Agenda

-Introduction - Framework of Transfer Pricing regime in India - Concept of Associated Enterprises - Global Developments - Traditional Transaction Methods - Profit based Methods - Q& A - Conclusion

Transfer Pricing

Indian Statutory Framework of the Transfer Pricing Regime

TP regulations initiated in 2001 Section 92, 92A to 92F and Rules 10A to 10E.

Broadly based on OECD Guidelines Major deviations : reliance on Arithmetic mean as a measure of average limited range of 5% - now done away with 2 year period limitation for use of data

Arms Length Principle

Arms length Price (ALP) is the hypothetical price at which unrelated parties would have transacted under the same terms and conditions as those of the international transactions. Defined in Section 92F(ii) means a price which is applied or proposed to be applied in a transaction between persons other than associated enterprises in uncontrolled conditions The arms length standard is the principle that governs the conclusion that an I nternational transaction is not influenced by the relationship between the Associated Enterprises (AEs) Section 92 income from any international transaction - determination of ALP Also allowance, expense or interest covered specifically Cost contribution agreements also included but no guidance provided; expense No application if taxable income gets reduced
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Associated Enterprise and International Transaction

Associated Enterprise (AE) commonality of management, capital or control Sec. 92A International Transaction - Sec. 92B transactions between two or more AEs where at least one is a non-resident (SC observations in Glaxo Smithkline) Nature of transaction 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 and cost/expense allocation or apportionment arrangement In certain situations even transactions between unrelated parties can also be deemed to be international transactions prior agreement with AE or where the substance of the transaction is influenced by the AE

Determination of ALP: Transfer Pricing Methods

Methods Applicability

Comparable Uncontrolled Price Comparison of actual price Method Resale Price Method Cost Plus Method Profit Split Method Comparison of gross margin for a distributor Comparison of gross margin for a manufacturer Sharing of profits among entities sharing proportionately in risks in a highly integrated operation Comparison on a net (operating) profit basis

Transactional Net Margin Method

Selection of Most Appropriate Method (MAM)

Rule 10C MAM is the method which is best suited to the facts and which provides the most reliable measure of ALP; and Factors to be considered are: nature and class of international transactions, functions, assets and risks analysis, availability of data, degree of comparability, possibility of making adjustments and the nature, extent and reliability of assumptions made
How does one select the most appropriate method Analyse and characterise the international transaction Assess the availability of data with respect to application of methods

Compliance Requirement
Taxpayers are required to put together the following on an annual basis:
Transfer Pricing report, which documents that all international transactions/ business arrangements with group companies and their compliance with ALP (Rule 10D) An Accountants certificate, in a prescribed format, that must be filed with Corporate tax return (Rule 10E) Use of Current year data controversial issue

TP Documentation
Significance of Documentation
Is generally a part of legal regulations Enables discharge of Burden of Proof Indispensable in multiple audits Protection against penalty

A Robust TP report
Adjustments to be statistically reasonable and replicable To develop alternate arguments/positions TP document to be in sync with Website/Public information Evidence of global consistency (wherever possible)

Supporting documents
Inter-company agreements Evidence(s) of business reasons i.e. limited risks, market penetration etc, used to negotiate or set TP Process map to evidence key decision nodes Documents generated as daily business processes Trail of negotiations with AE e.g. mail trail documenting reasons for price fluctuations Segmental/transactional profitability

Transfer Pricing Audits

Reference by AO to Transfer Pricing Officer Separate Directorate for TP audits AO has concurrent powers; above a threshold compulsory reference to TPO Primary onus on taxpayer TPO/AO can determine the ALP only if one of the conditions specified in Section 92C(3) is met: unreliable or deficient use of data/method, lack or non-maintenance of documentation, failure to furnish the documentation or determination of ALP in a manner contrary to the rules TP documentation is the fulcrum of TP audit

Dispute Resolution
Conventional litigation route Dispute Resolution Panel MAP Spate of Rulings by ITAT Proposed Safe harbour rules Proposed APA under DTC

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Methods Prescribed for Determination of ALP

Traditional transaction methods Comparable Uncontrolled Price method - compares prices Resale Price method - compares gross margins Cost Plus method - compares profit mark-ups on costs

Transactional profit methods Transactional Net Margin method - analyses net profits in relation to an appropriate base Profit Split method - refers to the (total) profits from transactions and splits them based on contribution

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Traditional Transaction Methods

Hierarchy of Methods - Indian position - OECD Position Most Appropriate Method (MAM) Factors determining the choice of MAM

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Comparable Uncontrolled Price (CUP) Method

-CUP method compares the price transferred in a controlled transaction to the price charged in a comparable un-controlled transaction. -CUP method is the most direct and reliable way to apply the arms length principle -External and Internal CUP -Illustrations - Sale of tangible property, supply of services, financing transactions, licensing or sale of intangible property

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Differences in Comparability
Two transactions can be considered comparable only when there is no material difference that can impact the price of the transaction in open market Or Reasonably accurate adjustments can be made to eliminate the material effect of such difference Real Challenge in the application of CUP - finding comparable transactions; and - making adjustments

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Adjustments to Account for Differences

Differences in -volume, type of products/services - terms of contract - geographical location, type and size of markets Feasible adjustments -Volume - credit period, freight cost Problem Areas -difference in product/service profile - difference in geographical location of markets

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Issues and Controversies

Geographical location of Markets Intervet case export price of goods sold by an Indian company to its AE in Thailand was compared with export price to unrelated party in Vietnam by the TPO adjustments had been made for volume and credit terms ITAT held that adjustments need to be made for disparity in market location OECD guidelines state the difficulty in this regard Essar Shipping case charter rate of a 22 year old ship was compared with a standard report that provided rates of ships less than 10 years old ad hoc adjustments made rate was 1/4th of the reported rate ITAT rejected the same

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Issues and Controversies

UCB and Serdia Pharmaceuticals Importance of intangibles in application of CUP Import of APIs to manufacture drugs purchase price (from AE) compared with purchase price paid by unrelated competitor companies for same APIs in UCB it was held to be unacceptable because of presence of intangibles (quality, brand etc.) whereas in Serdia ITAT accepted the comparison as the APIs were no longer protected by patents Just because CUP is the most reliable method it cannot be applied where available data is insufficient to justify comparison; CUP method requires a high degree of comparability with regard to quality, contractual terms, level of market, geography involved, date of transaction, intangible property, foreign currency and alternatives available with buyer and seller Clearplus case What is the relevant market to be examined Revenue contended that goods brought from China cannot be compared with goods brought from India despite both being sold in the US ITAT held that the relevant market is the market where goods are sold
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Resale Price Method (RPM)

Is applied where goods or services purchased from an AE is resold to non-AE Gross margin earned in same or similar uncontrolled transaction by the same party or a third party is determined The resale price is reduced by the gross profit margin The above price is further reduced by expenses incurred in connection with the purchase of property/service Adjustments are made to account for accounting, functional and other differences that materially affect gross profit margin in open market

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Use of RPM

Less product comparability required Best to test resellers Difficulty in applying RPM identifying identical or similar functional and risk profiles, facing differences in accounting practices, mainly with respect to costs of goods sold, and eliminating influences from different economies of scale.

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Cost Plus Method (CPM)

Involves comparison of mark-up on costs Direct and indirect costs of production of an enterprise are determined Normal gross profit mark-up on such costs earned in comparable uncontrolled transaction is determined Suitable adjustments made to account for differences that can impact gross profit mark-up in an open market The costs of the enterprise are increased by the adjusted gross profit mark-up to arrive at the ALP

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CPM Strengths and Weaknesses

Less product comparability required Less functional and risk comparability, as long as costs are well defined Difficulties in applying CPM ensure that inefficiencies do not result in higher profits as costs increase there is often no direct link between the amount of the costs incurred and the market price, i.e. arms length price it requires extensive information about the cost base used in comparing the mark-ups reasonable adjustments are difficult when looking at external comparables In the Indian context modified CPM is used where operating margin on total costs are

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Issues and Controversies

Supreme Tradelinks Choice of method RPM selected by a franchisee TPO rejects RPM on the ground that there was significant differences in operating costs which were below the line ITAT negated this view on the facts Higher level of below the line expenditure may warrant adjustment on account of difference in functions Ghardia Chemicals goods sold to overseas AE and RPM used to show that the gross margin of the AE was at arms length ITAT rejected the claim on the ground that RPM can be applied only on an Indian entity incorrect decision contrary to Rule 10B(1)(b) and OECD guidelines CPM cases MSS India Twinkle Diamond Diamond Dyechem

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