Some years ago very few people had heard of transfer pricing unless they were connected with multinational companies or their tax advisors.
Nowadays it has steadily moved up the agenda and today transfer pricing is regarded as being an important part of tax risk management.
The main reason is the firm onus on the taxpayer with self-assessment systems. As it is often useful to refresh the memory, a brief look back at the basic principles might be useful.
When one company in a national or multinational group sells goods, services, or know-how to a fellow group member in another country or within the country, the price charged for these goods or services is called the "transfer price".
This price might be simply the actual cost of the goods or services, the cost plus a modest profit, or a price quite unrelated to work done or value added.
This article will consider the concerns of revenue authorities; impact of section 108 of the Income Tax Ordinance, 2001 and relevant rules of Income Tax Rules, 2002 over taxpayers; historical perspective of transfer pricing, problems related thereto, global practices and suggestions for improvement.
Why CBR or any country's revenue authority is so concerned about transfer pricing?
This can be understood with the help of the following examples;
Company A and B run a multinational group.
They have a subsidiary in another country that buys goods at Rs 100 each, which they pack and send over to company B for Rs 200 each.
Thus, the transfer price is Rs 200.00. Company A has made a profit of Rs 100 and Company B's cost is Rs 200.
Company B then sells them for Rs 300 each because that is what the market will bear in this country, and company B makes a profit of Rs 100.
Now the group comes to the important bit. If the tax on companies in Company A's jurisdiction is 20% and in company B's jurisdiction is 40%, the overall tax paid is Rs 20 + Rs 40 or Rs 60 in aggregate.
But if company A transferred the goods to us at the actual cost of Rs 100, and company B sold them at the market price of Rs 300 making a profit of Rs 200, the overall tax bill would be Rs 80, or, to put it in another way, 1/3rd higher. This straightforward example illustrates how transfer pricing works.
This example will illustrate how profits can be shifted from a high tax regime to a low one. In this case company A and B agreed over a transfer price of Rs 290 and, again, company B sells the goods for Rs 300 each.
Of course, company B makes only Rs 10 profit, but the overall tax bill now is 20% on their profit of Rs 190 - Rs 38 and 40% on Rs 10 = 4, which adds up to an overall bill of Rs 42 instead of the Rs 80 unadjusted tax in the previous example.
Similarly, transfer pricing is also used to take refunds from the revenue authorities apart from some other legal avenues of transfer pricing.
All this is perfectly legal until a country introduces transfer-pricing rules, that is, section 108 of the Income Tax Ordinance, 2001.
It is little wonder then, that the revenue authorities are very concerned about losing tax revenues in this way.
Of course, these are somewhat simplified scenarios, but they do illustrate the point. And, of course, it must be said that responsible groups do not act in this way, but even they cannot ignore the issue because CBR will examine returns closely with transfer pricing in mind.
INCOME TAX ORDINANCE, 2001: Section 108, transaction between associates, is the first section of the chapter on Anti-Avoidance.
This new section has catered the transactions with resident and non-resident in contrast to section 79 of the repealed Income Tax Ordinance, 1979 which solely caters to the transactions with non-residents and much of the reported cases are related to transfer pricing transactions with non-residents.
In the light of such reported cases, the Central Board of Revenue has also framed the rules by specifically emphasising the concept of transfer pricing merely - refer rule 20 to 27 of Income Tax Rules, 2002.
As per the said section, the commissioner is authorised to distribute, apportion or allocate between the persons to reflect the income that the persons would have realised in an arm's length transaction, related to the following.
-- Income,
-- Deduction and
-- Tax credits
The commissioner may determine the following in relation to above referred adjustments.
SOURCE OF INCOME: Nature of any payment or loss as revenue, capital or otherwise
The word may as used in sub-section (2) of section 108 need not be construed as must but ought to.
This section enables the commissioner to demand tax, additional tax and challenging accounting practice; hence, she/he must support his/her action and must determine the basis. Central Board of Revenue needs to consider the implication of this change.
The obvious reason is that the commissioner may challenge whether the appropriate valuation methodology has been adopted and whether the arm's length price adopted is correct.
Enquiries may lead to lengthy and often protracted negotiations, with great expense to the taxpayer in terms of investment of time and advisors fees.
If the commissioners subsequently argue for a transfer pricing adjustment the taxpayer may be open to the imposition of penalties.
In order to avoid the frivolous challenge methodology of the legal transactions, which will ultimately be reversed in higher appellant forums, the Central Board of Revenue needs to replace the word may in sub-section (2) of section 108 with must.
INCOME TAX RULES, 2002: Chapter VI of Income Tax Rules, 2002 has specifically been devoted to the taxonomy of section 108.
If a transaction between associates is not made in accordance with arm's length principle then rule 20 empowers the commissioner to distribute, allocate or apportion the income, expense or tax credit between the associates according to the arm's length standard of rule 23.
The term arm's length is neither defined in Income Tax Ordinance, 2001 nor Income Tax Rules, 2002.
The term can be defined as of or relating to dealings between two parties who are not related or not on close terms and who are presumed to have roughly equal bargaining power; not involving a confidential relationship.
It is worthwhile here to note that and arm's length transaction does not create fiduciary duties between the parties.
The commissioner is authorised to apply arm's length standard to a transaction between associates whereby if the transaction's result is inconsistent with the arm's length result between uncontrolled persons, that is, unassociated persons.
In order to determine the arm's length result, the commissioner is equipped with following methods.
-- Comparable uncontrolled price method
-- Resale price method
-- Cost plus method
-- Profit split method
-- Any other method
Comparable uncontrolled price method is a judgmental method based on knowledge of the evidence.
In order to apply the method, the commissioner must demonstrate that such evidence' s evidential circumstances or facts resemble or closely related, whichever is applicable, with the transaction.
The concept of comparable uncontrolled transactions in rule 21(1)(a) is the most ill-defined concept due to bad drafting and will be subject to a conflict with basic law.
Resale price method compares the amount charged in a controlled transaction with resale gross margin realised in comparable uncontrolled transactions.
The resale price margin of a controlled transaction shall be determined with either reference to the person earns on products purchased and sold or an independent person earns in a comparable uncontrolled transaction. The formula for determining arm's length result is as follows.
Resale Price [Purchased from associate and sold to an unassociated person].
LESS: Gross margin [Selling cost and operating expenses/cost].
LESS: Associated purchase cost [custom duty, insurance, freight etc].
ARM'S LENGTH RESULT: Cost plus method determines the amount charged in a controlled transaction with cost plus mark-up realised in comparable uncontrolled transactions.
The cost plus mark-up of a controlled transaction shall be determined with either reference to the person or an independent person earns in a comparable uncontrolled transaction. The formula for determining arm's length result is as follows.
COST INCURRED BY THE PERSON IN A CONTROLLED TRANSACTION:
ADD: Mark-up [functions performed and market condition]
ARM'S LENGTH RESULT: Profit split method is applicable when the above-referred three methods cannot be applied reliably.
This method is applicable in the case where transaction is of complex nature and cannot be segregated.
This method requires the commissioner to treat the associates like an association of persons or firm, who agree to divide profits like independent persons in an arm's length transaction.
Under this method, the commissioner is authorised to divide the profit on any of the following basis.
-- Contribution analysis
-- Residual analysis
-- Any other base
As we know that contribution is the residue of sale and variable cost [more appropriately direct cost].
The commissioner is authorised to divide the contribution on the basis of relative value of functions performed by each participating person in the controlled transaction.
The residual analysis base is similar to the management accounting technique of return on investment [ROI].
The profit is allocated between the associated persons on the basis of basic market return on such similar transactions for this type of transactions.
Any residue will then be allocated on the basis of facts and circumstances of the transactions.
In any other case, the commissioner is authorised to use any other base, which is appropriate for the circumstances relating to the transaction.
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