transfer pricing - emerging controversies / challenges ... · transfer pricing - emerging...

Transfer Pricing - Emerging

Controversies / Challenges &

Way forward

Karishma R. Phatarphekar Chambers of Income-tax

International Tax Conference

Sahara Star Hotel, Mumbai

28th February 2014

1 © 2014 KPMG, an Indian Partnership and a member firm of the KPMG network of independent member firms affiliated with

KPMG International Cooperative (“KPMG International”), a Swiss entity.

All rights reserved.

Business

restructuring and

exit charges

Location

advantages

More audits,

disputes and

litigation

Increasing onus on

taxpayer

Scope of rules

expanding

More and more

complex regulation

Aggressive practices

by tax authorities

Dissatisfaction with

profit based

methods

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




Indian TP environment

TP Adjustment scenario at present

“Indian Revenue authorities are reckoned to be tough

globally in TP matters, with India accounting for about 70%

of all global TP disputes by volume”

(Source: Financial Express newspaper 16 July 2012)




Areas of discussion..

1 Management cross charges

Marketing Intangibles 2

Share valuation

Financial Transactions

Royalties

3

5

6

Location savings 4

Contract R&D 7

Way forward : Dispute resolution mechanism 8




Management Cross charges




Management Cross charge

5

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 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.




Basis of charge

Basis of charge

Inbound services Outbound services

Cost plus model Hourly / Man day

rate model

Determining cost Base

• Direct / Indirect cost

• Management overheads

• Notional cost

Determining a mark up

• Comparison of captive

unit with independent companies

• Possibility of risk adjustment

• Comparison of hourly rate charged in related and unrelated transactions and • Adjustment on account of idle capacity/under-utilization of capacity

• Global Transfer pricing policy • Benefit analysis • Documents evidencing that the services have been actually received

R

R

R

R = Key Requirements




Revenues approach towards allocation of Management fees

Benefits Payout

Management fee charged by AEs are investigated in great detail by the Revenue department

Robust / exhaustive documentation requirement demanded to substantiate the total receipt of services and

benefits received . In absence of substantial documentation demonstrating the services received such

allocations are disallowed completely or determined at a substantially lower amount

Revenue also enquire 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.




Best Practice for documentation

Maintenance of service contracts including:

• Nature and extent of services to be provided;

• Basis for determining the fees to be charged; etc

Maintenance of relevant documents to confirm rendering of services for the benefit of the recipient

Maintenance of a detailed narrative of benefits received and supporting documents to identify services (e.g.

emails, presentations etc.) and prove non duplication of services, etc.

8

Intra group services – Documentation and important points

Other Important points worth noting

Important to differentiate from shareholder activities.

Are “Benefits” always tangible/ quantifiable?

Years of specific group experience and expertise – can this be benchmarked with local market price?

Taxpayers’ commercial expediency vs. Revenue’s assessment of need (Case laws)

APA – perspective, and experience thus far;

Global perspective




Judicial Precedent

TNS India Pvt. Ltd vs. ACIT (ITA No. 944/Hyd/2007)

The Hyderabad Bench of Tribunal in the case of TNS India Pvt. Ltd. held that providing concrete evidences with

reference to the services in the nature of specific activities was difficult.

The Tribunal noted:

“for the advise given by various group centers to the group companies in day-to-day manner is difficult to

place on record by way of concrete evidence but the way business is conducted, one can perceive the

same….Unless the Assessing Officer steps into assessee’s business premises and observes the role of

these companies/assessee’s business transactions, it will be difficult to place on record the sort of

advice given in day-to-day operations. What sort of evidence satisfies the AO is also not specified.

Assessee has already placed lot of evidence in support of claims. Therefore, on that account, we are not

in agreement with the Assessing Officer and TPO that services were not rendered by the group

companies to the assessee.”

The Tribunal further noted that even under the TNMM as adopted by the TPO, the assessee’s PLI was 9.89%

which was more than the comparables whose average mean was only 5.60%. Even after payment of

management fees at 4% which was considered as an expenditure while computing PLI, the assessee’s PLI was

more than the comparables.




Judicial Precedent

McCann Erickson India Pvt. Ltd.

The Delhi Tribunal observed that :

- The taxpayer had placed substantial evidence in respect of the management service charges and client

coordination fee on record and had been able to establish the nature and benefits of services provided by the AE.

The tax department had not brought out anything to negate such evidence

- The taxpayer is engaged in only one class of business. There are no segments which can be said to be

independent of each other. Entity level benchmarking using the TNMM shall be most appropriate

- Considering the business environment of the taxpayer, it would be difficult to operate successfully without receipt

of services which carry huge intrinsic and creative value. Only a business expert can evaluate the true intrinsic

and creative value of such services. ITAT observed that taxpayer needs to establish that payments made against

Management Services Agreement are commensurate to the volume and quality of services

- The Tribunal relied on the High Court judgment in the case of Hive Communication Pvt. Ltd. wherein it was

held that the legitimate business needs of the company must be judged from the perspective of the company. It is

not for the AO to dictate what the business needs of the company should be

- The term “benefit” to a company in relation to its business has a very wide connotation & is difficult to accurately

measure




Judicial Precedent

Dresser Rand India Pvt. Ltd.

The Mumbai Tribunal observed that :

- When computing the ALP, the TPO/AO cannot question the commercial wisdom of the taxpayer. It is the

taxpayer’s prerogative to decide how to conduct its business.

- When evaluating the ALP of a service, it is wholly irrelevant as to whether the taxpayer benefits from it or not.

TPO/AO should restrict themselves to determining whether the price paid by the taxpayer was comparable to the

price paid by an independent enterprise for the same transaction.

- Tribunal also disapproved line of reasoning adopted by the AO/TPO that since the taxpayer has qualified staff on

its roll, there was no need to obtain such services from its AE.

- Allocation of cost on the basis of headcount and turnover is reasonable

- If services availed by the taxpayer is legitimate furtherance of its business interests and are wholly exclusively for

the purposes of business, such costs should be treated to have been computed in a fair and transparent manner.




Marketing Intangibles




Marketing Intangibles (Advertisement, Marketing and

Promotion – AMP expenses)

Issue involved / Approach of the Revenue

A assessee spends significant amount on AMP expense benefitting the AE by creating marketing intangibles

without corresponding compensation/ reimbursement to the assessee.

Revenue authorities compare expense to sales ratio of assessee with other comparables – disallows AMP

expense in excess of “bright-line” as 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




LG Electronics : Special Bench decision to deal

with legal issues not factual issues

Indian company, engaged in manufacturing of Electronic

goods in India , is a subsidiary of a Foreign Company

Indian Company incurs AMP expenses for marketing the

goods produced in India

Indian company has incurred AMP expenses which

exceeds the Bright Line limit

Excess AMP expenses incurred by the Indian Company

is perceived to enhance the brand value of Foreign

Company

Indian tax authorities have contended that AMP

expenditure incurred by a taxpayer at a level that exceeds

the “bright line” is to be reimbursed by the foreign AE with

a mark-up

Brand

Creation /

Marketing

Intangible

Indian Company

Foreign Company

Excessive

AMP

Expenses

Owner of

Brand

In India

Outside

India

Judicial Precedent

• Incurring of AMP expenses by the assessee towards brand legally owned by the foreign AE

constituted a 'transaction' subject to TP provisions;

• Upholds use of Bright Line Test for determining cost / value of such transactions:

• Under IT Act, it is legal ownership of brand that is recognized - Special Bench Majority View

• Matter on the quantification set aside to re-look at comparables and appropriate cost base




Judicial Precedent

BMW India Pvt. Ltd.- Delhi Tribunal

The Delhi Tribunal observed that:

BMW India though not a licensed manufacturer is fully responsible for sales promotion, full utilization of market

potential, providing customer service and for establishment of efficient distribution network and therefore the

functions far exceed the functions performed by a routine distributor.

The ITAT held that it was necessary for the assessee as a distributor to incur expenditure on sales promotion

and advertising but rejected assessees stand that incurring AMP expenditure is not an international

transaction by relying on LG’s ruling.

The ITAT observed that when the margins earned by the assessee were compared to those earned by the

comparables, it could be concluded that the assessee was sufficiently compensated for excess AMP

expenditure in terms of high profit margin,

The ITAT further observed that rewarding a distributor by way of price adjustment is well recognized and

well accepted remuneration model and that the department cannot insist in the absence of any

provision under the Act that the mode of compensation to the assessee by the foreign AE necessarily

be in the form of direct compensation.




Judicial Precedent

Sony India Pvt Ltd.- Delhi Tribunal

The Delhi Tribunal observed that expenses in connection with sales should be excluded from AMP expenses. The

Tribunal relied on the rulings in Canon India Pvt Ltd and Glaxo Smitkline Consumer Healthcare Ltd which had

considered the impact of Special Bench ruling in LG Electronics. The Tribunal further held that only the AMP

expenses ( after excluding the selling expenses ) should be verified by the TPO by applying proper

comparables in view of the directions of Special Bench in LGs case.

<< this space has been left blank intentionally>>




Casio India Co. Pvt Ltd – Delhi Tribunal The Indian co. is a wholly owned subsidiary of Casio

Japan. The Indian company is a full fledged distributor of

watches and consumer information and other related

products in India.

The TPO made an adjustment for excess AMP expense

relying on SB ruling in case of LG.

The CIT(A) deleted the addition holding that AMP

expense have been incurred as part of its distribution

function and the benefit accruing to the AE was only

incidental.

The revenue was in appeal before the ITAT. While the

assessee relied on ruling in case of BMW, since it was a

distributor and the margins earned by the company

higher than that of comparables.

However the ITAT in this case, held that SB ruling in LG

not only applies to a manufacturer, but also extends to a

distributor whether he is bearing full risk or least risk.

ITAT thus set aside CIT(A) order and restored the matter

to the AO/TPO to decide afresh in conformity with LG SB

ruling

Indian Company

Indian co.

Consumer

Outside

India

India

Judicial Precedent

Import of Goods

Distribution

Almost similar facts to BMW but set aside for deciding the matter afresh




Share Valuation




Share Valuation

Typical Facts

Foreign parent company infuses share capital in the Indian subsidiary (at face

value or at certain value per share arrived using DCF or other valuation

methodology prescribed by FEMA/RBI guidelines most common being

valuation carried out under the erstwhile CCI guidelines)

The Revenue takes a position that the shares have been issued to the Holding

Company at an undervalued price / less than the fair market value of the

shares;

Valuation methods are being challenged.

The TP adjustment carried out by the TPO is twofold:

• Difference between the actual issue price and the ALP considered as notional

income.

• Notional interest computed by considering the difference between the actual

issue price and the ALP i.e. considering the notional income receivable as a

deemed loan.

Foreign

Holding Co.

Indian Wholly

Owned

Subsidiary

In India

Outside India

Purchase of

shares of Indian

Company




Share Valuation

General contentions of the Taxpayers

Issue of equity share capital does not constitute ‘income’ hence not covered by section 92(1) of the Income Tax

Act and therefore there is no requirement to satisfy the arm’s length test laid down by the Act.

The valuation report ought to be accepted by the Revenue unless it is proved to be vitiated by fraud, bias or a

patent mistake.

The shortfall in the value of equity shares cannot be considered as a deemed loan, as no actual loan has been

given by the taxpayer and hence there is no question of Transaction as defined under section 92F of the Act.

The action proposed by the revenue in considering the shortfall as a deemed loan would tantamount to

consider every transfer pricing adjustment as a notional loan/receivable.

It is not open to the department to prescribe or dictate to the assessee as to how it should have conducted the

business or earned income on its funds.

General contentions of the Revenue

All type of transactions being in nature of Capital Financing under clause (v) of explanation to section 92F of

the Act have been included in the definition of international transactions from retrospective effect from 1st April

2002.

Issue of equity shares is in nature of Capital Financing and hence is an international transaction which is

required to be at arm’s length under the Indian Transfer Pricing regulations.

Adjustments arising out of Section 92 take the colour of a notional income




Time line on the issue so far…

Shell and

Vodafone file

writ petitions

with Bombay

High Court

(HC)

Huge TP

adjustments

made on

account of

under

valuation of

shares

Jan 2013

Apr 2013

Attorney General

seems to have

endorsed

adjustment for

alleged

undervaluation

of shares

May 2013

HC remitted the matter back to DRP to

decide preliminary issue of

jurisdiction

HC also held that income arising or

potentially arising is must for

applicability of TP provisions

Nov 2013

HC stays department’s

show cause to

Vodafone and Shell

on share valuation

issue for

subsequent AY 2010-

11

Jan 2014

Nov 2013

HC directs AO not

to take any

further steps

pursuant to

TPO’s order for

AY 2010-11 on

share valuation

Is

APA an

option?

VHC sends

Vodafone

to Tax Tribunal

and Directs

not to seek

any adjournments

Feb 2014




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 perspective of Transfer Pricing

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 an 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.




Judicial Precedent : GAP International Sourcing (India) Pvt. Ltd.

GAP International Sourcing (India) Pvt. Ltd. vs ACIT (ITA Nos. 5147/Del 2011 & 228/Del/2012)

The Delhi Bench of Tribunal in the case of GAP International Sourcing (India) Pvt. Ltd. held : “that Location

Savings arise to the industry as a whole and there is nothing to prove that the taxpayer was sole

beneficiary. The objective of sourcing from low cost countries is to survive in stiff competition by

providing a lower cost to its end-customers. The advantage of Location Savings is passed onto the end-

customer via a competitive sales strategy. Thus, no separate / additional allocation is called for on

account of Location Savings.”

GAP International Sourcing has rejected the applicability of “Location Savings” to the particular case in a

competitive situation (where the location advantages are passed onto customers), however, it has not rejected

the concept of “Location Savings”.




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.




Documentary evidences / analysis to substantiate Royalty

payouts

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




Air Liquide Engineering India P. Ltd [TS-43-ITAT-2014(HYD)-TP]

Facts of the case

The assessee engaged in manufacture and supply of air and gas separation equipments had entered into a

technical know how agreement with its French AE. The assessee was required to pay royalty at 5% on

domestic sales and 8% on export sales.

TPO disallowed royalty paid by the assessee on sales to its own AE on grounds that it would amount to

compensating one’s own-self and that such payment would be far away from the definition of arm's length

transaction, in a business sense.

The TPO adopted CUP method ( by considering payment of royalty at 5% in respect of sales to Non AE ) and made

an adjustment of Rs. 1.43 Cr.

CIT(A) failed to appreciate the contention of the assessee that the sales were entirely made to non-AEs and

considered 50% of the royalty payment for domestic sales and balance 50% for royalty on sales to AEs. CIT(A)

granted partial relief to the assessee and made a TP adjustment of Rs. 71.42 lakhs on account of royalty payments.




Air Liquide Engineering India P. Ltd contd…

ITAT observed that, the assessee had filed detailed submissions including agreement copies justifying the

importance and the crucial nature of the technical know how supplied by the AE for running the business.

ITAT relied on Delhi High courts judgment in EKL Appliances wherein it was held that so long as it is

demonstrated that the expenditure or payment by the assessee was for business purpose, it is of no concern of the

TPO to disallow the same on any extraneous reasoning.

Further, the ITAT relied on various Tribunal rulings in case of Ericsson India Pvt. Ltd., Dresser Rand India Pvt Ltd,

LG Polymers India Pvt Ltd, KHS Machinery (P) Ltd, SC Enviro Agro India Ltd and AWB India Pvt Ltd wherein it

was held that, Revenue authorities were not empowered to question the commercial wisdom of the assessee and

it was entirely the assessee to take such decisions that favour the advancement of the assessee’s business.

The ITAT also held that RBI approval of the royalty rates implies that the payments are at arm’s length and no

further adjustment is required in such cases. The ITAT relied on rulings in cases of Sona Okegawa Precision

Forgings Limited, Hero Motocorp Limited , ThyssenKrupp Industries India Ltd and Abhishek Auto Industries Ltd.

Further, with respect to the applicability of TNMM to benchmark payments of royalty, ITAT relied on Mumbai

Tribunals ruling in Cadbury India Limited wherein it was held that payment of royalty cannot be examined divorced

from production and sales. Royalty is inextricably linked with these activities.




EKL Appliances Ltd. – Delhi High Court (2012)

(ITA Nos. 1068/2011 & ITA Nos. 1070/2011)]

Taxpayer engaged in the business of manufacturing and trading of refrigerators, washing

machines etc.

For FYs 2001-02 and 2002-03 the TPO disallowed the transaction of payment of royalty to

AE, whereas accepting all other international transactions to be at arm’s length.

Revenue’s Allegations

Taxpayer has been incurring losses year after year. Royalty payments did not result in profits from operations

Increase in turnover did not result in any profit to the taxpayer.

The continuous losses incurred showed that the taxpayer did not benefit in any way from the royalty payment. Thus payment of royalty to the AE is not justified.

Taxpayer’s arguments

The allowance of royalty depends on the utility of the brand name and the technical knowhow in respect of which the payment is made and not on the profitability of the paying entity.

Royalty payment is a legitimate expenditure and non-payment of the same would have had serious implications for the taxpayer’s business.

There were profits at the gross level and the losses at the net level were due to significant increases in the operating expenses.

Due to availability of the brand name there was substantial increase in the turnover otherwise there would have been more losses.




EKL Appliances Ltd. continued

CIT(A) Ruling

It was imperative for the taxpayer to upgrade its technology due to market dynamics.

There were profits at the gross level and the losses at the net level were due to increase in

operating costs. The losses show significant reduction after technical up gradation.

The TPO disregarded the business and commercial realities of the business of the

taxpayer and acted in a mechanical manner ignoring the economic circumstances

surrounding the transaction. TPO cannot question the judgment of the taxpayer as to how it

should conduct its business.

Royalty payment was incurred for genuine business purposes and should have been

allowed even if the taxpayer had suffered continuous losses in the business.

Tribunal Ruling

Tribunal agreed with CIT(A) that the royalty payment was justified and the TPO was wrong

in disallowing the same.




EKL Appliances Ltd. continued

High court ruling

It is not for the Revenue authorities to dictate to the taxpayer as to how he should conduct his

business and what expenditure should be incurred.

It is not necessary for the taxpayer to show that any legitimate expenditure incurred by him

was also incurred out of necessity or

that the expenditure incurred by him for the purpose of business has actually resulted in profit

or income.

Taxpayer only needs to show that the expenditure should have been incurred “wholly and

exclusively” for the purpose of business.

Whether or not to enter into the transaction is for the taxpayer to decide. Quantum of expenditure

can be examined by the TPO but he has no authority to disallow the expenditure on the ground

that the taxpayer has suffered continuous losses.

High Court also relied on the OECD Guidelines - Tax administrations should not disregard and

restructure the transactions as actually undertaken by the taxpayer except

where the economic substance of a transaction differs from its form; and

where the form and substance of the transaction are the same but arrangements made in

relation to the transaction, differ from those which would have been adopted by independent

enterprises behaving in a commercially rational manner.




Financial Transactions




Interest on Loans

The Expert Group of the Government of India, constituted in April 2002 to recommend Transfer Pricing guidelines

for companies, in its Report specifies:

“Borrowing or lending on an interest-free basis or at a rate of interest significantly above or below market rates

prevailing at the time of the transaction is an undesirable corporate practice related to transfer pricing”

No specific Indian TP regulations provide guidance on how to determine an arm’s length rate of interest

39

Underlying security Duration of the loan

Factors determining

Interest rate

Guarantee if any

Size of the loan Currency in which

the loan

is provided and repaid

Credit standing of

the borrower

Prevailing interest

rate




Broad approach and issues involved in interest

benchmarking

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:

40

Determining

creditworthiness of

the borrower

Adjusting the risk

factors for specific

debt characteristics

Determining arm’s

length interest rate

range

Further 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

Guarantee is a legally binding agreement under which, the guarantor agrees to pay the amount due on a loan

instrument in the event of default by the borrower. From an economic point of view, the returns on guarantee are

linked more with risk than the cost of providing such facility

41

Period / Term

of guarantee

End utilization

of the loan amount

Factors for

charging guarantee fees

Economic benefits

of guarantee

Reasons for

requiring a guarantee

Implicit or Explicit

Debt to Equity ratio,

Quantity of interest savings,

Foreign currency risk

Whether quasi

equity in nature




Broad approach and issues involved in interest

benchmarking

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 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.

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

of guarantee from parent company – A challenge

42




Nimbus Communication Limited – Mumbai ITAT

Rate of interest charged on loan granted cannot be used as comparable for charging interest on outstanding

trade receivables

An outstanding debit balance on account of services rendered to the Group companies does not qualify as an

international transaction since the same is not an independent transaction, but merely the result of a

commercial transaction

The charging of interest is applicable only with the lending or borrowing of funds and not in the case of

commercial over dues

Logix Micro Systems - Bangalore ITAT

The Tribunal observed that funds parked with the AE do not partake the nature of a loan transaction and hence

LIBOR / US Fed rate cannot be used to calculate the interest.

Taxpayer losing an opportunity to pay off its working capital loans, if any and/or is also loosing an interest

income had the funds been deployed in a considerable investment destination in India and there by fixed the

rate at 5% based on short term deposit rates prevailing in India.

Judicial Precedents




Aurobindo Pharma Ltd – Hyderabad ITAT

LIBOR plus percentage points to be considered as arm’s length price on loan advanced to AE, provided there

is no other expenditure on borrowed funds.

Loan advanced to AE at LIBOR +3.5% on interest accrual can also be considered as arm’s length rate.

Other recent rulings where LIBOR plus percentage was considered as ALP for foreign

currency loans

Judicial Precedent

Case law Ruling

Apollo Tyres Ltd – Cochin ITAT LIBOR appropriate for benchmarking foreign currency loans and not

domestic prime lending rate.

CES Pvt. Ltd – Hyderabad ITAT Interest on loan advanced to AE should be determined on LIBOR plus

specified basis points

Cotton Natural (I) Pvt. Ltd – Delhi ITAT ITAT rejected argument of the Revenue of adopting domestic PLR for

benchmarking loan given to AE and held that LIBOR should be used

for benchmarking international transaction of loan given to AE.




Contract R&D




Contract R&D

Revenue‘s Allegations in select cases

Majority of Valuable & Unique IP generating work undertaken in India

India R&D Centre becomes Economic Owner of IP - IP transferred without adequate compensation

Functional characterization of ‘risk insulated service provider’ challenged

Arm’s Length Compensation = Global Profits of MNE allocated to India on ratios such as R&D Head Count,

etc

Prone to high litigation due to lack of clarity – prone to subjective interpretation;

Primary onus on tax payer to maintain detailed documentation and substantiate its functions

Circulars recently issued by CBDT provide guidance on characterization of R&D services ( The CBDT issued

new circular no. 6 of 2013 dated 29th June,2013 amending circular no. 3 of 2013 dated 26th March, 2013

Circular 6 recognizes R&D centres set up by foreign co’s in India can be classified into 3 broad categories Based

on functions, assets and risk assumed by them.

• Centres which are entrepreneurial in nature – Performing significant Functions and assumes substantial risk

• Centres which undertake contract R&D – Performing minimal functions, assets and risk: and

• Centres which are based on cost sharing arrangements – these entities would fall between the

entrepreneurial model and the contract R&D model.




Contract R&D

Guidelines for

identifying the

characterization

of R&D Centre

Parameters

Funding/ Assets

Risk Profile

Outcome of Research

Foreign Entity

Performs Economically Significant Functions

Economically significant functions’ to include critical functions such as

conceptualization and design of the product and providing strategic direction and

framework

Provides funds/ capital Significant assets & intangibles

Strategic decisions for Core Functions & Monitoring on regular

basis

Economically Significant Risks

Legal & economic owner of resultant IP

Indian Entity

Performs work assigned by foreign entity

Receives remuneration for the services

performed

Operates under direct supervision and actual

control

No Economically Significant realised Risks

No ownership of resultant IP

Functions

Supervision & Control

Entrepreneurial R&D Contract R&D Cost Sharing Arrangements of R&D

Favo

ura

ble

An

aly

sis

Unfavourable Analysis

Contract Research

Services

Note: In the case of a foreign principal being located in a country/ territory widely perceived as a low or no tax jurisdiction, it

will be presumed that the foreign principal is not controlling the risk. However, the Indian Development Centre may rebut

this presumption to the satisfaction of the revenue authorities.




Way Forward : Dispute Resolution Mechanism




Dispute Resolution Panel (DRP) – In practice yet to yield desired result to the taxpayers

Alternate dispute resolution mechanism to 1st level appellate proceeding before the CIT (A)

Specialist 3 member collegium for settling disputes on a fast track basis

Time bound 9 months

No demand till Assessing Officer issues final order after directions of DRP

From last year revenue can appeal against the DRP directions as well

Mutual Agreement Procedure (MAP) – To avoid double taxation and provide relief

MAP is an alternate mechanism incorporated into tax treaties for the resolution of international tax disputes

Resolution of disputes through the intervention of competent authorities of each country who evolve a

mutually acceptable solution

Relief through MAP possible irrespective of remedies available under domestic tax laws

Two Competent authorities appointed based on region

Dispute Resolution Panel and Mutual Agreement Procedures




Overview of MAP procedure

MAP request

Tax payer makes MAP application in prescribed form to CA of home country

Request can be made where there is double taxation or taxation inconsistent with treaty

Consultation

Host country CA called upon for dispute resolution where issue cannot be resolved unilaterally by home country CA,

Admission

Acceptance of Application at CA’s discretion

CA can call for additional information from tax payer at this stage

Representation

Tax payer may be called for making written or oral representations

Negotiations

CAs initiate negotiation and attempt to reach an amicable resolution

The tax payer is not involved in the negotiation process however he may be called upon to make submissions

Solution

Proposed agreement communicated to the Taxpayer for his acceptance

Solution to be given effect to within 90 days, if taxpayer consents

Generally the entire process takes 2 – 3 years for completion




Intercompany Transaction Value of Intercompany

Transaction

Safe Harbour

Software Development or Back-

office support Services

• Upto $80 million

• Exceeds $ 80 million

• 20% or higher

• 22% or higher

ITES being knowledge processes

outsourcing services

• No monetary limit • 25% or higher

Contract R&D services • No monetary limit • 30% or higher

Intra-group loan to wholly owned

subsidiary

• Upto $8 million

• Exceeds $8 million

• SBI base rate plus 150 bps

• SBI base rate plus 300 bps

Corporate guarantee • Does not exceed $16 million

• Exceeds $16 million and the

credit rating of the AE is of the

adequate to highest safety

• Commission rate not less

than 2% p.a. on the amount

guaranteed

• Commission rate not less

than 1.75% p.a. on the

amount guaranteed

Safe Harbor Rules




52

Safe Harbours are said to be convenience prices which are higher than the Arm’s Length Price.

The option of being governed by Safe Harbour Rules shall be valid for a period of five years starting with AY

2013-14 or for a lesser period at the option of the taxpayer.

No economic or other adjustments allowed to taxpayers opting for Safe Harbour.

Range of +/-3% not allowed.

No respite is provided from maintenance of mandatory documentation.

A taxpayer opting for Safe Harbour rules will not be able to avoid possibility of economic double taxation.

Introduced new concept of Knowledge Process Outsourcing (KPO) services with high markups

Companies opting for safe harbour not allowed to opt for MAP /CA proceedings

Due to apprehension in various industry sectors - Government has issued instructions that Safe harbour

margins not to be followed for general Audit or APA purposes.

Tepid response to safe harbour option due to very high markups

Safe Harbour Rules – Our observations




Indian APA Program – Key Features

Indian APA Program announced in August 2012

Provides certainty for 5 tax years

(FY 2014-15 through 2017-18)

Anonymous filing option

More cooperative approach, as

compared to desk audit

Significant cost saving (internal

and external resources)

Bilateral option would mitigate

double tax

Possibility of Roll-back (i.e. include open tax years)




Indian APA Program – Advantages

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

• Pre-filing application and meeting can be anonymous Anonymous

• LinkedIn 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 from LinkedIn’s team

Simple

• LinkedIn 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

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

Evaluate APA Approach

Primary Advantages Secondary Advantages




Indian APA Program – Experience so far (1/2)

• Indian Revenue received 158 formal pre-filing Advance Pricing Agreement (‘APA’)

applications as of March 31, 2013

• About 90 percent of the pre-filings were converted to actual APA applications

• About 30 Bilateral APA application have been filed, remaining were unilateral applications

• Primary focus of APA teams is to reach consensus on Function Asset Risk (FAR) analysis

for which site visits are planned

• More applicants have signed up in current year (around 35 companies) before March 31,

2014

• The tax authorities have recently confirmed that six APAs are ready to be signed by March

2014 (record time to complete an APA)




Sector-wise APAs filed*

Manufacturing Services

* Estimates based on

various sources

• Discussions on the various APA cases happening in Bangalore, Delhi and Mumbai

• Some cases are discussed at specific locations based on specific activities. For e.g. the IT/ ITES activities will be primarily done by APA team in Bangalore

• The initial focus is on the Functions Assets and Risks (‘FAR’) analysis to which the APA team is paying attention in great details

• Site visits by the APA teams in progress. To date the visits have been scheduled in consultation with the taxpayers and have been conducted in a cordial and un-intrusive manner.

• Based on the FAR analysis, the economic analysis will be done followed by rounds of discussions and negotiations

Indian APA Program – Experience so far (2/2)




Indian Transfer Pricing Environment – Way Forward

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




Questions & Answers

Questions

&

Answers