A separate code on transfer pricing under the Indian Income Tax Act, 1961 (The Act), covers intra-group cross-border transactions and is applicable from 1 April 2001. In view of the code, transfer pricing has become the most important international tax issue affecting multinational enterprises operating in India. The regulations are broadly based on the OECD Guidelines and describe the various transfer pricing methods, impose extensive annual transfer pricing documentation requirements and contain harsh penal provisions for non-compliance.

Indian TP Legislation – overview

The Act provides that income arising from ‘international transactions’ between Associated Enterprises (‘AE’) should be computed having regard to the ‘arm’s length price’.

Section 92B of the Act defines the term ‘international transaction’ to mean a transaction between two (or more) AEs involving sale, purchase or lease of tangible or intangible property, provision of services, cost-sharing arrangements, lending/borrowing of money, or any other transaction having a bearing on the profits, income, losses or assets of such enterprises.

Further, in certain cases, a transaction between an enterprise and a third party may be deemed to be a transaction between AEs, if there exists a prior agreement in relation to such transaction between the third party and an AE or if the terms of such transaction are determined in substance between the third party and an AE.

The relationship of ‘AEs’ is defined to cover direct/indirect participation in the management, control or capital of an enterprise by another enterprise. The AEs could be either two non-residents or a resident and a non-resident.

The term ‘arm’s length price’ is defined to mean a price that is applied/is proposed to be applied to transactions between persons other than AEs in uncontrolled conditions. The methods prescribed by the Act are broadly based on OECD TP Guidelines. The taxpayer is expected to determine the ‘most appropriate method’ for a particular transaction having regard to commercial and economic factors around the transaction.

It further provides that where more than one arm’s length price may be determined by applying the most appropriate transfer pricing method, the arithmetic mean (average) of such prices shall be the arm’s length price of the international transaction. The Act does not recognise the concept of ‘arm’s length range’ but requires the determination of a single arm’s length price. However, it provides flexibility to taxpayers to the extent the variation between the arm’s length price and price at which the international transaction has actually been undertaken does not exceed five per cent of the latter.

Documentation requirements – Taxpayers are required to annually maintain extensive information and documents relating to international transactions undertaken with AEs. This information and the documents have to be in place by the due date of tax return filing i.e. September 30, for Corporate.

Accountant’s report

It is mandatory for taxpayers to obtain an independent accountant’s report in respect of all international transactions between AEs, by the due date of tax return filing. The report requires the accountant to give an opinion on the proper maintenance of prescribed documents and information by the taxpayer. Further, the accountant is required to certify the correctness of an extensive list of prescribed particulars.

TP audit procedure

As per the Act the burden of proving the arm’s length nature of a transaction primarily lies with the taxpayer.

In the course of tax audit procedure the Assessing Officer (‘AO’) may refer the case to a specialised Transfer Pricing Officer (‘TPO’) for the purpose of computing the arm’s length price of international transactions. The TPO would pass a draft order determining the arm’s length price of the taxpayer’s international transactions. Based on this draft order, the AO computes the total income of the taxpayer and passes a draft assessment order within the time limit prescribed.

In case the taxpayer does not concur with the TP adjustment proposed in the draft assessment order he can approach the Dispute Resolution Panel (‘DRP’). The objective of setting up such a panel by the Indian Government is to expedite resolution of tax disputes involving TP matters. The decision of the DRP is binding on the Revenue and if the taxpayer feels aggrieved, he can directly approach the Appellate Tribunal. The DRP is an alternative mechanism and the taxpayer has the option to prefer the normal appellate channel.

Five rounds of TP audit have been completed, and the authorities have made adjustments to arm’s length price across a wide range of transactions in various industries.

Recent Developments

Safe Harbour
The introduction of Safe Harbour Rules by the Indian Finance (No. 2) Act 2009 is an effective step to reduce the impact of judgmental errors in determination of transfer price of international transactions. However, specific rules in this regard are yet awaited.

Advance pricing agreements (APAs)

The Indian Ministry of Finance is evaluating the introduction of an APA programme to enable taxpayers to agree pricing policies in advance with the tax authorities. However, setting up of the institutional mechanism and training of relevant manpower may prolong its introduction.

Dealing with Indian TP Legislation

Keeping in perspective the TP environment in India and the revenue authorities’ approach towards the same, it would be prudent for taxpayers to keep in mind the following:
1. Maintain a well defined TP policy focusing on internal price setting process.
2. Have systems and processes equipped to generate transactional data
3. Selection of Comparables based on a detailed quantitative and qualitative analysis.
4. Executing risk/working capital adjustments, backed by sound economic and statistical principles, to ensure better comparability
5. Documentation harmonised with various other requirements such as customs valuations and segmental reporting for statutory purposes.