Concept of Transfer PricingTransfer Pricing Documentation

Concept of Safe Harbour

Manoj Pardasani Partner – Transfer Pricing

B S R & Co.2 July 2010

What we would discuss today…

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02

04

05

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Evolution of Transfer Pricing in India

Overview of Indian Transfer Pricing Regulations

Requirement for Transfer Pricing Documentation Overview of Databases – Prowess and Capitaline

Finance Act 2009 – Amendments IntroducedSafe Harbour Rules – an Overview

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Direct Taxes Code Bill 2009 - Proposals07

Evolution of Transfer Pricing In India

Evolution of Transfer Pricing in India

• Transfer Pricing was introduced in India with effect from April, 2001 under Sections 92 to 92F of the Income Tax Act, 1961 (‘the Act’) and are broadly based on the OECD guidelines.

• The Indian Transfer Pricing prescribes that income arising from “international transactions” between “associated enterprises” should be computed having regard to the “arm’s length price”.

• The objective of the regulation is to prevent shifting of profits by manipulating prices charged or paid in the international transactions, thereby eroding the tax base of the country.

Evolution of Transfer Pricing in India (contd…)

The Finance Minister’s Speech on the rationale for Introducing Transfer Pricing Regulations:

“The presence of multinational enterprises in India and their ability to allocate profits in different jurisdictions by controlling prices in intra-group transactions has made the issue of transfer pricing a matter of serious concern. I had set up an Expert Group in November 1999 to examine the detailed structure for transfer pricing legislation. Necessary legislative changes are being made in the Finance Bill based on these recommendations”

- Mr. Yashwant Sinha

Finance Minister, Government of India

February 28, 2001

Overview of Indian Transfer Pricing Regulations

Sec 92 – Special Provisions relating to avoidance of Tax

Transfer Pricing

92E

92C

92F

92B

92A92D

Meaning of Associated Enterprise

Meaning of international transactionsComputation of arm’s length price

Maintenance of information and document by persons

Accountant’s Report Definitions relevant to Arm’s length price

A

C

B

Both A and B are associated enterprises of C

D and E are also associated enterprises of C since they have a common ultimate parent (A)

A

C

B E

D

Outside

India

In India

Direct or indirect participation (through one or more intermediaries) in management, control or capital – Sec 92A(1)

Sec 92A - Associated Enterprises

Outside

India

In India

This section is further supplemented by 13 clauses which enlist various situations under which two enterprises shall be deemed to be AE’s – Sec 92 A(2)

Situation 1

Situation 2

Sec 92A(2) - Deemed Associated Enterprises

Loan advanced constitutes not less than 51% of the book value of total assets

Guarantee by one enterprise constitutes not less than 10 % of total borrowings

Manufacture or processing of goods is wholly dependent on intangibles of the owner

90% of raw materials are supplied by the other enterprise; prices are also influenced

More than half of the board of directors or executive directors are appointed by the other enterprise

Person or enterprise holds not less than 26 % voting power in the other enterprise

There exists between the two enterprises any relationship of mutual interest

Sec 92B – Meaning of International Transactions

•Transactions between two or more associated enterprises

•Either or both of whom are non-residents

Transaction relates to:

•purchase, sale or lease of tangible or intangible property; or

•provision of services; or

•lending or borrowing money; or

•any other transaction having a bearing on the profits, income, losses or assets of the enterprises; or

•mutual agreements or arrangements for allocation or apportionment of, or any contribution to, any cost or expense incurred.

Third parties transactions deemed to be international transaction

- Sec 92B(2)Sec 92B(2)

A’s Parent 3rd party

A

Prior agreement

Service

s

A’s Parent 3rd party

A Servic

es

Determination of terms

Transaction between A and 3rd party also subject to transfer pricing norms, if:

•a prior agreement exists between A’s parent and 3rd party; or

•terms of transaction are determined in substance by A’s parent and 3rd party.

Deemed International Transactions

Sec 92C – Methods to determine Arm’s Length Price

• Most Appropriate Method shall be the method best suited to the facts and circumstances of each particular international transaction and which provides the most reliable measure of an arm’s length price in relation to the international transaction.

• Factors considered for selection of the Most appropriate method:Nature and class of international transactionClass of associated enterprise and functions performedAvailability, coverage and reliability of dataDegree of comparability between the international transactionsExtent to which reliable and accurate adjustments can be madeThe nature, extent and reliability of assumptions for application of method

• Computation of ALP –

• Determination of arm’s length prices using one of the prescribed methods

• In case of more than one price: ALP = Arithmetic Mean of such prices

• +/- 5% variance to arm’s length “price” permitted : (Safe harbour)

Parent Co.

Sub Co.Tra

nsfe

r Pric

eUnrelated Co. X

Internal CUP

Outside India

India

Unrelated Co. Y

Unrelated Co. Z

Exte

rnal

CU

P

Outside India

India

Comparable Uncontrolled Price Method (1/2) - CUP

Situation 1

Situation 2

Comparable Uncontrolled Price Method (2/2) - CUP

•Most Direct Method for testing ALP and the Prices are Benchmarked

•Requires strict comparability in products, contractual terms, economic terms, etc.

•Two types of CUPs available - Internal CUP & External CUP

•Calls for adjustments to be made for differences which could materially affect the price in the open market e.g.:

•Difference in volume/quality of product

•Difference in credit terms

•Risks assumed

•Geographic market

•OECD - Priority to Internal CUP over External CUP due to higher degree of comparability.

Resale Price Method (1/2) - RPM

Parent Co.

Sub Co.

Transfer Price INR 75

Unrelated Co.

Resale Price INR 100

Outside India

India

Price paid by Sub Co. to AE is at arm’s length if the 25% resale margin earned by Sub Co. is more than margins earned by similar Indian distributors

Resale Price Method (2/2) - RPM

•Compares the resale gross margin earned by associated enterprise with the resale gross margin earned by comparable independent distributors

•Preferred method for a distributor buying purely finished goods from a group company (if no CUP available)

•To be applied when a goods purchased or service obtained from an AE is resold to an unrelated enterprise.

•Under this method comparability is less dependent on strict product comparability and additional emphasis is on similarity of functions performed & risks assumed.

Cost Plus Method (1/2) - CPLM

Parent Co.

Sub Co.

Transfer Price INR

125

Co.Y / AE

CO

GS

IN

R

70

Outside India

India

Direct Cost & Indirect Cost

of Production INR 30

Co. Z

Price charged by Sub co to AE is at arm’s length if the 25% mark up on cost is more than that of similar Indian assemblers

Cost Plus Method (2/2) - CPLM

• Compares the mark up earned on direct and indirect costs incurred with that of comparable independent companies.

• Preferred method in case

• Semi finished goods sold between related parties

• Contract/toll manufacturing agreement

• Long term buy/supply arrangements

• To be applied in cases involving manufacture, assembly or production of tangible products or services that are sold/provided to AEs

• Identifies direct and indirect costs of production of goods/services

• Comparability under this method is not as much dependent on close physical similarity between the products – Larger emphasis on functional comparability

• To be applied in cases involving transfer of unique intangibles or in multiple international transactions that cannot be evaluated separately.

• Calculates the combined operating profit resulting from an inter-company transaction based on the relative value of each AEs contribution to the operating profit.

• Evaluates allocation of combined profit/loss in controlled integrated transactions.

• The contribution made by each party is based upon a functional analysis and valued, if possible, using external comparable data.

• The two methods discussed by OECD Guidelines

– Contribution PSM Analysis

– Residual PSM Analysis

Profit Split Method (PSM)

• Examines net operating profit from transactions as a percentage of a certain base (can use different bases i.e. costs, turnover, etc) in respect of similar parties.

• Ideally, operating margin should be compared to operating margin earned by same enterprise on uncontrolled transaction – Internal TNMM.

• Most frequently used method in India, due to lack of availability of comparable uncontrolled prices and gross margin data required for application of the comparable uncontrolled price method / cost plus method / resale price method.

• Broad level of product comparability and high level of functional comparability.

• Applicable for any type of transaction and often used to supplement analysis under other methods.

• The application of the TNMM to a specific tested party breaks down when factors other than transfer prices have a material impact upon profits.

Transactional Net Margin Method (TNMM)

Selection of Transfer Pricing Methods

MethodsProduct

Comparability

Functional Comparability

Approach

Comparable Uncontrolled Price Method

Very High MediumPrices are benchmarked

Resale Price Method

High MediumGross Profit

Margin (on sales) benchmarked

Cost Plus Method

High HighGross Profit

Margin (on costs) benchmarked

Profit Split Method

Medium Very High Profit Margins

Transactional Net Margin Method

Medium Very High Net Profit Margins

Need for Transfer Pricing Document in IndiaNeed for a Transfer Pricing Documentation in India

Need for Transfer Pricing Documentation in India

Documentation Requirements – Section 92D

Entity Related Price Related Transaction Related

Profile of Group

Profile of Indian Entity

Profile of associated Enterprises

Profile of industry

Transaction Terms

Functional analysis

Economic analysis

Forecasts, budgets and estimates

Agreements

Invoices

Pricing related correspondence

Contemporaneous Documentation requirement – Rule 10 DNo specific documentation requirement if the value of international transactions

Is less than one crore rupees.

• Preparation of project plan • Search strategy

• Access to local & global database

• Analysis of internal comparables

• Judicious identification of arm’s length range

• Understand existing costing mechanism

• Determination of billing methodology

Pre-project

planning

Stage 2Stage 3

Stage 4

Functional analysis -

Information gathering

Comparable data Analysi

s

• Interviews• Questionnaires

• Discussions with Management

• Characterisation of each entity

• Agreement reviews

Stage 5

• Consultation with management

• Finalization of Transfer pricing documentation

Issuance of Transfer Pricing Documentation

Stage 1

Compliance – A step by step approach

Filing of Accountant’s Report – Section 92E

•Sec 92E of the Act :

Every person who has entered into an international transaction during the previous year shall obtain a report from an accountant and furnish such report on the specified date duly signed and verified by an accountant.

•Form 3CEB prescribes (Rule 10E)

•Declaration by the accountant about examination of accounts.

•Opinion on information and documents prescribed by Rule 10D and maintained by the assessee

•Annexure to Form 3CEB are “True” and “Correct”

•Guidance Notes issued by the Institute of Chartered Accountants of India.

•The information contained in 3CEB helps the Assessing officer with an overview of the international transactions of the company.

Stringent Penalties

Default Penalty

In case of a post-inquiry adjustment, there is deemed to be a concealment of income

100-300% of tax on the adjusted amount

Failure to maintain documents

2% of the value of each international transaction.

Failure to furnish documents

2% of the value of the international transaction

Failure to furnish accountant’s report

Rs 100,000

Databases

Databases available in the public domain

•Suitable comparables can be selected in various ways viz. by search in database, through company websites, publicly available annual reports of the companies, information available in industry surveys etc.

•The Act does not provide any one way of collecting the data or selecting the comparable.

•The databases used for the search of comparable companies are publicly available databases - Prowess and Capitaline. The revenue authorities also have access to these databases.

• The other websites which are considered for selection of comparables through the use of publicly available annual reports are:

• Ministry of corporate affairs

• Capitaline – annual reports website

Overview of Databases – Prowess

• Prowess is a database of large and medium Indian companies developed by the Centre for Monitoring Indian Economy Private Limited (‘hereinafter referred to as ‘CMIE’).

• Analysis of over 24,000 companies

• Covers: Organized industrial activities, Banking, Organized Financial and other services sectors in India.

• Contains 1500 data items and ratios per company.

• Provides quantitative information on: Production, Sales, Consumption of raw material and Energy, etc.

• Provides contact information , share holding pattern, list of bankers, auditors, news abstracts and such other relevant information.

• Provides several querying power to the user.

Industry/ Information covered by Prowess

Sub Industry

•Base metals•Chemicals •Construction Equipment

•Electrical Machinery

other than Electronics.

•Electronics•Miscellaneous Manufactured Articles.

•Non metallic mineral products

•Non-electrical machinery

•Plastics and rubbers•Services•Transport Equipment

Major Industries covered

There are various sub-industries within each of the industries mentioned under the industry column.

Although it is not practical to enumerate them, it is definitely worthwhile to note that it helps reach the desired category of companies.

• Quantitative• Financial Ratios• Absolute values• Archive of Information

• Investment Indicators

• Directors report, Auditors’s report, management discussions and analysis, etc under one database.

Type of Information

Overview of the Database - CapitalinePlus

•Capitaline is a financial and non-financial database developed by the Capital Market Publishers India Private Limited which provides fundamental and market data on more than 21,000 Indian listed and unlisted companies.

•Extensive data analysis, company profile, director’s reports and more than 10 years financials, cash flow, segment data etc.

• It provides financial overview using key financial data, forex data, cash flow and market capitalization with rate of growth.

•Covers nearly 300 industries and has access to web pages from within the application.

•Provides facility to download Annual Reports for last 3 years from within the application.

Industry/ Information covered by Capitaline

Sub Industry

•Metals•Cement•Chemicals•Constructions•Engineering•Electronics•Pharmaceuticals•Automobiles•Auto Ancillaries•Plastics•Transport•Steel

Industry Groups

There are various sub-industries within each of the industries mentioned under the industry column.

Although it is not practical to enumerate them, it is definitely worthwhile to note that it helps reach the desired category of companies.

• Quantitative• Financial Ratios• Absolute values• Archive of Information

• Investment Indicators

• Directors report, Auditors’s report, management discussions and analysis, etc under one database.

•Last 3 year’s Annual Reports

Type of Information

Other Databases / Sources of Information

Stock Exchanges

London Inter Bank Offered Rates

Foreign Exchange Rates

Commodity Markets

Finance Act 2009 - AmendmentsFinance Act 2009 – Key Amendments

Recent Amendments – Finance Act 2009

•Determination of Arm’s Length Price – Concept of +/- 5 percent variance.

•Introduction of Safe harbour rules

•Creation of Dispute Resolution Panel

Concept of +/- 5 percent variance

Introduction to Safe Harbor rules

•Considering the increase in transfer pricing litigation, Central Board of Direct Taxes (CBDT) is to formulate safe harbour rules.

•Aim to reduce the impact of judgemental errors in transfer pricing.

•Safe harbour has been defined to mean ‘circumstances’ in which the revenue authorities shall accept transfer pricing declared by the tax payer.

Internationally safe harbour has taken various forms

•Exclusion of certain classes of transactions based on quantitative thresholds.

•Stipulations of margins/pricing norms for specified industries/functions (USA, Singapore)

•Specifying thresholds whereby the onerous documentation requirement is reduced (Brazil)

Creation of Dispute Resolution Panel

•When a Transfer Pricing adjustment is proposed, the Assessing Officer will issue a draft order to Tax payer.

•Tax payer will confirm or file objections with the Assessing officer and Dispute Resolution Panel within 30 days.

•Dispute Resolution Panel will issue guidance to the Assessing officer after having regard to the evidences, further queries etc within 9 months from the date draft order was issued to tax payer.

•Panel may confirm, reduce and enhance the proposed transfer pricing adjustments. It cannot set aside the proposed adjustment for further enquiry.

• In case of differences within the Dispute Resolution Panel, opinion of majority stands.

•Assessing officer shall pass the order in conformity with directors of Dispute Resolution Panel, within one month without granting any additional opportunity to the tax payer.

•Appeal by tax payers lies before the Appellate Tribunal and Dispute Resolution Panels order is binding on the revenue and no appeal lies for the revenue.

•The Central Board of Direct Taxes has notified the Income Tax (Dispute Resolution Panel) Rules, 2009 on 20 November.

Dispute Resolution Panel – Process Chart

Concept of Safe Harbor

What is Safe Harbor?

•Evolution of Safe harbour provisions

•OECD Committed on Fiscal affairs debated the concept in 1993.

•Task force recommended safe harbor for small businesses.

•US Regulations in 1960’s brought in 5 methods + unspecified methods

•Definition of a Safe harbor

A Safe harbour (referred to as a comfort mechanism in the OECD Guidelines) has been defined to mean ‘circumstances’ in which, the Indian Revenue Authorities shall accept the transfer pricing declared by the tax payer.

• Administrative requirements may vary from

•Total relief to targeted tax payers from Transfer Pricing regulations; to

•Obligation to comply with various procedural rules as a condition for qualifying for safe harbour.

Safe Harbor Regime in India

•Finance [ No 2 ] Act, 2009 introduced new section 92CB

• The determination of arm’s length price under Section 92C or section 92CA shall be subject to safe harbor rules

• The Board may, for the purposes of sub-section (1), make rules for safe harbor.

•Intention is to reduce tax disputes

Factors Supporting use of Safe Harbor

•Compliance Relief•Collection and Analysis of Data•Application of simplified method (instead of

Best Method)•Relief from search of comparables

•Certainty•Prices will be accepted by Tax Authorities•Qualified Taxpayers assured that they will not

be subject to Audit

•Administrative Simplicity•Once eligibility is established, minimal

examination of controlled transactions.•Tax administrator can allocate more resources

to examination of transactions and taxpayers.

Problems presented by use of Safe Harbors

•Impact of Tax calculations of tax payers as well as its AE in other jurisdiction.

•Safe harbor may not be consistent with the Arm’s Length principle as it will be broad based.

•Tax planning opportunities

•Risk of Double Taxation

•Mutual Agreement Procedure (MAP) Difficulties

Likely implications in India

General Factors that would require attention :

•Specification of Scope

•Determination of cost base

•Determination of mark up on cost base and its revisions.

•Documentation to be maintained

•Options for Tax payer to opt out of Safe harbor

•Potential Double Taxation.

•TP adjustments that can be carried out to cost base etc.

•Conflicting provisions within different countries.

•Shifting of Profits

Industries that may be impacted

•Indian Information Technology / Information Technology Enabled Services Industry

• Selection of comparables (Captive vs. risky and Intangible based).

• Locations savings impact – Quantification.

• Identification of cost and aggregation by category e.g. BPO (20%), ITeS (15%)

•Management Charges

•Royalties – RBI / Exchange Control norms

•Contract Manufacturing

Direct Taxes Code Bill 2009- Proposals

Advance Pricing Arrangements

•Upfront determination of the Arm’s Length Price.

•The Board would be empowered to make further adjustments to the price determined as per the transfer pricing rules.

•APA term would be limited to a maximum of five consecutive financial years.

•The APA would be binding on the tax payer and the tax authorities, and only in respect of international transactions for which the agreement is sought.

Proposals relating to Transfer Pricing Assessment

•Dispute Resolution Mechanism retained – however only for cases of adjustments exceeding INR 2.5 million.

•Form 3CEB lodged directly with the Transfer Pricing Officer instead of the Assessing Officer.

•Selection of Transfer Pricing audit through risk management strategy framed by the Board. Such strategy or criteria will not be made public.

•Change in timelines of submission of certificate, commencement and completion of scrutiny.

•Best judgement assessment if assessee does not co-operate.

Other Proposals

•Definition of Associated Enterprise widened – Thresholds criteria would reduce:-Direct and indirect participation – 10% to 26%Loan to asset ration – reduced from 26% from

51%Nomination of director – more than 1/3rd from

HalfRaw material / Components supply – 2/3rd from

90%

•Concept of impermissible avoidance arrangements introduced – thin capitalization.

•Safe Harbour Provisions - Retained.

•Penalty provisions - Eased.

Questions ???Questions ???

Let’s DiscussLet’s Discuss

Thank You

Presenter’s Contact Details Manoj Pardasani

Partner – Transfer Pricing B S R & Co.

mpardasani@kpmg.com+91- 98111 50600