Conceptual background Transfer Pricing in India Brief Legislative framework Arms Length Principles scope f TP legislation How does TP functions

AUDIT OF TRANSFER

PRICING IN DIRECT TAXES

SCHEME OF THE SESSION Conceptual background

Transfer Pricing in India

Brief Legislative framework

Arms Length Principles

scope f TP legislation

How does TP functions

SDT

Advance Pricing Agreement

Safe Harbour Rules

Challenges to Audit

What do we do in this audit

WHAT IS TRANSFER PRICING?• Transfer pricing is the price at which related parties transfer goods or services to each other, which may not be in accordance with the market price charged by them to unrelated parties.

• Transfer Pricing is best described as the price charged by one enterprise to an associated or connected enterprise for the supply of goods, services, know-how etc.

INTRODUCTION TO TRANSFER PRICINGRise of large number of multinational enterprises (MNEs) due to rapid advancement of the technology

Rise of intra group trade – including highly complex international transactions involving intangibles and multi-tiered services

MNE transaction structure determined not only by open market but also by group driven forces inclined towards the common interests of the entities of a group

At present the world economy is ruled by the MNEs

(Source: - World Trade Report 2014)

(Source: - World Trade Report 2014)

Luxembourg

Cayman IslandInterest transfer

payments

Royalty transfer payments

Developing Countries

Costa Rica

Supply Chain Transaction

Div

iden

dBermuda

BVI

Lease transfer payments

Intermediate Holding

Company

Foreign Parents

Capital G

ain

PRESENT DAY SCENARIO

CONCEPT OF TRANSFER PRICING

ABCH Co

ABC S Co

XYZ

Country A

Country B

Purchase of computer from S Co “Controlled Transaction”

Purchase of computer from third party“Uncontrolled Transaction”

Transfer price of controlled transaction to be equivalent to market price of a comparable uncontrolled transaction; If lower, Country B loses revenue.

CONCEPT OF TRANSFER PRICING

ABCH Co

ABC S Co

Country ACountry B

Customers

ABC S Co is the distributor of ABC H Co’s computer in Country B

Manufacturing Cost to H Co. Rs1400Distribution Cost to S Co. Rs100Transfer price Rs1500 Sale price in Country B Rs1600H Co Profit Rs100S Co Profit NIL(Cost

=Revenue)Tax authorities of Country B insists that S Co

should atleast report a profit of Rs 100; thus transfer price to be reduced to Rs 1,400 – Leads to economic double taxation.

BASIC ISSUES UNDERLYING TRANSFER PRICINGCross border tax situations involve issues related to jurisdiction, allocation of income and valuation.

A MNE Group may exploit the opportunity to shrink the overall tax burden of the group through either under-charging or over-charging the associated entity for intra-group trade.

Reduction of taxation not the only factor contributing to the transfer pricing policies and practices of a MNE Group

EVOLUTION OF TRANSFER PRICING

• US • First country to adopt a comprehensive transfer pricing legislation in 1968.

• OECD • Reports on transfer pricing in 1979 and 1984• issued the TP Guidelines in 1995 as amended by 2010 version

• United Nations (UN) • Report on “International Income Taxation and Developing Countries” in 1988.• The UN Conference on Trade and Development (UNCTAD) also issued a major report

on Transfer Pricing in 1999. • The United Nations (UN) is again taking a leadership role, through its Transfer

Pricing Manual, in trying to arrive at updated global transfer pricing guidance which can be used by countries all over the world in developing (or calibrating) their transfer pricing regulations.

• European Commission (EC) • Proposals on income allocation to EC members of MNEs

By the end of 2011 there were around 100 countries with some form of specific transfer pricing legislation as shown by the red shading in the diagram below

GLOBAL TRANSFER PRICING REGIMES

TRANSFER PRICING IN INDIA

TRANSFER PRICING LEGISLATION IN INDIA India has introduced comprehensive Transfer Pricing legislation w.e.f. April 1, 2001

Prior to this amendment, a limited provision existed in the Indian Income Tax Act Erstwhile section 92 mandated adjustment to the income of resident taxpayer

from a transaction with a non-resident

With opening of the economy in 1991 and afterwards by entering into DTAA with almost all major countries, India has become a major economic player in the world.

With the economic down-turn in the world, avoidance of Base Erosion and Profit Shifting has become a new object of most Tax Administrations including India.

TRANSFER PRICING LEGISLATION IN INDIA The Finance Minister's in his speech of 2001 on the rational for introducing

Transfer Pricing Regulations stated

"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. …. Necessary legislative changes are being made in the Finance Bill based on these recommendations.” Intention of Legislature: Circular No. 12/2001

“The aforesaid provisions have been enacted with a view to provide a statutory framework which can lead to computation of reasonable, fair and equitable profit and tax in India so that the profits chargeable to tax in India do not get diverted elsewhere by altering the prices charged and paid in intra-group transactions leading to erosion of our tax revenues.”

TRANSFER PRICING LEGISLATION IN INDIA Intent behind introduction of TP provision in India is-

Growth of investments by multinationals in India Increase in cross border transactions of multinational enterprises in India

Potential risk of erosion of India's tax baseNeed for a statutory framework to examine intra-group cross border transaction

LEGISLATIVE FRAMEWORK IN INDIA Sections 92 to 92F in the Income Tax Act, 1961 described various provisions of the Transfer Pricing in India.

Rules 10A, 10B, 10C, 10D and 10E of the Income Tax Rules, 1962 complementing the TP-Regulations with detailing the procedure.

These provisions deal with computation of income arising from "international transactions" with "associated enterprises".

The regulations provide that any income arising from an international transaction shall be computed having regard to the arm's length price.

ARM’S LENGTH PRINCIPLE

International transactions- goods- services- intangibles

Associated enterprise

Resident

Transfer price

Independent entity

Resident

Arm’s length price

MARKET TRANSACTIONMarket forces

Market forces

Profit motive Profit motiveSeller PurchaserPrice

Group

Profit motive

Group

Profit motive

MNE GROUP TRANSACTION

SellerAE

PurchaserAE

Price

INDEPENDENT PARTIES @ MARKET RATE

X Inc. US Y India Ltd.Independent

Cost=80Price=150Profit=70

Tax@30%=21

Independent customer

Cost=150+5Price=210Profit=55

Tax@40=22

Profit of X= 70Tax=21

Profit of Y=55Tax=22

RELATED PARTIES @ MARKET RATE

X Inc. USAE

X India Ltd.AE


Tax@30%=21

Independent customer


Tax@40%=22

Profit of X Group= 70+55=125Tax=21+22=43

X Inc. USAE

IndependentCustomer

X Ltd. IndiaAE


Tax@30%=36

Profit of X Group=120+5=125Tax=36+2=38


Tax@40%=2

RELATED PARTIES @ MANIPULATED RATE

TRANSFER PRICE USING TAX HAVENS

Profit of X Group=20+100+5=125

Tax=6+2=8

X Inc. USAE

IndependentCustomer

X Ltd. IndiaAE

X MauritiusAE


Tax@30%=6

Cost=100+5Price=205Profit=100Tax@0%=0 Cost=205+5

Price=215Profit=5

Tax@40%=2

LOSS OF REVENUE DUE TO TPTransaction at market rate:

Profit of X group: 125 Tax payable: 43

Transaction at manipulated rates: Profit of X group: 125 Tax payable: 38

Transaction involving tax haven Profit of X group: 125 Tax payable: 6

REASONS FOR PLAYING WITH PRICES

To lower corporate taxes To lower customs duty For repatriation of profits Exchange risk Capitalization To maximize subsidies To support a subsidiary Inflating capital contribution To enlarge market

ARMS LENGTH PRINCIPLETwo types of transactions

Uncontrolled Between independent parties Price determined by market forces Arms length price

Controlled Between related parties Relationships determine the price

INTERNATIONAL TRANSACTION

The term "international transactions" has been defined in Section 92B of the Act as a "transaction" between two or more AEs, either or both of whom are not residents.

The definition of international transaction also covers the transaction entered into by an enterprise with a person other than an associated enterprise, if there exists a prior agreement in relation to the relevant transaction between such other person and the associated enterprise, or the terms of the relevant transaction are determined in substance between such other person and the associated enterprise.

Further, Section 92F of the Act defines the term "transaction" as any arrangement, understanding or action in concert whether formal or in writing and whether enforceable or not.

ASSOCIATE ENTERPRISEOne enterprise participates directly or indirectly through one or more intermediary into management, control or capital of another enterprise.

The ultimate holders in both the enterprises are same, either directly or indirectly through intermediaries.

ASSOCIATE ENTERPRISES

Management/control/capital

Associate Enterprise


AE 1


Intermediary of company 1

AE1 and company 1 associate enterprise


AE 2



AE1 and AE2 are associate enterprise

AE 1



AE 2Management/control/capital


AE1 and AE2 are associate enterpriseAE 1

Management/control/capitalIntermediary of

company 2

Holding / Transaction Associated Enterprise (s)

1 A holds at least 26% of the voting power of B A & B

2 A holds at least 26% of the voting power of B & C B & C

3 A advances a loan to B, constituting at least 51% of the book value of total assets of B A & B

4 A guarantees at least 10% of the total borrowings of B A & B

5 A appoints, more than half the directors of B; or, one or more executive directors of B A & B

6 A appoints, more than half the directors of B & C; or, one or more executive directors of B & C;

B & C

7 The manufacture or processing of goods or articles or business carried on by A is wholly dependant on the use IPRs (know hows etc.) belonging to B or in respect of which B has exclusive rights

A & B

8 At least 90% of the raw materials and consumables required for the manufacturing or processing of goods or articles carried out by A, are supplied by B or by persons specified by B, and the prices and other conditions relating to the supply are influenced by B

A & B

9 The goods manufactured or processed by A are sold to B or persons specified by B, and the prices and other conditions relating thereto are influenced by ‘B’

A & B

10 Where A is controlled by B (an individual) a transaction between A and C, if C is controlled by B or his relative or jointly by B and his relative

A & C

11 Where A is controlled by B HUF, a transaction between A and C, if C is controlled by a member of B HUF or by a relative of a member of B HUF or jointly by such member and his relative

A& C

12 Where A is a firm, AOP or BOI and B holds at least 10% interest in A A & B

13 There exists any relationship of mutual interest between A and B as may be prescribed. A & B

SCOPE OF APPLICATION OF THE PROVISIONS

Any international transaction (as per Section 92B) with an associated enterprise/deemed associate enterprises (as per Section 92A) must be computed having regard to the arm’s length price. Also, costs or expenses allocated or apportioned between two or more associated

enterprises based on mutual agreement or arrangement, should be determined having regard to arm’s length prices.

The transfer pricing provisions are wide enough to cover transactions between a foreign entity and its permanent establishment in India.

The transfer pricing provisions would not however apply in cases where in the application of the arm’s length price results in a downward revision in the income chargeable to tax in India or results in an increase in the loss.

WHAT TP REGULATIONS DORe-compute profit of AEs

Treating them as independent concernsSubstituting arms length price for TP

To ensureEven distribution of taxes & profits between countries

ARM’S LENGTH PRICE - METHODS FOR DETERMINATION

Method Procedure Usage

Comparable uncontrolled price method

Comparison of price charged or paid for property transferred or services provided in a comparable uncontrolled transaction

Used mainly in respect of transfer of goods, provision of services, intangibles, loans, provision of finance.

Resale-price method Considers the price at which property purchased or services obtained by the enterprise from an AE is resold or are provided to an unrelated enterprise

Used mainly in case of distribution of finished goods or other goods involving no or little value addition

Cost-price method Considers direct and indirect costs of production incurred by an enterprise in respect of property transferred or services provided and an appropriate mark-up

Used mainly in respect of provision of services, joint facility arrangements, transfer of semi finished goods, long-term buying and selling arrangements

ARM’S LENGTH PRICE - METHODS FOR DETERMINATION

Method Procedure Usage

Profit-split method Considers combined net profit of the AEs arising from the international transaction and its split amongst them.

Used mainly in report of transactions involving integrated services provided by more than one enterprise, transfer of unique intangibles, multiple inter-related transactions, which cannot be separately evaluated

Transactional net margin method

Considers net profit margin realised by the enterprise from an international transaction entered into with an AE.

Used in respect of transactions for provision of services, distribution of finished products where resale price method cannot be adequately applied, transfer of semi-finished goods

Any other method as prescribed by the CBDT

Other method as prescribed by CBDT under rule 10AB.

Where all the above five methods fail to apply.

COMPUTATION OF ARM’S LENGTH PRICE

Traditional Transaction

Comparable Uncontrolled

Price(“CUP”)

Resale Price

Method(“RPM”)

Cost Plus

Method(“CPM”)

Methods for computation of ALP

Transactional Profit based

ProfitSplit

Method(“PSM”)

TransactionalNet Margin

Method (“TNMM”)

No hierarchy of methods suggested by Indian TP legislation

METHODOLOGY ADOPTED

The Assessing Officer (AO) may refer the case to a Transfer Pricing Officer (TPO) for the purpose of computing the arm's-length price of the international transactions or specified domestic transactions.

In accordance with prevailing internal administrative guidelines of the Revenue, selection for cases would be risk based.

The TPO would then follow the assessment procedure with limited purpose to determine Arm’s Length Price of the transaction and pass an order.

A copy of the order would be sent to the AO and the taxpayer.

On receipt of the TPO's order, the AO would compute the total income of the taxpayer by applying the arm's-length prices determined by the TPO and pass a draft order within the time limit prescribed for completion of scrutiny assessments.

The Transfer Pricing Officer shall determine the arm's length price and send a copy of his written order to the Assessing Officer and to the tax-payer.

METHODOLOGY ADOPTED

Wherever the Assessing Officer propose to make any variation in the income or loss returned of the assessee as a consequence of the above order of the Transfer Pricing officer, the assessing officer shall forward the draft order to assessee for his/her objections (if any).

On receipt of draft order the assessee shall communicate either his acceptance or file objections against such order with Dispute Resolution Panel (DRP) within 30 days.

The DRP being a collegiums of three Commissioner of income tax shall issue binding directions to assessing officer after due consideration of objections and evidences filed by assessee.

The assessing officer shall pass appropriate order in conformity with the directions of DRP within nine months from the end of the month in which the draft order is forwarded to the assessee.

Orders of DRP is appealable to ITAT.

If assessee opts not to go for DRP, AO proceeds to pass a Final Assessment Order which is appealable at CIT (Appeals).

Assessing Officer

Draft Assessment order

DRPFinal

Assessement Order

No Reference

To DRPFinal Assessm

ent OrderCIT

(Appeal)

ITATHigh

Court

Supreme

Court

Transfer Pricing Officer

With effect from 1 July 2012, with a view to solve the potential transfer pricing disputes in a cooperative manner, APA provisions were introduced.

It could be checked whether all the procedural aspects were followed before APA was entered into.

Whether the applicant furnished the requisite fees.

Right now, since only 8 APA are either signed or on advance stage of finalization and no APA file has been received, the check list would evolve with time. The audit of APA needs to be done at APA under MoF.

ADVANCE PRICING AGREEMENT

These Rules were notified on 18 September 2013 and hence the cases have not been found in audit so far.

The rule provides that if the margin declared by the assessee is within the range provided in the Rules, then the margin declared by the assessee would not be subjected to the TP proceedings.

It may be checked whether the assessee is involved in the same functional area which the Rules provide for and fulfills the eligibility given in the Rules.

Right now, since no file has been received, the check list would evolve with time.

SAFE HARBOUR RULES

These provisions shall come into force with effect from AY 2013-14 and hence would be available to audit from 55th or 56th Cycles only.

These provisions were brought on the specific recommendation of the Apex Court to discourage excessive exempt profit margins being shown in Exempt entities engaged in certain activities or for transactions with related parties.

The initial threshold limit was Rs.5 crore for reporting such cases which have now been raised to Rs.20 crore (in current finance bill).

Right now, since no file has been received, the check list would evolve with time.

SPECIFIED DOMESTIC TRANSACTION

CHALLENGES TO AUDIT The Transfer Pricing audit is a multi dimensional subject involving cross-skills right from knowledge of costing, finance, Economics, International Polity etc., auditor needs to equipped with the specialized knowledge and understanding of the subject.

Department has very little scope of rectifying the mistake made during the TP proceedings.

Indian TP regime is considered to be second most aggressive regime, hence we should focus on the system that is prevailing not only to “loss to revenue” Department has lost almost all the cases which went in appeal.

AUDIT OF TRANSFER PRICINGHow are we doing it?

Selection of the Audit Year/Cycle is important. If the audit of TP charges are provided during the February or March, the cases available for audit would be of that financial year while in case, the audit is provided in any other month, the cases would most probably be of previous year as TP year would be open.

The Audit program may be prepared based on this criteria.

PREPARATION OF AUDIT PROGRAMME

Like in the case of normal audits, the foremost criteria is to fill up the basic details like Name of the assessee, normal assessment charge, PAN, Status, Assessment Year, Date of reference to Transfer Pricing Officer, Date of issue of TP notice etc. meticulously.

The most important aspect of scrutiny is detailed analysis of the nature of business of the assessee.

The best source for the same is the FAR analysis done by the assessee.

PRIMARY DATA

The assessee represents a particular segment of business and it is of utmost importance to understand the exact nature of his business.

After all, the different business segments have different risk and reward parameters. For instance, the assessee involved in KPO cannot be compared with BPO under normal circumstances.

CONTINUE…

The start Point of audit is the Form 3CEB submitted by the assessee.

It should be analysed to check whether it has been prepared and certified before the due date of filing of return.

If the Form 3CEB is prepared beyond due date, it would be worth scrutiny from the assessment charge of the assessee to know whether the Department has rejected the return filed as defective and other sections of the Act applied or not.

STARTING POINT

Whether all the transactions appearing in the Related party transactions part of the Annual Accounts have been reported or not in the Form 3CEB. If not, whether the TPO has noticed such transactions and brought them to record.

From the AY 2012-13, whether penalty at the rate of 2 per cent of the International Transaction has been recommended for initiation for such non-reporting under section 271AA.

Further, whether the continuing transactions have been identified in Form 3CEB. For instance, loan provided during any previous year, though interest charged, may not be reported in the current Form 3CEB. Though no penalty till AY 2011-12, penalty leviable from AY 2012-13.

CONTINUE…

The second most important document is the note submitted by the TPOs to CIT (TP) for approval.

It becomes far more important in case of Nil order as this note is where the TPO discusses the grounds on which the ALP determined by the assessee in Form 3CEB is accepted.

Many a times, TP discuss only those issues in TP order where adjustments are made. However, in all International Transactions where adjustments are made or no adjustments are made, are discussed in the note submitted to CIT (TP).

TRANSFER PRICING ORDER

The most tricky part of the audit is the extensive use of databases both by the assessee and the Department notable being Prowess, Capitaline and ACE TP. There are some other databases like TiPs (for

Pharma Sector) and RoyaltySource (databases for Royalty rates).

However, the database subscriptions being costly and not available so far, the choice was to be made regarding the databases.

FIELD AUDIT

Two choices possible:Audit without databasesAudit with databases

Prowess, Capitaline and ACE TP are only three broad based databases relevant for almost every case of Transfer Pricing Audit.

CONTINUE…

The database being costly subscriptions, the audit without them involved inherent risk factors. Audit in such environment is carried out with the following assumptions: The TPO and assessee have selected the right comparables.

The comparables selected are essentially functionally similar and comparable on the basis of FAR criteria.

Unless the individual P&L accounts and Balance Sheets are available, the figures adopted by the TPO (and assessee) are correct.

AUDIT WITHOUT DATABASES

In such cases, the audit has constraint to check whether the figures have been adopted correctly (only in those cases where hard copies of comparables’ accounts kept in file). For instance, even a small error in adoption of numbers may be

magnified several times. For instance, even omission to include Rs.1 crore figure in comparable case may lead to short adjustment of Rs.3.51 crore (Thomas Cook India Ltd).

In most of the cases at Department level, the final computation (calculation) is submitted by the assessee and is adopted by the TPO.

CONTINUE…

This is one area for closer scrutiny as the assessee tries to adopt the figures selectively for assessee and comparables in order to inflate the Margin of the assessee and deflate the margin of the comparables so as to bring the gap to +/- 5 percent. For instance, in case of Sitel India Limited (AY 2011-12), while in case of

assessee, the provisions were excluded from Operating Expenditure, the same were not excluded from the comparables data.

CONTINUE…

Whether the assessee or TPO has adopted the publicly available data as only publicly available data is admissible for comparison or comparable data is faulty. For instance, in case of Serdia Pharmaceutials India Limited (AY 2011-12), notices u/s 133(6) were issued to parties listed in TIPs database. Thus, while the value was captured in the database figure, the same was taken again u/s 133(6) and average was taken. This had pushed the adjustment required in downward direction.

CONTINUE…

The averaging has a serious effect on the amount of adjustments. Hence, the assessee tries to repeat the lower value figures more often to suppress the average. For instance, Suppose, there are five Bank Guarantee rates available for few banks (say .5, 1, 1.5, 2, 2.5 percent pa). While adopting the CUP method for benchmarking the Corporate Guarantee Fees receivable, the assessee should normally compute the average of 1.5 percent pa.

However, the assessee would try to repeat the value of .5 percent transaction from the same bank to same assessee for different tranches so that each additional entry suppresses the overall average rate and hence, the adjustment required.

CONTINUE…

Whether the TPO is consistent in his premises and his conclusion. For instance, certain TPOs consider the amount of Compulsorily Non Convertible Preference Shares in AEs as loans advanced at the rate of prescribed dividend. However, while making adjustment, they ignore whether dividend was received or whether the CNCPS was non-cumulative. This may have huge bearing on adjustments. For instance, in case of Reliance Communication Ltd., this violation led to short adjustment of Rs.82 crore.

Whether the TPO has correctly identified the Operating and Non operating incomes and expenditures. For instance, the TPO may wrongly consider the income transferred from Reserve to Income as Operating resulting in enhanced margin and hence short adjustment.

CONTINUE…

Any of the database contains accounts of more than 25000 companies. Having database will create another problem of temptation of redoing the Accept-Reject Matrix by the Audit. Hence, a fine line is required for what we can see and what not.

If we redo the Accept Reject Matrix, it may be akin to stepping into the shoes of TPO’s discretion. So, database may be kept only for the purposes of revalidation of data/ computation.

AUDIT WITH DATABASE

Most of the time, the assessee submits Accept-Reject Matrix, out of which some are selected by the assessee. During the course of TP proceedings, the TPO accepts some and rejects some and brings some more from the Accept-Reject Matrix.

If database is available, the comparables selected should be checked for functional similarity.

The comparable should be selected for size analysis. For example, it has been held that two outlier sizes cannot be compared.

CONTINUE…

To check if for any comparable, the last year was abnormal year. For instance, whether the last year was year of amalgamation, demerger etc. In such cases, comparables are to be rejected.

To check whether the comparables have more than 25 percent of turnover with their AEs. If yes, such comparables are to be rejected.

Whether the financial results assigned to the comparables are correct as per database.

CONTINUE…

Whether the assessee’s Operating profit or operating Cost etc. are consistent with those of comparables. For instance, whether all the criteria were accepted or rejected uniformly for assessee as well as for the comparables. For example, whether the Bad debts, provisions for bad debts, donations etc. have been disallowed from both the assessee and comparables computation.

More often than not, this is the area where we found majority of audit points.

CONTINUE…

Documents

Conceptual background Transfer Pricing in India Brief Legislative framework Arms Length Principles scope f TP legislation How does TP functions