aicas annual direct taxes workshop - july 2, 2010 update on india transfer pricing audit and dispute...

PwC

AICAS Annual Direct Taxes Workshop - July 2, 2010

Update on India Transfer Pricing Audit and Dispute Resolution Panel proceedings

Tarun AroraVani Sharma

Topics

PricewaterhouseCoopers Slide 2

TP audits / assessments in India

• Salient Features

• Recent Trends

• Key Audit Issues

• Recent Mutual Agreement Procedure (MAP) Outcome

Dispute resolution panel (DRP) proceedings

• Salient Features

• Case Study – Captive IT enabled service provider

• Case Study II – Captive Procurement service provider

• Expectations from the DRP mechanism

PwCPricewaterhouseCoopers



Separate Transfer Pricing cell established for carrying out TP audits

TP audit of all taxpayers having international related party transactions above a threshold, currently INR 150 million - proposal to move to selective, risk based audits from April, 2011

Five rounds of TP audits completed in 2009 aggressive positions by TP Officers (TPOs) initial focus on IT/ BPOs [high margins – location savings]; increasingly more complex audits pursued

Trained team of TPOs High volume of cases handled per TPO TPOs vested with powers of inspection, discovery, enforcing attendance, examining a person under oath and compelling the production of books of accounts/ other relevant documents and information

No Advance Pricing Agreement (APA) mechanism in India till date proposal to introduce in April, 2011

DRP mechanism introduced in 2009


Salient features


Recent Trends

No. Charge Number of TP audits completed

Number of adjustment

cases

% of adjustment

cases

Amount of adjustment

in US$ million

1 New Delhi 445 243 55 1,028

2 Mumbai 559 179 32 390

3 Bangalore 427 244 57 750

4 Chennai 152 47 31 58

5 Kolkata 67 9 13 11

6 Ahmedabad 74 35 47 52

7 Pune 106 56 53 104

Total 1,830 813 44 2,393



Marketing Intangibles – Legal vs. Economic Ownership ?

Procurement / Marketing support service providers characterized as agents / distributors

Significant adjustment to IT / ITES companies (25-30% mark-up applied)

Attribution of income to Indian Permanent Establishment (PE) of foreign company

Detailed scrutiny of payments for licensed Intellectual Property (Royalty, technical know-how fee, brand / trademark fee etc.) and management service charges

Dispute on business strategies and economic principles, choice of comparables, comparability adjustments

Use of secret comparables & confidentiality of information

Key Audit Issues



Marketing Intangibles - General concept

Principal Co

Manufacturer

India Sub Co

Distributor Flow of legal title of goods Physical movement of goods

• India Sub Co has license of brand & distribution rights from Principal Co• Advertisement & Marketing (A&M); distribution network key drivers to business• Who should incur A&M, distribution expenses ?• No straight-jacket formula fact driven depends on profile of India Sub Co• Who performs significant people functions & takes key decisions on A&M ?• If India Sub Co is LRD Principal Co bears expenses & owns marketing

intangibles (customer list, dealers network, etc)• If India Sub Co is full risk/ marketing distributor India Sub Co bears expenses &

owns marketing intangibles• Revenue cannot dictate business model substance is the key

Indian customer


INDIA

PricewaterhouseCoopersPricewaterhouseCoopers Slide 8

INDIA

Technology/Brand

Royalty

Principal Co

Legal owner of IP

India Sub Co

Licensee of IP

Flow of legal title of goods Physical movement of goods

Supplier

• India Sub Co operates as licensed manufacturer• Raw materials primarily sourced from third parties• No royalty pay-out/ minimal royalty for mere license of technology/

brand• India Sub co takes all key decisions on A&M/ distribution, etc• India Sub Co bears all A&M/ distribution expenses (on own account)• Revenue makes addition in hands of India Sub co Principal Co to

pick-up “extra” A&M/ distribution expenses, as legal owner of brand• TP adjustments run into several millions of US$ major issue• TP adjustments primarily in R&C industry

Marketing Intangibles - Dispute in India

Indian customer



Marketing Intangibles - Relevant considerations

Evaluate contribution (& related benefits) of each entity in developing marketing intangibles do efforts/ costs lead to :

• increase in value of IP owned by Principal Co; or

• merely enhancing value of rights/ benefits of India Sub Co [sole distributor/ seller ]

Who undertakes key decision making activities – development of marketing strategy, authority to take decisions, evaluate/ approve budgets, compensation model of personnel ?

Significance of local marketing in taxpayer’s industry - specific characteristics and competition

Business/ commercial expediency of marketing efforts & costs in relation to benefits/ returns

Is business substance properly captured in the contracts ?

• Legal vs. economic ownership

• Economic substance, in case IP development is bundled with other transactions

Robust upfront documentation (including legal contract) covering Functional, Asset and Risk (FAR) analysis & economic/ commercial realities utmost necessity

Revenue’s acceptability of economic principles and international guidance/ case laws/ rulings (e.g. OECD, US, Australia) still a challenge



INDIA

Principal Co

Manufacturer/ Retailer

India Sub Co

Procuring Services


• India Sub Co carries out liaison/ co-ordination functions for Principal Co• Parameters of material, eg quality, design, trends, etc, as per Principal Co• Vendor list provided by Principal Co to India Sub Co• India Sub Co maintains day-to-day relationship with vendors• Vendors sell products directly to Principal Co• Principal Co remunerates India Sub Co at “Cost Plus”• Say, operating costs of India sub Co US$ 15 million• Mark-up on operating costs @ 20% Profits of India Sub Co US$ 3 million• Products sourced by Principal Co from Indian vendors US$ 2 billion

Service fee

Procurement Service Providers - Typical scenario in India

Indian vendor



• Revenue India Sub Co to receive commission @% of value of goods sourced• Typically, 5% rate (on US$ 2 billion) Commission imputed at US$ 100 million• Adjusted profits of India Sub Co US$ 85 million [100 – 15]• TP adjustment in hands of India Sub Co 82 million [85 – 3]• Imputed profits/ margin 566% on operating cost Berry Ratio of 666% !!• Large scale litigation in India adjustments worth several millions of US$

Principal Co


India Sub Co

Procuring Services


Indian vendor

INDIAService fee

Procurement Service Providers - Dispute in IndiaTP audits / assessments in India


Principal Co


Procurement

Service Co

Option 1Buy-SellMargin

Option 2Agency

Commission@% of value of goods

Option 3Services

Service Fee@ Cost Plus Mark Up


Indian vendor

Procurement Service Providers – Option of ModelsTP audits / assessments in India


Can Revenue question choice of model, unless not backed by substance

FAR profile determines model :

• Scouting for vendors; soliciting; signing contracts, etc

• Product designing; quality; process standards; etc

• Price & market risks; etc

• Product liability risk; etc

Can Berry Ratio be ignored, unless valuable hidden intangibles ?

Can Revenue impute hidden intangibles without evidence ?

Favourable Dutch Supreme Court ruling

Documentation & inter-company agreement extremely important substance is key

Rulings of Tribunal (Nike Inc) & Authority of Advance Ruling (Ikea Trading) Indian liaison

office of Foreign Co, facilitating procurement of goods held not to constitute PE of Foreign Co

low value added activity

Procurement Service Providers – Relevant ConsiderationsTP audits / assessments in India


Agency PE – dispute in India

Off-shore sales

Concludes contracts/ solicits orders

Third–party customers

Commission

F Co

Does Sub Co create PE of F Co ?

If yes, whether extra profits on F Co ?

Sub Co

Agency PE

Answer lies in transfer pricing

INDIA


In the case of Morgan Stanley, the Supreme Court held that no further attribution is required if the associated enterprise (that also constitutes a PE) is remunerated on an arm’s length basis given its FAR analysis (Other subsequent rulings have also given similar guidance)

PricewaterhouseCoopers

Indian and US competent authorities (CAs) have recently agreed upon the following cost-plus marks:

Absolute mark-ups determined – No further relief of +/-5%, adjustments Ruling applicable for respective assessment years only CAs had detailed discussion on comparable set used in TP documentation No involvement of tax payers during the negotiation Taxpayer to formally notify the acceptance of Ruling Domestic Route vs. MAP?

• Tax Payers have to evaluate the time duration for settlement – Domestic route vs. MAP• Higher Interest on tax demand due to delay in resolution under domestic route• MAP Ruling will affect Tribunal’s mindset while disposing the case • Whether penalty will be levied upon acceptance of MAP ruling??

Recent MAP Outcome

Assessment Year Software Development IT enabled services

2004-05 18.00% 24.00%

2005-06 17.50% 17.50%


Slide 15

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DRP proceedings

Objective of DRP mechanism as per Finance Minister “to encourage the growth of foreign investment in India by providing for a speedy dispute resolution mechanism”

Introduced under Section 144C of the Income Tax Act, 1961 read with the Income Tax (Dispute Resolution Panel) Rules, 2009

Applicable to taxpayers having TP adjustments as well as foreign companies for orders passed by the AO on or after October 1, 2009

Each DRP consists of 3 CITs

10 DRPs constituted in 8 locations across India – Delhi (2), Mumbai (2), Pune (1), Ahmedabad (1), Bangalore (1), Hyderabad (1), Chennai (1) and Kolkata (1)

Alternative to CIT (Appeals)


Salient features

DRP Proceedings


TPO/ AO

CIT (Appeals)

Tax Tribunal

High Court

Supreme CourtOnly legal issues

TPO/ AO

DRP

Tax Tribunal

High Court

Supreme CourtOnly legal issues

• AO issues draft order based on TPO’s order

• Taxpayer files acceptance or detailed objections to proposed additions (within 30 days of receipt of order)

• DRP may confirm, reduce or enhance proposed additions

• Dispute resolved within 9 months of issuance of draft AO order

• All directions of DRP binding upon AO

• No tax demand until DRP issues directions

• Taxpayer can challenge ruling before Tax Tribunal

Conventional mechanism

Alternate mechanism

• AO passes final order• Tax demand fastens on

taxpayer immediately• Stay of demand not

automatic• No time limit to dispose

appeal• Taxpayer & Revenue can

both challenge ruling before Tribunal

DRP Proceedings

Salient features

DRP members are part – timers also have existing administrative duty

DRP members do not have any TP background

Huge number of cases to be disposed off by DRPs in the next six months

Pro-revenue approach since directions of DRPs are binding upon the AO and there is no right of appeal with the Revenue

Taxpayers getting one or at the most two personal hearings before the DRP

To see whether the DRP mechanism will achieve its stated intent / objective


Salient features

DRP Proceedings


Captive IT enabled service provider – Facts of the case

DRP Proceedings

XYZ Corporation - incorporated in USA – a leading global engineering, construction and project management company

XYZ India - wholly owned subsidiary of XYZ Corporation – engaged in undertaking design and engineering services for the Group’s worldwide projects

In TP Documentation, XYZ India characterized as an engineering support services provider and benchmarked with similar engineering service providers


DRP Proceedings

Captive IT enabled service provider – TPO order TPO alleged that XYZ India was engaged in ‘development of computer software and

undertaking computer aided designing and engineering activities’

TPO rejected XYZ India’s characterization and comparable companies chosen in TP Documentation

TPO simply placed reliance upon comparable companies chosen in XYZ India’s prior year TP order which were engaged in software development and CAD / CAE activities

TPO made TP adjustment of about INR 50 million

FAR profile of companies chosen by TPO not comparable with FAR profile of XYZ India

2 companies selected by TPO have significant related party transactions

Comparability adjustments (working capital level differences etc.) be granted to XYZ India


Captive IT enabled service provider – Key arguments before DRP

DRP Proceedings


Captive IT enabled service provider – DRP’s Directions

DRP Proceedings

Provided only two opportunities of hearing on the case

Disposed off all submissions of the Company in a summary fashion and did not even allow rectification of AO / TPO’s order by excluding companies with significant related party transactions

ABC Inc. - incorporated in USA - an international specialty retailer - operates stores selling casual apparel, shoes and other accessories

No manufacturing activity within the Group - all manufacturing done by third party manufacturers across several countries - products sourced from them

ABC Sourcing Inc. - wholly owned subsidiary of ABC Inc. - does sourcing for the Group from various countries, including India

ABC India - operates as a sourcing support service provider and local communication liaison for ABC Sourcing Inc.

Remunerated at total cost plus 15% mark up for sourcing support, liaisoning and co-ordination functions performed (with minimal risks assumed)


Captive Procurement service provider – Facts of the case

DRP Proceedings

TPO alleged that ABC India carried out a range of important and key procurement functions in the value chain

TPO alleged that ABC India owned significant human asset and supply chain intangibles

TPO alleged that ABC India assumed significant risks of losing its specialized and skilled work-force

TPO alleged that ABC India operates in a low cost economy and has generated location savings which have not been factored into in its remuneration model


Captive Procurement service provider – TPO order

DRP Proceedings

Þ ABC India should have been remunerated a commission on value of goods sourced and not mark-up on value adding (operating) expenses

Þ Imputed profits/ margin @ 800% on operating/ value adding expenses

Þ TP adjustment of over INR 2 billion !!

Activities of ABC India did not lead to creation of any supply chain or human asset intangibles

Location savings arise due to bargaining power of Group and not due to bargaining power of ABC India

Reliance on Indian and international judicial precedents

Extensive tangible evidence / documents to corroborate contentions submitted

Detailed analysis of comparative margins earned by distributors of clothes and footwear from India, Europe and Asia-Pacific regions undertaken to show absurdity of margins imputed for ABC India


Captive Procurement service provider – Key arguments before DRP

DRP Proceedings


Captive Procurement service provider – DRP’s Directions

DRP Proceedings

Provided only two opportunities of hearing on the case

Disposed off submissions/ evidences running into several hundreds of pages in a half page order

Many misstated / erroneous facts in the order


Expectations from the DRP mechanism

DRP Proceedings

More number of DRPs to be constituted throughout India

DRP members to have single / dedicated charge

DRP members to have prior TP background / training

DRP to function like an independent judicial body and have statutory powers / authority

This publication has been prepared for general guidance on matters of interest only, and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is given as to the accuracy or completeness of the information contained in this publication, and, to the extent permitted by law, PriceWaterhouseCoopers its members, employees and agents do not accept or assume any liability, responsibility or duty of care for any consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it.

Tarun AroraPartner, Transfer PricingPriceWaterhouseCoopers, IndiaNew Delhi OfficeEmail : [email protected] Mobile : +91 9810044798

Vani SharmaSenior Manager, Transfer PricingPriceWaterhouseCoopers, IndiaNew Delhi OfficeEmail : [email protected] Mobile : +91 9899795851

Thank You

PwC

aicas annual direct taxes workshop - july 2, 2010 update on india transfer pricing audit and dispute...

Documents

india slide

tp audits tp audit

chargenumber of tp audits

rounds of tp audits

drp mechanism slide

manufacturer india sub

profile of india sub

complex audits