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TRANSFER PRICING DOCUMENTATION Navigating the Indian & Overseas waters!. Narayan Mehta Sudit K Parekh & Co,. 19 th November 2005, Pune Branch of WIRC (ICAI). Agenda. An overview of Indian documentation requirements Practical case study Indian owned US & Canadian software subsidiaries.

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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

Arm’s

length price

Documentation

Accountant’s

Report


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Importance of Compliance

  • Any related party transaction undertaken from 1st April 2001 onwards covered

    • Currently 60% of world’s 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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E&Y 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 Accountant’s 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 arm’s 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 Accountant’s 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

Legislative Framework

Associated

Enterprise

Associated

Enterprise

International

Transaction

Arm’s 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

  • 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 Revenue’s request [Section 92(D)(3)]

Information / documents in relation to an international transaction needs to be:


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Documentation- fixing the jigsaw puzzle!

Accountant’s

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 arm’s 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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US and Canadian subsidiaries

CASE STUDY

Indian

Owned


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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.

R&D

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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India

US/Canada

Functions

Assets

Risks

Profits $,$$$,$$$,$$$ $,$$$

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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Quantitative Filters

3 Year Track Record

Ratios

Any Other Parameters

Revenue

No. of Employees

Applying Filters

  • 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 arm’s 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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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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Adjustment to Ratios (extended sample)

  • Useful when feasible to increase ratio’s 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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Profit sharing based on TP policy (extended sample)

Rest of the profits!

Cost plus 8% only!

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! (extended sample)

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 (extended sample)

  • 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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India (extended sample)

Concept of arithmetic mean-5% variation allowed but range not permitted

Past data of only 2 years

US / Canada

Use of (inter-quartile) range generally allowed

Use of past data of even more than 2 years generally allowed

Balancing Indian / US / Canadian Regulations


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Taking advantage of Global Documentation (extended sample)

  • 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 (extended sample)

  • 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 (extended sample)

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

  • Even if PE, whether arm’s 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 (extended sample)

  • 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 (extended sample)

  • 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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Ownership structure & industry background (extended sample)

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

Other additional documentation


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STEP 1 (extended sample)

Undertaking a functional analysis & economic characterization

STEP 2

Selecting the most appropriate transfer pricing methodology

STEP 3

Applying the most appropriate method & determining the arm’s length result based on assessment of comparables

Step 4

Periodic review and effecting adjustments for significant changes

Transfer Pricing Study Process Summary

Maintaining necessary documentary evidence to support each of the above steps!


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Concluding remarks (extended sample)

  • 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 < 1 Cr

    • Benchmarking analysis may yet be reqd in absence of CUPs


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Thank You (extended sample)

?

Queries

Narayan Mehta

Tel: 91 22 22821141

Mob: 91 9820544495

E-Mail: [email protected]


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