By CA. Deepender Kumar Deepender Anil & Associates Chartered Accountants

 Backdrop  Transfer Price and Transfer Pricing  Indian TPR  Associated/Deemed Enterprises  International Transactions  Arm’s Length Price  Various Methods To Compute ALP  FAR Analysis  Transfer Pricing Process  Penalties  Safe Harbor Rules  Recent Circulars and Notifications 2

Liberalization of trade and foreign exchange policy started in India in the year 1991 This created huge increase in interest of MNEs in India The Standing Committee in March 1991 observed that provisions of Income Tax Act, 1961(Act) were inadequate to curb transfer pricing among MNEs The Expert Group constituted by Central Board Of Direct Taxes (CBDT) recommended complete revision of existing section 92 of the Act The Finance Act, 2001 introduced TPR in India by substituting existing Section 92 of the Act and introducing new sections 92A to 92F w.e.f April,

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OECD TP Guidelines lays the foundation of the Transfer Pricing Regulation in India Section 92 - Income arising to “Associated Enterprises” from “International Transactions” (or Specified Domestic Transactions w.e.f AY ) shall be computed having regard to the “Arm’s Length Price” Preconditions:  Two or more associated enterprises  Enter into an international transactions  Specified Domestic Transaction (w.e.f. AY ) Consequence:  Income to be computed having regard to the arm’s length price 5

Section 92A AE means direct or indirect participation in management control or capital:  by one enterprise into another enterprise; or  by the same person in both the enterprises Equity holding, Control of Board of Directors/ Appointment of one or more Executive Director, mutual interest will also constitute Associated Enterprise Either or both of Associated Enterprises should be non-residents 7

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Section 92B Means “transaction” between 2 or more Associated Enterprises:  Transaction between two or more associated enterprises (at least one of which will be non-resident) of purchase, sale or lease of tangible and intangible property, provision of services, capital financing, cost sharing/cost contribution arrangements, or  affecting profits, losses, income, assets or liability of the enterprise The expression “International Transaction” has been amended by Finance Act, 2012 w.e.f and specifically includes:  Inter-company Guarantees,  Advance payments, deferred payments, receivables,  Business restructuring / reorganisation,  Purchase / sale/ use of intangibles such as customer lists, customer contracts, customer relationships,  Transfer / secondment of trained employees, etc. 10

Section 92F(ii) Arm’s Length Price means a “price which is applied or proposed to be applied in a transaction between persons other than associated enterprises, in uncontrolled conditions” Arm’s length price can be determined by selection of most appropriate method from any of the following methods (Sec. 92C): – Comparable Uncontrolled Price Method – Resale Price Method – Cost Plus Method – Profit Split Method – Transactional Net Margin Method – Other Method as prescribed under Rule 10AB Where arms length price is within 3% range of the transaction price, no adjustment is warranted and the transaction price will be deemed to be the Arm’s Length Price. (5% range was applicable till A.Y ). 12

Transfer Pricing Methods Traditional Transaction Methods Comparable Uncontrolled Price Resale Price Method Cost Plus Method Transactional Profit Methods Profit Split Method Transactional Net Margin Method Other Method 14

CUP method can be applied where reliable data of similar uncontrolled transaction between two unrelated parties or between related party and third party is available. Here, Prices are to be compared. Internal CUP External CUP Adjustments permitted for volume discount, geographical differences, etc. Manufacturer A Sale to related party B Sale to non-related party C Non-related party P Non-related party Q 16

Identification of price charged or paid in comparable transaction(s) Such price adjusted to account for differences if any between international transaction and uncontrolled transaction(s) Adjusted price arrived above taken to be at arm’s length price 17

Compares the resale gross margin earned by AE, with gross margin of comparable independent distributors Comparable need not be in very same product Software distributor compared with FMCG distributor Difficult to use when processing is carried out before resale Group Manufacturer (Eligible Unit) Related Distributor (India) Unrelated Wholesalers INR 75INR

Identification of resale price by tested party Resale price reduced by normal gross profit with reference to uncontrolled transaction(s) Such price reduced by expenses incurred (customs duty etc.) in purchase of the product/services. This price may be adjusted to account for functional and other differences, if any. Adjusted price arrived above taken to be arm’s length price 20

Used predominantly when AE works for another AE as contract manufactures Typically applied to a contract manufacturer who:  Does not bear risk of marketing  Does not “normally” undertake high skill work May apply to contract manufacture, BPO, call centre, software developers, etc Direct & Indirect Cost of Production / service ALP = Comparable Margin + 22

Identification of direct and indirect costs production incurred in tested party transactions Identification of normal gross profit with reference to uncontrolled transaction(s) Normal gross profit adjusted to account for functional and other differences if any Adjusted gross profit added to total costs identified in step 1. Sum arrived above is taken to be at arm’s length price 23

Generally applicable in case of transaction involving  Transfer of unique intangibles OR  Multiple transactions which are interrelated not permitting separate evaluation Split global profit according to contribution of each AE. There are two approaches to this method  Total Profits Split  Residual Profit Split US Co A – Technology intangibles Mfg. Co B Mkt Co C Marketing intangibles Outside IndiaIndia 25

Determination of combined net profit of the associated enterprises arising out of international transaction Evaluation of relative contributions by each enterprise on the basis of functions performed, risks assumed and assets employed Splitting of combined net profit amongst enterprises in proportion to their relative contributions Profit thus apportioned to the tested party is used to arrive at the arm’s length price 26

Comparable Net profit adopted in relation to :  Costs incurred, or  Sales effected, or  Assets employed, or  Any other relevant base. Ideally, operating margin should be compared to operating margin earned by same enterprise on uncontrolled transaction – Internal TNMM Parent A Unrelated Cos. Subsidiary B Net margin 5% Unrelated Cos. Net margin 3% Outside India India 28

Computation of net profit as a percentage of a certain base realized from the international transaction Computation of net profit realized by the tested party or an unrelated enterprise in a comparable uncontrolled transaction Net profit from uncontrolled transaction adjusted to account for differences if any The net profit thus established is taken into account to arrive at an arm’s length price for the international transaction 29

Selection of the tested party Period of Comparison Aggregation of Transactions Identification of Comparable entities Profit Level Indicators Adjustment Calculations 30

31  An entity for which net profitability of the controlled transactions is to be tested – may not necessarily be the taxpayer  An entity for which the reliable data on closely comparable transactions can be identified  Generally a least complex entity without its own intangibles or unique assets and which only performs the routine functions For e.g., a distributor, sales agent, contract manufacturer

As per the IT Rules, multiple year data can also be used for comparability, in order to eliminate the accounting differences, product life cycles, varying businesses and discrepancies in short- tem economic conditions The averages for the multiple year data can be simple average or weighted average depending upon the facts of each case. 32

 Multiple transactions entered into by the enterprise which are so interlinked that they cannot be evaluated separately.  TNMM is applied by aggregating the such transactions with respect to closely linked products, similarity of functions, long- term arrangements, and intangible rights.  If aggregation using this criteria is not possible, then aggregation is done on entity wide basis. However, it is preferred to aggregate the transactions at the most micro level to the extent it can reliably be analyzed 33

 Internal or External comparison  External Comparison involves selection of comparable independent enterprise having similar FAR.  For external comparison the information which are available in public domain can only be used Two databases are basically considered to be reliable for selection of such comparable i.e. Prowess and Capitaline Plus 34

All of the profit-level indicators used in TNMM are based on operating income, which is gross profit less operating expenses 35 Overview of Various Profit Level Indicators Return on Assets (ROA)Operating profit divided by the operating assets (normally only tangible assets) Return on Capital Employed (ROCE) Operating profit divided by capital employed which is usually computed as the total assets minus cash and investments Operating margin (OM)Operating profit divided by sales Return on Total Costs (ROTC)Operating profit divided by total costs Return on Cost of Goods SoldGross profit divided by cost of goods sold Berry RatioGross profit divided by operating expenses

 Adjustment to comparable margin should be made to improve comparability. It shall be based on commercial practices, economic principles or statistical analyses.  Some familiar adjustments: Working Capital Depreciation Custom Duty Location Savings Foreign Exchange 36

As the name of method suggest, “transactional net margin method” calculate net margin of only “international transactions” and not of whole enterprise unless all transactions are with AEs only Therefore, operating, non operating and extraordinary items are considered from the point view of international transactions only and from the point of view of enterprise Non-operating income and expenses does not form part of the cost or revenue for calculating segmental PLI even they are of normal and recurring nature Revenue and expenses which does not affect the earning of margin of the relevant segment relating to international transactions of which the comparison have to be made, have to be ignored. 37

CALCULATION OF SEGMENTAL PLI A.Segmental Revenue Total revenue /sale  Less non operative revenue/sale (As per nature of business)  Less non segmental revenue /sale (As per nature of international transactions)  Less extraordinary/abnormal revenue/sale (As per frequency and amount of transactions)  Less revenue/sale relating to other years B. Segmental cost Total Cost  Less non operative cost (As per nature of business)  Less non segmental cost (As per nature of international transactions)  Less extraordinary/abnormal cost (As per frequency and amount of transactions)  Less cost relating income which does not form part of segmental normal revenue C. Segmental Margin (a-b=c) D. Segmental Margin % c/a% or c/b% (as the case may be) 38

Strengths  Net margins are less affected by transactional differences than price and by functional differences than gross margins  Less complex functional analysis is needed  Applicable to either side of the controlled transaction (i.e.to either the related party manufacturer or the distributor)  The results resembles the results of a modified RPM or CPM analysis Weaknesses  Net margins are affected by factors (e.g. variability of operating expenses) that do not have or have a less significant effect on price or gross margins  Information challenges, including the unavailability of information on profits attributable to uncontrolled transactions  Applied to only one of the related parties involved 39

CBDT has notified the “other method” vide a Notification and Rule 10AB has now been inserted in the Income-tax Rules, 1962 (the Rules). Applicable from FY Rule 10AB describes the other method as “any method which takes into account the price which has been charged or paid, or would have been charged or paid, for the same or similar uncontrolled transaction, with or between non-associated enterprises, under similar circumstances, considering all the relevant facts.“ “Other Method” refers to “price which has been charged or paid, or would have been charged or paid”. Effectively, this implies that under this “other method” “quotations” rather than prices “actually” charged or paid can also be used by the taxpayers. 41

Possible Applicability  Where the application of the five specific methods is not possible due to difficulties in obtaining comparable data or due to uniqueness of transactions  Intangibles or business transfers, transfer of unlisted shares, sale of fixed assets, revenue allocation/splitting, guarantees provided and received, etc. Possible third party references  Third party quotations  Valuation reports  Commercial, economic, financial models etc. 42

43 MethodComparability Requirements ApproachApplication CUPVery HighPrice BenchmarkingVery difficult but most preferred method RPMHighGP based Price Benchmarking Distributor CPMHighGP based Price Benchmarking Manufacturer/Service Provider PSMMediumNet Margin Benchmarking Manufacturer/Distribut or/Service Providers TNMMMediumNet Margin Benchmarking Manufacturer/Distribut or/Service Providers

Functions Performed: Analysis of critical functions performed in controlled environment with function performed in uncontrolled transactions that add value to transactions hence fetch higher returns. Assets Employed: Analyzing assets employed in transaction in controlled environment by identifying the assets.  Type of assets – Capital – Tangibles – Intangibles Risks Assumed: Analysis involve identification of various risk assumed by each party in controlled transaction.  Nature of Risk — Market Risk —Manpower Risk —Credit Risk —Technology Risk 45

Identification of intragroup transactions FAR Analysis Identification of comparable transactions Establishing comparability, adjustment for material differences Selection of most appropriate method Determination of ALP TP AdjustmentsDocumentationTax return filingTP Assessment 47

SectionsDefaultPenalty 271(1)(c )In case of a post-inquiry adjustment, there is deemed to be a concealment of income % of tax on the adjusted amount 271AAFailure to maintain and furnish documents 2% of the value of transaction 271BAFailure to furnish accountant’s reportINR 100, AAFailure to report a transaction in accountant’s report 2% of the value of transaction 271GMaintaining or furnishing incorrect information or documents under 92D 2% of the value of transaction 48

Safe Harbor (“SH”) Rules shall be applicable for a period of five fiscal years (i.e., tax AY onwards) and SH do not apply to specified domestic transactions Safe Harbour Rules are the circumstances under which tax authorities automatically accept the transfer prices declared by the taxpayer Provides certainty and compliance relief Could be in the form margin threshold or exclusion of certain classes of transactions from TP regulations Safe Harbour and Presumptive Taxation provisions (Similar in nature) Taxpayer would still be required to maintain TP documentation and Form 3CEB 50

S. No.International TransactionCondition 1ITS and ITeS – Max INR 500 crores (Insignificant risk bearer)OP/ OC >= 20% 2ITS and ITeS – Above INR 500 crores (Insignificant risk bearer)OP/ OC >= 22% 3ITES – KPO services - Max INR 100 crores (Insignificant risk bearer) OP/ OC >= 25% 4Intra Group Loan to WOS <= INR 50 croresBase rate on 30 June of PY (SBI) bsp 5Intra Group Loan to WOS > INR 50 croresBase rate on 30 June of PY (SBI) bsp 6Explicit Corporate Guarantee to WOS <= INR 100 crores2% or more P.A on amount guaranteed 7Explicit Corporate Guarantee to WOS > INR 100 crores (WOS rated to be of adequate to highest safety) 1.75% or more P.A on amount guaranteed 8Contract R&D for software development (Insignificant risk bearer)OP/ OC >= 30% 9Contract R&D for generic pharmaceutical drugs (Insignificant risk bearer) OP/ OC >= 29% 10Manufacture and export of core auto componentsOP/ OC >= 12% 51

Revised and Updated Guidance for Implementation of Transfer Pricing Provisions

CBDT issues instruction No. 15/2015 replacing Instruction No. 3 dated May 20, 2003 to give guidance to AO and TPO regarding transfer pricing assessments 1.Reference to Transfer Pricing Officer (TPO)  AO must record his satisfaction as jurisdictional requirement, that there is income/potential income arising from international transaction before proceeding to determine ALP on his own or making a reference to TPO, in following circumstances – (i) No accountant's report filed by assessee, but international transactions entered by assessee have come to the notice of AO; (ii) Taxpayer has not declared one or more international transaction in Form 3CEB which has come to AO's notice; (iii) where transaction is declared in Form 3CEB with qualifying remarks to the effect that such transaction is not international transaction or it does not have impact on taxpayers income 54

 In case no objection is raised by the taxpayer to the applicability of Chapter X [Sections 92 to 92F] of the Act, then the prima-facie view of the AO would be sufficient before referring the international transaction to the TPO for determining the ALP. However, where the applicability of Chapter X [Sections 92 to 92F] of the Act to the facts of the taxpayer's case is objected to, the assessee's objection should be considered and specifically dealt with so as to make sufficient compliance with the principles of natural justice.  Making a reference to TPOs on the basis of value of international transactions is no more necessary as selection of TP cases for scrutiny is to be based on risk assessment, consequently when a case is selected for scrutiny for non-TP issues, no reference to TPO is necessary irrespective of value of international transactions Only exception to above would be a situation where AO notices undisclosed international transaction during assessment proceedings due to non-filing of Form 3CEB/ non-reporting of such transaction in Form 3CEB 55

2.Role of Transfer Pricing officer  The TPO, being an Additional/Joint CIT, shall obtain the approval of the jurisdictional CIT (TP) before passing the order. On the other hand, the TPO, being a Deputy/Assistant CIT, shall obtain the approval of the jurisdictional Additional/Joint CIT before passing the order The jurisdictional CIT (TP) should assign a limited number of important and complex cases, not exceeding 50, to the Additional/Joint CslT [TPOs] working in the same jurisdiction  TPO's order being subject to judicial scrutiny, must contain adequate reasons/data regarding selection of most appropriate method, data used for computation of ALP and copies of all relevant documents in this respect to be made available to AO for his record and use at subsequent stage of appellate and penal proceedings  Instruction also highlights role of TPO in compliance audit in pursuance to APA signed and regarding safe harbour provisions 56

3.Maintenance of Database  References received from the AOs by the TPOs in his jurisdiction are dealt with expeditiously and accurate record of all events connected with the whole process of determination of ALP is maintained in the format enclosed as Annexure-I to this Instruction.  The ClT (TP)must ensure that the separate data maintained by all TPOs under their jurisdiction are consolidated into one report for the entire charge after the completion of each transfer pricing audit cycle. 4.Applicability  Guidance provided in instruction applicable only to scrutiny of 'international transactions' and CBDT is considering issue of separate guidance for specified domestic transactions  However, guidance regarding cases selected for scrutiny on non-TP parameters also applicable to specified domestic transactions 57

CBDT notifies transfer pricing (TP) rules to incorporate “range concept” and “use of multiple year data” 1.Applicablity Amended Rules applicable to international transactions and specified domestic transactions undertaken on or after April 1, Range Concept Range concept to be applicable in certain cases and data points lying between 35th and 65th percentile of comparable prices to be considered as arm’s length price Clarifies that the transaction price shown by taxpayers falling within the range will be accepted and no adjustment will be made 3.Weighted Average PLI Notification proposes use of weighted average of PLI for 3 years and gives illustrations on computation of weighted average PLI & arm's length range 59

4.Multiple Year Data CBDT states that use of multiple year data allows for yearly variations to be averaged out and would therefore add value to the TP analysis Stresses that amended rules would provide clarity in determination of price in TP cases and reduce disputes on TP issues and further, that it is a part of continuing initiative of providing a stable and certain direct tax regime 60

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