Tuesday, 7 June 2011

Oh, let them just evade taxes!

That isn't really the kind of statement you'd expect to hear from a tax-law student in India. I'm supposed to hold the law of the land in the highest regard and I come from a high-tax jurisdiction (a corporate taxpayer's nightmare). But you try and study Transfer Pricing regulations and that's all you can exclaim. Atleast I did.

At the outset, let me state that I'm not sure what this article (?) is about. I guess that's what blogs are for. The purpose of this "blog entry" is mainly to ascertain if I understand what I'm writing. And if I can write enough about Transfer Pricing to call it an article (?).

Transfer Pricing is probably one of the most complex computations a tax officer can come across and ironically, it has very little to do with tax. It is more about market conditions, economic scenarios, product knowledge and of course the glue that holds this all together; sister concerns. These regulations concern only international transactions (as of now) between associated enterprises, atleast one of which is a non-resident. The general idea behind these provisions is to ensure that cross-border transactions between them are at arm's length i.e. valued at the same price as such transactions would have been, had they taken place between unrelated parties. The transactions cover sale of both goods and services.

Why do international transactions between AEs make tax authorities wary? Apparently because the money exchanging hands in these cases may be a fishy business, designed to attract lower tax. As is well known, Indian tax authorities love to tax foreign corporate entities. The Vodafone case highlighted it enough. Textbook-like as it may sound, an example should help illustrate this.

Z is an Indian company which is a subsidiary of Y, an American company. Y sells certain goods to Z for Rs. 100 but makes an entry in its books of accounts, showing this amount to be 125. Z claims Rs. 125, instead of Rs. 100, as deduction from income on account of business expenditure. This lowers Z's income, thereby attracting lower tax. Since Z is ultimately the subsidiary of the American company, Y too derives indirect benefit from this arrangement. The Transfer Pricing regime dictates that the authorities will have to make sure that the amount of Rs. 125 is a reasonable price for the goods sold and in line with prevailing market trends.

All is dandy so far, but now arises the question as to HOW? There are so many things to be considered. The quality of the goods, the quantity of the goods, whether the value of the goods changes with different geographical locations, the cost of labor, etc. There are different methods to ascertain all this and compare the transaction with other independent and uncontrolled transactions. The factors to be considered while determining arm's length price differ from method to method and therefore, I will deal with them when I deal with the methods. For some reason, our lawmakers thought that these methods (enumerated in Section 92C of the Income Tax Act) would make the task 'simple.' (that totally backfired, I might add). These methods are essentially based on the internationally accepted OECD Transfer Pricing Guidelines. They are:

1. Comparable Uncontrolled Price (CUP) Method
2. Cost Plus Method
3. Resale Price Method
4. Profit Split Method
5. Transactional Net Margin Method

I wont discuss the methods in this post. They deserve a separate post of their own.

Moving on, the concept of an AE is fairly clear and comprehensively defined in Section 92A of the Income Tax Act. As far as I know, there has not been any litigation in this aspect. The concept of a Permanent Establishment has been the subject matter of many cases, the most important one being that of Morgan Stanley.
What constitutes an international transaction has also been discussed somewhat. An important case with regard to 'international transaction' is that of Tianjin Tianshi Pvt Ltd, a Chinese PE in India. A Delhi ITAT Bench held in this case, that international does not necessarily mean cross-border. A Indian company dealing with a foreign company's PE in India is subject to Transfer Pricing regulations.
Most of the Transfer Pricing litigation is only at Tribunal level right now, so I'm sure there will be much discussion on the basic aspects as the cases go to the High Court and Supreme Court level.

I'm not sure yet, whether I agree with the principles behind this regime. I'll need a much deeper knowledge of the subject. Not that my agreement/disagreement makes a shred of difference at this stage, but atleast it will clear things up for me. And who knows, perhaps the Finance Minister will ask for my opinion someday. Erm, anyhow.

This was a very basic article (?) with regard to the idea and purpose of Transfer Pricing. The next one will probably be more formal, with technical details and caselaws. By then, hopefully, I shall have a much better understanding of the subject. 

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