Transfer Pricing Rules and TP Assessment 27 October 2012 Manish Bafna Senior Manager, Global Transfer Pricing Services B

1. B S R & Co. Transfer Pricing Rules and TP Assessment 27 October 2012 Manish Bafna Senior Manager, Global Transfer Pricing Services B S R & Co., Mumbai, India

2. Agenda • Transfer Pricing Rules • Overview • Practical Experience • Case Laws • Penalties • Transfer Pricing Assessments • Advance Pricing Agreements - Overview

3. Transfer Pricing - Rules

4. Rule 10 of the Income-tax Rules, 1962 10A • Meaning of expressions used in computation of ALP 10B & 10 AB • Determination of ALP under Section 92C 10C • Most Appropriate Method 10D • Information / Documentation to be maintained 10E • Accountant’s Report 10 F – 10 T • Advance Pricing Agreements

5. Rule 10A - Meaning of expressions used in computation of ALP

6. Rule 10A – Meaning of expression used in computation of ALP • “uncontrolled transaction” means a transaction between enterprises other than associated enterprises, whether resident or non-resident Associated Enterprises Controlled transaction Uncontrolled transaction Assessee Third Party

7. Rule 10A – Meaning of expression used in computation of ALP

8. Rule 10A – Meaning of expression used in computation of ALP • “property” includes goods, articles or things, and intangible property • “services” include financial services • “transaction” includes a number of closely linked transactions

9. Rule 10B – Determination of arm’s length price under section 92C

10. Rule 10B & 10 AB – Determination of arm’s length price under section 92C (1) For the purposes of sub-section (2) of section 92C, the arm’s length price in relation to an international transaction or specified domestic transaction shall be determined by any of the following methods, being the most appropriate method, in the following manner, namely :— (a) comparable uncontrolled price method (Rule 10 B(1)a) (b) resale price method (Rule 10 B(1)b) (c) cost plus method (Rule 10 B(1)c) (d) profit split method (Rule 10 B(1)d) (e) transactional net margin method (Rule 10 B(1)e) (f) any other method (Rule 10 AB)

11. Unrelated Co. Y Outside India External CUP India Unrelated Co. Z Rule 10B(1)(a) - CUP Method Parent Co. • Most Direct Method for benchmarking • Requires strict comparability in products, contractual terms, economic terms, etc. • Two types of CUPs- Internal CUP & External CUP • Adjustments required for differences which could materially affect the price in the open market e.g.: Difference in • Volume / quality of product • credit terms • Risks assumed • Geographic market • OECD - Priority to Internal CUP due to higher degree of comparability Internal CUP Transfer Price Outside India Sub Co. Unrelated Co. X

12. Rule 10B(1)(b) - RPM • To be applied when a goods purchased or service obtained from an AE is resold to an unrelated enterprise. • Compares resale gross margin earned by AE with resale gross margin earned by similar independent distributors • Preferred method for distributor buying purely finished goods from a group company (if no CUP available) • dependant more on similarity of functions performed & risks assumed rather than product comparability Parent Co. Transfer Price INR 75 Outside India India Resale Price INR 100 Sub Co. Unrelated Co. Y 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`

13. Rule 10B(1)(b) - RPM • Involves use of gross margins • Identify the price at which goods / services purchased from AE are resold to non-AE • Reduce the resale price by normal gross profit margin arising from comparable uncontrolled transactions • Reduce the expenses incurred in connection with purchase (e.g. custom duty) • Adjust the resultant price for functional and other differences which could materially affect such gross profit margin in open market • Adjusted price is considered as ALP Usually used in case where the enterprise is engaged in pure resale, with no value addition

14. Parent Co. Outside India India Sub Co. Co. Z Co. Y / AE Rule 10B(1)(c) - CPLM • Compares mark up (profits) 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 • Applied in cases of manufacture, assembly / production of tangible products or services that are sold / provided to AEs • Comparability not dependent on close physical similarity between the products. • Larger emphasis on functional comparability Transfer Price INR 125 Direct cost & Indirect cost of Production INR 30 COGS INR 70 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

15. Rule 10B(1)(c) - CPLM • Involves use of gross margins • Identify direct and indirect costs of production of goods / services • Identify the normal gross profit mark-up arising from comparable uncontrolled transaction • Mark-up to be computed as per same accounting norms • Adjust the comparable mark-up for functional and other differences which could materially affect such mark-up in open market • Add the adjusted mark-up to the identified costs to arrive at the ALP Used in case where enterprise transfers goods / services to AE after adding substantial value

16. Rule 10B(1)(c) – CPLM… • Direct costs would generally include: • Purchased Material costs (including freight, custom duty, etc.); • Labour costs and manufacturing overheads • Indirect costs would generally include: • Fixed cost of production such as rent & property taxes on manufacturing facilities; • Variable indirect production costs such as consumables, utilities etc. • Following costs generally not included • Selling expenses, including advertising; general and administrative expenses; research & development, etc.

17. US Co A – Technology intangibles Outside India Mfg. Co B Mkt Co C Marketing intangibles Rule 10B(1)(d) - PSM • 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 • To be applied in cases involving transfer of unique intangibles or in multiple international transactions that cannot be evaluated separately • The two methods discussed by OECD Guidelines: • Contribution PSM Analysis • Residual PSM Analysis India

18. Rule 10B(1)(d) - PSM • Two alternate approaches to arrive at ALP • Relative Contribution approach: • Determine combined net profit of AEs • Split the combined net profit amongst the AEs in proportion to their ‘relative contributions’ • Relative contribution made by each of AE to the earning of such combined net profit is based on: • Functions performed, assets employed and risks assumed by each enterprise taken as basis for such evaluation • Reliable external market data which indicate how relative contribution would be evaluated by unrelated enterprises • Profit so split is taken into account to arrive at ALP

19. Rule 10B(1)(d) – PSM… • Residual Profit approach: • Allocate basic return to each enterprise based on markets returns achieved for comparable uncontrolled transactions • Allocate residual profit based on relative contribution as discussed above • Profit so split is taken into account to arrive at ALP Used in case of transfer of unique intangibles or multiple interrelated transactions

20. Rule 10B(1)(e) - 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 • Preferred method in India, due to broad level of product comparability and high level of functional comparability • Internal TNMM preferable –when entity has uncontrolled transactions also Parent A Unrelated Cos. Outside India India Subsidiary B Net margin 5% Unrelated Cos. Net margin 3%

21. Rule 10B(1)(e) - TNMM • Determine the net profit margin earned by the assessee from the international transaction, as a percentage of an appropriate base (e.g. percentage of costs incurred, sales effected, assets employed, etc.) • Using the same base, compute net profit margin from a comparable uncontrolled transaction • Adjust the comparable margin for differences which could materially affect such margin in open market • Adjusted net profit margin is taken into account to arrive at ALP Usually regarded as an indirect method, but is most widely used

22. Rule 10B(1) - Summary of Methods * Relevant for certain parts of the PSM analysis

23. Rule 10 AB – Other Method • Introduced by CBDT vide notification dated 23-5-2012 • Allows use of any method taking into consideration the price actually charged or would have been charged in an uncontrolled transaction • Whether quotations can be considered as comparable ? • Use of standard rate cards, price lists, etc; • Valuation Report • Whether the other method can be considered to justify specified domestic transaction ? • Whether other method can have priority over the five method as specified in Rule 10 B

24. Rule 10B(2) - Comparability Factors (a) Characteristics Depends on type: tangible, intangible or service (b) Functional Analysis Conduct is best evidence of risk bearing, should be consistent with control (c) Contractual terms Where not written, deduce from conduct Comparability factors (d) Economic Circumstances Geography, size of market, date and time

25. Rule 10B(2) - Comparability Factors • Practical Experience • Sources of information and reliability • Timing issues in comparability • Documenting a search of comparables • Identifying comparables having uncontrolled transactions • Comparability adjustments • Selecting or rejecting internal / external comparables • Single year vis-à-vis multiple year data • Other issues (Loss making companies, companies with extreme results, etc.)

26. Rule 10B(3) - Adjustments for Comparability • An Uncontrolled transaction shall be comparable to international transactions if: • (i) none of the differences between the transactions being compared or between the enterprises entering into such transactions are likely to materially affect the price, or cost charged, or profit arising from, such transactions in the open market; or • (ii) reasonable accurate adjustments can be made to eliminate the material effects of such differences. • Thus, the Indian regulations expressly require that adjustments to prices/margins should be made (where appropriate) to enhance comparability • Practical Experience – Kind of adjustments asked for: • Working capital adjustment • Volume adjustment • Idle capacity adjustment • Adjustment for difference in risk profile • Adjustment for differences in accounting policies • Adjustment for difference in depreciation rates

27. Rule 10B(3) - Adjustments for Comparability • Practical Experience: • Indian law permits adjustments only to comparables and not tested party • The TPOs generally reject adjustments inter-alia stating that the assumptions, approximations and estimations used in computation are not tenable • Challenge lies in obtaining reliable and adequate data of comparables for computation of adjustments • Lack of guidance on computation methodology • Courts favor adjustments for proper comparability • Quantification of adjustment is a huge challenge • Adjustments being accepted - Working capital adjustment, Risk adjustments

28. Rule 10B(3) - Adjustments for Comparability

29. Rule 10B(4) - Usage of Multiple Year Data • The data to be used in analysing the comparability of an uncontrolled transaction with an international transaction shall be the data relating to the financial year in which the international transaction has been entered into : • Provided that data relating to a period not being more than two years prior to such financial year may also be considered if such data reveals facts which could have an influence on the determination of transfer prices in relation to the transactions being compared. • Use of multiple year data considered useful to even out fluctuations caused by: • Adverse business scenarios, • Economic situation; and • Product life cycle • Multiple year data widely used due to non-availability of relevant year financial statements of comparable companies at the time of finalizing TP documentation

30. Rule 10B(4) - Usage of Multiple Year Data • Practical Experience: • TPOs follow first leg of rule 10B(4), reject multiple year data • Adopt only data relating to the relevant financial year and undertake adjustments • Courts allow usage of multiple year data if proper reasoning in terms of proviso to rule 10B(4) available • Case Laws

31. Rule 10B(4) - Usage of Multiple Year Data

32. Rule 10C - Most Appropriate Method

33. Rule 10C - Most Appropriate Method (1) For the purposes of sub-section (1) of section 92C, the most appropriate method shall be the method which is 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. (2) In selecting the most appropriate method as specified in sub-rule (1), the following factors shall be taken into account, namely:— • Nature and class of international transaction; • Class and functions performed by associated enterprises; • Availability, coverage and reliability of data; • Degree of comparability; • Possible adjustments; • Nature, extent and reliability of assumptions.

34. Rule 10C - Most Appropriate Method

35. Rule 10D - Information / Documentation to be maintained

36. Rule 10D - Information / Documentation to be maintained Entity related Price related Transaction related • Transaction terms • Functional analysis (functions, assets and risks) • Economic analysis (method selection, comparable benchmarking) • Forecasts, budgets, estimates • Profile of industry • Profile of group • Profile of Indian entity • Profile of associated enterprises • Agreements • Invoices • Pricing related correspondence (letters, emails etc) Contemporaneous documentation requirement – Rule 10D Documentation to be retained for 9 years No specific documentation requirement if the value of international transactions is less than one crore rupees

37. Rule 10D - Information / Documentation to be maintained

38. Rule 10E - Accountant’s Report

39. Rule 10E - Accountant’s Report • Report from an accountant to be furnished under section 92E. • 10E. The report from an accountant required to be furnished under section 92E by every person who has entered into an international transaction during a previous year shall be in Form No. 3CEB and be verified in the manner indicated therein. • FORM NO. 3CEB • [See rule 10E] • Report from an Accountant to be furnished under section 92E relating to • international transaction(s) • We have examined the accounts and records of <<Entity Name, Postal Address and PAN Number>> relating to the international transactions entered into by the assessee during the previous year ended on 31 March 2012. • In our opinion proper information and documents as are prescribed have been kept by the assessee in respect of the international transaction(s) entered into so far as appears from our examination of the records of the assessee. • The particulars required to be furnished under section 92E are given in the Annexure to this Form. In our opinion and to the best of our information and according to the explanations given to us, the particulars given in the Annexure are true and correct.

40. Accountant’s Report – Legal Requirement • Accountant’s Report contains following disclosures:- • Nature of international transactions • Book value and Arm’s length value of international transactions • Method adopted for the purpose of benchmarking • Documentation to justify arm’s length nature of international transactions

41. Transfer Pricing - Penalties

42. Penalties However, penalty for concealment of income shall not be levied if the taxpayer demonstrates that price charged or paid has been determined in ‘good faith’ and with ‘due diligence’.

43. Transfer Pricing Assessment

44. Transfer Pricing Litigation Scenario in India • Seven rounds of TP audits completed – AY 2002-03 to AY 2008-09 INR 44,500 crores of TP adjustment in recent concluded audit cycle for AY 2008-09

45. Audit Process File tax return and Accountant’s Report (30th November) DRP Mechanism-Finance Act 2009 Reference to be made to TP Officer (‘TPO’) by the Assessing Officer (‘AO’); Compulsory Reference to be made by AO if international transactions exceed INR 150 million (Internal guidelines) Appeal Procedure Notice to be issued by the TPO – TPO calls for supporting documents and evidence Appeal to CIT(A) Passes an order Income Tax Appellate Tribunal High Court – only on matters related to law Supreme Court Constitutional Bench TP Audit Based on results of above mentioned procedure assessing officer passes the order Rectification application can be made against the order of TPO for apparent mistakes Appeal can be made against the order of AO as order of TPO included within the order of the AO

46. Transfer Pricing Audit Experience • Triggers for Detailed Scrutiny • Consistent losses / low margins of the taxpayer attributable to inter-company transactions • Significant changes in profitability of the taxpayer • High value intra-group services such as royalty / technical payouts, cost allocations, etc. • Payment of ‘management charges’ and ‘royalty’ not passing the ‘benefit test’ • Net losses incurred by routine distributors • Low mark-ups for services • Significant marketing expenses by manufacturing / distribution companies • Others • Demanding information on transactions by AE with other AE • Insistence on use of ‘single-year’ data • Exclusion of loss making / low margin companies from the set of comparables

47. Transfer Pricing challenges • Comparability between branded products and generic products: • Tax authorities generally compare the import price of raw materials used for branded products with prices prevailing in local market for unbranded generics – “Serdia Pharmaceuticals” • Use of secret data - data sourced from Customs; Also data sourced by using statutory powers. 1 • Contract R & D Services: • Tax authorities require Indian entity to get a share of the global profit earned by the parent entity on the ground that Indian entity is part owner of the Intellectual Property as majority of R & D work is undertaken by it in India. • Definition of total cost for the purpose of computing mark-up in case of R & D activities. 2 • Marketing Intangibles: • Tax authorities require Indian Companies to be compensated for extra ordinary advertising and marketing expenses – Bright Line Test – “Maruti Suzuki”. 3 • Business Restructuring • Rationale for change in business model to be adequately documented • Exit charge and valuation of intangibles 4 • Management recharges / cost allocation: • Payment of management recharges disallowed unless the same is supported by robust documentation • Basis of cost allocation scrutinized in detail • Disallowances made on an arbitrary basis 5

48. Advance Pricing Agreement - Rule 10F to Rule 10T

49. APA Rules – Overview • APA legislation effective 1 July 2012 & APA Rules notified 30 August 2012 • Types - Unilateral, Bilateral, Multilateral • Validity – Up to 5 years (renewal possible) • Coverage – Existing/ongoing transactions & New transactions • Mandatory Pre-Filing Application & Consultation – option to remain anonymous • APA Directorate to include panel of experts - Economists, Statisticians, etc • Annual APA Compliance Report & Compliance Audit • Fees (only at APA Application stage):

50. Questions