46 Residential N T. Bombay Chartered Accountants Society. 10th to 13th January, Golden Palms Hotel & Spa, Bengaluru

Transcription

1 CMYK CMYK th 46 Residential Refresher Course SHARE TO LEARN Bombay Chartered Accountants Society 10th to 13th January, 2013 Golden Palms Hotel & Spa, Bengaluru L E A R N T O S H ARE CMYK CMYK

2 CMYK CMYK Bombay Chartered Accountants Society d th Resi e n ti al Refresher C o u r s e 46 SEMINAR COMMITTEE MANAGING COMMITTEE Rajesh S. Shah Chairman Deepak R. Shah President Naushad A. Panjwani Vice-President Salil B. Lodha Convenor Chandravadan C. Dalal Dhiren V. Dalal Nitin P. Shingala Hon. Joint Secretary Raman H. Jokhakar Hon. Joint Secretary Chetan M. Shah Treasurer Govind G. Goyal Manmohan R. Sharma Mulesh M. Savla Aliasgar Z. Kherodawala Bharatkumar K. Oza Himanshu V. Vasa Jayesh M. Gandhi Nayan C. Parikh Nina P. Kapasi Pranay H. Marfatia Krishna Kumar Jhunjhunwala Manish P. Sampat Mukesh G. Trivedi Nandita P. Parekh Rajesh R. Shah Sangeeta S. Pandit Subhash C. Mutha Uday V. Sathaye Narayan K. Varma Narayan R. Pasari Pradip K. Thanawala Saurabh P. Shah Following Managing Committee Members are also Members of Seminar Committee : Sonalee A. Godbole Suhas S. Paranjpe Sunil B. Gabhawalla Toral N. Mehta Deepak R. Shah, Naushad A. Panjwani, Toral N. Mehta (Convener), Bharatkumar K. Oza, Chetan M. Shah, Krishna Kumar Jhunjhunwala, Narayan R. Pasari, Pradip K. Thanawala, Saurab P. Shah. CMYK CMYK

3 Papers at RRC PAPERS FOR DISCUSSION I Domestic Transfer Pricing and some issues of International Transfer Pricing CA. Rajan Vora II Case Studies in Taxation CA. Sunil Lala III Case Studies in Accounting and Auditing CA. Sudhir Soni PAPERS FOR PRESENTATION IV CA firm of the future - Practice Management Mr. August Aquila & CA. Vaibhav Manek V Negative List and Reverse Charge Mechanism under Service Tax. CA. Madhukar Hiregange PRESENTATION VII Effective Harnessing of Information Technology by CAs CA. Gurunath Kanathur. BRAIN TRUST VI Questions on Income Tax and Service Tax CA. Rajesh Kapadia CA. H. Padamchand Khincha Advocate Mr. V. Raghuraman Schedule of Programme Thursday 10th January noon onwards : Check in Hotel 1.00 p.m. to 2.30 p.m. : Lunch 3.10 p.m. to 3.45 p.m. : Afternoon Tea 3.45 p.m. to 5.45 p.m. : Group Discussion, Paper I (Domestic Transfer Pricing and some issues of International Transfer Pricing by CA. Rajan Vora) 5.45 p.m. to 6.00 p.m. : Tea Break 6.00 p.m. to 7.30 p.m. : Inauguration by Mr. N. Santosh Hegde, Former Supreme Court Judge 7.30 p.m. to 9.00 p.m. : Reply to Paper I by CA. Rajan Vora 9.00 p.m. onwards : Dinner Friday 11th January a.m. to 8.30 a.m. : Breakfast 8.30 a.m. to a.m. : Group Discussion, Paper II (Case Studies in Taxation by CA. Sunil Lala) a.m. to a.m. : Presentation, Paper IV (The Future of Indian Chartered Accountancy Firms by August J. Aquila & CA Vaibhav Manek) a.m. to 1.15 p.m. : Reply to Paper II by CA. Sunil Lala 1.15 p.m. onwards : Lunch 6.30 p.m. to 8.30 p.m. : Networking : Session will be led by August J. Aquila 8.30 p.m. onwards : Dinner Saturday 12th January a.m. to 8.30 a.m. : Breakfast 8.30 a.m. to a.m. : Group Discussion, Paper III (Case Studies in Accounting and Auditing, by CA. Sudhir Soni) a.m. to a.m. : Presentation on Effective Harnessing of Information Technology by CA Gurunath Kanathur a.m. to 1.15 p.m. : Reply to Paper III by CA. Sudhir Soni 1.15 p.m. onwards : Lunch 6.30 p.m. to 8.30 p.m. : Entertainment Programme 8.30 p.m. onwards : Dinner Sunday 13th January a.m. to 8.30 a.m. : Breakfast 8.30 a.m. to 9.45 a.m. : Presentation Paper V Negative List and Reverse Charge Mechanism under Service Tax by CA. Madhukar Hiregange 9.45 a.m. to noon : Brain Trust Session Trustees Income Tax - CA. Rajesh Kapadia & CA. H. Padamchand Khincha Service Tax Advocate Mr. V. Raghuraman p.m. to p.m : Concluding Session p.m. to 1.30 p.m. : Lunch 1.30 p.m. onwards : To leave for Airport/ Railway Station i

4 Index of Papers Paper I Paper II Paper III Paper IV Paper V Domestic Transfer Pricing and some issues of International Transfer Pricing CA. Rajan Vora...1 Case Studies in Taxation CA. Sunil Lala...45 Case Studies in Accounting and Auditing CA. Sudhir Soni...55 CA firm of the future - Practice Management Mr. August Aquila & CA. Vaibhav Manek...75 Negative List and Reverse Charge Mechanism under Service Tax. CA. Madhukar Hiregange...89 ii

5 Domestic Transfer Pricing and some Issues in International Transfer Pricing Domestic Transfer Pricing and some Issues in International Transfer Pricing CA Rajan Vora Transfer Pricing, in both areas international and the newly introduced domestic, has been a subject matter of in-depth study and discussion. Its implication over the transactions are wide, impacting huge number of industries. This presentation intends to cover the key aspects involved in domestic transfer pricing and some important issues in international transfer pricing, which will have impact on domestic transfer pricing. PART I DOMESTIC TRANSFER PRICING 1) Brief Background 2) Overview and introduction of the provisions 3) Concept of Arm s Length Price (ALP) 4) Implications of Specified Domestic Transaction (SDT) Significant Industries which may be impacted Significant Transactions which may be impacted 5) Implications of amendment analysis of the provisions 6) Domestic TP documentation 7) Domestic TP Filing of form 3CEB 8) Domestic TP penal provisions 9) Key Challenges/ Issues 10) Case Studies 11) Summary of recent judicial pronouncements 12) Way forward PART II ISSUES IN INTERNATIONAL TRANSFER PRICING 1. Experience over the decade 2. Transfer Pricing Amendments in Finance Act, Impact of the amendments 4. Issues and challenges faced while applying transfer pricing provisions to international transactions. 1

6 Domestic Transfer Pricing and some Issues in International Transfer Pricing Major differences or the types of transfer pricing adjustments 4.1. Selection of most appropriate method to determine ALP of the international transactions 4.2. Calling for information by TPO which was not available in public domain by exercising powers u/s. 133(6) of the Act 4.3. Cherry picking by TPO without showing exact comparability 4.4. Adjustment on account of economic analysis Adjustment on account of capacity utilisation Adjustment on account of differences in depreciation Adjustment for differences in risk assumed Adjustment for working capital 4.5. Write off of bad debts/ advance/ write off of assets/ foreign exchange fluctuations whether to be considered in calculation of operating profits, while working out of ratio of operating profit to operating cost 4.6. Exclusion of super normal profit companies or companies having difference in operations 4.7. What should be taken as Profit Level Indicator, whether Profit Before Depreciation Interest Tax (PBDIT) or Profit Before Interest Tax (PBIT)? 4.8. Use of filters Turnover filter Persistent loss making filter Other filters 5. Some of the specific issues on transfer pricing on following aspects: 5.1. Loans to subsidiary / Corporate/ Bank Guarantee 5.2. Advertising marketing and Promotion (AMP) expenses 5.3. Cost Contribution for Research and Development (R&D) 5.4. Intra group services - Cost contribution for Management fees/ HR Support and service charges 6. Commercial expediency of transaction vs TPO s Powers 2

7 Domestic Transfer Pricing and some Issues in International Transfer Pricing Part I Domestic Transfer Pricing 1. BRIEF BACKGROUND 1.1. In order to check whether the Taxpayers carrying on business transactions with related parties made excessive and unreasonable payments/expenditure, provisions of section 40A(2) were introduced in the Income-tax Act (hereinafter referred as the Act ) in the year 1968, which empowered the tax authority to disallow payments to related parties which are excessive or unreasonable. Similarly, in case of inter-unit transfer of goods/services, in order to check whether the profits of eligible units for availing the deduction under section 80A, 80IA, 10AA/10A/10B etc. were not inflated, provisions were introduced in section 80A, 80IA, 10AA in the Act in the year 1980 (in section 80I), which empowered tax authority to re-compute tax holiday eligible profit if undertaking makes more than ordinary profits as a result of arrangements with closely connected persons or otherwise. However, there was no specific valuation machinery/methodology prescribed in the Act to find out whether the same is at fair market value / arm s length price or not Intent of Domestic transfer pricing Under tax holiday period Under normal provisions 3

8 Domestic Transfer Pricing and some Issues in International Transfer Pricing 1.3. Impact on transaction - Domestic tax rates Normal situation Particulars Co. P Co. Q Tax rate (Tax + Sc.+ Edu. Cess) 32.45% 32.45% Income Income from related party Expense Expense to related party Profit/ loss (100) 100 Tax Tax to group Under Domestic TP Particulars Co. P Co. Q Tax rate 32.45% 32.45% Income Income from related party Expense Expense to related party Profit/ loss (70) 70 Tax Tax to group 22.7 By shifting of expenses from a loss making company to a profit making company, the group could reduce its tax liability by ` 9.75 for the current year, to prevent such planning and even though there is no base erosion Domestic TP has been introduced Impact on transaction - Domestic tax rates and tax holiday unit Normal Particulars Co. P (SEZ) Co. Q Tax rate % Income Income from related party Expense Expense to related party Profit/loss Tax Tax to group

9 Domestic Transfer Pricing and some Issues in International Transfer Pricing Domestic Particulars Co. P (SEZ) Co. Q Tax rate % Income Income from related party Expense Expense to related party Profit/ loss Tax Tax to group 9.74 By shifting of expenses from a tax holiday unit to a unit in the Domestic Tariff Area, the group could reduce its tax liability by ` To check such transaction, Domestic TP has been introduced Analysis of existing provisions under the Act Following are the existing provisions under the Act, that provide for transactions between related parties should be valued at market value: 1) Section 40A(2) - Expenses or payments not deductible in certain circumstances. The existing provisions of clause (a) of sub-section (2) of the aforesaid section 40A provides that: where the assessee incurs any expenditure in respect of which payment has been or is to be made to any person referred to in clause (b) of the said section, and the Assessing Officer is of the opinion that such expenditure is excessive or unreasonable having regard to fair market value of the goods, services or facilities for which the payment is made or the legitimate needs of the business or profession of the assessee or the benefit derived by or accruing to him therefrom, so much of expenditure as is so considered by him to be excessive or unreasonable shall not be allowed as deduction. Relevant extracts of the Departmental Circular - Circular No. 6-P, dated and circular NO. 4-P[LXXVI-65], dated , is reproduced below: It may be noted that the new provision is applicable to all categories of expenditure incurred in businesses and professions, including expenditure on purchase of raw materials, stores or goods, salaries to employees and also other expenditure on professional services, or by way of brokerage, commission, interest, etc. Where payment for any expenditure is found to have been made to a relative or associate concern falling within the specified categories, it will be necessary for the Income-tax Officer to scrutinise the reasonableness of the expenditure with reference to the criteria mentioned in the section. The Income-tax Officer is expected to exercise his judgment in a reasonable and fair manner. It should be borne in mind that the provision is meant 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. (Emphasis provided) 5

10 Domestic Transfer Pricing and some Issues in International Transfer Pricing 2) Section 80A - Deductions To Be Made In Computing Total Income The term market value was also not defined in the Act. The Finance Act 2009, w.r.e.f defined market value, so as to determine that the transaction with the related party should correspond to the market value of such goods and services transferred. The provision of the Explanation to sub-section (6) (inserted by Finance Act 2009, w.r.e.f ) of the aforesaid section 80A provides the definition of expression market value in relation to any goods or services sold or supplied and in relation to goods or services acquired as under: (i) (ii) in relation to any goods or services sold or supplied, means the price that such goods or services would fetch if these were sold by the undertaking or unit or enterprise or eligible business in the open market, subject to statutory or regulatory restrictions, if any; in relation to any goods or services acquired, means the price that such goods or services would cost if these were acquired by the undertaking or unit or enterprise or eligible business from the open market, subject to statutory or regulatory restrictions, if any. 3) Section 80IA - Deductions in respect of profits and gains from industrial undertakings or enterprises engaged in infrastructure development, etc. The existing sub-section (8) of the aforesaid section 80-IA provides that where any goods or services are transferred from eligible business to any other business of the assessee or where the goods or services are transferred from any other business to eligible business, if the consideration for such transfer does not correspond to the market value of such goods or services, then for this purpose the deduction under this section will be computed as if the transfer has been made at market value of such goods. Explanation to the aforesaid section provides for the definition of market value in relation to goods or services, means the price that such goods or services would ordinarily fetch in the open market. The existing provisions of sub-section (10) of the aforesaid section provide that where it appears to the Assessing Officer, owing to the close connection between the assessee carrying on the eligible business to which this section applies and any other person, or for any other reason, the course of business between them is so arranged that the business transacted between them produces to the assessee more than the ordinary profits which might be expected to arise in such eligible business, the Assessing Officer shall, in computing the profits and gains of such eligible business for the purposes of the deduction under this section, take the amount of profits as may be reasonably deemed to have been derived therefrom. 4) Section 10AA - Special provisions in respect of newly established Units in Special Economic Zones. The provisions of sub-section (8) and sub-section (10) of section 80-IA shall, so far as may be, apply in relation to the undertaking referred to in this section as they apply for the purposes of the undertaking referred to in section 80-IA. Hence by applying the provisions of sub-section (8) and sub-section (10) of section 80-IA, any transfer of goods/services by an undertaking to another group company will be measured on arm s length basis. All of the above existing provisions did provide for valuation of transaction between related parties at market value, however there was no clear mechanism prescribed to compute/ determine the fair market value. 6

11 Domestic Transfer Pricing and some Issues in International Transfer Pricing 1.6. Supreme Court in the case of Glaxo Smithkline Asia Thereafter, the Supreme Court in its order in the case of Glaxo Smithkline Asia (P) Ltd [236 CTR 113] after examining the complications which arise in cases where fair market value is to be assigned to transactions between domestic parties, has ruled that, in order to reduce litigation, section 40A(2) and section 80-IA(10) need to be amended to empower Assessing Officer to make adjustments to income declared by taxpayer, having regard to fair market value of transactions between related parties by applying any of generally accepted methods of determination of arm s length price, including methods provided under Transfer Pricing Regulations and that, Law should also be amended to make it compulsory for taxpayers to maintain books of account and other documents on lines prescribed under rule 10D in respect of such domestic transactions and taxpayers should obtain an audit report from their chartered accountants so that taxpayers maintain proper documents and requisite books of account reflecting transactions between related entities at arm s length price, based on generally accepted methods specified under Transfer Pricing Regulations Thus in order to give effect to the observations of the Supreme Court (supra), the Finance Act has been amended to provide for applicability of transfer pricing provisions to domestic transactions by way of insertion of section 92BA w.e.f OVERVIEW/INTRODUCTION OF DOMESTIC TRANSFER PRICING (TP) PROVISIONS 2.1. The Explanatory Memorandum to Finance Bill 2012 clarifies that the genesis of these provisions lie in suggestion made by the Supreme Court (SC) in the case of CIT vs. Glaxo Smitkline Asia (P) Ltd (supra). The FA 2012 has inserted definition of SDT and extended scope of TP to SDT by generally incorporating references to SDT in existing TP provisions at places where Int. Tr is referred in ITA (Domestic TP). The relevant extracts of the explanatory memorandum is reproduced herewith: Transfer Pricing Regulations to apply to certain domestic transactions Section 40A of the Act empowers the Assessing Officer to disallow unreasonable expenditure incurred between related parties. Further, under Chapter VI-A and section 10AA, the Assessing Officer is empowered to re-compute the income (based on fair market value) of the undertaking to which profit linked deduction is provided if there are transactions with the related parties or other undertakings of the same entity. However, no specific method to determine reasonableness of expenditure or fair market value to re-compute the income in such related transactions is provided under these sections. The Supreme Court in the case of CIT vs. Glaxo SmithKline Asia (P) Ltd., in its order has, after examining the complications which arise in cases where fair market value is to be assigned to transactions between domestic related parties, suggested that Ministry of Finance should consider appropriate provisions in law to make transfer pricing regulations applicable to such related party domestic transactions. The application and extension of scope of transfer pricing regulations to domestic transactions would provide objectivity in determination of income from domestic related party transactions and determination of reasonableness of expenditure between related domestic parties. It will create legally enforceable obligation on assessees to maintain proper documentation. However, extending the transfer pricing requirements to all domestic transactions will lead to increase in compliance burden on all assessees which may not be desirable. 7

12 Domestic Transfer Pricing and some Issues in International Transfer Pricing Therefore, the transfer pricing regulations need to be extended to the transactions entered into by domestic related parties or by an undertaking with other undertakings of the same entity for the purposes of section 40A, Chapter VI-A and section 10AA. The concerns of administrative and compliance burden are addressed by restricting its applicability to the transactions, which exceed a monetary threshold of `. 5 crores in aggregate during the year. In view of the circumstances which were present in the case before the Supreme Court, there is a need to expand the definition of related parties for purpose of section 40A to cover cases of companies which have the same parent company. It is, therefore, proposed to amend the Act to provide applicability of transfer pricing regulations (including procedural and penalty provisions) to transactions between related resident parties for the purposes of computation of income, disallowance of expenses etc. as required under provisions of sections 40A, 80-IA, 10AA, 80A, sections where reference is made to section 80-IA, or to transactions as may be prescribed by the Board, if aggregate amount of all such domestic transactions exceeds Rupees 5 crore in a year. It is further proposed to amend the meaning of related persons as provided in section 40A to include companies having the same holding company. This amendment will take effect from 1st April, 2013 and will, accordingly, apply in relation to the Assessment Year and subsequent assessment years Section 92BA Specified Domestic Transaction Specified Domestic Transactions in case of an assessee means any of the following transactions, not being an international transaction, namely - i. Any expenditure in respect of which payment is made or to be made to a person under section 40A(2)(b) ; ii. Any transaction referred u/s 80A; iii. iv. Any transfer of goods/services u/s 80-IA; Any business transaction u/s 80-IA(10); v. Any transaction under Chapter VI-A or u/s 10AA to which provisions of Sec 80-IA (8) or (10) applies; or vi. Any other transaction as may be prescribed. Scope of TP provisions expended w.e.f AY by including SDT if aggregate value of such transaction exceeds INR 50 Million (5 Crores) It is further proposed to amend the meaning of related party of domestic transaction under section 40A(2)(b) to include companies having same holding company. Following are the sections amended by Finance Act 2012, to incorporate the provisions of domestic transfer pricing: Section 40A - Expenses or payments not deductible in certain circumstances Section 80A - Deductions to be made In Computing Total Income Section 80IA - Deductions in respect of profits and gains from industrial undertakings or enterprises engaged in infrastructure development, etc. Section 10AA - Special provisions in respect of newly established Units in Special Economic Zones. 8

13 Domestic Transfer Pricing and some Issues in International Transfer Pricing Chapter X - Special Provisions Relating To Avoidance Of Tax Section 92 - Computation of income from international transaction having regard to arm s length price. Section 92BA - Meaning of specified domestic transaction. Section 92CA - Reference to Transfer Pricing Officer Section Failure to furnish returns, comply with notices, concealment of income, etc. Section 271AA - Penalty for failure to keep and maintain information and document, etc., in respect of certain transactions Section 271G - Penalty for failure to furnish information or document under section 92D Concept of ALP Concept of ALP applicable for determining taxable income arising from international transactions introduced in 2001, now extended to SDT. ALP defined to mean a price which is applied or proposed to be applied in a transaction between persons other than Associated Enterprises (AEs), in uncontrolled conditions. Comparability and Functions, Assets and Risks (FAR) fundamental to the concept of ALP Comparison of conditions in a controlled transaction with conditions in transactions between uncontrolled enterprises Compensation usually reflects functions performed (taking into account assets used and risks assumed) (FAR) ALP concept usually relevant for transactions between separate enterprises ; may need to be applied by analogy to SDT involving inter-unit transfer of goods/ services Methods for computing ALP ALP is required to be computed using any of the following methods being the most appropriate method Comparable uncontrolled price method (CUP) Resale price method (RPM) Cost plus method (CPM) Profit split method (PSM) Transactional net margin method (TNMM) Such other method as may be prescribed by the Board method prescribed in May 2012 by inserting Rule 10AB The rule is reproduced herewith: 10AB. For the purposes of clause (f) of sub-section (1) of section 92C, the other method for determination of the arm s length price in relation to an international transaction shall be any method which takes into account the price which has been charged or paid, or would have been charged or paid, for the same or similar uncontrolled transaction, with or between non-associated enterprises, under similar circumstances, considering all the relevant facts. 9

14 Domestic Transfer Pricing and some Issues in International Transfer Pricing Rules provide guidance on application of the methods and factors to be considered in selecting the most appropriate method It is important to note that even though the provisions of SDT provide for determining the ALP of the domestic transactions by applying the methods that are prescribed for international transactions. However, it would be difficult to apply the 5 methods (that are prescribed for international transactions) to determine the ALP of domestic transactions. Due to this, it is most likely that the new 6th method will be followed for determining the ALP of domestic transfer pricing transactions. The 6th method is not precise in its applicability, which is as good as no method prescribed for determining the ALP of domestic transactions. This would lead to enormous litigation for tax authorities and taxpayers. 3. IMPLICATIONS OF SPECIFIED DOMESTIC TRANSACTION (SDT) 3.1. Key aspects In a case where a transaction is classified or covered under SDT, then FMV as contemplated by any of the specified provisions will need to be determined in accordance with ALP as defined in section 92F(ii) of the Act. It is important to keep in mind that Section 92BA does not impact operation of basic scope of provisions of section 40A(2) or section 80A(6) / 80-IA(8) or 80-IA(10). It merely provides that FMV as contemplated by any of the specified provisions will need to be determined in accordance with ALP as defined in section 92F(ii) of the ITA. Thus, section 92BA applies only if the conditions of section 40A(2) / section 80A(6) etc. are fulfilled and then FMV needs to be determined and applied in accordance with section 92BA. Question for consideration is, if assessee is able to establish that there is a bona fide transaction and no tax avoidance [as required under section 40A(2)] or no arrangement leading to inflating tax deduction [under section 80IA(8) or 80IA(10)], can assessee argue that since charging provisions are not applicable, SDT provisions dealing with valuation should not apply. If section 92BA is applicable, ALP as determined by adopting most appropriate method as per section 92C(1) will be considered as measure of FMV for transactions specified under section 92BA. This makes it mandatory for the taxpayer to compute ALP as per methods specified under section 92C (including sixth method recently notified on 23 May 2012). The taxpayer cannot adopt any other unspecified method for computing ALP. The taxpayer is also obliged to maintain contemporaneous documents under section 92D as also obliged to obtain & furnish auditor s report under section 92E of the Act Significant Industries which may be impacted Taxpayers with income from SEZ units under section 10AA Developers of SEZ under section 10AA Taxpayers claiming deduction under section 80IA for AY or later Infrastructure developers Developers of Industrial park Telecommunication service providers 10

15 Domestic Transfer Pricing and some Issues in International Transfer Pricing Producers or distributors of power Taxpayers claiming deduction under section 80IB for AY or later Commercial producers of mineral oil/natural gas and refiners of mineral oil Eligible housing projects Eligible hospitals Hotels and convention centre s claiming deduction under section 80ID Taxpayers with units in North-eastern states claiming deduction under section 80IE 3.3. Significant Transactions which may be impacted 1) Transfer of goods between related domestic companies eligible for tax holiday and others. 2) Inter-transfer of goods / services between tax holiday eligible business / units and other businesses / units of the taxpayer in India 3) Transfer of shares business re-organisation or restructuring 4) cash pooling and related funding transactions between related parties in India 5) Rent payments within Domestic associated enterprises e.g., between SEZ Developer and SEZ units 6) Expenditure incurred in case of Director fees, managerial remuneration. 7) Transactions of reimbursement of expenditure 8) Transaction under Cost sharing agreements/cost Contribution agreements. Payments for use of/access to common facilities like office/finance charges/ Human Resource services etc. 9) Transaction of Brand Equity Charges 10) Interest free loans or guarantees given to group companies 4. IMPLICATIONS OF AMENDMENTS ANALYSIS OF THE PROVISIONS 4.1. Amendment in section 40A The FA 2012 has added a proviso to specify that no disallowance, on account of any expenditure being excessive or unreasonable having regard to the FMV, shall be made in respect of a SDT referred to in s. 92BA, if such transaction is at ALP. Impact on the transactions/payments covered under section 40A(2): The impact of the above amendment will be that if payments to related parties under s. 40A(2) (b) along with other specified transactions crosses threshold of ` 5 Cr, TP compliance will apply to all such transactions and FMV will be calculated at ALP. If threshold of `.5 Cr is not crossed, the same will continue to be governed by unamended provisions of s. 40A(2) of the Act and FMV will be computed on general principles. Section 40A(2)(b) does not apply to the income receipts from the related parties. Refer illustratively judgements A. K. Subharaya Chetty & Sons [(1980) 123 ITR 592 (Mad)] Glaxo Smithkline Asia (P) Ltd [(2010) 191 Taxman 35 (SC)] 11

16 Domestic Transfer Pricing and some Issues in International Transfer Pricing Durga Rice & Gen Mills [TS-446-ITAT-2012 (Chan)] There may be relationships which are presently not covered as Int. Tr but are covered under section 40A(2)(b) and hence will be regarded as SDT, on account of different threshold under two sections. Certain illustrations: Non-resident shareholder/partner holding more than 20% but less than 26% in taxpayer. Non-resident company/firm/llp in which taxpayer holds more than 20% but less than 26%. Non-resident company in which a common company holds more than 20% but less than 26% as the taxpayer company. Directors or relatives of directors (including Indian or foreign directors working for PE of foreign company in India) Direct Indian subsidiaries of Indian intermediate holding company having foreign parent. Currently, payments to s. 40A(2)(b) related parties are required to be reported in Tax Audit Report in Form 3CD which will continue. The TP documentation, benchmarking and reporting requirement will be in addition to reporting in Form 3CD. Case Study - 1 Section 40A(2) generally covers relationships based on holding of substantial interest. Issue may arise whether the beneficial ownership of shares as referred in Explanation to section covers derivative relationship. Consider the following relationship: If A holds more than 50% in B and B holds more than 50% in C, can A be regarded as having substantial interest in C. Groups may examine applicability of section 40A(2) Case Study 2 Another issue which may arise is where an entity is held through a related party like director, whether 20% threshold needs to be examined qua an individual director or qua all directors put together. 12

17 Domestic Transfer Pricing and some Issues in International Transfer Pricing Consider the following relationship: 10% 10% 10% 10% 60% Directors For example, all directors of A Ltd. may be shareholders in B Ltd. such that individual shareholding of each director does not exceed the threshold of 20% but the aggregate shareholding of all directors put together exceeds 20%. Whether B Ltd. can be regarded as related party to A Ltd. in such scenario? Participants are requested to consider whether A Ltd and B Ltd are related parties Amendment in section 80A The impact of the above amendment is that, if it is covered as SDT, the market value shall be computed at ALP The provision, in essence, requires that the inter unit captive transfer of goods or services between eligible and other units of the same taxpayer as well as between associated enterprise/related parties should be recognised at market value of such goods or services on the date of transfer for the purpose of computing deduction admissible to the taxpayer under specified sections of Chapter VI-A. The provisions currently in force which grant profit linked tax holiday deductions and which are regulated by S. 80A(6) and, consequently, subject to Domestic TP are as follows: S. 80-IA Infrastructure development, etc. S. 80-IAB SEZ development S. 80-IB Industrial undertakings S. 80-IC Industrial undertakings or enterprises in special category states S. 80-ID Hotels and convention centres in specified area S. 80-IE Undertakings in North-Eastern states S. 80JJA Collection and processing of bio-degradable waste S. 80JJAA Employment of new workmen S. 80LA Offshore Banking units and International Financial Services Centre S. 80P Co-operative societies Sec 10A/10AA/10B The provision is limited in its operation to computation, on a notional basis, of profits and gains eligible for deduction under specified sections of Chapter VI-A and s. 10A/AA/B/BA. It does not envisage any change in the overall GTI of a taxpayer when both transferor and transferee units of 13

18 Domestic Transfer Pricing and some Issues in International Transfer Pricing the taxpayer are within India. Thus, any TP adjustment will not lead to any addition to the GTI of the taxpayer. It will merely impact the quantum of deduction available under Chapter VI-A or s. 10AA, etc. from the GTI. Refer case study 1 to 4 in later part of the Paper Corresponding amendment in sec 80IA(8) Inter-unit transfer of goods and services under s. 80-IA(8) The third limb of s. 92BA covers inter-unit transfer of goods and services referred in s. 80-IA(8). This provision overlaps with s. 80A(6). On lines of extension of Explanation to s. 80A(6) defining market value, the Explanation under this provision is also expanded to provide that the market value shall be computed at ALP if the inter unit transfer constitutes SDT Impact on the transactions/payments covered under section 80IA(10): If the taxpayer bona fide believes that his conduct with the AE is bonafide and dealings between them cannot be alleged to be evasive arrangement, s. 80-IA(10) is unlikely to be attracted. Accordingly, the transactions may not be regarded as SDT in terms of s. 92BA(iv). The taxpayer may further support non-applicability of s. 80-IA(10) on the basis that given the liability to pay MAT from AY despite enjoying s. 10AA tax holiday benefit under normal provisions, there is no real incentive to shift profits to s. 10AA eligible unit. The taxpayer may contend that burden to prove applicability of s. 80-IA(10) is on the AO. Considering, however, penal consequences of non-reporting and failure to maintain documentation, it may be practically advisable to comply with TP requirements Transactions in other provisions to which s. 80-IA(8)/(10) apply The following profit linked incentive provisions under Chapter VI-A are also governed by provisions of s. 80-IA(8) and s. 80-IA(10) and hence will be subject to Domestic TP in the event of aggregate of such transactions with other transactions referred in definition of SDT exceeding the quantum threshold of ` 5 Cr :- 80-IAB - Deductions in respect of profits and gains by an undertaking or enterprise engaged in development of Special Economic Zone. 80-IB - Deduction in respect of profits and gains from certain industrial undertakings other than infrastructure development undertakings 80-IC - Special provisions in respect of certain undertakings or enterprises in certain special category States 80-ID - Deduction in respect of profits and gains from business of hotels and convention centres in specified area 80-IE - Special provisions in respect of certain undertakings in North-Eastern States S. 35AD, an investment linked incentive provision, also has reference to provisions of s. 80-IA(10). It is for consideration whether s. 35AD is covered under Chapter VI-A or not, in absence of specific mention. 14

19 Domestic Transfer Pricing and some Issues in International Transfer Pricing 5. DOMESTIC TP DOCUMENTATION Entity related Price related Transaction related Supporting documents Profile of industry Transaction terms Agreements Official publications, reports by Government, Profile of group Functional analysis Invoices institutions of repute, (functions, assets and Stock exchanges risks) Profile of unit of the entity claiming tax holiday Profile of related parties Economic analysis (method selection, c o m p a r a b l e, benchmarking) Forecasts, budgets Documentation to be contemporaneous Pricing related correspondence (letters, s etc) Financial statements Due date for maintenance of TP documentation for FY is November 30, DOMESTIC TP FILING OF FORM 3CEB All taxpayers to whom the provisions apply required to file a Form 3CEB certified by a Chartered Accountant (CA) For FY , the due date of filing Form 3CEB is Nov 30, 2013 Requirement to file physical copy of the certified form No provision for filing electronic copy TP documentation forms the basis for certification of Form 3CEB Certificate contains details such as Compliance by taxpayer with the TP documentation requirements Nature/Quantum of transactions and method used to determine ALP Aimed at assisting tax officers in assessment proceedings 7. DOMESTIC TP PENAL PROVISIONS Section Trigger Quantum of penalty 271(1)(c) In case of an adjustment post assessment, if % of the tax regarded as concealment of income leviable on the amount of adjustments 271AA Failure to maintain TP documentation, failure to report the transaction, maintenance or furnishing of incorrect information/document 2% of the value of the transactions 271BA Failure to furnish Form 3CEB INR 100, G Failure to furnish TP documentation with the tax 2% of the value of the officer transactions Adjustment related penalty not leviable where taxpayer has acted in good faith and exercised due diligence TP documentation serves as a good basis to demonstrate good faith and due diligence 15

20 Domestic Transfer Pricing and some Issues in International Transfer Pricing 8. KEY ISSUES AND CHALLENGES Participants are requested to discuss and give their expert comments on each of the following key issues, to understand provisions better and have majority view. Participants may also consider the issue at long with study given in Paragraph Whether exclusion of Int. Tr from scope of SDT implies that all transactions with non-residents are outside the scope of SDT? Threshold trigger for applicability of TP to SDT and Int Tr. differs. A transaction is regarded as Int. Tr. if one or all the parties to the transaction are non-residents and the parties are related to each other as AE in terms of s. 92A of ITA. As against that, in terms of s. 92BA, certain transactions are regarded as SDT if they are not Int. Tr. and are covered by one of the specified clauses of s. 92BA In the Sec 40(A)(2)(b) threshold for substantial interest is 20% as against 26% in Sec 92A(2)(b) in case of AE s. Please consider correctness under the following situations: S. 40A(2) applies to remuneration paid to Directors. A director is not an AE in terms of s. 92A. As a result, remuneration paid by ICO, an Indian Company, to non-resident director would be SDT as it is not Int. Tr.? ICO, an Indian company, may make payment to FCO, a foreign company, which holds 21% in ICO. ICO and FCO are not AEs as threshold of 26% of voting power and other criterions envisaged by s. 92A(2)(a) are not met. However, payment by ICO to FCO is covered by s. 40A(2)(b)(iv) and hence constitutes SDT, which requires TP compliance in terms of s. 92BA? FCO may have PE in India in respect of which, FCO may pay service fees to non-resident director who has specific technical skills. Assuming that fees to directors is for services which are rendered for PE in India, the transaction would be covered by s. 40A(2) though both parties to the transaction are non-resident? 8.2. How is threshold limit of ` 5 Cr required to be computed for evaluating the application of Domestic TP? Is it required to be applied for all s. 92BA transactions or to each category? The threshold limit of ` 5 Cr is required to be applied on aggregate basis by taking sum total of all transactions covered under all six limbs of s. 92BA and not with reference to each category of transactions. The threshold is required to be examined on year-on-year basis. The threshold is required to be examined by adopting values as reported by taxpayer on the basis of entries in his books of account Can application of Domestic TP provisions lead to notional taxation of any income of the taxpayer (for instance, provision of bank guarantee by Indian parent company for credit facilities availed by its domestic subsidiary) or charging fair price by units eligible for income linked incentive deduction? Please consider correctness under the following situations: Application of Domestic TP provisions to transactions referred under first five limbs of s. 92BA cannot lead to taxation of any notional income. At the highest, they may lead to disallowance of excessive expenditure and/or reduction of quantum of deduction under Chapter VI-A. The transactions currently specified under s. 92BA do not include income transactions which can impact GTI unlike in case of International Transactions with AE s. 16

21 Domestic Transfer Pricing and some Issues in International Transfer Pricing The AO cannot enhance the eligible profits of the qualifying unit since any such adjustments will favour the taxpayer What is the significance of the term transaction referred to in s. 92BA? Does it necessarily require two separate legal or taxable entities? If yes, how will Domestic TP apply to inter-unit transactions between profit linked qualifying units (qualifying units) and other units of the same taxpayer as referred to s. 80-IA(8) and 80A(6)? Is it correct to say - SDT covers transactions between two legal/taxable entities as well as inter unit transactions referred to in s. 80A(6) and s. 80-IA(8) Explanatory Memorandum to Finance Bill 2012 which makes it clear that intent is not only to cover transactions between domestic related parties but also transactions entered into by an undertaking with other undertakings of the same entity If deduction on account of payment to a related party is reduced by application of Domestic TP provisions, whether the related party s income will automatically stand reduced to that extent? Please consider the following: While overall impact may be considered for determining applicability or otherwise of anti avoidance provision, once the provisions apply, generally no co-relative adjustment is permitted to give effect of consequences in the hands of both the parties. In respect of TP provisions, this is specifically achieved by second proviso to s. 92C (4) which permits single track adjustment and prohibit consequential adjustment in the hands of other party. This provision is made applicable to SDT as well Are specified businesses covered under s. 35AD (investment linked tax holiday) covered by Domestic TP provisions considering that provisions of s. 80A(6) and s. 80-IA(10) are applicable to s. 35AD? S. 92BA defines certain SDTs within the coverage of the section. In respect of profit linked incentive deduction it refers to a taxpayer claiming deduction under Chapter VI-A and s. 10AA. S. 92BA does not, however, contain any reference to a taxpayer who is entitled to investment linked incentive deduction under s. 35AD. Having regard thereto, and in absence of specific amendment to s. 35AD, a better view of the matter is that s. 92BA would not apply to s. 35AD. As a result, business which is eligible for investment linked incentive deduction under s. 35AD need not comply with requirements of maintaining documents, obtaining audit report, etc. Is it correct? Having regard to legislative intent, it is advisable that taxpayer claiming deduction under s. 35AD is able to substantiate compliance with s. 80A(6) and s. 80-IA(10) in substance, though it need not comply with s. 92BA. Is it correct? 8.7. If a qualifying unit has made payments to a related party under s. 40A(2) which is found to be excessive by applying Domestic TP provisions, whether the AO can enhance the income of the qualifying unit by disallowing the excess but refuse to grant tax holiday on such enhanced income by relying on the first proviso to s. 92C(4)? 8.8. If there is transfer of goods or services from one qualifying unit (Unit I) to another qualifying unit (Unit II), can the Tax Authority reduce the profits of Unit II by applying Domestic TP provisions, (as it is below ALP) while refusing to enhance the profits of Unit I on the basis that correlative adjustments 17

22 Domestic Transfer Pricing and some Issues in International Transfer Pricing are not possible and in any case, adjustments favourable to the taxpayer are not permitted under Domestic TP provisions? 8.9. What is the impact on profit linked tax holiday claimed under Chapter VI-A or s. 10AA on the amount of voluntary addition/adjustment due to Domestic TP adjustment (other than on account of payment to related party under s. 40A(2)(b)? In the above cases If a taxpayer discovers that the transactions specified under s. 92BA are at variance with ALP, he may choose to voluntarily make TP adjustment to his income and avoid consequences of the AO effecting TP adjustment and also claim deduction u/s VIA and u/s 10AA etc. The position adopted in context of Int. Tr should equally apply to SDT, being payment to related party under s. 40A(2)(b) Whether common overhead costs like interest, administration, HR, accounting, etc. incurred by HO needs to be allocated to qualifying units in view of Domestic TP provisions? If yes, whether the actual expenditure can be allocated or whether a FMV needs to be imputed by fictionally deeming HO as unrelated arm s length service provider? Please examine the following: Having regard to object of S. 80-IA(8) as explained by CBDT Circular No. 14 of 2001 when its scope was extended to services, an inference can be drawn that it applies only to those services which are marketable in nature. (For eg. power supply, specialized accounting services, etc) and where inter unit transfer of goods or service is in the course of business activity. In such cases, it will be necessary to apply ALP principle where transactions constitute SDT. Whether or not activities of an HO or corporate office qualifies as, business activity in the sense of marketable services is a fact based issue. Where the nature of dealings between qualifying unit and HO/corporate office do not answer to the rest of marketable services, it is arguable that such dealings are outside the scope of s. 80A(6) / s. 80-IA(8) at threshold. Introduction of Domestic TP does not alter the basic scope and ambit of s. 80A(6) / s. 80-IA(8) and ALP principles are not required to be applied to such dealings. However, in terms of general accounting principles, such costs may nevertheless be required to be allocated on a fair and rational basis to all units including qualifying units, on the basis of cost benefit principles What will be the implication where there is issue of shares by domestic company to directors or relatives, will domestic TP apply? If so, what will be the fair market value under section 56 read with rule 11UA? Will the value arrived at be considered as at arm s length? What will be the implications on sale of capital assets or capital goods to a related company, will provisions of section 40A(2) apply? What will be the fair value? Can it be said that consequential deduction u/ss. 32 or 35 or 35AD etc. is claimed, hence provisions of Sec 40A(2) are applicable? What will be the impact of Domestic TP on managerial remuneration? What will be the impact on giving commission to non working directors based on percentage of profit? Will impact be different, if the remuneration is given purely on the basis of profit? If the director is a shareholding director or a professional director, will the character of the transaction change? How to determine ALP in all these situations? 18

23 Domestic Transfer Pricing and some Issues in International Transfer Pricing Whether two separate set of documentations and audit reports need to be maintained/obtained viz. one for International TP and another for Domestic TP? Whether a taxpayer can appoint separate auditors for International TP and Domestic TP? Section 92CA(2A) was inserted with effect from 1 June 2011 to provide that where any other Int. Tr. (other than those referred to him by the AO) comes to the notice of TPO during the course of proceedings before him, the provisions of Chapter X (i.e., TP related provisions) shall apply as if such other Int. Tr. is an Int. Tr. referred to him under s. 92CA(1). Since s. 92CA(2A) is not amended to include SDT, whether TPO s power to compute ALP of transactions not referred by AO but noticed by him in the course of TP proceedings is restricted to Int. Tr only? Similarly, whether newly inserted s. 92CA(2B) also does not give power to TPO to compute ALP of SDT not reported in TP audit report? Whether taxpayer can enter into Advance Pricing Agreement (APA) with the AO in respect of SDT? Whether taxpayer can avail DRP route if adjustments are made in respect of SDT? A taxpayer can avail DRP route if there is variation to returned income/loss on account of TP assessment order passed by TPO under s. 92CA(3) Since s.92ca(3) has been amended to include SDT within its scope in addition to Int. Tr, DRP route should be available if adjustments are made in respect of SDT by TPO In case of assessment of PE in India of a foreign company enjoying deduction under s. 10AA, can provisions of s. 10AA(9) r.w.s. 80-IA(8)/80A(6) be invoked to deny s. 10AA deduction on profits in excess of ALP of comparable companies? In case operating profit of unit eligible for exemption under section 10AA is much higher than ALP determined by TPO for domestic and international transactions with AE and non AE (based on internal and external comparable), can AO invoke provisions of section 80IA(6) & (8) r.w.s 10A(7) and disallow deduction on the ground that super normal profit (i.e., over and above ALP) on account of arrangement and hence not eligible for deduction. Is the approach of AO correct? 9. Case studies Case Study 1 Applicability of Domestic TP to intra-group loans Facts A1 Ltd and A2 Ltd are Indian companies and related parties under s 40A(2)(b). A1 Ltd has given loan to A2 Ltd on which A2 Ltd pays 18% p.a. The ALP interest rate considering the tenure, repayment terms, collateral offered, etc. of the loan is determined at 11%. This rate of interest is also considered to be fair rate required to be paid by a borrower who is similarly placed. There is no explanation offered for payment at higher rate. A1 Ltd and A2 Ltd. are not entitled to any profit linked tax holiday. Interest paid by A2 Ltd exceeds ` 5 Cr. 19

24 Domestic Transfer Pricing and some Issues in International Transfer Pricing Issue What is the impact of Domestic TP in hands of A1 Ltd and A2 Ltd? Can differential 7% be disallowed in the hands of A2 Ltd If it is disallowed, can consequential relief be given in hands of A1 Ltd? Case Study 2 Applicability of Domestic TP to intra-group interest-free loans Facts Facts remain the same as in earlier case study no. 1. However, instead of 18%, A1 Ltd gives interest free loan to A2 Ltd. Thus A2 Ltd does not pay any interest to A1 Ltd. Issue What is the impact of Domestic TP in hands of A1 Ltd and A2 Ltd? Can A1 Ltd. be notionally taxed on interest free Loan 11% - If it is taxed can A2 Ltd get deduction of equivalent amount? Case Study 3 Applicability of Domestic TP to intra-group interest-free loans used for profit linked tax holiday qualifying unit Facts Facts remain the same as in earlier Case Study no. 2. An additional fact is that A2 Ltd has used interest free loan received from A1 Ltd in its undertaking which is entitled to profit linked tax holiday under s. 10AA (SEZ Unit). Issue What is the impact of Domestic TP in hands of A1 Ltd and A2 Ltd? can profit of A2 be notionally reduced while granting deduction u/s 10AA If it is done can it have consequential impact of Asstt. of A1 Ltd. 20

25 Domestic Transfer Pricing and some Issues in International Transfer Pricing Case Study 4: Applicability of SDT to transactions between non-residents Facts Mr. X is director of FCO which has a PE in India. Mr. X was deputed to work for PE in India from 1 November 2011 and continuing during F.Y For services rendered up to October 2011, Mr. X was paid salary outside India. For services rendered post 1 November, 2011, he is paid salary in India. PE is liable to tax on net basis in India. Mr. X s status is non-resident for F.Y and F.Y PE claims salary paid to Mr. X post 1 November, 2011 as deductible expenditure from its income. Issue : Whether salary paid to Mr. X in F.Y is subject to Domestic TP considering that both FCO (and hence its PE) as also Mr. X, are non-residents or will International TP provisions will apply? Case Study 5: Applicability of SDT to Section 10A(7) vis-a-vis ALP on ground of super normal profits. Allocation of costs amounts between various units/ AE s Facts PQR Ltd is engaged in diversified business. Unit A is a steam generating unit which is claiming deduction u/s 80IA. Unit B sells goods to outside parties and it is DTA. HO incurs expenses in the nature of research and development. Unit A (exempt unit) provides steam supply at ` 3 per unit. Whereas the rate charged by the State Board and other parties is ` 2 per unit. Unit B sells goods to outside parties on which the margin earned is at 75% (as per TNMM method). The ALP of comparables is 51%. HO is providing R&D activites to its AEs both in India and outside India. The R&D cost is allocated amongst the AEs on cost to cost basis. It has a common data/it centre. It also has common board of Directors. HO expenses are allocated amongst all units on equal basis. 21

26 Domestic Transfer Pricing and some Issues in International Transfer Pricing Issues involved: 1) What will be the implications of the above transactions under domestic transfer pricing provisions? 2) Can the provisions of domestic transfer pricing be invoked merely on the basis that exempt unit is making excessive profits? 3) Whether the provisions of sections 80IA (8) and (10) be invoked on the reason that it has earned more than ordinary profits. 4) Whether the cost allocation on cost to cost basis can be considered as pure reimbursement of expense? Whether the cost allocated as per the cost allocation agreement (CCA) is commensurate to the benefit derived? 10. SUMMARY OF RECENT JUDICIAL PRONOUNCEMENTS HAVING APPLICABILITY TO SDT Gist of relevant cases dealing with extraordinary profits under s. 80-IA(10), section 40A(2)(b) 1) Schmetz India Pvt. Ltd [ITA NO OF 2010 dt. 4th Sept, 2012] Bombay HC AO not correct in reworking profits eligible for deduction u/s 10A; High profit earned by assessee s manufacturing unit not a result of any arrangement between assessee and German holding co. (to whom manufactured products exported); Denial of benefit would penalize efficient functioning; 100% deduction available before setting off trading loss against manufacturing income; Co-ordinate bench ruling in Black & Veatch followed 2) Tweezerman (India) (P.) Ltd. (2010) 133 TTJ 308 (Chennai) A common shareholder (Mr. X) was holding 70% shares of US Co and 32.5% to 35% in taxpayer Co. The Taxpayer ICO had exported goods to US Co who was having common shareholder. Actual profits of the taxpayer (83%) were in excess of profits computed at ALP (48.7%) ITAT concluded that AO had not proved why he felt Taxpayer s profits were more than ordinary and hence deduction under section 10A cannot be reduced. 3) Digital Equipment India Ltd. (2006) 103 TTJ (Bang) 329 Taxpayer listed company was a joint venture of Netherland Co. (which was WOS of USCo) and Hinditron Group in India. The Taxpayer was engaged in sale of hardware and also in rendering of software services to US group companies Profits from software activities of two 10A units (24.22% and 19.30%) were found to be higher as compared to profit of the company as a whole (8.36%) ITAT held that the AO had not adduced any evidence to show that profits were more than ordinary and that given nature of activity being software development, the profits were reasonable. ITAT held close connection cannot be presumed. In this case since Taxpayer was listed company and Digital group was merely 50% shareholder. 4) Visual Graphics Computing Services (India) Pvt. Ltd. [ITA No. 2073/ Mds/ 2011) and Weston Knowledge Systems & Solutions India Pvt. Ltd. [ITA No. 914/Hyd/ 2006] Ordinary profits vs. Arm s length price for tax holiday units: Impact of Budget 2012 proposals. In two recent rulings favourable to taxpayers, the Income-tax Appellate Tribunal (the Tribunal) reversed the action of the revenue authorities to apply the provisions of section 80-IA(10) of the Income-tax Act, 1961 (the Act) to deny tax holiday benefits in excess of the arm s length price (ALP). 22

27 Domestic Transfer Pricing and some Issues in International Transfer Pricing 5) OPG Energy Pvt. Ltd [ 52 SOT 321] ITAT Chennai More profit from related than unrelated parties does not itself make it more than ordinary (SEB rates also used as support); profit comparison to be done for individual related parties. OPG Energy Pvt. Ltd. (the taxpayer) claimed deduction under section 80-IA of the Income-tax Act, 1961 (the Act), which was restricted by the Assessing Officer (AO), who alleged that the taxpayer had earned more than ordinary profits by selling to related parties at a higher price than that charged from unrelated parties. The Chennai bench of the Income-tax Appellate Tribunal (the Tribunal), while deciding the case in favour of the taxpayer, laid down the following principles: If taxpayer earns more profit from related parties in comparison to unrelated parties, that does not by itself make the profit from related parties more than ordinary. Profit realised by the taxpayer by charging rates to related parties which are lower than the rate charged by a government undertaking (a State Electricity Board or SEB ), cannot be said to be more than ordinary. Comparison of profit realised from one or more related parties must be undertaken for each party separately. 6) Durga Rice & Gen Mills [ITA 360/Chd/ 2012, dt ] ITAT Chandigarh Income from a domestic related party cannot be adjusted by applying transfer pricing provisions under section 40A(2) of the Act. Held that provisions of section 40A(2) of the Income-tax Act, 1961 (the Act) cannot be applied to adjust sale value realised by a taxpayer from its domestic related party. 7) Nahar Spinning Mills Ltd [ITA No.64 /Chd/2011 dt ] ITAT Chandigarh Impact of applicability of domestic transfer pricing provisions to allocation of common expenses. Managing Director s remuneration also to be allocated to units eligible for Sec. 10B deduction; Common expense must be deducted while computing eligible profits of tax holiday unit; But, restrictions of Sec. 80-IA(8) and Sec. 80-IA(10) not attracted to allocation of common expense, absent transfer of goods or services between different units 8) Panasonic Energy India Co. Ltd [I.T.A. No.45 / Ahd/2009 & 46/Ahd/2009 dt: ] ITAT Ahmedabad TPO justified in disallowing royalty payment made to AE u/s 40A(2)(b); Assessee failed to provide relevant details called for by TPO, relating to cost of developing technology & payments made by other group entities; Additional evidence sought to be adduced by assessee also rejected, as no separate application made The following are certain legal positions which emerge from the decisions on the section 40A(2): Judgments favourable to the taxpayer A. Determination of reasonableness of price paid to related party is essentially a question of fact CIT vs. Krishnamachari & Co. (2002) 256 ITR 82 (Mad.) 23

28 Domestic Transfer Pricing and some Issues in International Transfer Pricing B. No disallowance is warranted if purchase price paid to related party is comparable with sale price charged to outsiders CIT vs. Jain Cables P. Ltd. (2001) 252 ITR 785 (Raj.) C. Payments to related parties of marginally higher prices as compared to FMV if necessitated by business considerations cannot be disallowed under s. 40A(2) CIT vs. Dempo & Co Pvt. Ltd. (2011) 336 ITR 209 (Bom) D. If both related parties are in the same tax bracket, there is no difference in aggregate tax payment and hence no tax evasion CIT vs. Dempo & Co Pvt. Ltd. (2011) 336 ITR 209 (Bom) Tally Solutions Private Ltd. (2010) 8 ITR (Trib) 434 (Bang) E. Payments of remuneration as approved by CLB should be accepted as reasonable CIT vs. Shriram Pistons & Rings Ltd. (1990) 181 ITR 230 (Delhi) F. Reasonableness to be considered from point of view of businessman, not from view point of AO Raman & Raman Ltd vs. CIT (1962) 46 ITR 400 (Mad) G. Payment made to relatives cannot be denied without justifying that payments made were not worth the benefits / services received United Supply Agencies Pvt. Ltd. (1986) 155 ITR 262 (Cal) H. Trade discount to related parties not being expenditure is not covered by s. 40A(2)(b) Grandprix Fab (P) Ltd (2010) 128 TTJ 60 (Delhi) Judgments adverse to the taxpayer I. In absence of a prior agreement to pay commission in addition to salary to a related party, commission disallowed, as no evidence of additional services provided was placed on record Synpro Industries Ltd vs. CIT (1984) 146 ITR 176 (MP) J. Amount paid to related party considered excessive as compared to benefits derived and prevailing market rates Ganesh Soap Works vs. CIT (1986) 161 ITR 876 (MP) K. Absence of adequate evidence furnished by assessee to justify payment can warrant disallowance Coronation Flour Mills vs. ACIT (2009) 314 ITR 1 (Guj) L. Failure of the related person receiving the payment to justify his technical qualification / experience may warrant disallowance KR Motilal vs. CIT (1999) 240 ITR 810 (Mad) M. Failure to justify commercial rational of the payment may warrant disallowance Mangal Chand Tubes Pvt. Ltd. vs. CIT (1994) 208 ITR 729 (Raj) 24

29 Domestic Transfer Pricing and some Issues in International Transfer Pricing 11. WAY FORWARD Looking experience of international TP provisions in last 10 years or so, taxpayers need to, Analyse SDT provisions and applicability thereof well in advance Analyse and document technical positions relating to scope/coverage/ applicability of SDT Undertake impact assessment on current practices and policies Take corrective action as may be necessary Reset inter company/inter unit pricing policies, wherever required Properly document inter-company/ intra-company pricing policies Initiate steps for preparing SDT TP documentation We the professionals are going to have challenging as well as busy time, dealing with SDT. If the International TP study assessments, etc., is any indication, all of us will be busy throughout. However, there is lot of responsibility is cast on all of us. Therefore, we need to be ready to own up responsibility and render satisfactory services for SDT, which will be benefit taxpayers and all of us. Part II Some issues in International Transfer Pricing 1. EXPERIENCE OF THE DECADE 1.1. Initially when Transfer Pricing provisions were brought in Income-tax Act from A.Y , these were made applicable only to Transactions with Associated Enterprises (AE), either of which is in foreign jurisdictions. Since it was an initial and learning period, tax payers, tax professionals and tax officials, were all experimenting at the cost of each other. Periodically transfers of tax officials added more diversity and gave additional flavours leading to more and more complexity created in the TP assessments. The response from the law makers as well as the CBDT was not quick enough to retrace the growing litigations in the TP cases. Only thing regularly and religiously done by the law makers and CBDT was to make the amendments, if possible with retrospective effect, to supersede the decisions of the Tribunals and the Courts. The promises of the Government to bring in the Safe Harbour Rules, Advance Price Agreements (APAs) and making Mutual Agreement Procedures (MAP) speedy and effective, did not happen as desired by the taxpayers. With all this, India got distinguished of being most litigious country in the Transfer Pricing Area. The following figures of tax demands created in the TP assessments reflects, the ingenuity of the tax payers in taking their positions in the transfer pricing mechanism with AEs and for more aggressive approach of tax officials. Source: White Paper on Black Money, Ministry of Finance, May

30 Domestic Transfer Pricing and some Issues in International Transfer Pricing The functioning of DRP also did not reduce the litigation nor did it inspire the confidence as True Dispute Resolutions Mechanism In this paragraph, we have tried to summarise various approaches taken by tax officials in the TP assessments. Some of the issues have already reached to the Tribunal level and Courts. We have also summarised some of the important decisions on those topics Since the existing provisions related only to Transfer Pricing, these are also made in Income Tax Act related to International Transfer Pricing, the same are made applicable to the Specified Domestic Transactions (SDT) also, the principles laid down in these area will be helpful in understanding the applicability and implemention of SDT provisions Some of the important issues raised in TP assessments are as under : What is operating profit (OP), which should be a profit level indicator (PLI), whether it should be similar to Gross Profit or Net Profit or PBDIT or PBIT or PBT Whether OP is to be compared with Operating Cost (OC) or the Operating Revenue (OR) or Assets Employed Which is the most appropriate method applicable, based on the facts of the case of the tax payer Whether the results of the Tested Party (Taxpayer), should be segmental or entity level, while adopting Transactions Net Margin Method (TNMM) How to select and use comparables which satisfy the test of Funtions, Assets & Risks (FAR) analysis Whether segregation on the basis manufacturer, trader, service provider, logistic service provider, software developer, IT enable service provider, R and D centers, Captive service provider v/s full-fledged operator, the company owing IPRs v/s contract service providers, the difference in the risks undertaken etc, working capital adjustment, diminishing revenue filter Adjustments which are to be made from ALP, to make it comparable To make the comparison of the OP/ OC with the comparables companies, what filters should be used to make the comparison meaningful. Turnover filter, employee filter, offsite revenue filter, foreign exchange earning filter, asset ownership filter, capacity utilisation. Whether comparable is a government or semi-government or PSU, what further filter, discounting to be made. Is the comparable companies have Related Party Transactions (PRT) what are nature of transactions to be examined while selecting RPT & its threshold. Is comparable company loss making or persistent loss making company While comparing and determining ALP, whether it should be single year or multiple year data, if accounting years are different, can contemporaneous data be used diminishing revenue filter. 26

31 Domestic Transfer Pricing and some Issues in International Transfer Pricing If the comparable company has overseas branches or marketing subsidiaries, should the result be on the standalone basis, If segmental is not available how adjustment to be made Whether the reimbursement received or paid / made to be considered as part of OP/OC or whether to exclude from both sides Whether information / documents obtained by Tax Authorities by using power under section 133(6) can be used in Transfer Pricing Assessment, which is not available in public domain Whether the foreign exchange fluctuations, bad debts, capital write-offs, R & D and IPR write-offs, different depreciations accounting and policies to be considered while working out operating profit Whether the +/- 5%(now 3%) is standard deduction or only the permissible / safe harbour zone whether the amendment is retrospective or prospective. 2. TRANSFER PRICING AMENDMENTS IN FINANCE ACT, The Finance Act, 2012 has made several amendments in the TP provisions, including some retrospective. We have summarised the important amendments, which will have impact even on SDT. Only silver lining of those amendments is announcement of APAs. Let us see, how these will be implemented. Let s hope it does not have DRP experience and fate A number of far reaching amendments to TP provisions has been brought in Finance Act 2012: Exhaustive definition of International Transaction to widen the scope - The amendment will take effect retrospectively from 1 April 2002, i.e. from the tax assessment year (i.e. fiscal year ) Definition of Intangible Property - The amendment will take effect retrospectively from 1 April 2002, i.e. from the tax assessment year (i.e. fiscal year ) Advance Pricing Agreements - APA Determination of Arm s Length Price - Permissible Tolerance Band Introduction of a new transfer pricing method (TPM) for determining the arm s length price (ALP) Rule 10AB 6th Method - The amendment will apply to tax assessment year and subsequent years Powers of the TPO & Reassessment Proceedings The Finance Bill 2012 has now inserted another provision section 92CA (2B) of the Act, which retrospectively (from 1 June 2002) empowers transfer pricing officers to determine the arm s length price of an international transaction noted by them in the course of proceedings before them, even if that transaction was not referred to them by the tax officer, provided that such international transaction was not reported by the taxpayer in the Accountant s Report. Penalty Provisions Dispute Resolution Panel Assessment Timelines 27

32 Domestic Transfer Pricing and some Issues in International Transfer Pricing 2.3. Definition of International Transaction 2.4. Definition of Intangible Transaction 28

33 Domestic Transfer Pricing and some Issues in International Transfer Pricing 3. IMPACT Seeks to strengthen contention of tax department to apply TP provisions to: Business restructuring / re-organisation Transactions involving unique intangibles Cases involving trade credits, receivables, outstanding debt Guarantee commission transactions Necessity to charge mark up for rendering services in the form of incurring promotional expenses on behalf of AE, or in the form of provision of services by seconding employees Intra group services/ management cross-charges Capital funding / contribution, etc 4. ISSUES AND CHALLENGES FACED WHILE APPLYING TRANSFER PRICING PROVISIONS TO INTERNATIONAL TRANSACTIONS The Indian tax authorities have been taking aggressive positions on various transfer pricing issues, which is having a far-reaching impact on the decision-making process of Indian corporate entities. Transfer pricing adjustments, though are just now, applied to international TP, the same will now be applicable to domestic transfer pricing as well. The major differences or the types of transfer pricing adjustments made are as under: 29

34 Domestic Transfer Pricing and some Issues in International Transfer Pricing 4.1. Selection of most appropriate method to determine ALP of the international transactions Section 92C of the Act read with rule 10B prescribes the different methods to be followed to determine ALP. Rule 10C further prescribes that any one of the 5 methods best suited to the facts and circumstances of the case shall be selected as most appropriate method. While introducing transfer pricing provisions CBDT had clarified as under: Circular 12 dated 23rd August, 2001 issued by CBDT wherein it is stated that: where an international transaction has been put to a scrutiny, the AO can have recourse to subsection (3) of section 92C only under the circumstances enumerated in clauses (a) to (d) of that sub-section and in the event of material information or document in his possession on the basis of which an opinion can be formed that any such circumstance exists. In all other cases, the value of the international transaction should be accepted without further scrutiny. (Emphasis supplied) Tax authorities are however taking varying positions and rejecting the method applied by the assessee, stating that it is not the most appropriate method to determine the ALP and accordingly, fresh search and analysis is done by TPO, including calling of information from various taxpayers under section 133(6) even where no information is available in public domain. Issue Whether the method adopted by the assessee to determine the ALP is correct? Whether TPO can ignore the method used by assessee and use other method? Following is some of the important decisions where it is held that the method applied by the assessee should not be rejected, without giving any cogent and justifiable reasons. Sony India Pvt. Ltd. [288 ITR 52 (2007) (Delhi High Court)] M/s Indo American Jewellery [41 SOT 1 (Mum)] Mentor Graphics (Noida) Pvt. Ltd s case [2007] 109 ITD 101(Del ITAT) MSS India Private Limited vs. ACIT [32 SOT 132 (Pune)] Global Vantedge (P) Limited vs. DCIT [37 SOT 1 (Del)] 4.2. Calling for information by TPO which was not available in public domain by exercising powers u/s 133(6) of the Act and relying on the information for comparability analysis and using it against the assessee without sharing or partially sharing the information which is favourable to the tax department. Section 133(6) of the Act empowers the tax officer to obtain information from any person or a company as prescribed therein which in the opinion of the TPO will be useful for, or relevant to, any proceedings under the Act. The TPO in exercise of the powers conferred under section 133(6) have been obtaining the information and using it against the assessee for undertaking comparability analysis, to determine the ALP of the International transactions entered into by the assessee. Issues involved a) Whether the information gathered by the TPO u/s 133(6) should be provided to the assessee to enable it to verify the comparable figures with a right to file objection/ apply thereon? b) Whether TPO is justified in sharing only partial information collected and use it only where it is against taxpayer and not using where it is beneficial to taxpayer? 30

35 Domestic Transfer Pricing and some Issues in International Transfer Pricing c) Whether non-sharing of the information would lead to violation of the principles of natural justice? d) Whether the stand of TPO in not permitting cross examination of the information obtained to find out correct comparability is correct? Following are the illustrative list of the decisions for consideration/reference: Wherein it is held that assessee should be provided opportunity to examine and rebut the information gathered by the TPO under section 133(6) of the Act. M/s. Mercedes-Benz Research & Development India Pvt. Ltd., ITA No. 1369/Bang/2010 dt 30 April 2012] M/s Genisys Integrating Systems (India) Pvt. Ltd. [15 ITR (Trib.) 475], M/s Kodiak Networks (India) Pvt. Ltd. [15 ITR (Trib.) 610] M/s. Adobe Systems India Private Limited vs. ACIT [2011] 138 TTJ 122 (Del.) Continuous Computers India Pvt. Ltd. [1343/ Bang/2010] (ITAT Bang.) Intellinet Technologies India Pvt Ltd. [ITA No 1237/ Bang/ 2010] (ITAT Bang.) 4.3. Cherry picking by TPO without showing exact comparability Cherry picking in transfer pricing context is a situation where a tax authority tries to impose a TP adjustment on a taxpayer based on a few of cherry picked comparable companies with an intention to maximise its adjustment. Transfer pricing officers are resorting to cherry-picking of comparables, rather than adopting an objective approach to identify and screening comparables and disregarding the comparables identified by the assessee. Issue involved Whether the cherry picking of the comparables by the TPO which is favorable to the tax authority is acceptable or without demonstrating the exact comparability to the data of the assessee and without giving opportunity to the assessee, is correct? Following are the illustrative list of the decisions for consideration/ reference, wherein it is held that approach of the TPO in cherry picking of the comparables is not justified. Toshiba India Private Limited [2010]TII-14-ITAT(TDEL)] M/s.Daniel Measurement and Control (I) Pvt.Ltd [/I.T.A.No.3800/Ahd/2007 dt 3 May 2012] Agnity India Technologies Pvt. Ltd. Philips Software Centre Pvt. Ltd. vs. ACIT [2008] 119 TTJ 721 (Bang) M/s. Adobe Systems India Private Limited vs. ACIT [2011] 138 TTJ 122 (Del) M/s. SAP LABS INDIA Private Limited vs. ACIT [2010] 136 TTJ 1(Bang AT) 4.4. Adjustment on account of economic analysis Capacity utilisation, in initial period of operations where losses are forecasted or in case of entry in new market. In the business environment, a company/ undertaking newly set up or expansion of the existing activities, initially in its first/early years of operation may not be able to fully utilise its capacity. 31

36 Domestic Transfer Pricing and some Issues in International Transfer Pricing Accordingly, from a transfer pricing perspective, the company needs to find comparables which are operating at the same level. It is important to factor in the adjustment on account of capacity utilisation, as it directly impacts its ability to absorb the fixed costs. Low capacity utilisation has been a significant contributor to lower margins in the manufacturing segment for the taxpayer. It would be thus be imperative to make an adjustment to the operating margins to even out differences between the taxpayer and the comparable companies due to differences in capacity utilisation. Following are the illustrative list of the decisions for consideration/ reference: Favourable to assessee, wherein it is held that assessee is entitled to reasonable adjustment on account of start-up year costs owing to first year of operations that is abnormally affecting profit margin Global Vantedge Limited vs. DCIT [2010] 37 SOT 1 (Del AT) Brintons Carpets Asia P. Ltd. [TS-272-ITAT-2011(PUN)] Skoda Auto India (P.) Ltd. (30 SOT 319)(Pune ITAT) Fiat India P. Ltd. (ITA No. 1848/Mum/09) Genisys Integrating Systems [ 64 DTR 225 (Bang. ITAT)] MSS India Ltd. 123 TTJ 0657 (Pune ITAT) Schefenacker Motherson Ltd (Del ITAT) 2 ITR 196 Hope (India) Polishing Works (P) Ltd. 62 DTR 449 (Mum. Trib.) Haworth India Pvt. Ltd. (Del. ITAT) 140 TTJ 446 In following cases, the adjustment on account of capacity utilisation is denied: Sony India (P) Ltd. (118 TTJ 865) Del ITAT Adjustment for depreciation on account of difference in method/difference in accounting system followed. In the growing business scenario, many companies are being newly set-up or are expanding their existing activities, where huge additions are made to fixed assets. In such a case, the depreciation cost would be significantly higher, bringing down the profits also significantly. From a transfer pricing perspective, it thus becomes necessary to factor in the adjustment on account of depreciation to even out differences between the taxpayer and the comparable companies due to differences in depreciation. Following are the illustrative list of the decisions for consideration/reference: Favourable to assessee, wherein it is held that assessee is entitled to adjustment on account of depreciation. Fiat India Pvt. Ltd. (ITA No. 1848/Mum/09) Hope (India) Polishing Works (P) Ltd. 62 DTR 449 (Mum. Trib.) Philips Centre (P.) Ltd. (119 TTJ 721) (Bom) Schefenacker Motherson Ltd. (Del ITAT) 2 ITR 196 E Gain Communication (P.) Ltd. (118 ITD 243)(Pune ITAT) 32

37 Domestic Transfer Pricing and some Issues in International Transfer Pricing Adjustment for differences in risk assumed One of the principal elements for transfer pricing purposes is the analysis of risks assumed by the respective parties. In the open market, the assumption of increased risk is normally compensated by an increase in the expected return. Accordingly, controlled and uncontrolled transactions are comparable only when adjustments with respect to significant differences between them in the risks assumed is made. This becomes more important, where target company is captive service provider, whereas comparables available are full fledged service provider having R&D, marketing set up and taking integrated business. The effect of these risks needs to be factored while determining the ALP. Therefore, from a transfer pricing perspective it would be necessary to make adjustments for the risks mentioned below borne by the taxpayer with respect to the transactions executed for third party clients. Following is the illustrative list of the decisions for consideration/ reference: Insilca Semiconductors Pvt. Ltd. [1399/ Bang/2010] (ITAT Bang) Global Vantedge Limited vs. DCIT [2010] 37 SOT 1 (Del AT) M/s. Mercedes-Benz Research & Development India Pvt. Ltd., [ITA No. 1369/Bang/2010 dt 30 April 2012] Diamond Dye Chem [2010-TII-20-ITAT-Mum-19] Egain Communication (P.) Ltd. [23 SOT 385 (PUNE)] M/s Intellinet Technologies India Pvt. Ltd.,[134 TTJ 744] Mentor Graphics (Noida) P. Ltd. (112 TTJ 408) (Del. ITAT) Sony India (P) Ltd. (118 TTJ 865) Del. ITAT Philips Centre (P.) Ltd. (PLR based risk and working capital)(119 TTJ 721) (Bang ITAT) Actis Advisers Pvt. Ltd. (ITA No. 5277/D/2011) dated 12 October 2012 (Del.) Intervel India Pvt Ltd. [2010-TII-12-ITAT-Mum-TP] Decisions, wherein it is held that unless the risk is quantified in certain objective manner and can be represented by way of facts and numbers, it is very difficult to make adjustment on presumptions and surmises. Once the comparables were selected based on proper FAR analysis, risk adjustment need not be made. Risk adjustment not allowable in absence of details of risk borne by assessee Symantec Software Solutions (P) Ltd. vs ACIT [15 ITR (Trib.) 323] ADP (P) Ltd. vs DCIT 15 ITR (Trib) 203 Marubeni India (P) Ltd. vs. Addl. CIT [15 ITR (Trib.) 297] Vedaris Technology (P) Ltd. vs. ACIT [44 SOT 316] Deloitte Consulting Pvt. Ltd. [1082/ Hyd/ 2010] (ITAT Hyd.) Adjustment for working capital The extent to which companies extend and receive credit in the form of accounts payable and receivable affects their sales and cost of sales. Sellers extend credit to purchasers in the form of an accounts receivable balance. The selling price incorporates two elements: the price of the product 33

38 Domestic Transfer Pricing and some Issues in International Transfer Pricing and the time value of money lent. Presumably, if a company were to require all sales on a cash basis, it would be willing to accept a slightly lower price for its products than if the company were to allow its customers to pay at a later date. Of course, the argument works in reverse for companies that hold accounts payable. Their cost of goods sold reflects not only the purchase price of goods but also the time value for the credit period of amount outstanding from their suppliers. Difference in the terms of sale and purchase can affect comparisons. As a result, the cost of goods sold and sales of the comparable companies shall be adjusted in the analysis so the terms of purchase and sale are the same across all the companies. Comparable companies should be adjusted to the tested party s actual terms. The extent to which comparable companies profitability changes after adjustments depends upon the relative holdings of accounts payable and accounts receivable. The opportunity cost of the money tied up in holding inventory is an operating expense in an economic sense. Therefore, adjusting the comparable enterprise s financial results to account for differences in relative levels of inventory is necessary to more accurately evaluate transfer prices. In following decisions, Tribunal/Courts have considered whether adjustment on account of risk/ capacity utilisation/ working capital/ depreciation undertaken by the enterprise should be factored into while determining the ALP of a transaction? Recently, even TPO have started accepting such a claim, if working is furnished. On the facts peculiar in those cases, it is held that adjustment cannot be made: Symantec Softwares Solution Pvt. Ltd. (Mum ITAT) 46 SOT 48 Deloitte Consulting Pvt. Ltd. [1082/ Hyd/ 2010] (ITAT Hyd.) In some of the decisions, view was taken that since +/- 5% deduction is granted from ALP, there is no separate additional deduction need to be given. However, looking to the trend of amendment and ratio laid down in some of the decisions, +/-5% is held to be not a standard deduction but that if variation between operating profit/ operating cost of the target company falls within +/-5% of ALP, then no adjustment can be made. In view of this, there is every reason to get adjustment of risk/ working capital, etc Write off of bad debts/ advance/ write off of assets/ foreign exchange fluctuations whether to be considered in calculation of operating profits, while working out ratio of operating profit to operating cost. Provision for bad debts should be considered as operating expenses provided the same is incurred every year for at least three years and the manner, in which provision is made, is consistent. However, write off of bad debts/ credit balances etc to clean up accounts, on account of change of management, accounting policy etc is held to be not an operating expense. Trilogy E-business Software India Private Ltd. [ITA 1054 Bang/2011, Bang ITAT, dt. 23 Nov., 2012] Provision for doubtful debts & doubtful advances not normal expenses, hence to be excluded from computation of operating profit Telcordia Technologies India P. Ltd vs. ACIT [ITA No.7821 /Mum/2011 dt 11th May, 2012] Bad debts incurred by distributor irrelevant for ALP of royalty to AE, hence no disallowance 34

39 Domestic Transfer Pricing and some Issues in International Transfer Pricing CIT vs CA Computer Associates India (P) Ltd. [209 Taxman 382] No adjustment can be made for write off of capital assets/ amalgamation expenses/ share issue expenses, have been considered as non operating expense. Foreign exchange fluctuation arising in normal course to be considered while computing net margin; M/s. Brigade Global Services Pvt. Ltd. [I.T.A. No. 1494/Hyd/2010 dt 26 Nov 2012] Four Soft Limited vs. Deputy Commissioner of Income-tax (ITA No.1495/HYD/2010); SAP LABS INDIA Private Limited vs. ACIT, (2010-TII-44-ITAT-BANG-TP); Sujata Grover 74 TTJ 347 (Del) Deutsche Bank A.G. vs. Deputy CIT 86 ITD 431 Bestobell (India ) Ltd. [117 ITR 789 (Cal)] 4.6. Exclusion of super normal profit companies or companies having difference in operations I is held that companies with abnormal margins need to be excluded for comparability, if there are specific reasons for abnormal profits or losses or other general reasons as to why they should not be regarded as comparables including in FAR analysis. It is for the assessee to demonstrate existence of such abnormal factors. In absence of such abnormal factors, such comparable companies cannot be excluded. The companies having supernormal profits cannot be outright excluded. Capital IQ [ITA 1961/ Hyd/ 2011 dt. 23 Nov., 2012 (Hyd Trib)] Trilogy E-business Software India Private Ltd. [ITA 1054 Bang/2011, Bang ITAT, dt 23 Nov., 2012] 24/7 Customer Com Pvt. Ltd. [ITA No. 227/Bang/2010 Bang ITAT, dt 9 Nov 2012] M/s Quark Systems Private Limited [2010] 132 TTJ 1(Chd AT) M/s. Adobe Systems India Private Limited vs. ACIT [2011] 138 TTJ 122 (Del.) Sapient Corporation Pvt Ltd vs. DCIT (ITA No. 5263/Del/2010) Teva India Pvt Ltd vs. DCIT (ITA No & 1966/Mum/2009) M/s. SAP LABS INDIA Private Limited vs. ACIT [2010] 136 TTJ 1(Bang AT) 4.7. What should be taken as Profit Level Indicator, whether Profit Before Depreciation Interest Tax (PBDIT) or Profit Before Interest Tax (PBIT)? It is held that Profit Before Interest and Tax (PBIT) commonly adopted as profit level indicator in TNMM analysis, in case of normal manufacturing or trading companies. However, PBDIT (before considering depreciation) Is considered where particular industry, is capital/ asset intensive industry. M/s. Toyota Kirloskar Motors Pvt. Ltd., [I.T.A. No.828/Bang/2010 dt 22 Nov 2012] Fiat India P. Ltd. (ITA No. 1848/Mum/09) Chrys Capital Investment Advisors India Pvt. Ltd. [ ITA 3717/ Del/ 2010] (ITAT Delhi) E Gain communication (P.) Ltd. (118 ITD 243)(Pune ITAT) Picker India Ltd. [23 SOT 165] (ITAT Delhi) 35

40 Domestic Transfer Pricing and some Issues in International Transfer Pricing 4.8. Use of filters Turnover filter In following cases, it is held that companies with substantially high turnovers cannot be considered as comparable. Turnover filter is adopted at the range of ` 0 to 200 Cr, ` 200 Cr to ` 2000 Crs and above ` 2000 Crs. Accordingly, depending on the turnover, of the target company, comparables have to be selected 24/7 Customer Com Pvt Ltd [ ITA No 227/Bang/2010] (ITAT Bang) M/s. Mercedes-Benz Research & Development India Pvt. Ltd., ITA No.1369/Bang/2010 dt 30 April 2012] Capital IQ [ITA 1961/ Hyd/ 2011 dt 23 Nov 2012 (Hyd Trib)] Genisys Integrating Systems [64 DTR 225 (Bang ITAT)] Actis Advisers Pvt. Ltd. (ITA No. 5277/D/2011) dated 12 October 2012 (Del.) Persistent loss making filter, M/s. Brigade Global Services Pvt. Ltd [I.T.A. No. 1494/Hyd/2010 dt 26 Nov., 2012] M/s Quark Systems Private Limited [2010] 132 TTJ 1(Chd. AT) Additional filters/ adjustments which are regularly done by TPO during assessments are as under: Diminishing revenue filter Segmental v/s Entity level filter Onsite revenue filter Employee filter 4.9. Issue whether benefit of 5% variation u/s 92C(2) a standard deduction or not, put to rest by Finance Act 2012? Where variation between arithmetical mean and transaction price exceeds 5%, deduction not available a. Before the amendment to section 92C(2) made by Finance Act 2012, there was a controversy that in case the application of the most appropriate method results in two or more prices, is the taxpayer required to compute the ALP by determining an arithmetic mean of such prices, after a standard deduction of +/- 5% of the arithmetic mean thereof. The Tribunal in a number of cases had held that any adjustment to the income of the assessee should be computed after considering a standard deduction of +/ 5% variation from the arithmetic mean. ipolicy Network Private Limited [ITA No. 5504/Del/2010] SAP Labs India Private Limited [44 SOT 156 (Bang)] TNT India Pvt. Ltd TII-39-ITAT-BANG Electrobug Technologies Ltd. (2010-TII-39-ITAT-DEL-TP) Toshiba India Pvt. Ltd. (2010-TII-14-ITAT-DEL-TP) Cummins India Ltd. (ITA No. 149/PN/2007 & 1430/PN/2007 b. The question for consideration is whether 5% standard adjustment should be allowed while determining the ALP or the entire amount representing difference between ALP and the 36

41 Domestic Transfer Pricing and some Issues in International Transfer Pricing declared price should be added where the difference exceeds 5%, has been set to rest by the Finance Act, 2012 with the insertion of sub-section (2A) to section 92C with retrospective effect (from AY ). c. It is now clear that post amendment where the variation between arithmetical mean and price at which the transaction has actually been undertaken exceeds 5% of arithmetical mean, the taxpayer shall not be entitled to get the benefit. Issue for consideration is whether this is retrospective w.e.f AY , particularly when there was specific amendment carried on in 2009? Therefore, it will apply from AY or so Selection of comparables having related party transactions (RPT) The Indian TP regulations do not specifically provide guidance for analysis of RPT except for mention that it should be uncontrolled transaction. In such cases, the following issues arise in the TP assessments a) Whether to consider such comparable having RPT? b) If yes, what should be the threshold filter for such comparables having RPT? c) What kind of payments are to be considered, revenue (including reimbursements) as well as capital loan transactions? d) Where to get the details of such transactions, when the financials do not sufficiently disclose such details in notes to accounts? Some important decisions are as follows: Technimount ICB India Private Limited ITA No. 5085/Mum/2010. SAP Labs India Private Limited [44 SOT 156] Adobe Systems India (P) Ltd [14 ITR 0084] 5. SOME OF THE SPECIFIC ISSUES RAISED IN TRANSFER PRICING ASSESSMENTS 5.1. Loans to subsidiary / Corporate/ Bank Guarantee Inter-company transactions take place through transfers of tangible and intangible property, the provision of services, as well as inter-company financing. A parent company may guarantee a loan that is granted to the subsidiary by a third party (e.g, a bank). A loan guarantee fee may be required to be paid by the subsidiary to the parent for having provided the guarantee. The loan itself is primarily the responsibility of the subsidiary and must be repaid by the subsidiary. This may potentially cause a thin capitalisation problem for the subsidiary, if it could not have obtained the loan without the parent s guarantee, although in practice, the risk of tax authority attack is generally, much less than where the loan is made directly from the parent company to the subsidiary. Key issues that may arise in such a scenario are as under: 1) Whether the transaction of giving corporate guarantee to bank in India or direct to give loan to subsidiary or AE is an international transaction? 2) No Real Income Can Notional income be taxed? 3) Shareholder/investor function vis-à-vis service 37

42 Domestic Transfer Pricing and some Issues in International Transfer Pricing 4) No specific Indian Transfer Pricing regulations for benchmarking impact of 6th method. 5) Operating subsidiary vs Holding SPV 6) Benefit to Self Overall reduction in the borrowing rates for the Group / Parent to ultimately benefit parent 7) Ability to make acquisitions 8) It is letter of comfort vs actual guarantee given guarantee to bank with back to back guarantee to subsidy with or without actual cost. (Refer amendment in Finance Act 2012) 9) Letter of Comfort and Letter of Awareness scrutinized Arm s length compensation expected 10) Benchmarking - Yield Method, CUP, Savings in Interest rate (Reduction of rate in guarantee commission based on GE Canada case) Recent decisions for consideration/ reference, wherein the addition made on account of corporate guarantee has been deleted. It is also been held that transaction of giving corporate guarantee to its subsidiary cannot be equated with bank or financial institution which is a part of its business. Everest Kanto Cylinder Ltd. [542/M/2012, dt. 23 Nov (Mum. Trib.)] Four Soft (Bang.) [142 TTJ 358 (Hyd)] Asian Paints Ltd. [TS-633-ITAT-2011(Mum)] 5.2. Advertising Marketing and Promotion (AMP) expenses Transfer pricing aspects of Marketing Intangibles (AMP) have received renewed and more intense focus. A common issue raised is a situation when the promotional efforts of a marketing affiliate significantly enhance the value of a trademark that is legally owned by another affiliate. A common approach adopted by the tax department is to assert that the licensor should compensate the Indian affiliate for the part of its non-routine AMP expenditure that is attributable to or benefiting developing the brand or trademark, owned by the licensor. The tax department, while dealing with the deductibility of marketing spend, have disallowed a certain percentage of AMP expenses, on the ground that a portion of such expenditure benefits the brand owner and hence, such a portion does not relate to the business of Indian affiliates. However the above adjustment has been struck down by courts in certain cases on the ground that the expenses incurred by the taxpayers were solely for the benefit of the business and that benefits derived by foreign affiliates, if any, were merely incidental and hence, such expense expenses were fully deductible. In this regard, a special bench has been recently constituted in Delhi in case of LG Electronics India (P) Ltd to decide whether there should be any TP adjustment on AMP expenses and whether any mark up should have been charged from AE. The matter has been heard and the outcome of the decision is awaited on this contentious issue. Useful reference could be made to the decision of the Delhi High Court in case of Maruti Suzuki [328 ITR 210] even though the Supreme Court has restored the matter back to TPO, observations of the High Court would be useful while dealing with TP cases relating to AMP. Key issues that arise under allowability of AMP expense are as under: 1) Whether the incurring of AMP expenses can be characterized as international transaction, since expenditure is incurred in India, for effecting sale of goods or for rendering services. 2) Whether TPO can assume jurisdiction to examine such AMP expenses 38

43 Domestic Transfer Pricing and some Issues in International Transfer Pricing 3) Whether the incurring of AMP expense results in any market intangible and whether any benefit therefrom arises to AE. 4) Is such benefit only incidental, not requiring any charge from the AE. 5) What about expenditure incurred on AMP by foreign AEs which may benefit Indian entities. 6) Criteria of determining non-routine AMP expenses i.e. expenses on effecting of sale vs promotion of Global Brand. 7) Brightline Test (BLT) - whether a valid method? 8) Applicability of Profit Split Method (PSM) as a method to compensate for such excessive AMP expenditure 9) Validity of applying a standard of 35% markup from marketing activities based on Rolls Royce ruling of Delhi ITAT 10) When Indian entity not in the main business of doing advertising etc, whether charging of any mark up further justified. 11) Criteria for determining such markup. Decisions for consideration LG Electronics Special Bench constituted before Delhi Tribunal The question referred to the Special Bench is as under: 1. Whether in the facts and circumstances of the case, the Assessing Officer was justified in making transfer pricing adjustment in relation to advertisement, marketing and sales promotion expenses incurred by the assessee 2. Whether the Assessing Officer was justified in holding that the assessee should have earned a mark up from the Associated Enterprises in respect of AMP expenses alleged to have been incurred for and behalf of the AE The matter is heard and completed and order is awaited. In the following cases Courts/ Tribunals have held that if the expenditure is incurred by Indian Company/ subsidiary for effecting sales in India it is an allowable business expenditure, even if some incidental benefit is received by parent company, owning the brand. Observation in these decisions will be helpful in TP matters also. Nestle India 337 ITR 103 (Del.) Sony India (P) Ltd. (118 TTJ 865) Del ITAT Nokia India Pvt. Ltd. ITA No. 4559/D/2011 (Del.) (Trib.) dated 18 May 2012 (consider amendment by FA 2012) Nestle India 114 TTJ 498 (Del.) 5.3. Cost Contribution for Research and Development (R&D) Cost-sharing is based on the idea that a group of companies may gather together and share the expenditure involved in researching and developing new technologies or know-how. By sharing the costs, each participant in the arrangement obtains rights / ownership to all the R&D, although it funds only a small part of the expense. As soon as a viable commercial opportunity arises from the R&D, all contributors to the cost-sharing arrangement co-own it and are free to exploit it as they see fit, subject to any parameters laid down by the agreement. 39

44 Domestic Transfer Pricing and some Issues in International Transfer Pricing However, there are many complex issues, both in accounting and tax terms, which arise in practice from the establishment of a cost-sharing arrangement between companies under common control. Key issues that arise under the above: 1) Whether a cost allocation under a Cost Contribution Agreement (CCA) is consistent with the arm s-length principle? 2) Whether the allocation of costs among the CCA participants is consistent with the parties proportionate share of the overall expected benefits to be received under the CCA. 3) Whether any disallowance should be made of payment under the cost contribution agreement under section 37(1), 40(a)(ia), 40(a)(i) and 40A(2), even where the payment did not involve mark-up and was at arms length price and the services were for furtherance of the assessee s business interests. In order to reduce the litigation, there need to be clarity between cost contribution necessity or cost sharing and benefit test with supporting documents evidence. Illustrative list of decisions for reference: ABB LTD [(AAR) 322 ITR 564] AAR has held that if these are cost contribution agreement, then there is no rendering of services by R & D centre but more cost and ownership sharing. Hence it is not royalty which can be brought to tax in India, such arguments will also help in TP matter also. Aricent Technologies (Holdings) Ltd. 137 TTJ 209 (Delhi)(Trib.) Payment received by the assessee company from its AE / parent company was in the nature of reimbursement of incentives paid to the employees of the assessee and it did not have any element of income and therefore, no adjustment could be made in the computation of ALP by notionally imputing evidence with sufficient documents is required for cost a mark up on that amount, more so when no such adjustment can be made Intra group services - Cost contribution for use of IPR/ IT facilities/ Management fees/ HR Support and service charges In multinational groups, it is common to arrange for a wide scope of services to be made available to members of the group, particularly Centralized I.T facilities, administrative, technical, financial, HR and commercial services. Such services may include management, coordination, and control functions for the whole group. While the parent company is often the centralized service provider, in recent years,,model of one affiliate providing services on a central basis to several other affiliates has become popular. In these situations, cost contribution (or shared-service) arrangements can be constructed to charge the costs of the service providers to the affiliates that benefit from the services they provide. For transfer pricing purposes, it needs to be established that services have been provided by one member of a group to other members of that group at, arm s length pricing principle for these intra group services must be established. The issues that arise in this context include justifying that a benefit is anticipated to be or has been obtained from the performance of services and determining that the amount charged is arm s length. Appropriate treatment of the intra group provision of services has become a critical transfer pricing (TP) issue in India. These types of transactions are more susceptible to scrutiny by tax authorities in TP as well as normal assessment. 40

45 Domestic Transfer Pricing and some Issues in International Transfer Pricing Key issues that arise are as under: 1. Rational/ justification for payment of management fees 2. Whether the taxpayer has the ability to demonstrate that a service has been rendered by an overseas affiliate and that the Indian taxpayer has received an economic or commercial benefit that has enhanced commercial position of the recipient. This test, known as the benefit test, is critical to determine whether an unrelated party would pay for an intra group service and therefore, whether the service provider can justify a charge for the provision of the intra group service under arm s length conditions. Further, under the benefit test, following points need to be considered: Benefit derived by the taxpayer from use of IP continuously challenged In case of failure to justify the benefit derived, the ALP of the royalty payment treated as NIL Know-how royalty in respect of traded goods challenged Satisfaction of Benefits test most critical in case of loss Legal ownership vs. economic ownership: Typical in case of brand/ trademark royalty The Revenue authorities consider the licensor AE to be the legal owner and the licensee Indian entity to be the economic owner of the brand, hence no requirement of paying royalty, since brand is used in India to manufacture of sale goods. Combined benchmarking approach using TNMM not accepted Challenge if Indian entity engaged in providing R&D support 3. Whether a taxpayer has the ability to demonstrate that the benefits received are not remote or incidental or the activities are not shareholder activities or the services are not duplicative in nature. Inherent in the information/data request is the expectation of the tax authority of a functional analysis of the members of the group to establish the relationship between the relevant services and the members activities and performance. 4. Whether share of cost allocated to a particular group of entity in the total cost of services should be more or less in line with the share of turnover as against the scientific manner of cost allocation keys used by the taxpayer 5. Other issues Approvals provided by regulatory authorities (RBI/ SIA ) not accepted as appropriate CUPs favorable decision in the case of Sona Okegawa Precision Forgings Ltd and adverse decision in case of Coca Cola Basis of determination of royalty rates questioned Continuous payment of royalty at the same rate challenged First time payment, particularly when not paid in earlier years, looked into in detail - comparison of profits before and after payment of royalty 41

46 Domestic Transfer Pricing and some Issues in International Transfer Pricing Following are the illustrative list of decisions for consideration/ reference M/s Gemplus India Pvt. Ltd. Dresser-Rand India Pvt. Ltd. [13 ITR(Trib) 422] Abhishek Auto Industries Ltd. [15 - ITR(Trib) 168] M/s.Ericsson India Private Limited [17 ITR(Trib) 79] McCann Ericson India Pvt. Ltd [ITA No.5871/Del/2011] (ITAT Delhi) 6. Commercial expediency of transaction vs. TPO s Powers In a multinational business scenario, a taxpayer needs to incur expenditure for various goods and services that is avails. For determining the deductibility of such expenses from the income, a taxpayer needs to establish that the payment has been incurred or laid out wholly and exclusively for the purpose of business. Recently, in many cases the TPO have questioned the commercial expediency of a transaction entered into by the taxpayer while determining Act.. Key issues that arise are as under: a) Whether the TPO can question the commercial expediency/ business necessity of a transaction entered into by the taxpayer? b) Whether the payment by the Taxpayer to its AE can be disallowed on the basis that the Taxpayer had incurred persistent losses and therefore the Taxpayer had not derived any specific benefit from the same and accordingly no payment is warranted? c) Whether an expenditure can be disallowed on the basis that the payment is sham and the motive behind the same is to shift profits of the taxpayer? Following are the illustrative list of decisions for consideration/ reference, wherein it is held that TPO cannot questioned the commercial expediency of a transaction entered into by the assessee. M/s EKL Appliances Limited [345 ITR 241](Del. HC) LG Polymers India (P) Limited - [48-SOT-269] Ericsson India Pvt. Ltd. [17 ITR 79 (Delhi)(Trib.)] McCann Erickson India Pvt. Ltd. (ITA No 5871/ Del/ 2011) M/s Gemplus India Pvt. Ltd. [ITA No.352/Bang/2009] Dresser-Rand India Private Limited [53 SOT 173 (Mum Trib.)] 42

47 Domestic Transfer Pricing and some Issues in International Transfer Pricing NOTES 43

48 Domestic Transfer Pricing and some Issues in International Transfer Pricing NOTES 44

49 Case Studies in Taxation Case Studies in Taxation Sunil M. Lala, FCA, LLB Tax Incentive and disallowance u/s. 73 of the Act CASE STUDY 1 Facts: 1.1 Computation of Income as prepared at ATP Ltd. (All over The Place) ( the company ) Eligible to claim deduction under Section Nature of Business of the Undertaking Unit 1 Unit 2 Unit 3 Total 10AA 10AA 80IA Manufacture and sale of needles Manufacture and sale of machinery spares Port Operations Location (Gujarat) (Uttar Pradesh) (Cochin) Total Revenue (Gross sales / (A) receipts) Total Expenses (B) Income [(A) minus (B)] (C) (30.00) Deduction claimed under Section (D) AA Business Income [(C) minus (D)] (E) - (30.00) Less: Loss on account of trading in (F) (60.00) shares Business Income [(E) minus (F)] (G) (5.00) Income from house property (H) Capital Gains (I) Income from Other Sources (J) Gross Total Income [(G) + (H) (K) (I) + (J)] Deduction u/s 80IA (restricted (L) to gross total income) Total Income (K) minus (L) Nil 45

50 Case Studies in Taxation 1.2 During the assessment proceedings, the Assessing Officer calculated the income of the Company at ` 170 Crores. Working as per AO is as under: Unit 1 Unit 2 Unit 3 Total Deduction claimed u/s 10AA 10AA 80IA Business Manufacture and sale of Manufacture and sale of machinery Port Operations needles spares Location (Gujarat) (Uttar Pradesh) (Cochin) Business Income (as calculated by ATP Limited above) (30.00) Income from house property Capital Gains Income from Other Sources Total Income Contentions of the AO with regard to the claim of the Company and basis of calculating above income is as under: Tax incentives under Section 10AA and 80IA of the Act is not allowable to the Company, as no separate books of account are maintained. Reliance is placed on the judgment of the Hon ble Supreme Court in the case of Arisudana Spinning Mills Ltd vs. CIT (210 Taxman 233) Loss on account of trading in shares is a speculation loss u/s 73 of the Act and hence the same cannot be adjusted against business income Without prejudice, in any case the benefit under Section 10AA of the Act, cannot exceed ` 10 Crores (post adjusting loss of Unit 2 with profit of Unit 1), since both the units are eligible to claim deduction under Section 10AA of the Act Without prejudice, in any case the deduction under Section 80IA of the Act, cannot exceed ` 55 Crores (i.e. business income) and any excess amount cannot be claimed against capital gains, income from other sources and income from house property. Issues for consideration: 1.a Please examine whether the aforesaid contentions and the consequent working done by the AO are correct 1.b ATP Ltd is planning to hive off Unit 1 to another Company with effect from July Please recommend whether it should be done by way of demerger or slump sale, so that the benefit u/s 10AA can be claimed by both the Companies [i.e ATP Ltd for the period 1/4/13 to 1/6/13 and the successor Company for the period 1/7/13 to 31/3/14]. CASE STUDY 2 Reassessment and business expenditure [non-compete fee, additional depreciation and disallowance under Section 40(a)(ia) for short deduction of tax] Facts: 2.1 M/s. Radheshyam ( M/s. R ) is engaged in the business of manufacturing bearings. It filed its Return of Income ( ROI ) for AY on 28 September On 30 September it received 46

51 Case Studies in Taxation intimation under Section 143(1) of the Act accepting the returned income and no notice under Section 143(2) of the Act was issued for the captioned year. On 29 March 2010, M/s. R received notice under Section 148 of the Act proposing to reassess the income of M/s. R Assessing Officer ( AO ) provided following reasons for reopening of assessment: As per the Note No. 8 in the Notes to the Financial Statements, during the captioned year, M/s. R has paid ` 3 Crores to M/s X towards non-compete arrangement. As per the said agreement M/s. X will not compete with M/s R in the South Indian region for 5 years. The said payment to M/s X is debited to the profit and loss account under the head non-compete fees. Since, the said expense is capital in nature the same should be disallowed in the ROI As per clause 14 of the TAR, vide Note No. 2 it is mentioned that during the AY , M/s. R has purchased plant and machinery on 1 January 2004 which is eligible for additional 15% under Section 32(1)(iia) of the Act. Since, the said plant and machinery was used for less than 180 days in AY , the said depreciation was restricted to 50% of the eligible amount under proviso to Section 32(1)(ii) of the Act. Balance 50% of the said depreciation is claimed by M/s. R during the captioned year. M/s. R is not eligible for additional depreciation on plant and machinery purchased in the earlier year M/s. R has made payment of ` 3,750,000 for hire of generator set by erroneously deducting tax of ` 2% u/s. 194C instead of deducting tax of ` 10% u/s 194I. In the tax audit report ( TAR ), under Clause 27 while disclosing short fall on account of lesser deduction of tax, auditor of M/s. R has mentioned short deduction of tax of ` 300,000. Further, in clause 17(f) of the TAR disallowance u/s. 40(a)(i) is ` 3,000,000 (i.e. ` 300,000/` 375,000 * ` 3,750,000). However, the said amount has not been added back n the ROI. Issues for consideration 2.a Whether the AO is not justified in initiating reassessment proceedings in the absence of any new material notwithstanding the fact that: Original assessment was completed under Section 143(1) of the Act; and Section 148 notice has been issued within a period of 4 years from the end of the relevant assessment year? 2.b Please analyse - whether the aforesaid disallowances sought to be made by the AO are justified? Section 14A disallowances: Facts: 3.1 Mr. A is engaged in the following activities: CASE STUDY 3 i. manufacturing of machine spares in the state of Himachal Pradesh; ii. iii. trading in shares; and investment in shares. 3.2 With regard to manufacturing business, he has claimed deduction under Section 80IC of the Act till AY He earned the following dividend income from the above activities, which is not chargeable to tax: Source / Activity Shares held for trading purposes Shares held as investments Dividend Income (INR) 10 Lakhs 20 Lakhs 47

52 Case Studies in Taxation 3.4 He has also earned ` 50 lakhs from the share trading activity. 3.5 During the AY he has incurred following interest expenses: Sr. No. Interest Expenditure (` in Lakhs) Funds Borrowed (` in Lakhs) Invested in i 9 50 Shares acquired for investment purpose ii Shares acquired for trading purpose iii Assets of the manufacturing business iv General Purpose (i.e. used for any of the activities, specific breakup of which is not available) Total Balance Sheet of Mr. A as on 31 March 2010 is as under: Liabilities Amount Assets Amount (` in Lakhs) (` in Lakhs) Capital and Reserves 400 Fixed Assets 300 Loans 600 Investment in shares: Held for investment purposes 100 Held for trading purposes 200 Net Current Assets 400 Total 1,000 Total 1,000 Assume, average value of the investment is ` 100 lakhs for investment purpose and ` 200 lakhs for trading purpose and average value of total assets is ` 1,000 lakhs. 3.7 Mr. A made disallowance of ` lakhs under Section 14A based on the following working: Particulars Amount (` in lakhs) Interest expense on the funds invested in shares for investment purpose 9.00 Without prejudice, proportionate interest on account of the funds used for 2.70 general purpose [27 (Interest) *100 (Average value of shares held for investment purpose) /1000 (Average value of total assets)] Total Without providing any reason, the A.O rejected the aforesaid working of the assessee and computed disallowance u/s 14A by mechanically applying Rule 8D as under:- Particulars Amount (` in lakhs) Interest expense on the funds invested in shares for investment purpose (A) 9.00 Proportionate disallowance of interest expenditure not covered in A above [99 (B) (Interest) * 300 (Average value of shares) /1000 (Average value of total assets)] 0.5 per cent of average value of shares (0.5 % * 300) (C) 1.50 Total

53 Case Studies in Taxation Issues for consideration: Please analyse following points with respect to Section 14A of the Act: 3.a Whether provisions of Section 14A can be applied to share trading activity? 3.b Computation of disallowance of interest under Rule 8D(2)(ii) is to be made using following formula: A X B C A = interest expenditure other than the amount of interest included in Clause (i); [Clause (i) amount of expenditure directly relating to income which does not form part of total income] B = average value of investment, income from which does not or shall not form part of the total income; C = average value of total assets; Whether, the AO is correct in: i. Including interest expense of ` 54 lakhs in (A) which is directly related to manufacturing activity; ii. iii. iv. Including interest expense of ` 18 lakhs in (A) which is directly related to share trading activity; Including value of shares of ` 100 lakhs (i.e. entire value of shares held for investment purposes) in (B); and Including value of ` 200 lakhs in (B) on account of shares held for trading activities; 3.c In case, Mr. A had made investment in unlisted securities and had not earned any dividend income as mentioned in Point No. 4, could he have justifiably taken the stand that no disallowance can be made under Section 14A? CASE STUDY 4 Income earned from Portfolio Management Scheme and Section 54 EC of the Act Facts: 4.1 Mr. Manmohan Singh, an individual earns income on investment made through Discretionary Portfolio Management Scheme ( PMS ) providers. 4.2 Apart from above, he himself trades in shares and securities and has maintained a portfolio for the same. He also indulges in direct dealings in mutual funds, investments etc. 4.3 During the year under consideration, Mr. M paid portfolio management fee to the PMS providers for the services rendered by them. 4.4 In the same year, he sold his ancestral property for ` 1 crore on 1/11/2011. He received the consideration in two equal installments, the first installment being 21/11/2011 and the last installment on 10/12/2011. Thereafter he invested ` 50,00,000 in bonds by Rural Electrification Corporation Ltd (REC Bonds) on 30/03/2012 and another ` 50,00,000 in the said Bonds on 15/5/2012. Issues for consideration 4.a Whether income earned from Discretionary PMS would be taxable under the head of Income from Business or Capital Gains. 49

54 Case Studies in Taxation 4.b If the answer to (a) above is Capital Gains, then whether the fees paid to portfolio manager would be deductible while computing income from Capital Gains. 4.c If the answer to (a) above Income from Business, then whether the fees paid to portfolio manager would be deductible while computing Business Income. 4.d Whether the position would change if Mr. M has invested money in Non-Discretionary Portfolio Management Scheme. 4.e Whether the additional amount of ` 50 lakhs invested in REC Bonds on 15/5/2012 would qualify for exemption under section 54EC for the A.Y more so since the investment is made 6 months beyond the date of the transfer. 4.f Assuming that (i) Mr M wants to invest only ` 50 lakhs to avail section 54EC exemption (ii) the REC bonds were available only till 31st March 2012 and thereafter only after 01st May 2012, would Mr M be entitled to claim exemption under section 54EC in respect of (i) ` 10 lakhs invested in National Rural Development Bonds on 31/3/2012 (ii) ` 40 lakhs invested in REC on 11/5/2012. CASE STUDY 5 Carry forward of unabsorbed tax depreciation, unabsorbed book loss and minimum alternate tax credit on merger Facts 5.1 M Ltd is an Indian company engaged in the trading of goods. The position of loss of M Ltd. as per books and tax records is as under: Particulars As per books As per tax Business Loss Unabsorbed Depreciation Total MAT credit was available to M Ltd as on the date of amalgamation. (INR in Crores) 5.3 M Ltd merged with P Ltd vide a Scheme of Amalgamation ( the Scheme ) under section of the Companies Act. On the Scheme becoming effective, all assets and liabilities of M Ltd were transferred to and vested in P Ltd. The conditions mentioned in Section 2(1B) of the Income Tax Act ( IT Act) were satisfied. 5.4 M Ltd does not qualify as industrial undertaking within the meaning of the Section 72A. Issues for consideration 5.a Although the business activity of M Ltd do not comply with the provisions of Section 72A of the Act, whether P Ltd can still take benefit of tax unabsorbed depreciation of M Ltd? 5.b Whilst computing book profits under section 115JB of the IT Act, whether P Ltd can take into account the brought forward business loss and unabsorbed depreciation as per the books of account of M Ltd? 5.c In absence of specific provisions under the IT Act, whether MAT credit available in the hands of M Ltd can be availed of in hands of P Ltd? 50

55 Case Studies in Taxation CASE STUDY 6 Section 56(2)(viia) of the Act Facts: 6.1 AB Pvt Limited ( ABPL ) has two shareholders Mr. A and Mr. B. Mr A is father of Mr. B. 6.2 CD Pvt Limited ( CDPL ) has three shareholders AB Limited, Mr. C and Mr. D. Mr. C is father of Mr. D. 6.3 Mr. A and Mr. C are brothers. 6.4 CDPL is holding 95 % shares in E Pvt Limited ( EPL ) and balance 5% are held by Mr. D. 6.5 CDPL has also issued 10,000 debentures of ` 100 each fully convertible into 2.5 shares per debenture to ABPL 6.6 Over a period of time following transactions have taken place: i. 1 Aug 2010 CDPL issued 1000 equity shares under bonus issue to ABPL when the fair market value of the shares was ` 55 per share; ii. 1 Dec 2010 CDPL issued 10,000 equity shares under right ` 40 per share to ABPL when the fair market value of the shares were ` 50 per share; iii. 1 Feb 2011 Fully convertible debentures were converted into 25,000 equity shares (i.e. 2.5 shares per debentures) when the fair market value of the shares was ` 55 per share; iv. 1 May 2011 CDPL bought back 10,000 shares from AB PL on pro rata ` 45 per share when the fair market value of the shares was ` 52 per share; v. 1 Sep 2011 CDPL was liquidated and consequently 40% shares of EPL were received by ABPL in the liquidation process. Fair market value of the shares of EPL was ` 400,000. Note: The fair market value refers in the above is as per the Rules. 51

56 Case Studies in Taxation Issues for consideration Analyse taxability of following transactions under Section 56(1)(viia) of the Act in the hands of ABPL: 6.a Receipt of equity shares under bonus issue on 1 Aug 2010; 6.b Receipt of equity shares under right issue on 1 Dec 2010; 6.c Receipt of equity shares on conversion of debentures on 1 Feb 2010; 6.d Receipt of equity shares of EPL on 1 Sep 2010 consequent to liquidation of CDPL; and 6.e Whether threshold of ` 50,000 should be applied to each transaction or on aggregate of all the transactions. Analyse taxability of following transactions under Section 56(1)(viia) of the Act in the hands of CDPL: 6.f Would the buyback of shares on 1 May 2011, i.e. before liquidation, be taxable in the hands of CDPL under Section 56(2)(viia) of the Act. CASE STUDY 7 Permanent Establishment and Fees for Technical Services Facts: G Co. Germany German India Cranes sold (title passed outside India) along with after sales services (in India) for both the Ports Commissioning and Installation (in India) Port - Cochin I Co Operating Ports Port - Gujarat 1. I Co an Indian Company, is engaged in the business of operating and maintaining two Ports i.e. at Cochin and Gujarat. 2. For purchase of cranes for both the ports, I Co. had entered into following agreements with G Co: a. Supply contract [including after sales services for 6 months (for 185 days) after installation]; and 52

57 Case Studies in Taxation b. Installation and commissioning contract wherein installation was to be completed within 6 months (185 days) of supply of cranes. c. Consideration for each of the above agreements are as under: i. Supply contract ` 100 Crores (including ` 10 Crores for after sales services); and ii. Installation and commissioning contract ` 30 Crores. 3. For providing installation, commissioning and after sales services the period of stay of employees of G Co in India is as under: Service Installation and commissioning (Days) After Sales Services (Days) Contractual Period (for both cranes) Actual period of employees in India: Cochin Gujarat Total Both the installation and commissioning contracts were to be executed one after another. 5. The AO is of the view that consideration for installation and after sales services aggregating to ` 40 Crores for each crane is taxable in India as fees for technical services on gross basis. Alternatively, he is of the view that the G Co has an installation PE in India and consequently the aforesaid sums are also taxable in India as Business Profit on net basis. Issues for consideration: 1. Please analyse whether G Co has a Permanent Establishment ( PE ) in India under Article 5(2)(i) (i.e Installation PE) of India Germany Tax Treaty i.e. for determination of PE please consider: a. Whether contractual or actual period of stay of employees should be considered; b. Whether periods of stay of employees pertaining to installation and commissioning at Gujarat and Cochin should be aggregated (i.e. 345 days); and c. Whether period of stay of employees pertaining to after sales services should be aggregated with the period of stay of employees for installation purpose (i.e. 295 and 270 days). 2. Whether the payments made to G Co for installation and after sales services can be taxed as fees for technical services under Income-tax Act, 1961 ( the Act ) or India Germany Tax Treaty? Total 53

58 Case Studies in Taxation NOTES 54

59 Case studies in Accounting and Auditing Case Studies in Accounting and Auditing CA. Sudhir Soni 1. CASE STUDY FOR PREPARATION OF FINANCIAL STATEMENTS IN ACCORDANCE WITH THE REQUIREMENTS AS STIPULATED IN REVISED SCHEDULE VI TO THE COMPANIES ACT, 1956 Background: Sample Limited ( the Company ) is a leading global manufacturing Company engaged in the manufacturing, marketing and trading of consumer goods. The Company has various manufacturing facilities. Exercise: The Company needs to present its financial statements for the year ending 31 March 2012 under revised Schedule VI requirements. Based on the below presented financial statements under Indian GAAP, identify errors / non-compliance with revised Schedule VI. Balance Sheet as at 31 March 2012 Notes 31 March March 2011 Equity and liabilities Shareholders funds Share capital 3 Reserves and surplus 4 Employee stock options outstanding Share application money refundable Non-current liabilities Long-term borrowings 5 Other long-term liabilities 6 Long-term provisions 7 Current liabilities Short-term borrowings 8 Trade payables 9 Other current liabilities 9 Short-term provisions 7 TOTAL 55

60 Case studies in Accounting and Auditing Notes 31 March March 2011 Assets Non-current assets Fixed assets Tangible assets 10 Intangible assets 11 Capital work-in-progress (Including capital advances) Intangible assets under development Non-current investments 12 Deferred tax assets (net) 13 Long-term loans and advances 14 Trade receivables 15 Other non-current assets 15 Current assets Current investments 16 Inventories 17 Trade receivables 15 Cash and bank balances 18 Short-term loans and advances 14 Other current assets 15 TOTAL Summary of significant accounting policies 2 The accompanying notes are an integral part of the financial statements. Statement of profit and loss for the year ended 31 March 2012 Notes 31 March March 2011 Continuing operations Income Revenue from operations (gross) 19 Less: excise duty Less: service tax Less: Sales Tax/VAT Revenue from operations (net) Other income 20 Total revenue 56

61 Case studies in Accounting and Auditing Notes 31 March March 2011 Expenses Cost of raw material and components consumed 21 Purchase of traded goods 22 (Increase)/ decrease in inventories of finished goods, 22 work-in-progress and traded goods Employee benefits expense 23 Other expenses 24 Earnings before interest, tax, depreciation and amortization (EBITDA) Depreciation and amortization expense 25 Xxx Less: recoupment from revaluation reserve Xxx Net depreciation and amortization expense Finance costs 26 Profit/(loss) before tax Tax expenses Xxx Current tax Deferred tax Total tax expense Profit/(loss) for the year from continuing operations (A) Discontinuing operations Profit/(loss) before tax from discontinuing operations Tax expense of discontinuing operations Profit/(loss) after tax from discontinuing operations (B) Profit/(loss) for the year (A+B) Balance as per last financial statements Less: Appropriations Proposed final equity dividend (amount per share INR2 (31 March 2011: INR2)) Tax on proposed equity dividend Dividend on preference shares (amount per share INR (March 2011: INR )) Tax on preference dividend Transfer to debenture redemption reserve Transfer to general reserve Total appropriations Net surplus in the statement of profit and loss 57

62 Case studies in Accounting and Auditing Earnings per equity share [nominal value of share INR (31 March 2011: : INR ] Basic Computed on the basis of profit from continuing operations Notes 31 March March 2011 Computed on the basis of total profit for the year Diluted Computed on the basis of profit from continuing operations Computed on the basis of total profit for the year Summary of significant accounting policies 2 The accompanying notes are an integral part of the financial statements. For the purposes of this exercise, we assume that the Company has made adequate and correct disclosures and presentation accounting policies and Cash Flow Statement in line with the applicable requirements. 3. Share capital (refer note below) 4. Reserves and surplus (refer note below) For the purposes of this exercise, we assume that the Company has made adequate and correct disclosures and presentation of Notes 3 and 4 in line with the applicable requirements. Accordingly, no further analysis is required to be done. 5. Long-term borrowings Non-current portion 31 March March 2011 Current maturities 31 March March 2011 Term loans Indian rupee loan from banks (secured) Foreign currency loan from banks - - (secured) From financial institutions (secured) Other loans and advances Deferred sales tax loan (unsecured) Nil Nil Trade deposits (unsecured) Deposits (unsecured) Deposits from shareholders - - Deposits from public Finance lease obligation (secured) 58

63 Case studies in Accounting and Auditing Non-current portion 31 March March 2011 Current maturities 31 March March 2011 The above amount includes Secured borrowings Unsecured borrowings Amount disclosed under the head short () () term borrowings (note 8) Net amount Indian rupee loan from bank carries 9% p.a. The loan is repayable in 12 yearly installments of INR million each along with interest, from the date of loan, viz., 1 February Foreign currency loan is repayable after 6 years from the date of its origination, viz., 1 April Indian Rupee loan and foreign currency loan are secured by hypothecation of inventory, trade receivables of the company and against the plant and machinery at Golkunda plant and Hazira plant. 4. Term loan from financial institutions was taken during the financial year The loan is repayable in 20 half yearly installments of INR each along with interest, from the date of loan. Financial Institution Loans are guaranteed by the building owned by non-executive director of Father Limited, the ultimate holding company. 5. Finance lease obligation is secured by hypothecation of plant and machinery taken on lease. 6. Deferred sales tax loan is interest free and payable in 48 quarterly installments of INR million each, starting from 30 June Deposits from shareholders are repayable after 3 years from the respective date of deposit. 8. Deposits from public are repayable after 3 years from the date of deposit, viz., 1 September Other long-term liabilities 31 March March 2011 Deposits from dealers and customers 7. Provisions 31 March 2012 Long-term 31 March March 2012 Short-term 31 March 2011 Provision for employee benefits Provision for post-employment medical benefits (note 27) Provision for gratuity (note 27) Provision for leave benefits

64 Case studies in Accounting and Auditing Other provisions 31 March 2012 Long-term 31 March March 2012 Short-term 31 March 2011 Provision for warranties - - Provision for litigations Proposed equity dividend - - Provision for tax on proposed equity - - dividend Proposed preference dividend - - Provision for tax on proposed preference - - dividend Provision for warranties A provision is recognized for expected warranty claims on products sold during the last two years, based on past experience of the level of repairs and returns. It is expected that significant portion of these costs will be incurred in the next financial year and all will have been incurred within two years after the reporting date. Assumptions used to calculate the provision for warranties were based on current sales levels and current information available about returns based on the twoyear warranty period for all products sold. The table below gives information about movement in warranty provisions. 31 March March 2011 At the beginning of the year Arising during the year Utilized during the year Unused amounts reversed At the end of the year Current portion Non-current portion Provision for litigations During the year ended 31 March 2011, the Central Excise Department raised a demand for INR million toward differential excise duty on valuation of products from the Tarapore plant. The company has been contesting this claim and was of the view that the demand raised by the excise department was not tenable. To support its view, the company had also obtained legal opinion. Hence, it had not created provision toward this liability in the year ended 31 March The Excise Tribunal heard the matter during the current year and decided the case against the company. Although the company continues to contest the case in the high court, the management now believes that outflow of resources embodying economic benefits is probable and the estimated amount of outflow is INR million. Hence, the company has created a provision of INR million toward the obligation. 60

65 Case studies in Accounting and Auditing 8. Short-term borrowings Current maturities of long-term borrowings (note 5) (Includes current maturity of finance lease obligation million (31 March 2011: million)) 31 March March 2011 Cash credit from banks (secured) 10% loan from ABZ Finance Private Limited repayable on demand (unsecured) Interest free loan and advances from related parties repayable on demand (unsecured) (refer note 27) Deposits (unsecured) 10% Inter-corporate deposit repayable on demand The above amount includes Secured borrowings Unsecured borrowings Cash credit from banks is secured against margin money deposits, investment property, intangible assets except goodwill and second charge on all trade receivables. The cash credit is repayable on demand and carries 9 to 11% p.a. 9. Other current liabilities Trade payables (including acceptances) (refer note 27 for details of dues to micro and small enterprises) 31 March March 2011 Other liabilities Interest accrued but not due on borrowings Interest accrued and due on borrowings Investor Education and Protection Fund will be credited by following amounts (as and when due) Unpaid dividend Unpaid matured deposits Unpaid matured debentures - Others Service tax payable TDS payable Deferred payment liabilities for purchase of fixed assets repayable after 3 years Operating lease payable 61

66 Case studies in Accounting and Auditing Customer deposits are repayable within 6 9 months from the balance sheet date on completion of supply contracts. 10. Tangible assets 11. Intangible assets For the purposes of this exercise, we assume that the Company has made adequate and correct disclosures of Notes 10 and 11 in line with the applicable requirements. Accordingly, no further analysis is required to be done. 12. Non-current investments 31 March March 2011 Trade investments (valued at cost unless stated otherwise) Unquoted equity instruments Investment in subsidiaries million (31 March 2011: million) Equity shares of INR each fully paid-up in C Limited million (31 March 2011: million) equity shares of INR each fully paid-up in RED Investments Limited (At cost less provision for other than temporary diminution in value) Investment in joint ventures million (31 March 2011: million) equity shares of INR each fully paid-up in E-age Ltd Investment in associates million (31 March 2011: million) shares of INR each partly INR per share in Brother Ltd Non-trade investments (valued at cost unless stated otherwise) Investment in equity instruments (quoted) million (31 March 2011: million) equity shares of INR each fully paid-up in Red Limited (At cost less provision for other than temporary diminution in value) Government and trust securities (unquoted) Investment in government securities 62

67 Case studies in Accounting and Auditing Debentures (quoted) 20 million (31 March 2011: 20 million) 12% Secured redeemable non-convertible debentures of INR100 each partly paid-up in ABCD Limited. Aggregate amount of quoted investments (Market value: INR million (31 March 2011: INR million)) 31 March March 2011 Aggregate amount of unquoted investments Aggregate provision for diminution in value of investments 13. Deferred tax asset (net) For the purposes of this exercise, we assume that the Company has made adequate and correct disclosures of Note 13 is in line with the applicable requirements. Accordingly, no further analysis is required to be done. 14. Loans and advances 31 March 2012 Long term 31 March March 2012 Short term 31 March 2011 Security deposit Secured, considered good Unsecured, considered good Doubtful - - Provision for doubtful security deposit () () - - Loan and advances to related parties Unsecured, considered good (repayable - - on demand) Advances recoverable in cash or kind Secured considered good Unsecured considered good Doubtful Less: provision for doubtful advances () () () () 63

68 Case studies in Accounting and Auditing Other loans and advances 31 March 2012 Long term 31 March March 2012 Short term 31 March 2011 Advance income-tax (net of provision for - - taxation) Prepaid expenses - - Loans to employees Balances with statutory / government - - authorities Total Less: Amount shown under Other Current - - Assets Net Amount Loans and advances due by directors or other officers, etc. Non-current 31 March March March 2012 Current 31 March 2011 Loans to employees include Dues from non-executive directors Dues from officers Dues from non executive directors and officers jointly with other persons 15. Trade receivables and other assets 15.1 Trade receivables 31 March 2012 Non-current 31 March March 2012 Current 31 March 2011 Unsecured, considered good unless stated otherwise Outstanding for a period exceeding six months Secured, considered good Unsecured, considered good Doubtful 64

69 Case studies in Accounting and Auditing 31 March 2012 Non-current 31 March March 2012 Current 31 March 2011 Provision for doubtful trade receivables () () () () Other receivables Secured, considered good Unsecured, considered good Doubtful Provision for doubtful trade receivables () () () () 15.2 Other assets 31 March 2012 Non-current 31 March March 2012 Current 31 March 2011 Unsecured, considered good unless stated otherwise Non-current bank balances (note18) Unamortized expenditure Unamortized premium on forward contract Ancillary cost of arranging the borrowings Unsecured, considered good unless stated otherwise Interest accrued on fixed deposits Interest accrued on investments - - Current maturities of loans given - - Others 65

70 Case studies in Accounting and Auditing 16. Current investments Current investments (valued at lower of cost and fair value) Quoted equity instruments million (31 March 2011: million) shares of INR each fully paid-up in KFC Investments Limited 31 March March 2011 Unquoted government or trust securities 7.25% 6 months government securities - Unquoted bonds million (31 March 2011: million) Infrastructure Bonds Series II of INR each fully paid Unquoted mutual funds million (31 March 2011: million) units of INR each fully paid-up of AXZ Mutual Fund Aggregate amount of quoted investments (Market value INR millions (31 March 2011: INR millions)) Aggregate amount of unquoted investments 17. Inventories (valued at lower of cost and net realizable value) Raw materials and components (includes in transit INR millions (31 March 2011: INR millions)) (refer note 21) 31 March March 2011 Work-in-progress (refer note 22) Finished goods (refer note 22) Stores and spares Loose tools 66

71 Case studies in Accounting and Auditing 18. Cash and bank balances Cash and cash equivalents Balances with banks: 31 March 2012 Non-current 31 March 2011 Current 31 March March 2011 On current accounts Deposits with original maturity of less than three months On unpaid dividend account Cheques/ drafts on hand Unpaid matured deposits Unpaid matured debentures - Cash on hand Other bank balances Deposits with original maturity for - - more than 3 months to 36 months Margin money deposit - - Less: amount disclosed under non-current assets - - Margin money deposits given as security Margin money deposits with a carrying amount of INR million (31 March 2011: INR million) are subject to first charge to secure the company s cash credit loans. 19. Revenue from operations 31 March March 2011 Revenue from operations Sale of products Finished goods Traded goods Sale of services Other operating revenue Scrap sales Foreign Exchange differences (net) - 67

72 Case studies in Accounting and Auditing 31 March March 2011 Revenue from operations (gross) Less: Excise duty # Less : Sales tax/ VAT Less : Service tax Revenue from operations (net) # Excise duty on sales amounting to INR million (31 March 2011: INR million) has been reduced from sales in profit & loss account and excise duty on increase/decrease in stock amounting to INR million (31 March 2011: INR million) has been considered as (income)/expense in note 24 of financial statements. Detail of products sold 31 March March 2011 Finished goods sold Refrigerator Washing machine Air conditioner Microwave oven Other electronic appliances Traded goods sold Television Refrigerator Washing machine Spare parts Other electronic appliances 20. Other income 31 March March 2011 Interest income on Bank deposits Long-term investments Current investments Others 68

73 Case studies in Accounting and Auditing Dividend income on 31 March March 2011 Investment in subsidiaries (proposed) Current investments Long-term investments Net gain/ (loss) on sale of current investments () Other non-operating income (net of expenses directly attributable to such income of INR 30 millions (31 March 2011: INR 70 millions)) 21. Cost of raw material and components consumed 31 March March 2011 Inventory at the beginning of the year Add: Purchases Less: inventory at the end of the year Cost of raw material and components consumed Detail of raw materials consumed 31 March March 2011 Compressors Others (including packing material) Detail of inventory 31 March March 2011 Raw materials and components Compressors Others (including packing material) 22. (Increase)/ decrease in inventories 31 March March 2011 (Increase) / decrease Inventories at the end of the year Work-in-progress () Finished goods () () 69

74 Case studies in Accounting and Auditing 31 March March 2011 (Increase) / decrease Inventories at the beginning of the year Work-in-progress () Finished goods () () () () Detail of inventory 31 March March 2011 Finished goods Refrigerator Other electronic appliances 23. Employee benefit expense 31 March March 2011 Salaries, wages and bonus Contribution to provident and other fund Gratuity expense (Note 27) Post employment medical benefits (Note 27) Staff welfare expenses 24. Other expenses 31 March March 2011 Consumption of stores and spares Sub-contracting expenses Power and fuel Water charges Employee stock option cost Freight and forwarding charges Rent Rates and taxes Insurance 70

75 Case studies in Accounting and Auditing 31 March March 2011 Repairs and maintenance Plant and machinery Buildings Others Advertising and sales promotion Brokerage and discounts Travelling and conveyance Communication costs Printing and stationery Legal and professional fees Payment to auditor (Refer details below) Provision for warranties (net of reversals) Provision for litigations (net of reversals) Exchange difference (net) - Bad debts / advances written off Provision for doubtful debts and advances Loss on sale of fixed assets (net) Miscellaneous expenses Payment to auditor* 31 March March 2011 As auditor: Audit fee Limited review Taxation matters - Company law matters - Management services - Other services (certification fees) - * Including Out of pocket expenses (OPE) under respective line items 71

76 Case studies in Accounting and Auditing 25. Depreciation and amortisation expense 31 March March 2011 Depreciation of tangible assets Amortization of intangible assets Depreciation of investment property Less: recoupment from revaluation reserve 26. Finance costs 31 March March 2011 Interest Bank charges Amortisation of ancillary borrowing costs 27. For the purposes of this exercise, we assume that the Company has made adequate and correct disclosures of following in line with the applicable requirements. Employee benefit disclosures as per AS-15 Related Party disclosures as per AS-18 Earnings per share as per AS-20 Details of dues to micro and small enterprises Value of imports calculated on CIF basis Expenditure in foreign currency (accrual basis) Imported and indigenous raw materials, components and spare parts consumed Accordingly, no further analysis is required to be done for above stated disclosures. 28. Previous year figures Previous year s figures have been regrouped where necessary to confirm to this year s classification. Footnotes: The Company receives refundable deposits from its customers / dealers. In accordance with the agreement between parties, either the Company or the dealer can terminate the agreement by giving notice of one month. The deposits are immediately refundable on termination of the agreement. The Company s past experience shows that deposits refunded in a year are not material. The Company has entered into non-cancellable long-term supply agreements with its vendors for supply of raw materials. Such contracts, if cancelled would lead to high penalties. Other Case Studies 2. For start-up manufacturing companies which are yet to commence commercial production, how operating cycle should be determined? 3. Whether operating cycle needs to be disclosed in the financial statements? 72

77 Case studies in Accounting and Auditing 4. A Company is required to pay interest of ` 1, under section 234B and 234C of the Income-tax Act, The Company believes that such interest expense should be included in tax expenses in statement of profit and loss account and in provisions in the balance sheet. Is Company s contention correct? 5. A Limited (the Company) has the following timing differences, as per AS 22 Accounting for Taxes on Income, at year-end: (a) Unabsorbed depreciation and carry forward loss of tax losses INR 5,000,000 (b) Other differences resulting in deferred tax assets INR 2,000,000 (c) Timing differences resulting in deferred tax liabilities INR 1,500,000 The applicable tax rate is 30%. The management of the Company contends that according to AS 22, it needs to consider the virtual certainty supported by convincing evidence only for the recognition of deferred tax assets arising from unabsorbed depreciation and the carry forward of tax loss. For other difference, it can recognise the deferred tax asset on the consideration of reasonable certainty. The management also points out that if the above view is not acceptable, there will be zero deferred tax recognised in the financial statements. In such a case, can it avoid making deferred tax disclosures required under AS 22? 6. Ship Limited (the Company) manufacturers both standard type boats as well as large ship specifically designed to customer needs. The standard type boats are generally sold to customers over the counter; however, in certain cases, the customer may prescribe minor design changes. Such changes are executed within a period of maximum one month. The specifically designed shops are manufactured on receipt of order from customer. The manufacturing and delivery of these ships takes minimum seven to eight months. How should Ship Limited recognise revenue arising these two types of contracts? 7. Acquirer Limited acquired an engineering unit of Acquiree Limited, on a going concern basis. The unit has various fixed assets such as buildings, plants and machinery and furniture, which were recognised in the books of Acquirer Limited at their book value, on the date of acquisition. Acquiree has already used these assets for certain periods and claimed the depreciation thereon. For example, it has used the building for 20 years and its remaining useful life as per Schedule XIV to the Companies Act, 1956, in the books of Acquiree Limited is 38 years. Please comment (a) (b) Should Acquirer Limited recognise fixed assets at book value or fair value? Can Acquirer Limited consider the useful lives of fixed assets afresh or it needs to reduce the period of usage by the Acquire on arriving at useful lives as per Schedule XIV? 73

78 Case studies in Accounting and Auditing NOTES 74

79 The Future of Indian Chartered Accountancy Firms The Future of Indian Chartered Accountancy Firms August J. Aquila, PhD and Vaibhav Manek, FCA, CPA (US) The Future is What We Make of It This paper examines the key forces that may be influencing Indian chartered accountancy ( CA ) firms in the future and looks at the challenges and opportunities that await the profession in India. It also addresses the responsibility of the all stakeholders in the accountancy profession to become engaged with this debate by providing members with detailed insights into the challenges and opportunities that await them. The authors believe that during the next 10 to 15 years there will be major upheavals for CA practices in India. These upheavals will come about as management structures, staff issues, business processes, technology developments and clients undergo continuing transformation. The future of the India accounting profession we are talking about today has already occurred in many other countries throughout the world United Kingdom, Canada and the United States. We hold that what has transpired in these countries portend the future of CA practices in India. In this paper, we want to explore specific areas that CA practices in India will need to address in the next 10 years. Of course, trying to look into a crystal ball is always dangerous, but we feel comfortable that many of the following issues will soon become a reality for Indian CA firms. I. SPECIALISATION YOU CAN T BE ALL THINGS TO ALL PEOPLE What do you want to be when you grow up? While this is a question we often ask young people, it is an important question for CA firms to ask themselves. There are two choices for a professional firm in today s competitive environment: (1) A firm can allow itself to grow by randomly accumulating clients and then fitting the services to meet their needs. It s haphazard growth in which the practice becomes shapeless, the service capability arbitrary, and success can be achieved only by luck or labour that s harder than it has to be. (2) Or a firm can structure itself by meticulously defining its market focus, defining or developing its skills in terms of the needs of that market, and then projecting its ability to meet those needs. It is the CA firm with this kind of focus that succeeds and grows. Unfortunately, the majority of firms around the world have followed the first choice. For these firms, a client is anyone who is willing to pay their fees. These firms are unfocused when it comes to defining their core clients, are usually less profitable and lack a competitive marketing advantage. II. DEFINING A MARKET WHO DO YOU WANT TO SERVE? A market is a cohesive group of consumers with a generally common need or opportunity, and for whom your services are appropriate and needed, or whose members can be persuaded that your services are needed, and that your services are preferable to those of your competitor. 75

80 The Future of Indian Chartered Accountancy Firms A market can be defined by demographics (such as age, economic category, etc.), by industry (such as manufacturing, real estate, financial services, construction, etc.), by type of problem (such as litigation support, tax planning, etc.), or by opportunities (such as accounting & advisory, benchmarking, industry surveys, etc.), that demand specific skills. It can be broad or narrow; it can be small or large depending upon the criteria you define. III. SELECTING THE RIGHT BUSINESS MODEL 1) Evolving Business Models The world in which professionals work today is vastly different from the traditional work environment during the first 90 years of the twentieth century. Accounting firms have employed a number of business models over the years. In each of these models, the service provider remains the expert. Recently, however, this model has evolved so that the wise service provider collaborates with the client to design solutions. A brief history of the service provider and client relationship, described in the following pages sheds light on this. The four professional services delivery models are illustrated in the figure below: 2) Four Professional Services Delivery Models Black Box Ask the Expert Advertising Agency Creative Ideas Black Box Collaborator Model Let s Work Together Facilitator Model Knowledge Based 3) The Black Box Model Ask the Expert Historically, the humble client asks the expert accountant or tax adviser for answers and sage advice. The professional has specialized knowledge in a specific area (tax, accounting, consulting, wealth management, and so on) and delivers his or her advice as a black box service. This model assumes the individual (and, more recently, a software program) is considered to be the black box and has the answers himself or herself. Client Provides Raw Data Raw Data Converted Answer Given to Client to Service Provider Into Information With the advent of inexpensive tax, bookkeeping, and other software packages now available to the consumer, we find this model becoming obsolete. 4) The Traditional Advertising Agency Model Here Are Our Creative Ideas Madison Avenue, the home of America s advertising industry, also developed a black box method in serving the country s largest companies. Account executives would develop a series of great and not-so-great advertising ideas and then deliver them to the client. The interaction between client and service provider was richer than in the pure black box method. Yet, the real wisdom, knowledge, and brilliant ideas still rested with the professional rather than the client. Service Provider Input Converted Into Service Provider Interviews Clients Output (Creative Ads) Presents Ads to Client for Selection 5) Facilitator Model This Is What the Outcome Might Look Like As clients become more sophisticated and professionals specialized, more accountants have been facilitating outcomes with their clients rather than announcing them. We find one of the fastest growing business models is that of assisting clients in exploring and determining final answers for themselves rather than dictating them. Accounting advisory is one such service line. 76

81 The Future of Indian Chartered Accountancy Firms This model requires a professional with deep knowledge of the issues at hand, as well as the talent to work with the client to develop solutions. Service Provider Facilitates Service Provider Brings Provider Suggests Session With the Client Specialized Service Outcomes to the Client Knowledge to the Process 6) Collaborator Model Working in a True Partnership The collaborator model is a further development of the facilitator model. In this model, the service provider and client are in an equal partnership. The professional service provider brings to the table his or her deep content expertise using a knowledge-based approach to create solutions with the clients, not for the clients. When CPAs and professional services providers show evidence they are business consultants, many of them are operating in the facilitator or collaborator model. Service Provider Collaborates Service Provider Brings Client and Service Provider With the Client Content Expertise Jointly Develop Solutions In addition to the above models, CA firms need to determine if they will be a high volume, low cost operation, or a low volume high fee operation. Each one requires a different staffing model. Again, you don t want to be half of one and half of the other. This will be an important weapon for successful firms of the future as accountants choose what they want to do and set about doing it well. Some will build significant firms based on expertise and efficiency in traditional areas such as tax and compliance, while others will hone in on value-added services such as business planning, accounting advisory, financial planning, mentoring and coaching at the expense of traditional accounting work. Firms that are trying to do both aren t doing either very well. IV. INVEST IN TECHNOLOGY We have already witness the impact of technology on smaller firms the Internet, electronic tax filings and paperless tax processing, knowledge management, automation of financial data handling and changes in the working environment. Smart phones and tablets (ipads, etc.) will continue to impact the way we and our clients communicate and do business. The smarter firms will appreciate that an investment in technology can reduce the cost of doing low-margin work. The advantages will be far more sophisticated that just cutting costs, though. Inhouse IT specialists will ensure businesses run more smoothly internally, and be a viable resource to contract out to clients. This will improve revenue flow while delivering business benefits to firms and clients. Superior technology allows more staff to work remotely, but rising numbers of remote workers will test the social fabric and therefore the management skills of a firm. How do you develop a firm culture with so many of your people not being physically present in the firm? The challenge will be to use technology to delight clients and maximise profitability. Technology will provide a higher level of service to clients through virtual offices and client portals. V. INVEST IN PEOPLE Recruiting and retaining the best staff will continue to be a major issue for the foreseeable future in public practice. As the pool of talent diminishes the task of managing staff becomes increasingly difficult. If you can t replace the good people, then you can t lose them. It is going to be more important than ever to reward the firm s performers, manage performance and create an environment 77

82 The Future of Indian Chartered Accountancy Firms where people can grow professionally. You will also have to consider how you will share the success financially with your team. India is no different than the rest of the world. Small practices focus is on tax and small company audits. The larger audits tend to go to the larger firms; and the consulting/advisory engagements also tend to go to the niche firms/larger firms. Smaller firms may not be equipped to cater to demands of the larger Indian corporates or to compete with the resources of the larger accountancy firms. CA firms are not attracting the best talent today. In India, an estimated 90% or more of those who pass the CA exams join industry. The CA program is a grueling 3 year program of articleship and 3 levels of exams - entrance, intermediate and final exams. Joining industry means a pay differential of at least 20-30% over joining accounting firms. Thus, we are in an environment where a lesser talent pool is available for accounting firms. What can firms do to reverse the current trend? Here is what you can do to attract and retain some of the best people: Consider a pay for performance compensation program Implement a performance bonus/performance incentive program Create competency maps to show recruits and others how they will develop Create flexible work programs Learn how to work with different generations in the work place Focus on employee satisfiers Create an environment where people can succeed Keep a high degree of knowledge exchange Provide access to firm s knowledge repository VI. SUCCESSION PLANNING/MERGERS The number one issue facing the accounting profession today is not the economy, not competition; it is the lack of succession planning and the lack for future buyers of accounting firms. Succession planning can only occur if and when there are enough people willing to step into the roles occupied by today s partners. As new generations of professionals seek more personal and professional flexibility, they will be less willing to buy into a firm. Consequently, existing partners will work more years in their firm to delay the final resolution of the firm s future, and more practitioners will retire or pass away before attending fully to the firm s succession or sale. Because of the above dynamic in the market place we are seeing an influx of merger activity among accounting firms throughout the world. This was first witnessed by the consolidation of the Big 8 accounting firms into the Big 4. The Indian accounting market is not really different from the global accounting market. For example, in the US about 82% of the firms are either sole proprietorships or 2 partner firms. In Indian more than 95% of the firms are either sole proprietorships or 2 partner firms, with staff of not more than 8-10 people. There are only 100 odd firms having 20 partners or more and about 200 firms having 10 partners or more. The membership of ICAI stands at about 180,000 today, second only to the AICPA. 78

83 The Future of Indian Chartered Accountancy Firms The accounting profession is made up of small firms hence it is small business. And while there is a large membership base, the practitioners are still individuals or two partners in a vast majority. Thus, we see that consolidation is going to be a visible trend in years to come. In the US the competitive landscape is in a state of constant change. Mergers of large regional firms have become the strategy of the day. Nearly half the top 100 firms completed a merger in 2012, and it looks as if that trend will continue into the future. The same can be said in Canada and the United Kingdom. In India, we are seeing mergers now, more than ever. Only the strong firms will survive. That is why thinking and planning for your succession is the most important thing you can be doing today. Consolidation of firms will continue in the future, through existing firms buying more of the available firm or two or more firms using ICAI s Network Firm Programme. Selling a firm will not be done lightly or easily. Principals should take steps in coming years to position the firm for sale. Even if a sale does not eventuate, the firm will then be in good shape operationally and delivering sound profits and cash flow as a result of the management attention it has received. The biggest fear in any merger/acquisition is losing control and working under someone else. The second biggest fear is losing the firm s name. Our research has shown that clients will stay with a merged firm provided that the former service provided remains and fees do not drastically change. In any merger it is important to realize that if the pie grows, the firms can grow much faster; plus they can give a much better value proposition to a client and utilise the benefits and scale of a larger firm. VII. KNOWLEDGE AND COMPETENCIES Many CAs and CPAs tell us that they sell their time. This is not correct. They sell their knowledge and skills in order to help a client solve a problem. What we learned in school, twenty, thirty or more years ago does not serve us well in the twenty-first century. That is why continuous learning and building new competencies is so critical for success. Many CAs and CPAs do their best to keep up with changing laws. But, a larger number, especially the elder / senior members, find it difficult to cope with changing times. India is at the cusp of adopting a new tax code, a new company law code, a new GST regime and constantly evolving accounting and auditing standards- all of these have altered the fundamental fabric of a CA s practice. Clients today expect their professional service provider to be current with rules and regulations. In addition to the technical competencies, there are several other areas that successful CAs need to develop. For example: Client development Client management Business management Professional development Leading and developing others Administration As we mentioned at the start of this paper, firms need to identify their core clients. This in turn will help them identify skills that need to be developed. Many firms today employ competency tables to show employees what they need to become proficient in, in order to move ahead. The following is an abbreviated table: 79

84 The Future of Indian Chartered Accountancy Firms Sample Competency Table CATEGORY MANAGING PRINCIPAL PRINCIPAL DIRECTOR Client Development Client Management Business Management Technical Expertise and Work Quality Lead the development and implementation of firm wide marketing initiatives. Consistently increase and maintain personal and firm wide network of business contacts. Develop and maintain strong business-to-business relationships with client decision makers and community leaders. Lead firm wide formal efforts to collect client feedback to ensure that client expectations are being set and managed appropriately. Resolve critical client issues. Lead efforts to improve firm wide and departmental budgeting processes. Take responsibility for firm wide profitability and influencing departmental profitability. Stay current on relevant and emerging specialty issues, industry issues, market issues, and accounting issues. Lead the development and implementation of departmental marketing initiatives. Take specific leadership role(s) in firm wide marketing efforts. Develop and nurture prospective client relationships by introducing other principals, directors, managers, and so on into the relationship. Manage client retention or acceptance, and monitor risk reward. Lead the departmental formal effort (and participate in the firm wide effort) to collect client feedback to ensure that client expectations are being set and managed appropriately. Review and approve engagement budgets. Ensure that client service agreements are executed. Engage exceptional preparation or review skills in unique or special circumstances. Demonstrate exceptional knowledge of selected specialty areas. Demonstrate exceptional analytical and problemsolving skills. Take a leadership role in the development and implementation of firm wide marketing initiatives. Participate in firm wide marketing efforts. Actively seek opportunities for introducing additional services to existing clients (including the services and products of other departments). Develop and maintain strong working relationships with client contact(s) (for example, owners, leaders, or managers, as well as attorneys, bankers, and so on). Initiate new engagements, and empower others to lead, or teach others to plan, implement, and review the engagements. Attend client meetings; be present at executive or board meetings, as required. Monitor or review actual time charges on engagements in an effort to improve realisation or contribution margin on engagements. Review and approve client billings, as appropriate. Stay current on relevant and emerging specialty issues, industry issues, market issues, and accounting issues. Prepare and review complex correspondence, reports, recommendations, and proposals on behalf of the department or firm. 80

85 The Future of Indian Chartered Accountancy Firms Personal Participation and Professional Development Leading and Developing Others Administration Plays specific leadership role(s) at a national and state level, consistent with the strategic plan. Takes advantage of unique opportunities for speaking, teaching, and writing. Communicate and evaluate principal and director performance expectations (on behalf of the executive committee). Serve as a formal mentor for all principals and directors. Develop and communicate firm wide policies and procedures; hold people accountable for following them. Develop and communicate firm goals and strategies. Serve as the official spokesperson of the firm. Plays specific leadership role(s) in the community. Seeks out and takes advantage of speaking, teaching, and writing opportunities. Develops and maintains the department s strategic direction. Establish, communicate, and evaluate departmental team member performance expectations (win-win agreements). Set example of timeliness and attentiveness in firm wide, principal, departmental, and staff meetings. Develop and communicate departmental and firm goals and strategies. Lead all efforts to improve quality of products and services offered by the department and firm. Manage administrative responsibilities of the department (for example, budgets, financials, logistics, and so on). Develop and revise department procedures. Plays specific leadership role(s) in the community. Seeks out and takes advantage of speaking, teaching, and writing opportunities. Participates in the development of the department s strategic direction. Develop and facilitate formal staff training, and ensure training is delivered as needed. Exhibits interdepartmental and firm wide influence, and has achieved firm wide recognition as a leader. Generally leads or co-leads a subset of a department, a niche industry, or a service line. Provide valuable input in the development of firm wide policies and procedures; communicate them, and hold people accountable for following them. Take specific leadership for improving quality of products and services offered by the department and firm. While the ICAI and BCAS and other chambers and study circles do a great job of having numerous CPE programs, the burden really needs to fall on the individual practitioners because their clients will demand a higher level of service. Accountants will have to ramp up their technical skills, be able to market their firm more effectively and have the skills to offer financial planning, business advisory services and so on. It appears certain that the requirement for accountancy work will be strong over the next decade and beyond. The consensus among experts is that client demands for tax and compliance work at the very least are not about to dry up. In this environment, clients are becoming increasingly sophisticated and forward-looking and have higher expectations. Business owners want advisers who can cover accounting, tax, finance and business issues. They want value-for-money services; value added 81

86 The Future of Indian Chartered Accountancy Firms services and accountants with solid business knowledge. The client of the future will have a sharper understanding of finances and be more demanding of quality service at value-for-money rates. VIII. GENERATIONS X AND Y Firms will have to balance the needs of their baby boomer staff and clients, while at the same time dealing effectively with employees from Generations X and Y. Members of Generation Y relate more to their profession than to an employer, so firms will have to satisfy a broad range of employment requirements if they hope to retain young staff. Research reveals that Generation Y employees want to see strong and focused leadership within organisations for which they work. Older practitioners will have to get used to meeting the needs of a younger generation. It s all very well for senior members of the profession to say these people need to change because when I was 30 I did this and so on, he says. That s just falling on deaf ears. Female business owners will also change the nature of clients. Women account for a growing number of small business operators in Indian and numbers are also rising. Many of them run homebased operations, so accountants must gain a greater understanding of microbusinesses and how to support them. In the US, woman accountants make up more than 50% of the graduating accounting students. IX. RUNNING A CA PRACTICE LIKE A BUSINESS Accountants throughout the world have realised that there is the profession of accounting and the business of accounting running a profitable firm. Even small firms need to run their practices like a business in order to maximize client satisfaction and loyalty and profitability. Our consulting over the years have taught us that superior performance comes from alignment of the various aspects of a professional services firm. We often hear from managing owners that performance is only about people. Traditionally, firms placed emphasis on the individual performer. Let s fix employees, so they become better performers. Let s hire more A players, so we get better results. Although an individual s will and skill are certainly important, they do not stand alone nor do they sustain most employees or owners in the long run. We must also think about systems. A good performer will never win against a bad system, the system will win almost every time. Bottom line, are you spending too much time and energy trying to fix good people and too little time fixing broken systems? What, then, are the missing links that enable firms to achieve consistent superior performance when people are only part of the equation? Although the individual ultimately produces, the firm must be properly organised and managed and have effective systems in place. Consider the following equation: Organisation + Processes + Individual Track Record = Performance Many variables affect performance either positively or negatively. Examples that affect performance negatively include, but are certainly not limited to, owners who demotivate employees, firms without clear goals and strategies, rewards based on subjective measures, or resources that are not allocated appropriately. To improve the performance of any organisation, leaders must take a holistic look and understand how multiple variables influence performance, realising that people represent just one of them. In Compensation as a Strategic Asset: The New Paradigm, August noted, No matter how noble or powerful your organisational mission (why your firm exists), that mission (and your long-term vision) 82

87 The Future of Indian Chartered Accountancy Firms cannot be achieved unless you understand the ecosystem that supports it. To achieve your desired results, you must begin to create alignment by being clear about who you are, who you serve, and why and how you do so. Organisational alignment requires a linking of strategy, systems, processes, and people to best accomplish the mission, vision, and desired business results of an organization. Alignment occurs when the preceding elements are mutually supportive and focused on effective and efficient delivery of results. The first step is an understanding of why organisations get the good and not-so-good results they get, and it s not based on their compensation criteria or methodology. According to the late Jim Stuart, FranklinCovey consultant, All organisations are perfectly aligned to get the results they get. The 7S Model 1 The 7S model was developed by Tom Peters, Robert Waterman, and Julien R. Phillips, consultants at McKinsey & Company, a global management consulting firm, when they first published the 7S model in their 1980 article Structure Is Not Organization in Business Horizons. McKinsey s 7S model illustrates the seven key components of an organization, which are charted in figure 2-1. The model maintains that an organization is not just its structure, but it consists of seven distinct elements, three of which are dubbed hard and four of which are dubbed soft. The three hard S elements strategy, structure, and systems are tangible and easy to identify. They can be found in a firm s strategy statements, business plans, organisational charts, and other documentation. The four soft S elements skills, staff, shared values, and style are intangible. They are difficult to describe because capabilities, values, and elements of your firm s culture are continuously developing and changing. The soft elements are highly determined by the people who work in the organisation. Therefore, planning or influencing the characteristics of the soft elements is much more difficult. Although the soft factors are intangible, they have a significant impact on the hard strategy, structure, and systems of the organisation. 1. The 7S model is better known as the McKinsey 7S model because the two persons who developed this model, Tom Peters and Robert Waterman, were consultants at McKinsey & Company at the time. They published their 7S model in their 1980 article Structure Is Not Organization and their books The Art of Japanese Management and In Search of Excellence. 83

88 The Future of Indian Chartered Accountancy Firms The following table from In Search of Excellence: Lessons from America s Best Run Companies, illustrates Peters s, Waterman s, and Phillips description of the seven Ss: The Hard Ss Strategy Structure Systems The Soft Ss Style and culture Actions an organisation takes in light of changes in its external environment Basis for specialisation and coordination influenced primarily by strategy and by organisation size and diversity Formal and informal procedures that support the strategy and structure The culture of the organisation, consisting of two components: Organizational culture: The dominant values, beliefs, and norms that develop over time and become relatively enduring features of organisational life Staff Skills Shared values Management style: more a matter of what managers do than what they say; how they spend their time The people and human resource management processes used to develop managers, shape basic values of management cadre, introduce recruits to the company, manage the careers of employees The distinctive competences what the firm does best and what individuals do best Guiding concepts, fundamental ideas around which a business is built In the accounting environment, we would have the following: The Hard Ss Strategy Structure Systems The Soft Ss Style and culture Actions an organisation takes in light of regulatory, technological, economic or social changes that effect the accounting profession, the firm, or the firm s clients. The way the firm is organised (for example, departments, niches, services, groups, work teams and so on) and the way work flows through the firm Formal and informal procedures that support the strategy and structure The culture of the organisation, consisting of two components: Organizational culture: The dominant values, beliefs, and norms that develop over time and become relatively enduring features of organisational life Staff Skills Management style: more a matter of what managers do than what they say; how they spend their time. How firm leaders behave on a daily basis The people and human resource management processes: Recruitment and selection Orientation and onboarding Mentoring and coaching Learning and development Performance management Compensation The distinctive competences of the firm and of each individual within the firm. 84

89 The Future of Indian Chartered Accountancy Firms Shared values Guiding concepts, fundamental ideas around which a business is built how individuals within the firm treat each other and how they treat clients and other key stakeholders As in nature, organisations have an ecosystem in which each element has its place yet is dependent on the other elements for long-term survival. When you change one element in the ecosystem, you affect the others, whether planned or not. Effective organisations generally struggle to maintain a fine balance between and among the seven Ss. If one of the seven elements is changed, each of the other elements is affected. For example, a change in human resource systems, like internal career plans and management training, will have an impact on organizational culture (management style) and, thus, will affect structures; processes; and, finally, characteristic competencies of the organisation. According to Dagmar Recklies 2, when firms try to make changes, they usually focus their efforts on the hard Ss of strategy, structure, and systems, believing these are easier to change. If we change our strategy, says one managing owner, won t we get different results? Traditionally, public accounting firms have taken this approach when starting a change process. Unfortunately, however, it is the wrong place to start. Most companies and public accounting firms care less for the soft Ss of skills, staff, style, and shared values. In In Search of Excellence, Peters and Waterman observed that most successful companies work hard at these soft Ss. Few organisations, including public accounting firms, have taken their advice to heart. Because structures and strategies are difficult to build or refine when the organisation s culture is dysfunctional, or values are not shared, soft factors can make or break a change process. The dissatisfying results of most corporate mergers, whether small or spectacular megamergers, are often based on a clash of completely different cultures, values, and styles, making it difficult to establish effective, common systems and structures. X. INDIAN CA FIRMS NEED TO LEARN THE PRACTICE OF PERFORMANCE MEASUREMENT AND MANAGEMENT During the last 20 years, measuring performance has become an important tool in accounting firms in England, Australia, Canada and the US. While performance management has been gaining ground as a management technique, it still lags behind many other good business techniques. Even today, performance management is a weak spot in most firms throughout the world, India not being an exception. The appraisals are fairly subjective, with not much focus on goals, not enough mentoring, ad-hoc processes and the likes. Thus, this impacts the firm s growth. While profit margins will continue to be the focus of public practice accounting firms, there is more than just margins that firms need to focus on today. Firms also need to focus on building capacity for the future which will require future investments. However, a squeeze on finances can result in a strong focus on cost-cutting to maintain profits because of three elementary factors: 1. Relatively low hourly charge rates; 2. Principals expecting a high level of personal fee-generation; and 3. Firms not looking to expand their service range. 2. Dagmar Recklies is cofounder and managing director of Recklies Management Project GmbH. For more information see 85

90 The Future of Indian Chartered Accountancy Firms The outlook for productivity is troubling. Staff shortages will constrain growth and, in an age when work-life balance is vital, staff working hours are not likely to jump. XI. FUTURE CHALLENGES AND OPPORTUNITIES CA firms must ensure they are structured to embrace the demands associated with the future external environment and ICAI along with Indian CA Societies like BCAS need to take a leadership role in identifying new growth areas and areas of specialisation. Practitioners must embrace succession planning as an essential component of their risk management strategy. A good succession plan provides the firm with the opportunity to respond quickly to unexpected opportunities and it ensures a plan to maximise the value of a firm. Firm structures will change through mergers, consolidations and acquisitions. Different models for partner or employee equity will emerge. Sole practitioners will develop a comprehensive referral network and outsource support services. Compliance and regulation will increase. Recruiting and retaining staff will become more challenging. Firms will have to adapt to alternative staffing model, flexible work environment, and create new compensation schemes. More emphasis will be placed on developing soft skills (communication, presentations skills training, etc.). Technology will continue to play a critical role in the future. Social media and networking with change the way clients communicate with their accountants and with each other. Technology will also influence the type and nature of work done by accountants. Compliance/lower value transaction work will become more fully automated. While India today is the recipient of work from other others, as incomes rise in India, outsourcing will flow to cheaper markets throughout the world. CA firms of the future will need to move from transactional work to problem solving which involves human ingenuity, creativity and innovation. XII. CONCLUDING REMARKS While all of the above ideas may seem overwhelming, especially to the small firm, it is necessary to consider how they impact your practice. Obviously you cannot spend all of your time working on the firm. You still need to generate fees to keep the practice running (working in the firm). But, you should start spending some of your time, perhaps 10% 20% working on these issues. The external environment does not stand still or wait for us. It will continue to change workforce constraints will have a significant impact on the future delivery of accounting services; hiring and retaining people will still be an issues; rapid changes in technology will continue to cause us to change the way we operate. Firms of the future are working today to meet the coming demands and changes. You can meet the future with a well-thought out plan or you can watch the future pass you and your firm by. The choice is yours to make, choose wisely! 86

91 The Future of Indian Chartered Accountancy Firms NOTES 87

92 The Future of Indian Chartered Accountancy Firms NOTES 88

93 Negative List & Reverse Charge Service Tax Negative List & Reverse Charge Service Tax CA. Madhukar N. Hiregange Synopsis: Service tax law has attained majority in 2012 and consequently there has been a substantial change in the law. The negative list based taxation has come into effect from 1st July, This paper provides a brief overview of the changes and the concerns in various facets of the same as a background. The paper also covers the negative list of services briefly analysed. The concept of reverse charge and joint charge mechanism and the issues thereon have been discussed. NEGATIVE LIST Overview of the New Regime Many experts have argued that it will be desirable to tax services based on a small negative list, so that many untapped sectors are brought into the tax net. Such an approach will be very conducive for a nationwide GST. I propose to initiate an informed public debate on the subject to help us finalize the approach to GST. Shri Pranab Mukherji, H ble Union Finance Minister in his Budget Speech 2011 The delay in introduction of GST fast tracked the need to expand the tax base. In August 2011 the proposed negative list was hosted and introduced in the Finance Act The golden rule of anteriority was given a go bye at the cost of confusion/ harassment of the tax payer. Maybe the hurry was due to the fact that FM was to be President soon. Objectives: The Board (CBEC) with the guidance of the Ministry of Finance (MoF) on 11 August 2011 circulated a concept paper proposing the introduction of the Taxation based on the Negative List. In this concept paper, the board has cited the following reasons as to the need of this negative list based taxation: 1. The advantage of the positive list that it has definitiveness starts getting eroded as the number of services increases. 2. The fact that many services were kept out of the tax net invariably leads to unintended exemptions making the tax net/ base narrow. 3. The unintended exemption leads to breakage of input chain adding cost for the end-user. 4. That such introduction at an earlier stage (before GST) will pave the way for the smooth transition to the GST, and significantly ease the challenges arising out of implementing the GST. 5. This comprehensive taxation for the entire service sector would help mitigate litigation and prepare both the department as well as the taxpayers for the eventual transition towards the GST. 89

94 Negative List & Reverse Charge Service Tax Concerns in New Regime The Finance Minister assured that the new approach was not a revenue augmentation measure but intended to make compliance simple and administration of service tax law easier. However the experience in the last 6 months indicates that most of the above objectives other than that of augmentation of revenue would not be met. The professional who advises on whether or not a service is liable or not needs to necessarily understand several related definitions, rules and credit impact in addition to negative list read along with the exemption notification. a. Simplicity in compliance and administration?: The drafting leaves much to desired andthere is no exemption to certain activities, like construction meant primarily for non-commercial usage such as school/college buildings, which were exempted under earlier laws by virtue of being non-commercial in nature. There is no clarity on leviability or otherwise on transactions of a non commercial/ nonprofit oriented nature. The normal service provider would find it impossible to assess whether liable or not and in some transactions of works contract even the experts would have to hazard a guess. The issue of the Education Guide which clearly states that it cannot be relied on further complicates the understanding. The recent introduction of the classification into 120 categories for statistical purposes, the strong revenue bias of the administrators and audit wing would continue to increase/ fuel disputes. The pre budget memorandum in service tax has tripled in size. b. Seamless Cenvat Credit: The then Finance Minister, in his Budget speech of 2004 quoted, I propose to take a major step towards integrating the tax on goods and services. Accordingly, I propose to extend credit of service tax and excise duty across goods and services. The reality is that instead of a short negative list of credits, the denial of credit in construction, employee benefits related credits in the existing restricted definition has curtailed the credit. Thereby the objective of mitigating cascading effect may not be achieved. c. Definition of Service: The attempt to define what is a service seems to suffer from a few infirmities in so far as composite transaction in relation to movable property or immovable property, deemed sale especially in works contracts, coverage of social/ personal transactions, services of employer to employees, services provided to oneself [ associations, partners, divisions] amongst many others are concerned. d. Classification of Services: The stated objective was to do away with classification issues but dozens of services still need to be classified. Added to that the recent requirement of classifying for statistical purposes. The concept of bundled services is bound to lead to several disputes as the same is subjective. e. Negative List: This list contains those services which the revenue does not wish to tax, those that are under the State jurisdiction like VAT/ CST law, state excise, entertainment, immovable property, under other Central laws like Central Excise, education and services provided by Government. However the wordings and coverage requires study of each as there are many transactions which would still be taxable. f. Exemption of Services: There are specific exemptions, exemptions by way of refunds and one Mega exemption. The Mega Exemption list is a collation of majority of exemptions available earlier with some additions and a few deletions, which maybe intended or unintended. At times the result appears illogical. g. Place of Provision of Services Rules: The legal validity for taxation of services provided from outside India would definitely be raised. The unfair treatment for branches outside India providing services to parent or vice versa being considered as liable and the contra transaction not considered as an export would surely need a relook. 90

95 Negative List & Reverse Charge Service Tax h. Reverse / Joint Charge: Akin to TDS, the categories of service where the service provider is not available for enforcing compliance, or he is unorganized or uneducated, the responsibility of collection is shifted partially/ fully on the service receiver. In such cases the receiver is not eligible for the threshold exemption of ` 10 lakhs. Also the utilization of credit for payment of the liability has also been barred. i. Refund for Service Exporters: This is perhaps one aspect where the Government has failed miserably and exporters from India are disadvantaged due to delay of 3-6 years. This also highlights the lack of accountability of the administrators of law. A comprehensive method of taxation is normally adopted by advanced/ developed countries. This method does not differentiate between the organized and unorganized sector and covering all the service providers. Developing countries where the economy has not developed/ population not literate avoid this method of taxation to avoid the disputes due to large scale non compliance on account of ignorance. It is felt that the new law unless it goes though a spate of reforms would result in unnecessary hardship to the tax compliant assessee and lead to increased corruption of many tax administrators. Resistance to this un-understandable law and litigation is bound to increase exponentially in the coming years leading to suppression of transaction by the small and unorganised sector Negative List and its Analysis From 1st of July 2012, there was a sea change in the way services are to be taxed where all activities for a consideration would be liable to service tax unless they find a place in the negative list or are exempted. Most of the entries in the negative list are mentioning specified activities. However it is important to note that services in relation to the specified activities in the entries is not extended to most entries. This appears to be a deliberate attempt to whittle down the benefit merely to the activities in question and not to extend the same to various other incidental/ancilliary activities which could be taken up as a separate activity by the assessee. The term in relation to is very generally used in interpretation clauses in order to enlarge the scope of words or phrases occurring in the body of the statute; and when it is so used, these words or phrases must be construed as comprehending, not only such things as they signify according to their natural import but also those things which the interpretation clause declares that they shall include. This appears to be a conscious omission on part of drafters as if the phrase in relation to was to be used they could have ended up covering a number of activities which though not specifically enumerated could get inadvertently excluded from service tax levy This is also reinforced by the Section 66F (1) where it is provided that reference to a service shall not include a reference to a service used for providing main service. In other words, a service which is a specified entry in the negative list would be excluded from service tax levy. However a service which is an input service to provide a service specified in negative list would not be exempted/covered in negative list. An example in point could be negative list entry which covers access to a road or a bridge on payment of toll charges. The access to National highways or state highways, which are also roads, is hence covered in this entry. As it is a state subject it is validly covered in negative list. However the outsourced services of toll collection would continue to be liable. In case of revenue sharing arrangements also the possibility of liability to service tax exists. 91

96 Negative List & Reverse Charge Service Tax A few important caveats before the discussion on the negative list are: A. The onus which was with the revenue of proving that a service is taxable has now been shifted to the assessee proving that he is excluded. B. Like in the exemption notification it maybe prudent to see that all substantial conditions are met. C. In case of doubt unlike in taxing entries favouring the tax payer in the Negative List it would favour the revenue. D. The logic/ argument of benefit based on equality / fairness could not be easily be forwarded. E. Paying tax at the time of becoming aware or after an investigation could lead to doubt of recovery of the service tax itself as the client/ customer has closed the books, is too big..the possibility of denial of credit to offset the tax could have substantial impact in case of longer period being invoked. Penalty and interest could be costs which anyway cannot be passed on to the customer. We analyse the negative list of services as under: [some highlights provided in italics]. 1. SERVICES PROVIDED BY GOVERNMENT OR LOCAL AUTHORITY The services provided by the Central or State Government or Local authorities are in the negative list except the following: a) Services provided by the Department of Posts by way of speed post, express parcel post, life insurance and agency services carried out on payment of commission on non government business; b) Services in relation to a vessel or an aircraft inside or outside the precincts of a port or an airport; c) Transport of goods and/or passengers; d) Support services, other than those covered by clauses (a) to (c) above, to business entities. What is meaning of Government? Government has not been defined in the Act, the definition of Government as contained in the General Clause Act, 1897 would be applicable as per which Government includes both Central and State Government. Further as per the General Clause Act 1897, State includes Union Territory. Government would also include various departments and offices of the Central or State Government or the U.T. Administrations which carry out their functions in the name and by order of the President of India or the Governor of a State. What is meant by Local Authority? Local authority is defined in 65B and means the following:- A Panchayat as referred to in clause (d) of article 243 of the Constitution A Municipality as referred to in clause (e) of article 243P of the Constitution A Municipal Committee and a District Board, legally entitled to, or entrusted by the Government with, the control or management of a municipal or local fund A Cantonment Board as defined in section 3 of the Cantonments Act, 2006 A regional council or a district council constituted under the Sixth Schedule to the Constitution A development board constituted under article 371 of the Constitution, or 92

97 Negative List & Reverse Charge Service Tax A regional council constituted under article 371A of the Constitution. A number of organizations are created by the Government and many are in the form of corporations. All such organization like the various Electricity Companies BESCOM, JESCOM etc would not be covered. Coffee Board, Housing Development Board are created under an ACT and are managed by the Government. Even such organizations are exempted only for specified services. In the time where the line between public work is disappearing as many public/ private partnerships are found to be more effective, the possibility of service tax being attracted even to such enterprises would be quite high. What is meant by Support Services? Support services have been defined in section 65B of the Act as infrastructural, operational, administrative, logistic marketing or any other support of any kind comprising functions that entities carry out in ordinary course of operations themselves but may obtain as services by outsourcing from others for any reason whatsoever and would include advertisement and promotion, construction or works contract, renting of movable or immovable property, security, testing and analysis. All these services would now be liable when provided to others. However in such cases the recipient would be liable to pay for the same under reverse charge mechanism. Thus only services which are provided by Government in terms of their sovereign right to business entities are not support services e.g. grant of mining or licensing rights where service tax would not be liable. The professional advisor / Chartered Accountant who attests would now require to additionally examine the expenditures by way of payment to Government /Government authority and advise payment by the service receiver. It is important to note that for many services other than support services where liability exists, Government authorities would be required to be registered and pay the service tax as applicable to other private persons. Example- Dept of Posts, Indian Railways for freight, State Transport authorities etc. 2. SERVICES PROVIDED BY RESERVE BANK OF INDIA All services provided by the Reserve Bank of India are in the negative list. Services provided to the Reserve Bank of India are not in the negative list and would be taxable unless otherwise covered in any other entry in the negative list. 3. SERVICES BY A FOREIGN DIPLOMATIC MISSION LOCATED IN INDIA Any service that is provided by a diplomatic mission of any country located in India is in the negative list. This entry does not cover services, if any, provided by any office or establishment of an international organization. Some specific exemption also provided doe services to such entities. 4. SERVICES RELATING TO AGRICULTURE In the past also the specified services related to agriculture were exempted under Notification 14/2004-ST. Now the expanded list of services relating to agriculture that are specified in the negative list are services relating to: agricultural operations directly related to production of any agricultural produce including cultivation, harvesting, threshing, plant protection or seed testing; 93

98 Negative List & Reverse Charge Service Tax The operations directly related would not means those which have a nexus but something more. supply of farm labor; The manpower supply activity would not be covered. processes carried out at the agricultural farm including tending, pruning, cutting, harvesting, drying cleaning, trimming, sun drying, fumigating, curing, sorting, grading, cooling or bulk packaging and such like operations which do not alter essential characteristics of agricultural produce but makes it only marketable for the primary market; The place where such operations are carried out may not be relevant as some of the activities like ginning of cotton, de-husking of paddy, shelling of cashew nuts maybe done in processing units away from the farm. renting of agro machinery or vacant land with or without a structure incidental to its use; Even commercial transaction would not be covered. loading, unloading, packing, storage and warehousing of agricultural produce; Even commercial transaction would not be covered. agricultural extension services; These are restricted to farmer education or training and not as the name suggest any other services. services provided by any Agricultural Produce Marketing Committee or Board or services provided by commission agent for sale or purchase of agricultural produce; The other services of APMCs could be liable as only some activities have been specified. Further the activities like breeding of fish (pisciculture), rearing of silk worms (sericulture), cultivation of ornamental flowers (floriculture) and horticulture, forestry is also included in the definition of agriculture. The plantation crops like coffee, tea are also covered in agricultural produce. What is the meaning of agriculture? Agriculture has been defined in the Act as cultivation of plants and rearing or breeding of animals and other species of life forms for foods, fibre, fuel, raw materials or other similar products but does not include rearing of horses. What is agricultural produce? Agricultural produce means any produce of agriculture on which either no processing is done or such processing is done as is usually done by a cultivator or producer which does not alter its essential characteristics but makes it marketable for primary market. It also includes specified processes in the definition like tending, pruning, grading, sorting etc. which may be carried out at the farm or elsewhere as long as they do not alter the essential characteristics. For example: Potato chips or tomato ketchup are manufactured through processes which alter the essential characteristic of farm produce (potatoes and tomatoes in this case) therefore, it does not qualify as agricultural produce. 94

99 Negative List & Reverse Charge Service Tax 5. TRADING OF GOODS Transfer of title of goods is one of the essential conditions for a transaction to come under the ambit of trading of goods. However, the services supporting or ancillary to the trading of goods would not come under the above item of Negative List. What is covered? Futures contracts would be covered as these are contracts which involve transfer of title in goods on a future date at a pre-determined price. In commodity futures, actual delivery of goods does not normally take place and the purchaser under a futures contract normally offsets all obligations or closes out by selling an equal quantity of goods of the same description under another contract for delivery on the same date. There are, therefore, two contracts of sale/purchase involved which would fall in the category of trading of goods. What is not covered? Activities of a commission agent or a clearing and forwarding agent who sell goods on behalf of another for a commission would not be included in trading of goods. Auxiliary services relating to future contracts or commodity futures would not be covered in the negative list entry relating to trading of goods. The exclusion of transfer of property in goods in the definition of service makes this entry redundant but may have been included for abundant clarity or to be able to deny credit proportionately. The concept of essential/ predominant motive test of a transaction would have to be applied in cases where along with the sale a bit a service is provided. However for works contract and supply of food a separate entry has been provided in the declared list where the service portion of the same only would be liable. 6. PROCESSES AMOUNTING TO MANUFACTURE OR PRODUCTION OF GOODS The phrase processes amounting to manufacture or production of goods has been defined in section 65B of the Act as a process on which duties of excise are leviable under section 3 of the Central Excise Act, 1944 (1 of 1944) or any process amounting to manufacture of alcoholic liquors for human consumption, opium, Indian hemp and other narcotic drugs and narcotics on which duties of excise are leviable under any State Act. This entry, therefore, covers manufacturing activity carried out on contract or job work basis provided duties of excise are leviable on such processes under the Central Excise Act, 1944 or any of the State Acts. All processes and job work are not exempted and those such as cutting, polishing, sand blasting, milling, etc., where the resultant product is not different from the raw material /; input would not be eligible for this exclusion. They would be liable. In cases of products to which deemed manufacture applies, processes like branding, packing and those to make the product marketable may amount manufacture and consequently would be out of the levy of ST. The possibility of coverage under central excise levy needs to be examined. In most cases the ` 150 lakhs limit may come in useful. 95

100 Negative List & Reverse Charge Service Tax 7. SELLING OF SPACE OR TIME SLOTS FOR ADVERTISEMENTS OTHER THAN ADVERTISEMENTS BROADCAST BY RADIO OR TELEVISION When is Sale of space and time Taxable? Taxable Sale of space or time for advertisement to be broadcast on radio or television Sale of time slot by a broadcasting organization. Non-taxable Sale of space for advertisement in print media Sale of space for advertisement in bill boards, public places, buildings, conveyances, cell phones, automated teller machines, internet Aerial advertising The industry has opined that the cenvat chain is being cut due to this. However it maybe noted that the designing, creating, canvassing of/ for advertisements are not excluded and would be liable. 8. ACCESS TO A ROAD OR A BRIDGE ON PAYMENT OF TOLL CHARGES The negative list entry covers access to a road or a bridge on payment of toll charges. The access to National highways or state highways, which are also roads, is hence covered in this entry. This is a state subject. However the outsourced services of toll collection would be liable. In case of revenue sharing arrangements also the possibility of liability to service tax exists. 9. BETTING, GAMBLING OR LOTTERY Betting or gambling has been defined in section 65B of the Act as putting on stake something of value, particularly money, with consciousness of risk and hope of gain on the outcome of a game or a contest, whose result may be determined by chance or accident, or on the likelihood of anything occurring or not occurring. The State Government levy a betting tax on such activities. The term which is not used is- in relation to, therefore activities other than betting are excluded from this exemption. Sale of rights to cover the horse races, letting out spaces for restaurants/ bookies. 10. ENTRY TO ENTERTAINMENT EVENTS AND ACCESS TO AMUSEMENT FACILITIES What is Entertainment event? Entertainment event has been defined in section 65B of the Act as an event or a performance which is intended to provide recreation, pastime, fun or enjoyment, such as exhibition of cinematographic films, circus, concerts, sporting events, fairs, pageants, award functions, dance performances, musical performances, theatrical performances including cultural programs, drama, ballets or any such event or program. What is amusement facility? Amusement facility has been defined in the Act as a facility where fun or recreation is provided by means of rides, gaming devices or bowling alleys in amusement parks, amusement arcades, water parks, theme parks or such other place but does not include a place within such facility where other services are provided. The linkage to advertisement in any such activity may require further examination. A FMCG company pays a lump sum to advertise its products in a music concert to the producer and in turn receives 96

101 Negative List & Reverse Charge Service Tax the right of free entry to 250 persons. Similarly such facility being taken for a marriage allowing unlimited access. Both would be liable to service tax. Only the entry is excluded, the services provided by artists, outsourcers to such events/ facility could be liable. 11. TRANSMISSION OR DISTRIBUTION OF ELECTRICITY An electricity transmission or distribution utility has also been defined in section 65B of the act to means the following: the Central Electricity Authority a State Electricity Board the Central Transmission Utility (CTU) a State Transmission Utility (STU) notified under the Electricity Act, 2003 (36 of 2003) a distribution or transmission licensee licensed under the said Act any other entity entrusted with such function by the Central or State Government This exemption seems to be one to save / augment revenue as otherwise the users would be eligible for credit on the same. The electricity companies would be eligible for the capital goods credit.[ investments are huge] 12. SPECIFIED SERVICES RELATING TO EDUCATION The following services relating to education are specified in the negative list pre-school education and education up to higher secondary school or equivalent education as a part of a prescribed curriculum for obtaining a qualification recognized by any law for the time being in force; education as a part of an approved vocational education course Earlier the Institutions were exempt. Now with this change education upto 12th is excluded. However the phrase education as a part of curriculum does lead to some doubts. Some argue that the coaching facility for the CA students/ College degrees should be excluded. However the coaching for skill development/ entrance examination could be covered. Recognition from foreign universities is not the criterion and only those recognized under India law would be conserved. What are the courses which would qualify as an approved vocational education courses? Approved vocational education courses have been specified in section 65B of the Act. These are a course run by an industrial training institute or an industrial training centre affiliated to the National Council for Vocational Training, offering courses in designated trades as notified under the Apprentices Act, 1961(52 of 1961) a Modular Employable Skill Course, approved by the National Council of Vocational Training, run by a person registered with the Directorate General of Employment and Training, Ministry of Labour and Employment, Government of India; a course run by an institute affiliated to the National Skill Development Corporation set up by the Government of India. 97

102 Negative List & Reverse Charge Service Tax 13. SERVICES BY WAY OF RENTING OF RESIDENTIAL DWELLING FOR USE AS RESIDENCE Renting has been defined in section 65B as allowing, permitting or granting access, entry, occupation, usage or any such facility, wholly or partly, in an immovable property, with or without the transfer of possession or control of the said immovable property and includes letting, leasing, licensing or other similar arrangements in respect of immovable property. Snap shot on taxability/ non-taxability of Renting Transactions If Then A residential house taken on rent is used only or predominantly for commercial or non-residential use. A house is given on rent and the same is used as a hotel or a lodge Rooms in a hotel or a lodge are let out whether or not for temporary stay Government department allots houses to its employees and charges a license fee Furnished flats given on rent for temporary stay Paying guest accommodation to students Renting of property to educational body The end use of residential dwelling units has now to be determined. The renting transaction is not covered in this negative list entry. The renting transaction is not covered in this negative list entry because the person taking it on rent is using it for a commercial purpose. The renting transaction is not covered in this negative list entry because a hotel or a lodge is not a residential dwelling. Such service would be covered in the negative list entry relating to services provided by Government and hence non- taxable These are in the nature of lodges or guest houses and hence not treatable as a residential dwelling When it is given for reasonable period of time it would be covered in this entry. When given for short stay to different persons over a period of time same would be liable. Exempted if it is provided to educational institution for purpose of education exempted from service tax. For all others liable. 14. FINANCIAL SECTOR The services of loans, advances or deposits are in the list in so far as the consideration is represented by way of interest or discount. Any charges or amounts collected over and above the interest or discount amounts would represent taxable consideration. Some examples: Fixed deposits or saving deposits or any other such deposits in a bank for which return is received by way of interest. Providing a loan or over draft facility for a credit limit facility in consideration for payment of interest. Mortgages or loans with a collateral security to the extent that the consideration for advancing such loans or advances are represented by way of interest. Corporate deposits to the extent that the consideration for advancing such loans or advances are represented by way of interest or discount. 98

103 Negative List & Reverse Charge Service Tax The Invoice discounting is covered only to the extent consideration it is represented by way of discount. Any charges or amounts collected over and above the interest or discount amounts would represent taxable consideration. Services provided by banks or authorized dealers of foreign exchange by way of sale of foreign exchange to general public are not covered in Negative List. 15. SERVICE RELATING TO TRANSPORTATION OF PASSENGERS The following services relating to transportation of passengers, with or without accompanied belongings, have been specified in the negative list. Services by: a stage carriage; railways in a class other than (i) first class; or (ii) an AC coach; metro, monorail or tramway; inland waterways; public transport, other than predominantly for tourism purpose, in a vessel between places located in India ; and metered cabs, radio taxis or auto rickshaws. The various other equivalent modes of transport not specified herein could be cause of dispute as the above list is not complete within each segment. 16. SERVICE RELATING TO TRANSPORTATION OF GOODS The following services provided in relation to transportation of goods are specified in the negative list:- by road except the services of (i) a goods transportation agency; or (ii) a courier agency by aircraft or vessel from a place outside India upto the customs station of clearance in India; or By inland waterways. (. Services provided as agents for inland waterways are not covered in the negative list.) The difference in GTO and GTA continues and therefore for the former there is no liability. Also the charge of transportation in the bill of the jelly/sand supplier or machinery supplier is not subjected to liability since they are not the GTA or courier. 17. FUNERAL, BURIAL, CREMATORIUM OR MORTUARY SERVICES INCLUDING TRANSPORTATION OF THE DECEASED This entry exempts services in relation to cremation etc. of dead. Thankfully while leaving this material world we would not leave a service tax liability. Reverse Charge & Joint Charge Mechanism INTRODUCTION The background to this is early collection and shifting the burden of collection from the tax administrators to the tax compliant assessees. Reverse change was first introduced in 2004 was extended to notified services. The same was disputed for services which were not provided from within the taxable territory and with the insertion of Section 66A was finally legally enforceable wef This does not provide for 99

104 Negative List & Reverse Charge Service Tax the basic threshold exemption and is applicable to anyone who utilsies services other than for personal usage. Therefore traders, manufacturers and service providers, Government were all made liable. The new service tax law based on negative list taxation is effective from 1st of July Though there are a number of aspects and issues under the same, the issues about the joint charge mechanism would make compliance a challenge. WHAT IS REVERSE CHARGE? Every person providing a taxable service is required to pay service tax at the prescribed rate. However in certain cases the service recipient is made liable to pay service tax on the services received. Since the person receiving services is made liable to pay service tax, the mechanism of collection of such tax is called as reverse charge (RCM). This concept is set out in service tax law by virtue of section 68(2) by empowering the Central Government to notify services positively on which the said RCM would apply. To support this the person liable to pay service tax as defined in rule 2(1)(d) of the Service Tax Rules, 1994 also includes service recipients. Such a concept was in place even before introduction of the new scheme of negative based taxation. However, in addition to the concept of reverse charge a new concept of joint charge (recipient and provider of services liable to pay tax) is also introduced. WHAT IS JOINT CHARGE MECHANISM Under the concept of joint charge, for one service the service providers as well as the service receiver are made liable for payment of service tax to the extent notified. This liability is independent of the other person s liability. In other words the failure to comply with the provisions by one person on his part would not impact the compliance requirement of other person and vice versa. EFFECTIVE 01ST JULY 2012 WHO ARE ALL COVERED UNDER REVERSE CHARGE MECHANISM After changes in the service tax law have been made effective, the notification which applies to reverse charge as well as joint charge is Notification No. 30/2012-ST dated as amended by Notification No.45/2012-ST dated As per the said notification, the following persons with regards to the corresponding services mentioned are liable for payment of service tax on reverse charge. Sl.No. Description of a Service Person Liable to pay Service Tax 1 Services by an insurance agent to any person carrying on insurance business 2 Services by a goods transport agency in respect of transportation of goods by road 3 Services by way of sponsorship to anybody-corporate or partnership firm located in the taxable territory Person carrying on insurance business Specified person (explained below) who is liable to pay freight Such body corporate or partnership firm 4 Services by an arbitral tribunal to any Business Entity Such Business Entity 5 Services by individual advocate or a firm of advocates by Such Business Entity way of legal services to any business entity 6 Services other than Such Business Entity a. renting of immovable property; and b. speed post, express parcel post, life insurance and agency services provided by department of post to a person other than Government 100

105 Negative List & Reverse Charge Service Tax Sl.No. Description of a Service Person Liable to pay Service Tax c. Service in relation to aircraft or a vessel, inside or outside the precincts of a port or airport by Government; d. Transport of goods or passengers by Government Provided by Government or local authority by way of support services to any Business Entity located in taxable territory 7 Services provided or agreed to be provided by a director of a company to the said company (applicable only in case of non-employee directors ) 8 Services of renting of a motor vehicle designed to carry passengers provided by - any individual, - Hindu Undivided Family or - proprietary firm or - partnership firm, whether registered or not, - including association of persons wherein the service provider has claimed abatement of 60% following the conditions of the Notification No. 26/2012-ST dated And the services receiver is business entity who is a body corporate However if the service receiver is also in similar line of business, the service provider himself will have to pay service tax. For eg. Such service provided by to another person who will give the vehicle on rent. 9 Any taxable services received by any person who is located in taxable territory from any person who is located in a nontaxable territory Such Company Such business entity who is body corporate The person located in taxable territory who is receiving such service EFFECTIVE 1ST JULY 2012 WHO ARE ALL COVERED UNDER JOINT CHARGE MECHANISM Similar to the reverse charge the same Notification No. 30/2012-ST dated as amended by Notification No.45/2012-ST dated deals with even joint charge as well. As per the said notification, the cases in which the joint charge would be applicable and to what extent is provided below: Sl.No. Description of a service % age taxprovider 1. Services of renting of a motor vehicle designed to carry passengers provided by - any individual, - Hindu Undivided Family or % age taxreceiver 60% 40 % 101

106 Negative List & Reverse Charge Service Tax Sl.No. Description of a service % age taxprovider - proprietary firm or % age taxreceiver - partnership firm, whether registered or not, - including association of persons wherein the service provider is not claiming any abatement And the services receiver is business entity who is a body corporate However if the service receiver is also in similar line of business, the service provider himself will have to pay service tax. For eg. Such service provided by to another person who will give the vehicle on rent. 2. Services of supply of manpower for any purpose or security services provided by 25% 75 % - any individual, - Hindu Undivided Family or - proprietary firm or - partnership firm, whether registered or not, - including association of persons And the services receiver is business entity who is a body corporate 3. Services of service portion in execution of works contract provided by 50% 50% - any individual, - Hindu Undivided Family or - proprietary firm or - partnership firm, whether registered or not, - including association of persons And the services receiver is business entity who is a body corporate It may be noted that LLP is considered as Body corporate as well as partnership technically. OTHER RELEVANT ASPECTS While following the reverse charge or joint charge mechanism the following aspects are relevant. a. The service recipient is liable to pay service tax irrespective of the fact whether the service provider was exempted or not by virtue of small service provider exemption under Notification No. 33/2012- ST dated In other words even if the total value of service provider is less than 10 lakhs the service recipient wherever liable to pay service tax has to pay tax. b. The exemption if any available to service provider (other than small scale service provider exemption) can also be availed by the service recipient. For eg. if the works contract is for construction of public road, then service recipient need not pay service tax. 102

107 Negative List & Reverse Charge Service Tax c. The service recipient is given freedom to choose the methodology of computation of tax in case of works contract irrespective of the service provider s option to pay tax. d. The service recipient is eligible to claim CENVAT Credit of service tax paid by both the service provider if any and also recipient by himself subject to eligibility under Cenvat Credit Rules. e. The service tax has to be paid by the service recipient on making payment to service provider if the payment is made within six months from the date of invoice. If it is not so paid the liability would be considered to have been arisen when the invoice for the service is raised or if it is delayed beyond the period of 30 days from completion of service the date of completion of service would be considered. In such cases the recipient would be liable to pay interest for the delay. f. The specified persons in case of GTA services are as follows: any factory registered under or governed by the Factories Act, 1948 any society registered under the Societies Registration Act, 1860 or under any other law for the time being in force in any part of India any co-operative society established by or under any law; any dealer of excisable goods, who is registered under the Central Excise Act, 1944 or the rules made thereunder; any body corporate established, by or under any law; or any partnership firm whether registered or not under any law including association of persons; ISSUES AND CHALLENGES Can it be said that there is no Charging section w.e.f on reverse charge: There is no separate charging section to tax receipt of services under reverse charge and section 66B is the solitary section for charging service tax. Post when 66A was inserted it created two deeming fictions, one treating the service as a taxable service and deeming the recipient as the provider of such taxable service. No such treatment exists in the present 66B which is applicable to service provided within India only. There is no nexus or link or connection between 66B & 66C (in terms of which the POPOSR have been framed and which rules creates a charge on the receipt of service from outside India). In other words the situation is back to the pre era and the tax has turned a full circle. It is also to be noted that the charge under RCM is levied by virtue of the Place of Provision of Service Rules, 2012, which is illegal because essential legislative functions cannot be delegated. In other words the POPOSR are rules framed by a delegatee who does not have the power, competence or jurisdiction to frame a charge in terms of the rules when the section does not contemplate such a contingency. It is pertinent to mention here that the above interpretation can be taken only if assessees prefer to challenge the POPOSR before the appropriate forum. A contra view is possible as follows- Section 66C empowers to make rules to determine the place where services are provided. Though there is no separate charging section for levying service tax on a recipient of service, on a conjoint reading of Section 66B and 66C it could be possible to take an inference that the service tax would be leviable on services which are determined to be provided in taxable territory of India using POP Rules. Once such a determination is made, the charging section 66B which charges service tax on services provided in taxable territory would accordingly levy service tax on same. 103

108 Negative List & Reverse Charge Service Tax What form of organization is preferable for the service provider? The service provider should consider the possibility of becoming a company so that he can: a) avail the exemption as a small service provider, b) Avoid the customer having to comply with the ST { resultant angst/ costs/loss of business to companies}c) Be able to avail the cenvat credit to reduce the cost where paying. Whether the non compliance by the service provider puts any liability on the service receiver paying under joint charge? No. The service receiver would not be responsible and if eligible for Cenvat credit as per input service definition in CCR, 2004 can avail that which he has paid. Whether the piece rated jobs or labour charges charged for services would be covered under joint charge? No. Only the works contracts or manpower supply come under the purview of joint charge. Whether the labourers engaged on daily wages or measurable work basis by construction company. Whether company liable under joint charge mechanism under manpower supply? No, such services are provided to the company in course of employment and are not taxable under the JCM. CONCLUSION In some respects, the new scheme of taxation under reverse charge and joint charge mechanism is to enable wider coverage of especially unorganized sector and bring them into service tax net. However practically there may be lot of challenges which businessmen have to face initially to align the existing practices to the new scheme considering variations in business models. It is expected that in the unorganized sector, the cash transactions would increase as this type of compliance on the part of the service receiver with no threshold exemption is not possible in the case of such a complicated law which would find officers within the same jurisdiction having different views. The education guide which is to enable better understanding would also be a cause of confusion and it is expected that the Senior Departmental Representatives would argue that the fact that the same is not applicable is clear in the body of the guide itself. The area of construction has been further muddied by taking all care to trap the unwary and even experts may not be able to advise with regard to the classification. All in all, a goldmine for the professional practitioners especially those who would also take up representation services. For queries please host your queries on pdicai.org. 104

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112 Negative List & Reverse Charge Service Tax NOTES 108

113 Questions on Income Tax and Service Tax CA. Rajesh Kapadia CA. H. Padamchand Khincha Mr. V. Raghuraman 46th Residential Refresher Course, January, 2013 at Golden Palms Hotel & Spa, Bengaluru 1

114 Mr. Rajesh Kapadia is the Managing Partner of G. M. Kapadia & Company and Proprietor of Kapadia Associates. He is a Fellow member of the Institute of Chartered Accountants of India and has been practising as a Chartered Accountant in Mumbai since Mr. Kapadia has been closely associated with the Indian Merchants Chamber (IMC) and Bombay Chartered Accountants Society (BCAS): He was the President of the BCAS in ; and, He was the President of the IMC in Mr. Kapadia is a Member of Direct Taxation Committee of IMC. He is on the Panel of Arbitrators of the Bombay Incorporated Law Society and IMC. Rajesh Kapadia Mr. Kapadia was a member of the Committee on Speculative Transactions constituted by the Central Board of Direct Taxes. He has presented papers and delivered talks on various professional subjects at seminars organized by various professional and other bodies. Apart from being a Trustee for many charitable trusts, Mr. Kapadia is also an independent director on the boards of various companies. Mr. H. Padamchand Khincha, B.Com, LLB, FCA, 5th Rank in B.Com, Bangalore University 25th Rank in CA Final (November 1982). Presently partner in M/s. H. C. Khincha & Co. Other Activities: Teaching: (a) Visiting Faculty at IIM, Bangalore; (b) Was a Faculty at the intensive coaching classes of ICAI teaching Income Tax for CA final students; (c) Visiting faculty at the Direct Taxes Training Institute of the Income Tax Department. Professional: (a) Was writing a monthly column on Tax Patrika a magazine in Hindi devoted to H. Padamchand Khincha Direct & Indirect Taxes; (b) Presented papers at various Seminars, Conferences all over the country; (c) Was a panel member for answering queries at the NRI Taxation on line of the Economic Times; (d) Was on the advisory board for answering queries of Lex Site.Com a legal portal; (e) Convenor of the Study Group formed to prepare the approach paper on the Transfer Pricing Guidance Note. Authorship: (a) Co-author of Tax Holiday u/s.10a and 10B An analysys; (b) Author of Comparative Analysis of Indian Tax Treaties published by BCAS; (c) Author of three booklets: (i) Capital Gains of Non-Residents; (ii) Tax Deduction at Source; (iii) Concept of Indexation under Capital Gains; (d) Articles published in Current Tax Reporter, BCAJ, Taxwatch, Journal of CA Institute etc; Sports Achievements: (a) Was a keen cricket player. Was selected to represent All India Colts Vs the visiting West Indies team at Pune in 1978; (b) Won prizes in middle distance running in St Joseph s College Athletic Meet. Others: Adjudged the Best Outgoing Student of St Joseph s College of Commerce in Mr. V. Raghuraman is practicing as Advocate and CA over 22 years. Specialising in Excise / Customs / Service Tax, Foreign Trade Policy / FEMA and Indirect Tax planning and litigation. Appears frequently before Courts. He is a Visiting faculty of Indian Institute of Management, Bangalore CA Institute. He has addressed large number of seminars and published several papers in national magazines on Excise / Customs He is an author of the books: Landmark decisions in Indirect Taxes published by international publishing house CCH, Central Excise Law and Procedures published by RK Jain, New Delhi, the largest publisher on indirect taxes, Background Material for E-Learning course on SERVICE TAX published by ICAI. V. Raghuraman 2 Bombay Chartered Accountants Society