TRANSFER PRICING DOCUMENTATION

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TRANSFER PRICING DOCUMENTATION Navigating the
Indian Overseas waters!
Narayan Mehta Sudit K Parekh Co,
19th November 2005, Pune Branch of WIRC (ICAI)
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Agenda

• An overview of Indian documentation requirements
• Practical case study
• Indian owned US Canadian software subsidiaries

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Indian Transfer Pricing Regulations
Indian Income-tax Act, 1961
Arms length price
Documentation
Accountants Report
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Importance of Compliance

• Any related party transaction undertaken from
  1st April 2001 onwards covered
• Currently 60 of worlds cross-border trade is
  between
• related parties Indian tax authorities
• have taken the cue!
• UK every 1 spent on TP investigation has
  fetched
• 120 to UK Inland Revenue
• Japan transfer pricing has been a major revenue
  churner-
• individual cases exceeds 100 m!
• India - FY 01-02 assessments complete - Press has
  reported incremental tax revenues in excess of
  INR 600 Cr based on the first year of TP audit
  adjustments
• Around 25 to 30 of the case show adjustments!

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Enhanced audit exposure

• Percentage of completed scrutiny assessments
  resulting in an adjustment
• (E Y Survey)

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EY Transfer Pricing Survey 2003-
Key findings

• 86 of parent and 93 of subsidiary respondents
  identified TP as most important international tax
  issue
• 1/3 rd of audits concluded in TP adjustments
• Penalty actually imposed in 50 of cases in which
  penalty threatened by TP authorities
• 40 of TP adjustments have resulted in double
  taxation

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A bilateral exercise

• At least 9 out of 25 EU / accession countries
  have specific TP documentation requirements
• Denmark Hungary Portugal
• France Netherlands Spain
• Germany Poland UK
• Upward of 20 other countries have specific TP
  documentation requirements
• Japan Australia Korea
• China Canada Mexico
• TP documentation may be required in other
  countries under general anti-avoidance provisions
• Israel, Singapore, etc.

Need for balancing the Indian overseas
transfer pricing regulations!
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Importance of Compliance

• No exemption from compliance
• Transactions exceeding INR 50 million to attract
• compulsory transfer pricing audit
• Onus of proof- tax payer primarily liable
• Nestle India Ruling
• S.10A / 10B units- thin margin for error
• No deduction under section 10A / 10B on enhanced
  income!
• More than ordinary profits taxable may not be
  tax exempt!
• Double taxation for the Group in respect of
  enhanced income
• DHL Corp. Subsidiaries Ruling

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Penalties are high

• Failure to maintain documentation
• 2 of value of transaction
• Failure to furnish documentation
• 2 of value of transaction
• Addition to Income
• 100 to 300 of tax on addition
• Failure to furnish Accountants Report
• Rs. 100,000

Penalties are not tax deductible! Penal
regulations in many overseas jurisdictions as
well
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Dual advantage!

• An effective tax planning risk management tool
  to establish the appropriateness of transfer
  prices

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Integrated holistic approach

• May involve
• International tax
• Expatriate tax
• Exchange control
• Service Tax / VAT
• STPI issues

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Documentation- why necessary?

• To be better prepared for transfer pricing audit
• To support your arms length price in future
• Self review

Effective communication of TP policy is critical
for IRS to appreciate approve transfer pricing
documentation!
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Documentation when most critical?

• Continuous loss situation
• GP / Operating margin is very volatile
  fluctuating
• Market penetration strategy is adopted
• Changes in transfer pricing policy
• Unutilized / idle capacity
• Monopolistic situation
• Start up phase
• Transactions involving
• Royalties and / or intangibles
• Intra group services
• Cost sharing arrangements

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Onerous documentation retention reqt
Beginning of tax year
End of tax year
Deadline for maintaining documentation Filing
Accountants Report ROI
Limitation for initiation of assessment
Limitation for completion of assessment
Date till which docn. is required to be
maintained
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Legislative Framework
Associated Enterprise
Associated Enterprise
Transaction
International
Arms length computation maintenance of
necessary documentation
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Key definitions

• Document Section 2(22AA) of the Income tax
  Act, 1961
• includes electronic record as defined in sec
  2(1)(1) of the Information Technology Act, 2000
• Electronic record Section 2(1)(l) of the
  Information Technology Act, 2000
• means data, record or data generated image or
  sound stored, received or sent in an electronic
  form or micro film or computer generated micro
  fiche

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Indian statutory provisions
Information / documents in relation to an
international transaction needs to be

• kept and maintained in prescribed manner by every
  person Section 92(D)(1)
• kept and maintained for a prescribed time
  Section 92(D)(2)
• furnished within 30 / 60 days of Revenues
  request Section 92(D)(3)

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Documentation- fixing the jigsaw puzzle!
Accountants Report
Industry Analysis
Agreements
Benchmarking
Functional Analysis
Other Docn
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Primary Documentation required under Indian
Regulations

• Associated Enterprise related documents
• Transaction related documents
• Description of functions performed, risks assumed
  and assets utilised
• ALP computation related documents
• Record of transactions considered for determining
  price of international transactions
• Analysis performed to evaluate comparability
• Description of all methods considered and reasons
  for selection of the most appropriate method
• Record of actual working for determining arms
  length price
• Details of comparable data used in applying most
  appropriate method

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Additional Documentation required under
Indian Regulations

• Government publications, reports, studies,
  databases
• Market research studies and technical
  publications of recognized national or
  international institutions
• Price publications including stock exchange and
  commodity market quotations

• Relevant agreements and contracts entered into
  with associated enterprises or with unrelated
  enterprises
• Letters and correspondence documenting terms
  negotiated with the associated enterprise

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Documentation- guiding principles

• Taxpayers standpoint
• Principles of prudent business management to be
  followed for maintaining documentation
• Revenue authorities standpoint
• Documentation examined should be that which
  exists at the time of determining the transfer
  price
• Not burden the taxpayer to produce documentation
  which are not in its possession or over which it
  has no legal control
• No public disclosure of trade / scientific
  secrets

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CASE STUDY
Indian Owned

• US and Canadian subsidiaries

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US / Canadian subsidiaries
Consideration ?
Indian tax Rate 0 / 35
US / Canadian federal tax rate 35 / 39
Transfer Pricing issues!

• Marketing in US / Canada
• On site services and
• support

Indian Co
US/ Canadian WOS
Contract for outsourcing

• Software
• development
• Brand creation
• Entrepreneurial
• risk

Principal contract for software development
Contract value 100
Deputation / secondment of personnel at site
execution of the contract offshore onsite
Ultimate US/Canadian client
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Step 1- Functional Analysis
Compliance with documentation requirements
Understanding of where and how value is added
Criteria for Comparability
Assist in identification of simpler entity
Platform for Economic Analysis
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Functions performed
Income distribution within the MNC to be based on
economic value and activities
Each activity / enterprise receives a share of
total profits that reflects the contribution of
that activity / enterprise to earning those
profits.
RD
Software Development
Finance
Marketing
Sales Distribution
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Risks undertaken
Analysing risks associated in relation to various
business operations
Strategic Planning
Foreign Exchange
Project Scheduling Dvlpt Activities
Idle Capacity
Quality Control
Sales Distribution
Research Development
Marketing
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Assets employed
Analysing various assets intangibles employed
Technical/ Trade Intangibles
Marketing Intangibles
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Functional Analysis- findings in instant case

• Indian Co
• performs most of the functions
• owns most of the intangibles
• undertakes most of the risks
• Consequently,
• Indian Co relatively more complex entity
• US / Canadian Cos relatively simpler entities

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Functional Analysis- significance
XYZ Group of Companies
Profit f (F A R)
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Procedure followed in practice
Site visits
Background information
Review client documents
Client interviews
Tax audit files
Written questionnaire
Financial statements
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Step 2 Economic Characterization of simpler
entity

• Assists in determining the search parameters for
  comparables
• Determining the nature of the entities
• Re onsite contract support - ring fenced, risk
  mitigated contract service providers
• Re marketing support- routine market service
  providers

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Step 3 Selecting the most appropriate method
Most Appropriate Method ??? ??? ?
Cost Plus
Profit Split
TNMM
Resale Price Method
Comparable uncontrolled price
Others Yet to be prescribed
Most appropriate method - service provider - cost
plus / TNMM Document reasons for selection /
rejection of TP methods
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Step 4 Search and assessment of comparables

• External comparables- running queries on North
  American TP databases for searching functionally
  comparable companies preferably in the same line
  of business
• Compustat
• Disclosure
• .

In practice, Indian IRS more comfortable with
searches on Indian databases!
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Search for initial comparables

• Re Onsite support services
• Information Technology / Software service
  providers (based on Industry key words / SIC
  Codes)

• Re Marketing support services
• Marketing / advertising / commission agents

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Identifying initial rejection criteria

• Company undertakes different function
• Company involved in different product
• Company operates in different industry
• Company is not independent
• Company is dormant / inactive
• Company has no financial data
• Other reasons

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Applying Filters

• Quantitative Filters
• 3 Year Track Record
• Ratios
• Any Other Parameters
• Revenue
• No. of Employees

• Qualitative Filters
• Companies Incorporated In Foreign Countries
• Positive Word Search
• Negative Word Search
• Independent Companies

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Short listing final comparables

• Review business descriptions and other details
• Background information, Directors Report,
  Websites, Trend in sales, News Abstracts, Mgt
  discussion Analysis, Related Party Disclosures,
  SEC disclosures, etc
• Examine public documents (eg annual reports)
• Telephone interview / company contacts
• Select comparable companies

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Ascertaining margins of final selected
comparables

• Needed to benchmark the margins of the tested
  party
• Need for selection of the appropriate PLI to
  ascertain the margins of comparables

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Selection of PLI

• The three financial ratios generally considered
  as acceptable in the US context are
• Rate of Return on Capital Employed
• Berry Ratio (GP / Op exp)
• Operating Margin (Op profit / Sales or Cost)
• Selection of appropriate PLI depends upon
• Nature of the activities of the tested party,
• The reliability of the available data with
  respect to comparable uncontrolled taxpayers, and
  
• The extent to which a particular profit level
  indicator is likely to produce a reasonable
  determination of the income that the tested party
  would have earned had it dealt with the
  controlled taxpayer at arms length

PLI in instant case - Operating Margin (Op profit
/ Total Cost) - Also preferred in practice by
the Indian the US IRS
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Sample record of benchmarks used as comparable
data
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An alternative analysis

• What should be the sample size?
• US v/s Canadian practice

• Constructing an alternate broad base sample
• Use of lateral comparables to broad-base final
  sample size!

US IRS prefers an alternate sensitivity analysis
in practice
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Sample record of benchmarks used as comparable
data (extended sample)
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Arithmetic mean and median of extended sample
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Adjustment to Ratios

• Useful when feasible to increase ratios
  comparability to the tested party
• Three standard adjustments
• Inventory Differences
• Inv. Adj. (Inv./Sales taxpayer Inv./Sales
  comparable) Sales comparable Prime Lending
  Rate
• Receivables Differences
• Rec. Adj. (Receivables/Sales Taxpayer
  Receivables/Sales Comparable) Sales Comparable
  Prime Lending Rate
• Payable Differences
• Pay. Adj. (Payables/COGS or Sales Taxpayer
  Payables/COGS or Sales Comparable) COGS or
  Sales Comparable Prime Lending Rate

Not used in practice generally by Indian /
European IRS- however, US Canadian IRS prefers
this adjustment in practice
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US Subsidiary- SKP experience
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Profit sharing based on TP policy
Cost plus 8 only!
Rest of the profits!
Consideration ?
Indian tax Rate 0 / 35
US / Canadian federal tax rate 35 / 39
Transfer Pricing issues!

• Marketing in US / Canada
• On site services and
• support

Indian Co
US/ Canadian WOS
Contract for outsourcing

• Software
• development
• Brand creation
• Entrepreneurial
• risk

Principal contract for software development
Contract value 100
Deputation / secondment of personnel at site
execution of the contract offshore onsite
Ultimate US/Canadian client
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Transfer pricing a tax planning tool!
Total Profit

• Above-normal profit
• Goes to economic owner(s) developer(s) of
  intangible assets
• May also be zero or negative!

Return to entrepreneurial risk-taker
Return to routine service providers / suppliers
of labor and capital

• Normal profit
• Paid out for performance of normal tasks
  software development, sales, distribution,
  marketing support, etc

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Compliance with Indian TP Regulations

• US / Canadian entites remunerated on cost plus 8
  mark up
• Rest of the profits belongs to Indian entity!
• Undertaking supplementary search on Indian
  database to corroborate findings
• In practice, Indian IRS prefers Indian entity
• to be the tested entity

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Balancing Indian / US / Canadian Regulations

• US / Canada
• Use of (inter-quartile) range generally allowed
• Use of past data of even more than 2 years
  generally allowed

• India
• Concept of arithmetic mean-5 variation allowed
  but range not permitted
• Past data of only 2 years

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Taking advantage of Global Documentation

• Taking advantages of tax planning opportunities
• Consistency uniformity in documentation
• Cost savings killing two birds with
• one stone!

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US transfer pricing study - end results

• Compliance with the US transfer pricing
  regulations!
• Minimum corporate tax incidence in the US !
• Optimization of section 10A benefits complete
  tax exemption in India!
• Compliance with the Indian transfer pricing
  regulations !
• Compliance with exchange control regulations,
  STPI norms formulation of expatriate pricing
  policy

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Other Issues encountered

• Whether UK Co. is a PE of the Indian company?

• Even if PE, whether arms length mark-up would
  eliminate further tax incidence?
• Employees on dual payroll or overseas payroll?
• Compliances under STPI FEMA regulations for
  export billing
• W/ tax issues and remittances under FEMA

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Documenting the search process

• Industry overview
• Ownership structure
• A summary of international transactions
• Functional analysis
• Economic characterization of entities
• Reasons for selection of the most appropriate
  method and reasons for rejection of other methods
  for each of the international transactions
• Listing of database sources for undertaking a
  search
• Summary of search process
• Short business descriptions of accepted companies
• Completed search matrix accept / rejection
  reasons for all companies
• Number of companies at each stage of rejection
  during search and evaluation
• PLIs used in undertaking the search
• Financial margins other relevant data of
  comparables
• A copy of the prowess print screen / CD of the
  cut off date

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Contractual agreement

• Terms of the contract- very critical
• To provide for
• consistent risk and functional allocation between
  the parties
• what all cost included in the cost base
• re the flow through costs
• what would be the mark up to be applied

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Other additional documentation

• Ownership structure industry background
• Role of each AE in the overall scheme of things!
• Relevant correspondence
• Underlying supporting documentation (invoices,
  debit notes, etc)
• Accounts tax treatment of overseas associated
  enterprise in its home jurisdiction
• Press cuttings
• Brochures and catalogues
• Price lists / quotations

• Marketing material
• Management accounts / reports
• Internal presentations
• Business Plans
• information published by trade associations,
  other official publications, etc.
• Approvals received from Regulatory Authorities
  (RBI, GOI, etc.)
• Independent Valuation Reports

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Transfer Pricing Study Process Summary
Maintaining necessary documentary evidence to
support each of the above steps!
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Concluding remarks

• Contemporaneous documentation
• Indian IRS prefers a benchmarking analysis based
  on latest data on database
• Regular review update
• Uniformity and consistency in documentation
• Tailored to the needs of the IRS
• Global / centralized / regional documentation
• Relaxation if value of all international
  transaction lt 1 Cr
• Benchmarking analysis may yet be reqd in absence
  of CUPs

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Thank You
?
Queries
Narayan Mehta Tel [phone] Mob 91
9820544495 E-Mail narayan.mehta_at_skparekh.com