1. International Taxation and Transfer Pricing Conference February 17, 2007 Case Studies on Transfer Pricing Samir Gandhi

2. February ‘2007 2 Global TP Enforcement First level –Second level Third level –Fourth level 1996 & prior1997/ 19981999/ 20002001/ 20022003/2004 Italy New Zealand Mexico Korea France Czech Republic Spain Australia South Africa USA China Slovakia Brazil Italy New Zealand Mexico Korea France Czech Republic Spain Australia South Africa USA Germany Kazakhstan Russia Denmark Belgium Venezuela Argentina Canada UK China Slovakia Brazil Italy New Zealand Mexico Korea France Czech Republic Spain Australia South Africa USA Thailand Portugal Poland Peru India Netherlands Germany Kazakhstan Russia Denmark Belgium Venezuela Argentina Canada UK China Slovakia Brazil Italy New Zealand Mexico Korea France Czech Republic Spain Australia South Africa USA Hungary Colombia Malaysia Thailand Portugal Poland Peru India Netherlands Germany Kazakhstan Russia Denmark Belgium Venezuela Argentina Canada UK China Slovakia Brazil Italy New Zealand Mexico Korea France Czech Republic Spain Australia South Africa USA

3. February ‘2007 3 Transfer Pricing Audit Process Assessing Officer ( AO ) Transfer Pricing Officer (TPO) AO to refer TP cases to TPO – international transactions > INR 5 Crores ( 15 Crores) Copy of order sent to the AO and tax payer AO to incorporate TPO’s order in the Assessment Order Send Notice to tax payer - Hearing / Document Analysis / No site visits / No interviews

4. February ‘2007 4 TP Administration Structure DGIT International Taxation & Transfer Pricing) Director of Income-tax, (Transfer Pricing) (Each location) TPO I TPO III Additional Commissioner of Income-tax Additional Commissioner of Income-tax Support staff TPO II Additional Commissioner of Income-tax

5. February ‘2007 5 Experience from Initial Audits Major companies audited. –1,800 audits estimated. Only Selection Criteria. –International Transactions above INR 5 Crores. Adjustments - INR 1,500 Crores. –BPO/ITeS, Software, Banks, FMCG, Pharmaceuticals etc. TNMM method most commonly used by tax payers. Reliance on precedents of tax year(s) March 2002 & March 2003. Tax Board will develop case selection tools – more focused examinations in future years.

6. February ‘2007 6 Case Study

7. February ‘2007 7 Background XYZ Inc., a fortune 500 Company is in the business of manufacturing of automobiles XYZ India is a 100 % subsidiary and provides CAD designing services. XYZ India is a captive service provider and is compensated on a C + 10 % mark up. XYZ India has applied the TNNM as the Most Appropriate Method using comparables operating in ITeS industry. – PLI applied - Operating Margin / Operating Cost

8. February ‘2007 8 Analysis Position of the TPO Rejection of Loss Making Companies Rejection of Companies having only domestic transactions Rejection of Multiple year data Own set of Comparables provided without any search process (cherry picking) Proposed mark up of 30% -40% Position of the Tax Payer Loss cannot be the sole criteria for rejection (entrepreneurial risk) TNNM requires functional comparability Financial results of comparables exhibit high degree of variation Integrated Service Provider to be excluded Companies having intangibles to be excluded ( unique software, brand name etc) Adjustment for : Working Capital Intangibles Risk ( captive service provider Vs. entrepreneur)

9. February ‘2007 9 Audit Outcome Captive Service Provider (BPO/ITeS) –Losses not acceptable –Proposed cost plus markups range from 25% to 40% –“One size fits all” approach –Comparables proposed inappropriate (no consideration for intangibles, differences in business models, etc.) –Justifies markup saying “even after paying high markups, cost savings will be substantial” Adjustment of risk vis-à-vis third party comparables disallowed Working capital adjustments of 2% allowed in some cases

10. February ‘2007 10 Audit Experience

11. February ‘2007 11 Major issues in Audit Outcomes - Services Consideration for service rendered by Indian Enterprises. – R & D, Marketing, Technical Services etc. Composition of Costs. –Direct and Significant Allocations of Indirect Costs ! Denial of “Set–off”. Allocation of management fees ( Information Technology, Marketing, Budgeting etc ) by AE. –“Benefit Test” critical. –Evidence of receipt of services. –Determination of allocated amount.

12. February ‘2007 12 Major issues in Audit Outcomes – Intangibles Application of TNMM and Exchange Control Regulations not sufficient. Substantiation of receipt of know-how including updates. Evidence of negotiation. Concerns on losses by Indian enterprises. Details of Foreign Enterprise. –owner of intangibles. “Controlled Transactions” - Base for determination of ALP. Payments for trademark. –Economic v. Legal ownership. –Marketing Intangibles.

13. February ‘2007 13 Major issues in Audit Outcomes - Manufacturers Aggregation of Transactions –“ Single entity approach” –Transactionwise analysis preferred. Preference for CUPs ( Internal and External ) –Material differences – volume, quality, terms of sale, geographical differences etc. disregarded. Acceptance of TNMM with reluctance. –Product vs. Functional comparability. –Choice of profit level indicator. Disregarding Loss making companies from Comparables set.

14. February ‘2007 14 Major issues in Audit Outcomes - Distributors Enterprise with Losses – “Entrepreneur risk” not acceptable. Higher Gross Margin, but losses at Net level due to significant marketing expenses. Resale Price Method Vs. TNMM. Reimbursement of marketing expenses by Foreign Enterprise.

15. February ‘2007 15 Going Forward Rulings – Position of Revenue. – Comparables, Methodology, Cost Sharing, Compliance - Foreign Enterprises etc. Risk Assessment - Selection of Audits. Safe Harbors eg. Services. Manning of TP Cell & Appellate Authorities. Effective MAP Process and APA.

16. February ‘2007 16 Confessions to a Tax Auditor 10. Everybody does it! 9. It improves my bonus! 8. My country needs it more than you! 7. It’s part of the game! 6. Thought they wouldn’t notice!

17. February ‘2007 17 Confessions to a Tax Auditor (Contd…..) 1. My boss made me do it! 2. It makes good commercial sense! 3. We’ll shift some back here in later years! 4. We already have too much profit over here! 5. It’s really just an accounting adjustment!

18. February ‘2007 18 Inputs

19. February ‘2007 19 Thank You