Transfer pricing adjustments

CA. Karnik Gulati Transfer Pricing Adjustments

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Transfer Pricing Adjustments

by CA.Karnik Gulati

This article provides succinct explanation on transfer pricing adjustments (‘TP adjustments’) along

with some pragmatic examples to crystallise the understanding of our prospective readers.

Before we embark upon to explain the concept of TP adjustments, we shall take the opportunity to

provide the glimpse of transfer pricing mechanism.

Background of Transfer Pricing Mechanism

Transfer pricing, in simple terms, means a price established for a transaction between two or more

related parties. The said transaction could be for sale or purchase of goods, rendering or obtaining

services, borrowing or lending money, cost sharing arrangements, etc.

As mentioned above, with the transaction between two or more related parties, the tinkering of

prices is inevitable. As a businessman, who doesn’t like to keep the tax liabilities at minimum and

consequently increase wealth in its own hands? Price tinkering is mainly done with the objective of

shifting maximum profits to a low-tax or no-tax jurisdiction, often known as tax havens. Profits are

mainly shifted by inflating the income in low or no-tax jurisdictions, or by inflating the expenses in

the high-tax jurisdictions. To corroborate the said statement, we would like to present two examples

as mentioned below:

Example 1

Company A, tax resident of a high-tax jurisdiction (Country Y), sells goods to its wholly-owned

subsidiary, Company B, who is a tax resident of another high-tax jurisdiction (Country Z), at a price of

100, whereas the market price of the same product is 150. Assume, Company B makes some value

addition and sells it further to an unrelated party for 200. Further assume, purchase cost (purchased

from unrelated party) of Company A is 50. Also assume tax rate of both countries to be same, at

30%. The same is presented below in table form:

Description Company A Company B Group Total

Sales 100 200 300

- Purchase Cost 50 100 150

Net Profit (Taxable Profit)

50 100 150

- Tax @ 30% 15 30 45

Profit after Tax 35 70 105

Effective Tax Rate – 42.85% (45/105 x 100)

Market Price of goods sold by A to B – 150



In the above case, price tinkering would achieve no benefit for the taxpayer as the tax rate of both

the jurisdictions is identical (i.e. 30%). However, it is pertinent to note that the same may still cause

loss to the tax exchequer, as the tax revenue should rightly go to the jurisdiction which deserves it.

Therefore, the transfer pricing adjustment may still be made in order to maintain the tax equity.

Example 2

Assume same facts as above with some addition i.e. assume in order to reduce the group tax liability

the Company A decides to open another subsidiary, named Company C, in a tax haven where the

applicable tax rate is paltry 5%. And now instead of selling its products directly to Company B, it

decides to sell it through Company C i.e. it sells goods to Company C (new subsidiary) who in turn

sells them to Company B (old subsidiary).The same is presented below in table form:

Description Company A Company C (New Subsidiary)

Company B (Old Subsidiary)

Group Total

Sales 80 180 200 460

- Purchase Cost 50 80 180 310

Net Profit (Taxable Profit)

30 100 20 150

- Tax @ 30%/5%/30% 9 5 6 20

Profit after Tax 21 95 14 130

Effective Tax Rate – 15.38% (20/130 x 100)

Market Price of goods sold by A to C – 150 Market Price of goods sold by C to B – 200

Now, with the introduction of a new subsidiary in a low-tax jurisdiction, Group A has significantly

reduced its global tax outflow from 42.85% to 15.38%.

To deal with the above demonstrated practice, transfer pricing mechanism was introduced and has

been, and still remains, one of the most important issues in the international tax arena. Further, to

substantiate our above claim, we would draw your attention to the fact that, it is estimated that

about 60 percent of the international trade happens within, rather than between, multinationals:

that is within the same corporate group. This being the case, it would be a mistake to presume that

prices in such transactions are anywhere near to the market price (better known as arm’s length

price, in technical terms), as also seen in the above examples.

The arm’s length price means the price agreed between two unrelated

parties. It is a price determined by the market forces. This arm’s length

principle (ALP) is endorsed by the Organisation for Economic Co-

operation and Development (OECD) and United Nations’ tax

committee. It is therefore, widely used as the basis for bilateral

treaties between the governments and even used in domestic laws of

almost all the countries around the world.

“In addition to the

domestic laws of the

respective countries,

Article 9 of the model tax

conventions (OECD/UN/US)

deals with the transfer

pricing mechanism.”



Although ALP has drawn major criticism from various countries, especially the BRIC nations, it is still

followed religiously around the world. However, of late, certain substitutes like unitary taxation,

country by country reporting, common consolidated corporate tax base (better known as CCCTB),

etc. are talked about as a replacement to the arm’s length principle.

The task of determining ALP is by no means as easy as the term sounds; instead, it is practically a

herculean task to determine the ALP and then to justify the same to the tax authorities. This can be

supported by some facts and figures mentioned below:

Transfer Pricing Adjustments in India (2008-2012)

Financial Year

Number of TP assessments completed

Number of adjustment cases

Percentage of Adjustment cases

Amount of adjustment (in INR million)

2008-09 1726 670 39 61,400

2009-10 1830 813 44 109,080

2010-11 2301 1138 49 232,370

2011-12 2638 1343 52 445,310

Total 848,160

It can be clearly seen that the amount of adjustments have been increasing year after year.

Another important point to note is that the transfer pricing provisions

are generally applied in case of cross-border transactions, as normally

price manipulations would be of no avail within the domestic borders,

unless the parties involved have different tax rates (due to different

tax status such as individual, corporate, etc.), or if one of them is

enjoying a tax holiday.

We believe it is now apt for us to advance onto the concept of TP adjustments – what does

adjustments mean, what warrants making adjustments, types of TP adjustments, additional issues in

it, etc.

What does adjustment mean?

Adjustment, in common parlance, means adjustment made by the tax authorities in the price

declared by the taxpayer. It is mainly made to be in line with the arm’s length principle, as already

mentioned above. The scenarios put forward in the above two examples is what warrants the

transfer pricing adjustments.

Now this may raise a million-dollar question: when the tax authorities of first country makes the

TP adjustments, say increases the income of an entity, does the other country, in which said entity’s

related party is purchasing from entity of first country, allows deduction of purchase with the

revised amount as taken by the tax authorities of the first country? Well, this is what bucked us up

to pen down this article. But to swell the curiosity, this question would be answered at a later stage.

“Transfer pricing is one field

which has maximum number

of litigations, being a

complex and subjective area,

and that holds true not only

for India, but for all major

countries around the world.”



A very seminal point to note here is that TP adjustments are generally

made, at least in India, only when it doesn’t result in a loss to the tax

exchequer i.e. either taxpayer’s income is increased or loss is decreased,

as the case may be, and not the other way round. However, certain

countries like:

Australia, Canada, and USA, allow the adjustments even when the tax authorities are at loss, but

that comes with a qualification i.e. either subject to discretion of tax authorities or in cases where

the return is filed within the prescribed time limit.

For now, we move on to the types of TP adjustments.

Types of Transfer Pricing Adjustments

There are three types of TP adjustments namely:

A) Primary Adjustment:

“An adjustment that a tax administration in a first jurisdiction makes to a company’s taxable

profits as a result of applying the arm’s length principle to transactions involving an associated

enterprise in a second tax jurisdiction” - OECD Glossary (OECD Transfer Pricing Guidelines-2010)

In simple terms, these are the normal transfer pricing adjustments

made by the tax authorities. It’s the primary adjustment which

triggers the rest two adjustments. Say, for example, Company A

sells a product to its related party at 100 whereas the tax

authorities determine the arm’s length price to be 120, thereby

increasing the income of Company X by 20. Now this increase of

20 shall be known as primary adjustment. Similarly, if the expense

claimed is higher than the arm’s length price then also the

downward adjustment can be made by the tax authorities, and it

shall also be called a primary adjustment.

C) Corresponding Adjustment B) Secondary Adjustment

Trigger point It is made by the same

jurisdiction that makes the

primary adjustment.

It is made by the other

jurisdiction to eliminate or

mitigate the double taxation.

“Primary & secondary

adjustments lead to double

taxation, whereas

corresponding adjustments is

what eliminates or mitigates

the impact of double

taxation”

A) Primary Adjustment

“Total TP adjustments in

India in last four years =

INR 848,160 (USD 14.17

billion)”



In other words, we can say, primary adjustment means the very first adjustment made by the

concerned tax authority in consonance with the arm’s length principle.

B) Secondary Adjustment:

With primary adjustment comes secondary adjustment, which is based on the concept of

notional transaction. It is based on the premise that had the transaction been made originally

at the arm’s length price, the situation would have been different from what it is even after

making the primary adjustment. Taking the above example, we can say, only when the primary

adjustment is made, secondary can arise.

Secondary adjustment creates a constructive transaction which may be in the form of:

- Constructive Loan

- Constructive Equity Contribution

- Constructive Dividend

C) Corresponding Adjustment:

“An adjustment to the tax liability of associated enterprise in second tax jurisdiction, made by the

tax administration of first tax jurisdiction, corresponding to the primary adjustment made by the

tax administration of the first state, so that the allocation of profits of two jurisdictions is

consistent” – OECD Glossary (OECD Transfer Pricing Guidelines-2010)

To keep it simple, it means adjustment made by the other

tax jurisdiction which corresponds to the primary

adjustment made by the first tax jurisdiction. However, it

may not always be made with the same amount as the

primary adjustment, and could be of lesser amount.

It is also called correlative adjustment. The bottom line of

correlative or corresponding adjustment is to maintain

symmetry in the transactions.

Well, this also answers the above million-dollar question. Therefore, it’s the corresponding or

correlative adjustment which eliminates or mitigates the effect of double taxation.

All three types of TP adjustments can be further crystallised with the under mentioned examples.

Examples to expound the concept of TP adjustments

Example

Assume Company A, a resident of India, is selling goods to its associated enterprise (AE) in China.

Further assume Company A’s case was selected for transfer pricing scrutiny. Now we have taken two

“Either when only the primary

adjustment is made, or when

primary and secondary

adjustments both are made, it may

lead to double taxation, since the

other jurisdiction may not allow

the corresponding adjustment

arising due to the adjustment

made by first tax-jurisdiction”.



cases: one, wherein no corresponding adjustment shall be allowed and other in which the same shall

be allowed.

a) Where no corresponding adjustment given by the Chinese government

Description Reported by client

Determined by tax authorities

Books of Company A

Sales Goods sold to AE Goods sold to unrelated party

80 20

100

100 20

120

- Purchases 40 40

- Other expenses 10 10

Net Profit (1) 50 70

Books of AE in China

Sales (Goods sold to unrelated parties)

150 150

- Purchases from AE 80 80

- Other Expenses 20 20


Group Profit (1 + 2) 100 120

Now in this case, amount of 20 added by the Indian tax authorities is called the primary adjustment.

Now if no corresponding adjustment is granted by the Chinese government, it may lead to double

taxation on amount of 20 because the income taxed in India is 100, whereas deduction allowed in

China is 80. To eliminate this double taxation, the concept of corresponding adjustments plays a role

of a saviour.

b) Where corresponding adjustment given by the Chinese government

Description Reported by client

Determined by tax authorities

Books of Company A

Sales Goods sold to AE Goods sold to unrelated party

80 20

100

100 20

120

- Purchases 40 40

- Other expenses 10 10


Books of AE in China

Sales (Goods sold to unrelated parties)

150 150

- Purchases from AE 80 100

- Other Expenses 20 20


Group Profit (1 + 2) 100 100

NO CHANGE

PRIMARY

ADJUSTMENT – 20

(100-80)

DOUBLE TAXATION

ON 20 (120 -100)

PRIMARY

ADJUSTMENT – 20

(100-80)

SECONDARY

ADJUSTMENT -20 (100-

80)

DOUBLE TAXATION

ELIMINATED



In the second case, assuming that the Chinese tax authorities only agrees to allow 10 as

corresponding adjustment, then the group profit after adjustments would have reduced to 110 (120-

10) and thereby, mitigating the effect of double taxation, but not completely eliminating the same as

amount of 10 is still doubly taxed.

Now with the same facts as above, the below example shall clarify the concept of secondary

adjustment.

Extract of financials of Company A:

Actual Situation Situation if ALP followed from outset

Cash - 100 Cash - 120

Extract of financials of AE:

Actual Situation Situation if ALP followed from outset

Cash - (100) Cash - (120)

Now, had the transaction been taken place at arm’s length price (ALP) from the outset, the cash in

Company A’s books would have been 120 instead of 100 and therefore, Indian tax authorities can

say that this portion of 20 can be treated as a loan, for which interest should have been charged

from the associated enterprise. Therefore, this creation of notional transaction is known as

secondary adjustment.

Impact of secondary adjustment is also that it leads to double taxation, i.e. say if India treats excess

20 as loan given by the Indian entity to the Chinese entity and makes a secondary adjustment and

collects tax on it, it is not necessary that the Chinese tax authorities will grant deduction of notional

interest to the Chinese entity.

Cardinal Points to remember

It is important to note that no government will give corresponding credit suo-moto, and it

should be the related party, in the other jurisdiction (Chinese entity in our case), who should

approach the tax authorities in its jurisdiction in order to seek corresponding adjustment.

Now comes the question, whether the other government (Chinese government, in above

case) is obliged to give the corresponding credit?



No, it may only make corresponding adjustments if it considers that primary adjustment is

justified both in principle and in amount. Therefore, no jurisdiction is forced to accept the

consequence of arbitrary adjustment of another State. Practically, Article-25 (Mutual

Agreement Procedure-MAP) of tax conventions is used in such cases. MAP, as per Artcile-

25, is used in 3 cases:

- Taxation not in accordance with the tax convention

- Interpretation/application of tax convention

- Elimination of double taxation

Additional Issues in transfer pricing adjustments

Issue 1: Whether the corresponding adjustments should be made in the year of transaction, or in

the year in which the adjustment is made?

Since it is a well known fact that the taxation laws vary from country to country, this is a subjective

issue, and therefore depends on tax laws of respective countries. However, the OECD, in its

Transfer Pricing Guidelines, 2010, recommends that the adjustment should be made in the year of

transaction, but again to remind you that this view is just recommendatory.

Issue 2: Is tax payer entitled for interest on excess tax paid to the country (China, in our example)

granting corresponding adjustment?

This problem arises because the tax authorities around the world generally do not allow to suspend

the tax collection, even in cases where the corresponding adjustment request is made. This again

would depend upon the tax laws of respective countries, and therefore has no universally

acceptable view.

Conclusion

To conclude, we would say it is the voracity of multinational enterprises (MNEs), to increase the

group wealth, which lead to the birth of transfer pricing mechanism, wherein TP adjustments are

made by tax authorities to be in line with the widely followed arm’s length principle. Since the TP

Note: In addition to the above three types of TP adjustments, there is another type of adjustment which is known as

“Compensating adjustment”.

As per OECD Glossary (OECD Transfer Pricing Guidelines-2010) it means - An adjustment in which the taxpayer reports

a transfer price for tax purposes that is, in the taxpayer’s opinion, an arm’s length price for a controlled transaction,

even though this price differs from the amount actually charged between the associated enterprises. This adjustment

would be made before the tax return is filed.

This is mainly allowed to avoid making of primary adjustments. But, if compensating adjustments are permitted (or required) in the country of one associated enterprise, and not permitted in the country of the other associated enterprise, double taxation may result because corresponding adjustment relief may not be available if no primary adjustment is made. Due to this reason, these are not recognised by most of the OECD member countries. However, countries like Canada and USA allow the same to be made, but of course, subject to certain conditions.



adjustments (primary/secondary) made by one tax-jurisdiction may lead to double taxation, the

concept of corresponding adjustment works as a saviour to eliminate or mitigate the impact of the

double taxation.

Data & Analytics

Transfer pricing adjustments