Practical aspects - Documentation, Benchmarking and ... • Maintenance of Transfer pricing...

Practical aspects - Documentation , Benchmarking and Transfer Pricing Analysis – IT/ITES, KPO and Engineering

Vaishali ManeMumbai

Agenda

2

Transfer Pricing – A quick background

Operation Challenges

Litigation Issues

Latest updates

Case Studies & Judicial Precedents

||

||

||

||

||

Transfer Pricing –A quick background

3

4

• Maintenance of Transfer pricing documentation – Functional, financial and economic analysis – Determine arms-length range– Document past transactions– Support proposed transactions

• Transfer pricing risk assessment review – Review functional and risk profile – Review price setting policy – Determine arm’s-length range – Identify transfer pricing exposure (if appropriate) – Quantify transfer pricing exposure

• Safe Harbour provisions for IT/ITES, Engineering and KPO• Advance Pricing Arrangement (APA)

Import aspect of Transfer Pricing

5

Function, Assets and Risk (FAR) Analysis

What is FAR?

• FAR analysis - exercise to determine and document significant economic activities

performed by the enterprise and its AEs in an International Transaction

• The allocation of these activities between those entities involved in the transaction so each

entity can be fully characterised

• Price charged in any transaction reflects the functions performed (taking into account the

risks assumed and assets used)

• FAR analysis essential to determine comparability

• Functional analysis identifies and compares

– Economically significant activities

– Assets used

– Risks assumed

Assets

Risks

Functions

6


Purpose of FAR

• Gathering and organizing facts needed to analyze intercompany prices

• To identify an appropriate level of profit that related parties should earn with respect to

intercompany transactions under review

• To identify effects of functions, risks and assets on its profitability

• To determine the economic characterization of the entities in the international

transaction

• To determine the most appropriate method for benchmarking the international

transaction

• To identify any uncontrolled transaction involving one of the controlled parties

7


Why do a functional analysis?

• The arm’s length principle is based on comparability:

“[When] conditions are made or imposed between … two [associated] enterprises in

their commercial or financial relations which differ from those which would be made

between independent enterprises, then any profits which would, but for those conditions,

have accrued to one of the enterprises, but, by reason of those conditions, have not so

accrued, may be included in the profits of that enterprise and taxed accordingly.”*

*Paragraph 1 of Article 9 of the OECD Model Tax Convention

8

What goes into a Functional Analysis?

FAR Analysis

FunctionsRisks

Assets

Agreements / Terms

Financial Results

Organisation / StaffForecasts /

Business Plans

Business Processes

Markets / Competition

Products

Entities

Transactions

9

What comes out of Functional Analysis?

FAR Analysis

Internal Comparables

Basis to search for external comparables

Risk and opportunity assessment

Determination of the MAP Method

Characterization of entities

Documentation

Understanding of the Business

10

Importance of FAR Analysis

High Function & High Risk

Low Function & Low Risk

Contract IT/ITE Services

ContractManufacturer

Marketing/Distribution

Manufacturer/Developer

Full fledged service provider

SalesAgent

� Comprehensive FAR leads to in-depth understanding of the business and related

commercial considerations

� Allows correct characterization of the business

� Helps setting up of an appropriate pricing model for inter company transactions

� Robust FAR analysis - foundation of a sound economic analysis

Most Appropriate Method

11

• ‘Most appropriate method’ is method best suited to facts and circumstances,

providing most reliable measure of ALP

• ‘Most appropriate method’ to be selected having regard to the following factors:

- Nature and class of international transaction

- Functions performed, assets utilized, risks assumed

- Availability and reliability of data

- Degree of comparability between controlled and uncontrolled

transactions

- Possibility to make reliable and accurate adjustments

- Nature, extent and reliability of assumptions required

Typically, Transactional Net Margin Method is selected as the Most Appropriate Method to benchmark IT and ITES transactions

Operational Challenges

12

13

Challenges

Operational Challenges

Functional Challenges

Comparability Challenges

Risk and working capital

adjustment

14

Functional Challenges

1• Extensive Functional Analysis: Risk-Function Matrix• Unavailability of adequate data for conducting robust analysis

2• TP Reports of two AE's would have conflicting conclusion• Detailed FAR analysis for tested party and comparable companies is

crucial

3

• Some international transactions are so unique that can not be compared

• Corporates and Group Companies hesitant to disclose information of developed IP, etc.

15

Comparability Challenges

1

• Dearth of comparables• Due to emerging economies• Use of new technologies, products & services• Consolidation &Vertical Integration• Non‐availability of data

2• “Cherry‐picking” of comparables• Rejection of low mark-up companies selected in Transfer Pricing Study

Report

3

• Need to fulfill independence filter• Use of secret comparables• Overall process complexity

16

Risk and Working Capital Adjustments

1• Allowable only to comparables and not tested party but obtaining

adequate data on comparables is difficult in segment scenario

2• Adjustments such as idle capacity, differences for accounting policy,

depreciation etc., are not easily accepted by TPOs

3• Rejects any approximations, estimations and assumptions• Adjustments being accepted -Working capital adjustment for IT / ITES sets;

Transfer Pricing –Litigation issues

17

18

Transfer pricing audits – Key issues

Characterisation of income from resale of software, Determination of Royalty rate

Adopting unfavourable stand for the assessee, considering forex as operating or non operating

Bench cost adjustment (capacity utilization) allowed in comparability analysis

Reduction in size of comparable companies due to losses, non availability of financial info and business close down

Use of data not available in the public domain, Officer gathers information gathered U/S 133(6)

Skews arithmetic mean as high-margin companies are retained – resolved with range

Inclusion of super normal mark-up companies

Rejection of Turnover criteria

Tax authorities re-doing comparable search

Rejection of loss making companies selected in the Report

Risk Adjustments – to be allowed to be adjusted to comparables’ margins

Transfer Pricing –Latest updates

19

Transfer Pricing – Latest Updates

20

Updates from Finance Bill 2016

• Introduction of Country-by-Country (CBC) Report, effective from FY 2016-17 (AY 2017-18)

• Reduction in time limit for completion of assessment – limit for concluding tax assessment reduced from 36 months to 33 months

• Eliminated Assessing Officer's power to appeal against DRP’s Direction

• New guidelines issued by CBDT stating criteria for selection of cases for specialized transfer pricing scrutiny.

• Provides guidance for maintenance of the tax authorities’ database of transfer pricing case referrals.

Country-by-Country Report

21

• Require to file CBC Report from AY 2017-18 (FY 2016-17)

• Threshold to file CBC Report is in line with BEPS [The international consensus is for a threshold of €

750 million (i.e. around Rs 5,395 million)]

• Overview of allocation of income, taxes and business activities by tax jurisdiction and details of all the

Constituent Entities of the MNE group included in each aggregation per tax jurisdiction need to be

disclosed in the CBC Report

• Graded structure of penalty prescribed ranging from INR 5,000 to 50,000 per day for non-furnishing,

non-maintaining, furnishing inaccurate information, etc.

Key assessment related provisions

22

• Currently, the cases have been selected for TP assessment based on the value of international

transactions

• After completion of almost ten audit cycles, CBDT issued Instruction no. 15 of 2015, (October 2015)

in which focus shifted to risk based TP assessments with AO's continuing to being empowered to

perform TP assessments , in certain situations.

• Instruction no 3/2016 replaces Instruction no. 15 of 2015

• In 2016, CBDT come out with a new instruction clarifying that the AO is not empowered to conduct TP

Assessments.

Key assessment related provisions

23

Dispute Resolution Panel – Section 144C

24

• Eligible assessee means:

o Any person in whose transfer pricing adjustment is proposed and is prejudicial to interest of such assessee as a

consequence of order passed under section 92CA(3)

o Foreign company – Section 2 (23A)

• Assessing Officer mandated to pass draft order by time limit in case of eligible assessee

• Finance Bill 2016 provides reduction in time limit for completion of assessment – limit for concluding tax assessment

reduced from 36 months to 33 months

• Eligible assessee must within 30 days either file objections before the Dispute Resolution Panel (“DRP”) or accept the

variations

• On acceptance of variation, assessee will receive final order and he has option of filing further appeal before

Commissioner (Appeals), as an alternative.

• Assessing Officer must pass final order within 1 month from receipt of acceptance / expiry of period provided for

acceptance.

• The DRP after enquiry and examination must pass an order within 9 months from end of the month in which draft order

was issued either confirming, reducing or enhancing the variation but cannot set aside any matter.

• The Assessing Officer is bound to follow directions of DRP.

• Assessee can file further appeal before Income-tax Appellate Authority.

• Finance Bill 2016 eliminated Assessing Officer's power to appeal against DRP’s Direction

Alternate dispute resolution mechanisms

25

Safe Harbour (“SH”) Rules

• effective from the FY 2012-13 and available for a period of five years.

• safe harbours available for IT, ITES, KPO, corporate guarantee, loan, auto manufacturing, etc.

• safe harbours for specified domestic transactions – Government company engaged in business of generation, transmission or distribution of electricity.

Advance Pricing Agreement (“APA”)

• the detailed scheme is effective from 30 August 2012 and from FY 2013-14

• is an arrangement between the taxpayer and the Revenue to mutually agree on the transfer pricing method/price to be applied and its application for a period upto five years

• The Finance Bill, 2014 has introduced roll back provisions for a maximum of 4 years subject to certain conditions

1

2


26

Updates from Finance Bill 2016

• Introduction of Country-by-Country (CBC) Report, effective from FY 2016-17 (AY 2017-18)

• Reduction in time limit for completion of assessment – limit for concluding tax assessment reduced from 36 months to 33 months

• Eliminated Assessing Officer's power to appeal against DRP’s Direction

• New guidelines issued by CBDT stating criteria for selection of cases for specialized transfer pricing scrutiny.

• Provides guidance for maintenance of the tax authorities’ database of transfer pricing case referrals.


27

• The cases can be referred to the Transfer Pricing Officers when:

- Selection of cases under Transfer Pricing risk parameters for International Transactions or SDT

or both

- Taxpayer has not filed an accountant’s report or failed to disclose an international transaction or

SDT

- There is a transfer pricing adjustment of INR 10 crore or more in earlier years, and the

adjustment was upheld by judicial authorities or is pending an appeal

- There is a search and seizure or survey operation, and transfer pricing findings have

been recorded

- Some new guidelines set forth mentioning the role of the Transfer Pricing Officer, the role of

Assessing Officers after the determination of the arm’s length price, and other rules

- Notified role of AO after determination of ALP by the TPO

28

Evolving Developments

DTC

Dispute Resolution Panel (DRP)

Safe Harbor RulesKey lies in

implementation

Revised OECD Guidelines

AdvancedAdvancedAdvancedAdvanced

PricingPricingPricingPricing

AgreementAgreementAgreementAgreement

SpecifiedSpecifiedSpecifiedSpecified

DomesticDomesticDomesticDomestic

TransactionsTransactionsTransactionsTransactions

ScopeScopeScopeScope of of of of

InternationalInternationalInternationalInternational

TransactionsTransactionsTransactionsTransactions

Penalty on Penalty on Penalty on Penalty on

NonNonNonNon----reportingreportingreportingreporting

transactionstransactionstransactionstransactions

29

Safe Harbour Rules for IT/ITES, KPO and Engineering Services

Eligible international transaction

Threshold limit Prescribed (aggregate value of international transaction)

Safe harbor margin

Provision of software development services

Up to INR 500 crore 20% or more on total operating costs

Above INR 500 crore 22% or more on total operating costs

Provision of information technology enabled services

Up to INR 500 crore 20% or more on total operating costs

Above INR 500 crore 22% or more on total operating costs

Provision of knowledge process outsourcing services

No limit 25% or more on total operating costs

Provision of specified contract R&D services wholly or partly relating to software development with insignificant risks

No limit 30% or more on total operating costs

30


International transaction

Mean

Provision of softwaredevelopment services

i. business application software and information system development using known methods and existing software tools;

ii. support for existing systems;iii. converting or translating computer languages;iv. adding user functionality to application programmes;v. debugging of systems;vi. adaptation of existing software; orvii. preparation of user documentation,but does not include any research and development services whether or not in the nature of contract research and development services.

31



Mean

Provision of information technology enabledservices

i. back office operations;ii. call centres or contact centre services;iii. data processing and data mining;iv. insurance claim processing;v. legal databases;vi. creation and maintenance of medical transcription excluding medical advice;vii. translation services;viii. payroll;ix. remote maintenance;x. revenue accounting;xi. support centres;xii. website services;xiii. data search integration and analysis;xiv. remote education excluding education content development; orxv. clinical database management services excluding clinical trials,but does not include any research and development services whether or not in the nature of contract research and development services;

32



Mean

Provision of knowledge process outsourcing services

The following business process outsourcing services provided mainly with the assistance or use of information technology requiring application of knowledge and advanced analytical and technical skills, namely:—i. geographic information system;ii. human resources services;iii. engineering and design services;iv. animation or content development and management;v. business analytics;vi. financial analytics; orvii. market research,but does not include any research and development services whether or not in the nature of contract research and development services;

33



Mean

Provision of specified contract R&D services wholly or partly relating to software development with insignificant risks

"contract research and development services wholly or partly relating to software development" means the following, namely:—i. research and development producing new theorems and algorithms in the field

of theoretical computer science;ii. development of information technology at the level of operating systems,

programming languages, data management, communications software and software development tools;

iii. development of Internet technology;iv. research into methods of designing, developing, deploying or maintaining

software;v. software development that produces advances in generic approaches for

capturing, transmitting, storing, retrieving, manipulating or displaying information;

vi. experimental development aimed at filling technology knowledge gaps as necessary to develop a software programme or system;

vii. research and development on software tools or technologies in specialisedareas of computing (image processing, geographic data presentation, character recognition, artificial intelligence and such other areas);or

viii. upgradation of existing products where source code has been made available by the principal;

Landmark Judicial Precedent

34

35

Maersk Global - Background

Maersk Global for AY 2008-09

Mumbai Special Bench Ruling on classification of IT ES into KPO / BPO and exclusion of high profit making compa rables

36

Maersk Global - Background

Due to divert views of the tribunals on the issue of ITeS sector's classification into KPO / BPO, and

exclusion of high profit -making comparables, a special bench (SB) of the Mumbai Tribunal was

constituted in the case of Maersk Global for AY 2008-09. (Reported in [2014 ] 43 Taxman.com 100

(Mumbai – Trib) (SB)). M/s Omniglobe Information Technologies India Pvt. Ltd. and M/s CRM

Services India Ltd. joined as interveners in this matters.

Constitution of special bench

An individual who is not already a part to an existing lawsuit but who makes himself or herself a

party either by joining with the plaintiff or uniting with the defendant in resistance of the plaintiff's

claim.

Interveners

37

Questions raised before the Special Bench

1. Whether for the purpose of determining arm’s length price of international transactions of the

assesse-company, providing back office support services to their overseas associated enterprises,

companies performing KPO functions should be considered as comparable?

2. In the facts of the assessee’s case, whether companies earning abnormally high profit margin should

be included in the list of comparable cases for the purpose of determining the arm’s length price for

an international transaction?”

Questions raised before the Special Bench

38

1. Classification of ITeS as KPO/BPO

• The Taxpayer is engaged in the business of shared service center and renders services such as

transaction processing, data entry, reconciliation of statements, audit of shipping documents and

other similar support services.

• The Taxpayer also rendered I.T. services such as process support, process optimisation and

technical support services.

• The Dispute Resolution Panel (“DRP”) held that the assessee could neither be considered as a low-

end service provider nor high-end KPO. Hence, it is considered a mix selection of comparables of

I.T. enabled service sector.

Facts of the case

39


• The taxpayer is a back office service provider or low-end service provider. A KPO industry is

significantly higher on the value chain and involves processes that demand advanced information

analysis as well as some judgment and decision-making. Taxpayer in turn is a captive entity, which

does not have authority to make any decisions and operates as per the directions and instructions

provided by its AE.

• There is a clear distinction between KPO services and BPO services. Reliance was placed on

notification no. SO 2810 (E) dated 18 September, 2013 issued by the CBDT in relation to safe

harbour rules wherein the “Knowledge Process Outsourcing Services” have been defined in

distinction to the “Information Technology Enabled Services” services covering various BPO

services.

• Broad characterisation of BPO and KPO services as ITES, based on the ground of larger size of

sample, is not in accordance with the TP regulations.

Arguments by the taxpayer

40


The intervener further relied upon the report prepared by the National Skill Development Corporation

(NSDC) on “Human Resource and Skill Requirements in the IT and ITES Industry Sector” and an

article “KPO- An emerging opportunity for the Chartered Accountants” published in July, 2006 issue of

Journal “The Chartered Accountants” to bring out the difference between BPO and KPO.

Arguments by the intervener

• The Taxpayer cannot be considered either as BPO or KPO but it lies somewhere in between as the

services rendered by it are in the nature of BPO as well as KPO. Even the taxpayer has taken KPOs

as comparables.

• As per Rule 10-TD, safe harbour rules are applicable to the Taxpayer who exercises a valid option

for application of safe harbour rules and cannot be used for the purpose of Rule 10B.

• There is thus no need to make any distinction between BPO and KPO for TNMM and the broad

category of ITES can be taken for the purpose of comparability analysis.

Arguments by Departmental Representatives (DR)

41


ITES services cannot be further bifurcated or classified as BPO and KPO services for the purpose of

comparability analysis since –

– Classification of ITES sector either as low-end BPO or high-end KPO is not always possible and

there might be a third category of entities falling in between BPO and KPO.

– Determining exact portion of BPO and KPO services may also not be possible in the absence of

relevant data maintained by the entity.

Ruling of Special Bench

42

2. Exclusion of high profit making comparables

• The arithmetic mean as referred in section 92C of the Act, envisages existence of arithmetic

progression meaning thereby it expects the comparable figures in a specific range. Hence, anything

beyond that range should not be taken into consideration.

• Relied on Para 55.10 of the Circular No. 14 of 2001 to argue that expectation of the legislature was

that there would not be any significant diversion between various Arm’s Length Price (ALM) if there

are different sets of comparables data.

• Relied on several cases decided by the different benches of the Tribunal in support of the argument.

Arguments by the taxpayer

43


• The intervener further argued that if the high margin is earned due to efficiency, these entities cannot

be excluded merely on the ground of high margin. However, if such high margin is due to any exterior

factor, the concerned entities should be excluded from the list of comparables. Consistency of high

margin is also required to be seen to find out as to whether the high margin is a normal situation or

abnormal

Arguments by the intervener

44


• Arithmetic mean is the most commonly used measure of central tendency. It is defined as a sum of the

values of all observations divided by number of observations. By adopting the arithmetic mean to work

out the average profit margin of the comparables, Indian law has recognized the extreme values also

for comparability.

• Indian TP Rules specifically deviate from OECD guidelines in this aspect and specify the arithmetic

mean for determining the ALP as against the quartile method suggested in the OECD guidelines

which excludes the companies that fall in the extreme quartiles for comparability.

• There is no bar in the relevant Rule 10B(2) to consider the companies earning abnormal profits as

comparables to tested party as long as they are functionally comparables. The entity showing extreme

results, however, can be excluded for comparability if it is found there are specific or special reasons

for such extreme results.

Arguments by Departmental Representatives (DR)

45


• Indian TP regulations specify the Arithmetic Mean for determining the ALP which is in deviation with

the OECD guidelines suggesting quartile method which excludes the companies that fall in the

extreme quartiles for comparability. Even otherwise, OECD guidelines in para 2.63 suggest that where

one or more of potential comparables have extreme results consisting loss or unusual high profits,

further examination would be needed to understand the reasons for extreme results.

• In light of the above, potential comparables cannot be excluded merely on the ground that their profit

is abnormally high. However, in such cases further investigation should be undertaken to ascertain the

reasons for unusual high profit and in order to establish whether entities with such high profit can be

taken as comparables.

• In these cases, Functional assets & Risk analysis (FAR) may be reviewed to ensure that the potential

comparables earning high profit satisfies the comparability conditions. If it does not satisfy the

comparability analysis or the high profit margin does not reflect the normal business condition, then

the high profit margin making entity should not be included in the list of comparables for the purpose

of determining the ALM of an international transaction

Ruling of Special Bench

46

Questions and Answers

Thank you

47

Date post:	15-May-2018
Category:	Documents
Upload:	nguyennga
View:	225 times
Download:	1 times

Practical aspects - Documentation, Benchmarking and ... • Maintenance of Transfer pricing...

Documents