Practical Issues in Transfer Pricing Assessments

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Practical Issues in Transfer Pricing Assessments
Narayan Mehta Sudit K Parekh Co
19th November, 2005 Pune Branch of WIRC (ICAI)
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Contents

• Global Indian Trends
• TP Assessments The process administrative
  structure
• Revenue approach perspective- specific industry
  overview
• Selection of most appropriate method in practice
• Critical issues encountered
• Way ahead

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• Global
• Indian Trends

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Global trends

• Any related party transaction undertaken from 1st
  April 2001 onwards covered
• Currently 60 of worlds cross-border trade is
  between
• related parties Indian tax authorities
• have taken the cue!
• UK every 1 spent on TP investigation has
  fetched
• 120 to UK Inland Revenue
• Japan transfer pricing has been a major revenue
  churner-
• individual cases exceeds 100 m!

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Enhanced audit exposure

• Percentage of completed scrutiny assessments
  resulting in an adjustment
• (E Y Survey)

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EY Transfer Pricing Survey 2003-
Key findings

• 86 of parent and 93 of subsidiary respondents
  identified TP as most important international tax
  issue
• 1/3 rd of audits concluded in TP adjustments

• Penalty actually imposed in 50 of cases in which
  penalty threatened by TP authorities
• 40 of TP adjustments have resulted in double
  taxation

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Indian TP results- FY 01-02

• India - FY 01-02 assessments complete -
  Incremental tax revenues collections in excess of
  INR 600 Cr

• Around 25 to 30 of the case show adjustments!

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Composition of references received in
Mumbai- AY 2002-03
Source Mr Srinivasulus presentation on 26th
June 2004 IFA presentation
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Analysis of references received
Source Mr Srinivasulus presentation on 26th
June 2004 IFA presentation
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• T P Assessment
• The process administrative structure

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Transfer pricing audit selection process

• Cases with international transactions gt 5 Cr-
  subject to compulsory TP audits
• Notices missed out in many cases despite this
• Certain cases with lower threshold has been
  examined by AO

• Late references received in many cases
• Huge workload for TPOs
• Hopefully selection of cases based on case
  selection tools and focused examination in future!

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TP asst process- at macro level
AO(Assessing officer) to refer to TPO (Transfer
pricing officer) if value of International
transactiongt INR 50 million
TPO to send notice to the tax payer for the
hearing
Documentation analysis TP audit by the TPO
Copy of the order sent to the AO and the taxpayer
AO to incorporate the TPOs order in the
assessment order
Time frame internationally to frame TP asst- 2 to
5 yrs! In India- only 1 yr!
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TP asst process- at operational level
TPO will review tax payers documentation
TPO will make further enquiries
?
?
Does the TPO agree with the arms length analysis
No
Yes
Taxpayer given an opportunity to show cause to
TPOs stand
TP Adjustment
TPO would pass a favourable order without making
any TP adjustments!
Has the taxpayer responded suitably to enable the
TPO to reconsider
?
?
No
Yes
TPO re-visits his earlier stand
Does the TPO now agree with the taxpayers
contention
?
No
Yes
?
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TP adjustments when possible?

• Transfer Price has not been determined as per
  Section 92C(1) and (2)
• Mandatory documentation not maintained
• Information or data used for computation of the
  Arm's Length Price is not reliable or correct
• Taxpayer has failed to furnish the documentation
  within the specified time

No exemption / deduction allowed to the taxpayer
in case of adjustments
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TP Administration Structure
DGIT, International Taxation
Director of Income-tax, Transfer Pricing (Each
location)
TPO I
TPO III
TPO II
Additional Commissioner of Income-tax
Additional Commissioner of Income-tax
Additional Commissioner of Income-tax
Support staff
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Time frame

• Tax assessments- AY 2003-04 completed
• Appeals before CIT (Appeals) being heard
• Tax assessments- AY 2003-04 in process
• Statutory deadline- 31st March 2005

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• Revenue approach perspective
• specific industry overview

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Software sector

• Attempt to apply prevalent hourly software
  development rates
• NASSCOM website, annual reports, STPI filings,
  etc.
• Contractual Agreements invoices at
  transactional level
• Examination at a macro and transactional level
• Qualification, experience of the technical
  personnel involved
• Time Sheets on the basis of which billing was
  done
• In case of cost plus billing the costs marked up

• Technical comparison of the services provided by
  the companies used as comparables
• Attempt to use comparable data from public domain
  / websites etc
• Extension of credit period beyond agreed duration
  non charging of interest adjustments made!

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Secondment / HR services in software sector

• Secondment a valuable intra group service
  entailing cost, requiring determination of ALP
• How ALP determined by Indian IRS?
• Based on internal CUPs available, if any or
• Based on prevalent trade practices
• 8.33 or 25 of annual salary of employees

• Upward adjustments made to taxable income where
  this activity is not considered or considered
  without any profit mark-up

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Trading, distribution indenting

• Copies of Agreements other supporting documents
  forming the basis for imports / exports
• A detailed FAR analysis to ascertain economic
  characterization of the Indian entity
• Limited distributor v/s a full fledged
  distributor
• Global price list adherence to the same
• Inquiry into sales price by AE to other group cos.

• Analysis of the expenses incurred during the year
  marketing, advertisement, brand promotion, etc.
  its impact on profitability at operating level
• Attempt to ascertain the overseas pricing policy
  if the overseas AE is like an offshore trading
  co.
• In indenting models, the basis of commission

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Manufacturing

• Copies of Agreements and other supporting
  documents forming the basis for imports/exports
• Details of Quantity, Rate for each consignment
  imported / exported
• A detailed FAR analysis to ascertain the
  characterization of AEs
• Contract manufacturer or Entrepreneurial
  manufacturer
• Standard Price List of the Associated Enterprises
  for the items imported by the Indian Company

• Analysis at transactional level to ascertain the
  margins applied the pricing policy for each
  consignment
• Despite the use acceptance of entity level TNMM
  analysis

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Manufacturing

• Following stands taken, closely examined
• Underutilization of installed capacity
• Low margins / Start up losses
• Market penetration strategy
• Robust documentation is the key!
• Indian IRS has accepted these arguments in
  appropriate cases!

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Manufacturing a live case study

• Facts
• One of our jewellery clients based in Seepz
  earned very low operating profits
• Around 2.5 on sales as against comparable cos
  margin of around 9
• Second year of operation
• Predominant purchase 100 sales to a US based
  unrelated co.
• Associated vide section 92A(2)(i)

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Manufacturing a live case study

• Approach analysis
• TP not applicable in the instant case
• A without prejudice compliance undertaken to
  avoid litigation!
• Differences between assessee comparables
• No in-house designing done by assessee
• All designs supplied by the overseas co
• Other jewellery manufacturers deal in at least
  4,000 -10,000 designs
• Predominant purchase sales to the same US Co
• Assessee was like a job worker rather than an
  entrepreneurial manufacturing entity
• Assessee did not have to maintain large inventory
  for RM / FG
• Marketing, collection, bad debt risks mitigated
• In one of the subsequent years, assessee incurred
  bad debts in respect of sales made to a 3P
• All comparable companies also had provisions for
  doubtful debt and bad debts
• Margins low mainly due to the peculiar accounting
  treatment followed by the assessee
• Based on a slightly different and well recognized
  accounting presentation, the margins shot upto
  11.33!
• Favourable CUPs available in subsequent years
• Operating margins low but GP margins comparable

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Manufacturing a live case study

• Approach analysis
• Even operating margins need to be compared with
  job workers not other full fledged manufacturer
• Assessees margins commensurate with such job
  workers
• Huge idle capacity due to overall slack sales
  stiff competition
• Demonstrated idle capacity based on experts
  certification documents filed with Seepz
  Authorities
• Positive results for FY 02-03 03-04 also helped
• 5 years financial projections useful
• In line with the advance tax estimates of
  assessee
• Start up phase market penetration strategy
• No of parties increased from 1 in FY 01-02 to 4
  in FY 02-03
• Other arguments
• Deeming AE situation- no incentive to shift
  profits abroad
• Assessee- enjoying Sec 10B exemption- incentive
  to maximize profits in India
• of overseas Cos purchases from Indian Co
  constituted a small proportion
• US Co assessed to tax in US _at_ 35

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Intangibles Royalty Payments

• Royalty payments to meet the economic benefit
  test
• Royalty on established products questioned in
  practice
• Know-how / brand royalties not allowed in
  contract manufacturing situation
• Government approval for royalty payments? no
  justification per-se
• Availability of internal / external comparables
• Temptation to compare royalty paid by other AEs
  within the MNC

• Benchmarking Royalty rates
• Overseas
• Ten-K Wizard,
• Disclosure Incs Global Researcher
• SEC database
• SIA database
• Our associates in-house databases
• Any specific industry norms?
• Adjusting the rates for differences in royalty
  rates- quantification not always easy
• Relevant factors -description of implicit rights,
  geographical coverage, time horizon, exclusivity,
  level of capital investments needed, the
  possibility of sub-licensing, etc

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Intangibles Royalty Payments

• Entity level TNMM analysis
• However, separate economic analysis /
  justification for royalty payments advisable to
  corroborate findings
• Losses and Royalty documentation, very critical
• Future projections economic benefit received
  especially critical
• Contractual agreement
• Documentation reflecting negotiation of royalty
  rates useful

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Intra Group Services

• Administrative Services Planning/coordination
• Budget Control
• Financial Advice
• Book Keeping
• Internal Auditing of the Books
• Legal Matter
• Financial Treasury Services Cash Management
• Attracting Capital
• Concluding Loan Agreements
• Trading in Derivatives
• Refinancing
• Factoring
• Operational Logistics Services Manufacturing
• Warehousing
• Transport

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Intra Group Services

• Information Technology Services Software /
  Hardware Systems Training
• Specific Services Technical Advice with
  regard to Production
• Central Purchasing,
  distribution or marketing
• Personnel Services Recruitment and Selection
• Training Education
• Secondment of Personnel

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Intra Group Services

• Precise nature of services supplied?
• Does the recipient benefit from the services?
• Mere fact that the mark up meets with the arms
  length expectations not enough!
• An FAR analysis
• Whether shareholders cost and stewardship cost
  eliminated?
• Also relevant from Sec. 37(1) perspective!
• Basis on which IGS charged
• Basis of cost allocation
• Basis for the mark-up whether at arms length?
• Contractual agreement for IGS

• Other supporting documents
• Group policy document or IGS Manual
• Copies of time sheets or Cost Centre Reports
• Invoice copies
• CPA certificates certifying the method used and
  the authenticity of the cost apportioned
• Other correspondence

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Selection of Most Appropriate
Method in practice
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Preference for the use of CUP

• Specific inquiry by the Indian IRS for all
  internal controlled / uncontrolled transactions
• Preference for internal comparables
• Suitable documentation for rejection advisable
• Temptation to compare royalty paid by other AEs
  within the MNC
• If direct comparables not available, adjustments
  made for
• Volume, Credit period, Terms of delivery
• Adjustments not considered in all cases though
• Other methods accepted only if appropriate
  documentation for rejection of CUP
• CUPs examined closely by Indian IRS in loss
  situations
• Attempt to use or at least corroborate results
  with margin based methods in such cases

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Use of TNMM in practice

• Used in majority of cases by assessees
• Especially in profit situation
• Loss making comparables whether to be included
  in final sample?
• Disinclination to include loss making companies
• Indian IRS perception - loss cases are included
  to reduce the average operating margin
• Ignore cases involving losses due to abnormal
  factors
• Ignore sick and chronic loss making companies
  (three years continuous losses)
• Undertaking an alternative sensitivity analysis
• As per Indian IRS - wrong search filters applied
  in certain cases additional comparables
  detected from the same data base with same search
  filters
• Document the entire search process carefully
• Functional and preferably product comparability
  should be the basis
• Corroborate results based on lateral comparables
  wherever possible
• Use of alternate PLIs to corroborate the result!
• Data used for margin based analysis by Indian IRS
  Prowess, Capitaline, websites, etc

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Use of GP based methods

• GP Margin analysis not accepted by the Indian IRS
  in all cases
• Due to non availability of accurate gross margin
  data
• However, has been accepted in appropriate cases!
• A case study
• Indian Co procuring certain raw materials (dyes)
  from its overseas AE
• Indian Co incurring losses at operating level
  mainly due to high overheads and under capacity
  utilization
• The raw materials imported by the Indian
  subsidiary were not significant as compared to
  the total sale of the Indian subsidiary
• Analysis undertaken at the GP level to show that
  the margin is in line with comparable cos

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Establishing Most Appropriate Method
Methods
Functions
CUP Comparable Uncontrolled Price TNMM
Transactional Net Margin Method
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• Critical Issues
• Encountered

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Use of foreign database / comparables

• Indian IRS prefers benchmarking on Indian
  database even if the tested party is an
  Overseas AE!
• Revenue perspective
• Assessees Int Transactions need to be examined
• Stand not in line with the prescribed rules!
• Indian IRS does not have access to global
  database
• Difficulty in verifying the veracity of the
  foreign data base
• Copies of financial statements of comparable cos
  not available
• Difficulty in verifying the authenticity of the
  analysis of the assessee
• Supplementary benchmarking analysis on Indian
  database to corroborate results the key!

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Arms length range

• Use of Arms Length range a standard
  international practice
• US 482 Reg provides for the use of Inter Quartile
  range!
• India concept of arithmetical mean
• However, / - 5 variation permitted
• Issues in application of / - 5 variation
• Applicability in case of single comparable price
• Application in case of margin based methods-
  whether to use range on the margin or on
  derived arms length price?

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Use of secret comparables

• Indian IRS using secret comparables
• Notices issued u/s 133
• information / data disclosed before adjustments
  to the assessees
• Revenue perspective
• Indian IRS has taken a cue from the developed
  countries
• Australia, Canada, Japan, Malaysia, Germany allow
  the use of secret comparables
• India -a developing country
• Favourable precedents u/s 145(1) in case of GP
  adjustments
• SC decision in case of Rakeshwari mills
• Use of secret comparables restricted especially
  in cases involving lack of info on database and
  for specific industry
• Diamond, Shipping agents, etc

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Re-run of the comparable search

• Indian IRS prefers a fresh database search at the
  time of assessment
• Issues involved
• The search may throw up additional comparables,
  which were not available when study was conducted
  in relevant FY
• Data to be used for documentation vs. Data to be
  used for assessments
• Contemporaneous data given a go-by!?

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Aggregation segregation of transactions

• Aggregating transactions
• if it reflects the most reliable result of
  economic benefits
• However, Indian IRS has been examining this
  closely
• Segregating international transactions
  separately benchmark them
• If the transactions are different unconnected
• Can give an important insight and breakthroughs
  sometimes
• for instance when overall margins low due to
  non-AE transactions!

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• Way forward

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Way forward

• Emphasis on robust documentation
• Emphasis on CUP- should be thoroughly examined
  before accepting / rejecting
• Surrounding evidence also helpful
• for e.g. transactions with other AEs of the same
  MNC Group
• Support entity level TNMM analysis at a
  transactional level
• Corroborate with a gross margins analysis
  wherever possible
• Document the search process on database carefully
• Undertake alternate sensitivity analysis under
  alternate scenarios to fortify the documentation

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Thank You
?
Queries
Narayan Mehta Tel [phone] Mobile 91
9820544495 E-Mail narayan.mehta_at_skparekh.com