Robust Transfer Pricing Documentation: Can Recharacterization Be Avoided?
CA. Bhavya Bansal Goyal
The author is a member of the Institute of Chartered Accountants of India (ICAI). She can be reached at bhavyabansal@gmail.com and eboard@icai.in
1. Introduction & The Evolution of Indian Transfer Pricing
Transfer Pricing rules were enacted in the Indian Income Tax Act in 2001. Over the years there have been substantial developments in the jurisprudence of transfer pricing. With thousands of court rulings on varied issues, transfer pricing legislature has truly evolved.
With the Base Erosion and Profit Shifting (“BEPS”) guidelines, evolution of e-commerce and globalisation of companies the significance of transfer pricing cannot be stressed enough.
This article discusses the elementary issue of preparing a robust transfer pricing documentation. With the ever-growing emphasis on ‘substance over form’ and ‘commercial rationality’ globally, there is an increased focus on the functional asset and risk analysis. Transfer Pricing as a subject is not merely a mechanical exercise, it involves knowledge of economics, business, and industry in which both the company and its comparables operate.
2. Background: Dual Pillars of TP Documentation (FAR & Economic Analysis)
Transfer pricing (TP) documentation consists of analysis of functions performed, assets utilised, and risks assumed (FAR analysis) as well as an economic analysis.
Pillar I: FAR Analysis
The functional, asset, and risk analysis documents the actual conduct of the related parties in an international transaction and provides critical insight into the substantive functions executed, resources allocated, and operational/financial risks undertaken.
Pillar II: Economic Analysis
Economic analysis aims to establish the arm’s length nature of an international transaction. Therefore, before commencing economic analysis, one first needs to conduct a comprehensive FAR analysis of the tested party and thereafter identify comparables that closely match the tested party’s functional profile.
Indian TP Law & ICAI Guidance Note Requirements
The Indian TP law and the Institute of Chartered Accountants of India (ICAI) guidance note on transfer pricing provide that the documentation on economic analysis shall provide for the details of the:
“data used and data rejected with reasons thereof. Also, different companies follow different accounting policies. There may be differences in terms of sale, etc. These variations call for certain adjustments in the financials to make the data comparable. The reasons and the adjustments so made should also be recorded.”
Comparables Selection Under Rule 10B(2) of Income Tax Rules
Every transfer pricing report is unique to each international transaction. The comparables must be similar in all material aspects and be compared based on:
- Specific characteristics of products or services transferred;
- Functions undertaken by the respective enterprises;
- Assets employed, tangible and intangible; and
- Risks assumed by the respective entities.
Merely because a certain comparable has been upheld for its exclusion/inclusion by various court decisions should not necessarily lead to exclusion/inclusion in other cases as well. Therefore, exclusion or inclusion of any comparable must strictly be based on functional, asset and risk (FAR) analysis, which is in accordance with Rule 10B(2) of the Income Tax Rules, 1962.
Global Judicial Rulings Reinforcing FAR Conduct
Various court rulings reinforce the importance of robust FAR analysis in transfer pricing documentation. Multiple landmark rulings across the globe re-emphasize the need to document the actual conduct of the parties:
- Netherlands: Netherlands vs. Zinc Smelter B.V., March 2020, Court of Appeal;
- Denmark: Denmark vs. Software A/S, September 2020, Tax Court;
- France: France vs. Piaggio, July 2020, Administrative Court of Appeal.
3. Increased Focus on ‘Commercial Rationality’ & ‘Substance Over Form’
The Indian Tax Tribunals and courts have increased focus on the substance of the transaction and analysing the parties’ conduct before delivering a judgment. The Bangalore Income Tax Appellate Tribunal (“ITAT”) in the case of Google India Private Limited [TS-335-ITAT-2018(Bang)-TP] noted that characterisation of functions cannot be based merely on terms of contract or description of the services given by the assessee-company. It must be determined with regard to the actual conduct of the parties.
To justify the actual functions a well-maintained TP documentation is a must. In cases where there is inaccurate or lack of documentation, it can even give rise to complete disregard or recharacterization of a transaction.
The Judicial Two-Prong Recharacterization Test: Roche Products
On the issue of recharacterization, the Mumbai ITAT in Roche Products (India) Private Limited [TS-154-ITAT-2016(Mum)-TP] laid down the authoritative conditions under which tax authorities are permitted to recharacterize an international transaction:
“tax authorities can recharacterize the transaction in accordance with its substance only when:
1. the economic substance of the transaction differs from its form; and
2. the form and substance are the same but the arrangement, in totality, differs from that which would have been adopted by the independent enterprise behaving in a commercially rational manner.”
The principle of ‘substance over form’ typically allows tax authorities to disregard the written contractual terms between parties and consider the actual substance to recharacterize/disregard a transaction. The principle may seem relevant in cases where tax authorities are doubtful as to whether the legal form of transaction varies from its actual substance. The issue has been gaining popularity in recent years given the recommendations arising from the BEPS project of the OECD.
While the intercompany agreements are the first step to understand the legal form of a transaction, the parties’ actual conduct should reasonably reflect in the functional analysis (analysis of functions performed, risk undertaken, and assets employed). Any inconsistency between the two often leads to disputes in the Indian context. The discrepancies may at times be only optical yet can trigger the tax authorities to ignore the contractual arrangement and recharacterize the transaction keeping in view the substance, or the conduct as may reflect based on FAR analysis and other supporting facts.
4. Indian Judicial Precedents on Recharacterization
Over the last many years, various Courts and ITAT in India and worldwide have examined the issue of recharacterisation in the context of transfer pricing. Key Indian rulings are summarized below:
1. CIT v. EKL Appliances Ltd [TS-206-HC-2012(DEL)-TP] (Delhi High Court)
The Delhi High Court, referring to the 2010 OECD Transfer Pricing Guidelines, established that tax authorities cannot arbitrarily restructure legitimate business transactions:
“the significance of the guidelines mentioned above lies in the fact that they recognise that barring exceptional cases, the tax administration should not disregard the actual transaction or substitute other transactions for them and the examination of a controlled transaction should ordinarily be based on the transaction as it has been actually undertaken and structured by the associated enterprises. It is of further significance that the guidelines discourage restructuring of legitimate business transactions. As provided in the OECD guidelines, he is expected to examine the international transaction as he actually finds the same and then make suitable adjustments but a wholesale disallowance of the expenditure, particularly on the grounds which have been given by the TPO is not contemplated or authorised.”
2. Itochu India Pvt Ltd [TS-428-HC-2019(DEL)-TP] & Aegis Limited [TS-65-HC-2019(BOM)-TP]
In both cases, the Delhi High Court and the Bombay High Court upheld the ITAT’s view that the Transfer Pricing Officer (TPO) had wrongly recharacterized international transactions, holding firmly that nothing was brought on record by Revenue to demonstrate that the transaction was a sham. In the absence of evidence establishing artificiality or fraud, legitimate arrangements structured by commercial prudence cannot be rewritten.
3. McKinsey Knowledge Centre India Pvt Ltd [TS-49-SC-2019-TP] (Supreme Court)
The Supreme Court dismissed McKinsey India’s Special Leave Petition (SLP) against the High Court order. The High Court had upheld the ITAT’s characterization of research and information services rendered by McKinsey India to its AE as high-end knowledge-based research services (KPO), rather than a routine business process outsourcing (BPO) service. The High Court observed that the services were “specialized and require specific skill-based analysis and research that is beyond the more rudimentary nature of services rendered by a BPO”, concluding that “it would be incorrect to slot the services provided by the Assessee into that of a BPO, when it is more akin to a KPO.”
4. Sony Pictures Networks India Pvt Ltd [TS-508-ITAT-2020(Mum)-TP]
In this matter (successor of MSM Discovery Private Limited), the issue related to the recharacterization of distribution fees paid by the assessee (a distributor of television channels) to its AE as ‘Royalty’. Relying on the assessee’s factual submission that it only acted as a pure intermediary between the broadcaster and the ultimate customer who views the channel, neither held any right in the content broadcasted over the channel, nor had any right to make changes thereto, the Mumbai ITAT held that the distribution fee paid by the assessee to its AE could not be recharacterized as ‘Royalty’.
5. International Case Laws & Global Comparative Jurisprudence
Recharacterization has been litigated before superior courts across prominent international tax jurisdictions, establishing core boundaries on tax administrations:
Non-Recognition vs. Statutory GAAR Powers in India
As can be seen from the above rulings, while non-recognition in transfer pricing is a common approach adopted by the first level tax authorities across the world, complete disregard of a transaction is not very common. In the Indian context, non-recognition is discouraged by the ITATs and High Courts if done without prudent reasoning.
However, General Anti Avoidance Rules (GAAR) empower the revenue to deal effectively with and guard against schemes that are designed for tax avoidance. GAAR gives revenue extensive powers to disregard or recharacterize transactions and re-determine the resultant tax consequences if the assessee fails to prove the commercial rationality of the arrangement and that tax avoidance was not the main purpose.
6. BEPS Action 13, BEPS Actions 8–10 & DEMPE Functions
In 2016, BEPS Action 13 was adopted by the Indian Tax law, incorporating the preparation of the Master File and Country-by-Country (CbC) reporting into transfer pricing compliance requirements. If applicable, the preparation of the Master File and CbC reporting represents an extensive exercise requiring detailed global disclosures by multinational corporations.
The DEMPE Framework for Intangibles (BEPS Actions 8–10)
BEPS Action 8 provides a comprehensive framework for identifying members of a multinational Group that contribute to the creation of valuable intangibles, determining ‘arm’s length’ remuneration based on their contribution across the entire value chain. The Final Report on OECD’s BEPS Actions 8–10 (released in October 2015) provides guidance on applying the arm’s length principle to intangibles, focusing on economic substance, risk control, and corresponding rewards rather than mere legal ownership.
It establishes the foundational principle that the entity which creates value should be entitled to commensurate returns. Therefore, multinational enterprises must determine and document which entity performs the five DEMPE functions:
The rewards earned by an entity will fundamentally change depending on this analysis, bringing to light the crucial importance of granular documentation.
India’s Pioneering Role: CBDT Circular 6/2013
Much before the BEPS project of the OECD on DEMPE guidelines, the Indian Central Board of Direct Taxes (CBDT) had vide Circular 6/2013 given a preview into DEMPE functions. The circular laid explicit importance on the parties’ actual functions and actual conduct over contractual arrangements, marking a revolutionary shift in the way international transactions are scrutinized.
7. Group Transfer Pricing Policy & Internal Reviews
While it is essential to undertake annual TP compliances, it is also imperative to document the group Transfer Pricing Policy, which highlights the pricing policy and the flow of international transactions between the various entities of a multinational group. Hence, it is important to have a robust transfer pricing policy which, inter alia, lists:
- The comprehensive multinational group structure and legal ownership hierarchy;
- The specific economic functions undertaken by each entity globally;
- The intellectual properties (IPs) owned, developed, and commercialized; and
- The formal pricing methodology established for inter-group transactions.
Practical Review Illustration: Cost-Plus 5% Factory Pricing
It is highly advisable that periodic internal transfer pricing reviews be undertaken to ensure that TP policies are strictly adhered to in practice:
Example: The TP policy may stipulate that a manufacturing factory should charge cost plus 5% for goods produced and transferred to its group company for further distribution. However, regular internal TP reviews are essential to verify whether the factory has included all direct, indirect, and overhead costs as precisely defined in the TP policy. Any disconnect between documentation and actual plant accounting must be identified and corrected immediately to prevent tax adjustments upon audit.
8. Impact of COVID-19 & Benchmarking Challenges
COVID-19 has impacted businesses and governments across the world. Enterprises are transitioning into digital integration. The biggest challenge is to manage profitability and disrupted supply chains. During the COVID-19 crisis, companies recorded operational results that differed significantly from normal levels and were likely to incur unprecedented operating losses.
While tax authorities appreciate that losses can be incurred in independent situations due to unfavourable economic conditions or other legitimate business factors, it remains to be seen how these factors can be identified and quantified for transfer pricing purposes.
The Contemporaneous Data Asymmetry Dilemma
From a benchmarking perspective, the search for comparables entails inherent challenges, particularly for FY 2020-21:
- At the time of preparing contemporaneous documentation, public database availability is practically limited to prior financial years (FY 2018-19 and FY 2019-20);
- Both of these prior years reflect pre-pandemic economic conditions untouched by the COVID-19 downturn;
- Conversely, the true impact on profitability is visible only in FY 2020-21 margins for both taxpayers and comparables.
Taxpayers must therefore take proactive steps to mitigate potential audit risk by documenting capacity underutilization, abnormal idle costs, and supply chain disruptions. In turn, tax authorities must undertake transfer pricing audits considering prevailing economic headwinds rather than applying mechanical pre-crisis benchmarking filters.
The detailed TP documentation and economic analysis will have to factor in changes right down to the individual company level. Within the same industry, certain companies flourished and earned supernormal profits (e.g., healthcare and digital tech), while others were forced to shut down operations entirely.
9. Concluding Remarks & Strategic Imperatives
Transfer pricing as a practice has gradually evolved over the last couple of decades. There is an increased focus on whether the actual transaction possesses the ‘commercial rationality’ of arrangements that would be agreed between unrelated parties under comparable economic circumstances. This aligns directly with paragraph 1.122 of the OECD Transfer Pricing Guidelines 2017.
From an Indian as well as a global perspective, there has been an increased focus on the substance and commercial rationale of a transaction. Many corporates have undertaken restructuring of their businesses considering the COVID-19 pandemic. From a business perspective, restructuring is considered a favourable business decision to help companies grow or sustain.
Tax saving may not necessarily be the only driving force behind a restructuring; however, it attracts extra scrutiny from tax authorities worldwide under transfer pricing tax laws. Therefore, robust TP documentation, well-drafted intra-group agreements, and a commercial rationale driving the transformation are essential in reducing the risk of potential tax audits and consequent adjustments.
The functional analysis forms the bedrock of judicial decision-making for appellate tribunals and courts, providing the necessary factual matrix to assess economic reality. Hence, it is paramount that multinational enterprises properly document their international transactions through comprehensive, substance-driven functional and economic analyses.
“Robust TP documentation, well-drafted intra-group agreements, and a commercial rationale driving the transformation are essential in reducing the risk of potential tax audits and consequent adjustments. The functional analysis forms the basis of decision-making for the courts and helps them to assess the facts.”