Specified Domestic Transactions Transfer Pricing Specified Domestic Transactions Study Circle Baroda Branch of WIRC 14th May 2013

Agenda Introduction Transfer Pricing in India Background Snapshot of Indian Regulation Specified Domestic Transactions Related Party Transactions & Eligible Units Case Studies TP Methods and Documentations Procedures & Penalties

Introduction

Transfer Pricing - Background Since liberalization – Companies from developed or developing countries Collaborations with Indian entities by MNEs Setting up 100% subsidiaries in India Backdoor transfer of Profits Indian Government was losing revenue in form of Tax Finance Act, 2001 has introduced Transfer Pricing with effect from Assessment Year 2002-03

Tax Avoidance - International India Co. A Co. B Dubai S.P. Rs. 100 Cost Rs. 90 Tax @ 35% S.P. Rs. 120 Profit Rs. 20 Tax 0% Tax Heaven Co. B is 100% sub. Of Co. A Co. A Sells at Rs. 100 to B Co. B Sells at Rs. 120 to Co. C Profit by B is Rs. 20 (Tax Free) Maximum tax to Co. A of Rs. 3.5 USA Co. C

Tax Avoidance - Domestic Unit – 1 (Gujarat) Unit – 2 (Baddi) S.P. Rs. 100 Cost Rs. 90 Tax @ 35% S.P. Rs. 120 Profit Rs. 20 Tax 0% Unit -1 Manufactures radiators sells to Unit – 2 in Knocked Down Condition for Rs. 100 Unit -2 Assembles and sells to customers for Rs. 120 Profit of Unit – 2 is tax free u/s 80IB. Company pays tax only on profit of Rs. 10 under Unit -1.

Transfer Pricing in India

Transfer Pricing Litigation in India For Assessment Year Number of Transfer Pricing audits completed Number of cases adjusted Percentage of adjustment cases Adjustment Amount (INR Crores) 2002-03 1,081 238 22% 1,373 2003-04 1,501 345 23% 2,575 2004-05 1,768 477 27% 3,861 2005-06 1,479 370 25% 4,950 2006-07 1,717 1,019 59% 9,743 2007-08 2,102 1,089 52% 24,000 2008-09 2,589 1,338 44,500

Snapshot of Indian Regulation Transfer Pricing introduced from AY 2002-03 for international transactions Extended to Specified Domestic Transactions [SDT] from AY 2013-14 Sections 92 to 92F amended to include reference to SDT However, similar amendments to Rules 10 to 10E yet to be carried out Methodology to compute ALP is primarily provided in Rules It is expected that appropriate amendments would be carried out in Rules to apply broadly same methods and principles to SDT as well Discussion in this presentation is primarily based on ALP computation mechanism applicable to ‘international transactions’ assuming that the same would be applied to SDT

Snapshot of TP Provision 92 Computation of income from international transaction having regard to arm’s length price 92A Associated Enterprise 92B International Transaction 92BA Meaning of Specified Domestic Transactions 92C Computation of Arm’s Length Price 92CA Reference to Transfer Pricing Officer 92CB Safe Harbour Rules 92CC & 92CD Advance Pricing Agreement 92D Maintenance of information and documents 92E Report from Accountant to be filed 92F Definitions of certain terms relevant to computation of arm’s length price

SDT - Background Decision of the Appex Court in the case of Glaxo Smithkline Asia (P) Ltd [236 CTR 113] The H’ble Supreme Court while deciding on the issue of section 40A(2) made some of the important observations as under: The present Transfer Pricing Regulations does not apply to domestic transactions. CBDT should examine possibility of extending TP provisions to such transactions

SDT - Background In domestic transactions, under-invoicing and over- invoicing will be revenue neutral, except in two circumstances: where one of the related entities is loss making or where one of the related entities is liable to pay tax at a lower rate and the profits are shifted to such entity Concept of ALP is preferred over FMV to test the reasonableness of the controlled or related party transactions.

Specified Domestic Transactions Section – 92BA is inserted with effect from 01-04-2013, defines “Specified Domestic Transactions”. Under SDT these transactions are covered Expenditure under transactions with Related Party [Section- 40A(2)(b)] Any Transactions referred in Section – 80A Any transfer of goods or services referred to u/s 80IA(2) Any business transaction with person as referred u/s 80IA(10) Any transactions under for claiming deductions under chapter – VIA or 10AA where Section – 80IA(8) /(10) is applicable Other transaction as may be prescribed.

Related Party Transaction

40A(2) – Payments to related Parties Only expense side is covered and i.e. only revenue expenditure and not items of income. In case of transactions between two related parties of goods and services, only the purchaser is to comply and not the seller Definition of related party is restrictive compared to Associated Enterprise Multi-fold issues in identification of related parties

40A(2)(b) – Definition of Related party Individual Assessee Husband / Wife Whether these are related? Brother or Sister of spouse Lineal ascendants – descendants of the spouse Brother or Sister of Parents Lineal A-D of brother or sister of parents And spouse of all of the above HUF of the Assessee or his relative Lineal ascendants descendants Sister Assessee Where Assessee has substantial Interest Brother

40A(2)(b) – Definition of Related party Tax Payer Director / Partner/ member Relatives b(ii) Individual b(iii) >20% Company / Firm / HUF / AOP Company b(iv) All companies where such individual is director / partner / member b(v) Other Director / Partner/ member Person b(vi) Tax Payer = Company, HUF, Firm, AOP

40A(2)(b) – Definition of Related party Tax Payer Director / Partner/ member Relatives b(ii) Individual b(iii) >20% Company / Firm / HUF / AOP Company b(iv) All companies where such individual is director / partner / member b(v) Other Director / Partner/ member Person b(vi) Tax Payer = Company, HUF, Firm, AOP >20% >20% Company / entity

40A(2)(b) – Issues Tax Payer Tax Payer = Company, HUF, Firm, AOP 15% Relatives Individual 15% 15% Tax Payer

40A(2)(b) – Issues Tax Payer Tax Payer = Company, HUF, Firm, AOP 10% Relatives Director / Partner/ member Company / Firm / HUF / AOP 10% 10% 10% Tax Payer

40A(2)(b) – Issues Whether sub-subsidiary and ultimate parent company is relative? Transaction Relative? A & B Yes A & C A & X No A & Y B & C B & Y C & X X & Y Co. A Co. B Co. C Co. X Co. Y

Eligible Units / Undertaking

SDT – Tax Holiday Units Section Nature of Undertakings / units affected by SDT 80IA Undertaking engaged in Development and maintaining of infrastructure Generation / Transmission of Power Reconstruction / revival of Power Generating plants 80IB Undertakings located / engaged in Notified industrially backward districts Scientific research & development Refining mineral oil / generation of natural gas Operating cold chain facility for agricultural produce, etc 80IC Undertaking located in notified Centre / Parks / Areas in Sikkim, Himachal Pradesh / Uttaranchal North-Eastern states 80ID Undertaking engaged in business of Hotel / Convention centers in specified areas / districts 80IE Undertaking in North-Eastern States 10AA Undertakings having a unit in SEZ 35AD ?????

SDT – Tax Holiday Units 80IA(8) 80IA(10) Inter-unit transaction of goods or services Business transacted with any person generates more than ordinary profits Owing to either close connection or any other reason Applicable where transfer is not at market value Applicable to tax holiday units earning more than ordinary profit Onus on tax payer Onus on tax authorities as well

Threshold Limit & Coverage Domestic Transfer Pricing is applicable only where value of SDT exceeds INR 5 Crore. Important points need to be considered while considering the threshold limit Value of International transactions to be excluded Expense transactions covered in respect of 40A(2)(b) All transactions covered in respect of Chapter VI or 10AA transactions Aggregate amount of all transactions should be considered Once Exceeded 5 crore, all transactions whether significant or not are covered

Challenges Transactions / Issues Challenges Salary / Remuneration to Partners / Directors Benchmarking Whether limits prescribed under Sec – 40(b) or Schedule XIII of Companies Act can be considered Transfer of Land Valuation as per “Jantri” can be considered? Joint Development Agreement Project management fees Cost Benefit Analysis Allocation of Expenses between Units Covered by SDT? Definition of related party Direct V/s Indirect relationship Capital Expenditure Sales of goods and services Comparability

Posers Whether parties not engaged in business and profession is covered by the provisions of 40A(2)(b)? Whether following shall be covered – Public Charitable Trust paying remuneration to related persons Trusts created by the companies Co-operative societies Social Clubs having business undertaking Expenses disallowed under other provisions of the act say 40A(3) – whether covered by SDT?

Posers In respect of 40A(2)(b) the Law envisages a Corporate Tax Payer to know Whether the individual holding 20% interest is director in other company Identify all directors of the Company of which such individual is a director Relatives of all such directors Further it also envisages to identify the Company or the entity where relative of any director of the Assessee company holds 20% voting rights.

Posers For calculating 20% interest, preference shares or other securities having voting rights to be considered. Preference Shareholders where voting rights are vested under the provisions of Companies Act as consequences of default by Assessee Company. Corresponding Credit for tax neutrality or to avoid double taxation Small value transactions

Economy and Tax Provisions The tax provisions and it impact on Economy Incentivize Subsidize Encourage Tax Regulate

Case Studies

Case - 1 XYZ Inc, USA is engaged in manufacturing of wide range of Automotive engineering products YZ Ltd. Germany is engaged in R&D and manufacturing of Bearings X Ltd. is manufacturing TYPE A bearings Y Ltd. is manufacturing TYPE B bearings Z Ltd. is manufacturing Clutches – 10AA unit A Ltd. is provided technical services

Case - 1 Germany USA XYZ Inc. YZ Ltd. India X Ltd A Ltd Y Ltd Subsidiary India 15% 90% 90% 25% 20% X Ltd Z Ltd (10AA) A Ltd Y Ltd

Case - 2 A Ltd. is an Indian company B Inc., USA is 100% subsidiary of A Ltd. C Ltd is an Indian Company, 100% sub. of A Ltd. D Ltd and E Ltd (10AA eligible) are Indian Companies, 100% sub of A Ltd. A Ltd granted interest free loans to B C and D A Ltd granted loan to E Ltd at 18% p.a. interest

Corporate Guarantee (fees at 0.25% is charged) Case - 2 USA A Ltd. B Inc. Interest Free Loan Corporate Guarantee (fees at 0.25% is charged) India Loan at 18% ALP 11% Interest Free Loan Interest Free Loan Corporate Guarantee (No fees is charged) C Ltd D Ltd (10AA) E Ltd (10AA)

Case - 3 A Ltd, B Ltd, C Ltd, and D Ltd are Indian companies C Ltd holds 80% shares of B Ltd. B Ltd holds 100% shares of A Ltd X, Y, Z are the directors of A Ltd. Holds 10% share of D Ltd. Mrs. Y holds 15% and Mr. F son of Z holds 15% of D Ltd. FY is P’ship firm of Mrs. Y and Mr. F

Case - 3 C Ltd. Mr. X Mr. Y Mr. Z Mrs. Y Mr. F B Ltd D Ltd A Ltd Directors of A Ltd. Son of Mr. Z Mr. X Mr. Y Mr. Z Mrs. Y Mr. F Purchase of Finished Goods 80% 10% 10% 10% 15% 15% B Ltd 100% D Ltd A Ltd (Assessee) Purchase of Raw Material 50% 50% YF (Partnership Firm) Consultancy Fees

Transfer Pricing Methods

Transfer Pricing Methods Comparable Uncontrolled Price Method Resale Price Method Cost Plus Method Profit Split Method Transactional Net Margin Method

Transfer Pricing Methods Comparable Uncontrolled Price Method Resale Price Method Cost Plus Method Profit Split Method Transactional Net Margin Method Any Other Method (Rule 10AB)

Most Appropriate Method (MAM) ITA does not provide any specific hierarchy of methods It insists on applying the ‘Most Appropriate Method’ (MAM) MAM means a Method Which is best suited to facts and circumstances of transaction Which is the most reliable measure of an arm’s length price

Selection of MAM MAM is to be determined considering – Nature and class of transaction Functions, assets and risks undertaken assessee and other party Degree of comparability between underlying transaction and uncontrolled transactions Extent to which reliable and accurate adjustments can be made to account for differences, if any Availability, coverage and reliability of data necessary for application of method Nature, extend and reliability of assumptions required to be made in application of method

Stages of Economic Analysis Comparability Analysis Selection of Tested Party Selection of Most Appropriate Method Selection of Profit Level Indicator Benchmarking

Selection of MAM MAM is to be determined considering – Nature and class of transaction Functions, assets and risks undertaken assessee and other party Degree of comparability between underlying transaction and uncontrolled transactions Extent to which reliable and accurate adjustments can be made to account for differences, if any Availability, coverage and reliability of data necessary for application of method Nature, extend and reliability of assumptions required to be made in application of method Selection of Tested Party Comparability Analysis Selection of Tested Party & Comparability Analysis

Classification of Methods Comparable Uncontrolled Price Method (CUP) Resale Price Method (RPM) Cost Plus Method (CPM) Price based Methods Profit Split Method (PSM) Transactional Net Margin Method (TNMM) Profit based Methods Any other method which takes into account price charged or paid between uncontrolled parties considering all relevant facts Other

Documentation

Background Information Transactional Information Documentation Areas Functions Assets Risks Comparability Method Selection Benchmarking Covered entities Covered Transactions Company Group Industry Background Information Transactional Information Functional Analysis Economic Analysis

What are the Documentation Requirements? Entity Related Price Related Transaction Related Profile of Group Terms of Transaction Agreements Profile of Indian Entity Functional Analysis (FAR) Invoices Profile of Associated Enterprises Economic Analysis (Method Selection, comparables benchmarking) Price Mechanism, other pricing related documents Profile of Industry Forecasts, Budgets, Estimates Correspondences (letters, emails, etc.) Contemporaneous documentation requirement - Rule 10D Documentation to be retained for 9 years No specific documentation requirement if the value of international transactions is less than 1 crore rupees

Indicative Documentation Transaction entered Documents to be maintained Purchase/ sale of raw material Invoices Purchase/ Sale order Product details Sale details if sold to 3rd Party Pricing strategy Proof of price negotiation Quotes from competitors Terms of payment Remuneration to Directors Qualification Work Experience & Profile Minutes of Meeting authorizing the director’s remuneration Data from HR firms for Directors in the same line of business Corporate cost sharing Nature of expenses Auditor’s certificate allocating the expenses Basis of allocation between the companies Proof of usage (rendering) of services Cost benefit analysis

Indicative Documentation Transaction entered Documents to be maintained Rent paid toward use of premises Rent receipts Documents suggesting the rent of the surrounding area Rental agreement Fair market value of the property (municipal valuation, only if higher than the actual rent paid) Reimbursement of expenses Nature of expenses with detailed break-up Reason of expense incurred for Employee details Actual invoices of the expense Interest on loan (non- financial services company) Basis of determination of interest rate Interest Rate Card for the period of loan Loan agreement Basis on which the interest rate is pegged above standard rate

Procedures

Transfer Pricing Compliance Timeline – Illustration for March 2013 Sr. No. Compliance Timeline Relevant Provision 1. Filing Accountants Report along with Tax Return, Maintenance of Documentation 30 Nov. 2013 Section – 92E r.w. Section – 139(1) 2. Limitation for Initiating transfer pricing audit by the tax administration 30 Sep. 2014 Proviso to Section – 143(2)(ii) 3. Limitation for completing transfer pricing audit 31 Jan. 2017 Section – 92CA(3) r.w. Second Proviso to Section – 153(1) 4. Limitation for Completing regular assessment 31 Mar. 2017 If 144C BY 31 May 2017 Second Proviso to Section -153(1) 5. Limitation for Re-Assessment (where income escaped < Rs. 1,00,000) 31 Mar. 2018 Section – 149(1)(a) 6. Limitation for Re-Assessment (where income escaped ³ Rs. 1,00,000) 31 Mar. 2020 Section – 149(1)(b) 7. Date till which documentation is required to be maintained 31 Mar. 2021 Section – 92D and Rule – 10D(5)

Penalties Compliance Penalties Section Filing of Accountants Report (specified form) Rs. 1,00,000 271BA Reporting SDT and Int. Transactions 2% of value of transactions not reported 271AA Maintenance of Documentation 2% of value of transactions for which documentation is not maintained Furnishing correct information 2% of value of transactions for which incorrect or no information is furnished Failure to furnish information or documents as required under 92D(3) 2% of value of transaction for each such failure 271G

Audit Process File tax return and Accountant’s Report (30th November) DRP Mechanism- Finance Act 2009 Reference to be made to TP Officer (‘TPO’) by the Assessing Officer (‘AO’); Compulsory Reference to be made by AO if international transactions exceed INR 1500 million for AY 2005-06 onwards (Internal guidelines) Appeal Procedure Notice to be issues by the TPO - TPO calls for supporting documents and evidence Appeal to Commissioner of Income Tax Passes an order Income Tax Appellate Tribunal High Court - only on matters related to law Supreme Court Constitutional Bench TP Audit Based on results of above mentioned procedure assessing officer passes the order Rectification application can be made against the order of TPO for apparent mistake Appeal can be made against the order of AO as order of TPO included within the order of the AO

Questions

Thank You Prashant Kotecha Office: +91 265 3086467 Mobile: +91 98251 53981 Email: prashant.kotecha@kcmehta.com