UnionBudget2023 Proposals – Transfer Pricing

The Finance Minister presented the Union Budget for 2023-24. The alert captures the Transfer Pricing updates in the Finance Bill 2023 and includes:

1. Reduced time to submit information called by Assessing officer during audit proceedings, hence requiring contemporaneous documentation including supporting documents for international transactions.
2. New inclusion to Specified Domestic transaction (SDT)- Transactions between New manufacturing co-operative society set up and its closely connected person are subject to transfer pricing
3. Limitation of interest deductions (Section 94B) – Exclusion of Non-Banking Financial Companies (NBFC) thincapitalization
4. Introduction of New authority – Joint Commissioner (Appeals) – for cases when the disputed amount involved is small.
5. Option to file cross objections before the Tax tribunal available to respondents for all class of orders (including DRP order)

Several industry expectations such as implementation of Pillar One / Two, updates to Advance Pricing Agreement (APA) program, transition to interquartile range did not form part of Budget 2023.

Open Attachment…

Budget2023 Expectations – Transfer Pricing

On 01 February 2023, the Finance Minister will present the budget for 2023. Transfer Pricing expectations / recommendations from this budget is presented in the alert. The alert includes:

1. Advance Pricing Agreement (APA) – Allocation of more resources for APA program to reduce the pending inventory of APA applications, formulaic approach to fasten the conclusion of relatively less complex transactions and inclusion of standard information requested during the APA in the application itself.
2. Pillar One/ Pillar Two – Implementation of Pillar Two in India domestic tax legislation and interplay of Pillar One/ Two with transfer pricing depending on the how the model rules are implemented.
3. Safe Harbour Rules – Introduction of royalty as covered transaction, revision of base for intra-group loans from LIBOR to Alternate reference rates and updating the ratio of employee cost to total cost for determining the arm’s length mark-up for knowledge process outsourcing (KPO) services.
4. Ease of transfer pricing compliance for Startups
5. Adoption of interquartile range as arm’s length range.

Open Attachment…

Background

The Budget 2023-24 is the last full budget of the current government before the 2024 general elections. With the current global slowdown and with India’s 5 trillion economy target, this budget is key on various frontiers. The following are the expectations of the Budget 2023 announcements from a Transfer pricing perspective.

Expectations

Advance Pricing Agreement (APA):

APAs have been on the forefront as a mechanism for dispute prevention with respect to Transfer Pricing. However, of late there has been increase in the inventory of pending cases with reasons including lack of allocation of sufficient manpower towards this programme by the government. In this direction, it is expected that government would provide increased resources to expedite the process.

In addition, the CBDT can also consider use of formulaic approach to conclude on the relative less complex or simple APA cases. This approach can be specific to industry having parameters relevant for respective sector or sub-sector, as applicable. Similar formulaic approaches were adopted in other instances which include conclusion of significant MAP cases by India with partner countries—where a regression-based approach / model was used to arrive at the arm’s length mark-ups for captive IT/TeS services in India, and public consultation by the OECD on Amount B of Pillar One — where mechanical pricing tool approach was considered as an output option for benchmarking of baseline marketing entities.

Further in case of routine transactions, a standard information request for the respective transactions, can perhaps be included during the application itself to facilitate quicker ingestion of information to Tax authorities, thereby lowering the time frame for conclusion of APA.

Pillar One / Two Draft Rules:

India has been one of the early adopters of the BEPS (Base Erosion and Profit Shifting) program of the OECD such as three-tier documentation – Master File and Country-by-Country reporting. It can be expected that updates to the Tax legislation be introduced in the upcoming budget to implement Pillar One/Two, further considering that Pillar Two is expected to go live by 2024 globally in line with OECD. Further depending on how the model rules provided by the OECD are implemented will also decide the interplay between Pillar One / Two and transfer pricing regulations. For example, Article 3.2.3 of the model rules on Pillar Two issued by the OECD provides that intra-group transactions between group entities in different jurisdictions should be recorded at the same value and should in alignment with arm’s length principle. In this case, impact of transfer pricing adjustments made during the transfer pricing audits on the computation of GloBE income or loss will have to awaited, depending on the rules to be adopted in Indian tax legislations.

Currently South Korea has implemented Pillar Two rules in its domestic legislations.

Safe Harbour Rules (SHR):

These rules were introduced as a dispute resolution mechanism to entice taxpayers entering into international transactions having relatively low value and simple nature of transactions – small taxpayers. However, it has received a lukewarm response. SHR can also aid to lower the APA inventory if the agreed arm’s length price as per the SHR are made competitive. Since there were no changes in the agreed arm’s length price during the COVID pandemic, probability of any revision is limited. Some of the expectations / recommendation on updates in SHR in the budget include:

• Introduction of royalty as a covered transaction.Royalty expenses have been one of the most litigated international transactions. Similar to low-value adding activities, certain guard rails such as upper cap on the value of royalty transactions, obtaining of Chartered Accountant certificate on the relevant aspects such computation of royalty payments can be included, etc.
• Benchmarks for intra-group loans have been benchmarked using LIBOR as per SHR.Updating benchmarks to Alternate Reference Rates (ARR), to align with foreign exchange regulations can be expected, along with appropriate adjustments for movement from LIBOR to ARR.
• Arm’s length mark-up for knowledge process outsourcing services has been linked to ratio of employee costs to total cost.Post pandemic businesses have moved to hybrid model and correspondingly there has been reduction in overheads incurred such as office rentals, transportation costs for employees and accordingly there would be an increase in the ratio even though the assessee would have been undertaking the same functions. Hence revision in these ratios can be expected.

Ease for Start-up:

India’s start-up ecosystem is the second largest globally and boosting of start-ups is key from myriad aspects such as employment, growth, etc. Start-ups often explore foreign markets or at time cater to foreign markets. Hence easing of transfer pricing compliances for start-ups can aid organic growth of Indian start-up ecosystem.

Interquartile range:

Arm’s length range in the Indian transfer pricing regulations is 35th to 65th percentile as against globally accepted inter-quartile range. Adoption of inter-quartile range as the arm’s length range would be a move in the positive direction, in alignment with globally accepted practice.

Transfer Pricing – Pillar One – Amount B: OECD issues public consultation Document

The OECD / G20 InclusiveFramework (IF) issued public consultation document on AmountB of PillarOne on 08 December 2022.

Though the guidance of Amount B has been issued as part of Pillar 1 still Amount B applicability is not turnover, or profitability based, and its scope covers entities being – whole sale distributors (buy sell) and sales agency, commissionaire arrangements and hence most of the MNCs would need to evaluate the same.

The alert summarises the progress by the IF on various aspects as well as key considerations including:

• Amount B to provide a simplified & streamlined approach to determine an arm’s length remuneration (routine& limited return) for baseline marketing activities by distributors, mostly for low-capacity jurisdictions. Distribution of commodities & non-tangible goods, are being currently out scoped
• Amount B covers buy-sell as well as sales agency, commissionaire arrangements. There are certain quantitative and qualitative parameters for qualifying under Amount B
• Pricing methodology of Amount B consists of benchmarking criteria to arrive at comparable companies. Two output options viz., pricing matrix approach (matrix of various parameters based on which arm’s length profitability range is arrived) and mechanical pricing tool approach (formulaic way to arrive at arm’s length profitability by inputting parameters of the tested party)
• TNMM is considered for Amount B. Alterative PLIs are also being contemplated
• Other aspects cover:
  • Documentation – Capturing detailed FAR of distributor to ensure satisfaction of scoping criteria, rationale for comparability adjustments if availed. Alignment of local file, Master File and CbC report
  • Transitional issues – where MNE considers reorganising distribution entities to either bring them in or out of scope, MNE will have to be mindful if it would constitute restructuring
  • Tax certainty – Opting for AdvancePricingAgreement (APA) to agree on scoping & other aspects of Amount B or MutualProcedureAgreement (MAP) for relief on doubletaxation

Amount B would a milestone in dispute resolution as it is the first occasion where a detailed framework on undertaking benchmarking is issued. Since Amount B would be finalised by over 142 country members & that there are no threshold limits, there is a high probability of MNEs adopting it across jurisdictions, especially LCJ.

Open Attachment…

Transfer Pricing – Master File – Practical considerations

MasterFile (MF) in Form3CEAA to be efiled by Indian entities of MNE Group by the due date of filing IT return i.e., 30 November. While Part A of Form has no threshold, Part B to be filed when a) consolidated group revenue >Rs 500 cr & b)aggregate value of international transactions >Rs 50 cr, or aggregate value of IP transactions >Rs 10 cr.

Most countries adopt format provided in OECD Guidelines consisting of MNE Group’s Organizational structure, Description of businesses, Intangibles, Intercompany financing activities, & Financial & tax positions. In India there are certain additional requirements & hence for mncs in india , the Global MF needs to be customized with

1. Address of all constituent entities, entities involved in IP activity, central financing entity
2. FAR analysis of entities based on 10% of Group’s revenue or assets or profits
3. Address of top 10 unrelated lenders
4. Major geographical markets

Few practical pointers to be kept in mind:

1. Consistency to be maintained between MF & localfilea)     Classification of services – Services rendered by Indian entities are classified as software development services locally while the same are treated as R&D costs in the other jurisdiction & in  MF. One should be aware as to how this needs to be presented in Global MF.
   b)     Cross charging of Intragroup service costs-Consistency in Group policy for services (management charges) to be evaluated. Whether these costs are cross charged to all countries? What is the position of Group in case of certain countries which don’t permit management charges debits(e.g) China
   c)      Pricing policy for Financing, services arrangements, concluded APAs – Alignment of pricing policy for Indian entity transactions with other entities on financing, service arrangements as well as conclusions in APA.
2. Business Group wise disclosure: In case of big business Indian conglomerates, one needs to evaluate if a business unit wise presentation of MF can be captured considering OECD Guidance relevant for that entity
3. 10% FAR criteria – How to apply the criteria in case of loss making entities for 10% of group profits?
4. Indian HQ – MF to be prepared completely by India HQ & will initially call for perusing the financials of all group entities, collation & aggregation of details would be time consuming. Clauses specify furnishing of information for ‘important’ arrangements. As this is subjective,  extent of details provided to be evaluated on materiality. In some cases, due date for MF for certain subsidiaries in other countries is before the Indian Due date & one needs to factor that
5. Onlinefiling issues – Attention to be paid to Character restrictions. No separate offline utility for form, the same to be directly filled online.

Transfer Pricing – Structuring

(Re)Structuring – transfer pricing considerations

One comes across situations, wherein first the promoters establish an entity (startup)in India. As they look to expand to foreign market, for ease, the promoters incorporate another entity (100% promoter holding) in the foreign jurisdiction. In these situations, ability to unlock value is reduced due to absence of appropriate holding structures. Once the start-up expands their business globally, they seek investors support. At this stage restructuring takes place to streamline the Group from a legal & tax perspective more in terms of devising appropriate holding structures. One needs to bear in mind that any entity structuring should also consider substance/flow of transactions from a TP perspective. High level TP considerations are:

1. Transaction flow between the entities needs to be aligned w.r.t. value chain of activities & characterization of respective entities. Next step would be to revisit the remuneration mechanics of all entities & to check for any requirement to change transfer pricing methods for testing ALP

2. In cases where there is a change in the functions undertaken by the Group entities purely due to business reasons/market circumstances then a detailed analysis of facts is required to understand if it would be construed as business restructuring & whether it warrants an exit charge. Additional economic analysis / tools such as OBSA(off-balance sheet assets),RASCI Framework can be used.

3. Assumptions at time of structuring (Ex-ante analysis) need to be tested against actual outcomes (Ex-post analysis). Variance in such outcomes (such as revenue/profitability) to be analyzed for materiality (deviation >20%)

4. In event of transfer of intangible/IP, need to evaluate whether it warrants an exit charge (to compensate transferor for scaling down the activities)

5. Capability of transferee to undertake key functions i.e., DEMPE of  IP

6. Understanding functions undertaken by transferor pre & post restructuring is essential. What would happen if the transferor continues to undertake key functions relating to IP even after sale of IP?

7. Documentation is key for TP & assumes even greater importance during restructuring. Detailed documentation is required w.r.t. business rational (necessity, alignment with industry best practices) for the restructuring, changes in functional analysis of the Group entities – pre & post restructuring, TP implications for the respective entities, basis for arriving at the exit charges or non-applicability of exit charges, capturing transfer pricing implications based on laws & regulations of the respective jurisdictions as well as guidance provided by OECD / UN.

Always advisable to realign structure in initial years rather than doing it later to access investor funding to avoid major issues

Transfer Pricing – MF and Cbc Notifications

FILING OF FORM 3CEAB & 3CEAC – 31 OCTOBER 2022

While we prioritise on form 3CEB & TP documentation by 31 Oct 2022, one should not miss on filing two more forms related to transfer pricing whose due date is also 31 October.

1.    Form 3CEAB – Master file designation
In case of more than one constituent entity of an international group (“group”) operating in India, the Master file in Form 3CEAA may be furnished by any one designated entity. One needs to bear in mind that Part A of Masterfile is applicable to all constituent entities of the Group & there is no threshold for applicability.

Therefore this designation notification needs to be filed in Form 3CEAB by a designated entity. Designation is provided to ease the administrative compliance of MNE Groups having multiple entities in India.

Earlier, the rules permitted that designation could happen only for resident entities & therefore excluded foreign entities. However, rules were amended effective 1 April 2021, where the words ‘resident in India’ was omitted. Hence designation can be filed on behalf of all the constituent entities including foreign entities in India. Hence, all the foreign entities of the Group who have income accruing or arising in India & were filing return & Form 3CEB in India, have to file Masterfile & Masterfile designation notification by one entity will take care of these requirements for foreign entities

If this form is not filed within the timeline, each of the constituent entities of the Group would be required to separately file Form 3CEAA by 30 November 2022.

2.    Form 3CEAC – CbCR notification
This intimation is required to be filed by a resident constituent entity of the Group where the parent entity is not an Indian resident & where the consolidated group turnover crosses prescribed threshold for CbC reporting ie 750 mn Euros (INR 6400 crs) in the preceding accounting period. For CbC compliance, the accounting period of the ultimate parent entity is applicable. If year ending is 31Dec 2021, the consolidated turnover of 2020 is reckoned as the threshold.

For Groups where the year ending of the parent is 31 Dec 2021, the due date for filing this form would be 31 October 2022 (10 months from the end of the reporting accounting year).
Further the parent company should be filing the CbCR in its jurisdiction, & India should also have an existing agreement with that country providing for exchange of the CbCR. India is a signatory to the MCAA where most of the countries are also signatories. With US, India has entered into a separate bilateral agreement for exchange of CbCR. In case Indian tax authorities, want to obtain CbCR filed by the parent, they need to invoke MCAA to obtain this information. The Indian tax payer may not be required to share CbCR if called for.

Considering the above forms are relatively simple one should not miss these submissions

Transfer Pricing – Form 3CEB practical implications part 2

1. Interest free loan – Indian HQ has provided interest free loan to its AE, it needs disclosure & care to be taken in terms of its evaluation for ALP. Highly litigated. Hence one needs to evaluate the circumstances if it can be treated as quasi equity. for eg conversion into equity later, commercial relationship between parties, or understand the purpose – if for acquisition of another target entity
2. Business restructuring – Any change in the FAR profile & resulting characterisation of assessee to be evaluated from business restructuring perspective. No specific guidance in Indian law & reliance to be placed on OECD guidelines. Will a change in the billing model be construed as business restructuring to be evaluated
3. Service or reimbursements- Understanding nature of the transaction is most critical. E.g India employees salary costs are reimbursed by AE. When you deep dive, they may be carrying out some activity (sourcing/marketing) for AE & hence costs are recovered. However these are services & are not reimbursements per se. Pricing needs to revisited for these transactions. One should not go by the pricing policy to decide if it is a service or reimbursement but nature is the crux
4. . Management charges paid– First is proof of receipt of services including need benefit test & second is the pricing of the transaction (cost plus etc). Back up evidences including emails, travel details, minutes of meeting, to be collated. Cost pool workings, exclusion of shareholder activity costs, consistency across the group warrants attention. Cost plus could be substantiated by comparables in the country of the service provider. Is safeharbor an option?
5. Royalty – Can be for technology, brand or both- running royalty or lump sum. Royalty workings, documentation to prove the need for such payment on an annual basis needs to be evaluated. CUP or TNMM (through aggregation) to be evaluated.
6. SDT transactions – Transactions with tax holiday units, recent one new manufacturing entity under Sec 115BAB (concessional rate @15%) to be disclosed. Cross charge of common costs also needs disclosure.

If all supportings are gathered at time of documentation itself then one need not run around at the time of TP audit to comply with the request of the TPO.

Last year there were some practical challenges in upload where the Offline utility was not developed & 3CEBs had to be manually done through the ca login portal. Even though CSV upload was later introduced, the tables comprising of transaction details were not appearing in uploaded Form 3CEB and it was referenced as annexure only

For FY 21-22, the offline utility has been recently released.  Hope this would smoothen the process.

Transfer Pricing – Form 3CEB practical implications

TP CERTIFICATE – FORM 3CEB- POINTS FOR CONSIDERATION

1. Identification of Associated Enterprises(AEs) – Information in Form 3CEB has to be certified to be true & correct as against true and fair position which is certified by the CA in the audit report to the financials. Hence relying primarily on AS18 (related party disclosure) may not be sufficient for the purpose of 3CEB audit . While identifying AEs, one needs to bear in mind that conditions laid in 92A(1) and 92A(2) needs to be cumulatively satisfied. If PE is created in India by virtue of the activities a foreign entity carries out, then the PE should also carry out the TP compliance
2. Deemed AEs- commonly missed to report under the below situations
   • A taxpayer is wholly dependent on the license granted by non-resident for manufacture or processing of goods
   • Heavy reliance (more than 90%) on purchase of raw material from a supplier for manufacturing and prices are influenced by the supplier
3. Deemed International transaction – One should also check if there are any deemed transactions under section 92B(2) by asking pertinent questions relating to the contract such as pricing and other terms & condition with the third party
4. Foreign entities Compliances– In case where income accrues or arises in India for a foreign entity, then Form 3CEB to be filed. Exemption is given for certain class of transactions. Foreign entities cannot rely on the TP document maintained by the Indian subsidiary and has to maintain separately.
5. Free of cost (FOC) assets –  FOC assets provided by the AE to be disclosed. Common example – Microsoft licenses or other licenses may have been given free of cost to Indian entity by HQ. It is just not the disclosure but there are other implications which needs to be evaluated – considering it as a notional cost in cost base , treatment for GST purposes etc
6. Interest – In December 2021, there has been a transition from LIBOR to alternate referencing rates (ARR). So during FY 21-22, if the terms of contract have been amended to reflect the new ARR like SOFR,SONIA,SARON,ESTR,etc then comparability of terms while carrying out interest rate benchmarking may pose certain challenges and may require certain adjustments.
7. Corporate Guarantee – In Indian HQ companies there may be guarantee provided to AEs with no compensation. Guarantee is a service but whether it can be construed as shareholder activity warranting no payment- needs to be evaluated
8. Issue of shares- While the Supreme Court has ruled that it is not an international transaction, the form has not been amended to effect the same and hence caution needs to be exercised when any stand on disclosure is undertaken.

Transfer Pricing – Defending Loss making companies

APPROACH FOR DEFENDING TRANSFER PRICES OF LOSSMAKING COMPANIES

While preparing TP documentation, in instances where companies have incurred losses during the financial year, defending transfer prices using profitability analysis could prove challenging. In such situations, we have noticed cases where taxpayers resort to adopting CUP/Other Method to determine the arm’s length price, as against net profit ratios using Transactional Net Margin Method (TNMM). However in majority of the cases, they are not backed by robust supportings to approve the application of CUP/Other method, & the defence in the TP documentation is done referencing prevailing industry rates. Such adhoc basis would not stand the test of time during TP assessments.

Even in loss making situations it is still possible to adopt TNMM to defend your transfer price, if these losses were incurred due to genuine business reasons, the impact of which could be quantified in the form of suitable economic adjustments.

The Indian regulations, OECD guidelines, judicial pronouncements recognise the need to undertake economic adjustments to enhance comparability between tested party & uncontrolled transactions. Few adjustments which can be performed under TNMM are:

1. Capacity utilisation adjustment – It is performed to neutralize the impact of under absorption of a company’s fixed costs vis-a-vis comparables, in years where company has not operated at the optimal installed capacity. Currently there is no statutory requirement to publish capacity details in financials, hence obtaining capacity details would pose difficulties. However there are alternative approaches such as industry capacity, depreciation adjustment/Fixed cost adjustment or Breakeven point analysis
2. Working capital adjustment – It factors time value of money where there are differences in working capital levels between the tested party & comparables
3. Forex adjustment – In light of rupee depreciating heavily against foreign currencies, a forex fluctuation adjustment would be appropriate to substantiate dip in margins, in cases the tested party has significant imports in comparison with comparables. This is different from forex loss resulting on account of translation exposure appearing in the financials
4. Customs duty adjustment – This eliminates impact of higher customs duty incurred by the taxpayer while importing goods vis-à-vis comparables who might predominantly make local purchases

However one needs to bear in mind that any adjustment which can be claimed depends on the functional, asset and risk (FAR)profile & characterisation of the tax payer. Hence these cannot be randomly applied without it being in coherence to the FAR profile.

Transfer Pricing compliances timelines

TRANFER PRICING COMPLIANCES

As the individual tax return filing season has gone by, the next upcoming one would be for corporates. In case of companies not subject to transfer pricing provisions, the IT return due date would be 30 September and for tax payers with TP applicability the IT return timeline is 30 November and consequently the transfer pricing compliances in terms of TP documentation and Form no. 3CEB would be 31 October 2022 (1 month prior to IT return filing).

Why this assumes prominence is, right from the year when these TP compliance timelines were advanced by 1 month to the filing of the IT return , the tax payers had the leverage of extension of timelines because of COVID by few months. So perhaps this would be the first time the tax payers would be working to complete these TP compliances in October. Considering that there was no extension of the individual return deadline, possibility of extension may be remote.

There are instances where some of the tax payers file the Form 3CEB but delay the preparation of the detailed TP document though they would have some working files for defense. When the cases are picked up for TP scrutiny, there is a rush for completion of the same as per the procedure mandated under the Income Tax Act/ rules.

As one would be aware that the timelines for completion of the assessment proceedings before the TPO and consequently the AO has been shortened. We have noticed that the tax department has issued a flurry of notices to taxpayers calling for the TP document amongst other details for FY 2020-21 now though the timeline for completion of the same is December 2023. The cases referred for TP scrutiny has shown an upward trend from FY 2019-20 onwards. One of the reasons being that during FY 2018-19, there were very few cases picked for TP scrutiny as there was revision in timelines and revenue missed the bus for referring the cases to TPO.

On account of the shrinkage of the assessment timelines, it is all the more required by all taxpayers to complete the maintenance of the detailed documentation by 31 October 2022 without delaying the same. This would make the company more prepared to face the scrutiny and can also stand the test on contemporaneous data points.

Provided below is a summary of the timelines on TP compliances for FY 2021-22

1. Preparation and maintenance of TP documentation – 31 October 2022
2. Issuance of Form No. 3CEB – 31 October 2022
3. Filing of Masterfile notification (Form 3CEAB) – 31 October 2022
4. Filing of Masterfile (Form 3CEAA) – 30 November 2022
5. Filing of CbC notification (Form 3CEAC) – 31 October 2022 (if parent entity year ending is 31 December)
6. Filing of CbC report (Form 3CEAD) – Indian HQ/alternative reporting entity in India- 31 March 2023