Representation

Thanking you,

We remain,

Yours truly,

For Bombay Chartered Accountants’ Society

Naushad Panjwani                               Kishor Karia                            Deepak Shah
President                                             Chairman                                  Co-Chariman
                                                                   International Taxation Committe

Representation on applicability of Transfer pricing provisions to Specified Domestic Transactions covered u/s. 40A(2)

Legislative Intent behind introduction of Domestic Transfer Pricing provisions for certain Specified Domestic Transactions:

The introduction of the provisions for domestic transfer pricing was an outcome of the suggestions given by Honourable Supreme Court in CIT vs. Glaxo Smithkline Asia (P) Limited 236 CTR 113.

The Hon’ble Supreme Court while deciding on the issue of section 40A(2) made some of the important observations as under:

• The present Transfer pricing provisions does not apply to domestic transactions

• In domestic transactions, under invoicing and over invoicing will be revenue neutral, except in two circumstances:

i. Where one of the related entities is loss making or

ii. Where one of the related entities is liable to pay tax at a lower rate and the profits are shifted to such entity.

The Explanatory Memorandum to Finance Bill 2012 clarifies that the genesis of these provisions lies in suggestion made by the Supreme Court (SC) in the case of CIT vs. Glaxo Smitkline Asia (P) Ltd. (supra). The relevant points from the explanatory memorandum explaining the intent for introduction of domestic transfer pricing provisions are as follows:

• Presently there is no method prescribed to determine reasonableness of expenditure to re-compute the income in related party transactions

• There is a need to provide objectivity in determination of income and determination of reasonableness of expenditure in domestic related party transactions

• There is a need to create legally enforceable obligation on assessee to maintain proper documentation

Thus based on the observations of the Hon’ble Supreme Court, the Finance Act 2012 has extended the applicability of the transfer pricing provisions for specified domestic related party transactions with an intent:

• To discourage tax abuse where the companies resort to tax arbitrage by shifting of profits by undertakings having huge accumulated losses/ enjoying tax holidays/ differential tax rates.
• To shift from Fair Market Value (FMV)/ ordinary profit to Arms Length Price (ALP).

These SDT are contained in section 92BA of the Income Tax Act, 1961 (‘Act’) which is reproduced hereunder:

Section 92BA – Specified Domestic transaction

“Specified Domestic Transactions” in case of an assessee means any of the following transactions, not being an international transaction, namely –

i. any expenditure in respect of which payment has been made or is to be made to a person referred to in clause (b) of s/s. (2) of section 40A;

ii. any transaction referred to in section 80A;

iii. any transfer of goods or services referred to in s/s. (8) of section 80-IA;

iv. any business transacted between the assessee and other person as referred to in s/s. (10) of section 80-IA;

v. any transaction, referred to in any other section under Chapter VI-A or section 10AA, to which provisions of s/s. (8) or s/s. (10) of section 80-IA are applicable; or

vi. any other transaction as may be prescribed, and where the aggregate of such transactions entered in to by the assessee in the previous year exceeds a sum of Rs. 5 crore.

The major implication in a case where a transaction is classified or covered under SDT, then FMV as contemplated by any of the specified provisions will need to be determined in accordance with ALP as defined in the section.

If section 92BA is applicable,

• ALP as determined by adopting most appropriate method as per section 92C(1) will be considered as measure of FMV for transactions specified u/s. 92BA. This makes it mandatory for the taxpayer to compute ALP as per methods specified u/s. 92C (including sixth method recently notified on 23rd May 2012).

• The taxpayer is also obliged to maintain contemporaneous documents u/s. 92D as also obliged to obtain & furnish auditor’s report u/s. 92E of the Act.

While the objective for introduction of the domestic transfer pricing provisions to discourage tax abuse and curb tax evasion on account of tax arbitrage resorted by the tax payers seems laudable and the application of the said provisions with respect to transactions relating to sections 80A, 80IA, 10AA is reasonable but application of said provisions for transactions covered u/s. 40A(2) does not seem to have any logic and sound reasoning, as it is impossible to get comparable cases from public domain. Business is not conducted, either with third party or with related one, in the real life based on Public database or theory of methodology as prescribed u/s 92C of the Income Tax Act, 1961.

The host of transactions that could be covered under the ambit of domestic transfer pricing regulations u/s. 40A(2) are as follows:

• service, maintenance and administration charges

• construction cost and purchase of material

• corporate guarantee charges

• Interest payments on loans advanced amongst group companies

• payment of royalty

• shared services cost/management cross charges

• payments to directors and/or their relatives

•    ESOP and/or ESOS cost reimbursed

The provisions of section 40A(2) are analysed in detail below to rationalise the assertion that domestic transfer pricing provisions should not be applicable in case of section 40A(2).

Analyzing the provisions with respect to section 40A(2) to evaluate whether the intended objective is achieved:

Attention is invited to departmental Circular No. 6 – P dated 06-07-1968 and Circular No. 4 – P [LXXVI-65] dated 07-06-1968. Relevant extract of the said circular is reproduced below:

“It may be noted that the new provision is applicable to all categories of expenditure incurred in businesses and professions, including expenditure on purchase of raw materials, stores or goods, salaries to employees and also other expenditure on professional services, or by way of brokerage, commission, interest, etc. Where payment for any expenditure is found to have been made to a relative or associate concern falling within the specified categories, it will be necessary for the Income-tax Officer to scrutinise the reasonableness of the expenditure with reference to the criteria mentioned in the section. The Income-tax Officer is expected to exercise his judgment in a reasonable and fair manner. It should be borne in mind that the provision is meant 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 bonafide cases.” (Emphasis provided)

Thus the provisions of section 40A(2) were introduced in order to check whether the Taxpayers carrying on business transactions with related parties made excessive and unreasonable payments/expenditure, provisions of section 40A(2) were introduced in the Act in the year 1968, which empowered the tax authority to disallow payments to ‘related parties’ which are excessive or unreasonable.

Following are the existing provisions under the Act, that provide for transactions between related parties should be valued at market value:

Section 40A(2) – Expenses or payments not deductible in certain circumstances. The existing provisions of clause (a) of s/s. (2) of the aforesaid section 40A provide that:

•    where the assessee incurs any expenditure in respect of which payment has been or is to be made to any person referred to in clause (b) of the said section, and

•    the Assessing Officer is of the opinion that such expenditure is excessive or unreasonable having regard 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 of the assessee or the benefit derived by or accruing to him there from, so much of expenditure as is so considered by him to be excessive or unreasonable shall not be allowed as deduction.

A fair market value is required to be assigned to the transactions between related parties in terms of section 40A(2). However, there was no specific valuation machinery/methodology prescribed in the Act to find out whether the same is at fair market value or not. Thus, though the provisions have existed under the law since 1968, these were rendered subjective in absence of specific method being prescribed to ascertain and demonstrate the FMV. Thus, there has been an ongoing litigation on this subject and the desired objective of working out reasonable expenditure applying FMV has not been achieved in reality.

Having regard to judicial precedent on the subject, and particularly having regard to Circular 6-P of 1968, section 40A(2) can be regarded as anti abuse provision where the onus of proving fulfillment of all the conditions which result in disallowance lie on the AO.

It is respectfully stated that the intent of legislature for extending transfer pricing regulations to domestic transactions and bringing within the ambit of SDT the payments covered u/s. 40A(2) would become superfluous/ redundant where the parties amongst whom the transaction has been undertaken are subject to same rate of tax and there is no tax arbitrage.

It can be observed that the provisions of section 40A(2) were introduced way back in 1968 and were meant to cover cases of tax evasion. These regulations were issued / enforced at a point of time when there were soaring rates of tax and there existed host of incentive provisions under the Act. However, over a period of time the provisions have been rationalised and liberalised whereby most of the incentives have faded out. Currently the scenario is such that all entities are subject to almost the same rate of taxation and in cases not less than Minimum Alternate Taxes (MAT).

Though we agree and strongly believe that specified domestic transactions should be applicable in cases where there is possibility of resorting to tax arbitrage i.e. in case of transaction between a loss making entity and a profit making entity. However even in this case, it can be appreciated that the tax arbitrage available would be only in form of deferring the tax liability to later date since by shifting of income from a profit making company to a loss making company, the group could reduce its tax liability for the current year, though the impact will be reversed in future years given carry forward of losses. Also considering the position of book losses there could arise a situation where the loss making entity would be liable to pay the Minimum Alternate Tax. Accordingly in our view where the parties involved in the transaction are subject to almost same rate of tax there is little scope of resorting to tax arbitrage.

Further the provisions as prescribed currently have aroused various issues such as:

•    Whether indirect shareholding is covered?

•    Whether shareholding of individual directors can be aggregated for determining substantial interest?

•    Benchmarking issues?

Accordingly in our view, bringing the transactions covered u/s. 40A(2) under purview of domestic transfer pricing provisions necessitating the taxpayer to benchmark the transactions to arrive at arm’s length price of such transaction is burdensome, will lead to increase in compliance burden and causes lot of inconvenience for the assessees which may not be desirable.

Relevant issues arising with respect to benchmarking payments covered by section 40A(2):

ALP Concept

•    Concept of ALP applicable for determining taxable income arising from international transactions which was introduced in 2001 is now extended to SDT.

•    ALP defined to mean a price which is applied or proposed to be applied in a transaction between persons other than Associated Enterprises (AEs), in uncontrolled conditions.

•    Comparability and Functions, Assets and Risks (FAR) fundamental to the concept of ALP

•    Comparison of conditions in a controlled transaction with conditions in transactions between uncontrolled enterprises

•    Compensation usually reflects functions performed (taking into account assets used and risks assumed) (FAR)

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.

Methods prescribed for computing ALP

ALP is required to be computed using any of the following methods being the most appropriate method

•    Comparable uncontrolled price method (CUP)

•    Resale price method (RPM)

•    Cost plus method (CPM)

•    Profit split method (PSM)

•    Transactional net margin method (TNMM)

•    Such other method as may be prescribed by the Board – method prescribed in May 2012 by inserting Rule 10AB. The rule is reproduced herewith:

“10AB. For the purposes of clause (f) of s/s. (1) of section 92C, the other method for determination of the arm’s length price in relation to an international transaction shall be any method which takes into 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.”

Rules provide guidance on application of the methods and factors to be considered in selecting the most appropriate method.

Deficiency in prescribed methods and absence of introduction of practicable and thoughtful method/ approach

It is important to note that even though the provisions of SDT provide for determining the ALP of the domestic transactions by applying the methods that are prescribed for international transactions, however, it would be difficult to apply the prescribed methods to determine the ALP of domestic transactions. This would lead to enormous litigation for tax authorities and taxpayers.

It would be appreciated that no method has been formulated for the purpose of benchmarking the specified domestic transaction but the methods prescribed by OECD (Organization for Economic Co-operation Development) which is applicable for international transactions has been made applicable even for benchmarking specified domestic transactions. It is big challenge for the taxpayers to collate data of comparable transactions/ comparable companies from the public databases available for benchmarking the specified domestic transactions. In several instances it is impracticable to benchmark the specified domestic transactions.

For instance – Payment of managerial remuneration

It is impractical to benchmark payment of remuneration to the directors/ other payments to directors. Salary of directors is determined by the management based on several factors viz qualifications, experience which are individual traits and varies from company to company. Certain judicial precedents have accepted the view that if the managerial remuneration is within the limits prescribed in the Companies Act, 1956, the same is a reasonable expenditure u/s. 40A(2)(b).

The table below explains the concepts of FMV and ALP. There are lot of contentious issues on this subject as to whether FMV is different from ALP? Is ALP synonymous with Market value?

Applicability of regulations resulting in Economic double taxation

Further, application of the domestic transfer pricing provisions to payments covered by section 40A(2) may result in to economic double taxation. Here , one may appreciate that even the Hon’ble Supreme court in its observations have specified that under invoicing or over invoicing would be revenue neutral except under the two circumstances as specified. Thus, where the payment covered under section 40A is made amongst two entities both of which are subject to same rate of tax it is in effect a tax neutral situation. Specified Domestic Transactions are not meant to cover revenue neutral transactions lest it would result in economic double taxation. The transfer pricing adjustments for Specified Domestic Transactions would result in double taxation in revenue neutral cases and hence corresponding adjustments are warranted. The provisions of subsection 4 of section 92C ‘Computation of arm’s length price’ is reproduced below for ready reference:

(4)    Where an arm’s length price is determined by the Assessing Officer u.s/s. (3), the Assessing Officer may compute the total income of the assessee having regard to the arm’s length price so determined :

Provided that no deduction u/s. 10A 93[or section 10AA] or section 10B or under Chapter VI-A shall be allowed in respect of the amount of income by which the total income of the assessee is enhanced after computation of income under this sub-section :

Provided further that where the total income of an associated enterprise is computed under this sub-section on determination of the arm’s length price paid to another associated enterprise from which tax has been deducted 94[or was deductible] under the provisions of Chapter XVIIB, the income of the other associated enterprise shall not be recomputed by reason of such determination of arm’s length price in the case of the first mentioned enterprise.

It can be observed from the above provisions that the regulations do not contemplate any correlative adjustments and do not permit recomputation of income of the recipient enterprise 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.

Applicability    of    regulations    resulting    in Unreasonable  burden  of  compliance  cost  on industry and business
    
It  would  further  be  appreciated  that  the enforceability of the aforesaid provisions would result in unreasonable burden of compliance cost on industry and business. Firstly, it is a big challenge for the taxpayers to collate data of comparable transactions/comparable  companies  from  public databases  for  benchmarking  their  transaction, further maintaining documentation and observing the  compliance  requirements  would  lead  to unreasonable burden and cost for the taxpayers.

To conclude it is respectfully submitted that the introduction  of  Specified  domestic  transactions may be useful except in cases of Section 40A(2). In circumstances where there is no base erosion and in instances as described above which result in to tax neutrality, the provisions of domestic transfer pricing  should  not  be  extended  to  payments covered u/s. 40A (2) which cause undue hardship and compliance burden to the taxpayers withoutany significant benefits to the revenue. Accordingly, Section 40A(2) should be excluded from the net of Specified domestic transactions.