"We charge our UK parent whatever is convenient": What arm's-length pricing actually requires

"We charge our UK parent whatever is convenient": What arm's-length pricing actually requires

A founder running the Indian subsidiary of a UK software company invoices the parent ₹40 lakh a year for "development services" — a number picked because it roughly covers salaries plus a small margin. Another founder lets the Singapore holding company charge the Indian entity a ₹1 crore "management fee" to move profit out of India before the March close. Both believe this is an internal family matter that nobody outside the group cares about. Both are one transfer-pricing audit away from a primary adjustment, a 200% penalty, and a directors' report that failed to disclose what the Companies Act required. When your Indian private limited company transacts with a foreign parent, subsidiary, or fellow group entity, the price is not yours to set by convenience — it is set by law, and two separate laws are watching.

What the law actually requires

Two distinct regimes govern a transaction between your company and a related foreign entity, and founders routinely satisfy neither.

The first is the transfer-pricing code under the Income-tax Act, 1961, Sections 92 to 92F. Section 92 requires that any "international transaction" between "associated enterprises" be computed having regard to the arm's-length price — the price that would have been agreed between unrelated parties in comparable circumstances. Section 92A defines an associated enterprise: broadly, an enterprise that participates in the management, control, or capital of the other. A foreign parent that holds 26% or more of your voting power, that advanced loans exceeding 51% of your book value of assets, or that guarantees 10% or more of your borrowings is an associated enterprise. Section 92B defines "international transaction" to cover the sale of goods, provision of services, lending or borrowing, cost-sharing, and intangibles — so software development billed to a parent, a management fee paid to a holding company, an intra-group loan, and a royalty all fall inside it.

Section 92C prescribes the methods for arriving at the arm's-length price: Comparable Uncontrolled Price (CUP), Resale Price Method, Cost Plus Method, Profit Split Method, Transactional Net Margin Method (TNMM), and "such other method" as prescribed under Rule 10AB. You do not get to invent a number; you select the most appropriate method and document why. Section 92CE adds the secondary adjustment — where a primary adjustment exceeds ₹1 crore, the excess money that ought to have come to India but did not is treated as a deemed advance, on which notional interest is charged until repatriated.

The second regime is the Companies Act, 2013, Section 188 read with Rule 15 of the Companies (Meetings of Board and its Powers) Rules, 2014. A transaction with a foreign parent or subsidiary is almost always a related party transaction because the counterparty is a "related party" under Section 2(76) — a holding, subsidiary, or associate company. Section 188 requires Board approval (and, above prescribed thresholds, a shareholders' resolution) for specified transactions unless they are both in the ordinary course of business and at arm's length. That arm's-length qualifier is the bridge between the two laws: if your pricing is not defensibly arm's length, you lose the Section 188 exemption and needed approvals you never obtained.

Layered on top, if the foreign entity is remitting or receiving money, FEMA and the RBI's transfer-pricing expectations apply, and every such transaction must also be disclosed in Form AOC-2 attached to the Board's report under Section 134(3)(h).

Practical implications

Ignoring arm's-length pricing does not produce a polite query. It produces a cascade of adjustments and penalties.

If the Transfer Pricing Officer concludes your ₹40 lakh development invoice should have been ₹65 lakh, the ₹25 lakh difference is added to your taxable income as a primary adjustment under Section 92C — you pay corporate tax on income you never received. Because that adjustment arises from an international transaction, penalty exposure follows under Section 270A for under-reporting (50% of tax) or misreporting (200% of tax on the under-reported income). Where the arm's-length price itself is found to have been misstated, Section 271AA imposes a penalty of 2% of the value of each international transaction for failure to keep or furnish prescribed documentation, and Section 271G adds a further 2% for failing to produce documents the officer demands.

Documentation is not optional above a size threshold. Under Section 92D read with Rule 10D, if the aggregate value of your international transactions exceeds ₹1 crore in the year, you must maintain the prescribed transfer-pricing documentation. Separately, Section 92E requires an accountant's report in Form 3CEB, certified by a chartered accountant, to be filed for every company with an international transaction — regardless of value — by the due date (30 November of the assessment year). Missing Form 3CEB triggers a flat ₹1 lakh penalty under Section 271BA.

On the Companies Act side, a Section 188 transaction entered without the required Board or shareholder approval is voidable at the option of the Board, and the director or employee who authorised it can be required to indemnify the company for any loss. For a listed entity the penalty runs to ₹25 lakh, and for others up to ₹5 lakh under Section 188(5). And because AOC-2 disclosure is part of the annual filing package, an omission surfaces directly in MCA21 v3, whose validation and scrutiny layer increasingly cross-references AOC-4 financials against declared related-party dealings — a mismatch between a large intra-group balance in your financials and an empty AOC-2 is exactly the kind of anomaly the system is built to flag.

Step-by-step: what to do

• Map your associated enterprises. List every foreign entity that holds 26%+ of your voting power, lends you money above the 51% asset test, or shares common control. Each is an associated enterprise under Section 92A.
• Inventory every international transaction. Services billed either way, royalties, management or cost-sharing fees, intra-group loans and guarantees, and any sale of goods or intangibles. Total the annual value.
• Benchmark before you invoice, not after. For each transaction, select the most appropriate method under Section 92C (TNMM and CUP are the usual workhorses) and build a comparables set. A cost-plus markup on captive software development, for instance, should reflect what independent development shops actually earn.
• File Form 3CEB by 30 November. This is mandatory for any company with even a single international transaction, irrespective of the ₹1 crore threshold. Engage your CA early.
• Maintain Rule 10D documentation if aggregate international transactions cross ₹1 crore — the FAR analysis (functions, assets, risks), method selection rationale, and comparables. Keep it contemporaneous.
• Route it through the Board. Pass a Section 188 Board resolution recording that the transaction is in the ordinary course and at arm's length; obtain a shareholders' ordinary resolution if Rule 15 thresholds are crossed.
• Disclose in AOC-2 and attach it to the Board's report, so your Companies Act filing and your tax position tell the same story.
• Reconcile annually. Before the March close, check that the profit margin your Indian entity actually earned matches the benchmark — do not let a "convenient" management fee strip the subsidiary below its arm's-length return.

FAQ

Is Form 3CEB required even if my only international transaction is a small ₹5 lakh fee from my parent?
Yes. Section 92E and Form 3CEB apply to every international transaction with no minimum value. The ₹1 crore threshold only governs the heavier Rule 10D documentation, not the Form 3CEB filing. Skipping it invites a ₹1 lakh penalty under Section 271BA.

My foreign parent owns 100% of the Indian company. Isn't this just internal group money?
No. Wholly-owned status makes the parent an associated enterprise, which is precisely what brings the transaction inside Sections 92–92F and Section 188. Full ownership increases scrutiny; it does not exempt you.

What is the difference between a primary and a secondary adjustment?
A primary adjustment adds the shortfall to your taxable income. A secondary adjustment under Section 92CE applies where the primary adjustment exceeds ₹1 crore: the money that should have flowed to India but did not is treated as a deemed advance to the foreign party, attracting notional interest until it is actually repatriated.

Can a Board resolution alone satisfy the arm's-length requirement?
No. The Section 188 resolution records your position, but "arm's length" is a factual and economic test under the Income-tax Act. Without a benchmarking study and Form 3CEB, a Board resolution asserting arm's length is an unsupported claim a Transfer Pricing Officer can reject.

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