Where the transfer pricing is not at arm’s length and a potential tax advantage has been obtained, the transfer pricing rules require a ‘primary adjustment’ to be made to the original price. This adjustment is effective for tax purposes only, but does not address the additional cash benefit achieved from non-arm’s length pricing of the underlying transaction. The advantage of this cash benefit can be addressed by the use of secondary adjustment rule. The commentary on paragraph 2 of Article 9 of the Organisation for Economic Cooperation and Development (“OECD”) Model Tax Convention does not deal with the secondary adjustment and thus does not prevent or requires tax authorities to make them.

The OECD transfer pricing guidelines define secondary adjustment as ‘an adjustment that arises from imposing tax on a secondary transaction’.

The secondary adjustment is further defined as -

'an adjustment in the books of accounts of the assessee and its associated enterprise to make the actual allocation of profits between the assessee and its associated enterprise 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’.

The imbalance between the cash account and actual profit of the assessee is addressed by three distinctive methods, as provided by the OECD, namely, constructive dividend, equity contribution and constructive loan. The application and limitations of these methods are discussed in the following paragraphs.

Constructive Dividend

The constructive dividend rule provides that the non-arm’s length benefit derived because of the primary adjustment shall be treated as a dividend paid to the associated enterprise as a deemed dividend subject to dividend distribution tax (“DDT”)/withholding tax (“WHT”). This would mean on a one time payment of DDT/WHT on the benefit so derived would do away with the requirement of the said sum to be repatriated.

Putting it in the Indian context, it may be interested to note that some of the tax treaties for instance India USA double taxation avoidance agreement (“DTAA”), provides for an allowance of DDT in the country of residence of the shareholder. This would mean the associated enterprise, other than getting an undue benefit shall also be able to take benefit of the DTAA towards claiming for DDT as tax credit.

Equity Contribution

Another way to deal with the secondary adjustment is to treat the sum as a deemed equity contribution by the foreign associated enterprise. The said approach shall result in dilution of the share capital of the assessee and may result in the change of participation in the management and control of the assessee. This option would need to address the added complications of the group relationship between indirect parent and subsidiary or affiliated entities and how the deemed equity contribution be recognized by the group.

Constructive Loan/advance

The Indian provision regarding secondary adjustment, namely section 92CE, provides that the benefit of non-arm’s length price so achieved shall be repatriated in India within a reasonable time (to be notified), a failure shall treat the benefit as an advance subject to interest. Thereby, making a notional claim against the primary adjustment proposed. Further, interest shall be imputed on this notional loan at the time of assessment, thereby, charging the assessee on notional income that is resulted out of a deemed loan.

Though this option seems the most feasible of the stated methods, and rightly adopted in the Indian tax regime. However, it poses significant challenges for the taxpayers. These challenges are addressed as under:

1. The deemed loan is not guaranteed to be repatriated to India, thereby, posing unnecessary compliance and accounting burden for the taxpayer. Such as providing for interest on the deemed loan and restricting of the loan at the end of the year to account for unpaid interest on the said loan;
2. The deemed loan being attributable to a related party shall be subject to the Interest deduction rules provided under Section 94B titled ‘Limitation of interest deduction in certain cases’. Therefore, restricting the deduction of genuine interest expense during the relevant year;
3. The taxpayer shall be liable to pay tax on the interest accrued on the deemed loan, thereby making the taxpayer subject to additional income tax; and
4. Considering the sum is not repatriated in India, shall defeat the intent of providing for secondary adjustments by creating differences in the actual and reported cash position of the taxpayer.

Here it is important to note that, countries where secondary adjustment rules are already prevalent such as South Africa (Section 31 of the South African Income Tax Act), have considered the hardship of bringing in the amount of secondary adjustment and accordingly proposed the first option i.e. Constructive Dividend as the most appropriate option to provide for the cash benefit resulting from secondary adjustments.

It would have been of relevance had the government considered the constructive dividend option in addition to deemed advance to mitigate the hardship of the taxpayer by way of providing a sunset clause post which the impact of secondary adjustment shall cease for a certain assessment year.