in international transfer pricing ca t. p. o stwal w estern i ndia r egional c ouncil s ub r egional...

in International Transfer Pricing

CA T. P. OSTWAL

WESTERN INDIA REGIONAL COUNCILSUB REGIONAL CONFERENCE, BARODA

JUNE-2013

M/s. T. P. Ostwal & Associates

INTERNATIONAL OVERVIEW GLOBAL TRANSFER PRICING REGIMES

TRANSFER PRICING – A GLOBAL OUTLOOK [UN & OECD]

FUTURE OF TRANSFER PRICING IN DEVELOPING COUNTRIES

TRANSFER PRICING – RECENT TRENDS IN INDIA A BIRD’S EYE VIEW

EXISTING BACKDROP

CONCERN ON DISPUTE RESOLUTION PROCESS

INDIAN TRANSFER PRICING – EMERGING AREAS OF CONTROVERSIES FUNDAMENTAL ISSUES

SPECIFIC ISSUES

A SNAP SHOT


By the end of 2011 there were around 100 countries with some form of specific transfer pricing legislation as shown by the red shading in the diagram below

GLOBAL TRANSFER PRICING REGIMES


GLOBAL TRANSFER PRICING REGIMES (contd…)

Countries where Transfer Pricing Regulations are in existenceArgentina Australia Austria Belgium BrazilCanada Chile China Colombia CroatiaCzech Republic Denmark Dominican Republic Ecuador EgyptEstonia Finland France Germany Hong Kong Hungary India Indonesia Ireland IsraelItaly Japan Kenya Korea, North Korea, SouthLatvia Lithuania Luxembourg Malaysia MexicoNamibia Netherlands New Zealand Norway OmanPanama Peru Philippines Poland PortugalRomania Russia Singapore Slovakia SloveniaSouth Africa Spain Sweden Switzerland TaiwanThailand Turkey United Kingdom United States UruguayVenezuela Vietnam

Countries where Transfer Pricing Regulations is still emergingAlgeria Angola Armenia Aruba BangladeshBelarus Bolivia Botswana Bulgaria Burkina FasoCambodia Cote d'Ivoire Cyprus El Salvador EthiopiaGambia Georgia Ghana Greenland IcelandKazakhstan Kuwait Liberia Libya MacedoniaMalawi Mali Mauritania Mauritius MongoliaMorocco Mozambique Netherlands Antilles Nicargua Nigeria

Pakistan Papua New Guniea Qatar Senegal Sierra Leone

Sri lanka Trinidad and Tobago Ukraine Uzbekistan Zambia

Zimbabwe


INTERNATIONAL TRANSFER PRICING

A GLOBAL OUTLOOK-UN -OECD


Legal contracts asserting IP is held offshore will be disregarded If it is found that the developing country subsidiary has engaged in activities

that put it in control and create intangibles

Routine cost-plus returns will no longer be acceptable for those contract R&D companies that are found to exert control or to enjoy

a high-tech status

Limited risk distributors spending an excessive amount on AMP will be expected to enjoy a share of the excess profits related to the local

intangibles they are creating

Location rents should be booked in the developing country under certain circumstances

rather than being booked in either the tax favoured jurisdiction or the home country

Companies engaged in toll manufacturing will need to add back the cost of the consigned materials into their cost base

UNITED NATION’S TRANSFER PRICING MANUAL COUNTRY PRACTICES – CHINA AND INDIA’S VIEWS


Comparables should be viewed with caution given the paucity of information in developing countries.

MNEs that operate multiple entities, each with a single function, may not be able to claim that each entity is entitled to only a routine return

A holistic approach would be more appropriate.

Where a significant percentage of the global employees or assets are actually in developing country

A formulary approach may be the best method

UNITED NATION’S TRANSFER PRICING MANUAL COUNTRY PRACTICES – CHINA AND INDIA’S VIEWS


Proposed Action Plan/ Recent Updates

Improvements or clarifications to the transfer pricing rules

• Rules relating to intra-group financing (e.g. interest deductibility, withholding taxes, etc)

• Release of Draft Handbook on Transfer Pricing Risk Assessment by OECD's Global Forum on Transfer Pricing

• Release of discussion draft on the Transfer Pricing Aspects of Intangibles

Updated solutions to the ‘jurisdiction to tax’ issues

More effective anti-avoidance measures

RECENT DEVELOPMENTS - OECD


Safe Harbour Rules - OECD approves the revision of Section on safe harbours in the Transfer Pricing Guidelines

On 16 May 2013, the OECD Council approved the revision of Section E on safe harbours in Chapter IV of the Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (“TPG”).

Revised guidance advises countries to weigh benefit & concerns regarding safe harbour.

New guidance on safe harbours provides opportunities for countries to relieve some compliance burdens and to provide greater certainty for cases involving smaller taxpayers or less complex transactions. With that, it provides a basis for countries, especially developing countries, to design a transfer pricing compliance environment that makes optimal use of the limited resources available.

It further recommends use of bilaterally or multilaterally negotiated safe harbours for avoiding double taxation and double non taxation. It also provides a Sample MOU for bilateral safe harbours.

RECENT DEVELOPMENTS - OECD


The economic significance of the OECD is in rapid decline. In 2000, OECD nations controlled 60% of gross world product. Now it is at 50% and is expected to drop to about 40% in 2030.

Power and influence will need to be shared between developed and developing countries

With new players such as Brazil, Russia, India, China, and South Africa (BRICS), and the UN entering the fray,

India and China see themselves as "exceptional countries" and will want a say in writing the rules, whether it is greenhouse gases, transfer pricing, or intellectual property, and that is the way it will be.

Confidence levels among Indian and Chinese tax authorities are growing It is clear that these developing countries will not allow themselves to be pushed

around much longer.

Over 70% of the global transfer pricing litigation worldwide is in India a sign of that country's independent thinking.



The big question is whether India and China will pass new regulations to incorporate the positions expressed in the UN manual.

If so, the nature of global transfer pricing will shift. Location rents and local intangibles will become part of the analysis.

Finally, every global tax director of an MNE will need to figure out a new strategy

Because the principal structure used to provide developing countries a routine profit will get terminated



TRANSFER PRICING

RECENT TRENDS IN INDIA


Sr. No.

Year of Transfer Pricing

Assessments

Volume of Adjustments

Types of Issues

1. 1st & 2nd Year Low Rejection of comparables and insertion of new comparables

2. 3rd & 4th Year Moderate Rejection of selected method of benchmarking and application of new method

3. 5th & 6th Year High Bringing unconventional transactions within the ambit of Transfer Pricing

4. 7th & 9th Year High Application of retrospective amendment for bringing transactions under transfer pricing regime and treatment of transactions as deemed international transaction

5. Going Forward Expected to be high Introduction of transfer pricing on domestic transactionsReopening of closed assessments to bring transactions covered under the scope of transfer pricing due to retrospective amendments

Litigation Status: More than 650 decisions have been given by the tribunals over the last decade on transfer pricing issues, setting precedents for taxpayers/revenue on wide range of issues.

INDIAN TRANSFER PRICING A BIRD’S EYE VIEW


INDIAN TRANSFER PRICING A BIRD’S EYE VIEW (contd…)

6,4911,612

6,13810,907

23.238

44,536

70,000


Transfer Pricing is the focus area for the Revenue Authorities

‒ Legislative changes to plug potential loopholes

‒ Increasingly aggressive positions adopted by the revenue

‒ Augmented staffing and training of officers

Widened Scope & intrusive Approach of Transfer Pricing Assessments

‒ Request for higher level of documentation

‒ Legal back-up with greater investigation powers for revenue officials

Newer areas of challenge

‒ Cross-border Financing arrangements, Intangibles, Intra-group Services, Investments in group entities and Share Valuation

Growing cross-country collaboration

‒ Several exchange of information treaties effected

‒ Extensive interaction with OECD officials

INDIAN TRANSFER PRICING – EXISTING BACKDROP


INDIAN TRANSFER PRICING – EXISTING BACKDROP


Conventional Approach of Dispute Resolution - Tiers of Appellate Authorities [DRP/CIT(A)ITATHCSC] Time consuming and several tiers of appellate authorities Appeal by tax authorities in case of favorable resolution at lower levels Factual nature of issues results in matter being remanded back

Uncertainty on eventual outcome and impact on financial statements

Risk of economic double taxation, if matter is resolved against the taxpayer

Measures to Handle Dispute Resolution – Discouraging experiences with DRP Independence - Structural issues in constitution of Panel Achievement- A “fast track” to next level of litigation? Policy Moderation - Empowering tax authorities to appeal against order pursuant to

DRP directions – Will there be any change in approach of DRP?

Modern Approach – International Mutual Agreement Procedure (‘MAP’) - Emerged a viable alternative in recent times Advance Pricing Arrangements – Will it result into an approach to bring certainty?

INDIAN TRANSFER PRICING CONCERNS ON DISPUTE RESOLUTION PROCESS


Changes in Form 3CEB (Transfer Pricing Audit Report)

INDIAN TRANSFER PRICING REVISED REPORTING REQUIREMENTS [RULE 10E]

Sr. No.

Reference in Annexure to Form 3CEB

Reporting of Transaction(s)

1. Clause 14 to Part B Particulars in respect of lending or borrowing of money

2. Clause 15 to Part B Particulars in respect of transactions in the nature of guarantee

3. Clause 16 to Part B Particulars in respect of international transaction of purchase or sale of marketable securities, issue and buy-back of equity shares, optionally convertible/partially convertible/compulsorily convertible debentures/preference shares

4. Clause 17 to Part B Particulars in respect of mutual agreement or arrangement

5. Clause 18 to Part B Particulars in respect of international transactions arising out/being part of business restructuring or re-organisations

6. Clause 19 to Part B Particulars in respect of any other transaction including the transaction having a bearing on the profits, income, losses or assets of the assessee

7. Clause 20 to Part B Particulars of Deemed International Transactions

8. Part C Particulars in respect of Specified Domestic Transaction


INDIAN TRANSFER PRICING

EMERGING AREAS OF CONTROVERSIES


Fundamental issues Deemed International transactions – A Reasonable Approach?

Tested Party – The right questions?

Location savings

Transfer Pricing Adjustment – Whether restricted to the overall group profits or total revenue from the transaction ?

Specific Issues

Intra-Group Financing Transactions – Guarantee/Loans etc.

Marketing intangibles (AMP) – Focus on fundamentals?

Contract Research & Development –Step towards Profit splits Approach!

SIGNIFICANT ISSUES ON TRANSFER PRICING PRINCIPLES



FUNDAMENTAL ISSUES



DEEMED INTERNATIONAL TRANSACTIONS


Deemed International TransactionsSection 92B(2) of the Act states that a transaction entered into with a person other than AE shall is deemed to be a transaction between two AEs, if there exists a prior agreement in relation to the relevant transaction between such other person and the AE or the terms of relevant transaction are determined in substance between such other person and the AE.

DEEMED INTERNATIONAL TRANSACTION REASONABLE APPROACH?

A transaction entered into by an enterprise with a person other than

an associated enterprise shall be deemed to be an international

transaction if:

There exists a prior agreement in relation to the relevant transaction between

such other person and the associated enterprise

The terms of the relevant transaction are determined in substance between such

other person and the associated enterprise

OR


Kodak India Private Limited [ITA No. 7349/Mum/2012]

• The Tribunal discussed the provisions of section 92(1), section 92A(1) and section 92B(1), and the inter-linkage between them, to establish that they all relate to an international transaction between AEs, where both the AEs are non-residents or at least one of them is.

• Further, the Tribunal also concluded that section 92B(2) cannot be read independent of section 92B(1), and thus section 92B(2) cannot apply to transactions between domestic entities.

• A similar judicial precedent was laid down in the Tribunal ruling in the case of Swarnandhra IJMII Integrated Township Development Co. Pvt. Ltd. v. DCIT [ITA No. 2072/Hyd/2011]

Stratex Networks (India) Private Limited [353/2011 Delhi High Court]

• Indian Co. had agreements with local clients to install and maintain equipment supplied by its overseas associated enterprises.

• The High Court upheld the Tribunal’s ruling that the installation and maintenance services were not deemed international transactions u/s 92B(2) because none of the conditions stipulated u/s 92B(2) existed.




Indian Holding Co.

Indian Holding Co.

Foreign Wholly Owned

Subsidiary

Foreign Wholly Owned

Subsidiary

Outside India

Subscription of shares of Foreign Co.

TYPICAL FACTS – OUTBOUND INVESTMENT

Indian parent company infuses share capital in the Foreign subsidiary (at premium or at face value per share in case of negative networth of subsidiary)

The Revenue takes a position that the shares have been issued to the Indian Company at an overvalued price/more than the fair market value of the shares;

The difference between the actual issue price and the ALP computed by the department is characterized as:

• Deemed Loan by the Indian Parent - treated as TP adjustment

• Notional Interest on deemed loan- treated as TP adjustment In the recent decision of Vijai Electricals Ltd vs. Addl. CIT [ITA

No.842/Hyd/2012], tribunal held that investment made in subsidiaries abroad is not an international transaction u/s. 92B and TP provisions shall not apply as there is no income.



Foreign Holding Co.

Foreign Holding Co.

Indian Wholly Owned

Subsidiary

Indian Wholly Owned

Subsidiary

In India

Purchase / Subscription of

shares of Indian Co.

TYPICAL FACTS – INBOUND INVESTMENT Foreign parent company infuses share

capital in the Indian subsidiary (at face value or at certain value per share arrived using DCF or other valuation methodology)

The Revenue takes a position that the shares have been issued to the Holding Company at an undervalued price / less that the fair market value of the shares;

The difference between the actual issue price and the ALP computed by the department is characterized as:

• notional income of the Indian Subsidiary - treated as TP adjustment

• loan by the Indian Subsidiary to its Holding Company - notional interest on such alleged loan treated as the TP adjustment

The TP Officer made TP adjustment to the tune of Rs 15,200 Cr on the international transaction of receipt of Rs 870 Cr towards issue of fresh equity shares by Shell India stating that there was under-pricing in the issue of shares.

Outside India



SELECTION OF ‘TESTED PARTY’


Critical elements of a TP analysis, • Functions, Assets and Risk analysis (FAR analysis) and • Economic analysis,

The selection of tested party is the first step in any economic analysis and must find it’s “connect” back with the FAR analysis. The “connect” is the characterization of the transacting entities, which a FAR analysis must necessarily conclude with.

The characterization of the transacting entities is the critical determinant in deciding which entity would be the tested party.

While the concept of “tested party” does not find any mention in Indian regulations, the concept has been laid down in

• The US Regulations, • OECD Guidelines • UN TP Manual

RECENT CONTROVERSIES - TESTED PARTY


RECENT CONTROVERSIES – ‘TESTED PARTY’

SR. NO.

NAME OF DECISION (CITATION)

DISPUTED ISSUE FINDINGS OF THE APPELLATE AUTHORITIES

1 Onward Technologies Limited (7985/Mum/2010)

Selection of tested party – Whether taxpayer or the AE?

While the taxpayer had selected the AE as a tested party, the Tribunal held there can be no question of substituting the profit realised by the Indian enterprise from its foreign AE with the profit realised by the foreign AE from the ultimate customers and accordingly, the margin of the taxpayer (and not the AE) has to be tested.

2 Missionpharma Logistics (I) Pvt Limited [ITA No. 954 & 3149/Ahd/2010]

Indian procurer appropriate as 'tested' party over risk-bearing AE

Indian assessee, procuring medicines and disposables from suppliers selected by AE & selling medical kits to AE / third parties, to be taken as ‘tested party’. Assessee is less complex than AE, did not own any intangibles in form of ‘low cost suppliers' list whereas AE takes all decisions, bears all types of risk, can't be taken as 'tested party‘.

4 Development Consultants Pvt Ltd. [ITA No. 79 & 80/ Kol/2008]

Selection of tested party – Whether taxpayer or the AE?

The Tribunal accepted the characterization of the AE as a distributor and selection of the AE as a tested party, since the Indian taxpayer was considered as a more complex entity. Further, the Tribunal accepted the international benchmarking exercise supporting the margins earned by the AE.

3 Cybertech Systems and Software Limited [ITA No. 7303/Mum/2012]

Most appropriate transfer pricing method (Internal TNMM v. External TNMM)

The AE retained 12% of the client revenues for its marketing, coordination, client liaisoning, credit risk and market risk and the taxpayer had a similar arrangement with a third party. While the issue of tested party was not articulated and disputed, in its final ruling, the Tribunal has remanded the case to examine the application of internal TNMM vs external TNMM to the taxpayer’s margins, thereby treating the taxpayer as a tested party.


RECENT CONTROVERSIES – FUNDAMENTAL ISSUES

LOCATION SAVINGS


Location savings/ Location Specific Advantage/ Location rent & Market Premium

Who gets location rents ? Multinationals generate enormous cost-savings by off-shoring Often these savings end up in a tax haven or back in the home country UN manual proposes an approach that would give developing countries a bite

of the apple.

UN TP Model explains the Approach as under:

RECENT CONTROVERSIES - LOCATION SAVING

+/-+/-Other Location

Specific BenefitsOther Location

Specific Benefits ==Location Specific

Advantages (“LSAs”)

Location Specific Advantages

(“LSAs”)

Net location savings

Net location savings

Other Location Specific BenefitsOther Location

Specific Benefits==Location Specific Advantages

(“LSAs”)

Location Specific Advantages

(“LSAs”)

=>=>Location Rent

(i.e. incremental profit)

Location Rent

(i.e. incremental profit)

+/-+/-


Off-late, Indian authorities have made upward adjustments to the income of the Indian taxpayer by splitting the net location savings between the Indian taxpayer and overseas enterprise.

In many cases, the location savings are simply split equally between the Indian taxpayer and overseas enterprise assuming equal bargaining power.

In the recently released United Nations Transfer Pricing Manual for Developing Countries

(India Chapter), the Indian authorities has advocated that, in the quantification and allocation of location savings amongst the parties, the profit split method (PSM) can be used wherein the functional analysis and bargaining power of the parties to the transaction would be relevant factors for consideration – benchmarking against local comparables does not take into account the benefit of location savings.

The Tribunal ruling in the case of GAP International Sourcing (I) Pvt. Ltd v. ACIT [2012] 25 taxmann.com 414 (Delhi), has not echoed the above views of the Indian authorities and held that:

“the intent of sourcing from low cost countries for a manufacturer/retailer is to survive in stiff competition by providing a lower cost to its end-customers. Generally, the advantage of location savings is passed onto the end-customer via a competitive sales strategy. The arm’s length principle requires benchmarking to be done with comparables in the jurisdiction of tested party and the location savings, if any, would be reflected in the profitability earned by comparables which are used for benchmarking the international transactions. Thus in our view, no separate / additional allocation is called for on account of location savings...” (emphasis supplied)

RECENT CONTROVERSIES - LOCATION SAVING


EMERGING AREAS OF CONTROVERSIES SPECIFIC ISSUES



INTRA-GROUP FINANCING TRANSACTIONS


No agreement in place;

Terms & Conditions lack economic substance;

Non exercise of prepayment or call options;

High debt/equity ratios;

Debt pricing resulting in low profitability;

Interest rates or credit margins;

Credit Guarantee Fees

Interest rates / guarantee fees that are arbitrary or

based on a casual analysis, such as stray bank

quotations;

AREAS OF FOCUS BY TAXATION AUTHORITIES


Explanation to Section 92B(1) of Income Tax Act, 1961–

For the removal of doubts, it is hereby clarified that—(i)the expression "international transaction" shall include—

(c) capital financing, including any type of long-term or short-term borrowing, lending or guarantee, purchase or sale of marketable securities or any type of advance, payments or deferred payment or receivable or any other debt arising during the course of business;

What is a guarantee?“A legally binding agreement under which the guarantor agrees to pay any or all of the amount due on a loan instrument in the event of non-payment by the borrower”

Whether extension of charge of existing securities with Indian bank for issuance of SBLC to its foreign branch on behalf of Indian company’s foreign AE be treated as guarantee?

CORPORATE GUARANTEE – DEFINITION


Corporate Guarantees under consideration are generally in either of following forms:

Corporate Guarantee is extended by Indian company on behalf of its foreign AE to the foreign branch of an Indian bank – Is it transaction between two Indian entities?

Corporate Guarantee is extended by Indian company on behalf of its foreign AE to the foreign bank or foreign branch of foreign bank

Corporate Guarantee is extended by Indian company to an Indian branch of Indian bank for issue of Stand-By Letter of Credit (‘SBLC’) or Letter of Comfort (‘LOC’) to its foreign branch on behalf of its Indian company’s foreign AE.

Benchmarking?There is no transfer pricing regulation across the world which prescribes or

defines a method for benchmarking guarantee fees.

The various approaches for benchmarking guarantee fees are: CUP Approach Risk of Loss Approach Valuation of Benefit Approach/ Interest Saving Approach

CORPORATE GUARANTEE – WHETHER AN INTERNATIONAL TRANSACTION?



‘MARKETING INTANGIBLES (AMP)’


Issue/ControversyIndian tax authorities have been identifying excessive Advertising, Marketing and Promotion (‘AMP’) expenses incurred by the Indian taxpayer by applying the bright-line test and applying a markup on such expenses to allege that the taxpayer was provide a service to the foreign brand owner, for which a compensation is due.

In case of LG Electronics India Pvt. Ltd. v. ACIT [2013] 29 taxmann.com 300 (Delhi)(SB), tribunal held that TP adjustments in relation to the AMP expenses incurred by the Indian taxpayer for creating and improving the marketing intangible for and on behalf of the foreign parent company is permissible.

Following the LG ruling, there have been series of other rulings on TP adjustment on account of AMP Expenses & marketing intangibles in the case of

RECENT CONTROVERSIES – MARKETING INTANGIBLES

Name of the Decision Citation

Reebok India Co. v. Addl. CIT I.T.A. No. 5857/Del/2012

Sony India Pvt. Ltd. v. Addl. CIT ITA Nos. 4978/Del/ 2011 & 6389/Del/2012

Panasonic Sales & Services India Pvt. Ltd. v. ACIT

ITA No. 1911/Mad/2011

RayBan Sun Optics India Limited v. DCIT ITA No. 5933/Del/2012

Glaxo Smithkline Consumer Healthcare Ltd. v. ACIT

ITA No. 1148/Chd/2011

Canon India Pvt. Ltd. v. DCIT ITA Nos. 4602/Del/2010, 5593/Del/2011 & 6086/Del/2012)

Haier Appliances India (P) Ltd. V. DCIT ITA No. 4680/Del/2010 & ITA No. 5235/Del/2011

Ford India Pvt. Ltd. v. DCIT (ITA No. 2089/MDS/2011)


Key Issues in the Special Bench Ruling in case of LG Electronics

The special bench has specified the following considerations which need to be applied to a taxpayers’ facts in determining whether any adjustment needs to be made:

• Whether the foreign enterprise is compensating the Indian taxpayer for promotion of brand in any manner such as subsidy on goods sold to the taxpayer?

• Whether the level of subsidy is commensurate with the brand promotion expenditure?

• Whether the brand is at an entry level or at an established stage?

• Whether there have been any new product launches or continuation of existing product range?

• How the brand will be dealt with after termination of the agreement with the Indian taxpayer?

RECENT CONTROVERSIES – MARKETING INTANGIBLES


MARKETING INTANGIBLE – CHARACTERIZATION OF DISTRIBUTOR

A CRUCIAL ELEMENTTYPE OF

DISTRIBUTOR

PROFILE REMUNERATION MODELMARKETING INTANGIBLE /

REMUNERATION FOR EXCESS AMP EXPENSES

Limited Risk

Distributor

Limited function and risk profile

Key people functions performed by principal

Marketing strategies determined by manufacturer – Distributor merely executes the strategy

AMP expenses incurred by Distributor - not significant

Unlikely to incur start up losses

Low and steady returns guaranteed by the manufacturer – achieved either through (i) adjustment of pricing of products or (ii) reimbursement of expenses

Arm’s length return on sales ensures AMP expenses incurred by distributor are “picked up” by principal

Remuneration model of guaranteed return on sales automatically mitigates any further issue on account of marketing intangibles

Economic ownership and associated rewards of marketing intangibles vest with the principal

Full-Fledged Distribut

or

Takes necessary decisions and performs functions with respect to Advertising & Marketing and other distribution strategies

Bears entrepreneurial risks

Can suffer start up losses, entitled to future higher profits

Ideally remunerated with reference to gross margin and bears the volume risk – commensurate to comparable companies’ gross margin having similar “intensity of functions”

In case the “intensity of functions” i.e. advertising and marketing function intensity is higher than comparable distributors, there is a need for higher remuneration – such extra remuneration can even come either through reduction in purchase price of products and can be addressed through the intercompany pricing policy

Above guidance provided by Australian Revenue and the OECD

Reimbursement of AMP expenses not the only way of compensation



‘CONTRACT RESEARCH & DEVELOPMENT’


CIRCULAR 2 OF 2013 - CIRCULAR ON APPLICATION OF PROFIT SPLIT METHOD Methods such as Transactional Net Margin Method (‘TNMM’) evaluating value of

intangibles on a Cost plus Return basis discouraged – no correlation between R&D cost and return on intangibles.

Preference for Profit Split Method (‘PSM’) - determines appropriate return on intangibles considering relative contribution by each AE.

Selection and application of PSM dependent upon factors prescribed under Rule 10C(2)

Onus on TPO to record reasons for non-applicability of PSM before considering other methods. In such cases, TPO empowered to consider TNMM or CUP.

Onus on taxpayer to have sufficient reason for non-applicability of PSM due to non-availability of information

CIRCULAR 3 OF 2013 - CIRCULAR ON CONDITIONS RELEVANT TO IDENTIFY DEVELOPMENT CENTRES ENGAGED IN CONTRACT R&D SERVICES WITH INSIGNIFICANT RISK

Provides for 5 conditions to be satisfied cumulatively satisfied in order to treat a development centre in India as a contract R&D service provider:

Functions - economically significant functions are performed by AE Funding - economic significant assets are provided by AEs. Supervision & Control - direct control & supervision of the AE. Risk Profile - significant risks are borne by the AE Ownership Rights - rights of the intangible developed vests with the AE

RECENT CONTROVERSIES – CONTRACT R&D


Recently, the Delhi Tribunal in the case of GE India Technology Centre Pvt. Ltd. v. DDIT [ITA Nos. 789/Bang/2010, 487 & 925/Bang/2011] made some interesting observations in relation to Contract R&D services, as under:

“Identification of risk and the party who bears such risks are important steps in comparability analysis. The conduct of the parties is key to determine whether the actual allocation of risks conforms to the contractual risk allocation. Allocation of risk depends upon the ability of the parties to the transaction to exercise control over risk. Core functions, key responsibilities, key decision making and level of individual responsibility for the key decisions are important factors to identify the party which has control over the risks.........The notion that risk can be controlled remotely by the parent company and that the Indian subsidiary engaged in core functions, such as carrying out research and development activities or providing services are risk free entities is something which needs to be demonstrated by the assessee.” (Emphasis supplied)

The question as to “who exercises control” is a factual exercise i.e. the significant people functions and conduct of the parties involved must be necessarily substantiated and documented by taxpayers.

RECENT CONTROVERSIES – CONTRACT R&D


DisclaimerThe information provided in this presentation is for informational purposes only, and should not be construed as legal advice on any subject matter. No recipients of this presentation, clients or otherwise, should act or refrain from acting on the basis of any content included in this presentation without seeking the appropriate legal or other professional advice on the particular facts and circumstances at issue. The content of this presentation contains general information and may not be accurate or reflect current legal developments, verdicts or settlements. The presenter and M/s. T. P. Ostwal & Associates expressly disclaims all liability in respect to actions taken or not taken based on any or all the contents of this presentation.

THANK YOUTHANK YOU

M/s. T. P. Ostwal & AssociatesChartered Accountants

4th Floor, Bharat House, 104 Mumbai Samachar Marg, Fort, Mumbai-400001.

Tel No.: +91-22-40693900 Fax No.: +91-22-40693999 Mobile:+91 9004660107 Email: [email protected]

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