Transfer Pricing
Chapter 1
(Introduction)
1. Background: With the liberalization of the Indian economy in 1991, foreign capital, technology, and investments began flowing into India. To facilitate cross-border trade and prevent double taxation, India entered into several Double Taxation Avoidance Agreements (DTAAs). However, many multinational enterprises (MNEs) exploited the gaps in international tax systems by shifting profits to tax havens or low-tax jurisdictions. This was done by inflating or deflating intra-group prices in areas such as sale of goods, provision of services, licensing of intangibles, or financial arrangements. As a result, taxable income that should have been reported in India was artificially transferred abroad, eroding the country’s tax base.
2. Need for Transfer Pricing Regulations: The increasing scale of global trade highlighted the challenge of base erosion and profit shifting. Developing countries like India, whose resources were used to generate profits, were deprived of legitimate tax revenues. To address this, it became necessary to ensure that the profits reported by MNEs in India truly reflected the value created in India. Transfer pricing regulations were thus introduced to align intra-group transactions with market realities and to prevent artificial shifting of profits.
3. Purpose of transfer pricing provisions: The purpose of transfer pricing provisions is rooted in the need to protect the tax base of a country like India from erosion caused by profit shifting by multinational enterprises (MNEs). As highlighted in the passage, after the economic liberalization of 1991, foreign investments and cross-border transactions grew significantly. Alongside, corporate groups began exploiting the differences in tax regimes across countries—especially in tax havens or low-tax jurisdictions—by artificially diverting profits. This was done through manipulated intra-group transactions, such as inflating or deflating prices of goods, services, interest, royalties, or technical fees, so that higher profits accrued in tax havens while minimal profits were reported in India or other source countries.
The central purpose of transfer pricing provisions is therefore to ensure that income earned in India is taxed in India in accordance with its real economic value creation. These rules aim to determine the Arm’s Length Price (ALP) of international or specified domestic transactions so that profits attributable to Indian operations are not understated. By aligning controlled transactions (within group entities) to market-based pricing, the law prevents tax avoidance, ensures fairness, and safeguards revenue. In essence, transfer pricing provisions strike a balance between encouraging foreign investment and preventing abusive practices of profit shifting, thereby protecting the fiscal sovereignty of the country while adhering to internationally accepted principles.
4. FAQ:
(i) Q. Whether transfer pricing can be regarded as a precise science, or is it essentially an estimate requiring reasonable approximation in light of the facts of each case?
Ans. The Tribunal held that transfer pricing is not an exact science but a method of approximation subject to variations based on facts, circumstances, and comparables available. It emphasized that absolute accuracy is neither possible nor expected, and reasonable judgment in line with statutory provisions must guide the determination.
In Mentor Graphics (Noida) Pvt. Ltd. v. DCIT [2022] 145 taxmann.com 635 (Delhi – Trib.)/[2023] 199 ITD 147 (Delhi – Trib.), the assessee, a wholly owned subsidiary engaged in software development services, disputed adjustments proposed by the Transfer Pricing Officer (TPO). The TPO had made certain adjustments by selecting comparables and applying margins, which the assessee challenged as arbitrary and unscientific. The Tribunal noted that transfer pricing analysis is not an exact science but an exercise in estimation, involving approximations and judgment based on available data. It observed that since no two companies are perfectly alike, complete mathematical accuracy in comparability analysis is impossible. Instead, what is required under law is a reasonable, fair, and judicious application of methods prescribed under section 92C, without undue rigidity. The Tribunal stressed that while objectivity and transparency must guide the process, one cannot expect precision akin to a mathematical formula. Thus, the arm’s length price (ALP) determination is inherently an exercise of approximation, open to adjustments so long as they are rational and consistent with statutory guidelines. Accordingly, the Tribunal upheld the principle that transfer pricing is not a science of exactitude but a pragmatic tool to ensure fairness in international transactions. Mentor Graphics (Noida) Pvt. Ltd. v. DCIT [2022] 145 taxmann.com 635 (Delhi – Trib.)/[2023] 199 ITD 147 (Delhi – Trib., 26-12-2022).
In Sony India (P) Ltd. v. DCIT [2008] 114 ITD 448 (Delhi), the Tribunal clearly emphasized that transfer pricing is not an exact science but an approximation. It observed: “Transfer pricing exercise is not an exact science and it involves approximations. There is bound to be some element of guesswork and estimation in the process of determining the arm’s length price”. The judgment underlined that no two enterprises can be perfectly identical in their functional and risk profiles, and therefore, comparability analysis can only yield results within a broad range rather than a single precise figure. The methods prescribed under the law, such as CUP or TNMM, serve as guides to arrive at a reasonable approximation of what independent parties would transact at, but they cannot eliminate judgmental subjectivity. By acknowledging these limitations, the ruling reinforces that transfer pricing provisions are a pragmatic tool meant to curb profit shifting and safeguard revenue, while accepting the commercial realities of cross-border trade. Thus, the mechanism’s value lies not in mathematical precision, but in its ability to reasonably align related-party transactions with international norms.
(ii) Q. How transfer pricing provisions prevent revenue loss?
Ans: Transfer pricing provisions act as a safeguard against artificial profit shifting by multinational enterprises. They ensure that cross-border and specified domestic transactions are benchmarked at arm’s length, thereby protecting India’s tax base. In Iljin Automotive Pvt. Ltd. v. ACIT [2013] 33 taxmann.com 597 (Chennai – Trib.), the Tribunal observed: “The principle of transfer pricing is to prevent profit being shifted to foreign entities by manipulating prices in international transactions with associated enterprises.” This underlines the preventive intent of the law.
The Supreme Court in DIT v. Morgan Stanley & Co. [2007] 292 ITR 416 (SC) clarified that transfer pricing ensures adequate compensation in India for services rendered: “Once an associated enterprise is remunerated at arm’s length, there can be no further attribution of profits to the foreign enterprise.” This demonstrates that the provisions strike a balance between avoiding double taxation and preventing under-taxation.
Further, in Sony Ericsson Mobile Communications India Pvt. Ltd. v. CIT [2015] 374 ITR 118 (Delhi), the High Court reiterated: “Transfer pricing provisions are not intended to maximize revenue… but to determine correct arm’s length price so that the Indian entity’s taxable income is neither understated nor overstated.”
Together, these rulings show that transfer pricing provisions are essential in curbing revenue leakage, ensuring fair attribution of profits, and fostering certainty in international taxation.
(iii) How transfer pricing regulations are accepted internationally?
Ans: Transfer pricing regulations are widely regarded as an internationally accepted mechanism for governing cross-border transactions. Their foundation lies in the arm’s length principle, which is endorsed globally, particularly through the OECD Transfer Pricing Guidelines, and adopted into domestic laws of most major economies. The principle ensures that related party transactions are priced as if they occurred between independent enterprises, thereby preventing artificial profit shifting and base erosion. Indian tribunals, while interpreting transfer pricing provisions, have consistently recognized that these regulations are not isolated domestic constructs but part of a global consensus designed to bring uniformity, fairness, and predictability in international taxation. This acceptance across jurisdictions highlights that transfer pricing is not merely a local compliance measure but a harmonized framework enabling equitable allocation of tax bases among nations. Thus, transfer pricing rules embody a legitimate international standard, aligning India’s regime with global best practices and discouraging tax avoidance strategies. In this regard, Tribunal observed in Dresdner Bank AG v. Addl. CIT [2007] 108 ITD 375 (MUM.) as follows-
“The essence of transfer pricing regulations lies in the determination of income from international transactions as if they were entered into between independent enterprises under uncontrolled conditions. This is achieved by applying the arm’s length principle, which requires that the conditions of a controlled transaction do not differ from those which would be made between independent enterprises.”
(iv) What is the meaning of transfer pricing?
Ans: In the case of LG Electronics India (P.) Ltd. v. ACIT [2014] 42 taxmann.com 313 / 148 ITD 677 (Delhi - Trib.), the Tribunal elaborated upon the meaning and scope of transfer pricing provisions. It explained that transfer pricing refers to the pricing of goods, services, or intangibles between associated enterprises where conditions are not governed by market forces. The objective of the law is to ensure that such related-party transactions are benchmarked against those between unrelated parties, applying the arm’s length principle. The Tribunal emphasized that the essence of transfer pricing lies in aligning intra-group arrangements with fair market standards to prevent erosion of the tax base through artificial shifting of profits. It also underlined that transfer pricing is not a challenge to the commercial rationale of the transaction itself, but only to the fairness of the pricing. In doing so, the Tribunal clarified that the mechanism serves as a corrective tool to ensure neutrality and transparency, protecting revenue without hindering legitimate business models.
(v) How the transfer pricing mechanism are explained in OECD Guidelines?
Ans: Article 9 of the OECD Model Convention provides the international legal basis for transfer pricing rules by addressing profit allocation among associated enterprises. Article 9(1) states:
“Where … conditions are made or imposed between the two [associated] enterprises in their commercial or financial relations which differ from those which would be made between independent enterprises, then any profits which would, but for those conditions, have accrued to one of the enterprises, but, by reason of those conditions, have not so accrued, may be included in the profits of that enterprise and taxed accordingly.”
This embodies the Arm’s Length Principle (ALP), requiring that related-party transactions reflect pricing comparable to independent enterprises under similar circumstances. It ensures that profits are not artificially shifted to low-tax jurisdictions through intra-group arrangements.
Further, Article 9(2) safeguards against double taxation by providing that:
“Where a Contracting State includes in the profits of an enterprise … and taxes accordingly, profits on which an enterprise of the other Contracting State has been charged to tax, the other State shall make an appropriate adjustment…”
Thus, Article 9 not only empowers tax authorities to prevent base erosion but also establishes the mechanism for corresponding adjustments, ensuring neutrality and fairness in cross-border taxation. It harmonizes revenue protection with avoidance of double taxation, forming the cornerstone of international transfer pricing regulations.
(vi) Give brief introduction to transfer pricing provisions in India?
Ans. Introduction of Transfer Pricing Regulations in India
1) Legislative Basis: India introduced a comprehensive Transfer Pricing (TP) regime through Sections 92 to 92F of the Income-tax Act, 1961, effective from 1st April 2001, in line with OECD guidelines, to curb profit shifting and ensure fair taxation.
2) Scope: The TP provisions apply when income arises from an international transaction or a specified domestic transaction between associated enterprises (AEs). The objective is to compute income having regard to the arm’s length price (ALP).
3) Associated Enterprises & International Transactions: Section 92A defines when two enterprises are associated, based on participation in management, capital, or control. Section 92B defines “international transaction” to include purchase, sale, transfer of goods, services, intangibles, cost-sharing arrangements, financing, and business restructurings across borders.
4) Arm’s Length Price (ALP): Section 92F(ii) defines ALP as the price applied or proposed to be applied in a transaction between unrelated parties under uncontrolled conditions. This principle is central to transfer pricing regulations, ensuring that intra-group transactions do not erode the Indian tax base.
5) Methods for ALP Computation: Section 92C prescribes five primary methods (Comparable Uncontrolled Price, Resale Price, Cost Plus, Profit Split, Transactional Net Margin), along with a sixth method notified by the CBDT. The “Most Appropriate Method” must be selected depending on the facts of each case.
6) Role of the Transfer Pricing Officer (TPO):Section 92CA empowers the Assessing Officer to refer computation of ALP to a TPO, who then determines ALP after examining documentation and comparables.
7) Safe Harbour & APA Mechanisms: Sections 92CB and 92CC introduce Safe Harbour Rules and Advance Pricing Agreements (APAs), allowing certainty for taxpayers and reducing litigation by pre-determining ALP within an accepted margin.
8) Documentation & Reporting: Section 92D mandates detailed contemporaneous documentation justifying ALP determination. Section 92E requires filing of an Accountant’s Report in Form 3CEB on or before the specified date.
9) Definitions: Section 92F provides crucial definitions: “arm’s length price,” “enterprise,” “permanent establishment,” “specified date,” and “transaction” (which includes informal or non-binding arrangements).