Key Transfer Pricing updates for March 2016

Introduction

The Finance Minister, Arun Jaitley announced the Union Budget 2016 on 29 February 2016, amidst high expectations from several stakeholders including taxpayers, investors and consumers. From a Transfer Pricing (TP) perspective, one of the most important development is the introduction of Country-by-Country (CbyC) reporting norms for TP documentation with effect from the Financial Year (FY) beginning 1 April 2016. The Organisation for Economic Co-operation and Development (OECD) and G20¹ countries as part of their Base Erosion and Profit Shifting (BEPS) project under Action Plan 13, introduced the three-tier TP documentation structure, which includes master file, local file and CbyC reporting. India, being an active participant of OECD's BEPS project, has proposed to adopt the above recommendations of the OECD's Action Plan 13 in the TP regulations announced during this budget. Some other amendments in the TP arena have also been proposed.

Recently, the Delhi High Court (High Court) in the case of Denso India Limited², rejected aggregation of an import transaction under the Transactional Net Margin Method (TNMM), since the facts of the case demonstrated that the arrangements made in relation to the transaction, when viewed in their totality, differed from those which would have been adopted by independent enterprises behaving in a commercially rational manner. In a Tribunal ruling in case of Essilor India Pvt Ltd³, the Bangalore Tribunal (the Tribunal) held that in the absence of an arrangement and agreement between the taxpayer and its Associated Enterprise (AE), incurrence of more expenditure on Advertisement, Marketing and Sales Promotion (AMP) compared to comparable companies cannot be inferred as an international transaction between the taxpayer and its AE.

Further, the Central Board of Direct Taxes (CBDT) issued a new instruction No. 3/2016, replacing Instruction No. 15 issued on 16 October 2015, providing guidance to Assessing Officers (AOs) and Transfer Pricing Officers (TPOs) regarding administration of TP assessments.

1) Budget 2016 - Transfer Pricing Amendments

The Budget proposals with respect to three-tier TP documentation are discussed hereunder:

Master file and local file -The Memorandum to the Finance Bill (Memorandum) states that a master file will have to be maintained and the detailed rules regarding the same will be notified at a later date. However, no threshold for preparation of master file has been prescribed. Local file related regulations that already exist in the law may continue or may be aligned to the OECD's BEPS Action 13 recommendations, however the same will be clear only once the detailed Rules in this regard are issued.

CbyC reporting - A new section [proposed Section 286 of the Income-tax Act, 1961 (the Act)] on CbyC reporting has been introduced. These provisions require the Indian Parent entity of an international multinational group or any other designated group entity in India (referred to as alternate reporting entity) to file a CbyC report for financial year 2016-17 before the due date of filing of Return of Income i.e. 30 November 2017. The threshold for filing the CbyC report has been maintained at EUR750 million (as per the Memorandum).The detailed format shall be notified in the Rules at a later date. However, it is proposed in the memorandum that the OECD prescribed template will be adopted.

These proposals are elaborately discussed in the other articles of this publication and hence, for brevity's sake, not discussed in detail here.

2) Aggregation of transaction under TNMM is rejected since facts of the case indicated unusual features which remained unexplained by the taxpayer - Delhi High Court

The taxpayer was engaged in manufacturing and sale of auto electrical products and was held by Denso Corporation, Japan (Denso) and Sumitomo Corporation, Japan (Sumitomo) with 47.93 per cent and 10.27 per cent shareholding respectively. In AY 2002-03 and AY 2003-04, the taxpayer had various international transactions with its Associated Enterprises (AEs), such as payment of royalty, technical know-how, testing fees etc. and benchmarked these transactions along with the import of components on an aggregated basis using TNMM as the most appropriate method (MAM). During AY 2002-03, the taxpayer imported raw material components from Sumitomo. The taxpayer had taken a stand that since shareholding of Sumitomo is less than 26 per cent, it is not its AE and hence did not report this purchase transaction as an international transaction in Form 3CEB.TPO accepted all the transactions at arm's length using TNMM as the MAM. However, the TPO noticed that the components imported from Sumitomo were, in fact, manufactured by Denso and it was so routed through an intermediary with the sole objective of camouflaging the actual transaction of purchases being made from an AE.TPO treated this transaction of purchase of components from Sumitomo as an international transaction under 92B(2) of the Act. Comparable Uncontrolled Price (CUP) was applied by the TPO by comparing price of components imported with that of price of indigenous components purchased from domestic suppliers. Commissioner of Income Tax (Appeals) [CIT(A)]deleted the said adjustment. Tribunal restored the TP adjustment pertaining to transaction of import of components with directions on proper application of CUP method.

High Court ruling

•		The factual discussion in this case revealed that, the taxpayer chose to import components not from the manufacturer (which was its AE) but an intermediary, which normally, would have been accepted by revenue authorities as a commercial decision. However, in the instant case, the vendor of the components viz. Sumitomo was also connected with both the taxpayer and the manufacturer.
•		The High Court observed that the above realities compelled the TPO to closely scrutinise the value of such imports and seek further details from the taxpayer. The explanations by the taxpayer that were forthcoming, were apparently unconvincing.
•		It was observed by the High Court that the taxpayer's approach i.e. bundled or aggregated series or chain of transactions to benchmark the international transactions would normally be accepted by the authorities, if they did not show features that call for his interference. However, it was stated that the Assessing Officer/TPO should extend his inquiry in critically evaluating materials, where a detailed scrutiny is required. The unusual features in this case, which remained unexplained by the taxpayer, raised concerns and influenced the revenue authorities to benchmark the transaction separately.
•		The High Court, while upholding the approach adopted by the TPO, relied on decision of Sony Ericsson4, which discusses a test as to when the revenue authorities can disregard the actual transaction, and re-characterise the same, i.e. when the form and substance of the transaction though were the same but the arrangements made in relation to a transaction, when viewed in their totality, differ from those which would have been adopted by an independent enterprise behaving in a commercially rational manner.
•		Thus, the High Court upheld the restoration of adjustment made by the Tribunal.

It would be pertinent to note that the Punjab and Haryana High Court in the case of Knorr-Bremse⁵, rejecting taxpayer's stand for aggregation of transactions under TNMM, had held that merely because the purchase of each item and the acceptance of each service is a component leading to the manufacture/production of the final product sold or service provided by the taxpayer, it does not follow that they are not independent transactions for the sale of goods or provision of services. The High Court concluded that if the taxpayer fails to establish that the various transactions forming a composite agreement/various agreements with the various group entities, were part of one single indivisible transaction or pricing in respect of each transaction was dependent upon or interrelated to the pricing of the other transactions with the group entities, each transaction had to be treated (prima facie) as separate and independent of each other.

In contrast, recently the Delhi High Court in the case of Sony Ericsson (Supra) had observed that TNNM applied with equal force on single transaction as well as multiple transactions as per Chapter X of the Act and the TP rules. Thus, the word 'transaction' would include a series of closely linked transactions. Segregation of aggregated transactions requires detailed scrutiny without which there shall be no segregation of bundled transactions. Further, set-off of transactions segregated as a single transaction is just and equitable and not prohibited by Section 92(3) of the Act.

The above decision is principally in line with the decision of Sony Ericsson i.e. in a normal situation, the revenue authorities would not have questioned this bundled approach adopted by the taxpayer. However, this will not be a thumb rule in all cases, and if there are unusual features which raise doubts regarding the form and substance of the transaction, the same may be critically analysed and could be benchmarked separately.

The decision in the case of Knorr-Bremse is also to be kept in mind and it is important to maintain meticulous documentation to justify inter-relation of transactions aggregated and benchmarked together.

3) Incurring more expenditure on AMP compared to comparable companies, cannot be inferred as an international transaction between the taxpayer and its foreign AE

The taxpayer is a wholly owned subsidiary of Essilor International SA, France, engaged in the business of trading in finished, semi-finished ophthalmic lenses and processing of semi-finished ophthalmic lenses. The taxpayer purchases ophthalmic lenses from the AE and sells them after some processing. During AY 2009-10, the taxpayer had entered into various international transactions and since its Profit Level Indicator (PLI) under TNMM was higher than the arithmetic mean of comparables, it was claimed that the international transactions were at arm's length. The TPO observed that the taxpayer incurred sales promotion and advertisement expenditure, which was 14.2 per cent of the total revenue. The TPO benchmarked this transaction with the average expenditure of comparable companies on those items i.e. 3.3 per cent of the turnover. The TPO also applied a mark-up (operating margin on the total operating cost of 20.22 per cent, arrived at after excluding additional AMP expenditure from the total operating cost) on the AMP expenditure and proposed a TP adjustment. The DRP set aside the issue to the file of the TPO to examine the case in the light of the decision of the Special Bench of the Tribunal in the case of LG Electronics⁶ and determine the cost of services provided and apply a margin on the same by applying the cost plus method.

Tribunal's ruling

•		The AMP expenses incurred by the taxpayer are only for increasing the sales of its products and no benefit accrued to its AE and there is no international transaction on AMP expenditure as envisaged within the meaning of Section 92B of the Act.
•		Drawing references from the Sony Ericsson7 decision, the Tribunal held that the cases dealt by the Delhi High Court, were distributors of products manufactured by the foreign AE and not manufacturers themselves.
•		The Tribunal noted that the taxpayers in Sony Ericsson did not appear to have questioned the very existence of an international transaction with the foreign AE and also observed that the taxpayer has throughout been contesting before all the authorities, the very existence of an international transaction on account of incurring AMP expenditure between the taxpayer and its AE. Accordingly, the law laid down by the Delhi High Court in the Sony Ericsson ruling cannot be applied to the taxpayer.
•		Drawing references from the Delhi High Court decisions in the case of Maruti Suzuki8, Bausch & Lomb Eyecare9, Yum Restaurants10 and Honda Siel11, the Tribunal held that no TP adjustment can be made by deducing from the difference between AMP expenditure incurred by the taxpayer and that of the comparable entity, if there is no explicit arrangement between the taxpayer and its foreign AE.
•		In the absence of machinery provisions, to ascertain the price incurred by the taxpayer to promote the brand values of the products of the foreign entity, no TP adjustment can be made by invoking the provisions of Chapter X of the Act.
•		Merely because the taxpayer incurred more expenditure on AMP compared to the expenditure incurred by comparable companies, it cannot be inferred that there existed an international transaction between the taxpayer and its foreign AE. Therefore, the question of determination of the ALP on such a transaction does not arise.
•		Further, considering that the AMP expenditure was not included as part of the cost base for computing the PLI, the Tribunal directed the AO to include the same as part of the cost base for the purpose of determination of the ALP.

This ruling emphasises that in the absence of an explicit arrangement and action in concert between the taxpayer and its AEs, the TPO cannot infer the existence of an international transactions by way of rendering services of promoting the brand of the foreign AE. The fact that the benefit of such AMP expenditure accrue to the AE is not sufficient for such inference. The onus is on the Revenue to demonstrate through some tangible material, the existence of an 'arrangement' or 'understanding' between the taxpayer and its AE that the taxpayer would incur AMP expense in order to develop marketing intangibles for the AE.

It is also important for the taxpayers to contest that AMP is not an international transaction provided there is no explicit agreement or arrangement to incur the same at the behest of the AE so as to be covered by the favourable decisions in Maruti Suzuki, Bausch & Lomb Eye care, Yum Restaurants and Honda Siel.

4) CBDT replaces guidelines for selection and referral of TP cases for assessment

The CBDT issued a new Instruction No. 3/2016 replacing the existing Instruction No. 15 issued on 16 October 2015, regarding the 'Guidelines for Implementation of TP Provisions'. It has reiterated and prescribed an additional mandatory criteria to select specialised TP scrutiny cases and clarified the role of AOs and TPOs.

Reference to the TPO

The CBDT has decided that the AO shall henceforth make a mandatory reference to the TPO only under the following circumstances:

•

All cases selected for scrutiny on the basis of TP risk parameters either under the:

○		Computer assisted scrutiny selection system or
○		Compulsory manual selection system in accordance with the CBDT's annual instructions12

•

Cases selected for scrutiny on non-TP risk parameters shall be referred to TPOs only in the following circumstances:

○		The taxpayer has either not filed the Accountant's Report under Section 92E of the Act or has not disclosed an international transaction or Specified Domestic Transactions (SDTs) or both in the Accountant's Report;
○		There has been a TP adjustment of INR10 crore or more in an earlier AY and such an adjustment has been upheld by the judicial authorities or is pending in appeal; and
○		Where search and seizure or survey operations have been carried out and findings regarding TP issues have been recorded by the Investigation Wing or the AO.

•		Further, a case involving a TP adjustment in an earlier AY that has been fully or partially set-aside by the Tribunal, High Court or Supreme Court on the issue of the said adjustment, shall be invariably referred to the TPO for determination of ALP.
•		Before seeking approval for making a reference to the TPO, the AO must, as a jurisdictional requirement, record his satisfaction that there is an income or potential of an income arising and/or being effected from an international transaction or SDT, where the taxpayer has either not filed the Accountant's Report or has not disclosed such transactions in the Accountant's Report or has reported the transaction with a qualifying remark that such a transaction does not impact the income of the taxpayer.
•		It is imperative for the AO to ensure that all international transactions or SDTs are explicitly mentioned in the letter through which the reference is made to the TPO.
•		The determination of ALP should not be carried out at all by the AO in a case where reference is not made to the TPO. The AO must record in the assessment order that the TP issue has not been examined at all.

Role of the TPO

•		The role of the TPO is limited to determine the ALP in respect of international transactions or SDTs referred to it by the AO.
•		If any other international transactions come to the notice of the TPO during the course of the proceedings before him/her, then he/she is empowered to determine the ALP of such other international transactions also by virtue of Section 92CA(2A) and (2B) of the Act.
•		The TPO shall determine the ALP and pass a speaking order after taking into consideration all the relevant facts and data available on record.
•		The TPOs, being the Additional/Joint Commissioner of Income Tax (CIT) shall be assigned not more than 50 cases depending on the importance and complexity involved.
•		The TPO shall be responsible for conducting the compliance audit of Advance Pricing Agreements (APAs) and perform a scrutiny for cases referred to it by the AO with respect to taxpayers opting for safe harbour provisions.

Role of the AO after determination of the ALP - The AO has to compute the total income of the assessee in conformity with the ALP determined by the TPO.

Maintenance of the database - The CIT(TP) shall ensure the expeditious resolution of cases referred by the AO to the TPO in their respective jurisdictions and accurate records of the same will be maintained in a specified format and to use this database for determination of the ALP in identical/substantially identical cases.

Applicability - This instruction is applicable with immediate effect. Further, the references made to TPOs after the issuance of Instruction no. 15/2015, which are not in conformity with this instruction, may be withdrawn by the concerned Principal CIT or CIT.

This instruction is another step taken by the CBDT in moving towards a non-adversarial tax regime, wherein compliant taxpayers can expect a supportive interface with the tax department. Recognising that TP is a specialised subject and needs to be examined by an expert, the CBDT has made it mandatory that TP issues shall be examined only by the TPO.

The shift from 'monetary threshold' based to risk based parameters for selection of cases for TP scrutiny coupled with the restriction placed on the AO's power to make manual references may result in fewer cases being subject to a rigorous scrutiny by the TPO.