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January - March 2014A quarterly newsletter on

transfer pricing developments

India, at Arm’s LengthIn this edition:

Viewpoint 02

Insights 06

By order! 10

Around the world 16

We are pleased to present India, at Arm’s Length, our quarterly publication that focuses on Transfer Pricing (TP) developments in India and provides a round-up of key global TP developments.

On 30 January 2014, OECD issued a discussion draft on country-by-country (CbC) reporting including CbC reporting template along with parameters for master file/local file approach. The Companies Act, 2013, along with the recently notified implementation Rules, seeks to strengthen the corporate governance framework for related party transactions by prescribing the arm’s length standard and an approval process. TP aspects of financial transactions continue to be a contentious issue with appellate authorities adopting conflicting views on some issues. The Indian Advance Pricing Agreement (APA) program continued to receive a positive response from taxpayers. The program achieved a significant milestone with the signing of the India’s first APA involving five applicants.

The “View Point” section of this edition elaborates on a “big picture” approach on the TP documentation requirement and an Indian perspective in light of the OECD’s recent discussion draft.The “Insights” section, intends to highlight the current trends in the Indian APA program, controversy on corporate guarantee transactions and impact of changes in the definition of related party in the Companies Act 2013.

“By Order” covers TP decisions in India, while “Around the world” provides a round-up of key TP developments around the world.

We hope you find this publication both timely and useful, and we look forward for your feedback and suggestions.

Best regards,EY India Transfer Pricing Team

2 | India, at Arm’s Length

Viewpoint

IntroductionOn 19 July 2013 the OECD released its Action Plan on Base Erosion and Profit Shifting (BEPS) driven by the political and public focus around the world on the taxation of multi-national businesses. It listed 15 focus areas for potential change in international tax rules and treaties. The OECD Action Plan and the on-going activity in countries will have significant implications for all multinational enterprises (MNEs).

Action 13, which addresses new approaches for transfer pricing documentation and a new requirement for country-by-country (CbC) reporting, is a critical matter. On 30 January 2014, the OECD issued a Discussion Draft on Transfer Pricing and CbC Reporting, which includes a draft CbC reporting template together with parameters for a master file/local file approach to transfer pricing documentation.

As proposed by the OECD, the CbC template would require 17 data points on a “per legal entity” basis. the OECD will release a final recommended CbC reporting template by September 2014 after considering comments received on the draft. The details of the template are expected to be revised, perhaps substantially, after the comments.

Some, but not all, MNEs currently use a master file type concept for transfer pricing documentation, with one master report that covers high-level issues, such as an overview of the business, the industry and the company’s supply chain, combined with local files that provide limited data on the local entity. The OECD is proposing to mandate a two-tier approach involving a more robust master file and local files. The OECD’s approach involves specific requirements with respect to the breadth and detail of the global information to be included in the master file and similarly specific requirements with respect to the transactional information to be included in the local files.

This article provides an overview of the discussion draft on transfer pricing documentation and CbC released by OECD, practical challenges in the implementation of the proposed rules and related impact on prevalent practices from an India perspective.

Challenges existing in the current local country documentation regimes

The transfer pricing documentation plays a key role in the administration of transfer pricing rules for tax authorities and taxpayers. With a number of countries introducing specific transfer pricing documentation requirements with a local country focus, tax administrations face challenges in addressing the “big picture” view of the MNEs transfer pricing practices and results. This is likely to lead to countries pursuing matters of low importance instead of matters of high importance or increased transfer pricing risk. Some of the issues in the local documentation regimes are described below:

• Transfer pricing documentation addressed at a domestic level: The existing documentation practices are implemented with a strong domestic tax enforcement point of view. Consequently, there is a significant gap between domestic transfer pricing documentation requirements and the activity carried out by MNEs, which ought to have a more global focus.

• Country-specific documentation requirements can vary from country to country, which significantly increases the compliance burden on taxpayers.

• One-sided analysis of controlled transactions: The majority of countries adopt a one-sided approach strongly focusing mainly on the domestic tax treatment of cross-border controlled transaction.

• Incomplete understanding of the global business: The local country documentation requirements do not provide a clear picture of the global business context of individual transactions being documented. Only a few countries require a comprehensive list of information related to the global business of the MNE group, other cross-border controlled transactions between foreign associated enterprises belonging to the Group etc., which may directly or indirectly affect the pricing of the taxpayer’s controlled transactions.

• Divergent practices on timing of documentation disclosures: Some countries require information as of the time of audit while some countries seek information at the time of filing of tax returns. These differences in content requirements, timing of providing information, and the lack of clear focus on the purpose of documentation add to taxpayers’ difficulties in setting priorities and in providing the right information to tax authorities at the right time.

Transfer Pricing documentation: “big picture” approach to existing country-focused documentation requirements

3India, at Arm’s Length |

Several international organizations such as the OECD, European Union (EU) and the Pacific Association of Tax Administration (PATA) have undertaken initiatives as a response to the potential difficulties that MNEs face in complying with a continuously increasing number of local law and administrative requirements for transfer pricing documentation.

Chapter V of the OECD Transfer Pricing Guidelines provides general guidance for tax administrations to consider while developing rules and/or procedures on documentation to be obtained from taxpayers in connection with a transfer pricing inquiry. It also provides guidance to assist taxpayers in identifying documentation that would be most helpful in showing that their controlled transactions satisfy the arm’s length principle and hence, in resolving transfer pricing issues and facilitating tax examinations. The OECD TP guidelines does not provide for an exhaustive list of documents to be included in the transfer pricing package. Furthermore, there’s no clear guidance with respect to the link between the process for documenting transfer pricing/administration of penalties and of the burden of proof.

International efforts to create uniformity in documentation practice have not been particularly effective. Some international efforts contain promising approaches; however, because of their lack of universal application and a lack of flexibility they have not become as widely accepted or provided as important a savings in compliance burden as might be expected.

Objectives of two-tiered approach to transfer pricing documentationThe discussion draft on TPD and CbC reporting lays down the following objectives for transfer pricing documentation:

• Transfer pricing risk assessment: A proper assessment of transfer pricing risk by the tax administration requires access to sufficient, relevant and reliable information at an early stage, which would decide whether a taxpayer’s transfer pricing arrangements warrant an in-depth review. The Tax Administrations could use a variety of tools and sources of information (including transfer pricing forms, transfer pricing mandatory questionnaires focusing on particular areas of risk, etc.) for identifying and evaluating transfer pricing risks of taxpayers and transactions.

• Taxpayer’s assessment of its compliance with the arm’s length principle: Ensure that tax payers give adequate consideration to transfer pricing requirements and articulate consistent/cogent transfer pricing positions in the transfer pricing documentation. The compliance objectives are supported in two ways — first, tax administrations can require that transfer pricing documentation requirements be satisfied on a contemporaneous basis or in any event, no later than the time of completing and filing the tax return for the fiscal year in which the transaction takes place. The second way to encourage compliance is to establish transfer pricing penalty regimes in a manner intended to reward timely preparation of transfer pricing documentation and to create incentives for timely, careful consideration of the taxpayer’s transfer pricing positions.

• Transfer pricing audit: In cases where the risk assessment warrants an in-depth analysis of the controlled international transactions, the Tax Administration requires access to all the relevant information and documents to conduct a thorough audit. The information may include taxpayer’s operations and functions, relevant information on the operations, functions and financial results of associated enterprises with which the taxpayer has entered controlled transactions, information regarding potential comparables, including internal comparable, and documents regarding the operations and financial results of potentially comparable uncontrolled transactions and unrelated parties. Therefore, the tax administration should be able to obtain such information directly or through exchange of information mechanism between countries.

Two-tiered approach: The discussion draft on TPD and CbC reporting states that countries should adopt a standardized approach to documentation. The two-tier approach on transfer pricing documentation consists of the following:

• Master file (including CbC): The master file should contain common standardized information relevant for the MNE group. This will provide a complete picture of the global business, financial reporting, debt structure, tax situation and the allocation of MNE’s income, economic activity and tax payments to assist tax administrations in evaluating the presence of significant transfer pricing risks. The relevant information, as required to be maintained in the master file, has been grouped in five categories: a) the MNE group’s organizational structure; b) a description of the MNE’s business or businesses; c) the MNE’s intangibles; d) the MNE’s intercompany financial activities; and (e) the MNE’s financial and tax positions including CbC reporting1.

1 Refer EY global tax alert on “OECD releases draft country-by-country reporting template for comment” provides a detailed analysis on the CbC template dated 30 January 2014


CbC reporting: The Discussion Draft notes that the information in the CbC reporting template “may be helpful in risk assessment processes.” However, it further notes that such information “should not be used as a substitute for a detailed transfer pricing analysis” and that such information “would not constitute conclusive evidence that transfer prices are or are not appropriate.” On the CbC reporting, the discussion draft requires a detailed reporting of financial and tax information. In particular, for each constituent entity organized in the country, or permanent establishment maintained in the country, the CbC template requires place of effective management, important business activity code, revenues, earnings before interest and taxes, income-tax paid on cash basis, withholding taxes paid, stated capital and accumulated earnings, number of employees, total employee expense, tangible assets other than cash and cash equivalents, royalties/interest/service fees paid to (and received from) constituent entities. The CbC template prescribes a “bottom up” approach to reporting financial data based on local-country financial statements using local-country functional currency and accounting standards.

Based on the feedback from the tax industry, OECD has announced that CbC reporting will not be a part of the master file (to be maintained as a separate document) and have omitted reporting of interest/royalties/service fees paid to (and received from). Furthermore, it has been clarified that the detailed transactional reporting will form part of the local file.

• Local file: The information in local file is supplemental to the master file and helps to meet the objective of assuring that the taxpayer has complied with the arm’s length principle in its material transfer pricing positions affecting a specific jurisdiction. The local file focuses on information relevant to the transfer pricing analysis related to transactions taking place between a local country affiliate and associated enterprises in different countries and which is material in the context of the local country’s tax system. Such information would include relevant financial information regarding those specific transactions, a comparability analysis and the selection and application of the most appropriate transfer pricing method for the fiscal year in question.

The discussion draft also addresses compliance requirements with respect to the documentation requirements and the CbC.

While transfer pricing documentation requirements are included in domestic tax laws for many countries, the OECD suggests that in order to implement the two-tiered transfer pricing documentation consisting of master file and local file, the countries will be required to modify transfer pricing documentation rules to require the locally based affiliates of the MNE group to produce the necessary information. Furthermore, OECD recommends that master file portion of the proposed documentation should be completed under the direction of the parent company and shared with each country in which its affiliates exist. The master file can be obtained by local tax authorities from the local affiliate directly or through treaty exchange of information mechanisms.

Issues and comments on the draft TPD and CbC reportingThe OECD had invited comments on the Discussion draft from business representatives. While the OECD’s efforts on simplification and streamlining of transfer pricing documentation rules has been appreciated and supported, the detailed information sought in the master file, local file and the standard template on CbC lacks a balanced approach toward goals. In order to achieve the goal of simplification materiality concepts should be incorporated and a layered approach to materiality, providing for partial or full exemptions at specified thresholds, should be adopted. It is important to take a measured approach toward proportionality in identifying the content as well as the timing of the information to be provided, what and how much information should be provided as part of transfer pricing documentation versus the audit process. The effectiveness of such approach will be dependent on the way it is implemented. The challenges posed while implementing the two-tiered approach proposed by the OECD will be that combination of master file, local file and the detailed CbC, might lead to increased administrative burden for the taxpayers, instead of simplification.

The documents do not clearly define which tax administration should be formally held responsible for reviewing and enforcing MNEs compliance with transfer pricing documentation rules regarding the master file. The absence of guidance may imply that each country, in which the MNE has taxable presence, may need to have such documents and the failure to maintain may lead to penal consequences. The detailed financial information provided in the master file, the local file and the CbC might be considered as an evidence for the determination of arm’s length nature of the transaction and therefore, the basic principle of application of transfer pricing methods and detailed analysis of functions, assets and risks of entities may be undermined.


Implication in the Indian contextWhile India is not a member of the OECD, it has been engaging with the organization through various OECD meetings. India is a regular observer in the OECD Committee of Fiscal Affairs. Furthermore, as part of the G20, India is actively involved in OECD’s work on BEPS. Tax authorities and courts also generally refer to OECD guidelines for resolving TP disputes in India, unless the Indian TP regulations specifically deviate from OECD guidelines.

The Indian TP regulations require the taxpayer to disclose all international transactions and adequacy of the TP documentation in a report certified by an accountant before the due date of filing of tax return for the fiscal year. Furthermore, the taxpayer is required to maintain prescribed TP documentation, which shall be submitted to tax authorities during audit. The Indian tax authorities follow a “monetary threshold-based scrutiny” under which a taxpayer is subject to TP audit if the value of international transactions during the year exceeds a prescribed monetary threshold (currently prescribed at INR150 million). It has been reported that the Indian Tax Administration is considering replacing the monetary threshold with a “risk-assessment based approach”2.

The Indian Tax Law provides for a detailed list of information and documents to be maintained by the taxpayer for supporting determination of the arm’s length price of its international transactions with AEs. In addition, the Indian tax authorities have powers to call for specific information and documents considered relevant for determination of arm’s length price. While the reporting disclosure and prescribed documentation under the Indian TP regulations broadly covers the local file documentation of the discussion draft, the master file and the CbC report template could be looked upon by the Indian Tax Administration to undertake a better risk assessment-based approach.

While the discussion draft notes that the information in the CbC reporting template “may be useful in risk assessment processes” and “should not be used as a substitute for a detailed transfer pricing analysis”, the challenge for taxpayers could be defending the tax authorities analysis of such information. Given the global scope of the information provided in the master file and CbC report, use of the information provided would require a detailed analysis and focused audit, which, given the resource constraints, may not always be possible.

2 “India to scrap Rest. 15-cr threshold for auditing MNC deals,” The Financial Express, 11 April 2014.


InsightsThe Indian APA program, launched in 2012, provides a voluntary process whereby the revenue authority and the taxpayer may resolve transfer pricing (TP) issues in a principled and cooperative manner on a prospective basis.

Number of applications says it all!!!

The Indian APA program received an overwhelming response from taxpayers with close to 150 applications filed in the “first wave” of APA filings that concluded on 31 March 2013. This trend continued with an increase in number of applications by 60% (232 applications filed) in the “second wave” of APA filings that concluded on 31 March 2014. Of the 232 applications, 206 applications are for unilateral APAs, while the rest are for bilateral APAs

The CBDT signed five APAs in a record time of just one year of the end of the filing due date. The transactions covered in these APAs are interest on loan, corporate guarantee, investment advisory services and contract manufacturing. The APAs were signed across industries such as Pharmaceutical, Telecom and Financial Services. To put things into perspective, the US has taken an average of 34 months for concluding a new unilateral APA and 41 months for a new bilateral APA (according to the US Internal Revenue Service’s APA report 2013). This is a milestone achieved by the Indian revenue authorities, reflecting their commitment to resolve TP issues.

Designing a winning APA strategy: factors to be considered

Applicants to the Indian APA program would need to carefully consider the following factors to design a winning APA strategy:

• Selection and application of the transfer pricing method (TPM);

In a TP analysis, one picks the most reliable combination of TPM, comparables and adjustments. Choosing this combination requires judgment. The APA team must develop a clear, detailed understanding of the taxpayer’s business, including the taxpayer’s functional analysis, the industry involved, market conditions and contractual terms. This factual development is much easier to accomplish in cooperative efforts with taxpayers.

The various TPMs may need to be used in a creative manner, based on the economic circumstances and the legitimate concerns of both the Tax Authority and the taxpayer. In reviewing the TPMs, it is important to bear in mind the concept of “tested party” and the impact the same could have on the TP result. The choice of tested party (together with the choice of TPM) can reflect a choice about how to allocate risk.

In some cases, one PLI can be transformed into another PLI. The result is a hybrid combining some features of each. One example is transforming an operating margin into a gross margin. This transformation involves following steps. First, the comparables’ operating margins are computed for the analysis window. Next, the tested party’s operating expenses as a percentage of sales are added to each comparable’s operating margin, to compute what the comparable’s gross margin would have been if the comparable had the same level of operating expenses as the tested party. These “constructed” gross margins of the comparables are used to determine a gross margin range for the tested party for the APA years. One of the incentives behind usage of the hybrid model is that a taxpayer may want to use a gross margin PLI in order to assign more risk to the tested party than an operating margin PLI would or to give the tested party more incentive to control operating expenses. Yet it may not be reliable to use the comparables’ gross margins. Backing into a gross margin using comparables’ operating margin avoids these issues.

• The analysis window: deciding on the years over which comparables’ results are analyzed;

The comparables’ results are adjusted as needed to determine an arm’s length range and the taxpayer’s results are tested against the arm’s length range. Before all that can happen, however, one must decide the time period over which to compute the comparables’ results. As APAs are prospective, there is usually a mismatch between the period for which the comparables’ data is used and the period during which the tested party’s results are evaluated (the “APA period”). Taxpayers/APA team may therefore, need to consider using as late an analysis window as possible, to reduce the mismatch between the analysis window and the APA period. Typically at least three years data may need to be used. For industries with long business or product cycles, longer periods such as five years may need to be considered.

There are technical issues about how to use multiple year comparable data. One approach is averaging each comparable’s results over the analysis window, and then using those average values to construct an arm’s length range/result. There are different ways to do the averaging. One is a simple average. Another approach is a weighted average, i.e., weighting each year’s result by the denominator used in the PLI. An alternative to averaging each comparable’s result over the analysis window is “pooling.” Pooling can produce somewhat different results from averaging. The differences depend on the profit variations between comparables and between years, and which company years have missing data. Pooling might be considered in cases in which some of the comparables are missing data for some years in the analysis window.

Advance Pricing Agreement (APA) – an update


• Comparability adjustments After the comparables have been selected, if there are material differences between the controlled and uncontrolled transactions, adjustments must be made if the effect of such differences on prices or profits can be ascertained with sufficient accuracy to improve the reliability of the results. One type of adjustment, which may need to be considered, has been variously called an “asset intensity,” or “working capital” adjustment.

An issue that arises while undertaking an asset intensity adjustment concerns the tested party’s asset levels. Conceptually, the comparables’ results and the comparables’ and tested party’s asset intensities in the analysis window are used as a proxy for what these results and asset intensities are expected to be during the APA years. Typically, the assumption that the APA years will be similar to the analysis window, seems reasonable in this case, so that one proceeds on that basis. However, in some cases this assumption is not accurate. If the tested party’s receivables intensity increases substantially between the analysis window and the APA years, the computed arm’s length range of operating margins could change significantly in the direction of increased profitability. This may need to be addressed by considering the expected asset intensity levels as part of the critical assumptions.

Compensating adjustments: An APA process may need to envisage the use of compensating adjustments where the result falls outside the agreed price but is within the critical assumptions boundary. The reason for permitting such adjustments is that it is often difficult for taxpayers to ensure a result within the range during its tax year; only after the year’s end, when complete accounting data are available, can taxpayers take final stock of the results. APAs may also need to address the collateral consequences of such adjustments as well.

• Testing results during the APA periodOnce an arm’s length range is determined, the results of the tested party must be measured against that range. If the results are outside the range, an adjustment to income may be warranted and there may be other consequences. A preliminary question is the time period over which to test the tested party’s results. The simplest approach is to test each year’s results against the arm’s length range. Other approaches involve averaging over a multiple-year period. There are different approaches to such testing. One approach is to require only that the average results within all the APA years in aggregate fall within the arm’s length range. Another approach is to use a rolling average over

a number of years, for example a three-year rolling average. Taxpayers may need to consider average testing if their industry is subject to fluctuating return cyclical or otherwise. Sometimes compromised approach may need to be considered — for example, a taxpayer maybe willing to accept a narrower range in exchange for being tested on an average basis.

• Critical assumptionsAPAs include critical assumptions upon which their respective TPMs depend. Critical assumptions are objective business and economic criteria that form the basis of a taxpayer’s proposed TPM. Failure to meet a critical assumption may render an APA inappropriate or unworkable. The APA may need to be renegotiated or, failing that, cancelled. It would be useful to consider the following guidelines for avoiding problems with critical assumptions:

• ► Make critical assumptions extreme outer limits.

• ► When possible, make critical assumptions objective. For example, refer to sales dropping by a definite percentage rather than sales dropping “substantially.”

• ► Try to use TPM provisions rather than critical assumptions. For example, instead of having a critical assumption that sales not fluctuate too much from budgeted amounts, it might be possible instead to provide that such fluctuations will cause certain adjustments to the range.

• ► Do not confuse critical assumptions with the scope of the APA. For example, an APA may specify that new product types will not be covered. This provision should be part of the definition of covered transactions; the APA should not include a critical assumption that new products should not be introduced.

• ► Do not confuse critical assumptions with obligations of the taxpayer. For example, an APA may require a taxpayer to record certain information in a regularly compiled database. This obligation of the taxpayer is not a critical assumption and should not be so labelled.

Since the launch of the APA program, there has been an enthusiastic response from taxpayers. Taxpayers would need to consider a wide range of issues for designing a winning APA strategy as the APA process moves into the next stage. Failure to navigate or address some of these issues during the APA discussions stage could result in an adverse APA, which may not provide certainty nor reduce the compliance burden. Given the nascent stage of the Indian APA program, a number of these issues are still green field areas for the Indian APA Team as well as for taxpayers. Creativity and flexibility are often critical to reaching a successful APA resolution.


Corporate Guarantee: recent developments and implicationsOver the last few years, tax administrations and certain judicial bodies have given considerable attention to inter-company financial transactions — particularly corporate guarantees. There are several reasons for this increased concern over such transactions. One source of concern is the potentially large magnitude of many inter-company loans/guarantees. Another is the complex nature of these transactions and the difficulties they pose for taxpayers and taxing authorities in interpreting and applying the arm’s length principle. TP aspects of intra-group financing arrangements have emerged as a contentious issue in India. This is also reflected in the 2013 EY Global TP Survey result where 80% of the respondents indicated that TP issues relating intra-group financing arrangements has been the most important area of controversy in India over the last –three to four years. Extending guarantee on behalf of subsidiaries and other related entities, for enabling them to obtain finance, is a very common practice for MNCs.

Whether the mere presence of a guarantee support to an AE is subject to TP provisions has been a contentious issue in the Indian context

The income-tax law was amended in 2012 to clarify that provision of guarantee to an AE is an international transaction. It appears that the amendment was merely declaring or clarifying the position as a guarantee that may have qualified as an “international transaction” under the general definition, even though in an isolated instance the Hyderabad Tribunal in the case of M/s Four Soft Limited3 had taken a contrary view. However, subsequent to the amendment, Tribunal decisions have generally held that an inter-company corporate guarantee is an international transaction (e.g., M/s Everest Kanto Cylinder Limited4, Mahindra & Mahindra Ltd.5, Reliance Industries Ltd.6). Given the contentious nature of the issue, the Indian tax administration prescribed transfer pricing “safe harbours” for outbound corporate guarantees provided by Indian companies. However, in a recent ruling, the Delhi Tribunal ruled that despite the amendment, a guarantee would not, by itself, constitute an international transaction as the guarantor does not incur any costs while extending the guarantee7. Immediately, thereafter, the Hyderabad Tribunal in the case of Four Soft Pvt. Ltd.., [TS-104-ITAT-2014(HYD)-TP] took a different view of the amendment and therefore, did not followed its earlier decision on this matter in the Taxpayer’s own case.

One of the fundamental fact patterns in the evolution of international transfer pricing concepts and rules involves an enterprise’s use of a financial resource belonging to an associated enterprise. Although the OECD Transfer Pricing Guidelines, 2010 acknowledge the role of the use of money in transfer pricing matters, they do not yet provide specific guidelines regarding how such issues are to be addressed and resolved. Nonetheless, the elements that are typically important in evaluating transfer pricing issues involving the use of money within multinational enterprise groups can be outlined by drawing on general arm’s length principles.

Inter-company lending and related financial transactions are being more intensively audited by the Indian revenue authorities. Transfer pricing of inter-company loans and guarantees are increasingly being considered as some of the most complex transfer pricing issues in India according to the India country-specific chapter of the UN Practical Manual on Transfer Pricing for Developing Countries.

Guarantee transactions are difficult to characterize for TP purposes because they may involve an analysis of mixed elements of the time value of money and shareholder activity. Guarantee transactions may further raise the question of whether the facility confers a specific benefit on the recipient or a general benefit to the entire controlled group of companies. Accordingly, the issue of whether a charge should be imposed for provision of a guarantee is primarily a factual inquiry. Taxpayers should undertake a factual review of their intercompany guarantee arrangements to determine, which conclusion can be applied to their fact pattern.

“Related party”: a look at The Companies Act, 2013 and the Income Tax Act, 1961

The Companies Act, 2013 requires related party transactions to be approved by a special resolution at the general meeting, if the transaction is not in the ordinary course or business or not at arm’s length. For the above, the term “related party” is defined to (no definition in The Companies Act, 1956) to mean:

(i) A director or his relative;

(ii) Key management personnel or his relative;

(iii) A firm, in which a director, manager or his relative is a partner

(iv) A private company in which a director or manager is a member or director

3 TS-518-ITAT-2011 (HYD) -TP 4 TS -714-ITAT-2012 (Mum) -TP 5 TS-408-ITAT-2012 (Mum) - TP 6 TS-324-ITAT-2013(Mum) - TP 7 Bharti Airtel Limited (TS-76-ITAT-2014(DEL)-TP)


(v) A public company in which a director or manager is a director or holds along with his relatives, more than 2% of its paid-up share capital

(vi) A body corporate whose board, managing director or managers accustomed to act in accordance with the advice, directions or instructions of a director or manager, except if advice is given in the professional capacity

(vii) Any person on whose advice, directions or instructions a director or manager is accustomed to act, except if advice is given in the professional capacity

(viii) Any company which is:

a) A holding, subsidiary or an associate company of such company; or

b) A subsidiary of a holding company to which it is also a subsidiary;

(ix) Such other person as may be prescribed

The definition and the scope of “related party” under the Companies Act, 2013 is different from that of “international transactions and specified domestic transactions (SDT)” and “related party” under the Income-tax Act, 1961. For example, one of the thresholds for a public company to be treated as a related party is 2% of paid-up capital as provided under the Companies Act, 2013 as compared to 20%/26% for domestic/international transactions under the Income Tax Act. Furthermore, it also needs to be noted that for the purposes of SDT under the Income Tax Act, all expenses are covered and only limited types of income, for example, profit-linked tax holiday units are covered. However, the Companies Act, 2013 is wider in its scope than SDT provisions, since the former includes all types of income earned from a related party. Another significant difference between the provisions of the Companies Act and Income Tax Act is that the Companies Act has not made the concept of arm’s length applicable to financial transactions such as inter-company loans/ guarantees etc. unlike the Income-tax Act.

The ALP concept under the Companies Act appears to be more arm’s length price setting as compared to ALP under income tax law, which is more concerned with arm’s length price testing. For example, since Section 188 requires “pre-approval”, the BOD/ shareholders can obviously only consider the manner in which the company proposes to set its price with related parties rather than evaluate whether the outcome of the price setting has given an arm’s length result. Moreover, Rule 15 of the Companies (Meetings of Board and Power) Rules, 2014 talks about disclosing the manner of determining pricing and other commercial terms, which again suggests that the Act is looking at arm’s length price setting.

While the Companies Act, 2013 does not provide any guidance on determining the manner in which “arm’s length principles” should be applied, it needs to be seen whether it is useful/possible to refer to the manner in which the principle is applied under the Income Tax Act to test whether the transaction is in accordance with the “arm’s length principles” or not. Similarly, it also needs to be seen whether a transaction meeting the “arm’s length principles” under the Companies Act, 2013 can be used as a basis to support an arm’s length test under the Income Tax Act.


Special bench of Mumbai Tribunal lays down principles on approach on selection of comparable data The Maersk Global Centre (India) Private Limited (“Maersk India”) is a wholly owned subsidiary of Maersk GSC Holdings A/S (“Maersk Denmark”) forming a part of the Maersk Group. Maersk India renders transaction processing, data entry, reconciliation of statements, and audit of shipping documents, process support, process optimization, technical support services and other support services. During the Financial Year (FY) 2007–08, Maersk India carried out international transaction in the nature of provision of Information Technology Enabled Services (ITES) amounting to INR1,175.6 million and provision of IT services amounting to INR139.3 million.

During the Transfer Pricing (TP) audit proceedings for AY08-09, the Transfer Pricing Officer (TPO) noted that the Maersk India was operating with more than 2,000 employees out of its state of art facility and was providing support services to its Associated Enterprises (AEs) such as documentation, finance, operations, logistics, global information systems etc. According to him, these services were knowledge-based services and are in the nature of Knowledge Process Outsourcing (KPO) services, as opposed to Business Process Outsourcing (BPO) as documented in Maersk India’s TP study. It was also noted that Maersk India was rendering logistic outsourcing services, business analytic services, process support and technical support services to its AEs involving transfer of knowledge-intensive business process that requires significant domain expertise. On finding most of the filter applied by the Taxpayer to be inappropriate, TPO considered additional filters, and the significant one being “companies not mainly engaged in KPO services were excluded.” Therefore, TPO clearly characterized the nature of the industry to be that of a KPO, out rightly distinguishing it from BPO. TPO selected 07 companies as comparable to that of Maersk India and arrived at arm’s length margin of 45.74%, after allowing for working capital adjustment. With regard to, provision of IT services, TPO finalised on a set of 23 comparable companies and arrived at an arm’s length margin of 24.99%, without allowing for any working capital adjustment.

Maersk India then filed objections with the Dispute Resolution Panel (DRP). Maersk India objected to its characterization as a KPO and also raised various other objections. The DRP directed the AO to exclude a few companies and grant the benefit of an adjustment for differences in working capital. However, the DRP rejected the Taxpayer’s argument on BPO v. KPO and did not provide relief on some of the other grounds. Maersk India thereafter, filed an appeal before the Mumbai Income Tax Appellate Tribunal (ITAT), the ultimate fact-finding authority in the Indian dispute resolution framework, against the TP adjustment. As the ITAT was of the view that the issue raised by the Taxpayer was contentious, the matter was referred to a special bench.

Aggrieved by the order, Maersk India filed an appeal before ITAT. A special bench was constituted to answer the following specific questions;

• Whether for the purpose of determining the Arm’s Length Price (ALP) of the international transactions of Maersk India being provision of ITES services to their overseas AEs, companies performing KPO functions should be considered as comparable?

• Whether, in the case of Maersk India, companies earning abnormally high profit margin should be included in the list of comparable cases for the purposes of determining the ALP?

In adjudicating the matter, the special bench has ruled on various important aspects relating to Indian TP provisions. Some of the key observations of the special bench are stated below.

The taxpayer selected TNMM as the most appropriate method, which is based on broad functionality parameters while selecting potential comparables. However, it does not mean that standard of comparability is diluted merely because the method followed is TNMM. Placing reliance on the Delhi High Court’s decision in the case of Li and Fung India Pvt. Ltd. and the OECD transfer pricing guidelines, the Special Bench ruled that the standard of comparability for application of TNMM is no less than that for application of any other method.

Comparability analysis for ITES sector

There are peculiar issues governing the ITES sector such as absence of relevant financial data in public domain. Accordingly, it is appropriate to find a practical solution that assists in performing comparability analysis for cases belonging to the ITES sector. This problem can be resolved by splitting the comparability exercise into two steps in order to attain relatively equal degree of comparability.

By order!Maersk Global Centre (India) Private Limited v. ACIT — Mumbai tribunal — ITA No. 7466/Mum/2012


First step is to select potential comparables at the ITES sector level by applying “broad functionality” test. Therefore, all entities providing ITES can be taken as potential comparables. OECD TP guidelines further indicates “broad-based analysis” as an essential step in the comparability analysis and can be defined as an analysis of the industry, competition, economic and regulatory facts and other elements that affect taxpayers and their environment, but do not look at specific transactions in question.

Subsequent step is to ascertain whether bifurcation/ classification of ITES are possible for rejecting/ selecting comparables from the list of potential companies. Indian transfer pricing rules permit exclusion of certain entities selected as potential comparables by applying a broad functional test at the micro level to attain a relatively equal degree of comparability. OECD transfer pricing guidelines also advocates that uncontrolled transactions with a low degree of comparability be eliminated. Accordingly, bifurcation/ dissection of ITES can be done, depending on the facts and circumstances of each case, in order to select entities with a relatively equal degree of comparability.

Whether Maersk India qualifies as BPO or KPO service provider?

The special bench held that a perusal of the functional profile of Maersk India indicated that services such as process support/optimization and technical support are not in the nature of low-end services, since they require some degree of specialized knowledge and domain expertise. However, the revenue generated from such services was only about 10% of the total revenues generated during

FY07–08.

The special bench observed that Maersk India also rendered services such as contract drafting, audit functions based on different business strategies, tender handling etc. which cannot be, strictly considered as low-end services, as they involve some degree of special knowledge/expertise. However, such services are “incidental” to the main services involving data entry, transcription, consolidation, co-ordination, preparation, processing and review of shipping documents and such other similar support services. Furthermore, 96% of work-force employed comprised graduates/ postgraduates whereas only 4% workforce was highly skilled professionals (such as Chartered Accountants), which indicates that functions performed were mainly in the nature of providing back office support services of a low-end nature.

The special bench held, considering the functional profile, that Maersk India was only a captive contract service provider, mainly rendering back office support services. Some services are likely to involve a certain degree of special knowledge/expertise but those were only an insignificant portion of the total services performed and essentially in the nature

of incidental services. Accordingly, special bench ruled that potential comparable companies to be selected should also be low-end service providers and not a high-end KPO.

Using the above principle, the special bench examined two companies namely Mold-Tek Technologies and Eclerx Services, which is being disputed by Maersk India. The special bench directed the exclusion of these two companies on the grounds of them providing high-end services involving specialized knowledge and domain expertise in the field.

Distinction between KPO and BPO: relevant or otherwise?

ITAT is of the view that even though there is an apparent difference between BPO and KPO services, the line of distinction is very thin. Generally, BPO services are referred to as low-end services while KPO services are referred to as high-end services. Considering the range of services rendered under the ITES sector is wide, a classification of all services, either as low end or high end, is always not possible. On one hand, the KPO segment is referred to as an area moving beyond simple voice services suggesting that only simple voice and data services are low-end services, i.e., the BPO sector, while anything beyond this is to be considered as KPO services. Furthermore, even within the KPO segment, the level of expertise and special knowledge required to undertake different services might be different.

KPO services can be termed as an upward shift of the BPO industry in the value chain. The KPO therefore, is an evolution of BPO in the value chain. BPO trying to upgrade to a KPO is likely to render both BPO as well as KPO services in the process of evolution and therefore, such entity cannot be strictly considered to be either a BPO or KPO. Moreover, the mixed nature of services rendered will make it difficult to be classified as either a BPO or a KPO and going by its functional profile, it may actually fall somewhere in between. Furthermore, the exact determination of break-up of BPO and KPO services may also not be possible in the absence of relevant data maintained by the entity and in these circumstances and it may not be possible even to create a third category, i.e., “something between BPO and KPO.” There exists a significant overlap between various ITES activities (i.e., BPO and KPO) in terms of functions performed, which being very fact-sensitive, introducing segregation may lead to creation of more problems in the comparability analysis than solving the same. Therefore, ITES services cannot be further bifurcated as BPO and KPO services for the purpose of comparability analysis.


How relevant is Safe Harbour Rule’s (SHR) segregation of BPO and KPO?

SHR are framed by the Central Board for Direct Taxes (CBDT or Board) under the specific powers vested in the board under section 92CB of the Act and all the rules specified for SHR are for the purposes of the said section alone. Whereas the determination of ALP is governed by section 92C of the Act read with Rule 10B of the Income Tax Rules, 1962. ITAT pointed out that the definition of KPO and BPO (as defined in Rule 10TA) is exclusively for the purposes of SHR and not for the purposes of Rule 10B. ITAT also emphasized that SHR is applicable to the Taxpayer who exercised the option of SHR. Maersk India did not opt for SHR hence, the demarcation of KPO and BPO under Rule 10TA is not relevant to Maersk India. Moreover, the SHR was framed by CBDT vide circular dated 18 September 2013 and the same cannot be applied for this case for AY08–09. Relying on the decision of Hon’ble Supreme Court in the case of ITO vs. M.C. Ponnoose and Others - ITO vs. Excel Productions and Others [1970] 75 ITR 174 and in the case of Govinddas and Others vs. ITO [1976] 103 ITR 123, ITAT contended that the SHR cannot be applied retrospectively.

Exclusion of companies earning abnormally high profit margin as comparable companies

ITAT based its reliance on OECD TP guidelines and decisions rendered by division benches of the tribunal on the issue. Where one or more potential comparable companies have extreme results consisting of loss or unusual high profits, further investigation would be needed to understand the reasons for such extreme results. Such investigation should be to ascertain whether earning high profit reflects a normal business condition or whether it is a result of some abnormal conditions prevailing in the relevant year. Moreover, the profit margin earned by such entity in the immediate preceding year(s) may also be taken into consideration to find out whether the high profit margin represents normal business trend or otherwise. In such cases, the FAR would predominantly be to ensure that the potential comparable earning high margins reflect normal business conditions to be considered as a comparable. In other words, ITAT is of the view that high profit margin earning company reflecting normal business condition should not be rejected solely on the basis of abnormally high profit margin.

Implications

Globalization has led many multinational enterprises to establish information technology and back office operations in India. These centres have faced significant TP controversy relating to comparability analysis. The process followed to identify potential comparables is an important aspect of the comparability analysis. The choice of selection criteria has a significant influence on the outcome of the analysis and should, therefore, reflect the most meaningful economic characteristics of the subject transactions. The tax authority’s approach to select comparable data has generally been a contentious issue in most TP controversies. The Special Bench rejects a broad brush distinction between BPO and KPO services while undertaking a comparability analysis for provision of outsourced services. At the same time, the Special Bench recognizes that a wide set of potential comparables that operate in the same sector of activity and perform similar broad functions may need to be further refined using qualitative criteria with regard to facts and circumstances. This ruling, with clear emphasis on the functional aspect of comparability analysis, provides guidance on a number of issues that taxpayers as well as tax authorities face while undertaking a TP analysis for such transactions, especially with regard to the approach in selection of comparable companies. The ruling also provides guidance on comparability considerations when potential comparables demonstrate abnormally high profit results. Taxpayers should therefore appropriately consider the impact this ruling could have on their intercompany TP arrangements.

Lummus Technology Heat Transfer BV vs. DCIT – Delhi Tribunal - ITA No. 6227/Del/2012Delhi tribunal rules on use of un-audited segmental information for internal TNMM

Lummus Technology Heat Transfer BV (Lummus Dutch), is a Dutch company specializing in heat treatment equipment, has a Permanent Establishment (PE), by way of a branch in India (Lummus India-PE). During AY08–09, Lummus India-PE provided certain engineering services to Lummus Dutch and ABB Lummus Global Inc., USA (Lummus US) its AEs as well to other independent enterprises, i.e., non AEs. These engineering services were for projects undertaken in oil and gas, fertilizers and petrochemical industries. Lummus India-PE’s turnover with AEs was INR142.5 million and its turnover with non AEs is INR1.35 million for FY07–08. Lummus India-PE benchmarked its transaction with AE using internal Transactional Net Margin Method (TNMM) based on the profitability of its transaction with non AEs. Based on the segmental accounts prepared for the TP study, Lummus India-PE had earned a margin of 29.02% with respect to business with non


AEs and 40.68% with respect to business with AEs and therefore, concluded that its transaction with AEs to be at arm’s length.

During TP audit proceedings for AY08–09, TPO was of the view that the segmental accounts of the Lummus India-PE were not subject to the tax audit and hence, the segmental information, as disclosed, cannot be relied upon, stating that it was created to arbitrarily allocate the costs to show increased profitability with AE transactions. The TPO also stated that, though the quantum of revenue from non AE is only about 0.94% of the total revenue, Lummus India-PE’s allocation of operating cost was almost equal to both the segments. Accordingly, the TPO rejected the internal TNMM and proceeded to take up external comparable and proposed a TP adjustment amounting to INR27.24 million.

Aggrieved by the transfer pricing adjustment, Lummus India-PE filed its objection before the DRP. The DRP upheld the order of the TPO. Aggrieved by the directions of the DRP, Lummus India-PE filed an appeal before the Delhi ITAT. Delhi ITAT held it as follows:

Internal TNMM vs. external TNMM: audit of segmental information not mandatory

ITAT stated that as long as net profits earned from the controlled transactions are the same or higher than the net profits earned on uncontrolled transactions, no ALP adjustments are warranted. It is not at all necessary that such a computation should be based on segmental accounts in the books of accounts regularly maintained by the Taxpayer and subject to audit. Accordingly, it was held that it is incorrect to reject the segmental information provided by stating that the same was not maintained in the normal course of business and if they are subject to audit. Furthermore, it was also held that the TPO had erred in rejecting the internal TNMM by stating that the size of the transaction was too small. A comparable cannot be rejected based on its size at transaction level. Therefore, the ITAT upheld the use of internal TNMM.

TPO failed to observe that allocation of operating expenses was not arbitrary

ITAT also stated that the allocation of operating expenses by Lummus India-PE was not arbitrary as stated by the TPO. In fact the allocation was based on man-hours, which is fair and reasonable considering that every employee punches in number of hours spent on each project. ITAT emphasized that, though the basis of allocation was produced before the TPO, no specific defects were identified and pointed out and without considering the merits of the information furnished by Lummus India-PE, TPO concluded it to be un-reliable. Therefore, the TPO had indeed erred in rejecting the segmental accounts.

Cadbury India Ltd. v. ACIT (ITA No. 7641/Mum/2010) – Mumbai TribunalMumbai Tribunal rules that the payment of royalty to be arm’s length as the payment was duly approved by the RBI and SIA

Cadbury India Limited (Cadbury India) manufactures, distributes and markets malted food, drinks, cocoa powder, chocolates, toffees, drinking chocolates and sugar confectionaries. Cadbury India is a subsidiary of M/s Cadbury Schewepps PLC, UK (Cadbury UK). The Cadbury Group has presence in more than 200 countries and it enjoys the distinction of being the world’s third largest soft drinks company in sales volume and is among the fourth-largest confectionary company in the world.

During FY01–02, Cadbury India, inter alia, has entered international transaction relating to payment of royalty for the use of trademarks amounting to INR63.67 million and royalty for technical know-how amounting to INR56.62 million. Cadbury India has entered an agreement with Cadbury UK for payment of royalty on technical know-how. According to the agreement, Cadbury India pays royalty at 1.25% of internal sales and exports against which Cadbury UK will supply and disclose and make available to Cadbury India all know-how, advise and assist at all such times that may be mutually agreed between them. The company paid royalty on use of trademark at 1% of the net sale value.

During the Transfer Pricing (TP) proceedings for AY02–03, the TPO enquired as to why 1% of gross sales should not be considered to be at arm’s length instead of 1.25% as paid by the Taxpayer as royalty toward the use of technical know-how. The TPO also observed that Cadbury India had adopted TNMM as the most appropriate method for computing ALP of the international transaction by comparing the net margins of companies engaged in the business of food products, beverages and tobacco. The companies selected to be compared by Cadbury India did not pay any technical fee/royalty, as those companies had either developed their own technology or have acquired the technology long time back. On the other hand, Cadbury India, pays royalty for constant upgrade of technology. Hence the TPO concluded that such companies cannot be used for benchmarking the royalty payments at the first place. The TPO also suggested that the most appropriate method would be CUP since the international transaction pertaining to this segment amounts to only 2.24% of total sales and it should not affect the profitability at an entity level in order to adopt TNMM.


The TPO therefore, concluded that the royalty should not have been paid without the approval of the RBI. Though the royalty was paid w.e.f. 1 April 2001, the RBI approval was received only on 25 June 2001. Furthermore, the TPO has accepted that the royalty payment had not affected Taxpayer’s profitability. Therefore the royalty paid for the period of July 2001 to March 2002 can only be treated at arm’s length and proposed a TP adjustment of INR24.66 million.

Aggrieved by the order of the TPO, Cadbury India filed its appeal before the Commissioner of Income-tax (Appeals) [“CIT(A)”].

The impact of Intangibles on margin justifies the royalty payment

The CIT(A) held that, theoretically, TNMM takes a stance that, if the intangible property is attributable at an entity wide level, then such entity will earn profits in excess of what it would earn in the absence of such intangible property. Cadbury India’s operating margin is 13.28% as against the operating margin of the companies considered as comparable, i.e., 2.17%. This clearly establishes that intangible property has contributed to its excess margin. Despite the fact that the companies were never comparable, as they did not pay any technical fee/royalty, CIT(A) emphasized that, it is the intangible assets, which is acting as the crucial factor that gives it a tremendous competitive advantage translating into an operating margin of 13.28% and in the absence of such intangible assets the average margin earned by the comparable companies is 2.17%. This considerable gap in the margin justifies the 2.25% payment (1% toward royalty for trade mark and 1.25% toward technical know-how) made to the AE. Accordingly, CIT(A) ordered a deletion of the TP adjustment.

Aggrieved by the order of CIT(A), the revenue filed an appeal before the ITAT.

It was pointed out that according to the comparable information furnished during the TP assessments, the average royalty received by the parent AE from global entities works out to 2.32% (CUP being the method adopted). Therefore, the royalty payment is held to be within the prescribed limits.

Approval of the Reserve Bank of India (RBI) and Secretariat for Industrial Assistance, Government of India (SIA) adequate to conclude the transaction to be at arm’s length

ITAT held that Cadbury India had been paying royalty on technical knowhow since 1993 according to the approval of the RBI and SIA. Hence, there cannot be any scope of doubt that the royalty payment is not at arm’s length.

Indigene Pharmaceuticals v. ACIT (ITA No. 1541/Hyd/2011 & 1874/Hyd/2012) – Hyderabad TribunalHyderabad Tribunal rules that “Benefit-test” not relevant for determining ALP; cannot question the business wisdom of the Taxpayer in setting up a R&D center

Indigene Pharmaceuticals Private Limited (Indigene India) is a subsidiary of Indigene Pharmaceuticals Inc. US (Indigene US) and is engaged in the business of Research & Development (R&D) in the field of chemicals, agrochemicals, bulk drugs etc.

During FY06–07, the Taxpayer had undertaken international transaction in the nature of reimbursement of R&D costs to Indigene US amounting to INR83.34 million. Indigene US further outsourced these activities to third parties in the US and Canada.

During the TPO proceedings, the TPO noted that that Indigene India is a rapidly growing bio-pharmaceuticals and research-oriented company. The TPO also noted that Indigene India was incorporated on 24 April 2002 and Indigene US was incorporated on 7 March 2002. Both the entities came into existence in the same time span. During the FY06–07 the Department of Science and Technology (DST) advanced soft loan to Indigene India to promote R&D activities in India. The loan is unsecured in nature and carries a simple interest of 3% per annum. The TPO observed that during FY05–06, Indigene India had received share application money amounting to INR87.02 million and had also received a trade advance of US$0.45 million. However, during FY06–07 the share application money and the trade advance received was refunded back to Indigene US.

Considering Indigene US and its Indian subsidiary, Indigene India, started their operations at the same time in their respective geographies with similar capabilities and functionality, then the reason for which Indigene India started outsourcing its R & D work to its AE is not ascertained. He further noted that Indigene USA did not have any research facilities of its own and outsourced the R&D work to third parties. Furthermore, the documents entered into between Indigene USA and such third parties were not furnished for examination. The TPO noted that Indigene India could not demonstrate that the R&D work, which is outsourced to its AE cannot be undertaken in India.

15India, at Arm’s Length | 15

The TPO, contending that Indigene India had failed to substantiate the nexus between the outsourced work and actual work carried out, to say that Indigene India had actually benefitted from such work and also that the taxpayer had failed to explain the reason why the research work had not been directly outsourced to third parties in the US and Canada, determined the ALP of the transaction as NIL. Furthermore, the TPO considered the payment of INR 83.34 million as interest free loan and determined interest (INR 11.67 million) at 14% per annum and proposed a total adjustment of 95.01 million. The Assessing Officer (AO) passed draft assessment order incorporating the TP adjustments proposed by the TPO.

Aggrieved by the order, Indigene India filed its objections before the DRP. Indigene India objected to the TPO’s conclusion of terming the outsourcing of R&D work as a sham transaction without any basis. DRP upheld the order of the TPO.

Aggrieved by the directions of the DRP, Indigene India filed an appeal before the ITAT, Hyderabad.

The Hyderabad ITAT held as follows:

Revenue has no power to question Taxpayer’s business wisdom

The final project report had been submitted to the concerned authority. The project report mentions in detail about the result of R & D work undertaken with the financial assistance of DST and also clearly mentions that clinical trials were undertaken in Switzerland and Germany. Based on these facts it is clear that DST, as well as the monitoring committee, were aware of all the facts relating to the project and that a part of the project was carried out abroad. The authorities were also aware of the utilization of loan. Therefore, when neither DST nor the monitoring committee made any adverse remark with regard to R & D activity carried on by the Taxpayer itself or outsourced to its AE, the TPO or the DRP cannot term the transaction as sham merely on presumption without bringing cogent evidence to do so.

When Indigene India has taken a business decision to outsource a part of R&D activity, it is not for the department to question it. It is for the company to decide what is best for its business interest. It is beyond the powers of the AO to question the commercial wisdom of the Taxpayer on conduct of his business.

Benefit-test not relevant for determining ALP of a transaction: reimbursement of R&D cost not sham transaction

ITAT disregarded the observation of the TPO that services received from Indigene US did not benefit Indigene India in financial terms and hence, the ALP has to be Nil. ITAT held such analysis to be completely wrong. Whether services received actually benefits the Taxpayer or not has no role in determining ALP of services received. The relevant question in this case would be, whether the cost reimbursed is the price, which would have been paid if such services were received from an independent enterprise.

ITAT held that the only thing that the TPO is required to examine is whether the payment made to AE toward reimbursement of R&D expenditure is within arm’s length. Revenue authorities plan to raise a contention that, despite facilities being available in India, there was no commercial reason to outsource such activities, is beyond their power. In other words, the TPO has to examine the price paid by Indigene India and determine the ALP under TP provisions. It does not authorize the TPO to disallow any expenditure on the ground that it was not necessary or prudent for the Taxpayer to have incurred the same nor on the reason that Indigene India has not justified the benefit-principle. Accordingly, ITAT held that the transaction cannot be considered to be a sham transaction or diversion of funds.

In regard to the contention of the department that the Taxpayer neither produced any documentation or any evidence to substantiate its claim that reimbursement transaction is at arm’s length, ITAT noted that the TPO had ample power to call upon the Taxpayer to produce necessary documents. The company is of the contention that the invoices between the AE and other third parties in US/Canada are available to be considered as external CUP. The TPO failed to examine and make necessary inquiry to find out whether reimbursement of expenses for R&D is within arm’s length. This issue was therefore, is remitted back to the AO/TPO for examination.


Greece8 Establishes Advance Pricing Agreement procedures

On 31 December 2013, the General Secretary of Public Revenues of Greece decreed, in accordance with the newly introduced Tax Procedures Code, the procedures for the conclusion, amendment, revocation and annulment of an Advance Pricing Arrangement (APA). The decree refers to the procedures of both unilateral and bilateral APAs. Applications for an APA, under the newly issued decree, can be made in relation to cross-border intercompany transactions that take place in financial years starting 1 January 2014 onward. Moreover, an APA is valid for financial years that have not elapsed by the time the APA request is filed.

The APA refers to the criteria such as the transfer pricing method, the comparable data and relevant adjustments potentially made and the critical assumptions on the future conditions to be used in determining intercompany prices for a specified time frame up to four years with respect to transactions covered by the APA. Moreover, an APA can extend to any other particular issue in relation to the intercompany transaction pricing. APA requests are filed with the Directorate of Tax Audits.

Any taxpayer interested in an APA may request entering an informal preliminary consultation with the competent tax office directorate to explore its views on a likely APA content. Such consultation is protected by tax secrecy rules and any opinions exchanged throughout such process are not binding for either of the parties. For tax administrations to express its views on probable outcome of APA process, the taxpayer is required to provide all the relevant data, which should include the relevant business processes and transactions, the related parties concerned, the proposed transfer pricing method and duration of the APA. The APA request should consist of data such as group structure, details of all the related parties associated with inter-company transactions and critical assumptions on which APA is based. The tax audit directorate authority, in order to evaluate and deliver its views on the APA’s terms, may call for additional information from the applicant, approach foreign tax authorities for information considered critical.

The APA authorities would provide a report containing:

• ► Conclusion reached by the competent authority,

• ► Reason for potential rejection or amendment,

• ► Main facts supporting the conclusion of the tax authority,

• ► Information required for verification of critical assumptions and

• ► Suggestions on how implementation of the agreement will be monitored.

Within 10 days of drafting of the report, a final hearing with the applicant may be arranged. Within 20 days of the hearing and according to contents of the minutes, the decision, along with the minutes, is provided to the applicant. The decision consists of the data of the applicant, the inter-company transactions covered and conclusion reached by the tax authority on the approval or not of the APA application. In case approval is received, the report should further contain information on duration of the APA agreement, details of methodology agreed, critical assumptions applied documentation that must be retained during the term of agreement etc. The whole procedure from filing of the APA request till the issue of the decision cannot exceed 120 days. Once APA is concluded, the applicant will be required to file an annual compliance report along with the filing of income tax returns.

Overall, it is a positive development as long as in practice it will not have any discrimination effect on those taxpayers who opt not to request an APA. However, the fact that the APA report may eventually deviate from informal conclusions drawn during the preliminary stage, due to new facts that come to the attention of the tax office during the formal evaluation process, may undermine the purpose of the preliminary, informal consultation. Therefore, clarification is needed about which facts, derived from which sources can alter the preliminary position of the tax office. Moreover, more clarity would be needed on how the “non-binding character” of the preliminary consultation will be interpreted by the tax office.

Around the world

8 Global Tax Alert (News from Transfer Pricing) dated 07 January 2014


France9 New transfer pricing package entails a second, contemporaneous, documentation requirement

The French Constitutional Council validated a new contemporaneous transfer pricing documentation included in the Fight Against Tax Evasion and Financial Criminality Bill adopted by the French Parliament. The existing transfer pricing documentation requires companies or permanent establishments, which satisfy certain criteria to provide transfer pricing document within 30 days upon request by the tax inspector.

Taxpayers filing their Corporate Income Tax (CIT) return and that are subject to the provisions of Article L13AA of the French Procedural Tax Court (FPTC) must, in addition to the preparation of an L13AA report, file “light” transfer pricing documentation. The “light” transfer pricing documentation should contain information on the general description of the group and specific information regarding French entity. As such, no detailed functional analysis or economic analysis will be required, the purpose being to enhance the French Tax Authorities’ (FTA) capability to identify taxpayers with the highest transfer pricing exposure to allocate their audit resources accordingly. The taxpayers will be required to include in their transfer pricing documentation, tax rulings obtained by all related parties from foreign tax authorities.

After the enactment of the bill, companies in the scope of L13AA or with a turnover exceeding €152.4 million or €76.2 million depending on their business activity will have to communicate their management accounting in case of a tax audit. The current French regulations provide for a postponement of the payment of taxes resulting from a French transfer pricing reassessment (L189A of FPTC) in case of opening of a mutual agreement procedure (MAP). In light of Action No. 4 (limit base erosion via interest deductions and other financial payments) of the BEPS project released by the OECD, the French Government proposed to disallow the tax deduction of interest accrued to related parties if the French taxpayer cannot justify.

Furthermore, with respect to transactions involving business restructuring, it is recommended to taxpayers involved in business restructuring to prepare a documentation to support (i) the existence and (ii) the arm’s length nature of the compensation aforementioned. Although the FTA still bears the burden of proof, such documentation will facilitate discussions with the administration in case of tax audit.

Companies that fall within the scope of Article L13AA of the FPTC would have been subject to a penalty increased to 0.5% of their turnover, per fiscal year audited, potentially in case of lack of or incomplete L13AA documentation report and with a minimum of €10,000. The Constitutional Council censored this provision, on the grounds that the penalty was potentially not commensurate with the severity of the breach.

The introduction of an additional TP documentation requirement will significantly change the French TP landscape by empowering the FTA with a complete toolkit to quickly identify and characterize audit opportunities: increased transfer pricing documentation obligations; use of widely publicized police raids at taxpayers’ premises; access to management accounts; and a facilitated access to financial data in easily manipulated electronic format.

Nigeria10

Nigerian Tax Authorities issue transfer pricing guidance and forms

The Federal Inland Revenue Service Transfer Pricing (FIRS TP) Division took significant steps in its administration of Nigeria’s new TP regime. Specifically, the Division has requested that taxable persons maintain and submit their TP policy documents in addition to TP documentation and clarified the process for completing annual TP returns, as well as publishing updated TP declaration and TP disclosure forms.

Nigeria’s transfer pricing compliance process

The transfer pricing compliance process in Nigeria is now composed of the following:

• ► TP documentation: The TP Regulations require that the TP documentation is in place prior to the due date for filing the income tax return of the year in which the transactions in entered with the connected taxable persons. However, recently published FIRS guidance has indicated the FIRS expects taxable persons to start maintaining documentation at the time the transaction is taking place, i.e., contemporaneously.

• ► TP policy: Taxable persons are required to maintain TP policy documents (both Group and Domestic policies), which are to be submitted with the first annual transfer pricing return, and updated when there are material changes to the policy.

• ► Annual TP returns: An annual TP Return must be submitted at the time of filing the annual income tax return, and consists of TP disclosure form, audited financial statements, copy of income tax self-assessment, and tax computation with all schedules

9 Global Tax Alert (News from Transfer Pricing) dated 07 January 201410 Global Tax Alert (News from Transfer Pricing) dated 21 March 2014


In addition, for the first year of submission of TP returns, the TP policy documents and TP declaration form must also be submitted and thereafter, be updated when there are material changes to the information contained in them.

Transfer pricing policy requests

The FIRS TP Division has begun sending out requests to taxpayers subject to TP Regulations, asking them to submit their group and domestic transfer pricing policy within 30 days. The guidance indicates every taxpayer subject to the TP regulations is required to document its TP policy at both group and domestic levels and submit such policy to the FIRS either within 21 days upon request or, if no request is made, at the time of filing their first TP returns.

The FIRS guidance indicates that a Group TP policy refers to the set of principles adopted by the group upon which the pricing of intra-group transactions are based, depending on the objectives being pursued by the group and that a Domestic TP policy differs from the Group TP policy considering the requirements of the country’s TP legal framework.

FIRS expects a TP policy to contain information on the TP methods and the comparables used to assess arm’s length pricing. Companies may therefore, need to prepare specific policy documents in order to comply with the FIRS request, as existing internal documents are unlikely to fully address those expectations.

Declaration and disclosure forms

The TP disclosure form requires the provision of information about the reporting entity, its parent, subsidiaries, ownership structure, major shareholders, and directors, all the taxpayers controlled transactions, including transaction volumes and the transfer pricing methods, basic financial information from the financial statements of the reporting entity and its consolidated group.

Implications

These recent communications indicate that FIRS is continuing its strong commitment to the enforcement of TP regulations, and the transfer pricing regime in Nigeria is shaping up to be one of the more comprehensive regimes globally. Affected taxpayers will be advised to take immediate action to ensure they have their transfer pricing policy, documentation and returns completed in time to meet the deadlines.

Columbia11

Columbia modifies transfer pricing regulations

Colombia has modified its transfer pricing regulations in accordance with Law 1607 enacted in December 2012, which included reforms to transfer pricing rules.

Economic link

The Decree prescribes that the following transactions will be treated as creating an economic link:

Transactions between branches and their home offices, related parties made through third parties, related parties executed through joint venture type agreements and other collaborative agreements, a taxpayer and companies located in a free trade zone in Colombia and transaction in which a permanent establishment (PE) participates.

Transfer pricing obligation compliance

The Decree also established the following conditions for determining whether a taxpayer must comply with the transfer pricing obligations in Colombia:

• ► Income taxpayers that engage in transactions with residents or those domiciled in tax havens are obliged to fulfil transfer pricing requirements even when not exceeding the established caps of gross equity equal to or higher than 100,000 Taxable Units (TU) or gross income equal to or higher than 61,000 TU.

• ► Those transactions exceeding 32,000 TU by type of transaction are subject to transfer pricing analysis, only if the total amount of transactions exceeds 61,000 TU. For financing transactions with related parties, the amount of the debt must be considered when determining the total amount of transactions.

• ► Transactions with residents or those domiciled in tax havens are subject to transfer pricing analysis only if the total amount of transactions exceeds 10,000 TU.

Financing transactions

Colombian resident companies must comply with a 3:1 debt-to-equity ratio in order to deduct interest accrued on any type of loan, whether foreign or domestic, and with related or unrelated parties.

In addition, financing transactions with related parties must consider market terms and conditions, otherwise, those financing transactions will be deemed to be capital contributions, and interest will be regarded as dividends.

11 Global Tax Alert (News from Transfer Pricing and Americas Tax Center) dated 03 March 2014


Acquisitions

When acquiring used fixed assets from a related party, the comparable uncontrolled price (CUP) method may be applied by providing the invoice with the cost of the new asset at the time of original purchase from the third party and applying the corresponding depreciation after its acquisition. When this information is either not available or the assets have been built or assembled from several components, an asset valuation performed by a third party can be used.

The equity value cannot be used to analyze the purchase/sale of stocks that are not publicly traded on the stock market or those transactions that involve the transfer of other assets that have difficulties when being compared. Financial valuation methods must be used, particularly those that calculate the market value through the discounted cash flow method.

Transfer pricing analysis

For transfer pricing analysis purposes, only the financial information for the income year under review should be used. An explanation must be included if other financial information is used. Internal comparables should take priority when carrying out the transfer pricing analysis when they are available.

Taxpayers paying related parties resident or domiciled in a low tax jurisdiction must document and demonstrate the details of the functions performed, assets used, risks assumed and all costs and expenses incurred by the related party for the performance of the activities that generated those payments. With regard to the payment for services abroad, the taxpayer must demonstrate that services were in fact received and there is a benefit for the Colombian entity. Moreover, it is necessary to prove the fee paid complies with the arm’s length principle.

Additionally, cost contributions or cost sharing payments must comply with the arm’s length principle in order to demonstrate the benefit for the Colombian entity. Business restructuring, where functions, assets or risks of the Colombian entity are assigned or transferred to a foreign-related party must be compensated in compliance with the arm’s length principle.

The taxpayers are allowed to use other statistical measures, instead of the interquartile range, including the total range, to determine if a transaction complies with the arm’s length principle. If the interquartile range is used, the taxpayer must justify its use in the supporting documentation.

Segmented financial information, used for the preparation of the transfer pricing documentation, must be certified by a public accountant, independent auditor, or its counterpart.

The tested party may be either the Colombian party or the one abroad, based on which party’s functions are less complex, availability of information and requirement of adjustments. When the tested party is the one abroad, all supporting documentation must be provided and financials used must be certified by a public accountant, independent auditor, or someone similar. The Colombian entity’s non-monetary and industrial contributions to capital of foreign-related entities must be subject to transfer pricing rules. Intangible contributions made by Colombian entities to foreign-related entities abroad, must be reported in the transfer pricing return, regardless of amount.

Advanced Pricing Agreements (APA) may be signed with the tax authorities, for a five-year term (including a one-year rollback). The transfer pricing return can be voluntarily amended for two years from the original date of filing. When the taxpayer amends its transfer pricing documentation and transfer pricing return for inconsistencies or omissions, before the tax authority issues its penalty order, a non-deductible penalty will be applied. Moreover, the penalties for inconsistencies or omissions are reduced to 50% of the amount determined in the official assessment.

Iceland12

Introduces new transfer pricing rules

On 1 January 2014, the Icelandic Parliament introduced new transfer pricing rules. The rules are now regulated by Article 57 of Act No. 90/2003 on Income Tax. According to the law, tax authorities may assess and adjust pricing between related parties. The pricing methods are based on OECD Guidelines. The provision does not specify any one method or prioritize the methods in any way.

Legal entities that have turnover or total assets exceeding ISK1 billion (approximately US$8.6 million) in the previous year are required to document the nature and extent of transactions with related parties, including reasoning for transaction prices and other terms. The duty exists as of the beginning of the next operational year. The Government of Iceland will issue a regulation with additional guidelines on the subject of documentation and pricing.

12 Global Tax Alert (News from Transfer Pricing) dated 11 February 2014

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This publication contains information in summary form and is therefore intended for general guidance only. It is not intended to be a substitute for detailed research or the exercise of professional judgment. Neither Ernst & Young LLP nor any other member of the global Ernst & Young organization can accept any responsibility for loss occasioned to any person acting or refraining from action as a result of any material in this publication. On any specific matter, reference should be made to the appropriate advisor.

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