The Indian Advance Pricing Agreement Scheme: An Insight

On August 30^th 2012, Government of India has introduced detailed provision/ rules on the framework for Advance Pricing Agreement Scheme (‘APA Scheme’) in India. APA scheme introduced through Finance Act 2012, is applicable from July 1^st 2012.

Advance Pricing Agreement (‘APA’) is an agreement between the taxpayer and the tax authority in relation to an international transaction entered between associated enterprises for the purposes determining an arm’s length price or transfer pricing methodology in advance for future transactions. Once the APA has been entered between the tax payer and the tax authority, the arm’s length price of the transaction covered under an APA should be determined in accordance with the APA so entered. Accordingly, APA Scheme would provide conducive transfer pricing environment wherein taxpayer can be sure of certainty and consistency in respect of acceptability of intercompany pricing and transfer pricing methodology.

Types of APA

Following the best global practices, APA Scheme in India provides an option to the taxpayer to enter into any of the three types of APA;

(a)   Unilateral APA – Unilateral APA is an agreement between the tax authority and the taxpayer, it seeks confirmation of transfer pricing or methodology by the tax authority for the taxpayer within India. Accordingly, unilateral APA does not allow the taxpayer to avoid the risk of taxation by foreign tax administrations. Unilateral APA might be preferable wherein, in the foreign jurisdiction there is no or less active transfer pricing regime or say wherein India does not have tax convention with the other country. However, Unilateral APA may prove to have limited utility where both tax administrations actively review the transactions between group companies from transfer pricing perspective.

(b)   Bilateral APA – Bilateral APA is an agreement between the tax authority and the taxpayer subsequent to, and based on agreement between Indian competent authority and competent authority of another jurisdiction. In general, bilateral APA are preferred above unilateral APA since bilateral APA do provide certainty on two sides of the transaction whereas a unilateral APA does only provide certainty on one side of the transaction. Before concluding on Unilateral APA vis-à-vis Bilateral APA, it is suggested that the taxpayer must carry out the cost benefit analysis of Unilateral APA vis-à-vis Bilateral APA.

(c)  Multilateral APA – Multilateral APA is an agreement between the tax authority and the taxpayer subsequent to, and based on agreement between Indian competent authority and competent authorities of other jurisdictions. In general, multilateral APA is entered wherein stakes are high and more than two tax jurisdictions are involved.

It is to be noted that the process for bilateral or multilateral APA cannot be initiated unless the associated enterprise situated outside India has initiated process of advance pricing agreement with the competent authority in the other country.

Eligibility

As per sub section (1) of section 92CC of the Act read with Rule 10G of the Rules ;

(a)    any person, resident or non-resident, who proposed to enter into a new international transaction with its associated enterprise, and /or

(b)   any person, resident or non-resident, who is having continuing international transaction with its associated enterprise

can file an application for an APA. The Indian APA Scheme follows five stages as commonly seen also in APA schemes of other foreign tax jurisdiction;

(1)    Pre-filing consultation

(2)    Formal application for an APA

(3)    Analysis and evaluation

(4)    Finalising and signing an APA and

(5)    Execution, monitoring and review

Once concluded, the APA would be in effect for a maximum period of five years, depending on the actual agreement between the taxpayer and the tax authority. APAs may be revised, renewed or cancelled depending upon the change in the facts and assumptions.

Five Stages

(1)    Pre-filing consultation – Prior to an APA application, a taxpayer is required to make a written request, in Form 3CEC, to the Director General of Income Tax (International Taxation). This is the first step in APA process and should be taken seriously by the taxpayer. In this stage the taxpayer is required to  submit entity and group level business information, details of associated enterprise, details of international transactions including FAR analysis, proposed transfer pricing methodology, comparable data and history of transfer pricing audit. In case if the Applicant is seeking bilateral or multilateral APA, Indian Competent Authority would also be a party to the consultation.  

The objectives of the pre-filing consultation includes determining the scope an agreement, identifying transfer pricing issues, determining the suitability of international transaction for the agreement and discuss broad terms of the agreement.  The APA scheme specifies that pre-filing consultation is neither binding on the tax authorities and nor on the applicant.  Further, at this stage, the applicant is not required to deposit any fees. In particular, the opportunity to hold pre-filing meetings with the APA team on an anonymous basis will encourage taxpayers to explore the APA option.

(2)    Formal Application for an APA – An application for an APA must be submitted using Form 3CED to the Director General of Income Tax (International Taxation) in case of Unilateral APA and to the Competent Authority in case of Bilateral or Multilateral APA.  Along with an application, applicant the proof of payment of the required fees should be attached.

Amount of international transaction entered into or proposed to be undertaken in respect of which agreement is proposed during the proposed period of agreement.	Fees
Amount not exceeding Rs.1000 million	1 million
Amount not exceeding Rs.2000 million	1.5 million
Amount exceeding Rs.2000 million	2 million

On perusal of the Form 3CED, it seems that the tax authorities might be more inclined in entering into Bilateral or Multilateral APA wherein India has got Double Taxation Avoidance Agreement.

(3)    Analysis and Evaluation - Upon receipt of the APA application from the taxpayer, the tax authorities will evaluate the contents of the application and may seek further clarification from the taxpayer if necessary. A taxpayer who makes an APA application should note that acceptance of an APA application does not necessarily mean that the proposed transfer pricing methodology and other variables, e.g., arm’s length range, etc. put forth in the APA application will be accepted in its entirety. Tax authorities reserve the right to propose alternative methodologies, whether on its own, or in consultation with its treaty partner (in a bilateral or multilateral APA). In the course of the APA review and negotiation process, tax authorities may ask for additional information, proactive support in providing the requisite information might be critical to the success of the APA process. The taxpayer may withdraw the application at any time by filing an application in Form 3CEE, however, fees paid would not be refunded back.

(4)  Finalising and signing an APA - Once the analysis, discussion and evaluation is over, the tax authorities would proceed to finalise and formally sign an APA.  The terms on an agreement might include international transactions covered by the agreement, transfer pricing methodology, determination of arm’s length price, critical assumptions etc.

(5)    Execution, monitoring and review - Once the agreement is entered into, it would be binding on the tax payer and the tax authority. However, in case there is a change in any of the critical assumptions or failure to meet the conditions subject to which the agreement has been entered into, the agreement can be revised or cancelled, by the tax authorities.  It is required that the tax payer must file the annual compliance report, in Form 3CEF,in quadruplicate, for each of the years covered in the agreement, within thirty days of the due date of filing the income tax return for that year, or within ninety days of entering into an agreement, whichever is later.

Author's comment

This is a welcome move by the Government of India and we are happy to see that APA Scheme is largely best on the global accepted standards.  However, there are a few areas of concern:

(a)    Revision in APA - The fact that the APA team can revise an already existing APA in the event of a change in the law may reduce the benefit of having an APA.

(b)   Critical Assumption - Definition of the term “critical assumptions,” is quite vague and give ample opportunity for varied interpretation.

(c)    Firewall – As such the APA scheme do not provide any fire wall mechanism, which increases the risk of sharing of confidential and critical information by APA team with the tax officer at the time of Audit.

(d)   Timelines – The APA scheme does not prescribe any timeline for APA team to conclude, this might be deterrent to business decisions which are based on timeliness of action. However, in one of the conferences held in September 2012, officials from India's APA program noted that the team expects, and has the capacity to handle, 100 APA applications in the first year of operations. If more APA applications are filed, the government is ready and willing to provide the extra manpower to process these as well. India APA representatives estimated that it would take less than 9 months to conclude a unilateral APA and 12 to 18 months to conclude a bilateral APA.

(e)   Rollback – Request for application of transfer pricing methodology or arm’s length price to the tax years prior to those covered by the APA is known as rollback of APA. It could be an effective means of using available resources to address unresolved transfer pricing issues. However, APA Scheme does not have any such provision thus limiting the benefit to only future transactions.

Trust the same would be useful to you. For detailed Guidelines on Indian APA Scheme, you can refer notification No.36 date of issue 30/8/2012  http://law.incometaxindia.gov.in/DIT/Notifications.aspx

Best Regards

Gaurav Garg

JGarg Economic Advisors

New Delhi, India

Email: gaurav@jgarg.com

Mobile: +91 9899994934

AAR: Income not chargeable to tax are also covered under TP provisions

Recent ruling by Advance Ruling Authority (‘AAR’), dated August 14, 2012, in case of Castleton Investment Limited [A.A.R. No.999 of 2010] came as a surprise to many stake holders on applicability of transfer pricing.

Though the ruling was on other issues as well but this write-up is limited to the issue pertaining to applicability of transfer pricing provision in India.

The Applicant, M/s Castleton Investment Limited of Mauritius (‘CIL’), raised a question that if the transfer of shares by the applicant to its associated enterprise is not taxable, whether the provisions of section 92 to section 92F of the Act relating to transfer pricing would be applicable? In response to the same AAR observed that the applicability of section 92 does not depend on the chargeability under the Act. The only saving grace is that the judgement is only applicable in on that applicant and on that transaction for which it is sought.

Facts of the Case

Glaxo Smithlkine Pharmaceuticals Limited (GSKPL) is a company incorporated in India. The applicant had acquired 600,000 shares in it in the year 1993. It also acquired 1,680,170 shares in Burroughs Wellcome (India) Limited (‘BWL’) in the year 1996. GSKPL and BWL merged.  In the year 2004, the applicant received in lieu of the shares held by it in BWL, shares in GSKPL. These shares were held as investment in the books of CIL. As a part of reorganization, CIL propose to transfer shares held in GSKPL to its associated enterprise, Glaxo Smithlkine (Pte) Limited.

On transfer of shares, AAR observed that any capital gain arising from such transfer would not be taxable in India.

Question

Whether the provisions of section 92 to section 92F of the Act relating to transfer pricing would be applicable?

Observation of AAR

It is not material that the gain or income is taxable in the country or not, section 92 to 92F would apply if the transaction is one coming within those provisions. In case, where there is no liability what would be the purpose of undertaking a transfer pricing exercise is not a question that would affect the operation or rigour of a statutory provision on its plain word. There is nothing to show in transfer pricing provisions that the expression ‘income’ has to be given a restricted meaning and the applicability of section 92 does not depend on the chargeability under the Act. 

Comment

This ruling of AAR will only going to create confusion in the minds of taxpayer and consultant. It is quite strange to observe that AAR has disregarded its earlier ruling in the case of Praxair Pacific and Vanenburg Group BV. A view that transfer pricing provisions are applicable even on those transactions wherein income is not taxable in India, is like a shaft without arrowhead. 

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In case if you have any query on transfer pricing related issues, please feel free to write to us at gaurav@jgarg.com

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CA Gaurav Garg

JGarg Economic Advisors

www.jgarg.com

Mumbai ITAT: RPM preferred over TNMM to compute ALP in case of distributor of finished goods

In its recent judgment dated April 25, 2012, Mumbai Bench of Income Tax Appellate Tribunal (‘Mumbai ITAT’) in case of ITO vs. L’oreal India P. Ltd. [ITA No.5423/Mum/2009] upheld resale price method (‘RPM’) as the most appropriate method for computing arm’s length price ('ALP') of the transaction wherein the taxpayer in India was involved in purchase and resale of the finished goods.

 Facts of the case:

The taxpayer is a 100% subsidiary company of L’Oreal SA France and is engaged in the business of manufacturing and distribution of cosmetics and beauty products. During the year under review the taxpayer imported finished goods from its associated enterprises (‘AEs’) and resells it to independent parties. For the purpose of computation of the ALP, the taxpayer considered RPM as the most appropriate method.

During the course of transfer pricing audit, the transfer pricing officer (‘TPO’) rejected RPM as the most appropriate method and considered transactional net margin method (‘TNMM’) as the most appropriate method on the following grounds:

• The appellant is consistently incurring losses in India and hence the pricing policy is not at arm’s length.
• Gross margin in case of comparable cases cannot be relied upon because of product differences of comparable companies.
• The degree of similarity in the functions performed, assets employed and risks assumed between the taxpayer and the comparable companies identified by the appellant is not sufficient for the application of RPM but is sufficient for application of TNMM.
• Adjustment of the margin/profits of the appellant is not permissible under rule 10B.
• The taxpayer has incurred huge expenses on selling and distribution and hence there is a substantial value addition to the goods sold.


 Accordingly, the TPO suggested an addition equal to INR 4.90 cr.


Observation of CIT(A):
Against the above order of the assessing officer/ transfer pricing officer, the taxpayer appealed before Commissioner of Income-tax Appeals (‘CIT(A)’). The CIT(A) ordered in favor of the taxpayer on the basis of following:


• As per OECD guidelines RPM is easiest method to determine ALP where the reseller does not add substantially to the value of the product.
• RPM is based on the similarity of functions performed by the taxpayer and not similarity of product distributed.
• The contention of the TPO that the comparable companies selected by the appellant for the distribution segment should not be allowed on the ground of product differentiation cannot be accepted because the TPO has itself selected comparable companies for manufacturing segment from the category of FMCG products that are used for personal consumption.
• The losses incurred by the taxpayer are on account of business strategy of the taxpayer and can also be attributed to the initial years of the distribution segment. 
The TPO has erred in relating the losses to the transfer pricing policy of the taxpayer.
• The profit margin earned by the AE need to be considered for an all-round approach in transfer pricing.  The fact that the taxpayer was incurring losses and its AEs were earning low profits establishes that there is no motive on the part of the taxpayer to transfer profits to its AEs.

            

Observation of Mumbai ITAT:

Against the order of CIT(A), the AO appealed before the Mumbai ITAT  and ITAT uphold the order of CIT(A) and considered RPM as the appropriate method for computing ALP for import of finished goods from AEs.

Our Comments:               

This case is quite important from the perspective of creating robust documentation wherein the taxpayer is into losses. In this case though RPM is accepted as the most appropriate method for the purpose of computation of ALP, but something which needs appreciation is the justification of losses in India. The taxpayer was able to do so by sharing the profit margin earned by the AEs and also by co-relating the losses with business strategy. 

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CA Gaurav Garg

CA Vineeta Goyal

JGarg Economic Advisors Pvt. Ltd.

New Delhi, India

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Delhi ITAT: Information regarding secret data used by the tax department should be shared with the taxpayer

In the case of Adobe Systems India Pvt. Ltd. vs. JCIT (ITA No.5693, Del, 2011), Delhi Bench of the Income Tax Appellate Tribunal observed that in case tax authorities uses some information or data, in respect of which information is not available in public domain (secret data), for the purpose of computation of the arm's length price in such case such information/ data should be supplied to the taxpayer for his objection or examination. The absence of such opportunity violates the fundamental principle of natural justice. 

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Abhishek Agarwal

JGarg Economic Advisors Pvt. Ltd.

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Mumbai ITAT: Taxpayer should charge interest on loan given to non resident AEs

In its recent judgment in the case of M/s Tata Autocomp Systems Ltd. vs. ACIT Mumbai bench of Income Tax Appellate Tribunal (‘Mumbai ITAT’) observed that the lending or borrowing money between two associated enterprises comes within the ambit of international transaction and taxpayer should charge interest from its non resident associated enterprise.

Facts of the case:

The taxpayer is a company, involved in the manufacturing of indoor plastic, rendering engineering services, supply chain management services and administrative support for joint venture companies. In order to have better supply chain management and relationship with the customer in Europe, the taxpayer established a manufacturing company TACO Kunstsofftechnik GMBH (‘TKT’) in Germany. During the year under review, in order to assist TKT during start-up phase and because of commercial expediency, the taxpayer granted the interest free loan to TKT.

The case was referred to the transfer pricing officer (‘TPO’). The TPO rejected the interest free pricing of the transaction and re-computed the arm’s length price by considering lending rate equal to 10.25 % based on loans received by the taxpayer from Indian banks. The taxpayer took an alternative stand before the TPO, without prejudice to the its stand of interest free loan, that even if interest isto be charged on the interest free loan provided by the Assessee to TKT, the same should berestricted to 4.15% which is the rate specified in the benchmarking exercise conducted by theassessee for ascertaining the arm's length interest rate.

The taxpayer filed an appeal before the Dispute Resolution Panel (‘DRP’) against the order of the TPO. On review of the appeal, The DRP upheld the order of TPO but arrived at 12% rate ofinterest and directed the AO to recalculate the adjustment adopting rate of interest at 12% perannum instead of the calculation at 10.25% in the TPO's order.

Against the directions issued by the DRP, the taxpayer filed an appeal with the ITAT. The observation of the same are given below

Observations of Mumbai ITAT:

• Interest free loan extended to the associated concerns as at arm's length lending or borrowing money between two associated enterprises comes within the ambit of international transaction and whether the same is at arm’s length price has to be considered.
• The fact that the loan has the RBI's approval does not put a seal of approval on the true character of the transaction from the perspective of transfer pricing regulation as the substance of the transaction has to be judged as to whether the transaction is at arm’s length or not.
• Relying upon the judgment in the cases of DCIT v. M/s Tech Mahindra Ltd.(Mumbai Tribunal) and M/s Siva Industries & Holdings Ltd. v. ACIT ( (Chennai Tribunal), the tribunal ruled that the claim of the taxpayer to adopt EURIBOR rate as stated before the TPO is reasonable and deserves to be accepted. And also observed that the rate of interest to be used for benchmarking shall be the rate of interest in respect of the currency in which the underlying transaction has taken place in consideration of economic and commercial factors around the specific currency denominated interest rate.

Our Comments:

Judgement is in line with the well recognised arm’s length principle and also reinforces the pricing principle that for foreign currency loan one should not consider Indian currency loan rate. 

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CA Gaurav Garg

CA Parul Mittal

JGarg Economic Advisors Pvt. Ltd.

New Delhi, India

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Delhi HC: Continuous losses is not the criteria to disallow the payment for brand fees/ royalty under transfer pricing provisions

On March 29, 2012 Hon’ble High Court of Delhi pronounced a land mark judgment in case of ELK Appliances Ltd., wherein it observed that tax officer is not authorised to disallow the payment made for brand fee or royalty while determining an arm’s length price of the same.

Facts of the Case

This case relates to financial year 2001-02 and 2002-03. EKL Appliances Ltd. (‘taxpayer’), Group Company of Electrolux group, was engaged in the business of manufacturing of refrigerators, washing machines, compressor and spares thereof and also trading all these items and microwaive ovens, dish washers, cooking ranges, air conditioners and spares thereof. In respect of the assessment years 2002-03 and 2003-04, it filed returns of income declaring losses amounting to Rs. 148,23,80,117/- and  Rs. 1,14,59,660/- respectively. The Assessing Officer noticed that there were international transactions entered into by the taxpayer during the relevant previous years and accordingly invoked the provisions of Section 92CA(3) of the Act and referred the question of determination of the Arms Length Price (“ALP) to the Transfer Pricing Officer (“TPO”).

The TPO noticed that the taxpayer has been incurring huge losses year after year except for the financial year 1999-2000 and considering the perpetual losses, “the payment of royalty to the Associate Enterprise did not appear justified, as the technical knowhow/ brand fee agreements with A.E. had not benefited the taxpayer company in achieving profits from its operations”. The TPO further noted that the taxpayer itself stopped the payment from 01.10.1998 till 01.01.2002 and thus “the justification for payment of brand fee during the year under reference becomes questionable”.

He conceded that there was an increase in the turnover but observed that it has not resulted in any profit to the taxpayer. According to him, despite the payment of the brand fee for several years, the taxpayer has not been able to make a turnaround. He further held that the fact that the A.E. had charged similar brand fee from another company in New Zealand did not prove that the price paid by the taxpayer for obtaining the use of the brand name and the technical knowhow represented the ALP. He was of the view that the taxpayer had to demonstrate the actual benefit derived by it by using the brand name which it had failed to do. The continuous losses according to the TPO showed that the taxpayer did not benefit in any way from the brand fee payment. For these reasons, the TPO held that the brand fee payment made by the taxpayer to the A.E. was unjustified and the ALP of the transactions should be taken as nil.

Observations of Hon’ble High Court of Delhi

The Hon’ble High Court of Delhi ruled in favour of the taxpayer and observed,

•  It is not necessary for the taxpayer to show that any legitimate expenditure incurred by him was   also incurred out of necessity.
• In applying the test of commercial expediency for determining whether the expenditure was wholly and exclusively laid out for the purpose of business, reasonableness of the expenditure has to be judged from the point of view of the businessman and not of the Revenue.
• The quantum of expenditure can no doubt be examined by the TPO as per law but in judging the allow-ability thereof as business expenditure, he has no authority to disallow the entire expenditure or a part thereof on the ground that the taxpayer has suffered continuous losses.

Relying upon OECD guidelines, the Hon’ble High Court of Delhi also observed;

•    It is also not necessary for the taxpayer to show that any expenditure incurred by him for the purpose of business carried on by him has actually resulted in profit or income either in the same year or in any of the subsequent years. The only condition is that the expenditure should have been incurred “wholly and exclusively” for the purpose of business and nothing more.
•  The TPO is expected to examine the international transaction as he actually finds the same and then make suitable adjustment.

 Conclusion

This judgement should bring a good relief for other taxpayers also, as in number of cases the Revenue has disallowed payment of royalty or brand fee because of low profitability or no profitability. As the judgment suggests that profitability should not be the criteria to allow or disallow the payment, it is recommended that the taxpayer should try to benchmark transactions like payment of royalty/ brand fee or say management charges using comparable uncontrolled price method or cost plus method. Transactional Net Margin Method, considering payer of expenses as the tested party should be avoided.   

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CA Gaurav Garg

JGarg Economic Advisors Pvt. Ltd.

(M) +91 98999 94934

(E) gaurav@jgarg.com

www.jgarg.com