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1. Update on India Transfer Pricing Audit and Dispute Resolution Panel proceedings AICAS Annual Direct Taxes Workshop - July 2, 2010 Tarun Arora Vani Sharma PwC

2. Topics • TP audits / assessments in India • Salient Features • Recent Trends • Key Audit Issues • Recent Mutual Agreement Procedure (MAP) Outcome • Dispute resolution panel (DRP) proceedings • Salient Features • Case Study – Captive IT enabled service provider • Case Study II – Captive Procurement service provider • Expectations from the DRP mechanism PricewaterhouseCoopers Slide 2

3. TP audits / assessments in India 1 1

4. TP audits / assessments in India Salient features PricewaterhouseCoopers • Separate Transfer Pricing cell established for carrying out TP audits • TP audit of all taxpayers having international related party transactions above a threshold, currently INR 150 million - proposal to move to selective, risk based audits from April, 2011 • Five rounds of TP audits completed in 2009  aggressive positions by TP Officers (TPOs)  initial focus on IT/ BPOs [high margins – location savings]; increasingly more complex audits pursued • Trained team of TPOs High volume of cases handled per TPO  TPOs vested with powers of inspection, discovery, enforcing attendance, examining a person under oath and compelling the production of books of accounts/ other relevant documents and information • No Advance Pricing Agreement (APA) mechanism in India till date  proposal to introduce in April, 2011 • DRP mechanism introduced in 2009

5. TP audits / assessments in India Recent Trends PricewaterhouseCoopers

6. TP audits / assessments in India Key Audit Issues PricewaterhouseCoopers • Marketing Intangibles – Legal vs. Economic Ownership ? • Procurement / Marketing support service providers characterized as agents / distributors • Significant adjustment to IT / ITES companies (25-30% mark-up applied) • Attribution of income to Indian Permanent Establishment (PE) of foreign company • Detailed scrutiny of payments for licensed Intellectual Property (Royalty, technical know-how fee, brand / trademark fee etc.) and management service charges • Dispute on business strategies and economic principles, choice of comparables, comparability adjustments • Use of secret comparables & confidentiality of information

7. TP audits / assessments in India Marketing Intangibles - General concept Principal Co Manufacturer • India Sub Co has license of brand & distribution rights from Principal Co • Advertisement & Marketing (A&M); distribution network  key drivers to business • Who should incur A&M, distribution expenses ? • No straight-jacket formula  fact driven  depends on profile of India Sub Co • Who performs significant people functions & takes key decisions on A&M ? • If India Sub Co is LRD  Principal Co bears expenses & owns marketing intangibles (customer list, dealers network, etc) • If India Sub Co is full risk/ marketing distributor  India Sub Co bears expenses & owns marketing intangibles • Revenue cannot dictate business model  substance is the key INDIA India Sub Co Distributor Indian customer  Flow of legal title of goods  Physical movement of goods PricewaterhouseCoopers • Slide 7

8. TP audits / assessments in India Marketing Intangibles - Dispute in India • India Sub Co operates as licensed manufacturer • Raw materials primarily sourced from third parties • No royalty pay-out/ minimal royalty for mere license of technology/ brand • India Sub co takes all key decisions on A&M/ distribution, etc • India Sub Co bears all A&M/ distribution expenses (on own account) • Revenue makes addition in hands of India Sub co  Principal Co to pick-up “extra” A&M/ distribution expenses, as legal owner of brand • TP adjustments run into several millions of US$  major issue • TP adjustments primarily in R&C industry Principal Co Legal owner of IP Technology/Brand Royalty INDIA Supplier Indian customer India Sub Co Licensee of IP  Flow of legal title of goods  Physical movement of goods PricewaterhouseCoopers PricewaterhouseCoopers Slide 8

9. TP audits / assessments in India Marketing Intangibles - Relevant considerations • Evaluate contribution (& related benefits) of each entity in developing marketing intangibles  do efforts/ costs lead to : • increase in value of IP owned by Principal Co; or • merely enhancing value of rights/ benefits of India Sub Co [sole distributor/ seller ] • Who undertakes key decision making activities – development of marketing strategy, authority to take decisions, evaluate/ approve budgets, compensation model of personnel ? • Significance of local marketing in taxpayer’s industry - specific characteristics and competition • Business/ commercial expediency of marketing efforts & costs in relation to benefits/ returns • Is business substance properly captured in the contracts ? • Legal vs. economic ownership • Economic substance, in case IP development is bundled with other transactions • Robust upfront documentation (including legal contract) covering Functional, Asset and Risk (FAR) analysis & economic/ commercial realities  utmost necessity • Revenue’s acceptability of economic principles and international guidance/ case laws/ rulings (e.g. OECD, US, Australia)  still a challenge

10. TP audits / assessments in India Procurement Service Providers - Typical scenario in India • India Sub Co carries out liaison/ co-ordination functions for Principal Co • Parameters of material, eg quality, design, trends, etc, as per Principal Co • Vendor list provided by Principal Co to India Sub Co • India Sub Co maintains day-to-day relationship with vendors • Vendors sell products directly to Principal Co • Principal Co remunerates India Sub Co at “Cost Plus” • Say, operating costs of India sub Co  US$ 15 million • Mark-up on operating costs @ 20%  Profits of India Sub Co US$ 3 million • Products sourced by Principal Co from Indian vendors US$ 2 billion Principal Co Manufacturer/ Retailer INDIA Service fee India Sub Co Procuring Services Indian vendor  Flow of legal title of goods  Physical movement of goods PricewaterhouseCoopers

11. TP audits / assessments in India Procurement Service Providers - Dispute in India Principal Co Manufacturer/ Retailer • Revenue  India Sub Co to receive commission @% of value of goods sourced • Typically, 5% rate (on US$ 2 billion)  Commission imputed at US$ 100 million • Adjusted profits of India Sub Co  US$ 85 million [100 – 15] • TP adjustment in hands of India Sub Co  82 million [85 – 3] • Imputed profits/ margin  566% on operating cost  Berry Ratio of 666% !! • Large scale litigation in India  adjustments worth several millions of US$ INDIA Service fee India Sub Co Procuring Services Indian vendor  Flow of legal title of goods  Physical movement of goods PricewaterhouseCoopers

12. TP audits / assessments in India Procurement Service Providers – Option of Models Principal Co Manufacturer/ Retailer Option 1 Buy-Sell Margin Procurement Service Co Option 3 Services Service Fee @ Cost Plus Mark Up Option 2 Agency Commission @% of value of goods Indian vendor  Flow of legal title of goods  Physical movement of goods PricewaterhouseCoopers

13. TP audits / assessments in India Procurement Service Providers – Relevant Considerations • Can Revenue question choice of model, unless not backed by substance • FAR profile determines model : • Scouting for vendors; soliciting; signing contracts, etc • Product designing; quality; process standards; etc • Price & market risks; etc • Product liability risk; etc • Can Berry Ratio be ignored, unless valuable hidden intangibles ? • Can Revenue impute hidden intangibles without evidence ? • Favourable Dutch Supreme Court ruling • Documentation & inter-company agreement extremely important  substance is key • Rulings of Tribunal (Nike Inc) & Authority of Advance Ruling (Ikea Trading)  Indian liaison office of Foreign Co, facilitating procurement of goods held not to constitute PE of Foreign Co  low value added activity PricewaterhouseCoopers

14. TP audits / assessments in India Agency PE – dispute in India • In the case of Morgan Stanley, the Supreme Court held that no further attribution is required if the associated enterprise (that also constitutes a PE) is remunerated on an arm’s length basis given its FAR analysis (Other subsequent rulings have also given similar guidance) F Co Off-shore sales Commission INDIA Sub Co Third–party customers Does Sub Co create PE of F Co ? If yes, whether extra profits on F Co ? Agency PE Concludes contracts/ solicits orders Answer lies in transfer pricing PricewaterhouseCoopers Slide 14

15. TP audits / assessments in India Recent MAP Outcome • Indian and US competent authorities (CAs) have recently agreed upon the following cost-plus marks: • Absolute mark-ups determined – No further relief of +/-5%, adjustments • Ruling applicable for respective assessment years only • CAs had detailed discussion on comparable set used in TP documentation • No involvement of tax payers during the negotiation • Taxpayer to formally notify the acceptance of Ruling • Domestic Route vs. MAP? • Tax Payers have to evaluate the time duration for settlement – Domestic route vs. MAP • Higher Interest on tax demand due to delay in resolution under domestic route • MAP Ruling will affect Tribunal’s mindset while disposing the case • Whether penalty will be levied upon acceptance of MAP ruling?? PricewaterhouseCoopers Slide 15

16. DRP proceedings 1 1

17. DRP Proceedings Salient features • Objective of DRP mechanism as per Finance Minister  “to encourage the growth of foreign investment in India by providing for a speedy dispute resolution mechanism” • Introduced under Section 144C of the Income Tax Act, 1961 read with the Income Tax (Dispute Resolution Panel) Rules, 2009 • Applicable to taxpayers having TP adjustments as well as foreign companies for orders passed by the AO on or after October 1, 2009 • Each DRP consists of 3 CITs • 10 DRPs constituted in 8 locations across India – Delhi (2), Mumbai (2), Pune (1), Ahmedabad (1), Bangalore (1), Hyderabad (1), Chennai (1) and Kolkata (1) • Alternative to CIT (Appeals) PricewaterhouseCoopers Slide 17

18. DRP Proceedings Salient features • AO passes final order • Tax demand fastens on taxpayer immediately • Stay of demand not automatic • No time limit to dispose appeal • Taxpayer & Revenue can both challenge ruling before Tribunal • AO issues draft order based on TPO’s order • Taxpayer files acceptance or detailed objections to proposed additions (within 30 days of receipt of order) • DRP may confirm, reduce or enhance proposed additions • Dispute resolved within 9 months of issuance of draft AO order • All directions of DRP binding upon AO • No tax demand until DRP issues directions • Taxpayer can challenge ruling before Tax Tribunal TPO/ AO TPO/ AO CIT (Appeals) DRP Tax Tribunal Tax Tribunal High Court High Court Only legal issues Only legal issues Supreme Court Supreme Court Conventional mechanism Alternate mechanism PricewaterhouseCoopers

19. DRP Proceedings Salient features • DRP members are part – timers  also have existing administrative duty • DRP members do not have any TP background • Huge number of cases to be disposed off by DRPs in the next six months • Pro-revenue approach since directions of DRPs are binding upon the AO and there is no right of appeal with the Revenue • Taxpayers getting one or at the most two personal hearings before the DRP • To see whether the DRP mechanism will achieve its stated intent / objective PricewaterhouseCoopers Slide 19

20. DRP Proceedings Captive IT enabled service provider – Facts of the case • XYZ Corporation - incorporated in USA – a leading global engineering, construction and project management company • XYZ India - wholly owned subsidiary of XYZ Corporation – engaged in undertaking design and engineering services for the Group’s worldwide projects • In TP Documentation, XYZ India characterized as an engineering support services provider and benchmarked with similar engineering service providers PricewaterhouseCoopers Slide 20

21. DRP Proceedings Captive IT enabled service provider – TPO order • TPO alleged that XYZ India was engaged in ‘development of computer software and undertaking computer aided designing and engineering activities’ • TPO rejected XYZ India’s characterization and comparable companies chosen in TP Documentation • TPO simply placed reliance upon comparable companies chosen in XYZ India’s prior year TP order which were engaged in software development and CAD / CAE activities • TPO made TP adjustment of about INR 50 million PricewaterhouseCoopers Slide 21

22. DRP Proceedings Captive IT enabled service provider – Key arguments before DRP • FAR profile of companies chosen by TPO not comparable with FAR profile of XYZ India • 2 companies selected by TPO have significant related party transactions • Comparability adjustments (working capital level differences etc.) be granted to XYZ India PricewaterhouseCoopers Slide 22

23. DRP Proceedings Captive IT enabled service provider – DRP’s Directions • Provided only two opportunities of hearing on the case • Disposed off all submissions of the Company in a summary fashion and did not even allow rectification of AO / TPO’s order by excluding companies with significant related party transactions PricewaterhouseCoopers Slide 23

24. DRP Proceedings Captive Procurement service provider – Facts of the case • ABC Inc. - incorporated in USA - an international specialty retailer - operates stores selling casual apparel, shoes and other accessories • No manufacturing activity within the Group - all manufacturing done by third party manufacturers across several countries - products sourced from them • ABC Sourcing Inc. - wholly owned subsidiary of ABC Inc. - does sourcing for the Group from various countries, including India • ABC India - operates as a sourcing support service provider and local communication liaison for ABC Sourcing Inc. • Remunerated at total cost plus 15% mark up for sourcing support, liaisoning and co-ordination functions performed (with minimal risks assumed) PricewaterhouseCoopers Slide 24

25. DRP Proceedings Captive Procurement service provider – TPO order • TPO alleged that ABC India carried out a range of important and key procurement functions in the value chain • TPO alleged that ABC India owned significant human asset and supply chain intangibles • TPO alleged that ABC India assumed significant risks of losing its specialized and skilled work-force • TPO alleged that ABC India operates in a low cost economy and has generated location savings which have not been factored into in its remuneration model • ABC India should have been remunerated a commission on value of goods sourced and not mark-up on value adding (operating) expenses • Imputed profits/ margin @ 800% on operating/ value adding expenses • TP adjustment of over INR 2 billion !! PricewaterhouseCoopers Slide 25

26. DRP Proceedings Captive Procurement service provider – Key arguments before DRP • Activities of ABC India did not lead to creation of any supply chain or human asset intangibles • Location savings arise due to bargaining power of Group and not due to bargaining power of ABC India • Reliance on Indian and international judicial precedents • Extensive tangible evidence / documents to corroborate contentions submitted • Detailed analysis of comparative margins earned by distributors of clothes and footwear from India, Europe and Asia-Pacific regions undertaken to show absurdity of margins imputed for ABC India PricewaterhouseCoopers Slide 26

27. DRP Proceedings Captive Procurement service provider – DRP’s Directions • Provided only two opportunities of hearing on the case • Disposed off submissions/ evidences running into several hundreds of pages in a half page order • Many misstated / erroneous facts in the order PricewaterhouseCoopers Slide 27

28. DRP Proceedings Expectations from the DRP mechanism • More number of DRPs to be constituted throughout India • DRP members to have single / dedicated charge • DRP members to have prior TP background / training • DRP to function like an independent judicial body and have statutory powers / authority PricewaterhouseCoopers Slide 28

29. Thank You Tarun Arora Partner, Transfer Pricing PriceWaterhouseCoopers, India New Delhi Office Email : arora.tarun@in.pwc.com Mobile : +91 9810044798 Vani Sharma Senior Manager, Transfer Pricing PriceWaterhouseCoopers, India New Delhi Office Email : vani.sharma@in.pwc.com Mobile : +91 9899795851 This publication has been prepared for general guidance on matters of interest only, and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is given as to the accuracy or completeness of the information contained in this publication, and, to the extent permitted by law, PriceWaterhouseCoopers its members, employees and agents do not accept or assume any liability, responsibility or duty of care for any consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it. PwC