The UN transfer pricing subcommittee has released a revised draft of the Practical Manual on Transfer Pricing for Developing Countries, which is expected to be finalized in the spring of 2017 after necessary editing and checking.
The new draft of the UN TP manual includes key transfer pricing guidance on intra-group services, cost contribution agreements, treatment of intangibles, and transfer pricing documentation. It also includes several updated chapters on country transfer pricing practices, including a revised chapter on India transfer pricing practices.
In view of the significant transfer pricing litigation in India, the new draft India chapter serves as an important reference point on various transfer pricing issues, offering insight into the views of the Indian Revenue authorities who participated in drafting it.
Low value adding intra-group services
While India is a party to the consensus developed under the OECD/G20 Base Erosion Profit Shifting (BEPS) Action Plan, India has not endorsed the guidance in Action Plan 10 pertaining to low value adding intra-group services or opted for the simplified approach.
The India chapter explains that Indian Revenue considers payments for intra-group services to be base-eroding in nature. Hence, to this extent, India’s transfer pricing practice diverges from the BEPS guidance, which advises that a mark-up of 5 percent be considered as acceptable for low value adding intra-group services.
Surprisingly, the India chapter further provides that even if an arm’s length result is achieved in respect of such payments, the payments for intra-group services may also be subjected to an overall ceiling in the form of a percentage of the sales or revenue of the Indian entity.
The chapter explains that even arm’s length payments may result in the erosion of all the profits of the Indian entity or in the enhancement of its losses, thereby making the arm’s length nature of such payments questionable.
As India is a major player in information technology services, which may qualify as low value adding intra-group services, its reservations on the relaxation provided by the BEPS guidance on low value intra-group services are reconcilable.
However, the ceiling on the payment that could be made for intra-group services by an India taxpayer could create business impediments, as it could restrict the inflow of services into India which otherwise may meet the arm’s length pricing standard.
The ceiling could also create tax challenges for start-up companies, which may not have significant revenue at the initial stage of their operations and may need more initial support from group companies outside India.
The applicability of the ceiling would need to be evaluated on the basis of facts of each company.
India has also not accepted OECD BEPS guidelines which relax the transfer pricing documentation requirements for low value adding intra-group services. Given the same, Indian companies will need to continue to respond to Indian Revenue requests for detailed documentation pertaining to intra-group services, including documentation evidencing services rendered, which would need to be evaluated basis facts of each company, industry and others.
The new chapter notes that India has endorsed the recommendations of OECD BEPS Action Plan 13, supporting the three-tiered documentation structure comprising of a master file, local file, and country-by-country report.
The documentation requirement has already been incorporated into Indian law, in Income tax Act, 1961 (under section 286), and applies from financial year 2016-17 to group companies with consolidated turnover of Euro 750 million and higher.
India’s transfer pricing documentation requirements are broadly consistent with OECD BEPS Action Plan 13. However, detailed guidance on this issue is still awaited.
A significant concern for multinational enterprise taxpayers has been the position of Indian Revenue on advertisement, marketing, and promotion expenses (commonly referred to as AMP functions) incurred by Indian companies.
Indian Revenue has imposed transfer pricing adjustments for Indian taxpayers’ AMP expenditures on the premise that the taxpayer benefits its parent company (the brand owner) located outside India.
Indian Revenue argues that the AMP expenses incurred by the Indian taxpayers’ are for the development of the foreign associated enterprise’s intangibles, and thus the Indian taxpayer deserves arm’s length compensation.
It can be inferred from the updated India chapter that the Indian Revenue no longer will use the ‘bright line’ test for AMP expenditure to ascertain whether or not the foreign brand owner/licensor is being benefitted through the AMP functions of the Indian entity and, accordingly, whether the licensor should compensate the Indian entity for its marketing functions. This test has been struck down in Indian High Court decisions.
Instead, the India chapter states that Indian Revenue will assess marketing intangible functions by undertaking a detailed functional and economic analysis to identify the functions performed by the Indian taxpayer as well as the foreign associated enterprise. This analysis will determine whether the Indian taxpayer should not only be compensated for distribution but also for enhancing the value of the brands, trademarks, and other marketing intangibles.
Indian Revenue will examine whether the AMP functions performed by the Indian taxpayer, reflected by the expenses incurred by the Indian taxpayer and the foreign associated enterprise, are in conformity with the functional and risk profile of the Indian taxpayer and the foreign enterprise.
Indian Revenue will also determine which persons make important decisions relating to the AMP functions, such as deciding the strategy, fixing the budget, and exercising overall control over the AMP functions.
In the chapter, Indian Revenue refers to the OECD BEPS guidelines, explaining that the compensation for AMP undertaken by a taxpayer can be separate, such as on cost plus mark-up basis, or can be part of the price of another other transaction, such as through a reduction in royalty rates.
Further, Indian Revenue, in line with the OECD BEPS guidelines, has acknowledged that where the licensee to the brand performs the AMP functions with a view to exploit the benefit itself, compensation for AMP functions from the foreign licensor is not required.
Importantly, the India chapter states that, for Indian taxpayers undertaking AMP functions, the Indian Revenue will either accept the comparable uncontrolled price method or profit split method or evaluate the net operating profit margin of the distributor under the transactional net margin method for benchmarking, inferring that a gross profit margin based analysis may not be approved.
This, however, is inconsistent with judicial precedents in India, as well as the OECD BEPS guidelines, which allow use of resale price method, with the applicability of gross profit margin in the case of distributor.
Location savings, location specific factors
The revised India chapter reiterates India’s view that, apart from location savings, profit from location specific factors such as skilled manpower, access to market, a large customer base, superior information, and a distribution network should also be allocated between associated enterprises.
India is of the view that price determined on the basis of local comparables may not adequately allocate location savings and it is possible to use the profit split method to determine arm’s length allocation of location savings and location rents where comparable uncontrolled transactions are not available.
The India chapter states that if good local comparables are available, then the benefits of location savings can be said to have been captured in the arm’s length price so determined and no separate adjustment for local savings is required to be undertaken.
However, if good local comparables are not available that could capture the benefits of location savings or where the overseas associated enterprise is chosen as the tested party, the issue of capturing the benefits of location savings would remain open in determining the arm’s length price.
It is praiseworthy to see that the Indian Revenue authorities have accepted the position that no separate location savings adjustment required where local comparables are available, which has been repeatedly upheld by the judicial precedents in India, including the recent judgement by the Mumbai Bench of the ITAT in the case of Syngenta India Limited.
However, given the qualification of “good” local comparables used by the Indian Revenue in the communicating its position, it will be important for Indian taxpayers to carefully select comparable transactions to avoid any dispute on location savings.
Intangibles generated through research and development services
With the advent of globalization, many MNEs have established R&D centers in India. These centers are typically set up as contract R&D service providers, not eligible for intangible-related returns. There has been a fair bit of controversy on transfer pricing issues relating to the R&D centres.
Indian Revenue claims that the Indian R&D centres undertake significant functions and corresponding risks, and therefore should be entitled to intangible-related returns or more than routine return vis a vis taxpayers claiming themselves to be routine contact R&D services providers with insignificant risk and therefore only entitled to a cost plus mark-up.
The India chapter states that, in some cases, Indian R&D centres can be considered contract R&D service providers, with the researcher entitled only to a risk-insulated cost plus markup and the risks and associated rewards of success or failure of the R&D being attributed to the foreign principal company.
Such instances would occur when the foreign associated enterprise makes key decisions and performs functions around the conceptualization of research, namely determines what R&D subject or aspect the researcher should carry out and conducts ongoing monitoring of the researchers’ R&D activities.
The foreign enterprise must also provide funds and control the budget around R&D activities of the researcher, and the researcher must be considered to only execute or implement the instructions of the principal, the India chapter states.
Given the controversy, Indian Revenue has also issued Circular No. 6/2013 addressing transfer pricing aspects relating to development centres in India. The circular lays down guidelines for identifying a development center as a contract R&D service provider with insignificant risk. The guidelines generally follow the principle outlined in OECD Guidelines.
The new India chapter demonstrates that the tax authority has accepted several transfer pricing positions in OECD BEPS guidelines that had previously been the subject of significant litigation, revealing some light at the end of the tunnel.
However, there are certain inconsistencies, as well, from which one can infer that there is some road to travel, such as the discussion on low value intra-group services and the approach towards marketing intangibles.
It will be necessary for Indian taxpayers to acid test their transfer pricing documentation in view of the discussion in the India chapter to strengthen their positions and ward off potential disputes arising from intra-group transactions.