Sunday 21 August 2011

Methods of computing Arm's Length Price

I dealt with the basic concept of transfer pricing in an earlier post. As promised (to myself), I will now deal with the methods of computing arm’s length price (ALP).

ALP, crudely, is the fair market value at which transactions take place in the open market. Section 92C names the methods and Rule 10B elaborates on their application. There are primarily 5 methods of ALP computation:

1. Comparable Uncontrolled Transaction Method - CUP Method
2. Cost Plus Method - CPM
3. Resale Price Method - RPM
4. Profit Split Method - PSM
5. Transactional Net Margin Method - TNMM

The most complicated of these (and probably the most popular) is TNMM, I think. PSM has hardly ever been used in Indian cases. CUP is the simplest and most preferred one.

In this post however, I have discussed only the first three methods. I shall discuss PSM and TNMM in the next post.

CUP METHOD:

Under CUP method, the transacting enterprise has to:
  • Identify the price paid for goods or services provided in a (or a number of) comparable uncontrolled transaction(s).
  • Adjust such price to account for differences, which could materially affect it in the open market, between:
    • Transaction with AE and comparable uncontrolled transaction, or
    • The enterprises entering into such transaction



Sale price in uncontrolled transaction: 100

Add (in proportion to better quality goods sold to AE): 25

ALP = 125

In the above scenario, the transaction between the TE and Unrelated Enterprise 2 would be an ‘internal comparable.’ The transaction between the two unrelated enterprises would be an ‘external comparable.’ This is true for all methods of ALP computation; transactions of the TE with third parties would be termed as internal comparables. It is to be noted that internal comparables are preferred over external comparables, since they provide a greater degree of comparability.

CUP Method is generally preferred in all situations, where suitable uncontrolled transactions are available. The uncontrolled transactions can be considered comparable in terms of the goods sold, services rendered, prices charged, qualitative and quantitative comparability, etc.

COST PLUS METHOD:

Under CPM, the transacting enterprise has to:
  • Determine the costs of production (direct and indirect)
  • Determine the normal gross profit mark-up on such costs, incurred by an unrelated enterprise
  • Adjust this mark-up to account for functional or other differences that could materially affect it in the open market
  • Add the adjusted profit mark-up to the costs of production.







ALP = 150 + 10 + 2 = 162

CPM is most suitable for:
  • Sale of semi-finished goods
  • Provision of services
  • Long-term buy and supply arrangements

RESALE PRICE METHOD:

Under RPM, the transacting enterprise has to:
  • Identify price at which goods / services obtained from AE are re-sold to unrelated enterprise
  • Reduce such price by:
    • normal GP margin accruing to assessee / unrelated enterprise from similar uncontrolled transaction
    • expenses incurred by assessee for obtaining goods / services
  • Adjust the price on account of functional differences that could materially affect it in the open market






    Price of sale: 120
    Less: 15 (normal GP margin)
              10 (freight charges)
    Add:    5 (packaging expenses)
    ALP = 100


    RPM  is most suitable for:
    • Chain of distribution of goods through an intermediate company
    • Marketing operations


    Wednesday 17 August 2011

    The Vodafone Controversy

    The hottest issue of the tax world right now is the Vodafone case. There has already been enough discussion on the structure of the deal so I won't go into the details. Vodafone (Netherlands) paid 11 billion dollars to Hutch (Hong Kong), for purchasing Hutch’s wholly-owned subsidiary in Cayman Islands (HCI). HCI owned a company in Mauritius which directly and indirectly (through various companies) held a controlling stake of 67% in Hutchison Essar Ltd, India (HEL). By purchasing HCI, Vodafone acquired a controlling stake in HEL.

    The Department cried foul and sought to tax Vodafone on the deal, conducted and concluded outside India. The Department’s claim rested on the fact that the underlying purpose of the transfer of HCI was to acquire Indian operations of HEL and therefore, such transfer had a sufficient nexus with India to attract tax. And we’re not talking peanuts here; the tax liability is 2 billion dollars.

    The Bombay HC ruled against Vodafone and the case is currently in the Supreme Court. There has been enough debate on the applicability of section 9(1), whether there is ‘transfer’ of a ‘capital asset’ ‘situated in India.’ While it is true that Vodafone’s intention was to acquire Indian operations, the ultimate question that arises is, whether the IT Department can tax an ‘indirect’ transfer of a capital asset situated in India, effected through intermediary companies.

    My take is, no they cannot do that until the DTC is introduced or the present Section 9 is amended. Section 9 of the IT Act says that income accruing or arising, directly or indirectly, through the transfer of a capital asset in India is liable to tax in the hands of the non-resident. It is section 5 of the DTC, however that lays down that such ‘transfer’ can be ‘direct or indirect.’ The DTC is not an amendment to the current Income Tax Act, but is a whole new legislation, which will repeal and replace the Act. In my view, bringing indirect transfers into the ambit of taxation is possible only after DTC comes into effect or after Section 9 is amended to that effect.

    Moreover, other countries like China, Australia and Peru have specifically enacted provisions making indirect transfers taxable. Can India tax such transfers without a specific provision in place? Not unless there is clear tax evasion, in the garb of a colourable device (lawyers simply love to use this phrase). In my opinion, Vodafone has not evaded tax, it has merely structured an indirect transfer as a part of some creative tax planning, which is legal. In the glaring absence of a specific provision, it will be unfair to tax Vodafone.

    The outcome of the case is keenly awaited by foreign investors and MNCs who are waiting for settlement of the issue before structuring any deals involving Indian assets/operations.

    Tuesday 7 June 2011

    Oh, let them just evade taxes!

    That isn't really the kind of statement you'd expect to hear from a tax-law student in India. I'm supposed to hold the law of the land in the highest regard and I come from a high-tax jurisdiction (a corporate taxpayer's nightmare). But you try and study Transfer Pricing regulations and that's all you can exclaim. Atleast I did.

    At the outset, let me state that I'm not sure what this article (?) is about. I guess that's what blogs are for. The purpose of this "blog entry" is mainly to ascertain if I understand what I'm writing. And if I can write enough about Transfer Pricing to call it an article (?).

    Transfer Pricing is probably one of the most complex computations a tax officer can come across and ironically, it has very little to do with tax. It is more about market conditions, economic scenarios, product knowledge and of course the glue that holds this all together; sister concerns. These regulations concern only international transactions (as of now) between associated enterprises, atleast one of which is a non-resident. The general idea behind these provisions is to ensure that cross-border transactions between them are at arm's length i.e. valued at the same price as such transactions would have been, had they taken place between unrelated parties. The transactions cover sale of both goods and services.

    Why do international transactions between AEs make tax authorities wary? Apparently because the money exchanging hands in these cases may be a fishy business, designed to attract lower tax. As is well known, Indian tax authorities love to tax foreign corporate entities. The Vodafone case highlighted it enough. Textbook-like as it may sound, an example should help illustrate this.

    Z is an Indian company which is a subsidiary of Y, an American company. Y sells certain goods to Z for Rs. 100 but makes an entry in its books of accounts, showing this amount to be 125. Z claims Rs. 125, instead of Rs. 100, as deduction from income on account of business expenditure. This lowers Z's income, thereby attracting lower tax. Since Z is ultimately the subsidiary of the American company, Y too derives indirect benefit from this arrangement. The Transfer Pricing regime dictates that the authorities will have to make sure that the amount of Rs. 125 is a reasonable price for the goods sold and in line with prevailing market trends.

    All is dandy so far, but now arises the question as to HOW? There are so many things to be considered. The quality of the goods, the quantity of the goods, whether the value of the goods changes with different geographical locations, the cost of labor, etc. There are different methods to ascertain all this and compare the transaction with other independent and uncontrolled transactions. The factors to be considered while determining arm's length price differ from method to method and therefore, I will deal with them when I deal with the methods. For some reason, our lawmakers thought that these methods (enumerated in Section 92C of the Income Tax Act) would make the task 'simple.' (that totally backfired, I might add). These methods are essentially based on the internationally accepted OECD Transfer Pricing Guidelines. They are:

    1. Comparable Uncontrolled Price (CUP) Method
    2. Cost Plus Method
    3. Resale Price Method
    4. Profit Split Method
    5. Transactional Net Margin Method

    I wont discuss the methods in this post. They deserve a separate post of their own.

    Moving on, the concept of an AE is fairly clear and comprehensively defined in Section 92A of the Income Tax Act. As far as I know, there has not been any litigation in this aspect. The concept of a Permanent Establishment has been the subject matter of many cases, the most important one being that of Morgan Stanley.
    What constitutes an international transaction has also been discussed somewhat. An important case with regard to 'international transaction' is that of Tianjin Tianshi Pvt Ltd, a Chinese PE in India. A Delhi ITAT Bench held in this case, that international does not necessarily mean cross-border. A Indian company dealing with a foreign company's PE in India is subject to Transfer Pricing regulations.
    Most of the Transfer Pricing litigation is only at Tribunal level right now, so I'm sure there will be much discussion on the basic aspects as the cases go to the High Court and Supreme Court level.

    I'm not sure yet, whether I agree with the principles behind this regime. I'll need a much deeper knowledge of the subject. Not that my agreement/disagreement makes a shred of difference at this stage, but atleast it will clear things up for me. And who knows, perhaps the Finance Minister will ask for my opinion someday. Erm, anyhow.

    This was a very basic article (?) with regard to the idea and purpose of Transfer Pricing. The next one will probably be more formal, with technical details and caselaws. By then, hopefully, I shall have a much better understanding of the subject. 

    Thursday 3 March 2011

    Point(less) of Taxation Rules, 2011

    As expected, the Union Budget 2011 has brought with it a horde of changes to be made to the existing tax system. Some of the changes are welcome while others are plain ridiculous. One of these is the 'Point of Taxation Rules,' pertaining to taxability of services, brought in vide Notification 18/2011-ST, dated 1-3-2011. Set to come into force on 1-4-2011, these rules fix the point of time of 'when' a service is said to be provided. The more important of these rules are discussed below.

    Rule 3 lays down that a service will be deemed to be provided on the earliest of the following dates:

    i) The date on which the service is actually provided
    ii) The date on which the invoice is issued
    iii) The date on which payment is made

    Rule 4 (notwithstanding Rule 3), regarding determination of point of taxation in case of change of rate of tax, is a fantastic means of creating utter chaos. This rule lays down that in case a taxable service has been provided before any change in the rate of tax, the point of taxation will be:
    i)  the date of payment or issuing of invoice, whichever is earlier, where invoice has been issued and payment has been received after change of rate
    ii) the date of issue of invoice, where the invoice has been issued prior to change in tax rate but the payment is received after the change of rate.
    iii) the date of payment, where the payment is received before the change of rate, but the invoice has been issued after the change of rate.
    The rule also goes on to state that in case a taxable service has been provided after any change in the rate of tax, the point of taxation will be:

    i) the date of payment, where the invoice has been issued prior to change of rate but the payment is made after change of rate.

    ii) the date payment or issuing of invoice, whichever is earlier, where both events have occurred after change of rate.

    iii) the date of issue of invoice, where invoice is issued after the change of rate but payment has been received before the change of rate.

    Rule 6 lays down that in case of a continuous supply of service, every instance of periodical billing will determine the point of taxation of such service provided during such period, if such period is specified in the contract.

    As of today, collection of tax is on cash basis. Service tax is payable once the payment is received by the service provider. These rules will make the service provider liable to pay tax once the service is provided, whether or not payment has been received. Though the intention of the rules is to ensure that tax is paid at the earliest, this is certainly not a smart move because of the following reasons:

    1. Undue pressure to make payment will be created on the service receiver. The service receiver may not necessarily make immediate payment after the service is provided to him, owing to personal / financial constraints. Depending upon the requirement of the receiver, the service may need to be quantified first before any payment is made.

    2. Moreover, the payment may very well be in instalments. The entire payment need not be made at once. If the payment is made in instalments, what will be the point of taxation; the date of the first instalment or the date of the last instalment? Also, what will happen if some instalments are paid before the change in rate and some are paid after?
    3. As is the accepted norm, the service is provided first and payment is made later. However, if the rules come into effect, service providers will start demanding payment before actual provision of any service. The quality of service provided thereafter may not be up to the mark, since the payment is already received by them.
    4. The service receiver will be left with no means to ensure that the service is wholly and satisfactorily provided to him. Litigation will certainly increase in such cases, increasing the existing burden on the administrative machinery.

    5. What about that invoices that are raised before 1-4-2011 but the payment is received after this date? Will the Rules be applicable to such invoices?

    6. Where a service is continuously provided, it often happens that the invoices issued and payments made are based on the requirement and convenience of parties. How will the point of taxation be determined where no specific agreement with regard to period of billing exists?

    7. The accounting norms will be turned upside down. There may be several attempts to change the dates of payments / issuance of invoices / provision of services in order to escape any higher rates of tax prescribed after the taxable service has been provided. The balance sheets in such cases may not tally with the returns, leading to further confusion.

    Looking at the kind of hardship that will be caused to the service providers as well as service receivers, these rules are bound to be a source of much debate. Whether or not the rules come into force, the intense discussion on their implementation will certainly uphold the debating tradition followed every year after the announcement of the Budget.