Unspecified transfer pricing: Look beyond prescription
India, an emerging economic powerhouse, is no longer a topic of debate. It is now a proven fact evident with the ever-growing presence of multi-national companies (MNC) in the country and the rapidly expanding global footprints of Indian companies.
India, an emerging economic powerhouse, is no longer a topic of debate. It is now a proven fact evident with the ever-growing presence of multi-national companies (MNC) in the country and the rapidly expanding global footprints of Indian companies.
While this status is certainly something to cheer about, it also brings with itself greater complexities in both intra-group and inter-group transactions having tax and regulatory implications within and without the involved jurisdictions. To address some of these challenges, the transfer pricing regulations were introduced in India by the Finance Act, 2001.
Indian transfer pricing regulations, which are based on the internationally accepted arm’s length principle, require that transfer prices charged between related parties /associated enterprises are comparable to those that would have been charged between independent parties in similar circumstances.
The regulations specify five methods, namely Comparable Uncontrolled Price, Resale Price Minus, Cost Plus (referred to as traditional methods), Profit Split and Transaction Net Margin Method (referred to as transactional profit methods) for determination of arm’s length price.
The regulations though, do not attach any priority of method under the “Most Appropriate” method rule unlike the OECD guidelines on transfer pricing (“OECD Guidelines”) which gives precedence to traditional methods. The five methods specified under the regulations are consistent with similar legislations elsewhere in the world and to those specified by the OECD Guidelines.
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Transfer pricing methods enable taxpayers to determine the arm’s length price by their application in the prescribed manner. However, the five specified methods have their limitations too. These methods invariably involve comparison with uncontrolled transactions (for price comparison) or profits of uncontrolled companies at various levels (eg, contribution, gross profit or operating profit). This means that transactions should be closely or broadly similar between the tested party and uncontrolled entity and by inference necessitate the existence of comparables where either the price or the profitability is ascertainable.
In the real world though, there are transactions whose price or profitability may not be ascertainable, or there may not exist close or even distant comparables for such transactions.
To add to the complication, growing cross-border business is adding newer transactions to the list because of business reorganisation and restructuring, intangibles buy-ins, employee compensations, brand royalty valuations and a host of other reasons. Some of the common examples of such transactions are:
▪ Reorganisation and restructuring of businesses resulting in transfer of business, sale of shares, transfer of intangibles, sale of assets, etc.
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▪ Transactions involving financial instruments, such as purchase, sale or exchange of convertible debentures, preference shares, warrants, derivatives, distressed assets or even plain equity shares
▪ Transactions involving intangible property, such as purchase of brands, outright sale of software products with IPR, valuation of commercially exploitable rights (such as licenses to manufacture patented drugs)
▪ Cost sharing and cost contribution agreements involving buy-in payments. In fact, the OECD suggests global formulatory apportionment based on expected benefits in this case, but even then, for Indian regulations, it would be regarded as an unspecified method
The application of the five prescribed methods in case of the aforesaid transactions may not be practicable and even if one does it will be quite complex. Therefore, the taxpayer would have to consider other approaches or methods to arrive at the reasonability of the transfer price.
The regulations, envisaging such complex transactions, provide for inclusion of additional methods apart from the five specified ones, by providing for any other method as may be specified by the Central Board of Direct Taxes (“Board”). However, till date, the Board has not specified any other method. This uncertainty or let’s say non-prescription has put taxpayers into considerable difficulty while determining the transfer price for these types of transactions. Also, there is no clarity in administration especially at the assessment levels.
In view of this, it is time that the Board liberates the “Unspecified Methods” from prescription and allows taxpayers to use any approach or method that is appropriate and consistent with the arm’s length principle for determining the transfer price of the transaction under the circumstance. Examples of such methods could be valuation-based methods, option pricing models, credit ratings, joint and by-product costing and formulatory apportionment.
This unbinding will also be in line with similar legislations in other jurisdictions and the OECD guidelines. The Board can also allow use of methods or approaches available under other regulations such as the erstwhile Controller of Capital Issues guidelines for valuation of shares.
Rakesh Mishra
(The author is senior manager, transfer pricing, PwC)
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