The Transfer Pricing Menace

Transfer pricing has come to occupy an important place in the field of international taxation. Its significance has considerably increased in recent years due to its use as a tool for reducing tax liability by the multinational corporations (MNCs). Most countries have, therefore, adopted different regulations to tackle this issue.

The US enacted Final Regulations in July 1994 and the OECD revised its guidelines on the subject in July 1995. The European Union, North American Free Trade Agreement (Nafta) and the Asean Free Trade Area (Afta) have also made considerable efforts to harmonise their regulations related to transfer pricing. No efforts have, however, been made in India.

 

Over the years, various principles have been evolved, each suggesting a different approach to solve the problem arising out of transfer pricing. Most approaches are in the form of guidelines. It is, therefore, important that these and related pricing techniques are carefully examined before any policy is finally introduced in India.

Arms length technique: According to this principle if the price or the margin is not within the arms length range, the government is entitled to make necessary adjustments in the price. However, the taxpayer must be given the opportunity to present additional evidence. In this context, US regulations are far more rigid. They put the onus of proof on the taxpayer and the burden of documentation requirements is considerably difficult. The OECD guidelines are rather balanced.

Comparable uncontrolled prices: This technique (CUP) refers to a comparable situation. As it is possible to have a controlled price in a related party transaction, there must be a reference to a comparable situation where price is not controlled and can be a benchmark.

Cost plus technique: This technique uses the cost incurred by the supplier of the goods in a transaction between the related enterprises as the starting point in the pricing system. A profit mark-up is added to the costs. Although the international norms of mark-up vary between 5 and 10 per cent, the system is ideal in a sellers market as it is possible to include a fair return on investment, although the concept of fair return is disputable. It is, in fact, not a matter of law but of commerce.

Resale minus: The OECD guidelines refers to resale minus as a technique in which the fair price is the price at which the product is sold to an independent third party by a related enterprise, which subsequently resells the product. The resale price is reduced by a gross profit margin which takes into account the relevant costs and expenses and also a reasonable profit in the light of the functions performed, assets used, and risks assumed. It is possible that the product sold by a company may not be sold by any other company, but the point here is not the price of the product but the margin of the dealer. For example, generally speaking, a distributor earns a 15 per cent commission. If the commission exceeds vastly, the issue is relevant for tax investigations.

Transactional profit method: The transactional profit method or the profit split method is applicable to inter-related transactions. In this, the profit must be first identified. Following this, it can be split between the related enterprises and the other enterprises. This method is useful in the absence of comparable situations.

Net margin method: This method examines the net margin profit in relation to costs, sales, or assets that a taxpayer realises from one transaction or aggregated transactions with a related party.

These approaches suggest various arms length solutions to the problem of transfer pricing. There is no single multilaterally acceptable solution for the complex situations arising from the various techniques of transfer pricing. Different countries follow varying approaches; national rules differ with regard to the preferences for the methods. However, these principles serve as guidelines for the regulations to be framed in India.

At present, there are no specific regulations dealing with the problem of transfer pricing in India. However, there are various provisions in different statutes. For example, the income laws, the company law regulations, and the foreign exchange regulations deal with related issues. The custom duty provisions also present rules for valuation of imported goods. However, these do not cope with the problems effectively. It is, therefore, important that certain reforms are attempted.

As regards taxation of income (personal income tax or corporate profit tax) it is essential that the principle of arms length pricing is adopted. Also, wherever necessary there is need to adopt special rules to strengthen the hands of the assessing officer to enable him to apply a special clause of The Scheme of DIV 13, on the pattern of the Australian Income Tax Law (Ref. CCH (1996), Austrian Master Tax Guide, Section 30-500 pp. 1234-1244). This provision should take a superior place in the statute in addition to the existing laws.

It is significantly different from the existing provisions inasmuch as it is not limited to arrangements that have a dominant tax avoidance purpose, and can be applied to transactions where transfer pricing is one among many reasons. The discretion is, however, that of the assessing officer. The provisions of DIV 13 can also be applied to attribute income to a resident company if a non-arms length agreement results in shifting of income from the country. Its application to transfer pricing is regardless of the motive or purpose.

The important features of the DIV 13 are two-fold. First, it attracts an additional tax when applied. Second, the level of additional tax depends on the extent to which tax avoidance played a part in transfer pricing. Notwithstanding the overriding provisions, DIV 13 does not prevail over international agreements or any provision of a double taxation treaty.

The Companies Act deals with the form and contents of the balance sheets and the profit and loss account under Section 211. It also has the power to direct a special audit under Section 233A. Most of these provisions are of investigative nature. It would be useful if an amendment is made in this law to prevent adverse inference in the event of non-production of necessary information by the foreign companies under Section 239.

As regards customs duty, while deciding the transfer pricing for the import of goods, various principles are incorporated. This is primarily done to ascertain if the transaction is between related parties as also to ascertain the flowback of profits, direct or indirect. In effect, it follows the related party and the arms length technique.

To ascertain that the importer has in effect undervalued the imports through transfer pricing, the custom authorities should have their own research wing. They should prepare well-researched price lists for all imported items. This practice can help them determine the genuine import prices to combat the menace of transfer pricing.

Thus, issues related to transfer pricing in the Indian context not only continue to be a vexing problem but are critically important in the context of structural reforms adopted since 1991-92. These reforms have resulted in the removal of barriers of prohibitive custom duties and abolition of the other fiscal and regulatory measures. This, in turn, has paved the way for misuse of the procedure of transfer pricing. It is, therefore, important that India adopts concomitant provisions under the income tax, company law and the custom duties.

(The author is with the National Institute of Public Finance and Policy, New Delhi.)Issues related to transfer pricing in the Indian context not only continue to be a vexing problem but are critically important in the context of structural reforms adopted since 1991-92.