Valuation of related party transactions by taxmen

SERVICE TAX

Pricing of cross border supplies of goods and services assumes significance for the purpose of determining customs duties thereon and also for ascertaining the income tax liability of the person undertaking or receiving cross border supplies. It therefore becomes imperative for the tax authorities to ensure that the pricing of supplies reflect their true commercial value and is not controlled by the transacting parties to avoid taxes.

In the case of a transaction between independent parties, the pricing of supplies is determined on the basis of commercial consideration. In the case of transaction between related parties, the pricing of supplies can be affected by factors other than consideration.

In order to ensure that the pricing of supplies between related parties is not designed by the transacting parties to avoid taxes, both the Customs Act, 1962 and the Income Tax Act, 1961 provide mechanisms to compute the appropriate values of the cross border transactions between related parties.

The Customs Valuation Rules (CVR), 1988, lay down the principles to determine the transaction values of cross border supplies between related parties for the purposes of customs duty.

The methods of computing the value of transactions are based on the values of identical/similar goods sold between unrelated parties, the deductive value or the computed value whereby the price is determined on the basis of either the selling prices in India after deduction or on the basis of the cost of production of the goods in the exporting county respectively.

On the other hand, the Income Tax Act, 1961, vide the Transfer Pricing Rules, 2001, provides mechanism to determine the value of supplies (transfer price) made by multinational companies to their subsidiaries and associate companies, for the purposes of income tax. The yardstick for such transfer pricing is the arms length price that should represent the price charged in comparable transactions between independent parties, where price is not influenced by the relationship or business interest between the parties in the transaction.

The Transfer Pricing policies of several countries are based on the OECD (Organisation of Economic Co-operation and Development) Guidelines on the subject. The methods of computation of transfer price of cross border supplies effected between related parties under both the customs and income tax provisions are broadly similar. However, there are some dissimilarities in the respective definitions of 'related party' under both legislations.

The transfer pricing rules under the Income Tax treat enterprises as related even on the grounds of consumption of raw materials, dependence on patents, technology etc whereas the concept of relationship under CVR is a more limited one.

This difference between the CVR and transfer pricing rules could lead to one department treating the same transactions as between related parties and the other taking a contrary view. Thus, while customs may accept the declared price as at arm's length, the income tax authorities may not or may reduce the declared price. In this regard, harmonisation of the definition of related parties is an important objective.

It is significant to note that the Customs and income tax authorities are driven by diametrically opposite considerations to valuation. While the income tax authorities may seek to avoid diversion of profits to the exporting country by assessing lower transaction prices on imports, the Customs authorities would prefer to determine a higher transfer price to enhance Customs revenues. It would therefore be desirable to have a coordinated approach to the valuation of imported goods in cases involving transfer pricing so that the same price is adopted for both purposes after necessary verification for authenticity.

In this regard, the Ministry of Finance (MoF) has recently issued a circular dealing with the implementation of the recommendations of a Joint Working Group on Transfer Pricing. The Joint Working Group, comprising officers from Income Tax and Customs, was constituted to study the subject of Transfer Pricing and suggest measures for co-operation between the Income Tax and Customs Departments.

The substantive recommendations of the Joint Working Group and the corresponding implementation steps being taken by the MoF emphasise a three pronged strategy consisting of joint meetings and exchange of information between customs and income tax officers as well as joint training programmes for officers from both departments.

The Joint Working Group has recommended joint meetings at each of the four metros, ie Delhi, Mumbai, Chennai and Kolkata to be attended by Additional/Joint Commissioners and co-chaired by Directors/Commissioners of Income Tax and Customs, and also for six-monthly meetings of the Directors General/Chief Commissioners of Income Tax and Customs respectively.

The MoF has decided to implement this recommendation of the Working Group with immediate effect and has laid down that the minutes of the bi-monthly meetings be forwarded to the above officers of both departments and that the minutes of the six-monthly meetings be forwarded to the members of the Administrative Boards respectively, along with a listing of the issues requiring the immediate attention of the two Boards.

On the matter of exchange of information, the Joint Working Group has recommended the exchange of information on specific cases between the two authorities.

The MoF has decided that such exchange of information in specific cases would be done and the officers from the two departments would be designated at each of the four metros. Further, the field officers from the two departments will make available to each other databases relating to related parties/associated enterprises on a 'need to know' basis.

The Joint Working Group has also recommended training programs for the officers of both departments to familiarise themselves about the treatment of Transfer Pricing matters in the other department. It has further suggested that seminars and workshops be organised jointly for both Customs and Income Tax officers. The MoF has decided to develop and organise training programs to train the officials of both the departments.

The above circular can be seen as the first clear statement of intent of the Government of India towards addressing Transfer Pricing matters in a harmonious manner between the Customs and the Income Tax Departments. This also suggests that going forward, Customs and Income Tax authorities would be coordinating and exchanging information with each other on Transfer Pricing matters.

Such increase in interactions between the two departments makes it imperative for the companies operating in India to plan and document their transfer prices comprehensively, based on the valuation principles contained in both the Customs as well as Income Tax laws and also to deal with respective authorities in a harmonious and seamless manner.

In conclusion, these new developments have significant implications on companies with typical related party transactions and adequate care and consideration is required so that the arms length prices determined for such related party transactions can be appropriately defined. Corporates also need to closely work with the Centre to ensure that the coordinated approach between the customs and income tax authorities operates in a fair and transparent manner.

The writer is leader, indirect tax practitioner PricewaterhouseCooper