Transfer Pricing And Customs: Is Convergence Possible?
Transfer pricing is a discipline of income tax that deals with fair pricing of transactions between related parties and thus the fair allocation of profits and taxes.
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Globalisation coupled with technology disruptions has resulted in multi-fold growth of trade across borders. In fact, multiple studies have revealed that around 60 per cent of global trade is conducted between ‘related parties’ / ‘group companies’, which leads to the question, ‘Are there only commercial/business reasons for structuring operations in this way or are there tax motives?’ Transfer pricing is a discipline of income tax that deals with fair pricing of transactions between related parties and thus the fair allocation of profits and taxes. At the same time, custom duty is a levy on cross border trade, including cross-border transactions between related parties.
While the objective of both regulations is to establish whether or not the price at which the transaction has been entered into has been influenced by the relationship between the parties entering into the transaction; the major conflict arises on account of the difference in approach by administrators. On one hand, the transfer pricing officer would look at reducing the price of imports (to increase profit and thus income tax); whereas the customs officer would seek to increase the value of the imported goods (thus an increased customs duty).
Broad Comparison of Regulations in India
Income Tax Act, 1961 and Income Tax Rules, 1962
Customs Act, 1962 and Customs Valuation Rules, 1988 (modified in 2007)
Import/export of goods, services both tangible and intangible or any other transaction between taxpayer and its associated enterprise
Primarily, all import and export of goods; including transactions between related parties
Timing of Valuation
While setting up and reviewed regularly (annually) under self-compliance
At the time of every import/export.
Basis of pricing a transaction
‘Arm’s length price’, a price which would prevail for the transaction with an unrelated party under uncontrolled circumstances
Actual value transaction. Revaluation using prescribed methods in case the price is found to be influenced by the relationship between the parties
Methods of valuation prescribed (broad similarities)
Comparable Uncontrolled Price (CUP)
Transactional Value of similar/identical goods
Resale Price Method (RPM)
Cost Plus Method (CPM)
Profit Split Method (PSM) / Transactional Net Margin Method (TNMM) / Other Method
Comparability factors for determining the method
Type of transactions, the profile of the parties and the functional analysis of the transactions
Same or similar transactions (profile and functional analysis not relevant)
Comparable Data sources
Use of databases by independent service providers like CMIE, Capital Market, etc
Proprietary data available within the Customs database /archives/repository
Time of assessment by revenue
2-3 years from the end of the relevant year
At the time of clearance of the goods through the customs frontiers, into the territory of India
The focus of revenue authorities
Reduce the import price and thereby increase the profit base to tax
Increase the import price to increase the incidence of import duty; so as to enable the higher collection of duty on the value of import
Advance agreement with revenue authorities
Advance Pricing Agreement (APA) with the revenue authorities, can be entered into for a period up to 5 years
In case of related party transaction, where valuation is determined through SVB, the same is generally valid for a period 3 years
On several occasions, Indian taxpayers have argued before the revenue and the appellate authorities, seeking reference to the other regulation and bringing across the dichotomy in approach. However, in most cases, the judiciary was of the view that the methodology specified under both the regulations, while being different is specific and thus the valuation under one may not be interchangeable with the other. The global situation is no different, the contrast in objective and approach is becoming an increasing concern for global businesses. To add to the agony, revenue authorities in each country would consider a perspective favouring their country and any additional tax becomes a double whammy in the absence of any compensatory adjustment/credit in the other country.
Attempts to Resolve Conflict and Align Approach
With a view to addressing the concerns of the taxpayers arising out of the conflict, the Indian Government had set up a joint working group comprising of officers of both income-tax and customs authorities. This has then culminated into a Circulariii with an attempt to implement the recommendations of this working group. Some of the identified steps are listed below:
Co-operations through ‘Bi-monthly’ and ‘Six-monthly’ joint meetings
Sharing of information on specific cases
Exchange of ‘related party’ information on ‘need to know basis’
Training programmes for team members of both Transfer Pricing and Customs
WCO Guide to Customs Valuation and Transfer Pricing (2018)
The WCO is working with the OECD and the World Bank Group to encourage customs and tax administrations to establish bilateral lines of communication. The proposition is to exchange knowledge, skills and data, wherever possible, this will help ensure that each authority has the broadest picture of an MNE’s business, its compliance record and can make informed decisions on the correct revenue liability.
The scenario in Select Trade Partner Countries
China: The convergence of the two authorities is seemingly distant, unless the prices are same, based on a reasonable basis
Germany: Customs authority may accept the pricing arrived for transfer pricing purposes if appropriately supported by transfer pricing study
United Kingdom: The two branches of taxation operate more autonomously with a remote possibility of aligning the outcomes, but there are expectations of increased co-operation considering adoption of measures to counter BEPSiv and implementation of Union Customs Code (UCC) implemented in May 2016
United States of America: Possible to achieve the convergence if an APA is sought with participation by Customs Authority
Countering the Conflict
With different objectives of both the branches of taxation, a balance between the two is very critical for businesses. The attempts made by governments and global forums do offer some guidance on the subject, but there is a need to initiate the work internally within a group to counter the conflict.
If one were to look at the deeper thread connecting businesses, i.e. ‘economic’ criteria underlying any transaction, there is a possibility to reach to conclusions which can be balanced/harmonised. In the case of businesses approach these two authorities with a common methodology of valuation for cases like import of products under the touchstones of fundamentals of economics, the desired results could be achievable. This could be through conducting a detailed and appropriate functional analysis in the spirit of the facts and comparative benchmarks governing the various criteria. The acceptability of the valuations under the methods prescribed by both these regulations may seem converging at this particular point of ‘economic’ rationale. A comprehensive and transparent factual matrix presented by the taxpayer could be explained and conclusions drawn therefrom could be appreciated by those respective authorities. Businesses could look at using a base price and apply adjustments under respective regulations, use tolerance range/extremes, consider a wider period of comparable data, examine the applicability of different valuation methods to justify transaction/transfer price to the extent permissible and recommended under respective regulations. Using advanced pricing agreements and other similar pre-emptive alternative measures would help bring the medium to long term certainty around either or both streams of revenue.
With the ever-growing global trade, even the government could look at implementing the efforts to harmonise Transfer Pricing and Customs and to resolve the issues faced under the legislations, by setting up a common forum to address the advanced determination of prices. Cross participation by authorities in matters relating to assessments/audits/proceedings under the respective regulations could also assist in developing a harmonised pricing approach.
In conclusion, convergence while possible requires a more coordinated objective and focused approach by respective authorities and taxpayers across the globe, similar to the OECD initiative to counter BEPS.
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