1. Introduction

Finance Act, 2001 with effect from 1st April, 2002; i.e., from assessment year 2002-03 substituted erstwhile section 92 with sections 92 to 92F in chapter X of the Income-tax Act, 1961 (‘the Act’), for the purposes of computation of any income arising from an international transaction. These provisions are more popularly known as the Transfer Pricing provisions although not referred to as such in the Act. These provisions aim at legitimate sharing of tax revenues between two tax jurisdictions.

The erstwhile section 92 authorised the Assessing Officer to determine the profits arising from a business carried on between a resident and a non-resident where it appeared to him that owing to the close connection between the resident and the non-resident the business between them was so arranged that it produced to the resident either no profits or less than the ordinary profits which might be expected to arise in that business. However, the provision was very vague and further; no methodology was provided to compute ordinary profits which might be expected to arise in that business. Therefore, the erstwhile provision was as good as inoperative.

Apart from the above, section 40A(2) of the Act dealing with disallowance of excessive or unreasonable expenditure is also a category of transfer pricing tool given to the Assessing Officer. Section 40A(2) of the Act provides for disallowance of expenditure in respect of which payment has been or is to be made to any person specified in clause (b) of the said sub-section, where the Assessing Officer is of the opinion that such expenditure incurred is excessive or unreasonable having regard to the fair market value of the goods, services or facilities for which the payment is made or the legitimate needs of the business or profession of the assessee or the benefit derived by or accruing to him therefrom. This section also applies to transactions between residents and it is not a pre-condition that for application of this section one of the parties should be a non-resident as in the case of Chapter X of the Act.

In the Budget speech for the year 2001, the Finance Minister noted that the issue of transfer pricing is a matter of serious concern on account of the presenceof multinational enterprises in India and their ability to allocate profits in different jurisdictions by controlling prices in intra-group transactions. Hence these new transfer pricing provisions comprising of sections 92 to 92F of the Act were inserted by the Finance Act, 2001. Consequently, rules 10A to 10E have also been inserted in the Income-tax Rules, 1962 (‘the Rules’).

This article would seek to discuss briefly the various provisions with respect to Transfer Pricing regulation in India.

Section 92(1) of the Act provides that any income arising from an international transaction; i.e., a transaction between two associated enterprises either or both of whom are non-resident would be computed having regards to the arm’s length price (ALP).

It is not clear whether this provision is a charging provision or a computation provision. If it is regarded as a charging provision then one view is that the charge is ineffective. Section 4 of the Act prescribes that income-tax shall be charged in respect of the total income of the previous year of every person. Total income is defined in section 2(45) of the Act to mean the total amount of income referred to in section 5, computed in the manner laid down in this Act. Section 5 brings to tax income received or deemed to be received or income accrued or arising or income deemed to accrue or arise. The transfer pricing adjustment made under the transfer pricing provisions to bring the income in line with the ALP cannot be regarded as income received or deemed to be received or income accrued or arising or deemed to accrue or arise, as generally understood. Hence, the transfer pricing adjustment cannot be subjected to tax. To this the Revenues’ argument will be that the transfer pricing provisions are not charging provisions but computation provisions. Once an assessee has an income arising from an international transaction which is chargeable to tax then the income shall be computed having regard to the ALP. Hence, the transfer pricing adjustment is not required to be specifically brought within the scope of total income. But, then, if Revenues’ argument is to be accepted transactions like Gift which are by themselves not liable to tax cannot be brought within the tax net by applying the transfer pricing provisions.

2. International transaction

Transfer pricing provisions are applicable only with respect to international transactions. Section 92B defines international transaction to mean a transaction between two or more associated enterprises where at least one of them is a nonresident. This section includes transactions in the nature of

• purchase, sale or lease of tangible or intangible property, or

• provision of services, or• lending or borrowing money, or

• any other transaction having a bearing on the profits, income, losses or assets of such enterprises, or

• mutual cost sharing agreement.

It could be seen from above that the definition is an extremely wide one to include all types of transaction entered into by the parties. However, as the phrase (international transaction) itself suggests, transfer pricing provisions would apply to only those transactions in which at least one of the parties is a non-resident. When both the parties are residents then transfer pricing provisions would not apply.

A transaction has been defined in clause (v) of section 92F to include an arrangement, understanding or action in concert, whether or not such arrangement, understanding or action is formal or in writing; or whether or not such arrangement, understanding or action is intended to be enforceable by legal proceeding. This definition is inclusive and not exhaustive. Hence any agreement which falls within the general meaning of the term ‘transaction’, may also be regarded as a transaction though not specifically covered by the said clause.

3. Associated Enterprise

Clause (iii) of section 92F of the Act defines the term “enterprise” to mean a person (including a permanent establishment of such person) who is, or is proposed to be, engaged in any of the specified activities. Clause (iiia) of the said section defines the term “permanent establishment” to include a fixed place of business through which the business of the enterprise is wholly or partly carried on. The definition of the term enterprise is exhaustive while that of the term permanent establishment is inclusive.

Section 92A(1) of the Act defines an associated enterprise in relation to another enterprise to be an enterprise which participates, directly or indirectly, or through one or more intermediaries in the management or control or capital of the other enterprise, or when a person participates, directly or indirectly, or through one or more intermediaries in the management or control or capital of both the enterprises.

Sub-section (2) of section 92A provides thirteen (13) specific instances where two enterprises would be deemed to be associated enterprises. Some instances are where one enterprise holds, directly or indirectly, shares carrying 26% of the voting power in the other enterprise, or an enterprise which holds, directly or indirectly, shares carrying 26% of the voting power in each of such enterprises, or where loan advanced by one enterprise to the other enterprise constitutes not less than 51% of the book value of the total assets of the other enterprise, etc. Twoenterprises fulfilling the criteria in any one of the thirteen illustrations would be deemed to be associated enterprise for the purpose of sub-section (1). It is evident from the above that whereas sub-section (1) provides for a general management, control and capital criteria, sub-section (2) provides for thirteen specific instances to decide the relationship of association between two enterprises. Issue which arises under this sub-section is whether the 13 instances mentioned therein are exhaustive of the situations where there can be associated enterprises or they are merely illustrative of the forms of participation in management or control or capital contemplated in sub-section (1). If one goes by the memorandum explaining the Finance Act, 2002, wherein sub-section (2) was amended, then it would appear that unless any of the criteria mentioned in subsection (2) are satisfied, two enterprises would not be regarded as associated enterprise even though they fulfil the general criteria of participation in management or control or capital. However, this proposition cannot be said to be free from doubt and another view is also possible.

Sub-section (2) of section 92B deems a ‘transaction’ between an enterprise and a non associated enterprise to be a transaction entered into between two associated enterprises if there exists a prior agreement in relation to the relevant transaction between such non associated enterprise and the associated enterprise or the terms of the relevant transaction are determined in substance between such non associate enterprise and the associated enterprise. The heading of section 92B suggests that it is dealing with “international transaction”, but sub-section (2) of the said section actually deals with the aspect of a transaction being regarded as entered into between two associated enterprises. The distinction between section 92A and section 92B(2) both of which deals with associated enterprises is that the former regards the enterprises as associated to each other if the specified conditions are fulfilled, while the latter deals with a situation where though the enterprises are non-associated enterprises a particular transaction is deemed to be a transaction between associated enterprises.

Issue which arises for consideration is, would a transaction, which is deemed to be a transaction between associated enterprise under section 92B(2), be automatically regarded as international transaction or would it have to fulfil the requirement of at least one of the parties being a non-resident? Let us consider an example, X an Indian resident company is an associated enterprise of Y a nonresident company. X enters into a transaction with Z an Indian resident and non associated enterprise. There exists a prior agreement between Y and Z in relation to the transaction between X and Z. In the above example both X and Z are nonassociated enterprises but, under section 92B(2) of the Act the transaction would be regarded as a transaction between associated enterprise. The question which would then arise is whether under the deeming provisions of sub-section (2), can the transaction be regarded as an international transaction though both X and Z are Indian residents or the said sub-section would apply only in a case where at least one of the parties to the transaction is a non-resident. Further, as per sub-section (2) of section 92A of the Act, if the condition of association is satisfied anytime during the previous year, then they would be regarded as associated enterprise. In this view of the matter, the issue which arises is whether a transaction entered into between two enterprises which were nonassociated at the time of entering into of the transaction, but, who became associated later during the year, would be covered under this chapter. Similar would be the case when the enterprises were associated at some point of time during the year, however at the time of entering into the transaction, they are no longer associated.

4. Methods of computation of ALP

Section 92(1) of the Act mandates that income arising from an international transaction shall be computed having regard to the ALP. An arm’s length price is defined in clause (ii) of section 92F of the Act to mean a price which is applied or proposed to be applied in a transaction between persons other than associated enterprises, in uncontrolled transaction. Section 92C(1) provides that the ALP has to be determined following the most appropriate method having regard to the

• nature of transaction, or

• class of transaction, or

• class of associated persons, or

• functions performed by such persons, or

• such other relevant factors as may be prescribed by the board.

Sub-rule (2) of rule 10C of the Rules further elucidates the factors which have to be taken into account for selecting the “most appropriate method” which is described in sub-rule (1) of the said rule as the method which is best suited to the facts and circumstances of each particular international transaction, and which provides the most reliable measure of an ALP in relation to an international transaction. These factors are as under:

1. The nature and class of international transaction;

2. The class or classes of associated enterprise and the functions performed by them taking into account the assets employed and risks assumed;

3. The availability, coverage and reliability of the data;

4. Degree of comparability between the international transaction and comparable uncontrolled transaction and the extent to which reliable and accurate adjustment can be made for differences, if any, between the two; and5. The nature, extent and reliability of the assumptions required to be made in application of the methods.

The various methods for determination of ALP as prescribed under section 92C(1) of the Act are as follows:

(a) comparable uncontrolled price method;

(b) resale price method;

(c) cost plus method;

(d) profit split method;

(e) transactional net margin method;

(f) such other method as may be prescribed by the board.

Presently, as stated above, five methods of computing the ALP are available under the Act. CBDT has not prescribed any other method for determination of ALP for which power has been provided to them under clause (f) of section 92C(1). Rule 10B(1) provides the manner in which each of the aforesaid method is to be applied to arrive at the ALP. Each of the methods require a comparison of the international transaction with an uncontrolled transaction. Sub-rules (2) to (4) of rule 10B, deals with the manner in which such comparison is to be made and the data to be used for such comparison. A brief note on each of the aforesaid methods as prescribed by the Act and the Rules for determination of ALP is as under:

(a) Comparable uncontrolled price method

For applying this method one has to first identify the price charged or paid for the property transferred or services provided in a comparable uncontrolled transaction, or a number of such transactions. Such price is to be further adjusted to account for differences, if any, between the international transaction and the comparable uncontrolled transaction or between the enterprises entering into such transactions which would materially affect the price in the open market. The price so arrived at would be the ALP.

(b) Resale price method

Under this method the price at which the property purchased from an AE is resold or the services obtained from an AE is provided to an unrelated enterprise is taken to be the base price. Such price is reduced by the normal gross profit margin which could be earned by an enterprise in the same or similar comparable uncontrolled transaction. This is further reduced by the expenses incurred by the enterprise in connection with the purchase of property or obtaining of services. The price so arrived at is adjusted to takeinto account the functional and other differences between the international transaction and the comparable uncontrolled transaction or between the enterprises entering into such transactions which could materially affect the amount of gross profit margin in the open market. This adjusted price is taken as the ALP.

(c) Cost plus method

In essence it is reverse of the resale price method. Here, first the direct and indirect costs of production incurred by the enterprise in respect of the property transferred or service provided to an associated enterprise is determined. To this a normal gross profit mark up in the same or similar comparable uncontrolled transaction by the enterprise or an unrelated enterprise is added. The price so arrived at is then adjusted to take into account the functional and other differences between the international transaction and comparable uncontrolled transaction or between the enterprises entering into such transactions which could materially affect the amount of gross profit margin in the open market to arrive at the ALP.

(d) Profit split method

Under this method, first the combined net profit of the associated enterprises arising from an international transaction in which they are engaged is determined. The net profit is then split among the enterprises on the basis of the relative contribution made by each of them, having regard to the functions performed, assets employed and risk assumed, and on the basis of reliable external market data which indicates how such contribution would be evaluated by unrelated enterprises performing comparable functions in similar circumstances. The ALP would then be calculated taking into account the profits so apportioned. It is also prescribed that the combined net profit, in the first instance, be partially allocated to each enterprise so as to provide it with a basic return appropriate for the type of international transaction and thereafter the residual net profit remaining after such allocation may be split amongst the enterprises in proportion to their relative contribution and in such a case the aggregate of the net profit allocated to the enterprise in the first instance together with the residual net profit apportioned to that enterprise on the basis of its relative contribution shall be taken to be the net profit arising to that enterprise from the international transaction. This method is generally applied to international transactions involving transfer of unique intangibles or in multiple international transactions which are so interrelated that they cannot be evaluated separately for the purposes of determining the ALP of any one transaction.(e) Transactional net margin method This is the method of last resort i.e. this method is to be applied only when no other method could be applied to a particular case. Nevertheless, this is the most widely used method in transfer pricing analysis. Under this method, the net margin from the international transaction is computed in relation to cost incurred or sales effected or assets employed or any other base. Then the net margin realized by the enterprise or unrelated enterprise for a comparable uncontrolled transaction is calculated with respect to the same base, as adjusted to take into account the difference, if any, between the international transaction and comparable uncontrolled transaction or between the enterprises entering into such transactions which could materially affect the amount of gross profit margin in the open market. The net margin so arrived is then taken into account to arrive at the ALP.

5. Assessment procedure in relation to International transactions

Under section 92C(1) of the Act the prerogative to choose the most appropriate method for determining the ALP is with the assessee. Acceptance of the ALP arrived at by the assessee is the rule and its rejection an exception. Section 92C(3) gives jurisdiction to the Assessing Officer to determine the ALP, if, in the course of the assessment proceedings he on the basis of material or information or document in his possession of the opinion that:

1. the price charged or paid in an international transaction has not been determined as per any of the specified methods or the assessee has not followed the most appropriate method in the manner prescribed by rule 10C;

or 2. the assessee has not kept and maintained the information and documents relating to the international transaction in accordance with section 92D(1) of the Act and rule 10D of the Rules.

3. the information used in computing the ALP is not reliable or correct.

4. the assessee has failed to furnish within the specified time any information or document which he is required to furnish by a notice issued under section 92D(3).

Issue would arise whether forming of this opinion is an administrative function or a quasi-judicial function. If it is a quasi Judicial function, then, further issue would be whether the Assessing Officer is required to comply with the principles of natural justice before arriving at such opinion. This is further supported by the fact that certain information and documents would be required by the Assessing Officer from the assessee before arriving at any such opinion. One further issue would be whether this opinion has to be recorded by the Assessing Officer in writing. This should be so, though there is no specificprovision to that effect, as validity of such opinion would also be subject to scrutiny before the appellate authorities which would be meaningless if the opinion is not expressed in writing.

Upon forming opinion in respect of any of the above-mentioned four issues the Assessing Officer has to determine the ALP in accordance with sections 92C(1) and (2) of the Act and on the basis of such material or information or document available with him. However, before computing the ALP, the Assessing Officer is under an obligation to give an opportunity to the assessee to show cause as to why the ALP should not be so determined by him.

Instruction No. 3 of 2003 dated 20-5-2003 issued by the Central Board of Direct Taxes (the CBDT) initially, and thereafter proviso to section 92C(2) of the Act (as amended by Finance Act, 2002 with effect from 1st April, 2002) clarifies that if the price determined by the Assessing Officer is within the range of +/- 5% of the price so determined by the assessee, then the Assessing Officer would not make any addition. In view of the aforesaid instruction, the issue which arises for consideration is, in a case where the difference of the ALP and the price offered exceeds 5%, then whether the adjustment has to be made for the entire difference or whether the assessee can make a claim that there should be a discount of 5% allowed because if the price would have been within that limit, there would have been no adjustment. In our view, transfer pricing adjustment of the entire differential has to be made.

One important thing to be noted is that Assessing Officer would substitute the ALP so calculated for the assessee’s price only if it would benefit the revenue. Section 92(3) provides that if the applicability of the transfer pricing provision has the effect of reducing the income chargeable to tax or increasing the loss, as computed on the basis of entries made in the books of account in respect of the previous year in which the international transaction was entered into then the provisions would not apply. For example, if the ALP is less than the price for which the goods were actually sold, such that if the ALP is substituted for the actual price the income of the assessee would be less than what is offered to tax. In such situations the transfer pricing provisions would not apply.

6. Computation of ALP by the Transfer Pricing Officer

The income tax department has constituted a separate wing within the department, after the insertion of transfer pricing provisions, being the Transfer pricing department. The Assessing Officer, if he considers it necessary or expedient so to do, can refer the computation of ALP in relation to the international transaction to the officer of the aforesaid department, being the transfer pricing officer under section 92CA(1) of the Act. For this purpose, the Assessing officer has to take prior approval of the Commissioner before making the reference. Once a reference is made under this section then it would be the responsibility of theTransfer Pricing Officer to compute the ALP in relation to the said international transactions.

It is interesting to note that the reference is in respect of each individual transaction and not of the assessee. The effect is that, if during the course of the proceedings, the transfer pricing officer becomes aware of certain other international transactions which have not been specifically referred to him for determination of ALP, then he cannot determine the ALP of those transactions. Instead he would require a fresh reference in this regard from the Assessing Officer. This position is also clarified by Instruction 3 of 2003 dated 20-5-2003 issued by the CBDT.

Aforesaid Instruction 3 of 2003 also carries a direction from the CBDT that, whenever the aggregate value of the international transaction exceeds rupees five crores, the case should be picked up for scrutiny and a mandatory reference be made to the transfer pricing officer for determination of ALP. Constitutional validity of this direction has been upheld by the Delhi High Court in the case of Sony India Pvt. Ltd. vs. CBDT 288 ITR 52. On a practical note, it has also been the experience that although the provisions provides for the Assessing Officer to himself make a determination of the ALP, in almost all cases where there is a transfer pricing adjustment, it has always been after a reference has been made for the same to the Transfer Pricing Officer.

Issue would arise whether the reference to the Transfer Pricing Officer under section 92CA(1) of the Act is only for the limited purpose of computation of ALP or he is also authorized to carry out the procedure prescribed in section 92C(3) to acquire the jurisdiction for determination of ALP. One view is that the delegation under section 92CA(1) of the Act is clearly for the purposes of computation of ALP. It is an accepted principle of law that a person can delegate a function only if he himself has jurisdiction to carry out that function. As stated above, Assessing Officer will get the jurisdiction to determine the ALP only if he in the course of assessment proceedings forms an opinion that one of the conditions prescribed in section 92C(3) of the Act has been fulfilled in the case of an assessee. Therefore, before delegating the function of computation of ALP the Assessing Officer should himself have that jurisdiction, which he gets only after complying with the procedure prescribed in section 92C(3) of the Act. Hence, the procedure prescribed by section 92C(3) of the Act has to be carried out by the Assessing Officer only and this function cannot be delegated to the Transfer Pricing Officer. However, Delhi High Court in the case of Sony India Pvt. Ltd. vs. CBDT 288 ITR 52 has taken a contrary view and held that the functions to be performed under section 92C(3) can also be delegated by an Assessing Officer to a Transfer Pricing Officer.

The Transfer Pricing Officer has to then issue a notice to the assessee under section 92CA(2) of the Act requiring him to produce any evidence on which he may rely upon in support of the computation made by him of the ALP in relationto the international transaction. Under section 92CA(3) of the Act the Transfer Pricing Officer has to then determine the ALP by an order in writing, after taking into consideration all the material produced by the Assessee before him, including any information or documents which the assessee is required to maintain under section 92D of the Act and all relevant materials which has been gathered by him. This copy of the order passed by the Transfer Pricing Officer is then sent to the Assessing Officer as well as the assessee.

7. Computation of total income by the Assessing Officer

After receiving the order from the Transfer Pricing Officer, the Assessing Officer has to determine the total income of the assessee having regard to the ALP determined by the Transfer Pricing Officer.

The question to be considered here is whether the Assessing Officer is bound to accept the ALP as determined by the Transfer Pricing Officer in determining the total income of the assessee. Answering this question in the case of Sony India (P) Ltd. vs. CBDT 288 ITR 52, the Delhi High Couth has held that the provisions do not mandate that the Assessing Officer has to accept the ALP as determined by the Transfer Pricing Officer. And for good reason, as the Assessing Officer has himself not made up his mind at that stage about the ALP. He has, in a sense, only outsourced the exercise to the Transfer Pricing Officer. He can always be persuaded by the assessee at that stage to reject the report of the Transfer Pricing Officer and proceed to determine the ALP himself. However, an amendment has been proposed in Finance Bill, 2007 in section 92CA(4) of the Act which would bind the Assessing Officer to compute the total income in conformity with the ALP as so determined by the Transfer pricing Officer.

8. Requirement relating to information and documents

Section 92D of the Act mandates that every person entering into an international transaction shall keep and maintain the prescribed information and documents. Rule 10D(1) of the Rules gives a detailed list of information to be maintained by such person. Such information should also be supported by authentic documents as prescribed in rule 10D(3). This information and documents should, as far as possible, be contemporaneous and should exist latest by the due date for furnishing the return of income prescribed under Explanation to section 139(1) of the Act. Fresh documentation is not required to be made separately in respect of each of the previous years in a case where an international transaction continues to have effect over a period of more than one previous year unless there is significant change in the nature of terms of the international transaction, in the assumptions made, or in any other factor which could influence the transfer price. Under sub-rule (5) of the said rule this information and documents are required to be kept and maintained for a period of eight years from the end of the relevant assessment year. An assessee whose aggregate value of the internationaltransactions as recorded in the books of account does not exceed one crore rupees is not required to maintain the above referred information and documents. However, he may be required to substantiate the basis on which he has computed the ALP under section 92 in the course of assessment proceedings.

9. Requirement relating to Auditor’s report

Section 92E of the Act requires that every person who has entered into an international transaction during a previous year shall obtain a report from an accountant. This report is required to be furnished on or before the due date prescribed for filing the return of income under Explanation 2 to section 139(1).

This report is to be obtained from a Chartered Accountant in Form 3CEB prescribed by rule 10E of the Rules.

10. Penalties in relation to the Transfer Pricing provisions

Explanation 7 has been inserted in section 271 of the Act to provide for levy of penalty for concealment of income, in a case where any amount is added or disallowed in computing the total income under section 92C(4). Section 271AA of the Act provides for penalty in a case where a person fails to keep and maintain any such information and document as required by section 92D. Section 271BA provides for a penalty where a person fails to furnish a report from an accountant as required by section 92E. Lastly, section 271G levies penalty in a case where a person who has entered into an international transaction fails to furnish such information or document as required under section 92D(3).

Few of the various legal and practical issues which arise out of the application of the transfer pricing provisions have been raised in this article. Only time will clarify the position on these uncertainties, through judicial pronouncements made by the Courts and Tribunal.

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