Cost allocations – Between tax free and taxable units – Domestic Transfer Pricing

    Tax holiday undertakings are required to maintain separate books of account and get them audited. In respect of direct costs of such undertakings there is no issue. Whereas assessee at the entity level maintaining both tax holiday undertaking and non-tax holiday undertaking incurs common expenditure which may be chiefly called as "HO Expenditure" such as general administrative expenses like travelling, conveyance, communication, marketing, legal and professional expenses, etc. In respect of such expenditure a proper allocation must be made among all the undertakings of the assessee. This is where, how an allocation is made to a tax holiday undertaking is a subject matter for domestic transfer pricing provisions. In other words, whether the allocation made is complying with the arm’s length standard is to be examined by the domestic transfer pricing provisions.

    Common expenses have to be allocated among the undertakings on the basis of say turnover, number of employees, etc. Certain expenses like finance costs and human resource costs which do not directly relate to any eligible undertaking, cannot be apportioned in an easy manner. However the corporate office or the head office exists for the sake of various business activities carried on by different units of the assessee. Therefore even finance and HR costs have to be allocated to all the undertakings. In this context, Bangalore Bench of the ITAT in the case of Wipro Information Technology v. DCIT (2004) 88 TTJ (Bang.) 778 held that the corporate group does not carry on any business activity by itself and hence cannot be called to be the business of the tax payer. The expenditure incurred by the corporate office cannot be related to any undertaking and accordingly it was held that interest on funds borrowed for the purpose of the corporate office need not be apportioned to any of the tax holiday undertakings for the purpose of computing tax holiday profit. Similar view has been taken by the Hon’ble Bombay High Court in the case of Zandu Pharmaceuticals Works Ltd., v. CIT (2013) 213 Taxman 207.

    7.1 Whether every cost allocation should have a markup is a matter of debate in the context of domestic transfer pricing provisions.

    It is to be examined whether a particular cost allocation is a service by itself by one undertaking to the other. If so, the same must be marked up. In the OECD TP guidelines we have some guidance in the context of intra group services. If the service is more of a group management cost to enhance the image of the group and to ensure quality in services / products which is apportioned among the group companies then such apportionment should be on cost to cost basis and there should not be any markup. The same concept applies even in the context of intra-undertaking allocation of costs relating to group management. Sometimes a service is different from what is explained above and may be compared with any marketable service availed from a third party. In other words, a service availed from a group company is to be paid with a markup as such service if availed from a third party would also have been paid like a marketable service. Same concept would apply to marketable services rendered by one undertaking to the other when one of such undertakings is a tax holiday undertaking.

Directors’ remuneration – Domestic Transfer Pricing

    This is a SDT which is required to be benchmarked as per arm’s length standard. It is a challenge to benchmark each director’s remuneration. There may be a very highly qualified director who may be paid a very handsome remuneration. Whereas another director with ordinary qualification might have been paid in the normal way. How do we benchmark each one’s salary? Whether Schedule XIII of Companies Act, 1956 which deals with restrictions on managerial remuneration should be relied upon as an arm’s length standard? Alternatively director’s remuneration may be benchmarked by adopting Transaction Net Margin Method (TNMM) at the entity level of the tax payer. As of now no clear guidance is available from CBDT in this regard and we expect the same for a litigation free implementation of these provisions in the context of director’s remuneration.

Economic double taxation – Domestic Transfer Pricing

    Non-compliance with ALP would result in disallowance of expenditure in the hands of assessee incurring the same under sec. 40A(2)(b). However there is no mechanism to make corresponding downward adjustment of income in the hands of related party. This would obviously result in economic double taxation. Circular 6-P dated 6th July, 1968 dealt with the issue of disallowance under sec. 40A(2)(b) had clarified that there should not be any disallowance when there is no attempt to evade taxes. Para 74 of said circular reads as under:

    "It may be noted that the new provision is applicable to all categories of expenditure incurred in businesses and professions, including expenditure on purchase of raw materials, stores or goods, salaries to employees and also other expenditure on professional services, or by way of brokerage, commission, interest, etc. Where payment for any expenditure is found to have been made to a relative or associate concern falling within the specified categories, it will be necessary for the Income-tax Officer to scrutinise the reasonableness of the expenditure with reference to the criteria mentioned in the section. The Income-tax Officer is expected to exercise his judgment in a reasonable and fair manner. It should be borne in mind that the provision is meant to check evasion of tax through excessive or unreasonable payments to relatives and associate concerns and should not be applied in a manner which will cause hardship in bona fide cases."

    The import of the circular is intact and the benevolent portion of the same would be available for the assessees. In this context we need to address the issue of economic double taxation which is never the objective of domestic transfer pricing. In other words unless corresponding downward adjustments of income are allowed in the hands of recipients who are related parties, on the event of upward adjustment of income in the hands of assessee incurring the same, there is no legal justification as it would result in economic double taxation. In international Transfer Pricing we have the concept of corresponding adjustments as per Article 9(2) of OECD MC/UN MC and the same analogy should be brought in the context of domestic transfer pricing also.

Tax Holiday undertakings – Domestic Transfer Pricing

    The transactions of a tax holiday undertakings which are to be treated as SDTs are as under:

        transfer of goods and services from one tax holiday undertaking to non tax holiday undertaking of the same tax payer or vice versa

        any business transacted with entities having close connection

        non recurring and unique transactions such as purchase of undertaking from a closely connected person

        allocation of common expenses

        guarantees and loans for the purpose of the business of tax holiday undertaking.

    Sec. 80-IA(8) and 80-IA(10) deal with inter unit transfers and transactions with connected parties respectively by a tax holiday undertaking. The purpose of these provisions is to ensure that an assessee claims tax holiday computing his profit correctly. In other words, an assessee should not be allowed to inflate profits of a tax holiday undertaking and correspondingly reduce profits of taxable units and for this purpose domestic transfer pricing provisions have been put in place. In the regular international transfer pricing if profits declared by an assessee are higher than arm’s length profits then there is no objection under the TPR. Whereas when you examine the objective of sec. 80-IA(8) and 80-IA(10) it is to restrict the profit to the level of ordinary profits if the profits declared are higher than that. Now the domestic transfer pricing provisions which are brought into the statute book are expected to promote the objective of sec. 80-IA(8) and 80-IA(10) in computing ordinary profits of the tax holiday undertaking. In other words, unlike in the case of international transfer pricing, the domestic transfer pricing provisions in the context of computing profits of tax holiday undertakings would target to restrict the profits to the level of ordinary profits. This basic difference needs to be borne in mind.

    6.1 In this backdrop let us look at the issues that may be encountered.

        Ordinary profits vs arm’s length profit:

        If profits computed as per arm’s length principle are say 15 per cent net margin on the basis of average of comparable companies and if the actual profit reported by the tax holiday undertaking is at 30 per cent, whether there arises an issue whereby assessing officer would restrict the tax holiday profit to 15 per cent and disallow the balance 15 per cent from claim of tax holiday. There is case law in this regard in the context of international transfer pricing vis-à-vis sec. 10B(7) provisions. It was held by the Courts that once profits of a tax payer who is eligible to claim tax holiday under sec.10A / 10B are established at arm’s length then the assessing officer has no legal mandate to restrict or reduce such profits under sec. 10A(7) / 10B(7) alleging that assessee inflated profits for tax holiday claim – Visual Graphics Computing Services (India) Pvt. Ltd. v. ACIT (2012) 52 SOT 172 (URO), Weston Knowledge Systems & Solutions (India) Pvt. Ltd. v. ITO (2012) 52 SOT 120 (Hyd.) (URO). It is therefore to be debated whether ratio of this case law will help the assessee when arm’s length principle is to be applied for computing ordinary profits.

        Whether loss making tax holiday undertakings have to comply with domestic transfer pricing provisions is an issue for debate

        Whether a cost allocation is a service and is required to be marked up by one undertaking to the other?

FMV vs. ALP – Domestic Transfer Pricing

    Corresponding amendments in bringing the concept of ALP in the place of FMV are carried out in sec. 40A(2), sec. 80A, sec. 80IA(8) and sec. 80IA(10), etc. At the threshold the amendments create some confusion as to the concepts of FMV and ALP, which are explained as under:

    a) Sec. 40A (2) – proviso inserted to clause (a) reads as under:

    "Provided that no disallowance, on account of any expenditure being excessive or unreasonable having regard to the fair market value, shall be made in respect of a specified domestic transaction referred to in section 92BA, if such transaction is at arm's length price as defined in clause (ii) of section 92F."

    The wording of this proviso clearly indicates that FMV is different from ALP.

    b) Clause (iii) is inserted in Explanation to sec. 80A(6) which reads as under:

    "in relation to any goods or services sold, supplied or acquired means the arm's length price as defined in clause (ii) of section 92F of such goods or services, if it is a specified domestic transaction referred to in section 92BA."

    Explanation defines what is "market value" and adds clause (iii) as an additional dimension to such definition of market value. Here are we expected to understand ALP as synonymous with market value?

    c) Newly substituted explanation to sub-sec. 8 of 80-IA reads as under

    "For the purposes of this sub-section, "market value", in relation to any goods or services, means —

    (i) the price that such goods or services would ordinarily fetch in the open market; or

    (ii) the arm's length price as defined in clause (ii) of section 92F, where the transfer of such goods or services is a specified domestic transaction referred to in section 92BA."

    Plain reading suggests that FMV is synonymous with ALP

    d) Newly inserted proviso to sec. 80-IA(10) reads as under:

    "Provided that in case the aforesaid arrangement involves a specified domestic transaction referred to in section 92BA, the amount of profits from such transaction shall be determined having regard to arm's length price as defined in clause (ii) of section 92F."

    It suggests that only ALP needs to be adhered to, thereby it means that ALP is different from FMV.

    5.1 It is extremely important to remove this confusion of conflicting definitions of FMV and ALP. It is apparent from the very amendment that ALP is different and more scientific than FMV. Had it not been so there would not have been any requirement to bring in these amendments. In view of the same to avoid unwanted litigation CBDT has to clarify and remove the above explained confusion at the earliest.

Closely connected person – Domestic Transfer Pricing

    Sec. 80IA(10) deals with business transactions between assessee carrying on eligible business and a person closely connected to such assessee in terms of examining whether assessee computed tax holiday profits appropriately on the basis of arm's length principle. We need to examine what is meant by "closely connected person". Apparently there is no definition of the said term in the Income-tax Law. When there is no definition available in the statute, we need to go by the general contextual understanding of the term. If we examine the expanded definition of related party it now includes "any other company carrying on business or profession in which the first mentioned company has substantial interest". Earlier group companies like subsidiaries or joint venture companies were not included in the definition of related party under sec. 40A(2)(b). Whether it is to be understood that such group companies or entities fall within the scope of closely connected persons. In this context we have a decision rendered by Bangalore Bench of Hon’ble ITAT in the case of Digital Equipment India Ltd v. DCIT (2006) 103 TTJ 329 (Bang.) relating to erstwhile sec. 80I(9) dealing with closely connected person, wherein it was:

    "Held that the requirements of Section 80-I(9) are:

        There must be a close connection between the appellant and other person;.

        The course of business between them should be so arranged that it produces to the appellant more than the ordinary profits from such business.

    To satisfy the above tests the Assessing Officer has to adduce evidence and reasons cogently and the same are open to verification by the appellate authorities. The primary rule of evidence is that ‘what is apparent is real’ unless proved otherwise by the person alleging it otherwise. The manner of satisfaction outlined in the section should be based on evidence and not on surmise or suspicion. The question is not whether the onus is light or heavy but whether the Assessing Officer has discussed objectively the conditions mentioned in the section to disturb the results declared by the appellant. In this case, the Assessing Officer had failed to adduce any evidence or reason to satisfy the invoking of Section 80-I(9). First of all, a mere substantial profit does not give rise to any valid view that there could be any arrangement. It was a case of joint venture listed Indian company where all arrangements were open for scrutiny and acceptance not only by Digital Group worldwide but also from joint venture partners and share holders. Digital Group overseas would not pay undue sum which it could not recoup entirely to exclusion of others. Hence nothing could be arranged to the exclusive benefit of overseas partner. One cannot presume the existence of close connection or possibility of an arrangement for earning more than ordinary profits. In the instant case the profits earned were comparable with the profits earned by other companies in the same industry. Hence there was no case for further verification. The Assessing Officer had compared the profit of software unit with that of hardware unit. Thus the foundation itself was on wrong premise. There cannot be comparison between an orange and an apple. It is known fact that profitability of software units is always higher than that of hardware units. When the profits earned were reasonable and not excessive, there was no reason to sustain the addition. Further there was no evidence of existence of any arrangement as contemplated under section 80-I(9)."

    It is possible to infer from the above judgment that "close connection" would obviously require relationship such as joint venture or subsidiary, etc. In case an assessee has share holding of only 10% or less than 20% in another company whether it would amount to "close connection" is an issue to be debated. It is therefore to be noted that we have little guidance on the concept of "close connection" and need more clarification from CBDT in this regard.

Domestic Transfer Pricing - Related Party – Sec. 40A(2)(b)

Related Party – Sec. 40A(2)(b)

The amended sec. 40A(2)(b) reads as under:-

"(i) in clause (a), the following proviso shall be inserted, namely:—

"Provided that no disallowance, on account of any expenditure being excessive or unreasonable having regard to the fair market value, shall be made in respect of a Specified Domestic Transaction referred to in section 92BA, if such transaction is at arm's length price as defined in clause (ii) of Section 92F."

(ii) In clause (b), in sub-clause (iv), after the words "or any relative of such director, partner or member", the words "or any other company carrying on business or profession in which the first mentioned company has substantial interest" shall be inserted."

In the amended definition group companies are added which were hitherto not there in the erstwhile definition. "Substantial interest" is defined in explanation as the interest of a beneficial owner of shares carrying not less than 20 per cent of the voting power.

3.1 As per the definition it is not clear whether indirect holding of substantial interest is covered within the purview of "Related Party". Explanation to sec. 40A(2)(b) talks about beneficial ownership with regard to substantial interest held in an entity. Beneficial ownership is not defined under the Income-tax Law. Beneficial ownership is understood as a concept beyond the titular ownership. In other words beneficial ownership is not confined to legal ownership, in this regard we can rely on the ratio laid down by the Hon’ble Supreme Court in the case of CIT v. Podar Cements P. Ltd(1997) 226 ITR 625. Operative portion of the judgment reads as under

"We are conscious of the settled position that under the common law owner means a person who has got valid title legally conveyed to him after complying with the requirements of law such as Transfer of Property Act, Registration Act, etc. But in the context of Section 22 having regard to the ground realities and further having regard to the object of the Act, namely, 'to tax the income', we are of the view that the owner is a person who is entitled to receive income from the property in his own right."

Accordingly it was held by the Apex Court that an assessee who purchased a house property and enjoying the same pending formal registration was held to be the beneficial owner under sec.22 of the I.T. Act. In line with the same ratio the Apex Court also held that business assessee who owned a building pending registration was allowed to claim depreciation – Mysore Minerals v. CIT (1999) 239 ITR 775 (SC).

Therefore beneficial ownership obviously includes direct as well as indirect interest. One needs to look at the substance and find out who is the real owner. Applying the same analogy in the context of definition of related party under sec. 40A(2)(b) it would be incorrect to confine the scope only to direct holding of an interest in the entity. Thereby in the context of Domestic Transfer Pricing it is obviously justified to consider indirect holding as the same would come within the purview of beneficial ownership.

3.2 As per the definition of the related party under sec. 40A(2)(b) the following persons would be covered:

Sr. No	Payer / assessee	Payee
(i)	Individual	Any relative [defined in sec. 2(41) to mean husband, wife, brother, sister, lineal ascendant or descendant] Definition of Relative u/s. 56(2) not relevant
(ii)	Company	any director or relative of such director
	Firm (includes LLP)	any partner or relative of such partner
	AOP	any member or relative of such member
	HUF	any member or relative of such member
(iii)	Any assessee	any individual having substantial interest in the assessee’s business or relative of such individual
(iv)	Any assessee	a Company, Firm, AOP, HUF having substantial interest in the assessees business or any director, partner, member or relative of such director, partner or member or (newly inserted) any other company carrying on business or profession in which the first mentioned company has substantial interest. X Ltd. (subsidiary co.) A Ltd. (holding co.) Y Ltd. (subsidiary co.)

DOMESTIC TRANSFER PRICING - Specified Domestic Transaction (SDT) – Section 92BA

Sec.92BA reads as under:-

"For the purposes of this section and sections 92, 92C, 92D and 92E, "Specified Domestic Transaction" in case of an assessee means any of the following transactions, not being an international transaction, namely:—

• any expenditure in respect of which payment has been made or is to be made to a person referred to in clause (b) of sub-section (2) of section 40A;
• any transaction referred to in section 80A;
• any transfer of goods or services referred to in sub-section (8) of section 80-IA;
• any business transacted between the assessee and other person as referred to in sub-section (10) of section 80-IA;
• any transaction, referred to in any other section under Chapter VI-A or section 10AA, to which provisions of sub-section (8) or sub-section (10) of section 80-IA are applicable; or
• any other transaction as may be prescribed,
• and where the aggregate of such transactions entered into by the assessee in the previous year exceeds a sum of five crore rupees."

The following transactions constitute SDTs as per the definition given above:

• Expenditure incurred on related party as defined in sec. 40A(2)(b)
•  Any transaction referred to in sec. 80A
•  Inter unit transfers of goods / services between tax free and taxable units of an assessee;
• Business transactions between closely connected persons and the assessee running an eligible business;
• SEZ v. Non-SEZ units – transfer of goods / services;
• Any other transaction referred to in Chapter VIA to which provisions of sec. 80IA(8) or 80IA(10) are applicable;
• Any other transaction as may be prescribed.

SDTs are defined with an objective to check revenue leakage in respect of transactions that are susceptible for manipulation. In this regard typical transactions between a profit making entity and loss making entity of related parties, transactions between tax free unit and taxable unit of the same assessee and payment of managerial remuneration to directors of an assessee company etc., are covered to ensure that they are entered into at arm’s length and that there is no fiscal evasion. At the same time, it is critically important that administering arm’s length standard in respect of SDTs should not result in double taxation. What are the checks and balances in this regard is of utmost importance. We shall discuss this in more detail in later part of this article. CBDT reserved its power to notify any other transaction as SDT in future. This is generally called an "enabling clause" empowering the Board to notify any further transactions as SDTs. Till such notification is given by the Board neither the revenue nor the assessee has any power to rope in any other transaction as SDT.

2.1 The said amendments introducing Domestic Transfer Pricing from A.Y. 2013-14 are intended to examine related party transactions, transfers to SEZ from non-SEZ units of the same assessee, transactions between tax holiday assessee and closely connected persons and various other transactions of tax holiday assessees such as SEZ developer, etc., as to adherence with arm’s length principle. SDTs are to be examined in comparison with similar transactions with unrelated parties using the same six methodologies which are presently used in the international transfer pricing. Reference to Transfer Pricing Officer (TPO), service of notice and order to be made by the TPO are similar to what is available in the context of international transfer pricing. Documentation is to be maintained in respect of SDTs as per sec. 92D read with Rule 10D in the same manner as that of international transfer pricing. A report from an accountant is to be obtained under sec. 92E and the same should be filed along with the return.