advice on transfer pricing companies act & sebi

Advice on transfer pricing regulations, governing Companies Act & SEBI regulations on proposed transaction

September 16, 2014

of 29

Contents

1. Facts of the Case and Objective ........................................................................................................ 3

2. Overview of Indian Transfer Pricing Laws ........................................................................................ 5

3. Overview of relevant provisions under Corporate Law ................................................................ 13

4. Applicability of Transfer Pricing & Corporate Law on the proposed transactions .................... 17

5. Overview of Clause 49 (VII) of SEBI – Approval of related party transactions ........................... 19

6. Pricing options for each of the covered transactions ................................................................... 21

7. Conclusion and way forward ........................................................................................................... 29

of 29

1. Facts of the Case and Objective

1.1 Background:

The public sector Oil Marketing Companies (OMC’s); namely, Indian Oil Corporation Ltd (IOCL), Bharat

Petroleum Corporation Ltd (BPCL) & Hindustan Petroleum Corporation Ltd. (HPCL) are primarily

responsible for the marketing and distribution of petroleum products in India. OMC’s require a robust supply

chain to cater to growing energy requirements.

OMC’s set up POL infrastructure facilities (terminal / depots / LPG bottling plants) across India to manage

supply & logistics. POL infrastructure forms the backbone of OMC’s energy supply chain.

Presently, each OMC’s own & operate its POL infra facilities exclusively. It is understood that this results in

duplication of facilities and also leads to under-utilization of infrastructure / resources at industry level.

1.1 SPV to manage CUF:

In view of the above, the OMC’s propose to develop Common User Facilities or CUF (terminal / depots /

LPG bottling plants) in India. It is proposed to float a new Joint Venture Company (“JVC” or “SPV”) for the

purpose of rendering these CUF or terminalling services to all the OMC’s. OMC’s are motivated to develop

CUF since it would:

• Result in lower cost of capital expenditure / operational expenditure

• Cost efficiencies for OMC’s and existing POL facilities

• Eliminate duplicate investments

It is proposed that SPV would be equally held (shareholding) by each of the OMC’s.

1.2 Overview of activities proposed under new SPV:

• Constructing, maintaining and operating New LPG Plants/Terminals/Depots as Common User Facility

(CUF).

• Leasing/Purchasing existing LPG Plants/Depots/Terminals of OMC’s for integrating the same or for

using them on stand-alone basis for their usage as CUF and maintaining and operating them for CUF to

OMC’s.

• Receipt, storage and dispatch of LPG/Liquid petroleum requirements for OMC’s through CUF.

• Operations & Maintenance Contract for existing LPG Plants/Depots/Terminals of OMC’s for their usage

as CUF.

of 29

• Investment if any required for integration of facility would be done by the SPV.

• In cases of new facilities developed by Joint Venture Company, cross country pipeline input facilities

would be provided by OMC’s.

1.3 Proposed transactions between OMC’s & SPV

Based on the above facts, we have been given to understand that the related party transactions in the

proposed arrangement between OMC’s and SPV would be as follows:

• CUF services to be rendered by the proposed SPV to all the OMC’s.

• Transfer of existing asset from OMC’s to SPV

Applicability and consequent compliance requirements, under ITA & Corporate Laws need to be ascertained

in respect of the above referred transactions and for both SPV as well as OMC’s.

1.4 Objective:

The objective of this note is to highlight and discuss the requirements of Transfer Pricing regulations both

under Income Tax Act (“ITA”) , newly introduced Companies Act 2013 (“Companies Act” / “Corporate Law”)

and recently amended SEBI regulations on related party transactions between proposed SPV and OMC’s.

Also, this memo highlights broad overview of plausible pricing models and benchmarking method which

could be used to meet arm’s length standard contemplated under both the above referred laws viz ITA (for

transfer pricing) & Corporate Law.

of 29

2. Overview of Indian Transfer Pricing Laws

2.1 Introduction

Transfer pricing law in India has been introduced as anti tax avoidance measure under the ITA. The said law

is enacted to curb/avoid of manipulation of prices thereby leading to manipulation of tax liability of mainly a

multi-national group.

The relevant section 92 of the Income Tax Act, 1962 (hereinafter referred to as “ITA”) provides that income

arising from an international transaction between associated enterprises shall be computed having

regard to the Arm’s Length Price (hereinafter referred to as “ALP”).

Recently, in the Finance Act 2012, a new section 92BA has been introduced to cover certain specified

domestic transaction under the purview of transfer pricing regulations in India. Thus, transfer pricing

regulations are now applicable to Indian group for their domestic related party transactions.

2.2 International transactions

An international transaction as per Section 92B of the ITA would mean a transaction between two (or

more) associated enterprises involving the sale, purchase or lease of tangible or intangible property;

provision of services; cost-sharing arrangements; lending/borrowing of money; or any other transaction

having a bearing on the profits, income, losses or assets of such enterprises.

2.3 Specified domestic transactions

As mentioned, Finance Act 2012 widened the scope of transfer pricing provisions to include in its ambit

certain ‘specified domestic transactions’ (“SDT”), for transactions with certain related domestic parties, if

the aggregate value of all such specified domestic transactions exceeds INR 5 crore. The above provision

came in to effect from 01-04-2012.

The specified domestic transactions as defined under the ITA can be broadly categorised in to following:

• Expenses paid / to be paid to parties referred to in section 40A(2)(b) of the ITA

• Inter-unit transfers by a company, having multiple units & claiming tax holiday in one or more units;

• More than ordinary profits declared by tax holiday units as a result of dealing with related parties.

Definition of SDT as per ITA is enclosed as Exhibit 2.

of 29

An illustrative list of transactions that would be covered under the said clause is mentioned herein under:

• Expenditure on buying goods

• Expenditure on procurement of services

• Expenditure on purchase of tangible and intangible property

• Expenditure on interest payments

• Expenditure on salary, training services, marketing expenses

• Director’s remuneration, commission, sitting fees

• Group charges

• Reimbursement expenditure

• Guarantee fee expenditure

2.4 Associated enterprise

The definition of an associated enterprise (AE) covers an enterprise having direct/ indirect participation in

the management, control or capital of an enterprise by another enterprise. It also covers situations in which

the same person (directly or indirectly) participates in the management, control or capital of both the

enterprises.

For the purposes of the above definition, certain specific parameters have also been laid down based on

which two enterprises would be deemed as AE’s.

2.5 Related Parties for the purposes of SDT under section 40A(2)(b)

The list of related parties referred in the SDT related provisions is comprehensive enough to include majority

of the parties who could possibly influence the price of a transaction. Such related parties are defined under

Section 40A(2)(b) of the ITA. The relevant clause and sub-clause is mentioned as follows:

“The persons referred to in clause (a) are the following, namely:—

i. .........

ii. ........

iii. ........

iv. a company, firm, association of persons or Hindu undivided family having a substantial

interest in the business or profession of the assessee or any director, partner or member of

such company, firm, association or family, or any relative of such director, partner or

member [or any other company carrying on business or profession in which the first

mentioned company has substantial interest];

of 29

v. a company, firm, association of persons or Hindu undivided family of which a director,

partner or member, as the case may be, has a substantial interest in the business or

profession of the assessee; or any director, partner or member of such company, firm,

association or family or any relative of such director, partner or member;

vi. any person who carries on a business or profession,—

(A) where the assessee being an individual, or any relative of such assessee, has a substantial

interest in the business or profession of that person; or

(B) where the assessee being a company, firm, association of persons or Hindu undivided family,

or any director of such company, partner of such firm or member of the association or family,

or any relative of such director, partner or member, has a substantial interest in the business

or profession of that person###..”

The above provision with respect to corporate assessee has been illustrated by way of an example as

follows:

Additionally, all the directors of the assessee company and their relatives would also be covered. Further,

any individual having substantial interest in the assessee company is also covered under the above

provisions.

Note: Substantial Interest means beneficial ownership of shares with at least 20% voting right or beneficial

entitlement of at least 20% of the profits.

of 29

2.6 Steps to determine ALP and Benchmarking Approach

As discussed above, both Companies Act and SDT provisions require the transaction to be at arm’s length.

An arm’s length price in commercial parlance is the price at which independent enterprises deal with each

other, where the conditions of their commercial and financial relations ordinarily are determined by market

forces (uncontrolled transactions).

However, since the Companies Act does not lay down the methodology to arrive at an arm’s length price,

and, since the methodology is laid down under the ITA, we have discussed such methodology in subsequent

paragraphs.

As per section 92C of ITA, an ALP is a price which is applied or proposed to be applied in a transaction

between persons other than associated enterprises, in uncontrolled conditions. The application of ALP is

generally based on a comparison of the price, margin or profits from particular controlled transaction with the

price, margin or profit from comparable transactions between independent enterprises. Steps involved are

as under:

Business

understanding

Functions, asset and risk analysis

Analysis

Economic Analysis

Accountant’s

Certificate

Documentation

Selection of the

most appropriate transfer pricing

method

Benchmarking

of 29

2.6.1 Functions, Asset and Risk Analysis (FAR Analysis)

FAR analysis an important part in the transfer pricing analysis, as for dealings between two independent

enterprises; the compensation usually will reflect the functions performed, risks assumed and assets owned

by each enterprise for the transaction under consideration. The risks assumed by each entity plays a

significant role in FAR analysis since, assumption or allocation of risks would influence the conditions of

transactions between the associated enterprises. The OECD1 Guidelines provide that in the open market,

the assumption of increased risks will also be compensated by an increase in the expected returns2. Further,

Guidance Note3 states that what is important to consider is not the number of functions performed / assets

owned / risk assumed by a party but the criticality of each of them.

FAR analysis highlights the role of each entity in the transaction undertaken. For determining the arm’s

length prices for the international transaction / Specified domestic transaction, it is necessary to identify the

entity that has to be the point of reference or the “tested entity”. Generally, it is preferable, in a review of a

company’s operations, for that company to be the tested entity, which is simpler and less complex as

regards the type of functions performed, risks assumed, and ownership and control exercised over the

properties in the group.

2.6.2 Economic analysis

The purpose of carrying out the economic analysis is an important step in a transfer pricing study because it

defines the type / nature of entity and provides information on the type of comparables that will be required

to benchmark the related third party transaction.

1 "Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations" published by the Organisation for

Economic Co-operation and Development 2

OECD Guidelines, Chapter I, para 1.45 3 Guidance Note on Report on International transactions under section 92E of ITA issued by Institute of Chartered

Accountants of India

of 29

The economic theories suggest that higher the risk assumed, higher the reward and vice versa. It is

therefore important to distinguish between the returns realized by a "contract service providing entity" and an

"entrepreneurial service providing entity". A " low risk / captive / contract service providing entity" can be

defined as an entity that performs services for its clients on a fee basis, based on the precise requirements

of the clients and with the client funding the entire activity and owning the rights to the services. An

"entrepreneurial service providing entity" can be defined as an entity that funds services (which may be

performed by either its own employees or another entity under a contract service providing arrangement),

and which owns the results of the operations- i.e. the related technical know-how. Such an entity realizes a

profit or loss from the service providing activities, based on its ability to sell its services to others and to tap

unexplored markets.

Accordingly, based on the above and functional analysis carried out, it would be necessary to evaluate

which the risks undertaken by both the entities to transactions. The same would be helpful in deciding the

rewards that a particular entity should earn.

2.6.3 Selection of the most appropriate Transfer Pricing Method

Having conducted the FAR analysis, benchmark price could be arrived at considering the criticality of

functions performed, assets utilized, risks undertaken and taking into account the economic characterization

of an entity. The next step is to select the “most appropriate method” out of the six specified methods

prescribed under the Indian Regulations, to test the arm’s length nature of the intra-group transactions. This

evaluation is based on the facts and circumstances surrounding the examined transactions, functional

analysis, the economic characterization and the availability of external as well as internal data. Necessary

“Profit level indicators”, based on standard international transfer pricing practices for the purpose of analysis

and based on facts of the case needs to be selected too.

Following methods as laid down by the transfer pricing regulations could be used to benchmark the

transaction with related entities:

Method Explanation Illustrative list of transaction

where a particular method

could be applied

Comparable uncontrolled

price method

Arm’s length price is determined by

comparing the price charged for goods

or services transferred in a controlled

transaction with the price charged for

� Loans

� Royalty

� Service fees

� Transfer of tangibles

of 29

goods or services transferred in a

comparable uncontrolled transaction4 in

comparable circumstances.

Resale price method Arm’s Length Price is determined by

comparing resale price margin (i.e. the

gross margin) that the reseller earns

from the controlled transaction with the

gross margin from comparable

uncontrolled transactions.

� Distributor of products

Cost plus method Arm’s Length Price is determined by

comparing the mark-up on costs (gross

margin) that the manufacturer or service

provider earns from the controlled

transaction with the mark-up on costs

from comparable uncontrolled

transactions.

� Sale of raw material or

semi-finished products

� Joint facility or long term

buy and supply contracts

� Provision of services

Profit split method Arm’s Length Price is determined by

evaluating the allocation of the

combined profit or loss attributable to

one or more controlled transactions with

reference to the relative value of each

controlled taxpayer’s contribution to that

combined profit or loss.

Integrated services with

involvement of more than one

enterprise

Transactional net margin

method

Arm’s Length Price is determined by

comparing the net profit on costs or sale

that the manufacturer or service

provider earns from the controlled

transaction with net profit on costs or

sale from comparable uncontrolled

transactions.

Widely used in cases of

� Transfer of semi-finished

goods

� Distribution of products

� Provision of services

Method of last resort

Any other method as may be

prescribed by the board

Arm’s length price is determined by

comparing the prices charged or paid in

a controlled transaction with the price

charged or paid in a comparable

uncontrolled transaction in comparable

circumstances, considering all the

relevant facts.

Used in cases where following

are available:

� Third party Quotations

� Valuation reports

� Standard rate cards;

� Commercial & economic

business models

4 An uncontrolled transaction would means a transaction between two enterprises, one or both of whom are not a

related party

of 29

The regulations do not prescribe any order / preference for using these methods. Any of the above method

could be used which is best suited to the facts and circumstances of each of the international transaction /

specified domestic transaction, that provides the most reliable measure of an arm’s length price.

2.6.4 Statutory compliances with respect to reporting & documentation

• Filing of accountant’s report i.e. Form 3CEB for above mentioned transactions in the prescribed format

• Maintaining detailed contemporaneous documentation, supporting the intra-group pricing to meet with

arm’s length price, in respect of such transactions. Refer Exhibit 3 for the detail provision.

Consequences for non-compliance of the above

Stringent penal provisions have been prescribed for non-compliance with the requirements under the new

transfer-pricing regime. The same are briefly noted below:

Nature of default Quantum of penalty

Addition to Income on account of concealment

or furnishing of inaccurate details

100% to 300% of tax on addition to Income

Failure to furnish Accountants’ Certificate INR 100,000/-

• Failure to maintain documentation; Or

• Failure to furnish documentation i.e Form

3CEB to tax authorities, when called for; Or

• Failure to disclose a transaction in the

accountant’s report.

2% of value of the international / domestic

transaction entered into between related parties

of 29

3. Overview of relevant provisions under Corporate Law

3.1 Introduction

The newly introduced Companies Act, 2013 seeks to replace a 5 decade old Companies Act, 1956. The

Companies Act, 2013, has brought about few significant amendments ranging from company formation,

governance to corporate social responsibilities.

One of the changes includes the introduction of Section 188 of the new Companies Act, 2013 governing the

related party transaction which was earlier governed by Section 297 of the Companies Act, 1956. The same

is effective from April 1, 2014 and applicable to all private and public company.

The relevant provision under the Companies Act pertaining to related party transactions warrants a prior

board approval under the circumstances when specified related party transactions are:

Either

Not in the ordinary course of business;

OR

Not at arm’s length price

Furthermore, a prior approval of shareholders is suggested in case the specified transactions meets

the prescribed threshold criteria. See para 3.4 below for the prescribed thresholds.

3.2 Related Party Transactions under the Companies Act, 2013

• Sale, purchase or supply of any goods or materials (directly or through agent);

• Selling or otherwise disposing of, buying, property of any kind (directly or through agent);

• Leasing of property of any kind;

• Availing or rendering of any services;

• Such related party’s appointment to any office or place of profit of the company, its subsidiary or

associate company

• Underwriting the subscription of any securities or derivatives thereof, of the company.

<<This space is intentionally left blank>>

of 29

3.3 Overview of the related parties as covered under the Companies Act, 2013

The term ‘Related party’ is defined under the Corporate Law to mean:

Section

2(76)

Clauses

Particulars

(i) Director or his relative

(ii) Key managerial personnel or his relative;

(iii) Firm, in which a director, manager or his relative is a partner;

(iv) Private company in which a director or manager is a member or director;

(v) Public company in which a director or manager is a director or holds along with his relatives,

more than two per cent of its paid-up share capital;

(vi) Any body corporate whose Board of Directors, managing director or manager is accustomed

to act in accordance with the advice, directions or instructions of a director or manager (not in

a professional capacity)

(vii) Any person on whose advice, directions or instructions a director or manager is accustomed

to act (not in a professional capacity)

(viii)(A) Holding, subsidiary or an associate company (*) of the Company

(B) Subsidiary of the Company’s holding company

(ix) Any such person as may be prescribed

(*) An Associate company in relation to another company means a company in which that other company

has a significant influence, but which is not a subsidiary company of the company having such influence and

includes a joint venture company.

Note: Significant influence means a control of >= 20% of the total share capital of a company.

<<This space is intentionally left blank>>

of 29

3.4 Compliance requirements under Companies Act

* Any contract or arrangement entered into, without the consent of Board or approval by a special resolution

in general meeting, shall be ratified by Board / shareholders at a meeting within 3 months from the date on

which such contract or arrangement was entered into.

Further, every such contract or arrangement entered needs to be referred to in the board’s report to

the shareholders along with the justification for entering into such contract or arrangement.

Prescribed limits (referred to above) for obtaining shareholder’s approval

Transactions Conditions

Sale, purchase or supply of any goods or materials (directly or

through agent)

Lower of - 10% of the turnover of the

company or INR 100 cr

Selling or otherwise disposing of, or buying, property of any

kind (directly or through agent)

Lower of 10% of net worth of the


Leasing of property of any kind Least of 10% of net worth of company or

10% of turnover or INR 100 cr

Availing or rendering of any services Least of 10% of the turnover of the


Such related party's appointment to any office or place of profit

in the company, its subsidiary company or associate

Remuneration exceeds INR 2,50,000 per

month

Underwriting the subscription of any securities or derivatives

thereof, of Company

Remuneration exceeds 1% of net

Worth

of 29

However, the proviso to the relevant provisions under the Companies Act, further states as under-

“Provided also that, nothing in this sub-section shall apply to any transactions entered into by the

company in its ordinary course of business other than transactions which are not on an arm’s length

basis”.

The above proviso implies that the requirements of prior approval of the board / shareholders, as the case

may be, are not necessary if the transactions meet the arm’s length standard.

At this stage it is important to note that, while the Companies Act defines arm’s length price, it does not lay

down the methodologies to compute / arrive at the arm’s length price, unlike the transfer pricing provisions.

As a consequence, related party transactions covered under the provisions of Companies Act will now call

for benchmarking and convergence with the India transfer pricing regulations under ITA to justify the arm’s

length nature of related party transactions.

3.5 Consequences for non-compliance of the above

• Transaction shall be voidable at the option of the Board, unless ratified

• Where transaction are with directors (or related party of such director), directors to indemnify for any

losses

• Company can make recovery of any loss from directors or any employee who entered into any

transaction in contravention to this provision

3.6 Penal Consequences

Any director or any other employee of a company, who had entered into or authorised the contract or

arrangement in violation, shall face following consequences-

• Fine from Rs. 25,000 to Rs. 5 lakh - public and private company

• Imprisonment upto one year or fine as above or both - listed company

of 29

4. Applicability of Transfer Pricing & Corporate Law on the proposed transactions

4.1 Applicability of transfer pricing provisions under the ITA

As outlined hereinabove, the Indian transfer pricing regulations are attracted / applicable under the scenario

when there are either international transactions or specified domestic transactions with associated

enterprises.

In the instant case, in as much as OMC’s would be holding more than 20% shares of the JVC / SPV, the

provisions of domestic transfer pricing (Specified domestic transactions) are clearly attracted to SPV. The

applicability of Transfer pricing provisions vis a vis proposed transactions can be summarised as under:

Transaction Understanding of the

transaction

Implication on SPV Implication on OMC’s

CUF provided by

the SPV to

OMC’s

CUF services would

be provided by the

SPV to all the OMC’s.

Not covered by provision of

SDT since it is in receipt of

service charges

OMC’s need to comply with

the provisions of SDT since it

is availing the services

Transfer of asset

from OMC’s to

CUF

SPV would purchase

asset from OMC’s

SPV needs to comply with the

provisions of SDT, since it

would be incurring the expense

OMC’s – not covered since it

is transferring the assets

4.2 Applicability of Companies Act provisions to proposed transaction between SPV & PMC’s

In order to determine the applicability of Companies Act provisions it would be necessary to evaluate –

a. Whether the OMC’s and SPV can be referred to as related parties under the Companies Act? AND

b. Whether the proposed transactions between OMC’s & SPV can be said to be covered within the list

of transactions covered under the said provisions?

a. Are SPV and OMC’s related as per the provisions of Companies Act?

In the instant case, we understand that OMC’s propose to hold equal shares (1/3rd

each) of the SPV.

Accordingly, SPV and OMC’s would be referred to as related parties, since each OMC’s would hold more

than 20% of share capital in SPV thereby exercising significant influence over SPV.

of 29

b. Are the transactions between SPV and OMC’s covered under the provisions of Companies Act?

Transaction Understanding of the

transaction

Implication on SPV Implication on OMC’s

CUF provided by

the SPV

CUF services would be

provided by the SPV to

all the OMC’s.

Both the transactions are

covered under the

specified transactions as

per Companies Act and

consequent compliances

are triggered accordingly.

Both the transactions are

covered under the

specified transactions as

per Companies Act and

consequent compliances

are triggered accordingly.

Transfer of asset

from OMC’s to

CUF

SPV would purchase

asset from OMC’s

4.3 A combined reading of relevant provisions under Corporate Law & Transfer Pricing Law

It is important to note that there are significant variations in the coverage of related parties and the

reportable related party transactions on comparing the domestic transfer pricing regulations vis-a-vis

Companies Act, 2013. Such variations are discussed in detail under Exhibit 4.

As discussed above, both, transfer pricing regulations as well as Companies Act seeks adherence to arm’s

length standard in respect of related party transactions as defined under each of the laws separately.

Though, the coverage & consequent compliance requirements under both the statue in respect of related

party transactions are significantly different.

4.4 Conclusion on the applicability of above referred provisions

Transaction Concerned entity Compliance to

Transfer pricing Laws

under ITA

Compliance to

Companies

Act

CUF provided by the SPV to OM

C’s

OMC Yes Yes

SPV No Yes

Transfer of asset from OMC’s to

CUF

OMC No Yes

SPV Yes Yes

of 29

5. Overview of Clause 49 (VII) of SEBI – Approval of related party transactions

5.1 Related Party Transactions under the Clause 49 (VII) of SEBI

Related party transaction covered are any transfer of resources, services or obligations between a company

and a related party, regardless of whether a price is charged. Also, a transaction with related party shall be

constructed to include a single transaction or a group of transactions in a contract.

5.2 Overview of the related parties as covered under Clause 49 (VII) of SEBI

An Entity shall be considered as related if:

i. such entity is a related party under Section 2(76) of the Companies Act, 2013 (refer 3.3 of this note); or

ii. such entity is a related party under the applicable accounting standards

The definition of related party (RP) has been amended vide circular5 dated 15

th September, 2014 to bring

the same at par with the Companies Act [Section 2(76)] and applicable Accounting Standards [ AS -18,

21,23,27, etc. ]

5.3 Compliance requirements under Clause 49 (VII) of SEBI

# Transaction will be considered as material if the transaction (s) to be entered into individually or taken

together with previous transactions during a financial year exceeds 10% of the annual consolidated

turnover6 of the company as per the last audited financial statements of the company

5 Circular CIR/CFD/POLICY CELL/7/2014 dated September 15, 2014

6 Circular CIR/CFD/POLICY CELL/7/2014 has revised the limit from erstwhile 5% to now 10%

of 29

Accordingly, in the instant case if payments towards CUF service charges to SPV by any of OMC’s is

less than 10% of turnover of that respective OMC then it would not require shareholders approval.

Similarly, if the sale / transfer of assets to SPV is less than 10% of turnover of that respective OMC

then it would not require shareholders approval.

However, these transactions would require Audit Committee approval.

5.4 Exemption from above provisions

Vide circular dated September 15th, 2014; such provisions shall not be applicable if:

i. transactions are entered into between two government companies* or

ii. transactions are entered into between holding and its wholly owned subsidiary company whose

accounts are consolidated with such holding company and placed before the shareholders at the

general meeting for approval

* Government company shall have same meaning as defined in s. 2(45) of Companies Act, 2013 which means any company in which not less than fifty one per cent of the paid-up share capital is held by the Central Government, or by any State Government or Governments, or partly by the Central Government and partly by one or more State Governments, and includes a company which is a subsidiary company of such a Government company;

In this case, while OMC’s (HPCL, IOCL & BPCL) are government companies; we understand that

SPV/JVC is not a government company since none of OMC’s holds more than 50% in SPV. Thus, the

above exemption would not be applicable.

5.5 Other details :

• Audit committee to grant omnibus approval for all related party transactions subject to prescribed

conditions, validity being one year. Omnibus approval shall specify name of the related party, nature

and period of transactions, price details etc.

• However, if related party transaction cannot be foreseen and aforesaid details are not available,

omnibus approval can be given subject to the transaction value not exceeding INR. 1 cr per transaction

• Disclosure Requirement –

o All related party transaction shall be disclosed quarterly along with the compliance report on

corporate governance

o Disclose the policy on dealing with related party transaction on its website and a web link thereto

shall be provided in the annual report

of 29

6. Pricing options for each of the covered transactions

6.1. Transaction I- CUF services rendered by the SPV

Various pricing options available in respect of proposed transaction 1 between OMC’s and SPV are

evaluated hereunder. Under each of the options, we have also provided the general factors concerning the

respective pricing model and the points for consideration in case the said pricing model is selected for

implementation.

6.1.1 Model I - Cost plus model:

a. Description of the Model:

Cost plus model is a simplistic model to arrive at service price in case of provision of service. Under the cost

plus model, all the costs incurred by the service provider would get recovered along with a profit mark-up

that would act as a reward to the service provider for the efforts put in. Typically, the costs associated with

value added activities are charged to service recipients (based on usage etc) with some profit element

(arm’s length mark-up), while all other non-beneficial costs are determined to be either pass-through

expenses. These costs are then allocated to service recipients using an appropriate allocation method

(based on usage etc).

An arm’s length mark-up could be arrived at considering the margins earned by independent entities

operating in India which are functionally similar to the SPV. In this connection, a detailed search would have

to be conducted on the Indian databases to identify potentially comparable companies.

b. Cost Plus Model in combination with - Use or pay with minimum guaranteed volume

A use or pay with minimum guaranteed volume generally works as under:

• Use & pay the price for a minimum guaranteed volume each year or

• Pay the applicable price for such minimum guaranteed volume if it is not used during the year.

After considering the investments to be made by SPV to create infrastructure facility to render CUF facility

and other running / variable costs to be incurred, a minimum guarantee volume needs to be decided at a

point where at least the cost along with an arm’s length profit (mentioned herein under) would be recovered.

Services for over and above minimum guaranteed volume would result into profits for SPV.

c. General factors to be considered for Cost Plus Mark-up Model

of 29

The following paragraphs enumerate the factors that are to be considered while adopting cost plus model:

• Income of the service provider would always be linked to its costs;

• In respect of the CUF services, SPV would neither incur losses nor will it earn super profits

• The working capital requirements of the SPV could be adequately met.

There is no incentive to reduce cost or bring in efficiencies, and consequently, this model may result into

inefficiencies. However, these inefficiencies can be controlled by way of proper oversight as well as strict

reporting requirements.

− Usage of budget costing

− Degree of variation from the budgeted cost

d. Points for consideration

Following points needs to be considered while adopting cost plus method

• Usage of budgeted cost v/s Standard cost

• Treatment for the shortfall cost between budget / standard cost vis-à-vis actual cost

• Determination of value added activities

• Building documentation differentiating value added activities vis-à-vis non-beneficial costs

• Documentation / supporting evidences of pass through expenses

• Appropriate keys for allocation of costs between entities availing CUF

• Authorisation of costs from the related entities / service recipient

• Determination of minimum guaranteed volume

• Finding appropriate functionally similar companies and analysing the said companies vis-a-vis

transaction between OMC’s and SPV (controlled transaction / entity)

• Determination of most appropriate Profit Level Indicators (PLI) best suited in the instant case

• Adjusting the transaction price / margins of functionally similar companies (uncontrolled entities /

transaction) for the various adjustment factors.

6.1.2 Model II - Hybrid model

In view of above, an alternate approach of adopting the hybrid pricing option can be considered. This model

explains what earnings were generated from invested capital (assets). This model is a hybrid of two pricing

models:

• Return on Asset Model to be adopted for the costs / investments by SPV in deploying operating assets;

and

• Cost Plus Model to be adopted for the costs associated with value added activities.

of 29

• Other non-beneficial costs - pass-through expenses

These costs are then allocated to service recipients using an appropriate allocation method (based on usage

etc).

This model can be used when assets are a better indicator of the value added by the SPV.

Under this model return on asset is determined by using net profit to operating assets. Operating assets

include tangible operating fixed assets, operating intangible assets used in the business, working capital

assets are considered.

In the instant case return on net book value / market value of assets needs to be determined by evaluating

the return (arm’s length mark-up) that independent entities operating in India earn which are functionally

similar to the SPV. The percentile so arrived would then be applied on the fixed costs incurred by the SPV.

With respect to variable cost, cost plus mark up approach could be adopted as discussed in the preceding

pricing option.

Hybrid Model in combination with - Use or pay with minimum guaranteed volume

As mentioned earlier, even under this model, in order to arrive at the minimum guarantee volume that

enables recovery of cost with an arm’s length profit, hybrid model could be used.

General factors to be considered for return on asset Model (for cost plus the factors as discussed earlier

would be applicable here too)

− In cases where the net profit is weighted to book value of assets, it could possibly distort the

comparison, e.g. between those enterprises that have depreciated their assets and those that have

more recent assets with on-going depreciation, and between enterprises that use acquired intangibles

and others that use self-developed intangibles.

− In cases where the net profit is weighted to market value of assets, reliability issues where valuation of

assets is uncertain

Points for consideration

Apart from the ones mentioned under cost plus pricing option following are the additional points:

• Ensuring consistency of accounting standards between the controlled transaction and the comparable.

• Difference in assets deployed and their disclosures in the financial statements

• Analytical work to determine assets with respect to transaction at hand especially in cases of

uncontrolled entities balance sheets

of 29

• Treatment of newly acquired assets & their depreciation between controlled and uncontrolled entities

• Differences in methods of depreciation – SLM v/s WDV

• Parameters for determining life of the asset

• Methods to be used in case of valuation of assets in order to arrive at market value of the asset

• Choice between book value, adjusted book value, market value and other possibly available options

• Working capital employed or capacity utilization between controlled and uncontrolled entities.

Please note under both the above discussed models, it would be pertinent to maintain related entity

wise cost records to ensure that the charge to each entity is appropriate.

6.1.3 Model III - Comparable prices

Under this pricing option, there are following two possibilities:

Internal comparables - Prices charged for uncontrolled transaction other than OMC’s could be used as a

pricing option. Similarly, if OMC’s are availing similar services from any third party, it can also be considered

as internal benchmark. Internal comparables are considered a very good comparable as the functions

performed, risks undertaken and assets employed are all easily comparable – more so, on “an apple to

apple basis”.

External comparables – Prices charged by independent parties rendering similar services. An independent

enterprise buys or sells a particular product, in similar quantities and under similar terms from / to another

independent enterprise in a similar market. Such prices could be obtained by procuring quotations, from

government sources, Trade and professional organizations etc.

Accordingly, in the instant case, if SPV could procure the above mentioned prices, they could be used to

price services to related parties.

General factors to be considered for comparable prices model

• Under comparables prices model, strict product / service comparability is required

• Internal comparables may have a more direct and closer relationship to the transaction under review

than external ones due to one party to the transaction being the same and the use of identical

accounting standards;

• Internal comparables may be the best evidences considering differences in transaction volumes,

contractual terms, geographical markets and business strategy, which are material and cannot be

eliminated through reliable comparability adjustments.

• External comparables are difficult to obtain and, also, it may be incomplete and difficult to interpret.

• For transactions between related entities which are in the nature of services rendered, the difficulty

that may arise is the absence of the open market price (whilst using external comparables) for those

of 29

or similar services. CUP Method requires a high degree of comparability in the services provided in

the controlled and uncontrolled transactions. This standard of comparability is ordinarily extremely

difficult to meet.

Points for consideration

• Availability of reliable comparable prices

• Difference in transaction prices / terms for which reasonable accurate adjustments are required:

- Geographic location & the size of the markets;

- Type and quality of product / service (as discussed under cost plus model)

- Volumes between a controlled and an uncontrolled transactions

- Contractual terms (as discussed under cost plus model) – credit terms, delivery terms etc

- the nature and extent of government regulation of the market;

- Date and time of transactions;

• Treatment for differences in unique and valuable trademarks between controlled and uncontrolled

transactions

6.1.4 Various differentiating factors:

As discussed under each of the above mentioned pricing models it is important to make appropriate

adjustment towards various differentiating factors between the two transactions.

i. Characteristics of the property or services provided in international transaction

As per the OECD guidelines7, differences in the specific characteristics of property or services often

account, for differences in their value in the open market. Therefore, comparisons of these features

may be useful in determining the comparability of controlled and uncontrolled transactions.

• In the case of transfers of tangible property - the physical features of the property, its quality

and reliability, and the availability and volume of supply;

• In the case of the provision of services- the nature and extent of the services;

• In the case of intangible property, the form of transaction (e.g. licensing or sale) - the type of

property (e.g. patent, trademark, or knowhow), the duration and degree of protection, and the

anticipated benefits from the use of the property.

Depending on the transfer pricing method, this factor must be given more or less weight.

ii. Functional Analysis (Functions performed, Risks assumed and Assets owned – FAR)

7 Refer para 1.39 of the OECD guidelines

of 29

FAR analysis, as explained in the previous chapter of this Memo (Chpater 2) is a corner stone of

any transfer pricing analysis, as for dealings between two independent enterprises; the

compensation usually will reflect the functions performed, risks assumed and assets owned by each

enterprise for the transaction under consideration. Therefore, in determining whether the

uncontrolled transactions / companies selected in the instant case for benchmarking are comparable

to the activities of SPV, a functional analysis is necessary.

Further, the type of assets employed by the comparable companies and the level of risks assumed vis a vis the SPV / OMC’s would also be a very vital criteria to be evaluated.

Adjustments should be made for any material differences from the functions undertaken by identified

comparable vis a vis the SPV / OMC’s.

iii. Contractual terms

In arm’s length transactions, the contractual terms of a transaction generally define explicitly or

implicitly how the responsibilities, risks and benefits are to be divided between the parties.

Accordingly, an inter-company agreement between OMC’s & SPV should define the roles and

responsibilities of each entity in case of a contract entered into with an uncontrolled / controlled

entity. The contractual terms of the controlled transaction / entity needs comparison and accurate

adjustments for differences in contractual terms.

iv. Economics circumstances of each market

Comparison of economic circumstances between a controlled and an uncontrolled transaction /

entity is of relevance since an arm’s length prices may vary across different markets even for

transactions involving the same property or services. Therefore, in order to achieve comparability, it

is required that the markets in which the uncontrolled and associated enterprises / related parties

operate do not have differences that have a material effect on price or that appropriate adjustments

can be made.

Economic circumstances that may be relevant to determining market comparability include the

following:

• geographic location & the size of the markets;

• the extent of competition in the markets and the relative competitive positions of the buyers and

sellers;

• the availability (risk thereof) of substitute goods and services;

• the levels of supply and demand in the market as a whole and in particular regions, if relevant;

of 29

• consumer purchasing power;

• the nature and extent of government regulation of the market;

• costs of service,

• the date and time of transactions; and so forth.

The facts and circumstances of the particular case will determine whether differences in economic

circumstances have a material effect on price and whether reasonably accurate adjustments can be made to

eliminate the effects of such differences,

6.1.5 Justification of CUF charges to be incurred by OMC’s to JVC

Under each of the proposed pricing models referred above in 5.1.1 to 5.1.3, it would be necessary to

understand how & what justifications each of the OMC’s would have to build / document in order to qualify

the test of arm’s length nature under transfer pricing regulations.

In the recently concluded transfer pricing assessments of cross border transactions, it has been increasingly

observed that, there are huge Transfer pricing adjustments on account of group service charge. Meaning,

when one group company is providing certain support services (managerial in nature) to rest of the group

companies in the Multi-national group, the tax authorities have repeatedly disputed the benefits received by

the service recipient entities. In many case, the tax authorities have taken a very aggressive stand stating

that no benefits accrued to the service recipient, thus the arm’s length value of service is Nil. Consequently,

disallowing the entire expenditure incurred by service recipient.

Having regard to the above, it would be utmost important for each of the OMC’s to pass the benefit test in

order to justify the arm’s length nature of the proposed transaction. As regards the benefit test, it will be

pertinent to justify that the services so rendered by the SPV provides each of the OMC’s with economic or

commercial value to enhance its commercial position. The same can be justified by determining if the

independent enterprise in a comparable situation would be willing to pay for such services if the said

services were rendered by an independent entity (i.e. any third party) or was performed in house by that

enterprise. For the same it would be advisable for the OMC’s to maintain satisfactory documentary evidence

with respect to benefits received by Indian company.

6.2. Transaction II- Transfer of existing asset to the SPV

Following are the approaches that could be adopted to arrive at the consideration:

a. Model I - Market Value approach:

The asset can possibly be transferred by the OMC’s to the SPV at market value as on the date of

transaction. The transfer price could also be the price at which the SPV can purchase the said asset from a

third party (if available). Accordingly, such value could possibly be the value at which such assets could be

of 29

transferred.

b. Model II - Cost Approach

The asset can possibly be transferred at cost. The number of years for which the asset would be used for

could be estimated and the cost of the existing asset that was paid initially by the OMC’s to acquire them

could be allocated to the SPV. The said value so arrived at could be used as the transfer value.

In the above case, it will be utmost important to maintain back-up documents / workings relied upon to arrive

at the useful life of the asset. For the same it is advisable to obtain a certificate from an independent valuer.

c. Model III - Written Down Value approach

The existing asset held by the OMC’s could be transferred at Written Down Value (WDV). The WDV of the

assets in the books of account can be considered i.e. post deducting the depreciation from the initial cost of

the asset. Thereafter, the asset can be transferred to the SPV at WDV.

of 29

7. Conclusion and way forward

As discussed above, both the proposed transactions viz. Rendering CUF services by SPV to OMC’s and

Transfer of asset to SPV by OMC’s need to meet with the arm’s length standard as per the requirement

under ITA and Companies Act. The summary of the applicability and available pricing option for each of the

said transaction is as under:

Transaction Concerned

entity

Compliance to

domestic

transfer pricing

norms

Compliance

to Companies

Act

Pricing options

CUF provided by

the SPV

OMC

Yes

Yes

I. Cost plus Model

II. Hybrid Model

III. Comparable Prices

SPV

No

Yes

Transfer of asset

from OMC’s to

CUF

OMC

No

Yes

I. Market value approach

II. Cost approach

III. WDV approach

SPV

Yes

Yes

Accordingly, in order to ensure that the transactions are arm’s length compliant under both the Laws, it is

pertinent to do a detailed analysis and arrive at the best pricing option.

Please note, the pricing models suggested by us are basis the preliminary business understanding. A

detailed study would be required to ascertain the best pricing option which could be justifiable before tax /

company law authorities.

advice on transfer pricing companies act & sebi

Documents