CBDT Instruction No. 3/2016 : A game-changer for TP audits? - Part I Date: Fri, 04/22/2016-15:02 Ajay Kering (Direct or, Grant Thornt on India LLP) Dinesh Ramnani (Manager, Grant Thornt on India LLP) This new instruction replaces Instruction no. 15 of 2015. After receiving suggestions and queries on the earlier instruction, the Central Board of Direct Taxes ("CBDT" or the "Board") has taken an effort to resolve them in this new instruction. The important changes in this instruction as compared to earlier one are: (i) specifying instances, for reference to be made to the Transfer Pricing Officer (" TPO"), for cases selected under non-tp risk parameters. These instances also include where (i) TP adjustment has been made of INR 10 crore or more in earlier years which has been upheld by judicial authorities or pending in appeal; and (ii) where the AO/Investigation wing records findings on TP issues in case of search and seizure or survey operations; (ii) for administrating TP regime in an efficient manner, the Assessing Officer (" AO") should not exercise the powers to perform TP assessments; (iii) instruction applicable to Specified Domestic Transactions (" SDT") as well. The transfer pricing provisions came into force from Assessment year (" AY") 2002-03. Since the inception, the taxpayers were selected for TP assessment based on the value of international transactions. This approach was adopted by the tax authorities relying on the instruction no. 3 of 2013 issued by CBDT to have procedural uniformity and consistency across India for conducting TP assessment. After completion of almost ten audit cycles, CBDT issued Instruction no. 15 of 2015, (October 2015) in which focus shifted to risk based TP assessments with AO' s continuing to being empowered to perform TP assessments, in certain situations. However, this instruction was short-lived and the CBDT has come out with a new instruction clarifying that the AO is not empowered to conduct TP Assessments. This new instruction provides guidelines to: 1. the Assessing Officer ("AO") -- by providing instances for referring the case to the Transfer Pricing Officer ("TPO"); 2. the TPO -- for passing speaking orders, getting appropriate approvals and playing an important role in Advance Pricing Agreement (" APA") compliance and safe harbour applications; 3. the AO passing an order in conformity with the TPO's order and refrain from conducting TP Assessments; and 4. the Commissioner of Income-tax (" CIT") for TP -- to maintain appropriate database for TP assessments for taking future actions and adopting consistent stands. A. Reference to T PO Section 92CA of the Income tax Act, 1961 (" the Act") provides that where an AO considers it expedient, he may refer the computation of Arm' s length price (" ALP") in relation to an international transaction or SDT to the TPO. Under the new instruction, the AO shall make a reference to the TPO only under the following circumstances. 1. Case 1: For cases selected for scrutiny under Computer Assisted Scrutiny Selection or Page 1 of 4
compulsory manual selection system on the basis of TP risk parameters. 2. Case 2: For cases selected for scrutiny on non-tp risk parameters only in following circumstances: a) Where the AO comes to know that the taxpayer has entered into an international transaction or SDT, however the taxpayer has not filed the Accountant's Report ("AR") or has not disclosed the said transaction in AR. b) Where there has been a TP adjustment in taxpayer' s case of INR 10 crores or more in an earlier assessment year and such assessment has been upheld by judicial authorities or is pending in appeal. c) Where in the search and seizure or survey operations, the investigation wing or the AO has recorded findings regarding TP issues. Jurisdictional requirement of the AO for certain situations under cases 1 and 2: While making a reference to the TPO (in accordance with Cases 1 and 2 as above), in respect of transactions having following situations, the AO must record to his satisfaction that there is an income/potential income arising or being affected on determination of the ALP: i. Situation where the taxpayer has not filed the AR but the international transaction or SDT undertaken by it comes to the notice of the AO; ii. Situation where the taxpayer has not declared one or more international transaction or SDT in the AR and the same comes to the notice of the AO; iii. Situation where the taxpayer has disclosed the transactions but has made certain qualifying remarks that the said transaction is not an international transaction or does not affect the income of the taxpayer. In all the above 3 situations the taxpayer should be allowed an opportunity of being heard. In case no objection is raised by the taxpayer, the AO may proceed with his observations and refer the case to the TPO. If however the assesse objects to the findings of the AO, the AO has to pass a speaking order considering assessee' s objection and accordingly decide whether the reference should be made to the TPO or not. 3. Case 3 - A case involving TP adjustment in an earlier Assessment year that has been fully or partially set aside by Income-tax Appellate Tribunal (" ITAT"), High Court or Supreme Court on the issue of such adjustment, then it shall invariably be referred to the TPO by the AO. The following flow chart provides a birds eye view of making the reference to the TPO in the cases discussed above: Page 2 of 4
Our comments The rationale of having the jurisdictional requirement by the AO in certain situations, could be to appropriately filter the cases for the TPO. Effectively the new instruction aims at the TPO focusing on determining the arm' s length price of the transactions referred by the AO and the initial decisions for some of the questions (as follows) in taxpayer' s case to be addressed by the AO: whether the AR was required to be filed or not in light of certain transactions coming to the notice of the AO; whether a particular transaction was to be reported in the AR as international transaction / SDT or not; and whether the qualifying remarks provided by the taxpayer in AR to the effect that transaction recorded in AR is not an international transaction or SDT, are valid or not. Mandatory requirement for the AO to pass a speaking order in certain situations before the reference is made to the TPO is a welcome move. However, there are no remedial measures if the AO does not agree to the objections of the taxpayer. Nonetheless, significant onus is put on the AO to consider the taxpayer's objection by passing a speaking order. The definition of international transaction was widened by Finance Act 2012, wherein almost all transactions between associated enterprises (" AE") are required to be reported. Thus, practically the chances of AO determining that a transaction between AEs is not an international transaction or SDT is very meagre. Further, suitable amendments will be required to be made in the online Form 3CEB (AR) utility to capture the relevant data for the AO to determine that the taxpayer has made certain qualifying remarks, as currently there is no provision of providing any notes while filing the AR online. Further, the instruction provides that the AO shall refer to the TPO only the international transaction(s) and/or SDT(s) selected under TP risk parameters. Nonetheless, it has been clarified that since the international transaction(s) selected under TP risk parameters may be benchmarked at entity level due to inter-linkages amongst them, all the transactions should be referred by the AO to the TPO. Thus, practically if a case is selected under TP risk parameters, all international transactions would be referred by the AO to the TPO. Before making a reference to the TPO, the AO needs to seek approval of the Principal Page 3 of 4
Commissioner (" PCIT")/ the Commissioner (" CIT") through a letter explicitly mentioning all the international transactions and/or SDTs being referred. B. Role of T PO After the reference is received from the AO, the role of TPO begins: In case, the TPO notices any other international transaction or SDT during the assessment then he is empowered to determine the ALP of such transaction. The TPO should pass a speaking order and the order shall be supported by relevant documents like data used, reasons for arriving at a certain price and the applicability of methods. The instruction also refers to a specific situation where more than one TP method can be applied which provide different results but equally reliable. In such cases, further scrutiny may be necessary to evaluate the appropriateness of the method, the correctness of the data and the weight given to various factors. Copies of the relevant documents or the relevant data should be made available to the AO to be used at subsequent stages of appellate or penal proceedings. Conduct compliance audit of the Advanced Pricing Agreements. The TPO also has to play an important role for examining the safe harbour applications. Wherever a TPO is an Additional/Joint CIT he shall obtain the approval of jurisdictional CIT (TP) before passing the order and where the TPO is a Deputy/Assistant CIT he shall obtain the approval of Jurisdictional Additional/Joint CIT before passing the order. The jurisdictional CIT(TP) shall assign not more than 50 important and complex cases to each of the TPOs working in the same jurisdiction. For selection of such cases the CCIT (International Taxation) shall frame appropriate guidelines. C. Role of AO Where the case is referred to the TPO, the AO has to pass an order in conformity with TPO's order as per Section 92C(4) of the Income-tax Act. For administering the TP regime in an efficient manner, CBDT has clarified that the AO should not perform the TP Assessment where the matter has not been referred to the TPO. In such cases, the AO must record in the body of the Assessment Order that the TP issue has not been examined. D. Maintenance of database The onus of maintaining the database is on the CIT(TP). The TPO' s will maintain record of international transactions or SDTs in a format prescribed in this instruction by CBDT. This format is designed to serve as database for future action and also take consistent stands for determining arm' s length price in identical or substantially identical cases. CIT(TP) shall also ensure that a consolidated report for the entire charge is maintained after each transfer pricing audit cycle. With inputs from Vaishali Mane (Chartered Accountant) Click here to read Part II. Page 4 of 4
CBDT Instruction No. 3/2016: A game-changer for TP audits? - Part II Date: Fri, 04/22/2016-15:03 Ajay Kering (Direct or, Grant Thornt on India LLP) Dinesh Ramnani (Manager, Grant Thornt on India LLP) (continued from Part I) This instruction is applicable with immediate effect replacing the Instruction no. 15 of 2015. It provides that the references made to the TPO's after the issuance of Instruction no. 15 of 2015 which are not in conformity with this instruction, may be withdrawn by the concerned PCIT or CIT. A comparative analysis of the new instruction with the earlier ones in a tabular form is presented below: Page 1 of 6
Particulars Scrutiny criterion TP Assessment by AO Initial onus of determining the applicability of TP provisions (Chapter X applicability) Instruction no 3 Instruction no 15 of 2003 of 2015 Focus on threshold based scrutiny The AO could determine the ALP of international transactions or SDT if the case was not referred to the TPO TPO to record the reasons to his satisfaction that the TP provisions are applicable Reference to No clarity. AO at TPO for TP his discretion cases set aside could decide by higher whether a appellate reference is authorities required to be made to the TPO or not Approval required by AO before referring the case to the AO has to seek approval of Commissioner or Director Focus on risk based scrutiny and certain non TP risk aspects Instruction no 3 of 2016 Focus on risk based scrutiny and expanding the list of non-tp risk parameters to include cases with TP adjustments of 10 crores or more sustained at higher appellate levels for earlier years and findings on TP issues in search and seizure or survey operations. No change in this The AO should not aspect. The AO conduct TP could determine the Assessments where ALP of international the matter has not transactions or SDT been referred to the if the case was not TPO referred to the TPO AO to initially record the reasons to his satisfaction that the TP provisions are applicable after considering taxpayer' s objections, if any Same as Instruction no 15 of 2015 (unless in cases where TP adjustment was set aside by ITAT, HC or SC) No change this The AO has to aspect. AO to mandatorily refer decide whether the such set aside cases reference is to the TPO required to be made irrespective of the to the TPO or not fact that the initial TP Assessment was performed by the AO or the TPO AO has to seek approval of the Principal Commissioner / Commissioner Page 2 of 6 Same as Instruction no 15 of 2015
TPO Approval required by TPO before passing speaking order Approval of Director of Income Tax (Transfer Pricing) required before passing a speaking order Where a TPO is an Additional/Joint Commissioner of Income Tax, approval required from jurisdictional CIT (Transfer Pricing) and where the TPO is a Deputy/Assistant CIT approval of Jurisdictional Additional/Joint CIT required Same as Instruction no 15 of 2015 Maintenance of Onus of Onus of maintaining Same as Instruction database maintaining the database was on the Director of Income Tax. No mention of consolidated report the database is on the CIT. The CIT shall also ensure that a consolidated report for the entire charge is maintained after each transfer pricing audit cycle. no 15 of 2015 E. Global scenario on T P risk parameters There is still no clarity on what are the TP risk parameters that will be applied for selection of cases for scrutiny. It is quite possible that the tax authorities in India may rely on the Organisation of Economic Co-operation and Development (" OECD") guidance for selecting cases for scrutiny under TP risk parameters. The OECD in its draft handbook on TP risk assessment has provided a framework for assessing the TP risk. This Handbook provides a practical resource that can be used by any tax administration seeking to develop or improve its risk assessment procedure, methods and practices. The OECD has given some examples of the TP risk parameters along with guidance to the tax authorities as to where the tax authorities would be able to find such information. The below table provides some insight on this: Page 3 of 6
Sr. T P risk Brief description No. parameters as per OECD 1 Significant transactions with related parties in low Where the transactions take place with the entities located in low taxed jurisdictions, there is a risk that mispricing tax jurisdictions will incorrectly attribute excess profits to the low taxed jurisdiction. 2 Transfers of intangibles of related parties Transactions of this nature raise difficult valuation questions, especially where the intangibles are unique and consequently there is a lack of comparables. Where the tax authorities is likely to find this information Patent office 3 Business restructurings 4 Intra-Group services The business structures and transaction flows adopted in connection with restructuring an MNE s business need careful consideration. There are two aspects of such transactions to be considered. The first is the restructuring transaction itself. The transfers of assets, including intangibles, in connection with such transactions can give rise to difficult valuation and other transfer pricing issues. Often these transactions involve efforts to move valuable assets into more tax favoured environments. Parent companies or regional headquarters offices often provide administrative or other general services for members of the MNE group. Even when such services are charged at cost or at cost plus a small mark-up, questions may arise as to whether the level of the overhead charge is Page 4 of 6 Taxpayer s website Press reports / trade magazines Securities analysts reports
5 Specific types of payments appropriate to the size of the subsidiary given the nature of benefits received. Payments of interest, insurance premiums and royalties to related parties because the underlying rights are highly mobile and consequently there is a risk that the payments do not reflect the true value being added by the related party. 6 Loss making Year on year loss making where there is no attempt made to change business operations or financing. Sustained losses may be evidence that the reported results do not reflect the true value of the business. 7 Poor results Similarly results that are not consistent with industry norms or with the functions carried on by the enterprise in the country concerned may be evidence that related party transactions have not been correctly priced. Commercial databases Press reports / trade magazines Securities analysts reports 8 Effective tax rate 9 Poor/Nonexistent Significant variations between the effective tax rate reported at group level and the nominal rates to which it is subject can be the result of transfer pricing that allocates too much profit to low tax jurisdictions. Evidence that transfer prices and the methods used to compute them are inadequately recorded casts doubt on the reliability of the prices themselves. Consolidated financial 10 Excessive debt Debt that appears to be in Page 5 of 6
excess of the amount that an entity could borrow if it were a free standing entity, or interest rates that appear to be in excess of market rates Further, for some of the developed countries like UK, Germany and Australia, the tax authorities generally gives consideration to the size and nature of the related party dealings, the quality of any transfer pricing and whether or not the taxpayer s results appear to be commercially realistic. The tax authorities in these jurisdictions have developed a sophisticated risk engine that takes these factors, along with other financial and industry data, into consideration in determining which taxpayers to review. Some of the related party transactions that may attract their attention are: Business restructuring including Companies undergoing supply chain restructurings; Transactions with related parties in low tax jurisdictions; Financing arrangements, including interest-free loans, interest-bearing loans and guarantee fees; Intra-group services transactions such as management fees; Fluctuations contrary to market trends Intangible related transactions; Cost allocation arrangements. Closing remarks This instruction certainly lays down comprehensive conditions for the AO to refer the case to the TPO. The clarification that the AO cannot examine the arm' s length price is a big relief for the assessee' s not having substantial international transactions. The objective of the instruction is to formulate and implement the TP audit framework to select only high risk cases so as to effectively channelize the scarce resources available with the Board for monitoring TP challenges in India. It could be anticipated that the Board s strategy to collate relevant information will evolve in the near future, which could inter alia result in the Board making suitable amendments to certain source documents capturing information on international transactions. To sum up, this instruction reinforces the intention of the Government of India to reduce undesirable litigation and focus only on scrutinising key aspects of TP based on merits. Further, this instruction will also go a long way in providing much required transparency in the TP audit land scape in India. Page 6 of 6