• Bhavya Bansal Goyal, CA

Non-Recognition in Transfer Pricing: “Substance over Form”


It has been aptly said "Substance is enduring, form is ephemeral”- Dee Hock. Under the Income-tax law, the principle of "substance over form" allows tax authorities to disregard the written contractual terms between parties, identify the true nature of the transaction, and recharacterize or disregard a transaction. This article discusses an important global issue of non-recognition and recharacterization in transfer pricing. With the ever-growing emphasis on "substance over form" and "commercial rationality" globally, there is an increased focus on the actual conduct and functions performed. In the time of the Covid pandemic, when profitability is impacted, it has become even more imperative to justify the commercial rationality of an international transaction.


Over years, there have been substantial developments in the jurisprudence of transfer pricing since the enactment of the transfer pricing rules in the Indian Income-tax Act in the year 2001. With thousands of court rulings on varied issues, transfer pricing legislature has truly evolved.

With the Base Erosion and Profit Shifting (“BEPS”) guidelines, evolution of e-commerce and globalisation of companies, significance of transfer pricing has increased manifold. Following the adoption of the final reports on Action Points 8 to 10 of the BEPS Action Plan, the Organisation of Economic Cooperation and Development (“OECD”) in its Transfer Pricing Guidelines 2017 (“TP Guidelines”) discusses when a transaction can be disregarded. The OECD TP Guidelines permit a transaction to be non-recognised only in exceptional circumstances as mentioned in paragraphs 1.122 to 1.125. The TP Guidelines also recognise that the non-recognition of transactions is controversial and can lead to double taxation. Paragraph 1.121 states that: “every effort should be made to determine the pricing for accurately delineated transactions under the arm’s length principle.”

The OECD TP Guidelines state that when tax authorities are considering non-recognition, “the key question is whether the actual transaction has the commercial rationality of arrangements that would be agreed between unrelated parties under comparable economic circumstances, not whether the same transaction can be observed between independent parties”. When non-recognition takes place, if a substitute transaction is appropriate, the transaction will be replaced by a structure that closely corresponds with the facts of the actual transaction and achieves a commercially rationally expected result arriving at an acceptable price for both parties. Therefore, a transaction can be disregarded entirely or be substituted by a notional transaction.

Substance over Form

The "substance over form" principle allows the tax authorities to recharacterize or disregard an international transaction. The principle becomes relevant in cases where tax authorities doubt whether the legal form of transaction varies from its actual substance. There have been multiple rulings across the globe that re-emphasize the need to document the actual conduct of the parties.[1] The issue has been gaining popularity in recent years given the recommendations arising from the BEPS project of the OECD. While the intercompany arrangements are the first step to understanding a transaction's legal form, the parties' actual conduct should reasonably be reflected in the transfer pricing documentation. Any inconsistency between the two can often lead to disputes in the context of transfer pricing.

Over the last several years, various courts in India and worldwide have examined the issue of recharacterization in the context of transfer pricing. The Mumbai Income Tax Appellate Tribunal (“ITAT”), in the case of Roche Products,[2] held "that tax authorities can recharacterize the transaction in accordance with its substance only when (1) the economic substance of the transaction differs from its form and (2) the form and substance are the same but the arrangement, in totality, differs from that which would have been adopted by the independent enterprise behaving in a commercially rational manner". The Bangalore ITAT in the case of Google India noted that the characterization of functions could not be based on merely terms of the contract or description of the services given by the assessee-company. It has to be determined having regard to the actual conduct of the parties.[3]

As can be gathered from the various court rulings across the globe, recharacterization in transfer pricing is commonly adopted by the first level tax authorities; however, a complete disregard of a transaction is still not very common. In the Indian context, non-recognition is discouraged by the ITATs and the High Courts (“HC”), if done without any prudent reasoning.

Rulings on the issue

The Delhi HC in the case of Cotton Naturals India Pvt. Ltd[4] rejected the tax authority’s attempt to recharacterize the interest rate on loan transaction by an Indian taxpayer to its foreign Associated Enterprise (“AE”). The HC also held that the commercial expediency as relevant to a transaction could not be ignored. The HC held, “17. Chapter X and Transfer Pricing rules do not permit the Revenue authorities to step into the shoes of the assessee and decide whether or not a transaction should have been entered. It is for the assessee to take commercial decisions and decide how to conduct and carry on its business. Actual business transactions that are legitimate cannot be restructured.”

Similarly, in the case of EKL Appliances Ltd[5], the Delhi HC referring to the OECD 2010 TP guidelines, stated that “the significance of the guidelines mentioned above lies in the fact that they recognize that barring exceptional cases, the tax administration should not disregard the actual transaction or substitute other transactions for them and the examination of a controlled transaction should ordinarily be based on the transaction as it has been actually undertaken and structured by the associated enterprises. It is of further significance that the guidelines discourage restructuring of legitimate business transactions ...As provided in the OECD guidelines, he is expected to examine the international transaction as he actually finds the same and then make suitable adjustments but a wholesale disallowance of the expenditure, particularly on the grounds which have been given by the TPO is not contemplated or authorised.”

Further, in various cases, the High Courts have upheld the ITAT's view that transfer pricing officer (“TPO”) had wrongly recharacterized the international transactions (Itochu India Private Ltd[6] and Aegis Limited[7]). However, in Mckinsey Knowledge Centre India Pvt Ltd[8] the Supreme Court (“SC”) dismissed McKinsey India’s SLP against the HC order. The HC had upheld ITAT’s recharacterization of research and information services rendered by McKinsey India to its AE as high-end knowledge-based research services.

In Sony Pictures Networks India Private Limited,[9] issue related to the recharacterization of distribution fee paid by assessee (distributor of channels) to its AE as 'Royalty'. Relying on the assessee's submission that it only acted as an intermediary between the broadcaster and ultimate customer who views the channel, and neither held any right in the content broadcasted over the channel nor any right to make any changes thereto, the ITAT held that distribution fee paid by assessee to its AE was not 'Royalty’.

Canada has specific provisions in the domestic law regarding recharacterization. In Canada vs Cameco Corp[10]., the recharacterization provision under the Canadian transfer pricing rule was interpreted. The Federal Court of Canada (“FCA”) has provided textual, contextual, and purposive interpretations of recharacterization. The same may have a high precedential value not only from a Canadian transfer pricing litigation perspective but also for different jurisdictions, while interpreting principles of recharacterization. In the case of Australia vs Glencore[11], it was held that the transaction should be restructured only if the economic substance of the transaction differs from its form.

In the case of ‘A’ Group Finland[12], the Supreme Administrative Court (“SAC”) rejected the recharacterization of intra-group financial restructuring sans tax avoidance allegation. Similar to EKL case of Delhi HC (supra), the SAC referred to OECD guidelines, 2010 which observes that administration should not disregard actual transactions or replace them with other transactions unless in exceptional circumstances. The SAC observed that under the domestic tax provisions of Finland, the tax authorities are not entitled to recharacterize the transactions of the taxpayer unless the tax authorities allege tax avoidance as a motive.

Concluding remarks

I wish to reiterate that there is an increased focus on whether the actual transaction possesses the "commercial rationality" of arrangements between unrelated parties under comparable economic circumstances. Many corporates have undertaken restructuring of their businesses in light of the ongoing COVID pandemic. Large multinationals often pursue business restructuring not only as a way to achieve tax advantages but in the pursuit of cost efficiencies, better control, and as a way to improve their business. However, when such a restructuring generates tax advantages, the contractual arrangements must also meet the economic substance of the transaction.

Though tax saving may not necessarily be the only driving force behind the way a transaction is structured, however, it may attract extra scrutiny from the tax authorities worldwide under transfer pricing tax laws in case it is not commercially prudent. In these uncertain times, it has become highly imperative to justify the substance of a transaction to avoid unwarranted transfer pricing adjustments.

[1]Netherlands vs Zinc Smelter B.V., March 2020, Court of Appeal; Denmark vs. Software A/S, September 2020, Tax Court; France vs. Piaggio, July 2020, Administrative Court of Appeal; [2] Roche Products (India) Private Limited [TS-154-ITAT-2016(Mum)-TP] [3] Google India Private Limited [TS-335-ITAT-2018(Bang)-TP [4] [TS-117-HC-2015(DEL)-TP] [5] [TS-206-HC-2012(DEL)-TP] [6] [TS-428-HC-2019(DEL)-TP] [7] [TS-65-HC-2019(BOM)-TP] [8] [TS-49-SC-2019-TP] [9] [TS-508-ITAT-2020(Mum)-TP] [10] February 2021, Supreme Court, Case No 39368 [11] May 2021, High Court, Case No [2021] HCATrans 098 [12] 2020, Supreme Administrative Court, Case No. KHO:2020:35 [TS-730-FC-2020(FIN)-TP]


Cite this Article : Bhavya Bansal Goyal , 'Non-Recognition in Transfer Pricing: “Substance over Form”' (Tax Terminal Blog, 21 August 2021) <https://www.taxterminal.in/post/non-recognition-in-transfer-pricing-substance-over-form>

Non-Recognition in Transfer Pricing “Substance over Form” - CA Bhavya Bansal Goyal
Download PDF • 207KB

Disclaimer - The views presented in this Article represent solely the views of the Contributor and do not in any way reflect or represent the views of the Organization with which the Contributor is associated.