In this final and concluding Part on valuation under GST we look at the valuation rules approved by the GST Council as compared to the draft rules released earlier, the interplay between the valuation rules and rules for input tax credit and finally the consequential impact under GST arising from adjustments under transfer pricing provisions of Income-tax.

Revised Valuation Rules: 

The GST Council has recently approved the revised Valuation Rules. The important changes as compared to the earlier draft version dealt in Part I are:

1. A new proviso has been inserted to Rule 2 dealing with value of supply of goods or services or both between distinct or related persons, other than agent, and it reads as under:

“Provided that where goods are intended for further supply as such by the recipient, the value shall, at the option of the supplier, be an amount equivalent to ninety percent of the price charged for the supply of goods of like kind and quality by the recipient to his customer not being a related person”.

2. Rule 9 inserted to prescribe method to determine tax value for a supply inclusive of tax.

3. The proviso for enabling declared value to be deemed open market value where recipient is entitled for full tax credit is retained.

The new proviso to Rule 2 is a welcome move. This is better explained by below illustration

Illustration 1: ABC Ltd a detergent manufacturer has a manufacturing unit in Gujarat and it makes an interstate stock transfers of free samples to its depot in Maharashtra. The depot supplies the goods through distributors within the State of Maharashtra. The depot invoices the distributors for a supply of standard pack at Rs 100. The cost of manufacture of standard pack is Rs 70 per piece. What are the various valuation options available to ABC Ltd for valuation of free samples. 

The manufacturing unit in Gujarat has the following options of valuation

a. Open market value i.e. Rs 100; or

b. 90 percent of the value charged by the depot i.e. Rs 90.

Since the depot will not be eligible for credit on such stock transfers, valuation on 90 percent basis would be adopted. Had this provision not been there the valuation for stock transfer in the case of free samples would have been at full open market value and not at ninety percent of such value. This would partly reduce the cost as free samples are not eligible for input tax credit. The manufacturing unit cannot charge GST on a declared value it chooses under the other proviso to Rule 2 of valuation rules as depot will not be entitled for full input tax credit on free samples.

Interplay between valuation rules and conditions for claiming input tax credit:

We have seen in Part I of this article that one of the condition to claim input tax credit i.e. requirement of payment of value of supply along with the tax payable thereon within a period of one hundred and eighty days from the date of issue of invoice, and how impractical this can turn out to be in the case of stock transfers.

The input tax credit rules approved by the GST Council has addressed this issue. A new Proviso to Sub Rule 1 of Rule 2 of input tax credit rules has been inserted. It provides that the value of supplies made without consideration as specified in Schedule I shall be deemed to have been paid for the purposes of the second proviso to sub-section (2) of section 16.  This a welcome move and all stock transfers would be eligible to take full credit without any link to payment, which otherwise was impractical. However, this still does not address the issue where there is an exchange or barter of goods as book adjustment is not considered as payment.

Under current service tax law, Explanation (c) to Section 67 of Finance Act, 1994 provided that “gross amount charged includes payment by cheque, credit card, deduction from account and any form of payment by issue of credit notes or debit notes and book adjustment, and any amount credited or debited, as the case may be, to any account, whether called “Suspense account” or by any other name, in the books of account of a person liable to pay service tax, where the transaction of taxable service is with any associated enterprise”. Such a provision covering goods or services or both is missing in GST. This is better explained by below illustration.

Illustration 2: ‘ABC ltd’ buys laptops from a dealer ‘Y’ for Rs. 10 Lakhs along with exchange of old laptops. The value of the old laptops as agreed between both the parties is Rs 1.5 Lakhs. How does the requirement under second proviso to sub-section (2) of section 16 apply for the supplies involved in this transaction?

There are two supplies in this transaction one a supply of old laptops by ‘ABC ltd’ to ‘Y’ for Rs 1.5 lakhs and second a supply of new laptops by ‘Y’ ltd to ‘ABC ltd’ for a value of Rs 11.5 lakhs.  Accordingly, invoices will be issued by each party. To claim input credit both the parties as recipients of supply must pay invoice value including the tax within specified time. As per the contractual arrangement ‘ABC ltd’ will be paying 10 lakhs to ‘Y’ in money along with exchange of old goods and ‘Y’ will set off such value of old goods and take the balance in money and would not be paying anything in money to ‘ABC ltd’. Literal interpretation of second proviso to Section 16(2) means that ‘ABC ltd’ and ‘Y’ will not be able to claim input tax credit included in a value of Rs 1.5 lakhs. The tax value included therein would be worked out as per the Rule 9 of the valuation rules.

This issue will arise in all supply transactions not fully in money involving exchange or barter of goods.

Transfer pricing adjustments and consequential impact under GST:   

Can a transfer pricing adjustment, primary and secondary adjustments, under the Income-tax Act have an impact on GST?  Before we analyse the impact under GST let’s briefly look at what these adjustments are.  Where a transaction with an Associated Enterprise (AE) is not undertaken at arm’s length price a primary adjustment, either suo-moto or by the transfer pricing officer (TPO)- made by way of increasing in taxable profit or reduction in losses equivalent to such adjustment, to reflect the arm’s length price in the transaction price with the AE.  Primary adjustment does not seek to correct the cash position This is best explained by the following example.

‘I Co’ an Indian Company buys from ‘F Co’ its Holding Company in USA goods for USD 10 million. The arm’s length price for the import of goods is determined by the TPO to be at USD 8 million. TPO makes an adjustment to the taxable profits of I Co by reducing cost of goods by USD 2 million. This is called primary adjustment. The primary adjustment does not correct the cash position it only ensures that there is correct allocation of taxable profits among the two tax jurisdictions. Had the transaction been at arm’s length price I Co would not have paid the excess cash. Secondary adjustment seeks to correct such imbalance between cash and actual profit. Secondary adjustment can take form of constructive dividend or equity distribution or loan.

Finance Act 2017 has amended the transfer pricing provisions to introduce the concept of secondary adjustment. Secondary adjustment is made only where there is a primary adjustment and takes the form of a constructive loan. The excess cash of USD 2 million retained by ‘F Co’ is recorded in the books of ‘I Co’ and is considered as loan by 'I Co’ to ‘F Co’. Interest on the same shall be computed and added to profits of ‘I Co’ till the excess money is repatriated back to India. Secondary adjustment is made where the primary adjustment is more than 1 crore and is in respect of Financial Year commencing on or after April 16.

Apparently transfer pricing adjustments do have an impact from GST perspective and one cannot ignore the relationship between an Arms’ length price under transfer pricing provisions and value of supply under GST.  A primary adjustment was always considered as an adjustment to taxable profits for taxing the correct allocable profits and correspondingly no adjustment under indirect taxes was considered necessary or was viewed as an actionable claim not requiring any revisit to the valuation under the indirect taxes. However, the introduction of secondary adjustment, which seeks to correct cash imbalance where a transaction with Associated Enterprise is not at arm’s length by way of recording in the books the excess cash and treat such claim as advance given, might throw up characterization issue and potential litigation under GST especially on export of services as one of the condition for qualifying as export of services is that money should be received (section 2(6)(iv) of IGST Act). Moot question is whether a transfer pricing adjustment is an actionable claim under GST or a short fall in transaction value of supply?  The impact of transfer pricing adjustments from GST perspective is better explained by the following illustrations[1].

Illustration 3: ‘ABC ltd’ is granted during F.Y 17-18 right to use technical know-how by its AE for a consideration of royalty at 3% on net sale of goods in India and Emerging markets manufactured using the technology.  A royalty of USD 5 million @ 3% was paid during F.Y 17-18 on which under reverse charge a GST of USD 0.9 million at the rate of 18% was paid. The GST paid was an eligible input credit and was accordingly adjusted towards the output tax in sales in India and balance was claimed as refund. However, the transfer pricing officer after 3 -4 years re-determines the arm’s length price of the technology transfer as a royalty at 2% only and accordingly 1% excess royalty was disallowed. Further a secondary adjustment for excess royalty of 1% as loan receivable from AE is also made.  Is there a corresponding impact from GST perspective?

We have a situation where a law differs on transaction value from another law for the same transaction. If the GST paid by ‘ABC ltd’ can be utilized or is refunded, ‘ABC ltd’ may not revisit the accepted valuation under GST though it may be in excess as compared to the transaction value under transfer pricing provisions. It might continue with two different valuations under two different laws. Since always the valuation under GST would be higher the GST authorities might not question the valuation.

Issue would arise where such GST paid is ineligible, say used for exempt supply; ABC ltd would try to align with transfer pricing provisions. However, this may be litigated under GST as all along a valuation on 3% royalty basis was offered. Further even if ‘ABC ltd’ tries to amend the contract to align with the arm’s length price by TPO i.e. 2% Royalty rate, its AE may not agree as the same may not be commensurate with its TP study and transfer pricing provisions in its country.   

Illustration 4: ‘ABC ltd’ provides ITES services to its AE on a cost plus 12% basis. The Transfer Pricing Officer rejects the same and determines the Arm’s length price at cost plus 15%. ABC ltd disputes the same and the matter at ITAT level is also decided against ABC ltd. It decides not to pursue further. Accordingly, AO issues consequential order giving effect to the ITAT order with primary and secondary adjustments. The AE doesn’t agree to repatriate back the additional cost plus 3%. Consequently, interest on such amount is added back to the taxable profits.  what is impact from GST perspective?

From a GST valuation perspective export of services would have been accepted on a cost plus 12% basis.  Considering the AO order GST authorities might revisit the export value under GST and consider the additional 3% also as a supply of service but not necessarily a zero-rated supply as one of the condition under Section 2(6) dealing with definition of export of service is not met i.e. payment in convertible foreign exchange. Would this trigger consequential GST on the additional value of cost plus 3% along with interest and penalty?

Can it be argued that this additional amount to be claimed from AE is an actionable claim and hence by entry no 6 in Schedule III to the CGST Act is neither a supply of goods nor services and no GST can be levied? The introduction of secondary adjustment makes the issue more complex. The difference between the original transaction value and the arm’s length price as determined by the TPO must first has to be recorded as income in the books and as it remains unpaid at the time the entry is made it gets characterized as an advance given to AE. Does this mean that under GST the additional claim gets characterized as an amount due for supply and not a transaction in money or actionable claim?  Is this to be reported in the GSTR 1 as a supply of service?

Since the value of supply of service to AE is within the Rule 2 of Valuation rules of GST the additional claim should be ideally characterized as transaction in money or actionable claim and hence should not trigger any GST. Whether this would be the position under GST law is something that we will have more clarity in years to come. The additional claim arising because of transfer pricing adjustment would create issue of characterization more for export of services and not so much for goods; as unlike for export of services there is no requirement to get money in convertible currency for export of goods to be zero rated.   

Illustration 5: ‘F Co’ a Korean company manufacturer TV under the brand name ‘X’. ‘F Co’ licensed distribution rights to ‘I Co’ its Indian subsidiary. ‘I Co’ imports product ‘X’ from ‘F Co’ at USD 750 per unit and sells them in India at Rs 65,000. ‘I Co’ incurred an expense of Rs 250 crores towards advertisement, marketing and promotion expenses (AMP). ‘I Co’ benchmarked its imports under TNMM method. The operating margin is at 10% as compared to 8% for the comparable. The AMP to sales ratio of ‘I Co’ is 10% as compared to 3% for comparable. The TPO subjects AMP expenses to bright line test and considers non-routine AMP expenses as a separate international transaction. Accordingly makes primary adjustment of Rs 165 crores being excess AMP of Rs 150 crores with a mark-up of 10%. What is the impact under GST?

Here the TPO by applying bright line test determines excess AMP of Rs 150 crores and concludes that such excess expenses were primarily incurred for brand building activity for ‘F Co’. ‘I Co’ would have to record this adjustment in its books. The place of supply for such independent service of brand building activity by I Co to F Co would be Korea. In other words, there is an export of service by ‘I Co’ to ‘F Co’ for a value of Rs 165 crores which is not recorded in the books. The questions that might arise and consequential impact under GST are same as discussed in illustration 4 above. 

One finer aspect that needs to be further considered and differentiated is how the TPO makes adjustment for the excess AMP, is it by way of adjustment to the cost of goods imported or as a separate international transaction of service for which no consideration is received from the AE. The former from a GST perspective would be a situation of higher IGST on import and apparently has lesser impact under GST as compared to the latter.   

Further Section 92A (2) of the Income Tax Act specifies various situations under which two enterprises shall be deemed to be associated enterprises. Section 2(12) of the CGST Act defines “associated enterprise” -shall have the same meaning as assigned to in section 92A of Income Tax Act, 1961. There is no reference to such deeming relationship either in Section 15 of the CSGT Act nor in the GST valuation rules and rightly so such arrangements would not be subjected to valuation rules.

However, on the other hand Section 92B (2) of Income Tax Act can throw up challenges under GST. This is better explained by the below example.

‘F Co’ a UK entity is the holding company of Indian Company ‘I Co’. It supplies raw material to ‘I Co’ under a contract manufacturing arrangement and such arrangement is subjected to transfer pricing. The goods produced by ‘I Co’ using the raw material imported from ‘F Co’ are sold to ‘ABC ltd’ - another Indian entity but not a group entity of ‘F Co’, an unrelated party at a price as agreed between “F Co’ and ‘ABC ltd’. Section 92B (2) of the Income Tax Act brings the transaction between ‘I Co’ and ‘ABC ltd’ also within transfer pricing provisions as it is influenced by ‘F Co’ a related party of ‘I Co’.

Under GST the supply by ‘I Co’ to ‘ABC ltd’ is not a supply to related party and hence would not be subjected to valuation rules and transaction price is the price on which GST will be levied by ‘I Co’. The issue is if after 3 to 4 years any upward adjustment to the supply price between ‘I Co’ and ‘ABC ltd’ under the transfer pricing will have an impact under GST? Though under transfer pricing any upward adjustment of the supply price under TP would be made to the import price of goods by ‘I Co’ from ‘F Co’, the GST authorities may take a different position and consider the adjustment as an adjustment to transaction price between ‘I Co’ and ‘ABC ltd’ and seek additional GST with interest and penalty from ‘I Co’ for such shortfall.

Overall a great effort was made by the Government and GST council for putting in a simpler and less complex valuation rules. Industry should find it easier to follow and comply with. As we progress in GST the finer refinements would always happen to take care of any concerns in practical application of these rules.