Presentation on Transfer Pricing [Direct Tax] -CA Nimish Kumar

1. Presentation on Transfer Pricing [Direct Tax] -CA Nimish Kumar

2. What is Transfer Pricing? • Transfer pricing refers to the pricing of cross- border transactions between two related entities. • When two related entities enter into any cross-border transaction, the price at which they undertake their transaction is called Transfer Price. • Due to the special relationship between related companies, transfer price may be different than the price that would have been agreed between two unrelated companies.

3. Global Transfer Pricing – A Snapshot Top 10 toughest Tax Authorities for Transfer Pricing • Around 60 countries with full fledged transfer pricing regime. • Tax authorities are developing more knowledge both of transfer pricing and of tax payer’s information. • India, Australia, China, Korea and Japan have all seen an increase in audit activity; Singapore and other tax authorities have signaled intent to step up transfer pricing compliance and field audit work. • Hong Kong, India, China, Korea and Japan are significantly expanding and adding key new requirements to their transfer pricing regimes.

4. Why Transfer Pricing? • Finance Minister’s speech on the rationale for introducing Transfer Pricing Regulations • “Presence of multinational enterprises in India and their ability to allocate profits in different jurisdictions by controlling prices in intragroup transactions has made the issue of transfer pricing a matter of serious concern. I had set up an Expert Group in November 1999 to examine the detailed structure for transfer pricing legislation. Necessary legislative changes are being made in the Finance Bill based on these recommendations.” Mr. Yashwant Sinha Finance Minister, Government of India February 28, 2001

5. Transfer Pricing-Scheme Relevant Provisions • Computation of Income from International Transaction having regard to ALP Sec • Associated Enterprises Sec. 92A • International Transaction Sec. 92B • Specified Domestic Transactions Sec. 92BA • Arm’s Length Price - Sec. 92C + Rule 10B/ 10C • Power of AO and TPO - Sec. 92CA • Safe Harbour Sec. 92CB + Rules 10TA to 10TG • Advance Pricing Agreements Sec. 92CC and CD+ Rules 10F to 10T • Secondary Adjustment – Sec. 92CE • Documentation and Certificate Sec. 92D and Sec. 92E • Definitions of certain terms relevant to computation of ALP etc. Sec.92F • Dispute Resolution Panel - Sec. 144C • Penalties - Sec. 271 (1) (c), 271AA, 271BA, 271G, 271GB • Furnishing of report in respect of International Group – Sec.286

6. Transfer Pricing-Scheme Relevant Provisions • Rule 10A - Meaning of expressions used in computation of arm's length price • Rule 10AB - method of determination of arm's length price • Rule 10B - Determination of arm's length price under section 92C . • Rule 10C - Most appropriate method • Rule 10CA - Computation of arm's length price in certain cases • Rule 10D - Information and documents to be kept and maintained under section 92D . • Rule 10DA&DB - Information and documents to be kept and maintained under section 92D . & Furnishing of Report in respect of an International Group. • Rule 10E - Report from an accountant to be furnished under section 92E. • Rule 10F to T - Advanced Pricing Agreement • Rule 10TA to TG - Safe Harbour rules for International transaction • Rule 10TH to THD - Safe Harbour rules for SDT

7. Section 92

8. International Transaction Parent Co Non-Resident Transaction between two or more associated enterprises, either or both of whom are non-residents In the nature of – • Purchase, sale or lease of tangible or intangible property, or • Provision of services, or • Lending or borrowing money, or • Any other transaction having a bearing on the profits, income, losses or assets of such enterprises, • Any mutual agreement or arrangement on allocation or apportionment or any contribution of cost or expenses Definition expanded vide Finance Act, 2012 Supply of Goods and Services Singapore 10% India Subsidiary Co Resident

9. Deemed International Transaction: Section 92B(2) of the Act • Third Party transactions deemed to be international transaction - Section 92B(2) Transaction between A and Third Party also subject to transfer pricing, if: - a prior agreement exists between A’s parent and Third party; OR - terms of transaction between A and 3rd Party are determined in substance by A’s parent and Third Party. -Third party can be Non-resident or Resident - Clarified by Finance Act 2014, that deemed international transactions would also cover cases where both the contracting parties are residents Third Party A’s Parent Outside India AEs India Services A

10. Domestic Transfer Pricing (Section 92BA) Tax Payer enjoying tax holiday • Inter unit transfer of goods or services [80-IA (8)] • Transaction between the taxpayer and other person having close connection [80-IA (10)] • Inter unit or intra group transaction for taxpayer enjoying benefit of Chapter VI-A or section 10AA (SEZ units); or • Profits and gains of undertaking / unit / eligible business is to be computed having regard to arm’s length price in case of inter unit transfer of goods or services by the taxpayer [section 80A]; Applicability • Applicable where aggregate amount of exceeds INR 20 crores in a year • Applicable from Financial Year (FY) 2012-13 onwards Payment to specified person [section 40A(2)(b)] now excluded from SDT w.e.f 01-04-2017

11. Meaning of Associated enterprise (AE) Sec.92A(1) • Direct or indirect participation, in management / control / capital of the other enterprise (OR) • Direct or indirect participation of the same person(s), in management / control / capital of both enterprises D & E are also AE’s of C Ultimate parent (A) Both A & B are AE’s of C B - Direct A - Indirectly A A B D B C E C

12. Most Appropriate Method: Rule 10C of the Rules Factors considered for selection of the most appropriate method: • Nature and class of international transaction • Class of associated enterprise and functions performed • Availability, coverage and reliability of data • Degree of comparability between the International transaction • Extent to which reliable and accurate adjustments can be made • The nature, extent and reliability of assumptions for application of the method

13. Comparable Uncontrolled Price Method Parent Co • Requires strict comparability in products, contractual terms, economic terms, etc. Hence remote use. • Two types of CUPs available - Internal CUP & External CUP • Calls for adjustments to be made for differences which could materially affect the price in the open market e.g.: Difference in volume / quality of product Difference in credit terms Risks assumed Geographic market Outside India Transfer Price Internal CUP India Subsidiary Co Unrelated Co. X Unrelated Co. Y Outside India External CUP India Unrelated Co. Z

14. Resale Price Method • Compares the resale gross margin earned by associated enterprise with the resale gross margin earned by comparable independent distributors • Preferred method for a distributor buying finished goods from a related party for reselling to unrelated party (if no CUP available) • Preferred method where no value addition is involved. • Under this method comparability is less dependent on strict product comparability and additional emphasis is on similarity of functions performed & risks assumed Parent Co Transfer Price INR 75 Outside India Resale Price INR 100 India Subsidiary Co Unrelated Co. Y Price paid by Sub Co. to AE is at arm’s length if the 25% resale margin earned by Sub Co. is more than margins earned by similar Indian distributors

15. Cost Plus Method Parent Co Transfer Price INR 125 • Compares and identifies the mark up earned on direct and indirect costs incurred with that of comparable independent companies • Preferred method in case • Semi finished goods sold between related parties • Contract / toll manufacturing agreement • Long term buy / supply arrangements • Comparability under this method is not as much dependent on close physical similarity between the products. • Larger emphasis on functional comparability Outside India India Subsidiary Co Direct cost & indirect cost on production INR 30 COGS INR 70 Company Y/ AE Unrelated Co. Z Price charged by Sub co to AE is at arm’s length if the 25% mark up on cost is more than that of similar Indian assemblers

16. Profit Split Method Parent Co A Technology intangibles • To be applied in cases involving transfer of unique intangibles or in multiple international transactions that cannot be evaluated separately • Calculates the combined operating profit resulting from an inter-company transaction based on the relative value of each AEs contribution to the operating profit • Evaluates allocation of combined profit/loss in controlled integrated transactions • The contribution made by each party is based upon a functional analysis and valued, if possible, using external comparable data Outside India India Mfg Company B Mkting Co C Marketing intangibles

17. Transactional Net Margin Method • Examines net operating profit from transactions as a percentage of a certain base (can use different bases i.e. costs, turnover, etc) in respect of similar parties • Most frequently used method in India, due to lack of availability of comparable uncontrolled prices and gross margin data required for application of the comparable uncontrolled price method / cost plus method / resale price method • Broad level of product comparability and high level of functional comparability • Applicable for any type of transaction and often used to supplement analysis under other methods • The application of the TNMM to a specific tested party breaks down when factors other than transfer prices have a material impact upon profits Parent Co A Unrelated Cos Outside India India Subsidiary Co B Net margin 5% Unrelated Cos Net margin 3%

18. Transactional Net Margin Method • Grouping of transaction - Relevant controlled transactions require to be aggregated to test whether the controlled transaction earn a reasonable margin as compared to uncontrolled transaction • Selection of tested party - Least complex entity • Benchmarking exercise (on Databases) • Entity with similar industry classification to the tested party – through search in Prowess and Capitaline plus databases • Screen entities by applying appropriate quantitative filters, such as mfg sales <75%, R&D exp >5%, Advertisement exp >5%. • Review financial and textual information available in the public database of the selected entities for qualitative filters • Computation of ALP

19. “Other Method” - Sixth method • CBDT has notified the “other method” vide a Notification and Rule 10AB has now been inserted in the Income-tax Rules, 1962 (the Rules). Applicable from FY 2011-12. • Other method is described as “any method which takes into account the price which has been charged or paid, or would have been charged or paid, for the same or similar uncontrolled transaction, with or between non-associated enterprises, under similar circumstances, considering all the relevant facts." • Could be applied in case of revenue split / allocation in case of investment banking/ financial services, guarantee fees and other similar complex uncontrolled transactions wherein it is difficult to use the other five prescribed methods. • Proper documentation specifying the rejection reasons for non-application of the other five prescribed methods and the appropriateness of the “other method” based on the facts and circumstances of the case would have to be maintained by the taxpayer

20. Documentation Requirements

21. Transfer Pricing Documentation: Section 92D / Rule 10D Entity related Transaction related Price related • Profile of industry • Profile of group • Profile of Indian entity • Profile of associated enterprises • Transaction terms • Functional analysis (functions, assets and risks) • Economic analysis (method selection, comparable benchmarking) • Forecasts, budgets, estimates • Agreements • Invoices • Pricing related correspondence (letters, emails etc) No specific documentation requirement if the value of international transactions is less than one crore rupees.

22. Accountants Report: Section 92E • To be obtained by every person entering into an international transaction/SDTs • To be filed by the due date for filing return of income • Opinion whether prescribed documents have been maintained the particulars in the report are “true and correct” • Review is limited to international transactions/ SDT undertaken by the assessee • Annexure – –Part A – Particulars of the assessee, incl. aggregate value of transactions –Part B & C – List of AE’s , Specific details of international transactions & SDT incl. ALP & methods used.

23. Penalties: Section 271A / Sec 271AA Default Penalty Penalty for concealing particulars of income or furnishing inaccurate particulars of income 50%/ 200% of tax sought to be evaded on account of TP adjustments made 2 percent of the value of international transaction/ SDT Failure to maintain documents 2 percent of the value of international Transaction/SDT Failure to furnish documents Failure to furnish accountant’s report INR 100,000 Maintenance of contemporaneous and robust documentation is the key to avoid penalties

24. Transfer Pricing Litigation Scenario in India • Aggregate transaction value more than 150 million picked up by the AO and referred to the TPO for scrutiny . • Nine rounds of TP audits completed – AY 2002-03 to AY 2010-11 Adjustments (In INR Cr) Particulars No. of cases selected for scrutiny No of cases adjusted % of cases adjusted AY 2002-03 1081 236 22 1403 AY 2003-04 1501 345 23 2631 AY 2004-05 1768 477 27 3947 AY 2005-06 1479 370 25 5060 AY 2006-07 1600 800 50 10000 AY 2007-08 2301 1138 49 23237 AY 2008-09 2589 1338 52 44531 AY 2009-10 70016 AY 2010-11 60000 Not Available INR 60,000 crores of TP adjustment in concluded audit cycle for AY 2010-11

25. Key Triggers and Contributors for Transfer Pricing Litigation • Key Triggers for Aggressive Audits • Consistent losses / low margins of the assessee attributable to inter-company transactions • Significant changes in profitability of the assessee and its AEs • High Royalty / Technical fee payouts, Cost recharges, Management Fees, Cost allocations • Net losses incurred by routine distributors • Low mark-ups for services • Application of Ratio’s such as ROCE / Berry ratio / cash profit instead of net margins • Significant Advertisement and marketing spends by manufacturing / distribution companies • Contributors to Aggressive Audits: • Mounting fiscal demand on Government • Need to Preserve tax base • Constant competitive pressure to restructure business operations efficiently • Unprecedented sharing of information between revenue authorities Substantial increase in transfer pricing audits and disputes across the Globe , India is no exception….

26. BEPS

27. BEPS • BEPS initiative by OECD has brought a tectonic change in the global taxation system. • BEPS has been introduced to bridge the gaps in international taxation for companies that allegedly avoid taxation or reduce tax burden in their home country by engaging aggressive tax strategies. • It has already started percolating in the mindset of people. CFOs in the companies have to change their mindset totally. The global indication is that without introduction of BEPS, the income tax authorities were losing somewhere in the region of $200-240 billion annually. • It is expected that beside others, BEPS will sort out transfer pricing issues, in the years to come and consequently should reduce litigations too. • Tax will certainly become a topic of discussion at boardroom level also. The key here is to have public transparency and follow commercial substance.

28. Indian Regulations aligning with BEPS Action Plan 13 Master File - A global consistent overview Local File - Specific to country analysis CbCR - key data points for each group entity •Group organizational structure •Description of global value chain •Intangibles •Financing activities •Global Transfer pricing policies •Description of Intercompany transactions •Comparability analysis •Selection and Application of TP Method(s) •Financial information •Main business activity •Capital & Assets •Revenue (AE & Non-AE), Profits, Taxes •Number of Employees •Tax jurisdiction

29. Master File and CbCR • Master File & Local File to be filed with each tax jurisdiction • CbCR to be filed with tax jurisdiction of ultimate parent • CbCR mandatory if consolidated turnover > EUR 750 mn (approx. INR 5,632 Cr.) • CbCR to be used only for risk assessment; not for concluding audits Recent Amendments • New compliance by Finance act,2016 In response to BEPS action plan 13 • New Sec. (Sec. 286) inserted - for CBCR • Sec. 92D amended to include Master File • Rule 10DA - Master File • Rule 10DB - CBCR Master File – Rule 10DA • Applicability [10DA(1)]: • –Group revenue exceeds Rs. 500/- Cr AND • Aggregate value of international transaction > Rs.50Cr. • OR • Aggregate value of International transactions in IPR > Rs. 10Cr. • File form 3CEAA (part A & part B) – on or before due date u/s 139(1), (31st March 2018 for FY 16-17)

30. Thin Capitalisation- BEPS Action Plan 4 • What is thin capitalisation? Thin Capitalisation means having highly disproportionate debt capital in comparison to equity capital. Companies tend to borrow in high-tax jurisdictions to avail higher tax deductions • Why debt over equity? –No stamp duty required for infusion of debt capital, unlike equity capital –In most countries, dividends are subjected to economic double taxation, whereas interest is not; on the contrary interest is tax-effective –Easy and tax effective repatriation of borrowed funds as compared to capital infusion –Debt is more flexible; it can be converted into equity, when required –Debt can be borrowed in foreign currency to avoid currency fluctuation risk

31. Thin Capitalisation – Impact analysis

32. Limitation on interest deduction (Sec. 94B) • Introduced vide Finance Act 2017; Applicable from AY 2018-19 • Conditions triggering Section 94B Condition 1 : Borrower is an Indian Company or PE of a foreign company Condition 2 : Incurs any expenditure by way of interest or of similar nature exceeding INR 1 crore which is deductible in computing income chargeable under the head “Profits and gains of business or profession” Condition 3 : In respect of any debt issued by a non-resident: - being an AE; or - a third party lender (non-AE) but where the AE provides implicit or explicit guarantee to such lender or deposits a corresponding and matching amount of funds with the lender • Not applicable to borrowers engaged in banking or insurance business

33. Limitation on interest deduction Amount of disallowance (‘excess interest’) Lower of:- • Total interest paid or payable in excess of 30% of EBITDA; and • Interest paid or payable to AE’s Carry forward/set off • Interest disallowed can be carried forward and set-off up to eight assessment years Debt means: –any loan, financial instrument, finance lease, financial derivative, or an arrangement that gives rise to –interest, discounts or other finance charges that are deductible as business expenditures

34. Illustration - Sec. 94B

35. Illustration - Sec. 94B • A Ltd. has borrowing of INR 100 crore from its overseas AE i.e. B Ltd. @ 14% p.a. • Interest paid / payable to AE is INR 14 crore • EBITDA of A Ltd. for year ended 31.03.2017 is 30 crores • Impact u/s 94B: • Disallowance u/s 94B = Total deductible interest exceeding the 30% of EBITDA i.e. 5 crores [14 –(30%*30) = 5] • TP proceedings: • Arm’s length interest rate determined by TPO @ 11% and hence, made a transfer pricing adjustment of 3 crores [(14% -11%) * 100 crores] What would be the amount of interest allowed to be carried forward u/s 94B(4), INR 2 crores or INR 5 crores)??

36. Evolving Dispute Resolution Mechanism Dispute Resolution Panel (DRP) • Alternate dispute resolution mechanism to 1st level appellate proceeding before the CIT (A) • Specialist 3 member collegium for settling disputes on a fast track basis • No demand till Assessing Officer issues final order after directions of DRP Mutual Agreement Procedure (MAP) – To avoid double taxation and provide relief • MAP is an alternate mechanism incorporated into tax treaties for the resolution of international tax disputes • Resolution of disputes through the intervention of competent authorities of each State who evolve a mutually acceptable solution • Indo-US Competent Authorities arrived at a mutual agreement in respect of US captive providing software\ IT enabled services for FY 2004-05 Safe Harbor – Proposed to reduce transfer pricing disputes • Final Safe Harbor rules notified • Seeks to reduce the impact of judgmental errors in transfer pricing • Stipulation of margins-specified industries (Priority -IT/ITeS, KPO, contract R&D, etc.) • Safe Harbour regime would be valid for 5 years starting with AY 13-14 Advance Pricing Agreement (APA) – Introduced in Finance Act 2012 • Would be limited to a maximum term of five consecutive financial years • The ALP shall be determined on the basis of prescribed methods or any other method • Rules governing the APA regime notified by CBDT

37. Advanced pricing agreement (APA) Agreement between a tax payer and tax authority determining the transfer pricing methodology for pricing the tax payer’s international transactions for future years. Types: • Unilateral – tax payer and tax authority • Bilateral – tax payer, foreign AE, and respective tax authorities 93 Salient Features –To provide assurance of certainty and unanimity in transfer pricing approach –Valid upto five subsequent years and four previous years [Roll back] –Binding on tax authorities as well as taxpayers unless there is a change in the law or facts of the case –Pre–consultation process (anonymous application option)

38. Advanced pricing agreement (APA) Statistics as per CBDT Press Release dated 7th February 2018: •Important points to be considered: –Each year Annual Compliance Report in Form No. 3CEF needs to be filed before DGIT (IT) –The APA can be cancelled/revised if critical assumptions are violated or conditions are not met –If the Compliance Audit results in a finding that the assessee has failed to comply with the terms of the agreement, the agreement can be cancelled –Non filing of Compliance Report or the report contains material errors, it may result in cancellation of the agreement

39. Safe Harbour Rules • Safe Harbour (SH) Provisions were Introduced by Finance Act, 2009, however, CBDT released SH rules in September 2013. In June 2017, CBDT revised the SH rules w.e.f. 1 April 2017, decreasing the SH margins and the included low value adding intra group services as one of the eligible international transactions • No respite is provided from maintenance of mandatory documentation. • A taxpayer opting for Safe Harbour rules will not be able to avoid possibility of economic double taxation. • Due to apprehension in various industry sectors - Government has issued instructions that Safe harbour margins not to be followed for general Audit or APA purposes. • Tepid response to safe harbour option due to very high markups

40. Safe Harbour Rules

41. Safe Harbour rules

42. Safe Harbour rules

43. Safe Harbour rules

44. Safe Harbour rules • Procedural Aspects –Eligible taxpayers must furnish a self-attested form i.e. FormNo.3CEFA, containing various details of the eligible transactions on or before the due date for filing the income tax return –The Assessing Officer may make a reference to the Transfer Pricing Officer to verify the validity of option exercised by the taxpayer –Various other procedural aspects have been provided by the relevant Rules • Circumstances under which tax authorities to accept transfer price declared by the taxpayer for certain transactions like ITeS, Software, KPO, Guarantees etc. • Provisions applicable from FY2012-13 and applicable only to international transactions (does not cover SDTs) for a period of 5 years unless opted out by furnishing a declaration to that effect • Safe harbour rules not applicable if the transactions relates to AE located in any country or territory with no tax or low tax rates • Need to furnish Form 3CEFA (as a self-declaration) stating that taxpayer opts for safe-harbour before due date for filing of return for relevant assessment year

45. Mutual Agreement Procedure (MAP) What is MAP? • MAP is an alternative available to taxpayers to resolve disputes giving rise to double taxation, whether juridical or economic in nature. • An agreement for avoidance of double taxation between countries would give authorization for assistance of Competent Authorities (CAs) in the respective jurisdiction under MAP. Benefits of MAP • The main benefit of pursuing MAP is the elimination of double taxation (either juridical or economic). • The MAP resolution, once accepted, eliminates protracted litigation. • For certain jurisdictions, India has also entered into agreements wherein there is no immediate collection of the disputed demand.

46. Mutual Agreement Procedure (MAP) • Who can apply? - The taxpayer of the country having to bear the incidence of double taxation can apply for the assistance of CAs under MAP to resolve the issue of such double taxation. • It may be noted that under the Multilateral Instrument (MLI) to which India is a signatory, India has selected the option where cases can be presented by taxpayers but only in the countries of their residence.

47. Thanking You Nimish Kumar Mob:9007828224 canimishkumar@gmail.com