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International transactions between related entities and international transfer pricing

Under certain circumstances, international transactions, i.e., transactions between an Indian entity and a foreign entity which are related in the manner described below, may have to comply with transfer pricing norms stipulated under the Act. These norms have to be complied with, when the parties engaged in an international transaction qualify as "associated enterprises" under the Act. Broadly, parties which are connected by shareholding (i.e. one owns significant shares in the other), common ownership, or excessive financial transactions or excessive economic dependence are sought to be governed. The purpose is to eliminate tax arbitrage, or shifting income to another entity through artificial transactions to reduce tax effects. Two parties can qualify as ‘associated enterprises’ when any one of the following conditions is satisfied (the Act lists certain other conditions as well but the most common ones are listed below):
  1. one of the parties has 26% or more equity stake in the other,
  2. a party has the power to appoint more than half the board members or managers to the other,
  3. where a party is wholly dependent on the other for licenses, copyrights or raw materials,
  4. a party has granted loans exceeding 50 percent of the assets of the other party, or
  5. a party has provided guarantees to the other, which exceeds 10 percent of the total borrowings of the latter.
The transfer pricing provisions under the Act require the related parties to undertake the transaction at arm’s length price, i.e., the value at which the parties would have entered into had they been unrelated parties. Transactions with the Indian entity relating transfer of goods, intangibles, services, cost contribution arrangements, etc. would attract transfer pricing regulations.

A foreign entity contemplating a joint venture with an Indian entity (which satisfies the features listed points (i) to (v) above, i.e. if it is considering at least a 26% stake directly or through a common parent, or if it has significant control or has significantly contributed to the Indian JV either by way of loans, guarantees or by providing intellectual property rights, must comply with transfer pricing provisions while dealing with the Indian entity.

The transfer pricing regulations prescribe various arms' length pricing methods.[1] In addition, parties are required to maintain robust documentation and other evidence to substantiate that prices for transactions between such parties are on arms-length basis. They may also be required to file certain returns with tax authorities like Form 3CEB containing a list of transactions between the associated entities in the year, along with tax return.  Method of determining arms-length pricing, etc. must be maintained in transfer pricing documentation, which the tax payer should have ready with him (by the time of filing return), so that at the time of transfer pricing audit/ scrutiny assessment/ summary assessment taxpayer can submit the same if required.

(See Sections 92 to 92F of the Act for more details)
The link between international transfer pricing and the concept of permanent establishment

The Income Tax Act imposes the obligation to pay income tax on a non-resident. If the Indian company is not carrying on any independent business but is almost wholly carrying out the business of the offshore parent, or has the capacity to bind the offshore parent as an agent, then it will be considered as a PE of the parent. Determination of which economic relationships amount to a permanent establishment is an intricate inquiry and will not be undertaken here. However, we will explain what happens in the event a foreigner has a PE in India. If a PE is constituted for the offshore entity in India, tax assessment will be carried out in the following manner:
  1. Transactions between the offshore entity and the Indian entity will be scrutinised to find out if there are any transactions that are not on an arms-length basis (see the discussion under the head “Transactions between the offshore entity and the Indian company: International Transfer Pricing”).[2]
  1. Based on the transactions that are not on an arms-length basis, a portion of the income will be attributed to the foreign entity (on the basis of transactions that are not on an arms-length basis), and will be taxed at 40%, which is the rate applicable to foreign entities (plus applicable education cess and surcharge).


Note: If all transactions between the offshore and Indian entity are carried out on an arms-length basis, no attribution of income will be carried out, even when the Indian entity constitutes a PE, because it is understood that no tax arbitrage is involved in this instance.


[1] Comparable uncontrolled price method (CUP), resale price method, cost plus method, profit split method and transactional net margin method are some of the prescribed methods. Interested students are encouraged to read a book on transfer pricing for more details on these methods.
[2]Note: The foreign entity must have a minimum 26% stake for this analysis to be undertaken.

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