transfer pricing recent issues - wirc.ppt pricing recent issues... · analysis of important...

Analysis of important transfer pricing decisions, nuances

and practical application from India perspective

SEMINAR ON TRANSFER PRICING REGULATIONS

June 19, 2011 - CA Rajesh S. Athavale

� Evaluation of Transfer Pricing

� Recent Indian jurisprudence on Transfer

Pricing

� Way Forward

Agenda

� Way Forward

Evaluation of Transfer Pricing

“Transfer Pricing can deprive governments of their fair share of taxes from global corporations and expose multinationals to possible double taxation. No country – poor, emerging or wealthy – wants its tax base to suffer because of transfer pricing. The arm’s length

principle can help.”

Transfer pricing Evolution - OECD’s View

principle can help.”

By John Neighbour

Organisation for Economic Co-operation and Development

‘OECD’ Centre for Tax Policy and Administration

4

�Protection of tax base

�Equitable sharing of tax revenues between the

nations – i.e. Residence and Source countries

�Principles should be internationally acceptable to

avoid economic double taxation

Objectives of Transfer Pricing Regulations (TPR)

avoid economic double taxation

�Practical difficulties in applying the regulations

should be recognised by both countries

�No discrimination between Multinational

Enterprise (MNE) groups and Independent

Enterprises – the standard of comparability

should be impartial5

�Embedded in the Double Taxation Avoidance Agreement (‘DTAA’) Article (9) of the OECD Model Convention

�The OECD Report on Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (the Guidelines), is the Foundation

Evolution of TPR…

Foundation

�Based on Arm’s Length Principle – The universal principle which is the foundation of TP legislation globally

6

Above principles serve the dual objectives

- Securing the appropriate tax base in

each jurisdiction and avoiding double taxation

The Arm’s length Standard (ALS) is the Universal Standard that is applicable to the

various intra-group transactions of a Multinational Enterprise (MNE). It is based on the separate – entity approach and is enshrined

Arm’s Length standard – The Universal Standard (ALS)

the separate – entity approach and is enshrined in the DTAAs signed by the various countries.

7

� Revenue Authorities becoming extremely stringent in protecting tax base

� Relatively new subject but judicial pronouncements now available

� Separate set-up for administering TP

Revenue Authorities’ Approach

� Separate set-up for administering TP

� Dispute Resolution Alternatives available in domestic law and experiences

� Six rounds of TP audit completed – FY 2001-02, 2002-03, 2003-04, 2004-05, 2005-06 ,2006-07 and 2007-08

� All cases having transaction value > INR 50 million referred by AO to TPO for TP scrutiny

Particulars FY

2001-02

FY 2002-

03

FY 2003-

04

FY 2004-

05

FY 2005-

06

F Y 2006-

07

FY 2007-

08

Transfer Pricing Disputes – An Overview

2001-02 03 04 05 06 07 08

Cases picked

up for

scrutiny

800 Approx.

1500

Approx.

2500

Approx.

3500

Approx.

4500

Approx.

6000

Approx.

7000

Tax demands INR 1.2

billion

INR 2.5

billion

Approx.

INR 3.5

billion

Approx.

INR 5

billion

Approx.

INR 6.5

billion

Approx

INR 8

billion

Approx

INR 20

billion

9

Recent Case Laws

SAP Labs India Pvt. Ltd.

� Facts of the Case� SAP India engaged in software development and related services to SAP AG – STPI unit – Exempt under section 10A

SAP Labs (India) SAP AG (Germany)

Software Development

services

100% holding

SAP AG – STPI unit – Exempt under section 10A

� SAP India operated under R&D Agreement and remunerated at cost plus 6% or 1.5 times of wages bill, whichever was higher

� Transfer Pricing Officer (TPO) initially tried to apply CUP method, by comparing rates charged by comparable companies as per NASSCOM data

� TPO later applied TNMM ignoring the initial intention to apply CUP and made adjustment

� Tribunal held as under:

� Transfer Pricing provisions are applicable irrespective of the fact, whether income is taxable or not

� Under the Income Tax Act, even if income is exempt, transfer pricing adjustment is not exempt from tax

� Aim of transfer pricing provision is to determine the arm’s


� Aim of transfer pricing provision is to determine the arm’s length price by applying the most appropriate method (MAM)

� In the process of evaluation of MAM, all methods need to be evaluated, hence shifting from one method to another is within law

� Tribunal held……….

� Need to evaluate correctly the operating margin of the tested party � Foreign exchange fluctuation gain – operating income

� Interest in income tax refund – non-operating income

� Donation – operating cost

� Proviso to Section 92C(2) provides for +/- 5% range from arm’s


� Proviso to Section 92C(2) provides for +/- 5% range from arm’s length price as a standard deduction, however, after amendment by Finance (No. 2) Act, 2009, this leeway is not available and the amendment is prospective in nature

� Comparable analysis needs to consider the economics of the tested party. Thus in the present case, high profit making, loss making companies, different functionality need to be eliminated from the set of comparable companies

� Companies having margins less than that contracted by the tested party, needs to be eliminated

� +/-5% Range - Example

Particulars Amounts in

INR

Operating income

(Transfer Price)

110

Total operating cost (TC) 100

Particulars Amounts in

INR

Operating income

(Transfer Price)

110


Current Position Amended Position


14


Operating profit (OP) 10

OP/TC 10%

Comparables margin 17%

ALP 117.00

95% of ALP 111.15

105% of ALP 122.85


Operating profit (OP) 10

OP/TC 10%

Comparables margin 17%

ALP 117.00

95% of Transfer Price 104.50

105% of Transfer Price 115.50

As per the current position of law and the

view taken by various Tax Tribunals, in the

above example, the adjustment would be

Made as 111.15-110.00 i.e. 1.15

Here, the question arises as to whether

the adjustment shall be made

as 117.00-115.50 or 117-110?

� Take Aways

� Shifting of profit is not a criteria for applicability of TP

� Zero down on a particular method as the MAM

� Selection of MAM will depend upon the facts of the case and the factors mentioned in rules


the case and the factors mentioned in rules contained in rule 10C

� New proviso to section 92C(2) inserted by the Finance (No.2 ) Act is prospective in nature

� Limitation of data base

� Brief Facts

� Maruti India – subsidiary of Suzuki Motor Corporation, Japan, engaged in manufacture and sale of automobiles

� Enters into license agreement with prior approval of Government of India for use of Suzuki logo for sale of certain Suzuki model in India

Maruti Suzuki

certain Suzuki model in India

� Under license agreement, Suzuki was to provide technical information, know-how, etc.

� However, Maruti was to compulsorily use the trademark of ‘Maruti Suzuki’ on containers, packages and wrappings

� Brief Facts….

� According to the TPO the change of brand logo from ‘Maruti’ to ‘Suzuki’ amounted to sale of the brand ‘Maruti’ to ‘Suzuki’

� TPO computed the value of ‘Maruti’ brand at cost plus 8 % at INR 4,420 crores and issued show-cause notice as to why the international transaction not be adjusted on the basis of

Maruti Suzuki

international transaction not be adjusted on the basis of deemed sale to Suzuki

� Maruti in its reply stated that there was no transfer of ‘Maruti’ brand or logo by it and Suzuki had not charged any additional consideration for the use of such logo on the vehicles manufactured by Maruti

� Jurisdiction of TPO was challenged by Maruti

� Brief Facts…

� Action of TPO

� Issued detailed questionnaire on replacement of logo and clarified that this is transfer of economic value

� Maruti paid royalty of INR 198.6 to Suzuki but no compensation given by Suzuki to Maruti

� However ‘Suzuki’ trademark had piggybacked on ‘Maruti’ trademark without payment of any compensation

Maruti Suzuki

trademark without payment of any compensation

� Apportionment of 50% of the amount of royalty paid by Maruti to Suzuki and the ALP was determined at "Nil" using CUP method

� Maruti had developed marketing intangibles for Suzuki in India, at its own cost and Suzuki had not compensated for the same

� Based on the 3 comparable companies, TPO concluded that non-routine advertisement expenditure of INR 107.22 crores had to be adjusted

� Decision of the Delhi High Court� Suzuki Trade-mark was not piggybacking on Maruti logo

� No transfer of Maruti brand to Suzuki

� No right given to Suzuki for using Maruti logo

� Agreement is critical for payment of license fees

� Grounds of adjustment must be stated in the notice issued in clear, cogent, specific and in an unambiguous manner

Maruti Suzuki

cogent, specific and in an unambiguous manner

� The onus is on assessee to demonstrate whether transaction is at ALP or not

� Compulsory usage of logo of AEs results in creation of marketing intangibles for AEs, hence compensation from AE is required

� Level of marketing spend by licensee will determine whether the licensee needs to be compensated

� Maruti filed SLP before SC against observation made by HC

� The SC has now held that, the HC has not merely set aside the original show-cause notice but it has made certain observations on the merits of the case and has given directions to the TPO, which virtually conclude the

Maruti Suzuki

given directions to the TPO, which virtually conclude the matter. Accordingly, the SC has directed that the TPO should now pass his order uninfluenced by the observations/ directions of the High Court

� Take Aways

� Normal and excessive advertising and promotional expenditure

� Whether excessive marketing and advertisement expenditure or promotion of foreign brands create marketing intangibles in India

Maruti Suzuki

marketing intangibles in India

� Use of intangibles need to be compensated at arm’s length basis

� Facts of the case� Sardia Pharmaceuticals, a pharma company, was engaged in business of producing drugs mainly in field of anti-hypertension and metabolism

� Assessee imported active pharmaceutical ingredients

Sardia Pharmaceuticals India (P) Ltd

Sardia

Pharmaceuticals

India

pharmaceutical ingredients (API) from its Aes

� Assessee determined ALP by adopting TNMM method

� TPO rejected TNMM method and selected CUP as a MAM

� TPO obtained API data of competitors & made adjustment after allowing difference quality and purity standards

Servier Egypt Servier France

Purchase of

API

� Ruling of ITAT

� Selection of method for determining ALP is not on the unfettered decision on the taxpayer

� TPO can reject method adopted by assessee with cogent reasons and must be through speaking order

� CUP and traditional transaction methods are preferred over the transaction based profit methods


preferred over the transaction based profit methods

� Price movements and demand sensitivity to the price indicate that APIs imported are not unique items, and therefore by paying exorbitant price to AE for such items leave ample scope to manipulate API prices to regulate profitability of their controlled entities in the end use jurisdiction

� Ruling of ITAT

� APIs were generic drugs and not patent protected when they were purchased from AEs; hence attributing high price to cost and process of developing a new drug cannot be accepted

� It should compete with the generic drug manufacturers, in post patent period, on selling prices


manufacturers, in post patent period, on selling prices

� Re-characterization provisions in respect of payments made in excess of ALP as dividend, royalty or other income to AEs as done in Glaxo case have not yet been legislated in India

� The overseas judgement are no binding in India but their logic and rational can be relied upon

� Ruling of ITAT

� Branded API can be comparable to Generic API as benefit reaped before patent expiry

� Acceptance of value by custom authorities does not imply the compliance of the same under the Indian Transfer Pricing Regulations

� Sales to unrelated parties in different countries can not be


� Sales to unrelated parties in different countries can not be considered as internal CUP due to different to geographical location and inadequate data

� CUP has been considered as a MAM

� Take Aways

� Need and importance to demonstrate to revenue authorities the correct business model, so as to bring out the economic rationale behind the conduct of business

� Superiority of CUP over TNMM

� Residue supernormal profits lying with the Indian


� Residue supernormal profits lying with the Indian entity after applying the CUP method, rightfully belong to whom?

� it Branded API can be comparable to Generic API as benefit reaped before patent expiry

� Play between the intangibles and the business model

� Brief Facts� Perot Systems was engaged in

business of designing and developing technology enabled business transformation solutions and providing business consulting, systems

Perot Systems

Perot Systems

(India)

Foreign currency

Interest free business consulting, systems integration services and software solutions & services

� It had extended foreign currency interest free loans to its two AEs (one is located in tax haven)

� TPO held that interest free loans were not at arm’s length

HPS Global Systems Hungary

Liquidity Management LLC

HPS Global Systems (Bermuda)

Ltd

Interest free loans

� Observations and Ruling of the ITAT� Real Income theory not to apply to the Transfer Pricing� Agreement is silent on quasi-equity nature of loan � Agreement does not bring out the necessity of lending interest-free loan

� Economic substance of the transaction is that of the

Perot Systems

� Economic substance of the transaction is that of the debt and not in the nature of equity or quasi-equity

� Classic case of violation of transfer pricing norms where profits are shifted to tax havens or low tax regimes to bring down the aggregate tax incidence of a multinational group

� RBI’s approval for granting interest-free loan is not determinative of arm’s length nature of transaction

� Benefit of +/-5% not to be granted to LIBOR

� Take Aways

� Interest-free loan and guarantee to overseas subsidiary, whether interest/fees to be charged always necessary?

� Importance of legal agreement in synch with economic

Perot Systems

� Importance of legal agreement in synch with economic rationale, Robust documentation, Loan agreement , economic reasons, special circumstances, need for granting interest-free loan to be brought out

� Framing of Safe harbour Rules for such transactions

� Whether LIBOR is a single rate or average rate – Benefit of +/-5% under the new law

� Brief Facts� Birlasoft (India) Ltd. was engaged in the business of software development and related services

� For determining the ALP in respect of the international transactions with the AEs, the assessee applied internal TNMM

Birlasoft (India) Ltd

� TPO rejected the internal bench marking as assessee did not maintain segmental accounts for the related and non-related transactions and there was no segregation of these activities in the audited financials report

� DRP upheld the order passed by the TPO

� Observation of Delhi Tribunal � Lack of segmental reporting in the audited financial statements cannot be a

reason of rejecting method of computing the ALP

� Undertaking internal bench marking analysis on stand alone basis is justified

� OECD Guidelines provides that the net margin of the taxpayer from the controlled transaction should ideally be established by reference to the net


controlled transaction should ideally be established by reference to the net margin that the same taxpayer earns in comparable uncontrolled transactions, and only where this is not possible, the net margin that would have been earned in comparable transactions by an independent enterprise may serve as a guide

� TPO had no mandate to have recourse to external comparables when internal comparables were available

� Take Aways

� Internal TNMM is more reliable than external TNMM

� Assessee maintain segmental account, applying the proper keys for allocation of income and expenses


expenses

� Reporting of such segmental results in the Financials not necessary for Transfer Pricing Analysis

GV-India RCSEnd

Customer

Provision of I.T. Enabled servicesProvision of I.T. Enabled services

Flow of RevenueFlow of Revenue

Revenue = $ 100Revenue = $ 100Retains $9.4 and passes

$ 90.6

Retains $9.4 and passes

$ 90.6

Global Vantedge

Facts of the case

• Global Vantedge (‘GV-India’) was engaged in rendering of IT-enabled

services

• RCS Centre Corp (RCS), provided marketing services and enters into

contracts with the ultimate clients. Passed on the contract to GV-India

on a back-to-back basis

• RCS retained 9.4 % (marketing services) of the total revenue earned

from the client and then passed balance 90.6% of the revenue to GV

• Facts….

• For benchmarking the transaction GV-India considered

its AE, RCS, as tested party and compared profit margin

of RCS with foreign comparable companies

• TPO had chosen GV-India as tested party and arrives at

Global Vantedge

• TPO had chosen GV-India as tested party and arrives at

avg. operating margin of comparables was 11.88% as

against the loss incurred by GV-India

• Applying the Arm’s Length Margin of 11.88% on the total

operating cost, the TPO proposed the adjustment

• If the adjustment to be taken into account, the total value

exceeded the revenue earned from client ultimately

� ITAT upheld the findings of CIT(A) as under:

� Least complex entity should be selected as tested party

� If an entity is unable to earn adequate profits on account

of legitimate business exigencies and not due to

manipulation of transactions undertaken by AEs, such

entity cannot be penalized

Global Vantedge

entity cannot be penalized

� ALP of international transaction between the taxpayer

and its AE can not exceed the total amount of revenue

earned from clients by GV-India and AE together.

� Comparable companies with substantial related party

transactions should be rejected

� Take Aways

� International transaction to be evaluated from end to

end perspective while determining the arm’s length

nature of transaction

� Least complex entity should be selected as tested party,

subject to availability of comparable data

Global Vantedge

subject to availability of comparable data

� Facts of the Case� Symantic Software Solution (SSS) was engaged in business of providing technical and marketing, pre-sale, and after sales support of Veritas group products

� SSS provided two types of services to its AE� Marketing support services� Consultancy Services

Symantec Software Solution

� Consultancy Services

� For Marketing support services SSS was remunerated Cost plus 2 percent and for Consultancy Services SSS was remunerated Cost plus 8 percent

� SSS benchmarked transaction by using TNMM method

� TPO made transfer pricing adjustment by selecting different/new comparables

� Contention of Assessee� TPO can not consider comparables, whose financial information was not available at the time of TP study

� Multi year data of comparables could be considered

� Turnover filter had to be applied for identification of


� Turnover filter had to be applied for identification of comparable companies

� Adjustment for difference in functional and risk profile between comparable companies & assessee

� Benefit of +/-5% to be granted

� Tribunal held as under

� The comparison should be between the net margin on transaction basis and not at enterprise level

� Material available at public domain, even though not available to assessee at the time TP study is relevant


� Multi year data has limited role only when the data of earlier years reveals the facts which could have influenced the transactions; in this case the claim of multi year data can not be entertained

� Tribunal held….� Unless and until it is brought under record that turnover of comparables has undue influence on margin it is not general rule to exclude such comparables

� No economic adjustment difference in functional and risk profile as assessee fails to bring any relevant material on


profile as assessee fails to bring any relevant material on record

� Amendment in proviso to section 92(c) - not clarificatory in nature and therefore to be applied prospectively

� Take Aways

� Limitation of data base

� Contemporaneous date/updatation of data

� Economic analysis/Search filter

� Need for quantitative risk adjustment to be


� Need for quantitative risk adjustment to be brought out

� Use of multi-year data – Proposed price

� Facts of Case

� Dana Corporation, resident of US, filed bankruptcy

� As part of the bankruptcy proceedings, a reorganization plan was submitted to the US Bankruptcy Court

Dana Corporation

� The reorganization resulted in the transfer of shares of the three Indian companies to the new company

� The transfer was without consideration as per the share transfer agreement

� The AAR held as under:

� Transfer of Indian companies shares was without consideration; or

� At any rate the consideration is indeterminable

� Thus, the charging provision of Capital Gains (Section 45) is not applicable

Dana Corporation

is not applicable

� Hence, such transfer of shares are not chargeable to tax

� Where the charging section fails to operate, the transfer pricing provisions does not come to the rescue of the revenue authorities

� Take Aways

� Compliance under Transfer Pricing Regulations

� Filing of income tax return

Dana Corporation

Issue Position Case law

Functional Analysis Functional analysis of tested party as well as

comparables necessary

�Aztec Software

� E-Gain Communication

� Sony India Pvt. Ltd.

� Skoda India Pvt. Ltd.

� UCB India Pvt. Ltd.

�Quark System

Maintenance of segment wise P&L

for diversified activities

Separate evaluation for different functional

activities

� Development Consultants

� Star India Pvt. Ltd.

Recent case-laws - Key takeaways

45


Rejection of taxpayer’s method Taxpayer’s method / comparables should be

rejected by the RA before adopting another

method / comparables

�Aztec Software

�MSS India

Selection of tested party Party having least complex functions and not

owning valuable intangibles should be

selected as tested party. Foreign Company

may be selected as tested party.

Foreign Company rejected as tested party as

it is difficult to compare entitlements of

different geographical locations

� Development Consultants

� Ranbaxy Laboratories

�Global Vantedge


Comparables rejected on the basis

that they are incurring losses

Comparable cannot be rejected merely

because it is incurring losses.

� Sony India Pvt. Ltd.

� Quark System

Principles of natural justice Adjustments to be in synch with show

cause notice. Taxpayer should be given

opportunity to rebut Tax Officer’s material

�Moser Baer

� Dufon Laboratories

�Maruti Suzuki

� Quark System

Maintenance of documentation Taxpayer should reasonably comply with � Cargill India Pvt. Ltd.


46

Maintenance of documentation Taxpayer should reasonably comply with

documentation requirements under the

law. Tax Officer cannot reject taxpayer’s

analysis merely on the ground that all

documentation required under the

regulations is not maintained.

� Cargill India Pvt. Ltd.


Methods to be followed as

prescribed under section 92C

TPO cannot exceed his limitation by

following any method to determine the

ALP which is not authorised by the Act.

It is mandatory for the assessee to follow

one of the methods prescribed under the

Act

� CA Computer Associates

� Starlite


Payment for use of trademark Compulsory use of logo results in creation

of marketing intangibles of the AEs.

Compensation from AEs is required

Quantum of marketing spend by the

licensee will determine whether the

licensee needs to be compensated

�Maruti Suzuki

Adjustments under Transfer Pricing Transfer Pricing Adjustments cannot

exceed the total revenue earned by the

�Global Vantedge


47

exceed the total revenue earned by the

assessee and its AEs from the third parties

Non-applicability of Transfer Pricing

Provisions

Where the charging section fails to tax the

income, Transfer Pricing Provisions does

not come to the rescue of RA

�Dana Corporation

Applicability of Transfer Pricing

Provisions

Transfer Pricing Provisions are applicable

irrespective of the fact whether income is

taxable or not and whether assessee is

enjoying 10A / 10AA / 10B benefits

�SAP India

�Aztec Software

�Oracle India

Use of External CUP Data for

comparability analysis

Nasscom Rates used for evaluation of

transfer pricing

�Aztec Software (Against)

� 3 Global

Way Forward

� Revenue Authorities becoming extremely stringent in protecting tax base

� Multinationals need to factor in Revenue Authorities’ stand in their business strategy in India

� Taxpayers need to bring out the true economic substance of the controlled transaction, the depiction of risks undertaken

Way Forward

the controlled transaction, the depiction of risks undertaken and other relevant documentation to discharge their burden of proof, under the Indian TPR

� Mechanical approach to TP with emphasis only on mere quantification analysis may not be sufficient to protect the taxpayer

CA Rajesh S Athavale, Partner

Thank You

CA Rajesh S Athavale, Partner

Vispi T. Patel & Associates

Chartered Accountants

#10, Dwarka Ashish, Jambul Wadi,

Opp. Edward Cinema, Kalbadevi Road,

Marine Lines, Mumbai – 400 002

Contact No.: +91 22 2208 7742/+91 99670 64422

Email: [email protected]

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