1. DOMESTIC TRANSFER PRICING – EMERGING ISSUES NEERAJ K. JAIN VAISH ASSOCIATES ADVOCATES NATIONAL CONFERENCE ON DIRECT TAXES

2. Contents 2  Introduction of Domestic Transfer Pricing  Specified Domestic Transactions  Specified domestic transaction in terms of Section 40A  Specified domestic transaction in terms of Section 80IA/IB/IC/ID/ID/10AA  Case Studies  Concept of Arms Length Price  Compliance and Penalties

3. 3 INTRODUCTION

4. 4  Application of Transfer Pricing provisions was earlier limited to “International Transactions”- to prevent shifting of profits MNEs from one jurisdiction to other.  TP provisions contained in Chapter-X- self contained code - provide mechanism for determining ALP.  Although determination of arm’s length price is enshrined in various sections, viz., 40A(2), 80-A, 80-IA, etc., between related domestic parties, no rules or methods was prescribed for such determination. 

5. INTRODUCTION 5  An obiter dicta by the Supreme Court in the case of CIT Vs. Glaxo SmithKline Asia (P) Ltd. 236 CTR 113(SC) is the genesis for introduction of Domestic TP, applying chapter X to specified domestic transactions (SDT).  In that case: - SLP against order by DHC in a writ petition by the Revenue on a stay order by the ITAT. - payment of allocated cost by GSKAP to GSKCH.

6. INTRODUCTION 6  The SC noted that In the case of 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: [i] If one of the related Companies is loss making and the other is profit making and profit is shifted to the loss making concern; or [ii] If there are different rates

7. INTRODUCTION 7  The SC observed that : (i) To get over this situation, the matter needs to be examined by Central Board of Direct Taxes CBDT. (ii) The law can be amended to comply with Rule 10 D in respect of domestic related party transactions. (iii) The AO could be empowered to make adjustment to the value of transactions based on TP methods.  Based on the feedback from the Solicitor General appearing in that case the SC noted “We are informed that the matter has been examined by CBDT and it is of the view that amendments would be required to the provisions of the Act if such Transfer Pricing Regulations are required to be applied to domestic transactions between related parties under Section 40A(2) of the Act.”

8. INTRODUCTION 8  The purpose of introduction of specified domestic transaction-  To prescribe mechanism to determine reasonableness of expenditure or income in related party transactions having regard to arm’s length principle.  To provide objectivity and avoid tax arbitrage  To provide legally enforceable obligation by shift onus on taxpayer to maintain proper documentation

9. INTRODUCTION 9  Section 92BA was introduced in chapter X for applying, Transfer Pricing regulation to specified domestic related party transactions, for computation of allowance of expenditure or interest or allocation of any cost or income for the purpose of section 40A(2), 80A,80-IA, 10AA, etc. by Finance Act, 2012.  The Transfer Pricing provision for domestic transaction exists in many countries, e.g., US. UK. China, Indonesia, Netherlands with exceptions like Australia, Japan, etc.  However,such provisions are generally made applicable in situations where there is perceptible risk of tax evasion.

10. INTRODUCTION 10  Countries like UK provide mechanism of set off to other party in case Transfer Pricing adjustment results in double taxation.  No corresponding adjustment in Indian TP regulation

11. 11 SPECIFIED DOMESTIC TRANSACTIONS

12. 12  Specified domestic transactions are defined in section 92BA any of the following transactions, not being an international transaction, namely:— ( i ) any expenditure for which payment made or to be made to a person covered u/s 40(A)(2)(b) ( ii ) any transfer of goods and services between eligible units and non eligible unit of two associate of an undertaking- 80(IA)(8) (iii) Any business transaction with entities having close connection – 80 (IA)(10) (iv) Any transaction referred in sections 80A,80-IA, 10AA, etc. to which sub sections(8) /(10) of section 80(IA) applies. (iv) Any other transaction as may be specified.

13. SPECIFIED DOMESTIC TRANSACTIONS 13  Scope of TP provision extended to also include Specified Domestic Transactions:  Expenditure for which payment is made or to be made to domestic related parties:  Tax Holiday / Deductions claimed by the assessee  Transfer of goods or services between various businesses of same assessee  More than ordinary profits derived from transactions with closely connected persons

14. SPECIFIED DOMESTIC TRANSACTIONS 14  Sub-section (2A) inserted in section 92 providing that “any allowance for an expenditure or interest or allocation of any cost or expense or any income in relation to the specified domestic transaction shall be computed having regard to the arm’s length price”.  Determination of arm’s length price of each of the specified domestic transaction would have to be made qua the respective provisions,eg. 40A(2), 10AA, 80A, 80IA, etc.

15. SPECIFIED DOMESTIC TRANSACTIONS 15  In respect of Specified Domestic Transaction, an allowance for an expenditure or allocation of any cost or expense or income shall be computed as per ALP and however, no computation shall be made which result in reducing income or increasing loss. Sec 92(2A) or 92(3)

16. SPECIFIED DOMESTIC TRANSACTIONS 16  Domestic Transfer Pricing is applicable only where value of Specified Domestic Transactions crosses 5 Crs  While computing the aggregate value of transactions:  Value of the International transactions to be excluded  Value of transactions between 2 units of the same company to be covered (when undertaken with a tax holiday unit)  Inter-company transactions to be covered (when undertaken with a company having a tax holiday unit)

17. SPECIFIED DOMESTIC TRANSACTIONS 17 Aggregate Value of transaction below INR 5 Cr Subject to existing tax laws Fair Market Value- initial onus on the AO Aggregate Value of SDT above INR 5 Cr Subject to Domestic Transfer Pricing regulations Arms Length Price- initial onus on the Assessee

18. 18 CONCEPT OF ALP

19. 19 Domestic Transactions  Goods  Services  Intangibles  Loans Resident CONCEPT OF ARMS LENGTH PRICE Resident Independent enterprise Related Party  Arm’s length price means a price which is applied or proposed to be applied in a transaction in uncontrolled conditions between persons other than AEs [Section 92F(ii)].

20. CONCEPT OF ARMS LENGTH PRICE 20  Arm’s length price is determined using the most appropriate method (Sec 92C): MethodsApplicabilityComparability Comparable Uncontrolled Price Method Price of identical good/services sold/purchased between two unrelated parties or between related party and third party is available ‘Price’ of the transactions. Direct method – strict comparability required Cost Plus Method Where there is transfer of semi finished goods between related parties or in case of services ‘Gross profit margin’ on direct/indirect cost of production/service

21. CONCEPT OF ARMS LENGTH PRICE 21 MethodsApplicabilityComparability Resale Price Method Where an enterprise purchases goods or services from a related party and sells them to unrelated parties without value addition ‘Gross profit margin’ of company reselling products/services to unrelated parties. Profit Split Method In case of transfer of unique intangibles or in multiple inter- related transactions which cannot be evaluated separately ‘Split profits’ between parties to transactions based on economic parameters. Transactional Net Margin Method Residual method. Applies where reliable comparable data with broad functional similarity is available ‘Net Profit Margin’ (Operating Profit) of ‘Tested Party’ Other Method (Rule 10AB) Where the price which would be charged for similar transaction between unrelated parties is available () Price charged vs. price would be charged - valuation reports, stock or commodity indices independent price quotations, etc.

22. FMV vs. ALP 22 ParticularsFMVALP DefinitionThe price which goods or services would have fetched or cost in the open market A price which is applied in a transaction in uncontrolled conditions Computation mechanism No specific mechanism provided in law Most appropriate method out of six prescribed methods Transaction valueAny market pricing point can be treated as fair market value Arithmetic mean of comparable prices treated as ALP (except CUP) Sample sizeOne comparable may be sufficient to establish fair market value Requires bigger sample size for establishing arms length (except CUP) DeviationNo deviation permitted from FMV Deviation of +/- 3% permitted

23. 23 SECTION 40A

24.  Expenditure – Payment to related parties listed in Section 40A(2)(b)  The disallowance under section 40A(2) of the Act only after a finding is recorded by the assessing officer that the expenditure was excessive or unreasonable having regard to (i) the tax market value of goods or services; (ii) the legitimate business needs; (iii) benefit derived by or accruing to the assessee.  The onus was on the assessing officer to find out the fair market value of goods and services and to bring on record comparable instances – onus now shifted on the assessee 24 APPLICABILITY OF SECTION 40A

25. 25  The Central Board of Direct Taxes vide Circular No.6-P dated 6.7.1968 elaborated the scope of section 40A(2) of the Act in the following terms: “The Income-tax Officer is expected to exercise his judgment in a reasonable and fair manner. It should be borne in mind that the provision is meant 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.”  The Courts in a string of decisions have held section 40A(2) inapplicable on account of revenue neutrality.

26. APPLICABILITY OF SECTION 40A 26  The Supreme Court in the case of CIT vs. GlaxoSmithKline Asia Pvt. Ltd. (SLP No. 18121/25007), while examining the issue of application of section 40A(2) held that “no inference is called for as the entire exercise is revenue neutral exercise”.  TP provisions don’t provide for a corosponding adjustment -w.r.t. the specified domestic transaction, revenue neutrality no longer a relevant consideration.

27. APPLICABILITY OF SECTION 40A 27  Common transactions:  Buying of goods or semi - finished goods  Procurement of Services  Job work charges  Interest or royalty payments  Salary, Training & Marketing  Director’s Remuneration  Group Charges or sharing of costs  Rent  For 40A (2), only expenditure is to be benchmarked qua the payer

28. APPLICABILITY OF SECTION 40A 28 PayerReceiver of Payment Individual Relative of individual [S 40A(2)(b)(i)] Company / Firm Director of company or relative of the director Partner or his relative [S 40A(2)(b)(ii)] AoP/HUF Member of AoP/HUF or his relative [S 40A(2)(b)(ii)] Any Individual Payment to any individual who has substantial interest or his relative [S 40A(2)(b)(iii)]

29. SECTION 40A(2)(b) Director or any relative of Director – Section 40A(2)(b)(ii) Relative: in relation to an individual, means the husband, wife, brother or sister or any lineal ascendant or descendant of that individual Mr. AMr. BMr. C XYZ Director/Part ner 29

30. Substantial interest > 20% SECTION 40A(2)(b) To an individual who has substantial interest in the business of XYZ Ltd or relative of such individual - Section 40A(2)(b)(iii) Mr. AMr. BMr. C XYZ 30

31. SECTION 40A(2)(b) To a Company having substantial interest in the business of XYZ Ltd. or Director of such company or any relative of Director – Section 40A(2)(b)(iv) Mr. B Mr. C A Ltd. XYZ 31

32. Any other Company carrying on business in which the first mentioned company has substantial interest – Section 40A(2)(b)(iv) B Ltd. C Ltd. XYZ A Ltd. Substantial interest > 20% SECTION 40A(2)(b) 32

33. To a company of which director has substantial interest in the business of XYZ Ltd. or any other director of such company or relative of director – Section 40A(2)(b)(v) Mr. B A Ltd. XYZ Mr. CMr. D Director Relative Substantial interest > 20% SECTION 40A(2)(b) 33

34. To a company in which XYZ Ltd. has substantial interest in the business of the company – Section 40A(2)(b)(vi) XYZ Ltd B Ltd Substantial interest > 20% SECTION 40A(2)(b) 34

35. Any director or relative of a director of XYZ Ltd having substantial interest in that person – Section 40A(2)(b)(vi) Mr. CMr. B D Ltd XYZ A Ltd Substantial Interest > 20% Director Substantial Interest > 20% Relative SECTION 40A(2)(b) 35

36. 36  Whether Transfer Pricing provisions apply to any expenditure paid to a person specified in section 40A(2b), whether claimed as deduction or not?  Whether it include capital expenditure?  Judicial precedents - capital expenditure eligible for depreciation are not covered under section 40A(2)- depreciation is not a deduction but an allowance.  ICAI Guidance Note- SDT provisions are applicable to expenditures which are capital in nature and ranking for 100% deduction under provisions such as section 35(2AB), 35 or 35AD. SECTION 40A(2)(b) - Issues

37. 37  Whether indirect shareholding is covered?  Revised ICAI Guidance Note - consideration of only direct shareholding and emphasis on the real owner of the shares rather than the nominal owner.  Whether shareholding of individual directors can be aggregated for determining substantial interest? -No  Whether discounts given to related parties covered? - No SECTION 40A(2)(b) - Issues

38. EXAMPLES 38 TransactionBenchmarking Rent paid CUP method can be applied by comparing rent for similar property Chartered Engineers certificate or fair market value - other method Interest on loan Interest rates charged by Indian banks – SBI base rate Purchase of goods CUP data wherever applicable, RPM/TNMM may also be applied Commission or brokerage CUP/TNMM may be applied. Difficult to find comparable uncontrolled transaction. Royalty CUP or TNMM may be applied. Difficult to find comparable uncontrolled transaction – data bases may be referred Fees for professional services or fees for technical services or management services. CUP or TNMM may be applied. Difficult to find comparable uncontrolled transaction.

39. EXAMPLES 39 TransactionBenchmarking Remuneration to director, key management personnel Option 1: Ceilings provided in Companies Act, Listing agreement norms, Shareholder and Board of Director resolutions, Remuneration Committee approvals Limitation: Not applicable to private limited companies Upper ceilings can be challenged by Revenue Delhi High Court in the case of CIT vs. India Thermit Corporation - commission paid to the Managing Director/Director in accordance with the provisions of the Companies Act, cannot be challenged by the revenue authorities. Rule 10B(2)(d) – laws and Government order in force – to be taken into account for applying Transfer Pricing method.- ITAT decisions in the context of royalty.

40. EXAMPLES 40 TransactionBenchmarking Remuneration to director, key management personnel Option 2: Remuneration to director may be compared with remuneration paid by comparable companies. Limitation: Could be unreliable and difficult to obtain May lead to cherry-picking Option 3: Peer review Limitation: Availability of reliable data may be a constraint Option 4: Salary drawn elsewhere, simultaneously or previously Limitation: Generally not available for promoter directors

41. EXAMPLES 41 TransactionBenchmarking Remuneration to director, key management personnel Option 5: Comparison of ratio of Director’s remuneration to Total Cost (or Sales) with similar ratio for comparable companies Limitation: No emphasis on individual capabilities of a Director Limited comparable information on databases Requires high degree of comparability with selected companies No known correlation between remuneration and sales / cost of a company

42. EXAMPLES 42 TransactionBenchmarking Remuneration to director, key management personnel Option 6: Subsumed under overall net profit based approach (TNMM) Limitation: Cannot be applied for loss making companies Approach likely to be challenged by Revenue Option 7: Qualitative analysis of educational qualifications, work experience, etc. Limitation: Can only be used for corroborative analysis

43. 43 SECTION 80IA/IB/IC/ID/ID/10AA

44. SECTION 10AA/80IA/80IB/80IC/80ID 44 SECTIONNATURE OF UNDERTAKING 10AA Undertakings having a Special Economic Zone unit 80IA Undertakings engaged in Developing, operating and maintaining, developing and operating and maintaining infrastructure facilities Generation/ transmission or distribution of power Reconstruction/ revival of power generating plants 80IB Undertakings located/ engaged in Industrially backward districts as notified; Scientific research & development Refining of mineral oil/ commercial production of natural gas Operating cold chain facility for agricultural produce Processing, preservation and packing of meat/ meat products or poultry/ marine/ dairy products Operating and maintaining a hospital of specified capacity

45. SECTION 10AA/80IA/80IB/80IC/80ID 45 SECTIONNATURE OF UNDERTAKING 80IC Undertaking located in notified Centre/ Parks/ Areas in Sikkim Himachal Pradesh/ Uttaranchal North- Eastern states 80ID Undertaking engaged in business of hotel/ convention centre in specified areas/ districts

46. SECTION 80IA(8) 46 A Ltd. Unit B Manufacturing Business Unit A Telecom Business 80IA-Eligible Unit Taxable Unit

47. SECTION 80IA(10) 47 B Ltd. Trading Business A Ltd. Infrastructure Business 80IA-Eligible UnitTaxable Unit

48. SAMPLE TRANSACTION AND ISSUES 48 TransactionBenchmarking Allocation of corporate costs and overheads for computation of tax holiday Imperative to use appropriate allocation keys Use of ad hoc allocation keys may be questioned Transfer of semi- finished goods between domestic units and tax holiday units Valuation of transfers between business units Excise law provides valuation based on market price followed by 110% of cost of production based on Cost Accounting Standard 4 (CAS-4) Capital transactions including transfer of machinery, technology, etc. As per Foreign Trade Policy/ SEZ Regulations, transfer of used capital assets to be carried out at Written Down Value arrived at after provision of depreciation at prescribed rates.

49. SECTION 80IA(8) & (10) - ISSUES 49  Issues in claiming corresponding credit when both units are eligible for tax holiday.  Whether current year losses required to be set off against future tax holiday profits?  The term “Close Connection“ not defined and subject to litigation  Whether the term “more than ordinary profit” can be equated with ALP?  Burden of proving the ‘close connection’ between the assessee and the other party is on TPO?

50. CLOSE CONNECTION 50 ParticularsSubstantial interest - section 40A(2)(b) Associated enterprise - section 92A(2) Related party as per AS – 18 as issued by ICAI Voting power>= 20%>= 26%>50% Direct or indirect Holding covered No (with exception) Both Directors coveredcovered Key managerial personnel covered Key suppliers covered Not coveredSupplying more than 90% Specifically excluded

51. 51 CASE STUDIES

52. B Ltd. A Ltd.C Ltd. D Ltd. ITES -Distribution of Pharma products INDIA 100% 25% -Mfg of Raw material -10AA Eligible Company Supply of raw material -Brand owner Manufacturer of Pharma Products Royalty Payment OUTSIDE INDIA IT Enabled Services CASE STUDY 1 52

53. B Ltd. C Ltd. D Ltd. E Ltd. A Ltd. Interest Free Loan -Loan @ 18% Interest -ALP 11% - Foreign Company - Indian Company -Non Eligible Company - Indian Company -10AA Eligible Company - Indian Company -10AA Eligible Company - Indian Company -Non Eligible Company OUTSIDE INDIA INDIA CASE STUDY 2 53

54. A Ltd. Head Office Unit - 1Unit - 2Unit - 3Unit - 4 -Performs general management functions Third Party Rs.1200 per hour -Insurance business -SEZ -Back office support/ITES -10AA eligible -Insurance business Rs. 800 per hour -Telecom business Infrastructure business Rs. 900 per hour CASE STUDY 3 54

55. A Ltd.B Ltd. A Ltd.B Ltd. 25% 100% -Foreign co. -Indian co. -Software development -SEZ 10AA benefit -OP/OC 40% (TNMM) -Indian co. -Software development -SEZ 10AA benefit -OP/OC 40% (TNMM) -ALP 17% Payment based on cost + 20% to B Ltd. R & D Services Change in shareholding 01.10.2012 to 31.03.2013 (Close connection established) For the period of 01.04.2012 to 30.09.2012 CASE STUDY 4 55

56. 56 COMPLIANCE AND PENALTIES

57. DOCUMENTATION 57 Current Compliance Requirements Section 40A: Transactions to Be reported in Tax Audit Report in Form 3CD Section 80IA: Declaration of profit to be made in CA certificate in Form 10CCB Section 10AA: For claiming tax deduction, CA Certificate in Form 56F needs to be filed Additional Compliance Requirements Maintaining contemporaneous documentation as prescribed in Rule 10D and justify transaction to be at ALP Filing audit report in new Form 3CEB

58. DOCUMENTATION REQUIREMENTS 58 Documentation Requirement NATURE OF INFORMATION Clause of Rule 10D Group overview Entity Related (a), (b), (c), (d) Industry scenario Entity Related (c) Functional analysis Price Related (e) Terms of transaction Price Related (d), (g) Economic Analysis Price related (f),(g),(h),(i),(j),(k),(l),(m) Agreements Transaction Related (g) Invoice Transaction Related (g)

59. PENALTIES 59 It will be necessary to identify and map the transactions which will now be covered under the expanded scope of transfer pricing regulations The taxpayers need to ensure that such identified transactions are analyzed so as to comply with the Arm’s Length Principle based on the application of the most appropriate method adequately supported by a robust economic analysis Nature of DefaultNature of penalty Failure to maintain documentation 2% of the value of each international transaction or specified domestic transaction Failure to furnish documents 2% of the value of each international transaction or specified domestic transaction Failure to report a transaction in accountants report 2% of the value of each international transaction or specified domestic transaction Maintaining or furnishing incorrect information or documents 2% of the value of each international transaction or specified domestic transaction

60. OTHER ISSUES 60  APA provisions not applicable to Specified Domestic Transactions.  Whether safe harbor rules would be applicable on SDT?- No  Whether DRP route would be applicable in case there is addition only on account of SDT? - Yes.  The considerations for ALP introduced under the companies Act: - The method for determining ALP not provided, methods under the IT Act could be applied. - The transactions with related parties of income as well as expense to be taken in account. - The definition of related parties under the Companies Act to be taken in to account.

61. SDT - Impact 61 Expenses Expenses paid by domestic companies to related parties will be challenged Corresponding adjustment not permitted for disallowed expenses; will lead to double taxation. Transaction within company Company with multiple units and claiming tax holiday will be questioned on inter unit transfers. Authorities will attempt to reduce profitability of exempted unit for reducing the quantum of deduction. Tax Holiday Companies declaring ‘More than ordinary Profits’ for tax holiday units will loose excessive income-tax benefits. Shift of Approach Approach will shift from generic ‘Fair Market Value’ concept of ‘Arm’s Length Price’. Compliance Heavy compliance burden of maintaining: - Transfer pricing documentation and - Reporting of transactions (Form 3CEB) AssessmentAssessment / audit by specialized cell of TPO

62. 62 Thank You NEERAJ K. JAIN PARTNER, VAISH ASSOCIATES ADVOCATES