Tax Arbitrage…

1. Baroda Branch of WIRC of ICAIPresentation onSpecified Domestic TransactionsCA Hiren D ShahAhmedabad Email: hirenindia@hotmail.com

2. Tax Arbitrage… • In domestic transactions, the under invoicing of sales and over-invoicing of expenses ordinarily will be revenue neutral in nature except in two circumstances having tax arbitrage such as where one of the related entities is • Loss making or • Liable to pay tax at lower rate and the profits are shifted to such entity

3. Applicability.. Section 92BA • Transfer Pricing till A.Y. 2012-13 was applicable to Entities having International transactions with their Associated Enterprise • Honoring the Supreme Court ruling in case of CIT vs M/s Glaxo Smithkline Asia (P) Limited expanded the ambit of transfer pricing to Specified Domestic Transactions w.e.f. 1st April,2013

4. Intent of Domestic TP-DTA & Tax Holiday Unit Scenario 1 Scenario 2 150 225 25 50 By shifting of expenses from a tax holiday unit (Power) to a unit in the Domestic Tariff Area, the group could reduce its tax liability by 25. To avoid such cases, Domestic TP has been introduced.

5. Intent of Domestic TP-Domestic Tariff Area (DTA) Scenario 1 Scenario 2 100 150 17 33 By shifting of expenses fro a loss making company to a profit making company, the group could reduce its tax liability by 16 for the current year, though the impact will be reversed in future years given carry forward of losses.

6. Intent of Indian Transfer Pricing (TP) Regulations Indian Co. Associated Enterprise (AE Co.) India (Tax @ 33%) Overseas (Tax at Lower rates, say 10%) Shifting of Losses Tax Savings for the group -> Indian Govt. loses

7. Meaning of Specified Domestic Transaction • Applicability

8. Important Provisions of SDT • Threshold • Shift of focus • How would you interpret the close connection ? • Fair Market Value can established using basic market evidence • Determination of Arm’s Length Price • Advance Pricing Agreements NOT applicable to specified domestic transactions • Powers shifted

9. Scope – Domestic Transactions Aggregate Transaction value exceeds Rs. 50 millions in a financial year (Applicable from FY 2012-13) • Tax holiday undertakings covering : • inter-unit transfer of goods and services Transactions with entities having close connection Expenditure incurred between related parties defined u/s 40A Any other transaction that may be specified

10. Scope of Section 92BA Inter unit transfer of goods & services by undertakings to which profit-linked deductions apply – Sub section (8) of Section 80IA SDT Expenditure incurred between related parties defined under section 40A Any other transaction that may be specified Transactions between undertakings, to which profit-linked deductions apply, having close connection Sub section (10) of Section 80IA

13. Section 92BA Analysed...... For the purpose of sec. 92, 92C, 92D and 92E * Sec 92F – Definitions does not define terms relevant for domestic TP transactions

14. Impact of Domestic Transfer Pricing Intra Unit Transactions Tax Holiday Expenses 3 2 FMV to ALP 4 1 5 Compliance Assessment 6 Accountant’s Report

15. Steps

16. Legislature intention behind insertion of Section 40A(2) • To check evasion of tax through excessive or unreasonable payments to relatives and associate concerns and should not be applied in a manner which will cause hardship in bona fide cases. • AO is expected to exercise his judgment in a reasonable and fair manner

17. Reasonableness of expenses to be judges having regards to • Fair market value of the goods, services or facilities for which the payment is made, or • The legitimate needs of the business or Profession • The benefit derived by or accruing to the assesse from the expenditure • The above view is expressed by Hon’ble Guj High Court in the case of Coronation Flour Mills vs. Asst. CIT [ 2009] 314 ITR 1

18. Expenditure Between Related Parties • Expenditure paid or to be paid to related parties will require to be at arm’s length • Examples of related parties under section 40A(2)(b) Substantial Interest means beneficial ownership of shares with at least 20% voting right or beneficial entitlement of at least 20% of the profits

19. Definition of Relatives • Section 2(41) defines relative in relation to an individual to mean: • Husband; • Wife; • Brother; • Sister; or • any lineal ascendant or descendant;

20. Section – 92A ( AE) • Means an enterprise – • (a). Which participates, directly or indirectly, or through one or more intermediaries, in the management or control or capital of the other enterprises; or • (b). In respect of which one or more persons who participate, directly or indirectly, or through one or more intermediaries, in its management or control or capital, are the same person who participate, directly or indirectly, or through one or more intermediaries, in the management or control or capital of the other enterprise.

21. Difference in Applicability of TPR • Section 40A(2)(b) applies to payment made to the assesse’s relative or an associate concern is liable (Substantially Interested Parties) • Section 92A applies to transaction with AE directly or indirectly or through one or more intermediaries in the management or control or capital of the other enterprise.

22. A B Type of transactions covered (illustrations for payments made by a Company)… Transaction Covered A & B  A & C  A & D  A & E  B & C  D & E  C & D  B & E  C D E

23. Fair Market Value vs. Arm’s Length Price • Domestic Transfer Pricing usher shift from generic ‘Fair Market Value’ concept to Arm’s Length Pricing

24. What is Arm’s Length Pricing? • “Arm’s length price” means a price which is applied or proposed to be applied in a transaction in uncontrolled conditions • Arm’s Length price is determined using the Most Appropriate Method : • If more than one comparable price is obtained using above methods, then the arm’s length price would be ‘Arithmetic Mean’ of comparable prices • Deviation of plus / minus five percent is permitted from arm’s length price

25. Methods for Determination of ALP • Price applied in a transaction between independent enterprises in uncontrolled conditions • To be determined by applying the Most Appropriate Method, being one of the following five methods • Comparable Uncontrolled Price (CUP) Method • Resale Price Method (RPM) • Cost Plus Method (CPM) • Profit Split Method (PSM) • Transactional Net Margin Method (TNMM) • In case, more than one price is determined by MAM: • Apply Arithmetic mean • Range of + 5% of the arithmetic mean Traditional transaction methods Transactional profit methods

26. Tax Holiday Beneficiaries Impacted by Domestic Transfer Pricing

27. Profit based deduction to undertakings • anti-abuse provision brought to check the excessive tax holiday claims • Generic framework of ‘More than ordinary profit’ was provided in law to compute the excessive tax holiday claims • To plug the loophole, it is now proposed to compute more than ordinary profits through the ‘arm’s length price’ mechanism Issues • Eligible business will have to justify the ALP of the transactions between the eligible unit/ business and any other person having close connection • The term “Close Connection” not defined • Burden of the proving the “close connection” between the assessee and other party is on TPO Impact • Loss of tax holiday claim in excess of arm’s length profits • No corresponding adjustment allowed for other party for adjustments made, if any, by the TPO for transactions falling under this category

28. Most Likely effected Industries.. • Industries operating in SEZs • Infrastructure Developers • Infrastructure Operator • Telecom Services • Industrial Park Developers • Power Generations or Transmission

29. Most Likely Transactions under Scanner of SDT • Interest free Loans to Group Companies Sub section 8 of Section 80IA • Granting of Corporate Guarantees/ Performance Guarantees by Parent Company to its subsidiaries Sub section 8 of Section 80IA • Intra-group purchase/ sell/ service transactions Sub section 8 of Section 80IA • Payment made to key personnel e.g. transaction with Directors/CFO/CEO etc.. Section 40A(2)(b) • Payment made to key personnel of Group Companies. Section 40A(2)(b) • Payment made to relative of key personnel of the assessee/group companies. Section 40A(2)(b)

30. Difficult to establish Transactions at ALP • Commission to relatives of the directors/ partners • Salary paid to the relatives of the directors/Partners • Remuneration to the directors • Extra Purchase Price and Interest foregone to relatives • Good sold at lower than market price if bona fide • Higher Purchase Price than rates prevailing in the market • Interest paid to sister concerns at rate higher than normal rates • Hire Charges of Machinery or Rent paid for use of Immovable property

31. Compliance Burden • Maintenance of detailed TP Documentation, as specified in rule 10D demonstrating compliance with the ALP • Filing an Accountants’ report (Form 3CEB), certified by a Chartered Accountant with tax authorities containing details of specified domestic transactions

32. Penalties However, penalty for concealment of income shall not be levied if the taxpayer demonstrates that price charged or paid has been determined in ‘good faith’ and with ‘due diligence’

33. Challenges

34. …Challenges… Transfer pricing provisions are not applicable in case where income is not chargeable to tax at all. [Amiantit International Holding Ltd., (2010) 322 ITR 678 (AAR)] Provisions of section 40A(2) are not applicable to a co-operative society. [CIT vs. Manjara Shetkari Sahakari Sakhar Karkhana Ltd.(2008) 301 ITR 191 (Bom.)] Payment made by holding co. to subsidiary co. is not covered u/s 40A(2)(b), as the relationship does not fall under sub-clause (ii) nor under sub-clause (iv) of sec. 40A(2)(b). [CIT vs. V.S.Dempo & Co. (P) Ltd. (2011) 336 ITR 209 (Bom.) Note: In this decision, clause (vi) of s. 40A(2)(b) was not considered. When a person commits an offence by not maintaining the books of accounts as contemplated by section 44AA, the offence is complete. After that there can be no possibility of any offence as contemplated by section 44AB and therefore, the imposition of penalty is erroneous. [Surajmal Parasmal Todi vs. CIT (1996) 222 ITR 691 (Gauhati)] Note : This decision may be helpful in the context of sections 271AA, 271G and 271BA. 5. Correlative adjustments - if excessive or unreasonable expenses are disallowed in the hands of tax payer at time of the assessment then corresponding adjustment to the income of the recipient will not be allowed in the hands of recipient of income. Hence, it would lead to double taxation in India.

35. Critical Issues…….. • Provisions applicable only to expenditure where payment is made or to be made • Does this include capital expenditure? – Section 40A(2)(b) • Does this include transactions without consideration? – Section 80IA(8) & 80IA(10) • Does threshold apply to the amount recorded in the Books of Account or Amount determine as per ALP? • Whether Government approval u/s 295, 297 of the Companies Act would be relevant? • Whether close connection would be interpreted to mean the criteria mentioned in section 92A(2) or 40A(2)(b) (Inconsistency regarding definition of related parties

36. Critical Issues…….. • Does the limit of INR 50 million apply qua transaction or aggregate of all transactions ? • If aggregate of International and Domestic transaction exceeds INR 50 million, but the International Transactions are below INR 10 million, Do we need to maintain documents prescribe under Rule 10D? ( Reference Rule 10D(2) • Would claim of Depreciate comes under the ambit of Domestic Transfer Pricing?

37. FAQs… • How are SDT defined? • The following transactions with the aggregate value exceeding INR 50 million are covered • Expenditure for which payment is made or to be made to specified domestic parties • Transfer of goods or services to/from eligible business ( tax holiday) from/to other business ( non-tax holiday undertaking) • Business transactions between eligible business ( tax holiday unit) and other person(s) producing more than ordinary profits owing to close connection • Which tax payers covered under SDT? • Any tax payer incurring any expenditure with specified Domestic related parties are required to comply the regulation

38. FAQs… • How do you define specified domestic related party? • The domestic related party will inter alia include a director, a relative of the director, a person having substantial interest in the tax payer ( carrying not less than 20% of the voting power) and fellow related parties where a single person has substantial interest in two tax payers • Which are the illustrative list of SDT? • Transaction between the specified persons and also between the inter-unit transactions of taxpayers would be covered e.g. normal operating transactions, allocation of costs, etc…

39. FAQs… • What are the compliance requirements for tax payers that have SDT? Tax payer that have specified Domestic Transaction would need to do the following: • Identify the nature of Transactions • Maintain requisite information and documents as prescribed • Obtain and furnish a prescribed report from an accountant in Form 3CEB

40. Way Forward …….. • Applicability of OECD TP guidelines • Advance Pricing Arrangement • Benefit of range • Rule 10D and Form 3CEB requires modification to harmonise their applicability in relation to inter-units pricing and reporting of domestic transactions • Corresponding adjustment

41. Thank You