CA.

Karnik Gulati Transfer Pricing Adjustments

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 50 100 150
Profit)
- 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

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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 Company B Group Total

(New (Old
Subsidiary) Subsidiary)
Sales 80 180 200 460
- Purchase Cost 50 80 180 310
Net Profit (Taxable 30 100 20 150
Profit)
- 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
“In addition to the
domestic laws of the parties. It is a price determined by the market forces. This arm’s length
respective countries, principle (ALP) is endorsed by the Organisation for Economic Co-
Article 9 of the model tax operation and Development (OECD) and United Nations’ tax
conventions (OECD/UN/US)
committee. It is therefore, widely used as the basis for bilateral
deals with the transfer
pricing mechanism.”
treaties between the governments and even used in domestic laws of
almost all the countries around the world.

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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 Number of TP Number of Percentage of Amount of

Year assessments adjustment Adjustment adjustment (in
completed cases cases 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 “Transfer pricing is one field
are generally applied in case of cross-border transactions, as normally which has maximum number
price manipulations would be of no avail within the domestic borders, of litigations, being a
complex and subjective area,
unless the parties involved have different tax rates (due to different and that holds true not only
tax status such as individual, corporate, etc.), or if one of them is for India, but for all major
enjoying a tax holiday. countries around the world.”

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.

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“Total TP adjustments in A very seminal point to note here is that TP adjustments are generally
India in last four years = made, at least in India, only when it doesn’t result in a loss to the tax
INR 848,160 (USD 14.17
exchequer i.e. either taxpayer’s income is increased or loss is decreased,
billion)”
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 B) Secondary Adjustment C) Corresponding Adjustment

Trigger point It is made by the same It is made by the other

jurisdiction that makes the jurisdiction to eliminate or
primary adjustment. mitigate the double taxation.

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 “Primary & secondary
adjustments lead to double
triggers the rest two adjustments. Say, for example, Company A
taxation, whereas
sells a product to its related party at 100 whereas the tax corresponding adjustments is
authorities determine the arm’s length price to be 120, thereby what eliminates or mitigates
increasing the income of Company X by 20. Now this increase of the impact of double
taxation”
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.

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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

“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”.
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

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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 Determined by

by client tax authorities
Books of Company A
Sales PRIMARY
ADJUSTMENT – 20
Goods sold to AE 80 (100-80) 100
Goods sold to unrelated party 20 100 20 120
- Purchases 40 40
- Other expenses 10 10
Net Profit (1) 50 70

Books of AE in China
Sales (Goods sold to unrelated 150 150
parties)
- Purchases from AE 80 NO CHANGE 80
- Other Expenses 20 20
Net Profit (2) 50 50
DOUBLE TAXATION
Group Profit (1 + 2) 100 ON 20 (120 -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 Determined by

by client tax authorities
Books of Company A
Sales PRIMARY
ADJUSTMENT – 20
Goods sold to AE 80 (100-80) 100
Goods sold to unrelated party 20 100 20 120
- Purchases 40 40
- Other expenses 10 10
Net Profit (1) 50 70

Books of AE in China
Sales (Goods sold to unrelated 150 150
parties) SECONDARY
- Purchases from AE 80 ADJUSTMENT -20 (100- 100
80)
- Other Expenses 20 20
Net Profit (2) 50 30
DOUBLE TAXATION
Group Profit (1 + 2) 100 ELIMINATED 100

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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?

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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

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.

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

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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.

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