transfer pricing - emerging controversies / challenges ... · transfer pricing - emerging...
TRANSCRIPT
Transfer Pricing - Emerging
Controversies / Challenges &
Way forward
Karishma R. Phatarphekar Chambers of Income-tax
International Tax Conference
Sahara Star Hotel, Mumbai
28th February 2014
1 © 2014 KPMG, an Indian Partnership and a member firm of the KPMG network of independent member firms affiliated with
KPMG International Cooperative (“KPMG International”), a Swiss entity.
All rights reserved.
Business
restructuring and
exit charges
Location
advantages
More audits,
disputes and
litigation
Increasing onus on
taxpayer
Scope of rules
expanding
More and more
complex regulation
Aggressive practices
by tax authorities
Dissatisfaction with
profit based
methods
Transfer Pricing – A proliferation in recent times....
2 © 2014 KPMG, an Indian Partnership and a member firm of the KPMG network of independent member firms affiliated with
KPMG International Cooperative (“KPMG International”), a Swiss entity.
All rights reserved.
Indian TP environment
TP Adjustment scenario at present
“Indian Revenue authorities are reckoned to be tough
globally in TP matters, with India accounting for about 70%
of all global TP disputes by volume”
(Source: Financial Express newspaper 16 July 2012)
3 © 2014 KPMG, an Indian Partnership and a member firm of the KPMG network of independent member firms affiliated with
KPMG International Cooperative (“KPMG International”), a Swiss entity.
All rights reserved.
Areas of discussion..
1 Management cross charges
Marketing Intangibles 2
Share valuation
Financial Transactions
Royalties
3
5
6
Location savings 4
Contract R&D 7
Way forward : Dispute resolution mechanism 8
4 © 2014 KPMG, an Indian Partnership and a member firm of the KPMG network of independent member firms affiliated with
KPMG International Cooperative (“KPMG International”), a Swiss entity.
All rights reserved.
Management Cross charges
5 © 2014 KPMG, an Indian Partnership and a member firm of the KPMG network of independent member firms affiliated with
KPMG International Cooperative (“KPMG International”), a Swiss entity.
All rights reserved.
Management Cross charge
5
Group service
Centre
Arm’s length price based
on cost plus mark-up
determined based on:
• Functional and Economic analysis
• Availability of internal / external data
Beneficial
services Non-Beneficial
services
Chargeable
services
Non-
Chargeable
services
Payment towards management fees is generally towards the following services:
Planning & Coordination,
Budgetary Control,
Financial advice,
Accounting,
Auditing,
Legal services,
Computer services,
Financial services,
Management and administrative services,
Purchasing, marketing and distribution,
Human resource services etc.
6 © 2014 KPMG, an Indian Partnership and a member firm of the KPMG network of independent member firms affiliated with
KPMG International Cooperative (“KPMG International”), a Swiss entity.
All rights reserved.
Basis of charge
Basis of charge
Inbound services Outbound services
Cost plus model Hourly / Man day
rate model
Determining cost Base
• Direct / Indirect cost
• Management overheads
• Notional cost
Determining a mark up
• Comparison of captive
unit with independent companies
• Possibility of risk adjustment
• Comparison of hourly rate charged in related and unrelated transactions and • Adjustment on account of idle capacity/under-utilization of capacity
• Global Transfer pricing policy • Benefit analysis • Documents evidencing that the services have been actually received
R
R
R
R = Key Requirements
7 © 2014 KPMG, an Indian Partnership and a member firm of the KPMG network of independent member firms affiliated with
KPMG International Cooperative (“KPMG International”), a Swiss entity.
All rights reserved.
Revenues approach towards allocation of Management fees
Benefits Payout
Management fee charged by AEs are investigated in great detail by the Revenue department
Robust / exhaustive documentation requirement demanded to substantiate the total receipt of services and
benefits received . In absence of substantial documentation demonstrating the services received such
allocations are disallowed completely or determined at a substantially lower amount
Revenue also enquire into whether a similar charge is levied on other group entities and rates thereof are also
called for and examined
Typical mindset of the Revenue is that management charge are used for profit repatriation.
8 © 2014 KPMG, an Indian Partnership and a member firm of the KPMG network of independent member firms affiliated with
KPMG International Cooperative (“KPMG International”), a Swiss entity.
All rights reserved.
Best Practice for documentation
Maintenance of service contracts including:
• Nature and extent of services to be provided;
• Basis for determining the fees to be charged; etc
Maintenance of relevant documents to confirm rendering of services for the benefit of the recipient
Maintenance of a detailed narrative of benefits received and supporting documents to identify services (e.g.
emails, presentations etc.) and prove non duplication of services, etc.
8
Intra group services – Documentation and important points
Other Important points worth noting
Important to differentiate from shareholder activities.
Are “Benefits” always tangible/ quantifiable?
Years of specific group experience and expertise – can this be benchmarked with local market price?
Taxpayers’ commercial expediency vs. Revenue’s assessment of need (Case laws)
APA – perspective, and experience thus far;
Global perspective
9 © 2014 KPMG, an Indian Partnership and a member firm of the KPMG network of independent member firms affiliated with
KPMG International Cooperative (“KPMG International”), a Swiss entity.
All rights reserved.
Judicial Precedent
TNS India Pvt. Ltd vs. ACIT (ITA No. 944/Hyd/2007)
The Hyderabad Bench of Tribunal in the case of TNS India Pvt. Ltd. held that providing concrete evidences with
reference to the services in the nature of specific activities was difficult.
The Tribunal noted:
“for the advise given by various group centers to the group companies in day-to-day manner is difficult to
place on record by way of concrete evidence but the way business is conducted, one can perceive the
same….Unless the Assessing Officer steps into assessee’s business premises and observes the role of
these companies/assessee’s business transactions, it will be difficult to place on record the sort of
advice given in day-to-day operations. What sort of evidence satisfies the AO is also not specified.
Assessee has already placed lot of evidence in support of claims. Therefore, on that account, we are not
in agreement with the Assessing Officer and TPO that services were not rendered by the group
companies to the assessee.”
The Tribunal further noted that even under the TNMM as adopted by the TPO, the assessee’s PLI was 9.89%
which was more than the comparables whose average mean was only 5.60%. Even after payment of
management fees at 4% which was considered as an expenditure while computing PLI, the assessee’s PLI was
more than the comparables.
10 © 2014 KPMG, an Indian Partnership and a member firm of the KPMG network of independent member firms affiliated with
KPMG International Cooperative (“KPMG International”), a Swiss entity.
All rights reserved.
Judicial Precedent
McCann Erickson India Pvt. Ltd.
The Delhi Tribunal observed that :
- The taxpayer had placed substantial evidence in respect of the management service charges and client
coordination fee on record and had been able to establish the nature and benefits of services provided by the AE.
The tax department had not brought out anything to negate such evidence
- The taxpayer is engaged in only one class of business. There are no segments which can be said to be
independent of each other. Entity level benchmarking using the TNMM shall be most appropriate
- Considering the business environment of the taxpayer, it would be difficult to operate successfully without receipt
of services which carry huge intrinsic and creative value. Only a business expert can evaluate the true intrinsic
and creative value of such services. ITAT observed that taxpayer needs to establish that payments made against
Management Services Agreement are commensurate to the volume and quality of services
- The Tribunal relied on the High Court judgment in the case of Hive Communication Pvt. Ltd. wherein it was
held that the legitimate business needs of the company must be judged from the perspective of the company. It is
not for the AO to dictate what the business needs of the company should be
- The term “benefit” to a company in relation to its business has a very wide connotation & is difficult to accurately
measure
11 © 2014 KPMG, an Indian Partnership and a member firm of the KPMG network of independent member firms affiliated with
KPMG International Cooperative (“KPMG International”), a Swiss entity.
All rights reserved.
Judicial Precedent
Dresser Rand India Pvt. Ltd.
The Mumbai Tribunal observed that :
- When computing the ALP, the TPO/AO cannot question the commercial wisdom of the taxpayer. It is the
taxpayer’s prerogative to decide how to conduct its business.
- When evaluating the ALP of a service, it is wholly irrelevant as to whether the taxpayer benefits from it or not.
TPO/AO should restrict themselves to determining whether the price paid by the taxpayer was comparable to the
price paid by an independent enterprise for the same transaction.
- Tribunal also disapproved line of reasoning adopted by the AO/TPO that since the taxpayer has qualified staff on
its roll, there was no need to obtain such services from its AE.
- Allocation of cost on the basis of headcount and turnover is reasonable
- If services availed by the taxpayer is legitimate furtherance of its business interests and are wholly exclusively for
the purposes of business, such costs should be treated to have been computed in a fair and transparent manner.
12 © 2014 KPMG, an Indian Partnership and a member firm of the KPMG network of independent member firms affiliated with
KPMG International Cooperative (“KPMG International”), a Swiss entity.
All rights reserved.
Marketing Intangibles
13 © 2014 KPMG, an Indian Partnership and a member firm of the KPMG network of independent member firms affiliated with
KPMG International Cooperative (“KPMG International”), a Swiss entity.
All rights reserved.
Marketing Intangibles (Advertisement, Marketing and
Promotion – AMP expenses)
Issue involved / Approach of the Revenue
A assessee spends significant amount on AMP expense benefitting the AE by creating marketing intangibles
without corresponding compensation/ reimbursement to the assessee.
Revenue authorities compare expense to sales ratio of assessee with other comparables – disallows AMP
expense in excess of “bright-line” as TP adjustment alleging contribution by taxpayer is towards strengthening
AE owned brands.
Expectation of mark-up on recovery of AMP expense in excess of bright line. The average AMP expenses
incurred by companies in the industry is considered as Bright Line for the purpose of Transfer Pricing analysis.
Excess Assumed to be incurred
for strengthening brand
name of foreign AE
Indian licensee:
Must be reimbursed along
with suitable profit mark-up
AMP spend by
Indian licensee
Arm’s length
licensee
expenditure
(-)
Bright line
Bright line method adopted
by relying on US Tax
court case in DHL
14 © 2014 KPMG, an Indian Partnership and a member firm of the KPMG network of independent member firms affiliated with
KPMG International Cooperative (“KPMG International”), a Swiss entity.
All rights reserved.
LG Electronics : Special Bench decision to deal
with legal issues not factual issues
Indian company, engaged in manufacturing of Electronic
goods in India , is a subsidiary of a Foreign Company
Indian Company incurs AMP expenses for marketing the
goods produced in India
Indian company has incurred AMP expenses which
exceeds the Bright Line limit
Excess AMP expenses incurred by the Indian Company
is perceived to enhance the brand value of Foreign
Company
Indian tax authorities have contended that AMP
expenditure incurred by a taxpayer at a level that exceeds
the “bright line” is to be reimbursed by the foreign AE with
a mark-up
Brand
Creation /
Marketing
Intangible
Indian Company
Foreign Company
Excessive
AMP
Expenses
Owner of
Brand
In India
Outside
India
Judicial Precedent
• Incurring of AMP expenses by the assessee towards brand legally owned by the foreign AE
constituted a 'transaction' subject to TP provisions;
• Upholds use of Bright Line Test for determining cost / value of such transactions:
• Under IT Act, it is legal ownership of brand that is recognized - Special Bench Majority View
• Matter on the quantification set aside to re-look at comparables and appropriate cost base
15 © 2014 KPMG, an Indian Partnership and a member firm of the KPMG network of independent member firms affiliated with
KPMG International Cooperative (“KPMG International”), a Swiss entity.
All rights reserved.
Judicial Precedent
BMW India Pvt. Ltd.- Delhi Tribunal
The Delhi Tribunal observed that:
BMW India though not a licensed manufacturer is fully responsible for sales promotion, full utilization of market
potential, providing customer service and for establishment of efficient distribution network and therefore the
functions far exceed the functions performed by a routine distributor.
The ITAT held that it was necessary for the assessee as a distributor to incur expenditure on sales promotion
and advertising but rejected assessees stand that incurring AMP expenditure is not an international
transaction by relying on LG’s ruling.
The ITAT observed that when the margins earned by the assessee were compared to those earned by the
comparables, it could be concluded that the assessee was sufficiently compensated for excess AMP
expenditure in terms of high profit margin,
The ITAT further observed that rewarding a distributor by way of price adjustment is well recognized and
well accepted remuneration model and that the department cannot insist in the absence of any
provision under the Act that the mode of compensation to the assessee by the foreign AE necessarily
be in the form of direct compensation.
16 © 2014 KPMG, an Indian Partnership and a member firm of the KPMG network of independent member firms affiliated with
KPMG International Cooperative (“KPMG International”), a Swiss entity.
All rights reserved.
Judicial Precedent
Sony India Pvt Ltd.- Delhi Tribunal
The Delhi Tribunal observed that expenses in connection with sales should be excluded from AMP expenses. The
Tribunal relied on the rulings in Canon India Pvt Ltd and Glaxo Smitkline Consumer Healthcare Ltd which had
considered the impact of Special Bench ruling in LG Electronics. The Tribunal further held that only the AMP
expenses ( after excluding the selling expenses ) should be verified by the TPO by applying proper
comparables in view of the directions of Special Bench in LGs case.
<< this space has been left blank intentionally>>
17 © 2014 KPMG, an Indian Partnership and a member firm of the KPMG network of independent member firms affiliated with
KPMG International Cooperative (“KPMG International”), a Swiss entity.
All rights reserved.
Casio India Co. Pvt Ltd – Delhi Tribunal The Indian co. is a wholly owned subsidiary of Casio
Japan. The Indian company is a full fledged distributor of
watches and consumer information and other related
products in India.
The TPO made an adjustment for excess AMP expense
relying on SB ruling in case of LG.
The CIT(A) deleted the addition holding that AMP
expense have been incurred as part of its distribution
function and the benefit accruing to the AE was only
incidental.
The revenue was in appeal before the ITAT. While the
assessee relied on ruling in case of BMW, since it was a
distributor and the margins earned by the company
higher than that of comparables.
However the ITAT in this case, held that SB ruling in LG
not only applies to a manufacturer, but also extends to a
distributor whether he is bearing full risk or least risk.
ITAT thus set aside CIT(A) order and restored the matter
to the AO/TPO to decide afresh in conformity with LG SB
ruling
Indian Company
Indian co.
Consumer
Outside
India
India
Judicial Precedent
Import of Goods
Distribution
Almost similar facts to BMW but set aside for deciding the matter afresh
18 © 2014 KPMG, an Indian Partnership and a member firm of the KPMG network of independent member firms affiliated with
KPMG International Cooperative (“KPMG International”), a Swiss entity.
All rights reserved.
Share Valuation
19 © 2014 KPMG, an Indian Partnership and a member firm of the KPMG network of independent member firms affiliated with
KPMG International Cooperative (“KPMG International”), a Swiss entity.
All rights reserved.
Share Valuation
Typical Facts
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 prescribed by FEMA/RBI guidelines most common being
valuation carried out under the erstwhile CCI guidelines)
The Revenue takes a position that the shares have been issued to the Holding
Company at an undervalued price / less than the fair market value of the
shares;
Valuation methods are being challenged.
The TP adjustment carried out by the TPO is twofold:
• Difference between the actual issue price and the ALP considered as notional
income.
• Notional interest computed by considering the difference between the actual
issue price and the ALP i.e. considering the notional income receivable as a
deemed loan.
Foreign
Holding Co.
Indian Wholly
Owned
Subsidiary
In India
Outside India
Purchase of
shares of Indian
Company
20 © 2014 KPMG, an Indian Partnership and a member firm of the KPMG network of independent member firms affiliated with
KPMG International Cooperative (“KPMG International”), a Swiss entity.
All rights reserved.
Share Valuation
General contentions of the Taxpayers
Issue of equity share capital does not constitute ‘income’ hence not covered by section 92(1) of the Income Tax
Act and therefore there is no requirement to satisfy the arm’s length test laid down by the Act.
The valuation report ought to be accepted by the Revenue unless it is proved to be vitiated by fraud, bias or a
patent mistake.
The shortfall in the value of equity shares cannot be considered as a deemed loan, as no actual loan has been
given by the taxpayer and hence there is no question of Transaction as defined under section 92F of the Act.
The action proposed by the revenue in considering the shortfall as a deemed loan would tantamount to
consider every transfer pricing adjustment as a notional loan/receivable.
It is not open to the department to prescribe or dictate to the assessee as to how it should have conducted the
business or earned income on its funds.
General contentions of the Revenue
All type of transactions being in nature of Capital Financing under clause (v) of explanation to section 92F of
the Act have been included in the definition of international transactions from retrospective effect from 1st April
2002.
Issue of equity shares is in nature of Capital Financing and hence is an international transaction which is
required to be at arm’s length under the Indian Transfer Pricing regulations.
Adjustments arising out of Section 92 take the colour of a notional income
21 © 2014 KPMG, an Indian Partnership and a member firm of the KPMG network of independent member firms affiliated with
KPMG International Cooperative (“KPMG International”), a Swiss entity.
All rights reserved.
Time line on the issue so far…
Shell and
Vodafone file
writ petitions
with Bombay
High Court
(HC)
Huge TP
adjustments
made on
account of
under
valuation of
shares
Jan 2013
Apr 2013
Attorney General
seems to have
endorsed
adjustment for
alleged
undervaluation
of shares
May 2013
HC remitted the matter back to DRP to
decide preliminary issue of
jurisdiction
HC also held that income arising or
potentially arising is must for
applicability of TP provisions
Nov 2013
HC stays department’s
show cause to
Vodafone and Shell
on share valuation
issue for
subsequent AY 2010-
11
Jan 2014
Nov 2013
HC directs AO not
to take any
further steps
pursuant to
TPO’s order for
AY 2010-11 on
share valuation
Is
APA an
option?
VHC sends
Vodafone
to Tax Tribunal
and Directs
not to seek
any adjournments
Feb 2014
22 © 2014 KPMG, an Indian Partnership and a member firm of the KPMG network of independent member firms affiliated with
KPMG International Cooperative (“KPMG International”), a Swiss entity.
All rights reserved.
Location savings
23 © 2014 KPMG, an Indian Partnership and a member firm of the KPMG network of independent member firms affiliated with
KPMG International Cooperative (“KPMG International”), a Swiss entity.
All rights reserved.
Concept of Location Savings
Net ‘Cost savings’ realized by an MNC as a result of relocating manufacturing functions / production / operation
sites from a ‘high cost’ to ‘low cost’ jurisdiction to obtain competitive advantage.
Typical cost savings include savings pertaining to:
Labour costs;
Raw material costs;
Rent and property taxes;
Training costs
Infrastructure costs and
Incentives including tax exemptions
Most low cost locations are in the ‘Developing World’ (e.g.- India, China, Malaysia etc)
Location savings = Input cost in a high cost region – Input cost in a low cost region
`
24 © 2014 KPMG, an Indian Partnership and a member firm of the KPMG network of independent member firms affiliated with
KPMG International Cooperative (“KPMG International”), a Swiss entity.
All rights reserved.
Economic analysis necessary to assess location savings
Economic analysis necessary to assess:
Whether or not an MNE benefits from Location Savings in certain locations – Before/ After comparison
Which entity (parent/local subsidiary) is entitled to such benefits
Other Profit
Production Cost
Before Transfer
Other Profit
Savings due to difference in
input costs
Production Cost
Cost
Difference
After Transfer
Location
Savings
25 © 2014 KPMG, an Indian Partnership and a member firm of the KPMG network of independent member firms affiliated with
KPMG International Cooperative (“KPMG International”), a Swiss entity.
All rights reserved.
Issues involved from perspective of Transfer Pricing
Quantification and allocation of ‘location savings’ is a subject matter of controversy between tax payers and
revenue authorities.
Whether the entire cost difference after the transfer of functions / processes to low cost jurisdiction is ‘location
savings’ i.e. how to quantify location savings ?
Even if ‘location savings’ is quantified, who is rightful owner of additional profits from location savings, the parent
company or the overseas subsidiary (‘AE’) i.e. Attribution ?
Existence and allocation of ‘location savings’ depends upon the bargaining power of the parties. The bargaining
power is determined by 1) economic or beneficial ownership of intangible property, 2) monopoly power such
ownership bestows (uniqueness of the intangible) and 3) The relative competitive position.
Tax authorities in low-cost jurisdictions
seek to deepen their tax bases by
retaining back their portions of cost
savings through TP regimes ( i.e. the
overseas subsidiary )
Tax authorities in high cost jurisdictions
try to shift savings to their country by
applying CPM with a small profit mark-
up ( i.e. the Parent company )
26 © 2014 KPMG, an Indian Partnership and a member firm of the KPMG network of independent member firms affiliated with
KPMG International Cooperative (“KPMG International”), a Swiss entity.
All rights reserved.
UN TP Guidelines – India Chapter Abstracts
In view of Indian Transfer Pricing administration Location savings should be one of the major aspects to be
considered while carrying out comparability analysis during transfer pricing audits.
India provides operational advantages to the MNEs such as labour or skill employee cost, raw material cost,
transaction costs, rent, training cost, infrastructure cost, tax incentive etc.
Location specific advantage (LSA) that India provide to MNE’s in addition to location savings (Incremental profits
from LSA termed as Location rent):
• Highly specialized and skilled manpower and knowledge;
• Access and proximity to growing local/regional markets;
• Large customer base with increased spending capacity;
• Superior information networks;
• Superior distribution networks;
• Incentives; and
• Market premium
Indian transfer pricing administration believes it is possible to use profit split method to determine
allocation of location savings an rent in case comparable uncontrolled transactions not available).
Functional analysis and bargaining power should both be considered appropriate factors.
It is also emphasized that arm’s length compensation for cost savings and location rents should be such that
both parties would benefit from participating in the transaction. It should reflect a appropriate split.
27 © 2014 KPMG, an Indian Partnership and a member firm of the KPMG network of independent member firms affiliated with
KPMG International Cooperative (“KPMG International”), a Swiss entity.
All rights reserved.
Judicial Precedent : GAP International Sourcing (India) Pvt. Ltd.
GAP International Sourcing (India) Pvt. Ltd. vs ACIT (ITA Nos. 5147/Del 2011 & 228/Del/2012)
The Delhi Bench of Tribunal in the case of GAP International Sourcing (India) Pvt. Ltd. held : “that Location
Savings arise to the industry as a whole and there is nothing to prove that the taxpayer was sole
beneficiary. The objective of sourcing from low cost countries is to survive in stiff competition by
providing a lower cost to its end-customers. The advantage of Location Savings is passed onto the end-
customer via a competitive sales strategy. Thus, no separate / additional allocation is called for on
account of Location Savings.”
GAP International Sourcing has rejected the applicability of “Location Savings” to the particular case in a
competitive situation (where the location advantages are passed onto customers), however, it has not rejected
the concept of “Location Savings”.
28 © 2014 KPMG, an Indian Partnership and a member firm of the KPMG network of independent member firms affiliated with
KPMG International Cooperative (“KPMG International”), a Swiss entity.
All rights reserved.
Royalties
29 © 2014 KPMG, an Indian Partnership and a member firm of the KPMG network of independent member firms affiliated with
KPMG International Cooperative (“KPMG International”), a Swiss entity.
All rights reserved.
Royalty Payouts : Background
Royalty payments have faced stringent tax scrutiny in recent times.
Historically India has been a technology importing country.
With the advent of MNCs, royalties were increasingly viewed as cash repatriation tools – tax shield on royalty
payments plus credit of withholding tax in receiving country.
Various payment models
Normal Royalty streams Percentage on sales or profit, per unit royalty, lump sum payment etc.
Package Pricing Amount included in transfer price of goods, no separate royalty payment.
Industrial franchise arrangements Franchise fee paid by licensee to licensor for entire business format including
production process, marketing strategies, etc.
Others Separate royalty fees for trademark / trade name and technology.
30 © 2014 KPMG, an Indian Partnership and a member firm of the KPMG network of independent member firms affiliated with
KPMG International Cooperative (“KPMG International”), a Swiss entity.
All rights reserved.
Issues relating to Royalty payouts
Taxpayers asked to:
Satisfy ‘Benefits test’
Establish direct correlation with sales/ profitability
Whether royalty is embedded in price paid
Rebut the allegation that India performs high end activities that contribute to development of R&D intangibles
Justify royalty in a loss situation
Benchmarking Issues:
Approvals received by RBI not acceptable as external CUP
Aggregation approach under TNMM – Challenged and general lack of availability of comparables.
Transaction specific approach has been adopted by revenue – Outright rejection of rationale for payment. ALP
held to be NIL.
Non acceptance of foreign comparable / databases.
31 © 2014 KPMG, an Indian Partnership and a member firm of the KPMG network of independent member firms affiliated with
KPMG International Cooperative (“KPMG International”), a Swiss entity.
All rights reserved.
Documentary evidences / analysis to substantiate Royalty
payouts
Copies of license agreement.
Tangible benefits received / receivable by the tax payer and quantification
of the benefit
Quote of a comparable independent technology recipient for the
Intangible
Rates at which the royalty is paid for use of similar intangibles by any
other concern / subsidiary of the AE / Group and comparative profits
before and after the use of intangible
Unique nature of the intangible, market where it is used and strategic
advantage achieved
Rights of the taxpayer to receive upgrades
Whether there are any geographic restrictions such as to export based
on the licensed technology.
32 © 2014 KPMG, an Indian Partnership and a member firm of the KPMG network of independent member firms affiliated with
KPMG International Cooperative (“KPMG International”), a Swiss entity.
All rights reserved.
Documentary evidences / analysis to substantiate Royalty
payouts
Form and manner in which the technology was provided i.e. drawings,
specifications, moulds, formulae, etc.
Dependence of business on the technical know how obtained and inter-
linkages between business activities and technical know how
Detail of R&D activities undertaken by AE for developing (and continuously
improving) the technology.
Form and manner of initial technical guidance and troubleshooting
provided any ongoing/ continuous improvements provided
Record of updates received and record of on-call technical support
33 © 2014 KPMG, an Indian Partnership and a member firm of the KPMG network of independent member firms affiliated with
KPMG International Cooperative (“KPMG International”), a Swiss entity.
All rights reserved.
Air Liquide Engineering India P. Ltd [TS-43-ITAT-2014(HYD)-TP]
Facts of the case
The assessee engaged in manufacture and supply of air and gas separation equipments had entered into a
technical know how agreement with its French AE. The assessee was required to pay royalty at 5% on
domestic sales and 8% on export sales.
TPO disallowed royalty paid by the assessee on sales to its own AE on grounds that it would amount to
compensating one’s own-self and that such payment would be far away from the definition of arm's length
transaction, in a business sense.
The TPO adopted CUP method ( by considering payment of royalty at 5% in respect of sales to Non AE ) and made
an adjustment of Rs. 1.43 Cr.
CIT(A) failed to appreciate the contention of the assessee that the sales were entirely made to non-AEs and
considered 50% of the royalty payment for domestic sales and balance 50% for royalty on sales to AEs. CIT(A)
granted partial relief to the assessee and made a TP adjustment of Rs. 71.42 lakhs on account of royalty payments.
34 © 2014 KPMG, an Indian Partnership and a member firm of the KPMG network of independent member firms affiliated with
KPMG International Cooperative (“KPMG International”), a Swiss entity.
All rights reserved.
Air Liquide Engineering India P. Ltd contd…
ITAT observed that, the assessee had filed detailed submissions including agreement copies justifying the
importance and the crucial nature of the technical know how supplied by the AE for running the business.
ITAT relied on Delhi High courts judgment in EKL Appliances wherein it was held that so long as it is
demonstrated that the expenditure or payment by the assessee was for business purpose, it is of no concern of the
TPO to disallow the same on any extraneous reasoning.
Further, the ITAT relied on various Tribunal rulings in case of Ericsson India Pvt. Ltd., Dresser Rand India Pvt Ltd,
LG Polymers India Pvt Ltd, KHS Machinery (P) Ltd, SC Enviro Agro India Ltd and AWB India Pvt Ltd wherein it
was held that, Revenue authorities were not empowered to question the commercial wisdom of the assessee and
it was entirely the assessee to take such decisions that favour the advancement of the assessee’s business.
The ITAT also held that RBI approval of the royalty rates implies that the payments are at arm’s length and no
further adjustment is required in such cases. The ITAT relied on rulings in cases of Sona Okegawa Precision
Forgings Limited, Hero Motocorp Limited , ThyssenKrupp Industries India Ltd and Abhishek Auto Industries Ltd.
Further, with respect to the applicability of TNMM to benchmark payments of royalty, ITAT relied on Mumbai
Tribunals ruling in Cadbury India Limited wherein it was held that payment of royalty cannot be examined divorced
from production and sales. Royalty is inextricably linked with these activities.
35 © 2014 KPMG, an Indian Partnership and a member firm of the KPMG network of independent member firms affiliated with
KPMG International Cooperative (“KPMG International”), a Swiss entity.
All rights reserved.
EKL Appliances Ltd. – Delhi High Court (2012)
(ITA Nos. 1068/2011 & ITA Nos. 1070/2011)]
Taxpayer engaged in the business of manufacturing and trading of refrigerators, washing
machines etc.
For FYs 2001-02 and 2002-03 the TPO disallowed the transaction of payment of royalty to
AE, whereas accepting all other international transactions to be at arm’s length.
Revenue’s Allegations
Taxpayer has been incurring losses year after year. Royalty payments did not result in profits from operations
Increase in turnover did not result in any profit to the taxpayer.
The continuous losses incurred showed that the taxpayer did not benefit in any way from the royalty payment. Thus payment of royalty to the AE is not justified.
Taxpayer’s arguments
The allowance of royalty depends on the utility of the brand name and the technical knowhow in respect of which the payment is made and not on the profitability of the paying entity.
Royalty payment is a legitimate expenditure and non-payment of the same would have had serious implications for the taxpayer’s business.
There were profits at the gross level and the losses at the net level were due to significant increases in the operating expenses.
Due to availability of the brand name there was substantial increase in the turnover otherwise there would have been more losses.
36 © 2014 KPMG, an Indian Partnership and a member firm of the KPMG network of independent member firms affiliated with
KPMG International Cooperative (“KPMG International”), a Swiss entity.
All rights reserved.
EKL Appliances Ltd. continued
CIT(A) Ruling
It was imperative for the taxpayer to upgrade its technology due to market dynamics.
There were profits at the gross level and the losses at the net level were due to increase in
operating costs. The losses show significant reduction after technical up gradation.
The TPO disregarded the business and commercial realities of the business of the
taxpayer and acted in a mechanical manner ignoring the economic circumstances
surrounding the transaction. TPO cannot question the judgment of the taxpayer as to how it
should conduct its business.
Royalty payment was incurred for genuine business purposes and should have been
allowed even if the taxpayer had suffered continuous losses in the business.
Tribunal Ruling
Tribunal agreed with CIT(A) that the royalty payment was justified and the TPO was wrong
in disallowing the same.
37 © 2014 KPMG, an Indian Partnership and a member firm of the KPMG network of independent member firms affiliated with
KPMG International Cooperative (“KPMG International”), a Swiss entity.
All rights reserved.
EKL Appliances Ltd. continued
High court ruling
It is not for the Revenue authorities to dictate to the taxpayer as to how he should conduct his
business and what expenditure should be incurred.
It is not necessary for the taxpayer to show that any legitimate expenditure incurred by him
was also incurred out of necessity or
that the expenditure incurred by him for the purpose of business has actually resulted in profit
or income.
Taxpayer only needs to show that the expenditure should have been incurred “wholly and
exclusively” for the purpose of business.
Whether or not to enter into the transaction is for the taxpayer to decide. Quantum of expenditure
can be examined by the TPO but he has no authority to disallow the expenditure on the ground
that the taxpayer has suffered continuous losses.
High Court also relied on the OECD Guidelines - Tax administrations should not disregard and
restructure the transactions as actually undertaken by the taxpayer except
where the economic substance of a transaction differs from its form; and
where the form and substance of the transaction are the same but arrangements made in
relation to the transaction, differ from those which would have been adopted by independent
enterprises behaving in a commercially rational manner.
38 © 2014 KPMG, an Indian Partnership and a member firm of the KPMG network of independent member firms affiliated with
KPMG International Cooperative (“KPMG International”), a Swiss entity.
All rights reserved.
Financial Transactions
39 © 2014 KPMG, an Indian Partnership and a member firm of the KPMG network of independent member firms affiliated with
KPMG International Cooperative (“KPMG International”), a Swiss entity.
All rights reserved.
Interest on Loans
The Expert Group of the Government of India, constituted in April 2002 to recommend Transfer Pricing guidelines
for companies, in its Report specifies:
“Borrowing or lending on an interest-free basis or at a rate of interest significantly above or below market rates
prevailing at the time of the transaction is an undesirable corporate practice related to transfer pricing”
No specific Indian TP regulations provide guidance on how to determine an arm’s length rate of interest
39
Underlying security Duration of the loan
Factors determining
Interest rate
Guarantee if any
Size of the loan Currency in which
the loan
is provided and repaid
Credit standing of
the borrower
Prevailing interest
rate
40 © 2014 KPMG, an Indian Partnership and a member firm of the KPMG network of independent member firms affiliated with
KPMG International Cooperative (“KPMG International”), a Swiss entity.
All rights reserved.
Broad approach and issues involved in interest
benchmarking
Interest rate benchmarking analysis consists of two main components: Credit rating of the borrower; and
identifying comparable lending arrangements between third parties with comparable terms and credit ratings
Following broad process which can be followed to determine an arm’s length interest rate and the issues
involved are as under:
40
Determining
creditworthiness of
the borrower
Adjusting the risk
factors for specific
debt characteristics
Determining arm’s
length interest rate
range
Further corroboration
by using available
market data
Steps Issues
Availability of comparable data
Strict comparability a challenge
Adjustments on account of risk profiles
Appropriate interest rate ( PLR / Deposit rate
/ LIBOR / Base rate )
Thin capitalization provisions under GAAR
41 © 2014 KPMG, an Indian Partnership and a member firm of the KPMG network of independent member firms affiliated with
KPMG International Cooperative (“KPMG International”), a Swiss entity.
All rights reserved.
Guarantees
Guarantee is a legally binding agreement under which, the guarantor agrees to pay the amount due on a loan
instrument in the event of default by the borrower. From an economic point of view, the returns on guarantee are
linked more with risk than the cost of providing such facility
41
Period / Term
of guarantee
End utilization
of the loan amount
Factors for
charging guarantee fees
Economic benefits
of guarantee
Reasons for
requiring a guarantee
Implicit or Explicit
Debt to Equity ratio,
Quantity of interest savings,
Foreign currency risk
Whether quasi
equity in nature
42 © 2014 KPMG, an Indian Partnership and a member firm of the KPMG network of independent member firms affiliated with
KPMG International Cooperative (“KPMG International”), a Swiss entity.
All rights reserved.
Broad approach and issues involved in interest
benchmarking
Taxpayer’s Approach
If akin to an investor / shareholder activity - no fees attributed
If akin to services - fee attribution made
Benchmarking - guarantee fees /commission on basis of mutual agreement / bank quotes
Also rely on paragraph 7.13 of the OECD TP Guidelines:
Similarly, an associated enterprise should not be considered to receive an intra-group service when it obtains incidental benefits
attributable solely to its being part of a larger concern, and not to any specific activity being performed. For example, no service would
be received where an associated enterprise by reason of its affiliation alone has a credit-rating higher than it would if it were
unaffiliated
Tax Department’s Approach
Insistence on arm’s length compensation for giving guarantee, as AE avails benefit in form of reduced interest rates
and favourable terms
Domestic interest rates are used as potential benchmarks.
Information available on the website of Indian banks generally considered
Exorbitant guarantee fee in range of 3 to 14 percent considered resulting in huge TP adjustments.
Non availability of specialized database, complex inter-company loan instruments and implicit element
of guarantee from parent company – A challenge
42
43 © 2014 KPMG, an Indian Partnership and a member firm of the KPMG network of independent member firms affiliated with
KPMG International Cooperative (“KPMG International”), a Swiss entity.
All rights reserved.
Nimbus Communication Limited – Mumbai ITAT
Rate of interest charged on loan granted cannot be used as comparable for charging interest on outstanding
trade receivables
An outstanding debit balance on account of services rendered to the Group companies does not qualify as an
international transaction since the same is not an independent transaction, but merely the result of a
commercial transaction
The charging of interest is applicable only with the lending or borrowing of funds and not in the case of
commercial over dues
Logix Micro Systems - Bangalore ITAT
The Tribunal observed that funds parked with the AE do not partake the nature of a loan transaction and hence
LIBOR / US Fed rate cannot be used to calculate the interest.
Taxpayer losing an opportunity to pay off its working capital loans, if any and/or is also loosing an interest
income had the funds been deployed in a considerable investment destination in India and there by fixed the
rate at 5% based on short term deposit rates prevailing in India.
Judicial Precedents
44 © 2014 KPMG, an Indian Partnership and a member firm of the KPMG network of independent member firms affiliated with
KPMG International Cooperative (“KPMG International”), a Swiss entity.
All rights reserved.
Aurobindo Pharma Ltd – Hyderabad ITAT
LIBOR plus percentage points to be considered as arm’s length price on loan advanced to AE, provided there
is no other expenditure on borrowed funds.
Loan advanced to AE at LIBOR +3.5% on interest accrual can also be considered as arm’s length rate.
Other recent rulings where LIBOR plus percentage was considered as ALP for foreign
currency loans
Judicial Precedent
Case law Ruling
Apollo Tyres Ltd – Cochin ITAT LIBOR appropriate for benchmarking foreign currency loans and not
domestic prime lending rate.
CES Pvt. Ltd – Hyderabad ITAT Interest on loan advanced to AE should be determined on LIBOR plus
specified basis points
Cotton Natural (I) Pvt. Ltd – Delhi ITAT ITAT rejected argument of the Revenue of adopting domestic PLR for
benchmarking loan given to AE and held that LIBOR should be used
for benchmarking international transaction of loan given to AE.
45 © 2014 KPMG, an Indian Partnership and a member firm of the KPMG network of independent member firms affiliated with
KPMG International Cooperative (“KPMG International”), a Swiss entity.
All rights reserved.
Contract R&D
46 © 2014 KPMG, an Indian Partnership and a member firm of the KPMG network of independent member firms affiliated with
KPMG International Cooperative (“KPMG International”), a Swiss entity.
All rights reserved.
Contract R&D
Revenue‘s Allegations in select cases
Majority of Valuable & Unique IP generating work undertaken in India
India R&D Centre becomes Economic Owner of IP - IP transferred without adequate compensation
Functional characterization of ‘risk insulated service provider’ challenged
Arm’s Length Compensation = Global Profits of MNE allocated to India on ratios such as R&D Head Count,
etc
Prone to high litigation due to lack of clarity – prone to subjective interpretation;
Primary onus on tax payer to maintain detailed documentation and substantiate its functions
Circulars recently issued by CBDT provide guidance on characterization of R&D services ( The CBDT issued
new circular no. 6 of 2013 dated 29th June,2013 amending circular no. 3 of 2013 dated 26th March, 2013
Circular 6 recognizes R&D centres set up by foreign co’s in India can be classified into 3 broad categories Based
on functions, assets and risk assumed by them.
• Centres which are entrepreneurial in nature – Performing significant Functions and assumes substantial risk
• Centres which undertake contract R&D – Performing minimal functions, assets and risk: and
• Centres which are based on cost sharing arrangements – these entities would fall between the
entrepreneurial model and the contract R&D model.
47 © 2014 KPMG, an Indian Partnership and a member firm of the KPMG network of independent member firms affiliated with
KPMG International Cooperative (“KPMG International”), a Swiss entity.
All rights reserved.
Contract R&D
Guidelines for
identifying the
characterization
of R&D Centre
Parameters
Funding/ Assets
Risk Profile
Outcome of Research
Foreign Entity
Performs Economically Significant Functions
Economically significant functions’ to include critical functions such as
conceptualization and design of the product and providing strategic direction and
framework
Provides funds/ capital Significant assets & intangibles
Strategic decisions for Core Functions & Monitoring on regular
basis
Economically Significant Risks
Legal & economic owner of resultant IP
Indian Entity
Performs work assigned by foreign entity
Receives remuneration for the services
performed
Operates under direct supervision and actual
control
No Economically Significant realised Risks
No ownership of resultant IP
Functions
Supervision & Control
Entrepreneurial R&D Contract R&D Cost Sharing Arrangements of R&D
Favo
ura
ble
An
aly
sis
Unfavourable Analysis
Contract Research
Services
Note: In the case of a foreign principal being located in a country/ territory widely perceived as a low or no tax jurisdiction, it
will be presumed that the foreign principal is not controlling the risk. However, the Indian Development Centre may rebut
this presumption to the satisfaction of the revenue authorities.
48 © 2014 KPMG, an Indian Partnership and a member firm of the KPMG network of independent member firms affiliated with
KPMG International Cooperative (“KPMG International”), a Swiss entity.
All rights reserved.
Way Forward : Dispute Resolution Mechanism
49 © 2014 KPMG, an Indian Partnership and a member firm of the KPMG network of independent member firms affiliated with
KPMG International Cooperative (“KPMG International”), a Swiss entity.
All rights reserved.
Dispute Resolution Panel (DRP) – In practice yet to yield desired result to the taxpayers
Alternate dispute resolution mechanism to 1st level appellate proceeding before the CIT (A)
Specialist 3 member collegium for settling disputes on a fast track basis
Time bound 9 months
No demand till Assessing Officer issues final order after directions of DRP
From last year revenue can appeal against the DRP directions as well
Mutual Agreement Procedure (MAP) – To avoid double taxation and provide relief
MAP is an alternate mechanism incorporated into tax treaties for the resolution of international tax disputes
Resolution of disputes through the intervention of competent authorities of each country who evolve a
mutually acceptable solution
Relief through MAP possible irrespective of remedies available under domestic tax laws
Two Competent authorities appointed based on region
Dispute Resolution Panel and Mutual Agreement Procedures
50 © 2014 KPMG, an Indian Partnership and a member firm of the KPMG network of independent member firms affiliated with
KPMG International Cooperative (“KPMG International”), a Swiss entity.
All rights reserved.
Overview of MAP procedure
MAP request
Tax payer makes MAP application in prescribed form to CA of home country
Request can be made where there is double taxation or taxation inconsistent with treaty
Consultation
Host country CA called upon for dispute resolution where issue cannot be resolved unilaterally by home country CA,
Admission
Acceptance of Application at CA’s discretion
CA can call for additional information from tax payer at this stage
Representation
Tax payer may be called for making written or oral representations
Negotiations
CAs initiate negotiation and attempt to reach an amicable resolution
The tax payer is not involved in the negotiation process however he may be called upon to make submissions
Solution
Proposed agreement communicated to the Taxpayer for his acceptance
Solution to be given effect to within 90 days, if taxpayer consents
Generally the entire process takes 2 – 3 years for completion
51 © 2014 KPMG, an Indian Partnership and a member firm of the KPMG network of independent member firms affiliated with
KPMG International Cooperative (“KPMG International”), a Swiss entity.
All rights reserved.
Intercompany Transaction Value of Intercompany
Transaction
Safe Harbour
Software Development or Back-
office support Services
• Upto $80 million
• Exceeds $ 80 million
• 20% or higher
• 22% or higher
ITES being knowledge processes
outsourcing services
• No monetary limit • 25% or higher
Contract R&D services • No monetary limit • 30% or higher
Intra-group loan to wholly owned
subsidiary
• Upto $8 million
• Exceeds $8 million
• SBI base rate plus 150 bps
• SBI base rate plus 300 bps
Corporate guarantee • Does not exceed $16 million
• Exceeds $16 million and the
credit rating of the AE is of the
adequate to highest safety
• Commission rate not less
than 2% p.a. on the amount
guaranteed
• Commission rate not less
than 1.75% p.a. on the
amount guaranteed
Safe Harbor Rules
52 © 2014 KPMG, an Indian Partnership and a member firm of the KPMG network of independent member firms affiliated with
KPMG International Cooperative (“KPMG International”), a Swiss entity.
All rights reserved.
52
Safe Harbours are said to be convenience prices which are higher than the Arm’s Length Price.
The option of being governed by Safe Harbour Rules shall be valid for a period of five years starting with AY
2013-14 or for a lesser period at the option of the taxpayer.
No economic or other adjustments allowed to taxpayers opting for Safe Harbour.
Range of +/-3% not allowed.
No respite is provided from maintenance of mandatory documentation.
A taxpayer opting for Safe Harbour rules will not be able to avoid possibility of economic double taxation.
Introduced new concept of Knowledge Process Outsourcing (KPO) services with high markups
Companies opting for safe harbour not allowed to opt for MAP /CA proceedings
Due to apprehension in various industry sectors - Government has issued instructions that Safe harbour
margins not to be followed for general Audit or APA purposes.
Tepid response to safe harbour option due to very high markups
Safe Harbour Rules – Our observations
53 © 2014 KPMG, an Indian Partnership and a member firm of the KPMG network of independent member firms affiliated with
KPMG International Cooperative (“KPMG International”), a Swiss entity.
All rights reserved.
Indian APA Program – Key Features
Indian APA Program announced in August 2012
Provides certainty for 5 tax years
(FY 2014-15 through 2017-18)
Anonymous filing option
More cooperative approach, as
compared to desk audit
Significant cost saving (internal
and external resources)
Bilateral option would mitigate
double tax
Possibility of Roll-back (i.e. include open tax years)
54 © 2014 KPMG, an Indian Partnership and a member firm of the KPMG network of independent member firms affiliated with
KPMG International Cooperative (“KPMG International”), a Swiss entity.
All rights reserved.
Indian APA Program – Advantages
• No transfer pricing audits and adjustments for five years. Certainty
• Pre-filing application and meeting can be anonymous Anonymous
• LinkedIn can decide not to pursue an APA if it does not like the results
Non-committal
• Taxpayer does not have to pay any filing fee for pre-filing application
No Filing Fee
• Pre-filing application is simple - does not require significant time commitment from LinkedIn’s team
Simple
• LinkedIn may spend only a small portion of total APA budget for pre-filing
Cost Efficient
• The APA Team provides open and honest feedback based on facts presented during pre-filing meeting
Open Feedback
• LinkedIn can evaluate the APA environment without significant investment of time and money
Evaluate APA Approach
Primary Advantages Secondary Advantages
55 © 2014 KPMG, an Indian Partnership and a member firm of the KPMG network of independent member firms affiliated with
KPMG International Cooperative (“KPMG International”), a Swiss entity.
All rights reserved.
Indian APA Program – Experience so far (1/2)
• Indian Revenue received 158 formal pre-filing Advance Pricing Agreement (‘APA’)
applications as of March 31, 2013
• About 90 percent of the pre-filings were converted to actual APA applications
• About 30 Bilateral APA application have been filed, remaining were unilateral applications
• Primary focus of APA teams is to reach consensus on Function Asset Risk (FAR) analysis
for which site visits are planned
• More applicants have signed up in current year (around 35 companies) before March 31,
2014
• The tax authorities have recently confirmed that six APAs are ready to be signed by March
2014 (record time to complete an APA)
56 © 2014 KPMG, an Indian Partnership and a member firm of the KPMG network of independent member firms affiliated with
KPMG International Cooperative (“KPMG International”), a Swiss entity.
All rights reserved.
Sector-wise APAs filed*
Manufacturing Services
* Estimates based on
various sources
• Discussions on the various APA cases happening in Bangalore, Delhi and Mumbai
• Some cases are discussed at specific locations based on specific activities. For e.g. the IT/ ITES activities will be primarily done by APA team in Bangalore
• The initial focus is on the Functions Assets and Risks (‘FAR’) analysis to which the APA team is paying attention in great details
• Site visits by the APA teams in progress. To date the visits have been scheduled in consultation with the taxpayers and have been conducted in a cordial and un-intrusive manner.
• Based on the FAR analysis, the economic analysis will be done followed by rounds of discussions and negotiations
Indian APA Program – Experience so far (2/2)
57 © 2014 KPMG, an Indian Partnership and a member firm of the KPMG network of independent member firms affiliated with
KPMG International Cooperative (“KPMG International”), a Swiss entity.
All rights reserved.
Indian Transfer Pricing Environment – Way Forward
Timelines
8 months
Transfer Pricing Documentation
Transfer Pricing Audit
Dispute Resolution Panel (DRP) / 1st
Appeal (Commissioner (Appeals)
2nd Appeal
Income tax Appellate Tribunal
3rd Appeal
High Court
Final Appeal
Supreme Court
1 year 2 years 3 years 4 years 4 years
2 to 3 years
Total, over 12 years
for each tax year
APA process
58 © 2014 KPMG, an Indian Partnership and a member firm of the KPMG network of independent member firms affiliated with
KPMG International Cooperative (“KPMG International”), a Swiss entity.
All rights reserved.
Questions & Answers
Questions
&
Answers