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BASIC CONCEPTSANDOVERVIEW OF SPECIFIED DOMESTIC TRANSACTIONS
September 2013Presented by- CA Reena Gupta
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OVERVIEW
2
SDT – An Overview3
SDT – Impact Analysis
1 Basic concepts of transfer pricing
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Disclosure in Form 3CEB5
Introduction to SDT
3
1 Basic concepts of transfer pricing
WHAT IS TRANSFER PRICING? Transfer pricing is an ART
(and not a science)
Transfer pricing is consulting a PROCESS and not a product
Why Take the Trouble?
− Because you have to - i.e. Legislation
− To be prepared for a transfer pricing Audit
− As a contemporaneous record
− To demonstrate how pricing decisions were made
− To show that you did adopt arm’s length principle
− To eliminate/ minimise penalties
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WHAT IS ARM’S LENGTH PRICE?
Arm’s length Price means
at which
Transact with each other
‘PRICES’
INDEPENDENT PARTIES…
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Most direct and reliable measure Comparability relies on similarity of:
Must not have material product differences Minor adjustments tolerated
Product
Contractualterms
Economicconditions
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COMPARABLE UNCONTROLLED PRICE METHOD (‘CUP’)
Internal CUP
External CUP
Manufacturer A
Related party - B
Unrelated party
Non-related party BNon-related party A
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COMPARABLE UNCONTROLLED PRICE METHOD (‘CUP’)
RESALE PRICE METHOD (‘RPM’)
Measures the value of functions performed
Ordinarily used in cases involving the purchase and resale of tangible property
Reseller has not added substantial value
Reseller does not apply intangible assets to add substantial value
More reliable if internal comparables are present8
RESALE PRICE METHOD – HOW TO ARRIVE AT ALP?
Steps1
Determine the gross profit marginearned in comparable uncontrolled transactions
2Subtract the appropriate grossmargin and expenses from the applicable resale price
3The remainder will be thearm’s length price with thecontrolled entity 9
COST PLUS METHOD (‘CPM’)
Similarity of products/services transferred – not a prerequisite
Similarity of functions is a prerequisite for applying CPM
Gross margins are more sensitive to difference in functions and risks
Most useful method where, interalia, related parties undertake transaction in respect of:− Sale of semi-finished goods− Long term buy and supply arrangements− Provisions of services on contract basis
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Steps1 Compute the direct and indirect cost
incurred in controlled transaction
2Determine the normal gross profit margin earned in similar uncontrolled transaction
3 Apply the margin in step 2 on amount arrived at in step 1 after making the necessary adjustments, if any to arrive at the ALP
COST PLUS METHOD – HOW TO ARRIVE AT ALP
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• The TNMM is similar to RPM & CPM as it involves comparison of margins from transactions - controlled transactions vis-à-vis uncontrolled transactions
• It differs to the extent that it involves comparison of net margins as against gross margins as in case of RPM & CPM
• TNMM can be applied as internal TNMM as well as external TNMM
• TNMM aims to determine arm’s length price by comparing financial results of tested party and selected uncontrolled parties with the application of suitable Profit Level Indicators (PLIs) using multiple year data
TRANSACTIONAL NET MARGIN METHOD (‘TNMM’)
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• Choice of the tested party
• Years of Comparison
• Aggregation of Transaction
• Identification of comparables
• Applying suitable PLIs
• Adjustment Calculations, if any
• Assessment of profit comparison
Transactional Net Margin Method – Application
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• The PSM is typically applied in complex situations when other available methods (such as the CUP or the TNMM) are not sufficient to price the functions performed.
• Profit split methods are usually appropriate when:− Transactions are very interrelated it might be that they cannot be evaluated
on a separate basis− Valuable, non-routine intangibles exist in transactions and profit arising to
the group cannot be assigned to one of the entities of the group − Significant differences between controlled and uncontrolled transactions are
attributable to economies of horizontal/vertical integration− Adequate comparables are unavailable to set margins for all the entities
PROFIT SPLIT METHOD (‘PSM)
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Entity A Entity BProfits split by A and B (unrelated
parties) based on their relative contribution forms the basis for splitting profits in the controlled
transaction
Aggregate profits in the controlled transactionbased on contribution made by both parties
Profit share for Related Party X
Profit share for Related Party Y
Aggregate profits split based on
market’s valuation of each party’s
contribution
• Forms of the PSM:a. Comparable Profit Split Method (or the “Contribution” method)
Profit Split Method – Application
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Aggregate profits in the controlled transactionbased on contribution made by both parties
Residual Profit
Residual Profit Share for
Related Party X
Residual Profit Share for
Related Party Y
Residual profits split based on each party’s
ownership of non-routine intangibles
Minus functional returns to each party based on market benchmarks
• Forms of the PSM:b. Residual Profit Split Method (‘RPSM’)
Profit Split Method – Application
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OTHER METHOD
The introduction of the Other Method as the sixth method (insertion of rule 10AB vide notification no. 18/2012 by CBDT, DATED 23-5-2012) allows the use of ‘any method’ which takes into account:
(i) the price which has been charged or paid; or (ii) would have been charged or paid for the same or similar uncontrolled
transactions, with or between non-associated enterprises, under similar circumstances, considering all the relevant facts.
The various data which may possibly be used for comparability purposescould be:
(a) Third party quotations;(b) Valuation reports;(c) Tender/Bid documents;(d) Documents relating to the negotiations;(e) Standard rate cards;(f) Commercial & economic business models; etc.
Establishing Most Appropriate Method (Rule 10C)
CUP RPM CPM TNMM PSM
Distribution a a a
Manufacturing a a a
Servicesa
(Total cost plus)
Joint R&D a
Class of Transactions a a
MethodsFunctions
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Method Product Comparability
Functional Comparability Approach Remarks
CUP Very High Medium Prices are benchmarked
Very difficult to apply as very high degree of
comparability required
RPM High HighGPM (on sales) are
benchmarked
Difficult to apply as high degree of comparability
required
CPM High High
GPM (on cost) are
benchmarked
Difficult to apply as high degree of comparability
required
PSM Medium Very High Profit Margins Complex Method, sparingly used
TNMM Medium Very High Net Profit Margins
Most commonly used Method
Transfer Pricing Method – A comparative statement!
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2 Introduction to Specified Domestic Transactions
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OBSERVATION BY HON’BLE SUPREME COURT
Hon’ble Supreme Court of India in the matter of CIT vs. Glaxo Smithkline Asia (P) Ltd. [2010] 195 Taxman 35 (SC) observed as follows:
• Domestic related parties transactions are generally revenue neutral in nature except in the following cases:
If one of the related parties is loss making and the other is profit making and such profit earned is shifted to the loss making concern; or
If there are different rates for two related units (on account of different status, area based incentives, nature of activity, etc.) and if profits are channeled towards the unit with lower tax rates.
• AO is constrained by non-maintenance of necessary documents and no specific requirement of audit / scrutiny of domestic related party transactions
• CBDT should consider amending certain provisions [such as S. 40A(2) and S. 80-IA(10)] of the Income-tax Act, so that domestic related party transactions could be brought into the ambit of TP regulations
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SDT PROVISIONS ENACTED BY FINANCE ACT, 2012
• The Finance Act 2012, extended the scope of Transfer Pricing provision to ‘Specified Domestic Transactions’ (“SDT”)
• Broadly SDT includes the following: Expenditure for which payment is made or to be made to domestic
related parties-40A(2)(b) payment Tax Holiday/ Deductions claimed by the taxpayer u/s 80A(6)/80IA(8) or
80IA(10), where;• Transfer of goods or services between various businesses of same taxpayer• More than ordinary profits derived from transactions with closely connected
persons• No impact on the basic provisions of the above sections
Valu
e o
f S
DT Value more than 5 crs –
Arm’s Length Price
Value equal to / less than 5 crs –
Fair Market Value
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SDT - INTERNATIONALLY ACCEPTED PRINCIPLE
• In many countries including UK and US transfer pricing regulations are applicable to both domestic as well as cross-border transactions
• As per OECD’s Survey Report on Transfer Pricing Simplification Measures, in about 60% of the respondent countries, transactions among domestic related parties are subject to the arm’s length principle
• Countries: Austria, China, Czech Republic, Denmark, Estonia, Finland, France, Germany, Hungary, Indonesia, Ireland, Israel, Luxembourg, Malaysia, Mexico, Netherlands, Norway, Poland, Portugal, Russia, Slovenia, Spain, Turkey, the United Kingdom and the United States
Source: Multi-Country Analysis Of Existing Transfer Pricing Simplification Measures – 6 June 2012
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3 SDT – An Overview
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SDT [S. 92BA] – WHAT IT INCLUDES?Clauses Explanation
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
• Payment made or to be made for expenditure incurred with domestic related parties
• Expenditure/ payments only covered
any transaction referred to in section 80A • Any transfer of goods / services between various undertakings or units of the assesseeany 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
• More than ordinary profits derived from closely connected persons for claiming deduction to be brought down to reasonable profits
any transaction, referred to in any other section under Chapter VI-A or section 10AA (Taxpayers operating in Special Economic Zones), to which provisions of sub-section (8) or sub-section (10) of section 80-IA are applicable
Covers both the above provisions on:• Inter-undertaking transfer and • more than ordinary profits earned by tax
holiday / exempt unit
any other transaction as may be prescribed • to be prescribed by CBDT
Excludes transactions which qualify as International Transactions
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EXPENDITURE U/S 40A(2)(B)
“Substantial Interest” or “S.I.” - Beneficial ownership of equity shares carrying not less than 20% voting power or beneficially entitled to not less than 20% share in profit
“Relative” defined in s. 2(41) – means husband, wife, brother or sister or lineal ascendant or descendant of that individual
S.I.
S.I.
Company (vi)
Assessee / Taxpayer Company
Company (iv)
Company (iv)
Director (iv)
Relative (iv)
S.I.Director
(ii)
Relative (ii)
Company (vi)
Company (vi)
S.I.
S.I.
Relative (iii)
All Companies in which such individual is a
Director (v)
All Directors of all such
Companies (v)
Relative (v)
Individual (iii)
S.I.
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ILLUSTRATION – EXPENDITURE U/S 40A
100% 100%
20% 20%
A & B Yes
A & C Yes
A & D ?
A & E ?
B & C Yes*
D & E ?
Transactions covered ?
* Post Budget 2012 amendment under section 40A
A
B
D
Requirement to justify that expenditure not excessive or unreasonable and meets the
arm’s length criteria
C
E
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TRANSACTIONS COVERED U/S 80A
• Section 80A applies to deductions to be made in computing total income under Chapter VI-A
• 80A(6) has been amended by Finance Act 2012 to provide that in case of SDT, the market value shall be computed at Arm’s Length Price
• The provisions apply only to inter-unit transfer of goods and services, where one unit being the eligible unit. It does not cover transactions of eligible unit with third parties
• The provisions envisage the determination of profits and gains of the eligible unit for calculation of deduction, and may not have an impact on the Gross Taxable Income of the taxpayer
No deduction under chapter VI-A, where Arm’s Length Price determined by the TPO
is different from the ‘consideration recorded in accounts’
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TRANSACTIONS COVERED U/S 80-IA(8)
• Where any goods or services of the eligible business are transferred to any other business carried on by the assessee, or vice versa, and the consideration for such transfer is not at market value, then the profits and gains of eligible business shall be computed at the ‘market value’
• New explanation - 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.
• Similar (overlap) to section 80A ‒ the provisions apply only to inter-unit transfer of goods and services, where
one unit being the eligible unitNo deduction under chapter VI-A, where Arm’s Length Price determined by the TPO
is different from the ‘consideration recorded in accounts’
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TRANSACTIONS COVERED U/S 80-IA(10)
• Where it appears to the Assessing Officer that, owing to the “close connection” between the assessee carrying on the “eligible business” and any other person, the “course of business” between them is so arranged that the business transacted between them produces to the assessee ‘more than the ordinary profits’, the Assessing Officer shall, take the amount of profits as may be reasonably deemed to have been derived therefrom.
• New insert - Provided that in case the aforesaid arrangement involves a specified domestic transaction, the amount of profits from such transaction shall be determined having regard to arm's length price.
• Section 80-IA(10) refers to the “course of business”, which may have a wider meaning than business or a transactions, and may intend including the circumstances surrounding the transactions. The ALP analyses the transaction more ‘holistically’ and best represents such situations.
Close connection not defined, will pose a challenge at the time of filing Form 3CEB
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ILLUSTRATION – TAX HOLIDAY UNDERTAKINGS
B & C Yes
Tax holiday undertaking
DTA undertaking
Transactions covered ?
A
B C
D
At-least one transacting unit has to be an eligible unit under chapter VI-A or section
10AA
Taxpayer
Close connection
C & D No
B & D Yes*
*If D is closely connected to A
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OTHER SECTIONS TO WHICH S 80-IA(8)&80-IA(10) APPLY
• The provisions include any transaction, referred to in any other section under “Chapter VI-A” or “section 10AA” (Taxpayers operating in Special Economic Zones), to which provisions of sub-section (8) or sub-section (10) of section 80-IA are applicable
• The other sections under chapter VI-A, include:− 80-IAB – Undertakings engaged in SEZ development− 80-IB – Industrial undertakings− 80-IC – Industrial undertakings or enterprises in special category states− 80-ID – Undertakings engaged in Hotels and convention centers in specified area− 80-IE – Undertakings in North-Eastern states
• Sub-section (7) of section 35AD provides that − the provisions contained in sub-section (6) of section 80A and the provisions of sub-
sections (7) and (10) of section 80-IA shall, so far as may be, apply to this section in respect of goods or services or assets held for the purposes of the specified business.
• However, section 35AD does not fall within chapter VI-A, hence the SDT provisions do not apply to section 35AD
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4 SDT – Impact Analysis
IMPACT ANALYSIS - OLD VS. NEW
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Fair Market Value Arm’s Length Price
The price which goods or services would have fetched or cost in the open market
Most appropriate method out of the six methods
No documentation required to be maintained
Contemporaneous documentation required to be
maintainedOther than reporting in tax audit report, no statutory
compliance
Accountant’s Report Form 3CEB to be filed
Assessment done by the Assessing Officer
Assessment done by the Transfer Pricing Officer
No method prescribed for computing fair market value
A price which is applied in a transaction in uncontrolled
conditions
No specific penalty provision for reporting/maintaining
documents
Penalty for non-reporting/ not maintaining prescribed
documents
TAX BURDEN, IF SDT IS NOT AT ALP
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X Ltd.(non-tax holiday)
Y Ltd.(non-tax holiday)
Purchase at ` 120 v/s ALP i.e.
` 100
X Ltd.(tax
holiday)
Y Ltd.(non-tax holiday)
Sale at ` 120 v/s ALP i.e. `
100
X Ltd.(tax
holiday)
Y Ltd.(non-tax holiday)
Sale at ` 80 v/s ALP i.e. ` 100
Disallowance of ` 20 to Y Ltd
[40A(2)(b)]
Double AdjustmentTax holiday - ` 20 not
allowed to X Ltd – [80IA(10)] (more than ordinary profits)Disallowance of ` 20 to Y Ltd
-[40A(2)(b)]
Inefficient pricing structure – reduced tax
holiday benefit claimed by X Ltd., since, sale price is
lower than ALP[s. 92(3)]
TAX BURDEN, IF SDT IS NOT AT ALP …..CONTD.
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X Ltd.(tax
holiday)
Y Ltd.(non-tax holiday)
Purchase at ` 120 v/s ALP i.e.
` 100
Disallowance of ` 20 to X Ltd -
[40A(2)(b)]Increase in Gross Total
Income of X LtdWhether enhanced
deduction is allowed to X Ltd u/c VI-A:
No [Proviso to s. 92C(4)]
X Ltd.(tax
holiday)
Y Ltd.(non-tax holiday)
Purchase at ` 80 v/s ALP i.e. `
100
No effect on the Gross Total Income of X Ltd.
Whether reduced deduction is allowed to X
Ltd.Yes [s. 80-IA(10)]
TAX BURDEN, IF SDT IS NOT AT ALP ….. CONTD.
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X Ltd.’sU-1(tax
holiday)
X Ltd.’sU-2(tax
holiday)
No effect on the Gross Total Income of X Ltd.
Whether reduced deduction is allowed to
U-1: Yes [s. 80A(6) or s. 80-
IA(8)]Whether enhanced
deduction is allowed to U-2:
No [Proviso to s. 92C(4)]
Sale at ` 120 v/s ALP i.e. `
100
X Ltd.’sU-1(tax
holiday)
X Ltd.’sU-2
(non-tax holiday)
No effect on the Gross Total Income of X Ltd.
Whether reduced deduction is allowed to
U-1: Yes [s. 80A(6) or s. 80-
IA(8)]
Sale at ` 120 v/s ALP i.e. `
100
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5 SDT - Disclosure in Form 3CEB
On June 10, 2013, CBDT notified new Form 3CEB containing disclosure of SDT –
Part C to Form 3CEB
• Clause 21, inter alia, requires the taxpayer to disclose PAN number of the AE
• Clause 22 - disclosure of payment made to person referred to in S. 40A(2)(b)
• Clause 23A – disclosure of inter-unit transactions (in the nature of sale by the eligible business/ unit of the taxpayer) as referred to in S. 80A(6), 80-IA(8) or 10AA
• Clause 23B – disclosure of inter-unit transactions (in the nature of purchase by the eligible business/ unit of the taxpayer) as referred to in S. 80A(6), 80-IA(8) or 10AA
• Clause 24 – disclosure of business transacted with closely connected person (which has resulted in more than ordinary profits to an eligible business/ unit of the taxpayer) as referred to in S. 80-IA(10) or 10AA
• Clause 25 – disclosure of any other transaction not covered in the above clauses [residual clause]
ACCOUNTANT’S REPORT IN FORM 3CEB
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40
-
Open House
