Transfer Pricing, India, AS 18, Tax, Draft Tax Code, Tax evasion, Corporate Governance

1. What is Transfer Pricing – Transfer
pricing as the name suggests, is the transfer
of goods and services within the
organization. The key implication in the
process is that the prices are set within the
organization and hence a chance of
manipulation is always there. The
loopholes in the whole system can be
exploited by MNCs as well as the domestic
companies to book higher or lower profits
depending on the situation and hence strict
rules and regulations are needed to curb the
manipulations. Transfer Pricing Manipulation (TPM) as it is normally called is not only
relevant in cross border transactions where revenues of one country gets transferred to
another (where tax rates are more favorable) but is also relevant within country , where
companies try to take advantages of different level of sales tax and VAT by using the process
of TPM. But luckily or unluckily Transfer Pricing provisions are applicable only when –
1. Their is an international transaction(s) [defined in Sec 92B] „between‟
2. Two or more Associated enterprises [defined in Sec 92A].
Current Regulatory Regime in India & Globally:
(a) Indian and global tax authorities have armed themselves with substantial powers to plug
the tax evasion that arises from creative transfer pricing.
(b) Transactions between related parties come under the ambit of Accounting Standard AS
18 in India and IAS 24 internationally. These standards require disclosure of certain aspects
of such transactions.
(c) Neither in India nor elsewhere in the world have company law authorities prescribed
transfer pricing methods or disclosures.
(d) The methodologies for determining arm‟s length transfer prices (Comparable
Uncontrolled Price, Resale Price Method etc.) are broadly the same in India and abroad.
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2. (e) There is a great deal of diversity in the definition of related party.
Implications:
Tax Arbitrage- If there are no strict rules and regulations, an MNC would like to
operate in such a manner that most of its profits are booked in those subsidiaries
which are located in tax heavens. Hence they would adopt such transfer pricing
mechanisms that goods in subsidiaries are bought at the lowest minimum prices and
hence a supernormal profit resulting in lower taxes compared to other places. In order
to curb this practices, tax authorities are very strict worldwide in related party
transactions. Recently Glaxosmithkline in 2006 had to part away with US dollar 3.1
billion as penalty for adopting improper transfer pricing mechanisms.
Effects of TPM on countries:
Loss of tax revenue & Custom duty.
Unfavorable BOP statements.
Flow of FDI is more where there are easier norms for Transfer pricing.
Methods of price calculation: The Finance Act 2001 introduced detailed mechanism to deal
with TPM. The idea was to determine whether the transactions are carried on at “arm‟s length
price”.
Arm‟s Length Price is the price charged during uncontrollable transactions. Two most
common methods are –
1. Checking the price in a similar transaction between two unrelated parties,
A B Vs C D
2. Checking the price in a similar transaction where one party is related,
A B Vs A C
The various methods to find the arm‟s length price are -
Comparable uncontrolled price method- In order to judge the fairness of the price
charged, the prices of two independent companies are compared with the company
and its subsidiary in question.
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3. Cost plus method- This approach requires the companies to add a mark up on their
cost. The mark up must be comparable to the firm in the same sector. This method
also require the firm to stick to the below mentioned methods for their cost accounting
o Actual cost approach
o Standard cost approach
o Variable cost approach
o Marginal cost approach
The issue of fixed cost and cost of R&D though remains unanswered in this approach.
Resale Price method- It is the same as the cost plus method , the only difference being
here the mark up is subtracted from the final selling price to arrive at the fair price. The
mark up is obtained from the similar firm in same industry. Though the process is
difficult to implement in case of intangible goods as the cost of technological know-how,
R&D is difficult to ascertain correctly.
Non Transactional Methods: In non transactional methods, related parties income figures
are considered and adjusted according to their share. These are:
o Profit Split Method (PSM): PSM is used when AEs transactions are so integrated
that it becomes impossible to conduct a TP analysis on a transactional basis. First,
the combined net profit incurring to related enterprises from a transaction is
determined. Then, the combined net profit is allocated between related enterprises
with reference to market returns achieved by independent entities in similar
transactions. The relative contribution of related parties is then evaluated on the
basis of assets employed, functions performed or to be performed and risk
assumed.
o Transactional Net Margin Method (TNMM): TNMM is normally adopted in cases
of transfer of semi-finished goods, distribution of finished products (where resale
price method (RPM) cannot be adequately applied) and transactions involving the
provision of services. TNMM compares the net profit margin relative to an
appropriate base (sales, assets or costs incurred) of the tested party with net profit
margin of the independent enterprises in similar transactions after making
adjustments regarding functional differences and risk involved.
Under the Indian TP regime, there is no hierarchy in terms of preferred methods of
determining ALP. Indeed, as per section 92C (2) of the Income Tax 1961, the most
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4. appropriate method has to be applied for determining ALP in the manner prescribed
under Rules 10 A to 10C notified vide S.O. 808 E dated 21.8.2001.
Some of the difficulties in identifying the ALP are –
Copyright Administrative
Issues Problems
Specialised
Confidentiality
nature of
Issues
goods/services
Roadblocks
The major operational Problems are –
Determination of ALP
o Some intra-group transactions are so unique that they can-not be compared
o TP reports of two AE‟s would have conflicting conclusions
o No recommended Profit Level Indicator (PLI) – wide fluctuations may result
depending upon each PLI.
o Corporates hesitant to disclose information
o Major countries do not require rejection of other methods
Databases
o gap in search of Databases
o Non availability of recognized databases
o Lack of comparables
Benchmarking
o No recommended method for benchmarking
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5.  Transaction by Transaction
 Aggregate of similar Transactions
 Based on Functions
 For each AE separately
o Arm‟s Length Range Vs Arithmetic Mean
o Pricing of Intangibles – soft targets
o Difficulty in justifying adjustments for factors having a bearing on prices
o Insufficient information available for calculating gross margins
o In case of rapidly fluctuating prices, which prices to compare with.
To summarise the position of India in TP is –
Legal Position The Finance Act 2001 introduced with effect from Assessment Year 2002-
2003,
detailed Transfer Pricing regulations vide Section 92 to 92F of the Income
Tax Act ,
1961. The Central Board of Direct Taxes (CBDT) has come out with
Transfer Pricing
Rules - Rule 10A to Rule 10E.
Applicability Transfer Pricing provisions are applicable based on some criteria:
Firstly, There must be an international transaction,
Secondly, such international transaction must be between two or more
associated
enterprises, either or both of whom are non-resident/s.
Pricing Method Arm's Length Price is to be determined by adopting any one of the following
Allowed methods, :
being the most appropriate method:
CUP method,
Resale Price Method,
CPM,
Profit Split Method,
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6. TNMM, or
Any other method prescribed by the CBDT.
Documentation/ 13 Different types of documents are required to be maintained. These are-
Return (1) Enterprise-wise documents-
Description of the enterprise,
Relationship with other associated enterprises,
Nature of business carried out.
(2) Transaction-specific documents_
Information regarding each transaction,
Description of the functions performed,
Assets employed and risks assumed by each party to the transaction,
Economic & Market Analysis etc.
(3) Computation related documents-
Describe in details the method considered,
Actual working assumptions, policies etc.,
Adjustment made to transfer price,
Any other relevant information, data, documents relied for determination
of arm's
Length price etc.
A report from a Chartered Accountant in the prescribed form giving details
of
transactions is required to be submitted within a specific time limit.
Penalty Penalty for concealment of income or furnishing inacurate particulars
thereof- 100% to 300% of the tax sought to be evaded.
Penalty for failure to keep and maintain information and documents in
respect of
International transaction- 2% of the value of each international transaction
Penalty for failure to furnish report under Section 92E- Rs. 100000/-
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7. Undesirable Corporate Practices Related to Transfer Pricing
Some of the related party transactions, which are usually resorted to for diversion of funds are
detailed below.
(a) Purchase of goods or services from a related party at little or no cost or at inflated prices
to the entity.
(b) Payments for services never rendered or at inflated prices.
(c) Sales at below market rates to an unnecessary “middle man” related party, who in turn
sells to the ultimate customer at a higher price with the related party (and ultimately its
principals) retaining the difference.
(d) Purchases of assets at prices in excess of fair market value.
(e) Use of trade names or patent rights at exorbitant rates even after their expiry or at a
price much higher than the price, which can not be described as reasonable.
(f) Borrowing or lending on an interest-free basis or at a rate of interest significantly above
or below market rates prevailing at the time of the transaction.
(g) Exchanging property for similar property in a non monetary transaction.
(h) Selling real estate at a price that differs significantly from its appraised value.
(i) Accruing interest at above market rates on loans.
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8. Some examples of such abuses are given below:
Case 1 on evasion of customs duty and taxes
thereon
The parent unit is supplying raw materials to its
100% EOU subsidiary located separately at an
estimated cost which covers raw material costs
and variable conversion charges. The EOU unit
reckons this cost as its purchase cost of raw
materials and adds value to the raw material to
produce the final product which is exported
from this unit. Since the 100% EOU is exempt
from customs duty and excise duty on finished
product there is no payment of duty on this
account by the 100% EOU. The transfer of raw
materials from the parent unit being below the
full cost of the product there is an inbuilt mechanism to divert profits from the main company
to the 100% EOU unit which enjoys exemption from various duties and taxes.
The FOB value of exports being approximately Rs100 crores in a given year the impact of
taxes can be worked out.
Case 2 on investment in a subsidiary
The parent company is giving loans to its subsidiary companies on an interest free basis
which remains unpaid for more than 5 years now. The amount of interest free loans given to
its subsidiaries totals Rs1500 crores. The parent company is a flag ship company and has a
wide range of products in manufacturing and trading. Some of the subsidiary companies have
not taken off at all and some of them have become defunct and there is no action for recovery
by the parent. The annual loss on interest to the parent company on a notional basis at 15%
p.a. is estimated at Rs220 cr. This is a clear suppression of profits arising from evasion of
legitimate income resulting from the diversion of borrowed funds by pledging of assets by the
parent company. Since the company is making profits, no queries are raised by outside
agencies as they get regular interest payments and repayment of loans without a default. This
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9. is a case where diversion of funds and transfer of funds at below cost is resorted to in order to
avoid a legitimate return to the shareholders.
Case 3 Mismanagement by holding company of companies under the same
management
Many of the companies resort to formation of 100% holding companies to control totally the
management which is the company providing funds to various companies in the same
management. Many of them do not go for public finances as the holding company takes care
of the entire financial structuring for these related companies. These companies mostly do not
trade in the open market by listing, as the shares are closely held by the parent company. The
surpluses of the subsidiary go back to the parent company in the form of high rates of
dividends. The investment of funds gets a good return to the parent company which has
several baskets of companies to set off profits against losses and minimize the payment of
taxes to the authorities. This is a very clear case of legitimate tax avoidance beyond the legal
net. This type of promoter controlled business is widely resorted to as a corporate strategy to
avoid taxes by the holding company and this is well within the laws of land. The question
before the public is how is the profit suppression by business conglomerates to be addressed.
As more and more MNCs are stepping into our country the flight of foreign exchange by
diversion of funds is a serious concern to the country. The disclosures will not serve any
purpose as there is no violation of the accepted form of investment. What is required is to
consider payment of dividends to holding companies as a related party transaction and to
regulate such payments which may be beyond the prescribed investment norms.
Case 4 Siphoning of funds by formation of Joint ventures
In forming a JV Company „A‟, a foreign company supplies plant and machinery and
technology to Company „B‟ located in India. Mostly the plant and machinery is old but
categorised as refurbished to avail of the benefits of depreciation and other allowances.
For technology transfer the Company „A‟ is paid a hefty amount as technical fees by
Company „B‟ based on volume of sales. The Company „A‟ treats the supply of plant and
machinery as their share of the JV investments. Company „B‟ pays dividends treating the
value of plant and machinery as equity participation apart from paying royalty and technical
knowhow fees for technology transfer.
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10. The issue before the public is denying genuine Indian investors of the advantage of equity
participation by company „A‟ getting additional rights issue and bonus issues for no
consideration and beyond the value of plant and machinery supplied. Over the years it could
be found that Company A‟s share of equity and royalty payments far exceed the value of the
assets invested by the company. There is flight of capital as dividends paid for expanded
capital not to forget payments as technology transfer which is difficult to measure.
Case 5 – Indian MNC covering all aspects
The company was established over 50 years ago and is listed on the BSE. The sector in which
the company operated was reserved for the small scale industry. In order to maintain its
market leadership, the company had to find new methods of holding on to its manufacturing
base and expanding it to keep pace with market demand.
The company continued to invest heavily in R&D and Plant and Machinery. It floated joint
ventures and/or companies where the major shareholder was its distributor in each region. It
transferred its old plant and machinery to the new companies at a price just below the Rs. 20
lakh ceiling then in force for a company to qualify as an SSI unit. The management and
operational control of each of these smaller manufacturing entities rested entirely with the
MNC.
The MNC operated each of these smaller companies through 2 modes.
1. In the first mode, all Raw Material and Packing Material was supplied by the parent
company to each manufacturing facility. The finished product was shipped to
company warehouses and distributor godowns for onward movement in the
company‟s supply chain.
2. In the second mode of operation, each smaller company was allowed to negotiate
and source raw and packing material (primary items only from approved
suppliers) and do its own manufacturing. The manufacturing unit was run under a
very stringent Standard costing system where standard cost of procurement and
standard selling prices (TP) were fixed in March of each year. The TP was fixed with
a small profit margin based on the tight standard costs of material. The finished
product was sold to the MNC at the TP (based on Standard Cost+Margin). The MNC
would then sell the FG at it normal price after markup.
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11. The units operating under the second method were found to have vastly superior
manufacturing efficiencies.
This TP mechanism was designed to meet 4 objectives
1. Overcome the constraints imposed by government policy (reservation).
2. Take advantage of the lower excise duty for SSIs.
3. Drive towards greater manufacturing and operational efficiencies.
4. Continue to take advantage of utilizing almost fully depreciated assets while
keeping up new investment levels in the parent company.
Over the next 30 years the company continued to maintain its leadership position in the
market and its share continues to remain one of the most valuable shares in the Indian stock
market. The recent deregulation of the sector in which the company operates may see a
marked change in manufacturing strategy.
Case 6: Cement Industry:
A major plant, with a capacity of more than 0.60 Million TPA used to sell surplus Clinker to
Grinding units. Generally, every Cement plant keeps higher capacity upto clinker stage, in
order to ensure continuous supply of Cement in the market even during Kiln shut down for
periodical maintenance. The surplus clinker is sold to various other small grinding units. In
the instant case the close relatives of Promoters got other Small / Mini Cement Plants to
which the clinker is sold @ Rs.250/- to Rs.300/- per ton where as they use to sell @ Rs. 950/-
to Rs.1000/- in the market, the cost of production works out to more than Rs. 800/- per
ton. This practice is prevalent in many Cement units. In the instant case, the Cement unit
became Sick and FIs & Banks have to forge substantial amounts
Coal and Cement transport are generally done by outside transport contractors for a Cement
unit. Many of the Promoters also promote transport companies under benami names or
through relatives who are given contract for transport of Coal, Cement or other Raw
materials. Rates of the transport very substantially from period to period, on questioned for
such variations they are explained as market exigencies are the reasons for higher payments
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12. during some periods. Some times even the lean season rates are unjustifiably & very higher-
nothing but diversion of funds.
Case 7 - Paper Industry
Paper is sold through a large dealer network. Most of the dealers are either relatives or
relatives of relatives under benami Partnerships. Paper is sold to the related parties at a much
discounted / lower rates.
Similarly the transport of various Materials & Paper is also done through related party
transport companies. Major chemicals for e.g. Lime (high purity) is also purchased from
related party companies having Lime Kilns
Case 8 - Pharmaceutical Industry:
Third party Loan Licensing for manufacturing and system of distribution / selling agencies
for Sales are very common. The final rates for various conversion jobs are fixed as a part of
profit planning exercise. It is also observed that substantial year-end journal vouchers are
passed giving rebates / discounts / reimbursement of special expenses etc., for Selling
Agencies / Distributors in related party accounts.
Case 9 - Multinational Companies
Various multinational brands have certain ingredients which give the flavour / fragrance /
taste, to their brand patents. The cost of purchase of such items changes from period to
period, even some times quarter to quarter. The invoices and other documentations are built
up and journal vouchers are passed at the period end against advanced payments made from
time to time. Such entries are made even for Technical Services rendered on adhoc basis in
the name of a Technical Up-gradation, Consultancy Fees etc., in addition to huge Royalty and
Sales commission.
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13. Direct Tax Code – The way Forward:
o Introduction of the concept of Advance Pricing Agreement (APA), decision valid for
five consecutive years and binding on both parties.
o Introduction of Impermissible Avoidance Agreement.
o Widened the base for Transfer Pricing compliance by reducing the shareholding
criteria from present 26% to 10%.
o Replacement of value based strategy to risk based strategy.
o Reduction of penalty from 2% of the transaction value to a minimum of Rs 2 lakh.
The upper limit of income adjusted penalty has been reduced from 300% to 200% of
tax on adjustment.
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