Category Archives: International taxation

Domestic Transfer Pricing; a new Tax Compliance Requirement

Indian finance act of 2012 with effect from financial year 2013-14, introduced a new tax law compliance requirement in relation to transaction between group companies. According to which two domestic companies under the same management or under common control ( Associated enterprises)  do transaction aggregating five crore rupees in a year, is required to comply  with the following;-

(a)Ensure the value of transaction is at arms – length price as per the method prescribe by income tax act 1961, b) maintain and keep information and documents in relating to such transaction as statutorily required, c) obtain and file an accountant’s  report in respect of such transaction along with return of Income.

This amendment to the income tax act was caused to be made in accordance of Supreme court judgement , in CIT Vs Glaxo Smith Kline  Asia Pvt Ltd.(2010)195 Taxman 35 SC.  In this judgement, Supreme court addressed the issue whether transfer pricing regulation should be limited to cross border transaction, or that to be extended to domestic transaction as well. Supreme Court noticed that even in certain domestic transaction, the under invoicing of sale and over invoicing of expenses in certain circumstance create tax arbitrage. For example-by under invoicing of sale and over invoicing of expenses they could save tax a) if one of the related company is loss making, and other is profit making concern, b) if the tax rates are different from two related units, on account of different status and if profit is diverted to towards the unit of lower side of arbitrage, for example;- sale of goods and services from a non special economic zone(SEZ) areas,(Taxable unit ) to SEZ unit(non taxable unit),at a price below the market price so that taxable division will have less profit taxable, and non taxable division will have a higher profit exemption. Citing these two instances, Supreme Court  has suggested making amendments  to income tax act incorporating domestic transfer pricing provisions.

The amendment made to income tax act by finance act 2012 is based on the recommendation of Supreme Court. The finance act 2012 introduced section 92BA ,  40 A, 80 A, , 10 AA , 80 IA etc to the income tax Act

Based on this amendment transaction between two related domestic  parties ( it could e companies, individuals,  firm ) if they transact each other should ensure that, the transaction is at arms length price.   The method of arms length price determination are same as that applicable to international transaction between associated enterprises.

Internationally countries like UK, Malaysia, Ireland, Peru, Hong Kong, Norway and Russia had similar provisions in their tax laws.  The new amendment to the Income tax act is definitely  create additional tax revenue. However, the implementation of the same will definitely open up another window for litigation and friction between tax officers and assesses;  unless we have more standardization  and better approved processes in determination of arms length price.  Arms length price determination should not be left at whims and fancies of the tax officers.

By: Rajesh Vellakkat

 

 

Transfer Pricing- Safe Harbour Rule notified

Transfer pricing disputes are increasing these days. To avoid legal disputes between companies and tax department,  the Finance Act, 2009 had introduced the concept called safe harbour rules. This gives certainty in determination of arms length price for international transactions. Section 92 CB of the income tax act empowers the central board of direct taxes the power to make such safe harbour rules. Safe harbour means circumstances in which income tax authorities shall accept a transfer prize (arms length prize decided by the assessee). However, till recently the safe harbour rules were not notified by the Government.  Some time back Government appointed a committee headed by Mr. N. Rangachari to address the concerns of industry in this regard and suggest appropriate policy.  The committee made its recommendation and based on which the government of India on 18th September 2013 notified safe harbour rules. This rule is applicable from assessment year 2013-2014  onwards and is applicable for the next five assessment years.

An assesses can opt for safe harbour regime for a period of his choice but not exceeding five years. This option can be exercised filing of form 3CEFA. As per this rules for IT and IT enabled companies if  the aggregate transactions entered in to during the provisions year if doesn’t exceed a sum of 500 crores the safe Harbour declared  is (operating profit margin) not less than 20%  and  similarly  if the transaction value is above 500 crores then the operating profit margin ( safe harbour margin ) is not less than 22%. If a company declares profit margin as above, those transaction will be considered as arms length transaction. Similarly for knowledge process outsourcing industry margin stipulated is 25%. Depending on the kind of corporate guarantee given to the associate enterprise, if the commission of fee in relation to the guarantee is in the range of 1.75% – 2% of the amount guaranteed, such transactions are considered at arms length. Incase of contract research and development services relating to the software development the margin required is 30% and for research and development services relating to pharmaceutical process it is 29%.

On receipt of form 3CEFA the assessing officers shall verify whether the assesses exercising the options is an eligible assessee and whether the international transaction is an eligible transaction. Transfer pricing officer has the right to ask for more information and evidence and transfer pricing officer has the authority to declare that transfer pricing position declared by the assessee as invalid.

The new initiative of the income tax department would definitely help to reduce the transfer pricing litigation in future. It is worthwhile to mention here that total transfer pricing litigation is valued NR 60000 crores, according to some sources (not verified by the author). It would be appropriate if associated enterprises make use of the benefits of this new provision to avoid future tax litigation.

By: Rajesh Vellakkat

UNITED NATIONS TRANSFER PRICING MANUAL FOR DEVELOPING COUNTRIES AND INDIAN VIEW POINT

When two related parties (parent & subsidiary, group companies or companies under the same management) located in two different countries transact with each other, they are expected that those transaction be at an arm’s length price. The intent of this rule is to prevent companies from siphoning the profits from one territory at the cost of the other related entities and using this as a tool to reduce the tax burden by inflating the profits of the company located in a country where tax rates are less.The documentation that companies have to do, the method and manner of transaction with related enterprise are made by organisation for Organisation for Economic Co-operation and Development. (OECD). OECD is an organisation mainly dominated by developed economies. Brazil, India China and South Africa and other developing economies are not the part of this organisation. OECD guidelines on transfer pricing is thus more developed countries-focused. The developing countries including India were not comfortable with the same. Recently, Department of Economic and Social Affairs of the United Nations issued a practical manual on transfer pricing for developing nations. Chapter X of the said manual outlines individual countries point of view. India has expressed its point and same is the part of this manual. The following are the main view points of India.

Indian transfer pricing regulations are based on arm’s length principle, thus income arising from international transaction between associated enterprises shall be computed based on arm’s length price. For determination of arm’s length price few methods are prescribed:

  • Comparable price control method
  • Re-sale price method
  • Cost Plus price method
  • Transaction price method
  • Profit-split method

Indian transfer pricing regulations do not provide any hierarchy of methods and do not recommend any most appropriate method. Indian transfer pricing regulations prescribe mandatory annual audit and maintenance of documentation by a tax payer who is doing international transaction. The onus of proving arm’s length price of the transaction lies with the tax payer. The Income Tax department has a specialised directorate of transfer pricing to administer transfer pricing rules.

In recent years the tax litigation related to transfer pricing has increased manifold. The primary issue on all these tax litigation is the appropriateness of the method used for achieving arm’s length price. The uniqueness of every international transaction, increased market volatility, lack of comparable data are some of the challenges for determination of arm’s length price. Indian transfer pricing stipulates that data to be used in analysing the comparability of an uncontrolled transaction with an international transaction should be the data related to financial year in which an international transaction has been entered into. However, this rule has created many practical issues. Availability of comparable data when audit is to be conducted is a real challenge.

While determining the arm’s length price, the risk taken by the entity is the major factor. Multi-national entities while dealing with transfer pricing issues have a practice to argue that the risk of the business is with the foreign entity. Hence, it is justified in having a higher margin in relevant transaction to that of the foreign entity. But the Indian tax department believes that the risk of a multi-national enterprise is a by-product of ownership and is not an independent element. Therefore, an argument of multi-national enterprise that their contract research and development center in India is a risk-free entity and entitled to only low cost plus remuneration is not favoured by the tax department.

Indian tax department believes that if the core functions of research and development service are located in India, then, the Indian entity is exercising control on the operations and associated risk. Hence, allocation of risk to parent company is illogical and not accepted. Indian tax authorities believe that returns filed by Indian entities based on cost plus method will not reflect the true arm’s length price of the transaction.

As stated earlier, the onus of proving the accurate comparability of the price is on the tax payer. Therefore, mere claim of risk adjustment in favour of foreign entity without sufficient documentary support would not suffice. Indian tax department believe that locational saving is one of the factors to be considered for comparability analysis. The operational advantages, low labour cost, material cost, rent, infrastructure cost, tax incentives, etc. gives an incremental profit to the multi-national enterprises. This incremental profit is in short referred as location rents. Indian tax department consider that location savings and rents should also be considered to arrive arms length price. The transfer pricing administration believes that it is appropriate to have profit-split method to determine arm’s length allocation of location savings and rent. It says that arm’s length compensation for location savings should be distributed to benefit both the parties of the transaction and there must be an appropriate split of cost saving between the parties.

Indian tax department’s point of view on intangibles have a huge relevance in present day context as the world royalty and world licensing receipts are over $200 billion. The arm’s length price of the royalty allocation, cost of development of market, branding in a new country, remuneration for marketing, research and development of intangibles and co-branding cost are the factors in considering the arm’s length price.

With regard to payment of royalties for use of trademark, design and technology between parent and subsidiary, the rate of royalty is a challenge in determination of arm’s length price. Indian tax department’s view is that it is impossible to find comparable arm’s length price for such transactions. Income tax department believe that if a subsidiary has borne the cost of developing the market and made expenses on marketing and enhancement of brand value in its territory, then the subsidiary should get compensation on arms length on such cost.

Income tax department will also consider the value of Indian entity’s research and development efforts while determining arm’s length price of royalty for use of technical knowledge. When an Indian subsidiary is established for research and development on contract basis and uses cost plus mark up method for arriving arm’s length price stating that risk associated are with the parent company, at the same time if claim of controlling risk of core function of research and development with the parent entity are not documented and such claims are not justified. On most occasions monitoring the research and development activities were also carried out by Indian subsidiaries. So, mere reason that the funds for research and development activities are transferred from multi-national enterprises will not solely justify a higher allocation of margin favoring parent entity.

Income tax department believes that the assets of a business include capital and technically skilled manpower, know-how, etc., and capital contribution should not get a higher relevance. According to income tax department, risks are distributed between the enterprises and therefore, a cost plus method is not an appropriate method. Income tax department’s view is that transfer of legal ownership of intangibles under a contract by an Indian entity in favour of a parent company are in most cases without any appropriate compensation and an additional arm’s length compensation to be determined in such instances. Similarly, the effort of an Indian entity in marketing the intangible like brand, trademark in Indian market, creating product royalty in minds of the customer, creation of effective supply chain, distribution network, after sale service, etc., to be quantified while arriving arm’s length price. The normal practice of cost plus method is not favoured in such instances. Advertising, marketing and promotion expenditure if borne by Indian entity, while the ownership of those brands and trademark are with the parent entity, then in such cases reimbursement cost of excess arm’s length price along with mark up should be considered. While calculating arm’s length price or profit-split method should be adopted in these cases.

Increase of intra-group services between associated enterprises such as technical support is required have an arm’s length price computation. Income tax department have noticed that parent entities generally do not allow any profit mark-up on services rendered by Indian companies to them. On the other hand, where Indian companies receive intra-group services from the parent company, it often charges mark-up on all these services. It is also noticed that in many such claims of rendering services to be found incorrect, income tax department consider this as a high risk area and discourage all such malpractices.

Inter-company loans and terms of such loan is another transfer pricing issue that the income tax department is not favoring along with the practice of Indian parent company advancing loans to its foreign entities at LIBOR and EURIBOR rates. Indian transfer pricing authorities’ believe all should be at prime lending rates of Indian banks. Similarly, guarantees extended to foreign entities abroad where the Indian parent company is a guarantor. In such cases, income tax department says an arm’s length price to be determined on such guarantees.

These are some of the views of income tax department on transfer pricing issues reflected in the UN manual. While critically looking into the views, the effort of Indian tax administration to determine an appropriate arm’s length price at location rents and other territorial advantages should be applauded in the perspective of the state treasury. However, this would certainly nullify the investment attractiveness of India and I am worried that it would result in less foreign investment in this country.

We advise to all multi-national enterprises to consider all these view points while doing documentation on transfer pricing so that disputes can be avoided.