However, an economy as large and diversified as India would inevitably find itself embroiled in transfer pricing issues. And this is what is happening with the Indian tax authorities who are now seriously considering transfer pricing issues, the existing legislative and regulatory framework for addressing the issues and the manner in which the administration should deal the same.

This article examines briefly the existing legislative and regulatory framework that could reasonably be said to deal with transfer pricing issues and at the same time comments on the review processes now taking place.

Existing legislation
The Income Tax Act taxes only "real income" and allows deductions for expenditure incurred in the business. This general approach is subject to the following exceptions, in as much as the general approach would operate in cases of cross-border transactions.

Section 92: Transactions with non-residents A "close connection" between a resident and non-resident can lead to an adjustment to the income of the resident but not of the non-resident (eg an Indian branch of a foreign company). "Close connection" is not defined in the Act. A "rule of thumb" type of approach would be followed for making any adjustment - for example, a percentage of turnover/profits, or any other manner considered appropriate.

Transactions involving intangibles, financing, and services are not covered by this section. Also, there is no provision for compensating/ consequential adjustments. Disclosure and documentation requirements have also not been prescribed. In practice, however, this provision is rarely applied.

Section 40A(2): Fair value Expenditure that is considered to be excessive can be disallowed having regard to the "fair value" of the transaction. This provision can only be invoked in the case of a direct equity holding of at least 20 per cent, and not in cases of direct or indirect control/management or where there is an undercharging of income. The determination of "fair value" is arguable and attempts to invoke this section have been only partly successful.

Absence of thin capitalisation rules Interest on borrowings for business purposes is deductible. Although the rate and amount of interest require approval under exchange controls, the issue of reasonableness is not scrutinised.

Parallel concept The concept of dealing at arm's length is contained in several areas of the Act.

Section 9(1)(i): Attribution of income Income accruing from any business connection in India is taxable, to the extent it is reasonably attributable to the operations carried out in India. Determination of income follows the "rule of thumb" referred to earlier.

Sections 10A/10B/80 IA: Truncation of tax holiday Exempt profits can be reduced in the case where a higher claim has been arrived at due to the "close connection" between two entities. No specific guidelines exist in this regard.

Treaty v domestic law
India has a wide network of tax treaties with its major trading partners. The treaties contain specific articles which deal with controlled transactions, those articles being similar to Article 9(1) of the OECD model treaty. They also provide for consequential adjustment by the competent authority (CA) under mutual agreement procedure (MAP) articles. Internal guidelines and the administrative framework for operation of MAPs are currently being addressed by the Indian tax authorities.

PenaltiesWhile there is currently no specific penalty for a transfer pricing adjustment, it should be noted that penalties of up to 300 percent of the tax sought to be evaded may be applied in the case of concealment of income. Also, interest @ 18 per cent per annum is leviable for shortfalls in payment of tax in advance.

Application in other laws Excise Law The assessable value is the invoice price. If goods are sold to related persons, the assessable value will be the price at which the goods are subsequently sold to unrelated buyers. Related persons are exhaustively defined to include interconnected undertakings through direct and indirect control.

Customs Law
GATT valuation principles are followed for determining the assessable value. The price at which the goods are ordinarily sold between unrelated parties is accepted. Otherwise, the value of similar or identical goods will be assessable value. Companies Act Contracts in which directors have an interest require approval by the board of directors and a commentary by the company's auditors. Recent promulgation of accounting standards on "Related Party Disclosures" and "Segmental Reporting" will require disclosure of related party relationships and transactions. Also, financials would be required to be reported for each business and geographical segment. These disclosures will assist in the analysis of a company's financials for transfer pricing purposes.

Exchange Control Regulations
Remittances for goods and services are regulated and only a specified percentage of royalty is repatriable. Such artificial controls cannot determine the reasonableness of the consideration involved.

GlobalisationThe lowering of tariffs in the post-reforms era has removed the incentive to under-invoice imports. At the same time it has increased the incentive to over-invoice imports into India. Therefore, the Indian government suffers on account of lower indirect taxes and also potentially lower direct tax revenues through reduced profits from higher import prices, particularly in dealings between related parties.

Guidelines on the anvilUnder the above scenario, India realises the need to "play the game" of sharing the global tax pie and to have a comprehensive transfer pricing regime to enable it to participate effectively in the "tax competition". The dichotomy between India's desire to attract foreign investment and the operation of stringent anti-profit shifting measures may be raised in some quarters, however this is not likely to deter the Indian authorities from proceeding with the introduction of a transfer pricing regime.

The Indian tax authorities have convened an expert group to deal with the issue of transfer pricing. Recommendations of this group are expected to be incorporated in the ensuing Finance Bill in February 2001.

India's transfer pricing regime, which will be administered by the Directorate of Foreign Taxation, is likely to adopt the OECD's arm's length principle approach, as opposed to the use of minimum profitability standards applied by Brazil. The arm's length principle will necessitate the application of comparability standards, using recognised arm's length pricing methodologies.

In practice, it will be difficult for taxpayers to find benchmarks in the form of similar transactions between independent parties, and profit-based methodologies will be difficult to apply in industries where either all or some of the input or output is subject to price controls. It can be expected that the transfer pricing regime will contain elaborate disclosure and documentation obligations with consequential penalties for non-compliance. "Related persons" will likely include persons under direct or indirect control. Advance pricing agreements and the adoption of safe harbours are also likely to be considered within the regime.

Going forward
A transfer pricing regime in India is inevitable. Its introduction presents unique challenges and opportunities, even for companies that are enjoying the benefits of tax holidays in India. It is imperative for taxpayers to be proactive in managing the operations at an arm's length pricing standard, particularly for those who seek the benefits of tax incentives offered by India to attract foreign investment.