Concept of Transfer Pricing Transfer Pricing Documentation Concept of Safe Harbour

1. Concept of Transfer Pricing Transfer Pricing Documentation Concept of Safe Harbour Manoj Pardasani Partner – Transfer Pricing B S R & Co. 2 July 2010

2. What we would discuss today… 01 Evolution of Transfer Pricing in India 02 Overview of Indian Transfer Pricing Regulations 03 Requirement for Transfer Pricing Documentation 04 Overview of Databases – Prowess and Capitaline 05 Finance Act 2009 – Amendments Introduced 06 Safe Harbour Rules – an Overview 07 Direct Taxes Code Bill 2009 - Proposals

3. Evolution of Transfer Pricing In India

4. Evolution of Transfer Pricing in India • Transfer Pricing was introduced in India with effect from April, 2001 under Sections 92 to 92F of the Income Tax Act, 1961 (‘the Act’) and are broadly based on the OECD guidelines. • The Indian Transfer Pricing prescribes that income arising from “international transactions” between “associated enterprises” should be computed having regard to the “arm’s length price”. • The objective of the regulation is to prevent shifting of profits by manipulating prices charged or paid in the international transactions, thereby eroding the tax base of the country.

5. Evolution of Transfer Pricing in India (contd…) The Finance Minister’s Speech on the rationale for Introducing Transfer Pricing Regulations: “The presence of multinational enterprises in India and their ability to allocate profits in different jurisdictions by controlling prices in intra-group transactions has made the issue of transfer pricing a matter of serious concern. I had set up an Expert Group in November 1999 to examine the detailed structure for transfer pricing legislation. Necessary legislative changes are being made in the Finance Bill based on these recommendations” - Mr. Yashwant Sinha Finance Minister, Government of India February 28, 2001

6. Overview of Indian Transfer Pricing Regulations

7. Sec 92 – Special Provisions relating to avoidance of Tax 92B 92C Meaning of international transactions Computation of arm’s length price Transfer Pricing 92D 92A Maintenance of information and document by persons Meaning of Associated Enterprise 92F 92E Definitions relevant to Arm’s length price Accountant’s Report

8. 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)

9. 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 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

10. Sec 92B – Meaning of International Transactions • Transactions between two or more associated enterprises • Either or both of whom are non-residents Transaction relates to: • purchase, sale or lease of tangible or intangible property; or • provision of services; or • lending or borrowing money; or • any other transaction having a bearing on the profits, income, losses or assets of the enterprises; or • mutual agreements or arrangements for allocation or apportionment of, or any contribution to, any cost or expense incurred.

11. 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.

12. 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 • +/- 5% variance to arm’s length “price” permitted : (Safe harbour)

13. 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

14. 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.

15. 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.

16. 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.

17. 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

18. 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

19. 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

20. 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.

21. Selection of Transfer Pricing Methods

22. Need for Transfer Pricing Documentation in India Need for Transfer Pricing Document in India Need for a Transfer Pricing Documentation in India

23. Documentation Requirements – Section 92D Entity Related Price Related Transaction Related Profile of Group Profile of Indian Entity Profile of associated Enterprises Profile of industry Agreements Invoices Pricing related correspondence Transaction Terms Functional analysis Economic analysis Forecasts, budgets and estimates Contemporaneous Documentation requirement – Rule 10 D No specific documentation requirement if the value of international transactions Is less than one crore rupees.

24. Compliance – A step by step approach Stage 5 Stage 4 Stage 3 Stage 2 Stage 1 Functional analysis - Information gathering Issuance of Transfer Pricing Documentation Pre-project planning Comparable data Analysis • Preparation of project plan • Interviews • Questionnaires • Discussions with Management • Characterisation of each entity • Agreement reviews • Search strategy • Access to local & global database • Analysis of internal comparables • Judicious identification of arm’s length range • Understand existing costing mechanism • Determination of billing methodology • Consultation with management • Finalization of Transfer pricing documentation

25. Filing of Accountant’s Report – Section 92E • Sec 92E of the Act : Every person who has entered into an international transaction during the previous year shall obtain a report from an accountant and furnish such report on the specified date duly signed and verified by an accountant. • Form 3CEB prescribes (Rule 10E) • Declaration by the accountant about examination of accounts. • Opinion on information and documents prescribed by Rule 10D and maintained by the assessee • Annexure to Form 3CEB are “True” and “Correct” • Guidance Notes issued by the Institute of Chartered Accountants of India. • The information contained in 3CEB helps the Assessing officer with an overview of the international transactions of the company.

26. Stringent Penalties

27. Databases

28. 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

29. 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.

30. 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.

31. 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.

32. 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.

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

34. Finance Act 2009 - Amendments Finance Act 2009 – Key Amendments

35. Recent Amendments – Finance Act 2009 • Determination of Arm’s Length Price – Concept of +/- 5 percent variance. • Introduction of Safe harbour rules • Creation of Dispute Resolution Panel

36. Concept of +/- 5 percent variance

37. Introduction to Safe Harbor rules • Considering the increase in transfer pricing litigation, Central Board of Direct Taxes (CBDT) is to formulate safe harbour rules. • Aim to reduce the impact of judgemental errors in transfer pricing. • Safe harbour has been defined to mean ‘circumstances’ in which the revenue authorities shall accept transfer pricing declared by the tax payer. Internationally safe harbour has taken various forms • Exclusion of certain classes of transactions based on quantitative thresholds. • Stipulations of margins/pricing norms for specified industries/functions (USA, Singapore) • Specifying thresholds whereby the onerous documentation requirement is reduced (Brazil)

38. Creation of Dispute Resolution Panel • When a Transfer Pricing adjustment is proposed, the Assessing Officer will issue a draft order to Tax payer. • Tax payer will confirm or file objections with the Assessing officer and Dispute Resolution Panel within 30 days. • Dispute Resolution Panel will issue guidance to the Assessing officer after having regard to the evidences, further queries etc within 9 months from the date draft order was issued to tax payer. • Panel may confirm, reduce and enhance the proposed transfer pricing adjustments. It cannot set aside the proposed adjustment for further enquiry. • In case of differences within the Dispute Resolution Panel, opinion of majority stands. • Assessing officer shall pass the order in conformity with directors of Dispute Resolution Panel, within one month without granting any additional opportunity to the tax payer. • Appeal by tax payers lies before the Appellate Tribunal and Dispute Resolution Panels order is binding on the revenue and no appeal lies for the revenue. • The Central Board of Direct Taxes has notified the Income Tax (Dispute Resolution Panel) Rules, 2009 on 20 November.

39. Dispute Resolution Panel – Process Chart

40. Concept of Safe Harbor

41. What is Safe Harbor? • Evolution of Safe harbour provisions • OECD Committed on Fiscal affairs debated the concept in 1993. • Task force recommended safe harbor for small businesses. • US Regulations in 1960’s brought in 5 methods + unspecified methods • Definition of a Safe harbor A Safe harbour (referred to as a comfort mechanism in the OECD Guidelines) has been defined to mean ‘circumstances’ in which, the Indian Revenue Authorities shall accept the transfer pricing declared by the tax payer. • Administrative requirements may vary from • Total relief to targeted tax payers from Transfer Pricing regulations; to • Obligation to comply with various procedural rules as a condition for qualifying for safe harbour.

42. Safe Harbor Regime in India • Finance [ No 2 ] Act, 2009 introduced new section 92CB • The determination of arm’s length price under Section 92C or section 92CA shall be subject to safe harbor rules • The Board may, for the purposes of sub-section (1), make rules for safe harbor. • Intention is to reduce tax disputes

43. Factors Supporting use of Safe Harbor • Compliance Relief • Collection and Analysis of Data • Application of simplified method (instead of Best Method) • Relief from search of comparables • Certainty • Prices will be accepted by Tax Authorities • Qualified Taxpayers assured that they will not be subject to Audit • Administrative Simplicity • Once eligibility is established, minimal examination of controlled transactions. • Tax administrator can allocate more resources to examination of transactions and taxpayers.

44. Problems presented by use of Safe Harbors • Impact of Tax calculations of tax payers as well as its AE in other jurisdiction. • Safe harbor may not be consistent with the Arm’s Length principle as it will be broad based. • Tax planning opportunities • Risk of Double Taxation • Mutual Agreement Procedure (MAP) Difficulties

45. Likely implications in India General Factors that would require attention : • Specification of Scope • Determination of cost base • Determination of mark up on cost base and its revisions. • Documentation to be maintained • Options for Tax payer to opt out of Safe harbor • Potential Double Taxation. • TP adjustments that can be carried out to cost base etc. • Conflicting provisions within different countries. • Shifting of Profits

46. Industries that may be impacted • Indian Information Technology / Information Technology Enabled Services Industry • Selection of comparables (Captive vs. risky and Intangible based). • Locations savings impact – Quantification. • Identification of cost and aggregation by category e.g. BPO (20%), ITeS (15%) • Management Charges • Royalties – RBI / Exchange Control norms • Contract Manufacturing

47. Direct Taxes Code Bill 2009 - Proposals

48. Advance Pricing Arrangements • Upfront determination of the Arm’s Length Price. • The Board would be empowered to make further adjustments to the price determined as per the transfer pricing rules. • APA term would be limited to a maximum of five consecutive financial years. • The APA would be binding on the tax payer and the tax authorities, and only in respect of international transactions for which the agreement is sought.

49. Proposals relating to Transfer Pricing Assessment • Dispute Resolution Mechanism retained – however only for cases of adjustments exceeding INR 2.5 million. • Form 3CEB lodged directly with the Transfer Pricing Officer instead of the Assessing Officer. • Selection of Transfer Pricing audit through risk management strategy framed by the Board. Such strategy or criteria will not be made public. • Change in timelines of submission of certificate, commencement and completion of scrutiny. • Best judgement assessment if assessee does not co-operate.

50. Other Proposals • Definition of Associated Enterprise widened – • Thresholds criteria would reduce:- • Direct and indirect participation – 10% to 26% • Loan to asset ration – reduced from 26% from 51% • Nomination of director – more than 1/3rd from Half • Raw material / Components supply – 2/3rd from 90% • Concept of impermissible avoidance arrangements introduced – thin capitalization. • Safe Harbour Provisions - Retained. • Penalty provisions - Eased.