tax arbitrage…

In domestic transactions, the under invoicing of sales and over-invoicing of expenses ordinarily will be revenue neutral in nature except in two circumstances having tax arbitrage such as where one of the related entities is

◦ Loss making or

◦ Liable to pay tax at lower rate and the profits are shifted to such entity

Transfer Pricing till A.Y. 2012-13 was applicable to Entities

having International transactions with their Associated

Enterprise

Honoring the Supreme Court ruling in case of CIT vs M/s

Glaxo Smithkline Asia (P) Limited expanded the ambit of

transfer pricing to Specified Domestic Transactions w.e.f. 1st

April,2013

Intent of Domestic TP-DTA & Tax Holiday Unit

Particulars Co.A Co.B

Taxed in India @ 0% 33%

Income from RP 150 -

Other Income 300 600

Expense to RP -

Other Expenses 300 300

Profit / Loss 150 150

Tax - 50

Total Tax for the Group

50

150





Expense to RP -


Profit / Loss 225 75

Tax - 25


Scenario 1 Scenario 2

225

25

By shifting of expenses from a tax holiday unit (Power) to a unit in the Domestic Tariff Area, the group could reduce its tax liability by 25. To avoid such cases, Domestic TP has been introduced.

Intent of Domestic TP-Domestic Tariff Area (DTA)





Expense to RP -


Profit / Loss (100) 100

Tax - 33


33

100





Expense to RP -


Profit / Loss (50) 50

Tax - 17


Scenario 1 Scenario 2

150

17

By shifting of expenses fro a loss making company to a profit making company, the group could reduce its tax liability by 16 for the current year, though the impact will be reversed in future years given carry forward of losses.

Intent of Indian Transfer Pricing (TP) Regulations

Indian Co.AssociatedEnterprise

(AE Co.)

Overseas(Tax at Lower rates, say 10%)

India(Tax @ 33%) Shifting of Losses

Tax Savings for the group -> Indian Govt. loses

ApplicabilityTransaction covered under Section

Applicability

clause (b) of sub section (2) of Section 40

Any expenditure

Sub section (6) of 80A Computing Section ( Determination of ALP)

Sub section (8) of Section 80IAProfit based deduction

Any transfer of goods or services within units – Intra Units

Sub section (10) of Section 80IAProfit based deduction

Any business transacted within closely connected entities

Chapter VIA or Section 10AAProfit based deduction

Any transaction

In any of the section Any other transactions as may be prescribed

Threshold

Shift of focus

How would you interpret the close connection ?

Fair Market Value can established using basic market evidence

Determination of Arm’s Length Price

Advance Pricing Agreements NOT applicable to specified domestic transactions

Powers shifted

Scope – Domestic Transactions

Tax holiday undertakings covering :• inter-unit transfer of goods and services

Expenditure incurred between related parties defined u/s 40AAny other transaction that may be specified

AggregateTransaction value exceeds Rs. 50 millions in a financial year (Applicable Applicable fromfromFY 2012-13)FY 2012-13)

Transactions with entities having close connection

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SDT

Inter unit transfer of goods & services by undertakings to which profit-linked

deductions apply – Sub section (8) of Section 80IA

Transactions between undertakings, to which profit-linked deductions apply,

having close connection Sub section (10) of Section 80IA

Scope of Section 92BA

Section Tax Payers covered Applicability of TP provisions on SDT aggregating a value of more than

INR50 million40A(2) Substantial Interested

PartiesExpenses or payment made or to be made.

80A(6) Enterprise claiming profit linked deductions from total income under chapter VI-A

Intra Transfer of goods and services and within the closed connected entities. ( i.e. eligible business to non eligible business)

80IASub Section (8)And (10)

Infrastructure developersTelecommunications service providersDevelopers of Industrial parksProducers or distributors of powerAn enterprise with an eligible business and close connection with any other person

The goods and services of an eligible business transferred to any other business carried on by the same taxpayer and vice-a-versa, are to meet the arm’s length test. (sub section 8) Intra Unit Transfer

a business transacted between a taxpayer carrying on an eligible business transact with a close connection, which results in more than ordinary profits to the business, is to meet the arm’s length test. (sub section 10)

Section Tax Payers covered Applicability of TP provisions on SDT aggregating a value of more than

INR50 million

80-IAB Developers of SEZs

The goods and services of an eligible business transferred to any other business carried on by the same taxpayer and vice-a-versa, are to meet the arm’s length test. (sub section 8) Intra Unit Transfer

a business transacted between a taxpayer carrying on an eligible business transact with a close connection, which results in more than ordinary profits to the business, is to meet the arm’s length test. (sub section 10)

Small Scale industry engaged in operating Cold storage plant

Industrial undertaking in industrially backward state as mentioned in VIII Schedule (ex : Jammu and Kashmir)

Multiplex theaters and convention centers

Company carrying on scientific research and development

Eligible housing projects Eligible hospitals

80-IC / 80-IE

Persons with units in specified states / north-eastern states claiming deduction

80-ID Hotels located in districts with World Heritage sites

10AA Persons with income from SEZ units

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Section 92BA Analysed......

Section Relevance with provisions of Sec 92BA

92 : Computation of income having regard to ALP

92A : Meaning of AE

92B : Meaning of International transaction

92C : Methods of computation of ALP

92CA: Reference to TPO

92CB : Safe harbour rules

92CC : Advance Pricing agreement

92CD : Effect of TP agreement

92D : Maintenance of information and documents

92E : CA’s Report

92F : Definitions: Accountant, ALP, Enterprise, PE, Specified date, Transaction*

For the purpose of sec. 92, 92C, 92D and 92E

* Sec 92F – Definitions does not define terms relevant for domestic TP transactions * Sec 92F – Definitions does not define terms relevant for domestic TP transactions

4

Intra Unit Transactions

Accountant’s Report

Tax Holiday

Assessment

FMV to ALP

1 5

23

Expenses

6

To check evasion of tax through excessive or unreasonable payments to relatives and associate concerns and should not be applied in a manner which will cause hardship in bona fide cases.

AO is expected to exercise his judgment in a reasonable and fair manner

Fair market value of the goods, services or facilities for which the payment is made, or

The legitimate needs of the business or Profession

The benefit derived by or accruing to the assesse from the expenditure

The above view is expressed by Hon’ble Guj High Court in the case of Coronation Flour Mills vs. Asst. CIT [ 2009] 314 ITR 1

Expenditure paid or to be paid to related parties will require to be at arm’s length Examples of related parties under section 40A(2)(b)Payer Receiver of Payment

Individual • Relative of individualCompany • Director of company or relative of the directorAoP/ HUF • Member of AoP / HUF or relative of such memberAny taxpayer

• Payment to a person who has substantial interest • Payment to a director / partner / member / relatives of a person

who has substantial interest • Payment to a company in which parent (more than 20% holding) has

substantial interest• Payment to a person whose director/ partner/ member has

substantial interest • Payment to a director/ partner/ member/ relatives of a person

whose director/ partner/ member has substantial interest • Payment to a person in which entities have substantial interest • Payment to a person in which my director/ partner/ member/

relatives have substantial interest • Payment to any of director/ partner/ member/ relatives

Substantial Interest means beneficial ownership of shares with at least 20% voting right or beneficial entitlement of at least 20% of the profits

Section 2(41) defines relative in relation to an individual to mean:

◦ Husband;

◦ Wife;

◦ Brother;

◦ Sister; or

◦ any lineal ascendant or descendant;

Means an enterprise –

◦ (a). Which participates, directly or indirectly, or through one or more intermediaries, in the management or control or capital of the other enterprises; or

◦ (b). In respect of which one or more persons who participate, directly or indirectly, or through one or more intermediaries, in its management or control or capital, are the same person who participate, directly or indirectly, or through one or more intermediaries, in the management or control or capital of the other enterprise.

Section 40A(2)(b) applies to payment made to the assesse’s relative or an associate concern is liable (Substantially Interested Parties)

Section 92A applies to transaction with AE directly or indirectly or through one or more intermediaries in the management or control or capital of the other enterprise.

22

B

A

C

D E

Transaction Covered

A & B

A & C

A & D

A & E

B & C

D & E

C & D

B & E

Domestic Transfer Pricing usher shift from generic ‘Fair Market Value’ concept to Arm’s Length Pricing

Characteristic Fair Market Value Arm’s Length Pricing

DefinitionThe price which goods or services would have fetched or cost in the open market

A price which is applied in a transaction in uncontrolled conditions

Computation Mechanism

No specific mechanism provided in law

Most appropriate method out of five prescribed methods

Transaction ValueAny market pricing point can be treated as fair market value

Arithmetic mean of comparable prices treated as arm’s length price

Sample SizeOne comparable may be sufficient to establish fair market value

Require bigger sample size for establishing arm’s length

Deviation No deviation permitted from fair market value

Deviation of plus / minus three percent is permitted

“Arm’s length price” means a price which is applied or proposed to be applied in a transaction in uncontrolled conditions

Arm’s Length price is determined using the Most Appropriate Method :

If more than one comparable price is obtained using above methods, then the arm’s length price would be ‘Arithmetic Mean’ of comparable prices

◦ Deviation of plus / minus five percent is permitted from arm’s length price

Methods Comparability

Comparable Uncontrolled Price Method ‘Price’ of the transactions

Resale Price Method ‘Gross margin’ of company reselling products / services to unrelated parties

Cost Plus Method ‘Gross margin’ of company selling manufactured products / services to related parties

Profit Split Method ‘Splits profits’ between parties to transactions based on economic parameters

Transactional Net Margin Method ‘Net Profit margin’ (Operating Profit) of ‘Tested Party’

Methods for Determination of ALP Price applied in a transaction between independent enterprises in uncontrolled conditionsTo be determined by applying the Most Appropriate Method, being one of the following five methods

Comparable Uncontrolled Price (CUP) MethodResale Price Method (RPM)Cost Plus Method (CPM)Profit Split Method (PSM)Transactional Net Margin Method (TNMM)

In case, more than one price is determined by MAM:Apply Arithmetic meanRange of + 5% of the arithmetic mean

Traditional transaction methods

Transactional profit

methods

Section Nature of Undertakings covered80IA Undertakings engaged in

•Developing, operating and maintaining, developing and operating and maintaining infrastructure facilities•Generation/ transmission or distribution of power•Reconstruction/ revival of power generating plants

80IB Undertakings located/ engaged in•Industrially backward districts as notified;•Scientific research & development•Refining of mineral oil/ commercial production of natural gas•Operating cold chain facility for agricultural produce•Processing, preservation and packing of meat/ meat products or poultry/ marine/ dairy products•Operating and maintaining a hospital of specified capacity

80IC Undertaking located in notified Centre/ Parks/ Areas in•Sikkim•Himachal Pradesh/ Uttaranchal•North- Eastern states

80ID Undertaking engaged in business of hotel/ convention centre in specified areas/ districts

10AA Undertakings having a Special Economic Zone unit

anti-abuse provision brought to check the excessive tax holiday claims

Generic framework of ‘More than ordinary profit’ was provided in law to compute the excessive tax holiday claims

To plug the loophole, it is now proposed to compute more than ordinary profits through the ‘arm’s length price’ mechanism

Issues◦ Eligible business will have to justify the ALP of the transactions

between the eligible unit/ business and any other person having close connection

◦ The term “Close Connection” not defined◦ Burden of the proving the “close connection” between the assessee

and other party is on TPOImpact ◦ Loss of tax holiday claim in excess of arm’s length profits ◦ No corresponding adjustment allowed for other party for adjustments

made, if any, by the TPO for transactions falling under this category

Industries operating in SEZs

Infrastructure Developers

Infrastructure Operator

Telecom Services

Industrial Park Developers

Power Generations or Transmission

Interest free Loans to Group Companies Sub section 8 of Section 80IA

Granting of Corporate Guarantees/ Performance Guarantees by Parent Company to its subsidiaries Sub section 8 of Section 80IA

Intra-group purchase/ sell/ service transactions Sub section 8 of Section 80IA

Payment made to key personnel e.g. transaction with Directors/CFO/CEO etc.. Section 40A(2)(b)

Payment made to key personnel of Group Companies. Section 40A(2)(b)

Payment made to relative of key personnel of the assessee/group companies. Section 40A(2)(b)

Commission to relatives of the directors/ partners

Salary paid to the relatives of the directors/Partners

Remuneration to the directors

Extra Purchase Price and Interest foregone to relatives

Good sold at lower than market price if bona fide

Higher Purchase Price than rates prevailing in the market

Interest paid to sister concerns at rate higher than normal rates

Hire Charges of Machinery or Rent paid for use of Immovable property

Maintenance of detailed TP Documentation, as specified in rule 10D demonstrating compliance with the ALP

Filing an Accountants’ report (Form 3CEB), certified by a Chartered Accountant with tax authorities containing details of specified domestic transactions

Default Nature of penaltyIn case of a post-inquiry adjustment, there is deemed to be a concealment of income

100-300% of tax on the adjusted amount

Failure to maintain documents 2% of the value of each international transaction or specified domestic transaction

Failure to furnish documents 2% of the value of each international transaction or specified domestic transaction

Failure to report a transaction in accountants report

2% of the value of each international transaction or specified domestic transaction

Maintaining or furnishing incorrect information or documents

2% of the value of each international transaction or specified domestic transaction

However, penalty for concealment of income shall not be levied if the taxpayer demonstrates that price charged or paid has been determined in ‘good faith’ and

with ‘due diligence’

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Type of payments/ transactions Challenges

• Salary and Bonuses paid to the partners

• Remuneration paid to the Directors

• Transfer of land

• Joint Development agreements

• Project management fees

• Allocation of expenses between the same taxpayer having an eligible unit and non-eligible unit

• Definition of Related Party

• Benchmarking?• Whether the limit as mentioned in

section 40 (b) would be the ALP?

• Benchmarking?• Whether the limit as mentioned in

Schedule XIII would be the ALP?

• Rules defined by Local Authorities (Jantri) as ALP?

• Benchmarking?

• Benchmarking?

• Whether these allocation would be SDT – Sec 80-IA(10)?

• Directly v/s Indirectly

34

1. Transfer pricing provisions are not applicable in case where income is not chargeable to tax at all.

[Amiantit International Holding Ltd., (2010) 322 ITR 678 (AAR)]

2. Provisions of section 40A(2) are not applicable to a co-operative society. [CIT vs. Manjara Shetkari Sahakari Sakhar Karkhana Ltd.(2008) 301 ITR 191 (Bom.)]

3. Payment made by holding co. to subsidiary co. is not covered u/s 40A(2)(b), as the relationship does not fall under sub-clause (ii) nor under sub-clause (iv) of sec. 40A(2)(b).

[CIT vs. V.S.Dempo & Co. (P) Ltd. (2011) 336 ITR 209 (Bom.) Note: In this decision, clause (vi) of s. 40A(2)(b) was not considered.

4. When a person commits an offence by not maintaining the books of accounts as contemplated by section 44AA, the offence is complete. After that there can be no possibility of any offence as contemplated by section 44AB and therefore, the imposition of penalty is erroneous.

[Surajmal Parasmal Todi vs. CIT (1996) 222 ITR 691 (Gauhati)] Note : This decision may be helpful in the context of sections 271AA, 271G and

271BA.

5. Correlative adjustments - if excessive or unreasonable expenses are disallowed in the hands of tax payer at time of the assessment then corresponding adjustment to the income of the recipient will not be allowed in the hands of recipient of income. Hence, it would lead to double taxation in India.

Provisions applicable only to expenditure where payment is made or to be made

◦ Does this include capital expenditure? – Section 40A(2)(b)◦ Does this include transactions without consideration? –

Section 80IA(8) & 80IA(10)◦ Does threshold apply to the amount recorded in the Books of

Account or Amount determine as per ALP? Whether Government approval u/s 295, 297 of the Companies

Act would be relevant? Whether close connection would be interpreted to mean the

criteria mentioned in section 92A(2) or 40A(2)(b) (Inconsistency regarding definition of related parties

Does the limit of INR 50 million apply qua transaction or aggregate of all transactions ?

If aggregate of International and Domestic transaction exceeds INR 50 million, but the International Transactions are below INR 10 million, Do we need to maintain documents prescribe under Rule 10D? ( Reference Rule 10D(2)

Would claim of Depreciate comes under the ambit of Domestic Transfer Pricing?

How are SDT defined?

◦ The following transactions with the aggregate value exceeding INR 50 million are covered Expenditure for which payment is made or to be made to

specified domestic parties Transfer of goods or services to/from eligible business

( tax holiday) from/to other business ( non-tax holiday undertaking)

Business transactions between eligible business ( tax holiday unit) and other person(s) producing more than ordinary profits owing to close connection

Which tax payers covered under SDT?

◦ Any tax payer incurring any expenditure with specified Domestic related parties are required to comply the regulation

How do you define specified domestic related party?

◦ The domestic related party will inter alia include a director, a relative of the director, a person having substantial interest in the tax payer ( carrying not less than 20% of the voting power) and fellow related parties where a single person has substantial interest in two tax payers

Which are the illustrative list of SDT?

◦ Transaction between the specified persons and also between the inter-unit transactions of taxpayers would be covered e.g. normal operating transactions, allocation of costs, etc…

What are the compliance requirements for tax payers that have SDT?

Tax payer that have specified Domestic Transaction would need to do the following:

Identify the nature of Transactions

Maintain requisite information and documents as prescribed

Obtain and furnish a prescribed report from an accountant in Form 3CEB

Applicability of OECD TP guidelines

Advance Pricing Arrangement

Benefit of range

Rule 10D and Form 3CEB requires modification to

harmonise their applicability in relation to inter-units pricing

and reporting of domestic transactions

Corresponding adjustment

tax arbitrage…

Documents

total tax

tax liability

tax arbitrage

expendituresub section

tax holiday unit power

profit loss

overinvoicing of expenses

units intra unitssub