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

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

2 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 TRANSFER PRICING October 2013

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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 (lets 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 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… 1.Source Country (India) should tax local operations, including property or other pertinent matters. 2.Residual income should be earned by the country of Residence, which provided the knowledge and capital for the business. 3.Presence of an interim holding company should be treated as a Residence Country. Why was this assumed?: All countries would adopt a common model! 4.Subsidiaries should not be treated as a PE. 5.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: 1.Source Country earns a routine return. 2.Residence Country receives the residual income. 3.Interim holding companies would be treated as Residence Countries, even if located in a low tax country. October 2013

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: 1.Global/regional principal 2.Centralized risk-taker, intangibles owner 3.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 October 2013

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

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

14 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

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16 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 Introduction to Transfer Pricing October 2013

17 Concept of transfer pricing – Example 1 ABC H Co ABC S Co XYZ Country A Country B Purchase of computer from S Co Controlled Transaction Purchase of computer from third party Uncontrolled Transaction Transfer price of controlled transaction to be equivalent to market price of a comparable uncontrolled transaction; If lower, Country B loses revenue.

18 October 2013 Concept of transfer pricing – Example 2 PQR H Co PQR S Co Country A Country B Customers Illustration: PQR S Co is the distributor of PQR H Cos 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.

19 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 Transfer Pricing and Business Enterprises October 2013

20 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 October 2013

21 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 countrys 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 Basic issues underlying Transfer Pricing October 2013

22 The key issues in allocation of income: MNEs Optimal allocation of common resources and overheads and achieve competitive advantage Reduction of transaction cost Government Expand tax base Basic issues underlying Transfer Pricing October 2013 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

23 October 2013 Evolution of Transfer Pricing US First country to adopt a comprehensive transfer pricing legislation in 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 The UN Conference on Trade and Development (UNCTAD) also issued a major report on Transfer Pricing in 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

24 October 2013 Concepts in Transfer Pricing Transactions with related parties must be based on the arms length principle (ALP) Arms 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.

25 October 2013 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 arms 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

26 October 2013 Special Issues Related to Transfer Pricing 1. 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.

27 October 2013 Special Issues Related to Transfer Pricing 3. Cost – Contribution Agreements Jointly develop, produce or obtain rights, assets or services. 4.Use of secret comparables

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 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 Transfer Pricing in Treaties

30 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 Global Transfer Pricing Regimes October 2013

31 Countries where Transfer Pricing Regulations are in existence ArgentinaAustraliaAustriaBelgiumBrazil CanadaChileChinaColombiaCroatia Czech RepublicDenmarkDominican RepublicEcuadorEgypt EstoniaFinlandFranceGermanyHong Kong HungaryIndiaIndonesiaIrelandIsrael ItalyJapanKenyaKorea, NorthKorea, South LatviaLithuaniaLuxembourgMalaysiaMexico NamibiaNetherlandsNew ZealandNorwayOman PanamaPeruPhilippinesPolandPortugal RomaniaRussiaSingaporeSlovakiaSlovenia South AfricaSpainSwedenSwitzerlandTaiwan ThailandTurkeyUnited KingdomUnited StatesUruguay VenezuelaVietnam Countries where Transfer Pricing Regulations is still emerging AlgeriaAngolaArmeniaArubaBangladesh BelarusBoliviaBotswanaBulgariaBurkina Faso CambodiaCote d'IvoireCyprusEl SalvadorEthiopia GambiaGeorgiaGhanaGreenlandIceland KazakhstanKuwaitLiberiaLibyaMacedonia MalawiMaliMauritaniaMauritiusMongolia MoroccoMozambiqueNetherlands AntillesNicarguaNigeria PakistanPapua New GunieaQatarSenegalSierra Leone Sri lankaTrinidad and TobagoUkraineUzbekistanZambia Zimbabwe Global Transfer Pricing Regimes ….(contd) October 2013

32 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

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 1 st – 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 October 2013 Section & Rules Provisions 92Computation of income having regard to ALP 92AMeaning of Associated Enterprise 92BMeaning of International transaction 92BAMeaning of specified domestic transactions 92C (1) (Rule 10B, 10C) Methods of computation of ALP *Rule 10AB – Any other method for determination of ALP 92CAReference to Transfer Pricing Officer (TPO) 92CBSafe harbour rules 92CCAdvance Pricing agreement 92CDEffect 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) Accountants 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

36 Transfer Pricing Penal provisions (a.k.a rubbing salt into the wound) October 2013 Sr. No. Type of penaltySectionPenalty quantified 1a) Failure to maintain prescribed information/ documents 271AA2% of transaction value (b) Failure to report any such transaction or (c) Furnish incorrect information 2Failure to furnish information/ documents during assessment u/s 92D 271G2% of transaction value 3Adjustment to taxpayers income during assessment 271(1)(c)100% to 300% of tax on adjustment amount 4Failure to furnish accountants report u/s 92E 271BAINR 100,000

37 Indian TP vs. OECD Guidelines Snapshot view * Concepts Indian regulationsOECD Guidelines Associated EnterprisesVery wide definitionRestricted to controlled entities Comparable range(FY 2013)Allows 3% range band on avg. results of comparables Allows for range of comparable data Multiple year dataOnly allows data for current year (and earlier 2 years under limited circumstances) Permitted Foreign comparablesNot permitted in practicePermitted Priority of methodsMost appropriate method rule(Originally) preference for traditional methods Use of unspecified methodNow specifiedPermitted DocumentationStringentPrudent business principles Intangiblesdefinition 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 TPO reference TPO Order u/s 92CA(3) Appeal against CIT(A) order Form 3CEB Appeal against Asst. order Appeal against Draft Asst. order Appeal against Final Asst. Order Set-aside / Remanded back to AO Sept.2006 TPO: Dec AO:Dec May 2010 May FY Assessment timeline example T.P.Ostwal & Associates Specified transaction U/S 92BA

39 Part III. Specified Domestic Transactions

40 October 2013 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 arms 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

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

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 – Arms-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 a)an understanding of economically significant relevant characteristics of the Controlled transactions. b) 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.

48 October 2013 COMPARABILITY ANALYSIS PROCESS 1.Understanding the economically significant characteristics of the industry, taxpayers 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

49 October 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 7.Determination of an arm's length price or profit (or range or prices or profits) 8. Documentation of comparability analysis and monitoring. COMPARABILITY ANALYSIS PROCESS(contd)...

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 A.E. (USA network security software company) Assessee Indian subsidiary (Engaged in network security software development) TPO: Adopt TNMM with third-party Indian software cos taken as comparables 1. A transport logistics software company 2. A generic application outsourcing co. 3. An ERP (SAP) software vendor 4. Infosys - Indias a mega-IT major 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! Bottomline: An apple and orange are both fruits – hence valid comparables under TP! X October 2013 Cost-plus + 15%

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 Indian subsidiary (Engaged in back- office support services) Assessee (taxpayer) says…TPO says…. Reject high-turnover companiesReject low-turnover companies Reject super-profit companiesReject loss making comparables Reject company X, Y and Z - it is functionally different. (Look, my % is within arms-length range!) Reject company X, Y and add company X1, Y1 (Look your % is outside arms- length range!) Risk adjustment of 10% (ad-hoc!)No risk adjustment whatsoever Working capital adjustment 2%Working capital adjustment of 1.5% ……. 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 (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 TP provisions are delightfully vague! October 2013

55 TP adjustments in practice is not the same as theory. For example in India it is observed that: – Foreign AEs 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 Issue #2 Adjustments to comparables October 2013

56 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 Issue #2 Adjustments to comparables 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 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? AE (USA) Assessee (Indian automotive axles manufacturer) Mexico and Brazil axle manufacturers Axle raw material import October 2013

59 Issue #3 Data sources – TPO data gathering powers 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 AE (UK) Assessee (India) Third party Indian cos AO/TPO TP study Tax return 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) Assessee (Indian co) Coal import AO/TPO Non-AE (anywhere) Third-party coal importer (India) Customs Data External CUP (using customs data) Third-party Indian cos. TP study: Internal CUP October 2013

61 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. Issue #4 Multiple year data Rule 10B(4) states October 2013

62 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 Issue #4 Multiple year data October 2013

63 Issue #5 The Indian arms-length range fiasco ALP is computed with reference to arithmetic mean of comparables with a uniform tolerance of 5% around the transfer price (Provisos to Section 92C(1)) – Example: arithmetic mean of comparable PLI of operating profit/total cost is 10% would mean an arms-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 Amendment in Finance Act 2009 tried to rest controversy about arms-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 2009 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 Issue #5 The Indian arms-length range fiasco October 2013

65 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.) Entity RelatedPrice Related Transaction Related Section 92D : Maintenance and keeping information and document by persons entering into an international transaction read with Rule 10D October 2013 Description and analysis of uncontrolled transactions Description and analysis of methods considered and adopted Methodology Related

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 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?! Issue #6 Documents, documents everywhere; not a sheet to think! October 2013

68 Issue #7 Practical TP oddities - Few nuggets from the field 1.TNMM Adjustments applied to all transactions of taxpayer enterprise: 1.TPO to make adjustments to international transactions only and not entire transactions of taxpayer (Il Jin Electronics India Pvt. Ltd. – ITAT Delhi) 2.Adjustments resulting in illogical results 1.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 3.Excess profits being disallowed under regular provisions 1.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) 4.Contemporaneous data used even if not available at specified date 1.TPO empowered to determine ALP by using public domain data even after cut-off date (Kodiak Networks India vs. ACIT – ITAT Bangalore) 5.Current hot-topic of TP litigation 1.Whether in financial transactions i.e., corporate guarantees, interest-free loans etc.) between AEs arms-length rate of interest to be charged? (Retrospective amendment in Finance Act 2012 puts this to rest) Issue #7 Practical TP oddities - Few nuggets from the field 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 HANK Y OU October 2013


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