Transfer Pricing Assessments in India · Issues involved from Transfer Pricing perspective • Quantification and allocation of „locationsavings‟is a subject matter of controversy

B S R & Co LLP

Transfer Pricing

Assessments in India

Pankil Sanghvi

Director

Global Transfer Pricing Services

28 March 2015

12015 B S R & Co. LLP, a firm of Chartered Accountants, duly registered under the Indian Partnership Act, 1932. All rights reserved

Agenda

• Current Transfer Pricing Landscape

1

• Key Issues and Challenges

• Advance Pricing Agreements

• Base Erosion Profit Shifting

• Question & Answers

• Annexures


Current Transfer Pricing Landscape


Business

restructuring and

exit charges

Location

advantages

More audits,

disputes and

litigation

Increasing onus on

taxpayer

Scope of

regulations

expanding

More and more

complex regulation

Aggressive practices

by tax authorities

Dissatisfaction with

profit based

methods

Transfer Pricing – A proliferation in recent times....


Transfer Pricing in the news in Indian context…

`


…Transfer Pricing in the news in Indian Context


Transfer Pricing Litigation Scenario in India

Assessment Year Adjustments

(in INR Cr)

2002-2003 1,220

2003-2004 2,287

2004-2005 3,432

2005-2006 7,754

2006-2007 10,908

2007-2008 24,111

2008-2009 44,532

2009-2010 70,000

2010-2011 60,000

2011-2012 47,000

Ten rounds of TP Audits completed- AY 2002-2003 to AY 2011-2012:

Source: http://www.financialexpress.com/article/fe-columnist/cleaning-up-the-transfer-pricing-mess/57164/


Key Triggers and Contributors for Transfer Pricing audits

Contributors to Aggressive Audits:

• Mounting fiscal deficit on Government

• Need to preserve tax base

• Constant competitive pressure to

restructure business operations efficiently

• Unprecedented sharing of information

between revenue authorities

Key Triggers for Aggressive Audits

• Consistent losses / low margins of the assessee

attributable to inter-company transactions

• Significant changes in profitability of the assessee

and its Associated Enterprises

• High Royalty / Technical fee payouts, Cost

recharges, Management Fees, Cost allocations. ‟

• Net losses incurred by routine distributors

• Low mark-ups for services

• Significant Advertisement and Marketing spends

by manufacturing / distribution companies.

• Usage of foreign comparable / selection of

tested party

Countries like Canada, Germany, Japan, Australia and China are known to be very aggressive

in transfer pricing audits…. India also ranks amongst one of the most aggressive jurisdiction


CBDT Circular – Modi Effect

Key Features of Circular:• Highlighting the needs for non adversarial tax regime.

• Appointments given to the public to be honoured in terms of time and commitment

• Long / non specific questionnaires and high pitched assessment without proper basis to be avoided.

• Range Heads given responsibility to obviate frivolous additions without proper basis.

• Recovery of demand, stay of demand, etc. to be rationalized.

• Remand report in CIT(A) cases only on specified matters.

• Department appeals to be filed before appellate authority only in meritorious cases.

• Taxpayer grievances to be resolved expeditiously.

• Non adherence by tax officers to invite disciplinary action.


Landmark decision by Government – Vodafone case

High court in Vodafone case ruled as under:• “The tax can be charged only on income and in the absence of any income arising, the issue of applying the

measure of Arm's Length Pricing to transactional value/ consideration itself does not arise."

• “The amount received on issue of shares is admittedly a capital account transaction not separately brought

within the definition of Income.”

• “The ALP is meant to determine the real value of the transaction entered into between AEs.”

• “It does not warrant re-computation of a consideration received / given on capital account.”

• As per the press release dated 28th January 2015, the Government accepted the order of the high court and

decided not to file SLP against it before the Supreme Court of India.

• The Government was of the view that the decision will bring clarity and predictability for taxpayers as well as tax

authorities.

9


TP Team and their broad approach

TP Team Augmented:

• 2 DITs in Mumbai to become 4 DITs

• 17 TPOs to become 32 TPOs

• SC appeal pending on promotion matter – implementation stalled

Broad approach and mindset – practical aspects:

• HQ charges totally disallowed – intention to debate this matter at higher Court levels

• IT- ITeS – shown leniency – drop in margins alleged – in line with Safe Harbour – 22%

• Guarantee now based on Bank quotes (around 3%) as against interest rate differential alleged earlier – say 10-

12%

• Inbound loan – SBI / Indian rate accepted as against LIBOR

• Agreeing to transactional level justification rather than imposing aggregate level

• Differential mindset amongst different officers in approach – accommodative v/s aggressive

• No share issue adjustment raised – following Vodafone

10


Key Issues and Challenges


Key Issues and Challenges

1 Management Cross Charges

Marketing Intangibles2

Location savings

IT – ITES and Comparability issues

Financial Transactions

3

5

6

Royalties4


Management Cross Charges


Management Cross Charges

14

Group service

Centre

Arm‟s length price based on

cost plus mark-up determined

based on:

• Functional and

Economic analysis

• Availability of internal /

external data

Beneficial

services

Non-

Beneficial

services

Chargeable

services

Non-

Chargeable

services

Payment towards management fees by Indian

Associated Enterprises (AEs) to overseas

group company is generally towards the

following services:

• Planning & Coordination,

• Budgetary Control,

• Financial advice,

• Accounting,

• Auditing,

• Legal services,

• Computer services,

• Financial services,

• Management and administrative services,

• Purchasing, marketing and distribution,

• Human resource services etc.


Revenue approach towards allocation of Management fees

Benefits Payout

• Management fee charge-outs by AEs are investigated in great detail by the Revenue department

• Robust / exhaustive documentation requirement demanded to evidence

• appropriateness of fee charged

• receipt of services

• benefits received .

• Complete / partial disallowance of fee charged , if all of the above is not provided

• Revenue also enquires into whether a similar charge is levied on other group entities and rates thereof are also

called for and examined

• Typical mindset of the Revenue is that management charge are used for profit repatriation.


Key Consideration


Marketing Intangibles


Marketing Intangibles (Advertisement, Marketing and

Promotion – AMP expenses)

Issue involved / Approach of the Revenue

• Assessee spends significant amount on AMP expense benefitting the AE by creating marketing intangibles

without receiving corresponding compensation/ reimbursement from the AE.

• Revenue authorities compare expense to sales ratio of assessee with that of other comparables – Concept of

“bright-line”

• Disallow AMP expense in excess of comparables ratio and make TP adjustment - alleging contribution by

taxpayer is towards strengthening AE owned brands.

• Expectation of mark-up on recovery of AMP expense in excess of bright line. The average AMP expenses

incurred by companies in the industry is considered as Bright Line for the purpose of Transfer Pricing analysis.

Excess Assumed to be incurred

for strengthening brand

name of foreign AE

Indian licensee:

Must be reimbursed along

with suitable profit mark-up

AMP spend by

Indian licensee

Arm‟s length

licensee

expenditure(-)

Bright line

Bright line method adopted

by relying on US Tax

court case in DHL

Recent Delhi High Court Decision in LG Electronics India Private Limited


Location savings


Concept of Location Savings

• Net „Cost savings‟ realized by an MNC as a result of relocating manufacturing functions / production /

operation sites from a „high cost‟ to „low cost‟ jurisdiction to obtain competitive advantage.

Typical cost savings include savings pertaining to:

• Labour costs;

• Raw material costs;

• Rent and property taxes;

• Training costs

• Infrastructure costs and

• Incentives including tax exemptions

• Most low cost locations are in the „Developing World‟ (e.g.- India, China, Malaysia etc)

Location savings = Input cost in a high cost region – Input cost in a low cost region


Economic analysis necessary to assess location savings

Economic analysis necessary to assess:

• Whether or not an MNE benefits from Location Savings in certain locations – Before/ After comparison

• Which entity (parent/local subsidiary) is entitled to such benefits

Other Profit

Production Cost

Before Transfer

Other Profit

Savings due to difference in

input costs

Production Cost

Cost

Difference

After Transfer

Location

Savings


Issues involved from Transfer Pricing perspective

• Quantification and allocation of „location savings‟ is a subject matter of controversy between tax payers and

revenue authorities.

• Whether the entire cost difference after the transfer of functions / processes to low cost jurisdiction is „location

savings‟ i.e. how to quantify location savings ?

• Even if „location savings‟ is quantified, who is rightful owner of additional profits from location savings, the

parent company or the overseas subsidiary („AE‟) i.e. Attribution ?

• Existence and allocation of „location savings‟ depends upon the bargaining power of the parties. The

bargaining power is determined by 1) economic or beneficial ownership of intangible property, 2) monopoly

power such ownership bestows (uniqueness of the intangible) and 3) The relative competitive position.

Tax authorities in low-cost jurisdictions seek

to deepen their tax bases by retaining back

their portions of cost savings through TP

regimes ( i.e. the overseas subsidiary )

Tax authorities in high cost jurisdictions try to

shift savings to their country by applying

CPM with a small profit mark-up ( i.e. the

Parent company )


UN TP Guidelines – India Chapter Abstracts

• In view of Indian Transfer Pricing administration Location savings should be one of the major aspects to be

considered while carrying out comparability analysis during transfer pricing audits.

• India provides operational advantages to the MNEs such as labour or skill employee cost, raw material cost,

transaction costs, rent, training cost, infrastructure cost, tax incentive etc.

• Location specific advantage (LSA) that India provide to MNE‟s in addition to location savings (Incremental profits

from LSA termed as Location rent):

• Highly specialized and skilled manpower and knowledge;

• Access and proximity to growing local/regional markets;

• Large customer base with increased spending capacity;

• Superior information networks;

• Superior distribution networks;

• Incentives; and

• Market premium

• Indian transfer pricing administration believes it is possible to use profit split method to determine allocation

of location savings and rent in case comparable uncontrolled transactions not available).

• Functional analysis and bargaining power should both be considered appropriate factors.

• It is also emphasized that arm‟s length compensation for cost savings and location rents should be such that both

parties would benefit from participating in the transaction. It should reflect a appropriate split.


Royalties


Royalty Payouts - Background

• Royalty payments have faced stringent tax scrutiny in recent times.

• Historically India has been a technology importing country.

• With the advent of MNCs, royalties were increasingly viewed as cash repatriation tools – tax shield on

royalty payments plus credit of withholding tax in receiving country.

Various payment models

Normal Royalty streams Percentage on sales or profit, per unit royalty, lump sum payment etc.

Package Pricing Amount included in transfer price of goods, no separate royalty payment.

Industrial franchise

arrangements

Franchise fee paid by licensee to licensor for entire business format including

production process, marketing strategies, etc.

Others Separate royalty fees for trademark / trade name and technology.


Issues relating to Royalty payouts

Taxpayers asked to:

• Satisfy „Benefits test‟

• Establish direct correlation with sales/ profitability

• Whether royalty is embedded in price paid

• Rebut the allegation that India performs high end activities that contribute to development of R&D intangibles

• Justify royalty in a loss situation

Benchmarking Issues:

• Approvals received by RBI not acceptable as external CUP

• Aggregation approach under TNMM – Challenged and general lack of availability of comparables.

• Transaction specific approach has been adopted by revenue – Outright rejection of rationale for payment. ALP

held to be NIL.

• Non acceptance of foreign comparable / databases.


Documentary evidences / analysis to substantiate Royalty

payouts

• Copies of license agreement.

• Tangible benefits received / receivable by the tax payer and quantification of the benefit

• Quote of a comparable independent technology recipient for the Intangible

• Rates at which the royalty is paid for use of similar intangibles by any other concern / subsidiary of the AE /

Group and comparative profits before and after the use of intangible

• Unique nature of the intangible, market where it is used and strategic advantage achieved

• Rights of the taxpayer to receive upgrades

• Whether there are any geographic restrictions such as to export based on the licensed technology.

• Form and manner in which the technology was provided i.e. drawings, specifications, moulds, formulae, etc.

• Dependence of business on the technical know how obtained and inter-linkages between business activities

and technical know how

• Detail of R&D activities undertaken by AE for developing (and continuously improving) the technology.

• Form and manner of initial technical guidance and troubleshooting provided any ongoing/ continuous

improvements provided

• Record of updates received and record of on-call technical support


Financial Transactions


Interest on Loans - Broad approach and issues involved in

interest

• Interest rate benchmarking analysis consists of two main components: Credit rating of the borrower; and

identifying comparable lending arrangements between third parties with comparable terms and credit ratings

• Following broad process which can be followed to determine an arm‟s length interest rate and the issues

involved are as under:

29

Determining

creditworthiness of the

borrower

Adjusting the risk

factors for specific debt

characteristics

Determining arm‟s

length interest rate

range

Corroboration by using

available market data

Steps Issues

Availability of comparable data

Strict comparability a challenge

Adjustments on account of risk profiles

Appropriate interest rate (PLR / Deposit

rate / LIBOR / Base rate)

Thin capitalization provisions under GAAR


Guarantees - Issues involved

Taxpayer‟s Approach

• If akin to an investor / shareholder activity - no fees attributed

• If akin to services - fee attribution made

• Benchmarking - guarantee fees /commission on basis of mutual agreement / bank quotes

• Also rely on paragraph 7.13 of the OECD TP Guidelines:

Similarly, an associated enterprise should not be considered to receive an intra-group service when it obtains incidental benefits

attributable solely to its being part of a larger concern, and not to any specific activity being performed. For example, no service would

be received where an associated enterprise by reason of its affiliation alone has a credit-rating higher than it would if it were

unaffiliated

Tax Department‟s Approach

• Insistence on arm‟s length compensation for giving guarantee, as AE avails benefit in form of reduced interest rates

and favourable borrowing terms

• Domestic interest rates are used as potential benchmarks

• Information available on the website of Indian banks generally considered

• Exorbitant guarantee fee in range of 3 to 14 percent considered resulting in huge TP adjustments

30

Non availability of specialized database, complex inter-company loan instruments and implicit

element of guarantee from parent company – A challenge


IT- ITES and Comparability Issues


IT / ITES - Key Challenges faced by Captives

• Difficulty in finding exact comparables - In TP audits, compared with full

fledged entrepreneurs - Denial of economic adjustments citing single

customer, capacity, forex risk

• Extensive FAR analysis being done to re-characterize Indian entity

• Routine v/s. value added services (VAS) - Considering VAS as

Contract R&D and asking for arm‟s length compensation for

generation of Intellectual Property (IP)

• Cost base an issue – different views on points such as forex gain / loss,

provision for doubtful debt, pass through costs (eg travel) etc

• Non-charging of management costs / IT costs etc by parent results in

a lower cost base and consequently low profits in India

• Enhancement on account of Location Savings

• Use of secret comparables by exercise of powers u/s. 133(6) to gather

information not publicly available

• Cherry-picking of favorable / high margin companies for benchmarking

analysis

• TP authorities impute notional interest on receivables outstanding

beyond reasonable period


IT / ITES - Key Challenges faced by Entrepreneurs

• Foreign benchmarking not accepted by the Indian Revenue Authority

• Why not India as Tested Party?

• Fluctuating margins for India - adjustment on entity as a whole

• Profits transferred to Overseas Subsidiaries in case Indian Parent

making losses

• Demonstration of value addition overseas

• Indian Tax authorities emphasize on delivery capabilities more than

marketing

• Overseas tax authorities too expect subsidiaries to earn return on

revenue share

• No recovery of management costs from subsidiaries

• Why Indian entrepreneur saddled with costs

• Provision of corporate guarantees, performance guarantees for nil

consideration by Indian entrepreneur

• Secondment of trained personnel - whether to charge transfer/

secondment fees?


Comparability issues

• Sogo Shosha akin to trading activities and not provision of services –

to earn return on value of goods traded (Delhi Tribunal in the case of

Mitsubishi Corporation India)

• Trading arrangements – whether differences recognized/respected?

• Full-fledged distribution vs. limited risk distribution vs. commission

agent vs. marketing support services

• Consistent losses / low margins – whether RPM is the right approach?

• Manufacturing arrangements

• Unutilised / Idle capacity

• Different arrangements – full risk manufacturer vs. licensed

manufactures vs. contract manufacturer

• Filters:

• Turnover filter

• Related party transactions filter

• IP owning vs non-IP owning companies


Advance Pricing Agreements


Indian APA Program – Key Features

Indian APA Program announced in August 2012

(FY 2015-16 through 2019-20)

Provides certainty for 5 tax years

(FY 2015-16 through 2019-20)

Anonymous filing option

More cooperative approach, as

compared to desk audit

Significant cost saving (internal and external resources)

Bilateral option would mitigate

double tax


Indian APA Program – Advantages

• No transfer pricing audits and adjustments for five years.Certainty

• Pre-filing application and meeting can be anonymousAnonymous

• Can decide not to pursue an APA if it does not like the results

Non-committal

• Taxpayer does not have to pay any filing fee for pre-filing application

No Filing Fee

• Pre-filing application is simple - does not require significant time commitment form tax payers team

Simple

• May spend only a small portion of total APA budget for pre-filing

Cost Efficient

• The APA Team provides open and honest feedback based on facts presented during pre-filing meeting

Open Feedback

• Can evaluate the APA environment without significant investment of time and money

Evaluate APA Approach

Primary Advantages Secondary Advantages


Transfer Pricing litigation system V/s APA mechanism

Timelines

8 months

Transfer Pricing Documentation

Transfer Pricing Audit

Dispute Resolution Panel (DRP)

1st Appeal (Commissioner (Appeals)

2nd Appeal

Income tax Appellate Tribunal

3rd Appeal

High Court

Final Appeal

Supreme Court

1 year 2 years 3 years 4 years 4 years

2 to 3 years

Total, over 12 years for

each tax year

APA process


Our experience so far

FY 2012 - 13

• 146 APA applications filed in the first year

• Of the applications received, 117 applications have been received for

Unilateral APAs and 29 for Bilateral APAs

• Over 90 percent of pre-filings (146 out of 158) converted to applications

FY 2013 - 14

• CBDT signed 5 unilateral APAs i.e. within one year of filing which is highly

appreciated globally

• 232 applications filed in the second year

• Of the above, 206 pertain to unilateral APAs, while the rest 26 pertain to

bilateral APAs

Pragmatic approach of the APA authorities with strong emphasis on establishing and

mutually agreement on detailed FAR

FY 2014 - 15

• A total of about 500 APA applications are expected to be with income-tax

department currently.


Roll Back Rules

Salient Features of the rollback rules are as follows:

• An applicant for an APA is allowed to request a roll-back provision if:

• The international transactions for which the roll-back is requested are the same as the international

transactions proposed to be covered in the APA;

• The applicant has filed its return of income and Form 3CEB for the roll-back years within the due date;

• No order of the Income-tax Appellate Tribunal („ITAT‟) has been passed (before the signing of the APA)

covering the determination of the arm‟s length price of an international transaction proposed to be covered

during the roll-back, in any of the roll-back years; and

• The application of the roll-back provision does not have the effect of reducing the total income or

increasing the loss, as declared in the return of income pertaining to the roll-back years.

• The application for roll-back of an APA in Form 3CEDA is required to be filed along with the Main APA

application.

• If APA is already filed earlier, the Rollback application is to be filed on or before 31 March 2015.

• The government filing fee for the roll-back application is INR. 500,000.


Base Erosion Profit Shifting (BEPS)


Intangible related - Indian perspective…

• Location Savings - Where local comparable are available, specific adjustments on account of location savings

are not required.

• Marketing Intangibles - Whether the marketer / distributor should also be compensated for enhancing the value

of trademarks and other marketing intangibles.

• Adjustment (if any) to be subsumed in the FAR and comparability analysis - principle reiterated in

recent Delhi High Court ruling.

• R&D arrangements - appropriate compensation for research services will depend on all the facts and

circumstances (whether research team possesses unique skills and experience, bears risks, uses its own

intangibles etc.)

42

Various issues included in the Guidance are contemporary, highly debated and

frequently litigated transfer pricing issues in India

Also refer to the Annexure for more details


…Intangible related - Indian Perspective

• Even before the introduction of the BEPS action plan the Indian Revenue authorities issued Circular no. 6 which

discusses circumstances in which profit split method will apply for determination of compensation in case of R&D

centers developing intangibles. India also adopts the „Significant Peoples Function‟ as a criteria in allocation of

profits relating to intangibles which is in line with OECDs guidance.

43

Contract R&D

Entities with minimal functions, assets and risk, foreign

entity funds and monitors progress

Circular No. 6

Entrepreneurial R&D Centers

Entities performing significantly

Important functions, assets and risk

Cost plus remuneration is appropriate and

share in profits not necessary

Intangible related return to be attributed to the

Indian researchers under Profit Split Method


Action 13 – TP Documentation and CbC report

Three-tier documentation structure proposed for all countries

• Master file to provide the MNE‟s blueprint i.e.

• The group‟s organizational structure

• A description of the group‟s business, intangibles, intercompany financial activities and financial and tax

positions

• Local file to provide material transfer pricing positions of the local entity / taxpayer with its foreign affiliates

• Demonstrates arm‟s length nature of transactions

• Contains the comparable analysis.

• Country by Country („CbC‟) Report to provide

• Jursisdiction-wise information on global allocation of income, taxes paid / accrued, the stated capital,

accumulated earnings, number of employees and tangible assets

• Entity-wise details of main business activities which will portray the value chain of inter-company

transactions.

Hint of adoption by India – GAAR v/s BEPS an issue


Country by Country Reporting template…


…Country by Country Reporting template


Questions & Answers

Questions

&

Answers


Annexure to BEPS


Transfer Pricing aspects of intangibles

Objective

• Prevent BEPS that may result from abuse of

transfer pricing rules related to cross-border

relocation of intangibles and other transactions

involving use of intangibles

• Ensure that transfer pricing outcomes are in

line with 'Value Creation”

Guidance issued has certain areas in “interim

draft”

To be finalised in 2015 along with other BEPS

action points that are closely related (risks and

capital, high-risk transactions and hard to value

intangibles

Key areas covered in the Guidance

• Detailed guidance on location savings,

assembled workforce and MNE group

synergies as part of Chapter I of OECD

guidelines

• Broader definition of intangible property (six

specific categories of intangibles discussed)

• Ownership of intangibles and entitlement to returns –

who is entitled to returns from intangibles

• Relevant considerations for various transactions

involving intangibles

• Supplementary guidance around determining arm‟s

length conditions involving intangibles – considers

unique features of intangible transactions


Implementation and India Perspective

Implementation:

• OECDs endeavor to balance:

• usefulness of TP documentation under 3-tier structure to tax authorities, and

• increased compliance cost and efforts for taxpayers

• Though consented by OECD member countries and G20 countries, which includes India:

• Mechanism for sharing information with tax administrations yet to be formalized

• – whether Master File and CbC report to be filed by Parent Co. or local entity

• Taxpayers concerns about sharing business sensitive data

• CbC report ought not be used by tax administrations to propose transfer pricing adjustments based on

a global formulary apportionment of income.

• Indian Competent Authority commented – India is actively and closely involved in BEPS action plan and

will seek to implement OECDs recommendations on TP documentation*

Documents

Transfer Pricing Assessments in India · Issues involved from Transfer Pricing perspective • Quantification and allocation of „locationsavings‟is a subject matter of controversy