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Makeover for domestic transfer pricing
Fri, 12 Nov 2010 20:26:40 GMT
The Economic Times

Makeover for domestic transfer pricing

India has a relatively short history of transfer pricing (TP) legislation compared to some countries where this law is well developed. The detailed TP regulation in the country was introduced in the Finance Act, 2001, with a view to check erosion of tax base in the country. The domestic TP regulation is designed for an international transaction, which has been defined to mean a transaction between associated enterprises, either or both of whom are non-residents.

As per the domestic TP regulation, an international transaction between associated enterprises is required to adhere to arm’s-length standard. In order to ensure that the international transaction between associated enterprises is at arm’s length, there are reporting and detailed documentation requirements that a taxpayer must maintain to avoid stringent penalties.

A domestic transaction — a transaction between two tax residents of India — may not be governed specifically by the domestic TP regulation. Generally speaking, one may assume that the overall tax base of a country is unaffected by manipulation in the prices of domestic transactions between related parties, since it will have nullifying effect as far as overall taxability of the transaction is concerned. However, there may be situations where pricing of a domestic transaction could be manipulated for tax arbitrage opportunities.

For instance, price manipulation could result in shifting of profits between a loss-making entity and a profit-making entity to achieve an overall reduced tax rate. Similarly, profit shifting to an entity enjoying tax concessions under an incentive scheme could also be achieved through pricing of transactions of such entity with another related company.

The Income-Tax Act has provisions (sections 40A(2) and 80IA10) that empower the assessing officer to get into the aspect of pricing of the transaction between a taxpayer and a related person, and adjust the expense or income as per the market value of such transaction. However, a taxpayer is not required to maintain specific and detailed documentation to support the pricing of such transactions.

Also, there is no guidance in the Act or rules governing such provisions pertaining to determination of fair market value of the transaction. This often results in the tax officer exercising his best judgement in estimating the market value of the transaction and disregarding the excessive expenditure and income reported by the taxpayer.

In an interesting development, the Supreme Court in the recent case of Commissioner of Income Tax IV, Delhi, vs GlaxoSmithKline Asia (P) Ltd (SLP (Civil) no 18121/2007) discussed the above-mentioned limitations in the current provisions governing pricing of domestic transaction between related parties.

In this case, the court, on the facts of the case, declined to interfere and dismissed the special leave petition filed by the tax department. However, since the issue involved concerned section 40A(2) of the Act, the court took up a larger issue of the scope of domestic TP regulation being limited to cross-border transactions. The apex court observed that in the case of a domestic transaction, underinvoicing of sales and overinvoicing of expenses would ordinarily be tax neutral.

However, there could be situations where a tax arbitrage could be created. The court expressed the view that certain provisions of the Act, such as sections 40(A)(2) and 80IA(10), need to be amended to empower the tax officer to make adjustments to income having regard to the fair value of the transactions between related parties.

Identifying the shortcomings of current provisions and with a view to reduce litigation, the court has suggested that the ministry of finance should consider whether the law ought to be amended to provide for extensive documentation to be maintained by the taxpayer even for domestic transactions with related parties. This would align the provisions governing domestic transactions between related parties with the provisions of the domestic TP regulation.

The amendment of law to introduce documentation requirements even for domestic transactions between related parties would not be unique to India. There are many countries that mandate compliance requirements for domestic transactions within their transfer-pricing regimes. The UK, for instance, is a jurisdiction where TP provisions governing domestic transactions are fairly developed.

The issue is whether the objective of reduced litigation would be achieved? Considering that litigation surrounding TP issues has increased significantly, the change might not result in the desired outcome. However, it would rule out absolute discretion and bring out some objectivity in the application of the provisions.

So, are we ready for domestic transfer-pricing legislation? Or, more importantly, whether the increased burden on the taxpayer as well as the tax officers is worth the effort? The answer may not be a simple ‘aye’ or ‘nay’. However, as the Supreme Court has suggested, this is a change that merits consideration by lawmakers.

(Arun Chhabra, Partner, Walker Chandiok & Co was assisted by Ankit Goel, a manager with the same firm. Views are personal)
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