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The arm’s length principle is applied to the Indian Transfer Pricing Regulations. According to the legislation, any income deriving from a cross-border transaction between related businesses must be calculated using the arm’s length price (or ALP).
Various facets of the transfer pricing system in India, as well as outstanding transfer pricing issues that continue to provide challenges to transfer pricing administration, are explored in this article.
The key to evaluating an international transaction’s arm’s length price is to conduct a comparability analysis. But, rising market volatility and complexity in international transactions have posed significant problems to comparative analysis and determining the arm’s length pricing. Some of these problems, as well as the Indian transfer pricing administration’s countermeasures to handle them, are discussed here. For example, the use of current data from comparable companies yields a more realistic arm’s length price in a given year. As a result, the Indian transfer pricing regulations prioritized data from the current year, i.e., the year under audit.
As previously noted, the Indian transfer pricing regulations indicated that the data to be used in analyzing the comparability of an uncontrolled business transaction with an overseas transaction ought to be the data relevant to the fiscal year in which the foreign transactions were carried into. The law did, however, provide an exception that allowed the use of data from the previous two years if it could be demonstrated that such data could have an impact on the assessment of the arm’s length price. This exception resulted in numerous conflicts and prolonged litigation between taxpayers and tax authorities.
To avoid such controversies and provide taxpayers some leeway in defending their transfer pricing, the Indian government agreed to allow the use of multiple-year data. As a result, for transactions completed on or after April 1, 2014 (i.e., beginning with Assessment Year 2015-16), multiple-year data from comparable companies can be utilized to benchmark foreign transactions with related firms.
The foundation of every comparability analysis is a comparison of functions performed, assets used, and risks accepted. In India, risk has traditionally been assessed alongside functions and assets. In comparison to functions performed and assets used, India considers it unethical to place undue emphasis on risks in determining the arm’s length pricing.
In a comparability analysis, identifying risks and determining who bears those risks are critical tasks. India believes that the parties’ conduct is critical in establishing whether the real risk allocation matches the contractual risk allocation. The ability of the parties to the transaction to control risks affects risk allocation.
The core functions, key tasks, key decision-making, and levels of individual accountability for key decisions are all critical considerations in determining who has control over the risks. Furthermore, financial competence to carry the risk is also critical in determining whether a party genuinely bears or controls the risk.
MNEs in India assert in front of transfer pricing officers that associated companies engaged in contract R&D or other contract services in India are risk-free firms. As a result, these associated parties are considered to be entitled to just routine (low) cost-plus compensation. MNEs also claim that they control the risks associated with R&D activities or services and that Indian firms, as risk-free entities, are solely entitled to low-cost-plus remuneration.
The assumption that risks may be controlled remotely by the parent business and that an Indian subsidiary engaged in fundamental duties, such as research and development (R&D) or delivering services, is a risk-free corporation has not been deemed acceptable. India feels that in many situations, the main function of executing R&D activities or delivering services is based in India, which necessitates crucial strategic decisions to be made by the management and staff of the Indian subsidiaries. Such strategic decisions may pertain to the design of a product or software, the direction of R&D efforts or the provision of services, or the monitoring of R&D operations. As a result, the Indian subsidiary is in charge of the operational and other risks. In these circumstances, the parent company’s capacity to execute risk control remotely from a location where essential R&D and services capabilities are not situated is severely limited.
To harmonize the Indian transfer pricing rules with best worldwide practices, the law was recently updated to include a ‘Range’ concept for determining the Arm’s Length Price, which is applicable for foreign transactions completed on or after April 1, 2014. (i.e., effective from the assessment year 2015-16).
A dataset comprising the results or profit margins of six or more comparable organizations is to be sorted in ascending order, and an arm’s length range is to be generated starting at the thirty-fifth percentile of the dataset and ending at the sixty-fifth percentile of the dataset. If the price at which the foreign transaction was actually conducted falls within the above-mentioned range, the price of the transaction is judged to be the arm’s length price. But where the price at which the foreign transaction was actually conducted falls outside of the above-mentioned range, the arm’s length price will be taken to be the median of all values in the said dataset (i.e., the 50th percentile).
However, if the range is not employed because at least six comparable organizations are not available, then the arithmetic mean will be used to calculate the Arm’s Length Price.
Transfer pricing regulations in India, like those in many other nations, demand “reasonably correct comparability adjustments.” It is the taxpayer’s responsibility to justify and demonstrate a “reasonably correct comparability adjustment.” According to the perspective of the Indian transfer pricing administration, capacity utilization and working capital adjustments are achievable. However, in the lack of any reliable, strong, and internationally agreed-upon technique for the adjustment of risks, the Indian transfer pricing administration finds it difficult to make risk adjustments.
The notion of “location savings,” or cost savings in a low-cost jurisdiction such as India, is one of the factors considered for making a comparability analysis during transfer pricing audits. The term “location savings” has a far broader meaning; it refers to any cost advantage that a particular jurisdiction can bring, rather than simply transferring a business from a “high-cost” to a “low-cost” location. Multinational Enterprises are constantly looking for ways to cut costs in order to improve earnings. In this regard, India offers several operational benefits to MNEs, such as the availability of low-cost labor or trained staff, cheaper raw material costs, lower transaction costs, reasonably priced renting space, lower training costs, the availability of infrastructure at a lower cost, and so on. The incremental profit derived from Location Specific Advantages (LSAs) to Multinational Enterprises is called location rents.
The main difficulty in transfer pricing is calculating and allocating location savings and location rents among the related firms. Using an arm’s length pricing method, the division of location savings and location rents among related firms should be based on what independent parties would have agreed to in comparable situations. In circumstances where similar uncontrolled transactions are unavailable, the Profit Split Method can be used to establish an arm’s length division of location savings and rents.
However, in circumstances where comparable uncontrolled business transactions are available, the arm’s length price of a transaction with a related party in a low-cost jurisdiction can be determined through comparability analysis and benchmarking using the results or profit margins of such local comparable firms. If there are good local comparable firms available, the benefits of location savings can be deemed to have been captured in the ALP determined in this manner. But, if adequate local comparable data that could capture the benefits of location savings are not available, or if the overseas associated organization is chosen as the tested party, the challenge of capturing the advantages of location savings will remain a difficulty in determining the Arm’s Length Price.
Globalization and the aim to create efficiency within multinational groups have promoted the sharing of resources to give support to group entities in one or more locations via shared services. Some of the services are rather clear in nature, such as marketing, advertising, trading, management consulting, and so on. Other services, on the other hand, might be more sophisticated and can often be supplied either alone or as part of a package, and are tied in some manner to the supply of things or intangible assets.
It is critical to evaluate if the Indian subsidiary has received or delivered intra-group services that necessitate arm’s length remuneration. One of the major difficult issues for the transfer pricing governance is identifying the services that require arm’s length remuneration. India thinks that shareholder services, duplicate services, & incidental gains from group services do not give effect to intra-group services requiring arm’s length remuneration. Such a conclusion, however, would necessitate an extensive analysis. The most difficult problem in determining the arm’s length pricing is cost allocation utilizing allocation keys (i.e., basis for allocation of cost to various related firms). In general, the nature of allocation keys varies with the nature of services.
In light of the foregoing, transfer pricing of intra-group services is regarded as a high-risk area in India. India views the payment for such intra-group services to be base eroding in essence and, as a reason, places particular emphasis on the transfer pricing of such payments. Furthermore, even if an arm’s length outcome is obtained in respect of such payments from India, added protection in the manner of an overall ceiling on the amount of these payments might be required.
In 2001, the Indian Income-tax Act included transfer pricing rules. The provisions were broadly consistent with the OECD’s transfer pricing standards. Transfer pricing audits in India have revealed a number of concerns and challenges during the previous years. The administration of the transfer pricing law has also resulted in a number of disagreements and prolonged litigation.
Read our Article: Transfer Pricing Documentation and compliances