Thursday, March 14, 2013

"Associate Enterprises" (AE) under Indian TP - A detailed analysis

"Associate Enterprises" (AE) under Indian TP - A detailed analysis
Ms.B.Mala, Associate, SAPR Advocates,
Ms.Bhavya Rangarajan, Advocate, SAPR Advocates

  • Introduction:
  • Definition:
(i) Associated Enterprise 
(ii) Deemed Associated Enterprise
  • Applicability of Transfer Pricing to Joint Venture Structure:
  • Comparison With Model Convention:
    (i) OECD Model Convention
     (ii) UN Model Convention
  • Conclusion
When associated enterprises situated in different countries sell goods and services between themselves, the transfer price may, because of different reasons, diverge from the market price. The divergence may be a consequence of tax planning, but it may also arise from other circumstances.

When the transfer price diverges from the market price it must be established if the enterprises are associated or not, since the transfer pricing regulations only applies to associated enterprises.

The arm’s length principle, hereafter the ALP, is the internationally most accepted principle used to allocate profits made by enterprises involved in cross-border transactions. This principle is also the most common, in domestic legislation as well as in tax treaties. According to this principle the price set between associated enterprises should be the same as the price set between two unrelated parties engaged in the same or similar transactions, under the same or similar conditions on the open market.
Definition -Section 92A of the Income tax Act:
Associated enterprises are those which are owned or controlled by the same or common interest. The Transactions are between two or more associated enterprises either or both of which are non-residents. Transaction includes arrangement, understanding or action in concert whether or not formal or in writing, or intended to be enforceable by legal proceedings.
Arm’s length Price determination in transfer pricing is applicable to income arising from international transactions between two or more associated enterprises as defined under section 92A.which reads as:
Associated Enterprise (Sec 92A(1))
"Associated Enterprise", in relation to another enterprise, means an enterprise--
    1. which participates, directly or indirectly, or through one or more intermediaries, in the management or control or capital of the other enterprise ; or
    2. In respect of which one or more persons who participate, directly or indirectly, or through one or more intermediaries, in its management or control or capital, are the same persons who participate, directly or indirectly, or through one or more intermediaries, in the management or control or capital of the other enterprise.
We see that this definition talks about two situations:
  1. when one enterprise controls or is controlled by another, directly or indirectly; and
  2. when there is a relationship of indirect ownership or of mutual interest between the two.
The participation/control may be direct or indirect. The term ‘direct or indirect’ have been explained in Klaus Vogel on Double Taxation Conventions as follows:

"It is a case of direct participation within the meaning of Article 9(1)(a) whenever no third party is interposed between the two enterprises in their relationship (example : parent company and subsidiary). In the case of an indirect participation, however, one or both of the enterprises make use of one or more third parties in order to bring about the interconnection (examples: a parent company which, via its subsidiary, participates in a sub-subsidiary; two companies each of which holds a 50 per cent interest in the other).”

Therefore, on the basis of the aforesaid interpretation given by Vogel, “indirectly” means making use of third parties. However, in section 92A, such indirect participation is clearly covered by the use of the term ‘through one or more intermediaries’.
Example 1: If Company A holds 60% of the share capital of Company X:
Company A will become associate enterprise of Company X because Company A by holding majority of shares has control over Company X by way of majority voting power or decision making power.

Example 2: Company A holds 75% of share capital in Company B and Company B holds 60% of Company C.
Here both Company B and C will be associated enterprises of Company A.
Example 3: Company A participates in management of Company C and Company D. Company C and D are associate enterprises by virtue of Company A participating in the management of both Company C and D.
Example 4: If X has participation in Y, X will be associated enterprise of Y. If Z has participation in both X and Y, then, X and Y would be associated enterprise under section 92A(1)(b).
Deemed Associated Enterprise:
Enterprises can also be associates for the purposes of sub-section (1) under the deeming provisions which are contained in clauses (a) to (m) of Section 92 A (2) which defines ‘Deemed Associated Enterprise”:
Two enterprises shall be deemed to be associated enterprises if, at any time during the previous year, one enterprise holds, directly or indirectly, shares carrying not less than twenty-six per cent of the voting power in the other enterprise.
Two enterprises shall be deemed to be associated enterprises if, at any time during the previous year,--
(a) One enterprise holds, directly or indirectly, shares carrying not less than
twenty-six per cent. of the voting power in the other enterprise ;
(b) Any person or enterprise holds, directly or indirectly, shares carrying     not  less than twenty-six per cent. of the voting power in each of such enterprises;

Section 92A(2)(a) provides that two enterprises are deemed to be associated enterprises if one enterprise holds shares carrying at least 26% of the voting power in the other enterprises. On the other hand section 92A(1) does not provide for any minimum limit which is required to constitute participation in capital. (In Klaus Vogel on Double Taxation Conventions, it is stated that Article 9 provides neither minimum nor maximum limitation regarding direct or indirect participation in management, control or capital.) This apparent inconsistency is explained by way of an example:

Example: If an enterprise is holding 15% of the voting power shares in the other enterprise, the two entities would not be associate enterprises under the deeming clause which stipulates a minimum holding of 26%. On the other hand it would be covered in the participation clause if it is literally interpreted. It appears that the two provisions have to be read harmoniously.  
If section 92A(1) is interpreted to cover cases where the shareholding is less than 26% of voting power shares, then the provision in deeming clause would become redundant. It is now well settled that redundancy cannot be attributed to any provision [See CIT v. Kanpur Coal Syndicate, 53 ITR 225, 228 (SC), CIT v. Distributors (Baroda) P. Ltd., 83 ITR 377 (SC)]  
Having regard to this, it appears that the expression ‘capital’ should be interpreted to exclude capital in the form of voting power shares.

The control covered in the legislation extends not only to control through holding shares or voting power or power to appoint the management of the other enterprise, it extends also to control through debt, relatives and control over the various component of the business actively performed by the taxpayer such as control over raw materials and sales, intangibles etc.

In certain cases, a transaction between an enterprise and a third party may be deemed to be a transaction between associated enterprises, if there exists a prior arrangement in relation to such transaction between the third party and an associated enterprise or if the terms of such transaction are determined in substance between the third party and an associated enterprise.
(c) A loan advanced by one enterprise to the other enterprise constitutes not less than fifty-one per cent of the book value of the total assets of the other enterprise
Example: If A Ltd has given loan of INR 52 Million to B Ltd. Book Value of assets of B Ltd is INR 100 Million. Here A and B are associated enterprises. 
(d) One enterprise guarantees not less than ten per cent of the total borrowings of the other enterprise
Example: A Ltd is an Indian subsidiary which receives loan worth INR 100 Million from Indian banks on the basis of guarantees given by foreign subsidiary B Ltd to the extent of INR 12 Million. Here, A and B Ltd are associated enterprises. 
(e) more than half of the board of directors or members of the governing board, or one or more executive directors or executive members of the governing board of one enterprise, are appointed by the other enterprise
Example: If A Ltd appoints half of the board of directors or one or more executive member of the governing body of B Ltd. Then, A Ltd. and B Ltd are associated enterprises 
(f) more than half of the directors or members of the governing board, or one or more of the executive directors or members of the governing board, of each of the two enterprises are appointed by the same person or persons
The phrase used in section 92A(2)(e) is ‘are appointed’. Thus, it contemplates ‘actual appointment’ and not ‘a mere power to appoint’. Hence, two enterprises would not be deemed to be associated enterprises, if one enterprise has a power to appoint (but has not exercised that power) more than half of the board of directors or members of the governing board, or one or more of the executive directors or members of the governing board, of the other enterprise.  
Example: A Ltd appoints more than half of directors in B Ltd and also appoints 2 executive directors of C Ltd. Since A Ltd has appointed directors of both enterprises, B Ltd and C Ltd are associated enterprises.
(g) the manufacture or processing of goods or articles or business carried out by one enterprise is wholly dependent on the use of know-how, patents, copyrights, trade-marks, licences, franchises or any other business or commercial rights of similar nature, or any data, documentation, drawing or specification relating to any patent, invention, model, design, secret formula or process, of which the other enterprise is the owner or in respect of which the other enterprise has exclusive rights
Example: If A Ltd provides technical know-how for the manufacture of goods of B Ltd. Then, A and B Ltd will be associated enterprises. 
(h) Ninety per cent. or more of the raw materials and consumables required for the manufacture or processing of goods or articles carried out by one enterprise, are supplied by the other enterprise, or by persons specified by the other enterprise, and the prices and other conditions relating to the supply are influenced by such other enterprise 
(i) the goods or articles manufactured or processed by one enterprise, are sold to the other enterprise or to persons specified by the other enterprise, and the prices and other conditions relating thereto are influenced by such other enterprise
(j) where one enterprise is controlled by an individual, the other enterprise is also controlled by such individual or his relative or jointly by such individual and relative of such individual 
(k) where one enterprise is controlled by a Hindu undivided family, the other enterprise is controlled by a member of such Hindu undivided family, or by a relative of a member of such Hindu undivided family, or jointly by such member and his relative  
(l) where one enterprise is a firm, association of persons or body of individuals, the other enterprise holds not less than ten per cent. interest in such firm, association of persons or body of individuals ; 
(m) there exists between the two enterprises, any relationship of mutual interest, as may be prescribed.  
Example: If A of UK holds 26% voting power in B of Germany and also in C of India, then B and C shall be deemed to be associated enterprises.  
Example: If more than half of the directors of Company X are appointed by the Company A, then Company A will become associate enterprise of Company X, because Company A is participating in the management of Company X  
Example: The appointment of 7 out of 12 members of board of directors of B and 6 out of 10 of the board of directors of C is controlled and has been made by A Ltd. B and C are associated enterprises.
In CIT v. United Breweries1, the court held that if one company has the right and power to exercise functional control, in addition to capitalist control over the other company, the existence of the other company as a separate and distinct entity could not prevent the business of that company being treated as that of the company controlling.
The Supreme Court has in case of Erin Estate Galah, Ceylon v. CIT (34 ITR 001) defined control and management as the controlling and directing power. It further observed that in the said decision that it is true that control and management which must be shown to be situated and not merely theoretical control and power, not de jure control and power but the de facto power actually exercised in the course of the conduct and management of the affairs. 
In CIT V. VRNM Subhiah Chettiar2it was held that the expression “Control and Management” means de facto control and management and not merely the right or the power to control and manage.
In CIT V. Nandlal Gandalal3 it was held that the Associate enterprise means an enterprise which has ability to influence policy or management or functioning or its transaction of another to secure the maximum tax benefits.
In the case of Diageo India Pvt. Ltd v ACIT4 it was decided that If one enterprise controls the decision making of the other or if the decision making of two or more enterprises are controlled by same person, these enterprises are required to be treated as ‘associated enterprises’. Though the expression used in the statute is ‘participation in control or management or capital’, essentially all these three ingredients refer to de facto control on decision making.

Applicability of Transfer Pricing to Joint Venture Structures:
Due to various commercial and regulatory reasons, the entities in India are formed as a joint venture between Indian enterprise and a Foreign enterprise. If one were to closely analyse the JV structure, it would be pertinent to note that two or more independent parties with certain common objectives came together to optimize their available resources and share the results in the mutually agreed ratio.
The decision to agree to a prescribed ratio and the consideration in a particular transaction is after negotiations and based on commercial expediency and exigency, as two independent parties would have acted in comparable circumstances.
The commercial or financial relations between the JV entity and its associated entities owned by any one of the partners cannot be said to be differing from those, which would be made between independent parties.
In OECD, it is clear that the transactions between a JV entity and its associated entities owned by any one of the JV partners cannot arguably trigger Article 9 of the tax treaty, which deals with determination of income in respect of transactions between two associated enterprise in certain specified situation.
While computing the income from international transactions, due consideration should also be given to the fact that the taxpayer is a joint venture company and the transaction between the JV company and its AEs, is essentially at Arm’s Length, since they have been arrived at after prolonged negotiations between the JV partners and hence, they cannot be said to be differing from those, which would made between independent parties.
Comparison with Model Conventions:
Section 92A(1) is similar to Article 9(1) of the OECD Model Double Taxation Convention, 1997 and United Nations (UN) Double Taxation Model Convention, 1980 which read as follows :

OECD Model Convention

Article 9: defines Associated Enterprises

(a) an enterprise of a Contracting State participates directly or indirectly, in the management, control or capital of an enterprise of the other Contracting State, or
(b) the same persons participate directly or indirectly in the management, control or capital of an enterprise of a Contracting State and an enterprise of the other Contracting State,....

Art. 9 OECD MC states three trigger factors to determine if enterprises are to be considered “associated”; participation in capital, participation in management and participation in control.

UN Model Convention

Article 9: defines Associated Enterprises

Where (a) an enterprise of a Contracting State participates directly or indirectly in the management, control or capital of an enterprise of the other Contracting State; or
(b) the same persons participate, directly or indirectly in the management , control, or capital of an enterprise of a Contracting State and an enterprise of the other Contracting State.

The important differences between the definition of ‘associated enterprises’ in section 92A(1) and that in the OECD/UN model conventions are :

(a) Unlike the OECD/UN model conventions, section 92A(1) uses the words ‘through one or more intermediaries’ in section 92A(1). In other words, for the purpose of section 92A(1), even if the participation is through an intermediary, the investing and the investee enterprises could be considered as an associated enterprise.
(b) The provisions of section 92 read with section 92B apply to transactions even between two non-residents. Article 9 of the OECD or the UN Model apply to a transaction, only if one of the enterprise is a resident of one Contracting State and the other enterprise is a resident of the other Contracting State (non-resident). In other words, Article 9 would not apply when there is a transaction between two non-residents.
In a global economy where multinational enterprises (MNEs) play a prominent role, governments need to ensure that the taxable profits of MNEs are not artificially shifted out of their jurisdiction and that the tax base reported by MNEs in their country reflects the economic activity undertaken therein. 

For taxpayers, it is essential to limit the risks of economic double taxation that may result from a dispute between two countries on the determination of the arm’s length remuneration for their cross-border transactions with associated enterprises.

To this extent the Transfer Pricing Guidelines should provide guidance on the application of the "arm's length principle" for the valuation, for tax purposes, of cross-border transactions between associated enterprises
1 [1973] 89 ITR 17 (Mysore),
2 (1947) 15 ITR 502 (Mad.)
3 (1960) 40 ITR 1 (SC)
4 47 SOT 252

The Great Indian Transfer Pricing Circus – a critical view of Indian TP provisions

The Great Indian Transfer Pricing Circus – a critical view of Indian TP provisions
Vikram Vijayaraghavan, Advocate
M/s Subbaraya Aiyar, Padmanabhan & Ramamani (SAPR) Advocates, Chennai

Author's note & disclaimer: This Article appeared in the Third Quarter 2012  Volume 7 Issue 3 Page 7 of the Tax Justice Focus magazine available from this link. The content of the article relates to October 2012 and the TP provisions applicable at that time
The year 1991 was a watershed in modern India’s economic history; it was the year in which the Indian economy was `opened up’ or liberalized by the then widely-hailed Finance Minister, Dr.Manmohan Singh, now the Indian Prime Minister. The economic reforms of 1991 were far-reaching and opened up India for international trade and investment, taxation reforms, deregulation and privatization. These reforms caused huge cash flows into and out of India in the following decades.
The more liberal international trading regime established by Singh highlighted the issue of Transfer Pricing (TP).The Indian Government, like most others, is heavily dependent on tax revenue and simply cannot ignore the scope for tax avoidance created by transfers between subsidiaries of multinational companies. So it stepped up in 2001 and amended the Indian Income Tax Act of 1961 (via the Finance Act of 2001) and added a new chapter titled “Chapter X : Special Provisions Relating to Avoidance of Tax” and introduced Section 92 in Chapter X containing sub-sections 92A to 92F and Income Tax Rules (Rule 10A-10E) laying out specific TP provisions for the first time. In other words, the TP circus had begun in India.
Indian TP provisions were fairly OECD-like in the sense they based the TP regime on the arm’s-length principle or ALP (defined in Sec.92) of international transactions (Sec.92B) between associate enterprises (Sec.92A). The computation of ALP was laid down via five methods namely Comparable Uncontrolled Pricing (CUP), Cost-Plus (CPM), Resale Price Method (RPM), Transactional Net Margin Method (TNMM) and the Profit-split Method (recently a new sixth method has been prescribed by the Central Board of Direct Taxes, the tax administering body). Comprehensive documentation requirements are laid out in Sec.92D and Sec.92F contains all the definitions of the terms.
However, there are certain important differences between Indian provisions and the OECD TP guidelines. The definition of “Associate Enterprise” is quite broad under Indian TP compared to OECD; multiple-year data of the Financial results of comparable companies is not allowed in Indian TP except under certain circumstances unlike OECD Guidelines; arithmetic mean of comparables is used in Indian TP and not inter-quartile ranges; Indian TP has stringent documentation guidelines while lacking guidelines for intra-group set-offs, thin capitalization, intangibles etc. all of which are in contrast to the OECD guidelines.
There are two basic and serious problems with the current Indian TP provisions - firstly they are too general and vague to be useful laws; secondly their implementation has left very much to be desired. One worries that the first problem is intractable because TP by its nature seems an economic issue not lending itself to precise definitions which is essential for legalese and that the second problem is unsolvable because the ambiguity inherent in TP in general and the Indian TP provisions in general create opportunities for misinterpretation, over-reach and overzealous action.
Let us look at typical scenario, using the fictional multinational ABC to illustrate it. ABC (India) Pvt. Ltd. a subsidiary of American company ABC Inc., provides software development services to its foreign parent, a financial analytics application software firm. ABC (India) Pvt. Ltd. will likely choose cost-plus (CPM) and add a markup (say, 15%) to its costs. Given there are no benchmark figures for comparing the mark-ups in various sectors, the Revenue Department will normally not accept the taxpayers markup % and hold it as being too low adopting TNMM instead. It has become customary for the Department to try and apply TNMM to all varieties of International Transactions given that TNMM method is easy to apply without requiring too much precision. The Revenue Department will come up with a set of comparables to ABC (India) Pvt. Ltd. And therein lies the rub.
The comparable list of the Revenue Department will typically contain companies from the giants such as Infosys™ and TCS™ as well as small companies in unrelated software verticals (travel, healthcare etc.). These comparables make no sense whatsoever in the context of ABC; can a software megalith with more than 100k employees be compared to a 200 people firm? Can unrelated software verticals be compared at all? These comparables are there simply because proper comparables are incredibly hard to find. This is more so in a developing country like India where industry is still evolving, new industries are being opened up and the market hasn’t matured completely.
So due to this paucity of comparables, the only option in such a case is to take the existing comparables and perform ‘adjustments’. These adjustments are not enshrined anywhere and the TP provisions are delightfully vague on them! For example Rule 10B(e)(iii) on TNMM states “(iii)  the net profit margin referred to in sub-clause (ii) arising in comparable uncontrolled transactions is adjusted to take into account the differences, if any, between the international transaction and the comparable uncontrolled transactions, or between the enterprises entering into such transactions, which could materially affect the amount of net profit margin in the open market” . What `differences’ are to be accounted for and what will `materially affect’ the net profit margin is left to the taxpayer to substantiate and it is no surprise that the Department almost always disagrees. Many of the adjustments required such as risk, working capital, depreciation, idle capacity etc. are totally subjective and result in a lot of disputes between the taxpayer and Department. Furthermore, there are many “filters” applied for rejecting comparables such as those having export sales less than 25% of total revenue, those companies that make persistent operating losses and those companies that have high turnover and super-profits – well, what is super-profit? What is high turnover? Surprise, surprise – there are no quantifications for these filters and the result is the entire exercise often devolves into something farcical where the Department cherry-picks its comparables justifying a high profit % and the assessee picks its own set of comparables with a % close to its profit % and then both start bartering i.e., give and take of comparables. The difficulty is compounded by the fact that the comparables are selected on the basis of the published financials, which as we all know only display only the required minimum and so do not provide an adequate basis for comparing companies.
This is a simplified example and one can imagine much more complex scenarios in real life. Consider the case of software startups – their very USP is being incomparable to other companies; consider the cases of firms developing and/or trading in intangibles– the absence of clear guidelines makes it impossible to engage in a fruitful function, risks and assets (F.A.R) analysis as prescribed by TP provisions.
These issues with adjustments are not restricted to TNMM alone. Even when we use other methods, such as CUP, adjustments maybe required for both internal & external CUP causing very much the same confusion. Let us take a simple example: a toy company EFG India Ltd. exporting toys to its owner EFG PLC, UK on bulk contract basis as well as selling in the domestic retail market in India, has to make adjustments for the domestic vs. UK export market, wholesale vs. retail (i.e., volume discount) etc. in order to apply internal CUP.
In short, the TP provisions are not simple and practical enough to apply in reality and they more often than not lead to Pyrrhic battle for the taxpayer.
And it gets worse. Leaving the conceptual issues related to TP such as comparables, filters and adjustments, there are numerous practical problems in the implementation Indian TP provisions. The Transfer Pricing Officer (TPO) sometimes uses “customs data” blindly, uses powers to obtain information directly from third-party firms (under Sec.133(6)) without sharing the same or proceeding on the basis of cursory information obtained, applyies TNMM incorrectly, discards loss-making companies outright etc. In a recent case the TPO grabbed customs data directly from the Indian Custom authorities on coal imports without providing detailed information to the taxpayer; further investigation by the taxpayer revealed that the data compared coal of completely different calorific values and was unsuitable in a number of other respects..
These kinds of practical issues are common in Indian TP practice and combined with the theoretical flaws with TP it is no surprise that there has been a huge rise in litigation in Indian Courts on TP issues.
All these TP cases wind up in the traffic jam that is the judiciary (and quasi-judiciary) represented by the Commissioner (Appeals), the Income Tax Appellate Tribunal (ITAT), the High Court (HC) and the Supreme Court (SC) . The judiciary, for all its defects, is the place of last and often best resort for the taxpayer and it has slowly but surely pushed for a reasonable interpretation of TP provisions. However the entire process is uncertain and takes too long a time for the taxpayer. To make things worse, we now see an aggressive Revenue Department which does not wait for outcome of judicial proceedings but proceeds to attach properties & bank accounts unless some portion of the tax demand is paid. So, what is a taxpayer to do? The answer depressingly seems to be nothing, except to write articles such as these and hope for the best.
However, every cloud has a silver lining and the uncertainty of TP provisions and the Indian taxation regime in general has caused tremendous investor and public backlash in recent times. The Vodafone™ case relating to capital gains taxation is much publicized but it is symptomatic of the general discontent and angst at the terrible uncertainty, fickle nature and occasionally over-rigorous implementation of taxation provisions in India. This has led to tremendous pushback from those that matter i.e., those with money and the leviathan that is the Indian Government is slowly waking up. We recently saw some effort in the right directions by the Government in the recent formation of a Committee to study safe-harbor rules, in introducing a new placeholder section for such rules (Sec.92CB), by the introduction of Advance Pricing Arrangements (Sec. 92) and in prescribing a new TP method (Rule 10AB), though defined ambiguously, which basically allows use of any method (such as quotes, valuations etc.) for purposes of TP.
Frustratingly, we still see retrograde measures being introduced in tandem such as specified domestic transactions (Sec.92BA) now being brought under TP; retrospective amendments relating to definition of international transaction and to restrict the arm’s-length range, introduction of general anti-avoidance rules (GAAR). This last was so heavily criticized that it has been postponed.
What is the solution? This author feels that a three-pronged approach may work – first is to introduce sector-wide safe harbors which one believes the Government is working on and is great news for the industry. This would work by prescribing profit %’s for each sector tied to a published industry-wide index. Another solution is to consider the use of Formulary Apportionment (FA) wherever possible in addition to ALP – FA is an intuitive formulaic sharing approach splitting up the profits amongst the group companies across the globe. The third solution is of course to streamline the current provisions and make them more practical and applicable – some concrete suggestions are to use multiple year data, use inter-quartile ranges, to avoid cherry-picking comparables, to not discard loss making comparables outright, to provide clear and precise guidance on adjustments and filters, and to allow select technical expert references for comparability analysis.
Whether all this will happen is anybody’s guess. Unfortunately, from past experience one can say that the only certainty in Indian taxation is that there will always be uncertainty. Combined with the underlying ambiguity and hollowness of TP viz. a viz. the arm’s-length principle itself what we have here is a perfect storm.
In conclusion, it is clear that TP itself needs a fundamental re-think and that the ALP arm’s-length principle while good in theory does not pan out well in practice. It is time alternative systems in TP are thought through and brought to the fore. It is also clear that with respect to Indian taxation, the TP provisions are the most important in terms of tax revenue as well as one of the most controversial and highly litigated tax provisions and the pressing need of the hour is to reform them and make their language and implementation certain and practical for the taxpayer.