DEEPENDER ANIL AND ASSOCIATES

1. DEEPENDER ANIL AND ASSOCIATES DOMESTIC TRANSFER PRICING PROVISIONS CA DEEPENDER KUMAR Deepender Anil and Associates

2. INTRODUCTION TO DOMESTIC TRANSFER PRICING The Finance Act 2012 extended the scope of Transfer Pricing provision to ‘Specified Domestic Transactions (‘SDT’) between related parties w.e.f. 1st April, 2012. Shift from generic ‘Fair Market Value (FMV)’ concept to focused ‘Arm’s Length Price (ALP)’ concept in cases where the aggregate value of transactions falling under SDT exceeds INR 5 crores. Deepender Anil and Associates

3. OBJECTIVE BEHIND DOMESTIC TRANSFER PRICING The objective behind the introduction of the new domestic transfer pricing regulations has been explained in the Memorandum explaining the provisions of the Finance Bill, 2012 as follows:- “……….the application and extension of scope of transfer pricing regulations to domestic transactions would provide objectivity in determination of income from domestic related party transactions and determination of reasonableness of expenditure between related domestic parties. It will create legally enforceable obligation on assesses to maintain proper documentation Deepender Anil and Associates

4. From the following para of theExplanatory Memorandum, it appears that the said provisions have been made applicable only in a limited way to apply only for certain specified purposes:“Therefore, the transfer pricing regulations need to be extended to the transactions entered into by domestic related parties or by an undertaking with other undertakings of the same entity for the purposes of section 40A, Chapter VI-A and section 10AA.Hence, as evident from the above, it is intended that the domestic transfer pricing regulations would be applicable only to transactions, which fall within purview of the provisions of section 40A, section 10AA and Chapter VI-A of the Act. Not all types of transactions between related domestic parties would be subject to the domestic transfer pricing regulations. For eg: capital gains from sale of an asset by a resident assessee to another related resident assessee would not be covered by this regulation. Deepender Anil and Associates

5. CIT V GLAXO SMITHKLINE ASIA (P) LTD. The Supreme Court in case of CIT v GlaxoSmithkline Asia (P) Ltd. in its order has after examining the complications which arise in cases where fair market value is to be assigned to transactions between domestic related parties, suggested that Ministry of Finance should consider appropriate provisions in law to make transfer pricing regulations applicable to such related party domestic transactions. Deepender Anil and Associates

6. INTENT OF TP REGULATIONS…(DOMESTIC TRANSACTIONS Related Enterprise in Domestic Tariff Area (DTA) Indian Co. Tax Holiday undertaking CASE – 1:- Shifting of Expenses / Losses Shifting of income / profits Tax @ 32.45% Text Exemption Deepender Anil and Associates

7. Tax Saving for the Group – Loss to Indian Revenue Deepender Anil and Associates

8. CASE – 2:- Shifting of Expenses Related Related Enterprises Profit Making Indian Co. Loss Making Tax @ 32.45% Reduced tax due to shifting of Income Tax @ 32.45% No tax or reduced tax Due to loss Shifting of Income Deepender Anil and Associates

9. Tax Saving for the Group – Loss to Indian Revenue By shifting of income from a profit making company to a loss making company, the group could reduce its tax liability by 16.23 for the current year, though the impact will be reversed in future years given carry forward of losses. Deepender Anil and Associates

10. MEANING OF SPECIFIED DOMESTIC TRANSACTIONS (SECTION – 92BA):- For the purposes of this section and sections 92, 92C, 92D and 92E, "specified domestic transaction" in case of an assessee means any of the following transactions, not being an international transaction, namely:— • Any expenditure in respect of which payment has been made or is to be made to a person referred to in section 40A(2)(b) – • Section 40A(1) – Applicability restricted to the computation of income under the head “Profits and gains of business or profession”. • Section 40A(2):- – Applicable on expenditure in respect of which payment has been made or it to be made – Expenditure in respect of goods, services or facilities Questions arises:- – Interest free loan given to related party – Corporate guarantee without any charge – Goods sold at lower value – Capital expenditure Deepender Anil and Associates

11. 2. Any transaction referred to in section 80A Assessee Goods / Services Any other business Undertaking / Unit / Enterprize / eligible business • 3. Any transfer of goods or services referred to in sub-section (8) of section 80-IA Assessee Undertaking / Unit / Enterprize / eligible business Any other business Deepender Anil and Associates

12. 4. Any business transacted between the assessee and other person as referred to in sub-section (10) of section 80-IA Independent Tax Payer. Assessee Eligible business with more than ordinary profits Deepender Anil and Associates

13. 5. Any transaction, referred to in any other section under Chapter VI-A or section • 10AA - Special provisions in respect of newly established Units in Special Economic Zones. • 80IAB - Deductions in respect of profits and gains by an undertaking or enterprise engaged in development of Special Economic Zone. • 80IB - Deduction in respect of profits and gains from certain industrial undertakings other than infrastructure development undertakings. • 80 IC - Special provisions in respect of certain undertakings or enterprises in certain special category States. • 80ID - Deduction in respect of profits and gains from business of hotels and convention centers in specified area. • 80IE - Special provisions in respect of certain undertakings in North-Eastern States. Deepender Anil and Associates

14. 6. Any other transaction as may be prescribed; And where the aggregate of such transactions entered into by the assessee in the previous year exceeds a sum of Rupees Five Crores. DEFINITION OF SDT IS EXHAUSTIVE:- The use of word ‘means’ implies that the definitions restrictive and exhaustive. (Vanguard Fire & General Insurance Company Ltd., Madras v Fraser and Ross, AIR 1960 SC 971). This definition, unlike section 2, does not use the words “unless the context otherwise requires”. However, even in absence of an express qualification to that effect, such a qualification is always implied. [Knightsbridge Estate Trusts Ltd. V. Byrne (1940) AC (613)]. In view of the definition being restrictive and exhaustive, the term SDT whall cover only those items that are specifically covered in the section and it cannot extend to any item beyond the ones stated in the section. Deepender Anil and Associates

15. APPLICABILITY OF TP PROVISIONS MATRIX Deepender Anil and Associates

16. Comparison between applicability of transfer pricing provisions to international transactions and SDT Deepender Anil and Associates

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19. COMPLIANCE:- • Taxpayer must compute the arm’s length price of SDT as per the methods prescribed under section 92C. • Burden of proof is on the taxpayer to establish the arm’s length price and to maintain related documents. • Must obtain a report under Form 3CEB (or any other as prescribed) from a Chartered Accountant and file it before tax authorities within due date of filing of return of income. • For assessment year 2011-12 and onwards, due date would be 30 November. • Tax payer must submit the transfer pricing document to the tax authorities, within 30 days of the receipt of notice from the department. Deepender Anil and Associates

20. PENALTIES ON NON COMPLIANCE:- Deepender Anil and Associates

21. TRANSFER PRICING DOCUMENTATION:-(Section 92D of the Income Tax Act read with Rule 10D of the Income Tax Rules.) Deepender Anil and Associates

22. FAIR MARKET VALUE (FMV) VS ARM’S LENGTH PRICE (ALP) Deepender Anil and Associates

23. METHODS PRESCRIBED FOR DETERMINING ARM’S LENGTH PRICE (Section 92C): COMPARABLE UNCONTROLLED PRICE METHOD (CUP):- Most direct way of determining an ALP. It compares the price charged for goods or services transferred in SDT to the price charged for property or services transferred in a comparable uncontrolled transaction. Price is adjusted to account for differences, if any, between the SDT and the comparable uncontrolled transactions or between the enterprises entering into such transactions, which could materially affect the price in the open market Deepender Anil and Associates

24. Seller (RP) TYPES OF COMPARISON Buyer (RP) Seller INTERNAL COMPARISON :- 1 SDT Uncontrolled Transaction INTERNAL COMPARABLE :– 2 SDT Uncontrolled Transaction Seller Seller (RP) Buyer (RP) Deepender Anil and Associates

25. Seller (RP) Buyer (RP) EXTERNAL COMPARABLE Seller Buyer SDT Uncontrolled Transaction Deepender Anil and Associates

26. CASE STUDY FOR CUP:- FACTS:- A Ltd. does transactions with both AB Ltd. and XY Ltd. Tems and Conditions and the activities carried on by the three enterprises is summarized below:- Deepender Anil and Associates

27. CONCLUSION – Transaction between A Ltd. & AB Ltd. (‘Controlled transaction’) and A Ltd. & XY India Ltd (‘Uncontrolled transaction’) are comparable.– However, difference for adjustments in delivery terms need to be carry out.– Hence, CUP is the most appropriate method. Deepender Anil and Associates

28. STEPS TO FOLLOW:- Identify controlled transaction Identify uncontrolled transaction Is price data or data for calculating profit margin available for each transaction? Are the physical characteristics of inventories and nature of services involved in controlled transactions and uncontrolled transaction are same or similar? Is market level same – retail, wholesaler, OEM, secondary etc.? Do the transactions differ in volume or timing? Are there any differences in the terms of trade, payment terms, conditions for returns, or conditions regarding contract renewal? Are there any differences in the functions of the seller or buyer (e.g. in terms of R&D, marketing, and after-sales service)? Are there any differences in the terms of trade, payment terms, conditions for returns, or conditions regarding contract renewal? Deepender Anil and Associates

29. Contd… Are there any differences in the functions of the seller or buyer (e.g. in terms of R&D, marketing, and after-sales service)? Are intangible properties used by the seller or buyer in transactions? Are there any differences in terms of business strategy (e.g., policy toward market development and penetration) or timing of market entry? Are there any differences in government regulation (e.g. price regulation), market size, or competition, etc. affecting prices and profit margins? Are there any special circumstances dictating that transactions may not reasonably be regarded as comparable (e.g. bankruptcy situations)? Deepender Anil and Associates

30. RESALE PRICE METHOD (‘RPM’) The resale price method measures an arm's length price by subtracting the appropriate gross profit from the applicable resale price for the property involved in the controlled transaction under review. The price is adjusted to take into account the functional and other differences, including differences in accounting practices, if any, between the SDT and the comparable uncontrolled transactions, or between the enterprises entering into such transactions, which could materially affect the amount of gross profit margin in the open market. CASE STUDY:- A Ltd AB India Ltd Third Party Deepender Anil and Associates

31. FACTS:-1. AB India Ltd. is a distributor of product A in India.2. AB India does not engage in unique or original advertising or sales promotion activities, and makes no use of its own trademarks or other such properties in its distribution activities.3. No internal comparable available4. Financial data in respect of distributor of comparable product available Deepender Anil and Associates

32. CONCLUSION:-1. Transaction between A Ltd. & AB Ltd. (‘Controlled transaction’) and Comparable 1 transactions are comparable.2. Though Comparable 2 is distributor but cannot be considered comparable on account of different FAR, for which it might be tough to carry out reasonable adjustments. Deepender Anil and Associates

33. COMPARABILITY:1.Product comparability not very important, however better the product comparability better would be the results2. More functions and asset, higher risk would require higher gross margin3. Accounting variations should be taken care4. Other factors like geographical differences, volume, high operating cost may effect comparison. Deepender Anil and Associates

34. CASE STUDY:- 3. COST PLUS METHOD:- AB India Ltd A Ltd Distributors and agents The cost plus method tests whether a profit mark-up charged in a SDT is at arm’s length by reference to the mark-up charged in uncontrolled transactions. Transfer pricing is calculated by adding a mark-up, earned in uncontrolled transactions, to a direct and indirect cost of production/ services relating to SDT CASE STUDY:- Third Party manufacturer Deepender Anil and Associates

35. FACTS:-1. AB India Ltd is a manufacturer.2. A India Ltd. is a distributor of product “A100” manufactured by AB India Ltd.3. A Ltd. also procures another product “A200” from third party contract manufacturer and distributes the same.4. A India ltd owns all intangibles Deepender Anil and Associates

36. CONCLUSION:-1. AB India Ltd. being simpler entity should be considered as the ‘tested party’2. As financial data would be available for the tested party and third party, gross margin earned by the third party would be considered as arm’s length markup.3. If tested party would be earning less, it can be concluded that the transaction is at arm’s length.4. However, if financial data for third party contract manufacturer is not available, it may be tough to apply CPM. COMPARABILITY:- 1. Product comparability not very important, however better the product comparability better would be the results. 2. More functions and asset, higher risk would require higher gross margin. 3. Accounting variations should be taken care. 4. Other factors like geographical differences, volume, high operating cost may effect comparison. Deepender Anil and Associates

37. 4. PROFIT SPLIT METHOD:-1. This method aims to determine what division of total profits independent enterprise would expect in relation to the relevant transactions.2. The profits should be split on an economically valid basis that reflects the functions and risks of each of the parties.3. In order to apply this method, it is necessary to identify the total profit arising from the related party transactions and split that profit between the parties according to their respective contributions Approaches:-There are two approaches to this method:- 1. Total profits split, and 2. Residual profit split Deepender Anil and Associates

38. TOTAL PROFIT SPLIT:-Total profits from the controlled transactions made by all the enterprises involved in earning those profits are split between those enterprises based on the relative value of the functions that each carries out.RESIDUAL PROFIT SPLIT:-1. Total profit of the overall trade made by the associated enterprises is considered.2. Firstly, each participant is allocated sufficient profit to provide it with a basic return appropriate to the functions carried out.3. Secondly, any profit (or loss) left after the allocation of basic returns would be split as appropriate between the parties – based on an analysis of how this residual would have been split between third parties. Deepender Anil and Associates

39. 5. TRANSACTIONAL NET MARGIN METHOD (‘TNMM’)-- The TNMM examines the net profit margin relative to an appropriate base that a tax payer realizes from SDT vis-à-viscomparable uncontrolled transactions.-- Thus, the TNMM operates in a manner similar to the cost plus andresale price methods.-- The TNMM is based on the economic theory that returns earned by an enterprise operating under similar conditions, in the same market and industry, tend to become more equal after some time. Deepender Anil and Associates

40. PROCEDURE- Selection of Tested Party.- Data – Current year vs. Multiple year.- Aggregation of transaction.- Identification of comparables.- Profit level indicator- Operating Margin = OP/Sales X 100- Net Cost Plus = OP/ Total Operating Expenses X 100- Berry Ratio = GP/ Operating Expenses- Return on Asset = OP/ Operating Asset X 100 Deepender Anil and Associates

41. 6. Such other method as may be prescribed by the Board:- Independent entity's intention even if not materialized, if documented in form of offer to buy can act as an available price to prove arm's length. The comparability test will need to be established in order to use available price:- Contractual terms-In both transactions should be compared and should be same Economic circumstances-In both transactions should be compared and should besame Characteristics of property or service-Same property In case same is replaced with similar in any of the above, accurate and appropriate adjustments are required to be made. Differences in both transactions with respect to timing, terms & conditions (liability clause, payment terms, etc) need to be compared. Determination of arm's length pricewill be made with reference to the available price. In case Specified personis a tax holiday entity price needs to be fixed within a range such that it is arm's length for both the payee as well as the recipient. Deepender Anil and Associates

42. CASE STUDIES Deepender Anil and Associates

43. CASE STUDY 1: FACTS AND ISSUES UNDER CONSIDERATION A Ltd. (Sec 10AA unit) . Sale of components Provision of Remunerated Technical at cost plus service basis Facts •B Ltd is engaged in manufacturing and supply of components •A Ltd is an equipment manufacturer owning the technical know-how and the trademarks in respect of the components manufactured by B Ltd and provides the such knowhow to B Ltd free of cost •B Ltd sales the components to A Ltd and is remunerated on a cost plus mark-up basis incurred in respect of the manufacturing activity B Ltd. Deepender Anil and Associates

44. Factors to be considered while comparing B Ltd with third party full fledged manufacturers…… • Adjustments to be made for differences in the following: • Technical know-how development • Product development function • Capacity utilization • Scheduling function • Trade discounts • Incentive schemes • Differences in volume • Working capital adjustment • How do we quantify the following adjustments? • Market risk • Product liability risk • Risk of technology failure • Credit risk Deepender Anil and Associates

45. CASE STUDY :- 2 –SHARING OF EXPENSE THROUGH COMMON FACILITY COMPANY FACTS • A Co, is a private limited company wherein four companies of a software technology group are holding 25% shareholding each. • A Co. is set up mutually by these entities for sharing the common facilities like office space, utilities, conference rooms, boardrooms, canteen etc. • A Co. has obtained on lease the office building premises of 50,000 sq.ft. for a monthly lease rent of Rs. 1 crore per month. A Co. is responsible for maintaining housekeeping facility, security, canteen, telephone, internet, electricity etc. The total annual cost of maintenance & other facilities is Rs. 28 crores. • The four group entities are using common facilities allotted for their use and accordingly, costs incurred by A Co are shared by these entities in the ratio of 35:25:20:20 based on scientific and consistently followed method. • Thus, these entities pays Rs. 14 cr, Rs. 10cr, Rs. 8 cr & Rs. 8 cr respectively to A Co during the financial year 2012-13 Deepender Anil and Associates

46. CASESTUDY:- 2 –SHARING OF EXPENSE THROUGH COMMON FACILITY COMPANY K L M N 25% 25% 25% 25% Housekeeping facility, security, Canteen, Telephone, Internet, Electricity etc 35% 25% 20% 20% Payment of A Co. towards use of common facilities. A Co. Common Facilities Payment to Third Party K L M N Deepender Anil and Associates

47. CASE STUDY 2 – ISSUES UNDER CONSIDERATION… • ISSUES UNDER CONSIDERATION • The payment of apportioned cost towards common facilities made by the four entities shall fall under the scope of payments made to parties (ACo.) section 40A (2)(b)? • Cost plus: • Why cost plus? • How much mark up? • Isit necessary to add mark up? Deepender Anil and Associates

48. CASE STUDY 3 – FACTS & ISSUES UNDER CONSIDERATION Gem Co. • Transaction Mechanism • Gem-Co is a company engaged in manufacturing, branding and distribution of gem stones. • Gem-Co performs on a centralised basis and provides various functions such as finance, business development, HR, branding, etc. • Gem-Co has two units, Unit-1 and Unit-2. Unit-1 is a tax holiday unit and Unit-2 is a tax paying unit. • Key Considerations: • Whether Gem-Co needs to allocate corporate overhead costs to both Units considering these are necessary for day to day operations? • How will overheads be allocated ? Unit – 1 (tax holiday) Unit - 2 Deepender Anil and Associates

49. Case Study 4 • Facts • A Co, an Indian company, is engaged in business of polyester films. It has substantial interest in B Co and has a wholly owned subsidiary D Inc in USA. Both A Co and B Co are units covered u/s 10AA. • A Co has its own R&D Centre which develops the technology for product research, design and development and enhances efficiency in production of polyester films. • A Co manufactures raw materials namely, dimethylterephthalate, terephthalic acid and ethylene glycol and sells it to B Co. • A Co licenses technical know-how and formulas to B Co for processing of raw materials into finished goods i.e. polyester films. • B Co processes the raw materials into finished goods i.e. Polyester films and sells the finished goods to A Co at Rs. 100 per sq ft. B Co has also made a miniscule sale to third parties at Rs 120 per sq ft. • Royalty is charged for (use of tech know how by B Co) by A Co to B Co at the rate of 3% on sale of total polyester films to A Co as well as third parties. • A Co also purchase polyester films but of substantially different qualities from third parties at Rs. 80 per sq ft. Deepender Anil and Associates

50. Case Study 4(contd)… • C Co, an agent, provides marketing and sales promotion services to A Co for which it charges commission at 7% of sales made by A Co. A Co cuts polyester films into large master rolls and slit to precision widths before delivery to customer and packages as per customer requirement. • A Co sells polyester films to Indian customers at Rs. 125 per sq. ft. • D Inc is the face of A Co in US and overseas markets. A Co sells polyester films to the associated enterprise D Inc (USA) at cost plus 10% mark-up. • A Co follows Just‐in‐Time approach to manage inventory which in turn helps in balanced production and maintenance of required stock level of raw materials and finished goods. • Research on various geographical areas where market can be developed is done by C Co. Market development includes focus on existing customers and also on potential customers. Selling and distribution activities as well as after-sales activities are undertaken by C Co. • A Co and B Co perform administration functions independently for their respective organizations based on policies framed. Deepender Anil and Associates