Advertisement, Marketing and Promotion (“AMP”) Expenses

One of the most controversial issues in the transfer pricing arena which started in the past decade was treating Advertisement, Marketing and Promotion (AMP) expenses of Indian entities as an international transaction. Over the years the tax authorities have been consistently arguing that the excessive AMP spent by an Indian subsidiary lead to an increase in the Brand value of the foreign Associated enterprise (AE) and this is an international transaction and is subject to TP provisions.

The absence of any regulation dealing with AMP issue and the fact that the principle is completely fostered based on judicial pronouncements by various tax forums add to the controversy. The Delhi High Court (“HC”) in the case of Maruti Suzuki India Ltd explicitly held that AMP does not constitute an international transaction and that the use of ‘bright line test’ (BLT) approach as inappropriate for making an adjustment. However, the SLP filed before the Supreme Court against this HC decision is still pending and hence the issue is yet to attain finality. In the interim, apart from BLT, the transfer pricing authorities are adopting various innovative measures to impose adjustments such as:

• AMP intensity adjustment –Treating the assessee’s marketing activity as a separate function and factoring AMP intensity in profit rates of comparable companies while benchmarking the import transactions to arrive at the TP Adjustment.
• 50-50 adjustment – Attributing AMP spend as being incurred equally towards brand development of the foreign AE and towards the benefit of the Indian entity thereby imposing adjustment to recover the 50% of the expenses from the foreign AE. Some cases a profit mark-up is also expected on the cost to be recovered.
• Brand building as a service – Treating the AMP spend as a brand building service rendered by the Indian subsidiary to its foreign AE and thereby attributing notional income as a percentage on sales determined on an ad-hoc basis.

Until the issue is decided at the Apex Court, taxpayers are faced with these adjustments every year at the TPO level irrespective of favorable orders in their own case itself before the ITAT.

UAE TP Limits

• Conditions prescribed for maintenance of TP documentation under the new Corporate tax regime
• Explanatory guide on CT law issued

Last week, the UAE MoF had released the much-awaited notification regarding the conditions for maintenance of TP documentation (Local file & Master file) in the form of Ministerial decision no. 97 of 2023. Additionally, an Explanatory guide on the CT law was also published which provides a summary of the meaning and intended effect of each Article of the CT Law.

In our alert we have summarized the key aspects in relation to the decision as well as our analysis on the same. Though the Ministry has been considerate in fixing high thresholds and specifically excluding certain tax neutral transactions from the Local file, the following aspects would need to be taken into consideration:

• Arm’s length principle– The thresholds & inclusions/exclusions are specifically in connection with Master file/Local file. The requirement to comply with arm’s length principle would still apply irrespective of these and it becomes the Taxable Person’s responsibility to maintain sufficient supporting documents to substantiate the arm’s length nature of its transactions
• Disclosure form– No specific thresholds have been prescribed yet for filing of the Disclosure form. Once the format is notified one may obtain clarity if it requires a Taxable Person to provide details of its transactions/arrangements with all of its Related Parties & Connected Persons
• Qualifying Free Zones– The Definition of Taxable Person (Article 11) includes QFZ and hence the thresholds and conditions for maintenance of Local & Master file provided would equally applicable to QFZ. However, the QFZ may need to comply with the arm’s length principle (Article 34) irrespective of the thresholds in order to claim the benefits.
• Natural persons– As per the exclusions to Local file, Taxable Persons having transactions with Natural persons need not form part of Local file subject to conditions. In our view, where the Taxable Person is itself a Natural person, Local file will have to be prepared, subject to thresholds & conditions prescribed
• Arm’s length principle in other aspects of CT law– In various other sections of the CT law where the arm’s length principle would be applicable (eg: GAAR, Investment Manager Exemption, transfers with a foreign PE etc), sufficient supporting documentation should be maintained to substantiate the arm’s length nature of these transactions
• TP documentation guidelines– Further guidance regarding maintenance of TP documentation including specific formats for Local file & Master file are expected from the Authority. This guidance may also need to address where there are multiple entities of the same Group in UAE and whether filing and maintenance of single Master File for the Group would suffice.

Read more…

 Corporate Guarantee (CG) – TransferPricing aspects

In light of the recent Mumbai Tribunal ruling – Macrotech Developers (Lodha ), the below post explores the technical aspects on CG

OECD Guidelines states a legally binding commitment by guarantor (explicit guarantee) for the obligation of its associatedenterprise (AE) is relevant for TP analysis. Any implicit support (being a member of the Group) does not warrant any compensation.

In the Indian context, though CG partakes the character of a service, for clarity guarantee was included in the definition of internationaltransaction via Finance Act 2012. Indian jurisprudence is divided as some rulings state CG is not an international transaction, but of late Tax Tribunals (ITAT) opine otherwise. Unless proved that CG is a shareholding activity with robust evidence, ITAT does not accept taxpayer’s claim of receipt of CG fees may not be required.

It is noticed that Taxpayers initially contend that CG is not an international transaction, and when litigated by tax authorities’, Taxpayers resort to relying on certain rulings such as Everest Kanto where ITAT has accepted ALP CG fees around 0.5%.

Above is an easy reactive stop-gap approach to minimise adjustment but may not be the correct TP approach, since CG fee in ITAT rulings is based on facts specific to the taxpayer for which the ruling was pronounced and most likely facts will be different from that of the Company. Instead, Companies should proactively undertake benchmarking for CG fees, based on detailed transactional analysis. Hence, Companies should consider adopting an appropriate benchmarking analysis for arriving at the ALP of CG fees. One could adopt any of the below 5 approaches to price CG.:

1. CUP Method- Fees charged by independent guarantors for guaranteeing comparable loans,
2. Yield: Spread between interest rates of unguaranteed and guaranteed loans,
3. Cost: Value of additional risk to guarantor due to guarantee provided – computed through option pricing, credit default swaps
4. Expected loss: Calculating probability of default and adjusting for expected recovery rate
5. Capital support: Computing differential capital to make credit rating of borrower and guarantor equal. Computing expected return on such notional additional capital

Robust benchmarking study increases the probability of tax authorities not disputing the issue – providing certainty and also reduces the burden on resources due to tax litigation. This is also seen in the aforesaid ruling, where ITAT overruled DRP directions that relied on judicial precedence of 0.5% as CG fees and upheld the benchmarking undertaken by the taxpayer – 0.35% as CG fees.

Further as base rates for loans are moving from LIBOR to ARR, it is vital that Companies relook at pricing policy for intragroup CG fees, to be aligned with latest industry best practices and also from a TP perspective.

SC ruling sap labs

Softbrands SAP Labs Supreme Court (SC) Ruling – Key Takeaways:

Last week, in a landmark verdict in the case of SAP Labs, the SC overturned the HighCourt ( HC ) order in the case of Softbrands. The SC ruled that HC has to decide the appeals by examining whether determination of arm’s length price (ALP) by the Income Tax Appellate Tribunal (ITAT) is based on the Income Tax Act and Income Tax rules. Earlier in the case of Softbrands, the HC ruled that ITAT is the final fact-finding authority and unless the appellant states the perversity as well as demonstrates the perversity of the ITAT order, HC would not interfere in the findings of the ITAT.

While most of us are aware of the decision, in our alert, we have primarily focussed on the key takeaways and considerations of this landmark SC ruling viz.,:

1. For the cases remanded by the SC in the order, HC will have to adjudicate the cases within 9 months and the appellant will have to present before HC how the ITAT order did not adhere to Income Tax Act and rules in determining the arm’s length price.
2. Increase in cases before the HC based on the SC ruling. In the event of adverse order for the taxpayer, increase in cash outflow due to interest and penalties.
3. Impact on refunds and demand.
4. In existing cases, Two alternatives where appellant is aggrieved by the order of HC – in determination of ALP – Review petition and SLP before SC
5. Revisit the strategy/Framing of grounds before the ITAT.
6. Impact on contingent liability – evaluation and FIN 48 related disclosure.
7. Alternate dispute resolution currently available – APA, Safe harbor (SHR) , MAP,
8. Expectation from Government of India – enhancement of scope of SHR, hybrid programs, introduction of ICAP (International Compliance Assurance Programme) in India.

VSTN can support taxpayers in:

1. Understanding the impact on the ruling for the MNE Group.
2. Performing a health check to identify any gaps or red flags in the existing intragroup transactions and Group’s transfer pricing policy
3. Outline the strategy to overcome any issues that can arise from a Transfer pricing litigation perspective
4. Devise risk mitigation plans to reduce the possibility of litigation or transfer pricing adjustments, including use of dispute resolution mechanisms such as Safe Harbour Rules, Advance pricing agreement, as may applicable.

Read more…

Middle East TP Updates – UAE and KSA

KSA

The Zakat, Tax and Customs Authority of Kingdom of Saudi Arabia (KSA) has issued its directive in extending transfer pricing regulations and introducing advancepricingagreement (APA).

A) Currently, 100% Zakat taxpayers are exempt from Transfer pricing regulations in KSA, except for filing of Country-by-country report (CbCR) where applicable. In July 2022, the Tax authority issued a public consultation on making transfer pricing provisions applicable to Zakat taxpayers. As per the recent directive (unofficial translation), taxpayers paying Zakat Tax will the subject to transfer pricing regulations effective from 01 January 2024. However, this will be applicable in a phased manner and subject to monetary threshold limits as follows:

Phase 1-From 01 Jan 2024

i) Mandatory where value of relatedpartytransactions (RPT) is more than 100 million (mn.) SaudiArabianRiyals (SAR);

ii) Optional where value of RPT is between 100 mn. SAR and 48 million SAR;

iii) Not applicable where value of RPT is less than 48 mn. SAR.

Further investment funds are exempted in Phase1

Phase 2-From 01 Jan 2027

i) Mandatory where value of RPT is more than 48 mn. Riyals;

ii) Not applicable where value of RPT is less than 48 mn. Riyals.

Therefore, taxpayers currently under 100% Zakat tax, subject to the limits, will now have to prepare localfile and masterfile with effect from 01 January 2024, apart from CbCR where applicable.

B) The recent directive made applicable the provisions of APA effective from 01 January 2024. The Transfer pricing regulations was introduced in 2019 in KSA and with the introduction of APA programme it can be expected to cap any likelihood of significant TP disputes.

UAE

1. The UAE issued Ministerial Decision No. 68 of 2023 that states when a government entity(ies) conduct business under the License issued, i.e., where government entity is not exempted from UAE Corporatetax, Federal government business and business activities can be treated as single taxable person for the purpose of UAE Corporate Tax. This is aimed to simplify tax compliances for government business activities. This means transfer pricing related compliances will not be applicable for transactions between governmentbusinesses when treated as single Tax Group
2. Article 51 of UAE corporate tax law provides that taxable persons have to register with Federal Tax Authority, unless exempt under certain cases. The UAE Ministry of Finance has recently issued Ministerial Decision No. 43 of 2023 providing exemption from Tax registration for certain persons viz., government entities, government-controlled entities, as well as extractivebusinesses and non-extractive natural resource businesses. However, these persons will have to meet the necessary conditions specified under the Corporate Tax law in connection with exemption for registration.

UAE – Small Business Relief for Corporate Tax- Conditions – Impact for transfer pricing

Under the UAE Decree Law on Corporate Tax (Article 21- Small Business Relief) issued in December 2022, it was specified that a Taxable Resident Person may elect to be treated as not having derived any Taxable Income for a Tax Period where:

• the Revenue of the Taxable Person for the relevant Tax Period and previous Tax Periods does not exceed a threshold to be prescribed and
• the Taxable Person meets all other conditions prescribed.

Today (06 April 2023), the UAE MoF has issued Ministerial Decision No. 73 of 2023 which prescribes the mentioned threshold and other conditions for availing Small Business Relief. The key aspects are as follows:

• Revenue in the relevant tax period and previous tax periods is below AED 3 million for each tax period. Revenue can be determined based on the applicable accounting standards accepted in the UAE
• There is a sunset clause prescribed (3 years)– the revenue threshold will apply to tax periods starting on or after 1 June 2023 and will only continue till 31 December 2026
• Small business relief will not be applicable to Qualifying Free Zone Persons or members of MNE Groups (Groups of companies having operations in more than one country have consolidated Group revenues of > AED 3.15 billion.)
• Restriction on carry forward of losses only in periods where small business relief is elected
• Any artificial segregation of business to meet the thresholds will be viewed as arrangement subject to the General Anti Abuse Rules

IMPACT FOR TRANSFER PRICING

In case a Taxable Person meets the above conditions, various provisions of the Decree Law will not be applicable, including Article 55 which relates to Transfer Pricing documentation requirements. Persons who opt for Small Business Relief will be exempted from:

• The requirement to file a Disclosure form along with the Tax return providing details of transactions with Related Parties and Connected Persons
• Maintenance of Local file and Master file
• There may not be any requests from the Federal Tax authority to furnish information to support the arm’s length nature of transactions with Related Parties and Connected Persons

The above provisions are meant to support start-ups and other small or micro businesses by reducing their corporate tax burden and compliance costs. However it is to be noted that transfer pricing requirements will continue for all members of larger MNE groups which have consolidated group revenue of > AED 3.15 billion and entities operating in Qualifying Free zones.

Sale and leaseback of IP

Leaseback of tangible assets is a financing arrangement, mainly to freeup working capital as well to be the economic owner of the asset. Leaseback is an option/tool to divest certain risk associated with the asset. In an IP leaseback, IP is sold by the first owner (FO) to another person (second owner/SO). The SO leases back the IP to FO in consideration for royalty payment. While leaseback is familiar to fixed assets, it is viewed skeptically w.r.t. IP.

A recent US ruling in case of Skechers held IP leaseback as a sham transaction, basis its facts. Though the ruling was regarding transactions between domestic entities, ruling is relevant from a transfer pricing perspective as the court analysed from a economic substance perspective.

Skechers USA LLC (Skechers) incorporated Skechers USA Inc.II (SKII), a Delaware Corp.. Skechers transferred to SKII all IP for the domestic market (trademarks, copyrights, patents). SKII leased the rights back to Skechers. Skechers was to pay all of its operating margins in excess of 2% as royalty to SKII. During field audit tax authorities noted:

1. Post above structuring , ETR was lower by 1.25%, which was the primary objective.
2. Simple interest on unpaid royalties due to be paid by Skechers. All interest & royalties computed were journal entries for deduction of income for tax purposes.
3. . No detailed workings were available for royalty, management fees and interest paid and they varied from 1.7% to 3% of domestic sales.
4. All money transfers between Skechers and SKII began & ended in the same Skechers bank account.

In case of IP leaseback, anything without substance is viewed as entered only for tax purposes and below aspects needs to be evaluated:

• Is there a circular movement of funds. Are revenue streams taxed in low tax jurisdictions and expenses are booked in high tax jurisdiction -net reduction in effective tax.
• Does the SO have the substance and capability to assume economically significant risks transferred by the FO.
• Post IP transfer, is there any change in actual groundwork on the DEMPE activities regarding IP or the course of activities is based on earlier plan / strategy or only minor modifications in reporting just to check the box for review of work by SO. Consequently, if there are no DEMPE activities by SO and all of that is outsourced to the FO.
• How is it documented in the intercompany agreement – Is there an economic reasoning/rationale for transfer of IP or is it for purpose of paperreality.
• Does the IP transferred have huge market potential and difficult to replicate by competitors. Is the IP transferred during its development–Hardtovalueintangibles (HTVI). Is there significant variance (>20%) between the assumptions made during the transfer from FO to SO and the actual outcomes.

TP not a compliance – reviewed

Transfer Pricing (TP): Beyond being another Tax Compliance

TP rules are part of the tax laws of any country but is more deeply connected with business interests having roots deeper into economic reality. It is often that TP is given importance during mandatory tax filings and maintaining documentation, whereas establishment of appropriate TP policy improves overall business outcomes and maintains tax-efficiency organically.

Impact of TP on businesses is captured below:

• During Startup phase of the entity, the structuring and pricing of cross border transactions are decided based on immediate business needs, and are left for course correction at a later stage. Setting-up of TP policy ensures reaping of working capital efficiencies from the beginning, besides having robust documentation during tax scrutiny. TP requires to be aligned with indirect tax aspects such as Customs and FTA to ensure tax efficiencies and create value for the Group.
• Treating TP as a post-mortem exercise creates pressure on business resources during tax year end. With technology, Group’s operations and TP outcomes can be monitored on a concurrent basis and systems can be automated to raise flags to take corrective actions during the year itself. Through this working capital can be streamlined for the financial &tax years, taxes can be paid efficiently, and interest/penalties can be minimised. Where Group’s TP policy is aligned with Group’s risk management, TP outcomes would factor business realities and would be resilient to global economic / political/ financial crisis such as COVID, wars, and industry shocks such as supply chain disruption.
• Involvement of TP personnel during Statutory audit can help to streamline audit entries on TP and ensure more accurate disclosure of related party transactions. Making suo motto TP adjustments after closure of books would result in additional taxes (secondary adjustment) and create complications during TP audit scrutiny.
• Where selected for tax scrutiny, understanding the requirements of tax authority and filing submissions to address their requirements is key to avoid any TP adjustment. Businesses collating and maintaining contemporaneous documentation (intra group charges) would reduce hardship during course of tax scrutiny and ease Group’s resources. Filing of appropriate and complete information before lower tax authorities will reduce risk of higher appellate authorities remanding back to lower tax authorities and can reduce litigation costs.

Accordingly, there is a need to change the mindset how TP is approached: from a compliance tool to being a Business tool generating value.

VSTN can support in streamlining TP policy, thereby easing resources for core competence of business, increasing working capital efficiencies, tax optimization and increasing shareholder value.

Country-by-Country Report  (CbC)– Risk Assessment

As the due date for filing of CbC for applicable IndianHQ – FY 2021-22 (AY 2022-23) is approaching i.e., 31 March 2023, it is important to ensure accuracy of information flowing in CbC. However, an even more critical aspect is to understand how CbC will be consumed for risk assessment by tax authorities, which has tax implications across the jurisdictions it has presence. The article aims to broadly touch upon how a CbC can be read, from a risk assessment perspective, and other key points.

With various developments surrounding CbC such as public CbC, transitional CbC Safe Harbour for Pillar Two, it is even more key to analyze CbC of Group to identify any risk flags and streamline the operations from a transfer pricing perspective to pre-empt any tax litigation. Though CbC is a post-mortem exercise, it would aid in course correction for the future years.

How VSTN can support:

• Analyze CbC for MNE Groups (outbound and inbound where available) to understand any flags from risk assessment perspective, through:
  • Jurisdiction specific insights from analysis of both jurisdictional information and Group information at large.
  • Year-on-Year comparison to understand any perceived movement in functions, activities or revenue / profits accruing and follow-on documentation to mitigate any risk of attribution of restructuring.
  • Industry specific comparison and insights based on publicly available CbC information.
  • Assisting in streamlining the Group’s transfer pricing policy
• Transfer Pricing Readiness for transitional CbC Safe Harbour for Pillar Two

Read more…

TP ISSUES FOR ROYALTY TRANSACTION

In the attached article we have presented our analysis on royalty payment, which is a highly litigated transaction in the transfer pricing landscape in India. The broad aspects covered in the article are the common issues faced during the assessment proceedings, recommendations on approach for defending royalty and the changing landscape for the transaction in recent times.

Considering the high quantum of adjustments made by the tax authorities, it is essential to be proactive and have robust defence for substantiating the payment of royalty.

How we can support

1. Support in maintenance of cost benefit analysis documentation to substantiate royalty payment
2. Performance of CUT search using Global Royalty database to identify comparable license agreements and determine the arm’s length royalty range
3. Audit Defense before all forums  – Transfer Pricing officer, Dispute Resolution Panel, Commissioner of Income Tax (Appeals) and Income Tax Appellate Tribunal
4. Analysis of DEMPE functions
5. Assistance in APA proceedings

Read more…