Specific Issues in Transfer Pricing

Background of Indian Transfer Pricing:

Introduced in 2001, Indian Transfer Pricing regime has grown, evolved and matured in its life spanning close to two decades now. The transfer pricing disputes has evolved from litigative and controversial to more non-adversarial and business friendly. With systematic introduction of favourable tax regimes namely safe harbour rules and its revision, pruning down of controversial aspects in domestic transfer pricing, introduction of advance pricing agreements regime and subsequent insertion of rollback provisions in APA regime for 4 years, thereby providing certainty for almost 9 years etc. have contributed to the constant decline in Transfer pricing disputes.  With the aim of following global best tax practices, several changes have been introduced in Indian Transfer Pricing Regulations in line with OECD BEPS Action Plans viz. interest deduction, secondary adjustment, country by country reporting etc. Below are few of the specific and lingering transfer pricing issues that need clarity at the Apex Court level and the perspective on India’s stand on Action Plan 8-10.

Advertising, Marketing and Promotion expenses (AMP): 

AMP has been one of the most contentious issues in contemporary Transfer Pricing practices. There is no specific inclusion of Advertising, Marketing and Promotion expenses in the definition of international transaction. So the moot question arises as to whether AMP should at all qualify as an international transaction. The entire concept of AMP expenses revolves around the premise set up by the tax department wherein it is alleged that the AMP spend of Indian Company is applied towards enhancement of the brand value of Intellectual property of its overseas parent Company (AE of Indian Company). Accordingly, the parent Company should remunerate the Indian subsidiary for such AMP expenses with a profit top up. As per the tax authorities, this transaction should be treated as an international transaction and should be tested for Arm’s Length Price. 

With the Explanation to section 92B inserted in Finance Act 2012, intangible property has been defined as ‘marketing related intangibles’ such as trademarks, trade names, brand names, logos etc. In one of the cases, the tax department adopted ‘Bright line’ test as laid down in one of the US tax court cases. According to Bright Line Test, any excess AMP expense exceeding the average AMP expense incurred by comparable companies in India is considered as non-routine AMP expense and should be subject to benchmarking in accordance with the Arm’s length principles. Such non-routine AMP expenses represent expenses incurred for enhancing the value of Foreign AEs branch in India, thereby referred to as “marketing intangibles’. However, Hon’ble Delhi High Court in case of LG Electronics India (P.) Ltd. held that Bright Line Test should not be applied as a binding method for deriving non-routine expenses. However, Hon’ble HC also held that AMP may be treated as an international transaction.  It is pertinent to note the distinction between sales expenses i.e. expenses incurred ‘in connection with sales’ and sales promotion expenses i.e. expenses incurred ‘for promoting sales’. Hence, expenses incurred directly in connection with sales should be excluded from computing AMP expenses to be benchmarked. It is the sales promotion expenses that promote sales lead to brand building of the foreign AE in India and accordingly, the foreign AE should be compensated for such expenses on an arm’s length price. Accordingly, from a Transfer Pricing perspective, at the time of computing TP Adjustment for marketing intangibles, commission expenses, cash discounts, volume rebate, trade discount etc. should be excluded. Further the AMP Subsidy received by the Indian subsidiary from its   Parent Company should be excluded from the total AMP Expenses. It is also pertinent to note the treatment of Consumer Market Research Expenses and AMP Expenses that are incurred by the India Company on its other domestic brands that are self-owned. Such market research and AMP expenses should be excluded from AMP Expenses and no transfer pricing adjustment should be made for such expenses.                   Further, it is imperative to understand the difference between expenses incurred by a distributor as compared with a licensed manufacturer while understanding the concept of AMP from a transfer pricing perceptive. Generally, where a distributor receives sufficient profits and rewards as part of percentage of price of the goods (higher gross margins) imported from its foreign AE, so no separate compensation in the form of reimbursement of excess AMP expenses is paid. This is because in such cases, the distributor is already earning premium profits in comparison with its independent comparables with similar functional background. Accordingly, no separate compensation is needed for excessive AMP expenditure in case of distributors, where such distributor receives sufficient profits/ rewards as part of the pricing of goods imported from its foreign principal.  Currently, the AMP issue is pending adjudication before Hon’ble Supreme Court with the main issue to be decided being whether AMP expenses is an ‘international transaction’. Till the Apex Court of India resolves the issue, currently available opposite Tribunal judgements do not provide a clear guidance on the matter. 

Intra-group transactions:

The transfer pricing benchmarking analysis of intra-company services if one of the most complex areas of Transfer Pricing regulations in India. The lack of guidance in Indian TP regulations further adds up to the confusion. One of the tests recommended by OECD’s Transfer Pricing guidelines for identifying intra-group transaction is the ‘benefit test’ that involves citing the commercial or non-general benefit obtained by related party on account of undertaking of intra-company functions. Generally the Transfer Pricing Officer (‘TPO’) tends to examine whether an independent entity would have paid for an intra-group service in order to apply the ‘benefit test’ while determining ALP of intra-group services. However, it has been decided in many Tribunal judgements in the past that the TPO shall be said to be exceeding his authority where he questions the commercial wisdom of providing a particular service and that the commercial expediency of a transaction should be left to the best judgement of those running the business.  The tax department insists on producing evidence with regard to receipt of services and that those services were general in nature. As per the tax authorities, the evidence of receipt of services does not lie in mere documents viz. emails exchanged, agreement entered into between related parties. The biggest of all evidence is the benefit derived from receipt of services. Generally TPO applies CUP as the most appropriate method for benchmarking intra-group services and determines the Arm’s Length Price at NIL value, thereby resulting in a transfer pricing addition. In the absence of clear guidelines on the most appropriate method for determining ALP for intra-group services, there have been several Tribunal judgements wherein it has been upheld that CUP method cannot be applied in the absence of data pertaining to the price of the same product and service in uncontrolled circumstances. The Tribunals have emphasized that the process of evaluating the worth of services cannot be directly correlated with the benefit of such services. Accordingly, the taxpayer should maintain robust documentation to demonstrate reasonably sufficient evidence on rendition of services.  Intra group services can broadly be divided into two categories namely administrative/ management services and commercial services. Whilst administrative/ management services are more focused on management and staff related activities of an organisation viz. accounting, information technology, human resource management etc., the commercial services category refers to the popular line functions. Generally MNE operate through designing global policies made at the head-office level or in a centralised manner for undertaking management and administrative activities at group level in order to avoid work repetitions and procedural hick-ups and delays.  On the other hand, income producing services are services that are core to the business undertaken by an entity within a group namely R&D, product development, sharing of know-how etc. The aforesaid income producing activity are income generating and have associated operational and commercial risks involved. Accordingly, such functions may command a higher mark-up or charge. It is also pertinent to note that the diagnosis and characterisation of a particular service into administrative or business in nature shall depend upon facts and circumstances of each case. A particular transaction may constitute management or administrative service for one corporation and at the same time it may be characterised as a commercial or income-producing service for another. 

Centralized Procurement – Sogo Shosha Companies:

‘Sogo’ means general and ‘Shosha’ means trading Company. Sogo Shosha Companies are large Japanese trading Companies that trade in a wide range of products from pin to plane having huge volumes. Sogo Shosha companies engage in both import and export globally and generally tend to have large volumes with thin margins. Generally, the Indian group subsidiary of a Japanese Sogo Shosha Company assists its Parent Group in procurement and sales related activities in India. Such Indian procurement company obtains the title of goods to be sold to its overseas AE for a very short period of time, popularly called as “flash title” and since it enters into back to back trading cycle, the risk of inventory is almost negligible. No value add function is undertaken by the Indian Company post acquiring the product for further sale to the foreign AE.  The agreement of supply of goods between Indian Procurement Company and its overseas AE is usually on a principal to principal basis. Accordingly, such Indian Company does not typically fall within the definition of a Commission agent though the profit margins as low as that of a commission agent. This is primarily due to absence of any unique intangibles and low risk profile of the business due to confirmed orders from foreign AEs, back to back bookings of goods etc. However, both sales and purchase entries are typically found in the books of such Indian procurement Company which is in complete contrast to a Commission agent who does not maintain inventory and never has title of goods in his name, even for a short period of time. With the above contrasts in the FAR analysis of an Indian procurement Company with that of a Commission agent, there are multiple benchmarking related issues that emerge from a transfer pricing perspective. One of the key issues while benchmarking such a transaction between Indian procurement Company and its Japanese Sogo Shosha counterpart is the lack of availability of comparables in public domain with this type of unique FAR profile. Further, it becomes difficult to characterize such Indian procurement company in one typical way as a trader simpliciter or a plain service provider. Another benchmarking challenge with such Indian procurement companies is that of selection of appropriate method and profit level indicator (PLI) for computing Arm’s length margins. Comparable Uncontrolled Method (CUP) and Cost Plus Method (CPM) is generally impractical to apply due to non-availability of suitable comparable independent India companies. Since the Indian Company is engaged in procuring/ sourcing and not resale trading, Resale Price Method (RPM) also does not apply. Profit Split Method (PSM) may also be inapplicable due to absence of unique intangibles deployed by Indian Company. On the contrary, the Indian Company employs routine intangibles for undertaking its limited risk functions. Another issue typical to such Indian procurement companies is since they acquire flash title to the goods sourced from India and sold to its overseas AEs, there is inventory reflecting in their profit and loss account, even though they have such inventory for a very short duration and does not bear the inventory risk at all. In such circumstances, adopting a PLI having operating revenue computed as a return on value of goods (Cost of Goods Sold) may provide misleading results and an exorbitantly high return. Accordingly, ideally a PLI that excludes COGS should be taken into account. On the other hand, a PLI based on value added operating expenses should be adopted. This is because in case of Indian Procurement Company, it does not undertake COGS expenses but its overseas AE bears the risk of inventory. Further, COGS is a measure of return on value of goods traded, sourced or handled. It is not a measure of return on value add functions. Accordingly, COGS is not relevant from a benchmarking perspective in case of such Companies.  On the basis of above analysis, it can be concluded that Berry ratio can be adopted a fair measure of benchmarking the value of functions performed by a low risk distributor and/ or service provider. Berry ratio can be used as a PLI depicting operating expenses where no unique intangibles are employed and no expenses pertaining to manufacturing or warehousing are incurred. In such situations, COGS depicting the value of goods handled becomes irrelevant and the operating cost (excluding COGS) represents the value added services undertaken by the Indian procurement entity. Accordingly, Berry Ratio is used for arm’s length benchmarking in cases of limited risk distributors, service providers and procurement entities. Though there are limited legal precedents available on application of Berry ratio and exclusion of COGS from operating expenses while undertaking benchmarking analysis of Indian procurement Companies, there is room for ambiguity and interpretational differences between revenue and taxpayers. On the other hand, CBDT has signed a total of five bilateral APAs with Japan with roll back provisions being actively exercised in all of them. Tax certainty for up to 9 years has also been obtained through signing bilateral APA with roll back provisions with a Japanese Trading Company representing Sogo Shosha business model.

Location Savings:

Location savings are net savings in cost obtained by a multinational enterprise (MNE) usually through relocating its core operations from a high cost jurisdiction to a low cost jurisdiction with the motive. Generally, the types of benefits obtained include labour and material cost savings, cheaper or subsidized availability of capital, production, distribution, technology and logistics support, larger customer base with increased spending capacity, advanced infrastructure etc. that may support the MNE to in gaining competitive advantage. On the other hand, there are certain flip costs also namely enhanced quality control costs, logistic planning and capital investment costs. Location rent is the incremental profits obtained by a MNE from existence and exploitation of Location savings. However, all location saving advantages do not result in location rent. As an example, in locations that are growth stagnant due to competition, though there could be presence of locational advantages but those would get transferred to local customers through availability of goods/ services at competitively lower prices. Accordingly, Location savings may dissolve over time due to competitive pressures. Besides this, the location saving also depends upon the bargaining power of related parties.  Indian revenue has been making upwards transfer pricing adjustments on account of location savings and even came up with a substantive circular on it wherein Captive R&D centres shall bear the wrath of the concept. However, the circular was later withdrawn. With passage of time, more and more court decisions have appeared wherein the claim for transfer pricing adjustment due to locational saving has been dropped. Indian courts have been adopting generous and pro-taxpayer views by holding that where the benefit of locational savings is passed on to the end consumer due to competitive ecosystem and pricing or where Arm’s Length Price is computed through comparing with appropriate comparables, there is no need for separate adjustment on account of location savings.   

Also Read: International Transaction