RECENT ADVANCE RULINGS

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Transfer Pricing Documentation in India CA.
Vijay Iyer and CA. Nitin Narang
September 8, 2007
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Contents

• Transfer Pricing Documentation
• Fact gathering
• Functional Analysis
• Economic Analysis
• Transfer Pricing Study Report and Accountants
  Report

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Transfer Pricing Documentation
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Transfer Pricing Documentation - Overview

• Transfer Pricing (TP) regulations were
  introduced in India w.e.f. financial years
  beginning from April 1, 2001.
• The regulations require extensive TP
  documentation to be maintained by taxpayer
  undertaking international transactions with
  overseas group affiliates (AEs).
• The contemporaneous TP documentation is required
  to be maintained on or before the due date of
  filing the corporate income tax return, i.e. on
  or before October 31 every year in respect of the
  tax year.
• The detailed list of documents to be maintained
  as a part of TP documentation is provided in Rule
  10D of the Income Tax Rules, 1962 (Rules)

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Rule 10D Documentation
Transaction related
Price related
Entity related

• Profile of industry
• Profile of group
• Profile of Indian entity
• Profile of AEs

• Transaction terms
• Functional analysis (functions, assets and risks)
• Economic analysis (method selection, comparable
  benchmarking)
• Forecasts, budgets, estimates

• Agreements
• Invoices
• Pricing related correspondence (letters, emails,
  fax, etc)

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Documentation Rule 10D
The approach for TP documentation may be
summarised in the following phases of work
Documentation/ Accountants report
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TP Study Report and Accountants Report
Economic analysis
Calculation of arms length result
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Selection of Most Appropriate Method
Selection of Comparables
Functional analysis
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Analysis of Functions, Risks, Assets and
Intangibles
Fact gathering
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Mapping of international transaction
Industry Analysis
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Fact gathering
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Mapping of international transaction

• Applicability of TP regulations to the entity and
  its international transactions with its AEs.
• Keeping the legislative provisions in
  perspective, the following details about the AEs
  need to be documented
• Name and address of AEs.
• Legal status.
• Country of tax residence.
• Ownership linkages.
• Broad description of the business of the AEs.

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Industry analysis

• Understand industry dynamics in which entity
  operates
• Industry analysis examines industry trends, risks
  and overall environment, in which the entity/ the
  group operates.
• Generally, the following information should be
  documented about the industry
• Industry structure (including the Legal
  environment of the industry)
• Key players
• Key value drivers/ inhibitors of the industry
• Trends in profitability, turnover, market share,
  etc.
• Future outlook and
• Other important details, if any.

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Functional analysis
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Functional analysis

• The functional analysis includes
• Overview of the entity and the group to which it
  belongs.
• Analysis of functions performed by the entity and
  its AEs.
• Analysis of risks assumed by the entity and its
  AEs.
• Analysis of the intangibles owned by the entity
  and its AEs.
• Description of the assets utilised by the entity.
  
• The functional analysis is primarily based on the
  interviews with the entitys personnel.
• Information can also be gathered from portals of
  the entity, internet, intranet, entity brochures
  and audit documents.

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Functional analysis

• Interview with the entitys personnel, would
  generally include
• Discussing the organisation structure and
  operating procedures.
• Identifying all international transactions
  including deemed international transactions.
• Functions performed, risks assumed and assets
  utilised by each entity involved in the
  transaction.
• Identifying pricing strategies.
• TP methodology adopted by the group and its
  implementation in the entitys operations.
• Identifying internal / external comparable data.
• If losses are incurred, then reasons for the
  same.

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Functional analysis
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Economic analysis
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Economic Analysis

• Economic Analysis involves
• Determination of method to be applied and reasons
  for rejection of other methods.
• Description of the databases used in the analysis
  (e.g., Prowess, CapitaLine, etc) and search
  methodology used.
• Description of the financial analysis undertaken
  including descriptions of the comparables and
  adjustments to data.
• Determination of the arms-length price.
• Adjustment to the arms length price / tested
  party price to make them comparable
• Capacity utilisation
• Working capital
• Marketing
• Conclusion on whether the transaction meets the
  arms length test.

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Economic analysis Selection of Most Appropriate
Method
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Transfer Pricing Methods
OECD Transfer Pricing Methods
Traditional Transaction Methods
Transactional Profit Methods
Profit Split Method
Transactional Net Margin Method
Comparable Uncontrolled Price
Resale Price Method
Cost Plus Method

• 1. OECD traditional methods preferred to
  transactional methods
• Indian rules confirm OECD approach
• Any other method prescribed by the Central Board
  of Direct Taxes- None as of now

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Comparables

• All methods require comparables.
• Transfer price is set/ defended using data from
  comparable companies.
• Comparable company should be independent and
  similar to the entity.
• Following factors are generally used in judging
  comparability (Rule 10C(2))
• nature of transactions undertaken (i.e type of
  good, service etc.)
• company functions
• risks assumed
• contractual terms (i.e similar credit terms)
• economic and market conditions

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Comparable Uncontrolled Price Method -Rule
10B(1)(a)

• Comparable Uncontrolled Price (CUP) method is
  considered as the most appropriate method, for
  all transactions, if information is available.
• CUP method compares the price charged in a
  controlled transaction with the price in an
  uncontrolled transaction.
• It requires strict comparability in products,
  contractual terms, economic terms, etc.

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Comparable Uncontrolled Price Method
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Comparable Uncontrolled Price Method

• Internal CUP

Related party - Manufacturer B
Manufacturer A
Non-related party

• External CUP

Non-related party B
Non-related party A
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Resale Price Method- Rule 10B(1)(b)

• Resale Price Method (RPM) compares the resale
  gross margin earned by AEs with the resale gross
  margin earned by comparable independent
  distributors.
• An arms length gross margin should be sufficient
  for a reseller to cover its operating expenses
  and make an appropriate operating profit (in
  light of its functions and risks).
• Preferred method for a distributor buying purely
  finished goods from a group entity (if no CUP
  available).

Unrelated Wholesalers
Group Manufacturer (Outside India)
Related Distributor (India)
100
75
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Resale Price Method
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Resale Price Method
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Cost Plus Method Rule 10B(1)(c)

• Cost Plus Method (CPM) compares the gross
  profit on costs the AEs earns with the gross
  profit on costs earned by comparable independent
  companies.
• Preferred method for
• manufacturer supplying semi-finished goods
• entity providing services

Manufacturer A (Indian)
US Market
Related Manufacturer B (Outside India, say US)
Cost 40
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Cost Plus Method
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Cost Plus Method
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Profit Split Method-Rule 10B(1)(d)

• Profit Split Method (PSM) is appropriate for
  transactions which are not capable of being
  evaluated separately.
• Calculates the combined operating profit
  resulting from the whole inter-company
  transaction based on the relative value of each
  AE's contribution to the operating profit.
• The contribution made by each party is determined
  on the basis of a division of functions
  performed, valued, if possible using external
  comparable data.
• Applicable for analysing tangible, intangible or
  services issues.

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Profit Split Method
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Transactional Net Margin Method-Rule 10B(1)(e)

• Transactional Net Margin Method (TNMM) examines
  net operating profit from transactions as a
  percentage of a certain base (can use different
  bases i.e. costs, turnover, etc) in respect of
  similar parties, as the profit level indicator.
• Ideally, operating margin should be compared to
  operating margin earned by same enterprise on
  uncontrolled transaction Internal TNMM
• TNMM can also be used to compare the comparable
  transactions between independent parties
  External TNMM.
• It is applicable for any type of transaction and
  can also be used to supplement analysis under
  other methods.
• It is the most frequently used method in India,
  due to
• lack of availability of data to apply other
  methods.
• evens out business cycles, product
  dissimilarities.

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Transactional Net Margin Method
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Cost reimbursements / allocations

• Cost reimbursements
• In this case, pure third party costs borne by an
  Indian entity on behalf of its overseas AEs or
  borne by an overseas AE on behalf of the Indian
  entity in received / paid by the Indian entity
• Since, these expenses are in the nature of costs,
  without mark-up, margin based analysis for
  determination of arms length price is not
  required
• Necessary to prove that the Indian entity has not
  provided any service to the overseas AE
• Cost allocations
• Certain expenses incurred by the parent such as
  HO expenses, network expenses are allocated to
  all its subsidiaries worldwide (including India)
• These expenses are in the nature of allocation of
  costs, without mark-up.
• Necessary to demonstrate benefit-rule test.

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Economic analysis Selection of Comparables
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Comparable Search and Analysis Process
Database Search
Workpaper (WP)
Detailed Comparability Review Elimination
Additional Data Sources Telephone Interviews
Final Comparability Review Elimination
Financial Review Analysis
Final Comparables Set
Application to the Tested Party
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Search for comparables Steps

• Select an appropriate database based on
  geographical considerations, nature of the
  transaction etc.
• Select the appropriate search criteria on the
  chosen database
• Screen potential comparables
• Qualitative screening by review of short business
  description
• Review public documents such as annual reports,
  company websites, etc. for selected companies
• Document search process

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Search for comparables Database selection

• The following databases are most widely used to
  identify Indian comparables
• Caplitaline Plus
• Prowess

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Search for comparables Selection of search
criteria (Indian databases)

• A preliminary list of companies is identified
  from Prowess using a keyword filter, generally
  searching by the products/raw materials filter.
• Similarly a preliminary list of companies is
  obtained from Capitaline Plus using the screener
  module and then generally searching by
  Industry/product name/product code.
• The list of companies obtained on Prowess and
  Capitaline Plus is then merged to account for
  duplication.

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Search Process Screening of potential comparables

• A set of filters applied to the initial list of
  companies (obtained from the database) can be
  used to eliminate companies at the first stage.
• In addition, the Directors Report, Auditors
  Report, Notes to Accounts, Profit and Loss
  Account, Product details, Segmental information
  and Other company reports available on the
  database may be studied to eliminate companies
  that do not meet certain criteria.
• Finally, for the companies that appear to be
  comparable from the information available, other
  publically available information such as Annual
  Reports, company websites, etc. are reviewed.

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Broad criteria for rejection of companies

• The following filter are generally applied and
  are also accepted by the tax authorities
• Insufficient descriptive/ financial/ segmental
  information to perform analysis.
• Functionally different.
• No operations.
• Significant related party transactions.
• Persistent operating losses.
• Sick company.
• Other filters (e.g. turnover criteria,
  exceptional year of operations, etc.)

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Documentation of the Search process

• Summary of search process, including which
  databases were searched, search criteria and
  reasons for rejection
• Short business descriptions of accepted companies
• Completed Accept-Reject matrix
• Prepare a margin analysis summary sheet

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Arms length price
Price applied or proposed to be applied in a
transaction between persons other than AEs, in
uncontrolled conditions
Determination of arms length prices using one of
the Prescribed methods
Whether you arrive at a single price ?
Yes
No
The arithmetic mean of such prices or a price
which varies from such arithmetic mean by /-5
is the arms length price (92C(2))
The price thus determined is the arms length
price
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The Arms Length Range - How it works

• In most cases, it is not possible to identify a
  single price that can be considered to be an
  uncontrolled price.
• It may be that a number of different comparables
  are equally comparable. Several comparable
  transactions can therefore define an arms length
  range of possible transfer prices.
• Overall range may contain extremes. Indian TP
  legislation recognizes only arithmetic mean (with
  a /-5 variation) though statistically and
  internationally an inter-quartile range may be
  more appropriate.
• If transfer price falls within a /- 5 range,
  pricing should be defendable as arms length from
  tax authority audit perspective.

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TP Study Report and Accountants Report
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TP Study Report

• As discussed above, the contemporaneous TP
  documentation is required to be maintained on or
  before the due date of filing the corporate
  income tax return, i.e. on or before October 31
  every year in respect of the tax year.

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Accountants report

• The Indian TP legislation also requires that tax
  payers having international transactions with AEs
  to file Accountants report (in Form 3CEB) with
  the revenue authorities.
• The Accountants report should be filed on or
  before the due date for filing the corporate
  income tax return, i.e on or before October 31
  every year in respect of the tax year. (The
  Indian tax year is from April to March)

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Accountants report

• The Accountants report essentially comments on
  the following
• Whether the tax payer has maintained the
  prescribed TP documentation as required by the
  legislation
• Whether as per the TP documentation the prices of
  international transactions are at arms length
  and
• Certifies the value of the international
  transactions as per the books of account and as
  per the TP documentation are true and correct.

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Thank You