Summary: Chapter X of the Income Tax Act imposes transfer pricing regulations for transactions with associated enterprises (AEs) to determine the arm’s length price (ALP). This applies when an entity deals exclusively with AEs, as it controls profit margins through intercompany agreements. However, for entities transacting with AEs and non-AEs, Chapter X applies only to AE transactions. Non-AE transactions, carried out independently and without the same price control, do not fall within the scope of transfer pricing adjustments. The courts have clarified that any transfer pricing adjustments to non-AE profits contradict the intent of the law, reinforcing that the ALP should only be calculated for AE transactions.

Transfer Pricing Regulations (“TP”) apply to entities engaged in international transactions with its associated enterprise (“AE”), the scope of Chapter X of the Income Tax Act ( “Law”) is to determine the arm’s length price (“AE”). ALP’) of the transaction with a related party.

When the entity only transacts with its related party, such as a captive service provider that depends on the AE for business and generates revenue, the entire margins of the entity must be taken into account to calculate the ALP and apply the TP provisions at the entity level to compare the transaction. However, when an entity is engaged in a transaction with or without an AE to generate income, the provisions of Chapter X apply only to the transaction with AEs and not with non-AEs. The entity having both AE and non-AE revenue will make a profit which will be a mixture of AE and non-AE markup on cost.

Entities that transact exclusively with AEs will have control over the profit margin, as they agree to charge for their service at cost plus a markup in accordance with the intercompany agreement (“Agreement”). When the cost-plus markup is defined as part of the agreement, this entity successfully recovers the consideration from AE in accordance with the terms of the agreement and will rarely experience payment defaults. Whereas, when the entity deals with non-AEs or third parties, it does not have control over the margin and service fee recovery, due to business difficulties, trade agreements or financial stress of the customer and may even sell the service at a loss due to market demand.

Interaction between AE and non-AE transactions

When the entity engages with AE and non-AE, the margin of AE and non-AE is mixed at the entity level and this combined margin may not project favorable margins at the entity level for a comparison with comparable companies and must also not correspond to the margin as agreed under the intercompany agreement. In such a situation, the entity’s profits become inappropriate for determining the ALP.

Segmentation of revenues in the books of accounts is not possible, since the entity is not required to carry out segment reporting according to accounting standards. However, to determine the profits made between AE and non-AE segments, segmentation is carried out independently to support the TP analysis. Whereas when segment revenues or profits are not split between AE and non-AE in the financial statements, revenue may struggle to determine the ALP at the entity level and impose a TP adjustment on the profits of the entity.

Provisions of the Income Tax Act, 1961 (“Act”)

The company determines the ALP in the context of the international transaction with its AE, it must calculate the ALP by applying the most appropriate method in accordance with section 92C of the Act.

In accordance with the provisions of subsection 3 of section 92CA of the Act, the TPO will determine the ALP in relation to international transactions in accordance with subsection 3 of section 92C of the Act.

The law under sections 92C and 92CA clearly states that the ALP must be determined for international transactions and any deviation from the provisions of the law will cause it to be contravened. The provisions of Chapter X do not apply to non-AE transactions.

Views of the High Court and Tribunal

TP adjustment is mandatory only for international transactions with AE and not for independent transactions with third parties. The reason behind imposing TP is to scrutinize the ALP of the controlled transaction with AEs and avoid profit shifting. Tax evasion or profit shifting will not occur when transacting with an independent third party since the transactions are not monitored. When revenue determines ALP at the entity level, it indirectly imposes a TP adjustment on non-AE transactions, which will also result in increased profits from non-AE transactions.(1)which is contrary to the fundamental principles of transfer pricing and does not fall within the scope of Chapter X.(2) (3)

Illustration

The following illustration explains the issue of TP adjustments on non-AE transactions:

Intra-group companies sign an intercompany agreement for the transaction to be executed and will invoice the services provided at cost plus the agreed markup. In the illustration above, the AEs had accepted the increased cost of 17 percent. When it comes to non-AE transactions, they have no control over the costs and revenue generated, hence the non-AE segment earned a profit margin of 4.5 percent.

During the TP assessment, the Transfer Pricing Officer (“TPO”), while carrying out comparative analysis, must take into account the profit of the entity to determine the ALP. Since the the cost of AE and non-AE transactions is combined at the entity levelthis resulted in a profit margin of 14.75% and fails to achieve the profit margin as per the intercompany agreement.

The TP adjustment, when imposed for the benefit of the entity, will require the company to also accept the additions made on the adjustment on the non-AE segment and, therefore, the non-AE revenues and costs are adjusted , which goes against the fundamental merits of the TP regulations. The TP adjustment inevitably requires the company to maintain non-AE profit margins at ALP, which is inappropriate and against the law.

Conclusion

Therefore, when the entity engages in a transaction with AE and non-AE, the profit earned by that entity is the result of AE and non-AE transaction and in this case, revenue and cost segmentation is imperative. Since the determination of ALP is mandatory only for transactions with AEs, revenues should consider only transactions between the entity and AEs and should not take into account non-AE costs and revenues when determining calculation of the ALP.(4).

(1) Thyssen Krupp Industries India (P.) Ltd. Deputy Commissioner of Income Tax, Central Circle – 3(3), (2012) 27 taxmann.com 334 (Mumbai – Trib.)

(2) Commissioner of Income Tax Vs. Thyssen Krupp Industries India (P.) Ltd., reported in (2016) 70 TAXMANN.COM 329 (Bombay),

(3) RP. COMMISSIONER OF INCOME TAX-2 c. M/S TT STEEL SERVICE INDIA PVT. LTD

(4) FIS Global Business Solutions India (P.) Ltd Vs. ACIT, (2024) 166 taxmann.com 28 (Delhi – Trib.)