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India – Revised Country Chapter to United Nations Transfer Pricing Manual

Rahul Mitra, Dhruva Advisors, India

As part of the recently released report on the work done by the sub-committee on transfer pricing (TP) of the United Nations (UN), it is noted that India has revised its country chapter on TP. Several new stands have been taken by the Indian Revenue as part of the revised country chapter, some of which are really welcome and praiseworthy. An attempt is made to discuss the stands taken by the Indian Revenue on some of the key TP issues.

Marketing Intangibles

It appears that for the first time, the Indian Revenue is keen to address the issue on marketing intangibles under the economic fundamentals of TP, by moving away from the arbitrary manner of inflicting routine adjustments, which has been the norm in the last six or seven rounds of TP assessments.

The Indian Revenue acknowledges the fact that post judicial decisions rendered by some High Courts on the relevant issue, the Indian Tax Administration is looking towards carrying out a detailed functional, asset and risk (FAR) analysis to ascertain whether or not the foreign licensor of the brand is assuming a risk in; or benefitting from, the Indian market through the functions around advertisement, marketing and sales promotion (AMP) carried out by the Indian licensee. In case the answer is in the affirmative, then the Indian licensee may require compensation under an appropriate TP method, otherwise not.

The Indian Revenue thereafter refers to the OECD/ G-20 BEPS report (being the revised Chapter VI of the OECD TP guidelines, relating to intangibles) to state that compensation for AMP functions need not be separate; and can be part of the price of another transaction. Further, where the licensee of the brand performs the AMP functions with the intention to exploit the results itself, obviously in the capacity of the economic owner of the marketing intangibles, then no separate compensation is required to be paid in favour of the licensee taxpayer, as understandably, the licensee taxpayer would have enjoyed; or be enjoying, the fruits from the market itself.

Thus, the Indian Revenue appears to have finally accepted and acknowledged the concept of economic ownership of marketing intangibles, by the licensee of trademark, something, which it had been refraining from doing for past several years, which incidentally had been the fulcrum of most of the disputes on the relevant issue, particularly for entrepreneurial licensed manufacturers and buy-sell companies; and also for normal risk taking marketing distributors. Such acknowledgement on the part of the Indian Revenue, even though quite late in the day, but thankfully not late enough to make the scenario irretrievable, is indeed laudable.

In case the Indian Revenue sticks to such correct fundamental approach towards TP, then the entire litigation around the issue of marketing intangibles, which is currently pending before the Supreme Court, more on legal grounds, namely the presence of international transaction or otherwise, with respect to AMP expenditure incurred by licensees of brands, under the fact pattern of TP adjustments made till date, would actually be put at rest on positive terms.

The Indian Revenue would actually do a great service to the nation and also sentiments of MNCs, who have been unnecessarily locked in horns in litigation, to submit before the Supreme Court of the subsequent self realisation and understanding of such correct approach, based upon evolution of the principles around marketing intangibles, both through judicial decisions and guidelines of BEPS; and request the Supreme Court to lay down proper principles in this regard, instead of deciding the pending appeals with reference to legal issues engulfing the incorrect manner of TP adjustments made till date.

In case the Indian Revenue were to actually practice its preaching, as contained in the revised country chapter supplemented to the UN TP guidelines, which one is tempted to strongly believe, given the present-day positive mindset of the Indian Revenue, as is manifested though several recent actions around administering of income tax laws, then the principle that clearly emerges from the revised country chapter, is that economic ownership of marketing intangibles is an "intangible asset" in the hands of a licensee of trademark, which would be a pertinent factor to determine its FAR profile; and also the impact on other relevant international transactions with its overseas related parties, particularly the licensor of the trademark, instead of the Indian Revenue trying to identify a separate transaction with respect to the performance of AMP functions resulting in economic ownership of such intangible asset; and assigning a value with respect to such separate but non-existent transaction, which unfortunately had led to all, if not most of, the litigation around the topic of marketing intangibles thus far.

The relevance of such economic ownership of marketing intangibles for various classes of licensees would understandably be different. For instance, for entrepreneurial licensed manufacturers and buy-sell companies, the moot question would be whether the Indian licensee had over-rewarded the foreign licensor through payment of exorbitant royalties or loading excessive profits on the import of products. Payments of royalties can be properly tested under the comparable uncontrolled price (CUP) method with reference to third party license agreements; or in absence of such comparable and/ or for necessary corroboration thereof, through the adoption of residual profit split method (PSM). In this connection, the observations of the Indian Revenue in the revised country chapter, that applying PSM to verify royalties is not a feasible option due to lack of requisite data, is not at all acceptable, as applicability of residual PSM to determine and verify royalties is a tried and tested approach. Neither the Indian Revenue nor the taxpayers can be exonerated from carrying out such exercise on the pretext of non-availability of data, being a ground for resorting to sub-optimal TP methods, which might actually ignite or infuse unnecessarily litigation, which could have been otherwise avoidable.

The same principle applies to import of products from foreign related parties, by such entrepreneurial licensees. If the pricing policy for import of such products is cost plus at the supplier's end, which is also in line with the entrepreneurial FAR profile of the Indian licensee, then necessary data justifying the pricing policy would need to be adduced by the taxpayer and also verified by the Revenue. This would automatically resolve all issues relating to TP in the hands of the Indian entrepreneurial licensee, including that of marketing intangibles.

The relevance for such economic ownership of marketing intangibles in the case of a normal risk taking marketing distributor has been explained by the Indian Revenue in the revised country chapter itself, by taking cue from judicial decisions and also the BEPS report. In summary, if such distributor receives adequate remuneration, commensurate to its FAR profile, particularly the AMP functions, through the pricing of products, namely in the form of distribution margin, then there should not be any further or separate TP adjustment with respect to the AMP functions. Of course, though not expressly stated in the revised chapter, for such distributors, selection of comparable companies, having more or less similar intensity of functions, being the percentage of operating expenses to turnover, where operating expenses engulf AMP functions or expenses as well, would be a key consideration for the determination of adequate remuneration of the taxpayer distributor. Selection of sub optimal comparable companies, having significantly lower intensity of functions as compared to the taxpayer, would only aggravate problems.

Thus, in the end, one must admire the evolving understanding and realisation of the Indian Revenue on the issue of marketing intangibles; and if the Indian Revenue actually adopts such principles in real life TP assessments; and also places the same as its correct, albeit revised stand before the Supreme Court, unnecessary and protracted litigation may be avoided going forward; and also the Supreme Court may be well and truly assisted by the Indian Revenue to lay down the principles of marketing intangibles, by brushing aside the frivolous types of TP adjustments made in the past, which the Indian Revenue itself does not appear to be supporting anymore, as per the revised country chapter submitted by the Indian Revenue to the UN TP guidelines.

Location Savings

It is heartening to note that the Indian Revenue has come out of its earlier stand, as reflected in the earlier version of the country chapter, to now acknowledge that location specific advantages (LSAs) and location savings, which the Indian economy might provide to overseas MNCs, who have set up businesses in India, would stand duly subsumed or factored in, the results of proper local comparables selected for determining the arm's length price (ALP) of transactions entered into by the Indian subsidiary companies with their overseas related parties, where typically the Indian subsidiary companies would be acting as service providers of their overseas related parties. The Indian Revenue has clarified that if such proper comparables can be identified, then no further upward adjustment on account of premium profits, if any, emanating out of LSA or location savings, being referred to as location rent in TP parlance, would need to be made to the results of the Indian taxpayers.

It may further be noted that in perfect competition, location savings and/ or LSAs may not actually result in premium profits or location rent, residing within the coffers of the principal company, situated in a developed country, which has outsourced the work to a service provider in a developing economy, as the savings in cost are generally passed on to customers in order to maintain its competitiveness or market share. Only in monopolistic situations, particularly for "first movers", can location rent actually arise; and that too for a short period of time, namely until competition also resorts to outsourcing, when market forces would automatically bring down the end-prices to the customers.

In case the foreign principal company has unique intangibles in the form of superior technology and/ or brand, for which it earns premium profits out of exploitation thereof, then that by itself would not tantamount to location rent, even if the foreign principal were to have outsourced key functions of manufacturing, R&D, software development, etc., to group companies based in low-cost developing economies.

As further elucidation, location savings or cost benefits; and LSAs, e.g. highly skilled and specialised work force, access to large and vibrant local markets, efficient distribution and information network, regulatory policy incentives, etc., are not unique intangibles, which any specific taxpayer may possess ahead of other similarly placed players in the market, such that a proper comparability analysis would not have addressed the rewards capable of emanating out of unique intangibles. On the other hand, location savings and LSAs are general benefits or advantages, which the local economy provide might provide to all business houses, who operate in the local market; and thus the benefits emanating therefrom would be captured or factored in the results of proper local comparable companies chosen for determining the ALP of transactions entered into by the local taxpayers with their overseas related parties, ideally for providing various types of services, including manufacturing, to such overseas companies.

The issue of whether or not to make upward adjustments on account of location rent, might arise where comparable companies of more developed economies are selected to determine ALPs with respect to taxpayers residing in developing economies, which generally provide benefits of location savings and LSAs, given the growth curve of such buoyant low cost economies, as opposed to the relative stagnation or low growth rate faced by developed economies, where the profit margins of companies in general, with reference to higher cost bases, would be relatively low, as compared to developing economies, as were the situations in China and Mexico, when taxpayers, in absence of robust databases for local comparables, used to select comparable companies based in Japan and US respectively, to determine ALPs for contract manufacturing and other services, performed for their overseas headquarters, which were found to be at fault by Chinese and Mexican taxation authorities on the ground of not having captured location rents arising out of location savings and LSAs provided by the developing economies of China and Mexico respectively.

However, given that both taxpayers and the Indian Revenue, have all along been selecting comparable from local databases, the coverage of each of which has only increased and improved by every passing year, the issue of location rent arising out of location savings and LSAs ideally should not arise in TP assessments in India, if proper local comparables can be identified. As mentioned above, it is a most welcome move on the part of the Indian Revenue to acknowledge and admit the above aspect in the revised country chapter.

Contract research and development (R&D) services

Let us deal with the issue relating to R&D services carried out by several Indian subsidiary companies for their overseas foreign related parties, for development of intangibles under a contract service provider model.

The observations of the Indian Revenue on the relevant issue in the revised country chapter, remain the same as in the earlier version. The Indian Revenue had issued a circular in March, 2013 on the proper TP approach to be taken with respect to contract R&D services, which was in line with the guidelines of the OECD, both pre and post the BEPS recommendations, namely that if the facts suggest that the foreign related party, being the principal company, takes key decisions and performs functions around – (a) conceptualisation of the research, namely on what subject or aspect should the researcher carry out the activities of R&D, (b) on-going monitoring of the R&D activities carried out by the researcher, (c) provide funds and control the budget around R&D activities of the researcher, etc.; and the researcher was found to be only executing or implementing the instructions of the principal, then the structure could be accepted as that of a contract R&D service provider model, where the researcher would be entitled to a risk-insulated cost plus model of remuneration, with the risks and associated rewards of success or failure of the R&D being on the account of the foreign principal company, not merely by virtue of the contractual terms of the arrangement, but also in substance, namely arising out of the conduct of the two parties.

Incidentally, the OECD/ G-20, as part of the BEPS recommendations, have also categorically stated that it is quite acceptable for a company to outsource the execution functions of R&D to a related party researcher, even while properly putting in place and claiming, a contract service provider structure, resulting in a cost plus remuneration model for the researcher, provided that the principal does not outsource the strategic functions, as above, and retains the same at its level.

While it appears that the Indian Revenue is otherwise fine with accepting the concept of contract R&D service provider structure with a cost plus remuneration model for the researcher based in India, the Indian Revenue has observed in the revised country chapter, being on similar lines as its observations in the original chapter submitted in 2013, that its experience in handling the TP assessments of some of the companies in India, has been that notwithstanding the formal structures of contract R&D service provider model being put in place in such cases, the facts allegedly revealed that the Indian researchers were carrying out all the strategic functions; and therefore, were entitled to rewards commensurate to assumption of risks around the development and exploitation of intangibles, as associated with such performance of enhanced strategic functions. The Indian Revenue further stated that such researchers should not therefore be entitled to a routine and low cost plus remuneration model.

It is noted that the Indian Revenue has made the above observations with reference to practical experiences of witnessing supposed mismatches between form and substance with respect to the structures around contract R&D services, in TP assessments.

Now, there have not been much news in public on TP assessments being made in the cases of contract R&D service providers in the last four years, where the Indian Revenue has disregarded such contract R&D structures; and proceeded to adopt profit split method (PSM) to assign rewards to Indian researchers on the alleged ground of conceptualizing and monitoring the R&D functions; and accordingly economically owning trade intangibles emanating therefrom.

Further, one has not also witnessed litigation before the Tribunal in this regard in the last three or four years. After a few initial high-pitched TP assessments made by the Indian Revenue on some contract R&D structures around 2009 and 2010, by resorting to PSM, which invited significant concerns of global MNCs, thus necessitating restoration of confidence of global MNCs on the part of the Indian Revenue through the issuance of the circular in March, 2013, one is not aware of many cases where the Indian Revenue has, in the last three or four years, resorted to PSM by disregarding structures of contract R&D services.

If the Indian Revenue, more out of convenience, seeks to adopt very high mark-ups on costs, albeit under cost plus models, as substitute to PSM, even after purportedly disregarding the structure of contract R&D services, then, one is afraid that the approach of the Revenue cannot be appreciated. Incidentally, the exorbitantly high safe harbour numbers set for contract R&D services, namely around 29 or 30%, have resulted in practically zero takers thereof.

The Indian Revenue has observed in the revised country chapter, as above, that the tainted researchers should not be entitled to a routine and low cost plus remuneration model. Now, "low" is a relative term. The question is whether, having regard to a proper functional, asset and risk (FAR) analysis, a structure can be validly accepted to be one of contract R&D services ? If the answer is in the affirmative, then the remuneration model would ideally need to be cost plus, where the "plus" or "mark up" would need to be arrived at by adhering to necessary factors of comparability analysis, with nether the taxpayer nor Revenue having any right to preconceived mind with respect to the end result, namely "low" or "high" respectively. The benchmarking exercise carried out in a proper manner, by accepting comparable companies with similar FAR profile as the taxpayer, namely companies, which do not carry unique intangibles, would automatically unfold into an appropriate arm's length mark-up, which should not carry the stigma of either "low" or "high".

The nature of services rendered by a contract service provider, cannot or should not determine the percentage of "mark-up". On the other hand, selection of comparables with commensurate FAR profile would, in the normal course, lead to the determination of appropriate arm's length mark-up. It is expected that the Indian Revenue would take the correct stands around contract R&D services, both in TP assessments and also while negotiating advance pricing agreements, without any pre-conceived mind with respect to the result.

Intra-group services (IGS)

OECD/ G-20 BEPS guidelines had introduced the concept of low value adding services in the context of IGS, providing for a simplified mechanism of compliance and audit, relating to IGS, which are relatively low in the overall value chain of global MNCs. While the Indian Government has mentioned in the revised country chapter of its intentions to otherwise accept the various BEPS recommendations around TP, it has indicated strong reservations with respect to the liberised approach provided by such guidelines with respect to low value adding IGS, stating that the Indian Revenue would not adopt any such liberised approach around compliance and audit for such low value adding services.

The reason behind such stand, as explained in the revised country chapter, is that the Indian Revenue considers payment for IGS as a high risk area in TP, which according to it, often result in erosion of the tax base of the country; or in other words, the Indian Revenue feels that foreign MNCs often adopt mechanisms of IGS for undue extraction of profits from their Indian subsidiaries.

Even without considering the liberised compliance and audit model prescribed by the BEPS guidelines for low value adding IGS, which is in the form of an option granted to taxpayers, the BEPS guidelines do provide for certain minimum standards to be followed by taxpayers for obtaining deductibility for IGS, namely demonstration of rendering, and accordingly receipt, of services; and also the fact that the payer would have benefitted from such services; and would have been otherwise willing to pay for such services.

The BEPS guidelines had also mentioned that shareholder services would not generally be considered as IGS, requiring a cross charge. Of course, what would constitute shareholder services, would depend upon thorough examination of facts of each case.

Thus, to the extent the Indian Revenue requires taxpayers to conform to such minimum standards, one cannot be critical of the Indian Revenue. However, in certain cases, the Indian Revenue appears to have crossed the threshold of ultra-strictness, so as to hover around the realms of negativity.

For instance, the Indian Revenue has provided in the revised country chapter that one of the relevant questions to be asked for deciding whether IGS require arm's length remuneration, is whether an independent third party would be willing and able to provide such services ?

It is submitted that in many cases, several service offerings within an MNC group are proprietary in nature, having regard to the unique systems and synergies prevalent within the MNC group, which would be key to the proper functioning of the various group companies, yet may not be readily available to be provided by third party independent companies, if one seeks comparability with absolute precision.

In such situation, the recipient of such services is very much willing to avail of the services; and also immensely benefitted by the services, however, in reality may not find the same "off the shelf" at the disposal of third party independent companies. Now, that by itself, cannot certainly make the relevant IGS not valuable, so as not to deserve an arm's length remuneration.

The Indian Revenue has also mentioned that it generally seeks to cap the payment of IGS to certain percentage of sales or revenue of the Indian subsidiary companies. It is submitted that IGS, being ideally charged with reference to costs incurred by the central service provider of the MNC group, typically refers to routine, albeit valuable services, which are functions of costs of the service provider; and not linked to revenue of the payer companies, which one generally associates with license of intangibles and/ or provision of certain high end strategic services, which become value drivers of the business of the licensee or service recipient.

Thus, applying a cap on payment of IGS with reference to certain percentage of turnover of the Indian taxpayers, being service recipients, do not appear to be a reasonable approach on the part of the Indian Revenue; and the same is likely to cause genuine hardship to companies at the startup phase, where they would be more in requirement of support in the form of IGS from the MNC group, though it may not have been able to build up sizeable amount of revenue by that time.

It is suggested that the Indian Revenue may revisit its stand on the above two aspects while dealing with payments for IGS.