Embed Size (px)
Citation preview
Leveraging the reverse pulls
A special case in cross-border convergence of Transfer Pricing and Customs
Aditya Panse
Leveraging the Reverse Pulls | Aditya Panse P a g e | 2
About the Author
Aditya Panse is a Chartered Accountant and a Company Secretary from Pune, India. He has done his Master’s in Economics from University of Pune. He has also been awarded Diploma in IFRS by the Association of Chartered Certified Accountants (ACCA), UK.
Aditya currently works with Price Waterhouse & Co., a member firm of PwC, in Transfer Pricing team.
Contact details
Address: F-12 Samartha Park, Anandnagar, Sinhagad Road, Pune, Maharashtra, India 411051
Phone: Resi: +91 20 2435 5814
Mobile: +91 9420 696 589
Email: [email protected]
Word Count
Leveraging the Reverse Pulls | Aditya Panse P a g e | 3 Table of Contents
1. Abstract ....................................................................................................................................... 4
2. The issue of convergence between Transfer Pricing and Customs Valuation ...................... 5
2.1. Background .......................................................................................................................... 5
2.2. Taxation of International Trade ............................................................................................. 5
2.3. Relationship between customs valuation and transfer pricing ............................................... 6
2.4. Illustration of the “reverse pulls” ............................................................................................ 7
3. Convergence: attempts and hurdles ......................................................................................... 9
3.1. Attempts to convergence ...................................................................................................... 9
3.2. Transfer Pricing – Customs convergence: An Indian perspective ....................................... 10
3.3. Two schools of thought – to converge or not to converge ................................................... 11
3.4. Issues in convergence ........................................................................................................ 12
4. Counterparty convergence – a partial (but practical) solution ............................................. 15
4.1. One Transaction, One Price ............................................................................................... 15
4.2. Counterparty Convergence ................................................................................................. 15
4.3. Acceptability of analysis by foreign tax authorities .............................................................. 16
4.4. Principle of Comity .............................................................................................................. 17
4.5. Benefits of Counterparty Convergence ............................................................................... 17
5. Conclusion ................................................................................................................................ 19
6. Bibliography ............................................................................................................................. 20
Leveraging the Reverse Pulls | Aditya Panse P a g e | 4 1. Abstract
Taxation of international trade and commerce has long remained a topic of intense discussions. In context of the trade of tangible goods, two of the important taxes levied on international trade are Customs Duties and Income Tax. These taxes are levied by both the nations involved in the transaction.
Income Tax is levied on taxable profits, while Customs duties are (generally) ad valorem. Hence, the quantum of both Income Tax and Customs Duties are both determined by the value (or price) at which transaction has been entered into.
International trade between related parties are also subject to these taxes. When independent enterprises transact with each other, the conditions of their commercial and financial relations ordinarily are determined by market forces. When entities belonging to same MNE group transact with each other, their commercial and financial relations may not be directly affected by external market forces in the same way. Hence, the Tax Authorities have incentive to undertake a detailed scrutiny of pricing and valuation in case of transactions between related parties; in order to discourage erosion of tax base. Transfer Pricing Regulations (for Income Tax) and Special Valuation Regulations (in case of Customs) have thus been evolved.
In case of import of goods, Customs Authorities try and discourage undervaluation of goods (as undervaluation of imports results in lower customs duty). For the same transaction, the Transfer Pricing authorities seek to discourage overvaluation of goods (as overvaluation of imports results in lower taxable profits). In other words, for valuation of same transaction involving same goods; Customs Authorities and Transfer Pricing Authorities have policy objectives which are opposite to each other. This situation is better known as “reverse pulls of Transfer Pricing and Customs Valuation”. Practically, this results in increased cost of compliance for the taxpayer.
Efforts have been made for convergence of Transfer Pricing and Customs Valuation methodologies; both at institutional level and individual country level. World Customs Organisation (WCO) and Organisation for Economic Cooperation and Development (OECD) have held 2 joint conferences on convergence of Customs and Transfer Pricing.
There exist conceptual and practical barriers in converging Transfer Pricing and Customs; with the differences in the policy objectives (reverse pulls) being the foremost conceptual barrier.
While the efforts continue on banishing the barriers; convergence may be achieved in some scenarios. One such scenario is Counterparty Convergence, discussed in this paper.
The policy objectives of importing country’s Customs Authorities and exporting country’s Transfer Pricing Authorities are aligned; as both of the tax authorities seek to curb undervaluation of prices of goods in question.
This paper hypothesises that due to the overlapping policy objectives of importing country’s Customs Authorities and exporting country’s Transfer Pricing Authorities; dual-purpose data and analysis can be used for determining / demonstrating arm’s length / fair price of the goods being traded. This concept is termed as Counterparty Convergence.
This paper elaborates on the reverse pulls of Transfer Pricing and Customs; briefly refers to the convergence efforts; introduces the concept of Counterparty Convergence; discusses the legal perspectives in acceptance of analysis done by foreign tax authorities and touches upon the benefits of such convergence.
Leveraging the Reverse Pulls | Aditya Panse P a g e | 5 2. The issue of convergence between Transfer Pricing and Customs Valuation
The objective of this section is to describe in detail the conflicting interests of the Customs Authorities and Transfer Pricing Authorities, thereby giving rise to a situation of “reverse pulls”.
2.1. Background
2.1.1. International trade is exchange of capital, goods, and services across international borders or territories. While international trade has been present throughout much of history, the importance and quantum of it has been on the rise in recent centuries.
2.1.2. The spurt in international trade can be traced to economic globalisation. Economic globalisation refers to increasing economic interdependence of national economies across the world through a rapid increase in cross-border movement of goods, service, technology and capital. Economic globalisation comprises the globalisation of production, markets, competition, technology, and corporations and industries.1
2.1.3. Increasing economic globalisation has given opportunity to business organisations to operate across borders of various nations. This has given rise to complex cross-border organisational structures. For instance, an organisation can procure raw material from Sudan, process it in China to manufacture the finished product, which is distributed through Singapore to the end customer in USA, with back-office support being provided from India.
2.1.4. Since one organisation performs its activities across multiple countries, it will have its legal presence across those countries. Such enterprises are typically called multinational enterprises (MNEs). MNE, though not precisely defined by the Organisation for Economic Cooperation and Development (‘OECD’), comprises companies or other entities established in more than one country and so linked that they may co-ordinate their operations in various ways.2
2.1.5. As a direct result of business models driven by globalisation and existence of MNEs, the international trade between related parties comprises almost 60% of total international trade. International trade and globalisation have ignited many issues; one of the most important being taxation (both direct as well as indirect) on the transactions between MNE group entities.
2.2. Taxation of International Trade
2.2.1. Two of the taxes3 typically levied on cross border movement of goods are (a) customs duties and (b) income tax. Customs duties are levied on primarily on import of goods (and sometimes on export of goods); while income taxes are levied on business profits.
2.2.2. Taxable event is defined as any event that results in a tax consequence for the party who executes the event. Customs duties and income taxes are triggered by different ‘taxable events’. Import (or export) of goods is the taxable event for customs duties, while income tax is charged on ‘total income’4 of the assessee. It may be noted that taxable event for income tax and customs duties may be different, but the “tax subject” or the person sought to be taxed is same, i.e. the MNE in this case.
2.2.3. An aggregate of taxable events of various taxpayers in a country equals to the country’s “tax base”. For instance, taxable income of all the taxpayers in India would be the “income tax
1 Joshi, Rakesh Mohan, (2009) International Business, Oxford University Press, New Delhi and New York ISBN 0195689097 2 Paragraph 3 of OECD Guidelines for Multinational Enterprises ISBN 978‐92‐64‐05597‐1 3 For the purposes of this discussion, the term ‘duty’ is considered synonymous with ‘tax’. 4 Section 4 of the Income‐tax Act, 1961
Leveraging the Reverse Pulls | Aditya Panse P a g e | 6
base” of India. Similarly, the value at which goods are imported into India forms the “customs duty base” of India.
2.2.4. The prices of goods set by one MNE group company and agreed by another company in same MNE group is the starting point for:
(a) Assessing customs duties; and
(b) Determining the taxable profits arising to each party involved.
2.2.5. Ideally, the prices between MNE group companies should be subject to market forces. However, there is an incentive to the MNE group to set such prices which will reduce the consolidated tax incidence of MNE group as a whole. Hence, there may be instances of profits shifted to low-tax jurisdictions by overcharging for costs and undercharging for revenues; or purchase prices understated to avoid import duties.
2.2.6. Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations issued by OECD in 2010 (‘OECD TP Guidelines 2010’) stipulate that
“when independent enterprises transact with each other, the conditions of their commercial and financial relations (e.g. the price of goods transferred or services provided and the conditions of the transfer or provision) ordinarily are determined by market forces. When associated enterprises transact with each other, their commercial and financial relations may not be directly affected by external market forces in the same way.”
Though, it further warns the Tax Administrations not to automatically assume that such associated enterprises have manipulated their profits.5
2.2.7. "Transfer pricing" refers to the determination of the price and other conditions for the transfer of goods, services and assets between affiliated companies situated in different tax jurisdictions. On the other hand, Customs Duty is a tax levied on imports (and, sometimes, on exports) by the customs authorities of a country to raise state revenue, and/or to protect domestic industries from more efficient or predatory competitors from abroad. Customs duty is based generally on the value of goods or upon the weight, dimensions, or some other criteria of the item. Generally, the Customs Duties are levied on the value of the goods imported (ad valorem duties). The customs value of imported goods is determined mainly for the purposes of applying ad valorem rates of customs duties. It constitutes the taxable basis for customs duties.6
2.3. Relationship between customs valuation and transfer pricing
2.3.1. The intention of transfer pricing provisions and customs provisions is conflicting with each other.
Provisions Intention
Transfer pricing Protecting the income tax base of the country by discouraging the practice of disclosing lower taxable income by overvaluing the imports and/or undervaluing the exports.
Customs Protecting the customs duty base of the country by discouraging the practice of undervaluation of imports (declaring lower transaction value) in order to pay lower customs duty.
5 Paragraph 1.2 6 http://www.wcoomd.org/home_valoverviewboxes_valoverview.htm (accessed on 24 September 2011)
Leveraging the Reverse Pulls | Aditya Panse P a g e | 7
Thus, Transfer Pricing provisions seek to curb overvaluation of imports, while customs provisions seek to curb undervaluation of imports.
2.3.2. Both Transfer Pricing and Customs legislations seek to determine the “fair value” for the imports. In Transfer Pricing parlance it is called “arm’s length price” while Customs provisions dub it as “transaction value”.
2.3.3. Transfer prices of goods, thus, would have a bearing on customs duties as well as taxable profits; and consequently, income tax base as well as customs duty base. However, in case of imports, the transfer prices are inversely proportional to income taxes, while being directly proportional to customs duties.
1
1
2.4. Illustration of the “reverse pulls”
2.4.1. This interplay between Transfer Pricing and Customs Duties can be elaborated by way of an illustration. The vital facts and assumptions for the illustration are as follows:
- A Ltd., India (‘A-India’) exports goods to its Associated Enterprise A Plc, UK (‘A-UK’). Thus, sales of A-India would be purchases of A-UK.
- Operating Profitability of A-India and A-UK from intra-group cross border transaction:
Particulars Reference A-India A-UK
Sales [A] 100 140
Cost of Material [B] 60 100
Other Operating Costs [C] 30 20
Total Costs (‘TC’) [D] = [B + C] 90 120
Operating Profit (‘OP’) [E] = [A – D] 10 20
OP/Sales [F] = [E ÷ A] 10% 14.28%
OP/TC [G] = [E ÷ D] 11.11% 16.66%
Note: For sake of convenience, the complexities of currencies are not introduced, and a common currency is assumed. Furthermore, it is presumed that A-UK has consumed all the material it has imported.
- Income Tax Rates and customs duties assumed as follows:
Rates of India UK
Income Tax 30% 30%
Customs duty Nil
(No customs duty on exports)
10%
Leveraging the Reverse Pulls | Aditya Panse P a g e | 8 2.4.2. The profit from the transaction of sale of goods by A-India will attract Income Tax in India, and
would be subject to Transfer Pricing provisions. India generally does not have export duties; hence there will be no charge on that account.
2.4.3. On the other hand, HM Revenue and Customs (‘HMRC’) would perform valuation of the goods imported in order to assess ad valorem import duty amount. Furthermore, the profit of A-UK would be assessed for income tax, including Transfer Pricing.
2.4.4. Let us concentrate on taxation in UK. Customs duty wing of HMRC would have concerns about “undervaluation of imports”, i.e. declaring import prices less than 100 (in our example). Income tax / transfer pricing wing of HMRC would be concerned about “overvaluation of imports” with the intent of understating taxable profits; i.e. declaring import prices greater than 100. Furthermore, the Indian Income Tax department would be interested in discouraging “undervaluation of exports (i.e. imports from A-UK’s perspective)”. The position can be graphically summarised as follows:
2.4.5. Thus, UK Customs and Indian Transfer Pricing Authorities have incentive to increase the price of goods, while UK Transfer Pricing Authorities have incentive to decrease the Transfer Price.
2.4.6. From perspective of UK taxation, these mandates constitute “reverse pulls”; whereby one taxman tries to inflate the value, while the other tries to deflate it. The taxpayer, therefore, has to defend the same price with two different Revenue Authorities; thereby increasing the cost of compliances.
2.4.7. Notwithstanding the differences in the mandates of two tax authorities, common sense dictates that:
There cannot be two arm’s length prices / fair market values for same transaction, just because two tax authorities have different mandates;
Contradictory mandates of Customs Authorities and Transfer Pricing Authorities tantamount to Government “blowing hot and cold at the same time”;
In the interest of taxpayer, ideally, Customs Authorities should accept the Transfer Pricing Study or vice versa.
2.4.8. One interesting fact is noticed from the graphical representation above is that interests (and incentives) of UK customs and Indian Transfer Pricing authorities are aligned with each other. This issue is taken up in a greater detail in Section 4 below; and forms crux of this Paper.
Concerns that fair value is less than 100 (undervaluation)- UK Customs- Indian Transfer Pricing
Concerns that the fair value is above 100 (overvaluation)
- UK Transfer Pricing
Leveraging the Reverse Pulls | Aditya Panse P a g e | 9 3. Convergence: attempts and hurdles
The objective of this section is to briefly touch upon the attempts done for the convergence of Transfer Pricing and Customs Valuation and identify the obstacles for such convergence in existing Regulatory framework.
3.1. Attempts to convergence
3.1.1. Essentially, the issue of Transfer Pricing – Customs convergence is of importance in countries which have both Transfer Pricing Regulations and Customs Regulations. It may also be noted that more than 100 countries have Customs Regulations, but only a handful of countries have Transfer Pricing Regulations.
3.1.2. The problem of conflicting mandates of has been discussed at various forums for past decade. Ample literature is available on this subject in journals dedicated to Transfer Pricing as well as Customs.
3.1.3. On Revenue Authorities side, US, UK and Australia have been on forefront to harmonise the Transfer Pricing and Customs wings. Several other countries have been following in the wake.
3.1.4. U.S. Customs and Border Protection (CBP) has provided a guidance that Transfer Pricing Studies may be considered relevant for US Customs purposes if following conditions are satisfied7:
There exists a bilateral APA8 between USA and country of exporter in case of the goods being imported;
CBP is given an access to data used for reaching APA;
In case a transactional profit method is used in the APA, the comparables selected are product comparables; and
CBP approves the methodology and the tested party used in the APA.
3.1.5. In 2006, Canada Revenue Agency and Canada Border Services Agency issued a joint circular that discussed the appropriate use of Transfer Pricing methods to support Customs Valuation requirements.
3.1.6. In 2007, Australia established a process whereby importers could seek a Valuation Advice Ruling, whereby the Customs Valuation methods followed by the importer could be mapped with the OECD methods. In 2008, Korea introduced Advance Customs Valuation Agreement (‘ACVA’) similar to an APA.
3.1.7. OECD and World Customs Organisation (‘WCO’) have held 2 joint conferences to discuss the issue and reach a consensus. A need for encouraging dialogue between tax and customs authorities was expressed in the conference. At a conceptual level, the “whole of government” approach was put forth, thus combining the conflicting objectives of customs and tax administrations. OECD and WCO have decided to continue their cooperation in this field.
7 These are the principles emerging out of 42 binding rulings issued by the CBP 8 Advanced Pricing Arrangement
Leveraging the Reverse Pulls | Aditya Panse P a g e | 10 3.2. Transfer Pricing – Customs convergence: An Indian perspective
3.2.1. Mr. S. Dutt Majumdar, Director General of Revenue Intelligence once said in an interview "the convergence is no more desirable; it is inevitable, for the simple reason that it is only fair that the same goods are valued by the same standard under two or more statutes."
3.2.2. The Transfer Pricing Agenda on the website of Directorate General of Valuation, Central Board of Excise & Customs states that:
“Income Tax and Customs officials proceed independently to establish arm’s length valuations in related-party import transactions. This may lead to different results which may be far from reality. Legislative action and agency cooperation should create an environment in which the Income tax and Customs authorities can coordinate import valuations as a unified force... A similar legal basis could be introduced to harmonize the Income tax and Customs approaches in India also.”
3.2.3. The Transfer Pricing Agenda further goes on to prescribe the areas of convergence in terms of documentation requirements, comprehensive databases, joint action plan in important areas such as valuation rulings and audit controls, joint training of Transfer Pricing and Customs officers, etc.
3.2.4. Paragraph 11 of the Transfer Agenda states that:
“Finally, an institutional mechanism for harmonization and coordination of transfer pricing matters between Income Tax and Customs departments with adequate legal backing is desirable.”
3.2.5. From a purely legal perspective of judicial precedents, the road for convergence of Transfer Pricing and Customs is already paved in India, albeit in a different context9. The Income Tax Appellate Tribunal (‘Hon’ble Tribunal’) in case of Kinetic Honda Motors10 has given clear directions that:
"...if payments were approved by one wing of the Government there was no question of being treated as excessive and unreasonable having regard to the legitimate business needs."
This decision has been followed in the case of Honda Siel Cars11.
3.2.6. This view of the Hon’ble Tribunal is an implicit acceptance of the “single government approach”, where the fundamental principle is that government cannot contradict themselves; not even under garb of different “mandates” given to different departments of the same government.
3.2.7. However, practical experience has been that citing the precedents of Kinetic Honda and Honda Siel Cars has not benefitted the taxpayer, at least in transfer pricing cases.
3.2.8. Specific to Transfer Pricing cases, the opinion of Hon’ble Tribunal appears to be divided as regards the use of Customs data for Transfer Pricing purposes. In the case of Serdia Pharmaceuticals12, inter alia, the Hon’ble Tribunal has opined that:
9 Payment of Royalty 10 Kinetic Honda Motor Ltd. vs. CIT (2001) 72 TTJ (Pune) 72 : (2001) 77 ITD 393 (Pune) 11 Honda Siel Cars India Ltd. vs. Assistant Commissioner of Income Tax (2007) 111 TTJ (Del) 630 : (2007) 109 ITD 1 12 Serdia Pharmaceuticals (India) Private Limited vs Assistant Commissioner of Income Tax (2011‐TII‐02‐ITAT‐MUM‐TP)
Leveraging the Reverse Pulls | Aditya Panse P a g e | 11
“Merely because another arm of the Government considers this price at an arm’s length price, even though for the purposes of customs duty, the assessee cannot be relieved of the burden of establishing that it is an arm’s length, for the purposes of transfer pricing requirements, in terms of the provisions of the Income tax Act.”
3.2.9. Prima facie, it appears that the decision in case of Serdia Pharmaceuticals is in against the very notion of convergence of convergence of Transfer Pricing and Customs. However, a close reading of the relevant paragraph from Serdia Pharmaceuticals reveals otherwise.
3.2.10. The limited meaning which can be drawn from the Hon’ble Tribunal’s remark is that the assessee cannot be relieved of the burden of establishing that the prices are at arm’s length, even though it has been done earlier for the purposes of customs. The Hon’ble Tribunal has refrained from commenting whether or not the data used for the purposes of customs can be used for determination of arm’s length price under Transfer Pricing. The limited inference which can be drawn is that Customs analysis cannot be used as such for the purposes of Transfer Pricing analysis. The question of practicability of the convergence, whether or not it is possible, is not touched upon.
3.2.11. On the other end of the spectrum, the case of Coastal Energy13,14 propounds a diametrically opposite view, where the Hon’ble Tribunal states that:
We should state without fear of contradiction that the customs authorities are assigning values to the imported goods on the basis of scientifically formulated methods and they are responsible for making a fair assessment value of the imported goods. The valuation made by the customs authorities is not an arbitrary exercise. But on the other hand, it depends upon large volume of international data classified according to internationally accepted protocol. Therefore, it is not possible to say that the credibility of the price rate furnished by customs authorities needs to be discounted.
3.2.12. It may be noted that both of these decisions given by Hon’ble Tribunal. Though the Hon’ble Tribunal’s decisions are considered as valid (and binding) precedents, a decision from higher courts of law (Hon’ble High Court and Supreme Court) would be welcome.
3.3. Two schools of thought – to converge or not to converge
3.3.1. Not surprisingly, the academicians and the practitioners seem to be divided into two distinct (and opposing) factions on the issue of convergence.
3.3.2. One block is an advocate of the “single government approach”, which believes that two answers to same question raises questions on the credibility of the Government; thus believing that convergence is inevitable.
3.3.3. On the other hand, the other group is more cautious about the concept of convergence, stating that cost of convergence would outstrip the benefits of convergence; hence a status quo is the safest way. The pundits of this school point out the Transfer Pricing and Customs are artefacts of diametrically opposite taxing systems; viz. direct taxation and indirect taxation. Furthermore, especially in developing countries, the Revenue Authorities may not be geared up for convergence; as such countries find difficulties in administering the provisions of WTO Customs Agreement.
13 Coastal Energy Pvt Ltd Vs ACIT [TS‐356‐ITAT‐2011(CHNY)] 14 It may be mentioned here that the decision in the case of Coastal Energy is in respect of the data published by Customs which is submitted as CUP. However, the ratio in this judgement is relevant as it comments on the method of determination of value by the Customs Authorities. Whether such value is fair value / arm’s length price or not is the subject matter of this paper. Hence, the observations of the Hon’ble Tribunal in the case of Coastal Energy are considered relevant even though on a slight tangent.
Leveraging the Reverse Pulls | Aditya Panse P a g e | 12 3.4. Issues in convergence
3.4.1. Since both of the statutes are different in nature, there exist certain genuine issues in suitability to interchange the arm’s length / fair value from Transfer Pricing to Customs and vice versa. The principal issues are enumerated below. It would, however, be argued that Transfer Pricing (i.e. OECD) methodologies are better geared up to deal with these issues, rather than Customs (i.e. GATT/WTO/WCO) methodologies.
I. Year-end true-up / true-down adjustments
3.4.2. A limited risk / contract manufacturer typically operates under a pricing policy of Full Cost Mark Up15. At the end of the period, the manufacturer may adjust the invoicing based on the arm’s length margin at the end of the period.
3.4.3. If the arm’s length mark-up is higher than that earlier charged, the manufacturer receives additional compensation for same products sold during the period (‘true-up adjustment’). From a perspective of the buyer, the price of goods imported during the year is increased owing to year-end adjustment.
3.4.4. However, the buyer has already declared some price at time of importation, and paid Customs duty on it. Subsequent price increase means that the importer is subjected to higher Customs duty than already paid.
3.4.5. Situation can be stickier if the arm’s length mark-up is lesser than the mark-up already applied (‘true-down adjustment’). Such situation, from importer’s perspective, leads to decrease in the price of imported goods, which results into a lesser duty.
3.4.6. This issue was discussed in a great detail at May 2007 OECD – WCO Joint Conference. Especially, such adjustments assume a more controversial position if they are made on the basis of TNMM, following the method of aggregation of international transactions.
II. Role of Functional Analysis
3.4.7. The price comparability standard as adopted by the Customs is “comparison of same / similar product(s)”. For facilitating this comparison, Harmonised System of Nomenclature (‘HSN’) is utilised. Since the customs comparison focuses on “product”, it may sometimes be ignored that the “price” of same products can be determined differently in different circumstances.
3.4.8. It is an accepted principle of Transfer Pricing that the arm’s length price is affected by, inter alia16, functions performed, assets employed and risks assumed. Fewer functions / assets / risks command a lower return, and vice versa.
3.4.9. Hence, identical product (i.e. falling within same HSN classification code) may command different prices, based on the functional profile of a manufacturer.
3.4.10. Simple example of this phenomenon is a contract manufacturer17. A contract manufacturer is paid an FCMU, whereas a Principal receives market-minus returns. Hence, the price charged for the same product by a Principal is higher than that charged by a Contract Manufacturer.
15 Transactional Profit Methods are used for the purposes of Transfer Pricing analysis 16 The factors of comparability other than Functional Analysis are Characteristics of property or services, Contractual terms, Economic circumstances and Business Strategies. 17 The hiring firm (or a ‘Principal’) appoints a manufacturer with a fixed quantity contracts. The Contract Manufacturer is paid a FCMU, which is later on sold in open market by the Principal. Essentially, all the significant risks, (especially the market risk) lie with the Principal. This is a form of outsourcing / subcontracting the manufacturing.
Leveraging the Reverse Pulls | Aditya Panse P a g e | 13 3.4.11. By way of illustration, let us presume that a Contract Manufacturer in China exports product X
to a A Ltd., the Principal in India, which performs marketing and distribution functions and sells product X in Indian market. Chinese contract manufacturer is paid full cost of Rs. 100 plus an arm’s length mark-up of 10%; which is Rs. 110. The end customer price in Indian market is Rs. 150.
On the other hand, B Pvt. Ltd., a Japanese competitor manufactures identical product X (in Japan) and sells it in Indian market. The end customer directly imports it at Rs. 150.
3.4.12. From an Indian import perspective, same product X has following import prices:
Importer FAR profile of the exporter Price of import (INR)
A Ltd. (Principal) Contract Manufacturer 110
The end customer Entrepreneur 150
It can be seen that there are differences in functional profile of both the exporters; and thus the prices differ. In fact, the difference between the two exporters can be accurately described as the “value chain difference”. The difference in prices representing higher returns can possibly be attributed to the party undertaking market risk, performing marketing functions and returns thereon.
3.4.13. The product-based comparability standard enshrined in the Customs Regulations, thus, ignores the functional differences. There may be an obviously erroneous comparison of a manufacturer with a distributor.
III. Bundled vs. Bare prices
3.4.14. Moreover, there may be some products which may have a “bundled price”. The price of a product may consist of the basic price of the goods, and may have components for intellectual property, services, etc.
3.4.15. There are many examples ranging from telecommunications to pharmaceuticals to heavy equipments where the concept of “bundled prices” is applied regularly. However, for the sake of simplicity, a common example is considered below.
3.4.16. The ex-showroom (or on-road) price of a Car consists of the base price of the car plus local road taxes, etc. A certain number of “free servicing” are provided as a package along with the car. Notwithstanding any altruistic motives of the car company, the price of these “free servicing” is in-built in the price of the car. However, in practice, it is called (and many times, accounted for) as “sale of car” rather than “sale of car plus service”.
3.4.17. Due to these bundling practices, it may sometimes be difficult to identify the accurate price of “bare” or “basic” goods which are imported. This has tax implications basically in transaction-value-driven indirect taxes, viz. Import duties, VAT, etc. Income Tax is less affected by these anomalies, as these taxes commence with the outcome of price, i.e. profit (or income). Hence, in the context of import duties, bundled prices may not be directly comparable with bare (or unbundled) prices.
3.4.18. In this section, we have seen that though the convergence of Transfer Pricing and Customs is on the minds of professionals and tax authorities alike, and though the efforts have been made; there exist theoretical and practical obstacles in achieving it.
Leveraging the Reverse Pulls | Aditya Panse P a g e | 14 3.4.19. The barriers to Transfer Pricing – Customs convergence can be classified into two distinct
categories: viz. (a) Conceptual barriers and (b) Practical barriers. While the conceptual barriers focus on the question “why” not convergence, the practical barriers seek to identify “how” convergence is not possible. Different mandates of Transfer Pricing and Customs is clearly a conceptual barrier to convergence, while the other obstacles mentioned here may be classified as practical barriers.
Leveraging the Reverse Pulls | Aditya Panse P a g e | 15 4. Counterparty convergence – a partial (but practical) solution
The objective of this section is to introduce the concept of Counterparty Convergence; whereby analysis of Revenue Authorities of one country may be used by the Revenue Authorities of other country whose subject is involved in the transaction.
4.1. One Transaction, One Price
4.1.1. Keeping aside the hat of a tax professional, it would be difficult to contemplate that one Transaction18 (please note the capital ‘T’) may have more than one arm’s length / fair price. The process of price discovery under various economic theories may give a range of prices spanned over a period of time; but essentially the range is encompasses individual data points representing each Transaction bearing one single price.
4.1.2. At the risk of oversimplification and trivialisation; in a realistic third party situation, let us consider a situation where a Towel is bought and sold. No buyer would offer the seller - “I would buy a Towel from you at Rs. 150 or Rs. 200”. On the other hand, no seller would tell the buyer - “the price of this towel is Rs. 175 or Rs. 225”. What happens in reality is that there is a negotiation process, where the buyer may quote Rs. 150, seller may quote Rs. 225 and eventually the transaction takes place at Rs. 175. The point which is emphasised over here is that in actual single Transaction, there is no dichotomy of prices, but one single price at which the Transaction takes place and is recorded in the books of account.
4.1.3. Since there is only one arm’s length / fair price to a Transaction, it is only logical to use the same price for the purposes of taxation, may it be Customs duty or Income Tax (including Transfer Pricing). Hence, logically, there simply cannot be two arm’s length / fair prices, one for Customs valuation purposes, and other for Transfer Pricing purposes.
4.1.4. As we have seen earlier, at a conceptual level, the only barrier separating the convergence is the difference in the policy objectives of Transfer Pricing and Customs Authorities. This gives rise to “reverse pulls” of Transfer Pricing and Customs. If these “reverse pulls” are somehow mitigated, then, at least conceptually, there is no barrier to use Customs Valuation for Transfer Pricing and vice versa.
4.2. Counterparty Convergence
4.2.1. Turning back to the case study of goods from India exported to the UK in paragraph 2.4 above, a passing reference was made to the fact that the interests (and incentives) of UK customs and Indian Transfer Pricing authorities are aligned with each other. (Refer paragraph 2.4.8 above).
4.2.2. The relative positions and mandates of the Transfer Pricing and Customs authorities with reference to the captioned transactions are as follows:
Country Transfer Pricing Authorities Customs Authorities
India Will try and increase the price of goods sold
N/A
UK Will try and decrease the price of goods sold
Will try and increase the price of goods sold
18 The Transaction (with uppercase T) is intended to mean one single instance of purchase / sale of goods between parties in different countries at one point in time. From a practical perspective, the Transaction may be imagined as one single invoice for which Transaction Value is calculated at time of importation.
Leveraging the Reverse Pulls | Aditya Panse P a g e | 16 4.2.3. It can be seen from the above table that though the arm’s length / fair nature of the prices of
goods is being challenged by three separate authorities, the interests of two of the authorities are aligned with each other.
4.2.4. Indian Transfer Pricing authorities have incentives for increasing the prices of exports in order to increase the taxable profits of the Indian exporter, while Customs Authorities in the UK have (same) incentives for increasing the prices of imported goods so as to increase the Transaction Value for higher Customs duty.
4.2.5. Hence, the policy objectives / mandates of Transfer Pricing Authorities of Exporter’s country are aligned with the policy objectives / mandates of Customs Authorities of Importer’s country.
4.2.6. Hence, the actions of Transfer Pricing Authorities of Exporter’s country may be a very good indicator of for Customs Valuation for importer’s country; and vice versa.
4.2.7. Transfer Pricing analysis of exporter can be effectively leveraged by the counterparty, (i.e. the importer) for Customs Duty clearances. Conversely, Customs Valuation exercise of importer can be leveraged by the exporter for Transfer Pricing purposes. This may be termed as Counterparty Convergence.
4.2.8. In the strictest sense of terms, Counterparty Convergence is not an independent evaluation of arm’s length / fair value. It is an exercise whereby the data, methodology and results of one party to the transaction are used by the counterparty (i.e. the other party) for the purposes of compliance.
4.2.9. Ideally, the exercise should begin at time of setting prices. Transfer Pricing methods may be used to determine the arm’s length price of the goods at time of export. Most appropriate Transfer Pricing method may be selected for determining the arm’s length price19. The tested party selected is typically the least complex of the parties to the transaction. This exercise determines the arm’s length price / fair market value at time of export. This analysis may be utilised for the dual purpose of Transfer Pricing in exporter’s country and Customs in importer’s country.
4.3. Acceptability of analysis by foreign tax authorities
4.3.1. The most important question, which must be vexing the vigilant reader, is the practicality of the Counterparty Convergence arrangement. To be more specific, why on earth should Indian Transfer Pricing authorities (exporter’s Transfer Pricing Authorities) accept the valuation exercise by the UK Customs Authorities (importer’s Customs Authorities)?
4.3.2. The methodology used for Customs Valuation is not consistent with the Transfer Pricing methods, as is evident from ample literature available on the subject. Moreover, Counterparty Convergence may essentially mean that decision / analysis by a foreign state is being relied upon by the home state.
4.3.3. According to accepted principle of international law; foreign law, judgements and guidelines are not binding on tax authorities of a state. However, they may have a persuasive value. Specific to Indian Transfer Pricing context, there have been several instances where OCED Transfer Pricing Guidelines have been referred to by various courts. In decisions like Serdia
19 Merits and demerits of various Transfer Pricing methods vis‐à‐vis the methods as per WTO Agreement (especially the “circumstances of sale” test) is a topic not touched upon over here; which is an elaborate discussion in itself.
Leveraging the Reverse Pulls | Aditya Panse P a g e | 17
Pharmaceuticals and Maruti Suzuki, principles emanating from foreign judgements have been respectfully relied upon by Indian Courts.20
4.3.4. However, the fact remains that in absence of a binding bilateral treaty or agreement between two sovereign states; foreign jurisprudence cannot create a binding precedent, but can be viewed from a persuasive perspective. In the context of Counterparty Convergence, at least a bilateral APA may go a long way in one tax authority accepting the analysis of another tax authority. Such treaty / bilateral APA would further be augmented by the similarity of the policy objectives, which forms the foundation of Counterparty Convergence. As stated in paragraph 3.1.4 above, US CBP have already started accepting bilateral APA for the purposes of convergence of Transfer Pricing and Customs.
4.3.5. On this backdrop, with adequate dialogue between Tax Authorities, Counterparty Convergence may not be a distant horizon.
4.4. Principle of Comity
4.4.1. The principle of Comity refers to refers to the idea that courts should not act in a way that demeans the jurisdiction, laws, or judicial decisions of another jurisdiction. Part of the presumption of comity is that other jurisdictions will reciprocate the courtesy shown to them.21
4.4.2. The principle of Comity is usually invoked in situations of family law22. However, it is a broader principle which is at the very foundation of international trade and commerce, especially in a globalised world. Agreements, covenants and commercial transactions entered into a foreign jurisdiction are generally respected in other jurisdictions, unless there is anything contrary on the records.
4.4.3. This principle of Comity may be ratified by way of a treaty or a bilateral APA, for facilitating practical application.
4.5. Benefits of Counterparty Convergence
4.5.1. Transfer Pricing audits are characteristically undertaken after end of accounting period, while Customs Valuations are at time of importation, i.e. real-time. Hence, the outcome of Customs valuation exercise is available at time of Transfer Pricing Audit. Moreover, the Customs Valuation Analysis is “contemporaneous”, i.e. done at the time of importation, and thus may command more relevance at time of Transfer Pricing audit.
4.5.2. Customs Valuation tends to be a transactional determination of fair value. In the discipline of Transfer Pricing, transactional methods are favoured over profit-based methods. Thus, Transactional Customs Valuation exercise may at least be used as corroboration to Transfer Pricing analysis.23
4.5.3. It is stated in paragraph 3.4.7 above that one of the important practical barrier to convergence is that of differences in functional profile. A contract manufacturer’s price cannot be compared with a risk-bearing entrepreneur’s price. A bundled price cannot be compared with unbundled price. However, this obstacle is elegantly overcome in Counterparty Convergence. The analysis is essentially in respect of same Transaction; the only difference being that the price valuation is being done at different shores.
20 In case of Serdia Pharmaceuticals (India) Private Limited vs Assistant Commissioner of Income Tax (2011‐TII‐02‐ITAT‐MUM‐TP), the Federal Court of Australia decision in case of SNF (Australia) Pty Ltd v Commissioner of Taxation [2010]FCA 635 (25 June 2010) was favourably quoted. In case of Maruti Suzuki India Limited vs Addl Commissioner of Income Tax (2010‐TII‐01‐HC‐DEL‐TP), “bright line test” was extensively discussed. 21 http://en.wikipedia.org/wiki/Comity 22 Divorce and child custody 23 Having said that, even the Customs Valuation exercise may be a profit‐based analysis; especially if it is done on the basis of bilateral APA.
Leveraging the Reverse Pulls | Aditya Panse P a g e | 18
Illustration
X Telecom Ltd, a UK company has exported 100 mobile phone sim cards to X India Limited, its Group Company. The sim cards have an international talk time of 60 minutes in-built. Hence, the price of product sold is an embedded price of ‘sim card + international talk time of 60 minutes’.
The Customs valuation is done at time of importation of goods into India, where Indian Customs Authorities have accepted the (embedded) price declared. This may be treated as an indicator of arm’s length nature of pricing by the UK Transfer Pricing authorities.
4.5.4. In case of international transactions between MNE group, the group as a whole has to fight on three fronts (viz. importer customs, exporter Transfer Pricing and importer transfer pricing) on same issue (fair value of goods). Counterparty convergence, if undertaken in a centralised manner, would be instrumental in consolidating two analyses (importer customs and exporter transfer pricing). With adequate documentation, the same can also be used for Transfer Pricing in exporter’s country. Hence, such centralised / global documentation enshrining Counterparty Convergence, would bring down the compliance costs significantly.
4.5.5. Transfer Pricing and Customs audits are undertaken at periodic intervals, at significant costs to Revenue Authorities. Counterparty Convergence may enable joint audits by importer’s Customs Authorities and Exporter’s Transfer Pricing Authorities, thus economising on the audit costs.
4.5.6. In developed Transfer Pricing jurisdictions, Transfer Pricing audits are essentially undertaken on a risk-based methodology. Since there is a convergence of policy objectives in Counterparty Convergence, the risk is mitigated by Counterparty’s audit procedure; and the exporter’s Transfer Pricing Authorities may decide to soften the level of scrutiny involved in a typical Transfer Pricing audit, on the backdrop of this persuasive evidence. There may even be a “green channel” for such cases. This may optimise the resources of taxpayer as well as tax authorities.
4.5.7. However, a note of caution – if there is a price adjustment made by one of the authority (either exporter’s Transfer Pricing authorities or importer’s customs authorities), the other authority may consider it as a cue for mirroring the same adjustment. For example, if exporter’s Transfer Pricing authorities have made an upward adjustment of 10%, importer’s Customs authorities may want to mirror the adjustment and determine arm’s length price at 110%.
4.5.8. Practice statement number PS2009/21 from the Australian Customs and Border Protection Service (ACBPS) explains that a transfer pricing adjustment to a sale of goods between related parties may mean the Customs value of the imports may also need to go up or down after they have entered Australia.
Leveraging the Reverse Pulls | Aditya Panse P a g e | 19 5. Conclusion
5.1.1. As mentioned in paragraph 0 above, there exist Conceptual and Practical barriers to convergence. The Revenue Authorities, taxpayers and consultants, though grudgingly, have accepted the possibility of convergence at a conceptual level24.
5.1.2. The convergence of Transfer Pricing and Customs, per se, would require huge cooperation at and coordination international level. Admittedly, the efforts of cooperation are ongoing, with OECD – WCO joint conferences, etc.
5.1.3. As of date, it is safe to state that the Transfer Pricing – Customs convergence is a medium-to-long term horizon. Meanwhile, it is the taxpayer who is at a disadvantaged position, with rising costs and efforts at separate compliances. Hence, it is up to the taxpayer to devise ways to attain convergence, wherever possible. In this context, Counterparty Convergence may be instrumental in reducing the burden on taxpayer and thus achieving a practicable solution.
24 The school of thought mentioned in paragraph 3.3.3 above, which is cautious about the convergence, has its key objections on the practicability of the convergence, rather than the concept.
Leveraging the Reverse Pulls | Aditya Panse P a g e | 20 6. Bibliography
Smith, Todd R. and Chandler, Clark “Recent developments in integrating Customs, Transfer Pricing”, Transfer Pricing Report, Tax and Accounting Centre, Bureau of National Affairs (2010)
Methenitis, Willim M. And Wrappe, Steven “WCO endorses pricing studies to support customs valuation” 19 Transfer Pricing Report 859, Tax and Accounting Centre, Bureau of National Affairs
Nicols, Gregory G. “How a transfer pricing dream becomes a customs nightmare” 19 Transfer Pricing Report 440, Tax and Accounting Centre, Bureau of National Affairs
Ping, Liu (WCO) and Silberztein, Caroline (OECD) “Transfer Pricing, Customs Duties and VAT Rules: Can we bridge the gap?”
Minutes of 30th session of Technical Committee on Customs Valuation, document number VT0726E1A, dated 13 January 2009
Majumder, S Dutt “Convergence of Transfer Pricing and Customs Valuation - Is it a myth?” http://www.taxindiaonline.com/RC2/inside2.php3?filename=bnews_detail.php3&newsid=5671
Senguttuvan, K “Customs Valuation vs Transfer Pricing” www.taxmanagementindia.com
“Australian Customs produces guidance on valuation and transfer pricing” (http://www.tpweek.com/ ArticleID=2258810) dated 23 Jul 2009
“Revenue Watch: India” (http://www.tpweek.com/ArticleID=1450382) 09 Oct 2007
Australian Customs And Border Protection Service Practice Statement number PS2009/21
The Transfer Pricing Agenda on the website of Directorate General of Valuation, Central Board of Excise & Customs (http://www.dov.gov.in/newsite3/TP_AGENDA.asp)
Minutes of conference of Chief Commissioner’s meeting held at Mumbai Customs House on 1.10.2005, 15.1.2010 (www.dov.gov.in)
Joshi, Rakesh Mohan, (2009) International Business, Oxford University Press, New Delhi and New York ISBN 0195689097
Guidelines for Multinational Enterprises, Organisation for Economic Cooperation and Development ISBN 978-92-64-05597-1
Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations issued by Organisation for Economic Cooperation and Development (2010) ISBN 978-92-64-09033-0
http://www.wcoomd.org/home_valoverviewboxes_valoverview.htm
Kinetic Honda Motor Ltd. vs. CIT (2001) 72 TTJ (Pune) 72 : (2001) 77 ITD 393 (Pune)
Honda Siel Cars India Ltd. vs. Assistant Commissioner of Income Tax (2007) 111 TTJ (Del) 630 : (2007) 109 ITD 1
Serdia Pharmaceuticals (India) Private Limited vs Assistant Commissioner of Income Tax (2011-TII-02-ITAT-MUM-TP)
Coastal Energy Pvt Ltd Vs ACIT [TS-356-ITAT-2011(CHNY)]
SNF (Australia) Pty Ltd v Commissioner of Taxation [2010]FCA 635 (25 June 2010)
Leveraging the Reverse Pulls | Aditya Panse P a g e | 21 Maruti Suzuki India Limited vs Addl Commissioner of Income Tax (2010-TII-01-HC-DEL-TP)
http://en.wikipedia.org/wiki/Comity
