Directors' fees pose transfer pricing challenge for companies

India Inc, which has to comply with domestic transfer pricing provisions for the first time since the norms were introduced by the Finance Act, 2012, faces compliance challenges. The top-most concern is substantiating that directors' fees paid by companies are at an 'arm's length' — which refers to a true unbiased value.
 

The problem arises because transfer pricing provisions are based on establishing comparability. To illustrate, remuneration received by Reliance Industries chairman Mukesh Ambani is bound to be vastly different from what his counterpart at Wipro, Azim Premji, is paid. It also cannot be compared with director's remuneration paid by a medium-sized private company.

Fees payable to a director by a company depends on many factors such as the director's role and responsibility, experience, the size and area of operation of the company, performance of the company and performance of the industry (see table for examples). "Any kind of payment such as salary, commission, sitting fees, various allowances to any director - be it a comprehensive remuneration package to a chairperson or sitting fees running into a few thousand paid to an independent director — are all covered by domestic transfer pricing provisions. Benchmarking of payments to directors is not an easy task," says Sanjay Tolia, partner, PWC.

Traditionally, transfer pricing applied to international transactions entered into by a company in India with related parties, such as its foreign parent company or overseas group companies. However, the Finance Act, 2012 expanded the ambit to cover domestic transactions entered into by a company with related parties, if the aggregate of such transactions in a year is over Rs5 crore.

Domestic transfer pricing provisions cover expenditure under section 40A(2) of the I-T Act, which includes payments to 'any' directors. India Inc now has to file with the tax authorities a transfer pricing report, containing various details of both international and domestic transactions and a transfer pricing study which demonstrates arm's length pricing.

"The burden is on the company to prove that payments to its directors are at an arm's length. Thus, comprehensive documentation of the roles and responsibilities of its directors should be undertaken to substantiate that such payment is commensurate keeping in view the benefits obtained by the company," says Rajendra Nayak, partner, E&Y.

"The starting point in the documentation process could be the internal policies that are in place for fixing director's remuneration - be it policies of the remuneration committee or of an HR department for listed companies or private companies. These policies would show that the director did not in any way influence his remuneration, which is based on independent guidelines," adds Tolia.

In addition, recourse can also be taken both by private and public companies to the provisions of the Companies Act, which lay down limits for payments to directors across various categories and also provide for individual ceiling parameters. The aggregate remuneration to all directors is restricted to 11% of the net profits of the company in a given year and that of a managing director is restricted to 5% of the net profits.

High courts in the past have held that a director's remuneration cannot be disallowed as a deduction from business profits for income tax purposes. "Remuneration which is within such limits should be accepted by the transfer pricing officers and also the government should consider this for safe harbour provisions and thus ease the compliance cost and burden," says Porus Kaka, senior advocate.

In case of promoter-directors, it may be more challenging to demonstrate that the remuneration was at an arm's length. "If a director is also a substantial shareholder (holding more than 20%), then a range of remuneration payable across comparable companies could in addition be relied upon to prove arm's length pricing of the director's fees," suggests Tolia.

For the fiscal 2012-13, which is the first year of applicability of these provisions, the deadline for transfer pricing compliance is November 30. As of now, India Inc has to live with these provisions - a 2% penalty against the transaction value is prescribed for incorrect reporting or failure to maintain transfer pricing documentation. There is an additional 2% penalty for failure to furnish documentation to the tax authorities during assessment.