Key Transfer Pricing Controversies · provision of contract software development • Beta carries...

Key Transfer Pricing

Controversies

Shuchi Ray & Neha Arora, 14 March 2015

1

• Transfer Pricing Litigation Scenario

• Location Savings

• Valuation of shares

• Loans & Guarantees

• AMP

• Management Charges

Contents

© 2015 Deloitte Haskins & Sells LLP 2

Transfer Pricing

Litigation Scenario


• Ten years of TP audit completed – trends indicate greater scrutiny, ever increasing adjustments and

resultant litigation

• Approx 50% of cases picked up for audit adjusted by tax department

Trend of transfer pricing adjustment:

• About 1,200 transfer pricing cases disposed of by various Tribunals

• In less than 30% of cases, department’s position upheld by ITAT

India transfer pricing landscape – story so far

0

2000

4000

6000

8000

10000

12000

14000

16000

18000

2004-052005-062006-072007-082008-092009-102010-112011-122012-13

No of adjustmentcases

Amount of adjustment(USD in million)


Traditional dispute resolution mechanism and

outcome

5

9 months Varies;

normally 2

years

To be

completed by

November 30

Con

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cte

d b

y in

de

pe

ndent

jud

icia

ry

Con

du

cte

d b

y m

em

bers

of th

e

Ind

ian

reve

nu

e

Ma

y c

um

ula

tive

ly ta

ke

8 y

ea

rs

Tax Return/TP Documentation

Assessment 36/48 months

from financial

year

CIT(A) Dispute

Resolution Panel

ITAT

High Court

Supreme Court

Entire

process

takes

more

than 15

years

62% 11%

17%

10%

Analysis of 1230 no. of ITAT cases

Partly in

favour of

taxpayer and

revenue

Remanded

back for fresh

adjudication

In favour of

taxpayer

In favour of

revenue

© 2015 Deloitte Haskins & Sells LLP

Key Controversies – Traditional issues

Returns/ Mark-ups for services

Choice of the Most Appropriate Method

Selection of tested party

Economic adjustments

Application of quantitative filters

6

Key Controversies – Next wave

Intra Group and Management services

Attribution of Profits to Permanent Establishment

Financial Transactions including guarantees, inter-company loans

Intangibles – Brand and AMP issues

Imputation of interest on outstanding receivables

Location Savings

7 Every year new surprises arrive from Tax Office ….change is constant !

Location Savings

8 © 2015 Deloitte Haskins & Sells LLP

Name of Company Alpha Beta

Country A B

Activities - Pre

business

restructuring

• Business of providing software development services and

products to third parties globally

• Provides funds / capital and other significant assets

including intangibles for R&D development to Beta

• Controls and supervises activities of Beta

• Responsible for all the risks associated with R&D

• Legal and economic owner of the intangibles which are

developed during the course of research by Beta

• Engaged in the business of

provision of contract software

development

• Beta carries out research based on

the guidelines and framework

provided by Alpha

• Works under the direct supervision

of Alpha

Labour Costs High Significantly lower

Qualification • Highly skilled professionals, consisting of product

development team and management team

Graduates

Remuneration

model

• Beta is remunerated on a cost plus mark up basis in line

with its functional profile

• Thereafter, the residual profits belongs to Alpha being an

entrepreneurial entity

• Beta is characterised as a limited

risk service provider remunerated

on cost plus 15% mark-up basis

Illustration (1) - Location savings and intangibles

Facts of the case

9

• Tax authorities of Country B alleged that Beta was engaged in R&D activities, a high end

activity in the area of software development

• The cost plus 15% model does not reflect the economic realities and Beta should also be

compensated for the intangibles generated from its R&D activities

• Tax authorities applied PSM while noting the following:

- Economic ownership of the R&D intangibles is with Beta and not with Alpha;

- Both parties perform complex interrelated functions

- Beta creates unique intangibles

• Assumed 50% of the profits (earned by Alpha) attributable to the R&D Activities

• Head count was used as an allocation key to determine the profits attributable to Beta for

its software R&D activities


Analysis of the facts

10

Illustration

Consolidated Financials

Global Profits from sale of software 600

Tax authorities proposed adjustment based on profit split method

Profit attributable to R&D activities @ 50% of global

profits (A) 300

Worldwide R&D head count (B) 1000

Country B's R&D head count (C) 150

Profits attributable to Country B's R&D operations

(A*C/B) 45

Profit under contract R&D model (on cost +15%) 15


11

Name of Company Alpha Beta

Country A B

Business activities • Manufactures and sells various

products globally

• Owns intangibles related to

technology and brand name

• Entitled to residual profits in

the system

• Manufactures and sells product ‘X’ to

Alpha as a captive unit

• Does not own non-routine

intangibles

• Operates in a perfectly competitive

environment

• Is compensated at cost plus 15%

mark up as against local comparable

margin of 12%

Labor Costs High Lower

Illustration – (2) – Location savings on account of

labour costs: Facts of the case

12

• Tax authorities alleged that group has derived locational advantages in Country B by

having manufacturing facility for product X

• Proposes that Beta has not received any compensation for location savings in relation to

exports primarily centered around lower labour costs

• Makes and adjustment based on labour cost differential

• Benefit attributed in the ratio of 50:50 between Alpha and Beta

Illustration (2) – Location savings on account of

labour costs

13

Illustration (2) – Location savings on account of

labour costs

14

Particulars Total Cost (A) No of

Employees (B)

Cost per

employee (INR)

(A/B)

Cost of employees in Country A USD 2000 mn 25,000 4,800,000

Cost of employees in Country B INR 100 mn 250 400,000

Difference (C) 4,400,000

Value of adjustment (D= C x number of

Employees in Country B) 1,100,000,000

Savings allocated to Beta in ratio of

50:50

550,000,000

Facts

• Li & Fung India P. Ltd. ("the taxpayer”) is a part of Li & Fung Group, which had worldwide network in export trading. The taxpayer rendered ‘buying services’ to its AE, for sourcing of garments/handicrafts/leather products, etc. from India

• The taxpayer claimed that TNMM with cost plus 5% remuneration to be most appropriate method for determination of ALP. However, the AE was receiving remuneration from third parties at 5% on FOB value of export of sourced products

• Mark-up of 5% on the FOB value of goods exported was held to be the appropriate ALP by the tax authorities

• The tax authority re-characterised the taxpayer as performing critical functions, assuming significant risks, developed supply chain management, developed human capital intangible and passing location saving advantages to it’s AE

Li & Fung (India) Pvt. Ltd

Issues before the Delhi Tribunal

• Whether PLI based on sourcing cost plus mark-up or as a percentage of commission on FOB value of goods was the most appropriate method to remunerate taxpayer on an arm’s length basis?

Observations and ruling of the Delhi Tribunal

• Remuneration received by the taxpayer at cost plus mark up of 5% was not arm’s length

• All the critical functions were performed by the taxpayer and AE did not have technical capacity and manpower to support the taxpayer

• India offered both cost and operational advantages. But, such locational advantage was not considered in pricing by the AE

• Distribution of compensation @5% of FOB should be split between AE and taxpayer in the ration of 80:20

Ruling of the Delhi High Court

• Taxpayer’s net profit margin from an international transaction has to be calculated solely with reference to the costs incurred by it and not with reference to the costs incurred by any other third party vendor or its overseas AE

Li & Fung (India) Pvt. Ltd

Facts

• GAP International Sourcing (India) Pvt. Ltd. ("the taxpayer") was a wholly owned subsidiary of GAP International Sourcing Inc., USA ("AE") facilitating sourcing of apparel merchandise from India for the Group

• The taxpayer claimed that TNMM with cost plus 15% remuneration to be the most appropriate method for determination of ALP

• The authority view was that the taxpayer:

− Played a critical role in the AE’s value chain;

− Undertook “high value” procurement functions; and

− Owned “procurement intangibles.”

• The tax authority asserted that “location savings” arising from sourcing from a low-cost country such as India was not factored in the cost plus 15% compensation

• The authority held that commission of 5% on the Free-on-Board (“FOB”) value of goods sourced by the foreign enterprise through Indian vendors was ALP

Large Clothing Retailer – Pro taxpayer

Issues before the Delhi Tribunal

• In addition to the previous example – whether the taxpayer’s case is covered by the judgment given by the Delhi Tribunal in case of Li & Fung India Pvt. Ltd

Observations and ruling of the Delhi Tribunal

• Upheld the characterisation of the taxpayer as a routine service provider and observed that its activities did not result in creation or development of procurement related intangibles

• Acknowledged that location savings is generally passed on to the end customer in a competitive market

• Mentioned that the question of allocation truly needs to be addressed in light of the relative bargaining powers/intangible ownership

• Did not observe any distinctive competitive advantage vis-à-vis other sourcing companies which could have led to taxpayer wielding significant bargaining power

• Location specific savings, if any, would be captured in the profitability of the comparables used for benchmarking the international transaction. Accordingly, no separate allocation is called for on account of locational savings

• Observed functional difference with Li &Fung and rejected comparison

Large Clothing Retailer – Pro taxpayer

Facts

• Watson Pharma (taxpayer) was engaged in rendition of contract manufacturing and

contract Research and Development (‘R&D’) services to its AEs.

• The taxpayer used the transactional net margin method (‘TNMM’) to benchmark the said

transactions.

• While the Indian tax authorities accepted the use of TNMM, they purported that the tax

payer should additionally receive extra compensation on account of the location savings

that have arisen pursuant to the AE transferring the manufacturing activity from UK and

other European countries to a low cost jurisdiction (i.e., India).

Watson Pharma (India) Private Limited

Observations and ruling of the Mumbai Tribunal

• While observing the overall bargaining power, options realistically available and the

general market competition, the Tribunal noted that the tax payer and the AE, both,

operated in a perfectly competitive market.

• The Tribunal, following the ruling in the case of GAP International Sourcing (India) Pvt.

Ltd., held that location savings( if any) would be reflected in the profitability earned by the

local comparables (operating in similar economic circumstances as the taxpayer) which

are used for benchmarking the international transactions. Hence, no separate

compensation is called for on account of such location savings.

• The Tribunal mentioned about India’s participation as a part of G20. It categorically stated

the position which G20 countries have concurred upon on the pertinent matter - “where

reliable local market comparables are available and can be used to identify arm's length

prices, specific comparability adjustments for location savings should not be required”.

• As regards India’s views in the UN TP Manual, the Tribunal has specifically observed that

the claimed position is that of the Indian tax administration and not the view of Indian

Government.

Watson Pharma (India) Private Limited

Valuation of shares


Brief Overview

• Under Income-tax Act, normally tax can be levied only if the transaction is giving raise

to “income”.

• However, in the recent past, this basic approach has been subject matter of intense

discussions since the department took a position that shares issued at a price lower

than the arm’s length price to associated enterprise would give raise to income taxable

in India.

• Further, the short fall (i.e. the difference between the issue price and the arm’s length

price so determined) was considered as loan outstanding with AE and hence additional

payment in the form of interest receivable from AE was sought by the tax department.

2015 Deloitte Haskins & Sells LLP 22

Brief Overview

• Major cases:

Shell India Markets – Rs. 15,200 cr.

Essar Group – Rs. 8,000 cr.

Vodafone India Services – Rs. 1,400 cr

HSBC Securities – Rs. 935 cr.

• Few other cases :

Bharti Airtel, Standard Chartered Securities, Havells India and Patel Engineering

Amounts at stake - Rs. 35,000 cr.


Issue of Shares

Typical Facts

• Indian subsidiary issues shares to its foreign parent company (i.e. infusion of share capital

in Indian entity)

• Shares valued as per the existing methodology (i.e. CCI or DCF)

• Usually disclosed in Form 3CEB as a note, out of precaution

Revenue’s Contentions

• To be considered as an international transaction

• Shares have been undervalued / less that the fair market value

• The difference between actual issue price and ALP is computed and two-fold adjustment

made :

notional income of the Indian Subsidiary - treated as TP adjustment

notional interest on such alleged loan - treated as TP adjustment


Issue of Shares – Whether International

Transaction ?

Does the definition of international transaction include issue & subscription of

shares?

• Under section 92B, an "international transaction" is defined to mean "a transaction

between two or more associated enterprises, either or both of whom are non-residents, in

the nature of purchase, sale or lease of tangible or intangible property, or provision of

services, or lending or borrowing money, or any other transaction having a bearing on the

profits, income, losses or assets of such enterprises...".

• Further, the Explanation introduced to section 92B in 2012 (with retrospective effect from

2002) contains an inclusive definition of "international transaction" which includes "capital

financing... including ... purchase or sale of marketable securities...“ of the Indian Income

act in Finance Act 2012 ,which has an retrospective effect.

• It can be contended that the issue of shares would not fall under the phrase “purchase or

sale of marketable securities” since issue of shares is different from purchase or sale of

securities.

• However, it is pertinent to note that as per new Form No. 3CEB, issue of shares is

required to be disclosed under clause 16.

2015 Deloitte Haskins & Sells LLP 25

Issue of Shares – Whether International

Transaction ? (contd…)

The crucial question is whether Chapter X of ITA confers the jurisdiction to

• treat a transaction on the capital account as a revenue transaction?

• treat a single transaction of issue of shares as two transactions

as that of issue of shares and of grant of a financial accommodation (equal to the

difference in value of the arm's length price determined and the issue price of shares),

to bring to tax a notional amount as interest foregone on this notional amount of financial

accommodation?


Other Issues for consideration

• Whether the difference in the share price (‘alleged undervaluation’) can be considered as

an “income” under the Income Tax Act, 1961?

• How to value equity shares? – DCF method v/s CCI method

• Valuation methodology adopted by TPO and assumptions to apply DCF

• Whether TPO correct in treating the difference in valuation of shares treated as Deemed

Loan / Deemed Receivable ?

• Whether imputing a notional interest on Deemed Loan is correct?


Vodafone India – Bombay HC

Facts

• Vodafone India is a wholly owned subsidiary of a Mauritius Vodafone entity, issued equity

shares of face value of Rs. 10 at a premium of Rs. 8,591 per share to its holding

company.

TPO / DRP

• The TPO disputed the valuation of shares and re-computed the value per share [based on

the Net Asset Value (NAV) to Rs. 53,775. The TPO treated the shortfall in the value of

shares [Rs.53,775 less Rs. 8,591 per share] as deemed loan by the taxpayer to its foreign

parent and charged a notional interest @ 13.5% and accordingly made TP adjustment.

DRP also upheld the TP order.

High Court Ruling

• The Mumbai High Court held that TP regulations are applicable only to international

transactions that give rise to taxable income. Neither the capital receipt on issue of

equity shares nor the shortfall (if any) in share premium can be considered as taxable

income within the ambit of the Income Tax Act, 1961.

• Further, there is no specific provision in the Act for treating inflow of funds from shares

issued to non-residents as taxable income. Hence, TP provisions do not apply to capital

transaction itself.

•


Vodafone India – Bombay HC

Update

• Attorney General advised Government not to file SLP

• CBDT instruction No.2/2015 dated 29 January 2015: Board accepted decision of HC, field

officers directed to adhere

• Press release by Ministry of Finance: “bring greater clarity and predictability” and thereby

improve the investment climate in the county

•


Equity Infusion

View of ITATs (1/1)

30

Ruling Observations

Bharti Airtel Limited vs ACIT

(Delhi ITAT) I.T.A. No.: 5816/Del/2012

• Where transaction has no bearing on

profits, incomes, losses or assets of

such enterprise, it will be outside ambit

of expression ‘international transaction’

• Explanation to Sec 92B as amended by

Finance Act, 2012 does not alter basic

character of definition of ‘international

transaction’ u/s 92 B

• Pre-condition about impact on profits,

income, losses or assets of such

enterprises embedded in Sec 92B(1)

• Deeming fiction cannot be read into

"share capital subscription transactions",

when character as such not in dispute

• Rejects TPO's contention that the same

be treated as partly of nature of interest

free loan on ground that there has been

a delay in allotment of shares

Parle Biscuits Pvt Ltd

(Mumbai ITAT) ITA No. 9010/Mum/2010

Loans And Guarantees


Recent Litigation Experience

• Tightened transfer pricing laws, improved vigilance, enhanced enforcement and the power

for detailed investigation

• Adjustments on account of financial transactions – huge adjustments in this area

• Approach towards benchmarking is very elementary with no defined or structured

guidelines

• Differ from the internationally accepted guidelines in several parameters


Loans


Recent Litigation Experience

• General questions raised by the tax authorities:

Use of CUP methodology for pricing loans? Why not a markup on cost of borrowing?

Why PLR should not be considered as the borrowing rate?

Why borrower and not the lender is considered as the tested party ?

Why is the credit rating of the borrower considered?

Why is the consolidated rating of the borrower considered?

Why not consider the Indian ratings and interest rates?

• Terms and conditions of the intra-group debt are not analyzed and no synthetic credit

rating evaluation is performed for estimating borrower’s credit worthiness

• CRISIL local country ratings for all borrowers irrespective of jurisdiction are used along

with the PLR rates of Indian banks as a benchmark rate

• Further, the currency in which the debt is issued is not considered instead INR annualized

average rates for the given year are used

• Lastly, the transaction period interest rates very different from assessment period interest

rates


Scattered Approach By TPOs

35 © 2014 Deloitte Touche Tohmatsu India Private Limited

No proper

credit rating conducted by

TPO

Irrespective of the

maturity of the loan tenor

considered is of 5 years

Borrower’s country and

currency of the loan is

completely ignored

No proper loan

benchmarking is

conducted

Only CRISIL yield rates,

domestic PLR or deposit

rates are considered

No consideration for

other salient features

like seniority, collateral

attached etc.

Documentation Issues

• Lack of scientific and robust approach

• No inter-company agreement

• Abrupt interest rate (sometimes the interest rate charged as per agreement is 0%)

• Non-availability of financial statements

• Use of Bank quotes or websites of banking companies as reference

• Standalone/consolidated financials not available


Loans

Principles Adjudicated

37

Judicial precedence for

loan transactions

LIBOR based pricing for

foreign currency loan

Fixed and Floating interest – Distinction required

Terms & Conditions of

Loan Agreement

are important

Interest free Loans are in general not accepted

Credit risk – validity of

credit quality analysis of borrowers

CUP is the most

appropriate method

Due care for terms and conditions in the Loan agreement

-- interest can vary accordingly

Relevant Case Laws

Views of Tribunal


Rulings Observations

Cotton Naturals (I) Pvt Ltd. Vs.

DCIT

• Comparable transaction would be foreign currency

lent by unrelated parties.

• Domestic prime lending rate have no applicability

and international rate being LIBOR to be taken as

the benchmark rate

• Reliance placed on following case laws:

o Siva Industries & Holdings Ltd.

o Four Soft Ltd.

o Tech Mahindra Ltd.

o Tata Autocomp Systems

Relevant Case Laws

Views of Tribunal



ITO Vs. Maharishi Solar Technology

P.Ltd.

• LIBOR prevalent on the date of the loan agreement

should be considered rather than the average

LIBOR during the relevant financial year

• Size of the business of companies, quantum of

loans availed and the contractual terms of their

loan agreement should be comparable with that of

the taxpayer

• Not ruled on the principle whether the arm's length

interest rate to be considered is only 'LIBOR' or

'LIBOR + some basis points'

• Rejected the additional bps as alleged by the TPO

over the LIBOR on the basis that the comparables

chosen by the TPO were not comparable with the

assessee

Relevant Case Laws

Views of Tribunal



M/s Four Soft Limited Vs. DCIT

• Average LIBOR during the relevant period under

consideration should be used.

• Upheld use of LIBOR as against EURIBOR even

though the AE was based in Netherlands where the

bank lending rates are based on EURIBOR.

Aurionpro Solutions Ltd Vs. ACIT

• Noted that the interest on Bank FD for a term

equivalent to the term for which the loans were

given to the AEs would be safest comparable as it

is free from risk of credit and interest.

• However, in order to maintain rule of consistency

as held by various benches of ITAT - it accepted

Libor for benchmarking interest on interest free

loans.

Relevant Case Laws

Views of Tribunal



Siva Industries and Holdings

Limited Vs. ACIT

• Domestic PLR not applicable and international rate

fixed being LIBOR is to be used

• Interest rate charged by the assessee to be

compared with the average LIBOR rate prevailing

during the relevant financial year

VIP Industries Ltd

• Bank deposit rate and not lending rate suitable ALP

to benchmark AE loan

Hinduja Global Solutions Ltd Vs.

ACIT

• Domestic prime lending rate would have no

applicability and the interbank rate fixed should be

taken as benchmark rate for international

transactions

Videocon Industries Ltd Vs. ACIT • Interest rate charged at LIBOR by assesse was

upheld by Bombay Tribunal

Guarantees


Guarantee Fees – Outbound and Inbound

Inbound transaction Outbound transaction

• Foreign Parent with an Indian subsidiary • Indian Parent with an overseas subsidiary

• Guarantee fees would be an expense for

the Indian taxpayer

• Guarantee fees would be an income for

the Indian taxpayer

• Documentation to be established to

defend benefit test

• Documentation to be established for arm’s

length basis for value of the fees,

including free of cost

• Tested Party and data? • Tested party and data?

• Generally, Revenue not likely

to question free of cost transactions

• Protracted litigation in absence of proper

audit defense


Audit Experience

• Revenue authorities fail to evaluate whether the guarantee actually leads to any savings

or benefit to the borrower or is a mere administrative arrangement, like letters of comfort

or letter of awareness

• Adopt the interest saved approach but the applications have been erroneous – adoption of

domestic credit rating, Indian yield rates, data not available in public domain, credit rating

of borrower derived arbitrarily

• Fail to distinguish between performance guarantees and financial guarantees – adopt a

common pricing system

• Arbitrary adaptation of 3 % guarantee fee without any rationale for all guarantee fee

transaction across industry – some other cases the arbitrary application of interest

approach resulted in a guarantee commission of up to 11%

• Application of bank quotation for guarantee commission charged by Indian banks without

analyzing the terms and conditions

• Generally is not supportive of the “Shareholder’s Service” argument


Bharti Airtel – ITAT Delhi Ruling


Observations of Tribunal

• Analysed section 92B of the Act alongwith the Explanation to the definition of ‘International Transaction” as amended by Finance Act, 2012

• Observed that since the Explanation is clarificatory in nature, the retrospective amendment does not alter the basic character of the definition of international transaction

• Any transaction including capital financing, guarantees, business restructuring / reorganization can be regarded as an ‘international transaction’ only if such a transaction has a bearing on the profits, income, losses or assets of an enterprise (either immediately or in future)

• Impact in the future has to be certain (and not contingent) for covering a transaction in the definition of international transaction.

• Corporate guarantees issued by the taxpayer did not have any implication on the profits, income, losses or assets of the taxpayer. AE had not taken any borrowing from the bank based on the taxpayer’s guarantee

• Held that when a taxpayer extends any assistance to its AE without incurring any expenditure and for which the taxpayer otherwise also could have not realized any income by giving it to any third party, such assistance has no bearing on profits, income, losses or assets of the taxpayer

• Distinguished the case from the preceding Tribunal cases (on quantification of arm’s length guarantee fee) by holding that none of the earlier cases dealt with the issue of coverage of the guarantee transaction in the scope of international transaction as defined in the Act

Videocon – ITAT Mumbai Ruling

Facts

Tax payer provided corporate guarantees to its 3 AEs

TPO contention

• Arm’s length price was determined by TPO, basis the decision in Mahindra & Mahindra at 3%

guarantee fee

• Hence making an adjustment of Rs. 57.90 crores

Observations of Tribunal

• Based on the Bharti Airtel – Delhi ITAT ruling, it was held that corporate guarantees do not fall

within the ambit of International Transactions

• No costs involved in issuing of the corporate guarantee

• No bearing on profits, income, losses or assets of the AE

• Hence no adjustment


Glenmark Pharmaceuticals – ITAT Mumbai Ruling

Tribunal Ruling

• Approves guarantee commission fee at 0.53% and 1.47% charged by Glenmark

Pharmaceuticals Limited in connection with bank loans and L/C facilities

• Explains distinction between corporate guarantee and bank guarantee

• The comparables adopted by TPO are IUPs (i.e. Incomparable Uncontrolled Prices) and

dismisses the TPO’s CUP and orders deletions of the additions made by AO

• Naked bank guarantee quotes given on public websites not good external CUPs unless

they are adjusted as per Rule 10B to factors like risk profile of respondents for guarantee,

financial position of applicants, quantum of amount, terms of guarantee, etc.

• Rejects use of guarantee commission rates available on websites of Bank of India,

Allahabad Bank, HSBC, EXIM Bank-USA and Rabo India Finance P Ltd.


Conflicting views in various decisions

Recent Ruling Takeaways

To be or not to be!

48

Charge or no charge –

whether it is an international

transaction or not – can it be

“shareholder’s service”

• Airtel

• Videocon

• Four Soft Pvt. Limited

• Mahindra

• Nimbus Comm

Use of bank quotes –

whether such quotation

can be consummated as

CUP

• Glenmark

Pharmaceuticals Ltd

• Asian paints Ltd.

• Godrej Sara Lee Ltd

• Technocraft Industries

(India) Ltd


International Court Ruling –

General Electric Capital Canada Inc. Vs. The Queen Tax Court Ruling

• Tax Court decided in favour of taxpayer (upheld by Federal Court) –

Methodology the Court used to arrive at its conclusion provides a framework for pricing

guarantee fees:

o Determine the recipient's stand –alone /status quo creditworthiness

o Adjust the rating incorporating implicit support

o Price the guarantee using the yield approach

o Finalize the arm’s length range of guarantee fee

External lenders viewed explicit guarantee as much stronger protection as compared to

implicit support, resulting in reduction of interest rates

Credit ratings of GE Canada compared under two scenarios, i.e. with & without explicit

guarantee provided by GE US

Applying Yield approach, worked out “benefit” of 1.83% accruing to GE Canada, being

savings in interest cost due to explicit guarantee; guarantee fee of 1% at arm’s length


International Court Ruling –

Key Takeaways • Increased focus by the revenue authorities on financial transactions between the group

entities

• Robust, well-conceptualized transfer pricing policies/documentation defining parameters

and approaches towards intra-group funding and guarantee arrangements

• Necessity of using benchmarking methods and credit analysis to price

intercompany obligations in an arm’s length manner

• Consideration of factors such as terms of loan, tenor, security, currency and convertibility in

comparability analysis

• Periodical revisit of credit ratings to continue updating the continuing guarantee obligations

• Continue probing additional methods depending upon facts of each case

• The implicit differential of a guarantee between related parties needs to be reckoned


Advertisement

Marketing & Promotion

Expenses


Marketing Intangibles

• Meaning of “Marketing Intangibles”

− Ordinarily includes a bundle of IP

rights such as: Trade names,

trademarks, knowhow on distribution

channels and customer relationships

− Nebulous & unclear

− Varies in application by jurisdiction &

industry

− Breadth continues to grow as tax

authorities use it

• Main investment in marketing

intangibles is through advertising,

marketing & promotion spend (“AMP”)

52

Economic/ Legal

Owner

Developer User

IP:

Brand

OR

India

Rights

Indian AE?

Rights:

Exclusive? Perpetual?

Key Issues on AMP Globally

• How will AE benefit from residual AMP cost (and resulting intangible) for which it is required to bear the cost of development?

Benefit to Foreign AE:

• If legal ownership of intangible is more important than economic ownership, and brand name is legally owned by AE, then Indian sub should pay a healthy non-zero royalty for its use.

Economic vs. Legal Ownership:

• Impact of Indian sub being a low-risk entity vis-à-vis an entrepreneur on how the costs should be handled.

Entrepreneur vs. Limited Risk Entity:

53

Key Principles

54

Economic vs. Legal Ownership Entrepreneur vs. Limited Risk Entity

• Functionally subsidiaries may act as entrepreneurs and may claim to be economic owners of any intangibles developed through their efforts and for their benefit

• Has to be supported through a robust inter-co agreement

• The Bright Line test according to DHL is based on the principle that the economic owner should pay for the intangibles

• Delhi Tribunal Special Bench in LG case has held that only legal ownership can be recognized under statutes

• An entrepreneur invests in assets,

including intangibles, assumes major

risks of the business, and earns the

associated return

− It is free to invest in its business

− It is free to make mistakes by

spending too much or too little in one

area v. another (hence it takes the

risk)

• A limited risk entity earns a low

steady return and accordingly does

not bear any significant risk


Approach of the Indian Tax Authorities

− AMP expenses held as creating “marketing

intangible”

− by contributing to brand promotion of

“foreign owned” brand

− Indian distributor, even if not the “legal

owner”, held to be local “developer” of

trademark

TPOs indirectly

commanding

“payment” for

operating in

vast Indian

market

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Special Bench Decision of Delhi Tax Tribunal on

AMP

• There is a valid transaction in the form of excessive AMP expense incurred by Indian company (“Ico”) sub-enhancing the foreign brand, legally owned by the foreign associated enterprise (“AE”)

• Amount of the transaction calculated by applying Bright Line Test (“BLT”)

− BLT is ratio of AMP expenses of “comparable” companies on turnover

• Based on BLT, Ico’s AMP costs bifurcated towards:

− assisting local product sales

− enhancing global brand value

• Ico to be compensated by AE for amounts incurred towards “enhancing brand value” along with a markup

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Special Bench Decision: Important Economic

Aspects

57

Whether the Indian AE is a distributor or manufacturer

The extent of value addition made by the Indian AE

Whether the goods sold by the Indian AE bear the same brand name as the foreign AE

Whether the Indian AE is paying any royalty to the foreign AE

Whether the royalty is comparable with what comparable uncontrolled enterprises would pay

Whether the foreign AE is compensating the Indian AE for the promotion of the marketing intangibles

Whether in the year under consideration the foreign AE is entering the India market or is an established brand in India

Whether any new products are launched in India during the relevant period or the business is continuing with the existing range of products

How the brand will be dealt with after termination of the agreement between AEs

2015 Deloitte Haskins & Sells LLP

TP Controversy

OECD View

• In cases where local entity bears AMP costs, analysis needs to be undertaken

to determine the extent to which the local entity should have a share in the

potential benefits from such marketing activities.

Australian Tax Office View

• Critical Factors for assessing TP Risk

• Is the distributorship perpetual or time bound ?

• Is the distributor the sole distributor?

• Is the distributor compensated in some manner through a discounted royalty

or

• discounted purchase price ?

• What is the advertisement spend of third party comparables ?

In summary, if the User is the ‘economic owner’ of the intangible, then no TP

adjustment


Current Status of AMP Litigation – Key Issues

before High Court • Whether the expenditure on AMP by the Indian entity constitutes international transaction

within the purview of Indian Transfer Pricing Regulations;

• AMP expenditure vis-à-vis FAR profile and the pricing policy;

• Whether Bright Line Test is a correct method for determining excessive AMP expenditure;

• Comparable selection for application of BLT


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Marketing intangibles - AMP

60

BMW India Private Limited - Observations

• Taxpayer has performed advertisement function with greater intensity as opposed to

a routine distributor and has contributed to the brand building for the foreign entity

• Excess AMP expenses are an international transactions (reliance on LG India case)

and the bright line test is an accepted tool to determine the value of the international

transaction

• There can be different ways in which a distributor can be compensated by the

foreign entity

• Resultant profits of the Indian entity vis-à-vis the comparable companies both at the

gross level and at the net level demonstrated that the compensation for higher AMP

was embedded in the pricing arrangement of the imported goods

Management Charges


Management Charges

Generally, the management charges / payments made for Intra Group Services include the

following kinds of services:

• Corporate Risk Services – internal audit and risk management services

• Financial Management and Reporting Services – external financial reporting, financial

strategy and management services

• Legal Services – legal support and legal advice

• Human Resource Services – capability development and organizational health and safety

services

• Technical Services – sharing market intelligence reports and provision of insights on

competition

• Trading and Marketing Services – strategic services, risk management services and

assistance in marketing to international customers

• Information Technology Services – IT services and E-business services

62 2015 Deloitte Haskins & Sells LLP

Management Charges contd..

• What constitutes “Service” is not defined in Indian Transfer Pricing regulations and hence

guidance could be availed from International Transfer Pricing regulations.

• In this regard, as per OECD Transfer Pricing guidelines, to qualify an activity to be service,

test is whether the activity provides the respective group member with economic or

commercial value which enhances its commercial position.

• The following two criteria are useful in determining this aspect:

− Whether an independent enterprise in comparable circumstances would have been

willing to pay for the activity if performed for it by an independent enterprise or

− Whether the entity would have performed the activity in-house for itself.

• Following activities do not qualify for IGS charge :

- Shareholder activities

- Duplicative activities

- Services resulting in Incidental Benefits

63 2015 Deloitte Haskins & Sells LLP

Management charges- A Focus Area for Indian

TP authorities

• Payment for management services by an Indian company to its overseas AEs is being

examined in detail by the Indian TP authorities

• The primary concern is that these payments are being used as a tax planning tool for a high

tax country

• Even if the Indian taxpayer has arm’s length margins at an entity level, the Indian authorities

examine the payments as a separate and a stand alone transaction

• In almost all cases, payments for such services have been disallowed by the Indian

authorities on the basis that:

− The payments do not meet the benefits test

− No services have been rendered

• Following slides describe the type of evidence and analysis required by the Indian

authorities

Typical queries raised by the TPOs

• Taxpayers are required to give in writing:

− Nature of each of the services received within the overall category of management

services

− Need for each of the services

− Benefit received from each of the services

− Whether any of the service is duplicative in nature

• For costs, taxpayers are also required to provide information from the AE:

− Cost incurred by AEs in providing the services- to be given for each type of service

− Basis of allocation, is used, for allocating the management charges

− Evidence of these costs being incurred by the AEs

− Copy of AE accounts

− Certification by an independent auditor for both the costs as well as for the allocation

− Comparison of cost benefit analysis for each type of service

− Comparison with other group companies

65


• Besides this, the taxpayers are also required to file substantial and robust documentary

evidence (for each individual type of service) to show all of the above i.e.:

− Services were actually received

− Services were required

− Services were beneficial

− The benefits were commensurate with the costs paid to the AE

• Type of documentary evidence :

- Copies of agenda, minutes etc. for each category of services received

- Copies of manuals, reports etc. for each category of services received

- Names of personnel/ designation etc. of the team rendering such services

- E-mail correspondences demonstrating suggestions/ advice received for each service

category

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• Apart from this, a separate benchmarking analysis is required by the officers:

− Benchmarking the service fees vis a vis fees paid to any independent service

provider or

− if AE has provided similar services to other independent parties

• Typically, showing that company level profit margins are more than comparable

companies’ profit margins is not considered sufficient

-

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Relevant Case Laws

Views of Tribunal



Gemplus India Pvt. Ltd.

(Bangalore ITAT) ITA No.352/Bang/2009

• No details available on record in respect

of services rendered

• Taxpayer has not proved any

commensurate benefits against the

payments of service charges to its

Singapore affiliate

McCann Erickson India Pvt. Ltd.

(Delhi ITAT) ITA No. 5871/Del/2011

• Only a business expert can evaluate the

true intrinsic and creative value of

services received

• Engaged in only one class of business

i.e. advertising and its allied services.

There are no segments or different

activities which can be said to be

independent of each other. Hence TNMM

justified

Relevant Case Laws

Views of Tribunal



Knorr-Bremse India Pvt. Ltd.


• Cross subsidization is not permitted

under Indian regulations hence CUP is

payment for intra-group services need to

be benchmarked separately

• Commercial expediency and arm’s length

principle are two different concepts

• Taxpayer has not received any tangible

or real benefit

Dresser Rand India Pvt. Ltd.

(Mumbai ITAT) ITA No. 8753/Mum/2010

• Tax authorities cannot question the

commercial expediency

• Contemporaneous documentation

submitted

• No infirmity in the cost allocation method

adopted by the taxpayer

• TNMM most appropriate method as tax

authorities failed to dispute the same

Relevant Case Laws

Views of Tribunal



AWB India Pvt. Ltd.


• Not possible to document every receipt

of the service in question

• Tax authorities cannot question the

commercial expediency

• CUP method applied by the TPO cannot

be considered in view of non-availability

of CUP data

TNS India Pvt. Ltd.

(Hyderabad ITAT) ITA No. 944/Hyd/2007

• TPO not justified in determining ALP of

management fee at NIL

• It is difficult to place on record a concrete

evidence in respect of advise given by

AEs in day-to-day manner, but it can be

perceived from way of conducting

business

• TPO went beyond his jurisdiction in

denying payment out-rightly when his

role is limited to determination of ALP

Relevant Case Laws

Views of High Court



Cushman & Wakefield India Pvt Ltd

(Delhi High Court)

• Held that it was necessary to test if third party in

an uncontrolled transaction would have charged

lower, equal or greater amount as compared to

what was charged by AE

• Whether the cost itself is inflated or not is a

matter to be tested under comprehensive TP

analysis

• HC ruled that the authority of the TPO is

restricted to the determination of ALP and not to

determine whether there is a services or not

from which the taxpayer benefits

• Details of the specific activities for which cost

was incurred by both AEs and the attendant

benefit to the taxpayer have not been

considered till date

• Case remanded

Documentation expected by authorities

• Documentary evidence of rendering of services

• Cost allocation methodology

• Benchmarking study

• Report in local country format

• Intercompany agreements


Helpful checklist

SN Particulars Docs to be collected

Local

Entity

Parent

Entity

1. Copy of the intercompany service agreement

2.

Emails, correspondences, any other evidences (such as in the case of employees of parent

entity travelling to provide services – copies of air tickets, hotel bills, etc, if any. Minutes of

the meetings / agenda / training materials provided) etc., demonstrating the receipt of

services

3. Copy of emails, correspondences, etc., demonstrating scope of work and negotiation of

price between group companies

4. Copy of invoices raised

5. Backup document providing details of cost incurred by group company / shared service

centre for providing such services (if possible, under each head of service)

6. Documents demonstrating benchmarking study for calculation of markup on cost charged

7. Statement showing the charge made on other group entities

8. In case of allocation of cost, certificate from an independent auditor certifying the basis of

allocation key used, and calculation of charges

9. Benchmarking study done / transfer pricing report if any

10.

Detail write-up should be maintained to demonstrate following points

a. Differences between regular services received by local entity versus headquarter services received, so

as to prove that there is no duplication of services

b. Reasons for availing of such services

c. Documents to substantiate that the services were actually received and were consistently received


Conclusion

• Issue of management charges is a significant source of transfer pricing dispute

• Important to understand the framework to be followed in determining which

costs to charge and the basis of the charge-out mechanism

• Documentation is important – particularly if the amounts are large


This material has been prepared by Deloitte Haskins & Sells LLP (DHS LLP) and contains general information only. This information is not intended to constitute professional

advice or services or is to be relied upon as the sole basis for any decision which may affect you or your business. Before making any decision or taking any action that might

affect your personal finances or business, you should consult a qualified professional adviser. The information contained in this material is intended solely for you thereby, any

disclosure, copy or further distribution of this material or the contents thereof may be unlawful and is strictly prohibited.

None of DHS LLP or its affiliates shall be responsible for any loss whatsoever sustained by any person who relies on this material.


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