India, at Arm s Length

Transcription

1 January - March 2013 A quarterly newsletter on transfer pricing developments India, at Arm s Length In this edition: Dear readers, Viewpoint 02 Insights 04 By order! 05 Around the world 11 It gives us great pleasure to present the thirteenth edition of India at arm s length, our quarterly publication that focuses on developments in transfer pricing (TP) in India and provides a round-up of key developments in TP worldwide. Indian tax authorities have recently concluded the eighth round of TP audits, continuing with their rigorous enforcement on issues such as allocation of location savings, and payments for intra-group services and use of intangible property. One of these, which has received a fair bit of attention, is the primary TP adjustment of the pricing of allotment of shares and the secondary adjustment relating to this. The tax administration has also issued circulars on TP aspects relating to development centers. Some of the recent enforcement efforts and administrative developments may require taxpayers to review the impact of these on their existing TP policies and documentation, and consider appropriate actions to manage risk. The Viewpoint section of this edition discusses the circulars issued by the tax authorities in relation to the TP aspects of contract research & development (R&D) services. In our Insights section, we provide information on current trends and experiences in the field of TP controversy and dispute resolution. By order! covers TP decisions in India, while Around the world provides a round-up of key TP developments around the world. We hope you find this publication both timely and useful, and we look forward to your feedback and suggestions to improve it further. Best regards, Ernst & Young Transfer Pricing team

2 Viewpoint Contract R&D centers time to reassess the current scenario Globalization has led many multinational enterprises to establish R&D operations in India, to leverage the benefits inherent in its lowcost labor market. TP issues in these R&D centers have however resulted in some controversy. Generally, Indian affiliates that provide services are contract service providers and are insulated from business risks by their foreign affiliates, and are therefore remunerated by way of a routine return on their costs for functions performed. India s tax authority has proposed significantly increased returns, which could either be through augmented markups, or by allocation of additional location savings or some part of the returns relating to IP to Indian affiliates. In the India chapter of the United Nations Practice Manual (UN TP Manual) on TP issues for developing countries, it states that during TP audits, the Indian tax authority often finds that India-based R&D centers perform sophisticated and value-added activities that not only require significant investment in physical infrastructure, but also need Indian entities to attract, train and retain highly skilled personnel. In cases where India-based R&D centers were found to be engaged in the creation of unique intangibles, the Indian tax authority allocated additional compensation for the transfer of intangibles, in addition to the arm s length compensation for R&D activities, since it believes that the risk lies with the Indian entity. Similarly, according to the India Chapter of the UN TP manual, the Indian tax authority does not explicitly agree with the notion that risk can be controlled remotely by employees operating in the parent company and that the Indian entity engaged in core functions, such as carrying out R&D activities or providing services, can be risk free. The Indian tax authority believes that core R&D functions located in India require important strategic decisions to be made by the management and employees of an Indian subsidiary, and accordingly, it exercises control over operational and other risks. In this context, allocation of routine costs in addition to the return does not reflect the true arm s length price for services rendered. The observations in the UN TP Manual (given above) and some recent tax enforcement regulations mandated by the Indian tax authorities have created an uncertain environment for TP issues relating to such activities. Taking cognizance of the concerns of various stakeholders, the Government of India has formed a committee under the Chairmanship of Mr. N. Rangachary, a former Chairman of the Central Board of Direct Taxes to review taxation of development centers. The Rangachary Committee submitted its report on 14 September 2012 and made its recommendations on the following issues: Parameters to identity contract R&D services provider with insignificant risk Application of Profit Split Method (PSM) After having examined the recommendations of the Committee, the Central Board of Direct Taxes (the Board) issued Circulars 2 and 3 with the stated intention of providing certainty to taxpayers on issues relating to TP in development centers. Circular on conditions relevant to identification of development centers engaged in contract R&D services with insignificant risks (Circular 3) The Circular states that an R&D development center in India will be characterized as a contract R&D service provider bearing insignificant risks, only if the following conditions are cumulatively complied with: The foreign principal performs most of the economically significant functions in the R&D cycle, while the Indian affiliate largely performs economically insignificant ones. The principal provides funds or capital and other economically significant assets, including intangible assets, to the Indian affiliate for R&D. The latter does not use any economically significant assets in its R&D activity. The foreign principal performs the core functions; has the required control functions, and actually controls and supervises the R&D activity of its Indian affiliate by making strategic decisions. The Indian affiliate works under the direct supervision of its foreign principal. The Indian affiliate does not assume or bear any economically significant risks. Contractual terms are not recognized if these are not consistent with the conduct of the parties. Where the foreign principal is located in a low or no tax jurisdiction, it will be presumed that it is not controlling the risks unless the Indian affiliate can rebut this presumption with appropriate facts before the tax authorities. The foreign principal is the legal and economic owner of the outcome of the research and the Indian affiliate does not have any ownership rights on it. The Circular also states that satisfaction of the conditions mentioned above should be primarily determined by analyzing the conduct of the parties and not merely by the contractual terms. The Circular largely follows the principle outlined in OECD s 2012 Discussion Draft on the TP aspects of intangible property. With regard to identification of parties entitled to intangible related 2 India, at Arm s Length

3 returns, the OECD draft focuses on alignment of functional contributions. This typically requires the entity to physically perform the important functions and control the supporting contributions of any service provider in order to be entitled to intangible related returns. However, the conditions in the Circular issued by the Board appear to be more prescriptive than those contained in the OECD s draft. Furthermore, by making the prescribed conditions exhaustive, the Circular seeks to offer limited operational latitude to qualify an arrangement as contract R&D. This could result in its subjective application and unintended consequences, where an R&D arrangement substantively, but not completely, complies with the prescribed conditions. While the general principle relating to proper allocation of functions and risks, based on control and conduct, is appreciated, the conditions appear to be very prescriptive. It is also advisable that during an audit, taxpayers are provided greater flexibility in qualifying their arrangements as contract R&D services. Circular on application of PSM (Circular 2) The Circular seeks to provide clarification on the use of PSM as the Most Appropriate Method (MAM) in the context of TP for R&D centers. It states that in the absence of a correlation between the cost of R&D activities and the return on the intangible developed through these, the use of Transactional Net Margin Method (TNMM), which seeks to estimate the value of the intangible based on the R&D cost plus a return, is discouraged. In the event a TP officer (TPO) is of the view that the PSM cannot be applied due to non-availability of information and reliable data, he needs to give reasons for its non-applicability before considering other methods (e.g., TNMM). The Circular also states that there should be sound and sufficient reason for non-availability of such information with a taxpayer. In the event PSM cannot be applied, the Circular permits the use of other methods for such R&D centers by selecting comparables engaged in IP development in the same line of business, as well as by making appropriate adjustments to the value of IP transferred, location savings, etc. Although the Circular does not specifically refer to contract R&D centers, it may be reasonable to infer that it applies to R&D activity carried out by a taxpayer for its own account and risk or for R&D centers that do not satisfy the conditions stipulated in Circular 3/2013 in recognizing a contract R&D arrangement. Under general TP principles, it is a prerequisite for application of the PSM that each party makes non-routine contributions to the controlled transaction. Such non-routine contributions may include making available IP. The Circular seems to presume that an R&D center that does not qualify as a contract R&D service provider is either performing economically significant activities or is utilizing embedded IP while performing such services. The application of PSM in such cases would require that the service provider is given a share of the returns derived from the IP or economically significant activities relating to it. It is advisable that application of the MAM rule and certain skills or embedded intangibles are treated as non-routine contributions or factors that affect comparability and are determined on specific facts and circumstances, rather than mandating the use of one or other TP method in all cases. Comments Circulars issued by the Board for purpose of proper administration of a tax statute can be in the nature of contemporanea exposition (i.e., exposition by a contemporary authority) helping in constructing a provision. In the past, judicial decisions on the legal nature of Circulars have held that the tax administration may not impose a burden on taxpayers or otherwise put them in a worse position than they are under the terms of the statute while exercising its powers to issue general circulars. However, the administration can relax the rigor of the law or grant relief that is not found in the terms of the statute. taxpayers may therefore need to consider the legal effect of the Circular on their businesses with regard to these principles. Nevertheless, with regard to the current enforcement environment, and legislative and administrative developments, it is extremely important for taxpayers to develop or enhance their analyses and documentation associated with TP of their R&D operations. This helps to ensure that taxpayers analyses of risk control functions with regard to the managerial or operational control exercised over risks relating to their inter-company transactions is current and thorough. Taxpayers therefore need to consider undertaking an impact assessment of the Circulars in their TP arrangements. They should also consider a more proactive approach to controversy management and dispute resolution early in the lifecycle of an audit. In addition to relying on domestic tax law appeal and litigation, they can also consider the advance pricing agreement mechanism and treaty-based competent authority proceedings. India, at Arm s Length 3

4 Insights Recent TP audits share valuation and location savings emerge as key issues The eighth round of TP audits was completed by the Indian tax authorities on 31 January 2013 for Assessment Year (AY) It is estimated that the value of the total adjustments is around US$12 billion (around 40% higher than the TP adjustments conducted for AY ). Some new issues that emerged in this cycle of TP assessments include: Share valuation: This issue came into the limelight after the tax authorities sent a notice to the oil major Shell India, alleging underpricing of its sale of shares to Shell Plc., its parent company, by US$2.8 billion. The tax authorities claimed that the Indian entity had issued shares to its parent company at a price that was well below the market price, and therefore, treated the undervalued amount as a loan and taxed the notional interest applicable on such a loan. Shell challenged the claim by arguing that Shell India received capital and did not earn any income, and since only income can be taxed, no TP adjustment could be carried out in the case. It was discovered that similar adjustments had been made in at least cases, including in the case of some high-profile multinational companies. While the Law Ministry has endorsed the actions of TPOs that have sought to question the pricing of shares issued by the Indian arms of multinationals, it has referred the matter to the Attorney General for his final view. Location savings: An issue that has often been discussed is the impact of location savings on a multi-national enterprise by locating its operations in India, and how this should be allocated under arm s length conditions. In the recent round of TP audits, it has been reported that the tax authorities have attempted to allocate additional location savings to Indian enerprises. Marketing Intangibles: This has been a key TP issue over the last few years. The Special Bench ruling in the case of LG Electronics has left a number of issues open or ambiguous, but its decision has largely been in favor of Revenue. This has led to TPOs aggressively applying the Bright Line test to make high-pitched assessments. However, since the ruling was pronounced very close to the deadline for completion of TP audits, it is unlikely that the Bright Line test will be applied to some of the key principles laid down by the Special Bench in relation to determination of the cost or value of marketing intangibles and identification of comparables to conclude this years audits. First round of APA applications filed The Finance Act 2012 introduced a scheme of APAs with effect from 1 July 2012 by empowering the Board to enter an APA with a tax payer undertaking an international transaction. APAs will be valid for the number of financial years mentioned in the agreement, but they will not exceed a period of five consecutive years. Pursuant to the above, detailed rules have been issued relating to the mechanism for implementing the APA scheme. The APAs scheme has been welcomed by taxpayers. By 31 March 2013, close to 140 applications were filed by taxpayers, who found themselves in the challenging position of defending their intragroup pricing due to TP controversies witnessing a sharp rise in the country. APAs should offer certainty and convince taxpayers of the unanimity of the TP approach to MNEs. The tax authorities are pleased with the largely positive response to the scheme in the very first year of its implementation and plan to initiate work on applications received over the next one or two months. Intra-group services: This is another significant item in this year s assessments, with the tax authorities taking a close look at expenses incurred on intra-group services such as IT services, HR support and marketing. The TPOs, in many cases, have disallowed these expenses in their entirety, since the tax payer was unable to provide a line-by-line explanation or evidence justifying the benefit received. The Revenue is learnt to have rejected general s between India and associated enterprises (AEs) as not being adequate evidence to prove the benefit. On the other hand, taxpayers argued that it was practically impossible to provide evidence for every line item, which led to significant adjustments in relation to intragroup services. 4 India, at Arm s Length

5 By order! M/s. LG Electronics India Private Limited vs ACIT (ITA No.5140/Del/2011) Delhi Tribunal (Special Bench) Special bench rules on issues related to marketing intangibles S 92C, Rule 10B, Rule 10C; AY ; Statistically in favour of the revenue LG Electronics India Private Limited (LG India or the taxpayer) is a wholly owned subsidiary of Korean company L.G. Electronics Inc. (LG Korea) and is engaged in the manufacture, sale and distribution of electronic products and electrical appliances. The taxpayer has a technical assistance and royalty agreement with its foreign parent and has obtained the right to use its technical information, designs, drawings and industrial property to manufacture, market, sell and service the products agreed on by it. The foreign parent has allowed the taxpayer to use its brand name and trade marks in India, without any restriction. No royalty was paid by the taxpayer for this use. During LG s TP audit proceedings for FY , the TPO proposed an adjustment, charging LG India for its incurred excessive/ non-routine AMP expenses. Relying on the Bright Line test laid out by the US Tax Court in the case of DHL Inc. and its subsidiaries, the TPO alleged that LG India had incurred higher AMP expenses as compared to those of comparable uncontrolled companies, and disallowed expenses in excess of the company s average AMP. The TPO alleged that the excess AMP expense incurred by the taxpayer had enhanced the value of the trademark/marketing intangibles of the AE and that this excess expense ought to have been reimbursed by the AE under arm s length conditions. Aggrieved by the TPO s order, LG India appealed before the DRP, which upheld the TPO s order and also held that LG India should receive a mark-up on the expenditure incurred. The DRP suggested a mark-up of 13% on the adjustment made by the TPO. The taxpayer filed an appeal with the ITAT against the aforesaid adjustment. Since this issue arose in the case of many taxpayers, a Special Bench 1 was constituted by the ITAT to look into the following issues: Whether a TP adjustment in relation to the AMP expenses incurred by the taxpayer was justified Whether the taxpayer should have earned a mark-up from the AE with respect to the AMP expenses alleged to have been incurred by it for the AE Apart from the taxpayer, 22 other interveners also filed applications for intervention before the Special Bench (SB) constituted, and argued on legal issues along with the taxpayer. Existence of a transaction The SB stated that under the Indian Tax Law (ITL), to constitute a transaction, an arrangement, understanding or action in concert is required. As long as there is some understanding between two AEs on a particular point, it can be considered to be a transaction. However, an arrangement can be formal or informal, written or oral. Therefore, wherever there is no formal or written arrangement, the presence or absence of an arrangement can be inferred from the conduct of the parties involved. 1 An SB is generally constituted when there are conflicting decisions of the ITAT or the matter pending for adjudication is of considerable importance. SB decisions as binding on the other benches of the ITAT. India, at Arm s Length 5

6 According to the SB, merely spending a proportionately higher amount on advertisement as compared to similarly placed independent entities cannot be considered evidence of the existence of an arrangement. It further held that the amount of AMP expenditure is a business decision and a businessman s prerogative. Every businessman knows his or her interest best and it is for a business enterprise to decide on amount that needs to be incurred to carry on the business smoothly. There can be no restriction on the power of businessmen to spend as much as they want to on advertising. The fact that the taxpayer had spent proportionately more on advertising could only result in an examination, but was not a conclusive evidence of a transaction. The SB held that while excess AMP expenditure incurred does not constitute a transaction, but the fact that the taxpayer promoted its products and brands owned by the foreign associated enterprise (AE), coupled with such excessive expenditure, implied an agreement between the taxpayer and its AE. Therefore, in the case of the taxpayer, AMP expenses incurred by the taxpayer on brands legally owned by the foreign AE constituted an international transaction, which was subject to TP provisions and was in the nature of provision of service. Relying on the ruling in the case of EKL Appliances 2, the SB held that a transaction can be re-characterized if its arrangement is not what an independent enterprise would consider commercially viable. In this case, although the taxpayer had shown AMP expenses as its own, the arrangement of incurring high AMP expenses on advertisements displaying the brand/ logo or a third party would not be acceptable to a third party enterprise. Therefore, the SB had held re-characterization of this transaction as appropriate. Economic vs legal ownership The SB held that the ITL only recognizes legal ownership of intangibles and economic ownership only exists in the commercial sense. To substantiate its argument, the SB further stated that in the instance of sale of the brand by the foreign parent, the Taxpayer was not entitled to a share in the total consideration on its sale by virtue of the former being an economic owner. Influence of foreign parent The SB rejected the Tax Authority s claim of disregarding the separate legal character of the Taxpayer, merely due to the influence of its foreign parent on its economic policies. However, the SB held that the Tax Authority needed to investigate whether there had been any instance of influence, and that if this was not the case, it must accept the transaction to be arm s length. However, if there was evidence of influence for any transaction, the impact of the influence needed to be removed (by determining the ALP). In this case, the SB referred to the global marketing strategy, the Blue Ocean Strategy, followed by LG group entities under which they were to focus on new markets instead of competing in already saturated ones. In the SB s opinion, since the Taxpayer had complied with this strategy, it could not be contended that all decisions relating to the timing, areas and quantum of advertising were taken by it. On perusal of the interviews given by the Taxpayer s executives (filed as additional evidence by the Tax Authority), the SB concluded that they coordinated with foreign parent for market development. Due to these factors, the inference that there was an informal arrangement between the Taxpayer and its foreign parent was reinforced. International transaction The SB has held that only a transaction that is an international transaction within the meaning of section 92B of the Act can come under the purview of TP regulations. The SB also held that after the amendments made in the Finance Act 2012, the definition of international transactions has become extensive and inclusive but not necessarily exhaustive. Based on the definitions of provision of services and marketing related intangibles, as defined in the sub-clauses of section 92B of the Act, the SB held that brand-building constitues provision of service. Comparability and use of BLT While concurring with the argument that the provisions of foreign legislation cannot be imported into Indian legislation, the SB held that the Tax Authority had not used BLT to determine the ALP of the transaction, but simply to determine its value/cost, since the Taxpayer had not in any way assisted in determination of the value of the international transaction. The SB held that BLT is a valid method to determine the transaction value of AMP as the difference between the AMP expenses to sales ratio of the Taxpayer vs the AMP expenses to sales ratios of comparable companies. The SB also upheld that since the transaction was in the nature of services, the mark-up should be applied on it. 2 [(2012) 345 ITR 241 (Del)] 6 India, at Arm s Length

7 Section 37 vs Section 92 The SB held that TP provisions are special ones that override general provisions such as section 37(1) of the Act. Therefore, in the case of an international transaction, section 92 of the Act would prevail over other general provisions governing the deductibility or taxability of an amount from such a transaction. Since in the instant case, an international transaction has been identified, it would be analyzed under the provisions of section 92 and not section 37 of the Act. Comparability factors The SB held that the TPO s choice of comparables for applying the BLT was not acceptable. It listed down the following factors that need to be considered while determining a transaction and its quantification: Whether the Indian AE was a manufacturer or a distributor The extent of value addition made by the Indian entity Whether the Indian AE has been paying any royalty to the foreign AE and whether such royalty was comparable with what independent third parties pay Whether the foreign AE was compensating the Indian AE for promoting marketing intangibles Whether the brand was established in India Whether any new products had been launched in India during the year or was the business continuing with its existing range of products How the brand would be dealt with after termination of the agreement between the AEs The SB held that the mechanical application of BLT to compare the ratio of AMP expenses to sales of comparable cases, without giving effect to the comparability factors mentioned above, could produce the correct result. The manner of determination of the mark-up on the alleged service was also rejected by the SB and the matter was remanded back to the TPO for fresh, based on the factors mentioned above. Scope of AMP expenses The SB also upheld that expenses incurred in relation to sales do not constitute brand promotion and cannot be brought within the ambit of AMP expenses. Referring to the erstwhile section 37(3B) of the ITL and various relevant case laws, which hold that expenses in the nature of bonuses to dealers, commissions to sales agents or to dealers commissions cannot be brought under the purview of advertising, marketing and publicity. The SB also held that expenses by themselves are not in the nature of AMP expenses and need to be excluded at the very outset before a BLT is undertaken. Company-wide analysis The SB rejected the contention of the Taxpayer that since the net margin of the taxpayer is higher than the comparables, it can be said to be have been adequately compensated by the AE for its marketing activities. The SB held that the increased profitability of the Taxpayer can be due to several different factors and it needs to be established with specific evidence that the foreign AE sold goods to the former at reduced prices to compensate it for its AMP expenses. Furthermore, the SB held that in this case, purchase of goods from the foreign parent and provision of brand-building services are separate transactions and are not closely linked, and therefore, cannot be benchmarked together using TNMM. Validity of jurisdiction of TPO to analyze AMP expenditure The SB stated that it is a creature of the Act and hence has no power to declare any provision of the Act as unconstitutional, either fully or partly. Accordingly, it does not either have the power to ignore the retrospectively of the provision or have the jurisdiction to adjudicate on the appropriateness of the retrospective amendment. The SB also noted that while making the retrospective amendment, the Government has been cautious about not disturbing the finality of an assessment due to the retrospective operation of these provisions by also introducing provisions, which bar AOs from re-opening assessments that have already been completed by the date of amendment of these provisions. Therefore, the SB concluded that the TPO can determine the arm s length price of any transaction as long as there has been a reference from the AO for at least one transaction. In view of the above, the SB upheld the validity of the proceedings before the TPO. Applicability of ruling in the case of Maruti Suzuki 3 The SB held that the principles laid down by the Delhi High Court in the case of Maruti Suzuki India Ltd. continue to hold good, since its order has not been overruled by the Supreme Court on merits. Accordingly, the SB held it appropriate for the TPO to rely on the Delhi High Court s decision. 3 (2010) 328 ITR 210 (Del) and (2011) 335 ITR 121 (SC) India, at Arm s Length 7

8 Dissenting view In his dissenting order, the Judicial Member (JM) stated that AMP expenses were incurred in India and paid to Indian taxpayer entities. He also emphasized that AMP expenses incurred by the Taxpayer for its own benefit as well as any benefit received by the AE was incidental and does not require any compensation. In his view, the so-called non-routine expenses segregated from AMP expenses, alleged to have been incurred on brand-promotion, cannot be tantamount to an international transaction for which TP adjustment was required. The JM also held that there is no evidence of any written or oral agreement and the Tax Authority does not have the liberty to come to a subjective conclusion, purely based on his presumption, in the absence of any deeming provision in the ITL. The JM also held that such a presumption cannot be taken as proof of the existence of a transaction. In his order, the JM has opined that a brand cannot exist without a product. Therefore, the entire expenditure incurred on AMP needs to be treated as product-centric and no expenditure can be said to have been incurred on brandbuilding. The JM also stressed on the fact that even if a brand was incidentally promoted, the Taxpayer was not entitled to ask for any compensation from its foreign parent for this, and that it also needs to be considered whether the foreign parent can claim compensation from the Taxpayer in the event of a reduction in the value of the brand? Capgemini India Private Limited Mumbai Tribunal [TS-45-ITAT-2013 (Mum)] The Mumbai Tribunal rules on various TP aspects of intra-group software development services S 92CA(3), Rule 10B(2); AY ; partially in favor of Taxpayer The Taxpayer is engaged by its parent company to render software programming services and was remunerated on a cost-plus basis. The Taxpayer selected TNMM as the most appropriate method of benchmarking its international transactions and selected a final set of comparable companies, based on its application of a combination of quantitative and qualitative screening filters. The Taxpayer considered the multiple-year average of the net margins of the comparables to conclude that the transaction was at arm s length. The Taxpayer used consolidated financials to conduct a comparability analysis (if available). The Taxpayer also introduced additional companies that were also considered for analysis by the Tax Authority in the place of companies that were rejected on the related party transactions filter on a standalone basis. In addition, the TPO treated the ESOP cost incurred by the Taxpayer as operating expenses for the purpose of computing its net profit margin. The taxpayer also claimed an adjustment for differences in working capital to arrive at the arm s length margin of the comparable companies. The Taxpayer also contended that a quantitative criterion, based on its turnover, should be used and companies with higher turnovers should not be regarded as comparable, since they had economies of scale, better bargaining power, skilled employees and high risk-taking capabilities, etc. The Taxpayer also referred to various rulings, wherein a turnover filter of INR10 million INR2 billion had been applied. The Tribunal held as under: ESOP costs: The Tribunal accepted the contention of the Taxpayer on exclusion of the one-time ESOP cost while computing its margin. The Tribunal held that the ESOP cost incurred by the Taxpayer arose due to the acquisition of KSIL Worldwide by the Capgemini Group in the relevant year and was an exceptional item that was amortized by the Taxpayer over a period of five years. Therefore, it allowed an adjustment in the margin of the Taxpayer to eliminate the impact of any extraordinary factors. Use of consolidated financials: The Tribunal upheld the view of the Tax Authority that standalone financial statements should be considered to compare the margins of comparable companies and that consolidated results include profits from different jurisdictions in various geographies and market conditions, and therefore, were not comparable. Accordingly, the Tribunal rejected the use of consolidated financial statements and companies for their substantial related party transactions on a standalone basis. Use of turnover criteria: The Tribunal rejected the contention of the Taxpayer regarding the application of a quantitative filter for screening comparable companies, based on their size and turnover, relative to those of the Taxpayer. The Tribunal disregarded the reasons proposed by the taxpayer for the removal of high-turnover companies from the set of comparables, given their economies of scale, greater bargaining power, employees with enhanced skills and high risk-taking capabilities. The Tribunal upheld the views of the Tax Authority that the concept of economies of scale is relevant for manufacturing concerns with significant fixed assets, whose margins increase with the growth of their turnover. The Tribunal concluded that there was no linear relationship between profitability and turnover. It also stated that the need for skilled employees is dependent on the nature of a business and not on the turnover of a company. 8 India, at Arm s Length

9 In relation to its bargaining power, the Tribunal held that the Taxpayer was a part of a well- established multi-national group, and therefore, it could be accepted that it has less bargaining power than any other Indian company, however big it may be. Accordingly, it would not be appropriate to use a turnover filter to compare margins. The Tribunal clarified that Dun and Bradstreet makes classifications accordingly to the size of a company, large, medium and small, and not on the basis of their margins. However, it held that turnover criteria would have to be relevant, only to ensure that the comparable selected was also an established player that was capable of executing similar work as the Taxpayer. Accordingly, quantitative criteria of INR1 billion was applied to eliminate potential comparables with turnovers below this threshold. Use of comparables in abnormal year of operations and unusually high margins: The Tribunal held that comparable companies satisfying all comparability criteria cannot be rejected, merely on the ground of their showing an extremely high profit or loss, unless this was during abnormal business conditions. It agreed to reject companies with abnormal operations during the financial year. Furthermore, the Tribunal emphasized on OECD guidelines, which provide that loss-making uncontrolled transactions should be further investigated and only be rejected if their loss was not incurred in normal business conditions. Inclusion of new comparables: The Tribunal upheld the inclusion of new comparables during the DRP proceedings, since the Taxpayer was not given adequate opportunity to analyze new comparable companies at the time of TPO proceedings. Furthermore, the Tribunal stated that it would be appropriate to take into account as many comparables as possible, so that the mean margin was closer to the correct one, and small differences, if any, were eliminated by increasing the number of comparable companies. Adjustment of working capital: The Tribunal upheld the contentions of the Taxpayer that an adjustment needed to be made in its working capital because it would adversely affect the profitability of the company and also that Indian regulations mandate that comparability should be adjudged with respect to various factors. Accordingly, it stated that the average of the opening and closing balance of the company s accounts receivables/ payables for the relevant year could be considered to compute the working capital adjustment. The Tribunal highlighted the fact that the benefits gained by adjustment of working capital cannot be denied, merely because the Taxpayer had not made a claim in this respect in its TP documentation. Sumitomo Corporation India P. Ltd. vs DCIT (I.T.A. No. 5095/Del/2011) Delhi ITAT Indenting transactions not comparable with trading transactions S 92C, 92C(2),Rule 10B, AY ; In favour of the taxpayer The Taxpayer was engaged in indenting activities on behalf of its AE, for which it was remunerated on a commission basis as a percentage of its total sales in India (average rate of commission earned during the year being 1.58% of the value of its sales). The TP report claimed that in its indent transactions, the assessee s role was that of a mere service provider. It also claimed that apart from its indenting activities, Sumitomo India was also engaged in pure trading of the goods it procured from AEs and third-party vendors, India, at Arm s Length 9

10 wherein the gross margin earned by the Taxpayer in the case of its related party imports was 4.80%, and 4.45% in the case of its unrelated imports. The Taxpayer used the Transaction Net Margin Method (TNMM) as the most appropriate for it and its Berry Ratio ratio of gross profit margin to total value-added expenditure (GP/VAE) as its profit level indicator. Its gross profit margin on its trading sales (AE and non-ae segments) was added to the commission it had earned (in addition to other income) to arrive at the numerator of its Gross Profit on Sales PLI. This numerator was then divided by the taxpayer s operating expenses to compute the PLI of its Berry Ratio, since that of Sumitomo India (1.79), with an operating margin of 79% on its VAE, was higher than the Berry Ratio of comparables at 1.18 (operating margin of 18% on operating costs). Therefore, the transactions were considered to be at arm s length prices. During the audit proceedings, the Tax Authority rejected the use of the Berry Ratio as a PLI. It held that there was no significant difference between the trading and indenting activities of the Taxpayer. Furthermore, it took the position that the Taxpayer had created significant human intangibles and supply chain intangibles, for which it has not been compensated by the AE. Accordingly, the Tax Authority considered the gross margin earned by the Taxpayer from its non-ae segment as its arm s length remuneration (4.45%) and accepted this as the arm s length margin the Taxpayer should have earned on the FOB value of goods in its indenting business. The Taxpayer contended that the functional and risk profile of its trading activities was different from its indenting activities, and therefore, the two could not be compared. It also stated that the cost of goods sold could not be included in computing its net margin, since according to Rule 10B(1)(e) of the Indian Income Tax Rules, 1962 (Rules), no such cost had been incurred by the taxpayer. The Taxpayer also submitted that during the year, it had earned commission amounting to 2.26% from non-aes and of 1.58% from AEs. However, it stated that its non-ae indenting business amounted to only 4.2% of its AE indenting segment. Therefore, after making certain economic adjustments to its non-ae commission rate due to the difference in its turnover, etc., (computed at 50% by the Taxpayer), its arm s length commission rate was determined at 1.13% (50% of 2.26%) as compared to the commission rate of 1.58% earned by the Taxpayer from its AE. The ITAT agreed with the Taxpayer s contention that the nature of indenting transactions is different from trading ones. It held that trading transactions involve risks and finances, whereas in indenting transactions, taxpayers do not to have a financial obligation or face any significant risk. According to the ITAT, there was no evidence of the indent transactions being trading ones, and therefore held that the Taxpayer s business structure should be accepted as such. The ITAT held that the arm s length price should be determined by comparing the commission/service income earned by the Taxpayer from AEs with that of non-aes, since the functions performed and risks assumed in these activities are identical. However, it rejected the Taxpayer s contention that a discount of 50% is required in the commission percentage in the non-ae segment to make it comparable with that in the AE segment, and held that the commission percentage of 2.26% in the non-ae segment should be taken as the arm s length commission rate. This ruling, with its clear emphasis on the functional aspect of a comparability analysis, provides guidance on a number of issues that taxpayers and Tax Authorities face while undertaking a TP analysis for such transaction. 10 India, at Arm s Length

11 Around the world Brazil amends TP regulations: new rules for deduction of intercompany interest and new normative instruction On 28 December 2012, Law /12 introduced further changes in the recently enacted changes made in Brazil s TP rules on interest paid to related parties. Furthermore, Normative Instruction (IN) 1.312/12 was published the same day to consolidate the country s TP legislation and revoked all previous normative instructions, mainly IN 243/02, related to TP. In addition, IN 1.312/12 provides guidance on the application of Law /12. As we commented in our previous edition of Tax Alert (20 September 2012), the intention of Law /12 is to simplify compliance, reduce areas of controversy and attract more investment. More specifically, IN 1.312/12 provides guidance on how Law /12 should be applied, mainly relating to: Imports: Minimum requirement for application of Brazilian uncontrolled price method (PIC) using internal comparables Minimum statutory gross profit margins from 20% to 40%, depending on the industry in which the company operates, required for the Resale Price Method (PRL) Intercompany price to be tested under PRL method Exports: Changes made in safe harbor conditions by increasing their profitability from 5% to 10% and introducing a new threshold to cap intercompany export transaction amounts to 20% of total net export transactions TP methods for commodities (quotation on Imports PCI and quotation on exports- PECEX): Specific TP mode for import/export transactions with publicly traded commodities List of commodities, stock exchange markets and authorized institutions Reduced deviation margin (to 3%) in the case of transactions involving commodities Safe harbor analysis (known as Dispensas de Comprovação) not applicable for export of commodities Procedural changes: Determination of time/form to select TP method Back-to-back transactions also subject to TP analyses Interest: New Law /12 has introduced further changes in deduction of interest for financing transactions, with new benchmark rates, depending on the currency. According to it, the Ministry of Finance will establish a spread, based on the market average for inter-company financing agreements entered after 1 January China s SAT issues third APA Annual Report On 26 December 2012, China s State Administration of Taxation (SAT) published the China Advance Pricing Arrangement Annual Report (2011) (the 2011 Report). The 2011 Report includes statistical data and analyses for the period , and describes the mechanisms, procedures (including implementation procedures) and practical development of China s APAs. Number of cases signed as on 31 December 2011 The 2011 Report focuses on cases negotiated under Guoshuifa [2004] No. 118 and Chapter 6 of Guoshuifa [2009] No. 2 in , during which period China signed 73 APA agreements (53 unilateral and 20 bilateral). The SAT signed a total of eight unilateral APAs and four bilateral APAs in 2011, which represents a significant growth as compared to eight signed APAs in However, there are still 15 unilateral and 79 bilateral APA requests (and submission intentions) pending in the process (including five cases that have been concluded but have not yet been signed). The number of active APAs executed and monitored dropped from 24 in 2010 to 21 in 2011 and the number of APAs expired increased from 37 in 2010 to 52 in Interestingly, out of the 52 APAs expired on 31 December 2011, 41 were unilateral, and outof the 24 APAs executed and monitored on 31 December 2010, nearly half were bilateral. This is further evidence of the increasing popularity of bilateral APAs. The decline in the number of active APAs may be explained by the resource constraint of tax authorities and the fact that bilateral APAs are complex and time-consuming to conclude. India, at Arm s Length 11

12 Transaction types Among the cases concluded in , the 2011 Report indicates that 45% of the accepted applications involved tangible property transactions and the balance related to intangible property and service-related transactions. There were no applications covering intercompany financing transactions accepted in Bilateral APAs negotiated by region The report indicates that among the 20 bilateral APAs signed during the past seven years, the majority of them, i.e., 15, were signed with Asian countries; four with European countries and one with a North American country. Time required to conclude cases Out of the 53 unilateral APAs signed during , 28 cases were signed within 12 months, 24 in months and 1 case in months. Out of the 20 bilateral APAs mentioned, one took over three years to be signed, 15 were signed within 24 months and four cases were signed within 36 months. In 2011, two bilateral APAs were signed within 12 months, one within 24 months and one within 36 months. As for unilateral APAs, 4 were signed within 12 months, 3 within 24 months and 1 within 36 months. TP methods During , the TNMM, using the Return on Sales ratio as the profit level indicator (PLI), was the method most frequently used to conclude APAs, although similar approaches such as TNMM using the Full Cost Mark-up ratio as PLI or the Cost Plus method were also used. Among the 12 cases signed in 2011, 10 used the TNMM, 5 the Full Cost Mark-up ratio, 5 the Return on Sales ratio, 1 the Resale Price Method and 1 another method that was not disclosed 4. Industries covered by signed APAs From 2005 to 2011, 64 signed APAs were from manufacturing; 3 from commercial services; 3 from wholesale and retail trade; 1 from transportation, warehousing and postal services; 1 from scientific and technical services, and 1 from the electricity, thermal, gas, and water generation and supply segments. Philippines issues TP regulations The Philippine s Department of Finance has recently issued Transfer Pricing Regulations (TP regulations). These are found in its Revenue Regulations No dated 23 January The new regulations implement Section 50 of the Philippine Tax Code, which authorizes the Commissioner of Internal Revenue to distribute, apportion or allocate gross income or deductions between or among controlled organizations, trade or business if such distribution, apportionment or allocation is required to prevent evasion of taxes or reflect the income of such organizations, trades or businesses. The TP regulations are largely based on the Organization for Economic Cooperation and Development s (OECD s) Transfer Pricing Guidelines and refer to it for further guidance and examples. The key regulations include: Adoption of the arm s length principle as the most appropriate standard to determine the transfer prices of related parties Coverage: cross-border transactions between associated enterprises and domestic transactions between associated enterprises TP methodologies: adoption of methodologies prescribed under the OECD s Transfer Pricing Guidelines, e.g., the Comparable Uncontrolled Price (CUP) Method, the Resale Price Method, the Cost Plus Method, the Profit Split Method and the Transactional Net Margin Method (TNMM). There is no specific preference for any one method. Requirement of specific documentation Provision for penalty Option for APA and MAP US IRS issues 14th Annual APA report for 2012 The US IRS issued the 14th Annual Advance Pricing Agreement (APA) report (the Report) on 25 March 2013 in Announcement The report provides updated information on the APA program, including its activities and structure, for It offers useful insights into the operation of the program and indicates the processes companies applying for an APA can expect to comply with. The highlights of the APA report: APA applications, executed APAs and pending APAs The IRS has received a total of 1,745 APA applications, and executed 1,155 APAs since the inception of the APA program in 1991 till 31 December Some APAs involved two or more kinds of transactions and multiple transfer pricing methods may have been used. 12 India, at Arm s Length

13 In 2012, the IRS received 126 new APA applications, while the number of APAs executed during the year was 140 (against only 42 in 2011). Therefore, the number of pending APA applications came down from 445 at the end of 2011 to 391 at the close of Time required to conclude cases The average time for completion of the process mandated for new bilateral APAs increased from 43.9 months in 2011 to 47.5 in 2012, while the average time for renewals rose from 44.1 months in 2011 to 44.8 months in In the case of unilateral APAs, their average completion time decreased from 31.2 months in 2011 and to 28.4 months for new APAs in It increased from 14.2 months to 30.1 months for renewals during this period. Treaty partners in bilateral APAs The report also provides information on the treaty partners of bilateral APAs concluded during APAs with Japan represented more than half of all bilateral APAs executed in This can be attributed to the maturity of APA programs in the US and Japan, the APMA team s wide experience in conducting negotiations and the competence of the authority team representing the National Tax Administration of Japan. Canada is the second most frequently involved treaty partner due to its role as the US s largest trading partner. TP methods The Cost Plus Method or TNMM continues to be the method most commonly applied in cases involving transfer of tangible and intangible property, as well as in those entailing performance of services. Industries covered by signed APAs Manufacturing and wholesale or retail trade continued to account for the largest share of APA cases and represented three out of every four APAs completed in Nearly half of all manufacturing cases related to computers or electronic products, or chemicals, while wholesale or retail trade cases were dominated by wholesalers of durable goods. Critical assumptions A critical assumption is a fact on which a taxpayer s TPM is dependent. APAs typically list critical assumptions that relate to a particular mode of conducting business operations, a particular corporate or business structure, or a range of expected business volume. The model APA used by the IRS includes a standard critical assumption that there will be no material changes in the taxpayer s business or in its tax or financial accounting practices during the term of the APA, as well as that all the APAs executed in 2012 would need to include this standard critical assumption. Some bilateral cases have included critical assumptions tied to either a taxpayer s profitability in a certain year or over the term of the APA or to the volume of non-covered transactions as a percentage of the taxpayer s revenue. An APA can be canceled if a critical assumption is not met and the parties cannot agree on how it can be revised. The IRS did not cancel any APAs in 2012 due to their failure to meet a critical assumption. Adjustments made to comparables or tested parties The report takes note of the adjustments that were made for material differences between controlled and uncontrolled transactions. Balance sheet adjustments for payables, receivables and inventory continue to be the most widely used till date. India, at Arm s Length 13

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