Before, transfer pricing provisions were limited to International Transactions only. Since 01.04.2013, transfer pricing rules and regulations have been applied on ‘Specified Domestic Transactions’ from A.Y. 2013-14.
Now that Transfer Pricing is applicable on Specified Domestic Transactions, now the taxpayers are obliged to report/document & provide evidence of the Arm’s Length nature of such transaction.
The concept of International Transfer Pricing was there introduced sooner in other countries as compared to India. Other developing countries presented transfer pricing, such as Korea in 1998 and China in 1999, while India adopted international transfer pricing in 2001. Now the questions arise, Why is Transfer Pricing necessary? More than 100 countries have introduced International as well as Domestic Transfer Pricing Provisions.
Now we will discuss about the various concepts of Domestic Transfer Pricing
A domestic controlled transaction is a transaction between associated enterprises that live in the same country or the same tax jurisdiction. For example, XYZ Technology sells IT equipment to associated enterprise ABC Tech, and both of the enterprises are situated in the United Kingdom.
An international controlled transaction is a transaction between associated enterprises in different tax jurisdictions. For example, XYZ Technology sells IT equipment to associated enterprise ABC Technology US. XYZ Technology is situated in the United Kingdom, and the tax jurisdiction of ABC Tech US is situated in the United States.
You now understand that the tax jurisdiction is the relevant criteria that are required to determine whether you’re dealing with a domestic controlled transaction or an international controlled transaction. This can be puzzling when there are multiple tax jurisdictions within the same country. For example, Labuan is a federal territory with its own tax jurisdiction, yet, it is also a part of Malaysia. A transaction between associated enterprises in Kuala Lumpur and Labuan could therefore be categorized as an international controlled transaction, as Labuan has its own tax jurisdiction.
Risk of challenges
Tax authorities are less likely to examine carefully the transfer pricing of a domestic controlled transaction. The reason for this is that an adjustment to the terms and conditions of such a transaction at the level of one associated enterprise will be mirrored by a corresponding adjustment at the level of the other associated enterprise. And since both enterprises live in the same country or tax jurisdiction and pay taxes there, in most cases a correction will have a neutral result for the tax authorities in terms of tax revenues.
But in the case of international transfer pricing, a correction can result in additional tax revenues. To make this clearer, let us give you an example
XYZ Technology sells IT equipment to associated enterprise ABC Technology and the tax jurisdiction of both enterprises is the United Kingdom. The price for the sale is GBP 100,000 and both enterprises book this amount as revenue respectively costs of goods sold in their books. The HRMS, that is, the tax authority of the United Kingdom, takes the position that the price is not at arm’s length and should be increased with GBP 50,000. This means that the income of XYZ Technology increases by GBP 50,000 and normally corporate tax revenue also increases. However, the position of the HRMS results in that the costs of goods sold for ABC Technology increase with GBP 50,000, and normally corporate tax revenue decreases. Non-acceptance of the latter would be inconsistent with the HRMS! So, in most of the cases on balance, there is not much to win. There are cases that this doesn’t apply, for example where one of the associated enterprises has tax losses to be utilized.
Now XYZ Technology sells IT equipment to associated enterprise ABC Technology US. XYZ Technology is situated in the United Kingdom and ABF Technology US is situated in the United States. The price for the sale is GBP 100,000 and both enterprises book this amount as revenue respectively costs of goods sold in their books. The HRMS takes the position that the price is not at arm’s length, and should be increased with GBP 50,000. This means that the revenue of XYZ Technology increases by GBP 50,000 and normally corporate tax revenue also increases. This is a real gain for the HRMS. And contrary to the above example, the correction of the HRMS does not necessarily mean that the costs of goods sold for ABC Technology, US increase by the same amount. The IRS, the United States tax authorities, may have a different view on such an increase. In the worst-case scenario, this correction is not followed by the IRS and this gives birth to a new dispute. Solving such disputes takes a lot of time and costs.
The compliance requirements such as reporting of transactions in tax filings and transfer pricing documentation can be different in different countries. For domestic controlled transactions the compliance burden is generally less. In some countries, there is no documentation required for domestic transfer pricing at all.
There can be a difference in withholding taxes. Domestic transactions normally do not attract withholding tax. International transfer pricing may attract withholding tax on the basis of domestic legislation and subject to the application of dual tax treaties. Withholding taxes may apply to the payment of royalties, service charges, interest payments, and dividends. If the recipient of such payments cannot claim a credit for the withholding tax paid, that is a real cost to the company.
The nature and class of the international transaction.
The class or classes of related enterprises that enter into the transaction and the functions performed by them taking into account assets employed or to be employed and risks assumed by such enterprises.
The availability, coverage, and reliability of the data necessary for the method to be applied.
The magnitude of comparability existing between the international transaction and the uncontrolled transaction and between the enterprises entering into such transactions.
The extent to which reliable and accurate adjustments can be made to account for differences, if any, between the international transaction and the comparable uncontrolled transaction or between the enterprises entering into such transactions.
The nature, extent and reliability of assumptions required to be made in application of a method.