Practical Issues in Transfer Pricing Assessments

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

2. 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

3. Global & Indian Trends

4. Global trends • Any related party transaction undertaken from 1st April 2001 onwards covered • Currently 60% of world’s 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!

5. Enhanced audit exposure • Percentage of completed scrutiny assessments resulting in an adjustment (E & Y Survey)

6. E&Y 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

7. 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!

8. Composition of references received in Mumbai- AY 2002-03* * Source Mr Srinivasulu’s presentation on 26th June 2004 IFA presentation

9. Analysis of references received* * Source Mr Srinivasulu’s presentation on 26th June 2004 IFA presentation

10. T P Assessment: The process & administrative structure

11. Transfer pricing audit selection process • Cases with international transactions > 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!

12. TP asst process- at macro level AO(Assessing officer) to refer to TPO (Transfer pricing officer) if value of International transaction> 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 TPO’s order in the assessment order Time frame internationally to frame TP asst- 2 to 5 yrs! In India- only 1 yr!

13. TP asst process- at operational level TPO will review tax payer’s documentation TPO will make further enquiries ? ? Does the TPO agree with the arm’s length analysis No Yes Taxpayer given an opportunity to show cause to TPO’s 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 taxpayer’s contention ? No Yes ?

14. 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

15. TP Administration Structure DGIT, International Taxation Director of Income-tax, Transfer Pricing (Each location) TPO I TPO II TPO III Additional Commissioner of Income-tax Additional Commissioner of Income-tax Additional Commissioner of Income-tax Support staff

16. 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

17. Revenue approach & perspective – specific industry overview

18. 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!

19. 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 CUP’s 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

20. 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 %

21. 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

22. 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!

23. 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)

24. 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

25. Manufacturing – a live case study Approach & analysis: • Even operating margins need to be compared with job workers & not other full fledged manufacturer • Assessee’s margins commensurate with such job workers • Huge idle capacity due to overall slack sales & stiff competition • Demonstrated idle capacity based on expert’s 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 Co’s purchases from Indian Co constituted a small proportion • US Co assessed to tax in US @ 35%

26. 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 AE’s within the MNC • Benchmarking Royalty rates • Overseas • Ten-K Wizard, • Disclosure Inc’s 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

27. 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

28. 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

29. 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

30. Intra Group Services • Precise nature of services supplied? • Does the recipient benefit from the services? • Mere fact that the mark up meets with the arm’s 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 arm’s 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

31. Selection of Most Appropriate Method in practice

32. 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 AE’s 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

33. 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

34. 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

35. Establishing Most Appropriate Method Methods Functions CUP: Comparable Uncontrolled Price TNMM: Transactional Net Margin Method

36. Critical Issues Encountered

37. Use of foreign database / comparables • Indian IRS prefers benchmarking on Indian database even if the “tested party” is an Overseas AE! • Revenue perspective • Assessee’s 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!

38. Arm’s length range • Use of Arm’s 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 arm’s length price?

39. 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

40. 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!?

41. 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!

42. Way forward…

43. 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 AE’s 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

44. Thank You ? Queries Narayan Mehta Tel: +91 22 22821141 Mobile: +91 9820544495 E-Mail: narayan.mehta@skparekh.com