Market based transfer pricing issues for businesses expanding into China and India

These can pose greatest difficulties when groups operating internationally (“MNEs”) try to put in place pricing policies for intra group transactions that meet both transfer pricing guidelines issued by the Organisation for Economic Cooperation and Development (“OECD”), which apply in Ireland and most European jurisdictions, and local transfer pricing analyses. This is often the case in India and China where the local view is that organisations benefit from the location specific advantage of basing their business activities in these large and expanding markets.

What are location specific advantages

Location specific advantages (“LSAs”) that might be associated with the group’s business presence in India or China potentially include both location savings and local market features.

Location savings are the cost savings arising when a MNE relocates some of its activities to a place where labour or real estate costs are lower than in the location where the activities were initially performed.

Local market features are other attributes of the local market (growth rate of economy, population, competition, etc.) that may allow a MNE to obtain a premium price for its products or services in that market.

The local view

Taxing authorities in some countries have long argued that local entities in their jurisdictions should be compensated for LSAs when pricing the goods and services they provide to group members. They have taken the position that LSAs should be treated as intangible assets held by the local entities for which they should receive compensation.

In KPMG’s experience, when this stance is translated into agreements on transfer pricing with local tax audit teams in India and China, it can result in the local entity receiving a higher compensation for the activities it performs when compared to other entities within the MNE. This is despite the local entity performing the same functions, bearing the same risks and owning the same assets as other entities within the group based elsewhere.

This outcome can result in double taxation of MNE profits where the local tax authorities require compensation for the LSAs but the group counterparty to the transaction is not allowed to take a full deduction for the compensation in the jurisdiction where the payer is based. This is because, in the counterparty jurisdiction, the payment is considered to be in excess of an arm’s length payment.

Current position of the OECD

Under Action 8 of the Base Erosion Profit Shifting (“BEPS”) project, the OECD defined an intangible asset as something which is “not a physical or financial asset”, is “capable of being owned or controlled for use in commercial activities” and “whose use or transfer would be compensated had it occurred between independent parties”. As LSAs are not capable of being owned or controlled, the OECD’s position is clear that they should not be considered intangible assets.

The OECD further discusses LSAs in the new guidance in Chapter I of the OECD Guidelines. It acknowledges that LSAs may be a comparability factor when determining an arm’s length price for transactions between related parties and provides a broad framework to apply where LSAs are found to exist and where they are not passed to the end customer.

The OECD, similar to the US, holds the position that LSAs are essentially features in a market to be exploited by MNEs but are not features in a market that should result in

Karen Lynn of KPMG’s transfer pricing team takes a look at on the ground transfer pricing issues that Irish businesses face as they expand operations into China and India.

additional compensation to entities located in the market. It outlines that where local comparables are available, it should be possible to use the comparable data to determine how to allocate the LSAs between the parties on an arm’s length basis. This is based on the fact that the benefits of LSAs are already considered to be embedded in the returns earned by the local comparables.

However, tax authorities in countries such as China and India do not accept that there are local comparables which can be used. As the OECD Guidelines currently do not provide guidance for these circumstances, it leaves it open for tax authorities in some countries to negotiate a transfer pricing approach which reflects a sharing of the savings between the parties. This can result in setting transfer prices which result in a generous allocation of location savings to the local entity in that jurisdiction which, in turn, may give rise to double taxation.

Current position in China

In 2015, the Chinese State of Administration of Taxation (“SAT”) released a discussion draft of the revised Special Tax Adjustment Implementation Rules which proposes the recognition of LSAs in the Chinese transfer pricing rules for the first time. The discussion draft outlines that LSAs must be considered in a transfer pricing comparability analysis.

SAT has generally taken the view that suitable comparables for the purposes of a comparability analysis do not exist in the Chinese market. However, it acknowledges that valuing and allocating LSAs is a challenge and suggests that the entire value chain of the MNE should be considered. The discussion draft also provides that LSAs need to be considered in determining whether the profit split method should be used in a transfer pricing analysis. The discussion draft has yet to be finalised – which means that this remains an area that your business should monitor and keep under review.

Current position in India

Although Indian regulations do not provide any specific guidance on LSAs, the Indian tax authorities have made several transfer pricing adjustments in recent audits arguing that companies enjoy substantial cost savings in India due to its low cost labour, raw materials and infrastructure and therefore compensation should be allocated to the Indian entity in recognition of this. They do not agree that any location savings are embedded in margins drawn from local comparables. As a result, they do not accept that if the remuneration of the local entity is within an arm’s length range which has been determined by reviewing the margins of local comparables, no additional compensation should be provided for the LSAs.

The view of the tax authorities is however contrary to several recent Court decisions in India that have ruled that no separate compensation for LSAs is required if local comparables can be identified. In particular, recent case law has held that where the remuneration earned by the local Indian entity is based on local comparables operating in similar economic circumstances, no additional compensation for LSAs should be allocated to the Indian entity. These

recent judgments demonstrate that the view of the Indian courts in relation to LSAs is becoming more in line with international standards. However, not all MNEs will want to bear the costs of litigating a transfer pricing dispute with the tax authorities and therefore may find themselves making an additional payment for LSAs to close out an audit and reach a settlement agreement on transfer pricing dispute without going to court.

© 2017 KPMG, an Irish partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved. Printed in Ireland. Produced by: KPMG’s Creative Services. Publication Date: June 2017. (2769)

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Contact

Karen LynnDirectorTransfer PricingCHEC Tax

t: +353 1 700 4233m: +353 87 050 4233e: karen.lynn@kpmg.ie

What can your business do to mitigate the risk of double taxation?

Different views on the treatment of LSAs can result in double taxation for your business where local tax authorities insist that compensation is paid to local entities for LSAs but the group counterparty is not entitled to a full deduction for the payment made in computing its taxable profits. KPMG teams have worked with clients in many audits in India and China where the local tax authorities insist on the local entity receiving compensation for LSAs and will not finalise an audit until a payment is made.

MNEs have options when facing these issues. Advance insight into the likely stance of the local taxing authority can allow your business to identify those transactions and activities that present the greatest risk of tax authority challenge and can allow you to consider the scope for tailoring your transfer pricing approach accordingly. Where

it does not prove possible to reach a satisfactory outcome on audit, appealing to the Courts is one approach but consideration must be given to time and cost of this.

There is increasing local authority experience in dealing with Mutual Agreement Procedures which can be invoked where there is a double tax treaty between the countries involved. In addition, advance pricing arrangements can be considered where certainty on the future pricing is required by the MNE.

If your business has queries on transfer pricing matters as you expand abroad, please contact Karen Lynn or your usual KPMG team contact.