The Transfer Pricing Law Review: India

Overview

Transfer pricing laws in India are codified in the Income-tax Act, 1961 (the Act). The law is applicable to all taxpayers: corporates and non-corporates, residents and non-residents, with income chargeable to tax in India. The laws specifies situations in which transactions shall be covered in the ambit of transfer pricing provisions, namely, transactions with associated enterprises if either party or both parties to the transaction are non-resident, transactions with third parties that are deemed to be international transactions with associated enterprises, and specified domestic transactions. The terms 'international transaction', 'associated enterprises', 'specified domestic transactions' and 'deemed international transaction' are all defined in the law. The law broadly aligns with the Organisation for Economic Co-operation and Development Guidelines on Transfer Pricing (the OECD Guidelines). Methods to compute the arm's-length price, extensive annual requirements for transfer pricing documentation and penal provisions for non-compliance are also provided. Although the law covers both income and capital transactions with similar rules, it only covers capital transactions that have an incidence of income, such as business reorganisations and use of intangibles, that is enshrined in the charging provisions of the substantive law. Transactions are deemed to be arm's length, and while primary onus is on the taxpayer to support the arm's-length nature of its transactions, the tax authorities also need to arrive at the arm's-length price in the manner prescribed in the law, if they do not accept the taxpayer's price or the arm's-length price as arrived at by the taxpayer. However, there are stringent penalties on the taxpayer if it does not maintain the prescribed documentation. The term 'international transaction' covers:

  1. the sale, purchase, lease, transfer or use of tangible property;
  2. the sale, purchase, transfer, lease, or use including transfer of ownership or the provision of use of rights of intangible property;
  3. capital financing transactions, including any type of lending, borrowing or guarantee, payments or deferred payment or receivable, any type of advance, purchase or sale of marketable sercurities, any debt arising during the course of business;
  4. the provision of services;
  5. transaction of business restructuring or reorganisation;
  6. cost-sharing arrangements;
  7. lending or borrowing money; or
  8. any other transaction having a bearing on the profits, income, losses or assets of such enterprises. Business restructuring or reorganisation transactions have to be covered irrespective of whether they have a bearing on the profits, income, losses or assets. It is important to note the law provides that transactions include an arrangement, understanding or action in concert, whether or not it is formal or in writing, and whether or not it is intended to be enforceable by legal proceeding. Additionally, the law provides that if a transaction is entered into with a third party, but the terms of the transaction are determined in substance by the third party with the person's associated enterprise, then such transaction shall be deemed to be an international transaction between two associated enterprises and shall need benchmarking.

Associated enterprises are also widely defined to mean association by direct or common management, capital or control. Some situations in which enterprises shall be deemed to be associated, are as under:

  1. the direct or indirect holding of at least 26 per cent voting interests;
  2. controlling the appointment of more than half the board of directors or governing board;
  3. controlling the appointment of one or more of the Executive Directors;
  4. a significant dependence on intangibles, raw materials, or sales consumables;
  5. supplier lending or guaranteeing a loan for the substantial percentage of total assets from one enterprise; or
  6. any other relationship of mutual interest as prescribed.

The law provides for six methods to determine the arm's-length price:

  1. the comparable uncontrolled price (CUP) method;
  2. the resale price method (RPM);
  3. the cost-plus method;
  4. the profit split method;
  5. the transactional net margin method (TNMM); and
  6. a sixth additionally prescribed method, which is any method that, inter alia, takes into account the price paid or charged, or payable or chargeable in the same or similar uncontrolled transactions.

If there are six or more comparables, an interquartile range beginning with the 35th percentile and ending with the 65th percentile is considered as the arm's-length range. In other cases, a specified deviation (1 per cent or up to 3 per cent) from the mean or arm's-length price is available.

The law also provides avenues for obtaining certainty such as safe-harbour rules and Advance Pricing Agreements (APAs). APAs are available for transfer pricing, and from April 2020, were made available for profit attribution to permanent establishments (PEs). It is widely debated that this amendment signifies that the profit attribution of PEs is different from FAR analysis and indicative of the Indian Revenue authorities' shift from a FAR to a FARM analysis.

Additionally, the law also encompasses provisions for thin capitalisation and secondary adjustments. Thin cap provisions are applicable even where the debt is issued by a lender that is not associated if the debt is implicitly or explicitly guaranteed by an associated enterprise, or if the associated enterprise deposits a corresponding or matching amount of funds with the lender. Secondary adjustment provisions provide that in certain specified circumstances, such as voluntary adjustment made by taxpayer, addition made by tax officer and accepted by the taxpayer, adjustment resulting as a resolution of MAP proceedings, the excess money will need to be repatriated to India within a specified time frame. Failing this, the excess money is treated as advance and interest is computed on such advance.

Section 188 of the Companies Act 2013 prescribes the consent of the board of directors for specified related-party (domestic and international) transactions. This does not apply to transactions under the ordinary course of business. In November 2019, the capital markets regulator, namely the Securities and Exchange Board of India (SEBI), constituted a working group to review the policy pertaining to related-party transactions (RPTs) for listing entities. Consequently, in January 2020, SEBI announced policy proposals with respect to RPTs to protect the investor's interest and for ease of doing business.

Filing requirements

Taxpayers are required to annually maintain extensive supporting information and documents relating to international transactions undertaken with their associated enterprises. Rule 10D of the Income-Tax Rules, 1962 (the Rules), which has been widely interpreted by courts, prescribes that the documentation requirements may be broadly divided into two parts. The first part lists the following mandatory information that a taxpayer must maintain. This includes information on the ownership structure (e.g., group profile and business overview); the associated enterprises' contractual nature, terms, quantity and value of an international transaction or specified domestic transactions;2 relevant financial forecasts or estimates that form part of a comprehensive transfer pricing study, an analysis of functions performed; risks assumed; assets employed; details of relevant uncontrolled transactions; comparability analysis; benchmarking studies; assumptions; policies; details of economic adjustments; and explanations as to the selection of the most appropriate transfer pricing method. The annual documentation must be updated to reflect the latest financial data adjustments on such transactions.

The second part stipulates supporting documentation authenticating the information and analysis provided in the first part, which includes official publications, reports, studies, and databases from the Government, market research reports or technical publications by reputed institutes, published accounts and financial statements relating to the business affairs of associated enterprises, agreements and contracts entered into with associated enterprises or with unrelated enterprises, letters and other correspondence evidencing negotiations between associated enterprises and documents normally issued in connection with various transactions under the accounting practices followed.

This documentation must be contemporaneous, maintained for a period of eight years from the end of the relevant assessment year (i.e., nine years from the end of the relevant financial year) and presented to the tax authorities on request, at the audit, assessment or dispute resolution stage.

An accountant's report for all international transactions or specified domestic transactions between associated enterprises is mandatory; it is to be obtained from an independent accountant, who would certify the value of international transactions or specified domestic transactions (in accordance with the books of accounts) and state the arm's-length price based on the documentation and supporting information maintained by the taxpayer. The report has to be furnished in Form 3CEB by the due date of the tax return filing. The report requires the accountant to give an opinion on the proper maintenance of prescribed documents and information according to the rules, and to certify the correctness of an extensive list of transactions, including the methodology of the transactions. Failure to supply this report leads to a penalty of 100,000 rupees. A penalty of 2 per cent of the value of each international transaction or specified domestic transaction may be levied for failure to maintain the prescribed documentary report.

India is committed to implementing the recommendations of Action 13 of the OECD Base Erosion and Profit Shifting (BEPS) Action Plan (AP), and consequently the ITA was amended in 2016 to introduce a requirement to furnish a master file and country-by-country report (CbCR) together with the transfer pricing documentation for the year ending 31 March 2017. The master file has to be filed electronically. It has two parts: Part A specifies generic information about the constituent entities of a multinational enterprise (MNE) group operating in India; and Part B provides a high-level overview of the MNE group's business structure, operations, transfer pricing policies, among others. The key filing requirements are as follows:

  1. the filing of Part A of the master file in Form 3CEAA is applicable to every constituent entity operating in India, whether it has its parent entity resident in or outside India; and
  2. regarding the threshold for Part B of the master file in Form 3CEAA:
    • the consolidated revenue of the international group according to the consolidated financial statements for one accounting period must exceed the specified Indian equivalent of €750 million (amount is specified in rupees and amended periodically) and;
    • the aggregate value of international transactions of the constituent entity during the accounting period must exceed 640 million rupees; or
    • the aggregate value of international transactions in respect of purchase, sale, transfer, lease or use of intangible property during the accounting period, must exceed 100 million rupees.

Where an international group has multiple constituent entities, the group may designate one of its constituent entities as an alternate reporting entity to fulfil the requirement of filing Form 3CEAA on behalf of the group.

Presenting the case

i Pricing methods

The term 'arm's-length price' is defined under Section 92F of the ITA and applies to transactions between persons other than associated enterprises in uncontrolled conditions. As mentioned above, six methods have been prescribed by Section 92C of the ITA for the determination of the arm's-length price: CUP method, RPM, cost-plus method, profit split method, TNMM and an unspecified method.3

On the choice of methodology, the law prescribes the use of the 'most appropriate methodology'. The transfer pricing rules on this choice of methodology are in line with the OECD Guidelines. At the tax office level, there is a clear preference for internal comparables over external comparables, although in practice, at the audit stage for routine services, if a taxpayer has used an internal comparable, he or she is also expected to supplement their analysis with an entity level external TNMM. However, external gross margins such as those used in RPM or CPM are routinely accepted for benchmarking, although there may be disputes on choice of comparables or computation of margins.

The law provides for making adjustments to eliminate any material effects of differences between either the transactions or the enterprises entering into the transaction. Routine adjustments such as working capital adjustment are largely accepted by courts.

There is a plethora of disputes on the choice of most appropriate method, and courts have ruled that equal onus on choice of methods and comparability is on the revenue authorities, if they seek to reject the taxpayer's analysis.

ii Authority scrutiny and evidence gathering

In accordance with prevailing internal administrative guidelines, taxpayers are subject to risk-assessment rules (these are not made public) before being referred for an audit to a transfer pricing officer (TPO). Cases are selected for detailed audit by the issue of a notice under Section 143(2) of the ITA to the taxpayer within six months of the end of the financial year of the compliance calendar, which has been reduced to three months under the Finance Act 2021. There is a statutory requirement for the assessing officer (AO) to refer relevant transactions under Section 92CA of the ITA to the TPO for an audit, with prior approval of the jurisdictional commissioner, such that only select cases or transactions are audited. Although the criteria are not defined, a history of audits that resulted in an adjustment comprised of low margins, intangibles and intra-group services, among others, forms a basis for cases being picked out for audit. Typically, the TPO specifies the records, documents and details required to be produced for an audit. The TPO has wide assessment powers requiring the production of necessary evidence and material information to support the computation of the arm's-length price of transactions. Audit cases are scrutinised in detail to ensure that all relevant factors, such as appropriateness of the transfer pricing method applied and correctness of data, are verified. In practice, transfer pricing audits usually take place by having in-person meetings with the taxpayer or the taxpayer's authorised representatives. TPOs extensively use their powers to obtain data not available in public domain. Courts have ruled that access to the data should be provided to the taxpayer and the taxpayer should be given an opportunity to rebut such data. The use of expert witnesses during the audit stage is unheard of. Audits are usually concluded based on documentary submissions made and in-person hearings. Notably, during the financial year ending March 2021, India moved to a faceless audit regime for most audits; this regime is expected to extend to transfer pricing audits during the financial year beginning 1 April 2021. Under the faceless scheme, all correspondence will take place electronically and the taxpayer will not have in-person hearings with the tax officer.

TPOs are vested with powers of inspection, discovery, enforcing attendance, examining a person under oath and compelling the production of books of account and other relevant documents and information as part of the assessment function. These powers were further extended from 1 June 2017, to include conducting surveys for spot inquiries, verification for subsequent investigations and collation of data. These powers are enshrined in Sections 133A and 133B of the ITA, which empower the TPO to enter any premises to inspect such books of accounts, cash, valuables or any information as the TPO may require that may be useful or relevant for the proceedings. The investigative powers of the tax authorities in general, including in relation to transfer pricing law, are discussed in Section VI. A penalty of 2 per cent of the value of each international transaction or specified domestic transaction has been provided in Section 271AA of the ITA, both for failure to report transactions and for furnishing incorrect documentation at the audit stage.

Enhanced approaches such as adoption of practices suggested under BEPS APs, particularly the CbCR filings, have bolstered the transfer pricing mechanism. To facilitate the implementation of the exchange of CbCR among tax administrations, India signed the CbC Multilateral Competent Authority Agreement in May 2016, agreeing to comply with the provisions of the Agreement as provided in AP 13 of the OECD/G20 BEPS Inclusive Framework. The use of CbCR data is restricted via a Board notification. CBDT released an Instruction4 providing guidance on the appropriate use of CbCR making it clear that the CbCR data would only be used for risk assessment procedures and cannot be the sole basis for transfer pricing adjustments. Accordingly, it stipulates that all CbCR filed in India, as well as exchanged by other jurisdictions, shall be primarily accessed by the Competent Authority of India and Director General (Risk Assessment). The instruction specifically provides that when the information is made available to a TPO, the information in the CbCR can be used only for the following:

  1. high-level transfer pricing risk assessment;
  2. assessment of other BEPS related risks;
  3. economic and statistical analysis;
  4. planning a tax audit; and
  5. as the basis for making further enquiries into the group's transfer pricing arrangements and tax matters in the course of an audit.

Keeping commitment with the recommendations of the OECD regarding handling of the data, the CBDT has put into place a system to maintain confidentiality and monitor the activities of the transfer pricing officer by the jurisdictional Commissioner of Income Tax. Any breach could be brought to the notice of the Competent Authority of India who is required to disclose it to OECD's Coordinating Body Secretariat. Furthermore, a quarterly report of review of appropriate use of CbCR in the prescribed format shall be submitted within 30 days of quarter end by the Principal CCIT to the Board, who would get the review done through the Competent Authority of India. This instruction is aligned with the OECD recommendation on appropriate use of information contained in the CbCR. Hence, it is a welcome step in putting stringent control measures into place to use data appropriately and also prevent leakage of information contained in the CbCR. The notification specifically provides that use of information contained in CbC Reports shall be considered as inappropriate under the following circumstances:

  1. if the information is used as a substitute for a detailed transfer pricing analysis of international transactions and determination of arm's-length price based on a detailed functional and comparability analysis; and
  2. if the information is used as the only material to propose a transfer pricing adjustment.

Another mode of building capacity is the use of technology, artificial intelligence and data analytics to analyse the complex web of MNE structures and routing of transactions.

Intangible assets

Intangible property, which is understood to have a wider connotation than intangible assets, has been very broadly defined5 in the Act, and includes intangible assets related to marketing, technology, art, data processing, customers, engineering, human capital, location, goodwill methods, programmes, systems, procedures, campaigns, surveys, studies, forecasts, estimates, customer lists, technical data or any item that derives its value from intellectual content rather than its physical attributes. Moreover, the definition of 'international transaction' practically covers every direct or indirect transaction in relation to intangible property.

India has not specified any formal policy in response to the principles on the development, enhancement, maintenance, protection and exploitation of intangibles6 articulated in the BEPS AP other than the 2017 disclosure requirements. The CbCR requirement7 now mandates listing all multinational enterprise group entities engaged in the development of intangibles and the description of a multinational enterprise's strategy (transfer pricing policy) for development, ownership and exploitation of intangible property.

Before the BEPS initiative was underway, given the growing disputes over intangibles generated by R&D captives, the Central Board of Direct Taxation (CBDT) issued guidelines8 to TPOs about the characterisation of R&D units based on functions, assets and risk assumed. A set of qualitative criteria was laid out to drive decision-making on characterisation with an emphasis on the substance of an arrangement and not the contractual arrangement between the centre in India and its foreign associated enterprise. This guidance has classified R&D centres under the following three categories:

  1. entrepreneurial in nature;
  2. based on cost-sharing arrangements; and
  3. undertaking contract R&D.

On the basis of these categories, suitable methodology is prescribed as either the profit split method or cost-plus method, and the most appropriate methodology is forensically applied.

The tax office has extensively focused on the creation of marketing intangibles through advertising, marketing and promotion (AMP) spends, by subsidiaries of foreign multinationals. A batch of appeals in this regard is pending before the Supreme Court – the apex court of India, and the matter is soon expected to obtain some clarity. The principal debates around this focus on whether an AMP spend can be considered an international transaction for transfer pricing purposes under Indian law, what is the demarcated quantum that should be considered (tax offices usually rely on a bright line or intensity adjustment) and what should be adequate compensation for the creation of such intangibles, if any. High Courts have given conflicting rulings in this regard.9

Settlements

In contrast to other jurisdictions, there is no mechanism in India for the settlement of transfer pricing disputes with the tax authorities. For settlements, safe-harbour provisions and unilateral and bilateral APA mechanisms are viewed as means to mitigate risks in advance, and the mutual agreement procedure (MAP) under the treaty is considered, post-adjustment, to settle disputes. The rollback provision under an APA also enables settlement of past disputes given its binding nature.

In a move to reduce litigation and boost investor confidence, India introduced unilateral, bilateral and multilateral APAs with effect from 1 July 2012. In the nine years since its introduction, India has received over 1,000 applications and concluded over 300 APAs of which more than 240 are unilateral. These APAs cover various transactions, such as software services, IT-enabled services, intra-group payments or business support services commission. The bilateral APA process covers important jurisdictions, such as the United States, the United Kingdom, Japan, Germany, France, Italy and the Netherlands. In recent APA negotiations, the Revenue advocated expanding the scope of 'profit attribution' in the source jurisdiction, based not just on functions, assets and risk (FAR) analysis but also considering 'market' analysis, also referred to as functions, assets, risk and market (FARM) analysis. Value creation is taking centre-stage in APA negotiations, particularly for digital business models. Evaluation of intangibles using development, enhancement, maintenance, protection and exploitation (DEMPE) analysis and the focus on the significant people functions are also important aspects in APA negotiations and transfer pricing audits.

The MAP has often been viewed as a credible resort for settling transfer pricing-related disputes. Under the MAP process, the Indian competent authority allows the foreign-associated enterprise, a resident of the treaty country, to submit its MAP request via its country's competent authority. Under various administrative directions, tax demands arising out of adjustments with non-resident-associated enterprises that are residents of the United States, the United Kingdom, South Korea and Denmark are frozen until the MAP process is concluded, subject to the submission of suitable bank guarantees. Article 19 of the Multilateral Instrument (MLI) provides for mandatory binding arbitration when competent authorities are unable to reach a decision under MAP within two years. With the onset of MLI-based treaties from 1 April 2020, it is pertinent to note that India has not accepted such provision, taking a position that such binding arbitration would adversely impact its sovereignty.

The government introduced a hugely successful Vivad se Vishwas scheme in early 2020, which offered taxpayers an opportunity to settle disputed tax demands with a waiver of interest and penalty. However, this was more of a monetary settlement scheme and did not lay down any principles with respect to the merits of the matter. The scheme resulted in settling over 125,00 tax disputes with the government netting over US$13.5 billion. Almost 25 per cent of India's outstanding tax disputes have been reportedly settled under the scheme.

Investigations

Transfer pricing audits in India are part of the routine audit process. There is currently no specific concept of a standalone 'transfer pricing investigation' in India, other than the audit or assessment process, as discussed in Section III.

The tax authorities, however, have broad powers for assessment (e.g., reopening of past-year assessments and investigations), under the following provisions of the ITA:

  1. Section 143 – for regular audit or assessment;
  2. Section 144 – best-judgement assessment, where a taxpayer does not file a tax return or fails to comply with requests from the tax authorities;
  3. Section 147 – reassessment of income escaping assessment, where the tax authorities have reason to believe income chargeable to tax has escaped assessment; and
  4. Section 153A – assessment or reassessment in situations of search and seizure, where the tax authorities have reason to believe that the taxpayer's accounts do not reflect the true picture or the taxpayer has failed to produce the accounts.

In the course of an assessment, audit or reassessment, the TPO is empowered to carry out an adjustment if the TPO forms an opinion that:

  1. the price charged in an international transaction is not at arm's length;
  2. any information and documentation relating to an international transaction has not been maintained by the taxpayer;
  3. the information or data used in computation of the arm's-length price is not reliable or correct; or
  4. the taxpayer has failed to furnish requested information or documentation within the specified time.

The time limit for opening an investigation was six months from the end of the year in which the return was due – from 1 April 2021; this has been reduced to three months. Returns are usually due in the year immediately following the financial year; for example, returns for the financial year ending 31 March 2020 would be due in the financial year ending 31 March 2021. The time limit for issue of notice was six months, which would have been 30 September 2021. The Finance Act 2021 has now reduced the time limit to three months. Audits have to be completed within a period of nine months from the end of the assessment (the year in which the return is due) under the Finance Act 2021; this used to be 12 months. If the matter is referred to a TPO, the audit completion date is extended by a further 12 months.

The TPO can arrive at an arm's-length price based on information or documentation gathered over the course of assessment or audit. A show-cause notice has to be issued to the taxpayer to explain the basis of the adjustment and then (revised) benchmarking has to be performed to justify the adjustment. The order of the TPO shall be binding on the AO, who shall incorporate it in the taxpayer's main assessment and issue a draft order.

The primary onus is on the taxpayer to maintain documentation to demonstrate that the price charged in an international transaction or specified domestic transaction complies with the arm's-length price, and the method followed to ascertain the price is the most appropriate method. The taxpayer discharges this onus by maintaining the documentation and thereafter the onus shifts to the tax authorities. In the event that the tax authorities disagree with the taxpayer's view and seek additional explanation, the burden of proof again shifts (to the taxpayer) to prove why the method applied by the taxpayer is correct.

After categorically stating reasons for such rejection, the TPO is required to compute the arm's-length price by undertaking a fresh benchmarking analysis. The powers of the TPO have been widened to cover even the transactions not disclosed in the accountant's report. The Bombay High Court10 has held that where no such benchmarking exercise was undertaken to determine the value of intra-group services, such approach was not in accordance with the spirit of the law.

Litigation

Once the TPO proposes an adjustment, it directs the AO to issue a draft assessment within the time limit described above. It is mandatory for the AO to issue a draft assessment before issuing the final order, and at that point the taxpayer has the following options:

  1. accept the draft assessment and adjustment proposed;
  2. file an objection before the dispute resolution panel (DRP) by communicating its decision to the AO within 30 days of the draft assessment; or
  3. not file an objection, and instead allow the TPO or AO to convert the draft assessment into a final order and, if so advised, thereafter file an appeal before the Commissioner of Income Tax (Appeals) (i.e., the Appeals Commissioner) within 30 days of the final order.

The DRP as an alternative dispute resolution mechanism was introduced in law by the Finance Act 2009 to expedite resolution of disputes in transfer pricing. Once the taxpayer chooses to opt for the DRP process, no tax demand can be raised, given that the assessment is in a draft form at that stage. The salient features of the DRP mechanism are as follows:

  1. the DRP objections have to be filed within 30 days of the date of the draft assessment;
  2. the DRP, comprising three commissioners, must decide the taxpayer's objections within nine months of the date of reference by issuing written directions to the AO;
  3. these directions are binding on the AO, and it is expected that they shall be incorporated in the final order;
  4. the DRP has wide powers to examine additional evidence, inquire further into the case and, by a majority, issue directions to confirm, enhance or reduce the adjustment; and
  5. the DRP cannot, however, compromise or settle a dispute and its powers to adjudicate are limited.

In 2016, the law was amended whereby the Revenue was barred from filing an appeal against the DRP directions. Alternatively, if the taxpayer does not communicate its decision to refer the draft assessment to the DRP within 30 days, the AO shall finalise the assessment without modification of the draft. In summary, the tax demand is finalised only upon the AO's passing of the final order, which is appealable to the Appeals Commissioner (if the taxpayer does not file an objection) and to the Income Tax Appellate Tribunal (ITAT), if it is passed pursuant to the DRP directions.

The taxpayer has the right to appeal to the ITAT within 60 days of the final order pursuant to DRP directions or the order of the Appeals Commissioner. As the ultimate fact-finding authority, the ITAT examines the dispute afresh and adjudicates on most transfer pricing disputes. It has broad powers to decide questions of law or facts, including setting aside an assessment or restoring the order of the TPO or AO for fresh examination, and including admitting additional evidence.

Select ITAT orders travel to the jurisdictional High Court and from there to the Supreme Court. The High Court has to be satisfied that a 'substantial question of law' arises from the ITAT order before admitting an appeal.

Landmark cases

There have been a number of judicial opinions wherein transfer pricing disputes have been examined and crucial legal principles have evolved.

The Bombay High Court in the Vodafone and Shell cases:11 Indian subsidiary entity of Vodafone and Shell issued shares to its foreign associated enterprise. The TPO formed an opinion that the shares were issued at an undervalued price. Hence, they treated the shortfall in the premium on the issue of shares as 'income chargeable to tax' in the hands of the Indian entity, and made a transfer pricing adjustment. The TPO held the shortfall in the premium to be a loan given by the Indian subsidiary to its foreign associated enterprise. Hence, notional interest on arm's-length pricing of the deemed loan was charged as interest income by way of a secondary adjustment.

The issue before the court (under a writ jurisdiction) was whether the alleged shortfall in share valuation constituted income in the hands of the Indian entity, and was hence chargeable to tax.

The High Court held that transfer pricing provisions allow for recalculation of the arm's-length price to determine the real value of the transaction, but not recharacterisation of the transaction. Hence, there was no question of the transaction resulting in income and there could be no transfer pricing adjustment.

In SG Asia Holdings (India) Pvt Ltd 12 the Supreme Court has held that the ITAT was right in observing that by not making reference to the TPO, the AO had breached the mandatory instructions issued by the CBDT. However, the Supreme Court allowed the Revenue's plea for making a fresh transfer pricing audit.

High-pitched transfer pricing adjustments on intra-group services payments to AEs: The Mumbai ITAT in the landmark decision in the case of CLSA has held that ad hoc TP adjustments without following the due process of law should be deleted and no second opportunity should be given to the TPO,13 though a contrary decision has been taken by the Bangalore ITAT. There are other decisions where the ITAT has restored the case back to the tax officer, only for the limited purpose of verification of margins.14

The Revenue has been appealing against such decisions of the ITAT to the High Court. In 2018, the Karnataka High Court delivered a judgment in the case of Softbrands India Pvt Ltd,15 holding that adjustments based on the comparables cannot be challenged in the High Court unless the findings are ex-facie perverse and exhibit total non-application of mind. Subsequently, over 500 appeals were decided following this judgment, the correctness of which is currently being heard by the Supreme Court.

In another case,16 the High Court, while rejecting the appeal of the Revenue, concluded that 'a party is not barred in law from withdrawing from its list of comparables, a company, if the same is found to have been included on account of mistake as on facts, it is not comparable. The Transfer Pricing Mechanism requires comparability analysis to be done between like companies and controlled and uncontrolled transactions'.

In the Mitsui case,17 the ITAT upheld the taxpayer's international transactions using TNMM as the most appropriate method and use of the Berry ratio as the profit level indicator (PLI). The Revenue's appeal was rejected by the High Court on the grounds that no substantial question of law arose, though the Revenue has appealed to the Supreme Court, which is currently pending.

In another case,18 the ITAT has held that a Foreign AE can be taken as the tested party if it has a simpler FAR profile for analysing international transactions.

It is also held19 that the choice of method available to a taxpayer is not an unfettered choice. The CUP method, if found appropriate in a given situation for determination of arm's-length price, should be preferred over the other methods.

There is also a precedent,20 whereby the adjustment to a taxpayer's arm's-length price on account of 'location saving' without carrying out a comparability analysis with an uncontrolled transaction to show that location factor materially affected price and profit margin, was rejected.

Secondary adjustment and penalties

To align with the BEPS, India has amended the ITA to provide for secondary adjustments. India's secondary adjustment law came into effect on 1 April 2017. For APAs concluded before the law's effective date, the secondary adjustment law does not apply. Secondary transfer pricing adjustments are applicable for primary adjustments if made in one of the following situations:

  1. a voluntary adjustment by the taxpayer;
  2. an adjustment made by the TPO and accepted by the taxpayer;
  3. an adjustment determined by an APA;
  4. an adjustment determined pursuant to the safe-harbour rules; and
  5. an adjustment resulting from a MAP.

If the sums arising as a consequence of a primary adjustment are not repatriated to India within the prescribed period, the amount would be deemed an advance by the Indian associated enterprise and imputed interest would be payable on the advance, according to the arm's-length price standard.

A secondary adjustment has to be applied where the primary adjustment is above 10 million rupees and it relates to a primary adjustment for the fiscal years 2015 to 2016 onwards. The adjustment shall also apply in situations where the taxpayer is seeking rollback under the APA process. In 2019, the law was amended to prescribe a tax payment of 18 per cent of the adjustment amount plus surcharge and cess in lieu of the requirement to repatriate the quantum of a secondary adjustment.

With effect from 1 April 2018, it has been provided that the excess money may be repatriated from any of the associated enterprises of the assessee who is not a resident in India.

Finance Act 2019 inserted clause (2A) to Section 92CE applicable from 1 September 2019. Accordingly, an alternative has been provided to taxpayers to pay a final and one-time tax at 18 per cent (plus surcharge) on the unrepatriated amount to be treated as final payment of money, in respect of such excess money not repatriated. However, no credit shall be allowed in respect of the amount of such tax. Furthermore, no deduction shall be allowed under any other provision of the Act in respect of the amount on which the tax is paid. Where this additional one-time tax is paid, the assessee shall not be required to make secondary adjustment under Section 92CE of the Act.

India has strict penalties for non-compliance with transfer pricing provisions, which are as follows. Penalty for failure to maintain documentation – Section 271AA, which empowers the AO or the Commissioner (Appeals) to levy a penalty of 2 per cent of the 'value' of each international transaction or specified domestic transaction for the following:

  1. failure to keep and maintain documentation as required by Subsection (1) or Subsection (2) of Section 92D;
  2. failure to report transactions as required; or
  3. maintaining or furnishing inaccurate information or document.

A penalty of 500,000 rupees could also be imposed if the constituent entity of an international group fails to furnish information and documents as required by Section 286.

Penalty for failure to furnish documentation – Section 271G of the Act empowers the AO or the Commissioner (Appeals) to levy a penalty of 2 per cent of the value of each international transaction or specified domestic transaction in respect of which there has been a failure to furnish information or documentation required under Section 92D(3).

Penalty for failure to furnish form 3CEB – Section 271BA empowers the assessing officer to levy a penalty in the amount of 100,000 rupees for the failure to furnish a report from an accountant as required by Section 92E.

Penalty for under-reporting or misreporting of income: following the course on 'graded penalty' structure curated in the Union Budget 2016, Section 270A was introduced with effect from 1 April 2017, segregating penalties into two.

i Under-reporting of income

The AO, Commissioner (Appeals), Principal Commissioner or the Commissioner have been empowered to levy a penalty of 50 per cent of the amount of tax payable on under-reported income. In terms of transfer pricing, under-reporting of income could mean the following cases:

  1. where the income assessed is greater than income determined as per Section 143(1)(a);
  2. where the income assessed is greater than maximum amount not chargeable to tax, where no return of income is filed;
  3. where the income reassessed is greater than income assessed or reassessed immediately before such reassessment; and
  4. where the income assessed or reassessed has the effect of reducing the loss or converting such loss into income.

Such under-reported income shall not, however, include the amount represented by any addition made in conformity with the arm's-length price determined by the Transfer Pricing Officer if the taxpayer:

  1. maintained information and documents as prescribed under Section 92D; or
  2. declared the international transaction under Chapter X including a disclosure of all the material facts relating to the transaction.

While the Act safeguards the taxpayer against the penalty of under-reporting through disclosure of all 'material information', the meaning of the term is very subjective. The term may carry different meanings for different stakeholders; hence, it is imperative for the taxpayer to demonstrate that the position taken by it is purely bona fide.

ii Misreporting of income

Section 270A(8) empowers a levy of penalty of 200 per cent of the amount of tax payable on misreported income in the following cases:

  1. misrepresentation or suppression of facts; and
  2. failure to report any international transaction or deemed international transaction or specified domestic transaction to which provisions of Chapter X shall apply.

Initially, Section 270A seems to be very stringent with heavy penalties, more so because of the absence of the 'reasonable cause' clause. However, the Finance Act 2017 introduced Section 270AA to provide immunity from the imposition of penalty under Section 270A on:

  1. payment of tax and interest within the specified time; and
  2. non-filing of any appeal against the order of assessment or reassessment.

Notably, the immunity under Section 270AA is granted only in respect of under-reporting of income and not in the case of misreporting. However, CBDT circular dated 16 August 2018 clarified that the tax authority shall not take an adverse view in respect of penalty proceeding under Section 271(1)(c) from earlier assessment years merely because the taxpayer has applied for immunity under Section 270AA.

Penalty for furnishing incorrect information in reports and certificates, the Finance Act 2017, has introduced a penalty for accountants, merchant bankers and registered valuers who furnish incorrect information in reports and certificates issued under any provisions of the Act, by inserting Section 271J to the Act. To ensure that the person furnishing a report or certificate undertakes due diligence before making such certification, Section 271J provides that if an accountant, merchant banker or registered valuer furnishes incorrect information in a report or certificate under any provisions of the Act, the Assessing Officer or the Commissioner (Appeals) may direct him to pay a sum of 10,000 rupees for each such report or certificate by way of penalty.

Broader taxation issues

i Diverted profits tax, digital sales taxes and other supplementary measures

In 2016, India introduced a digital tax, known as 'equalisation levy', to provide for a charge of 6 per cent in the form of tax from amounts paid to a non-resident not having any permanent establishment in India, for specified services, which include business-to-business services such as online advertising and provisions for digital advertising space. The scope of the equalisation levy was substantially expanded in 2020 to cover potentially all kinds of digital transactions of sale of goods or provision of services supplied to Indian residents, and includes non-residents using an Indian internet protocol (IP) address. It imposes a 2 per cent levy on the gross considerations received or receivable by non-resident e-commerce operators from providing or facilitating e-commerce supply of services. It specifically covers transactions between non-residents and e-commerce operators where advertisements are targeted at Indian residents or customers using an Indian IP address; and sale of data collected from Indian residents or customers using an Indian IP address. Equalisation Levy 2020 must be paid by the e-commerce operator, unlike Equalisation Levy 2016.

In 2018, India introduced the concept of the 'significant economic presence' test to tax non-residents on profits generated through non-PE as per traditional rules under applicable double-tax treaties, although its implementation has been deferred to the assessment year 2022–2023 following treaty amendments resulting from the OECD BEPS multilateral process. Furthermore, the Finance Act 2020 inserted new Explanation 3A to Subsection 9 of the ITA. While Explanation 3 specifically states that only the income attributable to the business connection shall be deemed to accrue and arise in India, the new Explanation 3A categorically lists certain income that will be attributable to operations carried out in India. This list includes income from:

  1. such advertisement that targets a customer who resides in India or a customer who accesses the advertisement through an internet protocol address located in India;
  2. sale of data collected from a person who resides in India or from a person who uses an internet protocol address located in India; and
  3. sale of goods or services using data collected from a person who resides in India or from a person who uses an internet protocol address located in India.

ii Double taxation

CBDT has clarified that MAP and bilateral APA applications can be applied by any taxpayer operating in India (regardless of residence) with which India has a double-taxation avoidance agreement even though the agreement does not contain provisions for corresponding adjustment in matters of transfer pricing.

iii Consequential impact for other taxes

Indirect tax implications with regard to transfer pricing adjustments are independent of the ITA and are governed by distinct laws.

Under the Goods and Service Tax (GST) laws, which apply to all supplies of goods and services in India (including imports), the transaction value between the parties is the primary basis of valuation of supplies for the purposes of determining the GST liability. In the case of a related-party transaction, however, the transaction value is not accepted. Consequently, a related-party transaction must be benchmarked based on the stipulated rules, among which is the open market value (OMV) of identical goods or services supplied to an unrelated party. If such OMV is not available, then the taxable value is to be ascertained based on the value of similar supplies, the cost construction method or the resale price of goods to independent parties, in that order.

Indian customs law, which provides for levy of import and export duties on goods imported into and exported from India, is based on the World Trade Organisation's Customs Valuation Agreement in so far as determining taxable value for customs duties purposes is concerned. In case of any related-party transaction, the declared import price is not accepted unless it is established that the relationship between the buyer and the seller has not 'influenced the price' of the imported goods. Upon failure to establish this, the transaction value is rejected, and the valuation of the imports is referred, administratively, to the Special Valuation Branch (SVB) of Customs. The SVB sequentially applies valuation rules prescribed under Customs Valuation Rules to determine the arm's-length transaction value. As per the Customs Valuation Rules, this value is determined based on import value of identical goods or similar goods (with necessary adjustments), the deductive value method or computed value method, and thereafter the residual method.

Outlook and conclusions

As an active member of the G20, India has signed the multilateral instrument, is a key contributor to the OECD's BEPS initiative and has actively pursued changes in its domestic law policy.

India has undertaken the following changes in pursuance to BEPS APs:

  1. introduction of Section 94B under the Income-tax Act 1961 and the Finance Act 2017 to limit the deduction of interest expenditure in line with BEPS AP 4, 'Limiting Base Erosion involving Interest Deduction and Other Financial Payments';
  2. introduction of Patent Box Regime (Section 115BBF), the Finance Act 2016 in line with BEPS AP 5;21
  3. amendment to Section 90 vide the Finance Act 2020, which empowers the central government to enter into agreement for the avoidance of double taxation of income under the ITA and under the corresponding law in force in that country or specified territory, as the case may be, 'without creating opportunities for non-taxation or reduced taxation through tax evasion or avoidance (including through treaty-shopping arrangements aimed at obtaining reliefs provided in the said agreement for the indirect benefit to residents of any other country or territory Introduction of General Anti-Avoidance'. The amendment is in line with the preamble under BEPS AP 6;
  4. amendment to the definition of agency business connection under Section 9,22 the Finance Act 2018 in line with recommendation of BEPS AP 7 for commissionaire arrangements;
  5. introduction of country-by-country reporting and master file (Section 286), the Finance Act 2016 in line with the BEPS AP 13. The reporting requirements shall be applicable only if the consolidated revenues of the taxpayer group based on consolidated financial statements exceed 6,400 million rupees for the preceding accounting year;
  6. in terms of BEPS AP 12, in terms of reporting requirements, Clause 30C was inserted in the tax audit report23 requiring the tax auditor to report whether the specified taxpayer has entered into an impermissible avoidance arrangement and details regarding the nature of such arrangement and the amount of tax benefit in the tax year arising, in aggregate, to all the parties to the arrangement, among others. However, this reporting requirement was deferred until 31 March 2021;24
  7. no specific amendments in the Income-tax Act have been made in respect of BEPS APs 8–10;
  8. MAP guidance was issued on August 2020 containing detailed information regarding MAP processes for the benefit of taxpayers, tax authorities, the CAs of India and the respective foreign jurisdictions in light of the peer review report of India, which concluded that India met half of the elements of the BEPS AP 14 (minimum standard) on an overall basis.25 Furthermore, rules relating to MAP were amended vide Notification No. 23/2020 on 6 May 2020;26
  9. enactment of equalisation levy, the Finance Act 2016, which covers online advertising services (including provision and any other facility related to such services). The ambit of the equalisation levy was widened by the Finance Act 2020 to cover consideration received by non-resident e-commerce operators from e-commerce supply or services; and
  10. introduction of the significant economic presence (SEP) concept, which covers transactions of sale or purchase of goods, services or property through digital means and transactions involving download of data or software in India. Vide notification dated 3 May 2021, the CNDT has notied a threshold of 300,000 users and revenue of 20 million rupees.

India has expressed views supporting a consensus-based solution for profit allocation for PEs. A CBDT committee has proposed a fractional apportionment methodology that adopts the entire profit for allocation, as compared with the residual profit approach adopted under the formulary apportionment methodology proposed by the OECD under the Unified Approach.

India has also taken various steps to target anti-avoidance. It introduced General Anti-Avoidance Rule (GAAR) provisions effective from 1 April 2017, which are broad-based and counter any 'impermissible avoidance arrangement'. India has also concluded revised tax treaties with Mauritius, Singapore and Cyprus, with the 'limitation of benefits' clause to address the potential of abuse of these treaties. Simultaneously, India has ratified the Multilateral Instrument (MLI) and aligned the ITA to incorporate the 'principal purpose' test and other elements of the MLI in its tax treaties that are part of its 'covered agreements'. India is also presently seeking to overhaul the ITA. The Government is reviewing an expert committee report on the Direct Tax Code, submitted by the committee in September 2019. The report has not been made public, and it is yet to be seen when it will be translated into law.

Impact of covid-19 pandemic

Businesses will have to factor in disruption due to covid-19 and realign transfer pricing policies. Inter-company agreements that impact pricing policies will need to be amended. For limited risk distributors, contract manufacturers and contract R&D service providers, taxpayers will assess the profit margin impact. There is no administrative guidance available in relation thereto; however, taxpayers can renegotiate the terms of their APA.

Footnotes

1 Mukesh Butani and Seema Kejriwal are partners at BMR Legal Advocates.

2 The definition of Specified Domestic Transactions was inserted in the ITA by the Finance Act 2012, wherein certain transactions between domestic companies were considered as specified domestic transactions subject to conditions. The aggregate of such transactions entered into by the taxpayer should exceed the threshold limit of 200 million rupees from assessment year 2016–17.

3 The unspecified methodology was introduced as from the financial year 2011–2012.

4 Instruction No. 2 of 2018.

5 The expression 'intangible property' shall include: (1) marketing-related intangible assets, such as trademarks, trade names, brand names and logos; (2) technology-related intangible assets, such as process patents, patent applications, technical documentation including laboratory notebooks and technical know-how; (3) artistic-related intangible assets, such as literary works and copyrights, musical compositions, copyrights, maps and engravings; (4) data processing-related intangible assets, such as proprietary computer software, software copyrights, automated databases, and integrated circuit masks and masters; (5) engineering-related intangible assets, such as industrial design, product patents, trade secrets, engineering drawing and schema-tics, blueprints, proprietary documentation; (6) customer-related intangible assets, such as customer lists, customer contracts, customer relationship and open purchase orders; (7) contract-related intangible assets, such as favourable supplier, contracts, licence agreements, franchise agreements and non-compete agreements; (8) human capital-related intangible assets, such as trained and organised work force, employment agreements and union contracts; (9) location-related intangible assets, such as leasehold interest, mineral exploitation rights, easements, air rights and water rights; (10) goodwill-related intangible assets, such as institutional goodwill, professional practice goodwill, personal goodwill of professional, celebrity goodwill and general business going concern value; (11) methods, programmes, systems, procedures, campaigns, surveys, studies, forecasts, estimates, customer lists or technical data; and (12) any other similar item that derives its value from its intellectual content rather than its physical attributes.

6 Known as DEMPE functions.

9 [2015] 374 ITR 118 (Delhi), [2016] 381 ITR 117 (Del).

10 CIT v. Merck Ltd [2016] 389 ITR 70; CIT v. Lever India Exports Ltd [2017] 78 taxmann.com 88 (Bombay); CIT v. Johnson & Johnson Ltd [2017] 80 taxmann.com 337 (Bombay); CIT v. Kodak India Pvt Ltd [2017] 79 taxmann.com 362 (Bombay).

11 Vodafone [2014] 368 ITR 1 (Bombay); Shell [2015] 64 taxmann.com 262 (Bombay).

12 TS-775-SC-2019-TP.

13 CLSA India Pvt Ltd v. DCIT Circle 4(1)(1), Mumbai [2019] 101 taxmann.com 388 (Mumbai – Trib).

14 CWT India Pvt Ltd [2019] 109 taxmann.com 182 (Mumbai – Trib).

15 TS-475-HC-2018(KAR)-TP.

16 Tata Power Solar Systems Ltd [2019] 77 taxmann.com 326 and Lionbridge Technologies Pvt Ltd [TS-176-HC-2019(BOM)-TP].

17 Mitsui and India Pvt Ltd [TS-602-SC-2017-TP].

18 General Motors India Pvt Limited [2013] 37 taxmann.com 403 (Ahmedabad – Trib).

19 Serdia Pharmaceuticals (India) Pvt Ltd [2011] 9 taxmann.com 13 (Mumbai).

20 Syngenta India Ltd [2017] 77 taxmann.com 220 (Mumbai).

21 The BEPS AP 5 recommended that, in the context of preferential tax regime, the taxpayer should fulfil the nexus test. In terms of intellectual property (IP), AP suggested that to avail of preferential regime, the taxpayer should incur qualifying research and development (R&D) expenditures giving rise to the IP income. The nexus approach uses expenditure as a proxy for activity and builds on the principle that, because IP regimes are designed to encourage R&D activities and to foster growth and employment, a substantial activity requirement should ensure that taxpayers benefiting from these regimes do in fact engage in such activities and do incur actual expenditures on such activities.

22 Section 9(1) (i) Explanation 2(a) of the Income-tax Act 1961 covers:

'(a) has and habitually exercises in India, an authority to conclude contracts on behalf of the non-resident or habitually concludes contracts or habitually plays the principal role leading to conclusion of contracts by that non-resident and the contracts are as follows: (1) in the name of the non-resident; or (2) for the transfer of the ownership of, or for the granting of the right to use, property owned by that non-resident or that non-resident has the right to use; or (3) for the provision of services by the non-resident;…'

23 Notification No. 33/2018 dated 20 July 2018.

24 CBDT Circular No. 10/2020 dated 24 April 2020. Initially the reporting obligations were deferred until 31 March 2019, Circular No. 6/2018 dated 17 August 2018, and further until 31 March 2020, Circular No. 9/2019 dated 14 May 2019.

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