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B ASIC CONCEPTS AND OVERVIEW OF SPECIFIED DOMESTIC TRANSACTIONS September 2013 Presented by- CA Reena Gupta.

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Presentation on theme: "B ASIC CONCEPTS AND OVERVIEW OF SPECIFIED DOMESTIC TRANSACTIONS September 2013 Presented by- CA Reena Gupta."— Presentation transcript:

1 B ASIC CONCEPTS AND OVERVIEW OF SPECIFIED DOMESTIC TRANSACTIONS September 2013 Presented by- CA Reena Gupta

2 O VERVIEW 2 2 SDT – An Overview 3 SDT – Impact Analysis 1 Basic concepts of transfer pricing 4 Disclosure in Form 3CEB 5 Introduction to SDT

3 3 1 Basic concepts of transfer pricing

4 W HAT IS T RANSFER P RICING ? Transfer pricing is an ART (and not a science) Transfer pricing is consulting a PROCESS and not a product Why Take the Trouble? Because you have to - i.e. Legislation To be prepared for a transfer pricing Audit As a contemporaneous record To demonstrate how pricing decisions were made To show that you did adopt arms length principle To eliminate/ minimise penalties 4

5 W HAT IS A RM S LENGTH PRICE ? Arms length Price means at which Transact with each other PRICES INDEPENDENT PARTIES… 5

6 Most direct and reliable measure Comparability relies on similarity of: Must not have material product differences Minor adjustments tolerated Product Contractual terms Economic conditions 6 C OMPARABLE U NCONTROLLED P RICE M ETHOD (CUP)

7 Internal CUP External CUP Manufacturer A Related party - B Unrelated party Non-related party BNon-related party A 7 C OMPARABLE U NCONTROLLED P RICE M ETHOD (CUP)

8 R ESALE P RICE M ETHOD (RPM) Measures the value of functions performed Ordinarily used in cases involving the purchase and resale of tangible property Reseller has not added substantial value Reseller does not apply intangible assets to add substantial value More reliable if internal comparables are present 8

9 R ESALE P RICE M ETHOD – H OW TO ARRIVE AT ALP? Steps 1 Determine the gross profit margin earned in comparable uncontrolled transactions 2 Subtract the appropriate gross margin and expenses from the applicable resale price 3 The remainder will be the arms length price with the controlled entity 9

10 C OST P LUS M ETHOD (CPM) Similarity of products/services transferred – not a prerequisite Similarity of functions is a prerequisite for applying CPM Gross margins are more sensitive to difference in functions and risks Most useful method where, interalia, related parties undertake transaction in respect of: Sale of semi-finished goods Long term buy and supply arrangements Provisions of services on contract basis 10

11 Steps 1 Compute the direct and indirect cost incurred in controlled transaction 2 Determine the normal gross profit margin earned in similar uncontrolled transaction 3 Apply the margin in step 2 on amount arrived at in step 1 after making the necessary adjustments, if any to arrive at the ALP C OST P LUS M ETHOD – H OW TO ARRIVE AT ALP 11

12 The TNMM is similar to RPM & CPM as it involves comparison of margins from transactions - controlled transactions vis-à-vis uncontrolled transactions It differs to the extent that it involves comparison of net margins as against gross margins as in case of RPM & CPM TNMM can be applied as internal TNMM as well as external TNMM TNMM aims to determine arms length price by comparing financial results of tested party and selected uncontrolled parties with the application of suitable Profit Level Indicators (PLIs) using multiple year data T RANSACTIONAL N ET M ARGIN M ETHOD (TNMM) 12

13 Choice of the tested party Years of Comparison Aggregation of Transaction Identification of comparables Applying suitable PLIs Adjustment Calculations, if any Assessment of profit comparison Transactional Net Margin Method – Application 13

14 The PSM is typically applied in complex situations when other available methods (such as the CUP or the TNMM) are not sufficient to price the functions performed. Profit split methods are usually appropriate when: Transactions are very interrelated it might be that they cannot be evaluated on a separate basis Valuable, non-routine intangibles exist in transactions and profit arising to the group cannot be assigned to one of the entities of the group Significant differences between controlled and uncontrolled transactions are attributable to economies of horizontal/vertical integration Adequate comparables are unavailable to set margins for all the entities PROFIT SPLIT METHOD ( PSM ) 14

15 Entity A Entity B Profits split by A and B (unrelated parties) based on their relative contribution forms the basis for splitting profits in the controlled transaction Aggregate profits in the controlled transaction based on contribution made by both parties Profit share for Related Party X Profit share for Related Party Y Aggregate profits split based on markets valuation of each partys contribution Forms of the PSM: a.Comparable Profit Split Method (or the Contribution method) Profit Split Method – Application 15

16 Aggregate profits in the controlled transaction based on contribution made by both parties Residual Profit Residual Profit Share for Related Party X Residual Profit Share for Related Party Y Residual profits split based on each partys ownership of non- routine intangibles Minus functional returns to each party based on market benchmarks Forms of the PSM: b.Residual Profit Split Method (RPSM) Profit Split Method – Application 16

17 O THER M ETHOD 17 The introduction of the Other Method as the sixth method (insertion of rule 10AB vide notification no. 18/2012 by CBDT, DATED ) allows the use of any method which takes into account: (i)the price which has been charged or paid; or (ii)would have been charged or paid for the same or similar uncontrolled transactions, with or between non-associated enterprises, under similar circumstances, considering all the relevant facts. The various data which may possibly be used for comparability purposes could be: (a) Third party quotations; (b) Valuation reports; (c) Tender/Bid documents; (d) Documents relating to the negotiations; (e) Standard rate cards; (f) Commercial & economic business models; etc.

18 Establishing Most Appropriate Method (Rule 10C) CUPRPMCPMTNMMPSM Distribution Manufacturing Services (Total cost plus) Joint R&D Class of Transactions Methods Functions 18

19 Method Product Comparability Functional Comparability ApproachRemarks CUPVery HighMedium Prices are benchmarked Very difficult to apply as very high degree of comparability required RPMHigh GPM (on sales) are benchmarked Difficult to apply as high degree of comparability required CPMHigh GPM (on cost) are benchmarked Difficult to apply as high degree of comparability required PSMMediumVery HighProfit Margins Complex Method, sparingly used TNMMMediumVery High Net Profit Margins Most commonly used Method Transfer Pricing Method – A comparative statement! 19

20 20 2 Introduction to Specified Domestic Transactions

21 O BSERVATION BY H ON BLE S UPREME C OURT 21 Honble Supreme Court of India in the matter of CIT vs. Glaxo Smithkline Asia (P) Ltd. [2010] 195 Taxman 35 (SC) observed as follows: Domestic related parties transactions are generally revenue neutral in nature except in the following cases: If one of the related parties is loss making and the other is profit making and such profit earned is shifted to the loss making concern; or If there are different rates for two related units (on account of different status, area based incentives, nature of activity, etc.) and if profits are channeled towards the unit with lower tax rates. AO is constrained by non-maintenance of necessary documents and no specific requirement of audit / scrutiny of domestic related party transactions CBDT should consider amending certain provisions [such as S. 40A(2) and S. 80-IA(10)] of the Income-tax Act, so that domestic related party transactions could be brought into the ambit of TP regulations

22 SDT P ROVISIONS E NACTED BY F INANCE A CT, The Finance Act 2012, extended the scope of Transfer Pricing provision to Specified Domestic Transactions (SDT) Broadly SDT includes the following: Expenditure for which payment is made or to be made to domestic related parties-40A(2)(b) payment Tax Holiday/ Deductions claimed by the taxpayer u/s 80A(6)/80IA(8) or 80IA(10), where; Transfer of goods or services between various businesses of same taxpayer More than ordinary profits derived from transactions with closely connected persons No impact on the basic provisions of the above sections Value of SDT Value more than 5 crs – Arms Length Price Value equal to / less than 5 crs – Fair Market Value

23 SDT - I NTERNATIONALLY A CCEPTED P RINCIPLE 23 In many countries including UK and US transfer pricing regulations are applicable to both domestic as well as cross-border transactions As per OECDs Survey Report on Transfer Pricing Simplification Measures, in about 60% of the respondent countries, transactions among domestic related parties are subject to the arms length principle Countries: Austria, China, Czech Republic, Denmark, Estonia, Finland, France, Germany, Hungary, Indonesia, Ireland, Israel, Luxembourg, Malaysia, Mexico, Netherlands, Norway, Poland, Portugal, Russia, Slovenia, Spain, Turkey, the United Kingdom and the United States Source: Multi-Country Analysis Of Existing Transfer Pricing Simplification Measures – 6 June 2012

24 24 3 SDT – An Overview

25 SDT [ S. 92BA] – W HAT IT I NCLUDES ? 25 ClausesExplanation any expenditure in respect of which payment has been made or is to be made to a person referred to in clause (b) of sub-section (2) of section 40A Payment made or to be made for expenditure incurred with domestic related parties Expenditure/ payments only covered any transaction referred to in section 80A Any transfer of goods / services between various undertakings or units of the assessee any transfer of goods or services referred to in sub-section (8) of section 80-IA any business transacted between the assessee and other person as referred to in sub-section (10) of section 80-IA More than ordinary profits derived from closely connected persons for claiming deduction to be brought down to reasonable profits any transaction, referred to in any other section under Chapter VI-A or section 10AA (Taxpayers operating in Special Economic Zones), to which provisions of sub-section (8) or sub-section (10) of section 80-IA are applicable Covers both the above provisions on: Inter-undertaking transfer and more than ordinary profits earned by tax holiday / exempt unit any other transaction as may be prescribedto be prescribed by CBDT Excludes transactions which qualify as International Transactions

26 E XPENDITURE U / S 40A(2)( B ) 26 Substantial Interest or S.I. - Beneficial ownership of equity shares carrying not less than 20% voting power or beneficially entitled to not less than 20% share in profit Relative defined in s. 2(41) – means husband, wife, brother or sister or lineal ascendant or descendant of that individual S.I. Company (vi) Company (vi) Assessee / Taxpayer Company Company (iv) Company (iv) Company (iv) Company (iv) Director (iv) Director (iv) Relative (iv) Relative (iv) S.I. Director (ii) Director (ii) Relative (ii) Relative (ii) Company (vi) S.I. Relative (iii) All Companies in which such individual is a Director (v) All Companies in which such individual is a Director (v) All Directors of all such Companies (v) All Directors of all such Companies (v) Relative (v) Individual (iii) S.I.

27 I LLUSTRATION – E XPENDITURE U / S 40A % 20% A & B Yes A & C Yes A & D ? A & E ? B & C Yes* D & E ? Transactions covered ? * Post Budget 2012 amendment under section 40A A B D Requirement to justify that expenditure not excessive or unreasonable and meets the arms length criteria C E

28 T RANSACTIONS C OVERED U / S 80A 28 Section 80A applies to deductions to be made in computing total income under Chapter VI-A 80A(6) has been amended by Finance Act 2012 to provide that in case of SDT, the market value shall be computed at Arms Length Price The provisions apply only to inter-unit transfer of goods and services, where one unit being the eligible unit. It does not cover transactions of eligible unit with third parties The provisions envisage the determination of profits and gains of the eligible unit for calculation of deduction, and may not have an impact on the Gross Taxable Income of the taxpayer No deduction under chapter VI-A, where Arms Length Price determined by the TPO is different from the consideration recorded in accounts

29 T RANSACTIONS C OVERED U / S 80-IA(8) 29 Where any goods or services of the eligible business are transferred to any other business carried on by the assessee, or vice versa, and the consideration for such transfer is not at market value, then the profits and gains of eligible business shall be computed at the market value New explanation - For the purposes of this sub-section, market value, in relation to any goods or services, means ( i ) the price that such goods or services would ordinarily fetch in the open market; or ( ii ) the arm's length price as defined in clause ( ii ) of section 92F, where the transfer of such goods or services is a specified domestic transaction referred to in section 92BA. Similar (overlap) to section 80A the provisions apply only to inter-unit transfer of goods and services, where one unit being the eligible unit No deduction under chapter VI-A, where Arms Length Price determined by the TPO is different from the consideration recorded in accounts

30 T RANSACTIONS C OVERED U / S 80-IA(10) 30 Where it appears to the Assessing Officer that, owing to the close connection between the assessee carrying on the eligible business and any other person, the course of business between them is so arranged that the business transacted between them produces to the assessee more than the ordinary profits, the Assessing Officer shall, take the amount of profits as may be reasonably deemed to have been derived therefrom. New insert - Provided that in case the aforesaid arrangement involves a specified domestic transaction, the amount of profits from such transaction shall be determined having regard to arm's length price. Section 80-IA(10) refers to the course of business, which may have a wider meaning than business or a transactions, and may intend including the circumstances surrounding the transactions. The ALP analyses the transaction more holistically and best represents such situations. Close connection not defined, will pose a challenge at the time of filing Form 3CEB

31 I LLUSTRATION – T AX H OLIDAY U NDERTAKINGS 31 B & C Yes Tax holiday undertaking DTA undertaking Transactions covered ? A BC D At-least one transacting unit has to be an eligible unit under chapter VI-A or section 10AA Taxpayer Close connection C & D No B & D Yes* *If D is closely connected to A

32 O THER SECTIONS TO WHICH S 80-IA(8)&80-IA(10) A PPLY 32 The provisions include any transaction, referred to in any other section under Chapter VI-A or section 10AA (Taxpayers operating in Special Economic Zones), to which provisions of sub-section (8) or sub-section (10) of section 80-IA are applicable The other sections under chapter VI-A, include: 80-IAB – Undertakings engaged in SEZ development 80-IB – Industrial undertakings 80-IC – Industrial undertakings or enterprises in special category states 80-ID – Undertakings engaged in Hotels and convention centers in specified area 80-IE – Undertakings in North-Eastern states Sub-section (7) of section 35AD provides that the provisions contained in sub-section (6) of section 80A and the provisions of sub-sections (7) and (10) of section 80-IA shall, so far as may be, apply to this section in respect of goods or services or assets held for the purposes of the specified business. However, section 35AD does not fall within chapter VI-A, hence the SDT provisions do not apply to section 35AD

33 33 4 SDT – Impact Analysis

34 I MPACT A NALYSIS - O LD VS. N EW 34 Fair Market Value Arms Length Price The price which goods or services would have fetched or cost in the open market Most appropriate method out of the six methods No documentation required to be maintained Contemporaneous documentation required to be maintained Other than reporting in tax audit report, no statutory compliance Accountants Report Form 3CEB to be filed Assessment done by the Assessing Officer Assessment done by the Transfer Pricing Officer No method prescribed for computing fair market value A price which is applied in a transaction in uncontrolled conditions No specific penalty provision for reporting/maintaining documents Penalty for non-reporting/ not maintaining prescribed documents

35 T AX B URDEN, IF SDT IS NOT AT ALP 35 X Ltd. (non-tax holiday) Y Ltd. (non-tax holiday) Purchase at ` 120 v/s ALP i.e. ` 100 X Ltd. (tax holiday) Y Ltd. (non-tax holiday) Sale at ` 120 v/s ALP i.e. ` 100 X Ltd. (tax holiday) Y Ltd. (non-tax holiday) Sale at ` 80 v/s ALP i.e. ` 100 Disallowance of ` 20 to Y Ltd [40A(2)(b)] Double Adjustment Tax holiday - ` 20 not allowed to X Ltd – [80IA(10)] (more than ordinary profits) Disallowance of ` 20 to Y Ltd - [40A(2)(b)] Inefficient pricing structure – reduced tax holiday benefit claimed by X Ltd., since, sale price is lower than ALP [s. 92(3)]

36 T AX B URDEN, IF SDT IS NOT AT ALP …..C ONTD. 36 X Ltd. (tax holiday) Y Ltd. (non-tax holiday) Purchase at ` 120 v/s ALP i.e. ` 100 Disallowance of ` 20 to X Ltd - [40A(2)(b)] Increase in Gross Total Income of X Ltd Whether enhanced deduction is allowed to X Ltd u/c VI-A: No [Proviso to s. 92C(4)] X Ltd. (tax holiday) Y Ltd. (non-tax holiday) Purchase at ` 80 v/s ALP i.e. ` 100 No effect on the Gross Total Income of X Ltd. Whether reduced deduction is allowed to X Ltd. Yes [s. 80-IA(10)]

37 T AX B URDEN, IF SDT IS NOT AT ALP ….. C ONTD. 37 X Ltd.s U-1 (tax holiday) X Ltd.s U-2 (tax holiday) No effect on the Gross Total Income of X Ltd. Whether reduced deduction is allowed to U-1: Yes [s. 80A(6) or s. 80-IA(8)] Whether enhanced deduction is allowed to U-2: No [Proviso to s. 92C(4)] Sale at ` 120 v/s ALP i.e. ` 100 X Ltd.s U-1 (tax holiday) X Ltd.s U-2 (non-tax holiday) No effect on the Gross Total Income of X Ltd. Whether reduced deduction is allowed to U-1: Yes [s. 80A(6) or s. 80-IA(8)] Sale at ` 120 v/s ALP i.e. ` 100

38 38 5 SDT - Disclosure in Form 3CEB

39 On June 10, 2013, CBDT notified new Form 3CEB containing disclosure of SDT – Part C to Form 3CEB Clause 21, inter alia, requires the taxpayer to disclose PAN number of the AE Clause 22 - disclosure of payment made to person referred to in S. 40A(2)(b) Clause 23A – disclosure of inter-unit transactions (in the nature of sale by the eligible business/ unit of the taxpayer) as referred to in S. 80A(6), 80-IA(8) or 10AA Clause 23B – disclosure of inter-unit transactions (in the nature of purchase by the eligible business/ unit of the taxpayer) as referred to in S. 80A(6), 80-IA(8) or 10AA Clause 24 – disclosure of business transacted with closely connected person ( which has resulted in more than ordinary profits to an eligible business/ unit of the taxpayer ) as referred to in S. 80-IA(10) or 10AA Clause 25 – disclosure of any other transaction not covered in the above clauses [residual clause] A CCOUNTANT S R EPORT IN F ORM 3CEB 39

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