INTRODUCTION
The Make in India initiative has transformed India into a hub for manufacturing companies, attracting significant Foreign Direct Investment and driving overall industrial growth. As a result, several global companies like Samsung, Apple, etc., have established their manufacturing units in India. Given this manufacturing drive in India, the companies supplying baby parts to these giants have also established their manufacturing units in India.
In the process of setting up the entity in India, and establishing a manufacturing unit, multiple cross-border transactions happen between Indian subsidiaries and their foreign associate enterprise (AEs). The said transactions trigger the Transfer Pricing (‘TP’) compliances in India for both Indian subsidiary and the AEs.
In India, TP regulations are governed by the Income Tax Act of 1961 (the Act), specifically under the provisions of Sections 92 to 92F. Under these regulations, companies with international related party transactions are required to maintain comprehensive documentation to substantiate that the arm’s length pricing (ALP) of the said transactions.
In this article, we have identified possible transactions that such manufacturing companies may undertake with its AEs during the pre-commencement business phase and post-commencement business phase. Further, using our practical experience, we share our thoughts on what documentation needs to be kept by the manufacturing company for the said transactions to minimize tax litigation. Please note that this may not be an exhaustive list of documentation, but it may guide a path to the MNC on what documentation may be kept for the international transactions undertaken with the AEs.
Pre-commencement business phase
In the pre-commencement phase of the business, the manufacturing company generally enters into transactions like the issue of share capital, loan through ECBs, import of Plant and Machinery, import of Raw Materials for trial runs, etc. with AEs. A suggestive list of documentation that needs to be mentioned for the said transaction has been mentioned hereunder
I. Issue of Share Capital
The price of issue of share capital by the Indian Companies to its AEs should be at ALP. A company should maintain the following documentation to support its benchmarking and pricing.
- Valuation Report: A report from the SEBI registered category 1 Merchant Banker or Chartered Accountant specifying the value of the share capital and methodologies used for such valuation.
- Share Subscription Agreement defining the issuance of share capital and relevant terms and conditions.
- Board Resolutions: Board Resolution approving the share issuance.
- ROC Filings: Forms submitted to the Registrar of Companies (e.g., Form PAS-3)
- FIRC: Foreign Inward Remittance Certificate providing the details of the remittance received.
II. Issue of External Commercial borrowing (ECB)
In ECBs, the primary focus of the company should be to ensure that the interest rate paid by the company to its AEs complies with the ALP principle. To benchmark the said transaction, the interest rate should be well within the limits defined in the ECB Guidelines issued by the Reserve Bank of India.
Further, there are two approaches to benchmark this transaction. One benchmark can be the interest rate at which the loan is generally available to the Indian company internationally. Another option, to benchmark this transaction is the interest rate at which the loan is available to the company in India, and the said rate of interest is adjusted to foreign currency fluctuations.
A company should maintain the following documentation to support its benchmarking –
- Loan Agreement: The same clearly details the terms and conditions such as interest rate, tenure, repayment schedule, etc
- Board Resolutions approving the borrowing transaction.
- Ledger Account showing the loan amount and subsequently interest payment in the books of the related enterprise
- Internal data/External data for supporting the benchmarking of the transaction. The NSDL data can be maintained to support the benchmarking.
- ECB Return A copy of the ECB return file with the Authorized dealer.
- Hedge Ratio Supporting: A supporting document should be kept showing how the hedge ratio has been computed and applied.
III. Import of Plant and Machinery (P/M)
The company engaged in the manufacturing activity may have to purchase plant and machinery from its AEs. The purchase of such P&M from AEs must comply with the arm’s length principle. This is to ensure that the price paid for the machinery reflects what would have been agreed upon between unrelated parties under similar circumstances with third parties.
For benchmarking, the company generally conducts a search on the TP database to find out if the comparable company engages in similar transactions. For support benchmarking and price paid for the purchase of the plant and machinery, a company should maintain the following documents which are as under –
- Purchase agreement defines the terms of purchase, specifications, pricing, payment terms, and warranty terms.
- Invoice copies, Bill of entries and Custom valuation documents.
- Valuation report from the registered valuer.
- Cost Sheets showing the cost incurred by the related party in producing or acquiring the machinery.
- Market Data/comparable company data used in benchmarking the said transaction of similar machinery prices from unrelated parties.
IV. Purchase/Import of Raw materials
When raw materials are imported from a related enterprise, the transaction must comply with TP regulations and the arm’s length principle. The objective is to ensure the price paid for the raw materials is comparable to what unrelated parties would pay under similar circumstances.
To support benchmarking and price paid for Raw materials, a company should maintain the following documents namely –
- Agreements/Contracts copy detailing terms of trade, volume commitments, and pricing structure.
- Purchase Orders containing the details of raw materials ordered, including type, quality, and quantity.
- Invoices copies from the related supplier specifying price, discounts, and payment terms .
- Bills of Entry and Customs Valuation Reports showing the declared value of imported goods .
- Market Data/comparable company data used in benchmarking of the said transaction with unrelated parties.
V. Forecasted Financials/Projected Financials
Manufacturing setups in their early stages of operation might often incur losses due to high setup costs, R&D, or limited production capacity. Losses in the initial years raised concerns about profit shifting.
Proper TP documentation can justify these losses by demonstrating the nature of the business model.
Post-Commencement of Business: (Ongoing Documentation and Compliance)
In this stage, the manufacturing setup fully commenced its operation. The business is now actively engaged in intercompany transactions. In this stage, the TP documentation became more detailed and required ongoing updates. It is very important to maintain accurate and up-to-date documentation to reflect the actual activities and financial performance of the business.
The manufacturing setup in this stage may be involved in the following transactions with its related party.
I. Purchase of Raw materials/Consumables
The purchase of Raw materials from the related enterprise comes under the purview of Transfer pricing and must be complied with Transfer Pricing regulation. The objective is to ensure the price paid for the purchase of materials is comparable to what unrelated parties would pay under similar circumstances.
The company shall benchmark this transaction using the Most Appropriate Method which can range from the CUP method, CPM method, TNMM method, or etc.
For support is benchmarking and price paid for Raw materials, a company should maintain the following documents namely –
- Segmental working/Financials: A company that purchases the Raw material from its related enterprise, as well as an unrelated party, may apply the Internal comparable uncontrolled price (CUP) method to benchmark the said transaction. The company should maintain the segmental working purchase done from the AEs and non-AEs. This will be the essence of the internal CUP method.
- Pricing policies between AEs and non-AEs. This is applicable when the companies also purchase similar materials from 3rd parties as well.
- Purchase Orders containing the details of raw materials ordered, including type, quality, and quantity.
- Invoices copies from the related supplier specifying price, discounts, and payment terms .
- Agreements/Contracts detailing terms of trade, volume commitments, and pricing structure.
- Bills of Entry and Customs Valuation Reports showing the declared value of imported goods .
II. Sales/Export of Finished goods
Once companies process raw materials into finished goods, the finished goods become available for sale, either to the public or to related parties. Sales may be made to either unrelated parties or related parties. If sales are made to a related party, such transactions fall under the purview of TP regulations and must be benchmarked to ensure compliance with the arm-length principle.
When the finished goods are sold to both related and unrelated parties, the company may benchmark the transaction using the most appropriate method. Typically, companies may apply the Internal CUP Method or the Internal Cost-Plus Method (CPM) to determine arm’s length pricing.
In scenarios where sales are made exclusively to a related enterprise, the transaction should be benchmarked using methods such as the External CUP Method or the Transactional Net Margin Method (TNMM), as deemed appropriate based on the nature of the transaction and available data.
To support the benchmarking analysis and substantiate the transaction, the company must maintain the following documentation:
- Agreements with AEs (Intercompany sales/purchase agreements, distribution agreements) including details of the transaction, including pricing, volume, and terms of sale.
- Pricing policies between AEs and non-AEs.
- Segmental Financials reflecting the margin earned on sales made to AEs and non-AEs
- Comparable data set and adjustments, if any.
- Cost sheet for price justification
- Selection and application of the most appropriate benchmarking method.
- Supporting documents such as invoices, and shipping records.
III. Intra-group transactions
In addition to the above, the companies might be involved in certain intra-group services from the AEs. This shall include a wide range of services from the related enterprises, for e.g., technical and engineering services, human resource services, group-level shared services, etc.
These services may be either agreed to on a cost-to-cost basis or cost-plus markup. If these services are agreed upon on a cost-to-cost basis, there is no requirement to benchmark the transaction. However still the company is required to maintain sufficient information/documents to prove that services were actually provided and were not stewardship activities. Further, adequate cost allocation statements (certified by external auditor, if possible) should be kept to establish that transaction actually is in the nature of the reimbursement and no markup is involved. On the other hand, where the transaction is on cost plus markup, the said transaction shall be benchmarked using the most appropriate method. The most appropriate method can be CPM, TNMM, etc.
The company should maintain the following documentation:
- Agreement/Contract – outlining the scope, duration, and detailed nature of services provided.
- Cost-Benefit Analysis – Documentation demonstrates what economic or commercial benefit the company derived from these services.
- Cost Allocation Method- Details of the allocation keys used, if costs are shared among multiple entities, and an explanation of why the chosen allocation method is reasonable and reflects economic reality.
- Benchmarking Study- Selection of the Most Appropriate Method (MAM) to benchmark the transaction and Identification of comparable transactions or data to validate arm’s length pricing.
- Invoices and other supporting documents- Copies of invoices, 3rd party invoices.
Further, basis the transactions entered by the Indian Counterpart entity with foreign AE, the transfer pricing regulations shall be applicable to foreign entities as well. This is to ensure that the transaction from the end of the foreign AE point of view is also executed at arm’s length price. Broadly, the documentation shall remain the same.
In the above paragraphs, we have tried to guide what documentation should be kept by a manufacturing company with respect to the transactions undertaken with the AEs. The said list may not be exhaustive but shall guide the company to what document shall be required to benchmark the transaction with AEs and avoid litigation with the tax authorities. The company may keep any other document that suggests that the transaction is executed at the arm’s length price.
Vaansh Sharma
Vaansh Sharma is a Manager at the Tax and Regulatory division of Coinmen. He specialises in restructuring advisory, corporate tax, and M&A business and transaction advisory. Also, he has worked with clients from various backgrounds including Multinational Corporations, Charitable Institutions, and Ex-patriates.
