In this blog post, Mohammad Farooq, a fourth-year law student at Institute of Law, Nirma University, describes and analyzes transfer pricing disputes in offshore jurisdictions.
With the advent of the economic reforms of 1991, India saw a spurge of international companies dotting the markets like Pepsi, Mcdonald’s, Ford, Honda, etc. Globalization has modernized the way businesses are done in today’s era as companies are working under the umbrella of a group engaged in diverse fields and sectors in various countries leading to a plethora of transactions between related or associated parties.
“Transfer Price” is the price at which goods, services or technology are transferred from one company to another. In international commercial transactions, the phenomena of Transfer Pricing (TP) arises when a multinational company from one country sets arbitrary transfer prices to an Associated Enterprise (direct/ indirect participation in the management, control or capital of an enterprise by another enterprise) in another country in order to avoid tax liability or increase profits. These prices do not have any relation with the actual cost incurred or the market forces that is normally present between two independent and unrelated companies.
For instance, when a company A purchases goods for 100 rupees and sells it to an associated company B in another country for 200 rupees, which further sells it in the open market at 400 rupees, then by logic, it is apparent that, had A sold the goods directly, then it would have made a profit of 300 rupees. But, by routing it through B, it curtailed its profit to 100 rupees. Here, the goods are transferred on a price (transfer price) which is arbitrary or dictated, and the transaction is not governed by the market forces. This becomes useful if A is in a high tax country and B is in a tax haven country.
Consequently, the effect of such transfer pricing is that because of this manipulation in the transfer prices, the loss or profit on the transaction to either of the companies presents a distorted or misleading picture of the taxable income generated and leads to a loss of the revenue and also a drain on foreign exchange reserves of the country.
The growth of the economic activities between multinational groups in India led to complex transactional issues on TP and led to various litigations. A need was felt to come up with a mechanism to determine profits and taxes in an equitable, reasonable and fair manner. Eventually, in the Finance Act, 2001, the provisions relating to TP were introduced in the Income Tax Act, from section 92A to 92F. With the passage of time, tax authorities (like transfer pricing officers or TPOs) and courts began to interpret and clarify the legislation on TP. Today, TP disputes have become the major form of litigation in direct taxes in India. So what is the framework for settling the TP disputes and how does it arise in the first place? Let’s examine the procedure followed by the tax authorities under transfer pricing regulations in India.
Framework for settling Transfer Pricing Disputes
The Central Board Of Direct Taxes (CBDT) issued certain new instructions in 2015 to the income tax authorities with respect to the TP regulations. To begin with, after obtaining the permission of the commissioner, the assessing officer (AO) has the power to refer any international or domestic transaction in the previous year to the transfer pricing officer or TPO to compute the arm’s length price with regards to the transaction. After examining the evidence produced by the assessee and taking into account all relevant materials at his disposal, the TPO shall pass an order regarding the arm’s length principle in the domestic or international transaction in question. On receipt of the order, the AO computes the total income of the assessee after incorporating the ALP so determined by the TPO and prepares a draft order which is passed on to the assessee. Now the assessee has to either convey his acceptance or objection to the draft order within 30 days of receipt of the draft order. After receiving the objection/acceptance of the assessee, the AO passes a final order within one month. Subsequently, appeals against the AO order are made in the appellate forums beginning with the Commissioner of Income Tax (Appeals) [CIT(A)], Income Tax Appellate Tribunal (ITAT), High Court and Supreme Court.
Dispute Resolution Panel
Earlier, if the assessee wanted to object the assessment order, he had the option to approach the Commissioner of Income Tax Appeal CIT(A). However, after the formation of Dispute Resolution Panel (DRP), the assessee has an additional option to approach DRP on the basis Draft Order issued by AO. DRP mechanism was introduced by Finance Act, 2009 as an alternative to first appellate authority i.e. Commissioner of Income-tax (Appeals) [CIT(A)] with the objective of speedy disposal of disputes and to encourage the growth of foreign investment in India. It has collegium comprising of three Commissioners of Income-tax constituted by the CBDT for this purpose. After receiving the objections, the DRP conducts hearings and passes a direction to the AO within 9 months who passes the final order within one month pursuant to the direction of the DRP and then appeals could be made to the appellate authorities like the ITAT, High Court and so on.
Let us examine some of the cases to understand the types of TP disputes gain and some conceptual clarity on the issues.
Whether Issue of equity shares to holding company will come under the ambit of “income”
Transfer Pricing regulations are intended to apply to transactions that give rise to income or expenditure, but income tax authorities have in the recent past extended its applicability to investments made in subsidiary as “International Transaction” subject to transfer pricing.
In the recent judgment in the case, Vodafone India Services (P) Ltd. v Union of India (Bombay High Court), Vodafone India issued equity shares to its holding company, Vodafone Tele-Services (India) Holdings Ltd., a non-resident company situated in Mauritius in the assessment year 2009-10. Here, the holding company will be considered an Associate Enterprise (AE) of Vodafone India under transfer pricing provisions under the Income Tax Act, 1961.
It was alleged by the TPO that the equity shares were issued at below the fair market prices and the AE benefited from the same and accordingly TP provisions were invoked leading to an assessment of Rs. 1,555 crore based on Arm’s Length Price or ALP (section 92F) which is basically a price that is applied to transactions between persons other than AEs in uncontrolled conditions and the shortfall on this amount was considered by the TPO as a loan to AE. Vodafone, on the other hand, argued that TP provisions do not apply to this case as issuing equity shares to holding company does not lead to the accrual of any income as it is a capital receipt which cannot be taxed unless specifically brought to tax by the act.
The Bombay High Court, ruled in favor of Vodafone concurring with the petitioner’s submission and held that issue of shares to holding company is a capital receipt and does not come under the word ‘income’ under the act. Share premium received from a resident in excess of market value is taxable as income under section 2(24) (xvi) but in this case, capital not received from a non-resident i.e. premium allegedly not received based on the application of ALP is being taxed. This judgment came as a boost to the Indian business community and is seen as a ray of hope providing a much-needed clarity on Indian tax laws to other major global companies, that are also fighting transfer-pricing cases in India.
Following the judgment in this case, the Delhi Bench of the ITAT, in First Blue Home Finance Ltd. v. ACIT, held that the transaction on capital account or on account of restructuring would become taxable to the extent it impacts income i.e. under reporting of interest income, over reporting of interest paid or claiming of depreciation, etc. In other words, an international transaction of capital nature may not lead to the generation of any income itself, but the resultant transaction may have an impact on the income of the taxpayer which, if is not at arm’s length, would invoke and need to satisfy the provisions of Chapter X of the Act.
Whether call options are subject to transfer pricing adjustments
In another dispute involving the sale of Vodafone’s call center business company, Vodafone India Services Private Ltd. to Hutchison in the financial year 2007-08, a capital gains tax amounting to Rs. 3,700 crore was demanded by the tax authorities after adding Rs. 8,500 crore on the said sale as taxable income of the company. The TPO submitted that the deal had been structured with Hutchison, a company based in India in a manner so as to 
eschew the transfer pricing rules even though it was an international transaction and ALP was not followed. Vodafone argued that the transaction was not related to transfer pricing as it was not an international transaction and involved two domestic companies and therefore, the TPO department had no jurisdiction over the deal, but the ITAT ruled in favor of the department. The High Court, on appeal against the order of the ITAT, held that the IT department has no jurisdiction in the case as there had been no transfer of “call options” and do not come under TP regulations and accordingly set aside the Rs. 3, 700 crore tax demand.
Whether a corporate guarantee given by a parent company for a subsidiary is subject to transfer pricing adjustments
The Income Tax Appellate Tribunal (“Tribunal”), in TP case involving Micro Inks Limited (“Mi India”) which had a owned wholly owned subsidiaries in Austria named Micro Inks GmbH (“Mi Austria”) which further had a subsidiary Micro Inks Co, (“MI USA”), the parent company issued corporate guarantees on behalf to its subsidiaries and no consideration was charged for the same. Mi India argued before the TPO that ALP adjustment should not be made in giving corporate guarantees by a parent company for the benefit of its subsidiaries, because, firstly the parent company did not incur any cost or recover the same from the subsidiaries for the corporate guarantee and secondly, the guarantees were quasi-capital in nature and not given as a service. Rejecting these claims, TPO made ALP adjustments to a transaction on the ground of the notional charges incurred for the corporate guarantees. Mi India approached the tribunal after unsuccessful objection before the Dispute Resolution Panel.
The tribunal held that, when corporate guarantees are issued by the parent company for the benefit of the subsidiaries without incurring any cost on the same and without affecting the profit, losses, income or assets of the company, then it is beyond the ambit of “International Transaction.” The tribunal reasoned that corporate guarantees are not tantamount to bank guarantees as banks agree to provide guarantees only after assessing the financial credibility and repaying capacity of the subsidiaries, the feasibility of their underlying assets as security and the deposits made as payments for the bank guarantee. Further, corporate guarantees can not be compared with bank guarantees because ALP adjustment presupposes that transactions can be carried out in arm’s length situations. Here, the risk involved in giving corporate guarantees is entirely entrepreneurial as it aims at maximizing the profits of the subsidiaries through shareholding activity/quasi-capital and mere assistance to subsidiaries by extending the benefit of activities per se does not qualify it as a “service.”
Whether promotion of Marketing Intangibles by subsidiary is subject to ALP adjustment
Often, multinational companies allow other group companies to use their trademark or brand name (“marketing intangibles”) with or without royalty while retaining the ownership on them. Marketing intangibles are used by these other group companies who incur advertisement, marketing and promotion expenses (AMP expenses) for marketing the products in the respective country in which it is operational. Disputes arise as to whether the legal owner of these marketing intangibles needs to compensate the group companies for the promotion done by it on these marketing intangibles.
In M/s Ford India Private Limited v. DCIT, Ford India, a wholly owned subsidiary of Ford Motor Company, USA (FMC) was engaged in the manufacturing and distribution of vehicles. FMC and Ford India entered into a technical collaboration agreement wherein FMC granted Ford India the license to manufacture vehicles using the technical knowledge and knowhow provided by FMC for consideration in the form of royalty payment to FMC. The products were also allowed to be branded with the “Ford” logo.
After acquiring the rights to manufacture and use the “Ford” logo, Ford India incurred AMP expenses worth 1.26 billion rupees in the financial year 2006-07. FMC received 148.4 million rupees for product development expenses. During the assessment year 2007- 08, when the TP audit proceedings were underway, it was found that the use of the “Ford” logo was compulsory on the manufactured motor vehicles. Subsequently, the TPO imposed a royalty of 1% of Ford India’s sales as the ALP for the brand development owned by FMC. 
When the matter reached the ITAT, it was observed that Ford India was a 100% subsidiary of FMC and branded all the vehicles with the “Ford” logo and was consequently promoting the logo. Amid these conditions, it was difficult for Ford India to manufacture vehicles other than those branded with the “Ford” logo. As a result, FMC had absolute control over Ford India and the AMP expenses had been incurred in line with the plan of action designed by FMC. In light of these reasons, ITAT arrived at the conclusion that an international transaction in the nature of service was in place between the two companies with the purpose of fostering, developing and improving the marketing intangible “Ford” logo. In addition to that, no royalty was being charged by FMC to Ford India for using the logo in India and therefore the imposition of 1% on the sales of Ford India as royalty was unjustified, and the only objective criteria that could be applied here was the excess AMP expenditure.
Whether notional interest on unpaid receivables which are due to Indian taxpayer is subject to TP provisions
Recently, receivables due in the books of account of an Indian entity for sales transaction made to an AE that was a foreign entity was in dispute in the case CIT v Indo-American Jewellery. The argument put forth by the tax authorities was that if the Indian enterprise fails to realize the receivables or payments due to it within a reasonable period of time, then it should have charged interest on the same from the foreign AE. Accordingly, they adjusted the income of the Indian enterprise by adding 10% to it as interest due from the unpaid receivables. The Bombay High Court held that the Indian enterprise had similar unpaid receivables from export to unrelated entities and did not charge any interest on the same. Therefore, the court accepted the taxpayer’s plea that the foreign AE had not been treated with undue benefit and accordingly deleted the addition to its income. This contentious issue has been now dealt with in the Finance Act of 2012 favoring the tax authorities. Now, if there is a deferral in the receivables in an international transaction, it will have to conform with ALP principle.
Whether the sale of business between two domestic companies (neither of whom are non-residents), which were not AEs, can be considered as a deemed international transaction
In Kodak India Private Limited v. Additional CIT, Kodak India, a subsidiary of Kodak USA, sold its medical imaging business to Carestream Health India Private Limited for US$13.543 million, in the assessment year 2008-09. During the TP audit, the TPO found that this transaction was similar to a parallel transaction on a global basis between Kodak US and Carestream US (owner of subsidiary Carestream India). Accordingly, the TP lifted the corporate veil and deemed the transaction as an international transaction and proceeded to apply ALP adjustment over it.
As the dispute reached the ITAT, it was held that there was no evidence to show that the global agreement between Kodak US and Carestream US had any effect or relation with the domestic agreement or if Kodak India had any AE relation with Carestream US or Carestream India had any AE relation with Kodak US. As a result, ITAT concluded that there was nothing between the two transactions to deem the transaction between the domestic companies as an international transaction.
The myriad nature of Transfer Pricing disputes is manifest from the discussion above. It is clear that courts and tax authorities are still trying to feel their way through the interpretations and implications of the changes in the regulation that was introduced in 2001. Barely 15 years after the introduction of the TP regulations, it has become one of the most litigated areas in direct taxes. Today, India is among the top five nations having pending TP disputes. The discussion on the above disputes reflects the growing complexity and adjustments to income. This has become a cause of concern for the Multinational companies. In order to address this concern, the Finance Act, 2012 introduced the scheme for the Advanced Pricing Agreements.
Advanced Pricing Agreement (APA): The Way Forward
Under this agreement, the taxpayer enters into an upfront agreement with the tax authorities for a definite period of time (say 5 years) with respect to the ALP of its international transactions with AEs. The purpose of this scheme is to provide for certainty in the tax treatment in the face of complex international transactions that otherwise lead to the painstaking process of TP adjustments. In addition to this, APAs will also obviate the tedious and protracted domestic appeal procedure for the multinational enterprises. During the duration of this agreement, the company will have freedom from the frequent TP adjustments and double taxation. It is an efficient way to preempt TP litigations and save time and costs, which otherwise could run to as much as 10 – 12 years. The interest generated in the APA scheme has been huge, and nearly 700 applications have been filed by multinational companies in just four years. The CBDT has already entered into 98 bilateral APAs since the introduction of the scheme three years ago. The effective implementation of the APA scheme in recent years has aided the corporates in attaining certainty with respect to their related-party transactions for up to five years in the future.
References:
- http://www.incometaxindia.gov.in/Pages/international-taxation/transfer-pricing.aspx
- http://taxguru.in/income-tax/case-study-vodafone-india-services-uoi-bombay-hc-decision.html
- https://www.pwc.com/gx/en/international-transfer-pricing/assets/india.pdf
- https://www.kpmg.com/Global/en/IssuesAndInsights/ArticlesPublications/taxnewsflash/Documents/tp-india-june18-2015.pdf
- http://www.thehindu.com/business/Industry/relief-for-vodafone-in-transfer-pricing-case/article7738980.ece
- http://www.nishithdesai.com/information/research-and-articles/nda-hotline/nda-hotline-single-view/article/globalizing-india-inc-tribunal-holds-corporate-guarantee-for-benefit-of-offshore-subsidiary-not-su.html?no_cache=1&cHash=2158bc5513314a644995e0adff46baac
