Transfer Pricing
Chapter 3 -Various concepts in Transfer Pricing regulations
Transfer Pricing
Chapter 3
Various concepts in Transfer Pricing regulations
1. Introduction:
Transfer pricing has emerged as one of the most significant areas of international taxation, addressing the pricing of goods, services, funds, and intangibles exchanged between Associated Enterprises (AEs) across borders. Since such transactions are influenced by group relationships rather than market forces, there exists a potential for profit shifting and erosion of the tax base in source countries like India. To safeguard revenue and ensure fairness, Indian law, in line with global standards such as the OECD Model Convention and UN Transfer Pricing Manual, mandates that transactions between AEs must be evaluated at the Arm’s Length Price (ALP). The Income-tax Act, 1961, through Sections 92 to 92F, provides a comprehensive framework defining key concepts like transaction, controlled and uncontrolled transactions, arrangement, understanding, action, enterprise, associated enterprise, international and deemed international transactions, ALP, and tested party. Together, these concepts establish the foundation for determining and regulating transfer pricing compliance in India.
2. Transaction:
In transfer pricing, a transaction refers to any dealing or arrangement between two or more enterprises involving transfer of goods, services, funds, or intangibles. It includes purchase, sale, lease, provision of services, lending or borrowing of money, cost-sharing arrangements, or any activity having a bearing on profits, income, losses, or assets of the enterprises. Under Section 92B of the Income-tax Act, 1961, the scope of “transaction” is wide, covering both express and implied agreements, whether formal or informal. Transactions are the foundation for applying the Arm’s Length Principle, ensuring that dealings between Associated Enterprises reflect fair market conditions.
3. Uncontrolled Transaction:
An uncontrolled transaction is a transaction between two or more independent enterprises that are not associated and thus operate without any mutual influence over each other’s decisions. Such transactions reflect prices and conditions determined purely by market forces, free from group control or special relationships. In transfer pricing, uncontrolled transactions serve as the benchmark to test whether controlled transactions between Associated Enterprises (AEs) are at the Arm’s Length Price (ALP). By comparing controlled dealings with similar uncontrolled transactions, tax authorities can determine if profit shifting or manipulation has occurred, ensuring proper allocation of taxable income in India.
4. Controlled transaction:
A controlled transaction refers to a transaction between two or more Associated Enterprises (AEs), where mutual relationship influences the terms and conditions of the transaction. Unlike dealings between independent enterprises, these transactions are not governed purely by market forces but by group interests. As a result, the pricing, allocation of costs, or sharing of resources may deviate from fair market value. Under Section 92B of the Income-tax Act, 1961, such controlled transactions are treated as international transactions and must be examined with reference to the Arm’s Length Price (ALP) to ensure that taxable profits in India reflect genuine economic realities.
5. Arrangement:
In transfer pricing, an “arrangement” refers to any plan, scheme, or concerted action between Associated Enterprises (AEs) that governs the terms and conditions of their transactions. The arrangement may be formal or informal, written or oral, and may or may not be legally enforceable. What is essential is that such an arrangement influences the pricing of goods, services, funds, or intangibles between AEs, thereby affecting profits, income, losses, or assets. Under Section 92B of the Income-tax Act, 1961, such arrangements are deemed international transactions and must be benchmarked against the Arm’s Length Price (ALP) to prevent profit shifting.
6. Understanding:
In transfer pricing, an “understanding” refers to a consensus or informal agreement between Associated Enterprises (AEs) on the course of action in their business dealings. It may be written, oral, or implied, and need not be legally enforceable. If such an understanding influences pricing, allocation of costs, or transfer of goods, services, or funds between AEs, it is treated as an international transaction under Section 92B of the Income-tax Act, 1961. This ensures that arrangements, even without formal contracts, are benchmarked at the Arm’s Length Price (ALP).
7. Action:
In transfer pricing, the term “action” refers to any step, conduct, or commercial activity undertaken by an enterprise that directly or indirectly benefits its Associated Enterprise (AE). Such actions may involve provision of goods, services, funds, or managerial resources even if not formalized through contracts. If these actions have a bearing on profits, income, losses, or assets of an enterprise, they fall within the ambit of international transactions under Section 92B of the Income-tax Act, 1961, and must be benchmarked at Arm’s Length Price (ALP).
8. International Transaction:
The term international transaction is defined in Section 92B(1) of the Income-tax Act, 1961. It refers to a transaction between two or more associated enterprises, either or both of whom are non-residents, in relation to:
i. purchase, sale, lease or transfer of tangible or intangible property;
ii. provision of services;
iii. lending or borrowing of money;
iv. or any arrangement having a bearing on profits, income, losses, or assets of such enterprises.
It also includes agreements for allocation or apportionment of costs or expenses incurred for a benefit, service, or facility provided to one or more enterprises. Explanation 1 and 2 to Section 92B expand the scope to cover business restructuring, guarantees, delayed realizations, cost-sharing, marketing intangibles, and transactions involving capital financing.
Thus, the term has a wide and inclusive scope, ensuring that controlled transactions of every nature between Indian entities and their foreign AEs are benchmarked at Arm’s Length Price (ALP). However, transactions that do not affect income or are purely capital in nature (e.g., issue of shares) are generally outside the ambit of ALP adjustment, though depreciation on such capital assets may be computed on adjusted values.
For Example:
i. AMP expenditure for brand promotion of AE is an international transaction. LG Electronics India (P.) Ltd. v. Asstt. CIT [2013] 140 ITD 41/29 taxmann.com 300 (Delhi)
ii. Transactions having direct bearing on profits/losses/assets fall within Section 92C. Iljin Automotive (P.) Ltd. v DCIT [2025] 170 taxmann.com 375 (Chennai - Trib.)
iii. Interest-free loan to AE is an international transaction. Perot Systems TSI (India) Ltd. v DCIT [2010] 37 SOT 358 (DELHI)
iv. Issue of shares to AEs is not an international transaction as it does not affect income. Vodafone India Services (P.) Ltd v. UOI [2014] 50 taxmann.com 300 (Bombay)
v. Royalty treated as a separate international transaction for benchmarking. Sony Ericsson Mobile Communications India (P.) Ltd. v. CIT [2015] 55 taxmann.com 240 (Delhi)
vi. Delayed realization of AE dues is an international transaction under Explanation 2. Phillips Software Centre (P.) Ltd. v. ACIT [2008] 26 SOT 226 (Bangalore)
9. Deemed International Transaction:
Under Section 92B(2) of the Income-tax Act, 1961, certain transactions are treated as deemed international transactions even if they are not directly with an Associated Enterprise (AE). This provision applies where:
The assessee enters into a transaction with an independent third party;
There exists a prior agreement or arrangement between such third party and the AE of the assessee; and
The substantial terms and conditions of the transaction are determined by the AE.
In such cases, the transaction is deemed to be an international transaction, attracting transfer pricing regulations. For example, if an Indian company purchases goods from an unrelated supplier, but the pricing or terms are dictated by its foreign AE under a global framework, the purchase is treated as an international transaction.
This deeming provision prevents avoidance of transfer pricing rules by routing controlled transactions through unrelated intermediaries, ensuring that profits taxable in India reflect true arm’s length conditions.
10. Enterprise:
The term enterprise is fundamental to transfer pricing regulations, as it identifies the entity engaged in transactions subject to arm’s length scrutiny. Under Section 92F(iii) of the Income-tax Act, 1961, an enterprise means a person, including a Permanent Establishment (PE), engaged in any activity relating to production, storage, supply, distribution, acquisition, or control of goods, services, or rights. It covers businesses in manufacturing, trading, services, professional activities, financing, investments, and dealings in securities.
An enterprise includes activities involving intellectual property such as patents, trademarks, licenses, franchises, or commercial rights of a similar nature. It also encompasses provision of services of any kind, performance of contractual work, and investment or financing activities. Rule 10A further clarifies that an enterprise covers a unit, undertaking, or business of a person undertaking specified domestic or international transactions.
Thus, the definition is wide and inclusive, ensuring that all entities, including PEs, engaged in economic activities with associated enterprises fall within the scope of transfer pricing compliance.
Comparative Note on Enterprise – Section 92F and OECD Model Convention
Under Section 92F(iii) of the Income-tax Act, 1961, an enterprise includes any person, including its Permanent Establishment (PE), engaged in activities connected with production, storage, supply, distribution, acquisition, or control of goods, services, or commercial rights. It extends to professional services, intellectual property exploitation, financing, investment, and dealings in shares or securities. Rule 10A further clarifies that the term covers a unit, undertaking, or business of a person involved in international or specified domestic transactions. The intent is to capture all forms of economic activity that may influence transfer pricing outcomes.
By contrast, Article 3(1)(c) of the OECD Model Convention defines “enterprise” broadly as the carrying on of any business. Article 3(1)(h) explains “business” to include professional services and other activities of an independent character. The OECD approach is principle-based and flexible, leaving the precise scope to domestic law of contracting states.
Thus, while the Indian definition is detailed and exhaustive, the OECD definition is broad and general, both converging on the idea that any organized economic activity qualifies as an enterprise for transfer pricing purposes.
11. Associate Enterprise:
The concept of Associated Enterprise (AE) is central to transfer pricing regulations. Section 92A of the Income-tax Act, 1961 defines when two enterprises are considered associated. Broadly, enterprises are treated as AEs when there exists direct or indirect participation in management, control, or capital. This relationship can arise in several ways: holding more than 26% of voting power, appointing a majority of directors, substantial dependence on intellectual property of the other, significant purchases or sales influenced by one party, guarantees for borrowings, or existence of any prescribed mutual interest.
Thus, AEs include not only parent–subsidiary relationships but also arrangements where substantial influence exists over decision-making or business conditions. Importantly, the definitions of “enterprise” and “associated enterprise” are used interchangeably, meaning that in a given case, either entity may be treated as the AE depending on context.
In transfer pricing analysis, once a relationship of AE is established, transactions between them are presumed to be controlled transactions, not reflecting market realities. Hence, they must be evaluated by applying the Arm’s Length Price (ALP) principle, ensuring that profits in India are not understated due to influence of group relationships.
Comparative Note on Associated Enterprise – Section 92A and OECD Model Convention
Under Section 92A of the Income-tax Act, 1961, two enterprises are considered Associated Enterprises (AEs) when there is participation, direct or indirect, in the management, control, or capital of one by the other, or when the same persons participate in both. The statute provides detailed circumstances, such as shareholding exceeding 26%, control of board appointments, dependence on intangibles, substantial purchase or sale arrangements, guarantees of borrowings, or mutual interests. This detailed framework ensures that any significant influence in commercial or financial relations is captured.
Similarly, Article 9 of the OECD Model Convention defines associated enterprises in a cross-border context. It applies where (i) an enterprise of one contracting state participates directly or indirectly in the management, control, or capital of an enterprise of the other state; or (ii) the same persons participate in the management, control, or capital of both. If conditions in their relations differ from those between independent enterprises, profits can be adjusted to reflect arm’s length conditions.
Thus, while Indian law provides a comprehensive statutory list of control situations, the OECD framework sets out a broad principle-based definition, both serving to identify cases where transfer pricing rules and arm’s length adjustments apply.
12. Arm’s Length Price:
The Arm’s Length Price (ALP) is the benchmark used in transfer pricing to ensure that international transactions between associated enterprises (AEs) reflect fair market values. ALP represents the price which would be agreed upon between independent enterprises acting in uncontrolled market conditions, i.e., what a willing buyer would pay to a willing seller in an open market.
When two AEs engage in transactions, their prices are presumed to be influenced by group interests rather than market forces. Such controlled pricing can lead to shifting of profits and reduction of taxable income in the source country. To neutralize this, law treats AEs as if they were independent and recomputes prices to the arm’s length standard. Section 92F(2) of the Income-tax Act defines ALP, while Section 92C prescribes five methods (Comparable Uncontrolled Price, Resale Price, Cost Plus, Profit Split, and Transactional Net Margin Method) for its determination.
ALP is applied where: (i) transactions are not at market-determined prices; (ii) substance of the transaction differs from its form; (iii) AEs are located in low-tax regimes; or (iv) unusual price variations exist compared to unrelated party dealings By adjusting deviations, ALP ensures that taxable profits in India reflect genuine economic value.
Arm’s Length Price (ALP) – Key Points
i. Determination Method: ALP must be determined by a single method prescribed under Section 92C(1) (CUP, RPM, CPM, PSM, or TNMM); combination of methods is not allowed.
ii. Impact on Income: The test is whether the controlled price has a significant effect on income.
iii. Segmentation: If profit of each unit cannot be evaluated independently, they cannot be segregated for ALP; however, segmental results may be considered where direct comparables are unavailable.
iv. Capital Transactions: ALP adjustments apply only where income arises from international transactions. Capital account transactions (e.g., issue of shares at premium) are outside ALP adjustments.
v. Royalty: Royalty can be assessed independently for ALP if not interlinked with other transactions.
vi. Certified Accounts: Segmental results based on audited accounts must be respected; no adjustment if already at ALP.
vii. Unity of Business: Where there is unity of business, management, and funds, segregating units for ALP is improper.
viii. Scope of Adjustment: Adjustments can be made only in respect of AE transactions, not for unrelated party dealings or entire turnover.
ix. Transaction Basis: Each international transaction should be evaluated separately; aggregation is permissible only for closely linked transactions.
x. Case Law Applications:
a) ALP cannot be applied to capital account items like share issue (Vodafone India Services case principle).
b) Royalty payments can be benchmarked separately (Sony Ericsson Mobile Communications India (P.) Ltd.).
c) Interest-free loans to AEs compared against LIBOR plus basis, not domestic PLR (Perot Systems TSI (India) Ltd.).
d) Use of Berry Ratio accepted for low-risk distributors with high-volume trading.
e) ALP adjustment restricted to international transactions only, not to non-AE dealings (LG Electronics India Pvt. Ltd.).
13. Tested Party:
In transfer pricing analysis, the tested party is the entity whose financial results are examined to determine the Arm’s Length Price (ALP) of an international transaction. It is generally the party to the controlled transaction for which reliable data of comparables is most easily available, which is less complex in terms of functions, assets, and risks (FAR), and requires the least adjustments. The tested party can be either the Indian resident or the non-resident associated enterprise, depending on whose tax liability is under assessment. For example, if the Indian company’s income from transactions with its foreign associated enterprise is being assessed, the Indian company will be the tested party; conversely, if the non-resident’s Indian tax liability is under scrutiny, the non-resident will be tested. International guidelines, including OECD and UN Transfer Pricing Manuals, emphasize that the tested party should be the one with least intangibles, simpler FAR profile, and most reliable comparable data.
The OECD Transfer Pricing Guidelines (2010, para 3.18) provide that the tested party should generally be the entity to which a transfer pricing method can be most reliably applied, i.e., the party with the least complex functional profile and for which the most reliable comparables can be found. Similarly, the UN Transfer Pricing Manual (2013, para 5.3.3) emphasizes that when applying methods such as TNMM, the tested party should be the one with the simplest FAR (functions, assets, risks) and where reliable data for comparability exists. Indian jurisprudence aligns with these principles. In Ranbaxy Laboratories Ltd. v. ACIT [2008] 110 ITD 428 (Delhi Trib.), the Tribunal observed that the tested party may be local or foreign, but it must be the least complex entity, having minimum intangibles, and supported by reliable comparable data. Thus, across jurisdictions, the guiding principle is to select the entity with least complexity and maximum data reliability.
14. Conclusion:
The framework of transfer pricing seeks to strike a balance between the legitimate business needs of multinational enterprises and the imperative of tax administrations to protect their revenue base. Concepts such as transaction, enterprise, associated enterprise, international transaction, and tested party provide clarity on the scope of transfer pricing regulation, while the arm’s length principle ensures fairness and comparability with market-based outcomes. Judicial pronouncements, both in India and globally, have further enriched the interpretation of these provisions, ensuring that tax authorities respect genuine business arrangements but also curb artificial profit-shifting practices. By harmonizing with OECD and UN guidelines, India has aligned its system with international best practices while retaining safeguards suitable to its domestic context. Ultimately, transfer pricing is not merely a compliance requirement but a critical tool for ensuring tax equity, transparency, and certainty in cross-border transactions. It remains a cornerstone of modern international tax administration.