Will related-party transaction norms work?
The Financial Express
Partner & national leader, Transfer Pricing
Transfer pricing is one of the most controversial areas in international tax. Opinions differ and the computation of arm’s length price varies from person to person, thus making transfer pricing a contentious issue.
The Income-tax Act has very elaborate regulations for adherence to arm’s length price for protecting the tax base of the country through monitoring international as well domestic transactions. The Customs Law stipulates some level of arm’s length standard to meet. Therefore, there are regulatory checks and balances in place to ensure an arm’s length standard in related-party transactions.
The Companies Act, 2013, has also ventured into this area of arm’s length price in respect of related-party transactions. Clause 188 has mandated that related-party transactions need to meet an arm’s length basis. If these transactions do not meet the arm’s length standard, the Board of Directors need to pass a special resolution providing consent to such specified transactions with related parties, which further requires a pre-approval from the shareholders.
In case a transaction is determined to be not-at-arm’s-length, certain penal consequences arise if the pre-approvals of the shareholders and the Board are not obtained (depending on the size of the organisation and the size of the transaction). In respect of a non-listed company, financial penalties arise; however, in case of a listed company, the directors may be subject to prosecution as well. Also, since there is a risk of prosecution, listed companies need to pay special attention to determine arm’s length price of related-party transactions.
But who decides if the transaction is at arm’s length basis?
Section 92 of the Income-tax Act provides the rules on how the arm’s length principle is to be applied and the level of documentation that needs to be maintained. In the absence of such guidance in Clause 188, companies need to rely on an analogous application of the arm’s length principle and adopt the methodology prescribed under the tax law. This would definitely lead to onerous reporting requirement for a company. Imagine a situation where the company has been dealing with its related parties for the last 10 years and reporting such transactions under the provisions of the tax law (Section 92). If the same transaction continues, the company may have to undertake compliance under Clause 188 of the Companies Act, apart from the compliance under the Income-tax Act. If a transfer pricing officer, under the income tax rules, determines a transaction to be non-compliant with arm’s length standard, would that automatically trigger a conclusion under Clause 188 that the transaction of the Company is not at arm’s length, thereby resulting in applicable penal consequences? Would the company law provisions of penalties and prosecution be invoked only upon conclusion of the appeals under income tax or would a transfer pricing officer’s order trigger such a consequence?
Given the uncertainty and the risk of prosecution, it may be imperative for a public company to take pre-approvals from the shareholders and the Board of Directors, for all specified transactions with related parties, even if the company believes that it meets the arm’s length threshold.
And this process may insulate the directors from penal consequences. However, that would result in a burdensome and onerous reporting and approval requirement.
However, would a tax base erosion criterion apply?
The company law does not specify any base erosion criterion and, therefore, transactions that are not at arm’s length but are favourable from an Indian tax perspective (resulting in higher incidence of tax in India) while acceptable under the income tax transfer pricing rules may not be under the Companies Act. For example, transaction of an Indian-listed company obtaining free-of-cost services from a foreign affiliate is likely to be acceptable from an income tax perspective but is non-arm’s length according to the Companies Act. Would compliance need to be done in respect of such transactions and would penalties and prosecutions apply in case of non-compliance under the Companies Act (in respect of such transactions)?
Given the onerous responsibility of arm’s length standard, the potential risk of prosecution and the duplication of efforts under various laws, the compliance burden of the Indian companies would increase substantially. Such compliance is duplicative in nature and the government should do away with such onerous compliance requirements for Indian companies.
Views are personal.