In recent years India has been viewed as an attractive and dynamic investment destination, thereby seeing an increased presence of multinational companies (MNCs) and a consequential increase in cross-border trade. This has amplified the vigilance by the Indian Revenue in matters relating to transfer pricing. In the last round of transfer pricing audits conducted by the Revenue, which completed in October 2009, adjustments were made to almost 45% of the cases picked up for scrutiny, resulting in an aggregate transfer pricing adjustment of approximately $2.3 billion across the country.

With this backdrop, it is worth evaluating certain fundamental concepts that are quite often overlooked in the course of a transfer pricing audit. The audit process is envisioned to undertake a detailed scrutiny of the cross border intra-group transactions in order to ascertain their arm's length nature. However, in practice, instead of examining the underlying basis, profitability is often adopted as the sole yardstick to judge the arm's length nature of transactions, and any adverse impact on profitability from the Indian side, generally attracts an adjustment. With transactional net margin method (TNMM) being used to demonstrate the arm's length nature of transactions in majority of the cases, the Indian Revenue, in general, has inflicted adjustments upon taxpayers by tailoring the set of comparables on the following lines:

• arbitrarily excluding comparables selected by the taxpayer;

• rejecting loss-making companies and cherry-picking of super-profit making companies;

• comparing the margins of the risk-insulated captive service providers with risk bearing entrepreneurs;

• using a profit level indicator merely to derive adjustment by completely disregarding the nature of the activity of the tested party and so on.

The approach of the Indian Revenue reveals a deviation from the stated intentions of the Indian transfer pricing provisions and also the basic fundaments of transfer pricing, which emphasise a proper analysis of functions performed, assets employed and risks assumed (FAR) as the cornerstone of comparability study. The evaluation process embraces (a) FAR analysis; (b) characterisation of the entities based on such an analysis; (c) selection of the tested party; (d) selection of the most appropriate transfer pricing method; and (e) the consequent selection of the comparables, as the proper sequence of carrying out a transfer pricing study or audit. In essence, the law envisages comparable selection and analysis as the last step of the process and not the first. The approach of the Indian Revenue indicates a high degree of emphasis on mathematical calculations rather than evaluation of economic factors, as envisaged by the law.

Selection of the tested party has quite often been a bone of contention between taxpayers and the Indian Revenue. Though the Indian law does not provide any specific guidance on the subject, yet, the taxpayers would be entitled to select the least complex of the two entities as the tested party, keeping in line with the OECD guidelines and the US transfer pricing regulations. The Indian Revenue on the other hand, generally prefers to select the Indian entity as the tested party, irrespective of its level of complexity, which is in contrast to the transfer pricing principles, often producing incongruous results..

A question, which arises at this stage, is whether in the audit process, the fundamental principles of transfer pricing are being overlooked? The fact that profit is the end result of a process and what needs to be tested from a transfer pricing perspective is the appropriateness of the process itself and not necessarily the outcome must be appreciated. Just as third party transactions can result in loss, an intra-group transaction might also produce a similar result and therefore the same should not always be judged solely on the touchstone of profitability.

Significant industry issues

While the emphasis of the Indian Revenue in the initial years of transfer pricing audits was more on the services sector, namely IT and ITeS companies, rendering back office services to their foreign principals, where the controversy hovered around the mark-up on costs, the attention of the Indian Revenue has since shifted to the manufacturing sector, particularly to niche and contentious subjects of marketing intangibles, procurement function and so on.

Some of the key issues are discussed as under:

Manufacturing industry

The manufacturing industry in general, faces transfer pricing challenges in several unique ways. In an inbound investment scenario, unlike most developed nations, the Indian regime does not permit the setting up of a principal structure, where two subsidiaries are set up in India, namely one for manufacture, while the other for distribution.

Unlike most developed nations, the Indian regulatory regime does not permit setting up of a principal structure, where two subsidiaries are set up in India, namely one for manufacture, while the other for distribution. In a classical entrepreneurial model, the first subsidiary company manufacturers products under a toll or contract manufacturing arrangement on behalf of the foreign principal, which raises an invoice on the second subsidiary company, distribution company, while the products are transported within the country itself.

In this scenario, the manufacturing entity would receive routine returns under a cost plus arrangement and the distribution entity would also receive returns commensurate to the intensity of its distribution functions, in other words, either a return on sales in case of a limited risk distributor; or a gross margin, in case of a normal risk taking distributor. While the entrepreneurial profits or losses, relating to the intangibles and significant peoples functions performed with respect thereto, reside in the principal company, residing outside India.

However, due to regulatory restrictions, the entrepreneurial model is not enforceable in India, with the result that both manufacturing and distribution functions are forced to reside in the single Indian subsidiary company, by default and not by choice. Such an Indian subsidiary, being a licensed manufacturer, would typically have the following major transactions with its foreign related parties, namely import of raw materials or components and payment of royalties for technology and brand.

The general practice adopted in transfer pricing audits for Indian licensed manufacturers has been to select the same as tested parties and benchmark its operating margins, the return on sales, under an overall TNMM, by comparing such margins against those earned by Indian entrepreneurial companies operating in similar industries. In other words, all the international transactions are sought to be tested under an overall TNMM. This approach is flawed, leading to incongruous results in most cases, particularly where the Indian subsidiary does a significant amount of localisation for its manufacturing functions, for example where the cost of raw materials or components imported from its overseas group entities, as a percentage of the total cost of manufacture of the products, is low and not significant. The situation can be explained with the help of a practical example –

• Indian subsidiary company's turnover for manufacturing segment is $2 billion;

• Value of raw materials or components imported from global related parties is $600 million, supplied at cost plus low margin by global related parties suppliers, in accordance with the global policy of the MNC group;

• The value of raw materials or components imported from global group entities constitutes 30% of the total cost of production of the Indian subsidiary company;

• Royalty paid by the Indian subsidiary company to the foreign principal company, at 3% of turnover, is $60 million;

• Indian subsidiary's return on sales (ROS) is 2%

• Under overall TNMM, average ROS of comparables is 5%, resulting in transfer pricing adjustment of 3% of total turnover of India subsidiary company, which works out to $60 million

The folly lies in the attempt to benchmark the Indian subsidiary company, which operates in the capacity of an entrepreneur, albeit a licensed manufacturer, against results of other Indian entrepreneur comparables, thus exposing the entire third party sales of the Indian subsidiary company to potential transfer pricing adjustments. It is a cardinal principle in transfer pricing not to select an entrepreneurial company as the tested party, as its financial results primarily depend upon the vagaries of economy, arising out of the assumption of entrepreneurial risks, and not upon pricing of transactions between foreign related parties.

The better and more sensible approach would be to evaluate the placement of the Indian subsidiary company in the value chain under the FAR analysis and test the different transactions with related parties on stand-alone basis. For instance, if the Indian subsidiary company is characterised as an entrepreneur, albeit license manufacturer, then it should not ideally be selected as the tested party. In case the raw materials or components imported from the foreign group companies are not embedded with technology and the same are supplied, under the policy of the MNC group, at a low margin on costs, then the price of the imports need to be tested in the hands of the foreign related party suppliers under a cost plus method or TNMM.

Further, royalties for technology and brand should also be tested separately under a comparable uncontrolled price (CUP) method, by using data available from global databases, such as RoyaltyStat or LexisNexis. Thus, in case the import of raw materials or components are separately tested on stand-alone basis, then the results of the Indian company should ideally not be a point of concern of the Indian Revenue, since the same would be driven by the forces of the economy, which are absolutely beyond its control.

If the aforesaid basic and cardinal principles are adopted by taxpayers in framing their transfer pricing documentation, majority of the transfer pricing disputes relating to the manufacturing industry concerning inbound foreign direct investments, would be mitigated.

Procurement functions

Procurement services are critical aspects of a supply chain. By virtue of offering a significant cost advantage, India has emerged as a key destination for global sourcing of products for MNCs. Typically, MNCs operate under the following models for procurement functions -

• Buy-sell procurement company, which buys products from third party vendors and sells the same to foreign group companies, thus retaining a margin for functions and risks;

• Procurement agent, which identifies third party vendors and also participates in negotiation of the pricing and contract terms with the vendors on behalf of its foreign group companies, thus earning remuneration in the form of commission as a percentage of value of goods procured for the foreign group companies from such third party vendors; and

• Procurement services company, which merely performs coordination and liaising functions for its foreign group companies in maintaining relationship with vendors identified by the group companies and also ensuring that the vendors manufacture the products according to designs and quality standards or parameters set by the group companies, thus earning a service fee based upon reimbursement of full costs of operation and an arm's length mark-up thereon.

Off late, the Indian Revenue has been aggressively targeting procurement services companies, who work under a cost plus model, by imputing a transfer pricing adjustment, computed as a percentage of value of goods procured by the foreign group companies directly from the third party Indian vendors. In other words, the Revenue has been disregarding the business model and pricing policy of the MNC group and forcefully converting a service provider, working under a cost plus model to a procurement agent with a turnover linked remuneration, without appreciating that the remuneration model of a procurement services company, which performs routine coordination and liaising functions, as above, and do not carry any intangibles relating to product or vendor knowledge, should be a function of its operating costs and not the value of goods procured by the foreign group companies directly from third party vendors in India. The approach of the Indian revenue has resulted in transfer pricing adjustments worth millions of dollars in not the most logical of manners, as explained by the following simple example:

• Operating costs of Indian subsidiary company, working under routine procurement service provider model are $15 million;

• Mark-up of Indian subsidiary company is 20% on operating costs, thus reporting profits of $3 million;

• Value of goods sourced by foreign group company from third party Indian vendors is $2 billion;

• Indian Revenue holds that Indian subsidiary company should receive commission at a percentage (typically 5%) of value of goods sourced by foreign group company from third party Indian vendors;

• Value of commission imputed in the hands of Indian subsidiary company is $100 million; thus resultant arm's length net profit is worked out at $85 million [100 – 15]

• Transfer pricing adjustment in the hands of Indian subsidiary company works out to $82 million [85 – 3]

Now, the transfer pricing adjustment through the arbitrary disregarding of the business model of the Indian subsidiary company, results in an imputed profit margin of 566% [85 ÷ 15 x 100], with a corresponding Berry Ratio of 666%, which are astronomical or absurd figures for any routine service provider, not carrying any intangibles whatsoever and which merely executes express directions of its group related parties.

While such high-ended transfer pricing adjustments on account of procurement functions should surely obtain justice in appropriate higher forums, relevant taxpayers are also advised to prepare robust transfer pricing documentations and inter-company agreements to demonstrate and justify the actual characterisation of routine procurement service providers; and the resultant cost plus model.

The developing outlook

Being in the tenth year of the transfer pricing regime, Indian regulations have been inching towards maturity with significant advancements for the taxpayers as well as the Indian Revenue. The recent discussion by the Revenue of formulating safe harbour rules is an indication of its attempt to provide certainty to the taxpayers while relieving them of the burdensome compliance requirements. Likewise, the proposal of setting up a framework for advanced pricing agreements is yet another step to provide certainty to taxpayers by the Indian Revenue. Recently, the Indian government has also formed an alternate panel for dispute resolution in order to ensure expeditious resolution of the transfer pricing disputes.

While all the above are welcome measures, respecting the fundamental transfer pricing concepts would surely ensure that the transfer pricing issues are amicably understood and resolved at the stage of revenue audit itself. A concept that needs to be appreciated by the Indian Revenue is that in practice, application of the arm's length principle is fraught with difficulty, particularly because of the enormous challenges associated with the identification of comparable transactions between independent parties. Adopting such an approach would undoubtedly trigger greater compliances from the taxpayers and ensure that the newer initiatives of the Revenue meet their desired objective.

Biography
		Rahul Mitra Partner, PricewaterhouseCoopers, India Mobile: +91 98300 55281 Email: rahul.k.mitra@in.pwc.com Rahul Mitra has been a partner in the tax & regulatory services practice of PricewaterhouseCoopers, India since April 1999. He is the leader of the firm's national transfer pricing practice. Mitra has 17 years of experience in handling taxation and regulatory matters in India. He specialises in transfer pricing, particularly inbound and outbound planning assignments; advise on profit or cash repatriation planning; value chain transformation or supply chain management projects; profit attribution to permanent establishments and so on. He was instrumental in obtaining the first regulatory approval in India on industrial franchise model, based on transfer pricing methods. Mitra handles litigation for top companies at the level of the Advance Ruling Authority and the Income Tax Tribunals. At least 50 of the cases independently argued by Mitra have been reported in leading tax journals of India. Two of his major wins before the Tribunal in transfer pricing matters are in the cases of Development Consultants and Schefenacker Motherson. Mitra has written papers and spoken in several tax conferences held in India and abroad. Several of his articles on transfer pricing and matters relating to international tax treaties have been published in BNA and International Tax Review, the leading tax journals of the world. Mitra is a member of the global editorial board of the magazine, Transfer Pricing Forum, published by BNA. He has been a visiting faculty of the National Law School in the subject of transfer pricing and international tax treaties. Mitra was the country reporter on the topic, "Non Discrimination in international tax matters", for the IFA Congress held in Brussels in 2008. Some of the major clients handled by Rahul in transfer pricing are the ITC Group; Tata Steel; BMW; DIC Group; Merck Pharma; Honeywell; Timken Group; GAP; Mars; Hermes; Nuance Group; Watson Pharma; Spotless Group and Pepsi. Rahul is a chartered accountant and honours graduate in commerce.

Biography
		Arun Saripalli PricewaterhouseCoopers PwC House, Plot 18/A Guru Nanak Road (Station Road) Bandra (West) Mumbai 400 050 Tel: +91 22 6689 1325 Mob: +91 99201 67931 Fax: +91 22 6689 1888 Email: arun.saripalli@in.pwc.com Arun Saripalli is a senior manager in the transfer pricing practice of PricewaterhouseCoopers, India. He has been involved in advising clients on various transfer pricing matters for the past six years and has advised clients across industries including automation technologies, industrial equipments, turnkey projects, automobiles, pharmaceuticals, financial services, logistics, dredging and ports. Apart from advising on transfer pricing matters, Saripalli has worked on several advisory assignments involving restructuring of global operations, setting up overseas investment and intellectual property holding structures and migration of intellectual property. His areas of specialisation include tax optimisation strategies and value chain transformation, local and global transfer pricing documentation and transfer pricing litigation. He has represented a host of clients in audit proceedings at various levels. Saripalli is a chartered accountant and in his six years of experience, has authored or co-authored several articles on transfer pricing and has presented several papers on the subject at various forums.