Navigating Related Party Transactions under the Income Tax Act, 1961.

Introduction:

Related party transaction under income tax act must be computed at Arm’s Length Price, These provisions are introduced to prevent tax erosion through manipulation of prices in international transaction or specified domestic transactions. These provisions are introduced in income tax act with an intention to compute the pricing of goods, services, and intangibles between related parties or associated parties situated in different tax jurisdictions. The intention of these provisions is to these prices should reflect the price that would have been charged in an open market between unrelated parties.

 

Terms you should be aware of:

A.       Associated Enterprise (AE) – sec 92A

Under section 92A of income tax act, an “Associated Enterprise” refers to a relationship between two enterprises where one has the ability to exercise control or significant influence over the other, or where both are under the control or influence of the same person or persons. This relationship may be direct or indirect and can be established through various financial, managerial or ownership links.

Specifically, an enterprise is considered an associated enterprise of another if it participates either directly or indirectly, or through one or more intermediaries – in the management, control, or capital of both enterprises, they are also treated as associated enterprises.

Additionally, two enterprises are deemed to be associated enterprises if, at any time during the previous year below specified conditions are met:

• One enterprise holding at least 26 % of the voting power in the other, or a third party holding at least 26% in both;

• A loan from one enterprise constituting 51% or more of the book value of the other’s total assets;

• One enterprise guaranteeing 10% or more of the total borrowings of the other;

• More than half of the board or executive members of one being appointed by the other, or by the same person(s);

• The business  of on being wholly dependent on the intellectual property or commercial rights owned by the other;

• 90% or more of raw materials or inputs being sourced from other enterprise (or persons specified by it), with pricing influenced by such enterprise;

• The finished goods of one being sold to the other (or to its specified person), with prices influenced accordingly;

• Common control by an individual, relative, or a Hindu Undivided Family (HUF);

• One enterprise holding at least 10% interest in a firm, AOP, or BOI;

• Or if any mutual interest exists between the two enterprises, as prescribed.

  
  

In essence, Section 92A of Income Tax Act 1961, sets out a broad and inclusive definition of associated enterprises to cover various direct and indirect relationships that could potentially affect transfer pricing and profit sharing.

B.       International Transaction – sec 92B

An international transaction, as defined under Section 92B of the Income Tax Act, is a transaction between two or more associated enterprises, where at least one is a non-resident, involving the purchase, sale, lease or transfer of tangible or intangible property, provision of services, lending or borrowing of money, or any other transaction that affects the income, profits, losses, or assets of such enterprises. It also includes agreements for cost-sharing of services or facilities. Even transactions with unrelated parties can be treated as international transactions if an associated enterprise influences the terms or is involved through a prior agreement. The scope covers dealings like use or transfer of IP, capital financing, service arrangements, and business restructurings, ensuring that any cross-border transaction with a related party is subject to transfer pricing rules.

C.       Specified Domestic Transaction – sec 92BA

Specified Domestic Transactions (SDTs) refer to certain transactions between domestic related parties, such as payments to specified persons under Section 40A(2)(b), inter-unit transfers, and transactions involving profit-linked deductions. These are subject to transfer pricing rules if the aggregate value exceeds ₹20 crore in a financial year.

D.       Arm’s Length Price- 92(F)ii

Arm’s Length Price means a price which is applied or proposed to be applied between unrelated parties in an open market.

Methods of determining Arm’s Length Pricing: (Sec 92C, Rule 10B)

As per Section 92C of the Income Tax Act, the Arm’s Length Price (ALP) for any international transaction or specified domestic transaction between associated enterprises must be determined using the most appropriate method, depending on the nature of the transaction and the relationship between the parties involved. The Act provides a set of recognized methods for this purpose, which must be selected based on suitability and relevance to the specific case.

These methods include the Comparable Uncontrolled Price (CUP) Method, Resale Price Method (RPM), Cost Plus Method (CPM), Profit Split Method (PSM), Transactional Net Margin Method (TNMM), and any other method prescribed under Rule 10AB.

For instance, if the Cost Plus Method is the most suitable method for a transaction, but the taxpayer instead applies the Resale Price Method for a more favorable outcome, the Assessing Officer (AO) may challenge this during assessment. The AO can recompute the ALP using the correct method (in this case, Cost Plus Method) and impose additional tax liability and penalties. However, under the principle of natural justice, the taxpayer has a right to be heard before any adjustment is made. If the taxpayer is able to justify the choice of method and explain why it was more appropriate in the given context, the AO may accept the explanation and not insist on using a different method. Thus, proper documentation and reasoning are key to defending the chosen transfer pricing method.

i.       Comparable Uncontrolled Price:

The Comparable Uncontrolled Price (CUP) Method is used to determine the arm’s length price when there are reliable and comparable transactions of the same or similar goods or services between unrelated parties. It is most appropriate when the terms, conditions, and characteristics of the controlled and uncontrolled transactions are sufficiently similar, such as product type, market conditions, and contractual terms. For example, if a company sells a product to an associated enterprise and also sells the same product to an unrelated customer under similar terms, the price charged to the unrelated party can be used as the benchmark. This method is highly reliable but suitable only when close comparables are available.

ii.       Resale Price Method:

The Resale Price Method (RPM) is used when a product is purchased from an associated enterprise and then resold to an unrelated party without significant value addition. It is most appropriate in cases involving distributors, traders, or marketing entities who do not alter the product substantially but incur selling and administrative costs. Under this method, the arm’s length price is determined by reducing an appropriate gross profit margin (based on comparable uncontrolled transactions) from the resale price charged to the independent customer. RPM is best suited for evaluating distribution or resale activities, especially where the reseller does not perform complex functions or own valuable intangibles.

iii.      Cost Plus Method:

The Cost Plus Method is used to determine the Arm’s Length Price in cases where goods or services are supplied by one associated enterprise to another, especially when the supplier performs manufacturing or service functions. Under this method, the ALP is calculated by taking the direct and indirect costs of production incurred by the supplier and adding a suitable gross profit mark-up based on comparable uncontrolled transactions.

iV.      Profit Split Method:

The Profit Split Method (PSM) is used when two or more associated enterprises are involved in closely integrated or interdependent transactions, and it is difficult to evaluate them separately. This method is most suitable when both parties contribute significantly to the value creation, such as through unique intangibles, shared risks, or joint development of products, services, or intellectual property.

Example:

An Indian company and its US-based associated enterprise jointly develop a new software product. Both contribute skilled teams, proprietary technology, and funding, and the product is marketed globally. Since both companies are deeply involved in development and marketing, and it’s hard to separately benchmark each entity’s function, PSM is used to allocate the combined profits based on each party's relative contribution (e.g., development cost, assets used, risks borne).

V.       Transactional Net Margin Method:

The Transactional Net Margin Method (TNMM) is a transfer pricing method used to determine the Arm’s Length Price by comparing the net profit margin earned by an enterprise from an international or specified domestic transaction with the net profit margins earned by unrelated parties in similar transactions under comparable conditions.

Example:

An Indian IT services company provides support services to its associated enterprise abroad. Its net profit margin (Operating Profit/Total Cost) is 12%. Comparable independent IT service providers in India earn an average of 10%. Since the company’s margin is higher than the industry standard, the transaction is considered to be at arm’s length under TNMM.

Procedure that is commonly followed in these transactions:

a.       Step 1: Determination of ALP

Before making payments to AEs, determine the most appropriate method to compute ALP. Transfer pricing documentation should be maintained to justify the pricing in case of scrutiny.

b.       Step 2: Deduction of TDS

If making a payment to a non-resident AE, TDS under Section 195 must be deducted on the transaction value, based on the ALP and applicable DTAA provisions.

c.       Step 3: Filing of Form 3CEB (Section 92E)

Every person who has entered into an international transaction or a specified domestic transaction during the previous year is required to obtain a report from a Chartered Accountant in Form 3CEB, as mandated under Section 92E of the Income Tax Act. This report must contain the details of all such transactions, the method used for determining the Arm’s Length Price (ALP), and a certification that the pricing is in line with the provisions of Indian transfer pricing laws. The due date for furnishing Form 3CEB is 31st October of the relevant assessment year. Non-filing or delayed filing of Form 3CEB can attract a penalty of ₹1,00,000 under Section 271BA of the Act. Proper and timely filing ensures compliance and significantly reduces the risk of transfer pricing litigation.

 

Safe Harbour Rules:

Safe Harbour Rules provide predefined profit margins or pricing thresholds for certain eligible international and specified domestic transactions. If a taxpayer opts to apply these margins, the income tax department automatically accepts the declared transfer price as being at arm’s length, thereby reducing the risk of disputes, scrutiny, and prolonged litigation.

Eligible transactions under Safe Harbour Rules include:

• Software development services

• IT-enabled services (ITES)/BPO services

• Contract R&D services related to software development

• Contract R&D services in the field of generic pharmaceuticals

• Manufacture and export of core auto components

• Provision of corporate guarantee to a wholly owned subsidiary

• Intra-group loans to wholly owned subsidiaries

• Advancing low-value intra-group services

Each eligible category comes with a prescribed operating margin or interest rate, and if the taxpayer’s declared margin matches or exceeds it, the transaction is presumed to be at arm’s length. While Safe Harbour provides certainty and ease of compliance, it is available only to eligible taxpayers who meet the specific conditions laid down in the rules.

 

Advance Pricing Agreements:

APAs are agreements between a taxpayer and the income tax department to predetermine the transfer pricing method and ALP for future transactions.

• Can be unilateral, bilateral, or multilateral

• Valid for up to 5 years, with a rollback option for 4 prior years

• Helps avoid future disputes and ensures certainty in tax positions

Conclusion:

Transfer pricing regulations under the Income Tax Act are essential to ensure that profits are fairly allocated between associated enterprises, especially in cross-border and related-party transactions. With increasing scrutiny from tax authorities, businesses must maintain accurate documentation, choose the right method for determining Arm’s Length Price, and comply with key reporting obligations like filing Form 3CEB. Leveraging options such as Safe Harbour Rules or Advance Pricing Agreements can provide greater certainty and reduce the risk of disputes.

At Prolead, we help you navigate these complex tax regulations with confidence. From evaluating transfer pricing methods and preparing documentation to ensuring regulatory compliance and representing your case before tax authorities, Prolead ensures that you stay compliant and make well-informed financial decisions. Our expert guidance empowers your business to manage risks and optimize cross-border and domestic related-party transactions efficiently.