Financial year-end: Checkpoints from a Transfer Pricing perspective
As we approach the closure of accounts for FY 2023-24, it is crucial for the taxpayers to review the effective implementation of transfer pricing policies. This ensures alignment with these policies, compliance with the arm's length principle, and congruence with business objectives. Throughout the year, the taxpayers would have diligently monitored their intercompany transactions and assessed their adherence to arm's length standards. As the financial year ends, it is opportune for taxpayers to reflect and confirm their transfer pricing outcomes, considering the following key points:
- True-up/True-down Adjustment: Assess the actual year-end results and compare them to the predetermined margins outlined in the agreed Transfer Pricing policy. If there is a deviation (either shortfall or excess), the taxpayer can perform a true-up/true-down adjustment before closing the books for the year. The timing of this adjustment is crucial, considering its implications from both withholding tax and GST perspectives, wherever relevant.
- Segmental financials: Segmented financials are necessary for audited financials when certain criteria are met. From a transfer pricing perspective, they are essential when dealing with multiple revenue streams or transactions with related/unrelated parties (based on functions, activities, pricing policies, etc.). Preparing and analyzing these segmental financials before finalizing accounts is crucial to ensure compliance with arm's length criteria. If some segments do not meet these criteria, there's still room for true-up/true-down adjustments to align transactions appropriately. Moreover, while direct expenses can be allocated based on actual cost centers, identifying suitable allocation keys is essential for allocating indirect expenses.
- Losses incurred by distributors: Though seemingly simple, distribution business models often pose complexity to align with transfer pricing policies. Limited risk distributors must maintain guaranteed net operating margins, while normal risk distributors can incur net losses with a strong arm's length rationale. Losses incurred by normal risk distributors require robust documentation, analyzing whether they stem from market penetration strategies and are 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 cases of losses, evaluating subvention or credit notes from associated enterprises and adjusting pricing in future budgets becomes necessary, particularly for exceptional years. Complications arise, especially when distributors undertake significant marketing functions, which are highly litigated by Indian tax authorities.
- Deemed International Transactions (DIT): DIT, a concept in Indian transfer pricing regulations, applies when transactions between independent parties come under transfer pricing provisions and must adhere to the arm's length principle. Identifying DIT can be complex, with the taxpayer responsible for recognizing, reporting, and justifying such transactions from an arm's length perspective. It is crucial for taxpayers to review contractual arrangements with independent parties, determine DIT applicability, and communicate this to consultants to ensure compliance. Though true-up/true-down options are not available/limited with third-party transactions, early identification and risk analysis mitigate the risk of non-reporting.
- Need-benefit test for availing intragroup services: A significant area of dispute between tax authorities and Indian taxpayers stems from the receipt of intra-group services, often questioning the necessity and benefits received. Thus, maintaining thorough documentation is essential, including records of services provided, like emails, meeting minutes, internal memos, and timesheets. Additionally, it is crucial to include details of costs incurred by the associated enterprise, the basis for cost allocation, and benchmarking studies supporting hourly rates or markups charged. While such information is typically available, waiting until tax scrutiny to compile it poses challenges, especially if key employees have left or accessing historical data is difficult. This delay can result in the disallowance of charges, leading to tax, interest, and penalties. It is advisable to record and compile documents in real-time to mitigate such risks.
- Free of Cost goods/services: Cost-plus entities are captive service providers, and contract manufacturers often face a dilemma from receipt of free of cost goods/ services/assets. From a GST perspective, the taxpayer is required to identify the goods/services/ assets and pay GST on a reverse charge basis to avoid interest and penal implications. Similarly, from a transfer pricing standpoint, there is an expectation that these costs will be considered in the cost base and recovered with a markup. 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, which 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 markup from the associated enterprise.
- Overdue receivables: Litigation over overdue receivables has intensified in recent years. Taxpayers must ensure the timely realization of outstanding receivables within agreed credit periods to prevent notional interest charges during field audits. It is advisable for corporates to align their credit policies with those extended to independent parties and maintain thorough documentation, including purchase orders, invoices, and agreements to support their case. Judicial precedents have favored taxpayers with strong documentation, emphasizing the importance of maintaining proper records tailored to each specific case.
- Importance of documentation: Documentation plays a pivotal role in transfer pricing, serving as a cornerstone for ensuring compliance with regulations and defending against potential disputes with tax authorities. Adequate documentation provides a clear and transparent record of the company’s transfer pricing policies, methodologies, and transactions, demonstrating that pricing decisions are in line with the arm’s length principle. It helps justify the chosen transfer pricing methods, delineate the functions, risks, and assets among related entities, and provide evidence of comparability analysis. Additionally, documentation enables taxpayers to proactively assess and mitigate transfer pricing risks, ensuring consistency in approach across jurisdictions and facilitating smoother audits. Strong documentation not only enhances tax compliance but also builds credibility with tax authorities, potentially reducing the likelihood of adjustments, penalties, and double taxation. Therefore, maintaining comprehensive and contemporaneous documentation is essential for companies to navigate the complexities of transfer pricing effectively and minimize tax-related risks.
These remarks highlight the essential considerations for concluding the financial year from a transfer pricing standpoint, underscoring the significance of compliance, risk management, and strategic alignment. By focusing on these aspects, taxpayers can strengthen their transfer pricing practices, mitigate compliance risks, and align with our broader financial objectives. Diligent adherence to regulations fosters transfer pricing excellence and reinforces the integrity of our global operations. Concurrently, it is prudent for taxpayers to initiate planning for the upcoming financial year, identifying potential transfer pricing implications of new business initiatives or restructuring endeavors. Proactive planning empowers taxpayers to anticipate challenges and implement timely solutions, ensuring continued compliance and operational efficiency.