1. “Overview of Transfer Pricing”
INSTITUTE OF CHARTERD ACCOUNTANTS OF INDIA
WEBCAST –
“Overview of Transfer Pricing”
CA T. P. OSTWAL

2. TRANSFER PRICING Brief history Post World War I
What is Transfer Pricing?
Basic Issues Underlying Transfer Pricing
Evolution of Transfer Pricing
Concepts in Transfer Pricing
Transfer Pricing Methods
Special Issues Related to Transfer Pricing
Transfer Pricing in Treaties
Transfer Pricing in Domestic Law
Global Transfer Pricing Regimes
Transfer Pricing as a Current and Future Issue for Developing Countries
Indian Regulation on Transfer Pricing
October 2013

3. Brief history Post World War I
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4. Where and why did the OECD/UN model treaty policy arise as it has?
In , the ICC commenced a process to develop a model income tax treaty in the immediate aftermath of World War I. This was the period of conception for the model treaties of today. This work has been lost as the world has evolved. It is instructive with respect to the current tax policies being espoused by Source Countries.
October 2013

5. The Post-World War I World (1920 – 1923)
Imagine a world, long ago, in which the paradigm of commerce and international taxation was a developed country (let’s call it “England”) and an under-developed country that was a colony of England (“India”). A global war ended, with England having enormous war debt. There was a material flow of commerce between England and India. For the most part, England transferred to affiliates in India capital, technology, and access to global markets. India responded with commodities and produced goods. England was a creditor and India a debtor.
The policy issue for consideration was how income from these activities should be shared between “Resident” and “Source” countries.
October 2013

6. ICC Proposal in 1923 League of Nations (1923 – 1928)
In its interim report in 1923, the ICC proposed what we would call today a profit split or formulary allocation methodology to address income allocation between Residence (Creditor) and Source (Debtor) countries.
Rather close to the combined income methodologies that we typically use today to resolve major CA cases between countries with an MNE in the middle. Frankly, it is also similar to the methodologies for evaluating intangibles in the 2012 OECD discussion draft.
League of Nations (1923 – 1928)
The ICC work was taken over by the League of Nations in The LofN took an entirely different approach. It formulated 5 principles:
October 2013

7. League of Nations (1923 – 1928) cont…
Source Country (India) should tax local operations, including property or other pertinent matters.
Residual income should be earned by the country of Residence, which provided the knowledge and capital for the business.
Presence of an interim holding company should be treated as a Residence Country. Why was this assumed?: All countries would adopt a common model!
Subsidiaries should not be treated as a PE.
TP is to be evaluated on a consistent basis.
The model treaties that eventually became the OECD Model, and subsequently the UN Model, are based on these 5 principles.
October 2013

8. What was the net impact of these principles?
Answer: A system that allowed:
Source Country earns a routine return.
Residence Country receives the residual income.
Interim holding companies would be treated as Residence Countries, even if located in a low tax country.
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9. MNE Tax Planning Strategies
Not surprisingly, the international tax and effective tax rate (“ETR”) strategies of MNEs evolved based on this treaty model. Common structures included what we today describe as:
Global/regional principal
Centralized risk-taker, intangibles owner
Limited risk activities in high tax countries
October 2013

10. Effective Tax Rates (‘ETR‘) strategies are often based on easily applied one-sided TP methodologies, which typically test the earnings of Source Country affiliates.
These strategies are precisely what was contemplated in the work of the LofN, which is the model of OECD/UN model treaties.
Today, MNEs are commonly pilloried for base stripping Source Countries.
October 2013

11. Imperial Paradigm
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12. Present Day Scenario Foreign Parents Costa Rica Developing Countries
Intermediate Holding Company
Dividend
Capital Gain
Costa Rica
BVI
Supply Chain Transaction
Developing Countries
Cayman Island
Bermuda
Interest transfer payments
Luxembourg
Lease transfer payments
Royalty transfer payments
October 2013

13. ANATOMY OF INCOME SHIFTING
(BASE EROSION)
Tax Havens
& many more…
October 2013

14. Is the criticism appropriate
Is the criticism appropriate? Whether this answer is “yes” or “no,” it is apparent to me that this is the behavior that was encouraged by the LofN model. At the time, it may have been intended to facilitate repatriation of revenue to Residence countries to repay war debts.
October 2013

15. What is Transfer Pricing?
October 2013

16. Introduction to Transfer Pricing
Rise to a large number of multinational enterprises (MNEs)
Rise of intra group trade – including highly complex international transactions involving intangibles and multi- tiered services
MNE transaction structure determined not only by open market but also by group driven forces inclined towards the common interests of the entities of a group
Determination of transfer price becomes imperative
Transfer price to be determined on arms length basis
Transfer pricing therefore refers to the setting of prices (arms length price) for transactions between associated enterprises the transfer of property or services
1 Rapid advances in technology, transportation and communication have given rise to a large number of multinational enterprises (MNEs) which have the flexibility to place their enterprises and activities anywhere in the world. 2 A significant volume of global trade nowadays consists of international transfers of goods and services, capital (such as money) and intangibles (such as intellectual property) within an MNE group; such transfers are called “intra-group” transactions. There is evidence that intra-group trade is growing steadily and arguably accounts for more than 60 per cent of all international transactions. 3 In addition, transactions involving intangibles and multi-tiered services constitute a rapidly growing proportion of an MNE’s commercial transactions and have greatly increased the complexities involved in analysing and understanding such transactions. 4 The structure of transactions within an MNE group is determined by a combination of the market and group driven forces which can differ from the open market conditions operating between independent entities. Thus, a large and growing number of international transactions are no longer governed entirely by market forces, but by forces which are driven by the common interests of the entities of a group. 5 In such a situation, it becomes important to establish the appropriate price, called the “transfer price”, for intra-group, cross-border transfers of goods, intangibles and services. Transfer pricing is the general term for the pricing of cross-border, intra-firm transactions between related parties. “Transfer pricing” therefore refers to the setting of prices for transactions between associated enterprises the transfer of property or services. These transactions are also referred to as “controlled” transactions, as distinct from “uncontrolled” transactions between companies that, are not associated and can be assumed to operate independently (“on an arm’s length basis”) in reaching terms for such transactions.
October 2013

17. Concept of transfer pricing – Example 1
ABC
H Co
S Co
XYZ
Country A
Country B
Purchase of
computer
from S Co
“Controlled
Transaction”
from third party
“Uncontrolled
Example: Consider a profitable computer group in country A that buys “flash-memory drives” from its own subsidiary in country B: how much the parent company in country A pays its subsidiary company in country B (the “transfer price”) will determine how much profit the country B unit reports and how much local tax it pays. If the parent pays the subsidiary a price that is lower than the appropriate arm’s length price, the country B unit may appear to be in financial difficulty, even if the group as a whole shows a reasonable profit margin when the completed computer is sold.   From the perspective of the tax authorities, country A’s tax authorities might agree with the profit reported at their end by the computer group in country A, but their country B counterparts may not agree - they may not have the expected profit to tax on their side of the operation. If the computer company in country A bought its flash-memory drives from an independent company in country B under comparable circumstances it would pay the market price, and the supplier would pay taxes on its own profits in the normal way. This approach gives scope for the parent or subsidiary, whichever is in a low-tax jurisdiction, to be shown making a higher profit by fixing the transfer price appropriately and thereby minimising its tax incidence.
Transfer price of controlled transaction to be equivalent to market price of a
comparable uncontrolled transaction; If lower, Country B loses revenue.
October 2013

18. Concept of transfer pricing – Example 2
Illustration:
PQR S Co is the distributor of PQR H Co’s watches in Country B
Manufacturing Cost to Hco.  $1400
Distribution Cost to SCo  $100
Transfer price  $1500
Sale price in Country B  $1600
H Co Profit  $100
S Co Profit  NIL (Cost =Revenue)
Tax authorities of Country B insists that S Co should atleast report a profit of $100; thus transfer price to be reduced to $1,400 – Leads to economic double taxation.
PQR
H Co
Country A
Country B
PQR
S Co
Example Consider next the example of a high-end watch manufacturer in country A that distributes its watches through a subsidiary in country B. Let us say the watch costs $1400 to make and it costs the country B subsidiary $100 to distribute it. The company in country A sets a transfer price of $1500 and the subsidiary unit in country B retails the watch at $1600 in country B. Overall, the company has thus made $100 in profit, on which it is expected to pay tax.   However, when the company in country B is audited by country B’s tax administration they notice that the distributor itself is not showing any profit: the $1500 transfer price plus the country B unit’s $100 distribution costs are exactly equal to the $1600 retail price. Country B’s tax administration considers that the transfer price should be shown as $1400 so that the country B’s unit shows the group’s $100 profit that would be liable for tax.   However this poses a problem for the parent company, as it is already paying tax in country A on the $100 profit per watch shown in its accounts. Since it is a multinational group it is liable for tax in the countries where it operates and in dealing with two different tax authorities it is generally not possible to just cancel one out against the other .So the MNE can end up suffering double taxation on the same profits where there are differences about what constitutes the appropriate transfer pricing.
Customers
October 2013

19. Transfer Pricing and Business Enterprises
Pricing multiple transactions with associated entities in different tax jurisdictions
Measurement of performance of the individual entities in a MNE
MNE intra-group transactions are undertaken only of its profitable
Identifying and valuing intangibles transferred and services provided
Transfer price of non-accounted intangibles
Transfer price of intra department transactions
A possible reason for associated entities charging transfer prices for intra-group trade is to measure the performance of the individual entities in a multinational group. The individual entities within a multinational group may be separate profit centres and transfer prices are required to determine the profitability of the entities. However not every entity would necessarily make a profit or loss in arm’s length conditions. Rationally, an entity having a view to its own interests as a distinct legal entity would only acquire products or services from an associated entity if the purchase price was equal to, or cheaper than, prices being charged by unrelated suppliers. This principle applies, conversely, in relation to an entity providing a product or service; it would rationally only sell products or services to an associated entity if the sale price was equal to, or higher than, prices paid by unrelated purchasers. Prices should on this basis gravitate towards the so-called “arm’s length price”, the transaction price to which two unrelated parties would agree transaction. Though the above explanation of transfer pricing sounds logical and innocuous, arriving at an appropriate transfer price may be a complex task particularly because of the potential difficulties in identifying and valuing intangibles transferred and services provided. For example, intangibles could be of various different types such as: industrial assets like patents, trade types, trade names, designs or models, literary and artistic property rights, know-how or trade secrets. Sometimes such intangibles are reflected in the accounts and sometimes not. Thus, there are many complexities involved which have to be taken into account while dealing with transfer pricing in cross-border transactions between MNE entities. Transfer pricing is an term used in economics so it is useful to see how economists define it. In business economics a transfer price is considered as the amount that is charged by a part or segment of an organisation for a product, asset, or service that it supplies to another part or segment of the same organisation.
October 2013

20. Basic issues underlying Transfer Pricing
Cross border tax situations involve issues related to jurisdiction, allocation of income and valuation.
A MNE Group may exploit the opportunity to shrink the overall tax burden of the group through either under-charging or over-charging the associated entity for intra-group trade:
Illustration:
Tax rate in the resident country A of HCo.  30%
Tax rate in the resident country B of SCo.  20%
HCo shifts profits from Country A to Country B through HCo. being over-charged for the acquisition of property and services from SCo.
A group may transfer the tax loss of an associated enterprise in a jurisdiction where losses cannot be carried forward beyond the prescribed time limit to a jurisdiction without such restrictions so as to fully utilize the same.
In some cases loss may be transferred to take the benefit of deductions as quickly as possible.
Evidently profits may sometimes be shifted to certain countries in order to obtain specific tax benefits.
Reduction of taxation not the only factor contributing to the transfer pricing policies and practices of a MNE Group
Basic issues underlying Transfer Pricing Transfer prices serve to determine the income of both parties involved in the cross-border transaction. The transfer price therefore tends to shape the tax base of the countries involved in cross-border transactions. In any cross-border tax scenario, the parties involved are the relevant entities of the MNE group along with the tax authorities of the countries involved in the transaction. When one country’s tax authority adjusts the profit of a group member of the MNE group, this may have an effect on the tax base of another country. In other words, cross border tax situations involve issues related to jurisdiction, allocation of income and valuation. The key jurisdiction issues are which government should tax the income of the group entities engaged in the transaction, and what happens if both governments claim the right to the same income. If the tax base arises in more than one country, should one of the governments give tax relief to prevent double taxation of the relevant entities’ income, and if so, which one? An added dimension to the jurisdictional issue is motivation for transfer pricing manipulation as some MNEs engage in practices that seek to reduce their overall tax bills. This may involve profit shifting through non-arm’s length transfer pricing in order to reduce the aggregate tax burden of a multinational group. It may be noted that the reduction of taxation may be a motive influencing an international enterprise in the setting of transfer prices for intra-group transactions, but it is not the only factor contributing to the transfer pricing policies and practices of an international enterprise.
October 2013

21. Basic issues underlying Transfer Pricing
The key issues in jurisdiction:
Which country should tax the income of the group entities engaged in the transaction?
What happens if both countries claim the right to tax the same income?
If the tax base arises in more than one country, should one of the country’s give tax relief to prevent double taxation of the relevant entities’ income, and if so, which one?
What needs to be done to minimise profit shifting from one country to another?
The key issues in valuation:
Valuation of intra-group transfers that are prone to manipulations
With the MNE being an integrated structure with the ability to exploit international differentials and to utilise economies of integration not available to a stand- alone entity, transfer prices within the group are unlikely to be the same prices that unrelated parties would negotiate
The aim of non-arm’s length transfer pricing in such cases is to usually to reduce a multinational group’s worldwide taxation. This can be achieved by shifting profits from associated entities in higher tax countries to associated entities in relatively lower tax countries through either under-charging or over-charging the associated entity for intra-group trade.
For example, if the parent company an international MNE group has a tax rate in the residence country of 30% and it has a subsidiary entity resident in another country with a tax rate of 20%, the parent may have an incentive to shift profits to its subsidiary to reduce its tax rate on these amounts from 30% to 20%. This may be achieved by the parent being over-charged for the acquisition of property and services from its subsidiary.
A motivation for an international enterprise to engage in such practices is to use a tax benefit, such as a tax loss, in a jurisdiction in which it operates. This may be either a current year loss or a loss that has been carried forward from a prior year by an associated company. In some cases an international enterprise may wish to take advantage of an associated company’s tax losses before they expire, in situations where losses can only be carried forward for a certain number of years. Even if there are no restrictions on carrying- forward tax losses by an associated company, the international enterprise has an incentive to use the losses as quickly as possible. In other words profits may sometimes be shifted to certain countries in order to obtain specific tax benefits.
In short, international taxation, especially transfer pricing related issues, throws open a host of issues, the complexity and magnitude of which are often especially daunting for smaller tax administrations.
October 2013

22. Basic issues underlying Transfer Pricing
The key issues in allocation of income:
MNE’s
Optimal allocation of common resources and overheads and achieve competitive advantage
Reduction of transaction cost
Government
Expand tax base
Transfer pricing rules are essential for countries (for Tax administration and Tax Payers) in order to
- Protect their tax base;
- Eliminate double taxation ; and
- Enhance cross border trade
MNEs are global structures which may share common resources and overheads. From the perspective of the MNE, these resources need to be allocated with maximum efficiency in an optimal manner.
From the governments’ perspective, the allocation of costs and income from the MNE resources needs to be addressed to calculate the tax. There sometimes tends to be a dispute between countries in the allocation of costs and resources owing to their objective of maximising the tax base in their respective nation states. From the MNE’s perspective, any trade or taxation barriers in the countries in which it operates raise the MNE’s transaction costs while distorting the allocation of resources. Furthermore, many of the common resources which are a source of competitive advantage for the MNEs cannot be separated from the income of the MNE’s group members for tax purposes this is especially true in the case of intangibles and service-related intra-group transactions. Mere allocation of income and expenses to one or more members of the MNE group is not sufficient; the income and expenses must also be valued.; key issue of transfer pricing is therefore, the valuation of intra-group transfers.
With the MNE being an integrated structure with the ability to exploit international differentials and to utilise economies of integration not available to a stand- alone ,entity, transfer prices within the group are unlikely to be the same prices that unrelated parties would negotiate.
In short, transfer pricing rules are essential for countries in order to protect their tax base, to eliminate double taxation and to enhance cross border trade. For developing countries, transfer pricing rules are essential to provide a climate of certainty and an environment for increased cross-border trade while at the same time ensuring that the tax administration is not losing out on critical tax revenue. Transfer pricing is of paramount importance and hence detailed transfer pricing rules are essential.
October 2013

23. Evolution of Transfer PricingUS
First country to adopt a comprehensive transfer pricing legislation in 1968.
OECD
Reports on transfer pricing in 1979 and 1984
issued the TP Guidelines in 1995 as amended by 2010 version
United Nations (UN)
Report on “International Income Taxation and Developing Countries” in 1988.
The UN Conference on Trade and Development (UNCTAD) also issued a major report on Transfer Pricing in 1999.
The United Nations (UN) is again taking a leadership role, through its Transfer Pricing Manual, in trying to arrive at updated global transfer pricing guidance which can be used by countries all over the world in developing (or calibrating) their transfer pricing regulations.
European Commission (EC)
Proposals on income allocation to EC members of MNEs
October 2013

24. Concepts in Transfer Pricing
Transactions with related parties must be based on the “arm’s length principle” (ALP)
Arm’s length principle” (ALP)
Origins in Contract law
to arrange an equitable agreement that will stand up to legal scrutiny, even
though the parties involved may have shared interests.
Not specifically used in Article 9 of both OECD MTC and UN MTC. However it is well accepted by countries as encapsulating the approach taken in Article 9 with some differing interpretations.
October 2013

25. Concepts in Transfer Pricing (contd)...
Using the arm's length principle
Argument in favour
Geographically neutral, as it treats profits from investments in a similar manner
An alternative to the arm’s length principle
Global Formulary Apportionment method
Currently used by
Some states of USA,
Cantons of Switzerland and
Provinces of Canada.
EU is also considering a formulary approach - Common Consolidated Corporate Tax Base (CCCTB) and home state taxation
October 2013

26. Special Issues Related to Transfer Pricing
Intangibles
Trade intangibles
such as know-how relate to (production of goods and the provision of services)
Marketing intangibles (aid in the commercial exploitation of a product or service)
Trade names,
Trademarks and
Client lists
2. Intra-group services
Financial Services (guarantee fees, etc.)
Managerial,
legal,
accounting and finance,
credit and collection,
training and personnel management services.
October 2013

27. Special Issues Related to Transfer Pricing
3. Cost – Contribution Agreements
Jointly develop, produce or obtain rights, assets or services.
Use of “secret comparables”
October 2013

28. Transfer Pricing in Domestic Law
Time limitations
For TP adjustments possible India vis a vis other countries
May lead to double taxation
Safe harbours
Dispute Prevention Measure
Advance Pricing Agreements
Transfer Pricing and / or Controlled foreign corporation provisions
If both applicable – Then first preference to be given to which provisions
If only TP is applicable, whether bringingCFC is necessary – as both are anti avoidance provisions.
Necessity of domestic transfer pricing rules.
October 2013

29. Transfer Pricing in Treaties
Corresponding adjustments - To avoid economic double taxation
eg. Section 482 of Under Section 482 of the Internal Revenue Code (IRC) of U.S
Transfer pricing dispute resolution mechanism
Mutual Agreement Procedure (MAP) – in Article 25.
Arbitration to resolve transfer pricing disputes.
The EU Arbitration Convention
October 2013

30. Global Transfer Pricing Regimes
By the end of 2011 there were around 100 countries with some form of specific transfer pricing legislation as shown by the red shading in the diagram below
October 2013

31. Global Transfer Pricing Regimes ….(contd)
Countries where Transfer Pricing Regulations are in existence
Argentina
Australia
Austria
Belgium
Brazil
Canada
Chile
China
Colombia
Croatia
Czech Republic
Denmark
Dominican Republic
Ecuador
Egypt
Estonia
Finland
France
Germany
Hong Kong
Hungary
India
Indonesia
Ireland
Israel
Italy
Japan
Kenya
Korea, North
Korea, South
Latvia
Lithuania
Luxembourg
Malaysia
Mexico
Namibia
Netherlands
New Zealand
Norway
Oman
Panama
Peru
Philippines
Poland
Portugal
Romania
Russia
Singapore
Slovakia
Slovenia
South Africa
Spain
Sweden
Switzerland
Taiwan
Thailand
Turkey
United Kingdom
United States
Uruguay
Venezuela
Vietnam
Countries where Transfer Pricing Regulations is still emerging
Algeria
Angola
Armenia
Aruba
Bangladesh
Belarus
Bolivia
Botswana
Bulgaria
Burkina Faso
Cambodia
Cote d'Ivoire
Cyprus
El Salvador
Ethiopia
Gambia
Georgia
Ghana
Greenland
Iceland
Kazakhstan
Kuwait
Liberia
Libya
Macedonia
Malawi
Mali
Mauritania
Mauritius
Mongolia
Morocco
Mozambique
Netherlands Antilles
Nicargua
Nigeria
Pakistan
Papua New Guniea
Qatar
Senegal
Sierra Leone
Sri lanka
Trinidad and Tobago
Ukraine
Uzbekistan
Zambia
Zimbabwe
October 2013

32. Lack of knowledge and requisite skill-sets Complexity to administer
Specific challenges – Developing Countries face in dealing effectively with Transfer Pricing Issues
Lack of comparables
Lack of knowledge and requisite skill-sets
Complexity to administer
Growth of the “E-commerce economy”- various ways in which transactions can be done
Location savings
October 2013

33. Part II. The Indian TP Regime

34. Indian TP provisions
Indian TP provisions were introduced under “Chapter X : Special Provisions Relating to Avoidance of Tax”
Chapter X, Section 92 of the Income Tax Act (1961) and Rule 10A-D of the Income Tax Rules (1962)
TP regime was introduced via Finance Bill 2001 w.e.f April 1st 2001.
In other words, India is a relatively new entrant into the TP vortex!
Birds-eye, one-line overview of Indian TP:
Run-of-the-mill TP provisions, OECD-lite and delightfully vague (like most TP provisions)!
October 2013

35. Indian TP Provisions – Section 92
& Rules
Provisions 92
Computation of income having regard to ALP
92A
Meaning of Associated Enterprise
92B
Meaning of International transaction
92BA
Meaning of specified domestic transactions
92C (1)
(Rule 10B, 10C)
Methods of computation of ALP
*Rule 10AB – Any other method for determination of ALP
92CA
Reference to Transfer Pricing Officer (TPO)
92CB
Safe harbour rules
92CC
Advance Pricing agreement
92CD
Effect of advance pricing agreement
92D
(Rule 10D)
Maintenance of information and documents by persons entering into an international transaction or specified domestic transaction
92E
(Rule 10E, Form 3CEB)
Accountant’s Report entering into an international transaction or specified domestic transaction
92F (Rule 10A)
Definitions: Accountant, ALP, Enterprise, PE, Specified date, Transaction *
* Sec 92F – Definitions does not define terms relevant for domestic TP transactions
October 2013

36. Transfer Pricing Penal provisions (a. k
Transfer Pricing Penal provisions (a.k.a ‘rubbing salt into the wound’)
Sr.
No.
Type of penalty
Section
Penalty quantified 1
a) Failure to maintain
prescribed information/
documents
271AA
2% of transaction value
(b) Failure to report any such
transaction or
(c) Furnish incorrect
information 2
Failure to furnish information/
documents during assessment
u/s 92D
271G 3
Adjustment to taxpayer’s
income during assessment
271(1)(c)
100% to 300% of tax on
adjustment amount 4
Failure to furnish accountant’s
report u/s 92E
271BA
INR 100,000
October 2013

37. Indian TP vs. OECD Guidelines Snapshot view*
Concepts
Indian regulations
OECD Guidelines
Associated Enterprises
Very wide definition
Restricted to controlled entities
Comparable range
(FY 2013)Allows 3% range band on avg. results of comparables
Allows for range of comparable data
Multiple year data
Only allows data for current year (and earlier 2 years under limited circumstances)
Permitted
Foreign comparables
Not permitted in practice
Priority of methods
Most appropriate method rule
(Originally) preference for traditional methods
Use of unspecified method
Now specified
Documentation
Stringent
Prudent business principles
Intangibles
definition vegue and unclear No guidelines
Defined and described but progress still not full achieved.
* Modified version of table in ‘Transfer pricing Law and Practice in India – a fine print analysis’
October 2013

38. Indian TP Assessment & Litigation
Commissioner of Income Tax (Appeals)
Assessing Officer (AO)
Transfer Pricing Officer (TPO)
Dispute Resolution panel (DRP)
Income Tax Appellate Tribunal (ITAT)
High Court
Supreme Court
Assessment timeline
example
2011+
2011+
May 2011
Appeal against
CIT(A) order
Appeal against
Final Asst. Order
May 2010
Appeal against
Asst. order
Appeal against
Draft Asst. order
Set-aside / Remanded back to AO
AO:Dec. 2009
TPO reference
TPO: Dec. 2008
TPO Order
u/s 92CA(3)
Form 3CEB
Specified transaction U/S 92BA
Sept.2006 FY
T.P.Ostwal & Associates

39. Part III. Specified Domestic Transactions

40. TP was earlier limited to ‘International Transactions’
The Finance Act 2012, extends the scope of TP provision to ‘Specified Domestic Transactions’ between related parties w.e.f. 1 April 2012
The Supreme Court in the case of CIT vs Glaxo Smithkline Asia Pvt Ltd [ Taxman 35 (SC)] recommended introduction of domestic TP provisions
SDT previously reported/certified but onus was on revenue authorities
Obligation now on taxpayer to report/ document and substantiate the arm’s length nature of such SDT transactions
Shift from generic FMV concept to focused ALP concept
These new provisions would have ramifications across industries which benefit from the preferential tax policies such as SEZ units, infrastructure developers or operators, telecom services, industrial park developers, power generation or transmission etc.
Apart from this, business conglomerates having significant domestic intra-group transactions would be largely impacted
October 2013

41. Overview of Provisions of Section 92BA
Inter unit transfer of goods & services by undertakings to which profit-linked deductions apply
SDT
Expenditure incurred between related parties defined under section 40A
Any other transaction that may be specified
Transactions between undertakings, to which profit-linked deductions apply, having close connection
October 2013

42. Few observations about Indian TP
Six methods – no preferred method
CUP, Cost-Plus, RPM, TNMM, Profit-split and any other method for determination of ALP
TNMM (and CUP) rule the roost
TNMM is like a panacea for its ease of application at the enterprise (or segment level) using an operating margin/cost PLI
Throw in some comparables in the same “industry” and you are set!
“Profit-Split” method is very rarely used
ALP is calculated via arithmetic mean of comparable prices
Threshold limit of international transactions for reference to TPO reference is Rs.15 crores (Rs.150 million)
October 2013

43. Few observations about Indian TP
Prowess™ , CapitalLine™ & Ace TP™ company databases are used for TP reports by all parties including Revenue Department
High volume of transfer pricing litigation today
Many cases pending at appellate stages (mainly, DRP and Tribunals)
Most TP litigations have not reached High Courts and Supreme Court
“Litigation loop” – in many of the cases Tribunal sends back the case to the AO/TPO with certain directions. Time consuming, costly & strain on the system. No quick closure to TP litigation.
October 2013

44. Few observations about Indian TP Finance Act 2012
Many new TP changes with Finance Act 2012
Overall not pro-taxpayer but more a reaction to number of recent judicial rulings!
Retrospective amendments are strewn all over the Indian IT Act (300+ and counting). Budget 2012 introduced many controversial retrospective amendments in TP and otherwise.
Summary of main changes in Finance Act 2012
Specified domestic transactions to come under Indian TP regime
Increase in scope of powers of Transfer Pricing Officer (TPO)
Allow “re-opening” of certain TP assessments where 92E
Arm’s-length range is restricted to +/- 3% tolerance band from FY 2013
October 2013

45. Few observations about Indian TP Finance Act 2012
Summary of main changes in Finance Act 2012 (continued)
Retrospectively deny taxpayers benefit of 5% variation as standard deduction from 1/4/2002 though no reopening of cases completed before 1/10/2009
Retrospectively enlarge the scope of ‘international transactions’ to include guarantees, any debts, business restructuring etc.
Power of DRP to enhance TP variations
Power of appeal by Department against DRP order
GAAR introduced but then postponed
APA introduced - only real welcome step!(Bi-lateral still an issue? Already 147 applications have filed telecom giant semiconductors manufacturer etc.
October 2013

46. RATIONALE OF COMPARABILITY ANALYSIS
Finding the most reliable comparables.
Comparability analysis is used to designate two distinct related analytical steps
an understanding of economically significant relevant characteristics of the Controlled transactions.
comparison between the conditions of the controlled transactions and conditions in transactions between independent enterprises taking place in similar circumstances
October 2013

47. RATIONALE OF COMPARABILITY ANALYSIS
Comparability factors, include:
characteristics of the property or service transferred
functions performed by the parties taking into account assets employed and risks assumed, in short referred to as the “functional analysis”
contractual terms
economic circumstances and
business strategies pursued.
October 2013

48. COMPARABILITY ANALYSIS PROCESS
Understanding the economically significant characteristics of the industry, taxpayer’s business and controlled transactions
- Gathering of basic information about the taxpayer
- Transaction analysis
Evaluation of separate and/ or combined transactions
2. Examination of comparability factors of the controlled transaction
- Characteristics of the property or service transferred
- Functional analysis of the controlled transaction under examination
- Contractual terms of transaction
- Economic circumstances of transaction
- Business strategies of parties
October 2013

49. COMPARABILITY ANALYSIS PROCESS (contd)...
3. Selecting the tested party
4. Identifying potentially comparable transactions - internal and external
5. Comparability adjustments where appropriate
6. Selection of most appropriate transfer pricing method
Determination of an arm's length price or profit (or range or prices or
profits)
8. Documentation of comparability analysis and monitoring.
October 2013

50. Issue #1 Comparables: Whither art thou?
There is a complete lack of comparables in many segments
Problem especially acute in developing countries where there are a number of ‘sunrise’ industries
Result of this data paucity is not merely a lack of comparables but the serious consequence of using incorrect comparables in the TP assessment
Corners are cut when choosing comparables. Absurd comparables seem to get into the mix
International comparables data is nearly impossible to gather
No truly effective analysis of comparables possible with lack of resources and data
It often becomes a case of non-technical people trying to do technical work (example: choosing software verticals)
Bottomline: The whole comparability analysis exercise is at times unsound and indefensible
October 2013

51. Issue #1 Example 1 : Software development industry
Department rejected cost-plus and used TNMM with its set of comparables
Comparables in completely different software verticals – an apples to oranges comparison.
This is not only a problem with the TP assessment order but also a flaw in the underlying system
Comparable search in “software services” may yield these companies!
A.E.
(USA network security software company) X
Cost-plus + 15%
Assessee
Indian subsidiary
(Engaged in network security software development)
TPO: Adopt TNMM with third-party Indian software co’s taken as comparables
1. A transport logistics software company
2. A generic application outsourcing co.
3. An ERP (SAP) software vendor
4. Infosys™ - India’s a mega-IT major
Bottomline: An apple and orange are both fruits –
hence valid comparables under TP!
October 2013

52. Issue #1 Example 2: The Comparables Barter
AE is USA software company, Indian assesse provides back-office support services. Department rejects cost+plus and adopts TNMM. Barter begins!
A.E.
(USA software company)
Assessee (taxpayer) says…
TPO says….
Reject high-turnover companies
Reject low-turnover companies
Reject super-profit companies
Reject loss making comparables
Reject company X , Y and Z - it is functionally different. (Look, my % is within arm’s-length range!)
Reject company X, Y and add company X1, Y1 (Look your % is outside arm’s-length range!)
Risk adjustment of 10% (ad-hoc!)
No risk adjustment whatsoever
Working capital adjustment 2%
Working capital adjustment of 1.5%
…….
Assessee
Indian subsidiary
(Engaged in back-office support services)
In the Fiscal year , two sets of comparables were seen widely used by TPO for determining ALP of IT (Software) and ITES (Back-office/BPO) companies
IT set: 26 comparables, OP/Total cost from 1.38%-60.23% (avg %)
ITeS set: 27 comparbales, OP/Total cost from 13.55% % (avg %)
Bottomline: Most TP studies, especially software, end up being a re-hash of same comparables
October 2013

53. Issue #1 Example 3: Startup companies “an incomparable confusion”
What are the comparables for these three startup scenarios?
If cost-plus is used, the dispute will be on % markup. We will end up with TNMM again looking at sub-optimal comparables
All these transactions involve intangibles. There is absolutely no guidance whatsoever on intangibles in Indian TP
October 2013

54. Issue #2 Adjustments to comparables
TP provisions are delightfully vague!
“(iii)  the net profit margin referred to in sub-clause (ii) arising in comparable uncontrolled transactions is adjusted to take into account the differences, if any, between the international transaction and the comparable uncontrolled transactions, or between the enterprises entering into such transactions, which could materially affect the amount of net profit margin in the open market” Rule 10B(e)(iii) on TNMM
October 2013

55. Issue #2 Adjustments to comparables
TP adjustments in practice is not the same as theory. For example in India it is observed that:
Foreign AE’s are typically not accepted as tested party
Indian TP typically does not allow for adjustments to tested party but only comparables
Foreign comparables are almost always not accepted due to data paucity on adjustments
What are the adjustments which will be accepted?
No specific guidance on this. From practice, adjustments typically not accepted by Revenue are:
Idle capacity, depreciation, risk, differences in accounting policy
Working capital adjustments are accepted to some extent
October 2013

56. Issue #2 Adjustments to comparables
How to quantify these TP adjustments?
How to quantify risk?
How to quantify adjustments for different geographical markets?
Quantification of adjustments are usually ad-hoc or supported using suitably tweaked formulae
Department and taxpayer spar regularly on this issue
Bottomline: Fundamental lack of clarity & guidance with respect to Transfer Pricing Adjustments
October 2013

57. Issue #2 Adjustments to comparables (contd.)
Comparables are rejected using “filters” . Some popular filters used are:
Minimum employee cost of 25% over sales
Different year ending filter
Diminishing revenue filter
Related party filter
On-site revenue filter
Turnover filters
Super-profit (& loss-making) filters
Functional difference filters
These filters are not prescribed in any provision or Rule nor any sort of guidance is provided for them.
October 2013

58. Issue #2 Example 1: Adjustments to comparables
AE (USA)
Internal CUP with company AE as tested party rejected by TPO
Typically foreign companies are not allowed as tested parties.
No good answers for India vs. Brazil, India vs. Mexico geographical market adjustments
TNMM chosen with “Auto ancillaries”
Only one proper comparable but no segmental data available
Other comparables are in “shock-absorbers”, “battery companies”
Moving from one incomplete puzzle (CUP) to an incorrect result (TNMM) is better?
Axle raw material import
Assessee
(Indian automotive axles manufacturer)
Mexico and Brazil axle manufacturers
October 2013

59. Issue #3 Data sources – TPO data gathering powers
AE (UK)
TPO has the “power to call for information” under Section 133(6) of the Act to obtain information from any firm
This power is used often in the TP assessment to gather data on comparables
Practically speaking, assessee may not be given a chance to analyze or provide rebuttal to the info
Also many companies supply information which are prone to wide interpretation
This is a common issue across the board in TP assessments in India
Third party
Indian co’s
Tax return
Assessee
(India)
AO/TPO
TP study
October 2013

60. Issue #3 Data sources – Using customs data
Taxpayer: Internal CUP with Indonesian AE as the tested party was submitted
TPO:
Rejects Internal CUP and uses External CUP
Uses customs data of third-party transactions not in public domain
Cherry-picks data and chooses transactions without reference to gross-calorific value (quality) of coal, quantity etc.
Assessee requests competitors and obtains few invoices used by TPO which show even CIF vs. FOB difference ignored!
AE (Indonesia)
Non-AE
(anywhere)
Customs Data
AO/TPO
Coal import
Assessee
(Indian co)
Third-party
Indian cos.
Third-party coal importer
(India)
TP study:
Internal CUP
External CUP
(using customs data)
October 2013

61. Issue #4 Multiple year data
Rule 10B(4) states
“The data to be used in analysing the comparability of an uncontrolled transaction with an international transaction shall be the data relating to the financial year in which the international transaction has been entered into
Provided that data relating to a period not being more than two years prior to such financial year may also be considered if such data reveals facts which could have an influence on the determination of transfer prices in relation to the transactions being compared.”
October 2013

62. Issue #4 Multiple year data
Not accepting multiple year data flies against the face of logic
What about business cycles, recessionary effects, gestation period for industries and startups etc. ?
Onus on the assessee to prove usefulness of multiple-year data in the transfer pricing study
Guess what? Rarely there is a case where multiple year data has been accepted
October 2013

63. Issue #5 The Indian arm’s-length range fiasco
ALP is computed with reference to arithmetic mean of comparables with a uniform tolerance of 5% around the transfer price (Proviso’s to Section 92C(1))
Example: arithmetic mean of comparable PLI of operating profit/total cost is 10% would mean an arm’s-length range of 4.76% to 15.79%
It was further interpreted by taxpayers to mean that this +/-5% standard deduction was available to the taxpayer and not a binary band.
Example: In case of standard deduction, if net profit margin were 4.75% in the above scenario then only 0.01% is the adjustment and not entire 4.75% as in the case of a band where you are either in the band or out.
Number of cases in different Tribunals in favour of and against the assessee
October 2013

64. Issue #5 The Indian arm’s-length range fiasco
Amendment in Finance Act 2009 tried to rest controversy about arm’s-length range by saying the 5% tolerance is not a standard deduction (as well as changed base of determination of allowable band linking it to transaction price instead of arithmetic mean)
However post period also remained ambiguous due to conflicting judicial decisions
Retrospective amendment recently in Finance Act 2012 w.e.f 1/4/2002 clarifying the 5% is not a standard deduction (from 1/4/2013 to be 3%)
Bottomline: Lots of litigation on simple issues due to lack of clarity
October 2013

65. Section 92D : Maintenance and keeping information and document by persons entering into an international transaction read with Rule 10D
Methodology Related
Entity Related
Price Related
Transaction Related
Profile of Industry
Profile of group
Profile of related parties
Transaction terms
FAR related
Economic Analysis (method selection, comparable benchmarking)
Forecasts, budgets, estimates
Agreements
Invoices
Pricing related correspondence (letters, s, fax, etc.)
Description and analysis of uncontrolled transactions
Description and analysis of methods considered and adopted
October 2013

66. Issue #6 Documents, documents everywhere; not a sheet to think!
Indian TP documentation requirements are staggering
Rule 10D prescribes detailed set of requirements pertaining to
Organizational Structure
Nature of business/industry and market conditions
Controlled transactions
Background documents
Comparability, functional and risk analysis
Selection of transfer pricing method
Application of the transfer pricing method
Assumptions, strategies, policies
Supporting information
October 2013

67. Issue #6 Documents, documents everywhere; not a sheet to think!
Too much data to decipher and analyze meaningfully given the systems resource constraints
Key details tend to be overlooked in this data deluge
Foreign comparables are really tough to obtain – prohibitive costs, lack of resources and knowledge.
Penal provisions are in place for not maintaining documentation and enforced
Strain on the entire system including Dept. and taxpayer
Bottomline: Is TP not just bad for taxpayer but also bad for the environment?! 
October 2013

68. Issue #7 Practical TP oddities - Few nuggets from the field
TNMM Adjustments applied to all transactions of taxpayer enterprise:
TPO to make adjustments to international transactions only and not entire transactions of taxpayer (Il Jin Electronics India Pvt. Ltd. – ITAT Delhi)
Adjustments resulting in illogical results
Total amount of adjustment made, along with ALP already reported, exceeded total revenues earned by the taxpayer and its AE from dealing with third party clients! (Global VantEdge Pvt. Ltd – ITAT Delhi)
October 2013

69. Issue #7 Practical TP oddities - Few nuggets from the field
Excess profits being disallowed under regular provisions
AO held that excess profits (above ALP) would be disallowed u/s 10B i.e., special tax exemption provisions for IT companies in export zones (ACIT vs. Tweezerman India Pvt. Ltd. – ITAT Chennai)
“Contemporaneous” data used even if not available at specified date
TPO empowered to determine ALP by using public domain data even after “cut-off date” (Kodiak Networks India vs. ACIT – ITAT Bangalore)
Current hot-topic of TP litigation
Whether in financial transactions i.e., corporate guarantees, interest-free loans etc.) between AE’s arm’s-length rate of interest to be charged? (Retrospective amendment in Finance Act 2012 puts this to rest)
October 2013

70. Problems with (Indian) TP summarized
TP is not art, its not science….. its magic!
No proper comparables available
Grossly improper comparables being used
No clear method or quantification for adjustments
Cherry-picking of comparables by all parties
Disparate Data sources are a bone of contention
Documentation requirement overload
Lack of knowledge & skill-set
Concepts such as ‘location savings’ not even acknowledged
Growth of “intangible” economy ignored completely
Overburdening of taxpayer
Bottomline: Current TP implementation devolves frequently into absurdities and can provide inequitable results
October 2013

71. T. P. Ostwal & Associates
Thank You
October 2013