Transfer Pricing

A Presentation by Vikram Singh Sankhala

● Where tax rates are different between the countries,there is a strong incentive to shift income to a lower tax country and deductions to a higher tax country so that

● the overall tax effect is minimized.

The Logic behind Transfer Pricing

● Suppose a subsidiary company, resident in country A (which has a tax rate of, say, 30%) manufactures goods and transfers them to its parent company in country B (which has a tax rate of 20%) for trading. In order to increase the overall profits of the group company, it will seek to supply the goods at prices which are lower than the market price. So, in effect, the subsidiary company in country A will have lower profits and hence, a lower tax incidence whereas the parent company in country B is affected in the opposite manner higher profits due to low costs, but lower taxes because of the tax rate.

What was its impact on Governments?

As the aggregate tax payable by MNCs is reduced, tax authorities across the world incur significant losses.

So what did the Tax Authorities do ?

● To guard against such losses, many countries have introduced transfer pricing legislation to govern the pricing of cross border transactions between related parties.

● India has introduced rules and regulations on transfer pricing as of 2001 through sections 92A to 92F of the Indian Income tax Act, 1961 which guides computation of the transfer price and suggests detailed documentation procedures..

SCOPE and APPLICABILITY

Transfer Pricing Regulations ("TPR") are applicable to the all enterprises that enter into an 'International Transaction' with an 'Associated Enterprise'. Therefore, generally it applies to all cross border transactions entered into between associated enterprises.

● The aim is to arrive at the comparable price as available to any unrelated party in open market conditions and is known as the Arm's Length Price ('ALP').

Associated Enterprises ('AEs')- How Identified?

The basic criterion to determine an AE is the participation in management, control or capital (ownership) of one enterprise by another enterprise.

The participation may be direct or indirect or through one or more intermediaries.

Participation in management

● Appointment of more than half of Board of Directors/ Board of Members/ one or more Executive Directors/ Executive Members by :

● - The other Enterprise● - The same person(s)

in both the enterprises.

Participation through Capital

Holding not less than 26%of the voting power directlyor indirectly- in the other enterprise- in each of such enterprise

Participation through Control

● Loan not less than 51% of Book value of Total Assets

● Guarantee not less than 10% of Total borrowings

● Use of Know how, patents, copy right, etc., of which

other enterprise is owner or has exclusive rights

● Purchase of 90% or more Raw Materials and

Consumables for which prices and other

conditions are influenced

● Sale of goods manufactured or processed to other

enterprise or person specified by it for which

prices and other conditions are influenced

or Controlled by same person

● Apart from the above, any relationship of mutual interest, as may be prescribed

● shall also be considered as Associated enterprise.

What is an International Transaction?

● ‘International transaction’ means any of the following nature of transactions between

● Two or more “Associated enterprise” where, either or both of whom are non-residents

● (a) purchase,● (b) sale,● (c) lease of tangible or intangible property,● (d) provision of services,● (e) lending or borrowing money, or● (f) any other transaction having a bearing on the profits, income,

losses or assets of such enterprise.● (e) Mutual agreement between AEs for allocation/apportionment

of any cost, contribution or expense.

● Further section 92B provides that, where a transaction entered into by an enterprise with a person other than an associated enterprises and there exist a prior agreement in relation to the relevant transaction between such other person and associated enterprise, or the terms of the relevant transaction are determined in substance between such other person and the associated enterprises then such transaction shall also be treated as an international transaction.

ARM’S LENGTH PRICE● ‘Arms length price ‘ means a price which is applied or

proposed to be applied in a transaction between persons other than associated enterprises, in uncontrolled conditions.

Section 92C● Section 92C which provides as follows: The

arm’s length price in relation to an international transaction shall be determined by any of the following methods, being the most appropriate method, having regard to the nature of transaction or class of transactions or class of associated persons or functions performed by such persons or such other relevant factors as the Board may prescribe, namely:

TP Methods● (a) Comparable uncontrolled price method● (b) Resale price method● (c) Cost plus method● (d) Profit split method● (e) Transactional net margin method● (f) Such other method as may be prescribed by

the Board

Comparable uncontrolled price method

● In this method, price charged in an uncontrolled deal between comparable entities is recognized and evaluated with the verified entity price to determine the Arm’s Length Principle.

● The CUP method offer the finest evidence of ALP.

Resale price method● This method is used where the vendor adds

similarly little value to goods owned from associate enterprises. Here, Arm’s Length Price is determined by reducing the relevant gross profit mark-up from the sale price charged to free entity.

● The resale price method begins with the price at which a product is resold to an independent enterprises(IE) by an associate enterprises (AE).

● -x sold to AE at Rs.1000 (profit Rs.300)● -AE sold to an IE at Rs.2000● (profit of Rs.500 from relevant IE)● -ALP =Rs.2000-Rs.500 = Rs.1500

Cost plus method● In CP method first

the cost incurred is determined.

● An appropriate cost plus mark up is then added to the cost to arrive at an appropriate profit.

● The resultant is the ALP

Profit Split method● PSM is used when transaction are inter related

and is not possible to evaluate separately.● PSM first identifies the profit to be split for AE.

The profit so determined is split between the AE on the basis of the function performed

Transaction Net Margin Method● Compares the net profit margin of a taxpayer

arising from a non-arm's length transaction with the net profit margins realized by arm's length parties from similar transactions; and

● Examines the net profit margin relative to an appropriate base such as costs, sales or assets.

Points● Arithmetical mean of

prices obtained by most appropriate method to be taken as Arm’s Length Price

● Concept of Arm’s Length Range not found feasible

● Tolerance zone of 5 percent. allowed at taxpayer’s option.

Choice of Most Appropriate Method

Safe Harbour● Section 92CB provides that w.r.ef asst. year 2009-10 Income

tax authorities will accept the transfer price declared by the assessee provided they are in accordance with the Safe Harbour Rules to be notified by CBDT. Safe Harbour means circumstances in which the income tax authorities shall accept the transfer price declared by the assessee.

Comparable uncontrolled price method

● Comparable uncontrolled price method is relevant in case of ● transaction of loans, ● royalties, ● services, ● transfer of tangibles.

Resale price method● Resale price method is

relevant in case of marketing operations of finished products more particularly in case of distribution of products not involving significant value addition.

● In this method the vendor adds comparatively small or no value to goods taken from associate enterprises.

Cost plus method● Cost plus method is

more relevant where raw materials or semi finished products are sold.

● Similarly, it can also be used where joint facility agreements or long term buy and supply arrangements or provisions of services are involved

Profit split method● Profit split method is relevant

where the transactions involved provision of integrated services by more than one enterprise.

● PSM method is used when associate enterprises are so combined that it turns into difficult to make transfer pricing analysis on transactional methods basis.

Transactional net marginal method● Transactional net marginal method is used in

most of the cases including transfer of semi-finished goods, distribution of products where resale price method appears to be inappropriate and also in case involving provision of services.

The obligations of an assessee having international transactions:

● (1) The income from the international transaction should be computed as per arm’s length price

● (2) Every person who has entered into an international transaction shall keep and maintain such information and document in respect thereof and for such period, as may be prescribed by the board and produce before the A.O or commissioner (Appeals) as and when required in the cource of proceedings under Income Tax Act within a period of 30 days from the date of receipt of notice. (3) The assessee entering into an international transaction is also required to firnish an audit report in the form 3CEB by a chartered accountant by 31st of October of relevant A.Y where the assessee is a company and by 31st day of july in other cases.

DOCUMENTATION● The provisions contained in the TPR are exhaustive as far as

the maintenance of documentation is concerned. ● This includes background information on the commercial

environment in which the transaction has been entered into, information regarding the international transaction entered into, the analysis carried out to select the most appropriate method and to identify comparable transactions, and the actual working out of the ALP of the transaction.

● This also includes report of an accountant certifying that the ALP has been determined in accordance with the TPR and that prescribed documentation has been maintained.

● This documentation should be retained for a minimum period of 8 years.

However● In case the value of the international transaction

is below INR 10 million, it would be sufficient for the taxpayer to maintain documentation and information which substantiates his claim for the ALP adopted by him.

● In effect, they need not maintain the prescribed documentation.

Procedure to be followed by TPO while determining ALP:

● (1) Where a reference is made to the TPO, the Transfer Pricing Officer shall serve a notice on the assessee requiring him to produce or cause to be produced on a date to be specified therein, any evidence on which the assessee may rely in support of the computation made by him of the arm’s length price in relation to the international transaction in question.

● (2) On the date specified in the notice , or as soon thereafter as may be, after hearing such evidence as the assessee may produce, including any information or documents referred to in sub-section (3) of section 92D and after considering such evidence as the Transfer Pricing Officer may require on any specified points and after taking into account all relevant materials which he has gathered, the Transfer Pricing Officer shall, by order in writing, determine the arm’s length price in relation to the international transaction and send a copy of his order to the Assessing Officer and to the assessee.

● (3) On receipt of the order under from TPO, the Assessing Officer shall proceed to compute the total income of the assessee in conformity with the arm’s length price as so determined by the Transfer Pricing Officer.

BURDEN OF PROOF - TAXPAYER OR TAX OFFICER

● The primary onus is on the taxpayer to determine an ALP in accordance with the TPR and to substantiate the same with the prescribed documentation.

● Where such onus is discharged by the taxpayer and the data used for determining the ALP is reliable and correct there can be no intervention by the tax officer.

Reference to TPO● In other cases, where the tax officer is of the view that the

● (a) price charged in the international transaction has not been determined in accordance with the methods prescribed,

● (b) or information and documents relating to the international transaction have not been kept and maintained by the assessee in accordance with the TPR,

● (c) or the information or data used in computation of the ALP is not reliable or correct,

● (d) or the assessee has failed to furnish any information or document which he was required to furnish under the TPR

● the tax officer may reject the ALP adopted by the assessee and determine the ALP in accordance with the TPR.

● For this purpose, he would then refer the matter to a Transfer Pricing Officer ('TPO') (a special post created for valuation of ALP) who would determine the ALP after hearing the arguments of the taxpayer.

EFFECTS OF ADJUSTMENT TO THE ALP

In case the ALP determined by the TPO indicates understatement of income by the taxpayer,it could result into the following(a) Adjustment to reported income of the taxpayer(b) Levy of penalty

Adjustment to the Reported Income

● The tax officer is bound to adjust the reported income of the taxpayer with the amount of adjustment proposed by the TPO.

● This would have an effect of increasing the assessed income or alternatively decreasing the assessed loss.

● Furthermore, the eligible deductions available to the taxpayer under section 80 could not be availed on the enhanced income.

● However, those taxpayers who are eligible for deductions under section 10A and 10B remain unaffected as these deductions remain available on the enhanced income.

● Section 92 also provides that its provisions shall not apply where it has effect of reducing the income chargeable to tax or increasing the loss,

Penalties(a) Penalty for Concealment of

Income - 100 to 300 percent on tax evaded

(b) Failure to Maintain/Furnish Prescribed Documentation - 2

percent of the value of the international transaction

(c) Penalty for non-furnishing of accountants report - INR 100,000 (fixed)

● The above penalties can be avoided if the taxpayer proves that there was reasonable cause for such failures.

Drawbacks of the Regulations● Advance Pricing Agreements (“APA”) which are written

agreements between a business enterprise and the tax authorities of the State in which it is a resident, are used to determine a method for determining the ALP in advance of filing returns for a limited period of time. Several countries such as the U.S., Canada, Australia and Japan allow for APAs and have brought APAs within the ambit of their transfer pricing regulations.

● However, the Regulations in India do not providefor an APA mechanism.

● Further, the Regulations do not envisage more uniquesituations such as intangibles, e-commerce, global trading derivatives and so on. Also, matters such as intra-group services and cost-sharing arrangements are not dealt with comprehensively.

Emerging Issues From Recent TransferPricing Audits

● The tax authorities are more comfortable with the CUP Method as compared to the other four methods for determining the ALP.

● Cost sharing arrangements are challenged, if proper documentation is not maintained and furnished for establishing the cost-benefit analysis arising from such cost sharing arrangements

● The tax authorities are generally not comfortable with the use of foreign companies as comparables.

● The tax payers and tax authorities have experienced difficulty in obtaining “exact comparables” on account of difference in risk levels with uncontrolled functionally comparable companies.

● The tax authorities are more comfortable with a transaction wise analysis as opposed to aggregate company wide analysis for determining the ALP.

● In certain cases, the tax authorities have also used secret comparables for determining the ALP.

Data for comparability analysis● India’s TP rules require the use of “current year”

data (data pertaining to the year in which the taxpayer has transactions with group concerns) for transfer pricing analysis.

● The use of prior data (up to two years) is permitted only in certain circumstances when it reveals facts that could influence the determination of current transfer prices.25

Data for comparability analysis● Where profit-based methods are used for TP

analysis, taxpayers generally compute the margins of functionally comparable companies from publicly available data/databases.

● Although these databases are updated regularly, the current-year data is usually not available before taxpayers file their tax return and finalise their TP analysis.

● Taxpayers thus use the past two years’ average data to support the transfer prices.

Data for comparability analysis● However, by the time the case comes up for a TP audit, current-

year data has become available. ● Then TP officers request that data and test a taxpayer’s transfer

prices based on the updated results. ● The practice of conducting fresh searches for comparables and

using current-year data causes undue hardship to taxpayers. ● Even though they may have undertaken a thorough

contemporaneous TP analysis while setting transfer prices, the taxpayers face the risk of TP adjustments and harsh penalties from 100 to 300% of the tax on the adjustment amount.

● Therefore, taxpayers should keep constantly updated about prevailing industry/market trends and undertake comparables selection and economic analysis with utmost care.

Use of ‘nonpublic’ comparables● In some cases, TPOs seek pricing information

from competitors of the taxpayers (for computing the arm’s length price of the taxpayer’s transactions) by exercising the powers granted to them under the tax laws of India.

● The issue requires careful handling and analysis, from a legal/tax as well as an economic viewpoint.

Global arrangements determining India transactions

● Under the Indian TP legislation, a taxpayer’s transaction with a third party is also covered by the TP code if such transaction is a part of an arrangement that the third party has with a group concern of the taxpayer.

● Indian TP authorities have started evaluating such transactions in detail to test them from an Indian TP perspective.

Risk adjustment● The issue of risk adjustment assumes more

significance in view of the huge TP adjustments undertaken by transfer pricing officers in the information technology/IT enabled services/business process outsourcing sectors, where captive service units bearing limited risk have been compared with companies having different business and revenue models and bearing full entrepreneurial risks.

Risk adjustment● The requirement for comparability adjustments

(including risk adjustments) is an integral part of the Indian regulations. Recent rulings of appellate authorities have reinforced the need for such adjustments.

● However, neither the regulations nor the rulings provide any guidance on the methodology to be adopted for computing such adjustment.

Risk adjustment● Any such risk adjustment needs to be

undertaken based on a detailed and well-documented analysis.

● Companies can use various economic theories/methods as well as statistical tools for making a sound risk adjustment.

● Globally accepted TP techniques can be utilised for undertaking this adjustment on a rational and scientific basis.

Risk adjustment● In the absence of a robust technical and well-

documented risk adjustment, the revenue/ appeal authorities may not permit the adjustment during audit/appeal proceedings or may allow an ad-hoc adjustment that may not be appropriate or adequate.

● Accordingly, in the absence of specific guidance under law, it is imperative for taxpayers to focus on this issue and make a strong case upfront for computing and claiming the risk adjustment.

Royalties● The payment of a royalty for the use of intellectual property

such as trademarks, knowhow, brand names, etc., is a significant focus of the revenue authorities.

● In many cases, the authorities have rejected the taxpayer’s analysis and disallowed payments for use/transfer of intellectual property, on the grounds that the taxpayer has failed to commensurately demonstrate the following:

● Need for sourcing such intellectual property and its actual receipt

● Appropriate documentation evaluating and describing such intellectual property

● Fulfilment of the benefits test by the Indian entity● Whether the royalty is embedded in the import price of

goods, etc.

Management charges● Similarly, management charges paid by Indian taxpayers invite

significant attention from tax authorities. ● Extensive documentation is sought by the revenue authorities to

justify the management charges paid by Indian enterprises. ● Such documentation includes ● composition of costs allocated, ● methodology of cost allocation, ● benefits derived from each constituent of the costs, ● need for procuring such services, ● actual receipt of services, etc.

Business restructuring● TP issues relating to business restructuring

have recently started attracting the attention of tax authorities across the globe.

● Indian TP authorities have also started focusing on issues such as disposition of intangibles and consequential exit charges required for implicit or deemed migrations of intellectual property as part of acquisitions, reorganisations, conversions, or business restructurings.

Business restructuring● Such restructuring could include conversion of an entrepreneurial

manufacturer to a contract or toll manufacturer, conversion of a full-fledged product developer to a contract R&D service provider, or conversion of a distributor to a commission agent.

● The issue requires detailed analysis of intricate matters, such as whether it involves a transfer of valuable, protected or unprotected intellectual property (including identification of it); a loss or migration of profit potential; a required exit charge and, if so, how to quantify such charge, and similar issues.

● Therefore, the restructuring necessitates a detailed analysis of contracts, financial and functional analyses, and industry/market structure review, followed by preparation of robust, related TP documentation, economic analysis, written agreements, and the like.

Marketing intangibles● Another issue that has started receiving significant attention during

TP audits in India is marketing intangibles. ● This issue is particularly relevant for Indian group concerns of

multinational enterprises that undertake significant local marketing in India.

● In recent audits, the TP authorities have examined the marketing activities and spending by Indian subsidiaries developing local market intangibles that are legally owned by overseas parents or other affiliates.

● For instance, where the Indian entity undertakes significant marketing expenditure above the industry average or comparables levels, transfer pricing authorities have reduced the transfer prices (of goods or other transactions) paid by the Indian subsidiary to its group concerns.

Marketing intangibles● In certain cases, the authorities have imputed a cost reimbursement

to be received by the Indian entity, and in other cases, they have simply disallowed the “excessive” marketing expenditure incurred by the Indian entity. In all such cases, the intention has been to compensate the Indian subsidiary for its contribution toward development of marketing intangibles.

● It needs to be evaluated whether the local marketing efforts contribute to the increase in value of marketing intangibles owned by a group concern or enhance only the value of the contributing entity’s own rights under a long-term license or distribution arrangement.

● Further, it also needs to be evaluated whether the compensation for such contributions is already embedded within another transaction or requires a separate service fee.

Marketing intangibles● In the absence of detailed upfront TP economic analysis as well as

robust documentation (including explicit contracts), such Indian operations could be exposed to significant issues during TP audits.

● Indian TP authorities are closely following international developments including case law and overseas regulations on this matter.

Attribution of profits to permanent establishments

● Indian TP law has defined a permanent establishment as an “enterprise”28 and has applied the “functionally separate entity” approach authorised by the OECD for attributing profits to permanent establishments.

● Further, the courts in India have upheld the application of TP principles for attributing profits to permanent establishments in India.

● The Supreme Court of India and other courts have held that where the functions, assets, and risks of the permanent establishment have been appropriately captured while remunerating the enterprise which created the permanent establishment, attribution of profits to the permanent establishment stands subsumed in such remuneration and there can be no further attribution.

The Tax Authorities Perspective● F.Y.2004-05 was the first year of transfer pricing

audits● Cases involving transactions above threshold

value taken up● Adjustments made in about 25% of cases

Some typical grounds for adjustments

● Rejection of method – taxpayer’s method not found ‘most appropriate’ having regard to degree of comparability, availability of data

● Set of comparables modified – comparables found through FAR (Functions, Assets and Risk analysis)

● Interest free loans, free inter-company services

● Operating margin recomputed by excluding non-operating income and including expenditure re-imbursed by parent

● Taxpayer’s working in using CUP modified, ● Rejecting adjustments not supported by

documentation● Choice of tested party

●

Moser Baer India Ltd. and Others vs.ACIT(Delhi HC)December 2008

●Brief Facts / Assessee’s contentions

● Writ petitions were filed before the Delhi HC by six taxpayers against the orders passed by the TPOs in their respective Cases.

● As all the writ petitions had a common issue on violation of the principle of natural justice, the same were clubbed together

● Orders passed by TPOs without giving oral hearings as required under the Act

● Taxpayers were not provided an opportunity to verify or rebut the material used by the TPOs during assessments

● In some of the cases, adjustments made were not in synch with the show cause notices

Revenue's contentions

● In the absence of a specific requirement, oral hearing was not a necessary facet of natural justice and a right to effective representation (by way of submissions etc.) would suffice

● Failure to afford oral hearings does not render the decision invalid as the same can be cured during appellate proceedings

●

Decision / Observations

● Order passed by the TPO is in breach of the principles of natural justice and is a nullity in the eye of law

● Oral hearing is required to be accorded

● Section 92CA(3) of the Act has cast an obligation on the TPO to grant an opportunity of oral hearing even in cases where no specific request is made by the tax payer for oral hearing.

● Appellate proceedings as provided for under the Act are not a substitute for the original proceeding before the TPO

● Show-cause notice issued by the TPO should make a reference to the materials and evidence available and also give an option to the assessee to inspect materials available with the TPO

● Order passed by the TPO should not travel beyond the show cause notice

● Proper analysis should be carried out by the TPO for accepting / rejecting any comparables and the reasons for the same should be provided to the tax payer, so that the tax payer can rebut the same

Skoda Auto India Pvt. Ltd. vs. ACIT(ITAT Pune)March 2009

Brief Facts

● The Assessee/taxpayer is an Indian company engaged in the business of manufacturing and selling of passenger cars

● The international transactions consisted purchase of raw material and payment of royalty and technical know how fees

● Assessee used TNMM as most appropriate method● Assessee corroborated the raw material purchase transaction

by using CUP method● TPO rejected certain comparables used viz. General Motors

(onaccount of persistent losses) and Ford India (on unavailability of contemporaneous data)

● TPO relied on the remaining comparables and made an adjustment to the tune of Rs.23.59 crores

Assessee’s Contentions● If any company is functionally comparable, it cannot be

rejected on account of sustained losses● Benefit of (+/-) 5 percent variation from the arm’s length

price should be allowed● Adjustment towards differences between comparables and

the assessee on account of high import by taxpayer not considered

● Adjustments on account of lower capacity utilization affecting the profitability were not considered by the TPO

● Use of multiple year data should be allowed

Decision / Observations● Application of CUP:● Rejected the CUP analysis observing that a

transaction can be considered as an internal CUP only when it has been entered into between two independent parties.

Decision / ObservationsDetermination of ALP under TNMM:

● The vast variation in proportion of imported raw materials could be on account of difference in the functionality. Hence, adjustment for high content of imported raw materials is required

● It is permissible in principle to make adjustments in the costs and profits in fit cases

● If information required for making the adjustment as available in the public domain is not sufficient, it is permissible to make some approximations and reasonable assumptions while making the adjustments for functional and other differences

● TPO should provide adequate opportunity to the assessee to support its claim in relation to the multiple year data since its use hinges on the impact of product life cycle on the profitability

● TPO should give due consideration to the proportion of raw materials imported by the assessee in the succeeding years while deciding whether an adjustment on account of high content of imported raw materials is warranted

Decision / Observations● Benefit of 5% range given based on the

decision in case of Sony India Private Limited

UCB India Pvt. Ltd. vs. ACIT(ITAT Mumbai)February 2009

Brief Facts● UCB India Pvt. Ltd. (‘UCB India’), is a 100% subsidiary of UCB SA, Belgium

(‘UCB Belgium’),● Engaged in the business of manufacturing and marketing of prescription

drugs● During AY 2002-03 and AY 2003-04 UCB India had imported raw materials

i.e. Active Pharmaceutical Ingredients (‘APIs’) from UCB Belgium● UCB India characterised itself as a ‘licensed manufacturer’ and selected

TNMM as the most appropriate method●

Brief Facts● Dissatisfied with the analysis carried out by UCB India, the TPO questioned

the veracity of the analysis and posed UCB India certain questions regarding applicability of CUP method

● TPO also gathered information from UCB India’s competitors by issuing notices to them u/s 133(6) of the Act

● TPO summoned the managing director and marketing manager of UCB India and recorded their statements on oath

● While rejecting the application of TNMM and applying the CUP method, the TPO proposed an addition to the UCB India’s transfer price

Questions before the ITAT● Aggrieved by the order of the TPO, on filing of an appeal before

the CIT(A) part relief was granted to UCB India. ● UCB India further carried the appeal to the ITAT and raised

objections and disputed the determination of arm’s length price by the TPO, especially with regard to following matters

● Non acceptance of TNMM by the TPO, especially in light of scientific and robust process followed

● Erroneous application of CUP by the TPO

Assessee’s contentions● UCB India had complied with all the documentation

requirements ● Robust analysis carried out and accordingly TNMM was

selected as a most appropriate method● CUP was rejected due to absence of information in the

public domain● Revenue department did not carry out proper analysis and

also failed to substantiate the comparability of the companies selected by them

Revenue’s contentions● UCB India failed to produce documentation as

required by Rule 10D● Rejected the whole entity approach followed by

UCB India while carrying out TNMM● UCB India did not produce information to

demonstrate the non-comparability of the transactions selected by the department

Decision / observations● Non-maintenance of or deficiency in the

maintenance ofso me records should be seen in light of fact that whether such non-maintenance fundamentally affects or distorts the computation of ALP.

● What needs to be seen is that the assessee has substantially complied with the law in relation to maintenance of records

Decision / observationsOn issue of entity level margin:

● The international transaction contributed only to 50% of UCB India’s production and that UCB India also had trading activity,

● Hence, the analysis carried out by UCB India by aggregating all the transactions is not in accordance with the law and hence not correct;

With regard to comparability analysis carried out by UCB India:

● The revenue of comparable companies consisted of licensed manufacturing, patented drugs, trading and other revenues.

● Hence, UCB India’s comparability analysis, without making any adjustments to the comparables for the aforementioned factors, was wrong and hence was set aside

On applicability of CUP:● While considering whether controlled and

uncontrolled transaction are comparable, regard should be had to the effect on price of broader business functions and not just the product comparability.

● Accordingly, ITAT set aside the CUP analysis as it suffered from many deficiencies and infirmities.

● The ITAT remanded the matter to the files of the assessing officer for adjudication of the issue afresh. While doing so the ITAT directed as under:

● UCB India may file fresh documentation report and any other document or evidence to support its report

● UCB India is to apply any of the prescribed methods, even the TNMM

● The assessing officer to adjudicate issue afresh after giving adequate opportunity to UCB India and after examining the documents placed on record with an open mind

MSS India Pvt. Ltd.(ITAT Pune)June 2009

Brief Facts● MSS India, a 100% EOU, was engaged in business of

manufacturing and supplying of strap connectors● International transactions and methodology of justification was

as under:

International Transaction

TP Method Selected Comparable Selected

Import of raw material and components (Copper and lead)

Cost Plus Method London Metal exchange prices plus a mark-up

Sale of finished goods Cost Plus Method Internal – Gross margin earnedfrom sale to unrelated parties

Interest paid on foreign currency loan

CUP

TPOs’s Order● Import of raw materials – MSS India having

losses at the net level;● Sale of finished goods – MSS India’s allocation

basis is inconsistent and ambiguous;● The TPO selected TNMM as the MAM and

proposed an adjustment to MSS India’s international transactions

CIT(A) order● MSS India being a 100% EOU didn’t have

reasons to manipulate prices;● No TP adjustment therefore can be made to

MSS India’s international transactions (Relied on Philips Software [119 TTJ 721])

Revenue’s contentions● The decision of Aztec Software should have

been adopted by the CIT(A), being a special bench decision

● The decision had held that for application of transfer pricing provisions it is not necessary for the revenue to establish any tax evasion;

● TNMM was the most appropriate method best suited to the facts and circumstances of the case and same should have been adopted by the CIT(A)

MSS India’s contentions● The decision of Philips India should be applied

as it had considered the decision of Aztec India while delivering judgment;

Decision / observations by ITAT● Decision of special bench (Aztec India) prevails

over the divisional bench (Philips India)● Traditional methods shall have preference over

profit based methods; profit based methods shall be applied only when application of traditional method fails;

● Less than industry average profits or losses per se cannot lead to the conclusion that the taxpayer’s international transactions are not at arm’s length;

● Prices quoted on independent organization like LME can provide most reliable prices vis-à-vis comparable uncontrolled transactions and therefore can be adopted;

● When internal comparison is made, as long as the taxpayer does not follow different accounting norms for different transaction, the nuances of allocation of costs are not relevant

Rolls Royce Plc. vs. DDIT(ITAT Delhi)

October 2007

Facts● Rolls Royce PLC (RR Plc), a UK resident

company, was a ‘non-resident’ for the purpose of the Income Tax Act and was not filing return in India

● RR Plc was supplying aero-engines and spare parts of Indian Customers, mainly to M/s. Hindustan Aeronautics Limited (HAL), Indian Navy and Indian Air force

Facts● RR Plc entered into support service agreement

with Rolls Royce India Ltd. (RRIL) and remunerated at 5.1% to 6% over cost

● RRIL has a liaison office in India which was carrying out activities only in respect of RR Plc in India.

● RRIL’s responsibility included securing orders and soliciting requests for quotation / purchase price of RR Plc’s products

● The employees of RR Plc visit India frequently and use premises of RRIL

● Employees of RRIL participate in the meetings with customers where matters regarding contracts with RR Plc are discussed and decisions are taken

● RRIL also marketed certain after sales and other services to RR Plc’s existing/ potential customers and also provided advice / recommendations to RR Plc as regards certain customer proposals

Questions before the ITAT● Whether the assessee has any income chargeable to tax

in India u/s 5(2) of the Act and whether it has any business connection in India u/s. 9(1)(i)?

● Whether, in terms of DTAA between India and UK, the appellant has any PE in India?

● If answer to the above is in affirmative to what is the extent of income earned in India and whether the same can be held as paid by the appellant to RRIL and no further income is attributable to the PE in India?

● To what extent the income arises in India which can be charged to tax in India?

Decisionregarding Business connection

● RRIL was providing various services to RR Plc like marketing, advertising, media relations, business development etc.

● Customers were requested to correspond with RRIL

● Consequently, it was held RR Plc had business connection in India

Agency PE● RRIL was totally dependent on RR Plc● RRIL was soliciting and receiving orders wholly

and exclusively on behalf of RR Plc● It was held that RR Plc had Agency PE in India

Fixed Place PE● • Fixed place PE would be constituted if foreign

entity is entitled to:● – Use any premises and● – There is an identified distinct location on

which the foreign entity can exercises control

In the present case:● – RR Plc employees visited RRIL regularly and

– RRIL premises was available to all employees of RR Plc for business operations in India

● – RR Plc reimbursed the cost of maintenance of such premises

● RR Plc was held to have Fixed Place PE in India

Preparatory and auxiliary● RRIL acted as marketing office to receive

orders / promote business / negotiate and receive business orders

● The activities were held not to be Preparatory and Auxiliary in nature

Attribution of Profit● The appellant has a PE in India and hence profits

attributable to the PE need to be identified● Article 7 - All the profits accruing directly or indirectly

attributable to the PE are taxable in a State in which such PE is situated

● The profits attributable are to be computed as if the PE is a distinct and separate enterprise

● The profits could be determined on the basis of separate accounts maintained by the appellant for its PE operations or on the based on attribution for its significant activities

Attribution of Profit● The Tribunal identified the following

economically significant activities carried on by the PE and attributed the profits as follows:● Manufacturing – 50% (Not liable to tax in India)● Research and Development – 15% (Not liable to tax

in India)● Marketing – 35% (Liable to tax in India)

Key Takeaways● The decision acknowledged the principle of

substance over form● Brought to the fore the importance of economic

nexus in attributing profits to a Permanent Establishment.

● Importance of FAR analysis and synchronizing business model with operational realities brought out

Gist of some Important Judgements

● TNMM requires comparison of net profit margins from an international transaction and not net profit of the enterprises as a whole.

● Notional interest on interest free loans can be assessed under transfer Pricing law.

● Merely because a comparable is making loss, the same cannot be excluded from TP Comparision.

● Data for comparision should be data in the year in which international transaction is carried out.

Honeywell Automation India Ltd.● The taxpayer is engaged in providing integrated

automation and software solutions for industrial and residential applications.

● In its transfer pricing documentation, the taxpayer bifurcated the system integration division into two functionally separate segments, one of which was incurring losses.

● The taxpayer argued that the loss in that segment was due to certain economic and commercial reasons.

● During the assessment proceedings, the TPO did not approve of the arm’s-length

nature of international transaction involving purchase of raw material for the system

integration division, which was benchmarked by the taxpayer applying TNMM as

the most appropriate method.● However, the TPO held that since the subsegments were part of the business of

rendering system integration activities under the system integration division, the operating profit of the entire division ought to be considered for benchmarking analysis. Furthermore, not agreeing with the comparables selected by the taxpayer, the TPO conducted a fresh comparables search.

● On an appeal by the taxpayer to the appellate commissioner, the latter upheld the adjustment made by the TPO.

● Aggrieved by the order, the taxpayer appealed before the Appellate Tribunal and raisedlim ited arguments pertaining to the following:

● Rejection of one loss-making comparable, which was considered by the TPO as a comparable company in the previous year’s assessment; and

● Exclusion of certain expenses while computing the operating margin.

● Specifically, in respect of provision for future losses made in the financial statements, countering the appeal of the taxpayer, the

● Revenue argued that the financial statement of the loss-making comparable was not available for the relevant financial year and submitted that the appeal of the taxpayer on exclusion of costs should not be entertained, as it was not made before the TPO and appellate commissioner.

Ruling● On perusal of the case, the Appellate Tribunal ruled that the

comparable financial data of earlier or subsequent years may be considered under India’s transfer pricing regulations only in certain circumstances, wherein such data revealed facts or has an influence on the determination of transfer prices in relation to the transaction being compared.

● Accordingly, exclusion of a loss-making comparable to which the financial data was not available for the financial year ended 31 March 2004, was upheld. In other words,where the financial data of the company transgresses the relevant financial year, it may not be regarded as a valid comparable. Furthermore, the Appellate Tribunal

● upheld that in the application of TNMM as the most appropriate method, only those incomes or losses having nexus to operating income or loss of the enterprise should be considered. The matter was remanded to the TPO for determination on this account.

Schefenacker Motherson Limited● Wherever necessary, economic adjustments (for capacity

utilisation, unusual high startup costs) should be made;● The taxpayer cannot be expected to get detailed

information, which is not available in the public domain;● In the absence of information in the public domain for

making the adjustments, approximations and assumptions can be relied upon; and

● • The benefit of the +/-5% range should be allowed to the taxpayer

Quark Systems Pvt Ltd● The ruling emphasised that selection of

comparables rests on a proper FAR analysis and principle of substantial justice to be considered in applying the burden of proof.

● In addition, the Appellate Tribunal held that the taxpayer may reject its own comparable selected in the TP study on merits, in light of the additional/substantive facts available at the time of a transfer pricing audit.

CA Computer Associates Pvt Ltd● The ruling emphasises that the Revenue is

bound to follow only the methods prescribed in Indian transfer pricing regulations and may not go beyond the four walls erected by the Income Tax Act.

Vertex Customer Services India Pvt Ltd

● This ruling is significant because it highlights that penalties should not be levied in case of any transfer pricing adjustment for which the taxpayer has made reasonable efforts to establish that the transfer price meets the arm’s-length standard.

Customer Services India Pvt. Ltd● The ruling emphasises the use of current-year

data for determination of the arm’s length price and allowed +/-5% range in line with the earlier Tribunal rulings.

Perot Systems TSI (India) Ltd● This is the first Indian transfer pricing ruling that dealt

with the arm’s-length nature of an outbound loan transaction.

● The Indian transfer pricing regulations applicable for all cross-border transactions and an MNC cannot escape its tax liability by arguing that its interest-free loan was actually a capital contribution to its AEs.

● An interest-free loan between two related parties is a clear case of transfer of profit from India to its AE located in a tax haven where there is no corporate tax.

Morgan Stanley and Co.● In this case, MS Co., which is engaged in financial

advisory, corporate lending, and securities underwriting services, outsourced some of its activities to MSAS. MSAS was to support the main office functions of MS Co., which included equity/fixed income research, account reconciliation and providing IT-enabled services.

● MS Co. sent certain staff members to India for stewardship activities to ensure that its standards of quality are met. MS Co. also sent staff members on deputation to MSAS (as and when requested by MSAS), where such employees continued to be employed by MS Co. and their salaries and fees paid directly by MS Co.

Morgan Stanley and Co.● The Supreme Court ruled that MS Co. did not have a fixed-

place PE or an agency PE in India under the tax treaty, as a consequence of the back-office operations outsourced to MSAS.

● Further, the visit by employees of MS Co. to MSAS for stewardship activities was also not found to create a PE in India under the tax treaty.

● However, with reference to the personnel of MS Co. on long-term deputation to MSAS, the Supreme Court held that as such personnel continued to be employees of MS Co., having a lien on their jobs with MS Co., the employees could result in MS Co. having a service PE in India.

Morgan Stanley and Co.● As regards profits attributable to the PE, it was

observed by the Supreme Court that as MSAS was remunerated at operating cost plus arm’s-length markup determined using TNMM, and as the transfer pricing analysis of MSAS adequately reflected the functions performed and the risks assumed by it, no further profits would be attributable to the PE. Here, it would be necessary to ensure that all operating costs are adequately captured in the cost base, on which the markup is to be applied, before a taxpayer can be said to be at arm’s length.

Morgan Stanley and Co.● However, there have been two judicial cases in the recent

past that diverge from the above principle. In the case of SET Satellite Singapore, it was held by the Appellate Tribunal that payment of arm’s-length remuneration to a dependent agent PE does not necessarily extinguish the tax liability of the non-resident in India. Furthermore, in the case of Rolls Royce Plc, the Appellate Tribunal has disregarded the argument of the taxpayer that payment of arm’s-length remuneration to a PE extinguishes the tax liability of the non-resident in India and has proceeded to attribute the profits of Rolls Royce Plc, which can be said to accrue or arise directly or indirectly through the operations of its PE in India.

Mentor Graphics (Noida) Private Limited

● The Appellate Tribunal thus held that once a taxpayer undertakes appropriate due diligence in preparing a transfer pricing analysis to justify the arm’s-length nature of its international transactions, the analysis may not be arbitrarily rejected during audits based on inferences and presumptions

Development Consultants Private Limited

● The TPOs often have been hesitant to use or review foreign benchmarking studies, but this ruling strengthens the taxpayer’s position for using such benchmarking studies.

Cargill India Private Limited● The Appellate Tribunal, while reversing the levy of penalty

on account of nonsubmission of documents, arrived at certain fundamental conclusions, which will have far-reaching implications on almost all transfer pricing cases in India.

● The Appellate Tribunal clarified that the documents and information to be kept and maintained as per Rule 10D is extensive, and the information and documents prescribed under all the clauses of Rule 10D would be required only in the rarest of cases. Therefore, the taxpayer and the tax authorities, depending upon the facts and circumstances of the case, are required to consider relevant information and documents needed for determining the arm’s-length price.

● The Appellate Tribunal further observed that, having regard to the purpose of the regulations, a notice issued by the TPO requiring the taxpayer to furnish any prescribed information/documents, cannot be vague or nonspecific.

● Such a notice must require the taxpayer to furnish specific information, which according to the TPO, is necessary for determination of the arm’s-length price of the international transactions of the taxpayer and should be issued after examination of documents on record and proper application of mind.

● The Appellate Tribunal noted that such a notice issued undersection 92D(3) is a serious notice, as noncompliance could lead to imposition of penalty, and accordingly specifying the information and documents in the notice was important.

● Furthermore, the specific clause of the rule or the details of the international transaction relating to which default was committed by the taxpayer also should be stated in the show-cause notice in order to treat it as valid, and to enable the taxpayer to file a proper reply in defence.

Thank You