India: Transfer pricing controversy and dispute resolution
Rahul K Mitra, Pawan Kumar, Sanjay Tolia, Amitava Sen, Suchint Majmudar and Prajwala Pai PwC
Since its inception, transfer pricing (TP) has been one of the most litigated areas in the Indian tax landscape. Over the years, the TP challenges faced by taxpayers have undergone a momentous change. During the initial years of audit, the controversies arose over fundamental issues such as time period of data, choice of TP methodology, application of arm's-length range, and so on. Today, although some of these issues are attaining closure through rulings of the tax tribunal and the courts, and occasional legislative clarification, newer and more complex areas of dispute are emerging, such as the valuation of equity transfers, marketing intangibles, location savings, financial guarantees, business restructuring, high value R&D services, and others. With each passing year, the number of disputes going to the tax tribunals and the courts is mounting, and while cases are being adjudicated, the disposals have not kept pace. The recently concluded eight round of audit cycle has seen an exponential increase in the nature and quantum of TP adjustments, which would again result in considerable new litigation. One of the biggest tax disputes of recent years, the Vodafone case, was adjudicated by the Supreme Court in favour of the taxpayer. However, the relevant law was amended retrospectively to reinstate the original tax demand. Recently, the government has agreed to engage with Vodafone to enter into a non-binding conciliation to resolve the issue. Conciliation proceedings are an uncharted territory in the fast-evolving Indian tax environment and hence several stakeholders are eagerly awaiting the outcome of this development.
Key changes in policy and legislation
There have been some significant changes to India's TP policy and legislation over the last year which are expected to have an impact on TP dispute resolution. These developments are outlined below.
Introduction of advance pricing agreement (APA) programme
India introduced its APA regime, which had been a long-standing item on the wish list of the multinational taxpayer community, in 2012. The APA programme mostly incorporates global best practices and the enthusiastic response from taxpayers is clear. Almost 140 applications have been filed in the initial year itself. Post-filing discussions with the APA officials have also commenced. Taxpayers are expecting the APA regime to provide a pragmatic, open-minded and flexible route of managing tax risks and constructively attaining certainty, as against the conventional, routine dispute resolution route through judicial appeals.
The APA programme allows applications for bilateral, multilateral and unilateral APAs for a maximum of five years on a prospective basis. Taxpayers have to attend a pre-filing consultation meeting before the formal application. The APA regulations are detailed yet user-friendly, and provide for application, processing, finalisation, annual review, cancellation and renewal of APAs.
Response to United Nations (UN) TP Manual
The UN TP Manual, which was released in 2012, included a country chapter on India. This chapter includes India's response to a number of topics prevalent in an Indian context such as the use of contemporaneous data, the treatment of contract R&D services, 3% variation around the arithmetic mean as the arm's-length range and comparability adjustments for working capital, capacity and risk.
The India chapter also outlines India's response to issues such as location savings, royalties for brands and trademarks, development of marketing intangibles, intra group services and intercompany financial transactions. It is expected that the India chapter will often be used as a reference point in litigation involving the issues covered, though it may not necessarily have binding force in a court of law.
Revenue Circular on contract R&D service providers
The Central Board of Direct Taxes recently released a Circular 6/2013 which lists the conditions and factual circumstances under which low risk contract R&D service providers can be identified. This Circular is expected to bring about convergence and consistency in the Indian Revenue Service's (IRS) approach for accepting the functional profile of an R&D centre which typically operates under a net margin-based pricing model. The Circular should also be helpful as a reference guideline in settling TP litigation.
Introduction of domestic TP
Until now, the Indian TP regulations were applicable only for international transactions. However, the Finance Act 2012 extended the application of TP regulations to specified domestic related party transactions as well, effective from financial year 2012-2013. The annual TP compliance norms and audit provisions will now cover domestic transactions too.
Wait for safe harbour
Provisions for safe harbours were introduced in 2009, but the Indian government is yet to promulgate the norms. To this end, the government formed an expert group in 2012, called the Rangachary Committee. Pursuant to the recommendations of this committee, safe harbour norms are expected to be issued shortly.
Salient case laws
To date, India has witnessed about 600 judicial pronouncements in TP, whereby a number of issues arising from TP audits have been addressed by tax tribunals across the country, and the majority have been in favour of taxpayers. Some of the noteworthy decisions of the tribunals, addressing some of the major TP issues, are briefly discussed below:
One such ruling is Gap International wherein the Delhi Income Tax Appellate Tribunal (ITAT) dealt with the dispute relating to determination of an appropriate remuneration model for a procurement service provider. In this case, the ITAT accepted the characterisation of the taxpayer as a procurement service provider, for apparel to be exported directly by the vendors to the overseas affiliates, and rejected the IRS's attempt to re-characterise the taxpayer as a re-seller of apparel. The ITAT ruled that where all substantial directions relating to procurement from third party vendors, such as designs and trends of apparel, quality parameters of materials and terms and conditions for dealing with vendors, were provided by the overseas affiliates, the Indian taxpayer could not be considered to be undertaking services akin to an independent reseller. On the contrary, the taxpayer being a routine sourcing entity, was acting on the guidelines and procedures prescribed by the overseas affiliates and therefore it should ideally be expected to earn a return on the administrative and other operating costs – similar to a service provider – rather than earning commission on sales like a reseller. On the issue of location savings, the ITAT held that no further allocation of profits was required as the location savings to the developing economy arise to the industry as a whole and not necessarily to the taxpayer alone. Also, it was noted that the very objective of moving to a low-cost location was to survive in stiff competition by providing a lower cost to end-customers, whereby the advantage of location savings was passed on to them through a competitive sales strategy.
Another issue which is gaining increased attention during TP audits in India is marketing intangibles. This issue is particularly relevant for Indian group concerns of multinational enterprises that undertake significant local marketing in India. In recent audits, the TP authorities have examined the marketing activities and spending by Indian subsidiaries in the course of developing local market intangibles that are legally owned by overseas parents or other affiliates. Indian TP authorities are closely following international developments including case law and overseas regulations on this matter.
In a more recent case on this matter, the Special Bench of the ITAT in LG Electronics India ruled that the TP adjustment in relation to the advertising, marketing and promotion (AMP) expenses incurred by the assessee for creating or improving the marketing intangible for and on behalf of the group is permissible. The Special Bench has laid down a 14 point test to evaluate each case and determine the value of brand building services, if any. Further, it also endorsed earning a mark-up from the associated enterprise (AE) in respect of such AMP expenses incurred. In the same ruling, a majority decision of the ITAT observed that economic ownership of a brand is a concept which only exists in a commercial sense and that in the context of the Act, it is only the legal, and not economic ownership which is recognised. A dissenting, minority view was also given. It is expected that the guidance laid down by the Special Bench will assist taxpayers facing similar issues to obtain relief and arrive at a reasonable settlement in future.
Royalty payout is also an area receiving intense scrutiny from India's tax authorities. In many cases, the authorities have rejected the taxpayer's analysis and disallowed payments for the use or transfer of intellectual property, on the grounds that the taxpayer has failed to commensurately demonstrate the receipt of benefit.
In June 2013, the tax tribunal addressed this matter in the case of Reebok India. The ITAT concluded that the royalty payment satisfied the benefit test as the entire business of the appellant, Reebok India, was dependent on the technology provided by its AE. Also, the ITAT held that lower profitability by itself cannot be the basis for concluding that Reebok India had not received any benefit from the payment, and the tax authorities cannot question the commercial wisdom of the taxpayer in deciding the necessity of availing technology or services.
Need for strategic management of tax disputes
As is evident from the flurry of TP activity, it is becoming critical for multinational enterprises with operations in India to receive updates about current audit issues, to plan their TP arrangements, as well as audit and appeal strategy, based on such information. As India continues its progress in discovering the inexact science of TP, guidance from the Indian legislature, policymakers and the judiciary would be welcomed to clarify the law and to lay down basic principles that will eventually form the basis not only for assessing TP, but also for enabling multinational corporate taxpayers to plan their Indian tax affairs with relative confidence. Various aspects such as group organisational structures, significant people functions, and conduct and substance of the parties need to receive attention and be kept alive to change. Taxpayers should continuously assess their approaches to dispute resolution, to try and reach relatively certain and optimal positions in dynamic circumstances. In this context, the remedies available under alternative dispute resolution processes such as under the mutual agreement procedure (MAP) and APA can be evaluated.
With the current economic and tax climate, there are more risks around tax – both reputational and strategic – that no business leader can afford to ignore. CEOs should recognise that while their company's future depends on their ability to get their strategy right, tax planning does form a key element of such strategy.
Rahul K Mitra, Pawan Kumar and Sanjay Tolia are partners; Suchint Majmudar and Amitava Sen are associate directors and Prajwala Pai is an assistant manager in PwC.