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It is well recognised that India has developed as an investment jurisdiction for multinational enterprises (MNEs) for carrying on information technology, R&D and back-office operations. The resultant increase in transactions involving entities in multiple tax jurisdictions has given rise to transfer pricing (TP) issues in each of these jurisdictions. In this backdrop, TP has evolved as one of the most significant and complex tax issues for both multinationals and the revenue authorities. In recent audits, the Indian revenue authorities are seen to be adopting an increasingly aggressive approach on TP-related issues and a significant brunt of the TP onslaught has been borne by captive IT companies in India, specifically in the software services and the IT-enabled services/BPO industry as most of them enjoy the benefit of a tax holiday under the Income-Tax Act, 1961, and upward adjustments pursuant to an audit is not eligible for tax holiday benefits.
Typically, a mark-up of 10-15 per cent on costs could be considered to be reasonable for captive IT service providers keeping in mind the low level of risks which these entities bear. However, in a number of cases, the revenue authorities have determined mark-ups of 25-35 per cent on costs to be the arm's length margin for captive IT service providers. Key issues While the Indian TP rules have outlined certain factors for judging comparability, it does not provide adequate guidance on certain key aspects relating to a TP analysis such as use of multiple year data, screening criteria for comparables, classification of income/expense items, quantitative adjustments, etc. The lack of quality comparable data in public domain is also a challenge leaving room for subjectivity in any transfer pricing analysis. This challenge is further compounded by the approach adopted the transfer pricing officers (TPOs) during audits. A practical problem arises at the time of preparing the TP documentation report by the taxpayer, as at that point of time the relevant financial year data may not be available.
The TPOs have rejected the use of multiple year data and considered only the single year (the relevant financial year) data for determination of the arm's length price. The TPOs are of the view that while the documentation based on prior year data could satisfy the mandatory and contemporaneous documentation requirements, the same does not necessarily limit them from making a TP adjustment if additional data available at the time of audit so warrants. On occasions, during ongoing audits TPOs have used information which is not available in the public domain and have also eliminated loss making/low turnover comparables, creating a bias in favour of profitable companies in the comparable data, resulting in transfer pricing adjustments for the taxpayers. Captive IT service providers in India typically function in a 'risk-mitigated' environment as compared to comparables who bear a range of risks such as R&D, market risks, service liability risk, etc.
I The appropriate resolution of an issue in one situation may be entirely different from the same issue's resolution for another taxpayer in the same business. a taxpayer has no option but to resolve issues through the normal domestic tax appellate procedure or the Mutual Agreement Procedure (MAP) prescribed under the tax treaties. in an effort to spare themselves the time and expense of a tax audit and potential dispute resolution proceedings. the foreign entity in the international transaction approaches its Competent Authority. ~ V Under the MAP process. that is. Introduction of such a mechanism in India should help in resolving these issues. In this backdrop. This difference in views between tax authorities of two (or more) countries on what an appropriate transfer price should be increases the risk of international economic double taxation to an MNE. Compared to developed tax regimes. in case of a TP adjustment in the hands of the Indian entity. an increase in income in the hands of the Indian entity does not automatically result in a corresponding increase in expenditure in the hands of the foreign entity. safe harbour benchmarks for capti ve IT service providers are some measures that would prove beneficial. there is an urgent need to revisit some of the TP provisions and resolve the key issues by providing additional guidance and introducing more certainty and fairness in the manner in which TP regulations are applied. introducing measures such as AP As. ~ducing penalties. resulting in economic double taxation. In this situation.While the TP regulations permit adjustment to comparable data to account for the risk differences. Keeping in view the difficulties being faced by MNEs operating in India. MNEs may desire to resolve their transfer pricing issues in advance by entering into an APA with the tax administration. which deals with the Mutual Agreement Procedure (MAP). the approach adopted for making the risk adjustment has been quite subjective and arbitrary. it does no~provide guidance on the manner of making such adjustments. Recent negotiations between the Competent Authorities (CAs) of India and the USA under Article 27 of the India-US tax treaty (Tax treaty). taxpayers may need to consider performing risk adjustments based on certain financial and economic models. which in turn will approach the Indian Competent Authority for resolution of the dispute. However. transfer pricing disputes have become a significant subject of the Competent Authority dispute-resolution process between treaty countries because these issues are factual in nature and often applied differently in each country. are essentially anti-abuse mechanisms aimed at preventing shift of profits through inter-company transfer prices to a favourable tax jurisdiction. Scope for double taxation TP regulations. provides . where a taxpayer <!Ild revenue authorities can agree in advance on the transfer price. In the absence of a formal Advance Pricing Agreement (APA) programme in India. Despite the underlying law being essentially the same in all countries. including those introduced in India. While TPOs acknowledge the need to factor such risk differentials. India is still on the learning curve in relation to transfer pricing.
R&D and back-office operations for providing intra-group services. The proposed resolution involves the CAs agreeing to accept a m3rk-up on costs of 18% as the arm's length price as compared to an adjustment in the range of 25-30% made by the Indian revenue authorities.~ for a dispute resolution mechanism where the CAs shall endeavor by mutual agreement to resolve the situation of taxpayers subject to taxation not in accordance with the provisions of the Tax Treaty. ' The MAP article of a tax treaty allows designated representatives i. the US and Indian CAs have proposed to resolve a transfer pricing (TP) dispute involving provision of intra-group information technology services. it has been reported that India and the US CAs have proposed to the taxpayers on whether a resolution based on a mark-up of 18% on costs would be acceptable. A ~P arti~_e in most t~x treaties does not ~ompel CAs to actually reach an agreement an~ resolve their :ax disputes. r Facts and proposed settlement:-During the course of TP audits for the tax year 2004-Q. The Indian revenue authorities asserted these adjustments largely by adopting a different approach/criteria . by an Indian affiliate to a US multinational enterprises (MNE).e. These MAP applications have ~sulted in discussions between the CAs of India and the US to reach a settlement on the TP adjustments made by the Indian revenue authorities. Further. would not qualify for the tax holiday. a TP adjustment in the hands of the Indian affiliate could potentially result III economic do'uble taxation for the MNE if the MNE is not able to obtain a correlative relief. with effect from 1 April ~2001. Pursuant to ongoing discussions. The taxpayers involved have the optiol} to either accept the MAP resolution or follow the course of appeal prescribed under the domestic tax laws./ for accepting/rejecting comparable data.5. including TP disputes. 1 hey are obliged to only use their best endeavors to reach an agreement. any income allocated pursuant to an upward TP adjustment made during the course of an audit. While a number of these operations may enjoy the benefit or[a tax holiday under the ITL. Some of the US MNEs invoked MAP under Article 27 of the Tax Treaty. a number of Indian affiliates of US MNEs. TP disputes have emerged as a significant challenge faced by MNEs doing business in India. A Memorandum of Understanding (MoU) between the two countries provides that the CAs would endeavor to resolve such disputes within a period of two years and also provides for obtaining a stay on collection of the disputed taxes during the pe~dency of the MAI(tJ\~ ~'r"~ f'(tl~-9 It has recently been reported that. . A number of MNEs have established information technology (IT). as compared to the taxpayer's apprQach. The !ndian affiliates providing such services have been subject to adv~se TP adjustments in recent times.. CAs from the governments of the contractmg states to interact with the intent to resolve international tax disputes. ~~ Background -The TP provisions were introduced in the Indian Tax Laws (ITL). The disputes resolution under the MAP article of a tax treaty is in addition to the dispute resolution and appellate remedies that a taxpayer may have under the domestic tax laws. which were engaged in providing intragroup IT services were subject to /adverse TVitdJustments.Ths resulted in the Indian revenue authorities determining mark-ups on costs in the range of 24-3Q%as the arm's length price for such transactions.. pursuant to an MAP. Over the past few years.
If the taxpayers choose to give their consent to the MAP resolution.vis comparables. For multinational companies with Indian subsidiaries providing these services to their affiliates worldwide.a . while benchmarking the transactions pricing needs to be modelled after considering the identified comparables' mean. India has emerged as a globally preferred outsourcing destination. A MAP resolution does not typically set a binding precedent for either the taxpayers or the revenue authorities in regard to adjustments or issues relating to subsequent years or for CA discussions on the same issues for other taxpayers. Further. including media reports. The rationale for such margins is unclear as it is unlikely similar independent service providers in India would be earning margins anywhere near that level. Indian and US Tax Authorities Reach Agreement on Pricing of Information Technology Services The Indian tax authorities in recent years have been taking an aggressive position on transfer prices for software. especially in a similar fact pattern. The best practical method to be applied is TNMM. The growth achieved by India's information technology (IT) services and information technology enabled services CITeS) sectors stand testimony to this. growing English. Nevertheless. it could also enable the US taxpayer to consider whether it could be eligible to seek correlative relief based on the MAP resolution. leading to the often vexed question of what constitutes an arm's-length remuneration for a captive unit When we speak of captive units we need to take into consideration the capacity utilisation. the Indian tax authorities have been insisting on a markup upwards of 25-30 percent of total costs. business and knowledge process outsourcing (BPO & KPO) and information technology companies. Where a MAP resolution has been arrived at and accepted in respect of a particular issue for a relevant tax year. M official Endowed with the advantages oflow-cost base and a large. Nevertheless the captive units have one risk of "single customer". In addition. The taxpayers in the above case have the option to either accept the MAP resolution or follow the course of appeal prescribed under the domestic tax laws. The resulting transfer pricing assessments have been drastic and can lead to double taxation for the affected multinationals.speaking workforce. the comparables would be independent service providers. Indian transfer pricing regulations require captive units having international transactions with its associated enterprises to be remunerated on an "arm's-length" basis. Commentsr-The above information is based on secondary sources. the Indian affiliate would need to withdraw any appeal filed under the domestic tax appellate procedure. it does provide an indication of settlements that could be expected from MAP proceedings. the risk undertaken and the functional profile of the tested party vis . The factors and the principles that were considered by the CAs before making the above proposal are also not known at this stage. . and there is confirmation from the CAs. the Indian affiliate would be subject to tax based on the MAP agreement. Taking all the factors into account. it should have effect only for the specific taxpayer for that relevant tax year and for that particular issue. as the financial records of captive units are not available on the public databases. In a captive service provider model the ultimate risk are borne by the Holding Co.If the taxpayers accept the proposal of the CAs.
the agreed upon markup is only valid for the fiscal years 2004 and 2005. thereby eliminating the risk of double taxation. In conformity with the OEeD guidelines. Transfer Pricing methods The Indian legislation prescribes the following methods: CUP. Transfer Pricing authority and tax law Income Tax Department. the revenue authorities generally recognize the OECD guidelines and refer to the same for guidance. Further. it is unclear how such an agreement would impact future tax years. The enactment of detailed Transfer Pricing Laws in India in 2001 brought the issue of Transfer Pricing to the forefront amongst the various multinational corporations operating in India as well as Indian companies. some US multinationals have invoked the Mutual Agreement Procedure (MAP). there has not yet been a formal confirmation from the CA of either country. As a result. India and the US have apparently reached a negotiated settlement whereby they have agreed to a markup of 17. Additionally. While unofficial reports of this agreement have spread among taxpayers and practitioners. OEeD guidelines of Transfer Pricing The Indian legislation is broadly based on the OECD guidelines. which takes into consideration the organization's overall business strategy and operating structure. The settlement provides relief for those taxpayers who have made applications under the MAP and could also provide correlative adjustments/corresponding deductions at the US end. Resale Price. Profit Split and Transactional Net Margin Method. Transfer Pricing is one of the critical tax issues for growth oriented businesses having international operations wherein substantial senior management's time and attention is necessary. 271. 1961. The MAP provides an opportunity for resident taxpayers to approach the Competent Authorities (CA) in India in conjunction with the CA in other affected countries to come to an agreement on such issues.·In order to try to address this issue. Transfer Pricing regulations and rulings Rule 10 to 10E of the Income Tax Rules. Section 40A (2). The legislation also grants the power to the Central Board of Direct . 1962. 271AA. 271BA and 271G of the Income Tax Act. At this point. Irrespective of their size.5 percent on total costs for BPO. a mechanism provided under double-tax avoidance agreements entered into by India with various countries. to the extent they are not inconsistent with the domestic law. the legislation prescribes the same five methods to compute the arm's length price. KPO and IT service providers in India. organizations need an effective and dependable Transfer Pricing policy. 92-92F. Cost Plus.
the taxpayer is not required to furnish the transfer pricing documentation with the Accountant's Report at the time of filing the tax return. the taxpayer is fined 2% of the transaction value.Taxes (CBDT) to prescribe any other method. The categories of documentation required are: • • • • • • • • • • • Ownership structure Profile of the multinational group Business description The nature and terms (including prices) of international transactions Description of functions performed. Transfer Pricing Documentation requirements A detailed list of mandatory documents are listed in Rule 10D (1). Although an Accountant's Report must be submitted along with the tax return. This is also demonstrated through proper documentation and timely submission of documentation to the revenue authority during assessment proceedings. If due diligence efforts to determine the arm's length price have not been made by the taxpayer. the taxpayer is fined Rs. Statute of limitations of transfer pricing assessments . risks assumed and assets employed Record of any financial estimates Record of uncontrolled transaction with third parties and a comparability evaluation Description of methods considered Reasons for rejection of alternative methods Details of transfer pricing adjustments Any other information or data relating to the associated enterprise which may be relevant for determination of the arm's length price A list of additional optional documents is provided in Rule 10D (3). be contemporaneous and exist by the specified date of filing the income tax return.one lakh. For not furnishing an Accountant's Certificate (Form 3CEB) along with the return of income. Penalties in Transfer Pricing For inadequate documentation. as far as possible. The most appropriate method should be applied. Transfer pricing documentation must be submitted to the tax officer within 30 days of the notice during assessment proceedings. no other method has been prescribed by the CBDT to date. No hierarchy of methods exists. For not furnishing sufficient information or documents requested by the tax officer. which has been changed to September 30 instead of October 31 following the end of the financial year. Penalty relief in Transfer Pricing Penalties may be avoided if the taxpayer can demonstrate that it exercised good faith and due diligence in determining the arm's length price. The taxpayer is required to obtain and furnish an Accountant's Certificate (Form 3CEB) regarding adequacy of documentation maintained. the taxpayer is fined 2% of the transaction value. Documentation deadlines for Transfer Pricing The information and documentation specified should. then 100% to 300% of incremental tax on transfer pricing adjustments may be levied by the tax officer. however.
an Accountant's Report is required to be provided along with the tax return.00 Crores are being scrutinized. The information technology. banking and pharmaceutical sectors have received particular attention. During recent audits. However.In accordance with Indian Accounting Standard 18. with officers in different locations taking divergent positions on similar taxpayer fact patterns. pursuant to which companies with related party transactions in excess ofRs. Advance Pricing Agreements of tansfer pricing APAs are not available yet. but may become available as India increases its third-party com parables database and gains more experience in cross-border transfer pricing issues. The accountant certifies whether proper documentation is maintained by the taxpayer.5.Tax assessments (where a matter has been referred to the transfer pricing officer) are to be completed within three years and nine months from the end of the financial year (1 April to 31 March). an assessment may be re-opened within seven years from the end of the financial year. Transfer Pricing Audit risk/transfer pricing scrutiny Internal guidelines have been issued by the revenue authority. if the revenue authority determines that income has escaped assessment. the revenue authority does not seem to have adopted a centralized or coordinated approach to audits. The revenue authority has sought an updated analysis using data that may not be available to the taxpayer at the time of the preparation of contemporaneous documentation. In most cases. the company is required to disclose related-party transactions in its financial statements. Substantial documentation is being requested in the course of audit proceedings. officers have insisted on unbundling transactions in cases where the taxpayer has adopted an aggregate or combined approach to its transfer pricing documentation. . Return disclosures/related-party disclosures 92E. business process outsourcing. the approach adopted by the taxpayer in the selection of comparable data has received considerable attention from the revenue authorities. Furthermore.