Transfer Pricing
Chapter 5
Associate Enterprise: A Comprehensive Study
(based on my book on Basic Concepts OF International Taxation)
1. Introduction: Globalization has fundamentally transformed the way businesses operate, creating a highly interconnected world where multinational enterprises (MNEs) carry out complex cross-border transactions. As businesses expand beyond national borders, it becomes necessary to regulate the tax implications of these interactions to prevent double taxation and profit shifting. The concept of “Associate Enterprise” plays a central role in international taxation by defining relationships between related entities and ensuring that transactions between them are conducted on fair and equitable terms.
The OECD Model Tax Convention (OECD MC), particularly Article 9, provides the international framework for taxing transactions between associated enterprises. It lays down the principle that profits must be allocated between jurisdictions in a way that reflects genuine economic activity. This essay is focusing on how India and other jurisdictions have adopted OECD principles through transfer pricing regulations and Double Taxation Avoidance Agreements (DTAAs).
2. Historical Background: The origins of the concept of associate enterprise can be traced back to the early 20th century when increasing globalization began to raise concerns about double taxation and tax base erosion. During this period, businesses were shifting profits to low-tax jurisdictions through intra-group transactions, creating disparities in revenue allocation between countries. The League of Nations, in the 1920s, first addressed these concerns by proposing methods for adjusting profits among related enterprises to reflect true market conditions.
The OECD, which succeeded the League of Nations’ efforts, published the first Model Convention in 1963. Over time, the convention has undergone continuous revisions to address emerging challenges posed by technological advances, new business structures, and globalization. Article 9 of the OECD MC specifically deals with associated enterprises, providing clarity on how profits should be determined and taxed when entities are related.
3. Definition of Associate Enterprise:
3.1 OECD MC Definition: According to Article 9(1) of the OECD MC, an associated enterprise relationship exists when:
“Where an enterprise of a Contracting State participates directly or indirectly in the management, control, or capital of an enterprise of the other Contracting State, or where the same persons participate directly or indirectly in the management, control, or capital of two enterprises, and in either case conditions are made or imposed between the two 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.”
The key components of this definition are:
(i) Participation in Management, Control, or Capital: This may be direct or indirect.
ii) Common Control: The same group of persons exercises control over both enterprises.
(iii) Non-Arm’s Length Conditions: The commercial or financial relations between the two enterprises differ from those between unrelated parties operating independently.
3.2 Indian Perspective: India adopts a detailed approach to defining associated enterprises under Section 92A of the Income Tax Act, 1961. It specifies various criteria to establish the relationship, such as:
(i) Direct or indirect shareholding of at least 26% in the capital of another entity.
(ii) Dependence on technology, raw materials, or financial arrangements provided by another entity.
(iii) Common decision-making authority or management personnel.
(iv) Exclusive purchase or supply agreements influencing business operations.
While aligned with the OECD’s broad principles, the Indian framework is more granular, ensuring effective monitoring of cross-border transactions and curbing tax avoidance practices.
4. Arm’s Length Principle: The arm’s length principle (ALP) is the foundation of Article 9 and global transfer pricing regulations. It requires that transactions between associated enterprises be conducted as though they were between independent parties in comparable circumstances.
The primary objectives of ALP are:
(i) Prevention of Profit Shifting: Ensuring enterprises cannot artificially shift profits to low-tax jurisdictions.
(ii) Fair Allocation of Tax Revenue: Each country receives tax revenues corresponding to economic activities performed within its territory.
(iii) Tax Neutrality: Business decisions remain unaffected by tax considerations, promoting fair competition.
The OECD Transfer Pricing Guidelines recommend several methods for determining ALP, such as:
i. Comparable Uncontrolled Price (CUP) Method,
Resale Price Method,
Cost Plus Method,
Transactional Net Margin Method (TNMM), and
Profit Split Method.
5. Profit Adjustment Mechanism:
5.1 Primary Adjustment: When a tax authority identifies that intra-group transactions between associated enterprises deviate from the arm’s length principle, it can make a primary adjustment by increasing the reported profits of the enterprise. For example, if a company sells goods to its subsidiary at an artificially low price, the tax authority will increase the company’s profits to match fair market value.
5.2 Corresponding Adjustment: To avoid double taxation, Article 9(2) of OECD MC provides for a corresponding adjustment:
If one country adjusts profits, the other country must make an equivalent adjustment to ensure the same profits are not taxed twice.
This mechanism requires coordination between tax authorities, often achieved through the Mutual Agreement Procedure (MAP) outlined in Article 25 of the OECD MC.
6. Practical Scenarios of Associate Enterprise:
6.1 Common Situations:
(i) Parent-Subsidiary Relationship: A parent company in one country controls subsidiaries in another.
(ii) Joint Ventures: Two unrelated companies jointly manage a third entity.
(iii) Group Financing Arrangements: Loans or guarantees provided at non-market terms.
(iv) Intellectual Property Transfers: Licensing trademarks or patents to related parties in low-tax jurisdictions.
6.2 Indicators of Association: Common signs of association include:
(i) Reliance on technology or trademarks provided by another enterprise.
(ii) Exclusive purchase or supply arrangements.
(iii) Financial dependency or guaranteed loans.
(iv) Common branding and shared marketing strategies.
7. Transfer Pricing and Associate Enterprises:
7.1 Purpose of Transfer Pricing Rules: Transfer pricing regulations ensure that profits are reported in jurisdictions where the actual economic activities take place. They safeguard against tax avoidance by associated enterprises engaging in artificial pricing arrangements.
7.2 Indian Framework: India’s transfer pricing regime, governed by Sections 92 to 92F, requires:
(i) Mandatory maintenance of detailed documentation for all international transactions.
(ii) Transfer Pricing Officers (TPOs) to assess and determine ALP.
(iii) Strict penalties for non-compliance or misreporting.
7.3 OECD and BEPS Initiative: The OECD’s Base Erosion and Profit Shifting (BEPS) Action Plan, particularly Action 13, introduced Country-by-Country Reporting (CbCR) to enhance transparency. This compels multinational groups to disclose detailed financial information across jurisdictions, aiding tax authorities in detecting manipulation.
8. Case Law Illustrations:
8.1 Indian Judicial Decisions:
(i) CIT v. EKL Appliances Ltd. [2012] 24 taxmann.com 199 (Delhi): Established that tax authorities must respect the commercial rationale of business decisions unless they are shown to be sham or artificial.
(ii) DIT(IT) v. Morgan Stanley & Co. [2007] 162 Taxman 165 (SC): Clarified profit attribution principles to permanent establishments and their link to transfer pricing.
8.2 International Cases:
(i) GlaxoSmithKline Holdings (Americas) Inc. v. Commissioner of Internal Revenue, United States Tax Court [Citation: T.C. Docket No. 5750-04 et al., U.S. Tax Court, Washington, D.C.], U.S. Tax Court Docket Nos. 5750-04, 6959-05, and 6960-05, Decision Date: September 11, 2006 (settled in 2006)]
A landmark case involving billions in adjustments due to under-pricing inter-company sales.
(ii) Starbucks Manufacturing EMEA BV v. Commissioners for Her Majesty’s Revenue & Customs (HMRC), United Kingdom First-tier Tribunal (Tax Chamber), Decision Date: June 29, 2018, Citation: [2018] UKFTT 0301 (TC), Docket No.: TC/2015/06892]
Examined royalty payments and transfer pricing practices in low-tax jurisdictions.
These cases underscore the global importance of accurately defining associated enterprises and applying ALP consistently.
9. Challenges in Application:
(i) Digital Economy: Difficulty in identifying where value creation occurs for digital services.
(ii) Valuation of Intangibles: Complexities in assessing intellectual property transfers.
(iii) Hybrid Structures: Entities treated differently across jurisdictions create mismatches.
(iv) Dispute Resolution: Lengthy and inconsistent MAP processes hinder quick resolution.
(v) Developing Country Constraints: Limited resources to monitor multinational transactions effectively.
10. OECD Commentary and Guidance: The OECD provides extensive commentary to guide interpretation of Article 9. Key principles include:
(i) Substance over Form: Emphasis on actual conduct and economic substance rather than just legal agreements.
(ii) Comparability Analysis: Ensuring related party transactions are benchmarked against independent dealings.
(iii) Risk Alignment: Profits should follow entities that bear significant economic risks.
The 2017 update incorporated BEPS measures to strengthen anti-avoidance provisions and improve tax transparency globally.
11. Role of Double Taxation Avoidance Agreements (DTAAs): DTAAs, modeled closely on the OECD MC, play a crucial role in regulating associated enterprises. These agreements:
(i) Define relationships and rights of taxation between countries.
(ii) Provide mechanisms for resolving disputes, such as MAP.
(iii) Protect businesses from double taxation while preventing double non-taxation.
(iv) Promote international trade and foreign investment by offering certainty and clarity.
India has signed over 80 comprehensive DTAAs, each incorporating Article 9 principles to maintain consistency with international norms.
12. Policy Considerations: For developing countries like India, source-based taxation is essential to prevent erosion of domestic revenue. At the same time, global cooperation through forums like the OECD and United Nations helps harmonize rules and prevent harmful tax competition. Continuous reforms, such as India’s introduction of the Equalization Levy to tax digital services, demonstrate how national policies evolve to address modern challenges.
13. Section 92A and related authorities: Section 92A of the Income-tax Act, 1961 provides the definition and scope of Associated Enterprises (AEs), which is crucial for transfer pricing regulations. The key principle is that when one enterprise participates directly or indirectly in the management, control, or capital of another enterprise, or when the same persons participate in both enterprises, they are deemed to be AEs. This participation can be direct or through intermediaries.
(i) Control by Individual and Relatives (Sec. 92A(2)(j)): When one enterprise is controlled by an individual and the other by the individual’s relatives or jointly by the individual and relatives, both enterprises are treated as AEs.
Case Law: ITO v. V. Rajendra Exports [2010] 46 DTR 193 (Jaipur-Trib.) — Even if the shareholding was below 10% in one firm, managerial control and participation by family members established the AE relationship.
(ii) Voting Power Threshold (Sec. 92A(2)(a)): If one entity directly or indirectly holds 26% or more of voting power in another, both are AEs.
Case Law: Essar Shipping Ltd. v. DCIT [2009] 27 SOT 409 (Mum.- Trib.) — Large voting power establishes significant influence, making both entities AEs for transfer pricing applicability.
(iii) Participation in Management or Control: The basic rule emphasizes de facto control over decision-making. Even without shareholding, if there is significant participation in management or policy decisions, the relationship qualifies as AE.
Case Law: Diageo India (P.) Ltd. v. DCIT [2011] 13 taxmann.com 62 (Mum. Trib.) — Control through appointment of majority directors or decision-making powers is sufficient to establish AE status.
(iv) Multiple Enterprises and Literal Interpretation Issues: Section 92A(2) contains deeming provisions to illustrate control situations. Literal interpretation may lead to absurd results when multiple enterprises are involved. Courts have held that these provisions must be interpreted practically to make them workable and avoid redundancy.
Case Law: Diageo India (P.) Ltd. v. DCIT (supra) ruling highlighted that even if multiple companies have common controlling persons, each pair must be assessed based on actual control and decision-making.
(v) Transactions with Tax Havens: Mere location of an AE in a tax haven does not affect the method of determining ALP but may invite closer scrutiny. The focus remains on pricing methodology and comparables, not on geographic location alone.
(vi) Form 3CEB and AE Relationship: Merely filing a transfer pricing report (Form 3CEB) or declaring transactions does not automatically establish an AE relationship unless specific conditions of Section 92A are met.
Case Law: Sanchez Capital Services (P.) Ltd. v. ITO [2012] 26 taxmann.com 61 (Mum. Trib.)— The Tribunal clarified that AEs must meet statutory conditions beyond reporting compliance.
(vii) Indirect Control and Intermediaries: Control may be exercised indirectly through layers of entities or intermediaries. Even if there is no direct shareholding, effective decision-making control is sufficient to deem enterprises as AEs.
Case Law: Jyoti Ceramic Industries v. DCIT ITA No. 1087 of 2010 dated 14-09-2012 — A relationship through relatives and management participation satisfied the AE test.
(viii) Importance of Practical Application: Courts have emphasized that while interpreting deeming provisions, substance over form must be applied. The test is effective control, not just formal structures.
14. Other key judicial pronouncements:
(i) DIT(IT) v. Morgan Stanley & Co. [2007] 162 Taxman 165 (SC)
MSCo, a U.S. investment bank, outsourced back-office functions (research support, account reconciliation, IT-enabled services) to its Indian group company MSAS. Under the services arrangement, MSCo also placed personnel in India—some merely for stewardship (quality/coordination), others as educationists who continued to hold lien with MSCo.
Decision on Service PE / Associated Enterprise: The Supreme Court held (i) no fixed-place PE for mere back-office operations (preparatory/ auxiliary), (ii) no agency PE as MSAS had no authority to conclude contracts, (iii) stewardship does not create a PE, but (iv) deputationists furnishing services in India do create a Service PE under Art. 5(2)(l) (UN concept adopted via treaty interpretation), since services were rendered in India through MSCo’s employees retaining their MSCo employment. As MSAS was an associated enterprise, the Court affirmed that if MSAS is remunerated at arm’s length (TNMM accepted; 29% cost-plus) reflecting all risk-taking functions, no further profits are attributable to the PE; only where transfer-pricing analysis is functionally inadequate would additional attribution arise.
(ii) Serdia Pharmaceuticals (India) (P.) Ltd. v. ACIT— [2011] 44 SOT 391 (Mum.)
Serdia India sourced active pharmaceutical ingredients (APIs) from its associated enterprises (Servier France/Egypt) and justified pricing under TNMM on overall operating margins. The Transfer Pricing Officer rejected TNMM, finding reliable Comparable Uncontrolled Prices (CUP) available for the same generic APIs (Indapamide, Trimetazidine) purchased by unrelated Indian companies at far lower prices. The Tribunal held that an assessee’s choice of method is not unfettered: under section 92C read with Rule 10C, the most appropriate method must be selected on sound, case-specific reasoning, and the TPO may substitute it where warranted. While Indian law does not prescribe a formal hierarchy, where CUP can be reliably applied, it is generally preferred over profit-based methods because it directly neutralizes the AE relationship’s effect on price. On facts, the APIs were generic (non-patented); market CUPs in India were good comparables. Limited quality adjustments were allowed for Trimetazidine, but overall the CUP-based ALP adjustments were sustained, confirming AE pricing above arm’s length.
(iii) Arviva Industries Ltd. v. ACIT [2011] 15 taxmann.com 233 (Mumbai - ITAT)
Arviva Industries, a fabric manufacturer, exported goods to its associated enterprise (AE) in Panama. The Transfer Pricing Officer (TPO) compared these export prices with domestic sales and unrelated exports, adopting higher domestic prices as the arm’s length price (ALP). Three key adjustments were made:
A) Fabric sold to the AE at $1.16/meter vs. domestic price of Rs.72 ($1.515).
B) Fabric design 50001 sold to AE at $2.06/meter vs. unrelated exports at $2.19.
C) Fabric design 55023 sold to AE at $1.62/meter, slightly lower than unrelated UAE exports at $1.67.
The CIT(A) upheld adjustments citing Panama as a tax haven, implying profit shifting.
The ITAT held that merely being located in a tax haven does not affect ALP determination; focus must remain on pricing methodology under section 92C. It ruled that export incentives, discounts, and market differences were ignored by TPO, and AE prices were not below independent party prices. All TP adjustments were deleted, affirming proper AE pricing.
(iv) CIT v. Nestle India Ltd. [2011] 11 taxmann.com 106 (Delhi HC):
Nestle India Ltd., a subsidiary of Swiss-based Nestle, manufactured and marketed food products and beverages under Nestle’s global brands. It entered into an agreement with its foreign associated enterprise (AE) to receive continuous technical know-how and support, for which it paid royalty at 3.5% of turnover. The Assessing Officer disallowed ₹47 crores royalty for AYs 1997-98 and 1998-99, alleging it was excessive and a method of profit diversion to the foreign parent.
The Tribunal found that the technical assistance had helped Nestle India achieve record exports and strong domestic market growth, proving the royalty was reasonable and essential for business, and allowed the deduction under section 37(1). The Delhi High Court upheld this, holding that while tax authorities can examine the reasonableness of AE payments under section 40A(2), no evidence showed excessiveness. It clarified that section 92 (transfer pricing) did not apply to such royalty payments not forming part of regular ongoing business between a resident and non-resident.
(v) Sony Ericsson Mobile Communications India (P.) Ltd. v. CIT — [2015] 55 taxmann.com 240 (Delhi HC)
Multiple Indian subsidiaries of foreign associated enterprises (AEs) (e.g., Sony, Reebok, Canon) distributed branded goods in India and incurred substantial advertising, marketing and promotion (AMP) expenses. The Court held that AMP outlays of an Indian subsidiary can constitute an “international transaction” under section 92B, and—post the retrospective insertion of section 92CA(2B) (Finance Act, 2012)—a TPO may examine even unreported AE transactions. However, where the assessee’s overall benchmarking (e.g., TNMM/RPM) and comparables are accepted as a bundled distribution-AMP transaction, it is improper to carve out AMP separately via the bright line test (which lacks statutory mandate). Distribution and marketing functions are intertwined; selling expenses (trade/volume discounts, dealer commissions) are not AMP. If AMP is separately analyzed, the TPO must give reasons, allow set-offs, and apply an appropriate method (including CPM) with proper comparability. On royalty paid to the AE (Reebok), once know-how/technical information is provided, ALP cannot be set at NIL merely due to profitability; royalty must be benchmarked by comparables, not outcomes.
(vi) Chryscapital Investment Advisors (India) (P.) Ltd. v. DCIT [2015] 56 taxmann.com 417 (Delhi HC):
Chryscapital India rendered investment advisory services to its foreign associated enterprise (AE) and benchmarked them under TNMM. Dispute centered on comparables and data period for determining the ALP of AE transactions. The TPO/Tribunal included three exceptionally high-margin companies (Brescon, Keynote, Khandwala) and rejected the assessee’s use of multiple-year data. The High Court held that high or extremely high profits/losses do not, by themselves, disqualify a comparable; instead, Rule 10B(3) requires an enquiry whether material differences (including risk, functions, assets) can be eliminated by reasonably accurate adjustments. Only if such differences cannot be eliminated should exclusion follow. On data, Rule 10B(4) mandates use of the current year’s data; earlier years may be considered only if shown to influence pricing, with the onus on the assessee. The Court remanded: (i) Brescon and Khandwala—to the DRP for a Rule 10B(3) analysis; and (ii) Keynote—first to test functional comparability, then apply Rule 10B(3) if comparable.
(vii) Kaybee (P.) Ltd. v. ITO [2015] 57 taxmann.com 449 (Mumbai ITAT):
Kaybee (P.) Ltd., engaged in running a business center and providing procurement services for textiles and yarn, received commission from K Ltd., Singapore. During assessment, the AO discovered that Mr. G was the Director and 99.9% shareholder of Kaybee and also the Director and Chief Operating Officer of K Ltd., Singapore. The assessee argued that there was no direct or indirect shareholding between the two companies and thus they could not be treated as Associated Enterprises (AEs) under section 92A(2).
The ITAT held that section 92A(1) operates independently of section 92A(2). Even without shareholding, if one enterprise participates directly or indirectly in the management or control of another, they qualify as AEs. Since Mr. G was actively involved in decision-making and held key positions in both companies, there was clear managerial participation. Hence, Kaybee and K Ltd., Singapore were correctly classified as AEs under section 92A(1).
15. Conclusion: The concept of associate enterprise lies at the heart of international tax regulation. By clearly defining relationships between related entities and applying the arm’s length principle, countries can ensure fair allocation of profits and equitable distribution of tax revenues. The framework provided by Article 9 of the OECD MC serves as a universal standard, while domestic laws like India’s transfer pricing regime operationalize these rules on the ground.
As globalization and digitalization continue to reshape business models, tax authorities face increasing challenges in preventing abuse and protecting tax bases. Ongoing cooperation, robust DTAAs, and evolving international guidelines will remain essential tools to achieve the twin goals of avoiding double taxation and curbing tax evasion. In this dynamic environment, the regulation of associated enterprises will continue to play a pivotal role in global tax governance.