Integration of Indian economy with global economy

India began to emerge on the global stage in 1991 with various liberalisation measures relating to industrial licencing, quota system, foreign trade and foreign direct investment. This move towards globalisation brought about new requirements relating to taxation and other laws as many multinational corporations began investing in India and local companies started acquiring companies outside India. The Y2K event made India the service hub to the world as very well explained by Thomas Friedman in his book “The World is Flat”.

In light of the sudden increase of globalisation, an amendment in taxation laws for such transactions between multinational enterprises (MNEs), became the need of the hour so that the tax base for India is not eroded.

The Finance Act, 2001 introduced the Transfer Pricing (TP) regime in India after 10 years of liberalisation by substituting existing Section 92 of the Act and introducing new sections 92A to 92F (w.e.f 1 April 2002) .

The Finance Minister’s speech on the rational for introducing TP Regulations

“The presence of multinational enterprises in India and their ability to allocate profits in different jurisdictions by controlling prices in intra-group transactions has made the issue of transfer pricing a matter of serious concern. I had set up an Expert Group in November 1999 to examine the issues relating to transfer pricing. Their report has been received, proposing a detailed structure for transfer pricing legislation. Necessary legislative changes are being made in the Finance Bill based on these recommendations.”

Rules 10A to 10E were subsequently notified on 21 August 2001.

Income arising from international transactions (IT) amongst associated enterprises (AEs) were now required to be computed at arm’s length price. Methodologies were prescribed to determine the arm’s length price.

The Central Board of Direct Taxes (CBDT) brought revamped rules under chapter X of the Income-tax Act, 1961. The new rules were pivoted on arm’s length price determination for related party transactions through the five standard methods prescribed by the Organization for Economic Cooperation and Development (OECD). Since then, TP in India has taken firm root, with full support of tax administration to verify the arm’s length price. While recounting the developments that have taken place since 2001, it is also time to examine whether the TP practice in India has matured in the last 20 years, and of course, the way forward.

Interplay with Other Laws

Principles of TP were also contained in the Companies Act, 1956 (Sec. 297, S. 299 and S.301) and were also embedded in the concept of valuation under Excise Act and Customs Act in India, which laid down specific rules for valuation in case of transactions between related entities.

Conceptually, both the TP regime and the Customs regulations are designed to determine arm’s length price for transactions between related parties. However, the imperatives of the two regimes are different. While TP regime is a Special Anti-Avoidance Measure, the Custom Valuation Rules are designed to promote global trade with minimum barriers. OECD and World Customs Organisation (WCO) periodically hold summits to bring convergence between the two regimes.

Evolution of the Concept

The world has experienced fundamental changes in international business over the past few decades. Flow of goods and services across countries had increased manifold and there has been larger movement of capital and funds from one country to another. Various trade agreements and regulations under the aegis of GATT and WTO had reduced and removed the quantitative restrictions on movement of goods, services and funds across the countries. Entities not restricting their operations to home market, had expanded rapidly, turning into MNEs and transnational enterprises. 

With the growth in global trade, the price at which related parties sell their products, offer services, provide funds or conduct research and development – commonly referred to as TP - has become of interest to tax authorities. Dealings between the entities across international borders, led to issues of proper allocation of income, profits and expenses between the respective tax jurisdictions. The tax authorities of various countries provided mechanism by which they can ensure that they received fair share of the tax based on the economic value added by activities carried out in their country or involving use of assets, infrastructure and skill in that country. As 60% of the world trade is by MNEs and 50% of that is within business groups, TP came to occupy the centre stage of international taxation.

US took lead in introducing aggressive TP legislation backed by an efficient administrative machinery. In order to discourage MNEs to show higher profits in US and lower in their jurisdiction, other countries started introducing comprehensive TP legislation, regulations and administrative set-ups. Developing countries also became aware of the loss to their revenue caused by TP legislation. China also introduced a comprehensive TP system. Hence, in order to discourage the erosion of the tax bases by MNEs such legislations were introduced by many countries by 1990.

An overview of the increase in the number of countries with Transfer Pricing Regulations (TPR) by 2003-2004 is attached in Appendix A.

Origin of Transfer Pricing in India

The concept of TP was not new to India. The Indian Income-tax Act, 1922 had conceptual application of TP principles for the determination of income that would be arising from specified transactions.

In case of CIT vs Abdul Aziz Sahib (7 ITR 647 (Mad)), the Madras High Court estimated the income on the basis of average rate of profits made by other manufacturers and also considered the profits made by the taxpayer in earlier years. (Application of present concept of TNMM and Multi-year analysis)

The Supreme Court (SC) in the case of Anglo-French Textile Company Limited vs. CIT (25 ITR 27) held that there should be allocation of the income between various business operations of the taxpayer company, demarcating the income arising in the taxable territories and without taxable territories. The Court also upheld the apportionment of income between manufacturing and selling operations by holding that profits are not wholly made by act of sale and do not accrue, necessarily at the place of sale. (Significance of present concept of Functions Asset & Risk Analysis)

In the case of Mazagaon Dock Ltd v CIT, (34 ITR 368), the SC held that it would be business of the resident which would be chargeable to tax under the section 42(2) of the 1922 Act, and not the business of the non-resident. It was also held that dealings between the parties formed concerted and organized activities of a business character and the fact that the dealings were such as to yield no profit to non-resident companies, was held to be immaterial.

Section 42(2) of the Indian Income-tax Act, 1922 was replicated as Section 92 of the Indian Income-tax Act, 1961. The principle of dealing at arm’s length is laid down at many places in the Indian Income–tax Act, 1961 e.g.

S. 9(1)(i) - ‘Business connection’ in India and determination of income as is reasonably attributable to the operations in India

S. 40A(2)(b) - Dealings between ‘related persons’ and the ‘concept of fair market value’

S. 80 1A, S. 10A/10B - Close connection between two entities and ‘more than ordinary profits’

S. 92 - Close connection between resident and non-resident and transactions between them producing no profits or less than ordinary profits to resident

S. 93 - Avoidance of income tax by transactions resulting in the transfer of income to non-resident

Arm’s Length Principle

The evolution of the concept of TP had led to the development of internationally accepted Arm’s Length Principle (ALP). It covers cases where there have been undercharging in respect of sale of products and services or funds supplied or overcharging for the product or services or funds acquired, regardless of any resulting shortfall in the tax due to deliberate tax avoidance or merely due to adoption of incorrect pricing methods for taxation purposes. In considering the application of such adjustments, terms of relevant Double Taxation Avoidance Agreement (DTAA) must be looked into. Most such agreements contain their own provisions to deal with profit shifting arrangements in certain circumstances. These provisions similar to arm’s length TP provisions, are based on the same principle.

The ‘ALP’ as stated in Article 9(1) of the OECD model double taxation convention, provides as under:

“When conditions are made or imposed between associated enterprises in their commercial or financial relations which differ from those which would be made between independent enterprises, then any profits which would, but for those conditions, have accrued to one of the enterprises, but, by reason of those conditions have not so accrued may be included in the profits of that enterprise and taxed accordingly.”

The ALP was laid down on the basis of adjusting profits by reference to conditions which would have existed between independent parties under comparable circumstances. Application of the principles requires that the enterprise be treated as operating as a separate and independent entity. In setting the price to be charged, independent entities would have regard to the functions they are to perform, assets and skills to be used and the degree and nature of business and financial risks involved in the process of deriving the income.

Genesis of TP regulations

The Standing Committee in March 1999 observed that provisions of the Act were inadequate to curb TP among MNEs.

An Expert Group was constituted by the CBDT under Mr. Raj Narain, the then CBDT member, with one professional member in addition to other senior Revenue officers. An Expert Group was set up to bring an efficient TP system that should not only primarily protect the India tax base but also provide a reasonable method for allocating revenue to the concerned taxation jurisdictions.

The Expert Group had discussions with various stakeholders including professional associations, chambers of commerce and industry bodies. The Expert Group also made in-depth study of TP laws of various other countries and interacted with senior Revenue officers of other tax jurisdictions. It also deliberated various relevant issues with OECD. Various thought papers were published and knowledge-sharing sessions were held during the year 2000, some of which are referred here in Appendix B.

OECD Model of TP V. Formulary Apportionment V. Brazilian Model

During an interesting interaction with the Expert Group in the year 2000, along with Deloitte TP specialists from Asia Pacific, the aspect of whether India should follow the OECD TP model of or other options was discussed.

India’s major trading partners and foreign direct investors (US, UK, Germany, France, Japan and South Korea) follow ALP as enunciated by OECD. It was, therefore, advised that India should also follow a similar model as those countries, so as to minimise the administrative burden of documenting the transfer prices and make the process of resolving of TP disputes between countries, efficient.

One is aware of the revocation of the tax treaty between Brazil and Germany few years back due to the inconsistency of application of different TP models.

Recommendation of the Expert Group

After examining the existing provisions in Indian law, the Expert Group felt that Section 92 of the Income Tax Act, 1961 was required to be substituted by a more comprehensive legislation. It would require changes in both substantive as well as procedural laws. Arm’s Length Principle was proposed to be the foundation stone for examining the transfer price of international transactions with AEs.

The entire approach in suggesting various changes in laws and procedures was to safeguard the interest of the Revenue and at the same time to provide an efficient and friendly tax regime to foreign investors in India.

India also entered into agreements for DTAA with various countries. These treaties generally included specific Article(s) (generally Article 9) dealing with AEs. While Article 9 had fairly wide magnitude, its applicability in India was debatable because its effect was considerably diluted in terms of the provisions of then Section 92 of the Income Tax Act, 1961. A need was thus felt to incorporate into the Act, a specific chapter on TP. Also, with the increase in anti-dumping measures by various countries, principle of TP was assumed to be of greater importance.

The fact was that the erstwhile provisions of Section 92 was quite vague with terms such as “close connection” not being defined. Furthermore, no detailed methodology was also prescribed to compute what was considered as “ordinary profits”. This lack of overall clarity and fundamental change in international business led to the evolution of the “TP” regime in India.

The Government of India in order to have real time mechanism for testing of the related party transactions created a separate post of Directorate of International Tax to deal with the complex issues of TP. To ensure smooth implementation of TPR, the CBDT was taking assistance from OECD for training of tax officials as a capacity building measure.

Methodologies

The following methods have been prescribed for determination of the arm’s length price:

·        Comparable uncontrolled price method;

·        Resale price method;

·        Cost plus method;

·        Profit split method;

·        Transactional Net Margin Method;

·        Such other methods as may be prescribed (with effect from 1 April 2012).

Documentation

A set of extensive information and documents relating to IT undertaken is required to be maintained, on an annual basis.

 

It was also mandatory for all taxpayers, to obtain an independent accountant’s report in respect of all IT.

Penalty

Penalty provisions were introduced for failure to maintain the prescribed documentation or failure to furnish the prescribed report from an accountant as also for TP adjustments.

Though the penalties prescribed are substantially higher than other countries, in practice the provisions are more as deterrents rather than actual levies.

Assessment

A separate cell consisting of TP Officers (TPOs) was set up under the Director of Transfer Pricing for the purpose of determining the arm’s length price for taxpayers. The Assessing Officer was empowered to refer the determination of the arm’s length price for IT, to the TPO.

TP adjustment for any resulting shortfall in tax can be due to tax avoidance or merely due to adoption of an incorrect pricing method for taxation purposes. As experienced in other countries, the India TP regime has been maturing with learnings from various assessments leading to various alternative dispute resolution mechanisms and adoption of international best practices.

Dispute Resolution Mechanisms

In addition to the normal appeal process of CIT(A), considering the significant TP disputes, the Dispute Resolution Panel (DRP) was set up as an alternate dispute resolution mechanism.

Other Alternative Dispute Resolution was introduced in 2012 by way of the Advance Pricing Agreements scheme. TP disputes are also resolved under the Mutual Agreement Procedure, under the relevant article of the tax treaty between the two countries.

Safe Harbour regulations were also introduced in 2009 to reduce litigation and provide certainty to taxpayers while reducing the administrative burden.

The tax authorities are adopting enhanced approaches such as adoption of practices suggested under BEPS Action Plans, following a risk-based tax audit approach or a faceless assessment or appeal; these have further strengthened the TP mechanism. During the past few audit periods and outcomes from appeals before appellate forums, the Revenue has been adopting innovative ways to view a particular transaction and experiences from APA as well as CbCR have also boosted the tax policy framework. Tax authorities are also looking at capacity building by the use of technology, artificial intelligence and data analytics.

There have been a number of judicial opinions wherein TP disputes have been examined and crucial legal principles have evolved over these two decades.

What’s lies ahead?

The regulations on TP were clearly inevitable. While there can be no denial of the necessity of setting a framework for TP, it was always expected that TP in future would carry more tax exposure due to aggressive and sometimes conflicting positions of tax authorities of various countries. The documentation approach was also expected to produce reasonable results with minimal tax exposure, while dealing with TP assessments. TP was also expected to help in the proper evaluation of the performance of economic activities carried out by various affiliates and assist in managerial decision making.

Two decades since its introduction in India, the TP regime has evolved and matured significantly. India is also a very active member of G20 initiative under aegis of OECD on Base Erosion and Profit Shifting (BEPS). India has also introduced the three-tiered TP documentation approach as per BEPS Action Plan 13, and has also brought in other approaches from BEPS Action Plan, e.g., exchange of CbCR, concept on Development, Enhancement, Maintenance, Protection and Exploitation, Thin Capitalisation rules etc.

With BEPS-related regulations being implemented in India and worldwide, and with more information at the disposal of the tax authorities, tax authorities are expected to be extensively scrutinising MNE businesses. Taxpayers will likely need to have robust underlying documentation and ensure that their global TP policies are aligned to local TP policies in various jurisdictions.

The TP regime has evolved via a consultative manner right from its inception of the Expert Group in November 1999. In fact this led to a consultative approach amongst various stakeholders in other Direct Tax and Indirect Tax areas. Adherence to TP regime in India by all stakeholders – taxpayers, professionals and tax administrators in a collaborative manner will be helpful as India makes it contribution in the forthcoming decade, widely believed to favour Asia and to achieve its potential of becoming a US$ 5 trillion economy in the near future.

To summarise, while we have traversed 20 years of TP, it is time to think on how to improve its working and provide a basis that leads to its maturity. The inward FDI into India has increased from US $75 million in 1991 to US $42,285.68 million in 2018, registering an annual average growth rate of about 38%. With the government pushing the envelope further, we would soon see larger MNEs’ participation in India, which would certainly call for a modern transfer pricing regime, with global standards not only in law but also in practice.

 

Appendix A
 
Navigating MAP Procedure 
 
ALP in Cyberspace - Appendix B    
 
Reconciling Treaty with Domestic Law - Appendix B
 
Stress on TP Documentation - Appendix B
 
Transfer Pricing Rules - Appendix B

 

 

Introduction

Financial Year 2020-21 culminates two decades of Transfer Pricing regulations (“TP regulations”) in India. The detailed TP regulations were introduced in India vide Finance Act, 2001, by insertion of sections 92A to 92F in the Income Tax Act, 1961 (“the Act”) and since then, there has been constant evolution not only in the legislation but also in its practical application by key stakeholders such as appellate authorities, tax authorities, taxpayers and tax practitioners.

With maturity of legislation and application by stakeholders, functional analysis i.e. an analysis of functions performed, assets employed and risks assumed (FAR) analysis of related party transactions has emerged as the cornerstone for determination of arm’s length margin/ price.

Genesis and Concept of FAR Analysis

The concept of arm’s length principle in itself is not new and its origins can be found in the contract law which propounded for an equitable agreement that will stand up to legal scrutiny, even though the parties involved may have shared interests.[1] Over the years, arm’s length principle gained recognition in international taxation and was adopted by OECD and the UN model tax conventions as the basis for bilateral tax treaties. Article 9(1), while seeking to adjust profits between related parties in reference to the conditions between independent enterprises in comparable transactions and circumstances, established the concept of comparability analysis as the heart of the arm’s length principle.[2] In order to compare the conditions made or imposed between related parties with independent enterprises, accurate delineation of the transaction and for ascertaining the functions undertaken, assets utilised and the risks assumed by the transacting parties, a FAR analysis is required to be undertaken. The detailed TP guidance issued by OECD and UN also discussed several aspects with regard to the importance and applicability of FAR while undertaking comparability analysis.

 

With the advent of concept of arm’s length and comparability analysis in the international forum, the principle was also adopted by several countries as part of their domestic tax regulations. In the Indian context, prior to introduction of detailed TP regulations in 2001, the lone Section 92 of the Act, while proposed an arm’s length principle, but did not provide any detailed guidance with regard to undertaking a Transfer Pricing (TP) analysis. The Government of India, vide Finance Act, 2001 introduced detailed TP regulations, as enshrined under Section 92A to 92F (read with relevant rules).

In these detailed TP regulations as well, the importance of FAR analysis is deeply engraved as it forms the basis for the following key aspects of an arm’s length analysis:

·       Selection of the most appropriate method- Each of the TP methods prescribed[3] have certain attributes associated with them which make them more suited for a particular fact pattern. FAR analysis helps in identifying such attributes which are then used for selecting the most appropriate method.

·       Selection of the tested party – For application of any one-sided TP methods (i.e. Cost Plus Method, Resale Price Method or Transactional Net Margin Method) one of the transacting party is selected as the tested party. Generally, such tested party is the least complex entity in relation to the transaction, which undertakes simple operations, does not own unique intangibles and its financial data is easily available for undertaking an accurate arm’s length analysis.[4]

·       Selection of independent comparable companies/ transactions – A detailed FAR analysis of an accurately delineated transaction also helps in identifying key comparability factors that need to be evaluated while selecting independent comparable companies/ transactions.[5]

·       Ascertaining if any economic adjustment is required to be undertaken– While FAR analysis forms the basis of evaluating the appropriateness of selecting independent comparables/ transactions, it also becomes relevant for identifying the need for undertaking any economic adjustments (such as working capital, risk, capacity adjustments, etc.). Such adjustments are required to be undertaken to eliminate the impact of any differences between the tested party and the comparable companies/ transactions and thus helps in improving comparability.[6]

A detailed FAR analysis is also required to be documented by all taxpayers as part of annual compliance documentation (“TP Documentation”) along with comparability analysis undertaken to demonstrate the arm’s length nature of related party transactions.[7] Considering the above, it can be seen that FAR analysis forms the basis of several important aspects of an arm’s length analysis.

Having discussed FAR as a concept and its relevance, let us now look at application of FAR during TP audits. 

FAR and TP audits

TP documentation maintained by taxpayers, capturing the FAR and arm’s length analysis, is one of the key documents requested by Transfer Pricing Officers (“TPOs”) during TP audits. It provides the contemporaneous analysis undertaken by the taxpayer for establishing the arm’s length nature of related party transactions.

The approach of TPOs, while evaluating the said TP documentation, has also evolved over the years. During the initial cycles of TP audits, due to lack of sufficient resources (in terms of technical knowledge, experience, tools, manpower, etc.) with the TPOs, the primary focus was on superficial/ quantitative issues of comparability and arm’s length analysis. Such issues included:

·       Use of single versus multiple year data – As a thumb rule, the use of multiple year data by taxpayers was rejected by TPOs, without appreciating whether business cycles actually have an impact on the functional profile, business activities and the results earned by the comparable companies.

·       Selection of TP method – In several cases, for instance, involving distributors, the gross level analysis undertaken by taxpayers (under Resale Price Method/ Cost Plus Methods) was rejected by the TPOs in favor of net level testing, while ignoring that specific attributes of the taxpayers’ operations warranted a gross level testing.

·       Classification of income/ expenses as operating or non-operating, etc. – Often TPOs arbitrarily treated certain items of income/ expenses as operating/ non-operating (for example foreign exchange gain/ loss) without appreciating the functions undertaken and risks assumed by the taxpayer and the understanding between the parties as borne out by their conduct with regard to such expenses / income.

·       Arbitrary classification of taxpayers’ operations as high-level/ complex – In certain cases, routine operations of taxpayers were arbitrarily classified as high-level/ complex functions, without appreciating the level of contribution made by the taxpayer in the overall value chain of the group.

While the TPOs focused on quantitative aspects, there was less focus on functional attributes of the taxpayers and corresponding issues emanating from them. This led to a large number of TP adjustments being proposed, without taking into cognizance the specific facts and circumstances of the taxpayers. More often than not, these specific facts and circumstances, which had been documented by taxpayers as part of their FAR analysis, were appreciated by higher appellate authorities, thereby resulting in deletion of adjustments proposed.

Despite the quantitative approach adopted by on-ground officers, the higher appellate authorities appreciated the importance of a FAR analysis early on in the journey of TP regulations in India. The importance of a robust FAR analysis was established in the landmark case of Mentor Graphics[8] wherein it was held that selection of comparables is to be made considering the specific characteristics of the controlled transaction, functions performed and assets deployed (including intangibles) rather than just a broad comparison of category of activity undertaken.

With time, as more guidance[9] and technical tools were available to the TPOs, a shift was seen towards a more qualitative approach. As part of such approach, the TPOs also started appreciating the importance of aligning any TP adjustment to the case specific facts and FAR profile of the taxpayer. In fact, in several cases it was seen that TPOs also supplemented the FAR analysis undertaken by the taxpayers further, with additional information that is available in the public domain, as follows:

·       Evaluating functions performed by key personnel of the taxpayers – Rather than placing reliance only on the documented FAR analysis, the TPOs in certain cases interviewed key personnel of the taxpayer to understand their roles and responsibilities and to understand the contribution of the taxpayer in the overall value chain. They also conducted internet searches on public platforms such as LinkedIn to gather details of such personnel regarding educational qualifications, experience, job profiles, etc. This was observed in the case of GE Energy,[10] wherein despite taxpayer’s documented submission that their the liaison office in India was only engaged in communication channel activities, the tax authorities summoned several key personnel of the taxpayer and perused their LinkedIn profiles to evaluate their roles and responsibilities and ascertain their contribution in the overall value chain. Based on the statements of employees and analysis of documents, the tax authorities alleged that the liaison office constituted a Permanent Establishment in India as it was engaged in rendering services to overseas group entities and thus, the income attributable to such Permanent Establishment was taxable in India. These LinkedIn Profiles were subsequently admitted and accepted by the higher authorities as additional evidence.  

·       Evaluating contribution by taxpayer in overall value chain – In a few cases, the TPOs evaluated the contribution made by the taxpayer to patents / technology/ IP developed and registered in the name of overseas related parties by analysing patent filings and other regulatory documents available in the public domain. Such an approach is also evident from certain Tribunal[11] rulings, wherein based on patent filings with the name of Indian employees available in the public domain, the tax authorities re-characterised routine software development functions performed by the taxpayer as high-end contract research and development services. This was in complete contradiction to the FAR profile documented by the taxpayer, which involved rendering of routine software development services in the nature of testing and coding services.

It can be seen that with the evolving TP landscape, an approach which considers both quantitative and qualitative aspects of the taxpayer is being adopted by the tax authorities. The tax authorities are also learning from detailed FAR analysis, experiences gained under the Advanced Pricing Agreement (APA) programme. With such an approach, complex issues are being identified and litigated upon, these include marketing intangibles, location saving, applicability of complex methods such as profit split method, etc. The genesis of such issues is linked to the functions performed and the contribution made by the taxpayer to the overall value chain of an MNE group. In cases where the taxpayer had undertaken a detailed FAR, backed up by contemporaneous documentary evidences, and an appropriate arm’s length analysis based on such FAR, the appellate authorities are more inclined to accept the same. However, in cases where a detailed FAR was not provided or the FAR did not seem to correspond to the actual conduct, the appellate authorities either reject the taxpayer’s contentions or remand the matter back to the lower authorities for accurate determination of FAR.

With the enhanced skillset and experience, Indian tax authorities are catching up to the global standards of TP. However, there still seems to be a long road ahead with the global landscape evolving regularly. In this regard, key global developments on account of FAR analysis which would have an impact on how the same is viewed by tax authorities, are discussed below:

Global developments

Aligning Returns to Value Creation

The OECD under Actions 8-10, of G-20 BEPS[12] initiative, proposed valuable guidance to ensure that allocation of profits is aligned to value creation by the respective transacting parties. The above guidance placed greater emphasis on actual conduct of the parties instead of merely relying on the contractual terms agreed between them. This approach provided for a more granular FAR analysis, based on actual conduct, decision making and capacity to control and bear risks by the transacting parties instead of placing reliance on inter-company agreements.

Three Tiered Documentation - Enhanced Focus on Transparency

The OECD under the BEPS initiative also identified transparency of information as one of the key measures to tackle BEPS. Accordingly, under Action 13, of G-20 BEPS initiative, the OECD proposed a three-tiered documentation structure consisting of Local File, Master File and a Country-by-Country report.

Given that the three-tiered documentation structure requires taxpayers to provide information regarding global supply chain, key value drivers of the business, intangibles and R&D related contributions, etc., it is no longer sufficient to undertake an isolated FAR analysis for a transaction. Instead, it is important to undertake a detailed Value Chain Analysis of the entire group to understand how value is created by the MNE and to analyse if allocation of profits is in line with the contribution made by the taxpayer towards such value creation.

Digital Economy- From FAR to FARM

One of the key thrusts of OECD under the BEPS initiative was to identify and evaluate cases of digitally enabled MNEs which may have a significant market presence in a particular jurisdiction and may engage with the user base without even having a legal/ physical presence in that jurisdiction. In this regard, the OECD identified that apart from a FAR analysis, relevant importance is also required to be given to contribution made by the underlying market (M). This led to a further evolved variant of the FAR analysis into a FAR(M) analysis, which not only required a detailed FAR analysis but also an in-depth analysis of the MNE group’s engagement with the market and the contribution made by users of such market towards value creation. The recently released Pillar One blueprint by OECD also acknowledges the importance of both FAR to ascertain “material and sustained contributions” by entities to group’s residual profits and of a market linked analysis, while allocating tax liability to entities having “market connection” to eliminate double taxation.

Conclusion

The journey of TP regulations in India has been of evolution. While the Indian TP landscape has evolved and certainly matured, it is still catching up to the fast evolving global landscape. It would be interesting to see how the next decade turns out for TP, especially considering the recently introduced provisions for risk-based and faceless assessment. It is expected that the relative importance of a well-documented FAR analysis would grow manifold with a central team being constituted for selection and evaluation of complex cases for scrutiny and with limited face-to-face interaction with TPOs.

 

Almost two decades after the introduction of transfer pricing (TP) regulations in 2001, the Indian TP space has evolved immensely. Working capital adjustment, although a mature concept now, has passed under the lenses of all stakeholders in TP and has developed over the years in India. While working capital adjustment to an arm’s length price has always remained important, its significance and impact in TP has been acknowledged gradually over the years.

Background

The cornerstone of transfer pricing provisions is to determine/ arrive at appropriate arm’s length price/ margin (“ALP”) for intra-group transactions.

Indian regulations specify six methods that can be applied to determine the ALP. All of these methods, except for the CUP (comparable uncontrolled price) and other method, involve comparison with comparable uncontrolled companies (herein referred as ‘comparables’), wherein the profit margins of these companies determine the applicable arm’s length margin range (normally referred to as transaction profit methods).

The ALP determination, based on comparability methods, often requires economic adjustments to consider business realities of comparable companies, as the selected comparables may belong to varied economic conditions and there may be different set of economic arrangements and policies vis-à-vis the tested party (typically the taxpayer).

Therefore, with an intention to enhance the comparability analysis, rule 10B(3) of the Indian Income Tax (I-T) Rules, 1962, in line with international practices, allows for economic adjustments / comparability adjustments to adjust for the differences (if any) between the tested party vis-à-vis the comparables. Further, Chapter III of the revised transfer pricing guidelines issued by the Organization for Economic Co-operation and Development (OECD), 2017 and United Nations Practice Manual on Transfer Pricing for Developing countries, 2017 (UN Manual) also recommends comparability adjustments, if (and only if) they are expected to increase the reliability of the results.

One of the most carried out comparability adjustment in transfer pricing is working capital adjustment.

What is working capital adjustment and why is it important in TP?

Working capital adjustment is an adjustment for the opportunity cost of capital for investments made in working capital (i.e. inventories, accounts receivable/debtors and accounts payable/creditors) of a taxpayer. It is undertaken when a taxpayer or the tested party exhibits different working capital intensities relative to a set of comparable companies.

Working capital adjustments seek to adjust for differences in time value of money between tested parties and potential comparables as the difference should be reflected in profits because high levels of working capital create costs either in the form of incurred interest or through opportunity costs.

Practical example

I Co Private Limited (ICo) is a wholly owned subsidiary of a Multi-National Enterprise (MNE) which is headquartered in UK. ICo primarily functions as a captive unit in India and is engaged in rendering routine software development services only to its parent entity (and no other entity) and operates on a remuneration model of total cost (direct plus indirect cost) plus a mark-up of 17%.

The ICo receives its remuneration from its parent company, on an average, in 60 days. ICo takes on an average, 120 days to pay its creditors. Thus, it can be seen that the average payment period of ICo is greater than its average debtors’ collection period, thereby giving it a negative working capital requirement position.

On the other hand, the average receivable period of uncontrolled comparables which are engaged in rendering similar software development services, has been found to be 90 days whereas their average creditors payment period is 60 days.

Thus, it can be seen that the comparables are carrying a relatively high working capital position as compared to ICo as the said comparables are allowing their customers a relatively longer period to pay their accounts while they are paying their creditors in a relatively lesser time frame.

Therefore, it can be deciphered that the working capital cycle of ICo is less aggressive and shorter vis-à-vis comparables and as a result, the comparables would be making higher sales revenue to account for the cost of borrowed capital. As a result, the comparables would be earning high operating profit margins compared to ICo.

Taxpayers, such as captive service providers or contract manufacturers, who principally operate on a cost plus mark-up remuneration based model, or a limited risk distributor who principally earns an assured return on sales, are typically in a position to receive advances for services to be provided in future, thereby having lower working capital position vis-à-vis comparables. On the other hand, comparable companies are typically unlikely to receive such advances and hence in such cases they tend to account for it in the form of higher sales price which eventually leads to higher operating profit results of comparables, when the comparison is drawn. Therefore, adjustments have to be made to make the transactions comparable.

In other words, no profit maximising/entrepreneurial company would hold working capital without an additional return as working capital yields a return resulting from a) higher sales price or b) lower cost of goods sold which would have a positive impact on the operating profit margin.

Thus, the principal objective of working capital adjustment is to eliminate interest element embedded in sales and cost of goods sold.

In practice, the working capital adjustment is usually done when applying a transactional net margin method (“TNMM”), although it could also be applicable in cost plus or resale price methods.

Global acceptability

Chapters I and III of the OECD Transfer Pricing Guidelines for MNEs and Tax Administrations 2017 (herein referred as ‘OECD TP guidelines’) contain extensive guidance on comparability analyses for transfer pricing purposes. The annexure to Chapter III of the OECD TP guidelines discusses the need and process of performing working capital adjustment.

According to the United Nations Transfer Pricing (UNTP) Manual, comparability adjustments can be divided into the following three broad categories:

  - Accounting adjustments

  -  Balance sheet/working capital adjustments

  - Other adjustments

The most important amongst them is balance sheet /Working Capital Adjustments. Balance sheet adjustments are intended to account for different levels of inventories, receivables, payables, interest rates etc. The most common balance sheet adjustments made to reflect different levels of accounts receivable, account payable and inventory are known as working capital adjustments.

Working capital adjustment in India – journey so far

In many cases, Transfer Pricing officers did not accept the rationale for applying working capital adjustment. The different arguments provided by TPOs can be summarised into the following buckets:

·   The analysis provided by the taxpayer did not demonstrate that an adjustment for working capital differences has improved comparability in the said case;

·   TNMM method allows broad flexibility tolerance in the selection of comparables and hence no further adjustment is required;

·   The adjustment does not significantly impact the average margins being earned by the comparable companies

Additionally, for service providers, tax authorities were of the view that the issue of difference in working capital was more pertinent for manufacturers or distributors where inventories are tied up, unlike in case of service providers who start working on projects only after a contract is awarded.

All these observations led to a more detailed and nuanced analysis, wherein the need and benefits arising from the economic adjustments from working capital adjustment were explained and discussed. The litigation around such adjustment was also the result of other factors such as:

·       Absence of specific provision allowing working capital adjustment: Rule 10B of Income Tax Rules, 1962, which deals with determination of arm’s length price under section 92C, permits comparability adjustments. However unlike OECD, there has been no specific provision or rule under Indian Income Tax Act or Rules discussing or describing working capital adjustments and how to perform them.

·       No common formula suggested under law: There was no guidance in law on the appropriate formula to be adopted

Some factual and methodology related aspects on this topic started getting settled through decisions by Hon’ble ITAT in several cases. 

In these rulings, the ITAT held that an adjustment needs to be made to the margins of comparable companies to eliminate differences on account of different functions, assets and risks. More specifically, the adjustment needs to be made for (a) differences in risk profiles, (b) differences in working capital position and (c) differences in accounting policies. Thus, conducting a working capital adjustment in a competitive environment is important and relevant to improve comparability. As on date, there are numerous decisions of Tribunal allowing working capital adjustment. However, in some rulings, working capital adjustment has also been denied stating that the onus of proof is on taxpayer to demonstrate the such adjustment is necessary and improves comparability.

It is also settled by numerous decisions that working capital adjustment are also to be provided for service industry.

There have been instances, when in case of captive service providers, the department has made negative working capital adjustment to the detriment of the taxpayer. There is plethora of judgements which hold that negative working capital adjustments are not warranted in case of captive service providers with no working capital risk.

Following this evolution through domestic jurisprudence, in the current environment, Indian taxpayers as well as tax authorities follow the formula prescribed by OECD guidelines for carrying out working capital adjustments.

A snapshot of the process of computing working capital adjustment as per OECD is given below:

Working capital adjustment	Reference	Financial Year 1
Tested party’s (R+I-P)/Sales	[A]	26%
Comparables’ (R+I-P)/Sales	[B]	30%
Difference	[C=A-B]	4%
Interest rate	[E]	10%
Adjustment	[F=C*E]	0.40%
Comparables’ OP/Sales (%)	[G]	1.32%
Working capital adjusted OP/Sales for comparables	[H=G+F]	0.92%

R = Receivables; I = Inventory; P = Payables; OP = Operating Profit

Working capital adjustment and the TP litigation on inter-company receivables

Over the last few years, tax authorities have been consistently taking the stand that an overdue balance receivable by an Indian enterprise from its overseas AE is akin to interest free loan advanced by the Indian entity to its overseas AE.

After being litigated for several years, the question whether inter-company receivables is to be treated as a separate  international transaction or not, was addressed by way of a retrospective amendment (w.e.f. April 2002) by the Ministry of Finance vide the Finance Act 2012, wherein the amendment was made to the definition of ‘international transaction’, to include “capital financing, including any type of long-term or short-term borrowing, lending or guarantee, purchase or sale of marketable securities or any type of advance, payments or deferred payment or receivable or any other debt arising during the course of business”.

Tax authorities claim that by carrying high accounts receivable, a company is allowing its AEs a relatively longer period to settle their accounts. It would need to borrow money to fund the credit terms and/or suffer a reduction in the amount of cash surplus which would have been otherwise available for investment. In this case, tax authorities consider any amount outstanding for more than a normative period, generally 30 days, as being in the nature of a loan arrangement and impute a notional interest on such outstanding amounts.

However, most taxpayers have claimed that outstanding debtor balances are not a separate transaction and arise out of primary transaction of sales and/ or service income. Taxpayers have also considered that even if the debtors are considered as separate transaction, the benchmarking should be an integrated analysis as the transactions are interrelated. Therefore, under a TNMM (or RPM or CPM) analysis, the working capital adjustment addresses the concern of benchmarking inter-company receivables. The taxpayers claim that if after performing working capital adjustment, the margin of tested party is more than the adjusted margin of comparable companies, it can be concluded that the prices charged by the taxpayer includes an embedded interest element to reflect the extended credit terms.

In various rulings, this approach of working capital adjustment has been accepted as a reliable measure to substantiate the arm’s length nature of inter-company receivables. The Delhi Tribunal^[1] held that the impact of delayed receivables from AEs are subsumed in working capital adjustments made by the taxpayer. This decision of ITAT was also confirmed by the Delhi High court.[2] It may be noted that the concept of embedded interest element in profits, on account of credit/payment period, has been accepted in APAs also, wherein the agreed arm’s length profit margin may vary, per agreed credit period.

Further in case of a debt-free company, the Delhi Tribunal[3], held that no adjustment can be made in respect of notional interest on outstanding receivable. The above decision has further been affirmed by the Hon’ble Delhi High Court[4].

Important aspects to be kept in mind

Average or year-end balances: A key issue in making working capital adjustments is the time when the receivables, inventory and payables are compared between the tested party and the comparables. Averages might be used if they better reflect the level of working capital over the year. There are judgements which have held that insisting on daily balances of working capital to compute working capital adjustment is not proper as it will be impossible to carry out such exercise and that working capital adjustment has to be based on the opening and closing working capital deployed. Further, with the introduction of concept of weighted average and multiple year analysis in Indian Transfer Pricing Regulations, the weighted average of three years of each item i.e. receivable, inventory and payable may be computed for comparable companies vis-à-vis current year data of tested party, in the similar manner as prescribed for comparison of unadjusted weighted average margins.

Interest rate: Another major issue in making working capital adjustments involves the selection of the appropriate interest rate (or rates) to use. The rate (or rates) should generally be determined by reference to the rate(s) of interest applicable to a commercial enterprise operating in the same market as the tested party. In most cases, a commercial loan rate will be appropriate. In India, in our experience, the tax authorities generally prescribe SBI[5] base rate or prime lending rate or MCLR^[6] as on June 30 of the relevant year. It may be noted that while APA[7] authorities do not provide for working capital adjustment. However they generally allow a credit period (period is based on case to case) and thereafter prescribe an interest rate on overdue receivables, which is generally 6 months LIBOR or PLR of the currency in which the billing is done, plus 300 to 400 basis points; the Delhi High Court[8] has upheld the direction given by the ITAT[9] of not using the prime lending rate considering the taxpayer was receiving only in foreign currency.

Other current assets/liabilities: Another question that arises is what to include for the purpose of calculating receivables and payables for working capital. Apart from sundry debtors and sundry creditors, there are other current assets and liabilities items in the balance sheet such as advance from customers, advance to suppliers, etc. which are also considered for calculation of working capital.   

Conclusion

Based on the above, it can be said that finding a perfect comparable for benchmarking purposes, i.e. having a FAR profile similar to the taxpayer, is a daunting task as no two independent entities are exactly similar in today’s perfect competition. Hence, working capital adjustment is necessitated for the purposes of improvement of comparability, wherever required. In India, judicial principles have provided clarity on some key aspects on working capital adjustment and this has been helpful in reducing disputes between taxpayers and tax authorities over time.

 

 

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Background

In today’s ever transforming and competitive world environment, companies have to carve out a niche in the marketplace to remain competitive and stand out as differentiators. The world economy has moved towards globalisation and digitalisation. The key value drivers of a business today include digital assets, brand/trademark, technical knowhow, etc. All these may include, inter alia, what are commonly referred to as “intangible assets”.

Definition of intangibles under Indian TP law

Section 92B (1) of the Indian Income Tax Act 1961 provides the definition of an international transaction as a transaction between two or more associated enterprises (AEs), 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.

A specific reference to intangible property was provided in this clause to include within the ambit of Indian TP regulations.

The Finance Act 2012, further amended section 92B wherein an explanation was added and specific inclusions to the definition of “international transactions” were provided. In addition to other inclusions it specifically provided that “the purchase, sale, transfer, lease or use of intangible property, including the transfer of ownership or the provision of use of rights regarding land use, copyrights, patents, trademarks, licences, franchises, customer list, marketing channel, brand, commercial secret, know-how, industrial property right, exterior design or practical and new design or any other business or commercial rights of similar nature” would be covered under the scope of an international transaction. Further, it was also categorically provided that the intangible property would include intangibles related to marketing, technology, artistic, data processing, engineering, customer, contract, human capital, location, goodwill, methods, procedures, customers lists, technical data and any other item that derives its value from intellectual content. It is also interesting to note here that these clarifications were brought in as a retrospective amendment.  

Transfer Pricing and intangibles

Transfer pricing of intangibles is a vexed issue that has not only perturbed taxpayers but has also caught the attention of tax authorities. Discussions have revolved around what should be the arm’s length remuneration that a legal owner of an intangible be provided; what arm’s length remuneration that other group entities to which functions relating to development, enhancement, maintenance, protection and exploitation (DEMPE functions) of intangibles have been outsourced by the legal owner, should be allocated and taxed in the their relevant jurisdictions? Like in other situations, tax authorities are keen to see that transactions related to intangibles are structured between AEs such that they are reflective of an arm’s length scenario as exists between uncontrolled independent enterprises.

What is important here is to accurately delineate the transactions related to intangibles and understand the following aspects prior to undertaking an economic analysis for any transaction pertaining to intangibles:

• Identification of the legal owner of the intangibles
• Identification of the relevant entity/entities of the MNC Group which have contributed to the development of the intangibles,
• Identification of the entity/entities which have exploited those intangibles and to what extent,
• Distinction between legal owner and the economic owner,
• Which entity/ jurisdiction should actually be allocated the profits/ losses arising out of the commercial exploitation of the intangibles?

Definition of intangibles in OECD

In order to address TP issues related to intangibles, the Organization for Economic Cooperation and Development (OECD) released Base Erosion and Profit Shifting (BEPS) Action Plan (AP) 8-10 titled “Aligning Transfer pricing outcomes to value creation” in October 2015. The principles suggested in the BEPS AP 8-10 are reflected and were confirmed in the 2017 edition of OECD TP guidelines.

This guidance broadly deals with explanations to ensure that the profits and returns generated by valuable intangibles be allocated to the economic activities that result in value creation.

A broad and clearly delineated definition of intangibles has been adopted in BEPS AP 8-10 and correspondingly in Chapter VI of the OECD 2017 (Para 6.6) and provides that “the word “intangible” is intended to address something which is not a physical asset or a financial asset, which is capable of being owned or controlled for use in commercial activities, and whose use or transfer would be compensated had it occurred in a transaction between independent parties in comparable circumstances.” An illustrative list of intangibles has been provided in para 6.18 to 6.27 which includes patents, know-how and trade secrets, trademark, trade names and brands, rights under contracts and government licenses, licenses and similar limited rights in intangibles, goodwill and ongoing concern value. It has also been provided in para 6.30 and 6.31 that group synergies, market specific characteristics are not considered as intangibles for TP purposes since these are not capable of being owned or controlled but can be value drivers for a business. The guidance suggests that these factors may instead be considered as the basis for making any TP adjustments during a comparability analysis.  

For the purpose of TP analysis, the identification of an intangible cannot solely be determined by its characterisation by the taxpayer or for any legal/ accounting purpose but has to satisfy the conditions mentioned in the OECD definition. An item may not be an intangible from tax/ accounting purpose but may be an intangible from a TP perspective and hence may require detailed examination and TP analysis. A common example is where research and development (R&D) expenditure may be expensed in the P/ L account and not capitalised for accounting purposes and hence the intangibles may not be reflected in the accounting books. However, the investment made by a company in R&D may create significant economic value for the group and therefore the contribution of the entity undertaking R&D functions to group profits may need an evaluation from a TP perspective. In other words, from a TP perspective, evaluation would be required whether the entity can be considered to contributing to enhancing the value of intangibles by undertaking DEMPE functions (in as much as it may also have the capacity to make decisions and assume risks arising out of the DEMPE functions). This analysis will then enable evaluation of the appropriate transfer pricing method that should be applied in such transactions e.g. whether Profit Split Method (PSM) needs to be applied or whether a differentiated mark-up on costs of services can be considered.

Circular 6/2013: Precursor to DEMPE

The Central Board of direct taxes (CBDT) in India had issued a circular no. 6 which gave a preview into the concept of DEMPE functions in 2013. This was much before the OECD formally issued its guidance on DEMPE. The said circular classified the R&D centres of the foreign groups in India into three broad categories i.e. entrepreneurs, joint developers and risk insulated contract R&D centres. This was done basis the functions, assets and risks of the centres established in India. The circular, inter alia, laid down certain guidelines for characterising the development centre as a contract R&D service provider with insignificant risks. These guidelines primarily focused on identification of the economically significant functions and consequently identification of the party that is engaged in their performance i.e. the Indian centre or foreign entities. The circular also included examples of the economically significant functions that are to be identified such as conceptualization and design of the product, providing the strategic direction and framework, etc. The guidelines also provided that the actual functions carried out and the actual conduct of parties be considered over and above the contractual arrangement. Hence, as can be seen from the above, Indian TP authorities had sought to provide a framework on the classification of the Indian R&D centres based on performance of economically significant functions, bearing of risks and providing of funding/ capital/ assets prior to the DEMPE framework announced by the OECD. Further, while the CBDT circular focuses on R&D centres of MNEs in India, DMEPE is a concept that has wider application as has also been analysed and explained in OECD.   

Concept and importance of DEMPE

The concept of DEMPE was introduced by BEPS AP 8-10. DEMPE provides that (Para 6.32) the entities of the MNC Group that contribute to the functions related to the development, enhancement, maintenance, protection and exploitation of the intangibles of the Group (which have been identified with specificity), owned assets and assumed risks in relation to the intangibles, should be compensated for their contribution to the DEMPE functions on an arm’s length basis (over and above other routine functions performed by them), post remunerating other group entities for activities performed. This guidance also clearly supports the concept of substance over form, by focusing and remunerating based on the actual functions carried out and risks undertaken, rather than being guided only by the terms of inter-company contracts.

The OECD provided guidance on the important functions that can be considered as value adding functions, since they contribute to intangibles and need to be identified and analysed for DEMPE. These include design/ control of research and marketing programmes, controlling the strategic decisions regarding intangible development programs, management and control of budgets, important decisions regarding defense and protection of intangibles, etc.  

OECD guidelines 2017 (Para 6.34) has laid down a six-step framework for analyzing the transactions involving intangibles and to determine the arm’s length price for related transactions. These are as under:

1. Identify the intangibles used or transferred in the transaction with specificity;
2. Identify the full contractual arrangements, with special emphasis on determining legal ownership of intangibles based on the terms and conditions of legal arrangements;
3. Identify the parties performing functions  using assets, and managing risks related to DEMPE of the intangibles by means of the functional analysis;
4. Confirm the consistency between the terms of the relevant contractual arrangements and the conduct of the parties;
5. Delineate the actual controlled transactions related to the DEMPE of intangibles in light of the legal ownership of the intangibles, the other relevant contractual relations under relevant registrations and contracts, and the conduct of the parties, including their relevant contributions of functions, assets and risks;
6. Where possible, determine arm’s length prices for these transactions consistent with each party’s contributions of functions performed, assets used, and risks assumed.

We know that conducting a robust Functional, Asset and Risk (FAR) analysis is the building stone of any economic and arm’s length analysis. OCED guidelines 2017 also emphasised on conducting and analysing detailed FAR analysis with a focus on DEMPE functions, to understand the value addition functions undertaken by each entity of the MNC Group. It has also been provided that it is not sufficient to go by contractual terms and arrangements agreed/ documented between AEs, but it is critical to accurately delineate the actual transaction to understand actual conduct of the parties to conclude on actual functions undertaken.

An important takeaway here is that in addition to the risks assumed by the parties in relation to the DEMPE functions, the control over the risks and the financial capacity to assume the risks in relation to the DEMPE functions, is also significant. Herein, right of decision making with respect to the intangible and financial capacity to bear the consequences of the loss arising out of said decisions, is required to be analysed.

The crux of the discussion is that if the legal owner of the intangibles does not contribute to the value addition functions in relation to intangibles, then should it be provided residual returns arising from the exploitation of the intangibles? Per this guidance, the group entities that actually undertake the DEMPE functions and assume and control the related risks, should be allocated a fair proportion of the residual returns attained by exploitation of the intangible assets. 

An example of TP model of a limited risk distributors (LRDs) is worth a mention here. In case of a LRD model, the principal bears the majority risks of the business and the LRD is compensated basis an assured return on the limited functions carried out by it. Herein, a detailed analysis may be required on the functions carried out by the LRD because if it shows that a LRD is contributing significantly to any of the value drivers of the business for e.g. developing customer lists, marketing, etc. then a question may arise if a return higher than its limited functions should be provided to it.     

TP methods

The OECD has also provided guidance on the selection of the appropriate TP method for economic analysis pertaining to transactions involving intangibles. Herein, it has stated that one-sided methods including the Resale Price Method (RPM) and the Transactional Net Margin Method (TNMM) are generally not reliable methods for directly determining the arm’s length price for contributions to intangibles as they usually allocate all residual profit to the owner of intangibles, after providing a limited return to those performing the relevant functions. Given the unique nature of the intangibles, OECD supports the use of Comparable Uncontrolled Price (CUP) method, transactional profit split method (PSM), such as valuation-based methods (e.g. discounted cash flow technique) depending on facts and circumstances of the case and availability of information.  

UN manual perspective

The guidance on intangibles as provided by the OECD is also supported by the guidance provided by the United Nations (UN) Practice Manual on TP (2017). The basic principles guiding intangibles including concept and identification of intangibles, comparability factors to be considered, identification of important DEMPE functions, etc. as are contained in the OECD are further supplemented with appropriate illustrations in the UN manual.

HTVI – definition and determination of ALP

BEPS AP 8/ OECD 2017 has also introduced a concept of Hard-to-value intangibles (HTVI). Para 6.189 of the OECD 2017 defines HTVI as “intangibles or rights in intangibles for which, at the time of their transfer between associated enterprises, (i) no reliable comparables exist, and (ii) at the time the transactions was entered into, the projections of future cash flows or income expected to be derived from the transferred intangible, or the assumptions used in valuing the intangible are highly uncertain, making it difficult to predict the level of ultimate success of the intangible at the time of the transfer.”

The valuation of the HTVI is highly ambiguous since an accurate comparable uncontrolled transaction (CUT) is not available and a valuation on the basis of financial projections would be required, however, the probability of ultimate success/ failure of HTVI is unpredictable at the time of its transfer. Therefore valuation of HTVIs will necessarily be in the nature of an “Ex-ante” analysis.  

In the present case, there may be significant differences between ex-ante and ex-post analysis arising out of a situation of unavoidable information asymmetry between taxpayers and tax authorities. The tax authorities, using information which can only be available after the event has occurred, may challenge the assumptions used by the taxpayer for determination of the arm’s length price of the HTVI at the time of its transfer. Typically, the OECD guidance is that if there are significant differences between ex-ante projections and ex-post outcome of the intangibles, and if the differences cannot be reliably explained by the taxpayer, then the tax authorities can challenge the arm’s length price determined by the AEs at the time of the transaction and also make a TP adjustment. However, given the unique nature of HTVIs, certain additional guidance on exemptions have been provided to the stakeholders:

• Situations wherein the taxpayers are able to substantiate with sufficient documentary evidence that the differences between the projections and the actual outcomes is due to enforceable events which are beyond control and could not be anticipated at the time of the transaction;
• Transaction is covered by Bilateral/ multilateral APA;
• Difference between ex-ante projections and ex-post outcomes does not result in increase or decrease in compensation by 20 percent;
• Difference between ex-ante projections and ex-post outcomes are not greater than 20 percent of the projections during commercialisation period.

Way forward and point of focus for taxpayers

With the introduction of 3-tier documentation under the BEPS regime, tax authorities have access to particulars such as details of global transactions, TP policy framework and distribution of economic substance. The master file also contains specific details related to intangibles such as the description of the overall strategy of the Group for development, ownership and exploitation of intangible property and the details of the entities engaged in these functions, legal ownership details, details of important agreements related to intangible property, etc. 

Therefore, it can be expected that tax authorities may also focus more on the role of intangibles in the MNE group, including aspects like:

1. Important risks and functions being undertaken and performed by each group entity
2. The contributions made by different entities of the group to value creation, with an objective to bifurcate DEMPE functions
3. Whether the form of the inter-company agreement is in sync with the  actual conduct of the related parties?

Taxpayers have also recognised the increasing focus on TP aspects of intangibles and there is greater emphasis on delineating DEMPE functions and entities performing the DEPME functions and updating the TP policy as well as the inter-company agreements. As intangibles drive profits and questions around allocation of those profits, MNCs would need to maintain continued focus on regularly updating their TP analysis and documentation.

COVID-19 pandemic has resulted in a global economic downturn, impacting not only the demand side but also disrupting the supply chain — global as well as domestic. This has spurred stakeholders in the value chain, ranging from consumers, retailers, distributors, manufacturers to governmental agencies, to reconsider their operations and make requisite changes. While the impact of such changes is visible in the short run, this article attempts to evaluate key trends and aspects of the post COVID-19 period (“COVID recovery”) from a transfer pricing (TP) perspective.   

Measures undertaken during the pandemic

The solution to a problem can be offered only when the nature of the problem is clearly deciphered. Applying this to the present context, implications arising from COVID recovery would essentially involve identification of various changes in the organisational, operational and transactional dynamics, deployed by enterprises due to the COVID-19 outbreak:

• Operational changes – Sudden global onslaught experienced due to the COVID-19 pandemic adversely impacted both the demand side as well as enterprises’ ability to cater to even the impacted demand. To address such changes, enterprises tried to implement several operational measures, targeted towards – (i) optimising their supply chain / operations, and (ii) increasing their reach to the customers:

 

1. Re-organisation of supply chain– With lockdown in several key manufacturing locations, supply chains of the manufacturing entities were severely impacted. Enterprises started evaluating alternate sourcing locations/ suppliers, either as a temporary arrangement or even on a long-term basis. Enterprises which had centralised manufacturing/ procurements, evaluated alternate sourcing locations to mitigate risks associated with the failure of centralised sourcing. Other manufacturing enterprises with multi-sourced key inputs went on to evaluate mobilisation of secondary suppliers to ensure that sufficient resources were available for sustaining the supply chain. While still others considered creating “shared resource pools” which would help in ensuring the availability of critical raw materials to key manufacturing locations.

 

2. Transition to enhanced reliance on digital sales channels – Restricted movement of consumers and social distancing norms lead to the traditional brick-and-motor sales channels shrinking.  This disruption drove adoption and growth in online/ digital sales channels, which provided consumers a more secure shopping environment from the comfort of their homes. Such convenience steered growth in online shopping by consumers and led several enterprises to move their products to online / digital sales channels. Such movement also required digitising their product portfolio to provide online shopping. However, it still relied on establishment of physical warehousing to feed into delivery service providers.

 

3. Work from home – A new order emerged with the onset of the COVID-19 pandemic -  ‘work-from-home’, ‘remote working’, ’video conferencing‘, etc. This new working arrangement was the immediate requirement for sustenance of most of the service companies. Recently several researches show that substantial portion of the workforce which responded positively towards the new working order, may continue with work-from-home. For instance a global research report by Lenovo of 20,262 workers worldwide, states that 74% of survey respondents from India may want to continue to work from home; more than they did before the COVID-19 pandemic.[1] Considering the short term and long term implications of such paradigm shift, industry players have expedited deployment of additional information technology (“IT”) tools and assets to ensure that the business continues with the same level of security and efficiency.

 

4. Reverse outsourcing with the use of digital tools – During the pre-COVID times, there was an ever-increasing trend of outsourcing routine / mundane activities / processes to outsourcing service providers. This helped businesses in reducing their cost of operations and focus on core / critical activities / processes. However, it also made them more dependent on external factors and exposed them to disruption risk. With the experience gained from COVID-19 pandemic lockdown, several enterprises started to re-organise their processes / activities using digital tools such as artificial intelligence, robotics and automation. This was not only to provide business continuity and resilience for the enterprises for such an unprecedented time, but also to move for business reengineering which would give them more efficiency and sustainability. In this regard, it is important to highlight that a McKinsey report indicates how firms have taken a leap through partial or full digitisation in improving their products or services.[2]  This report also shows that the COVID-19 pandemic has acted as a catalyst of sorts for ushering in technological revolution, which is seen across industries.

 

 

 

 

• Implications on intra-group transactional terms – With the sudden change in the economic and industrial circumstances, and considering the additional costs incurred and risks being assumed, several businesses, as a knee-jerk response to the COVID-19 pandemic, re-evaluated the transactional terms of their existing intra-group transactions.

 

1. Identification and treatment of COVID impacted costs – With the operational changes in business (as discussed above) there were certain cost elements incurred by the enterprises that were idle (i.e. non-productive) or were extra-ordinary in nature. While manufacturing and distribution entities faced additional costs on account of complete cessation of business during lockdown, service entities were still able to continue with remote working by incurring additional enabling costs (such as costs for IT tools and remote working hardware) and idle costs (such as workspace rent and costs associated with lower productivity).

 

With changes in the mode of operation, costs earlier considered as normal (such as retail space and office rent) were no longer contributing towards value creation. The treatment of such costs, especially in the case of entities transacting with related parties was a key point of concern for several enterprises. Apart from this, as mentioned above, several enterprises also decided centrally to invest in digital tools to further streamline their business operations. While several enterprises centrally managed and funded such costs, in certain other cases, it was also seen that local costs incurred on account of COVID-19 was absorbed by the respective local entities.

 

2. Re-aligned remuneration model – Sudden economic downturn in the second half of March 2020 required several enterprises to revisit the applicable remuneration model and there was also a requirement to align policy adopted for transacting with group companies to the changed business and economic circumstances. Such revisit included re-aligning the applicable margin being earned by the companies. As contemporaneous data for comparable companies was not readily available in the public domain for undertaking an ex-ante analysis, other sources of information were required to be used for estimating COVID impact on the arm’s length range. Such estimation was based on statistical methods such as regression analysis - an analysis essentially based on industry estimates or performing economic adjustments to simulate COVID impacted arm’s length margin.  

 

3. Modifying key terms of intra-group transactions –Several enterprises also tweaked key terms of intra-group transactions to ease the working capital pressure on transacting entities. Such changes involved re-visiting the invoicing milestones from monthly to quarterly / half yearly intervals. With customers demanding a higher credit period, by way of enhancing the credit period at the back end, several enterprises were able to ease working capital funding pressure.

 

• Introduction of new transactions – Another key response to the COVID-19 pandemic was initiation of certain new intra-group transactions by enterprises:

 

1. Provision of strategic services – In several cases, enterprises felt the need for creation of a central task force for strategic response towards COVID-19 at the group level. Such task force enabled quick decision making to reduce the reaction time taken by enterprises within the group. Such services inter alia included taking time critical decisions towards closing / scaling down / re-opening operations, monitoring and controlling discretionary expenses, and handling sourcing / supply chain issues. For provision of such strategic services, intra-group cost allocation / service transactions were initiated by enterprises.

 

2. Financial transactions – As cash flows of several enterprises shrunk, there was a pressing need for financial support to fuel regular business operations. This saw an influx of new transactions to provide financial support amongst several group entities. These included provision of loans and issuance of financial guarantees. Further, in jurisdictions where cash pooling facility was available within local laws, enterprises also considered moving to such a facility to better utilize the liquid resources available in other entities within the group.

While several of the above outlined changes, helped in addressing the abrupt challenges and ensured continued operations of enterprises, it also impacted the long-term operations. Accordingly, it is important to recognise that such changes should be considered in COVID recovery and post COVID period to ascertain the appropriate arm’s length nature of intra-group arrangements within a group.

COVID recovery implications

Certain key aspects of the COVID recovery period and their corresponding transfer pricing implications are discussed below:

• Data available in the public domain for COVID period – In several cases, as discussed above, to counter the impact of the COVID-19 pandemic, enterprises had revisited intra-group remuneration policies. In the absence of contemporaneous data of comparable companies, such adjustment was essentially based on best estimates and assumptions. However, the actual contemporaneous data for comparable companies will become available in the public domain during the COVID recovery. The enterprises and their tax practitioners would thus get a chance to evaluate whether the assumptions and corresponding adjustments to the intra-group pricing are supported by actual data. For instance, as part of an ex-ante analysis, the margins of a captive service provider were reduced based on industry expectations, with the availability of contemporaneous data on margins earned by comparable companies, the appropriateness of assumptions taken during ex-ante adjustment can be evaluated. As part of the said exercise, enterprises may also use the actual data to corroborate and improve the robustness of their analysis and adjustments, by maintaining data that would help in justifying the assumptions undertaken during the COVID period. Recently released OECD guidance on transfer pricing implications of the COVID-19 pandemic also stresses upon the importance of maintaining appropriate documentation to demonstrate that reasonable and appropriate due diligence was undertaken while evaluating the likely effects of the COVID-19 pandemic.

 

• Revisit pricing agreed for pre-COVID and COVID period to align with economic and commercial realities of the recovery period – One may say that in COVID recovery period, the pricing for various intra-group transactions would be expected to resume normalcy, that is revert to pre-COVID era. However, this transition may not be as simple as it looks. As discussed above, several enterprises may have undertaken operational changes to counter the pressing challenges presented by the COVID-19 pandemic which would in turn impact certain core elements of their operations. Impact of such changes on the long-term operations of the enterprises would need to be closely evaluated while arriving at the appropriate remuneration policies for COVID recovery:

 

1. In cases where the enterprise undertook changes in supply chain, such as moving to alternate location, multi-supplier or creation of “shared resource pools”, any additional functions performed towards managing such supply chain and corresponding risks assumed by the transacting entities would need to be considered while ascertaining arm’s length remuneration in the long run.

 

2. In cases where distributors moved to a digitally supported sales channel, contribution of various group entities towards marketing and pushing sales on such digital channels may be very different from the erstwhile contribution to brick-and-motor stores. This change in contribution, for instance by a central group entity assisting in managing and operating such digital sales channel would need to be considered while ascertaining appropriate remuneration.

 

While ascertaining the transition and the recovery of the relevant industry, economy and key competitors would also need to be taken into account, though the recovery experienced by the enterprise would have primary importance. Just like the impact of the COVID-19 pandemic varied across industries, with industries like travel and tourism being impacted significantly whereas insurance and healthcare industries bore a limited impact, the recovery path of various industries could be different. Such recovery trajectory would need to be considered while evaluating the pricing agreed for pre-COVID and COVID period.

 

• Align future remuneration with changes in functional profile – Another key point of consideration in the COVID recovery period would be to analyse the impact of changes, in functional profile of transacting entities on future remuneration models. In several cases, operational and other changes may have been affected by enterprises while transacting with group entities. Such changes may have also led to a change in the underlying functional profile of one or more of the transacting entities. The OECD guidance on transfer pricing implications of the COVID-19 pandemic also propounds that careful consideration should be given to the commercial rationale for any change in the risks assumed by a company before and after the outbreak of the COVID-19 pandemic. In such cases, accurate delineation will determine whether the revision of intercompany agreements is consistent with the behaviours of third parties in comparable circumstances. Let us look at two business instances in this regard:

 

1. During the COVID period, limited risk entities participated in risks / costs / losses being incurred by the group. Such entities can be regarded as “limited risk” once normalcy is achieved. In such cases, whether reverting to an assured return model, which was followed earlier would be appropriate or would such entities also need to participate in future group profits post recovery is a moot question. In order to arrive at the response to such question, the enterprises would have to evaluate the relative contribution made by the respective entities, while bearing the risks / costs / losses of the group and the relative contribution that would be made in future operations.

 

2. While the use of digital tools may bring in a change in the operations of certain group entities, it would also need to be seen if the same actually impacts any core value creation, being undertaken by the enterprise as a whole. A back-office support provider enterprise, by way of digital tools like AI, robotics, etc. would essentially start moving up the value chain with operations more focused on analytics, consulting, etc. The impact of such evolution in the overall value chain would in turn affect the remuneration model. 

 

• Evaluation of cost base – Alongwith revisiting the margin / policy based on economic factors and changed functional profile of the enterprise, it may be equally important for enterprises to re-evaluate the cost base to identify costs which are non-productive / idle in nature in the medium to long term. These costs would essentially be costs which are being incurred on account of lock-in period or are continued to be incurred as part of a strategic business decision, however, which do not contribute towards value creation at the same level. For instance, while a distributor may have moved its sales to a digital channel, it may still choose to maintain retail outlets to retain a physical presence in the market, despite the fact that the level of sales contributed by the said outlet may have significantly reduced in the COVID recovery period. As an immediate response to the COVID-19 pandemic, such idle and other extra-ordinary costs might have been absorbed by the local entities. However, in the long run and during COVID recovery stage, appropriate treatment of such costs, especially considering the decision-making process behind incurrence of such costs, would need to be evaluated.

Besides the above, the treatment of strategic support costs and costs associated with investments made towards digital assets would also need to be evaluated and shared across benefiting group entities in an appropriate manner. While making such allocation, the character of such costs, whether a shareholder or a stewardship cost, would also need to be evaluated in the long run to implement a robust arm’s length policy. In this regard, the OECD guidance emphasises that while undertaking such analysis, cost allocation should be aligned to risk allocation amongst transacting parties and should take into account industry specific considerations along with behaviour amongst third parties.

Introduction

As a result of globalisation, multinational enterprises (“MNEs”) across the world have expanded their operations by establishing entities, performing entrepreneurial activities and support functions. While entrepreneurial entities perform focused high value-added activities such as innovation and protection of intangibles, development of new and improved technologies and developing marketing strategies, the entities providing ancillary functions support the activities of the entrepreneurial entities.

Over the years, India has developed as an investment jurisdiction for MNEs to carry on information technology (“IT”) services, research and development (“R&D”), and support and back-office operations (“BPO”) owing to the availability of huge skilled work force. IT sector in India over last two decades has evolved from being a mere captive support services, performing limited functions and assuming negligible risks to entrepreneurial entities, performing significant functions and assuming substantial risks.

With this backdrop, inter-company transfer pricing (“TP”) disputes have emerged as one of the most significant and complex tax issues for both MNEs and the revenue authorities.  The Indian Transfer Pricing Officers have also started deep diving into the conduct of the parties and substance of the transactions instead of merely relying on the inter-company agreement. Much of the disputes are on account of mismatch of Functions, Asset and Risk analysis (“FAR analysis”) as undertaken by the MNEs vis-a-vis the FAR analysis as perceived by the tax department. Though the Income Tax Appellate Tribunal (“ITAT”) have in a significant number of cases provided substantial relief to the taxpayer, prolonged litigation and time & efforts involved in the process has been an area of concern for many taxpayers.

This article is aimed at providing an insight into the issues faced by captive software development service providers in relation to R&D support , their role in the entire value chain of an MNE Group and aspects to be considered by them in anticipation of any potential TP litigation in India.

Captive software development service

Traditionally, MNEs operating in the technology sector have offshored activities such as software coding, testing, maintenance, de-bugging, updates, on call support and documentation to India by setting up captive service centers. Such captive units perform routine functions under the instruction and overall supervision of the parent entity or foreign associated enterprises (“AEs”). Further, the Indian captive unit neither hold any significant non-routine intangibles nor bear significant economic risks. Owing to the limited functions and the corresponding limited risks assumed, such captive units are usually remunerated a mark-up on total costs.

However, over a period of time, the Indian talent pool have started providing substantial value addition in the form of software design support, creating new algorithms, efficient ways of coding, generating new ideas, etc. Hence, it is imperative that the captive units are compensated, commensurate to the functions performed and the risks assumed.

With the advent of the Base Erosion and Profit Shifting (“BEPS”) action plan and  the introduction of global master files (“MF”) and Country-by-country Reporting (“CbCR”), Indian tax administrations have direct access to numerous global documents and are also able to collate other documents from overseas jurisdiction by invoking the exchange of information article under the tax treaties. In this regard, it has been observed that off late disputes are also arising on account of mismatch in FAR analysis in such global report vis-a-vis local TP documentation.  

R&D vs. Software development as service 

Typically, the parent/ entrepreneurial entity would be responsible for strategic functions such as corporate strategy/ management, marketing/ business development, product development including software architecture & design, requirement analysis, etc. while the Indian captive software development service providers perform functions such as  software coding, upgradation of software, de-bugging, maintenance, testing, etc. 

So, the question that arises is whether such Indian captive software development service providers should be considered as a risk mitigated service providers or as entrepreneurial entities, responsible for creation of intangibles and thereby the co-owners of the software developed by the MNE Group. This would depend on the FAR profile of the Indian captive unit.

Software R&D - Intangible ownership rights

In case of R&D operations of foreign MNE Group , generally the entire market research to assess consumer preferences, trends, expected features in the software, ease of use, etc. is undertaken by the foreign AEs and Indian unit may not contribute much to such market research functions performed by the foreign AE.

So the question of right to software intangible is not with respect to market research aspect but with regards to the development aspect of the software as huge skilled work force is deployed by the captive units in India. However, in order to claim right(s) in intangible, the entity should have either funded the project or performed significant R&D functions or borne critical risks.

The Organisation for Economic Co-operation and Development (“OECD”) in BEPS Action 8 has provided that the ultimate allocation of returns derived by the MNE Group from the exploitation of intangibles is accomplished by compensating members of the MNE Group for functions performed, assets used, and risks assumed in the development, enhancement, maintenance, protection and exploitation of intangibles.

Concept of Development, Enhancement, Maintenance, Protection & Exploitation (“DEMPE”)

The DEMPE concept is a proxy for a functional analysis in the sphere of intangibles with a focus on development, enhancement, maintenance, protection and exploitation functions.

• Development:  The development of intangibles refers to everything that is associated with coming up with the ideas for the products and putting plans and strategies in place for their creation.  During development, an entity or multiple entities within an MNE Group may be engaged to formulate ideas and processes for creation of the intangible. Hence, it would be critical to document which entity of the Group performs the core R&D functions.
• Enhancement:  Enhancement refers to the work undertaken on the intangibles to make sure that they can always perform well and are future ready with continuous improvements made from time to time. Hence, the entities which are involved in the enhancement functions needs to be analysed in detail to determine the extent of contribution made by each entity in the enhancement value chain.
• Maintenance: Maintenance function involves undertaking required measures to ensure that the intangibles perform well and generate the desired revenue for the business.  It is important for an MNE Group to ensure and monitor the performance of the intangible i.e. to check the intangible’s consistency in the market. Hence, entities involved in maintenance of the software should also be recognised.
• Protection: Protection of an intangible property is important for ensuring that the value of brand’s assets remains strong. It involves securing legal rights of the intellectual properties, making sure that the ideas can’t be copied or leveraged, ensuring privacy protection and monitoring competitor’s activities. Typically, parent company would be involved in protection of the intangibles.
• Exploitation: Exploitation refers to how the intangible is commercially exploited in the market to generate the desired profits. Entities which undertakes extensive marketing and commercially exploits the intangible should be identified and due weightage should be provided for their functions.

The current rules envisage that the DEMPE functions should be considered when allocating the returns derived from an intangible, as well as costs connected with it, among related parties. The OECD Guidelines provides that a mere legal ownership does not confer any right to retain returns derived by the MNE Group from exploiting the intangible, even though such returns may initially accrue to the legal owner as a result of its legal or contractual right to exploit the intangible. DEMPE is thus a substance requirement; entitlement to returns from an intangible cannot be shifted with the transference of contractual rights, but rather depends on the functions, assets, and risks connected with the intangible.

To summarise, under the whole process of the DEMPE analysis, MNE Group must clarify which group entities are: -

1. Performing the DEMPE functions or contributing towards a part of DEMPE function;
2. Using the assets related to the DEMPE functions; and
3. Undertaking the economically significant risks related to the DEMPE functions.

The OECD Guidelines likewise require an analysis of risks. While the OECD Guidelines does not ignore contractual assumptions of risk, however such contractual assumptions of risks are respected only where the party assuming the risk, both controls the risk and has the financial capacity to assume it. For this purpose, for a party to possess adequate control over a risk, it must either possess the ability to decide whether to take on, decline, or lay off opportunities that involve risk, or whether and how to respond to such risks, and actually engage in such decision making.

R&D Circular by the CBDT

Given the divergent views amongst tax authorities and taxpayers, regarding the functional profile of Indian captive service providers vis-à-vis R&D centers, the Central Board of Direct Taxes (“CBDT”) released a circular (hereinafter referred as “R&D Circular”), classifying R&D centers set up by MNE’s into three broad categories based on FAR analysis. These are:

1. Centers which are entrepreneurial in nature, which undertakes significant economic functions and assumes substantial risks;
2. Centers which are based on cost sharing arrangements; and
3. Centers which undertake contract R&D with minimal functions, assets and risks.

The CBDT has also emphasised on the conduct of the parties in addition to identifying what constitutes economically significant functions, in creation of an intangible for determination of the entity “controlling the risk”.

Based on guidance provided by the OECD on DEMPE activities and the R&D Circular, let us analyse these aspects to determine its applicability to a captive software development unit.

Core R&D functions: The entity which performs core functions and undertakes the key decisions such as type of product to be developed, R&D budget, features to be included, software design architecture, etc., will have the right to higher compensation.

R&D funding: The entity which decides on the budget and the team size for the R&D projects and funds such R&D project would also be entitled to higher returns. Generally, the captive units are compensated on cost plus basis for its services and hence, R&D project may not be said to have been funded by captive units.

Critical R&D Risks: These risks are generally associated with the enterprise which performs core R&D functions and assumes related R&D risks by undertaking key decisions. As the captive units are generally compensated on a cost-plus basis irrespective of the outcome of the R&D project (i.e. commercial viability of product being developed), captive units are risk mitigated entities.

Hence, prima facie in the view of the authors, routine captive software development units may not have the right to claim returns emanating from the exploitation of the intangible, especially given that the captive software units are developing the software on behalf of the foreign AE and under their instructions.

Off late, India has become a hub for Global in-house centers (“GIC”) set up by multinational companies. Such GICs are initially set up as captive development service providers and they move up the value chain to become full-fledged R&D service providers. Based on the FAR analysis, if it is concluded that core R&D functions and the related decisions are undertaken by the captive unit / GICs, a higher compensation may be warranted for such units based on their level of contribution. This higher compensation may also be in the form of share in profits under the Profit split method (“PSM”).

While applying PSM, it should be ensured that the determination of the relevant profit to be split and the profit splitting factors should be consistent with the FAR analysis of the controlled transactions and should reflect the economically significant risks borne by the parties and should also be capable of being measured in a reliable manner^[1]. However, in the view of authors, the possibility of captive units bearing R&D risks would be remote as captive units may not have the financial capacity to bear such risks unless the entity under which the captive unit is housed has third party revenue stream from other businesses, providing it with the financial capacity to bear such risks.

In a nutshell, it is important to periodically review the level of activity undertaken to assess whether compensation paid is commensurate with the functions performed and risks assumed by the captive unit.

Aspects to be considered in TP documentation

The foundation of any TP analysis lies in its strength of the FAR analysis. A highly meticulous FAR assessment of the taxpayer and its AEs coupled with appropriate economic analysis would ensure a robust documentation, which could be used to defend any TP litigation.

While undertaking the FAR analysis, apart from delineating the transaction, aspects like whether the business transactions reflect alignment between contractual engagement and economic reality should also be captured.  Further, in case, if the captive unit has various divisions such as coding, software maintenance, testing, on-call support, R&D support, etc., it would be prudent to segregate the transactions so as to capture the FAR appropriately.  This is critical as functions performed by R&D team may command a higher compensation as compared to other routine services, depending on the level of support provided in the R&D value chain.

Practically, there may be instances where the captive software development service provider or the GIC may sub-contract certain activities to a third-party service provider. This could be on account of various reasons such as lack of specific skill sets, abrupt short-term resource requirement, etc. Tax authorities in such cases could potentially use the manner in which compensation has been paid to third parties by the GIC as a guideline while determining the arm’s length price of the services provided by the GIC.  In this regard, it will be advisable to analyse the activities undertaken by the captive unit vis-à-vis the third-party service provider and document the differences in addition to outlining special circumstances, warranting the sub-contracting of activities.

Further contractual allocation of risks should be respected only if supported by actual decision-making matrix and financial capacity to bear such risks. Also, in line with BEPS Action 8, entities providing capital funding without undertaking any critical functions should be allocated only “risk free returns” i.e. no premium returns to cash boxes.

Conclusion

Recent global developments have highlighted the importance of economic substance issues in the arena of taxation. The judicial doctrines that “substance” must prevail over “form” and inter-company transactions in an MNE Group must have “business purpose”, have played a direct role in TP cases.

It is imperative for MNEs to maintain robust global documentation, having regard to the current legislative and enforcement environment by global tax administrators. Further, with the voluminous information available in CbCR and MF around Group TP policies, the tax administrations would be keen to cross verify the pricing policies adopted by the MNE Group across jurisdictions. Also, tax administrations could possibly challenge characterisation of captive unit, in case of any inconsistency between global documentation, MF and the local TP documentation. Hence, it is important for MNE Groups to ensure that FAR analysis and other data/information is captured correctly, both in local documentation and in global reports, thereby leaving no room for inconsistency.

 

[1] Revised Guidance on Application of the Transactional Profit Split Method issued by Inclusive Framework on BEPS

Assisted by CA. Rohan Vesuna, CA. Puneet Bothra

Credibility of a tax administration depends to a large extent on the credibility of its dispute resolution mechanism. Quick, consistent, transparent and a fair dispute resolution mechanism is part of the taxpayer service. However, the Indian tax dispute resolution system has not been up to the mark in that regard. It has seen protracted disputes and lack of effective means to prevent such disputes. Indian transfer pricing (“TP”), which started about 20 years ago, has similar lengthy dispute resolutions, despite some key changes made about 10 years ago through introduction of the dispute resolution panel.

In this paper, we divide the TP dispute journey into two identifiable decades and discuss how certain issues dominated in each decade. Further, we have also covered how the mindset of taxpayers has changed over the last few years.

1. Evolution of TP litigation issues over the last two decades:

We have attempted to look at some key issues that arose over the past 20 years of TP to understand how the issues progressed from basic ones (such as, comparability analysis, use of most approprite method) in the first decade, to some advance transaction-specific issues (such as re-characterisation of the entity, intangible transactions, attribution of profits to PE, disallowance of intra-group services, use of more sophisticated methods such as Profit Split Method, Other Method, etc.) during the second part of the 20-years journey.

A] First decade [starting from FY 2002-03]

TP provisions were introduced into the Indian law with effect from 1 April 2002. For the first 10 years or so, there were interpretational and implementational issues. The journey of Indian TP litigation started with a five-member Special Bench ruling of the Income-tax Appellate Tribunal (“Tribunal”)[1] which laid down the manner in which TP regulations should be applied, such as use of methods of benchmarking, selection of comparable companies, implementing provisions in cases of complex transactions involving intangibles, etc.  This judgement is often referred to as the “Encyclopedia on Indian transfer pricing regulations”.  

Another Special Bench of the Tribunal held that it was not necessary to demonstrate the tax avoidance motive before invoking TP provisions. This view has been confirmed by various High Courts (“HC”)[2] and also reiterated by the Tribunal where the base erosion theory adopted by taxpayers for benchmarking a transaction from a foreign taxpayer’s perspective was rejected[3]. It was held that TP compliances are required to be adhered to by every party to an international transaction individually.

The next important issue was on the importance of Functions, Assets and Risk (“FAR”) analysis. TP analysis commences with a detailed FAR analysis by the parties to the transaction. Comprehensive and robust FAR analysis forms the basis for a robust economic analysis. It has been held in several cases that comparables cannot be selected based on classification of companies in the databases. Comparables should be evaluated on the basis of similarity in FAR analysis[4] and consequent characterisation of the enterprises. Even in cases of attribution of profits to Permanent Establishments, importance of FAR analysis has always been emphasised, since an additional attribution may be warranted only if any additional activities are performed over and above those covered in the FAR analysis[5].

The next major area of litigation was on comparability analysis.  The issues inter alia consisted of selection of internal versus external comparables, use of single year vs multiple year data, selection of Indian vs foreign tested party and aggregation vs segregation of transactions. Most of these issues were dependant on availability of data based on facts and circumstances of the case and taxpayers used to take positions that may provide them with the best possible outcomes.  Similarly, Revenue authorities used to propose adjustments based on positions contrary to the ones adopted by taxpayers which would yield maximum tax collections.  Evolution of judicial precedents over time has settled some issues while others have been put to rest with changes in the legislation as the tax administration also accepted the hardships faced by taxpayers. For example, Revenue authorities and the Tribunals were largely against the use of the multiple year data by taxpayers, though there were some Tribunals who had accepted the same.  This controversy was put to rest with the amendment in 2014, wherein the government allowed use of 35^th and 65^th percentile range as well as multiple year data. Similarly, it has been accepted that the tested party should be the least complex entity out of the various parties to the transaction.  This view has been confirmed by various HCs as well[6].

However, certain issues such as aggregation vs segregation of transactions while benchmarking are still grey areas.  While taxpayers prefer aggregation of transactions due to non-availability of data to benchmark transaction wise / availability of segmental data / administrative convenience, Revenue authorities often emphasise on the concept of transaction specific approach requiring separate benchmarking for each category of international transaction.  Being an area that is highly fact specific, courts have held contrary views.  The matter is still unsettled, wherein the Revenue appeals at the HC level have been admitted and a future ruling from the Hon’ble Supreme court may settle the issue.

B] Second decade [FY 2012-13 to date]

 

The second decade saw Revenue authorities picking up more complex issues using learnings from other countries as well as the international customary law.  During this period, Mutual Agreement Procedure (“MAP”) as an additional dispute resolution mechanism for resolving international tax disputes, gained significant attention of taxpayers.  India’s endeavour is to resolve MAP cases within an average timeframe of 24 months in conformity with the minimum standards recommended in the BEPS Action 14 final report[7], especially with countries like the US where an agreement on framework for resolving pending MAP cases in the technology sector was entered into in 2014‑15.  Further, considering the settlement of most of the fundamental issues of TP, the issues covered in the second decade are more niche and specific to certain types of transactions rather than being routine comparability issues.

One of the significant issues was regarding applicability of TP to fresh issue of equity shares. The government accepted the landmark order passed by Bombay HC by not appealing against the verdict[8] wherein the court held that “income” arising from an international transaction is a condition precedent for application of TP provisions[9]. This conveyed greater clarity and predictability for taxpayers as well as for Revenue authorities, thereby facilitating tax compliance and reducing litigation on similar issues. 

Another interesting issue picked up by the Revenue in this period was allocation of additional profits to Indian subsidiaries on account of Location Specific Advantages (“LSAs”) / Location Savings[10]. It was ironical for them to demand huge margins in the range of 20-30% for captive units and on the top of it, use profit split method to allocate LSAs. LSA typically tries to capture additional profits that accrue to the parent company on account of moving work from a high cost to a low-cost country. After much dispute and debate on this issue, the Indian tribunal[11] and courts[12] struck down this proposition on the fundamental point argued by taxpayers that, a taxpayer operates in a perfectly competitive market and benchmarking is done using local comparables in the jurisdiction of the tested party. Therefore, if the comparables are accepted, then no additional allocation is required for LSA. This issue seems to be settled until we have a Supreme court order on a Revenue appeal.

Applicability of TP provisions on corportate guarantee (“CG”) has been one of the most debated issues under the Act. This issue was primarily from the first decade but later evolved with a different variation even during the second decade.  Initially it was held that provision of CG did not constitute an ‘international transaction’ and thus an Indian parent was not required to charge any fee from the overseas entity. As an immediate fallout, definition of the term "international transaction" was amended by the Finance Act, 2012, with retrospective effect from 1 April 2002, by inter alia extending its scope to include provision of guarantees.  Post the amendment, it was felt that the issue was put to rest.  However, just like we are now seeing mutation of the Corona virus, this issue too saw a different variation which led to continuation of the debate.  Taxpayers have started taking positions that even after retrospective amendment that CG with no implications on profits, income, losses, or on assets of taxpayer should not be considered as “international transaction”. It was also contended that where a parent company provided CG for loans obtained by overseas subsidiary for augmenting its funds, it constituted “shareholder’s function”.  These contentions of taxpayers were also blessed by some Tribunals. The appeal filed by Revenue authorities against these Tribunal orders are pending before the HCs.

Among many controversial issues in TP, the adjustment on account of Advertisement, Marketing and Promotional (“AMP”) expenditure is certainly one of the most litigated and controversial issue, and one that involves high stakes. Revenue authorities have perpetually taken the view that excess AMP expenditure incurred by Indian taxpayers contributes to brand building which is legally owned by associated enterprises (“AEs”) outside India, and Indian taxpayers should be compensated for such brand building services.  In January 2013, the Special Bench of the Tribunal[13] held that AMP expenditure by an Indian AE is an international transaction and that expenses incurred “in connection with sales” are only sales specific. However, expenses “for promotion of sales” lead to brand building of the foreign AE, for which Indian taxpayer needs to be compensated on an arm’s length basis by applying Bright Line Test.  There were two landmark rulings from Delhi HC on this issue. One which confirms that AMP is not an international transaction (this is a case of a manufacturer)[14] and the other which rejects application of bright line test and affirms that AMP is not a separate international transaction and can be compensated on an aggregate basis as part of the distribution activities[15].  This issue is pending before the Apex court.

 

Another interesting debate has been on the benchmarking of IGS.  While most earlier issues were primarily on account of different interpretations of the statute, this issue has been primarily on account of lack of sufficient guidance under the statute.  Many Indian entities of MNC Groups avail various IGS from their AEs across the globe.  Indian TP regulations do not have any special provisions for IGS and expect these to be benchmarked using one of the six prescribed methods. Revenue authorities have always considered the ‘benefit test’ to be the pre-requisite while determining arm’s length price (“ALP”) of IGS. Taxpayers were required to substantiate the receipt, need and purpose along with the benefits of availing such services from its AE(s). 

Various courts have held that ‘benefit test’ does not have much relevance[16] and that questioning the business and commercial expediency of the taxpayer was unwarranted. Later, the "benefit test concept" was overshadowed and the aspect of "rendition of services by the AE" for allowability of the expense was followed. Further, in case the agreement is akin to a retainer arrangement, it is not incumbent upon the taxpayer to demonstrate rendition of each and every service, so long as some services are availed out of the bouquet of eligible services.  

Choice of MAM to determine ALP of IGS has also been controversial. In many cases, where a taxpayer applied TNMM as MAM, the Revenue determined ALP of IGS as ‘NIL’ by using the CUP method stating that such services are valueless and of no relevance[17]. However, some decisions ruled that unless Revenue can demonstrate some other method for ascertaining ALP, TNMM cannot be simply rejected[18].  Indirect charge method (i.e. based on fixed percentage of sales) has also been accepted for determining ALP of IGS in some cases.   The need of the hour is for the CBDT to formulate certain guidelines on the documentation requirements to be maintained to reduce unwanted and protracted litigation revolving around IGS.

Similar to IGS, there is hardly any guidance provided under the law on the benchmarking of royalty payments to AE. Key issues involved are the requirement to substantiate the need and benefit test for royalty payment and the benchmarking of such payment.  Disallowance on the ground that such an action was not necessary or prudent for an assessee; or because the company had incurred losses, is not authorized as per Rule 10B(1). Further, commercial expediency is not the jurisdiction of the tax authority and should be left for the taxpayer to decide.  For benchmarking royalty payments, there have been contrary decisions in relation to use of the Residual Profit Split Method (“PSM”).  Taxpayers also often use TNMM or the CUP method based on the facts of their cases.  Thus, the issue is yet open to debate based on facts and circumstances of each case.

Other aspect is that TP disputes are largely fact based. Appeals to HC on TP issues can be preferred only on ‘substantial question of law’ and not on questions of fact. There is yet a third class of cases i.e. a question of mixed law and fact. Though, such a conclusion is based upon primary evidentiary facts, its ultimate form is determined by application of relevant legal principles.  Perversity may also be a ‘substantial question of law’. If the findings on fact or conclusions drawn by the Tribunal are perverse, then the HC can set aside such findings.  From a TP perspective one instance of perversity, given by the Karnataka HC, could be a case where unequals like a software giant Infosys or Wipro are compared to a newly established small size captive company engaged in software services[19]. Such wild comparison would obviously be wrong and perverse.

Recently the Bombay HC has cautioned the tax department against ritualistic filing of appeals in TP matters[20]. The HC mentioned that in respect of exclusion/inclusion of a comparable company, the Tribunal is the final fact-finding authority. Challenge to such Tribunal orders before the HC should not be made without pointing out, perversity or failure to adhere to the settled principles of law. This issue is also pending before the Hon’ble Supreme Court and while it had come up for hearing, the court instructed the Advocate on Record to bucket the cases into different category of issues to enable it to decide the matter in an effective manner.

While the issues around selection of the MAM were mainly arising during the first decade, the PSM has always been a debated method not only in India but worldwide.  Specific guidance on PSM has not been issued yet, except for what came through CBDT circular no. 14 of 2001, or in some manner in circular no. 6 of 2013, on contract R&D centres. The guidance therefore has to be drawn from some judicial decisions as well as from the evolution of the international customary law like the OECD and UN.  The debate is primarily around the use of PSM as the MAM and the method of application of PSM.  PSM is generally applied in cases where it is successfully demonstrated that the transactions are highly integrated and inextricably linked and the relevant entities make significant contributions.  PSM involves attribution of profit to the entities involved in the transaction based on specific methods like contribution analysis or residual splitting of profits based on value drivers after attributing a routine return.  Again, splitting of residual profits based on external market data may not be practical in all cases. In such a scenario, the regulation may be interpreted liberally (which has also been affirmed by the courts) and profits can also be split based on internal data on value drivers and allocation methodology for arriving at each AE's contribution. Thus, over the years PSM has come out of the shadows of traditional one-sided methods, with Revenue authorities and taxpayers alike resorting to profit split models in situations which warrant such an analysis.

CBDT introduced the sixth method i.e. ‘other method’ for computing ALP under the Indian TP regulations vide notification dated 23 May 2012.  Based on a plain reading of the provisions, while the other method provides flexibility to adopt any method for benchmarking a transaction, it is understood that the transaction needs to be compared with some form of an uncontrolled transaction or third party data.  It is observed that Revenue authorities often resort to using other methods for justifying their ad-hoc or best judgement approach for determination of ALP under the garb of other method.  It seems that the Revenue authorities are of the belief that the other method devolves them from bringing on record a comparable instance which is mandated by the five methods. However, this belief is evidently against the provision of Rule 10AB, which require comparison with a comparable uncontrolled instance.   

2. Evolution in mindset of taxpayer - Dispute prevention over dispute resolution

When the TP provisions were introduced, there were only the standard dispute resolution measures that were available to taxpayers.  While measures for dispute resolution are more traditional and include usual appeals and redressal options before the courts, they often consume substantial time before any matter reaches finality. Therefore, alternate dispute prevention programmes like Advance Pricing Agreement (“APA”) and safe harbor rules aimed at preventing disputes between taxpayers and Revenue authorities have gained popularity globally over the last decade.

Over the last decade, considering the intensity of TP disputes in India, the APA programme has been the go-to option for MNEs wanting certainty, which is evidenced by the conclusion of 240 unilateral APAs and over 30 bilateral APAs as on 31 March 2019[21]. 

Also evident from the recent statistics, the number of APA conclusions have been on a downward trend since FY 2017-18 onwards.  This is mainly on account of the limited resources to handle huge pendencies and also the change in mindset in becoming more liberal or preference to practical resolutions, as it was in the initial days of the program launch. Ultimately APA is all about win-win than win-lose.

Another dispute prevention mechanism, whose success was in contrast to the APA program, was the safe harbor rules, which were introduced by the Finance (No. 2) Act, 2009 and later rationalised in 2017. Taxpayers have always envisaged rates to be higher (even under the so called rationalised provisions) than those reflective of the industry trends or that which may be available through an APA route and accordingly, have not been the first preference as a measure of dispute prevention for MNEs.

3. Conclusion

The Indian judicial system has dealt with many TP issues than other courts around the world. In fact, courts across look towards India for picking trends they could apply in their country as well. Indian TP jurisprudence has matured over time. However, there is still the need to rationalise the Indian dispute resolution mechanism by taking cues from other countries and introducing measures such as joint audits and mediation (may be as a replacement to the current Dispute Resolution Panel mechanism) to enable a reduction in the number of pending cases that have piled up in the judicial system. Hopefully the Indian TP jurisprudence would reach full maturity in less than a decade!

 

 

In the current backdrop of unprecedented COVID-19 pandemic crisis and even otherwise, the Financial Services Industry (‘FSI’) vaccinates and immunises global economies with a dosage of monetary/fiscal measures for recovery, resilience and thriving economic development.

The FSI ecosystem primarily includes banks, financial institutions, insurance/reinsurance companies, Non-Banking Financial Companies (‘NBFCs’), brokers, Asset Management Companies (‘AMC’), Alternate Investment Funds (‘AIFs’), private equity, real estate investment funds, etc.

Since economic liberalisation in 1991, India has witnessed significant reforms and investments in the FSI – both inbound and outbound. Transfer pricing (‘TP’) issues within FSI have been a major concern, particularly since global crisis in 2008. International regulatory framework (Basel III rules) influences intra-group financial transactions in the FSI sector.

Tax authorities across the globe ensure to receive a fair share of the “income tax pie”.

Recent United Nations (UN) Practical Manual on TP for developing countries (2021) encapsulates Chapter 9 – Intragroup Financial Transactions. The Organisation for Economic Co-operation and Development (‘OECD’), released guidance on Financial Transactions in February 2020 under inclusive framework on BEPS Action Plans 4, and 8-10. UN TP manual and OECD TP guidelines elucidate TP considerations for financial transactions, including capital financing, intra-group debt, cash pooling, hedging, financial guarantees and captive insurance.

Since the inception of TP regulations in 2001, it has been a challenging aspect for Multinational Enterprises (‘MNE’) in India. TP litigation has been evolving with intensity of audits and tax adjustments. Effect of aggressive audits is across industries, and FSI is no exception. Evolving growth in the FSI sectors over two decades witnessed emerging tax and TP issues, coupled with no formal guidelines on Financial transactions in India.

This series of article includes key TP issues and considerations for the Banking and Capital Market (‘BCM’) sectors.

Background

BCM is a regulated sector in India. The Reserve Bank of India (‘RBI’) and Securities and Exchange Board of India (‘SEBI’) are central bodies to regulate BCM operations.

Few banks/FSI players headquartered in India have entities incorporated abroad. The permanent establishments (‘PE’)/branches of Indian headquartered entities are considered ‘residents’ under the Income Tax Act, 1961 (‘the Act’). Accordingly, Indian TP provisions are not applicable for transactions between India headquartered entities and its branches incorporated abroad. However, TP provisions apply for transactions with overseas subsidiaries. The branches of Indian headquartered entities are required to comply with TP norms of the countries where incorporated. 

Foreign banks typically have PE via registered branches in India, by obtaining license from the RBI. TP provisions are applicable for transactions between Indian branch and Head Office (‘HO’)/other affiliates outside India. Indian branches being ‘non-residents’ and separate entities under the Act should comply with TP provisions in India.

BCM sector usually undertake transactions such as intra-group services (e.g. origination, correspondent banking, business/back-office support, etc.), intra-group loans, money market transactions, guarantee/counter guarantee transactions, financial derivatives transactions, risk participations, etc.

Few typical transactions under TP limelight in India are discussed below:  

Correspondent banking, origination and marketing support services

Branches of foreign banks in India provide origination and correspondent banking services to the HO/overseas affiliates to promote structured financial products and services. Typical activities undertaken by India branch vis-a-vis HO/overseas affiliates are tabulated below:

Indian Branch

HO/overseas affiliates

Maintaining relationships with local banks/financial institutions.   ·Identification of target customers for offering financial products and services.   Undertaking credit review, KYC checks and due diligence of potential customers.   Providing origination, marketing support for financial products/services, including standard/exotic derivatives products.    Intermediating deals between the customers and foreign banks or executing mirror deals with HO/other branches on back-to-back basis.   Providing support to local customers, providing account information, ongoing debt/deal monitoring etc.

Product and policy development.   Structuring of trades and contracts.   Transaction funding.   Loan booking, credit and counterparty risk management.     Management of derivatives positions.   Performing certain middle/back-office support activities.

Transactional Net Margin Method (‘TNMM’) is usually applied to determine Arm’s Length Price (‘ALP’) of such transactions in absence of Comparable Uncontrolled Price (‘CUP’) data. TP authorities perceive these services of significant value, based on the position that Indian branches perform Key Entrepreneurial Risk Taking (‘KERT’) functions. Cost plus mark-up, ranging from 20% to 40% and even revenue splits are applied in few cases where portion of income earned by HO/foreign affiliates is attributed to the Indian branch.

The Bombay High Court, in one of the landmark rulings[1] upheld the decision of Mumbai Tribunal on attribution of income to Indian branch of a foreign bank. While TP authorities attributed 20% of interest income earned by foreign bank to its Indian branch, Tribunal provided relief and limited ALP to 20% of agency/processing fee income, attributable to Indian branch. This ruling has been relied in other cases[2].

TP authorities have also challenged considerations for marketing of derivatives products by Indian branch. It is contended that Indian branch deserve 100% of initial dealer spread (difference between price quoted to counterparty and price quoted by trading desk), considering that this spread is solely attributable to the marketing efforts of Indian branch. Tax authorities contend that Indian branch bears default risk as it initially enters derivative swaps and options on its own account, resulting in blocking of capital.

Investment banking

Many overseas banks and SEBI registered brokers provide investment banking services, including advisory on Mergers and Acquisition, securities issues, underwriting and distribution management, etc. Hub-spoke model is usually applied, whereby Indian entity as spoke is responsible for performing research, origination and assistance in structuring deals. The hub (HO/overseas entity) perform execution, capital structuring and deployment. TP authorities have taken a position that services of Indian entity are high value activities, requiring attribution of higher percentage of fees earned.

In few instances, some investment banks form consortium to offer loans and guarantee to corporate customers. The HO/overseas entities are lead arranger and risk participants (funded or non-funded) for such transactions, alongwith other banks/financial institutions. The transactions are typically originated by Indian branch. The Indian branch may also be involved in providing due diligence support, KYC checks and ongoing monitoring of deals. 

Investment banks get participation/commitment fees from borrowers/beneficiaries. Such fees are usually based on a percentage of credit allocations, mutually agreed amongst the consortium. TP issues revolve around determining appropriate split for such charges between the Indian branch and HO/other group entity. The allocation of commitment fees depends upon functions performed, assets deployed, and risks assumed by each party in the arrangement. The Tax Tribunal in a recent ruling[3] held that where the role of the Indian branch was limited to identification and referring opportunity, remuneration received in lieu of such services cannot be termed as interest income of the branch from alleged advancing of loans. Robust TP analysis is required to determine functional and risk profiles of the participants.  

Intra-group services and HO cost allocation

Most foreign banks have regional hubs or HO providing shared services like accounting, Human Resources, Information Technology, legal, etc. Common expenses are allocated amongst group entities using appropriate allocation keys. For allowing deduction towards HO cost allocation and computing taxable income of the Indian branch, tax authorities lay stress on various factors viz. evidence of services availed, benefits derived, duplication of services, etc.

The maximum permissible allowance for HO overheads expenditure allocated to Indian branches of foreign banks (non-resident) in India is restricted to 5% of adjusted total income u/s 44C of the Act. TP authorities in few cases held that deduction for expenditure incurred towards services availed from HO should also be restricted to limit prescribed u/s 44C of the Act. However, Tax Tribunals have distinguished HO overhead expenses with expenses incurred for availing services and accepted ALP basis verification of documentations.[4]

The intra-group services also have implications under the Goods and Service Tax (‘GST’) Act, 2017. The GST authorities have been issuing show cause notices on ‘deemed supply’ of services to levy GST on intra-group services with no/inadequate consideration. This includes allowing the right to use intangibles like ‘corporate brand’ or ‘logo’.

Like any intra-group services, in cases where payments are made by Indian branch to the HO towards availing of any services, documentary evidences demonstrating need and benefit of such services, basis of charge (i.e. cost base, allocation keys, mark-up, if any) should be maintained to mitigate potential risks, both from TP and GST perspective.

TP guidelines governing intra-group services and cost allocations are also applicable to Indian headquartered banks/financial entities providing such services.

Inter-company loans and guarantees

Intercompany loan are benchmarked using internal CUP data (if available), open market lending rates based on London Interbank Offered Rate (‘LIBOR’), Marginal Cost of Funds based lending (‘MCLR’) in India, interest rates as per External Commercial Borrowing (‘ECB’) guidelines + spread, as applicable. The challenge for taxpayers is non-availability of comparable data for such transactions. One of the contentious issues is usage of interest rates prevailing in the Indian financial markets or interest rates prevailing in borrowers’ market abroad i.e. LIBOR vs. Indian lending rates. It is settled in many judicial precedents[5] that interest rates depend on the currency in which the borrower has to repay the loan.

In relation guarantee transactions, various judicial rulings, including landmark Tax Tribunal judgement[6], upheld that guarantee commission depends on several factors, such as terms and conditions of the underlying loan, risk undertaken, economic and business interests.

The interest rates are generally linked to LIBOR for foreign currency loans. However, with LIBOR phasing out in 2023/2024, alternate indices e.g. Secured Overnight Financing Rate (‘SOFR’), Sterling Overnight Interbank Average Rate (‘SONIA’), etc. are applied.

The OECD TP guidelines on Financial Transactions, 2020 and recent UN TP manual, 2021 contains principles around intra-group loans and financial guarantee transactions with examples. Paragraph 3.14 of the recent UN TP manual, 2021 elucidates above issues from India context.

Delineation of transactions and interest deductions

Banks in few global countries such as UK, Germany, Japan, Korea, Singapore, etc. are subject to thin capitalisation rules. Principles governing attribution of ‘free capital’ to PE in accordance with the Authorised OECD Approach (‘AOA’) are recommended. AOA suggests functional analysis based KERT concepts and 3 approaches i.e. capital allocation, comparable thin capitalisation and minimum regulatory approach.

In India, presently interest limitation/thin capitalisation norms are not applicable to banks and insurance companies. However, banks are subject to regulatory capital levels set out by the RBI. The attribution of profits to PE using AOA recommended under OECD BEPS Action Plan 4 Report should be on the horizon from Indian context.

Certain instruments like Innovative Perpetual Debt Instruments (‘IPDI’) can be construed as debt for tax purpose. Interest expenses deductions can be allowed on such instruments at present. However, re-characterisation of debt into equity under General Anti-Avoidance Rules (‘GAAR’) can limit interest payment deductions. The decision to characterise transaction presented as loan to something other than loan requires careful analysis based on adequate information, as such conclusions may lead to double taxation. OECD TP guidelines and recent UN TP manual, 2021 elucidate guiding principles on accurate delineation of actual transactions with examples.

Centralised treasury functions

MNEs may designate an entity/department for centralised cash pooling arrangements for liquidity management, minimising external interest/transactional costs, flexible working capital and increasing bargaining power. The hub may also be responsible for centralised collateral management of traded derivative products under the Credit Support Annex (‘CSA’) contracts.

Treasury department/entities operating as ‘service centre’ may be remunerated by applying CUP method or TNMM. However, in case where they operate as ‘profit centres’, the remuneration may depend upon the “spread” between cost of funding and return on cash invested. Profit split method is typically applied for global trading of financial instruments and cash pooling transactions. The functions performed, economically significant risks and ‘substance’ in the designated hub providing centralised intra-group treasury functions should be evaluated.  

Devising TP policies for treasury functions under such hub-spoke model is essential. While there are no specific guidelines from India context, reliance can be placed on the OECD TP guidelines, UN TP manual and global practices, like guidelines recently issued by the Inland Revenue Authority of Singapore for centralised group operations[7].

Brokerage services

Taxpayers providing brokerage services typically apply TNMM for benchmarking brokerage transactions. The position of tax authorities has been to apply CUP method, disregarding factors such as differences in volumes, current and future business from related entities, economic dynamics such as market penetration, etc. In one of the landmark TP rulings[8] and others[9] the Tax Tribunal emphasised appropriateness of CUP method over TNMM for brokerage services.

Global in-house Centres (‘GICs’)

Large foreign banks/ financial groups have incorporated GICs in India owing to advantages of low cost, efficient resources and availability of skilled talent. GICs provide captive back office services like accounting, IT, administration, business support, etc. to group entities on a cost-plus mark-up basis.

TP authorities in few cases have perceived such services as high-end services and attributed higher cost-plus mark-up, ranging from cost plus 25% to 30%. Many such GICs have opted for Advance Pricing Agreement (‘APA’) mechanism to attain certainty and mitigate potential TP audit risks.

IFSC, GIFT city operations

Indian government has developed Global Financial Hub with an objective to promote offshore financial services using high technology, qualified talent pool, economic and world class infrastructure. International Financial Services Centre (‘IFSC’) in the Gujarat International Finance Tec-City (‘GIFT City’) offers offshore banking, capital market, insurance/reinsurance and investment management operations like global financial service centres in New York, London, Dubai, Singapore, etc.

Various benefits and tax incentives are provided to promote operations in the IFSC GIFT city. International Financial Services Centres Authority (‘IFSCA’), a unified regulatory body is established to monitor IFSC GIFT city operations vide Gazette notification No. 50 dated 19 December 2019[10]. IFSCA issued circular, including framework for ancillary services that can be provided by GICs of financial organisations and included aircraft leasing within the ambit of “financial products” and “financial services” defined under the International Financial Services Centres Authority Act, 2019 (‘IFSCAA’)[11].

International Banking Units (‘IBUs’) of major Indian banks and few global banks are incorporated in the IFSC GIFT city. IBUs are eligible for income tax deduction u/s 80LA of the Act. Accordingly, transactions entered by the IBUs qualify as Specified Domestic Transactions (‘SDT’) under provisions of section 92BA of the Act. Typical related party transaction of IBUs include trade finance, inter-unit loans, money market transactions, treasury derivatives transactions, intra group services, cost allocations, etc.

In capital market space, the Bombay Stock Exchange (‘BSE’) and National Stock Exchange (‘NSE’) have set up exchanges in the IFSC GIFT city (INX Limited and NSE Ltd., respectively), offering various foreign currency/Indian Rupee denominated tradeable instruments. The transactions entered by branches of Indian headquartered intermediaries in the IFSC GIFT city are subject to Indian TP regulations. TP regulations also apply to entities set-up/proposed to be set-up by global broking houses in the IFSC GIFT city. Recently the IFSCA has even approved NBFCs to operate in the IFSC GIFT city. While the overseas groups may be attracted to the IFSC GIFT city given the benefits of competitive tax regime and smooth repatriation of funds, this move will help local NBFCs to explore their global presence.

The nexus between provisions of section 80LA and TP provisions u/s 92BA of the Act being relatively nascent, is not tested during audits. With evolving phase, it is necessary to evaluate such transactions, contractual terms and alignment thereof with actual conduct. Robust functional and economic analysis is paramount to determine arm’s length nature of such transactions.

Emergence of digitalisation and Fin-Tech

India is a bed of opportunities for unique ideas. Start-ups are evolving in the arena of digitalisation, especially after the COVID 19 pandemic. The FSI players are embracing digitalisation and upscaling business with the help of technology and digitalisation. Incubation investments in Fin-Tech start-ups leads to operational efficiencies for origination, distribution, loan book management, etc. FSI groups acquire stakes in Fin-Tech start-ups. Consequent to acquisition, contractual arrangements include transfer/sharing of Intangible Properties (‘IPs’) like customer network, standard operating processes, Information Technology, workforce and services at arm’s length considerations. With changes in value chain, TP methodologies (based on functional and economic analysis) are needed as prescribed under the Act and global TP guidelines.

Corporate governance under other regulations

As mentioned earlier, BCM sector is highly regulated. Related Party Transactions (‘RPTs’) should meet arm’s length standards from corporate governance perspective under the Companies Act, 2013 and SEBI Listing Obligation and Disclosure Requirements (LODR), 2015.

For example, referral arrangements are prevalent in large FSI conglomerates engaged in varied businesses like commercial/retail banking, loans, credit cards, insurance, mutual funds, asset management, etc. The considerations for referral arrangements are generally based on third party comparable rates, standard rate charts, open market quotes, industry practices, regulatory ceilings, etc. In absence of prescribed methodologies under the Companies Act or SEBI LODR, TP provisions under the Act are suitably applied for review of RPTs. 

Concluding remarks

TP has evolved drastically in the past two decades. The complexities of issues arising from intra-group transactions (cross border & domestic) has increased manifold, and FSI is no different!

In line with global best practices, India has adopted measures in taxation and TP, like introduction of APAs, transparency through Master File and Country-by-Country reporting, faceless assessments, etc. so as to meet the objective of ‘non-adversarial tax regime’.

The evolving business models, stringent regulatory framework on corporate governance and aggressive positions of tax authorities during audits necessitates the taxpayers in FSI sectors to undertake detailed evaluation of intra-group transactions. Further, with the adoption of OECD BEPS Action Plans, it is essential for the taxpayers to focus on the aspects of transparency, robust TP analysis and effective documentation.

*****

The Organisation for Economic Co-operation and Development’s (“OECD”) attempt to tax digital economy in Pillar 1 blueprint is nothing short of a Fosbury Flop. The current international taxation rules were designed a century ago and are unable to address the significant changes in business models, brought about with the adoption of technology by businesses. Today, businesses can operate at scale without physical presence. This was not true in 1928 when the League of Nations adopted the Permanent Establishment (“PE”) concept to address challenges from cross border double taxation. The OECD later formally adopted the PE concept in its Model Convention in 1963 which laid the foundation for most of the bilateral tax treaties we see today. At that time, in absence of digitisation, businesses needed to be physically present to conduct and conclude sales.

The OECD had commenced work to address challenges arising from digital economy as early as in the year 2010 and had released its first report in 2013 - Addressing Base Erosion and Profit Shifting (“BEPS”). Then the same year it released its report ‘Action Plan on BEPS. The 15 final action plans envisaged in the 2013 report were released by the OECD in 2015.

Action Plan 1 of the BEPS project addresses the Tax Challenges arising from digitisation and has seen significant development since its release. In 2018, OECD also released an interim report wherein it not only discussed the problems arising from digitisation but also had a thorough analysis on the prevalent business models in the digital economy. In early 2019, based on an agreement between the OECD and G20 countries, two pillars were identified to address tax challenges from digitisation. Pillar 1 deals with nexus and profit allocation rules in the digital economy whereas Pillar 2 is focused on a global minimum tax intended to address remaining BEPS issues with the primary objective to nullify any tax arbitrage an MNE Group can receive through cross-border arrangements. This was also incorporated into a Programme of Work which was endorsed by the OECD and G20 countries. As its latest addition, the OECD in October 2020 published Blueprints to Pillar 1 and Pillar 2 and invited public comments on the same.

While the initial focus of Pillar 1 was on business models arising on account of digital economy, OECD increased the scope to include consumer facing businesses which has significant traces of digital economy. This endorses the point that the OECD realised early on that “digital economy is economy as a whole”. The Pillar 1 Blueprint is focused on new nexus and profit allocation rule to ensure that in an increasingly digital age the allocation of taxing rights with respect to business profits is no longer exclusively circumscribed by reference to physical presence. We have discussed forthwith the mechanics of Amount A discussed in the Pillar 1 Blueprint (hereafter referred to as “Blueprint”) and the impact it may have on MNE Groups.

The Programme of Work released by the OECD had envisaged a three-tier mechanism for addressing issues dealing with nexus and profit allocation. The tiers are called –

1.    Amount A – deals with new taxing right under which a share of residual profit is allocated to market countries under a formulaic approach. The allocable share of profits of the MNE Group towards market jurisdictions is Amount A;

2.    Amount B – fixed baseline marketing return on an arm’s length principle; and

3.    Amount C – additional return for marketing intangibles.

However, in the Blueprint, only Amount A and Amount B are discussed. A possible reason of not discussing Amount C is that the local regulations already appropriately address the concerns highlighted for Amount C. 

To whom is Amount A applicable?

The Blueprint is recommending that large MNEs (earning consolidated group revenues greater than Euro 750 million) having operations in automated digital services (“ADS”) or consumer facing businesses (“CFB”) should test for applicability of Amount A. Hence, ADS and CFB are referred to as in-scope activities. The Blueprint seeks to target those MNEs that can participate in an active and sustained manner in the economic life of a market jurisdiction, without having commensurate level of taxable presence under the current regime of conventional taxation rules. For this, the Blueprint recommends a second revenue test “a de minimis foreign in-scope revenue test”.

For ADS services the Blueprint further elaborates a positive list and a negative list along with definitions. The positive list includes companies earning revenues from online advertising services, sales or other alienation of user data, online search engines, social media platforms, online intermediation platforms, digital content services, online gaming, standardised online teaching services and cloud computing services.

The negative list includes companies engaged in customised professional services, customised online teaching services, online sale of goods or services other than ADS, revenue from sale of physical goods, services providing access to the internet or other electronic network.

Many Indian IT service providers are engaged in providing IT services through cloud computing solutions. Depending on the level of automation involved in the activity, it can be a matter of debate whether the IT services provided through cloud computing solutions satisfy the definition of ADS as it may also be considered as customised professional services. Hence, given the dual nature of cloud computing, further clarifications are still required from OECD on the exact nature of services that should be covered under cloud computing.

For CFB, it is defined as those businesses that generate revenue from sale of goods and services of a type commonly sold to consumers, including those selling indirectly through intermediaries and by way of franchising and licensing. OECD is also contemplating to have a “plus” factor such as an additional market revenue filter to ensure that only those CFB MNE groups are brought within the ambit who have a significant economic presence without a physical presence in a country.

How is Amount A calculated?

Given that Amount A is a new taxing right, it is also aiming to rewrite the revenue sourcing rules for attributing revenue and profits to a market jurisdiction. Hence, for calculating Amount A, MNEs will need to restate the revenue from a particular jurisdiction in line with the revenue sourcing rules recommended by OECD in the Blueprint. For ADS services, primarily the focus is on restating the revenue based on geolocation of the consumer. If this data is not available then the IP address of the consumer can be considered and on non-availability of this, the billing address of the end consumer or other methods as may be deemed fit. Thus, OECD has interestingly proposed to use “Digital Footprints” to track and tax digital economy as otherwise it was not traceable.

Similarly, for CFB, depending on whether it is goods or services, the criteria have been established with focus primarily being given to establishing the jurisdiction of the consumer. 

The current difficulty is that a hierarchy of the conditions is currently given by the OECD and it is the onus of the taxpayer to establish why a superior hierarchy condition is not used. For e.g.: why the IP address of the consumer is used as against the consumer’s geolocation. This can be a potential area of debate with the tax authorities given that there is no learning curve and hence the taxpayer would need to robustly document the selection of the conditions in the hierarchy.

OECD envisages that companies may already be preparing segmental reports by geography and hence restatement for the purpose of revenue sourcing may not be a cumbersome exercise. However, this may not be true for diversified businesses who prepare segmental based on lines of business. Further, the current accounting standards are also not aligned to capture the data as required under revenue sourcing rules and it maybe possible that the existing customer systems are also not aligned to capture such data points. Representations in this regard have been made to the OECD and we will need to wait and watch for the developments in this regard.

Finally, once the revenue as per the new revenue sourcing rules is determined, a pre-determined percentage of the profits earned by the MNE group will be redistributed based on this revenue ratio amongst the market jurisdiction as Amount A. The pre-determined percentage is indeed a million-dollar question and thus still under discussion.

Who amongst the MNE Group will pay Amount A and to which tax authority?

Once it is established that an MNE meets the revenue threshold criteria, it is required to identify within the MNE Group who shall be bearing the Amount A tax liability. For this, a four-step process has been recommended.

Step 1: Activities Test: First, identify the entities within an MNE group that perform activities that make a material and sustained contribution to the group’s ability to generate residual profits;

Step 2: Profitability Test: Apply a profitability test to ensure the entities identified have the capacity to bear the Amount A tax liability;

Step 3: Market Connection Priority Test: Allocate, in order of priority, the Amount A tax liability to the entities that have a connection with the market(s) where Amount A is allocated;

Step 4: Pro rata allocation to other entities: Where the entity or (entities) identified under the market connection priority test do not have sufficient profits to bear the full Amount A tax liability for a given market jurisdiction(s), other paying entities within the group or segment will be required to bear the remaining portion of the Amount A tax liability. This portion of the Amount A tax liability would be apportioned between these entities on a formulaic pro-rata basis.

Hence, by following the above process the MNE Group can establish against which tax administration does a paying entity need to absolve its Amount A tax liability.

Finally, once the paying entities absolve their tax liability towards Amount A, they would be required to claim its payment in their local filings with jurisdictional tax authorities to avoid double taxation. For this, it is expected that jurisdictions will modify their tax laws to provide for resolution against double taxation either under credit of taxes method or exemption of income method.

Given that OECD and G20 countries have convergent views to such an approach, it is likely that the tax laws will be modified to enable the payment and credit of Amount A tax liability.

How will taxpayers notify tax authorities about Amount A?

To minimise the burden on MNE groups and to ensure that the same information is available to all relevant tax administrations, an Amount A coordinating entity within an MNE group will file a single self-assessment return and documentation package on behalf of the entire MNE group, with its lead tax administration, by an agreed filing deadline. Hence, for this a coordinating entity needs to be determined by the MNE Group.

 

The lead tax authority will then share the self-assessment return with all tax administrations where the MNE Group has a presence.

How will tax certainty be achieved?

Given the number of controversies transfer pricing audits have generated over last few decades, tax certainty will be critical for successful and effective roll-out of this program. Preempting the potential tsunami of litigation, the proposed law can create, both on scope and on attribution, the OECD has upfront done substantial work to inbuild enough certainty mechanism in addition to the existing conventional remedies like APA and MAP proceedings. The certainty mechanisms are founded on the hope that Amount A will resolve the digital taxation void that has existed so far. Also, it is expected that once the Amount A law has been enacted, countries will roll back any unilateral laws such as Digital Service Tax, equalisation levy, etc. which targets online businesses.

Under certainty measures, the lead tax administration will voluntarily review the self-assessment return filed by selected MNE Groups and determine if the MNE Group has appropriately prepared the self-assessment return and discharged its tax liability towards Amount A. Every country where the MNE Group is present will have a window for it to review the self-assessment package shared with it and report to the lead tax administration whether it believes the self-assessment package has been filed appropriately. In case of difference, the coordinating entity will need to respond to the lead tax authority against the observations raised by the specific country.

Similarly, the taxpayer can also approach the lead tax authority for voluntarily having the case reviewed by tax authority. In this case, for review, the lead tax authority and 6-8 or fewer jurisdictions will form a review panel to review the self-assessment return. The review panel is then expected to either provide its agreement or otherwise on the positions adopted by the MNE Group. In case of disagreement either between the review panel members or by the MNE Group, the case will be referred to a determination panel who will comprise of subject matter experts and will give the final decision on the self-assessment return positions.

Conclusion

Like the Flosbury Flop, the OECD has attempted a revolutionary long jump on the turf of international taxation, for which it wants to win nothing less than a Gold. The recommendations suggested in Amount A is very unconventional and transformational. In the short-term, as with anything new, taxpayers may have to deal with uncertainties and difficulties. However, this exercise undertaken by the OECD needs to be looked at from a long-term perspective as this will shape the tax laws for the next era. Just like how the OECD PE clauses had to go through various iterations before we see the existing finer products today, the Blueprint of Pillar 1 will need to go through several iterations before it can be implemented. In this regard, speaking during a panel discussion in an Irish Department of Finance seminar on April 21, Pascal Saint-Amans, Director of the OECD Centre for Tax Policy and Administration said that the frameworks for implementation of an agreement are already in place, and that remaining issues for agreement can be worked out at G20 meetings in July and October.

As OECD is working towards finalisation of the frameworks, MNE Groups also need to assess their readiness. Implementation of the Pillar 1 framework within an MNE Group will require collaboration of multiple teams and will not be limited to involvement of the tax team. The legal team needs to deliberate on the changes in the customer contracts while the MIS teams will need to determine if the current reports are capable to produce results envisaged in the Blueprint.

Lastly, it is the information technology team that needs to ensure that the systems are upgraded to capture the necessary information. Hence, an MNE Group should upfront assess the applicability of the Blueprint to it and establish a working committee within the global organisation that can monitor the development of Pillar 1 so that they are better prepared for the upcoming changes. As the adage goes – “when one is prepared, difficulties do not come”.

 

 

With the advent of urbanisation and industrialisation, demand for power from individuals to industries has risen rapidly. Climate change and soaring energy costs are driving alternative approaches to doing business, especially regarding use of energy. Companies have been asked to show environmental responsibility at each point of their supply chains, i.e. from the product source/production to delivery, including the point of consumption.

Governments around the world are striving to advance transformation from the existing fossil-nuclear energy system to a sustainable energy system. Renewable energies are a fundamental part in this process and are expected to take over the major share of energy supply in the future. To achieve this ambitious target, many governments are trying to make investments more attractive by providing a good framework. This includes tax incentives for investment as well as tax measures for ecological steering of consumer behavior.

Multinationals are spending significant sums on projects that in some way help them meet the environmental and sustainability goals with more focus on renewable/alternate energy sources. This also gives rise to expansive transfer pricing issues that require companies to consider the new concepts along with the traditional ones.

Transfer Pricing Outlook

A renewable energy project typically starts with a development company that evaluates a site for energy potential, environmental impact, zoning, stakeholder’s approval and transmission. Assuming the site meets the requirements, the company will proceed with permissions, selecting suppliers, securing a power purchase agreement (PPA), purchasing equipment, and constructing the facility. The development company may either operate the facility itself or sell the constructed facility to an operating company, which will take over the PPA and operate the facility. Each decision in the process can have an impact on a company’s transfer pricing policies and consequent results.

In case of a multinational organisation, activities of one entity may create costs and benefits for part or all the group entities, forming part of the organisation. This impacts the function, asset and risk profile across a multinational group and thereby alters the flow of intra-group transactions or creates new value transfers that must be considered from a transfer pricing perspective.

Transfer pricing rules apply to all inter-company transactions. While it applies to transactions that cross international tax jurisdictions, it also applies to domestic inter-company transactions where the value of such inter-company transaction crosses prescribed threshold limits or either party to such a transaction is eligible for specific tax incentives prescribed under the regulations. This is very relevant as tax credits and incentives plays a very important role in the renewable energy sector.

Transfer pricing issues that are arising pursuant to the shift from traditional energy to renewables pertains to:

• Arm’s length price for development of renewable energy sites and related services;
• Transfer pricing methods – addressing the risk element; 
• Seamless implementation of transfer pricing policies across the project stages;
• Consistency in policy implementation using operational transfer pricing approach;
• Comparability challenges in a niche segment;
• Cost allocation - Engineering and management services;
• Justification of losses or low profit in initial year of operations;
• Structuring financial arrangements;
• Delineation of complex transactions in a digital world; and
• Intellectual properties – establishing ownership and related compensation.

Key Considerations

In order to address the aforementioned matters, transfer pricing policies and procedures of companies must be versatile to achieve the arm’s length standard and comply with the regulations. Companies need to adopt a 360-degree view and advantageously structure their business models as well as inter-company transfer pricing policies to put their best foot forward and ensure conformability to the transfer pricing matters.

In subsequent paragraphs, we shall look at specific actions/considerations to be considered by companies engaged/proposing to engage in the renewable energy sector:

• Arm’s length price for development of renewable energy sites and related services

Development companies involved in renewable energy development often place each development project in a separate legal entity, with a parent company or partner offering development and/or management services. Transfer pricing of these services must be addressed to potentially qualify for credits and incentives. Also, development fee and centralised engineering and management services would require a detailed benchmarking analysis and documentation.

The income method can be a useful way to value the development fee as it includes a feature for risk adjustment. An application of the income method may be used to identify the income attributable to various income streams by using both comparable uncontrolled transaction and comparable profits approach. For uncontrolled transactions approach, it may be possible to get data on what third parties have charged for development fees versus the total project costs. Alternatively, one may be able to apply a comparable profits approach by evaluating the routine returns expected for construction and operation for use in the income method.

• Transfer pricing methods – addressing the risk element 

Transfer pricing requires inter-company transactions to be priced according to the functions performed and risks assumed by each party. Since renewable energy development is inherently risky, understanding these risks is critical to properly pricing the development fee. In case of renewable energy, risk decreases with each stage in the development cycle and hence, it is important to understand these stages and select a transfer pricing method that explicitly addresses the risk element.

However, it is important to note that ‘one size doesn’t fit all’ and being a niche sector, there is no established set of methods that can be universally applied for each phase. Thus, the differentiating elements of a company in comparison to its comparables must be taken into consideration and appropriately factored in the choice of method and economic analysis therein.

As such projects are risk averse, traditional methods may rarely be suitable for entities operating in this sector and thus, one needs to explore the possibility of applying profit split method individually or in combination with transactional net margin method. Considering the complexities of adopting a profit split, one may always choose to opt for Advance Pricing Agreement (APA) to ensure certainty with respect to cost allocations, attributable profits and as a necessity, splitting of functions into routine vis-à-vis non-routine.

• Seamless implementation of transfer pricing policies across the project stages

Generally, renewable energy projects go through three main stages - assess, construct, and commission a power project. These three stages make up the renewables economic value chain. The value related to the development varies depending on what steps within these stages have been completed. The operational approvals in the site assessment stage and the PPA are key milestones.

In the changing transfer pricing landscape with increased regulation and tax authority scrutiny, it has become more important to have effective and continuous implementation and monitoring of TP policies throughout an organisation. 

• Consistency in policy implementation using operational transfer pricing approach

Under the BEPS regime, business models are also changing. These changes represent a great opportunity to integrate transfer pricing planning and commercial opportunities. Operational transfer pricing provides confidence to the business that the agreed-upon transfer pricing policies are implemented on the ground, all around the world. This not only enables the business to implement these policies, but also to confirm that they are consistent in all the company’s records.

For many companies, transfer pricing represents the largest tax risk if the company and tax authority cannot agree on the appropriate arm’s length price. This can result in large penalties levied by the tax authorities, which has implications not only on finances, but also on the organisation’s reputation in the market.

• Comparability challenges in a niche segment

Considering that renewable energy sector still forms a small part of overall energy sector, it can be difficult to find appropriate comparables.  Due to consolidation in the industry, where larger players purchase startup operations to expand their renewable portfolios, there is a difficulty in identification of pure renewables players.

Renewables operations are often a small part of large energy conglomerates and they do not provide segmented information for their renewables’ operations. Therefore, one can select a comparable set for renewables operations composite of the entire industry rather than a benchmark of the specific activities undertaken, requiring adjustments to increase comparability.

• Cost allocation - Engineering and management services

Many renewable energy companies structure their business with each entity specialising in an activity. This can lead to the provision of engineering or management services between affiliates. For services transactions, companies need to document both the benefit provided and the appropriateness of the charge. This charge can be based on cost alone, costs with a markup, or another market rate (such as hourly engineering rate).

The challenge often arises in allocating the costs between affiliates. While timesheets can be helpful, they are not mandatorily required. Even with timesheets, tax authorities can question the benefit received from the service. Hence, it is critical to determine which entity truly benefits from the service and provide support for that assertion.

• Justification of losses or low profit in initial year of operations

Losses or low profits resulting from new projects or operations will need support from the company’s transfer pricing policy, which should provide a clear and robust defense of any profit profile changes. The distribution of income and losses must reflect not only a company’s strategic value drivers and its assumption of risk, but also its unique market structure in promoting green initiatives.

For example, the emerging photovoltaic or solar energy production industry is heavily supported by certain government programs and incentives specific to geographic regions or markets. In Indian context, companies must consider effects of programs (such as PLI scheme) and incentives on transfer pricing policy. Multinational companies should consider how these programs relate to the distribution of income and losses across divisions.

• Structuring financial arrangements

As multinationals take leap into the fast-growing renewable energy sector, such business initiatives will also require finance. While achieving an arm’s length lending rates is always a transfer pricing concern, structuring such financing transactions would need detailed analysis and supporting documentation. Care should be taken in analysing regulations around levels of debt and thin capitalisation, while creating defense around lending rates, impact on profit, and asset levels.  

• Delineation of complex transactions in a digital world

Taxing entities based on their locational presence is no longer a logical approach. Digitalisation is a game changer in the business world and as a consequence, traditional ways of analysing transfer pricing matters have been rendered redundant. While digitalisation of economy has raised several tax challenges, here are a few areas which have been impacted from a transfer pricing perspective:

Automated Services

Shared services are often rendered on digital platforms which may be on a common website for the group or such similar centralised network. With the changes in regulations and introduction of equalisation levy, such international transactions now fall under the purview of transfer pricing and shall be required to be undertaken at an arm’s length range/price. Thus, normal principles of transfer pricing shall be applicable.

Delineation of complex structures

With the emergence of digital economy, the focal points of BEPS[1] initiative, the business models have changed drastically and thereby, elevating the complexities within the inter-company arrangements and structures. No longer can the functional and risk matrix of the group be portrayed in black and white. Models are ever shape-shifting, and no single function can be confined to any specific entity which leads to complex structures. Owing to these factors, delineation has gained prominence for appropriately evaluating the contribution of each link in the value chain. To enable accuratedelineation of complex functional and risk structures, an entity needs to follow guidelines as provided by the OECD Transfer Pricing Guidelines.[2]

By adopting the given approach, core and support functions can be identified appropriately, making it feasible to assign a value to each such function. Many a times, the functions may be split across entities as digitalisation has made group entities self-sufficient. Thus, risk also plays an important role especially in decentralised structures with complex entities undertaking both strategic functions as well as routine / low-value added services.

Impact on intangibles

Digitalisation has enabled entities to undertake functions in jurisdictions wherein they do not have a presence. Further, with marketplace now being online, marketing intangibles are no longer attributable to the legal owner. Entities operating in a virtual space need to address the nuances on how one can attribute the risk and corresponding benefits to the intangibles developed or correlating to the digital marketplace. Marketing intangible has always been a controversial topic with added emphasis in the digital world.

Thus, while digital economy accelerates the growth, it gives birth to several transfer pricing related complexities and challenges which one needs to proactively address.

Each country wants to protect its tax base, however, intangibles in the digital world come with exceptional challenges. Intellectual property is a key element of renewable energy sector. This has been addressed in detail in the succeeding section.

• Intellectual properties – Establishing ownership and related compensation

Development costs of new technologies, products, and processes may also contribute in creating intellectual property. A multinational group will need to review their brand and product portfolios to develop new intangible with strong appeal and create a policy for providing use of such intellectual property to group users at an arm’s-length rate.

Also, brand protection and enhancement may be one of the main drivers of creating transfer pricing policies around intangibles. Brand owners within a multinational group may be expected to share the risks and rewards through a transfer pricing policy. With respect to technical intellectual property, it is critical to establish both clear ownership and, where the brand is the driving force, the appropriate substance, at the earliest. Towards that a detailed analysis using the DEMPE[3] criteria as prescribed under the OECD[4] rules should be followed.

Way Forward

As more and more companies move towards taking benefit of government incentive schemes for renewable energy sector which forms an important part of the renewable energy investment, appropriately addressing tax issues in structuring the investment may create a successful one. The business models and structuring of inter-company transactions would certainly trigger many transfer pricing challenges, requiring critical attention be paid to transfer pricing issues while selecting the structure, the nature of investment, and the timing of a potential sale.

However, this will also give opportunities for effective planning so that businesses can understand the implications of their existing as well as planned business strategies. The strategies would depend upon various drivers including regulation, innovation, new market conditions, etc. Companies would need to stay aware of such changes and build its transfer pricing policies that are both robust and stable for new and existing business streams and business models and, also flexible enough to achieve maximum tax benefits from future developments.

To summarise, changes to business models, and creation of and investment in new businesses and technologies will always generate risks and rewards. A possibility of achieving certainty by entering into APA with the central government should also be considered as it will help companies to focus on business and avoid litigations on various aspects of inter-company transactions.

 

Stepping back a few decades, the ‘90s saw the wave of globalization. Many multinational enterprises (“MNEs”) re-organized their operations such that there was centralization of intangibles and risk and consequently of the profit potential attached to them. The resulting tax impact was studied and discussed in OECD’s chapter on Business Restructuring (“BR”) in the OECD Transfer Pricing Guidelines (“TPG”) in 2010.

Since its introduction, the concept of BR has garnered lot of attention from taxpayers and tax consultants alike on account of the absence of a definitive definition of what constitutes BR. Even Indian tax authorities in the amended definition of international transactions covered BR as an international transaction, however, did not explicitly define “BR”.

Business representatives who participated in the OECD consultation process (2005 to 2009) explained that maximizing synergies and economies of scale, streamlining the management of business lines, improving supply chain efficiency and introducing internet based technologies that facilitated trade, were some of the reasons for undertaking BR.

While these reasons still hold true in the current day and businesses are free to structure their operations as they deem fit, tax authorities observed, inter alia, BRs within a MNE group generally involved transfer of “something of value” or renegotiation of “commercial and financial relations” between Associated Enterprises. This was followed by reduced profitability in the company that transferred “something of value” or gave up activities/ risks.

Even when BR is undertaken for business purposes, it could result in loss of significant taxes to the government and hence it is of no surprise that tax authorities would want to thoroughly scrutinize such transactions to catch any tax leakages. Many a times, because of lack of information or inability to completely comprehend the business of the taxpayer, the tax authorities had difficulty to conclude if the BR was tax motivated.

This difficulty was aimed to be solved through the introduction of the Master File wherein MNEs are required to discuss complete value chain along with entities which make principal contributions to the value chain.

In this backdrop, we will proceed to discuss the significance of an MNE’s Value Chain Analysis (“VCA”) and the direction it provides in understanding if there is a BR within the Group. 

What is VCA and why is it needed for understanding BR?

A VCA can be said to be a blueprint of the MNE Group’s operations. It commences with laying down the supply chain of the services/ products sold by the MNE Group and then identification of drivers of profits of the MNE Group. The analysis then lists the functions, assets and risk (“FAR”) profile of each entity within the Group. It is important to note that for FAR profile, the conduct should take precedence over the contract. Also, emphasis should be paid to understand who has the ability to control the function/ risk as against who is contractually assuming it. This is in line with the principles enunciated in the 2017 version of OECD TPG. The next step of action would be to understand the remuneration model of various entities within the MNE Group. 

The above analysis presents an understanding of what can be considered as “something of value” within the group and within individual entities. While OECD did not provide an exhaustive definition of what can be considered “something of value”, in Chapter IX of the 2017 OECD TPG it has provided guidance on what could potentially be considered as transfer of “something of value”.

The VCA will also present the economically significant functions or risks of the MNE Group and the individual entities. Further, by understanding if an entity is really controlling the function/ risk, it becomes easier to understand whether such an entity would need to be remunerated if there is a transfer of such function or risk from that entity. Hence, the VCA is the first step to understand if any BR within the Group could have tax significance.

Transfer of “something of value” or “changes in commercial and financial relations”

As discussed, the pretext of analyzing BR transactions is that MNE Groups may decide to reallocate “something of value” or rearrange the “commercial and financial relations” between group companies. Let us understand this through the below illustrations.

Something of Value: Let us consider that an Entity A within an MNE Group has been entering into customer contracts for delivery of certain services. These customer contracts with attached revenue streams can be considered as “something of value” as per the OECD TPG. In this illustration, as part of the VCA it was observed that while Entity A entered customer contracts, it did not undertake performance of services under the contract neither did it bear any economically significant risks. It only undertook sales and marketing activities for the Group. The performance of services and bearing of significant risks were undertaken by another Group Entity B. Hence, it was decided by A and B that since B was undertaking the economically significant functions and risks with the customer, the customer contracts should be transferred to B. One may consider that since A is transferring the existing customer contracts to B, this would tantamount to transfer of “something of value” as envisaged by OECD. A VCA in this case would throw light on the role played by A and B in the overall supply chain, who controls what profit drivers and assumes what responsibility and consequently, whether transfer of contracts from A to B would constitute a BR or mere realignment of operations not constituting a BR.

Commercial and Financial relations: It may so happen that entities of the MNE Group renegotiate their inter-company pricing. This may be considered as a change in commercial or financial relations. However, the VCA can be referred for understanding if such renegotiations would constitute a BR. It may so happen that renegotiation in pricing is just to align with changing business dynamics and not necessarily something the MNE Group undertook as part of a restructuring exercise. Broader analysis will need to be carried out to determine if the same would tantamount to a BR as a change in pricing policy which may impact the entity’s profit potential.

BR in the digital age

Digitization has changed the way business is carried out and COVID-19 pandemic has acted as a catalyst in the digitization process. Traditional business models are being wiped out or are evolving to keep pace with technological advances. For example, media and news houses are increasingly going online through social media or launching OTT platforms to cater to audiences dropping newsprint, cable or satellite television subscriptions. These platforms also provide the ability to scale up in any jurisdiction without having a significant physical presence.

While countries are still grappling with the changes and trying to come to a consensus on taxation of the digital economy, it is possible that traditional BR issues will soon be replaced by newer ones. For e.g.. on account of lockdown initiated by various governments, many employees were caught outside their home jurisdiction and because of the digital evolution, continued working from outside home country. Some employees even changed base to holiday homes. While the lockdown related events are one-off cases, it showcased that cross jurisdictional working can be carried out easily and many employees may prefer to continue working in the same way. If that is the case, one would need to relook whether such an arrangement would be considered as transfer of “something of value” from one jurisdiction to the other, particularly when based on VCA, these people were controlling the decision making or performing Key Entrepreneurial Risk Taking (“KERT”) functions (e.g. asset management).

BR in times of COVID-19

COVID-19 has impacted the way companies undertake their operations. While disruption on the supply side has forced companies to look for new avenues of sourcing goods and services, the demand side disruption has motivated them to explore new markets or approach customers through different channels. For example, digitization has enabled companies to adopt direct-to-consumer strategies thereby bypassing distributors. In fact, because of the pandemic, many brands saw an increase in sales via their own websites which led to an increase in self-shipped orders. Such an event may automatically result in a shift of role of the distributor in the value chain which would warrant a relook at the inter-company pricing. At the same time, the role and inter-company pricing of other enablers such as logistics management and customer support in the value chain may need to be reanalyzed.

While the evolution discussed above is driven by market forces and it is important for MNEs to keep pace with innovation and evolving business models, it is imperative that the VCA be appropriately revamped since any change in functions or inter-company pricing may result in transfer of “something of value” or “renegotiation of commercial and financial relations”. 

One needs to also bear in mind that the impact of BR may spread over the years and hence a downward adjustment made during COVID times, should also be supplemented with an analysis that explains whether the entity agreeing for a reduced margin in current times would be eligible for higher margins when the situation improves.

Conclusion

 

 

Risk plays a crucial role in a business matrix. The risks can be internal as well as external to businesses. There exists a positive correlation between risk and return. Transfer pricing (“TP”) analysis takes into account risk factors, along with functions carried out and the assets used in the business. In that context, Multinational Enterprises (“MNE’s”) pay considerable attention to risk, and associated profit allocation, for any inter-jurisdiction related party transaction. As it often happens in any TP comparability analysis, even the characterisation of the tested party is dependent on functions and risks undertaken by the party.

The Organization of Economic Cooperation and Development’s (“OECD”) in its 15 Action Plans emphasised on importance of risk allocation, and Action 9 provided guidance on how allocation of risks among related parties should be made on the basis of conduct of the parties irrespective of the contractual obligations, a principle not new to TP analysis but one that seems to have fallen by the wayside over time.

Indian courts have also recognised the importance to Functional, Risk & Asset Analysis (“FAR”) analysis as seen in a plethora of judicial rulings including in 292 ITR 416 where the courts have emphasised on FAR analysis – i.e., analysis of the functions performed, associated resources employed and risks controlled, and held that if the taxpayer is remunerated on an arm’s length basis, taking into account all risk-taking functions of the MNE, then no further adjustments are warranted.

In this article, we shall discuss how risk analysis has been emphasised by the OECD over the last 20 years of India’s TP journey and its role in the current situation.

Evolution of OECD Guidelines in relation to risk analysis under TP

Risk analysis is important as it provides an overview of the value creation and responsibility matrix within the supply chain in general and of the related party transaction in particular. It provides an understanding of the relative contributions of the parties to the transaction and their roles in overall value creation. Risk analysis plays significant role in FAR and the OECD has recognised and emphasised on this in its evolved guidelines.

In 1976, the OECD first established its Guidelines for MNEs, a comprehensive set of recommendations by governments to MNEs to voluntarily adopt to minimise and resolve impacts which may arise from their operations in foreign jurisdictions and to encourage positive contributions to economic, social and environmental progress. The guidelines, in their 1995 version, began to develop the topic of risk as part of functional analysis by stating that in comparing the functions performed, risks assumed by parties should be considered and that in the open market, the assumption of increased risk will be compensated by an increase in the expected return. Therefore, functional analysis would be incomplete unless the material risks assumed by each party have been considered.

These guidelines were further enlarged in 2010, where although the risk treatment as part of functional analysis did not change significantly, Chapter IX on business restructurings was added to these guidelines. Part I of this chapter called “Special considerations for risks”, attaches great importance to contractual terms in risk allocation. It considers three perspectives: i) Whether the conduct of the associated enterprises conforms to the contractual allocation of risks; ii) Determining whether the allocation of risks in the controlled transaction is at arm’s length and iii) Consequences of the risk allocation.

Further, in 2015, the OECD as part of Base Erosion and Profit Shifting (“BEPS”) Action Plan issued 15 Action Plans and created a comprehensive and cohesive approach to the international tax framework, with a view to ensuring that the profits of MNEs should be better aligned with economic activity and value creation. These were classified broadly as “minimum standard”, “best practices” or “recommendations” for governments to adopt, which later was included in 2017 update of the OECD Guidelines.

Under the said guidelines, Actions 8-10 provide guidance to prevent base erosion and profit shifting by aligning TP outcomes with value creation. Action 9 specifically covers cases where there are artificial and inappropriate allocation of risks and capital, amongst group members of an MNE group. It considers the contractual allocation of risks, and the resulting allocation of profits to those risks, which may not correspond with activities actually carried out. It provides guidance which responds to these issues and ensures that TP rules secure outcomes that see operational profits allocated to the economic activities which generate them.

BEPS Action 9 – An in-depth analysis of Risks

The guidelines provide below steps in the process in order to accurately delineate the actual transaction in relation to risk:

1. Identification of economically significant risks;
2. Identification of contractual terms of these significant risks;
3. Undertaking Functional analysis for identifying risks, conduct of parties, entity performing control and risk mitigation functions, entity bearing consequences of risks and whether they have financial capacity to bear the risks;
4. Interpreting the information gathered and determine whether;

• contractual assumption of risk is consistent with the conduct of the associated enterprises
• party assuming risk exercises control over the risk and has the financial capacity to assume risk.

5. If the party assuming the risk does not control the risk or does not have the financial capacity to assume the risk, allocate the risk to the group company having the most control and having the financial capacity to assume the risk; and
6. Take account of all facts, including the analysis of risk in determination of pricing.

The guidance emphasises that while contractual assumption of risk is the starting point, the agreement must have been made in advance of the risk outcomes being known (i.e., ex ante). A party is required to have both capability (competence) and functional performance (decision-making) in order to exercise control over a risk. Control includes taking on, laying off or otherwise responding to a risk. Risk mitigation and preparatory work relating to the decision-making may be outsourced. Where such outsourcing takes place, the company controlling the risk should set objectives for the outsourced activity, assess whether the objectives are met, and hire (and terminate the arrangements with) the service provider. Merely formalising decisions that were made in other locations in, for example, board meetings where documents relating to the decision are signed, does not qualify as exercising a decision-making function sufficient to demonstrate control over risk. Furthermore, setting the policy environment relevant to a particular risk also does not sufficiently demonstrate control over a risk.

Financial capacity to assume a risk is included as a criterion that ranks equally with control when analysing the assumption of risk. The test of “financial capacity to bear risk” looks at access to funding (assuming company is independent) to take on or lay off risk, to pay for risk mitigation functions and to bear the consequences of risk if the risk materializes. Where a party does not assume a risk or contribute to control of the risk, it will not be entitled to any unanticipated profits or be required to bear unanticipated losses arising from that risk. The guidance addresses the situation where a capital-rich member of the group provides funding but performs little or no activities (cash boxes). If a cash box is not exercising control over the financial risk that is associated with its funding (for example, because it simply provides money when it is asked to do so, without any assessment of whether the party receiving the money is creditworthy), then the risk is allocated to the group entity that is performing the control functions and that has the financial capacity to assume the risk. Therefore, a party performing only financing activities in relation to a transaction without exercising any control over the risks, is entitled to only a risk adjusted return for its financing activities.

Thus, the group companies performing important functions, controlling economically significant risks, and contributing assets, as determined through the accurate delineation of the actual transaction, should be entitled to an appropriate return reflecting the value of their contributions. This has become more relevant and imperative in current business scenario. With colossal impact of COVID-19 on businesses, the existing supply chain has also been disrupted. This has led to re-examination of the intra-group transactions and allocation of risks amongst the parties of the MNE group.

Impact of COVID-19 on TP analysis specific to risk and OECD guidance on same

The impact of the COVID-19 pandemic has been deep. Businesses continue to face significant cash flow constraints, nose-dive drop in profitability, local restrictions affecting supply chains and businesses. In the presence of significant financial hardship, some enterprises have reviewed their contractual arrangements with third parties to ascertain whether they remain bound by them or whether they have attempted to renegotiate key commercial terms including key risks.

Accordingly, in December 2020, the OECD released a report containing guidance on the TP implications of the COVID-19 pandemic. The report notes that unique economic conditions arising from COVID-19 and government responses to the pandemic have led to practical challenges for the application of the arm’s length principle.

The report focuses on following four priority issues which are discussed in separate chapters in the report.

1. Comparability analysis – Guidance is provided on what sources of contemporaneous information may be used to undertaken comparability analysis wherein reference is drawn towards use of macroeconomic information such as country specific GDP data or industry indicators from central banks, government agencies, industry or trade associations, regression analysis and variance analysis, budgeted/forecasted data.
2. Losses and allocation of COVID-19 specific costs – Guidance is provided on how MNEs can re-look into allocation of exceptional costs and losses arising because of COVID-19. Allocation of operating or exceptional costs would follow risk assumption and how third parties would treat such costs. Hence, it is necessary to first delineate the controlled transactions accurately. A very interesting reference is drawn to the fact that the party initially incurring an exceptional cost may not be the party assuming risks associated to that cost at arm’s length, and consequently such costs may need to be passed on to parties that do assume such risks.

It has emphasised on the allocation of risks between parties to an intercompany arrangement and how the profits and losses would be allocated between third parties under the said comparable situation. The COVID-19 pandemic, which constitutes a hazard risk, has led to unusual outcomes of other risks such as “market place risks” relating to demand for products/services, “operational risks” resulting out of disruption from supply chains, “financials risks” relating to cost of capital. For example, the term “limited-risk entities” are very common but not defined specifically under OECD guidelines. It is not possible to establish a general rule that such entities should or should not incur losses. Paragraph 3.64 of Chapter III of OECD guidelines holds the possibility that simple or low risk function entities may incur losses in the short term. For example, an LRD (“Limited Risk Distributor”) classified as such because of limited risk of inventory, may incur losses because of marketplace risk which arises due to decline in demand which results into insufficient sales to cover local fixed cost. In all circumstances, it will be necessary to consider specific facts and circumstances and an analysis should be performed through accurate delineation of the transactions and through the performance of a robust comparability analysis.

Thus, the inter-relation between the COVID-19 hazard risk and other resultant risks should be analysed when considering risk assumption between related parties.

 The guidance has also discussed the issue arising out of the invoking of force majeure clause by parties under contractual agreement. It has referred that care should be taken to assess whether the magnitude of the disruption caused by COVID-19 in the specific related party situation, qualifies as a force majeure event, and to review the force majeure clause in the context of the overall relationship, contractual agreement and how third parties would have behaved under such situation.  

3. Government assistance programs – The guidance has also referred to some aspects that need to be considered while analysing impact of government assistance programme on pricing of controlled transactions such as availability, purpose, duration, and other conditions imposed by the government as conditions for availing benefits. The guidance has stated that this needs to be considered as an overall approach i.e., whether it provides a market advantage to the recipient, impact on comparable vis-à-vis tested parties, extent of benefit passed on to customers and also allocation of such benefits among related parties.
4. Advance pricing agreements - The guidance encourages taxpayers to adopt a collaborative and transparent approach by analysing and discussing relevant issues with the tax administrations.

The guidelines are not very specific on what should be the approach of taxpayers or administrations while undertaking arm’s length analysis. It focuses on the objective to find a reasonable estimate of an arm’s length outcome. The approaches described circle around “what would be the conduct of the third party under the said circumstances”. This principal-based approach to assessing inter-company prices is equally robust for evaluating controlled transactions in the COVID-19 pandemic phase. The guidance maintains that businesses should seek to contemporaneously document as to how, and to what extent, they have been impacted by the pandemic.

Conclusion

TP has evolved during its journey as a subject matter globally as well as in India in the past 20 years. While the Indian TP landscape has evolved and matured, it is still catching up to the fast evolving global landscape. OECD has invested significantly in addressing various critical issues and has come up with guiding principles for adoption by MNEs and tax authorities.

With the sword of COVID-19 still hanging over the economic recovery in numerous countries around the world including India, MNEs should ensure that any new risk allocation or change in risk assumption among related parties must be supported by commercial rationale and analysis of all facts and circumstances to substantiate the position.

MNEs will have to keep assessing the impact specific to their businesses. While economic recovery may have started for a few countries, many are facing unpredictable and unprecedented economic conditions. This would enable them to take appropriate action in a timely manner, while also responding to the ever-changing and dynamic situation.

 

 

 

 

 

 

 

India introduced ‘Equalisation Levy’ (‘EL’) in the year 2016 as a measure to tax certain specific digital transactions. Although three rounds of amendments have already been introduced, there is still much ambiguity in the practical implementation of EL. This article deals with the uncertainties around the application of EL provisions on inter-company transactions, which are also covered under the existing Indian TP regulations.

Background:

One of the most significant developments which has virtually transformed the way in which businesses are carried out across the globe is, digitalization. Digital technologies are transforming societies and creating opportunities on an everyday basis. They are changing the content and structure of markets. The digital economy is characterised by an unparalleled reliance on intangible assets, extensive use of data and the difficulty in determining the jurisdiction in which value creation occurs, owing in part to user contributions. The place of value creation has been the main concern with respect to digital economy and has been a potential source of disagreement among countries. 

The Organisation of Economic Cooperation and Development (‘OECD’) has acknowledged that digital economy is in a continuous state of evolution and there was the need to evaluate the impact on tax systems. The current taxation laws, based on the traditional brick and mortar system, have so far failed to keep pace with the challenges posed by digital economy. In the backdrop of OECD’s analysis of the impact of digitalization on tax matters in the Base Erosion and Profit Shifting (‘BEPS’) Action Plan 1, several options were evaluated to tackle the upcoming tax challenges arising out of digitalization. Accordingly, the following three interim options were proposed to tackle the issues emerging from digital transactions-:

a) Significant economic presence (‘SEP’);

b) Withholding tax on digital transactions; and

c) Equalization levy

Global Perspective

The delay in consensus for a global framework has led countries across the world to implement unilateral measures for taxing digital companies. Countries such as Argentina, Austria, France, Greece, Hungary, Italy, Malaysia, Poland, UK have enacted legislations for either a Digital Service Tax (‘DST’) or a tax on a Digital PE or a withholding tax on certain digital payments.

Accordingly, India is not unique in taxing digital businesses, and is aligned with many countries on its approach around a digital tax.

Indian story so far:

Taking a cue from the OECD’s BEPS Action Plan 1 dealing with the digital economy, India introduced multiple levies through EL or the nexus- based rules in the form of SEP.

India first introduced EL in 2016. EL was chargeable at the rate of 6% (referred to as EL 1.0) on the amount of consideration for specified services received (or receivable) by a non-resident (not having a Permanent Establishment in India), from a resident in India who carries out business or profession, or from a non-resident PE in India. The services covered within this tranche of EL were advertising, digital advertising and other specified services[1].

It is pertinent to mention that, the provisions of equalisation levy are not part of the Income-tax law; this levy was introduced as a separate chapter (Chapter VIII) in the Finance Act 2016.

Expanded provisions of EL as introduced in 2020

Thereafter, the scope of EL provisions was expanded by Finance Act 2020, to levy EL of 2% (referred to as EL 2.0) on the consideration received (or receivable) by an ‘e-commerce operator’, from ‘e-commerce supply or services’ provided or facilitated on or after April 1, 2020. The expression ‘e-commerce operator’, ‘scope of supply or service’ and ‘e-commerce supply or services’ were also defined in the expanded provisions[2].

Amendments as per Finance Act, 2021

Further amendments were made by Finance Act, 2021 in respect of EL 2.0 which have been discussed below:

a) Amendment to provide that consideration liable for EL shall not include consideration, which is taxable as royalty or fees for technical services (‘FTS’) in India under the Income Tax Act, read with tax treaties

b) Amendment in the Income-tax Act to provide for exemption on any income (of a non-resident) subject to EL arising from any e-commerce supply or services made/ provided/ facilitated on or after 1 April 2020.

c) Widened the definition of term ‘online sale of goods’ and ‘online provision of services’. (discussed in detail below)

d) Amended the term ‘consideration received or receivable’ from e-commerce supply or services to include consideration:

• For sale of goods irrespective of whether the e-commerce operator owns the goods; or
• For provisions of services irrespective of whether the service is provided or facilitated by the e-commerce operator.

EL and interplay with Transfer Pricing

•  Impact of the Royalty/ FTS amendment on Transfer Pricing

From an Indian transfer pricing (‘TP’) perspective, if taxable income is received by a non-resident MNE entity from its associated enterprise (‘AE’) located in India, then the non-resident MNE entity may be covered within the purview of Indian TP regulations. Generally, these income streams are:

1. Fees for technical services
2. Royalty Income
3. Intra group services not covered in FTS
4. Capital gains in the hands of non-resident MNE entity wherein it has sold a capital asset located in India, to its Indian AE/ Non-resident AE

As discussed above, amendment made vide Finance Act 2021 has provided that EL shall not apply on consideration which is taxable in the nature of royalty or FTS under the Income Tax Act, read with the relevant tax treaty, retroactively from April 1, 2020. Therefore, per the Indian TP regulations, for these receipts from an Indian AE, that would constitute income chargeable to tax in India in the hands of the NR, the non-resident MNE entity will continue to have to examine royalty income/ FTS income received from an arm’s length perspective and undertake necessary transfer pricing compliances as provided in the Income Tax Act.

• Impact of EL provisions on inter-company transactions other than Royalty/ FTS

As discussed above, the transactions subject to EL are to be not considered liable to applicability of normal income tax provisions, including transfer pricing provisions (if EL is applied on any inter-company transactions) for the non-resident MNE entity. While the treatment vis-a-vis royalty and FTS has been clarified, this still leaves room for interpretation and possibly litigation on applicability of EL on several other intra-group services like intra-group service fees which are generally not considered as transactions taxable under the provisions of royalty or FTS, but rather as business income, hinging on the assertion of a PE. If these services are deemed to be covered under the EL provisions, then the non-resident enterprise providing these services must discharge the EL on the consideration received from its Indian associated enterprise.

• Factual Analysis underpins both EL and TP

With the widening of the EL provisions vide Finance Act 2021, an additional leg of analysis will also have to be undertaken to analyse the applicability of EL provisions on inter-company transaction receipts by non-resident MNE entity and the compliances thereof. Where the transactions from an NR’s perspective are liable to tax in India, and by consequence, fall under the purview of the Indian TP regulations, rather than the EL, a detailed functional, asset and risk analysis of the said intercompany transactions would have been undertaken to demonstrate the arm’s length nature of the said transactions. Therefore, while analysing the implications from an EL standpoint, it should be ensured that the factual matrix basis which the transaction is qualified under the purview of EL provisions, should be consistent with the disclosures as made in the TP documentation of the Indian AE.

The following approach may be adopted to test the applicability of any income under the EL provisions:

• Analyse whether an income is chargeable to tax as royalty or FTS.
• If the income is not chargeable to tax as royalty or FTS, then analyse the applicability of EL on such income (contingent on conditions such as the NR being regarded as an e-commerce operator).
• Factual basis that serves as the foundation of the detailed functional analysis in the TP report may also be considered for analysing the applicability of the EL provisions

Let us take a few examples to understand the applicability of EL provisions under different scenarios:

Example 1:- Intercompany payment of IT charges by an Indian subsidiary to its parent entity is classified as royalty/ FTS under the Income Tax Act as well as the treaty.

EL provisions will not be applicable (by virtue of amendment in Finance Act 2021) as payment is classified as royalty/ FTS, taxable under the Income Tax Act. Here, the non-resident MNE entity may continue to undertake tax and TP compliances in India as required under the Income Tax Act.

Example 2:- Intercompany payment of management charges by an Indian subsidiary to its NR parent entity, classified as royalty/ FTS under the Income Tax Act, but is exempt under the treaty on account of make available clause for FTS.

Applicability of EL provisions will have to be tested as the payment is not taxable as royalty/ FTS by virtue of treaty benefit which overrides the Income Tax Act and hence takes away India’s jurisdiction to tax under domestic law. As suggested above, this analysis may be based on the detailed factual and functional analysis, that would normally also be undertaken for compliance with the arm’s length regulations.

Herein, it is important to highlight that the TP provisions still continue to be applicable for the Indian taxpayer.

• Amendment w.r.t the definition of ‘online sale of goods’ or ‘services’

Finance Act 2021 has also amended the definition of ‘online sale of goods’ or ‘services’ to include any one or more of the following-:

(a) acceptance of offer for sale;

(b) placement of purchase order;

(c) acceptance of purchase order;

(d) payment of consideration; or

(e) supply of goods or provision of services, partly or wholly.

Pursuant to above, the term ‘online provision of service’ should be read broadly to include the below mentioned scenarios:

a) Contract is concluded online, services are rendered offline and payment is also made offline; or

b) Contract is concluded online, services are rendered online but payment is made offline; or

c) Contract is concluded offline, services are rendered online and payment is made offline; or

d) Contract is concluded offline, services are rendered offline but payment is made online.

Based on the above, if contract for provision of services/ sale of goods are concluded online or delivery of services (including part delivery) is online or payment for such services/ goods is made online, then such service/ sale of goods may likely be considered as ‘e-commerce supply or services’.

The above amendment will have a direct impact on inter-company transactions of sale of goods and services from an NR particularly in cases where orders are placed through websites or payments are made online even though goods are delivered physically.

Example: Indian distributor purchases from its NR parent entity

Let us take an example to understand the impact of said amendment on an intercompany transaction-:

Suppose an Indian distributor places an order for purchase of finished goods through offline/physical mode with its NR parent company who qualifies as an e-commerce operator. The goods are also delivered by the parent company physically to the Indian subsidiary. The payment for the same is made by the Indian entity through an online mode. Currently, the above sale of goods is not taxable in the hands of the NR parent entity in India and accordingly no tax and TP compliances need to be undertaken for the NR. However, considering the amendments made by Finance Act 2021 in this regard, this transaction could potentially be subject to EL as the payment was made through an online medium.

Accordingly, such transactions will have to be examined from an EL perspective, since the EL provisions do not provide for any exemption for inter-company transactions as of now.  Pertinent to note that EL is a levy based on transaction price (i.e. declared value), and hence valuation aspects (such as arm’s length or open market value) do not come into play in order to determine the liability to the levy.

Impact on transfer pricing

An approach similar to the one suggested above for non-royalty, non-FTS incomes may be considered to ensure consistency between TP positions and the impact of EL provisions:

a) Review intra-group arrangements, particularly the manner of supplying goods/ rendering services to analyze whether the NR qualifies as an ‘e-commerce operator’ and thereby applicability of EL

b) Identify the intra-group transactions and transaction amount that will be subjected to EL; and assess whether there is any mismatch between actual consideration and arm’s length price. If there is, then measures may be required to determine the considerations in a manner that it meets the arm’s length test, at least from the perspective of the Indian taxpayer.

c) Review the inter-company agreements to assess who shall bear the economic burden of EL and thereby its impact, if any on the profits of the Indian entity of the MNE Group. In case there is an adverse impact on the margins retained by the Indian arm of the MNE Group, then appropriate analysis may also be required to assess whether the proposed change in the inter-company pricing terms impacts the risk characterisation of the Indian entity. 

d) Review the contracts to assess if any changes are required to the terms because of an additional levy being discharged on the transaction

Conclusion[3]

Digital tax introduced by various countries in quick succession is set to change the dynamics of world trade and the equation between countries is likely to have an impact on account of these developments.

Going forward, EL imposed on e-commerce transactions will have a significant impact on non-residents supplying goods or services through digital means, given the wide definition of the term ‘e-commerce supply or service’. From a global tax management point of view, it is essential for MNEs to factor in these equalisation levies as part of their global tax planning.

Arm’s length principle is the bedrock of Transfer Pricing (TP). The arm’s length principle requires taxpayers and tax administrations to evaluate uncontrolled transactions and business activities of independent enterprises and compare with transactions between related parties. This requires data, which is often voluminous, incomplete and difficult to obtain. The objective hence is to find a reasonable estimate of arm’s length outcome based on reliable information. TP is not an exact science and requires exercise of judgement in arriving at the arm’s length price[1].

In order to ensure that these judgments are rational, various statistical techniques could be employed in TP. Statistical techniques have proven to be useful tools for estimates and are capable of providing greater degree of accuracy and reliability.

Currently, there is limited guidance in Indian TP regulations and in the Organisation for Economic Co-operation and Development (OECD) Guidelines on use of statistical techniques in TP. This article covers various aspects on application of statistics, permitted by the current regulations / OECD guidelines, methods adopted by tax authorities and interpretations by the courts. This article also provides various areas where statistics can be more effectively used in TP.

Reference to statistical techniques under the existing laws/Guidance

Guidance available on usage of statistics either in the TP guidelines issued by the OECD or other guidances, have focused only on the below aspects:

a) Computation of arm’s length price

The Indian TP regulations permit application of traditional statistical methods such as mean, median and percentiles in computing the arm’s length price / range.[2] OECD and UN TP Guidelines refer to statistical measures such inter-quartile range for arriving at the arm’s length range.

b) Financing Transactions

The OECD in its recent guidance on Financial Transactions states that concept of probability of default can be used to calculate approximate credit ratings in determining arm’s length price for guarantees[3].

c) Comparability Analysis

Recently, OECD issued Guidance on Transfer Pricing implications of the COVID-19 pandemic that cites use of statistical methods such as regression, in support of comparability analysis during the ongoing crisis.[4]

d) Singapore tax authority, IRAS has, in the context of the current pandemic, issued guidance on additional information to be included in TP documentation viz., statistical methods such as regression and variance analysis, to predict extent of variance of dependent variable based on independent variable (i.e., predicting the response of corporate profits to estimated GDP movements).  

Practical Application

a) India

Indian TP regulations give limited guidance on use of statistics. Nevertheless, taxpayers and tax authorities have adopted certain statistical measures to defend their positions. Some commonly used measures are:

i. Box plot

Box-plot is a method for graphically depicting groups of numerical data through their quartiles. This method was used by taxpayers to identify and eliminate companies which are outliers, (i.e., earning very high margins) using interquartile range and therefore functionally non-comparable[5].

ii. Regression analysis

In the case of an Indian subsidiary of a MNE Group, the Transfer Pricing officer (TPO) attributed a notional income to the taxpayer on account of compensation for deemed brand development services rendered by the taxpayer for its foreign parent company i.e., benefit accruing to the foreign parent company as a result of increased brand value due to sale of its branded products in India. TPO used statistical methods - non-linear regression using a third-degree polynomial fit to establish the correlation between market capitalization and the brand value, based on which an adjustment for brand building activity was made. However, the Tribunal ruled that brand building exercise is not an international transaction and hence computational limb was not considered / disregarded[6].

iii. Correlation

Tax Tribunals have ruled that there is no correlation (linear relationship) between turnover and profitability and hence companies cannot be rejected for high turnover. However, High Courts have ruled that high turnover companies cannot be comparable, though not based on arguments on correlation[7].

iv. Probability of default

TPOs during recent audits have used probability-based models such as Hull-White Model to determine arm’s length guarantee fees by equating corporate guarantee with Credit Default Swaps. The expected loss or loss given default was arrived using the model and substituted as guarantee fees to be received by the Indian HQ taxpayer for the guarantee given to its foreign subsidiaries.

b) Global Experience

i. Mutual Agreement Procedure (MAP): Indian competent authorities and US IRS in 2015, used regression analysis of financial ratios while drafting the framework agreement to expedite resolution of MAP cases of IT/ITeS captive services providers.

ii. Evidence during Financial Crisis: In 2009, the EU Joint Transfer Pricing Forum discussed an analysis which linked variation in the profitability of routine service providers in Europe with the health of the European economy[8].  

The COVID-19 pandemic, has been a catalyst for adoption of various statistical techniques in TP, be it for forecasting comparable data for the future years or computing COVID related adjustments.

In the forthcoming sections, we will explore some statistical techniques which may be applied to provide solutions to complex issues on data availability / comparability:

Scenarios where statistical techniques could be applied in Transfer Pricing

A. Alternative to fixed cost adjustment – using Regression and CVP analysis

Taxpayers in their initial years of operations and  those operating in competitive sectors, typically face unanticipated reduction in demand. Sales close to break-even levels are not met resulting in the taxpayer incurring losses. However, due to lack of information in general databases, comparable companies may be selected from allied industries, which would not have experienced such market conditions.

In such circumstances, the taxpayer would have incurred losses or registered lower levels of profits vis-à-vis comparable companies, resulting in adjustments being made during the course of TP scrutiny, without considering the level of operations between comparable companies and taxpayer.

The OECD Guidelines state that to be comparable, none of the differences between the situations being compared, could materially affect the condition being examined or reasonably accurate adjustments can be made to eliminate the effect of such differences[9].

From FY 2011-12[10], disclosing information on installed capacity and actual production was not mandatory (Revised Schedule VI) resulting in difficulty for effecting an accurate fixed cost adjustment. Taxpayers have adopted various ways of computing capacity adjustment either by considering fixed cost as a percentage of sales, or by reference to RBI report on average capacity utilization, or by adopting ratio of depreciation to average written down value of assets between taxpayer and comparable companies and recomputing fixed cost of comparable companies based on fixed overheads to sales ratio of taxpayer[11].

Where information on capacity utilized vs installed capacity is available for comparable companies, then the fixed cost adjustment for the taxpayer helps in addressing the question “What if the taxpayer operated at the level of comparable companies”? In case of adoption of CVP (Cost-Volume-Profit) analysis combined with regression analysis, the question “What if comparable companies operated at the level of taxpayer?” can perhaps be answered.

The following concepts in CVP analysis can be applied. Costs are bifurcated into fixed and variable. Contribution margin is excess of sales over variable costs. With increase in the quantity of sales, contribution margin would set off fixed costs, assuming that total fixed costs remain constant. At certain level of sales, contribution margin would be equal to total fixed costs which is break-even point (no-loss no-profit). With further increase in sales, contribution margins would become profits. In order words, farther the actual sales are from break-even sales on the positive side, greater will be the profits. Difference between actual sales and break-even sales is known as margin of safety (MoS).

Using CVP analysis, a close approximation for capacity utilization can be arrived.

MoS is an absolute value and may not be an appropriate measure to be adopted as an independent variable for regression analysis. Comparable companies having higher sales volume may have higher MoS, though they would have only marginally exceeded the break-even level. To eliminate this anomaly, a ratio needs to be arrived at. The ratio of MoS/Break-even sales can be used in this connection. Differences in capacity utilization would be reflected through differences in actual sales, resulting in differences in MoS.

The above ratio will indicate how far comparable companies and taxpayers have moved away from break-even points. Prima facie comparison of the ratios of comparable companies and the taxpayer itself, would show that an adjustment is warranted, to eliminate material differences.

It is a logical extension that greater the ratio of MoS/break-even sales, greater will be the profitability of a business. However, this will have to be proved statistically through correlation / R2. by establishing relationship between MoS/break-even sales and the profit level indicator (assuming operating profit / operating income or OP/OI).

Once a statistically strong relationship is established, a model will have to be created to numerically bridge capacity utilization (MoS/ break-even sales) and profitability. This can be achieved through regression analysis.

Based on the OP/OI and MoS/break-even sales data of comparable companies, the regression equation will have to be derived. This equation would estimate profitability at a given level of MoS/ break-even sales. In other words, this equation would answer what comparable companies would have earned had they operated at the level (MoS/ break-even sales) of taxpayer. The regression equation for the given data points can be derived. The regression would be:

Y (OP/OI) = a + (b * (MoS/Break-even sales)) [12]

Based on the equation, the MoS/ break-even sales of the taxpayer can be updated and the arm’s length operating profit margin (OPM) obtained. The arm’s length OPM so arrived at can be compared with that of the actual OPM of the taxpayer. The above analysis can be used to substantiate that the taxpayer has earned similar or greater profits as compared to profits earned by comparable companies, had they operated at the level of taxpayer.

Sample set of actual data of comparable companies have been used to compute the above-mentioned ratios to prove the existence of the theoretical relationship between MoS/BEP and OP/OI.

Particulars	MoS	BEP	Total Sales	MoS/BEP	OP/OI
Comp. A	51.30	360.33	411.63	14.24%	3.16%
Comp. B	-0.40	9.57	9.17	-4.19%	-2.03%
Comp. C	8.11	18.17	26.28	44.62%	9.20%
Comp. D	394.02	922.82	1316.84	42.70%	5.22%
Comp. E	126.59	233.75	360.34	54.15%	8.58%
Comp. F	31.27	71.04	102.31	44.02%	8.94%
Comp. G	247.29	548.97	796.26	45.05%	7.36%
Comp. H	43.92	82.81	126.73	53.04%	6.32%
Taxpayer	5.99	139.08	145.07	4.30%	1.74%

The arm’s length range based on the above comparable companies is 5.22% to 8.58% and the taxpayer margin i.e., 1.74% is not at arm’s length. However, on analysis of the MoS/BEP sales, we can identify that the comparable companies achieved higher level of MoS Sales /BEP Sales ( 40-50%) as compared to taxpayer (4.30%).  

Based on the above data points, the contrast in the level of operations of comparable companies and the tested party, can be brought out, thereby requiring an adjustment to be made. Regression analysis can be used to plot the revised profitability of the comparable companies which can defend taxpayers’ transfer prices. However, one needs to bear in mind the adoption of sufficient sample size meeting significance tests, to ensure that the regression model adopted is robust.

In most cases there are differences in the sub-industry / sector between comparables and the taxpayer, due to limitation of data availability. The above analysis brings out such differences to warrant comparability adjustment. Further a detailed note on non-availability of close competitors in the database or their rejection due to various quantitative filters, identification of sub-industry of the comparable companies (through extracts of the industry overview documented in the annual report of the comparable companies) and comparing with the taxpayer, would provide credence to the analysis.

Tax authorities could possibly dispute the above approach in instances where sales are to related parties and that lower the MoS/BEP is attributed to reduction in selling price, while the production and sales volume would have taken place at or beyond break-even level. This could be rebutted by supplementary analysis of the contribution margin (CM) percentage of comparables and taxpayer. Where the CM% of the taxpayer is within range or beyond the 65th percentile of comparables, it can be proved that there is no intention of profit shifting by manipulating the inter-company selling price.

B. Use of regression in TP – General

Regression can be used when causation exists between two variables and numerical relationship is required to be established statistically to accurately predict the value of the dependent variable given an independent variable. Few other areas where this approach could fit are provided below:

a) Ex-Ante Analysis:

Relevant regression models can be used to arrive at the margins of comparable companies using macro-economic indicators such as GDP[13], equity return index, bond yield movement, which can be used as ex-ante analysis for substantiating the arm’s length prices.

b) Ex-post Analysis:

The following can be considered while undertaking an ex-post analysis to substantiate the arm’s length price where data of comparable companies is not available. However, they need to be applied depending on the factual circumstances around the case and other relevant factors.

• Due to COVID-19 pandemic, if a taxpayer wants to estimate the margins of comparable companies based on the decrease in sales volumes, an elementary way is establishing a relationship between costs and revenue for comparable companies based on past year data, and factor the decrease in sales of the taxpayer to estimate the cost of comparable companies based on the regression equation, to arrive at profit margins of comparable companies[14].
• Where taxpayer makes sales to associated enterprises as well as to third parties, but at different price points due to volume discounts; there is an inverse linear relationship between price and volume. In such cases, a regression equation can be established between volume and price. Based on the regression equation, the arm’s length price can be arrived based on quantity sold to AEs.
• Usage of SG&A/turnover ratio as opposed to AMP/Sales in the case of distributors would help understand the intensity of functions undertaken. This approach can be substantiated by establishing a correlation and fitting a regression line for Gross Profit and SG&A, which can predict the arm’s length gross profits at specific levels of SG&A incurred by the tested party.[15]

C. Justifying Full-Range using Confidence Interval

The OECD guidelines provide that where data points in a range are equally reliable, the ‘full range’ can be considered[16]. However, the guidelines also state that when there are sizeable number of data points and some unidentified / unquantifiable comparability defects, statistical measures such as mean, median, interquartile range or percentiles can be used to narrow the range,[17] which tax authorities generally prescribe. Transfer pricing regulations in India do not permit use of ‘full-range’ concept. However, the full range concept can be considered as a corroboration to other positions taken by the taxpayer to defend transfer prices.

In one of its rulings, the Swedish Supreme Court decided that companies beyond the interquartile range, were as comparable as those within the range and hence full-range has to be adopted against the contention of tax authorities to use interquartile range[18].

Due to COVID-19, MNEs would require undertaking a benchmarking study, as part of ex-ante analysis. However, as databases would not have been updated with latest information, the comparable companies used for the earlier year might be rolled forward or searched using the earlier year data.

In such cases and where all the comparable companies can be proved to be equally comparable, a full range can be adopted as against interquartile range, based on the OECD Guidance. To add credence, the concept of confidence intervals can be used.

Traditionally, confidence intervals are used where samples are selected from a population and an estimate is needed on whether the population mean occurs within the range constructed from the sample mean based on a specified probability, or whether the population mean is within acceptable threshold limits with generally acceptable levels of confidence[19].

Deploying confidence intervals, a range can be constructed using the arrived mean / median at the required confidence level.

Below is an example of how confidence intervals can be used to substantiate adopting full-range. The margins of comparables have been estimated for FY 2020-21. Based on ‘back-of-the-envelope’ calculations, the comparable companies are assumed to follow normal distribution[20]. Since the statistics of the population is unknown, t distribution has been considered.

Particulars	OP/OC
Comp. A	2.23%
Comp. B	0.94%
Comp. C	-0.15%
Comp. D	5.40%
Comp. E	4.77%
Comp. F	5.96%
Comp. G	9.55%
Comp. H	11.21%
Average	4.99%
Median	5.08%
35th Percentile	2.23%
65th Percentile	5.96%

As the number of comparable companies are 8, range was computed.

Now computing the confidence intervals for the mean using 99% confidence level, we would arrive at the range 0.06% to 9.92%[21]. Assuming that we compute using 99.5% confidence level, the interval would be -0.69% to 10.67%, which is approximately the full range.

However, the moot point in the above discussion is the assumption of normal distribution. Generally, it is assumed that margins of companies follow normal distribution. There are also discussions that operating margins follow gamma[22] or lognormal distribution. As gamma and lognormal can be applied only for positive data points, it can perhaps be argued that at times of a downturn or during COVID-19 pandemic, not considering non-positive data might be unrealistic. Perhaps these distributions can be considered for license rates such as royalty rates, which cannot be non-positive.

Conclusion

Since TP is not an exact science, appropriate statistical techniques can be deployed on a case-to-case basis. However, before applying any statistical technique, the assumption of the respective technique needs to be tested for the data on which the technique is to be used, This also needs to be documented on a contemporaneous basis.

India introduced transfer pricing (TP) regulations in 2001 with certain mandatory compliances and documentation requirements. The law has evolved over the last twenty years in many ways – expanding the coverage of applicability, witnessing the rise in TP litigation, in measures taken to provide certainty to taxpayers and reduce litigation, bring in international best practices, BEPS action plan and related regulatory changes, and not to overlook, introduction of technology platform for compliances and audits.

TP compliances have covered a long journey from standardised forms - filled manually and filed physically with the tax departments - to the adoption of electronic filings. This applies to various annual compliances such as filing of Accountant’s Report, Master File, Country by Country Report, etc. Apart from compliances, tax authorities across the globe are expecting the data submitted during the audits and assessments, to be detailed and accurate. Consequently, businesses are now under more pressure than ever to find efficient ways to manage their TP affairs, processes, data, and documentation-related matters.

Another fact which demands attention is that TP and tax teams in multinational corporations typically face time and resource constraints with changing regulatory environment and reporting requirements. As per a Deloitte survey on “Reporting in a digital world” conducted in 2019, tax teams spend almost half of their time creating and updating reports. Interestingly, as per the more recent “Tax transformation trends” survey conducted by Deloitte in May 2021, 92% of the survey respondents said that the transformative changes to the way companies are required to provide tax information (electronic filing, real-time reporting, etc.) to Revenue authorities, is by creating an imperative to modernize the tax and TP departments within multinational corporations at a faster pace. According to the survey, shifting Revenue authority demands on digital tax administration will have significant impact on tax operations and resources over the next few years and the trend is moving faster than expected. Needless to mention, the ongoing pandemic has also contributed to an acceleration of digital transformation.

While it is evident that the use of technology will further increase in the coming years, our experience suggests that the TP departments within multinational corporations have generally adopted technology more as a response to the mandatory regulatory requirements in India and barely as a focused transformational and value-add activity. This mindset needs a change now as next-generation technologies, such as robotics (RPA), Artificial Intelligence (AI), machine learning, blockchain, and data analytics, are set to transform the way tax and TP departments have been functioning.
It is need of an hour that multinational corporations revisit their TP policies and processes with emerging technologies and automation opportunities. This transformation may take place throughout the TP process lifecycle of planning, implementation, monitoring, documentation and compliances, and dispute resolution. However, not all processes may perhaps be suitable for automation. For instance, in undertaking a benchmarking analysis, data collation from databases, application of quantitative filters and computation of financial ratios could be automated. However, selection of appropriate comparables would require review of qualitative information and application of human judgement. As such, people have to work with various tech solutions to harness data, automate execution of rote tasks, comply in real time, and free themselves up to add greater value within their corporations. That not only transforms how work gets done, it also transforms the talent needed to do it.

In the subsequent paragraphs, we have shared our perspective on some of the emerging TP use cases wherein we are experiencing that organisations are using or evaluating innovative technology-based solutions.

Use of technology to deal with data

Data collection has always been an ad hoc and laborious process in TP analysis. Multiple classifications, segmentations, and rework is required for data analysis. Various TP compliance may require extracting huge amount of data from disparate sources including accurate reporting of such data in a prescribed format.

In the Indian context, TP regulations require filing of an accountant’s report, master file and country by country (CbC) reports as part of TP annual compliance and to maintain contemporaneous TP documentation. Taking example of TP documentation, technology enabled platform can be used to streamline the efficient preparation of TP documentation reports, while enabling collaboration and reducing duplication. This could be a web-based interface wherein data can be uploaded and sorted into various modules as per the requirements. Data in these modules can then be edited for drafting of TP documentation without the duplicity of efforts. This technology enabled process assures accurate and consistent TP reports for various jurisdictions where the multinational corporation may be operating.

Data extractor tools can be used for extracting data of related party transactions which are reported in multiple places in the financial statements. Apart from these, big data and robotics can assist organisations in managing the possible data overlap wherein same data set is filed and reported with other tax regulators, such as income tax authorities, GST authorities, customs authorities, and the registrar of companies.

Operational transfer pricing

When a group has global operations transcending several countries, there is a need for a systematic approach, defined processes and appropriate controls to ensure adherence to TP regulations for each of the jurisdiction at a transaction level. Tax and statutory audits often flag up issues with inconsistent application of TP policies. The year-end TP adjustments due to forecast or control anomalies may raise questions on the overall process of organisation. Such adjustments also create an issue for other tax reporting purposes. Further, the age old and continuing TP practice raises many concerns such as “keyman” risk wherein only a single employee or a group of employees are aware of the actual functionalities of TP at an operational level, leaving a huge void in the case of retrenchment.

Further, the OECD's BEPS Action Plan 13 initiative and the evolving TP landscape have augmented TP policy implications worldwide. Streamlining the TP process is almost as important as planning and executing it. This is where Operational Transfer Pricing (‘OTP’) would assist users. Multinational organisations often encounter inconsistent TP data from business units that dramatically increase the complexity and staff workload. In many tax audits/assessments, this is one of the major reasons for huge TP adjustments. OTP helps in aligning the entire TP life cycle, ranging from policy formulation and documentation, to tax assessments.

The OTP process can help organisations integrate their TP policies with day-to-day operations, improve integrity of inter-company accounting, increase operating efficiencies, and reduce risks in various areas. Stakeholders in multinational corporations can rely on OTP to provide them an assurance that the agreed upon TP policies are being followed at the grassroots level, across jurisdictions.

OTP can also assist in erasing anomalies arising due to incorrect and inefficient TP data, such as year-end or quarterly adjustments (resulting in volatile margins across different years), Customs/VAT issues (arising from differential payments), and allocation of cost amongst group entities.

Using a technology platform in OTP would facilitate a proactive TP process with in-year monitoring, analytics, and adjustment capabilities. It would also ensure accurate implementation of TP policies and provide an improved tax insight to the tax department.

Further, OTP based tech platform can help corporations create a tax data warehouse, and a staging area for the relevant TP data from various sources. Tax data warehouses provide companies the ability to centralise data for tax purposes to ensure prompt access to accurate, correct, and complete data with easy retrieval capabilities.

Facilitate reporting and decision-making through use of AI

Until now, tax software programmes were mostly compliance oriented. The focus on analytics was almost non-existent. Even data analytics was primarily used to apprehend large data volumes that gave users a hindsight on the data used. In the current and near future, we expect tax departments in multinational corporations to use AI for predictive and prescriptive analysis. Here, past data is analysed to form predictive statistical models projecting future tax outcomes. Prescriptive analysis further deciphers these projections, and charts out plans and strategies.

From a tax and TP standpoint, such analysis may be used to monitor year-on-year data to analyse tax and legal trends from case laws, flag potential outliers from the CbC reporting etc. Data analytics tools can also be used to identify potential opportunities, risks, anomalies and trends, by analysing inter-company data to the granular level.

Conclusive remark

With a changing tax landscape and increasing adoption of digitization across businesses, it is imperative for TP departments to reimagine the entire TP process using technology. This would help organisations adopt the correct technology platform suitable to their needs. By combining technology with skilled workforce, tax and TP departments will get the much-needed facelift. Better delivery turnaround time, a reduction in overall costs, maximising efficiencies and adoption of best practices with futuristic analytics and dashboards for key management teams, would help the organisation in more ways than one.

Consequently, there is a need for change in the way the TP department of an organization operates. The tax and TP departments will need to upskill to work with technology. There is a need for collaborative functioning of the TP practice along with technology.

The industrialized world has hitherto experienced three Industrial Revolutions: The Steam Power Revolution, The Electric Revolution, and then the Information Technology Revolution. We are now in the era of the fourth Industrial Revolution which is complemented by advanced manufacturing, smart machines, digital supply chains and end-to-end ecosystems, that have completely changed the way businesses operate and leading to creation of new value drivers. In today’s dynamic and competitive business environment, the key value drivers of business are heavily based on new intangibles such as customer lists, contracts, algorithms, industrial design, networks, data, brands and content, to name a few.

At the outset, it is worthwhile to mention that the Organisation for Economic Co-operation & Development (“OECD”) recognises that intangibles considered for transfer pricing (“TP”) purposes are not always recognised as intangible assets from an accounting perspective. For example, costs borne to develop intangibles such as expenditures of research & development and advertisement, are usually charged as an expense in profit & loss account and will not be reflected in the balance sheet. Such intangibles may however be required to be considered for TP purposes as they generate significant economic returns. Accordingly, whether an item should be considered as an intangible for TP purposes should not be determined solely based on its accounting treatment.

Intangibles – Meaning & Definition                                                         

The Finance Act, 2012 amended the definition of the term international transaction under section 92B to provide that the intangible property (“IP”) would include intangibles related to marketing, technology, artistic, data processing, engineering, customer, contract, human capital, location, goodwill, methods, programmes, systems, procedures, campaigns, surveys, studies, forecasts, estimates, customer lists, or technical data, and any other item that derives its value from intellectual content rather than its physical attributes.

The OECD has also defined intangibles from a TP perspective in Para 6.6 of Chapter VI of OECD Guidelines 2017 as "something which is not a physical asset or a financial asset which is capable of being owned or controlled for use in commercial activities, and whose use or transfer would be compensated had it occurred in a transaction between independent parties in comparable circumstances."

Before we delve into Hard-to-Value Intangibles (“HTVI”) & its pricing uncertainty, let us first understand the litigation issues that follow.

Litigation on Intangibles

One of the most litigated topics in the history of TP has been the issue of intangibles as there has always been challenges on identification of which entity is the legal owner vis-à-vis which entity really contributes to the constructive development of the intangibles. One such example is the issue of Advertisement, Marketing and Promotion expenses (“AMP”) wherein the tax department adopted the Bright Line Test (“BLT”) where excess AMP expense (above average AMP expenses of comparable companies) is considered non-routine. It would be considered as an international transaction and arm’s length price (“ALP”) would be required to be computed.

One important case law on this subject was the case of ITA No. 5140/Del/2011, wherein the special bench of Tribunal observed that the AMP expenses incurred in connection with promotion of sales are only sale specific and does not lead to development of brand, while expenses for promotion of sales directly leads to brand building for which Indian taxpayer needs to be compensated on an arm’s length basis by applying BLT.

There have been two favorable landmark rulings for taxpayer by the Delhi High Court on the AMP issue, one is in the case of ITA Nos.110/2014 & 710/2015 wherein it was rightly held that AMP expense is not an international transaction. The other is in the case of ITA No. 16/2014 wherein the High Court rejected the application of BLT and affirmed that AMP can be closely linked to overall marketing and distribution activity and hence, can be aggregated.

Another litigated topic is intra-group arrangements post business restructuring, involving transfer of intangibles. An important ruling on this issue has been in the case of ITA No. 3297 & 3240/AHD/2014 wherein, the Tribunal considering the facts of the case accepted that the Indian company was a routine contract manufacturer whereas the foreign parent company which was the owner of the intangibles, carried all the risks associated with owning of intangibles such as litigation, technology and obsolescence. The Tribunal on further analysis held that Profit Spilt Method (“PSM”) can be applied when the international transaction involved transfer of unique intangibles or in multiple international transactions which are so inter-related that they cannot be evaluated separately which was not the case after the restructuring. Accordingly, the tax authorities’ contention was rejected, and Transactional Net Margin Method was selected as most appropriate method (“MAM”).

Given the above, there is a motivation by the Revenue authorities, that the challenges in verifying the appropriateness of the pricing undertaken by related parties leads to base Erosion and profit shifting, from one country to another. Accordingly, the OECD published 15 Action Plans on Base Erosion and Profit Shifting (“BEPS”). One of the items identified by BEPS Action Plan 8 was to develop an approach to determine the ALP for a category of intangibles known as HTVI. In the subsequent sections, we shall understand the concept of HTVI in detail.

HTVI

Background & Definition

The term HTVI was first introduced by the OECD in 2013 as part of its efforts to revise TP guidance relating to intangibles. Action 8 of the OECD’s BEPS Action Plan 2013 mandated the development of TP rules or special measures for transfers of HTVI. Accordingly, in June 2018, the OECD released the guidance for tax administrators on application of the approach to HTVI. The aim of the guidance is to create a common understanding amongst tax administrators on application of HTVI concept, its valuation mechanism, and thereby, improving consistency and reducing the risk of double taxation. Also, it is aimed at preventing base erosion and profit shifting by moving intangibles among group members.

Para 6.189 of the OECD Guidelines 2017 defines HTVI as an intangible or rights in intangible for which, at the time of their transfer between associated enterprises,

(i) no reliable comparables exists; and

(ii) at the time the transaction was entered into, the projections of future cash flows or income expected to be derived from the transferred intangible, or the assumptions used in valuing the intangible are highly uncertain, making it difficult to predict the level of ultimate success of the intangible at the time of transfer.

Features of HTVI

Transactions which involve transfer or use of HTVI may exhibit one or more of the following features:

• The intangible is only partially developed at the time of transfer.
• The intangible is not expected to be exploited commercially until several years following the transaction.
• The intangible does not itself fall within the definition of HTVI but is integral to the development or enhancement of other intangibles, which fall within that definition of HTVI.
• The intangible is expected to be exploited in a manner that is novel at the time of transfer and the absence of a track record of development or exploitation of similar intangibles makes projections highly uncertain.
• The intangible has been transferred to an associated enterprise for a lumpsum payment. The intangible is either used in connection with or developed under cost contribution arrangements or similar arrangements.

The next step after identification of the HTVI is the appropriate valuation / identification of ALP.

Valuation of HTVI

Valuation of HTVI not only involves very case-specific analysis in view of the “unique” element attached to it but also because the valuation techniques requires the taxpayer to consider possible foreseeable events and make appropriate assumptions to identify the consideration of such HTVI.

The valuation is highly ambiguous since an accurate comparable uncontrolled transaction is not available and a valuation on the basis of financial projections would be required, however, the probability of ultimate success / failure of HTVI is unpredictable at the time of its transfer. Therefore, valuation of HTVIs will necessarily be in the nature of an “ex-ante” analysis.

The main issue for such intangibles is information asymmetry between taxpayer and tax authorities, as there may be significant differences between ex-ante and ex-post analysis. The OECD acknowledges that such information asymmetry restricts the ability of tax administrations to establish or verify, at an early stage, the developments that might be considered relevant for the pricing of transfer of intangible transaction and whether such developments might have been reasonably foreseeable at the time transfer.

The guidance also prescribes that tax administrations may make appropriate adjustments in case there are significant differences between ex-ante projections and ex-post outcome of the intangible and such differences cannot be reliably explained by the taxpayer or should reasonably have been known to the taxpayer.

However, if the below exceptions are established by the taxpayer before the tax administration then no adjustment to the pricing arrangements would be required to be made by the tax authorities:

• details are provided on the ex-ante projections used upon transfer of the HTVI and sufficient documentary evidence are produced by the taxpayer that the difference between the ex-ante and the ex-post outcomes is due to unforeseeable or extraordinary events;
• the transaction is covered by a bilateral or a multilateral advance pricing agreement (“APA”);
• the difference between the ex-ante projections and the ex-post outcomes is less than 20%; or
• five years of commercialisation have elapsed since the year in which the HTVI first generated third-party revenue for the transferee and in which during commercialisation period any significant difference between the financial projections and actual outcomes mentioned in was not greater than 20% of the projections for that period.

The OECD has provided few examples intended to clarify the application of HTVI approach in different scenarios.

Example 1 – In first scenario, Company A has transferred in year 0 a patented product after successful completion of Phase I and Phase II trials, to its foreign associated enterprise, Company B for conducting Phase III trials at a value of 700. The Phase III trials were completed much earlier than anticipated, allowing the commercial production of the product to begin in year 3 which otherwise would have begun in year 6. Sales in Years 3 and 4 correspond to sales that were projected, to be achieved in Years 6 and 7. Accordingly, when the case is picked up for assessment, the taxpayer cannot demonstrate that its original valuation took into account the possibility that sales would arise in earlier periods, and cannot demonstrate that such a development was unforeseeable. The tax administration uses the presumptive evidence provided by the ex-post outcome to determine the valuation made at the time the transaction took place. The taxpayer’s original valuation of 700 is revised to 1000, which is based on net present value of future cash flows, thereby leading to an adjustment of 300 in year 0.

In the second scenario, the ALP of the transaction is determined at 800, instead of 1000, and since the difference between original transaction value (700) and the revised valuation is less than 20%, the case would be covered under exceptions and no adjustment would be warranted.

Example 2 – Keeping the initial facts identical to the above example, in this case the Phase III trials were anticipated to be begin in Year 6 and the taxpayer assumed that sales would not exceed 1,000 a year. Based on these facts, assume that in Year 7, the tax administration of Country A audits Company A for Years 3-5 and obtains information that sales in Years 5 and 6 of the products to which the patent relates were significantly higher than those projected. In the original valuation, the taxpayer had not projected sales any higher than 1,000 in any year, but outcomes in each of Years 5 and 6 show sales of 1,500.

The taxpayer cannot demonstrate that sales would reach substantially high level. The tax administration uses the presumptive evidence provided by the ex-post outcomes, resulting in a revised net present value in Year 0 of 1300 instead of 700. The revised net present value also takes into account the functions performed, assets employed and risks assumed in relation to the HTVI by each of the parties. Therefore, the ALP anticipated in Year 0 should have been 1300, and the tax administration is entitled to make an adjustment to assess the additional profits of 600 (i.e. 1300 less 700).

The OECD has listed down some practical ways in which the approach to HTVI can be applied. Such approach should be underpinned by the following principles:

• Where the HTVI approach applies, tax administrations can consider ex-post information and evidence about the actual financial outcomes of the transaction to verify if the ex-ante pricing arrangements was suitable.
• The ex-post outcomes help in determination of the valuation that would have been made at the time of the transaction. The valuation should be based on actual income or cash flows and whether the associated enterprises could or should reasonably have known and considered, at the time of transfer of the HTVI, the information related to the probability of achieving such income or cash flows.
• Where a revised valuation shows that the intangible was transferred at an undervalue or overvalue compared to the ALP, the revised price can be used for making adjustments.
• Tax administrations should apply audit practices to ensure that HTVI transactions are identified and acted upon as early as possible.
• APA, if concluded bilaterally or multilaterally between competent authorities of treaty partners, provide an increased level of certainty in the jurisdictions involved, lessen the likelihood of double taxation, and may proactively prevent TP disputes.
• Countries can permit taxpayer for the multi-year resolution through the Mutual Agreement Procedures  after an initial tax assessment for recurring issues with respect to filed tax years, where the relevant facts and circumstances are the same and subject to the verification of such facts and circumstances on audit.

Methods

For benchmarking of intangibles, the OECD has provided its recommendations for selection of MAM. The OECD recommends the use of Comparable Uncontrolled Price Method, PSM and valuation-based methods (corresponding to Other Method under Rule 10AB of the Income-tax Rules, 1962) e.g. discounted cash flow technique (“DCF”) depending on the facts and circumstances of the case and availability of information.

It is relevant to observe that Para 6.5.4 of the United Nations Practice Manual on Transfer Pricing, 2021 re-iterates that where reliable comparable uncontrolled transactions cannot be identified, application of valuation techniques like DCF, derived from the exploitation of the intangible being valued, can be used. The manual states that with the application of DCF analysis, tax authorities should be able to compare anticipated profitability with actual profitability. Although there will be discrepancies between the results, it will help determine whether the ex-ante analysis undertaken by the taxpayer, truly reflected an appropriate assessment of the anticipated profitability and risk associated with the intangible.

An important judgment on the use of DCF method was in case of ITA No. 1235/Bang/2010 wherein the Tribunal accepted tax authorities’ analysis of Excess Earning Method (“EEM”) as a scientific method to determine comparable price. Further the Tribunal has also noted that the use of EEM has been recognised by the US tax courts as well. Given that this ruling was rendered prior to the HTVI guidance, the reliance on hindsight and its implications under HTVI circumstances were not dealt with therein. 

Conclusion

With the evolution of TP subject internationally & in India, greater emphasis has now been put on intangibles and value drivers of business. The 3-tier documentation has been introduced under the BEPS regime, whereby the tax authorities across the globe have access to particulars such as details of global transactions, TP policy framework, and distribution of economic substance. The Master File also contains specific details related to intangibles such as description of the overall strategy of the group for ownership, development and exploitation of intangibles, list of important intangibles with ownership, and important IP agreements.

MNE groups would thereby need to pay more focus on aspects such as performance of Development, Enhancement, Maintenance, Protection & Exploitation (“DEMPE”) functions, functional and risk analysis of each entity, value drivers of the group, entities with economic ownership, and whether the form of the inter-company agreement is in sync with the actual conduct of the related parties. MNEs such as unicorns and decacorns that witness rapid-surge growth in valuations should watch out for the possibility of assertion of HTVI being created via performance of DEMPE functions in their contract development centres, even as the legal ownership remains overseas. MNE groups will have to give greater emphasis on which entity performs functions, owns significant assets, and assumes key risks relating to group’s intangibles. As intangibles are profit drivers, MNEs need to keep monitoring and updating their TP analysis. In case of transfer of intangibles, an extra-cautious approach needs to be adopted by maintaining robust documentation, including laying out critical assumptions used for preparation of projections and valuation of intangibles. It is also worthwhile to keep in mind that the use of hindsight is discouraged by OECD guidelines (Para 3.74 of the OECD guidelines). However, in the case of HTVI, its usage is specifically contemplated given the highly uncertain nature of the development and fruition of the intangible, leading to monetary outcomes that may compromise the interests of Revenue. This represents yet another “bend in the road” in the evolution of TP. 

-         Changes in domestic law;

-         Amendment in OECD model treaty, commentaries/ TP guidelines; or

-         Development of Multilateral Instrument (MLI)

This event led to the formation of the MLI which is a transparent mechanism for countries to incorporate BEPS measures in their existing bilateral tax treaties, in a harmonised and efficient manner.

India, being a part of G20 nations and also being an active member in BEPS discussions in OECD, has been committed to adopt the required strategies recommended by OECD. India signed the MLI in the first joint signing ceremony held in Paris on June 7, 2017. Based on the deposition of ratification instrument, the MLI entered into force for Indian treaties with effect from October 1, 2019. India has currently notified 93 tax treaties and also given provisional list of reservations and notifications. For evaluating extent of modification of the Indian tax treaty, India's MLI positions need to be compared with the MLI positions adopted by its counterpart. The effects of the provisions of the MLI on a specific bilateral tax treaty of India can easily be analysed by using the MLI Matching Database, a tool developed by the OECD as a depository of the MLI. It provides a tabulated data extracted from the list of MLI positions provided by each party to the MLI.

Though the provisions of MLI are predominantly focused on prevention of base erosion and profit shifting, however it also provides for certain minimum standards and best practices aimed towards dispute resolution and better administration of Transfer Pricing (TP) standards across countries. There are many implications which fall within the TP ambit as a result of MLI.

In this article, we will discuss only those features of the MLI which have a bearing on TP issues, i.e. articles 16, 17 and a brief discussion on TP impact from other articles.

 

 

Article 16 of MLI – Mutual Agreement Procedure

Under this article, OECD recommends that a taxpayer should be provided with an option to resolve treaty related disputes through the mutual agreement procedure (MAP) route. This article intends to provide access to and resolution of MAP cases to the taxpayer in a timely manner and is one of the minimum standards recommended by OECD.

The article primarily focuses on following aspects:

• Availability and access to MAP

1. Timely and easy access to MAP to taxpayers in all eligible cases;
2. Taxpayer should be able to approach Competent Authority of either of the contracting states
3. Taxpayer should get a period of three years from the first notification of the action resulting in double taxation, to present his case to the Competent Authority
4. The agreement reached between the Competent Authorities shall be implemented irrespective of the time limits in the domestic laws.

• Resolution of MAP cases – Countries should endeavour to reach resolution in a timely manner (the article on arbitration provides that suggested time period for reaching a resolution is 2 years)

Availability and access to MAP

• Given that this article is a minimum standard, countries adopted this pro-actively. Prior to MLI being in place, access to MAP in an Indian context was procedurally restricted for certain taxpayers. Indian Revenue authorities have been taking a stand that MAP route for allowing corresponding TP adjustments will not be available for cases where article 9(2) was absent in DTAA with the treaty partner[1]. However, given that article 17 of the MLI has done away with such reservation for all Indian tax treaties, the MAP can be accessed even in those cases now. Accordingly, this provision has now opened the doors for many MNEs doing business in India which were earlier unable to get access to MAP.
• The timeline for filing MAP application within three years from the first notification has also been a boon for various taxpayers. Earlier, there were certain tax treaties[2] signed by India which provided a time limit of two years for filing MAP with the Competent Authority. The tax treaty between India and UK does not provide for any time limit for presenting the case to the Competent Authorities. For all these cases, the taxpayers will now be allowed a minimum period of three years from the first notification of double taxation (the time period could be increased based on domestic legislation of specific countries).
• However, India has reserved its right for not adopting the modified MLI provision which allows taxpayers to approach Competent Authority of any of the contracting states. India has taken a position that it will meet the minimum standard by allowing MAP access in the state in which the taxpayer is a resident and by implementing bilateral notification or consultation process.

Resolution of MAP cases

In October 2019, OECD released the peer review report of MAP highlighting the concerns over India’s MAP cases wherein certain recommendations were made for the improvement of the programme. As per the peer report, India was not in full compliance with the minimum standards and average time taken to close the MAP cases was more than the desired time frame of 24 months.

To address these concerns, CBDT amended the domestic MAP rules (Rule 44G and 44H) and issued MAP specific guidance in August 2020 to align the regulations with the minimum standards laid down in BEPS Action Plan 14. The Indian rules now provide that the Indian Competent Authority shall endeavour to arrive at a mutually agreeable resolution within an average time frame of 24 months.

However, Indian Revenue has maintained its stance regarding the non-application of the provisions on mandatory binding arbitration for MAP cases, by stating that it would adversely impact its sovereignty. The absence of an arbitration clause poses an additional burden on taxpayers and is likely to further increase the pending litigation in domestic courts. To note that pendency is greater for pre-2016 MAP cases; post-2015 cases are getting closed in a timeframe of about less than 24 months. Also, it may be noted that the Competent Authorities are aware that in the absence of an arbitration article, it is incumbent on them to reach resolution as far as possible.

It was only after the implementation of the MLI, that the CBDT for the first time issued the consolidated and comprehensive guidelines dated 7 August 2020, on the regulations and practices which the Indian government intends to follow for the MAP.[3]

Summarily, one can say that Indian regulations have undergone a massive change with regards to access, implementation and resolution of MAP cases post the MLI coming into effect. Indian Competent Authority is now focused on completing the pending MAP cases with an aim to reduce the average MAP resolution period in India. As per the experience with Indian Competent Authority, we understand that they have taken steps to reduce the average time taken by India to resolve TP related MAP cases, with an objective to eliminate double taxation.

However, the actual results of the possible impact of MLI on India’s MAP journey, i.e. related to access to MAP/BAPA, MAP outcome timelines, etc., will be available only after OECD publishes the second MAP Peer Review Report for India (Stage 2). Stage 2 reports[4] will focus on analysis of the progress made by the assessed jurisdictions in addressing any recommendations which were made as a result of the Stage 1 peer review reports. It has been noticed that the outcome of the Stage 2 peer review reports establishes an overall constructive change across the assessed jurisdictions.

Article 17 of MLI – Corresponding Adjustment

TP adjustments carried out in the context of transactions between associated enterprises may give rise to economic double taxation. Article 17 of MLI is based on article 9(2) of the OECD Model and requires compensatory or corresponding adjustment if there is a double taxation arising out of TP adjustments.

In simple terms, a corresponding adjustment allows the taxpayer in one country to claim corresponding relief of the taxes paid by its associated enterprise in other country on account of TP adjustment. This provision aims to eliminate economic double taxation in the TP cases and to ensure that allocation of profits between the two jurisdictions is consistent.

The inclusion of article 9(2) of the OECD Model Tax Convention in tax treaties is a best practice under Action Plan 14 and is not required as part of the Action 14 minimum standard. However, given the interplay of article 9(2) of the OECD Model tax with MAP related to TP adjustments and bilateral APAs, most countries adopted this article without much reservations.

India has chosen to apply the said provision under MLI except for the Covered Tax Agreements (“CTAs”) where the provisions already exist. For instance, India’s existing tax treaties with many countries such as Netherlands, Ireland, Japan, Luxembourg USA, UK and Singapore already contain similar provisions.

There are certain tax treaties[5] signed by India where there is no provision for corresponding adjustments. However, after adoption of this article under MLI, India has opened its doors for corresponding adjustments (post ratification of MLI) to all covered treaty partners, provided they have also adopted this article and have categorised India under their covered tax agreements.

Out of these countries, Belgium, France and Sweden have also opted for corresponding adjustments. Accordingly, Indian taxpayers and the taxpayers of these countries shall now be able to seek corresponding adjustment for any hardship due to double taxation on account of TP adjustments.

India has welcomed the process of providing corresponding adjustments. This is evident from the fact that prior to signing of MLI, few treaties which were amended/ newly signed by India[6], article 9(2) were specifically included.

Accordingly, the MLI will help many taxpayers to seek relief from economic double taxation irrespective of whether the bilateral tax treaty between India and another country provides for an article similar to article 9(2) or not, provided that both countries have notified each other and not put any specific reservations on its application.

Till date, there have been numerous cases where Indian Competent Authorities were the beneficiaries of the outcome of corresponding adjustments being granted as a result of double taxation on TP matters. However, it would be interesting to see whether and how (extent) Indian Competent Authorities would allow when the foreign company would ask for a refund of tax on doubly taxed income from the Indian Competent Authorities, as a result of the corresponding adjustment being commonly available under MLI.

Other provisions

Purpose of MLI (article – 6)

The main objective of article 6 is to prevent any opportunities of double non-taxation through tax evasion or tax avoidance means. In simple words, treaty shopping measures adopted by some MNEs to evade taxes by exploiting treaty provisions, would no longer be acceptable. This is an important article of MLI as it is a minimum standard that all participating nations must adhere to. This tends to modify the preamble of a CTA to notify that whereas the treaty is meant to prevent double taxation, however it shall not be used to give rise to cases of double non-taxation/tax avoidance. This article also complements the objective of article 7.

Earlier, in certain circumstances while deciding the transfer prices, MNEs could structure their functional profile, supply chain or value chain structure, IP holdings, etc. in a manner where a group entity performing substantial value creating functions in a high-tax jurisdiction, could end up with low, routine profit and thus pay very low amount of taxes, while the counterparty jurisdiction, that was relatively light on functions while being structured to be high on intangible ownership and associated risks, could be ascribed the residual profit. However, such kind of structures would be targeted under MLI and denied the treaty benefits if it is established that the motive of the taxpayer to devise such TP model was to evade/avoid paying taxes.  This purposive statement is buttressed by GAAR and PPT, in addition to BEPS Actions 8-10.

India’s position has been silent on this and thus the same would apply to all Indian treaties wherein the CTA matching result is positive. For instance, treaties with Japan, Australia, Canada, Singapore, etc. would get impacted, while treaties with countries such as China, Germany would not be impacted as they have not notified India in their CTAs.

Introduction of Principle purpose test (article – 7)

India has also agreed to implement the provisions relating to prevention of treaty abuse in the form of acceptance to apply principle purpose test (“PPT”) to its tax treaties through MLI. The PPT intends to avoid creation of opportunities for non-taxation or reduced taxation through tax evasion or avoidance, and through treaty shopping (especially in case of dividends, interest, royalties and capital gains). India already had similar provisions in the Income tax Act in the form of domestic General Anti Avoidance rules (“GAAR”), while the PPT would now supplement GAAR rules from a global treaty perspective. Therefore, from a TP perspective, it becomes even more important for MNEs to reevaluate their supply chain/ value chain and reassess their entire business models. The advent of modified TP guidelines along with BEPS measures (specifically PPT) implemented through MLI, it is quite possible that the value chains of MNEs and the flow of international transactions of MNE businesses might get challenged based on their overall contribution to the Group.

There may be serious repercussions for those MNE groups in the form of denial of treaty benefits, whose contractual arrangements of the value chain and booked profits are not aligned to the significant people functions being performed by those entities, and which fail the substance test. There are references in the TP guidelines which strengthen the importance of actual conduct over the contractual arrangements.

MNEs could establish commercial substance of their functions based upon the following, viz. certificate/documentation for beneficial ownership, robust functional profile, controlling power over profits or discretion over income received, ownership of assets, number and management level of personnel that should match the amount of income received, etc.

Increasing threshold of Agency PE (article – 12)

India’s acceptance to the Agency PE related provisions of MLI also gives rise to additional TP disputes wherein the allocation of arm’s length profits to the PE would be computed using the TP regulations. Accordingly, it is important for MNEs operating in India to check the implications of a combined reading of the new Agency PE rules and its interplay with the TP guidelines. The attribution of profits to a PE have been aligned to arm’s length principle in the OECD’s Model Tax convention and thus the importance of reviewing existing TP arrangements increases. The anti-fragmentation rule (such that a combination of preparatory and auxiliary activities that comprises a business activity would be regarded as constituting a PE) is also intended to counter erstwhile lower PE thresholds.

Future of MLI

As on June 8, 2021, 95 countries have signed the MLI, and most of them have even deposited their instrument of ratification. Further, there are certain other jurisdictions that have expressed their intent to sign MLI, viz. Algeria, Thailand, Lebanon and Eswatini.[7] These statistics are based on latest data available on the website of OECD. This shows that the treaty-web of MLI is still expanding across the globe.

Further, the alignment of profits with value creation has also been a focal point of the ongoing discussions at OCEDs Digital Taxation meetings wherein certain proposals (Pillar 1 & Pillar 2) have been suggested to ensure that every jurisdiction gets to tax the fair share of profit from a MNE’s profits. In its previous consultation documents, the OECD Secretariat could implement the profit alignment formula under Pillar 1 either through a modification to the existing MLI or through introduction of a new MLI (once Pillar 1 proposals are accepted among the OECD & G20 nations).

Therefore, the MLI and its variants still have a long, yet purposeful way to go towards creation of fairly-taxed global economy.

Disclaimer - The reference of various treaties in the above article is not with the intention of providing any accurate statistics but to have a broader understanding of the changes made in the said treaties. Hence, one should refer to the provisions of the above treaties while dealing with the issue concerning the said treaties.

 

The investment management sector broadly comprises asset management companies, mutual funds, and investment management/advisory entities. These entities provide services to Alternate Investment Funds (‘AIFs’) having pooled investment vehicle in various categories such as Venture Capital (‘VC’), Private Equity (‘PE’), Real Estate (‘RE’), hedge funds, sovereign wealth/pension funds, open/close ended traded securities/debts funds, derivatives, Funds of Funds (‘FoF’) and Special Purpose Acquisition Companies (‘SPAC’), etc. The investment management sector is regulated by the Securities and Exchange Board of India (‘SEBI’).

With above regulatory and policy liberalization, the intra-group transactions of many Multinational Entities (‘MNEs’) operating in the insurance and investment management sectors have also evolved. Twenty years of Indian TP witnessed changes in these sectors.  

A. Insurance sector:

     1. Background

The insurance/reinsurance business is highly regulated and locally controlled in India. Insurance entities (life and non-life) are traditionally incorporated as Joint Ventures (‘JV’) with global insurance players. After regulatory amendment in 2015, the global reinsurance companies were permitted to establish branches, commonly known as Foreign Reinsurance Branches (‘FRBs’). TP issues in insurance sector are evolving with liberalised inbound cross-border investments, stringent corporate governance norms, guidelines from the OECD and UN TP manual on complex issues such as attribution of profits to PE, profit split method for integrated transaction, role of intangibles and global practices/controversies. In recent times, TP issues in India include cost- plus mark-up remuneration for the services provided by Global In-house Centres (‘GICs’) of insurance players, payments by JVs towards management charges, cost allocations, royalty etc.

Typical value chain in an insurance/reinsurance business may broadly include the following:

• Structuring/development of insurance/reinsurance products based on technical, legal, and mathematical considerations.
• Underwriting and management of the insured risk.
• Treasury and asset/investment management.
• Marketing, sales, and distribution of policies.
• Back office support functions, etc.

MNEs in the insurance sector leverage their positions to tap worldwide market potential. The typical business model adopted in the insurance sector are as below:

• Hub and Spoke: ‘Hub and Spoke model’ is adopted with an objective to effectively manage capital, compliances, streamlining operations and consolidation of underwriting into a single platform for reducing cost and attain efficiencies.The global/regional HO (‘Hubs’) are generally responsible for setting overall business strategies and underwriting framework within which local entities operate. The role of subsidiaries or branches (‘Spokes’) may include maintaining customer relationship, delegated underwriting authority arrangements to bind customers within underwriting limits/framework authorised by the Hubs.
• Managing General Agent (‘MGA’): The HO/principal insurer are responsible for overall strategic and underwriting functions. MGAs or cover holders are delegated underwriting authority to conclude insurance contracts on behalf of the insurer with full or limited authority. MGAs may also undertake support functions as claim management under delegated authority basis.

     2. Key TP considerations

The insurance business is different from other businesses. Underwriting of the insured risk and detailed evaluations of risk management is critical in the value chain analysis. Key TP issues and consideration in the insurance/reinsurance sectors are explained below.

• Applicability of TP provisions to life insurance companies

Income from insurance business is computed vide special provisions under First Schedule[4] (Part A & Part B) to the Income Tax Act, 1961 (‘the Act’). The Hon’ble Supreme court rulings[5] has held that the assessment of insurance companies should be carried as per special provisions under the First schedule to the Act. During audit proceedings, taxpayers have contended that TP provisions are not applicable to life insurance businesses as business profits and tax thereon are computed under special regime. The taxpayers contend that section 44 of the Act starts with a non-obstante clause stating that the income from insurance business shall be computed in accordance with First Schedule to the Act. Once the income is computed under First Schedule to the Act, application of all other sections, including TP provisions under the Act are inoperative.

However, Delhi Tribunal in one of the rulings[6] upheld the decision of tax authorities and observed that TP are applicable to life insurance business. The Tribunal observed that there are two computational provisions under the Act, first computation under various heads of income and other are the TP provisions. It further observed that section 44 of the Act overrides the first computation and not the computation of arm’s length price under TP provisions. The Hon’ble Delhi High Court has admitted the appeal filed by taxpayer[7]. This issue has been debated, especially for life insurance entities operating in India.

• Sharing of premium

With liberalisation of reinsurance sector in India, intra-group arrangements have material TP considerations. The ceding insurance entities (‘Cedants’) enter into ‘re-insurance’ contracts with reinsurance companies (‘Reinsurers’) for protecting losses, managing capital and risk management, regulatory requirements, business strategies, etc. The reinsurers may enter ‘retrocession’ contracts with other reinsurers, where the reinsurer cedes all or part of the reinsurance to another reinsurer. The ceding reinsurer is known as ‘retrocedent’, while the assuming reinsurer is known as ‘retrocessionaire’.

Comparable Uncontrolled Price (‘CUP’) method (subject to data availability) may be applied for sharing of premium amongst the entities under reinsurance/retrocession arrangements. While applicability of CUP method may be challenging, in some cases third party may participate in same layer of risk as the intercompany reinsurer and therefore internal CUP may be applied. It depends upon various factors such as form of reinsurance business - proportional or non-proportional (facultative or treaty), type of insurance policy underwritten e.g. life insurance, non-life insurance (fire, marine, automobile, personal accident, etc.), sum assured, covered territories, layers of risk, volumes, expected loss ratios, etc.

TP analysis also involve review of risks allocated between the entities having regards to conduct of each party in line with contractual obligations. Sharing of premium ceded is generally based on similar reinsurance transactions entered by insurance companies with third party reinsurers and minimum premium retention norms and other guidelines prescribed under the IRDAI regulations[8] i.e. minimum 50% premium retention for Indian life insurers (25% for pure life protection), reinsurers and FRBs.

• Ceding commission

Ceding commission payments in intra-group reinsurance contracts is worth examining. The key TP consideration for such transaction is whether commission received by the cedant will cover proportionate compensation for busines acquisition and administration costs. TP issues may arise when insurance/reinsurance policies are sold to the customers where negotiation, agreement and management of risk occur at the global or HO level. In such cases, even where local reinsurance branch is required to book premium, in substance it bears little or no risk. The cedants may be functionally characterized as agent/broker in the event where significant risks in relation to reinsurance are transferred to the reinsurer. Transactional Net Margin Method (‘TNMM’) may be applied to benchmark routine profits generated from such ceding transaction. Details about the transaction, negotiation between cedent and reinsurer, commercial rationale for reinsurance arrangements and description of benefits obtained needs to be well documented.

• Sharing of reinsurance brokerage

The reinsurance intermediaries receive brokerage from third party insurers as compensation for origination of reinsurance business. In case of multinational reinsurance intermediaries, sharing of brokerage income needs evaluation. Based on review of transactions, functional analysis, the economic analysis includes selection of most appropriate transfer pricing method having regards to comparable third-party data and practice followed in the reinsurance brokerage industry.

• Attribution of profits to Permanent Establishment (‘PE’)

In absence of fixed place of business, negotiation, and conclusion of insurance contracts by the branches/MGAs may create dependent agent PE of primary insurer or reinsurer in the source jurisdiction. It is important to evaluate attribution of global profits to establish PE of insurance companies, in absence of specific exclusions under tax treaties. The TP issues revolve around determining appropriate pricing policies for intra-group functions in the value chain such as sales and customer relationships, allocation of underwriting profits and investment incomes, commission sharing, etc., based on key entrepreneurial risk taking (‘KERT’) functions performed by the entities.

The Organisation for Economic Cooperation and Development (‘OECD’) has published a report in 2010 on attribution of profits to PE. Globally, tax authorities follow the Authorised OECD Approach (‘AOA’). The concept of KERT function for insurance entities is the guiding principle for allocating underwriting profits and investment income. Similar principles are applied in few judicial rulings from India context. The Mumbai Tribunal in the cases[9] held that a subsidiary of the foreign reinsurance company does not constitute a service PE or agency PE having regards to facts of the case, functional profiles and specific exclusion of reinsurance business in the tax treaty as applicable.

• Captive insurance

Large MNEs engaged in production and distribution of goods/services, face inherent business risks. Instead of obtaining insurance from external insurance players, such MNEs may manage insurance risks within the group through captive insurance entities. The purpose of captive insurance is to minimise dealings with third party insurance companies, managing volatile pricing, cost effectiveness, attain group synergies and providing insurance coverage (e.g. accidental damage/theft coverage) at the point of sales.  

The OECD TP report on financial transaction dated February 2020 elucidate TP considerations for captive insurance such as accurate delineation of transaction, assumption and diversification of economically relevant risks, outsourcing underwriting functions, captive reinsurance etc. The CUP method may be applied to determine arm’s length price of premium charged by captive insurers vis-a-vis independent third parties. However, application of CUP method becomes difficult due to difference in functional and risk analysis. Profit split or other alternate methods based on actuarial pricing, benchmarking combined ratio i.e. two-staged approach which considers profitability of claims and return on capital earned by independent insurers, are mentioned in this report. While captive insurance arrangements are not practiced in India, the above guidelines can be relied upon where such practice gain prominence.

B. Investment Management sector:

Investment Management is essential for FSI players. For example, insurance companies and banks need investment channels to manage their capital effectively. Many FSI players have in-house entities for investment management. Independent entities also undertake business of managing assets/investments on behalf of investors. Investments are reinvested on ‘pooled’ basis through AIF structures such as securities or debt funds, hedge funds, VC/PE/RE funds, sovereign wealth funds, pension funds, fund of funds, etc.

TP issues revolve around arm’s length considerations for fund management activities based on functional/risk profile of entities and comparability analysis. The global PE/RE players operating in India typically have entities incorporated in India providing non-binding investment sub-advisory services. These entities provide support to offshore investment managers including financial research analysis, support for diligence undertaken by third party vendors, provide recommendation for investment/divestment opportunities, liaise with potential investee companies, ongoing monitoring and reporting of investments, etc. The investment managers are responsible for formulating investment/divestment strategies, shortlist and finalise the deal proposals, presenting deals before the investment committee for finalisation, negotiation with investee companies, deal monitoring, etc.

The captive investment sub-advisors are usually compensated by investment managers on a cost-plus mark-up basis. Over the past few years, transfer pricing authorities have proposed cost plus mark-up as high as 60% to 70% for such investment sub-advisory services. In various judicial rulings, tax authorities have contended that sub-advisors perform significant marketing/origination activities for investment managers and services are more akin to investment banking/merchant banking operations. In some cases, these services are also perceived as high end KPO services. Selection of comparable companies has been contentious issue during TP audits and appeals. Various appellate decisions have supported contention of taxpayers that investment sub-advisory cannot be compared to investment/merchant bankers having regards to functional and risk profile.

Since the introduction of Advance Pricing Agreement (‘APA’) regime in 2012, there have been efforts to mitigate onerous litigation challenges faced by such taxpayers providing investment sub-advisory services. Recently, tax authorities have been examining cost base of such service providers. The enquiries are made to examine whether cost base of investment sub-advisory entities include cost of any intra-services/software tools availed with no/inadequate consideration, expenses for Employee Stock Option Plans (‘ESOPs’), stock units, carried interest/carry or any other benefits/privilege granted to the employees of Indian sub-advisors by another group companies. These issues are relatively pre-matured, facts specific and are being addressed having regards to global TP policies and industry practices.

C. Other common considerations:

• Global in-house Centres (‘GICs’)

Large multinational insurance/reinsurance companies, large intermediaries and investment management groups have incorporated GICs in India owing to advantages of low cost, efficient resources, and available skilled talent. These GICs provide Information Technology enabled Services (‘ITeS’) related to contract administration, claim processing, underwriting support, actuarial assistance, legal, accounting, payroll, other back-office support, etc.

GICs providing captive services are typically remunerated on cost-plus mark-up. The attention of TP authorities has been on characterisation of such services, comparable companies, cost base and mark-up. TP authorities perceive such services as high-end Knowledge Process Outsourcing (‘KPO’) services and have attributed higher cost-plus mark-up, ranging from cost plus 25% to 30%.  Few GICs have opted for APA mechanism to attain certainty and mitigate transfer pricing audit risks.

• Centralised intra-group services and allocation of common cost

Most insurance/reinsurance and investment management entities have central/regional hub or HO providing shared services like accounting, Human Resources, IT networks, legal, corporate management services etc. Common expenses for such intra-group services are allocated amongst group entities using appropriate allocation keys, with or without mark-up. TP authorities examine various factors viz. evidence of services availed, benefits derived, duplication of services, etc. Intra-group services also have implications under the Goods and Service Tax (‘GST’) Act, 2017. GST authorities have been issuing show cause notices on ‘deemed supply’ of services to levy GST on intra-group services with no/inadequate consideration. This include allowing right to use intangibles like ‘corporate brand’ or ‘logo’.  Accordingly, it is essential to evaluate such intra-group services/cost allocations in light of documentary evidences demonstrating need and benefit of such services, basis of charge (i.e. cost base, allocation keys, mark-up, if any) to mitigate potential risks, both from TP and GST perspective.

• Technology and digitalisation

Role of technology has gained significant momentum in the BFSI space, especially in the current pandemic scenario. As mentioned in Series 1 of this article, the FSI players are upscaling their business value chain by incubating and acquiring technology companies. ‘InsureTech’ is the future of insurance sector. Shift from traditional sourcing, distribution and business operations towards digitalised mobile application based, web-based aggregators, etc. warrants re-visiting the functions and risks of each entities in the value chain, role of intangibles and determining transfer prices in accordance with arm’s length principles.

• Corporate governance under other regulations

As mentioned in Series 1, Related Party Transactions (‘RPT’) should meet arm’s length standards from corporate governance perspective under the Companies Act, 2013 and SEBI Listing Obligation and Disclosure Requirements (‘LODR’), 2015, as applicable. IRDAI and SEBI has prescribed disclosure requirements on RPT. The insurers, investment managers/funds are required to maintain appropriate disclosure to substantiate that RPT are entered into ‘ordinary course of business’ and meets arm’s length principle.

With an objective to avoid conflict of interest, IRDAI has issued notification[10] on outsourcing activities, applicable to all insurers/intermediaries registered with IRDAI (excluding those engaged in reinsurance business). Insurers are required to meet prescribed compliances where outsourcing service providers are related parties/group entities. In addition to other prescribed norms, the notification requires that amount of consideration agreed upon and modifications thereon, if any, shall be subject to specific approval of the Outsourcing Committee of the Insurer. The SEBI vide recent notification[11] has also laid down various regulations and procedure for AIF managers aimed towards confidentiality, conflict of interest, prevention of money laundering and protecting investors interest. IRDAI and SEBI have powers to impose penalty for non-compliance/failure to meet these requirements. TP provisions are suitably applied for review of RPT from corporate governance perspective.

• IFSC, GIFT City operations

As discussed in Series 1, Indian government has been promoting offshore financial operations in the IFSC GIFT city. The thrust is also to attract global insurance/reinsurance players and offshore funds for undertaking operations in the IFSC GIFT city by offering favourable tax regime and fiscal benefits. The International Financial Services Centres Authority (‘IFSCA’) has been taking active steps to promote insurance/re-insurance business in the IFSC GIFT City. IFSCA Insurance Committee is being constituted for developing insurance regulations. IFSCA has obtained membership of International Association of Insurance Supervisors (‘IAIS’), headquartered in Switzerland for development of insurance business with other global members.  IFSCA has issued circular[12] providing additional benefits for AIFs to encourage in setting up their operations in IFSC GIFT city aligning with international standards. IFSCA has also issued circular[13] for GICs providing services relating to financial products and financial services, as eligible financial service to claim benefits offered. Further, separate regulations are notified[14] to provide a framework for recognition and operation of GICs in IFSC.

The intra-group international transactions/specified domestic transactions entered with the entities established in the IFSC GIFT city involves TP considerations.

D. Concluding remarks

In addition to traditional contentious TP issues, the insurance and investment management sectors of FSI have witnessed evolving regulatory developments, key tax (direct and indirect) considerations, stringent disclosure norms under corporate governance and digitalisation in the value chain.

Like in any other industry, the above factors necessitate focused review of TP policies, in sync with international TP guidelines and global practices.

MNEs also need to evaluate interplay of TP with various other contentious taxation areas such as equalisation levy, permanent establishment, withholding tax, GST etc.

Blockchain is a ubiquitous term in our everyday parlance made popular by the wildly hyped cryptocurrency Bitcoin. It promises to disrupt the manner in which the world conducts business, and consequently the taxation aspect of such businesses. In this article, we explore whether Blockchain technology can traverse the distance of ‘possible’ to ‘plausible’ in connection with its application in TP.

What is Blockchain

To understand its application in TP, we must first understand the technology. Blockchain, a part of a suite of technologies known as Distributed Ledger Technologies (DLT), in which a transaction is stored as ‘block’ and linked to each other via ‘chains’. To approach it differently, this ledger of information is replicated and distributed across computers that are joined over a peer-to-peer network. Result? That single transaction, known as a ‘block’, serves as a permanent record, maintained in a single, shared digital ledger, ‘chains’. Any related new transaction can be added on top of that original records, creating an interconnected blockchain of complex transactions and counterparties, mapped in the single digital ledger shared by all parties involved.

Like any other disruptive technology, blockchain aims to replace traditional models, by offering an alternative that is devoid of the weaknesses that would have crept into these models over time, which are:

• Consensus: Information can be added onto a Blockchain only if all, or a defined number of participants in the network agree on the correctness of information.
• Immutability: The ‘Blocks’ are cryptographically locked into a ‘Chain’, meaning that it is impossible to delete or alter the information stored in the block.
• Chronological and time-stamped: Blockchain is a chain of blocks, each one storing data on a wide range of information. Each one is linked to the previous block, forming a chronological chain of the data uploaded onto the Blockchain.

The implications: recordkeeping in a decentralized, time-stamped, tamper-proof (to the extent that it is near impossible to alter or overwrite without the other party’s tacit approval), quick and cost effective manner. The identification of new instruments to improve the efficiency of TP and its control is a priority on the international tax law agenda.

Thus, there is a need to explore the applications of Blockchain technology in real world scenarios. A couple of examples include:

Smart Contracts

‘Smart Contracts’ are programs stored on a block, that execute when predetermined conditions are met. Smart contracts can be used to automate the execution of an agreement, so all parties can be certain of the outcome, without any intermediary’s involvement or loss of time. Smart contracts are finding applications in a wide array of businesses, especially in the Financial Services Sector, for trade clearing and settlement (managing approval workflows between parties, calculation of trade settlement amounts, and automatic transfer of funds), coupon payments (calculation and payment of periodic coupon payments and returns of principal upon expiration of period), calculation and distribution of royalty payments, apart from other sectors such as Life Sciences, Healthcare, Supply Chain, Logistics and public authorities.

Digitization of assets

‘Digitization of Assets’ is a process wherein the rights to an asset are converted into a digital token (on a blockchain). Ownership rights are transmitted and traded on a digital platform, and the real-world assets on the blockchain are represented by digital tokens.

Digital Tokens can be created for tangible or intangible assets, fungible or non-fungible assets. Once created, the Digital Token can be traded freely, and royalties arising from rights to use such tokens can be automated using Smart Contracts for further ease of business and accuracy.

Adoption of Blockchain Technology

As per a Deloitte’s 2020 Global Blockchain Survey, the Telecom, Media, Telecommunications industry along with Financial Services are the early adopters of Blockchain technology.  Approximately 36% of the respondents to the survey reported that their organization planned to invest at least US$5 million in the next 12 months in Blockchain. As can be expected, the top three barriers felt by organizations in adopting blockchain technology is Implementation: replacing or adapting existing legacy systems, potential security threats and concerns of sensitivity of information.

At this juncture, it would be pertinent to mention the discussion paper released by the NITI Aayog: Blockchain: The India Strategy – Part 1. This discussion paper released in 2020 signals both India’s eagerness and trepidations in adopting Blockchain technology. The three case studies that the NITI Aayog has explored use of Blockchain technology are: (i) Land Records, (ii) Pharmaceutical drugs supply chain and (iii) SuperCert: anti-fraud identity intelligence blockchain solution for educational certificates. The NITI Aayog is also working on part II of the paper, which will cover specific recommendations on the growth and expansion of use of Blockchain ecosystem in India.

Further, both the Organisation for Economic Cooperation and Development (‘OECD’) and United Nations (‘UN’) have taken note of the potential of Blockchain and its applications. The OECD has constituted the Blockchain Policy Centre in 2018, which intends to work as an international reference point for policy makers on Blockchain technology. The OECD also recently released a discussion paper on ‘Draft OECD high-level guidance regarding policy considerations on responsible innovation and adoption of distributed ledger technology (DLT)’, with a view to providing high-level, non-sector-specific guidance on responsible innovation and adoption of Blockchain, to all stakeholders involved in the development and use of blockchain, including but not limited to governments. Further, the UN has also responded positively, particularly in the areas of humanitarian cause, fight against climate change, disbursing funds to refugees using blockchain-verified iris scans instead of ID cards etc.

Blockchain and TP

Blockchain has the power to disrupt and strongly reorganize accounting and the way tax payments are processed. It particularly is attractive since it will reduce administrative burden, cost of tax collection, and reduce data gap / data corruption, for both taxpayers and tax administrations.

Focusing on TP, blockchain technology promises to be a boon, rather than a bane in the following scenarios:

- Standardized ‘Decentralized’ Data: Large MNEs often have decentralized operating structures and multiple corporate units, with decision making individuals located in multiple jurisdictions (often in the form of Regional Headquarters). This often leads to data being stored on local servers in varying formats. This leads to the MNE embarking on a data centralizing exercise, which is cumbersome and costly. Blockchain technology is well suited for merging data (and possibly processes) in the case of a decentralized organization structure. Visualize an ERP system based on Blockchain with standardized data formats across the globe, with TP and arm’s length calculations (on pre-determined rules which can be updated time-to-time). Further visualize such an ERP system that can be used as an interface to funnel data into pre-defined TP formats (for statutory compliances, including CbCR, Master Files, Local Files, or internal management reporting / tracking). 

- Audit Readiness: Blockchain, by default, undertakes archiving of audit data, since inter-company transactions are mapped in a standardized format and available for dissemination to tax authorities on an almost real-time basis. Further, the efficacy of the data using Blockchain will be beyond question / challenge, as it is near impossible to manipulate / edit data once stored.

- Smart Intercompany Contracts: Tracking and maintaining physical intercompany contracts is cumbersome and smart intercompany contract can displace the physical one. As discussed above, a smart contract is an agreement or set of rules that governs a transaction and is coded into the blockchain network. If the pre-defined conditions are satisfied, the transaction is executed. For example: a smart intercompany contract may define contractual conditions under which a cash pooling arrangement works, trading of commodities at pre-determined arm’s length prices etc. Further, Blockchain reduces the risk of loss of data. Visualize, inter-company securities transactions being executed at prices which satisfy the requirements under Comparable Uncontrolled Transaction (CUT), on a real time basis, with such data being maintained and recorded instantaneously. Further, implementation of prices / methodology determined under Advance Pricing Agreements (APA) can also be made instantaneous and in accordance with the APA, especially beneficial for bilateral and multilateral APAs and questioning the need for audits post signing an APA.

- Smart Contracts in Intra-Group Services: In our TP world, the correct transfer price calculation is the first stage to be mandated. The mechanism involves a situation in which there is a ‘green light’ for validating the transaction any time the transfer price of an intra-group transaction is within the range of prices calculated by the smart contract. The second stage is focused on transaction validation and determines the corresponding actions from MNE entities that operate as nodes of the network. Once there is a green light for an intra-group transaction, MNE entities, have the right to validate that transaction allowing the adding of a new block to the blockchain. Therefore, as transfer price calculation and transaction validation become a fully automated process, there is no longer a need for dedicated reporting activities from MNEs.

- Performance of DEMPE Functions: Blockchain technology could be used to identify where a related-party transaction originated, exactly when it occurred, and the terms under which it occurred. Thus, it provides the hope that blockchain will clearly show the development, enhancement, maintenance, protection, and exploitation of intangibles by creating a trail back to the location(s) of value creation. In application of Profit Split Method, the first hurdle is the determination of profits to be split. Blockchain will enable the MNE to collate the data effectively, as it will capture the entire supply chain in an efficient manner. Further, implementation of results of the contribution analysis can also be standardized and made real-time, rather than a post-facto exercise. Blockchain will also assist in identifying where the actual substance lies in a transaction over its legal structure.

- Country-by-Country Reporting (CbCR): CbCR poses added risk and administrative burden for finance and tax departments of MNEs. Use of blockchain technology may provide potential ability to access aggregated CbCR information from a single distributed ledger source available for review and approval by all parties. The ability to validate and share secure data between parties on the blockchain will redefine how CbC reporting is done.

- Pillar 1&2: Since Blockchain works on pre-defined rules, it may provide ease in the implementation of Pillar 1 principles – agreed upon allocation of profits between entities. Without the need for manual intervention, it can enforce trust into conduct of parties and make work easier. Blockchain may enable tax authorities to implement the global minimum tax rule across countries and organizations in an efficient and cost-effective manner.

- Interplay with other laws: Since data stored on Blockchain is standardized, the format can be made such that the data can be used for other laws / purposes with ease (GST Laws, Customs, Cost Audits) without having the need for customizing the same for different applications. It can also facilitate capturing data in a format desired by organizations to ensure accurate reporting for business decision making.

As is with any emerging technology, there certainly are drawbacks to Blockchain, the biggest being scalability, since it generates a large amount of data, being based on a P2P network, it requires constant computing power, reliance on the private key of users. The decentralized nature of Blockchain is a double-edged sword for organizations, since the centralized data management is a security feature, which also leads to single-point of failure. Further, since the record is permanent, accuracy of data being fed into the system is of paramount importance.

Thoughts to ponder