Global Tax Alert (News from Transfer Pricing) | 30 May 2014
India’s High Court of Delhi rules on transfer pricing aspects of intra-group service transactions
India's High Court (HC) of Delhi, in the case of M/s Cushman & Wakefield India Private Limited (the Taxpayer),1 has ruled on the transfer pricing aspects of payments made for certain intra group services.
The Taxpayer had received certain liaison and coordination services from its Associated Enterprises (AEs) for which the AEs charged the Taxpayer actual costs, allocated based on an allocation key. The Transfer Pricing Officer (TPO) disallowed the payment on grounds that the Taxpayer did not establish the arm's length nature of the same. Since the AEs charged only the actual costs without adding a profit element, the Taxpayer argued that it was not required to benchmark the transaction. The Taxpayer was of the view that determination of the arm's length price (ALP) in this case would only have the effect of reducing the tax incidence in India, which is not permitted under the provisions of Section 92(3) of the Income-tax Act, 1961 (the Act). The taxpayer's contention was earlier affirmed by the Income Tax Appellate Tribunal (ITAT).
The HC rejected the Taxpayer's contention that no benchmarking is required where the AEs have only recovered costs without charging any mark up. The HC ruled that even though the transaction involves only a recovery of cost, as the transaction is between two AEs, it is necessary to test whether an uncontrolled entity for the same or comparable services charges an amount less than or equal to or more than what was charged to the Taxpayer by the AEs. Application of Section 92(3), which does not permit application of ALP if it has the effect of reducing tax incidence, cannot be inferred merely because the AEs recover costs without a mark-up. A comprehensive transfer pricing (TP) analysis is required to test the appropriateness of the costs that are allocated as well as for determining applicability of Section 92(3). The HC also observed that while examining whether an independent entity would have paid for such services, the Tax Authorities cannot question the commercial judgment of the Taxpayer.
The HC thereafter remanded the matter back to the Tax Authority for a re-determination of the ALP for the transaction.
The Taxpayer is an Indian company engaged in the business of rendering services connected to acquisition, sales and lease of real estate and provision of advice and research on such matters, project management etc. within and outside India. The Taxpayer availed certain intragroup services viz. (a) coordination and liaison services from Cushman and Wakefield, Singapore (CWS) and Cushman and Wakefield, Hong Kong (CWHK) and (b) payment of referral fees for the referrals of clients to several AEs. The AEs charged the Taxpayer actual costs for coordination and liaison services (determined on reasonable allocation methodology) and referral fees were paid according to ”international fee sharing rules and referral fees on Tenant Representation Transactions.” Based on the TP documentation maintained, it was concluded that the transactions were undertaken on an arm's length basis.
During TP audit proceedings, the TPO disallowed the entire payment made toward coordination and liaison services. No adverse inference was drawn with respect to the referral fee paid by the Taxpayer. The TPO opined that the Taxpayer did not derive any benefit from coordination and liaison services and hence, determined the ALP as ”Nil.” The Assessing Officer (AO) in his draft assessment order proceeded to make addition to the income of the Taxpayer by disallowing payment made to CWS and CWHK based on the TPO order. Further, the AO disallowed the referral fees as a deductible expenditure under general provisions of Act, on grounds that the same was not incurred for the purpose of the business of the Taxpayer.
In response to the draft AO order, the Taxpayer filed its objections with the Dispute Resolution Panel (DRP), an alternate dispute resolution mechanism under the Act. The DRP upheld the adjustments proposed by the AO. The Taxpayer filed an appeal before the Tribunal, the second-level appellate authority, against the adjustments, which ruled in favor of the Taxpayer and deleted the adjustments. The Tribunal held that the Taxpayer has indeed received the services from its AEs and subsequent benefit was derived from services. The Tax Authority challenged the order of the Tribunal before the HC.
Coordination and liaison services availed from AEs
The Tax Authority argued that no benchmarking of the costs charged by the AEs has been conducted by the Taxpayer and the costs paid by the Taxpayer to the two AEs (CWS and CWHK) must be compared to costs paid on other similar transactions, on the basis of one of the methods of determining the ALP. In the absence of such an exercise by the TPO – who only concerned himself with whether a service was rendered or not – the finding of the Tribunal is incorrect. On the other hand, the Taxpayer submitted that the Tribunal's approach is statutorily sanctioned under Section 92(3) of the Act, which provides that TP provisions will not apply if the result of the ALP determination is a reduction of the overall tax incidence in India. The Taxpayer argued that in the present case, the AEs have not charged any amount for their services, but only recovered costs in accordance with the intra-group service agreements, which means that the ALP for such a transaction would be above or equal to what was claimed. Also, by reference to any other uncontrolled transaction, the amount payable by the Taxpayer would necessarily be greater, as the cost would be supplemented with some profit margin for the other entity.
Having heard the contentions placed by the Tax Authority as well as the Taxpayer, the HC noted that the underlying issues need to be addressed under the following two parameters:
- • Whether services have indeed been provided by the AEs to the Taxpayer.
- • Whether these services ought to be benchmarked to determine ALP under the Indian TP provisions considering the fact that TP provisions will not apply if the result of the ALP determination is a reduction of the overall tax incidence in India.
Based on the analysis, the HC observed that costs incurred by CWS and CWHK have not been disputed by the Tax Authority. Equally, it is an admitted fact that the Taxpayer did not attempt to benchmark this international transaction through any of the methods prescribed under the Indian TP provisions. The HC noted that certain amounts were charged by the AEs as reimbursement for actual costs incurred. Nevertheless, whether a third party – in an uncontrolled transaction with the Taxpayer would have charged amounts lower, equal to or greater than the amounts claimed by the AEs, CWS and CWHK has to perforce be tested under the various methods prescribed under the Indian TP provisions. Further, HC opined that concept of base erosion is not a logical inference from the fact that the AEs have only asked for reimbursement of cost. This being a transaction between related parties, whether that cost itself is inflated or not only is a matter to be tested under a comprehensive transfer pricing analysis. The basis for the costs incurred, the activities for which they were incurred, and the benefit accruing to the Taxpayer from those activities must all be proved to determine first, whether, and how much, of such expenditure was for the purpose of benefit of the Taxpayer, and secondly, whether that amount meets ALP criterion.
Relying on Tribunal ruling in Dresser-Rand India Pvt. Ltd.,2 HC observed that the authority of the TPO is to conduct a transfer pricing analysis to determine the ALP and not to determine whether there is a service or not from which the Taxpayer benefits. The HC held that the TPO cannot question the commercial wisdom or reasoning for providing the services and should restrict itself to determining the ALP.
The details of the specific activities for which cost was incurred by both AEs, and the attendant benefit to the Taxpayer, have not been considered till date. This must be provided, in addition to a consideration of the ALP vis-à-vis the total cost claimed by these AEs. To this extent, for the consideration of ALP in respect of these transactions, the HC has remanded the matter back to the Tax Authority for a re-determination in accordance with law.
Payment of referral fees for referral of clients
The second issue, in the case, was the disallowance of referral fees paid by the Taxpayer to various AEs, for the referral of clients in the real estate business. The AO found that no services were actually rendered for which referral fees were to be paid. The Tribunal, however, reversed this finding on two grounds.
- • Scrutiny of transactions by AO, which are referred to the TPO under Indian transfer pricing provisions
- • Expenditure incurred vis-à-vis demonstration of benefits received
On the first ground, the HC noted that the jurisdiction of the AO and the TPO are distinct. A referral by the AO to the TPO is only for the limited purpose of determining the ALP, based on a prima facie view that such a referral is necessary. It does not imply a concrete view as to the existence of services, or the accrual of benefit (such that allowance under general provisions of Act must be permitted). The AO can, therefore, determine that the expenditure claimed (in this case, the referral fees) was not for the purpose of the business, and thus, disallow that amount. This does not restrict or in any way bypass the functions of the TPO.
The HC ruled that the quantum of payment, i.e., the value of transaction or the percentage referral fees paid was confirmed by the TPO in his determination and the transaction was concluded to be at arm's length. Hence, the AO cannot reassess that issue or draw adverse conclusions from the percentage value of the referral fees. The AO can, however, in his assessment decide whether work or services were actually rendered as claimed by the Taxpayer. In other words, the AO may determine whether the stated transactions are real and genuine, i.e., the existence of a referral from the AEs to the Taxpayer.
The HC noted that neither the AO nor the Tribunal have discussed the correctness of evidence of the existence of referral transactions, or any other material concerning the transactions. As the HC could not conclude on the correctness of the approach adopted by the AO and the Tribunal, the HC remanded the matter back to the Tax Authority for a detailed verification of facts and provision of reasoned conclusions, with the AO being bound by the TPO's approval of the pricing of the referral fees.
The TP analysis and documentation of intercompany services is among the most complex and burdensome areas of TP compliance, and can represent a significant compliance risk for multinational companies having operations in India. In the absence of prescriptive guidance in the Indian TP rules regarding intra-group services, the guidance contained in Chapter VII of the OECD TP Guidelines regarding special considerations for intra-group services is often relied upon by the Tax Authority as well as by taxpayers. A core concept of the Guidelines is that a charge to affiliates must provide a specifically identified benefit. Thus a benefit test is required to substantiate the non-general benefits received by a related party due to the services for which it is receiving an intercompany charge.
The HC's observation that the role of the TPO is to examine whether an independent entity would have paid for such services implicitly seems to recognize the need to consider the benefits test while determining the ALP for intra-group services. The HC's observation that the TPO cannot question the commercial wisdom or reasoning for providing the services is welcome as it seeks to respect the business judgment of a taxpayer. The HC's view that a comprehensive TP analysis is necessary before determining applicability of Section 92(3) may result in increasing the compliance burdens for taxpayers especially where certain low-value/ routine services are charged at cost.
Taxpayers need to consider the impact of this ruling on the TP analysis and compliance obligations for intercompany service transactions.
2. See EY International Tax Alert, Mumbai Tribunal ruling explains the term “associated enterprise” for transfer pricing purposes, dated 12 September 2011.
For additional information with respect to this Alert, please contact the following:
Ernst & Young LLP (India), Bengaluru
- • Rajendra Nayak
+91 80 6727 5454
Ernst & Young LLP (India), New Delhi
- • Vijay Iyer
+91 11 6623 3240