From the viewpoint of a developing country, the Indian authorities consider it essential for them to be able to tax the profits on certain intangible‐related transactions because of the perceived economic connection with that country, even if the intangibles are not legally owned by an enterprise in that India. With the amendments introduced by the Finance Act 2012, the Indian Tax Law (ITL) now contains a definition of the term intangible property for transfer pricing purposes. There is, however, no specific guidance in ITL on aspects of intangibles.
However, courts in India have often acknowledged the role of the OECD transfer pricing guidelines while applying Indian transfer pricing regulations. In this backdrop, the OECD’s recently published proposals for revised guidance on the transfer pricing of intangibles assumes importance from an Indian perspective.
What is an intangible?
According to the draft, the word intangible is intended to address something that is not a physical asset or a financial asset, and which is capable of being owned or controlled for use in commercial activities. The thrust of a transfer pricing analysis in a matter involving intangibles should be the determination of the conditions that would be agreed upon between independent parties for a comparable transaction. The draft therefore only provides an illustrative list of items that may be regarded as intangibles.
The ITL, on the other hand, adopts a prescriptive approach and contains a detailed – though not exhaustive – list of intangibles. In addition to covering generally accepted categories of marketing and technology intangibles, the ITL also covers human capital related intangibles such as trained and organised workforce and employment agreements. With regard to assembled workforce, the draft - while not listing it as an intangible - mentions that the existence of such an employee group may affect the arm’s-length price for services provided. Such a factor should ordinarily be taken into account in a transfer pricing comparability analysis.
Identification of parties entitled to intangible-related returns
With regard to the identification of parties entitled to intangible-related returns, the draft focuses on the alignment of functional contributions. This would typically require the entity to physically perform the important functions itself and control the supporting contributions of any service provider to be
Globalisation has led many
The OECD’s draft guidance would require MNEs to review the functional alignment of their R&D operations to assess whether the same is consistent with contractual arrangements that establish intangible ownership with the foreign principal and characterise the Indian R&D centre as a low-risk service provider. The issue would also be relevant in the context of distribution activities and marketing intangibles, which have emerged as contentious issues in India. According to the draft, if a distribution affiliate bears more costs and has greater control than the available comparables, a higher remuneration for the affiliate would be appropriate to effectively provide it with an entitlement to
The draft guidance also addresses the question whether services rendered in connection with developing intangibles are compensated on an arm’s-length basis. While such service providers do not claim entitlement to
In the context of Indian MNEs’ R&D centres, as the operations move up the value chain, it becomes important to periodically review the level of activity undertaken to assess whether the compensation paid adequately considers the higher level of activity undertaken.
Valuation
The draft states that pricing analysis should be two sided and consider the realistic alternatives of both parties as part of the comparability analysis. The draft calls for caution to be adopted in accepting valuation performed for accounting or other purposes when determining arm’s-length prices. The draft also recognises the use of discounted cash flow analysis as a tool in pricing.
Until recently, Indian transfer pricing rules permitted the taxpayer to use only the five OECD prescribed methods. In the absence of flexibility in selection of transfer pricing methods, taxpayers often encountered difficulties in applying the prescribed methods for intangible transactions. India recently issued a notification introducing a new transfer pricing method. As per the notification, any method that takes into account the price that has been charged or paid, or would have been charged or paid, for the same or similar uncontrolled transaction, with or between non-associated enterprises, under similar circumstances, considering all the facts, shall be regarded as one of the recognised methods.
The new method may permit the use of methods that are commonly used for financial valuation purposes, including methods relying on projected income and cash flow analysis. The new method is expected to provide flexibility to the taxpayers for valuing transactions involving
The draft places considerable emphasis on the functions performed, assets used and risks assumed by the parties in determining whether an intangible exists for transfer pricing purposes and in the determination of which entity should be entitled to the returns from an intangible.
The approach contained in the draft may be useful to evaluate the transfer pricing aspects of intangibles. Taxpayers may need to consider the impact of the draft guidance on their transactions involving intangibles.
By Rajendra Nayak and Shweta Pai of Ernst & Young
