ITAT does a reality check on computation of transfer price
November, 12th 2007
The Income-tax Appellate Tribunal (ITAT), Delhi, has ruled that the income tax department merely on the basis of inferences and presumptions should not arbitrarily reject the taxpayers transfer pricing calculations and analysis. The ITAT observed that transfer pricing is not a science in which mathematical precision is possible. There should be room for some degree of approximation. Trade and industry should be happy with this ruling of ITAT. Being the first on the subject, the ruling will have a bearing on transfer pricing assessments in the country.
Well, if the mechanism of transfer pricing is not misused or abused by business, then it helps the business concerned to reduce taxes by moving money across borders. In other words, is a tax planning tool for the business concerned. On the other hand, if the said mechanism is misused or abused by business, it leads to tax evasion on the part of the business concerned. This explains why tax authorities take a rather critical look at the transfer pricing calculations of the tax-paying assessees. While doing so, they err on the side of caution at times since they want to save their own skin. But they do so at a great cost to the assessee.
Obviously, transfer prices are attributable to cross-border business. In cross-border business, transfer of goods and services between the parent company and foreign subsidiaries and between foreign subsidiaries themselves, is quite common. This is because the value creation activities of the business are generally conducted at the various cost-effective locations across the globe. The price of the said goods and services which are transferred between entities within the business is called transfer price. Businesses move funds out of a country by specifying high transfer prices for goods and services supplied to a subsidiary in that country and by specifying low transfer prices for the goods and services provided by that subsidiary. On the other hand, if businesses want to retain the funds in a country, they do the opposite: specifying low transfer prices for goods and services supplied to a subsidiary in that country and specifying high transfer prices for the goods and services provided by that subsidiary.
Why would businesses want to move funds out of a country or retain funds in a country? The answer is to be found in the differing tax regimes that obtain across the world. The business in question can shift earnings from a high-tax country to a low-tax country, courtesy transfer prices. The business can also use transfer prices to reduce the import duties payable if an ad valorem tariff (tariff computed as a percentage of value) regime is in force. A lower transfer price attracts a lower tariff. There are a couple of other equally important reasons too but anyway we do not need to necessarily consider these reasons for the present discussion.
Governments generally believe that transfer prices are used by businesses to understate their profits and thus minimise tax payment. But on this pretext the government should not view computation of transfer prices rather cynically. The correct transfer price is the arms-length price. As long as the transfer price computed by the assessee is more or less equal to this arms-length price, the tax authorities should have no reason to complain. As I said earlier, when in doubt, the tax authorities err on the side of caution which means the assessee ends up paying enormous tax. It is not easy for the business or for that matter the tax department itself to compute the arms-length price accurately. Some margin has to be allowed to the assessee in question. As the ITAT has rightly said, transfer pricing is not a science in which mathematical precision is possible. Thus, the taxpayers transfer pricing calculations and analysis should not be arbitrarily rejected by the income tax department merely on the basis of inferences and presumptions.
The ITAT held that the transfer pricing officer should carry out a fresh research into the issue only if there is a valid ground to presume that the companys approach to the issue of transfer pricing is insufficient. For example, the department can re-look into the issue if it feels that the factors taken into account for comparing the pricing with the pricing of other companies profitability, risk factor are not correct. If the FAR (functions, asset and risk) analysis made by the company is correct, there is no need for the transfer pricing officer to initiate a fresh research into their issue.
The ITAT has also observed that companies that take higher risk are bound to make higher profits or higher losses. Hence a sound risk analysis is necessary while selecting the comparables for determining the profitability of a transaction. Now the question is whether our income tax department has the expertise to undertake the said sound risk analysis to select the comparables. I do not think it has; it can hire experts to access their service, though. In such a case, the benefit-cost analysis should favour such hiring!