AN ESSAY ON:

Burning Issues In The Field Of International Transfer Pricing And

Advance Pricing Arrangement In The Indian Context

The complications in the field of international transfer pricing in India have led to

plethora of litigation1 and there is still ambiguity in the field of Transfer pricing as

far as India is concerned. It is the need of the hour to have crystal clear view about

issues that arise in the field of Transfer Pricing. Before we discuss issues that

require attention in the field of International transfer pricing in India we need to

have a crystal clear view about the concept of transfer pricing. The entire concept

and legal aspects of Transfer Pricing in India has been succinctly explained by the

Chennai bench of the Tribunal in the case of Iljin Automotive Private Ltd vs.

ACIT2. There are three basic concepts of transfer pricing that are highlighted by

this judgement a) Arm‟s Length Price (ALP) (ii) International transactions (I.Ts)

iii) Associated Enterprises (AEs).

BASIC CONEPTS

Associated enterprise in relation to another enterprise, means an “enterprise

which participates, directly or indirectly, or through one or more

intermediaries, in the management or control or capital of the other

enterprise; or in respect of which one or more persons who participate,

directly or indirectly, or through one or more intermediaries, in its

management or control or capital, are the same persons who participate,

directly or indirectly, or through one or more intermediaries, in the

1 See http://thefirm.moneycontrol.com/news_details.php?autono=616535 (last viewed on 25

th

October, 2012) 2 S.P.No.67/Mds/2011& I.T.A No.2182/Mds/2010 here ITA refers to Income Tax Appeal

management or control or capital of the other enterprise”3 thus associated

enterprises are entities linked to each other through participation in management,

contribution in capital or having control over other entity by virtue of owning

shares or through other means. The linkage may be direct or indirect in nature and

the thread joining the associated enterprise may have a third entity or entities in

between which relate them to each other.

These enterprises interact with each other for facilitating business between

them. These interactions may be domestic or international in nature. An

international transaction may be defined as “transaction between two or more

AEs, 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; and any other transaction having a bearing on the

profits, income, losses or assets of such enterprises”4.

Transfer pricing refers to the “value attached to transfers of goods,

services and technology between related entities and it also refers to the value

attached to transfers between unrelated parties which are controlled by a

common entity5 which means associated enterprises interact with each other on an

international platform for a monetary value. The problem arises when the value or

price is set by the company with malafide intentions for the sole purpose of tax

saving and mobilising money to a tax haven6 or a country with lower tax regime,

this illegal conduct is aptly defined by the Iljin judgement as “manipulation of

prices in relation to international transactions between the parties which are

controlled by the same interest, involving two or more countries with differing tax

3 Indian Income Tax Act, 1961 Section 92A.

4 Iljin Automotive Private Ltd vs. ACIT ¶ 11

5http://law.incometaxindia.gov.in/DIT/File_opener.aspx?fn=http://law.incometaxindia.gov.in/Dir

ecttaxlaws/act2005/tp1.htm (Oct. 20, 2012) 6 A jurisdiction, especially a country that imposes little or no tax on the profits from transactions

carried on there or on person‟s resident there.

rates and legislation a realizing profits in the country with the most favourable tax

regime so that total tax liability is reduced”7. According to Indian law in order for

an international transaction between associated enterprises to be legitimate it

should be at Arm‟s length price which means “The price at which two unrelated,

unaffiliated, and non desperate parties would freely agree to do business”8

which means the price at which two entities not linked to each other would

transact. The issues that require our focus at this juncture and are likely to arise in

the future leading to ambiguity are discussed below with aid of relevant case laws

TREATMENT OF ROYALTY

The question that arises is whether the payment of royalty by the Indian

entities (Tax payer) to associated enterprises located in foreign countries is subject

to deduction and if it is deducted under what circumstances. To begin with the

term royalty can be defined as the transfer of all or any rights (including the

granting of a license) in respect of a patent, invention, model, design, secret

formula or process or trade mark or similar property ;the imparting of any

information concerning the working of, or the use of, a patent, invention,

model, design, secret formula or process or trade mark or similar property

;the use of any patent, invention, model, design, secret formula or process or

trade mark or similar property ;the imparting of any information concerning

technical, industrial, commercial or scientific knowledge, experience or skill

;the use or right to use any industrial, commercial or scientific equipment ;the

transfer of all or any rights (including the granting of a license) in respect of

any copyright, literary, artistic or scientific work including films or video

tapes for use in connection with television or tapes for use in connection with

radio broadcasting, but not including consideration for the sale, distribution

7IILJIN, supra note 3, at ¶ 12

8 BLACK‟S LAW DICTIONARY 1337 (9

th ed. 2009)

or exhibition of cinematographic films ; the rendering of any services in

connection with the above mentioned activities9. Thus the above definition

provides a comprehensive view about royalty by including in its ambit the

payment made for the use of various kinds of intellectual property and

different classes of equipments in direct and indirect manner.

In the case of Commissioner of Income Tax Versus M/S. Oracle India Pvt.

Ltd10

the department came in an appeal to the High Court of Delhi contending that

the deduction allowed by the tribunal form the income in respect of royalty paid

should be disallowed. The facts of the case are as follows Oracle India was a 100%

(Hundred percent) subsidiary of a US (United States of America) based company

Oracle US. It imported master compact disc (CD‟s) of software and then by

copying the software on blank disc‟s sold it in Indian market and granting sub-

licenses for its use. The Indian entity paid royalty to the US based entity amounting

to 30% of the Indian Published Price (IPP) for selling and sub-licensing.

The contentions of the revenue authorities were on the following grounds

firstly, that the royalty was paid as a percentage IPP and not the price at which the

software was sold in India which resulted in the amount paid as IPP being greater

than actual sales making the transaction colorable secondly, Since the transaction

was colorable no deduction should be disallowed under section 37 (1) of the Indian

Income Tax Act, 1961 (ITA)11

thirdly, As the royalty was paid at IPP and not

9 Indian Income Tax Act, 1961, Section 9 (iv)

10 I.T.A No.383 of 2009 with ITA No.987 of 2010 ITA No.1242 of 2010 ITA No.1247 of 2010

here ITA refers to Income Tax Appeal 11 Indian Income Tax Act, 1961, Section 37 (1) Explanation.—For the removal of doubts, it is

hereby declared that any expenditure incurred by an assessee for any purpose which is an offence

or which is prohibited by law shall not be deemed to have been incurred for the purpose of

business or profession and no deduction or allowance shall be made in respect of such

expenditure.

actual price at which the goods were sold it was argued that the firm was incurring

losses and section 92(3)12

of the ITA can be used to add the royalty to the income

as section 93 (3) clearly states that incase the expense leads an entity to incur

losses it can use the power vested by the act to add such expense to the income of

the assessee.

The assessee on the other hand contended Firstly, that since section 37 was

expense oriented and section 92 of ITA pricing oriented they should not be mixed

up and the whole aim of section 37 was whether the assessee had incurred expense

or not if there is no expense incurred this leads to disallowance of deduction which

should not happen in this case because there was expense incurred in the form of

royalty. Secondly, since the royalty was already at Arm‟s length and the authorities

were unable to show that the assessee was incurring no profits or less than ordinary

profits as decided in the case of Reuters India Pvt. Ltd. vs. Deputy Commissioner

of Income Tax13

and Assistant Commissioner of Income Tax Vs. Nestle India Ltd14

they could not use power vested under 92(3) of the ITA act.

The court in its judgement observed that in order to invoke section 92(3) of

ITA and add income to assessee income there are certain perquisites that need to

be fulfilled firstly, the Business should be carried between a resident and a non-

resident secondly, close connection between resident and a non- resident thirdly,

12 Indian Income Tax Act, 1961, Section 92 (3) The provisions of this section shall not apply in a

case where the computation of income under sub- section (1) or the determination of the

allowance for any expense or interest under that sub-section, or the determination of any cost or

expense allocated or apportioned, or, as the case may be, contributed under sub-section (2), has

the effect of reducing the income chargeable to tax or increasing the loss, as the case may be,

computed on the basis of entries made in the books of account in respect of the previous year in

which the international transaction was entered into."

13 ITA Nos.1089 & 4744/Del/04 here ITA refers to Income Tax Appeal

14 94 TTJ (Del.) 53.

the course of business between the resident and a non-resident is so arranged that

the business transacted between them provides to the resident either no profits, or

less than the ordinary profits, which might be expected to arise in the business. The

first two requisites were present but the Assessing Officer (A.O.) was unable to

prove the third requisite which could be examining the circumstances prevailing in

the present case in the light of comparable cases as it was sine qua non for A.O. to

prove the third requisite as decided in the case of Reuters India Pvt. Ltd. vs. Deputy

Commissioner of Income Tax15

and Assistant Commissioner of Income Tax Vs.

Nestle India Ltd16

.The court also agreed to ground contended by the assessee that

there was mixing up of provision by the A.O as the two section 92 and 32 of ITA

had different orientations and did not dispute the fact that royalty was expenditure

upholding the Tribunal‟s stand and allowing the deduction.

After analysing the above judgement there are certain important points

that can be chalked out that can be used as an instrument for framing

transfer pricing policies by business entities and would aid in paves the path

for deduction of royalty by presenting a clear view firstly, royalty is an

expense which is not disputed by the Indian courts and is subject to deduction

which is also mentioned in explanation to section 92 (1)17

of the ITA secondly,

the royalty should be calculated according to Arm‟s length principle so that

payment of royalty amounts to vanilla transaction and is in consonance with

the act thirdly, the revenue authorities in order to invoke section 92(3) should

prove the three requisites mentioned in the Oracle judgement and the burden 15

I.T.A supra note 12 16

TTJ supra note 13

17 Explanation.—for the removal of doubts, it is hereby clarified that the allowance for any

expense or interest arising from an international transaction shall also be determined having

regard to the arm's length price.

of proving the same lies on the authorities lastly, the value of royalty should be

fixed at a percentage which does not erode profits or leads to losses.

In the recent case of Commissioner Income Tax vs. EKL Appliances

Limited18

the revenue appealed against the order of tribunal for allowing the

deduction of royalty. The assessee was public limited company engaged in the

business of manufacturing electronic appliances. At the nascent stage it did not pay

royalty fees as it was waived off by AB Electrolux, Sweden but later on it paid

royalty fees to this associated enterprise. The Transfer Pricing Officer observed

that in spite of recurring losses the assessee continued to pay royalty fee and called

for a justification the assessee justified its position by giving the following reasons

Firstly, the transaction was certified by Ernst and Young a firm of global repute

and the same price was paid by an unrelated entity to AB Electrolux as royalty.

Secondly, the allowance of brand fee as expenditure does not depend on the

profitability of the concern, but on the utility of the brand name and the technical

knowhow in respect of which the payment is made. Thirdly, if it weren‟t for the

brand name the assessee would not be able to increase its turn over leading to more

losses which were blatantly rejected by the Transfer Pricing Officer.

At this stage observation made by Commissioner of income tax (Appeals)

proved to be critical and formed integral part of the Tribunal‟s and High Court‟s

judgement. The commissioner of income tax appeal observed that Transfer Pricing

Officer in determining the price (which was according to Arm‟s length price) as

contended by the assessee, but erred when comparison was made by Transfer

18

I.T.A. Nos.1068/2011 & I.T.A. Nos.1070/2011, it should be noted that same order has been

passed by the High Court for the assessment year 2002-2003& 2003-2004 in the above

mentioned income tax appeals. Here ITA refers to Income Tax Appeal

Pricing Officer between controlled transactions19

and uncontrolled transactions20

as

he did not take business strategies into consideration which is laid in the OECD

(Organisation for Economic Co-operation and Development) transfer pricing

guidelines for comparing uncontrolled and controlled transaction. The tribunal

ruled in the favour of assessee and observed the same.

The appeal came before the Delhi High Court the court observed in its

judgement that tribunal had very rightly pointed out the way transactions have to

be compared and that the Transfer Pricing Officer should examine the controlled

transaction carried out by the associated enterprises without restructuring it until it

falls in the ambit of exception21

. The court further observed that that it is not for

the revenue authorities to dictate to the assessee as to how he should conduct his

business and it is not for them to tell the assessee as to what expenditure the

assessee can incur, the expenditure should be for business purpose and the OECD

guidelines have been recognized in the tax jurisprudence of our country. The court

ruled in favor of assessee allowing the deduction.

The judgemnt highlights certain key points that facilitate clear view

about royalty and transfer pricing firstly, the tax authorities cannot use fragile

grounds like incurring losses to disallow deduction of any expense which is

paid to associated enterprises secondly, when comparing controlled and

uncontrolled transaction business strategies should be taken into account by

tax authorities and reference should be made transfer pricing guidelines

19

Transactions between two enterprises that are associated enterprises with respect to each other.

See also, OECD TRANSFER PRICING GUIDELINES FOR MULTINATIONALS AND TAX

ADMINISTRATIONS at 18, 22nd

July, 2010 20

Transactions between two enterprises that are independent with respect to each other. See

also, OECD TRANSFER PRICING GUIDELINES FOR MULTINATIONALS AND TAX ADMINISTRATIONS at

23, 22nd

July, 2010 21

OECD TRANSFER PRICING GUIDELINES FOR MULTINATIONALS AND TAX ADMINISTRATIONS at ¶

1.64, 22nd

July, 2010

framed by the OECD for multinationals and tax administrations to have a

better idea about taxing implications lastly, the losses incurred are commercial

in nature and are not colorable devices to mobilise money to associated

enterprises.

TREATMENT OF CORPORATE GUARANTEE

The issue of corporate guarantee provided by the companies has caught the

attention of tax authorities22

and one should not be surprised if the term corporate

guarantee find its place in the definition of international transaction in the coming

years but as expected corporate guarantee was not included in the definition of

„international transaction‟ by finance bill 2012. The term corporate guarantee can

be defined as “A guarantee of payment made by a corporation on behalf of another

business entity. The guarantee is provided in consideration of a vendor providing

credit to a business on whose behalf the guarantee is made”23

.The recent

judgement of Income Tax Appellate Tribunal Hyderabad in Four soft private

limited vs. Deputy commissioner of income24

tax clarified the legal status of

corporate guarantee and the court ruled that corporate guarantee does not fall

within the ambit of term international transaction and hence it cannot be brought

under the purview of transfer pricing study. The corporate guarantee is provided by

the company in two ways either by providing it directly to its subsidiary or through

special purpose vehicles (SPV‟s) that are set up in foreign countries with the

purpose to acquire a new company abroad since the special purpose vehicle don

not have source of revenue or any assets it banks upon the guarantee provided by

the Indian entity.

22

See also, http://articles.economictimes.indiatimes.com/2011-10-31/news/30342070_1_transfer-

pricing-guarantees-tax-assessment

23 See also, http://www.crfonline.org/orc/glossary/c.html (last viewed on 25th October, 2012)

24 ITA No. 1495/HYD/2010 here ITA refers to Income Tax Appeal

The facts of Four soft private limited vs. Deputy commissioner of income25

that relate to the corporate guarantee are, the assessee an Indian entity provided

loan to its subsidiary 4S BV Netherlands and corporate guarantee to ICICI bank

UK and also DCS Group. The Transfer Pricing Officer concluded that corporate

bonds (14%) will be used for benchmarking the loan transaction between the

associated enterprise . The Transfer Pricing Officer‟s view was not in consonance

with the suggestions of Dispute resolution panel which observed that London

interbank offer rate (“LIBOR”) plus rate was the apt rate for determination of

Arm‟s length price. The assessee company provided corporate guarantee to ICICI

bank UK and also DCS Group. The TPO held that guarantee is an obligation and if

the principal debtor fails to honour the obligation, the guarantor is liable for the

same and hence the TPO determined a commission at the rate of 3.75% as the

Arm‟s length price under Comparable Uncontrolled Prices method26

on the basis of

the commission charged by the ICICI bank as bench mark, aggrieved by the same

the case went in an appeal to the Income Tax Appellate Tribunal Hyderabad.

The court held that the Dispute resolution panel was right in its suggestions

that LIBOR rate should be taken into consideration for benchmarking Arm‟s length

price and this is also supported by the case law Siva Industries and Holdings

Limited vs. ACIT27

and that since corporate guarantee was not covered under the

term „international transaction‟ in the absence of any charging provision it was not

25

Id. 26

A transfer pricing method that compares the price of property and service transferred in a

controlled transaction to the price of property and services transferred in an uncontrolled

transaction in comparable circumstances. See also, OECD TRANSFER PRICING GUIDELINES FOR

MULTINATIONALS AND TAX ADMINISTRATIONS at 18, 22nd

July, 2010 27

ITA No.2148/mad/2010, the court in this case upheld LIBOR rate for benchmarking loan

transaction between the assessee and associated enterprise because the transaction of lending

money between the assessee and the AE is in foreign currency and the transaction is an

international transaction, it has to be evaluated by applying the commercial principles applicable

to international transaction. Here ITA refers to Income Tax Appeal

right for the tax authorities to scrutinize it under transfer pricing guidelines which

can be termed as ultra vires to certain extent. The court further held the corporate

guarantee is very much incidental to the business of the assessee and hence, the

same cannot be compared to a bank guarantee transaction of the Bank or financial

institution. The court ruled in favor of assessee by making no transfer pricing

adjustments related to corporate guarantee.

The judgemnt aids in forming clear view points about the legal status of

corporate guarantee in India because firstly, it helps to clear the air with regard

to corporate guarantee not being covered under the ambit of international

transaction secondly, it makes it clear in absence of any charging provision

any aspect of business transaction cannot be brought under transfer pricing

study, thirdly the benchmark for determining of Arm‟s length price for

international transaction concerning loans provided by Indian entities to

associated enterprises should be the LIBOR plus rate.

TREATMENT OF INTANGIBLES

One of the burning issues that clearly lay in the midst of ambiguity is

taxation of royalty paid in lieu of acquiring intangibles28

which is generally seen by

28

Section 2 (ii) of the Indian Income Tax Act, 1961 defines intangible as:

(a) marketing related intangible assets, such as, trademarks, trade names, brand names, logos;

(b) technology related intangible assets, such as, process patents, patent applications, technical

documentation such as laboratory notebooks, technical know-how; (c) artistic related intangible

assets, such as, literary works and copyrights, musical compositions, copyrights, maps,

engravings; (d) data processing related intangible assets, such as, proprietary computer software,

software copyrights, automated databases, and integrated circuit masks and masters;

(e) engineering related intangible assets, such as, industrial design, product patents, trade

secrets, engineering drawing and schema-tics, blueprints, proprietary documentation;

(f) customer related intangible assets, such as, customer lists, customer contracts, customer

relationship, open purchase orders; (g) contract related intangible assets, such as, favourable

supplier, contracts, license agreements, franchise agreements, non-compete agreements;

(h) human capital related intangible assets, such as, trained and organised work force,

employment agreements, union contracts;(i) location related intangible assets, such as, leasehold

interest, mineral exploitation rights, easements, air rights, water rights; (j) goodwill related

intangible assets, such as, institutional goodwill, professional practice goodwill, personal

tax authorities as a colorable device to mobilise money to associated enterprises.

The intangibles can be broadly categorized into marketing and trade

intangibles29

.The case laws discussed below help in understanding taxing

implication with respect to royalty paid for acquiring intangibles.

In the case Maruti Suzuki India Ltd versus Additional Commissioner Of

Income Tax Transfer Pricing Officer New Delhi30

which went before the Delhi

High Court in form of a writ petition when Transfer Pricing Officer made arbitrary

additions.(the decision was later upheld by the Supreme Court) The assessee had

acquired an exclusive license from associated enterprise under which it received

the following benefits the use of brand name Suzuki, receiving technical

collaboration, exclusive use of information imparted by Suzuki, development of

human resources (training of personnel), providing advice on procurement of

machinery for setting up of plants etc. which can be referred to as technical know

how in a comprehensive manner.

The Transfer Pricing Officer alleged that there was a deemed sale of the

brand name Maruti because the change of brand name Suzuki in 2004-05 and

calculated the price of brand name Maruti at 4,420 crores. The figure was reached

by the assessing officer as the amount by Maruti on advertising, marketing and

distribution plus 8 percent mark up. The transfer pricing further observed since

goodwill of professional, celebrity goodwill, general business going concern value; (k) methods,

programmes, systems, procedures, campaigns, surveys, studies, forecasts, estimates, customer

list or technical data; (l) any other similar item that derives its value from its intellectual content

rather than its physical attributes. 29

Marketing intangible- An intangible that is concerned with marketing activities, which aids in

the commercial exploitation of a product or service and/or has an important promotional value

for the product concerned.

Trade intangible- A commercial intangible other than a marketing intangible. See also OECD

TRANSFER PRICING GUIDELINES FOR MULTINATIONALS AND TAX ADMINISTRATIONS at 27 and at 30,

22nd

July, 2010 30

W.P.(C) 6876/2008 Delhi High Court

there was use of the brand Suzuki with Maruti this led to impairment of brand

Maruti and it promoted the Brand Suzuki indirectly which amounted to

“piggybacking” thus promoting the brand without payment of single penny

therefore Suzuki needs to pay compensation to Maruti. The Transfer Pricing

Officer calculated the Arm‟s length price to be nil and held that Maruti had created

marketing intangibles using the bright-line test31

. The Transfer Pricing Officer

relied on OECD transfer pricing guidelines for Multi nationals and tax

administration mainly32

to support the contention of compensation. The Transfer

Pricing Officer further held that the growth rate of Maruti was much lower than

other enterprises in the automobile industry to which it was compared. The

assessee on the other hand contended that transfer of a brand name required

execution of a legal instrument and registration of the same with registrar of

trademarks and it did not perform any execution of such instrument at any point of

time. The assessee argued acquiring the license aided in warding off the

competition brought by the entry of foreign players after the de-licensing of Indian

passenger car industry and would lead to decrease in royalty rate and purchase

price.

The court held that there was no deemed sale of the brand Maruti and was

of the view that Maruti had taken a right step as it was the need of the hour to

protect its market share though it observed some benefit had been received by

Suzuki as it was mandatory for Maruti to use its brand name. The court held with

respect to the question of royalty the Transfer Pricing Officer did not calculate the 31

A test which notes that, while every license or distributor is expected to spend a certain

amount of cost to exploit the items of intangible property to which it is provided, it is when the

investment crosses the “bright line” of routine expenditure into the realm of non routine that,

economic ownership likely in form of a marketing intangible is created. 32

¶ 6.36 Difficult transfer pricing problems can arise when marketing activities are undertaken

by enterprises that do now own the trademarks or trade names that they are promotional (such as

a distributors of branded goods) In such a case, it is necessary to determine how the marketer

should be compensated for. (relevant portion)

royalty at all and the comparable enterprises were not appropriate33

The court

further held that royalty should be calculated based on right parameters equivalent

the amount of royalty that Suzuki charges other independent enterprises. There

were certain important conclusions drawn by the High Court in this case:

Firstly, if the Indian associated enterprise or independent enterprise uses

marketing tangibles owned by foreign associated enterprise it is not necessary

for the Indian entity to pay the foreign entity any compensation whether it is

obligatory or discretionary unless agreed by the Indian entity and foreign

entity.

Secondly, if the Indian associated enterprise mandatorily uses marketing

tangibles owned by foreign associated enterprise payment in this regard

should be made by the foreign entity to the domestic entity, on account of the

benefit it derives in the form of marketing intangibles and the payment should

be calculated at Arm‟s length.

Thirdly, if the expenditure is incurred by an independent enterprise or Indian

associated enterprise on advertising, promotion and marketing of its products

using marketing tangibles owned by foreign entity, it is not necessary for the

Indian entity to pay the foreign entity any compensation unless mutually

agreed by them.

Fourthly, if The expenditure is incurred by Indian associated enterprise on

advertising, promotion and marketing of its products using marketing

tangibles owned by foreign associated enterprise is more than expenditure

incurred by comparable independent enterprises the associated foreign entity

needs to compensate the domestic entity in respect of the advantage obtained

33

(Tata motors dealt mainly in trucks and busses with only few vehicles in passenger car

segment while Hindustan motors supplied cars mainly for government purposes).

by it in the form of brand building and increased awareness of its brand in the

domestic market at price calculated at arm‟s length.

Lastly, if the expenditure is incurred by Indian associated enterprise on

advertising, promotion and marketing of its products using marketing

tangibles owned by foreign entity is more than expense incurred by

comparable independent it would be necessary to identify appropriate

comparables for the purpose of comparison of their expenditure with the

expenditure incurred by the Indian entity.

On analysing the above judgement in toto it can be seen that the court

ignored that Maruti was an exclusive licensee and it was bound to incur

advertising, marketing, distribution expenses as it was the sole entity to reap

benefit in India, Suzuki receiving only incidental benefits and only those products

which were supplied or incorporated technology by Suzuki or technical know how

was provided by Suzuki carried the Suzuki logo. Though the court has ignored

certain aspects it serves as guiding light for international transaction involving

payment of royalty for marketing intangibles.

In Abhishek Auto Industries Limited Vs DCIT, New Delhi34

the assessee

manufactured seat belts in technical collaboration with M/s. Takata of Japan which

owned 30 percent shares in the Indian entity. The assessee imported kits from the

foreign entity assembled it in India added certain raw materials to finish car belts.

The assessee had fixed its sale prices after taking into consideration the cost of

materials and the higher rate of gross profit in comparison to the other types of seat

belts. The royalty and technical fee was paid in lieu of technical know how

provided by the Foreign collaborator according to the agreement between the

Indian entity and associated enterprise approved by regulatory authority. The

assessee was unable to determine the Arm‟s length price with respect to price of 34

I.T.A.No.1433/Del/2009 here ITA refers to Income Tax Appeal

material procured from foreign collaborator as it could not be acquired from any

source in India

The Transfer Pricing Officer held that technology transfer had not taken

place therefore Arm‟s length price for royalty fee and technical know how should

be nil as of amount of technical know how fee and royalty is bundled in the price

charged for supply of material. The Transfer Pricing Officer further held that

royalty technical fee cannot be based on an agreement. The Transfer Pricing

Officer calculated average net operating margin taking comparable enterprises into

consideration therefore difference arose with net operating margin35

of the

company calculated by the assessee leading to the conclusion price paid for the

material acquired should be calculated by Transactional net margin method and

additions (downward adjustment) were made by Transfer Pricing Officer to the

value of international transaction. The tribunal further enhanced the additions. The

assessee went in an appeal before income tax appellate tribunal

The court held that the Transfer Pricing Officer had erred on the following

grounds:

Firstly the agreement being genuine and approved by the central government can

be regarded as the basis of determining the royalty and technical know how. This

aspect was further substantiated by the court that business expediency is the

domain of the assessee.

Secondly, the average net operating margin of the company should be taken into

account rather average net operating margin of the comparable enterprises if

comparision is to be made. The court in short held that preference should be

given to internal comparables over external comparable as it presents a more

succinct view of the company.

35

The difference arose because average net operating margin takes into account whole set of

transactions by the company.

Thirdly, if transactional net margin method is applied profits from related

transaction should be taken into consideration rather than taking whole set of

transaction performed by the company36

therefore net profit margin should be the

basis of comparision in this case. The transaction of the company with foreign

collaborator should be studied formed basis of comparision in the present case.

The judgement makes it clear that royalty for trade intangibles such as

technical know how can be decided under an agreement by the parties to

international transaction approved by regulatory authorities.

In recent judgement by the Canadian Supreme Court in the case of Canada

vs. GlaxoSmithKline37

the court upheld that the licenser agreement is an important

parameter that should be taken into consideration while comparing transfer price of

a commodity with arm‟s length price. The facts of the case are as follows the

Glaxo Canada purchased rantidine from Adechsa S.A., a related non resident

company (a Glaxo group clearing company) from $1,512 to $1,651 per kilogram38

set under the supply agreement however on the other hand during the same period

two Canadian generic pharmaceutical companies, Apotex Incorporated and

Novopharm Limited purchased ranitidine from other sources for use in their

generic anti-ulcer drugs for between $194 and $304 per kilogram39

from arm‟s

length suppliers. Rantidine was an active ingredient in Zantac a patented and

trademarked anti ulcer drug which was owned by Glaxo group. The Glaxo group

had conferred the patent and trademark rights of the anti ulcer drug under the

license agreement to Glaxo Canada.

36

See, http://www.bcasonline.org/ContentType/Contentin.asp?10107 (last viewed on 26th

October, 2012) 37

2012 SC 52 (Canadian citation) 38

Glaxo group used resale price method to arrive at this transfer price.

The combined effect of the License and Supply agreements enabled Glaxo

Canada, to purchase ranitidine, put it in a delivery mechanism, and market it under

the trademark Zantac. The tax authorities contended that price at which rantidine

was bought by Glaxo was not in consonance with the Arm‟s length principle as the

price at which other companies brought rantidine from arm‟s length price was

much lower.

The court held that according to OECD guidelines it is important to consider

the economically relevant factors40

and license was an economically relevant factor

in this case because when a closer view is taken at the prevailing circumstances it

seems that Glaxo Canada had to acquire the active ingredient from Adechsa in

order to acquire patent, trademark and other peripheral rights attached to Zantac.

The court felt that high purchase price was the result of benefits that Glaxo reaped

under the license agreement and an independent entity might have ended up paying

the same price however the court made no determination with respect to arm‟s

length price.

The court in this case presented a very liberal and logical view by

considering license agreement, the benefits attached in the form of intellectual

property and peripheral rights for comparing transfer price with arm‟s

length price. The judgement may serve as precedent for considering

parameters that can be used to compare transfer price set by multinationals

to arm‟s length price and aiding the tax administrations worldwide to decide

the legitimacy of transaction. It rightly observed that “Transfer Pricing is not

an exact science, evaluation of transactions through which the process of

determination is carried is an art where mathematical certainty is indeed not

possible and some approximation cannot be ruled out, yet it has to be shown

40

OECD GUIDELINES REGARDING THE ARM‟S LENGTH PRINCIPLE at ¶ 1.15, 1995

that analysis was „judicial‟ and was done after taking into account all the

relevant facts and circumstances of the case‟‟ 41.

TREATMENT OF SERVICES

Last but not the least is the issue of the services provided by the

associated enterprises to domestic entity which are constantly scrutinized by

the tax authorities as business entities try to shift profits to their associated

enterprises covered in the veil of payment made in the name of services

rendered. The companies in order to prove that transactions are at arm‟s

length and legitimate must show that they reap benefits from these

transactions substantiated by proper evidence. General and detailed

explanation do not suffice the appetite of the tax authorities and these should

be supported by proper documentation related to rendering of services,

documentation focusing on specific benefits derived from such service and

calculations with respect to the time for which the services were rendered42

.

The issue can be better understood in the light of case law Gemplus India

Private limited 43

in this case the assessee is an Indian company and wholly owned

subsidiary of Gemplus SA, France. The assessee company in India is functioning

under the regional headquarters of the mother firm at Singapore, mentioned as

Gemplus Singapore. The assessee company in India had entered into an agreement

called Management Services Agreement (MSA) with its associate Gemplus

Singapore for providing services in respect of marketing and sales support,

customer service support, finance, accounting & administration support and legal

support.

41

Transfer Pricing as held by the Commissioner of Income Tax (Appellate) Aztech Computer

case Aztech Software & Technology Services Ltd. v. ACIT 42

See also, http://thefirm.moneycontrol.com/story_page.php?autono=501226 (last viewed on

27th

October, 2012) 43

ITA No.352/Bang/2009 here ITA refers to Income Tax Appeal

The assessee company had filed its return the Assessing Officer referred the

it to Transfer Pricing Officer as the international transaction was in the need of

scrutiny. The Transfer Pricing Officer observed that the transaction could be

divided into three parts the payment made for sim cards, reimbursement of

expenses and lastly payment of management fees. The Transfer Pricing Officer

further observed that payment made for sim cards, reimbursement of expenses

were at arm‟s length but payment of management fees was unjustified reason being

the comparables had not paid any management fees and The Transactional Net

Margin Method (TNMM) analysis made by the assessee company cannot be

accepted for the purpose of ALP. The assessee pointed that for marketing and sales

support it had spent Rs.60, 89,428/- and six persons received training in lieu of this

payment. The Transfer Pricing Officer found out only two person had training

certificates to substantiate the same and the training went on for only two days

which is not commensurate to the money spent and even the premier management

institute of India do not charge such amounts (as the amount spent on every person

worked out to be whopping 10 lakhs). The assessee further claimed that it paid

towards customer service support finance and accounting services and for legal

support all these payment were supported by fragile reason which were prima facie

rejected by Transfer Pricing Officer. The Chartered Accountant‟s arguing on

behalf of the assessee contended that the company had achieved commendable

amount of sales turnover , had only handful of expertise in India to handle there

work and the payment was justified kipping in mind the nature of business. The

commissioner on the other hand contended that there were certain grey areas like

having qualified personnel, incurring expenditure on similar genre of services and

the fact that the service agreement had been entered into by the assessee the

previous year making it impossible to analyze the nature and volume of services

and calculating compensation for the same.

The court ruled in favour of the tax authorities as the abyss created by

the lack of evidence supporting the benefits derived from payments made for

services was quiet evident to turn a blind eye.

ADVANCE PRICING ARRANGEMENT(APA)

With the insertion of provisions for advance pricing arrangement in the

Indian Income Tax Act, 1961 the companies can breathe a sigh of relief as they

have an option of making advance arrangements with tax authorities in respect to

taxing implications in the uncertain field of transfer pricing . Before we analyze the

provisions of the Indian income tax act it is essential for us to understand the

concept of Advance Pricing Arrangement. The Organisation for Economic Co-

Operation and Development (OECD) Transfer Pricing Guidelines for Multi

National Enterprises and Tax Administration defines an Advance Pricing

Arrangement (APA) as “An arrangement that determines, in advance of

controlled transactions, an appropriate set of criteria for the determination of

the transfer pricing for those transactions over a fixed period of time”. The

Black‟s law dictionary (9th

edition) defines APA as “advance pricing agreement

is a usually Binding arrangement made between a multinational company and

one or more national tax authorities about what method the company will use

to calculate transfer prices. The agreement's purpose is to reduce or eliminate

double taxation”. Advance pricing arrangement is an arrangement between the

taxpayer and the taxing authority on an appropriate methodology for a set of

transactions over a fixed period of time in future. The APA offers better assurance

on transfer pricing methods and is conducive in providing certainty and unanimity

in approach.44

This definition in my view is best suited for Indian taxing

environment as it is in proximity with the APA provision in the Indian Tax statute.

The advance pricing agreement can be unilateral, bilateral or multilateral.

Bilateral Advance Pricing Agreement is “an advance pricing agreement made

between a company and two tax authorities”45

. Multilateral advance pricing

agreement is an “advance pricing agreement made between a company and more

than two tax authorities”46

. Unilateral advance pricing agreement is an “advance

pricing agreement made between a company and one tax authority”47

. This does

not necessarily allow a company to avoid double taxation. A tax authority that is

not a party to the agreement is not bound by the transfer-pricing method specified

in the agreement.

The provisions for Advance Pricing Arrangement hereinafter referred to as

APA) are contained in section 92 CC of the Indian Income Tax Act (hereinafter

referred to as the act).

92 CC (1) says that board48

with prior approval of the central government can enter

into advance pricing arrangement any person determining the arm‟s length price or

the manner in which arm‟s length price is to be determined for the international

transaction entered into by the person.

92 CC (2) says the method in which the arm‟s length price is calculated should be

in consonance with methods specified in Section 92 C (1). The methods specified

in 92 C (1) are:-

44

2 DR. VINOD K. SINGHANIA AND DR. KAPIL SINGHANIA TAXMANN‟S DIRECT TAXES LAW &

PRACTICE 1193 ¶ 514. (2012) 45

Blacks, supra note 8, at 61 46

Id. 47

Id. 48

Section 1 (12) of the Indian Income Tax Act, 1961 says that for purpose of this act the term

board means central board of direct taxes.

a) comparable uncontrolled price method; (b) resale price method; (c) cost plus

method; (d) profit split method;(e) transactional net margin method;(f) such other

method as may be prescribed by the Board.

92 CC (3) says that arm‟s length price of any international transaction which falls

under the ambit of APA shall be determined in accordance with APA superseding

section 92C which and 92 CA which aid in determination arm‟s length price.

92 CC (4) the time span for which an APA would be valid cannot exceed period of

five years. Suppose a business entity and the board enter into APA the APA would

be valid for maximum time period of five years.

92 CC (5) the APA shall be binding on the party and commissioner including

persons subordinate to him with respect to the international transaction for which

APA is entered. Suppose a business entity enters into two international transaction

A and B and APA is entered into only with respect to A the business entity and the

tax authorities are bound by the conditions laid down in agreement only with

respect to transaction A.

92 CC (6) says that if there is change in fact or law which has an effect on the

agreement the agreement shall not be binding. Suppose a business entity enters into

APA with the Board but the statute is amended to include only one method for

calculating the arm‟s length price for APA then the APA entered into is not

binding on either of the parties.

92 CC (7) says that if the Board finds out that the agreement is entered into by

misrepresentation of facts or fraud the board with prior approval of the government

declare the agreement void ab initio.

The proviso to this section says that if the agreement is declared voids ab intio the

period between the date of entering into agreement and the order declaring the

agreement void would be excluded while computing limitation period under this

act. However after exclusion of this period the limitation period under any

provision works out to less than sixty days it should be extended to 60 days.

Suppose an APA is entered into 1.01.2013 and it is declared void on 01.02.2012

the period of one month would be excluded while calculating any limitation period

under this act but in this situation if the relevant provision for calculating limitation

period states that limitation period is 30 days it would be extended to 60 days.

92 CC (8) says that The Board is vested with the power to prescribe a scheme

specifying the manner, form, procedure and any other matter generally in respect

of the advance pricing agreement. For example: the board can chalk out a scheme

prescribing the documentation to be furnished before entering into APA.

92 CC (9) says that if an application is made under this section to enter into an

APA, proceedings shall be deemed to be pending for the purpose of the act.

Suppose a business entity files an application to enter into an APA with the board

the proceedings under this act would come to halt like section 133 (1) of the act

requiring any firm to furnish him with a return of the names and addresses of the

partners of the firm and their respective shares.

If the above provisions are analysed an APA has the following salient features

firstly, it is an Agreement between a taxpayer and one or more tax authorities

secondly, it aids in covering the future transactions entered into by the company

thirdly it is for a fixed time span fourthly, it is in consonance with domestic and

Internationally accepted transfer pricing principles and lastly it is arrived at in

subtle corporate environment between the tax payer and authorities aiding in

avoiding tedious litigation and wastage of resources.49

49

See also, Shyamlal Mukherjee, Ketan Dalal & Rahul Mitra, Certainity In The Uncertain Field

Of Transfer Pricing, ( Aug. 2011), http://www.pwc.com/en_IN/in/assets/pdfs/publications-

2011/PwC_India_-_Mutual_Agreement_Procedure_Answering_Queries-130112.pdf

Section 92 CD deals with the effects of Advance pricing arrangement. 92 CD

(1) says that if a person enters into an agreement and the agreement applies to a

year for which he has already filed income tax return complying with section 133

of the act he has to file another return known as modified return within 3 months of

enter4ing into agreement. The three months are calculated form end of the month

in which the agreement is entered.

92 CD (2) says all the provisions of Section 139 which deals with return of income

shall apply to the modified return unless anything contrary is contained in the

APA.

92 CD (3) says if the assessing officer has completed the assessment/ reassessment

for previous year to which the agreement applies before the statutory period of

three months granted to the assessee for filing the modified return the assessing

officer shall make assessment in consonance with the APA.

92 CD (4) says when the assessment/ reassessment for the previous year to which

the agreement applies is pending and modified return has been filed by assessee the

assessing officer shall make assessment in consonance with the APA and keeping

in view the modified return.

92 CD (5) the assessment / reassessment carried out for the purpose of section 92

CD (3) and (4) shall be completed within one year. The limitation periods specified

in sections 153, 153A and 144 shall be extended to twelve months. Section 153

deals with limitation period for assessment and reassessment, 144C specifies the

limitation period with respect to completion of assessment by the assessing officer

when a matter is referred to dispute resolution panel and section 153 B of the act

specifies the limitation period for completion of assessment in case of search and

requisition.

CONCLUSION AND SUGGESTIONS

In my view to curb the menace of uncertainty with respect taxing

implications the government should promote advance pricing arrangements

and provide assistance with regard to structuralisation of international

transaction so that the companies do not have to face the brunt of tedious

litigation process. The government of New Zealand on its official site has

provided a checklist which should be adhered to by the taxpayer while

entering into an international transaction concerning royalties, intangibles

and other transfer pricing issues50

thus facilitating structuralisation of

international transaction. This is a good example that the Indian government

should follow in order to assist the tax payer in structuralisation of

international transaction which involve complex transfer pricing issues.

It is important for the tax authorities bring international transactions

into scrutiny but the approach should not be quantum based (the amount of

money involved) but the focus should be on the issues that make the

transaction illegitimate in nature. A recent example of this erroneous

approach is the Vodafone case where the tax Authorities went after the

quantum of tax involved and lost before the apex though retrospective

amendment was carried out it reflected very badly on the image of

government and the tax authorities giving rise to the question is there any

difference between tax evading citizen and a promise evading government? as

the legal luminary Nani Palkivala mentions in one of his essays in the book

We The Nation: Lost decades51

.

50

Link to the site http://www.ird.govt.nz/transfer-pricing/practice/ (last viewed on 27th

October,

2012) 51

Lubna Kably, Promises Shouldn’t Be Broken, The Times of India, Oct. 26th

, 2012, at 10

The concept of transfer pricing is still in the nascent stage and it

depends upon the tax authorities to take a succinct approach for computation

of arm‟s length price by analysing the transaction on various parameters. The

courts on the other hand also play a pivotal role in shaping the concept of

transfer pricing and in my view the judgments should reflect the

developments taking place worldwide in the field of transfer pricing as the

concept of transfer pricing relates to taxation which exhibits a variable

nature.