Transfer Pricing in India

Two Most Overlooked Aspects of Transfer Pricing Audits

In the new global finance world, transfer pricing has become one of the most critical tax issues for MNEs. The Indian regulations concerning transfer pricing are based on Sections 92 to 92F of the Income Tax Act of 1961.

These sections ensure that transactions between related parties, whether domestic or international, are done at an “arm’s-length price,” meaning a price mutually agreed upon by two independent, unrelated parties under similar conditions. This framework prevents profit shifting to low-tax jurisdictions by transferring income and secures India’s tax base.

While transfer pricing audits are a common feature for MNEs in India, there are still areas which are usually neglected and may lead to potential compliance risks. In this blog, we take a closer look at two of the most commonly overlooked aspects of transfer pricing audits, that is:

• Non-reporting of Deemed International Transactions under Section 92B(2)
• Incorrect Application of the Definition of Associated Enterprises (AE) under Section 92A of the Income Tax Act

Such non-compliance may result in severe consequences, such as penalties and adjustments, which can virtually skew a company’s financials. Below is a detailed look at these overlooked aspects and why taxpayers and auditors call for their attention.

However, to stay ahead of compliance risk in your transfer pricing audits, get tax audit services to ensure you are fully aligned with regulations and safeguard your business from costly penalties.

Non-Reporting of Deemed International Transactions

One of the common gaps observed in transfer pricing audits is the non-reporting of “deemed international transactions.” Many taxpayers fail to recognize that even domestic transactions can qualify as international under certain circumstances, as described in Section 92B(2) of the Income Tax Act.

What is a Deemed International Transaction?

Section 92B(2) states that even when a transaction is wholly domestic, that is, between an Indian entity and a third-party enterprise located in India, the said transaction would be considered an international transaction if an associated enterprise is involved as a third party. This is said to take place when:

• There is a prior agreement between the third party and an AE that influences the terms of the transaction or
• The AE and the third party decide the transaction terms directly or indirectly. The provision aims to avoid distortions where MNEs are structured through intermediary entities to reduce their tax liabilities in India by characterizing what is, in substance, an international transaction as a domestic transaction.

Situations where Deemed International Transactions may Arise

Deemed international transactions often arise in the context of global deals, including:

• Global procurement or supply arrangements: Suppose an Indian subsidiary acquires goods with another third-party supplier. Now, assume that MNE’s foreign parent company highly influences the supplier; therefore, such a transaction should be reported as international.
• Global service agreements: If the Indian entity is paying for services rendered by a third party, but the terms are decided by its associated enterprise located overseas, then it would be a deemed international transaction.
• Common technology agreements: Most Indian subsidiaries receive software or technology purchased through third parties whose pricing or terms are very much influenced by the foreign AE. Such contracts have to be scrutinized for any possible deemed international transaction. For example, if an Indian subsidiary is required by its foreign parent company to purchase products from a certain vendor, and the terms with that vendor are negotiated by the parent company, the transaction constitutes a deemed international transaction even if the vendor is an unrelated Indian party.

Compliance Requirements for Deemed International Transaction

As per the Indian transfer pricing regulations, a report of all international transactions, including the deemed ones, must be made in Form 3CEB. The form is required to be filed with the Income Tax Department and is also a prerequisite that needs to be certified by a Chartered Accountant.

Whether any deemed international transaction has been entered into is specifically asked under clause 20 of Form 3CEB. Unfortunately, many taxpayers fail to report such transactions due to ignorance or various misconceptions regarding the rules, which could lead to substantial penalties and transfer pricing adjustments that may substantially affect a business’s taxable income.

Misapplication of the Definition of Associated Enterprises (AE)

Another important but commonly missed aspect in transfer pricing audits involves incorrectly applying the definition of Associated Enterprises. A comprehensive definition of an enterprise as an Associated Enterprise under Section 92A of the Income Tax Act goes beyond merely meeting such representation criteria that may be applied for financial reporting purposes by accounting standards, such as Ind-AS 24.

Broad Definition of Associated Enterprises under Section 92A

As per the Income Tax Act, the definition of an AE contains any enterprise that has been engaged in another enterprise’s management, control, or capital by itself or along or through one or more other enterprises. It also encompasses entities influenced by the same persons or entities that control or both the enterprises. This definition is further extended to various situational definitions like:

• Having control of at least 26% of voting power in another enterprise.
• Loan dependency, where at least 51% of the total assets of the other enterprise consist of a loan from the first enterprise.
• Giving a guarantee for at least 10% of another enterprise’s borrowing.
• Having more than half of the board of directors appointed by another enterprise.

This broad definition is expected to make many entities not considered related parties under financial accounting standards still be AEs for transfer pricing purposes.

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Differences Between Section 92A and Ind-AS 24

Many taxpayers make the mistake of relying on related-party disclosures in their financial statements to identify AEs for transfer pricing purposes. However, there is a sea of difference between the criteria for related parties under Ind-AS 24, the accounting standard governing financial disclosures, and the criteria in Section 92A of the Income Tax Act.

For instance, Ind-AS 24 defines “related party” as an entity or person with control, joint control, or significant influence over the reporting entity. For example:

• Parent companies, subsidiaries, and joint ventures.
• Key management personnel and members of their families.

However, Ind-AS 24 does not provide the threshold for control or significance or account for the detailed scenarios provided in Section 92A. Therefore, an entity that may be an AE under the Income Tax Act may, even if it is not, be reported as a related party in the financial statements.

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Implications for not Correctly Applying the AE Definition

The incorrect use of an AE definition leads to incomplete information in transfer pricing documentation and may prevent proper benchmarking of transactions. Thus, the taxpayer is exposed to the following risks of compliance:

• Penalties: Non-compliance with the policies on transfer pricing will attract penalties. These penalties can include hefty fines arising from failure or under-reporting of international transactions.
• Adjustments: In case of incorrect transaction benchmarking or non-inclusion of AEs in the transfer pricing documentation, the tax authorities can make significant adjustments, thus increasing taxable income and tax liability.

Taxpayers would have to analyze their control relationships defined under Section 92A rather than merely rely on financial disclosures to identify their related parties.

Conclusion

Transfer Pricing Audits must be highly detailed to ensure full compliance with the regulations. Two of the more common mistakes that invite considerable compliance risks are not reporting ‘deemed international transactions’ and incorrectly applying the ‘Associated Enterprise’ definition.

To minimize these risks, you are required to recognise the scope of deemed international transactions and understand the broader definition of AEs under Section 92A

By addressing such often-overlooked areas, the taxpayers minimize their compliance risk in making the transfer pricing documentation accurate, comprehensive, and fully aligned with the regulations in India. This also helps them avoid the possible financial and reputation risks arising from non-compliance. Don’t let compliance risks cost you, so visit our website https://enterslice.com/ to ensure your transfer pricing audits are spot on with expert guidance.

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