ISSUES, STRATEGIES & SOLUTIONS

1. TRANSFER PRICING ISSUES, STRATEGIES & SOLUTIONS CA VINOD JAIN B.Com (H), FCA, FCS, FICWA, LL.B, DISA (ICAI) INMACS MANAGEMENT SERVICES LIMITED 909, Chiranjiv Tower, 43 Nehru Place, New Delhi-110019 Global Business Square, Bld. No. 32, Sec. 44, Institutional Area, Gurgaon, Haryana- 122001 Ph: 011-26223712, 6933, 8410 ; +91-9811040004; vinodjainca@gmail.com

2. A B C D A B E C Sec 92A - Associated Enterprises Direct or indirect participation (through one or more intermediaries) in management, control or capital – Sec 92A(1) Outside India Situation 1 This section is further supplemented by 13 clauses which enlist various situations under which two enterprises shall be deemed to be AE’s – Sec 92 A(2) In India Both A and B are associated enterprises of C Outside India Situation 2 In India D and E are also associated enterprises of C since they have a common ultimate parent (A)

3. Sec 92A(2) - Deemed Associated Enterprises Person or enterprise holds not less than 26 % voting power in the other enterprise Loan advanced constitutes not less than 51% of the book value of total assets Guarantee by one enterprise constitutes not less than 10 % of total borrowings Manufacture or processing of goods is wholly dependent on intangibles of the owner

4. Sec 92A(2) - Deemed Associated Enterprises 90% of raw materials are supplied by the other enterprise; prices are also influenced More than half of the board of directors or executive directors are appointed by the other enterprise There exists between the two enterprises any relationship of mutual interest

5. Prior agreement 3rd party A’s Parent Services A Determination of terms 3rd party A’s Parent Services A Deemed International Transactions Third parties transactions deemed to be international transaction - Sec 92B(2) • Transaction between A and 3rd party also subject to transfer pricing norms, if: • a prior agreement exists between A’s parent and 3rd party; or • terms of transaction are determined in substance by A’s parent and 3rd party.

6. Concept Independent entity Associated enterprise International transactions - goods - services - intangibles - loans Resident Resident Transfer price Arm’s length price

7. Comparable Uncontrolled Price Method (1/2) - CUP Parent Co. Outside India Transfer Price Situation 1 Internal CUP India Sub Co. Unrelated Co. X Unrelated Co. Y Outside India External CUP Situation 2 India Unrelated Co. Z

8. Comparable Uncontrolled Price Method (2/2) - CUP • Most Direct Method for testing ALP and the Prices are Benchmarked • Requires strict comparability in products, contractual terms, economic terms, etc. • Two types of CUPs available - Internal CUP & External CUP • Calls for adjustments to be made for differences which could materially affect the price in the open market e.g.: • Difference in volume/quality of product • Difference in credit terms • Risks assumed • Geographic market • OECD - Priority to Internal CUP over External CUP due to higher degree of comparability.

9. Resale Price Method (1/2) - RPM Price paid by Sub Co. to AE is at arm’s length if the 25% resale margin earned by Sub Co. is more than margins earned by similar Indian distributors Parent Co. Outside India Transfer Price INR 75 India Resale Price INR 100 Unrelated Co. Sub Co.

10. Resale Price Method (2/2) - RPM • Compares the resale gross margin earned by associated enterprise with the resale gross margin earned by comparable independent distributors • Preferred method for a distributor buying purely finished goods from a group company (if no CUP available) • To be applied when a goods purchased or service obtained from an AE is resold to an unrelated enterprise. • Under this method comparability is less dependent on strict product comparability and additional emphasis is on similarity of functions performed & risks assumed.

11. Cost Plus Method (1/2) - CPLM Outside India Price charged by Sub co to AE is at arm’s length if the 25% mark up on cost is more than that of similar Indian assemblers Parent Co. Transfer Price INR 125 India Sub Co. Direct Cost & Indirect Cost of Production INR 30 COGS INR 70 Co.Y / AE Co. Z

12. Cost Plus Method (2/2) - CPLM • Compares the mark up earned on direct and indirect costs incurred with that of comparable independent companies. • Preferred method in case • Semi finished goods sold between related parties • Contract/toll manufacturing agreement • Long term buy/supply arrangements • To be applied in cases involving manufacture, assembly or production of tangible products or services that are sold/provided to AEs • Identifies direct and indirect costs of production of goods/services • Comparability under this method is not as much dependent on close physical similarity between the products – Larger emphasis on functional comparability

13. Profit Split Method (PSM) • To be applied in cases involving transfer of unique intangibles or in multiple international transactions that cannot be evaluated separately. • Calculates the combined operating profit resulting from an inter-company transaction based on the relative value of each AEs contribution to the operating profit. • Evaluates allocation of combined profit/loss in controlled integrated transactions. • The contribution made by each party is based upon a functional analysis and valued, if possible, using external comparable data. • The two methods discussed by OECD Guidelines • Contribution PSM Analysis • Residual PSM Analysis

14. Sec 92C – Methods to determine Arm’s Length Price • Most Appropriate Method shall be the method best suited to the facts and circumstances of each particular international transaction and which provides the most reliable measure of an arm’s length price in relation to the international transaction. • Factors considered for selection of the Most appropriate method: • Nature and class of international transaction • Class of associated enterprise and functions performed • Availability, coverage and reliability of data • Degree of comparability between the international transactions • Extent to which reliable and accurate adjustments can be made • The nature, extent and reliability of assumptions for application of method • Computation of ALP – • Determination of arm’s length prices using one of the prescribed methods • In case of more than one price: ALP = Arithmetic Mean of such prices • +/- 3% variance to arm’s length “price” permitted : (Safe harbour)?

15. Transactional Net Margin Method (TNMM) • Examines net operating profit from transactions as a percentage of a certain base (can use different bases i.e. costs, turnover, etc) in respect of similar parties. • Ideally, operating margin should be compared to operating margin earned by same enterprise on uncontrolled transaction – Internal TNMM. • Most frequently used method in India, due to lack of availability of comparable uncontrolled prices and gross margin data required for application of the comparable uncontrolled price method / cost plus method / resale price method. • Broad level of product comparability and high level of functional comparability. • Applicable for any type of transactionand often used to supplement analysis under other methods. • The application of the TNMM to a specific tested party breaks down when factors other than transfer prices have a material impact upon profits.

16. Selection of Transfer Pricing Methods

17. Databases

18. Databases available in the public domain • Suitable comparables can be selected in various ways viz. by search in database, through company websites, publicly available annual reports of the companies, information available in industry surveys etc. • The Act does not provide any one way of collecting the data or selecting the comparable. • The databases used for the search of comparable companies are publicly available databases - Prowess and Capitaline. The revenue authorities also have access to these databases. • The other websites which are considered for selection of comparables through the use of publicly available annual reports are: • Ministry of corporate affairs • Capitaline – annual reports website

19. Overview of Databases – Prowess • Prowess is a database of large and medium Indian companies developed by the Centre for Monitoring Indian Economy Private Limited (‘hereinafter referred to as ‘CMIE’). • Analysis of over 24,000 companies • Covers: Organized industrial activities, Banking, Organized Financial and other services sectors in India. • Contains 1500 data items and ratios per company. • Provides quantitative information on: Production, Sales, Consumption of raw material and Energy, etc. • Provides contact information , share holding pattern, list of bankers, auditors, news abstracts and such other relevant information. • Provides several querying power to the user.

20. Industry/ Information covered by Prowess Major Industries covered Sub Industry Type of Information • Base metals • Chemicals • Construction Equipment • Electrical Machinery • other than Electronics. • Electronics • Miscellaneous Manufactured Articles. • Non metallic mineral products • Non-electrical machinery • Plastics and rubbers • Services • Transport Equipment • Quantitative • Financial Ratios • Absolute values • Archive of Information • Investment Indicators • Directors report, Auditors’s report, management discussions and analysis, etc under one database. There are various sub-industries within each of the industries mentioned under the industry column. Although it is not practical to enumerate them, it is definitely worthwhile to note that it helps reach the desired category of companies.

21. Overview of the Database - CapitalinePlus • Capitaline is a financial and non-financial database developed by the Capital Market Publishers India Private Limited which provides fundamental and market data on more than 21,000 Indian listed and unlisted companies. • Extensive data analysis, company profile, director’s reports and more than 10 years financials, cash flow, segment data etc. • It provides financial overview using key financial data, forex data, cash flow and market capitalization with rate of growth. • Covers nearly 300 industries and has access to web pages from within the application. • Provides facility to download Annual Reports for last 3 years from within the application.

22. Industry/ Information covered by Capitaline Sub Industry Industry Groups Type of Information • Metals • Cement • Chemicals • Constructions • Engineering • Electronics • Pharmaceuticals • Automobiles • Auto Ancillaries • Plastics • Transport • Steel • Quantitative • Financial Ratios • Absolute values • Archive of Information • Investment Indicators • Directors report, Auditors’s report, management discussions and analysis, etc under one database. • Last 3 year’s Annual Reports There are various sub-industries within each of the industries mentioned under the industry column. Although it is not practical to enumerate them, it is definitely worthwhile to note that it helps reach the desired category of companies.

23. Stock Exchanges London Inter Bank Offered Rates Foreign Exchange Rates Commodity Markets Other Databases / Sources of Information

24. Other Method Rule 10AB – Sixth Method notified by CBDT • Rule 10AB has now been inserted in the Income-tax Rules, 1962 - Applicable from FY 2011-12. • “any method which takes into account the price which has been charged or paid, or would have been charged or paid, for the same or similar uncontrolled transaction, with or between non-associated enterprises, under similar circumstances, considering all the relevant facts." • Effectively, this implies that under this “other method” “quotations” rather than prices “actually” charged or paid can also be used by the taxpayers • Could also cover new instances of ALP computation which would now arise due to the various amendments introduced in the Finance Act 2012 like expansion/clarification of the definition of “international transaction” and introduction of domestic transfer pricing. (e.g. intangibles, exit charge)

25. Most Appropriate Method – Rule 10C of the Rules Factors considered for selection of the Most Appropriate Method: • Nature and class of specified domestic transaction • Class of domestic related enterprise and functions performed • Availability, coverage and reliability of data • Degree of comparability • Extent to which reliable and accurate adjustments can be made • The nature, extent and reliability of assumptions for application of the method

26. STRATEGIES… Finance Act 2009 - Amendments

27. STRATEGIES… • To plan that relationship of all the enterprise do not exist while undertaking intermediary transactions. • Restructure Relationship • Restructure Transactions • Route transaction through unrelated enterprises without attracting “PRIOR AGREEMENT”, “DOWN DECIDED BY AE” • Price on margin along with comparables • To dig date about competitors or other player in market from MCA 21, National Databases as well as International databases, websites of concerned companies etc. • Undertake FAR analysis and then decide the price.

28. STRATEGIES… • Develop Internal comparables • Undertake transactions with unrelated parties for similar goods or services at comparable prices • Apply Rule 10C • Obtain quotations at the time of undertaking transactions • Preserve emails, public offers • Include all the above in TP Study and submit to TPO and AO (Bring on record justification).

29. Important Aspects of Strategy • Determination of Arm’s Length Price – Concept of +/- 3 percent variance. • Introduction of Safe harbour rules • Creation of Dispute Resolution Panel

30. Important Aspects of Strategy • ISSUES • Which Method to use? • Since CUP method provides most direct comparison, it is preferable to other profit based methods like TNMM.Hughes Systique India (P.) Ltd. vs. Assistant Commissioner of Income-tax, Range-12(1), [2013] 36 taxmann.com 41 • How to apply CUP?How third parties had procured similar products in similar circumstances.Kodak Polychrome Graphics (I) (P.) Ltd. vs. Additional Commissioner of Income-tax, Circle-7(1), Mumbai, [2013] 36 taxmann.com 42 • In view of provisions of section 92C, ALP is to be determined by any one of prescribed methods which is most appropriate under facts of case, however, it is neither open to assessee nor TPO to discard prescribed methods and invent a new method or apply any other yardstick for determining ALP. • Onward Technologies Ltd. vs. Deputy Commissioner of Income-tax, (OSD), Range 8(1), Mumbai, [2013] 35 taxmann.com 584

31. Important Aspects of Strategy • Internal Comparables vs. External Comparables • Internal comparables are preferable over external ones due to similarly in product, economic factors, management factors, finance involvement etc.Pino Bisazza Glass (P.) Ltd. vs. Assistant Commissioner of Income-tax (OSD), Circle -5, Ahmedabad, [2013] 36 taxmann.com 43 • Internal comparability analysis could not be rejected merely because unrelated party transactions constituted 20.3 per cent of aggregate revenue.Hughes Systique India (P.) Ltd. vs. Assistant Commissioner of Income-tax, Range-12(1), [2013] 36 taxmann.com 41

32. Important Aspects of Strategy • Number of Comparables • Arm's length price can be calculated even on basis of one comparable.Pino Bisazza Glass (P.) Ltd. vs. Assistant Commissioner of Income-tax (OSD), Circle -5, Ahmedabad, [2013] 36 taxmann.com 43 • The Delhi ITAT Bench has held that where assessee benchmarked its international transactions with AE, making internal comparison with its international transactions with unrelated parties, same was acceptable, on basis of assessee's own case for preceding two assessment years.Birla Soft (India) Ltd. vs. Deputy Commissioner of Income-tax, Circle - 3(1), New Delhi, [2013] 34 taxmann.com 269 • In absence of evidence on records that comparables belonging to high end segments, cannot be excluded. Vodafone India Services (P.) Ltd. vs. Deputy Commissioner of Income-tax, 3 (3), [2013] 36 taxmann.com 127

33. Important Aspects of Strategy • The Bangalore ITAT bench has held that Where lower turnover filter had been applied for selection of comparables, application of upper turnover filter was also warranted. NDS Services Pay-TV Technology (P.) Ltd. vs. Additional Commissioner of Income-tax, Range - 12, Bangalore, [2013] 33 taxmann.com 414 • The Mumbai ITAT bench has held that comparability in such a case has to be examined on segment level.Deputy Commissioner of Income-tax, Circle-1(2), Pune vs. Haworth (India) (P.) Ltd., [2013] 33 taxmann.com 111 • The Bangalore ITAT bench has held that Turnover filter of Rs. 1 crore to Rs. 200 crore is justified for selecting comparables.Witness Systems Software India (P.) Ltd. vs. Deputy Commissioner of Income-tax, Circle - 11(1), [2013] 34 taxmann.com 183

34. Important Aspects of Strategy • Interest Rate • Which is the comparable interest rate? • The Chennai ITAT Bench has held that while determining arm's length interest rate in respect of international transaction between assessee and associated enterprises, domestic prime lending rate is not applicable and LIBOR rate should be consideredSiva Ventures Ltd. vs. Assistant Commissioner of Income-tax, Company Circle-VI (3), Chennai, [2013] 36 taxmann.com 498 • The Mumbai ITAT Bench has held that for benchmarking lending in foreign currency, interbank rate should be taken for international transaction instead of domestic prime lending rate.Hinduja Global Solutions Ltd. vs. Additional Commissioner of Income-tax, Circle-6(3), Mumbai, [2013] 35 taxmann.com 348

35. Important Aspects of Strategy • Interest Rate • Which is the comparable interest rate? • Under CUP method to determine arm's length value of interest charged on overdue balance with AE, comparable should be interest that had been charged on overdues with independent enterprises or interest that had been charged by other enterprises in similar business transaction.Assistant Commissioner of Income-tax - 11(1) vs. Nimbus Communications Ltd., [2013] 34 taxmann.com 298

36. Important Aspects of Strategy • Advertisement, Sales Promotion, Brand Promotion • The Mumbai ITAT bench has held that advertisement, marketing and sales promotion expenses incurred by assessee, resulting in brand promotion of foreign AE is an international transaction, triggering transfer pricing mechanism.Diageo India (P.) Ltd. vs. Deputy Commissioner of Income-tax, Range-7(3), [2013] 34 taxmann.com 284 • The Delhi ITAT bench has held that Advertisement, marketing and sales promotion expenses incurred by assessee are international transactions, constituting brand promotion and development of marketing intangible for its associated enterprise.Reebok India Co. vs. Additional Commissioner of Income-tax, Range-15, [2013] 35 taxmann.com 578

37. Important Aspects of Strategy • Advertisement, Sales Promotion, Brand Promotion • The Delhi ITAT bench has held that where assessee was totally dependent on its associated enterprise for providing technology for manufacturing goods, arm's length price of royalty could not be taken as nil.Reebok India Co. vs. Additional Commissioner of Income-tax, Range-15, [2013] 35 taxmann.com 578 • The Chennai ITAT bench has excess advertisement, marketing and promotion expenditure incurred by assessee in comparison to its comparables only could be treated as expenditure towards brand developmentFord India (P.) Ltd. vs. Deputy Commissioner of Income-tax, [2013] 34 taxmann.com 50

38. Important Aspects of Strategy • Advertisement, Sales Promotion, Brand Promotion • The Chennai ITAT Bench has held that expenses incurred in brand building of foreign AE falls within purview of 'International Transaction' and accordingly, TP adjustment is to be made in ALP.Panasonic Sales & Services India (P.) Ltd. vs. Assistant Commissioner of Income- tax, Circle - V(1), [2013] 34 taxmann.com 276 • The Mumbai ITAT bench has held that expenditure incurred in connection with sales which does not lead to brand promotion, cannot be brought within ambit of advertisement, marketing and promotion (AMP) expenses for determining cost/value of international transactions.Haier Appliances India (P.) Ltd. vs. Deputy Commissioner of Income-tax, OSD, CIT-IV, New Delhi, [2013] 35 taxmann.com 203

39. Important Aspects of Strategy • Advertisement, Sales Promotion, Brand Promotion • The Chennai ITAT ITAT bench has held that half of product development expenditure incurred by assessee, which also benefited its AE, are not allowable.Ford India (P.) Ltd. vs. Deputy Commissioner of Income-tax, [2013] 34 taxmann.com 50

40. Important Aspects of Strategy • Non Comparables • The Hyderabad Bench of ITAT has held that where there were extraordinary events like merger or demeger during relevant financial year having effect on financial results of companies, they could not be taken as comparables.Zavata India (P.) Ltd. vs. Deputy Commissioner of Income-tax, Circle -3(3), Hyderabad, [2013] 35 taxmann.com 423 • The Hyderabad ITAT bench has held that companies outsourcing considerable portion of their business to third party vendor unlike assessee, could not be taken as comparableZavata India (P.) Ltd. vs. Deputy Commissioner of Income-tax, Circle -3(3), Hyderabad, [2013] 35 taxmann.com 423

41. Important Aspects of Strategy • Non Comparables • The Bangalore ITAT bench has held that where assessee was carrying out BPO services by itself, companies outsourcing such work could not be taken as comparables.Income-tax Officer, Ward-11 (1) vs. Business Process Outsourcing India (P.) Ltd., [2013] 35 taxmann.com 574 • The Hyderabad ITAT Bench has held that where high operating profit of company was reflected due to extraordinary event, such company cannot considered as comparable.Intoto Software India (P.) Ltd. vs. Assistant Commissioner of Income-tax, Circle -2(1), Hyderabad, [2013] 35 taxmann.com 421 • `

42. Important Aspects of Strategy • Non Comparables • The Delhi ITAT bench has held that where assessee along with its parent company incorporated in Korea entered into an agreement with Global Cricket Corporation (GCC) to sponsor Cricket World Cup 2003 to promote sale of LG products and cost of sponsorship was shared between assessee and its parent company in ratio of 40:60, since assessee's sales had increased by 35.04 per cent during financial year 2002-03 pursuant to sponsorship of cricket event, TPO's action of apportionment of GCC contribution in ratio of 5.40:94.60 between assessee and parent company was not correct.Assistant Commissioner of Income-tax, Circle, Noida vs. LG Electronics India (P.) Ltd., [2013] 35 taxmann.com 344

43. Important Aspects of Strategy • Non Comparables • The Mumbai ITAT bench has held that Functionally dissimilar companies and persistently loss-making companies cannot be taken as comparables for computing arm's length price solely on ground that they were taken as comparables for subsequent years, as comparability is tested independently and separately for each year.Advance Power Display Systems Ltd. vs. Advance Power Display Systems Ltd., [2013] 35 taxmann.com 145

44. Important Aspects of Strategy • Importance of Data • The Pune Bench of ITAT has held that Where TPO only provided unsupported reasoning and no data for excluding comparables adopted by assessee, adjustment was not sustainable.Cummins Turbo Technologies Ltd. vs. Deputy Director of Income-tax (International Taxation) - 1, Pune • The Chennai Bench of ITAT has held that there is no legal requirement that segment wise working of ALP submitted before TPO should be audited by assessee's CA.3i Infotech Ltd. vs. Income-tax Officer, Company Ward-II (1) Chennai, [2013] 35 taxmann.com 582

45. Important Aspects of Strategy • Importance of Data • The Pune Bench of ITAT has held that Where TPO only provided unsupported reasoning and no data for excluding comparables adopted by assessee, adjustment was not sustainable.Cummins Turbo Technologies Ltd. vs. Deputy Director of Income-tax (International Taxation) - 1, Pune • The Chennai Bench of ITAT has held that when non-resident AE sold items to assessee at very same price at which AE had purchased from a non-AE, there cannot be any question of under-pricing or over-pricing.Redington (India) Ltd. vs. Additional Commissioner of Income-tax, Company Range - V, Chennai, [2013] 34 taxmann.com 279

46. Important Aspects of Strategy • Importance of Data • The Mumbai ITAT bench has held that in course of transfer pricing proceedings, there can be no question of substituting profit realized by Indian enterprise from its foreign AE with profit realized by foreign AE from ultimate customers for purposes of determining ALP of international transaction of Indian enterprise with its foreign AE.Onward Technologies Ltd. vs. Deputy Commissioner of Income-tax, (OSD), Range 8(1), Mumbai, [2013] 35 taxmann.com 584 • The Mumbai ITAT bench has held that data of current year and up to past two years can be compared and not data of any subsequent year.Vodafone India Services (P.) Ltd. vs. Deputy Commissioner of Income-tax, 3 (3), [2013] 36 taxmann.com 127

47. CA VINOD JAIN