Transfer Pricing Issues - IT/ITES Industry - Financial Services Industry Darpan Mehta March 22, 2014

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IT/ITES Industry

Financial Services Industry

Agenda

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IT/ITES Industry

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Issues and challenges Why IT/ITeS?

Favourite area for transfer pricing assessments in India – sector dominated by MNCs.

Most common approach to establish ALP is to apply TNMM.

No tax holiday on TP adjustments

Transactions resulting in more than ordinary profits, excess disallowed.

Transition from tax holiday to non-tax holiday

Potential areas?!

Permanent Establishments

- Attribution of location savings for Niche researches undertaken

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Issues and challenges Comparability, key area of focus

Large outbound multinationals having turnover multiple times when compared to the low-end captives are often not appreciated by tax authorities.

Several ITAT rulings have examined and ruled on comparability aspects considering functions, assets and risk (FAR) analysis, turnover criteria, etc. Few examples – Infosys, Wipro, Tata Elxsi, I-Gate, E-clerx, etc. TPOs continue to select these companies as comparable.

Low end back office support services (BPOs) and high-end service providers (KPOs) – Not differentiated

Tax authorities disregard the qualification/skill sets of employees and re-characterize taxpayers as KPO (which requires them to earn high profit margin) and accordingly make adjustments

New areas of comparability are being looked at every year & Increasing focus on the high end functions of the tax payer

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Issues and challenges Typical favourites of tax administration

IT/Software development services segment

IT enabled services segment

Infosys Technologies Ltd. Infosys BPO Ltd.

Kals Information Systems Ltd. Accentia Technologies Ltd.

Wipro Ltd. TCS e-serve Ltd.

Tata Elxsi Ltd. TCS e-serve International Ltd.

Acropetal Technologies Ltd. E-clerx Services Ltd.

Moldtek

Coral hubs Ltd

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Issues and challenges Other key issues faced during assessments

1.Use of single year data – TPOs and appellate authorities have consistently denied use of multiple year data

2.Secret comparables - use of powers conferred u/s 133(6)

3.Rejection of filters adopted by tax payer

4.Rejection of TP documentation maintained – liberal use of powers u/s 92C(3)

5.Re-perform tax payer’s qualitative BM analysis and choose high margin companies

6.Challenges in PLI computation for comparables: pass through costs; un-realised foreign exchange loss/gain

7.Denial of economic adjustments such as risk adjustment, working capital adjustments, etc.

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Issues and challenges Substance over Form

Substance over form creates further anxiety during audits, certain instances:

1. Terms as per inter-company agreements - scope of work, etc.

While the actual work performed would be that of back office support or low end IT services, scope of

services in the inter-company agreements would be more elaborate and indicate high end services. Invoices may further not speak the language of the actual service provision.

2. Billing – hourly rates vs. cost plus

While the functions performed would be that of a captive, be it IT/ITeS, the remuneration model would not indicate the same. Further, behaviour of the tax payer for the purpose of retaining profits in tax holiday units.

3. Where in value chain?

TPOs often tend to oversee the position/roles of the tax payer in the entire value chain of Group companies’ business.

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Issues and challenges Entrepreneurs vs. captives – need for differentiation

Differences in the functions and risks between entrepreneurial IT/ITeS companies and captive IT/ITeS companies:

Entrepreneurial companies Captive companies

Operates on a time & material (T&M) basis with a split for man hour charges for offshore and onshore

Operates as a part of the in-house team of the parent generally operating as a wholly owned subsidiary of the parent

Business model – extended arm of the client & generally provide access to source codes and IPR for execution of the contract

Business model - provided with access to all source codes along with technical know-how.

Does business development and marketing of the services.

No marketing element involved

Responsible for warranties on the programmes developed along with provision support upto certain period of time.

Captives does not take any warranty for the programmes developed

Generally end-to-end projects are sought by customers Involved in providing low-end support to the services provided by parent

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Issues and challenges Certain case laws… contd…

Captives do not constitute PEs

The Hon’ble Delhi High Court in the context of Permanent Establishment, rendered in the case of e-funds Corporation and e-funds IT Solutions Inc. that an Indian subsidiary, on a standalone basis or by itself, would not create a PE of the foreign principal.

Disallowance - Super normal profits

Hon’ble Pune Tribunal decision in the case of Tweezerman India P Ltd. TS-344-ITAT-2013(CHNY)-TP held that the AO was not right in disallowance of deduction u/s 10B on excess transaction price over ALP.

[In this case, the AO held that the benefit u/s 10B was disallowable to the extent of excess of assessee's profit for computation of Sec. 10B over arm's length profit determine by the TPO. Accordingly, it was held that the assessee was not entitled to Sec. 10B benefit on Rs. 3.66Cr.]

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Issues and challenges Certain case laws… contd…

BPO vs KPO & High Profit comparables

Hon’ble Mumbai Tribunal (SB) decision in the case of Maersk ruled on the following important principles.

• ITES services could not be further bifurcated or classified as BPO and KPO services for the purpose of comparability analysis.

If a taxpayer was found to have provided low-end back office support services like voice or data processing services as a whole, or substantially the whole, then companies providing mainly high-end services by using their specialized knowledge and domain expertise could not be considered as comparables.

• Potential comparables could not be excluded merely on the ground that their profit was abnormally high.

Abnormally high profit margin should trigger further investigation, including profit margin earned in the immediately preceding year/s to find out whether the high profit margin represented the normal business trend. If the high profit margin did not reflect normal business conditions, the high profit margin making entity should not be included in the list of comparables.

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Issues and challenges Turnover filter – Trends of ITAT judgements

Rulings Taxpayer

turnover (Cr) Observation by ITAT

Kodiak Networks India P. Ltd 24 • Select companies with turnover between 1-200 Cr

24/7 Customers.com Pvt Ltd 66 • Select companies with turnover between 1-200 Cr.

Capital IQ Information Systems (India) Private Limited

60

Trilogy E-Business Software India Private Limited

47

Sandstone Capital Advisors Private Limited

32 • Reject companies with turnover of 20 lakhs

Capgemini India Private Limited 500 • Reject company with less than 100 Cr revenue • Economies of scale are relevant for

manufacturing companies and not for service companies

• No linear relationship between turnover and profit

Hellosoft India Private Limited 14

• Reject company having turnover more than 100 Cr

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Safe Harbour Rules Coverage and rates

# Eligible International Transaction Proposed Safe Harbour (OP/OE not less than)

1. Software development services* 20% for transaction value up to INR 5 Billion; 22% for transaction greater than INR 5 Billion 2.

Information technology enabled services*

3. KPO 25% - no range

4. Contract R&D services (software) 30% - no range

* With insignificant risk

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(a) interest income;

(b) income arising on account of foreign currency fluctuations;

(c) income on sale of assets/investments;

(d) refunds relating to income tax expense;

(e) provisions no longer required written back;

(f) extra-ordinary items;

(g) other incomes not relating to operating activities

Operating Income Excludes

(a) interest expense;

(b) provision for unascertained liabilities;

(c) pre-operating expenses;

(d) loss arising on account of foreign currency fluctuations;

(e) extra-ordinary expenses;

(f) loss on transfer of assets/investments of;

(g) expenses on account of income-tax;

(h) other expenses not relating to operating activities

Operating Expense Excludes

Safe Harbour Rules Insignificant risk

The description of an eligible taxpayer with insignificant risk is in line with criteria prescribed in a recently issued Circular (No. 6/2013 dated 29 June, 2013)

Foreign Principal Indian Service Provider (ICo)

Economically significant functions

(Conceptualisation, Design, etc.)

ICo is largely involved in economically insignificant

functions

Funds/capital and other economically

significant assets including intangibles

ICo does not use any other economically significant

assets including intangibles

Capability to control or supervise through

its strategic decisions to perform core

functions as well as monitor activities

ICo works under direct supervision of foreign principal

Assumption of risks ICo does not assume or has no economically significant

realised risks

Ownership right (legal or economic) on

outcome of research

ICo has no ownership right on outcome of research

which shall also be evident from conduct of the parties

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Issues and challenges Learning lessons

Learning Lessons

Detailed FAR / BM Analysis

Robust TP documentation-

Alignment of Form &

Substance

Timely representation

Periodic review of TP policy & inter-company

agreements

Suo-moto adjustment

Supplement Analysis

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Financial Services Industry

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Offshore Loans

India Branch

Functions • Origination and sales support

(documentation, credit review support, etc.) • Loan monitoring and administration

Overseas Branch

Functions • Sales conclusion • Loan management • Risk assumption • Capital Raising

Risks • Operational risk (minimal) • Reputational risk

Risks • Credit risk • Interest rate risk • Liquidity risk

ABC Bank Singapore

Third party borrower

Overseas

India

ABC Bank India branch

Assists in loan origination and sales support

Approaches Indian branch

for foreign currency loan

Loan advanced by Singapore branch to the

third party borrower

Fees and interest paid by third party borrower to Singapore branch

Typical Functions / Risks

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Offshore Loans

Possible approaches

• Confirmation of functional analysis in relation to roles performed by India branch and overseas AE

• Arm’s length pricing based on comparability analysis, considering:-

- Approaches based on global databases such as LoanConnector, Deal Scan, etc. that provide data as a proxy for origination, support functions.

- Back Testing / corroborating results

- Using internal data, if available

Typical Issues

• Scrutiny to analyze role of each group entity and whether pricing commensurate with functions

• Indian tax authorities typically adopt an approach to apply a percentage in the range of 20 to 25% of the net income to the originating location

• Varied fee split mechanisms adopted by the industry players

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Key Issues in Financial Services

Cost Allocations

Generally large Banking Groups centralise various support functions such as IT, Legal, Finance, HR on a global / regional level and such costs are allocated across affiliates, including Indian entity, on the basis of reasonable allocation keys (with or without mark-ups)

Typical Issues

• Demonstration of benefit test analysis with adequate documentation

• Determining whether there is any duplication of services / shareholder costs being charged

• Determining the appropriateness of the cost pool and allocation keys used

• Justification for charging a mark-up, if any

• Absence of independent Accountant’s Certificate to support the amount allocated to India

• No deduction available to India bank branch, in absence of actual payment

Possible approaches

• Guidance on level of documentation that could be maintained on an annual basis to demonstrate receipt of benefits

• Certainty on the allocation basis

• Documentation to support accuracy of cost allocation to India – audited statements

• Confirmation on mark-up on certain costs

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Key Issues in Financial Services

Long tenor borrowings from Head Office

• Long tenor borrowings gaining relevance from a liquidity perspective.

• Long tenor FCY borrowings availed by Indian bank branches from its Head Office are priced at LIBOR plus a spread (which is based on factors such as liquidity premium, funds available within the group, etc.).

Typical Issues

• Non-availability of comparable data to benchmark the spread component

• Documentation to support the basis of arriving at the spread charged by the Head Office

Possible approaches

• Seeking global comparable data and performing country risk adjustments

• Aligning the spread charged to the Indian bank branch to the global cost of funding

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Issues

• Transactional Net Margin Method (‘TNMM’) selected as the most appropriate method by the tax payer.

• Comparable Uncontrolled Price (‘CUP’) Method applied by the Indian tax authorities using other third party (3P) transactions.

Possible approaches

• Selection of most appropriate method

- Use of TNMM considering various products and operational mechanism selected.

- In case of CUP, agree on mechanics for adjustment towards:

◦ Distinguishing functions performed for AEs vis-à-vis non AEs (i.e. marketing, research) and it impact on pricing.

◦ Consideration of volume adjustments on pricing brokerage rates.

Indian Broker

AE FII client

3P FII clients

Domestic clients

Brokerage income

India

Overseas

Equity Broking

FII - Foreign Institutional Investor

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Private Equity and Asset Management

Issues

• An Indian company provides non-binding investment recommendations to its overseas group company and receives a cost plus mark-up in the range of 15% to 20%

• During TP audits, mark-ups upwards of 50% applied by tax authorities by selecting asset management companies and investment bankers as comparables (Tribunals have granted relief)

Possible approach

• Certainty on methodology, characterisation (Indian entity and AEs) and mark-up

Funds

Investment management

agreement

Investment Advisor

Investment sub-advisor

Investment Advisory

agreement

Sub- Advisory / Consultancy

agreements

Investment Manager

Outside India

India

• Fund raising and investor relations

• Investment management • Evaluation of opportunities • Final decision making

• Identification and advising Manager

• Screening & evaluation of Sub-advisor’s recommendation

• Preliminary analysis • Detailed analysis • Support / monitoring

services

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Investment Banking

Type of IB transactions / deals

1. Mergers & Acquisitions 3. Underwriting 2. Debt and Equity Capital

Market

Typical functions 1. Origination 3. Structuring

2. Execution 4. Distribution / Underwriting

Pricing mechanisms 1. Pooling of revenues and costs & profit split based on key driver

2. Revenue split on deal by deal basis

Allocation keys / Weights 1. Market Surveys 3. HR Index

2. Employee cost 4. Time spent

Most Appropriate Method

Integrated functions

1. Revenue Split (Other Method)

2. Profit Split Method

Support functions

1. TNMM

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Investment Banking

• Application of global policy to Indian operations / basis of pricing

• Consistent allocation for profits and losses

• Confirmation on basis of allocation /application of global policy (e.g. compensation, HR index, etc.)

• Framework for treatment of policy exceptions, if any

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Questions?

Thank You

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