16.1 Transfer Pricing rules provide that in case an Indian company earns less income from dealing with a related party abroad, than it would have earned from dealing with a third party, then the income can be “adjusted”, i.e., the income will be increased. This is known as “primary adjustment”.
It may be noted that Transfer pricing rules do not require the accounts and finances to be adjusted. These may remain as they are. However for tax purposes, the taxable income will be increased. This additional income due to primary adjustment does not have to be remitted to India. The accounts do not have to be re-written.
16.2 To make further adjustment on account of funds not coming into India, the finance bill has made amendments. It provides that if the additional income is not received by the Indian entity within a reasonable time (to be specified later), then it will be considered that the Indian entity has given a loan to the foreign related party. Interest on the same can be considered for tax purposes.
This adjustment is known as “Secondary adjustment”.
If the additional income due to primary adjustment is brought into India, no further “secondary adjustment” will be made.
This is also a fall out of BEPS Action reports on Transfer Pricing. Some countries consider such income outside India as dividend paid by the Indian entity to the foreign entity. Tax on dividend is levied. India has considered interest on loan as the secondary adjustment.
16.3 This secondary adjustment was considered by the department in the case of Vodafone-II case where Vodafone invested in the equity capital of its 100% Indian subsidiary. Vodafone invested at a particular price. The officer held that the market value of Indian company’s share was higher. Hence more funds should have been invested in India. He considered the difference in the market value of shares and the amount invested as income. This was primary adjustment. Further, as the funds were not brought into India, the officer considered the funds which were not brought into India, as loan given by the Indian company to Vodafone. On this, interest was also assumed. This was secondary adjustment.
The High Court struck down both adjustments. The first adjustment of increase in the amount due to higher premium was struck down as share investment was a capital receipt.
The secondary adjustment of interest was also struck down as the law did not provide for secondary adjustment.
Now with the amendment in law, secondary adjustment will be possible. However, as per the wording of the provision, this will be possible only in cases where primary adjustment impacts the taxable income. Primary adjustment in case of capital receipts cannot be made as they do not impact taxable income. Therefore, a view can be taken that secondary adjustment is not applicable in cases where primary adjustment is not possible.
16.4 The secondary adjustment has to be made from FY 2016-17.
If the secondary adjustment is less than Rs. 1 cr., then no secondary adjustment will be made.
16.5 Can further adjustment (tertiary adjustment and so on) be made if the deemed interest is not brought into India? That does not seem to be the case.
The reason is that “primary adjustment” and “secondary adjustment” have been specifically defined. “Primary adjustment” means the first adjustment made in case of actual transaction as per Transfer Pricing rules which leads to an increase in total income or reduction in loss, as the case may be. “Secondary adjustment” is dependent on “Primary adjustment”. If there is a primary adjustment, there can be secondary adjustment. Secondary adjustment has not been deemed to become primary adjustment.
Therefore there is no requirement of any further adjustments if interest is not remitted into India.
16.6 It may be noted that as in case of primary adjustment, the country where the related party is situated, may not allow the deduction of expense towards secondary adjustment too. (See para 16.7 below). This can lead to double taxation for the group as a whole. Any adjustment in the other country will require a Mutual Agreement Procedure. This is a time consuming and expensive process.
16.7 Compensatory Adjustment:
(i) In India & (ii) Abroad.
This is explained with an illustration.
Consider that I Co is an Indian Company. F Co is a Foreign Company & Associated to I Co.
I Co pays Rs. 100 to F Co as interest expenditure. Under S. 94B it is determined that allowable expense is only Rs. 50. Hence I Co will get a deduction of only Rs. 50.
However, F Co’s income will be Rs. 100. So I Co is expected to deduct Indian Income-tax at source on Rs. 100.
If I Co’s deduction is restricted to Rs. 50, will F Co’s income be reduced Rs.50; and hence TDS to be reduced appropriately?
Such an adjustment is called Compensatory Adjustment within India.
If F Co’s own income-tax department in the foreign country also considers the income to be reduced to Rs. 50; then that would be Compensatory Adjustment abroad.
CBDT has declared under second proviso to S. 92(C)(4) that no Compensatory Adjustment will be made within India. As far as foreign adjustment is concerned, it has to be decided by the Government of the foreign country. Indian law and DTA don’t provide any procedure to facilitate Compensatory Adjustment Abroad.