When independent enterprises deal with each other, the conditions of their commercial and financial relations (e.g. the price of goods transferred or services provided and the conditions of the transfer or provision) ordinarily are determined by market forces. When related enterprise deal with each other, their commercial and financial relations may not be directly affected by external market forces in the same way, although associate enterprises often seek to replicate the dynamics of market forces in dealings with each other. This is because; the primary motive in the dealings between the associated enterprises is driven by the group’s objective rather than the objective of an individual enterprise.

The consideration flow of related enterprise transactions may lead to erosion of tax base even though their transfer pricing policies may not be necessarily with that intention. When transfer pricing does not reflect market forces, the tax revenues of either or both of the tax jurisdictions could be distorted. Therefore, for tax purposes, tax authorities may adjust the profits of the associate enterprises to correct such distortions and ensure that the country gets its fair share of taxes.

However, there is an unfair assumption by the tax authorities that the transaction between the associated enterprises is never at arm’s length. This often leads to hardship on the company in the form of additional burden to prove vice versa.

Finance Act, 2001 introduced detailed provisions relating to transfer pricing, requiring all ‘international transactions’ between ‘associated enterprises’ to be at arm’s length. These provisions are applicable to the transactions with effect from 1st April, 2001. The law with respect to transfer pricing in India is to a great extent in lines with that prescribed by the Organization for Economic Cooperation and Development (‘OECD’). India is not a member nation of OECD (it now has an "Observer Status"); however, there has been an increasing and greater reliance being placed by the tax authorities in India on the OECD Model.

Any income/expense arising from an international transaction with an associated enterprise must be computed having regard to the arm’s length price. Also, costs or expenses allocated or apportioned between two or more associated enterprises based on mutual agreement or arrangement, should be determined having regard to arm’s length prices. The transfer pricing provisions are wide enough to cover transactions between a foreign entity and its permanent establishment in India. The transfer pricing provisions would not however apply in cases wherein the application of the arm’s length price results in a downward revision in the income chargeable to tax in India or results in an increase in the loss.

Ideally, the transfer pricing provision should apply in cases where there is a base erosion of taxes in any jurisdiction and accordingly, the same should be factored by the tax authorities before making any adjustment to the transfer price. Since transfer price for any transaction depends upon the commercial reality, the tax laws should consider the same and accordingly, the concept of base erosion should take into account the commercial need of the transaction vis-à-vis tax advantage.

• The term covers a wide range of revenue and capital transactions between two or more associated enterprises where either or both are non-residents;

• The term also includes arrangements between associated enterprises for cost sharing in connection with benefits, services or facilities provided to any of such enterprises.

Additionally, under certain circumstances transactions between two unrelated entities can be deemed to be an international transaction. This is when an enterprise, say X Ltd., has entered into a transaction with an unrelated person, say A Inc. and there exists a prior agreement in relation to this transaction between A Inc. and Y Inc. (an associated enterprise of X Ltd.); or the terms of this transaction (i.e., the transaction between X Ltd. and A Inc.) are determined in substance between A Inc. and Y Inc. The important point to be considered is that there is a deeming fiction under the Act for considering two unrelated parties to be associated enterprise; however, the basic condition of either or both of the associated enterprise should be a non-resident should be satisfied for transfer pricing provisions to apply to the said deemed associated enterprise. Accordingly, in the example cited above, either or both transacting entities should be a non-resident.

The term ‘Associated Enterprise’ is defined in a broad manner based on the criteria of direct or indirect participation in the management, control or capital of the other enterprise or by the same persons in such enterprise. The regulation gives illustrative list of relationships to which transfer pricing rules apply: equity holding of 26%; control of board of directors; loans/guarantees; dependence on the use of specified intangibles of the other enterprise; influence over supply of raw material/finished products etc. However, mere participation in management, control or capital shall not make two entities associated enterprises, unless the specified illustrative criteria are fulfilled. Accordingly, in all given circumstances, in addition to the basic condition of having direct or indirect control, the illustrative tests as specified should also be satisfied for two enterprises to be termed as associated enterprise.

In addition to above, from 1 June 2011, transfer pricing provisions will apply to transactions with parties located in notified jurisdictional areas. The benefit of variation between actual and arm’s length price will not apply to such transactions.

The arm’s length price in relation to an international transaction is to be determined using the most appropriate method out of the specified methods as prescribed by the Board in Rule 10B, having regard to the nature or class of transaction or class of associated persons or functions performed by such persons or such other relevant factors as may be prescribed. The five specified methods are:

• Comparable Uncontrolled Price Method (‘CUP’);

• Resale Price Method (‘RPM’);

• Cost Plus Method (‘CPM’);

• Profit Split Method (‘PSM’); and

• Transactional Net Margin Method (‘TNMM’)

Though the provisions allow for use of any other method as the Central Board of Direct Taxes may prescribe, no other method has been prescribed till date. The OECD makes a distinction between the methods by grouping them under the ‘traditional method’ and ‘profit method’; however the regulations in India refer to the ‘most appropriate method’ and has no preference of one method over the other.

It is pertinent to note that the regulations prescribe that the data used in comparing the uncontrolled transaction with the international transaction should relate to the same financial year in which the international transaction was entered into. However, if the previous years’ data reveals facts that could have an influence on the determination of transfer prices in relation to the international transactions being compared, then, data relating to a period of up to two years prior to the financial year in which the international transaction is carried out could be considered.

It should however be noted at this juncture, that the Indian tax authorities prefer the latest year data vis-à-vis multiple year data.

The provisions specify that where more than one price is determined by the most appropriate method, the arm’s length price shall be the arithmetical mean of such prices.

Currently, if the variation between the arm’s length and the actual price of the transaction is within a range of 5%, then a transfer pricing adjustment to the price is not made. However, the Finance Act, 2011 provides that instead of 5%, the allowable variation will be such percentage as may be notified by the Central Government.

Technically, there is a debate whether the benefit of +/- five per cent should apply to a situation where there is only a single comparable. This is based on the argument that there can be arithmetical mean only in cases where there is more than one comparable. However, this may not be the correct view since the arithmetical mean of a single number is the number itself. Further, this view is also supported by the jurisprudence laid down in various decisions which states that the beneficial provisions should read in manner that gives maximum benefit to the assessee.

The concept of Arithmetic Mean in the Indian Regulations is a unique feature not commonly found in similar legislations of other countries, which generally place reliance on the ‘inter-quartile range’ concept.

The Assessing Officer, if he considers necessary, may refer the computation of the arm’s length price in relation to any international transaction to the Transfer Pricing Officer, with the previous approval of the Commissioner. However, the Assessing Officer is bound to refer all cases involving the determination of Arm’s Length Price to the Transfer Pricing Officer, where the aggregate value of the International transactions with Associated Enterprise exceeds Rs. 15 crores.

Currently the TPO can determine the arm’s length price of an international transaction, only if such transaction is referred by the AO. The Finance Act 2011 provides that effective 1 June 2011; the jurisdiction of the TPO shall extend to the determination of arm’s length price of any international transaction that comes to his notice in the course of proceedings. Further the TPO is also granted additional powers of survey, so as to conduct on-the-spot enquiry and verification.

The Transfer Pricing Officer shall determine the arm’s length price and send a copy of his written order to the Assessing Officer and to the tax-payer. Wherever the Assessing Officer propose to make any variation in the income or loss returned of the assessee as a consequence of the above order of the Transfer Pricing officer, the assessing officer shall forward the draft order to assessee for his/her objections (if any).

On receipt of draft order the assessee shall communicate either his acceptance or file objections against such order with Dispute Resolution Panel (DRP) within 30 days. The DRP being a collegium of three Commissioner of income tax shall issue binding directions to assessing officer after due consideration of objections and evidences filed by assessee. The assessing officer shall pass appropriate order in conformity with the directions of DRP within nine months from the end of the month in which the draft order is forwarded to the assessee. The Income Tax Department cannot appeal against such order, however the assessee has the option to appeal against such order before Income Tax Appellate Authorities.

If, in the course of assessment proceedings, the Assessing Officer, on the basis of material or information or document in his possession, is of the opinion that:—

• the price charged or paid in an international transaction has not been determined based on the methods prescribed and the arithmetic mean as discussed aforesaid; or

• any information or document relating to an international transaction has not been maintained as prescribed; or

• the information or data used in computation of the arm’s length price is not reliable or correct; or

• the tax-payer has failed to furnish any information or document within the specified time as required,

he may determine the arm’s length price in accordance with the methods prescribed and on the basis of such material or information or document available with him, compute the tax-payer’s income accordingly. Where the Assessing Officer determines an arm’s length price, and computes the total income of the tax-payer having regard to the arm’s length price so determined, no tax benefits under section 10A, 10AA or 10B or under Chapter VI-A of the Act will be allowed in respect of the amount of income by which the total income of the tax-payer is enhanced after such computation by the Assessing Officer.

The determination of arm’s length price shall be subject to safe harbour rules. The Central Board of Direct Tax is empowered to formulate safe harbour rules specifying the circumstances for acceptance of transfer price of the taxpayer.

In cases where the total income of a tax-payer is re-computed after determination of the arm’s length price paid to another associated enterprise from which tax has been deducted or was deductible at source, the income of the other associated enterprise shall not be recomputed by reason of such re-determination of arm’s length price in the case of the tax-payer.

Statute of limitation for transfer pricing adjustments is forty five months from tax year end. This is in contrast to normal assessments wherein the statute of limitation is thirty three months. The need for additional period was felt as transfer pricing is an intensive fact finding exercise that requires additional time and resources. Further, the time limit of forty five months will be further extended where the assessee raises objection on the draft order with the Dispute Resolution Panel.

Finance (No. 2) Act 2009 had introduced section 144C in respect of the provisions relating to Alternate Dispute Resolution Mechanism (‘ADRM’). The purpose of ADRM is to expedite resolution of disputes on a fast track basis.  The dispute resolution mechanism is applicable for taxpayers subject to transfer pricing adjustment and to foreign companies.  The entire process of ADRM would be handled by a dispute resolution panel (‘DRP’) comprising of three commissioners of income tax constituted by the Central Board of Direct Tax (‘CBDT’) and having powers as vested in a civil court.  The DRP may confirm, reduce or enhance the adjustment as proposed by the AO.

Every person who has entered into an international transaction with an associated enterprise would be required to keep and maintain the prescribed information and documentation. Such information and documentation need not be maintained in cases where the aggregate book value of international transactions entered into by the tax-payer does not exceed Rs. One Crore. However, in such cases, the tax-payer would need to substantiate, on the basis of material available with him, that income arising from international transactions entered into by him has been computed in accordance with the arm’s length principle.

It is prescribed that in cases wherein an international transaction continues to have effect over more than one financial year, fresh documentation need not be maintained separately in respect of each financial year, unless there is any significant change in the nature or terms of the international transaction, in the assumptions made, or in any other factor which could influence the transfer price. In case there is a significant change, fresh documentation shall be maintained bringing out the impact of the change on the pricing of the international transaction.

However, there have been cases under Indian transfer pricing regulations that although transfer price for an international transaction have been accepted in one tax year, the same has been rejected by the transfer pricing officer in the next year without there being any change in the commercials of the transaction. Accordingly, an assessee is forced to test its transfer price on a year on year basis.

Though the regulations recommend contemporaneous maintenance of documentation, it is also prescribed that the documentation should be maintained latest by 30th November following the financial year in case of companies; 30th September for persons (other than corporates) whose accounts are required to be audited under Income-tax Act (Tax Audit) or any other Act and 31st July following the financial year in other cases.

The specified information and documents are required to be maintained for a period of eight years from the end of the relevant assessment year.

It is prescribed that every person who has entered into an international transaction shall obtain a report from an independent practising Chartered Accountant. This Report (Form No. 3CEB) should be furnished to the Income Tax department before the due date of filing the return as per Explanation 2 u/s. 139(1). The filing date for corporate assesse is extended to 30th November in view of practical difficulties of accessing contemporaneous comparable data that is required to file such a transfer pricing report.

The Accountant Report gives particulars of associate enterprises, international transactions, arm’s length price and the method used for determining arm’s length price.

Finance (No. 2) Act, 2009 had introduced a new section i.e. Section 92CB which empowers the Central Board of Direct Taxes (‘CBDT’) to formulate safe harbour rules to alleviate the uncertainty faced by taxpayers and at the same time ensuring a reasonable level of taxable profit to the exchequer. Such rules are to be formulated by the CBDT in due course. A safe harbour has been defined to mean circumstances in which the tax authorities in India will accept the transfer price declared by the tax payer to be at arm’s length. Till date, no formal rules have been prescribed.

The provisions have prescribed levy of penalties for non-compliance with the statutory requirements, as follows:

• Failure to maintain prescribed documentation could attract penalty at the rate of 2% of the value of each international transaction in respect of every such failure.

• Failure to furnish documentation required by the tax authorities could lead to a penalty at the rate of 2% of the value of each international transaction in respect of every such failure.

• Failure to furnish the prescribed report of the accountant can attract penalty of one hundred thousand rupees.

In the above cases if the tax-payer can prove to the satisfaction of the tax authorities that he had reasonable cause for not complying with the relevant statutory requirements, no penalty can be levied.

If tax authorities make an adjustment to the income of the tax-payer by re-determining the transfer pricing for an international transaction entered into by the tax-payer with its associated enterprise, such adjustment to the income would be added to the taxable profits of the enterprise. Moreover, such transfer pricing adjustment made by the tax authorities, may, be subjected to a penalty ranging from 100% to 300% of tax payable on the additional income or the disallowance made by the officer. However, penalty would be mitigated if the tax-payer can prove to the satisfaction of the tax authorities, that the price charged or paid in such transaction was computed in accordance with the transfer pricing provisions in good faith and with due diligence.

Flow Chart of Transfer Pricing Regulation