Domestic Transfer Pricing Provisions Ca .t. P. Ostwal

Domestic Transfer Pricing Provisions Ca .t. P. Ostwal

Baroda Branch of WIRC of ICAI Study Circle Meeting Domestic Transfer Pricing CA Manish Baxi 21 June 2016 CA Manish Baxi 1 Introduction to Transfer Pricing 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 SC in the case of CIT vs Glaxo Smithkline Asia Pvt Ltd [2010195Taxman 35 (SC)] recommended introduction of domestic TP provisions SDT previously reported/certified but onus on revenue authorities Obligation now on taxpayer to report/ document and substantiate the arms length nature of such transactions

Shift from generic FMV concept to focused ALP concept IMPACT : 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. ApartCA Manish from this, business Baxi 21 June 2016 2 Domestic Transfer Pricing Intent of the Law Bringing in objectivity in the interpretation and governance Doing Doing away away with with tax tax introduction of arbitrage arbitrage abuse abuse that that stems ALP mechanism stems from from differential differential tax

tax rate, rate, tax tax holiday/benefits holiday/benefits availed availed by by undertaking undertaking and and presence presence of of accumulated accumulated losses losses Protecting Protecting the the revenue revenue of of the the Indian Indian Government Government CA Manish Baxi 21 June 2016 3 Intent of Indian TP Regulations (International transactions)

Shifting of Profits India Overseas Associated Enterprise (AE Co.) Indian Co. Tax @ 32.45% Tax @ lower rate approx 10% Shifting of Losses Tax Saving for the Group Loss to Indian revenue CA Manish Baxi 21 June 2016 4 Intent of Indian TP Regulations (Domestic transactions) India India Shifting of expenses/losses Indian Co. Tax Holiday undertaking Tax Exemption

Related Enterprise in Domestic Tariff Area (DTA) Tax @32.45% Shifting of income/profits Tax Saving for the Group Loss to Indian revenue CA Manish Baxi 21 June 2016 5 Intent of Indian TP Regulations (Domestic transactions) Particulars (Ordinary Situation) Co. X (SEZ) Co. Y (DTA) Income 500 1000 Income from related party 100 -

Expenses 300 800 Expense to related party - 100 Profit/ Loss 300 100 Tax rate applicable 0% 32.45% Tax - 32.45 (100*32.45%) Particulars (Planned Situation) Co. X (SEZ) Co. Y (DTA)

Income 500 1000 Income from related party 200 - Expenses 300 800 Expense to related party - 200 Profit/ Loss 400 - Tax rate applicable 0% 32.45% Tax

- - CA Manish Baxi Loss to Revenue Tax Saving to the Group 21 June 2016 6 Intent of TP Regulations (Domestic transactions) Shifting of expenses India Indian Co. Loss making India Related Enterprise Profit making Tax @ 32.45% Reduced tax due to shifting of profits Tax @ 32.45% No tax or reduced tax due to loss Shifting of income

Tax Saving for the Group Loss to Indian revenue CA Manish Baxi 21 June 2016 7 Intent of TP Regulations(Domestic transactions) Particulars (Ordinary Situation) Co. X (DTA) Co. Y (DTA) Income 500 1000 Income from related party 100 - Expenses 700 800 Expense to related party -

100 Profit/ Loss (100) 100 Tax rate applicable 32.45% 32.45% Tax - 32.45 (100*32.45%) Particulars (Planned Situation) Co. X (DTA) Co. Y (DTA) Income 500 1000 Income from related party 150 -

Expenses 700 800 Expense to related party - 150 Profit/ Loss (50) 50 Tax rate applicable 32.45% 32.45% Tax - 16.23 (50*32.45%) Present Loss to Revenue* Tax Saving to the Group

** By By shifting shifting of of income income from from a a profit profit making making company company to to a a loss loss making making company, company, the the group group could could reduce reduce its its tax tax liability by 16.23 for the current year, though the impact will be reversed in future years

given carry forward of losses. liability by 16.23 for the current year, though the impact will be reversed in future years given carry forward of losses. CA Manish Baxi 21 June 2016 8 Introduction of domestic transfer pricing provisions The Explanatory Memorandum to Finance Bill 2012 clarified that the genesis of these provisions lies in decision of Supreme Court (SC) in the case of CIT vs. Glaxo Smitkline Asia (P) Ltd (supra). The FA 2012 has inserted definition of SDT and extended scope of TP to SDT by generally incorporating references to SDT in existing TP provisions at places where International Transaction is referred in ITA (Domestic TP). The relevant extracts of the explanatory memorandum : Transfer Pricing Regulations to apply to certain domestic transactions Section 40A of the Act empowers the Assessing Officer to disallow unreasonable expenditure incurred between related parties. Further, under Chapter VI-A and section 10AA, the

Assessing Officer is empowered to re-compute the income (based on fair market value) of the undertaking to which profit linked deduction is provided if there are transactions with the related parties or other undertakings of the same CA Manish Baxi 21 June 2016 entity. 9 No specific method to determine reasonableness of expenditure or fair market value to re-compute the income in such related transactions is provided under these sections. Therefore, the transfer pricing regulations need to be extended to the transactions entered into by domestic related parties or by an undertaking with other undertakings of the same entity for the purposes of section 40A, Chapter VI-A and section 10AA. The concerns of administrative and compliance burden are addressed by restricting its applicability to the transactions, which exceed a monetary threshold of Rs. . 5 crores in aggregate during the year. In view of the circumstances which were present in the case before the Supreme Court, there is a need to expand the definition of related parties for purpose of section 40A to cover cases of companies which have the same parent company. CA Manish Baxi

21 June 2016 10 It is, therefore, proposed to amend the Act to provide applicability of transfer pricing regulations (including procedural and penalty provisions) to transactions between related resident parties for the purposes of computation of income, disallowance of expenses etc. as required under provisions of sections 40A, 80-IA, 10AA, 80A, sections where reference is made to section 80-IA, or to transactions as may be prescribed by the Board, if aggregate amount of all such domestic transactions exceeds Rupees 5 crore in a year. It is further proposed to amend the meaning of related persons as provided in section 40A to include companies having the same holding company. This amendment will take effect from 1st April, 2013 and will, accordingly, apply in relation to the Assessment Year 2013-14 and subsequent assessment years. CA Manish Baxi 21 June 2016 11 Section 92BA Meaning of SDT For the purposes of this section and sections 92, 92C, 92D and 92E, specified domestic transaction means any of the following transactions, not being an international transaction, namely:(i) any expenditure in respect of which payment has been made or is to be

made to a person referred to in section 40A(2)(b); (ii) any transaction referred to in section 80A; (iii) any transfer of goods or services referred to in sub-section (8) of section 80-IA; any business transacted between the assessee and other person as referred to in section 80-IA (10); (v) any transaction, referred to in any other section under Chapter VIA or section 10AA, to which provisions of section 80-IA(8) or section 80IA(10) are applicable; (vi) any other transaction as may be prescribed, and where the aggregate of such transactions entered into by the assessee in the previous year exceeds a sum of five crore rupees amended to twenty crore (w.e.f 01.04.2016) CA Manish Baxi 21 June 2016 12 Overview of Provisions of Section 92BA Inter unit transfer of goods & services by undertakings to which profit-linked deductions apply Expenditure incurred between related parties defined under section 40A Any other transaction that may be specified

SDT SDT Transactions between undertakings, to which profit-linked deductions apply, having close connection CA Manish Baxi 21 June 2016 13 TERMS Used in DTP S. S. S. S. S. 10AA uses the term close connection. 40A(2)(b) uses the term Related party. 80IA (8) inter unit. 80IA (10) uses the term close connection. 92A uses the term Associated Enterprises.

No guidance or limited guidance on the meaning of close connectionS 42 (2) of ITA 1922, [1958] 34 ITR 368 (SC) Mazagaon Dock Ltd.vs. C.I.T. s CA Manish Baxi 21 June 2016 14 For the purpose of sec. 92, 92C, 92D and 92E Section 92BA Analysis 92 Section Relevance with provisions of Sec 92BA : Computation of income having regard to ALP 92A : Meaning of AE 92B : Meaning of International transaction

92C : Methods of computation of ALP 92CA: Reference to TPO 92CB : Safe harbour rules 92CC : Advance Pricing agreement 92CD : Effect of TP agreement 92D : Maintenance of information and documents 92E : CAs Report 92F : Definitions: Accountant, ALP, Enterprise, PE, Specified date, Transaction* * Sec 92F Definitions does not define terms relevant for domestic TP transactions CA Manish Baxi 21 June 2016

15 Sec. 92 Computation of income from having regard to ALP (1) international Computation of transaction income from international transaction having regard to ALP. (2) mutual agreement etc for allocation or apportionment or contribution to any cost or expense shall be determined having regard to ALP. (2A) Any allowance for an expenditure or interest or allocation of any cost or expense or any income in relation to specified domestic transaction shall be computed having regard to ALP. ( w.e.f 1.4.2013) (3) section does not apply if the effect is reducing the income or increasing the loss. CA Manish Baxi 21 June 2016 16 Sec. 92 C Computation of ALP The words specified domestic transaction has been inserted appropriately in various sub-sec. (1) Any of the following methods, being most appropriate method : (a) Comparable uncontrolled price method; (b) Resale price method; (c) Cost plus method; refer

rule 10B (d) Profit split method; (e) Transactional net margin method; (f) other method of determination of arms length price (any method that takes in to account the price which has been charged or paid or would have been charged or paid for same or similar uncontrolled transaction with or between non associated enterprises) (2) Most appropriate method as per criteria laid down in rule 10C considering FAR analysis . FAR : Functions performed, Assets employed, Risks assumed [Rule 10C(2)] CA Manish Baxi 21 June 2016 17 Transfer Pricing Methods 1. Traditional transaction methods Comparable Uncontrolled Price (CUP) Resale Price Method (RPM) Cost Plus 2.Transactional Profit Methods Profit Split Method (PSM) Transactional Net Margin (TNMM) 3. Other Methods As prescribed by CBDT Notification No 18/2012 Dt.23.5.12 CA Manish Baxi 21 June 2016 18 Other Method - Rule 10AB

Other Method can be used for following transactions. Revenue split Valuation of intangible property Valuation of shares Cost allocation Reimbursements Any method that takes in to 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. Similar to CUP in many ways Quotations, Commercial Negotiations, Tenders can be used to substantiate ALP under this method which was not possible under CUP CA Manish Baxi 21 June 2016 19 Comparable Uncontrolled Price Method (CUP)

Compares price charged for property/ service transferred in controlled transactions with price charged in comparable uncontrolled transactions Requires very high standard of comparability Most direct and reliable way to apply the arms length principle Conditions for use of CUP none of the differences between the transactions can materially affect price in the open market reasonably accurate adjustments can be made to eliminate the material effects of such differences CA Manish Baxi 21 June 2016 20 Types of CUPs available -Internal CUP - The price that the company has charged in a comparable uncontrolled transaction with an independent party -External CUP - The price charged in a comparable uncontrolled transaction between third parties when compared to a price of controlled transactions CUP When to apply? 1. When internal comparables exist for transactions involving generic goods 2. When pricing certain type of financial transactions. CUP Pros and Cons Pros - Simple to understand Cons 1.Difficult to apply 2. High level of comparability required CA Manish Baxi

21 June 2016 21 Resale Price Method (RPM) Method used in case of purchase of goods or services from related parties for resale to unrelated parties without substantial value addition The price is reduced by the normal gross margins earned by unrelated party for same or similar products or services Need for similarity of functions performed and risks undertaken Gross margins used as the profit level indicator CA Manish Baxi 21 June 2016 22 RPM How it works Resale Price xx Less: Gross Margin (xx) Less: Associated Costs

(xx) ( e.g. Customs duty) ____ Arms Length Price xx CA Manish Baxi 21 June 2016 23 RPM - When to apply? 1. When internal comparables exist but CUP cant be applied due to product differences 2. When reseller does not add significant value to products sold to final consumer RPM - Pros and Cons Pros -Less sensitive product differences Cons - One sided analysis Only margin of reseller CA Manish Baxi 21 June 2016 24 Cost Plus Method (CPM) Method using the costs incurred by the supplier of goods (or services) in a controlled transaction for goods or services provided to an related party. An appropriate cost plus mark-up is added to the above cost in light of the FAR

Arms Length Price = Direct and Indirect Cost of Production (+) mark-up (based on benchmarking analysis) done by comparables conditions for use of CPM none of the differences between the transactions can materially affect cost plus margin in the open market reasonably accurate adjustments can be made to eliminate the material effects of such differences Tolerant to product differences as compared to CUP method CA Manish Baxi 21 June 2016 25 CPM How it works Costs incurred by supplier* Add: Mark Up** Arms Length Price xx xx xx *Costs incurred by supplier 1. Direct costs: Material, Labour etc 2. Indirect costs: Factory overheads **Mark Up based on 1. Internal Comparable Transactions 2. External Comparable Transactions

CA Manish Baxi 21 June 2016 26 CPM - When to apply? 1) In intercompany sale of tangible property where the related party manufacturer performs limited manufacturing functions and Incurs low risks 2) E.g. Contract manufacturer, low risk assembler who do not own product intangibles and incurs little risks. 3) The related customers involved in the controlled transaction are usually more complex in terms of: a) functions b) risks incurred c) assets owned CA Manish Baxi 21 June 2016 27 CPM - Pros and Cons Pros : Large pool of comparable uncontrolled transactions Cons : Identification of comparable mark ups and cost basis difficult in practice. Mark up information may not be reported. Differences in accounting practices.

CA Manish Baxi 21 June 2016 28 Profit Split Method (PSM) PSM is applied, where: Both the entities have unique intangibles Operations of both the entities are so integrated that identifying the tested party is very difficult CA Manish Baxi 21 June 2016 29 PSM - When to apply? Highly interrelated transactions Unique and valuable intangibles used by both parties Render all other methods inappropriate /inapplicable PSM - Pros and Cons Pros - Can handle complex TP issues two sided method Can be applied when both parties to the transactions make unique and valuable transactions Cons - Difficult to apply in practice Difficult to assess necessary information CA Manish Baxi

21 June 2016 30 Transactional Net Margin Method (TNMM) Comparison at operating margin level Comparison at transactional level, where possible Broad level of similarity of FAR Operates in a similar manner to the CPM and RPM Most preferred and practical method CA Manish Baxi 21 June 2016 31 TNMM - When to apply? 1) On comparable independent enterprises (controlled transactions) 2) Results attributable to transactions between the tested party and independent enterprises shouldbeexcluded when evaluating controlled transactions. 3) It should not be applied on a companywide basis if the company is involved in a number of different controlled transactions which are not properly evaluated on an aggregate basis. CA Manish Baxi

21 June 2016 32 TNMM - Pros and Cons Pros - Less affected by product differences Less sensitive to minor differences in functions Cons -Requires thorough comparability analysis One sided analysis like CUP, RPM and CPM Advantage: 1. Most Commonly used Since Comparable information easily available Since Differences in AS are less of an issue 2.Less sensitive to functional and product differences 3. Variety of net profit indicators CA Manish Baxi 21 June 2016 33 TNMM - Disadvantage As NP easily impacted by factors which barely affect GP For e.g. Differences in capacity utilization, Management Efficiency, Cost structures, lifecycles of the business CA Manish Baxi 21 June 2016

34 Section 92CA - Reference To TPO The word specified domestic transaction inserted in various sub-sections. (1) AO may refer the computation of ALP to TPO (2) TPO to issue notice to Assessee to produce evidence in support of ALP (2A) Any other international transaction coming to notice of TPO* (2B) Non-furnishing of CAs report and TPOs power * (3) TPO shall pass the order determining ALP (3A) Explanation to section 153, if period of limitation available to TPO for making an order is less than sixty days, such remaining period extended to sixty days. ( W.e.f 01.06.2016) (4) AO to compute total income accordingly (7) TPOs power of summons (s.131), survey (s.133A) and collecting information u/s 133(6)applies even in Domestic Transaction Sec. 144C (15)(b)..Reference to DRP AO to forward draft of proposed order to eligible assessee eligible assessee means any person in whose case order u/s 92CA is passed * 92CA (2A ) & (2B) do not cover specified domestic transactions and hence the TPO cannot suo moto upon the transaction coming to his notice apply the TP provisions CA Manish Baxi 21 June 2016 35 Section 92D : Maintenance and keeping information and document by persons entering into an international transaction or specified domestic transaction Entity Price Related Transaction Related Related Profile of

Industry Transaction terms Profile of group FAR related Profile of related parties Economic Analysis (method selection, comparable benchmarking) Agreements Invoices Pricing related correspondence (letters, e-mails, fax, etc.) Forecasts, budgets, estimates The onus of proving SDT at ALP is on tax payer CA Manish Baxi 21 June 2016 36

Documentation to be contemporaneous Due date for maintenance of TP documentation for the every Financial Year is November 30th DOMESTIC TP FILING OF FORM 3CEB All taxpayers to whom the provisions apply required to file a Form 3CEB certified by a Chartered Accountant (CA) For the every Financial Year, the due date of filing Form 3CEB is Nov 30th Requirement to file physical copy of the certified form No provision for filing electronic copy TP documentation forms the basis for certification of Form 3CEB Certificate contains details such as Compliance by taxpayer with the TP documentation requirements Nature/Quantum of transactions and method used to determine ALP Aimed at assisting tax officers in assessment proceedings CA Manish Baxi

21 June 2016 37 Section 271 Penalty Implications Sr. No. 1 Type of penalty Section Penalty quantified a) Failure to maintain prescribed information/ documents (b) Failure to report any such transaction or 271AA 2% of transaction value 271G 2% of transaction value 271(1)(c) 100% to 300% of tax on

adjustment amount (c) Furnish incorrect information 2 Failure to furnish information/ documents during assessment u/s 92D 3 Adjustment to taxpayers income during assessment 4 Failure to furnish accountants report u/s 92E 271BA CA Manish Baxi INR 100,000 21 June 2016 38 Section 40A(2) Transactions covered Mapping to be done for the companys transactions with domestic Related Parties Primary reliance on disclosures u/s 40A(2)(b) and Related Party Schedule Different divisions enter into different transactions with various group

companies Broad categories of me Pay f nt o ty l transactions roya ge r cha s likely to be covered : Payment of interest Purchase of goods and services CA Manish Baxi 21 June 2016 39 Sec 40A (2)(b) Related Party Sr.No Payer / assessee Relationship can exists any time during the year Payee

(i) Individual (ii) Company any director or relative of such director Firm (includes LLP) any partner or relative of such partner AOP any member or relative of such member HUF any member or relative of such member (iii) Any Assessee any individual having substantial interest in the assessees business or relative of such individual (iv) Any assessee a Company, Firm, AOP, HUF having substantial interest in the assessees business

Any relative [defined in sec. 2(41) to mean husband, wife, brother, sister, lineal ascendant or descendant] * Definition of Relative u/s 56(2) not relevant or any director, partner, member or relative of such director, partner or member or (newly inserted) any other company carrying on business or profession in which the first mentioned company has substantial interest. A Ltd. (holding co) X Ltd. (subsidiary co) Y Ltd. (subsidiary co) CA Manish Baxi 21 June 2016 40 Type of transactions covered (illustrations for payments made by a Company) Case 1 - Director or any relative of the Director of the taxpayer Section 40A(2)(b) (ii) Case 2 - To an individual who has substantial interest in the business or profession of the taxpayer or relative of such individual Section 40A(2)(b)(iii) Substantial interest >20% Mr.

Mr. A A Assessee Assessee (Taxpayer) (Taxpayer) tor c e Dir Director Assessee Assessee (Taxpayer) (Taxpayer) Mr. Mr. D D Relative Mr. Mr. C C Mr. Mr. A A Relative Mr. Mr. D

D Relative Mr. Mr. C C Covered transactions Holding Structure CA Manish Baxi 21 June 2016 41 Type of transactions covered (illustrations for payments made by a Company) Case 4 Any other company carrying on business in which the first mentioned company has substantial interest Section 40A(2)(b)(iv) Case 3 To a Company having substantial interest in the business of the taxpayer or any director of such company or relative of the director Section 40A(2)(b)(iv) Mr. Mr. D D A A Ltd Ltd Mr.

Mr. C C Assessee Assessee (Taxpayer) (Taxpayer) A A Ltd Ltd Substantial interest >20% Substantial interest >20% C C Ltd Ltd Substantial interest >20% Relative Director Assessee Assessee (Taxpayer) (Taxpayer) Substantial interest >20% B B Ltd Ltd

Covered transactions Holding Structure CA Manish Baxi 21 June 2016 42 Type of transactions covered (illustrations for payments made by a Company) Case 5 To a Company of which a director has a substantial interest in the business of the taxpayer or any director of such company or relative of the director Section 40A(2)(b)(v) Director B B Ltd Ltd Dire c tor Mr. Mr. A A Substantial interest >20% Relative Mr. Mr. C C

Assessee Assessee (Taxpayer) (Taxpayer) Mr. Mr. D D Covered transactions Holding Structure CA Manish Baxi 21 June 2016 43 Type of transactions covered (illustrations for payments made by a Company) Substantial interest >20% Assessee Assessee (Taxpayer) (Taxpayer) B B Ltd Ltd Case 7 Any director or relative of the director of taxpayer having substantial interest in that person Section 40A(2)(b) (vi)(B)

A A Ltd Ltd Substantial interest >20% ec Dir tor Assessee Assessee (Taxpayer) (Taxpayer) D D Ltd Ltd Mr Mr C C Relative Case 6 To a Company in which the taxpayer has substantial interest in the business of the company Section 40A(2) (b)(vi)(B) Substantial interest >20% Mr Mr B B

Covered transactions Holding Structure CA Manish Baxi 21 June 2016 44 Type of transactions covered (illustrations for payments made by a Company) Transaction Covered A&B A B D C E A&C A&D A&E

B&C D&E C&D D&E CA Manish Baxi 21 June 2016 45 CA Manish Baxi 21 June 2016 46 2 a company in which A has 20% or more voting power; any company of which a director has 20% or more voting power in A; any company in which a director of A has 20% or more voting power; 3

any director of A or of Company B or to any relative of such director; & any individual having 20% or more voting power in A or any relative of such individual. Company B having 20% or more voting power in A; any other company in which Company B has 20% or more voting power; 1 Thus for Company A payments to following persons are covered Tax burden, if transaction not at ALP X Ltd. (non-tax holiday) Sale at 120 v/ s ALP i.e. 100 Sale at 120 v/ s ALP i.e. 100 X Ltd. (tax holiday) X Ltd. (tax holiday) Sale at ` 80 v/ s ALP i.e. ` 100 Y Ltd. (non-tax holiday)

Disallowance of ` 20 to Y Ltd [40A(2)(b)] Y Ltd. (non-tax holiday) Double Adjustment Tax holiday on 20 not allowed to X Ltd [80IA(10)] (more than ordinary profits) Disallowance of 20 to Y Ltd [40A(2)(b)] Y Ltd. (non-tax holiday) Inefficient pricing structure reduced tax holiday benefit since sale price is lower than ALP CA Manish Baxi 21 June 2016 47 Section 80IA (8) & 80IA (10) Deduction in respect of profits and gains from industrial undertaking or enterprise engaged in infrastructure development, etc. 80IA (8) 80IA (10) Inter-unit transaction of goods or services

Business transacted with any person generates more than ordinary profits Owing to either close connection or any other reason Applicable where transfer is not at market value Applicable to tax holiday units earning more than ordinary profit Onus on tax payer Primary onus on taxpayer Onus on tax authorities as well CA Manish Baxi 21 June 2016 48 Other Sections under Chapter VI-A......to which s. 80-IA(8) or (10) are applicable 80-IA Income from Infrastructure, Telecommunication, Industrial Park & Power sector etc. 80-IAB Income of an undertaking or enterprise engaged in development of SEZ 80-IB Income from certain Industrial undertaking and Housing Projects etc.

80-IC Income from certain Industrial undertaking set up in Sikkim, HP...etc. 80-ID Income from hotels etc in Delhi, Faridabad and other specified districts. 80-IE Income from eligible business undertaking in North Eastern States CA Manish Baxi 21 June 2016 49 Implication post amendments FMV ALP No method prescribed for computing FMV Six methods prescribed for computing ALP No documentation required to be maintained Contemporaneous documentation required to be maintained

Other than reporting in tax audit report, no statutory compliance Accountants report signed by a CA to be filed Assessment done by the AO Assessment done by the TPO CA Manish Baxi 21 June 2016 50 Points for Consideration Whether the threshold limit of Rs. 20 crore applies to the aggregate amount under all the relevant sections taken together OR under each section separately i.e. 40A(2), 80A, 80-IA(8), 80-IA(10), 10AA etc. ? Whether payment for capital expenditure Or expenditure capitalized is also covered ? Whether the provisions will apply in case the payers income is chargeable to tax under the head Income from other sources, because section 58(2) says The provisions of section 40A shall, so far as may be, apply in computing the income chargeable under the head Income from other sources as they apply in computing the income chargeable under the head Profits and gains of business or profession ? Whether new provision applies to Public Charitable Trust paying remuneration to related persons. Co-operative Societies Social Clubs having a business undertaking Transfer pricing provisions are not applicable in case where income is not chargeable to tax at all.

Correlative adjustments - if excessive or unreasonable expenses are disallowed in the hands of tax payer at time of the assessment then corresponding adjustment CA Manish Baxi 21 June 2016 to the income of the recipient will not be allowed in the hands of recipient of51 Challenges Type of payments/ transactions Challenges Salary and Bonuses paid to Benchmarking? the partners Whether the limit as mentioned in section 40 (b) would be the ALP? Remuneration paid to the Directors Transfer of land Joint Development agreements Project management fees Allocation of expenses between the same taxpayer having an eligible unit and non-eligible unit Benchmarking? Whether the limit as mentioned in Schedule XIII would be the ALP? Whether the rates mentioned in the ready reckoner be considered as ALP? Benchmarking? Benchmarking? Whether these allocation would be SDT Sec 80-IA(10)? Directly v/s Indirectly

CA Manish Baxi 21 June 2016 52 CASE STUDY 1 21 June 2016 CA Manish Baxi 53 Case Study 1 Facts HCO, an Indian company, is a manufacturer of FMCG products. It has four Indian subsidiaries; namely IndCo1, IndCo2, IndCo3 and IndCo4 in different segment of FMCG products. Neither HCO nor its subsidiaries (except IndCo4) enjoy any profit linked deduction under Chapter VIA or sec 10AA. HCO also has 21% shareholding in UK Co (a company incorporated in UK) and 79% shareholding of UK Co is held by others. HCO has taken two loans i.e. one from Bank1 at an interest rate of 14% and other from an unrelated party at an interest rate of 13%. HCO has advanced following loans to its subsidiaries: IndCo1 at an interest rate of 16%. IndCo2 at an interest rate of 10% as the company is suffering huge losses. Interest-free loan to IndCo3 as it is a startup company and loan given are primarily to provide seed funding to develop a sound strategy and transform its ideas and innovations into demand and gain market share. Interest-free loan to IndCo4 and it is utilized for its SEZ Unit u/s 10AA so that it is working efficiently. 21 June 2016 CA Manish Baxi 54

Case Study 1 (contd) HCO given an interest free loan to UK Co IndCo1 has taken a loan from Bank2 at an interest rate of 14% for which HCO has given a guarantee to Bank2. HCO does not charge any guarantee fee to IndCo1. IndCo1 has also taken another loan from Bank 3 at an interest rate of 14%. For this loan, HCO has given a letter of comfort to Bank3, as sole shareholder of IndCo1that it will exert its influence to ensure that IndCo1 would meet its liabilities to Bank 3 in the agreed manner. Moreover; HCO has confirmed that no changes are planned in the ownership structures of the subsidiaries for the terms of loans. HCO has provided a performance guarantee to IndCo3 to make IndCo3 eligible to bid on a project. If the bid is successful, HCO will then add substance to IndCo3 in the form of providing further working capital finance, making it sufficiently robust to operate the project on its own and in turn making the performance guarantee a mere formality, . A guarantee in this context confers an economic benefit and allows IndCo3 to bid and perchance to win and thus is compensable. Whereas if the bid is not successful, the guarantee will be of little practical value or benefit to the subsidiary and should be regarded as a non-compensable shareholder activity because the subsidiary derives no benefit from the guarantee. In each company, the specified domestic transactions exceed threshold limit for all four subsidiaries.

21 June 2016 CA Manish Baxi 55 Case Study 1 (contd) Question Analyze the applicability of the Domestic TP provisions in the hands on HCO, IndCo1, IndCo2, IndCo3 and IndCo4 as well as UK Co in respect of their financial dealings. H Co contends that no guarantee fees is chargeable due to the fact that IndCo1 was inadequately capitalized and it was its benefit to give guarantee on the basis of which bank loan were obtained by IndCo1 at the same rate of interest without any benefits to HCO. 21 June 2016 CA Manish Baxi 56 Case Study 1 (contd) India HCO Loan from Bank1 @ 14% Loan against bank guarantee from Bank 2 @ 16%

Loan from Bank [email protected]% Against Letter of Comfort of H CO 21 June 2016 Loan @ 17% Loan @ 10% Interest free loan IndCo1 IndCo2 IndCo3 UK Loan from Unrelated Party @13% Interest free loan IndCo4 SEZ Unit u/s10AA Interest free loan

UK Co 21% by H Co Performance Guarantee of H CO CA Manish Baxi 57 Case Study 1 (contd) For IndCo1 1. Loan taken from HCO a. Loan taken by IndCo1 from HCO at interest rate of 17% for which Interest payment by IndCo1 u/s 40A(2)(b) constitutes SDT(u/s 92BA) and hence IndCo1 will be liable to comply with Domestic TP provisions. b. Interest payment to related party needs to be benchmarked by selecting the most appropriate method u/s 92C r.w Rule 10B and Rule 10C for computation of arms length price. c. IndCo1 has also taken two other loans. First, loan taken from Bank2 at an interest rate of 16%. Second, loan taken from Bank3 at an interest rate of 16%. Therefore, CUP Method is the most appropriate method. Thus, ALP interest rate works out to be 16% (arithmetic mean of 16% and 16%). d. Having regard to the facts, the Assessing Officer possibly will try to make TP adjustment by disallowing excess interest of 1% (17%-16%) ,not being arms length but the fact needs to be demonstrated that other loans are with guarantees and without that there could be an extra charge by the bank (normally I.T. dept. takes 3% as guarantee fees in other cases and hence if appropriate adjustment is made to the rate of interest with such guarantee commission the lending rate of bank would go up by almost 3% and hence interest paid is at arms length.)However it is not established then IndCo1 would be exposed to penalty u/s 271(1)(c)

r.w.t. Explanation 7 as deemed to be concealment of income or furnishing inaccurate particulars in respect of addition to income by way of TP adjustment. e. IndCo1 may be exposed to penalty u/s 271G if it has defaulted on maintenance of TP documentation and/or u/s 271BA if it has defaulted on furnishing of TP audit report. 21 June 2016 CA Manish Baxi 58 Case Study 1 (contd) For IndCo1 (contd) 2. Guarantee given by HCO for loan taken from Bank2 Since no guarantee fees is paid by IndCo1, provisions of sec 40A(2)(b) r.w.s. 92BA are not applicable. Therefore, this transaction is not SDT u/s 92BA. 3. Letter of Comfort given by HCO for loan taken from Bank3 Since no consideration is paid by IndCo1, provisions of sec 40A(2)(b) r.w.s. 92BA are not applicable. Therefore, this transaction is not SDT u/s 92BA. For HCO (w.r.t IndCo1 Transaction) i. 17% Interest is received by HCO on loan given to IndCo1 is not covered u/s 40A(2)(b) and hence it does not constitute SDT(u/s 92BA) for HCO. ii. HCO has given guarantee to Bank2 on loan taken by IndCo1 and HCO has not charged any guarantee fee for the same. Only expenditure on payment made or to be made to related party is covered u/s 40A(2)(b) and thus even if there was any receipt or nonreceipt of guarantee fee income, it would not have been covered u/s 40A(2)(b). Thus, it is not SDT (u/s 92BA) for HCO. iii. HCO has also given letter of comfort to Bank3 on loan taken by IndCo1 and no monetary benefit is received for this transaction. Therefore, it does not constitute SDT (u/s 92BA) for HCO. 21 June 2016 CA Manish Baxi 59

Case Study 1 (contd) For IndCo2 a) Loan taken by IndCo2 from HCO at interest rate of 10% for which Interest payment by IndCo1 u/s 40A(2)(b) constitutes SDT(u/s 92BA) and hence IndCo1 will be liable to comply with Domestic TP provisions. b) Interest payment to related party needs to be benchmarked by selecting the most appropriate method u/s 92C r.w. Rule 10B and Rule 10C for computation of arms length price. c) Having regard to the facts, CUP Method is the most appropriate method wherein External CUP can be applied for benchmarking the transaction by adopting PLR of any nationalized banks in India or by adopting rate of interest paid by HCO on loans taken from bank i.e. 14% and IndCo1s borrowings @16%. Thus, ALP interest rate works out to be above 10%. d) In this case, interest rate of 10% is lesser than ALP interest rate. Therefore, transaction entered into by IndCo2 of interest payment to related party is at arms length. Therefore, no TP adjustments is warranted in this case. For HCO (w.r.t IndCo2 Transaction) 10% Interest is received by HCO on loan given to IndCo2 is not covered u/s 40A(2)(b) and hence it does not constitute SDT (u/s 92BA) for HCO. 21 June 2016 CA Manish Baxi 60 Case Study 1 (contd) For IndCo3 1. Interest free Loan taken from HCO a. Since no interest is paid by IndCo3, provisions of sec 40A(2)(b) r.w.s. 92BA are not applicable. Therefore, this transaction is not SDT u/s 92BA.

b. But, interest free loan taken from related party is required to be reported in TP Audit Report i.e Form 3CEB. IndCo3 may be exposed to penalty u/s 271G if it has defaulted on maintenance of TP documentation and/or u/s 271BA if it has defaulted on furnishing of TP audit report. 2. Performance guarantee given by HCO for loan taken from Bank3 Since no consideration is paid by IndCo1, provisions of sec 40A(2)(b) r.w.s. 92BA are not applicable. Therefore, this transaction is not SDT u/s 92BA For HCO (w.r.t IndCo3 Transaction) 3. HCO has given an interest free loan to IndCo3. It has not charged any interest to IndCo3 as IndCo3 is a startup company. Only expenditure on payment made or to be made to related party is covered u/s 40A(2)(b) and thus even if there was any receipt or non-receipt of interest, it would not have been covered u/s 40A(2)(b). Thus, it is not SDT (u/s 92BA) for HCO. 4. HCO has provided a performance guarantee to IndCo3 to make IndCo3 eligible to bid on a project. HCO has not charged any guarantee fee for the same. Only expenditure on payment made or to be made to related party is covered u/s 40A(2)(b) and thus even if there was any receipt or non-receipt of guarantee fee income, it would not have been covered u/s 40A(2)(b). Thus, it is not SDT (u/s 92BA) for HCO. 21 June 2016 CA Manish Baxi 61 Case Study 1 (contd) For IndCo4 1. Interest free loan taken by IndCo4 (having an eligible unit ie SEZ unit u/s 10AA) from HCO (non eligible unit) and utilized the said loan for its sec 10AA unit. 2. We have to analyze whether the said transaction is falling within the any of the provisions of section 92BA i e whether it is SDT ? 3. As per section 92BA(v) any transaction , referred to in section 10AA to which provisions of section 80IA(10) are applicable is SDT. As per section 80IA(10) where an eligible unit enters into SDT with any other person, then for the purpose of availing benefit under section 80-IA, the transaction recorded in the books of accounts of eligible unit should correspond to the ALP of such goods or services worked out as per section

92C. 4. However, Sec 80IA(10) is attracted only to those transactions in which, when it appears to the AO that, owing to the close connection between the assessee carrying on the eligible business (to which section 80IA applies) and any other person, or for any other reason, the course of business between them is so arranged that the business transacted between them produces to the assessee more than the ordinary profits which might be expected to arise in such eligible business. 5. Thus, it is clear that the onus of proving that provisions of s. 80-IA(10) are attracted and that the business affairs are so arranged that it produces more than ordinary profits is on the AO and AO may deny deduction u/s10AA on the ground that interest free loan given by HCO to IndCo4 was to enable IndCo4 to earn more than ordinary profits by invoking provisions of sec 10AA(9) r.w.s. 80-IA(10) r.w.s. 92BA(v). (contd).. 21 June 2016 CA Manish Baxi 62 Case Study 1 (contd) For IndCo4 1. Therefore, in the given case if the IndCo 4 believes that business transacted with HCO is bonafide and it cannot be considered as tax evading arrangement then such transaction may not be regarded as SDT in terms of s. 92BA(V).Ind Co4 can also take an argument that MAT provisions are applicable to 10AA units also hence there is no incentive to shift profit to 10AA unit by not charging any interest for the loan utilised for 10AA unit. Hence, provisions of section 80IA(10) r.w.s 92BA(V) are not applicable to such transaction. 2. IndCo4 may be exposed to penalty u/s 271G if it has defaulted on maintenance of TP documentation and/or u/s 271BA if it has defaulted on furnishing of TP audit report . For HCO (w.r.t IndCo4 Transaction) HCO has given an interest free loan to IndCo4. IndCo4 has utilized interest free loan for its SEZ Unit u/s 10AA. Only expenditure on payment made or to be made to related party is covered u/s 40A(2)(b) and thus even if there was any receipt or non-receipt of interest, it would not have been covered u/s 40A(2)(b). Thus, it is not SDT (u/s 92BA) for HCO.

21 June 2016 CA Manish Baxi 63 Case Study 1 (contd) For UK Co. No tax effect in the hands of UK Co as UK Co is not to be assessed to tax in India. Hence it is neither covered by SDT no by international transaction u/s 92B. For HCO (w.r.t UK Co Transaction) HCO has given an interest free loan to UK Co in which HCO has only 21% shareholding. Therefore, UK Co is not an associated enterprises u/s 92A(2)(b).But UK Co would become a related party (of HCO) u/s 40A(2)(b)(iv) for a loan given to Non-Resident Related Party. Only expenditure on payment made or to be made to related party is covered u/s 40A(2)(b) and thus even if there was any receipt or non-receipt of interest, it would not have been covered u/s 40A(2)(b). Thus, it is not SDT (u/s 92BA) for HCO. 21 June 2016 CA Manish Baxi 64 CASE STUDY 2 21 June 2016 CA Manish Baxi 65

Case Study 2 Facts A Co, an Indian company, is engaged in business of polyester films. It has substantial interest in B Co and has a wholly owned subsidiary D Inc in USA. Both A Co and B Co are units covered u/s 10AA. A Co has its own R&D Centre which develops the technology for product research, design and development and enhances efficiency in production of polyester films. A Co manufactures raw materials namely, dimethyl terephthalate, terephthalic acid and ethylene glycol and sells it to B Co. A Co licenses technical know-how and formulas to B Co for processing of raw materials into finished goods i.e. polyester films. B Co processes the raw materials into finished goods i.e. Polyester films and sells the finished goods to A Co at Rs. 100 per sq ft. B Co has also made a miniscule sale to third parties at Rs 120 per sq ft. Royalty is charged for (use of tech know how by B Co) by A Co to B Co at the rate of 3% on sale of total polyester films to A Co as well as third parties. A Co also purchase polyester films but of substantially different qualities from third parties

at Rs. 80 per sq ft. 21 June 2016 CA Manish Baxi 66 Case Study 2 (contd) C Co, an agent, provides marketing and sales promotion services to A Co for which it charges commission at 7% of sales made by A Co. A Co cuts polyester films into large master rolls and slit to precision widths before delivery to customer and packages as per customer requirement. A Co sells polyester films to Indian customers at Rs. 125 per sq. ft. D Inc is the face of A Co in US and overseas markets. A Co sells polyester films to the associated enterprise D Inc (USA) at cost plus 10% mark-up. A Co follows JustinTime approach to manage inventory which in turn helps in balanced production and maintenance of required stock level of raw materials and finished goods. Research on various geographical areas where market can be developed is done by C Co. Market development includes focus on existing customers and also on potential customers. Selling and distribution activities as well as after-sales activities are undertaken by C Co.

A Co and B Co perform administration functions independently for their respective organizations based on policies framed. 21 June 2016 CA Manish Baxi 67 Case Study 2 (contd) All three companies (A Co, B Co and D Inc) deploy its tangible assets in the form of fixed assets and working capital for manufacturing and sale operations. The tangible assets include office facilities, warehouses, material handling equipments, computer hardware, quality control equipments, etc. B Co does not have significant exposure to market risk since it is primarily involved in the processing of raw materials to finished goods polyester films. A Co has a significant exposure to market risks in order to meet consumer needs. A Co bears a significant exposure to technology risk as the changes of finished goods i.e. quality of polyester films becoming obsolete is high and thus, it is a challenge for the company to keep up with the developments in technology in order to face market competition. Whereas B Co faces almost no technology risk as it uses technology of A Co and processing job has lesser chances of technology becoming obsolete.

All major credit risks related to sales are borne by A Co whereas B Co faces less / no risk since its major sales are to A Co and a miniscule amount of sales to third parties. A Co is exposed to foreign currency fluctuation risk due to export of polyester films to its associated enterprises abroad. Operating Margin on Total Cost for: A Co 8% whereas Comparables 13% B Co 6% whereas Comparables 9.5% 21 June 2016 CA Manish Baxi 68 Case Study 2 Question (contd) 1. Analyze of the applicability of Domestic TP provisions in the hands of B Co in respect of following transactions: Purchase of Raw Materials by B Co Purchase of Polyester films by A Co Royalty paid by B Co 2. Analyze the applicability of transfer pricing provisions in respect of international transaction for sale of polyester films by A Co to its associated enterprise D Inc USA. 21 June 2016 CA Manish Baxi 69

Case Study 2 (contd) Third Parties Purchase of Polyester Film of substantially different quality Royalty Paid for Tech Know-how Sale of Polyester Films A Co Commission Paid @7% B Co (Substantial Interest held by A Co) Sale of Manufactured Raw Materials Sale of Polyester Films Third Parties Sale of Polyester Films Customers

C Co India USA Sale of Polyester Films D Inc (WOS of A Co) 21 June 2016 CA Manish Baxi 70 Case Study 2 (contd) Analysis Applicability of Domestic TP - B Co Transaction 1:- Purchase of Raw Materials by B Co from A Co Category Level of Intensity Functions Performed 1. Market development 2. Product development 3. Manufacturing 4. Quality control 5. Post sales activities 6. General management functions 7. Corporate strategy determination 8. Finance, accounting, treasury & legal 9. Human resource management Assets Employed

1. Tangibles 2. Intangibles Risks Assumed 1. Market risk 2. Product liability risk 3. Technology risk 4. Research & Development risk 5. Credit risk 6. Inventory risk 21 June 2016 CA Manish Baxi B Co A Co

71 Case Study 2 (contd) Transaction 1:- Purchase of Raw Materials by B Co from A Co Criteria Analysis Result / comments Company Profile Manufactures and markets polyester films Earns Operating profit margin (entity level) of 6% FAR Analysis

B Co is a manufacturer and seller of polyester films B Co is simpler and comparable For benchmarking, the operating profit margins of data is available and hence, comparable companies have been compared with selected as the tested party the operating profit margin of B Co at entity level as well as with reference to operating margins earned on the sale transactions with associated enterprises. Selection of Methodology CUP: Unavailability of internal/external CUP data CPM or TNMM could be RPM: Taxpayer is a manufacturer and not a selected as most appropriate reseller of products method PSM: Routine manufacturer hence not applicable CPM: May be applied if reliable cost data is available TNMM: Relatively less stringent comparability standards and external comparables data available on public database 21 June 2016 CA Manish Baxi

Arms length nature of revenue to be tested 72 Case Study 2 (contd) Transaction 2 :- Purchase of Polyester films by A Co from B Co Level of Intensity Category A Co B Co Assets Employed 1. Tangibles 2. Intangibles

Risks Assumed 1. Market risk 2. Product liability risk 3. Technology risk 4. Research & Development risk 5. Credit risk 6. Inventory risk Functions Performed 1. Product development 2. Manufacturing 3. Quality control 4. Post sales activities 5. General management functions 6. Corporate strategy determination 7. Finance, accounting, treasury & legal 8. Human resource management

21 June 2016 CA Manish Baxi 73 Case Study 2 (contd) Transaction 2 :- Purchase of Polyester films by A Co from B Co Criteria Company Profile (A Co.) FAR Analysis A Co is a trader of polyester films A Co. is simpler and comparable For benchmarking, the operating profit margins data is available and hence, of comparable companies have been compared selected as the tested party with the operating profit margin of the A Co at entity level Selection of Methodology CUP: Unavailability of internal/external CUP data RPM or TNMM could be RPM: A Co is cutting rolls into different sizes to selected as

the most make the product marketable and is not making appropriate method substantial value addition to it and therefore, A Co is a pure reseller of products CPM: Unavailability of comparable data at gross level PSM: Routine manufacturer/trader hence not applicable TNMM: Relatively less stringent comparability standards and external comparables data available on public database 21 June 2016 Analysis Result / comments Trader of polyester films (besides being Arms length nature of revenue manufacturer of raw material) to be tested Earns Operating profit margin (entity level) of 8% CA Manish Baxi 74 Case Study 2 (contd) Transaction for royalty paid by B Co to A Co

Since data on uncontrolled comparable transactions (i.e. rates of royalty) is not available in public domain, benchmarking of payment of royalty by B Co to A Co. could be done by applying External TNMM International transaction for sale of polyester films by A Co to its associated enterprise D Inc USA. Being an international transaction, all the transfer pricing provisions relating to international transaction would be applicable and the transaction would be benchmarked u/s 92C r.w. Rule 10B and Rule 10 C. 21 June 2016 CA Manish Baxi 75 CASE STUDY 3 21 June 2016 CA Manish Baxi 76 Case Study 3 Facts 1. US Co is having a permanent establishment (PE) in India, Mr. A, a director of US Co, is deputed to Indian PE in financial year 2015 16 i.e from 1st December 2015. 2. Salary is paid to Mr. A by US Co and PE in India for respective periods worked in both (US Co and Indian PE). 3. Mr. A is a non-resident in India for the financial year 2015-16.

4. Indian PE (taxed on net basis) has claimed deduction for salary paid to Mr. A in its return of income for FY 2015-16. Question 1. Whether domestic transfer pricing provisions are applicable to Indian PE for salary paid to Mr. A? 2. Assume Indian PE is a subsidiary company of US Co and Mr. A is a nonresident and is also a Director of subsidiary company getting salary from subsidiary company. Whether payments made to director is a specified domestic transaction? 21 June 2016 CA Manish Baxi 77 Case Study 3 (contd) Where US Co has PE in India Salary paid by US Co (1/4/2015 to 30/11/2015) US CO Mr. A Director of US CO USA India Salary paid by Indian PE (1/12/2015 to 31/03/2016)

21 June 2016 CA Manish Baxi Indian PE 78 Case Study 3 (contd) Where Ind Co is Subsidiary of US Co US CO Salary paid USA Mr. A Director of Ind Co & US CO India Ind Co Salary paid (WOS) 21 June 2016 CA Manish Baxi 79

Case Study 3 Salary paid to Mr. A is not an International Transaction in terms of s. 92B r.w.s. 92A since data on shareholding of Mr A is not given. Therefore, Mr.A is not an AE of US Co as defined u/s 92A. But if Mr. A held at least 26% of shares in US Co, it would constitute as an international transaction and any salary paid to Mr. A would be regarded as an international transaction. However, if he does not hold any shares still Mr. A is a director of US Co and hence covered as a related party u/s 40A(2)(b)(ii). Since payment is made to related party covered by s. 40A(2)(b), the transaction constitutes SDT in terms of s. 92BA(i) Being SDT, salary payment to Mr. A will be liable to Domestic TP and PE will be required to benchmark it to ALP, maintain documentation and furnish TP audit report. Salary paid to Mr. A is required to reported in TP Audit Report i.e Form 3CEB by Indian PE. Thus, Indian PE may also be exposed to penalty u/s 271G if it has defaulted on maintenance of TP documentation and/or u/s 271BA if it has defaulted on furnishing of TP audit report. Million dollar question is how do you demonstrate it to be at Arms Length. 21 June 2016 CA Manish Baxi

80 THANK YOU Thank You ALL 21 June 2016 CA Manish Baxi 81

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