Transfer Pricing : A Global Update & India perspective CA. Anuj Khorana

1. Transfer Pricing : A Global Update & India perspective CA. Anuj Khorana June 23, 2007

2. Global Trends Managing Challenges & Future Outlook Outline Transfer Pricing in India India Audit Experience Key Points to Take Away!

3. Global Trends

4. Transfer Pricing: The Most Important Tax Issue • Overall • TP continues to be, and will remain, the most important tax issue facing Multinational Enterprises (MNEs) • More and more countries have introduced comprehensive documentation and penalty regulations • Increasingly aggressive audit environment • Increasing questioning and data gathering for in-depth scrutiny • Recruiting and training of specialist resources to examine more complex transactions • Increasing level of cross country co-operation among tax authorities in audits

5. Global Trends: Changing Approaches • Changing Environment • “New wave” of entrants to enforcement of transfer pricing • “Old guard” making significant changes to approaches • Trends • ‘In principle’ acceptance of arm’s length principle on a consistent basis with Organization for Economic Co-operation and Development (OECD) norms and guidelines • However, Major divergence of approaches in practice (e.g. multiple year data, adjustments, etc) • Threatens resolution of bilateral disputes (MAP proceedings) and increases risk of economic double taxation • Increase in number of cases going for litigation

6. Transfer Pricing in India

7. Legislative Overview • Legislation introduced with effect from April 1, 2001 • Built on OECD Guidelines, but with significant deviations • Provisions applicable only if: • Their is an international transaction(s) [defined in Sec 92B] ‘between’ • Two or more Associated enterprises[defined in Sec 92A]. • Exceptions • Provisions do not apply in certain cases [Section 92(3)] • Deeming provisions [Section 92B(2)] • Transaction between an enterprise and a person (other than an associated enterprise) shall be deemed to be a transaction between two associated enterprises, if there exists a prior agreement or the terms of such a international transaction are in substance determined between one of these entities and the associated enterprise of the other contracting entity.

8. Key requirements of Indian TP Regulations • Computation of Arm’s length price by applying the ‘most appropriate’ method out of: • Comparable Uncontrolled Price (CUP) • Resale Price Method (RPM) • Cost Plus Method (CPM) • Transaction Net Margin Method (TNMM) • Profit Split Method (PSM) • Mandatory contemporaneous documentation requirements • Documentation requirements • The statute requires information / documents in relation to an international transaction to be: : • kept and maintained in by every person • List of documents prescribed in Rule 10D • kept and maintained for a prescribed time – 8 years • furnished within 30 / 60 days of Revenue’s request. • Stringent Penal Consequences on Non-compliance / TP adjustments

9. India Audit Experience

10. A Nationwide Overview • Separate administrative structure with specialist Transfer Pricing Officers (TPOs) created for TP audits • Taxpayers with related party transactions in excess of approximately INR 15 crores in value subject to compulsory audit • Transfer pricing audits for the financial years ended March 31, 2002, March 31, 2003, March 31, 2004 have been concluded • Audits intensive in IT, Pharmaceuticals, Financial services, Automobiles and Chemicals Sector • Not many cases of penalty enforcement • Absence of APA/ Transfer Pricing Rulings

11. Experience in New Delhi Increase in cases picked up for scrutiny and the quantum of adjustment 1,200 1,000 1,000 800 700 (Rs. crores) Value of TP adjustment 600 400 290 125 90 200 cases 60 cases cases - AY 2004-05 AY 2003-04 AY 2002-03 TP Adjustment (in value) Trend - Value of TP adjustment

12. TP Audits - Key experiences • Loss making/ low margin companies (e.g. – White goods manufacturer / distributor) • ‘Cost plus’ service companies with low mark-up • Indian Companies of ‘Big Global brands’ • Marketing Expenditure – Support from Associated Enterprise • Application of deeming provisions u/s 92B(2) of IT Act • Use of un-reliable internal / external data for CUP analysis (like SVB Custom valuations) • Companies paying Technical know-how/ Royalty/ Management fee (Benefits test)

13. TP Audits: General Observations… • Cherry picking of comparables – exclusion of ‘loss making low turnover’ comparables; • Comparables used in preceding year, tested for current year even if they fail to meet comparability criteria, or non information was available at the time of search; • Use of ‘Single year’ or ‘Current year’ data by TPO’s as against ‘multiple year’ data used by taxpayer; • Disregarded transaction wise analysis in case of low profit/ loss at ‘net margin’ on a company wide level; • Dispute on ‘allocation of common costs’ in case of segmental data in TP analysis; • Application of CUP method using comparative prices of localised vis-à-vis Import price;

14. ….General Observations (Contd.) • Use of the 5% range • Tax payer granted the option of using a 5% range from arithmetic mean in determining arm’s length price. • Where transaction price is outside the range, the TPOs determine quantum of adjustment upto the arithmetic mean and not the lower end of the 5% range. • Held to be a safe harbour provision and not a standard deduction. • Denial of adjustments for Functional, Risk and Asset differences between ‘tested party’ and comparables • Inventory Adjustments (e.g. - Agent vs. Trader) • Risk Adjustments • Market differences (Local ‘tested party’ vs. foreign comparables) • Working capital adjustments (for differences in debtors / creditors)

15. Managing Challenges & Future Outlook

16. Expected Changes / Guidance • Criteria for selecting taxpayers for audit • Application of a more scientific screening process instead of a monetary threshold • Statistical methods • Use of IQ range, median etc instead of mean / 5% range • More detailed guidance on specific TP issues • Aggregation of transactions, Services, Intangibles transactions • Guidance on collateral consequences of TP adjustments • Compensating adjustments, set-offs, correlative relief, secondary adjustments • Improving dispute resolution process • Improving effectiveness of MAP, introduction of APAs

17. Managing TP Risks • Need for comprehensive documentation for all inter-company transactions • Increased pressure for comparability analysis based on local comparables • Exceptions to global transfer pricing policy / common structures may be required • Review of existing supply chain structures from a PE exposure / Income Attribution perspective • Full range of dispute resolution mechanisms such as MAP could be considered for large TP disputes

18. Key Points to Take Away

19. Managing TP risks Key Points to Take Away • TP audit proceedings • Perform risk Assessment • Involve professional advisor at early stage • Provide best defense strategy • Maintain high and visible standards of good faith • TP disputes • Consider alternative dispute resolution process • Maintain proper documentation • Annual economic analysis update • Evaluate whether mark-up needs to be enhanced based on impact assessment and current trends • Assess the impact of the change in mark-up/ true-up adjustment on • Global TP policy • Tax holiday and • Profit accumulation in India • Consider the manner in which the change should be reflected: • Change in inter-company Agreement • Limited to a true-up adjustment in the financial statements • Adjustment only in tax returns

20. THANKYOU

21. 43% of European and 49% of Asian-Pacific respondents identified transfer pricing as the most important tax issue facing their organization The Most Important Tax Issues 0% 10% 20% 30% 40% Source: Ernst & Young Global Transfer Pricing Survey 2005-06

22. Global Growth in Importance Source: Ernst & Young Global Transfer Pricing Survey 2005-06

23. Asia–Pacific: Transfer Pricing Growth in Importance Result for Asia–Pacific parent company respondents is very similar to the global result for 2005 0% 10% 20% 30% 40% 50% 60% Source: Ernst & Young Global Transfer Pricing Survey 2005-06

24. Major World Economies with Effective Documentation Rules 6 Countries 7 Countries 20 Countries 25 Countries 31 Countries

25. Country Updates • United States • Introduced on July 31, 2006 temporary regulations on Inter-company services transactions and allocation of income from intangibles. Key features of the new regulations are: • Evaluates arm’s length price for certain “covered” services using total Services Costs either with ‘no’ markup or low median comparable mark-up of 7%; • Examples of covered services: • Payroll and processing certain benefits payments • Processing accounts receivable and payable (bookkeeping) • General administrative – ministerial and clerical tasks • Public relations – preparation and dissemination of corporate communications, but not public relations strategy • Meeting coordination • Accounting and audit – compliance • Tax – paying tax and processing returns, but not tax planning • Compliance – regulatory, licenses and permits Evaluates the economic benefits of services availed by the ‘buyer’ in the entire supply chain

26. Country Updates • Singapore • Introduced Transfer pricing guidelines in February 2006. Salient features are: • General acceptance to arm’s length principle outlined in OECD guidelines • Provision of APA / MAP mechanism to minimize / eliminate economic double taxation (detailed guidelines yet to be issued) • Acceptance of 5% mark-up for inter-company services, provided ‘routine’ and ‘non-core’ in nature • Interest-free loans by Singaporean to affiliates will be subject to TP review • France • Released new instructions and transfer pricing guidelines on November 28, 2006, on a simplified APA procedure for “small and medium-size companies” • Provides for a special cell at the tax authorities to assist small and medium companies in functional analysis, selection of the appropriate transfer pricing method, and, the performance of the benchmarking exercise (at the request of taxpayer) • Eligibility criteria of such companies / taxpayers: fewer than 250 employees, revenue below €50 million, and assets below €43 million. Moreover, the French company must not be owned more than 25 percent by a company exceeding the criteria above • Relaxation of APA submission for small and medium-size groups.

27. Country Updates • Malaysia • 2007 Budget provisions proposes to allows taxpayers to request for an advance ruling (including advance pricing agreements) from the tax authorities on the application of Income-tax/ TP provisions on transactions with related parties. • Hungary • Advance Pricing Agreements (APA) • Effective January 1, 2007, the Hungarian tax authority has prescribed APAs for establishment of arm’s-length price of future transactions covering both unilateral and multilateral arrangements • An APA request should include the countersignature of certified experts • APA would be binding under unchanged conditions for 3 to 5 years and can be extended once for an additional 3 years. • Centralized Audit Systems • Introduced a new centralized audit system to focus on sophisticated transfer pricing documentation.

28. Associated Enterprises – Some considerations • Very wide definition and includes enterprises “economically” related • Where one entity or one or more persons, directly or indirectly, or through one or more intermediaries, participates in the management or control or capital of the other enterprise (26% criteria) • Where Loan provided by one enterprise constitutes 51% of the assets of the other enterprise. • Where one entity is “wholly” dependent on the intangibles provided by the other entity. • Where one entity buys 90% or more, of its raw materials from the other enterprise. • Where one entity sells goods / services to the other entity and is in a position to “influence” the price. • Where one entity stands guarantee for the other entity and the guarantee amount is more than 10% of the total borrowings of the other enterprise. • Definition of Associated Enterprise also includes “a permanent establishment”

29. Entity related Price related Transaction related • Transaction terms • Functional analysis (functions, assets and risks) • Economic analysis (method selection, comparable benchmarking) • Forecasts, budgets, estimates • Profile of industry • Profile of group • Profile of Indian entity • Profile of associated enterprises • Agreements • Invoices • Pricing related correspondence (letters, emails etc) Contemporaneous documentation requirement Documentation to be retained for 9 years from financial year Documentation is not required to be maintained if the aggregate value of all international transactions does not exceed one crore rupees Documentation – Rule 10D