Transfer Pricing (“TP”) provisions were introduced in the Indian Income Tax Act with effect from 1 April 2002. During the initial years of TP provisions, there were many interpretational and implementational issues. As with any other direct tax dispute resolution in India, TP dispute resolution involves a lengthy process. Since multi-national business enterprises undertake similar international transactions across years, an unresolved issue can create uncertainty over the different years. In terms of the amount of adjustment, this can be quite substantial. The below article discusses the TP dispute resolution journey in India and highlights specific key issues that have dominated the past two decades of TP legislation.
In the initial years of TP litigation, the emphasis was more on the comparability analysis, use of most appropriate method, which tested party to use etc. Over the years disputes have progressed to advanced issues such as intangible transactions, attribution of profits to Permanent Establishment, re-characterization of the entity, use of Profit Split Method, etc.
TP Rulings on the initial issues
One of the first landmark TP ruling was by a 5 member special bench of the Income-tax Appellate Tribunal (“ITAT”) in the case of Aztec Software & Technology Services Ltd. v. Asstt. CIT [TS-4-ITAT-2007(Bang)-TP]. It laid down how TP regulations should be applied, such as benchmarking methods, selection of comparable companies, implementing provisions in cases of complex transactions involving intangibles, etc.
In the case of Coca-Cola India Inc v ACIT [TS-2-HC-2008(P&H)-TP] Punjab & Haryana High Court upheld the constitutional validity of Chapter X. Also, it held that the legislature was competent to make the relevant provisions applicable to non-resident without there being any evidence showing transfer of profits out of India or tax evasion motive. High Court rejected the Petitioner’s argument that TP provisions do not apply to parties subject to jurisdiction of Indian taxing authorities, without establishing a tax evasion motive.
Comparability analysis is one of the most litigated areas in transfer pricing dispute resolution. It mainly relates to selection of comparable; internal vs external comparable; use of single year vs multiple year data; selection of Indian vs foreign tested party and aggregation vs segregation of transactions. Though judicial precedents have settled specific issues, some issues are still pending before High Courts and Supreme Court to achieve finality. Some others have been put to rest due to the changes in the legislation. Such as the Tax authorities and the ITATs were largely against the use of the multiple-year data. This controversy was put to rest with the amendment made by the Legislature in Income Tax Act in 2014, wherein the government allowed use of 35th and 65th percentile range as well as multiple year data.
Similarly, it has been accepted that the tested party should be the least complex entity out of the related parties to the transaction. Madras HC has confirmed this view in the case of Virtusa Consulting Services Private Limited [TS-45-HC-2021(MAD)-TP]. TP legislation provides for use of the Most Appropriate Method (“MAM”) to determine the arm’s length price (“ALP”) of international transaction. In many cases, this has also been subject to litigation.
TP Rulings on more complex issues
Capital receipts: In the case of Shell India Markets Pvt Ltd [369 ITR 516] and Vodafone India Services Pvt Ltd. (Vodafone IV)[368 ITR 1], it was settled that capital receipt transactions will not be subject to transfer pricing provisions. These cases dealt with the applicability of TP to fresh issue of equity shares at a premium. Therefore, they do not fall within the ambit of “income” within section 2(24) of the Act.
Corporate Guarantee Commission is another most commonly litigated issues. It is contended that provision of corporate guarantee does not constitute an ‘international transaction’ and thus there is no requirement to charge any fee from the overseas entity. An explanation was added to the definition of the term “international transaction” under section 92B by the Finance Act, 2012, with retrospective effect from 1 April 2002. This explanation aimed to include the provision of guarantees within its scope. However,even after retrospective amendment the ITATs have held that issuing corporate guarantee without any effect on profits, income, losses, or on taxpayer assets should not be considered an “international transaction” {Bharti Airtel Ltd 43 Taxman.com 150 and MicroInk Ltd v. ACIT [63 Taxman.com 353]}. The appeal filed by Revenue authorities against these Tribunal orders are pending before the High Court. Though various rulings rely on the case of Everest Kanto Cylinders Ltd [TS-714-ITAT-2012(Mum)-TP] and Glenmark Pharmaceuticals [TS-1268-SC-2018-TP] and consider a rate of 0.5% of Corporate Guarantee Commission as being adequate.
Advertisement, Marketing and Promotional (“AMP”)Amongst many other controversial issues, the adjustment on account of AMP expenditure is one of the most litigated issues and it even involves high stakes. The Tax authorities have consistently held that excess AMP expenditure leads to brand building for the foreign associated enterprises (“AEs”), and hence Indian taxpayers should be compensated for such brand-building services. There were two landmark rulings from Delhi High Court on this issue. In Maruti Suzuki India Ltd. v. ACIT [TS-395-ITAT-2015(DEL)-TP] it was confirmed that AMP is not an international transaction. In the case of Sony Ericsson Mobile Communications India (P.) Ltd. v. CIT [TS-543-HC-2016(DEL)-TP] the High Court rejected the application of the bright-line test and affirmed that AMP is not a separate international transaction and can be compensated on an aggregate basis as part of the distribution activities. The issue of AMP is pending before the Supreme court and the hearing is scheduled in September end.
Substantial question of law: In a landmark ruling in the case of Principal. CIT v. Softbrands India (P.) Ltd [TS-475-HC-2018 (KAR)-TP], the Karnataka HC held that under section 260A, appeals to the HC can be preferred only on ‘substantial question of law’ and not on questions of fact unless it is established that the ITAT order was perverse. As a result, many issues were considered as “questions of fact” and “not questions of law”. However, if the findings by the Tribunal were perverse, then the HC can set aside such results.
Re-characterization: Another issue faced under TP has been relating to re-characterization. In the case of EKL Appliances Limited, the Delhi HC has held that situations, where re-characterization could be considered, are exceptional and should not be a routine permissible practice by the revenue. On the significance of the OECD Guidelines that deal with re-characterization, the HC noted as follows:
“17. The significance of the aforesaid guidelines lies in the fact that they recognize that barring exceptional cases, the tax administration should not disregard the actual transaction or substitute other transactions for them and the examination of a controlled transaction should ordinarily be based on the transaction as it has been actually undertaken and structured bythe associated enterprises. It is of further significance that the guidelines discourage re-structuring of legitimate business transactions. The reason for characterization of such re-structuring as an arbitrary exercise, as given in the guidelines, is that it has the potential to create double taxation if the other tax administration does not share the same view as to how the transaction should be structured.”
Central Board of Direct Taxes (“CBDT”) issued a Circular No.06/2013 by way of which it gave certain conditions for the classification of contract research and development centres in India. This was before the actual Development, Enhancement, maintenance, protection, and exploitation (“DEMPE”) analysis guidelines were outlined by the OECD BEPS action plan 8-10. The main principle that emerged is about defining the parties’ actual conduct and looking at the substance of the transaction rather than the form.
Mutual Agreement Procedure and Advance Pricing Agreement
Mutual agreement procedure (“MAP”) is a mechanism through which two or more countries tax administrations consult each other to resolve disputes regarding the application of double tax treaties. It is also used to eliminate double taxation that could arise from a transfer pricing adjustment. This procedure is described and authorised by Article 25 of the OECD Model Tax Convention. On 7 August 2020, India’s CBDT issued detailed guidance on the regulations and processes that the Indian government intends to follow when implementing the MAP. India’s endeavour is to resolve MAP cases within an average timeframe of 24 months in conformity with the minimum standards recommended in the BEPS Action 14 final report. The biggest advantage of MAP is that it is a consultative process. It has become an increasingly important tool for taxpayers and tax authorities alike in addressing double taxation, as it allows for competent authorities to consult with each other on the application of double taxation treaties.
Further, to deal with the rise in transfer pricing litigation, reforms such as the Advance Pricing Agreements (APA) was introduced in 2012. To start with APAs were applicable for a period of five years starting from the previous year in which it was applied. Subsequently, with the introduction of the rollback provision by the Finance Act 2014, the APA also became applicable to four years preceding the first previous year for which APA is applied. To operationalize the APA scheme, notification no. 36/2012 [F. No. 133/5/2012-SO(TPL)]/SO 2005 (E), dated 30 August, 2012 was notified and the APA Scheme [Rules 10F to 10T] were inserted in the Income-tax Rules. Thus, the Indian APA programme, though it commenced from 1 July, 2012, actually became functional and operational from 30 August 2012 with the notification of the rules. The rules lay down the detailed procedures for filing of pre-filing consultation; payments of fees; filing of APA application; processing of APA application; withdrawal of APA application; terms and conditions of APA; filing of Annual Compliance Report; Compliance Audit; revision, cancellation and renewal of APA; etc.
Safe Harbour Rules
Safe harbour rules list down specific rates/circumstances in which the tax authority shall accept the transfer price declared by the taxpayer to be at an arm’s length. Safe harbour rules were introduced by the Finance (No. 2) Act, 2009 and later rationalised in 2017. The taxpayers have always envisaged the safe harbour rates to be higher than those reflective of the industry trends or that which may be available through an APA route, and accordingly, they have not been the first preference as a measure of dispute prevention for multinationals.
Concluding remarks
During the initial years of the TP dispute resolution, only the traditional dispute resolution measures were available to the taxpayers. Traditional dispute resolution includes transfer pricing audit, appeals and redressal options before the courts. They often are long drawn and consume substantial time before any matter reaches finality. Therefore, alternate dispute prevention and resolution programmes like MAP, APA, and safe harbour rules, which are additional mechanisms for dispute resolution and prevention between taxpayers and tax authorities have gained popularity globally over the last decade.
Further, there are issues such as repeated litigation on identical grounds and remand orders that place companies in litigation cycles. Even the DRP mechanism could not be as successful as was the intent while introducing the same. Since often grounds for litigation are similar across years specially in transfer pricing, block transfer pricing assessment for multiple years in one cycle may be a good strategy for transfer pricing cases. Various nations across the world follow the approach of multiple year audits in one cycle. It reduces the uncertainty, cost, time and increases efficiencies in the audit process.
Another challenge being faced is the actual implementation of the APA programme. The CBDT needs to provide better infrastructure, resources and expertise to achieve the full potential of the APA programme. While India has come a long way in the TP dispute resolution; there are still many milestones to be achieved.
(Source : Article published in Souvenir released at National Tax Conference held at Katra on 2nd & 3rd October, 2021)