Chapter Eleven

Transfer Pricing Litigation in India

Transfer Pricing has been developing rapidly in India. This rapid development includes the implementation of regulations, audit techniques, and case law. The case law itself is worthy of note. India, unlike most of Asia, is litigious. More cases are on the way.

BACKGROUND

India was a highly regulated economy until 1991, when the country began free market reforms. India is a capital importer, and that fact impacts its tax and trade policy. India attracts direct investments primarily due to its lower labor costs. The country is seeking to protect its tax base, and that fact takes precedence in governmental tax planning rather than seeking equity between taxpayers and the government. The Indian government focuses on transfer pricing as a means of protecting its tax base. Recent case law developments focus on this protectionism. To further implement its tax base concerns, India exempts wholly domestic entities and focuses on international businesses.

India has a number of peculiarities in its tax system. Like the United Kingdom, India uses an assessment year that begins on April 1 rather than determining amounts on a calendar-year basis. India does not use a consolidated return system.

India has other peculiarities in the transfer pricing context. India taxes foreign companies at a higher tax rate than it taxes domestic companies, a rate of more than 41+% for foreign companies compared with a rate of 33+% for domestic Indian companies. India does not require the taxpayer to provide a tax return. Instead, the company’s financial statements determine the amount of the corporate tax payable, a procedure that the United Kingdom had used in the past. India imposes double taxation as to royalties and technical fees paid by Indian companies to foreigners.

India requires the taxpayer to maintain contemporaneous documentation. The country has enacted stringent noncompliance penalties, especially for willful negligence. It provides transfer pricing exemptions for small businesses.

TRANSFER PRICING CHRONOLOGY AND ADMINISTRATION

The Income Tax Act of 1961 in India did not address transfer pricing per se, but the government disallowed “excessive payments” that one party makes to a related party. These early excessive payment provisions were based on the “close connection concept.” India had sought to curtail the shifting of profits to offshore entities.

India adopted Organisation for Economic Co-operation and Development (OECD) transfer pricing concepts in 2000, and India’s Parliament approved transfer pricing legislation in April 2001. The tax authority in India is the Central Board of Direct Taxes (CBDT). The CBDT issued transfer pricing rules in August 2001.

India is an extremely diverse country. It is no surprise that India divides its tax powers geographically and by administrative power. India divides its tax powers in this way:

• CBDT. Direct taxes, including income tax
• Central Board of Excise and Customs. Indirect taxes, including excise duties and customs duties
• Geographic areas, headed by a chief commissioner, commissioners, and assessing officers in five regional locations: Mumbai, Delhi, Bangalore, Chennai, and Kolata
• Transfer pricing officers: one or more in each jurisdiction

Unlike transfer pricing regimes in most other countries, India limits its transfer pricing regime solely to international businesses and exempts wholly domestic Indian businesses. These businesses are within the purview of the transfer pricing provisions:

• Either of the two parties to a transaction where one or both parties are nonresident.
• The transfer pricing provisions do not apply to all-domestic transactions.
• The transfer pricing provisions do not apply between two residents of India.

RELATED PARTIES

India determines related party status by an “Associated Enterprises” concept. That Associated Enterprises concept applies to the following relationships: As a general matter, affiliated status applies to both direct participation and to indirect participation; to management; to control; and to capital. For reference as to the term “affiliated enterprise,” see OECD Model Convention Article 8.

Affiliated enterprises status in India can depend on the presence of loans or the presence of equity. Equity holdings of at least 26% cause the relationship to constitute affiliated status. Analogously, Form 5472 in the United States speaks of shareholdings of 25% or more for reporting purposes. Control is determined through the composition of the board of directors. Affiliated enterprise status in India applies because of financial control: providing loans equal to 51% of the assets or providing guarantees equal to 10% of total borrowings.

Affiliated enterprises status in India can result through dependence based on intangibles, such as dependence based on patents, on licenses, or on business or commercial rights. Affiliated enterprises status in India can result through a franchisor/franchisee relationship.

India views the franchisor as the dominant party and views the franchisor as being dominant over each franchisee. As a result, India views the franchisor/franchisee relationship as an affiliated enterprise subject to transfer pricing. Note that Indian companies tend to be in licensee status, and the tax authorities eschew transfer pricing intangibles.

Affiliated enterprises status applies in India through a supply of raw materials.

India treats the providers of raw materials as being affiliated to the users of these raw materials. India, then, recognizes that the raw material provider might have effective influence over the supply of raw materials. The user of the raw materials might purchase 90% of its materials from the raw material supplier, creating an affiliated party relationship. The supplier of the raw materials might influence the price and related conditions of the sale in those circumstances.

Affiliated enterprises status applies in India through the finished product. For example, one party might have “effective influence” over another party as to the sale of a finished product. This provision appears to reflect the manufacturer’s domination over its distributors. India might view the manufacturer and its distributors as affiliated enterprises. India might apply the effective influence rule without ascertaining whether the parties are dependent or independent.

Affiliated enterprises status applies in India by virtue of board membership (i.e., when one enterprise appoints more than half of the board members of another enterprise).

In some situations, though, it might be difficult to ascertain whether one party appoints another party. India does not address the indirect control of board members—through attorney, accounting, or banking relationships—in determining affiliated status.

Affiliated enterprises status applies in India because of a relationship of “mutual interest.” Note, however, that the term “mutual interest” is vague and might apply to supplier issues, distributor issues, financial issues, and so forth.

TRANSFER PRICING METHOD SELECTION IN INDIA

The transfer pricing method selection criteria in India is based on the most appropriate method (MAM). The MAM is the transfer pricing method that is “best suited to the facts and circumstances.” The MAM rule differs from the priority of methods approach used in many countries in Asia, thus raising the likelihood of double taxation. The MAM rule differs from the “best method” rule used in the United States and in other countries.

This is how India’s MAM works: The taxpayer and the CBDT are to select a transfer pricing method based on these criteria:

• Nature and class of the transaction
• Class or classes of the associated enterprises
• Availability of data
• Coverage of data
• Accuracy and reliability of data
• Degree of comparability
• Extent to which reliable adjustments can be made
• Assets and risks of the enterprise
• Assumptions used

India permits the taxpayer to apply these transfer pricing methods:

• Comparable uncontrolled price (CUP)
• Resale price method (RPM)
• Cost plus method, including the “normal” gross profit market as adjusted
• Profit split method, based on functions performed, assets employed, and risks assumed, based on reliable external data, in proportion to their relative contributions (India permits the basic return approach)
• Transaction net margin method (TNMM), based on costs incurred, sales effectuated, or assets utilized

India permits taxpayers to use cost sharing procedures, but cost sharing procedures are rarely used in India.

The Indian transfer pricing provisions address the issue of applicable comparable databases. India has widely used databases. The country does not prohibit foreign comparable data, but the tax authorities strongly prefer domestic comparative data. Like the United States, but unlike most of Asia, an Indian taxpayer can look to the two prior taxable years. A case law decision in India permitted the taxpayer to determine the results of one particular tax year standing alone.

As a general matter, countries in Asia and elsewhere permit the taxpayer to develop a range of prices. The reader is forewarned that India does not permit the taxpayer to use such a range of prices. Some countries (e.g., the United States and sometimes Singapore) use the interquartile range concept to narrow the pricing range. India requires an arithmetic mean of prices but then permits a range of 5% from that arithmetic price. The goal in India is to ascertain the one true arm’s length price—a transfer pricing approach that other countries had applied in the past.

CONTEMPORANEOUS DOCUMENTATION IN INDIA

Contemporaneous documentation rules in India require the taxpayer to prepare and preserve the following documents. The taxpayer is to prepare documentation by the due date for filing the annual tax return—similar to contemporaneous documentation timing in Japan. India does not require immediate reflection of actual transactions, as the United States and Australia do. The taxpayer need not file contemporaneous documentation with the tax return. The taxpayer must maintain documentation for eight years. The taxpayer is to furnish the documentation within 30 days after the CBDT requests these documents.

A non-Indian company that receives royalties or technical fees from an Indian company is subject to tax in India. In other words, India treats payment as a direct business activity in India rather than being subject to withholding. India’s royalty and technical fee approach appears to be taken from the United Nations model tax treaty.

The payment is subject to transfer pricing rules, and both parties are subject to India’s documentation rules. The home country might also tax the royalty or technical fee.

India requires the taxpayer to provide three types of documentation to the Indian tax authorities:

These Indian documentation rules are similar in many respects to the U.S. transfer pricing rules.

The Indian transfer pricing documentation rules require the taxpayer to provide general information to the tax authorities. The taxpayer must provide the ownership structure of the Indian entity and indicate the ownership specifics of that particular entity. In addition, the taxpayer is to provide the worldwide ownership structure of the group, including linkages and tax status of each entity. Further, the taxpayer is to describe the business from a business standpoint, including its activities and competition.

The Indian transfer pricing documentation rules require the taxpayer to provide this transaction-specific information to the tax authorities:

• The nature and terms of the transaction, including prices of the transaction
• Functions performed, risks assumed, and assets employed
• Economic and marketing analysis
• Record of uncontrolled transactions, including the use of transaction as in-house comparable
• Comparative analysis
• Transfer pricing methods considered
• Difference adjustments
• Assumptions, policies, and price negotiations
• Adjustment details
• Other information

The Indian tax authorities expect the taxpayer to provide supportive transfer pricing documentation, including market research studies, stock exchange data, and commodity market data, if available. The taxpayer may need to rely on databases in the non-Indian jurisdiction. If so, the taxpayer is to provide that information to the Indian tax authorities. The taxpayer is to provide the tax authorities with its published accounts and financial statements, agreements and contracts, and letters and correspondence impacting transfer pricing. The taxpayer is to provide the tax authorities with the normal documents the company issued under its accounting practice.

The accountant’s report plays a significant role in India. The rules require the taxpayer to obtain a transfer pricing report, which is normally prepared by a chartered accountant. The accountant must provide this report to the taxpayer before the taxpayer files its tax return. This disclosure is similar to Form 5472 in the United States and Schedule 25A in Australia. The accountant must certify the taxpayer’s proper documentation.

AUDIT PROCEDURES

Two separate governmental parties play a role in a transfer pricing audit in India, the assessing officer (AO) and the transfer pricing officer (TPO). The division between these roles has been before the courts. It is possible that India developed this dual system to limit corruption. The AO has limited powers when the issue pertains to transfer pricing. The TPO, not the AO, takes charge of the case from the government’s standpoint. The TPO, having charge of the case, puts in writing its opinion as to the taxpayer’s arm’s length price. The TPO then sends to the taxpayer its opinion as to the taxpayer’s arm’s length price. The TPO’s letter to the taxpayer is to include its reasons for the redetermination and the application of the method chosen. The taxpayer can challenge the TPO’s determination and, if necessary, challenge the TPO’s determination in court.

The TPO selects and adjusts the taxpayer’s transaction price, based on available information and other material. The TPO is required to issue a notice to the taxpayer, giving the taxpayer the opportunity to show why the TPO should not make the adjustment. The AO then computes the transfer pricing adjustment, computes the taxpayer’s total income, and issues a final assessment order to the taxpayer.

India is currently auditing thousands of companies for transfer pricing purposes.

India is increasing the number of transfer pricing audits by 50% per year. The amount of adjustments is increasing 30% per year. The transfer pricing audit process applies only to audits that reach a threshold of 50 million rupees ($1.1 million) per year, based on related party transactions.

Transfer pricing audits in India begin as desk audits. The tax authorities can later expand the audit process. The government and the taxpayer divide the burden of proof. The taxpayer has the burden of proof during the audit process, but the government has the burden of proof in making transfer pricing adjustments. The confidentiality rules apply for audits in India.

The Indian government can request foreign comparables, but the government does not trust foreign comparables without substantiation. India may be using secret comparables—the data the government obtains from other audits—but the burden of proof issue limits the use of secret comparables in making adjustments.

It is important to evaluate India audit issues by industry segment. Services are an important facet transfer pricing issue in India. The CBDT makes frequent adjustments for fulfillment, marketing, research and development, and technical services. India makes very frequent use of the cost plus method because many businesses are service enterprises. The government seeks to impose high markups (i.e., 25% to 40%), thus exacerbating double taxation, as India’s trading partners view these services as being low in value. India views research and development activities as being high in value and subjects the taxpayer to a high markup. The TPOs tend to apply market rates for employees as a comparable.

India permits the foreign owner to claim management fees for running its operations in India and to claim a share of common expenses, but the country imposes a benefits test on the foreign owner. India applies internal comparables, relying on product comparability and/or the TNMM in the case of manufacturers. The tax authorities frequently apply the TNMM rather than the resale cost method to a distributor.

PENALTIES

India, like many countries new to transfer pricing, imposes severe transfer pricing penalties. For example, penalties for a transfer pricing adjustment can be a minimum of 100% and a maximum of 300% of the transfer pricing adjustment. However, the taxpayer can avoid the penalty by showing due diligence and good faith. These penalties are stringent, given India’s arithmetic mean requirement to determine the transfer price.

India, like the United States, imposes a separate documentation penalty, over and above the transfer penalty, for a taxpayer’s failure to maintain or submit documentation in India. The documentation penalty is 2% of the taxpayer’s transactions. The penalty applies to information and documents pertaining to the international transaction.

The documentation penalties apply to general business records. The penalty for failure to submit the accountants’ transfer pricing report is 100,000 rupees (approximately $2,500).

APPELLATE PROCEDURES

The taxpayer can appeal before the Commissioner of Income Tax (Appeals) CIT(A). The appellate procedure is regional, so that the results might not be consistent on a national basis. Appeals can go to the Income Tax Appellate Tribunal (ITAT), a quasi-judicial authority independent of the revenue authorities, the final fact-finding authority. Then appeals can go to the High Court if the issue is based on the legal issues rather than on facts.

Unique among transfer pricing regimes in Asia, India does not accept the concepts of advance pricing agreements (APAs); nevertheless, the Authority for Advance Ruling (AAR) might serve in essence as a unilateral APA but for the fact that the AAR process does not include valuation issues in its purview. India provides for a tax ruling authority, the AAR. The AAR procedure is available to both residents and nonresidents. The AAR ruling is binding on the taxpayer and on the tax authorities, but taxpayers and the tax authorities have sought to challenge this power.1

India set up the AAR, a quasi-judicial body, in 1993, as an alternative dispute mechanism. The AAR procedure can apply to nonvaluation transfer pricing issues, but the AAR process is not limited to transfer pricing issues. High Court judgments take precedence over the AAR ruling.

India makes use of the competent authority procedures when the country is a party to these tax treaties. India’s tax treaty network includes the United States and the United Kingdom. India established active double tax avoidance systems in the case of the United States and the United Kingdom in 2003, but it has not applied these tax avoidance systems with other jurisdictions.

The taxpayer should be aware of the negative transfer pricing factors in India. India takes a strong stand against losses, even initial start-up losses. Indian companies are payers of intangible rights, not recipients of intangible rights. As such, to protect its tax base, India takes a strong stand against making payments for intangibles. Further, India imposes exchange control requirements.

India provides investor taxpayers with tax holidays that are designed to increase productivity. Tax holidays benefits do not apply to transfer pricing adjustments. Some taxpayers pump up the markup because of tax holiday, raising the comparable amount to its nonholiday competitors. Taxpayers that use high markups during the holiday period will be stuck with the high markup after the tax holiday period.

As to the AAR ruling in the transfer pricing context, see Instrumentarium Corporation, a Finnish company. Instrumentarium had provided a tax-free loan to its affiliate in India at a zero interest rate. This interest rate, quite obviously, was not arm’s length. If the Indian subsidiary paid interest as a rate above zero to comply with the arm’s length rate precepts, this positive tax rate would diminish taxable income in India. The AAR concluded that it could provide a ruling in 2003 as the issue did not involve valuation. The AAR required Instrumentarium to use the arm’s length transfer pricing rate.

TRANSFER PRICING LITIGATION

Transfer pricing litigation began in earnest in India in 2006, with these cases:

• Sony India (P) Ltd. v. Central Board of Direct Taxes2
• Central Board of Direct Taxes v. Morgan Stanley & Co. Inc.3
• Aztec Software & Technology Services, Ltd., v. ACIT 4

Sony India v. Central Board of Direct Taxes addressed procedural issues impacting the conflict between the assessment officer (AO) and the TPO. The Indian transfer pricing regulations require the AO to proceed to compute the taxpayer’s total income after the TPO makes its transfer pricing determination.

The High Court of Delhi upheld the government’s procedure in Sony India. The Court held that determination is within the authority of the Central Board of Direct Taxes under Indian law and confirmed that the TPO order does not bind the AO.

Permanent Establishment and Morgan Stanley

The tax authorities in India are actively pursuing their potential permanent establishment claims against foreign-based multinational corporations, undertaking this action to protect the Indian tax base. The Indian government’s claims against multinational corporations are of two types:

A multinational corporation doing business in India, then, faces a double risk of permanent establishment exposure, all before addressing transfer pricing exposure. Consider the case of DIT v. Morgan Stanley & Co. decided by the Supreme Court of India.5

Morgan Stanley is a global investment firm that provides a range of financial services to its clients around the world. The company established a subsidiary in India, Morgan Stanley Advantage Services (MSAS). Morgan Stanley used MSAS to provide “support services” to Morgan Stanley entities outside India.

MSAS is an internal entity and does not directly interact with Morgan Stanley’s customer clients. Instead, MSAS directly interacts with members of the Morgan Stanley group. MSAS provides such support services as bookkeeping, accounting, research assistance, and analytics.

From a U.S. perspective, one should note the ambiguous nature of the categorization of the MSAS services in light of section 1.482–9. Thus, it is not certain that the low-valued services provisions under section 1.482–9(b) necessarily would apply to the MSAS fact pattern.

The issue arose as to the applicable transfer pricing method under Indian law to determine the arm’s length amount. Morgan Stanley undertook a transfer pricing analysis in India specifically examining MSAS’s functions performed. Morgan Stanley was concerned that the Indian tax authorities could make a transfer pricing adjustment and attribute a portion of its overall profits to India.

Morgan Stanley sought a ruling from the appropriate regulatory agency in India, the AAR. The purpose of the ruling was to ensure that the Indian tax authorities would not attribute any portion of the profits of Morgan Stanley to MSAS. The AAR ruled that, once Morgan Stanley remunerated MSAS for the services costs at arm’s length rates, the Indian tax authorities could not tax any future benefits. In other words, the AAR rejected a second-tier permanent establishment.

The Indian revenue authorities rejected the AAR ruling, arguing before the Supreme Court of India that they could further attribute a portion of Morgan Stanley’s world profits. The Indian revenue authorities asserted that, notwithstanding MSAS receiving arm’s length compensation from Morgan Stanley, they could attribute a portion of Morgan Stanley’s profit to India.

The Indian Supreme Court rejected the revenue authorities’ claim for further profits attributable to India. Commentators close to the scene consider the further attribution theory to remain in other contexts.

Aztec Software

The courts in India had the opportunity to revisit the Sony India case with Aztec Software. Litigation took place at the ITAT in Bangalore before a five-judge panel, a special bench. Here the court held that the AO must demonstrate tax avoidance before bringing a transfer pricing adjustment. The TPO order did not bind the AO. Subsequent legislation, however, changed the relationship between the AO and TPO. The TPO binds the AO as of June 1, 2007. Aztec Software provides that the government has the burden of proof if it seeks a different arm’s length price.

Aztec Software addressed the interrelationship between transfer pricing and tax holidays, holding that the transfer pricing provisions apply even when the taxpayer enjoys a tax holiday. Here the TPO rejected the taxpayer’s transfer pricing method without providing a basis for this transfer pricing determination. The court criticized the TPO for this lack of analysis. The court in Aztec Software did not reach finding as to the most appropriate transfer pricing method. Here the tax authorities applied a single year’s data. The court accepted the single-year approach. However, the court addressed the sample size issue, suggesting that a sample size of ten companies might be inadequate.

VODAFONE: HUTCHISON ESSAR ACQUISITION

Vodaphone acquired Hutchison Essar, the fourth largest mobile phone operator in India, paying $10.9 billion in May 2007. The tax authorities in India sought $2.1 billion from Vodaphone as a result of Vodaphone making that purchase of Hutchison Essar shares. The taxpayers expressed two alternative theories to confront the Indian tax authorities:

This is the Hutchison structure and its ostensible tax consequences: Hutchison Whampoa (the parent company) is based in Hong Kong. Hutchison held its controlling stake in Hutchison Essar through a Mauritius company. The tax authorities in India assert that the Vodaphone-Hutchison transaction is subject to capital gains taxation in India because the assets are in India. The capital gain was $9.6 billion, levied at the 22% rate, an amount of $2.1 billion. The tax authorities in India argue that Vodaphone should have withheld the $2.1 billion and paid the $2.1 billion to India. The Indian Supreme Court held for Vodaphone on January 20, 2012.

NOTES

1. In this regard, see the Morgan Stanley case (2007), infra.

2. Sony India (P) Ltd. v. Central Board of Direct Taxes, High Court of Delhi, WP (C) no. 9594/2005, 288 ITR 52, decision October 10, 2006.

3. Central Board of Direct Taxes v. Morgan Stanley & Co. Inc., High Court of India, 292 ITR 416, 2007.

4. Aztec Software & Technology Services, Ltd., v. ACIT, 107 ITD 141, Bangalore SB, 2007.

5. DIT v. Morgan Stanley & Co., 2007 292 ITR 416.