Arm’s Length Pricing -Navigational Tools for the Audit Committee

India has one of the most detailed set of laws and regulations governing disclosures and approvals of related party transactions (RPT) regulating both listed and unlisted companies. The provisions of Section 188 of the Companies Act, 2013 (the Act) are applicable if:

  1. a company enters into a transaction with a ‘related party’ as defined under Section 2(76) of the Act;
  2. such transaction falls under any of the categories specified under sub-clause (a) to (g) of Section 188(1) of the Act, an approval of the board of directors will be required prior to entering into such transaction; and
  3. such transaction exceeds the monetary thresholds prescribed under Rule 15(3) of the Companies (Meeting of Board and its Powers) Rules, 2014, prior approval of the shareholders will also be required by way of an ordinary resolution.

Regulation 23 of the SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015 (LODR) provides that all material RPTs require shareholder approval through an ordinary resolution and no related party entity shall vote to approve such resolutions whether the entity is a related party to the particular transaction or not. However, all RPTs, whether material or not, require approval of the audit committee.

Contours of Arm’s Length Transaction

The fourth proviso to Section 188(1) of the Act provides that “nothing in this sub-section shall apply to any transactions entered into by the company in its ordinary course of business other than transactions which are not on an arm’s length basis.” In other words, the Act exempts transactions from the purview of Section 188(1) of the Act if it is done in the ‘ordinary course of business’ and at ‘arm’s length’, albeit, without adequately defining the contours of those terms. The term ‘ordinary course of business’ has been a matter of discussion in various judgments[1] and several factors have been identified for determining whether or not a particular transaction is in the ordinary course of business.

Explanation (b) to Section 188(1) of the Act defines the expression ‘arm’s length transaction’ as “a transaction between two related parties that is conducted as if they were unrelated, so that there is no conflict of interest”. However, apart from this generic legislative guidance, there is no methodology prescribed to arrive at an ‘arm’s length price in a given case.

Regulation 23(3) of the LODR provides the conditions for granting omnibus approval by the audit committee including specifying the indicative base price/ current contracted price and the formula for variation in the price, if any. However, the LODR does not have any reference to the arm’s length price principles. Further, the SEBI Report of the Working Group on Related Party Transactions[2] has proposed changes to the definitions of related parties and RPTs but has not brought in the concept of arm’s length pricing for the RPTs.

The inadequacy in defining the terms ‘ordinary course of business’ and ‘arm’s length transaction’ allows companies to use it as an escape hatch to declare RPTs to be at arm’s length and in the ordinary course of business. These companies then only require the approval of the audit committee for the RPT, conveniently escaping the process of shareholder/ board approval required under Section 188(1) of the Act.

Arm’s Length Transaction under the Income Tax Act, 1961

‘Arm’s length pricing’ was introduced in the Income Tax Act, 1961 (Income Tax Act) by the Finance Act, 2001 as an anti-abuse provision. Section 92F(ii) of the Income Tax Act defines ‘arm’s length price’ as “a price which is applied or proposed to be applied in a transaction between persons other than associated enterprises, in uncontrolled conditions.” The Income Tax Act has prescribed detailed methods for determination of ‘arm’s length pricing’. These methods are largely based on the OECD Transfer Pricing Guidelines and are comparable with global best tax practices around the world. As per Section 92C of the Income Tax Act, read with Rule 10B of Income Tax Rules, 1962, the arm’s length price in relation to an international transaction or specified domestic transaction shall be determined by any of the following methods:

  1. Comparable Uncontrolled Price Method
  2. Resale Price Method
  3. Cost Plus Method
  4. Profit Split Method
  5. Transaction Net Margin Method
  6. Such other methods as may be prescribed by the board

Where the application of the five specific methods is not possible either due to difficulties in obtaining comparable data or due to uniqueness of transactions, any other method can be used. Possible methods of determining arm’s length price under other methods are third party quotations, valuation reports, tender/bid documents, documents relating to negotiations, standard rate cards, commercial and economic models etc. A company may opt for the most appropriate method, but where more than one price is determined by the most-appropriate method, the arm’s length price shall be taken to be the arithmetical mean of such prices. The second proviso to Section 92C(2) of the Income Tax Act provides that if the variation between the arm’s length price so determined and the price at which the international transaction or specified domestic transaction has actually taken place does not exceed such percentage not exceeding 3% of the latter, as may be notified by the Central Government, the price at which the international transaction or specified domestic transaction has actually been undertaken shall be deemed to be the arm’s length price.

Acceptability of the computation methods

It is no secret that RPTs, their related tax avoidance and transfer pricing regulations are always at the center stage of both local and international transactions. The methods of computation of arm’s length pricing, which are broadly based on OECD Transfer Pricing Guidelines, have found acceptance. They are being tested in various courts of law in India as well as international guidance/ international legal forums. Countries like Singapore and United Kingdom have also incorporated OECD Transfer Pricing Guidelines into their domestic transfer pricing legislations, including the five methods of computation for determination of ‘arm’s length price’.  The ICSI Guidance Note on Related Party Transactions[3] also refers to the computation methods for determination of ‘arm’s length pricing’ for RPTs under the Act.

With over two decades of transfer pricing methods, the Government has been proactive in taking several measures over the years to reduce transfer pricing litigation, bring certainty and improve ease of doing business by introducing safe harbour rules, unilateral advance pricing agreements, etc. The industry is well accustomed to the methods for computation of ‘arm’s length pricing’ with expert guidance of tax professionals. The transfer pricing litigation in India has developed a body of legal jurisprudence through rulings of different Tribunals, High Courts and Supreme Court on various principles of the transfer pricing and the methods of computation for determining arm’s length pricing like parameters for comparison and benchmarking. Therefore, the concept of arm’s length pricing and transfer pricing methods have been tested, evolved and matured providing a good reference point, if required, to be implemented under other legislations.

Concluding thoughts

Currently, there are no methods prescribed or guidance provided for the computation of arm’s length pricing for RPTs. Until the time Ministry of Corporate Affairs comes up with specific guidelines or rules to specify the computation method for determination of arm’s length pricing, the computation methods prescribed under the Income Tax Act can be beneficially used to determine whether or not a RPT is done at arm’s length basis. This may specifically be introduced by amending the Act/Rules and the LODR. This will help set a benchmark for the audit committee in evaluating arm’s length basis for RPTs. Given that the transfer pricing methods under the Income Tax Act are tested before the courts of India and the industry has experience in applying those tests in transfer pricing, they can be specifically used by listed companies to reduce confusion and minimize the scope of abuse of RPT. This will also help companies to achieve consistency in their approach in relation to the relevant RPT regulations while entering into RPT, avoid duplication, reduce compliance costs and avoid complexity of divergence between income tax and corporate law compliances.

[1] Somanath Baraman v. S. V. Jagannatha (AIR 1973 AP 144); Herbertsons Ltd. v. Deputy Commissioner of Income Tax (2004 87 TTJ (Mumbai) 840); State of M.P. v Bengal Nagpur Cotton Mills Ltd. (1960 12 STC 333 MP); Countrywide Bank Corporation Limited v. Brian Norman Dean (1998) A.C. 338); Commissioner of Income Tax v. Birla Brothers P Ltd (1970 2 SCC 88); Seksaria Bawan Sugar Factory v. Commissioner of Income Tax (AIR 1950 Bom 200).

[2] SEBI Report of the Working Group on Related Party Transactions, published on January 27, 2020.

[3] Guidance Note on Related Party Transactions by the Institute of Company Secretaries of India.