Global contracts: ensuring the price is right across borders

Multinational corporations (MNCs) leverage global contracts to align business objectives across different markets. In such contracts, a group entity enters into contracts with vendors to negotiate supplies for group entities. Global contracts often enable the group to negotiate better prices for the group entities, through a volume-based commitment made by the parent entity. However, the ability of these contracts to influence the pricing of contracts entered into by group entities warrants a closer look from a transfer pricing standpoint.

In the context of transfer pricing provisions in India, a taxpayer is required to demonstrate that the ‘international transactions’ it enters into are conducted at an arm’s-length price (Section 92, the Income-tax Act, 1961). Generally, an international transaction is understood to be entered into by a person with an associate enterprise where either or both are non-residents of India (Section 92B(1), the Income-tax Act, 1961).

However, since the introduction of transfer pricing provisions in India – through the Finance Act, 2001, with effect from April 1 2002 – it has been provided that a transaction entered into by a taxpayer with an unrelated person will be subject to transfer pricing provisions if the terms are, in substance, influenced by an associated enterprise of the taxpayer (Section 92B(2), the Income-tax Act, 1961). Such a transaction is referred to as a ‘deemed international transaction’ (DIT). The application of transfer pricing provisions to transactions entered into by an Indian entity with a seeming third-party vendor has to be viewed in light of the DIT provisions.

In the case of global contracts, the parent entity or the group entity may agree to terms of supply with a vendor. An Indian entity that is a party of the group may enter into a transaction with the vendor or an Indian affiliate of the vendor on the basis of the global contract signed by the group entity. Normally, transfer pricing provisions do not apply to a transaction between unrelated parties. However, because the transaction is entered into by the Indian group entity pursuant to a global understanding, it may initially seem that the transaction should be regarded as a DIT. After all, apart from other operational efficiencies, at a group level there may be a possibility of tax planning through the use of such contracts.

Illustratively, India may be seen as a high-tax jurisdiction by the group and the pricing for Indian procurement could be positioned higher to subsidise procurements by other group entities in low-tax jurisdictions. However, practically, the application of the DIT provision to such contracts is far more complex and may depend on factors such as independence exercised by the Indian entity in entering into such contracts.

There could be cases where the contract entered into by the group entity binds the Indian entity (impliedly or explicitly) to the contract and compels the Indian entity to conclude a transaction with a vendor at prices and terms agreed by the group entity. In such cases, the DIT provisions should apply to the transaction concluded by the Indian entity with the vendor.

Similarly, the provision of supplies by a group entity to a vendor with a direction to make onward supplies to an Indian entity only at pre-agreed terms and prices may entail the application of transfer pricing provisions. This conclusion was upheld by a Bangalore bench of the Income Tax Appellate Tribunal in Novo Nordisk Pharma India Private Limited v The Deputy Commissioner of Income Tax, Circle 5(1)(2), Bangalore (2015).

The application of transfer pricing provisions to global contracts cannot be taken for granted. In many cases, the global contracts capture a broad understanding of the group and do not bind Indian entities. In such cases, if the Indian entity independently negotiates critical terms of the contract with an independent vendor (while accepting certain general terms agreed in a global contract), it may be possible to conclude that the DIT provisions should not apply. The global contract may result in the initiation of a transaction for the Indian entity but may not determine the substantial terms of a transaction between the Indian entity and the vendor.

Thus, the application of the DIT provisions to transactions entered into by an Indian entity pursuant to a global contract is a subjective issue that is dependent on the independence exercised by the Indian entity in the transaction. In cases where the Indian entity is free to negotiate critical terms and pricing in the contract, the DIT provisions may not apply.

However, MNCs exercise control over group entities in various ways. In many cases, such control may be exercised rather impliedly, or the global contract may not bind the group entities.

However, if the parent or group entity practically compels the group entity to conclude the contract on the same terms as those stated in the global contract, the DIT provisions may apply. Irrespective of the mode of exercise of control, a DIT could be inferred if the independence of an Indian entity to enter into such transactions is diluted by any group entity.

It is also worth considering the probable consequences that may arise where the entities have not reported transactions arising from global contracts that are alleged to be DITs.

If the Indian entity has justified profit margins using methods such as the transactional net margin method (TNMM) and the transactions resulting from global contracts can be grouped with other business transactions, the application of transfer pricing provisions may not result in any adjustment. However, where an Indian entity has applied transactional methods such as the comparable uncontrolled price method to justify international transactions, the application of the DIT provisions could result in a profit adjustment.

Even in cases where an Indian entity applies the TNMM method, there could be transactions that may warrant a transfer pricing adjustment. This issue is more pertinent in global restructuring and hive-off transactions, wherein the parent entity may agree to transfer part of its business to a buyer. In such cases, the Indian entity may enter into various forms of share sale or business transfer agreements with the buyer or its group entity to fulfil the obligation created by the parent entity. If the transactions are concluded to be DITs and the price attributed to the transfer made by the Indian entity is less than the arm’s-length price, the capital gains earned by the Indian entity could be subject to transfer pricing adjustments.

More importantly, irrespective of the adjustment to the transaction, a penalty of 2% of the transaction value can be levied for non-reporting of a DIT.

Global contracts are crucial to the business of MNCs and such transactions ensure that group entities function within the broad framework set by the parent entity. Supplies to or from vendors at a global level also simplify the integration of functions across borders.

However, it is equally important for the group to understand the transfer pricing implications arising from such contracts and benchmark/report such transactions where necessary. This will ensure that the group can achieve the commercial and operational efficiencies of global contracts while avoiding any adverse transfer pricing implications.