(2)[1]

Investigation Manual

Techniques of Investigation for Assessment, Volume - 3

Chapter

Heading

1 Multinational Corporations

2 Information Technology

3 E-commerce

4 Chain stores & retail franchising 5 Newspaper and journals

6 Printing & publishing

7 Motion picture industry

8 TV channels

9 Cable TV operators

10 Entertainment industry

11 Advertisement

Expert group constituted by CBDT

Acknowledgments

©Directortate of Income Tax ( Systems )

Investigation Manual

Volume - 3

Chapter - I

MULTINATIONAL CORPORATIONS

1. During the last decade of the twentieth century, especially after the liberalisation of economy, there has

been substantial growth in the business operations of multinational companies in India. Upto the end of eighties the operations of multinationals in India were limited to supply of plant and machinery, technical know how and operations through FERA companies in which multinationals held majority stakes or

through joint ventures with Indian partners. However, recent years have witnessed the trend towards shift of full scale manufacturing, distribution and assembly functions to India through fully owned subsidiaries of multinationals.

Cross border activities

2.1 International - Import and export of goods and merchandise is the most traditional international

activity of a corporation. Goods are produced in the domestic market and then exported to foreign buyers. Apart from goods some transfer of know-how may also be done to earn profits from foreign markets where direct operations may not possible due to local regulations.

2.2 Multinational - As international business expands, there is a tendency for a corporation to reach

closer to the consumer, and the cheaper sources of inputs. It needs to produce abroad as well as sell abroad in order to profit from cheaper inputs and cheap labour in some cases. When the domestic corporation expands its operations across borders, incorporating its business activities in other countries, it is classified as a multinational. While still maintaining a domestic identity and a central office in a particular country, the multinational corporation now aims to maximise profits on a world-wide basis. The corporation is so large and extended that it may be outside the control of a single government. Besides subsidiaries, a multinational corporation may have joint ventures with individual companies, either in its home country or foreign countries.

2.3 Transnational - As the multinational corporation expands its branches, affiliates, subsidiaries, and

network of suppliers, customers, distributors, marketers, and all others that fall under the firm's umbrella of activities, the once traditional "home country" becomes less and less well defined. Such corporations are termed as 'transnational corporations‟. Examples of such corporations are Unilever, Philips, Ford, Sony, Schlumberger, Royal Dutch Shell and Asea Brown Boveri which are intricate networks with home offices defined differently for products, processes, capitalisation and even taxation.

Tax avoidance

3.1 The primary purpose of multinationals like any other business organisation is maximisation of profit.

As such they often resort to avoidance or evasion of tax through various devices. They also, like resident companies, exploit various loopholes in law and resort to methods which may be similar to those resorted by domestic companies. However, some of these methods are peculiar to scale of operations carried out by the multinational companies. The stage of operations in the host country and the rate of tax in the home and the host country also play a role in the tax planning of multinationals. While it is difficult to give a comprehensive list of devises resorted to by multinationals, some of the commonly adopted methods are discussed below.

3.2 Multinationals carrying business without a permanent establishment : Under tax laws of many

countries business profits of non-resident companies are not taxable in the absence of a business connection or a permanent establishment. To take advantage of this provision multinational corporations, especially those which are only exporting goods or know how etc., tend to do so without maintaining a permanent establishment. However, after a stage they can not avoid appointing a local agent or opening a local branch. In such cases it is not possible to tax their profits unless the agent is a dependent agent or there is permanent establishment whose activities are not restricted to auxiliary and preliminary activities. Multinationals, often exploit these provisions and carry out business operations but claim that there is no dependent agent or a permanent establishment in India. They may also claim that there is no „business connection‟ and hence the incomes which fall under the category of "business profits" are not taxable in India. In some cases all activities ranging from advertisement, negotiation of contract and conclusion of contract, except the actual signing of contract and payment are done by the branch in India and still it is claimed that the activities of the branch are limited to preliminary or auxiliary activities. In such cases the facts and circumstances need to be carefully examined by making suitable enquiries to see if the agent is rendering such services on a regular basis and can be held to be a dependent agent. In the case of a branch, the role played by the branch in negotiation and conclusion of contract also needs to be examined. The multinational companies, sometimes enter into contract to provide plant and machinery along with erection and commissioning services. A composite contract is made for the whole deal. However, at the time of remittance of payment it is claimed that as no permanent establishment was maintained in India the business profits are not taxable in India. In such cases the Assessing Officer

should examine the contract carefully and "unbundle" the component which would fall under 'fees for technical services' or 'royalty'. It is only the profit from sale of plant and machinery which would fall under the head business profit. The payments for erection and commissioning services would fall under the head fees for technical services on which tax would need to be deducted at source under Section 115 of the Act or at the rate prescribed in the relevant DTA Agreement.

3.3 Multinationals carrying operation through a branch - Multinationals often use the vehicle of a

branch in the initial phases of their manufacturing operations in a foreign country. This is especially so in cases in which losses are expected to arise in the initial years of operations as such losses can be set off against the income of the parent company in the host country. In such cases the Assessing Officer should examine if any inflation of expenses, especially head office expenses has been resorted to.

3.4 Operations through a locally incorporated publicly held or wholly owned subsidiary - Once the

business of multinational in the host country expands beyond a certain level the usual practice is to float a company with majority share holding or a fully owned subsidiary. Transfer pricing (which is dealt with separately) is a device which is used most often by such companies to reduce their tax liability by shifting taxable profits to associate concerns in low tax jurisdictions.

Other devices

4.1 Other methods utilised by multinationals and their expatriate employees are as under :

4.2 Failure to file return - Deliberate failure of resident aliens to file tax return in the country in which

they are residing is quite common, because it is easy for persons who spend a portion of each year in a different jurisdiction to frequently make inconsistent claims of residence.

4.3 Failure to report all income subject to tax - Another important practice in this category is the willful

or negligent failure to report all items of international income which are subject to tax. The items more often omitted are salaries, wages, and noncommercial incomes, like interest and dividends, income form real estate and royalties.

4.4 Fictitious deductions - In a variety of circumstances fictitious business expenses may be claimed as

deductions particularly if the purported recipient of the expense payment is outside the taxing jurisdiction and is therefore not subject to scrutiny by tax authorities of that jurisdiction. For example, if the tax payer purchases goods outside the taxing jurisdiction, false invoices may be prepared to show a purchase price greater than that actually paid by the tax payer. In many cases, commissions, royalties, technical service fees and similar expenses will be paid by a resident of the taxing jurisdiction to a related nonresident and claimed as deduction, even though the related nonresident has done nothing to earn such fees.

4.5 Suppression of business Income - Taxes on business income are frequently reduced by omitting to

keep accurate books and records within the taxing jurisdiction. Generally, a second set of books of accounts, which is accurate is maintained outside that taxing jurisdiction, but those records are normally beyond the reach of the authority of that jurisdiction. In respect of incomes to which the rule of territoriality often applies, some of the devices most frequently employed to shift profits properly allocable to the source country, include

- the establishment of artificial transfer prices for imports and exports;  the improper allocation of profits and losses; and

 licensing agreements under which the user of technology is obliged to purchase imported inputs, equipment and spare-parts.

Such devices, which transnational corporations are particularly well situated to use, are of great concern to the host country. It may also be advantageous purely for tax purposes for a company of a particular country to conduct operations with partners in another country to create a relay in the form of a company established in a third country where taxes are low.

4.6 Credit for fictitious tax - A tax payer residing in one country and receiving international income from

another country may seek to reduce tax in the first country, which allows a foreign tax credit as a method of reducing double taxation, by claiming fictitious or excessive credits for taxes allegedly paid to the other country.

4.7 Improper characterization of income or expense items - Tax is also reduced by improperly

characterizing an income or expense item in order to make use of an exemption or a reduced rate of tax.

4.8 Inconsistent characterizations - A tax payer may characterize a particular transaction in one way in

advances by a parent in country A to a subsidiary in country B may be treated as equity in country A - in order to avoid the necessity for reporting interest income to country A, but as debt in country B - in order to avoid a capital stock taxes in country B. Payments made by a subsidiary in country A to its parent in country B may be treated as the purchase price of goods in country A, but as royalties or dividends in the country B.

4.9 Flight to evade payment of tax - Where the taxing jurisdiction determines that a resident alien has

taxable income or assesses tax against him, the individual may flee the jurisdiction to escape tax.

4.10 Fake bank loans - Another technique for international tax evasion may consist of purportedly

borrowing funds which are actually owned by the borrower. This not only enables the borrower to make open use of funds previously concealed in the name of a nominee or in a numbered bank account, but also gives him a pretext for claiming fictitious interest deductions. For example, a resident of country „A‟ who has deposited unreported income in a numbered bank account in country „B‟ may arrange to „borrow‟ an equivalent amount from the bank at say 12% interest. If the bank is paying 10% interest to him on his numbered account, he will actually be out of pocket only to the extent of 2% but in the return which he filed in country A, he will treat the receipt of the unreported income as a „loan‟ and will claim a deduction for the entire 12% interest charge which he pays to the numbered bank account in country „B‟ and may arrange to have the bank in country B forward funds to an unrelated bank in country C from which he will borrow an equivalent amount. Similarly use of dummies, nominees, numbered bank accounts, and bearer securities are some other means to diversify income or to introduce investments.

4.11 Use of related tax haven entities to reduce taxes - Associate enterprises incorporated in tax

havens are also used by multinationals for their tax planning. The following situations are worth considering -

 A commonly used method is to transfer income-producing assets at an artificially low cost from the taxing jurisdiction to a controlled entity in a foreign tax-haven country where the potential income from the assets will be subject to tax at a lower rate, or escape tax entirely. These assets may be stocks, securities, rental properties and intangibles such as licensed patents, trade marks and copy rights which will generate continuing passive investments income, or property or any kind which will be resold by the tax haven entity to an unrelated third party at a gain.

 Nominal transfer of income-producing functions to a tax haven entity that may be only a shell corporation which is incapable of performing the services unless it uses personnel and / or property of the controlling entity.

 Payment of deductible expenses to a tax-haven entity.

 Payment of deductible expenses which benefit a tax haven entity.

Transfer Pricing

5.1 The expression 'transfer pricing‟ relates to transactions in goods and services between related

enterprises. The prices charged between related parties in relation to goods, services, tangibles, and loans are broadly considered in transfer pricing issues. The transfer pricing process determines the amount of income that each party earns. Taxpayers and the tax authorities focus exclusively on related party transactions, which are termed controlled transactions, and have no direct impact on independent transactions, which may be called uncontrolled transactions.

5.2 The arm‟s length principle - The evolution of the concept of transfer pricing has led to the

development of arm‟s length principle. An arm‟s length price is a price that would be charged for the same goods or services between two parties dealing on independent basis. The principle governs the evaluation of transfer pricing in case of transactions between related parties. The application of the principle is generally based on a comparison of the conditions in a controlled transaction between related parties, with the corresponding conditions in transactions between unrelated parties. The Principle is laid down on the basis of adjusting profits with reference to the conditions, which would have existed between independent parties under comparable circumstances. It covers cases of under invoicing or over invoicing of goods and services regardless of whether any resulting shortfall in the tax revenue is due to deliberate tax avoidance or merely due to adoption of incorrect pricing method for taxation purposes. The

application of arm‟s length principle requires that enterprises be treated as operating as separate and independent entity. The tax laws permits adjustment in pricing in accordance with the principles of arm‟s length, considering the price to be charged by independent enterprises. Many countries of the world, notably USA, Canada, UK, Germany, France, the Netherlands and countries in Asia Pacific Region like Australia, Japan, Korea and China have laid down in their respective Income tax legislation specific provisions dealing with transfer pricing.

5.3 Methods of application of arm‟s length principle - There are a varieties of ways to determine

whether the arm's length principle is followed in transactions between related parties. The guidelines issued by the Organization for Economic Cooperation and Development (OECD) contain a description of specific methods which are followed by several countries in transfer pricing regulations. Some countries do not prescribe any specific method though they agree with the principles of OECD guidelines. Some of the commonly used methods are discussed below:

5.3.1 Comparable uncontrolled price method (CUP) - The CUP method compares the price charged in

a controlled transaction to the price charged in a comparable uncontrolled transaction in comparable circumstances. This method is most direct and reliable way to apply the arm‟s length principle. In practice it is difficult to apply the CUP method as it is unusual for multinationals to have the details about comparable transactions. Therefore, the OECD report suggests that multinationals and tax authorities should take a more adaptable approach, possibly working with data prepared for CUP purposes, supplemented by other appropriate methods.

5.3.2 Resale price method (RPM) - Under Resale price method, the arm‟s length price of goods

purchased from a related party is determined by deducting an arm‟s length gross profit from the resale price of goods resold to an unrelated party. The method is ordinarily used in cases involving the purchase from a related party and resale to an unrelated party of property in which the reseller has not added substantial value to the goods.

5.3.3 Cost plus method (CPM) - The Cost plus method is generally applied when the manufacturer is a

contract manufacturer or when determining the arm‟s length charge for services. Under this method the arm‟s length price is determined by adding an appropriate mark up to the cost of production. The appropriate mark up is the percentage earned by the manufacturer on unrelated party sales which are similar to inter company transactions.

5.3.4 Profit split method - Under this method the net income form transactions is allocated to the

respective entities based on the value of their contributions to the net profit.

5.3.5 Transactional profit method - The TPM method deals with the profits that arise from particular

transactions. The profits in this case maybe assessed in different ways- in relations to total sales, operating expenses incurred or assets.

5.3.6 Other methods - The OECD guidelines also permit the use of other methods when none of the

above methods yield satisfactory results and accurate information isn't available to estimate the arm‟s length price. In such a case any other method maybe adopted provided they result in conclusions consistent with the arm‟s length principle.

The Indian scenario

6.1 The concept of arm‟s length principle is also recognized in our tax laws. The principle is incorporated

in the term “fair market value” as defined in Section 2(22B) and Section 40A(2)(b) of the Act. The arm‟s length principle is also followed in determining ordinary profits under old Section 92 of the Act and forms the basis of provisions incorporated under Section 9(1) (i) of the Act dealing with “business connection”, Section 80IA dealing with close connection and Section 2(22)(e) dealing with deemed dividend.

6.2 Income from Transactions with Non-resident (Old Section 92) - The transactions with related

parties are at times coined solely with a view to obtaining tax advantage. The courts all over the world have consistently condemned transactions having no commercial justification and recognized the right of tax authorities to tax the reasonable profits accruing from such transactions.

6.3 The arm‟s length principle is also recognized in Section 92 of the Income Tax Act as existing prior to

its amendment by Finance Act, 2001. The Section dealt with income derived from transactions with non-residents. The Section gives power to an Assessing Officer to determine profits accruing to a Resident, which may reasonably be taken as to have been derived from business with non-resident, if it is found that the transactions between the parties have been so arranged that owing to close connection between them the transactions produce to the Resident either no profit or less than ordinary profits.

- The business is carried on between a resident and a non-resident.

 A close connection exists between the parties.

 As a result of arrangement between the parties, the resident earns either no profits or less than ordinary profits.

 The Assessing Officer shall determine the amount of profits which may reasonably deemed to be derived therefrom, and

 The profits so determined shall be included in the total income of the resident.

6.4 Section 92 (corresponding to Section 42(2) of IT Act, 1922) empowers the Revenue to charge the

resident assessee in respect of profits which on dictates of ordinary commercial principles & expediency should have resulted from transactions with nonresident irrespective of whether or not the resident made the profit. There is thus the concept of deemed or notional profit embedded in the provision. What is required to be established on record is “business transaction” between the resident assessee and a non-resident who have a “close connection”.

6.5 In order to invoke the provisions of this Section it is essential that business is carried on between a

resident and non-resident. Normally, as defined in Section 2(13) of the Act, business includes any trade, commerce or manufacture or any adventure in the nature of trade. The essential pre-requisite is that business must be carried on between a resident and non-resident which normally implies regular course of activities. It cannot be applied to isolated transactions like export of machinery as capital contribution to a foreign company. (CIT Vs. Kusum Products Ltd. (1993) 71 Taxman 611, 615-16(Cal).

6.6 The Assessing Officer has been given powers to determine the amount of profit, which may

reasonably be deemed to have been derived from such business and to include such amount in the total income of the resident. It is also to be noted that it is only the income of the resident , which is affected. So far as the income of the non-resident is concerned, the same will have to be determined with reference to Section 9 and Sections 160/161 of the Act.

6.7 In one case two nonresident companies in the business of playing ships entered into an arrangement

with their Indian subsidiary engaged in the business of repairing ships. Under the arrangement the resident Indian company recovered only the cost without charging any profit from repairs of ships it did for the non-resident associates. Supreme Court in that case [ MAZAGAON DOCK LTD V CIT.(1958) 34 ITR 368 (S.C.)] held that the dealings between parties formed concerted and organized activities of a business character and the non-resident companies carried on business in association with the resident company. The provisions of section 42(2) [ now Section 92] were accordingly held as rightly invoked. The apex court, rejecting all contentions of the assessee, held that profits, if any foregone, must be taxed separately. According to the court the fact that the dealings were such as to yield no profit to the non-resident was immaterial.

6.8 Under the old law, Rules 10 & 11 of I.T. Rules 1962, prescribed following alternative modes of

calculation of arm‟s length profits -

 The percentage of turnover so accruing or arising as A.O may consider reasonable;  The amount which bears the same proportion to the total profits & gains of business as

receipts so accruing or arising bear to the total receipts of the business; or  Any other manner the AO may consider suitable.

Since the law did not define the term “Close connection” & determination of profit were based on definitive ground of reasonableness, the job of AO was difficult as he had to collect the requisite material for applying the provisions of Section 92 of the Act.

6.9 It does not call for an extensive reasoning to persuade one to appreciate that old Section 92 basically

tries to deal with the practice of “parking profits” in an off shore tax haven. It is also apparent that the provision aims at reconstructing profits rather than income or expenditure. It is also doubtful as to how the scheme can tackle transactions involving supply/acquisition of property with or without transfer of services.

6.10 In view of the above discussion above tax authorities need information to evaluate relationship as

also to ascertain respective tax liabilities of parties involved when trans-border transactions/relationship are involved. Artificial/Engineered transfer pricing between related parties as a mode of parking profits where incidence of tax is lower/lowest has been made subject matter of scrutiny in assessment vide Sections 40A(2) & 80IA of the IT Act, 1961.

6.11 Section 40A(2) stipulates that any expenditure incurred on extra commercial considerations can be

denied deduction as admissible revenue expenditure of business. An „associated enterprise‟ for purpose of Section 40A(2) is determined with reference to the assessee in whose case the disallowance is to be made. An enterprise may be an individual or an artificial entity like a company, a partnership firm, an Association of persons or a Trust. One enterprise may be deemed to be associated with another not only if it has members or relatives in common but also if it has a substantial (business) interest in the other. „Relative‟ in relation to an individual is defined [Sec.2(41)] to mean the spouse, brother, sister or any lineal descendant /ascendant of the assessee individual.

6.12 It may be noted that in fixation of arm‟s length prices profits the provisions of old Section 92

conspicuously omit factors like, volume of business, after sale or associated services, considerations of capacity utilization, compulsions of maintaining confidentiality, credit terms, dictates of competitive prices & market forces etc. Therefore, it becomes a theoretical exercise to compare circumstances under which unrelated parties transact vis-a-vis that of related parties. Further, the law did not specifically lay down any specific documents to be provided by a taxpayer, and therefore, the AO could consider only calling general information in respect of transfer pricing cases.

Case Studies

7.1 In a case of MNC, it was found that the company had suppressed export profits and had shown loss

on export sales of Rs. 1,87,50,394/-. The exports sales were contracted in Indian Rupees as against the normal practice of such sales in convertible foreign exchange. The materials exported were components required in manufacture of escalators, which cannot be sold indiscriminately. Scrutiny revealed that the assessee company had „close connection‟ with an overseas company, and the foreign company held shares in Indian company. There was also no apparant reason for resident company to negotiate the contract at a lesser price than what was fair and reasonable. As the losses claimed in the transactions were not found to be genuine the Assessing Officer determined profits applying Section 92 of the Income-tax Act. The benefit of Section 80 HHC was also denied as the sale proceeds had not been received in convertible foreign exchange in India.

7.2 In another case of a pharmaceutical company it was found that the company was importing certain

drug formulations from Germany, from a company with which it had close business connection. The management of the German company had control and interest in the Indian company and as such cross border transactions were with a related party. It was also found that German company had not been charging arm‟s length price for the supply of raw material as the prices were much higher than the prevailing international price. The resident company was buying similar goods from Korea at much cheaper rates. This showed that inflated price was paid to German Company because of close connection between parties. The AO invoked the provisions of Section 92 of the Act and redetermined profits after applying the arm‟s length principle.

7.3 The issue of applicablility of Section 92 was also considered in another case of an Indian company

which was a subsidiary of a US based multinational company. The company was dealing in medical equipments. It was found that the commission received by Indian company from foreign based multinational was not based on arm‟s length principle. Further the gross profit on the goods purchased from the parent was approximately 50% less than the gross profit on goods purchased from third parties. The AO held that it was the case of transfer pricing and accordingly made additions u/s 92 of the Act.

Transfer Pricing - New Provisions in Section 92 to 92F

8.1 The Finance Act, 2001, introduced a new set of provisions relating to transfer pricing by amending

existing Section 92 and incorporating Sections 92 to 92 F in the Act. The amended provisions are effective from 1st April, 2002 and accordingly apply from AY 2002-2003 onwards. These provision are exhaustive in many respects and generally in line with international practices prescribing methodologies, documentation requirements and penalties.

8.2 The object of introducing the new provisions is explained in the Memorandum to the Finance Bill 2001

-“The increasing participation of multinational groups in economic activities in the country has given rise to new and complex issues emerging from transactions entered into between two or more enterprises belonging to the same multinational group. The profits derived by such enterprises carrying on business in India can be controlled by the multinational group, by manipulating the prices charged and paid in such intra-group transactions, thereby, leading to erosion of tax revenues.

With a view to provide a statutory framework which can lead to computation of reasonable, fair and equitable profits and tax in India, in case of such multinationals enterprises, new provisions are proposed to be introduced in the Income-tax Act. These provisions relate to computation of income from international transactions having regard to the arm‟s length price, meaning of „associated enterprises‟, meaning of „international transaction‟, determination of arm‟s length price, keeping and maintaining of information and documents by persons entering into international transactions, furnishing of a report from an accountant by persons entering into such transactions and definitions of certain expressions occuring in the said sections”.

8.3.1 Transfer pricing transaction - The amended Section 92 provides that any income arising from

international transaction shall be computed having regard to arm‟s length price. It further provides that cost or expenses allocated or apportioned between two or more associated enterprises shall be at arm‟s length price. The provisions would apply to all transactions between members of a MNC group including supplies of material, components, finished products, payments for intangible viz. Intellectual property, royalties, interest and loans and payments for technical assistance and know-how.

8.3.2 Arm‟s length principle - The transfer pricing regulations, of almost all countries of world recognise

the arm‟s length principle. This principle is also incorporated in the proposed Section 92(2) of the Income Tax Act. The arm‟s length principle suggests that two „Associated Enterprises‟ (AEs) should be treated as independent enterprises and all transactions would be considered at the market price. The arm‟s length principle is also incorporated in Article 9 of the UN/OECD Model Conventions. The said Article provides that transactions between Associated Enterprises should be evaluated as if they are independent of each other and, if it is found that owing to special conditions between two countries, prices are not comparable with those of the independent enterprises, then suitable adjustments be made for the price differentials. The principle is also recognised in Double Taxation Avoidance Agreements (DTA) that India has signed so far with other countries.

8.3.3 Associated Enterprise (AE) - Section 92 A contains the definition of „Associated Enterprises‟

which is quite elaborate and wider in scope than that prevails in conventions not only of OECD/UN but also of many other developed and developing nations.

The basic criteria to determine „associated enterprises‟ are management, control and/or capital. In addition to these criteria some other criteria are also prescribed in the Section to determine AE‟s such as -

 Holding of 26% voting power;

 Advancing of loans of not less than 51% of the total assets of the borrowing company;

 Guarantees for not less than 10% on behalf of the borrower;

 Appointment of more than 50% of the Board of directors or members of the governing board.

 Dependence on the enterprise possessing exclusive rights for manufacturing / processing of goods or articles by using know-how, patents etc;

 Dependence up to 90% or more for raw materials and consumables on another enterprise;

 Influence on prices for goods or articles manufactured or processed;

 One individual (or his relative jointly or separately) controlling two different enterprises;

 One Hindu Undivided Family (HUF) (or relative of member of HUF – either jointly or separately) controlling two different enterprises;

 Firm/AOP/BOI holding not less than 10% interest in the other firm/AOP/BOI;

The amended law provides that „associated enterprise‟ will come into existence if any of the above criteria is met with at any time during the previous year.

8.4 Methods for determining arm‟s length price - The regulations prescribe the application of an arm‟s

length test in all transactions relating to transfer pricing. A number of methods may be used to determine arm‟s length price, in particular

- The comparable uncontrolled price (CUP) method;

 The cost plus method;

 The resale-price method;

 The profit-split method;

 The transactional net margin (TNM) method; and

 The comparable profits (CP) method.

Section 92 C recognises only the first five method for determining arm‟s length prices in international transactions. Apart from this, the CBDT has reserved its right to prescribe additional methods.

8.4.1 Most appropriate method - The law provides that the arm‟s length price shall be determined by following most appropriate method, having regard to the nature of transactions or class of transactions or a class of „associated persons‟ or functions performed by such persons or such other relevant factors as may be prescribed in this behalf.

8.4.2 Transfer Pricing Adjustment (TPA) - Section 92 C provides that the Assessing Officer may

determine the arm‟s length price in relation to any „international transaction‟ under the following circumstances :

(a) When the price charged or paid in an international transaction is not in accordance with provisions of the Act; or

(b) Any information an/or document relating to an international transaction have not been kept and maintained by the assessee in accordance with the provisions contained in the Act or the rules made thereunder; or

(c) The information or date used in computation of the arm‟s length price is not reliable or correct; or (d) The assessee had failed to furnish, within the specified time, any information or document which he was required to furnish by an notice issued under he Act

However, the provisions lay down that Assessing Officer must give an opportunity to the tax payer by serving a notice calling upon him to show cause, why the arm‟s length price should not be so determined on the basis of material or information or document in his possession.

8.4.3 It is further provided that in cases where the total income of the tax payer is enhanced after the

transfer pricing adjustments, deduction under Section 10A (in respect of industrial undertaking in free trade zones) or Section 10B (in respect of newly established hundred percent export oriented undertakings) or under Chapter VI A (Business and other deductions) shall not be allowed in respect of such enhanced income.

8.5 Documentation - Section 92D provides that every person who has entered into an international

transaction shall keep and maintain such information and documents as may be specified by rules made by the Board. The Board may also specify by rules the period for which the information and documents are required to be retained. It is also laid down that during the course of any proceedings under the Act, an Assessing Officer or Commissioner (Appeals) may require any person who has undertaken an „international transaction‟ to furnish any of the information and documents specified under the rules within a period of thirty days from the date of receipt of a notice issued in this regard. The period may be extended by a further period not exceeding thirty days.

8.6 Penalties - The transfer pricing provisions also give authorities power to levy penalty to curb tax

avoidance by abuse of legislation. The approach in this regard is similar to Section 271(1) of the Income Tax Act. The concepts of „good faith‟ and „due diligence‟ have been incorporated in the legislation. Therefore, no penalty would be levied if the tax payer is able to prove to the satisfaction of the Assessing Officer or the Commissioner (Appeals) that the price charged or paid was computed in accordance with the provisions contained in Section 92C in good faith and with due diligence.

8.6.1 The penalties prescribed in this regard are as under -

(1) In a transfer pricing case, if the assessee is unable to prove good faith and due diligence in arm‟s length price, a penalty upto 300% of the amount of tax sought to be evaded may be levied. Explanation 7 to Section 271(1), also lays down that the amount added or disallowed in computing income under Section 92C(4) shall be deemed to represent income in respect of which particulars have been concealed.

(2) Where the assessee has failed to maintain the prescribed information or documents, the assessee may be liable for penalty @ 2% of the value of each „international transaction‟.

(3) Where the assessee fails to furnish information or document as required by the Assessing Officer, penalty @ 2% of the value of the „International transaction‟ may be levied for each such failure.

(4) Where the assessee fails to furnish a report from an accountant penalty of Rs.1,00,000/- may be levied.

8.7 Audit requirements - The regulations also contain provisions relating to audit requirement in respect

of „international transactions‟. Section 92 E provides that every person who has entered into an international transaction during a previous year shall obtain a report from an accountant and furnish the same with tax authorities. The Auditor‟s report on transfer pricing transactions must be submitted on or before the 31st October of the relevant assessment year in case of a company and on before 31st July in case of other tax payers.

8.8 Rules governing taxation of transfer pricing cases - The Central Board of Direct taxes vide its

notification S.O.808(E) dated – 21st

August, 2001 have notified detailed rules in regard to transfer pricing provisions covered by section 92 to 92 F of the Income Tax Act.

8.8.1 Rule-10 A - This Rule provides definitions of various expressions used in computation of arms

length prices. The terms defined are -  Uncontrolled transaction  Property

 Services

 Transaction

8.8.2 Rule-10B - This Rule concerns the methods of determination of arms length price under Section 92

C of the Act. It also provides the manner in which arms length price will be determined under each prescribed method. The Rule further lays down the comparability factors with reference to which an international transaction shall be judged with an uncontrolled transaction.

The Assessing Officer must keep in mind the following aspects while examining a transfer pricing case.

 The specific characteristics of the property transferred or services provided.

 The functions performed and risks assumed by the respective parties

 The contractual terms between the respective parties.

8.8.3 Rule-10 C - The Rule provides the manner of selection of most appropriate method for

determination of arm‟s length price in relation to the international transaction.

8.8.4 Rule-10D - The Rule lays down the nature of information & documents to be kept and maintained

under Section 92D. The prescribed documents need not be maintained in case the value of „international transaction‟ does not exceed one crore rupees.

8.8.5 Rule-10 E - The Rule prescribes the form of report to be furnished under Section 92E of the Act. It

may be worthwhile to state that with the notification of rules a lot of clarity and certainty has been brought in transfer pricing regulation. However, as these are new provisions the AO will have to refer the case studies available under tax laws of other countries where similar provisions exist.

8.9 Guidelines for applying arms length principle - As already stated, the new provisions relating to

transfer pricing lay down that the income arising from „international transactions‟ between „associated enterprises‟ shall be computed having regard to arm‟s length price.

8.9.1 While the primary responsibility of determining and applying an arm‟s length price is on the

assessees, Section 92C(3) empowers the AO to determine the arm‟s length price and compute total income accordingly. Rule 10B (2) lays down the comparability factors of an „international transaction‟ which should be considered while examining a transfer pricing case.

8.9.2 The following aspects should be borne in mind in applying arm‟s length principle.

 Comparability analysis

 Characteristics of property or services

 Functional analysis (taking into account the assets used and the risks assumed)

 Contractual terms

 Economic circumstances

 Business strategies

8.10 Selection of most appropriate pricing method - The law provides that most appropriate method

shall be the method which is best suited to the facts and circumstances of each transaction and which provides the most reliable measure of arm‟s length price. Organisation for Economic Cooperation and Development (OECD) recommends following approach for selecting appropriate pricing method. 8.10.1

Selection criteria - The following factors may be considered in this regard :

 Extent of comparability between controlled and uncontrolled transaction

 Quality and reliability of data

 Complexity of transaction

 Number, magnitude and accuracy of adjustments

8.10.2 Besides, in making comparability analysis the AO is advised to consider following other factors

apart from the one prescribed in rules.  Geographic markets

 Size of transactions

 Market share strategy

 Start up

 Alternative available to buyer and seller

8.10.3 Methodology - The Assessing Officer may consider following steps in determining arm‟s length price under various methods prescribed in the regulations.

8.10.4 CUP method - Under Comparable Uncontrolled Price (CUP) method, price charged for property or

services transferred in a controlled transaction is compared to price charged in a comparable uncontrolled transaction. The sources of data in these situations are

Internal CUP -

 Internal company data.

 Company price list

 Web site

 Trade direction

 Govt. Publications

The steps involved in determining the arm‟s length price under the CUP method are - Identify price charged or paid in a comparable uncontrolled transaction;

 Adjust such price to account for material differences which would affect the price in open market;

The following factors may be taken into consideration for making adjustments

- Level of market

- Intangibles associated with sales

-

8.10.5 Resale price method (RPM) - This method begins with the resale price of the product sold to an

independent enterprise from which resale margin is reduced to arrive at arm‟s length price. The steps involved in applying this method are -

 Identify price at which goods, articles or things are ultimately resold to an unrelated enterprise.

 Deduct reasonable expenses & normal profit margin

 Adjust resultant price for material differences, if any, in the transactions being compared

 The adjusted price thus arrived at is taken to be arm‟s length price in respect of purchase of goods, articles or things by the assessee from the associated enterprise.

The analysis of international transaction under Resale price method may be considered in the following manner -

 Comparability under this method is dependent on the similarity of functions performed, risks borne and contractual terms

 The amount of resale margin will be influenced by the level of activities performed by the reseller.

 Inventory level of goods

 Contractual terms

 Level of market

8.10.6 Cost plus method (CPM) - This method begins with the cost incurred by the supplier of property

or services in a controlled transaction. An appropriate mark up is then added to this cost, in the light of functions performed and market conditions. The price arrived at after adding the cost plus mark up to

these costs may be regarded as an arm‟s length price of controlled transactions. The steps involved in applying this method are

- Determine the cost in respect of goods, articles, or things or intangible property transferred to the associated enterprise.

 Determine the normal profit margin arising from the transfer of similar property or services by the assesses or by an unrelated enterprise.

 Adjust the normal profit for material differences, if any, between the transactions being compared and the enterprises entering into such transactions.

 Costs are increased by the normal profit margin or adjusted profit margin as the case may be.

 The price so arrived at is the arm‟s length price in relation to supply of the property or services.

8.10.7 Profit split method - Under this method, the arm‟s length price is determined through a division of

the consolidated profits of the „associated enterprises‟. The commonly applied methods in this regard are contribution analysis and residual analysis. The method is applicable in cases involving multiple transactions which are so interrelated that they cannot be evaluated separately. The steps involved in applying this method are -

 Determine combined profits of the associated enterprises.

 Evaluate relative contributions of each enterprise towards earning of profits based on functions performed, assets employed and risks assumed.

 Split combined profits in proportion to relative economic contributions.

 The profit thus apportioned is taken into account to arrive at the arm‟s length price.

8.10.8 Transactional net margin method (TNMM) - The transactional net margin method examines the

net profit margin that a tax payer realises from a transaction with an associated enterprise. The net margin is calculated with reference to appropriate base say costs, sales and assets etc. The net margin of the tax payer from the controlled transaction is determined by reference to the margins earned in comparable uncontrolled transactions for establishing arm‟s length price. The comparability of the transaction under this method are judged with reference to following

- Specific characteristics of the property or services

 Functions performed

 Contractual terms

 Market conditions

The main limitation of this method is that comparable data of net profit margin is not easily available for analysing transactions. The steps involved in applying this method are

- Compute net profit margin of associated enterprise transactions.

 Compute net profit margin of comparable uncontrolled transactions.

 Adjust latter net profit margin for material differences which can affect net profit margin in open market.

 The net profit established is taken into account to arrive at the arm‟s length price.

Exchange control implications to transfer pricing

9.1 To ensure that there is no under-invoicing of merchandise exports, an exporter needs to file a

foreign exchange corresponding to such value into India. Customs authorities certify the value declared by the exporter. Similarly, to guard against over-invoicing on imports, the Reserve Bank of India has directed authorized dealers to exercise due precautions while releasing foreign exchange for importers. The Assessing Officers need to look into these aspects before deciding issues relating to transfer pricing.

Implications under the Companies Act

10.1 Under the provisions of the Companies Act, 1956, the financial statements of a company are

required to give a true and fair view of the state of affairs of the company. The auditors are also required to opine in their report on whether or not the accounts portray a true and fair view of the state of affairs of the company. As related party transactions could have a significant bearing on the financial position of a company, it would be worthwhile to study the auditor‟s report and comments made in the Balance-sheet in regard to cross-border transactions. At present the statutory auditors of public companies also are required to include in their report an opinion on whether related party transactions are at arm‟s length. For this purpose, auditors generally apply broad level tests to determine whether the transactions are at arm‟s length. As and when transfer-pricing legislation in India matures, the auditors would be in a position to take a close look at transfer pricing issues.

Recent developments

11.1 Accounting Standard for related party transactions - Recently Institute of Chartered Accountant

of India, have issued a Draft of proposed Accounting Standard on related party disclosures. The Exposure draft requires a disclosure of related relationships and transactions (including pricing policies) necessary for an understanding of the effects of related party transactions on the financial statements. It is pertinent to state here that currently the Auditors are required to comment on the arm‟s length pricing in transactions with only specific related parties, i.e. the parties in which either directors are interested or are under the same management. The proposed Accounting Standard however has a broader definition of „related parties‟ and will, therefore, require a specific disclosure of transactions which are currently not being commented upon. Secondly, the disclosures would tend to alert any Assessing Officer to examine whether or not the disclosed related party transactions are at arm‟s length.

11.2 Segment reporting - The ICAI has also announced an Accounting Standard on Segment reporting,

effective accounting periods commencing on or after 1st April, 2001 which requires corporates to furnish detailed information on each business segment, including country wise breakup with the Balance sheet. This would provide ready-to-appreciate data in respect of various activities carried on by an entity. This would facilitate analysis of transfer pricing both by the taxpayer and tax collector.

Transactions resulting in transfer of income to Nonresident

12.1 Under the Indian Income Tax Act, a Resident is taxed on world income basis irrespective of the

place of accrual, whereas a non resident is chargeable in respect of income received / accrued / arose or deemed, under explicit provisions of the Act, to have been received or have accrued or arisen within India.

12.2 At times, an Indian taxpayer may transfer ownership over an asset located abroad in favour of a

nonresident while contriving to secure benefits to himself or his own men, relations, dependents and the like . To discourage such schemes aimed at reducing a resident assessee‟s tax liability, Section 93 has been enacted to provide that the income arising to the non resident in consequence of such transfer of assets shall be deemed to be income in respect of which transferor is liable to Indian taxation. the enactment is almost on the lines of Sections 60 to 64 of the IT Act.

12.3 The provision conforms to the basic principles of taxation in India that a transfer of asset to evade

to a nonresident from a transfer of assets either alone or in conjunction with “associated operation” [defined in Section 93(4)(b)]. The essential requirement for application of the fiction is that the Resident must have “power to enjoy” the income arising, on account of the transfer, to the non resident. It is not necessary that the transfer must be by the resident assessee [MCt.M CHIDAMBARAM CHETTIAR V CIT, (1996) 60 ITR 28 (SC)]. Strictly speaking, Section 93 although providing for adjustment of income in the hands of the Indian party to a transaction between a resident & a non resident, does not require artificial determination of any price/ value as such.

12.4 The following ingredients must exist for invoking the provisions of Section 93 of the Act

- There must be a transfer of assets :

 by reason of that transfer, income traceable to the said assets becomes payable to a person who is a nonresident :

 the resident by means of the transfer alone or in conjunction with associated operations, acquires a right to enjoy such income :

 the income from the said assets, if it were the income of the resident would have been chargeable to income-tax : and

 in that event, the income of the nonresident would be deemed to be the income of the resident for all the purposes of the Act.

Treatment of Head Office expenses

13.1 Section 44 C of the Act lays down the provisions for determining the Head Office expenses which

are allowed as a deduction in computing the income of a nonresident in India. The term 'head office expenses' is defined to include following expenses:

 Rent, rates, taxes, repairs or insurance of an premises outside India used for the purpose of business or profession.

 Salary, wages, annuity, pension, fees, bonus, commission, gratuity, perquisites or profits in lieu of or in addition to salary, whether paid or allowed to any employee or other person employed in, or managing the affairs of, any office outside India,

 Traveling by any employee or other person employed in, or managing the affairs of, any office outside India, and

 Such other matters connected with executive and general administration as may be prescribed.

13.2 The head office expenses attributable to the business or profession of the assessee in India, are

allowable as expenditure subject to a ceiling of 5% of the adjusted total income. For the purpose of this Section 'adjusted total income' means income computed prior to making deduction under Sections 32 (2), 43A, 33, 33A, 36 (1) [ first proviso] or chapter VI-A and without making adjustment for the brought forward losses. If the adjusted total income of the assessee is a loss, the deduction under this Section is determined on the basis of the average of adjusted total income of the preceding three assessment years. If the income is not assessed for three years then adjusted income for the preceding two or preceding one year as the case may be is taken into account.

Applicability of Double Taxation Avoidance Agreements to MNCs

14.1 As is obvious from its name a Double Taxation Avoidance Agreement (DTAA) is entered into by two

countries to avoid income of their residents having operations in both the countries, getting taxed twice, first in the country of residence and then in country of source. These agreements are therefore very important in the cases of multinationals. Although the primary objective of DTAAs is avoidance of double taxation, their provisions are sometimes misused by multinationals to avoid taxation in the country where

income generating activity or asset is situated and sometimes both in the country of source as well in the country of residence.

14.2 Tax treaties of most countries are based on either the OECD model or the United Nations Model

(UN model) for Agreement on avoidance of double taxation and prevention of fiscal evasion. Under the OECD model the taxation rights are usually assigned to the country of residence of the taxpayer. Under the UN model the taxation rights are given to the country of source of income though concessional rates are prescribed for various types of income subject to fulfillment of certain conditions. Our treaties, especially with the developed countries are based on the UN model.

14.3 The following are some of the common issues arising in assessments relating to cases of

multinational corporations

-14.3.1 Permanent Establishment - Permanent Establishment is one of the most important concepts

relating to taxation of business income of an enterprise of a country from operations in another country. Permanent Establishment postulates the existence of a substantial element of an enduring or permanent nature of a foreign enterprise in another country, which can be attributed to a fixed place of business in that country. It should be of such a nature that it would amount to a virtual projection of the foreign enterprise of one country into the soil of another country. [CIT vs. Vishakhapatnam Port Trust (1983), 144 ITR 146 (AP) ] The phrase “place of business” used in the definition refers to the localization of a business activity by reference to a physical space or object. The business activity is not restricted to a place of business. It is sufficient that it is carried on "through" the place of business. The business may be carried by the employees in the State in which the fixed place of business is situated. Thus, it is clear that concept is broader than a single focal point or headquarters from the fact that an enterprise may maintain several permanent establishment in the same state.

14.3.2 In some of tax treaties building site or construction or assembly project has been included in the

definition of permanent establishment, provided the activities last more than the specified period viz, six or twelve months. Sometimes the "supervisory activities" or installation of assembly project is also covered in the definition of permanent establishment. All the issues need to be addressed in the context of the treaty, which has relevance in a particular case. In Vishakhapatnam Port Trust case 144 ITR, 146 the Court after examining European and Indian authorities, concluded that an engineer's activities did not constitute a permanent establishment under the general construction project category of the applicable tax convention.

14.3.3 Following are some examples of a Permanent Establishment usually included in the DTA

Agreements:  A place of management

 A warehouse used for delivery of goods

 A mine an oil or gas well, a quarry or any other place of extraction of natural resources.

 An offshore oil rig in territorial waters

 A building site, construction, installation of a project which is carried on for a specified period (this period may be 6 months or 12 months depending on the Agreement)

 Business carried on through dependent agents even though the enterprise does not have a fixed place of business. An agent is called a Dependent Agent if he has the authority to conclude contracts on behalf of the enterprise and he exercises this authority regularly.

14.3.4 Most DTA agreements include a provision which specifies certain activities which do not constitute

a Permanent Establishment even if they are carried out through a fixed place of business. These are :  Use of facilities for mere storage or display of goods of the concern.

 Maintenance of a fixed place for mere storage and display of goods.

 Maintenance of a fixed place for purchase of goods or collecting information.

 Maintenance of a fixed place of business for the purpose of any preparatory or auxiliary activities.

 Maintenance of a stock of goods belonging to the enterprise solely for processing by another enterprise.

14.3.5 Although 'fixedness' of the place of a business is a prerequisite for determining whether a

Permanent Establishment exists it does not exclude a case where a company changes its address during the period under consideration. Thus, a company which is running its business in the other State through a branch or office etc. but which shifts such office etc. to one or more places during the year will still constitute a Permanent Establishment. Further, it is not essential that the business at the fixed place of business must be carried on through some personnel of the company. For example a company carrying on its business through automatic vending machines in the other country will be held to be maintaining a fixed place of business, and therefore having a Permanent Establishment. Ownership of fixed place of business or the fact that the business is conducted through a public place are issues which do not have relevance in determining if a Permanent Establishment exists. Thus, a company which has a certain area earmarked to it on a permanent basis on a dockyard or Customs warehouse and which conducts its business through such area was held to own a Permanent Establishment.

14.3.6 In the opinion of the OECD Fiscal Committee, its twelve-month test applies to each individual site

or project. Unless a particular project is totally unconnected with every other project in the host country, the time spent on one or more of those other projects may be aggregated with the time spent on the project in question. The criterion is not the number of contracts upon which the projects are based, but rather upon whether together they form a coherent whole commercially and geographically.

14.3.7 If an enterprise (general contractor) which has undertaken the performance of a comprehensive

project, subcontracts part of such project to other enterprises (subcontractors), the period spent by a subcontractor working on the building site must be considered as time spent by the general contractor on the building project. The subcontractor himself has a Permanent Establishment at the site if his activities there last more than twelve months.

14.3.8 A dependent agent will constitute Permanent Establishment even though the definition in Article 5

(1) is not directly satisfied. By contrast an independent agent (including a broker, general commission agent or other agent of an independent status) will not result into a Permanent Establishment of an enterprise. Dependent agency is defined merely in terms of the 'regular' 'habitual, or unqualified exercise of contractual authority by an agent in the taxing State.

14.3.9 Even if the requisite contractual authority exists, no Permanent Establishment can exist if such

authority is exercised by an independent agent acting in the ordinary course of his business; or the authority is limited to the type of preparatory or auxiliary activities which may be conducted through a fixed place of business without creating a Permanent Establishment; or the agent is only a purchasing agent.

14.3.10 In Tekniskill [Sendirian] Berhad vs CIT (222 ITR 551), the Authority for Advance Rulings (AAR)

held that a Malaysian Company which supplied skilled workers to a Korean Company for enabling the latter to execute certain contracts awarded to it in the Indian territorial waters near Bombay by the Oil and Natural Gas Commission [ONGC] from September 1993, did not have a PE in India and was not, therefore, liable to tax in India in terms of India's tax treaty with Malaysia.