Basics of Transfer Pricing National Convention -Bangalore Page 1

Basics of Transfer Pricing - Manesh Kumar Gupta The theory of Transfer Pricing The globalisation and liberalisation of the modern world has led to increase in cross-border transactions and emergence of multinational enterprises which have the suppleness to place their enterprise and activities anywhere in the world. In this context, the area of international taxation particularly Transfer Pricing has assumed significant importance. United Nation practical manual on Transfer Pricing defines Transfer Pricing as the setting of prices for transactions between associated enterprises involving transfer of property and services. Therefore when supply of goods, services or finance is made to another related / associated company, the negotiated price is called Transfer Price. From the perspective of a taxing jurisdiction, Transfer Pricing is of considerable importance since it influences the taxable income of an enterprise and therefore the tax base of that jurisdiction. An important dimension to the whole concept is the potential of an MNE to substantially reduce its tax bill by the use of tax arbitrage that stems from differential tax rates in various taxing jurisdictions. The Ar ’s le gth o ept The a s le gth p i iple e ui es that the p i i g of a y i te o pa y t a sa tio is o pa a le to the price that would be arrived at if the same transaction were conducted in the open market, between two unrelated companies. This principle is driven by the economic rationale that every entity works on the sole business objective of profit maximisation. Esta lishi g the ar ’s le gth ature Organisation for economic cooperation and development (OECD) in its publication Transfer Pricing Guidelines for Multination Enterprises and Tax Administration, 2010 has categorised the methods of benchmarking into two - Traditional Transaction methods and Transactional Profit methods. The Traditional Transaction method is d i e y the p i es at hi h transactions are undertaken and comprise of Comparable Uncontrolled Price (CUP) Method, Resale Price Method (RPM) and Cost Plus Method (CPM). The Transactional Profit methods are based on the profitability of companies involved in comparable uncontrolled transactions and include Profit Split Method (PSM) and Transactional Net Margin Method (TNMM). Other methods may be used where none of the methods National Convention - Bangalore Page 1 Basics of Transfer Pricing discussed above is applicable. CUP This method compares price charged for property / services transferred in a controlled transaction with that of a comparable uncontrolled transaction. CUP is the most direct and reliable way to apply the arm's length principle and is preferred over other methods but the degree of comparability is very strict. CUP can be internal or external. Internal CUP can be available where the same party that engages in a controlled sale/purchase transaction also engages in an uncontrolled sale/purchase transaction of the same product/service, in the same financial year. Whereas an external CUP can be established wherein the pricing of transaction similar to that of controlled transaction, is available in case of unrelated third parties. Internal CUP would in most cases produce more accurate results due to identical nature of the transactions and greater possibility of data availability. Application of CUP method requires that the identified price charged or paid in comparable transactions be adjusted to account for differences if any between international transaction and uncontrolled transactions such as contractual terms and quality of the product etc. RPM Under this method the price at which property purchased or services obtained from AE and resold to non-AE is identified and is reduced by either the normal gross profit margin earned by the entity from trading of similar product or services in uncontrolled transaction (i.e. Internal RPM) or the normal gross profit margin realized by the third parties from trading of similar product or services (i.e. external RPM). The price so arrived at is reduced by expenses incurred by taxpayer in connection with purchase of property or service. This price is finally adjusted to account for difference if any between controlled and uncontrolled transaction which could materially affect the amount of gross profit margin. RPM is ideal for distribution activity where reseller does not add substantial value to the goods. CPM CPM compares the gross profit earned by an entity in a controlled transaction with the gross profit on cost earned by either the entity in an uncontrolled transaction (i.e. Internal CPM) or external parties in uncontrolled transactions (i.e. external CPM). When applying CPM, it is important to ensure that a comparable mark-up is being applied to a comparable cost base. If there are material differences between controlled and uncontrolled transactions that would affect the gross profit margin, adjustments should be made to the gross profit. Similar to RPM, CPM does not require strict product comparability but similarity of functions performed and risk undertaken is must for its application. This method is preferred in cases involving manufacture or production of tangible products or services that are sold to related parties. National Convention - Bangalore Page 2 Basics of Transfer Pricing PSM The first step under this method involves calculating the total operating profit resulting from operation of transacting entities combined together. The second step would entail determination of the individual contribution of each of the entities and determining a split. The contribution made by each party is determined on the basis of a division of functions performed, risk assumed and assets employed, valued, if possible using reliable external comparable data. The profit allocation between the related entities should reflect as closely as possible, the actual profits that would be achieved by independent enterprises participating in a comparable transaction. This method is used in situations involving transfer of unique intangibles or in multiple international transactions that cannot be evaluated separately. TNMM TNMM examines net operating profit from transactions as a percentage of a certain base (can use different bases i.e. costs, turnover, etc) in respect of similar transactions. Ideally, operating margin should be compared to operating margin earned by same enterprise on uncontrolled transaction (i.e. Internal TNMM) but if internal data not available then it can be compared to the operating margin of comparable third parties performing similar functions, undertaking similar risk and having similar asset profile (i.e. external TNMM) Benchmarking The first step in the process of benchmarking involves fact gathering. Applicability of the concerned TP regulations to the entity and its international transactions with its AEs should be studied. Keeping the legislative provisions in perspective, the important details about the associated enterprises (AEs) like legal status, country of residence, ownership linkages and remuneration model should be collected. Following this, an industry analysis should be conducted to understand the industry dynamics along with industry trends and overall environment, in which the entity/ the group operates. Next step involves carrying out a functional analysis of the entity which includes studying the overview of the entity and the group to which it belongs, functions performed by the entity and its AEs, risks assumed by the entity and its AEs, intangibles owned by the entity and its AEs and assets utilised by the entity. The fu tio al a alysis is p i a ily ased o the i te ie s ith the e tity s personnel. Information can also be gathered from portals of the entity, internet, intranet, entity brochures and audit documents. I te ie ith the e tity s personnel, would generally include discussing the organisation structure and its operating procedures, Identifying pricing strategies, TP methodology adopted by the group a d its i ple e tatio i the e tity s ope atio s. Basis the functional analysis, a characterization of the entity is mapped. Final step involves carrying out an economic analysis whereby first the tested party is chosen considering the characterization of the entity and its AEs and then the most appropriated method basis its characterization, the tested party choice and extent and reliability of data available. Then an appropriate database based on geographical considerations, nature of the transaction etc. is National Convention - Bangalore Page 3 Basics of Transfer Pricing selected. Using this database, an appropriate set of comparables is extracted basis the review of short public documents such as annual reports, company websites, etc. Fact gathering Industry Analysis Functional, Asset and Risk analysis Economic analysis comparable search Issuance of Transfer Pricing Documentation Transfer Pricing regulations in India The basic principles and provisions did exist under section 92 of the Income Tax Act, 1961 (the Act) until detailed transfer pricing law was introduced by the Finance Act 2001 by making amendment to the same section. Erstwhile section 92 empowered the revenue to re-compute the income if a transaction between a resident and a non- eside t esulted i less tha o di a y p ofits fo the resident owing to a 'close connection' between the two. Detailed transfer pricing provisions under the section 92 to 92F of the Act and Rule 10A to 10T the Income Tax Rules, 1962 (the Rules) have been introduced with the objective of preventing the erosion of the tax base in India. Section 92(1) of the Act states that a y income arising from an international transaction shall be computed having regard to the arm's length price’. The scope of transactions understood to be covered is fairly exhaustive, so as to include any transaction having a bearing on an enterprise's income, expenditure, profits, assets, etc. The relationship of AEs is defined by Section 92A of the Act to cover direct/indirect participation in the management, control or capital of an enterprise by another enterprise. It also covers situations in which the same person (directly/indirectly) participates in the management, control or capital of both the enterprises and other parameters mentioned explicitly in the section. Section 92B of the Act defines the term "international transaction" to mean a transaction between two (or more) associated enterprises involving the sale, purchase or lease of tangible or intangible property; provision of services; cost-sharing arrangements; lending/borrowing of money; or any other transaction having a bearing on the profits, income, losses or assets of such enterprises. The associated enterprises could be either two non residents or a resident and a non resident. Section 92BA of the Act has been introduced recently, extending the applicability of Transfer Pricing regulations to domestic transactions involving tax holiday units and related parties under section 40A(2)(b), applicable from assessment year 2013-14 onwards. The term arm's-length price is defined by Section 92F of the Act of the act to mean a price that is applied or is proposed to be applied to transactions in uncontrolled conditions between persons other than AEs. The following methods have been prescribed by Section 92C of the act for the determination of the arm's-length price: CUP, RPM, CPM, PSM, TNMM and the other method introduced by the Central Board of Direct Taxes by way of Notification No 18/2012, dated May 23, 2012. The first five methods have been discussed in detail in above paragraphs. The other method, popularly known as the sixth method gives the flexibility of using any method which takes into account the price which has been charged or paid, or would have been charged or paid, for the same National Convention - Bangalore Page 4 Basics of Transfer Pricing or similar uncontrolled transaction, with or between non-associated enterprises, under similar circumstances, considering all the relevant facts . The legislation requires a taxpayer to determine an arm's-length price for international transactions using any of the six methods. It further provides that where more than one arm's-length price is determined by applying the most appropriate transfer pricing method, the arithmetic mean (average) of such prices shall be the arm's-length price of the international transaction. Accordingly, the Indian legislation does not recognise the concept of arm's-length range but requires the determination of a single arm's-length price. However, some flexibility has been extended to taxpayers by allowing a + / - 1% range benefit for wholesale traders and + / - 3% for other entities. Section 92D of the Act requires that transfer pricing documentation should exist as on the date of filing the tax return for the relevant year. This documentation should include company overview, industry analysis, functional analysis, and economic analysis, etc. It is mandatory for all taxpayers to obtain an independent accountant's report as per section 92E of the Act in respect of all international and specified domestic transactions between AEs. The report has to be furnished by the due date of the tax return. The form of the report has been prescribed. The report requires the accountant to give an opinion on the proper maintenance of prescribed documents and information by the taxpayer. Furthermore, the accountant is required to certify the correctness of an extensive list of prescribed particulars. National Convention - Bangalore Page 5