Transfer Pricing of Related Party Transactions – Only a Tax Concern?
The author is a member of the Institute of Chartered Accountants of India (ICAI). He can be reached at eboard@icai.in.
1. Introduction: Beyond the Tax Lens
Related Party Transactions are subject to intensive scrutiny by tax authorities and consequently subject to additional recognition, valuation and disclosure requirements. This emerges out of the conviction that transfer pricing of related party transactions do not reflect pricing as determined by the market forces. From the point of view of the tax regulator, the relationship between the entities provides an opportunity to the taxpayer to determine the transfer price in a manner that could result in tax savings in the aggregate on account of differential tax regimes for the entities. Accordingly, regulations regarding valuation and pricing of the transactions have been prescribed to control such practices.
However, from the point of view of the management, the pricing of a transaction needs to comply with various regulations and at the same time also satisfy the apprehensions of stakeholders other than the tax regulator.
2. Stakeholders and the Diverse Risks Perceived by Them
A. Tax Regulators (Direct vs. Indirect Contradictions)
Tax regulators are concerned by pricing of the related party transactions since any deviation from the arm’s length price would have the impact of reducing the tax applicable on the transaction or consequent profits arising out of the transaction.
B. Bankers and Financial Institutions (Lenders)
“Any lender would want to monitor proper end-use of borrowed funds and ensure that the borrower always gives preference to repayment of the loan and regular payment of interest.”
Diversion of borrowed funds from banks and financial institutions by making over-priced purchases of goods and services from related parties or investments in related parties at exorbitant valuations is a concern for the banker or lender. If any funds are being diverted or being channelled out of the entity, it would create scarcity of liquidity within the entity to repay the loan or interest. Any lender would want to monitor proper end-use of borrowed funds and ensure that the borrower always gives preference to repayment of the loan and regular payment of interest. Lender is thus on the watch as related party transactions can be used by the entity to transfer out funds, consequently impacting the interest of the lender.
C. Minority Shareholders vs. Controlling Promoters
Majority shareholders in companies having controlling interest could drive the decisions of purchasing goods and services at higher prices from related parties or supplying at lower prices to related parties which are exclusively owned by them. This would drain the profits out of the companies and build up the profits of the related parties. Such practices deprive the minority shareholders of their share of profits and reserves in the companies and hence is a matter of concern to them.
D. Employees and Key Management Personnel
Employees are impacted if the funds or liquidity of the Company is diverted to related parties and there are insufficient funds available for payment of their remuneration, bonus and retirement benefits. Further, any deviation from the arm’s length price in related party transactions, results in companies within the same group not reporting profits of individual entities correctly. This makes evaluation of the Company’s results and performance of the managers distorted on account of incorrect valuation of related party transactions.
E. Public Partners in Public-Private Partnerships (PPP)
In Public-private partnership (PPP) which is a funding model for a public infrastructure project, the public partner representing the Government has apprehensions about pricing of related party transactions which would adversely impact the public infrastructure project and result in the funds being channelled out to the private sector partner.
It is thus a herculean ordeal for the corporate, to balance the concerns of the different stakeholders, while complying with all the applicable tax and non-tax regulations.
3. Regulations Governing Related Party Transactions: Tax and Non-Tax Regimes
Considering that the interest of the stakeholders is to be protected, the Government brought in several regulations to monitor the related party transactions entered into by companies. This includes both tax related regulatory measures as well as non-tax related regulatory measures.
Tax Related Regulatory Measures
From the perspective of tax related regulatory measures, transfer pricing regulations were introduced in the Income-tax Act, wherein every entity is required to maintain extensive documentation and file report from a Chartered Accountant stating the nature and value of international transactions entered into with the related parties and the method of transfer pricing adopted.
“The scope of transfer pricing regulations is also extended to domestic transactions to safeguard the interest of the revenue, in case of transactions between companies existing in jurisdictions having tax differences.”
The scope of transfer pricing regulations is also extended to domestic transactions to safeguard the interest of the revenue, in case of transactions between companies existing in jurisdictions having tax differences. Apart from that, the transactions between related parties are regulated by Clause 2(a) of Section 40A of the Income-tax Act, 1961, wherein if expenditure is excessive or unreasonable having regard to the fair market value of the goods, services or facilities for which the payment is made, or the legitimate needs of the business or profession of the assessee or the benefit derived by, or accruing there from, so much of the expenditure as is so considered to be excessive or unreasonable shall not be allowed as a deduction.
Similarly, indirect tax regulations specify separate valuation rules for related party transactions, such as in the Customs regulations and the Goods and Services Tax valuation rules.
The methods prescribed under these regulations can be grouped under two categories. The first is where the market price of the transaction is compared with the transfer price of the related party transactions. The second is where the transfer price is justified by deriving the price from the cost, selling price or by justifying the margins by comparing a profit level indicator. The methods prescribed are tabulated as follows:
| Sr. No. | Particulars | Market price-based transfer pricing methods | Other transfer pricing methods |
|---|---|---|---|
| A) | Income Tax regulations in case of International Transactions or Specified Domestic Transactions | • Comparable Uncontrolled Price method (CUP) |
• Resale Price Method (RPM); • Cost Plus Method (CPM); • Profit Split Method (PSM); • Transactional Net Margin Method (TNMM); • Such other method as may be prescribed by the Board. |
| B) | Income Tax regulations in case of other payments to related parties | • Fair Market Value | • Not applicable |
| C) | Goods and Service Tax |
• Open Market Value. • Value of supply of like kind and quality. • Amount equivalent to 90% of the price charged for the supply of goods of like kind and quality by the recipient to his unrelated customer. |
• Value of supply based on cost i.e., cost of supply plus 10% mark-up. • Value of supply determined by using reasonable means consistent with principles and general provisions of GST law. (Best Judgement method) |
| D) | Customs Laws | • The transaction value of identical goods, or of similar goods, in sales to unrelated buyers in India; |
• The deductive value for identical goods or similar goods; • The computed value for identical goods or similar goods; • Residual method |
Non-tax Regulatory Measures
From the perspective of non-tax regulatory measures, firstly the Accounting Standards require that all related parties, nature of relationship and the value of transactions are disclosed in the financial statements.
Further, the Companies Act 2013 requires that all related party transactions are approved by the Board of Directors as well as the Audit Committee and also requires the auditor to report whether these related party transactions have been correctly disclosed and have been done at a fair value. If the transactions have not been carried out at arm’s length price, the auditor is required to qualify the audit report to bring it to the attention of the various stakeholders such as shareholders, lenders, creditors, employees, regulatory authorities and other users of the financial statements.
Till date, no method for determining the arm’s length price has been specifically prescribed either by the Accounting Standards or the Companies Act, 2013. Further, there is no requirement to disclose the method of transfer pricing adopted by the management for these transactions.
Other Legal & Economic Considerations
Various studies have shown that the transfer pricing of related party transactions is influenced by factors beyond the tax related regulations and non-tax regulations. These comprise of legal factors such as technical or quality norms for products and services, intervention of Government in terms of restrictions on price or volumes, trade policies. Apart from legal factors, the management has to consider the economic factors such as exchange rate, inflation, competition, market penetration, financing modes and investor expectations.
4. Examples from Case Studies: Judicial Jurisprudence in the Automobile Industry
The fact that transfer pricing of related party transactions is not merely tax motivated can be observed from the following two case laws relating to transfer pricing disputes from the automobile industry. The method of transfer pricing adopted by companies is not available in the public domain. However, orders on transfer pricing disputes issued by the Income Tax Appellate Tribunal (ITAT) could be analysed.
Case 1: Mercedes-Benz India Pvt. Ltd. vs. Assistant Commissioner of Income Tax
The company is a manufacturer of automobiles, specifically luxury passenger cars for sale in the Indian market. The company also undertook resale in the Indian market of certain models of Mercedes-Benz cars by importing them from its associated enterprise outside India in the form of Completely Built Units (CBU). Apart from this, the company also entered into transactions for payment of royalty and import of raw materials and spare parts with its associated enterprise.
The transfer price was justified using the Transaction Net Margin Method (TNMM) by the company using net profit as the Profit Level Indicator (PLI) for all transactions by taking the view that the transactions were closely inter-related and inter-linked to the main activity of the company. On the other hand, the Assessing Officer considered resale of CBUs and spare parts as similar activities as having no value addition and having common source of products and intermediary, and hence applied Resale Price Method (RPM) by applying similar margins for both activities. In case of royalty, the Assessing Officer applied Comparable Uncontrolled Price (CUP) Method by considering the rate of royalty paid by a comparable company.
Tribunal Findings & Rationale:
- Import of CBUs: The Tribunal observed that the intention behind the import was to make available the entire global range of products to Indian customers, which ensures customer satisfaction and helps to target and identify the market conditions for a particular range of cars and also to bring new products which would take time to manufacture in India.
- Spare Parts & Warranty: The Tribunal observed that the company under terms of warranty had an obligation to provide replacement and dealers were obliged to purchase the same from the company only, which ensures genuineness of parts, and to maintain and enhance the performance of vehicles. Further, as the passenger cars had to be sold at competitive prices, the company could compensate from premium pricing of spare parts.
- Royalty on Know-How: The Tribunal observed that royalty was intrinsically linked with production and sales activity.
Case 2: Deputy Commissioner of Income Tax vs. Man Trucks India Pvt. Ltd.
The company manufactured cargo line shell trucks which is a special line of trucks specifically for Indian market and other developing countries’ markets. The trucks were manufactured as per emission norms which were acceptable in India and other developing countries, but not acceptable in Germany.
Due to excess manufacturing capacity available, the company manufactured trucks for export sale to Germany, for ultimate sale in developing countries like South Africa, Ethiopia and Indonesia. Due to stricter emission norms in Europe, these trucks were directly dispatched to the developing countries.
The sales were invoiced to Germany at Cost plus 25% less EUR 500 for warranty commitments which would not been borne by the company but would be passed on to the Associated Enterprises. However, the Assessing Officer aggregated the transactions and applied TNMM after rejecting CUP and CPM method adopted by the company.
5. Analysis of the Case Law: Factors Affecting Transfer Price and Objectives
The appeals in question are on account of dispute regarding the taxation arising from the pricing of the transactions wherein the Assessing Officer has demanded higher tax. Hence, the objective of the Company to reduce the overall tax is indicated and that of the Assessing Officer to regulate such practices is apparent. Further, other factors affecting transfer pricing can be identified from the case based on the various aspects that have been considered by the ITAT in the course of arriving at the conclusion regarding the method of pricing to be adopted:
“Management of the company has to reconcile various regulatory and non-regulatory factors and objectives at the time of pricing of the related party transactions which are beyond tax saving motivations or compliance with tax regulations.”
Corporate Objectives Manifested in the Decisions
Further, various objectives behind transfer pricing can be identified from the cases based on the various aspects that have been considered by the ITAT in the course of arriving at the conclusion regarding the method of pricing to be adopted:
Mercedes-Benz India Objectives
- Customer Satisfaction & Market Penetration: Bringing CBU units to India indicates motives to provide the entire global range, satisfy customers, build brand reputation, and penetrate luxury markets.
- Warranty & Quality Preservation: Importing genuine spares and restricting dealers preserves operating efficiency and standard of cars.
- Application Simplification: Aggregation of transactions and application of TNMM on an entity-wide basis simplifies compliance.
- Intangible Control & Fund Repatriation: Paying royalty for know-how protects group IP, ensures compensation for use, enables repatriation of funds, and facilitates performance evaluation.
Man Trucks India Objectives
- Competitiveness & Capacity Utilization: Exporting trucks to emerging markets due to domestic slowdown maximizes fixed asset utilization.
- Regulatory Compliance & Penalty Avoidance: Direct dispatch to developing countries without entering Europe bypasses strict EU emission standards.
- Internal Simplification: Applying internal TNMM benchmarks internal margins while keeping export contracts manageable.
- Centralized Asset Control: Routing orders and third-party material via the German parent with handling surcharges asserts ownership and enables performance tracking.
The companies have thus balanced multiple objectives, by efficiently managing the corporate concerns of fixing product quality and customer service, while ensuring compliance with the transfer pricing tax law.
6. Core Findings: Reconciling Business Reality with Tax Scrutiny
It is clear that the management of the company has to reconcile various regulatory and non-regulatory factors and objectives at the time of pricing of the related party transactions which are beyond tax saving motivations or compliance with tax regulations. Further, the management is also bound by commitments, whether contractual or not, to other stakeholders.
“The management has to be sensitive to the market, competition and economic environment in order to retain its market share and to sustain operations.”
The management has to be sensitive to the market, competition and economic environment in order to retain its market share and to sustain operations. Objectives of compliance with regulations and prudent decision-making practices to manage the business need to be brought together to adopt a single method of pricing for a transaction.
The method so adopted needs to play a dual role of satisfying the business requirements and also be acceptable to the tax regulators. In the first case, the assessee adopted TNMM whereas the tax authority chose CUP method and RPM. In the second case, the tax authority adopted TNMM whereas the assessee had chosen CPM. In both cases, the management adopted the transfer pricing method after due consideration of various factors and objectives affecting the transaction. The tax authorities on the other hand chose a different method to arrive at the transfer price with the primary objective of protecting the interest of the revenue.
7. Conclusion: The Need for Harmonization and Mutual Recognition
Transfer pricing of related party transactions needs to be perceived in a comprehensive manner and not just as a tax motivated act which needs to be regulated by the authorities.
“A broad-based approach from the perspective of all stakeholders needs to be adopted wherein factors beyond tax regulatory requirements need to be considered while evaluating the transfer pricing method adopted.”
A broad-based approach from the perspective of all stakeholders needs to be adopted wherein factors beyond tax regulatory requirements need to be considered while evaluating the transfer pricing method adopted.
“A more comprehensive approach is the need of the hour wherein uniformity is introduced in the methods and reporting of related party transactions under the various tax and non-tax regulations.”
There cannot be separate pricing for tax compliance and for accounting since both are oriented towards reporting transactions at their fair values. Hence, a more comprehensive approach is the need of the hour wherein uniformity is introduced in the methods and reporting of related party transactions under the various tax and non-tax regulations.
Further, mutual recognition of the methods by the regulators should be brought in. A uniform reporting system with mutual recognition would benefit all stakeholders facilitating the evaluation of the impact of the same. This would bring in relief to the management, reduce compliance costs and would be a major step towards achieving ease of business.