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Issues and challengesWhy IT/ITeS?
Favourite area for transfer pricing assessments in India – sector dominated by MNCs.
Most common approach to establish ALP is to apply TNMM.
No tax holiday on TP adjustments
Transactions resulting in more than ordinary profits, excess disallowed.
Transition from tax holiday to non-tax holiday
Potential areas?!
-Permanent Establishments
- Attribution of location savings for
Niche researches undertaken
Slide 4
Issues and challengesComparability, key area of focus
Large outbound multinationals having turnover multiple times when compared to the low-end captives are often not appreciated by tax authorities.
Several ITAT rulings have examined and ruled on comparability aspects considering functions, assets and risk (FAR) analysis, turnover criteria, etc. Few examples – Infosys, Wipro, Tata Elxsi, I-Gate, E-clerx, etc. TPOs continue to select these companies as comparable.
Low end back office support services (BPOs) and high-end service providers (KPOs) – Not differentiated
Tax authorities disregard the qualification/skill sets of employees and re-characterize taxpayers as KPO (which requires them to earn high profit margin) and accordingly make adjustments
New areas of comparability are being looked at every year & Increasing focus on the high end functions of the tax payer
Slide 5
Issues and challengesTypical favourites of tax administration
IT/Softwaredevelopment services segment
IT enabled services segment
Infosys Technologies Ltd. Infosys BPO Ltd.
Kals Information Systems Ltd. Accentia Technologies Ltd.
Wipro Ltd. TCS e-serve Ltd.
Tata Elxsi Ltd. TCS e-serve International Ltd.
Acropetal Technologies Ltd. E-clerx Services Ltd.
Moldtek
Coral hubs Ltd
Slide 6
Issues and challengesOther key issues faced during assessments
1.Use of single year data – TPOs and appellate authorities have consistently denied use of multiple year data
2.Secret comparables - use of powers conferred u/s 133(6)
3.Rejection of filters adopted by tax payer
4.Rejection of TP documentation maintained –liberal use of powers u/s 92C(3)
5.Re-perform tax payer’s qualitative BM analysis and choose high margin companies
6.Challenges in PLI computation for comparables: pass through costs; un-realised foreign exchange loss/gain
7.Denial of economic adjustments such as risk adjustment, working capital adjustments, etc.
Slide 7
Issues and challengesSubstance over Form
Substance over form creates further anxiety during audits, certain instances:
1. Terms as per inter-company agreements - scope of work, etc.
While the actual work performed would be that of back office support or low end IT services, scope of
services in the inter-company agreements would be more elaborate and indicate high end services. Invoices may further not speak the language of the actual service provision.
2. Billing – hourly rates vs. cost plus
While the functions performed would be that of a captive, be it IT/ITeS, the remuneration model would not indicate the same. Further, behaviour of the tax payer for the purpose of retaining profits in tax holiday units.
3. Where in value chain?
TPOs often tend to oversee the position/roles of the tax payer in the entire value chain of Group companies’ business.
Slide 8
Issues and challengesEntrepreneurs vs. captives – need for differentiation
Differences in the functions and risks between entrepreneurial IT/ITeS companies and captive IT/ITeS companies:
Entrepreneurial companies Captive companies
Operates on a time & material (T&M) basis with a split for man hour charges for offshore and onshore
Operates as a part of the in-house team of the parent generally operating as a wholly owned subsidiary of the parent
Business model – extended arm of the client & generally provide access to source codes and IPR for execution of the contract
Business model - provided with access to all source codes along with technical know-how.
Does business development and marketing of the services.
No marketing element involved
Responsible for warranties on the programmes developed along with provision support upto certain period of time.
Captives does not take any warranty for the programmes developed
Generally end-to-end projects are sought by customers Involved in providing low-end support to the services provided by parent
Slide 9
Issues and challengesCertain case laws… contd…
Captives do not constitute PEs
The Hon’ble Delhi High Court in the context of Permanent Establishment, rendered in the case of e-funds Corporation and e-funds IT Solutions Inc. that an Indian subsidiary, on a standalone basis or by itself, would not create a PE of the foreign principal.
Disallowance - Super normal profits
Hon’ble Pune Tribunal decision in the case of Tweezerman India P Ltd. TS-344-ITAT-2013(CHNY)-TP held that the AO was not right in disallowance of deduction u/s 10B on excess transaction price over ALP.
[In this case, the AO held that the benefit u/s 10B was disallowable to the extent of excess of assessee's profit for computation of Sec. 10B over arm's length profit determine by the TPO. Accordingly, it was held that the assessee was not entitled to Sec. 10B benefit on Rs. 3.66Cr.]
Slide 10
Issues and challengesCertain case laws… contd…
BPO vs KPO & High Profit comparables
Hon’ble Mumbai Tribunal (SB) decision in the case of Maersk ruled on the following important principles.
• ITES services could not be further bifurcated or classified as BPO and KPO services for the purpose of comparability analysis.
If a taxpayer was found to have provided low-end back office support services like voice or data processing services as a whole, or substantially the whole, then companies providing mainly high-end services by using their specialized knowledge and domain expertise could not be considered as comparables.
• Potential comparables could not be excluded merely on the ground that their profit was abnormally high.
Abnormally high profit margin should trigger further investigation, including profit margin earned in the immediately preceding year/s to find out whether the high profit margin represented the normal business trend. If the high profit margin did not reflect normal business conditions, the high profit margin making entity should not be included in the list of comparables.
Slide 11
Safe Harbour RulesCoverage and rates
# Eligible International Transaction Proposed Safe Harbour (OP/OE not less than)
1. Software development services*20% for transaction value up to INR 5 Billion;22% for transaction greater than INR 5 Billion2.
Information technology enabled services*
3. KPO 25% - no range
4. Contract R&D services (software) 30% - no range
* With insignificant risk
Slide 12
(a) interest income;
(b) income arising on account of foreign currency fluctuations;
(c) income on sale of assets/investments;
(d) refunds relating to income tax expense;
(e) provisions no longer required written back;
(f) extra-ordinary items;
(g) other incomes not relating to operating activities
Operating Income Excludes
(a) interest expense;
(b) provision for unascertained liabilities;
(c) pre-operating expenses;
(d) loss arising on account of foreign currency fluctuations;
(e) extra-ordinary expenses;
(f) loss on transfer of assets/investments of;
(g) expenses on account of income-tax;
(h) other expenses not relating to operating activities
Operating Expense Excludes
Safe Harbour RulesInsignificant risk
The description of an eligible taxpayer with insignificant risk is in line with criteria prescribed in a recently issued Circular (No. 6/2013 dated 29 June, 2013)
Foreign Principal Indian Service Provider (ICo)
Economically significant functions
(Conceptualisation, Design, etc.)
ICo is largely involved in economically insignificant
functions
Funds/capital and other economically
significant assets including intangibles
ICo does not use any other economically significant
assets including intangibles
Capability to control or supervise through
its strategic decisions to perform core
functions as well as monitor activities
ICo works under direct supervision of foreign principal
Assumption of risksICo does not assume or has no economically significant
realised risks
Ownership right (legal or economic) on
outcome of research
ICo has no ownership right on outcome of research
which shall also be evident from conduct of the parties
Slide 13
Issues and challengesLearning lessons
Learning Lessons
Detailed FAR / BM Analysis
Robust TP documentation-
Alignment of Form &
Substance
Timely representation
Periodic review of TP policy & inter-company
agreements
Suo-moto adjustment
Supplement Analysis
Slide 14
Private Equity and Asset Management
Issues
• An Indian company provides non-binding investment recommendations receives a cost plus mark-up in the range of 15% to 20%
• During TP audits, mark-ups upwards of 50% applied by tax authorities by selecting asset management companies and investment bankers as comparables (Tribunals have granted relief in various cases such as Carlyle, Bain Capital, Tamasek, etc)
• Possible approach
• Certainty on methodology, characterisation (Indian entity and AEs) and mark-up
Funds
Investment management
agreement
Investment Advisor
Investment sub-advisor
Investment Advisory
agreement
Sub- Advisory / Consultancy
agreements
Investment Manager
Outside India
India
• Fund raising and investor relations
• Investment management• Evaluation of opportunities• Final decision making
• Identification and advising Manager
• Screening & evaluation of Sub-advisor’s recommendation
• Preliminary analysis• Detailed analysis• Support / monitoring
services
Slide 16
Issues
• Transactional Net Margin Method (‘TNMM’) selected as the most appropriate method by the tax payer.
• Comparable Uncontrolled Price (‘CUP’) Method applied by the Indian tax authorities using other third party (3P) transactions.
Possible approaches
• Selection of most appropriate method
- Use of TNMM considering various products and operational mechanism selected.
- In case of CUP, agree on mechanics for adjustment towards:
◦ Distinguishing functions performed for AEs vis-à-vis non AEs (i.e. marketing, research) and it impact on pricing.
◦ Consideration of volume adjustments on pricing brokerage rates.
Indian Broker
AE FII client
3P FII clients
Domestic clients
Brokerage income
India
Overseas
Equity Broking
FII - Foreign Institutional Investor
Slide 17
Investment Banking
Type of IB transactions / deals
1. Mergers & Acquisitions 3. Underwriting
2. Debt and Equity Capital Market
Typical functions 1. Origination 3. Structuring
2. Execution 4. Distribution / Underwriting
Typical pricing mechanisms
1. Pooling of revenues and costs & profit split based on key driver
2. Revenue split on deal by deal basis
Allocation keys / Weights 1. Market Surveys 3. HR Index
2. Employee cost 4. Time spent
Most Appropriate Method
Integrated functions
1. Revenue Split (Other Method)
2. Profit Split Method
Support functions
1. TNMM
Slide 18
Investment Banking
Key points for consideration :
• Application of global policy to Indian operations / basis of pricing
• Consistent allocation for profits and losses
• Confirmation on basis of allocation /application of global policy (e.g. compensation, HR index, etc.)
• Framework for treatment of policy exceptions, if any
Slide 19
Key Issues in Financial Services
Cost Allocations
Generally large Banking Groups centralise various support functions such as IT, Legal, Finance, HR on a global / regional level and such costs are allocated across affiliates, including Indian entity, on the basis of reasonable allocation keys (with or without mark-ups)
Typical Issues
• Demonstration of benefit test analysis with adequate documentation
• Determining whether there is any duplication of services / shareholder costs being charged
• Determining the appropriateness of the cost pool and allocation keys used
• Justification for charging a mark-up, if any
• Absence of independent Accountant’s Certificate to support the amount allocated to India
• No deduction available to India bank branch, in absence of actual payment
Possible approaches
• Guidance on level of documentation that could be maintained on an annual basis to demonstrate receipt of benefits
• Certainty on the allocation basis
• Documentation to support accuracy of cost allocation to India – audited statements
• Confirmation on mark-up on certain costs
Slide 20
Offshore Loans
India Branch
Functions• Origination and sales support
(documentation, credit review support, etc.)• Loan monitoring and administration
Overseas Branch
Functions• Sales conclusion• Loan management • Risk assumption• Capital Raising
Risks• Operational risk (minimal)• Reputational risk
Risks• Credit risk• Interest rate risk• Liquidity risk
ABC Bank Singapore
Third party borrower
Overseas
India
ABC Bank India branch
Assists in loan origination and sales support
Approaches Indian branch
for foreign currency loan
Loan advanced by Singapore branch to the
third party borrower
Fees and interest paid by third party borrower to Singapore branch
Typical Functions / Risks
Slide 21
Offshore Loans
Possible approaches
• Confirmation of functional analysis in relation to roles performed by India branch and overseas AE
• Arm’s length pricing based on comparability analysis, considering:-
- Approaches based on global databases such as LoanConnector, Deal Scan, etc. that provide data as a proxy for origination, support functions.
- Back Testing / corroborating results
- Using internal data, if available
Typical Issues
• Scrutiny to analyze role of each group entity and whether pricing commensurate with functions
• Indian tax authorities typically adopt an approach to apply a percentage in the range of 20 to 25% of the net income to the originating location
• Varied fee split mechanisms adopted by the industry players
Slide 22