TRANSFER PRICING DOCUMENTATION

In a world where multinationals are seated across various locations around the globe, with centralised functions, varied operations and complex inter-company transactions, documentation assumes a crucial role for taxpayers. India, with regard to documentation has been no different. Indian revenue authorities, with regards to documentation, have always been stringent, leading to significant litigation for multinational organisations. Rule 10D of the Income Tax Rules, 1962 (the Rules) prescribes detailed information and documentation that has to be maintained by the taxpayer. While some of the requirements are general in nature, others are more specific to the relevant international transactions.

Further, in recent years, the Organisation for Economic Cooperation and Development (OECD) has been concerned with the effectiveness of current transfer pricing documentation guidance. As part of the several initiatives around Base Erosion and Profit Shifting (BEPS), the OECD has released its action plan on transfer pricing documentation. Action 13 of the BEPS Action Plan relates to re-examination of transfer pricing documentation seeking to enhance transparency to tax administrations, taking into consideration compliance costs for business. Action 13 of the BEPS Action Plan proposes a replacement to ‘Chapter V- Documentation” of the OECD transfer pricing guidelines providing a general guidance on documentation process from the perspective of both the taxpayer and the tax administration and consists of the following three parts:

i) Master file containing information relevant for all Multinational group members;

ii) Local File referring specifically to material transactions of the local taxpayer, and analysis of the same; and

iii) T emplate of country-by-Country report (CBC) illustrating global allocation of profits, taxes paid, and other indicators of economic activity.

REGULATORY FRAMEWORK
Section 92D of the Income-tax Act, 1962 (The Act) read with Rule 10D(1) of the Rules deal with maintenance of prescribed information and documentation by the taxpayer. The said requirement can be broadly segregated into two parts: I. The first part of the Rule lists out mandatory documents/ information that a taxpayer must maintain. The extensive list under this part can be further classified into the following three categories:

• Enterprise-wise documents (capturing the ownerships structure, group profile, business overview of the tax payer and the AEs etc.). These documents would typically cover requirements of Rule 10D(1)(a) to (c) of the Rules

• Transaction-Specific documents [capturing the nature and terms of contract description of the functions performed, assets employed and risks assumed (popularly known as ‘FAR ’ Analysis) of the each party to the transaction, economic and market analyses etc.] These documents would typically cover requirements of Rule 10D(1)(d) to (h) of the Rules; and

• Computation related documents (capturing the methods considered, actual working assumptions, adjustments made to transfer prices, and any other relevant information/data relied on for determining the arm’s length price etc.). These documents would typically cover requirements of Rule 10D(1) (i) to (m) of the Rules.

II. The second part of the Rule provides that adequate documentation be maintained such that it substantiates the information/analysis/studies documented under the first part of the Rule. Such informationcan include government publications, reports, studies, technical publications/ market research studies undertaken by reputable institutions, price publications, relevant agreements, contracts, and correspondence, etc.

While the transfer pricing regulations have laid down the requirement for maintenance of various types of documents, tax payers need to assess and ensure that the extensiveness of each of the above documents/ information should be in sync with the nature, type and complexity of the transaction under scrutiny.

Further, Rule 10D(4) of the Rules require that all the prescribed information and documents maintained by the tax payer to demonstrate the arm’s length nature of the transactions documents and information have to be contemporaneously maintained (to the extent possible) and must be in place by the due date of the tax return filing. E.g.,Companies to whom transfer pricing regulations are applicable are currently required to file their tax returns on or before 30th November following the close of the relevant tax year. The prescribed documents must be maintained for a period of nine years from the end of the relevant tax year, and must be updated annually on an ongoing basis.

As an exception to the above, the Proviso to Rule 10D(4) of the Rules provides that if a transaction continues to have effect over more than one previous year, fresh documentation need not be separately maintained in respect of each year, unless there is a change in nature and terms of the transaction, assumptions made and/ or any other factor that would have a bearing on the transfer price. Given this, it is extremely important for tax payers to scrutinise, on a yearly basis, whether any fresh documentation is required to be maintained for any of the continuing transactions.

Further, there is relaxation provided in case of the taxpayers having aggregate international transactions below the prescribed threshold of Rs. 1 crore and specified domestic transactions below the threshold of Rs. 5 crore from the requirement of maintaining the prescribed documentation. However, even in these cases, it is imperative that the documentation maintained should be adequate to substantiate the arm’s-length price of the international transactions or specified domestic transactions.

The above documentation requirements are also applicable to foreign companies deriving income liable to tax in India.

The regulations entail penal consequences in the event of non-compliance with documentation requirement. Failure to maintain the prescribed information/document/reporting covered transaction/ furnishing incorrect information or document attracts penalty @ 2% of transaction value.

MAINTENANCE OF INFORMATION AND DOCUMENTATION

Typically, taxpayers undertake transfer pricing exercise culminating in a Transfer Pricing Study Report, which can be said to be meeting the information and documentation required to be maintained under law. Further, such Report would also form the basis of obtaining and furnishing the required Accountants’ Certificate (Section 92E of the Act). Such exercise generally involves the following steps: Information gathering

General information

This would include structural, operational /functional set up of the tax payer and the related parties and the group to which they belong to,information in the form of global transfer pricing policy, if any, etc.

Industry details

This would include tax payers’ key competitors’ information, pricing factors, etc.

Financial

Budgets (including process followed and assumptions) and earlier years’ financial statements (including segmental information if available). Further, details of government policies, approvals, any tax exemptions availed and past assessment would be relevant to understand.

Transaction specific

List of transactions with associated enterprises alongwith related commercial parameters, pricing methodology followed details of similar product dealings with third parties (by tax payer and associated enterprises), availability of comparable prices in public domain, etc.

Functional, Asset and Risk Analysis

Typically referred to as the “FAR analysis”, this is the key element to any transfer pricing exercise. It involves identifying functions performed, assets deployed and risks assumed by the parties to the transaction. The exercise entails determining income attribution between entities basis functions performed, assets deployed and risks assumed by the entities to the transaction.

Further, the above analysis facilitates process of determination of the “Most Appropriate Method” (‘MAM’), identifyingthe “tested party” and ultimately leading to economic/comparability analysis [determination of the Arm’s Length Price (‘ALP’)].

Determination of the MAM and the computation of the ALP

These are concluding steps of the transfer pricing exercise with following key elements:

Determination of the MAM for each tested transaction basis prescribed factors.

Identifying the tested party ie. one of the party to the transaction, which is the one that is least complex (functionally), not owning/owning few intangibles and in respect of which data is more reliable.

Having identified the tested party, one needs to undertake the comparability analysis and compute the ALP.

While undertaking the comparability analysis, it is important that right comparables are used. Further, in this regard, wherever required it is necessary to carry out necessary adjustments so as to have more robust comparability analysis.

As    regards    computation    of    the  ALP,    an    important component for the same is use of appropriate “Profit Level Indicator” (‘PLI’). There are no specific guidelines on the choice of PLI under law; hence, giving taxpayers an option. Further, in the context of Resale Price Method or the Cost Plus Method, the PLI usually adopted is gross margin on operating revenue and gross margin (mark up) on operating cost respectively. Under the Transactional Net Margin Method, the PLI depends on the nature of the transaction (ie, revenue or expense) in the hands of the tested party.

The whole of the above process (step wise) would need to be documented in detail with back up information/ details. Such documentation is typically maintained in the form of a Transfer Pricing Study Report from compliance perspective. Taxpayers undertake such studies on a yearly basis as required under law.

    CONCLUSION

Documentation is the most important and essential element of transfer pricing. From taxpayers perspective, documentation is critical to demonstrate compliance/ meeting with the arm’s length principle. From tax department’s perspective, it has the right to call for the documentation for verifying the compliance with the arm’s length principle.

Further, as discussed earlier, documentation has time and again been a matter of discussion/debate across jurisdictions and has been continues evolving process. The recent development at OECD (BEPS initiative discussed earlier) which seeks to replace its earlier guidance on transfer pricing documentation and proposing information to be provided in the master file and the CBC report; it is believed that the tax administrations will have the resources and information required to conduct a detailed analysis and focused audit.

    JUDICIAL PRECEDENTS

There have not been many precedents per se in the context of adequacy of the prescribed information and documentation maintenance requirements.

    In case of Cargill India Pvt. Ltd, the Delhi Tribunal had adopted a practical interpretation of documentation requirements laid u/s. 92D(3) read with Rule 10D of the Rules. The Tribunal had observed as under:

“It is clear from the consideration of Rule 10D and its various sub-rules, that documents and information prescribed under the above rule is voluminous and it would only be in the rarest cases that all the clauses of sub-rules would be attracted.

….

It is, therefore, clear that one or more clauses of Sub-rule (1) are applicable and not all clauses of the Rule in a given case. It would all depend upon the facts and circumstances of the case more particularly the nature of international transaction carried or service involved.”

As it can be seen from the above, the Tribunal noted that all kinds of information mentioned in Rule 10D of the Rules need not be maintained in each and every case. The nature of information that is relevant would vary depending upon the facts and circumstances of each case. Further, the Tribunal also observed that since the penalty leviable for non-compliance with requirements u/s. 92D(3) of the Act is onerous, its conditions must be strictly met. The notice u/s. 92D(3) of the Act cannot be vague and must require only information prescribed under Rule 10D of the Rules. It must also specify on which particular points the information is required.

Having stated as above, on the other hand, there are various decisions dealing with the importance of documentation in the context of determination of the MAM, selection of tested party and PLI, aggregation of transactions, relevance of FAR analysis, comparability analysis, including manner of identification of comparables, economic and other adjustments carried out so as to undertake meaningful profitability analysis, etc. The underlying principle in each of these precedents has been the need to have adequate and robust documentation, which ultimately assists both, the tax department and the tax payer. Wherever the tax payer has been found to having maintained such information and documentation, it has been able to successfully defend the transfer pricing adopted.