Transfer Pricing in India

Transfer Pricing Rules in India

The transfer pricing rules in India apply to both domestic and international transactions that fall above a threshold in terms of deal value.

Contributing Advisor

Rohit Kapur

Managing Director,

According to the transfer pricing rules in India, income arising from international transactions or specified domestic transactions between Associated Enterprises (AE) should be computed using the arm’s-length price principle.

India’s transfer pricing rules provide a detailed statutory framework for the computation of reasonable, fair, and equitable profits.

Relationships falling under the AE category include direct/indirect participation in the management, control, or capital of an enterprise by another enterprise. They also cover situations in which the same person participates in the management, control, or capital of both enterprises.

They also cover situations in which the same person participates in the management, control, or capital of both enterprises.

For tax purposes, companies are required to record the exchange of goods using the arm’s-length principle, which states that the prices charged by affiliated companies should be equivalent to the prices that would have been charged by an unrelated third party.

Transfer pricing provisions under India’s Income Tax Act

• Two or more enterprises are associated enterprises if:

• One of them participates in the management, control, or capital of another; or
• There is common management, control, or capital exercised by some persons.

• An international transaction is a transaction between two or more associated enterprises (AEs), and either or both of them are non-residents.
• Arm-length price refers to a price that is applied to transactions between persons other than AEs in uncontrolled conditions.
• Five methods prescribed for the computation of arm’s-length price are as follows:

• Specified domestic transactions (SDT): Transfer pricing regulations are applicable to domestic transactions that fall under domestic pricing only if the aggregate value is more than the threshold limit of INR 200 million (US$2.7 million). Transactions with related domestic parties that qualify as SDT include: 
  • Two or more enterprises are associated enterprises if:

⇒ One of them participates in the management, control, or capital of another; or

⇒ There is common management, control, or capital exercised by some persons.

• Transactions relating to the transfer of goods or services, such as profit-linked deductions for enterprises engaged in infrastructure development or industrial undertakings, producers and distributors of power, or telecommunication service providers.
• Transactions between the entity located in a tax holiday area and the one which is situated in a non-tax holiday area in case both are under the same management structure.

Introduction of a master file and country-by-country reporting (CbCR)

The efforts by OECD’s BEPS project have led to the formulation of proposals to implement the “minimum standards,” including Country-by-Country Reporting (CbCR). Globally, CbCR applies to MNCs with a combined revenue of US$837 million at a maximum. Under the CbCR requirement, large MNCs have to provide local tax authorities visibility to revenue, income, tax paid and accrued, employment, capital, retained earnings, tangible assets and activities.  

Transfer pricing compliance

All income acquired by a company or associated enterprise by means of any international transaction is calculated at the arm’s-length price.

The respective methods to calculate the arm’s-length price are applied depending on the nature and type of the transaction, the nature of the group or the association involved, or any other features of the transactions involved. If there are two or more appropriate prices assumed for a certain transaction, the arm’s-length price will be calculated as the average of the prices.

The group or person who does not adhere to these rules is liable to pay the penalties as imposed by the CBDT.

Maintaining TP documentation

Taxpayers are required to maintain information related to international transactions undertaken with AEs. The rules prescribe detailed information and documentation that must be maintained by the taxpayer.

Such requirements can broadly be divided into two parts:

• Information on the ownership structure of the taxpayer, a group profile, and a business overview of the taxpayer and AEs, including prescribed details such as the nature, terms, quantity, and value of international transactions. The rules also require the taxpayer to document a comprehensive transfer pricing study.
• Adequate documentation must be maintained to substantiate the information, analysis, and studies documented under the first part of the rule. It also contains a recommended list of such supporting documents, including:
  • Government publications;
  • Reports, studies, technical publications, and market research studies undertaken by reputable institutions;
  • Price publications;
  • Relevant agreements,
  • Contracts, and 
  • Correspondence.

Taxpayers having aggregate international transactions below the prescribed threshold of INR 10 million and specified domestic transactions below the threshold of INR 200 million are relieved from maintaining the prescribed documentation.

It is essential that the documentation maintained should be adequate to substantiate the arm’s-length price of the international transactions or specified domestic transactions.

Companies to which transfer pricing regulations are currently applicable are required to file their tax returns on or before November 30, following the close of the relevant tax year.

The prescribed documents must be maintained for a period of eight years from the end of the relevant tax year and must be updated annually on an ongoing basis. 

The categories of documentation required are:

• Documentation regarding the ownership hierarchy and structure of the group.

• Overview of the business activities and operations of the multinational group.

• Details of international transactions, including their nature, terms, and pricing.

• Explanation of the roles, assets, and risks involved in the transactions.

• Documentation of any financial projections or estimates used in relation to the transactions.

• Information on comparable transactions between the group and independent third parties.

• Assessment comparing the international transaction with similar uncontrolled transactions.

• Explanation of the various transfer pricing methods considered.

• Justification for dismissing alternative transfer pricing methods.

• Information on any adjustments made to align with the arm's-length principle.

• Any additional data or documents related to the associated enterprise relevant to determining the arm’s-length price.
• Certificate from a licensed Chartered Accountant (3CEB) confirming the maintenance of required documentation.

It is also imperative to obtain an independent accountant’s report with respect to all international transactions between AEs, and the same must be submitted by the due date of the tax return filing, on or before November 30.

Industry-Specific Transfer Pricing Issues

Transfer pricing poses unique challenges and opportunities across different industries. In India, industries such as IT services, manufacturing, and pharmaceuticals encounter distinct transfer pricing issues that require tailored strategies for compliance and optimization.

IT Services

The IT services industry in India is characterized by significant cross-border transactions, especially with parent companies and subsidiaries in the United States and Europe. The primary transfer pricing challenge here is the valuation of software development and IT-enabled services. Key issues include, accurately valuing intangibles like software and proprietary algorithms, ensuring that service agreements between related entities are at arm's length, and properly allocating costs between different geographical locations and ensuring these allocations reflect the actual economic activity.

Manufacturing

The manufacturing sector in India faces transfer pricing issues related to the pricing of goods, raw materials, and intercompany services. This industry often deals with complex supply chains that span multiple countries. Key issues include, pricing transactions for raw materials and finished goods between related entities, conducting value chain analysis to allocate profits, and ensuring that the transfer of tangible goods complies with the arm's length principle.

Pharmaceuticals

The pharmaceutical industry is heavily regulated and involves significant R&D activities, making transfer pricing particularly complex. Key issues include, the valuation of intellectual property, the allocation of profits from drug sales, and allocating R&D costs among entities in different jurisdictions.

Impact of digital economy on transfer pricing

The rise of the digital economy has fundamentally altered traditional business models, bringing new challenges to the realm of transfer pricing. The proliferation of digital business models and intangible assets, such as software, patents, and trademarks, complicates the application of conventional transfer pricing methods.

Digital business models, characterized by high reliance on intangible assets and the ability to operate across borders with minimal physical presence, pose unique transfer pricing issues. These models often involve complex value chains where intangible assets play a pivotal role in value creation.

The OECD has acknowledged these issues and provided guidance through its Base Erosion and Profit Shifting (BEPS) project. The BEPS Action 1 report specifically addresses the tax challenges of the digital economy. Key recommendations include adopting new nexus rules based on significant economic presence and ensuring that profits are taxed where economic activities and value creation occur.

The OECD also emphasizes the importance of transparency and information sharing among tax authorities to combat base erosion and profit shifting.

India’s response to digital economy challenges

India has implemented several measures to ensure that digital businesses contribute their fair share of taxes.

Introduced in 2016, the Equalization Levy initially targeted online advertisement services and was later expanded to cover a broader range of digital services. This levy is designed to tax digital transactions involving foreign companies that derive significant income from Indian users but lack a physical presence in India.

The 2 percent equalization levy (EL) on non-resident digital companies was abolished in India as of August 1, 2024, as part of the Union Budget 2024. This change was made in recognition of the progress being made on the OECD Pillar 1 negotiations on how to tax foreign earnings from digital service providers.

In 2018, India introduced the concept of Significant Economic Presence as part of its domestic tax law. This concept expands the scope of taxable presence to include digital businesses that engage significantly with Indian users.

SEP criteria are based on factors such as revenue generated from Indian users and the number of users, aiming to capture value created through digital interactions.

Dispute resolution mechanisms

Transfer pricing disputes can arise due to the complex nature of cross-border transactions and differing interpretations of transfer pricing regulations. To address these challenges, India offers several dispute resolution mechanisms, including Advance Pricing Agreements (APAs), Mutual Agreement Procedures (MAP), and Safe Harbour Rules. This section provides a detailed explanation of these mechanisms and their effectiveness, supported by relevant case studies.

Advance Pricing Agreements (APAs)

An APA is a pre-emptive agreement between a taxpayer and the tax authority determining the transfer pricing methodology for transactions over a specified period. APAs aim to provide certainty and reduce disputes.

Types of APAs:

• Unilateral APA: Agreement between the taxpayer and the tax authority of one country.
• Bilateral APA: Agreement involving the tax authorities of two countries.
• Multilateral APA: Agreement involving the tax authorities of more than two countries.

Process:

• An informal meeting to discuss the potential APA application.
• Submission of a detailed application, including transaction descriptions, proposed transfer pricing methods, and supporting documentation.
• Discussion between the taxpayer and tax authorities to finalize the terms of the APA.

Mutual Agreement Procedure (MAP)

MAP is a dispute resolution mechanism under tax treaties, allowing competent authorities of the involved countries to resolve issues related to double taxation and transfer pricing adjustments.

• The taxpayer initiates the MAP by submitting a request to the competent authority in their home country.
• Competent authorities from the involved countries negotiate to resolve the dispute, aiming to eliminate double taxation and ensure a consistent transfer pricing approach.
• The agreed resolution is implemented, typically through corresponding adjustments in the tax assessments of the involved countries.

Safe harbour rules

The safe harbor provisions provide relief from compliance and litigation, as well as simplify the administrative process. They prescribe the eligibility criteria for taxpayers, eligible international transactions, the target operating margin, procedural aspects, timeline for audit, etc.

Safe harbor rules refer to those legal provisions that reduce or eliminate the liability of the taxpayers given certain conditions are fulfilled, as they provide for circumstances in which a certain category of taxpayers can follow a prescribed set of rules under which transfer prices are automatically accepted by the income tax authorities.

• Specific categories of international transactions are covered under Safe Harbour Rules, such as software development services, IT-enabled services, and contract R&D services.
• The Safe Harbour Rules specify the acceptable profit margins for eligible transactions. If the taxpayer’s margins fall within these predefined limits, the transactions are accepted without detailed scrutiny.
• An Indian company providing IT-enabled services to its foreign parent company opted for Safe Harbour Rules. By ensuring its operating margins were within the specified range, the company avoided detailed transfer pricing audits and minimized compliance costs.