Fixing arm's length price

The Transfer Pricing Regime was introduced into the Indian income-tax law more than 15 years back.

Controversies continue to arise in applying the law to a given situation. It was the presence of multinational enterprises in India and their ability to allocate profits in different jurisdictions by controlling prices in intra-group transactions that formed the rationale behind the TP law.

Profits derived by enterprises belonging to the same multinational groups, carrying on business in India, could be controlled by the multinationals, by manipulating the prices charged and paid in such intra-group transactions, thereby leading to erosion of tax revenue in India.

A statutory framework was sought to be devised to compute reasonable, fair and equitable profits and tax of such multinational enterprises in India.

This objective was sought to be achieved by computing income from international transactions, having regard to the arm's length price, keeping in mind the principle that the amount charged by one relative party to another for a product or service must be the same as if the parties were not related. This meant going into the open market price.

The TPO needs to refer to comparable transactions made under comparable circumstances.

The objective behind the new law is to ensure that entities which are connected to each other on account of shareholding or managerial control and therefore in a position to influence the business decisions of Indian entity, are not able to shift payment of taxes from India to other countries, by shifting the income genuinely belonging to the Indian entity, to the non-resident entity, which is not taxed in India.

Maruti Suzuki case

Maruti Suzuki was once using the Logo ‘M' to represents its brand name. It entered into a licence agreement with its Japanese collaborator Suzuki and started using the Logo ‘S' in its new models of cars manufactured and sold in India.

It continued to use the mark Maruti along with the word Suzuki.

The Assessing Officer assumed that the addition of ‘S' should have warranted a payment from Suzuki to Maruti since the use of Suzuki would benefit the Japanese company giving rise to marketing intangibles arising out of the marketing of Maruti Suzki on all the cars manufactured and sold in India.

The company contended that substitution of the logo was not meant to benefit Suzuki but to promote its own product using the name and logo in exports.

The TPO felt that marketing and advertising expenses were incurred on large scale requiring apportionment between the resident and its non-resident associate.

Maruti was not receiving reimbursement for any part of the expenditure which should have been shared equally by the two entities. Maruti had already paid royalty to Suzuki. The company challenged the inference that Suzuki had derived benefit from the Maruti trademark without paying compensation for the same.

HC observations

On a writ petition by the company, the Delhi High Court noted that the broad approach of the TPO should have been to find out comparable cases of an independent Indian entity making payment of royalty to its associate collaborator.

There was no question of the trademark being sold and the TPO made out no case in this regard.

The TPO did not try to find out what royalty if any, a comparable Indian entity would have paid for the benefits derived by Maruti from Suzuki. There was no basis with the TPO for taking half of the royalty payment as payment for use of brand name and logo of Suzuki.

The High Court set aside the order of the TPO and laid down broad guidelines for determining the arm's length price. The onus of proving that the transaction was at arm's length price was on the assessee.

Before rejecting the transaction price, the TPO has to give an opportunity to the assesseee to prove the price. Arms' length price can be subject matter of substitution for international transactions under the Indian law.

If the foreign entity insists on the use of its trademark or logo, appropriate payment may be expected by the Indian enterprise from the foreign party for the advantage gained in the promotion of its trademark and logo.

Arm's length price depended upon the rights and obligations between the parties. There should be data relating to expenses incurred by comparable independent domestic entities to show the reasonableness of the expenditure incurred and apportioned.

These guidelines were found salutary and useful at a time when the Indian law does not have provisions for advance pricing mechanism.

SC ruling

Unfortunately, on appeal by the company, the Supreme Court erased these guidelines and directed the TPO to pass a final order uninfluenced by the observations given by the High Court. The matter was to be decided de novo.

Our Supreme Court is now presided over by an eminent tax jurist. A golden opportunity to lay down useful guidelines in a complicated branch of our tax law has been lost.

(The author is a former Chief Commissioner of Income-Tax.)