TRANSFER PRICING. Issues of Litigation

Transcription

1 TRANSFER PRICING Issues of Litigation

2 Litigation in Transfer Pricing And Indian Jurisprudence

3 Substantive Issues What do Indian Courts Say

4 Cases Discussed.ITAT Aztec Software July 2007, Bangalore Spl Bench ITAT Mentor Graphics Nov 2007, Delhi ITAT Ranbaxy Labs Ltd Jan 2008, Delhi ITAT Cargill India (P) Ltd Feb 2008, Delhi ITAT E Gain Communication (P) Ltd June 2008, Pune ITAT Sony India (P) Ltd, Sept 2008, Delhi ITAT Phillips Software Center Sept 2008, Bangalore ITAT

5 Substantive Issues Comparability Analysis

6 Comparability Analysis..it was held E Gain Communication (P) Ltd June 2008, Pune ITAT Comparison to take into account Not only turnover but also FAR analysis, nature & line of business, Product or service, market size & scope of operation Stage of business /product cycle

7 Comparability Analysis..it was held E Gain Communication (P) Ltd June 2008, Pune ITAT Comparison not possible if Differences between comparables & tested party very material Potentially comparable companies show extraordinary results

8 Comparability Analysis..it was held E Gain Communication (P) Ltd June 2008, Pune ITAT Comparison POSSIBLE only if Adjustment made to OP of both tested Party & comparables Accounting standards are adjusted (depreciation as per US GAPP to be substituted for Depr as per Indian Companies Act) Non-operating Income/expenses excluded for benchmarking

9 Comparability Analysis..it was held Aztec Software July 2007, Bangalore Spl Bench ITAT Proper FAR analysis very important TPO should give valid reasons for rejecting method adopted by taxpayer Adjustment is warranted only if there are material differences between Transactions of tested party & comparables

10 Comparability Analysis..it was held Mentor Graphics Nov 2007, Delhi ITAT Transfer pricing is not an exact science in which mathematical certainty is possible. Held if a company has conducted its due diligence correctly, Revenue cannot arbitrarily reject its methodology & outcomes

11 Comparability Analysis..it was held Mentor Graphics Nov 2007, Delhi ITAT Proper study of all the specific characteristics of the transaction needs to be undertaken, With FAR analysis & responsibilities of entities A A fresh search should be undertaken only if the current search was found to be insufficient Difference with comparables to be adjusted Like contract risk, credit risk, market risk, warranty risk, price risk etc

12 Comparability Analysis..it was held Ranbaxy Labs Ltd Jan 2008, Delhi ITAT Emphasized sanctity of FAR analysis, Importance of geographical markets contractual obligations specific characteristics of controlled transaction For which adjustments to be made

13 Comparability analysis.. Sony India (P) Ltd, Sept 2008, Delhi ITAT If a reasonable accurate adjustment for the difference to eliminate material effect of the differences cannot possibly be made, then such uncontrolled comparables are to be rejected. Consistently loss making, negative growth companies to be rejected

14 Comparability Super Profit Companies Phillips Software Center Sept 2008, Bangalore ITAT The TPO has grossly erred in 'normalising the profits of super profit companies. Such companies should have been excluded from the list of comparables.

15 Comparability analysis..adjustments Sony India (P) Ltd, Sept 2008, Delhi ITAT Can adjustments for various factors be made on estimate basis..? We are of the view that there are differences on account of no ownership of intangibles, various risks assumed etc. in the case of taxpayer as compared with other comparables. It is by no means an easy job to evaluate the differences for each of the factor. Taking an overall view of the matter, we are of view that order of TPO for the assessment year allowing deduction at 20 per cent was fair and reasonable and should be upheld.

16 Comparability analysis..adjustments Phillips Software Center Sept 2008, Bangalore ITAT Adjustment to be made to Comparables margins to eliminate differences on account of different functions, assets &risks. More specifically, adjustment to be made for: a) Differences in risk profile. b) Difference in working capital position, c) Differences in accounting policies.

17 Substantive Issues Documentation & Natural Justice

18 Calling for Documentation.. Cargill India (P) Ltd Feb 2008, Delhi ITAT Calling for documents u/s 92D(3)(1) TPO can require any person who has entered into an international transaction to furnish any information or document prescribed under RULE 10D(1) & (3)

19 Calling for Documentation.. Cargill India (P) Ltd Feb 2008, Delhi ITAT ITAT held that any information or document used in section 92D(3) did not mean all information and documents. A valid and legal notice u/s 92D(3) must specify information/ documents required notice should not be an omnibus one, Requiring furnishing of all information/ documents prescribed u/rule 10D(1) & (3)

20 Calling for Documentation.. Cargill India (P) Ltd Feb 2008, Delhi ITAT If notice requires furnishing of non-prescribed information/ documents also, it would not be valid notice u/s 92D(3). Again if notice requires furnishing of information/ documents already furnished Under other sections 92CA(2), non application of mind would be inferred making the notice invalid

21 Penalty for Documentation.. Cargill India (P) Ltd Feb 2008, Delhi ITAT Conclusion TPO cannot mechanically call for All information specified in TP rules Has to specify particular rule applicable To taxpayers case

22 Penalty for Documentation.. Cargill India (P) Ltd Feb 2008, Delhi ITAT Penalty levied u/s 271G of Indian Law Section 271G If taxpayer fails to furnish information or document as required under TP section 92D(3), of Income Tax Act penalty can be levied, equal to a sum 2% of the value of the international transaction for each such failure. Unless Taxpayer can show Reasonable cause for such failure

23 Penalty for Documentation.. Cargill India (P) Ltd Feb 2008, Delhi ITAT Initiation of penalty for late submission of documents struck down TPO had recorded no finding on whether Taxpayer as prevented by reasonable cause Tribunal deleted the penalty u/s 271G as non specific notice u/s 92D(3) was invalid

24 Substantive Issues Tested Party Use of foreign comparables & Safe harbour of 5%

25 Tested Party.. Ranbaxy Labs Ltd Jan 2008, Delhi ITAT Held that tested party should be one in respect of which reliable data for comparison is easily & readily available Even the party with complex functions Can be a tested party if reliable comparables are available No adjustment can be made if foreign tested party Earns margins as earned by foreign comparables After allowance of 5% flexibility from arithmetic mean

26 Tested Party.. Development Consultants April 2008, Kolkatta ITAT held each transaction to be benchmarked separately. (Profit & Tested Party may vary for each transaction) Tested Party should be identified for each transaction. Tested Party should be one which performs least complex functions & does not own unique intangible assets Tested party can be a foreign party A Party having only 6% of transactions with AE can not be taken as Tested Party

27 Safe harbour of +/- 5%.. Development Consultants April 2008, Kolkatta ITAT Tolerance margin of 5% from the ALP was required to be allowed as per law even in cases where the transaction value was beyond 5% of the ALP. This issue not specifically raised before ITAT but while confirming part of TP adjustments the ITAT proceeded on these lines.

28 Safe harbour of +/- 5%.. Sony India (P) Ltd Sept 2008, Delhi ITAT Tolerance margin of 5% from the ALP was required to be allowed as per law even in cases where the transaction value was beyond 5% of the ALP.

29 Safe harbour of +/- 5%.. Phillips Software Center Sept 2008, Bangalore ITAT The safe harbour of +/- 5% is a standard deduction of 5% to the taxpayers. The only condition for availing this benefit is that it is subject to the option of the taxpayer.

30 Substantive Issues Should tax avoidance be demonstrated by TPO before applying TP Provisions Is order of TPO binding on the Assessing Officer?

31 Should tax avoidance be demonstrated. Aztec Software July 2007, Bangalore Spl Bench ITAT Whether it was legal requirement that AO should prima facie demonstrate tax avoidance before invoking Sec. 92C or 92CA.(TP Provisions) NO These sections do not contain any such stipulation. Head notes & FMs speech not relevant when substantive section unambiguous A Different view taken in Phillips case

32 Should tax avoidance be demonstrated. Phillips Software Center Sept 2008, Bangalore ITAT On the issue ot tax avoidance. A Different view taken here where entitlement of taxpayer to exemption u/s 10A/10B has led ITAT to decide that there was no motive for tax avoidance so TP adjustment not called for

33 TP order binding on Assessing Officer. Aztec Software July 2007, Bangalore Spl Bench ITAT Whether TPO s s order u/s 92CA(3) is binding on the AO. NO Under section 92CA(4), the AO has to compute the total income having regard to the ALP determined by the TPO. It is not having regard only to. Taxpayer can produce other relevant material before the AO on basis of which AO may change ALP. From , law has been amended. Now words are in conformity with

34 Substantive Issues Burden of Proof

35 Burden of Proof. Aztec Software July 2007, Bangalore Spl Bench ITAT Primary burden is on taxpayer to select Most Appropriate Method Then primary burden for collecting inputs for computing ALP under that method i.e. finding comparables is again on taxpayer If taxpayer fails to discharge this burden, burden shifts to Revenue on a much reduced scale on parity with best judgment assessment.

36 Primary burden to prove ALP is on taxpayer (approved Aztec Case) TPO can make Adjustments TO ALP if BURDEN NOT DISCHARGED Importance of Burden of Proof. Ranbaxy Labs Ltd Jan 2008, Delhi ITAT accurate documentation emphasized

37 Burden of Proof. Phillips Software Center Sept 2008, Bangalore ITAT The TP Study or choice of Most Appropriate method by taxpayer cannot be ignored by the TPO, in absence of any deficiency or insufficiency

38 Substantive Issues Contemporaneous data

39 Contemporaneous data. Aztec Software July 2007, Bangalore Spl Bench ITAT Taxpayer had taken 10 US companies as comparables & used their profit margins for the calendar years 1999, 2000 and HELD by ITAT The margins used should have been for the financial year as mandated by Rule 10B(4)

40 Contemporaneous data. Mentor Graphics Nov 2007, Delhi ITAT ITAT upheld the position taken by TPO that under Rule 10B(4), profit margins of comparables for the year of transaction only could be considered and not for the other calendar years

41 Substantive Issues OECD Guidelines Important Useful reference can be drawn from them

42 OECD Guidelines. Aztec Software July 2007, Bangalore Spl Bench ITAT Mentor Graphics Nov 2007, Delhi ITAT E Gain Communication (P) Ltd June 2008, Pune ITAT

43 OECD Guidelines. Mentor Graphics Nov 2007, Delhi ITAT Arms length Range referred to ITAT referred to the OECD Guidelines regarding Arm s s Length Range and observed that even if one point in the Range was satisfied, transaction would be considered at ALP However, Indian TP Regulations do not admit Arm s s Length Range concept. India refers to Arm s s Length Price as the mean of comparables.

44 Substantive Issues Making of Adjustments

45 Making of Adjustments.Natural Justice Phillips Software Center Sept 2008, Bangalore ITAT Can TPO make adjustments without giving a finding that ONE of the clauses of Section 92C(3) applies? NO TPO has to communicate to the taxpayer Which particular clause applies To the taxpayer s s case

46 Making of Adjustments.Calculation Phillips Software Center Sept 2008, Bangalore ITAT How much adjustment to be made for risk free working? (Taxpayer bears no inventory or credit risk) Extra 5% to 5.5% as WORKING CAPITAL adjustment To be given

47 Making of Adjustments.calculation Sony India P Ltd Sept 2008, Delhi ITAT How much adjustment to be made for risk free working? (Taxpayer bears no inventory or credit risk) 20% for risk to be given. Once risk adjustment given NO NEED FOR Working Capital or R&D adjustment

48 Substantive Issues Use of Controlled Comparables

49 Use of controlled comparables. Sony India (P) Ltd, Sept 2008, Delhi ITAT An entity can be taken as uncontrolled if its related party transaction does not exceed 10 to 15 per cent of total revenue. Within the above limit, transactions cannot be held to be significant to influence the profitability of comparable However a different stand has been taken by ITAT Bangalore in the Phillips Software Center case. Next slide

50 Use of controlled comparables. Phillips Software Center Sept 2008, Bangalore ITAT For the purpose of comparability, companies with even a single rupee of transaction with associated enterprises cannot be considered as comparables

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52 Litigation in Transfer Pricing And Foreign Jurisprudence

53 Substantive Issues ALP of Royalty

54 ALP of Royalty. Hyatt Group Holdings US Tax Court Hyatt US owner of trademark Hyatt Formed subsidiary outside US who used this trademark No trademark Royalty paid to US owner Taxpayer argued that Trademark had no value in international hotel market as location of Hotel was more important Courts emphasized importance of BRAND NAME

55 ALP of Royalty. Hyatt Group Holdings US Tax Court Held Brand name of a hotel chain attracts guests leading to incremental business and high credit rating Income of subsidiary in excess of normal rate of return on funds employed could be due to intangibles and services provided by US Hyatt ROYALTY SHOULD HAVE BEEN CHARGED

56 Substantive Issues Taxation of Locational Advantage

57 Taxation of locational advantage. Compaq Computer Corp, US Tax Court CCC, USA, designs manufactures, sells computers Set up subsidiary in Singapore Compaq Asia (CA) CA had unique market position was only Asian entity that could meet stringent quality standards While calculating Transfer Prices to USA CA included locational savings in transfer Price Which were generated due to its unique market position

58 Taxation of locational advantage. Compaq Computer Corp, US Tax Court CCC USA used CUP method which fully supported that transfer prices (inclusive of locational savings) at which CA transferred goods to USA were at Arms Length US IRS denied CA benefit of locational savings Courts accepted CUPs which fully justified ALP

59 Taxation of Locational Advantage Compaq Computer Corp, US Tax Court By inference Courts accepted that locational savings (LS) belonged to Compaq Asia Decisive factor in allocation of LS is bargaining position of parties which is influenced by its ownership of product related intangibles These intangibles create monopoly which may be such that all locational savings are retained by it.

60 Taxation of Locational Advantage Sunstrand Case, US Tax Court Sunstrand makes components for power transmission Set up subsidiary called Sunpac in Singapore because of low labour costs Began manufacturing CSD Spare parts there Sold entire production to parent Locational savings allocated to Sunpac Paid Royalty to parent for use of IP

61 Taxation of Locational Advantage Sunstrand Case, US Tax Court US IRS challenged allocation of LS said none existed IRS said Sunpac only a contract manufacturer Courts held Sunpac a licensee had MONOPOLY In related to manufacture of CSD parts This advantage to Sunpac would cause all LS To remain with Sunpac This case again shows that LS could be allocated evaluating the bargaining strengths Of respective parties

62 Substantive Issues Comparability

63 Comparability. United States Steel Corp, US Tax Court Taxpayer a a major producer of Steel Exploited iron ore mines in Venzuela For transportation of iron ore floated a Company called Navios To Charter vessels and give transport services To taxpayer as well as independents Navios provided services to Taxpayer 73% of revenues Navios provided similar services to independents 5% Rates charged to both were same

64 Comparability. United States Steel Corp, US Tax Court US IRS said both transactions not comparable Navios should have charged less rates from taxpayer As Taxpayer was a long term charterer And independents were short term charterers Courts reversed IRS view Said transaction was at ALP Said price for long term & short term relationship May be same if they are market prices

65 Comparability. United States Steel Corp, US Tax Court Said comparability analysis should recognize economic reality.. HELD To engraft a crippling degree of economic sophistication onto a broadly drawn statute (where comparable is equal to identical ) would allow the taxpayer no safe harbour from the tax authority s virtually unrestricted discretion to reallocate

66 Comparability. Case dated Italian Court Said comparability analysis should recognize That transactions are comparable in terms of quality & quantity CUP should be applied product wise And not according to average percentage applied indiscriminately to all products

67 Comparability.CUP method National Semiconductor Corp US Tax Court When revenue has determined deficiencies in TP analysis burden shifts to taxpayer to show that transactions are at ALP Subsidiaries cannot allow Parent to be in loss While continuing to receive high profits themselves CUP only applicable if physical properties can be strictly compared Adjustments can be made if differences have definite & reasonably ascertainable effect on price

68 Comparability.Geographical location Compagnia Italiana della Frutta Italian Court Said comparability analysis should recognize Location of geographical markets Courts held as VALID Higher prices charged by US parent to Italian AE For bananas destined for sale in Italian market As compared to lower prices charged to another AE For bananas destined for other Mediterranean countries

69 Comparability.Secret comparables San Remo Macaroni Australian Court Held if price paid for transaction not commensurate with FAR analysis Adjustment to ALP called for FACTS A Ltd was importing pasta from I ltd exclusively through Swiss Company S Ltd A Ltd directed its Italian shipping company to place order with I ltd who invoices S Ltd whom n turn billed A ltd with markup of 55% ATO held that S Ltd had no economic or commercial substance and did not add value to the transaction

70 Comparability.Secret comparables San Remo Macaroni Australian Court Hence even though a contract existed bonafides of the transaction through S Ltd were suspect as S ltd was only doing Minor paper shuffling activities Hence ATO used secret comparables to benchmark Prices of transaction using data obtained secretly The action was upheld by courts to be in good faith

71 Substantive Issues Levy of Penalties

72 Levy of Penalties. DHL Corporation 1998 US Tax Court Penalty cannot be imposed To the extent taxpayer can demonstrate that It relied on Arms length standard used by uncontrolled entities in similar industry & the method of setting price was reasonable even though not exact

73 Levy of Penalties. DHL Corporation 1998 US Tax Court If taxpayer wishes to establish value of property (in this case valuation of trademark) By relying on an appraiser Then it should retain an independent valuer and rely On that valuer to set the price It should not determine a value itself and then seek out a valuer to confirm the value

74 Substantive Issues Marketing Intangible

75 Marketing Intangible. Glaxo Smithkline US Tax Court Primary issues was determination of ALP for marketing services rendered by GSK USA subsidiary to GSK UK parent GSK UK developed the drug Zantac GSK US marketed drug Zantac due to which It became a blockbuster drug GSK UK attributed the success to patented molecules developed & held by it

76 Marketing Intangible. Glaxo Smithkline US Tax Court IRS US argued that the commercial success of Zantac Was driven by innovative & effective marketing strategy developed by GSK US subsidiary Hence GSK US had a marketing intangible for which it ought to have been compensated Ultimately GSK opted for settlement and paid $3.4 billion in taxes Whereby validating the concept of marketing intangibles

77 Substantive Issues Restrictions on payment imposed by Law of other countries

78 Restrictions on Payment by Law. Proctor & Gamble 1990 US Tax Court If foreign Tax authority s s law put restrictions on payment of Royalty for technology transfer In this case Spanish Law prohibited making Royalty payments to P&G US Hence it precluded the US entity from receiving them Then TP adjustment cannot be made deeming income in the other US entity s s hand

79 Restrictions on Payment by Law. Texaco Inc 1996 US Tax Court Taxpayer not allowed to set its prices at market value due to restrictions imposed by law by Saudi Arabia Courts held that no adjustment possible to income of Taxpayer as taxpayer could not have sold at market prices Due to Saudi Govt putting a Cap on Resale prices.

80 Restrictions on Payment by Law. Exxon Corp (1993) US Supreme Court Letter issued by Petroleum ministry of Saudi Arabia Restricting off takers of crude oil from reselling At Prices above those prices as mentioned in the letter Constituted a valid legal restriction on the prices That could be set by the taxpayer. In view of the letter. US IRS was debarred from making adjustment to prices As taxpayer had no control over the prices The letter constituted sufficient restriction

81 Substantive Issues No remuneration charged for services rendered

82 No remuneration charged. Central de Gas de Chihuahua US Tax Court No rent charged by taxpayer to related party for use of fleet of trucks for transportation of petroleum Courts held rent should have been charged Appropriate tax was deductible on rent income To do otherwise would allow foreign corporations To use property in the USA without payment And thereby avoid any taxes

83 No remuneration charged. Upjohn AB Swedish Court Whether reasonable Profit markup (10%) must be included in prices charged for services performed? In this case no markup was charged Courts held that tax authority failed to show that a profit was required to be charged for services or that whatever amount was charged was below market price

84 No remuneration charged. Societe Carrefour French Court Taxpayer provided guarantees on loans Taken by foreign AEs Did not charge for this service Courts held Not charging compensation was an abnormal act of management Attributed 1% of the amount guaranteed As value of services rendered

85 Interest not charged on loans. Edet AB RA 1984 Swedish Court Whether parent company could be taxed on interest not charged on loans to its subsidiary..as loans were regarded as venture capital by parent? Courts held NO parent company NOT taxable Held that in an attempt to enter new market through subsidiary taxpayer can have legitimate business reasons for not burdening subsidiary during gestation period with interest on loans

86 Interest not charged on loans treated as capital Business relationship does not exist if loan is treated as capital contribution Courts held.. no income adjustment possible if loan treated as capital contribution However, if no finding of capital contribution Then Arm s s Length interest to be charged on loans Participation by capital contribution may create related parties but not business relationship Case No IR 97/ German Court

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