Audit for Transactions: Section 92E of Income Tax Act
The advent of globalisation in the early 90s saw India becoming the preferred destination for multinational corporations. These MNCs around the globe are attracted to the country’s largely underserved market. From fast food to electronics, every industry saw a rise in competitors vying for the attention of the Indian consumer.
For ease of doing business in a country, a corporation generally needs to establish a subsidiary there or build a relationship with a resident company. The parent company and a resident entity are referred to as Associated Enterprises (AE).
The transactions between AEs may differ in pricing from the regular market. The management of prices for selling tangible or intangible assets and services between AEs is called Transfer Pricing.
Section 92E and other related sections are how the income tax department regulates Transfer Pricing. These provisions were added to Chapter X of the IT Act in 2001.
At this stage, you may be wondering:
How Does Transfer Price Influence Tax?
The ease of being present and doing business in different jurisdictions allows corporations the chance to take advantage of the difference in tax rates between countries by structuring their transactions in such a way that shifts their profits to lower tax jurisdictions.
For example, let us consider X is a company from Country 1 that manufactures smartwatches and sells them in India through their subsidiary Y.
So, X designs and manufactures the smartwatches at a cost price of INR 6,000 and then ships them to their subsidiary Y in India.
Y receives the shipment while also doing the work of marketing, distributing, and maintaining the smartwatch for INR 3,000.
Suppose that the selling price of the smartwatch in India is INR 12,000 the profit recorded would ideally be:
Sale Price – Cost Price
= 12000 – (6000 + 3000)
= 12000 – 9000
Now, this INR 3000 is the taxable income which X will need to record in their books, whether in India or Country 1. If the tax rate of India is higher than Country 1, X can choose to manage that profit by saying Y is “buying” the smartwatches from X.
Suppose they want to move the entire profit to Country 1. In that case, they would say Y buys the smartwatches from X for INR 9,000. As a result, the following would be their breakup of profits:
Country 1 (lower tax)
Cost of manufacturing: INR 6,000
Income from selling to Y: INR 9,000
Net Profit: INR 3,000
India (higher tax)
Cost of buying from X: INR 9,000
Cost of marketing and distribution: INR 3,000
Sale price in the market: INR 12,000
Net Profit: INR 0
This price that X charges from Y is known as the Transfer Price and, as you can see, it can be used to structure transactions in such a way as to lower a company’s tax obligations. This is why countries around the world have specified Transfer Price Regulations under their respective tax codes.
Transfer Pricing Regulations in India
Indian transfer pricing regulations went into effect on April 1st 2001 as a result of the Finance Act of the same year. Sections 92 to 92F form the backbone of this legislation.
Here are the relevant provisions:
- Section 92: Income arising from international transactions between associated enterprises is computed from the “arm’s length price”. The “arm’s length price” is the price of the service/item when a trade is conducted between two entities that do not share any relationship. It also clarifies that Transfer Pricing provisions will not apply to those cases where applying them causes a reduction in the taxable income or a loss
- Sections 92A and 92B deal with defining “associated enterprises” and “international transactions”
- Section 92C lists the various methods that can be used to compute the “arm’s length price” mentioned above. These include the comparable uncontrolled price method, resale price method, cost plus method, profit split method, transactional net margin method and any other method deemed fit as per the Central Board of Direct Taxes (CBDT)
- Section 92D provides the way entities are required to keep and maintain information regarding international transactions including documents specified by the CBDT
- Section 92E necessitates all entities who have conducted international transactions in previous years to obtain a report from a chartered accountant that is to be filed before November 30th of the relevant assessment year
- Section 92F simply clarifies the meanings of the various terms mentioned above including “accountant”, “arm’s length price”, “enterprise”, “specified date” and “transaction”
Here are a few key features of India’s Transfer Price Regulations that all entities must keep in mind while conducting international transactions:
The regulations apply to international transactions conducted between two or more Associated Enterprises, either or both of whom are non-residents. These provisions can also be applied to certain specified domestic transactions.
The following kinds of transactions are mentioned as applicable under this section:
- Transaction in the nature of purchase
- Sale or lease of tangible or intangible property
- Provision of services
- Lending or borrowing money
These transactions include mutual agreements or arrangements b/w two or more AEs that have a bearing on profits, income, losses, or assets.
For example, if a transaction takes place between a corporation and a non-associated enterprise, it will be considered an international agreement between two AEs if the following conditions are met:
- The assessee and the other party have a previous agreement in connection to the applicable transaction.
- This is applicable regardless of the residence status of the other party. So even if it is a domestic company with which the assessee has made an agreement, it will be considered an international agreement between two AEs under this section
In 2009, the Finance Act empowered the Board to frame safe harbour rules where authorities accept the Transfer Price declared by the assessee for transactions of specific nature. While this feature was originally only meant to last until 2019, a CBDT notification has extended these provisions to AYs 2020-21 and 2021-22.
For example, transactions related to software development services are taxed at 22% if the annual transaction value is greater than INR 500 crores while transaction values lower than INR 500 crores attract a 20% rate.
Multiple Year Data
Sometimes it can be hard to find comparable data for transactions in the current assessment year. To help assessment officers conduct comparability analysis with ease, data from up to two preceding financial years may be used in case the data for the current year is unavailable.
While conducting comparability analysis, assessment officers may also make use of the “range method” under which margins in the data set should be arranged in ascending order. Once this is done, the range of “arm’s length price” is said to be between the 35th and 65th percentile of the data set.
The primary document in connection with this section is Form 3CEB and it should be filed by November 30th of the applicable evaluation year. Here are the relevant parts of the form:
- The first part is where the auditor states that they have reviewed the financial statements and other documents pertaining to applicable transactions carried out by the assessee in the reporting year. Here, a statement from the auditor is also required on how the assessee has stored the information relating to Transfer Pricing on their books.
- In the second part, the auditor fills in the following information regarding applicable transactions:
1. List of affiliated businesses
2. Information and description of transactions
3. Arm’s length price of the transactions
4. Overall sum of the transaction determined according to the assessee’s books
Transfer Pricing Penalties
The penalties under these regulations are applied when the assessee fails to submit a report by the specified date. These penalties are calculated under sections 271BA and 271AA of the IT Act.
Frequently Asked Questions
Is transfer pricing taxable?
Transfer pricing is a practice of accounting that allows businesses to easily conduct transactions amongst one or several Associated Enterprises. Tax is charged on the “arm’s length price” in the applicable transactions, which is calculated in any of the methods listed under Section 92C of the IT Act.
Is transfer pricing illegal?
No, transfer pricing is not illegal. It allows businesses to conduct their affairs in a manner that they deem fit. However, acts such as obfuscating international transactions, not submitting reports on time, and non-maintenance of records may attract suitable penalties.
Who regulates transfer pricing in India?
In India, the Central Board of Direct Taxes creates and amends legislation regarding transfer pricing.