Rano Jain
CA	Introduction 
1. The Finance Act, 2017 has introduced a new section 92CE related to secondary adjustment rule into the India's transfer pricing legislation. It would be a new rule within the transfer pricing regime. The existing transfer pricing rules calculate the taxable profits on the price that would have been charged between Associated Enterprises (AEs) acting at arm's length. This is achieved via an adjustment to the price that is effective for tax purposes. This adjustment for tax purposes is called as the primary adjustment, which is only effective for tax purposes. In such circumstances a cash benefit from the non-arm's length pricing can still accumulate. To understand the issue, let us take a simple example. An Indian entity 'A' imports some raw material from one of its foreign AEs at Rs. 100/-. After the Transfer Pricing study, it is implored that the Arms' length price of such imports is Rs. 80/- only. For Income tax purposes, on Rs. 20/- the Income Tax is charged from the Indian entity, the underlying philosophy being that under ideal circumstances the Indian entity should have bought the material at Rs. 80/- only and not at Rs. 100/-. This way an amount of Rs. 20/- has flowed outside India more then what should have gone ideally out. In the present scenario, income-tax on this 20/- is charged from the India entity. However, no tinkering is done to the principal amount of Rs. 20/- gone extra to the foreign country. Adjustment on account of this 20/- Is what is known as secondary adjustment.
Definition of secondary adjustment 
2. As per clause (v) of sub-section (3) of section 92CE, the definition of secondary adjustment is as follows:
""Secondary adjustment" means an adjustment in the books of account of the assessee and its associated enterprise to reflect that the actual allocation of profits between the assessee and its associated enterprise are consistent with the transfer price determined as a result of primary adjustment, thereby removing the imbalance between cash account and actual profit of the assessee."
It was precisely the definition given in the memorandum explaining the Finance Bill, 2017.The underlying principle of such secondary adjustments is to recognize that while the primary transfer pricing adjustment is to the taxable profits of the associated enterprises, it does not rectify the situation where one enterprise actually retains funds that it would not have held, had the transactions in question been conducted on arm's length terms.
Recognition of secondary adjustment rules worldwide 
3. Secondary adjustment rules are recognized in a number of other jurisdictions including the United States and a number of EU Member States. The OECD Model Tax Convention does not prevent nor requires tax administrations to make secondary adjustments. However, it has been apprehended that difficulties can arise in mutual agreement procedure, with some jurisdictions not prepared to admit secondary adjustments within their claims and negotiations. It provides an agreed basis for the fair allocation of profit on cross border transactions between connected parties and also provides measures to avoid double taxation. However, this also means that changes in these principles need the same kind of international agreement which may take some time to agree to. As the primary adjustment is only effective for tax purposes, any cash benefit from non-arm's length pricing can accumulate in an overseas company and often may be located in a low tax jurisdiction. The above cash benefit can be reversed by the secondary adjustment rule, which applies a tax charge on the excess cash arising on non-arm's length pricing. The rules are internationally recognized and are already part of the transfer pricing rules applied in many leading economies, including in the United States, Canada, France and other EU Member States.
While the approaches to secondary adjustments by individual countries vary, they represent internationally recognized methods to realign the economic benefit of the transaction with the arm's length position. It restores the financial situation of the associated enterprises to that which would have existed if the transactions had been actually conducted on an arm's length basis.
Modes of secondary adjustments worldwide 
4. A secondary adjustment seeks to rectify the imbalance arising out of a transaction not being carried out at arm's length price. It commonly done through any of the following three methods wordwide:
(1)	
 	
Constructive dividend  - a jurisdiction making a primary adjustment to the income of an assessee dealing with a foreign AE may treat the excess profits in the hands of the foreign parent as having been transferred as a dividend, in which case it may consider that withholding tax should be levied. This method would treat the excess profits transferred to the overseas company as a deemed dividend subject to withholding tax.	

(2)	
 	
Constructive equity contribution  - where the excess profits are treated as a deemed equity contribution by the other AE, it would have limited application until there is a capital disposal. Again, for the rule to be effective any capital disposal would need to move away from the tax exemptions currently in place for some corporate share disposals.	

(3)	
 	
Constructive interest-bearing loan  - Under this method the excess amount transferred to the other AE is treated to be interest bearing loan given to it and a specified rate of interest is imputed on said deemed loans.	

The Indian Approach 
5. India has not previously sought to introduce a secondary adjustment rule. In fact, this approach seeks to ensure a correct allocation of taxable profit linked to activities undertaken in India from transactions between AEs, typically two companies belonging to the same group. The rules require the terms of the transaction, and thereby the profits arising from it to be calculated by reference to those which would have been agreed to if the companies were independent. This is applied whenever an Indian company is transacting with one that is based overseas.
Though the memorandum explaining the budget proposal mentioned all the three approaches as stated hereinabove, yet the Government's preferred approach to secondary adjustments is a deemed loan from one related party to the other related party. Interest on the deemed loan would be imputed and would be taxable in the hands of the first party. The excess profits from non-arm's length pricing are supposed to be transferred to the parties on which the primary adjustment arises. It is the government's view that on account of secondary adjustment, loan should be deemed between the same two parties. The loan should be created as an account receivable, of the same amount as the primary adjustment, for each accounting period in which it arises.
Principles 
6. The memorandum explaining the budget proposals, in this regard, reads as under:
"Secondary adjustment" means an adjustment in the books of account of the assessee and its associated enterprise to reflect that the actual allocation of profits between the assessee and its associated enterprise are consistent with the transfer price determined as a result of primary adjustment, thereby removing the imbalance between cash account and actual profit of the assessee. As per the OECD's Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (OECD transfer pricing guidelines), secondary adjustment may take the form of constructive dividends, constructive equity contributions, or constructive loans. 
The provisions of secondary adjustment are internationally recognised and are already part of the transfer pricing rules of many leading economies in the world. Whilst the approaches to secondary adjustments by individual countries vary, they represent an internationally recognised methods to align the economic benefit of the transaction with the arm's length position. 
In order to align the transfer pricing provisions in line with OECD transfer pricing guidelines and international best practices, it is proposed to insert a new section 92CE to provide that the assessee shall be required to carry out secondary adjustment where the primary adjustment to transfer price, has been made suo motu by the assessee in his return of income; or made by the Assessing Officer has been accepted by the assessee; or is determined by an advance pricing agreement entered into by the assessee under section 92CC; or is made as per the safe harbour rules framed under section 92CB; or is arising as a result of resolution of an assessment by way of the mutual agreement procedure under an agreement entered into under section 90 or 90A. 
It is proposed to provide that where as a result of primary adjustment to the transfer price, there is an increase in the total income or reduction in the loss, as the case may be, of the assessee, the excess money which is available with its associated enterprise, if not repatriated to India within the time as may be prescribed, shall be deemed to be an advance made by the assessee to such associated enterprise and the interest on such advance, shall be computed as the income of the assessee, in the manner as may be prescribed. 
It is also proposed to provide that such secondary adjustment shall not be carried out if, the amount of primary adjustment made in the case of an assessee in any previous year does not exceed one crore rupees and the primary adjustment is made in respect of an assessment year commencing on or before 1st April,2016. 
This amendment will take effect from 1st April, 2018 and will, accordingly, apply in relation to the assessment year 2018-19 and subsequent years. 
The salient features of the provision are:
(1)	
 	
New section-92CE has been inserted to provide for secondary adjustments.	

(2)	
 	
Instances: the need for secondary adjustment will arise in case of the following eventualities, which are provided in sub-section (1) of section 92CE:	

(i)	
 	
Suo motto  adjustment - As the procedure is, the assessee needs to conduct a detailed Transfer Pricing Study in relation to international transactions entered into by it with its foreign enterprise. In case a difference in said price occurs and the assessee, suo motto makes the adjustment in relation to its taxable income, in such cases a need will arise to make a secondary adjustment.	

(ii)	
 	
Adjustment made by the A.O. accepted by assessee : though the assessee itself does not suo motto make an adjustment, however, on an adjustment on this account made by the Assessing Officer, the assessee accepts the same and prefers not to challenge the same before a higher forum.	

(iii)	
 	
APA under section 92CC: Once an assessee enters into an Advance Pricing Agreement with the board in relation to determination of Arms' Length Price of certain international transaction having been entered into with a foreign Associate Enterprise, the ALP having been finally determined, the instance of secondary adjustment arises.	

(iv)	
 	
Safe harbour rules under section 92CB: Rules provided under section 92CB oblige the Income Tax Authorities to accept the ALP of an international transaction as per the safe harbour Rules provided in this regard. In such a scenario, also the ALP having been freezed, the occasion for secondary adjustment arises.	

(v)	
 	
MAP under section 90 or 90A: The ALP of an international transaction having attained finality as per the Mutual Agreement Procedure, the secondary adjustment has to be made.	

 	
From the above instances it is evident that the occurrence of secondary adjustment will arise only on the finality having been attained that of the primary adjustment. This is quite a logical thing since an assessee having controverted any such primary adjustment, putting the secondary adjustment at that point of time will lead to a number of operational difficulties.	

(3)	
 	
Result being increase in total income or decrease in loss: Definitely in the context of an Indian entity, the primary adjustment arises only in cases where as a result of exercise of determining Arms' Length Price results either in the increase in total income or decrease in losses, only in such circumstance, the secondary adjustment will come into picture. Base Erosion being the underlying theory.	

(4)	
 	
Treatment of excess money available to AE if not repatriated within the prescribed time: It is to be understood, as explained hereinabove through the example, that the background reasoning for making ALP adjustment is that some more money should have come to India or some lesser amount should have gone out of India. Thought process is to bring back that deficit amount, a time frame will be given within which the money has to be repatriated back to India.	

(5)	
 	
Treated as advance to AE: In case the money is not repatriated back to India within the time given, the excess amount supposed to be lying with the foreign AE will be treated as the loans advanced by the Indian entity.	

(6)	
 	
Interest will be imputed as prescribed - Though the rate will be prescribed later on, yet the rule is that on the above said loan amount an interest at the rate so prescribed will be levied and taxed accordingly.	

(7)	
 	
Primary adjustment exceeding 10 Crores: The provision will be applicable only if the primary adjustment made exceeds an amount of Rs.10 Crores.	

(8)	
 	
Primary adjustment not being made in respect of assessment year commencing on or before 1.04.2016: the provisions are applicable in cases where primary adjustment is made only after 1.04.2016.	

(9)	
 	
Applicable to A.Y. 2018-19 onwards: These provisions shall be made effective from Assessment Year 2018-19 onwards.	

Relevant Questions 
7. Though the provision relating to the secondary adjustments at first instance looks good, yet there are certain questions which remain unanswered and may get resolved once the concept takes its proper place under the statute after sometime.
Between which parties should the loan be deemed? 
7.1 The excess profits from non-arm's length pricing have been transferred between the parties on which the primary adjustment arises. It is the government's view that any loan should be deemed between the same two parties. The loan should be created as an account receivable, of the same amount as the primary adjustment, for each accounting period in which it arises.
How should that loan be recognised for accounting purposes? 
7.2 Financial accounts are prepared so as to give a true and fair view and in order to do that must be prepared in accordance with Generally Accepted Accounting Practice. As noted above, the transfer pricing rules calculate the taxable profits on the price that would have been charged at arm's length. Where the pricing is not at arm's length a 'primary adjustment' is made to the original price and this adjusted price is effective for tax purposes. If the adjustment is not required to be reflected through the accounts in order for them to show a true and fair view of profit, then the primary adjustment will just be made in the tax computation .When a secondary adjustment arises it is unlikely that the accounts will be adjusted to reflect it, unless the impact of the secondary adjustment is that the accounts do not show a true and fair view. Therefore, if the secondary adjustment results in a deemed loan between the two parties, that deemed loan and any interest arising is likely to be reflected in the tax computation and not in the accounts.
Uncertainities Involved 
8. The new secondary adjustment regime coming in the Income Tax Act may bring with it a number of uncertainties in the form of following consequences, which, though may be very far-fetched, but as on date one can perceive the same:
(1)	
 	
Businessmen need to take immediate action to review structures where transfer pricing adjustments might be made to identify whether those adjustments are at risk of being treated as deemed loans, with imputed interest. Businesses with a risk of a transfer pricing adjustment in excess of Rs. 10 Crores are going to be affected by the new rules. Groups should urgently review structures where this is likely to be an issue.	

(2)	
 	
The deemed loan and applicable interest rate, which is most likely not to be repaid by foreign entities for a number of reasons, including that there is no obligation to do so. Certain taxpayers can avoid detrimental tax consequences of a secondary adjustment by choosing to repatriate cash corresponding to the amount allocated in a primary adjustment.	

(3)	
 	
A secondary adjustment, however, may itself give rise to double taxation, unless a corresponding credit or some other form of relief is provided by the other country for the additional tax liability resulting from the secondary adjustment. The government may consider the merits of claims to deduct interest relating to the deeming of a constructive loan by a treaty partner following a transfer pricing adjustment.	

(4)	
 	
Keeping track of secondary adjustments in the form of a deemed loan may prove to be a significant administrative burden, both for the taxpayer and the tax authorities. In practice, there will not be legal basis for the foreign company to repay the deemed loan and the deemed interest because there are no contractual legal obligations supporting the settlement of the loan. It may also create difficulties in relation to the accounting treatment of the deemed loan and the relevant currency of the deemed loan and deemed interest.	

(5)	
 	
Such a rule would create significant added complexities, for example, whether in the following year the secondary adjustment itself will be treated as primary adjustment?	

(6)	
 	
For how long the interest will be kept on imputing year after year as most likely the probability of actual repatriation of the money involved is very less.	

Conclusion 
9. Actual fruits of any new legislation, to a nation, can be witnessed only once it gets evolved. However, one should hope that the prospect of such complexity and uncertainties may itself be the reason of achieving the government's objective of pushing groups to transact on an arm's length basis, rather than just accept that transfer pricing adjustments can be made in their tax returns.
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