1. Introduction The Domestic Transfer Pricing Regulations were introduced in India by the Finance Act, 2012 with effect from the Assessment Year 2013-14. The amendment has been brought in basically by amending Chapter X of the Income-tax Act, 1961 (“the Act”) whereby the applicability of the international transfer pricing provisions has been extended to certain domestic transactions between specified related parties referred to as the ‘Specified Domestic Transactions’ (“SDTs”). Corresponding amendments have also been brought in the specific provisions of the Act – i.e. sections 40A(2), 80A(6), 80IA(8) and 80IA(10). Thus, with effect from the Financial Year 2012-13, the SDTs are subject to the transfer pricing provisions, which hitherto, were applicable only to international transactions and accordingly, a new concept of ‘Domestic Transfer Pricing’ (“DTP”) has been introduced in India. The DTP regulations essentially provide for a mechanism to determine the arm’s length price (ALP) in cases of SDTs, require the assessees to maintain information and documents supporting the ALP of such transactions as also obtain and file an accountant’s report in respect of such transactions along with the return of income. The DTP regulation does not apply to small assessees, since a monetary limit of Rs. 5 crores has been set in respect of the SDTs for the DTP provisions to apply.
1.2. Hence, an assessee who undertakes SDTs during a financial year, aggregating in value by more than Rs. 5 crore, would require to comply with the following:
ensure that the value of such transactions is at arm’s length price having regard to the methods prescribed under the Act;
maintain and keep information and documents in relation to such transactions as statutorily required;
obtain and file an accountant’s report in respect of such transactions along with his return of income.
1.3. Genesis of the DTP provisions is the decision of the Supreme Court in the case of CIT vs. GlaxoSmithkline Asia P. Ltd. (2010) 195 Taxman 35 (SC). The Apex Court gave suggestions, in order to “reduce litigation” to consider amendments in the law with a view to:
Make it compulsory for the tax payer to maintain books and documentation on the lines of Rule 10D;
Obtain audit report from a CA;
Reflect the transactions between related entities at arms’ length price;
Apply the generally accepted methods specified in TP regulations.
1.6. T he above suggestions have been duly carried out by the legislature. The Explanatory Memorandum (“EM”) clearly recognises the suggestions of the Supreme Court. It talks about extending the TP provisions “for the purposes of section 40A, Chapter VI-A and section 10AA”. The EM states the objective to amend the Act is to provide applicability of the transfer pricing regulations to domestic transaction “for the purposes of” computation of income, disallowance of expenses, etc. “as required under provisions of sections 40A, 80- IA, 10AA, 80A, sections where reference is made to section 80-IA, or to transactions as may be prescribed by the Board…”. The relevant extract of the EM reads as under:
“the application and extension of scope of transfer pricing regulations to domestic transactions would provide objectivity in determination of income from domestic related party transactions and determination of reasonableness of expenditure between related domestic parties. It will create legally enforceable obligation on assessees to maintain proper documentation”….Therefore, the transfer pricing regulations need to be extended to the transactions entered into by domestic related parties or by an undertaking with other undertakings of the same entity for the purposes of section 40A, Chapter VI-A and section 10AA.” (emphasis supplied)
1.7. T he fundamental propositions that emerge out of this analysis are:
a. DTP provisions are computation provisions and are neither charging provisions nor disallowance provisions;
b. DTP provisions have limited applicability to specified provisions of the Act;
c. DTP provisions, in addition to governing computation, impose administrative obligation of maintaining documentations and getting accounts audited.
2. Meaning of SDT
1.1. Section 92BA of the Act defines the term ‘Specified Domestic Transactions’ in an exhaustive manner. It basically refers to the following transactions:
a. Any expenditure in respect of which payment has been made or is to be made to a person referred to in section 40A(2)(b);
b. Any transaction referred to in section 80A; c. A ny transfer of goods or services referred to in section 80-IA(8); d. A ny business transacted between the assessee and other person as referred to in section 80- IA(10);
e. Any transaction referred to in any other section under Chapter VIA to which provisions of section 80 IA(8)/(10) are applicable;
f. Any transaction referred to in section 10AA to which provisions of section 80-IA(8)/(10) are applicable; where the aggregate value of such transactions in a previous year exceeds Rs. 5 crore.
1.2. T he definition starts with the phrase “for the purposes of this section and sections 92, 92C, 92D and 92E”. Thus, ordinarily, this meaning of SDT will not be extended to any other provision of the Act. However, the term SDT is referred to in the proviso to sections 40A(2), clause (iii) of the Explanation to section 80A(6), Explanation to section 80IA(8) and the proviso to section 80IA(10). It is nothing but incorporation by reference and since these sections refer to this phrase as understood within the meaning of section 92BA, its meaning for the purposes of those sections will have to be understood as given in section 92BA.
1.3. Further, the definition excludes “an international transaction” from the scope of the term SDT. Hence, “international transaction” and “specified domestic transactions” are two mutually exclusive concepts. As a corollary, a single transaction would not be subject to both International Transfer Pricing regulations and DTP regulations. It can be subject to only one of the two regulations.
1.4. Further, the word “domestic” in the expression “specified domestic transactions” is a bit misleading, since a specified domestic transactions may be a transaction within the domestic territory of India or it may also be a cross border transaction between parties who are not “associated enterprises” as defined u/s. 92A but are covered within the scope of the specific sections included in various clauses of section 92BA. For example, take a transaction of payment of an expenditure by an Indian company to its foreign shareholder holding, say, 25% shares in the said Indian company. Since the shareholding is less than 26%, the parties will not be related as associated enterprises within the meaning of section 92A. However, since the shareholding of more than 20% amounts to “substantial interest” within the meaning of section 40A(2)1 , the transaction will qualify as a SDT.
1.5. T o constitute SDT, the value of all the transactions referred to in the definition entered into by an assessee in a previous year should exceed Rs. 5 crore. As per the EM of the Finance Bill, 2012, such monetary limit has been prescribed with a view to provide relaxation to small assessees from the requirements of the DTP regulations, such as maintenance of documents, filing of accountant’s report, etc. The monetary limit of Rs. 5 crore is applicable with respect to the aggregate value of all the transactions and not individual transactions. Hence, where several transactions of less than Rs. 5 crore sum up to the total of more than Rs. 5 crore, all such transactions would be regarded as SDTs, even though their individual value is less than Rs. 5 crore.
1.6. It is not specified in the definition as to what value has to be considered while computing the aggregate value of the transactions i.e. is it the arm’s length price or the actual price of the transactions that needs to be considered. however, since the monetary limit has been prescribed to determine whether the ALP of the transactions have to be computed or not, logically, the monetary limit would have to computed having regard to the actual recorded value of the transactions.
1.7. Further, where the transactions referred to in the definition cover both income as well as expense items, both the receipt as well as outflow from the transactions would be required to be aggregated for testing the monetary limit. in other words, both income side and expense side of the transactions referred to in the definition would need to be aggregated to test whether the monetary limit of Rs. 5 crore has been exceeded or not. However, while deciding as to whether the income or the expense item has to be added up or not, it should be first ascertained as to whether such item is covered within the definition or not. For example, transaction referred to in clause
(i) Of section 92BA is ‘any expenditure…..’. hence, in such cases, only expense items would need to be considered.
1.8. Cases may arise where the same transaction falls in more than one clauses of section 92Ba. For example, transfer of goods and services between two units would fall both within clauses (ii) and (iii) of section 92Ba. Similarly, purchase of goods from a person specified u/s. 40a(2)(b) for the purpose of an eligible unit may fall within clauses (i) as well as clause (iv) of section 92Ba, which refers to transactions referred to in section 80ia(10). In such cases, it has not been clarified as to whether such transactions should be considered twice for determining the aggregate value. However, since the section requires to aggregate the value of the transactions ‘entered into’ by the assessee, a single transaction cannot be considered twice, for the purpose of determining the sum total.
1.9. Further, consider a case of a company getting converted into a LLP with effect from, say, october 1, 2014. it borrowed monies from a party covered u/s. 40a(2). interest cost for the period april 1, 2014 to September 30, 2014 is rs. 1.5 crores and for the period october 1,2014 to march 31, 2015 is rs. 4.5 crore. there are no other transactions falling under any of the clauses of section 92BA. A question that arises is as to whether for determining the applicability of the provisions of Chapter X, should the aggregate interest expense of the two periods be considered or whether the interest expense of the two periods on a stand-alone basis should be considered.
1.10. One view is that upon conversion of a company into LLP, new assessee comes into existence. the company is succeeded by the LLP. For the period from april to September 2014, the company would file its return of income and for the period october 2014 to march 2015, the LLP would file a separate return of income. Section 170(1) of the act provides that where a person carrying on any business or profession (such person hereinafter in this section being referred to as the predecessor) has been succeeded therein by any other person (hereinafter in this section referred to as the successor) who continues to carry on that business or profession,—
(a) the predecessor shall be assessed in respect of the income of the previous year in which the succession took place up to the date of succession;(b) the successor shall be assessed in respect of the income of the previous year after the date of succession. hence, the threshold should be considered separately for both the assessees.
1.11. The other view is also possible. it proceeds on the following lines :
- Section 92Ba refers to the aggregate of such transactions entered into by the “assessee” ;
- the word “assessee” would include even its predecessor, in the view of the decision of the Supreme Court in the case of CIT vs. T. Veerbhadra Rao (155 ITR 152) (SC).
- the case was concerning section 36(2) which requires that for allowing deduction in respect of a bad debt, such debt should have been taken into account in computing the income of the “assessee” and the Supreme Court held that debt if the predecessor had taken that debt into account in computing its income, the successor would be eligible for claiming bad debts if it writes off such debt in its Profit and Loss account.
- thus a combined total ought to be taken of the predecessor and successor with a view to apply threshold of rs. 5 crore.
1.12. Personally, the auditors prefer the first mentioned view. however, having regard to the general adversarial approach of the tax department, it may be safer to go by the second view and ensure compliance of the transfer Pricing Provisions anyway.
3. DTP in relation to section 40A(2)
3.1. Clause (i) of section 92B, which defines Sdt, refers to any expenditure in respect of which payment has been made or is to be made to a person referred to in clause (b) of section 40a(2). Section 40a(2) is a computation provision, providing for disallowance of an expenditure incurred in a transaction entered into with specified persons, subject to satisfaction of other conditions mentioned in that section. Under this section, such expenditure is disallowed if it is considered as excessive or unreasonable having regard to the following:
– the fair market value of the goods, services or facilities for which the payment is made; or
– the legitimate needs of the business or profession of the assessee; or
– the benefits derived by or accruing to him therefrom.
3.2. The said three conditions are separated by the conjunction ‘or’, which indicates that all the three circumstances need not exist simultaneously and that these requirements are independent and alternative to each other. Further, in respect of the first condition that the expenditure incurred should be at fair market value, the Finance act, 2012 has inserted a new proviso to section 40a(2)(a) with effect from assessment year 2013-14, which reads as under:
“Provided that no disallowance, on account of any expenditure being excessive or unreasonable having regard to the fair market value, shall be made in respect of a specified domestic transaction referred to in section 92BA, if such transaction is at arm’s length price as defined in clause (ii) of section 92F.”
3.3. This amendment is consequential to the introduction of the dtP regulations in the act. hence, post amendment, the reasonableness of an expenditure in respect of a SDT needs to be ascertained based on the transfer pricing methods prescribed in Chapter X of the act. Further, the assessee also needs to maintain proper documents to demonstrate that the transactions are entered into on arm’s length basis.
3.4. The said clause refers only to “expenditure”. hence, items of income are not covered for the purpose of this clause. Therefore, the section applies only to an assessee who has incurred the expenditure and not the assessee who has earned the income in the very same transaction.
3.5. Further, though it refers to ‘any’ expenditure in respect of which payment has been made or is to be made to a person referred to in section 40a(2) (b), it does not cover such expenditure, which is not claimed as deduction by the assessee while computing its income under the head ‘Profits or Gains from Business or Profession’. in other words, it does not cover expenditure of, say, capital nature or say, claimed as deduction while computing “income from house property”, since the scope of section 40a(2)(b) is restricted only to compute “Profits and Gains from Business or Profession”. this is also clear from the em of the Finance Bill, 2012, which clearly states that the dtP provisions have been introduced ‘for the purpose of’ section 40a(2), etc. hence, clause (i) of section 92Ba cannot be applied for purpose other than for section 40a(2). the only exception to the above would be computation of income under the head “income for other Sources”, since section 58(2) of the act, imports the provisions of section 40a(2) for the purpose of computation of income under that head.
3.6. Clause (b) of section 40a(2) provides for an exhaustive list of persons for various kinds of assessees. hence, where any transaction involving an expenditure is entered into with such specified persons, and such expenditure is deductible while computing the income under the “Profits or Gains from Business or Profession” or “income from other Sources”, it would automatically fall within clause (i) of section 92Ba.
4. DTP in relation to section 80A/80IA(8):
4.1. Clauses (ii) and (iii) of section 92Ba refers to transactions referred to in sections 80a(6) and 80ia(8), respectively. Both these sections contain provisions for computation of the eligible profits claimed as deduction under the sections specified therein having regard to the market value, in a case where there has been transfer of goods or services to or from the eligible undertaking/unit/enterprise/ business of an assessee from or to other business of the assessee. Further, the Explanation to these sections has been amended by the Finance act, 2012, providing that where such transfer of goods or services is regarded as an Sdt, the market value of the goods or services would mean the ALP as defined under section 92F(ii).
4.2. The transaction referred to in section 80a(6)/80ia(8) is inter-unit transfer of goods or services. hence, the transaction referred to in these sections is internal transfer of goods and services as against transaction between two persons. Hence, transfers within separate businesses of an assessee covered under these sections would also need to be considered and aggregated for the purpose of determining the monetary limit of Rs. 5 crore u/s. 92Ba. Further, unlike clause (i) of section 92BA, it would cover both items of income as well as expenses. however, where a transaction is covered under both section 80a(6) and section 80ia(8), it would be considered only once for the purpose of finding the aggregate total.
4.3. However, mere allocation of common costs between several units/businesses of the assessee would not be covered under these sections. the said sections provides that the profits of an eligible business shall be determined based on the market value of the goods and services, where such goods or services have been ‘transferred’ by such unit to ‘any other business’ or vice versa and, in either case, the consideration, if any, for such transfer as recorded in the accounts of the eligible business does not correspond to the market value of such goods or services as on the date of the transfer. hence, u/s. 92Ba r.w.s. 80a(6)/80ia(8), the transfer pricing provisions have been applied to a particular unit of the assessee, whose profit is to be determined based on arm’s length principles only in certain specified scenarios, the same being:
a. there should be inter-unit ‘transfer’ of goods or services;
b. Such transfer should be to/from any other ‘business’ of the assessee; and
c. Such transfer should be at a consideration that does not correspond to the market value.
4.4. In case of common expenses, such as managerial remuneration, general administrative expenses or research, marketing and finance expenses, etc., it may be noticed that they are not ‘transferred’ by any one unit of the assessee to another unit. Further, such activities may qualify as “services”, the same cannot be regarded as another “business” of the assessee. Hence, it may not be strictly covered u/s. 80ia(8), implying that such common cost need not be allocated to the eligible unit on an arm’s length basis.
4.5. However, attention may be brought to sub-section (5) of section 80IA, which requires that the profits of the undertaking claiming deduction under section 80ia should be computed as if the undertaking is the only source of income of the assessee. in view of this provision, Courts have held that the essence of the phrase ‘as if such eligible business was the only source of income’ used in the said sub-section (5) is that the expenses of the business, whether direct or indirect; project-specific or common expenses, had to be considered and allocated for computation of the profits and gains of an eligible business. See:
Nitco Tiles Ltd. vs. Deputy Commissioner of Income-tax [2009] 30 SOT 474 (MUM.);
Kewal Kiran Clothing Ltd., Mumbai vs. Assessee ITA No. 44/Mum/2009;
Control & Switchgear Co. Ltd. vs. Deputy Commissioner Of Income Tax;
Nahar Spinning Mills Ltd. vs. Joint Commissioner of Income-tax, Range VII, Ludhiana [2012] 54 SOT 134 (CHD)(URO):[2012] 25 taxmann.com 342 (Chd.);
Synco Industries Ltd. vs. Assessing Officer of Income-tax [2002] 254 ITR 608 (Bom)
4.6. Hence, the common costs do need to be allocated to the eligible unit u/s. 80ia(5). however, such allocation is not required u/s. 80IA(8) or section 80a(6), since these provisions apply only when there is a ‘transfer’ of goods and services from an eligible ‘business’ to another or vice versa. Hence, the pre-requisite for invoking these provisions is that goods or services should be ‘transferred’ from one unit to another. in absence of any transfer, this provision would not be triggered. Indeed, when there is no transfer, no price would be regarded for any transfer of goods in the books of the eligible unit and hence, there would be no occasion to examine as to whether such price adopted by the eligible unit is as per the market value of such goods or not.
4.7. In this context, attention may be invited to the decision in Cadila Healthcare Ltd. vs. Additional Commissioner of Income-tax, Range – I, [2013] 56 SOT 89 (Ahmedabad – Trib.). In that case, the assessee was carrying out only one manufacturing business that was eligible for deduction under section 80iC. Hence, it carried out both manufacturing and selling and distribution activity as a part of one single business. The issue arose before the tribunal as to whether such manufacturing and distribution businesses need to be segregated and a notional transfer of goods from the manufacturing business to the selling business needs to be assumed for determine the profits of the manufacturing business.
4.8. It was held that for applying this provision, one cannot assume an artificial or notional transfer of good or services between the units. Section 80iC(7) read with section 80IA(8) does not require that eligible profit should be computed first by transferring the product at an imaginary sale price to the head office and then the head office should sell the product in the open market. in that case, the ao had suggested two things; first that there must be inter-corporate transfer, and second that the transfer should be as per the market price determined by the ao. it was held that both these suggestions are not practicable. If these two suggestions are to be implemented, then a Pandora box shall be opened in respect of the determination of arm’s length price vis-a-vis a fair market and then to arrive at reasonable profit. rather a very complex situation shall emerge. Specially when the Statute does not subscribe such deemed inter-corporate transfer but subscribe actual earning of profit, then the impugned suggestion of the ao does not have legal sanctity in the eyes of law. When the method of accounting as applicable under the Statute, does not suggest such segregation or bifurcation, then it is not fair to draw an imaginary line to compute a separate profit of the eligible unit. it was held that there is no such concept of segregation of profit. rather, the profit of an undertaking for section 80ia deduction purposes should be computed as a whole by taking into account the sale price of the product in the market. If the Statute wanted to draw such line of segregation between the manufacturing activity and the sale activity, then the Statute should have made a specific provision of such demarcation. But at present the legal status is that the Statute does not do so.
4.9. Thus, this provision cannot be invoked by the revenue authorities for allocating the common expenses of the assessee to the eligible business of the assessee. For example, allocation of the expenditure incurred on managerial remuneration to an eligible unit, which was debited to another non-eligible unit by the assessee, was held in Nahar Spinning Mills Ltd. vs. Joint Commissioner of Income-tax, Range VII, Ludhiana [2012] 54 SOT 134 (CHD)(URO) to be not covered u/s. 80ia(8), in absence of any transfer of goods or services between the two units. Indeed, managerial services would qualify as “services”. Also, managerial services is not the “business” of an assessee. These provisions apply when the goods and services held for an eligible business are transferred to other business or vice-versa. Therefore, these provisions do not apply to such allocation of expenses
4.10. Further under 80ia(5), the common cost needs to be only allocated i.e. apportioned between various eligible units on actual basis without adding any notional mark-up. had section 80ia(8) applied, then a mark-up would have been added, since in that case, it would have been regarded as transfer of goods and services by one unit to another, and as per the arm’s length principle, such transfer would have been made not at cost but at a price, which obviously includes mark – up.
4.11. Besides, reference may also be made to sections 92(2a) and 92(2) of the act. Section 92(2a) provides that allocation of any cost or expense in relation to the Sdt shall be computed having regard to the ALP. Similarly, section 92(2) provides that where in a Sdt, two or more associated enterprises enter into a mutual agreement or arrangement for the allocation or apportionment of, or any contribution to, any cost or expense incurred or to be incurred in connection with a benefit, service or facility provided or to be provided to any one or more of such enterprises, the cost or expense allocated or apportioned to, or, as the case may be, contributed by, any such enterprise shall be determined having regard to the ALP of such benefit, service or facility, as the case may be.
4.12. As would be observed, though these sections deal with computation of allocation of cost/expense having regard to ALP, such allocation should be in respect of a transaction, which is a SdT. In other words, the allocation should be in respect of a transactions referred to in sections 40a(2), 80a(6), 80ia(8), 80ia(10) for the purposes of those sections. as stated earlier, the allocation of common cost between units of an assessee is not a transaction covered u/s. 80a(6)/80(8). Further, sections 80ia(10) and 40a(2) are totally inapplicable for the purpose of such allocation. Accordingly, since there is no Sdt at the first place, the question of applying section 92(2) or section 92(2a) would not apply.
4.13. Also, as far as section 92(2) is concerned, it applies only in respect of Sdt between two ‘associated enterprises’. Clearly, two units of same assessee cannot be regarded as ‘associated enterprises’ as defined u/s. 92a of the act. though sub-clause (ii) of clause (a) of rule 10a, defines the term ‘associated enterprise’, in relation to Sdt entered into by an assessee to include “other units or undertakings or businesses of such assessee in respect of a transaction referred to in section 80a or, as the case may be, sub-section (8) of section 80ia”, the said definition is applicable only for the purposes of the rules and cannot be imported for the purpose of section 92(2). Hence, even u/s. 92(2)/(2a), the transfer pricing methods need not be applied in allocating the common expenses to the eligible unit.
4.14. Difficulties could arise also where different entities of a group that are related to each other u/s. 40a(2) have arranged their affairs in such a manner that some employees and some resources are jointly used and each entity raises debit note on the other towards sharing of costs every month based on certain fixed criteria – like number of staff, turnover, etc. Since the charges are essentially towards sharing of costs, companies would like to contend that the inter-company charge is reasonable having regard to ALP as determined under CUP method. however, the point that is being missed is that the basis of sharing should really meet the arm’s length principle because if such basis is not scientific, then, the condition in section 40a(2) that the expenditure should be reasonable having regard to not only the ALP but also to the legitimate needs of the business and benefits derived therefrom may come under a challenge.
4.15. Section 80ia(8) has been referred to in various other provisions of Chapter VIA and in section 10aa, so that while computing the profits eligible for deduction under those provisions, effect needs to be given to this sub-section of section 80ia.
Clause (v) of section 92Ba provides that even such transactions of assessee claiming deduction under these other provisions to which section 80ia(8) applies would also be covered for the purpose of SDT. For example, sections 80iB(13), 10aa(9), 80iaB(3), 80iC(7), 80id(5) and 80ie(6) provides that while computing the provisions contained in section 80ia(8) shall, so far as may be, apply to the eligible business under this section. Hence, inter unit transfer of goods and services where one of the unit is eligible to claim deduction u/s. 80iB would also be regarded as transactions covered under clause (v) of section 92Ba.
5. DTP in relation to section 80IA(10):
5.1. Clause (iv) of section 92BA refers to any business transacted between the assessee and another person as referred to in section 80IA(10). unlike sections 80A(6) and 80IA(8), which deal with inter-unit transfer of goods and services, section 80IA(10) deals with a case where the assessee having an eligible business enters into a transaction with another person, which owing to the “close connection” between them or otherwise, is arranged in a manner which results in the eligible business showing more than ordinary profits.
5.2. Hence, for a transaction to be covered u/s. 80IA(10) and therefore under clause (iv) of section 92Ba, it should be a transaction which is ‘arranged’ to show more than ordinary profits from the eligible business.
5.3. Further, invoking section 80IA(10) is a prerogative of the ao. the ao can recompute the profits eligible for tax holiday if the tax payer having business with another party of “close connection” earns more than ordinary profits because of such “close connection” or “for any other reason”. The section does not provide for any objective criteria to decide whether there is any “close connection” between two parties doing business with each other. Generally, the expression ‘close connection’ has been interpreted to cover all companies which belong to the same group 2.
5.4. Also, “any other reason” is a term that is subjective and which reflects the legislative intent of providing freedom to the ao to examine all facts and circumstances of the case and decide. For example, an unrelated person who has lived with the assessee as a paying guest for several years and for whom he develops affection may be covered under “close connection”. At the same time two brothers separated from each other may run independent companies which may do business with each other, but the “close connection”, in substance, is absent.
5.5. The new law casts the onus on the assessee and the auditors to identify and report such transactions! it is impossible to comply with such a requirement unless, like section 40A(2) or section 92A there are objective criteria to determine the persons having “close connection”. Also, cases of “any other reason” can never be imagined by the assessee or the auditors for reporting.
5.6. Further, like sub-section (8) of section 80IA, even sub-section (10) of section 80ia has been referred to in various other sections. hence, even such transactions of assessee claiming deduction under these other provisions to which section 80IA(10) applies would also be considered as Sdt.
6. Issues in relation to DTP regulations
6.1. Whether DTP regulations can be made applicable even in a case where there is no tax arbitrage:
The Supreme Court in CIT vs. GlaxoSmithkline Asia P. Ltd. (supra), on the facts of that case, refused to interfere “as the entire exercise is revenue neutral” and accordingly dismissed the SLP filed by the revenue. The Court has also observed that in the case of domestic transactions, the under-invoicing of sales and over-invoicing of expenses ordinarily would be revenue neutral in nature, except in those cases, which involve tax arbitrage. The Court has then listed the circumstances where there could be tax arbitrage as under:
(i) if one of the related companies is a loss making company and the other is a profit making company and profit is shifted to the loss making concern; and
(ii) if there are different rates for two related units [on account of different status, area-based incentives, nature of activity, etc.] and if profit is diverted towards the unit on the lower side of the tax arbitrage. For example, sale of goods or services from non-SEZ area, [taxable division] to SEZ unit [non-taxable unit] at a price below the market price so that taxable division will have less taxable profit and non-taxable division will have a higher profit exemption.
Hence, applying the ratio of this decision, the DTP regulations should be applicable only to such cases that involve tax arbitrage.
Further, in the context of section 40a(2), the CBDT vide Circular no. 6P dated 06-07-1968 has clearly specified that the same cannot be applied in cases where there is no tax evasion. The relevant extract of which reads as under:
“No disallowance is to be made u/s. 40A(2) in respect of payment made to relatives and sister concerns where there is no attempt to evade tax. ITO is expected to exercise his judgment in a reasonable and fair manner. It should be borne in mind that the provision is meant to check evasion of tax through excessive or unreasonable payments to relatives and associated concerns and should not be applied in a manner which will cause hardship in bona fide cases.” (emphasis supplied)
In CIT vs. V.S. Dempo & Co (P) Ltd [2011] 196 Taxman 193 (Bom), it has been observed that the object of section 40A(2) is to prevent diversion of income. an assessee, who has large income and is liable to pay tax at the highest rate prescribed under the act, often seeks to transfer a part of his income to a related person who is not liable to pay tax at all or liable to pay tax at a rate lower than the rate at which the assessee pays the tax. In order to curb such tendency of diversion of income and thereby reducing the tax liability by illegitimate means, Section 40a was added to the act by an amendment made by the Finance act, 1968. hence, in cases where there has been no attempt to evade tax, section 40A(2) cannot be attracted. Also see:
CIT vs. Jyoti Industries (2011) 330 ITR 573 (P&H);
CIT vs. Udaipur Distillery Co Ltd. (2009) 316 ITR 426 (Raj);
Deputy Commissioner of Income-tax vs. Ravi Ceramics [2013] 29 taxmann.com 22 (Ahmedabad – Trib.);
CIT vs. Indo Saudi Services (Travel) (P.) Ltd. [2008] 219 CTR 562 (Bom);
Orchard Advertising (P.) Ltd. vs. Addl. CIT [2010] 8 taxmann.com 162 (MUM);
DCIT vs. Lab India Instruments (P.) Ltd. [2005] 93 ITD 120 (PUNE);
ACIT vs. Religare Finvest Ltd. [2012] 23 taxmann. com 276 (Delhi);
Aradhana Beverages & Foods Co. (P.) Ltd. vs. DCIT [2012] 21 taxmann.com 135 (Delhi);
CIT vs. J. S. Electronics P. Ltd. (2009) 311 ITR 322 (Del).
Hence, it can be said that the dtP regulations should not be applied where there is no tax advantage to the parties, especially in cases where section 40A(2) is being applied. However, the act, as it stands today, does not so provide. transactions between related resident parties may be subject to the rigours of DTP regulations even if there is no tax arbitrage or an advantage obtained by any of the parties from such a transaction. For example, transaction of sale and purchase of goods between two indian companies, which are subject to the same maximum marginal rate of tax, would not lead to any tax advantage to either of them. However, if the said two companies are related to each other under section 40A(2)(b) of the act and the volume of the transactions between the two companies exceeds rs. 5 crore in a given financial year, the transactions between the two companies would still be subject to the domestic transfer pricing regulations and accordingly, the companies would be required to maintain proper documents in support of the arm’s length price of such transactions and would also be required to obtain an accountant’s report in respect of such transactions. Similarly, in case of an assessee having two eligible units u/s. 80IA of the act, transfer of goods between the two units would not lead to any tax advantage to either of them, but nevertheless, they would be subject to the domestic transfer pricing regulations.
The irony, thus, is that while the transactions that are revenue neutral shall not suffer any disallowance in terms of the Supreme Court ruling, the related parties entering into such transactions will, nevertheless, be required to maintain documentation and records under the new transfer pricing provisions.
6.2. Whether ‘corresponding adjustments’ are allowed under the DTP regulations in the hands of the other assessee:
On a plain reading of section 92(2a), it may appear that since ALP adjustment is required both in the case of income as also expense, the total income of both the parties to the transaction would be adjusted for the difference, if any, between the recorded/actual price and the aLP of the transaction.
However, this is not the case, when this provision is read along with section 92(3), which provides that the provisions of section 92 would not apply where such ALP adjustment has the effect of reducing the income chargeable to tax or increasing the losses.
Hence, though ALP adjustment may be required in case of the assessee whose income stands increased, corresponding adjustment in the case of the counter- party would not be permissible, since that would result in reduction of his taxable income. this would lead to double taxation of same income twice. This is apparently contrary to an important canon of taxation, namely, the rule against double taxation of the same income.3
Unlike this, in case of international transactions, in most of the DTAAs, Article 9 provides that if an adjustment on account of ALP is made for determining the income of enterprise of the first contracting state, then corresponding adjustment shall be made to the income of enterprise of the second contracting state. hence, where there has been adjustment to the total income of the indian assessee u/s. 92(1) or section 92(2), the DTAA generally provides for a corresponding adjustment to the counter non-resident party, upon satisfaction of certain conditions.
Article 9(2) of the OECD Model provides as under:
“2. Where a Contracting State includes in the profits of an enterprise of that State — and taxes accordingly —profits on which an enterprise of the other Contracting State has been charged to tax in that other State and the profits so included are profits which would have accrued to the enterprise of the first-mentioned State if the conditions made between the two enterprises had been those which would have been made between independent enterprises, then that other State shall make an appropriate adjustment to the amount of the tax charged therein on those profits. In determining such adjustment, due regard shall be had to the other provisions of this Convention and the competent authorities of the Contracting States shall if necessary consult each other.”
Article 9 of the united nations model Convention too provides for such corresponding adjustments, though subject to certain further conditions. The relevant paras of Article 9 read as under:
“2. Where a Contracting State includes in the profits of an enterprise of that State—and taxes accordingly—profits on which an enterprise of the other Contracting State has been charged to tax in that other State and the profits so included are profits which would have accrued to the enterprise of the first-mentioned State if the conditions made between the two enterprises had been those which would have been made between independent enterprises, then that other States hall make an appropriate adjustment to the amount of the tax charged therein on those profits. In determining such adjustment, due regard shall be had to the other provisions of the Convention and the competent authorities of the Contracting States shall, if necessary, consult each other.
3. The provisions of paragraph 2 shall not apply where judicial, administrative or other legal proceedings have resulted in a final ruling that by actions giving rise to an adjustment of profits under paragraph1, one of the enterprises concerned is liable to penalty with respect to fraud, gross negligence or wilful default.”
Hence, though section 92(3) of the act prohibits corresponding adjustments even in the cases of international transactions, a relief of corresponding adjustments, subject to certain conditions, is available to the non-resident assessees in the relevant dtaas. in such cases, there is no double taxation of the said amount.
Such unequal treatment of the Indian assessees and foreign assessees would lead to hostile discrimination between them, which is not permitted under article 14 of the Constitution of india. hence, such discrimination between the two assesses may be constitutionally challenged.
6.3. DTP and section 35AD:
Section 35ad provides for deduction/weighted deduction in respect of certain capital expenditure incurred by an assessee wholly and exclusively, for the purposes of any business specified in that section, carried on by him during the previous year.
Sub-section (7) of this section provides that “the provisions contained in sub-section (6) of section 80a and the provisions of sub-sections (7) and (10) of section 80-IA shall, so far as may be, apply to this section in respect of goods or services or assets held for the purposes of the specified business”. Hence, the provisions of section 80a(6) and section 80IA(10) are applicable even to section 35AD.
Prima facie, it may appear that in view of the reference to sections 80A(6) and 80IA(10), the DTP regulations would also be applicable to this section. however, for applying the dtP provisions, existence of a SDT is a pre-requisite. Now, on close reading of the definition of Sdt4, it would be clear that it covers transactions referred to in section 80a(6), any business transaction referred to in section 80IA(10) as also any transaction, referred to in any other section ‘under Chapter VI-A or section 10AA’, to which provisions of section 80IA(10) are applicable. however, it does not cover transactions referred to in any other provision of the act other than Chapter VIA and section 10AA, to which the provisions of section 80IA(10) apply. Now, SDT has been defined “to mean……”, so that it is an exhaustive definition and cannot be construed widely to cover transactions other than those mentioned therein. hence, since the transactions referred to in section 35AD are not covered within the ambit of SDT, the DTP provisions contained in sections 80A(6) and 80IA(10) would not apply to it. Further, the other dtP provisions contained in Chapter X, which are applicable to SDT, would also not apply to transactions covered under section 35ad.
6.4. Directors’ Remuneration -: Whether Companies Act provisions/approval is valid benchmark?
A director of a company is covered in the list of persons specified under clause (b) of section 40a(2). Hence, the remuneration paid to it by the company would be subject to the provisions of section 40A(2) and consequently, to the DTP regulations.
Now, u/s. 92C, the aLP of a transaction needs to be determined by applying the most appropriate method. Rule 10C deals with the criteria for the selection of the most appropriate method. the most appropriate method is one which best suits to the facts and circumstances of each particular transaction and which provides the most reliable measure of an arm’s length price in relation to the transaction. Now, under CUP method, the prices charged/paid for a comparable uncontrolled transaction are considered. However, having read the provision of section 92Ba read with section 40a(2)(b) of the act, payment of remuneration to a director, being a party specified in section 40a(2)(b) of the act, would always be a controlled transaction. Hence, since CUP method works only in case where comparable uncontrolled transaction exists, this method may not apply from that angle. Nevertheless, under this method, tribunals have taken a view5 that payments, if approved by appropriate authorities would be considered as being at arm’s length royalty under CUP method. See:
– DCIT vs. Sona Okegawa Precision Forgings Ltd. [2012] 17 taxmann.com 98 (Delhi);
– Sona Okegawa Precision Forgings Ltd. vs. ACIT[2012] 17 taxmann.com 141 (Delhi);
– Thyssenkrupp Industries India (P.) Ltd. v. ACIT [2013] 33 taxmann.com 107 (Mumbai – Trib.);
– SGS India (P.) Ltd. vs. ACIT [2013] 35 taxmann. com 143 (Mumbai – Trib.)
However, there also exist views contrary to the same. See:
– Perot Systems TSI (India) Ltd. vs. DCIT [2010] 37 SOT 358 (Delhi);
– SKOL Breweries Ltd. vs. ACIT [2013] 29 taxmann. com 111 (Mumbai – Trib.)
Hence, it is arguable that so long as the directors’ remuneration is within the limits prescribed under the Companies act, 1956/2013, such remuneration should be regarded as at ALP under CUP method, though contrary view cannot be ruled out.
now, RPM is generally preferred where the entity performs basic sales, marketing, and distribution functions (i.e. where there is little or no value addition) and therefore, it cannot be applied in the instant case. Similarly, CPm which is generally adopted in cases of provision of services, joint facility arrangements, transfer of semi-finished goods, long term buying and selling arrangements, etc, the same fails in the present case. PSm method is applicable in cases where there are multiple interrelated transactions between aes and when such transactions cannot be evaluated independently. Since payment of remuneration by Company to its directors is a single transaction capable of being evaluated separately, applicability of PSm method fails in the present case. TNMM requires a comparison between the income derived by unrelated entities from uncontrolled transactions and the income derived by the assessee from its transactions with related parties. In this method, it is the profit and not the price that forms the basis for comparison. In case of a transaction of payment of director’s remuneration, the profits of unrelated parties shall always be from “controlled transactions” because the directors are covered within the meaning of related parties u/s. 40a(2). Therefore, it is not possible to find any comparable company that qualifies for selection for comparison of profits. Accordingly, this method is also not capable of being implemented.
As would be observed, all the methods prescribed, (except, arguably, the CUP method) are rendered unsuitable for determining the aLP in the present case. Hence, recourse may be made to the residuary method prescribed under rule 10AB of the rules, which permits application of any rational basis for determining the ALP, where none of the other methods are applicable.
Now, the CBDT has, in its Circular No. 6P (LXXVI-66), dated july 6, 19686 , while clarifying the introduction to section 40a to act vide Finance act, 1968, at para 75 remarked that when the remuneration of a director of the Company is approved by a Company Law administration, the reasonableness of the same cannot be doubted. the relevant extract of the said circular reads as under:
“In regard to the latter provisions, the Deputy Prime Minister and Minister of Finance observed in Lok Sabha (during the debates on the Finance Bill, 1968) that where the scale of remuneration of a director of a company had been approved by the Company Law Administration, there was no question of the disallowance of any part thereof in the income-tax assessment of the company on the ground that the remuneration was unreasonable or excessive.”
Thus, as per the CBDT’s own views, if the remuneration paid by a Company is within the ceiling limits provided under the provisions of the Companies act, 1956 or approved by the Company Law administration, then disallowance u/s. 40a(2) of the act cannot be sustained.
Hence, having regard to this Circular, one may proceed to benchmark the remuneration paid by a Company to its directors under the residuary method. Indeed, the aforesaid CBDT circular has not been withdrawn even after the introduction of DTP regulations under Chapter X of the act. also, one may keep in mind the decision of the Supreme Court7 that circulars issued by the Board are binding on all officers and persons employed in the execution of the act.
Thus, it may safely be concluded that where the remuneration paid to the directors (including commission and sitting fees) is within the permissible limits expressly provided under the Companies act, it is at ALP.
6.5. Whether persons indirectly related would get covered under clause (b) of section 40A(2):
Clause (b) of section 40a(2) provides for the list of persons the transactions between whom would be covered under that section. the said clause does not use the words ‘directly or indirectly’. hence, it appears that the transactions between persons who are indirectly related would not be covered within its ambit. Indeed, whatever indirect relationships were intended to be covered, the same have been specifically provided in the said clause. For example, a company, the director of which has substantial interest in the business of the assessee has been covered as a specified person. Clearly, such company has no direct relation with the assessee. Indeed, wherever the Legislature has intended to cover even indirect relationships, it has been specifically provided in the act. For example, section 92a of the act defines the term ‘associated enterprise’ to, inter alia, mean an enterprise, which participates, directly or indirectly…..in the management or control of the other enterprise.’ Hence, apart from the persons specifically mentioned in clause (b), no other person indirectly related to the assessee would be regarded as a related party.
For example, where A holds 20% equity share capital in B and B holds 20% equity share capital in C, transactions between a and B as well as between B and C could be hit by section 40a(2). However, transactions between a and C would not covered by these provisions.
In Para 73 of Circular no. 6P dated 06-07-1968, explaining the provisions of the Finance act, 1968 (through which section 40a was inserted), it is mentioned that ‘the categories of persons payments to whom fall within the purview of this provision comprise, inter alia………… persons in whose business or profession the taxpayer has a substantial interest directly or indirectly’.
However, the said phrase so used in the Circular cannot be construed to mean that in all cases of assessee holding indirect substantial interest in another person’s business, they would be regarded as related persons. The said phrase basically refers to sub-clause (vi) of Section 40a(2)(b), which provides for specific instances where the assessee and another person in whose business he has substantial interest (directly or indirectly to the extent specified in the section), would be regarded as related persons. the indirect substantial interests so covered in the said sub-clause (vi) are in case of an individual, substantial interest through his relative and in case of other specified assessees, substantial interest through its director or partner or member, as the case may be or any relative of such director, partner or member.
Hence, the interpretation of the word ‘indirectly’ used in the Circular should be restricted to mean only the foregoing indirect interests envisaged in the section and should not be widely construed to cover cases beyond the scope of the section. For example, substantial interest of a company in another person indirectly through a company is not covered within this clause. indeed, the word “indirectly” appears to be used in the Circular merely to avoid reproducing the entire clause from the section once again and therefore, should not be interpreted to widen the scope of that section. Besides, it is an established principle that a delegated legislation (such as circulars, rules, etc.) cannot travel beyond the scope of main legislation. A circular cannot even impose on the taxpayer a burden higher than what the act itself on a true interpretation envisages.
Recently, the institute of Chartered accountants of india has also clarified in its Guidance note on report u/s. 92e of the income-tax act, 19618, at Para 4a.16 that, for the purpose of section 40a(2), it would be appropriate to consider only direct shareholding and not derived or indirect shareholding.
6.6. Whether section 40A(2) applies only to expenditure for which deduction has been claimed, can it made applicable to adjust the expenditure capitalised on which depreciation is subsequently claimed?
Section 40A(2) applies when there is a claim for deduction of an expense. u/s. 37(1), expenditure in the nature of capital expenditure is not allowed as deduction in computing the income chargeable under the head ”Profits and gains of business or profession“. Hence, strictly speaking, such expenses would not be covered by section 40A(2), since this section is applicable only for computing the deductions which are otherwise allowable while computing the “Profits and gains of business of profession”.
A question arises as to whether the section can be applied to the depreciation claimed on such capital expenditure. now, it is a settled legal position that depreciation is not an ‘expenditure’. In Nectar Beverages P. Ltd. vs. DCIT (314 ITR 314), the apex Court has held that “depreciation is neither a loss nor an expenditure nor a trading liability”. in Vishnu Anant Mahajan vs. ACIT (137 ITD 189)(Ahd) (SB) and Hoshang D Nanavati vs. ACIT (ITA No. 3567/Mum/07)(TMum), it has been held to be an ‘allowance’ and not an ‘expenditure’. Hence, since depreciation cannot be regarded as an ‘expenditure’, its disallowance/allowance cannot be governed by section 40A(2) of the act. it is has been held that section 40A(2) does not operate when a transaction concerns only the assets of the assessee.
