Key Transfer Pricing updates for March 2016

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The Finance Minister, Arun Jaitley announced the Union Budget 2016 on 29 February 2016, amidst high expectations from several stakeholders including taxpayers, investors and consumers.

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Key Transfer Pricing updates for March 2016 Customer Care No. 91-11-45562222 www.taxmann.com

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Introduction The Finance Minister, Arun Jaitley announced the Union Budget 2016 on 29 February 2016, amidst high expectations from several stakeholders including taxpayers, investors and consumers. From a Transfer Pricing (TP) perspective, one of the most important development is the introduction of Country-by-Country ( CbyC ) reporting norms for TP documentation with effect from the Financial Year (FY) beginning 1 April 2016. The Organisation for Economic Co-operation and Development (OECD) and G20 1  countries as part of their Base Erosion and Profit Shifting (BEPS) project under Action Plan 13, introduced the three-tier TP documentation structure, which includes master file, local file and CbyC reporting. India, being an active participant of OECD's BEPS project, has proposed to adopt the above recommendations of the OECD's Action Plan 13 in the TP regulations announced during this budget. Some other amendments in the TP arena have also been proposed. 2 Customer Care No. 91-11-45562222 www.taxmann.com

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3 Customer Care No. 91-11-45562222 www.taxmann.com Recently, the Delhi High Court (High Court) in the case of Denso India Limited 2 , rejected aggregation of an import transaction under the Transactional Net Margin Method (TNMM), since the facts of the case demonstrated that the arrangements made in relation to the transaction, when viewed in their totality, differed from those which would have been adopted by independent enterprises behaving in a commercially rational manner. In a Tribunal ruling in case of Essilor India Pvt Ltd 3 , the Bangalore Tribunal (the Tribunal) held that in the absence of an arrangement and agreement between the taxpayer and its Associated Enterprise (AE), incurrence of more expenditure on Advertisement, Marketing and Sales Promotion (AMP) compared to comparable companies cannot be inferred as an international transaction between the taxpayer and its AE. Further, the Central Board of Direct Taxes (CBDT) issued a new instruction No. 3/2016, replacing Instruction No. 15 issued on 16 October 2015, providing guidance to Assessing Officers (AOs) and Transfer Pricing Officers (TPOs) regarding administration of TP assessments. 1) Budget 2016 - Transfer Pricing Amendments The Budget proposals with respect to three-tier TP documentation are discussed hereunder: Master file and local file - The Memorandum to the Finance Bill (Memorandum) states that a master file will have to be maintained and the detailed rules regarding the same will be notified at a later date. However, no threshold for preparation of master file has been prescribed. Local file related regulations that already exist in the law may continue or may be aligned to the OECD's BEPS Action 13 recommendations, however the same will be clear only once the detailed Rules in this regard are issued . CbyC reporting  - A new section [proposed Section 286 of the Income-tax Act, 1961 (the Act)] on CbyC reporting has been introduced. These provisions require the Indian Parent entity of an international multinational group or any other designated group entity in India (referred to as alternate reporting entity) to file a CbyC report for financial year 2016-17 before the due date of filing of Return of Income i.e. 30 November 2017. The threshold for filing the CbyC report has been maintained at EUR750 million (as per the Memorandum).The detailed format shall be notified in the Rules at a later date. However, it is proposed in the memorandum that the OECD prescribed template will be adopted.

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These proposals are elaborately discussed in the other articles of this publication and hence, for brevity's sake, not discussed in detail here. 2) Aggregation of transaction under TNMM is rejected since facts of the case indicated unusual features which remained unexplained by the taxpayer - Delhi High Court The taxpayer was engaged in manufacturing and sale of auto electrical products and was held by Denso Corporation, Japan (Denso) and Sumitomo Corporation, Japan (Sumitomo) with 47.93 per cent and 10.27 per cent shareholding respectively. In AY 2002-03 and AY 2003-04, the taxpayer had various international transactions with its Associated Enterprises (AEs), such as payment of royalty, technical know-how, testing fees etc. and benchmarked these transactions along with the import of components on an aggregated basis using TNMM as the most appropriate method (MAM). During AY 2002-03, the taxpayer imported raw material components from Sumitomo. The taxpayer had taken a stand that since shareholding of Sumitomo is less than 26 per cent, it is not its AE and hence did not report this purchase transaction as an international transaction in Form 3CEB.TPO accepted all the transactions at arm's length using TNMM as the MAM. However, the TPO noticed that the components imported from Sumitomo were, in fact, manufactured by Denso and it was so routed through an intermediary with the sole objective of camouflaging the actual transaction of purchases being made from an AE.TPO treated this transaction of purchase of components from Sumitomo as an international transaction under 92B(2) of the Act. Comparable Uncontrolled Price (CUP) was applied by the TPO by comparing price of components imported with that of price of indigenous components purchased from domestic suppliers. Commissioner of Income Tax (Appeals) [CIT(A)]deleted the said adjustment. Tribunal restored the TP adjustment pertaining to transaction of import of components with directions on proper application of CUP method. 4 www.taxmann.com Customer Care No. 91-11-45562222

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High Court ruling • The factual discussion in this case revealed that, the taxpayer chose to import components not from the manufacturer (which was its AE) but an intermediary, which normally, would have been accepted by revenue authorities as a commercial decision. However, in the instant case, the vendor of the components viz. Sumitomo was also connected with both the taxpayer and the manufacturer. • The High Court observed that the above realities compelled the TPO to closely scrutinise the value of such imports and seek further details from the taxpayer. The explanations by the taxpayer that were forthcoming, were apparently unconvincing. • It was observed by the High Court that the taxpayer's approach i.e. bundled or aggregated series or chain of transactions to benchmark the international transactions would normally be accepted by the authorities, if they did not show features that call for his interference. However, it was stated that the Assessing Officer/TPO should extend his inquiry in critically evaluating materials, where a detailed scrutiny is required. The unusual features in this case, which remained unexplained by the taxpayer, raised concerns and influenced the revenue authorities to benchmark the transaction separately. • The High Court, while upholding the approach adopted by the TPO, relied on decision of Sony Ericsson4, which discusses a test as to when the revenue authorities can disregard the actual transaction, and re- characterise the same, i.e. when the form and substance of the transaction though were the same but the arrangements made in relation to a transaction, when viewed in their totality, differ from those which would have been adopted by an independent enterprise behaving in a commercially rational manner. • Thus , the High Court upheld the restoration of adjustment made by the Tribunal. 5 Customer Care No. 91-11-45562222 www.taxmann.com

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It would be pertinent to note that the Punjab and Haryana High Court in the case of Knorr-Bremse 5 , rejecting taxpayer's stand for aggregation of transactions under TNMM, had held that merely because the purchase of each item and the acceptance of each service is a component leading to the manufacture/production of the final product sold or service provided by the taxpayer, it does not follow that they are not independent transactions for the sale of goods or provision of services. The High Court concluded that if the taxpayer fails to establish that the various transactions forming a composite agreement/various agreements with the various group entities, were part of one single indivisible transaction or pricing in respect of each transaction was dependent upon or interrelated to the pricing of the other transactions with the group entities, each transaction had to be treated (prima facie) as separate and independent of each other. In contrast, recently the Delhi High Court in the case of Sony Ericsson (Supra) had observed that TNNM applied with equal force on single transaction as well as multiple transactions as per Chapter X of the Act and the TP rules. Thus, the word 'transaction' would include a series of closely linked transactions. Segregation of aggregated transactions requires detailed scrutiny without which there shall be no segregation of bundled transactions. Further, set-off of transactions segregated as a single transaction is just and equitable and not prohibited by Section 92(3) of the Act. The above decision is principally in line with the decision of Sony Ericsson i.e. in a normal situation, the revenue authorities would not have questioned this bundled approach adopted by the taxpayer. However, this will not be a thumb rule in all cases, and if there are unusual features which raise doubts regarding the form and substance of the transaction, the same may be critically analysed and could be benchmarked separately. The decision in the case of Knorr- Bremse is also to be kept in mind and it is important to maintain meticulous documentation to justify inter-relation of transactions aggregated and benchmarked together. 6 Customer Care No. 91-11-45562222 www.taxmann.com

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7 Customer Care No. 91-11-45562222 www.taxmann.com To read more, please click here

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