IFA Worshop

8/2/2019 IFA Worshop

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Agenda

-Introduction

- Framework of Transfer Pricing regime in India- Concept of Associated Enterprises

- Global Developments

- Traditional Transaction Methods

- Profit based Methods

- Q& A- Conclusion

TransferPricing

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Indian Statutory Framework of the Transfer Pricing Regime

TP regulations initiated in 2001 Section 92, 92A to 92F and Rules 10A to 10E.

Broadly based on OECD Guidelines

Major deviations :

reliance on Arithmetic mean as a measure of average limited range of 5% - now done away with

2 year period limitation for use of data

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Arms Length Principle

Arms length Price (ALP) is the hypothetical price at which unrelated parties would

have transacted under the same terms and conditions as those of the internationaltransactions.

Defined in Section 92F(ii) means a price which is applied or proposed to be

applied in a transaction between persons other than associated enterprises in

uncontrolled conditions

The arms length standard is the principle that governs the conclusion that an I

nternational transaction is not influenced by the relationship between the

Associated Enterprises (AEs)

Section 92 income from any international transaction - determination of ALP

Also allowance, expense or interest covered specifically

Cost contribution agreements also included but no guidance provided; expense

No application if taxable income gets reduced

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Associated Enterprise and International Transaction

Associated Enterprise (AE) commonality of management, capital or control -

Sec. 92A

International Transaction - Sec. 92B transactions between two or more AEs

where at least one is a non-resident (SC observations in Glaxo Smithkline)

Nature of transaction purchase, sale or lease of tangible or intangible property, orprovision of services, or lending or borrowing money or any other transaction

having a bearing on the profits, income, losses or assets and cost/expense

allocation or apportionment arrangement

In certain situations even transactions between unrelated parties can also be

deemed to be international transactions prior agreement with AE or where thesubstance of the transaction is influenced by the AE

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Determination of ALP: Transfer Pricing Methods

Methods Applicability

Comparable Uncontrolled PriceMethod

Comparison of actual price

Resale Price Method Comparison of gross margin fora distributor

Cost Plus Method Comparison of gross margin for

a manufacturerProfit Split Method Sharing of profits among entities

sharing proportionately in risks ina highly integrated operation

Transactional Net MarginMethod Comparison on a net (operating)profit basis

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Selection of Most Appropriate Method (MAM)

Rule 10C MAM is the method which is best suited to the facts and

which provides the most reliable measure of ALP; and

Factors to be considered are: nature and class of international

transactions, functions, assets and risks analysis, availability of data,

degree of comparability, possibility of making adjustments and the

nature, extent and reliability of assumptions made

How does one select the most appropriate method Analyse and characterise the international transaction Assess the availability of data with respect to application of methods

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Compliance Requirement

Taxpayers are required to put together the following on an annual basis:

Transfer Pricing report, which documents that all international transactions/ business

arrangements with group companies and their compliance with ALP (Rule 10D)

An Accountants certificate, in a prescribed format, that must be filed with Corporate tax

return (Rule 10E)

Use of Current year data controversial issue

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TP Documentation

Significance of Documentation

Is generally a part of legal regulations

Enables discharge of Burden of Proof

Indispensable in multiple audits

Protection against penalty

Supporting documents

Inter-company agreements

Evidence(s) of business reasons i.e. limited risks, market penetration etc, used to negotiate or set TP

Process map to evidence key decision nodes Documents generated as daily business processes

Trail of negotiations with AE e.g. mail trail documenting reasons for price fluctuations

Segmental/transactional profitability

A Robust TP report

Adjustments to be statistically reasonable and

replicable

To develop alternate arguments/positions

TP document to be in sync with Website/Publicinformation

Evidence of global consistency (whereverpossible)

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Transfer Pricing Audits

Reference by AO to Transfer Pricing Officer

Separate Directorate for TP audits

AO has concurrent powers; above a threshold compulsory reference to TPO

Primary onus on taxpayer

TPO/AO can determine the ALP only if one of the conditions specified in Section

92C(3) is met: unreliable or deficient use of data/method, lack or non-maintenance

of documentation, failure to furnish the documentation or determination of ALP in a

manner contrary to the rules

TP documentation is the fulcrum of TP audit

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Dispute Resolution

Conventional litigation route

Dispute Resolution Panel

MAP

Spate of Rulings by ITAT

Proposed Safe harbour rules

Proposed APA under DTC

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Methods Prescribed for Determination of ALP

Traditional transaction methods

Comparable Uncontrolled Price method - compares prices

Resale Price method - compares gross margins

Cost Plus method - compares profit mark-ups on costs

Transactional profit methods

Transactional Net Margin method - analyses net profits in relation to an

appropriate base

Profit Split method - refers to the (total) profits from transactions and splits

them based on contribution

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Traditional Transaction Methods

Hierarchy of Methods

- Indian position- OECD Position

Most Appropriate Method (MAM)

Factors determining the choice of MAM

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Comparable Uncontrolled Price (CUP) Method

-CUP method compares the price transferred in a controlled transaction to the

price charged in a comparable un-controlled transaction.

-CUP method is the most direct and reliable way to apply the arms length principle

-External and Internal CUP

-Illustrations - Sale of tangible property, supply of services, financing transactions,

licensing or sale of intangible property

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Differences in Comparability

Two transactions can be considered comparable only when there is no material

difference that can impact the price of the transaction in open market

Or

Reasonably accurate adjustments can be made to eliminate the material effect of

such difference

Real Challenge in the application of CUP

- finding comparable transactions; and

- making adjustments

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Adjustments to Account for Differences

Differences in

-volume, type of products/services- terms of contract

- geographical location, type and size of markets

Feasible adjustments

-Volume- credit period, freight cost

Problem Areas

-difference in product/service profile

- difference in geographical location of markets

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Issues and Controversies

Geographical location of Markets

Intervet case export price of goods sold by an Indian company to its AE inThailand was compared with export price to unrelated party in Vietnam by the

TPO adjustments had been made for volume and credit terms ITAT held that

adjustments need to be made for disparity in market location

OECD guidelines state the difficulty in this regard

Essar Shipping case charter rate of a 22 year old ship was compared with a

standard report that provided rates of ships less than 10 years old ad hoc

adjustments made rate was 1/4th of the reported rate ITAT rejected the same

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UCB and Serdia Pharmaceuticals Importance of intangibles in application of

CUPImport of APIs to manufacture drugs purchase price (from AE) compared with

purchase price paid by unrelated competitor companies for same APIs in UCB it

was held to be unacceptable because of presence of intangibles (quality, brand

etc.) whereas in Serdia ITAT accepted the comparison as the APIs were no longer

protected by patents

Just because CUP is the most reliable method it cannot be applied where available

data is insufficient to justify comparison; CUP method requires a high degree of

comparability with regard to quality, contractual terms, level of market, geography

involved, date of transaction, intangible property, foreign currency and alternatives

available with buyer and seller

Clearplus case What is the relevant market to be examined Revenue

contended that goods brought from China cannot be compared with goods brought

from India despite both being sold in the US ITAT held that the relevant market is

the market where goods are sold

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Resale Price Method (RPM)

Is applied where goods or services purchased from an AE is resold to non-AE

Gross margin earned in same or similar uncontrolled transaction by the same party

or a third party is determined

The resale price is reduced by the gross profit margin

The above price is further reduced by expenses incurred in connection with the

purchase of property/service

Adjustments are made to account for accounting, functional and other differences

that materially affect gross profit margin in open market

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Use of RPM

Less product comparability required

Best to test resellers

Difficulty in applying RPM

identifying identical or similar functional and risk profiles,

facing differences in accounting practices, mainly with respect to costs of

goods sold, and

eliminating influences from different economies of scale.

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Cost Plus Method (CPM)

Involves comparison of mark-up on costs

Direct and indirect costs of production of an enterprise are determined

Normal gross profit mark-up on such costs earned in comparable uncontrolled

transaction is determined

Suitable adjustments made to account for differences that can impact gross profit

mark-up in an open market

The costs of the enterprise are increased by the adjusted gross profit mark-up to

arrive at the ALP

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CPM Strengths and Weaknesses

Less product comparability required

Less functional and risk comparability, as long as costs are well defined

Difficulties in applying CPM

ensure that inefficiencies do not result in higher profits as costs increase

there is often no direct link between the amount of the costs incurred and the

market price, i.e. arms length price

it requires extensive information about the cost base used in comparing the

mark-ups

reasonable adjustments are difficult when looking at external comparables

In the Indian context modified CPM is used where operating margin on total costs

are

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Supreme Tradelinks Choice of method RPM selected by a franchisee TPO

rejects RPM on the ground that there was significant differences in operating costswhich were below the line ITAT negated this view on the facts

Higher level of below the line expenditure may warrant adjustment on account of

difference in functions

Ghardia Chemicals goods sold to overseas AE and RPM used to show that the

gross margin of the AE was at arms length ITAT rejected the claim on the ground

that RPM can be applied only on an Indian entity incorrect decision contrary to

Rule 10B(1)(b) and OECD guidelines

CPM casesMSS India

Twinkle Diamond

Diamond Dyechem

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