Transfer pricing, simply put, is the art of pricing cross-border transfer of goods and services that take place between companies belonging to the same multinational group.  The subject gains high significance owing to the growth of globalisation of world economy and the increasing number of multinationals operating in several countries. More than 60 per cent of global trade takes place between related parties (i.e. companies within the same group).  This provides huge potential for efficient tax planning through proper transfer pricing.  No wonder the tax authorities are becoming more and more interested in this subject.

Moreover, given the current economic scenario, the tax authorities worldwide are rehashing their inter-national tax regimes to curb the use of aggressive tax planning ideas.  There is a common move towards aligning the tax planning with economic sub-stance.  Transfer pricing achieves this beautifully as it goes hand-in-hand with substance since the former is fundamentally based on the relevant functions and risks involved in a particular transaction.  Therefore, it is the view of the authors that once the international tax scene is reset, transfer pricing will be the only effective tax planning tool in a global context.

Lately, there have been several changes in transfer pricing rules in various countries, including the US which is one of the countries with the most developed transfer pricing regime. In India, transfer pricing was introduced in 2001. It is commendable that India has developed its transfer pricing rules and regime at an extremely fast pace. The Indian transfer pricing scene started with the introduction of detailed regulations in the Income Tax Act in 2001. Under these regulations, companies with cross-border inter-company transactions (with related parties) were required to transact at an arm’s length standard. Put plainly, the arm’s length standard reflects the pricing that one would expect in similar transactions with third (unrelated) parties. 

With any such development, there comes the baggage of its own issues. Currently, the Indian transfer pricing scenario is characterised with very high quantum of litigation. In fact, the country is considered to have one of the most aggressive tax authorities in the world when it comes to transfer pricing. Here are some peculiar characteristics of transfer pricing litigation in India:

• An extremely large number of cases picked for scrutiny by the tax office – based on a fixed thresh-old of inter-company transactions which was originally set at Rs 5 crore and was recently increased to Rs 15 crore. This has resulted in an unprecedented quantum of transfer pricing litigation, with the number of cases handled by each transfer pricing office ranging from 100 to 150. Clearly, with such a work load, it is extremely difficult to do full justice to any particular case, especially about transfer pricing, which is a highly fact-intensive subject. 

• Till date, five rounds of transfer pricing audits have been completed in India. The tax authorities, in all these audits, have been heavily focused on captive service provid-ers, mainly engaged in the software and back office processing services. Also, the focus has been on debat-ing the right profit mark-up on the cost of providing these services. Most of the transfer pricing dis-putes over these years have revolved around the selection of compa-rables. 

• In India where more than nine out of ten cases apply the transactional net margin method (i.e. test the operating profit by comparison to those of comparables), and with lack of quality comparables, undue focus on comparables can be very dangerous and would often miss the objective of determining the arm’s length price. Also, it is extremely important to first analyse whether TNMM is the most appropriate method to apply in the first place. It is alarming to see the amounts blocked in transfer pricing litigation – over a period of only three years (2004 through 2007), the total amount of transfer pricing adjustments made has crossed Rs 35,000 crore. As regards the progression of transfer pricing litiga-tion in India, over this three-year peri-od, while the number of cases audited and adjusted has remained more or less the same, the amount of adjustment has increased exponentially.  This pos-sibly indicates two things:[PAGE BREAK]

• There are higher amount of adjust-ments on the same issues. 

• New issues are being picked up by the transfer pricing officers. 

Given the above, it is no surprise that all the appellate levels are flooded with transfer pricing cases. In this regard, the government is concerned about the potential impact of foreign direct investment in India. This very concern prompted the finance minister of India to make the following obser-vations while introducing the Finance Bill, 2009 on July 6, 2009

:“In order to further improve the investment climate in the country, we need to facilitate the resolution of tax disputes faced by foreign companies within a reasonable time frame. This is particularly relevant for such com-panies in the information technology (IT) sector. I, therefore, propose to create an alternative dispute resolu-tion mechanism within the Income Tax Department for the resolution of transfer pricing disputes. To reduce the impact of judgmental errors in determining the transfer price in inter-national transactions, it is proposed to empower the Central Board of Direct Taxes (CBDT) to formulate ‘safe har-bour’ rules.

”Following this, the government has been working on the following initia-tives to address the situation:

• Dispute Resolution Panel (DRP): As an alternative dispute resolu-tion mechanism, DRPs were con-stituted in several major locations in December 2009. This process is nearing the end of the first cycle now and while there is a steep learning curve ahead, it can be a good mechanism to reduce protracted litigation as it develops further. 

• Safe Harbour Rules: The Central Board of Direct Tax (CBDT) is in the process of formulating rules for the ‘safe harbour’ provisions — a set of rules that would enable the income tax authorities to accept the transfer pricing returns with-out scrutiny. Depending on the rules that will be formed, it can surely help reduce the quantum of transfer pricing litigation as well as the compliance burden on the taxpayers. 

• Advance Pricing Agreements (APA): The Direct Tax Code (that is expected to be released in 2011) proposes to introduce APA rules in India. APAs are agreements entered into by the taxpayers with one or more national tax authorities in advance for a period of time usually ranging from 3-5 years. These agreements contain the terms agreed between the parties at which the covered inter-company transactions would be effected dur-ing the term of the APA. While not for everyone, APAs are an excellent tool to achieve certainty on transfer pricing matters. 

Also, it is encouraging to note that the Indian and the US’ competent authorities have recently reached reso-lutions on several pending cases under the Mutual Agreement Procedure (MAP). MAP is an alternative dispute resolution mechanism available to tax-payers under the bilateral tax treaty provisions to mitigate economic dou-ble taxation. Transfer pricing is highly subjective. It is very commonly under-stood and embraced that reasonable minds can disagree on transfer pricing matters. Therefore, one should always be mindful that litigation is only one alternative, and might not always be the best approach. With the growing understanding of the subject and the adoption of transfer pricing rules by the various growing economies, it is very important to understand the vari-ous alternative mechanisms available to resolve potential disputes.