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Introduction
Transfer Pricing is like twirling
a baton or eating with chopsticks – it looks very easy until you try
it!!
Transfer Pricing is one of
the key international tax issues in recent times. It requires fulfilment
of onerous compliance requirements under the Transfer Pricing provisions
coupled with mounting vigour and vigilance of the tax authorities
worldwide in investigating Transfer Pricing arrangements.
Ensuring compliance of the
Transfer Pricing provisions is one of the top priorities of the tax
authorities. Penalties are often imposed to ensure and encourage compliance.
In past years, the Organization of Economic Cooperation and Development
("OECD") has extensively addressed the subject of penalties and Transfer
Pricing. A rather comprehensive study on penalties was carried out
in 1990, within the context of a survey on taxpayers’ rights and obligation.
The subject of penalties was however, addressed in detail at a later
stage in the Transfer Pricing guidelines issued by the OECD in 1995.
The OECD guidelines on Transfer
Pricing state that penalties are most often directed toward providing
disincentives for non-compliance, where the compliance at issue may
relate to procedural requirements such as maintaining necessary documentation,
providing necessary information, or filing returns/compliance certificates,
or
to the substantive determination of tax liability.
Penalties can involve either
civil or criminal sanctions – criminal penalties are virtually always
reserved for cases of very significant fraud, and they usually carry
a very high burden of proof for the tax authorities that levy the
penalties. Criminal penalties are not the preferred means to promote
compliance. Non-compliance usually results in civil (or administrative)
penalties, which typically involve a monetary sanction. Civil monetary
penalties for tax understatements are frequently triggered by one
or more of the following:
-
an understatement of tax
liability exceeding a threshold amount;
-
negligence of the tax-payer,
or wilful intent to evade tax (and also fraud, although fraud
can trigger much more serious criminal penalties).
Many countries impose civil
monetary penalties for negligence or wilful intent, while only a few
countries (e.g., Denmark and Greece) penalise "no-fault" understatements
of tax liability. A specific penalty regime in relation to Transfer
Pricing adjustments exits in only a few countries. In many countries,
the general penalty regime applies. In many countries the tax authorities
are entitled to waive or reduce civil monetary penalties levied on
non-compliance with Transfer Pricing documentation requirements. Some
countries like Belgium, Denmark, Finland, and Portugal limit the discretionary
powers of their tax authorities to reduce or waive the civil monetary
penalties upon a Transfer Pricing adjustment.
The following table provides
a high-level overview of penalties levied by certain countries in
the Asia-Pacific, Americas and Europe region for non-compliance with
Transfer Pricing provisions:
| Country |
Penalty Provisions |
| Asia-Pacific |
|
| Australia |
50% of additional
tax – tax avoidance motive 0% to 25% of additional tax – other
cases |
| Japan |
General
penalty provisions apply 35% of additional tax – concealment
of facts 10% to 15% of additional tax – other cases |
| Singapore |
General
penalty provisions apply up to 300% of tax underpaid |
| Americas |
|
| United States |
20% to 40% of
the additional tax for adjustments exceeding objective thresholds |
| Canada |
10% of Transfer
Pricing adjustment (if adjustment exceeds threshold of 10% of
gross revenue of the tax-payer or 5 million Canadian Dollars) |
| Europe |
|
| United Kingdom |
Fixed penalty
of 3,000 pounds for failure to keep proper records Up to 100%
of tax unpaid through fraud or negligent conduct (Currently
there is a grace period up to 31st March, 2006 whereby penalties
are not imposed in certain circumstances) |
| The Netherlands |
General penalty
provisions apply Up to 100% of tax if additional assessment
is caused by fraud or gross negligence |
| Germany |
5% to 10% of
adjusted income subject to minimum of 5,000 Euro if documentation
is not submitted or if it does not comply with requirements
100 Euro per day for late submission of documentation (subject
to maximum of 1 million Euro) |
The Finance Act, 2001 has brought
in detailed Transfer Pricing provisions in the Income-tax Act, 1961
(‘the Act’) with effect from 1st April 2001. As compared to international
practices (e.g., OECD guidelines on Transfer Pricing), the compliance
requirements under the Indian legislation are very onerous and complex.
Notably, one of the most striking features of the Indian Transfer
Pricing legislation is the enactment of significant penalty provisions
for non-compliance with the legislation.
Penalties which may be levied
for non-compliance with the Transfer Pricing legislation are as follows:
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Re-determination of the
arm’s length price by the Assessing Officer could attract penalty
ranging from 100% to 300% of tax payable on the adjustment
to the arm’s length price;
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Failure to maintain prescribed
documentation could attract penalty at the rate of 2% of the value
of each international transaction;
-
Failure to furnish documentation
required by the tax authorities could lead to a penalty at the
rate of 2% of
the value of each international transaction;
-
Failure to furnish the
prescribed report of the accountant can attract penalty of one
hundred thousand rupees.
We
give hereunder, the penalty provisions in the Act relating to the
Transfer Pricing legislation:
-
Penalty for concealment of income or
furnishing inaccurate particulars of such income – re-determination
of the arm’s length price
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Scope of application of the provision
Section 271(1)(c) of the Act
deals with levy of penalty for concealment of income or furnishing
of inaccurate particulars of income. Explanation 7 to section
271(1)(c) of the Act, which deals with levy of penalty in case
of Transfer Pricing adjustment, provides as under:
Where in the case of an assessee
who has entered into an international transaction defined in section
92B, any amount is added or disallowed in computing the total
income under sub-section (4) of section 92C, then, the amount
so added or disallowed shall, for the purposes of clause (c) of
this sub-section, be deemed to represent the income in respect
of which particulars have been concealed or inaccurate particulars
have been furnished, unless the assessee proves to the satisfaction
of the Assessing Officer or the Commissioner (Appeals) or the
Commissioner that the price charged or paid in such transaction
was computed in accordance with the provisions contained in section
92C and in the manner prescribed under that section, in good faith
and with due diligence".
Thus, if the Assessing Officer
makes an adjustment to the income of the asssessee by re-determining
the arm’s length price for an international transaction entered
into by the asssessee with its associated enterprise, such adjustment
to the income shall be treated as concealed income of the tax-payer.
Moreover, the tax-payer in such a case, could be subjected to
a penalty ranging from 100% to 300% of tax payable on the
additional income or the disallowance made by the Assessing Officer.
It is pertinent to note that
the Explanation creates a rebuttable presumption of concealment
of income or furnishing of inaccurate particulars. The onus of
rebuttal is on the assessee, who is required to prove that he
has acted in "good faith" and with "due diligence". It is pertinent
to note that section 273B of the Act, which states that penalty
shall not be imposed if the assessee proves that there was reasonable
cause for the said failure, does not apply to a penalty under
section 271(1)(c) of the Act. Therefore, in order to avoid the
penalty, it is essential that the assessee discharges the burden
laid down in Explanation 7; i.e., proves to the satisfaction of
the relevant tax authorities that he had acted in good faith and
with due diligence in determining the arm’s length price of the
international transaction.
The concept of "concealment of
income", "good faith" and "due diligence" has been covered in
detail in other articles contained in this issue and hence, have
not been explained in detail here. In context of Transfer Pricing,
penalty may not levied if the assessee can prove to the satisfaction
of the Assessing Officer or the Commissioner (Appeals) or the
Commissioner that the price paid or charged has been computed
in accordance with the provisions contained in section 92C and
in the manner prescribed under that section, in good faith and
with due diligence.
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Illustration of cases where no
penalty could be levied
Given the complexity of most
Transfer Pricing issues, it is likely that tax authorities and
assessees apply different conditions in order to determine an
arm’s length price for a related party transaction. Such difference
may give rise to an adjustment of a tax-payer’s taxable base.
The OECD Guidelines on Transfer
Pricing recommend that owing to the nature of Transfer Pricing
problems, care should be taken to ensure that administration of
a penalty system as applied in such cases is fair and not unduly
onerous for tax-payers.
The Transfer Pricing provisions
in the United Kingdom (‘UK’) provide that where the tax-payers
can show that they have made an honest and reasonable attempt
to comply with the legislation, there will be no penalty even
if there is adjustment. In fact, when new Transfer Pricing legislation
was introduced in UK during 1998-99, the UK Inland Revenue acknowledged
that the issue of penalties on Transfer Pricing adjustments will
be a sensitive one, especially in the early years of the new regime.
As a result, and to ensure that a consistent approach is taken,
it was decided that all potential penalty cases will be monitored
by International Division, working in conjunction with Compliance
Division. Another example is Luxemborg, which does not impose
a penalty upon a Transfer Pricing adjustment if the tax-payer
has timely filed its initial return and the tax due (on the adjusted
profits) is paid on time.
The Indian penalty provisions
also provide a leeway in cases where the assessee has acted in
good faith and with due diligence.
Due of various factors such as
lack of guidance available to the assessees on account of nascent
stage of the Transfer Pricing legislation, dearth of comparable
uncontrolled data in the public domain, etc., it is possible that
assessees sometimes may not be able to substantiate the transfer
prices for international transactions with associated enterprises
to the satisfaction of the tax authorities. To illustrate, associated
enterprises may engage in transactions that independent enterprises
would not normally undertake (e.g., sale of intangibles such as
brand/trade mark, cost contribution/ allocation arrangements,
etc). These situations may create problems for assessees in benchmarking
the international transactions to the satisfaction of the tax
authorities.
Currently, the Indian Transfer
Pricing regulations prescribe that the data to be used in analysing
the comparability of an uncontrolled transaction with an international
transaction shall be the data relating to the financial year in
which the international transaction has been entered into. However,
experience shows that it is difficult to get data (e.g., profit
margin), for the same financial year in the case of the comparable
companies, during the financial year itself. For example, even
by the due date of filing of the tax return (October 2002), data
of most comparable companies for the year ended 31st March, 2002
was not available in the publicly available databases, as companies
were required to file their data with the Registrar of Companies
only by 30th September, 2002. Thus, the assessees rightly used
multiple year data for three immediately preceding years to the
extent available (i.e., for assessment year
2002-03, comparable data of fiscal year 1999-2000, 2000-01 and
2001-02 to the extent available was used). This approach is also
in line with the OECD guidelines on Transfer Pricing. However,
the tax authorities during assessments have disapproved the use
of multiple year data and have called upon assessees to justify
their position by once again benchmarking their transactions with
a fresh set of comparable data for the year under consideration
itself (i.e., fiscal year 2001-02 in the above example). It is
quite possible that current availability of a fresh set of comparable
data may trigger adjustment to arm’s length price.
Thus, there could be a situation
where the Assessing Officer makes an adjustment to the arm’s length
price, even in cases where there is no intent to conceal income
or furnish inaccurate particulars of income.
The OECD guidelines on Transfer
Pricing, acknowledging such situations, state the following:
"Since penalties are only one
of many administrative and procedural aspects of a tax system,
it is difficult to conclude whether a particular penalty is fair
or not without considering the other aspects of the tax system.
Nonetheless, OECD Member countries agree that the following conclusions
can be drawn regardless of the other aspects of the tax system
in place in a particular country:
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First, imposition of a sizable
"no-fault" penalty based on the mere existence of an understatement
of a certain amount would be unduly harsh when it is attributable
to good faith error rather than negligence or an actual intent
to avoid tax.
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Second, it would be unfair
to impose sizable penalties on tax-payers that made a reasonable
effort in good faith to set the terms of their transactions
with related parties in a manner consistent with the arm’s
length principle.
-
In particular, it would be
inappropriate to impose a Transfer Pricing penalty on a tax-payer
for failing to consider data to which it did not have access,
or for failure to apply a Transfer Pricing method that would
have required data that was not available to the tax-payer.
Tax administrations are encouraged
to take these observations into account in the implementation
of their penalty provisions."
It may be interesting to note
that certain countries like UK and China have introduced transitional
relaxation of penalties for certain period after legislating new
Transfer Pricing provisions.
In the Indian context, the above
philosophy is also, to an extent, acknowledged by CBDT in Circular
No. 12 of 2001 (dated 23rd August, 2001), which states as follows:
"However, this is a new legislation.
In the initial years of its implementation, there may be room
for different interpretations leading to uncertainties with regard
to determination of the arm’s length price of an international
transaction. While it is necessary to protect our tax base, there
is a need to ensure that the tax-payers are not put to avoidable
hardship in the implementation of these regulations."
As for any new legislation, currently,
administering of the Transfer Pricing legislation in India is
in a twilight zone. This being so, and Transfer Pricing not being
an exact science, the Indian Transfer Pricing provisions are open
to diverse interpretations and at present, are beset with a myriad
of controversial issues. These issues have assumed more significance
in light of the ongoing Transfer Pricing assessments by tax authorities
for the first year (i.e., financial year ended 31 March 2002).
It is expected that as the law and practice of Transfer Pricing
evolves in India, these issues will be suitably addressed. Until
then, it would be fair and just to defer imposition of penalty
under section 271(1)(c) read with Explanation 7 thereto particularly
in cases where the price of the international transactions is
determined using a particular set of comparables and adjustment
is made in the basis of comparables available in the public domain
at a subsequent point in time. If this is not done, assessees
acting in good faith and with due diligence will be subject to
untoward hardship, particularly considering that tax holiday shelter
is not available for any transfer pricing adjustment.
- Penalty for failure to keep and maintain prescribed
information and documents and furnish such information and documents
- Scope of application of the provision
Section 271AA of the Act provides
for levy of penalty for failure to keep and maintain prescribed
documentation. The Section reads as under:
"Without prejudice to the provisions
of section 271, if any person fails to keep and maintain any such
information and document as required by sub-section (1) or sub-section
(2) of section 92D, the Assessing Officer or Commissioner (Appeals)
may direct that such person shall pay, by way of penalty, a sum
equal to two per cent of the value of each international transaction
entered into by such person."
The above provision is without
prejudice to Section 271 and is invoked when the assessee fails
to keep and maintain any such information and document as required
by Section 92D(1) and (2) of the Act. It is pertinent to note
that whether or not the price of an international transaction
is determined at arm’s length, in order to avoid documentation
penalty, any person who has entered into such a transaction is
required to keep and maintain requisite information and documents
in respect of such transaction.
Section 271G of the Act provides
for levy of penalty for failure to furnish information or documents.
The Section reads as under:
"If any person who has entered
into an international transaction fails to furnish any such information
or document as required by sub-section (3) of section 92D, the
Assessing Officer or the Commissioner (Appeals) may direct that
such person shall pay, by way of penalty, a sum equal to two per
cent of the value of the international transaction for each such
failure."
The Indian Transfer Pricing regulation
(Rule 10D of the Income-tax Rules, 1962) provides a detailed "laundry
list" of the information and document to be kept and maintained
by the assessee. As compared to international practices (e.g.,
OECD guidelines on Transfer Pricing), the requirement under the
Indian legislation is very wide and complex. The information and
documents required for transfer-pricing purposes represents a
great level of detail about some of the most intimate aspects
of the business, unparalleled by any other tax requirements, either
in India or overseas.
Section 92D(1) of the Act provides
that every person who has entered into an international transaction
with an associated enterprise is required to maintain such information
and documentation in respect thereof, as may be prescribed. The
draft documentation guidelines were first issued for comments
by the Central Board of Direct Taxes (‘CBDT’) on
May 18, 2001. The final guidelines
were legislated as Rule 10D of the Income-Tax Rules, 1962 (‘the
Rules’) by the Income-tax (21st Amendment) Rules, 2001.
Rule 10D of Rules prescribes
maintenance of 13 different types of information and documents.
These information and documents may be broadly classified into
the following categories:
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Primary documents and information
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Enterprise-wise documents
and information – documents and information related to
description of multinational group, the relationship matrix,
the nature of business carried out, etc.
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Transaction specific
documents and information – underlying transaction documents
and information including description of the functions
performed, risk assumed and assets employed by each associated
enterprise, explanation as to selection of appropriate
methods considered for determining the arm’s length price.
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Supporting documents and
information – includes documents and information related to
external government publication, industry reports, etc.
The Rule further provides that
the prescribed documentation and information must be "contemporaneous"
in nature and must be kept and maintained latest by the due date
for filing the income-tax return for the year under consideration.
The information and documentation prescribed by Rule 10D is required
to preserved for a period of 8 years from the end of the relevant
assessment year.
Interestingly, the Rule provides
that primary documentation need not be maintained in cases where
the aggregate book value of international transaction entered
into by the tax-payer does not exceed rupees one crore.
It is also important to note
that any order imposing penalty under section 271AA or section
271G of the Act has not been made appealable under section 246A
of the Act.
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Illustration of cases where no
penalty could be levied
While the Transfer Pricing provisions
were enacted with effect from 1st April, 2001, it is important
to note that Rule 10D, which prescribes the documentation requirements,
was notified only on 21st August, 2001. Recognizing this fact,
CBDT vide Circular 12 (supra), has instructed that penalty
proceedings under section 271AA or 271G should not be initiated
in cases where the assessee has failed to maintain the prescribed
information or documents in respect to international transactions
entered into during the period 1st April, 2001 to 31st August,
2001.
The stringent penalty imposable
for non-maintenance of documentation may put some assessees to
hardship in certain situations where there is no clarity whether
documentation is required to be maintained. For example, the Indian
Transfer Pricing legislation casts an onerous responsibility on
assessees by requiring them to substantiate, on the basis of
material available with him, that income arising from international
transactions entered into by him has been computed in accordance
with the arm’s length principle even in a case where the value
of the international transaction does not exceed rupees one crore.
In such situations, it is not clear what documents the tax authorities
would consider sufficient for demonstrating arm’s length basis.
Another example could be situations where the transaction has
been entered with an unrelated enterprise which later became an
associated enterprise during the year. Keeping and maintaining
the required transfer-pricing documentation on a contemporaneous
basis may prove to be a daunting task in such situations. Having
regard to this, it would not be fair to impose a penalty for non-maintenance
of prescribed documentation.
To possibly address the above
situations, section 273B of the Act has been amended with effect
from 1st April, 2001, to provide that penalty under sections 271AA
and 271G shall not be imposable if the assessee proves that there
was "reasonable cause" for such failures. Needless to say, what
constitutes a "reasonable cause" would depend on the facts and
circumstances of a given case. Further, a reasonable opportunity
of being heard has to be given to the assessee prior to imposition
of the penalty (Section 274(1) of the Act).
"Transfer Pricing is like
a work of art. A question of reasonableness" The concept of "reasonableness"
has been an accepted proposition universally. It may be interesting
to note that the recently amended UK Transfer Pricing legislation
contains a transitional provision which states that even where
there is an obligation to adjust actual results to arm’s length
results, there will be no penalty for failure to keep evidence
to demonstrate that a result is an arm’s length result for the
period up to April 2006.
The issue whether penalty for
non-maintenance of documentation and non-furnishing of documentation
can be cumulatively levied (i.e., 4% penalty in case of non-availability
of documentation) is a subject matter of debate. In this context,
the decision in cases of Surajmal Parsuram Todi vs. Commissioner
of Income-tax (222 ITR 691 Gauhati High Court) and Ram
Prakash C. Puri vs. Assistant Commissioner of Income-tax (77 ITD
210 Income-tax Tribunal, Pune Bench) are worth noting. In
these cases it was held that when a person commits the offence
of not maintaining books of account, penalty under section 271A
of the Act is the only one that can be slapped on the assessee.
Failure to audit the accounts under section 44AB of the Act cannot
be viewed as another lapse for imposing penalty under section
271B of the Act. The mere fact that the assessee has not maintained
books of account will show that he cannot obtain tax audit report,
and the basic failure; i.e., non-maintenance of books alone can
be considered for penalty.
In
case of non-maintenance of information and documents, the question
of furnishing the same cannot arise. Accordingly, a considered
view would be that no penalty should be levied for non-furnishing
of the prescribed information and documentation where information
and documentation itself is not maintained.
- Failure to furnish the prescribed report
of the accountant
As per section 92E of the Act,
every person entering into an international transaction with an associated
enterprise is required to furnish a prescribed report obtained from
an accountant by the specified date (i.e., the due date for filing
the income-tax return).
Section 271BA of the Act empowers
the Assessing Officer to levy penalty of one hundred thousand rupees
for failure to furnish the prescribed report. Needless to say, no
penalty may be levied if the assessee shows reasonable cause for such
failure (Section 273B of the Act) and without a reasonable opportunity
of being heard given to the assessee (Section 274(1) of the Act).
It
is important to note that the order imposing penalty under section
271BA of the Act has not been made appealable under section 246A of
the Act.
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In conclusion
"The fear of punishment may
be necessary to the suppression of vice; but it also suspends the
finer motives to virtue!!" – William Hazlitt
As the intent to impose penalties
is mostly to ensure and encourage compliance, they have to be commensurate
to the level of negligence or wilful conduct by the tax-payer. The
Indian Transfer Pricing provisions are exhaustive in many respects
and are generally in line with international practices prescribing
methods and documentation. Indian Transfer Pricing penalties are arguably
however, the harshest in the world!
While it remains to be seen
how aggressively the tax authorities will invoke the penalty provisions,
it needs to be acknowledged that Transfer Pricing regulations have
a fair level of complexity. The tax authorities should consider this
fact at the time of imposing penalties. Also, the penalties for non-maintenance
and non-furnishing of Transfer Pricing documentation and penalty for
non-furnishing of prescribed report of the accountant should be made
appealable in the interest of providing natural justice to assessees,
as injustice anywhere is a threat to justice everywhere!!
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