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October 21, 2020

CBDT restates tolerance range under transfer pricing rules

by CA Shivam Jaiswal in Income Tax

CBDT restates tolerance range under transfer pricing rules

The economic impact of the 2020 coronavirus pandemic in India has been largely disruptive. The lockdown though necessary has led to a disastrous impact on the economy. The Government of India announced a variety of measures to tackle the situation, from food security and extra funds for healthcare and for the states, to sector related incentives and tax deadline extensions. However, the Central Board of Direct Taxes (CBDT) on Monday restated tolerance range of 1-3% under transfer pricing rules for the current financial year even though experts said it was expected that the tax department would provide concession given the Covid-19 pandemic.

What do you mean by transfer price?

Commercial transactions between the different parts of the multinational groups may not be subject to the same market forces shaping relations between the two independent firms. One party will transfer to another, goods or services, for a price. That price is known as “transfer price”. This may be arbitrary and dictated, with no relation to cost and added value, diverge from the market forces. Transfer price is, thus, a price which represents the value of goods or services between independently operating units of an organisation.

But, the expression “transfer pricing” generally refers to prices of transactions between associated enterprises which may take place under conditions differing from those taking place between independent enterprises. It refers to the value attached to transfers of goods, services and technology between related entities. It also refers to the value attached to transfers between unrelated parties which are controlled by a common entity.

For instance, a subsidiary company, resident in country A (which has a tax rate of 30%) manufactures goods and transfers them to its parent company in country B (which has a tax rate of 20%) for trading. In order to increase the overall profits of the group company, it will seek to supply the goods at prices which are lower than the market price. So, in effect, the subsidiary company in country A will have lower profits and hence, a lower tax incidence whereas the parent company in country B is affected in the opposite manner higher profits due to low costs, but lower taxes because of the tax rate.

Transfer pricing deals with the technique where companies sell goods and services to related entities at an inflated price to deliberately reduce profits and tax liability. The law requires that goods and services should be sold to subsidiary companies at arm’s length price.

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What do you mean by ‘specified domestic transactions’?

In order to mitigate tax arbitrages in transactions entered into between domestic companies, the concept of Specified Domestic Transactions was introduced in the Income-tax Act, 1961 by Finance Act, 2012.

The definition of Specified Domestic Transactions was inserted in the Income-tax Act, 1961 by the Finance Act, 2012 wherein certain transactions between domestic companies were considered as specified domestic transactions being subject to domestic transfer pricing regulations. Following are the specified conditions that are required to classify transactions as specified domestic transaction:

  • The transaction should not be an international transaction;
  • The transaction should be covered under sub-section (ii) to (vi) of section 92BA
  • The aggregate of such transactions entered into by the taxpayer should exceed the threshold limit of Rs 20 cores.

As per the provisions of the Act, once a transaction falls under Specified Domestic Transaction, all the compliance requirements relating to transfer pricing documentation, accountant’s report, etc. shall apply to it in the same manner as they apply for international transactions.

What do you mean by ‘arm’s length price’?

In simple words, arm’s length price or ALP is the price at which goods are traded between unconnected companies. According to Section 92C of the Income Tax Act, the arm’s length price in relation to an international transaction or specified domestic transaction shall be determined by any of the following methods, being the most appropriate method, having regard to the nature of transaction or class of transaction or class of associated persons or functions performed by such persons or such other relevant factors as the Board may prescribe:

  • comparable uncontrolled price method
  • resale price method
  • cost plus method
  • profit split method
  • transactional net margin method
  • such other method as may be prescribed by the Board.

The most appropriate method referred to above shall be applied, for determination of arm’s length price, in the manner as may be prescribed.

What do you mean by tolerance range in transfer pricing?

To establish an arm’s length price, Indian transfer pricing rules prescribe a range of the 35th to the 65th percentile. However, the range concept is not applicable in certain circumstances. In these cases, the arithmetic mean is used to measure the arm’s length price and the tolerance range, is brought into play

Other countries prescribe a wider interquartile range as a measure of the arm’s length range in all cases. The concept of arithmetic mean and tolerance range is not used in any other country. By retaining the tolerance range, the Indian government has provided a modest leeway to taxpayers.

If variation (both positive and negative) between the ALP and the price at which the transaction has actually been undertaken does not exceed such percentage as may be notified, then actual transaction price shall be deemed to be the arm’s length price.

The CG has the power to notify the tolerance limit applicable for every AY in determining ALP. Central Board of Direct Taxes (CBDT) had announced 1% tolerance range for wholesale trading and the 3% range for all other international transactions and for specified domestic transactions.

CBDT Notification 83/2020 dated 19th October, 2020 pertaining to tolerance range

The CBDT vide Notification 83/2020 dated 19th October, 2020re-notified the prevailing 1% tolerance range for wholesale trading and 3% range for all other transactions undertaken during the financial year ending March 31, 2020.

To qualify as “wholesale trading,” the purchase cost of finished goods must be 80% or more of the total cost pertaining to such trading activities. Further, the average monthly closing inventory of such goods must be 10% or less of sales pertaining to such trading activities.

However, no specific explanation or clarification has been provided regarding why wholesale traders have a different tolerance range.

The tolerance range can be seen as one of the effective tools available to the government to rationalise transfer pricing risk perception of multinationals doing business in India. However, considering the pandemic, it was expected the CBDT would take into account economic and business realities while notifying the tolerance range for transfer pricing cases. While, the government had provided many tax and regulatory relaxations in order to enable businesses to meet challenges erupting out of COVID-19, it was surprising to see that the tolerance range for transfer pricing was left unchanged.

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