Dr M S Vasan and Vijay Iyer: Transfer Pricing Audit Practices in India, Edition 2013

This book is based on Indian transfer pricing audit experiences for the period ranging from 2003-04 till date, right from TPO to Appellate Authorities, thereby providing guidance to the tax authorities, taxpayers and tax professionals on technical issues and compliance relating to transfer pricing and an insight into the tax audit process.The authors have drawn from their practical experience of dealing with transfer pricing in their respective roles to provide the taxpayer’s perspective on how to mitigate transfer pricing risk and reduce transfer pricing controversy.The book also highlights the gap in the positions and approach of the tax authorities and taxpayers, and is a good starting point to explore some form of alignment of these positions to ease the pain of taxpayers and potential investors.A manual to tackle transfer pricing, this book will help:
• clarify the technical aspects of transfer pricing,
• present practical, on-the-ground facts arising during transfer pricing audits,
• explain some of the relevant court rulings on transfer pricing that taxpayers are able to use in defending their transfer
• pricing litigation, and
• provide solutions for risk mitigation and controversy resolution.

xiChapter I-Introduction to Copyright LawContentsTitle Page iii vPreface viiForeword ixTable of Cases xxiiiGlossary xxixCHAPTER PAGEI. Introduction ... 11. Evolution of transfer pricing ... 12. Why transfer pricing in India ? ... 72.1 Pre 2001 scenario ... 82.2 Post 2001 scenario ... 93. Evolution of TP administration ... 104. TPOs order binding on AO ... 115. Transfer pricing audit and revenue collection ... 136. Evaluation of transfer pricing audit process ... 157. Uniqueness from that of advanced countries ... 158. Salient Features of TP regulation in India ... 178.1 Computation of arm’s length price ... 178.2 Arithmetic mean ... 188.2.1 Old proviso (applicable up to A.Y. 2008-09) ... 188.2.2 New proviso (applicable from A.Y. 2009-10) ... 198.2.3 Retrospective amendment(w.e.f. 1 April 2002) ... 198.3 Documentation ... 208.3.1 What constitutes transfer pricingdocumentation ... 208.3.2 Documents Required ... 218.3.3 Relaxation of requirement to maintain freshdocumentation ... 238.3.4 Period of maintenance of documentation ... 238.3.5 Accountant’s Report ... 248.4 Penalties ... 248.5 Burden of proof ... 259. TP and Indian Customs Act ... 25xii Contents of Transfer Pricing Audit Practices in IndiaCHAPTER PAGEII. Administrative Set-up Appellate Authorities and ADRMechanisms ... 271. Administrative set-up ... 271.1 CBDT ... 271.1.1 Organisational structure of the CentralBoard of Direct Taxes ... 281.2 Transfer pricing administrative set-up ... 291.2.1 Director General of Income Tax(International Taxation) ... 302. Jurisdiction of Assessing Officer (AO)/Transfer PricingOfficer (TPO) ... 303. Dispute resolution ... 323.1 Dispute Resolution Panel ... 323.2 Disptute resolution mechanism ... 323.3 The mechanism ... 333.4 DRP-Benefits and concerns ... 354. First Appeal–Commissioner (Appeals) ... 355. Income Tax Appellate Tribunal ... 376. High Court ... 387. Supreme Court of India ... 388. Alternative Dispute Resolution and Mitigation Channels: ... 388.1 Advance Ruling ... 38Authority for Advance Rulings ... 388.2 Advance Pricing Agreements (APA) ... 398.2.1 Types of APA ... 408.2.2 Scope and objective of APA ... 408.2.3 Advantages of APA ... 408.2.4 Countries with APA ... 418.2.5 APA process in India ... 418.2.6 Contents of APA report ... 418.2.7 Considerations for APA ... 428.2.8 Concerns about APA ... 429. Safe Harbour Rules in India ... 439.1 Final Safe Harbour Rules notified by the CBDT ... 449.1.1 Eligible international transactions ... 459.1.2 Operating profit margin ... 469.1.3 Filing of Form 3CEFA ... 479.1.4 Validity of safe harbor option ... 479.1.5 Assessment procedure ... 479.1.6 Ineligible taxpayers ... 489.1.7 Other key aspects ... 4810. Mutual Agreement Procedure (MAP) ... 4810.1 Transfer pricing dispute resolution using MAP ... 50Contents of Transfer Pricing Audit Practices in India xiiiCHAPTER PAGEIII. TP Methodology-Application and Issues ... 531. Comparability of international transaction ... 532. Relevant data ... 542.1 Internal comparable data ... 542.2 External comparable data ... 543. Comparability with uncontrolled transactions ... 544. Choice of tested party ... 555. Computation of ALP ... 555.1 Comparable Uncontrolled Price (CUP) Method ... 555.1.1 What the Income Tax Act, 1961 statesabout CUP ... 555.1.2 Methods of CUP ... 565.1.3 Applicability of CUP Method ... 575.1.4 OECD view on CUP Method ... 575.1.5 CUP, in comparison with other methods ofevaluation for comparability ... 605.2 Resale Price Method ... 615.3 Cost Plus Method ... 635.4 Profit Split Method ... 655.4.1 Development centers ... 655.4.2 Circular 5 rescinding Circular 2 onapplication of PSM ... 675.4.3 Comparative analysis between Circular 3and Circular 6 ... 675.4.4 Comments ... 685.5 Transaction Net Margin Method ... 686. Sixth Method ... 697. Selection of Most Appropriate Method ... 708. OECD explanatory notes for application of TP method ... 719. United Nations Manual–Specific Guidelines for DevelopingEconomies ... 7310. Conclusion ... 73IV. TP Analysis ... 751. Introduction ... 752. TP Analysis ... 753. Functions, Assets and Risk Analysis ... 753.1 Risk Allocation ... 774. Economic Analysis ... 804.1 Selection of comparable data ... 804.2 Tested Party ... 814.3 Computation of operating profit ... 834.4 Factoring impact of business strategies ... 864.5 Capacity Utilisation Adjustment ... 87xiv Contents of Transfer Pricing Audit Practices in IndiaCHAPTER PAGE4.6 Working Capital Adjustment ... 884.7 Risk Adjustment ... 89V. Selection of Comparables ... 931. Introduction ... 932. Selection of comparables ... 943. Application of filters ... 944. Trade and industry databases ... 944.1 Databases for price related data ... 954.2 Corporate databases for financial data ... 954.2.1 Selection of comparable companies ... 954.2.2 Extraction of financial data ... 974.3 Foreign databases ... 984.3.1 General database ... 994.4 Financial services ... 1024.4.1 Bloomberg (Screen Shots Only) ... 1024.4.2 Thomson Reuters Eikon ... 1024.4.3 Moody’s RiskCalc ... 1024.4.4 Loan Connector ... 1034.5 Industry analysis ... 1034.5.1 Business Monitor International ... 1034.5.2 ISI Emerging Markets ... 1034.5.3 Standard & Poor’s Market Insight ... 1034.5.4 Dow Jones Factiva ... 1045. Additional benchmarking as supplementary approach ... 1045.1 Issues with reference to other benchmarkingapproaches ... 1045.2 Permissibility of change in method from year to year ... 1046. Use of appropriate profit level indicator ... 1056.1 Overview of various profit level indicators ... 1056.2 Judicial precedents ... 1067. Contemporaneous data use of subsequent year data, use ofpast year data ... 1078. Onus on the taxpayer ... 1079. Undue hardship on the taxpayer ... 1089.1 Para 5.9 of the OECD guidelines, 2010 ... 1099.2 Para 5.10 of the OECD guidelines, 2010 states ... 10910. A combined and harmonious reading of TP regulations isdesirable ... 10911. Judgments/Rulings ... 10912. Use of updated margins leads to anomalous results ... 11013. Use of multiple year data is permitted by the Act ... 11113.1 Interplay between Rule 10B(4) and Para 3.75 to3.79 of the OECD Guidelines ... 112Contents of Transfer Pricing Audit Practices in India xvCHAPTER PAGE13.1.1 Para 3.75 of the OECD Guidelines states ... 11213.1.2 Para 3.76 of the OECD Guidelines states ... 11213.1.3 Para 3.77 of the OECD Guidelines states ... 11313.1.4 Para 3.78 of the OECD Guidelines states ... 11313.1.5 Para 3.79 of the OECD Guidelines states ... 11314. Data cut off and search process ... 114VI. Special Transactions ... 1171. Transactions involving intangible assets ... 1181.1 Technology-related ... 1181.2 Trade-related ... 1181.3 Marketing-related ... 1181.4 Customer-related ... 1181.5 Benchmarking of intangibles from TP perspective ... 1191.6 Valuation of intangibles ... 1201.6.1 Comparable Uncontrolled Price (CUP)Method ... 1201.6.2 Transactional Net Margin Method(TNMM) ... 1201.6.3 Profit Split Method (PSM) ... 1211.7 Valuation of transaction of sale of intangibles ... 1241.7.1 Discounted Cash Flow Method (DCF) ... 1251.7.2 Other method of intangible valuation ... 1251.8 Payment of royalty ... 1251.8.1 DHL Corporation and Subsidiaries v.Commissioner of Internal Revenue ... 1261.8.2 Canada v. GlaxoSmithKline Inc. ... 1261.9 Marketing Intangibles ... 1271.9.1 Existence of a transaction ... 1281.9.2 Economic ownership v. legal ownership ... 1291.9.3 Implications of foreign parent’s influence ... 1291.9.4 Presence of express agreement in instantcase ... 1291.9.5 Factors to be considered while determiningvalue of transaction ... 1301.9.6 Elements of AMP expenses ... 1301.9.7 Method to determine arm’s length price ... 1302. Technical support services ... 1313. Global treasury services ... 1324. Global procurement services ... 1334.1 Li & Fung (India) Pvt. Ltd. v. DCIT ... 1334.2 GAP International Sourcing (India) Pvt. Ltd. v.ACIT ... 1345. Contract manufacturing ... 1356. Knowledge process outsourcing ... 136xvi Contents of Transfer Pricing Audit Practices in IndiaCHAPTER PAGE6.1 Indian subsidiary of a foreign parent ... 1366.2 Software development life cycle–Functionaldifferences ... 1366.3 Captive service provider v. Third party serviceprovider ... 1376.4 Risk differences ... 1396.5 Intangible differences ... 1396.5.1 Adjustment for functional differences ... 1416.5.2 Risk adjustments ... 1416.5.3 Adjustment for intangibles ... 1427. Cost Contribution Arrangement (CCA) ... 1447.1 Categorisation of companies in the IT Sector ... 1447.2 IT-enabled services ... 1458. Management cross charges and cost allocation ... 1468.1 Gemplus India Pvt. Ltd. ... 1479. Inter-co goods and services–Cost plus methodology ... 14710. Transfer of semi-finished goods ... 14811. Joint facility arrangements/long term buy and supplyarrangements ... 14912. Research and development services ... 14913. Valuation of shares ... 15013.1 Vodafone International Holdings B.V. v. Union ofIndia ... 15314. Reimbursement of expenses ... 15415. Business restructuring ... 15416. Distribution entities ... 15816.1 Classification of entities ... 15916.2 Distributor Models ... 15916.3 Categories of Distributors ... 161VII. TP Audit Practices ... 1631. Introduction ... 1642. Standard audit practices ... 1653. TPO’s fact finding mechanism ... 1654. TPO’s preferred method ... 1675. TPO’s soft targets ... 1676. TP audit–Controversial issues ... 1686.1 Transfer Pricing for Companies with PresumptiveTax ... 1686.2 Use of inexact comparables and adjustments ... 1696.3 Alignment of financial years ending at dates otherthan March 31 ... 1696.3.1 Multiple year data ... 1706.4 Threshold for determining the functionalcomparability of a company ... 172Contents of Transfer Pricing Audit Practices in India xviiCHAPTER PAGE6.5 Threshold for related party transactions ... 1736.6 Acceptance of segmental data as per AS–17 issued byThe Institute of Chartered Accountants of India ... 1736.7 Use of consolidated financial statements ... 1736.8 Other common rejection criteria ... 1736.9 Treatment of foreign exchange profit/loss ... 1746.10 Use of foreign comparables ... 1746.11 Use of foreign tested party ... 1746.12 Use of CUP data-Price publications andcommodity exchanges as valid comparableuncontrolled price data ... 1756.13 Adjustment be made to international transactionvalues ... 1756.14 Working capital adjustment ... 1756.15 Method of computation of Bright Line (AMP) ... 1766.16 Use of section 133(6), Income Tax Act, 1961 ... 1766.17 Management fee ... 1766.18 Procurement services ... 1776.19 Low margin/Loss making v. High profit margincompanies ... 1776.20 Abnormal transactions v. Normal transactions ... 1806.21 Cost burden- Parent Associated Enterprise ... 1816.22 Transaction level v. Enterprise level TP adjustment ... 1816.23 Combined transaction approach v. Transactionalapproach ... 1827. Filters through TPO’s lenses ... 1837.1 Rejection of companies with different financial year ... 1837.2 Mergers and acquisitions ... 1847.3 Employee cost to sales ... 1847.4 Turnover filter ... 1857.5 Manufacturing v. Trading filter ... 1868. Other pertinent issues ... 1878.1 Suo Moto transfer pricing adjustments ... 1879. Writ petition for stay the demand ... 18710. Orders by the Special Valuation Branch (SVB), CustomsDepartment ... 18810.1 Burden of proof is on the importer ... 18910.2 Identical goods ... 18910.3 Similar goods ... 19010.4 Deductive Valuation Method ... 19010.5 Computed Value Method ... 19110.6 Residual Method ... 191xviii Contents of Transfer Pricing Audit Practices in IndiaCHAPTER PAGE10.7 Process to be followed for order of the SVB withreference to the CBEC Circular No. 11/2001-Cusdated 23 February 2001, issued as PN 68/2001dated 2 April 2001 ... 192VIII. Attribution of Profits to Permanent Establishment ... 1951. Nexus between transfer pricing and permanentestablishment ... 1952. Attribution of profits under transfer pricing regulation ... 1963. ITAT decisions ... 1973.1 Motorola Inc. and Others ... 1973.2 Galileo International Inc ... 1983.3 Morgan Stanley ... 1993.4 SET Singapore case ... 1993.5 Rolls Royce case ... 199IX. Domestic Transfer Pricing ... 2031. Introduction ... 2032. Glaxo Smithkline Case ... 2042.1 Facts ... 2042.2 Key questions before the Supreme Court ... 2042.3 Suggestion by the Supreme Court for domestic TPlaw ... 2053. Specified Domestic Transactions under domestic transferpricing law ... 2053.1 Specified Domestic Transactions covered undervarious provisions of Income Tax Act, 1961 ... 2073.2 Separate enterprise ... 2084. TP process for Specified Domestic Transactions ... 210X. TP Audit Preparation and Guidance Note ... 2131. Introduction ... 2132. Inter-company service agreements ... 2132.1 Tax authority’s approach: Recent developments ... 2133. Cost allocation methodology ... 2154. Extended definition of international transactions ... 2175. Deemed international transaction ... 2206. Transfer pricing–International audit practices ... 221XI. TP Risk Management ... 2251. Transfer pricing risk assessment ... 2251.1 High risk entities ... 2261.2 Medium risk entities ... 2271.3 Low risk entities ... 228Contents of Transfer Pricing Audit Practices in India xixCHAPTER PAGE1.4 Risk assessment process ... 2281.5 Audit approach ... 2281.6 Third party information ... 2281.7 Information held by foreign related parties ... 2292. Relevance of TP policy ... 2292.1 Standard contents of TP Policy ... 230ABC Group’s Transfer Pricing Policy ... 2303. TP documentation & practice ... 235XII. Base Erosion and Profit Shifting (BEPS)-A New Lookat Transfer Pricing ... 2371. Evolving scenario of BEPS ... 2371.1 Treaty shopping ... 2391.2 Form v. Substance ... 2391.3 Limitation in traditional transfer pricing methods ... 2391.4 A major issue is transfer pricing and the enforcementof the arm’s length principle ... 2401.5 Alternative income allocation systems, includingformula based systems, are sometimes suggested ... 2402. Alignment of returns with value creation ... 2403. Few global expenses being charged to all the entities ... 2404. Significance of BEPS project on international taxation ... 2415. Examples of MNEs’ tax planning structures ... 2416. Key tax principles and opportunities for Base Erosion andProfit Shifting ... 2426.1 Key principles for the taxation of cross-borderactivities ... 2426.2 Jurisdiction to tax ... 2426.3 Transfer pricing ... 2437. Conclusion ... 244XIII. Important Case Law and Key Learnings ... 245Digest of Important Case Law ... 2461. Functionality Test ... 2461.1 Philips Software Centre Private Limited v. Asst.Commissioner of Income Tax, Bangalore ... 2461.2 DCIT, Chandigarh v. Quark Systems P Ltd, ITAT,Special Bench, Chandigarh ... 2481.3 Mentor Graphics (Noida) Pvt Ltd v. DCIT ... 2492. Comparability Test ... 2512.1 Intervet India Pvt Ltd v. ACIT, Mumbai– ITAT ... 2512.2 Assisstant Commissioner v. Workhardt Ltd ... 2523. Financial Transactions ... 2533.1 VVF Limited v. DCIT ... 253xx Contents of Transfer Pricing Audit Practices in IndiaCHAPTER PAGE4. Marketing Intangibles ... 2554.1 Maruti Suzuki India Ltd v. Addl. Commissioner ofIncome Tax, Transfer Pricing Officer, Delhi HighCourt ... 2555. Controlled comparables ... 2625.1 Sony India Private Ltd v. DCIT, Delhi ... 2625.2 UCB India Private Ltd v. CIT ... 2646. Documentation process ... 2656.1 ACIT v. Vedaris Technologies Pvt Ltd ... 2657. Foreign tested party ... 2667.1 General Motors India P Ltd v. ACIT ... 2668. Penalty proceedings ... 2668.1 Cargill India Pvt Ltd v. CIT ... 2669. Adjustments ... 2679.1 LG Electronics (India) Private Limited v. ACIT ... 2679.2 E-gain communications Pvt Ltd v. CIT ... 2679.3 Aztec Software & Technology Services Ltd v. ACIT ... 26810. Cost allocation ... 27410.1 Dresser Rand India Pvt Ltd v. Addl. CIT ... 27410.2 Royalty and intangibles -Delhi High Court (HC),Commissioner Income Tax v. EKL AppliancesLimited (Taxpayer) ... 27511. Investment in foreign subsidiaries not internationaltransaction as no income element ... 27611.1 Vijai Electricals Ltd v. ACIT ... 27612. TP adjustment for control premium, non-compete withrespect to strategic investor’s share sale ... 27712.1 Lanxess India Private Ltd v. Ad. CIT ... 277XIV. Conclusion: The Reality of Transfer Pricing ... 281APPENDICESAPPENDIX PAGE1. Transfer Pricing–Suggested Answers … 2871. When can international transaction be referred to TPO? ... 2872. What all TP methods can be used by taxpayer as per ITL? ... 2883. Can a taxpayer shift methods after submission of Form No.3CEB? ... 2884. Can a taxpayer add or delete comparable set submittedbefore TPO? ... 2885. Is DRP bound by ITAT orders of the same jurisdiction? ... 2896. Can TPO/AO disregard taxpayer’s comparables and use hisfor TP order? ... 2897. Can AO interfere/modify the orders passed by TPO? ... 290Contents of Transfer Pricing Audit Practices in India xxiAPPENDIX PAGE8. Can a taxpayer opt to go through CIT (Appeals) instead ofDRP? ... 2909. Whether ITAT orders of other jurisdictions binding onTPO ... 29010. Is India bound to follow OECD principles? ... 29111. Can TPO disregard taxpayer’s choice for safe harbor and doTP audit? Whether TPO is bound to give an opportunity totaxpayer before rejecting his claim for safe harbor? ... 29112. If any restructuring of business happen outside India afteran international transaction with a third party who fallsunder AE definition, should the taxpayer disclose to TPO atthe time of audit, as extended/deemed internationaltransaction? ... 29113. Is TP audit done transaction wise and benchmarked? ... 29214. Can Specified Domestic Transactions (SDT) apply forincomes earned by a taxpayer? ... 29315. For netting of expenses under reimbursement, should thetaxpayer disclose it in Form No. 3CEB and if not, will itattract penalty, what could be the quantum of penalty? ... 29316. Can multiple year data be used, is it allowed as per IncometaxLaw (ITL)? ... 29317. Can multiple geographies comparable be used to benchmarkforeign tested party? ... 29318. Can Customs SVB orders be used to defend ALP forimports under TP? ... 29419. If an international transaction is left out of audit, can theaudit be re-opened to do TP audit like that of Income-taxAct? If so, how many years can they go back? ... 29420. Will there be a separate TP study and audit for foreignentities having PE with India? ... 29421. Will the TP order on Indian entity be binding on theforeign entity, even if it is done in different jurisdictions? ... 29522. Can Profit Split Method be used for Contract R&Dservices? ... 29523. Can Penalty be levied by the Revenue for non-disclosure ofthe reimbursement of costs for secondment of employees toits AEs ... 29524. What can be the approach to benchmark Director’sremuneration under Domestic Transfer Pricing? ... 29525. Whether capital receipts by way of subscription to shares iscovered under Transfer Pricing Regulation? ... 2962. Analysis of Case Law … 2973. Relevant Circulars and Press Release … 309(1) Safe Harbour Rules finalized after considering comments ofvarious stake holders; Rules to be applicable for 5 assessmentyears beginning from Assessment Year 2013-14 ... 309xxii Contents of Transfer Pricing Audit Practices in IndiaAPPENDIX PAGE(2) Circular on conditions relevant to identify developmentcentres engaged in contract R&D services with insignificantrisk ... 311(3) Press Release ... 313(1) Rescind circular No. 2/2013 dated 26th March, 2013. ... 315(2) Amend and reissue circular No. 3 dated 26thMarch, 2013 ... 3154. Form No. 3CEB 3175. Form No. 3CEFA 3276. Examples of Marketing Intangibles and Tax Office 333Example 1-This example illustrates a renewable long-term royaltyfreecontractual arrangement (with exclusive right), wherethe marketer/distributor does not bear the costs and risks ofdeveloping the market ... 333Example 2- This example illustrates a renewable long-termroyalty-free contractual arrangement (with exclusive right),where the marketer/distributor bears the costs and risks ofits marketing activities ... 335Example 3-This example illustrates a renewable long-term royaltyfreecontractual arrangement (with exclusive right), wherethe marketer/distributor bears the costs and risks ofdeveloping the market and incurs marketing expenses farbeyond those of comparable independent enterprises ... 336Example 4-This example illustrates a short-term royalty-freecontractual arrangement (with exclusive right), with nooption to renew, where the marketer/distributor bears thecosts and risks of developing the market ... 338Example 5-This example illustrates the renegotiation of arenewable long-term royalty-free contractual arrangement(with exclusive right), before its term expires, into arenewable licensing agreement (with exclusive right) underwhich the marketer/distributor pays a royalty, and bears thecosts and risks of developing the market ... 339Example 6-This example illustrates the renegotiation of arenewable long-term royalty-free contractual arrangement(with exclusive right), before its term expires, into arenewable licensing agreement (with exclusive right) underwhich the licensee agrees to pay a royalty for processing,marketing and distributing the branded product, and thelicensee bears the costs and risks of developing the market.The licensee incurs expenses far beyond those of comparableindependent enterprises ... 340