obligation of the State to adopt a procedure which is both fair and just while dealing with its citizens. The fact that a citizen is unaware of his legal right cannot be used as a plank to seek legal sustenance for its actions which are otherwise invalid. It is duty of the State, in its role as a litigating party, to inform the citizen of his right i.e., to seek an oral hearing.

(3) The argument of the department that the failure to grant an oral hearing is a defect which could be cured by providing such an opportunity in the appellate forum is not acceptable.

(4) As a matter of procedure, the show-cause notice issued by the TPO just prior to the determination of ALP should refer to the documents or material available with the AO in relation to the international transaction in issue. The show cause notice should also give an option to the assessee:-

(a) To inspect the material available with the AO as give the leeway to file further material or evidence if he so desires, and

(b) to seek a personal hearing in the matter.

(5) An order is passed in breach of the principles of natural justice is a nullity in the eye of law and consequently a writ petition is maintainable notwithstanding the availability of alternate remedy.

Tribunal:

Philips Software vs. ACIT (ITAT Bangalore)

Note: The “operation and all further proceedings” of the said judgement has been stayed by the Karnataka High Court until further orders.

Where the assessee was rendering captive contract software development services to its’ associated enterprises on a “cost plus” basis and its profits enjoyed exemption u/s 10A and the question arose whether the AO/TPO were justified in rejecting the assessee’s transfer pricing study and substituting it with their own, HELD allowing the appeal that:

(i) While the motive of tax avoidance need not be shown at the time of initiating transfer pricing provisions, the same is required to be shown at the stage of making the assessment. The AO has to show that the assessee manipulated prices to shift profits outside India. In view of the fact that the assessee enjoyed exemption u/s 10A, the transfer pricing provisions ought not to have been applied;

(ii) The AO/TPO have to satisfy and communicate to the taxpayer which one of the four conditions prescribed in s. 92C (3) are satisfied before applying the transfer pricing provisions and the failure to demonstrate this to the assessee renders the transfer pricing order void;

(iii) The assessee’s selection of the Cost Plus Method (CPM) using the Capitaline database as the most appropriate method could not be substituted by the AO/TPO with the Transactional Net Margin Method (TNMM) using the Prowess database without showing how the assessee’s method was erroneous;

(iv) For purposes of making a comparability analysis it is essential that (a) the data should relate to the financial year and (b) be contemporaneous i.e. exist on the specified date. If one of the conditions is not fulfilled, the data should not be included for comparison;

(v) In view of the definition of “uncontrolled transaction” in Rule 10A (a), for purposes of comparability analysis, the comparables should not have any transactions with its associated enterprises. A company having even a single rupee of related party transaction cannot be considered as a comparable transaction;

(vi) Adjustment needs to be made to the margins of the comparables to eliminate differences on account of different functions, assets and risks and in particular for (a) differences in risk profile (b) difference in working capital position and (c) differences in accounting policies;

(vii) The profits of super profit companies should not be “normalized”; instead they should be excluded from the list of comparables;

(viii) The proviso to section 92 C (2) provides a standard deduction of 5% to the taxpayers at their option.

Aztec Software & Technology Services Ltd. vs. ACIT (2007) 107 ITD 141 (Bang)(SB)

Note: The “operation and all further proceedings” of the said judgement has been stayed by the Karnataka High Court until further orders.

(1) Conditions precedent to the applicability of ss. 92C and 92CA. Before invoking the provisions of ss. 92C and 92CA, there is no legal requirement for the AO to prima facie demonstrate tax avoidance. These provisions can be invoked by the AO and he can proceed to determine the arm’s length price where he either finds the existence of circumstances mentioned in cls. (a) to (d) of sub-s. (3) of s. 92C or where he considers it necessary and expedient to refer the determination of ALP to the Transfer Pricing Officer.

(2) Provisions of s. 40A do not override the provisions of Chapter X—Even otherwise, the provisions of s. 40A being general and the provisions of Chapter X being special as regards transfer pricing, the latter would prevail in a case involving transfer pricing;
(3) Availability of exemption under s. 10A to assessee is no bar to applicability of ss. 92C and 92CA;

(4) Conditions precedent to the reference to Transfer Pricing Officer. The AO is not required to demonstrate the existence of the circumstances set out in cls. (a) to (d) of sub-s. (3) of s. 92C before referring the case of the assessee to the TPO for determining the ALP under s. 92CA(1). Proceedings under both the sections are quite independent of and distinct from each other. The AO may refer the case of assessee to TPO if he considers it necessary or expedient to do so independent of circumstances mentioned in s. 92C(3). The fact that the AO even in cases covered by s. 92C(3) may consider it necessary and expedient to make a reference to TPO does not mean that the powers of AO to refer the case to TPO are restricted to cases covered by sub-s. (3) of s. 92C only;

(5) Opportunity of being heard before a reference is made to the Transfer Pricing Officer. Before making a reference to TPO under s. 92CA (1), it is not a condition precedent for the AO either to record his opinion/reason or to provide the assessee an opportunity of hearing. Making a reference to TPO is a step in the process of collection of material at which stage the assessee need not be associated. The assessee will be associated at the stage such material is proposed to be used against him. The TPO is statutorily required to provide opportunity of hearing to assessee in the process of determining ALP. The assessee cannot be asked to have a choice whether in his case ALP should be determined by AO or TPO. However, the AO must have some material with him which would enable him to get approval of the CIT for making a reference to TPO;

(6) Instruction No. 3, dt. 20th May, 2003 directing all officers of the Department to refer the matter to TPO for determination of ALP where the aggregate value of international transaction(s) exceeds Rs. 5 crores is binding on the Departmental authorities;

(7) Binding nature of TPO’s order under s. 92CA(3). Prior to substitution of sub-s. (4) of s. 92CA by the Finance Act, 2007 w.e.f. 1st June, 2007, order of TPO under s. 92CA(3) was not final and binding on the AO and after recording reasons, the AO could take transfer pricing other than one determined by TPO. However, it was enjoined upon the AO to adopt the transfer pricing determined by the TPO unless there were very good grounds to modify or alter the transfer pricing as determined by the TPO—In this case, AO having adopted transfer pricing as determined by the TPO, there is no illegality in the same—Sub-s. (6) is relevant only where, after the adoption by AO of transfer pricing as determined by TPO, the TPO makes any amendment therein;

(8) Appropriate method and burden of proof. The selection of the most appropriate method (MAM) is based on the nature of transaction, the availability of relevant data and the possibility of making appropriate adjustments. The burden to establish that international transaction was carried at ALP is on the taxpayer. He has also to furnish comparable transactions, apply appropriate method for determination of ALP and justify the same by producing relevant material and documents. Where the Revenue authorities are not satisfied with ALP and the supporting documents, the responsibility of determination of ALP is shifted to the Revenue authorities who are to determine the same in accordance with statutory regulations, and on the basis of material collected or available on record.

Mentor Graphics vs. DCIT (2007) 109 ITD 101 (Del)

Selection of comparable cases under Transactional Net Margin Method.

The assessee was developing specific software for its parent company which was used by the latter in-house for integrating the same with other software components developed by itself. The whole software in turn supported the hardware manufactured by the parent and was sold as a package. Thus, the assessee was a contract software development support service provider. Most of the business risks such as contract risk, market risk, credit risk, warranty risk, price risk, etc. were essentially borne by the parent associated enterprise (AE). All intangibles including discoveries, improvements, inventions and trade secrets were exclusive property of the parent AE. The assessee only maintained and deployed necessary human resources and infrastructure for development of software. The above characteristics of the controlled transactions were not kept in mind by the TPO in selecting comparables.

The first step in the determination of arm’s length price is to analyse the specific characteristics of the controlled transaction whether it relates to transfer of goods, services or intangibles. Without proper study of specific characteristics of controlled transaction, no meaningful comparison or location of comparable is possible. For example, a mere consideration that controlled transaction relates to “software supply” is not sufficient as there are hundreds of softwares with different characteristics which materially affect their open market value.

E-Gain Communication (P) Ltd vs. ITO (2008) 118 TTJ (Pune) 354

Selection of comparable cases under Transactional Net Margin Method. The assessee, a 100 per cent EOU, was engaged in the business of software development and approved by Software Technology Park of India. It developed and supplied software to its parent company in US against consideration of actual cost plus 5 per cent mark up. Both parties accepted that TNMM was the most appropriate method for determining ALP. It was held that:

(i) As per Rule 10B, while comparing transactions or enterprises (in case TNMM is applied), the differences which are likely to materially affect the price, cost charged or paid in, or the profit in the open market are to be taken into consideration with the idea to make reasonable and accurate adjustment to eliminate the differences having material effect;

(ii) There is no justification for taking oversized companies by the TPO. Further, turnover only is not the relevant factor but factors like functions performed, assets employed and risk taken (FAR) were also required to be considered. This having not been done, comparison was unsound and unreliable. Even though assessee had pointed out that two of the compared parties were showing extraordinary profits because they were having income from sources other than software development business, the same was not considered by the CIT (A). These companies were, therefore, required to be excluded;

(iii) The assessee filed results of comparable companies with which the profit margin of assessee matched and neither the AO nor the CIT (A) found any fault with the working of average profit margin of these companies by the assessee. Therefore, there was no justification for making addition to ALP worked out by assessee;

(iv) The assessee was also entitled to take lower rate of depreciation as stipulated under the Companies Act.

(v) The addition on account of adjustment in ALP was deleted.

Sony India (P) Ltd. vs. DCIT (2008) 114 ITD 448 (Del)

Computation of arm’s length price under the TNMM method – inclusion of reimbursement of expenditure by AE and other items of write-backs.

(1) The assessee had entered into an advertisement contribution agreement with AE, whereby the latter undertook to reimburse 50 per cent of the expenditure incurred by the assessee by way of advertisement and sales promotion of ‘Sony’ products subject to a specified limit. There was no allegation that the transaction had any other purpose than one reflected and shown by the parties. The genuineness or bona fides of the agreement has not been doubted or disputed. It was accepted that the agreement had been given effect to and reimbursement had been received by the assessee as per the agreement. There was also no finding that the AE did not derive any benefit from the advertisement campaign. Therefore the AO was directed to include the reimbursement as part of operating income of the assessee for computation of the ALP.

(2) Creation of unpaid liability and its write back was a normal incident of business operation which is shown in accounts to have true picture of profits of the relevant period. It was not the case of the Revenue that the liabilities written back were wrongly provided for. It could not be said that other comparable entities taken into consideration were not making and writing back provision of liabilities no more required. The provisions no longer required by the assessee were reversed in the books of account as per mercantile system of accounting and shown as income. It was held that provisions or balances written back in the P&L a/c could not be excluded from the operating profit of the assessee for computation of ALP;

(3) Insurance claims pertained to recovery of loss/damage suffered by the assessee company during its day-to-day operations such as transit of goods, pilferage, etc. are directly connected to the operations. Damages received from insurance company cannot be treated differently from the price of goods realized from customers and cannot be excluded while computing operating profit for determination of ALP;

(4) Interest received on delayed payment could not be excluded while computing operating profit of the assessee for determination of ALP;

(5) The assessee had assembled and exported colour TVs to its AE. The export price was quite comparable to local sale price of similar model after making adjustment for excise duty, sales-tax and other taxes which are not leviable on export sales and also export benefit. No error was pointed out in the computation made by the assessee. Therefore, the transaction of export to SJ was carried out by the assessee at arm’s length by application of CUP method and no adjustment is called for;

(6) The statutory levy of local area development tax has nothing to do with operating profits of the assessee. Other enterprises taken into account by the TPO are not subjected to such levy. Even if one of several comparables is also paying LADT, then while working average operating profits, this levy is to be excluded in that case also. Besides, the levy has been struck down as unconstitutional by the Supreme Court. Therefore, the amount paid as LADT by the assessee has to be excluded while calculating the margin of profit for determination of ALP;

(7) Miscellaneous income receipts from damages for defective items, insurance claim and sales-tax/service-tax refunds can reasonably be treated as operational income of the assessee and accordingly, the same can be included in working out its operating profit. However, membership and subscription received cannot be included in the operating profit of the assessee;

(8) Scope and applicability of proviso to s. 92C (2). It is the choice of the assessee to take ALP with a marginal benefit and not the arithmetical mean determined by the most appropriate method. There is nothing in the language to restrict the application of the proviso only to marginal cases where the price disclosed by the assessee does not exceed 5 per cent of the arithmetic mean. The second limb only allows marginal relief to the assessee at his option to take ALP not exceeding 5 per cent of the arithmetic mean. Therefore, the benefit of the second limb of the proviso to s. 92C (2) is available to all assessees irrespective of the fact that price of international transaction disclosed by them exceeds the margin provided in the proviso;

Development Consultants vs. DCIT (2008) 115 TTJ (Kol) 577

Where the assessee entered into international transactions with its three associated enterprises and the TPO ignored the separate analysis made by the assessee for each of the international transactions by the assessee and adopted a global approach whereby all the international transactions of the assessee were aggregated and combined gross profit margin over direct and indirect and cost for such international transactions was computed and compared with the gross margins earned by the assessee for transactions with third parties and based on such global approach, the TPO made an adjustment in ALP of the assessee and accordingly made an upward adjustment, HELD

(i) that this approach was not justified and that the ALP should be determined on a transaction-by-transaction basis and not on an aggregate basis as done by the TPO.

(ii) In order to determine the most appropriate method for determining the ALP it is first necessary to select the ‘tested party’ and the tested party will be the least complex of the controlled taxpayer and will not own valuable intangible property or unique assets that distinguish it from potential uncontrolled comparables.

Dresdner Bank AG vs. ACIT (2007) 108 ITD 375 (Mumbai)

The scope and nature of the expression ‘PE’ has been clarified in s. 92F, introduced w.e.f. 1st April, 2002. This section was inserted to define certain expressions, in the light of the introduction of transfer pricing regulations, and, these definitions are no more than clarificatory in nature. Sec. 92F (iiia) defines ‘PE’ as a “fixed place of business through which the business of the enterprise is wholly or partly carried on”. Sec. 92F(iii) recognizes a PE also as an enterprise. The effect of this position is that the transactions between a foreign company and its PE in India is to be viewed as an international transaction between two enterprises—between two associated enterprises though, in the light of provisions of s. 92A. Sec. 92(1), r/w Explanation thereto, makes it clear that interest transaction between head office of a foreign company i.e. GE and its PE in India, are to be accounted as income on arm’s-length price. Transfer pricing provisions cannot, and do not introduce new incomes in the tax net, but only provide that incomes from international transactions are to be computed at arm’s length price. The fact that head office-branch office interest transactions are also to be computed as income on the basis of transfer pricing provisions, only confirms the correct legal position, that interest earned by the branch office from head office is a taxable event, so far as taxability of branch office is concerned.

Ranbaxy Laboratories ltd. vs. ACIT (2008) 110 ITD 428 (Del)

A failure by the AO to examine fundamental questions relating to transfer pricing regulations and having accepted the claim of assessee without due enquiries and without application of mind and without referring the matter to the TPO which was mandatory renders the order erroneous and prejudicial to interests of Revenue and liable to revision by the Commissioner.

Authority for Advance Rulings:

Instrumentarium Corporation, in re (2005) 272 ITR 499 (AAR)

A non-resident company had given an interest-free loan to D, its wholly-owned subsidiary company incorporated in India. The application for advance ruling raised a question which required the Authority to determine the effect of the transaction of loan without adhering to the principle of arm’s length price on the Government exchequer or the tax revenue of the country. Held that such a determination was outside the ambit of the expression “advance ruling” incorporated in sub-cl. (i) of cl. (a) of s. 245N. Under s. 245N(a)(i), a proposed question of law or of fact must relate to tax liability of the applicant arising out of such transaction and not to consequences of implementation of provisions of the Act on the State exchequer and the like.