Law relating to Transfer Pricing
by
Pradeep S Shah
Rajesh S Kadakia

  1. Law relating to transfer pricing at a glance

  2. Introduction

  3. Enterprise

  4. Associated Enterprise

  5. International Transaction

  6. Income computation on arm’s length price

  7. ARM’s Length price computation

  8. Assessment and assessing officer’s powers

  9. Record keeping & Accountant’s Report

  10. Penalties

  11. Other Issues

Chapter Seven
Assessment and assessing officer’s powers 

7.1

General

7.2

Power to call for information or document in relation to an international transaction

7.2-1

Confidentiality of information

7.3

Power to determine the arm’s length price

7.4

An analysis of section 92C(3)

7.4-1

Opportunity of being heard should be real and effective

7.4-2

Disclosure of material to the assessee

7.4-3

Service of notice essential

7.4-4

Provisions directory and not mandatory

7.4-5

Assessing Officer’s duties

7.5

Computation of total income having regard to arm’s length price

7.5-1

Set off of losses

7.5-2

Minimum Alternate Tax (MAT)

7.5-3

Implication of the phrase ‘having regard to’

7.5-4

Exemption under section 10C

7.5-5

Order should be a speaking order

7.5-6

Provisions of section 92C(4) are directory and not mandatory

7.6

Recomputation of total income for the other associated enterprises

General

7.1 Broadly speaking, the powers/duties of Assessing Officer/Commissioner (Appeals) [CIT(A)] for the purpose of application of the provisions are as follows:

  (a)  Assessing Officer/CIT(A) have power to call for information

  (b)  Assessing Officer may proceed to determine arm’s length price

   (c)  Assessing Officer may proceed to determine total income having regard to arm’s length price

These are elaborated in subsequent paragraphs.

Power to call for information or document in relation to an international transaction

7.2 An Assessing Officer or CIT(A) may, in the course of any proceeding under the Act, require any person who has entered into an international transaction to furnish any information or document in respect thereof which the assessee is required to maintain.

This information or document will have to be furnished within a period of 30 days from the date of receipt of notice in this regard. The Assessing Officer or the CIT(A) may grant an extension of not more than 30 further days to furnish the said information or document.

The Assessing Officer or CIT (A) can require a person to furnish any information or document which is required to be maintained. In other words, they cannot ask for information which he is not required to maintain under section 92D(1).

Section 92D(3) provides that the Assessing Officer or CIT (A) may ‘in the course of any proceeding under this Act require any person who has entered into an international transaction to furnish any information or document in respect thereof. While the expression ‘in the course of any proceeding under this Act’ apparently seems to be very wide, it seems that the reference to ‘any proceeding under this Act’ should be regarded as a reference to a proceeding which is in existence at the material time.

It is with reference to such an existing proceeding that the Assessing Officer/CIT (Appeals) may require the said information or document which is likely to be useful or relevant to such existing proceeding. The phrase ‘any proceeding under this Act’ cannot include, contemplated or uncontemplated future proceeding. Hence, section 92D(3) cannot be regarded as permitting a fishing or roving enquiry and obtaining information or documents which are unrelated to an existing pending proceeding merely in order to enable the Assessing Officer to decide whether or not to institute the proceedings. In other words, the following seems to be the pre-requisites to enable the Assessing Officer to exercise the power under section 92D(3) :

  (a)  There ought to be a pending existing proceeding at the time when the information or documents is sought; and

  (b)  The information or document sought must be of the type which is useful or relevant to such a pending existing proceeding.

Reference in this regard may be made to the judgment in D. B. S Financial Services (P.) Ltd. [1994] 207 ITR 1077, 1082-84 (Bom.) & Grindlays Bank Ltd. v. ITO [1998] 231 ITR 612, 615 (Cal.) rendered in the context of section 133.

Again section 92D(3) empowers the Assessing Officer or CIT (Appeals) to seek such information or document from ‘any person’ who has entered into an international transaction. In this regard it seems that the expression ‘any person’ though apparently very wide in scope should be confined to the assessee in course of whose proceedings information is sought or a person intimately connected with the said proceeding. The said power cannot permit the Assessing Officer to seek information in respect of completely unrelated international transaction entered into by a total stranger or a person who cannot be said to be in anyway connected with any part of the proceeding in the course of which the information is sought. Support in this regard may be drawn from the judgment in Daulatram v. ITO [1990] 181 ITR 119, 137 (AP) and ITO v. Murlidhar Bhagwan Das [1964] 52 ITR 335 (SC).

7.2-1 Confidentiality of information - In this connection, the OECD Guidelines provide as follows :

“Tax administrations should take care to ensure that there is no public disclosure of trade secrets, scientific secrets, or other confidential data. Tax administrations therefore should use discretion in requesting this type of information and should do so only if they can undertake that the information will remain confidential from outside parties except to the extent disclosure is required in public court proceedings or judicial decisions. Every endeavour should be made to ensure that confidentiality is maintained to the extent possible in such proceedings and decisions.” (para 5.13)

Power to determine the arm’s length price

7.3 Section 92C(3) provides that the Assessing Officer may determine the arm’s length price, in certain situations. The following are the pre-conditions for applicability of section 92C(3):

  (a)  There should be a proceeding for assessment of income.

  (b)  The Assessing Officer has material or information or document in his possession.

   (c)  On the basis of this material or information or document in his possession, the Assessing Officer is of the ‘opinion’ that—

the arm’s length price charged or paid in an international transaction has not been determined in accordance with prescribed methodology to determine the ‘arm’s length price’; or

the assessee has not kept the prescribed information and document relating to an international transaction; or

the information or data used in computation of the arm’s length price is not reliable or correct; or

the assessee has failed to furnish, within the specified time, any information or document which he was required to furnish by the Assessing Officer.

If the aforesaid conditions exist, the Assessing Officer ‘may’ proceed to ‘determine’ the arm’s length price. However, before doing that the proviso to section 92C(3) requires the Assessing Officer to serve a notice calling upon the assessee to show cause on why the arm’s length price should not be determined on the basis of material or information or document in possession of the Assessing Officer. Such arm’s length price has to be determined in accordance with the provisions of section 92C(1) and 92C(2).

On having determined the arm’s length price under section 92C(3), the Assessing Officer ‘may’ compute the total income of the assessee having regard to the arm’s length price [section 92C(4)]. In doing so, following may be noted :

           if the total income is enhanced, no deduction under section 10A or section10B or under Chapter VIA would be allowed [First proviso to section 92C(4)].

           where the total income of an associated enterprise is computed on determination of arm’s length price paid to another associated enterprise from which tax has been deducted under Chapter XVIIB, the income of the other associated enterprise would not be recomputed by reason of such determination [Second proviso to section 92C(4)].

An analysis of section 92C(3)

7.4  The Assessing Officer can determine arm’s length price ‘on the basis of’ material, information or documents in his possession.

On the basis of

According to section 92C(3), the Assessing Officer can require the assessee to show cause only ‘on the basis of’ material or information or document’ in his possession.

Black’s Law Dictionary (Sixth Edition) defines the word ‘basis’ as follows:

“Fundamental principle; groundwork; support; the foundation or groundwork of anything; that upon which anything may rest or the principal component parts of a thing”

Thus, the Assessing Officer can require the assessee to show cause only on the support of such material or information or document in his possession.

A similar language is used even in section 143(1)(a). Section 143(1)(a) provides that if any tax and/or interest is found due on the basis of the return of income, an intimation would be sent to the assessee demanding payment thereof. If the refund is found due ‘on the basis of’ such return, it would be granted to the assessee. The section prior to its amendment by the Finance Act, 1999 empowered the Assessing Officer to make certain adjustments in computing such tax or interest payable by or refundable to the assessee. There are two relevant judgments in the context of section 143(1)(a). In S.R.F. Charitable Trust v. Union of India [1992] 193 ITR 95 (Delhi), the Assessing Officer, while issuing the intimation under section 143(1)(a), made certain additions to the returned income. These additions were made by the Assessing Officer only on account of the reason that no proof in respect of the claim was filed with the Assessing Officer. The Court held as follows:

           Section 143(1)(a) provides that the Assessing Officer could make an adjustment to the returned income or loss if the deduction, allowance, or relief claimed was found prima facie inadmissible on the basis of the information available in such return, accounts or documents.

           The conclusion that the claim of the assessee was inadmissible must flow from the return as filed.

           There was no power in the hands of the Assessing Officer to disallow a claim for the reason that there was no proof in support of the claim made by the assessee. In other words, if proof in support of the claim was not furnished by the assessee, then for the lack of proof no disallowance or adjustment could be made.

A similar conclusion was reached in Khatau Junkar Ltd. v. K.S. Pathania [1992] 196 ITR 55 (Bom.)

This also implies that an Assessing Officer should have some material or information or document in his possession before he can proceed further.

Material, information or document

‘Material’, ‘information’ or ‘document’ in possession is required to determine arm’s length price.

Section 92C(3), as discussed above, provides that an Assessing Officer can proceed only on the basis of material or ‘information’ or document in his possession.

The term ‘information’ has not been defined in the Act, Section 147 prior to its amendment by the Direct Tax Laws (Amendment) Act, 1987 used a similar language as in section 92C(3). Section 147(b) empowered the Assessing Officer to reassess income, in consequence of ‘information’ in his possession if he had reason to believe that income chargeable to tax has escaped assessment. Again, section 132 permits a search action only on the basis of information in possession of specified authority.

In the context of section 147(b), it has been held by several Courts that information cannot include mere apprehension, suspicion or misgi-ving.

It appears that, a similar interpretation should be placed on the expression ‘information’ appearing in section 92C(3). Thus, the Assessing Officer cannot proceed on the basis of any wayside gossip, any inference, or surmise drawn by a person from certain facts which are assumed to exist and not supported by any data or any general opinion expressed by a person qualified, experienced, or acquainted with the subject matter [see Bai Aimai Gustadji Karaka v. GTO [1975] 99 ITR 257 (Guj.)]. This interpretation is further supported by the use of the expression ‘opinion’ in section 92C(3). The Delhi High Court in VLS Finance Ltd. v. CIT [2000] 246 ITR 707 has given the following meaning to the expression:

“Opinion means something more than mere retailing of gossip or hearsay; it means judgment or belief, that is a belief to or a conviction resulting from what one thinks on a particular question. It means judgment or belief based on grounds short of proof. If a man is to form an opinion and his opinion is to govern, he must form it himself on such reasons and grounds as seem good to him.”

Further, taking support from the judgments rendered under section 132 and the erstwhile section 147(b), it can be argued that the expression ‘material or information or document’ should be construed as some valid and definite material, information or document and not any imaginary or invalid material, information or document. The material, information or document should not be vague and far fetched but must be relevant and have a rational nexus with and relevant bearing on the formation of the Assessing Officer’s opinion under section 92C(3).

7.4-1 Opportunity of being heard should be real and effective - According to the proviso to section 92C(3), the Assessing Officer may proceed to determine the arm’s length price only after he has served a notice calling upon the assessee to show cause on why the arm’s length price should not be determined on the basis of material or information or document in his possession.

A similar provision is contained in section 144. Section 144 which deals with best judgment assessment, requires the Assessing Officer, in certain circumstances, to provide an opportunity to the assessee to show cause why the assessment should not be completed to the best of his judgment. In the context of section 144, the Courts have held as follows :

           The assessee should be given a reasonable opportunity of being heard. It has been held that where the notice is received by the assessee only on the date fixed or a particular hour for compliance is mentioned and this is alleged to have been exceeded, the Court may hold that the assessee has had inadequate opportunity of compliance [refer amongst others - S. Velu Palandar v. Dy. CTO [1972] 83 ITR 683 (Mad.) and Rudrappa Ningappa Ganijera v. Agrl. ITO [1983] 139 ITR 367 (Kar.)]

           The issue and service of a notice is not a mere procedural formality. The assessment would be vitiated on failure to provide a reasonable opportunity to the assessee of being heard [Addl. CIT v. Radhey Shyam Jagdish Prasad [1979] 117 ITR 186 (All.); S. Velu Palandar v. Dy. CTO [1972] 83 ITR 683 (Mad.); Munnalal Murlidhar  v. CIT [1971] 79 ITR 540 (All.) and Sadaram Puranchand v. CIT [1931] 5 ITC 459 (Cal.)]

It appears that similar principles would apply vis-a-vis section 92C(3) also.

7.4-2  Disclosure of material to the assessee - In terms of the proviso to section 92C(3), the Assessing Officer, is required to give the assessee an opportunity to show cause as to why the arm’s length price should not be determined on the basis of material or information or documents in the Assessing Officer’s possession and on the basis of which the Assessing Officer proposes to determine the arm’s length price. Now, it is only when such information or document is made available to the assessee that the assessee will be able to meaningfully represent himself and be able to show cause as to why arm’s length price should not be so determined as proposed by the Assessing Officer. Hence the assessee is entitled to know the material, information or document on the basis of which the Assessing Officer formed the opinion under section 92C(3) that the price charged/paid has not been determined in accordance with section 92C(1) and (2).

It may be noted that in the context of section 263, it has been held that the opportunity to be heard to the assessee under section 263 should be in the form of a notice which should state the points on which the CIT is of the view that the order is erroneous and the reason for such view [Silver Cloud Estates (P.) Ltd. v. State of Tamil Nadu [1996] 219 ITR 244 (Mad.)]. The Court held as follows :

“If the revisional authority proposes to revise any order of the sub-ordinate authority, he should come forward with relevant materials warranting such revision and such material should be placed before the assessee giving him an opportunity to rebut it. Simply saying the deduction of expenditure allowed is in excess, will not give the revisional authority power to invoke section 34 of the Tamil Nadu Agricultural Income-tax Act, 1955.”

7.4-3 Service of notice essential - The proviso to section 92C(3) requires the Assessing Officer to serve a notice calling upon the assessee to show cause why the arm’s length price should not be determined on the basis of material or information or document available with the Assessing Officer. It has been held that non-service of notice or improper service of notice (that is where notice is not served in the manner prescribed under sections 282 to 284) invalidates the assessment proceedings - CIT v. Baxiram Rodmal [1934] 2 ITR 438 (Nag.), CIT v. Dey Bros. [1935] 3 ITR 213 (Rang.); C.N. Nataraj v. Fifth ITO [1965] 56 ITR 250 (Mys.); Thangam Textiles v. First ITO [1973] 90 ITR 412 (Mad.); Lakshmibai v. ITO [1972] 86 ITR 804 (Mys.); C.T. Rajagopal v. State of Mysore [1972] 86 ITR 814 (Mys.)

In view of this, it is essential for the Assessing Officer to ‘serve’ the notice upon the assessee to validate his action under sections 92C(3) and 92C(4). Thus, mere issue of notice is not sufficient; there should be a service of the notice. The service of such a notice should be in the manner laid down in sections 282 to 284.

7.4-4 Provisions directory and not mandatory - Section 92C(3) provides that if the Assessing Officer is, on the basis of material or information or document in his possession, of the opinion that the price charged or paid in an international transaction has not been determined in accordance with section 92C(1) and (2), he may proceed to determine the arm’s length price.

In view of the word ‘may’, it can be argued that there is no rigid/inflexible rule that in every case where the price charged/paid is not in accordance with section 92C(1) and (2), the arm’s length price must be determined under section 92C(3). [See also paras 5.6 and 5.7]

7.4-5 Assessing Officer’s duties - The OECD guidelines provide as follows :

“In a difficult transfer pricing case, because of the complexity of the facts to be evaluated, even the best-intentioned taxpayer can make an honest mistake. Moreover, even the best-intentioned tax examiner may draw the wrong conclusion from the facts. Tax administrations are encouraged to take this observation into account in conducting their transfer pricing examinations. This involves two implications. First, tax examiners are encouraged to be flexible in their approach and not demand from taxpayers in their transfer pricing a precision that is unrealistic under all the facts and circumstances. Second, tax examiners are encouraged to take into account the taxpayer’s commercial judgment about the application of the arm’s length principle, so that the transfer pricing analysis is tied to business realities. Therefore, tax examiners should undertake to begin their analyses of transfer pricing from the perspective of the method that the taxpayer has chosen in setting its prices.” (para 4.9)

Computation of total income having regard to arm’s length price

7.5 As mentioned earlier, on having determined the arm’s length price under section 92C(3), the Assessing Officer may compute the total income of the assessee having regard to the arm’s length price [section 92C(4)]. A detailed analysis of the provision is given below :

7.5-1 Set off of losses - Section 92C(4) empowers the Assessing Officer to compute the total income of the assessee having regard to the arm’s length price so determined by him. The section speaks about ‘computation of the total income’. It is well accepted that a computation can take place only after the provisions of section 32(2), dealing with set off of unabsorbed depreciation, and section 70 and section 71, dealing with losses, are given effect to. To illustrate, suppose say an assessee, X, has determined its total income at ‘Nil’ after having set off its brought forward business loss of Rs. 100 against its profits and gains of Rs. 40. Thus, according to X, it is entitled to carry forward a business loss of Rs. 60. Now, during the course of the assessment proceedings, the Assessing Officer finds that certain international transactions did not take place at arm’s length prices. On determining these arm’s length price, he finds that the profits and gains work out to Rs. 70. These profits and gains would be set off against the brought forward business loss of Rs. 100 and the balance loss of Rs. 30 can be carried forward by the assessee as against Rs. 60 which was claimed by him in the return of income.

7.5-2 Minimum Alternate Tax (MAT) - An issue arises as to whether the ‘book profit’ as determined under Explanation to section 115JB should also reflect the adjustment carried out by the Assessing Officer under section 92C(4) after determining the arm’s length price.

Having regard to the provisions for computation of book profit, it appears that the book profit cannot be increased by the recomputation of total income under section 92C(4).

7.5-3 Implication of the phrase ‘having regard to - Section 92C(4) empowers the Assessing Officer to compute the total income ‘having regard to’ the arm’s length price. Such a phrase is also found in section 92. [See also para 5.5]

7.5-4 Exemption under section 10C - Section 92C(4) provides that the Assessing Officer is empowered to recompute the total income of the assessee having regard to the arm’s length price. In doing so, if the total income is enhanced, no deduction under sections 10A, 10B or under Chapter VIA would be allowed. However, section 10C is not mentioned in the proviso. This suggests that an undertaking which qualifies for the benefit of section 10C, would be entitled to claim exemption under section 10C even in respect of the enhanced income.

7.5-5 Order should be a speaking order - The Assessing Officer should provide reasons in support of his conclusions drawn while computing the total income of the assessee on the basis of arm’s length price. A non-speaking order without giving reasons has been held to be invalid and hence, is liable to be quashed [refer Baidya Nath Sarma v. CWT [1983] 140 ITR 801 (Gau.), Mohammed Ali v. CWT [1983] 141 ITR 690 (Gau.) and CIT v. Sunder Lal [1974] 96 ITR 310 (All.).

7.5-6 Provisions of section 92C(4) are directory and not mandatory - Section 92C(4) provides that where the arm’s length price is determined by the Assessing Officer under section 92C(3), the Assessing Officer may compute the total income of the assessee having regard to the arm’s length price.

Having regard to use of word ‘may’, it can be argued that the Assessing Officer having determined the arm’s length price in section 92C(3) need not necessarily in every case invoke section 92C(4) and compute the total income having regard to the arm’s length price. Section 92C(4) confers a power or discretion on the Assessing Officer which would be exercised in appropriate cases. If however the circumstances of the case do not call for invoking section 92C(4), the Assessing Officer should not invoke the said section and should not proceed to compute the total income having regard to the arm’s length price as per section 92C(4). In this regard, reference may be made to the judgment of the Supreme Court in CIT v. Smt. P.K. Noorjahan [1999] 237 ITR 570.

In the said case, the assessee had made certain investments and the explanation of the assessee regarding the source of money for making these investments was rejected by the Assessing Officer. The Assessing Officer accordingly proceeded to treat the amount as the income of the assessee under section 69. On appeal, the Tribunal took the view that although the explanation of the assessee was not satisfactory and hence liable to be rejected, section 69 conferred only a discretion on the Assessing Officer to treat such unexplained investment as the income of the assessee and did not make it mandatory on the part of the Assessing Officer to treat the investment as the assessee’s income as soon as the explanation happened to be rejected. The Tribunal was of the view that although the assessee’s explanation was not satisfactory, having regard to her age and the circumstances she could not be credited with having made any such income.

The Supreme Court on these facts observed that there is no error in the said finding recorded by the Tribunal. It rejected the argument of the revenue that the word ‘may’ appearing in the section 69 should be read as ‘shall’.

While so holding it noted that in the corresponding clause in the Bill introduced in Parliament, the word used was ‘shall’ and that during the course of consideration of the Bill, the said word was substituted by the word ‘may’ on the recommendation of the Select Committee.

The Supreme Court held, that section 69 uses the word ‘may’ and thus confers a discretion on the Assessing Officer to treat the source of investment as the income of the assessee if the explanation offered by the assessee is not found satisfactory and that the said discretion has to be exercised, keeping in view the facts and circumstances of the particular case. The Supreme Court opined that the Assessing Officer is not obliged to treat such investment as income in every case where the explanation offered by the assessee is found to be not satisfactory.

It is pertinent to note that while the old section 92 used the word ‘shall’, the new section 92C uses the word ‘may’. Hence, drawing an analogy from the above judgment of the Supreme Court, it can be argued that the Assessing Officer is not obliged under section 92C(4) to compute the total income of the assessee ‘having regard to’ the arm’s length price in every case where the arm’s length price is determined under section 92C(3). Section 92C(4) confers a discretion on the Assessing Officer and the said discretion has to be exercised keeping in view the facts and circumstances of the particular case and there can be no rigid/inflexible rule that in every case where the arm’s length price is determined under section 92C(3), the total income must be determined under section 92C(4) having regard to the arm’s length price. [See also paras 5.6 and 5.7]

Recomputation of total income for the other associated enterprise

7.6 As mentioned above in para 7.3, where the total income of an associated enterprise is computed on determination of arm’s length price paid to another associated enterprise from which tax has been deducted under Chapter XVIIB, the income of the other associated enterprise would not be recomputed by reason of such determination.

Thus, the second proviso to section 92C(4) is attracted if the following conditions are satisfied :

   (i)  The total income of an associated enterprise (payer) is computed on determination of arm’s length price paid to another associated enterprise (recipient). Thus, the Assessing Officer of the payer should reduce the allowable expenditure (on the ground that expenditure incurred is more than the arm’s length price) which would increase its taxable income.

  (ii)  Tax has been deducted under Chapter XVIIB by the payer.

If these conditions are satisfied, the proviso stipulates that the income of the recipient cannot be correspondingly reduced by the amount of adjustment to arm’s length price in the assessment of the payer.

This proviso was not a part of the Finance Bill, 2001 when it was presented by the Hon’ble Finance Minister on 28-2-2001. However, it was proposed to be inserted in the Act while he was moving the Finance Bill, 2001 for consideration of the Lok Sabha on 25-4-2001. While proposing so, the Hon’ble Finance Minister observed as follows :

“Transfer Pricing provisions are proposed to be modified to clarify.... that adjustment made to the transfer price in case of one enterprise shall not by itself form the basis of a consequential adjustment in case of the other enterprise.”

The effect of insertion of the second proviso to section 92C(3) can be understood with the help of the following illustration :

X, a foreign company, and Y, an Indian company, are associated enterprises, X allows Y to use certain trade-marks which it (X) owns. For this purpose, Y has paid royalty to X of US $ 1,00,000 on which it has withheld tax under section 195 at the rates in force. Now, by applying sections 92D and 92C(3), the Assessing Officer of Y determines the arm’s length price of the transaction of use of trade mark at US $ 80,000. Having regard to this arm’s length price, he increases Y’s total income by US $ 20,000 (1,00,000 - 80,000). Now, according to the second proviso to section 92C(3), X’s income will not be correspondingly reduced by US $ 20,000.

In connection with the second proviso, it may be noted as follows :

           The second proviso uses the terms ‘on determination of the arm’s length price paid to another associated enterprise.’ Now, the ‘arm’s length price’ has not been paid to another associated enterprise; what has not been paid is the ‘contracted price’. Hence, the phrase could be read as ‘on determination of the arm’s length price in respect of payment to another associated enterprise’.

           The second condition mentioned above applies only if the tax is ‘deducted’. It does not apply when the tax though ‘deductible’ had not been deducted. in other words, it does not apply when there is a default in deducting the tax. Furthermore, it will not apply to situations where tax is not required to be withheld at all under Chapter XVII-B.

           The second proviso does not deal with a situation wherein the income is increased in the hands of the recipient having regard to the arm’s length price and consequentially the payer contends that even the expenditure in his hands has to be correspondingly increased. The Hon’ble Finance Minister’s speech, as stated above, appears to indicate that he sought to cover even this situation. However, the proviso does not reflect this.