International Taxation – Int. Transactions, Profit Shifting, ALP ComputationAtul Khurana
Let’s proceed further…..
An international transaction means:
- a transaction between two or more associated enterprises, either or both of whom are nonresidents; and
- transaction in the nature of:
- sale/ purchase/ lease of tangible property; or
- sale/ purchase/ lease of intangible property; or
- provision of services; or
- lending/borrowing money; or
- any other transaction having a bearing on profits, income, losses or assets of such enterprises; or
- mutual agreement or arrangement between two or more associated enterprise 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.
Deemed International Transaction :
Where, in respect of a transaction entered into by an enterprise with a person other than an associated enterprise (hereinafter referred to as “other person”),
- there exists a prior agreement in relation to the relevant transaction between the other person and the associated enterprise or,
- where the terms of the relevant transaction are determined in substance between such other person and the associated enterprise; and
- Either the enterprise or the associated enterprise or both of them are non-residents,
then such transaction entered into between the enterprise and the other person shall be deemed to be an international transaction entered into between two associated enterprises, whether or not such other person is a non-resident.
Example: If A Ltd., an Indian company, has entered into an agreement for sale of mobiles to Mr. B, an unrelated party, on 1/6/2017 and Mr. B has entered into an agreement for sale of product mobiles with C Inc., a non-resident entity, which is a specified foreign company in relation to A Ltd. (Means A Ltd. holds 26% or more in the nominal value of the equity share capital of C Inc), on 30/5/2017, then, the transaction between A Ltd. and Mr. B shall be deemed to be an international transaction entered into between two associated enterprises, irrespective of whether or not Mr. B is a nonresident.
Because ultimately A Ltd is selling to C Ltd (Associate co. of A ltd) indirectly via B Ltd.
Meaning of Transaction:
I know you are pretty much aware about the meaning of transaction but when it comes to a definition which is a part of the Act then the scope of a particular term increases many folds.
So let us see what is a transaction as per the Act:
As per section 92F(v) of the Act, “transaction” includes an arrangement, understanding or action in concert –
- whether or not such arrangement, understanding or action is formal or in writing; or
- whether or not such arrangement, understanding or action is intended to be enforceable by legal proceeding.
Section 92F(v) provides an inclusive definition of the term “transaction”. Based on the reading of the section, it is evident that it is not necessary that for a transaction undertaken between two enterprises there needs to be a formal written agreement between them. It is only relevant whether a transaction has been entered into in substance. The section also negates the requirement as to the legal enforceability of agreement or understanding.
Profit Shifting Transactions:
Here comes the interesting and important part i.e. the shifting of profits from
- Profit making entity to loss making entities or,
- Domestic Tariff Area (DTA) to Tax Holiday Unit
See the following pictures (Example 1 & Example 2) and you will understand the whole scenario.
I Hope that you have got the whole scenario in your mind. This is how the MNC’s evades the tax.
Till now we have talked about the ALP, International transactions and associated enterprises. Now let’s understand how to calculate ALP for a particular transaction or entity.
Section 92C – Computation of ALP:
Income Tax Act, 1961 prescribes total 5 + 1 methods for the computation. Yes, Its 5 + 1 but not 6. See how…
- Comparable uncontrolled price method;
- Resale price method;
- Cost plus method;
- Profit split method;
- Transactional net margin method;
- such other method as may be prescribed by the Board
So the 6th method is not known to anyone. That’s why I do not count it in methods but also we cannot ignore it as we can’t go beyond the Act.
I am giving you the brief idea of the above methods, not detaailed because whenever there will be a need to practically apply these methods, the only thing will be required is your ability to judge that which method will be more appropriate in that case, rest all will be the calculations part.
Method 1: Comparable Uncontrolled Price (CUP) method:
A comparable uncontrolled price is the price agreed between unrelated parties for the transaction of goods or services under similar circumstances.
The comparable uncontrolled price method requires a high degree of comparability of products, services and functions and such comparability can be improved by carrying out necessary reasonable adjustments, in respect of differences arising on account of various factors such as quality of the product or service, contractual terms, credit terms, transport terms, level of the market (i.e. wholesale, retail, etc.), geographic market in which the transaction takes place, etc.
For Example: Father Ltd (US) sold 50 mobiles to Son Ltd and Stranger Ltd at the following prices:
Son Ltd (Subsidiary in India): 2500 per mobile
Stranger Ltd (Unrelated party in India): 2000 per mobile including warranty for 3 months.
The cost of 1 month warranty period generally charged by Father Ltd is Rs. 100
So, it shows that transactions with Son Ltd are not at ALP. Therefore, we have to calculate the ALP for Son Ltd.
Father Ltd, the foreign company and Son Ltd., the Indian company are associated enterprises since Father Ltd. is the holding company of Son Ltd. Father Ltd. sells computer mobiles to Son Ltd. for sale in India. Father Ltd. also sells identical mobiles to Stranger Ltd., which is not an associated enterprise. The price charged by Father Ltd. for a similar product transferred in comparable uncontrolled transaction is, therefore, identifiable. Therefore, Comparable Uncontrolled Price (CUP) method for determining arm’s length price can be applied.
For sale of mobiles by Stranger Ltd., Father Ltd. is responsible for warranty for 3 months. The price charged by Father Ltd. to Stranger Ltd. includes the charge for warranty for 3 months. Therefore, this price needs to be adjusted and Hence ALP is as follows:
Sale price charged by Father Ltd. to Stranger Ltd = Rs. 2000
(Less) Cost of warranty included for 3 months (100*3) = Rs. 300
Arm’s Length Price (2000-300) = Rs. 1700
Actual price paid by Son Ltd. (given) = Rs. 2500
Difference in price (2500-1700) = Rs. 800
Total mobiles sold = 50 sets
Therefore, addition required to be made in the computation of total income of Son Ltd. = 800*5 = Rs. 4000
No deduction under chapter VI-A would be allowable in respect of the enhanced income of Rs. 4000.
The other methods will be discussed in the next article.
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