“Overview of Transfer Pricing”

CA T. P. OSTWAL

INSTITUTE OF CHARTERD ACCOUNTANTS OF INDIA

WEBCAST –

Brief history Post World War I

What is Transfer Pricing?

Basic Issues Underlying Transfer Pricing

Evolution of Transfer Pricing

Concepts in Transfer Pricing

Transfer Pricing Methods

Special Issues Related to Transfer Pricing

Transfer Pricing in Treaties

Transfer Pricing in Domestic Law

Global Transfer Pricing Regimes

Transfer Pricing as a Current and Future Issue for Developing Countries

Indian Regulation on Transfer Pricing

TRANSFER PRICING

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Brief history Post World War I

Where and why did the OECD/UN model treaty policy arise as it has?

In 1920-1923, the ICC commenced a process to develop a model income tax treaty in the immediate aftermath of World War I. This was the period of conception for the model treaties of today. This work has been lost as the world has evolved. It is instructive with respect to the current tax policies being espoused by Source Countries.

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The Post-World War I World (1920 – 1923)

Imagine a world, long ago, in which the paradigm of commerce and international taxation was a developed country (let’s call it “England”) and an under-developed country that was a colony of England (“India”). A global war ended, with England having enormous war debt. There was a material flow of commerce between England and India. For the most part, England transferred to affiliates in India capital, technology, and access to global markets. India responded with commodities and produced goods. England was a creditor and India a debtor.

 

The policy issue for consideration was how income from these activities should be shared between “Resident” and “Source” countries.

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ICC Proposal in 1923

In its interim report in 1923, the ICC proposed what we would call today a profit split or formulary allocation methodology to address income allocation between Residence (Creditor) and Source (Debtor) countries.

Rather close to the combined income methodologies that we typically use today to resolve major CA cases between countries with an MNE in the middle. Frankly, it is also similar to the methodologies for evaluating intangibles in the 2012 OECD discussion draft.

League of Nations (1923 – 1928)

The ICC work was taken over by the League of Nations in 1923. The LofN took an entirely different approach. It formulated 5 principles:

 

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League of Nations (1923 – 1928) cont…

1. Source Country (India) should tax local operations, including property or other pertinent matters.

2. Residual income should be earned by the country of Residence, which provided the knowledge and capital for the business.

3. Presence of an interim holding company should be treated as a Residence Country. Why was this assumed?: All countries would adopt a common model!

4. Subsidiaries should not be treated as a PE.

5. TP is to be evaluated on a consistent basis.

The model treaties that eventually became the OECD Model, and subsequently the UN Model, are based on these 5 principles. October 2013

What was the net impact of these principles?

Answer: A system that allowed:

1.Source Country earns a routine return.

2.Residence Country receives the residual income.

3.Interim holding companies would be treated as Residence Countries, even if located in a low tax country.

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MNE Tax Planning Strategies

Not surprisingly, the international tax and effective tax rate (“ETR”) strategies of MNEs evolved based on this treaty model. Common structures included what we today describe as:

1.Global/regional principal

2.Centralized risk-taker, intangibles owner

3.Limited risk activities in high tax countries

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Effective Tax Rates (‘ETR‘) strategies are often based on easily applied one-sided TP methodologies, which typically test the earnings of Source Country affiliates.

These strategies are precisely what was contemplated in the work of the LofN, which is the model of OECD/UN model treaties.

 

Today, MNEs are commonly pilloried for base stripping Source Countries.

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Imperial Paradigm

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Luxembourg

Cayman Island

Interest transfer payments

Royalty transfer payments

Developing Countries

Costa Rica

Supply Chain Transaction

Divide

nd

Bermuda

BVI

Lease transfer payments

Intermediate Holding Company

Present Day ScenarioForeign Parents

Capital Gain

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& many more…

ANATOMY OF INCOME SHIFTING(BASE EROSION)

Tax Havens

Is the criticism appropriate? Whether this answer is “yes” or “no,” it is apparent to me that this is the behavior that was encouraged by the LofN model. At the time, it may have been intended to facilitate repatriation of revenue to Residence countries to repay war debts.

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What is Transfer Pricing?

Rise to a large number of multinational enterprises (MNEs) Rise of intra group trade – including highly complex

international transactions involving intangibles and multi-tiered services

MNE transaction structure determined not only by open market but also by group driven forces inclined towards the common interests of the entities of a group

Determination of transfer price becomes imperative Transfer price to be determined on arms length basis Transfer pricing therefore refers to the setting of prices (arms

length price) for transactions between associated enterprises the transfer of property or services

Introduction to Transfer Pricing

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Concept of transfer pricing – Example 1

ABCH Co

ABC S Co

XYZ

Country A

Country B

Purchase of computer from S Co “Controlled Transaction”

Purchase of computer from third party“Uncontrolled Transaction”

Transfer price of controlled transaction to be equivalent to market price of a comparable uncontrolled transaction; If lower, Country B loses revenue.

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Concept of transfer pricing – Example 2

PQRH Co

PQR S Co

Country A

Country B

Customers

Illustration:

PQR S Co is the distributor of PQR H Co’s watches in Country B

Manufacturing Cost to Hco. $1400Distribution Cost to SCo. $100Transfer price $1500 Sale price in Country B $1600H Co Profit $100S Co Profit NIL (Cost =Revenue)Tax authorities of Country B insists that S Co

should atleast report a profit of $100; thus transfer price to be reduced to $1,400 – Leads to economic double taxation.

Pricing multiple transactions with associated entities in different tax jurisdictions

Measurement of performance of the individual entities in a MNE

MNE intra-group transactions are undertaken only of its profitable

Identifying and valuing intangibles transferred and services provided

Transfer price of non-accounted intangibles

Transfer price of intra department transactions

Transfer Pricing and Business Enterprises

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Cross border tax situations involve issues related to jurisdiction, allocation of income and valuation.

A MNE Group may exploit the opportunity to shrink the overall tax burden of the group through either under-charging or over-charging the associated entity for intra-group trade: Illustration:

Tax rate in the resident country A of HCo. 30% Tax rate in the resident country B of SCo. 20% HCo shifts profits from Country A to Country B through HCo. being over-charged for the

acquisition of property and services from SCo. A group may transfer the tax loss of an associated enterprise in a jurisdiction

where losses cannot be carried forward beyond the prescribed time limit to a jurisdiction without such restrictions so as to fully utilize the same.

In some cases loss may be transferred to take the benefit of deductions as quickly as possible.

Evidently profits may sometimes be shifted to certain countries in order to obtain specific tax benefits.

Reduction of taxation not the only factor contributing to the transfer pricing policies and practices of a MNE Group

Basic issues underlying Transfer Pricing

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The key issues in jurisdiction: Which country should tax the income of the group entities engaged in the

transaction? What happens if both countries claim the right to tax the same income? If the tax base arises in more than one country, should one of the country’s

give tax relief to prevent double taxation of the relevant entities’ income, and if so, which one?

What needs to be done to minimise profit shifting from one country to another?

The key issues in valuation:

Valuation of intra-group transfers that are prone to manipulations

With the MNE being an integrated structure with the ability to exploit international differentials and to utilise economies of integration not available to a stand- alone entity, transfer prices within the group are unlikely to be the same prices that unrelated parties would negotiate

Basic issues underlying Transfer Pricing

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The key issues in allocation of income: MNE’s

Optimal allocation of common resources and overheads and achieve competitive advantage

Reduction of transaction cost

Government Expand tax base

Basic issues underlying Transfer Pricing

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Transfer pricing rules are essential for countries (for Tax administration and Tax Payers) in order to

- Protect their tax base;

- Eliminate double taxation ; and

- Enhance cross border trade

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Evolution of Transfer Pricing• US

• First country to adopt a comprehensive transfer pricing legislation in 1968.

• OECD • Reports on transfer pricing in 1979 and 1984

• issued the TP Guidelines in 1995 as amended by 2010 version

•United Nations (UN) • Report on “International Income Taxation and Developing Countries” in 1988.

• The UN Conference on Trade and Development (UNCTAD) also issued a major report on Transfer Pricing in 1999.

• The United Nations (UN) is again taking a leadership role, through its Transfer Pricing Manual, in trying to arrive at updated global transfer pricing guidance which can be used by countries all over the world in developing (or calibrating) their transfer pricing regulations.

•European Commission (EC) • Proposals on income allocation to EC members of MNEs

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Concepts in Transfer Pricing

• Transactions with related parties must be based on the “arm’s length principle” (ALP)

• Arm’s length principle” (ALP)

• Origins in Contract law

• to arrange an equitable agreement that will stand up to legal scrutiny, even

though the parties involved may have shared interests.

• Not specifically used in Article 9 of both OECD MTC and UN MTC. However it is

well accepted by countries as encapsulating the approach taken in Article 9 with

some differing interpretations.

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Concepts in Transfer Pricing (contd)...

• Using the arm's length principle

• Argument in favour

• Geographically neutral, as it treats profits from investments in a similar

manner

• An alternative to the arm’s length principle

• Global Formulary Apportionment method

• Currently used by

• Some states of USA,

• Cantons of Switzerland and

• Provinces of Canada.

• EU is also considering a formulary approach - Common Consolidated

Corporate Tax Base (CCCTB) and home state taxation

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Special Issues Related to Transfer Pricing1. Intangibles

• Trade intangibles

• such as know-how relate to (production of goods and the provision of

services)

• Marketing intangibles (aid in the commercial exploitation of a product or service)

• Trade names,

• Trademarks and

• Client lists

2. Intra-group services

- Financial Services (guarantee fees, etc.)

- Managerial,

- legal,

- accounting and finance,

- credit and collection,

- training and personnel management services.

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Special Issues Related to Transfer Pricing

3. Cost – Contribution Agreements

• Jointly develop, produce or obtain rights, assets or services.

4. Use of “secret comparables”

Transfer Pricing in Domestic Law

Time limitations

For TP adjustments possible India vis a vis other countries

May lead to double taxation

Safe harbours

Dispute Prevention Measure

Advance Pricing Agreements

Transfer Pricing and / or Controlled foreign corporation provisions

If both applicable – Then first preference to be given to which provisions

If only TP is applicable, whether bringingCFC is necessary – as both are anti avoidance provisions.

Necessity of domestic transfer pricing rules.

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• Corresponding adjustments - To avoid economic double taxation eg. Section 482 of Under Section 482 of the Internal Revenue Code (IRC) of U.S

• Transfer pricing dispute resolution mechanism • Mutual Agreement Procedure (MAP) – in Article 25.

• Arbitration to resolve transfer pricing disputes. • The EU Arbitration Convention

Transfer Pricing in Treaties

By the end of 2011 there were around 100 countries with some form of specific transfer pricing legislation as shown by the red shading in the diagram below

Global Transfer Pricing Regimes

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Countries where Transfer Pricing Regulations are in existenceArgentina Australia Austria Belgium BrazilCanada Chile China Colombia CroatiaCzech Republic Denmark Dominican Republic Ecuador EgyptEstonia Finland France Germany Hong Kong Hungary India Indonesia Ireland IsraelItaly Japan Kenya Korea, North Korea, SouthLatvia Lithuania Luxembourg Malaysia MexicoNamibia Netherlands New Zealand Norway OmanPanama Peru Philippines Poland PortugalRomania Russia Singapore Slovakia SloveniaSouth Africa Spain Sweden Switzerland TaiwanThailand Turkey United Kingdom United States UruguayVenezuela Vietnam

Countries where Transfer Pricing Regulations is still emergingAlgeria Angola Armenia Aruba BangladeshBelarus Bolivia Botswana Bulgaria Burkina FasoCambodia Cote d'Ivoire Cyprus El Salvador EthiopiaGambia Georgia Ghana Greenland IcelandKazakhstan Kuwait Liberia Libya MacedoniaMalawi Mali Mauritania Mauritius MongoliaMorocco Mozambique Netherlands Antilles Nicargua NigeriaPakistan Papua New Guniea Qatar Senegal Sierra Leone

Sri lanka Trinidad and Tobago Ukraine Uzbekistan ZambiaZimbabwe

Global Transfer Pricing Regimes ….(contd)

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Specific challenges – Developing Countries face in dealing effectively with Transfer Pricing Issues

• Lack of comparables

• Lack of knowledge and requisite skill-sets

• Complexity to administer

• Growth of the “E-commerce economy”- various ways in which transactions can be done

• Location savings

Part II. The Indian TP Regime

Indian TP provisions• Indian TP provisions were introduced under “Chapter

X : Special Provisions Relating to Avoidance of Tax”– Chapter X, Section 92 of the Income Tax Act (1961) and

Rule 10A-D of the Income Tax Rules (1962) – TP regime was introduced via Finance Bill 2001 w.e.f April

1st 2001. – In other words, India is a relatively new entrant into the

TP vortex!

• Birds-eye, one-line overview of Indian TP:– Run-of-the-mill TP provisions, OECD-lite and delightfully

vague (like most TP provisions)!

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Indian TP Provisions – Section 92

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Section & Rules

Provisions

92 Computation of income having regard to ALP

92A Meaning of Associated Enterprise

92B Meaning of International transaction92BA Meaning of specified domestic transactions

92C (1)(Rule 10B, 10C)

Methods of computation of ALP*Rule 10AB – Any other method for determination of ALP

92CA Reference to Transfer Pricing Officer (TPO)92CB Safe harbour rules

92CC Advance Pricing agreement92CD Effect of advance pricing agreement

92D (Rule 10D)

Maintenance of information and documents by persons entering into an international transaction or specified domestic transaction

92E(Rule 10E, Form 3CEB)

Accountant’s Report entering into an international transaction or specified domestic transaction

92F (Rule 10A) Definitions: Accountant, ALP, Enterprise, PE, Specified date, Transaction *

* Sec 92F – Definitions does not define terms relevant for domestic TP transactions

Transfer Pricing Penal provisions(a.k.a ‘rubbing salt into the wound’)

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Sr.No.

Type of penalty Section Penalty quantified

1 a) Failure to maintain prescribed information/ documents

271AA 2% of transaction value (b) Failure to report any such transaction or(c) Furnish incorrect information

2 Failure to furnish information/ documents during assessment u/s 92D

271G 2% of transaction value

3 Adjustment to taxpayer’s income during assessment

271(1)(c) 100% to 300% of tax on adjustment amount

4 Failure to furnish accountant’s report u/s 92E

271BA INR 100,000

Indian TP vs. OECD GuidelinesSnapshot view*

Concepts Indian regulations OECD Guidelines

Associated Enterprises Very wide definition Restricted to controlled entities

Comparable range (FY 2013)Allows 3% range band on avg. results of comparables

Allows for range of comparable data

Multiple year data Only allows data for current year (and earlier 2 years under limited circumstances)

Permitted

Foreign comparables Not permitted in practice Permitted

Priority of methods Most appropriate method rule (Originally) preference for traditional methods

Use of unspecified method Now specified Permitted

Documentation Stringent Prudent business principles

Intangibles definition vegue and unclear No guidelines

Defined and described but progress still not full achieved.

* Modified version of table in ‘Transfer pricing Law and Practice in India – a fine print analysis’October 2013

Indian TPAssessment &

Litigation

Commissioner of Income Tax (Appeals)

Assessing Officer (AO)

Transfer Pricing Officer (TPO)

Dispute Resolution panel (DRP)

Income Tax Appellate Tribunal (ITAT)

High Court

Supreme Court

TPO reference

TPO Order u/s 92CA(3)

Appeal againstCIT(A) order

Form 3CEB

Appeal againstAsst. order

Appeal againstDraft Asst. order

Appeal againstFinal Asst. Order

Set-aside / Remanded back to AO

Sept.2006

TPO: Dec. 2008

AO:Dec. 2009

May 2010

May 2011

2011+

2011+

FY 2005-06

Assessment timelineexample

T.P.Ostwal & Associates

Specified transaction U/S

92BA

Part III. Specified Domestic Transactions

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TP was earlier limited to ‘International Transactions’ The Finance Act 2012, extends the scope of TP provision to

‘Specified Domestic Transactions’ between related parties w.e.f. 1 April 2012

The Supreme Court in the case of CIT vs Glaxo Smithkline Asia Pvt Ltd [2010-195Taxman 35 (SC)] recommended introduction of domestic TP provisions

SDT previously reported/certified but onus was on revenue authorities

Obligation now on taxpayer to report/ document and substantiate the arm’s length nature of such SDT transactions

Shift from generic FMV concept to focused ALP concept These new provisions would have ramifications across

industries which benefit from the preferential tax policies such as SEZ units, infrastructure developers or operators, telecom services, industrial park developers, power generation or transmission etc. Apart from this, business conglomerates having significant domestic intra-

group transactions would be largely impacted

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SDT

Inter unit transfer of goods & services by

undertakings to which profit-linked deductions

apply

Expenditure

incurred

between

related

parties

defined

under

section 40A

Transactions between undertakings, to which

profit-linked deductions apply, having close

connection

Any other

transaction

that may be

specified

Overview of Provisions of Section 92BA

THANK YOU

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