Financial Year (FY) end: Points to ponder from Transfer Pricing (TP) perspective
Background
Following the close of FY 2024–25, it is pragmatic for taxpayers to review effective implementation of their TP policies and ensure that financial statements are reflective of defined transfer pricing policies so as to mitigate differences, if any, arising on account of non-alignment with the arm’s length principle. While closing the books of accounts for the year under consideration, the taxpayer may consider the following:
TP Checkpoints
Value of international transactions disclosed in the related party schedule are meticulously reconciled with transactions accounted for in books of accounts.
Appropriate provisions are recognized for ongoing TP litigations basis the likely outcomes in line with applicable accounting standards.
Segmental financial information is prepared and maintained in case of taxpayers having multiple revenue streams and transactions with related parties and/or unrelated parties with adequate allocation of common cost using rational allocation ratios.
All TP related supporting documents viz. invoices, workings, valid intercompany agreements etc are thoroughly maintained.
Intercompany agreements are valid for the relevant period under consideration or renewed accordingly.
TP Adjustments
Taxpayers shall compare actual year-end financial results against the predetermined margins set in their TP policies. If discrepancies exist, adjustments (true-up or true-down) should be performed before finalizing financial statements. The timing of these adjustments is critical, particularly concerning potential implications arising viz. withholding tax and Goods and Service tax (GST), Customs, Accounting Standards and Forex fluctuations etc.
Distributors' losses
Distribution business models, though seemingly simple, often pose challenges in implementing transfer pricing policies. Limited risk distributors must maintain assured net operating margins, while normal risk distributors can incur net losses with strong arm's length rationale. Losses incurred by normal risk distributors require robust documentation, analyzing whether they stem from market penetration strategies. They need to be supported by realistic projections, as for third-party distributors, incurring losses or investing for another third party is unlikely unless they perceive a realistic chance of recouping past losses and achieving a fair market return on their investments.
In case of losses, evaluating subvention or credit notes from Associated Enterprises (AE) and adjusting pricing in future budgets becomes necessary, particularly for exceptional years. Complications arise, especially when distributors undertake significant marketing functions, which is highly litigated by Indian tax authorities for the corresponding returns.
Free of Cost Goods/Services
Cost plus entities being captive service providers, contract manufacturers often face a dilemma from receipt of free of cost goods/services/assets. From an Indirect Tax perspective, the taxpayer is required to pay customs duty on goods/assets and GST on services on reverse charge basis (if not eligible to full Input Tax Credit), to avoid interest and penal implications.
Similarly, from a transfer pricing standpoint there is an expectation that these costs are considered in the cost base and recovered with a mark-up. While services such as shareholder services should not be charged, there are other services such as management services or technical services which the taxpayer would have otherwise availed from third parties for providing the captive services, should be charged.
Similarly, laptops and off the shelf software such as Microsoft software should be charged to the taxpayer and these costs (in the profit and loss account) should be recovered with a mark-up from the AE in a captive scenario. The approach adopted from the GST perspective needs to be aligned from the TP perspective and appropriate disclosure needs to be made in the Form 3CEB for the relevant year under consideration to avoid any misreporting of such transactions from a completeness perspective.
Secondary Adjustments
Timely TP adjustments undertaken in the books of accounts would avoid triggering any suo-moto adjustments in the annual returns for the relevant year under consideration and secondary adjustment implications thereon.
Alternate Dispute Resolution Mechanism
Based on past litigation history, the taxpayer may evaluate to opt for any dispute resolution mechanism viz. safe harbour rules or advance pricing agreements. Further, the taxpayer may leverage on the rates prescribed under safe harbour as indicative rates and align its pricing policy based on the economies of scale to mitigate the risk of litigation in future.
Treatment Of Extraordinary Items
Examine any extraordinary income or expense items recorded during the fiscal year to determine their appropriate inclusion/exclusion from the cost base for mark-up calculations or revenue for margin computations. It is pertinent to note that there are a plethora of rulings already available in the Indian judiciary on the treatment of such costs and income while computing the margin earned by the tested party for the relevant year under consideration.
Deemed International Transactions (DIT)
Under Indian TP regulations, transactions undertaken between the taxpayer and independent party, wherein the key terms of such transactions are determined by the foreign AE - either through contractual arrangement or in substance, are construed as DIT. Akin to other international transactions, DIT transactions must adhere to the arm’s length principle. Identifying DIT can be complex, requiring taxpayers to recognize, report, and justify such transactions. Thus, reviewing contracts with independent parties is crucial to determine DIT applicability to avoid any misreporting of such transactions.
Overdue Receivables
Litigation over overdue receivables has intensified, with tax authorities often imputing notional interest charges on such overdue receivables. Taxpayers in such cases shall pro-actively ensure that outstanding receivables are settled within agreed credit periods. Aligning credit policies with those offered to independent parties and maintaining strong documentation such as purchase orders, invoices, and agreements can help substantiate compliance. Judicial precedents have favored taxpayers with well-documented cases, reinforcing the importance of thorough record-keeping.
Need-Benefit Test for Availing Intragroup Services
Tax authorities frequently scrutinize intragroup services, questioning their necessity and benefits. To substantiate these services, taxpayers must maintain detailed records, including emails, meeting minutes, internal memos, and timesheets. Additionally, documentation should outline cost details, allocation methods, and benchmarking studies supporting mark-ups. Delays in compiling this information - especially when key employees leave or historical data is inaccessible - can lead to disallowances, attracting additional tax, interest, and penalties. To mitigate risks, it is prudent to maintain documentation on a real-time basis.
Foreign entities TP compliance in India
In case the foreign AE of the taxpayer earns taxable income, viz. fees for technical services, royalty, interest etc. in India then, the foreign AE is required to file its return of income and undertake prescribed TP compliances i.e., Form 3CEB and maintain the transfer pricing study report in India. Further, the taxpayer needs to obtain a Permanent Account Number (PAN), evaluate and opt between withholding tax provisions as prescribed by the Income-tax Act, 1961 (ITA) vis-à-vis Double Taxation Avoidance Agreement (DTAA) provisions while making payments to foreign entities. A reconciliation of total value income derived by foreign entities and 26AS of AE should be maintained.
As the financial year closes, addressing key transfer pricing considerations is crucial to ensure compliance, mitigate risks, and align business strategies. By systematically addressing the above areas, Multi-national Enterprises (MNEs) can strengthen their compliance framework, reduce disputes, and build a robust defense mechanism during TP audits. A proactive approach, including early planning for the next financial year, enables businesses to anticipate challenges, implement timely solutions, and maintain operational efficiency.