mechanism of transfer pricing. Income Tax provisions need to be revamped to combat the menace, says Mahesh C Purohit
Transfer Pricing refers to the value attached to the transfer of goods or services including technology between related entities, which could be parent and subsidiary corporations. For example, if there is a domestic company X which has a subsidiary Y to whom it transfers some products, the value attached to the products transferred by X to Y is the transfer price. It is important from the point of tax revenue to determine the fairness of the transfer price of the products in question.
Transfer pricing is currently one of the most important issues in international taxation. Following the enactment of Section 482 (Final Regulations) by the United States and the publication of the revised guidelines by the Organisation of Economic Cooperation and Development (OECD), many countries have harmonised their regulations.
The issue is important because almost half of the transactions in international trade are potentially susceptible to transfer pricing. India has long recognised the importance of transfer pricing. However, the issues have become critical during the last five years due to some important factors. First, India has gone in for structural reforms since 1991-92. This has paved the way for the globalisation of the Indian economy and resulted in the removal of barriers of prohibitive customs duties.
Secondly and more importantly, as the prevailing trends suggest there is a feeling that, in general, the multinational corporations operate in such a way that they do not pay the requisite amount of tax compared to domestic organisations of the same size. In the Indian context, where the tax administration is lax and the management information system in the tax departments is practically nonexistent, the multinationals would certainly not pay the requisite amount of tax. As the inflow of direct foreign investment is increasing over time, the issues of transfer pricing are bound to come to the fore.
Finally, with the expansion of the export sector, Indian undertakings engaged in exporting their products could take the increasing benefits of transfer pricing. For domestic companies tend to undervalue their exports to their related or affiliated counterparts located in low tax regimes outside India. These related enterprises in turn transfer these products back to the same enterprise in India at higher prices and avoid the incidence of tax in India.
Under the income tax laws, if a business transaction between a resident and a non-resident is so structured that it results in no profit or less than ordinary profit, the tax authorities may determine a reasonable amount of profit from the transaction. The profit which has been so deciphered is added to the taxable income of the resident assessee. The profit may be determined with reference to the value of the transaction by applying the ratio of total business receipts or by using any other appropriate method.
Section 92 of the Indian Income Tax Act, 1961 covers transfer pricing among other devices designed to avoid tax between a resident and a non resident. When it appears to the assessing officer that owing to the close connection between them, the course of business is so arranged that the business transacted between them produces to the resident either no profits or less than the ordinary profits which might be expected to arise in that business, the assessing officer shall determine the amount of profits which may reasonably be deemed to have been derived therefrom and include such amount in the total income of the resident. Rules 10 and 11 of the IT Rules, 1962 prescribe the methods for determining such income. However, this provision has rarely been invoked.
Section 142(2A) of the Income Tax Act further envisages that if, at any stage of the proceedings before him, the assessing officer, having regard to the nature and complexity of the accounts of the assessee and the interest of the revenue, is of the opinion that it is necessary so to do, he may with the previous approval of the chief commissioner or commissioner, direct the assessee to get the accounts audited.
Some related provisions also exist in Section 93 concerning income from an asset transferred to non-resident as income of the resident under certain situations and Section 94 relating to avoidance of tax on certain transaction in securities. However, it is clear from the laws that the mere fact that the transfer resulted in the avoidance of tax liability cannot be proof of the intention to avoid the liability.
In addition there are provisions governing calculation of income through Sections 37(1), 40A(2), and 44C, each dealing with one or the other aspect relating to expenses for calculating income. Here it is important to note that for checking evasion of tax, sufficient powers are provided by the Income Tax Act to the assessing officer to determine taxable income from business or profession. Section 37(1) entitles the assessing officer to examine whether or not expenditure has been incurred wholly and exclusively for the purpose of the business.
Section 80 I or 80 IA, empowers the assessing officer to determine the deduction allowable to reduce the total income of the company. Section 40A(2) specifically states that where the assessee incurs any expenditure in respect of which payment has been made to any person, and the assessing officer is of the opinion that such expenditure is excessive or unreasonable, so much of the expenditure as is considered by him to be excessive or unreasonable shall not be allowed as a deduction. Also, Section 44C imposes a ceiling on the allowances of the head office expenditure in the case of non-residents.
The existing provisions therefore indicate that it is essential to revitalise them to take care of the intricate issues involved in transfer pricing by multinationals. This is one reason why the OECD has also revised its guidelines on transfer pricing. In the Indian context, the following suggestions would be worth considering.
First, we adapt suitable measures of arms length pricing on the lines suggested by the OECD (Guidelines for Multinational Enterprises and Tax Administration, 1995).
Secondly, where necessary we adopt special rules to strengthen the hands of the assessing officer to enable him to apply some special clauses. Recognising the prevailing practices of avoidance of tax through the mechanism of transfer pricing, the report of the export group to rationalise and simplify tax law has suggested that the following sub section be added to the Indian Tax Act, 1961: Sub section 1:
Where the assessing officer is satisfied that the purpose or effect of any arrangement is directly or indirectly (a) to alter the incidence of any tax which is payable by or which would otherwise have been payable by any person;(b) to relieve any person from any liability to pay tax or to make a return under this act; or (c) to reduce or avoid any liability imposed or which would otherwise have been imposed on any person by this act, the assessing officer may, without prejudice to such validity as it may have in any other respect or for any other purpose, disregard or vary the arrangement and make such adjustment as he considers appropriate, including the computation or recomputation of gains or profits, or the imposition of liability to tax, so as to counteract any tax advantage obtained or obtainable by that person from or under that arrangement.
The proposed provision is however not to be applied in case of ordinary commercial transactions. Notwithstanding the above recommendations of the committee, it is felt that the corporate veil cannot be pierced with the existing provisions when there is a fraud or attempted evasion of tax. There is a need to have the other provision of the OECD guidelines to better able to combat the emerging menace of transfer pricing in India.
It is also important to appreciate the importance of the emerging trade blocks that provide a movement towards economic integration. India should play a key role in harmonising the tax systems of all the Asean countries who are signatories to the Asean Free Trade Area (AFTA) in 1992. This would help the creation of common market and strengthen economic cooperation. It could also be used to exchange information and experiences in tax matters to check the problems of transfer pricing.
(Mahesh C Purohit is on the faculty of the National Institute of Public Finance and Policy, New Delhi) India should play a key role in harmonising the tax systems of all the Asean countries who are signatories to the Asean
Free Trade Area (AFTA) in 1992. This would help the creation of a common market and strengthen economic cooperation.