aligning tp outcomes with value / documentation (actions 8 ... · • holding company, subsidiary...

Aligning TP Outcomes with Value / Documentation

(Actions 8-10 & 13)

FICCI, August 31, 2017

By: Mukesh Butani

Contents

• BEPS AP 8 -10: Aligning TP Outcomes with Value Creation

• Value chain to value analysis, a paradigm change

• Intangibles

• Contract R&D

• Marketing Intangibles (AMP)

• Hard-to-value intangibles

• Cost Contribution Arrangements

• Low value adding Intra-Group services

• Location savings

• Transactional Profit Split Method

• BEPS Action Plan 13: TP Documentation and CbC Reporting

• Future of TP Regulations – Certainty or Chaos

• Annexures - Attribution of profits to PE

BEPS Action Plan 8 -10: Aligning TP Outcomes with Value Creation

• Worldwide context: Fight against tax evasion

OECD BEPS Works

• 15 action points

• 3 pillars: Coherence, Substance and Transparency

• No action dedicated to APAs but rules on transfer pricing (“TP”) and ensuring substance/transparency

• Multilateral Instrument (“MLI”) to ensure efficient implementation of Actions

• Further works expected until 2020 (e.g., review of implementation of the TP documentation)

Value chain to value analysis, a paradigm change

Importance of Intangibles

• TP Guidelines puts excessive emphasis on contractual allocation of functions, assets and risks which has proven vulnerable to manipulation, leading to outcomes which do not correspond to the value created by an economic activity undertaken by the members of a multinational group.

• Arm’s Length Principal, cornerstone of Transfer Pricing rules with Actions 8 to 10 aim to reinforce this principle by ensuring that the allocation of profits is aligned to economic activity

• Guidance clarifies that legal ownership alone does not necessarily generate a right to (or indeed any) returns generated by the exploitation of an intangible

• Marketing spend in India (known as AMP) has created noise around marketing intangibles on account of significant economic activity

• Companies engaged in R&D activities to have margins commensurate to activities (Characterisation, Margins) vis-à-vis the return accrued to them is subject matter of dispute in India

• MNE’s using India as low cost manufacturing / services to caution on location savings

• Identifying intangibles – Broad based definition under Indian TP law (few differences with OECD guidelines)

• Ownership of intangible - increasing focus on economic ownership (i.e. value creating functions of DEMPE)

• Situs of Intangibles - Does Foster's HC-ruling [TS-401-HC-2016(DEL)] dilute "economic ownership" concept explained in Sony Ericsson [TS-96-HC-2015(DEL)-TP] ?

• Stress importance on a thorough FAR analysis based on conduct of parties

• Legal ownership does confer a right to returns generated from exploitation of intangibles – return should accrue to entity which carries DEMPE functions

• Key challenges:

o Segregation of centralised marketing intangibles and decentralised trade intangibles can create complex FAR issues

o Arm’s length rate of royalties;

o Allocation of cost of development of the market and brand in a new country;

o Remuneration for development of marketing and R&D intangibles, their use;

o Transfer pricing of cobranding, etc.

Intangibles

• Planning around intangibles perceived as core issue in BEPS debate - lead to fundamental changes in transfer pricing regulations for intangibles:

Broad definition of intangible

Allocation of intangible-related returns based on important functions/risks/assets

Selection of Most Appropriate Method for testing the ALP

• Practicability: New rules working in practice and coherence with domestic regulations.

• Not possible to identify relevance and evaluate functions involved in full consideration of DEMPE (theoretical approach).

• Exacerbation of transfer pricing documentation requirements. Initial goal of increased transparency on transfer pricing of intangibles turns into uncontrolled claims.

Exploring Intangibles

• Holding Company, Subsidiary S1 and Subsidiary S2 are a group of companies in a pharmaceutical industry.

• Subsidiary S1 performs contract R&D for Holding Company. It employs about 100 researchers in its R&D department, including the global head of R&D.

• Holding Company is the legal owner of the IP. It licenses the IP to Subsidiary S2, the production and distribution entity.

• Holding Company has 3 employees responsible for patent registrations and enforcement. All strategic decisions regarding R&D are made by the management of the group in Luxembourg, based on advice of Subsidiary S1’s head of R&D.

• Holding Company performs the protection and exploitation (IP license) function. The other “DEMPE”-functions are carried out by Subsidiary S1 for Holding Company.

Contract R&D – Case Study

Contract R&D – Case Study (2/3)

• Are the protection and exploitation function of Holding Company sufficient to qualify as owner of the IP based on the DEMPE-criterion of the OECD?

• If no, what further functions would Holding Company have to perform?

• Are the 3 employees of Holding Company sufficient to fulfil the control-over-risk criterion?

• If no, how can this criterion be fulfilled?

• Would it make any difference if Holding Company licenses the IP back to Subsidiary S1 (instead of Subsidiary S2) which uses the license for manufacturing?

• How should the contract R&D activities of Subsidiary S1 be remunerated? If a cost based approach is applied, what would an appropriate mark-up be?

• Can a contract R&D arrangement be used for the development of digital services?

Contract R&D – Case Study (3/3)

• Expenditure on AMP function by an Indian entity - considered for TP adjustment alleging that

• expenses are incurred on behalf of parent companies situated outside India

• expenses promoted the brands / trademarks that are legally owned by foreign parent AEs

• expenses created or developed marketing intangibles

Authorities argue this as development of the intangibles & deserve compensation.

• Moot question is whether AMP spend can be regarded as an international transaction - several ruling for

and against, the apex court to decide.

• Benefit to foreign AE: How will AE benefit from residual AMP cost (and resultant intangible) for which it is

required to bear the cost of development?

• Economic Vs. Legal Ownership: If legal ownership of intangible is more important than economic

ownership, and brand name is legally owned by AE, then Indian sub should pay a healthy royalty.

• Entrepreneur vs. Limited Risk Entity: Impact of Indian sub being a low-risk entity vis-à-vis an entrepreneur

on how the costs should be handled.

Marketing intangibles (AMP issues)

• MNEs generally claims they control the risk and assets and hence are entitled to a major part of the profits

from R&D

• Issues that have emerged in the TP audits of contract R&D centres:

o most parent companies of MNEs were not able to file relevant documents to substantiate their claim;

o personnel of subsidiary company were engaged in actual R&D activities and borne operational risks;

o decision taken by management of the Indian subsidiary i.e. budget allocation, strategic decisions;

o control over risks of R&D activities with the MNE parent and the Indian subsidiary

o Identifying specific risk associated with intangible transactions, as well as identifying who within the organization

exercises control over those risks

Intangibles generated through R&D activities

• Identification of HTVI - high uncertainty of future cash flows and no reliable comparable

• Appropriate valuation/ identification of ALP of HTVI - key considerations

o No specific guidance in the domestic tax law

o OECD and Judiciary are keen to adopt DCF method basis projected cash flows at the time of transaction.

o Dispute between taxpayer and the Revenue on use of “ex post” data as opposed to “ex ante” data

o Use of hindsight approach using actual cash flows was rejected in valuing intangible asset transfer* Vs Approach by BEPS

o Modalities of computation remain open to differences of opinion between the taxpayer and administration

o Excess earnings method and capitalized cost method are also adopted in practice

• Intangibles used in connection with or developed under CCA or “similar arrangements” is covered under

the scope of HTVI – may open doors to different interpretations of “similar arrangements”

• MAP may potentially resolve cases of double taxation arising from the ex ante/ ex post approach to HTVI

pricing

Hard-to-value intangibles

* DQ (International) Ltd v. Asstt CIT (TS-367-ITAT-2016 (HYD) - TP

• CCA’s are contractual arrangements allow parties to share the contributions and risks involved in either:

• the development, production, or acquisition of intangible or tangible assets; or

• the execution of services

• With an expectation that the parties will enjoy the anticipated benefits from their contributions equitably.

• OECD Guidelines released on Oct 5th 2015 that require participants that provide CCA funding to significantly increase substance around such arrangements and in many cases change the method of valuing CCA contributions

• Guidelines cover both asset-development CCA and service-provision CCA

• Determination of ALP – participants share of contributions to the CCAs will be in proportion to their share of expected benefits.

• Valuation of CCAs – contribution made by participants must be identified and valued at the time of the contributions.

• Predicting expected benefits - same will be exploited by the participants in the proportion of their contribution

Cost Contribution Arrangements (CCA)

• MNE often provide affiliates intercompany support in the nature of HR, finance, IT, legal etc. commonly

known as LVA IGS

• Disputes in India from a recipient standpoint entailing actual receipt of services, benefit test, shareholder

and duplicative services, allocation mechanism and mark-up thereon.

• BEPS AP suggested simplified approach – services which qualify as LVA IGS and routine 5% mark-up

• India restrictively adopted the Guidelines in its safe harbour Rules (inbound) predominantly to safeguard

the home-grown IT/ITeS sector

• Indian entities can receive LVA IGS at a mark up of 5%

o Services are specified/ excluded

o Gaps in safe harbour rules vis-a-vis BEPS Action Plan 8 to 10 in respect of LVA IGS

o Value of international transaction (including mark up) should not exceed INR 100 Mn

Low value adding Intra-Group services (LVA IGS)

• Consideration of location savings (i.e. cost savings in a low cost jurisdiction eg India) while carrying out a

comparability analysis

• Quantification and allocation of location savings and location rents (i.e. incremental profit from LSA)

among the AEs

• Possibility to use PSM to determine arm’s length allocation of location savings and rents in case where

comparable uncontrolled transactions

• In the case of Syngenta India Ltd [TS-988-ITAT-2016(Mum)-TP] Mumbai ITAT held that “Relying on BEPS

Action 8 guidelines and India Chapter in Draft UN Transfer Pricing Manual, observes that no location

savings adjustment is required to be made separately if reliable local market comparables are available”.

Locational Savings

• May be used where both parties to a transaction make unique and valuable contributions (eg contribute

unique and valuable intangibles)

• PSM provides a solution for highly integrated operations in cases for which a one-sided method would not

be appropriate.

• PSM can be a most appropriate method where the intangibles transferred are hard-to-value intangibles.

• Accurate delineation of the actual transaction is important in determining whether a transactional

profit split is potentially applicable.

• Lack of comparables on its own is not a reason to apply PSM

• Allocation of profits may be based on the contributions made by the AEs, by reference to the relative

values of their respective functions, assets and risks.

• OECD recently released revised discussion draft on profit splits – to clarify the application of transactional

PSM, to provide guidance on determining the profits to be split

Transactional Profit Split Method (TPSM)

BEPS Action Plan 13: TP Documentation and CbC Reporting

• Objective of TP documentation – interpreting the value chain of Group, informed risk based assessment of

transaction by tax authorities

• Introduction of three layered documentation

o Master File to provide the MNE’s blueprint

o Local File to provide material TP positions of the local entity / taxpayer with its foreign affiliates

o CbCR to provide jurisdiction wise information of revenue, profits, employees, taxes etc. and entity-wise

details of main business activities which will portray the value chain of inter-company transactions.

CbcR mandatory in India from FY 2016-17, with consolidated turnover exceeding Euros 750 million

CbCR for JVs – dilemma of multiple parents (applicability of CbcR to JVs, determination of Euros 750 million

threshold, Master File, confidentiality of data)

BEPS Action Plan 13: Three - Tier Reporting

• Content & threshold for applicability of Master file

• Entities operating in India only through a PE are required to maintain and file Master File and Local File

• Parent Surrogate Filing – Voluntary filing requirements from India perspective

• CbCR reporting – addressing the differences in GAAP, currency, accounting year related party definitions

etc.

• Aggregation of data for CbCR reporting purposes if there are multiple constituent entities

• Practical Considerations:

• Do existing processes of MNEs support to collate the level of data and exchange required

• How do we interpret the required data given the inconsistencies

• Level of explanatory notes to be provided with CbCR

• Ascertaining the accuracy of data and the risk areas

BEPS Action Plan 13: Three-Tier Reporting

Future of TP Regulations - Certainty or Chaos

• CBCR requirement & Compliance

• Risk-based TP audit process has been introduced in place of quantum- based audit process

• Introduction of range concept and multiple year benchmarking

• In recent audit cycles, TP adjustments have decreased in India* - will BEPS increase?

• Success of Indian APA – Is APA a solution

• Relief for AMP transactions:

o Indian courts have preferred an aggregated approach** for benchmarking of AMP transactions

o In absence of an agreement between Indian entity and foreign AE for AMP, can an international transaction be presumed

o Intensity based adjustment – A new concept

• Nuanced jurisprudence on the categorization of distributors (low-risk, routine, full fledged) is expected

• Future of CBDT circulars on R&D

• Revised Safe harbour is a retrograde step.

Future of TP Regulations – Certainty or Chaos

* In 2012-13, TP adjustments were at INR 700 billion, which recently came down to INR 465 billion in 2014-15 ** Sony Ericsson Mobile Communications (P.) Ltd v CIT (TS-96-HC-2015 (DEL) – TP)

Annexures

• Two step approach – OECD 2010 Report

o Step 1 – Functional and factual analysis

o Step 2 – Determining profits of the hypothesized PE based on comparability analysis

• As part of Action Plan 7, discussion draft on attribution of profits to PE was issued in July 2016

• OECD recently released revised discussion draft on attribution of profits to PEs

• Questions for discussion -

o Arm’s length approach OR global formulary approach (i.e. as provided in Rule 10 of IT Rules, 1962)?

o PE Attribution in the case of digital economy?

o APA an effective tool to resolve attribution issue?

o Extent of attribution different for single PE v multiple PEs?

o Would attribution result differ based on type of PE (physical presence, management, service PE, dependent agent)?

Attribution of profits to PE

Glossary

Term Description

AE Associated Enterprise

ALP Arm’s Length Price

AMP Advertisement, Marketing and Promotion

AP Action Plan

APA Advance Pricing Agreement

BEPS Base Erosion and Profit Shifting

CbCR Country by Country Report

CCA Cost Contribution Arrangements

DCF Discounted Cash Flow

DEMPE Development, Enhancement, Maintenance, Protection and Exploitation

FAR Functions, Assets and Risks

HC High Court

Glossary

Term Description

HTVI Hard to Value Intangibles

IT Income Tax

ITAT Income-tax Appellate Tribunal

JV Joint Venture

LSA Location Savings Adjustment

LVAS Low Value Adding Services

MN Million

MNE Multinational Enterprise

OECD Organization for Economic Co-operation and Development

PE Permanent Establishment

PSM Profit Split Method

R&D Research and Development

TP Transfer Pricing

Contacts

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Mukesh Butani +91 9811132000 [email protected]

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