APPORTIONMENT OF DEDUCTION AND ANTI-AVOIDANCE PROVISIONS Asif Kasbati FCA, FCMA & LLB

APPORTIONMENT OF DEDUCTION AND

ANTI-AVOIDANCE PROVISIONS

Asif KasbatiFCA, FCMA & LLB(Director Tax Services)A.F. Ferguson & Co. (A member firm of PwC network)

[email protected]

Karachi Tax Bar Association– August 19, 2011

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APPORTIONMENT OF DEDUCTION – Section 67 and Rule 13

(A) Reasonable Basis – Where an expenditure relates to – (a) the derivation of more than one head of income; or

(b) derivation of FTR income; or

(c) derivation of income chargeable to tax under a head of income and to some other purpose

The expenditure may be apportioned on any reasonable basis taking account the relative nature and size of the activities to which amount relates

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(B) Proration basis as per Rule 13

Rule 13(2) Any expenditure that is incurred for a

particular class or classes of income shall be

allocated to that class or classes, as the case may

be.

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Rule 13(3)(a) Any common expenditure allocation formula is A x B/C where – A. is the amount of the expenditure incurred; B. is the total amount gross receipts (without deduction

of expenditures) for the tax year for the class of income; and C. is the total amount gross receipts (without deduction

of expenses) and net gains for the tax year of all classes of income;

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Rule 13(3)(b) where, however, there is net gain, brokerage, commission and other income is to be taken into account on turnover of such transactions, such income shall be compared with gross profit from business for adopting figures for components “B” and “C” of the formula at (a) above.

Other income allocations issues for discussion.

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Rule (4) Where expenditures are to be allocated among different classes of income under sub-rule (3), consideration shall be given to the nature and source of each class of income, on reasonable basis to earn each class of income (particularly, in allocating selling expenses).

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Rule (5) Where the allocation of expenditures is made in accordance with sub-rule (3) {should be (4)} a certificate by the CA or CMA stating the basis of allocation shall be accepted unless significant variations are found; and where books are not required to be audited, the reasonable basis based on the sub-rule (3) and (4) may be adopted which would be accepted by Commissioner, unless variation is found. Significant variations would be beyond the limits of 10 + in collection as in sub-rule (3) under any head of account.

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Class of income means – (a)Pakistan-source income and foreign-source income chargeable under the head “Salary” (b)Pakistan-source income and foreign-source income chargeable under the head “Income from Property”; (c) Pakistan-source income and foreign source income chargeable under the head “Income from Business” (other than income subject to section 19);

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Class of income means –

(d) Pakistan-source income and foreign-source income from a speculation business chargeable under the head “Income from Business”;

(e) Pakistan-source income and foreign-

source income chargeable under the head “Capital Gains;

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(f) Pakistan-source income and foreign-source income chargeable under the head “Income from Other Sources”

(g) income exempt from tax; (h) chargeable to tax under section 5, 6 or 7;

and (i) amounts to which section 169 applies.

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Common expenditure means expenditure that is not clearly allocable to any particular class or classes of income, such as general administrative and other such allocable expenditures.

Case-law - Reasonable allocation VS Proration basis

Apportionment on the basis of Gross Profit (instead of turnover) is correct on a reasonable basis under section 67(1) and application of rule 13 is not compulsory (ITA No. 361/LB/09 dated December 3, 2009).

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RECHARACTERISATION OF INCOME AND DEDUCTION – Section 109(1) The Commissioner may –

(a) recharacterise a transaction or an element of a transaction that was entered into as part of a tax avoidance scheme;

(b) disregard a transaction that does not have substantial economic effect; or (c) recharacterise a transaction where the form of the transaction does not reflect the substance.

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RECHARACTERISATION OF INCOME AND DEDUCTION – Section 109

(2)Tax avoidance scheme means any transaction where one of the main purposes of a person in entering into the transaction is the avoidance or reduction of any person‘s liability to tax under this Ordinance.

(3)Discussion Tax Planning and Tax Avoidance

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TRANSACTIONS BETWEEN ASSOCIATES - Section 108

The Commissioner may, in respect of any transaction between persons who are associates (as defined in section 85), distribute, apportion or allocate income, deductions or tax credits between the persons as is necessary to reflect the income that the persons would have realised in an arm‘s length transaction.

For the above purposes, the Commissioner may determine the source of income and the nature of any payment or loss as revenue, capital or otherwise.

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TRANSFER PRICING – Rules 20 to 2721. Interpretation.- (1) In this Chapter,

(a) Comparable uncontrolled transaction, in relation to a controlled transaction, means an uncontrolled transaction that satisfies one of the following conditions, namely:-(i) the differences (if any) between the two

transactions or between persons undertaking the transactions do not materially affect the price in the open market, the resale price margin or the cost plus mark up, as the case may be; or

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(ii) if the differences referred to in sub-clause (i) do materially affect the price in the open market, the resale price margin or the cost plus mark up, as the case may be, then reasonably accurate adjustments can be made to eliminate the material effects of such differences;

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(b)Controlled transaction means a transaction between associates;

(c) Transaction means any sale, assignment, lease, license, loan, contribution, right to use property or performance of services;

(d) Uncontrolled persons means persons who are not associates; and

(e) Uncontrolled transaction means a transaction between uncontrolled persons.

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TRANSACTIONS BETWEEN ASSOCIATES - Section 108 22.The Commissioner may take guidance from international

standards, case law and guidelines issued by the various tax-related internationally recognized organizations.

23.Arm’s length standard.- a) the comparable uncontrolled price method;b) the resale price method;c) the cost plus method; ord) the profit split method.

The profit split method shall be applied only where the methods in clauses (a), (b) and (c) cannot be reliably applied.

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As between clauses (a), (b) and (c), the method that, having regard to all the facts and circumstances, provides the most reliable measure of the arm’s length result as in the opinion of Commissioner shall be applied.

Where the arm’s length result cannot be reliably determined under above 4 methods, the Commissioner may use any method provided it is consistent with the arm’s length standard.

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24. Comparable uncontrolled price method.- The comparable uncontrolled price method determines whether the amount charged in a controlled transaction gives rise to an arm’s length result by reference to the amount charged in a comparable uncontrolled transaction.

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25. Resale price method.-(1) The resale price method determines whether the amount charged in a controlled transaction gives rise to an arm’s length result by reference to the resale gross margin realized in a comparable uncontrolled transaction.

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(2) Steps to calculate arm’s length result under Resale price method

a) determine the price that a product purchased from an associate has been sold to a person who is not an associate (referred to as the “resale price”); and

(b) from the resale price is subtracted a gross margin (referred to as the “resale gross margin”) representing the amount that covers the person’s selling and other operating expenses and, in light of the functions performed (taking into account assets used and risks assumed), make an appropriate profit;

(c) from that amount is subtracted any other costs associated with the purchase of the product, such as customs duty; and

(d) the amount remaining is the arm’s length result.

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(3) The resale price margin of a taxpayer in a controlled transaction may be determined by reference to:-

a) the resale price margin that the taxpayer earns on products purchased and sold in a comparable uncontrolled transaction; or

b) the resale price margin that an independent person earns in comparable uncontrolled transaction.

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26. Cost plus method.- (1) The cost plus method determines whether the amount charged in a controlled transaction gives rise to an arm’s length result by reference to the cost plus mark up realised in a comparable uncontrolled transaction.

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(2) Steps to determine arm’s length result in cost plus method

a) determine the costs incurred by the person in a controlled transaction; and

b) to this amount is added a mark up (referred to as the “cost plus mark up”) to make an appropriate profit in light of the functions performed and market conditions; and

c) the sum of the amounts referred to in clauses (a) and (b) is the arm’s length result.

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(3) The cost plus mark up of a taxpayer in a controlled transaction may be determined by reference to:-

a) the cost plus mark up that the taxpayer earns in a comparable uncontrolled transaction; or

b) the cost plus mark up that an independent person earns in comparable uncontrolled transaction.

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27.Profit split method.- (1) The profit split method may be applied where transactions are so interrelated that the arm’s length result cannot be determined on a separate basis.

(2)The profit split method determines the arm’s length result on the basis that the associates form a firm and agree to divide profits in the manner that independent persons would have agreed on the basis that they are dealing with each other at arm’s length.

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(3) The Commissioner may determine the division of profits on the basis of a contribution analysis, a residual analysis or on any other basis as appropriate having regard to the facts and circumstances.

(4) Under contribution analysis, the total profits from controlled transactions shall be divided on the basis of the relative value of the functions performed by each person participating in the controlled transactions.

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(5) Under residual analysis, the total profits from controlled transactions shall be divided as follows:-a) each person shall be allocated sufficient profit to provide the person with a basic return appropriate for the type of transactions in which the taxpayer is engaged; andb) any residual profit remaining after the allocation in clause (a) shall be allocated on the basis of division between independent persons determined having regard to all the facts and circumstances.

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(6) The basic return shall be determined by reference to market returns achieved for similar types of transactions by independent persons.

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CASE-LAWS

(2007) PTD 1946 Kar HC-Cynamid Section 79 (pari materia to section 108) is applicable in the case where apparently assessee had not asked the Tax Department to supply information regarding the parallel raw materials.

(2009) 100 Tax 309 (Kar Trib)Distinguished the above case, if comparative information was sought but not provided by the Tax Department.

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CASE-LAWS

(1967) 15 Tax 56(Kar HC)

As per Natural justice, the Tax Department is supposed to provide full evidence of two or more comparable cases. It should not take the rate, which is against the assessee or less favourable to assessee.

1993 PTD 209 (Trib)

Principle of natural justice cannot be sacrificed at the altar of confidentiality inspite of section 216 of the 2001 Ordinance (pari materia to section 150 of the repealed Ordinance, 1979).

ISSUE - Transfer Pricing additions under Section 108 and

Apportionment under Section 67/Rule 13

THANK YOU

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APPORTIONMENT OF DEDUCTION AND ANTI-AVOIDANCE PROVISIONS Asif Kasbati FCA, FCMA & LLB