One of the most significant features of the Ordinance remains the self-submission basis of assessment, whereby the complete return of income filed by the taxpayer with the taxation authorities shall, for all practical purposes, constitute an assessment order issued to the taxpayer by the Commissioner of Income Tax on the day the return is so filed.
Further, such an assessment order can only be amended and further amended under specific circumstances and within a distinct time frame as specified in section 122 of the Ordinance.
Keeping in view the self-submission basis of assessment, and understanding the wide ranging powers of section 108 of the Ordinance, it would appear that the taxation authorities can put to challenge the arm's length basis of transaction between associates where they hold 'definite information', acquired via audit or otherwise, that the transaction between associates is not correct. This would mean that an amendment cannot be made by the taxation authorities' suo moto, based on their intuition or the history of the case.
Rule 20 through 27 of the Income Tax Rules, 2002 (the Rules) lays down the methods by which the taxation authorities are permitted to determine the arm's length result in relation to transactions between associates.
ADOPTED FROM THE OECD MODEL CONVENTION, THESE METHODS ARE:
a) Comparable Uncontrolled Price Method (CUPM);
b) Resale Price Method (RPM);
c) Cost Plus Method (CPM);
d) Profit Split Method (PSM); and
e) Any other suitable method which the Commissioner considers suitable and is consistent with the arm's length standard.
Selection of the method to determine the arm's length result is based on the judgement of the taxation authorities as to the suitableness of the method to give a reliable measure of the arm's length result under all the given facts and circumstances of the case. The "profit split method" is however stated to be adopted only where neither of the CUPM, RPM or CPM is applicable. The last method ('any other method') should only be used where none of the other methods is applicable.
COMPARABLE UNCONTROLLED PRICE METHOD (CUP): A transaction executed in a controlled environment, (ie between associates), is regarded as a 'controlled transaction'. Obviously, when the transaction is executed between two unrelated persons, it would become an 'uncontrolled transaction'. When an uncontrolled transaction is comparable with a controlled transaction, it is regarded as a 'comparable uncontrolled transaction'.
For an uncontrolled transaction to be construed as 'comparable' with the controlled transaction, it is essential that it must be of the similar quantity and quality, conducted under similar terms and conditions and at similar time and stage of production and/or distribution. This uncontrolled transaction may either be of the same person (ie the associate) or of a different person, such as the industry practice.
Thus, prices at which drugs are supplied by 'A' Ltd to its associate in Pakistan may be compared with the price at which the same drugs are being supplied by 'A' Ltd to its other associates and non-associates. Another comparison may be the import of the same drug by an independent person from an independent source, provided other criterias of quality, quantity etc are duly met.
To date, only this method has been used in Pakistan for the purposes of evaluating the arm's length results in relation to the transactions between associates. The price charged or paid in a controlled transaction must be the same as those in a comparable uncontrolled transaction. Difference, if any, is accordingly adjusted.
RESALE PRICE METHOD (RPM): The method to determine whether the price charged on goods acquired or services obtained from an associated undertaking gives an arm's length result with reference to the amount realised at the time of resale of goods/services to an unrelated party after deducting the resale gross margin, if any, from the resale price. The method involves three steps:
i) determine the resale price of the products acquired from an associated undertaking
ii) from this price deduct the resale gross margin. (Gross margin is the operating and selling expenses incurred by the person and an appropriate profit of the associate assumed to resell the goods)
iii) deduct any other cost, such as custom duty, transportation cost etc. The figure arrived at is the "arm's length result". This must also be the transfer price of the goods between associates.
Thus, for example, let's assume A Ltd, being a manufacturer of goods, sells whole of its product line to B Ltd, being a wholesaler distributor of goods and an associate of A Ltd at a unit price of Rs 100/-. B Ltd then distributes such goods to the retailers, in the same form/shape, at a unit price of Rs 225/-.
From this resale price of Rs 225/- there shall be deducted the distribution expense (say approx. Rs 30/- per unit) and the profit margin in such distribution business (say Rs 50/- per unit). Hence, the arm's length result is Rs 145/-. (ie Rs 225 - 30 - 50).
This should be the transfer price of goods from A Ltd, to B Ltd. In our example of the foreign toy manufacturing company selling goods to the Pakistan subsidiary, the resale price method may have been adopted to determine the arm's length transfer price by the parent company to the subsidiary.
As in the case of CUP method, the resale price margin may be adopted that exists for products purchased and sold under comparable-uncontrolled transaction for the same person or by an independent person. Further, this method is generally adopted where the seller adds little or no value addition to the goods acquired from the related party.
COST-PLUS METHOD (CPM): This method determine whether the amount charged for goods purchased or services acquired under controlled environment gives arm's length result with reference to cost - plus mark-up under comparable uncontrolled transaction. This method involves two steps.
i) determine the total cost incorrect in a controlled transaction
ii) to this amount, add an appropriate mark-up/profit.
The sum so arrived at is the arm's length result. Thus, for example, Mr A is the owner of a poultry farm from where he supplies chicken to a fast-food restaurant in which he and his brother are partners. Mr A may use the cost -plus method to determine the arm's length price that he should charge to the fast food restaurant. To the total cost incurred in his farm, he may add a mark-up to determine the transfer price.
As in the case of CUP method or RPM, the cost-plus mark-up of the products under comparable uncontrolled transaction may be of the same person or of an independent person. This method is generally used when the CUP or resale price method is not applicable and there is a long-term buy and supply arrangement between the associates.
PROFIT-SPLIT METHOD (PSM): Profit-split method may be adopted when the transactions are interrelated so that the arm's length result cannot be determined on a separate basis. Profit from such transaction is divided amongst the associates in the same manner as if amongst independent person entering into such transaction on an arm's length basis.
ANY OF THE FOLLOWING METHODS MAY BE ADOPTED TO SPLIT THE PROFIT AMONGST THE ASSOCIATES:
a) Contribution Analysis - based on the functions performed by each associate. Hence, rent expense in respect of office space occupied by two or more associates may be apportioned amongst them on the basis of square footage occupied by each of the associate.
b) Residual Analysis - total profit from controlled transactions are dividend as follows:
i) each associate is allocated a basic return appropriate for the type of transaction; and
ii) residual profit is allocated on a reasonable basis as would in an independent arrangement.
Developed on the ROI basis, as is commonly understood by the financial community, profits arising to an association of persons (AOP) may be distributed amongst the members/partners of the AOP using the residual analysis method.
c) any other appropriate basis
CONCLUSION: Even though the tax legislation has attempted to cater to the transfer pricing issue to some extent, the Ordinance does not specify any documentation to be maintained by each of the associate in relation to transactions amongst themselves.
This would mean that instead of requiring the taxpayer to make a declaration as to the transaction between associates being carried out at an arm's length and the method adopted for determining the arm's length price, the onus lies on the taxation authorities to prove as otherwise.
This appears a bit strange on the part of the Central Board of Revenue, especially under the circumstances that transfer pricing documents constitute an important and integral part of the return filing documents submitted by the taxpayer to the taxation authorities of other countries. Whereas exchequers of other jurisdictions are introducing new and stricter documentation requirements, we continue to operate without any fear.
It will also be recalled that Listing Regulations and disclosure requirements were duly introduced for transfer pricing and related party transactions by the respective Stock Exchanges and the Securities and Exchange Commission of Pakistan.
However, they are in abeyance since their introduction. Whether by way of a casual and insincere attitude of our administrative authorities, or because of undue influence by the business community for not requiring proper documentation of transfer pricing policies and related party transactions, as a nation, we are losing good money which infact is justly ours.
The need of the day, especially with the budget round the corner, is to introduce proper documentation requirements in relation to transactions between associates.
The taxpayers, at the time of filing returns of income, may also be specifically required to restate their transactions with an associate on an arm's length basis, and hence make due adjustment in the income for the relevant tax year, if the same has not originally been recorded at an arm's length.
As to the taxpayers, I would simply say what Robert Francis Kennedy once said: 'Laws can embody standards; governments can enforce laws--but the final task is not a task for government.
It is a task for each and every one of us. Every time we turn our heads the other way when we see the law flouted--when we tolerate what we know to be wrong--when we close our eyes and ears to the corrupt because we are too busy, or too frightened--when we fail to speak up and speak out--we strike a blow against freedom and decency and justice.'
(Concluded)