Transfer
Pricing Issues
in India
Focus
on Software
& Information
Technology
Enabled Companies
An
Overview of
the Indian Transfer
Pricing Regulations
(TPR's)
To
curb tax avoidance,
The Finance
Act 2001 introduced
the detailed
Transfer Pricing
Regulations
(TPR) in India
with effect
from April 1,
2001. The basis
of the regulations
has been primarily
the Organisation
for Economic
Co-operation
and Development
(OECD) guidelines
on TP. The Indian
TPR's, comprising
of Sections
92 to 92F, is
a separate self-sufficient
code by itself,
where all the
sections are
inseparably
blended. Section
92 is the charging
section, which
states that
“any income
arising from
an international
transaction
shall be computed
having regard
to the arm's
length price”.
The Arm's length
price (ALP)
computed as
per the specified
methods has
to be supported
by the provisions
of documentation
prescribed by
the Indian TPR.
Thus, computation
of ALP cannot
be divorced
from documentation
requirements
and the onus
is on the tax
payer to justify
the arm's length
nature of its
international
transactions.
The key provisions
of the Indian
TPR are as follows:
The documentation
requirements
can broadly
be divided into
two parts. The
first part of
the Rule lists
out mandatory
documents/ information
that have to
be maintained
by a taxpayer,
which include:
• Ownership
Structure;
• Profile
of the multinational
group;
• Business
overview of
the taxpayer
/ AE and overview
of industry;
• Nature
and terms (including
prices) of international
transactions;
• Description
of the functions
performed, risks
assumed and
assets employed
by the tax payer/AE;
• Economic
and market analyses,
forecasts, budgets
or any other
relevant financial
estimates;
• Comparability
analysis performed;
• Description
of methods considered
& selected
with underlying
rationale;
• Actual
working carried
out for determining
the ALP, including
details of comparable
data, financial
information
used and adjustments;
• Assumptions,
policies and
price negotiations,
which have critically
affected the
determination
of the ALP;
• Details
of adjustments,
if any, made
to transfer
prices to align
them with ALP
determined under
these rules
and consequent
adjustment made
to the total
income for tax
purposes.;
• Any
other information,
data or document,
including information
or data relating
to the AE, which
may be relevant
for determination
of the ALP.
The second part
of the Rule
requires adequate
supporting documentation
to be maintained
for substantiating
the information/analyses/studies
documented in
the first part
of the Rule
(discussed above).
This part of
the Rule also
contains a recommendatory
inclusive list
of such supporting
documents, which
includes Government
publications,
reports, market
research studies
undertaken by
reputed institutions;
relevant agreements,
contracts, correspondence;
etc.
Taxpayers having
aggregate international
transactions
within the prescribed
threshold of
INR 10 million
have been relieved
from maintaining
the prescribed
documentation.
However, even
in such cases,
it is imperative
that the documentation
maintained should
be adequate
to substantiate
ALP of international
transactions.
The prescribed
information
and documents
have to be kept
and maintained
for period of
eight years
from the end
of the relevant
assessment year.
Indian
Transfer Pricing
Assessment ('Audit')
Experience
1) Overall Scenario
Transfer Pricing
audits in India
have generated
great controversies
due the nature
of adjustments
made and resulting
quantum of adjustments.
The Revenue
Authorities
seemed to be
focused on generating
huge revenues
from Transfer
Pricing adjustments,
due to non-adherence
to the arm's
length standard
by taxpayers
in their cross-border
dealings.
The following
table depicts
the cases selected
up for transfer
pricing scrutiny
by the tax authorities
and the resulting
transfer pricing
adjustments
made1:
2) Transfer
Pricing audit
and Software
('IT') and Information
Technology Enabled
Services ('ITES')
companies
Some of the
Transfer Pricing
issues faced
by the IT/ITES
companies during
the audit over
the last couple
of years are
as under:
a) Losses made
by captive IT/ITES
companies:
Most of the
software and
ITES companies
based in India
are subsidiaries
of the overseas
Multinational
Corporations
('MNC') and
operate as the
offshore captive
companies of
these MNC's.
The MNC's outsource
the software
development
and ITES work
to them. Being
the dedicated
captive units
of the MNC's,
these IT/ITES
companies are
expected to
be compensated
on a Total Cost
Plus Mark-up
basis. Companies
having Time
and Material
or Lumpsum basis
as its compensation
model which
resulted into
operating losses
were subject
to transfer
pricing adjustments
as these companies
were not expected
to bear any
market or unutilised
capacity risk.
The Indian tax
authorities
are of the opinion
that, the MNC's,
who are the
entrepreneurs,
are expected
to bear all
these risks
and keep the
captive IT/ITES
companies insulated
from ensuing
risks. It is
pertinent to
mention that
no start-up
or gestation
phase is allowed
for such captive
units.
b) Margins expected
to be earned
by captive IT/ITES
companies:
As mentioned
in the previous
paragraph, the
captive IT/ITES
companies were
expected to
be compensated
on a Total Cost
Plus mark-up
basis in India.
The Transactional
Net Margin Method
('TNMM') was
the most resorted
Method used
for benchmarking
the mark-ups
earned by the
IT/ITES companies
against the
mark-ups earned
by similar IT/ITES
comparable companies
operating in
the software
and IT Enabled
industry.
The tax authorities,
especially those
based in South
India in the
cities of Bangalore
and Hyderabad,
came up with
abnormally high
mark-ups in
the range of
25% to 35% to
benchmark the
returns of the
IT and ITES
industry. Further,
these mark-ups
varied from
region to region
and thus were
not consistent
across India.
The objective
of the tax authorities
in demanding
such high mark-ups
from the Indian
IT/ITES companies
was to capture
a pie of the
'Locational
Savings' made
by the MNC's.
As a result
of India's low
cost and skilled
manpower, a
number of MNC's
had set up IT/ITES
companies in
India and were
relocating work
back to India.
This process
resulted into
huge cost savings
for the MNC's
and the resultant
increase in
profits. This
increase in
profit was on
account of 'Locational
Savings' which
most of the
tax authorities
in emerging
economies such
as India and
China are trying
to tax. In fact,
currently 'Locational
Savings' is
a very hot topic
in China.
These high mark-ups
expected by
the tax authorities
for the IT/ITES
industry created
a huge dissatisfaction
amongst the
taxpayers. Many
of the taxpayers
are in appeal
against these
orders while
some of them
have resorted
to Mutual Agreement
Procedures to
eliminate the
Double Taxation.
In light of
this issue,
The NASSCOM
(the National
Association
of Software
Companies) has
demanded the
rationalisation
of the transfer
pricing legislation
in India and
demanded the
introduction
of Advance Pricing
Agreements.
c) Transfer
Pricing and
Exempt Profits
Some of the
IT/ITES companies
based in India
were of the
opinion that
since profits
derived by them
from the export
of Software
or IT Enabled
services was
not liable to
tax, they are
not required
to comply with
the Transfer
Pricing legislation
in India. This
is a misconception
as Proviso to
Section 92C(4)
clearly provides
that IT/ITES
companies would
be liable to
pay tax on any
adjustments
made in their
transfer pricing
audits. Infact
there was a
recent decision
issued by the
Income-tax Appellate
Tribunal (ITAT)
in the case
of Aztec Software
a Bangalore
based company,
wherein the
ITAT overruled
the decision
of the Commissioner
of Income-tax
(Appeals), which
was in favour
of demonstrating
avoidance of
tax for TP to
apply. The ITAT
decision states
that, demonstration
of tax avoidance
is not a pre-requisite
when the law
clearly provides
that companies
exempt from
tax are required
to comply with
the arm's length
standard. It
is therefore
important to
reiterate that,
even the tax
exempt IT/ITES/Export
Oriented Units
are expected
to comply with
the contemporaneous
documentation
requirements
of India and
the arms length
standard.
d) Re-imbursements
received by
Indian companies
/ Delayed payments
for services
There were some
instances where
the Indian companies
received re-imbursement
of expenses
incurred on
behalf of the
related entities.
These re-imbursements
involved the
Indian company
incurring expenses
on behalf of
the related
entities in
the first place
and then the
related entities
returning the
amounts to the
Indian companies
at a subsequent
point of time.
The Indian companies
contended that
these transactions
were carried
out on 'actual
cost basis'
thus fulfilling
the requirements
of the arms
length standard.
The tax authorities
held that these
seemingly harmless
transactions
were actually
an innovative
way of providing
interest free
finance to related
entities. It
was contended
by the tax authorities
that these reimbursements
were advantageous
to the related
entities in
the sense that
they were short
of cash flow
and if these
expenses were
not borne by
the taxpayer,
the related
entity would
have to borrow
money at interest
to pay for these
expenses.
As these reimbursements
gave a distinct
benefit to the
related entities
and at a distinct
financial cost
to the taxpayer
these transactions
were not accepted
to be at arm's
length resulting
into adjustments
(adding notional
interest). This
was more so
where reimbursements
were one way
i.e. recoveries
by the tax payer
in India.
Charging of
notional interest
was not only
evidenced in
case of reimbursements,
but these were
also implemented
in case the
credit period
for invoices
raised by the
tax payer exceeded
the industry
norm of 30-45
days. Based
on these practical
experiences,
it is therefore
not only essential
for the compensation
to meet the
arm's length
standard but
also essential
for the tax
payer to demonstrate
that the terms
of trade are
compliant with
such standards.
e) Provision
of skilled manpower
to the related
entity
Many of the
IT companies
in India provided
skilled manpower
to the related
entities. Basically
this involved
the Indian IT
company recruiting
software personnel,
providing the
requisite training
to these personnel
and then transferring
them to the
related entities
on an H1B visa.
The tax authorities
(at the level
of Transfer
Pricing Officers')
have held that
provision of
skilled manpower
is a valuable
service rendered
by the taxpayer
to its related
entities. Therefore
in this case
the transfer
pricing officers
are of the view
that, charging
a fee which
is comparable
to that charged
by placement
agencies for
a similar service
of providing
skilled manpower,
would meet the
arm's length
situation.
Most of the
IT companies
were caught
unaware on this
ground resulting
into huge transfer
pricing adjustments,
though we understand
that at higher
appellate levels
this adjustment
is getting reversed,
based on facts
and commercial
factors.
C. CONCLUSION
The above are
few of the transfer
pricing complexities
being faced
by the IT/ITES
companies operating
in India.
Currently a
lot of restructuring
has taken place
in the Transfer
Pricing Department
and a substantial
increase has
been made in
the number of
officers. The
strength of
Transfer Pricing
Officers in
India has increased
from 18 (approx)
to 70 all over
India. Further,
the time limit
for completion
of assessment
has been increased
to 33 months
from the end
of the concerned
assessment from
the erstwhile
limit of 21
months.
This highlights
the growing
importance being
attached to
Transfer Pricing
by the government
and the increased
attention and
focus that the
tax authorities
would give to
each case selected
for scrutiny,
thereby increasing
the compliance
burden for tax
payers. The
tension between
commercial and
compliance drivers
is a constant
issue for multinational
businesses in
the modern tax
environment
but bridging
the gap is the
key. In the
context of transfer
pricing, such
gap could be
bridged through
only one solution
and that is
to maintain
contemporaneous
documentation.
It is extremely
important to
appreciate that,
a TP policy
and documentation
cannot be established,
set in stone
and then ignored.
If it is to
have any value,
it must be reviewed
on an ongoing
basis to make
it contemporaneous.
