1. No category

Transfer Pricing Issues
- IT/ITES Industry
- Financial Services Industry
Darpan Mehta
March 20, 2015
Agenda
IT/ITES
Industry
1
Financial
Services
Industry
2
Slide 2
IT/ITES Industry
1
Issues and challenges
Why IT/ITeS?
Favourite area for transfer pricing
assessments in India – sector
dominated by MNCs.
Most common approach to establish
ALP is to apply TNMM.
No tax holiday on TP adjustments
Transactions resulting in more than
ordinary profits, excess disallowed.
Transition from tax holiday to
non-tax holiday
Potential areas?!
-Permanent
Establishments
- Attribution of
location savings for
Niche researches
undertaken
Slide 4
Issues and challenges
Comparability, key area of focus
Large outbound multinationals having turnover multiple times when
compared to the low-end captives are often not appreciated by tax authorities.
Several ITAT rulings have examined and ruled on comparability aspects
considering functions, assets and risk (FAR) analysis, turnover criteria, etc. Few
examples – Infosys, Wipro, Tata Elxsi, I-Gate, E-clerx, etc. TPOs continue to
select these companies as comparable.
Low end back office support services (BPOs) and high-end service providers
(KPOs) – Not differentiated
Tax authorities disregard the qualification/skill sets of employees and re-characterize taxpayers as
KPO (which requires them to earn high profit margin) and accordingly make adjustments
New areas of comparability are being looked at every year &
Increasing focus on the high end functions of the tax payer
Slide 5
Issues and challenges
Typical favourites of tax administration
IT/Software
development services
segment
IT enabled services
segment
Infosys Technologies Ltd.
Infosys BPO Ltd.
Kals Information Systems Ltd. Accentia Technologies Ltd.
Wipro Ltd.
TCS e-serve Ltd.
Tata Elxsi Ltd.
TCS e-serve International Ltd.
Acropetal Technologies Ltd.
E-clerx Services Ltd.
Moldtek
Coral hubs Ltd
Slide 6
Issues and challenges
Other key issues faced during assessments
1.Use of single year data – TPOs and appellate
authorities have consistently denied use of
multiple year data
2.Secret comparables - use of powers conferred
u/s 133(6)
3.Rejection of filters adopted by tax payer
4.Rejection of TP documentation maintained –
liberal use of powers u/s 92C(3)
5.Re-perform tax payer’s qualitative BM analysis
and choose high margin companies
6.Challenges in PLI computation for
comparables: pass through costs; un-realised
foreign exchange loss/gain
7.Denial of economic adjustments such as risk
adjustment, working capital adjustments, etc.
Slide 7
Issues and challenges
Substance over Form
Substance over form creates further anxiety during audits, certain
instances:
1. Terms as per inter-company agreements - scope of work, etc.
While the actual work performed would be that of back office support or low end IT services, scope of
services in the inter-company agreements would be more elaborate and indicate high end services.
Invoices may further not speak the language of the actual service provision.
2. Billing – hourly rates vs. cost plus
While the functions performed would be that of a captive, be it IT/ITeS, the remuneration model
would not indicate the same. Further, behaviour of the tax payer for the purpose of retaining profits
in tax holiday units.
3. Where in value chain?
TPOs often tend to oversee the position/roles of the tax payer in the entire value chain of Group
companies’ business.
Slide 8
Issues and challenges
Entrepreneurs vs. captives – need for differentiation
Differences in the functions and risks between entrepreneurial IT/ITeS
companies and captive IT/ITeS companies:
Entrepreneurial companies
Captive companies
Operates on a time & material (T&M) basis with a split
for man hour charges for offshore and onshore
Operates as a part of the in-house team of the parent
generally operating as a wholly owned subsidiary of the
parent
Business model – extended arm of the client & generally
provide access to source codes and IPR for execution of
the contract
Business model - provided with access to all source
codes along with technical know-how.
Does business development and marketing of the
services.
No marketing element involved
Responsible for warranties on the programmes
developed along with provision support upto certain
period of time.
Captives does not take any warranty for the programmes
developed
Generally end-to-end projects are sought by customers
Involved in providing low-end support to the services
provided by parent
Slide 9
Issues and challenges
Certain case laws…
contd…
Captives do not constitute PEs
The Hon’ble Delhi High Court in the context of Permanent Establishment, rendered in the case of efunds Corporation and e-funds IT Solutions Inc. that an Indian subsidiary, on a standalone
basis or by itself, would not create a PE of the foreign principal.
Disallowance - Super normal profits
Hon’ble Pune Tribunal decision in the case of Tweezerman India P Ltd. TS-344-ITAT2013(CHNY)-TP held that the AO was not right in disallowance of deduction u/s 10B on excess
transaction price over ALP.
[In this case, the AO held that the benefit u/s 10B was disallowable to the extent of excess of assessee's
profit for computation of Sec. 10B over arm's length profit determine by the TPO. Accordingly, it was
held that the assessee was not entitled to Sec. 10B benefit on Rs. 3.66Cr.]
Slide 10
Issues and challenges
Certain case laws…
contd…
BPO vs KPO & High Profit comparables
Hon’ble Mumbai Tribunal (SB) decision in the case of Maersk ruled on the following important
principles.
•
ITES services could not be further bifurcated or classified as BPO and KPO services for the
purpose of comparability analysis.
If a taxpayer was found to have provided low-end back office support services like voice or data
processing services as a whole, or substantially the whole, then companies providing mainly
high-end services by using their specialized knowledge and domain expertise could not be
considered as comparables.
•
Potential comparables could not be excluded merely on the ground that their profit was
abnormally high.
Abnormally high profit margin should trigger further investigation, including profit margin
earned in the immediately preceding year/s to find out whether the high profit margin
represented the normal business trend. If the high profit margin did not reflect normal business
conditions, the high profit margin making entity should not be included in the list of
comparables.
Slide 11
Safe Harbour Rules
Coverage and rates
#
Eligible International Transaction
Proposed Safe Harbour (OP/OE not less than)
1.
Software development services*
2.
Information technology enabled
services*
3.
KPO
25% - no range
4.
Contract R&D services (software)
30% - no range
20% for transaction value up to INR 5 Billion;
22% for transaction greater than INR 5 Billion
* With insignificant risk
Operating Income Excludes
(a) interest income;
Operating Expense Excludes
(a) interest expense;
(b) income arising on account of foreign currency fluctuations; (b) provision for unascertained liabilities;
(c) income on sale of assets/investments;
(c) pre-operating expenses;
(d) refunds relating to income tax expense;
(d) loss arising on account of foreign currency fluctuations;
(e) provisions no longer required written back;
(e) extra-ordinary expenses;
(f) extra-ordinary items;
(f) loss on transfer of assets/investments of;
(g) other incomes not relating to operating activities
(g) expenses on account of income-tax;
(h) other expenses not relating to operating activities
Slide 12
Safe Harbour Rules
Insignificant risk
The description of an eligible taxpayer with insignificant risk is in line with
criteria prescribed in a recently issued Circular (No. 6/2013 dated 29 June,
2013)
Foreign Principal
Indian Service Provider (ICo)
Economically significant functions
ICo is largely involved in economically insignificant
(Conceptualisation, Design, etc.)
functions
Funds/capital and other economically
ICo does not use any other economically significant
significant assets including intangibles
assets including intangibles
Capability to control or supervise through
its strategic decisions to perform core
ICo works under direct supervision of foreign principal
functions as well as monitor activities
ICo does not assume or has no economically significant
Assumption of risks
realised risks
Ownership right (legal or economic) on
outcome of research
ICo has no ownership right on outcome of research
which shall also be evident from conduct of the parties
Slide 13
Issues and challenges
Learning lessons
Detailed FAR /
BM Analysis
Robust TP
documentationAlignment of
Form &
Substance
Supplement
Analysis
Learning
Lessons
Suo-moto
adjustment
Timely
representation
Periodic review
of TP policy &
inter-company
agreements
Slide 14
Financial Services Industry
2
Private Equity and Asset Management
Issues
Funds
• An Indian company provides nonbinding investment
recommendations receives a cost
plus mark-up in the range of 15% to
20%
• During TP audits, mark-ups
upwards of 50% applied by tax
authorities by selecting asset
management companies and
investment bankers as comparables
(Tribunals have granted relief in
various cases such as Carlyle, Bain
Capital, Tamasek, etc)
•
Possible approach
• Certainty on methodology,
characterisation (Indian entity and
AEs) and mark-up
Investment
management
agreement
Investment Manager
Investment
Advisory
agreement
Investment Advisor
Outside India
India
Sub- Advisory
/ Consultancy
agreements
Investment sub-advisor
• Fund raising and investor
relations
• Investment management
• Evaluation of opportunities
• Final decision making
• Identification and
advising Manager
• Screening & evaluation
of Sub-advisor’s
recommendation
• Preliminary analysis
• Detailed analysis
• Support / monitoring
services
Slide 16
Equity Broking
Issues
AE FII
client
3P FII clients
• Transactional Net Margin Method (‘TNMM’)
selected as the most appropriate method by
the tax payer.
• Comparable Uncontrolled Price (‘CUP’)
Method applied by the Indian tax authorities
using other third party (3P) transactions.
Overseas
Possible approaches
India
• Selection of most appropriate method
Indian
Broker
- Use of TNMM considering various products
and operational mechanism selected.
- In case of CUP, agree on mechanics for
adjustment towards:
Domestic
clients
Brokerage income
FII - Foreign Institutional Investor
◦ Distinguishing functions performed for
AEs vis-à-vis non AEs (i.e. marketing,
research) and it impact on pricing.
◦ Consideration of volume adjustments on
pricing brokerage rates.
Slide 17
Investment Banking
Type of IB transactions /
deals
1. Mergers & Acquisitions
3. Underwriting
2. Debt and Equity Capital
Market
Typical functions
Typical pricing
mechanisms
1. Origination
3. Structuring
2. Execution
4. Distribution /
Underwriting
1. Pooling of revenues and costs & profit split based on
key driver
2. Revenue split on deal by deal basis
Allocation keys / Weights
Most
Appropriate
Method
1. Market Surveys
3. HR Index
2. Employee cost
4. Time spent
Integrated
functions
1. Revenue Split (Other Method)
2. Profit Split Method
Support
functions
1. TNMM
Slide 18
Investment Banking
Key points for consideration :
• Application of global policy to Indian operations / basis of pricing
• Consistent allocation for profits and losses
• Confirmation on basis of allocation /application of global policy (e.g.
compensation, HR index, etc.)
• Framework for treatment of policy exceptions, if any
Slide 19
Key Issues in Financial Services
Cost Allocations
Generally large Banking Groups centralise various support functions such as IT, Legal,
Finance, HR on a global / regional level and such costs are allocated across affiliates,
including Indian entity, on the basis of reasonable allocation keys (with or without mark-ups)
Typical Issues
Possible approaches
• Demonstration of benefit test analysis
with adequate documentation
• Guidance on level of documentation
that could be maintained on an annual
basis to demonstrate receipt of benefits
• Determining whether there is any
duplication of services / shareholder
costs being charged
• Certainty on the allocation basis
• Determining the appropriateness of the
cost pool and allocation keys used
• Documentation to support accuracy of
cost allocation to India – audited
statements
• Justification for charging a mark-up, if
any
• Confirmation on mark-up on certain
costs
• Absence of independent Accountant’s
Certificate to support the amount
allocated to India
• No deduction available to India bank
branch, in absence of actual payment
Slide 20
Offshore Loans
Typical Functions / Risks
Overseas Branch
ABC Bank
Singapore
Loan advanced
by Singapore
branch to the
third party
borrower
Functions
• Sales conclusion
• Loan management
• Risk assumption
• Capital Raising
Fees and interest
paid by third
party borrower to
Singapore
branch
Risks
• Credit risk
• Interest rate risk
• Liquidity risk
Overseas
India
Third party
borrower
Assists in loan
origination and
sales support
Approaches
Indian branch
for foreign
currency loan
ABC Bank
India branch
India Branch
Functions
• Origination and sales support
(documentation, credit review support, etc.)
• Loan monitoring and administration
Risks
• Operational risk (minimal)
• Reputational risk
Slide 21
Offshore Loans
Typical Issues
Possible approaches
• Scrutiny to analyze role of each group
entity and whether pricing
commensurate with functions
• Confirmation of functional analysis in
relation to roles performed by India
branch and overseas AE
• Indian tax authorities typically adopt an
approach to apply a percentage in the
range of 20 to 25% of the net income to
the originating location
• Arm’s length pricing based on
comparability analysis, considering:-
• Varied fee split mechanisms adopted by
the industry players
- Approaches based on global databases
such as LoanConnector, Deal Scan, etc.
that provide data as a proxy for
origination, support functions.
- Back Testing / corroborating results
- Using internal data, if available
Slide 22
Questions?
Thank You
Slide 24