India Tax Insights – ninth edition
Post-BEPS application of the arm’s length principle: India charts a new course
Rajendra Nayak - Partner – Tax & Regulatory Services, EY India
An updated version of the United Nations Transfer Pricing Manual for Developing Countries (UNTP Manual) was presented to the UN Tax Committee for approval, at the twelfth session held in Geneva in October 2016, with a view to publish the revised UNTP Manual in 2017. The revised draft of the UNTP Manual (2016 Draft) gives due consideration to the outcome of the Organisation for Economic Co-operation and Development (OECD)/G20 Action Plan on Base Erosion and Profit Shifting (BEPS) relating to TP. The 2016 Draft also includes chapters on the practices and positions of emerging countries such as India, Mexico, China, South Africa and Brazil.
The Indian tax administration in the country-specific Chapter in the 2016 Draft has revised and updated its comments on a number of emerging TP issues from an Indian perspective, including issues pertaining to comparability analysis, allocation of risk, use of multiple year data, location savings, intra-group services and transactions involving transfer/use of intangibles. The India Chapter of the 2016 Draft also contains an acknowledgment of India’s endorsement of the recommendations contained in the final report on TP under Actions 8—10 (Aligning Transfer Pricing Outcomes with Value Creation) and Action 13 (Transfer pricing Documentation and Country-by-Country Reporting) of the OECD/G20 Action Plan on BEPS.
India’s position on BEPS Reports on Actions 8—10 and Action 13
After having endorsed the final reports of the BEPS projects on Actions 8—10, the Indian tax administration has acknowledged that some of the TP issues as addressed in the BEPS reports are in conformity with the long-standing views of the Indian tax administration, namely:
- The broad objective of “aligning TP outcomes with value creation”
- Giving importance to the development, enhancement, maintenance, protection and exploitation (DEMPE) functions in respect of intangibles for remunerating the group entities of multinational enterprises (MNEs)
- Testing of contractual allocation or contractual assumption of risk on the parameters of exercising control over risk and/or the financial capacity to bear the risk, and disregarding such contractual allocation or assumption of risk
- Harmonizing contracts with the conduct of parties, and identifying and accurately delineating the transaction by analyzing the economically relevant characteristics
- Preventing the “cash box” entities from contributing to base erosion or profit stripping
- Non-recognition of commercially irrational transactions that cannot be seen between independent parties
Accordingly, the Indian tax administration is of the view that the guidance flowing from the final report of the BEPS project on Actions 8—10 should be utilized by both transfer pricing officers (TPOs) and taxpayers in situations of ambiguity in interpretation of the law. However, India has not endorsed the guidance in the BEPS report pertaining to low value-adding intra group services under Action 10 and has not opted for the simplified approach. Further, India has endorsed the recommendations contained in the BEPS final report on Action 13, which supported the three-tiered documentation regime comprising a Local File, a Master File and a Country-by-Country Report and has already carried out legislative changes in its domestic law.
Key considerations for risks
BEPS Action Plans 8—10 provide detailed guidance on analyzing risks as an integral part of a functional analysis, including a new six-step analytical framework. In view of the assumption that increased risk should be remunerated by an increase in expected return, it is critical to determine which risks are assumed, what functions are conducted in connection with the assumption or impact of risks and which party or parties assume these risks. The Action Plans provide that detailed guidance on risk does not mean that risks are more important than functions and assets, but arises from the practical difficulties introduced by risks. The Action Plans further state that if the associated enterprise (AE) contractually assuming the risk does not exercise control over the risk or does not have the financial capacity to assume the risk, then the risk should be allocated to the enterprise exercising control and having the financial capacity to assume the risk.
According to the India Chapter of the 2016 Draft, the Indian practice has been to evaluate risks in conjunction with functions and assets, and it is unfair to give undue importance to risk in the determination of an arm’s length price (ALP) in comparison to the functions performed and assets employed. There is also reference to situations where research and development (R&D) functions are “controlled” by a related party situated outside India, while the actual R&D functions take place within India. The India Chapter states that the Indian tax administration disagrees with the notion that risk can be controlled remotely by (employees operating out of) the parent company and that the Indian entity engaged in core functions, such as carrying out R&D activities or providing services, can be risk-free entities. According to the India Chapter, the Indian tax administration believes that in many cases core R&D functions that are located in India require important strategic decisions by the management and employees of the Indian subsidiary and accordingly, in such cases, the Indian subsidiary exercises control over operational and other risks and the ability of the related party to exercise control over risks remotely is very limited.
Intangibles generated through R&D activities
Globalization has led many MNEs to establish information technology, R&D and back-office operations in India in order to take advantage of savings inherent in its relatively moderate-cost-labor market. Typically, the Indian affiliates providing services operate as “captive service providers” and are insulated from business risks and hence remunerated by providing a routine return for the functions performed.
The India Chapter of the 2016 Draft observes that India-based R&D centers may take strategic decisions pertaining to the day-to-day activities and allocation of budgets to different streams of R&D activities. While funds for R&D activities are provided by the entity that bears the financial risk of the R&D activities, other important aspects of R&D activities, such as technically skilled manpower and know-how for R&D activities, are developed and owned by the Indian subsidiaries. Accordingly, control over risks of R&D activities rests both with the AE and the Indian subsidiary, but the Indian subsidiary could control more risks as compared to its AE. Therefore, the Indian tax administration is of the view that a routine cost plus return may not be appropriate in such cases and the Indian subsidiaries should be entitled to a suitable return for their functions (including strategic decision-making and monitoring of R&D activities), use of their tangible and intangible assets and exercising control over the risks.
According to the India Chapter of the 2016 Draft, TP aspects of marketing intangibles have been a focus area for the Indian revenue authorities. The Chapter states that the marketing expenditure incurred by the Indian entities has been considered for adjustment by the Indian revenue authorities on the premise that the Indian taxpayers were incurring these expenses for and on behalf of the brand owner outside India. The Indian tax authorities are also of the view that these expenditures provide a direct and indirect benefit to the brand owner and therefore the Indian entity needs to be compensated for that.
The guidance provided in BEPS Action Plans 8—10 on marketing intangibles contains a clear recognition of the implications of the advertising, marketing and promotional (AMP) activities of the distributor on the development and enhancement of marketing intangibles. The guidance states that returns should be earned on performance of DEMPE functions in relation to the marketing activities. A thorough functional analysis is required to determine whether the distributor should be compensated only for promotion and distribution or also for enhancing the value of the trademarks and other marketing intangibles. Where remuneration is required, it can be in the form of cost plus mark-up basis, reduction in royalty rates or share of profits associated with enhanced value of intangibles. Depending on the individual case, the PSM may be considered to eventually better reflect value contribution rather than a one-sided analysis such as the transactional net margin method (TNMM).
Since the approach of the Indian tax authorities has been subject to judicial review in India, the India Chapter states that the present approach of the Indian tax administration for carrying out TP reviews is in line with the judicial rulings as well the recommendations contained in the BEPS Action Plans 8—10. The approach of the Indian tax authorities, as stated in the India Chapter, is to carry out a detailed functional analysis to identify all the functions of the taxpayer and the AEs pertaining to international transactions as well as to determine the DEMPE functions.
In recent years, appropriate treatment of the intra-group provision of services has become a critical TP issue in India. The India Chapter of the 2016 Draft states that TP of intra-group services is considered a high risk area in India. Further, India considers the payment for such intra-group services to be base-eroding in nature and, accordingly, attaches a great importance to the TP of such payments. The Chapter sets forth the approach to be adopted for determining the arm’s length nature of these charges.
The Indian tax authorities believe that shareholder services, duplicate services and incidental benefit from group services do not qualify as intra-group services requiring arm’s length remuneration. The Chapter also identifies choice of allocation keys and treatment of pass-through costs as key challenges. Further, the Chapter states that even if an arm’s length result is achieved in respect of such payments from India, an additional protection in the form of an overall ceiling on the amount of such payments may be required. This may be justified because even an arm’s length payment might result in erosion of all the profits of the Indian entity or in enhancement of losses of the Indian entity, thereby making the arm’s length nature of such payments questionable. Thus, an overall ceiling on such payments in the form of a certain percentage of the sales or revenue of the Indian entity is being used in appropriate cases.
The 2016 Draft of the UN TP Manual is a response to the need expressed by developing countries to align the guidance with the OECD Guideline on BEPS Action Plans. The revisions made to the India Chapter of the 2016 Draft demonstrate India’s commitment to implementing a number of the BEPS recommendations relating to TP. The work of the OECD under Actions 8—10 is expected to result in changes to the OECD TP Guidelines. In India, the OECD TP Guidelines are often referred to as a source of interpretation of the arm’s length principles by courts, tax authorities and taxpayers, even though they are not binding and cannot contradict existing legislative rules. India’s endorsement of the BEPS Actions 8—10 (with the exception of the recommendations relating to low value-adding intra group services) can therefore be expected to have an immediate impact in terms of TP audits and enforcement. Further, as the reference to the BEPS reports and OECD TP guidelines could be “ambulatory,” this could impact existing inter-company pricing arrangements as well. MNEs with Indian operations must evaluate the implications on their TP practices, documentation and defense positions. In addition, enterprises should focus on the new reporting and TP documentation requirements in order to assess whether the necessary data is available, what must be done to gain access to such data in the required form, and how tax administrations are likely to interpret such data.