Navigating the Indian & Singapore waters! TRANSFER PRICING Navigating the Indian & Singapore waters! Opening thoughts Narayan Mehta Partner, Sudit K. Parekh & Co. 25th May 2005

An Overview of Indian Transfer Pricing Regulations

Transfer Pricing- an Introduction Denotes price charged by one related party to another for goods, services, etc. Objective: To check the erosion of tax base and plug the leakage of revenue

An Illustration- Outsourcing Contract for software development Singapore Parent Singapore Client Singapore tax rate= 20% Consideration @ S $ 35 per hour 100% Equity Outsourcing Arrangement Consideration?? Transfer pricing issues Indian Subsidiary Indian tax rate -Nil Offshore software development Need for balancing the Indian and Singapore TP/ Tax regulations!!

Importance of Compliance Any related party transaction undertaken from 1st April 2001 onwards covered Currently 60% of world’s cross-border trade is between related parties- Indian tax authority is also going to be vigilant! UK – for every £1 spent investigating transfer pricing cases, £120 was recovered in extra taxes Japan –transfer pricing has been a major revenue churner- individual cases exceeds $100 m! US – transfer pricing remains the topmost priority of IRS’s agenda on international tax India - FY 01-02 assessments complete - Press has reported incremental tax revenues in excess of INR 50 million based on the first year of TP audit adjustments

Importance of Compliance No exemption from compliance Transactions exceeding INR 50 million to attract compulsory transfer pricing audit Onus of proof- tax payer primarily liable S.10A / 10B units- thin margin for error No deduction under section 10A / 10B on enhanced income! More than ordinary profits taxable & not tax exempt! Adverse tax incidence for the Singapore parent outsourcing BPO operations to Indian entity Double taxation for the Group in respect of enhanced income

Penalties are not tax deductible! Importance of Compliance Penalties are high ! Addition to Income Failure to maintain documentation Failure to furnish documentation Failure to furnish Accountant’s Report 100% to 300% of tax on addition 2% of value of transaction Rs. 100,000 Penalties are not tax deductible!

Importance of Compliance An effective tax planning tool to establish the appropriateness of transfer prices

Transfer Pricing- The Indian Perspective Income arising to “Associated Enterprises” from “International Transactions” shall be computed having regard to the “Arm’s Length Price” Indian regulations largely modeled on OECD guidelines

Legislative Framework International transaction Associated Enterprise Legislative Framework Income needs to be computed on an arm’s length basis

Associated Enterprise Means direct or indirect participation in management, control or capital by one enterprise into another enterprise; or by the same person in both the enterprises Either or both of Associated Enterprises should be non-residents

Associated Enterprise “Deemed Associated Enterprises” include: Holding of 26% of voting power by one enterprise into another enterprise; or by the same person in both the enterprises Dependence on intangible assets Sale of goods influence on price and conditions of supply by buyer Control by individual or his relative Loan transaction 51% or more of book value of total assets of the borrowing enterprise

Associated Enterprise Term of wide import - following parties also covered: VC investors with 26% stake FI’s advancing loans exceeding 51% stake of assets of borrowing enterprise Franchisers, licensees, technical collaborators, etc. Term of wide import- is your company covered?

International Transaction Means “transaction” between 2 or more Associated Enterprises: For sale of products / other properties OR Affecting profits, losses, income, assets or liability of the enterprise

Arm’s Length Price Denotes price which is applied or proposed to be applied in a comparable transaction between unrelated independent parties in uncontrolled conditions Corresponds to the open market price

Computing Arm’s Length Price Arm’s Length Price to be computed as per “Most Appropriate Method”, to be selected out of: Price based method Comparable Uncontrolled Price Method (CUP) Margin based method Resale Price Method (RPM) Cost Plus Method (CPM) Profit Split Method Transactional Net Margin Method (TNMM)

Comparable Uncontrolled Price Method or CUP Compare price charged in a controlled transaction with uncontrolled transaction Adjustment for differences materially affecting the price is permissible

Comparable Uncontrolled Price Method or CUP 3P-India AE - Singapore $ 60 (internal comparable) TP $ 60 (external comparable) AE-India $ 60 (internal comparable) 3P - Singapore 3P - Singapore Price charged by AE–India to AE–Singapore should be as per open market price $ 60 represents the open market price - Internal comparable preferable to external comparable

Resale Price Method (RPM) Reduce arm’s length Gross Profit Margin and procurement expenses from resale price of goods / services resold to an unrelated party Certain adjustments permissible

Resale Price Method $ 100 $ 100 – 20% AE-India AE - Singapore 3P - Singapore 3P-India 3P-Singapore 3P-Singapore 20% GP Margin on sales $ 100 = The price at which sales made by AE-Singapore to 3P- Singapore 20% = Gross Profit Margin identified from gross profit margin earned by Italian distributors on similar / comparable uncontrolled transactions

Cost Plus Method Add an arm’s length gross profit margin to the production cost of supplier providing goods / services to related purchaser Certain adjustments permissible

Cost Plus Method $ 100 – 15% AE-India AE - Singapore 3P - Singapore 3P-India 3P - Singapore 3P - Singapore 15% GP Margin on sales Production Costs of AE-India = 100 15% = Gross Profit Margin on production costs earned by 3P-India on comparable sales made by other Indian software manufacturers

Profit Split Method Splitting the combined net profit of associated enterprises arising from international transaction between respective entities based on their relative contribution to the net profits Rarely used in practice

Transactional Net Margin Method (TNMM) Comparing net profit margin of Associated Enterprise arising from international transaction with adjusted net profit margin for similar transaction with unrelated parties in comparable circumstances Similar to RPM / CPM

How methods are chosen in practice? Most Appropriate Method ??? ??? ? Cost Plus Profit Split TNMM Resale Price Method Comparable uncontrolled price Other Yet to be prescribed

Computing Arm’s Length Price- summary Selection of the most appropriate method – relevant factors: Business model and organizational structure Functional and risk profiling of related parties Contractual terms Nature of products and services

Powers of Indian Tax Authorities Powers to: Call for information Determine Arm’s Length Price Determine total income having regard to Arm’s Length Price 5% difference allowed No deduction under section 10A / 10B / 80HHC on enhanced income! Corresponding adjustments not permitted ! Permitted under certain Indian Treaties! No adjustment to withholding tax! Compulsory scrutiny for transactions exceeding INR 50 million

Transfer Pricing Assessment TPO will make further enquiries TPO will review compliance by the tax payer with the arm’s length principle ? ? Does the TPO agree with the views of the tax payer No Yes Taxpayer given an opportunity to respond to TPO’s position TP Adjustment TPO would pass a favourable order in relation to the international transaction examined Has the taxpayer responded with sufficiently detailed facts & arguments to enable a re-evaluation of TPO position ? This is very much a simplified process It is the application where the hurt starts and continues: - loss of control of agenda - incredible diversion for management - defensive / reactionary behaviour - costly in professional advice - likely to revisit in penalties and interest Will almost always exceed cost of doing a proper study and/or having a good process of contemporaneity This is the very serious end of the journey - to be avoided at all cost. ATO re-evaluates its position: Your response may just correct ATO mistakes & disclose your basic defence if litigation was pursued Is ATO view materially diff from taxpayers: Generally set out in a “Position Paper” Taxpayer invited to respond to ATO position: Silence may be acquiescence Has taxpayer responded with detailed facts: If “No” or poor response, assessment will issue ? No Yes TPO re-evaluates his position Does the TPO now agree with the taxpayer’s position ? No Yes ? 18

Documentation- why necessary? To be better prepared for transfer pricing audit To support your arm’s length price in future Especially important in loss situations The tax authorities will never understand your business as well as you, therefore… Effective communication of your TP policy is critical!

Documentation- fixing the jigsaw puzzle! Accountant’s Report Documentation Agreements Functional Analysis Benchmarking Industry Analysis

Primary Documentation required under Indian Regulations Associated Enterprise related documents Transaction related documents Description of functions performed, risks assumed and assets utilised ALP computation related documents Record of transactions considered for determining price of international transactions Analysis performed to evaluate comparability Description of all methods considered and reasons for selection of the most appropriate method Record of actual working for determining arm’s length price Details of comparable data used in applying most appropriate method

Secondary Documentation required under Indian Regulations Government publications, reports, studies, databases Market research studies and technical publications of recognized national or international institutions Price publications including stock exchange and commodity market quotations Relevant agreements and contracts entered into with associated enterprises or with unrelated enterprises Letters and correspondence documenting terms negotiated with the associated enterprise

Indian Documentation No need for fresh documentation every year Requirement for filing of CA’s report 31st Oct/31st July

Transfer Pricing Regulations Summing Up Indian Income-tax Act, 1961 Transfer Pricing Regulations Arm’s length price Documentation Accountant’s Report

Compliance and Certification Timeline April 1st ’05 March 31st ’06 Oct 31st ’06 Oct 31st ’07 March 31st ’09 March 31st ’15 Beginning of tax year End of tax year Deadline for maintaining documentation Filing tax return Filing Accountant’s Report Limitation for initiation of assessment Limitation for completion of assessment Date till which docn. is required to be maintained

? Thank You Queries Contact Narayan Mehta Tel: +91 22 22821141 Fax: +91 22 22024193 Mobile: +91 9820544495 E-Mail: narayan.mehta@skparekh.com ? Queries