PwC

1. Pune Camp CPE Study Circle Transfer Pricing: Legislation, Experiences and Recent Developments Presented by : Dinesh Supekar April 24, 2010 PwC

2. Part I Transfer Pricing Legislation Brief Legislative framework Brief on Assessment Procedures The charging Section and international transactions Associated Enterprises Principles of Comparability Computation of Arm’s Length Price Documentation requirements What is it that the taxpayer should do

3. Brief legislative framework Background : Why TP • Increasing participation of MNCs in world economic activities • General tendency to control profits and transfer the same to low tax heavens • Legislation felt essential by Governments for protection of their respective tax base • OECD issued TP guidelines for MNEs and Tax Administrations in 1979 (amended in 1995 and onwards) • India is an observer of OECD guidelines: not a member, yet

4. Independent entity Associated enterprise Resident Resident Transfer price Arm’s length price Brief legislative framework Arm’s length principle International transactions - goods - services - intangibles

5. Brief legislative framework TP in India : Background • Sections 92 to 92F of the Act read with rules 10A to 10E referred to as framework of Indian TP legislation • Various circulars, notifications and administrative instructions issued by CBDT

6. Brief legislative framework Compliance requirements • Any income arising from international transaction : to be computed having regard to Arm’s Length Price (also covers cost allocation & cost sharing arrangements) • Tax payers required to maintain prescribed information & documentation [Section 92D read with Rule 10D] • Accountant’s Report on international transactions to be filed along with the return of income : irrespective of value of international transactions

7. Brief legislative framework Penalties The Indian TP legislation prescribes stringent penalties for not maintaining / furnishing annual documentation and Accountant’s Report: No deduction available for TP adjustments after scrutiny by the AO under Sec. 10A, 10AA, 10B or Chapter VI-A

8. Part I Transfer Pricing Legislation Brief Legislative framework Brief on Assessment Procedures The charging Section and international transactions Associated Enterprises Principles of Comparability Computation of Arm’s Length Price Documentation requirements What is it that the taxpayer should do

9. Brief on Assessment Procedures Timelines and selection of cases • The Assessing Officer may make reference to the Transfer Pricing Officer (‘TPO’) if he considers it necessary or expedient to do so [Sec. 92CA (1)] with previous approval of the Commissioner • CBDT had issued internal guidelines for selection of cases for TP scrutiny in cases where the aggregate value of international transactions exceeds Rs. 5 crores [Circular 3/2001] • The threshold limit for selection of cases for scrutiny : Rs. 15 Crores • Irrespective of the threshold limit instructed by CBDT : the cases may be picked up for scrutiny if the AO deems it fit or the AO may undertake the scrutiny on his own Reference to TPO if value of international transactions exceed Rs. 5 Crores but the case selected for scrutiny due to norms other than filter of International transactions?

10. Commissioner Approval for Reference Draft Assessment Order AO TPO’s order Reference Notice u/s 92CA (2) TPO Show cause notice Reply to SCN Determination of ALP By TPO after hearing Brief on Assessment Procedures TP Audits : framework • AO to compute total income • in conformity with the ALP • determined by TPO Assessee Can AO change the order by TPO?

11. Rectification application can be made against the order of TPO for apparent mistakes Appeal can be made against the Draft order of AO as order of TPO included within the order of the AO Brief on Assessment Procedures Appeals : Framework Draft Order by AO adjusting Taxable Income of Assessee Appeal to DRP Appeal to CIT(A) ITAT High Court Supreme Court Constitutional Bench

12. Part I Transfer Pricing Legislation Brief Legislative framework Brief on Assessment Procedures The charging Section and international transactions Associated Enterprises Principles of Comparability Computation of Arm’s Length Price Documentation requirements What is it that the taxpayer should do

13. The Charging Section & International Transactions The Charging Section • Any income arising from an international transaction shall be computed having regard to the arm’s length price [Section 92 (1)] • Arm’s Length Price is price applied or proposed to be applied by unrelated enterprises under uncontrolled conditions • Following transactions also require compliance with Arm’s Length Principle: • allowance for any expense or interest arising from an international transaction [Explanation to Section 92 (1)] • costs or expensesallocated/apportioned under mutual agreement/arrangement for provision of benefit or service or facility by one enterprise to other [Section 92 (2)] Base erosion is the important principle for attraction of TP provisions

14. Parent P Issue of Share Capital Subsidiary S Parent P Sale of fixed Assets Subsidiary S The Charging Section & International Transactions Case studies on Charging Section • Whether it would be required for S to comply with TP provisions for issuance of share capital? • Would it make difference • if the shares are Preference Shares : entitled to fixed rate of dividend? • if S issues convertible debentures bearing fixed rate of interest to P? • if S avails loan from P, bearing interest? • if the loan is interest-free loan? • Whether dividends paid by S to P would require compliance with TP provisions? • Whether S would be required to comply with TP provisions for purchase of fixed assets? • Would it make difference • if S did not start manufacturing activities and carried the cost of fixed assets as CWIP? • If S purchased raw material and carried it as stock in trade, since it did not start its manufacturing activities?

15. The Charging Section & International Transactions International Transaction [Section 92B] • International transaction is • Transaction between the Group companies : either or both of whom are non-residents • for purchase, sale, lease of : tangible property or intangible property • for provision of services or lending or borrowing money • other transactions having bearing on profits / income / losses or assets of an enterprise • also to include cost allocations/apportionments for benefits/ services or facility provided by one to other • Transaction includes arrangement, understanding or action in concert: • whether formal or in writing • whether intended to be enforceable with legal proceedings or not [Section 92F (v)] • Transaction also includes number of closely linked transactions [Rule 10A (d)]

16. Prior agreement Third party Parent Company Services Subsidiary Determination of terms Third party Parent Company Services Subsidiary The Charging Section & International Transactions Deemed International Transaction Transaction between subsidiary & third party may also be subject to TP: Prior agreement exists between parent company and third party Terms of transaction are determined in substance by parent company and third party Global sourcing?

17. Group Co : ABC Claim for reimbursement Sale Sale Customer of PQR Group Co : PQR Settlement of warranty claims The Charging Section & International Transactions Case studies on International Transactions • Are the warranty claims settled by PQR – claimed for reimbursements the International Transactions? • Whether the provisions for warranties are International Transactions: • If PQR had to bear warranty costs? • If ABC was Indian enterprise? PQR uses the IT infrastructure of ABC for maintenance of its accounting records, mails, sales tracking data, etc. ABC proposes to charge PQR an allocation for the IT infrastructure costs based on an agreed allocation key : Would the IT Cost allocations qualify to be International Transactions?

18. Parent P Sale under contract Assignment of contract Customer of P Subsidiary S Sale at prices as per contract The Charging Section & International Transactions … Case studies on International Transactions Whether sales by S to the Indian customer would qualify as International Transactions : though S and Indian customer are both residents of India? Transactions not taxable under DTAA? Transactions taxable under presumptive basis under law?

19. Part I Transfer Pricing Legislation Brief Legislative framework Brief on Assessment Procedures The charging Section and international transactions Associated Enterprises Principles of Comparability Computation of Arm’s Length Price Documentation requirements What is it that the taxpayer should do

20. Associated Enterprises Enterprises • Section 92F (iii) defines enterprise as any person (including PE) engaged in: • any activity relating to production, storage, supply, acquisition or control of articles, goods or specified intangibles. • any activity pertaining to provision of services or carrying out any work in pursuance of a contract • any investment or financing activity • The term PE has been defined to be an inclusive term to include a fixed place of business through which the business of the enterprise if wholly or partly carried on [S.92F(iiia)]

21. Associated Enterprises Associated Enterprises Associated Enterprises have been defined to include: • Participation in Management / Control or Capital [Section 92A(1)(a)] • Common persons in Management/Control or Capital [Section 92A(1)(b)] • 13 Categories of deeming fictions for enterprises to qualify as Associated Enterprises [Section 92 (2)]

22. A B D A Management/ Control/ Capital Management/ Control/ Capital C Management/ Control/ Capital B E Management/ Control/ Capital C Associated Enterprises … Associated Enterprises : participation criterion Associated Enterprise for an enterprise means an enterprise which participates : • Directly or indirectly or • Through one or more intermediaries in management or control or capital of other enterprise [Section 92A (1) (a)] Participation in management/control/capital: by A INDIRECTLY and by B DIRECTLY Thus both A and B are AEs of C Participation in management/control/capital: by A INDIRECTLY by B DIRECTLY By D and E DIRECTLY Thus all A, B, D and E are AEs of C

23. Company A A & B are AEs Mr. X is a Director Company B Associated Enterprises … Associated Enterprises : Common control criterion Associated Enterprise for an enterprise means an enterprise in respect of which : One ore more persons who participate • directly or indirectly or • through one or more intermediaries in its management or control or capital ARE THE SAME PERSONS WHO PARTICIPATE • directly or indirectly or • through one or more intermediaries in its management or control or capital of the other enterprise

24. Associated Enterprises … Associated Enterprises : deeming fictions Enterprises deemed to be AEs [Section 92 A (2)]: • one has direct or indirect share holding carrying not less than 26% voting power in the other • common parent / person holds 26% of voting power in both enterprises • one advances loan constituting not less than 51% of book value of total assets of the other enterprise • one provides guarantees of not less than 10% of total borrowings of the other enterprise • more than half of board of directors of one enterprise are appointed by the other enterprise • more than half of the board of directors of both enterprises are appointed by the same person or persons • one enterprise is wholly dependent on use of IPRs of the other enterprise • At least 90% of raw materials and consumables required by a enterprise are supplied by the other enterprise, or by persons specified by the other enterprise, and prices and conditions relating to supply are influenced by such other enterprise • Goods or articles manufactured or processed by one enterprise, are sold to the other enterprise or to persons specified by the other enterprise, and prices and conditions relating thereto are influenced by such other enterprise • Both enterprises controlled by same the same individual singly or jointly with relatives • One enterprise controlled by HUF and other controlled by member of HUF or his relative or jointly • One enterprise being a firm, association of persons or body of individuals, the other enterprise holds not less than 10% interest therein • There exists between the two enterprises, any relationship of mutual interest, as may be prescribed

25. Associated Enterprises … Associated Enterprises : deeming fictions The deeming fictions may cover genuine third party transactions: • Joint Ventures [Section 92 A (2) (a)] • Extensive financing by Bank to an enterprise [Section 92 A (2) (c)] • Global arrangements for supply of bulk material [Section 92 A (2) (h)] • Use of exclusive technology by an enterprise on which it is fully dependent [Section 92 A (2) (g)] There may still be loopholes in catching the enterprises as AEs Acceptance of influence in anticipation of proposed takeover and takeover occurs after the financial year?

26. A A acquires B on December 1, 2008 Sales B Associated Enterprises Case study on AEs and International Transactions • Whether A & B would be treated as AEs for the transactions entered into before takeover, i.e. during April 1, 2008 till November 30, 2008? • Whether the transactions for sale of goods by A to B during the period before takeover would qualify as International Transactions? • Which amount should be reported by the CA of B in his report in Form 3CEB?

27. Part I Transfer Pricing Legislation Brief Legislative framework Brief on Assessment Procedures The charging Section and international transactions Associated Enterprises Principles of Comparability Computation of Arm’s Length Price Documentation requirements What is it that the taxpayer should do

28. Whether = Principles of comparability Let’s look at principles of comparability before understanding the methods Apple to apple comparability !!!

29. Principles of comparability Factors to be used to judge comparability [Rule 10B(2)] • Characteristics of the property transferred (service provided) • FAR by the respective entity • Contractual terms • Conditions prevailing in the market • geographical location • size of the market • laws and regulations • capital invested • level of competition, etc. Can related party transactions be considered?

30. A Inc. Export of Product ‘X’ Export of Product ‘X’ B Ltd. (AE) Third Party Rs. 2500 per Kg, CIF Rs. 2000 per Kg FOB Principles of comparability • Criteria for uncontrolled transaction to be comparable [Rule 10B(3)] • None of the differences between the transactions being compared are likely to materially affect the price or cost or profit in the open market • OR • Reasonably accurate adjustments can be made to eliminate the material differences The transactions can comparable after adjustments for to Freight & Insurance Expenses incurred Freight Rs. 500/Kg Insurance Rs 100/Kg

31. Principles of comparability Use of data for comparability [Rule 10B(4)] The data for analysis of comparability shall pertain to the financial year in which the international transaction has been entered into However data for previous 2 years to financial year may be used • if such data could have an influence on the determination of TP Use of multiple year data also recommended by OECD to consider • Losses, • business or product life cycle, • economic conditions, etc. Availability of data at the time of entering into transactions?

32. Part I Transfer Pricing Legislation Brief Legislative framework Brief on Assessment Procedures The charging Section and international transactions Associated Enterprises Principles of Comparability Computation of Arm’s Length Price Documentation requirements What is it that the taxpayer should do

33. Computation of ALP How to determine ALP [Section 92C (1)] By use of any of the prescribed methods being the most appropriate method having regard to : • nature of transaction or • class of transaction or • class of associated persons or • functions performed by such persons Factors to consider for selection of Most Appropriate Method (MAM) (Rule 10C) : • Nature and class of the international transactions • Class of enterprise and FAR • Availability, coverage and reliability of necessary data • Degree of comparability between international transaction & uncontrolled transaction • Extent of reliable and accurate adjustment

34. Methods for computation of ALP Traditional Transaction Transactional Profit based Profit Split Method (“PSM”) Transactional Net Margin Method (“TNMM”) Comparable Uncontrolled Price (“CUP”) Resale Price Method (“RPM”) Cost Plus Method (“CPM”) Computation of Arm’s Length Price Section 92C : Computation of arm’s length price No hierarchy of methods suggested by Indian TP legislation

35. Parent Company Third Party Outside India India External CUP Internal CUP Subsidiary Third Party Computation of Arm’s Length Price Comparable Uncontrolled Method (“CUP”) Steps : • Identify price charged in comparable uncontrolled transaction; • Adjust for differences materially affecting the price; • The adjusted price is the ALP Types of CUP

36. Computation of Arm’s Length Price Resale Price Method (“RPM”) Steps • Identify the third party selling (service) price (fee) for products (services) purchased (procured) from Group Companies • Reduce the comparable uncontrolled GP Margin in similar products (services) • Reduce the expenses incurred for procuring products/services • Adjust for functional and other differences, if any • The adjusted price is the ALP GP margin should recover operating costs and ALP profit based on the FAR

37. Computation of Arm’s Length Price Cost Plus Method (“CPM”) Steps • Identify direct and indirect costs of production for property (services) • Add uncontrolled normal GP mark-up • Adjust for functional and other differences, if any • The adjusted price is ALP Whether Cost Plus Pricing mechanism = CPM for computation of ALP?

38. Computation of Arm’s Length Price Profit Split Method (“PSM”) Steps • Determine combined NP for Group from international transactions • Evaluate relative contribution by each of the AEs based on the FAR • Split the combined NP amongst the AEs proportionate to relative contributions • The apportioned portion of the profit is taken to compute ALP Applicability : • Transactions involving transfer of unique intangibles or interrelated multiple transactions Detailed guidance about PSM in Proposed OECD Guidelines

39. Computation of Arm’s Length Price Transactional Net Margin Method (“TNMM”) Steps • Compute NP margin for • costs incurred • sales effected • assets employed or • any other relevant base • Compare NP margin realised from comparable uncontrolled transaction • Adjust for functional and other differences, if any • The NP is to be taken to compute ALP Popular amongst tax payers Favoured by Revenue Authorities since protects tax base erosion

40. Computation of Arm’s Length Price … TNMM Points to be considered: • Use of databases : Indian databases : PROWESS, CAPITALINE, etc. • Selection of tested party? • Use of foreign databases : PAN European : AMADEUS, North American : Compustat, etc. • Issues encountered in selection of comparables • Availability of data in public domain, • Computation of GP?, • FAR of comparables, etc. • Possible adjustments for comparability: • Working capital adjustment, • Risk adjustments, etc.

41. Computation of Arm’s Length Price … TNMM Profit Level Indicator (PLI)

42. Computation of Arm’s Length Price Choice of MAM : General categorisation

43. Computation of Arm’s Length Price Peculiarities in computation of ALP Options under proviso to Section 92 C (2) where more than one price is determined by the most appropriate method the ALP shall be taken to be the arithmetical mean of such prices OR if the variation between the ALP so determined and price at which the international transaction has actually been undertaken does not exceed five per cent of the latter, the price at which the international transaction has actually been undertaken shall be deemed to be the arm’s length price. (Amended by the Finance (No. 2) Act, 2009) Whether +/- 5% benefit can be availed if only one ALP computed ?

44. Computation of Arm’s Length Price Case studies on computation of ALP Subsidiary S purchases article A from Parent P at Rs. 104. Parent P also sells the article A to the third party Indian companies at negotiated prices. Following would be illustration of computation of ALP: More than one price determined by MAM: Therefore, the transaction of purchase of article A would be at arm’s length. What if S purchased article A at Rs. 107?

45. Computation of Arm’s Length Price … Case studies on computation of ALP S can opt for availing benefit under proviso to Section 92C (2) and compute the ALP with +/-5% range Situation before 2009 amendment Situation after 2009 amendment

46. Computation of Arm’s Length Price … Case studies on computation of ALP Application of +/-5% under TNMM The ALP so determined (Rs. 113) does not exceed 105% of the operating income (Rs. 115.50). Therefore the transactions would be considered to be at arm’s length. Important to note that +/-5% can be applied on arithmetical mean of ALP and NOT the margins

47. Computation of ALP When can AO compute ALP himself??? Mandatory satisfaction of any ONE of the following conditions for AO to compute ALP [Section 92C (3)]: • Price not determined under Section 92C • Information & document have not been maintained under Section 92D • Use of incorrect/unreliable data • Failure to furnish information & document under notice

48. Part I Transfer Pricing Legislation Brief Legislative framework Brief on Assessment Procedures The charging Section and international transactions Associated Enterprises Principles of Comparability Computation of Arm’s Length Price Documentation requirements What is it that the taxpayer should do

49. Documentation Requirements Mandatory documentation Mandatory maintenance of prescribed information and documents by every person entering into an international transaction [Section 92D read with Rule 10D] • Entity Related • Profile of the Group • Profile of the Indian entity • Profile of AE • Profile of Industry • Price Related • Transaction terms • Functional Analysis (Functions, Assets, Risks) • Economic Analysis • (Method selected, • Benchmarking analysis) • Forecasts, budgets, • estimates, etc. • Transaction Related • Agreement • Invoices • Price related correspondence

50. Documentation Requirements … Mandatory documentation Supporting Documents [Rule 10D(3)] • Official publications, reports, studies from Government • Reports of market research studies, technical publications • Price publications • Published accounts and financial statements • Agreements & contracts related to international transaction • Letters and other correspondences The information and documents should be contemporaneous and shall be kept for a period of eight years from the end of the relevant assessment year [Rule 10D (5)]