INTERNATIONAL FISCAL ASSOCIATION

1. INTERNATIONAL FISCAL ASSOCIATION Panel Discussion TP Dispute trends on intangibles, intra-group services and R&D (including APA & MAP option) 28 February 2019 IFA – India WRC Conference on International Taxation ITC Parel Mumbai

2. Panelists Chairman - Shri G. S. Pannu Honorable Vice President, ITAT Mumbai Panelists - Shri Rajan Vora - Ms. Shikha Gupta - Ms. Karishma Phatarphekar - Mr. Narendra Kumar Chand

3. CONTENT Backdrop Key Transfer Pricing Issues Will TP issues get Natural Burial after ITAT Future Litigation Landscape Questions & Answers

4. Backdrop

5. TP adjustment – last 10 years In summary, over 24,000 cases were scrutinized by the TPOs with almost 45% of the cases scrutinized having faced adjustments. The total value of these adjustments is estimated to be about INR 2,700 billion.

6. CBDT Policy on selection of cases for TP scrutiny • Reference by AO to TPO • The CBT vide circular no. 3 of 2016 dated 10 March 2016 laid out instructions for reference of Transfer Pricing cases to the TPO on the basis of risk parameters. • If one of the reasons for selection of case for scrutiny is a TP risk parameter, then the case has to be mandatorily referred to the TPO by the AO • Cases selected for scrutiny on non-transfer pricing risk parameters by having international transaction or specified domestic transaction, shall be referred only in the following circumstances • Not filed Form 3CEB or not reported the same. • TP adjustment of Rs. 10 crore or more in previous year and upheld by judicial authorities or is pending in appeal • In case of search and seizure, findings on TP issue recorded by investigation wing or the AO • Case involving TP adjustment in earlier assessment year hat has been fully or partially set-aside by the ITAT, High Court or Supreme Court on the issue of the said adjustment.

7. CBDT Policy on selection of cases for TP scrutiny • Jurisdictional requirement to record satisfaction • That there is an income or a potential of an income arising and/or being affected on determination of the ALP • Not filed Form 3CEB and transaction comes to notice of the AO • Filed Form 3CEB, but one or more transaction not declared comes to notice of the AO • Declared the transaction, but with qualifying remark. • In the above three situations, the AO must provide an opportunity of being heard to the taxpayer before recording his satisfaction or otherwise. Applicability of chapter X

8. ITAT perspective

9. Dispute Resolution Options Litigation APA Dispute Resolution MAP Settlement Commission

10. India APA Program – Story So far • Total applications filed in India exceeds 980 in six filing cycles • Total 245 - 220 Unilateral and 25 Bilateral APA concluded so far Gained significant momentum in 3rd year – 55 APAs signed in FY 2015 –16. Further, the APA program crossed the 150 milestone in the 4th year-88 APAs signed in FY 2016-17. 01 India had so far signed bilateral APAs with USA, UK, Japan and Netherlands. 02 Reasons for success of APA Program in India • Business rationale given due importance • APA team is independent and has no targets for tax collections • More balanced views being adopted by the APA team

11. India MAP Scheme – Story so Far • Overall 250 disputes resolved under MAP cases till date covering both TP and non TP cases with various countries such as US, UK, Japan and China • More than 100 MAP Cases resolved with US under framework Agreement • Successful MAP resolution paved the way for Bilateral APA with the US Resolution of 250 MAPs

12. Whether APA concluded has any binding precedence before Tribunal • Option is on the taxpayer (roll-back is optional) • If taxpayer’s contention and facts similar, then binding (Ranbaxy Del Trib) • If revenue’s contention to apply, then not mandatory (Apax Partner – Mum Tri) • Principles of consistency could be applied by ITAT Settlement Commission also an avenue to resolve TP disputes

13. Variation from OECD principles while deciding TP issues • OECD guidelines have persuasive value, however court principle not always aligned with OECD guidelines

14. Variation from OECD principles while deciding TP issues

15. Comparison of TP issues in other countries • EY conducted a Transfer Pricing survey in 2016-17. Around 623 respondents from 36 jurisdiction answered different question in relation to transfer pricing disputes • The below table highlights data (in percentage) in relation to issues faced by respondents in their respective countries

16. Comparison of TP issues in other countries 11

17. Major TP Issues Recent Continuing • Imputation of interest on outstanding balances • Marketing service provider considered as distributor • Financial transactions including guarantees, inter-company loans • Contract R&D services • Marketing intangibles - AMP issue • Intra-group services • Characterization • Selection of most appropriate method • Selection of comparables • Selection of tested party - typically Indian entity preferred by the authorities • Comparability/ economic adjustments • Computation of mark-up, treatment of foreign exchange, provisions etc. • Net margin or gross margin to be the point of analysis for distributors Data as on May 2018

18. Key Transfer Pricing Issues in India

19. Characterization • Captive Service providers – mark-up challenged • Low end BPO characterized as High end KPO • High margin companies mainly providing KPO services are generally alleged as comparables • Economic adjustments for working capital considered only selectively and Risk adjustment normally not allowed • Stringent Quantitative Filters applied Issues • Companies primarily engaged in high end support services cannot be compared to companies mainly providing low end support services. • Where services rendered are clearly in nature of lower end ITeS not involving domain knowledge then the inclusion of KPO service provider is not warranted while conducting Transfer Pricing study itself • FAR analysis important rather than nomenclature Judicial Precedence APA Outcome • Easier to understand the characterization as site visit is carried out • Site visit brings out the actual tangible outcome in terms of characterization of an entity rather than relying on documentary evidences / TP Study Report • MAP framework agreement / stay of demand

20. CharacterizationCase study Consultancy Medical Transcription Provision of consultancy service on cost plus Provision of medical transcription service on cost plus ABC India ABC US (HQ) ABC India ABC US (HQ) Provision of back office support service on cost plus • Agreement and deliverable can easily establish the nature of activities carried out • Characterization not an issue • Issue majorly on comparable companies • A mixed bag of function and agreements may not clearly establish nature of activities • Characterization becomes an issue since both BPO/KPO services are being performed • Issue majorly on segmentation, characterization and if entity level approach used than kind of comparable companies to be used Should take APA approach and try getting a blended rate for a BPO/KPO Can be dealt in normal litigation

21. Supreme Court – Mckinsey India • Key Observations • The SC dismissed the special leave petition (SLP) filed by McKinsey Knowledge Centre India Pvt. Ltd. (McKinsey India, appellant, company) against the Delhi High Court order in its own case • The company disputed the HC order, characterizing the research and information services rendered by it to its AE as high-end KPO services • The company considered itself a routine BPO service provider. The company had also disputed the HC ruling on the interest on the delayed realization of receivables, considering it a separate international transaction • The Apex Court, after hearing the counsels, was not inclined to entertain the SLP and dismissed it • Key Takeaways • There are differentiating features between the BPO and the KPO, based on functions, assets and risks • Grey Area - Once the TPO has finalized its comparables, can the Department or the Assessee bring in new comparable companies/ Can improve the case. • The interest on delayed receivables is a separate international transaction and that would require independent benchmarking

22. Contract R&D Services Issues Judicial Precedence APA Outcome • Functional characterization of ‘risk insulated service provider’ challenged • Allegation that majority of Valuable & Unique IP generating work undertaken in India • India R&D Centre becomes Economic Owner of IP - IP transferred without adequate compensation • Arm’s Length Compensation = Global Profits of MNE allocated to India on ratios such as R&D Head Count, etc. • FAR of the entity to be looked in detail – mere nomenclature of transaction not to constitute Contract R&D • Functionally similar companies selected even if comparable companies are incurring losses • Microsoft India (R&D) Pvt. Ltd. [2018] 97 taxmann.com 360 (Delhi - Trib.) • Outcome in the range of 18% - 20% • Open and positive mindset of APA authorities allows to justify and explain FAR and business rationale • Safe Harbour rules not to impact the APA process

23. Contract R&D ServicesCase study Value added cost plus model Full cost plus model ABC India • Remunerated on a value added cost plus model. No margin on pass through cost • Patents registered abroad have names of Indian employees • Number of aspects to be considered, understanding the control over the pass through, role of the employees in whose name Patent is registered. ABC India • Remunerated on a full cost plus model • No patents are being registered in India • No complexity, can be explained through contracts Provision of contract R&D services Provision of contract R&D services ABC US (HQ) ABC US (HQ) Can be better understood through APA process Issue only about comparability which can be dealt with under normal litigation

24. Marketing Intangibles

25. Intangibles – APA Outcome • Bright Line Test • Aggregation based on RoS to find out AMP intensity Marketing Intangibles • No stringent documentation required • Brand up to 2%, Know How up to 3%, total 4 – 5 % • If net loss discounting of the above percentages • Residual Royalty also possible (recent conclusion) Royalty

26. RoyaltyCase study Fixed Royalty Residual Royalty I Co. Entrepreneur • I Co. is an Entrepreneurial entity. • I Co. manufactures and sells in India market • HQ charges separate royalty for Brand and Know How • I Co. has incurred a net loss I Co. Licensed Manufacturer • HQ engages I Co. as licensed manufacturer • I Co. manufactures and sells in India market • I Co. pays residual royalty to HQ after retaining limited return for licensed manufacturing Payment of residual royalty Payment of fixed royalty US (HQ) US (HQ) TNMM would not be defensible due to loss. CUP usually not available / not of good quality. APA a better forum Courts would be better receptive to the argument of I Co. as tested party and TNMM based Benchmarking

27. Intra-group services • Question of duplication over multiple payments/activities • Whether the tax officer can question the need for availing the services • Difficulty in establishing that payments are commensurate to the services received • Extensive documentary evidence required • Separate benchmarking analysis required • Impact of BEPS recommendation wr.t. “Low Value Adding Services” • Whether services are “shareholder activities” in nature Issues • Tax payer needs to demonstrate a proper pricing policy which is in line with the Group TP policy • The need to avail services/IP is a business decision • TNMM analysis at entity level along with documentary evidence accepted in some decisions • TPO’s act of merely disallowing entire amount on ad-hoc basis not as per the rules, bad in law • Remand in such case not appropriate (Kodak Bom HC) Judicial Precedence APA Outcome • No need to submit voluminous documentation • Service Received and Benefit test can be demonstrated by site visit • Allows overseas entity as the tested party with an overall cap • No need to make profit – management fees allowed even if entity is making loss, but imposes an overall cap based on revenue

28. Intra-group servicesCase study General Agreement No specific agreement Retainer Agreement Fixed Monthly payments A bouquet of services Only 2-3 services actually requested and availed Cost plus mechanism of remuneration On-call services Onus may be cast to demonstrate request of services, as one may technically interpret ‘cost’ as relating to only those where actual services are availed General intra-group services being availed No specific documentation maintained Good margins enjoyed This is better resolved through the litigation route as favorable precedents available High documentation requirement – depending on availability dispute resolution route can be chosen APA authorities may be able to close this despite negligible documentation. Services received and implicit benefit test can be evaluated during site visit

29. Will TP issues get Natural Burial after ITAT – KHC Softbrands case

30. Karnataka High CourtJudgement – Softbrands Case • KHC holds that in a TP case, aspects related to choice of comparables, choice of filters used, correctness of application of filters, choice of method, etc. are factual exercises; the HC will not admit any question arising from these, unless perversity is demonstrated based on the parameters laid out in the judicial precedents referred to - • (a) it is of general public importance OR • (b) if it directly and substantially affects the rights of parties; • and in either cases, it is either an open question that is not finally settled by the SC/PC/FC OR is not free from difficulty OR calls for discussion of alternate views • (c) where the legal position is clear, but lower Court has decided the case either ignoring or acting contrary to such legal principle • (d) HC could interfere with concurrent findings of lower Courts if – • (i) Lower Courts have ignored material evidence or acted on no evidence (‘no evidence’ includes cases, where the evidence taken as a whole, is not reasonably capable of supporting the finding) • (ii) While arriving at a finding, lower Court has not taken into consideration relevant admissible evidence OR inadmissible evidence has been taken into consideration OR legal principles have not been applied in appreciating the evidence OR when the evidence is misread • (iii) Wrong inferences drawn from proved facts by applying law erroneously • (iv) ‘burden of proof’ wrongly cast • Bombay High Court carved out its own exceptions (Ness Technologies)

31. Future Litigation Landscape

32. Future Litigation Landscape Future TP Litigation Issues • FAR to FARM (Functions, Assets & Risk to • Functions, Assets, Risk and Market) Push towards Profit Split Method Valuation / consideration for business restructuring Secondary adjustment Impact of BEPS – MF / CBCR on TP audits

33. Question and Answers

34. Thank You