The Union Budget 2017 has introduced the concept of secondary adjustment to transfer pricing regulations, aligning it to transfer pricing regulations of many advanced jurisdictions. A new section 92CE has been proposed in Finance Bill 2017, which requires the taxpayer to make secondary adjustment where the primary adjustment to the transfer price has been made in certain cases.
Existing transfer pricing regulations
Transfer pricing provisions were introduced in India in 2001 which prescribe that income arising from international transactions between associated enterprises ('AEs') should be computed having regard to the arm's length price ('ALP').
Under the existing regulations, if any adjustment is made to the ALP (ascertained by the taxpayer or by the tax authorities), such an adjustment would result in addition to the taxable income. Illustratively, I Co sells goods to its AE, F Co at INR 100 crores. At the time of audit, the tax authorities determine the ALP of the said transaction at INR 120 crores. This will lead to increase of INR 20 crores to the taxable income of I Co. Presently, there are no provisions mandating I Co to recover INR 20 crores from F Co.
Hence, the present provisions does not tackle the cash benefit that accumulates to the overseas AE. With conclusion on number of Advanced Pricing Agreements ('APAs') and Mutual Agreement Procedure ('MAP'), there was a need felt to introduce the concept of secondary adjustment.
What is secondary adjustment?
OECD1 subscribes to the concept of secondary adjustments in its Transfer Pricing guidelines2.
Before we discuss in detail on the concept of secondary adjustment, it is worthwhile to understand what primary adjustment means in this context.
Primary adjustment is an adjustment that a tax authority makes to a taxpayer's taxable profits as a result of applying the arm's length principle to transactions with an associated enterprise. It would invariably result in additional taxable income.
The OECD's Transfer Pricing guidelines define secondary adjustments as 'an adjustment that arises from imposing tax on a secondary transaction'.
A secondary transaction is further defined as 'a constructive transaction that some countries will assert under their domestic legislation after having proposed a primary adjustment in order to make the actual allocation of profits consistent with the primary adjustment. Secondary transactions may take the form of constructive dividends, constructive equity contributions, or constructive loans.'
While primary adjustments only change the allocation of taxable profits of a Multi-National Enterprise ('MNE') group for tax purposes, the secondary adjustments aim to restore the cash position of the MNE group to that which would have existed if the transaction had been conducted on arm's length.
To illustrate, in continuation to the above example, INR 20 crores, being the difference between the ALP determined by the tax authorities and actual price paid (primary adjustment) will be construed as loan provided by I Co to F Co. Hence, F Co will be obligated to repay the deemed loan. The tax authorities may then seek to apply the arm's length principle to this secondary transaction and impute an arm's length rate of interest, if the amount of deemed loan is not repatriated to I Co.
Many countries like the United States, Canada, France and South Africa have adopted secondary adjustment rule into their domestic transfer pricing legislation in order to ensure the actual allocation of profits is consistent with the primary adjustment.
Secondary adjustment rule in India
Section 92CE, as proposed in the Finance Bill 2017, provides that where as a result of primary adjustment to transfer price, there is an increase in the total income or reduction in the loss of the taxpayer, the excess money which is available with its associated enterprise, if not repatriated to India within the time as may be prescribed, shall be deemed to be an advance made by the taxpayer to such associated enterprise and the interest on such advance, shall be computed as the income of the taxpayer. Secondary adjustment shall be applicable where the primary adjustment to transfer price has been made:
■ By means of a suo-motu adjustment carried out by the taxpayer in its return of income
■ By the Assessing Officer and subsequently accepted by the taxpayer
■ Pursuant to an agreement reached in an Advance Pricing Agreement
■ In conformity to the margins/ rates as prescribed by the Safe Harbour Rules
■ Pursuant to a Mutual Agreement Procedure resolution
It is important to note that secondary adjustment shall not be applicable for adjustments made on specified domestic transactions.
The secondary adjustment provisions will not be applicable if the amount of primary adjustment does not exceed INR 1 crore and the primary adjustment pertains to any financial year prior to 1st of April, 2016. This amendment will take effect from 1st of April, 2018 and will, accordingly, apply in relation to the assessment year 2018-19 and subsequent years.
Thus, on strict reading of the Finance Bill 2017 and the Memorandum, one may interpret that if the primary adjustment pertaining to AY 2018-19 or subsequent years does not exceed INR 1 crore, secondary adjustment can still be made. This would make a threshold of INR 1 crore redundant and lead to increased litigation in India.
India is aligning its transfer pricing policy with OECD TP guidelines and international best practices, showing its readiness to converge with international tax regime.
Though this concept has just been introduced in India, many Indian taxpayers, in the past, have already faced secondary adjustments during transfer pricing audits especially involving share capital related transactions.
Although the time limit within which the tax payer is required to bring the cash back is yet to be prescribed, this adjustment will certainly affect the cash position of the tax payers as well as the group. Tax payers who apply profit based methods and deal with multiple associated enterprises, may face a challenge as to which foreign associated enterprise needs to repatriate the amount. Issues may further arise with regards to the date at which the advance will be deemed to have been provided and the interest rate that should be applied.
Further, it would be interesting to observe whether a corresponding relief will be provided to the associated enterprise in its tax jurisdiction for the additional tax liability resulting from secondary adjustment or would it lead to double taxation. Challenges may arise in MAP with some jurisdictions which are not prepared to admit secondary adjustments within the claim and negotiations. Further, the tax authorities' view on providing relief to associated enterprises which are assessed in India is also not clear. It would also be interesting to know how the authorities under other regulations such as FEMA and Indirect tax would treat such adjustments.
1. Organisation for Economic Co-operation and Development.
2. OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administration 2010