CA Hiren D. Shah Ahmedabad Email: [e-mail]

1
CA Hiren D. ShahAhmedabad Email
hirenindia_at_hotmail.com
Presentation on
Specific
Domestic
Transactions
2
Introduction

• 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
• These new provisions would have ramifications
  across industries which benefit from the said
  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
Implication post - budget 2012 for SDT
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
4
Impact of Domestic Transfer Pricing
5
Intent of Indian TP Regulations (International
transactions)
Shifting of Profits
India
Overseas
Associated Enterprise (AE Co.)
Indian Co.
Tax _at_ 32.45
Tax _at_ lower rate approx 10
Shifting of Losses
Tax Saving for the Group Loss to Indian revenue
6
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
7
Intent of Domestic TPDomestic Tariff Area (DTA)
Scenario 1
Scenario 2
Particulars
Co.A
Co.B
Particulars
Co.A
Co.B
Taxed in India _at_
33
33
Taxed in India _at_
33
33
Sales to RP
150
-
Sales to RP
100
-
Other Income
200
400
Other Income
200
400
Purchases from RP
-
150
Purchases from RP
-
100
Other Expenses
400
200
Other Expenses
400
200
Profit/Loss
(50)
50
Profit/Loss
(100)
100
Tax
-
17
Tax
-
33
Total Tax for the
Total Tax for the
17
33
Group
Group
By shifting of expenses from a loss making
company to a profit making company, the
group could reduce its tax liability by 16.
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Intent of Domestic TPDTA Tax Holiday Unit
Scenario 1
Scenario 2
Particulars
Power
DTA
Particulars
Power
DTA
Taxed in India_at_
0
33
Taxed in India_at_
0
33
Sales to RP
225
-
Sales to RP
150
-
Other Income
300
600
Other Income
300
600
Purchases from RP
-
225
150
Purchases from RP
-
Other Expenses
300
300
Other Expenses
300
300
Profit/Loss
225
75
Profit/Loss
150
150
Tax
-
25
Tax
-
50
Total Tax for the
Total Tax for the
25
50
Group
Group
By shifting of expenses from a tax holiday
unit(Power ) to a unit in the
Domestic Tariff Area, the group could reduce its
tax liability by 25.
To avoid such cases, Domestic TP was introduced.
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What is Specified Domestic Transaction?
Explanation
Payment made or to be made for expenditure
incurred with domestic related parties
Aggregate transaction value exceed INR 50 million
in a financial year
Expenditure incurred between related parties
defined u/s 40A(2)(b)
Section 80IA(8) Any transfer of goods/services
between various undertakings or units of the
assessee. Transfer at market value. Onus on tax
payer. Section 80IA(10) More than ordinary
profits derived from closely connected persons
for claiming deduction to be brought down to
reasonable profits. Primary onus on tax payer.
Onus on tax authorities as well

• Undertaking to which profit linked deductions are
  provided, covering
• Inter-Unit transfer of goods and services 80 IA
  (8)
• Transactions between entities having close
  connection and generating more than ordinary
  profits 80 IA (10)

Any Allowance for an expenditure or interest or
allocation of any cost or expense or any income
in relation to the specified Domestic transaction
shall be computed having regard to the arms
length price
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CONCEPT OF ARMS LENGTH PRICE (ALP)

• Concept of ALP applicable for determining taxable
  income arising from international transaction
  introduced in 2001, now extended to SDTs
• ALP defined to mean a price which is applied or
  proposed to be applied in a transaction between
  persons other than AEs, in uncontrolled
  conditions
• Comparability and FAR fundamental to the concept
  of ALP
• Comparison of conditions in a controlled
  transactions with conditions in transactions
  between uncontrolled enterprises
• Compensation usually reflects functions performed
  (taking into account assets used and risks
  assumed)
• ALP concept usually relevant for transactions
  between separate enterprises may need to be
  applied by analogy to SDT involving inter-unit
  transfer of goods/ services

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What is Arms Length Pricing?

• Arms length price means a price which is
  applied or proposed to be applied in a
  transaction in uncontrolled conditions
• Arms Length price is determined using the Most
  Appropriate Method
• If more than one comparable price is obtained
  using above methods, then the arms length price
  would be Arithmetic Mean of comparable prices
• Deviation of plus / minus three percent is
  permitted from arms length price

Methods Comparability
Comparable Uncontrolled Price Method Price of the transactions
Resale Price Method Gross margin of company reselling products / services to unrelated parties
Cost Plus Method Gross margin of company selling manufactured products / services to related parties
Profit Split Method Splits profits between parties to transactions based on economic parameters
Transactional Net Margin Method Net Profit margin (Operating Profit) of Tested Party
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Fair Market Value vs. Arms Length Price

• Domestic Transfer Pricing usher shift from
  generic Fair Market Value concept to Arms
  Length Pricing

Characteristic Fair Market Value Arms Length Pricing
Definition The price which goods or services would have fetched or cost in the open market A price which is applied in a transaction in uncontrolled conditions
Computation Mechanism No specific mechanism provided in law Most appropriate method out of five prescribed methods
Transaction Value Any market pricing point can be treated as fair market value Arithmetic mean of comparable prices treated as arms length price
Sample Size One comparable may be sufficient to establish fair market value Require bigger sample size for establishing arms length
Deviation No deviation permitted from fair market value Deviation of plus / minus three percent is permitted
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Determination of Arms Length Price-the approach
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Methods for Determination of ALP

• Price applied in a transaction between
  independent enterprises in uncontrolled
  conditions
• To be determined by applying the Most Appropriate
  Method, being one of the following five methods
• Comparable Uncontrolled Price (CUP) Method
• Resale Price Method (RPM)
• Cost Plus Method (CPM)
• Any other method
• Profit Split Method (PSM)
• Transactional Net Margin Method (TNMM)
• In case, more than one price is determined by
  MAM
• Apply Arithmetic mean
• Range of 3 of the arithmetic mean

Traditional transaction methods
Transactional profit methods
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Six methods to determine the ALP of the
transaction
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• Comparable Uncontrolled Price Method
• Comparison of price charged to a related party
  with the price charged to independent third
  parties or price charged between two independent
  parties under similar circumstances.
• Resale Price Method (RPM)
• This method is generally used in the case of
  distributor or re-seller model with reference to
  gross profit earned from such transactions.

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• Cost Plus Method
• CPM is used for examining transactions comprising
  provision of services or manufacturing activities
  with reference to gross profit earned from such
  transactions.
• Profit Split Method (PSM)
• It is used where transaction involves intangibles
  or transaction is complex. In the Indian context,
  the use of this method is very limited.

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• Transactional Net Margin Method (TNMM)
• The method examines net profit margin relative to
  an appropriate base that a taxpayer realises
  from a transaction with related party. This
  method is widely used and the most preferred
  method.
• Any other Method
• It can be any method which can help in
  determining the arms length price (ALP) of the
  transaction.

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Steps
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KEY PROVISIONS OF SDT

• S. 40A(2)
• S. 80A(6)
• S. 80IA(8)
• S. 80IA (10)

21
Legislature intention behind insertion of Section
40A(2)

• To check evasion of tax through excessive or
  unreasonable payments to relatives and associate
  concerns and should not be applied in a manner
  which will cause hardship in bona fide cases.
• AO is expected to exercise his judgment in a
  reasonable and fair manner

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Reasonableness of expenses to be judges having
regards to

• Fair market value of the goods, services or
  facilities for which the payment is made, or
• The legitimate needs of the business or
  Profession
• The benefit derived by or accruing to the assesse
  from the expenditure
• The above view is expressed by Honble Guj High
  Court in the case of Coronation Flour Mills vs.
  Asst. CIT 2009 314 ITR 1

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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
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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)
Assessee (Taxpayer)
C Ltd
Mr. D
Director
Substantial interest gt20
Relative
Assessee (Taxpayer)
Substantial interest gt20
Substantial interest gt20
A Ltd
Substantial interest gt20
B Ltd
A Ltd
Mr. C
Covered transactions
Holding Structure
25
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
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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
27
Domestic TP may even apply to cross border
transactions

• Generally, Domestic TP covers domestic
  transactions. However it does not indicate that a
  SDT should not be a cross border transaction.
• It does not also mean that both parties should
  necessarily be residents.
• Example Payment to a non-resident director
  covered u/s 40A(2)

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Categories of assessee not covered u/s 40A(2)

• Person indirectly related circular No. 61 dated
  July, 6 1968
• Body of Individuals
• Co-operative Societies
• Trust

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Expenditure

• Scope of section is restricted only to
  disallowance of any expenditure incurred.
• 40A(2) cannot be applied in a case where no
  expenses have been claimed as a deduction by the
  assessee.
• It does not embark upon measuring the
  reasonableness of income earned by the assessee
  for the related party transaction in the nature
  of income not covered.
• (sale at a lower price or trade discount)

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Notional Income

• International TP gives tax authorities authority
  to impute notional income while it is not
  possible in case of domestic TP.
• Domestic TP may best lead to disallowance of
  excessive expenditure as only expenditure is
  covered by section 40A(2) of the Act.
• Only certain capital expenditure covered (fully
  claimed as deduction)

31
Tax burden, if transaction not at ALP
32
S.80A(6) S.80 IA(8)

• SDT provisions apply to business transactions/
  transfers referred to in section 80A, 80IA(8),
  80IA(10), 10AA, Chapter VI-A provisions Section
  80A(6) and Section 80IA(8) require adjustment to
  tax holiday profits where
• Goods and services of eligible business are
  transferred to any other business carried on by
  the same taxpayer and vice versa
• Consideration for such transfer as recorded in
  the accounts of eligible business does not
  correspond to market value of such goods/
  services
• In such cases, tax authorities/ taxpayer
  required to re-compute tax holiday claim by
  reference to ALP of such goods/ services

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• Overlap between 80A(6) and 80IA(8) not of much
  consequence
• Is in the nature of notional adjustments for
  determining profits eligible for tax holiday
• Applies to all tax holiday claims under Chapter
  VI-A/ Section 10AA
• Onus on tax payer to establish that goods and
  services transferred at market value.

34
Section 80 IA(8) vis-à-vis Section 80 IA(10)
Difference Section 80 IA(8) Section 80 IA(10)
Deals with Internal transfer of goods and services External transfers, i.e. transactions with other parties
Applicability Application of this section is automatic. Application of this section requires the AO to form an opinion that the transaction has been arranged by the assessee for showing higher profits in the eligible business
Assessing Officers Role AO needs to prove only whether the recorded values of the transfers is at market value or not and accordingly, determine the eligible profits Here, AO is required to prove both the fact that the profits shown by the eligible business is inflated as also the motive/intension of the assessee to inflate such profits.

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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
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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

• No guidance on the meaning of close connection
• To align ordinary profits with arms length
  price. For example
• OP/ TC of 30 considered to be at arms length by
  the TPO
• Under 801A(10) the AO states that the profits are
  more than ordinary
• Solution Defend price or evaluate alternate
  methods (other then profit based)
• Impact of non-charging of services/ costs to tax
  holiday undertaking

ALP of 5 comparable companies OP/TC Mark-up of the tax holiday entity OP/TC
Arithmetic mean 15 30
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Close connection

• The language used in Section 80IA (10) states
  that owing to the close connection . the
  course of business is so arranged.
• However, the close connection used in Section
  80 IA(10) has not been defined in the Act.
• Hence, for the purpose of this section, close
  connection is only a method of ascertaining as to
  whether there is any arrangement made by the
  assessee for inflating the eligible profits.
• But one cannot presume the existence of close
  connection or possibility of arrangement for
  earning more than ordinary profits.
• Unlike Section 40A(2)(b), 92A, even though the
  scope of Section 80IA (10) has been left wide and
  open to cover any transaction, as long as the AO
  cannot substantiate that the course of business
  has been so arranged, owing to whatever
  reasons, Section 80 IA (10) can not be invoked.

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Close connection?
Particulars
AS-18
40A(2)(b)
92A(2)
Voting Power
gt50
gt20
gt26
Direct or indirect
Both
Direct
Both
holding
Directors
Key Managerial
Directors
Not covered
Personnel
Key Suppliers
Specifically excluded
Not covered
More than 90
supplies
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Comparative Analysis
Section 40A(2)(b) Section 80 IA (10)
Substantial Interest is defined under the Act. No guidance provided for closely connected persons
SDT will not be applicable on any payment made to step down subsidiaries for providing goods or services SDT will be applicable for any transactions between company and its step down subsidiaries carrying on eligible business
40
Meaning of Specified Domestic Transaction

• Means

Transaction covered under Section Applicability
clause (b) of sub section (2) of Section 40 Any expenditure
Sub section (6) of 80A Computing Section ( Determination of ALP)
Sub section (8) of Section 80IA Profit based deduction Any transfer of goods or services within units Intra Units
Sub section (10) of Section 80IA Profit based deduction Any business transacted within closely connected entities
In any of the section Any other transactions as may be prescribed
41
Key differences in the provisions relating to
Domestic TP and International TP
42
Types of Transactions covered

• International TP inter alia covers both income
  and expenditure transactions while Domestic TP
  covers transactions of expenditure only ie
  transactions covered u/s 40A(2).
• As regards other transactions falling under
  sections 80A(6)/ 80-IA(8)/ 80-IA(10)/ 10AA of the
  Act specified for Domestic TP purposes, both
  expense or profit from transactions are covered.

43
Shareholding criteria for applicability of TP
Provisions

• International TP provisions prescribe a
  shareholding criteria of 26 for applicability
  of TP while under Domestic TP a beneficial owner
  of shares carrying not less than 20 of voting
  power or beneficially entitled to share not less
  than 20 of profits shall be treated as a person
  covered u/s 40A(2).
• Indirect shareholding is covered under
  International TP while clarity is not there in
  this regard in case of Domestic TP.

44
Most Likely effected Industries..

• Industries operating in SEZs
• Infrastructure Developers
• Infrastructure Operator
• Telecom Services
• Industrial Park Developers
• Power Generations or Transmission

45
Most Likely Transactions under Scanner of SDT

• Interest free Loans to Group Companies Sub
  section 8 of Section 80IA
• Granting of Corporate Guarantees/ Performance
  Guarantees by Parent Company to its subsidiaries
  Sub section 8 of Section 80IA
• Intra-group purchase/ sell/ service transactions
  Sub section 8 of Section 80IA
• Payment made to key personnel e.g. transaction
  with Directors/CFO/CEO etc.. Section 40A(2)(b)
• Payment made to key personnel of Group Companies.
  Section 40A(2)(b)
• Payment made to relative of key personnel of the
  assessee/group companies. Section 40A(2)(b)

46
Critical Issues..

• Provisions applicable only to expenditure where
  payment is made or to be made
• Does this include capital expenditure? Section
  40A(2)(b)
• Does this include transactions without
  consideration? Section 80IA(8) 80IA(10)
• Does threshold apply to the amount recorded in
  the Books of Account or Amount determine as per
  ALP?
• Wide coverage and goes beyond the related parties
  covered under AS-18
• Whether Government approval u/s 295, 297 of the
  Companies Act would be relevant?

47
Critical Issues..

• Applicability of OECD TP guidelines
• Advance Pricing Arrangement
• Benefit of range
• Corresponding adjustment

48
Should capital expenditure be considered under
provisions of Sec 92BA?
49
Difficult to establish Transactions at ALP

• Commission to relatives of the directors/
  partners
• Salary paid to the relatives of the
  directors/Partners
• Remuneration to the directors
• Extra Purchase Price and Interest foregone to
  relatives
• Good sold at lower than market price if bona fide
• Higher Purchase Price than rates prevailing in
  the market
• Interest paid to sister concerns at rate higher
  than normal rates
• Hire Charges of Machinery or Rent paid for use of
  Immovable property

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Domestic TP- Key Issues
51
Indian Company having both SDT as well as
international transactions

• When an Indian company is having both
  international transactions as well as SDT,
  whether SDT are required in the following
  scenarios
• When the value of aggregate of international
  transactions and SDT is less than INR 5 crores.
• When the value of aggregate of international
  transactions and SDT is more than INR 5 crores,
  but value of SDT is less than INR 5 crores.
• The taxpayer would need to report only
  international transactions and not SDT if the
  aggregate value of SDT is less than INR 5 crores.

52
Benchmarking of Directors Remuneration

• Domestic TP provisions cover expenditure under
  section 40A(2) of the Act, which includes
  payments to any directors.
• Fees payable to a director depends on factors
  such as directors roles-responsibilities,
  experience, size and area of operation of company
  etc..
• Any kind of payment such as salary, sitting fees,
  commission, various allowances to any director be
  it a comprehensive package to a chairperson or
  sitting fees to independent director will all be
  covered under Domestic TP.

53
Reference to Transfer Pricing Officer (TPO) with
respect to transactions covered under Domestic TP

• In case of international TP, there is a set of
  process for reference to the TPO.
• However, as stated earlier in this note, there is
  yet no legislation in relation to Domestic TP.

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Compliance Requirements
55
What documentation would be required?
Entity Related
Price Related
Transaction Related
Entity Related
Price Related
Transaction Related

Profile of Industry

Transaction terms

Agreements

Functional

Profile of group

Invoices
Analysis

Profile of related

Pricing related
(functions, assets
parties
correspondence
and risks)
(letters, e-mails,
Economic

fax, etc.)
Analysis (method
selection,
comparable
benchmarking)
Forecasts,

budgets,
estimates
56
Taxpayer would need to comply with the following

• Maintain and keep information and documents in
  relation to such transactions as statutorily
  required.
• Obtain and file an accountants report in respect
  of such transactions along with his return of
  income.
• All existing TP compliance requirements,
  mandatory documentation, TP audits (assessments)
  and penalty provisions would be applicable,
  though provisions have yet not been legislated
  for TP audits for SDT.

57

• 10th June 2013 CBDT, vide Notification No. 41
  amended the Income Tax Rules, 1962 10A to 10E and
  included SDT as regards application of various
  methods, comparability etc.
• The Rules now include the definitions of the
  terms Associated Enterprise and Enterprise in
  relation to SDT.
• The new form 3CEB now includes SDT.

58
Documentation requirements

• In case of SDT, documentation is required where
  aggregate value exceeds INR 5 Crores.
• In case of International TP, detailed
  documentation is not required if aggregate value
  of transactions is less than INR 1 Crore.

59
New Accountants Report Form 3CEB

• The new Form 3CEB (the Form) contains 25
  clauses requiring disclosure of the details of
  the various international transactions and
  specified domestic transactions.
• The Form is broadly divided into 3 parts.
• ? Part A deals with general information about
  the taxpayer
• ? Part B is in relation to International
  transactions and
• ? Part C deals with Specified domestic
  transactions
• This new Accountants Report has to be signed by a
  Chartered Accountant and submitted to the Tax
  Department before the due date of filing return
  of income

Issuance of Accountants Report in Form 3CEB
Timeline is before 30 November 2013
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APA SAFE HARBOUR AND DRP
APA - No
APA framework will apply only to international
transactions and
not to SDT
Safe Harbour

• Safe Harbour provisions are not applicable to
  transactions covered under Domestic TP.

DRP - Yes
Eligible assessee as defined under Sec 144C
means any person in whose case the variation of
total income arises as a consequence of TPO?s
order u/s 92CA(3)
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Penalty Implications
Impact Impact Quantum of Penalty
Penalty Sec 271AA Failure to keep and maintain Transfer Pricing documentation Failure to report such transaction which is required to do so Maintaining or furnishing incorrect information or documents 2 of value of each international transaction
Penalty Section 271G Failure to furnish / submit any information / document to the transfer pricing officer 2 of value of international transaction for each such failure
Penalty Section 271BA Failure to furnish accountants report in Form No. 3CEB INR 100,000
Penalty Section 271(1)(c) Transfer pricing adjustment Concealment of income or furnishing inaccurate particulars of income 100-300 of amount of tax sought to be evaded on concealment of particulars of income or furnishing inaccurate particulars of such income

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