The Viewpoint: Secondary Adjustment- A Perspective

The Viewpoint: Secondary Adjustment- A Perspective

Bar & Bench

by Arijit Chakravarty and Gohan Raj

  1. Background

As early as in 2014, in the case of PMP Auto Components (P) Limited TS-263-AT-2014 (Mum) the tax authorities had made a secondary adjustment on account of interest chargeable on loan transaction with Associated Enterprise (AE) as the tax payer assessee had not realized any amount of interest from additional capital investment made to its AE. The same was deleted by the Dispute Resolution Panel (DRP). The said deletion was challenged by Revenue before the tribunal, which agreed with the view of the DRP and upheld the deletion in respect of the secondary adjustment.

  1. Introduction of Secondary Adjustment in Indian TP laws

In Finance Act 2017, new provision has been inserted to introduce the secondary adjustment norms, which is based on OECD’s transfer pricing guidelines. The new section 92CE has been inserted with effect from April 1, 2018 namely, “Where a primary adjustment to transfer price

  • Has been made suo motu by the taxpayer in his tax return;
  • Made by the tax officer and accepted by the taxpayer;
  • Is determined by an advance pricing agreement entered into by the assessee;
  • Is made as per safe harbour rules, or
  • Is arising as a result of resolution of an assessment by way of mutual agreement procedure (MAP)

in such cases, the taxpayer has to make a secondary adjustment.”

It has been provided that the above shall not be applicable if

  • The amount of primary adjustment made in any previous year does not exceed INR 10 million, and
  • The primary adjustment is made in respect of an assessment year commencing on or before April 1, 2016.

Further, 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 maybe, the excess money which is available with its AE, if not repatriated to India within the time as may be prescribed, shall be deemed to be advance made by the taxpayer to such AE and the interest on such advance, shall be computed in such manner as may be prescribed.

The term “primary adjustment” to a transfer price, means the determination of transfer price in accordance with the arm’s length principle resulting in an increase in the total income or reduction in the loss, as the case maybe, of the taxpayer. The term “secondary adjustment” has been defined to mean an adjustment in the books of account of the taxpayer and its AE to reflect that the actual allocation of profits between the taxpayer and its AE 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 taxpayer.

  1. Reason behind secondary adjustment

Secondary adjustments may be defined as adjustments that are intended to restore the financial situation of the AEs which have entered into the transactions giving rise to the transfer pricing adjustment to that which would have existed had the transactions been conducted on arm’s length terms. The primary transfer pricing adjustment aim at correcting 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. A secondary adjustment therefore seeks to rectify this, most commonly by assuming that a constructive dividend, constructive equity contribution or constructive interest-bearing loan has been made in an amount equal to the transfer pricing adjustment.

  1. OECD Transfer Pricing Guidelines 2010 on Secondary Adjustment

The 2010 OECD transfer pricing guidelines states that the transfer pricing adjustments do not alter the fact that the excess profits represented by the adjustment are not consistent with the result that that would have arisen if the controlled transactions had been undertaken on an option prices. To make the actual allocation of profits consistent with the primary adjustment, some countries under their domestic legislation, make a secondary adjustment, whereby the excess profits resulting from a primary adjustment are treated as having been transferred in some other form and taxed accordingly. Ordinarily, the signal transactions will take the form of constructive dividends, constructive equity contributions or constructive loans. The exact form that the second transaction takes and of the consequent secondary adjustment depends on the facts of the case and on the loss of the country that makes the secondary adjustment. The commentary on paragraph 2 of article 9 of the OECD model tax Convention notes that the article does not deal with secondary adjustments and thus it neither forbids nor requires tax administrations to make secondary adjustment.

The MC notes that some of the countries that have adopted secondary adjustments also give the taxpayer receiving the primary adjustment another option that allows the taxpayer to avoid secondary adjustment by having the taxpayer to repatriate the excess profits to enable the taxpayer to conform its accounts to the primary adjustment.

  1. Country Practices relating to Secondary Adjustment
  • UK

Currently, the UK transfer pricing rules calculate the taxable profits on the price that would have been charged at arm’s length between two individual entities. Where a potential ‘tax advantage’ arises due to non-arm’s length price, a primary adjustment is made to the original price, which is effective for tax purposes only. This however, does not address the cash benefit achieved from the non-arms-length pricing of the underlying transaction. A secondary adjustment rule will in effect apply a tax charge on the excess (cash) that arises as a result of a non-arms-length transaction. The OECD Transfer Pricing guidelines discussed two secondary adjustments concepts – constructive dividends and equity contributions. Since neither of them is likely to generate any revenue in the UK due to the UK not having dividend withholding tax, the government has proposed constructive loans as an alternative secondary adjustment.

The excess cash will therefore be deemed as a loan in the hands of the advantaged company, which will be subject to interest – potentially above the market rate to support the rule’s deterrent effect. It is proposed that a secondary adjustment would be required whenever a de minimis primary adjustment of £1 million is made. It is clarified that the deemed loan should be between the same parties as the provision upon which the primary adjustment was made. The secondary adjustment rule sees when the excess profits are repatriated to the UK which are treated as repayment of the deemed loan, should not be taxed at the point of receipt in the UK. A primary concern arising in the application of the secondary adjustment rule is the creation of non-relievable double taxation. Whether there would be any deduction for the imputed interest would depend on the terms of the relevant tax treaty and the mutual agreement procedure.

HM Revenue and Customs is still considering the feedback from the consultation, therefore, the proposed UK legislation relating to secondary adjustment has not yet been finalized.

Means for avoiding double taxation

If the UK considers that the adjustment does not accord with the provisions of the tax treaty, for example because it does not accept that a transfer pricing adjustment complies with the arm’s length principle, the UK competent authority will take up the matter with its counterpart in the treaty partner state. If negotiations between the competent authorities provide adequate evidence to satisfy the UK competent authority that an adjustment made by a tax treaty partner is in accordance with the tax treaty, and was required in order to comply with the arm’s length principle, there will normally be no difficulty in granting a corresponding adjustment. If, however, the UK remains dissatisfied, there is no obligation on it to grant relief and at the taxpayer’s request the matter may progress to arbitration if the Arbitration Convention is applicable or if the relevant treaty contains an arbitration article.

The UK considers the merits of claims to deduct interest relating to the deeming of a constructive loan by a treaty partner following a transfer pricing adjustment. The issue is, however, subject to the arm’s length principle and is considered in the light of any relevant provisions relating to payments of interests. Where a treaty partner applies a secondary adjustment by deeming a distribution to have been made, the UK neither taxes the deemed distribution nor grants relief for tax suffered on the distribution in the other jurisdiction.

  • South Africa

For fiscal years beginning on or after April 1, 2012, transfer pricing adjustments gave rise to a deemed loan by the taxpayer to the foreign AE by way of a secondary adjustment. The taxpayer was subjected to tax on interest on the deemed loan. However, to the extent the deemed loan was regarded as having been repaid to the taxpayer by the end of the year of assessment in which the primary adjustment was made, this adjustment was not treated as loan. It is understood that effective January 1, 2015, the deemed loan secondary adjustment has been replaced with a deemed dividend mechanism. All existing deemed loans are treated as deemed dividends declared on January 1, 2015 (subject to dividend withholding tax at the rate of 15 percent). Transfer pricing adjustments made subsequent to January 2015 are subject secondary adjustment by way of being treated as deemed dividend. An unresolved issue was as to whether there might be tax treaty relief from withholding tax when the counterparty to the adjusted transaction is a shareholder in the South African entity and is resident in a country with which South Africa has entered into a double tax agreement. Clarity on this issue is being sought by means of an application to SARS for a ruling. The normal penalty regime also applies. 

  • USA

In USA, the second adjustments are also known as compensating/collateral adjustments to take care of the financial consequences of transactions undertaken between associated enterprises on a non-arm’s-length price basis.

  1. Some issues that may be relevant in Indian context relating to “secondary adjustment”
  • Whether secondary adjustment has to be made if “both” the conditions stated in the proviso are not satisfied?

The proviso states that secondary adjustment shall not be made if both the conditions are satisfied viz.

  • the primary adjustment does not exceed INR 10 million and
  • the primary adjustment pertains to assessment year 2016-17 or earlier years.

Assuming hypothetically, that a primary adjustment is made in tax year 2012 in excess of INR 10 million, in such a situation both the conditions of the proviso would not be satisfied. The primary adjustment made in earlier years in our example is in excess of INR 10 million, therefore, the first condition is not satisfied. In such a situation, would it require a secondary adjustment to be made for earlier years also? In such a situation, a view may be taken that the secondary adjustment would apply for tax year 2012 also though the section is introduced now. This may not have been the intention of the legislature. Can therefore, the word “and” be read as “or” in the proviso to section 92CE?

Where a primary adjustment is made in situations stated in 92CE (1), the taxpayer shall make a secondary adjustment. It seems that the provision is mandatory in nature. The issue is, whether to avoid the secondary adjustment, the repatriation would be required in respect of excess money determined for all such preceding years, failing which, secondary adjustment would be made? If yes, when would the time prescribed for repatriation commence?

  • Whether the secondary adjustment is entity-wise or transaction-wise?


Primary AdjustmentYearAmount
Sell of goods to AE20145 million
Interest on Receipt of loan from AE20147.5 million
12.5 million

In the example above, if the primary adjustment is considered to be transaction-wise, both the primary adjustments are below INR 10 million. It may be possible to take a view that since the primary adjustments do not exceed the threshold limit of 10 million, the provisions of section 92CE of the Act is not applicable. If however, the primary adjustment is considered an entity level, then the provisions would be attracted. The term primary adjustment to a transfer price means the determination of the transfer price in accordance with the arm’s length principle. It appears that a “transaction-by-transaction” approach is required. If that be the case, secondary adjustment may not be applicable in the example given above. A better view would be t consider the primary adjustment at transaction level, which would lead to adjustments which are less than INR 10 million being inapplicable for any secondary adjustment, being inconsequential in nature in monetary terms. However, since the proviso states that “nothing contained in this section shall apply if the amount of primary adjustment in any previous yea does not exceed one crore” can also be interpreted as “total amount of primary adjustment in any previous year”. If such an interpretation is adopted, then all primary adjustments, if totaling INR 10 million would be covered.

  • Excess amount paid as a result of primary adjustment whether deemed dividend

As stated above, many countries impose withholding tax on the amount subject to secondary adjustment. In the Indian context, the amount not repatriated (the excess money) shall be deemed to be an advance made by the Indian taxpayer to its non-resident AE on which interest, to be computed in the manner to be prescribed. Can it be said that the excess amount is to be treated as a deemed dividend under the Act since the amount paid to the AE which is in excess, is due to a primary adjustment and is deemed to be an advance under section 92CE of the Act? Internationally, the secondary adjustment is either treated as deemed dividend or deemed advance. If it is treated as a deemed advance, it is expected to be returned within the prescribed period. The Indian law is treats the amount as deemed advance. Further, the deeming fiction can apply only for the purpose for which it has been created. In case, the deemed advance is not repatriated within the prescribed time, it would entail a secondary adjustment by way of interest at prescribed rate. Therefore, it can be argued that since there was no advance de facto but it is a deemed advance, the same would not fall within the ambit of deemed dividend.

  • Treatment of excess amount repatriated by non-resident AE in the books of accounts of the Indian entity  

Assuming the foreign AE repatriates the excess amount to the Indian entity within the prescribed period, would that be taxable in the hands of the Indian entity? Assuming the amount was claimed as an expense by the Indian entity in an earlier year (which was subject to ALP adjustment), the receipt would have to be accounted for as an income or reversal of earlier expenses. Anyway, the same would be a credit entry in the profit and loss account of the Indian entity. Since the same is arising out of the primary transaction entered into between the AEs, it is likely that the tax officer may take a view that it is a remission of liability and is taxable under section 41 of the Act. This issue has to be addressed, so that the repatriated amount is not subject to tax under the normal provision of the Act. Further, the book profit is also likely to be increased due to the credit in the profit and loss account. There should be a provision to allow for reduction of book profits too so that the book profit is not impacted by the repatriation of the excess money by the foreign AE.

  • Secondary adjustment and WHT

The meaning of interest under the domestic law defines it as “interest means interest payable in any manner in respect of any moneys borrowed or debt incurred (including any deposit, claim or other similar right or obligation) any includes any service fee or other charge in respect of the moneys borrowed or debt incurred or in respect of any credit facility which has not been utilized.” It may be argued that the interest payable by way of secondary adjustment is as a result of deemed advance and therefore it does not fall within the ambit of interest as defined above since there is no debt incurred or moneys borrowed by the AE.

  • Avoidance of double taxation arising from secondary-adjustment

Since the secondary adjustment is not covered by Article 9 of the treaties, tax neutralization may not be automatic and may involve MAP proceedings or international arbitration.

  1. Conclusion

Based on the above, it would interesting to see how the laws in India relating to secondary adjustment develops and the various issues relating to secondary adjustments (some of which are discussed above) are dealt with and addressed. Would it become another vexatious issue and lead to more complications, only time will tell.

Mr Arijit Chakravarty is a LL.B., CPA(USA) and FCA. He is a Senior Principal at Advaita Legal. Ms Gohan Raj is a qualified Taxation Technician from the Association of Tax Technicians, U.K. She has also completed her B.Sc. (Hons.) in Mathematics from University of Manchester.

Bar and Bench - Indian Legal news