The TP Adjustment That Cost a UK Company 3x

The Situation: A UK Engineering Firm's India Subsidiary

In 2023, a UK-based engineering services company with GBP 40 million in global revenue set up a wholly owned subsidiary in India. The subsidiary provided two functions: back-office engineering support for UK projects and direct engineering services to Indian clients. Annual revenue of the Indian subsidiary was approximately INR 18 crore (roughly GBP 1.7 million), with approximately 60% coming from intercompany services rendered to the UK parent and 40% from third-party Indian clients.

The intercompany pricing structure included three transaction categories:

• Management fees: The UK parent charged the Indian subsidiary INR 2.4 crore annually (approximately 13% of subsidiary revenue) for corporate overheads, HR services, IT infrastructure, and strategic management
• Royalty payments: The subsidiary paid INR 1.8 crore (10% of revenue) for use of the parent's proprietary engineering methodologies, software tools, and brand name
• Intercompany service charges: The subsidiary billed the parent INR 10.8 crore for engineering services at a cost-plus 12% markup

On the surface, these arrangements appeared reasonable. The management fee percentage was within ranges the company had seen in industry benchmarks. The royalty rate looked conservative against the rates the group had used in its other licences. The cost-plus markup for services was positive. The total transfer pricing structure left the Indian subsidiary with a pre-tax profit margin of approximately 8% — modest but defensible, or so the company believed.

The Assessment: What the Transfer Pricing Officer Found

The Indian subsidiary filed its income tax return for Assessment Year 2025-26 with a Form 48 (Transfer Pricing Audit Report) certified by a Chartered Accountant. The return reported total international transactions of INR 15 crore (management fees + royalties + intercompany services). There is no statutory value threshold for a Transfer Pricing Officer reference: under Section 166 of the Income-tax Act, 2025 (section 92CA of the Income-tax Act, 1961) the Assessing Officer may refer the determination of the arm's-length price to the TPO whenever he considers it necessary or expedient, with the previous approval of the Principal Commissioner or Commissioner. At this transaction value a reference is routine.

The Assessing Officer referred the case to the Transfer Pricing Officer (TPO) in January 2026. The TPO's examination revealed three critical failures:

Failure 1: Inadequate Documentation for Management Fees

The TPO challenged the INR 2.4 crore management fee on the ground that the subsidiary could not demonstrate tangible benefit received. Under Indian transfer pricing regulations and OECD Transfer Pricing Guidelines, management fees charged by a parent to a subsidiary must satisfy the "benefit test" — the subsidiary must demonstrate that it actually received services, that those services provided a tangible economic benefit, and that an independent enterprise in comparable circumstances would have been willing to pay for them.

The UK parent had allocated costs to the Indian subsidiary using a global allocation key (headcount-based). However, the subsidiary could not produce:

• Service-level agreements specifying the services to be provided
• Time sheets or activity logs showing services actually rendered
• Evidence that the subsidiary could not have obtained the services independently at a lower cost
• Board minutes or management reports showing how the subsidiary utilised the management services

The TPO applied the "need and benefit" test and determined that approximately INR 1.6 crore of the INR 2.4 crore management fee represented shareholder costs (costs the parent incurred for its own benefit as owner, not for the subsidiary's operational benefit). Shareholder costs are not arm's-length deductible under Indian law. The TPO allowed only INR 80 lakh as an arm's-length management fee — a 67% reduction.

Failure 2: Royalty Rate Exceeded Arm's-Length Benchmark

The subsidiary paid royalties at 10% of revenue for the parent's engineering methodologies and brand. The TPO rejected the company's Comparable Uncontrolled Price (CUP) method, which had relied on a single licence agreement between the UK parent and its Middle Eastern affiliate as the comparable. The TPO's objections were:

• The Middle Eastern licence was between related parties — it was not an uncontrolled transaction
• No external CUP (a comparable licence between independent parties) was provided
• The engineering methodology was not patented or registered as intellectual property in India — weakening the claim that it constituted licensable IP

The TPO applied the Transactional Net Margin Method (TNMM) instead, benchmarking the subsidiary's overall profitability against comparable Indian engineering companies. The TNMM analysis showed comparable companies operating at a median operating profit margin of 14-16%, while the subsidiary was reporting only 8% — suggesting the combined effect of management fees and royalties was compressing margins below arm's-length levels.

The TPO reduced the arm's-length royalty rate from 10% to 3% of revenue, citing the absence of registered IP and the subsidiary's ability to develop similar methodologies independently. This reduced the deductible royalty from INR 1.8 crore to INR 54 lakh — a 70% reduction.

Failure 3: Cost-Plus Markup Was Below Arm's-Length Range

The 12% cost-plus markup on intercompany services (subsidiary billing the parent) was below the arm's-length range identified by the TPO. Using TNMM with Indian engineering services companies as comparables, the TPO found that independent companies performing similar services earned a net markup of 18-22% on their operating costs. The TPO determined the arm's-length markup should be 20% of cost, not 12%.

On the same cost base of INR 9.64 crore, that restates the intercompany service billing from INR 10.80 crore to INR 11.57 crore, lifting total revenue of the Indian entity from INR 18.00 crore to INR 18.77 crore. Standing alone this looks like a win for the subsidiary — more revenue recognised in India. Combined with the management fee and royalty disallowances, it was devastating, because every rupee of it landed in the Indian tax base.

The Financial Impact: How 3x Happened

Here is the arithmetic of how the TP adjustment tripled the company's India tax cost:

The TP adjustment increased the subsidiary's taxable profit from INR 1.44 crore to INR 5.07 crore — a 3.5x increase in taxable income. The corporate tax liability increased from INR 36 lakh to INR 1.28 crore. But the story did not end with the tax adjustment.

The Penalty Exposure: Section 439

Under Section 439 of the Income-tax Act, 2025 (section 270A of the Income-tax Act, 1961), underreporting of income attracts a penalty equal to 50% of the tax payable on the underreported income, rising to 200% where the underreporting is in consequence of "misreporting". Two features of that section decide cases like this one.

There is a transfer-pricing shield, and this company forfeited it. Section 439(8)(d) (section 270A(6)(d) of the 1961 Act) provides that underreported income does not include an addition made in conformity with the arm's-length price determined by the Transfer Pricing Officer, where the assessee maintained the prescribed information and documents, declared the international transaction, and disclosed all material facts relating to it. A TP adjustment on its own therefore carries no penalty at all for a taxpayer whose documentation is in order. The penalty here was not the price of losing a pricing argument; it was the price of failing the documentation condition.

"Misreporting" is a closed list. Section 439(11) (section 270A(9) of the 1961 Act) sets the cases out in a closed list, which includes: misrepresentation or suppression of facts; failure to record investments in the books of account; claim of expenditure not substantiated by any evidence; recording a false entry; failure to record a receipt bearing on total income; and failure to report an international transaction to which Chapter X applies. Inadequate documentation is not, by itself, an item on that list. But an unsubstantiated management-fee deduction can fall within the "expenditure not substantiated by any evidence" limb, and that is the limb the department relied on here.

The TPO's order specifically noted that the company's documentation failed to meet the contemporaneous documentation requirements under Rule 10D of the Income-tax Rules, 1962 (made under section 92D of the Income-tax Act, 1961; from tax year 2026-27 the obligation sits in section 171 of the Income-tax Act, 2025 and the documents are prescribed by rule 84 of the Income-tax Rules, 2026). The draft assessment order proposed to treat the underreporting as misreporting on the following grounds:

• The CUP method relied on a related-party transaction as the comparable — a fundamental methodological error
• The management fee documentation lacked a benefit-test analysis
• Form 48 (formerly Form 3CEB) was filed with a transfer pricing report that did not work through each of the six prescribed methods before selecting the most appropriate one

On that basis the department's exposure calculation ran as follows. The classification is contested — see The Resolution below.

The original tax bill was INR 36 lakh. The total liability after TP adjustment, penalty, and interest was INR 1.28 crore (adjusted tax) plus INR 1.84 crore (penalty) plus INR 29 lakh (interest) = INR 3.41 crore. That is more than nine times the original tax liability, and roughly 3 times what the company had budgeted for even after allowing for its own estimate of a possible adjustment.

What Went Wrong: A Documentation Post-Mortem

This case was not lost because the intercompany pricing was inherently unreasonable. Many multinational enterprises charge management fees, royalties, and cost-plus service charges at comparable levels. The case was lost because the company failed to build a defensible documentation fortress. Here is what they should have done:

1. Contemporaneous Documentation Is Not Optional

Indian law requires transfer pricing documentation to be maintained contemporaneously — meaning it must be prepared at the time of the transaction, not retroactively when the TPO comes calling. Under Rule 10D of the Income-tax Rules, 1962 — which governs tax years up to FY 2025-26, the equivalent list for tax year 2026-27 onwards being prescribed by rule 84 of the Income-tax Rules, 2026 under section 171(1) of the Income-tax Act, 2025 — the documentation must include:

• A description of each international transaction, including the nature and terms
• A functional analysis of the parties (functions performed, assets used, risks assumed)
• A detailed analysis of each prescribed transfer pricing method
• Justification for why the selected method is the most appropriate
• Details of comparable transactions or companies, with adjustments for differences
• Financial data supporting the arm's-length range

The UK company had prepared a transfer pricing report, but it was a generic document adapted from a global template. It did not contain India-specific comparables, did not work through each of the six prescribed methods, and did not include a detailed functional analysis of the Indian subsidiary's actual operations.

Keep it, too. Rule 84(8) of the Income-tax Rules, 2026 requires the information and documents to be retained for nine years from the end of the relevant tax year. That is not an extra year of exposure: Rule 10D(5) of the 1962 Rules ran eight years from the end of the relevant assessment year, and because the anchor moved back a year the outer date is unchanged — the drafting was re-based, not lengthened.

2. The Benefit Test for Management Fees Requires Evidence

India's tax authorities apply a rigorous benefit test to intercompany management fees. The test requires demonstrating that:

• The services were actually provided (not just allocated)
• The services provided a tangible economic benefit to the recipient
• An independent enterprise would have paid for the services, or performed them in-house
• The charges are not for shareholder activities (strategic oversight, group reporting, investor relations)

Best practice is to maintain a service-level agreement, quarterly service delivery reports, time logs from parent company personnel, and evidence of actual benefit (e.g., cost savings, process improvements, risk mitigation) attributable to the management services.

3. CUP Requires a Genuinely Comparable Uncontrolled Transaction

The Comparable Uncontrolled Price method is considered the most reliable when a true comparable exists. But the comparable must be between independent parties, in a comparable market, with comparable terms. Using a related-party transaction as the CUP comparable was a fundamental error that immediately undermined the company's position. If no external CUP is available, it is better to use TNMM proactively and demonstrate that the overall profitability of the subsidiary falls within the arm's-length range.

4. Royalty Payments Need IP Substantiation

Indian TPOs are increasingly sceptical of royalty payments, particularly where the licensed IP is not formally registered or protected in India. To defend a royalty payment, the company should have:

• Registered the IP (patents, trademarks, copyrights) in India where applicable
• Prepared a valuation of the IP using accepted methodologies (income approach, cost approach, market approach)
• Demonstrated the economic benefit the subsidiary derived from the IP (e.g., revenue attributable to the brand, cost savings from proprietary methodologies)
• Benchmarked the royalty rate against arm's-length licence agreements between independent parties

How to Avoid This: A Transfer Pricing Defence Playbook

For any foreign company with an Indian subsidiary engaging in international transactions, here is the playbook to avoid a similar outcome:

Step 1: Engage India-Specific TP Advisors

Do not rely on a global TP report adapted for India. Indian TPOs apply Indian law, Indian comparables, and Indian judicial precedents. Engage a Big 4 or specialised Indian transfer pricing firm to prepare India-specific documentation annually. The fee scales with the number and complexity of the covered transactions, and is in almost every case a fraction of the penalty exposure from inadequate documentation.

Step 2: Prepare Documentation Before Year-End

Transfer pricing documentation must be contemporaneous. Start preparing during the financial year, not after it ends. The documentation due date aligns with the accountant's report deadline — October 31 of the assessment year, one month before the return due date. For FY 2025-26 (AY 2026-27), documentation must be ready by October 31, 2026. From tax year 2026-27 that report is Form No. 48 (formerly Form 3CEB) under rule 85 of the Income-tax Rules, 2026, and rule 85(2) states the one-month lead time in the rule itself. Failure to maintain documentation attracts a penalty of 2% of the value of each international transaction under Section 442 of the Income-tax Act, 2025 (section 271AA of the Income-tax Act, 1961).

Step 3: Apply the Most Appropriate Method Correctly

Section 165(1) of the Income-tax Act, 2025 (section 92C(1) of the Income-tax Act, 1961) prescribes six methods — CUP, Resale Price Method, Cost Plus Method, Profit Split Method, TNMM, and such other method as may be prescribed (the residual "other method") — and the most appropriate one must be selected from among them. The selection must be justified based on the nature of the transaction, availability of reliable data, degree of comparability, and extent of adjustments needed. Simply choosing CUP because it appears most direct, without testing whether genuinely comparable uncontrolled transactions exist, is a common and costly mistake.

Step 4: Consider Advance Pricing Agreements (APAs)

For recurring international transactions, consider applying for an Advance Pricing Agreement (APA) with the Indian tax authorities. An APA fixes the arm's-length price, or the manner in which it is to be determined, for a period not exceeding five consecutive tax years (section 168(4) of the Income-tax Act, 2025; section 92CC of the Income-tax Act, 1961), and it can be rolled back to cover up to four tax years preceding that period (section 168(9); section 92CC(9A) of the 1961 Act). Rollback is available for unilateral and bilateral APAs alike — it is not a bilateral-only feature. The programme is now at scale: CBDT signed a record 219 APAs in FY 2025-26, taking the cumulative total past the thousand mark to 1,034 — 750 unilateral and 284 bilateral (CBDT press release, 31 March 2026). The application is made in Form No. 51 (formerly Form 3CED) under rule 106 of the Income-tax Rules, 2026 and carries a flat fee of INR 20 lakh whatever the value of the covered transactions (rule 106(1) and (4)), not refunded if the application is withdrawn (rule 107(2)). The slab scale of INR 10 lakh / 15 lakh / 20 lakh belonged to Rule 10-I of the Income-tax Rules, 1962, so an applicant below INR 100 crore of covered transactions now budgets INR 20 lakh rather than INR 10 lakh. CBDT does not publish an average conclusion time, so plan an APA as a multi-year process rather than a quick fix.

Step 5: Build the Benefit-Test Evidence File

For management fees and service charges, maintain a running evidence file throughout the year. This should include service delivery reports, time tracking data, emails documenting service requests and deliverables, and quarterly benefit assessments. The cost of maintaining this evidence is minimal compared to the risk of a management fee disallowance.

Step 6: Leverage Safe Harbour Rules

India's Safe Harbour Rules give deemed arm's-length margins for specified categories of transaction: declare a transfer price at or above the notified margin and the income-tax authorities accept it. For tax year 2026-27 onwards, rule 89(2) of the Income-tax Rules, 2026 sets a single safe-harbour margin of 15.5% of operating expense for the provision of information technology services — software development, IT-enabled services, knowledge process outsourcing and software-related contract R&D together — where aggregate operating revenue from the transaction does not exceed INR 2,000 crore. Contract R&D relating to generic pharmaceutical drugs keeps a separate 24% of operating expense up to INR 300 crore, and the provision of data centre services enters as a new category at 15%. For FY 2025-26 and earlier tax years the position was different: 17% of operating expense for software development and IT-enabled services up to INR 100 crore of transaction value and 18% between INR 100 crore and INR 300 crore, with a knowledge-process-outsourcing ladder of 24% / 21% / 18% by employee-cost ratio and the transaction-value ceiling raised from INR 200 crore to INR 300 crore (Rule 10TD of the Income-tax Rules, 1962, as amended by Notification 21/2025). Two different multi-year periods apply, and they are not the same thing: the rate table itself is fixed for a block of three tax years from tax year 2026-27 (rule 89(4)), while for IT services the taxpayer's election, once validly made in Form No. 49, runs for five consecutive tax years (rule 91(1)), with the INR 2,000 crore threshold tested only in the first of them (rule 91(2)). If the subsidiary's transactions fall within a safe-harbour category, electing safe harbour removes the TP risk on those transactions — but a price accepted under safe harbour cannot then be taken to Mutual Agreement Procedure (rule 93).

The India-UK DTAA Dimension

The India-UK DTAA adds a layer of complexity to this case. Under Article 13 of the India-UK DTAA:

• Royalties: Can be taxed in India at a rate not exceeding 10-15%, depending on the category. Royalties for industrial, commercial, or scientific equipment are taxed at 10%; other royalties are capped at 15%
• Fees for Technical Services (FTS): Taxable in India at 10-15% under the DTAA, against 20% before surcharge and cess under domestic law (section 207(2) (Table, Sl. Nos. 1 and 2) of the Income-tax Act, 2025; section 115A of the Income-tax Act, 1961, doubled from 10% by the Finance Act 2023 with effect from AY 2024-25). Note that the treaty definition is narrower than the domestic one: Article 13(4) covers technical or consultancy services only — the word "managerial" does not appear — and only where they are ancillary to the licensed property or equipment, or "make available" technical knowledge, experience, skill, know-how or processes. A generic parent-company management charge will often fall outside it altogether
• Withholding tax: The Indian subsidiary was required to withhold tax under section 393(2) of the Income-tax Act, 2025 (Table, Sl. No. 17; section 195 of the Income-tax Act, 1961) on royalty and management fee payments to the UK parent. Failure to withhold correctly triggers additional liability under section 398 of the Income-tax Act, 2025 (section 201 of the Income-tax Act, 1961)

In this case, the subsidiary had been withholding tax at the DTAA rate on royalty payments. But with the TP adjustment reducing the deductible royalty, the previously withheld amounts now had to be reconciled — creating additional compliance complexity and potential short-withholding exposure on the management fee component that was reclassified.

For companies navigating UK-India cross-border transactions, see our UK country guide and our detailed guide on transfer pricing basics for foreign subsidiaries.

The Resolution

The Indian subsidiary — the eligible assessee, because the proposed variation follows an order of the Transfer Pricing Officer — filed objections against the draft assessment order with the Dispute Resolution Panel (DRP) under Section 275 of the Income-tax Act, 2025 (section 144C of the Income-tax Act, 1961) — the DRP route is an objection to a draft order, not an appeal against a completed assessment, and the objections must be filed within thirty days of receiving the draft order. The DRP cannot issue its directions later than nine months from the end of the month in which the draft order was forwarded. Simultaneously, the company initiated a Mutual Agreement Procedure (MAP) application under Article 27 of the India-UK DTAA to seek relief from potential double taxation — since the TP adjustment increased the Indian subsidiary's income, but the corresponding deduction in the UK remained unchanged, creating economic double taxation.

As of March 2026, the case is still with the DRP. However, based on the documentation gaps, the company's advisors estimate that the best realistic outcome is a partial reduction of the adjustment — not a full reversal. The expected final additional tax cost is 2-2.5x the original tax liability, even with successful appeals.

For companies facing similar situations, our tax advisory services and FEMA compliance services include transfer pricing documentation review and TPO assessment defence.

Key Takeaways

• Transfer pricing documentation is your first and last line of defence: The TP adjustment was not primarily about pricing — it was about the inability to prove the pricing was arm's-length. Contemporaneous, India-specific documentation is mandatory, not optional.
• Management fees face the strictest scrutiny: Indian TPOs regularly disallow a large part of an intercompany management fee — and sometimes all of it — when the subsidiary cannot demonstrate tangible benefit. Maintain service-level agreements, time logs, and benefit evidence throughout the year.
• Using a related-party transaction as a CUP comparable is fatal: The CUP method requires genuinely uncontrolled transactions between independent parties. If no external CUP exists, use TNMM proactively with India-specific comparables.
• Documentation is what stands between a TP adjustment and a penalty: Section 439(8)(d) takes a TPO-determined adjustment outside "underreported income" entirely where the prescribed documents were maintained, the transaction was declared, and all material facts were disclosed. Fail that condition and the 50% penalty is in play, and a deduction with no supporting evidence can be pushed into the 200% misreporting band. Penalty is not automatic and can be litigated — but the shield is only available to the well-documented.
• Advance Pricing Agreements remove TP risk for the transactions and years they cover: For recurring transactions of this size, the cost and elapsed time of an APA application are small compared with the penalty exposure from a failed TP assessment — and an APA can be rolled back over the four preceding tax years as well.