Volume 5, Issue 31

19th February, 2013

Tax Alert
Changing face of Transfer Pricing Audits in India


Transfer Pricing (TP) issues have been one of the most contentious issues faced by multi national corporations (MNCs) and governments of the world alike. Various surveys put transfer pricing as the number one concern for CFOs of MNCs operating in multiple jurisdictions and at the same time it has been one of the major areas of focus by Governments across the world. India too has seen a sharp increase in disputes relating to transfer pricing, with the tax authorities adopting an aggressive stand while arriving at arm’s length price for the transaction. Recent round of completed TP audits saw the Government raising claims of about approx. USD 10-12 billion.

Over a period of time, TP challenges faced by multinational enterprises operating in India have undergone a sea change. In the initial years of TP audit, controversies arose over fundamental issues such as time period (single vs. multiple year data) for comparability analysis, choice of TP methodology, application of + 5% range, filters for selecting comparables and other procedural matters. Today, although some of these issues are nearing settlement through rulings of appellate bodies and courts and a few through retrospective amendments in the provisions itself, newer, more complex challenges are emerging for taxpayers.

This document highlights major issues faced by taxpayers and emerging areas of focus of Indian tax authorities on the transfer pricing front.

Issue of shares by Indian entity to its associated enterprise (AE):

In recent weeks, several controversial transfer pricing tax assessments have hit the headlines. Many of these orders are on a new item - subscription of shares. These orders are raised on the grounds that the foreign entity subscribed to shares of its Indian arm at prices much lower than the market price or fair price. It is in the calculation of the market price of unlisted shares that the tax department is taking recourse to Discounted Cash Flow (DCF) Methodology which is very subjective on growth projections and various assumptions providing an opportunity to tax authorities to challenge the valuation done by the company.

While Shell and Vodafone are in the news, with adjustments of INR 152 billion & INR 13 billion respectively, it is believed that such adjustments have been made in a number of other companies also. In Shell’s case, the independent valuation of INR 7 per share was stretched to INR 183 per share by tax authorities while in case of Vodafone, a valuation of INR 8,000 per share was increased to INR 50,000 per share.

While, it is not yet known as to how such adjustment would be sustained as in any case it is a capital receipt not subject to tax, however, given the above scenario, valuation of shares is an emerging area of focus and taxpayers need to tread with care while entering into such transactions. Another case in example was that of M/s Ascendas where the Indian company had sold shares to its Associate Enterprise (AE). Here too, the tax authorities alleged an undervaluation of shares and adopted DCF method to make an adjustment of INR 2.4 billion, which was principally upheld by the Income Tax Appellate Tribunal (ITAT). Hence, now it is imperative for taxpayers to have a proper valuation and create robust justification and documentation to support the valuation.

Financial transactions:

Adjustments on account of financial transactions have mainly hit the Indian corporates. Indian companies’ outbound structures have gone awry in view of aggressive approach of the tax authorities on financial transactions such as inter-company loans, guarantees and letter of comforts. If Indian companies thought that insisting on charging of interest on loans given to fund subsidiary’s working capital or even to fund the acquisitions of the group was the only issue, they were in for rude shock when tax authorities ignored pleas of considering London Interbank Offered Rate (LIBOR) as the rate for making adjustments for interest. Despite several ITAT rulings approving LIBOR as the base rate, the tax authorities are making adjustments based on Indian Prime Lending rate of 12-16%. Similarly, notional guarantee fees have been added / charged in cases where guarantees / letters of comfort etc. are being issued by Indian entities to lenders of overseas subsidiaries / group companies. The guarantee fees adjusted ranges from 3%-12% of the guarantee amount.

Overdue receivables:

Another issue under the spot light is that of notional interest being added to income in cases of delayed receipts on account of trade transactions from group companies. In respect of international transactions where goods are sold / services are rendered to AEs, tax authorities are thoroughly scrutinizing the credit period allowed to AEs vis-à-vis third party customers and the actual receipts of the sales proceeds. In case of delay in receipt of payments from related parties, an interest adjustment is made on such overdue receivables at a rate of 12%-16%.

Marketing intangibles:

Another issue that has started receiving significant attention during recent TP assessments is marketing intangibles. The tax authorities have examined the marketing activities and spend of Indian subsidiaries in the local market and based on this alone, it is alleged by the tax authorities that the Indian subsidiaries are developing intangibles that are legally owned by their AEs. Tax authorities have imputed a cost reimbursement with mark-up to be received by the Indian entity for such activities / spend. The recent Special Bench (SB) ruling in case of LG India which has confirmed the action of lower tax authorities by adjudicating that the additional spend on marketing efforts results in rendition of services to its AEs has vindicated the position adopted by the tax authorities and they have adopted a more aggressive approach in the recent round of assessments. This becomes a very important area of concern for MNCs setting up their business in India where penetration into the market is achieved by advertisements and marketing efforts. Selection of comparable companies, understanding the products of the comparables, their life cycle, industry etc. and analysing their own & comparable companies AMP expenses, would help companies face this emerging challenge.

Royalty & Management Fees payments:

The payment of royalty for the use of intellectual property such as trademarks, know-how, brand names etc. is also a significant focus area of the tax authorities. In many cases, the authorities have rejected the taxpayer’s analysis and disallowed payments for use / transfer of intellectual property. The arguments put forward are that the taxpayers have failed to justify the need for sourcing such intellectual property and its actual receipt, appropriate documentation evaluating and describing such intellectual property, fulfilment of the benefit test by the Indian entity and its quantification, whether the royalty is embedded in the import price of goods etc. The only answer to satisfy the above criteria is to maintain a robust and comprehensive documentation. Similar is the fate of payment of “Management Fees” or “Corporate fees” to the group “Head Office” for support services. Extensive documentation is sought by the tax authorities to justify the management fees paid by the Indian entity. The quality as well as adequacy of documentation is thoroughly examined by the tax authorities and they are scrutinising in great details corresponding economic benefit, and often disallowing the payment on the ground that it is merely a profit extraction tool.

Benchmark margins:

In case of various captive service providers, the tax authorities have denied adjustments on account of risk differentials, differences on account of working capital etc. In many cases the comparable companies selected by the taxpayer are rejected and a set of cherry-picked high margin companies is applied instead. In fact, the search process adopted by taxpayers has also been rejected in a majority of cases, and margins of around 25-35% on costs (for software and ITES companies) have been used as benchmarks. Similar approach is adopted for knowledge process outsourcing (KPOs) (mark-up in the range of 40%-50%), captive research & development units (mark-up in the range of 35%-45%), captive investment advisory services (mark-up in the range of 40%-50% and in a few cases, as high as 80%).

Way Forward:

Given this approach of the tax authorities, it is clear that transfer pricing is the major worry of MNCs – both Foreign & Indian - in their expansion and growth plans and strategies. The most dangerous and damaging aspect of transfer pricing adjustments is the resultant double taxation for the group.

The key to mitigate this risk is formulating a proper pricing policy before or along the time of entering into the transaction rather than doing a “post mortem” at the year end. Another important key for success is a robust documentation evidencing the facts of a transaction coupled with in depth economic analysis and underlying commercial rationale for the transaction. Also, a good transfer pricing documentation is one which is maintained on an “as and when” basis. In other words, the documentation must be maintained at the very moment when the transaction takes place i.e. it must be contemporaneous.
Apart from above, MNCs should explore the recently introduced Advanced Pricing Agreements (APA) to bring certainty and avoid double taxation.

Lastly, these trends in transfer pricing are also a major worry for Indian corporate groups undertaking related party transactions within India itself, with the extension of transfer pricing regulations to specified domestic related party transactions. The Indian corporate groups must now act quickly to assess their inter-company transactions and put in place appropriate and justifiable transfer pricing policy and also maintain robust documentation.