Under TP regulations, income from international transactions between associated enterprises (AEs) should be computed having regard to an arm’s length price. Five methods have been prescribed to determine arm’s length price out of which the most appropriate method is selected based on the nature of transactions, availability of comparables and other factors.
A TP study essentially requires information regarding functions performed, assets utilised and risks assumed by entities, which is commonly known as FAR analysis. A cornerstone for analysis of TP is information about practices followed by the party being analysed as also of others similarly placed, which can be culled out inter alia from published accounts.
The Institute of Chartered Accountants of India has recently issued Accounting Standards (AS) 17, 18 and 21, which are applicable from April, 1 2001. With introduction of these three accounting standards, the financial statements of an enterprise would be a more useful starting point for a TP analyst.
21 on Consolidated Financial Statements
An enterprise that presents consolidated financial statements should prepare these statements in accordance with AS-21. As per Sebi’s directive, all listed companies should provide (in addition to their financial statements) consolidated financials of their subsidiaries. While consolidating, entire group is treated as a single reporting entity.
AS-21 effectively provides an insight into transactions between controlled parties. It thus provides indirect information about pricing between parent and subsidiary on account of reversal of unrealised profits/ losses; changes to follow same accounting policies; and elimination of intra group transactions and balances.
17 on Segmental Reporting
AS-17 is mandatory for companies listed or companies intending to list their stocks on a recognised stock exchange in India. It is also mandatory to companies whose annual turnover exceeds Rs 50 crores. In case of consolidated financial statements, AS-17 applies to the consolidated statement as opposed to individual statements.
Under segment reporting, the company has to recast its financial statements into both business segments and geographical segments, until atleast 75 per cent of total revenue is included in reportable segments. In business segment reporting, different types of products/services are bifurcated into segments having similar risks and returns. In geographical segment reporting, segments are identified based on geographical areas having similar economic and political conditions.
Nature of risks and returns of each product/service or geographical location would determine whether the primary reporting format should be business segments or geographical segments. In other words, companies are required to carry out an analysis of risk and profitability element for each product/service or geographical location. This information can be handy to the TP analyst for evaluating FAR analysis.
Segmental reporting will be very helpful for the TP analyst to arrive at data of comparables, which is the focal point in any transfer pricing study. Availability of segmental financial results serves as an invaluable tool to compare profitability for each product/service or geographical location.
18 on Related Party Transactions
AS-18 is mandatory with an objective to define related parties and establish disclosure requirements of related party transactions. Basic presumption under AS-18 and IT Act appears to be in harmony with each other ie transactions with related party/ AE are not necessarily on an arm’s length basis and there may be extra commercial considerations involved in such transactions. Further, the definition of related party and AE strikes some common chords in laying down criteria for shareholding limits, common directorship, common control and influence in decision making. Accordingly, it may appear that AS-18 can be relied for identifying AEs as defined under IT Act.
However, one needs to bear in mind the differences in the definition of related party under AS-18 and AEs under IT Act. As per AS-18, single customer/ supplier with whom an enterprise transacts a significant volume of business would not be related party merely by virtue of resulting economic dependence. This is in contrast to IT Act, wherein specific deeming provisions have been made to bring them within the ambit of TP regulations.
As per AS-18, a person having 20 per cent of the voting power and power to direct the financial and operating policies of the enterprise would be considered as a related party. As against this, a person is deemed to be AE under the IT Act only if he has a minimum of 26 per cent of voting power. Thus, the TP analyst should be aware that in certain cases definition of related party under AS-18 is narrower than that of AE under the IT Act, while in other cases it is wider.
AS-18 requires disclosure of ’any other elements of related party transactions necessary for an understanding of the financial statements’. For eg transfer of a major asset at an amount materially different from that obtainable on normal commercial terms. However, issue is that AS-18 does not stipulate methodology to arrive at a price obtainable on ’normal commercial terms’. Thus, arm’s length price determined under IT Act could be used as a benchmark for price obtainable on ’normal commercial terms’.
Currently, we have different sets of definitions for related parties ie under AS-18, Customs Act, section 40A(2) and section 92A of IT Act. Related party transactions are evaluated by different persons at different points of time.
At the time of transacting, a company is expected to conduct TP analysis to arrive at arm’s length price and maintain contemporaneous documentation under IT Act. Customs authorities examine related party transaction at the time of import. Thereafter, the company has to abide by disclosure requirements under AS-18. Lastly, IT authorities would examine all international transactions with AEs.
Ideally, there should be a common definition for ’related party’, which could be utilised by IT authorities, customs authorities and for the purpose of AS-18 as well. With budget 2002 round the corner, lawmakers could realign the definition of ’related party’ thereby making requirements for related party transactions much simpler.