Covid-19: A cry for relooking transfer pricing APAs and safe harbour rules


A significant volume of global trade consists of international transfer of goods, services, capital and intangibles. As per the United Nations Practical Manual on Transfer Pricing, 2013, international transfers within MNE group entities which are called intragroup transfers are growing steadily and account for more than 30% of the total international transactions. What is paid by one entity to another entity in the intra-group transfer is called the transfer price. Such transactions are controlled transactions because they are between two associated or connected enterprises as distinct from uncontrolled transactions which are between two entities which are not associated and operate on arm’s length basis. Transfer pricing adjustment enables the tax administration of a country to correct the transfer price and compute the same on arm’s length price, to check, avoid and ensure correct payment of taxes. Arm’s length price (“ALP”) in simple words means the price which a willing buyer would pay to a willing seller in an uninfluenced situation.

ALP is arrived at by applying various methods (discussed below). The gravamen of ALP is that transaction between associated enterprises is compared with the transaction between unrelated enterprises. This process is known as Benchmarking. Detailed Transfer Pricing documents are required to be maintained to substantiate the Benchmarking process. The tax department often challenges the Benchmarking undertaken by the taxpayer, and adjustments are made in transfer price, leading to plethoric income.

Therefore, to eschew litigation, apart from such Benchmarking, the Act also provides Safe Harbour Rules (“SHR”) and Advance Pricing Agreements (“APA”). The purpose of SHR is to ensure that ALP is not intransigent but allow some latitude. APA is an agreement between the taxpayer and the tax department regarding use of preagreed margins for computing ALP.

This article aims to highlight the possible impact of the current pandemic on the determination of ALP.

Impact on ALP computation

Section 92 of the Income Tax Act,1961 (“the Act”)  deals with the computation of income from international transactions lays down that any income arising from an international transaction shall be computed having regard to the ALP.

 The arm›s length principle as adumbrated in Article 9 of the OECD Model Convention stipulates that «where conditions are made or imposed between two enterprises in their commercial or financial relations which differ from those which would be made between independent enterprises, then any profit which would, but for those conditions, have accrued to one of the enterprises, but by reason of those conditions, having so accrued, may be included in the profits of that enterprise and taxed accordingly.»

Section 92F of the Act defines ALP is the price applied (or proposed to be applied) when two unrelated persons enter into a transaction in uncontrolled conditions.

Section 92C(1) is of significance and relevance as it stipulates that ALP in relation to an international transaction can be determined by any of the five methods specified therein, with authority to the Central Board of Direct Taxes (“CBDT”) to prescribe the sixth method.

The five methods are (a) Comparable Uncontrolled Price Method; (b) RP Method, i.e. Resale Price Method; (c) CP Method, i.e. Cost Plus Method; (d) Profit Split Method; and, (e) TNM Method, i.e. Transactional Net Margin Method. Subsections (1) and (2) to Section 92C casts an obligation on the assessed to compute arm’s length price as per the methods prescribed. 

Comparable Uncontrolled Price Method compares price charged for the property or service in a controlled transaction with the price charged for comparable property or service in an uncontrolled transaction in comparable circumstances.

In RP Method, the price paid for the product by an independent third party, i.e. the resale price received by an AE is taken as the basis. A reverse exercise computes the arm’s length price by determining the normal gross profit margin, i.e. gross profit margin, of an unrelated enterprise. Expenses incurred are thereafter, reduced and adjustments for differences in comparable is made to arrive at the arm’s length price.

 Cost Plus Method requires determination of the appropriate gross profit margin which would be charged by a comparable and adding the same mark up to the expenditure/cost incurred by the AE to determine the proper profit given market conditions and functions performed. The three methods above are treated as traditional transactional methods.

TNM Method or Profit Split Method are called transactional profit methods or profit-based methods. TNM Method measures the net operating profits realized from controlled transactions. It then compares the profit level to the profit level realized by independent enterprises engaging in comparable transactions. Profit Split Method takes the combined profit earned by two related parties from one or a series of transactions. It then divides those profits using an economically valid defined basis. It aims at replicating the division of profits which would have been anticipated in an agreement made at arm’s length. It requires working back from the profit to the price.

The five methods stipulated in sub-section (1) to Section 92C, are set out and articulated step-wise in detail in Rule 10B of the Income Tax Rules, 1962(“the Rules”).

 Be it any of the five methods, the first step to be exercised is to identify the international transaction and the transfer price paid for the same by two AEs. The second step is to carry out functional analysis, i.e. the functions to be performed by the two AEs taking into account the assets employed, risk assumed, the contractual terms, the economic circumstances of the parties and the business strategy pursued by the parties.

 On the question of comparability analysis, United Nations’ Practical Manual on Transfer Pricing in paragraph 5.1.1 states that the analysis is used to designate two distinct but related analytical steps. First, being to understand the significant economic characteristic of the controlled transaction between the two AEs and the respective roles of the parties thereto. The second analytical step is the comparison of those conditions of the controlled transactions with uncontrolled transactions, i.e. transactions between the two AEs taking into account the economically significant characteristics of the controlled transactions and the respective roles of the five comparability factors.

The analysis mentioned above, therefore, requires selection of appropriate comparable, i.e. an uncontrolled transaction which is to be compared with a tested party. The comparable can be internal, i.e. one of the AEs enters into a similar uncontrolled transaction with an independent enterprise; or external, i.e. involving an independent enterprise in the same market or industry.

The comparison must be about the comparability analysis as elucidated in paragraph 5.1.1 of the United Nations Practical Manual on Transfer Pricing. In other words, the economically relevant characteristics of the two transactions being compared must be sufficiently comparable. This entails and implies that difference, if any, between controlled and uncontrolled transaction, should not materially affect the conditions being examined given the methodology being adopted for determining the price or the margin. When this is not possible, it should be ascertained whether reasonably accurate adjustments can be made to eliminate the effect of such differences on the price or margin.

 Thus, identification of the potential comparable is the key to the transfer pricing analysis. As a sequitur, it follows that the choice of the most appropriate method would be dependent upon availability of potential comparable keeping in mind the comparability analysis, including befitting adjustments which may be required. As the degree of the comparability increases, the extent of possible differences which would render the analysis inaccurate necessarily decreases.

Therefore, the current situation of the pandemic has jeopardized the very basis of comparability exercise based on which the Transfer Pricing is based.

 Indeed, transfer pricing is not an exact science but a method of legitimate quantification which requires the exercise of judgment on the part of the tax administration and the taxpayer to have a certain degree of certainty. It is a method and formulabased and, therefore, rational and scientific. However, not being sacrosanct or infallible, first and the second proviso to sub-section (2) along with stipulations in Sub-section (2A) and 2(B) of section 92C posit a ‘getaway’ clause when the arm’s length price so determined and the controlled price does not exceed 5% (reduced to 3% w.e.f. 1st April 2012).

The “gateway” of 5% or 3%, as the case may be, can be applied if the variation in arm’s length price and transaction/ controlled price does not exceed the specified percentage. Sub-section (2A), therefore, stipulates that where the difference exceeds the prescribed rate, the taxpayer would not be entitled to exercise the option under the first proviso to sub-section (2) to Section 92C and claim reduction.

Since the selection of comparable may not give an appropriate picture, therefore, the Government may consider increasing the gateway limit to account for the changed circumstances.

 Impact on SHR

SHR were introduced by the CBDT in the year 2009 and provides for circumstances in which a specified category of taxpayers can follow a simple set of rules under which the revenue authorities automatically accept transfer prices.

After its enactment in 2009, the first set of rules were notified in 2013 for three years, followed by a revision in 2017 in the SHR were applicable until FY 2019.

The SHR is applicable on certain eligible international transactions. ‘Eligible international transaction’ means an international transaction between the eligible taxpayer and its associated enterprise, either or both of whom are non-resident, and which comprises of:

 (i)  provision of software development services;

(ii)  provision of information technology-enabled services;

(iii) provision of knowledge process outsourcing services;

(iv) advance of intra-group loan;

(v)  provision of a corporate guarantee, where the amount guaranteed,— (a)  does not exceed one hundred crore rupees; or (b)  exceeds one hundred crore rupees, and the credit rating of the associated enterprise, done by an agency registered with the Securities and Exchange Board of India, is of the adequate to highest safety;

(vi)  provision of contract research and development services wholly or partly relating to software development;

(vii)  provision of contract research and development services wholly or partly relating to generic pharmaceutical drugs;

(viii)  manufacture and export of core auto components; 

(ix)  manufacture and export of non-core auto components; or by the eligible assessee.

(x) receipt of low value-adding intra-group services from one or more members of its group,

Rule 10TD of the Rules specifies the rates which if shown by the Assessee are accepted by the tax department. For example: The operating profit margin declared by the eligible assessee from the Provision of software development services in relation to operating expense incurred is acceptable, if – (i) not less than 20 per cent, where the aggregate value of such transactions entered into during the previous year does not exceed a sum of five hundred crore rupees; or (ii) not less than 22 per cent, where the aggregate value of such transactions entered into during the previous year exceeds a sum of five hundred crore rupees.

The CBDT has notified changes in SHR vide notification no. 25/2020 dt. 20th May 2020. The notification said that the rates with the changes applicable for AY 2017-18 to AY 2019-20 would continue to apply for AY 2020-21 also, i.e. for the Financial Year 2019-20.

 Earlier, these were made applicable for three years. Still, this time the Government seems to have decided to announce only for one year considering that the Covid-19 disruptions would impact businesses in FY 2020-21.

 It is, therefore, expected that the minimum rates of profit margins might be reduced when the SHR are notified for the FY 2020-21 as the overall margins of the industries described above have declined.

Impact on Advance Pricing Agreements

An APA is an agreement between the CBDT and any person, which determines, in advance, the ALP or specifies the manner of the determination of ALP (or both), in relation to an international transaction.

The primary objective of an APA is to provide certainty and comfort to taxpayers so that predictable and foreseeable conditions and outcomes can be expected regarding transfer pricing practices. The benefits of an APA are many. The risk of double taxation is eliminated in the bilateral APA. The APA also provides for an agreement on maintenance of documentation, so that the burden of record-keeping is reduced. Further, there is no full-scale transfer pricing audit and only a compliance audit to check the adherence to the agreed terms and conditions.

The APA was introduced in the year 2012 in the Act. The provisions regarding the rollback of the APA were added later in the year 2015. 

 India has created a legal framework providing for a legally binding agreement between the taxpayer and the CBDT. The Finance Act, 2012, inserted sections 92CC and 92 CD in the Act to provide the legal basis for APA in India. These statutory provisions, effective from 1st July 2012, empowered the CBDT to enter an agreement with any person, with the approval of Central Government, determining the ALP or specifying the manner of determination of ALP in relation to an international transaction to be entered into by that person.

The rules regarding the implementation aspects of the APA Scheme were notified later on 30 August 2012 in the form of Rules 10F to 10T and rule 44GA of the Rules. These provisions lay down the detailed procedures for the filing of pre-filing consultation application, prefiling consultation, fees, the filing of APA application, processing of the application, amendment of application, withdrawal of application, terms and conditions, filing of Annual Compliance Report, Compliance Audit, revision, cancellation and renewal of the APA.

Rollback provisions in the APA Scheme were introduced through the insertion of sub-section (9A) in section 92CC by the Finance Act, 2014. The relevant rules (10MA and 10RA) for the rollback of the APA were notified on 14 March 2015.

A taxpayer would be able to have certainty in matters of transfer pricing for a maximum period of 9 years (prospective five years and four rollback years) by applying for an APA along with an application for the rollback of the APA.

Taxpayers with existing APAs which were entered under the normal circumstances may soon have to grapple with honouring the same. APAs are conditional on a set of critical assumptions, and this crisis may invalidate one or more of the premises for the remaining term of the APA. APAs which are in the stage of negotiation should consider deferring the consultation until the market comes on track for having proper adjustments and/or comparable.

 Transfer Pricing Audit compliance

In practice, comparable company financial data are not audited and released until after the end of the applicable fiscal year-end reporting date. Thus, the comparable company information relied upon in setting prices will usually lag behind the tested party data. As such, the most recently available data for analyzing 2020 tested party results contemporaneously will likely be information from 2018 or 2019. It may cause practical challenges concerning comparability, as the economic conditions in 2020 due to the Covid-19 outbreak are very different from those of the immediately preceding years when most industries operated under relatively normal market conditions. Accordingly, comparable company data from the years immediately preceding the downturn years may not provide appropriate benchmarks in economic downturns.

Therefore, the pragmatic approach should be to extend the compliance for audit report by a year or so to get the most appropriate comparable. Otherwise, it will adversely affect the transfer pricing tax regime, resulting in unnecessary litigation on contravention of transfer pricing settled principles. In these odd times, tax authorities may be advised to formulate such exceptions, changes, and measures which taxpayers can undertake on their transfer pricing arrangements to dampen and mitigate the adverse effects on their businesses, to acclimatize with the downturn economy of the world.


 The prodigious economic disruption caused due to the menace of COVID, which started in China has brought the whole world on its knees. The tax department has always been very considerate while formulating transfer pricing rules, as evidenced by the introduction of SHR and APAs regimes. Consequently, the taxpayer awaits such an altruistic approach from the administration again as the global outbreak of COVID-19 is already arguably the most socially and economically disruptive worldwide event of our lifetime. As the pandemic persists, it is clear the economic impact of the crisis will worsen. Businesses will suffer, and industries may be transformed in unforeseen ways. From a transfer pricing perspective, it is crucial to understand the implications of this pandemic. Through careful consideration of transfer pricing and economic theory, the evaluation of heuristic approaches, and formulating some mitigating strategies considering all the prevailing factors, will put out intense positive energy.

 Adv. Gagan Kumar, a Chartered Accountant and Advocate practices as an Arguing counsel at the Supreme Court & Delhi High Court. He is the founder of Krishnomics Legal