Pandora's Box Opens With Domestic Transfer Pricing

MUMBAI: Having tasted blood with huge transfer pricing orders slapped on companies with cross-border operations this financial year, the finance minister has cast his net wider and deeper for the next one. Budget announcements will substantially expand the scope of transfer pricing (TP) provisions by including domestic transactions for the first time.
Transfer pricing is a new international area of taxation affecting large companies.
“The tax base (for transfer pricing) will simply double. Earlier, it was only cross-border transactions of multinationals. Now, it will cover all related party transactions. For multinationals, compliance doubles as they have to report even transactions between their domestic arms,” said Ajit Tolani, associate partner, Economic Laws Practice.
The move would impact companies that operate units in Special Economic Zones (SEZ) and park the bulk of their profits in these to take advantage of the tax holidays applicable. Real estate firms, which route transactions through hundreds of subsidiaries and associate companies, will also need to comply with transfer pricing documentation and reporting norms.
The Finance Bill has amended the definition of international transactions. It has been extended to include “specified domestic transactions” of Rs 5 crore and more. Certain expenses, transfer of goods and services between related parties, extraordinary profits and profits earned by SEZs will now be liable for scrutiny by transfer pricing officers.
“Transfer pricing will not be limited to just the large groups any more. Many mid-sized groups, partnership firms, Hindu Undivided Families (HUFs) and even individuals in smaller cities will now have to adhere to the TP rules,” said Samir Gandhi, partner-transfer pricing, Deloitte Haskins and Sells. “This will lead to an increase in the administrative and compliance burden for the taxpayer in respect of such transactions and a focused examination by the tax authorities.”
According to tax experts, currently under the normal provision of the Income Tax Act, 1961, the revenue authorities are empowered to disallow unreasonable expenditure incurred between related parties. The authorities can also reduce the reported income based on fair market value in respect of the undertaking to which profit linked deduction is provided. Such determinations today are made on a discretionary basis.
The latest amendments have extended the concept of arm’s length pricing to these transactions. The move was in line with a Supreme Court recommendation in the case of CIT versus Glaxo SmithKline Asia, the Finance Bill said.
“The above amendment has opened a Pandora’s box for taxpayers, with specified domestic related party transactions,” said a post-Budget note by Economic Laws Practice (ELP).
The penalty for non-compliance has also been made severe. Earlier, it was a flat fee of Rs 1 lakh for not reporting a transaction irrespective of its size. Now, the penalty is two per cent of the transaction. Thus, even if one forgets to disclose a transaction of Rs 5 crore, which is the minimum threshold for reporting, the penalty is Rs 10 lakh.
Some lawyers point out that the Advance Pricing Agreement (APA) introduced to reduce disputes will not cover the domestic related party transactions, making the plight of local firms even more severe. “While the APA regime has been introduced with respect to international transactions, the same benefit has not been extended in cases of domestic transactions,” Nishith Desai said in the note.
In addition, the finance minister has also included transactions such as capital financing, valuation of intangibles and provision of services under the definition of “international transactions”.
Capital financing could emerge as a key area in domestic transfer pricing, say consultants. Many domestic companies make inter-corporate advances and give guarantees to group firms. At market rates, these transactions attract charges of three-four per cent. These charges will be added to the taxable income.
“TP officers will put to use all lessons learnt from foreign firms over the past 10 years. They know exactly where to attack. Questions will be raised on routing of transactions through multiple entities, and adjustment entries,” said Tolani of ELP. “The whole system will be cleaner.”