Transfer Pricing:

1

• Transfer Pricing
• Comparing the Indian Approach with the OECD
  Transfer Pricing Guidelines

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Panel

• Chairman
• Gautam Doshi, Joint Managing Director, Reliance
  Anil Dhirubhai Ambani Group.
• Speakers
• Shyamal Mukherjee, PricewaterhouseCoopers India
• Rupak Saha, GE India
• Caroline Silberztein, OECD

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Agenda

• Implementation of the arms length principle in
  India selected issues
• Comparability and TP documentation
• Lack of guidance for certain transactions
• Dispute resolution and dispute prevention
• Transfer pricing and customs valuation of related
  party transactions
• Conclusion what does the future hold?

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• Implementation of the arms length principle in
  India selected issues

5
Access to comparables information

• Indian Rules permit use of public data- supported
  by authentic documents, illustrative list of
  documents suggest comparable data to be
  maintained by the taxpayer must be published data
  and available in public domain Rule 10D(3)
• OECD guidance on documentation taxpayer to
  determine transfer pricing based upon information
  reasonably available at the time of determination
  Para 5.3 OECD Guidelines (TPG)

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Access to comparables information

• Documentation considered to be adequate based on
  the extent to which that information reasonably
  could have been available to the taxpayer at the
  time transfer pricing can be established Para
  5.9 OECD TPG
• - Tax administrations further should not require
  taxpayers to produce documents not in the actual
  possession or control of the taxpayer or
  otherwise reasonably available, e.g. information
  that cannot be legally obtained, or that is not
  actually available to the taxpayer because it is
  confidential to the taxpayers competitor or
  because it is unpublished and cannot be obtained
  by normal enquiry or market data para 5.10 of
  OECD TPG

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Access to comparables information OECD
perspective

• Sources of information commercial database
  taxpayers knowledge of competitors or
  comparables industry analyses etc.
• How detailed / transactional are public data?
• Non-domestic comparables
• Increased focus on functional comparability for
  integrated industries

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Access to comparables information
Confidentiality

• Secret comparables
• Information relating to comparables used by
  authorities needs to be shared with the taxpayer-
  settled position in India
• Secrecy of information of strategic importance
  sharing competitors strategic pricing policy may
  harm business interest
• Economic analysis in absence of complete details
  of comparable transactions, not robust- may not
  lead to right arms length result
• Data not available in public domain should not be
  used during audit proceedings

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Data for Comparability Analysis timing issues

• Contemporaneous documentation required Rule
  10D(4)
• Preference for current year data for
  comparability analysis Rule 10B(4)
• Use of past 2 years data permitted only in
  certain circumstances
• Multiple year analysis more robust - allowed
  globally
• Paras 1.49, 1.50 and 3.44 of the OECD TPG

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Data for Comparability Analysis

• Fresh search for updated data at the time of
  audit - such data not available with the taxpayer
  while setting arms length prices (Paras 5.3 and
  5.9 of the OECD TPG)
• Data available with taxpayer at the time of
  documentation should be acceptable and used in
  audits

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Timing issues OECD perspective
Different country approaches the arms length
price setting and the arms length outcome
testing approaches
Year Y-1
Year Y
Year Y1
Year Y2
Transaction
Agreement / negotiating the terms of transaction
Filing of tax return
Audit
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Timing issues OECD perspective

• OECD TPG paragraph 1.51
• Data from years following the year of the
  transaction may also be relevant to the analysis
  of transfer prices, but care must be taken by tax
  administrations to avoid the use of hindsight.
  For example, data from later years may be useful
  in comparing product life cycles of controlled
  and uncontrolled transactions . Subsequent
  conduct by the parties will also be relevant in
  ascertaining the actual terms and conditions that
  operate between the parties.

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Data for Comparability Analysis multiple year
data

• Average data analysis more robust
• Better comparability analysis
• Evens out product/ business life cycles, short
  term economic conditions etc.
• Indian Regulations should unconditionally permit
  use of past years data

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Comparability Adjustments

• Both Indian regulations and OECD require
  comparability analysis to be based on FAR.
  Adjustments to be made for material differences.
• OECD TPG Para 1.23 in the open market, the
  assumption of increased risk will also be
  compensated by an increase in the expected
  return
• Guidance for application/acceptance of
  adjustments in case of differences in market,
  entrepreneurial risks, viz.
• - Overall adjustment using various models
  like CAPM etc.
• - Use of IQR remove outliers
  representing risk takers
• - Use of longer term average margins of
  comparables

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Comparability Adjustments

• Indian TP authorities have expected limited risk
  captives to earn margins comparable to
  entrepreneurs disregard of the risk and asset
  profile of the taxpayer vis-à-vis comparables
• Indian authorities have in most cases accepted
  adjustment made to comparables primarily for
  working capital differences
• More guidance for application/ acceptance of
  other adjustments
• Excess capacity adjustments - Credit risk
  adjustments
• Adjustment for non-comparable functions, pass
  through costs etc.
• Adjustment for RD activities - Other
  adjustments

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Acceptability of Business Strategies and Economic
Principles

• OECD recommends consideration of business
  strategies for determining comparability TPG
  para 1.31 to para 1.35
• Acceptability of business strategies adopted by
  taxpayer
• Start-up companies - Market penetration
  strategies initial/interim losses as part of
  bigger strategy
• Intentional set-offs - Use of budgets and
  forecasts
• Other business and commercial practices
• Acceptability of economic techniques and methods
• Business realities and commercial considerations
  should be recognized and accepted documentation
  guidelines

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Acceptability of Business Strategies and Economic
Principles - Losses

• Indian TP authorities may not appreciate business
  dynamics and strategies while conducting audits
  profit position of the taxpayer is the prime
  focus
• General resistance to losses earned by taxpayers
  as well as loss comparables
• Cherry picking of profitable companies for
  comparison purposes
• Losses justified, if part of business strategy
  para 1.52 and 1.54 of the OECD TPG

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Losses OECD perspective

• No reason to systematically exclude loss-making
  comparables. No cherry picking.
• But re-examine whether the selection of
  comparables was well done. What are the reasons
  for the comparable to be loss-making ? Is it
  because of a different risk profile (e.g. if
  tested party is risk-less and loss making
  comparable is full-risk).
• In addition, many countries reject long-term loss
  making distributors.

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Transactional/ segment-level analysis

• OECD TPG permit aggregated analysis if
  transactions are closely interlinked paras 1.42
  to 1.44
• Indian TP authorities preference for
  transactional or product-wise analysis over
  overall, aggregated company-level analysis
  disregarding
• principles of aggregation and materiality of
  transactions
• taxpayer may adopt basket of products approach
  to manage business dynamics and achieve
  sustainability on a consistent basis, organize
  their business into various baskets or product
  portfolios
• Typically have sought product-wise
  profitability. Guidance needed.

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Transactional / aggregated analysis OECD
perspective

• Need balance between theoretical soundness and
  workability transactional focus of all methods,
  but recognise that third party data often not
  transactional
• Difference between
• Taxpayer data segmentation possible according to
  coherent parts, e.g. product or business line
• Third party comparables company-wide data
  acceptable if most reliable data available and
  reasonably homogeneous
• gt Segmented taxpayer data often compared to
  several sets of company-wide third party data

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Intentional set-off

• Intentional set-offs are consistent with the
  arms length principle para 1.60 and 1.62 of the
  OECD TPG
• Such approach reflects commercial realities of a
  business/transactions
• No specific guidance on intentional set-off in
  the Indian TP regulations
• Guidance (including documentation) needs to be
  included, drawing support from the OECD TPG

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Arms Length Range

• Indian regulations permit limited 5 variation
  from Arms Length Price (ALP) proviso to Section
  92C(2)
• ALP computed as mean of comparable prices
• OECD Guidelines permit use of complete arms
  length range- entire range of outcomes obtained
  by application of most appropriate method all
  such results are considered relatively equally
  reliable para 1.45 of the OECD TPG
• Recent Indian Tribunal Ruling step in the right
  direction

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Arms Length Range

• Many countries allow use of Inter Quartile Range
  (IQR)
• Limited flexibility in view of the mean and 5
  tolerance band- leads to mathematical approach
  and cherry picking of comparables
• Indian rules should recognize the concept of
  range/ IQR and replace mean with median

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Lack of guidance for certain transactions

• Lack of guidance in the Indian TP regulations on
  transactions like
• Transfer of intangibles
• Cost contribution agreements
• Other complex transactions
• OECD TPG Chapters VI VIII
• Guidance/ Rules required in Indian Regulations

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Dispute resolution elimination of double
taxationDispute prevention APAs
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Secondary adjustments

• Refund of withholding tax not allowed in case of
  expense adjustments to paying Indian entities
  second proviso to Section 92C(4)
• Results in double taxation of group profits
  against basic principles of taxation
• Corresponding adjustment should be permitted

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MAPs and Arbitration OECD perspective

• Next panel Resolution of Tax Treaty Disputes
• Transfer pricing disputes are among the most
  costly and complex international tax disputes
• Essential to have efficient mechanisms to
  eliminate double taxation

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Advance Pricing Arrangements

• Arms Length an abstract concept
• APAs allowed globally
• Need for comprehensive procedure to obtain APA
• Adequate mechanism for negotiating bilateral and
  multilateral APAs required
• Need to introduce APA mechanism in domestic tax
  law

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APAs the OECD perspective

• APAs involve a lengthy and resource intensive
  process (especially for bilateral ones),but one
  which is remarkably short compared with TP
  examinations litigation mutual agreement
  procedure to resolve double taxation
• They cannot be a wide scale solution and in
  particular they cannot be a substitute for the
  legal certainty provided by clear regulations.
• But APAs can be part of a more constructive
  dialogue between taxpayers and tax authorities
  and be instrumental in limiting double taxation
  issues.

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APAs the OECD perspective

• Voluntary process
• Non controversial (each party can withdraw at any
  time)
• In advance of the transactions gt not an archive
  digging
• Only transfer pricing, agreed scope of selected
  transactions gt more focused than examinations in
  general
• If bilateral or multilateral eliminate risk
• of double taxation
• Can provide certainty for up to 5 years
• (renewable)

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APAs the OECD perspective

• APA programmes can be adapted to the economic
  realities of the country
• Mexico extensive APA programme developed mostly
  for the maquiladora industry (unilateral and
  bilateral APAs)
• China introduced the APA concept in its transfer
  pricing regulations in 1998. In 1998-2007
  approx. 160 unilateral APAs completed in China.
  In 2005 first bilateral APA between China and
  Japan 2007 first bilateral APA between China
  and the United States and first bilateral APA
  between China and Korea.
• Russia has indicated willingness to implement
  APAs in 2010

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Transfer pricing and customs valuation of related
party transactions
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Approach To Valuation Under Customs and Income
Tax Laws
Jurisdiction Exporting Country Exporting Country Importing Country Importing Country
Authority Customs Department Tax Department Customs Department Tax Department
Primary Objective Prevent money laundering Maximize taxable income Maximize import duty Maximize taxable income
Achieving the Objective Determine correct export value Maximize export value Maximize import value Minimize import value
Customs Department
Higher price for higher customs duty
Assessee
Lower price for higher taxable income
Income Tax Department
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Global Convergence Initiatives

• Many countries have initiated processes to
  increase interaction between the Customs and
  Transfer Pricing authorities
• Various governments have issued guidelines to
  resolve the Customs / TP conflicts
• Review of TP Studies, Advance Pricing
  Arrangements and other TP documentation for
  determining customs value
• WCO/OECD Conference on TP and Customs Valuation
  in Brussels
• Indian Governments initiative - Customs
  Circular No. 20/2007 dt. 8th May, 07

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Indian Initiative /

• Implementation of the recommendations of the
  Joint Working Group, on transfer pricing,
  comprising officers from Income-tax and Customs
• Two Tier co-operation through recommended
  Bi-monthly and Six-monthly joint meetings
• Exchange of information on specific-cases
• Sharing of Related Party information on a Need
  to Know basis
• Training programs for officers of both
  Departments

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Indian Initiative (contd)

• Questionnaire issued by Chief Commissioner of
  Customs to various institutions to gather
  information on several issues surrounding
  valuation
• Aim to increase the co-ordination and exchange of
  information between the Customs and Income Tax
  Authorities on Transfer Pricing matters
• Transfer Pricing Officers (TPOs) have started
  focusing on Customs Valuation to evaluate the
  appropriateness of transfer prices

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Customs and TP Common Objective, Differing
ApproachContd.
Key Aspects Transfer Pricing Customs
Methods Specified Comparable Uncontrolled Price (CUP) Using exact comparables Using inexact comparables (with appropriate adjustments) Transaction Value of Identical goods Similar goods
Resale Price Deductive Value
Cost plus method Computed Value
Profit split / TNMM Residual method
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Customs and TP Common Objective, Differing
ApproachesContd.
Key Aspects Transfer Pricing Customs
Choice of valuation methodology Arms-length Price Based on the choice of the Most Appropriate Method. No Priority to any Methods. Based on the concept of Arithmetic mean. Transaction Value (TV) based on the specified methods Upon rejection of the assessee determined TV, the hierarchy of the valuation methods followed to re-determine the price.
Deviation from ALP Deviation of / - 5 Range from the ALP is permissible No such range specified
Documentation requirements Enterprise and Transaction wise Contemporaneous Documentation to be maintained by the company. Specified in Rule 10D. No requirements specified by the legislation.
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Customs and TP Common Objective, Differing
Approaches
Key Aspects Transfer Pricing Customs
Adjustments to the book value of imports No legislated adjustments specified. Reasonable adjustments may be made by the Assessee or the TPO, to eliminate material effect Mandatory adjustments provided under Rule 9 of Customs Valuation Rules (CVR). For eg Commission and brokerage, container costs, packing costs, assists, royalties and license fees, etc.
Time period for which data used TP allows for usage of data upto 2 years prior to the relevant financial year 3-6 months
Timing of audit and Validity of the order The TP audit concluded within a period of 31 months from the end of the relevant assessment year TP order valid for the year for which the audit takes place The Customs audit is conducted on need basis (limitation period 6 months - 5 years) SVB order is valid for three years if no change in the facts (relationship / product, etc.)
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Issues and Challenges

• Divergence of definitions and other requirements
  specified in the Income Tax Act and the CVR
• Effective ground level administrative
  coordination between tax and customs authorities
  to achieve the same price for Transfer Pricing
  and Customs
• Applicability of prices established under customs
  valuation methods for income tax purposes (and
  vice versa)
• Reconciliation of Aggregate Profit Level
  adjustments in Transfer Pricing to the
  Individual Transaction Level used in Customs
• Mechanism for refund of customs duty due to
  subsequent TP Adjustments

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Conclusionwhat does the future hold?
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Arms Length Standard As The International
Consensus In Theory

• Follows separate entity approach that
  approximates economic realities and market forces
• Relies on comparables analysis for verification
• Substantial shared international experience
  minimizes double taxation

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But Is Arms Length simplistic in a complex
business environment ?
(1) Difficulties to a separate entity approach
Outsourcing and integrated functions/ matrixed
organizations/ isolation of functions and
riskschanging business models (2) In practice,
do true comparables exist for various common
transactions? Bundled transactions/ Specialized
captive services/ embedded intangibles and unique
value drivers (3) Recent International Experience
Few examples of aggressive assertions of source
based taxation (permanent establishment, location
savings, local marketing intangibles) seek to
re-allocate residual profits
More prescriptive guidance on adjustments by
revenue authorities a must
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Concerns on Arms length Standard ..
-- Uncertainty and disputes on subjective
matters of comparable analysis on a steep rise --
Instances of formulatory apportionment in recent
judicial precedents -- Consideration of Common
Consolidated Corporate Tax Base (CCCTB) in the
EU -- Continued urge for reform for certainty and
administrative ease of compliance
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Other Alternatives ?

• Arms length methodologies could be re-evaluated
• -- Transactional Net Margin Method to be
  elevated from the method of last resort
• -- Profit split approach ideal for integrated
  transactionsbut greater guidance required for
  its application
• Global formulary apportionment unrealistic
  requires international agreement of formulae for
  each transaction to be successful
• -- De Minimis rules and Safe Harbors potential
  tools to contain disputes, and add certainty to
  taxpayers

Need for reforms to increase certainty to
taxpayers while staying within the Arms Length
framework
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The future of TP the OECD perspective

• Today the arms length principle is confronted
  with difficult challenges, among which
• Scarcity of comparables in integrated industries
  (few comparable independents)
• MNEs implement transactions and business models
  that are hardly found between independents (e.g.
  global business models)
• Need more consistency in implementation of the
  arms length principle by countries

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The future of TP the OECD perspective

• In theory, 2 possible responses
• Replace the arms length principle with a
  different system which would provide
  theoretically sound allocation of tax bases, as
  large an international consensus, and be more
  practical but what are the viable options?
• Improve the arms length principle gt the OECDs
  choice so far

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The future of TP the OECD perspective

• Review and update the 1995 TP Guidelines
• Promote risk assessment techniques and better use
  of taxpayers and tax administrations resources
• Provide more certainty clearer guidance, more
  guidance, more efficient dispute prevention and
  dispute resolution mechanisms
• Improve consistency of application across
  countries

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Thank You !