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TRANSFER PRICING
By CA. Deepender KumarDeepender Anil & Associates
Chartered Accountants
SEMINAR ON
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AGENDA Backdrop Transfer Price and Transfer Pricing Indian TPR Associated/Deemed Enterprises International Transactions Arm’s Length Price Various Methods To Compute ALP FAR Analysis Transfer Pricing Process Penalties Safe Harbor Rules Recent Circulars and Notifications
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BACKDROP
• Liberalization of trade and foreign exchange policy started in India in the year 1991
• This created huge increase in interest of MNEs in India• The Standing Committee in March 1991 observed that provisions of
Income Tax Act, 1961(Act) were inadequate to curb transfer pricing among MNEs
• The Expert Group constituted by Central Board Of Direct Taxes (CBDT) recommended complete revision of existing section 92 of the Act
• The Finance Act, 2001 introduced TPR in India by substituting existing Section 92 of the Act and introducing new sections 92A to 92F w.e.f April, 2001
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What Is Transfer Price?• When evaluations are based on profit, etc. we need to establish price for
internal transfers• “Transfer price is the price one subunit (department or division) charges for
a product or service supplied to another subunit of the same organization.” • Transfer prices can have a dramatic effect on the reported profitability of a
division but not on overall profit
What Is Transfer Pricing?• Transfer Pricing is a mechanism for the pricing of goods and services
between related entities, Tangible Goods Intangible Goods – trademarks, trade-names, patents Services – management, engineering, after-sales services
• Transfer pricing mechanism provide the conceptual framework for pricing intercompany transactions and ensuring an appropriate allocation of income between the various tax jurisdictions in which a multinational company operates.
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Indian TPR
• OECD TP Guidelines lays the foundation of the Transfer Pricing Regulation in India
• Section 92 - Income arising to “Associated Enterprises” from “International Transactions” (or Specified Domestic Transactions w.e.f AY 2013-14) shall be computed having regard to the “Arm’s Length Price”
• Preconditions: Two or more associated enterprises Enter into an international transactions Specified Domestic Transaction (w.e.f. AY 2013-14)
• Consequence: Income to be computed having regard to the arm’s length price
ASSOCIATED ENTERPRISESECTION 92A
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Associated/ Deemed Enterprises
Section 92A
• AE means direct or indirect participation in management control or capital: by one enterprise into another enterprise; or by the same person in both the enterprises
• Equity holding, Control of Board of Directors/ Appointment of one or more Executive Director, mutual interest will also constitute Associated Enterprise
• Either or both of Associated Enterprises should be non-residents
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• Deemed Associated Enterprises” includes:
– Holding of 26% of voting power by one enterprise into another enterprise; or by the same person in both the enterprises
– Dependence on intangible assets
– Sale of goods influence on price and conditions of supply by buyer
– Control by individual or his relative
– Financial transaction Loan - 51% or more of book value of total assets of the borrowing
enterprise Guarantee - 10 % or more of the total borrowings of an enterprise
INTERNATIONAL TRANSACTIONS
SECTION 92B
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International TransactionsSection 92B• Means “transaction” between 2 or more Associated Enterprises:
Transaction between two or more associated enterprises (at least one of which will be non-resident) of purchase, sale or lease of tangible and intangible property, provision of services, capital financing, cost sharing/cost contribution arrangements , or
affecting profits, losses, income, assets or liability of the enterprise
• The expression “International Transaction” has been amended by Finance Act, 2012 w.e.f 1.04.2002 and specifically includes: Inter-company Guarantees, Advance payments, deferred payments, receivables, Business restructuring / reorganisation, Purchase / sale/ use of intangibles such as customer lists, customer
contracts, customer relationships, Transfer / secondment of trained employees, etc.
ARM’S LENGTH PRICE
SECTION 92F(II)
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Arm’s Length PriceSection 92F(ii)• Arm’s Length Price means a “price which is applied or proposed to be
applied in a transaction between persons other than associated enterprises, in uncontrolled conditions”
• Arm’s length price can be determined by selection of most appropriate method from any of the following methods (Sec. 92C):– Comparable Uncontrolled Price Method– Resale Price Method– Cost Plus Method– Profit Split Method– Transactional Net Margin Method– Other Method as prescribed under Rule 10AB
• Where arms length price is within 3% range of the transaction price, no adjustment is warranted and the transaction price will be deemed to be the Arm’s Length Price. (5% range was applicable till A.Y.2012-13).
MOST APPROPRIATE METHOD
SECTION 92C(1)
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Prescribed Methods
Transfer Pricing Methods
Traditional Transaction Methods
Comparable Uncontrolled
Price
Resale Price Method
Cost Plus Method
Transactional Profit Methods
Profit Split Method
Transactional Net Margin
Method
Other Method
COMPARABLE UNCONTROLLED PRICE METHOD
RULE 10B(1)(A)
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CUP Method• CUP method can be applied where reliable data of similar uncontrolled
transaction between two unrelated parties or between related party and third party is available. Here, Prices are to be compared.
• Internal CUP
• External CUP
• Adjustments permitted for volume discount, geographical differences, etc.
Manufacturer A
Sale to related party B
Sale to non-related party C
Non-related party P
Non-related party Q
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Application of CUP Method
Identification of price charged or paid in comparable transaction(s)
Such price adjusted to account for differences if any between international transaction and uncontrolled transaction(s)
Adjusted price arrived above taken to be at arm’s length price
RESALE PRICE METHOD
RULE 10B(1)(B)
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RPM
• Compares the resale gross margin earned by AE, with gross margin of comparable independent distributors
• Comparable need not be in very same product• Software distributor compared with FMCG distributor• Difficult to use when processing is carried out before resale
Group Manufacturer (Eligible Unit)
Related Distributor (India)
Unrelated Wholesalers
INR 75 INR 100
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Application of RPM Method
Identification of resale price by tested party
Resale price reduced by normal gross profit with reference to uncontrolled transaction(s)
Such price reduced by expenses incurred (customs duty etc.) in purchase of the product/services.
This price may be adjusted to account for functional and other differences, if any. Adjusted price arrived above taken to be arm’s length price
COST PLUS METHOD
RULE 10B(1)(C )
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CPM• Used predominantly when AE works for another AE as contract
manufactures
• Typically applied to a contract manufacturer who: Does not bear risk of marketing Does not “normally” undertake high skill work
• May apply to contract manufacture, BPO, call centre, software developers, etc
Direct & Indirect Cost of Production
/ serviceALP = Comparable
Margin+
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Application of CPMIdentification of direct and indirect costs production incurred in tested party transactions
Identification of normal gross profit with reference to uncontrolled transaction(s)
Normal gross profit adjusted to account for functional and other differences if any
Adjusted gross profit added to total costs identified in step 1. Sum arrived above is taken to be at arm’s length price
PROFIT SPLIT METHOD
RULE 10B(1)(D)
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PSM• Generally applicable in case of transaction involving
Transfer of unique intangiblesOR
Multiple transactions which are interrelated not permitting separate evaluation
• Split global profit according to contribution of each AE.• There are two approaches to this method
Total Profits Split Residual Profit Split
US Co A – Technology intangibles
Mfg. Co BMkt Co C
Marketing intangibles
Outside India India
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Application of PSMDetermination of combined net profit of the associated enterprises arising out of international transaction
Evaluation of relative contributions by each enterprise on the basis of functions performed, risks assumed and assets employed
Splitting of combined net profit amongst enterprises in proportion to their relative contributions
Profit thus apportioned to the tested party is used to arrive at the arm’s length price
TRANSACTIONAL NET MARGIN METHOD
RULE 10B(1)(E)
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TNMM• Comparable Net profit adopted in relation to :
Costs incurred, or Sales effected, or Assets employed, or Any other relevant base.
• Ideally, operating margin should be compared to operating margin earned by same enterprise on uncontrolled transaction – Internal TNMM
Parent A Unrelated Cos.
Subsidiary B
Net margin 5%
Unrelated Cos.
Net margin 3%
Outside India
India
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Application of TNMMComputation of net profit as a percentage of a certain base realized from the international transaction
Computation of net profit realized by the tested party or an unrelated enterprise in a comparable uncontrolled transaction
Net profit from uncontrolled transaction adjusted to account for differences if any
The net profit thus established is taken into account to arrive at an arm’s length price for the international transaction
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Procedure for application
Selection of the tested party
Period of Comparison
Aggregation of Transactions
Identification of Comparable entities
Profit Level Indicators
Adjustment Calculations
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Selection of Tested Party
An entity for which net profitability of the controlled transactions is to be tested – may not necessarily be the taxpayer
An entity for which the reliable data on closely comparable transactions can be identified
Generally a least complex entity without its own intangibles or unique assets and which only performs the routine functions For e.g., a distributor, sales agent, contract manufacturer
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Period of Comparison
As per the IT Rules, multiple year data can also be used for comparability, in order to eliminate the accounting differences, product life cycles, varying businesses and discrepancies in short- tem economic conditions
The averages for the multiple year data can be simple average or weighted average depending upon the facts of each case.
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Aggregation of Transactions
Multiple transactions entered into by the enterprise which are so interlinked that they cannot be evaluated separately.
TNMM is applied by aggregating the such transactions with respect to closely linked products, similarity of functions, long- term arrangements, and intangible rights.
If aggregation using this criteria is not possible, then aggregation is done
on entity wide basis. However, it is preferred to aggregate the transactions at the most micro level to the extent it can reliably be analyzed
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Identification of Comparable
Internal or External comparison
External Comparison involves selection of comparable independent enterprise having similar FAR.
For external comparison the information which are available in public domain can only be used
• Two databases are basically considered to be reliable for selection of such comparable i.e. Prowess and Capitaline Plus
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Selection of Profit Level IndicatorAll of the profit-level indicators used in TNMM are based on operating
income, which is gross profit less operating expenses Overview of Various Profit Level Indicators
Return on Assets (ROA) Operating profit divided by the operating assets (normally only tangible assets)
Return on Capital Employed (ROCE)
Operating profit divided by capital employed which is usually computed as the total assets minus cash and investments
Operating margin (OM) Operating profit divided by sales
Return on Total Costs (ROTC) Operating profit divided by total costs
Return on Cost of Goods Sold Gross profit divided by cost of goods sold
Berry Ratio Gross profit divided by operating expenses
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Adjustment Calculations
Adjustment to comparable margin should be made to improve comparability. It shall be based on commercial practices, economic principles or statistical analyses.
Some familiar adjustments:• Working Capital• Depreciation• Custom Duty• Location Savings• Foreign Exchange
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SEGMENTAL PLI
• As the name of method suggest, “transactional net margin method” calculate net margin of only “international transactions” and not of whole enterprise unless all transactions are with AEs only
• Therefore, operating, non operating and extraordinary items are considered from the point view of international transactions only and from the point of view of enterprise
• Non-operating income and expenses does not form part of the cost or revenue for calculating segmental PLI even they are of normal and recurring nature
• Revenue and expenses which does not affect the earning of margin of the relevant segment relating to international transactions of which the comparison have to be made, have to be ignored.
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CALCULATION OF SEGMENTAL PLI
A. Segmental RevenueTotal revenue /sale Less non operative revenue/sale (As per nature of business) Less non segmental revenue /sale (As per nature of international transactions) Less extraordinary/abnormal revenue/sale (As per frequency and amount of transactions) Less revenue/sale relating to other years
B. Segmental costTotal Cost Less non operative cost (As per nature of business) Less non segmental cost (As per nature of international transactions) Less extraordinary/abnormal cost (As per frequency and amount of transactions) Less cost relating income which does not form part of segmental normal revenue
C. Segmental Margin (a-b=c)D. Segmental Margin % c/a% or c/b% (as the case may be)
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Strengths and Weaknesses
Strengths Net margins are less affected by
transactional differences than price and by functional differences than gross margins
Less complex functional analysis is needed
Applicable to either side of the controlled transaction (i.e.to either the related party manufacturer or the distributor)
The results resembles the results of a modified RPM or CPM analysis
Weaknesses Net margins are affected by
factors (e.g. variability of operating expenses) that do not have or have a less significant effect on price or gross margins
Information challenges, including the unavailability of information on profits attributable to uncontrolled transactions
Applied to only one of the related parties involved
OTHER METHOD -Sixth method notified by CBDT
RULE 10AB
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Other Method• CBDT has notified the “other method” vide a Notification and Rule 10AB has
now been inserted in the Income-tax Rules, 1962 (the Rules). Applicable from FY 2011-12.
• Rule 10AB describes the other method as “any method which takes into account the price which has been charged or paid, or would have been charged or paid, for the same or similar uncontrolled transaction, with or between non-associated enterprises, under similar circumstances, considering all the relevant facts.“
• “Other Method” refers to “price which has been charged or paid, or would have been charged or paid”. Effectively, this implies that under this “other method” “quotations” rather than prices “actually” charged or paid can also be used by the taxpayers.
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Possible Applicability Where the application of the five specific methods is not possible due to
difficulties in obtaining comparable data or due to uniqueness of transactions
Intangibles or business transfers, transfer of unlisted shares, sale of fixed assets, revenue allocation/splitting, guarantees provided and received, etc.
Possible third party references Third party quotations Valuation reports Commercial, economic, financial models etc.
Application of Other Method
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TP Method & Applicability
Method Comparability Requirements
Approach Application
CUP Very High Price Benchmarking Very difficult but most preferred method
RPM High GP based Price Benchmarking
Distributor
CPM High GP based Price Benchmarking
Manufacturer/Service Provider
PSM Medium Net Margin Benchmarking
Manufacturer/Distributor/Service
ProvidersTNMM Medium Net Margin
BenchmarkingManufacturer/
Distributor/Service Providers
FAR ANALYSIS
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• Functions Performed: Analysis of critical functions performed in controlled environment with function performed in uncontrolled transactions that add value to transactions hence fetch higher returns.
• Assets Employed: Analyzing assets employed in transaction in controlled environment by identifying the assets.
Type of assets– Capital – Tangibles– Intangibles
• Risks Assumed: Analysis involve identification of various risk assumed by each party in controlled transaction. Nature of Risk— Market Risk— Manpower Risk— Credit Risk— Technology Risk
TRANSFER PRICING PROCESS
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Identificationof intragrouptransactions
FAR Analysis
Identificationof comparabletransactions
Establishing comparability,adjustment for
material differences
Selection of mostappropriate
method
Determination ofALP
TP Adjustments
Documentation
Tax return filing
TP Assessment
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PENALTIESSections Default Penalty
271(1)(c ) In case of a post-inquiry adjustment, there is deemed to be a concealment of income
100-300% of tax on the adjusted amount
271AA Failure to maintain and furnish documents
2% of the value of transaction
271BA Failure to furnish accountant’s report INR 100,000
271AA Failure to report a transaction in accountant’s report
2% of the value of transaction
271G Maintaining or furnishing incorrect information or documents under 92D
2% of the value of transaction
SAFE HARBOR RULES
SECTION 92CB
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• Safe Harbor (“SH”) Rules shall be applicable for a period of five fiscal years (i.e., tax AY 2013-14 onwards) and SH do not apply to specified domestic transactions
• Safe Harbour Rules are the circumstances under which tax authorities automatically accept the transfer prices declared by the taxpayer
• Provides certainty and compliance relief• Could be in the form margin threshold or exclusion of certain classes of
transactions from TP regulations• Safe Harbour and Presumptive Taxation provisions (Similar in nature)• Taxpayer would still be required to maintain TP documentation and Form
3CEB
Introduction to Safe Harbor Rules
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S. No. International Transaction Condition
1 ITS and ITeS – Max INR 500 crores (Insignificant risk bearer) OP/ OC >= 20%
2 ITS and ITeS – Above INR 500 crores (Insignificant risk bearer) OP/ OC >= 22%
3 ITES – KPO services - Max INR 100 crores (Insignificant risk bearer) OP/ OC >= 25%
4 Intra Group Loan to WOS <= INR 50 crores Base rate on 30 June of PY (SBI) + 150 bsp
5 Intra Group Loan to WOS > INR 50 crores Base rate on 30 June ofPY (SBI) + 300 bsp
6 Explicit Corporate Guarantee to WOS <= INR 100 crores 2% or more P.A onamount guaranteed
7 Explicit Corporate Guarantee to WOS > INR 100 crores (WOSrated to be of adequate to highest safety)
1.75% or more P.A onamount guaranteed
8 Contract R&D for software development (Insignificant risk bearer) OP/ OC >= 30%
9 Contract R&D for generic pharmaceutical drugs (Insignificant risk bearer)
OP/ OC >= 29%
10 Manufacture and export of core auto components OP/ OC >= 12%
Recent Circulars and Notifications
Instruction No. 15/2015F. No. 500/9/2015-APA-II
Revised and Updated Guidance for Implementation of Transfer Pricing Provisions
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CBDT issues instruction No. 15/2015 replacing Instruction No. 3 dated May 20, 2003 to give guidance to AO and TPO regarding transfer
pricing assessments
1. Reference to Transfer Pricing Officer (TPO) AO must record his satisfaction as jurisdictional requirement, that there
is income/potential income arising from international transaction before proceeding to determine ALP on his own or making a reference to TPO, in following circumstances – (i) No accountant's report filed by assessee, but international transactions entered by assessee have come to the notice of AO;(ii) Taxpayer has not declared one or more international transaction in Form 3CEB which has come to AO's notice; (iii) where transaction is declared in Form 3CEB with qualifying remarks to the effect that such transaction is not international transaction or it does not have impact on taxpayers income
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In case no objection is raised by the taxpayer to the applicability of Chapter X [Sections 92 to 92F] of the Act, then the prima-facie view of the AO would be sufficient before referring the international transaction to the TPO for determining the ALP. However, where the applicability of Chapter X [Sections 92 to 92F] of the Act to the facts of the taxpayer's case is objected to, the assessee's objection should be considered and specifically dealt with so as to make sufficient compliance with the principles of natural justice.
Making a reference to TPOs on the basis of value of international transactions is no more necessary as selection of TP cases for scrutiny is to be based on risk assessment, consequently when a case is selected for scrutiny for non-TP issues, no reference to TPO is necessary irrespective of value of international transactionsOnly exception to above would be a situation where AO notices undisclosed international transaction during assessment proceedings due to non-filing of Form 3CEB/ non-reporting of such transaction in Form 3CEB
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2. Role of Transfer Pricing officer The TPO, being an Additional/Joint CIT, shall obtain the approval of the
jurisdictional CIT (TP) before passing the order. On the other hand, the TPO, being a Deputy/Assistant CIT, shall obtain the approval of the jurisdictional Additional/Joint CIT before passing the orderThe jurisdictional CIT (TP) should assign a limited number of important and complex cases, not exceeding 50, to the Additional/Joint CslT [TPOs] working in the same jurisdiction
TPO's order being subject to judicial scrutiny, must contain adequate reasons/data regarding selection of most appropriate method, data used for computation of ALP and copies of all relevant documents in this respect to be made available to AO for his record and use at subsequent stage of appellate and penal proceedings
Instruction also highlights role of TPO in compliance audit in pursuance to APA signed and regarding safe harbour provisions
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3. Maintenance of Database References received from the AOs by the TPOs in his jurisdiction are
dealt with expeditiously and accurate record of all events connected with the whole process of determination of ALP is maintained in the format enclosed as Annexure-I to this Instruction.
The ClT (TP)must ensure that the separate data maintained by all TPOs under their jurisdiction are consolidated into one report for the entire charge after the completion of each transfer pricing audit cycle.
4. Applicability Guidance provided in instruction applicable only to scrutiny of
'international transactions' and CBDT is considering issue of separate guidance for specified domestic transactions
However, guidance regarding cases selected for scrutiny on non-TP parameters also applicable to specified domestic transactions
Notification
Dtd 19th October, 2015
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CBDT notifies transfer pricing (TP) rules to incorporate “range concept” and “use of multiple year data”
1. Applicablity Amended Rules applicable to international transactions and specified domestic transactions undertaken on or after April 1, 2014
2. Range ConceptRange concept to be applicable in certain cases and data points lying between 35th and 65th percentile of comparable prices to be considered as arm’s length priceClarifies that the transaction price shown by taxpayers falling within the range will be accepted and no adjustment will be made
3. Weighted Average PLINotification proposes use of weighted average of PLI for 3 years and gives illustrations on computation of weighted average PLI & arm's length range
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4. Multiple Year DataCBDT states that use of multiple year data allows for yearly variations to be averaged out and would therefore add value to the TP analysis
Stresses that amended rules would provide clarity in determination of price in TP cases and reduce disputes on TP issues and further, that it is a part of continuing initiative of providing a stable and certain direct tax
regime
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THANK YOU