Transfer Pricing in India CA Hiren D.Shah Ahmedabad hirenindia@hotmail

1. Transfer Pricing in India CA Hiren D.Shah Ahmedabad hirenindia@hotmail.com

2. Indian Regulations

3. Genesis for New TPR • In India, while introducing the new transfer pricing regulations the Finance Minister said: • The presence of multinational enterprises in India and their ability to allocate profits in different jurisdictions by controlling prices in their intra-group 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.

4. Features • Introduced by the Finance Act, 2001 • Finance Act 2002 - clarificatory amendments • Circular 14 – Memorandum explaining new TPR • Based on the Arm’s Length Principle • Initial Burden of Proof is on the Assessee

5. Overview of Presentation • Meaning & Introduction • Important Concepts • Documentation & Audit • Transfer Pricing Audit Process • Powers of Assessing Officers • Impact of Adjustments made to TP

6. Meaning & Introduction

7. The process of fixation of Pricing of any Transaction between Associated Enterprises of MNC’s is known as “Transfer Pricing”

8. Overview - Indian Regulations

9. Developments – Indian Regime Finance Act 2001, introduces detailed Transfer Pricing Regulations April 2001 21 Aug 2001 Rules 10A to 10E notified Circular No. 12 issued – Guidelines to AO’s. Beneficial to Assesses 23 Aug 2001 Circular No. 14 issued – Explaining Provisions of Finance Act, 2001 Dec 2001 April 2002 Guidance Note issued by the ICAI. Finance Act, 2002 introduced – Clarificatory Amendments made Dec 2001

10. Section 92 • Provides for computation of – - Income - Expenses - Cost Contributions at Arms Length Price (ALP) • ALP means price applied or to be applied in transactions between unrelated persons & in uncontrolled conditions. • TPR not to apply to cases which has the effect of reducing income chargeable to tax or increase the loss [s. 92(3)]

11. Concept Independent entity Associated enterprise International transactions - goods - services - intangibles - loans Resident Resident Transfer price Arm’s length price

12. Associated Enterprises • Enterprise regarded as AE – Section 92A (1) • Based on the concept of commonality of Control. Management or Capital as contained in Article 9 of the OECD Model Tax Convention • Enterprises deemed to be AE – Section 92A (2) • Capital – • Shareholding (a & b), Loan ( c ), Guarantee for borrowing (d), interest (e); • Management • Appointment of Directors or Executive Director (e & f) • Control • Intangible property (g), production/trading activities (h & i) , others (j & K ) • Relationship of mutual interest (m)

13. Transaction [S. 92F(v)] • Transaction includes an arrangement, understanding or action in concert – • whether or not formal or in writing; • whether or not intended to be enforceable by legal proceedings.

14. International Transaction [S. 92B] A transaction between two Associated Enterprises, Either or both of whom are Non - Residents, in the nature of Purchase, sale, lease of Provision of Services Borrowing/Lending of money Tangible/intangible property Cost Sharing arrangements

15. Applicability of Transfer Pricing Branch & HO Issues Whether TPR would apply to transactions between Indian residents & their foreign branches. Whether, TPR would apply to transactions between foreign residents & their Indian branches.

16. Specified Date & Accountant • Important in the context of transfer pricing Documentation & Audit. • Every assessee to whom TP applies shall keep the documentation ready upto the specified date and also furnish a report of an accountant. • Specified date means the due date for filing the income tax return of the respective assessee u/s 139. • Accountant means a ‘Chartered Accountant’ in practice and would also include ‘Restricted state auditors’.

17. Methods • Price applied in a transaction between independent enterprises in uncontrolled conditions • To be determined by applying the Most Appropriate Method, being one of the following five methods • Comparable Uncontrolled Price (CUP) Method • Resale Price Method (RPM) • Cost Plus Method (CPM) • Profit Split Method (PSM) • Transactional Net Margin Method (TNMM) • In case, more than one price is determined by MAM: • Apply Arithmetic mean • Range of + 5% of the arithmetic mean Traditional transaction methods Transactional profit methods

18. Computation Provisions

19. ALP to be determined by any the methods, specified under s. 92C, being the Most Appropriate Method (MAM). • MAM to be applied in the manner prescribed by Rule 10C • Range of +/- 5% permitted.

20. Factors to be considered for selecting comparables (Rule 10B)

21. Characteristics of property / services. • Functions performed, risks assumed, assets / resources employed by the respective enterprises. • Contractual Terms • Credit terms & mode of payment • Volume of Sales / Purchase • Selling or Buying Commitments, etc. • Economic conditions: • size of the enterprises • geographical locations • size of the market • regulatory framework • cost of layout & capital, etc.

22. Documentation & Audit

23. Background… • Transfer Pricing, not a science but an art. • Transfer Price for the same transaction can be different for the assessee & the assessing officer. • Transfer pricing depends upon both the nature of the enterprise & the transaction. • Proper documentation shifts the burden of proof on the assessing officer.

24. Legal Framework • Legal requirements for maintenance of information & documentation contained in s. 92D r.w. Rule 10D. • S. 92D r.w. rule 10D prescribes the categories of documentation to be maintained and the period for which it is to be maintained. • Legal requirement for submission of report of an accountant (T.P. Audit) contained in section 92E r.w. Rule 10E.

25. Prescribed Documentation Documents to be maintained Principal [Rule 10D(1)] Supportive [Rule 10B(3)] ICAI’s Classification Enterprise related Transaction specific Computation related

26. Brief Classification of Principal Documents Enterprise related Transaction specific Computation related • Reasons for rejection of a particular method • Methods selected for determining ALP • How is MAM arrived at & how it is applied • Nature & terms of International Trns. (IT) • Records having a bearing on IT.. • Records of Forecasts & analysis • Analysis Performed (FAR Analysis) • Records of Comparable uncontrolled transactions • Ownership structure • Group Profile and details of AEs • Business overview

27. Ownership Structure of Group • Shareholding pattern / Membership interest; viz. Name of the shareholder / partner and % of shareholding / int. • Reference may be had to the Statutory registers maintained, if any • Generic classification in case of large number of shareholders • Changes in the shareholding pattern needs to be properly documented • Direct and indirect ownership interest in the taxpayer

28. Graphical Presentation of Group Profile

29. Profile & Business Overview • Profile of the multinational group: • Ownership Linkages & Legal Structure • Principal line of business • Geographical areas of operation • Summarised global financials • Overview of Business & Industry: • Broad description of industry in which the taxpayer operates (Reference can be made to ITC / NIC codes) • Business Model used • Technology employed • Products manufactured / traded • Markets addressed / competition faced • Geographical Dispersion of activities

30. Computation related Documents • Workings of all the methods used for determining ALP • Reasons for rejection / selection of particular method • Reasons for selecting a particular method as MAM • Workings of actual application of MAM • includes details of adjustments made to account for differences between controlled & uncontrolled transactions MAM should be the reliable measure of Arm’s Length Price

31. Supportive Documents [10B(3)] • Official publications, reports, studies & databases from Government of foreign countries • Research reports & technical publications of institutions of national or international repute • Published accounts & financial statements relating to business affairs of associated enterprises • Price publications including stock market quotations or commodity market quotations • Agreements, etc. with AEs or unrelated parties in respect of similar international transactions. • Letters & other correspondence documenting any terms negotiated between the assesse & the AE • Documents normally used in this connection under the accounting practices followed

32. Relief & Other Requirements • Assessees having aggregate value of international transactions as recorded in the books of accounts less than Rs. 1 crore exempted from maintaining prescribed documentation • However, assessee shall be able to substantiate its transfer price based on the material available with him • Documentation, so maintained shall be contemporaneous to the extent possible • Prescribed documentation to be kept & maintained for 8 years from the end of the relevant AY • No fresh documentation required in respect of same international transaction continuing over more than one year unless there is significant change in: - nature or terms of international transactions - assumptions made or other factors

33. Transfer Pricing Study Benchmarking Manage the process Functional Analysis 3 2 4 Documentation 1 5 Accountant’s Report Gathering Background Information

34. Transfer Pricing Study Report includes.. • Nature of International Transaction • Details of Associated Enterprise • Profit Level Indicator • Selection of Most appropriate Method – Justification for selected method and reasons for rejecting other methods • Access to Database • List out Comparables • Accept – reject matrix ( Filtration Process) • Benchmarking Analysis • FAR Analysis

35. :Development of Data Search Criteria • Data Search is an Art • Initial Identification and Screening • Secondary Screening, Verification and Selection. • Data Search is tedious Process • Prowess and Capital Online Software available for Data Search DATA SEARCH STRATEGY

36. DATA SEARCH STRATEGY Database A Database B Database C Database Industry Core Manufacturing 40 Companies Elimination of companies with insufficient data 25 Companies • Data – Non Availability, • Continuous Loss making, • Companies not engaged into R&D • Sales Filter 5. Government Ownership Quantitative Criteria 15 Companies Qualitative Criteria 1. Segment Analysis 2. Must not engage in significant related party transactions 3. Must not own valuable IPRs 8 Acceptable Companies for Comparison

37. Comparability Analysis • Document the entire Data Search Strategy which may include: • Identification & Listing of internal & external comparable uncontrolled transactions • Nature & Terms of such comparable uncontrolled transactions • Document all the comparables found in the search process, which may include: • Sources utilised • Initial List • Rejection Criteria • Final List Electronic Databases facilitates effective Data Search Strategy

38. Functional Analysis By Functional Analysis - one also refers to FAR analysis, which means an analysis of Functionsperformed, Assets employed & Risks assumed by various components of a Group. Understand ‘Business process’ for effective FAR Analysis

39. Transfer Pricing Audit Process

40. Identification of Intra Group Transactions A Selection of most appropriate method FAR Analysis Determination of ALP Identification of comparable transactions Adjustments Documentation Establishing Comparability, Adjustment for material differences Report Filling A

41. Identification of Intra Group Transactions: • Business operations of the company should be analysed and a brief summary should be prepared. • The company is the ‘TESTED PARTY’ for the purpose of Transfer Pricing Review Process. T • The company’s relevant cross border transactions with AE should be identified and briefly described.

42. FAR Analysis: • A brief functional analysis should be prepared exhibiting functions performed, risks assumed and assets deployed by the participating entities. • A preliminary search was performed for ‘potentially comparable’, uncontrolled transactions’.

43. Identification of comparable transactions: For identifying comparable transactions, one must understand what comparability is. Comparability means • Comparisons of conditions of taxpayer’s relations with those of independents. • Comparability is wider than just a search for (external) comparable or than a mere systematic comparison of financial information. • But it is more emphasis on quality and reasonableness

44. One must satisfy five comparability factors • Five factors determining comparability: • Characteristics of property or services • Functional analysis (functions performed, assets used, risks assumed) • Contractual terms • Economic circumstances • Business strategies

45. Some other points are also kept in mind such as: • Recognition of the actual transactions undertaken • Evaluation of separate and combined transactions • Use of an arm's length range • Use of multiple year data • Losses • The effect of government policies • Intentional set-offs • Use of customs valuations • Use of transfer pricing methods

46. Establishing Comparability, Adjustment for material differences For establishing comparability, 10 steps of search process are essential to follow: Step 1: Broad based analysis (e.g. industry analysis, analysis of value drivers…) Step 2: Determination of years to be covered Step 3: Review of the controlled transaction(s) in order to identify the relevant factors that will influence both the selection of the appropriate transfer pricing method(s) and the comparability analysis Step 4:Review of existing internal comparable. Where necessary, decision to look for external ones. Step 5:Determination of available sources of information (including, but not limited to, commercial databases) and of their reliability

47. Step 6: Selection of the relevant transfer pricing method(s) and definition of the relevant indicia (e.g. what net margin indicator in case of a TNMM). Step 7: Identification of potential comparables: defining the key characteristics to be met by any uncontrolled transactions to be potentially comparable, on the basis of the relevant factors identified under step 3 and in accordance with the comparability standard established under paragraphs 1.19 to 1.35 of the TP Guidelines Step 8: Determination of and making comparability adjustments, where and as needed (comparison of taxpayer’s profits with profits which would have accrued at arm’s Length) Step 9: Interpretation and use of data, determination of the arm’s length remuneration. Step 10: Implement support process. Install review process to ensure adjustment for material changes and document these processes

48. Selection of most appropriate method • The Regulations identify five transfer-pricing methods; 1. COMPARABLE UNCONTROLLED PRICE (‘CUP’) METHOD 2. RESALE PRICE METHOD 3. COST PRICE METHOD, 4. PROFIT SPILT METHOD 5. TRANSACTIONAL NET MARGIN METHOD • Section 92C read with RULE 10C provides no priority of methods. Rather, the selection of the pricing method to be used to test the arm’s length character of a controlled transaction must be made under the “MOST APPROPRIATE/ BEST METHOD RULE”.

49. The ‘best method’ is that method which, under the facts and circumstances of the transaction under review, provides the most reliable measure of an arm’s length result. • Completeness and accuracy of data, reliability of assumption and the sensitivity of the results for possible deficiencies in the data/ assumptions are some of the key factors to be kept in mind while determining and documenting the most appropriate method.

50. Determination of ALP • The Indian Regulations, which have to a great extent have been adopted from OECD Guidelines, require that income arising from international transactions between ‘associated enterprises’ be computed having regard to the arm’s length price. • Compliance with the arm’s length principle can be established by showing that the conditions of the controlled transaction are consistent with those actually made in comparable transactions between independent enterprises under comparable circumstances ( ‘comparable uncontrolled transactions’).