Transfer Pricing

Transfer Pricing
Introduction
It is now being recognised that international exchange of goods and services, like
equivalent domestic exchange, takes place both through hierarchies and on markets. The
growth of management contracts, technical assistance agreements, licensing rrangements,
etc. probably implies the expansion of non-market hierarchical influences even upon
àrms length' market transactions. The increasingly problematic role of the market as the
main instrument in the allocation of resources which these tendencies imply, seems to be
the result of increases in mechanisation, organisational scale and R and D activities which
are the basis of the joint production operations so characteristic of modern capitalism.
They often make the market irrelevant even for the distribution of end products, as prices
which earlier operated as equilibrating mechanisms now are merely accounting devices to
serve corporate objectives. It is not surprising therefore that many ostensibly arms' length
transactions can now easily take on some of the characteristics of intra-firm trade.
Opportunities for the pursuit of `restrictive business practices' within intra-firm trade
(however defined) are certainly great. The practices which are conventionally so
described, when undertaken within transnational corporate hierarchical systems are
considered the basics of good transnational corporate management. This contradiction in
approach (of the state on the one hand and private corporate entities on the other), is
reflected in their respective strategies of operation vis-a-vis each other, often to the
detriment of the economy as a whole.
Transfer pricing is one such practice, which refers to prices used for ìnternal' sales of
goods, services and technology between divisions and/or associated companies of a
business enterprise. The concept relates not only to trade operations proper, but also to
other intra-firm transactions, such as those relating to transfer of technology, dividend
remittances, royalties and technical fees payments. These transactions are mostly market
transactions between unrelated parties (ie. from arms' length prices). However transfer
pricing may also arise in transactions between unrelated parties, for eg. where one
company supplies an LDC company with more than one item, and receives more than
one kind of payment. In such cases (eg.when machinery and parts are supplied along with
know-how) payments for one item may be artificially attributed to another, for tax or
other reasons. The scope for transfer pricing in such transactions also increases in cases
with `tie-in' clauses in licensing agreements or technical/ financial collaborations which
require the purchase of goods from the licensor or party designated by the licensor.
In keeping with this broad definition of transfer pricing, in this essay we outline the
variety of forces which influence the inception, use, regulation, control and estimation of
such pricing practices. In doing so we attempt to move towards a framework within
which to analyse and check transfer pricing by large international corporations in
developing countries.
Corporate Tax Planning 1

Transfer Pricing
Motivational and Operational Aspects
By virtue of their international spread TNCs can avail simultaneously of complex tax
laws, corporate structural and other organisational laws to achieve the overall goal of
profit maximisation. Taxation of foreign income provides a legal incentive to invest
abroad and also the proliferation of ùnfair' transactions and financial manipulations.
Operationally the financial manipulations for transfer pricing take the form of false
invoicing. This practice is defined by the OECD Committee on Fiscal Affairs (1976), as
à transaction intended to evade tax by putting taxable objects outside the reach of
national tax authorities by means of an invoice that does not accord with economic facts.'
This objective is achieved through both under and over invoicing (of imports and
exports), often by the same company.
Over invoicing of imports occurs in those commodities with low or zero import tariffs,
mostly for illegal repatriation of capital to head offices; and also in sectors with internal
price control to increase the cost of production so that higher official prices/ subsidies can
be obtained. Under invoicing may be found in imports of products with high tariffs or
sales tax. Over invoicing of exports is found to be practiced by transnationals, which
produce or assemble manufactured products. The objective may be to obtain a greater
value from government export incentive schemes. Under invoicing may be undertaken to
avoid foreign exchange stipulations of domestic banking authorities.
Typically the issue of transfer pricing arises because of the existence of intra-firm trade
across national borders; but direct foreign investment, licensing agreements, joint
ventures (both technical and financial), often also provide ample scope for transfer
pricing, not only to circumvent adverse government policies, but also as a part of the
corporate strategy and organisational structure of transnational entities.
Policy induced motivation for transfer-pricing manipulations may arise because of both
tax and non-tax factors. Corporate tax rates and fiscal provisions, exchange rate
fluctuations and import duties as also labor laws, policies restricting monopolies and
restrictive trade practices, laws governing profit repatriation in particular and foreign
capital in general and import substituting/export promoting policies; all influence (and in
turn are affected by) the nature and extent of transfer pricing by transnational
corporations. But such manipulations can occur even in the absence of government
policies designed to advance domestic economic and social goals, often in variance with\
those of TNCs. Structural motivation for replacing arms length market transactions in
the acquisition of inputs, or disposal of outputs by non market devises, may arise out of
considerations of security (with respect to both prices and access to supplies, especially in
cases of long gestation period investments), transaction costs, externalities and the need
for secrecy.
Such a motivation for transfer pricing, cannot in practice be separated from policy related
inducements as both together form the framework within which TNCs operate in order to
minimise tax payments and maximise profits. However a TNC may transfer price even in
the absence of adverse government policy, in order to: maintain its market power, sustain
a high rate of self-financed DFI for further expansion, hide information from competitors,
finance R and D projects, compensate losses of one or more subsidiaries, finance
portfolio investments in other firms or sectors, finance joint ventures, provide for losses
due to nationalisation etc.

Transfer Pricing
TNCs combine centralised control and integrated corporate functioning with a

geographical dispersal of their production and investment activities. Their multinational
character is an attempt to ìnternalise' market imperfections so as to maximise current
global profits or minimise future risks and uncertainties in order to ensure long-term
gains for the corporation as a whole. A key profit motivator is global tax minimisation
and their often exists an explicit tax strategy that best serves the interests of the
corporation.
International tax avoidance to achieve these and other objectives may occur through
general manipulations, as well as through specific items in the balance sheet and the
profit and loss account.2 The former category would include: location of affiliates in tax
havens3 and their dual use as intermediaries both in purchase and sale of goods. By
adroitly invoicing goods through tax haven affiliates, the greater portion of profits
unrelated to any function performed by the tax haven affiliate, can be erroneously
recorded in the affiliate.
The existence of` unexplained' corporations in the organisation, which do not seem to
have a valid function, may also be a vehicle for tax avoidance. The same may be true in
the case of the operation of permanently loss making units and transactions between
companies which are under common control but which do not belong to the same
corporate group.
In the Balance Sheet, loans to foreign affiliates may represent the repatriation of foreign
profits in an attempt to avoid domestic payment of dividends, as also may, excessive
balances with affiliates. Write-off of inter-company debt may be attempted to reduce
balances that may have resulted from non arms length transactions. Omissions in the
balance sheet of expected assets or liabilities may indicate transfer or sale of intangible
assets like patents, knowhow etc. to tax haven affiliates.
In the Profit and Loss Account, R and D expenditures may be hidden, pooled or
distributed among companies to avoid taxes; royalties may be excessive and may go to
unlikely recipient affiliates; patents and trademarks may be charged for at monopolistic
rates, or involve reciprocal benefits and may be priced even after their expiry. In the case
of payments, for both royalties and patents and trademarks, to affiliates, the charges may
not meet with the arms length criterion. Payments for home-office administrative support,
R and D etc., may be excessive and may contain hidden profits, which are not assessed in
the country of receipt. Sales of partly finished goods, third party commissions or
discounts to foreign affiliates, unexpected purchases or sales, rentals, office and travel
expenses, changes in the pattern of accounts, liquidation and sales of foreign affiliates
etc., also provide ample opportunity for transfer pricing and consequently tax avoidance.
Thus merely by being true to themselves the TNCs can come in conflict with the state
which considers that it has suffered losses of tax revenue and see in this a challenge to its
sovereignty; and with domestic firms which see it as a serious distortion of competition
and one of the chief reasons for the expansion of TNCs. This attitude of the state reflects
the structural and resource constraints faced by most LDCs and determines the nature of
regulations to which the activities of TNCs in host economies, are subjected. The
predominance of anti-monopoly and taxation related measures to deal with TNC
operations in general and transfer pricing manipulations in particular, seem to be a

Transfer Pricing
response to factors endemic to LDCs. The effectiveness of these measures depends on the
extent to which they take into account the tendency of TNCs to maximise global profits.
Regulation of Transfer Pricing
Rules and regulations affecting transfer pricing activities of any corporate entity are
usually a combination of preventive, penalisation and adjustment measures to minimize
the impact of such manipulations on the economy. One set is concerned with
restricting/preventing such pricing manipulations. This would require the creation of an
economic environment in which the incentive to indulge in transfer pricing is minimised.
Given the intrinsic propensities of large corporations on the one hand, and the structural
constraints faced by LDCs on the other, such measures may prove difficult to implement.
Others help in identifying such manipulations and in penalisation once they have been
found to exist.Such regulation usually takes the form of either information disclosure
requirements at various levels, or valuation rules in cases of ambiguous related party
transactions.
The impact of TNCs on world output arises partly from the extent to which these
enterprises are themselves more efficient, as a result of their multinationality, and partly
by the response of such companies to government policies designed to advance their own
economic and social goals. Wherever they occur, the response of TNCs and their
affiliates to the economic environment of which they are a part, or to changes in that
environment, will, to some extent be different from other (similar) firms. This along with
the fact that some of the output generated by the affiliates in one country will accrue to
owners of resources in other countries causes both international allocation of resources
and the distribution of economic welfare to be affected. Although in a world context
transfer pricing is primarily a distributional matter, from the point of view of a particular
country, it would influence efficiency of resource usage and share of output produced. In
a mixed economy like ours this could mean a misallocation of resources (away from
planned priorities), accompanied by an adverse redistribution of incomes away from
national entities and the related BOP effects. Besides dealing with transfer pricing before
it can occur (preventive measures) and after it has occurred (penalisation measures),
policy regulation is therefore also required, to deal with its macro and micro economic
consequences. The adverse impact on host government foreign exchange inflows and
hence on the balance of payments; the growth of a parallel (black) market for foreign
exchange; revenue losses and the consequent implications for internal resource
mobilisation; distortion in the functioning of specific policy instruments resulting in the
non-achievement of plan targets; all call for an active role of the state. Similarly, at the
micro level the proliferation of market concentration and oligopolistic practices require
state intervention.
The policy environment in most LDCs, characterised as it is by greater protection
of domestic industry and closer regulation of TNC operations, is thought to be conducive
to the practice of transfer pricing manipulations. Rules regarding corporate taxation,
import duties and exchange controls, (including restrictions on repatriation of returns on
foreign investment), usually prompted by weak BOP positions and overvalued currencies,
often create incentives for transfer pricing.

Transfer Pricing
In India, the emphasis on self reliant, import substituting industrialisation and

consequently strict regulation of foreign investment, has led to the belief that
manufacturing and trading operations are over protected. The result, it is said, is
inefficiency and high cost in production, and backwardness in technology, marketing and
management techniques.
The encouragement of foreign investment, especially foreign technical collaborations and
joint ventures, since the late 1970s has thus been in response to the need for greater
competition, superior technology and more efficient organisational techniques. This has
been accompanied by tax regulations, equity restrictions and foreign exchange controls,
through FERA, MRTP, and provisions in the income tax, customs and companies acts, to
restrict malpractices associated with TNCs and prevent foreign exchange outflows. The
chronic foreign exchange problem and the corresponding negative impact on the BOP has
also led to a proliferation of measures to monitor and control outward remittances. These
include an upward limit for royalties and technical fees payments, discretionary control
on lumpsum payments, monitoring of dividend remittances, high levels of corporate taxes
etc.
If such a policy framework increases the (theoretical) possibility of transfer pricing
manipulations by TNCs , the new industrial policy6 and the budget of 1991-92, which
give greater freedom to TNCs, both in the areas, and in the nature, of participation in
domestic manufacturing and services activity, should reduce the incentive for such
practices. Indeed a major objective of these policy initiatives is to increase the net foreign
exchange inflow as a result of the activities of the TNCs in the economy. The automatic
clearance of foreign equity participation upto 51 per cent in high priority industries and in
the case of trading affiliates, the allowing of even higher equity participation in high-tech
areas and in case of 100 per cent EOUs, the freedom to import capital goods if they are
paid for in foreign exchange, the hiring of foreign technicians and foreign testing of
indigenous technologies without prior clearance and the flexibility given to the special
board on foreign investment, to overrule industrial policy provisions if necessary; are all
measures which ostensibly constitute a more liberal environment for the operation of
foreign affiliates. However, the nature of the deregulation in the new policy statement is
defined by the regulatory framework, which was already in existence. The deregulation
(as also the previous regulation) focuses on the foreign/ domestic, equity/asset
considerations, rather than on an understanding of corporate structures and organisational
forms. It therefore suffers from the same inadequacies as the previous formulations.
Secondly, while the emphasis is on improving the adverse BOP position, through
reduction in the trade deficit, linking of outward remittances to export requirements,
encouraging inflow of foreign exchange through various concessions for NRIs etc.; there
are no additional measures to prevent illegal syphoning-off of funds, through transfer
pricing and other manipulations. In fact, some incentives in the budget, like the
exemption of inward remittances from NRIs from scrutiny and (gift) taxation by the
authorities, will encourage the diversion of normal NRI remittances from legal channels
to illegal ones. Adverse implication for outward remittances (specially illegal ones) may
also result from the complete freedom to hire foreign technicians and get foreign testing
of indigenously developed technologies. Further linking capital goods imports to foreign
equity holdings, at least at the installation stage, would certainly encourage transfer
pricing. Besides this some proposals, like that of monitoring dividend repatriation to

Transfer Pricing
ensure that they are balanced by export earnings over a period of time, may be extremely
difficult to implement. These factors together with the problems of the existing legal
provisions, discussed later in this section, could exacerbate the tendency for transfer
pricing manipulations. Thirdly, the new policy statement may not be a significant
departure from earlier statements, at least as far as foreign investment is concerned.
Foreign equity upto 80 per cent in high-tech areas and upto 100 per cent in 100 per cent
EOUs was allowed for even in the 1977 Industrial Policy Statement. Freedom for
remittances of royalties, dividends and profits, for all approved foreign investments,
under given rules, was also allowed for in this statement. The only change in the 1991
policy is in terms of freeing remittances of lumpsum payments upto 1 crore from the
requirement of prior official approval.
For assessing the possible impact of changes in corporate taxes, customs duties and
exchange rates on transfer pricing manipulations by TNCs, one has to look at the budget
proposals for 1991-92.
In India nominal corporate tax rates have been higher even than tax rates in
developing countries. This together with taxes on repatriated dividends, interest and
royalties may have increase tax burdens on TNC affiliates operating in India and hence
encouraged under invoicing of sales and rerouting funds to tax haven affiliates. If this be
the case then the proposals in the current budget will only exacerbate this tendency.
Corporate tax rates have been increased by 5 percentage point and now range from 45 to
50 per cent of profits for all companies. This is not inclusive of the 15 per cent surcharge
which will still be levied. Besides this, depreciation allowance on fixed capital has been
decreased from 33.33 per cent to 25 per cent. These changes increased both the taxable
funds and the tax rates faced by foreign affiliates.
The existence of customs duties on imports, (especially ad valorem duties), as they
increase the price of imported goods, provide great scope for transfer pricing
manipulations through the under invoicing of imports. Tariffs are often a multi target
policy instrument in LDCs, used not only as protective devices to nurture ìnfant
industries' but also as a major source of revenue for the government and as an instrument
to achieve BOP equilibrium.
As such they are considered to be very high (relative to home country rates) in most
LDCs including India. In the recent budget proposals the preoccupation of the
government with considerations of resource mobilisation, has caused the customs duty
structures to remain almost unchanged. Specific duties such as those on import of
machinery for marine products industry and finished leather industry have been reduced
to encourage exports from these industries. Import duties on capital goods and
components have also been reduced by 5 percentage points. These changes may be too
insignificant to cause a decline in the incentive to under invoice imports. Similarly the
elimination of tariff peaks above 150 per cent affects imports of a limited number of
product, and leaves comparative tariff rates still to high relative to home country rates, at
least from the point of view of importing
TNCs affiliates. In other words, these policy proposals may not provide a policy
environment which will limit the illegal transfer of funds. Further, in the absence (at
present) of a nominal tariff structure if one relies on the budget to provide collection
rates, for the stated revenue targets to be achieved, these rates would have to go up by
about 9 to 12 per cent, on policy dependent imports. This would mean a even higher

Transfer Pricing
increase in nominal tariff rates, as exemptions etc. would have to be included, in their
calculation.
Currency risks, as denoted by fluctuations in exchange rates, faced by TNCs in
trade transactions in foreign (LDC) currencies, are also conducive to transfer pricing
manipulations. To avoid exchange losses TNCs often convert assets in a currency which
is expected to weaken into a stronger one, before devaluation occurs. This is done by
accelerating prospective payments in weak currencies (`leading') and delaying payments
in strong currencies (`lagging'). Transfer pricing manipulations reshuffle cash balances
between units of TNCs but cannot avoid exchange risks. If however, such manipulations
are grafted on to successful leading or lagging moves they could amplify the outcome as
more funds in weak currency could be converted into the strong currency or less units of
the strong currency could be exchanged into the weak one.9 The recent two stage
devaluation of rupee may have provided an incentive for such leading-cum-transfer
pricing manipulations combinations.
It is important to note that given these temptations for transfer pricing manipulations
which the policy environment provides, such practices can only be indulged in to the
extent governments are unable to monitor them. Therefore, the specific measures to
scrutinise relative party transactions have great significant. In India, provisions under the
Companies Act, Customs Act, Income Tax Act, and FERA exist to regulate such
transactions. Sections 212, 594 and 615 of the Companies Act require disclosure of
information about operations and finances of subsidiaries of all units falling under the
purview of the Act. Section 14 1(A) and 14 1(B) of the Customs Act, the Customs
Valuation Rules and the Customs Valuation Act (1988), all provide for customs
valuation of transactions which are not arms length; Sections 112 and 114 (or Section
167(8) of the Sea Customs Act), penalise ìmproper' trade transactions and Section 111,
allows for their confiscation. Over- as well as under invoicing of imports(section 112)
and exports(section 114) are recognized as punishable economic offenses. The taxation of
various sources of income (viz. dividends, royalties, technical fees), of foreign companies
and non-residents falls under Section 115 A, of the Income Tax Act; while section 44 D
of the act and Rules 10, 11 (Income Tax Rules), relate to the computation of this income.
Sections 92, 93 deal with cases of tax avoidance in related party transactions involving
nonresidents, and Section 173 with the recovery of these taxes. The domestic and
unilateral powers regarding discovery, production of evidence or attendance of any
person (Section 131); search and seizure (Section 132); requisition of books of accounts
(Section 132A); calling for information (Section 133); survey (Section 133A); collection
of information (Section 133B); inspection of registers of companies (Section 134);
inquiry before assessment (Section 142, 143(2), 143(3)), are ineffective in obtaining
overseas information. The Income Tax Act does not provide any investigative power to
tax administrators to have access to information relating to an international transaction. A
foreign company cannot be compelled to produce relevant books and records kept by it
abroad and foreign nationals cannot be compelled to give evidence or produce
documents. This underlies the need for international cooperation. Such cooperation is
sought and extended through double taxation agreements. Sections 90, 91 relate to the
existence of double taxation agreements with different nations, according to the UN
model (1980). Article 26(1) of this model provides for the exchange of relevant
information between tax administrators of the contracting states. The Foreign Exchange

Transfer Pricing
Regulation Act, covers foreign exchange violations of RBI directives. Section 12 (1)
requires exporters to declare the full value of goods to be exported. Violation of this
section is dealt with invoking Section 19, which gives powers of inspection and Section
22, which penalises false statements; Section 23 (1A), punishes any contravention to the
provisions of the Act for which no penalty is expressly provided.
While laws/rules do exist for dealing with malpractices in related party transactions, they
do not seem to be based on an understanding of the intrinsic logic of these manipulations.
This leads not only to inadequate coverage of intra-firm transactions at the detection
stage but also to a lack of coordination between the various statutory authorities at the
implementation stage. Each set of rules is implemented in isolation from the others and
fulfills a separate objective. The Customs Rules deal only with goods traded across the
national border and focus on their àrms length' valuation; FERA regulations are
concerned with the violation of RBIs foreign exchange directives and prevention of
undue foreign exchange losses therefrom; and the income tax laws deal with the taxation
aspect of nonresident remittances abroad. Any specific malpractice, in this case transfer
pricing, is thus approached in a fragmented and disintegrated manner. For example, either
from the tax angle or the valuation angle or the FERA violation angle.
Overall the general policy towards foreign investment does not recognise TNCs as
tangible legal entities. Rather subsidiaries of transnationals are treated in isolation from
their global operations. Such an approach precludes the possibility of detection (and
hence monitoring) of a large number of related party transactions; both within the
economy and in trade/investment transactions with the international economy.
In contrast to the national level where legal/professional requirements for disclosures
about amounts transferred and accounting policies used are sparse, at the international,
inter-government level, the UN (UNCTAD, UNCTC), OECD and EEC have been for
many years attempting to standardise accounting methods and information disclosure
norms world wide. The global reach of TNCs is sought to be countered by global
regulations. To this end, the UN proposals (1977, 1988, 1989) and the OECD guidelines
(1976, 1979, 1984, 1988), recommended disclosures of the volume and value of transfer
pricing and/or related party transactions, as well as of the accounting methods used to
determine their prices, both for the TNC as a whole and its individual sub-groups. The
Report of the Committee on Fiscal Affairs (OECD, 1979), even attempts to set out
detailed guidelines for actually determining arms length prices in transactions between
associated enterprises.
More generalised formulations, regarding harmonisation of divergent accounting
standards (UN Commission on Transnational Corporations,1989), use of market/arms
length prices in intra-corporate transactions (UNCTC, Code of Conduct for TNCs), and
Customs valuation of goods in conformity with commercial realities (GATT, Article VII)
also exist as part of the global efforts to regulate transfer pricing policies of TNCs.
However, what seems to be required is a more integrated, coordinated and consistent
approach towards related party transactions based on a deeper understanding of the
specific structural factors underlying them. Both at the policy level and at the
implementation level, there is a need to try not only to improve but also to move beyond
the information disclosure- market valuation approaches; towards a regulatory framework
which incorporates the specific structural factors endemic to LDCs on the one hand and
transnational affiliates on the other.

Transfer Pricing
Introduction of Transfer Pricing Regulaions
The Finance Act 2001 introduced the detailed Transfer Pricing Regulations (T.P.R.) in
India w.e.f.1stApril 2001 corresponding to the assessment year 2002-2003. The rules for
transfer pricing have been notified on August 21, 2001.
Need and rational for introduction of the T. P. R.
A need was felt for a detailed and separate regulation for administering transfer pricing
with globalisation of Indian economy. Absence of such Regulations not only results in
litigation but loss of revenue to the exchequer. In absence of Transfer Pricing
Regulations, India was losing its legitimate share of revenue.
How do tax authorities detect transfer pricing?
Globally several methods of detecting transfer pricing have been set out to check whether
transactions between related parties have been at arm's length.
The transaction method relies directly or indirectly on information of prices at which
similar transactions have been entered into by unrelated parties. This method is further
divided into the comparable uncontrolled price (CUP) method and the cost plus (C+)
method.
Prices charged in similar business transactions between two independent parties is the
yardstick adopted under the CUP method. Whereas under the C+ method, an arm's length
price is determined by applying an appropriate mark-up on the costs incurred.
The transactional profit method, as the name indicates, is transaction-specific: it
examines whether or not profits from a particular deal are reasonable.
Why do transfer pricing regulations gain importance in a developing country like

India?
Import of raw material, semi-finished goods for assembling and most important of all,
intellectual property such as know-how and technology are areas prone to transfer
pricing. Such goods or services can be sent to associate companies in India either at a
higher or lower rate than prices charged to unrelated parties to secure a global tax
advantage.
In a high-tech age, Indian companies often rely on technology and know-how from their
foreign joint venture partners: thus strict regulations are very important.

Transfer Pricing
What are the regulations in India that tackle transfer pricing?
The important sections relating to transfer pricing in the Income Tax Act 1961 are set in
section 40A(2), section 80 1A(9) and section 80 IA (10). The first enables tax authorities
to disallow any expenditure made to a related party which they feel is excessive. Certain
tax benefits are available under section 80 1A such as a tax holiday for a certain number
of years. If transfer pricing is suspected then the tax authorities can deny such tax
holidays.
The most important provisions in the tax laws is section 92. Here, if owing to a close
connection between an Indian entity and a foreign party, the Indian tax authorities feel
that the prices charged in a transaction were not at an arm's length they can adjust the
taxable income of the Indian party. In other words, taxable income can be enhanced if the
transaction has led to a lower profits for the Indian party.
Are the regulations in India adequate to curb transfer pricing abuse?
Transfer pricing regulations are extremely stringent in developed countries such as the
United States of America, United Kingdom, Canada, Australia and Germany.
In these countries, the tax payer has to maintain extensive records of all transactions with
related parties. In the UK, such disclosures have to be made in the self assessment returns
filed with tax authorities. In India, though provisions relating to transfer pricing
regulations are there in the Income Tax Act, 1961, they are not very effective as tax
payers are not required to maintain detailed documents or voluntarily disclose
information of related party transactions.
Transfer pricing sections under India Income-tax Act, 1961
Section 92. Computation of income from international transaction having regard to

arm's length price
1. Any income arising from an international transaction shall be computed having

regard to the arm's length price.
2. In computing income under sub-section (1), the allowance for any expense or
interest shall also be determined having regard to the arm's length price.
3. Where in an international transaction, two or more associated enterprises enter

into a mutual agreement or arrangement for the allocation or apportionment of, or
any contribution to, any cost or expense incurred or to be incurred in connection
with a benefit, service or facility provided or to be provided to any one or more of
such enterprises, the cost or expense allocated or apportioned to, or, as the case
may be, contributed by, any such enterprise shall be determined having regard to
the arm's length price of such benefit, service or facility, as the case may be.

Transfer Pricing
Section 92A. Meaning of associated enterprise
1. For the purposes of this section and sections 92, 92B, 92C, 92D, 92E and 92F,
"associated enterprise", in relation to another enterprise, means an enterprise--
a. which participates, directly or indirectly, or through one or more
intermediaries, in the management or control or capital of the other
enterprise ; or
b. in respect of which one or more persons who participate, directly or

indirectly, or through one or more intermediaries, in its management or
control or capital, are the same persons who participate, directly or
indirectly, or through one or more intermediaries, in the management or
control or capital of the other enterprise.
2. Two enterprises shall be deemed to be associated enterprises if, at any time during
the previous year,--
a. one enterprise holds, directly or indirectly, shares carrying not less than
twenty-six per cent. of the voting power in the other enterprise ; or
b. any person or enterprise holds, directly or indirectly, shares carrying not

less than twenty-six per cent. of the voting power in each of such
enterprises ; or
c. a loan advanced by one enterprise to the other enterprise constitutes not

less than fifty-one per cent. of the book value of the total assets of the
other enterprise ; or
d. one enterprise guarantees not less than ten per cent. of the total borrowings
of the other enterprise ; or
e. more than half of the board of directors or members of the governing

board, or one or more executive directors or executive members of the
governing board of one enterprise, are appointed by the other enterprise ;
or
f. more than half of the directors or members of the governing board, or one
or more of the executive directors or members of the governing board, of
each of the two enterprises are appointed by the same person or persons ;
or
g. the manufacture or processing of goods or articles or business carried out

by one enterprise is wholly dependent on the use of know-how, patents,
copyrights, trade-marks, licences, franchises or any other business or

Transfer Pricing
commercial rights of similar nature, or any data, documentation, drawing

or specification relating to any patent, invention, model, design, secret
formula or process, of which the other enterprise is the owner or in respect
of which the other enterprise has exclusive rights ; or
h. ninety per cent. 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, or by persons specified by
the other enterprise, and the prices and other conditions relating to the
supply are influenced by such other enterprise ; or
i. the goods or articles manufactured or processed by one enterprise, are sold

to the other enterprise or to persons specified by the other enterprise, and
the prices and other conditions relating thereto are influenced by such
other enterprise ; or
j. where one enterprise is controlled by an individual, the other enterprise is

also controlled by such individual or his relative or jointly by such
individual and relative of such individual ; or
k. where one enterprise is controlled by a Hindu undivided family, the other

enterprise is controlled by a member of such Hindu undivided family, or
by a relative of a member of such Hindu undivided family, or jointly by
such member and his relative ; or
l. where one enterprise is a firm, association of persons or body of

individuals, the other enterprise holds not less than ten per cent. interest in
such firm, association of persons or body of individuals ; or
m. there exists between the two enterprises, any relationship of mutual

interest, as may be prescribed.
Section 92B. Meaning of international transaction
1. For the purposes of this section and sections 92, 92C, 92D and 92E, "international
transaction" means a transaction between two or more associated enterprises,
either or both of whom are non-residents, in the nature of purchase, sale or lease
of tangible or intangible property, or provision of services, or lending or
borrowing money, or any other transaction having a bearing on the profits,
income, losses or assets of such enterprises and shall include a mutual agreement
or arrangement between two or more associated enterprises for the allocation or
apportionment of, or any contribution to, any cost or expense incurred or to be
incurred in connection with a benefit, service or facility provided or to be
provided to any one or more of such enterprises.
2. A transaction entered into by an enterprise with a person other than an associated
enterprise shall, for the purposes of sub-section (1), be deemed to be a transaction

Transfer Pricing
entered into between two associated enterprises, if there exists a prior agreement
in relation to the relevant transaction between such other person and the
associated enterprise ; or the terms of the relevant transaction are determined in
substance between such other person and the associated enterprise.
Section 92C. Computation of arm's length price
1. The arm's length price in relation to an international 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, namely :--
a. comparable uncontrolled price method ;
b. resale price method ;
c. cost plus method ;
d. profit split method ;
e. transactional net margin method ;
f. such other method as may be prescribed by the Board.
2. The most appropriate method referred to in sub-section (1) shall be applied, for
determination of arm's length price, in the manner as may be prescribed :
Provided that where more than one price may be determined by the most
appropriate method, the arm's length price shall be taken to be the arithmetical
mean of such prices.
3. Where during the course of any proceeding for the assessment of income, the
Assessing Officer is, on the basis of material or information or document in his
possession, of the opinion that--
a. the price charged or paid in an international transaction has not been

determined in accordance with sub-sections (1) and (2) ; or
b. any information and document relating to an international transaction have

not been kept and maintained by the assessee in accordance with the
provisions contained in sub-section (1) of section 92D and the rules made
in this behalf ; or
c. the information or data used in computation of the arm's length price is not
reliable or correct ; or

Transfer Pricing
d. the assessee has failed to furnish, within the specified time, any
information or document which he was required to furnish by a notice
issued under sub-section (3) of section 92D,
the Assessing Officer may proceed to determine the arm's length price in
relation to the said international transaction in accordance with sub-
sections (1) and (2), on the basis of such material or information or
document available with him :
e. Provided that an opportunity shall be given by the Assessing Officer by

serving a notice calling upon the assessee to show cause, on a date and
time to be specified in the notice, why the arm's length price should not be
so determined on the basis of material or information or document in the
possession of the Assessing Officer.
4. Where an arm's length price is determined by the Assessing Officer under sub-
section (3), the Assessing Officer may compute the total income of the assessee
having regard to the arm's length price so determined :
Provided that no deduction under section 10A or section 10B or under Chapter
VI-A shall be allowed in respect of the amount of income by which the total
income of the assessee is enhanced after computation of income under this sub-
section :
Provided further that where the total income of an associated enterprise is

computed under this sub-section on determination of the arm's length price paid to
another associated enterprise from which tax has been deducted under the
provisions of Chapter XVIIB, the income of the other associated enterprise shall
not be recomputed by reason of such determination of arm's length price in the
case of the first mentioned enterprise.
Section 92D. Maintenance and keeping of information and document by persons

entering into international transaction
1. Every person who has entered into an international transaction shall keep and
maintain such information and document in respect thereof, as may be prescribed.
2. Without prejudice to the provisions contained in sub-section (1), the Board may
prescribe the period for which the information and document shall be kept and
maintained under that sub-section.
3. The Assessing Officer or the Commissioner (Appeals) may, in the course of any
proceeding under this Act, require any person who has entered into an
international transaction to furnish any information or document in respect
thereof, as may be prescribed under sub-section (1), within a period of thirty days
from the date of receipt of a notice issued in this regard :

Transfer Pricing
Provided that the Assessing Officer or the Commissioner (Appeals) may, on an

application made by such person, extend the period of thirty days by a further period not
exceeding thirty days.
Section 92E. Report from an accountant to be furnished by persons entering into

international transaction
Every person who has entered into an international transaction during a previous year
shall obtain a report from an accountant and furnish such report on or before the specified
date in the prescribed form duly signed and verified in the prescribed manner by such
accountant and setting forth such particulars as may be prescribed.
Section 92F. Definitions of certain terms relevant to computation of arm's length

price, etc.
In sections 92, 92A, 92B, 92C, 92D and 92E, unless the context otherwise requires--
i. "accountant" shall have the same meaning as in the Explanation below sub-
section (2) of section 288 ;
ii. "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 ;
iii. "enterprise" means a person (including a permanent establishment of such person)

who is, or has been, or is proposed to be, engaged in any activity, relating to the
production, storage, supply, distribution, acquisition or control of articles or
goods, or know-how, patents, copyrights, trade-marks, licences, franchises or any
other business or commercial rights of similar nature, or any data, documentation,
drawing or specification relating to any patent, invention, model, design, secret
formula or process, of which the other enterprise is the owner or in respect of
which the other enterprise has exclusive rights, or the provision of services of any
kind, or in investment, or providing loan or in the business of acquiring, holding,
underwriting or dealing with shares, debentures or other securities of any other
body corporate, whether such activity or business is carried on, directly or through
one or more of its units or divisions or subsidiaries, or whether such unit or
division or subsidiary is located at the same place where the enterprise is located
or at a different place or places ;
iv. "specified date" means,--
a. where the assessee is a company, the 31st day of October of the relevant
assessment year ;
b. in any other case, the 31st day of July of the relevant assessment year ;
v. "transaction" includes an arrangement, understanding or action in concert,--

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A. whether or not such arrangement, understanding or action is formal

or in writing ; or
B. whether or not such arrangement, understanding or action is

intended to be enforceable by legal proceeding.'.
Section 271(1)
Explanation 7
Where in the case of an assessee who has entered into an international transaction defined
in section 92B, any amount is added or disallowed in computing the total income under
sub-section (4) of section 92C, then, the amount so added or disallowed shall, for the
purposes of clause (c) of this sub-section, be deemed to represent the income in respect of
which particulars have been concealed or inaccurate particulars have been furnished,
unless the assessee proves to the satisfaction of the Assessing Officer or the
Commissioner (Appeals) that the price charged or paid in such transaction was computed
in accordance with the provisions contained in section 92C and in the manner prescribed
under that section, in good faith and with due diligence.".
Section 271AA. Penalty for failure to keep and maintain information and document
in respect of international transaction
Without prejudice to the provisions of section 271, if any person fails to keep and
maintain any such information and document as required by sub-section (1) or sub-
section (2) of section 92D, the Assessing Officer or Commissioner (Appeals) may direct
that such person shall pay, by way of penalty, a sum equal to two per cent. of the value of
each international transaction entered into by such person."
271BA. Penalty for failure to furnish report under section 92E

If any person fails to furnish a report from an accountant as required by section 92E, the
Assessing Officer may direct that such person shall pay, by way of penalty, a sum of one
hundred thousand rupees.".
271G. Penalty for failure to furnish information or document under section 92D
If any person who has entered into an international transaction fails to furnish any such
information or document as required by sub-section (3) of section 92D, the Assessing
Officer or the Commissioner (Appeals) may direct that such person shall pay, by way of
penalty, a sum equal to two per cent. of the value of the international transaction for each
such failure.".
Transfer Pricing Guidelines
In April 2002, the Central Government constituted an Expert Group to recommend

transfer pricing guidelines for companies for pricing their products in connection with the
transactions with related parties and transactions between different segments of the same
company

Transfer Pricing
The Group began by studying the laws and practices relating to transfer pricing in India
and abroad.
The following conclusions can be drawn
(a) Indian and global tax authorities have armed themselves with substantial powers to
plug the tax evasion that arises from creative transfer pricing.
(b) Transactions between related parties come under the ambit of Accounting Standard
AS 18 in India and IAS 24 internationally. These standards require disclosure of certain
aspects of such transactions.
(c) Neither in India nor elsewhere in the world have company law authorities prescribed
transfer pricing methods or disclosures.
(d) The methodologies for determining arm’s length transfer prices (Comparable
Uncontrolled Price, Resale Price Method etc.) are broadly the same in India and abroad.
(e) There is a great deal of diversity in the definition of related party.
Current Corporate Practices in India
The Group also looked at current corporate practices related to transfer pricing in India.
While some Indian companies have no doubt set high standards of corporate governance
and fairness in this area, many Indian companies have more to do. Several members of
the Group observed that in the course of their professional life, they had come across
companies that have resorted to unhealthy practices in the area of transfer pricing.
Considerable anecdotal evidence is also found in the financial press. Annexure 4
summarises some of the transfer pricing abuses that have given rise to concerns among
shareholders, creditors and other stakeholders about transfer pricing regulation.
Global Best Practices and Beyond
This analysis suggests the need for a transfer price guideline under the Companies Act to
ensure the fairness of transfer prices from a shareholder/creditor perspective. At the same
time, the Group is well aware that the current regulatory regime in India is similar to that
elsewhere in the world. In most jurisdictions in the world, the company law is yet to
regulate transfer prices. All over the world, this appears to have been left to company
management alone to determine in accordance with the business judgement rule.
In today’s environment where we are attempting to incorporate global best practices in all
our laws and regulations, introducing a new regulation that is yet to be introduced
anywhere else in the world is not something to be done lightly. The Group debated this
issue at length. A number of factors swung the Group’s thinking in favour of such a
guideline despite this concern:
1. There is global dissatisfaction with corporate governance and corporate disclosure

practices in the wake of some well publicized corporate failures during 2001 and

Transfer Pricing
2002 in the United States and elsewhere. Regulators in many jurisdictions are
rethinking their approach towards regulation and contemplating measures to tighten
the laws regarding corporate abuses. In this situation where global regulatory
practices are evolving, there is scope for countries like India to innovate and set new
standards of disclosure and transparency that leapfrog current global best practices.
2. There have been corporate governance abuses in India too. Many observers
believe that violations of investor and creditor rights have damaged the financial
system severely. On the one hand, the erosion of investor confidence has dealt a body
blow to our capital markets. On the other hand, mounting corporate delinquencies
have debilitated the banking system. In this situation, it could be argued that there is a
case for a regulatory regime to check transfer-pricing abuses.
Transfer Pricing Guidelines under the Companies Act
After extensive discussion and deliberations, the Group came to the conclusion that
transfer pricing guidelines should be framed under the Companies Act. The Group noted
that the Companies Act (S 209 and S 211) requires that the books of account of the
company as well as its Balance Sheet and Profit and Loss Account present a true and fair
view of the affairs of the company. The Group believes that the “true and fair view”
obligation requires substantial disclosures of transfer pricing policies. It also requires a
mechanism to ensure that transfer prices approximate arm’s length prices.
The need for transfer pricing guidelines therefore arises for all users of the financial
statements of the company who rely on these statements for a true and fair view:
 shareholders who wish to evaluate the performance of the company management

and assess the future prospects of the company
 creditors who wish to ascertain the credit worthiness of the company and monitor
compliance with debt covenants
 revenue authorities who may rely partly or wholly on the financial statements to
determine tax liability
 other government authorities who may rely on the financial statements to monitor
compliance with various laws and regulations (for example, exchange control) or
for statistical purposes (for example, price indices or GDP statistics)
 other stakeholders (for example, employees, customers, suppliers) who may use
the financial statements for various purposes
For some of these purposes the requirement of arms length transfer prices applies to inter-
divisional transfers within the same legal entity. For example, shareholders need a true
and fair view of segment revenues and profits as different valuation and performance

Transfer Pricing
benchmarks may apply to different segments. Revenue authorities may also require this
when different tax rates apply to different segments.
Transfer Pricing Guidelines: Core Principles
The Group recommends that the proposed transfer pricing guidelines be guided by the
following core principles:
Requirement of arm’s length transfer prices
All transactions between a company and a related party or between two business
segments of a company shall be at arm’s length transfer prices except as provided
below.
Remarks It must be emphasised that even a transfer price more favourable to the
company than an arm’s length price is problematic. This is so because (a)
valuation is impacted by the possibility that the related party may demand an
arm’s length price in the future and (b) the threat to charge an arm’s length
price in future could become a form of poison-pill/blackmail.
Exceptions to arm’s length transfer price
In exceptional cases, the company may decide to use a non-arm’s length transfer price
provided:
The Board of Directors as well as the audit committee of the Board are satisfied for
reasons to be recorded in writing that it is in the interest of the company to do so, and
The use of a non-arms length transfer price, the reasons therefore, and the profit impact
thereof are disclosed in the annual report
Remarks: Examples of such exceptional cases could be a company giving an interest free
loan to a loss making subsidiary or a company accepting the offer of a
controlling shareholder to work as the CEO on a nominal salary.
Transfer Price Policy Statement and Implementation Report
The company shall prepare a Statement on Transfer Price Policy (the “Policy Statement”)
and a Report on Implementation of Transfer Price Policy (the “Implementation Report”).
The Policy Statement would explain the specific transfer pricing methods used for
different classes of transactions with different parties with special emphasis on those
transactions where a Comparable Uncontrolled Price/Transaction (CUP/CUT) method
could not be adopted.

Transfer Pricing
The Implementation Report would document the compliance with the Policy Statement
and would include the actual detailed computation of an arm's length price for every
material transaction with a related party or internal business segment.
The Implementation Report would be audited by an independent Chartered Accountant or

Cost Accountant.
The Policy Statement and the Implementation Report would be placed before the Audit
Committee for approval
The Policy Statement would also be placed before the Board for approval
Related party transactions should be undertaken only after the Policy Statement relating
to that party has been approved by the Audit Committee and the Board.
Remarks: The Policy Statement is the primary responsibility of management. The

Implementation Report is subject to audit.
The Implementation Report could contain commercially confidential

information that is not suitable for wider disclosure. The Policy Statement
while not compromising commercially confidentiality would provide sufficient
information for an evaluation of the adequacy and fairness of the transfer price
policy in the company.
CUP/CUT is a reliable and objective method in those cases where it is

applicable. Cases where no comparable uncontrolled price is available present
a greater challenge for transfer pricing. Highlighting these cases and explaining
the transfer pricing policy in these cases is important from a disclosure point of
view.
Disclosures in Annual Report
The Transfer Pricing Policy Statement would be annexed to and form part of the
Directors’ Report.
The Directors’ Report would also certify that the Transfer Pricing Guidelines have been
complied with and that transactions entered into are at arm’s length unless otherwise
stated and are not prejudicial to the company.
The Directors’ Report would disclose any use of a non-arms length transfer price, the
reasons therefor, and the profit impact thereof.
The Auditors would certify that they have examined the implementation of the transfer
pricing policy and found it to be in conformity with the Transfer Pricing Guidelines and
with the Policy Statement.
The Annual Report would contain the disclosures required under the Transfer Pricing
Guidelines as well as the disclosures required in AS 18. These disclosures would appear

Transfer Pricing
together in the Annual Report in order to be more meaningful and to enhance ease of
understanding.
Remarks: Though the Implementation Report is not disclosed to the shareholders, the
auditors’ certification, which is based on their audit of the Implementation
Report, provides substantial comfort to them.
The revenue authorities and other regulatory/governmental agencies could call

for the audited Implementation Report where needed and might in most cases
be able to rely on it without carrying out their own transfer pricing study.
The disclosures required under AS 18 include the following:
Name of the related party and nature of the related party relationship where control exists
should be disclosed irrespective of whether or not there have been transactions between
the related parties.
If there have been transactions between related parties, during the existence of a related
party relationship
The name of the transacting related party;
 a description of the relationship between the parties;
 a description of the nature of transactions;
 volume of the transactions either as an amount or as an appropriate

proportion;
 any other elements of the related party transactions necessary for an

understanding of the financial statements;
 the amounts or appropriate proportions of outstanding items

pertaining to related parties at the balance sheet date and provisions
for doubtful debts due from such parties at that date; and
 amounts written off or written back in the period in respect of debts

due from or to related parties
How is transfer pricing abused?
With globalisation, transfer pricing became an unwanted reality. Price charged by one
company in Country A to another company in Country B is reflected in the profit and loss

Transfer Pricing
account of both companies, either as an income or an expenditure. Thus prices charged

impact the tax paid by the two related companies.
By resorting to transfer pricing, related entities can reduce the global incidence of tax by
transferring higher income to low-tax jurisdictions or greater expenditure to those
jurisdictions where the tax rate is very high.
For example, the current tax rate on domestic companies in India is 35 per cent.
Company A is located in India and Company B in Country XYZ. Both belong to the same
group. If tax rate in Country XYZ is 15 per cent, then Company B will transfer raw
material to Company A at slightly higher prices. This will enable Company A to show a
higher expenditure and reduce its taxable profits. On the other hand, slightly higher
income will not harm Company B much as the tax rate in its country is very low. Thus the
global group as a whole will benefit from tax savings.
Undesirable Corporate Practices Related to Transfer Pricing
Some of the related party transactions, which are usually resorted to for diversion of
funds are detailed below.
(a) Purchase of goods or services from a related party at little or no cost or at

inflated prices to the entity.
(b) Payments for services never rendered or at inflated prices.
(c) Sales at below market rates to an unnecessary “middle man” related party, who
in turn sells to the ultimate customer at a higher price with the related party (and
ultimately its principals) retaining the difference.
(d) Purchases of assets at prices in excess of fair market value.
(e) Use of trade names or patent rights at exorbitant rates even after their expiry or
at a price much higher than the price, which can not be described as reasonable.
(f) Borrowing or lending on an interest-free basis or at a rate of interest

significantly above or below market rates prevailing at the time of the transaction.
(g) Exchanging property for similar property in a non monetary transaction.
(h) Selling real estate at a price that differs significantly from its appraised value.
(i) Accruing interest at above market rates on loans.

Transfer Pricing
Some examples of such abuses are given below:
Case 1 On evasion of customs duty and taxes thereon
The parent unit is supplying raw materials to its 100% EOU subsidiary located
separately at an estimated cost which covers raw material costs and variable
conversion charges. The EOU unit reckons this cost as its purchase cost of raw
materials and adds value to the raw material to produce the final product which is
exported from this unit. Since the 100% EOU is exempt from customs duty and
excise duty on finished product there is no payment of duty on this account by the
100% EOU. The transfer of raw materials from the parent unit being below the
full cost of the product there is an inbuilt mechanism to divert profits from the
main company to the 100% EOU unit which enjoys exemption from various
duties and taxes.
The FOB value of exports being approximately Rs100 crores in a given year the
impact of taxes can be worked out.
Case 2 On investment in a subsidiary
The parent company is giving loans to its subsidiary companies on an interest free
basis which remains unpaid for more than 5 years now. The amount of interest
free loans given to its subsidiaries totals Rs1500 crores. The parent company is a
flag ship company and has a wide range of products in manufacturing and
trading. Some of the subsidiary companies have not taken off at all and some of
them have become defunct and there is no action for recovery by the parent. The
annual loss on interest to the parent company on a notional basis at 15% p.a. is
estimated at Rs220 cr. This is a clear suppression of profits arising from evasion
of legitimate income resulting from the diversion of borrowed funds by pledging
of assets by the parent company. Since the company is making profits, no queries
are raised by outside agencies as they get regular interest payments and repayment
of loans without a default. This is a case where diversion of funds and transfer of
funds at below cost is resorted to in order to avoid a legitimate return to the
shareholders.
Case 3 Mismanagement by holding company of companies under the same

management
Many of the companies resort to formation of 100% holding companies to control

totally the management which is the company providing funds to various

Transfer Pricing
companies in the same management. Many of them do not go for public finances
as the holding company takes care of the entire financial structuring for these
related companies. These companies mostly do not trade in the open market by
listing, as the shares are closely held by the parent company. The surpluses of the
subsidiary go back to the parent company in the form of high rates of dividends.
The investment of funds gets a good return to the parent company which has
several baskets of companies to set off profits against losses and minimize the
payment of taxes to the authorities. This is a very clear case of legitimate tax
avoidance beyond the legal net. This type of promoter controlled business is
widely resorted to as a corporate strategy to avoid taxes by the holding company
and this is well within the laws of land. The question before the public is how is
the profit suppression by business conglomerates to be addressed. As more and
more MNCs are stepping into our country the flight of foreign exchange by
diversion of funds is a serious concern to the country. The disclosures will not
serve any purpose as there is no violation of the accepted form of investment.
What is required is to consider payment of dividends to holding companies as a
related party transaction and to regulate such payments, which may be beyond the
prescribed investment norms.
Case 4 Siphoning of funds by formation of Joint ventures
In forming a JV Company ‘A’, a foreign company supplies plant and machinery

and technology to Company ‘B’ located in India. Mostly the plant and machinery
is old but categorised as refurbished to avail of the benefits of depreciation and
other allowances.
For technology transfer the Company ‘A’ is paid a hefty amount as technical fees
by Company ‘B’ based on volume of sales. The Company ‘A’ treats the supply of
plant and machinery as their share of the JV investments. Company ‘B’ pays
dividends treating the value of plant and machinery as equity participation apart
from paying royalty and technical knowhow fees for technology transfer.
The issue before the public is denying genuine Indian investors of the advantage
of equity participation by company ‘A’ getting additional rights issue and bonus
issues for no consideration and beyond the value of plant and machinery supplied.
Over the years it could be found that Company A’s share of equity and royalty
payments far exceed the value of the assets invested by the company. There is
flight of capital as dividends paid for expanded capital not to forget payments as
technology transfer which is difficult to measure.
Case 5 – Indian MNC covering all aspects
The company was established over 50 years ago and is listed on the BSE. The
sector in which the company operated was reserved for the small scale industry. In
order to maintain its market leadership, the company had to find new methods of

Transfer Pricing
holding on to its manufacturing base and expanding it to keep pace with market
demand.
The company continued to invest heavily in R&D and Plant and Machinery. It
floated joint ventures and/or companies where the major shareholder was its
distributor in each region. It transferred its old plant and machinery to the new
companies at a price just below the Rs. 20 lakh ceiling then in force for a
company to qualify as an SSI unit. The management and operational control of
each of these smaller manufacturing entities rested entirely with the MNC.
The MNC operated each of these smaller companies through 2 modes.
1. In the first mode, all Raw Material and Packing Material was supplied by
the parent company to each manufacturing facility. The finished product
was shipped to company warehouses and distributor godowns for onward
movement in the company’s supply chain.
2. In the second mode of operation, each smaller company was allowed to

negotiate and source raw and packing material (primary items only from
approved suppliers) and do its own manufacturing. The manufacturing
unit was run under a very stringent Standard costing system where
standard cost of procurement and standard selling prices (TP) were fixed
in March of each year. The TP was fixed with a small profit margin based
on the tight standard costs of material. The finished product was sold to
the MNC at the TP (based on Standard Cost + Margin). The MNC would
then sell the FG at it normal price after mark-up.
The units operating under the second method were found to have vastly superior
manufacturing efficiencies.
This TP mechanism was designed to meet 4 objectives
1. Overcome the constraints imposed by government policy (reservation).
2. Take advantage of the lower excise duty for SSIs.
3. Drive towards greater manufacturing and operational efficiencies.
4. Continue to take advantage of utilizing almost fully depreciated assets

while keeping up new investment levels in the parent company.
Over the next 30 years the company continued to maintain its leadership position
in the market and its share continues to remain one of the most valuable shares in
the Indian stock market. The recent deregulation of the sector in which the
company operates may see a marked change in manufacturing strategy.

Transfer Pricing
Case 6: Cement Industry:
A major plant, with a capacity of more than 0.60 Million TPA used to sell surplus
Clinker to Grinding units. Generally, every Cement plant keeps higher capacity
upto clinker stage, in order to ensure continuous supply of Cement in the market
even during Kiln shut down for periodical maintenance. The surplus clinker is
sold to various other small grinding units. In the instant case the close relatives of
Promoters got other Small / Mini Cement Plants to which the clinker is sold @
Rs.250/- to Rs.300/- per ton where as they use to sell @ Rs. 950/- to Rs.1000/- in
the market, the cost of production works out to more than Rs. 800/- per ton. This
practice is prevalent in many Cement units. In the instant case, the Cement unit
became Sick and FIs & Banks have to forge substantial amounts
Coal and Cement transport are generally done by outside transport contractors for
a Cement unit. Many of the Promoters also promote transport companies under
benami names or through relatives who are given contract for transport of Coal,
Cement or other Raw materials. Rates of the transport very substantially from
period to period, on questioned for such variations they are explained as market
exigencies are the reasons for higher payments during some periods. Some times
even the lean season rates are unjustifiably & very higher- nothing but diversion
of funds.
Case 7 - Paper Industry
Paper is sold through a large dealer network. Most of the dealers are either
relatives or relatives of relatives under benami Partnerships. Paper is sold to the
related parties at a much discounted / lower rates.
Similarly the transport of various Materials & Paper is also done through related
party transport companies. Major chemicals for e.g. Lime (high purity) is also
purchased from related party companies having Lime Kilns.
Case 8 - Pharmaceutical Industry:
Third party Loan Licensing for manufacturing and system of distribution / selling
agencies for Sales are very common. The final rates for various conversion jobs
are fixed as a part of profit planning exercise. It is also observed that substantial
year-end journal vouchers are passed giving rebates / discounts / reimbursement
of special expenses etc., for Selling Agencies / Distributors in related party
accounts.
Case 9 - Multinational Companies

Transfer Pricing
Various multinational brands have certain ingredients which give the flavour /
fragrance / taste, to their brand patents. The cost of purchase of such items
changes from period to period, even some times quarter to quarter. The invoices
and other documentations are built up and journal vouchers are passed at the
period end against advanced payments made from time to time. Such entries are
made even for Technical Services rendered on adhoc basis in the name of a
Technical Up-gradation, Consultancy Fees etc., in addition to huge Royalty and
Sales commission.
Comparative Chart Showing Provisions Relating to Transfer Pricing under

Different Laws and Regulations
INCOME TAX CUSTOMS ACT, CENTRAL EXCISE ACCOUNTING

ACT, 1961 1962 ACT, 1944 STANDARD-18
I Type of Transactions

Transfer Pricing

ACT, 1961 1962 ACT, 1944 STANDARD-18
This Act relates to This Act relates to This Act relates to This Standard covers
International transactions transactions relating to related party
Transactions. relating to Captive consumption transactions. These
exportation and of goods and related transactions involve
These transactions importation in the party transactions. transfer of resources
has been defined course of or obligations
under Section 92B International between related
of the Act. Trade. parties, regardless of
whether or not a
(However, the term price is charged.
International Trade This Standard
has not been became effective in
defined under the respect of
Act) accounting periods
commencing on or
after 1.4.2001.
AS-18 is mandatory
only in respect of
following enterprises
and not all
enterprises as at
present :
(i) (i)
Enterprises
whose equity or
debt securities
are listed on a
recognized stock
exchange in
India, and
enterprises that
are in the process
of issuing equity
or debt securities
that will be listed
on a recognized
stock exchange
in India as
evidenced by the
Board of

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ACT, 1961 1962 ACT, 1944 STANDARD-18
directors’
resolution in this
regard.
All other
commercial,
industrial and
business reporting
enterprises, whose
turnover for the
accounting period
exceeds Rs.50
crores.
II. Associated enterprise/Associated persons/ Related party/Related person (see

below for Companies Act and MRTP Act definitions)
The term This Act provides The Act provides for Accounting
“Associated for the definition the definition of the Standard-18
enterprise has been of the term Related term related person provides for the
defined under person under Rule under Section 4 (3)(b) definition of the
Section 92A of the 2 (2) of the which provides- term ‘related party’
Act. As per this Customs Valuation as per which parties
Section- (Determination of Persons shall be are considered to be
Price of Imported deemed to be "related" related if any time
(1)"associated Goods) Rules, if- during the reporting
enterprise", in 1988. As per this (i) they are inter- period one party has
relation to another rule— connected the ability to control
enterprise, means undertakings; the other party or
an enterprise - Persons shall be exercise significant
deemed to be (ii) they influence over the
(a)which "related" only if - are relatives; other party in
participates, making financial
directly or (i) they are officers (iii) amongst them and/or operating
indirectly, or or directors of the buyer is a decisions.
through one or one another's relative and a
more businesses; distributor of the The term control
intermediaries, assessee, or a sub- means :
in the (ii) they are legally distributor of such
management or recognised distributor; or (a)ownership,
control or partners in (iv) they are so directly or
capital of the business; associated that they indirectly, of
other have interest, more than one
enterprise; or (iii) they are directly or half of the voting

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ACT, 1961 1962 ACT, 1944 STANDARD-18
(b) in respect of employer and indirectly, in the power of an
which one or employee; business of each enterprise, or
more persons other;
who participate, (iv)any person Explanation to the (b) control of the
directly or directly or clause provides “inter- composition of
indirectly, or indirectly owns, connected the Board of
through one or controls or holds undertakings" shall directors in the
more 5 per cent or have the same case of a
intermediaries, more of the meaning as provided company or of the
in its outstanding in section 2(g) of the composition of
management or voting stock or MRTP Act, 1969 and the corresponding
control or shares or both of the term "relative" governing body
capital, are the them; shall have the same in case of any
same persons meaning as provided other enterprise,
who participate, (v)one of them in Section 2(41) of the or
directly or directly or Companies Act, 1956.
indirectly, or indirectly (c) a substantial
through one or controls the interest in voting
more other; power and the
intermediaries, power to direct,
in the (vi) both of them by statute or
management or are directly or agreement, the
control or indirectly financial and/or
capital of the controlled by a operating
other enterprise. third person; policies of the
enterprise.
(2) Two enterprises (vii) together they
shall be deemed to An enterprise is
directly or
be associated considered to have a
indirectly control
enterprises if, at substantial interest
a third person; or
any time during the in another enterprise
previous year, - if that enterprise
(viii)they are
owns, directly or
members of the
(a) one enterprise indirectly, 20 per
same family.
holds, directly cent or more interest
or indirectly, Explanation I to the in the voting power
shares carrying Rule provides that of the other
not less than the term "person" enterprise.
twenty-six per also includes legal Similarly, an
cent of the persons. individual is
voting power in considered to have a
the other Further it has been substantial interest
enterprise; or in an enterprise, if
provided in
that individual owns,
Explanation II that

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ACT, 1961 1962 ACT, 1944 STANDARD-18
(b) any person or Persons who are directly or indirectly,
enterprise associated in the 20 per cent or more
holds, directly business of one interest in the voting
or indirectly, another in that one power of the
shares carrying is the sole agent or enterprise.
not less than sole distributor or
twenty-six per sole
cent of the concessionaire,
voting power in however described, The term significant
each of such of the other shall influence refers to
enterprises; or be deemed to be participation in the
related for the financial and/or
(c) a loan advanced purpose of these operating policy
by one rules, if they fall decisions of an
enterprise to the within the criteria enterprise, but not
other enterprise of this sub-rule. control of those
constitutes not policies. Significant
less than fifty- influence may be
one per cent of exercised in several
the book value ways, for example
of the total
assets of the - by representation
other on the Board of
enterprise; or directors,
- participation
(d) one enterprise
in the policy making
guarantees not
process,
less than ten per
cent of the total - material inter-
borrowings of company
the other transactions,
enterprise; or
- interchange of
(e) more than half managerial
of the Board of personnel, or
directors or
members of the - dependence on
governing technical
board, or one or information.
more executive
directors or For the purposes of
executive this standard an
members of the associate is an
governing enterprise in which

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ACT, 1961 1962 ACT, 1944 STANDARD-18
Board of one an investing
enterprise, are reporting party has
appointed by significant influence
the other and which is neither
enterprise; or a subsidiary nor a
joint venture of that
(f) more than half party.
of the directors
or members of
the governing
Board, or one A joint venture is a
or more of the contractual
executive agreement whereby
directors or two or mere parties
members of the undertake an
governing economic activity
Board, of each which is subject to
of the two joint control. The
enterprises are term joint control
appointed by refers to the
the same person contractually agreed
or persons; or sharing of power to
govern the financial
(g) the manufacture and operating
or processing of policies of an
goods or economic activity so
articles or as to obtain benefits
business carried from it.
out by one
enterprise is
wholly
This standard
dependent on
provides for the
the use of
definition of the
know-how,
term relative as per
patents,
which relative in
copyrights,
relation to an
trade-marks,
individual, means
licenses,
the spouse, son,
franchises or
daughter, brother,
any other
sister, father and
business or
mother who may be
commercial
expected to
rights of similar
influence, or be
nature, or any

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ACT, 1961 1962 ACT, 1944 STANDARD-18
data, influenced by, that
documentation, individual in his/her
drawing or dealings with the
specification reporting enterprise.
relating to any
patent,
invention,
model, design,
secret formula
or process, of
which the other
enterprise is the
owner or in
respect of
which the other
enterprise has
exclusive
rights; or
(h) ninety per cent

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,
or by persons
specified by the
other enterprise,
and the prices
and other
conditions
relating to the
supply are
influenced by
such other

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ACT, 1961 1962 ACT, 1944 STANDARD-18
enterprise; or
(i) the goods or

articles
manufactured
or processed by
one enterprise,
are sold to the
other enterprise
or to persons
specified by the
other enterprise,
and the prices
and other
conditions
relating thereto
are influenced
by such other
enterprise; or
(j) where one

enterprise is
controlled by an
individual, the
other enterprise
is also
controlled by
such individual
or his relative
or jointly by
such individual
and relative of
such individual;
or
(k) where one

enterprise is
controlled by a
Hindu
undivided
family, the
other enterprise
is controlled by
a member of

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ACT, 1961 1962 ACT, 1944 STANDARD-18
such Hindu
undivided
family, or by a
relative of a
member of such
Hindu
undivided
family, or
jointly by such
member and his
relative; or
(l) where one

enterprise is a
firm,
association of
persons or body
of individuals,
the other
enterprise holds
not less than ten
per cent interest
in such firm,
association of
persons or body
of individuals;
or
(m) there exists

between the two
enterprises, any
relationship of
mutual interest, as
may be prescribed.
III. Basis of Determination of Price
Computation of Section 14 of the Section 4 of the Act It requires disclosure

Income from Act provides for provides for valuation of information
International valuation of goods. of excisable goods for regarding related
Transactions shall Valuation of the purposes of charging parties and
be done having such goods shall be of duty of excise transactions with
regard to arm’s deemed to be the where under, the duty related parties that

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ACT, 1961 1962 ACT, 1944 STANDARD-18
length price as per price at which of excise is chargeable are recognized in the
section 92C where such goods or like on any excisable financial statements
under six methods goods are goods with reference of an enterprise.
are prescribed ordinarily sold or to their value. On
namely : offered for sale for each removal of the
(a) (a) delivery at the time goods, such value
comparable and place of shall in a case where This standard
uncontrolled importation or the goods are sold by establishes the
price method; exportation, as the the assessee for requirements for
case may be, in the delivery at the time disclosure of :
(b) (b) resale course of and place of removal,
price method; international trade the assessee and the
where the seller buyer of the goods are
(b) (b) cost plus and buyer have no - - related
not related and the
method; party
interest in the price is the sole
relationships; and
business of each consideration for the
(c) (c) profit other and the price sale will be the
split method; - -
is the sole transaction value. transactions
consideration for between a
(d) (d) In any other case,
sale or offer for reporting
transactional including the case
sale. enterprise and its
net margin where the goods are
method; not sold, the value related parties.
Rule 4(3) of
shall be determined in
Customs Valuation Disclosures under
(e) (e) such such manner as may
(Determina-tion of this standard is a
other method as be prescribed.
Price of Imported means of conveying
may be However, this section
Goods) Rules, to the users that
prescribed by is not applicable in
1988 provides that certain related party
the Board. respect of any
where the seller relationship exists or
excisable goods for
“Arm’s length and buyer are related party
which a tariff value
price” means a related to each transactions have
has been fixed under
price which is other, the value taken place and that
Section 3(2) of the
applied or shall be accepted the results of these
Act. Where the
proposed to be provided that the transactions have
excisable goods are
applied in a examination of the been incorporated in
not sold by the
transaction circumstances of the financial
assessee but are used
between persons the sale of the statements. These
for consumption by
other than imported goods disclosures will
him or on his behalf in
associated indicate that the make financial
the production or
enterprises, in relationship did not statements more
manufacture of other
uncontrolled influence the price. transparent and users
articles or where the
conditions. assessee so arranges of financial
However, Where statements can make
that the excisable
the buyer and informed decisions

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ACT, 1961 1962 ACT, 1944 STANDARD-18
seller are related, goods are not sold by based on it.
the transac-tion him except to or
value shall be through a related
accepted provided person in such a
that the situation the value
examination of the shall be determined as
circumstances of per Rules 8, 9 and 10
the sale of the of the Central Excise
imported goods (Determi-nation of
indicate that the Price of Excisable
relationship did not Goods) Rules, 2000.
influence the price. These Rules provide
that—
In a sale between Where the excisable
related persons, the goods are not sold by
transaction value the assessee but are
shall be accepted, used for consumption
when-ever the by him or on his
importer behalf in the
demonstrates that production or
the declared value manufacture of other
of the goods being articles, the value
valued, closely shall be one hundred
approximates to and fifteen per cent of
one of the the cost of production
following values or manufacture of
ascertained at or such goods. (Rule 8)
about the same
time - When the assessee so
arranges that the
(i) the transaction excisable goods are
value of not sold by an
identical goods, assessee except to or
or of similar through a person who
goods, in sales is related in the
to unrelated manner specified in
buyers in India; either of sub-clauses
(ii), (iii) or (iv) of
(ii) the deductive clause (b) of sub-
value for section (3) of section
identical goods 4 of the Act, the value
or similar of the goods shall be
goods; the normal transaction
value at which these

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ACT, 1961 1962 ACT, 1944 STANDARD-18
(iii)the computed are sold by the related
value for person at the time of
identical goods removal, to buyers
or similar (not being related
goods. person); or where such
goods are not sold to
Provided that in such buyers, to buyers
applying the values (being related person),
used for who sells such goods
comparison, due in retail :
account shall be It is however provided
taken of that in a case where
demonstrated the related person
difference in does not sell the goods
commercial levels, but uses or consumes
quantity levels, such goods in the
adjustments in production or
accordance with manufacture of
the provisions of articles, the value
Rule 9 of these shall be determined in
rules and cost the manner specified
incurred by the in Rule 8. (Rule 9)
seller in sales in When the assessee so
which he and the arranges that the
buyer are not excisable goods are
related; not sold by him except
to or through an inter-
Substituted values connected
shall not be undertaking, the value
established under of goods shall be
the above determined in the
provisions. following manner,
namely :-
(a) If the under-
takings are so
connected that they
are also related in
terms of sub-clause
(ii) or (iii) or (iv) of
clause (b) of sub-
section (3) of Section
4 of the Act or the
buyer is a holding
company or subsidiary

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ACT, 1961 1962 ACT, 1944 STANDARD-18
company of the
assessee, then the
value shall be
determined in the
manner prescribed in
rule 9.
(b)In any other case,
the value shall be
determined as if they
are not related persons
for that purposes of
Section 4(1). (Rule
10) .

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Definition of Associated enterprise/Associated persons/ Related party/Related

person under Companies Act and MRTP Act
COMPANIES ACT, 1956 MRTP ACT, 1969
There is only one provision The term “Inter-connected undertaking” as

under section 370(1B) of the defined under Section 2(g) of this Act means
Act which provides for the two or more undertakings which are inter-
instances when two body connected with each other in any of the
corporates shall be deemed to following manner, namely :-
be under the same
management. It provides, two (i) if one owns or controls the other.
bodies corporate shall be (ii) where the undertakings are owned by firms,
deemed to be under the same if such firms have one or more common
management— partners.
(iii) where the undertakings are owned by
(i) if the managing agent, bodies corporate, -
secretaries and treasures, (a) if one body corporate manages the other body
managing director or corporate, or
manager of the one body, or (b) if one body corporate is a subsidiary of the
where such managing agent other body corporate, or
or secretaries and treasures (c) if the bodies corporate are under the same
are a firm, any partner in the management, or
firm, or where such (d) if one body corporate exercises control over
managing agent or the other body corporate in any other manner;
secretaries and treasures are (iv) where one undertaking is owned by a body
a private company, any corporate and the other is owned by a firm,
director of such company, is if one or more partners of the firm, -
— (a) hold, directly or indirectly, not less than fifty
per cent of the shares, whether preference or
(a) the managing agent, equity, of the body corporate, or
secretaries and treasurers, (b) exercise control, directly or indirectly,
managing director or whether as director or otherwise, over the
manager of other body; or body corporate,
(v) if one is owned by a body corporate and the
(b) a partner in the firm acting other is owned by a firm having bodies
as managing agent or corporate as its partners, if such bodies
secretaries and treasures of corporate are under the same management ,
the other body; or (vi) if the undertakings are owned or
controlled by the same person or by the same
(c) a director of a private group,
company acting as (vii) if one is connected with the other either
management agent, or directly or through any number of
secretaries and treasures of undertakings which are inter-connected
the other body; undertakings within the meaning of one or
more of the foregoing sub-clauses.
(ii) if a majority of the directors Explanation 1 to the Clause provides that two

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of the one body constitute, or bodies corporate, shall be deemed to be under

at any time within the six the same management, -
months immediately (i) if one such body corporate exercises control
preceding consti-tuted, a over the other or both are under the control
majority of the directors of of the same group or any of the constituents
the other body or, of the same group; or
(ii) if the managing director or manager of
(iii) if not less than one-third of one such body corporate is the managing
the total voting power with director or manager of the other; or
respect to any matter relating (iii) if one such body corporate holds not less
to each of the two bodies than one-fourth of the equity shares in the
corporate is exercised or other or controls the composition of not less
controlled by the same than one-fourth of the total membership of
individual or body corporate, the board of directors of the other; or
or (iv) if one or more directors of one such body
corporate constitute, or at any time within a
(iv) if the holding company of period of six months immediately preceding
the one body corporate is the day when the question arises as to
under the same management whether such bodies corporate are under the
as the other body corporate same management, constituted (whether
within the meaning of clause independently or together with relatives of
(i), clause (ii) or clause (iii), such directors or the employees of the first
or mentioned body corporate) one-fourth of the
directors of the other; or
if one or more directors of the (v) if the same individual or individuals
one body corporate while belonging to a group, while holding
holding, whether by themselves (whether by themselves or together with
or together with their relatives, their relatives) not less than one-fourth of
the majority of shares in that the equity shares in one such body corporate
body corporate also hold, also hold (whether by themselves or together
whether by themselves or with their relatives) not less than one-fourth
together with their relatives, of the equity shares in the other; or
the majority of shares in the (vi)if the same body corporate or bodies
other body corporate. corporate belonging to a group, holding,
whether independently or along with its or
their subsidiary or subsidiaries, not less than
one-fourth of the equity shares in one body
corporate, also hold not less than one-fourth
of the equity shares in the other; or
(vii) if not less than one-fourth of the total
voting power in relation to each of the two
bodies corporate is exercised or controlled
by the same individual (whether
independently or together with his relatives)
or the same body corporate (whether
independently or together with its

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subsidiaries); or
(viii) if not less than one-fourth of the total
voting power in relation to each of the two
bodies corporate is exercised or controlled
by the same individuals belonging to a
group or by the same bodies corporate
belonging to a group, or jointly by such
individual or individuals and one or more
of such bodies corporate; or
if the directors of the one such body corporate
are accustomed to act in accordance with the
directions or instructions of one or more of the
directors of the other, or if the directors of both
the bodies corporate are accustomed to act in
accordance with the directions or instructions of
an individual, whether belonging to a group or
not.
Explanation II provides that if a group exercises
control over a body corporate, that body
corporate and every other body corporate,
which is a constituent of or controlled by, the
group shall be deemed to be under the same
management.
Explanation III to clause provides that if two or
more bodies corporate under the same
management hold, in the aggregate, not less
than one-fourth equity share capital in any
other body corporate, such other body corporate
shall be deemed to be under the same
management as the first mentioned bodies
corporate.
It is further provided in Explanation IV that in
determining whether or not two or more bodies
corporate are under the same management, the
shares held by financial institutions in such
bodies corporate shall not be taken into account.
The Act defines the term Group under section
2(ef) as per wghich `group’ means a group of –
(i) two or more individuals, associations of
individuals, firms, trusts, trustees or bodies
corporate (excluding financial institutions) or
any combination thereof, which exercises, or is
established to be in a position to exercise,
control, directly or indirectly, over any body
corporate, firm or trust; or

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(ii) associated persons.
Explanation : For the purposes of this clause—
(I) a group of persons who are able, directly or

indirectly, to control the policy of a body
corporate, firm or trust, without having a
controlling interest in that body corporate, firm
or trust, shall also be deemed to be in a position
to exercise control over it;
(II) "Associated persons" -
(a)in relation to a director of a body corporate,

means -
(i) a relative of such director, and includes a
firm in which such director or his relative is a
partner;
(ii) any trust of which any such director or his
relative is a trustee;
(iii) any company of which such
director,whether independently or together
with his relatives, constitutes one-fourth of its
board of directors;
(iv)any other body corporate, at any general
meeting of which not less than one-fourth of
the total number of directors of such other
body corporate are appointed or controlled by
the director of the first mentioned body
corporate or his relative, whether acting
singly or jointly;
(b) in relation to the partner of a firm, means a
relative of such partner and includes any
other partner of such firm; and
(c) in relation to the trustee of a trust, means any
other trustee of such trust;
(III) where any person is an associated person in
relation to another, the latter shall also be
deemed to be an associated person in relation to
the former;

Transfer Pricing
DRAFT TRANSFER PRICING GUIDELINES
In exercise of the powers conferred by sub-section (1) of section 642, read with
clause (e) of sub-section (1) of section 209 of the Companies Act, 1956 (1 of
1956), the Central Government hereby makes the following guidelines, namely ;-
1. Short title and Commencement.-
These guidelines may be called “Transfer Pricing Guidelines, 2002”

These guidelines shall come into force on the date of their publication in the official
gazette.
2. Application.-
These guidelines shall apply to such transactions, which a company may enter
into with its related party or within its segments per se.
Provided that nothing contained herein shall apply to those transactions where
the transaction price is fixed by any Government department or authority
pursuant to any Law or Act of Parliament.
3. Definitions.-
In these guidelines, unless the context otherwise requires -

(1) “arm’s length price” means the price, which is applied in a transaction
between persons other than related party in uncontrolled conditions.
(2) “related party”, in relation to a company, means an entity -
(a)which participates, directly or indirectly, or through one or more
intermediaries, in the management or control or capital of such
company or vice versa; or
(b)in respect of which one or more persons who participate, directly or
indirectly, or through one or more intermediaries, in its management
or control or capital, are the same who participate, directly or
indirectly, or through one or more intermediaries, in the management
or control or capital of such company or vice versa.

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An entity shall be deemed to be a related party in relation to a company if,

at any time during the previous year -
(a) The entity holds, directly or indirectly, shares carrying not less than
twenty-six percent of the voting power in such company or vice
versa; or
(b) Any person or entity holds, directly or indirectly, shares carrying not
less than twenty-six percent of the voting power in each of the
entities; or
(c) A loan advanced by the entity to the company constitutes not less than
fifty-one percent of the book value of the total assets of the company
or vice versa; or
(d) The entity guarantees not less than fifty-one percent of the total
borrowings of the company or vice versa; or
(e) More than half of the board of directors or members of the governing
board, or one or more executive directors or executive members of
the governing board of the entity, are appointed by the company or
vice versa; or
(f) More than half of the directors or members of the governing board, or
one or more of the executive directors or members of the governing
board, of each of the entity and the company are appointed by the
same person or persons; or
(g) The manufacture or processing of goods or articles or business carried
out by the entity is wholly dependent on the use of know-how,
patents, copyrights, trade-marks, licences, franchises or any other
business or commercial rights of similar nature, or any data,
documentation, drawing or specification relating to any patent,
invention, model, design, secret formula or process, of which the
company is the owner or in respect of which the company has
exclusive rights or vice versa; or
(h) Ninety percent or more of the raw materials and consumables
required for the manufacture or processing of goods or articles carried
out by the entity, are supplied by the company, or by persons
specified by the company, and the prices and other conditions relating
to the supply are influenced by such company or vice versa; or
(i) The goods or articles manufactured or processed by the entity, are
sold/transferred to the company or to persons specified by the
company, and the prices and other conditions relating thereto are
influenced by such company or vice versa; or
(j) Where the entity is controlled by an individual, the other company is
also controlled by such individual or his relative or jointly by such
individual and relative of such individual; or
(k) Where an entity has the power to direct, by statute or agreement, the
financial and operating policies of the company or vice versa;
(l) There exists between two entities, any relationship of mutual interest
as may be prescribed provided one of them is a company.

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(3) “entity”.- the term “entity” means an individual or a Hindu undivided

family or a partnership firm or an association of persons or a trust or a
company.
(4) “relative”.- A person shall be deemed to be a relative of another; if, and
only if,-
(a)(a) they are members of a Hindu undivided family; or
(b)(b) they are husband and wife; or
(c)(c) the one is related to the other in the manner indicated in
Schedule I A of the Companies Act, 1956.
(5) “segment” means any business segment for which financial results are
prepared either for the purpose of segmental reporting or for complying
with or availing benefits under the provisions of any of the Acts or Laws.
(6) “transaction” includes any sale, purchase, transfer, arrangement,
understanding or action, whether formal or informal, whether oral or in
writing, whether legally enforceable or not with respect to :
a) raw materials, process materials, utilities like water, steam, gas,
air, power, effluent treatment facility, finished products and
rejected goods including scraps, etc;
b) utilisation of plant facilities and technical know-how;
c) rendering or receiving of services including deputation of man
power;
d) administrative, technical, managerial or any other consultancy
services;
e) capital goods including plant and machinery;
f) lease of tangible or intangible property;
g) provision of finance (including loans, advances and equity or other
contribution in cash or in kind);
h) agency and distribution arrangements;
i) leasing or hire purchase arrangements;
j) transfer of or sharing of the benefits of research and development;
k) licence or know-how agreements;
l) guarantees and collaterals;
m) management contracts;
n) any work in pursuance to a contract;
o) any other sharing or provision of resources or undertaking of
obligations between or on behalf of related parties regardless of
whether or not a price is charged.
4. Transactions to be at arm’s length price
All transactions between a company and a related party or between two

business segments of a company shall be at arm’s length transfer prices
determined in accordance with Clause 5.
Provided that in exceptional cases, the company may decide to use a non-
arm’s length transfer price if the Board of Directors as well as the audit

Transfer Pricing
committee of the Board are satisfied for reasons to be recorded in writing that
it is in the interest of the company to do so. In all such cases, the use of a non-
arms length transfer price, the reasons therefor, and the profit impact thereof
shall be disclosed in the annual report.
5. Methods Of Computation Of Arm’s Length Price
The arm’s length price 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, namely :-
(1) Comparable Uncontrolled Price Method
(2) Resale Price Method
(3) Cost Plus Method
(4) Profit Split Method
(5) Transactional Net Margin Method
Any other basis approved by the Central Government, which has the
effect of valuing such transaction at arm’s length price.
(1) Comparable Uncontrolled Price (CUP) Method :
The price charged or paid in a comparable uncontrolled transaction or a

number of such transactions shall be identified. Such price shall be adjusted to
account for differences, if any, between the related party transaction and the
comparable uncontrolled transactions or between the enterprises entering into
such transactions, which could materially affect the price in the open market.
The adjusted price shall be taken as arm’s length price.
The uncontrolled transaction means a transaction between independent
enterprises other than related parties and shall cover goods or services of a
similar type, quality and quantity as those between the related parties and
relate to transactions taking place at a similar time and stage in the
production/distribution chain with similar terms and conditions applying.
(2) Resale Price Method :
The price at which the goods purchased or services obtained from a related
party is resold or is provided to an unrelated entity shall be identified. Such
resale price shall be reduced by the amount of a normal gross profit margin
accruing to the enterprise or to an unrelated enterprise from the purchase and
resale of the same or similar goods or services in a comparable uncontrolled
transaction or a number of such transactions. The price so arrived at shall be
further reduced by the expenses incurred by the enterprise in connection with
the purchase of goods or services. Such price shall be further adjusted to take
into account the functional and other differences including differences in
accounting practices, if any, between the related party transaction and the
comparable uncontrolled transactions or between the enterprises entering into
such transactions, which could materially affect the amount of gross profit
margin in the open market. The adjusted price shall be taken as arm’s length

Transfer Pricing
price in respect of goods purchased or services obtained from the related

party.
The resale price method would normally be adopted where the seller adds
relatively little or no value to the product or where there is little or no value
addition by the reseller prior to the resale of the finished products or other
goods acquired from related parties. This method is often used when goods are
transferred between related parties before sale to an independent party.
(3) Cost Plus Method :
The total cost of production incurred by the enterprise in respect of goods

transferred or services provided to a related party shall be determined. The
amount of a normal gross profit mark-up to such costs arising from the
transfer of same or similar goods or services by the enterprise or by an
unrelated enterprise in a comparable uncontrolled transaction or a number of
such transactions, shall be determined. The amount of a normal gross profit
mark-up shall be adjusted to take into account the functional and other
differences, if any, between the related party transaction and the comparable
uncontrolled transactions or between the enterprises entering into such
transactions, which could materially affect such profit mark-up in the open
market. The total cost of production referred to above increased by the
adjusted profit mark-up shall be taken as arm’s length price. It is also
important here to ensure that the cost base to which mark-up is applied is
comparable to the cost base of the third party transaction which serve as
comparable. For example, it may be necessary to make an adjustment to cost
where one person leases its business assets while other owns its business
assets.
The cost plus method would normally be adopted if CUP method or resale
price method cannot be applied to a specific transaction or where goods are
sold between associates at such stage where uncontrolled price is not available
or where there are long term buy and supply arrangements or in the case of
provision of services or contract manufacturing.
(4) Profit Split Method :
The combined net profit of the related parties arising from a transaction in
which they are engaged shall be determined. This combined net profit shall be
partially allocated to each enterprise so as to provide it with a basic return
appropriate for the type of transaction in which it is engaged with reference to
market returns achieved for similar types transactions by independent
enterprises. The residual net profit, thereafter, shall be split amongst the related
parties in proportion to their relative contribution to the combined net profit.
This relative contribution of the related parties shall be evaluated on the basis
of the function performed, assets employed or to be employed and risks

Transfer Pricing
assumed by each enterprise and on the basis of reliable market data which
indicates how such contribution would be evaluated by unrelated enterprises
performing comparable functions in similar circumstances. The combined net
profit will then be split amongst the enterprises in proportion to their relative
contributions. The profit so apportioned shall be taken into account to arrive at
an arm’s length price
This method would normally be adopted in those transactions where integrated
services are provided by more than one enterprise or in the case multiple inter-
related transactions which cannot be separately evaluated.
(5) Transactional Net Margin Method :
The net profit margin realised by the enterprise from a related party transaction
shall be computed in relation to costs incurred or sales effected or assets
employed or to be employed by the enterprise or having regard to any other
relevant base. The net profit margin realised by the enterprise or by an
unrelated enterprise from a comparable uncontrolled transaction or a number of
such transactions, shall also be computed having regard to the same base. This
net profit margin shall be adjusted to take into account the differences, if any,
between the related party transaction and the comparable uncontrolled
transactions or between the enterprises entering into such transactions, which
could materially affect such net profit margin in the open market. The cost of
production referred to above increased by the adjusted profit mark-up shall be
taken as arm’s length price. The adjusted net profit margin shall be taken as
arm’s length price.
This method would normally be adopted in the case of transfer of semi finished
goods.; distribution of finished products where resale price method cannot be
adequately applied; and transaction involving provision of services.

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Transfer Pricing

Corporate Tax Planning 1

Motivational and Operational Aspects

Corporate Tax Planning 2

TNCs combine centralised control and integrated corporate functioning with a

Corporate Tax Planning 3

Regulation of Transfer Pricing

Corporate Tax Planning 4

In India, the emphasis on self reliant, import substituting industrialisation and

Corporate Tax Planning 5

Corporate Tax Planning 6

Corporate Tax Planning 7

Corporate Tax Planning 8

Introduction of Transfer Pricing Regulaions

Need and rational for introduction of the T. P. R.

How do tax authorities detect transfer pricing?

Why do transfer pricing regulations gain importance in a developing country like

Corporate Tax Planning 9

What are the regulations in India that tackle transfer pricing?

Are the regulations in India adequate to curb transfer pricing abuse?

Transfer pricing sections under India Income-tax Act, 1961

Section 92. Computation of income from international transaction having regard to

1. Any income arising from an international transaction shall be computed having

3. Where in an international transaction, two or more associated enterprises enter

Corporate Tax Planning 10

Section 92A. Meaning of associated enterprise

b. in respect of which one or more persons who participate, directly or

b. any person or enterprise holds, directly or indirectly, shares carrying not

c. a loan advanced by one enterprise to the other enterprise constitutes not

e. more than half of the board of directors or members of the governing

g. the manufacture or processing of goods or articles or business carried out

Corporate Tax Planning 11

commercial rights of similar nature, or any data, documentation, drawing

i. the goods or articles manufactured or processed by one enterprise, are sold

j. where one enterprise is controlled by an individual, the other enterprise is

k. where one enterprise is controlled by a Hindu undivided family, the other

l. where one enterprise is a firm, association of persons or body of

m. there exists between the two enterprises, any relationship of mutual

Section 92B. Meaning of international transaction

Corporate Tax Planning 12

Section 92C. Computation of arm's length price

1. The arm's length price in relation to an international transaction shall be

b. resale price method ;

c. cost plus method ;

d. profit split method ;

e. transactional net margin method ;

f. such other method as may be prescribed by the Board.

a. the price charged or paid in an international transaction has not been

b. any information and document relating to an international transaction have

Corporate Tax Planning 13

e. Provided that an opportunity shall be given by the Assessing Officer by

Provided further that where the total income of an associated enterprise is

Section 92D. Maintenance and keeping of information and document by persons

Corporate Tax Planning 14

Provided that the Assessing Officer or the Commissioner (Appeals) may, on an

Section 92E. Report from an accountant to be furnished by persons entering into

Section 92F. Definitions of certain terms relevant to computation of arm's length

iii. "enterprise" means a person (including a permanent establishment of such person)

iv. "specified date" means,--

v. "transaction" includes an arrangement, understanding or action in concert,--

Corporate Tax Planning 15

A. whether or not such arrangement, understanding or action is formal

B. whether or not such arrangement, understanding or action is

271BA. Penalty for failure to furnish report under section 92E