L _ ~ . It is well recognised that India has developed as an investment jurisdiction for multinational enterprises (MNEs) for carrying on information technology, R&D and back-office operations. The resultant increase in transactions involving entities in multiple tax jurisdictions has given rise to transfer pricing (TP) issues in each of these jurisdictions. In this backdrop, TP has evolved as one of the most significant and complex tax issues for both multinationals and the revenue authorities. In recent audits, the Indian revenue authorities are seen to be adopting an increasingly aggressive approach on TP-related issues and a significant brunt of the TP onslaught has been borne by captive IT companies in India, specifically in the software services and the IT-enabled services/BPO industry as most of them enjoy the benefit of a tax holiday under the Income-Tax Act, 1961, and upward adjustments pursuant to an audit is not eligible for tax holiday benefits. Typically, a mark-up of 10-15 per cent on costs could be considered to be reasonable for captive IT service providers keeping in mind the low level of risks which these entities bear. However, in a number of cases, the revenue authorities have determined mark-ups of 25-35 per cent on costs to be the arms length margin for captive IT service providers. Key issues While the Indian TP rules have outlined certain factors for judging comparability, it does not provide adequate guidance on certain key aspects relating to a TP analysis such as use of multiple year data, screening criteria for comparables, classification of income/expense items, quantitative adjustments, etc. The lack of quality comparable data in public domain is also a challenge leaving room for subjectivity in any transfer pricing analysis. This challenge is further compounded by the approach adopted the transfer pricing officers (TPOs) during audits. A practical problem arises at the time of preparing the TP documentation report by the taxpayer, as at that point of time the relevant financial year data may not be available. The TPOs have rejected the use of multiple year data and considered only the single year (the relevant financial year) data for determination of the arms length price. The TPOs are of the view that while the documentation based on prior year data could satisfy the mandatory and contemporaneous documentation requirements, the same does not necessarily limit them from making a TP adjustment if additional data available at the time of audit so warrants. On occasions, during ongoing audits TPOs have used information which is not available in the public domain and have also eliminated loss making/low turnover comparables, creating a bias in favour of profitable companies in the comparable data, resulting in transfer pricing adjustments for the taxpayers. Captive IT service providers in India typically function in a risk-mitigated environment as compared to comparables who bear a range of risks such as R&D, market risks, service liability risk, etc.
While the TP regulations permit adjustment to comparable data to account for the risk differences, it does no~provide guidance on the manner of making such adjustments. While TPOs acknowledge the need to factor such risk differentials, the approach adopted for making the risk adjustment has been quite subjective and arbitrary. In this backdrop, taxpayers may need to consider performing risk adjustments based on certain financial and economic models. Scope for double taxation TP regulations, including those introduced in India, are essentially anti-abuse mechanisms aimed at preventing shift of profits through inter-company transfer prices to a favourable tax jurisdiction. However, in case of a TP adjustment in the hands of the Indian entity, that is, an increase in income in the hands of~ the Indian entity does not automatically result in a corresponding increase in expenditure in the hands of the foreign entity, resulting in economic double taxation. In the absence of a formal Advance Pricing Agreement (APA) programme in India, where a taxpayer <!Ild revenue authorities can agree in advance on the transfer price, a taxpayer has no option but to resolve issues through the normal domestic tax appellate procedure or the Mutual Agreement Procedure (MAP) prescribed under the tax treaties.V Under the MAP process, the foreign entity in the international transaction approaches its Competent Authority, which in turn will approach the Indian Competent Authority for resolution of the dispute. Despite the underlying law being essentially the same in all countries, transfer pricing disputes have become a significant subject of the Competent Authority dispute-resolution process between treaty countries because these issues are factual in nature and often applied differently in each country. I The appropriate resolution of an issue in one situation may be entirely different from the same issues resolution for another taxpayer in the same business. This difference in views between tax authorities of two (or more) countries on what an appropriate transfer price should be increases the risk of international economic double taxation to an MNE. In this situation, MNEs may desire to resolve their transfer pricing issues in advance by entering into an APA with the tax administration, in an effort to spare themselves the time and expense of a tax audit and potential dispute resolution proceedings. Introduction of such a mechanism in India should help in resolving these issues. Compared to developed tax regimes, India is still on the learning curve in relation to transfer pricing. Keeping in view the difficulties being faced by MNEs operating in India, there is an urgent need to revisit some of the TP provisions and resolve the key issues by providing additional guidance and introducing more certainty and fairness in the manner in which TP regulations are applied.~ducing penalties, introducing measures such as AP As, safe harbour benchmarks for capti ve IT service providers are some measures that would prove beneficial. Recent negotiations between the Competent Authorities (CAs) of India and the USA under Article 27 of the India-US tax treaty (Tax treaty), which deals with the Mutual Agreement Procedure (MAP), provides
for a dispute resolution mechanism where the CAs shall endeavor by mutual agreement to resolve the situation of taxpayers subject to taxation not in accordance with the provisions of the Tax Treaty. A Memorandum of Understanding (MoU) between the two countries provides that the CAs would endeavor to resolve such disputes within a period of two years and also provides for obtaining a stay on collection ~ of the disputed taxes during the pe~dency of the MAI(tJ~ ~r"~ f(tl~-9 It has recently been reported that, pursuant to an MAP, the US and Indian CAs have proposed to resolve a transfer pricing (TP) dispute involving provision of intra-group information technology services, by an Indian affiliate to a US multinational enterprises (MNE). The proposed resolution involves the CAs agreeing to accept a m3rk-up on costs of 18% as the arms length price as compared to an adjustment in the range of 25-30% made by the Indian revenue authorities. The taxpayers involved have the optiol} to either accept the MAP resolution or follow the course of appeal prescribed under the domestic tax laws.~~ Background -The TP provisions were introduced in the Indian Tax Laws (ITL), with effect from 1 April~2001. Over the past few years, TP disputes have emerged as a significant challenge faced by MNEs doing business in India. A number of MNEs have established information technology (IT), R&D and back-office operations for providing intra-group services. The !ndian affiliates providing such services have been subject to adv~se TP adjustments in recent times. While a number of these operations may enjoy the benefit or[a tax holiday under the ITL, any income allocated pursuant to an upward TP adjustment made during the course of an audit, would not qualify for the tax holiday. Further, a TP adjustment in the hands of the Indian affiliate could potentially result III economic double taxation for the MNE if the MNE is not able to obtain a correlative relief. The MAP article of a tax treaty allows designated representatives i.e. CAs from the governments of the contractmg states to interact with the intent to resolve international tax disputes, including TP disputes. A ~P arti~_e in most t~x treaties does not ~ompel CAs to actually reach an agreement an~ resolve their :ax disputes. 1 hey are obliged to only use their best endeavors to reach an agreement. The disputes resolution under the MAP article of a tax treaty is in addition to the dispute resolution and appellate remedies that a taxpayer may have under the domestic tax laws. r Facts and proposed settlement:-During the course of TP audits for the tax year 2004-Q.5, a number of Indian affiliates of US MNEs, which were engaged in providing intragroup IT services were subject to /adverse TVitdJustments.Ths resulted in the Indian revenue authorities determining mark-ups on costs in the range of 24-3Q%as the arms length price for such transactions. The Indian revenue authorities asserted these adjustments largely by adopting a different approach/criteria ..,/ for accepting/rejecting comparable data, as compared to the taxpayers apprQach. Some of the US MNEs invoked MAP under Article 27 of the Tax Treaty. These MAP applications have ~sulted in discussions between the CAs of India and the US to reach a settlement on the TP adjustments made by the Indian revenue authorities. Pursuant to ongoing discussions, it has been reported that India and the US CAs have proposed to the taxpayers on whether a resolution based on a mark-up of 18% on costs would be acceptable.
If the taxpayers accept the proposal of the CAs, the Indian affiliate would be subject to tax based on theMAP agreement. In addition, it could also enable the US taxpayer to consider whether it could be eligibleto seek correlative relief based on the MAP resolution.Commentsr-The above information is based on secondary sources, including media reports, and there isM official confirmation from the CAs. The factors and the principles that were considered by the CAsbefore making the above proposal are also not known at this stage.Where a MAP resolution has been arrived at and accepted in respect of a particular issue for a relevant taxyear, it should have effect only for the specific taxpayer for that relevant tax year and for that particularissue. A MAP resolution does not typically set a binding precedent for either the taxpayers or the revenueauthorities in regard to adjustments or issues relating to subsequent years or for CA discussions on thesame issues for other taxpayers. Nevertheless, it does provide an indication of settlements that could beexpected from MAP proceedings, especially in a similar fact pattern.The taxpayers in the above case have the option to either accept the MAP resolution or follow the courseof appeal prescribed under the domestic tax laws. If the taxpayers choose to give their consent to the MAPresolution, the Indian affiliate would need to withdraw any appeal filed under the domestic tax appellateprocedure.Endowed with the advantages oflow-cost base and a large, growing English- speaking workforce, Indiahas emerged as a globally preferred outsourcing destination. The growth achieved by Indias informationtechnology (IT) services and information technology enabled services CITeS) sectors stand testimony tothis. Indian transfer pricing regulations require captive units having international transactions with itsassociated enterprises to be remunerated on an "arms-length" basis, leading to the often vexed questionof what constitutes an arms-length remuneration for a captive unitWhen we speak of captive units we need to take into consideration the capacity utilisation, the riskundertaken and the functional profile of the tested party vis - a - vis comparables. In a captive serviceprovider model the ultimate risk are borne by the Holding Co. Nevertheless the captive units have one riskof "single customer". Taking all the factors into account, while benchmarking the transactions pricingneeds to be modelled after considering the identified comparables mean. The best practical method to beapplied is TNMM. Further, as the financial records of captive units are not available on the publicdatabases, the comparables would be independent service providers.Indian and US Tax Authorities Reach Agreement on Pricing of Information Technology ServicesThe Indian tax authorities in recent years have been taking an aggressive position on transfer prices forsoftware, business and knowledge process outsourcing (BPO & KPO) and information technologycompanies. For multinational companies with Indian subsidiaries providing these services to theiraffiliates worldwide, the Indian tax authorities have been insisting on a markup upwards of 25-30 percentof total costs. The rationale for such margins is unclear as it is unlikely similar independent serviceproviders in India would be earning margins anywhere near that level. The resulting transfer pricingassessments have been drastic and can lead to double taxation for the affected multinationals.
·In order to try to address this issue, some US multinationals have invoked the Mutual Agreement Procedure (MAP), a mechanism provided under double-tax avoidance agreements entered into by India with various countries. The MAP provides an opportunity for resident taxpayers to approach the Competent Authorities (CA) in India in conjunction with the CA in other affected countries to come to an agreement on such issues. As a result, India and the US have apparently reached a negotiated settlement whereby they have agreed to a markup of 17.5 percent on total costs for BPO, KPO and IT service providers in India. At this point, the agreed upon markup is only valid for the fiscal years 2004 and 2005. The settlement provides relief for those taxpayers who have made applications under the MAP and could also provide correlative adjustments/corresponding deductions at the US end, thereby eliminating the risk of double taxation.While unofficial reports of this agreement have spread among taxpayers and practitioners, there has notyet been a formal confirmation from the CA of either country. Additionally, it is unclear how such anagreement would impact future tax years.The enactment of detailed Transfer Pricing Laws in India in 2001 brought the issue of Transfer Pricing tothe forefront amongst the various multinational corporations operating in India as well as Indiancompanies. Transfer Pricing is one of the critical tax issues for growth oriented businesses havinginternational operations wherein substantial senior managements time and attention is necessary.Irrespective of their size, organizations need an effective and dependable Transfer Pricing policy, whichtakes into consideration the organizations overall business strategy and operating structure.Transfer Pricing authority and tax lawIncome Tax Department. Section 40A (2), 92-92F, 271, 271AA, 271BA and 271G of the Income TaxAct, 1961. Transfer Pricing regulations and rulings Rule 10 to 10E of the Income Tax Rules, 1962. OEeD guidelines of Transfer Pricing The Indian legislation is broadly based on the OECD guidelines. In conformity with the OEeD guidelines, the legislation prescribes the same five methods to compute the arms length price. Further, the revenue authorities generally recognize the OECD guidelines and refer to the same for guidance, to the extent they are not inconsistent with the domestic law. Transfer Pricing methods The Indian legislation prescribes the following methods: CUP, Resale Price, Cost Plus, Profit Split and Transactional Net Margin Method. The legislation also grants the power to the Central Board of Direct
Taxes (CBDT) to prescribe any other method; however, no other method has been prescribed by theCBDT to date. No hierarchy of methods exists. The most appropriate method should be applied.Penalties in Transfer PricingFor inadequate documentation, the taxpayer is fined 2% of the transaction value. For not furnishingsufficient information or documents requested by the tax officer, the taxpayer is fined 2% of thetransaction value. If due diligence efforts to determine the arms length price have not been made by thetaxpayer, then 100% to 300% of incremental tax on transfer pricing adjustments may be levied by the taxofficer. For not furnishing an Accountants Certificate (Form 3CEB) along with the return of income, thetaxpayer is fined Rs.one lakh.Penalty relief in Transfer PricingPenalties may be avoided if the taxpayer can demonstrate that it exercised good faith and due diligence indetermining the arms length price. This is also demonstrated through proper documentation and timelysubmission of documentation to the revenue authority during assessment proceedings.Transfer Pricing Documentation requirementsA detailed list of mandatory documents are listed in Rule 10D (1). The categories of documentationrequired are: • Ownership structure • Profile of the multinational group • Business description • The nature and terms (including prices) of international transactions • Description of functions performed, risks assumed and assets employed • Record of any financial estimates • Record of uncontrolled transaction with third parties and a comparability evaluation • Description of methods considered • Reasons for rejection of alternative methods • Details of transfer pricing adjustments • Any other information or data relating to the associated enterprise which may be relevant for determination of the arms length priceA list of additional optional documents is provided in Rule 10D (3). The taxpayer is required to obtainand furnish an Accountants Certificate (Form 3CEB) regarding adequacy of documentation maintained.Documentation deadlines for Transfer PricingThe information and documentation specified should, as far as possible, be contemporaneous and exist bythe specified date of filing the income tax return, which has been changed to September 30 instead ofOctober 31 following the end of the financial year. Although an Accountants Report must be submittedalong with the tax return, the taxpayer is not required to furnish the transfer pricing documentation withthe Accountants Report at the time of filing the tax return. Transfer pricing documentation must besubmitted to the tax officer within 30 days of the notice during assessment proceedings.Statute of limitations of transfer pricing assessments
Tax assessments (where a matter has been referred to the transfer pricing officer) are to be completedwithin three years and nine months from the end of the financial year (1 April to 31 March). However, ifthe revenue authority determines that income has escaped assessment, an assessment may be re-openedwithin seven years from the end of the financial year.Return disclosures/related-party disclosures92E, an Accountants Report is required to be provided along with the tax return. The accountant certifieswhether proper documentation is maintained by the taxpayer.In accordance with Indian AccountingStandard 18, the company is required to disclose related-party transactions in its financial statements.Transfer Pricing Audit risk/transfer pricing scrutinyInternal guidelines have been issued by the revenue authority, pursuant to which companies with relatedparty transactions in excess ofRs.5.00 Crores are being scrutinized. In most cases, the revenue authoritydoes not seem to have adopted a centralized or coordinated approach to audits, with officers in differentlocations taking divergent positions on similar taxpayer fact patterns. Substantial documentation is beingrequested in the course of audit proceedings. The information technology, business process outsourcing,banking and pharmaceutical sectors have received particular attention. The revenue authority has soughtan updated analysis using data that may not be available to the taxpayer at the time of the preparation ofcontemporaneous documentation. Furthermore, officers have insisted on unbundling transactions in caseswhere the taxpayer has adopted an aggregate or combined approach to its transfer pricing documentation.During recent audits, the approach adopted by the taxpayer in the selection of comparable data hasreceived considerable attention from the revenue authorities.Advance Pricing Agreements of tansfer pricingAPAs are not available yet, but may become available as India increases its third-party com parablesdatabase and gains more experience in cross-border transfer pricing issues.