‘TRANSFER PRICING’ – AN INTERNATIONAL TAXATION ISSUE

CONCERNING THE BALANCE OF INTEREST BETWEEN THE

TAX PAYER AND TAX ADMINISTRATOR
SAYANTAN GUPTA
[The variance in tax rates across different countries prompts many corporations
which operate in more than one country to shift their profits to low-tax locations. This
results in tax revenue loss to countries with high tax regimes. Transfer pricing (TP)
legislation is used as a tool to curb tax avoidance by manipulating prices charged on
intra-group cross-border transactions in such a way as to maximize the taxable profits
in low tax jurisdictions and minimise such profits in high tax countries. Though the
transfer pricing (TP) provisions are exhaustive in many respects and are, generally, in
line with international practices prescribing methodologies, documentation
requirements and penalties, they fail to provide the taxpayer the facility of obtaining
Advance Pricing Agreement and do not specifically address special situations such as
intangibles, e-com, global trading derivatives and so on, which require special
consideration. While transfer pricing is a necessary tax provision to get our share of
revenue from international transactions, it should be administered with sensitivity so
as not to kill the goose that lays the golden egg!]
Introduction
Transfer pricing has become an important international taxation issue for both
tax administrations and taxpayers.1 With the rapid globalization, multinationals
see national boundaries as increasingly less relevant to how they conduct
business. Revenue authorities on the other hand do not see things in quite the
same way and zealously guard the tax base of their respective countries.
As a result transfer pricing has become one of the most important and
complex tax issues facing modern businesses today. Revenue authorities
worldwide are investigating transfer pricing arrangements with increased vigor.
Transfer pricing issues arise with respect to the movement of goods,
intangibles, services, or capital across international borders, where there is value
or benefit on either side of the transaction. Generally, transfer pricing looks at
whether the price charged for a transaction in goods, services, capital or
intellectual property between affiliated enterprises (related parties) is at ‘arm's
length’.
The purpose of the arm’s length standard is that related parties generally care
about their global profit as a group and may not care where the profit is reported.
Accordingly, such parties may be motivated to report more profit in a jurisdiction
with a lower tax rate or where they could utilize a loss. Tax authorities apply the
arm's length standard to prevent arbitrary shifting of income by requiring related

1 See O’Haver, ‘Transfer Pricing: A Critical Issue for Multinational Corporations’, Tax Analysts Doc. No.
2006-5915 (4 May, 2006).
[J-40]

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(JOURNAL) ‘TRANSFER PRICING’: AN INTERNATIONAL TAXATION 41

party transactions to be priced as if they were not related parties. Thus, tax
authorities use the arm's length standard to prevent tax base erosion.
Transfer pricing generally being the first tax consideration of any cross border
transaction between related parties, developed countries such as USA and UK
have had transfer pricing law for decades. To deal with such problems in India,
the Finance Act, 2001 substituted section 92 with a new section and introduced
new sections 92A to 92F in the Income-tax Act, relating to computation of income
from an international transaction having regard to the arm’s length price,
meaning of associated enterprise, meaning of information and documents by
persons entering into international transactions and definitions of certain
expressions occurring in the said section.
Understanding transfer pricing
Commercial transactions between the different parts of the multinational
groups may not be subject to the same market forces shaping relations between
the two independent firms. One party transfers to another goods or services, for a
price. That price is known as transfer price. This may be arbitrary and dictated,
with no relation to cost and added value, diverge from the market forces.
Transfer price is, thus, a price which represents the value of good; or services
between independently operating units of an organization. But, the expression
‘transfer pricing’ generally refers to prices of transactions between associated
enterprises which may take place under conditions differing from those taking
place between independent enterprises. It refers to the value attached to transfers
of goods, services and technology between related entities. It also refers to the
value attached to transfers between unrelated parties which are controlled by a
common entity.
Thus, the effect of transfer pricing is that the parent company or a specific
subsidiary tends to produce insufficient taxable income or excessive loss on a
transaction. For instance, profits accruing to the parent can be increased by
setting high transfer prices to siphon profits from subsidiaries domiciled in high
tax countries, and low transfer prices to move profits to subsidiaries located in
low tax jurisdiction. As an example of this, a group which manufactures products
in high tax countries may decide to sell them at a low profit to its affiliate sales
company based in a tax haven country. That company would in turn sell the
product at an arm's length price and the resulting (inflated) profit would be
subject to little or no tax in that country. The result is revenue loss and also a
drain on foreign exchange reserves.
Indian position
In India, the void in the Income-tax Act, 1961 (‘the Act’) relating to detailed
transfer pricing regulations was finally filled with Finance Act, 2001 introducing
detailed transfer pricing provisions as an anti-avoidance measure into Chapter X
of the Act with effect from 1 April 2001.

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42 COMPANY LAW JOURNAL (2009) 2 Comp LJ

Prior to this amendment, a limited provision existed in the Act23, which

provided for making adjustment to the income of a resident taxpayer from a
transaction with a non-resident, if the Assessing Officer was of the view that the
income from such a transaction was understated in the hands of the resident due
to the close connection between the two. No rules were prescribed for
implementing the erstwhile Section 92 and it was almost never invoked in
practice.
The legislative intent behind the introduction of detailed transfer pricing
provisions is brought out on provisions relating to Finance Act, 2001, which, inter
alia, states:
“The basic intention underlying the new transfer pricing regulations is to
prevent shifting out of profits by manipulating prices charged or paid in
international transactions, thereby eroding the Country’s tax base.”4
Indian transfer pricing regulations are exhaustive in many respects and
broadly based on the OECD5 Transfer Pricing Guidelines for Multinational
Enterprises and Tax Administrations (‘OECD Guidelines’) and prescribe
methodologies to be followed, documentation to be maintained, and penalties to
be levied, though in some respects they have their own peculiar flavour. The
central theme of the Indian TP regulations, like in most regulations, is the arm’s
length principle, which requires charging of an arm’s-length price for all
international transactions between associated enterprises, supported as such by
appropriate documentation.
The regulatory framework of Indian TP regulations encompasses (i)
provisions of the Act, viz., anti-avoidance provisions6 and penalty provisions 7 (ii)
provisions contained in the Income-tax Rules, 1962 (‘the rules’)8 and (iii)
administrative guidance9.
Notwithstanding the fact that Indian transfer pricing law is still in its infancy,
assessments for the very first year of transfer pricing (AY 2002-03) are widely
reported to have yielded incremental taxes of over Rs. 600 crores10, stemming
from transfer pricing adjustments.
These figures strongly point towards transfer pricing becoming a key focus
area for income-tax authorities in years to come. As the globalization of Indian
business continues to accelerate, transfer pricing will remain foremost on the
agenda of Indian income-tax authorities into the foreseeable future.

2 Section 92, Income-tax Act, 1961.

3 Section 92, IT Act.
4 Para 55.6 of CBDT Circular No. 14 / 2001.
5 Organization for Economic Co-operation and Development.
6 Sections 92-92F.
7 Sections 271(1) (c), 271AA, 271BA, 271G
8 Rules 10A to 10D .
9 CBDT Circular No. 12/2001, dated 23 August 2001 and Instruction No. 3 of 2003, dated 20 May 2003.
10 Reported in Economic Times, Mumbai edition on Saturday, 2 April 2005.

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(JOURNAL) ‘TRANSFER PRICING’: AN INTERNATIONAL TAXATION 43

Transfer pricing manipulations

Transfer pricing manipulation (TPM) is discouraged by Governments as
against transfer pricing which is the act of pricing.
However, in common parlance, it is the transfer pricing which is generally
used to mean TPM. TPM is fixing transfer price on non-market basis which
generally results in saving the total quantum of organization’s tax by shifting
accounting profits from high tax to low tax jurisdictions. The implication is
moving of one nation’s tax revenue to another.
A similar phenomenon exists in domestic markets where different states
attract investment by undercutting sales tax rates, leading to outflow from one
state to another, something the Government is trying to curb by way of
implementation of VAT.
Having understood the implications and growing importance of transfer
pricing, more precisely, transfer pricing manipulation, we look at what
regulations have been enacted to counter this by India.
The Finance Act 2001 introduced detailed transfer pricing regulations with
effect from 1 April, 2001. The basic idea behind regulations is determining
whether ‘international transactions’ between ‘associated parties’ are conducted at
‘arm’s length price’.11
Arm’s length price
The arm’s length principle (ALP), despite its informal sounding name, is
found in article 9 of the OECD Model Tax Convention and is the framework for
bilateral treaties between OECD countries, and many non-OECD governments,
too. The arm’s length price12 can be determined by using any one of the five
methods and all methods should ideally lead to the determination of the same
arm’s length price. These five methods can be divided into two parts, i.e.,
transactional methods13 and non-transactional methods.14.
Transactional methods
Comparable Uncontrolled Price Method (CUP) — This is the most preferred
method. It is based on price at which uncontrolled transactions takes place. Use
of Internal CUP is favored as against external CUP.
Resale Price Method (RPM) — In this method entrepreneurial risk bearing
distributors are usually differentiated from limited risk distributors. And in this
method margins would depend on functions performed rather than product
differences. This method is similar to CPM.

11 Mayank K. Agarwal, ‘Transfer Pricing – A beginner’s Perspective’.

12 This is the price that would be charged in the transaction if it had been entered into by unrelated
parties in similar conditions.
13 These methods emphasize each transaction specifically rather than considering the overall profit figure
of related entities to arrive at the ALP.
14 In non transactional methods, related parties income figures are considered and adjusted according to
their share.
44 COMPANY LAW JOURNAL (2009) 2 Comp LJ

Cost Plus Method (CPM) — The total cost of production incurred by the tested
enterprise15 in transferring goods and services to Associated Enterprises (AEs) is
calculated and the total gross profit mark up used by comparable entities in
similar transactions with independent enterprises is determined. The total gross
mark-up16 arrived at is adjusted to take into account functional and other
differences to determine ALP.
Non-transactional methods
Profit Split Method (PSM) — This is used when AEs’ transactions are so
integrated that it becomes impossible to conduct a TP analysis on a transactional
basis. First, the combined net profit incurring to related enterprises from a
transaction is determined. Then, the combined net profit is allocated between
related enterprises with reference to market returns achieved by independent
entities in similar transactions. The relative contribution of related parties is then
evaluated on the basis of assets employed, functions performed or to be
performed and risk assumed. In this method as per OECD guidelines not only
comparability of transactions are to be kept in view but FAR17 analysis is also to
be considered in evaluation.18
Transactional Net Margin Method19 (TNMM) — This is normally adopted in
cases of transfer of semi-finished goods, distribution of finished products (where
resale price method (RPM) cannot be adequately applied) and transactions
involving the provision of services. TNMM compares the net profit margin
relative to an appropriate base (sales, assets or costs incurred) of the tested party
with net profit margin of the independent enterprises in similar transactions after
making adjustments regarding functional differences and risk involved. It is
evident from the observations made by the Bench in Mentor Graphics (Noida) (P)
Ltd. Case20 that even as per OECD guidelines while applying TNMM method not
only comparability of transactions are to be kept in view but FAR analysis is also
to be considered in evaluation.
Indeed, as per section 92C(2) of the Income Tax, 1961, the most appropriate
method has to be applied for determining ALP in the manner prescribed under
rules 10A to 10C notified vide SO 808 E dated 21.8.2001.21 Wherever more than

15 Tested party normally should be party in respect of which reliable data for comparison is easily and
readily available and fewest adjustments in computations are needed; it may be local or foreign entity
i.e. one party to transaction.
16 Mark-up will be usually linked to the “core costs” associated with the activity .
17 Functions performed, Assets utilized or Risk assumed.
18 H’Ranbaxy Laboratories Ltd. v Additional Commissioner of Income-tax (Appeal No. 2146 (Delhi) of 2007)
(Assessment year 2004-05) 22 January, 2008.
19 This is broadly aligned to the comparable profits method prescribed in the US transfer pricing
regulations.
20 Mentor Graphics (Noida) (P) Ltd. v Dy. CIT (2007) 109 ITD 101.
21 Draft rule ‘C’ an Indian subsidiary of an MNC requires them to provide the names and addresses of all
its associates, whether or not they deal in India. The Regulation also requires companies to submit
(JOURNAL) ‘TRANSFER PRICING’: AN INTERNATIONAL TAXATION 45

one price is determined to be the most appropriate method, the arm’s length price
shall be taken to be the arithmetical mean of such prices or at the option of the
assessee, a price which may vary from the arithmetical mean by an amount not
exceeding 5 per cent. The introduced provisions are exhaustive in many respects
and are generally in line with international practices prescribing methodologies,
documentation requirements and penalties.
Advance pricing agreements
One of the ways that will facilitate certainty in tax liability is through advance
pricing agreements. APA is an agreement between taxpayer and the tax
administration for a specified number of years mentioning the criteria for
determining transfer prices for future transactions between related enterprises.
While concluding an APA, comparability with open-market conditions and
assumptions vis-à-vis future events may play a role. APA finds a place in the
transfer pricing provisions of the American and British tax laws. The APA may be
retroactively revoked in fraud or malfeasance, cancelled in the event of
misrepresentation, mistake/omission of fact or lack of good faith compliance and
revised if the critical assumptions change. It is not clear why our regulations are
silent on APA.
APAs may be bilateral, unilateral or even multilateral. Bilateral or multilateral
APAs may cover conditions in more than one country and thus might confer
greater credibility and universality of application. One must, however, guard
against over allocating profits to any one country where the APA has been
arrived at depending on the tax shelter or relief. In Germany, unilateral APAs of
foreign tax authorities are not accepted by the German revenue department
without an audit in accordance with German tax standards. The intention is
apparently to ensure that such imbalances do not occur.22
Since Indian transfer pricing regulations are already six years old and about
three years of transfer pricing assessments have been completed, this may be an
opportune time for India to consider introducing APA provisions to provide an
opportunity to enterprises to draw up a binding taxation agreement in advance
with the authorities on the price or profitability for the controlled transactions.23
Coca-Cola transfer pricing issue: recent development
The Punjab and Haryana High Court has ruled on 27 December 200824 against
Coca-Cola India’s contention that the proof of profit transfer outside India is a
precondition for applying transfer pricing rules. In this case, Coca-Cola was

accounts of their associates. This would be difficult for an Indian company to comply with, as the
parent company may not supply information to its subsidiary.
22 Parthasarathy, ‘Transfer Pricing – Preserving the golden egg –laying goose’, Business Line, 6 April, 2001.
23 Rohan Phatarphekar, ‘Transfer Pricing – Keeping Issues at arm’s length’, Business Line, 21 February, 2008.
24 Coca Cola India Inc. v Assistant Commissioner of Inome-tax (CWP No. 16681 of 2005, decided on 17
December 2008 by Adarsh Kumar Goel and L.N. Mittal, JJ, since reported as (2009) 1 Comp LJ 460
(P&H).
46 COMPANY LAW JOURNAL (2009) 2 Comp LJ

assessed under the Income-tax Act, 1961, in 2004, for the year 1998-99. The
dispute arose after the income-tax department had concluded that the income
had escaped assessment under the Income-Tax Act.25
Coca-Cola had approached the High Court after it was served a notice on
transfer pricing. The soft drink company had an agreement to offer advisory
services to Britco at the rate of cost plus 5%. Coca-Cola’s main contention was
that transfer pricing rules cannot be applied in the absence of prima facie evidence
of profit transfer outside India.
The High Court said that India’s transfer pricing rules can be applied to any
cross-border transaction between associated enterprises, irrespective of profit
transfer outside India. The court said the only requirement is income generation
in a cross-border transaction and income has been computed at arms length.
Coca-Cola stated before the court that transfer pricing rules were meant to
check profit erosion outside India and therefore could not be applied in cases
where there is no prima facie evidence of profit transfer outside the country.
The High Court rejected this view. It held that existence of a cross-border
transaction and computation of the resultant income at arm’s length price are
sufficient grounds for applying transfer pricing rules.
According to Coca-Cola, the transfer pricing provisions have been
incorporated in the Income-tax Act by the Finance Act 2001 and the applicability
of these provisions has been limited to situations involving profit diversion
outside India.
There is no material evidence to show that profits have been diverted outside
India, the company said. The court said that it is the prerogative of the income-
tax department to issue such a notice and expressed its inability to intervene in
the matter.
Concluding remarks
Transfer pricing is inherent in the way the global economy is structured with
sourcing and consuming destinations being different, with numerous
organizations operating in multiple countries and most importantly due to
varying tax and other laws in different nations. Also nations have to achieve a
fine balance between loss of revenues in the form of outflow of tax and making
their country an attractive investment destination by giving flexibility in transfer
pricing.
When the transfer pricing regulations were introduced in 2001, this subject
was completely unknown. The onerous documentation requirements and
stringent penalties prescribed by the regulations were a cause of concern for any
taxpayer with international transactions, particularly as there was no basis of
knowing how the law would be implemented.

25 The Economic Times, 6 January 2009.

(JOURNAL) ‘TRANSFER PRICING’: AN INTERNATIONAL TAXATION 47

At present, Indian transfer pricing regulations do not have a specific provision

dealing with the transfer pricing of intangibles. Sub-section (2) of Section 92 of the
Act is an omnibus provision dealing with intra-group arrangements for services,
cost allocations, cost contributions, etc.
Also, the five prescribed transfer pricing methods are generally not found
adequate to deal with the transfer pricing issues related to intangibles.
Accordingly, in line with international practice and OECD principles, guidance
should be issued to recognize certain methodologies/approaches for evaluating
the arm’s length character of transactions involving intangibles.
With three transfer pricing assessments having been completed, certain
controversies as detailed above have emerged even as the income-tax department
and practitioners have made a lot of efforts to move up the learning curve within
a relatively short span of time.
A time has come to re-examine the provisions and settle these controversies so
that there is more certainty and fairness in the manner in which the law will be
applied.
Moreover, the introduction of measures such as advance pricing arrangements
(APAs) and safe harbor benchmarks for certain activities, aligning our transfer
pricing regulations to OECD guidelines and other international best practices
coupled with a drastic reduction in the penalties would go a long way in
enhancing India’s reputation as an attractive foreign direct investment
destination – a goal which successive governments have sought to achieve.
_________________

“The principles of interpretation are applied to ascertain the intention of the

Legislature and though they are considered to be good servants, they are bad masters.
Intention of the Legislature is best understood from the language used, which is the
golden rule of interpretation. Only when there is ambiguity or absurdity, external aids
may be pressed into service. Statement of objects and reasons or the speech of the
Finance Minister may be referred to, to ascertain the history and object, but they
cannot control meaning of a provision when language is clear and free from
ambiguity. …. Further, in the light of catena of decisions dealing with the issue of
interpretation of the statute and the power of the Legislature, it is well-settled
principle that primary rule of construction is the language used and in case of
ambiguity or absurdity, meaning consistent with object and purpose of a statute has to
be assigned without doing violence to the statute. Statement of objects can be referred
to find out the history and object of the statute but it does not control the
interpretation when language is clear.” 26

26 Coca Cola India Inc. v Assistant Commissioner of Inome-tax (CWP No. 16681 of 2005, decided on 17
December 2008 by Adarsh Kumar Goel and L.N. Mittal, JJ, since reported as (2009) 1 Comp LJ 460
(P&H).