GST and Transfer Pricing – Need for Harmonization (GST vis-à-vis Income Tax)

[CASanjay Kumawat]

In the present age of globalization, it is a universal phenomenon that multinational Companies (MNCs) have branches/subsidiaries/divisions operating in more than one country. In such a situation, it is common event for MNCs to transfer goods produced by a branch in one tax jurisdiction to an associate branch operating in another tax jurisdiction. While doing so, the MNCs concerned has in mind the goal of minimizing tax burden and maximizing profits but the two tax jurisdictions/countries have also the consideration of maximizing their revenue while making laws that govern such transactions.

It is an internationally accepted practice that such ‘transfer pricing’ should be governed by the Arm Length Price (ALP) Principle and the transfer price should be the price applicable in case of a transaction of arm’s length. In other words, the transaction between associates should be priced in the same way as a transaction between independent enterprises.

The “Arm’s Length Price (ALP)” of a transaction between two associated enterprises is the price that would be paid if the transaction had taken place between two comparable independent and unrelated parties, where the consideration is only commercial.

Under Income Tax Act, 1961, in order to provide a statutory framework empowering the tax authorities to determine reasonable, fair and equitable profits and tax in respect of cross border transactions, section 92 to 92F had been included in Chapter X of the Income Tax Act, 1961, through the Finance Act, 2001, providing for a transfer pricing mechanism based on computation of income from cross border transactions.

Section 92 of the Income Tax Act, 1961, provides that any income arising from an international transaction shall be computed having regard to the arm’s length price. In order to provide objectivity in determination of income from domestic related party transactions and determination of reasonableness of expenditures between related domestic parties, the provisions of section 92 have been extended to include within its ambit the specified domestic transaction.

Under GST regime, in Indian context, supply of goods and/or services between distinct person, as described in section 25(4) and (5) of the CGST Act, 2017, and related person, as defined in an explanation (a) attached with section 15 of the CGST Act, 2017, would be subject to levy of GST. Therefore, it is important to determine the correct value of supply of goods and services to distinct persons or related persons to avoid the litigation.  

As business entities look into the appropriate transfer price of transactions, they should be mindful of the GST implications arising from the transfer pricing adjustments.

For instance, the retrospective increase in the transfer price of sales of goods is effectively an increase in the GST value of the supply of these goods. The increase in the value should be duly accounted for in GST returns. If the goods were exported and existing export documentation is not sufficient to support the adjusted price of goods, it is not clear how the GST authority would accept these documents for the purposes of allowance of benefit of zero-rated supply under section 16 of the IGST Act, 2017.

This article focuses on the expectations of the taxpayers around the arm’s length principle introduced, in GST framework, for the goods and services transactions between the distinct persons and related parties locally as well as for the cross border flow of services between them considering its potential interplay with the transfer pricing provisions enshrined in the Indian Income Tax Act, 1961.

Meaning of ‘Associates Enterprises’, ‘Related Persons’ and ‘Distinct Person’ under GST

Associated Enterprise

Transfer pricing provisions as defined under Income Tax Act, 1961, are applicable in context of transactions between assessee and its associated enterprises. Meaning of the term “associated enterprises” has been defined in section 92A of the Income Tax Act, 1961.

Under GST Act, 2017, section 2(12) provides meaning of the term “associated enterprises”. Accordingly, “associated enterprises” shall have the same meaning as assigned to it in section 92A of the Income Tax Act, 1961.

Accordingly, the term ‘Associated Enterprise’ generally means any entity that participates directly or indirectly or through one or more intermediaries in the management or control or capital of another entity. Further, where two entities are commonly controlled by one or more controlling entities, such entities are also considered as ‘Associated Enterprises’.

The Regulations further provide specific conditions and circumstances under which two entities are deemed to be Associated Enterprises. Some of these basic conditions include, ownership in the voting power of an enterprise exceeding the stipulated limit and right to appoint more than half of the directors on the governing Board of an entity. Other specific relationships applicable to firms and family businesses are also prescribed.

In the context of Specified Domestic Transactions, a related party (also referred to as ‘Associated Enterprise’) includes, amongst others, a director of a Company, a relative of such director, an entity having substantial interest (i.e., holding more than 20% of the voting power) in the other entity, subsidiaries, fellow subsidiaries, etc.

Related Persons

Under GST, as per explanation (a) attached with section 15 of the CGST Act, 2017, persons shall be deemed to be “related persons” if––

1. such persons are officers or directors of one another’s businesses;
2. such persons are legally recognised partners in business;
3. such persons are employer and employee;
4. any person directly or indirectly owns, controls or holds twenty-five per cent. or more of the outstanding voting stock or shares of both of them;
5. one of them directly or indirectly controls the other;
6. both of them are directly or indirectly controlled by a third person;
7. together they directly or indirectly control a third person; or
8. they are members of the same family.

Distinct Persons

As per section 25(4) of the CGST Act, 2017, a person who has obtained or is required to obtain more than one registration, whether in one State or Union territory or more than one State or Union territory shall, in respect of each such registration, be treated as distinct persons for the purposes of GST Act.

As per section 25(5) of the CGST Act, 2017, where a person who has obtained or is required to obtain registration in a State or Union territory in respect of an establishment, has an establishment in another State or Union territory, then such establishments shall be treated as establishments of distinct persons for the purposes of GST Act.

Valuation aspects for transactions between distinct persons and related persons

Under Income Tax Act, 1961, the Transfer Pricing (TP) Regulations require computation of ALP based on the prescribed TP methods. The Regulations have prescribed the following five methods for determination of ALP -

1. Comparable Uncontrolled Price Method (CUP),
2. Cost Plus Method (CPM),
3. Resale Price Method (RPM),
4. Profit Split Method (PSM), and
5. Transactional Net Margin Method (TNMM).

The Transfer Pricing Regulations also provide for use of any other method which takes into consideration a price charged in a similar transaction between unrelated parties in uncontrolled circumstances.

In cases where there is more than one price determined using the most appropriate from the above methods, ALP shall be taken to be at arithmetic mean of such prices. Where the transfer price differs from ALP, no TP adjustment is made where the arithmetic mean falls within the tolerance range of transfer price. Currently, the tolerance range available for wholesale traders is 1%, while that for other taxpayers is 3% of the value of International Transaction/ Specified Domestic Transaction.

Under GST, section 15 of the CGST Act, 2017, provides provisions for determination of value of supply. Accordingly, the value of a supply of goods or services or both shall be the transaction value, which is the price actually paid or payable for the said supply of goods or services or both where the supplier and the recipient of the supply are not related and the price is the sole consideration for the supply.

Section 15 of the CGST Act, 2017 deals with a situation where supplier and the recipient of the supply are not related persons. But in our case, we are discussing the situation where supplier and the recipient of the supply are related person.

As per Rule 28 of the CGST Rules, 2017- “Value of supply of goods or services or both between distinct or related persons, other than through an agent” provides the valuation methods for the determination of value of supply. The text of Rule 28 is reproduced below:

“The value of the supply of goods or services or both between distinct persons as specified in sub-section (4) and (5) of section 25 or where the supplier and recipient are related, other than where the supply is made through an agent, shall-

1. be the open market value of such supply;
2. if the open market value is not available, be the value of supply of goods or services of like kind and quality;
3. if the value is not determinable under clause (a) or (b), be the value as determined by the application of rule 30 or rule 31, in that order.

Provided that where the goods are intended for further supply as such by the recipient, the value shall, at the option of the supplier, be an amount equivalent to ninety percent of the price charged for the supply of goods of like kind and quality by the recipient to his customer not being a related person.

Provided further that where the recipient is eligible for full input tax credit, the value declared in the invoice shall be deemed to be the open market value of the goods or services.

Accordingly, the Rule 28 of the CGST Rules, 2017 provides 4 methods to determine the value of supply, are as follows:

1. Open Market Value (“OMV”) Method
2. Like kind and Quality Method (Or comparable method)
3. Cost Plus Method (Rule 30 )
4. Residual Method (Rule 31 )
5. Resale price Method

The various methods given in Rule 28 of the CGST Rules, 2017 have been discussed below:

1. Open Market Value (“OMV”) Method

The value of the supply of goods or services or both between distinct persons or where the supplier and recipient are related shall be the open market value of such supply. As per explanation (a) attached after Rule 35 of the CGST Rules, 2017, “open market value” of a supply of goods or services or both means the full value in money, excluding the integrated tax, central tax, State tax, Union territory tax and the cess payable by a person in a transaction, where the supplier and the recipient of the supply are not related and the price is the sole consideration, to obtain such supply at the same time when the supply being valued is made.

It means the price at which the supplies of goods or services are made when the supplier and recipient are not related and the price is the sole consideration for supply. This can be explained by way of an example.

A manufacture of electronic items sells the AC to a customer for ₹ 1 lakh but he provides the AC to related person for ₹ 0.75 lakhs. The related person supplied goods to manufacturer for which amount charged by him is only ₹ 0.25 lakh and it was agreed that he will be provided the AC at the price of 0.75 lakh.

In this case the price is not the sole consideration for supply of AC. The value of AC reduced as the manufacturer has received supply of goods from the related party. Therefore, as per Rule, 28 of the CGST Rules, 2017, the value of AC will be ₹ 1.00 lakh on which GST will be payable by the manufacturer to the Government.

Definition of term ‘open market value’ is as follows:

1. As per Black's Law Dictionary: The cost of items as determined by supply and demand.

2. As per International Valuation Standards (IVS 1 - Market Value Basis of Valuation, Seventh Edition): The estimated amount for which a property should exchange on the date of valuation between a willing buyer and a willing seller in an arm’s-length transaction after proper marketing wherein the parties had each acted knowledgeably, prudently, and without compulsion.

From a taxpayer’s perspective, open market value (OMV) is the value at which supply of goods and services being made to an unrelated person as per the market trend. The concept of OMV is most commonly invoked in inefficient markets or disequilibrium situations where prevailing market prices are not reflective of true underlying market value. Therefore, a taxpayer’s may suffer in determination of value of supply for the similar goods in similar market conditions which is tedious task. Hence, the Department should issue suitable guidance note or advisory to determine the open market value in favorable market conditions or unfavorable market conditions.

2. Like kind and Quality Method (Or comparable method)

The value of the supply of goods or services or both between distinct persons or where the supplier and recipient are related shall be the, where if the open market value is not available, value of supply of goods or services of like kind and quality. As per explanation (b) attached after Rule 35 of the CGST Rules, 2017, “supply of goods or services or both of like kind and quality” means any other supply of goods or services or both made under similar circumstances that, in respect of the characteristics, quality, quantity, functional components, materials, and the reputation of the goods or services or both first mentioned, is the same as, or closely or substantially resembles, that supply of goods or services or both.

The essential characters of the definition are as follows:

1. Supply shall be made under similar circumstances.

2. Comparable should be selected on the basis of similar to the characteristics, quality, quantity, functional components, materials, and the reputation of the goods or services or both first mentioned, is the same as, or closely or substantially resembles.

This method is similar to the Comparable Method provides under Income Tax Act, 1961. Under GST, selection of comparables will be a tedious task for the taxpayers and any wrong determination of value of supply will invite the litigation in near future.

For the purpose of selection of comparables, comparability analysis is to be performed by a comparison of the business activities and the Functions, Assets and Risks of the taxpayer vis-à-vis that of independent taxpayers.

Several financial parameters and quantitative filters are applied while screening comparables. Finally, qualitative analysis is carried out to identify final set of comparables. There is a lot of subjectivity in this matter, leading to numerous litigations. For instance, issues in determination of comparables could be:

1. Accurate adjustment for difference in Geographic segment is not possible to perform.
2. Selection of loss-making or abnormal profit-making taxpayers as comparables;
3. Comparison of high-end services with low-end services;
4. There are some differences like business relations, future expectations, use of Trademark and other marketing intangibles, specific circumstance, etc. which cannot be accurately adjusted.
5. Comparison of trading functions with agency functions;
6. Comparison of turnover, employee costs, transactions in foreign currency, etc.;
7. Comparability of cross border transactions and domestic transactions is difficult.
8. Comparison of taxpayers catering to export markets to those catering to domestic markets.

Different circumstances can prevail at the time of supply of goods or services. The Rule requires that the supply shall be made in similar circumstances. Similar circumstances needs to be determined based on the external factors or the position of the supplier and the position of the recipient. Clause (b) of Explanation requires that the comparison of the product shall be made between the product in respect of characteristics, quality, quantity, functional components, materials, and the reputation of the goods or services or both.

The GST authorities or Department must demonstrate comparability of these factors in order to determine the value of supply of goods or services of like kind and quality otherwise it will add various interpretational issues, classification issues, etc in newly launched GST, hence, lead to litigation. There are so many judicial pronouncements on selection comparables under Income Tax Act, 1961, some of industry wise issues, for instance, are as follows:

1. Consultancy Services : In TA Associates Advisory Private Limited v. DCIT 2016 (2) TMI 503 - ITAT MUMBAI , it was held that the assessee, rendering non-binding investment advisory services to associated enterprise could not be compared to a company engaged in providing merchant banking and investment banking services.

2. ITES Sector : In Hewlett Packard (India) Software Operation (P) Limited v. DCIT 2016 (3) TMI 1242 - ITAT BANGALORE , it was held that company having revenue from software licensing could not be compared to a company providing software development services. 

3. Support Services : In C3I Support Services (P) Limited v. DCIT 2016 (4) TMI 1279 - ITAT HYDERABAD , it was held that assessee, a BPO, could not be compared with a company that was into KPO services.

4. Manufacturing Industry : In Essilor Manufacturing India (P) Limited v. DCIT  2016 (4) TMI 377 - ITAT BANGALORE , it was held that a company catering to needs of defence and armed forces and other organizations in field of space applications, night vision equipment, etc would not be functionally comparable to assessee engaged in the manufacturing of optical plastic lenses of human care.

From the above discussion, it can be said that for the purpose of determination of value of supply of goods and/or services, selection of comparables is important aspect. Out of goods and/or services, in case of services, the application of this Rule will be very difficult task for the authorities because quality of services or services for the satisfaction can’t be measured.

3. Cost Plus Method

If the value is not determinable under earlier valuation methods, value of supply shall be the value as determined by the application of Rule 30 or Rule 31, in that order. Accordingly, Rule 30-“Value of supply of goods or services or both based on cost” of the CGST Rules, 2017, provides that where the value of a supply of goods or services or both is not determinable by any of the preceding rules of this Chapter, the value shall be one hundred and ten percent of the cost of production or manufacture or the cost of acquisition of such goods or the cost of provision of such services.

Accordingly, in this method, value of supply of goods and services shall be 110% of the cost of production or cost of manufacturing of the product or cost of provision of services. As such law does not specify the clear guidelines or procedure or standards to determine the cost of the goods or provision of services. However, similar provisions of value based on cost of production or manufacture is contained in Rule 8 of Central Excise Valuation (Determination of value of excisable goods) Rules, 2000 issued under the Central Excise Act, 1994. As per CBEC Circular No. 692/08/2003 dated 13.02.2003 read with Cost Accounting Standard-4 (Known as CAS-4) may be referred for the purpose of determination of cost of production or manufacture of the goods. Further, with reference to Rule-30, it appears that the method can be only applied in case of manufactured goods / goods on which further processing has been done.

For determination of value of provision of services, basic principles of CAS-4 shall be applied. In determining the cost of service, cost of employee is main cost. As per para 5.2 of the CAS-4 specify that direct wages and salaries include fringe benefits such as:

1. Contribution to provident fund and ESIS
2. Bonus/ ex-gratia payment to employees
3. Provision for retirement benefits such as gratuity and superannuation
4. Medical benefits
5. Subsidised food
6. Leave with pay and holiday payment
7. Leave encashment
8. Other allowances such as children’s education allowance, conveyance allowance which are payable to employees in the normal course of business etc.

It is important to note that in the case of supply of services, the supplier may opt for Rule 31, ignoring rule 30.

Hence, If the value is not determinable under Open market value method and like kind and quality method then value of the supply may be determined after application of the basic principles given in CAS-4 and same is approved by the CBEC vide Circular Number 692/08/2003 dated 13.02.2003.

4. Residual Method

If the value is not determinable under earlier valuation methods, value of supply shall be the value as determined by the application of Rule 30 or Rule 31, in that order. Accordingly, Rule 31-“Residual method for determination of value of supply of goods or services or both” of the CGST Rules, 2017, provides that where the value of supply of goods or services or both cannot be determined under rules 27 to 30, the same shall be determined using reasonable means consistent with the principles and the general provisions of section 15 and the provisions of this Chapter. It may be noted that in the case of supply of services, the supplier may opt for this rule, ignoring rule 30.

Accordingly, in this case, value shall be determined by using reasonable means consistent with basic principles and provisions of section 15 of the CGST Act, 2017. For the purpose of assessment, Department officials will have to make proper efforts to come out with the most suitable value of the supply after considering the various external and internal factors.

5. Resale price Method

As per first proviso to Rule 28 of the CGST Rules, 2017, where the goods are intended for further supply as such by the recipient, the value shall, at the option of the supplier, be an amount equivalent to ninety percent of the price charged for the supply of goods of like kind and quality by the recipient to his customer not being a related person.

The essential characters of this provision are as follows:

1. There must be ‘as such’ supply (i.e., supply in the same form in which received.). In other words, this method can be applied for trading industry only.
2. This method is available at the option of supplier only.
3. The value of supply shall be an amount equivalent to 90% of the price charged for the supply of goods of like kind and quality by the recipient to his customer not being a related person.

Accordingly, taxpayers can pay GST on 90% of the market value as against 100% under the current excise laws in case of supply of goods to entities such as subsidiaries, branches and joint ventures. By opting to pay GST on 90% value of supply of goods instead of 100% value of supply of goods, a taxpayer can save working capital blockage of GST on 10 % value of the supply of goods.

6. Other

As per second proviso to Rule 28 of the CGST Rules, 2017, where the recipient is eligible for full input tax credit, the value declared in the invoice shall be deemed to be the open market value of the goods or services.

Accordingly, the declared invoice value will be accepted but only where the recipient (or buyer) is eligible to claim credit of GST charged. In cases where credit is not available, GST will be applicable on open market value, which is the full value of money payable by the recipient to obtain such goods or services where supplier is not related and price is the sole consideration.

However, it should not be presumed that any value declared in the invoice will be accepted by the Department as the manner of determining the value is contained in section 15 read with Determination of Value Rules as given in CGST Rules, 2017. The value shall be more or less equivalent to the value determined under section 15 or the Rules. If required, supplier will have to substantiate the manner of determining the value of supply.

Tolerance limit for value of supply under GST

Under Income Tax Act, 1961, the tolerance range available for wholesale traders is 1%, while that for other taxpayers is 3% of the value of International Transaction/ Specified Domestic Transaction.

On other hand, no tolerance range available under GST hence it will invite the accuracy related issues, correctness issues, hence, resultant in disputes between the Department and assesse.

Conclusion

Transfer pricing itself is not a means of tax avoidance if transaction value matches with what the supplier would charge to an unrelated recipient. As the objective of the arm’s length principles and mechanism is basically to ensure that the affairs of distinct persons or related persons are not arranged in a manner that results in lower GST payment to the Government, therefore, the governing principles need to be harmonized. The governing principles can be obtained from the judicial precedence available on several transfer pricing issues in other taxation laws in India as well as taxation laws of other Countries where similar provisions are applicable.

From a taxpayer’s perspective, the GST framework governing arms’ length standard or method(s) to determine value of supply would need to be aligned with the Income Tax provisions on transfer pricing viz, the methodologies adopted, the nature of documentation to be maintained and any GST specific Compliances.

 

Notes: Bibliography: Transfer Pricing Prism 2017- BDO ICAI’s Study Guide Compendium of Transfer Pricing and International Taxation Judicial Precedents. I would like to mention and acknowledge the contribution received from CA Deepesh Korjani. He is having rich experience in Direct Taxation and Transfer Pricing. He has worked with Chir Amrit Legal LLP and KPMG where he has handled various taxation assignments including advisory and litigation for various corporate entities. For any feedback or queries, reader may write at [email protected].

Discussions to this article

[S.Anil IYER]

Lucid and beautifully written. Thank you for sharing..!!