Income Tax 2025

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Determination of arm's length price. ​

165(1) ​

The arm’s length price in relation to an international transaction or specified domestic transaction shall be determined by any of the following methods, being the most appropriate method––

  • (a) comparable uncontrolled price method;
  • (b) resale price method;
  • (c) cost plus method;
  • (d) profit split method;
  • (e) transactional net margin method;
  • (f) such other method as prescribed by the Board.

165(2) ​

The most appropriate method referred to in sub-section (1) shall be,––

  • (a) selected having regard to the nature of transaction or class of transaction or class of associated enterprise or functions performed by such enterprises or such other relevant factors as the Board may prescribe;
  • (b) applied for determination of arm’s length price in such manner as prescribed.

165(3) ​

The arm’s length price shall be—

  • (a) in case, only one price is determined by the most appropriate method,–– (i) the price determined by that method; or (ii) the price at which the international transaction or specified domestic transaction has actually been undertaken, if the variation between the arm’s length price so determined and price at which the international transaction or specified domestic transaction has actually been undertaken does not exceed such percentage not exceeding 3% of the latter, notified by the Central Government in this behalf; or
  • (b) in case, more than one price is determined by the most appropriate method, the price determined in such manner as prescribed.

165(4) ​

The Assessing Officer, during the course of any proceeding for the assessment of income, may proceed to determine the arm’s length price in relation to an international transaction or specified domestic transaction as per sub-sections (1), (2) and (3) if, on the basis of material or information or document in his possession, he is of the opinion that—

  • (a) the price charged or paid in an international transaction or specified domestic transaction has not been determined as per sub-sections (1), (2) and (3); or
  • (b) any information and document relating to an international transaction or specified domestic transaction has not been kept and maintained by the assessee as per section 168(1); or
  • (c) the information or data used in determination of the arm’s length price by the assessee is not reliable or correct; or
  • (d) the assessee has failed to furnish, within the specified time, any information or document which he was required to furnish by a notice issued under section 171(2).

165(5) ​

The Assessing Officer, before determining the arm’s length price under sub-section (4), shall give a notice calling upon the assessee to show cause, on the date and time to be specified in the notice, why the arm’s length price should not be determined on the basis of material or information or document in his possession.

165(6) ​

The Assessing Officer, on determination of arm’s length price under sub-section (4), may compute the total income of the assessee having regard to the arm’s length price so determined.

165(7) ​

No deduction shall be allowed under section 144 or under Chapter VIII in respect of income by which the total income of the assessee is enhanced after computation of income under sub-section (6).

165(8) ​

When the total income of an associated enterprise is computed under sub-section (6) on determination of the arm’s length price paid to another associated enterprise from which tax has been deducted or was deductible under the provisions of Chapter XIX-B, the income of the other associated enterprise shall not be recomputed by reason of such determination of arm’s length price in the case of the first mentioned enterprise.

Explanation

Section Summary: ​

Section 165 of the Income Tax Act deals with the determination of the arm's length price (ALP) for international transactions and specified domestic transactions. The ALP is the price that would have been charged between independent parties under similar circumstances. This section ensures that transactions between related parties (e.g., subsidiaries, parent companies, or associated enterprises) are conducted at fair market value to prevent tax evasion through profit shifting.

The section outlines the methods for determining ALP, the conditions under which the Assessing Officer can intervene, and the consequences of adjustments made to the ALP.

Key Changes: ​

  1. Inclusion of Specified Domestic Transactions: Earlier, ALP rules primarily applied to international transactions. Now, they also apply to certain domestic transactions between related parties.
  2. 3% Variation Tolerance: A new provision allows a 3% variation between the ALP and the actual transaction price without triggering adjustments, provided the Central Government notifies this tolerance limit.
  3. Enhanced Compliance Requirements: The Assessing Officer has broader authority to intervene if documentation is inadequate, information is unreliable, or compliance is not met.

Practical Implications: ​

  1. For Taxpayers:

    • Businesses engaged in international or specified domestic transactions must ensure their pricing aligns with the ALP principles.
    • Proper documentation and adherence to prescribed methods are critical to avoid disputes with tax authorities.
    • Failure to maintain records or provide required information can lead to ALP adjustments and higher tax liabilities.

  2. For Businesses:

    • Companies must select the most appropriate method for determining ALP based on the nature of the transaction, functions performed, and other relevant factors.
    • The 3% tolerance limit provides some flexibility but requires careful calculation to avoid penalties.

  3. For Compliance:

    • Taxpayers must maintain detailed records and documentation to substantiate their ALP calculations.
    • The Assessing Officer can initiate ALP adjustments if discrepancies are found during assessments.

Critical Concepts: ​

  1. Arm's Length Price (ALP): The price at which unrelated parties would agree to transact under similar circumstances.
  2. Most Appropriate Method (MAM): The method best suited to determine ALP based on the transaction's nature, functions, and risks.
  3. Specified Domestic Transactions: Certain domestic transactions between related parties that are subject to ALP rules (e.g., transactions exceeding a specified threshold).
  4. 3% Tolerance Limit: A permissible variation between the ALP and the actual transaction price, subject to government notification.

Compliance Steps: ​

  1. Select the Most Appropriate Method:

    • Choose from the prescribed methods (e.g., Comparable Uncontrolled Price, Resale Price, Cost Plus, Profit Split, Transactional Net Margin, or other Board-prescribed methods).
    • Justify the selection based on the transaction's nature and other relevant factors.

  2. Maintain Documentation:

    • Keep records of the ALP determination process, including data, assumptions, and calculations.
    • Ensure compliance with Section 168(1) for maintaining and furnishing documents.

  3. Respond to Notices:

    • If the Assessing Officer issues a notice under Section 165(5), provide a timely response with supporting evidence to justify the ALP.

  4. Monitor Tolerance Limits:

    • Ensure the transaction price does not exceed the 3% variation limit from the ALP (if notified by the government).

Examples: ​

  1. Scenario 1: Comparable Uncontrolled Price Method:

    • Company A (India) sells goods to its subsidiary, Company B (USA), at $100 per unit. An independent company sells similar goods to an unrelated party at $105 per unit. The ALP is determined as $105, and Company A must adjust its pricing to align with this.

  2. Scenario 2: 3% Tolerance Limit:

    • Company X (India) provides services to its parent company, Company Y (UK), at $1,000. The ALP is determined as $1,030. If the government has notified a 3% tolerance limit, no adjustment is required since the variation ($30) is within the 3% limit ($1,030 × 3% = $30.90).

  3. Scenario 3: Assessing Officer Intervention:

    • Company Z fails to maintain proper documentation for its international transaction. The Assessing Officer determines the ALP based on available information and adjusts the income, leading to higher tax liability for Company Z.

This section ensures fair pricing in related-party transactions and strengthens compliance mechanisms to prevent tax avoidance. Taxpayers must carefully follow the prescribed methods and maintain robust documentation to avoid disputes.