NRI setting up business in India? Watch out for transfer pricing

Over the past decade, India has become a big opportunity for global entrepreneurs looking to grow a successful business. The liberalization, booming middle class, and growing jobs and salaries have made India an attractive destination. At the same time, setting up a business in India means navigating through the various tax and legal complexities. And one of the major tax laws that needs to be kept in mind is the one on transfer pricing.
Principal - Transfer Pricing, BDO. "For instance, take the case of a US parent company with a subsidiary in India. Both companies may make inter-company transfer of funds, often without a proper documentation and support for tax purposes. They tend to believe that transfer pricing is not an issue because the funds remain within the same commonly owned group, and the intercompany transfers are eliminated in consolidation anyway. While it is true that intercompany transactions are eliminated in consolidation, it is important to remember that the two companies are located in different tax jurisdictions and the tax authorities in each jurisdiction will want it's fair share of profits and taxes" she adds.
So in a series of articles, we will explore the various aspects of transfer pricing. Let us begin with understanding the transfer pricing rules in India.

The crux of Indian transfer pricing rules
Transfer pricing refers to the pricing of intercompany transfers of goods or services. Most countries around the world have implemented transfer pricing regulations with the aim of preventing tax evasion.. The Indian Government tries to ensure that it does not face tax leakages on account of an Indian company overpaying or being underpaid respectively, for goods and services received or rendered, both these situations will lead to lower profits in India and therefore lower taxes.
Transfer pricing rules can be found under Section 92 to 92F of the Indian Income Tax Act. To put it in a single sentence, the transfer pricing code states that income arising from international transactions between associated enterprises should be computed having regard to the arm's-length price. The three main aspects are 'international transaction,' 'associated enterprise' and 'arms length price.'

What is international transaction?
International transaction means a transaction between two or more associated enterprises involving:
- sale, purchase or lease of tangible like machinery, equipment, tools, commodities, products etc.
- sale, purchase or lease of intangible property like copyrights, trademarks etc.
- provision of services like market research, design, consultation, administrative services etc.
- cost-sharing arrangements.
- lending/borrowing of money.
- Any other transaction having a bearing on the profits, income, losses or assets of such enterprises.
Example: Company A is a US holding company with operations in India through subsidiary company B. Company A transfers $ 1 million to company B for vendor payments. At the end of the financial year, all such amounts must be accounted for as funds received for specific purposes, such as administrative services or consultancy services or any other appropriate transaction. If they are loans, then appropriate interest payments must be reported.

Who are associated enterprises?
Two companies are said to be 'associated' if one company participates, directly or indirectly, or through one or more intermediaries, in the management or control or capital of the other enterprise. The participation can also be through people.
The Act goes on to define participation. For instance, if one company holds 26% of voting power of the other, the former is said to be participating in the latter. Or if 90% or more of the raw materials and consumables required for the manufacture or processing of goods or articles carried out by one enterprise, are supplied by the other enterprise, they are said to be associated.
The associated enterprises for transfer pricing purposes could be either two non-residents or a resident and a non-resident. A permanent establishment (PE) of a foreign enterprise also qualifies as an associated enterprise.

What is arms-length pricing?
Arm's length price means a price which is applied or proposed to be applied in a transaction between persons other than associated enterprises, in uncontrolled conditions. That means the price that would have been charged if the two companies were not related.
There are several methods of calculating transfer price and no method is accorded greater or lesser priority. Therefore, in calculating transfer price of your company, you would need to choose the method that best suits your company's business environment.
Example: Continuing the example of companies A and B, if the payment is indeed toward administrative expenses, then there must be a valid agreement between the two companies showing the agreed price for transfer of services and that price must be at arms-length.

Conclusion
"The Indian government is very aggressive in auditing multinational companies for compliance with transfer pricing regulations," cautions. "Transfer pricing documentation is mandatory for all international transactions above INR 10 million. Further, international transactions above INR 150 million are compulsorily required to undergo audit. So it is critical to plan your transfer pricing policy before you begin your cross border operations."

In the next part we will look at best practices in developing your company's transfer pricing policy.

Businesses usually know what to look out for on the transfer of goods within a group, but what about services? This is an area of risk not only for multinationals with large Head Offices, but also for SMEs. For example, the French entrepreneur who expands into Belgium and centralizes the bookkeeping or sets up a loan for the Belgian business should beware.

This article gives a basic outline of the principles and practice of transfer pricing as it applies to intergroup services. Ultimately, transfer pricing is a complex subject and professional advice is needed to avoid expensive surprises from the taxman.

Does your business model need transfer pricing?

Some groups use a decentralized model made up of self-contained subsidiaries with little interference from the parent. The shareholder acts as a financial investor in operating companies that are measured on their bottom line and behave almost like independent businesses. Here, the businesses share few services, making their transfer pricing less of an issue.

More commonly, international groups adopt a centralized model, because of economies of scale or concentration of expertise or know-how. Transfer pricing then becomes critical to a head office supplying services to its operating companies. While, for example, separate manufacturing companies and distribution subsidiaries may assume many of the normal risks associated with running a business, they may receive non-core services, such as IT, legal and HR support, from the head office. These services need to be charged and paid for. The nature of some industries demand centralization of services: courier companies must use common systems, tech companies centralize research and development, as does the pharmaceutical sector.

OECD transfer pricing guidelines and the ‘arm’s length principle’

The guidelines look to establish two facts for intergroup services: whether a service has been provided and the price that should be paid for those services.

The price should conform to the ‘arm’s length principle’: looking at any transaction between related parties, would two unconnected third parties have entered the agreement under the same terms and conditions (assuming a willing buyer and a willing seller)? If not, then the taxman can adjust the profits from the transaction.

What is a service?

A service must confer an economic or commercial advantage to the recipient. Put another way, would an independent company be willing to pay for such a service? Examples of typical services include: administration, accountancy, marketing, recruitment, and training.

But just because a head office incurs a cost does not mean it provides a service.

Duplicated services seldom qualify because of the commercial benefit test. On the other hand, a group company should not be charged for incidental economic benefits; for example, a group acquisition that enhances sales, because they could not be sold to or by an unconnected third party. Equally, an advantage gained purely from being a subsidiary of a creditworthy owner should also fail the test, although tax authorities are developing policy around ‘affiliation benefit’ in interest rate pricing.

Methods of charging

There are two methods of charging for a service: direct or indirect.

A direct charge is the approach preferred in the OECD guidelines. This is straightforward when the service is quantifiable and you can point to a market rate of pricing. An example would be legal services where you can quantify the hours worked and charge a market hourly rate. This method is known as comparable uncontrolled price or CUP.

But what if it’s not that simple to quantify the service? Where a direct charge is not practicable, you may use an indirect charging method by allocating costs across group companies. However, you can’t just divide costs arbitrarily; the method must be sensible and the allocation key relevant.

Take, for example, marketing services: turnover is an acceptable key, as the larger the turnover the more support may be needed. By contrast, the main business driver for payroll services is headcount.

Risk management

Regular TP risk management helps avoid tax surprises resulting from profit adjustments or non-compliance penalties. The board and its advisers should review questions such as:

• Will your transfer pricing strategy pass audit?
• Will your transfer pricing pass investigation by local tax authorities?
• Is your documentation adequate?

Remember, with good documentation it is up to a tax inspector to prove your TP is wrong. Without it, you make it easy for an inspector to substitute different (usually disadvantageous) numbers for the related party transactions in the tax return.

Poor documentation poses the commonest risk of all. Contemporaneous documentation is a legal requirement in many countries; its absence often means a fine, sometimes monthly until the documentation is produced. Directors could even be committing a criminal offence if they sign a tax return without checking the TP position.