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Agenda
-Introduction
- Framework of Transfer Pricing regime in India- Concept of Associated Enterprises
- Global Developments
- Traditional Transaction Methods
- Profit based Methods
- Q& A- Conclusion
TransferPricing
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Indian Statutory Framework of the Transfer Pricing Regime
TP regulations initiated in 2001 Section 92, 92A to 92F and Rules 10A to 10E.
Broadly based on OECD Guidelines
Major deviations :
reliance on Arithmetic mean as a measure of average limited range of 5% - now done away with
2 year period limitation for use of data
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Arms Length Principle
Arms length Price (ALP) is the hypothetical price at which unrelated parties would
have transacted under the same terms and conditions as those of the internationaltransactions.
Defined in Section 92F(ii) means a price which is applied or proposed to be
applied in a transaction between persons other than associated enterprises in
uncontrolled conditions
The arms length standard is the principle that governs the conclusion that an I
nternational transaction is not influenced by the relationship between the
Associated Enterprises (AEs)
Section 92 income from any international transaction - determination of ALP
Also allowance, expense or interest covered specifically
Cost contribution agreements also included but no guidance provided; expense
No application if taxable income gets reduced
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Associated Enterprise and International Transaction
Associated Enterprise (AE) commonality of management, capital or control -
Sec. 92A
International Transaction - Sec. 92B transactions between two or more AEs
where at least one is a non-resident (SC observations in Glaxo Smithkline)
Nature of transaction purchase, sale or lease of tangible or intangible property, orprovision of services, or lending or borrowing money or any other transaction
having a bearing on the profits, income, losses or assets and cost/expense
allocation or apportionment arrangement
In certain situations even transactions between unrelated parties can also be
deemed to be international transactions prior agreement with AE or where thesubstance of the transaction is influenced by the AE
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Determination of ALP: Transfer Pricing Methods
Methods Applicability
Comparable Uncontrolled PriceMethod
Comparison of actual price
Resale Price Method Comparison of gross margin fora distributor
Cost Plus Method Comparison of gross margin for
a manufacturerProfit Split Method Sharing of profits among entities
sharing proportionately in risks ina highly integrated operation
Transactional Net MarginMethod Comparison on a net (operating)profit basis
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Selection of Most Appropriate Method (MAM)
Rule 10C MAM is the method which is best suited to the facts and
which provides the most reliable measure of ALP; and
Factors to be considered are: nature and class of international
transactions, functions, assets and risks analysis, availability of data,
degree of comparability, possibility of making adjustments and the
nature, extent and reliability of assumptions made
How does one select the most appropriate method Analyse and characterise the international transaction Assess the availability of data with respect to application of methods
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Compliance Requirement
Taxpayers are required to put together the following on an annual basis:
Transfer Pricing report, which documents that all international transactions/ business
arrangements with group companies and their compliance with ALP (Rule 10D)
An Accountants certificate, in a prescribed format, that must be filed with Corporate tax
return (Rule 10E)
Use of Current year data controversial issue
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TP Documentation
Significance of Documentation
Is generally a part of legal regulations
Enables discharge of Burden of Proof
Indispensable in multiple audits
Protection against penalty
Supporting documents
Inter-company agreements
Evidence(s) of business reasons i.e. limited risks, market penetration etc, used to negotiate or set TP
Process map to evidence key decision nodes Documents generated as daily business processes
Trail of negotiations with AE e.g. mail trail documenting reasons for price fluctuations
Segmental/transactional profitability
A Robust TP report
Adjustments to be statistically reasonable and
replicable
To develop alternate arguments/positions
TP document to be in sync with Website/Publicinformation
Evidence of global consistency (whereverpossible)
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Transfer Pricing Audits
Reference by AO to Transfer Pricing Officer
Separate Directorate for TP audits
AO has concurrent powers; above a threshold compulsory reference to TPO
Primary onus on taxpayer
TPO/AO can determine the ALP only if one of the conditions specified in Section
92C(3) is met: unreliable or deficient use of data/method, lack or non-maintenance
of documentation, failure to furnish the documentation or determination of ALP in a
manner contrary to the rules
TP documentation is the fulcrum of TP audit
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Dispute Resolution
Conventional litigation route
Dispute Resolution Panel
MAP
Spate of Rulings by ITAT
Proposed Safe harbour rules
Proposed APA under DTC
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Methods Prescribed for Determination of ALP
Traditional transaction methods
Comparable Uncontrolled Price method - compares prices
Resale Price method - compares gross margins
Cost Plus method - compares profit mark-ups on costs
Transactional profit methods
Transactional Net Margin method - analyses net profits in relation to an
appropriate base
Profit Split method - refers to the (total) profits from transactions and splits
them based on contribution
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Traditional Transaction Methods
Hierarchy of Methods
- Indian position- OECD Position
Most Appropriate Method (MAM)
Factors determining the choice of MAM
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Comparable Uncontrolled Price (CUP) Method
-CUP method compares the price transferred in a controlled transaction to the
price charged in a comparable un-controlled transaction.
-CUP method is the most direct and reliable way to apply the arms length principle
-External and Internal CUP
-Illustrations - Sale of tangible property, supply of services, financing transactions,
licensing or sale of intangible property
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Differences in Comparability
Two transactions can be considered comparable only when there is no material
difference that can impact the price of the transaction in open market
Or
Reasonably accurate adjustments can be made to eliminate the material effect of
such difference
Real Challenge in the application of CUP
- finding comparable transactions; and
- making adjustments
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Adjustments to Account for Differences
Differences in
-volume, type of products/services- terms of contract
- geographical location, type and size of markets
Feasible adjustments
-Volume- credit period, freight cost
Problem Areas
-difference in product/service profile
- difference in geographical location of markets
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Issues and Controversies
Geographical location of Markets
Intervet case export price of goods sold by an Indian company to its AE inThailand was compared with export price to unrelated party in Vietnam by the
TPO adjustments had been made for volume and credit terms ITAT held that
adjustments need to be made for disparity in market location
OECD guidelines state the difficulty in this regard
Essar Shipping case charter rate of a 22 year old ship was compared with a
standard report that provided rates of ships less than 10 years old ad hoc
adjustments made rate was 1/4th of the reported rate ITAT rejected the same
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Issues and Controversies
UCB and Serdia Pharmaceuticals Importance of intangibles in application of
CUPImport of APIs to manufacture drugs purchase price (from AE) compared with
purchase price paid by unrelated competitor companies for same APIs in UCB it
was held to be unacceptable because of presence of intangibles (quality, brand
etc.) whereas in Serdia ITAT accepted the comparison as the APIs were no longer
protected by patents
Just because CUP is the most reliable method it cannot be applied where available
data is insufficient to justify comparison; CUP method requires a high degree of
comparability with regard to quality, contractual terms, level of market, geography
involved, date of transaction, intangible property, foreign currency and alternatives
available with buyer and seller
Clearplus case What is the relevant market to be examined Revenue
contended that goods brought from China cannot be compared with goods brought
from India despite both being sold in the US ITAT held that the relevant market is
the market where goods are sold
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Resale Price Method (RPM)
Is applied where goods or services purchased from an AE is resold to non-AE
Gross margin earned in same or similar uncontrolled transaction by the same party
or a third party is determined
The resale price is reduced by the gross profit margin
The above price is further reduced by expenses incurred in connection with the
purchase of property/service
Adjustments are made to account for accounting, functional and other differences
that materially affect gross profit margin in open market
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Use of RPM
Less product comparability required
Best to test resellers
Difficulty in applying RPM
identifying identical or similar functional and risk profiles,
facing differences in accounting practices, mainly with respect to costs of
goods sold, and
eliminating influences from different economies of scale.
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Cost Plus Method (CPM)
Involves comparison of mark-up on costs
Direct and indirect costs of production of an enterprise are determined
Normal gross profit mark-up on such costs earned in comparable uncontrolled
transaction is determined
Suitable adjustments made to account for differences that can impact gross profit
mark-up in an open market
The costs of the enterprise are increased by the adjusted gross profit mark-up to
arrive at the ALP
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CPM Strengths and Weaknesses
Less product comparability required
Less functional and risk comparability, as long as costs are well defined
Difficulties in applying CPM
ensure that inefficiencies do not result in higher profits as costs increase
there is often no direct link between the amount of the costs incurred and the
market price, i.e. arms length price
it requires extensive information about the cost base used in comparing the
mark-ups
reasonable adjustments are difficult when looking at external comparables
In the Indian context modified CPM is used where operating margin on total costs
are
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Issues and Controversies
Supreme Tradelinks Choice of method RPM selected by a franchisee TPO
rejects RPM on the ground that there was significant differences in operating costswhich were below the line ITAT negated this view on the facts
Higher level of below the line expenditure may warrant adjustment on account of
difference in functions
Ghardia Chemicals goods sold to overseas AE and RPM used to show that the
gross margin of the AE was at arms length ITAT rejected the claim on the ground
that RPM can be applied only on an Indian entity incorrect decision contrary to
Rule 10B(1)(b) and OECD guidelines
CPM casesMSS India
Twinkle Diamond
Diamond Dyechem
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