Advance pricing system must in TP norms

Mukesh Butani

The recently introduced Indian transfer pricing provisions have broadly been modeled based on internationally accepted principles, though they do differ on certain key counts. A broad comparison follows:

Arms length price v. range
In determining arms length basis for a transaction, while in some instances it will be possible to arrive at a single arms length price or margin, there will also be many instances where a range of figures could be considered ’relatively equally reliable’.

Differences in prices or margins within the range can be explained by the fact that arms length principle only produces an ’approximation’ of conditions that would exist between independent enterprises and that even on an arms length basis, prices in comparable transactions might differ. OECD (Organisation for Economic Co-operation & Development) guidelines as well as US transfer pricing provisions therefore suggest that no adjustment should be made where a taxpayer’s price or margin is within arms length range of comparables prices or margins.

On the other hand, Indian legislation requires computation of income from a controlled international transaction, having regard to ’arms length price’ and where more than one comparable price exists, their arithmetical mean would be considered the arms length price.

The taxpayer in India would therefore be required to compute and pay taxes with reference to the arms length price so determined (even though its transaction price may be within the inter-quartile range of prices). By requiring a taxpayer to necessarily declare the mean of a range of prices as its taxable price, the Indian legislation clearly fails to recognise the factors that OECD and US IRS (Internal Revenue Service) considered in recommending the range concept. The recent circular issued by Central Board of Direct Taxes, prescribing a tolerance zone of 5 per cent, does not strictly adhere to OECD principles in their entirety.

Transfer Pricing methods
Indian transfer pricing provisions prescribe broadly the same methods for computing arms length price, as contained in the OECD and US provisions. OECD however does prescribe a hierarchy of methods giving preference to the traditional methods.

The Indian rules do not prescribe such a hierarchy and instead require the ’most appropriate’ method to be considered (akin to US’s best method rule). US provisions go further to allow a taxpayer flexibility in choosing a method other than that prescribed, though this freedom is currently not provided to an Indian taxpayer.

Considerations for intra-group services
Both OECD guidelines and US transfer pricing provisions contain guidance on factors to consider, in arms length pricing for intra-group services. Specifically discussed are two main factors:

* When are services said to be rendered. US provisions specifically define situations where services are ’beneficial’ as opposed to ’duplicative’ and hence, deserve to be charged for.
* When should a mark up be earned on services. US provisions also define circumstances where services are said to be ’integral’ in nature and hence should be charged with a mark up.

The Indian legislation is currently silent on these aspects and there is a need for clarity, as there would be a number of instances where certain services (such as shareholder services) should not be charged for or certain other instances involving reimbursement of salary of deputed personnel, which should not necessarily be charged with a mark up.

Cost contribution arrangements
Indian legislation requires that costs or expenses incurred or to be incurred in cost allocation, apportionment or contribution arrangements, shall be determined having regard to the arms length price of the expected or received benefit, service or facility. However, the terms have not been defined or distinguished from one another.

OECD guidelines define and devote an entire chapter to Cost Contribution Agreements (“CCA”s), providing guidance on features of CCAs, including a description of types of arrangement, methods of determining participants’ contributions, illustrations of various allocation keys to allocate the benefits having regard to arms length standard, entry into or withdrawal from CCAs and documentation to demonstrate the contributions made and benefits realised. Further, US guidelines also give similar guidance on such arrangements which they term as ’cost sharing arrangements’.

Intangibles
Both the OECD guidelines as well as the US transfer pricing provisions separately explicate the special considerations for applying the arms length principle in the case of intangibles, such as the expected benefits from the intangibles, exclusive or non-exclusive rights transferred, possibility of sub-licensing, licensee’s distribution network, etc.

Guidance is also provided for circumstances where valuation is highly uncertain at the time of entering into the transaction.

US provisions also specify the methods that may be applied for intangibles as distinguished from other transactions involving tangibles or services. Indian legislation is yet to provide any such guidance, though the purchase, sale or lease of intangibles has been specifically brought within the scope of Indian transfer pricing norms.

Business strategies
The Indian transfer pricing rules state a number of factors to consider in judging comparability. A key factor that has been omitted is ’business strategies’. OECD guidelines lay stress on this as a factor to be examined in determining comparability for transfer pricing purposes. OECD recognises some special aspects of an enterprise’s strategy that may have an impact on its business such as innovation and new product development, penetration policies, degree of diversification, risk aversion, etc.

US provisions also acknowledge certain special circumstances that will affect comparability, such as market penetration or market share strategies. These factors should not be ignored in judging comparability as they are often key to establishing bona fides of a taxpayer’s transfer prices.

Advance Pricing Arrangements
The OECD guidelines provide direction on advance pricing arrangements (“APA”) which may be entered into between tax payers and tax administrators to agree in advance on the arms length pricing for controlled transactions, for a fixed period of time. Similarly, detailed provisions relating to APAs are also contained in the US Code. Given the uncertainties associated with the current Indian transfer pricing legislation, India would do well to institute an advance pricing mechanism immediately.