L _ ~ .

It is well recognised that India has developed as an investment jurisdiction for multinational enterprises
(MNEs) for carrying on information technology, R&D and back-office operations. The resultant increase
in transactions involving entities in multiple tax jurisdictions has given rise to transfer pricing (TP) issues
in each of these jurisdictions.

In this backdrop, TP has evolved as one of the most significant and complex tax issues for both
multinationals and the revenue authorities.

In recent audits, the Indian revenue authorities are seen to be adopting an increasingly aggressive
approach on TP-related issues and a significant brunt of the TP onslaught has been borne by captive IT
companies in India, specifically in the software services and the IT-enabled services/BPO industry as
most of them enjoy the benefit of a tax holiday under the Income-Tax Act, 1961, and upward adjustments
pursuant to an audit is not eligible for tax holiday benefits.

Typically, a mark-up of 10-15 per cent on costs could be considered to be reasonable for captive IT
service providers keeping in mind the low level of risks which these entities bear.

However, in a number of cases, the revenue authorities have determined mark-ups of 25-35 per cent on
costs to be the arm's length margin for captive IT service providers.

Key issues

While the Indian TP rules have outlined certain factors for judging comparability, it does not provide
adequate guidance on certain key aspects relating to a TP analysis such as use of multiple year data,
screening criteria for comparables, classification of income/expense items, quantitative adjustments, etc.
The lack of quality comparable data in public domain is also a challenge leaving room for subjectivity in
any transfer pricing analysis.

This challenge is further compounded by the approach adopted the transfer pricing officers (TPOs) during
audits. A practical problem arises at the time of preparing the TP documentation report by the taxpayer, as
at that point of time the relevant financial year data may not be available.

The TPOs have rejected the use of multiple year data and considered only the single year (the relevant
financial year) data for determination of the arm's length price. The TPOs are of the view that while the
documentation based on prior year data could satisfy the mandatory and contemporaneous documentation
requirements, the same does not necessarily limit them from making a TP adjustment if additional data
available at the time of audit so warrants.

On occasions, during ongoing audits TPOs have used information which is not available in the public
domain and have also eliminated loss making/low turnover comparables, creating a bias in favour of
profitable companies in the comparable data, resulting in transfer pricing adjustments for the taxpayers.
Captive IT service providers in India typically function in a 'risk-mitigated' environment as compared to
comparables who bear a range of risks such as R&D, market risks, service liability risk, etc.
 While the TP regulations permit adjustment to comparable data to account for the risk differences, it does
no~provide guidance on the manner of making such adjustments. While TPOs acknowledge the need to
factor such risk differentials, the approach adopted for making the risk adjustment has been quite
subjective and arbitrary. In this backdrop, taxpayers may need to consider performing risk adjustments
based on certain financial and economic models.

Scope for double taxation

TP regulations, including those introduced in India, are essentially anti-abuse mechanisms aimed at
preventing shift of profits through inter-company transfer prices to a favourable tax jurisdiction. However,
in case of a TP adjustment in the hands of the Indian entity, that is, an increase in income in the hands of
~ the Indian entity does not automatically result in a corresponding increase in expenditure in the hands of
the foreign entity, resulting in economic double taxation.

In the absence of a formal Advance Pricing Agreement (APA) programme in India, where a taxpayer <!Ild
revenue authorities can agree in advance on the transfer price, a taxpayer has no option but to resolve
issues through the normal domestic tax appellate procedure or the Mutual Agreement Procedure (MAP)
prescribed under the tax treaties.

V Under the MAP process, the foreign entity in the international transaction approaches its Competent
Authority, which in turn will approach the Indian Competent Authority for resolution of the dispute.

Despite the underlying law being essentially the same in all countries, transfer pricing disputes have
become a significant subject of the Competent Authority dispute-resolution process between treaty
countries because these issues are factual in nature and often applied differently in each country.
I
The appropriate resolution of an issue in one situation may be entirely different from the same issue's
resolution for another taxpayer in the same business. This difference in views between tax authorities of
two (or more) countries on what an appropriate transfer price should be increases the risk of international
economic double taxation to an MNE.

In this situation, MNEs may desire to resolve their transfer pricing issues in advance by entering into an
APA with the tax administration, in an effort to spare themselves the time and expense of a tax audit and
potential dispute resolution proceedings. Introduction of such a mechanism in India should help in
resolving these issues.

Compared to developed tax regimes, India is still on the learning curve in relation to transfer pricing.
Keeping in view the difficulties being faced by MNEs operating in India, there is an urgent need to revisit
some of the TP provisions and resolve the key issues by providing additional guidance and introducing
more certainty and fairness in the manner in which TP regulations are applied.

~ducing penalties, introducing measures such as AP As, safe harbour benchmarks for capti ve IT service
providers are some measures that would prove beneficial.

Recent negotiations between the Competent Authorities (CAs) of India and the USA under Article 27 of
the India-US tax treaty (Tax treaty), which deals with the Mutual Agreement Procedure (MAP), provides
 for a dispute resolution mechanism where the CAs shall endeavor by mutual agreement to resolve the
situation of taxpayers subject to taxation not in accordance with the provisions of the Tax Treaty. A
Memorandum of Understanding (MoU) between the two countries provides that the CAs would endeavor
to resolve such disputes within a period of two years and also provides for obtaining a stay on collection
~ of the disputed taxes during the pe~dency of the MAI(tJ\~ ~'r"~ f'(tl~-9
It has recently been reported that, pursuant to an MAP, the US and Indian CAs have proposed to resolve a
transfer pricing (TP) dispute involving provision of intra-group information technology services, by an
Indian affiliate to a US multinational enterprises (MNE). The proposed resolution involves the CAs
agreeing to accept a m3rk-up on costs of 18% as the arm's length price as compared to an adjustment in
the range of 25-30% made by the Indian revenue authorities. The taxpayers involved have the optiol} to
either accept the MAP resolution or follow the course of appeal prescribed under the domestic tax laws.

~~ Background -The TP provisions were introduced in the Indian Tax Laws (ITL), with effect from 1 April
~2001. Over the past few years, TP disputes have emerged as a significant challenge faced by MNEs doing
business in India.

A number of MNEs have established information technology (IT), R&D and back-office operations for
providing intra-group services. The !ndian affiliates providing such services have been subject to adv~se
TP adjustments in recent times. While a number of these operations may enjoy the benefit or[a tax holiday
under the ITL, any income allocated pursuant to an upward TP adjustment made during the course of an
audit, would not qualify for the tax holiday. Further, a TP adjustment in the hands of the Indian affiliate
could potentially result III economic do'uble taxation for the MNE if the MNE is not able to obtain a
correlative relief. '

The MAP article of a tax treaty allows designated representatives i.e. CAs from the governments of the
contractmg states to interact with the intent to resolve international tax disputes, including TP disputes. A
~P arti~_e in most t~x treaties does not ~ompel CAs to actually reach an agreement an~ resolve their :ax
disputes. 1 hey are obliged to only use their best endeavors to reach an agreement. The disputes resolution
under the MAP article of a tax treaty is in addition to the dispute resolution and appellate remedies that a
taxpayer may have under the domestic tax laws.
r

Facts and proposed settlement:-During the course of TP audits for the tax year 2004-Q.5, a number of
Indian affiliates of US MNEs, which were engaged in providing intragroup IT services were subject to
/adverse TVitdJustments.Ths resulted in the Indian revenue authorities determining mark-ups on costs in
the range of 24-3Q%as the arm's length price for such transactions.

The Indian revenue authorities asserted these adjustments largely by adopting a different approach/criteria
..,/ for accepting/rejecting comparable data, as compared to the taxpayer's apprQach.

Some of the US MNEs invoked MAP under Article 27 of the Tax Treaty. These MAP applications have
~sulted in discussions between the CAs of India and the US to reach a settlement on the TP adjustments
made by the Indian revenue authorities.

Pursuant to ongoing discussions, it has been reported that India and the US CAs have proposed to the
taxpayers on whether a resolution based on a mark-up of 18% on costs would be acceptable.
If the taxpayers accept the proposal of the CAs, the Indian affiliate would be subject to tax based on the
MAP agreement. In addition, it could also enable the US taxpayer to consider whether it could be eligible
to seek correlative relief based on the MAP resolution.

Commentsr-The above information is based on secondary sources, including media reports, and there is
M official confirmation from the CAs. The factors and the principles that were considered by the CAs
before making the above proposal are also not known at this stage.

Where a MAP resolution has been arrived at and accepted in respect of a particular issue for a relevant tax
year, it should have effect only for the specific taxpayer for that relevant tax year and for that particular
issue. A MAP resolution does not typically set a binding precedent for either the taxpayers or the revenue
authorities in regard to adjustments or issues relating to subsequent years or for CA discussions on the
same issues for other taxpayers. Nevertheless, it does provide an indication of settlements that could be
expected from MAP proceedings, especially in a similar fact pattern.

The taxpayers in the above case have the option to either accept the MAP resolution or follow the course
of appeal prescribed under the domestic tax laws. If the taxpayers choose to give their consent to the MAP
resolution, the Indian affiliate would need to withdraw any appeal filed under the domestic tax appellate
procedure.

Endowed with the advantages oflow-cost base and a large, growing English- speaking workforce, India
has emerged as a globally preferred outsourcing destination. The growth achieved by India's information
technology (IT) services and information technology enabled services CITeS) sectors stand testimony to
this. Indian transfer pricing regulations require captive units having international transactions with its
associated enterprises to be remunerated on an "arm's-length" basis, leading to the often vexed question
of what constitutes an arm's-length remuneration for a captive unit

When we speak of captive units we need to take into consideration the capacity utilisation, the risk
undertaken and the functional profile of the tested party vis - a - vis comparables. In a captive service
provider model the ultimate risk are borne by the Holding Co. Nevertheless the captive units have one risk
of "single customer". Taking all the factors into account, while benchmarking the transactions pricing
needs to be modelled after considering the identified comparables' mean. The best practical method to be
applied is TNMM. Further, as the financial records of captive units are not available on the public
databases, the comparables would be independent service providers.

Indian and US Tax Authorities Reach Agreement on Pricing of Information Technology Services
The Indian tax authorities in recent years have been taking an aggressive position on transfer prices for
software, business and knowledge process outsourcing (BPO & KPO) and information technology
companies. For multinational companies with Indian subsidiaries providing these services to their
affiliates worldwide, the Indian tax authorities have been insisting on a markup upwards of 25-30 percent
of total costs. The rationale for such margins is unclear as it is unlikely similar independent service
providers in India would be earning margins anywhere near that level. The resulting transfer pricing
assessments have been drastic and can lead to double taxation for the affected multinationals.
·In order to try to address this issue, some US multinationals have invoked the Mutual Agreement
Procedure (MAP), a mechanism provided under double-tax avoidance agreements entered into by India
with various countries. The MAP provides an opportunity for resident taxpayers to approach the
Competent Authorities (CA) in India in conjunction with the CA in other affected countries to come to an
agreement on such issues. As a result, India and the US have apparently reached a negotiated settlement
whereby they have agreed to a markup of 17.5 percent on total costs for BPO, KPO and IT service
providers in India. At this point, the agreed upon markup is only valid for the fiscal years 2004 and 2005.
The settlement provides relief for those taxpayers who have made applications under the MAP and could
also provide correlative adjustments/corresponding deductions at the US end, thereby eliminating the risk
of double taxation.

While unofficial reports of this agreement have spread among taxpayers and practitioners, there has not
yet been a formal confirmation from the CA of either country. Additionally, it is unclear how such an
agreement would impact future tax years.

The enactment of detailed Transfer Pricing Laws in India in 2001 brought the issue of Transfer Pricing to
the forefront amongst the various multinational corporations operating in India as well as Indian
companies. Transfer Pricing is one of the critical tax issues for growth oriented businesses having
international operations wherein substantial senior management's time and attention is necessary.
Irrespective of their size, organizations need an effective and dependable Transfer Pricing policy, which
takes into consideration the organization's overall business strategy and operating structure.

Transfer Pricing authority and tax law

Income Tax Department. Section 40A (2), 92-92F, 271, 271AA, 271BA and 271G of the Income Tax
Act, 1961.

Transfer Pricing regulations and rulings

Rule 10 to 10E of the Income Tax Rules, 1962.

OEeD guidelines of Transfer Pricing

The Indian legislation is broadly based on the OECD guidelines. In conformity with the OEeD
guidelines, the legislation prescribes the same five methods to compute the arm's length price. Further,
the revenue authorities generally recognize the OECD guidelines and refer to the same for guidance, to
the extent they are not inconsistent with the domestic law.

Transfer Pricing methods

The Indian legislation prescribes the following methods: CUP, Resale Price, Cost Plus, Profit Split and
Transactional Net Margin Method. The legislation also grants the power to the Central Board of Direct
Taxes (CBDT) to prescribe any other method; however, no other method has been prescribed by the
CBDT to date. No hierarchy of methods exists. The most appropriate method should be applied.

Penalties in Transfer Pricing

For inadequate documentation, the taxpayer is fined 2% of the transaction value. For not furnishing
sufficient information or documents requested by the tax officer, the taxpayer is fined 2% of the
transaction value. If due diligence efforts to determine the arm's length price have not been made by the
taxpayer, then 100% to 300% of incremental tax on transfer pricing adjustments may be levied by the tax
officer. For not furnishing an Accountant's Certificate (Form 3CEB) along with the return of income, the
taxpayer is fined Rs.one lakh.

Penalty relief in Transfer Pricing

Penalties may be avoided if the taxpayer can demonstrate that it exercised good faith and due diligence in
determining the arm's length price. This is also demonstrated through proper documentation and timely
submission of documentation to the revenue authority during assessment proceedings.

Transfer Pricing Documentation requirements

A detailed list of mandatory documents are listed in Rule 10D (1). The categories of documentation
required are:

• Ownership structure
• Profile of the multinational group
• Business description
• The nature and terms (including prices) of international transactions
• Description of functions performed, risks assumed and assets employed
• Record of any financial estimates
• Record of uncontrolled transaction with third parties and a comparability evaluation
• Description of methods considered
• Reasons for rejection of alternative methods
• Details of transfer pricing adjustments
• Any other information or data relating to the associated enterprise which may be relevant for
determination of the arm's length price

A list of additional optional documents is provided in Rule 10D (3). The taxpayer is required to obtain
and furnish an Accountant's Certificate (Form 3CEB) regarding adequacy of documentation maintained.

Documentation deadlines for Transfer Pricing

The information and documentation specified should, as far as possible, be contemporaneous and exist by
the specified date of filing the income tax return, which has been changed to September 30 instead of
October 31 following the end of the financial year. Although an Accountant's Report must be submitted
along with the tax return, the taxpayer is not required to furnish the transfer pricing documentation with
the Accountant's Report at the time of filing the tax return. Transfer pricing documentation must be
submitted to the tax officer within 30 days of the notice during assessment proceedings.

Statute of limitations of transfer pricing assessments

Tax assessments (where a matter has been referred to the transfer pricing officer) are to be completed
within three years and nine months from the end of the financial year (1 April to 31 March). However, if
the revenue authority determines that income has escaped assessment, an assessment may be re-opened
within seven years from the end of the financial year.

Return disclosures/related-party disclosures

92E, an Accountant's Report is required to be provided along with the tax return. The accountant certifies
whether proper documentation is maintained by the taxpayer.In accordance with Indian Accounting
Standard 18, the company is required to disclose related-party transactions in its financial statements.

Transfer Pricing Audit risk/transfer pricing scrutiny

Internal guidelines have been issued by the revenue authority, pursuant to which companies with related
party transactions in excess ofRs.5.00 Crores are being scrutinized. In most cases, the revenue authority
does not seem to have adopted a centralized or coordinated approach to audits, with officers in different
locations taking divergent positions on similar taxpayer fact patterns. Substantial documentation is being
requested in the course of audit proceedings. The information technology, business process outsourcing,
banking and pharmaceutical sectors have received particular attention. The revenue authority has sought
an updated analysis using data that may not be available to the taxpayer at the time of the preparation of
contemporaneous documentation. Furthermore, officers have insisted on unbundling transactions in cases
where the taxpayer has adopted an aggregate or combined approach to its transfer pricing documentation.
During recent audits, the approach adopted by the taxpayer in the selection of comparable data has
received considerable attention from the revenue authorities.

Advance Pricing Agreements of tansfer pricing

APAs are not available yet, but may become available as India increases its third-party com parables
database and gains more experience in cross-border transfer pricing issues.