Practical Issues in Transfer Pricing Assessment

Transcription

1 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF INDIA Practical Issues in Transfer Pricing Assessment CA DIGESH RAMBHIA

2 Synopsis Current Indian Transfer Pricing ( TP ) Environment Experiences in TP Audits Key TP principles p and Issues Recent litigations Key takeaways 2

3 PURPOSE OF TRANSFER PRICING COMPUTATION OF REASONABLE, FAIR AND EQUITABLE PROFITS OF INDIAN COMPANIES 3

4 Budget Memorandum The increasing participation of multinational groups in economic activities i i in the country has given rise to new and complex issues emerging from transactions entered into between two or more enterprises belonging g to the same multinational group. The profits derived by such enterprises carrying on business in India can be controlled by the multinational group, by manipulating the prices charged and paid in such intra-group transactions, thereby, leading to erosion of tax revenues. With a view to provide a statutory framework which can lead to computation of reasonable, fair and equitable profits and tax in India, in the case of such multinational enterprises, new provisions are proposed to be introduced d in the Income-tax Act. PURPOSE - COMPUTATION OF REASONABLE, FAIR AND EQUITABLE PROFITS 4

5 TP Statistics in India Indian TP regulation broadly in line with OECD s TP guidelines 6 rounds of TP audits completed in 2010 and 7 th round on verge of completion TP adjustments in the 6th round ~ INR 20, crores and till date INR 50,000 crores Approximately 7000 cases selected for scrutiny for AY and 60% of cases suffered a TP adjustment Aggressive TP adjustments at TPO and CIT(A) level. However, much relief is coming at tribunal level Dispute Resolution Panel (DRP) introduced in 2009 Safe harbour Rules and APA expected 5

6 TRANSFER PRICING EXPERIENCE 6

7 Experiences in TP Audits TPOs showed a general preference over CUP Method Transactional Net Margin Method ( TNMM ) - not being easily accepted by the TPO; attempt to use other methods as well Use of CUP method by TPOs Applicability of CUP for raw materials details regarding finished goods were asked. Comparison of export prices with domestic prices and vice versa. Demanding information on transactions by Associated Enterprises with other Associated Enterprises to pass the smell test t Use of TNMM Method by TPOs transactional, product-wise or segmental level analysis instead of an overall, aggregated company level analysis. If segmental not maintained, analysis done on entity level 7

8 Experiences in TP Audits Use of current year data of comparables Indian TP regulations - preference for current year data. However, such data is not available at the time of preparing the documentation. TPOs carried out an update of the data to use only current year data of selected comparables. TPOs have indicated that earlier years data can be used where the assessee can demonstrate t that t such data has influenced the price setting for the year under consideration. ALP - Loss situations ignored both in case of assessee as well as comparable companies. Payment of royalty in loss situations not accepted unless commercial rationale/benefits test is strongly demonstrated. 8

9 Experiences in TP Audits In many cases, business strategies, industry dynamics and commercial realities i proposed by assessee s have not been accepted on the ground that assessee s have not been able to substantiate their claims with adequate documentation. Details regarding overall pricing policy Inter group pricing policy Non AEs pricing policy Domestic customers International customers Use of Secret Comparables Sec 133(6) Used powers to get competitors pricing information and applied to the taxpayers case. Confidentiality issues 9

10 Typical Q s from Income-tax Department Q s on Facts How are Transfer prices determined? Are Transfer Price set in accordance with the global TP policy? Does your return commensurate risk undertaken by the Company? Q s on TP Valuations and Mechanism How is transactional / segmental profitability determined? Can this be verified with the audited financials? Internal budgets, credit period for related party realisations? Why CUP is not the Most Appropriate Method ( MAM )? Q s on Intangibles How is technology shared in the group? Is there a cost sharing arrangement? Who takes key decision on advertising and marketing ( A&M ) and who benefits from A&M activities? 10

11 KEY TP PRINCIPLES AND ISSUES EXPECTED REVENUE PRINCIPLES Do it OneTIME Do it Right Do it Quickly Keep it Simple TRUST ME 11 I AM ACCOUNTABLE

12 Key TP Principles and Issues FAR ANALYSIS AND BENCHMARKING COMPARABILITY ADJUSTMENT USAGE OF MULTIPLE YEAR DATA MAINTENANCE OF SEGMENTAL APPLICABILITY PROVISIONS OTHER PRINCIPLES 12

13 FAR Analysis and Benchmarking Law Rule 10B(2) The comparability of an international transaction with an uncontrolled transaction shall be judged with reference to the following, namely: the specific characteristics the functions performed, taking into account assets employed or to be employed and the risks assumed the contractual terms conditions prevailing in the markets Issues Availability of adequate data for conducting robust analysis Foreign comparables are not being accepted even if functional comparability present 13

14 Comparability Adjustment Law Rule 10B(3): An uncontrolled transaction should be comparable to an international transaction if there are no differences that materially affect price/margin or reasonably accurate adjustments can be made to account for such differences. Thus Indian regulation expressly require that adjustments to prices/margins should be made (where appropriate) to enhance comparability. Issues The Indian law permits adjustments only to comparables and not tested party, however obtaining adequate data on comparables is a challenge. However, TPOs do not easily accept adjustments such as idle capacity, differences for accounting policy, depreciation etc., by rejecting any approximations, estimations and assumptions Adjustments being accepted -Working capital adjustment for IT / ITES sets; Risk adjustments Lack of guidance 14

15 Use of Multiple Year Data Law Rule 10B(4): The data to be used in analysing the comparability of an uncontrolled transaction with an international transaction shall be the data relating to the financial year in which the international transaction has been entered into Provided that data relating to a period not being more than two years prior to such financial year may also be considered if such data reveals facts which could have an influence on the determination of transfer prices in relation to the transactions being compared. Issues Taxpayers are using multiple year data as a norm also due to non-availability of relevant year financial statements of the comparable companies at the time of finalisingthe transfer pricing documentation TPOs reject multiple year data adopt only data relating to the relevant financial year and undertake adjustments 15

16 Use of Multiple Year Data Issues... cont d TPOs hold mandatory rule of adopting current year data for computing ALP cannot be dispensed with Contemporaneous data The data adopted by the TPO is not Contemporaneous since it is generally data existing at the time of audit which may not have been present at the time of filing the Form 3CEB 16

17 Maintenance of Segmental Law Rule 10B(1)(e)(i): the net profit margin realized by the enterprise from an international transaction entered into with an associated enterprises is computed in relation to costs incurred or sales affected or assets employed or to be employed by the enterprise or having regard to any other relevant base; OECD Guidelines The net margin of the taxpayer from the controlled transaction ti should ideally be established by reference to the net margin that the same taxpayer earns in comparable uncontrolled transactions, and only where this is not possible, the net margin that would have been earned in comparable transactions by an independent enterprise may serve as a guide. Issues TPO generally rejects the internal bench marking if taxpayers do not maintain segmental accounts for the related and non-related transactions and there was no segregation of these activities in the audited financials report. 17

18 TP Applicability principles Need to prove tax avoidance Tax holiday companies Should transfer pricing apply? -Intention to shift profits need to be proved; No prerequisite to prove shifting of profits outside India / erosion of tax base in India, even if both the entities are chargeable to tax in India (Aztec Software & Technology Services Limited, i Bangalore ITAT(SB)) Charging provisions or machinery provisions Transfer of shares outside India -The Indian transfer pricing provisions are machinery provisions yp and would not generally apply in the absence of a liability to pay tax in India (AAR in the case of Vanenburg Group BV). The fact that t AE is loss making, effect of international ti taxation ti on the tax liability of the Group, quantum of tax paid by the foreign enterprise are irrelevant facts for determining applicability of transfer pricing provisions - Gharda Chemicals, Mumbai ITAT 18

19 Other principles Exclusion of provision of doubtful debts from the operating expenses being a debatable issue and considering full disclosure made by the taxpayer; the taxpayer could not be held liable for penalty. It reinforces basic transfer pricing principles laid down in the Indian tax laws which states that penalty proceedings could not be levied id on the taxpayer when the computation of the transfer price is done in accordance with the relevant provisions of the Indian transfer provisions in good faith and with due diligence. [Vertex Customer Services, Delhi ITAT] In a case where revenue authorities seek to disturb the method of determining the arm s length price adopted by the taxpayer, it is necessary for them to demonstrate that, on the given facts of the case, a particular method will be more appropriate than the method adopted by the taxpayer. Taxpayer's business results showing lesser profits than industry averages, such profits cannot lead to the conclusion that the international transactions with AEs are not at arm s length. Merely because a method of arm s length price determination i presents complexity in approach, it cannot be discarded dd by the TPO [ MSS India, Pune ITAT] 19

20 RECENT LITIGATIONS 20

21 Intangibles Trade Intangibles Abhishek h Auto Industries Ltd. Ruling [2010-TII-54-ITAT-DEL-TP] ITAT TP] Facts The Taxpayer, py an Indian company, is engaged gg in manufacturing of car seat belts in technical collaboration with its AE in Japan. The Taxpayer imports completely knocked down (CKD) kits from its AE and then follows a manufacturing process to manufacture car seat belts. This manufacturing process is carried out with the technical know-how received from AE. The finished seat belts are then supplied to independent third-party car manufacturers. During the FY , the taxpayer had international transactions with its AE in respect of the purchase of raw materials and machines, the payment of a royalty and technical knowhow and interest on loans. The Taxpayer selected the Cost Plus Method (CPM) as the most appropriate p method to substantiate the arm s length nature of its international transactions. 21

22 Intangibles Trade Intangibles Abhishek h Auto Industries Ltd. Ruling [2010-TII-54-ITAT-DEL-TP] ITAT TP] Facts The Taxpayer py submitted that its gross margin rates on the sale of seat belts manufactured from the materials procured from the AE were higher as compared to the gross margin rates earned from selling seat belts manufactured from raw materials procured from other suppliers. Accordingly, the international transactions were at arm s length. TPO Action The TPO rejected the Taxpayer s contention and conducted a fresh search to arrive at a new set of external comparable data which had an average net profit that was higher than the net profit margins earned by the Taxpayer. The TPO applied this net profit margin to the total sales made by the Taxpayer and made a downward transfer pricing adjustment to the value of purchases. Further, TPO also disallowed the royalty on the premise that the cost of intangibles is built in the purchase price of raw materials 22

23 Intangibles Trade Intangibles Abhishek h Auto Industries Ltd. Ruling [2010-TII-54-ITAT-DEL-TP] ITAT TP] Delhi Tribunal Ruling The Tribunal did not agree with the tax officer stating that legally binding agreements between parties cannot be disregarded without assigning any cogent reasons particularly when these agreements were approved by the RBI and other regulatory agencies. The best comparability can be of transactions of the tested party itself. In this case, the taxpayer had higher margins from the use of the imported technology and imported raw material, whereas the segment which did not have the benefit of foreign technology and foreign raw material had lower margins. Therefore, the Tribunal held that the transactions are at arm s length and no adjustments are called for. 23

24 Intangibles Trade Intangibles Abhishek h Auto Industries Ltd. Ruling [2010-TII-54-ITAT-DEL-TP] ITAT TP] Key takeaways For payments py related to trade intangibles, taxpayers py are required to demonstrate: Whether royalty is embedded in the price paid for raw material What are the costs incurred by the owner of intangibles (i.e. foreign enterprise) Whether the trade intangibles were actually received Whether there are ongoing benefits from such trade intangibles Whether such payment py enhances the commercial position of the Indian taxpayer py What is the going industry rate for similar trade intangibles in India or comparable geographies Whether any other group companies is also paying royalty for similar trade intangibles Critical to focus on benefits derived with the help of robust documentation Economic analysis based on CUP or external valuation of the royalty rate TNMM analysis as a supporting analysis 24

25 Intangibles Marketing Intangibles Maruti Suzuki India Ltd Ruling [WP [W.P. (C) 6876/2008] Landmark decision on marketing intangibles put under abeyance by the Supreme Court of India Facts Maruti India subsidiary of Suzuki Motor Corporation, Japan, engaged in manufacture and sale of automobiles Enters into license agreement with prior approval of Government of India for use of Suzuki logo for sale of certain Suzuki model in India Under license agreement, Suzuki was to provide technical information, know- how, etc. However, Maruti was to compulsorily use the trademark of Maruti Suzuki on containers, packages and wrappings. According to the TPO the change of brand logo from Maruti to Suzuki amounted to sale of the brand Maruti to Suzuki 25

26 Intangibles Marketing Intangibles Maruti Suzuki India Ltd Ruling [W.P. [WP (C) 6876/2008] TPO Action TPO computed the value of Maruti brand at cost plus 8 % at INR 4,420 crores and issued show-cause notice as to why the international transaction not be adjusted on the basis of Maruti Suzuki deemed sale to Suzuki Issued detailed questionnaire on replacement of logo and clarified that this is transfer of economic value Maruti paid royalty of INR to Suzuki but no compensation given by Suzuki to Maruti However Suzuki trademark had piggybacked on Maruti trademark without payment of any compensation Apportionment of 50% of the amount of royalty paid by Maruti to Suzuki and the ALP was determined at "Nil" using CUP method. Maruti had developed marketing intangibles for Suzuki in India, at its own cost and Suzuki had not compensated for the same 26

27 Intangibles Marketing Intangibles Maruti Suzuki India Ltd Ruling [W.P. [WP (C) 6876/2008] TPO Action Based on the 3 comparable companies, TPO concluded that non routine advertisement expenditure of INR crores had to be adjusted High Court Order Suzuki Trade-mark was not piggybacking on Maruti logo No transfer of Maruti brand to Suzuki No right given to Suzuki for using Maruti logo Agreement is critical for payment of license fees Grounds of adjustment must be stated in the notice issued in clear, cogent, specific and in an unambiguous manner The onus is on assessee to demonstrate whether transaction is at ALP or not Compulsory usage of logo of AEs results in creation of marketing intangibles for AEs, hence compensation from AE is required 27

28 Intangibles Marketing Intangibles Maruti Suzuki India Ltd Ruling [W.P. [WP (C) 6876/2008] High Court Order Level of marketing spend by licensee will determine whether the licensee needs to be compensated Maruti filed SLP before SC against observation made by HC The SC has now held that, the HC has not merely set aside the original show-cause notice but it has made certain observations on the merits of the case and has given directions to the TPO, which virtually conclude the matter. Accordingly, the SC has directed that the TPO should now pass his order uninfluenced by the observations/ directions of the High Court 28

29 Intangibles Marketing Intangibles Maruti Suzuki India Ltd Ruling [W.P. [WP (C) 6876/2008] Key takeaways Transfer pricing policy for marketing expenses should be based on fact analysis Nature and detail of AMP expenses trade promotion or brand promotion? Trade promotion expenses being in the nature of selling expenses incurred by the Indian entity Robust inter-company agreement and TP policy Should clearly bring out whether the Indian company s functions would result in brand promotion Proper documentation on the nature of expenses Treatment of non-routine marketing expenses like sponsorship of an event Proper treatment of reimbursement expenses Proper selection of comparables to meet bright line test 29

30 Management Services Gemplus India Pvt. Ltd. Ruling [ITA No.352/Bang/2009] Landmark decision i on management services Facts The Taxpayer, py an Indian company, entered into a Management Services Agreement (MSA) with its regional headquarters and AE in Singapore. As per the terms of the agreement, the AE would provide need-based services with respect to marketing and sales support, customer service support, finance, accounting and administration support and legal support. Taxpayer selected the Transactional Net Margin Method (TNMM) as the most appropriate method to substantiate the arm s length nature of the payment. As per the Taxpayer, the charges for the services rendered by the AE were billed on the basis of the time spent for the services rendered to the Taxpayer with an overall cap of US$300,000 per annum. 30

31 Management Services Gemplus India Pvt. Ltd. Ruling [ITA No.352/Bang/2009] TPO s action TPO held that the Taxpayer had not derived any specific benefit from the management services and that the payment towards management services was not justified. Also, the Taxpayer has not established the necessity for availing such services from its AE. The Taxpayer already has qualified personnel in its service in India and the Taxpayer has already incurred expenditure for similar services. The TNMM method could not be accepted to determine the arm s length nature of the service fees as none of the comparables identified by the Taxpayer have paid any management service fees. The cost has been apportioned by the AE for different country-centres on a mutual agreed basis and not on the basis of actual services rendered. 31

32 Management Services Gemplus India Pvt. Ltd. Ruling [ITA No.352/Bang/2009] Bangalore Tribunal Ruling The Tribunal upheld the adjustment made by the TPO. It is imperative on the part of the Taxpayer to establish that the payments were made commensurate to the volume and quality of services and such costs are comparable. The payment py terms of the MSA were independent of the nature or volume of services and, hence, the TPO was justified in making the observation that the expenses were apportioned by the AE among different country-centres on the basis of their own agreements and not on the basis of the actual services rendered to individual units. There were no details available on record with respect to the nature of services rendered by the AE to the Taxpayer and, hence, the TPO was justified in holding that the Taxpayer has not proved the commensurate benefits against the payment of service fees to the AE. 32

33 Management Services Gemplus India Pvt. Ltd. Ruling [ITA No.352/Bang/2009] Key takeaways Establishing proper pricing policy for intra-group services at the outset defining the right allocation keys and also establishing the authenticity of costs incurred Sanity check Indirect charges using allocation keys are commensurate with volume and quality of services received To satisfy the benefits test, robust documentation must be maintained including Inter-company agreements Composition of costs allocated Methods of cost allocation Actual receipt of services and benefits derived by Indian entity from each component of cost tangible evidence sought The need for procuring such services In-house capability of Indian entity to perform such services to check for duplicate / shareholder services and need for procuring such services Benchmarking analysis 33

34 Internal Benchmarking - Segmentals Birlasoft (India) Ruling [ITA 3839/DEL/2010] Facts Birlasoft (India) Ltd. was engaged in the business of software development and related services For determining the ALP in respect of the international transactions with the AEs, the assessee applied internal TNMM TPO rejected the internal bench marking as assessee did not maintain segmental accounts for the related and non-related transactions and there was no segregation of these activities in the audited financials report DRP upheld the order passed by the TPO 34

35 Internal Benchmarking - Segmentals Birlasoft (India) Ruling [ITA 3839/DEL/2010] Delhi Tribunal Decision i Lack of segmental reporting in the audited financial statements cannot be a reason of rejecting method of computing the ALP Undertaking internal bench marking analysis on stand alone basis is justified OECD Guidelines provides that the net margin of the taxpayer from the controlled transaction should ideally be established by reference to the net margin that the same taxpayer earns in comparable uncontrolled transactions, and only where this is not possible, the net margin that would have been earned in comparable transactions by an independent enterprise may serve as a guide TPO had no mandate to have recourse to external comparables when internal comparables were available 35

36 Internal Benchmarking - Segmentals Birlasoft (India) Ruling [ITA 3839/DEL/2010] Key takeaways FAR Analysis needs to be done of each business segments FAR Analysis needs to be backed by robust and logical basis of allocation of costs and revenue Not only the underlying basis but also the rationale of segmentation must be clearly documented Segmentation is required, whether its on account of FAR differences or any other differences such as differences in geographical area where services is rendered etc 36

37 KEY TAKEAWAYS 37

38 Key takeaways No need to establish diversion of profits outside India to determine applicability of the transfer pricing provisions Detailed FAR analysis for tested party and comparable companies is crucial International transactions should not be aggregated unless they are inextricably linked Least complex entity to be selected as the tested party Adjustments be made to improve comparability Use multiple year data where the business is cyclic and the trend has impacted the business results If taxpayers have a robust documentation with sound FAR analysis and well developed economic analysis to justify the transfer prices - it becomes increasingly challenging for the TPOs to disprove the same. Mere finding of faults with the approach adopted by TPO will not help to delete the adjustments at the appellate level 38

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40 Ca Digesh Rambhia, Partner Gawande & Associates Chartered Accountants 801, Mahalaxmi Chambers, 22, Bhulabhai Desai Road, Mumbai Contact id - digeshr@gawandes.com 40