Transfer pricing rules are not new to businesses that operate across multiple jurisdictions. In our globalised world, most developing and developed countries have an extensive transfer pricing framework covering international transactions between a taxpayer and its offshore related parties. As one of the fastest growing large economies, India too has similar rules in place under its income-tax law, which has evolved since 2001.
What are transfer pricing rules?
Essentially, transfer pricing laws ensure fair and correct income computation and taxation commensurate with the economic activities undertaken in India. If an Indian company has overpaid its foreign parent company, for instance, or has received income from the parent company that is lesser than what the rate should have been, transfer pricing rules will be applied in order to rectify the difference. The rules apply what is called an “arm’s length price test” to check whether a transaction meets the requirements. If it doesn’t, then the overpayment is nullified, or the under-payment is appropriately identified to ensure that the correct tax is collected in India.
Notably, India’s transfer pricing framework under the Income Tax Act, 1961, not only aims at enhancing the income and tax based on the arm’s length differences but also goes one step further. It requires actual repatriation of the flow of cash to India because it treats the arm’s length adjustments as a deemed loan transaction. The transfer pricing framework here also levies additional tax on notional interest computed thereon or alternatively necessitates payment of incremental tax.
The scope of transfer pricing rules
The application of transfer pricing rules extends to all cross-border transactions such as royalty payment, purchase and sale of goods and intellectual property transfer. Certain capital transactions such as capital infusion may also get covered as per the recent budget proposals surrounding angel tax (seeking to tax excess premium on allotment of shares to non-residents), though they may not have a material impact for businesses so long as valuation aspects are appropriately adhered to. Debt transactions involving high leverage in India are targeted additionally by focused thin-capitalisation rules (rules made to prevent businesses from using debt financing or international debt shifting for tax planning reasons). This further limits the interest deduction, besides the arm’s length interest test requirement.
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The ambit of “related parties” is wide and extends to foreign entities that may not necessarily be a group entity of the taxpayer (based on several objective thresholds of capital, management, and control).
From a compliance standpoint as well, Indian tax law requires all entities having transactions with related parties outside India to maintain extensive documentation in support of the prices charged by it or paid by it vis-à-vis all foreign related parties. Such records are also required to be examined and certified by a chartered accountant. Extremely large groups (group revenue of EUR 750 million or more) are also required to file a detailed report of assets and operations of all entities across the globe. Non-compliance with these provisions attracts several material penalties.
Bones of contention
Several interesting issues have been heavily litigated in India under the transfer pricing provisions. Examples are excessive royalty payment to foreign group companies, corporate guarantee fees, brand promotion expenses, situs of IP, etc. Even today, transfer pricing cases feature among the most litigated before the appellate authorities.
The information technology sector, which has been the shining star of Indian entrepreneurship over the past three decades, has seen significant cases of litigation under transfer pricing provisions. The government, too, has recognised this issue and taken steps to mitigate this by providing alternative avenues to mitigate this. These include:
(Vinita Krishnan is director and Jimmy Bhatt is principal associate at Khaitan & Co, one of India’s leading full-service law firms. The views expressed are personal)
(Disclaimer: The opinions expressed in this column are that of the writer. The facts and opinions expressed here do not reflect the views of www.economictimes.com.)
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