Transfer Pricing Law on Intra-Group Services

There has been a rise in participation of multinational groups in various economic activities in India. This has given birth to new and complex issues, which arise primarily from transactions made between two or more companies that belong to the same group of multinational entities. The profits generated by such companies can be controlled by the multinational group they belong to, who can manipulate the prices charged and paid in the intra-group transactions between them. This leads to erosion of tax revenues.

Certain provisions were introduced in the Income Tax Act, 1961 to establish a legal structure that makes it possible to aptly calculate profits and taxes of such multinational companies in India.

Intra-Group Services

Intra-Group Services (IGS), which include management services, refers to services provided by the parent entity or any entity to other entities within its Multinational Enterprise Group (MNE Group). IGS is considered a vital aspect required to sustain competitiveness, consistency and collaboration between the companies of the same MNE Group.

The Arms-Length Prices for IGS have often been disputed by tax authorities in India. IGS can generally be categorized into two categories - Common Administrative Services and Value-Added Services.

• Comon Administrative Services

Also known as ‘Low Value-Added Services,’ common administrative services generally consist of exchanging resources or information between entities. This exchange is generally done between entities of the same group for a certain price. The first step to do so is to determine the cost base for such sharing of information.

For example, if an entity of the group has primarily purchased a software, say, Microsoft Office 365 and offers it to other entities of its MNE Group, it would be logical for them to establish a certain cost for offering such a software to all the other entities. This may be determined by considering the number of people using the software in other entities along with the expense of managing a system admin, if any, and dividing the cost of the software equally amongst them.

As of now, in India, the safe harbor markup rate for common administrative services has been capped at 5%.

• Value Added-Services

These services comprise various management and technical services. The first aspect that must be dealt with for such services is establishing a cost for such services. This is quite often not easy as the importance of a certain service shall vary from entity to entity, which makes it quite problematic to determine an arm’s length price for such services.

The next problem is to ensure that receipt of such services is documented. For example, if a strategizing service is provided by one entity of the MNE Group to another, the decisions are generally made and communicated via informal mediums, like phone calls and meetings, which are not always aptly documented. Keeping in mind that tax authorities demand tangible documentation of proof of any transaction during an audit, such services create a dispute between the taxpayers and the tax authorities.

Note: Some Courts, while addressing some tax matters, held that taxpayers do not need to document 100% of the evidence pertaining to a transaction. An aptly structured and logical approach of documents and evidence shall be enough to safeguard an MNE Group from any legal proceedings against them.

Applicability of the Transfer Pricing Regulation

Regulations of transfer pricing shall be applicable to transactions that fulfill the following criteria:

• It is an international transaction.
• The transaction has been made between two or more entities, either or both of which are non-residents.

In addition, the transaction must be in the nature of:

• Purchase, sale or lease of tangible properties.
• Purchase, sale or lease of intangible properties.
• Provision of services.
• Lending/borrowing of money.
• Any other transaction that has a bearing on the profit, income, loss, or assets of such entities.
• A mutual agreement or agreement between two or more companies to allocate any cost/expense incurred in relation to a benefit, service or facility availed by one or more of such companies.

Note: The concerned transaction must exceed INR 20 crores.

Furthermore, if a transaction takes place between an entity of a MNE Group and an individual other than an associated company, it shall be considered as a transaction between entities of the same MNE Group if any of the following are fulfilled:

• An agreement related to such a transaction between the individual and the company was signed prior to the transaction, or
• The terms of such transactions are determined in substance between the individual and the company.

Note: Transfer pricing regulations do not intend to be applicable to instances where their application can reduce the income that can be charged for tax in India or increase the loss.

Associated Enterprise

As per Section 92A (1) of the Income Tax Act, 1961, an associated enterprise refers to a company that participates directly, indirectly or through its intermediaries in the management, control or capital of another company. Section 92A (2) of the Income Tax Act, 1961 provides a more descriptive explanation of the individual or entities who fall under the definition of an ‘associated enterprise.’ An individual/entity shall be deemed an associated enterprise if any of the following is true at any time during the preceding year:

• One of the two entities owns 26% shareholding with voting rights during the previous year.
• An individual or company holds 26% of the shares with voting rights in both entities.
• The lender provides a loan that is equal to or more than 51% of the borrower’s book value. It must be noted that the aspect to be reviewed is the book value of the borrower’s assets and not the market value of the assets.
• One entity guarantees 10% or more of the total borrowing of the other entity during the preceding year.
• If any of the following conditions are fulfilled at any instance during the preceding year, both parties shall be deemed as associated enterprises:
    - One of the companies appoints more than 50% of the board/governing body of the other entity.
    - One entity appoints one or more executive directors or executive members of the board/governing body of the other entity.

Note: -    Having the power to appoint 50% of the directors or one or more executive directors is not sufficient. This power must be exercised for both parties to be considered as associated entities. -    In this scenario, the company shall be appointing the authorities in the other company. It shall not be applicable if a single director of the company makes such appointments in the other company.

• If the same individual appoints more than 50% of directors or any executive director in both enterprises at any time during the preceding year, both parties shall be deemed associated enterprises.
• One company is entirely (100%) reliant on the exclusive rights of the other company.

Arm’s Length Price (ALP)

ALP refers to the price at which independent companies deal with each other, where their commercial and financial relations’ conditions are generally controlled by market forces. To put it simply, the transfer price should represent the rate that can be charged from an independent entity in uncontrolled conditions. It is crucial for an enterprise to determine the ALP. If the transfer price is not set at the ALP, it shall have the following effects:

• Inaccurate assessment of a company’s performance.
• Incorrect pricing of the final product (in cases where the manufacturing of final product required usage of certain goods/services).
• Failure in adhering to relevant laws/regulations, resulting in attracting certain penalties.

Determining ALP

Section 92C of the Income Tax Act, 1961 provides that ALP shall be determined by the Comparable Uncontrolled Price Method (CUP Method), Resale Price Method, Cost Plus Method, Transactional Net Margin Method, Profit Split Method, or any other method prescribed by the Central Board of Direct Taxes (CBDT).

• Comparable Uncontrolled Price (CUP) Method

The CUP method involves comparing the prices and conditions of products/services in a controlled transaction with that of an uncontrolled transaction that takes place between unrelated entities. For an uncontrolled transaction to be considered as a comparable price, it must meet high comparability standards or must be extremely similar to be eligible for comparison under this method.

• Resale Price Method (RPM)

This resale price of a product/service is used in this method. This number is reduced with a gross margin. Thereafter, the purchasing cost of the product, such as custom duty, is deducted from the amount. The number thus obtained shall be the ALP.

• Cost Plus Method (CPLM)

This method involves comparing the company’s gross profits to the overall cost of sales. First, the costs incurred by the supplier in controlled transactions are calculated. Thereafter, a market-based markup is added to the amount.

• Transaction Net Margin Method

This method involves calculation of net operating profits from controlled transactions and comparing them with the profits generated by third-party companies that make comparable transactions.

• Profit Split Method

In certain cases, associated enterprises are involved in interconnected transactions, which basically means that they cannot be considered separately.

Transfer Pricing Documentation

• General Documentation Requirements

Taxpayers must maintain the transfer pricing documentation if the aggregate value of international transactions with their associated entities is more than INR 1 crore. In case of domestic transactions, the amount must exceed INR 20 crores.

Note: Some of the prescribed documents required for this purpose are the ownership structure, business description, multinational group’s profile, nature & terms of international/specified domestic transactions, and functional asset & risk analysis.

The transfer pricing documentation must be maintained annually by the due date for submitting Accountant’s Report in Form No. 3CEB. It must be submitted to the revenue authorities when details pertaining to the same are requested during transfer pricing audits.

Further, taxpayers must also maintain and submit master file and Country by Country Reports (CbCR) to the tax authorities.

• Master and Local Files

Local File: In India, local files must be maintained if the aggregate value of international transactions with associated entities is more than INR 1 crore in the relevant financial year. It must exceed INR 20 crores in case of domestic transactions.

Master File: Master file needs to be submitted in instances where:

• The aggregate value of international transactions between associated entities is more than INR 50 crores in the relevant accounting year (INR 10 crores in case of intangible related transactions), and
• The consolidated global turnover of the multinational enterprise group is more than INR 500 crores.

Note: The due date to file the master file under Form No. 3CEAA is 30 November of the relevant assessment year.

• Penalties

Following are the penalties under the transfer pricing regulations in India:

• Failing to maintain relevant information/documents, failing to report transactions in Form No. 3CEB & transfer pricing documentation, maintaining inaccurate information, failing to submit information during transfer pricing audits – 2% of the international/domestic transaction’s value.
• Failing to file Form No. 3CEB – INR 1 lakh.
• Underreporting income – 50% of the tax amount.
• Misreporting income – 200% of the tax amount.
• Concealing income or furnishing inapt particulars of income in relation to ALP adjustments – 100% to 300% of the tax that was attempted to evade.
• Failing to submit master file – INR 5 lakhs.
• Failing to furnish CbCR by the prescribed due date:
    - INR 5,000 per day for one month,
    - INR 15,000 per day after one month, and
    - INR 50,000 per day after the date on which the penalty order was serviced.
• Failing to submit the information before the prescribed authority for the purposes of filing CBC – INR 5,000 per date for one month and INR 50,000 per day from the date the penalty order was serviced.

Conclusion

Considering not all transactions between companies of the same MNE Group are recorded, it is imperative to have an apt record of the flow of transactions for the purpose of computing reasonable, fair and equitable profits and taxes in India.