The Finance Act 2001 has, effective from assessment year 2002 to 2003, introduced specific transfer pricing regulations under the Income Tax Act 1961 (IT Act) for computing income and costs or expenses allocated or apportioned under an international transaction with an associated enterprise on an arm's length basis. Arm's length basis operates on the hypothesis that associated enterprises are independent of each other in their commercial and financial dealings. The basis for determination of whether an entity is an associated enterprise includes participation, whether directly or indirectly, by an enterprise in the capital, control or management of another enterprise. Where an enterprise is in a position to influence, restrain or regulate the other, the two entities are considered associated enterprises. An international transaction is defined as a transaction between two or more associated enterprises, either or both of them non-residents, involving a purchase, sale, lease, provision of services, lending, borrowing or any transaction having a bearing on profits, income, loss or assets of such enterprises.
Prices at which associated enterprises deal with each other in international transactions must be computed on an arm's length basis which may be determined by applying the most appropriate of the following methods: (i) comparable uncontrolled price method; (ii) resale price method; (iii) cost-plus method; (iv) profit split method; (v) transactional net margin method; (vi) any other method prescribed by Central Board of Direct Taxes. Detailed rules have been notified by the Ministry of Finance with regard to computation of arm's length price by any of the methods described above. The most appropriate method, according to the Rules, is that which is best suited to the facts and circumstances in each particular international transaction and which provides the most reliable measure of an arm's length price. This is in regard to factors including: (i) nature and class of international transactions; (ii) class of associated enterprises and functions performed by them; (iii) availability, coverage and reliability of data necessary for application of the method; (iv) degree of comparability existing between the international transaction and the uncontrolled transaction and between enterprises entering into such transactions; and (v) the nature, extent and reliability of assumptions required to be made in application of a method.
If the price computed by an enterprise differs from the price computed by the assessing officer by not more than 5% either way, ie 5% more or less, then the price declared by the enterprise is accepted. For the choice of a method of computation over other methods of computation, an enterprise must maintain and provide supporting information and documents. Failure to do so can attract a penalty of 2% of the value of such transaction. However, the requirement to maintain and furnish documentation does not apply to companies where the aggregate value of the transaction is up to Rs 10 million ($212,314). Transactions below this amount, however, are still required to justify the price transacted as arm's length price.