Domestic Transfer Pricing

1

Baroda Branch of WIRC of ICAI Study Circle
Meeting

• Domestic Transfer Pricing

CA Manish Baxi
2
Introduction to Transfer Pricing

• TP was earlier limited to International
  Transactions
• The Finance Act 2012, extends the scope of TP
  provision to Specified Domestic Transactions
  between related parties w.e.f. 1 April 2012
• The SC in the case of CIT vs Glaxo Smithkline
  Asia Pvt Ltd 2010-195Taxman 35 (SC) recommended
  introduction of domestic TP provisions
• SDT previously reported/certified but onus on
  revenue authorities
• Obligation now on taxpayer to report/ document
  and substantiate the arms length nature of such
  transactions
• Shift from generic FMV concept to focused ALP
  concept
• IMPACT
• Ramifications across industries which benefit
  from the preferential tax policies such as SEZ
  units, infrastructure developers or operators,
  telecom services, industrial park developers,
  power generation or transmission etc. Apart from
  this, business conglomerates having significant
  intra-group dealing would be largely impacted

3
Domestic Transfer Pricing Intent of the Law

• Bringing in objectivity in the interpretation and
  governance introduction of ALP mechanism

• Doing away with tax arbitrage abuse that stems
  from differential tax rate, tax holiday/benefits
  availed by undertaking and presence of
  accumulated losses

• Protecting the revenue of the Indian Government

4
Intent of Indian TP Regulations (International
transactions)
Shifting of Profits
India
Overseas
Indian Co.
Associated Enterprise (AE Co.)
Tax _at_ 32.45
Tax _at_ lower rate approx 10
Shifting of Losses
Tax Saving for the Group Loss to Indian revenue
5
Intent of Indian TP Regulations (Domestic
transactions)
India
Shifting of expenses/losses
India
Indian Co. Tax Holiday undertaking
Related Enterprise in Domestic Tariff Area (DTA)
Tax Exemption
Tax _at_32.45
Shifting of income/profits
Tax Saving for the Group Loss to Indian revenue
6
Intent of Indian TP Regulations (Domestic
transactions)
Particulars (Ordinary Situation) Co. X (SEZ) Co. Y (DTA)
Income 500 1000
Income from related party 100 -
Expenses 300 800
Expense to related party - 100
Profit/ Loss 300 100
Tax rate applicable 0 32.45
Tax - 32.45 (10032.45)
Particulars (Planned Situation) Co. X (SEZ) Co. Y (DTA)
Income 500 1000
Income from related party 200 -
Expenses 300 800
Expense to related party - 200
Profit/ Loss 400 -
Tax rate applicable 0 32.45
Tax - -
Loss to Revenue Tax Saving to the Group
7
Intent of TP Regulations (Domestic transactions)
Shifting of expenses
India
India
Indian Co. Loss making
Related Enterprise Profit making
Tax _at_ 32.45 Reduced tax due to shifting of
profits
Tax _at_ 32.45 No tax or reduced tax due to loss
Shifting of income
Tax Saving for the Group Loss to Indian revenue
8
Intent of TP Regulations(Domestic transactions)
Particulars (Ordinary Situation) Co. X (DTA) Co. Y (DTA)
Income 500 1000
Income from related party 100 -
Expenses 700 800
Expense to related party - 100
Profit/ Loss (100) 100
Tax rate applicable 32.45 32.45
Tax - 32.45 (10032.45)
Particulars (Planned Situation) Co. X (DTA) Co. Y (DTA)
Income 500 1000
Income from related party 150 -
Expenses 700 800
Expense to related party - 150
Profit/ Loss (50) 50
Tax rate applicable 32.45 32.45
Tax - 16.23 (5032.45)
Present Loss to Revenue Tax Saving to the
Group
By shifting of income from a profit making
company to a loss making company, the group could
reduce its tax liability by 16.23 for the current
year, though the impact will be reversed in
future years given carry forward of losses.
9
Introduction of domestic transfer pricing
provisions

• The Explanatory Memorandum to Finance Bill 2012
  clarified that the genesis of these provisions
  lies in decision of Supreme Court (SC) in the
  case of CIT vs. Glaxo Smitkline Asia (P) Ltd
  (supra).
• The FA 2012 has inserted definition of SDT and
  extended scope of TP to SDT by generally
  incorporating references to SDT in existing TP
  provisions at places where International
  Transaction is referred in ITA (Domestic TP).
• The relevant extracts of the explanatory
  memorandum
• Transfer Pricing Regulations to apply to certain
  domestic transactions
• Section 40A of the Act empowers the Assessing
  Officer to disallow unreasonable expenditure
  incurred between related parties. Further, under
  Chapter VI-A and section 10AA, the Assessing
  Officer is empowered to re-compute the income
  (based on fair market value) of the undertaking
  to which profit linked deduction is provided if
  there are transactions with the related parties
  or other undertakings of the same entity.

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• No specific method to determine reasonableness
  of expenditure or fair market value to re-compute
  the income in such related transactions is
  provided under these sections.  
• Therefore, the transfer pricing regulations need
  to be extended to the transactions entered into
  by domestic related parties or by an undertaking
  with other undertakings of the same entity for
  the purposes of section 40A, Chapter VI-A and
  section 10AA.
• The concerns of administrative and compliance
  burden are addressed by restricting its
  applicability to the transactions, which exceed a
  monetary threshold of Rs. . 5 crores in aggregate
  during the year.
• In view of the circumstances which were present
  in the case before the Supreme Court, there is a
  need to expand the definition of related parties
  for purpose of section 40A to cover cases of
  companies which have the same parent company.

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• It is, therefore, proposed to amend the Act to
  provide applicability of transfer pricing
  regulations (including procedural and penalty
  provisions) to transactions between related
  resident parties for the purposes of computation
  of income, disallowance of expenses etc. as
  required under provisions of sections 40A, 80-IA,
  10AA, 80A, sections where reference is made to
  section 80-IA, or to transactions as may be
  prescribed by the Board, if aggregate amount of
  all such domestic transactions exceeds Rupees 5
  crore in a year. It is further proposed to amend
  the meaning of related persons as provided in
  section 40A to include companies having the same
  holding company.
• This amendment will take effect from 1st April,
  2013 and will, accordingly, apply in relation to
  the Assessment Year 2013-14 and subsequent
  assessment years.

12
Section 92BA Meaning of SDT

• For the purposes of this section and sections 92,
  92C, 92D and 92E, specified domestic
  transaction means any of the following
  transactions, not being an international
  transaction, namely-
• any expenditure in respect of which payment has
  been made or is to be made to a person referred
  to in section 40A(2)(b)
• any transaction referred to in section 80A
• any transfer of goods or services referred to in
  sub-section (8) of section 80-IA
• any business transacted between the assessee and
  other person as referred to in section 80-IA
  (10)
• any transaction, referred to in any other
  section under Chapter VIA or section 10AA, to
  which provisions of section 80-IA(8) or section
  80-IA(10) are applicable
• any other transaction as may be prescribed,
• and where the aggregate of such transactions
  entered into by the assessee in the previous year
  exceeds a sum of five crore rupees amended to
  twenty crore (w.e.f 01.04.2016)

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Overview of Provisions of Section 92BA
Inter unit transfer of goods services by
undertakings to which profit-linked deductions
apply
SDT
Expenditure incurred between related parties
defined under section 40A
Any other transaction that may be specified
Transactions between undertakings, to which
profit-linked deductions apply, having close
connection
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• TERMS Used in DTP
• S. 10AA uses the term close connection.
• S. 40A(2)(b) uses the term Related party.
• S. 80IA (8) inter unit.
• S. 80IA (10) uses the term close connection.
• S. 92A uses the term Associated Enterprises.
• No guidance or limited guidance on the meaning of
  close connectionS 42 (2) of ITA 1922,
• 1958 34 ITR 368 (SC)
• Mazagaon Dock Ltd.vs. C.I.T.
• s

15

• Section 92BA Analysis

For the purpose of sec. 92, 92C, 92D and 92E
Section Relevance with provisions of Sec 92BA
92 Computation of income having regard to ALP ?
92A Meaning of AE ?
92B Meaning of International transaction ?
92C Methods of computation of ALP ?
92CA Reference to TPO ?
92CB Safe harbour rules ?
92CC Advance Pricing agreement ?
92CD Effect of TP agreement ?
92D Maintenance of information and documents ?
92E CAs Report ?
92F Definitions Accountant, ALP, Enterprise, PE, Specified date, Transaction ?
Sec 92F Definitions does not define terms
relevant for domestic TP transactions
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Sec. 92 Computation of income from
international transaction having regard to ALP
(1) Computation of income from international
transaction having regard to ALP. (2) mutual
agreement etc for allocation or apportionment or
contribution to any cost or expense shall be
determined having regard to ALP. (2A) Any
allowance for an expenditure or interest or
allocation of any cost or expense or any income
in relation to specified domestic transaction
shall be computed having regard to ALP. ( w.e.f
1.4.2013) (3) section does not apply if the
effect is reducing the income or increasing the
loss.
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Sec. 92 C Computation of ALP
The words specified domestic transaction has
been inserted appropriately in various sub-sec.
(1) Any of the following methods, being most
appropriate method (a) Comparable
uncontrolled price method (b) Resale
price method (c) Cost plus method

refer rule 10B
(d) Profit split method (e)
Transactional net margin method (f)
other method of determination of arms length
price (any method that takes in to account the
price which has been charged or paid or would
have been charged or paid for same or similar
uncontrolled transaction with or between non
associated enterprises) (2) Most appropriate
method as per criteria laid down in rule 10C
considering FAR analysis .
FAR Functions performed, Assets employed,
Risks assumed Rule 10C(2)
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Transfer Pricing Methods

• 1. Traditional transaction methods
• Comparable Uncontrolled Price (CUP)
• Resale Price Method (RPM)
• Cost Plus
• 2.Transactional Profit Methods
• Profit Split Method (PSM)
• Transactional Net Margin (TNMM)
• 3. Other Methods
• As prescribed by CBDT Notification No 18/2012
  Dt.23.5.12

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Other Method - Rule 10AB

• Other Method can be used for following
  transactions.
• Revenue split
• Valuation of intangible property
• Valuation of shares
• Cost allocation
• Reimbursements
• Any method that takes in to account the price
  which has been charged or paid, or would have
  been charged or paid, for the same or similar
  uncontrolled transaction, with or between
  non-associated enterprises, under similar
  circumstances, considering all the relevant
  facts.
• Similar to CUP in many ways
• Quotations, Commercial Negotiations, Tenders can
  be used to substantiate ALP under this method
  which was not possible under CUP

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Comparable Uncontrolled Price Method (CUP)

• Compares price charged for property/ service
  transferred in controlled transactions with price
  charged in comparable uncontrolled transactions
• Requires very high standard of comparability
• Most direct and reliable way to apply the arms
  length principle
• Conditions for use of CUP
• none of the differences between the transactions
  can materially affect price in the open market
• reasonably accurate adjustments can be made to
  eliminate the material effects of such
  differences

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Types of CUPs available -Internal CUP -
The price that the company has charged in a
comparable uncontrolled transaction with an
independent party -External CUP - The price
charged in a comparable uncontrolled transaction
between third parties when compared to a price of
controlled transactions CUP When to apply?1.
When internal comparables exist for transactions
involving generic goods2. When pricing certain
type of financial transactions.CUP Pros and
ConsPros - Simple to understandCons
1.Difficult to apply2. High level of
comparability required
22
Resale Price Method (RPM)

• Method used in case of purchase of goods or
  services from related parties for resale to
  unrelated parties without substantial value
  addition
• The price is reduced by the normal gross margins
  earned by unrelated party for same or similar
  products or services
• Need for similarity of functions performed and
  risks undertaken
• Gross margins used as the profit level indicator
  

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• RPM How it works
• Resale Price xx
• Less Gross Margin (xx)
• Less Associated Costs (xx)
• ( e.g. Customs duty) ____
• Arms Length Price xx

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RPM - When to apply?

• 1. When internal comparables exist but CUP cant
  be applied due to product differences
• 2. When reseller does not add significant value
  to products sold to final consumer
• RPM - Pros and Cons
• Pros -Less sensitive product differences
• Cons - One sided analysis Only margin of
  reseller

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Cost Plus Method (CPM)

• Method using the costs incurred by the supplier
  of goods (or services) in a controlled
  transaction for goods or services provided to an
  related party.
• An appropriate cost plus mark-up is added to the
  above cost in light of the FAR
• Arms Length Price Direct and Indirect Cost of
  Production
• () mark-up (based on benchmarking analysis) done
  by comparables
• conditions for use of CPM
• none of the differences between the transactions
  can materially affect cost plus margin in the
  open market
• reasonably accurate adjustments can be made to
  eliminate the material effects of such
  differences
• Tolerant to product differences as compared to
  CUP method

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CPM How it works

• Costs incurred by supplier xx
• Add Mark Up xx
• Arms Length Price xx
• Costs incurred by supplier
• 1. Direct costs Material, Labour etc
• 2. Indirect costs Factory overheads
• Mark Up based on
• 1. Internal Comparable Transactions
• 2. External Comparable Transactions

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CPM - When to apply?

• 1) In intercompany sale of tangible property
  where the related party manufacturer performs
  limited manufacturing functions and Incurs low
  risks
• 2) E.g. Contract manufacturer, low risk assembler
  who do not own product intangibles and incurs
  little risks.
• 3) The related customers involved in the
  controlled transaction are usually more complex
  in terms of
• a) functions
• b) risks incurred
• c) assets owned

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CPM - Pros and Cons

• Pros Large pool of comparable uncontrolled
  transactions
• Cons Identification of comparable mark ups and
  cost basis difficult in practice.
• Mark up information may not be reported.
• Differences in accounting practices.

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Profit Split Method (PSM)

• PSM is applied, where
• Both the entities have unique intangibles
• Operations of both the entities are so integrated
  that identifying the tested party is very
  difficult

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PSM - When to apply?

• Highly interrelated transactions
• Unique and valuable intangibles used by both
  parties
• Render all other methods inappropriate
  /inapplicable
• PSM - Pros and Cons
• Pros - Can handle complex TP issues two sided
  method
• Can be applied when both parties to the
  transactions make unique and valuable
  transactions
• Cons - Difficult to apply in practice
• Difficult to assess necessary information

31
Transactional Net Margin Method (TNMM)

• Comparison at operating margin level
• Comparison at transactional level, where possible
  
• Broad level of similarity of FAR
• Operates in a similar manner to the CPM and RPM
• Most preferred and practical method

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TNMM - When to apply?

• 1) On comparable independent enterprises
  (controlled transactions)
• 2) Results attributable to transactions between
  the tested party and independent enterprises
  should be excluded when evaluating controlled
  transactions.
• 3) It should not be applied on a company-wide
  basis if the company is involved in a number of
  different controlled transactions which are not
  properly evaluated on an aggregate basis.

33

• TNMM - Pros and Cons
• Pros - Less affected by product differences
• Less sensitive to minor differences in functions
• Cons -Requires thorough comparability analysis
• One sided analysis like CUP, RPM and CPM
• Advantage
• 1. Most Commonly used
• Since Comparable information easily available
• Since Differences in AS are less of an issue
• 2.Less sensitive to functional and product
  differences
• 3. Variety of net profit indicators

34
TNMM - Disadvantage

• As NP easily impacted by factors which barely
  affect GP
• For e.g. Differences in capacity utilization,
• Management Efficiency, Cost structures,
  lifecycles of the business

35
Section 92CA - Reference To TPO

• The word specified domestic transaction
  inserted in various sub-sections.
• (1) AO may refer the computation of ALP to TPO
• (2) TPO to issue notice to Assessee to produce
  evidence in support of ALP
• (2A) Any other international transaction coming
  to notice of TPO
• (2B) Non-furnishing of CAs report and TPOs
  power
• (3) TPO shall pass the order determining ALP
• (3A) Explanation to section 153, if period of
  limitation available to TPO for making an order
  is less than sixty days, such remaining period
  extended to sixty days. ( W.e.f 01.06.2016)
• (4) AO to compute total income accordingly
• (7) TPOs power of summons (s.131), survey
  (s.133A) and collecting
• information u/s 133(6)applies even in
  Domestic Transaction
• Sec. 144C (15)(b)..Reference to DRP
• AO to forward draft of proposed order to eligible
  assessee
• eligible assessee means any person in whose
  case order u/s 92CA is passed
• 92CA (2A ) (2B) do not cover specified
  domestic transactions and hence the TPO cannot
  suo moto upon the transaction coming to his
  notice apply the TP provisions

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Section 92D Maintenance and keeping information
and document by persons entering into an
international transaction or specified domestic
transaction
Entity Related
Price Related
Transaction Related

• Agreements
• Invoices
• Pricing related correspondence (letters, e-mails,
  fax, etc.)

• Profile of Industry
• Profile of group
• Profile of related parties

• Transaction terms
• FAR related
• Economic Analysis (method selection, comparable
  benchmarking)
• Forecasts, budgets, estimates

The onus of proving SDT at ALP is on tax payer
37

• Documentation to be contemporaneous
• Due date for maintenance of TP documentation
  for the every Financial Year is November 30th
•  DOMESTIC TP FILING OF FORM 3CEB
•  
• All taxpayers to whom the provisions apply
  required to file a Form 3CEB certified by a
  Chartered Accountant (CA)
•  
• For the every Financial Year, the due date of
  filing Form 3CEB is Nov 30th
• Requirement to file physical copy of the
  certified form
• No provision for filing electronic copy
•  
• TP documentation forms the basis for
  certification of Form 3CEB
• Certificate contains details such as
• Compliance by taxpayer with the TP
  documentation requirements
• Nature/Quantum of transactions and method used
  to determine ALP  
• Aimed at assisting tax officers in assessment
  proceedings

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Section 271 Penalty Implications
Sr. No. Type of penalty Section Penalty quantified
1 a) Failure to maintain prescribed information/ documents 271AA 2 of transaction value
1 (b) Failure to report any such transaction or 271AA 2 of transaction value
1 (c) Furnish incorrect information 271AA 2 of transaction value
2 Failure to furnish information/ documents during assessment u/s 92D 271G 2 of transaction value
3 Adjustment to taxpayers income during assessment 271(1)(c) 100 to 300 of tax on adjustment amount
4 Failure to furnish accountants report u/s 92E 271BA INR 100,000
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Section 40A(2) Transactions covered

• Mapping to be done for the companys transactions
  with domestic Related Parties
• Primary reliance on disclosures u/s 40A(2)(b) and
  Related Party Schedule
• Different divisions enter into different
  transactions with various group companies
• Broad categories of transactions likely to be
  covered

40
Relationship can exists any time during the year
Sec 40A (2)(b) Related Party
Sr.No Payer / assessee Payee
(i) Individual Any relative defined in sec. 2(41) to mean husband, wife, brother, sister, lineal ascendant or descendant Definition of Relative u/s 56(2) not relevant
(ii) Company any director or relative of such director
Firm (includes LLP) any partner or relative of such partner
AOP any member or relative of such member
HUF any member or relative of such member
(iii) Any Assessee any individual having substantial interest in the assessees business or relative of such individual
(iv) Any assessee a Company, Firm, AOP, HUF having substantial interest in the assessees business or any director, partner, member or relative of such director, partner or member or (newly inserted) any other company carrying on business or profession in which the first mentioned company has substantial interest. X Ltd. (subsidiary co) A Ltd. (holding co) Y Ltd. (subsidiary co)
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Type of transactions covered (illustrations for
payments made by a Company)
Case 2 - To an individual who has substantial
interest in the business or profession of the
taxpayer or relative of such individual Section
40A(2)(b)(iii)
Case 1 - Director or any relative of the Director
of the taxpayer Section 40A(2)(b)(ii)
Assessee (Taxpayer)
Assessee (Taxpayer)
Director
Director
Substantial interest gt20
Relative
Mr. A
Mr. C
Mr. D
Mr. A
Mr. D
Mr. C
Relative
Relative
Covered transactions
Holding Structure
42
Type of transactions covered (illustrations for
payments made by a Company)
Case 4 Any other company carrying on business
in which the first mentioned company has
substantial interest Section 40A(2)(b)(iv)
Case 3 To a Company having substantial interest
in the business of the taxpayer or any director
of such company or relative of the director
Section 40A(2)(b)(iv)
Mr. D
Assessee (Taxpayer)
C Ltd
Director
Substantial interest gt20
Assessee (Taxpayer)
A Ltd
Relative
Substantial interest gt20
Substantial interest gt20
Substantial interest gt20
Mr. C
B Ltd
A Ltd
Covered transactions
Holding Structure
43
Type of transactions covered (illustrations for
payments made by a Company)
Case 5 To a Company of which a director has a
substantial interest in the business of the
taxpayer or any director of such company or
relative of the director Section 40A(2)(b)(v)
B Ltd
Director
Director
Substantial interest gt20
Assessee (Taxpayer)
Mr. A
Mr. C
Relative
Mr. D
Covered transactions
Holding Structure
44
Type of transactions covered (illustrations for
payments made by a Company)
Case 6 To a Company in which the taxpayer has
substantial interest in the business of the
company Section 40A(2)(b)(vi)(B)
Case 7 Any director or relative of the director
of taxpayer having substantial interest in that
person Section 40A(2)(b)(vi)(B)
Substantial interest gt20
Assessee (Taxpayer)
Mr C
A Ltd
Director
Assessee (Taxpayer)
Substantial interest gt20
Relative
B Ltd
Substantial interest gt20
Mr B
D Ltd
Covered transactions
Holding Structure
45
Type of transactions covered (illustrations for
payments made by a Company)
Transaction Covered A B ? A C
? A D ? A E
? B C ? D E
? C D ? D E
?
46
Thus for Company A payments to following persons
are covered
47
Tax burden, if transaction not at ALP
48
Section 80IA (8) 80IA (10) Deduction in
respect of profits and gains from industrial
undertaking or enterprise engaged in
infrastructure development, etc.
80IA (8) 80IA (10)
Inter-unit transaction of goods or services Business transacted with any person generates more than ordinary profits Owing to either close connection or any other reason
Applicable where transfer is not at market value Applicable to tax holiday units earning more than ordinary profit
Onus on tax payer Primary onus on taxpayer Onus on tax authorities as well
49

Other Sections under Chapter VI-A......to which
s. 80-IA(8) or (10) are applicable
80-IA Income from Infrastructure, Telecommunication, Industrial Park Power sector etc.
80-IAB Income of an undertaking or enterprise engaged in development of SEZ
80-IB Income from certain Industrial undertaking and Housing Projects etc.
80-IC Income from certain Industrial undertaking set up in Sikkim, HP...etc.
80-ID Income from hotels etc in Delhi, Faridabad and other specified districts.
80-IE Income from eligible business undertaking in North Eastern States
50
Implication post amendments
ALP
FMV
Six methods prescribed for computing ALP
No method prescribed for computing FMV
Contemporaneous documentation required to be
maintained
No documentation required to be maintained
Accountants report signed by a CA to be filed
Other than reporting in tax audit report, no
statutory compliance
Assessment done by the TPO
Assessment done by the AO
51
Points for Consideration

• Whether the threshold limit of Rs. 20 crore
  applies to the aggregate amount under all the
  relevant sections taken together OR under each
  section separately i.e. 40A(2), 80A, 80-IA(8),
  80-IA(10), 10AA etc. ?
• Whether payment for capital expenditure Or
  expenditure capitalized is also covered ?
• Whether the provisions will apply in case the
  payers income is chargeable to tax under the
  head Income from other sources, because section
  58(2) says The provisions of section 40A shall,
  so far as may be, apply in computing the income
  chargeable under the head Income from other
  sources as they apply in computing the income
  chargeable under the head Profits and gains of
  business or profession ?
• Whether new provision applies to -
• Public Charitable Trust paying remuneration to
  related persons.
• Co-operative Societies
• Social Clubs
• having a business undertaking
• Transfer pricing provisions are not applicable in
  case where income is not chargeable to tax at
  all.
• Correlative adjustments - if excessive or
  unreasonable expenses are disallowed in the hands
  of tax payer at time of the assessment then
  corresponding adjustment to the income of the
  recipient will not be allowed in the hands of
  recipient of income. Hence, it would lead to
  double taxation in India.

52
Challenges
Type of payments/ transactions Challenges
Salary and Bonuses paid to the partners Remuneration paid to the Directors Transfer of land Joint Development agreements Project management fees Allocation of expenses between the same taxpayer having an eligible unit and non-eligible unit Benchmarking? Whether the limit as mentioned in section 40 (b) would be the ALP? Benchmarking? Whether the limit as mentioned in Schedule XIII would be the ALP? Whether the rates mentioned in the ready reckoner be considered as ALP? Benchmarking? Benchmarking? Whether these allocation would be SDT Sec 80-IA(10)? Directly v/s Indirectly  
53
CASE STUDY 1
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Case Study 1

• Facts
• HCO, an Indian company, is a manufacturer of FMCG
  products. It has four Indian subsidiaries namely
  IndCo1, IndCo2, IndCo3 and IndCo4 in different
  segment of FMCG products. Neither HCO nor its
  subsidiaries (except IndCo4) enjoy any profit
  linked deduction under Chapter VIA or sec 10AA.
  HCO also has 21 shareholding in UK Co (a company
  incorporated in UK) and 79 shareholding of UK Co
  is held by others.
• HCO has taken two loans i.e. one from Bank1 at an
  interest rate of 14 and other from an unrelated
  party at an interest rate of 13.
• HCO has advanced following loans to its
  subsidiaries
• IndCo1 at an interest rate of 16.
• IndCo2 at an interest rate of 10 as the company
  is suffering huge losses.
• Interest-free loan to IndCo3 as it is a startup
  company and loan given are primarily to provide
  seed funding to develop a sound strategy and
  transform its ideas and innovations into demand
  and gain market share.
• Interest-free loan to IndCo4 and it is utilized
  for its SEZ Unit u/s 10AA so that it is working
  efficiently.

55
Case Study 1 (contd)

• HCO given an interest free loan to UK Co
• IndCo1 has taken a loan from Bank2 at an interest
  rate of 14 for which HCO has given a guarantee
  to Bank2. HCO does not charge any guarantee fee
  to IndCo1.
• IndCo1 has also taken another loan from Bank 3 at
  an interest rate of 14. For this loan, HCO has
  given a letter of comfort to Bank3, as sole
  shareholder of IndCo1that it will exert its
  influence to ensure that IndCo1 would meet its
  liabilities to Bank 3 in the agreed manner.
  Moreover HCO has confirmed that no changes are
  planned in the ownership structures of the
  subsidiaries for the terms of loans.
• HCO has provided a performance guarantee to
  IndCo3 to make IndCo3 eligible to bid on a
  project. If the bid is successful, HCO will then
  add substance to IndCo3 in the form of providing
  further working capital finance, making it
  sufficiently robust to operate the project on its
  own and in turn making the performance guarantee
  a mere formality, . A guarantee in this context
  confers an economic benefit and allows IndCo3 to
  bid and perchance to win and thus is compensable.
  Whereas if the bid is not successful, the
  guarantee will be of little practical value or
  benefit to the subsidiary and should be regarded
  as a non-compensable shareholder activity because
  the subsidiary derives no benefit from the
  guarantee.
• In each company, the specified domestic
  transactions exceed threshold limit for all four
  subsidiaries.

56
Case Study 1 (contd)
Question Analyze the applicability of the
Domestic TP provisions in the hands on HCO,
IndCo1, IndCo2, IndCo3 and IndCo4 as well as UK
Co in respect of their financial dealings. H Co
contends that no guarantee fees is chargeable due
to the fact that IndCo1 was inadequately
capitalized and it was its benefit to give
guarantee on the basis of which bank loan were
obtained by IndCo1 at the same rate of interest
without any benefits to HCO.
57
Case Study 1 (contd)
UK
India
Interest free loan
UK Co 21 by H Co
Loan from Bank 3_at_16 Against Letter of Comfort of
H CO
Performance Guarantee of H CO
58
Case Study 1 (contd)

• For IndCo1
• Loan taken from HCO
• Loan taken by IndCo1 from HCO at interest rate of
  17 for which Interest payment by IndCo1 u/s
  40A(2)(b) constitutes SDT(u/s 92BA) and hence
  IndCo1 will be liable to comply with Domestic TP
  provisions.
• Interest payment to related party needs to be
  benchmarked by selecting the most appropriate
  method u/s 92C r.w Rule 10B and Rule 10C for
  computation of arms length price.
• IndCo1 has also taken two other loans. First,
  loan taken from Bank2 at an interest rate of 16.
  Second, loan taken from Bank3 at an interest rate
  of 16. Therefore, CUP Method is the most
  appropriate method. Thus, ALP interest rate works
  out to be 16 (arithmetic mean of 16 and 16).
• Having regard to the facts, the Assessing Officer
  possibly will try to make TP adjustment by
  disallowing excess interest of 1 (17-16) ,not
  being arms length but the fact needs to be
  demonstrated that other loans are with guarantees
  and without that there could be an extra charge
  by the bank (normally I.T. dept. takes 3 as
  guarantee fees in other cases and hence if
  appropriate adjustment is made to the rate of
  interest with such guarantee commission the
  lending rate of bank would go up by almost 3 and
  hence interest paid is at arms length.)However it
  is not established then IndCo1 would be exposed
  to penalty u/s 271(1)(c) r.w.t. Explanation 7 as
  deemed to be concealment of income or furnishing
  inaccurate particulars in respect of addition to
  income by way of TP adjustment.
• IndCo1 may be exposed to penalty u/s 271G if it
  has defaulted on maintenance of TP documentation
  and/or u/s 271BA if it has defaulted on
  furnishing of TP audit report.
• (contd).

59
Case Study 1 (contd)

• For IndCo1 (contd)
• 2. Guarantee given by HCO for loan taken from
  Bank2
• Since no guarantee fees is paid by IndCo1,
  provisions of sec 40A(2)(b) r.w.s. 92BA are not
  applicable. Therefore, this transaction is not
  SDT u/s 92BA.
• 3. Letter of Comfort given by HCO for loan
  taken from Bank3
• Since no consideration is paid by IndCo1,
  provisions of sec 40A(2)(b) r.w.s. 92BA are not
  applicable. Therefore, this transaction is not
  SDT u/s 92BA.
• For HCO (w.r.t IndCo1 Transaction)
• 17 Interest is received by HCO on loan given to
  IndCo1 is not covered u/s 40A(2)(b) and hence it
  does not constitute SDT(u/s 92BA) for HCO.
• HCO has given guarantee to Bank2 on loan taken by
  IndCo1 and HCO has not charged any guarantee fee
  for the same. Only expenditure on payment made or
  to be made to related party is covered u/s
  40A(2)(b) and thus even if there was any receipt
  or non-receipt of guarantee fee income, it would
  not have been covered u/s 40A(2)(b). Thus, it is
  not SDT (u/s 92BA) for HCO.
• HCO has also given letter of comfort to Bank3 on
  loan taken by IndCo1 and no monetary benefit is
  received for this transaction. Therefore, it does
  not constitute SDT (u/s 92BA) for HCO.

60
Case Study 1 (contd)

• For IndCo2
• Loan taken by IndCo2 from HCO at interest rate of
  10 for which Interest payment by IndCo1 u/s
  40A(2)(b) constitutes SDT(u/s 92BA) and hence
  IndCo1 will be liable to comply with Domestic TP
  provisions.
• Interest payment to related party needs to be
  benchmarked by selecting the most appropriate
  method u/s 92C r.w. Rule 10B and Rule 10C for
  computation of arms length price.
• Having regard to the facts, CUP Method is the
  most appropriate method wherein External CUP can
  be applied for benchmarking the transaction by
  adopting PLR of any nationalized banks in India
  or by adopting rate of interest paid by HCO on
  loans taken from bank i.e. 14 and IndCo1s
  borrowings _at_16. Thus, ALP interest rate works
  out to be above 10.
• In this case, interest rate of 10 is lesser than
  ALP interest rate. Therefore, transaction entered
  into by IndCo2 of interest payment to related
  party is at arms length. Therefore, no TP
  adjustments is warranted in this case.
• For HCO (w.r.t IndCo2 Transaction)
• 10 Interest is received by HCO on loan given to
  IndCo2 is not covered u/s 40A(2)(b) and hence it
  does not constitute SDT (u/s 92BA) for HCO.

61
Case Study 1 (contd)

• For IndCo3
• Interest free Loan taken from HCO
• Since no interest is paid by IndCo3, provisions
  of sec 40A(2)(b) r.w.s. 92BA are not applicable.
  Therefore, this transaction is not SDT u/s 92BA.
• But, interest free loan taken from related party
  is required to be reported in TP Audit Report i.e
  Form 3CEB. IndCo3 may be exposed to penalty u/s
  271G if it has defaulted on maintenance of TP
  documentation and/or u/s 271BA if it has
  defaulted on furnishing of TP audit report.
• Performance guarantee given by HCO for loan taken
  from Bank3
• Since no consideration is paid by IndCo1,
  provisions of sec 40A(2)(b) r.w.s. 92BA are not
  applicable. Therefore, this transaction is not
  SDT u/s 92BA
• For HCO (w.r.t IndCo3 Transaction)
• HCO has given an interest free loan to IndCo3. It
  has not charged any interest to IndCo3 as IndCo3
  is a startup company. Only expenditure on payment
  made or to be made to related party is covered
  u/s 40A(2)(b) and thus even if there was any
  receipt or non-receipt of interest, it would not
  have been covered u/s 40A(2)(b). Thus, it is not
  SDT (u/s 92BA) for HCO.
• HCO has provided a performance guarantee to
  IndCo3 to make IndCo3 eligible to bid on a
  project. HCO has not charged any guarantee fee
  for the same. Only expenditure on payment made or
  to be made to related party is covered u/s
  40A(2)(b) and thus even if there was any receipt
  or non-receipt of guarantee fee income, it would
  not have been covered u/s 40A(2)(b). Thus, it is
  not SDT (u/s 92BA) for HCO.

62
Case Study 1 (contd)

• For IndCo4
• Interest free loan taken by IndCo4 (having an
  eligible unit ie SEZ unit u/s 10AA) from HCO (non
  eligible unit) and utilized the said loan for
  its sec 10AA unit.
• We have to analyze whether the said transaction
  is falling within the any of the provisions of
  section 92BA i e whether it is SDT ?
• As per section 92BA(v) any transaction , referred
  to in section 10AA to which provisions of section
  80IA(10) are applicable is SDT. As per section
  80IA(10) where an eligible unit enters into SDT
  with any other person, then for the purpose of
  availing benefit under section 80-IA, the
  transaction recorded in the books of accounts of
  eligible unit should correspond to the ALP of
  such goods or services worked out as per section
  92C.
• However, Sec 80IA(10) is attracted only to those
  transactions in which, when it appears to the AO
  that, owing to the close connection between the
  assessee carrying on the eligible business (to
  which section 80IA applies) and any other person,
  or for any other reason, the course of business
  between them is so arranged that the business
  transacted between them produces to the assessee
  more than the ordinary profits which might be
  expected to arise in such eligible business.
• Thus, it is clear that the onus of proving that
  provisions of s. 80-IA(10) are attracted and that
  the business affairs are so arranged that it
  produces more than ordinary profits is on the AO
  and AO may deny deduction u/s10AA on the ground
  that interest free loan given by HCO to IndCo4
  was to enable IndCo4 to earn more than ordinary
  profits by invoking provisions of sec 10AA(9)
  r.w.s. 80-IA(10) r.w.s. 92BA(v). (contd)..

63
Case Study 1 (contd)

• For IndCo4
• Therefore, in the given case if the IndCo 4
  believes that business transacted with HCO is
  bonafide and it cannot be considered as tax
  evading arrangement then such transaction may not
  be regarded as SDT in terms of s. 92BA(V).Ind Co4
  can also take an argument that MAT provisions are
  applicable to 10AA units also hence there is no
  incentive to shift profit to 10AA unit by not
  charging any interest for the loan utilised for
  10AA unit. Hence, provisions of section 80IA(10)
  r.w.s 92BA(V) are not applicable to such
  transaction.
• IndCo4 may be exposed to penalty u/s 271G if it
  has defaulted on maintenance of TP documentation
  and/or u/s 271BA if it has defaulted on
  furnishing of TP audit report .
• For HCO (w.r.t IndCo4 Transaction)
• HCO has given an interest free loan to IndCo4.
  IndCo4 has utilized interest free loan for its
  SEZ Unit u/s 10AA. Only expenditure on payment
  made or to be made to related party is covered
  u/s 40A(2)(b) and thus even if there was any
  receipt or non-receipt of interest, it would not
  have been covered u/s 40A(2)(b). Thus, it is not
  SDT (u/s 92BA) for HCO.

64
Case Study 1 (contd)
For UK Co. No tax effect in the hands of UK Co
as UK Co is not to be assessed to tax in India.
Hence it is neither covered by SDT no by
international transaction u/s 92B. For HCO
(w.r.t UK Co Transaction) HCO has given an
interest free loan to UK Co in which HCO has only
21 shareholding. Therefore, UK Co is not an
associated enterprises u/s 92A(2)(b).But UK Co
would become a related party (of HCO) u/s
40A(2)(b)(iv) for a loan given to Non-Resident
Related Party. Only expenditure on payment made
or to be made to related party is covered u/s
40A(2)(b) and thus even if there was any receipt
or non-receipt of interest, it would not have
been covered u/s 40A(2)(b). Thus, it is not SDT
(u/s 92BA) for HCO.
65
CASE STUDY 2
66
Case Study 2

• Facts
• A Co, an Indian company, is engaged in business
  of polyester films. It has substantial interest
  in B Co and has a wholly owned subsidiary D Inc
  in USA. Both A Co and B Co are units covered u/s
  10AA.
• A Co has its own RD Centre which develops the
  technology for product research, design and
  development and enhances efficiency in production
  of polyester films.
• A Co manufactures raw materials namely, dimethyl
  terephthalate, terephthalic acid and ethylene
  glycol and sells it to B Co.
• A Co licenses technical know-how and formulas to
  B Co for processing of raw materials into
  finished goods i.e. polyester films.
• B Co processes the raw materials into finished
  goods i.e. Polyester films and sells the finished
  goods to A Co at Rs. 100 per sq ft. B Co has also
  made a miniscule sale to third parties at Rs 120
  per sq ft.
• Royalty is charged for (use of tech know how by B
  Co) by A Co to B Co at the rate of 3 on sale of
  total polyester films to A Co as well as third
  parties.
• A Co also purchase polyester films but of
  substantially different qualities from third
  parties at Rs. 80 per sq ft.

67
Case Study 2 (contd)

• C Co, an agent, provides marketing and sales
  promotion services to A Co for which it charges
  commission at 7 of sales made by A Co. A Co
  cuts polyester films into large master rolls and
  slit to precision widths before delivery to
  customer and packages as per customer
  requirement.
• A Co sells polyester films to Indian customers at
  Rs. 125 per sq. ft.
• D Inc is the face of A Co in US and overseas
  markets. A Co sells polyester films to the
  associated enterprise D Inc (USA) at cost plus
  10 mark-up.
• A Co follows Just-in-Time approach to manage
  inventory which in turn helps in balanced
  production and maintenance of required stock
  level of raw materials and finished goods.
• Research on various geographical areas where
  market can be developed is done by C Co. Market
  development includes focus on existing customers
  and also on potential customers. Selling and
  distribution activities as well as after-sales
  activities are undertaken by C Co.
• A Co and B Co perform administration functions
  independently for their respective organizations
  based on policies framed.

68
Case Study 2 (contd)

• All three companies (A Co, B Co and D Inc) deploy
  its tangible assets in the form of fixed assets
  and working capital for manufacturing and sale
  operations. The tangible assets include office
  facilities, warehouses, material handling
  equipments, computer hardware, quality control
  equipments, etc.
• B Co does not have significant exposure to market
  risk since it is primarily involved in the
  processing of raw materials to finished goods
  polyester films. A Co has a significant exposure
  to market risks in order to meet consumer needs.
• A Co bears a significant exposure to technology
  risk as the changes of finished goods i.e.
  quality of polyester films becoming obsolete is
  high and thus, it is a challenge for the company
  to keep up with the developments in technology in
  order to face market competition. Whereas B Co
  faces almost no technology risk as it uses
  technology of A Co and processing job has lesser
  chances of technology becoming obsolete.
• All major credit risks related to sales are borne
  by A Co whereas B Co faces less / no risk since
  its major sales are to A Co and a miniscule
  amount of sales to third parties. A Co is exposed
  to foreign currency fluctuation risk due to
  export of polyester films to its associated
  enterprises abroad.
•  
• Operating Margin on Total Cost for
•  
• A Co 8 whereas Comparables 13
• B Co 6 whereas Comparables 9.5
•  

69
Case Study 2 (contd)

• Question
• Analyze of the applicability of Domestic TP
  provisions in the hands of B Co in respect of
  following transactions-
• Purchase of Raw Materials by B Co
• Purchase of Polyester films by A Co
• Royalty paid by B Co
• 2. Analyze the applicability of transfer pricing
  provisions in respect of international
  transaction for sale of polyester films by A Co
  to its associated enterprise D Inc USA.

70
Case Study 2 (contd)
Third Parties
Royalty Paid for Tech Know-how
Purchase of Polyester Film of substantially
different quality
Sale of Polyester Films
A Co
B Co (Substantial Interest held by A Co)
Third Parties
Sale of Polyester Films
Sale of Manufactured Raw Materials
Commission Paid _at_7
Sale of Polyester Films
Customers
India
C Co
USA
Sale of Polyester Films
D Inc (WOS of A Co)
71
Case Study 2 (contd)
Analysis Applicability of Domestic TP - B
Co Transaction 1- Purchase of Raw Materials by
B Co from A Co
Category Level of Intensity Level of Intensity
Category B Co A Co
Functions Performed Market development Product development Manufacturing Quality control Post sales activities General management functions Corporate strategy determination Finance, accounting, treasury legal Human resource management ? - ??? ??? ? ??? ??? ??? ??? - ??? ? ??? ??? ??? ??? ??? ???
Assets Employed Tangibles Intangibles ??? ??? ???
Risks Assumed Market risk Product liability risk Technology risk Research Development risk Credit risk Inventory risk - ??? ? - ? ??? ??? ??? ??? ??? ??? ?
72
Case Study 2 (contd)
Transaction 1- Purchase of Raw Materials by B
Co from A Co
Criteria Analysis Result / comments
Company Profile Manufactures and markets polyester films Earns Operating profit margin (entity level) of 6 Arms length nature of revenue to be tested
FAR Analysis B Co is a manufacturer and seller of polyester films For benchmarking, the operating profit margins of comparable companies have been compared with the operating profit margin of B Co at entity level as well as with reference to operating margins earned on the sale transactions with associated enterprises. B Co is simpler and comparable data is available and hence, selected as the tested party
Selection of Methodology CUP Unavailability of internal/external CUP data RPM Taxpayer is a manufacturer and not a reseller of products PSM Routine manufacturer hence not applicable CPM May be applied if reliable cost data is available TNMM Relatively less stringent comparability standards and external comparables data available on public database CPM or TNMM could be selected as most appropriate method
73
Case Study 2 (contd)
Transaction 2 - Purchase of Polyester films by A
Co from B Co
Category Level of Intensity Level of Intensity
Category A Co B Co
Functions Performed Product development Manufacturing Quality control Post sales activities General management functions Corporate strategy determination Finance, accounting, treasury legal Human resource management ??? - ? ??? ??? ??? ??? ??? - ??? ??? ? ??? ??? ??? ???
Assets Employed Tangibles Intangibles ??? ??? ??? ?
Risks Assumed Market risk Product liability risk Technology risk Research Development risk Credit risk Inventory risk ??? ??? ??? ??? ??? ? ? ? - ? ???
74
Case Study 2 (contd)
Transaction 2 - Purchase of Polyester films by A
Co from B Co
Criteria Analysis Result / comments
Company Profile (A Co.) Trader of polyester films (besides being manufacturer of raw material) Earns Operating profit margin (entity level) of 8 Arms length nature of revenue to be tested
FAR Analysis A Co is a trader of polyester films For benchmarking, the operating profit margins of comparable companies have been compared with the operating profit margin of the A Co at entity level A Co. is simpler and comparable data is available and hence, selected as the tested party
Selection of Methodology CUP Unavailability of internal/external CUP data RPM A Co is cutting rolls into different sizes to make the product marketable and is not making substantial value addition to it and therefore, A Co is a pure reseller of products CPM Unavailability of comparable data at gross level PSM Routine manufacturer/trader hence not applicable TNMM Relatively less stringent comparability standards and external comparables data available on public database RPM or TNMM could be selected as the most appropriate method
75
Case Study 2 (contd)
Transaction for royalty paid by B Co to A
Co Since data on uncontrolled comparable
transactions (i.e. rates of royalty) is not
available in public domain, benchmarking of
payment of royalty by B Co to A Co. could be done
by applying External TNMM
International transaction for sale of polyester
films by A Co to its associated enterprise D Inc
USA. Being an international transaction, all the
transfer pricing provisions relating to
international transaction would be applicable and
the transaction would be benchmarked u/s 92C r.w.
Rule 10B and Rule 10 C.
76
CASE STUDY 3
77
Case Study 3

• Facts
• US Co is having a permanent establishment (PE) in
  India, Mr. A, a director of US Co, is deputed to
  Indian PE in financial year 2015 16 i.e from
  1st December 2015.
• Salary is paid to Mr. A by US Co and PE in India
  for respective periods worked in both (US Co and
  Indian PE).
• Mr. A is a non-resident in India for the
  financial year 2015-16.
• Indian PE (taxed on net basis) has claimed
  deduction for salary paid to Mr. A in its return
  of income for FY 2015-16.
• Question
• Whether domestic transfer pricing provisions are
  applicable to Indian PE for salary paid to Mr. A?
• Assume Indian PE is a subsidiary company of US Co
  and Mr. A is a non-resident and is also a
  Director of subsidiary company getting salary
  from subsidiary company. Whether payments made to
  director is a specified domestic transaction?

78
Case Study 3 (contd)
Where US Co has PE in India
79
Case Study 3 (contd)
Where Ind Co is Subsidiary of US Co
Salary paid
80
Case Study 3

• Salary paid to Mr. A is not an International
  Transaction in terms of s. 92B r.w.s. 92A since
  data on shareholding of Mr A is not given.
  Therefore, Mr.A is not an AE of US Co as defined
  u/s 92A. But if Mr. A held at least 26 of shares
  in US Co, it would constitute as an international
  transaction and any salary paid to Mr. A would be
  regarded as an international transaction.
• However, if he does not hold any shares still Mr.
  A is a director of US Co and hence covered as a
  related party u/s 40A(2)(b)(ii).
• Since payment is made to related party covered by
  s. 40A(2)(b), the transaction constitutes SDT in
  terms of s. 92BA(i)
• Being SDT, salary payment to Mr. A will be liable
  to Domestic TP and PE will be required to
  benchmark it to ALP, maintain documentation and
  furnish TP audit report.
• Salary paid to Mr. A is required to reported in
  TP Audit Report i.e Form 3CEB by Indian PE. Thus,
  Indian PE may also be exposed to penalty u/s 271G
  if it has defaulted on maintenance of TP
  documentation and/or u/s 271BA if it has
  defaulted on furnishing of TP audit report.
• Million dollar question is how do you demonstrate
  it to be at Arms Length.

81
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