1 TRANSFER PRICING - DOMESTIC TRANSACTIONS AN INSIGHT GAURAV SHAH OCTOBER 2012
Table of Contents Introduction to Transfer Pricing International Transfer Pricing Background Domestic Transfer Pricing Differences and Similarities Case Studies Typical Structures where Domestic TP will be applicable Addressing Domestic TP Challenges 2
Introduction to Transfer Pricing
Background of Transfer Pricing 60% of world trade is understood to be carried out within related parties Pricing between related parties is commonly used for tax management Transfer Pricing (TP) Regulations were introduced to ensure fair collection of taxes TP is a mechanism to determine the Arm s Length Price (ALP) of transactions between Associated Enterprises ALP = price at which unrelated parties would have entered into the transaction under uncontrolled conditions (similar to market price) Generally, adjustments are made to taxable income of the taxpayer in case the relevant transactions are not carried out at ALP Thus, poor TP management may result in double taxation for the group as a whole 4
Transfer Pricing in India Legislative Framework TP Introduced in India w.e.f. FY 2001-02 Indian TP Law contained in Sections 92 to 92F, and Rules 10A to 10E Administrative Framework Separate Transfer Pricing wing of Income Tax Department Increase in the number of Specialist Transfer Pricing Officers Extensive local and international training imparted to Transfer Pricing Officers Ground-level Scenario TP adjustments estimated over US$19 bn in past 7 audit cycles, and continuously rising Incremental coverage of Indian Transfer Pricing Regulations 5
Transfer Pricing Process Identification of Associated Enterprises / Related Parties Identification of Transactions subjected to Transfer Pricing Determination of Arm s Length Price (ALP) Benchmarking Analysis Documentation & Certification 6
Basic Compliance Requirements in India Maintenance of Prescribed Documentation Issuance of Form 3CEB To be physically filed by due date with the Income Tax Department Cannot be revised Stringent Penalties for non-compliance No exemption from compliance Even transactions worth Re 1 covered Relaxation in documentation requirements if transactions < Rs1crore Compulsory Scrutiny / Reference if transactions > Rs 5 / 15 crores 7
International Transfer Pricing
Key Concepts Associated Enterprises International Transactions Arm s Length Price (ALP) 9
Methods of Determining ALP Other Method TNMM CUP Arm s Length Price RPM CPM PSM 10
Background Domestic Transfer Pricing
Tax Arbitrage between Related Parties 12 Scenario 1 Scenario 2 Particulars A Ltd. B Pvt. Ltd. Particulars A Ltd. B Pvt. Ltd. Tax Rate 30% 30% Tax Rate 30% 30% Sale to Related Party 1000 - Sale to Related Party 1500 - Sales to third parties 2000 4000 Sales to third parties 2000 4000 Purchase from Related Party - 1000 Purchase from Related Party - 1500 Other Expenses 4000 2000 Other Expenses 4000 2000 Profit/ Loss -1000 1000 Profit/ Loss -500 500 Tax NIL 300 Tax NIL 150 Total Tax for the Group 300 Total Tax for the Group 150
Tax Arbitrage for Tax Holiday Units 13 Scenario 1 Scenario 2 Particulars Unit 1 Unit 2 Particulars Unit 1 Unit 2 Tax Rate 0% 30% Tax Rate 0% 30% Sale to Ineligible Unit 1000 - Sale to Ineligible Unit 2500 - Sales to third parties 2000 4000 Sales to third parties 2000 4000 Purchase from Eligible Unit - 1000 Purchase from Eligible Unit - 2500 Other Expenses 4000 2000 Other Expenses 4000 2000 Profit/ Loss -1000 1000 Profit/ Loss 500-500 Tax NIL 300 Tax NIL NIL Total Tax for the Group 300 Total Tax for the Group NIL
Relevant Amendments & Background TP provisions have been traditionally applied only to international transactions Taking cue from Supreme Court s suggestion in case of GlaxoSmithkline Asia (P) Ltd, Finance Act 2012 has extended TP provisions to Specified Domestic Transactions (SDTs), including: Payment to Related Parties, covered under Section 40A(2)(b) Inter-unit transactions by units covered under Section 80-IA, 80-IB, 80-IC, 80-ID, 80-IE, SEZ units and SEZ Developers Intra-group transactions by taxpayers covered under Section 80-IA, 80-IB, 80-IC, 80-ID, 80-IE, SEZ units and SEZ Developers Other prescribed transactions TP Regulations apply if sum of above transactions exceed Rs. 5 Cr. Corresponding amendments also carried out in relevant sections 14
Relationships Covered in Domestic Transfer Pricing Any Taxpayer Tax Holiday Taxpayer Tax Holiday Taxpayer Related Parties as defined in Section 40A(2)(b) Any other eligible or noneligible unit of the same Taxpayer Any person with whom the course of business is so arranged, which results in excess profits in the tax holiday unit either due to close connection or any other reason 15
Transactions Covered in Domestic Transfer Pricing Related Parties Tax Holiday Taxpayer Tax Holiday Taxpayer Any payments of expenditure to related parties Inter-unit transfer of goods or services Any business transacted between the taxpayer and the other person 16
Which Transactions will be Impacted by These Provisions? All payments to related parties Purchase of goods / services Management fees / royalties Interest payments on loans taken from Related Parties / guarantee fees paid to related parties Purely domestic transactions - Managerial Remuneration, payment of rent, equipment hire etc. Cost allocations Specific Transactions for Tax Holiday Taxpayers Transfer of goods and services between tax holiday unit and another unit Any business transacted with any person, where such business produces more than ordinary profits eligible for tax holiday; owing to close connection or any other reason 17
Differences and Similarities
Differences between pre and post amendment scenarios... Area of Difference Pre-Amendment Post-Amendment Concept Nature Ad-hoc adjustments Burden of Proof Approach of Taxpayer Compliance Burden Fair Value / FMV Open / flexible Commonly being made Revenue Reactive Basic Reporting in TAR Arm s Length Price Systematic / static Should be avoided Taxpayer Proactive Onerous 19
Differences between pre and post amendment scenarios Area of Difference Pre-Amendment Post-Amendment Cost based analysis Tax Evasion Managerial Remuneration High Interest Paid Tax Holiday Units AE as Comparables Accepted / not accepted Relevant Broad Justification Nexus with loan given ALP not relevant Allowed / not allowed Accepted Not Relevant Justification of amounts Nexus not required ALP specifically applied Not allowed 20
Similarities between pre and post amendment scenarios 21 Applicability Related Parties for 40A(2); Specific relationships for 80-IA & related Sections Coverage of transactions Payments for 40A(2); Specific transactions for 80-IA & related Sections Comparability considerations Payments to entities performing different functions cannot be compared Comparables need to be comparable and not identical Internal comparables are valid comparables Interest on loans with different characteristics (short term vs long term, normal vs emergency etc.) cannot be compared Need for making appropriate comparability adjustments Relationship between 37(1) and 40A(2) - 40A(2) overrides 37(1)? Use of Appropriate Allocation Keys for tax holiday units, for inter-unit transfers
Differences between International and Domestic TP... Area of Difference International Domestic International Guidance APA Managerial Remn / Rent Threshold for compliance Tested Party Revenue Loss to Govt. Available Available Not Applicable NIL Preferably Taxpayer Generally Relevant Not Available Not Available Applicable INR 5 Crores Taxpayer or other party Not Always Relevant 22
...Differences between International and Domestic TP Area of Difference International Domestic Applicability Ownership Threshold Transactions Covered ALP Options for Interest Forex Fluctuations Reporting / Form 3CEB Associated Enterprises 26% All Transactions LIBOR / Eurobor / Rupee Relevant Practically easier Related Parties 20% Limited Transactions Only Rupee Denomination Not Applicable Needs modification 23
Similarities between International and Domestic TP Compliance requirements Documentation and Form 3CEB Burden of Proof on the Taxpayer Methods for determining ALP Any of the 6 methods can be used, provided it is Most Appropriate Method Scrutiny by TPO Corresponding Adjustments not allowed Poor Transfer Pricing would lead to additional tax cost Deadlines for compliances and scrutiny 24
Case Studies
Relationships covered under Section 40A(2) Is Domestic TP applicable in case where: B pays to A? C pays to A? D pays to B? B pays to C? D pays to A? D pays to C? A pays to B? 26
Relationships covered for tax holiday units Eligible Unit u/s 80-IA Eligible Unit u/s 80-IA 27
Tax Arbitrage on Sales to Related Party 28 Particulars A Ltd. B Pvt. Ltd. Tax Rate = 30% Scenario 1 Scenario 2 Particulars A Ltd. B Pvt. Ltd. Sale to Related Party 3000 - Sale to Related Party 1000 - Sale to third parties 5000 4000 Sale to third parties 5000 4000 Purchase from Related Party - 3000 Purchase from Related Party - 1000 Other Expenses 2000 3000 Other Expenses 2000 3000 Profit/ Loss 6000-2000 Profit/ Loss 4000 NIL Tax 1800 NIL Tax 1200 NIL Total Tax for the Group 1800 Total Tax for the Group 1200
Director s Remuneration Benchmarking of Director s Remuneration (Rs. 4x paid to Director Mr. A1) Rs. x paid to other Director Mr. A2? Rs. 7.5x paid by B Ltd. to Director Mr. B? Incase of increase in remuneration previous years value comparable? What should be the approach for benchmarking Director s Remuneration? 29
Payment to Partners by Partnership Firm 30 Benchmarking of payment of interest to partner covered under section 40(b) Is section 40A(2)/ transfer pricing applicable? Should ALP be determined? Can 12% interest rate as provided by section 40(b), be considered as ALP? Can payment of interest @ 15% be justified if ALP = 15% or more? Can section 40(b) disallowance be made to the extent of 3%? If ALP = 9%, is section 40(b) still applicable? If interest is paid @ 12%, will 3% be disallowed? What will be the scenario in case of remuneration?
Income from Other Sources A Ltd. is in the business of letting out machinery on rent Payment for repairs of machinery A Ltd. 100% B Ltd. Payment made by A Ltd. to B Ltd. in the nature of repairs expenses, is a business expenditure. Such a payment would come under the purview of section 40A(2), and transfer pricing would be applicable. If A Ltd. was not involved in the business of letting out machinery on rent, would domestic TP be applicable? Would section 40A(2) apply to a non business expenditure? 31
Capital Expenditure Is Domestic TP applicable? Implication of depreciation? Is domestic TP applicable to reduced depreciation? What will be the scenario if B Ltd. is eligible for tax holiday? What will be the scenario if B Ltd. is engaged in specified business as per section 35AD 32
Need for Close Connection for Section 80-IA(10)? Will Domestic TP be applicable to such a transaction structure? Close Connection under section 80-IA(10) What if the intermediary does not have a close connection with the taxpayer? any other reason section 80-IA(10) Is the business transacted so arranged? Which transaction to report in form 3CEB / justify arm s length pricing? 33
Financing Transactions Eligible Unit u/s 80-IA Will Domestic TP be applicable for the Transaction involving transfer of funds? Does Unit 1 need to pay Unit 2 an arm s length interest on the funds transferred? What will be the scenario if the funds were transferred to bank account of Unit 1 from the bank account of a party having close connection with the taxpayer? What will be the scenario if the funds were transferred to bank account of Unit 1 from the bank account of a third party? 34
Allocation of R&D Expenses 35 Facts: Issues: R&D expenses incurred by HO and various units booked in respective books Indirect costs of ABC Ltd. booked in HO books Allocation for R&D Expenses booked by HO? Allocation for common costs booked by HO? At cost, or with mark-up? Basis of cost allocation? What if no allocation made to units? Implication of similar arrangement with X Ltd? Reporting requirements
Transfer Pricing Section 40A(2) Vs. Section 80-IA Assume, arm s length price of the rent paid is Rs. 100 Cr. What if the transaction price is Rs. 80 Cr.? What if the transaction price is Rs. 120 Cr.? Practical issues in price setting! 36
Typical Structures where Domestic TP will be applicable
Different group entities in the value chain 38
Integrated Business Group Manufacturing 39
Integrated Business Group Services 40
Sharing of Common Resource Pool Lease Rentals Lease Rentals for Office Space Allocated Share of Lease Rentals 41
Points to Ponder
Points to Ponder Is 40A(2) still relevant? Reconciliation between disclosures in Notes to Accounts (AS 18), Tax Audit Report, Form 3CEB, cost audit reporting & company law requirements Practical Issues in Form 3CEB Does 5 / 15 Cr. Threshold for compulsory transfer pricing scrutiny also include Domestic Transactions? 43
Addressing Domestic TP Challenges
Tools to Address Domestic TP Challenges Transfer Pricing policy formulation and benchmarking Health check-up of policies, procedures, SOPs and documentation generated Designing pricing policy in relation to specified domestic transactions within the group (planning exercise) Formulating / reviewing cost allocation policies for entities having tax holiday units, or entities sharing common pool of resources Post-facto justification of arm s length pricing of transactions with domestic related parties Rationalizing business structure and model Restructuring the business model (business restructuring) Restructuring the transaction flow Corporate Restructuring in respect of group entities involved in the transaction 45
Transfer Pricing Risk Mitigation Amend structure & policy if required Review Structure of Transactions Evaluate benefits to respective parties Evaluate the policy regularly Real Time Documentation Find comparables / basis of pricing Create / Review Agreement & Relevant Documents Formulate group-level transfer pricing policies 46
THANK YOU gauravshah@mzsk.in +91-9867978894 Senior Manager Direct Tax Advisory (Transfer Pricing Services)