Transfer Pricing Litigation in India

Transcription

1 Transfer Pricing Litigation in India Pramod Joshi Senior Director, Transfer Pricing April 27, 2013 Pune Branch of WIRC of ICAI Direct Tax Refresher Course 2013

2 Trends in TP Audits in India- Increasing volumes Trends indicate greater scrutiny, leading to increased adjustments and resultant litigation Favorable decisions from Income Tax Appellate Tribunal Looking Ahead- Safe Harbour and Advance pricing agreement (APA) Approximately 9.3 Billion EUR addition on account of transfer pricing for FY Financial year No. of cases Cases adjusted Cases adjusted (%) % 234 mn % 439 mn % 658 mn % 844 mn Estimated addition (EUR) % 1661 mn (approx.) More than 50% % 3410 mn. (approx) 6829 mn. (approx.) Note-The above figures are estimations based on various presentations by the Department and news reports 2

3 Normal Dispute Resolution Mechanisms Apex Court High Court Tribunal (final fact finding authority) Commissioner (Appeals) / Dispute Resolution Panel Most tax disputes are dealt under traditional dispute resolution avenues 60 to 70 % of decisions by Tribunal on transfer pricing disputes in favor of the tax payer Each level of hierarchy involves substantial period of time Tax officer 3

4 Recent Key Transfer Pricing Assessment Issues Royalties for know-how and trademark/ trade names Intra-group services - management services fees / Cost contributions Guarantee fee, intercompany loans and other financial transactions Mark-ups for captive intra-group service providers, particularly ITES / BPO industry Service companies and intangibles development in India Losses incurred Adjustments for functional differences Comparability of Domestic and Export Segment Comparable with higher profits/ losses Marketing intangibles (and the access to market argument) Valuation of Shares 4

5 Method Selection, Functional Adjustments and its Application 5

6 Schefenacker Motherson Ltd (SML) Facts SML manufactures rear view mirrors and cable assemblies for the automobile industry International transactions include import of components, exports of cable assemblies and payment of royalty for technical know-how TNMM with cash profit (CP) / sales as PLI used for benchmarking to eliminate differences in technology used, age of assets, capacity utilisation and different depreciation policies adopted by comparables TPO rejected the above PLI stating that Rule 10B(1)(e)(iii) provides for adjustment to be made only to the results of comparable companies and not to the tested party; and making a depreciation adjustment has no sanction in law Tribunal Decision / Observations Tribunal held that Cash Profit / sales or Cash Profit / total cost excluding depreciation can be adopted as an appropriate PLI under TNMM, to adjust for material differences in the assets utilized between tested party and comparable companies Discussed the concept of Operating Income. There is no standard test for deciding what constitutes operational income (or profit) and that it would depend on the facts and circumstances of each case 6

7 Skoda Auto India Pvt Ltd (SAIPL) Facts SAIPL is engaged in the business of manufacturing and selling passenger cars First full year of the operation for SAIPL International transactions include import of material and payment of royalties and technical know-how fees SAIPL adopted TNMM as the most appropriate method and also relied on CUP method by contending that ex-factory selling price by parent company would remain same for all AEs TPO rejected certain comparables on account of persistent losses and non-availability of contemporaneous data and made the TP adjustment 7

8 Skoda Auto India Pvt Ltd (SAIPL) Pune Tribunal Decision / Observations CUP analysis rejected The transaction has to be between two entities which cannot influence or control each other s decision Tribunal observed that the business models of the comparable companies having an import content ranging from 26 percent to percent is fundamentally different from that of SAIPL having import contents as high as percent Adjustment would be required for unusually high costs on account of initial stages of business 8

9 Fiat India Facts Taxpayer engaged in the business of manufacturing and selling of passenger cars and trading of spare parts Taxpayer adopted TNMM and made comparability adjustments Under utilization of capacity Higher incidence of octroi and excise duty (due to slow moving stock) Low volume from otherwise profitable spare parts business Relatively higher employee salary costs due to underutilization TPO considered PBDIT as the PLI and made adjustment Mumbai Tribunal s Decision / Observations Taxpayer sufficiently explained and demonstrated material differences in the facts of the taxpayer and comparable companies Taxpayer being in asset intensive industry depreciation should be considered on actual usage of fixed assets for the purpose of computing the operating margin to lead to a meaningful outcome 9

10 Cheminova Facts Taxpayer engaged in manufacturing of agrochemicals, pesticides, weedicides and plant growth stimulators Taxpayer purchased raw material from its AE and Non-AEs (Chinese suppliers) Purchased from domestic market at a higher rate than the price paid to AE Taxpayer selected CUP method Tribunal Decision / Observations Importance of economic and commercial factors in ALP determination Substitution to Chinese supplier was not feasible until quality was established Key takeaway even in a case where adverse CUP exists, proper documentation of the business reasons and robust economic analysis can come to the rescue 10

11 IL Jin Electronics Facts Taxpayer was engaged in manufacture of Printed Circuit Boards Taxpayer imported 45.51% of the raw materials from its AEs TNMM was selected as the most appropriate method The TPO proposed an adjustment by rejecting certain high loss making comparables Taxpayer contended that working capital adjustments should be made to the margins of comparable companies. Further, adjustment if any should be restricted having regard to the proportion of the international transaction with total turnover. Delhi Tribunal s Decision / Observations TNMM was selected as the most appropriate method in absence of data with regard to purchase of raw material by the AE from third parties Working capital adjustment depends on the credit period extended and availed by the taxpayer The adjustment was restricted to the ratio of international transaction to the total cost of raw material 11

12 Global Vantedge Facts GV India is engaged in rendering IT-enabled services in the field of credit collection and telemarketing services and is eligible for deduction under Section 10A GV India adopted TNMM as the most appropriate method considering AE as a tested party. GV India had losses at operating level TPO considered GV India as tested party and made an adjustment to the international transactions by comparing comparables margin of (-)11.88% with loss of GV India (-)53.5% Delhi Tribunal s Decision / Observations Foreign entity could be selected as the tested party if it is least complex. However, due to nonavailability of data for carrying out FAR / adjustments and geographical differences in entitlements foreign entity could not be treated as tested party Total adjustment along with the ALP reported by the taxpayer cannot exceed total revenue earned from the transaction from an end to end perspective Adjudicated that the taxpayer s transactions with third parties should not be considered while using TNMM It was held that comparables engaged in dissimilar activities and those having substantial related party transactions should be rejected. Further, as the taxpayer was in the start-up phase, accordingly adjustments due to surplus capacity should be carried out for the comparables. 12

13 Internal Comparability 13

14 Genisys Integrating System Facts The assessee was engaged in the business of providing software development and IT enable services (Call Centres) The assessee provided similar software development services to its AEs and non-aes and adopted internal TNMM as the most appropriate method to determine ALP The TPO rejected internal TNMM and adopted external TNMM to determine ALP resulting in adjustment to software development services The DRP confirmed the adjustment proposed by the TPO relating to software development services Ruling by Bangalore Tribunal Internal TNMM as the most appropriate method for determining ALP of software services Assessee had provided basis of apportionment of direct and indirect cost between AE and non AE and documentary evidence and in absence of reasons to reject TNMM, TPO to adopt internal TNMM after verifying the cost allocation and margin computation 14

15 Drilbits International Private Limited Facts The taxpayer was manufacturing bits for industrial drill machines and were selling to overseas parent as well as in India to third parties The manufacturing units was earlier owned by another third party who was supplying to the same overseas entity and the rates remained same even after the overseas entity acquired the manufacturing unit through its Indian arm Ruling by Pune ITAT On appeal the tax court deleted the adjustment by pointing out that comparison between domestic and export segment not tenable considering material differences in risks assumed and functions undertaken and no reasonable adjustment was possible to quantify The Tax court also asked the tax authorities to follow rule of consistency as the approach of tax payer (TNMM as a method) was accepted in subsequent year by the field officer The field TP officer rejected the CUP (price at which the earlier owner of factory was selling the bits) The field TP officer used cost plus as a method resorting to comparison between domestic and export segment and made TP adjustment 15

16 Tecnimont ICB Facts The taxpayer Tecnimont ICB Private Limited, an Indian company was engaged in EPC turnkey contracts, design/ supervision/ translation services and feasibility studies Tecnimont ICB Private Limited had a 100% subsidiary in India ICB Contractors Private Limited Out of the total revenues of ICB Contractors Private Limited, 59% revenue was from one of the AEs (JTS) In the TP assessment, the assessee, contended that ICB Contractors Private Limited is a better comparable, after the TPO rejecting 12 external comparables TPO rejected on the ground of ICB Contractors Private Limited having related party transactions and made addition of Rs. 7 crores CIT(A) deleted the addition Ruling by Mumbai ITAT Accountant member of ITAT held that ICB Contractors Private Limited could not be a comparable as it is having related party transactions Judicial member of ITAT took a view that since transactions between ICB Contractors Private Limited and JTS are at arm;s length, it could be considered as a comparable company The third member held that ICB Contractors Private Limited can not be taken as a comparable company as comparable could be internal or external but in case comparable must be that of uncontrolled transaction or number of such transactions There is no statutory sanction for roping in a comparable controlled transaction for the purposes of benchmarking. When it has been clearly mandated in all the relevant methods for determining ALP that the comparison has to be made by the enterprise's international transaction with comparable uncontrolled transaction, by no sheer logic a comparable controlled transaction can be employed for the purposes of making comparison. There is no warrant for diluting the prescription given by the statute or rules when such prescription itself serves the ends of justice properly and is infallible. If the view of the Revenue that a controlled transaction should not be shunted out for the purposes of benchmarking is accepted, then all the relevant provisions contained in Chapter X in this regard, will become otiose. 16

17 Turnover Filter, Functional Comparability 17

18 Trilogy E-Business Software India Facts Trilogy India was engaged in the supply of software research and development services to its U.S. parent Trilogy India was remunerated at cost plus 10 % and adopted TNMM and while selecting comparable companies used maximum turnover filter of INR 200 crores as its own sales was INR 47 crores 18 The TPO accepted the TNMM but challenged selection of comparable by rejecting maximum turnover filter as well as didn t exclude comparables with abnormally high margins The TPO revised the set of comparables which resulted in high margins Ruling by Banaglore Tribunal Turnover filter of Rs.1 crore to Rs.200 crore may be applied in this case and export filter is a must if the assessee renders services to export market Onsite revenue filter may be used if the assessee renders offshore software development Comparables owning intangibles are functionally not comparable with the assessee who does not own intangibles Abnormal profit making companies may be excluded as comparables if supported by sufficient evidence for such abnormal profit Comparables outsourcing majority of its work to third parties may be excluded

19 Genisys Integrated Systems India Private Limited Facts Assessee was engaged in business of software development and rendering of ITES services to AEs TPO rejected turnover filter of the assessee (1 to 200 crore rupees) contending that Indian TP regulations as well as OECD guidelines did not prescribe turnover filter and once the company is functionally similar then it could be compared irrespective of turnover, size, scope of operations Ruling by Banaglore Tribunal Considering size of business of the assessee 1 to 200 crore turnover filter is appropriate In this case ITAT also held in favor of the TPO on issue of use of data which becomes available after the due date of filing the return of income (i.e. the date generally by which companies undertake the search and prepares the comparability analysis as a part of transfer pricing documentation) TPO applied several other filters and rejected 10 comparables 19

20 Aggregation of Closely Linked Transactions 20

21 Demag Cranes & Components Facts The taxpayer was providing state of the art material handling solutions to Indian customers Taxpayer was basically having the project business consisting of: Manufacture of material handling equipment Purchase and distribution of imported material handling equipment Availing of technical services and rendering of marketing services The TPO applied TNMM by segregating the business into manufacturing, distribution and services segment and consequently made TP adjustments Ruling by Tax Court On appeal the Pune tribunal noted that Indian TP regulations allows aggregation of closely linked transactions for determining arm s length price which is in line with OECD approach While ruling out the TP adjustment, the tax court observed that the taxpayer enter into a single contract negotiation with customer for manufacturing and sale of cranes and hoists which includes manufacture, supply and services For determining the need for aggregation one need to look at facts and circumstances of each business and cannot define parameters in a water tight compartment 21

22 RBI thresholds for ALP? Mumbai ITAT s 2 Opposite Rulings 22

23 RBI thresholds for ALP? Mumbai ITAT s 2 opposite rulings 23 ThyssenKrupp Industries India Private Limited The assessee was engaged in business of turnkey projects and paid 2% of contract value to its AE for know-how. It also paid royalty of 5% of the selling price to the AE as per the collaboration agreement Assessee through Central bank of India applied to RBI for approval and RBI asked the bank to consider assessee s case in accordance with AP (DIR Series) No. 76 dated and under the deemed approval given by RBI under automatic route, ThyssenKrupp India made the payment The TPO determined ALP at NIL proposing an adjustment of Rs crores Mumbai ITAT Held that when the rate of royalty payment and fee for drawings etc. has been approved or deemed to have been approved by the RBI, then such payment has to be considered at ALP SKOL Breweries Limited SKOL Breweries was engaged in manufacturing and marketing of beer in India and it was paying royalty at the rate of 5% to SAB Miller for using of technical know-how provided TPO rejected CUP and applied TNMM to benchmark royalty with other transactions Mumbai ITAT ruled that RBI approval has no relevance on issue of Arms Length Price and RBI, at the time of giving such permission would not keep in mind the provisions of the I T Act and that is the function of the income tax authorities When a proper mechanism is provided under the provisions of the I. T. Act and Rules for determination of the ALP, then the approval by other than the I. T. Authorities, for the purpose of remittance/outflow of the foreign exchange, does not ipso facto, partake the character of ALP, which has to be determined as per TP regulations

24 Inter-company Loans, Debt and Guarantees 24

25 Perot Systems Facts The taxpayer was an Indian company engaged in the business of designing and developing technology enabled business transformation solutions The taxpayer had extended interest free foreign currency loans to its AEs The TPO adopted LIBOR % as the arm s length interest Taxpayer s Contentions before Delhi Tribunal The loans were in the nature of quasi-equity Hungary thin capitalization rules kicked in and part of the debt was treated as capital The AEs were start-up companies and no lender would have lent money The intention of advancing loan was to earn dividend and not to earn interest Real income concept argued 25

26 Perot Systems Delhi Tribunal s Decision / Observations No income arising argument rejected Interest free loan does not satisfy the arm s length principle No special feature in contract demonstrated to treat the loan transaction to be equity in nature Contentions re commercial expediency / inability of the Sub to borrow - rejected 26

27 Nimbus communication Facts Taxpayer had receivables outstanding from AEs for > 180 days TPO attributed interest on extended credit and made adjustment For adjustment TPO used rate of interest charged for inter-company loan Tribunal Decision / Observations Taxpayer has not charged interest on delayed payments from third parties Taxpayer has not paid interest on delayed payments to its creditors TPO has not followed any of the methods in making adjustment Loans and trade credit are different and not comparable ITAT deleted adjustment on merits and law 27

28 Cotton Naturals (I) Private Limited Facts The assessee was engaged in manufacture of apparel and had provided loan at 4% p.a. to its AE Applying CUP the interest rate was comparable with export packing credit rate obtained from independent banks in India TPO considering the domestic lending rate of 17.26% and made an adjustment and DRP recomputed the adjustment by applying interest rate of 13.25% Ruling by Delhi Tribunal Where transactions was of lending money in foreign currency to its foreign AE, the comparable transaction would be foreign currency lending by unrelated parties Domestic prime lending rate would have no applicability and LIBOR should be taken as the benchmark rate for international transaction relying on following ITAT judgments Siva Industries and Holdings Ltd (Chennai Tribunal) Four Soft Ltd (Hyderabad Tribunal) Tech Mahindra Ltd (Mumbai Tribunal) Tata Autocomp System (Mumbai Tribunal) 28

29 Intra Group Services Management Services Fees/ Cost-recharges 29

30 Dresser Rand India Private Limited Facts The assessee was a wholly owned subsidiary of Dresser Rand Co., USA engaged in the business of manufacturing various types of process gas compressors The assessee paid towards cost contribution allocation ( CCA ) made by the parent company owing to lack of facilities or manpower for various fields (such as legal, marketing, technical, etc.) The TPO held that no real service was availed and the expenditure was not genuine and as such ALP is NIL Ruling by Mumbai Tribunal revenue officers had no authority to question the assessee s commercial wisdom or decide what was necessary, in order to conduct business effectively It can not be said that since the assessee had qualified staff on its roll, there was no need for it to obtain services from AE it is wholly irrelevant as to whether the assessee benefits from it or not; the real question is whether the price of this service is what an independent enterprise would have paid for the same. allocation of cost on the basis of head count and turnover was reasonable 30

31 Marketing Intangibles 31

32 Marketing Intangibles Within a multinational group, the trade mark owner is typically a separate entity, legally and geographically, from the subsidiary that undertakes the marketing investment Typically, development of the market is at the risk and economic cost of the distributor (or) the foreign parent indirectly subsidises the development of the market through a reduced transfer price (or) the foreign parent provided the distributor with a rebate of a portion of the distributor s advertising & market promotion spend (AMP) based on sales volumes High marketing expenditure by a subsidiary is increasingly being scrutinised by revenue authorities The authorities are either a) Disallowing AMP expenditure of distributor b) Deeming a service fee for the marketing effort c) Expect higher marketing margins as return for investment 32

33 LG Electronics ITAT Special Bench Background LG Electronics Inc. ( LGK/AE ) is a Korean Company engaged in the manufacture, sale and distribution of electronic products and electrical appliances LG Electronics India Pvt. Ltd. ( LG India/ assessee ) is wholly owned subsidiary of LGK and has been engaged in manufacture and sale of LG brand goods LGK allowed LG India to use the LG brand name without any royalty Transfer pricing field officer observed that LG India incurred AMP expenses of 3.85% of sales, which is more than the average AMP/ Sales ratio of two of comparables, Videocon and Whirlpool (1.39%) Questions Whether transfer pricing adjustment can be made in relation to AMP expenses incurred by the taxpayer? Whether the taxpayer ought to have been compensated by the associated enterprises (AE) in respect of such AMP expenses alleged to have been incurred for and on behalf of the AE? 33

34 LG Electronics ITAT Special Bench Ruling in Brief by majority of Judges There is a valid transaction in the form of excessive AMP expenses incurred by LG India enhancing the LG brand, legally owned by LGK. Amount of the transaction is calculated by applying the bright line test, i.e. based on level of AMP expenses of comparable companies LG India s AMP cost were divided between Those assisting local product sales Those enhancing global brand value The amounts enhancing brand value should be paid by LGK along with a mark-up 34

35 Glaxo Smithkline Consumer Healthcare Limited Facts The assessee engaged in manufacturing and selling of nutritional products under the brands Horlicks, Boost, Maltova and Viva in India Per TPO assessee had created a marketing intangible by incurring a huge AMP expenditure on a brand owned by an AE and thus, should have been compensated at ALP by AE The TPO added a mark-up of 13.04% to the excessive AMP expenditure incurred by the assessee after deducting the brand development expenditure Ruling by Chandigarh Tribunal In view of the majority decision in LG Electronics Special Bench case, incurring of AMP expenses constitute an international transaction Expenses incurred in connection with sales such as discount on sales, market research expenses, sales promotion expenses, selling and distribution expenses and service charges paid to selling agents were to be excluded from AMP expenses The ITAT directed the TPO to determine ALP only in relation to AMP expenditure incurred for promotion of only the foreign brand and no adjustment is required to be made in respect of the advertisement expenses attributed to the promotion of domestic brand owned by the assessee 35

36 Key Takeaways 36

37 Key Takeaways Detailed FAR analysis for tested party and comparable companies is crucial ; taxpayers must have a robust documentation with sound FAR analysis and well developed economic analysis to justify the transfer prices 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 Considering the factual nature of the transfer pricing disputes - the rulings have a limited precedent value in case there are variation in facts 37

38 Avoiding the Litigation: Introduction of APAs 38

39 Features of Indian APA Program Any person who has undertaken or is proposing to undertake an international transaction shall be eligible to enter into an APA Unilateral, bilateral and multilateral APAs may be entered into For bilateral and multilateral APAs application to be filed with Indian Competent Authority APA team to include experts in economics, statistics, law or any other field Pre-filing consultation available including anonymous pre-filing route taxpayer may withdraw the application of APA at any time before the finalization of the terms of the APA The APA shall be entered into after its approval by the Indian Government APA shall not be binding on the Government or the taxpayer if there is a change in any of the critical assumptions Taxpayer to file annual compliance return and tax authorities to carry out yearly compliance audit Revision of APA possible in case of change in critical assumptions/ law/ Request from competent authority of other country in case of bilateral and multilateral agreements Renewal of the agreement is permissible No provision for roll-back as well as no formal firewalls between APA and tax authorities 39

40 The APA Process in India Phase 1: APA Planning Phase 2: Pre-filing Phase 3: APA Submission Phase 4: Post- Submission Process Phase 5: Drafting and Compliance APA strategy Fact gathering and analysis Economic analysis Prepare prefiling documents Pre-filing meetings with tax authorities Prepare and file APA request /submission Acceptance letter Receive/Reply to tax authority questions Second, third round questions Finalize APA and sign agreements Adjustments and APA annual reports Meetings with tax authorities Site visits Annual Audit by tax authorities Position Paper APA negotiations 40

41 Q & A 41

42 This material prepared by Deloitte Haskins & Sells (DHS) is intended to provide general information on a particular subject or subjects and are not an exhaustive treatment of such subject(s).further, the views and opinions expressed herein are the subjective views and opinions of DHS based on such parameters and analyses which in its opinion are relevant to the subject. Accordingly, the information in this materials is not intended to constitute accounting, tax, legal, investment, consulting, or other professional advice or services. The information is not intended to be relied upon as the sole basis for any decision which may affect you or your business. Before making any decision or taking any action that might affect your personal finances or business, you should consult a qualified professional adviser. None of DHS, its member firms, or its and their respective affiliates shall be responsible for any loss whatsoever sustained by any person who relies on this material. This material is intended only for the use of the entity/person to whom it is addressed and the others authorized to receive it on their behalf. The recipient is strictly prohibited from further circulation of this material. 42