Ernst

1
Transfer Pricing A Global Update India
perspective CA. Anuj Khorana
June 23, 2007
2
Outline
Transfer Pricing in India
India Audit Experience
Key Points to Take Away!
3
Global Trends
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Transfer Pricing The Most Important Tax Issue

• Overall
• TP continues to be, and will remain, the most
  important tax issue facing Multinational
  Enterprises (MNEs)
• More and more countries have introduced
  comprehensive documentation and penalty
  regulations
• Increasingly aggressive audit environment
• Increasing questioning and data gathering for
  in-depth scrutiny
• Recruiting and training of specialist resources
  to examine more complex transactions
• Increasing level of cross country co-operation
  among tax authorities in audits

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Global Trends Changing Approaches

• Changing Environment
• New wave of entrants to enforcement of transfer
  pricing
• Old guard making significant changes to
  approaches
• Trends
• In principle acceptance of arms length
  principle on a consistent basis with Organization
  for Economic Co-operation and Development (OECD)
  norms and guidelines
• However, Major divergence of approaches in
  practice (e.g. multiple year data, adjustments,
  etc)
• Threatens resolution of bilateral disputes (MAP
  proceedings) and increases risk of economic
  double taxation
• Increase in number of cases going for litigation

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Legislative Overview

• Legislation introduced with effect from April 1,
  2001
• Built on OECD Guidelines, but with significant
  deviations
• Provisions applicable only if
• Their is an international transaction(s) defined
  in Sec 92B between
• Two or more Associated enterprises defined in
  Sec 92A.
• Exceptions
• Provisions do not apply in certain cases Section
  92(3)
• Deeming provisions Section 92B(2)
• Transaction between an enterprise and a person
  (other than an associated enterprise) shall be
  deemed to be a transaction between two associated
  enterprises, if there exists a prior agreement or
  the terms of such a international transaction are
  in substance determined between one of these
  entities and the associated enterprise of the
  other contracting entity.

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Key requirements of Indian TP Regulations

• Computation of Arms length price by applying the
  most appropriate method out of
• Comparable Uncontrolled Price (CUP)
• Resale Price Method (RPM)
• Cost Plus Method (CPM)
• Transaction Net Margin Method (TNMM)
• Profit Split Method (PSM)
• Mandatory contemporaneous documentation
  requirements
• Documentation requirements
• The statute requires information / documents in
  relation to an international transaction to be
• kept and maintained in by every person
• List of documents prescribed in Rule 10D
• kept and maintained for a prescribed time 8
  years
• furnished within 30 / 60 days of Revenues
  request.
• Stringent Penal Consequences on Non-compliance /
  TP adjustments

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India Audit Experience
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A Nationwide Overview

• Separate administrative structure with specialist
  Transfer Pricing Officers (TPOs) created for TP
  audits
• Taxpayers with related party transactions in
  excess of approximately INR 15 crores in value
  subject to compulsory audit
• Transfer pricing audits for the financial years
  ended March 31, 2002, March 31, 2003, March 31,
  2004 have been concluded
• Audits intensive in IT, Pharmaceuticals,
  Financial services, Automobiles and Chemicals
  Sector
• Not many cases of penalty enforcement
• Absence of APA/ Transfer Pricing Rulings

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Experience in New Delhi
Increase in cases picked up for scrutiny and the
quantum of adjustment
1,200
1,000
1,000
800
700
(Rs. crores)
Value of TP adjustment
600
400
290
125
90
200
cases
60
cases
cases
-
AY 2004-05
AY 2003-04
AY 2002-03
TP Adjustment (in value)
Trend - Value of TP adjustment
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TP Audits - Key experiences

• Loss making/ low margin companies (e.g. White
  goods manufacturer / distributor)
• Cost plus service companies with low mark-up
• Indian Companies of Big Global brands
• Marketing Expenditure Support from Associated
  Enterprise
• Application of deeming provisions u/s 92B(2) of
  IT Act
• Use of un-reliable internal / external data for
  CUP analysis (like SVB Custom valuations)
• Companies paying Technical know-how/ Royalty/
  Management fee (Benefits test)

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TP Audits General Observations

• Cherry picking of comparables exclusion of
  loss making low turnover comparables
• Comparables used in preceding year, tested for
  current year even if they fail to meet
  comparability criteria, or non information was
  available at the time of search
• Use of Single year or Current year data by
  TPOs as against multiple year data used by
  taxpayer
• Disregarded transaction wise analysis in case of
  low profit/ loss at net margin on a company
  wide level
• Dispute on allocation of common costs in case
  of segmental data in TP analysis
• Application of CUP method using comparative
  prices of localised vis-à-vis Import price

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.General Observations (Contd.)

• Use of the 5 range
• Tax payer granted the option of using a 5 range
  from arithmetic mean in determining arms length
  price.
• Where transaction price is outside the range, the
  TPOs determine quantum of adjustment upto the
  arithmetic mean and not the lower end of the 5
  range.
• Held to be a safe harbour provision and not a
  standard deduction.
• Denial of adjustments for Functional, Risk and
  Asset differences between tested party and
  comparables
• Inventory Adjustments (e.g. - Agent vs. Trader)
• Risk Adjustments
• Market differences (Local tested party vs.
  foreign comparables)
• Working capital adjustments (for differences in
  debtors / creditors)

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Managing Challenges Future Outlook
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Expected Changes / Guidance

• Criteria for selecting taxpayers for audit
• Application of a more scientific screening
  process instead of a monetary threshold
• Statistical methods
• Use of IQ range, median etc instead of mean / 5
  range
• More detailed guidance on specific TP issues
• Aggregation of transactions, Services,
  Intangibles transactions
• Guidance on collateral consequences of TP
  adjustments
• Compensating adjustments, set-offs, correlative
  relief, secondary adjustments
• Improving dispute resolution process
• Improving effectiveness of MAP, introduction of
  APAs

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Managing TP Risks

• Need for comprehensive documentation for all
  inter-company transactions
• Increased pressure for comparability analysis
  based on local comparables
• Exceptions to global transfer pricing policy /
  common structures may be required
• Review of existing supply chain structures from a
  PE exposure / Income Attribution perspective
• Full range of dispute resolution mechanisms such
  as MAP could be considered for large TP disputes

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Key Points to Take Away
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Key Points to Take Away

• TP audit proceedings
• Perform risk Assessment
• Involve professional advisor at early stage
• Provide best defense strategy
• Maintain high and visible standards of good faith
• TP disputes
• Consider alternative dispute resolution process

• Maintain proper documentation
• Annual economic analysis update
• Evaluate whether mark-up needs to be enhanced
  based on impact assessment and current trends

• Assess the impact of the change in mark-up/
  true-up adjustment on
• Global TP policy
• Tax holiday and
• Profit accumulation in India

• Consider the manner in which the change should be
  reflected
• Change in inter-company Agreement
• Limited to a true-up adjustment in the financial
  statements
• Adjustment only in tax returns

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THANK YOU
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The Most Important Tax Issues
0 10 20 30 40

• 43 of European and 49 of Asian-Pacific
  respondents identified transfer pricing as the
  most important tax issue facing their organization

Source Ernst Young Global Transfer Pricing
Survey 2005-06
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Global Growth in Importance
Source Ernst Young Global Transfer Pricing
Survey 2005-06
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AsiaPacific Transfer Pricing Growth in
Importance
0 10 20 30 40 50 60

• Result for AsiaPacific parent company
  respondents is very similar to the global result
  for 2005

Source Ernst Young Global Transfer Pricing
Survey 2005-06
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Major World Economies with Effective
Documentation Rules
6 Countries
7 Countries
20 Countries
25 Countries
31 Countries
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Country Updates

• United States
• Introduced on July 31, 2006 temporary regulations
  on Inter-company services transactions and
  allocation of income from intangibles. Key
  features of the new regulations are
• Evaluates arms length price for certain
  covered services using total Services Costs
  either with no markup or low median comparable
  mark-up of 7
• Examples of covered services
• Payroll and processing certain benefits payments
• Processing accounts receivable and payable
  (bookkeeping)
• General administrative ministerial and clerical
  tasks
• Public relations preparation and dissemination
  of corporate communications, but not public
  relations strategy
• Meeting coordination
• Accounting and audit compliance
• Tax paying tax and processing returns, but not
  tax planning
• Compliance regulatory, licenses and permits

Evaluates the economic benefits of services
availed by the buyer in the entire supply chain
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Country Updates

• Singapore
• Introduced Transfer pricing guidelines in
  February 2006. Salient features are
• General acceptance to arms length principle
  outlined in OECD guidelines
• Provision of APA / MAP mechanism to minimize /
  eliminate economic double taxation (detailed
  guidelines yet to be issued)
• Acceptance of 5 mark-up for inter-company
  services, provided routine and non-core in
  nature
• Interest-free loans by Singaporean to affiliates
  will be subject to TP review
• France
• Released new instructions and transfer pricing
  guidelines on November 28, 2006, on a simplified
  APA procedure for small and medium-size
  companies
• Provides for a special cell at the tax
  authorities to assist small and medium companies
  in functional analysis, selection of the
  appropriate transfer pricing method, and, the
  performance of the benchmarking exercise (at the
  request of taxpayer)
• Eligibility criteria of such companies /
  taxpayers fewer than 250 employees, revenue
  below 50 million, and assets below 43 million.
  Moreover, the French company must not be owned
  more than 25 percent by a company exceeding the
  criteria above
• Relaxation of APA submission for small and
  medium-size groups.

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Country Updates

• Malaysia
• 2007 Budget provisions proposes to allows
  taxpayers to request for an advance ruling
  (including advance pricing agreements) from the
  tax authorities on the application of Income-tax/
  TP provisions on transactions with related
  parties.
• Hungary
• Advance Pricing Agreements (APA)
• Effective January 1, 2007, the Hungarian tax
  authority has prescribed APAs for establishment
  of arms-length price of future transactions
  covering both unilateral and multilateral
  arrangements
• An APA request should include the
  countersignature of certified experts
• APA would be binding under unchanged conditions
  for 3 to 5 years and can be extended once for an
  additional 3 years.
• Centralized Audit Systems
• Introduced a new centralized audit system to
  focus on sophisticated transfer pricing
  documentation.

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Associated Enterprises Some considerations

• Very wide definition and includes enterprises
  economically related
• Where one entity or one or more persons, directly
  or indirectly, or through one or more
  intermediaries, participates in the management or
  control or capital of the other enterprise (26
  criteria)
• Where Loan provided by one enterprise constitutes
  51 of the assets of the other enterprise.
• Where one entity is wholly dependent on the
  intangibles provided by the other entity.
• Where one entity buys 90 or more, of its raw
  materials from the other enterprise.
• Where one entity sells goods / services to the
  other entity and is in a position to influence
  the price.
• Where one entity stands guarantee for the other
  entity and the guarantee amount is more than 10
  of the total borrowings of the other enterprise.
• Definition of Associated Enterprise also includes
  a permanent establishment

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Documentation Rule 10D