Transfer Pricing – Secondary Adjustments Under Section 92CE

1.0   Introduction

      As the name suggests,
a Secondary Adjustment [SA] follows and is directly consequent upon a primary
transfer pricing adjustment to the taxpayer’s income. The purpose of a SA, as
articulated in the OECD Guidelines is “to make the actual allocation of
profits consistent with the primary transfer pricing adjustment.” SAs are imposed
by the same country imposing the primary adjustment and are based upon the
domestic tax law provisions of that country. Most often, a SA is expressed as a
constructive or deemed transaction (dividend, equity contribution or loan) and
is premised on the view that not only an underpayment or overpayment which must
be corrected and adjusted (primary adjustment), but also the benefit or use of
those funds must be recognized for tax purposes (the SA).

     OECD’s Transfer
Pricing Guidelines for Multinational Enterprises and Tax Administrations (‘OECD
TP Guidelines’) defines the term ‘Secondary Adjustment’ as “a constructive
transaction that some countries will assert under their domestic legislation
after having proposed a primary adjustment in order to make the actual
allocation of profits consistent with the primary adjustment.” SA legislation
is already prevalent in many tax jurisdictions like Canada, United States,
South Africa, Korea, France etc. Whilst the approaches to SAs by
individual countries vary, they represent an internationally recognised method
to realign the economic benefit of the transaction with the arm’s length
position. It restores the financial situation of the relevant related parties
to that which would have existed, if the transactions had been conducted on an
arm’s length basis.

       The underlying
economic premise for the SA is perhaps best expressed in the OECD TP
Guidelines, which state: “… secondary adjustments attempt to account for
the difference between the re-determined taxable profits and the originally
booked profits.”

         OCED Model Convention
only deals with corresponding adjustment. It neither forbids nor requires tax
administrator to make SA. Relevant extract of commentary in OCED model
convention provides that “…nothing in paragraph 9(2) prevents such secondary
adjustments from being made where they are permitted under domestic law of the
contacting state.”

1.1   International
Approaches to SAs

         Globally, the OECD
prescribes SA to take any form including constructive equity contribution, loan
or dividend.

A.     Deemed Capital
Contribution Approach

B.     Deemed Dividend Approach

C.     Deemed Loan Approach.

1.2   Secondary Adjustment
– Global Scenario

1.3   Secondary Adjustment
under the income-tax Act [the Act] – Section 92CE

        India is considered as
one of the most aggressive Transfer Pricing (TP) jurisdictions in the world.
The scope of TP provisions in India is very wide compared to many countries and
the provisions are vigorously implemented resulting in huge adjustments,
demands and lot of litigations. A new provision called “Secondary Adjustment”
is introduced in the Indian TP regulations with insertion of section 92CE by
the Finance Act, 2017.

1.4   Meaning of the term
“Secondary Adjustment”

        Secondary adjustment,
as defined u/s. 92CE(3)(v), means “an adjustment in the books of accounts of
the assessee and its associated enterprise to reflect that the actual
allocation of profits between the assessee and its associated enterprise are
consistent with the transfer price determined as a result of primary
adjustment, thereby removing the imbalance between cash account and actual
profit of the assessee.”

         SA has been recognised
by the OECD and many other jurisdictions. As explained above, normally it may
take the form of characterisation of the excess money as constructive
dividends, constructive equity contributions or constructive loans. However,
section 92CE(2) considers such an adjustment as “deemed advance”.

1.5   Applicability of the
Provisions

         Section 92CE (1)
provides that in the following cases, the tax payer shall make a SA:

        where a primary
adjustment to transfer price (i) has been made suo motu by the assessee
in his return of income; (ii) made by the Assessing Officer has been accepted
by the assessee; (iii) is determined by an advance pricing agreement entered
into by the assessee u/s. 92CC; (iv) is made as per the safe harbour rules
framed u/s. 92CB; or (v) is arising as a result of resolution of an assessment
by way of the mutual agreement procedure under an agreement entered into u/s.
90 or section 90A for avoidance of double taxation.

         It is provided that
the SA provisions will take effect from 1^st April, 2018 and will,
accordingly, apply in relation to the assessment year 2018-19 and subsequent
years.

         Proviso to section
92CE(1) further provides that provisions of SA would not apply in following
situations:

         If, the amount of
primary adjustment made in the case of an assessee in any previous year does
not exceed one crore rupees and the
primary adjustment is made in respect of an assessment year commencing on or
before 1^st April, 2016 i.e. up to AY 2016-17.

1.6   Impact of the
Secondary Adjustment

         Section 92CE(2)
provides that “Where, as a result of primary adjustment to the transfer
price, there is an increase in the total income or reduction in the loss, as
the case may be, of the assessee, the excess money which is available
with its associated enterprise, if not repatriated to India within the time as
may be prescribed, shall be deemed to be an advance made by the assessee
to such associated enterprise and the interest on such advance, shall be
computed in such manner as may be prescribed.” (Emphasis supplied)

         Primary adjustment to
a transfer price has been defined u/s. 92CE(3)(iv) to mean the determination of
transfer price in accordance with the arm’s length principle resulting
in an increase in the total income or reduction in the loss, as the case may
be, of the assessee; (Emphasis supplied)

         “Excess Money” has
been defined u/s. 92CE(3)(iii) to mean the difference between the arm’s length
price determined in primary adjustment and the price at which the international
transaction has actually been undertaken.

1.7   Example

(i)   An Indian company “A” has
sold goods worth Rs. 10 crore to its overseas subsidiary “B”. The arm’s length
price is say Rs.15 crore.

(ii)  The primary adjustment is
made by the AO by applying arm’s length principle amounting to Rs. 5 crore
(15-10).

(iii)  Excess Money Rs. 5 crore.

(iv) “A” will have to debit the
account of “B” by Rs. 5 crore in its books of accounts.

(v)  “A” will have to receive
Rs. 5 crore from “B” within the prescribed time provided in Rule 10CB(1).

(vi) If “A” fails to receive
the sum, then Rs. 5 crore will be deemed advance from “A” to “B” and the
interest on such advance shall be computed in the manner to be prescribed in
Rule 10CB(2).

1.8   Time Limit for
repatriation of excess money [Rule 10CB(1)]

CBDT vide Notification No. 52 /2017 dated 15
June 2017 inserted Rule 10CB providing for Computation of interest income
pursuant to secondary adjustments.

1.9   Rate of Interest for
computation of interest on excess money not repatriated within time limit [Rule
10CB(2)]

The rate of interest is applicable on annual basis.

1.10 Analysis of section
92CE and Rule 10CB

a)   Extra territorial
application – The foreign AE cannot be compelled to accept SA. Even if they pay
up interest, the home jurisdiction may not allow deduction of such interest.
The taxpayer in India will pay tax on such interest but corresponding deduction
may not be available to AE in its home jurisdiction. To that extent there could
be economic double taxation.

b)   Taxpayer would be in a
precarious position if repatriation is not possible due to exchange control
regulation or some other difficulties in AE’s country.

c)   It appears that there may
not be any additional tax consequences in case interest on deemed advance is
not repatriated to India.

1.11 Non-Discrimination –
Domestic Law and Tax Treaty

      Whether the SA in
India may be challenged citing non-discrimination article in DTAA?

         Article 24(5) of UN
Model:

         “5. Enterprises of
a Contracting State, the capital of which is wholly or partly owned or
controlled, directly or indirectly, by one or more residents of the other
Contracting State, shall not be subjected in the first-mentioned State to any
taxation or any requirement connected therewith which is other or more
burdensome than the taxation and connected requirements to which other similar
enterprises of the first-mentioned State are or may be subjected.”

         In the light of
Article 24(5), it may be observed that this paragraph forbids a Contracting
State to give less favorable treatment in terms of taxation or any requirement
connected therewith to an enterprise owned or controlled by residents of the
other Contracting State.

         In India, there is no
provision for SA if an Indian company transacts with another Indian AE whereas
SA rule is applicable when an Indian company transacts with non-resident AE.

         This may tantamount to
discrimination as per non-discrimination provisions in DTAA.

         In this regard useful
reference could be made of the decision in case of Daimler Chrysler India
(P.) Ltd. vs. DCIT [2009] 29 SOT 202 (Pune).

1.12 Probable Issues

         Several issues could
arise from the enactment of the above provisions. Some of them could be as
follows:

(i)    SA in respect of
Transfer Price determined under a Mutual Agreement Procedure (MAP)

       Combined reading of the
section 92CE(1) and the definition of the “primary adjustment” suggest that SA
can be made only when the primary adjustment has been made in accordance
with the arm’s length principle. However, in case of a MAP the price may
not be strictly determined based on arm’s length principles and may be a result
of negotiated price. In such a case, whether SA would sustain?

(ii)   Adjustment by AO

       Section 92CE(1)(ii)
provides for the SA where the assessee has accepted the primary adjustment made
by the AO. Thus, from the plain reading of the provision, it appears that if
the said adjustment is made by CIT(A), then provisions of SA may not be
applicable even if the assessee accepts the same. However, Rule 10CB(1)(ii)
provides that for the purposes of section 92CE(2), the time limit for
repatriation of excess money shall be on or before 90 days from the date of the
order of the AO or the appellate authority, as the case may be, if the primary
adjustments to the transfer price as determined in the aforesaid order has been
accepted by the assessee.

       Further, if the order is
passed by the Dispute Resolution Panel (DRP) and accepted by the assessee, then
the SA would be applicable as in case of reference to DRP u/s. 144C, the
assessment is ultimately made by the AO only.

(iii)  Increased Litigation

       Section 92CE(1) lists
situations wherein the primary adjustment is accepted by the assessee. Thus,
acceptance of primary adjustment is a precondition for invoking provisions of
SA. Accordingly, till the time assessee has not exhausted his appellate
options, he cannot be compelled to accept primary adjustment and consequently
SA cannot be made.

       Another related issue
will be whether SA would apply with prospective effect i.e. from the date of
final judicial determination or will it apply with reference to the date of the
original assessment order.

       Hitherto, an assessee
could accept the primary adjustment by AO to buy the mental peace and avoid
long drawn litigation, but hence forth he will have to continue his fight to
avoid SA.

(iv)  Computation of threshold
of Rs. 1 Crore

       Proviso to section
92CE(1) provides that SA would not be applicable if, the amount of primary
adjustment made in the case of an assessee in any previous year does
not exceed one crore rupees.

       It is not clear as to whether
this limit would be applicable to the aggregate of adjustments during a
previous year (qua previous year) or qua each transaction or
adjustment. To illustrate, if two adjustments are made each amounting to Rs. 65
lakh, then whether cumulative limit is to be considered or limit on a
standalone basis has to be considered. Also, it is not clear as to where the
primary adjustment in respect of one transaction is exceeding Rs. 1 crore and
the other is only for Rs. 10 lakh, whether the SA would be required for both
the transactions.

(v)   Exceptions to the SA

       Proviso to section 92CE
(1) reads as follows:

“      Provided that nothing
contained in this section shall apply, if,– (i) the amount of primary
adjustment made in any previous year does not exceed one crore rupees; and
(ii) the primary adjustment is made in respect of an assessment year commencing
on or before the 1st day of April, 2016.”

       Use of the conjunction
“and” results in lot of confusion. The literal interpretation of the above
provision suggests that both the conditions need to be fulfilled to claim
exemption from SA. If that interpretation is adopted, then it would lead to
absurd results, such as SA would be required for each and every transaction
from AY 2016-17 (even for Re. 1 of the primary adjustment) and if the amount of
adjustment exceeds Rs. 1 crore then the SA would be required in respect of all
past transactions, may be from the start of the TP regulations.

       The logical
interpretation should be to read both the conditions/situations separately. One
should read “or” as a conjunction in place of “and”. This interpretation draws
strength from the Notes on Clauses to the Finance Bill, 2017 where both the
conditions are mentioned separately.

(vi)  Adjustment in the Books
of Accounts

       The definition of the SA
provides for an adjustment in the books of the assessee and it’s AE.

       The above provision
raises several issues:

       How can an Indian TP
regulation provide for adjustments in the books of an AE which is situated in
some other sovereign jurisdiction? Any such adjustment would render the books
and audit procedure of the AE questionable.

       It is also not provided
in which year’s books of accounts of the assessee such adjustments are to be
made, as by the time TP assessment is made the relevant year’s books must be
closed, audited and finalised. Thus, logically the adjustment has to be made in
the year of finalisation (acceptance) of the primary adjustment. Once assessee
makes SA, it may go against him as it will prove that the accounts of the year
in which the original transaction was effected was not recorded correctly and
therefore true and fair view of the accounts was impacted, (assuming the impact
of primary adjustment and SA are material). Transfer pricing is an art and not
an exact science and therefore to avoid such a situation it must be provided
that any such adjustment shall not affect the true and fair view of audited
accounts.

(vii) Transfer Pricing
Regulations in respect of SA

       A question may arise as
to whether the SA could be regarded as a fresh “international transaction” as
it would be deemed to be an advance. However, it would be too farfetched; the
SA is result of international transaction and cannot be cause in itself. If we
interpret it otherwise, then we go into a loop. Accordingly, other requirements
pertaining to reporting, documentation etc. should not apply. However, a
clarification to this effect is highly desirable.

(viii)          Computation of
Interest

       It is provided that the
excess money would be regarded as deemed advance and interest on such advance
shall be computed in the manner prescribed in Rule 10CB(2). However, from the
computation mechanism provided in Rule 10CB(2), it is not clear as to from
which date one needs to compute the interest. Ideally, it should not be from
the date of individual transaction, to avoid complexity in case of multiple
transactions. Logically, it should be from the expiry of the time limit within
which the excess money is required to be repatriated to India.

(ix)  Secondary Adjustment –
Double taxation

       The provision of SA is a
unilateral one. The other country may or may not agree to it. Even primary
adjustment results in double taxation, the SA would only compound the problem
and put assessee to undue hardships. Whereas each country has a sovereign right
to protect its tax base, bilateral or multilateral treaties could help reduce
the rigours of double taxation.

(x)   Repatriation of amount of
SA

       Section 92CE(2) provides
that the excess money owing to SA must be repatriated to India within the
prescribed time period provided in Rule 10CB(1). However, where the SA is made
between an Indian PE of a foreign company and its subsidiary in India, then the
conditions of repatriation would be difficult to comply, unless the Head Office
of the PE remits the amount of SA on behalf of its Indian PE.

(xi)  Implications of SA under
FEMA

       Section 92CE(2) provides
that the excess money to be considered as deemed advance by an Indian
entity/company to its foreign AE. As per FEMA, an Indian entity can lend money
to its foreign AE only upon fulfilling certain conditions and subject to limits
and compliance procedure. Passing an entry in the books of account without
proper compliances could result in FEMA violations.

(xii) Deemed dividends u/s
2(22)(e) of the Act

       Section 2(22)(e) of the
Act provides that payment by way of loan or advance by a company to a specified
shareholder (where the company is holding more than 10% of the voting power) or
to any concern in which he has a substantial interest shall be regarded as
deemed dividend.

       A question arises as to
whether deemed advance due to SAs u/s. 92CE would be regarded as deemed
dividend u/s. 2(22)(e) in the event AE satisfies the conditions of requisite
shareholding or is considered as an interested concern?

       Two views are possible
in this case:

       According to one view,
once a sum is considered as an “advance” all logical consequences under the Act
would follow and accordingly it ought be regarded as advance for the purposes
of section 2(22)(e).

       The other and more
plausible view is that section 2(22)(e) should not apply in such a situation
for various reasons. One of the important reason could be that the section
2(22)(e) refers to “any payment by a company….., of any sum… made.. by way of
advance…” and hence the emphasis on actual payment and not
deemed/constructive payment. Since advance arising out of SA are on deemed
basis, such deemed advance cannot be regarded as deemed dividends u/s. 2(22)(e)
of the Act.

(xiii)   Other issues

a)   Presently, there is no
specific provision to levy any penalty for non-compliances of SA.

b)   Multiple transactions with
multiple AEs – How does an Indian entity allocate the amount of overall / lump
sum primary adjustment arising out of various transactions with many AEs in
order to comply the provisions of SA ?

c)   Whether revised book
profit as a result of recording of SA will be subject to MAT, and if so, in
which year?

d)   The AE may not be in a
position to repatriate the amount of SA because (a) it is incurring losses; or
(b) the country where it is located prohibits such remittance under its
exchange control regulations; or (c) the AE ceases to be AE before the SA is
made; or (d) the AE is not financially sound to repatriate the excess money.
Thus, if repatriation is not possible due to any of the foregoing reasons, will
the impact of SA be perpetual, is not clear.

e)   Whether taxpayer can write
off this advance if it is not recoverable and claim deduction of write off as
there is no express provision to disallow such write off?

f)    It is not clear whether taxpayer will be allowed to set off the amount
of deemed advance against the amount of loan to be repaid to its AE.

g)   Foreign Tax Credit [FTC]:
Issues regarding FTC may arise as to (a) will FTC be available in India if
foreign withholding tax applies on repatriation of deemed advance to India; (b)
If yes, at what rate will such FTC be given; or (c) What would be the nature of
such receipts i.e. if the jurisdiction of the foreign AE treats the payment as
a dividend and accordingly applies withholding tax and will India still grant
FTC, in such cases?

h)   Whether interest on deemed
advance chargeable to tax even if AE declines to accept this as its liability?

i)    Whether SA needs to be
made in relation to deemed international transaction u/s. 92B(2)?

j)    A further question may
arise as to whether SA of interest as recorded in the books of taxpayer will be
considered for the purpose of disallowance u/s. 94B.

         For a satisfactory
resolution of the above issues, one hopes that the CBDT would issue the
necessary clarifications at the earliest to avoid cumbersome/repetitive / time
consuming and costly litigation which is already clogging the overburdened
judiciary.

1.13 Conclusion

         It is true that the
concept of SA is prevalent in many developed jurisdictions. In that sense,
introduction of SAs rules in Indian transfer pricing regime is in conformity
with international practice. However, considering the level of maturity of
transfer pricing regime in India, it is debatable whether this is right time to
introduce SA rules in India. Indian revenue authorities are still striving to
cope up with many contentious issues arising out of transfer pricing disputes.
In the midst of such melee, introducing another dimension of transfer pricing
appears to be a pre-mature act. Debate may arise over whether SAs are
appropriate in the current global arena, where they are not consistently
applied and where various countries take different views on corresponding or
correlative relief. Provisions of SA are complex in nature and would result in
lot of hardships and increased litigation.

         Further, in view of
various issues and complications, as discussed above, we wonder whether it
would not have been better if India also had adopted the deemed dividend
approach as adopted by many advanced tax jurisdictions rather than the deemed
loan approach, to obviate most of the probable issues arising due to the deemed
‘advance’ approach. _