Revamp transfer pricing regulations

With the Budget around the corner, expectations on legal/policy issues are rife and the transfer pricing (TP) regime is no exception. Year after year, practitioners and taxpayers have expressed the need for various changes in Indian TP regulations to set the stage for an advanced and balanced TP regime.

Introduced in 2001, the comprehensive TP regulations aim at preventing multinational companies (MNCs) from cross-border shifting of profits out of India. In brief, given an MNC’s control over setting intra-group prices, the TP regulations seek to ensure that prices are not artificially set in a manner that erodes the Indian tax base.

‘Arm’s length range’

Indian TP regulations require the determination of a single arm’s length price, calculated as the arithmetic mean of comparables’ prices [variation up to (+/-) 5 per cent around the arithmetic mean is permitted].

However, the determination of a single arm’s length price poses several difficulties. In the real world, no two companies or transactions are exactly alike. Hence, even where companies are closely comparable, a range of results may be reached.

It is for this reason that the OECD Guidelines (TP Guidelines issued by the OECD that are widely referred to by member and non-member countries) and the TP regulations of many countries (including the US, the UK and Australia) apply the concept of an ‘arm’s length range’ of prices.

Indian TP regulations should be amended to incorporate the concept of ‘arm’s length range’ (that is, a range of prices set by close comparables). Alternatively, where close comparables are hard to find, to increase the reliability of the analysis, use of inter-quartile range should be permitted (similar to the US regulations).

In case a single representative price is sought to be determined, the concept of mean should be replaced with median, since the latter is a better statistical measure of determining the representative from a sample set.

Business strategies

It is a commercial reality that even independent enterprises cannot make profits on a year-on-year basis. Market strategies (such as entry strategy, market penetration, loss leadership, etc) followed by some companies may result in losses in the initial years with profits to follow subsequently. In such circumstances, it would be inappropriate to disregard business realities and expect taxpayers to earn margins similar to well-established companies.

The OECD Guidelines and TP regulations of several countries (including the US and Australia) expressly incorporate ‘business strategy’/ economic circumstances as a relevant factor for comparability analysis and also provide guidance on acceptability of such strategies.

In sharp contrast, Indian regulations do not provide any guidance on these issues and TPOs have generally disregarded business dynamics/strategies while analysing transfer prices.

With a view to honour commercial realities and to avoid undue hardship to taxpayers, it is recommended that detailed guidance be provided in the regulations on acceptability of business strategies of taxpayers, both for comparability analysis as well as maintaining TP documentation.

Risk Adjustment

The requirement for comparability adjustments (including risk adjustment) is an integral part of Indian regulations. The need for the same has also been reinforced by recent jurisprudence.

However, neither the regulations nor the rulings provide any guidance on the adjustment methodology. The lack of guidance on this issue could result in ad hoc adjustments or simply a rejection by the tax authorities of risk adjustments undertaken by taxpayers.

Accordingly, the regulations should expressly permit risk adjustment and provide explicit guidance on methodologies for quantification of risk that may be followed by taxpayers.

Accepted statistical tools and methodologies like the Capital Asset Pricing Model (CAPM) may be explored as practical solutions for undertaking the risk adjustment.

Transactions of intangibles

Cross-border transactions involving intangibles now constitute a significant portion of intra-group transactions. Current Indian TP regulations do not provide any guidance/rules on inter-company transactions involving intangibles. Since the realm of intangibles is complex, it is necessary that Indian regulations provide detailed guidance on various aspects like definition of intangibles, kinds of transactions involving intangibles, choice of method for determining the arm’s length price of intangibles, ownership of intangibles, etc.

In this regard, legislation of advanced TP jurisdictions such as the US and Australia, may be referred to as they have detailed rules on intangibles.

Almost all developed countries and several others (like China, Taiwan and Poland) have a comprehensive procedure for securing binding “Advance (transfer) Pricing Arrangement (APA)” with the tax authorities.

An APA is an agreement on transfer prices, entered into between the taxpayer and the tax administration in advance of the cross-border transaction. Thus, an APA provides certainty to taxpayers and reduces costly/ time consuming litigation.

With Indian TP regulations being nearly a decade old and in view of the significant audit adjustments faced by taxpayers in the past, the time is ripe for an APA mechanism to be introduced in India.

Apart from these measures, the Government may also strengthen the Mutual Agreement Procedure (available under tax treaties) for resolution of TP disputes. This may be achieved by increasing the strength of personnel and stressing on timely completion of cases. The implementation of above measures would go a long way in providing certainty and avoiding hardship to taxpayers.

Article by Tarun Arora and Ashutosh Mohan Rastogi ,  The authors are Executive Director and Assistant Manager, Transfer Pricing Practice, PricewaterhouseCoopers