Domestic Transfer Pricing-

Analysing the impact on Tax

Holiday undertakings

T
he Finance Act, 2012 ushered in significant Transfer pricing amendments
- APAs and extension of Transfer Pricing provisions to specified
domestic transactions (‘SDTs’), being the most significant ones. In this
article, the Authors discuss the application of transfer pricing provisions to
tax holiday undertakings, as under:
1. Introduction
2. Scope and Coverage:
Q1: Which undertakings are covered?
Q2: What are the typical transactions covered?
3. Key Issues and Challenges
Issue 1: Ordinary profits vs arm’s length
Issue 2: Loss making tax holiday undertakings
Issue 3: Impact on Cost allocations
Issue 4: Close connection?
Issue 5: Impact of recent judicial precedents
4. Way forward

The Supreme Court in the case of Glaxo Smithkline 1 opined on the need to
extend the existing Transfer Pricing provisions to domestic transactions, with
a view to counter tax evasion between domestic related parties, as illustrated
below:

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INTERNATIONAL TAXATION n VOL. 8 n MAY 2013 n 25 517

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Scenario Particulars Impact

Expenditure to Group Co. A (loss making) could Reduction in current year’s tax
Domestic related party charge an excessive amount liability
to Group Co. B (profit making)

Transactions by Tax Tax Holiday Undertaking could Claiming higher tax holiday
Holiday undertakings charge an excessive amount for
sales to related parties

Consequent to the above, section 92BA of the
Income-tax Act, 1961 has been introduced w.e.f.
Assessment Year (‘AY’) 2013-14 i.e. April 1, 2012,
to cover the following domestic related party
transactions:
u any expenditure in respect of which pay-
ment is made/to be made to related parties
as enlisted under section 40(A)(2)(b);
u inter-unit transactions of tax holiday units
eligible to claim profit linked deduction
under sections 80(A)(6) and 80-IA(8);
u any business transacted between the tax
holiday unit and other person as referred
in section 80-IA(10);
u any transaction referred to in Chapter
VI-A or section 10AA to which provisions
of section 80-IA(8)/80-IA(10) apply; and
u any other transaction as notified by CBDT.
In relation to tax holiday undertakings, the
provisions essentially extend to the following
transactions:
u ‘transfer of goods and services’ with other
undertakings of the same taxpayer; and
u business transacted with other entities having
‘close connection’ with the taxpayer.
The Act prescribes a safe harbour i.e. minimum
threshold of À 5 crore (i.e. À 50 millions) on an
aggregate basis in order to apply the provisions.
îò ͽ±°» ¿²¼ ݱª»®¿¹»
Q1. Which tax holiday undertakings are cov-
ered?
The provisions cover the following undertakings:

Particulars Coverage

Undertakings claiming industry • Undertakings engaged in generation/transmission/

based tax holidays distribution of power or developing/operating/
maintaining infrastructure facilities

• Companies engaged in refining oil, undertakings

engaged in developing and building housing projects,
etc

Undertakings claiming • Undertakings located in Special Economic Zone

geographical location based tax
holidays • Undertakings located in backward industrial areas
(Rajasthan, Bihar etc.)

• Undertakings located in Himachal Pradesh, Uttaranchal

or notified areas in North Eastern States

• Undertakings engaged in business of hotels/

convention centre in specified area/district

Q2: What typical transactions are covered? (a) Transfer of goods and services from one
In respect of tax holiday undertakings, the tax holiday undertaking to another under-
following transactions are likely to be covered: taking of the same taxpayer or vice versa.
To illustrate:

518 INTERNATIONAL TAXATION n VOL. 8 n MAY 2013 n 26

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u Purchase or sale of goods need to be determined having regard to the arm’s

u Receipt or provision of services;
u Purchase or sale of capital assets; and
u Further, any other income and ex-
pense transactions that impact the tax
holiday profits of the undertaking,
where they qualify as transfer of goods
and services should also be covered.
(b) Any business transacted with entities hav-
ing close connection with the taxpayer. To
illustrate:
u Each of the transactions listed under
(a) above would ordinarily be cov-
ered.
length principle and the transfer pricing methods.
The challenges likely to be faced by taxpayers in
this regard, have been illustrated below:
u A taxpayer (say ABC Ltd., a tax holiday
unit) has earned a margin of 30% while
arithmetic mean of the margins earned by
comparables is 15%. OP/TC of 30% is
considered to be at arm’s length by the
transfer pricing officer, since it is in excess
of the comparables.
Particulars Profit level indicator
Total Income 150
Cost (TC) 105

Profits (OP) 45
u The term ‘business transacted’ has a
wider connotation than ‘transfer of OP/TC 30%
goods and services’ and specific facts
of any transaction which could have Comparable Operating profits/
an impact on tax holiday would need Companies Total cost (OP/TC)
to be examined. Company A 35%
Some additional situations which are likely to Company B 10%
need detailed examination are:
Company C 25%
u Purchase of a tax holiday undertak- Company D 14%
ing by a taxpayer from a closely
connected person (whether at ‘book Company E -8%
value’ or ‘market value’). Arithmetic Mean 15%
u Allocation of common expenses – i.e.
u In the above case, if price based method
strategy, marketing, design & engi-
(say, the Comparable Uncontrolled Price
neering, human resources, accounting,
method) has been applied to benchmark
finance etc. as to whether the same
the transaction between ABC Ltd. and a
qualifies as a ‘service’ and needs to
person closely connected with it, the de-
be at a mark-up to be at fair value.
rived profits should be considered as or-
u Guarantees and loans for the purpose dinary profits.
of the business of the tax holiday
u However, where ABC Ltd.’s arm’s length
undertaking.
price was benchmarked using profit based
íò Õ»§ ×--«»- ¿²¼ ݸ¿´´»²¹»- methods (such as net margins of compa-
rable companies), a question arises as to
Issue 1: Ordinary profits v. arm’s length
whether tax holiday benefits will be denied
Section 80-IA(10) provides that where the Revenue when the ABC Ltd. has earned profits (30%)
authorities believe that the tax holiday undertaking in excess of the arithmetic mean of
produces more than ordinary profits due to a comparables (15%).
close connection with any person, only a reasonable
In this regard, the Authors are of the view that
level of profits will be eligible for the tax holiday
taxpayers can seek to rely on Tribunal rulings2
benefit. With introduction of domestic transfer
in the context of section 80-IA(10) [even though
pricing, ordinary profits for tax holiday units would

INTERNATIONAL TAXATION n VOL. 8 n MAY 2013 n 27 519

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in respect of years before transfer pricing provisions
were extended to section 80-IA(10)], which have
held the following principles:
u The tax authorities was not justified to invoke
the provisions of section 80-IA(10) read with
section 10B(7) so as to reduce the eligible
profits on the basis of the arm’s length
price computed by the transfer pricing officer
without showing how he determined that
the taxpayer had shown more than “ordi-
nary profits”.
u The provisions of section 80-IA(10) do not
given an arbitrary power to the tax au-
thorities to fix the profits of the taxpayer3.
In cases where the transfer pricing officer
has confirmed that no adjustment on ac-
count of transfer pricing is required to be
made, then any reduction of eligible profits
by the AO is not sustainable unless the tax
authorities can show that the taxpayer has
earned more than ordinary profits.
The Authors acknowledge that a question may
arise as to whether the ratio of the above rulings
will continue to be applicable in the future
given that transfer pricing provisions now apply
to section 80-IA(10) and which require ordinary
profits to be referenced to the arm’s length
price. The Authors suggest taxpayers focus on
establishing through robust transfer pricing
documentation how the profits of the tax holiday
units are ‘ordinary’ to support their case before
the tax authorities to support their case where
unintended controversies and litigations arise.
Issue 2: Loss making tax holiday undertakings?
Where a tax holiday undertaking incurs losses,
tax holiday provisions continue to be applicable
to such undertakings though tax holiday claimed
is ‘NIL’.
Taxpayers may argue that in the event of losses,
the ‘motive’ of shifting tax holiday profits is
absent and accordingly, the provisions ought
not to apply. However, this would depend upon
the treatment accorded by the taxpayer as well
as tax authorities to such losses i.e. whether the
losses are set-off against profits of other businesses
or carried forward to be set-off against future
profits of the tax holiday undertaking, which
520 INTERNATIONAL TAXATION n VOL. 8 n MAY 2013 n 28
has been a debated issue in various Tribunals
and High Courts.
Accordingly, the Authors are of the view that
non-applicability of provisions to loss making
tax holiday undertakings is not free from doubt
and it is advisable for the taxpayers to disclose
the position sought to be adopted in the Form
3CEB.
Issue 3: Impact on Cost allocations
Determination of allocable costs
Under the provisions of the Act, the Tax holiday
undertakings are required to maintain separate
audited accounts. The costs directly relatable to
the individual undertakings are assigned/charged
to such undertakings. However, some common
Head Office expenditures (‘common HO expenses’)
benefit all the undertakings of the taxpayer/
Group in general. These expenses could be in
the nature of general administrative expenses
like research, travelling, conveyance, communi-
cation, marketing, legal and professional expenses,
accounting and finance expenses etc. In order
to arrive at the correct amount of profits eligible
for tax holidays, it is important to consider
whether such HO expenses are allocable to the
tax holiday undertakings or otherwise.
The issue of allocation of common Head Office
expenditures between entities claiming tax holiday
undertakings and other undertakings of the
taxpayer/Group has been a debated issue in
various Tribunals and High Courts. There are
a number of rulings4 available on the subject,
in favour of cost allocation of common HO
expenditures, encompassing the following
guidelines:
u All common expenses ought to be allocated
on a reasonable and scientific basis (say
turnover, head-count, etc.);
u Even if the expenses are in the nature of
finance department, human resources etc.,
which do not directly relate to qualifying
undertakings, they ought to be reasonably
allocated to the undertakings on the premise
that the HO does not exist for its own sake,
but its existence is relevant for all activities
undertaken by various undertakings/divi-
sions/profit centres; and
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u Non-allocation of common HO expenses
might lead to inflation of profits of tax
holiday undertakings and consequent de-
flation of income in the hands of the HO,
leading to erosion of domestic tax base.
As opposed to the above, in the case of Wipro
Information Technology v. Dy. CIT [2004 88 TTJ
(Bang) 778], it was held by the Income-tax
Appellate Tribunal that the corporate group does
not carry on any business activity by itself, and
hence, cannot be called to be the business of
the taxpayer. The taxpayer is required to maintain
its corporate image, set up corporate house and
employ various persons for such purposes. The
funds used for such purposes cannot be related
to any of the individual undertakings, and
accordingly interest on such funds is not required
to be apportioned to any of the tax holiday
undertakings, for the purpose of deduction under
Chapter VI-A.
Further, in the case of Ponds India Limited (now,
Hindustan Lever Limited) [ITA No. 2047/Mad/
88], the Madras High Court has upheld the
order of the Tribunal and accepted the contention
that pure and simple common administrative
HO expenses need not be allocated to individual
undertakings, if not directly relatable to such
undertakings and if used in the day to day
monitoring requirements of finance and other
actions.
A similar view has also been taken by the Bombay
High Court in the case of Zandu Pharmaceuticals
Works Ltd. v. CIT [2013] 31 taxmann.com 191/
213 Taxman 207. The Bombay High Court has
held that there must be a direct nexus between
an industrial undertaking and the expenses which
are sought to be apportioned/attributable to it.
Expenses which do not relate to an industrial
undertaking/unit under consideration and they
relate to other units or to the head office cannot
be taken into consideration while computing
the deduction.
In relation to the abovementioned precedents,
the following aspects draw key consideration
and attention:
u The common interest expenses incurred by
the HO could not be allocated to the in-
dividual undertakings, on the footing that
the funds so borrowed were not diverted
towards the qualifying undertakings.
u The determination of ‘pure and simple’ ad-
ministrative expenses is subjective and prone
to several litigative challenges. Further, the
determination of expenses having ‘direct
nexus’ with the individual undertakings is
subjective and prone to several litigative
challenges.
In view of the above judicial precedents as well
as the ambiguity surrounding the precedents in
favour of taxpayers, taxpayers would be advised
to weigh their options carefully and make adequate
disclosures in their filings.
Whether a cost allocation is a ‘service’ and is re-
quired to be at a ‘mark-up’?
Circular No. 14 of 2001 explains the perspective
of the CBDT behind the introduction of the
word ‘services’ in section 80-IA(8):
“...As in certain cases, the transfer may relate
to services, the provision has been accordingly
amended to clarify that this would include
services. Such services may include marketable
services of operations and maintenance in
case of infrastructure facilities, marketable
services for distribution of electricity and
specified marketable services in telecom...”
From the above, an inference could be drawn
that the introduction of the arm’s length principle
by section 92BA would require computation of
fair market value as per the specified transfer
pricing methods where the undertakings provide
‘marketable services’ to other undertakings. Whether
or not the activities of the HO or corporate
office qualify as a ‘business activity’ or marketable
service is a fact driven issue. In the Authors’
view, ordinarily, common HO functions should
not constitute marketable services requiring more
than a pure allocation to the tax holiday
undertakings i.e. no markup ought to be charged.
Reliance for the above can be also drawn from
commentaries on Article 7 of the OECD/UN
Model which state that in respect of dealings
between HO/other undertakings, which are in
the nature of ‘general management’, nothing
INTERNATIONAL TAXATION n VOL. 8 n MAY 2013 n 29 521
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beyond third party costs should be allocated
and no mark-up can be charged by one
undertakings to another. Accordingly, common
HO expenses could be allocated by taxpayers
on a reasonable basis. An appropriate mark-up
Issue
Whether allocation of costs is a trans-
action covered under section 92BA
Determination of allocable costs
Determining reasonable allocation keys
Allocation of costs – whether at actual
or at mark-up
Issue 4: Meaning of ‘close connection’
Section 80-IA(8) covers business transactions
undertaken by a taxpayer claiming tax holiday
with other entities having ‘close connection’ with
the taxpayer. The term ‘close connection’ has
not been expressly defined in the Act. In this
regard, reference could be drawn from other
522 INTERNATIONAL TAXATION n VOL. 8 n MAY 2013 n 30
would be required to be charged in the event
of characterisation of such services as ‘marketable’
from HO perspective.
The Authors have summarized their
recommendations on common costs below:
Approach
• Arguably, no, based on judicial precedent5.
• However, reference can also be placed on Revised
ICAI Guidance Note6 which opines that allocation
of costs constitutes a SDT
• In the Authors’ view, treating allocation of common
costs as a transaction covered under section 92BA
and requiring reporting, seems a more prudent
view
• An ideal cost allocation policy would entail allocation
of ‘all’ common costs based on rational allocation
keys
• Based on a recent judicial precedent7, a view could
be taken that pure and simple common administrative
costs incurred for the purpose of monitoring day
to day requirements of finance and other actions
may not be allocated. However the determination
of ‘pure and simple’ administrative expenses is
subjective and prone to several litigative challenges
• All common expenses ought to be allocated on a
reasonable and scientific basis (say on the basis
of ratio of turnover, head-count, Cost of sales, FTE
etc.) depending upon the nature of business of the
entities/undertakings to which such costs are
allocated.
• The relevant costs could be charged at a mark-up
if the services provided by the HO partake the
character of marketable services; otherwise, a pure
allocation should suffice.
provisions of the Act to define ‘close connection’
as under:
u Substantial interest [Section 40A(2)(b)];
u Associated Enterprise [Section 92A(2)]; and
u Related party as per Accounting Standard
– 18 issued by ICAI.
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Particulars Substantial Associated Related Party as

interest Enterprise per AS-18

Voting Power >= 20% >= 26% >50%

Directors covered? Directors Not covered Key Managerial

Personnel

Key suppliers covered? Not covered More than 90% Specifically

supplies excluded

The Authors are of the view that since DTP as a reference point, for the purposes of
provisions have been introduced on similar lines determining/defining ‘close connection’ between
as the normal transfer pricing provisions, taxpayers tax holiday undertakings and other entities.
may consider the definition of ‘Substantial Interest’

Issue 5: Impact of recent judicial precedents

Case law Summary & Impact analysis

Cadilla Healthcare Ltd. (Supra) • The assessee was claiming deduction under sections 80-IB and 80-
IC of the Act.

• The Assessing Officer contended that the Baddi unit of the assessee
was earning abnormally high profits. The profits from manufacturing
activity ought to be separated from profits for marketing activity
and on account of brand value (which were not attributable to the
Baddi unit) and only the manufacturing profits are eligible for
deduction.

• The assessee contended that the Assessing Officer should not disturb
computation of deduction of the eligible unit on the ground that
profit earned by other units is lower than profits earned by the
eligible unit. There are no provisions in the Act that provide for
segregation of profits of eligible unit with regards to various operations
of the units.

• The Tribunal, upholding the assessee’s contentions, observed that

the profits of Baddi unit have been computed based on valid accounting
principles and based on separately maintained books of account,
after appropriate allocation of HO expenses. The Tribunal held that
the Assessing Officer has not pointed out any defect in the working
of the profit of the Baddi unit. There is no concept of imaginary
sale price to the HO and segregation of profits based on such
imaginary sales price under section 80-IA.

With the introduction of domestic transfer pricing provisions based on

arm’s length principle, the above principles laid down by the Tribunal
would need to be followed in consonance with the transfer pricing
regulations.

Nahar Spinning Mills Ltd. v. JCIT [TS- • The Assessing Officer contended that the assessee did not allocate
622-ITAT-2012 (Chandi)] MD remuneration to tax holiday units and overstated profits of the
undertaking, claiming higher deduction.

• The assessee contended that the allocation was unwarranted since

it was never questioned in the past and the assessee maintained
proper books of account.

INTERNATIONAL TAXATION n VOL. 8 n MAY 2013 n 31 523

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• The Tribunal observed that the provisions of section 80-IA(8) applies

where goods and services are transferred by the eligible undertaking
to any other business of the assessee. In the instant case, there is
no transfer of goods and services, hence the provisions of section
80-IA(8) do not apply to cost allocations. Further, provisions of
section 80-IA(10) are also not applicable as the transaction only
involves re-allocation of MD’s remuneration from one unit of the
assessee to another.

• However, for the purposes of section 10B, all expenses relating to

eligible unit should be deducted, accordingly, managerial remuneration
ought to be allocated to eligible units as well. The above ruling
suggests that allocation of common expenditures to tax holiday
units, to the extent this does not qualify as ‘provision of services’
is not covered. However, the revised ICAI Guidelines state that cost
allocations are to be considered as specified domestic transactions.
In such cases, taxpayers are recommended to develop and maintain
the following documents which would help them in defending the
allocation:–

- An appropriate cost allocation policy;

- A description of the nature of costs and an explanation as to

why these do not qualify as “provision of services”.

The above approach will help taxpayers address the implications of

the onerous compliance requirements enforced through the domestic
transfer pricing provisions.

ìò É¿§ º±®©¿®¼ compliance requirements. However, this

Domestic transfer pricing provisions have created
unique challenges for taxpayers given onerous
documentation requirements and challenges in
applying the provisions to tax holiday undertakings
in areas such as ‘ordinary profits’, ‘close connection’
and cost allocations, as discussed in the earlier
sections.
Taxpayers expected Finance Act, 2013 to address
some of these challenges and rationalize the
expectation is unmet and the provisions are
here to stay. Further, Advance Pricing Agreements
are also not available for DTPs.
Taxpayers now need to focus on preparing for
the first year of compliance due by 30 November
2013, taking into consideration the suggestion
of the Authors and cognizance of the likely
issues and potential solutions.

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524 INTERNATIONAL TAXATION n VOL. 8 n MAY 2013 n 32