key transfer pricing controversies · provision of contract software development • beta carries...
TRANSCRIPT
Key Transfer Pricing
Controversies
Shuchi Ray & Neha Arora, 14 March 2015
1
• Transfer Pricing Litigation Scenario
• Location Savings
• Valuation of shares
• Loans & Guarantees
• AMP
• Management Charges
Contents
© 2015 Deloitte Haskins & Sells LLP 2
Transfer Pricing
Litigation Scenario
© 2015 Deloitte Haskins & Sells LLP 3
• Ten years of TP audit completed – trends indicate greater scrutiny, ever increasing adjustments and
resultant litigation
• Approx 50% of cases picked up for audit adjusted by tax department
Trend of transfer pricing adjustment:
• About 1,200 transfer pricing cases disposed of by various Tribunals
• In less than 30% of cases, department’s position upheld by ITAT
India transfer pricing landscape – story so far
0
2000
4000
6000
8000
10000
12000
14000
16000
18000
2004-052005-062006-072007-082008-092009-102010-112011-122012-13
No of adjustmentcases
Amount of adjustment(USD in million)
© 2015 Deloitte Haskins & Sells LLP 4
Traditional dispute resolution mechanism and
outcome
5
9 months Varies;
normally 2
years
To be
completed by
November 30
Con
du
cte
d b
y in
de
pe
ndent
jud
icia
ry
Con
du
cte
d b
y m
em
bers
of th
e
Ind
ian
reve
nu
e
Ma
y c
um
ula
tive
ly ta
ke
8 y
ea
rs
Tax Return/TP Documentation
Assessment 36/48 months
from financial
year
CIT(A) Dispute
Resolution Panel
ITAT
High Court
Supreme Court
Entire
process
takes
more
than 15
years
62% 11%
17%
10%
Analysis of 1230 no. of ITAT cases
Partly in
favour of
taxpayer and
revenue
Remanded
back for fresh
adjudication
In favour of
taxpayer
In favour of
revenue
© 2015 Deloitte Haskins & Sells LLP
Key Controversies – Traditional issues
Returns/ Mark-ups for services
Choice of the Most Appropriate Method
Selection of tested party
Economic adjustments
Application of quantitative filters
6
Key Controversies – Next wave
Intra Group and Management services
Attribution of Profits to Permanent Establishment
Financial Transactions including guarantees, inter-company loans
Intangibles – Brand and AMP issues
Imputation of interest on outstanding receivables
Location Savings
7 Every year new surprises arrive from Tax Office ….change is constant !
Location Savings
8 © 2015 Deloitte Haskins & Sells LLP
Name of Company Alpha Beta
Country A B
Activities - Pre
business
restructuring
• Business of providing software development services and
products to third parties globally
• Provides funds / capital and other significant assets
including intangibles for R&D development to Beta
• Controls and supervises activities of Beta
• Responsible for all the risks associated with R&D
• Legal and economic owner of the intangibles which are
developed during the course of research by Beta
• Engaged in the business of
provision of contract software
development
• Beta carries out research based on
the guidelines and framework
provided by Alpha
• Works under the direct supervision
of Alpha
Labour Costs High Significantly lower
Qualification • Highly skilled professionals, consisting of product
development team and management team
Graduates
Remuneration
model
• Beta is remunerated on a cost plus mark up basis in line
with its functional profile
• Thereafter, the residual profits belongs to Alpha being an
entrepreneurial entity
• Beta is characterised as a limited
risk service provider remunerated
on cost plus 15% mark-up basis
Illustration (1) - Location savings and intangibles
Facts of the case
9
• Tax authorities of Country B alleged that Beta was engaged in R&D activities, a high end
activity in the area of software development
• The cost plus 15% model does not reflect the economic realities and Beta should also be
compensated for the intangibles generated from its R&D activities
• Tax authorities applied PSM while noting the following:
- Economic ownership of the R&D intangibles is with Beta and not with Alpha;
- Both parties perform complex interrelated functions
- Beta creates unique intangibles
• Assumed 50% of the profits (earned by Alpha) attributable to the R&D Activities
• Head count was used as an allocation key to determine the profits attributable to Beta for
its software R&D activities
Illustration (1) - Location savings and intangibles
Analysis of the facts
10
Illustration
Consolidated Financials
Global Profits from sale of software 600
Tax authorities proposed adjustment based on profit split method
Profit attributable to R&D activities @ 50% of global
profits (A) 300
Worldwide R&D head count (B) 1000
Country B's R&D head count (C) 150
Profits attributable to Country B's R&D operations
(A*C/B) 45
Profit under contract R&D model (on cost +15%) 15
Illustration (1) - Location savings and intangibles
11
Name of Company Alpha Beta
Country A B
Business activities • Manufactures and sells various
products globally
• Owns intangibles related to
technology and brand name
• Entitled to residual profits in
the system
• Manufactures and sells product ‘X’ to
Alpha as a captive unit
• Does not own non-routine
intangibles
• Operates in a perfectly competitive
environment
• Is compensated at cost plus 15%
mark up as against local comparable
margin of 12%
Labor Costs High Lower
Illustration – (2) – Location savings on account of
labour costs: Facts of the case
12
• Tax authorities alleged that group has derived locational advantages in Country B by
having manufacturing facility for product X
• Proposes that Beta has not received any compensation for location savings in relation to
exports primarily centered around lower labour costs
• Makes and adjustment based on labour cost differential
• Benefit attributed in the ratio of 50:50 between Alpha and Beta
Illustration (2) – Location savings on account of
labour costs
13
Illustration (2) – Location savings on account of
labour costs
14
Particulars Total Cost (A) No of
Employees (B)
Cost per
employee (INR)
(A/B)
Cost of employees in Country A USD 2000 mn 25,000 4,800,000
Cost of employees in Country B INR 100 mn 250 400,000
Difference (C) 4,400,000
Value of adjustment (D= C x number of
Employees in Country B) 1,100,000,000
Savings allocated to Beta in ratio of
50:50
550,000,000
Facts
• Li & Fung India P. Ltd. ("the taxpayer”) is a part of Li & Fung Group, which had worldwide network in export trading. The taxpayer rendered ‘buying services’ to its AE, for sourcing of garments/handicrafts/leather products, etc. from India
• The taxpayer claimed that TNMM with cost plus 5% remuneration to be most appropriate method for determination of ALP. However, the AE was receiving remuneration from third parties at 5% on FOB value of export of sourced products
• Mark-up of 5% on the FOB value of goods exported was held to be the appropriate ALP by the tax authorities
• The tax authority re-characterised the taxpayer as performing critical functions, assuming significant risks, developed supply chain management, developed human capital intangible and passing location saving advantages to it’s AE
Li & Fung (India) Pvt. Ltd
Issues before the Delhi Tribunal
• Whether PLI based on sourcing cost plus mark-up or as a percentage of commission on FOB value of goods was the most appropriate method to remunerate taxpayer on an arm’s length basis?
Observations and ruling of the Delhi Tribunal
• Remuneration received by the taxpayer at cost plus mark up of 5% was not arm’s length
• All the critical functions were performed by the taxpayer and AE did not have technical capacity and manpower to support the taxpayer
• India offered both cost and operational advantages. But, such locational advantage was not considered in pricing by the AE
• Distribution of compensation @5% of FOB should be split between AE and taxpayer in the ration of 80:20
Ruling of the Delhi High Court
• Taxpayer’s net profit margin from an international transaction has to be calculated solely with reference to the costs incurred by it and not with reference to the costs incurred by any other third party vendor or its overseas AE
Li & Fung (India) Pvt. Ltd
Facts
• GAP International Sourcing (India) Pvt. Ltd. ("the taxpayer") was a wholly owned subsidiary of GAP International Sourcing Inc., USA ("AE") facilitating sourcing of apparel merchandise from India for the Group
• The taxpayer claimed that TNMM with cost plus 15% remuneration to be the most appropriate method for determination of ALP
• The authority view was that the taxpayer:
− Played a critical role in the AE’s value chain;
− Undertook “high value” procurement functions; and
− Owned “procurement intangibles.”
• The tax authority asserted that “location savings” arising from sourcing from a low-cost country such as India was not factored in the cost plus 15% compensation
• The authority held that commission of 5% on the Free-on-Board (“FOB”) value of goods sourced by the foreign enterprise through Indian vendors was ALP
Large Clothing Retailer – Pro taxpayer
Issues before the Delhi Tribunal
• In addition to the previous example – whether the taxpayer’s case is covered by the judgment given by the Delhi Tribunal in case of Li & Fung India Pvt. Ltd
Observations and ruling of the Delhi Tribunal
• Upheld the characterisation of the taxpayer as a routine service provider and observed that its activities did not result in creation or development of procurement related intangibles
• Acknowledged that location savings is generally passed on to the end customer in a competitive market
• Mentioned that the question of allocation truly needs to be addressed in light of the relative bargaining powers/intangible ownership
• Did not observe any distinctive competitive advantage vis-à-vis other sourcing companies which could have led to taxpayer wielding significant bargaining power
• Location specific savings, if any, would be captured in the profitability of the comparables used for benchmarking the international transaction. Accordingly, no separate allocation is called for on account of locational savings
• Observed functional difference with Li &Fung and rejected comparison
Large Clothing Retailer – Pro taxpayer
Facts
• Watson Pharma (taxpayer) was engaged in rendition of contract manufacturing and
contract Research and Development (‘R&D’) services to its AEs.
• The taxpayer used the transactional net margin method (‘TNMM’) to benchmark the said
transactions.
• While the Indian tax authorities accepted the use of TNMM, they purported that the tax
payer should additionally receive extra compensation on account of the location savings
that have arisen pursuant to the AE transferring the manufacturing activity from UK and
other European countries to a low cost jurisdiction (i.e., India).
Watson Pharma (India) Private Limited
Observations and ruling of the Mumbai Tribunal
• While observing the overall bargaining power, options realistically available and the
general market competition, the Tribunal noted that the tax payer and the AE, both,
operated in a perfectly competitive market.
• The Tribunal, following the ruling in the case of GAP International Sourcing (India) Pvt.
Ltd., held that location savings( if any) would be reflected in the profitability earned by the
local comparables (operating in similar economic circumstances as the taxpayer) which
are used for benchmarking the international transactions. Hence, no separate
compensation is called for on account of such location savings.
• The Tribunal mentioned about India’s participation as a part of G20. It categorically stated
the position which G20 countries have concurred upon on the pertinent matter - “where
reliable local market comparables are available and can be used to identify arm's length
prices, specific comparability adjustments for location savings should not be required”.
• As regards India’s views in the UN TP Manual, the Tribunal has specifically observed that
the claimed position is that of the Indian tax administration and not the view of Indian
Government.
Watson Pharma (India) Private Limited
Valuation of shares
© 2015 Deloitte Haskins & Sells LLP 21
Brief Overview
• Under Income-tax Act, normally tax can be levied only if the transaction is giving raise
to “income”.
• However, in the recent past, this basic approach has been subject matter of intense
discussions since the department took a position that shares issued at a price lower
than the arm’s length price to associated enterprise would give raise to income taxable
in India.
• Further, the short fall (i.e. the difference between the issue price and the arm’s length
price so determined) was considered as loan outstanding with AE and hence additional
payment in the form of interest receivable from AE was sought by the tax department.
2015 Deloitte Haskins & Sells LLP 22
Brief Overview
• Major cases:
Shell India Markets – Rs. 15,200 cr.
Essar Group – Rs. 8,000 cr.
Vodafone India Services – Rs. 1,400 cr
HSBC Securities – Rs. 935 cr.
• Few other cases :
Bharti Airtel, Standard Chartered Securities, Havells India and Patel Engineering
Amounts at stake - Rs. 35,000 cr.
© 2015 Deloitte Haskins & Sells LLP 23
Issue of Shares
Typical Facts
• Indian subsidiary issues shares to its foreign parent company (i.e. infusion of share capital
in Indian entity)
• Shares valued as per the existing methodology (i.e. CCI or DCF)
• Usually disclosed in Form 3CEB as a note, out of precaution
Revenue’s Contentions
• To be considered as an international transaction
• Shares have been undervalued / less that the fair market value
• The difference between actual issue price and ALP is computed and two-fold adjustment
made :
notional income of the Indian Subsidiary - treated as TP adjustment
notional interest on such alleged loan - treated as TP adjustment
© 2015 Deloitte Haskins & Sells LLP 24
Issue of Shares – Whether International
Transaction ?
Does the definition of international transaction include issue & subscription of
shares?
• Under section 92B, an "international transaction" is defined to mean "a transaction
between two or more associated enterprises, either or both of whom are non-residents, in
the nature of purchase, sale or lease of tangible or intangible property, or provision of
services, or lending or borrowing money, or any other transaction having a bearing on the
profits, income, losses or assets of such enterprises...".
• Further, the Explanation introduced to section 92B in 2012 (with retrospective effect from
2002) contains an inclusive definition of "international transaction" which includes "capital
financing... including ... purchase or sale of marketable securities...“ of the Indian Income
act in Finance Act 2012 ,which has an retrospective effect.
• It can be contended that the issue of shares would not fall under the phrase “purchase or
sale of marketable securities” since issue of shares is different from purchase or sale of
securities.
• However, it is pertinent to note that as per new Form No. 3CEB, issue of shares is
required to be disclosed under clause 16.
2015 Deloitte Haskins & Sells LLP 25
Issue of Shares – Whether International
Transaction ? (contd…)
The crucial question is whether Chapter X of ITA confers the jurisdiction to
• treat a transaction on the capital account as a revenue transaction?
• treat a single transaction of issue of shares as two transactions
as that of issue of shares and of grant of a financial accommodation (equal to the
difference in value of the arm's length price determined and the issue price of shares),
to bring to tax a notional amount as interest foregone on this notional amount of financial
accommodation?
© 2015 Deloitte Haskins & Sells LLP 26
Other Issues for consideration
• Whether the difference in the share price (‘alleged undervaluation’) can be considered as
an “income” under the Income Tax Act, 1961?
• How to value equity shares? – DCF method v/s CCI method
• Valuation methodology adopted by TPO and assumptions to apply DCF
• Whether TPO correct in treating the difference in valuation of shares treated as Deemed
Loan / Deemed Receivable ?
• Whether imputing a notional interest on Deemed Loan is correct?
27 © 2015 Deloitte Haskins & Sells LLP
Vodafone India – Bombay HC
Facts
• Vodafone India is a wholly owned subsidiary of a Mauritius Vodafone entity, issued equity
shares of face value of Rs. 10 at a premium of Rs. 8,591 per share to its holding
company.
TPO / DRP
• The TPO disputed the valuation of shares and re-computed the value per share [based on
the Net Asset Value (NAV) to Rs. 53,775. The TPO treated the shortfall in the value of
shares [Rs.53,775 less Rs. 8,591 per share] as deemed loan by the taxpayer to its foreign
parent and charged a notional interest @ 13.5% and accordingly made TP adjustment.
DRP also upheld the TP order.
High Court Ruling
• The Mumbai High Court held that TP regulations are applicable only to international
transactions that give rise to taxable income. Neither the capital receipt on issue of
equity shares nor the shortfall (if any) in share premium can be considered as taxable
income within the ambit of the Income Tax Act, 1961.
• Further, there is no specific provision in the Act for treating inflow of funds from shares
issued to non-residents as taxable income. Hence, TP provisions do not apply to capital
transaction itself.
•
28 © 2015 Deloitte Haskins & Sells LLP
Vodafone India – Bombay HC
Update
• Attorney General advised Government not to file SLP
• CBDT instruction No.2/2015 dated 29 January 2015: Board accepted decision of HC, field
officers directed to adhere
• Press release by Ministry of Finance: “bring greater clarity and predictability” and thereby
improve the investment climate in the county
•
29 © 2015 Deloitte Haskins & Sells LLP
Equity Infusion
View of ITATs (1/1)
30
Ruling Observations
Bharti Airtel Limited vs ACIT
(Delhi ITAT) I.T.A. No.: 5816/Del/2012
• Where transaction has no bearing on
profits, incomes, losses or assets of
such enterprise, it will be outside ambit
of expression ‘international transaction’
• Explanation to Sec 92B as amended by
Finance Act, 2012 does not alter basic
character of definition of ‘international
transaction’ u/s 92 B
• Pre-condition about impact on profits,
income, losses or assets of such
enterprises embedded in Sec 92B(1)
• Deeming fiction cannot be read into
"share capital subscription transactions",
when character as such not in dispute
• Rejects TPO's contention that the same
be treated as partly of nature of interest
free loan on ground that there has been
a delay in allotment of shares
Parle Biscuits Pvt Ltd
(Mumbai ITAT) ITA No. 9010/Mum/2010
Loans And Guarantees
© 2015 Deloitte Haskins & Sells LLP 31
Recent Litigation Experience
• Tightened transfer pricing laws, improved vigilance, enhanced enforcement and the power
for detailed investigation
• Adjustments on account of financial transactions – huge adjustments in this area
• Approach towards benchmarking is very elementary with no defined or structured
guidelines
• Differ from the internationally accepted guidelines in several parameters
© 2015 Deloitte Haskins & Sells LLP 32
Loans
© 2015 Deloitte Haskins & Sells LLP 33
Recent Litigation Experience
• General questions raised by the tax authorities:
Use of CUP methodology for pricing loans? Why not a markup on cost of borrowing?
Why PLR should not be considered as the borrowing rate?
Why borrower and not the lender is considered as the tested party ?
Why is the credit rating of the borrower considered?
Why is the consolidated rating of the borrower considered?
Why not consider the Indian ratings and interest rates?
• Terms and conditions of the intra-group debt are not analyzed and no synthetic credit
rating evaluation is performed for estimating borrower’s credit worthiness
• CRISIL local country ratings for all borrowers irrespective of jurisdiction are used along
with the PLR rates of Indian banks as a benchmark rate
• Further, the currency in which the debt is issued is not considered instead INR annualized
average rates for the given year are used
• Lastly, the transaction period interest rates very different from assessment period interest
rates
© 2015 Deloitte Haskins & Sells LLP 34
Scattered Approach By TPOs
35 © 2014 Deloitte Touche Tohmatsu India Private Limited
No proper
credit rating conducted by
TPO
Irrespective of the
maturity of the loan tenor
considered is of 5 years
Borrower’s country and
currency of the loan is
completely ignored
No proper loan
benchmarking is
conducted
Only CRISIL yield rates,
domestic PLR or deposit
rates are considered
No consideration for
other salient features
like seniority, collateral
attached etc.
Documentation Issues
• Lack of scientific and robust approach
• No inter-company agreement
• Abrupt interest rate (sometimes the interest rate charged as per agreement is 0%)
• Non-availability of financial statements
• Use of Bank quotes or websites of banking companies as reference
• Standalone/consolidated financials not available
© 2015 Deloitte Haskins & Sells LLP 36
Loans
Principles Adjudicated
37
Judicial precedence for
loan transactions
LIBOR based pricing for
foreign currency loan
Fixed and Floating interest – Distinction required
Terms & Conditions of
Loan Agreement
are important
Interest free Loans are in general not accepted
Credit risk – validity of
credit quality analysis of borrowers
CUP is the most
appropriate method
Due care for terms and conditions in the Loan agreement
-- interest can vary accordingly
Relevant Case Laws
Views of Tribunal
© 2015 Deloitte Haskins & Sells LLP 38
Rulings Observations
Cotton Naturals (I) Pvt Ltd. Vs.
DCIT
• Comparable transaction would be foreign currency
lent by unrelated parties.
• Domestic prime lending rate have no applicability
and international rate being LIBOR to be taken as
the benchmark rate
• Reliance placed on following case laws:
o Siva Industries & Holdings Ltd.
o Four Soft Ltd.
o Tech Mahindra Ltd.
o Tata Autocomp Systems
Relevant Case Laws
Views of Tribunal
© 2015 Deloitte Haskins & Sells LLP 39
Rulings Observations
ITO Vs. Maharishi Solar Technology
P.Ltd.
• LIBOR prevalent on the date of the loan agreement
should be considered rather than the average
LIBOR during the relevant financial year
• Size of the business of companies, quantum of
loans availed and the contractual terms of their
loan agreement should be comparable with that of
the taxpayer
• Not ruled on the principle whether the arm's length
interest rate to be considered is only 'LIBOR' or
'LIBOR + some basis points'
• Rejected the additional bps as alleged by the TPO
over the LIBOR on the basis that the comparables
chosen by the TPO were not comparable with the
assessee
Relevant Case Laws
Views of Tribunal
© 2015 Deloitte Haskins & Sells LLP 40
Rulings Observations
M/s Four Soft Limited Vs. DCIT
• Average LIBOR during the relevant period under
consideration should be used.
• Upheld use of LIBOR as against EURIBOR even
though the AE was based in Netherlands where the
bank lending rates are based on EURIBOR.
Aurionpro Solutions Ltd Vs. ACIT
• Noted that the interest on Bank FD for a term
equivalent to the term for which the loans were
given to the AEs would be safest comparable as it
is free from risk of credit and interest.
• However, in order to maintain rule of consistency
as held by various benches of ITAT - it accepted
Libor for benchmarking interest on interest free
loans.
Relevant Case Laws
Views of Tribunal
© 2015 Deloitte Haskins & Sells LLP 41
Rulings Observations
Siva Industries and Holdings
Limited Vs. ACIT
• Domestic PLR not applicable and international rate
fixed being LIBOR is to be used
• Interest rate charged by the assessee to be
compared with the average LIBOR rate prevailing
during the relevant financial year
VIP Industries Ltd
• Bank deposit rate and not lending rate suitable ALP
to benchmark AE loan
Hinduja Global Solutions Ltd Vs.
ACIT
• Domestic prime lending rate would have no
applicability and the interbank rate fixed should be
taken as benchmark rate for international
transactions
Videocon Industries Ltd Vs. ACIT • Interest rate charged at LIBOR by assesse was
upheld by Bombay Tribunal
Guarantees
© 2015 Deloitte Haskins & Sells LLP 42
Guarantee Fees – Outbound and Inbound
Inbound transaction Outbound transaction
• Foreign Parent with an Indian subsidiary • Indian Parent with an overseas subsidiary
• Guarantee fees would be an expense for
the Indian taxpayer
• Guarantee fees would be an income for
the Indian taxpayer
• Documentation to be established to
defend benefit test
• Documentation to be established for arm’s
length basis for value of the fees,
including free of cost
• Tested Party and data? • Tested party and data?
• Generally, Revenue not likely
to question free of cost transactions
• Protracted litigation in absence of proper
audit defense
© 2015 Deloitte Haskins & Sells LLP 43
Audit Experience
• Revenue authorities fail to evaluate whether the guarantee actually leads to any savings
or benefit to the borrower or is a mere administrative arrangement, like letters of comfort
or letter of awareness
• Adopt the interest saved approach but the applications have been erroneous – adoption of
domestic credit rating, Indian yield rates, data not available in public domain, credit rating
of borrower derived arbitrarily
• Fail to distinguish between performance guarantees and financial guarantees – adopt a
common pricing system
• Arbitrary adaptation of 3 % guarantee fee without any rationale for all guarantee fee
transaction across industry – some other cases the arbitrary application of interest
approach resulted in a guarantee commission of up to 11%
• Application of bank quotation for guarantee commission charged by Indian banks without
analyzing the terms and conditions
• Generally is not supportive of the “Shareholder’s Service” argument
© 2015 Deloitte Haskins & Sells LLP 44
Bharti Airtel – ITAT Delhi Ruling
© 2015 Deloitte Haskins & Sells LLP 45
Observations of Tribunal
• Analysed section 92B of the Act alongwith the Explanation to the definition of ‘International Transaction” as amended by Finance Act, 2012
• Observed that since the Explanation is clarificatory in nature, the retrospective amendment does not alter the basic character of the definition of international transaction
• Any transaction including capital financing, guarantees, business restructuring / reorganization can be regarded as an ‘international transaction’ only if such a transaction has a bearing on the profits, income, losses or assets of an enterprise (either immediately or in future)
• Impact in the future has to be certain (and not contingent) for covering a transaction in the definition of international transaction.
• Corporate guarantees issued by the taxpayer did not have any implication on the profits, income, losses or assets of the taxpayer. AE had not taken any borrowing from the bank based on the taxpayer’s guarantee
• Held that when a taxpayer extends any assistance to its AE without incurring any expenditure and for which the taxpayer otherwise also could have not realized any income by giving it to any third party, such assistance has no bearing on profits, income, losses or assets of the taxpayer
• Distinguished the case from the preceding Tribunal cases (on quantification of arm’s length guarantee fee) by holding that none of the earlier cases dealt with the issue of coverage of the guarantee transaction in the scope of international transaction as defined in the Act
Videocon – ITAT Mumbai Ruling
Facts
Tax payer provided corporate guarantees to its 3 AEs
TPO contention
• Arm’s length price was determined by TPO, basis the decision in Mahindra & Mahindra at 3%
guarantee fee
• Hence making an adjustment of Rs. 57.90 crores
Observations of Tribunal
• Based on the Bharti Airtel – Delhi ITAT ruling, it was held that corporate guarantees do not fall
within the ambit of International Transactions
• No costs involved in issuing of the corporate guarantee
• No bearing on profits, income, losses or assets of the AE
• Hence no adjustment
© 2015 Deloitte Haskins & Sells LLP 46
Glenmark Pharmaceuticals – ITAT Mumbai Ruling
Tribunal Ruling
• Approves guarantee commission fee at 0.53% and 1.47% charged by Glenmark
Pharmaceuticals Limited in connection with bank loans and L/C facilities
• Explains distinction between corporate guarantee and bank guarantee
• The comparables adopted by TPO are IUPs (i.e. Incomparable Uncontrolled Prices) and
dismisses the TPO’s CUP and orders deletions of the additions made by AO
• Naked bank guarantee quotes given on public websites not good external CUPs unless
they are adjusted as per Rule 10B to factors like risk profile of respondents for guarantee,
financial position of applicants, quantum of amount, terms of guarantee, etc.
• Rejects use of guarantee commission rates available on websites of Bank of India,
Allahabad Bank, HSBC, EXIM Bank-USA and Rabo India Finance P Ltd.
© 2015 Deloitte Haskins & Sells LLP 47
Conflicting views in various decisions
Recent Ruling Takeaways
To be or not to be!
48
Charge or no charge –
whether it is an international
transaction or not – can it be
“shareholder’s service”
• Airtel
• Videocon
• Four Soft Pvt. Limited
• Mahindra
• Nimbus Comm
Use of bank quotes –
whether such quotation
can be consummated as
CUP
• Glenmark
Pharmaceuticals Ltd
• Asian paints Ltd.
• Godrej Sara Lee Ltd
• Technocraft Industries
(India) Ltd
© 2015 Deloitte Haskins & Sells LLP
International Court Ruling –
General Electric Capital Canada Inc. Vs. The Queen Tax Court Ruling
• Tax Court decided in favour of taxpayer (upheld by Federal Court) –
Methodology the Court used to arrive at its conclusion provides a framework for pricing
guarantee fees:
o Determine the recipient's stand –alone /status quo creditworthiness
o Adjust the rating incorporating implicit support
o Price the guarantee using the yield approach
o Finalize the arm’s length range of guarantee fee
External lenders viewed explicit guarantee as much stronger protection as compared to
implicit support, resulting in reduction of interest rates
Credit ratings of GE Canada compared under two scenarios, i.e. with & without explicit
guarantee provided by GE US
Applying Yield approach, worked out “benefit” of 1.83% accruing to GE Canada, being
savings in interest cost due to explicit guarantee; guarantee fee of 1% at arm’s length
© 2015 Deloitte Haskins & Sells LLP 49
International Court Ruling –
Key Takeaways • Increased focus by the revenue authorities on financial transactions between the group
entities
• Robust, well-conceptualized transfer pricing policies/documentation defining parameters
and approaches towards intra-group funding and guarantee arrangements
• Necessity of using benchmarking methods and credit analysis to price
inter- company obligations in an arm’s length manner
• Consideration of factors such as terms of loan, tenor, security, currency and convertibility in
comparability analysis
• Periodical revisit of credit ratings to continue updating the continuing guarantee obligations
• Continue probing additional methods depending upon facts of each case
• The implicit differential of a guarantee between related parties needs to be reckoned
© 2015 Deloitte Haskins & Sells LLP 50
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Marketing & Promotion
Expenses
51 © 2015 Deloitte Haskins & Sells LLP
Marketing Intangibles
• Meaning of “Marketing Intangibles”
− Ordinarily includes a bundle of IP
rights such as: Trade names,
trademarks, knowhow on distribution
channels and customer relationships
− Nebulous & unclear
− Varies in application by jurisdiction &
industry
− Breadth continues to grow as tax
authorities use it
• Main investment in marketing
intangibles is through advertising,
marketing & promotion spend (“AMP”)
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Economic/ Legal
Owner
Developer User
IP:
Brand
OR
India
Rights
Indian AE?
Rights:
Exclusive? Perpetual?
Key Issues on AMP Globally
• How will AE benefit from residual AMP cost (and resulting intangible) for which it is required to bear the cost of development?
Benefit to Foreign AE:
• If legal ownership of intangible is more important than economic ownership, and brand name is legally owned by AE, then Indian sub should pay a healthy non-zero royalty for its use.
Economic vs. Legal Ownership:
• Impact of Indian sub being a low-risk entity vis-à-vis an entrepreneur on how the costs should be handled.
Entrepreneur vs. Limited Risk Entity:
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Key Principles
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Economic vs. Legal Ownership Entrepreneur vs. Limited Risk Entity
• Functionally subsidiaries may act as entrepreneurs and may claim to be economic owners of any intangibles developed through their efforts and for their benefit
• Has to be supported through a robust inter-co agreement
• The Bright Line test according to DHL is based on the principle that the economic owner should pay for the intangibles
• Delhi Tribunal Special Bench in LG case has held that only legal ownership can be recognized under statutes
• An entrepreneur invests in assets,
including intangibles, assumes major
risks of the business, and earns the
associated return
− It is free to invest in its business
− It is free to make mistakes by
spending too much or too little in one
area v. another (hence it takes the
risk)
• A limited risk entity earns a low
steady return and accordingly does
not bear any significant risk
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Approach of the Indian Tax Authorities
− AMP expenses held as creating “marketing
intangible”
− by contributing to brand promotion of
“foreign owned” brand
− Indian distributor, even if not the “legal
owner”, held to be local “developer” of
trademark
TPOs indirectly
commanding
“payment” for
operating in
vast Indian
market
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Special Bench Decision of Delhi Tax Tribunal on
AMP
• There is a valid transaction in the form of excessive AMP expense incurred by Indian company (“Ico”) sub-enhancing the foreign brand, legally owned by the foreign associated enterprise (“AE”)
• Amount of the transaction calculated by applying Bright Line Test (“BLT”)
− BLT is ratio of AMP expenses of “comparable” companies on turnover
• Based on BLT, Ico’s AMP costs bifurcated towards:
− assisting local product sales
− enhancing global brand value
• Ico to be compensated by AE for amounts incurred towards “enhancing brand value” along with a markup
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Special Bench Decision: Important Economic
Aspects
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Whether the Indian AE is a distributor or manufacturer
The extent of value addition made by the Indian AE
Whether the goods sold by the Indian AE bear the same brand name as the foreign AE
Whether the Indian AE is paying any royalty to the foreign AE
Whether the royalty is comparable with what comparable uncontrolled enterprises would pay
Whether the foreign AE is compensating the Indian AE for the promotion of the marketing intangibles
Whether in the year under consideration the foreign AE is entering the India market or is an established brand in India
Whether any new products are launched in India during the relevant period or the business is continuing with the existing range of products
How the brand will be dealt with after termination of the agreement between AEs
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TP Controversy
OECD View
• In cases where local entity bears AMP costs, analysis needs to be undertaken
to determine the extent to which the local entity should have a share in the
potential benefits from such marketing activities.
Australian Tax Office View
• Critical Factors for assessing TP Risk
• Is the distributorship perpetual or time bound ?
• Is the distributor the sole distributor?
• Is the distributor compensated in some manner through a discounted royalty
or
• discounted purchase price ?
• What is the advertisement spend of third party comparables ?
In summary, if the User is the ‘economic owner’ of the intangible, then no TP
adjustment
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Current Status of AMP Litigation – Key Issues
before High Court • Whether the expenditure on AMP by the Indian entity constitutes international transaction
within the purview of Indian Transfer Pricing Regulations;
• AMP expenditure vis-à-vis FAR profile and the pricing policy;
• Whether Bright Line Test is a correct method for determining excessive AMP expenditure;
• Comparable selection for application of BLT
© 2015 Deloitte Haskins & Sells LLP
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Marketing intangibles - AMP
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BMW India Private Limited - Observations
• Taxpayer has performed advertisement function with greater intensity as opposed to
a routine distributor and has contributed to the brand building for the foreign entity
• Excess AMP expenses are an international transactions (reliance on LG India case)
and the bright line test is an accepted tool to determine the value of the international
transaction
• There can be different ways in which a distributor can be compensated by the
foreign entity
• Resultant profits of the Indian entity vis-à-vis the comparable companies both at the
gross level and at the net level demonstrated that the compensation for higher AMP
was embedded in the pricing arrangement of the imported goods
Management Charges
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Management Charges
Generally, the management charges / payments made for Intra Group Services include the
following kinds of services:
• Corporate Risk Services – internal audit and risk management services
• Financial Management and Reporting Services – external financial reporting, financial
strategy and management services
• Legal Services – legal support and legal advice
• Human Resource Services – capability development and organizational health and safety
services
• Technical Services – sharing market intelligence reports and provision of insights on
competition
• Trading and Marketing Services – strategic services, risk management services and
assistance in marketing to international customers
• Information Technology Services – IT services and E-business services
62 2015 Deloitte Haskins & Sells LLP
Management Charges contd..
• What constitutes “Service” is not defined in Indian Transfer Pricing regulations and hence
guidance could be availed from International Transfer Pricing regulations.
• In this regard, as per OECD Transfer Pricing guidelines, to qualify an activity to be service,
test is whether the activity provides the respective group member with economic or
commercial value which enhances its commercial position.
• The following two criteria are useful in determining this aspect:
− Whether an independent enterprise in comparable circumstances would have been
willing to pay for the activity if performed for it by an independent enterprise or
− Whether the entity would have performed the activity in-house for itself.
• Following activities do not qualify for IGS charge :
- Shareholder activities
- Duplicative activities
- Services resulting in Incidental Benefits
63 2015 Deloitte Haskins & Sells LLP
Management charges- A Focus Area for Indian
TP authorities
• Payment for management services by an Indian company to its overseas AEs is being
examined in detail by the Indian TP authorities
• The primary concern is that these payments are being used as a tax planning tool for a high
tax country
• Even if the Indian taxpayer has arm’s length margins at an entity level, the Indian authorities
examine the payments as a separate and a stand alone transaction
• In almost all cases, payments for such services have been disallowed by the Indian
authorities on the basis that:
− The payments do not meet the benefits test
− No services have been rendered
• Following slides describe the type of evidence and analysis required by the Indian
authorities
Typical queries raised by the TPOs
• Taxpayers are required to give in writing:
− Nature of each of the services received within the overall category of management
services
− Need for each of the services
− Benefit received from each of the services
− Whether any of the service is duplicative in nature
• For costs, taxpayers are also required to provide information from the AE:
− Cost incurred by AEs in providing the services- to be given for each type of service
− Basis of allocation, is used, for allocating the management charges
− Evidence of these costs being incurred by the AEs
− Copy of AE accounts
− Certification by an independent auditor for both the costs as well as for the allocation
− Comparison of cost benefit analysis for each type of service
− Comparison with other group companies
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Typical queries raised by the TPOs
• Besides this, the taxpayers are also required to file substantial and robust documentary
evidence (for each individual type of service) to show all of the above i.e.:
− Services were actually received
− Services were required
− Services were beneficial
− The benefits were commensurate with the costs paid to the AE
• Type of documentary evidence :
- Copies of agenda, minutes etc. for each category of services received
- Copies of manuals, reports etc. for each category of services received
- Names of personnel/ designation etc. of the team rendering such services
- E-mail correspondences demonstrating suggestions/ advice received for each service
category
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Typical queries raised by the TPOs
• Apart from this, a separate benchmarking analysis is required by the officers:
− Benchmarking the service fees vis a vis fees paid to any independent service
provider or
− if AE has provided similar services to other independent parties
• Typically, showing that company level profit margins are more than comparable
companies’ profit margins is not considered sufficient
-
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Relevant Case Laws
Views of Tribunal
© 2015 Deloitte Haskins & Sells LLP 68
Rulings Observations
Gemplus India Pvt. Ltd.
(Bangalore ITAT) ITA No.352/Bang/2009
• No details available on record in respect
of services rendered
• Taxpayer has not proved any
commensurate benefits against the
payments of service charges to its
Singapore affiliate
McCann Erickson India Pvt. Ltd.
(Delhi ITAT) ITA No. 5871/Del/2011
• Only a business expert can evaluate the
true intrinsic and creative value of
services received
• Engaged in only one class of business
i.e. advertising and its allied services.
There are no segments or different
activities which can be said to be
independent of each other. Hence TNMM
justified
Relevant Case Laws
Views of Tribunal
© 2015 Deloitte Haskins & Sells LLP 69
Rulings Observations
Knorr-Bremse India Pvt. Ltd.
(Delhi ITAT) ITA No. 5097/Del/2011
• Cross subsidization is not permitted
under Indian regulations hence CUP is
payment for intra-group services need to
be benchmarked separately
• Commercial expediency and arm’s length
principle are two different concepts
• Taxpayer has not received any tangible
or real benefit
Dresser Rand India Pvt. Ltd.
(Mumbai ITAT) ITA No. 8753/Mum/2010
• Tax authorities cannot question the
commercial expediency
• Contemporaneous documentation
submitted
• No infirmity in the cost allocation method
adopted by the taxpayer
• TNMM most appropriate method as tax
authorities failed to dispute the same
Relevant Case Laws
Views of Tribunal
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Rulings Observations
AWB India Pvt. Ltd.
(Delhi ITAT) ITA No. 4454/Del/2011
• Not possible to document every receipt
of the service in question
• Tax authorities cannot question the
commercial expediency
• CUP method applied by the TPO cannot
be considered in view of non-availability
of CUP data
TNS India Pvt. Ltd.
(Hyderabad ITAT) ITA No. 944/Hyd/2007
• TPO not justified in determining ALP of
management fee at NIL
• It is difficult to place on record a concrete
evidence in respect of advise given by
AEs in day-to-day manner, but it can be
perceived from way of conducting
business
• TPO went beyond his jurisdiction in
denying payment out-rightly when his
role is limited to determination of ALP
Relevant Case Laws
Views of High Court
© 2015 Deloitte Haskins & Sells LLP 71
Rulings Observations
Cushman & Wakefield India Pvt Ltd
(Delhi High Court)
• Held that it was necessary to test if third party in
an uncontrolled transaction would have charged
lower, equal or greater amount as compared to
what was charged by AE
• Whether the cost itself is inflated or not is a
matter to be tested under comprehensive TP
analysis
• HC ruled that the authority of the TPO is
restricted to the determination of ALP and not to
determine whether there is a services or not
from which the taxpayer benefits
• Details of the specific activities for which cost
was incurred by both AEs and the attendant
benefit to the taxpayer have not been
considered till date
• Case remanded
Documentation expected by authorities
• Documentary evidence of rendering of services
• Cost allocation methodology
• Benchmarking study
• Report in local country format
• Intercompany agreements
72 © 2015 Deloitte Haskins & Sells LLP
Helpful checklist
SN Particulars Docs to be collected
Local
Entity
Parent
Entity
1. Copy of the intercompany service agreement
2.
Emails, correspondences, any other evidences (such as in the case of employees of parent
entity travelling to provide services – copies of air tickets, hotel bills, etc, if any. Minutes of
the meetings / agenda / training materials provided) etc., demonstrating the receipt of
services
3. Copy of emails, correspondences, etc., demonstrating scope of work and negotiation of
price between group companies
4. Copy of invoices raised
5. Backup document providing details of cost incurred by group company / shared service
centre for providing such services (if possible, under each head of service)
6. Documents demonstrating benchmarking study for calculation of markup on cost charged
7. Statement showing the charge made on other group entities
8. In case of allocation of cost, certificate from an independent auditor certifying the basis of
allocation key used, and calculation of charges
9. Benchmarking study done / transfer pricing report if any
10.
Detail write-up should be maintained to demonstrate following points
a. Differences between regular services received by local entity versus headquarter services received, so
as to prove that there is no duplication of services
b. Reasons for availing of such services
c. Documents to substantiate that the services were actually received and were consistently received
73 © 2015 Deloitte Haskins & Sells LLP
Conclusion
• Issue of management charges is a significant source of transfer pricing dispute
• Important to understand the framework to be followed in determining which
costs to charge and the basis of the charge-out mechanism
• Documentation is important – particularly if the amounts are large
74 © 2015 Deloitte Haskins & Sells LLP
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