Partner, BMR &Associates LLP

Suchint Majmudar

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Suchint Majmudar superadmin Wed, 09/12/2020 - 00:56

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Partner, BMR & Associates LLP

Partner, BMR Advisors

Partner, BMR &Associates LLP

Transfer Pricing Partner, BMR & Associates LLP

Partner, Deloitte Haskins & Sells

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Safe Harbour for Low Value Added Intra-Group Services – A beacon of hope?

superadmin — Thu, 15 Jun 2017 05:51:27 +0000

Safe Harbour for Low Value Added Intra-Group Services – A beacon of hope? superadmin Thu, 15/06/2017 - 11:21

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Introduction

Intra-group Services (IGS) has been the subject matter of a great deal of controversy between the Multi National Enterprises (MNE) taxpayers and the Indian Revenue Authorities (IRA). There are increased instances of cross border IGS with globalization as centralised services help streamline business operations and achieve economies. The practical difficulties faced by MNEs to substantiate the cost allocated by the overseas parent company/ associated enterprise (AE) is compounded by the lack of regulations and guidance by the Indian tax administration on this contentious issue. In what can be seen as a panacea to the afore mentioned predicament, the Central Board of Direct Taxes (CBDT) issued amended safe harbour rules (SHR)[1] on 7 June 2017, whereby a new eligible international transaction i.e. receipt of Low Value Added IGS (LVA IGS) was introduced. As per the newly amended SHR, the entire value of the LVA IGS including a mark-up of 5 per cent should not exceed a sum of INR 100 Million.

Interplay between OECD and Indian tax laws

The definition of LVA IGS and the SHR for LVA IGS introduced by the IRA is influenced by the Organisation for Economic Co-operation and Development (OECD) Action Plan 8 to 10 on Base Erosion and Profit Shifting Aligning transfer pricing outcomes with value creation (AP). The AP lays down extensive guidance on dealing with matters relating to LVA IGS. It defines LVA IGS as services performed by one member or more than one member of an MNE group on behalf of one or more other group members which^[2] (the same has also been incorporated by the IRA):

Are of a supportive nature;
Are not part of the core business of the MNE group (i.e. not creating the profit-earning activities or contributing to economically significant activities of the MNE group);
Do not require the use of unique and valuable intangibles and do not lead to the creation of unique and valuable intangibles; and
Do not involve the assumption or control of substantial or significant risk by the service provider and do not give rise to the creation of significant risk for the service provider.

The AP advocates a simplified approach to the determination of the arm s length price (ALP), which would help reduce the compliance effort of meeting the benefit test, provide greater certainty for MNE groups that the price charged for the qualifying activities will be accepted by the tax administrations and provide tax administrations with targeted documentation enabling efficient review of compliance risks[3]. A mark-up of upto 5 percent has been recommended by the OECD on the provision of LVA IGS and adopted by the SHR.

Indian TP audit experience and judicial precedents

The Indian Income-tax rules and regulations do not lay down any guidelines for the tax administration on dealing with the aspect of LVA IGS. In the absence of the same, reference is taken from the OECD Guidelines and the United Nations Practical Manual on Transfer Pricing for Developing Countries. The Tribunals/ High Courts while determining the ALP for LVA IGS have given importance to the following:

The Evidence Test, where the taxpayer is expected to provide documentary evidence to prove that the services have actually been rendered by the overseas AE.

The Arm s length Test, where the taxpayer is expected to prove that in an uncontrolled scenario, independent third parties availing similar services would pay for the same. Where cost has been apportioned on the basis of allocation keys, the appropriateness of such allocation also needs to be demonstrated.

Most of the judgments have rendered a settled view on the Need Test or the Benefit Test, in as much as the IRA cannot exercise judgment over the business operations of the taxpayer or question the need for such services as those purely depend on commercial considerations. However the following practical difficulties do arise on the implementation of the judgements:

What constitutes as evidence is subjective in nature. The documentation requirement will differ based on the facts of the situation and there cannot be a straight-laced answer.

The taxpayer has to establish that the services availed are not duplicative in nature.

The taxpayer is called upon to substantiate why the services were not outsourced to third party vis-Ă -vis they being availed by the AE, in the quest for an internal comparable uncontrolled transaction.

Where the decision to provide the services to its AEs is taken centrally, the taxpayer may find it challenging to substantiate that such services were actually required and that they were not foisted on it by the AE.

Points to consider

In the light of the above, the introduction of a SHR for the provision of LVA IGS seems to be a beacon of hope. However, there are certain aspects that need a deeper introspection by the taxpayer:

Specific exclusions- The amended SHR provide a list of services which have been specifically excluded from the ambit of LVA IGS which are similar to the exclusions prescribed in the BEPS AP - they are: research and development services, manufacturing and production services, purchasing activities relating to raw materials or other materials that are used in the manufacturing or production process, sales, marketing and distribution activities, financial transactions, extraction, exploration, or processing of natural resources and insurance and reinsurance.

The additional excluded services prescribed by the amended SHR are information technology (software development services), knowledge process outsourcing services and business process outsourcing services.

The SHR are reasonably clear in their definition of what constitutes an LVA IGS and what does not and there seems to be no room for debate. The OECD provides an illustrative commentary on services which fall under the ambit of LVA IGS, like accounting and auditing services, human resource activities, processing and management of accounts receivable and payable and IT services which are not the principal activities of the Group. No such inclusive definition exist in the amended SHR. So where a taxpayer is availing services which can be characterized as LVA IGS as per the OECD BEPS AP, such as accounting and administrative services, or IT services, that are not the principal activity, the taxpayer will not acquire the benefit of the same under SHR, as such service forms a part of the exclusion list. The taxpayer will have to go down the normal assessment route, where the commentary on LVA IGS as per the BEPS AP may come to its aid.

Use of external comparable data- The SHR mandate that a service can be characterised as LVA IGS only when there are no reliable external comparable services that can be used for determining ALP. It is worthwhile to note that AP 8 to 10 has recommended an exclusion where internal comparable data exist for the LVA IGS. To this extent, amended SHR are, to some extent, at variance with the OECD guidelines. For certain low value added services like accounting and administration support and human resource support, under the Transactional Net Margin Method approach to determine ALP, data on third party comparable service providers could be available in the public domain. Accordingly, tax authorities may deny benefit of SHR for such services and the taxpayer may be required to meet the arm s length standard under regular TP audit.

Where the services fall within the definition of a LVA IGS and they are out of the ambit of the exclusion list, the rider of the service not having reliable external comparable date seems absurd to establish. Even where third party comparable data is found, the margin cannot exceed 5 percent of the cost base as it would have to be within the confines of the SHR, so in essence the impact on the taxpayer will not be that significant.

It is recommended that the amended SHR should be in line with the OECD on the existence of comparable data.

Benefit test - The amended SHR do not talk about the need to evidence benefits which have accrued to the taxpayer by the use of these services, which is a welcome relief. The demonstration of benefits which warrant payment to the overseas AE has been the crux of the debate surrounding the determination of ALP of such services to be Nil. The requirement of an accountant s certificate which will provide assurance that the cost have been incurred for provision of services and are not in the nature of shareholder and duplicative services can assist in establishing the bonafides of provision of service.

Coverage of benefit- The amended SHR have limited the eligibility of the transaction to INR 100 Million. As a result, several taxpayers can avail the benefits of LVA IGS to the extent they are covered by SHR and the balance charge of IGS can be substantiated under the regular TP audit. In effect, a portion of IGS will be covered by SHR and the balance will have to be dealt with in the course of assessment.

Certification by an Accountant-The amended SHR require an accountant to certify the method of cost pooling, the exclusion of shareholder and duplicate costs and the reasonableness of allocation keys used. Thus the onus has been put on taxpayer to obtain certification as a pre requisite for availing SHR benefits. Such certification can also be used as documentary evidence where the taxpayer has to avail of the normal audit and litigation channels for IGS that are not subject to LVA IGS SHR.

Provision of LVA IGS - A margin of 5 percent has been deemed to be appropriate for the payment for availing LVA IGS. However, the same will not be deemed as appropriate in a situation where the Indian taxpayer renders such services to its AEs. Hence, India s position on IGS presently does not extend to the rendition of LVA IGS to AEs â€“ these services have to carry an arm s length markup on the operating cost base of the Indian taxpayer.

Documentation- While judicial precedents have held that documentation is essential to prove receipt of services, in view of the muted level of documentation called for under the SHR, the adjudication of safe harbour applications basis TP documentation will provide a sense of direction on what can constitute adequate documentary support to prove that services are indeed LVA IGS, ie pass muster to qualify as IGS as a precondition.

Way Forward

The introduction of LVA IGS as an eligible international transaction and prescribing a mark-up of 5 percent is a welcome move on part of the Indian tax administration as it is in sync with the business aspirations of international business community that would not want to get mired into â€œsweating the small stuff. â€œ In the process, the LVA SHR provide respite for companies from having to go through a detailed audit or litigation, or seek an APA as a matter of course, that can be tedious and cumbersome. That said, the adoption of LVA SHR has to be approached with caution in light of the above discussion.

[1] Notification No. 46/2017/F. No. 370142/6/2017-TPL on 7 June 2017

[2] Para no. 7.45 of the BEPS Action Plan 8-10- Aligning transfer pricing outcomes with value creation

[3] Para no. 7.52 of the BEPS Action Plan 8-10- Aligning transfer pricing outcomes with value creation

State aid & preferential tax regimes – Analyzing the implications

superadmin — Tue, 04 Apr 2017 11:27:35 +0000

State aid & preferential tax regimes – Analyzing the implications superadmin Tue, 04/04/2017 - 16:57

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A measure by which the public authorities grant certain undertakings a favourable tax treatment which places them in a more favourable financial position than other taxpayers amounts to State aid within the meaning of Article 107(1) of the Treaty on the Functioning of the European Union (TFEU)[1].

While the Member States enjoy fiscal autonomy in the design of their direct taxation systems, any fiscal measure a Member State adopts must comply with the EU State aid rules, which bind the Member States and enjoy primacy over their domestic legislation. As early as 1974, the Court of Justice of the European Union clarified that the Commission's competence in the field of State aid control also covers the area of direct business taxation. As a rule, fiscal measures of a general nature that apply to all undertakings without distinction fall within the remit of the Member States fiscal autonomy and cannot constitute State aid, since they do not selectively advantage certain undertakings over others. By contrast, fiscal measures that discriminate between taxpayers in a similar factual and legal situation constitute, in principle, State aid[2].

Since 1958, the Member States of the European Union are obliged to inform the European Commission of any plans to grant State aid and the Commission has the responsibility to assess whether measures notified by the Member States to it constitute State aid and, if so, whether those measures can be deemed compatible with the internal market.

State aid is the subject of considerable recent debate, especially because of preferential tax regimes granted to select taxpayers, whose transactions with their group companies may not be necessarily reflective of the arm s length principle. In 2006, the European Court of Justice endorsed the arm s length principle for determining whether a fiscal measure prescribing a method for an integrated group company to determine its taxable profit gives rise to a selective advantage for the purposes of Article 107(1) TFEU[3]. Accordingly, a fiscal measure which endorses a method for determining an integrated group company's taxable profit in a manner that does not result in a reliable approximation of a market-based outcome in line with the arm s length principle can confer a selective advantage upon its recipient. That would be the case where such a fiscal measure results in a reduced taxable profit, and thus reduced corporate income tax liability[4].

In view of increased transparency arising out of 3-tier documentation, it is expected that the transfer pricing outcomes of taxpayers will come under the lens on account of State Aid rules. Especially in situations where a single-sided profit based method such as the Transactional Net Margin Method is resorted to, with the residual profit being allocated to another EU member State, questions may be raised around the adequacy of such allocation. For multinational enterprises ( MNEs ) operating in the EU, it is therefore advisable to seek certainty not only by way of Advance Pricing Agreements, but rather bilateral rulings (APAs and MAPs), that are likely to gain more prominence - this will ensure testing both sides of the international transaction to assess whether compensation for both parties (or more in case of multiple parties to a transaction) is commensurate with the functions performed, risks assumed and assets employed by each party in respect of the subject international transaction. This finds force in the Working Paper, which states, In general, rulings that cover intra-group transactions between two different Member States, where both companies carry out genuine economic activities on which they are taxed, have been found to be unproblematic .

EU is not alone in relation to the State aid matter. Countries such as Singapore and Malaysia have been prominent in Asia in providing preferential tax regimes to MNEs at negotiated, concessional rates of tax. These unilateral rulings that are provided by bodies such as the Economic Development Board of Singapore, or are based on the Pioneer tax incentive in Malaysia, provide for such concessional rates of tax for International Headquarters or Regional Manufacturing Headquarters for an extended length of time, based on the fulfilment of certain conditions, such as the generation of local employment and a committed level of domestic capital and revenue expenditure on an annual basis. For an MNE, that has been otherwise been operating from existing high-tax jurisdictions, the transition into such regimes can lead to the restructuring of its operations so as to reduce its existing manufacturing or R&D into contract operations and its marketing and distribution into low risk distribution functions, or otherwise, a conscious scaling down of its operations in other jurisdictions and an increased investment in factors of production into the country of the preferential tax regime. Essentially, the preferential tax regime would enable the adoption of an entrepreneur-led headquarter structure in such country with the remaining countries of operation being entitled to more-or-less assured returns under a profit-based transfer pricing methodology. Such structures, while not necessarily qualifying under EU State aid rules, are likely to come under scrutiny on account of increased transparency and access to rulings under Action 5, Countering Harmful Tax Practices more effectively, taking into account Transparency and Substance. To this end also, the grant of such preferential tax regime ought to be supplemented by bilateral or multilateral rulings that would enable the intercompany transfer pricing policy that is designed around the preferential tax regime to operate without the possibility of the incidence of double taxation. The recent amendment in the Singapore treaty that allows for the adoption of mutual agreement procedure and bilateral APA in terms of Article 9(2) is a case in point.

Further, with the visibility to the level of profit in each jurisdiction and the effective tax rate, the stress on transactional profit split in some form (such as heighted comparability analysis for incremental functions, as we see in India, or location specific advantages as in the case of China, or depiction of intangible transfers and benefit test in Indonesia) is expected to increase. Therefore, concurrent documentation (by undertaking value chain analysis) is required to be maintained by MNCs to correlate compensation received with the value generated at each jurisdiction of operation. Such documentation goes beyond its traditional form and would entail the digital capture and archiving of activities, decisions and communications as they occur, which of course, is not without its challenges, not least because of multiple communication channels and data privacy issues.

Obtaining tax advantageous rulings may seem attractive to MNEs and may potentially reduce overall corporate tax liabilities in the present; however, the same comes with uncertainty of acceptability in the future and may lead to higher tax burden with retrospective effect. In light of the ongoing disputes involving prominent MNCs in various jurisdictions, especially in Europe, it will become important to ensure that outcome of any ruling obtained by taxpayers by way of MAPs, APAs or Advance Rulings have cognizance to arm s length principle as defined in OECD Transfer Pricing Guidelines so as to avoid getting classified under State Aid Rules. Therefore such outcomes will be required to be corroborated with transfer pricing analysis undertaken and documented by the taxpayer.

As set out in the Commission Notice on the Notion of State aid, the OECD Guidelines 'provide useful guidance to tax administrations and multinational enterprises on how to ensure that a transfer pricing methodology produces an outcome in line with market conditions. Consequently, if a transfer pricing arrangement complies with the guidance provided by the OECD Transfer Pricing Guidelines, including the guidance on the choice of the most appropriate method and leading to a reliable approximation of a market based outcome, a tax ruling endorsing that arrangement is unlikely to give rise to State aid.'[5]

While dealing with transfer pricing methods, reliance on comparability analysis is an essential, and by resorting to the sixth method, barring cases involving valuation (and even there, a combination of approaches, including comparable transaction method could be adopted), there could be questions asked around how it can be demonstrated that the transaction represents how third parties actually transact in the open market (and in a flat world, which market is also a question!). And therefore also, while negotiating preferential tax regimes, it does become necessary to take a holistic view of the MNE group value chain and assess whether the commitments given in order to secure such preferential tax outcomes are consistent with the arm s length principle. As is apparent from the pronouncements in the BEPS actions around group synergies, transfer pricing is no longer only a matter of determining the arm s length price of transactions in isolation having regard to the tested party alone, but rather striking a balance between adopting orphan (standalone MNE entity) and family (MNE group) approaches[6].

[1] DG Competition Working Paper on State Aid and Tax Rulings

[2] Ibid

[3] Joined Cases C-182/03 and C-217/03 Belgium and Forum 187 ASBL v. Commission EU:C:2006:416.

[4] DG Competition Working Paper, Ibid

[5] Commission Notice on Notion of State Aid, referred to in Article 107(1) of TFEU, para 173

[6] Orphan and Family/ Parental affiliation are expressions used in the Working Paper, Mind the Gap â€“ The arm s length principle and MNE value creation. Melissa Ogier, Tax and Transfer Policy Institute, September 2016

Foreign-AE as tested party - Should India follow global practice?

superadmin — Thu, 21 Jul 2016 06:40:24 +0000

Foreign-AE as tested party - Should India follow global practice? superadmin Thu, 21/07/2016 - 12:10

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The Delhi Bench of the Income Tax Appellate Tribunal (“ITAT”) in a recent ruling in the case of GE Money Financial Services Pvt. Ltd (“the taxpayer”) rejected the taxpayer’s approach of selecting its foreign associated enterprise (“AE”) as the tested party, further stating that a foreign AE can never be selected as the tested party as per Indian statute. The ruling has delved into two important principles of transfer pricing – relevance of benefit test for intra group services and selection of foreign AE as tested party.

Facts of the case

In the said case, the taxpayer received certain intra group services in the nature of finance, human resource, IT, consulting and system support services from its foreign AE during the Assessment Year (“AY”) 2009-10. In order to establish the arm’s length nature of the transaction, the taxpayer applied Transactional Net Margin Method (“TNMM”) and selected foreign AE as the tested party.

During the Transfer Pricing (“TP”) assessment proceedings of AY 2009-10, the Transfer Pricing Officer (“TPO”) selected the taxpayer instead of foreign AE as the tested party and further selected Comparable Uncontrolled Price (“CUP”) as the most appropriate method (“MAM”) over TNMM. The TPO further contended that services received by the taxpayer were duplicative in nature and no benefit was received by the taxpayer from such services – on this basis, the TPO determined the Arm’s Length Price (“ALP”) payable for such services to be Nil.

Upon receipt of draft assessment order, the taxpayer filed objections before the Dispute Resolution Panel (“DRP”) which upheld the TPO’s approach. Aggrieved, the taxpayer filed an appeal before the ITAT.

The ITAT’s verdict

Whether Foreign AE can be selected as a tested party?

In relation to selection of foreign AE as the tested party, the ITAT referred to clause (e) of Rule 10B of Income Tax Rules, 1962 (“Rules”), which states that under TNMM, the net profit margin realized by the enterprise from an international transaction entered into with an associated enterprise is computed in relation to costs incurred or sales effected or assets employed or to be employed by the enterprise or having regard to any other relevant base, which is then compared with the net profit margin.

The ITAT interpreting the Indian law concluded that under TNMM, the profit earned by the Indian enterprise (and not the foreign AE) has to be tested. Further the ITAT stated that the manner of determining the ALP is prescribed in the law and the same has to be strictly followed. The ITAT opined that the selection of foreign AE as the tested party lacks statutory sanction and therefore cannot be allowed. The ITAT further determined that foreign comparables selected by the taxpayer lacked comparability. On the basis of all these objections, the ITAT rejected the taxpayer’s contention of selecting the foreign AE as the tested party.

Concept of tested party and divergent view of ITAT’s

The concept of “tested party” is one of the most fundamental and critical aspects of undertaking an economic analysis under transfer pricing. One of the reasons for continued controversy surrounding "tested party" is that this term has not been specifically defined in the Income-tax Act, 1961 (“Act”). However, the Organisation for Economic Co-operation and Development (“OECD”) in the Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations in its 2010 Edition ("OECD TP Guidelines”) as well as the UN Practical Manual on Transfer Pricing (“UN Manual”) have dealt with this issue in great detail.

The OECD TP Guidelines defines 'tested party' as "the one to which a transfer pricing method can be applied in the most reliable manner and for which the most reliable comparable can be found, i.e. it will most often be the one that has the less complex functional analysis."

The UN Manual defines tested party in a similar manner and clarifies that the tested party can be local or foreign party. It further states that "if a taxpayer wishes to select the foreign associated enterprise as the tested party, it must ensure that the necessary relevant information about it and sufficient data on comparables is furnished to tax administration and vice versa in order for the latter to be able to verify the selection and application of the transfer pricing method".

Based upon these definitions, one can infer that the "tested party" should have the following attributes i.e. the entity involved in an intercompany transaction:

Whose functions are less complex in nature;
Which does not own intangibles or owns routine/ limited intangibles with respect to the transaction involved;
The results of which can be verified using reliable data that requires the fewest and most reliable adjustments.

Different benches of the ITAT have accepted the approach of selecting the "tested party", as envisaged by the OECD TP Guidelines and the UN Manual, which are highlighted in Annexure. On the contrary, there have been certain rulings like Onward Technologies Limited. [TS-94-ITAT-2013(Mum)-TP] and Aurionpro Solutions Ltd [TS-75-ITAT-2013(Mum)-TP] which go against the selection of foreign AE as the tested party. Incidentally, one of the Tribunal members who rendered and authored the ruling in the case of Onward Technologies (supra) is common to the GE Money ruling (supra) and the rationale provided in both the orders for not being able to regard the foreign company as the tested party is the same. However, these are fact-specific rulings which have been discussed in detail and dealt with in the case of General Motors India Pvt. Ltd. [TS-215-ITAT-2013(Ahd)-TP] to arrive at a conclusion that foreign AE can be taken as a tested party.

While there are a few rulings which over-ruled the selection of foreign AE as tested party, the majority view acknowledges the selection of foreign AE as tested party relying on the fundamental transfer pricing principles. The most significant of all these rulings would be the recent Delhi bench ITAT ruling in the case of Ranbaxy Laboratories (TS-173-ITAT-2016(DEL)-TP) that has ruled in favor of selection of foreign AE as the tested party. This ruling is also one of its kind wherein the Advance Pricing Agreement (“APA”) has been relied upon to settle disputes which pertains to prior years not specifically covered under APA. The ITAT in the said ruling has also emphasized that once Central Board of Direct Taxes has approved of the concept, the same must be appreciated and followed by lower authorities.

Conclusion and Key points

The principle of “tested party” is well enshrined in the fundamentals of transfer pricing. However, lack of guidance in the Indian transfer pricing regulations on selection of tested party and on when and how to apply a particular TP method has led to divergent views being taken by Indian judicial authorities.

While the Delhi Bench of ITAT in the case of GE Money Financial Services Pvt. Ltd has sagely ruled in stating that no benefit test is required to determine the actual receipt of service, it has failed to provide any virtuous ruling on key principles of selection of tested party. The present ruling in contrast with various earlier rulings has examined the Rule 10B of the Rules for application of TNMM verbatim. In our humble view, this ruling provides a very narrow interpretation and has misinterpreted the term “enterprise” by stating that only Indian entity can be selected as the tested party.

As per Section 92F of the Income Tax Act 1961 (“the Act”) the term “enterprise” means

……… a person (including a permanent establishment of such person) who is, or has been, or is proposed to be, engaged in any activity, ………...”

A “person” as defined under Section 2(31) of the Act includes “Company” under its ambit which is further defined in section 2(17) of the Act as:

"company" means-

(i) any Indian company, or

(ii) any body corporate incorporated by or under the laws of a country outside India; or

………..”

From the above, it can be clearly interpreted that the term enterprise includes a company incorporated outside India. Thus, it can inferred that under TNMM, profit margin earned by the foreign AE can also be tested for establishing the arm’s length nature of the transaction.

While concluding that profits of Indian entity should be tested to determine arm’s length nature of the said transaction, the ITAT failed to appreciate the basic principles of comparability. Using the Indian entity as the tested party will lead to benchmark its entire profits (probably earned from various business activities) merely to test an isolated transaction of payment made in relation to intra group services. This runs counter to the basic principles of TP, because it would imply that any difference in profit rates, between the Indian company and the comparables, however large (potentially exceeding the quantum of the international transaction as well), would be attributable to the international transaction of availing of intra-group services. It also disregards the concept of transaction level approach to benchmarking, because ultimately what is sought to be established is that the taxpayer did not pay more than what a third party (ie comparables) would have charged for the services. Further, selection of appropriate comparables under the said approach will be a major challenge for taxpayers.

The ITAT has further stated that the selection of foreign AE as the tested party lacks statutory sanction, and there is no need for seeking any guidance from OECD TP Guidelines. While the Indian regulations do not specifically endorse the OECD TP Guidelines, the courts have placed reliance on the same as well as other international guidance such as UN TP Manual (to which India has also contributed and which incidentally recognizes that a foreign entity could be a tested party). It is also pertinent to observe that, as part of G20 countries, India has also given its consensus to adopt reports on Base Erosion and Profit Shifting (“BEPS”) Action 8-10 and 13. The guidance set out in these reports is ultimately incorporated into the OECD TP Guidelines and it would be interesting to see how the Indian tax administration will view the guidance on other transfer pricing concepts (including tested party) while being a party to BEPS. In any event, more liberal interpretations around the Rules such as use of residual profit split (in the case of Global One India Pvt Ltd vs ACIT – ITA Nos 5571/Del/2011 & 5896/Del/2012) and Berry ratio (in case of Mitsubishi Corporation India Pvt Ltd - ITA No 5042/Del/11) allow for a practical approach to be adopted that enables the ends of justice to be met, while being consistent with global practices. The acceptance of the concept of tested party (whether Indian or foreign) should likewise follow global practice.

The Indian Revenue has not issued any official guidelines in the form of circulars on approaches around the fundamentals of transfer pricing in the absence of which taxpayers, Revenue & Judiciary would need to rely on the guidance available globally in this area from the OECD, UN Manual, US regulations etc.

It is also important for taxpayers to ensure that while maintaining TP documentation, all the requisite criteria are met and since the onus of selecting foreign entity as "tested party" would be on the taxpayer, the taxpayer needs to ensure that the test of appropriateness of method and selection of appropriate comparables are duly fulfilled and documented. Transfer pricing is a subject of law and fact, the latter more intensive than the former, and hence even if the law is stacked against the taxpayer, the facts of the transaction and comparability analysis could come to the rescue of the taxpayer.

Click here to read and download the Annexure.

Supported by Ruhi Gupta (Associate, BMR & Associates LLP)

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Not enough Fortune for internal TNMM?

superadmin — Mon, 18 Apr 2016 12:17:46 +0000

Not enough Fortune for internal TNMM? superadmin Mon, 18/04/2016 - 17:47

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Background

A recent ruling by the Ahmedabad Bench of the Income Tax Appellate Tribunal (“ITAT”) in the case of Fortune Infotech Limited[1] (“taxpayer”) has delved into the approach for comparables’ selection in a transfer pricing (“TP”) analysis specifically on the reliability of the use of an internal comparability analysis vis-à-vis external comparability analysis as well as the limit if any that can be placed on quantum of TP adjustment based on facts of the instant case.

India has been seeing several rulings coming from the ITAT on transfer pricing issues ranging from functional characterization as well as selection and application of TP methods for the purpose of determination of arm’s length price (“ALP”). One of the key aspects of a taxpayer’s TP documentation viz. selection of comparables has been a focal point of many of such disputes in the Indian context. Taxpayers in India have been over the years facing the practical challenge on carrying out a robust economic analysis due to non-availability of qualitative and financial data for comparables at the time of filing of their return of income as against the Revenue authorities having access to more data at the time of an audit. This aspect combined with the fact that over 60% of world trade takes place between or within multinational enterprises (“MNEs”)[2] makes it even more difficult for taxpayers to access and use data for comparable transactions between independent enterprises.

In this context, taxpayers often rely on internal comparable data where available e.g. price/profit results from transactions entered into by a taxpayer with an unrelated party is used to support the results of transactions entered into with their associated enterprise (“AE”) – this ruling throws light on the reliability of such internal comparable transactions and the level of diligence required of taxpayers under such circumstances.

Summary of Facts

The taxpayer was involved in provision of Information Technology enabled services (ITES) comprising of insurance claim processing, mortgage loan processing and document processing services to its AE based in the US. The AE on the other hand was involved in business development and marketing functions in the US so as to procure more business for the taxpayer. During AY 2008-09, the taxpayer had a similar arrangement of providing similar services to a third party in the US – Fidelity Information Services Inc. US (“Fidelity US”) – the taxpayer therefore used the Transactional Net Margin Method (“TNMM”) and applied the operating profit results (-21.75%) from its transaction with Fidelity US to support the fact that it earned a higher return or in other words, lower loss (-3.82%) in its transaction with its AE. On this basis, the taxpayer demonstrated that its transaction of provision of ITES to its AE was arm’s length. During the TP assessment proceedings, the Transfer Pricing Officer (“TPO”) while not disputing the TNMM, however questioned the reliability of using of such an internal comparable transaction on the basis that although Fidelity US was a third party during AY 2008-09, it was a related party of the taxpayer in the earlier years – on this basis, the TPO and subsequently the Dispute Resolution Panel doubted the reliability of such an internal comparable. The internal comparability approach was therefore rejected by the TPO and instead a set of external comparable companies were identified by the TPO to determine the ALP. The taxpayer also submitted to the TPO that its group was making a loss overall and therefore there could not be any adjustment made by the Revenue to the transfer price of the taxpayer.

The ITAT’s Verdict

Application of internal TNMM

The ITAT raised a concern that the third party service recipient – Fidelity US was earlier a related party and therefore can the transaction results during the year be considered to be reflective of arm’s length results? – The ITAT raised concerns that the taxpayer and Fidelity US were AEs in the past and in spite of the change in the relationship, the taxpayer continued to perform services for the independent enterprise at a loss during the year – this cast a doubt on whether the relationship between the enterprises could still be considered to be independent and whether this single uncontrolled transaction could be relied upon as a comparable. The taxpayer presented a set of documents before the ITAT to support the fact that the terms were re-negotiated with Fidelity US subsequent to the termination of its relationship as AE and therefore could be considered to be reflective of the arm’s length standard. The ITAT however did not consider necessary to go through these documents;

The ITAT while agreeing to the use of TNMM however raised the question of reliability of the data i.e. whether results of one comparable transaction/arrangement under the internal TNMM can be said to be more reliable than a set of comparables under the external TNMM? – the ITAT agreed with the taxpayer that the taxpayer was permitted under law to use internal comparability approach. At the same time, it added that the use of such an approach is case- specific and is factually dependent on the reliability of the internal comparable transaction. While rendering the said verdict, the ITAT stressed that “the availability, coverage and reliability of data necessary for application of the method” are the key factors for what will constitute the most appropriate method.

Other aspects dealt with by the ITAT:

Computation of the transfer pricing adjustment – restricted to the revenue derived by the AE considering the services received from the taxpayer

The ITAT rejected the Assessee’s general contention that the TP adjustment should be restricted to the overall profits of the Group as a whole. The ITAT held that if the principle that the TP adjustment in India should be restricted to global profits of the Assessee’s Group is upheld, it will result in interaction of too many tax jurisdictions involving irreconcilable tax laws.

The ITAT relying on the Delhi ITAT decision in the case of Global Vantedge[3] (on which the Revenue’s Special Leave petition was dismissed by the Delhi High Court) has laid out the following principles to evaluate whether the TP adjustment could or could not exceed the Group’s revenues:

Functional profile of the AE needs to be validated to assess the basis of revenue allocation between the taxpayer and the AE;

From the revenues earned by the AE arising from the services rendered by the taxpayer, an appropriate deduction needs to be made for average selling expenses based on the industry trend;

If the balance revenue of the AE is less than the service revenue earned by the taxpayer from its AE or within 5% of the latter, the TP of the taxpayer could be considered to be at arm’s length.

On this basis, the ITAT remitted the matter back to the TPO for de-novo adjudication on the taxpayer’s contention. The ITAT did not comment on the arm’s length return that should accrue to the AE. The approach recommended by the ITAT can generally be said to apply in a situation where both entities are involved in simple and binary functions.

The following table illustrates the methodology set out by the ITAT as a guidance:

Particulars	Actual	Arm’s length computation
Particulars	Amount (Rs)	Scenario I - Amount (Rs)	Scenario II - Amount (Rs)
Group revenue earned from sale of services received from taxpayer (earned by overseas AE)	300	300	300
Less: actual expenses of the AE for marketing/business development	90
Less: average selling expenses based on industry trend prevailing in the jurisdiction of the Group entity		60	72
Balance revenue	210	240	228
Less: cost of services received from taxpayer	240	240	240
Operating profit/(loss)	(30)	0	(12)
Result		No TP adjustment warranted to taxpayer

Adjustment towards capacity under utilization

The ITAT rejected the taxpayer’s claim for capacity underutilization adjustment on account of high employee costs in the absence of any factual submission and quantification in support of this argument.

Analysis and key principles

Transfer Pricing analysis is factual and therefore the importance of selection of tested party and use of comparables data is of paramount importance.

The approach of the ITAT to direct the Assessing Officer to look at the entire value chain of the arrangement is in line with international TP principles. After a plethora of rulings (e4e [4] and Agila[5]) which upheld the use of internal TNMM over external TNMM, this ruling has further emphasised on the need for reliability of data for application of a method.

The ITAT has observed that in an indirect method like TNMM, a reasonable number of comparables and their reliability is an important factor to ensure that the results are truly representative of the segment to which the tested party belongs. At the same time, the ITAT did not completely write off the internal TNMM approach as long as the comparables’ data is reliable.

In summary, taxpayers need to review their comparability analysis and approach to documentation especially where internal comparables exist – legal arguments are themselves not enough and will need to be supplemented by factual analysis.

(With inputs from Ganesh Krishnamurthy, Director, BMR & Associates LLP and Hussain Sunel, Assistant Manager, BMR & Associates LLP)

[1] [TS-37-ITAT-2016(Ahd)-TP]

[2] http://oecdinsights.org/2013/02/13/beps-why-youre-taxed-more-than-a-multinational/

[3] [TS-12-ITAT-2009(DEL)]

[4] [TS-542-ITAT-2015(Bang)-TP]

[5] [TS-500-ITAT-2015(Bang)-TP]

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Tax-avoidance motive must for invoking TP-provisions - An analysis

superadmin — Wed, 16 Mar 2016 09:33:37 +0000

Tax-avoidance motive must for invoking TP-provisions - An analysis superadmin Wed, 16/03/2016 - 15:03

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The issue of parking profits in tax holiday units by assessees by undertaking transactions with related parties and the applicability of transfer pricing provisions to such transactions has been a long standing debate which has seen appellate authorities taking different stands on the point.

In the recent case of Tata Consultancy Services Limited [TS-521-ITAT-2015(Mum)-TP], the Mumbai Income Tax Appellate Tribunal ( ITAT ) has adjudicated specifically that transfer pricing adjustment cannot be made in case where the assessee avails the benefit of section 10A or 80HH. In a concurrent yet separate development, the High Court of Bombay has also admitted an appeal by Capgemini India Private Limited [TS-587-HC-2015(BOM)-TP] on applicability of Chapter X to international transactions entered into by assessees not having a tax avoidance motive owing to availing of benefits under section 10A.

The purpose of this article is to discuss the whether the legislative intent under section 10A and Chapter X permits the assessees in tax holiday units to carry on business without adhering to the provisions of transfer pricing, ie determination of income having regard to the Arm's Length Price ( ALP ).

The moot question here is whether the provisions of Chapter X would apply to income thatis exempt from taxation under Chapter III of the Act.

The introduction of transfer pricing provisions in 2001 was with an intention to provide a statutory framework which can lead to computation of reasonable, fair and equitable profits and consequent tax in India, in the case of multinational enterprises having transactions with one or more enterprise of the same group.Section 92 states that any income arising from an international transaction shall be computed having regard to the arm s length price. From the plain reading of the section, it appears that thesection seeks to determine the ALP of income from an international transaction regardless of the chargeability of the same to tax.

The Bombay High Court in the share issue case of Vodafone has upheld that the provisions of Chapter X is not applicable in case of issue of share where there is no occasion to allocate, apportion or contribute any cost and/or expenses. The High Court held that income must be chargeable under normal provision of the Act before provisions of Chapter X could be invoked to test whether the transaction has been undertaken at ALP. The decision of the High Court was also accepted by the Government of India thus bringing a great relief to the investors in India.

Accordingly, while one can take a reasonable view that transfer pricing provision will not apply when there is no income based on the decision of the Bombay High Court and its subsequent acceptance by the Government, the question on whether the provisions of Chapter X would apply to income which is not taxable in India either by virtue of exemption or deduction under Chapter III or not liable to tax under the provision of the DTAA still remains.

To address the same, the pertinent question to answer is what would be the consequence if there is an enhancement of an income that is exempt owing to a transfer pricing adjustment.

The Act apparently seeks to draw a distinction between income that is exempted ie not liable to tax by virtue of section 10 or provisions of DTAA and income from which a deduction is allowed. The same is evident from section 92C where, while equipping the Assessing Officer to determine the appropriateness of the transfer price under section 92C (3), it is specifically provided as proviso to section 92C (4) that no deduction under section 10A or section 10AA or section 10B or under Chapter VI-A shall be allowed in respect of the amount of income by which the total income of the assessee is enhanced by way of an adjustment to the transfer price by the Assessing Officer.

This evidently indicates that while providing for deductions from income, the law still envisaged a situation where the companies not having atax avoidance intent still transact at a lower price and thus not be at arm s length. A company claiming 100 percent deduction would not ordinarily have a tax avoidance intent since the entire profits are allowed as deduction. The memorandum to finance bill 2006 also stresses upon this where the application of proviso to section 92C (4) was extended to section 10AA as well which was introduced in 2006.

Accordingly, while certain appellate authorities have been holding that on harmonious reading of provisions of Chapter X and Section 10A, 10AA or 10B, assessees availing tax deduction need not be subject to transfer pricing analysis, the intent and the letter of law wherein the benefit of section 10A, 10AA, 10B and Chapter VI-A is specifically denied on the enhancement to the transfer price to meet the ALP indicate otherwise. Hence notwithstanding the decisions upholding non?applicability of provisions of chapter X to assesseesavailing deductions under section 10A or the likes, the same would still be considered as a risky position to adopt.The jurists have comprehended the larger intent and spirit of transfer pricing but have not been able to reconcile this with the actual provisions of the act. The key to this may be is to distinguish between exempt income not liable to tax and income from which deductions are allowed. Certainty on the same might be obtained once the Bombay High Court decides on the same in the case of Capgemini India Private Limited.

The next question that would thenariseis whether the transfer pricing provisions would apply to income exempt under Section 10or not liable to tax under the provisions of DTAA since the proviso to section 92C (4) specifically denies the benefit of deduction only to income enhanced by way of transfer pricing adjustment and is sought be claimed as deduction under section 10A or section 10AA or section 10B or under Chapter VI-A.

For example, there could be a situation where a foreign enterprise is deriving income from an Indian company engaged in the business of operation of aircraftbased on the approval from Central Government. The same is exempt income under section 10(6BB). Assuming that the foreign enterprise and the Indian company are associated enterprises, would that mean that the provisions of Chapter X would not apply to the income earned by foreign enterprise?If the same would apply, would the benefit of Section 10(6BB) be available to any enhancement in income to adhere to the principles ALP.

As discussed earlier,in case of an enhancement by way of transfer pricing adjustment, the transfer pricing provisions deny the benefit of deduction on enhanced income only under section 10A or section 10AA or section 10B or under Chapter VI-A and not under any other sections or chapter. Accordingly, even if an enhancement is proposed on an income exempt under section 10, the enhanced income would still continue to be exempt under section 10.Hence, seeking to apply the operating provisions of transfer pricing (ie determination of ALP) to exempt income would appear to be a meaningless exercise.

While the rationale would be to conclude that exempt income as illustrated in terms of 10(6BB) above, would not be covered by chapter X, the same would still not be a litigation free position considering the varied interpretation of law, especially in the context of compliance, ie documentation and certification.

All said and done, the litigation around the interplay of transfer pricing and exemptions continues unabated, as the judiciary wrestles with the spirit and the letter of the law.

With inputs from Ruby Thomas (Assistant Manager, BMR & Associates LLP

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CBDT’s revised guidance on TP-audits procedure – A new anvil for the tax-administrator?

superadmin — Wed, 21 Oct 2015 13:06:22 +0000

CBDT’s revised guidance on TP-audits procedure – A new anvil for the tax-administrator? superadmin Wed, 21/10/2015 - 18:36

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As a series of measures to curtail transfer pricing (TP) litigation, the CBDT last week rolled out updated guidance for the Assessing officers (AOs) and the Transfer pricing officers (TPOs) regarding assessment of transfer pricing cases. This guidance is contained in Instruction No. 15/2015 dated October 16, 2015 which replacedthe last guidance issued in this regard in May 20, 2003 (Instruction No. 3/2003). The subject instruction focusses on procedure for reference made by AO to TPO and outlines the respective roles of the AO and TPO with reference to international transactions.

The jurisdiction of the AO and the TPO had been challenged by the tax payer in some recent cases, and adjudicated by the Honourable Delhi High Court. The CBDT seems to have taken on board the decision of the High Court on issues involving jurisdiction and taken a progressive step of issuing appropriate guidance.

Key change in procedure regarding reference made by AO to TPO

Section 92CA of the Income Tax Act, 1961 (Act) provide that where the AO considers it necessary or expedient to do so, he may refer the computation of ALP in relation to an international transaction to the TPO. Hitherto, a simplistic approach based on the aggregate quantum of international transactions – initially INR 5 crores and subsequently increased to INR 15 crores was adopted for selection of cases by the AOs for making a reference to TPOs. The quantum based threshold was dropped in September 2014, and a switch to selection of cases based on risk based parameters was made last year, in line with international best practices.

A further change is sought to be implemented in the reference process by placing onus on the AO to record his satisfaction that ‘there is an income or a potential of income’ before making a reference. It has been stated categorically that in the following situations, reference to the TPO is mandatory and a matter of ‘jurisdictional requirement’:

1) where the taxpayer has not filed the accountant’s report ie Form 3CEB under section 92E of the Act but international transactions undertaken by it come to the notice of the AO;

2) where the taxpayer has not declared one or more international transaction in the Form 3CEB and the said transaction come to the notice of the AO;

3) where the taxpayer has declared the international transaction or transactions in the accountant’s report but has made certain qualifying remarks to the effect that the said transaction or transactions are not international transactions or do not impact the income of the taxpayer.

In all the above situations, the guidance stipulates that the AO must also provide an opportunity of being heard to the taxpayer, and specifically deal with the objections of the tax payer before recording his satisfaction or otherwise. This revised process stands out as an interesting nuance as there is no specific provision in the law obligating the AO to provide an opportunity to the taxpayer and deal with the assessee’s objections, before making a reference of the case to the TPO for determination of the ALP.

Preliminary/Upfront determination of applicability of transfer pricing provisions

Clause 3.3 of the instruction elucidates the rationale considered by the CBDT in framing the above guidance. It is heartening to note the progressive acknowledgment from the department that before applying TP provisions, an exercise of first finding whether any income arises or is affected by the determination of the ALP of the international transaction is necessary. However the inclusion of the words whether any income arises or potentially arises or is affected, casts some aspersions on the meaningfulness of the upfront assessment that will be made by the AO. The AO’s are not obligated to conduct detailed enquiries at this stage and essentially have to form their opinion basis the Form 3CEB.

Given that the instruction is applicable with immediate effect, taxpayers selected for scrutiny could now expect a new letter from their AO’s seeking reasons why certain transactions have either not been reported or where reported, disclosure has been qualified to the effect that the same are not international transactions within the purview of section 92(1) of the Act. This kind of a notice could be expected by several companies as almost all taxpayers report transactions like cost reimbursements, cost allocations, cost recoveries, outstanding payables and receivables to related parties on a conservative basis ie with a qualifying remark.

Such notices would entail detailed counterarguments from the taxpayer on non-applicability of Chapter X of the Act basis a combined analysis of law and facts. Whilst the instruction obligates the AO to specifically deal with the objections raised by the assessee, it appears that the AO need not issue any order/communication to the assesseeand is only required to internally record his satisfaction regarding potential impact on income and seek approval from his superiors (ie the Principal Commissioner or Commissioner as applicable). The taxpayer should be entitled to receive a copy of such reasons recorded in writing by the AO, in line with principles of natural justice.

In case the taxpayer’s position on non-applicability of Chapter X of the Act is summarily dismissed, this new guidance may just be an eye-wash and not mitigate unavoidable TP ligation as desired. Take the case of a transfer of shares of an Indian company between its non-resident associated enterprises, which is not required to be reported where capital gains from the transfer of shares are not chargeable to tax in India, under the provisions of the double taxation avoidance agreement between India and the country of residence of the foreign transferor. It is more likely than not that the AO will disagree with the claim for tax exemption under the treaty and proceed to refer the matter to the TPO for determination of ALP. The entire focus and effort of the TPO and the tax payer on determination of ALP for the said transfer of shares would be futile and redundant, where the treaty benefit is finally granted to the tax payer by an appellate authority.

It would be laudable if the legal framework could be modified to enable the taxpayer to appeal against the AO’s incorrect reference to the TPO where chargeability of income from the alleged international transaction is disputed. Introduction of such enabling provisions would significantly prevent escalation of TP disputes.

Another concern stems from the provisions of section 92CA(2A) and 92CA(2B) of the Act, wherein the TPO is empowered to determine ALP of any international transactions even though not referred to him. This suggests a clear contradiction and overall casts a doubt on the extensive emphasis being placed on the reference procedure that should be adopted by an AO, where the same can be legally overridden by the TPO.

Reference for international transactions where applicability of TP is not questionable

This instruction also does not provide necessary direction on reference procedure with respect to regular international transactions such as purchase/sale of goods, provision of services etc, where applicability of Chapter X is not the moot point. The risk parameters that the AO’s should consider in selecting such transactions for scrutiny have not been spelt out - perhaps these maybe a part of internal protocol. It would be appropriate if the risk parameters are clearly defined and notified for everybody’s benefit.

Also useful to highlight in this context the provisions of Instruction no. 8 of 2015 dated August 31, 2015 which stipulates compulsory manual selection of cases for scrutiny, where TP addition in an earlier assessment year is in excess of Rs 10 crores, on a substantial and recurring question of law or fact which is either confirmed in appeal or is pending before an appellate authority.

In our practical experience, cases are routinely referred by AOs to TPOs even though the TP addition in prior year is less than Rs 10 crores, without adequate analysis of risk factors. The clear test of success for this guidance would be to achieve an overall decline in the number of cases selected for TP audit, and thereby an overall relief for the taxpayers from undergoing annual TP audits and litigation.

Role of AO and TPO are distinct

When reference is made by AO to TPO, the TPO’s role is restricted to determination of the ALP of the international transactions. The TPO is obligated to pass a speaking order containing detailed rationale for choice of most appropriate method and sources of data used for determination of ALP. However, the instruction does not practically address the subjective manner in which the TP documentation and ALP determination by the assessee is commonly rejected by the TPOs.

Once the determination of ALP is done by the TPO under section 92CA (3) of the Act, the AO has to compute the total income of the assesseeunder section 92CA (4) of the Act in conformity with the ALP so determined by the TPO.

The CBDT’s diktat that a TPO at the level of Additional/Joint CIT should not be assigned more than 50 important and complex cases and the mandate to follow an internal approval process also reflects an underlying intent of following an exception based approach and reducing litigation.

Guidance for specified domestic transactions (SDT)

Similar guidance in respect of TP provisions pertaining to SDT are under consideration of the CBDT.Pending issuance of such guidance, AO’s have been restrained from referring cases involving SDT to TPOs. An exception has been carved out where a case is selected for scrutiny on non TP parameters and AO observes that the taxpayer has undertaken SDT but the same are not reported in an accountant’s report. In such case, the AO may refer the case to the TPO after giving an opportunity of being heard to the taxpayer.

Overall, the guidance reiterates the need for adequate analysis and deliberate action on the part of AOs and TPOs in implementing TP provisions and determination of ALP. Appropriate clarification on the jurisdiction of the AO and the TPO is most notable and if implemented in the right spirit, can make a positive contribution in reducing TP litigation. The authors are optimistic about more constructive advice from the CBDT on choice of most appropriate method and acceptable approaches with respect to some of the typical international transactions undergoing unending rounds of litigation.

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