Transforming India's transfer pricing landscape

India's rules broadly follow the OECD guidelines Source: www.oecd.org

India's transfer pricing provisions were introduced in 2001. Since its introduction, the transfer pricing environment in India has moved on rapidly. Notably, the last 18 months has seen significant transformation of the Indian transfer pricing landscape with the courts pronouncing some landmark judgments, the Indian government introducing or proposing significant changes to the transfer pricing laws, and the multinational enterprises (MNEs) experiencing significant increase in the audit activity. This article provides an overview of these developments.

One of the most challenging issues in transfer pricing pertains to the creation and use of intangible property. A related issue is when the promotional efforts of a marketing affiliate in one country significantly enhance the value of the trademark that is owned by another affiliate in another country.

In a recent ruling, the Delhi High Court in the case of Maruti Suzuki Ltd has ruled on the transfer pricing aspects of marketing intangibles for a licensing arrangement between the Indian company and its associated enterprise (AE). The taxpayer, an India joint venture company of Suzuki, entered into a license agreement with Suzuki under the terms of which Suzuki agreed to provide technical collaboration and license necessary for manufacture, sale and after sale service of Suzuki products and parts. Suzuki also granted exclusive right to use its trademarks. The taxpayer was required to pay a royalty for the use of the intangible property.

The Maruti Suzuki case offered taxpayers some vital information on marketing intangibles Source: www.marutisuzuki.com

The tax authority proposed to make an adjustment by disallowing the royalty paid for the use of trademarks and by disallowing the advertising, marketing and promotional (AMP) expenses incurred in promoting Suzuki intangibles in India. According to the tax authority, the taxpayer had incurred huge AMP expenditure to develop the Suzuki brand in India and Suzuki should have compensated the taxpayer for the assistance provided in developing the marketing intangibles. Accordingly, non-routine AMP expenditure was adjusted as being the value of the marketing intangibles accruing to the benefit of Suzuki.

On an appeal to the high court by the taxpayer, the court held that in the case of AEs, payment of royalty should satisfy the arm's-length test. The test is to determine what a comparable entity placed in the position of the taxpayer would have done. The court also held that use of a trademark belonging to a foreign AE, by itself, would not entail a payment from the foreign AE to the domestic entity so long as the benefit of such brand name accrues to the Indian enterprise alone. With regard to the AMP expenditure, the court held that if AMP expenses incurred by the Indian affiliate using the trademark are more than what a similarly situated and comparable enterprise would have incurred, the owner of the intangible needs to suitable compensate the licensed user for the advantage obtained by it in the form of brand building and increased awareness of the intangible. In such a situation the arm's-length price for the arrangement would need to be determined taking into consideration all the rights obtained and obligations incurred by the associated enterprises. Further, to determine whether the AMP expenses incurred are more than what a similarly situated and comparable enterprise would have incurred it would be necessary to identify appropriate comparables for the purpose of comparison.

The above ruling appears to be broadly consistent with the OECD approach to intangibles even though the ruling does not make an explicit reference to the guidelines in reaching the conclusion. The ruling therefore provides a useful paradigm for the evaluation of transfer pricing issues in the context of marketing intangibles, though there are a number of open issues that flow from the elements of the paradigm. In a recent development, the Supreme Court in response to a petition filed by Maruti, ordered the transfer pricing officer to pass his order on this issue without considering the directions or observations of the high court. However, the Supreme Court does not seem to have commented or annulled the principles laid down by the high court on marketing intangibles.

Globalisation has led many MNEs to establish back-office and shares services operations in India to take advantage of savings inherent in low-cost labour markets such as India. Generally, these Indian affiliates operate as captive service providers insulated from all kinds of business risks. Recent audit experience indicates that tax authorities expect the service providers to earn a margin in the range of 25% to 30% on operating costs as compared to the margins determined by the taxpayers which are in the range of 10%-15% on costs. The approach adopted by the tax authorities to justify these margins is by adopting a different approach to accepting/rejecting comparable data as compared to that adopted by the taxpayer.

In a recent ruling, the Bangalore Tribunal in the case of SAP Labs India Pvt Ltd has adjudicated on the determination of the arm's-length price with respect to the software development services rendered by the taxpayer to its AE.

The taxpayer, a wholly-owned subsidiary of a German MNE is engaged in the business of software development and related services to the MNE at a cost plus 6% mark up basis. The taxpayer applied the transactional net margin method as the most appropriate method (MAM) and determined its net profit margin to be within the arm's-length range. During the audit proceedings, the tax authority rejected the set of comparables that were selected by the taxpayer and undertook a fresh search for the comparable data and determined the arm's-length price to be at 22.24%. While undertaking such an assessment, the tax authority included companies having super profits by normalising their profits; excluded foreign exchange gain earned by the taxpayer in order to compute the net profit margin and made an adjustment without giving the benefit of the 5% range.

The tribunal having regard to the functional profile of the taxpayer held that comparables having extreme results should neither be considered nor can their results be normalised for inclusion. The tribunal also held that as the taxpayer's transfer pricing policy was cost plus 6%, comparable companies that have margins less than the taxpayer's mark-up should be excluded, thereby creating bias in favor of comparables with higher margins of profitability. The tribunal also ruled that foreign exchange gain arising from ordinary business activities should be considered as an operating item. The tribunal determined the margins at 20.57% on cost and allowed the benefit of the 5% range under the erstwhile provisions of the income tax law.

While this ruling provides guidance on some transfer pricing issues faced by taxpayers, it also raises some questions on the approach to dealing with comparables that have extreme results, especially rejecting potentially comparable companies merely because they have margins lower than the tested party's markup.

The future for transfer pricing rests with multinationals and with the country's politicians Source: www.voyagesphotosmanu.com

The last 18 months has seen significant changes being introduced/proposed to the country's transfer pricing law through the Finance (No 2) Act, 2009 (FA 2009) and the Direct Taxes Code 2010 (DTC).

The provisions on the computation of the arm's-length price under the tax law provide that where more than one price is determined by the MAM; the arm's-length price shall be taken to be the arithmetic mean of such prices. Under the erstwhile provisions, the taxpayers were given the option to adopt a price which may vary from the arithmetical mean by an amount not exceeding 5% of such arithmetical mean.

The interpretation of the 5% range has been subject to disputes between taxpayers and the revenue authorities. In cases where the revenue authorities proposed an adjustment to the transfer price, taxpayers would argue that the adjustment should be made upto the lower end of the 5% range of the proposed transfer pricing adjustment. However, the revenue authorities would argue that the benefit of range was not available where variance between the proposed adjustment and the taxpayer's transfer price exceeded 5%. The taxpayer's position was supported by various tribunal judgments. To illustrate, if the transfer price is $100 and if the arm's-length price is determined as $110, under the previous provision that the revenue authorities would determine the adjustment at $10 (110-100) while the taxpayer could have limited the adjustment to $4.5 (95% of (110-100)).

Under the new provisions introduced in the FA 2009, if the variation between the arithmetic mean of the comparable prices and the taxpayer's transfer price is not more than 5% of the latter, the transfer price would be accepted as the arm's-length price. However, if such difference is greater than 5%, the taxpayer would not get the benefit of the 5% range and the arithmetic mean computed shall be deemed to be the arm's-length price. The amendment seeks to confirm the position of the revenue authorities. Thus in the example above, the new provisions would result in adjustment of $10 (110-100).

However, there appears to be some ambiguity on the effective date of this amended provision. The memorandum introducing the FA 2009 suggests that the amended provision would apply for orders passed after October 1 2009. However, a subsequent administrative circular issued by the tax administration suggests that the provisions would apply for the assessment year 2009-10 onwards.

The law was amended by the FA 2009 to provide for an ADR mechanism. Under the ADR mechanism, a dispute resolution panel (DRP) comprising of three commissioners of income tax was constituted in various cities. The DRP now exists in eight cities with Mumbai and Delhi having two panels. An administrative instruction issued by the tax administration also clarifies that use of the ADR mechanism is optional for the taxpayer.

The main benefits of approaching the DRP are that the tax demand proposed by a tax authority is kept in abeyance until disposal of the matter by the DRP. The ADR mechanism provides a fast track to dispute resolution as the DRP is under an obligation to dispose the matter within nine months. Further, the DRP replaces the first-level appellate authority under the hierarchy of appeals under the tax law as the DRP orders are appealable before the tribunal. In case the DRP's order is in favour of the taxpayer, the tax authority is bound by the order and is precluded from further appeal, while the taxpayer has right of further appeal in case of an adverse order.

Initial experiences before the DRP suggest that while taxpayers may be getting an additional opportunity to present their factual positions, especially on selection of comparable data by the tax authority, the panel may be reluctant to disturb any substantive or legal issues of dispute. Taxpayers may therefore need to consider evaluating alternative approaches to controversy management in case of adverse orders from the panel at an early stage. Suggestions have also been made to the government to introduce some structural changes in the ADR mechanism such as having independent and full time members as well as empowering the DRP to engage in a negotiated settlement of the dispute.

The Indian transfer pricing legislation already incorporates some administrative safe harbours such as the alleviation of documentation requirements and examination/scrutiny procedures for small taxpayers. To further provide administrative simplicity for small taxpayers and allocate more resources to the examination of larger transactions and taxpayers, safe harbour rules were proposed to be introduced under the transfer pricing regulations by the FA 2009, to provide for circumstances under which the income tax authorities will accept the transfer price declared by the taxpayer. The Central Board of Direct Taxes (CBDT), the apex authority for policy and administration of direct taxes in India has been empowered to notify the safe harbour rules in this regard. These rules are yet to be notified and it will be interesting to see the form and the manner in which these regulations are introduced.

To date, an APA programme has not been implemented in India and the taxpayer has to go through the normal compliance machinery available to him under the law, including the mutual agreement procedure of an applicable tax treaty. Although a mechanism exists in India for advance rulings; transfer pricing being a valuation issue, is excluded from its scope. The DTC, which was tabled in parliament on August 30 2010 and is proposed to come into effect from April 1 2012, has empowered the CBDT to formulate a scheme for introducing APAs where the taxpayer can approach the CBDT for determination of the arm's-length price in relation to an international transaction which may be entered into by the taxpayer. Under the DTC, the APA would be binding only on the taxpayer and the transaction to which the agreement has been entered into. APAs would be valid for a specified period, subject to a maximum of five years provided there are no changes on law on the basis of which the APA was entered into. The APA provisions also seem to provide a fair degree of flexibility to the tax administration in making adjustments to arrive at an acceptable transfer price. However, at this stage, the provisions seem to envisage only a unilateral APA.

The rules and scheme for APAs are yet to be formulated and notified in India. One expects the CBDT to give due consideration to all the aspects associated with the APA program before notifying the applicable rules to ensure successful implementation in India as well.

The transfer pricing adjustments made by tax officers in India during audit proceedings is often coupled with a time consuming dispute resolution mechanism for the taxpayer to seek any redress. Further, a transfer pricing adjustment in the hands of the Indian affiliate could potentially result in economic double taxation for the MNE, if the MNE is not able to obtain a correlative relief. These factors have made MNEs take the mutual agreement procedure (MAP) route. A MAP is an alternate dispute resolution mechanism where the competent authorities (CA) of both countries endeavour by mutual agreement to resolve any issue. Under the India-US tax treaty, the dispute is expected to be resolved within a period of two years and also provides for obtaining a stay on collection of the disputed taxes during the pendency of the MAP proceedings.

It has been reported in the media that pursuant to a MAP, the US and Indian CAs have proposed to resolve transfer pricing disputes involving provisions of intra-group information technology services by an Indian affiliates to a US MNE. The proposed resolution covers nearly 35-40 taxpayers relating to FY 2003-04 and 2004-05 who were subject to transfer pricing adjustments in the range of 25% to 30% on operating costs, as against their transfer pricing policy of 10% to 15% on operating costs. It has been reported that the proposal involves the CAs agreeing to accept a mark-up on costs of in the range of 17% to 24%, depending upon the year and nature of activity.

Where a MAP resolution has been arrived at and accepted for a particular issue for a relevant tax year, it will have effect only for the specific taxpayer for that relevant tax year and for that particular issue. A MAP resolution does not typically set a binding precedent for either the taxpayers or the tax authority for adjustments or issues relating to subsequent years or for CA discussions on the same issues for other taxpayers. Nevertheless, it does provide an indication of settlements that could be expected from MAP proceedings, especially, in a similar fact pattern. The taxpayers involved have the option to either accept the MAP resolution or follow the course of appeal prescribed under the country's tax law.

The OECD Council, on July 22 2010, approved the revision to the 1995 Transfer Pricing Guidelines. The OECD has issued revisions to the transfer pricing guidelines relating to hierarchy of transfer pricing methods, comparability analysis and application of transactional profit based methods. A new chapter providing detailed guidance on the transfer pricing aspects of business restructurings has also been included.

Indian transfer pricing rules are broadly based on the OECD standard, with some deviations, and over the years, courts in India have acknowledged the relevance of the OECD guidelines while interpreting Indian rules. The revisions introduce a number of significant clarifications and should help in providing clarity to taxpayers as well as to the Indian tax authority on a number of issues where the Indian rules are silent or do not contain adequate detail/guidance. This is particularly true for issues pertaining to comparability, application of transaction net margin method and profit split method and determination of the net profit margin indicator. Taxpayers should review their transfer pricing practices in light of the revised guidelines and assess impact. Some of the guidance contained in the revisions has already been endorsed by recent case laws in India. One would also hope that the government could give due consideration to the revisions and look at aligning some aspects of the Indian rules with OECD thinking.

Transfer pricing audits today go beyond pricing of products and include complex issues like services and intangibles. Recent trends in India indicate that transfer pricing will continue to be a contentious issue for taxpayers. Taxpayers are also concerned about the dispute resolution process. In recognition of this, the steps taken by the government to set up an ADR mechanism, provision for safe harbors and proposals to introduce APAs have been welcomed by taxpayers as this will help in reducing controversies and disputes and also provide for a resolution in a manner that is fair and impartial to both the tax administrators and the taxpayers. It would also be advisable for taxpayers to consider OECD's risk management recommendation contained in the 2010 revision to the transfer pricing guidelines. According to the OECD it is a good practice for taxpayers to set up a process to establish, monitor and review their transfer prices, taking into account the size of the transactions, their complexity, level of risk involved, and whether they are performed in a stable or changing environment. Such an approach would conform to a pragmatic risk management strategy.

Srinivasa Rao
		Ernst & Young Tel: +91 80 4027 5455 Email: srinivasa.rao@in.ey.com Srinivasa (Srini) is the national director of tax & regulatory services at Ernst & Young, India. He is also the national leader of Ernst & Young's international tax services practice in India. In recent years, he has been serially rated as among the leading tax and transfer pricing advisers in the country by Euromoney, International Tax Review and the Legal Media Group. Rao has worked with some of the world's leading multinational companies operating in India, across multiple sectors. He has also worked with some of India's leading multinational companies – principally in the Technology sector – in establishing their international operations. Over the years, he has worked across a range of direct tax specialisations – corporate tax, expatriate tax and international tax – besides Indian foreign investment policy and exchange control regulations. He now specialises in India inbound and outbound cross-border structuring and transfer pricing / supply chain planning.

Rajendra Nayak
		Ernst & Young Tel: +91 80 4027 5454 Email: rajendra.nayak@in.ey.com Rajendra Nayak (Rajen) is a partner with Ernst & Young's tax practice and is based in Bangalore. He is a partner in the tax knowledge & solutions group and also has responsibility for transfer pricing and international tax services. The knowledge & solutions group of Ernst & Young is a dedicated team of tax professionals that provides technical support to the tax practice and is engaged in developing tax solutions and strategies. Nayak has over 15 years of experience in tax and has specialised in the area of international taxation. He has considerable experience in advising companies on cross-border transactions, transfer pricing planning, documentation and controversy management and assisting companies in international tax planning. He works with a number of leading Indian and multinational companies in the information technology and manufacturing sector.