Every civilised society permits the business community to transact their businesses in a manner that is most efficient to achieve their objectives. It is a trite law that when two contracting parties agree to do something by a mutual valid contract or intend doing so, and it is not prohibited by law, a third party; like the exchequer or the Court for that matter, has no power to modify either the contract or with what they intended to do with it.
The same principle is as much recognised in Islam, and in Bokhari, Kitabul-Baua-No 3709, Abu Daud; Kitabul-Ajara No 3442, it is said that "People be left alone in their mutually agreed transactions so that they be blessed by Allah through free circulation of wealth amongst themselves".
However, when the affairs and transactions between associates are arranged with the object of avoiding tax, such transactions lack legal sanctity. The right to transact business in a manner as to be the most beneficial to the person is abused so as to cause harm to the revenue of the country where from the profit is intended to be shifted.
To cater to such arrangement, provisions are generally incorporated in the tax laws to put a check on such transactions between associates with the object of determine the true income that would accrue or arise to each of the associate if the transaction had been carried out at an arm's length. The income tax law of Pakistan, via sections 85 and 108 of the Income Tax Ordinance, 2001 (the Ordinance), read with Rules 20 through 27 of the Income Tax Rules, 2002 contains specific provisions relating to transactions between associates and the basis available to determine the arm's length results.
In substance, the term 'transfer pricing' signifies the price which one associate adopts to transfer its goods, services or technology to another. The term, however, connotes a negative impression and generally confers the intuition of manipulation and secrecy. This is because associates generally tend to adopt a price other than the arm's length price to transfer goods, services or technology to their associates.
Such a non-arm's length price mechanism primarily moots with the object of artificially diverting profits so as to avoid, or evade, taxes, circumvent exchange control or reduce the economic exposure arising from political or economic uncertainties. Instances have been observed that not only transnational enterprises engage in transfer pricing abuses, but also local individuals and companies use transfer pricing to their benefit.
Just as transfer pricing is abused to gain some tax or other economic benefit, it is also used to balance-off the payment of taxes in two different jurisdictions by a multinational enterprise to avoid double taxation of income arising to the enterprise at group level.
For example a foreign toy manufacturing company manufactures its gadget at say US $100 per unit. The gadgets are then sold to a subsidiary of the foreign company in Pakistan which then distributes these gadgets at a retail price of say US $150 per unit.
The price charged by the foreign parent company to the subsidiary company in Pakistan is say US $125. Further assume that the distribution cost for the Pakistan subsidiary is US $25 per unit. This would mean that the overall cost of the Pakistan subsidiary would be US $150 [ie US $125 as original cost + US $25 as distribution cost] resulting in a no-profit/no-loss situation to the Pakistan subsidiary, so however that the entire profit of US $25 is parked in the books of the foreign parent company.
The taxation authorities in Pakistan, at the time of assessment of the Pakistan subsidiary, may put to question the shift of the entire profit to the parent company and may attempt to tax the entire profit in Pakistan. However, such profits are already being taxed in the country in which the parent company resides.
Hence a double taxation issue of the profit may arise. This dilemma may be resolved by transferring the gadget to the Pakistan subsidiary at an arm's length basis so as to allow both the Pakistan and the foreign taxation authorities to tax the appropriate profit within their respective jurisdiction. Adopting a basis other than arm's length may cause double taxation of profit arising to the group at overall level.
With the exception of certain transaction, all activities between two taxpayers are expected to be carried out at an arm's length. Where a transaction is culminated on a non-arm's length basis, the fair market value principle would apply with the result that the person disposing off or acquiring the asset is treated as having received a consideration or incurred a cost, as the case may be, equal to the fair market value of the asset at the time of disposal or acquisition.
Section 108 of the Ordinance specifically empowers the taxation authorities to evaluate the sanctity of the transaction between the associates so as to determine the arm's length income that would arise to each of them.
For the purpose of the Ordinance, two persons are considered to be associates where the relationship between the two is such that one may reasonably be expected to act in accordance with the intentions of the other, or both persons may reasonably be expected to act in accordance with the intention of a third person.
Whereas mere employer - employee relationship does not render the arrangement to be that of associates, section 85 lists down the various instances wherein two or more persons are invariably considered as associates of each other:
a) an individual and his/her relative, unless the Commissioner is satisfied otherwise;
b) members of an association of persons (AOP), unless the Commissioner is satisfied otherwise;
c) a member of an AOP and the AOP, where the member, either alone or together with an associate(s), controls:
(i) 50% or more of the right to income of the association; or
(ii) 50% or more of the right to capital of the association;
d) a trust and its beneficiaries;
e) a shareholder in a company and the company where the shareholder, either alone or together with an associate(s), controls directly or indirectly:
(i) 50% or more of the voting powers in the company;
(ii) 50% or more of the right to dividend of the company; or
(iii) 50% or more of the right to capital of the company; and
f) two companies where a person, either alone or together with an associate(s), controls directly or indirectly:
(i) 50% or more of the voting rights in both the companies;
(ii) 50% or more of the right to dividend in both the companies; or
(iii) 50% or more of the right to capital in both the companies.
It may be noted that both in terms of International Accounting Standard 24 (IAS-24) and the Fourth Schedule to the Companies Ordinance, 1984; relating to disclosure requirements for related party transactions, the determining factor whether two persons are related to one another or not is the 'control' and 'significant influence' which one person has over the other. Whether control and/or significant influence exist between two entities or not is then determined on the basis of certain definite parameters which, inter alia, include specific percentage of ownership and/or decision making powers by one entity over the other entity.
However, the definition of the term 'associate' as contained in the Ordinance is more judgmental when it lays down the general rule of 'acting in accordance with the intention of another' as the basis for determining whether the two persons are associates or not.
In order to avoid any abuse of the said expression it is suggested that the definition should be constructed on the same principles as contained in the IAS and the Companies Ordinance so as to appear harmonised with the disclosure requirements made in the financial statements.
Once it is established that the relationship between the two persons is that of associates, the taxation authorities, by virtue of section 108 of the Ordinance, may probe into the transaction so as to determine whether the same has been carried out at an arm's length or not. For this purpose, the taxation authorities may distribute, apportion or allocate income, deductions or tax credits amongst the associates so as to determine the arm's length result.
BEFORE MAKING ANY FURTHER COMMENTS, SECTION 108 OF THE ORDINANCE IS BEING REPRODUCED AS UNDER:
108. Transactions between associates.- (1) The Commissioner may, in respect of any transaction between persons who are associates, distribute, apportion or allocate income, deductions or tax credits between the persons as is necessary to reflect the income that the persons would have realised in an arm's length transaction.
(2) In making any adjustment under sub-section (1), the Commissioner may determine the source of income and the nature of any payment or loss as revenue, capital or otherwise.
The most significant feature of the transfer pricing provisions as contained in the Ordinance when compared with the provisions of the repealed Income Tax Ordinance, 1979 (the repealed Ordinance) is that it allows the taxation authorities to evaluate all the transactions between associates without any reference to their territorial jurisdiction.
This would mean that all the transactions between associates, whether resident of Pakistan or not, would be exposed to scrutiny by the taxation authorities as to the fairness thereof. Further, while evaluating the arm's length income of each of the associate, the taxation authorities are required to consider the source of income and the nature of any payment or loss as the case may be.
It needs to be highlighted that sub section (2) of section 108 uses the word 'may', as against 'shall', for the purpose of determining the source of income and the nature of payment for the purpose of adjustment in relation to transaction between associates. This would mean that the taxation authorities may or may not look into the source of the transaction and the nature of payment for the purpose of evaluating the transaction between associates. Such a power appears arbitrary as all the transactions between associates need to be evaluated while taking into account the source and nature of the transaction.
(To be concluded)
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