International Taxation and Transfer Pricing ConferenceFebruary 17, 2007

Case Studies on Transfer Pricing Samir Gandhi

February ‘2007

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Global TP Enforcement

• First level– Second level

• Third level– Fourth level

1996 & prior 1997/ 1998 1999/ 2000 2001/ 2002 2003/2004

Italy

New Zealand

Mexico

Korea

France

Czech Republic

Spain

Australia

South Africa

USA

China

Slovakia

Brazil

Italy

New Zealand

Mexico

Korea

France

Czech Republic

Spain

Australia

South Africa

USA

Germany

Kazakhstan

Russia

Denmark

Belgium

Venezuela

Argentina

Canada

UK

China

Slovakia

Brazil

Italy

New Zealand

Mexico

Korea

France

Czech Republic

Spain

Australia

South Africa

USA

Thailand

Portugal

Poland

Peru

India

Netherlands

Germany

Kazakhstan

Russia

Denmark

Belgium

Venezuela

Argentina

Canada

UK

China

Slovakia

Brazil

Italy

New Zealand

Mexico

Korea

France

Czech Republic

Spain

Australia

South Africa

USA

Hungary

Colombia

Malaysia

Thailand

Portugal

Poland

Peru

India

Netherlands

Germany

Kazakhstan

Russia

Denmark

Belgium

Venezuela

Argentina

Canada

UK

China

Slovakia

Brazil

Italy

New Zealand

Mexico

Korea

France

Czech Republic

Spain

Australia

South Africa

USA

February ‘2007

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Transfer Pricing Audit Process

Assessing Officer( AO )

Transfer Pricing Officer (TPO)

AO to refer TP cases to TPO – international transactions > INR 5 Crores ( 15 Crores)

Copy of order sent to the AO and tax payer

AO to incorporate TPO’s order in the Assessment Order

Send Notice to tax payer - Hearing / Document Analysis /

No site visits / No interviews

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TP Administration Structure

DGIT International Taxation & Transfer Pricing)

Director of Income-tax, (Transfer Pricing)(Each location)

TPO I TPO III

Additional Commissioner ofIncome-tax

Additional Commissioner ofIncome-tax

Support staff

TPO II

Additional Commissioner ofIncome-tax

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Experience from Initial Audits

• Major companies audited. – 1,800 audits estimated.

• Only Selection Criteria.– International Transactions above INR 5 Crores.

• Adjustments - INR 1,500 Crores.– BPO/ITeS, Software, Banks, FMCG, Pharmaceuticals etc .

• TNMM method most commonly used by tax payers.

• Reliance on precedents of tax year(s) March 2002 & March 2003.

• Tax Board will develop case selection tools – more focused examinations in future years.

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Case Study

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Background

• XYZ Inc., a fortune 500 Company is in the business of manufacturing of automobiles

• XYZ India is a 100 % subsidiary and provides CAD designing services.

• XYZ India is a captive service provider and is compensated on a C + 10 % mark up.

• XYZ India has applied the TNNM as the Most Appropriate Method using comparables operating in ITeS industry. –

• PLI applied - Operating Margin / Operating Cost

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Analysis

Position of the TPO

• Rejection of Loss Making Companies

• Rejection of Companies having only domestic transactions

• Rejection of Multiple year data

• Own set of Comparables provided without any search process (cherry picking)

• Proposed mark up of 30% -40%

Position of the Tax Payer• Loss cannot be the sole criteria for

rejection (entrepreneurial risk)• TNNM requires functional

comparability• Financial results of comparables

exhibit high degree of variation • Integrated Service Provider to be

excluded • Companies having intangibles to be

excluded ( unique software, brand name etc)

• Adjustment for :• Working Capital• Intangibles• Risk ( captive service provider Vs.

entrepreneur)

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Audit Outcome

• Captive Service Provider (BPO/ITeS)

– Losses not acceptable

– Proposed cost plus markups range from 25% to 40%

– “One size fits all” approach

– Comparables proposed inappropriate (no consideration for intangibles, differences in business models, etc.)

– Justifies markup saying “even after paying high markups, cost savings will be substantial”

• Adjustment of risk vis-à-vis third party comparables disallowed

• Working capital adjustments of 2% allowed in some cases

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Audit Experience

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Major issues in Audit Outcomes - Services

• Consideration for service rendered by Indian Enterprises.– R & D, Marketing, Technical Services etc.

• Composition of Costs.– Direct and Significant Allocations of Indirect Costs !

• Denial of “Set–off”.

• Allocation of management fees ( Information Technology, Marketing, Budgeting etc ) by AE.– “Benefit Test” critical.– Evidence of receipt of services.– Determination of allocated amount.

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Major issues in Audit Outcomes – Intangibles

• Application of TNMM and Exchange Control Regulations not sufficient.

• Substantiation of receipt of know-how including updates.

• Evidence of negotiation.

• Concerns on losses by Indian enterprises.

• Details of Foreign Enterprise.– owner of intangibles.

• “Controlled Transactions” - Base for determination of ALP.

• Payments for trademark.– Economic v. Legal ownership.– Marketing Intangibles.

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Major issues in Audit Outcomes - Manufacturers

• Aggregation of Transactions – “ Single entity approach”– Transactionwise analysis preferred.

• Preference for CUPs ( Internal and External )– Material differences – volume, quality, terms of sale,

geographical differences etc. disregarded.

• Acceptance of TNMM with reluctance.– Product vs. Functional comparability.– Choice of profit level indicator.

• Disregarding Loss making companies from Comparables set.

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Major issues in Audit Outcomes - Distributors

• Enterprise with Losses – “Entrepreneur risk” not acceptable.

• Higher Gross Margin, but losses at Net level due to significant marketing expenses.

• Resale Price Method Vs. TNMM.

• Reimbursement of marketing expenses by Foreign Enterprise.

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Going Forward

• Rulings – Position of Revenue.

– Comparables, Methodology, Cost Sharing, Compliance - Foreign Enterprises etc.

• Risk Assessment - Selection of Audits.

• Safe Harbors eg. Services.

• Manning of TP Cell & Appellate Authorities.

• Effective MAP Process and APA.

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Confessions to a Tax Auditor

10. Everybody does it!

9. It improves my bonus!

8. My country needs it more than you!

7. It’s part of the game!

6. Thought they wouldn’t notice!

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Confessions to a Tax Auditor (Contd…..)

1. My boss made me do it!

2. It makes good commercial sense!

3. We’ll shift some back here in later years!

4. We already have too much profit over here!

5. It’s really just an accounting adjustment!

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Inputs

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Thank You