Imagine a business world without documentation – no invoice for purchases, no statements from banks, no agreements, no records,in short, a complete mess? There are television series which depict such situations and even the directors couldn’t imagine a less horrifying world. Trade and commerce thrive on documentation and records. No record means no evidence, and no evidence means dubious clouds of concern hovering your claims though you may rightfully own it. Documentations provide a definitive source of details and a sense of agreement between parties involved.The laws and regulations recognize the same as more reliable than human words. This is the reason why modern businesses are proficient when it comes to record-keeping, as it would be important while claiming, negotiating or justifying their end. However, documentations often get lenient when they pertain to internal transactions between the group companies, as they do not have definitive terms and conditions, and thereby do not entail any real rights and obligations for the group, as in the case of third parties.Thus, these transactions become more about accounting treatment rather than having a commercial impact. Now, the accounting treatments have a direct nexus with taxability, and if the taxpayers have even a little sway on how a transaction is treated, the tax officers are going to be interested in understanding how the same was determined. This is exactly the case with Transfer Pricing and why it is one of the most litigated areas of taxation. Maintaining the right documentation now can help you save huge costs on litigation’s later, as ‘A stitch in time often saves nine.’
What is Transfer Pricing Documentation?
Imagine a tax assessment probe has been launched against your company and you (as the person responsible) have been asked to explain “When you submitted the tax returns, how did you ensure that the transfer price charged to the related party were at arm’s length and there is no manipulation to evade taxes?”Failure to answer this question may lead to levy of additional taxes and even 30% or such higher penalties. So, to avoid this burden you will have to answer the question to the satisfaction of the tax officer. Now, the only way to adequately answer this query raised is with documentation that shows the transfer price was at arm’s length. These records are referred to as Transfer Pricing documentation.
Transfer Pricing documentation is a set of records and other requirements specified by the law that a taxpayer must maintain if they are involved in transactions with associated enterprises. In such transactions, the price at which the product or service has been transferred to/from another related enterprise has to be at arm’s length price, so that appropriate taxes are paid by the enterprise. Since there is an opportunity to distort the numbers and manipulate the tax returns, it is pertinent that tax officers may ask for evidence with regards to pricing during tax assessments. Therefore, sufficient documentation has to be maintained to prove that the transfer price was determined logically, without any biasedness and equivalent to the price as it would have been in case of transactions with third parties. Therefore, transfer pricing documentation serves three main purposes:
- Ensures that the enterprise comply with the transfer pricing requirements
- Ensure that the documentation tax authorities may ask for tax assessments is prepared at the time of occurrence of the transaction itself and available when required
- Saves the entity from litigation’s and tax penalties, by establishing the appropriateness of the transfer price and accurate payment of taxes.
Contents of Transfer Pricing Documentation
The documentation requirements are laid down by each country’s taxation laws, and while an entity has to comply with its local laws, the group has to ensure that it complies with laws in every country it operates. However, the Organisation for Economic Co-operation and Development (OECD) has laid down the model requirements for an international group, based on which participating nations have developed their laws. The documentations support and cater to the general needs of all tax authorities on how the transfer value has been derived and that the enterprises have paid taxes suitably. These three components are:
- Master File
- Local File
- Country by Country Report
Master File –Master file provides a high-level overview of the entire groupfrom a transfer pricing perspective. It is a common document for all entities involved in a group, adjusted suitably to ensure the country-specific laws are complied with.The master file intends to provide tax authorities with an overview of the group to which the individual enterprise belongs to. It sets out the economic analysis of the entire group and includes information such as –
- chart illustrating the legal and ownership structure, the financing structure, description of restructuring transactions occurred recently, description of geographical spread and key economic factors
- description of the business operations, the products and services, the supply chain, main geographic areas from the supply as well as buy perspective, details of any other material product and service
- the location of key management, a brief functional analysis of individual entities
- list of important intangibles, policies surrounding intellectual property, the ownership of the intangibles, description relating to research and development activities and the transfer pricing policies surrounding the same
- financial and tax position of the group, the consolidated financials of the group if prepared otherwise, advanced pricing agreements of the group, significant tax rulings
- details of key inter company transactions
Local File –Local file is enterprise-level documentation that supports the master file; however, it contains details only for the individual enterprise and the transactions if any it has been part of. It provides a detailed overview of such transactions which may or may not have been covered in the master file depending on how significant the same may be for the group. The contents of this file are country-specific and maintained by the enterprise for itself, in addition to the master file maintained by the group. It usually includes information such as –
- the management structure of the entity, organisation chart, description of the individuals forming key management, the officials/enterprises to which the entity reports
- description of the business carried out by the entity, the industry in which it operates, the products and services, the key customers and suppliers, the geographical areas in which the entity operates, details of key competitors
- details of controlled transactions, the associated enterprises, the assets or intangibles held by each enterprise
- details for methodology adopted, the selection of the same, reasons for selection, which enterprise is the tested party, important assumptions, how the comparable data was obtained and method adopted for comparability analysis and functional analysis, financial information used in pricing, key terms and conditions
- details of advanced pricing agreements, significant tax rulings in the past
- annual financial statements, reconciliation of data used in pricing to the financial statements, summary schedules of relevant financial data used in pricing
Country by Country Report –The Country by Country Report (also referred as CbCR) is a report that consolidates the global allocation of income, taxes paid, and economic activity amongst jurisdictions in which the group operates. It is an attempt of the BEPS Project (Base Erosion and Profit Shifting) by OECD to standardise international taxation amongst tax jurisdictions and prevent multi-national entities from exploiting international tax laws with corporate tax planning. The Country by Country Report also contains the details of constituent entities, their country of incorporation, and the major business activities carried out. It is a master report prepared for the entire group and not individual entities; however, the reporting requirements vary amongst countries. This does not apply to all entities, instead of mandatory only if the enterprise forms part of a large multinational group, determined based on consolidated group revenue or total transactions of the individual entity. The report contains the following details for each tax jurisdiction in which the group operates –
- Profit before tax
- Income paid and accrued
- Total employment by the entity
- Capital employed and retained earnings
- Tangible assets
Transfer Pricing Documentation requirements in India
Section 92D read with Rule 10D of Income Tax Act, 1961 specifies the transfer pricing documentation for taxpayers in India. Accordingly, the documents maintained by the enterprise must contain the following details:
- the ownership structure of the enterprise
- profile of the multinational group of which the enterprise is a part of
- details of each enterprise with whom the enterprise has entered into international transactions including name, address, legal status, country of tax residence and the ownership linkage
- description of the business and the industry in which the enterprise operates, and the same for each associated enterprise with whom the enterprise has transactions with
- the nature and terms of transactions, details of property transferred or services provided, the quantity and the value of each transaction
- a description of the functions performed, risks assumed and assets employed or by the enterprise and by the associated enterprises involved
- record of the economic and market analysis, forecast, budget or any other financial estimates prepared for the business as a whole and each division or product separately
- record of uncontrolled transactions considered as comparable transactions, including nature, terms and conditions which may affect the pricing
- record of the analysis performed to evaluate the comparability of uncontrolled transactions
- description of the methods considered for determining the arm’s length price, the method selected as the most appropriate method, explanations as to why the method was selected, and how the method was applied
- record of the workings carried out for determining the arm’s length price, the comparable data used, the adjustments, if any, to account for the differences
- the assumptions, policies and price negotiations, which may have affected the price
- details of adjustments, made to actual transfer priceto align them with the rules and consequent impact on the total income
- any other information or document which may be relevant for the determination of the arm’s length price.
Further, the above documentation must be supported with authentic documents such as:
- official government publications, reports, studies or databases relating to associated enterprises or any other country as may be relevant
- reports of market research studies carried out and technical publications from reputed institutions
- price publications from stock exchanges and commodity markets
- published financial statements of the associated enterprises
- agreements and contracts with the associated enterprises or with uncontrolled enterprises
- documents for any terms negotiated between the enterprises
- other documents usually issued in connection with the transactions as per the accounting practices followed.
Other Rules concerning Transfer Pricing Documentation
The other significant rules concerning transfer pricing documentation are as follows:
- An entity which is constituent of an international group has to maintain transfer pricing documentation, as required by the law, irrespective of whether it has entered into a related party transaction or not.
- Detailed documentation is not required to be maintained if the total value of international transactions during a financial year does not exceed one crore rupees (INR 10 Million)
- During tax assessments, the assessing officer may ask for further documentation and information about the related party transactions entered into by the enterprise. Such information has to be provided by the entity within 30 days.
- The documentation has to be maintained for a period of nine financialyears, after the end of the financialyear to which it pertains to.
Transfer Pricing litigation’s can be hefty as there is an element of subjectivity involved in deciding the transfer price which leads to multiple opinions. Besides, the onus to prove the appropriateness of the transfer price lies with the taxpayer and not the tax authorities. Maintaining appropriate documentation can help in significantly reducing the litigation’s and allow a clean exit for the entity in tax assessments. More importantly, the background documentation of the transfer price must be created regularly at the time of occurrence of transactions and continuously, rather than waiting for an invite from the tax authorities to present the same, as the information is more accessible at the time of occurrence of transactions and thereby, helps in maintaining authentic and reliable records.