CONCEPT & PRACTICE

TRANSFER PRICING

12th January, 2014

CA Vijay Goel98101-29835

vijay@vkgc.com

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Transfer Pricing – Meaning & Concept

� The Price at which two related parties transact business between themselves.

� When two related parties decide between themselves the transaction price, there is a scope for such parties affecting the price which will be different from the price if transacted between the unrelated parties. This is mis-pricing.

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Impact of not regulating

� Example:

� A is US based parent company having B as Indian WOS. B selling services to A at a price of Rs.100 Cr. and incurs Rs.90 Cr. as expenses making Rs.10 Cr. PBT. Given corporate tax of 30%, PAT is Rs.7 Cr. Assuming 100% distribution as dividend, DDT @ 15% will be Rs.1.05 Cr. and net Rs.5.95 Cr. Will be repatriated.

� Suppose, If the price between the unrelated parties would have been Rs.120 Cr., the difference will be as follows-

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Impact of Mis-Pricing

Situation 1 Situation 2 Difference

Sales 100 120 20

Less: Expenses 90 90 -

PBT 10 30 20

Less: Corporate Tax

3 9 6

PAT 7 21 1

DDT 1.05 3.15 2.10

Net Repatriation 5.95 17.85 14.90

� Tax Avoidance � Flight of Capital

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How is this regulated?-Transfer pricing adjustment

Situation 1 Situation 3(After Transfer

Pricing adjustments)

Difference

Sales 100 100 -

Less: Expenses 90 90 -

PBT 10 10 -

Less: Corporate Tax

3 9 6

PAT 7 1 -6

DDT 1.05 0.15 -0.90

Net Repatriation 5.95 0.85 -5.10

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Areas not addressed?

Situation 2 Situation 3(After Transfer

Pricing adjustments)

Difference

Sales 120 100 -20

Less: Expenses 90 90 -

PBT 30 10 -20

Less: Corporate Tax

9 9 0

PAT 21 1 -20

DDT 3.15 0.15 -3

Net Repatriation 17.85 0.85 -17

Secondary Adjustments; Consequent Flight back of Capital

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Indian TP Regulations

�International Transactions

Introduced by Finance Act 2001 w. e. f. 01.04.2002. AY 2002-03.

� Specified Domestic Transactions

Introduced by Finance Act 2012 w. e. f. 01.04.2013. AY 2013-14.

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TP- International TransactionsScheme of Regulations

� Income from International Transactions to be computed having regard to Arm’s Length Price.

� Cost sharing arrangements also covered.� Not applicable if, reduces tax liability or increases loss.� International transaction defined. Deemed international transactions. � Associated Enterprise (related parties) defined.� ALP defined. Methods prescribed for computation. Most appropriate

method to be used. Guidance provided.� Documentation requirements prescribed.� Filing requirements prescribed.� AO / TPO can re-determine ALP and make adjustments in income. � Option to go to DRP.� Normal appeal route available.� Safe Harbour Rules prescribed.� Advance Pricing Agreement.

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TP- Specified Domestic TransactionsOrigin, Rationale & Scheme of Regulations

� Observations of Supreme Court in CIT vs. Glaxo SmithKline Asia (P) Ltd.

� Tax arbitrage from loss making concern.

� Tax arbitrage from exempted on low tax unit.

� Complications where fair market value to be assigned under sec 40A(2).

� Documentation requirement.

� Applicable to “Specified Domestic Transactions” as defined.

� Allowance for expenditure, interest, cost allocation or income in relation to SDT to be computed on ALP.

� Determination of ALP, documentation requirements and filing obligations similar to those for international transactions.

� Safe Harbour and APA not applicable.

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Practice of Transfer Pricing

� Check for international transaction - if any transaction with associated enterprise.

� Check for specified domestic transactions, If value is more than Rs. 5 Crore

� If Yes, maintain the documentation on contemporaneous basis.

� Determine ALP towards the end of financial year and if possible adjust pricing by true-up or true-down.

� While filing the tax return conduct testing by the prescribed methods to check if within ALP range. If not, volunteer addition to that extent.

� Get 3CEB report from a CA and file the same online by the due date (30th

Nov).

� When required by AO or TPO, submit the documents maintained and supply the information called for in support of ALP.

� If AO or TPO reject assessee’s ALP and re-determine ALP, insist on show cause notice before the order.

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Practice of Transfer Pricing (contd.)

� Carefully examine the show cause notice and the points raised in the notice.

� Make a thorough research on the comparables used by the AO/TPO and also on the comparables rejected by the AO/TPO to objectively evaluate the comparability in light of the guidance given under the regulations.

� Refer to the documentation maintained, relevant provisions of regulations , guidance available in OECD TPG, decisions of the ITAT, HC and SC on the relevant issues to respond to the notice.

� If adverse order, evaluate option to go for appeal before the CIT(A) and in case of international transactions to go before the DRP.

� See, if in case of international transactions, going forward safe harbour or APA can be considered.

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International Transaction - Meaning

� Transaction between two or more AEs where at least one is a non-resident.

� Purchase, sale or lease of tangible or intangible property

� Provision of services

� Lending or borrowing money

� Any other transaction having a bearing on the profits, income, losses or assets.

� Includes mutual cost contribution or cost sharing or cost allocation or cost apportionment agreements or arrangements.

� Deemed International transaction. Prior agreement or terms determined in substance with AE.

� Explanation inserted by Finance Act 2012. Capital financing, provision of services, business restructuring, intangible property clarified.

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Associated Enterprise - Meaning

� Participation in management, control or capital, directly or indirectly.

� Commonality of management, control or capital, directly or indirectly.

� 13 situations spelt encompassing-� Capital or voting power – 26% or more.

� Lending in more than 51% of assets value.

� Guaranteeing 10% or more of borrowings.

� Control on appointment of majority of Directors or ED or governing board members.

� Exclusive control over critical business inputs - intangibles.

� 90% or more raw material and consumables supply and price controlled.

� Common individual /HUF/member, with or without relatives, controls.

� 10% or more interest in firm, AOP or BOI.

� Any relationship of mutual interest, as may be prescribed.

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Specified Domestic Transactions - Meaning

� Any of the following, not being an international transaction-

1. Expenditure where payment to 40A(2)(b) persons; or

2. 80A transaction; or

3. 80-IA (8) transfer of goods or services; or

4. 80-IA (10) business transactions; or

5. 10AA or any other where 80-IA(8) or 80-IA(10) applicable; or

6. any other transaction as may be prescribed, and

Where the aggregate value of transactions more than Rs 5 crore.

Note: A. For computing Rs 5 crore-

a) International transactions value to be excluded.

b) Transactions between 2 units of the same company to be covered when undertaken with a tax holiday unit.

c) Inter-company transactions to be covered when undertaken with a company having a tax holiday unit.

B. If transaction value less than Rs 5 crore, existing tax laws and FMV to apply.

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Related parties u/s 40A(2) – Important point

� SDT would cover shareholding of 20% or more.

� International transaction requires shareholding of 26% or more.

� Where in case of cross border transactions, shareholding is lessthan 26%, it is not covered under International Transactions butif still it is 20% or more, it will be covered under SDT.

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Documentation

S.no.

Nature of document

Contents

1 Assessee Level -ownership structure or other interest held in

2 Group Level - Profile of Group with name, address, status, residence of entities with whom transacted.

3 Business and industry

- Description of assessee’s and AE’s business and of assessee’s industry.

4 Transaction Level - Nature, value and terms of transaction, property transferred or services rendered.

5 FAR analysis -of both, assessee and the AE.

6 Economic and market analysis

Budgets, forecasts or other financial estimates for the business as a whole and for the divisions or product, having bearing on the transaction.

7 Record of Comparables considered

Record, including nature, terms and conditions, of internal and external comparables taken into account

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Documentation (contd.)

S.no.

Nature of document

Contents

8 Record of comparables’Analysis

Analysis performed to evaluate comparability of uncontrolled transactions with the tested transaction.

9 Methods and MAM Methods considered, selected with reasons and also how applied.

10 Workings of ALP determination

Details of the comparable data and financial info used in applying the MAM, adjustments, if any made.

11 Assumptions, policies and price negotiations

Which have critically affected the determination of ALP.

12 TP Adjustment Details of TP adjustment, if any made to align with ALP determined. Also, the consequent adjustment to the total income for tax purposes.

13 Any other Relevant data, information or document of assessee or of AE relevant for determination of ALP.

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Methods of ALP computation

Method What is compared? Appropriateness

1 Comparable Uncontrolled Price Method (CUP)

Price of the transaction Where there is a very close similarity in product/service and either internal or external comparable price is available.

2 Resale Price Method (RPM)

Gross Profit Margin Where purchases from a related party and sales to an unrelated party with little value addition.

3 Cost Plus Method (CPM)

Gross Profit Margin on direct cost or indirect cost

Where purchase or sale is of semi finished goods/services

4 Profit Split Method Relative contribution by each entity, to total value addition

Where use of unique intangibles is involved or where there are multiple inter-related transactions and cannot be evaluated separately.

5 Transactional Net Margin Method (TNMM)

Net Profit Margin with reference to cost incurred, sales affected or assets employed

Residual method. Where reliable comparable data and broad functional comparable available

6 Other Method Price charged Where none of the above is suitable and info is available by way of valuation reports, quotes, etc. to establish price charged or that would be charged.

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Most Appropriate Method – Factors to consider

S. no.

Factors

1 Nature and class of the international transaction

2 Class of AEs, taking into account their FAR

3 Availability, coverage and reliability of data necessary for application of the method.

4 The degree of comparability between – international transaction and uncontrolled transaction; enterprises entering into such transactions.

5 The extent to which reliable and accurate adjustments can be made, if any between- international transaction and comparable uncontrolled transaction;enterprises entering into such transactions.

6 Nature, extent and reliability of assumptions required to be made in application of a method.

-best suited to the facts and circumstances of each particular international transaction, and - provides the most reliable measure of ALP in relation to the international transaction

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Comparability factors

S. no. Factors

1 Specific characteristics of the property transferred or services provided in either transaction

2 FAR of the respective parties to the transactions

3 Contractual terms of the transactions which lay down explicitly or implicitly how the responsibilities, risks and benefits are to be divided between the respective parties to the transactions

4 Conditions prevailing in the market in which respective parties operate, including –• the geographical location and size of the markets, • the laws and Government orders in force, • costs of labour and capital in the markets, • overall economic development and level of competition and • whether the markets are wholesale or retail.

Comparable If -none of the differences likely to materially affect; reasonable accurate adjustments can be made to eliminate the effect of such differences.

Current year data to be used. Previous 2 years’ data can also be used if reveals the facts having bearing on the determination of TP.

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Search for comparables

� Quantitative Search

� Qualitative Search

� Accept/Reject Matrix

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Rejection by TPO/AO – 92C(3)

1 The price charged or paid has not been determined in accordance with 92C(1) and 92C(2); or

2 Any information and document have not been kept and maintained as per 92D and 10D; or

3 The information and data used in computation of ALP is not reliable or correct; or

4 The assessee has failed to furnish, within the specified time, any information or document which was required by 92D(3) notice.

• During the course of assessment proceedings,• On the basis of material or information or

document in possession,• AO (or TPO) is of the opinion that -

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Penalties

Default Penalty

Documentation not maintained 2% of value of transaction (s).

Required documents not furnished 2% of value of transaction (s).

Transaction(s) not reported in 92E/3CED Report

2% of value of transaction (s).

Incorrect documents maintained or furnished

2% of value of transaction (s).

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SDT- Certain cases

S. no.

Transaction Guidance

1 Remuneration to director or key management personnel

-Look into job profile, experience and knowledge and compare with remuneration paid to key management personnel of comparable companies.- TNMM as a last resort.

2 Rent payment - Look into the size, area, location, quality of construction, lease term and other relevant factors and check if CUP can be used.

- Independent Chartered Engineer’s certificate, as “other method”.

3 Interest on loan, guarantee fee - Compare with Indian bank’s rates.

4 Purchases - CUP, RPM or TNMM

5 Royalty, FTS, Commission or Brokerage

- CUP or TNMM

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Uniqueness of Indian TP Regulations

s. no. Unique nature

1 Arithmetic Mean

2 Single year data

3 Contemporaneous data can be refreshed during TP audit

4 TP Report (92E)

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TP Controversies

1 Single year data 8 Intangibles/Advertising and Marketing Promotion expenses- Bright line test

15 Under valuation of shares allotted

2 Tested Party 9 Capacity utilization adjustment 16 Loan/interest

3 Burden of proof 10 Location savings 17 Use of customs data

4 Turnover filter, Employee cost filter, Related Party filter

11 Entity level vs. transaction level 18 Applicability to exempt / non-taxable income

5 Internal vs External comparables

12 PLI selection, computation and adjustments

19 5% tolerance limit

6 Secret Comparables 13 Selection of MAM 20 Risk adjustment

7 Management charges 14 Guarantee fee 21 Working capital adjustment

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Defense Strategy

� Analysis and Benchmarking prior to transaction

� Inter entity contract

� Contemporaneous documentation and review on regular basis.

� True-up/True-down with year end testing

� Testing again while filing tax return and volunteering adjustment, if any.

� Take TP audit with all seriousness and put best foot forward at that level itself.

� Evaluate Safe Harbour option, if applicable

� Evaluate APA option.

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Safe Harbour

� Circumstances where tax authorities shall accept the TP declared by the assessee. Safe Harbour is an exception to ALP rule.

� Eligible International Transaction and Eligible assessee defined.

� Safe Harbor operating margins range – IT/ITES: 20% to 25% ; Intra group loans: SBI rate+1.5% to 3%; Corporate guarantee fee: 1.75%; contract R&D software 30% and pharma 29%; manufacture and export of core auto 12%, and non-core auto 8.5%.

� Operating profit margin, operating expenses, operating revenue defined.

� Insignificant risk – factors to consider

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Safe Harbor (contd.)

� Applicable for AY 13-14 and 4 AY thereafter. Can exit and re-enter.

� No comparability adjustments

� 3CEB and documentation continue to be maintained.

� Procedure-

-File tax return by due date offering safe harbour rates.

-File Form 3CEFA by due date

- wait for 60 days, if no reply treat accepted. If get a notice or rejection, attend.

- Can go to Commissioner who to dispose of in 60 days.

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CA Vijay Goel

98101-29835

vijay@vkgc.com

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Thank you