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INTERNATIONAL TRANSFER PRICING – CONCEPTS AND INDIAN APPROACH

BY

N.RAVEENDRANATH KAUSHIK
MA, MPhil, MBA, AICWA, PG Tax Law

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BACK GROUND – TRANSFER PRICING

A large share of world trade consists of Transfer of goods, intangibles and services within Multinational enterprises. The growth in International Trade and the complexity of Business and economic activity has resulted in bringing many challenges to the Taxation aspect. Today many MNEs are generating more taxable income outside their home jurisdiction. The growth of MNEs has resulted in creating more and more problems in the Economy especially on the tax front. Variations in tax rates in various jurisdictions, shifting of profit to low tax locations are benefiting the MNEs, which operate in more than one jurisdiction. In order to protect the interest of government from the erosion of tax base by these MNEs and inorder to generate the Tax revenue the concept of transfer pricing has been introduced.

The expression Transfer Pricing refers to transactions goods and services between related parties. The emergence of transfer pricing as an international tax issue resulted in MNEs facing the problems of allocating their global profits among the different related parties under a reasonable methods and there by avoiding the fear of creating an international Double Taxation. If there is proper transfer pricing method then MNCs should have adjusted their intra groups transactions in such a way as to maximise their taxable profits in low tax jurisdictions. So, by using Transfer pricing method the tax authorities can

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counter such practices by substituting Arms Length Price for the price actually realised by the parties..

Transfer pricing strategy is an integrated and co-ordinated process concept of Global documentation is thought of where in it acts as a platform for providing the opportunity to examine the practice of various tax authorities in various jurisdictions and there by arriving at the optimum global tax liability. In 1994 the transfer pricing documentation dn penalty rules where applicable only to USA, by 2000 the countries which are using transfer-pricing documentation has been increased to 11 and it is expected to rise in future.

USA has a significant number of transfers pricing regulations in place and they are aggressively applied. United Kingdom (UK) has also recently introduced new transfer pricing legislation that applies to accounting period ending on or after July 1999.The new legislation in UK is closely assigned with Articles 9 of OECD Model Tax Convention on Income and Capital. UK has also introduced a statutory system for APAs.This process is limited to complex Transfer Pricing issues only and is aimed at providing solutions where there is considerable difficulty in determining the method.

OECD model is the pioneer model, which provides the guidelines for issues relating to transfer pricing. It has given guidelines on how to determine the ALP. Commercial transactions between different parts of multinational groups are not subject to same market operations shaping relationship between two independent firms. So, it becomes very important to determine one best method to compute the price at which transactions takes place between two related parties. This has lead to the concept of “ ARMs length principal which is explained under the Article 9 of OECD Model Tax Convention. The guidelines relating to ALP determination and how to apply it was issued in 1979 and later

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was revised and updated in 1995.In 1996 new chapter relating to determination of ALP for intangibles and services was introduced. A new chapter relating to cost contribution arrangements (CCAs) was introduced in 1997.In 1999 annexes were published with examples where in it clearly aimed at monitoring the implementation of the guidelines. In 1999 an annexes covering the guidelines for conducting advanced pricing arrangements under mutual agreement procedures (MAP APA’s) was brought in to effect. In 1998 a updated version of discussion draft THE TAXATION OF GLOBAL TRADING OF FINANCIAL INSTRUMENTS was introduced with an intention of arriving at a fair way of allocating and taxing the profits in each country where global trading was carried out.

CONCEPT OF TRANSFER PRINCING IN INDIA

Globalisation of the Indian economy has resulted in creating serious problems on the Tax authorities. Following upon report submitted by committee under chairmanship of Mr. Raj Narian, the Union Budget 2001-02 proposes to incorporate the far reaching amendments to the Income Tax Act, 1961.

The Budget speech of Finance Minister 2001-02 contained following-

“The multinational enterprises in India and their ability to allocate profits in different jurisdictions by controlling prices in intra group transactions has made the issue of Transfer Pricing a matter of serious concern, had set up an Expert Group in NOV.,99 to examine the issues relating to transfer pricing. Their report has been revised, proposing a detailed structure of transfer pricing legislation. Necessary legislative changes are being made in the Finance Bill based in their recommendations.

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The increasing participation of multinational groups ion economic activities in the country has given rise to new and complex issues emerging from transactions entered into between complex issues emerging from transactions entered into between two or both enterprises belonging to same multinational groups, by manipulating the prices changed and paid in such intra group transactions, there by, leading to erosions of tax revenues.

With a view to provide a statutory frameworks which can lead to computation of reasonable, fair and equitable profits and tax in India, in the case of such MNEs new provisions relate to computation of Income from international transactions having regards to the ALP, meaning of associate enterprises, meaning of international transactions, determination of ALP, keeping and maintaining of information and documents by persons entering in to international transactions, furnishing of a report from an accountant by persons entering in to such transactions and definitions of certain expressions occurring in the said sections.”

The Finance Act 2001 has introduced with effect from A.Y. 2002-03, detailed Transfer Pricing regulations vide Section 92 to 92F of the Income Tax Act, 1961 for computing income from international transactions between associated enterprises on Arms length basis.

India’s CBDT released draft Transfer pricing regulations in May 2001 that provides the nations first detailed transfer pricing regulations. Foreign Transfer pricing specialists were also invited to India to provide practical training to Indian Tax officials on transfer pricing rules. The CBDT plans to establish a separate office to oversee MNC tax compliance in anticipation of a surge in Transfer pricing related assessments. Foreign Tax unit will be headquartered in Delhi, with four sub offices in Mumbai, Bangalore,Kolkata and Chennai each headed by a commissioner of Income Tax.

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There are several provisions in Income Tax Act, which deals with transfer pricing. Sec. 40A(2) empowers to examine the appropriateness of expenditure incurred where the payments is to specified related parties.Sec. 10A/B, Sec.80IA etc.,which deals with Tax exemptions relates to transfer pricing. India has entered in to Double Taxation Treaties with various countries. These treaties contain specific articles dealing with Associated enterprises.

OBJECTIVES:
The main intention of the study is to find out the importance of the concept of Transfer Pricing policy on the Global Trade. The other objectives of the study can be classified in to following -. 1. The study aims at providing all the necessary information relating to the concept of Transfer Pricing Policy. 2. The study aims at determining the best ARM’s Length method of Transfer Price so that there is uniformity in valuation of International Transactions in Global context. 3. As there is a drastic changes taking place in Global Trading due to advent of WTO it becomes necessary to have some control over the prices of International transactions between the related parties. So, the study recognises the areas where there is ample opportunity to value International transactions.

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4.

As the concept of International Transfer Pricing in India was thought of only on 2001 it becomes much necessary and importance for India to be familiar with International Transfer Pricing rules and guidance as given by US models or OECD model.

5.

The study of different methods of determining ALP method helps in providing a platform, wherein the parties to international transactions can easily get access to such methods as and when the need arises.

6.

The study recent amendments and changes brought in to Income Tax Act,1961 and Accounting Standards reveals the Indian Approach to the International Transfer Pricing.

7.

As the concept of Transfer Pricing is new to India but, it is decade old in case of USA and other countries. The study demarcates the line between the system of transfer pricing followed in USA and other countries with that of Indian system of transfer pricing.

SOURCE OF INFORMATION The various information relating to Concepts and Transfer Pricing and Indian approach to it were collect from many sources. As the subject is very new in Indian context the availability of information is limited. But, honest efforts were made to collect information from scarcely available sources. 1. Following Web site were referred to collect the information-

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a. WWW.OECD.org b. WWW.transferpricing.com c. WWW.taxmanagement.com d. WWW.BNA.com e. WWW.Taxmann.com 2. The various articles which appeared in the daily news papers and periodicals. The newspapers which were handy providing information were – a. Financial Express b. Economic Times c. Business Lines d. The Chartered Accountants e. Business Reports and Statistics – UNDP and World Bank 3. Seminars conducted on the subject of Transfer Pricing by the Institute of Chartered Accountants of India. 4. 5. 6. Publications brought out by KPMG and Earnest & Yong. Text on Union Budget 2001-02. Information from practicing Chartered Accountants and Tax consulting firms.

STUDY METHOD

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For the purpose of studying the concept and approaches in details the study was done in two different sections. Section I deals with the CONEPTS OF TRANSFER PRICING And Section II deals with the INDIAN APPROACH TO TRANSFER PRICING. The details of the study chapter wise is given below-

SECTION I- Concept of Transfer Pricing
CHAPTER 1- INTORDUCTION A brief introduction dealing with the background and the history of the subject is dealt with. CHAPTER 2 – METHODS OF TRANSFER PRICING In this chapter a detailed study is made with respect to different methods of determining the Arm’s Length method of Transfer pricing . CHAPTER 3 – APPROACHES TO TRANSFER PRICING In this chapter a study is made with respect to different approaches to Transfer pricing. CHAPTER 4 – MULTINATIOANL ENTERPRISES The distinction between core and non core enterprises and how to value determine transfer prices under each of these methods are studied under this chapter.

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CHAPTER 5 – ARM’s LENGTH METHOD – INTNAGIBLES AND SERVICES In this chapter study of pricing intangibles and services providing MNE’s are dealt. CHAPTER 6 – GLOBAL TRADING
A brief study of the present conditions prevailing in the International

Transactions and the new dimensions taking place in the Global Trade is made under this chapter.

SECTION II- Indian Approach CHAPTER 1 – INTORDUCTION A brief introduction about the Economic and trade changes taking place in the Indian Economy is studies under this chapter. CHAPTER 2 – TRANSFER PRICING AND INCOME TAX ACT,1961
In this chapter study of various provisions which have been amended

new sections which are introduced in to Income Tax Act, 1961 which related to Transfer Pricing are studies. CHAPTER 3 – OTHER SECTIONS IN INCOME TAX ACT. A brief study is made on those sections of Income Tax, which has something to do with Transfer pricing. CHAPTER 4 – ASSESSING OFFICER – ROLE, POWERS AND RESPONSIBILITY This chapter deals with the appointment of AO, his powers, roles,

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duties and responsibility with respect to determining the Transfer price.

CHAPTER 5 – RECORD KEEPING AND ACCOUNT REPORT This chapter deals with the study of Record keeping and Accounting report which needs to be maintained as per the Income Tax act with respect to the International transactions. CHAPTER 6 – CASE ANALYSIS In the last part of study under this chapter a CASE as studies by KPMG with respect to finding of whether a transaction between two countries is at ARM’s Length or not is studies. This will enable us in giving clear picture about the method used for determining the ARM’length transfer price.

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INTORDUCTION
The recent changes one can notice globally is that there is a shift in the Economic activities when compare to previous two decades. There is enormous growth in various sectors of the business. The formation of WTO , European Union (EU) and other Trade Blocks between the member nations has resulted in bringing many structural changes to the Trading activities. Severe completion is prevailing in all the sectors of trade. Globalization and liberalization of the Economy in the line of International Trade agreements have resulted in bringing many changes in domestic as well as international trade of both developing and developed countries.

International Trade is one of the major areas where the Globalization has greater impact on the countries that are parties to the cross border trade. The setting up of Multi National Enterprises (MNE) in different geographical location as not only resulted in diversification of various productive activities but also has encouraged the optimum use of available resources. Specialization of production and distribution of various activities are spread over different geographical location according to the availability of resources. There is frequent shifting of Tax Burden from one country to another in order to avoid payment of heavy taxes. The country, which falls under the category of high tax burden zone, shifts its profit to the country where the tax burden is low. In this way they are

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escaping from the eyes of government of the countries in which cross border trade is taking place. In order to have a base for calculating the exact pricing for the transactions in trade between two related parties internationally, the concept of Transfer Pricing is developed. The Major portion of the guidelines relating to Transfer Pricing comes from OECD (Organization for Economic Cooperation and Development) and US guidelines. These two premier bodies are engaged in reviewing and giving suggestions from time to time to the related parties regarding the method of determining the arm’s length method of transfer price for transactions involving cross border trade, necessary documents to be maintained, penalties and legal consequences.

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IMPORTANCE OF MULTINATIOANL COMPANIES IN INTERNATIOANL TRADE (PER CENT)

EXPORTS

IMPORTS

1982

1992

1982

1992

A. Share of trade by multinational Companies in total trade (a) U.S. JAPAN B. Share of intra firm trade In multinational companies Trade (b) U.S. JAPAN C. Share of intra firm trade In total trade © U.S. JAPAN 22 22 23 26 16 4 18 8 31 30 40 33 37 21 43 35 71 76 58 78 43 19 41 23

Source: OECD Economic Outlook

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Transaction between two related parties does not only include the physical or tangible transactions but also includes intangibles like patent rights, royalties and other services provided. Some of the inter company transactions that is transaction between group companies or related parties which exists in the modern environment are: a) Transfer of Intangible goods b) Transfer of Intangible property c) Inter Company services d) Loans e) Leases

It is very important to access properly the basis on which the respective countries to which the related parties belong should calculate the tax. The question of whether the market price should be treated as the basis or the cost actually incurred in the production should be taken in order to calculate the Transfer Price leads to lot of confusion and doubt among the Assessing Officer. In this regard both OECD and US guidelines suggests various methods for determining the Arm’s Length method for Transfer Pricing with respect to the nature of transactions and the related parties involved in the transaction.

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Due to globalization the competition has become severe. In order to face the competition it has become very much need for the companies to go in for merger of other type of diversification. The recent trend shows that formations of MNES are one way of facing competition. Technological change and financial deregulation have dramatically globalised financial markets. Financial firms have organized themselves to sell financial products 24 hours a day. This phenomenon of global trading challenges taxpayers and tax administration to come up with a fair way of allocating and taxing the profits in each country where global trading is carried on.

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ARM’S LENGTH METHOD (ALM) FOR TRANSFER PRICING
ARM’S LENGTH PRINCIPLE The Arm’s Length Principle suggests that the two Associated Enterprises should be treated as independent enterprise and all transactions would be considered as the Market Price. The principle of Arm’s Length Principle is incorporated in Article 9 of the UN/OECD model convention. Para 1 of Article 9 provides that transactions between Associated Enterprises should be evaluated as if they are independent to each other and if, it is found that owing to special conditions between two countries, prices are not comparable with those of the independent Enterprises, then suitable adjustment would have to be made for price differentials.

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ARM ‘s LENGTH METHOD

CUSTOMARY ALM

TRADITIONAL FORMULA APPORTIONMENT

TRANSACTIONAL METHOD

PROFIT SPLIT METHOD

COMPARABLE UNCONTROLLED PRICE (CPU)

OECD GUIDELINES

US GUIDELINES RESALE PRICE METHOD

COST PLUS & CPM/TNMM METHOD

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TRANSACTIONAL METHODS

I COMPARABLE UNCONTROLLED PRICE (CUP)

OECD guidelines:

“ A Transfer Pricing method that compares the price for property or service transferred in a controlled transaction to the price charged for property or services transferred in a comparable uncontrolled transaction in comparable circumstances.”

In this method of determining A.L.P, price charged in a controlled transaction is compared with the price changed in comparable transaction. To make it clear, if the Vendor Company which sells the product, or goods or provides service to one of its related parties and also sells same product to one or more unrelated enterprises then these will be “ less controlled price” with which the transfer pricing can be compared. It is very important to note that some of the factors like quality, quantity, terms of offers, after sales service etc., are to be considered while arriving at the price which is to be compared. Use of CUP method is most likely feasible when there are internal comparability. The success for determining ALP under this method thus depends on the degree of comparable factors, which are considered for determining the price. It should be kept in mind that,

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this method couldn’t be applied when there is a monopoly for the product offered by MNC group or when it enjoys the licensing power of patent or other trademark rights. Still, it is one of the direct and reliable methods for determining the price, which can be applied as arm’s length price.

II RESALE PRICE & COST PLUS METHOD

These methods are based on the comparability of functions, risk and assets. These methods are applied to the party on parties on only one side of the controlled transaction.

a. RESALE PRICE METHOD (RPM)

OECD guidelines:

“ Resale Price Margin is a Margin representing the amount out of which a reseller would seek to cover his selling and other operating expenses and in the light of the functions performed (taking in to account assets used and risk assumed), make an appropriate profit.”

It focuses on the gross margin earned by distributor of goods or services. In this method the A.L.P is determined through backward method i.e. first the price at which the product is sold to an independent enterprise is determined and from that price the reasonable mark up is deducted in order to arrive at a proper price.

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Arm’s Length Price of Goods Purchased from Related parties

Resale Price of the

Arm’s Length ---Gross Profit

=

Goods resold to Unrelated party Or parties

Thus, RPM is used in cases, which involves the Purchase of goods and services from related parties and reselling them to unrelated parties in which the reseller has not added substantial value of the goods. It is very important to note that the goods and services, which are resold, should be of same nature and type and should be sold without making any change to the goods or services.

b. COST PLUS METHOD

OECD guidelines defines –

“Cost incurred by supplier of property or services in a controlled transaction. An appropriate Cost plus Markup is added to the cost, to make an appropriate profit in light of the functions performed (taking in to account assets used and risk assumed) and the market conditions. What is arrived at after adding the Cost plus Markup to the above cost may be regarded as an arm’s length price of the original controlled transactions.”

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This method states that with a initial cost for product or service which is incurred by the vendor or supplies and adds there to an appropriate markup to determine the fair market price or Arm’s Length price.

Cost of supply made

Arm length’s mark up

A.L.P =

by supplier to a Related party

+

on the cost of supply

The mark up to the cost incurred is added in order to determine the appropriate profit in relation to the functions performed risks involved and asset used in the manufacture. The marks up are determined by comparing the markups earned by

comparable independent manufactures performing comparable functions. This method finds its application very useful in conditions wherein semi finished products is sold between related parties and where services are provided between related parties.

III TRANSACTION NET MARGIN METHOD (TNMN)

OECD guidelines –

“ A Transactional profit method that examines the net profit margin relative to an appropriate base ( eg., Cost, Sales, Assets) that a tax payers realise from a controlled transaction ( or transaction that it is appropriate to aggregate).”

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Revenue Canada defines TNMN as follows:

“It compares the net profit margin of a tax payer arriving from a non- arm’s length transaction with the net profit margin realized by arm’s length parties from similar transactions”.

In TNMN method A.L.P is determined after comparing the net profit margin attained by various multinational enterprises against those attained by independent forms. While comparing the net profit margin some appropriate base like sales, assets, operating expenses incurred etc. are considered. The independent firm, which is compared, should be engaged in similar type of business and should operate in similar market. This method of determining the A.L.P is adopted as last resort by the enterprise because they might not be in a position to ascertain the ALP in any one of the forms as discussed above.

Thus, TNMN method and cost plus method is most appropriate when it can be applied to a distributor, manufacture or service provider who does not own unusual intangibles or bear unusual risk. The success of these methods namely resale price method, Cost Plus method and TNMN depends on all the entrepreneurial activities of the commonly controlled groups which are actually on the untested side of controlled activity.

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PROFT SPLIT METHOD (PSM)
OECD guidelines defines –

“ A transactional profit method that identifies the combined profit to be split for the associated enterprise from a controlled transaction and then split those profit between the associated enterprises based upon a economically valid basis that approximates the division of profit that would have been anticipated and reflected in an agreement made at Arm’ Length.”

In this method combined profit is determined from a controlled transaction and the same is apportioned or allocated between the parties or different entities on such a manner that it nearly equals to the division in arm length transaction. In simple words P.S.M can be defined to mean the allocation of Net Income from the transaction to respective units, based on the value of their contribution to the net profit.

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Profit Split Method of determining Arm’s Length Price is suggested by U.S. regulation and also by OECD guidelines.

I U.S. REGULATIONS

a) Residual Profit Split MethodIn this method a certain fixed return is attributed to each of the party based on the external comparables. The Residual Profit i.e. Actual Profit minus the attributed return is then attributed to intangibles and are allocated to the parties in proportion to the parties respective claims to the intangibles.

Residual Profit split would be considered more appropriate only if reasonably comparable uncontrolled entities could not be identified. Evaluating the parties in the entities in most likely to improve the determination of arm’s length price, when both entities to the controlled transactions own the valuable intangible or when the entities share the significant risk in the market. So, this method clearly considers all those factors which play the major role in the determination of the profit of the entity. Intangibles in the entity and also the risk factors are considered while allocating the residual Profit among the parties to the transaction.

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b) Capital Employed Allocation Method
In this method the combined Profit determined by the entity is allocated on the basis of equal returns to each controlled entity. Capital employed was considered as the best way to allocate the returns to a controlled entity. One important part was that the Regulation allowed this method to be applied only if the controlled entities bore the same risk with respect to capital employed. But, unfortunately this method is not considered for determining arm’s length price because the parties to the transactions will be placed in the similar risk category only when they (i.e. parties) agree in advance to the same costs and benefits proportionately. This point is considered very rare in the existing situation and as such cannot be viewed as the method for determining the arm’s length price.

II OECD GUIDELINES

a) Contribution Analysis Approach In this method the combined Profit arriving from controlled transaction of the entity is divided between the parties (i.e. Associated Enterprises to the transaction) based upon the relative values of the various functions performed by the associated enterprises individually in the controlled transaction. While dividing the profit and analysing the functional factor, careful analysis in made with respect to the market dates which shows the various situations in which the independent enterprises divide their derived Profit when it faces similar circumstances.

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b) Residual Analysis Approach This approach is in the same line as given by the US Regulation. The residual Profit is divided among the parties in proportion to their (i.e. parties) respective share in the claims with respect to intangibles.

Conclusion:-

Thus, each of the method discussed above has its own significance. Choosing of best method depends on the functional factors and also the risk factors prevailing among the entities. Accordingly, CPU, cost plus method, Resale method, TNMM method and Profit Split method can be followed for determining the arm’s length price. Both US Regulations and OECD Guidelines describes various ways for allocating the income to intangibles in certain circumstances but fails to prescribe a particular method to be followed. These Guidelines are relatively flexible regarding the use of Profit splits and very flexible regarding the form of profit split that might be used.

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APPROACH TO TRANSFER PRICING
TRADITIONAL FORMULA APPORTIONMENT

Traditional Formula Apportionment approach assumes that the trade between inter company transaction are so much integrated that only a Profit split can be judged as one of the best appropriate measure to allocate the derived income among the various Tax Jurisdictions. Tax plays a major role for the country concerned, the government thinks of determining the appropriate formula based on the various functional factors which help in gaining more tax revenue.

I TAX BASE FOR FORMLA APPORTIONMENT

The concept of “unitary business” is the foremost concept which describes the Tax Base for Formula apportionment. The major area, which governs the unitary business, is that when there are activities of certain entities, which are interdependent or interrelated to comprise of a single entity, that single entity should be treated as a single unit for Tax purpose and the net income arriving out of the transactions for whole of the entity should be divided among the jurisdictions in which the entity does the business according to a formula, instead of finding the various functional factors and attempt to find the source of each item of income and expenses on geographical basis.

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II THE STANDARD FORMULA (W.R.T TO STATE }

Payroll, Property and Sales are treated as three important factors for apportionment of the corporate income tax by the state. It is very important to judge the factors because the Tax from one state to other differs and also there is a possibility of shifting of Tax burden from one state to another.

FACTORS CONSIDERED FOR FORMULA APPORTIONMENT

1. PAYROLL: - It is the compensation paid by the entity to the employees for the work performed by them. Payroll factor is determined by dividing the compensation paid to employees by the operations within the state.

2. PROPERTY: - These refers to the value of property both real and tangible personal property and also includes the value of rented property. Historical cost i.e. the cost of purchase of property plus modification or addition made to the property without charging any depreciation is treated as the basis for valuing the cost of property.

3.

SALES: - In this case clear distinction should be made between the physical

distribution of goods and the sales receipt with respect to the state. The sale of tangible property is attributed to the state in which the unrelated buyer takes the delivery of goods.

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The receipt from the sale and also the services rendered are attributed to the state in which the associated costs are incurred.

The standard formula apportionment factor plays a major role in the interstate transaction. The tax rate differs from one state to another this may result in shifting of Tax burden from one state to another. In order to over come this shortfall the factors as stated by standard formula should be taken as the basis for apportionment. These factors however will not cause serious effects because the taxes levied by states are usually much lower than the Tax levied by the Central.

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Arm’s Length Method v/s Traditional Formula Apportionment

When both methods for arriving at a transfer price are carefully analyzed one can find that the major difference between two methods is that of the treatment considered for the concept of risk and intangibles. All entities, which form the unitary business, are made to share both risks and intangibles on the basis of proportional factors which do not consider the factors of risk and intangibles.

Sales v/s Payroll v/s Property which is the best factor

SALES: U.S. Regulation or OECD Guidelines does not give much importance to sales factors. As distribution of sales either through geographical or through sellers does not give any information about functions, risks and intangibles which plays a vital role in sales, the sales factor is not considered appropriate in traditional arm’s length profit split method.

PAYROLL: This factor plays a major role in deterring the Arm’s Length Price, if-

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1 The payroll factor is distributed apart from property factor and 2 The payroll factor is determined more accurately when compared to property factor.

PROPERTY: This is an accepted factor for both traditional formula apportionment method and Arm’s Length Method. Property here refers to the physical existence and it is a stock, which is acquired at a particular period. This property is treated as a capital used in generating the Net Profit of the enterprises. So, Property valued on the basis of cost of the asset before depreciation is treated as one of the best way of determining the property factor for valuation..

From the point of determining the profit and the best factors of arm’s length method it is very important to distinguish between Core and Non core entities. In traditional method of determining the arm’s length it treats the MNEs as a group in which the geographical factor corresponds to the functional divisions. Modern MNE does not operate singly in one country. Its production and distributions are spread over in many countries, which have different legal entities and different tax jurisdiction. So, it is very important to have the knowledge of core and non-core entities in order to find out the effect of cross border transaction and determining the proper transfer pricing.

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MNE s

CORE ENTITIES

NON-CORE ENTITIES

CORE ENTITIES

These are the entities which are interrelated and which performs those activities, which is required in order to fulfill the objectives for which it is established. These core groups of entities are specialised in doing different types of production work, which are later pooled together to complete the task. For e.g. some MNEs sets up in different geographical location small entities in order to utilise the resources and factors of production. The main aim of setting up of core entities is to have economics of scale, to meet the demands

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of supplier regularly and to expand the activities of cross border inter company transaction.

A core entity creates a problem at the time of determining the arm’s length price. This is because it is difficult to ascertain the functional factors, which plays a major role in evaluating the risks and profit among the core entities. Even determining the arm’s length payment for the intangibles would be very difficult.

NON CORE ENTITIES

The entities which are independent and which individually carries on production and distribution with out depending on any other activity is called as Non Core Entity. It is very easy to determine the arm’s length because of clearly available functions and also the factors, which plays a role in the ascertainment of cost.

Difference:

A core entity as discussed above clearly gives the picture that it depends on the performance of the group of entities. Thus, profit of an entity depends on the overall profits of the group of entities. In case of Non Core Entities it is the other way i.e. the entity profit is directly linked to the functions it performs or the cost it incurs. In Non Core Entity the independent functional factors or comparable can be identified. But,

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identification of independent comparable is not possible in case of core entities. As factors or independent comparable are easily identified the determination of payment on arm’s length can be calculated easily but the same cannot be applied to core entity because determination of payments on arm’s length method is very difficult. Exchange rate variation plays a major role in determination of arm’s length in case of core entities but there is no worry for exchange rate in case of non-core entity.

TRANSFER PRICING IN MODERN MNEs

ARMS LENGTH TRANSFER PRICING METHOD FOR MNEs

Formula apportionment within the Core

Choosing allocation method for the Core

Special Circumstances Transactional ALM for Non Core Entity

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TRANSACTIONAL ALM FOR NON CORE ENTITY

Transactional Arm’s Length Transfer Pricing are appropriate for transactions involving distributors, contract manufacturing or service providers because of existence of comparable independent companies in the Economy. The use of Transactional Arm’s Length Method allows each non core entity and its government to concentrate as measuring and testing that entity’s result, without attempting to track and account for what is happening through out the rest of the commonly controlled group.

II

FORMULA APPORTIONMENT WITHIN THE CORE

When separate entity have chosen to share risks and rewards from their activities, a Profit Split method that allocates the income from the activities in proportion to each entity’s contribution is appropriate. The prices for all transactions between core and noncore related companies should be accepted as Arm’s Length as long as they are consistent with the Arm’s Length range determined by application of appropriate transactional Arm’s Length to each of the non core entities. Therefore, the total income for which profit split is appropriate is the aggregating profit earned by the Core group. Income earned by the Core group is taken as the total income under profit split method of allocation. There should not be any objections on the method of allocation by the government where the Core group exists. It is also important that the Non core entities, if

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any should also be excluded from the profit-split method while apportioning the income among the Core entity groups.

Tax rates adopted by various countries differs from each other. Even the Tax rates adopted within the country may not be same. There is always wide difference between the National tax rates and State tax rates. National tax rates are usually higher than the State tax rates. So, it becomes very important for the Core entities to consider the effect of tax rates in order to frame formula for the purpose of apportionment of profit among the Core groups.

There are also changes in adopting financial frameworks by different countries. There is no such universal practice of Accounting principles, Financial valuations, Government requirements to be fulfilled at the time of reporting etc.. These factors should also be considered in order to arrive at a formula for allocating the profit among the Core groups.

III

CHOOSING THE ALLOCATION METHOD FOR THE CORE

Allocation method considers various factors which are common to most of the Core entities as basis for the allocation of available profits among the Core groups. These factors are derived in such a way that they play a major role at the time of calculating the

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profit. There are three traditional factors which are available for the purpose of allocation which are usually followed by most of the enteritis all over the world. The three factors which are commonly adopted are briefly discussed below:

SALES : In traditional approach sales are attributed to the state where the buyer resides or where there is actual transfer of ownership and goods. So, the state where the sales where effected deserves a portion of taxable income to be allocated. There are many difficulties in determining the sales factors and also applying them for the purpose of allocation. Some of the difficult areas are as follows :

a. If the sales based factors are derived and adopted on basis of specialisation at the stage of PROCESSING or for PARTICULAR COMPONENTS then the factors so derived allocates very high at the final stage and very less at the initial and production stage. b. If the sales based factors are derived and adopted on the basis of specialization at the stage of CUSTOMERS or PRODUCTS then the factors so derived allocates too much to the risk associated with the fluctuation in sales among the particular customers or to the particular products. c. In case of sales made by the core entity to the third party distributors are at the same level of market sales effected to a non core entity then the sales factor should be determined on the basis of the sale price charged to the third party

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PAYROLL & PROPERTY : Payroll is attributed to the state in which the employee operates and property to the state in which it is located. Taxable portion arising from payroll and property is allocated to entities in those states where they contribute in the derivation of profit. It is very important to note here that the Payroll factors when applied universally will not match from one country to another. The reason for difference is that the social welfare cost differs from one state to another. Opting payroll factors for allocation purpose is very dangerous because if there is any mismatch between the payroll compensation and labour productivity then it will result in reduction of productive profit. It is to be noted that the productivity of labour differs from one country to another as such the factors to be used in payroll will not match with each other. Property is also subject to many changes when it is valued globally. There exists difference in the Depreciation rate adopted by different countries, the age wise classification of assets and the variations in foreign exchange rates. These factors bring changes in the value of same property when used in different countries. Thus, it becomes very difficult to consider the property factor in the allocation of profits derived from various core enterprises.

CUSTOMISED FACTORS Customized factors are those which has the impact on the operating profit in general and on the Companies performance in particular. These factors depend on the operations of

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the Entities in their business environment. Factors are derived on the basis of the nature of business carried on by the Core entities. The factors are derived in such a way that the factors selected should have a maximum impact on returns to capital employed. For eg. If the Core entity is engaged in the business of manufacturing using comparable technology, then the factors like operating profits, production labour and production capital which has the bearing on the returns to capital employed must be selected. This is because the level of technology used in the manufacturing depends on the quantum of capital invested in arriving at the desired profit and the technical skill of the labour employed for completing the task. So, labour and capital productivity is the important factor for the entity which is engaged in the manufacturing by use of comparable technology. If part of the core entity specializes in mass production and another part in labour intensive customization , then both production labour and production capital factors might be used with the two factors weighted according to relative contribution of mass production and consumption in aggregate profits.

IV ARM’s LENGTH METHOD UNDER SPECIAL CIRCUMSTANCES LICENCEES:

The modern MNEs which are spread all over the world would prefer to choose the licensee form method for doing their business. According to this method the related

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parties to the international transaction continues to carry on their business with the help of license agreement entered into between the various related parties who are spread over the world. The licence is granted for the purpose of use after paying some amount towards royalty. This consideration paid by the licencee in the form of royalty for the rights used also forms a part of expenditure which should be deducted from the operating income in order to arrive at a proper allocation method. Excluding the licencee from the core will protect the size and stability of the tax bases of countries that host the core entities.

RISK POOLING FOR DISTRIBUTORS / SERVICE PROVIDERS It is very important to note that there exists lot of Distributors and Service providers within the Core group all over the world. Their operation along with the core results in changes in operating income. So, appropriate formula for the purpose of allocation of operating income should be derived in order to consider the impact of such Distributors and Service providers. The Manes should include the Distributors or Service providers in its Core entities only if they share the risk of core groups at the time of increase or decrease of profit.

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Arm’s LENGTH METHOD FOR PRICING INTANGIBLES & SERVICES

It so happens in the international transaction that some of the intangibles like patents, trademarks, designs, intellectual property etc., arises in the transactions between two related parties to trade. It becomes noteworthy to value these intangibles to the transaction on a particular basis. Intangibles may be in the form of commercial intangibles, market intangibles or intellectual property rights. Commercial intangibles are designed by the enterprises concerned after going in for series of research and development. They find importance in developing a product to meet the needs of the customer. Whereas a marketing intangibles are those which aids the commercial intangibles in marketing of the products so as to reach the wide areas of market. So, at the time of arriving at a Arm’s Length price for tangibles it becomes necessary to carefully study all the intangible factors. It happens in the world market that most of the intangibles used by one country is also used by another country. Thus, the transfer pricing method should compare the controlled parties’ price in order to arrive at the best Arm’s Length price. In case of uncontrolled transaction the parties to the transaction should compare the transaction relating to intangibles with that of other parties to other uncontrolled transactions. Comparable Uncontrolled Transaction method, Comparable Profit method or Profit Split method of determining Arm’s length can be used in case of intangibles.

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Factors that are to be considered at the time of comparing intangibles with other uncontrolled transactions may be summarised as follows – a. Details about the intangibles granted should be aralysed. Here the rights granted, restrictions on use of intangibles and limitation of applicability are to be arranged before making any comparison. b. The various stages on which the Development of intangibles takes place should be analysed. c. Any modifications, changes or alterations brought to the intangibles should be noted. d. e. Protection and usage of the intangible right should be clearly stated. Any risks faced at the time of transferring the rights to the transferee should be analysed. f. Contractual obligations arising between the parties who are transferor and transferee. g. Analyzing various other related functions performed by the transferor and transferee through the use of intangible rights.

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GLOBAL TRADING
Beyond WTO negotiation multilateral support is needed at four levels in devising sound policy, strengthening the regulatory environment, enhancing developing country participation in the development of international standards, and ensuring access to essential services in the poorest areas.

There are four core policy as reported by the Expert group which they think can reshape Global Trade – 1. Policy to ignite a successful development sound in the WTO that would produce tangible and dual benefits for developing countries. 2. Policies for global co-operation outside the WTO necessary to expand trade on a suitable basis and to promote development. 3. Policies of high-income countries to ensure continued global growth and to facilitate trade expansion trough provision of access and aid. 4. Domestic policies that developing countries might undertake to promote trade led development with or without the help of international community.

As trading activities are diversifying there are large scope for changing the various methods of apportionment. IRS regulations and OECD guidelines to global trading distinguishes integrated risk sharing activities from non integrated service segments and applies profit allocation formula only to the integrated risk sharing activities.

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IRS REGULATION AND GLOBAL TRADING

IRS regulations for global trading are intended to cover activities related to Global Dealing Operations which are defined as “ the execution of customer transactions, including marketing, sales, pricing and risk management activities in a particular financial product or line of financial product in multiple tax jurisdiction.” IRS regulations identify three transactional methods and two profits split methods to determine Arm’s length method for allocation.

Comparable Uncontrolled Financial Transaction (CUFT) is one of the methods suggested by IRS Regulation in order to arrive at the Arm’s length price for transactions involving the purchase and sales of financial products. This method considers the comparable transactions between unrelated entities, where comparability and reliability of factors to transaction depends on the similarities in which the factors are placed with respect to functions of the related parties, their contractual terms, risks and economic conditions.

Gross Margin Method and Gross Mark up methods are two important method followed in order to derive the Arm’s length prices for purchase and sale of Financial products. This method considers the Gross profit margin realised on the sale of financial products in comparable uncontrolled transactions.

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Gross Mark up Method is based on the Gross profit markup realized in comparable uncontrolled transactions.

Both, Gross Margin method and Gross Mark up method are described as potentially reliable only in such situations wherein the participants purchases and sells the financial products without having any understanding relating to developing or tailoring the product according to the requirement of the customer.

IRS guidelines suggested the Profit Split method as the best method for allocation of Profit among the participants in Global Trading. Profit split method is preferred because it considers the relative contribution made by participants in their transactions.

Routine and Non Routine functions The profit split method should consider various factors, which has the impact on profit or income of the participant in global trading. While choosing the factors careful attention should be paid to understand the routine and non-routine functions performed by the participants.

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Routine Functions are those functions, which are performed regularly with no gap in time intervals. The Routine functions like transaction processing, credit analysis, provision of credit support or other guarantees are performed regularly.

Non Routine Function are contributions which are integral to the Global dealings. It is highly impossible to segregate such contributions from the operations and find out a separate market return for the contribution.

OECD GUIDELINES AND GLOBAL TRADING

The importance of Global Trading was felt earlier in the 1990s and OECD had already brought out the guidelines for dealing with Global trading partners. The global trading profits are the very important and major concern for the tax authorities. They are facing difficulties in arriving at a method to value the profits arising out of global transactions. In this regard OECD guidelines acts as a catalyst between the parties to the transaction and the countries, which are involved in the transaction. If residual method is to be applied to a global trading case the first stage would be to reward the less integrated functions. The type of reward depends on the nature of the functions performed but it often happens that the reward would be determined by traditional transaction methods, such as arm’s length service fees. OECD approach to Global Trading provides a strong

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precedent for distinguishing between the core and non-core activities and applying profit allocation formulas for only core operations.

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INTORDUCTION

Indian Economy noticed drastic changes from June 1991 onwards. During this period, far reaching changes took place in trade, fiscal and industrial policy reforms with major thrust on improvement of competitive efficiency of Indian Industry by utilizing foreign investment and technology. Liberalisation of the economy aimed at promoting the integration of Indian economy with Global economy. The effects Globalisation and Liberalisation of the Indian economy can be seen with the rapid changes taking place in all the forefront sectors. As India is one of the signatories to the GATT agreement, it is the question of survival in the global competitive markets that has forced India to sign MOUs with many Foreign Countries with respect to trade and commerce. One can notice that the Foreign Direct Investment (FDI) is rising consistently since 1995. The post GATT agreement period shows that there is enormous growth in the number of Multinational Enterprises (MNEs) in India.

MNEs are those enterprises, which are setup in various geographical locations with the purpose of producing and distributing the products manufactured by utilizing the available resources. One single company sets up two or more related companies in different geographical location in order to diversify from the current activities or to specialize in the ongoing activities.

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Approaches to MNEs – Indian Model

The setting up and operation of MNEs are some what different in Indian situation when compared with the Global Economy. The recent study of MNEs spread over the country shows the different models on which basis and purpose MNEs are setup. All these models are the live examples which the enterprises came across before formation of MNEs. Some of the important models are explained below:

SUNDARAM FASTERNERS MODEL

In this model the main reasons for setting up of MNEs is that there existed a opportunity in identifying the global market for the products, large-scale demand and building a presence as a manufacturer and sub contractor.

ARVID MILLS MODEL

This model considers the identification and mastery of markets and also tries to achieve its aim of market share by sharing domestic cake in order to get a share of global cake.

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RANBAXY MODEL

This model tries to find the potential markets globally and thereby resorts to the act of investing in Overseas. They also acquire the existing enterprise and sets up new projects.

COMPETATIVE ADVANTAGE MODEL.

This model aims at growing globally in those areas in which they have the competitive advantage. These enterprises usually have a traditional strength in the product in which they are presently existing in the market. Eg of such companies are Tata Tea and Dabur.

One of the biggest question which haunts the Revenue Authority is that, How to value the transactions between the related parties in International Transactions?. This question has gone unnoticed for several years and has resulted in loss of corers of revenue to the Government. The reason is that the MNEs are shifting its profit earned in one country to another country where it has a related business in order to avoid the Tax burden. There are no strict and proper regulations followed in our country to value the international transactions like the above, which has resulted in tax evasion by most of MNEs. Even though there is a provision in Section 40A(2) and Section 92 of the Income Tax Act,1961 relating to examining the appropriateness of expenditure incurred where the payment is to specified related parties and determination of profits which may reasonably to have been derived by a resident when he undertakes transaction with a non-resident with which he has a close connection, still there is a need to bring changes to the said Act keeping in mind the universally accepted guidelines given by OECD and US in respect of Transfer Pricing.

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With the intention of bringing changes to the existing Income Tax Act, 1961 in the light of changes which is taking place globally and to frame necessary rules and regulations in order to avoid evasion of the tax by the MNEs a committee was setup by the Union Government with Ram Narian as its chairman. The Committee went in to a detail study of the operation of MNEs and their impact on the Tax revenue of the Central Government. It was noticed that there existed some loopholes in the framework of the Income Tax Act, 1961, which completely neglected the basis for determining the Arm’s length method for Transfer pricing. The committee in its report to the Union Government suggested various amendments to be made in the Income Tax Act, 1961. The Union Budget 2001-02

proposes to incorporate the amendments to the Income Tax Act, 1961 in the line of the suggestions made by Ram Narian committee.

Accounting Standard 18 has issued by ICAI (Institute of Chartered Accounts of India) under the lines of International Accounting Standard 24 which will be effective on or after April 01, 2001. According to Accounting Standard 18 a disclosure of related relationships and transactions necessity for an understanding of the effects of related party transactions financial statements is required. The ICAI has promoted Accounting stated or segment reporting for awaiting periods commencing on or after April 01 which requires company to furnish detailed information on each business segment.

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INDIAN INCOME TAX ACT AND TRANSFER PRICING
Since, the Finance Act , 2001 which envisaged the practice of Transfer Pricing in India several changes have brought in to the Income Tax Act. The major changes brought in the Act are –

a) Computation of Income from International Transactions b) Meaning of Associated enterprises and International Transactions. c) Determination of Arm’s Length Price for Transfer Price. d) Maintenance and disclosure of information and documents relating to International Transaction. e) Review and updation of proposal as and when need arises.

In order to make the act more comprehensive and complete the existing Section 92 of the Income Tax Act is substituted by new Section 92, Section 92A, Section 92B, Section 92C, Section 92D, Section 92E and Section 92 F. These changes will come in to picture from the Assessment year 2002-03. The brief description about each of the above the Sections will be carried out from next chapter onwards.

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SECTION 92 A ASSOCIATED ENTERPRISES

Section 92A(1) and Section 92A(2) deals with the concept of Associated Enterprises. According to these Sections there are two approaches to study concept of Associated Enterprises.

1. Enterprises which are purely regarded as Associated enterprises. Those enterprise which by virtue of their existence becomes an associated enterprises. 2. Those Enterprises which are deemed to be Associated Enterprises.

Defnition

ASSOCATED ENTERPRISE – SECTION 92 A(1)

An Enterprises would be regarded as “ assocated enterprise , if the enterprise/individual participate directly or indirectly or through one or more intermediaries, in the management or control or capital of other enterprise”.

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DEEMED ASSOCIATED ENTERPRISE - SECTION 92 A(2)

An Enterprise would be regarded as “ Deemed enterprise if the enterpise is in any one of the following situtations.

26% of Voting powers : If at any time during the previous year any person or enterpise holds directly or indirectly , shares carrying at lease 26% of voting powers in other enterprise. Loan : If loan advance by one enterprise to another eenterprise constitutes at least 51% of the Book value of total assets of other enterprise. Guarantees borrowing : If one enterprise guarantees at least 10% of total borrowings of other enterprise. Appointment of Board of Directors. If more than half of the BOD or members of the governing bodies or one or more executive directors or members of governing bodies of one enterprises are appointed by the other enterprise or by same person. Dependence on Intangible Assets. If during any previous year the manufacturing and process of goods or article3s or business carried out by one enterprise is wholly dependent upon the use of know how, patents, copy rights, trade marks, license, franchise or any commercial rights or any documents , drawing or spcifications relating to inventions, design, model or process , of which the other enterprise as the owner has or has exclusive rights.

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Supply of Raw Materials . If during any previous year, 90% or more of raw materials and consumables required for manufacture or process of goods carried out by one enterprise, are supplied by another enterprise/person and conditions relating to supply and price are influened. Sale of Goods. If during any previous year the goods or articles manufactured or processed by one enterprise are sold to other enterprise or to person specified by other enterprise and if the price and other conditions relating thereto are influenced by such other enterprise. Control by HUF. If one enterprise is controlled by an HUF and other enterprise is controlled by a member of such HUF or by relative of a member os such HUF or jointly by member and his relative. AOP or BOI . If any enterprise is an Association of Person (AOI) or Body of Individuals (BOI), the other enterprise hold at least 10% interest in such enterprise. Mutual Interest . If there is any mutual interest between two enterprise as may be specified

Eg. 1 If A has participation in B, A will be associated enterprise of B under Sec. 92 A(1). If C has participation in both A and B, then A and B would be associated enterprise under Section 92A(2).

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Eg. 2 – Enterprise becoming a Deemed Enterprise. If say, A an Indian subsidiary of a Foreign company purchases raw material from B , another Foreign Company , A and B are not associated enterprise under Section 92 A at the time of transaction. If suppose, because of international restructuring if B acquires shares carrying 51% of voting power in A. Then the two enterprises A and B are said to be Deemed Enterprise.

OECD/UN MODEL compared with SECTION 92 A

Accoring to Section 92A the Associated Enterprise means to include participation through one or more intermediaries. But as OECD/UN models defines an Associated enterprise as an enterprise of a contracting state participate directly or indirectly, in management, control or capital of an enterprise of other state, or same person participate directly or indirectly in the management, control or capital of an enterprise of a contracting state and an enterprise of the other contracting state. Here it becomes clear from the definition that OECD\US guidelines remains silent about the number of parties to be included in the transaction.

It is also important to note that the definition of Associated enterprises as given by Section 92 A includes to mean transactions between two non residents. But, OECD/UN model does not apply when there is a transaction between two non-residents.

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SECTION 92 B INTERNATIOANAL TRANSACTION
It refers to a transaction between two or more associated enterprises either or both of whom are non residents. The transaction between the associated enterprises may be any of the following types : a. Purchase b. Sale or Lease of Tangible or Intangible property c. Provision of service d. Lending or borrowing of money e. Other transaction having bearing on the profit, income, losses or asset.

International Transaction also includes mutual agreement or arrangements between two or more associated enterprises for allocation or apportionment of any cost or expenses incurred in connection with benefit, service or facility provided to any one or more associated enterprises.. It is important to note that only those international transactions where in the transaction having impact on profits, income, losses or assets of the enterprise should be considered. Deemed International Transaction – SECTION 92B(2) A transaction is said to be a Deemed Transaction when there is a prior agreement in relation to relevant transaction between such other person and other associated enterprise.

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SECTION 92 C COMPUTATION OF ARM’S LENGTH PRICE.
ARM’S LENGTH PRICE is defined as – “ A price which is applied or proposed to be applied in transaction between persons other than associated enterprises, in uncontrolled conditions.” Section 92C(1) and (2) gives the broader view of selecting and determining the ARM’S LENGTH PRICE, which are summarised as follows – 1) ALP shall be determined by most appropriate method which shall be one of the methods specified. 2) Most appropriate method shall be ascertained having regard to the nature or class of transactions or class of associated persons. 3) Most appropriate method shall be applied in manner prescribed by the board for determination of ALP. 4) If there is more than one method determined, then ALP should be Arithmetic Mean of such prices as determined under various methods. It becomes necessary to consider some of the factors which has a lot of influence on determining the ALP . These factors are –

a) Characteristics of property or services in transaction : Property should be classified in to tangible or intangible property . While considering the tangible property important attention should be paid towards supply,

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quality , quantity and reliability of tangible property. While classifying the transactions on basis of intangible property the duration and degree of protection and the type of property should be considered. While considering the importance of services the nature and extent of the services provided in the transactions should be considered. b) Contractual terms in Transactions : The terms and conditions present in the Arm’s Length Transactions helps in analyzing the risk involved and returns enjoyed in the transaction. c) Functional analysis : Various functions such as design, manufacturing, assembling, financing , management etc., should be assessed at the time of determing the Arm’s length price of Transfer Pricing. d) Economic situation : Economic situation prevailing in the countries which are party to the international transaction should be studied because they play a major role in assessing the Market situation, competion , resource availability and its utilization , geographical location , availability of substitutes, bargaining power of buyers and suppliers , government regulations and types and modes of transport. e) Business strategies : Business strategies such as those designed to penetrate new markets or to expand market share often reduce the taxpayers current profit in hopes of greater profit in the future.

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ARM’S LENGTH PRICE is computed under the same methods as stated by OECD/US guidelines. Following methods are used for deriving Arm’s length price for the transactions. I) II) III) IV) V) VI) Comparable Uncontrolled Price (CPU) Resale Price Method (RPM) Cost Plus Method Profit Split Method Transaction Net Margin Method Any other method prescribed by CBDT.

As the above methods have already been discussed , I would like to briefly explain these methods with examples.

CUP “ A Transfer Price method that compares the price for property or service transferred in a controlled transaction to the price charged for property or service transferred in a comparable uncontrolled transaction in comparable circumstances.” - OECD Example 1 Let A be a foreign company which sells to its Indian subsidiary B. A also sells its product to other distributors in India, Let these distributors be called as C. Then, according to CUP method if, A sells the product to C at Rs. 5000 then the price sold to B should be Rs. 5000 and it is the arm’s length price for transaction.

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In the above example if C sells the product and also provides its own warranty, then the CUP will be Rs. 5000 only. If A is responsible for warranty for the sales effected by B and if the warranty agreed is for Rs. 1000 PA and warranty cover for 3 months then CPU is calculated as follows-

Third party sales price LESS : Value of warranty for

-

Rs. 5000

3 months i.e Rs.1000/12*3

Rs. 250 ********

CPU

Rs. 4750 ********

RPM

“ RPM is a margin representing the amount out of which a reseller would seek to cover its selling and other operating expenses and in the light of the functions performed ( taking in to account assets used and risk assumed), make an appropriate profit.”

Example 2 In our above example B is the Indian subsidy of Foreign Company A . The end customer price or Resale price for the products distributed is RS. 3000/-. Assuming comparable independent distributor in India earns margin of 10%, the Arm’s Length Price would be as follows-

Final Retail Price in India

-

RS. 3000

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LESS : Margin earned by comparable Distributor RS. 300

-------------------Transfer Pricing using RPM RS. 4500

--------------------CPM (Cost Plus Method)

“Cost incurred by supplier of property ( or services) in a controlled transaction. An appropriate profit is light if the functions performed (taking in to account asset used and risk assumed) and the market conditions. What is arrived at after adding the cost plus mark up to the above cost may be regarded as on arm’s length price of the original controlled transactions.”

Example 3 In our example we considered that B company as the Indian subsidiary of a foreign Company A. If suppose B has the assembly plant and if it does not supply any capital or automotive knowledge and if it is full of risk free then the mark up on cost is determined by analysing the similar type of companies existing. Let us suppose that the similar assembly done by a comparable company incurs a cost of 20%, applying the margin to B company if it is assumed that the B’s Cost is RS. 100 then the Transfer Price under Cost plus method will be RS. 100 + 20% of RS.100 = RS. 120

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PROFIT SPLIT METHOD (PSM) “ A transactional profit method that identifies the combined profit to be split for the associated enterprise from a controlled transaction and then split those profits between the associated enterprise based upon an economically valid basis that approximates the division of profit that would have been anticipated and reflected in an agreement made at Arm’s Length.”

Example 4 In our above example 1 let us say that A (Foreign Company) gives its related pary B (Indian Subsidy) a patent for manufacturing. If B, sells its manufactured products to its related party C (a marketing company). Then royalty payable by B to A should be valued on the following basis. a) A set of Companies which are comparable to Company B is found. b) The optimum profit that should be earned by B is found out by analysing the profit earned by the comparable companies . c) Set of Marketing Company which are comparable with C is identified. d) The optimum profit of C is determined by the aggregate of profit earned by the comparable Company of C . e) The entire actual profit of A, B and C, the optimum profit to activities of Company B and Company C as determined in step b) and d) above are deducted.

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f) The balance of profit give the value of intangibles held by A and will indicate the optimum level of royalty to be paid by B .

TRANSACTIONAL NET MARGIN METHOD (TNMM)

“ A Transactional profit method that examines the net profit margin relative to an appropriate base ( example costs, sales, assets) that a tax payer realise from a controlled transactions ( or transaction that it is appropriate to aggregate).”

Appropriate TPM Tangible Property : When there is possibility to locate comparable uncontrolled transactions, CUP method is more appropriate to arrive at Arm’s Length Price. Service : CUP or Cost Plus Method in the best suitable method for pricing intra group services. CUP method is used where there is a comparable service provided by interdependent enterprises in recipient market or by associated enterprises providing services to an independent enterprise in comparable circumstances. Intangible Property : If the same owner has transferred or licensed comparable intangibles property under comparable circumstances to independent enterprises then CUP (Comparable Uncontrolled Price) method of determining Arm’s length price can be used. If the enterprise sub lease the property to third party then RPM (Resale Price Method) method of determining Arm’ s length price can be used. In case of valuing

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highly valuable intangible property where it is difficult to find comparable uncontrolled transaction PSM (Profit split method) of determining Arm’s length price can be used.

SECTION 92 D MAINTENANCE OF INFORMATION AND DOCUMENTS
According to Section 92 D every person who are party to international transaction shall keep and maintain such information and documents for a specified period as specified by rules made by the Central Board for Direct Taxes (CBDT).The detail study of this section will be dealt under the heading RECORD KEEPING & ACCOUNTANT REPORT .

SECTION 92 E REPORT OF ACCOUNTANT
Every person who has entered in to an international transaction during a Previous Year shall obtain a report of an accountant and furnish such report on or before the specified date in the prescribed manner as directed by the CBDT.

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OTHER SECTIONS IN INCOME TAX ACT DEALING WITH TRANSFER PRICING
SECTION 40A(2) Empowers Assessing Officer to examine appropriateness of

expenditure incurred where the payment is to specified related parties. SECTION 92 : Determination of profit derived by a resident when he undertakes transaction or with a non resident with whom he has a close connection. SECTION 271 AA – It relates to penalty for failure to keep and maintain information and documents in respect of each of international transaction. A penalty of 2% of value of international transaction entered into by such person is charged.

SECTION 271 BA – If any person fails to furnish from an accountant as required by Section 92 E, the Assessing Officer may direct that such person shall pay by way of penalty a sum of one hundred thousand rupees.

SECTION 271 G – Penalty for failure to furnish certain information or document under Section 92 D, shall be inserted.

SECTION 273 B – No penalty shall be imposed on the person or assessee for any failure referred to in certain sections specified in said sections, if he proves that there was reasonable cause for such failure.

Tax emption / deduction for profit of an undertaking (Section 10AB, Section 80-IA etc.) also contains provisions for examination of appropriateness of price where goods are transferred from such undertaking to other undertaking of the same assessee or to a related party.

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ASSESSING OFFICER – ROLES, POWERS AND RESPNSIBILITY

Assessing Officer as per Income Tax Act is defined to mean –

Assistant Commissioner / Deputy Commissioner or the Income Tax Officer who is vested with the relevant jurisdiction by virtue of directions or orders issued under sub setion (1) or (2) of Section 120 or any other provisions of the Act, and it also includes Joint Commissioner / Joint Director who is directed under clause (b) of sub section (4) of that section to exercise or perform all or any of the poers and functions conferred on , or assigned to an AO under this Act.

POWERS/DUTIES OF AO ( i.e. Commissioner ( Appeals) [CIT(A)]

I) Power to call for information AO has power to call for such information from the party to international transaction if, there exists any proceeding against the party. Such information asked for should be furnished with in a period of 30 days frim the date of receipt of the issued notice. However, a further extensions of not more than 30 days can be granted in case of failures to furnish the documents with in the allotted 30 days.

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Section 92 D (3) - AO or CIT(A) may “ in the course of any proceeding under the act require any person who has entered into an international transaction to furnish any information or documents in respect there of.” According to Section 92 D(3) following are the pre requisite to enable the AO to exercise power – a) There should be a pending existing proceedings at the time of requirement of information or documents. b) Information asked for by AO should be of such type and nature that it becomes useful for conducting the proceedings. c) Any person, means the person who is related to international transaction on whom proceedings are carried on. d) Information should be collected on those international transactions which are related. II) Power of AO to determine ARM’S LENGTH PRICE. AO has special power to determine ALP if certain preconditioned are satisfied according to Sec. 92C(3). The preconditions are – a) ALP can be determined by AO only when there is a proceeding for assessment of income. b) AO has material or information or documents in his pocession. c) If AO is of opinion that –

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i)

ALP determined or paid in international transaction is not according to one of the methods as defined under Sec. 92C., or

ii)

If Assessee has not kept prescribed information and document relating to an international transactions, or

iii)

IF there is ambiguous or mistake in the information on which basis ALP is determined, or

iv)

IF an assessee has failed to provide information or documents as required by AO.

According to Sec. 282 to 284 the Assessing Officer can determine ALP only after serving notice and mentioning in it the reasons why the ALP should not be determined in accordance with the basis of materials or information or documents in his pocession. It is important and becomes necessary to give an ample time limit so that he can express his views in defending the APL method adopted and price determined. III) Power to Compute Total Income having regard to ALP It becomes necessary to compute the Total Income arising out of International Transactions in order to arrive at a proper ALP. Computation of Total income should be subject to following important factors and accordingly proper care should be taken while arriving at a ALP. 1) Set Off of Losses – Computation of Total Income should consider the provisions of Sec. 32(2) and Sec. 70 and 71, dealing with losses and set off of losses.

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2) Minimum Alternate Tax (MAT) – While arriving at the total income for determining the ALP proper adjustments with regard to Sec. 115JB should also be reflected by AO. Here the AO should also note that Book Profit should not exceed the recomputed total income as per Sec. 92 C(4). 3) Importance of Sec. 10A,Sec. 10B and Sec. 10C – The AO at the time of re computation of Total Income of the Assessee should take care of some of the important Sections when total income is enhanced. The AO should not allow any deductions u/s 10A (i.e. newly established industry in FTZ) and u/s 10B ( i.e newly established 100% EOU). However, if the party concerned falls u/s 10C (i.e industrial undertaking established in North Eastern Regions) then he can claim exemption as per the act even on the enhanced income.

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RECORD KEEPING AND ACCOUNANT REPORT
RECORD KEEPING Sec. 92 D(1) – Every person who has entered in to a international transaction should keep and maintain in prescribed format the information and documents in respect of transactions. Nature of information and documents to be maintained is prescribed by CBDT. Sec.92 D(2) – Information and Documents would be required to be kept and maintained for such period as CBDT would prescribe. Every person who even if he does not have any income chargeable but if he is a party to international transaction should maintain the documents in such format and up to such period as prescribed by CBDT.

ACCOUNTANT REPORT Sec. 92 E – States that every person who has entered into an international transactions during Previous Year shall obtain a report from an accountant and furnish such report on or before the specified date in prescribed form duly signed and verified in the prescribed manner by such accountant and setting with with such particulars as may be prescribed.

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CASE ANALYSIS Whether the transactions between two countries is at ARM’s length or not ?
X India, a supplier of process control system maintains a significant presence in India and UK. Y of UK acts as a selling agent for a commission for X India and occasionally it also purchases system from X India for purpose of resale.

The object is to analyse whether the dealing between X India and Y UK for year 99 are at ARM’s length.

STEPS

1. Characterising the transaction activities

It is very important to first analyse the factors which is going to play a major role in the transactional activities. Structure of organisation, terms and condition which affects the operations of industry, competetion prevailing in the market, Economic factors prevailing , important economic functions, risks and assets attributable to each

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party to the transactions. When ones these factors are analysed then the degree of comparability and availability of various comparabilities can be determined.

2. Indentification of best method

The best method for determining ARM’s length method is analysed with the help of the characterstics of transactions which is already arrived. Below given table shows the various ways of choosing the best ARM’s kenth method for the given transaction.

Method

Decision

Reasons

CPM, PSM

wrong

x India performs complicated Functions and owns all intangible Property.

CUP, RPM

wrong

lack of information

CPM, TNMN

Correct

Availability of data for Unrelated UK comparable Company.

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3. Identification of tested parity

The results of Y UK are bench marked against the result of unrelated parties because, Y UK does not hold any intangibles property, as such it is less complicated than X INDIA. So, Y UK is compared with the related entities in UK which carries on the same line of transaction..

Selecting Criteria for related entities in UK
1. Companies are classified by primary standard industrial classification (i.e SIC)

CODE 504 - Wholesale distributors of Commerical Equipments CODE 506 – Wholesale distributors of Electrical goods.

2.Comparable companies depends upon 3 electronic data bases

a. Standard and Poors global vantage b. Disclosure’s world scope c. Buran Van Dijk’s Amadous

These contained detailed about the financial and business information of the comparable companies. The comparable companies where eliminated on the basis of following three factors.

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1. Dupicate Companies – That is those companies which appeared in all the three methods which were used to determine the base for comparing comparable entities.

2. Those entitites which did not pass the Research and Development test, had no sufficient inventory level and which did not have financial data for the past three years were eliminated for the purpose of comparison.

3. Finally, in the last stage still more companies were eliminated because of then products which was not upto the mark of Y Company UK. 4. The final Companies with their Berry ratio is given below-

Comparable Companies

Berry Scale

Alro Holdings Electro Components E’zwo computer variables Getronuis ISA internatioanl Northamber Otra Trace computers WF Electricals -.98 .52 1.62 1.19

1.30 1.52

1.11 1.28

1.15

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Inter quartile range 25th percentile 75th percentile Y UK (1997-98) 1.19 1.28 1.23 ( 1.19+1.28 = 2.47/2 )

ARM’s length range is limited to interquartile range that is range of results between the 25th and 75th percentile. So, final ARM’s length range for Berry ratio extends from 1.19 to 1.28. The average Berry ration for Y UK is 1.16. So, the transaction between Y UK and X India are ARM’s length.

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Note

FINANCIALS OF Y UK

1998

1999

1997

3yrs. Avg.

Comission Sales

7188 12523

6607 8863

3561 6607

5785 9361

TOTAL Cost of Sales

19711 12229

15470 8534

10258 6360

15146 9041

Gross Profit Selling expenses Administration Expenses Others Other Income

7482 6200

6936 5872

3898 3291

6105 5121

8 183 1091

22 22 1020

0 132 475

10 112 862

Berry Ratio (i.e Gross profit to operating expenses) 1.17 1.17 1.14

1.16

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Comparable Company

B/R (i.e Berry Ratio)

Alro Compiter 2000 E’zwo Computer Elutro Components Eurodis Flactron Getronus Magemerger Holders Tech. ISA Intern Medarys Digital system Metrologic inter Northamber Otra Senderson Ic Trace computers WF Electrical

1.30 .86 .52 1.52 1.16 1.62 1.29 1.18 1.19 1.03 .98 1.11 1.28 1.16 .98 1.15

Inter quartile range 25th percentile 75th percentile Y UK (1997-98) 1.03 1.28

1.16 ( 1.03+1.28 = 2.31/2 )

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