Month: December

Object of introducing section 194-IA
In case the language of the provision is capable of two interpretations then the one which advances the object of introducing the provision will have to adopted. The Memorandum explaining the salient features of the Finance Bill, 2013 classified this provision under the caption `Widening of Tax Base and Anti Tax Avoidance Measures’. The Heydon’s Mischief Rule of Interpretation states that while interpreting a provision that interpretation has to be adopted which removes the mischief which was prevalent before the introduction of the provision. The Object of introducing the provision and the Mischief which the Legislature sought to remove can be better understood from the following extracts from the Explanatory Memorandum to the Finance Bill:

“E. WIDENING OF TAX BASE AND ANTI TAX AVOI DANCE MEASURES
Tax Deduction at Source (TDS) on transfer of certain immovable properties (other than agricultural land)

…………. However, the information furnished to the department in Annual Information Returns by the Registrar or Sub-Registrar indicate that a majority of the purchasers or sellers of immovable properties, valued at Rs. 30 lakh or more, during the financial year 2011-12 did not quote or quoted invalid PAN in the documents relating to transfer of the property.

……… In order to have a reporting mechanism of transactions in the real estate sector and also to collect tax at the earliest point of time, it is proposed to insert a new section 194-IA to provide that every transferee, at the time of making payment or ………”

A perusal of the above, clearly indicates that the difficulty faced was that the Annual Information Return, furnished to the Department, by the Registrar or Sub-Registrar, in a majority of the cases, did not have a PAN or had an invalid PAN in the documents relating to transfer of property. This is what is sought to be curbed by introducing the provisions of section 194-IA.

The two objects of introducing the provisions of section 194-IA are:-

(i) to have a reporting mechanism of transactions in the real estate sector; and
(ii) to collect tax at the earliest point of time.

These objectives will have to be kept in mind while interpreting some of the provisions, the language whereof is capable of two interpretations.

Text of Section 194-IA:
For the sake of convenience, the provisions of section194- IA are reproduced hereunder:

“194-IA. (1) Any person, being a transferee, responsible for paying (other than the person referred to in section 194LA) to a resident transferor any sum by way of consideration for transfer of any immovable property (other than agricultural land), shall, at the time of credit of such sum to the account of the transferor or at the time of payment of such sum in cash or by issue of a cheque or draft or by any other mode, whichever is earlier, deduct an amount equal to one per cent of such sum as income-tax thereon.

(2) No deduction under sub-section (1) shall be made where the consideration for the transfer of an immovable property is less than fifty lakh rupees.

(3) The provisions of section 203A shall not apply to a person required to deduct tax in accordance with the provisions of this section.

Explanation.–– For the purposes of this section,––

(a) “agricultural land” means agricultural land in India, not being a land situated in any area referred to in items (a) and (b) of sub-clause (iii) of clause (14) of section 2;

(b) “immovable property” means any land (other than agricultural land) or any building or part of a building.”

Analysis of Section 194-IA:
Conditions for applicability of the section:
(i) there is a transferee;
(ii) there is a transferor;
(iii) the transferor is a resident;
(iv) there is a transfer of an immovable property, as defined, from the transferor to the transferee;
(v) the transferee is responsible for paying any sum;
(vi) such sum is by way of consideration for transfer of any immovable property;
(vii) the amount of consideration is Rs. 50 lakh or more;
(viii) the transferee is not a person referred to in section 194LA;
(ix) the transferee either :
(a) credits such sum referred to in (vi), or
(b) makes a payment of such sum;
(x) the payment referred to in (ix)(b) is made either by

(a) cash, or
(b) by issue of cheque, or
(c) by issue of draft, or
(d) by any other mode.

Consequences if the above conditions apply:
(i) The transferee becomes liable to deduct tax at source;
(ii) such deduction shall be of an amount;
(iii) the amount of deduction shall be equal to 1% of the sum referred to in (vi) above;
(iv) such a liability arises upon credit of such sum or at the time of making the payment, whichever is earlier;
(v) provisions of section 203A shall not apply to the transferee.

Exceptions: This section would not apply if –
(i) The transferee is a person covered by section 194LA; or
(ii) the transferor is a non-resident; or
(iii) consideration for transfer of immovable property is less than Rs. 50 lakh; or
(iv) the immovable property transferred is an agricultural land as explained subsequently.

Analysis of certain terms used in section 194-IA:
Immovable Property has been defined in Explanation (a) to section 194-IA to mean:
• any land [including land described in section 2(14) (iiia) and 2(14)(iiib) i.e. land which is commonly known as urban agricultural land];
• any building; and
• any part of a building;
• but does not include `agricultural land’.

Agricultural land has been defined in Explanation (b) to section 194-IA – Agricultural land situated in India not being land referred to in section 2(14)(iiia) and 2(14)(iiib). Transferee: The obligation to deduct tax is on the transferee of any immovable property, as defined. The transferee may be any person. He may be an individual, Hindu undivided family, firm, LLP, company, AOP, BOI, cooperative society. He could even be a builder / developer. However, where Government is the purchaser, the section may not apply since Government is not a person (CIT vs. Dredging Corporation of India) (174 ITR 682) (AP). Residential status of the transferee is immaterial. The section applies even to a non-resident buyer or even to a buyer who is an agriculturist. Other conditions being satisfied, the section will apply even when the purchaser / transferee is a family member / relative of the seller / transferor. However, the purchaser / transferee should not be a person referred to in section 194LA. If the purchaser / transferee is a person referred to in section 194LA, such a person is not required to deduct tax under this section. Joint transferee: In case of joint transferee each coowner will be liable for compliance with this section. Transferor: The transferor / seller may be any person. The transferor should be a resident. He may even be Resident but Not Ordinarily Resident. If the transferor / seller happens to be a non-resident the provisions of section 195 may apply but certainly not the provisions of this section.

Any sum: The section states that the purchaser / transferee should be responsible for paying to the seller / transferor any sum by way of consideration for transfer of immovable property. The term `sum’ has not been defined in the Act.

The expression “any sum paid” has been interpreted by the Hon’ble Supreme Court in the case of H.H. Sri Rama Verma vs. CIT (187 ITR 308) (SC) to mean only amount of money given as donations and not to donations in kind.

In the context of section 194-IA an issue would arise as to whether the section applies when the consideration is in kind e.g. in cases of exchange. This issue has been dealt with, in detail, subsequently under the caption `Issues’.

Consideration: The term `consideration’ has not been defined in the Act. The term is also not defined in the Transfer of Property Act. The Patna High Court in Rai Bahadur H.P. Banerjee vs. CIT ([1941] 9 ITR 137)(Pat) held that the word ‘consideration’ is not defined in the Transfer of Property Act and must be given a meaning similar to the meaning which it has in the Indian Contract Act. Similar view has been taken by the Kerala High Court in the case of CGT vs. Smt. C K Nirmala (215 ITR 156)(Ker) and by the Bombay High Court in the case of Keshub Mahindra vs. CGT (70 ITR 1)(Bom). Section 2(b), of the Indian Contract Act defines `consideration’ as under:

“When, at the desire of the promisor, the promisee or any other person has done or abstained from doing, or does or abstains from doing or promises to do or to abstain from doing, something, such act or abstinence or promise is called a consideration for the promise.”

An issue which arises for consideration is whether the amount of service tax, VAT payable by the transferee to the transferor constitutes part of consideration and therefore tax is required to be deducted even on these amounts. By virtue of Circular No. 1/2014 dated 13.1.2014, tax is not required to be deducted at source on the amount of service tax. The question of deduction of tax at source, therefore, survives only in respect of VAT . Looked at it from a common man’s perspective the amount of service tax and VAT agreed to be paid by the transferee to the transferor would certainly form part of consideration for transfer of immovable property. The liability to pay these amounts under the respective statutes is of the transferor. Accordingly, it appears that VAT amount constitutes consideration and tax will have to be deducted even on the amount of VAT . In addition, these amounts may also attract stamp duty under the stamp law of a State. However, in cases where the transferee is faced with a show cause notice for failure to deduct tax at source on the amount of VAT , the transferee may contend that the analagoy of excluding service tax would apply equally to VAT as well.

Immovable Property: This term is defined exhaustively to mean land (other than agricultural land) or any building or a part of a building. Agricultural land is not immovable property. Agricultural land is defined for this purpose. Urban agricultural land is immovable property. Immovable property could be land, agricultural land outside India, urban agricultural land, office, flat, shop, godown, theatre, hotel, hospital, etc. Immovable property could be stock-intrade of the developer. Immovable property could be held as either stock-in-trade or as capital asset.

Meaning of ‘transfer’: The section applies to consideration for transfer. The question which arises is whether the term `transfer’ would mean only transfer by way of conveyance under general law through a registered instrument or it would even cover the transactions / agreements referred to in section 2(47)(v) and (vi) i.e. in cases where possession is given in part performance of the contract u/s. 53A of the Transfer of Property Act or a transaction of becoming a member of a co-operative society, company, etc. Also, would the provisions be applicable to part payments made but not in the year of transfer (conditions of 2(47)(v) not being satisfied)?

Immovable Property located outside India: The section does not mention that the immovable property should be situated in India. Therefore, a literal interpretation would be that the immovable property could be situated any where may be in India or may be outside India. Further, the term `agricultural land’ has been defined to mean agricultural land situated in India. The fact that agricultural land in India is excluded from immovable property could be understood in two ways – one that from the immovable property in India exclusion is to be made of agricultural land in India and the other could be that from the immovable property wherever situated only the agricultural land in India is excluded. Thus, two interpretations are possible. However, if a view is taken that the section applies even in respect of immovable property situated outside India then the position will be that a buyer who is outside India and who is neither a citizen of India nor a resident of India who is buying immovable property located outside India from a resident of India, will be required to deduct income-tax under the provisions of the Act. Therefore, it would mean that it is expected of every person dealing with a resident of India to be aware of the provisions of the Indian laws. Assuming that such a buyer is aware of these provisions and decides to comply with the provisions of this section, he will have to obtain a PAN so as to be able to make payment of the amount of TDS. A question would arise as to whether the Government of India can cast an obligation on a non-resident to deduct tax from payments made by him for purchase of a property which is situated outside India. The only nexus which such a transferor has with India being that he is buying immovable property from a person who is a resident of India. In case of default in complying with the provisions of this section, the buyer would be regarded as an assessee-in-default and would be liable to pay interest and penalty as well. Such an interpretation may not be upheld by Courts. Therefore, it appears that the section would apply to only immovable property situated in India.

Threshold for non-deduction: Sub-section (1) of section 194-IA casts an obligation on the transferee to deduct tax at source. S/s. (1) does not have a threshold limit. S/s. (2) provides that no deduction under subsection (1) shall be made where the consideration for the transfer of an immovable property is less than fifty lakh rupees. The issue for consideration is whether the limit of fifty lakh rupees is qua the immovable property or is it qua the transferee. This issue is dealt with, in detail, subsequently under the caption `Issues’.

Quantum of tax to be deducted: Deduction is to be of an amount equal to one per cent of such sum as incometax. Surcharge and cess on this amount are not to be deducted. If the transferor / seller does not provide PAN, technically, the rate of tax could be 20% by virtue of provisions of section 206AA. However, the challan for payment of tax deducted u/s. 194-IA requires PAN as a compulsory field and it does not proceed without PAN having been filled in. Challan No. 281 which is applicable for payment of TDS other than TDS u/s. 194-IA, does not have a field to make payment of TDS u/s. 194-IA, though the same may have been deducted at the rate mentioned in section 206AA. It seems that the procedure has been so designed so as to further the objective stated in the Memorandum explaining the salient features of the provisions of the Finance Bill, 2013 viz. to overcome the difficulty which was being faced viz. the PAN Nos. not being quoted or invalid PAN Nos. being quoted in the AIR.

At this stage, it would be relevant to note the Karnataka High Court in the case of A. Kowsalya Bai vs. UOI (346 ITR 156)(Kar) has read down the provisions of section 206AA and has held it to be inapplicable to persons whose income is less than the taxable limit.

The deduction is with reference to consideration and not with reference to valuation as done by stamp valuation authorities though in the case of transferor / seller section 50C / section 43CA may be attracted.

No deduction / Deduction at lower rate: There is no provision of either the transferor giving a declaration to the transferee asking him not to deduct tax at source or to deduct tax at lower rate. Transferor cannot even obtain an order from the Assessing Officer authorizing the transferee / buyer not to deduct tax or to deduct it at a lower rate. Thus, tax is deductible at source even in cases where the transferor is entitled to exemption u/s. 54, 54EC, 54F. Similar is the position where the transferor is to suffer a loss as a result of transfer or has brought forward losses which are available for set off against gain on transfer of immovable property.

Consequences of non-deduction: Failure to deduct tax under this section may result in the person i.e. the transferee being deemed to be an assessee in default. Failure to deduct tax will attract interest and penalty. Also, provisions of section 40(a)(ia) will be attracted with effect from assessment year 2015-16.

No requirement to obtain TAN / file quarterly returns: The transferee is not required to obtain TAN if he does not have one. Also, he is not required to file quarterly returns / statements.

Obligation to pay tax so deducted and issue certificate: The tax deducted by the transferee has to be paid to the credit of the Central Government within 7 days from the end of the month in which the deduction is made. TDS payment shall be accompanied by a challancum- statement in Form 26QB. Payment is to be made by remitting it electronically to RBI or SBI or any authorised bank or by paying it physically in any authorised bank. Payer / Transferee is required to issue TDS certificate in Form 16B, to be generated online from the web portal. The TDS certificate is to be issued within 15 days from the due date for furnishing challan-cum-statement in Form 26QB.

Issues: Various issues arise in day to day practice on the applicability of the provisions of section 194-IA of the Act. The author does not necessarily have an answer to all the issues which may arise. Some of the important and more common issues are as under: –

(a) Amounts paid before the provision coming into effect – Provisions of section 194-IA have been introduced in the Income-tax Act, 1961 with effect from 1.6.2013. The obligation to deduct tax under this section arises at the time of payment or at the time of credit of the amount to the account of the transferor, which ever is earlier. Therefore, in a case where either the payment or the credit has been made before 1.6.2013, the question of deduction of tax at source under this section should not arise. While this position may appear to be quite obvious interpretation of the provision, if an authority is required for this proposition a reference can be made to the order dated 3rd June, 2015 of the Karnataka High Court while deciding the Writ Petition in the case of Shubhankar Estates Private Limited vs. The Senior Sub-Registrar, The Union Bank of India and the Chief Commissioner of Income-tax (Writ Petition No. 57385/2013). The Karnataka High Court in this case directed the Registrar to complete the registration without insisting on the deduction of tax at source and to release the document to the petitioner. The Court has, in para 5 of the order, held as under –

“5. In that light, if the provision contained in Section 194-IA as extracted above is noticed, the obligation on the transferee to deduct 1% of the sale consideration towards TDS had come into effect only on 1.6.2013. If that be the position, as on 2.3.2012 when the petitioner in the instant case as the transferee had paid the amount to the transferor, there was no obligation in law on the petitioner to deduct the said amount. If this aspect of the matter is kept in view, even though the provision had come into force as on the date of presentation of the sale certificate for registration, the petitioner having parted with the sale consideration much earlier, was not expected to deduct the amount and produce proof in that regard to the Sub-Registrar. It is no doubt true that in respect of the said amount the third respondent would have the right to recover the taxes due. But, in the instant case, the communication as addressed from the third respondent to the first respondent could not have been held against the petitioner in the circumstances stated above. In the peculiar circumstances of the instant case, where the petitioner being an auction purchaser had paid the entire sale consideration much earlier to the provision coming into force, the endorsement dated 4.12.2013 requiring the petitioner to deduct the income-tax and indicating that the registration would be made thereafter cannot be sustained.”

(b) Applicability of section 206AA – Section 194-IA requires deduction of tax at source at the rate of one per cent. In a case where the transferor does not provide the payer with his PAN, technically, the provisions of section 206AA would be attracted and the deduction would have to be made at the rate of 20%. However, such a situation seems to be quite unlikely since the challan by which the tax is required to be paid by the deductor, transferee, requires the PAN of the transferor as a compulsory field. Hence, in the event that the deduction has to be made, it will have to be made at the rate mentioned in section 194- IA i.e. one per cent.

(c) Applicability to composite transactions where both land and building are subject matter of transfer – Under provisions of section 194-IA tax is required to be deducted, subject to satisfaction of other conditions mentioned in the section, on the amount of consideration for transfer of immovable property. The term `immovable property’ is defined in Explanation (a) to the section as meaning any land or any building or part of a building. Provisions of sections 43CA, 50C and 56(2)(vii) use the term land or building or both. The word `both’ is absent in section 194-IA. Therefore, in cases where tax has not been deducted (not deliberately as a planning measure) on amount of consideration for transfer of a composite transfer comprising of land and building both, one may contend that the Legislature has consciously used a different language in section 194-IA and has left out composite transactions of both land and building e.g. purchase of a bungalow comprising of building and also the land beneath it.

(d) Payment of consideration by a Bank / Housing Finance Institution to a transferor on behalf of the transferee – In a case where the transferee has taken a loan for discharge of consideration to the transferor, the bank / housing finance institution disburses the loan by issuing a cheque / pay order to the transferor towards consideration due to him from the transferee. In such a case, a question arises as to how does a transferee comply with his obligation to deduct tax at source under this section. The banks / financial institutions in such a case issue a cheque / pay order in favour of the transferor of the net amount and the amount equivalent to tax deductible at source under this section is given to the transferee upon his producing a challan evidencing the amount deposited by him towards tax deducted at source. The alternative to this could be that the transferee requests and authorises the bank / financial institution, in writing, to disburse the net amount to the transferor and to deposit the amount required to be deducted at source under this section to the credit of the Central Government on behalf of the transferee i.e. in such a case, the bank / financial institution will deposit tax at source as an agent of the transferee and the challan will contain the PAN and other particulars of the transferee. In actual practice, it is understood that, the first option is what the banks / financial institutions have been following.

(e) Limit of Rs. 50 lakh – whether it is qua an immovable property or qua the transferee / transferor – Threshold for non-deduction: Sub-section (1) of section 194-IA casts an obligation on the transferee to deduct tax at source. S/s. (1) does not have a threshold limit. S/s. (2) provides that no deduction under subsection (1) shall be made where the consideration for the transfer of an immovable property is less than fifty lakh rupees. The issue for consideration is whether the limit of fifty lakh rupees is qua the immovable property or is it qua the transferee. The following paragraphs attempt to address this issue :-

(i) The Memorandum explaining the salient provisions of Finance Bill, 2013 says the Annual Information Returns filed by sub-registrars often indicate that in majority of the cases purchaser or sellers of immovable property did not quote or quoted an invalid PAN in the documents relating to transfer of immovable property. The Sub-Registrar in terms of Rule 114E read with section 285BA is required to report each transaction involving purchase or sale of an immovable property valued at Rs. 30 lakh or more in the Annual Information Return.

(ii) Thus it is clear that the purpose of the newlyinserted section 194-IA is to augment what is already being reported by the Sub-Registrar.

(iii) It may be noted that the Sub-Registrar has got to report a transaction even if the share of each buyer, in case of joint ownership, is below Rs. 30 lakh.

(iv) Following the purpose for which the section 194-IA was inserted, one may conclude that the threshold limit of Rs. 50 lakh for applicability of Section 194-IA is to be determined property-wise and not transferee-wise. This is so because the buyers of immovable properties can’t be allowed to do what the sub-registrar couldn’t do i.e. split up the sale consideration buyer-wise and claim immunity from deduction of TDS since consideration attributable to each buyer is below Rs. 50 lakh.

(v) Thus, the provisions of section 194-IA will apply to a property transaction involving more than one buyer though the share of each buyer in the property is less than Rs. 50 lakh, but the consideration for transfer of the immovable property, in aggregate, is more than Rs. 50 lakh. In such case, tax will be deducted and deposited by each buyer in respect of their respective share in the immovable property.

(vi) Similarly, in case of a transaction involving more than one seller, tax will be deducted in respect of amount paid to each seller and their respective PAN will be quoted in Form 26QB while making payment.

(vii) Judicial pronouncements under Chapter XX-C of the Income-tax Act, 1961 (hereinafter referred to as Chapter XX-C) propose a similar philosophy that immovable property which is the subject matter of the transfer has to be seen in real light and provisions of Chapter XX-C shall apply when by a single agreement of transfer, co-owners of a property agreed to sell the property to the respondent which was above the limit prescribed for application of 269C.

(viii) Chapter XX-C dealt with purchase by Central Government of immovable properties in certain cases of transfer and provided for pre-emptive right of purchase of immovable property by the Government in a case where the apparent consideration for transfer of such property exceeded the specified limit mentioned under Section 269UC.

(ix) Section – 269-UC (1) read as follows:

“Notwithstanding anything contained in the Transfer of Property Act, 1882 (4 of 1882), or in any other law for the time being in force, no transfer of any immovable property in such area and of such value exceeding five lakh rupees, as may be prescribed, shall be effected except after an agreement for transfer is entered into between the person who intends transferring the immovable property (hereinafter referred to as the transferor) and the person to whom it is proposed to be transferred (hereinafter referred to as the transferee) in accordance with the provisions of s/s. (2) at least four months before the intended date of transfer.”

(x) The Bombay High Court in the case of Jodharam Daulat Ram Arora vs. M. B Kodnanai (120 CTR 166)(Bom) wherein there was one vendor and three purchasers, held as under:

‘The agreement in question before it was a composite agreement in respect of the flat and there was nothing in the agreement which indicate that the purchasers had agreed to buy individually an undivided 1/3rd share of the flat from the vendor. All the concerned parties had filed Form No.37-I and therefore it was not open to them to contend that section 269UD had no application and the appropriate authority had no jurisdiction.’

(xi) However, the Madras High Court took a contrary view in the case of K. V. Kishore vs. Appropriate Authority (189 ITR 264)(Mad). The Court held that –

‘What is sold, is the individual undivided share in the property and the value of each such share in the said immovable property was less than Rs. 25 lakh. The transferors were co-owners and each coowner was getting an apparent consideration that was less than the limit prescribed i.e less than Rs. 25 lakh. The provisions of Chapter XX-C was not attracted even though the amount that all the coowners received exceeded Rs. 25 lakh.’

(xii) Other High Courts in various judgments also upheld the above stated view of the Madras High Court.

(xiii) However, in Appropriate Authority vs. Smt. Varshaben Bharatbhai Shah (248 ITR 342)(SC), where two co-owners entered into an agreement to transfer immovable property, situated in Ahmedabad, to a seller for a sum of Rs. 47 lakh which was above the limit prescribed for application to appropriate authority u/s. 269UC of the Act, the Supreme Court reversing the decision of Gujarat High Court in Varshaben Bharatbhai Shah vs. Appropriate Authority (221 ITR 819)(Guj) and various judgments of other High Courts held that :

‘What, in our opinion, has to be seen for the purposes of attracting Chapter XX-C is: what is the property which is the subject-matter for such transfer and what is the apparent consideration for such transfer. This has to be seen in a real light with due regard to the object of the Chapter and not in an artificial or technical manner. Looked at realistically, it was the immovable property which was the subject matter of transfer. If the apparent consideration for the transfer is more than the limit prescribed for the relevant area under Rule 48K, what has then to be seen is whether the apparent consideration for the property is less than the market value thereof by 15 % or more. If so, the notice for pre-emptive purchase can be issued and it is then for the parties to the transaction to satisfy the appropriate authority that the apparent consideration is the real consideration for the transfer.’

‘In the present case the said agreement is for the sale of the immovable property and that the equal shares of the Respondent Nos. 2 and 3 therein were to be transferred to Respondent No. 1 is a necessary incident of such sale. The parties had also in Form 37-I correctly stated that what was being sold was the property and not the onehalf shares of the transferors and that the total apparent consideration for the transfer was Rs. 47 lakh. It was of no consequence that Respondents owned the property as tenants-in-common or that that was how they had shown their ownership in their income-tax returns. The provisions of Chapter XX-C applied.’

(xiv) The Supreme Court further added that: ‘Even if the agreement had been so drawn so as to show the transfer of the equal shares of the second and third respondents in the said immovable property, our conclusion would have been the same for, looked at realistically, it was the said immovable property which was the subject of transfer.’

‘We are of the opinion that the judgments of the Madras, Karnataka, Delhi and Calcutta High Courts referred to above are based on a wrong approach and are erroneous. We approve of the view taken by the Bombay High Court in Jodharam Daulatram Arora’s Case [1996]’

(xv) From the above judgment of the Apex Court, it is the law of the land that even if the property is owned by more than one persons and the apparent consideration in relation to the interest of each co-owner in the property is less than the ‘specified limit’, the provisions of Chapter XXC would be applicable if such property is transferred under a single agreement and the apparent consideration for the property as a whole exceeds the ‘specified limit’.

(xvi) Therefore, u/s. 194-IA also, if the consideration for the purchase of an immovable property shoots beyond 49,99,999/-, one has to withhold tax @ 1 per cent. The number of buyers signing up the agreement for transfer will not make a difference nor would the number of sellers make any difference either.

(f) Applicability of the section to a transaction of transfer by way of an exchange / where the consideration is in kind – The section requires deduction of tax at source by the transferee to a resident transferor out of any sum paid by way of consideration for the transfer of any immovable property (other than agricultural land). Questions do arise as to whether the provisions of this section are to be complied with, in cases, where the consideration is in kind eg., transactions of exchange or cases where the agreement is for joint development of the land belonging to the transferor by the transferee and the transferor is entitled to receive from the transferee a portion of the developed area i.e. a certain percentage of flats. There is no monetary consideration involved in such transactions. Assuming that the other conditions of the section are satisfied, the question being examined in this paragraph is whether the section contemplates the deduction only in cases where the consideration is in monetary terms or even in cases where the consideration is in kind. This controversy arises because of the words `any other mode’ used in sub-section (1) of section 194-IA.

The following arguments can be considered to support the proposition that the provisions of section 194-IA would apply only when the consideration is fixed in monetary terms:-

As has been stated earlier, the expression “any sum paid” has been interpreted by the Hon’ble Supreme Court in the case of H. H. Sri Rama Verma vs. CIT (187 ITR 308) (SC) to mean only amount of money given as donations and not to donations in kind.

The provision contemplates `deduction’ – in cases where consideration is paid in kind ‘deduction’ is not possible.

Section 194B which deals with deduction from payment of any income by way of winnings from any lottery or cross word puzzle or card game or other game of any sort. This section has a specific proviso which was inserted by the Finance Act, 1997, w.e.f. 01.06.1997 which specifically deals with winnings wholly in kind or partly in cash and partly in kind, but the part in cash not being sufficient to meet liability of tax. Prior to the insertion of the proviso the CBDT had in Circular No. 428 dated 8.8.1985 stated that the section does not apply where the prize is given only in kind. The relevant portion of the circular is reproduced hereunder –

Circular : No. 428 [F. No. 275/30/85-IT(B)], dated 8-8-1985.

“3. The substance of the main provisions in the law insofar as they relate to deduction of income-tax at source from winnings from lotteries and crossword puzzles, is given hereunder :

(1) No tax will be deducted at source where the income by way of winnings from lottery or crossword puzzle is Rs. 1,000 or less.

(2) Where a prize is given partly in cash and partly in kind, income-tax will be deductible from each prize with reference to the aggregate amount of the cash prize and the value of the prize in kind. Where, however, the prize is given only in kind, no income-tax will be required to be deducted. ………..” U/s. 194B deduction is out of specified income.

U/s. 194-IA deduction is out of consideration for transfer of immovable property. Like consideration, income could be in cash or in kind. Following the above mentioned circular it can be safely argued that tax is not deductible when consideration is in kind. Recently, the Karnataka High Court in the case of CIT vs. Chief Accounts Officer, Bruhat Bangalore Mahanagar Palike (BBMP) (ITA NO. 94 of 2015 and ITA No. 466 of 2015; order dated 29th September, 2015), was dealing with a case where BBMP had taken over certain lands which were reserved and in lieu thereof it had allotted CDR (Certificate of Development Rights) to the persons who were the owners of the land so taken over. The owners of land were allotted CDR rights in the form of additional floor area, which shall be equal to one and a half times of area of land surrendered. The AO treated the BBMP as an assessee in default for not having deducted TDS u/s. 194LA. The language of section 194LA is materially similar to the language of section 194-IA. The Court has in para 9 held that where there is neither any quantification of the sum payable in terms of money nor any actual payment is made in monetary terms, it would not be fair to burden a person with the obligation of deducting tax at source and exposing him to the consequences of such default.

Thus, for the reasons stated above, it appears that the tax will be required to be deducted at source only in those cases where consideration is fixed in monetary terms. The consideration having been fixed by the parties in monetary terms the same may be discharged in kind. In cases, where the consideration is fixed in monetary terms but is discharged in kind, it is possible to argue that the provisions of the section may apply. In cases where consideration is fixed in kind (e.g. exchange transactions or cases of development agreement where the land owner is entitled to a share in the developed area and no monetary consideration), the better view appears to be that tax will not be required to be deducted at source. (f) Applicability of the section to rights in land or buildings or to reversionary rights -The section applies to consideration for transfer of immovable property (other than agricultural land). Immovable property has been defined to mean land or building or part of a building. Questions do arise as to whether tax is required to be deducted at source when the subject matter of transfer is not land or building or part of a building but rights in land or rights in building e.g. transfer of tenancy rights, grant of lease, etc. In the context of section 50C which applies to cases of transfer of land or building or both, the Tribunals have in the following cases taken a view that the provisions of section 50C do not apply to cases of transfer of rights in land or building but applies only when there is a transfer of land or building:
Kishori Sharad Gaitonde (ITA No. 1561/M/2009) (Mum SMC)(URO)
DCIT vs. Tejinder Singh [2012] 50 SOT 391 (Kol.)(Trib.)
Atul G. Puranik vs. ITO [2011] 58 DTR 208 (Mum.)(Trib.)
ITO vs. Yasin Moosa Godil [2012] 18 ITR 253 (Ahd.)(Trib.)

Following the ratio of the above decisions, it is possible to take a view that the provisions of section 194-IA do not apply to transfer of rights in land or building.

However, when reversionary rights are transferred by the landlord, the consideration paid for acquiring reversionary rights would be subject to deduction of tax at source in accordance with the provisions of this section.

(g) Applicability of the section to introduction of an immovable property by a partner of a firm into a firm – When a partner of a firm introduces land or building into a partnership firm where he is a partner, question arises whether tax is required to be deducted at source. If yes, who will deduct tax at source and on what amount? In a case where a partner of a firm introduces immovable property into a firm as his capital contribution, there is undoubtedly a transfer. Supreme Court has in the case of Sunil Siddharthbhai vs. CIT (1985) (156 ITR 509) (SC) held that what was the exclusive interest of a partner in his personal asset is, upon its introduction into the partnership firm as his share to the partnership capital, transformed into a shared interest with the other partners in that asset. Qua that asset, there is a shared interest. For the purposes of computing capital gains, the amount credited to the capital account of the partner is deemed to be full value of consideration by virtue of the deeming fiction created by section 45. The deeming fiction had to be introduced to overcome the observations of the Supreme Court in the case of Sunil Siddharthbhai (supra) where the SC held that the interest of a partner in the partnership firm is an interest which cannot be evaluated immediately. It is an interest which is subject to the operation of future transactions of the partnership, and it may diminish in value depending on accumulating liabilities and losses with a fall in the prosperity of the partnership firm. The evaluation of a partner’s interest takes place only when there is a dissolution of the firm or upon his retirement from it. While it may be an arguable proposition, to contend that the deeming fiction is only for the purposes of computation of capital gain and cannot be extended to provisions of section 194-IA of the Act, it would certainly be safer for the partnership firm to deduct tax at source u/s. 194-IA by considering the amount credited to the partner’s capital account as the amount of consideration.

Conclusion:
The above are some of the issues which arise in connection with the applicability of the provisions of section 194-IA. There are several other issues which are not covered here e.g. Applicability to cases of slump sale, amalgamation, amount paid by builder to a co-operative housing society/member thereof on redevelopment of property, applicability to acquisition of shares with occupancy rights attached to them, assignment of booking rights, etc. It would now be worthwhile to remind the reader of the golden rule applicable while interpreting the provisions of TDS i.e. when in doubt – Deduct. The arguments stated above can be resorted to in the event of any inadvertent slip in complying with the provisions.

Under transfer pricing, the transaction (controlled transaction) between the taxpayer and its associated enterprise or related party, as the case may be, has to be at Arm’s Length Price (‘ALP) i.e. the price at which the independent parties would have entered into the same or similar transaction under similar circumstances. The Chapter II of the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (‘OECD guidelines’) prescribe the following methods in order to determine the arm’s length price of the controlled transaction:

The old OECD hierarchy of methods suggested that the CUP method was the most preferred, next came the other “traditional transactional” methods (resale price and cost plus) followed, in “exceptional” cases where the first three methods cannot reliably be applied, by the profit based methods (the transactional net margin method and profit split). Profit based methods were described as ‘methods of last resort’. This distinction is now removed. The basis for choosing one method over the others is now expressed as “finding the most appropriate method for a particular case”. Nevertheless, it is clear that some sort of comparison is required and that the basis for that comparison includes the availability and reliability of the comparable data that can be used when applying any particular method.

In line with the OECD guidelines, the Indian Transfer Pricing Regulations (‘TPR’) provides that the arm’s length price of an international transactions and specified domestic transactions is to be determined by adopting any one of the above methods, being most appropriate (i.e. the method which provides the most reliable measure of the arm’s length price considering the facts and circumstances in each case). However, in addition to above, the Central Board of Direct Taxes (‘CBDT’) under the Indian TPR has prescribed such other method which tests the arm’s length price of the controlled transaction with reference to the price which has been charged or paid for the same or similar uncontrolled transaction under similar circumstances.

2. Conceptual framework

Mechanism to apply TNMM has been mentioned Rule 10B(1)(e) of the Income Tax Rules, 1962 as under:

“(i) the net profit margin realised by the enterprise from an international transaction entered into with an associated enterprise is computed in relation to costs incurred or sales effected or assets employed or to be employed by the enterprise or having regard to any other relevant base;

(ii) the net profit margin realised by the enterprise or by an unrelated enterprise from a comparable uncontrolled transaction or a number of such transactions is computed having regard to the same base;

(iii) the net profit margin referred to in sub-clause (ii) arising in comparable uncontrolled transactions is adjusted to take into account the differences, if any, between the international transaction and the comparable uncontrolled transactions, or between the enterprises entering into such transactions, which could materially affect the amount of net profit margin in the open market;

(iv) the net profit margin realised by the enterprise and referred to in sub-clause (i) is established to be the same as the net profit margin referred to in sub-clause (iii); (v) the net profit margin thus established is then taken into account to arrive at an arm’s length price in relation to the international transaction.”

TNMM is applied with an objective to examine the ratio of net profit in relation to an appropriate base (e.g., costs, sales, assets) that a taxpayer realises from a controlled transaction. In the event where such uncontrolled transaction of the taxpayer are not available, net profit relative to identical base realised by unrelated enterprises from comparable uncontrolled transaction is determined. The net profit of taxpayers under controlled transaction is compared either with net profit margins of taxpayer under uncontrolled transaction or with the net profit margins of unrelated enterprises from comparable uncontrolled transactions after making appropriate adjustments, if any. The net profit margin earned under uncontrolled transactions after necessary adjustments, if any is considered as arm’s length margin in respect of the international transaction or specified domestic transaction.

TNMM does not require strict product and functional comparability as is required in case of traditional methods such as CUP, RPM and CPM. The TNMM primarily focuses on comparison of net profit margin realised by the associated enterprises in their controlled transactions with that of uncontrolled transactions. Typical transactions where TNMM can be applied are provision of services, distribution of finished products where RPM cannot be applied, transfer of semi-finished goods where CPM cannot be applied, transactions involving intangibles where PSM cannot be used, etc.

TNMM is generally the preferred method amongst the taxpayers and the tax authorities. However, the manner of applying TNMM is often seen as cause of dispute in most of the practical cases. More often there exists difference of opinion between taxpayers and the revenue authorities in respect of considering the TNMM as the most appropriate method against the traditional methods. For example, practically in most of the cases of a distributor having import transactions from related parties for onward distribution in the Indian market, while the taxpayers select RPM for benchmarking such international transactions, the tax authorities select TNMM as the most appropriate method. Further, application of CUP method/CPM over TNMM or vice versa is often seen as a matter of disputes during transfer pricing audits in India.

3. Application of TNMM, pertinent issues and few judicial rulings

The steps involved in application of TNMM are as under:

Each of the above steps on application of TNMM, practical difficulties/challenges during the transfer pricing audits in India and few of the judicial rulings are briefly described as under:

Step 1: Selection of the tested party
When applying TNMM, it is necessary to choose the party to the transaction for which a financial indicator (mark-up on costs, gross margin, or net profit indicator) is tested. As a general rule, the tested party is the one to which a transfer pricing method can be applied in the most reliable manner and for which the most reliable comparables can be found, i.e., it will most often be the one that has the less complex functional analysis. However this has been an area of litigation during transfer pricing audits in India. The revenue authorities and the tax payers have divergent views on selection of tested party i.e., whether tested party should be Indian tax payers or foreign Associated Enterprise (AE). Selection of foreign comparables is also one of the area where litigation subsists during transfer pricing audits in India.

Judicial Rulings:

However diverse are the judicial pronouncements supporting selection of foreign AE as a tested party, including Development Consultants P. Ltd. vs. DCIT [2008] 115 TTJ 577 (Kol), Mastek Ltd. vs. ACIT [2012]
53 SOT 111 (Ahd.), AIA Engineering Ltd. vs. ACIT [2012] 50 SOT 134 (Ahd.), Global Vantedge Private Limited vs. DCIT  (2010-TIOL-  24-ITAT-DEL),  General  Motors India P. Ltd. vs. DCIT [ITA nos. 3096/Ahd 2010  and  3308/ Ahd 2011.], the outcome of said Tribunal rulings are in accordance with the international best practices with regards to selection of tested party. It has been settled  in these rulings that tested party should be the least complex entity for which reliable data in respect of itself and in respect of comparables is available. In such cases it was held that the tested party could be the local entity or a foreign AE. Such rulings gave credence to the fact that the foreign AE can also be selected as a tested party depending upon the facts and circumstances of the case.

Step 2: Selection of data for comparison
The Indian TPR requires that the arm’s length analysis be based on data for the relevant financial year only.

While applying TNMM, one of the conflicts prevails where the taxpayers are required to maintain contemporaneous documentation i.e. documentation should exist before the Form 3CEB is filed. As per the Income-tax rules, the data to be used for arm’s length analysis has to be for the relevant financial year under consideration. However, as has been experienced till date, the data for comparable companies (in case where external TNMM using search process from databases is preferred) for the arm’s  length analysis in respect of the relevant financial year  is generally not available before the Form 3CEB is filed due to search database limitations. This leads to need for usage of multiple year data in order to undertake arm’s length analysis. Internationally also, multiple year data analysis is considered as it takes into account relevant economic factors like business cycles etc., which may impact the determination of arm’s length price.

Judicial Rulings:
Practically it has been noticed that the India tax authorities do not consider multiple year data analysis and proceed to perform the TNMM analysis using single year data i.e. the data related to financial year under consideration. There are host of rulings against the taxpayers disregarding the usage of multiple year data including Aztec Software and Technology vs. ACIT (294 ITR 32, Bang ITAT), Symantec Software Solutions Pvt. Ltd vs. ACIT (ITAT No. 7894/ MUM/2010, etc.

However, contrary to the above rulings, the jurisdictional Bangalore Income Tax Appellate Tribunal in the case of Phillips Software Centre Private Limited (ITA No. 218/ Bang/2008) has held that the TPO cannot use data during assessment that was not available to the assessee at the time of preparation of documentation. Further, the Hon’ble Delhi Tribunal in case of Panasonic India Private Limited vs. Income Tax Officer (ITA No.1417/Del/2008) held that proviso to Rule 10B(4) would allow the taxpayer to adopt the previous two year’s average PLI along with the current year’s PLI of the tested party and on a similar footing allow the taxpayer to adopt the three year’s average PLI of comparable companies.

The above practical difficulty should be now resolved   by the recent amendment in the Finance Act, 2014. It was proposed in the Budget Speech of 2014 by the Hon’ble Central Finance Minister that use of multiple year data (instead of single year data) would be allowed for comparability analysis. However, the detailed rules in this regard would be notified subsequently.

Step 3: Aggregation of transactions
While computing profits under TNMM, the international transactions in relation to a particular activity which are subject to transfer pricing are aggregated and the net profit for the activity is arrived for benchmarking with   the uncontrolled transaction. While, the Indian TPR is silent on the aggregation of transactions, the principles on aggregation of transactions are contained in the OECD guidelines. For example, consider as case where there are multiple sales transaction entered by an India taxpayer, being a manufacturer to its various group companies located in different parts of the world. Due to inherent practicalities of determining net profits earned by the taxpayer in respect of each of such sales transactions, it is more often seen that all the sales transactions are ‘aggregated’ and the net profit of the taxpayer arising  out of its manufacturing activities is benchmarked as a separate ‘class of transaction’.

Further, practically it is seen that while applying TNMM, all the international transactions are aggregated and entity wide net profit is determined for benchmarking purpose. For example consider a scenario  where  a  taxpayer  has entered into multiple  international  transactions such as sales from manufacturing activities, sales from distribution activities, payment of royalty, payment of corporate charges, interest payments, etc. It is seen that in many cases, all the transactions are aggregated and net profit of the taxpayer is determined and compared  for benchmarking analysis. However, as per the various judicial pronouncements it is well settled that each and every transaction needs to be benchmarked separately taking into consideration the functions performed, assets employed and risks assumed (typically called as FAR analysis) under each of such transactions.

Aggregation  and  segmentation  is  often   challenged by the income tax authorities. Appropriate level of segmentation of the taxpayer’s financial data is needed while determining the  net  profits  of  the  taxpayers  from controlled transaction. Therefore, it would be inappropriate to apply TNMM on a company-wide basis if the company engages in a variety of different controlled transactions that cannot be appropriately compared on an aggregate basis with those of an independent enterprise. Similarly, when analysing the transactions between the independent enterprises to the extent they are needed, profits attributable to transactions that are not similar to the controlled transactions under examination based on the FAR  analysis should be excluded for the purpose   of comparison.

Practically, there are numerous cases wherein while making the transfer pricing adjustments, the tax authorities have applied TNMM on overall entitywide basis instead of restricting the adjustments to international transactions only. The TNMM analysis should be restricted only to the international transaction.

Judicial Rulings:
The issue related to the principle of aggregation of transaction  vis-a-vis  segmentation  of  transactions  and restriction of transfer pricing adjustment to the international transactions only is covered under various ITAT rulings such as Aztec Software and Technology vs
.ACIT, (294 ITR 32 – Bang ITAT); Ranbaxy Laboratories Ltd vs. ACIT (299 ITR 175 – Del ITAT), M/s Panasonic India Pvt Ltd vs. Income Tax Officer (2010) TII-47-ITAT- DEL-TP; UCB India Private Ltd. vs. ACIT (reference: ITA No. 428 & 429 of 2007); DCIT vs. M/s Starlite (reference: ITA No. 2279/Mum/06), Birlasoft (India) Limited vs. DCIT [TS-227-ITAT-2014(DEL)-TP]; Tecnimont ICB Pvt. Ltd. [TS-251-ITAT-2013(Mum)-TP],etc.

Application of TNMM on aggregated basis in case where unique intangibles are involved:

In certain cases, comparability analysis could be difficult where the transactions include unique intangibles. Following extracts from the OECD  guidelines  deals  with a typical case where the transaction involves sale  of branded products and difficulty that could arise in determining ALP of the transaction.

“6.25 For example, it may be the case that a branded athletic shoe transferred in a controlled transaction is comparable to an athletic shoe transferred under a different brand name in an uncontrolled transaction both in terms of the quality and specification of the shoe itself and also in terms of the consumer acceptability and other characteristics of the brand name in that market. Where such a comparison is not possible, some help also may be found, if adequate evidence is available, by comparing the volume of sales and the prices chargeable and profits realised for trademarked goods with those for similar goods that do not carry the trademark. It therefore may be possible to use sales of unbranded products as comparable transactions to sales of branded products that are otherwise comparables, but only to the extent that adjustments can be made to account for any value added by the trademark. For example, branded athletic shoe “A” may be comparable to an unbranded shoe in all respects (after adjustments) except for the brand name itself. In such a case, the premium attributable to the brand might be determined by comparing an unbranded shoe with different features, transferred in an uncontrolled transaction, to its branded equivalent, also transferred in an uncontrolled transaction. Then it may be possible to use this information as an aid in determining the price of branded shoe “A”, although adjustments may be necessary for the effect of the difference in features on the value of the brand. However, adjustments may be particularly difficult where a trademarked product has a dominant market position such that the generic product is in essence trading in a different market, particularly where sophisticated products are involved.”

Application of TNMM is such cases could be more useful as the net margins are less affected and are more tolerant to product differences and other conditions prevailing in case of controlled transactions vis-a-vis uncontrolled comparable transactions.

Further, practically let us consider an example in case  of a Manufacturing concern, say A Ltd. There are sales by A Ltd. to its various group companies and also there are royalty payments to a group company towards use  of brand, technical know-how, etc. The ideal approach would be to benchmark the sales transactions and royalty payment transaction separately. However, quite often due to practical difficulties related to availability of comparability of data etc., separate benchmarking of such transactions becomes difficult. To counter such scenario, TNMM is generally applied on an aggregate entitywide basis, wherein net profit from a “class of transactions” i.e. Manufacturing sales is benchmarked using comparable data either internally or using external database with appropriate adjustments, if any.

Step 4: Identification of comparables
Comparable analysis is the essence of Transfer pricing and that too while applying TNMM. Under TNMM, the comparable analysis is required at broad functional level based on the FAR analysis. For example, comparables can be chosen depending upon broad category of business i.e., trading function, manufacturing function, service function etc. The comparables (uncontrolled transaction) typically can be internal comparable or external comparables.

TNMM should ideally be established by  reference  to the net profit indicator  that  the  same  taxpayer  earns in comparable uncontrolled transactions, i.e., by reference to “internal comparables” Where the internal comparables are not available, the net margin that would have been earned in comparable transactions by an independent enterprise (“external comparables”) may serve as a guide. A functional analysis of the controlled and uncontrolled transactions is required to determine whether the transactions are comparable and what adjustments may be necessary to obtain reliable results.

External comparables are found out using publicly available databases. Prowess (a database developed by Centre for Monitoring Indian Economy Private Limited) and CapitalinePlus (a database developed by Capital Market Publishers India Private Limited) are  widely  used amongst the taxpayers and transfer pricing authorities in India.

The OECD guidelines specifies the use internal TNMM over external TNMM. However, the controversy in respect of the same subsists between the taxpayer and the revenue authorities. Internal TNMM has been considered to be preferable by the Indian appellate tax authorities. While the internal TNMM is more preferred choice, it is not applied due to lack of comparable data. Further while applying external TNMM over database, there are host of differences on the manner of selection of comparable companies – commonly called as “search process”. There are continual disputes between taxpayers and tax authorities on selection of appropriate search filters. For example the prominent disagreements over quantitative filters could be application of minimum/maximum sales turnover (for example considering software giants like Infosys, Wipro etc., having huge turnover while comparing with pygmies software players), filter for service revenue over total revenue, export sales filter, employee cost to total sales filter, filter on related party transactions, etc.

Further, as we understand that in practical world no company can have its exactly comparable company with same functionalities; application of TNMM sometimes becomes a challenging task for taxpayers as well as tax authorities. Therefore qualitative analysis under TNMM more often fails to reach consensus between tax payers and tax authorities on identification of ‘ideal’ comparables.

Judicial Rulings:
The various judicial rulings placed emphasise on selection of comparable companies considering the Functions, Assets and Risk (FAR) analysis of the controlled transactions vis-a-vis uncontrolled transactions. The few important rulings include Mentor Graphics (P) Ltd. vs. DCIT (112 TTJ 408, 2007 18 SOT 76, 109 ITD 101 – Delhi
ITAT), UCB India Private Limited vs. ACIT [2009-TIOL- 184-ITAT-MUM, (2009) 30 SOT 95)], DCIT vs. Quark Systems (P) Ltd. (2010-TIOL-31-ITAT-CHDSB), etc.

Step 5: Selection of suitable PLI
The application of TNMM requires the selection of an appropriate PLI. The PLI measures the relationship between (i) profits and (ii) either costs incurred, revenues earned, or assets employed.

In applying the TNMM, an appropriate PLI needs to be selected considering a number of factors, including the nature of the activities of the tested party, the reliability  of the available data with respect to the comparable companies, and the extent to which the PLI is likely to produce an appropriate measure of an arm’s length result.

A variety of PLIs can be used. TNMM aims at arriving   at the arm’s length operating profit (i.e., profit before financial and non-operating expenses).  The  examples of PLI commonly used while applying TNMM are net operating profit/total operating cost (OP/TC), net operating profit/total sales (OP/Sales), net operating profit on total assets employed (return on assets), net operating profit on capital employed (return on capital employed), berry ratio (i.e. ratio of gross profit over operating value added expenses), etc.

Determination of the appropriate base while choosing PLI: The denominator of a PLI should be focused on the relevant indicator(s) of the value of the functions performed by the tested party in the transaction under review, taking account of its assets used and risks assumed. For instance, capital- intensive activities such as certain manufacturing activities may involve significant investment risk, even in those cases where the operational risks (such as market risks or inventory risks) might be limited. Where a transactional net margin method is applied to such cases, the investment- related risks are reflected in the net profit indicator if the latter is a return on investment (e.g. return on assets or return on capital employed).

The denominator should be reasonably independent from controlled transactions; otherwise there would be no objective starting point. For instance, when analysing a transaction consisting in the purchase of goods by a distributor from an associated enterprise for resale to independent customers, one could not weight the net profit indicator against the cost of goods sold because these costs are the controlled costs for which consistency with the arm’s length principle is being tested. Similarly, for a controlled transaction consisting in the provision    of services to an associated enterprise, one could not weight the net profit indicator against the revenue from the sale of services because these are the controlled sales for which consistency with the arm’s length principle is being tested.

During the transfer pricing audits, the selection of appropriate PLI is one of the disputed issues. For example, in case where the taxpayers has imports as well as export transactions with its AEs. In such an event, selection of PLI i.e. OP/cost, OP/sales or berry ratio could be a debatable issue. The transfer pricing authorities typically do not accept usage of PLI such as return on assets or return on capital employed disregarding the functional profiles, nature of industry and other critical business or economic reasons. Usage of Berry ratio in case of typical limited risk distributors or service provider is quite often not considered appropriate by the transfer pricing authorities in India.

Judicial Rulings:
Various judicial rulings in dealt with the aspect of PLI selection, few of important ones being Schefenacker Motherson Ltd vs. DCIT [123 TTJ 509 (Del)], Kyungshin Industrial Motherson Limited vs. DCIT, New Delhi [2010-TII-61-ITAT-DEL-TP], etc.

Step 6: Economic adjustments, if any
The Indian TPR provides that the net profit margin should be adjusted to take into account the differences, if any, between the international transaction and the comparable uncontrolled transactions, which could materially affect the amount of net profit margin in the open market. Typical comparability adjustments while applying TNMM are working capital adjustments, market risk adjustment, capacity utilisation adjustments, etc. However, in absence of concrete guidance on manner of carrying out such adjustment workings under the Indian TPR, practically   it becomes difficult for the taxpayers to convince the tax authorities on veracity of such adjustments. However, in case of working capital adjustments, guidance is more often taken from OECD guidelines on mechanisms to carry our such adjustments and this is too some extent accepted by the Transfer Pricing authorities in India.

Judicial Rulings:
There are multiple judicial rulings on economic adjustments while applying TNMM. The rulings dealt with allowance of working capital adjustments, capacity utilisation adjustments, adjustments due to accounting policies (depreciation charge), etc. The important ones being Mentor Graphics (P) Ltd. vs.  DCIT  [112  TTJ  408, 2007 18 SOT 76, 109 ITD 101 (Del ITAT)], E-gain
Communication (P) ltd. vs. ITO [118 TTJ 354, 23 SOT 385 (Pune ITAT)], Philips Software Centre Pvt. Ltd. vs. ACIT [2008-TIOL-471-ITAT-BANG], TO vs. CRM Services India
(P) Ltd., CRM Services India (P) Ltd. vs. ITO [ITA No. 4796(Del)/2010,ITA No. 4796(Del)/2010], etc.

Step 7: Assessment of profit for comparisons
As a matter of principle, only those items that (a) directly or indirectly relate to the controlled transaction at hand and (b) are of an operating nature are taken into account in the determination of the net profit indicator for the application of the TNMM. However, in a practical scenario, there are many controversies in the treatment of revenue items into operating or non-operating. For example, treatment of foreign exchange fluctuations, bad debts, provision for bad debt, amortisation of goodwill, etc. as operating/non-operating items. The assessment of profit depends upon appropriate selection of cost base and    in absence of appropriate guidance and host of diverse judicial pronouncements, practical difficulty in applying TNMM still prevails.

Judicial Rulings:
In absence of any guidelines as to what should form  part of “operating costs”/”operating revenue” while determining “operating net profit” for TNMM application is debatable under the Indian transfer pricing regime. The various judicial pronouncements in India dealt with the issue related to computation of net profits of the tested party and comparable companies in  order  to  assess the arm’s length price. The prominent rulings being Schefenacker Motherson Ltd. vs. DCIT [123 TTJ 509 – Delhi ITAT], Chrys Capital Investment Advisors India Pvt. Ltd. [2010-TII-11-ITAT-Delhi-TP], Sap Labs India Private Limited vs. ACIT Bangalore [2010-TII-44-ITAT-BANG-TP], DHL Express India Pvt. Ltd. [TS-353-ITAT-2011(Mum)], Trilogy E business Software India Pvt. Ltd. [TS-455-ITAT- 2011(Bang)],etc.

Step 8: Determination of the arm’s length price
In order to apply the arm’s length principle, sometimes it is possible to test the same with a single uncontrolled price/ margin. However, transfer pricing is not an exact science and therefore, in most of the cases, application of the most appropriate method results in a range of prices/margin which are comparable to the controlled transaction. In such cases, as provided under the Indian TPR, the arm’s length price must be determined considering the average mean of such range of prices/margin.

The Indian TPR also provides that the average mean as mentioned above can be adjusted by +/- 1% in case of wholesale traders and 3% in case of others to fit in the arm’s length principle.

Judicial Rulings:
There are judicial rulings such as Mentor Graphics (P) Ltd. vs. DCIT [112 TTJ 408, 2007 18 SOT 76, 109 ITD 101 – Del ITAT], ACIT vs. MSS India Pvt. Ltd. [123 TTJ
657 2009-TIOL-416-ITAT-PUNE], etc. on the principles on determination of arm’s length price.

Summary of few judicial rulings on each of the above aspect related to application of TNMM is enclosed as Annexure 1.

4.    advantages and limitations of applying the TNMM

5.    revised chapters i-iii of the OECD guidelines

The erstwhile OECD guidelines included five comparability factors – characteristics of property or services, functional analysis, contractual terms, economic circumstances and business strategy. Under the revised OECD guidelines, while the said comparability factors are still applicable, revised Chapter III of the OECD guidelines sets out a ten-step process for performing a comparability analysis. Application of the steps is stated as being “good practice” and is not compulsory “as reliability of the outcome is more important than the process”. The ten steps, which are not necessarily sequential, are:-

?    Broad based analysis of the taxpayer’s circumstances;
?    Determination of years to be covered;
?    Functional analysis;
?    Review of existing internal comparables;
?    Determination of available sources of information on external comparables;
?    Selection of the most appropriate transfer pricing method;
?    Identification of the potential comparables;
?    Determination of and making appropriate comparability adjustments where appropriate;
?    Interpretation and use of data collected; and
?    Implementation of the support processes.

In terms of comparability adjustments, the revised OECD guidelines suggests the basis of undertaking or not undertaking adjustments to the comparables and tested party and concludes that, if possible, adjustments must be made where differences exist, which could materially affect the comparison. The revised OECD guidelines also state that where internal comparables exist, it may not be necessary to search for external comparables. However, it also recognises that internal comparables are not always necessarily a more reliable basis for evaluating arm’s length nature of transaction between taxpayer and related party.

The revised OECD  guidelines  reinforces  that  TNMM  is unlikely to be reliable if both parties to a transaction contribute unique intangibles. Where TNMM is applicable, the OECD guidelines provides guidance on the comparability standard to be applied, reinforcing the importance of determining an appropriate profit level indicator as the basis of the analysis and discussing the importance of undertaking adjustments so that interest and foreign exchange income and expenses are treated in a comparable manner in the profit level indicator of both the tested party and the comparables. Annexure I to Chapter II of the revised OECD guidelines has laid down certain numerical illustrations on sensitivity of gross and net profit indicators.

Illustrations on sensitivity of gross and Net Profit Margins Due To Functional Differences

llustration 1 – Difference in functional and risk profile of distributors:

Enterprises  performing  different  functions  may  have  a wide range of gross profit margins while still earning broadly similar levels of net profits. For instance, TNMM would be less sensitive to differences in volume, extent and complexity of functions and operating expenses.

Let us consider an example of a distributor, say X Ltd. importing certain goods from its group companies for further distribution in India. X Ltd. performs significant marketing function and bears product obsolescence risk. Also let us assume that there is another distributor, say Y Ltd. importing similar goods from its group companies for further distribution in India. The import price for X Ltd. and Y Ltd. for the goods would be different in view of difference in the functions and risk borne by each of them. The import price in case of X Ltd. should typically be lower than that of import price in case of Y Ltd. The gross profits of X Ltd. and Y Ltd. would be influenced by such functional differences. However, TNMM is more tolerant to such functional differences. This can be explained by way of numeric illustration as under:

(*) Assume that in this case the difference of INR 100    in transaction price corresponds to the difference in the extent and complexity of the marketing function performed by the distributor and the difference in the allocation of the obsolescence risk between the manufacturer and the distributor.

From the above table, it can be observed that the risk   of error at gross margin level would amount to INR 100 (10% x 1,000), while it would amount to INR 20 (2% x 1,000) if a TNMM was applied.

This illustrates the fact that, depending on the circumstances of the case and in particular of the effect of the functional differences on the cost structure and on the revenue of the “comparables”, net profit margins can be less sensitive than gross margins to differences in the extent and complexity of functions.

Illustration    2    –    Effect    of    a    difference    in manufacturers’ capacity utilisation:
 
In certain scenario TNMM may be more sensitive than the cost plus or resale price methods to differences in capacity utilisation, because differences in the levels of absorption of indirect fixed costs (e.g. fixed manufacturing costs or fixed distribution costs) would affect the net profit but may not affect the gross margin or gross mark-up on costs if not reflected in price differences. Let us consider an example where P Ltd. a manufacturer of certain goods operates in full capacity (say 1000 units per year) vis-a- vis. Q Ltd., a manufacturer of similar goods which operates at a lesser capacity of what it could manufacture in full year (say 800 units per year in case where full capacity is 1000 units).

case and in particular on the proportion of fixed and variable costs and on whether it is the taxpayer or the “comparable” which is in an over-capacity situation.

In addition to above, the OECD guidelines have under Annexure to Chapter III has provided an example of a working capital adjustment typically undertaken while applying TNMM.

6.    Conclusion

TNMM does not require stringent comparability norms (product comparability, exact functional comparability, etc.) unlike in case of other prescribed transfer pricing methods like  CUP, RPM,  CPM  and  PSM.  Therefore  it can be noticed that TNMM is generally the preferred method amongst the taxpayers and transfer pricing authorities in India. (*) This assumes that the arm’s length price of
 
However, the TNMM has its own practical difficulties and nuances explained above. As discussed, over a decade old Indian transfer pricing regime has witnessed significant number of judicial rulings  relating  to  various  aspects on application of TNMM. This include aspects such as preference of other transfer pricing methods over TNMM, selection of tested party, selection of comparable period, choosing appropriate PLIs, segmentation vs. aggregation of transactions, selection of comparable companies, application of appropriate search filters, validation of transfer pricing adjustments, determination of appropriate cost base while applying TNMM,  etc.  Such  difference of opinion between the taxpayers and transfer pricing authorities on application of TNMM has led to disputes and controversies during transfer pricing audits in India. Reference on ten step process of comparability analysis under the revised OECD guidelines and numerical examples on sensitivity of gross and net profit indictors
 
The manufactured products is not affected by the manufacturer’s capacity utilisation.

From the above table it can be observed that the risk of error when applying at gross margin level could amount to 16 (2% x 800) instead of 50 (5% x 1000) if TNMM is applied.

This illustrates the fact that net profit indicators can be more sensitive than gross mark-ups or gross margins to differences in the capacity utilisation, depending on the facts and circumstances of the

Under typical circumstances could serve as guiding factor for applying TNMM under the Indian Transfer Pricing context.

Thus, in view of above, the need for hour in the Indian transfer pricing regime is to reinforce certain regulatory framework and lay out concrete guidelines on application of TNMM and mitigate the practical challenges on application of TNMM as the most appropriate method. This will certainly help in resolving perpetual uncertainty, hardship and never ending litigation for the taxpayers and transfer pricing authorities in India.

Annexure 1 – Few Judicial rulings on various aspects related To application of TNMM:
1.    selection of tested party:

2.    selection of data for comparison:

3. aggregation of transactions vs. segmentation:

4. Identification of comparables:

5.    selection of PLI:

6. economic adjustments:

7. Assessment of profits for comparison:

8.    Determination of arm’s length price: