Transfer Pricing Presentation Important Lesson

Convergence between Customs and Transfer Pricing,
Application of Transfer Pricing to Section 10AA,

Corporate Governance

CA Milind Kothari

4th Intensive Study Course on Transfer Pricing CA Milind Kothari
12 April 2014
TABLE OF CONTENTS

Convergence of Transfer Pricing and Customs
Background of Transfer Pricing and Customs
Key Similarities and Differences
Comparison of Key Evaluation Methods
Issues and Impact
Achieving Price Certainty
Indian Jurisprudence
Recent Convergence Initiatives
Applicability of Transfer Pricing to Section 10AA
Transfer Pricing and Corporate Governance
12 April 2014
BACKGROUND

Introduction to Transfer Pricing and Customs Regulations...

Page 4
Transfer Pricing Customs
Transfer Pricing provisions seek to prevent shifting of
profits by MNCs from high tax rate jurisdiction to low
tax rate jurisdictions to minimize tax cost at group
level
Customs Valuation is the process where customs
authorities assign a monetary value to goods for
the purposes of import
Transfer Pricing regulations form a part of the Income
Tax Act, 1961
It is covered under the provisions of Customs Act,
1962
Arms Length Concept used for all inter-company
transactions
Arms Length Concept used in respect of imports
from related parties
Principally, OECD Transfer Pricing guidelines are
followed
Provisions of WTO Agreement on Customs
Valuation for determination of value on imported
goods are followed
... Introduction to Transfer Pricing and Customs Regulations

TP Adjustment
Risk
Customs Duty
Risk
0
50
100
150
200
250
Page 5
Price of
Product
Low Medium High
Challenge for Taxpayer - Optimum balance between Transfer Pricing and Customs
12 April 2014
KEY SIMILARITIES AND DIFFERENCES

Page 7

Transfer Pricing and Customs
Concern and Objectives
Key Aspects Transfer Pricing Customs
Concern That price paid in a related party purchase
transaction is too high and/or the price
charged in a related party sale transaction is
too low
That price paid in a related party
purchase transaction is too low.
Primary Objective of
Importing County
Maximizing taxable income by minimizing the
value of goods imported [which, in turn, will
show lesser expenditure and greater profits]
Maximizing import duty by maximizing
the value of goods imported
Page 8

Transactions covered
Transactions Covered /
Scope
Covers import and export of services,
tangibles and intangibles from Associated
Enterprise
Restricted to imports of tangibles
from related parties
Associated Enterprise /
Related Party tests
Enterprise which participates directly or
indirectly or through one or more
intermediaries in the management, control
or capital of the other enterprise.
Enterprise in which one or more persons
who participate directly or indirectly or
through one or more intermediaries in the
management, control or capital are the
same persons who participate in the
management, control or capital of the
other enterprise.
One of them directly or indirectly
controls the other
Both of them are directly or
indirectly controlled by third
persons
Together they directly or indirectly
control a third party
Page 9

Valuation Related Aspects
Valuation
objective

Assess whether the transaction price for
purchase of goods/services does not
exceed the arms length price
To determine whether the relationship
between the parties has affected the
price
Deviation from ALP /
fair market value
Deviation of + / - 3% between transaction
value and Arms Length Price is
permissible
No such range specified; left to the
discretion of the Appraiser/ Customs
Valuation Officer
Deviation from ALP No hierarchy of method to be applied
- Use of Most Appropriate Method (see
next slide for details)
Methods to be sequentially followed (see
next slide for details)
Page 10

Valuation Methods
Comparable Methods
which can be applied
Comparable Uncontrolled Price Method Transaction Value (of
Identical/Similar goods)
Resale Price Method Deductive Value Method
Cost Plus Method Computed Value Method
Profit Split Method No Corresponding Method
Transactional Net Margin Method No Corresponding Method
Other Method Residual Method
Page 11

Procedures and Compliances
Frequency of valuation Annual At the time of import of goods
Documentation
requirements
Enterprise and Transaction wise
Contemporaneous Documentation to be
maintained by the taxpayer
No requirements specified by the
legislation
Reference to
special
valuation
authorities
Reference to Transfer Pricing Officer (TPO)
made if found necessary, generally based on
certain monetary thresholds
Reference to Special Valuation Branch
(SVB) per import consignment
Audit Prescribed under law lower threshold limit
leads to audit on year to year basis
Conducted on need basis
Validity of the
order
TP order valid for the year for which
the audit takes place
Generally, SVB order is valid for three
years unless manner in which import
transactions occur changes materially
Page 12

Penalties
Penalties 100% to 300% of tax on adjustment amount
on account of concealment of income
2% 4% of transaction value for non-
maintenance of prescribed documentation
and non-furnishing the same before the TPO
INR 100,000 for non-furnishing of Form
3CEB
100% to 300% of Customs duty not
paid/short paid
Interest on non-payment/ short
payment of Customs duties
Possible confiscation of import
consignments
Possible punitive action on importer
12 April 2014
Comparison of Key Valuation Methods

Page 14
Similarities
Both methods compare the prices charged for identical goods imported at or about the same time as the goods being
valued.
Following adjustments from the value of identical goods sold are to be considered (common to both the methods):
- Quantity Factors
- Commercial Level Factors
- Significant differences in costs and charges included in goods being valued and transaction value of identical goods

Differences
While under CUP Method, product comparability is to be seen strictly; customs regulations provide for consideration of
transaction of similar (if not identical) goods imported.
Where more than one price has been determined, Transfer Pricing Regulations consider arithmetical mean of prices;
however as per customs regulations, the lowest value of the transaction values found is to be considered
Transfer Pricing and Customs A Comparison of Valuation Methods
Comparable Uncontrolled Price Method vs. Transaction Value of Identical Goods
Page 15
Illustration
XYZ imports 10 kgs of raw materials from its foreign associated enterprise at a unit price of INR 1000 per kg.
Details of comparable imports made in India at the same time are as follows:

In the above illustration, the arms length price for transfer pricing purposes would be considered as the arithmetical mean of INR
965 per kg. Accordingly, the transfer pricing officer may propose a transfer pricing adjustment for the excess price of INR 35 per
kg paid by XYZ to its associated enterprise.
On the other hand, customs authorities may value the related party import at INR 1050, being the lower of prices for the same
quantity as that purchased by XYZ from its associated enterprise (i.e. 10 kgs) and may thereby levy additional import duty on INR
50 per kg.
Transfer Pricing and Customs A Comparison of Valuation Methods
Comparable Uncontrolled Price Method vs. Transaction Value of Identical Goods
Quantity (in Kgs) Price
10 1050
12 830
8 905
10 1075
Arithmetical Mean 965
Page 16
Similarities
These methods are adopted if the imported goods are resold as such, without any processing which might add value to
the goods so imported.
Under Resale Price Method, gross margins earned by the taxpayer (from uncontrolled transactions) or by companies
engaged in a similar business and direct costs incurred by the taxpayer are reduced from the price at which the imported
goods are resold by taxpayer to an unrelated person to arrive at the arms length price of the imported goods
Similarly, under the Deductive Value Method, the following adjustments from the value of identical goods sold are to be
considered:
- either the commission usually paid or agreed to be paid or the additions usually made for profits and general expenses in connection
with sales in India of imported goods of the same class or kind;
- the usual costs of transport and insurance and associated costs incurred within India;
- the customs duties and other taxes payable in India by reason of importation or sale of the goods.
Differences
While the Resale Price Method would fail in a situation where imported goods are resold after processing, deductive
value method provides for consideration of such resale value, after providing for due allowances for value added on
account of processing.

Transfer Pricing and Customs A Comparison
Resale Price Method vs. Deductive Value Method
Page 17
Similarities
Both the methods use the cost or value of materials and fabrication or other processing employed in producing the
imported goods as the base
They deal with adding an amount for profit and general expenses equal to that usually reflected in sales of goods of the
same class or kind as the goods being valued which are made by producers in the country of exportation for export to
India.

Issues
Such an approach may not be feasible especially from a transfer pricing perspective as it entails selection of the foreign
Associated Enterprise as the tested party, relevant data for which might not be available to the taxpayer.
Further, determining the profit markup to be added to the cost of materials and/or processing would entail conducting
a benchmarking analysis on foreign databases, which again might not be feasible, especially for small taxpayers.
Cost Plus Method vs. Computed Value Method
Page 18
Other Method, under transfer pricing law, indicates any method which takes into account the price which has been
charged or paid, or would have been charged or paid, for the same or similar uncontrolled transaction, with or between
non-associated enterprises, under similar circumstances, considering all the relevant facts.

Residual method, under customs law, provides that where the value of imported goods cannot be determined under the
provisions of any of the specific methods, the value shall be determined using reasonable means consistent with the
principles and general provisions of these rules and

on the basis of data available in India.

Other Method vs. Residual Method
12 April 2014
ISSUES AND IMPACT

Page 20
Impact on customs should be considered while setting a Transfer Price or changing it prospectively
Retroactive upward adjustments to transfer prices may trigger issues from a customs perspective
- May lead to suspicions that previous imports were undervalued
- May result in additional customs duty owed and disclosures
Retroactive downward adjustments to transfer prices, on the other hand, may not be acceptable to customs authorities.
Therefore, excess customs duty paid on the differential is an added cost to the taxpayer
ALP under tax law may result in Customs valuation risk
- Under transfer pricing law, it may be possible to justify the arms length nature of purchase of diverse range of products with
differential purchase prices, or setting off of higher margin products against lower margin products (say, by adopting TNMM, where
entity level margins are benchmarked). However, the same may not be possible from a customs perspective since examination under
customs is of each transaction, as opposed to annual averages/results.
- Under transfer pricing law, it may be possible to justify a lower import price on the basis of arguments such as new product launches;
marketing spend by importer, etc. However, these arguments may not succeed with the customs authorities.

Issues and Impact
Issue Trigger Points
Page 21
Local adoption of Global TP policies
- Global transfer pricing policies might be acceptable for determination of arms length price under local transfer pricing
regulations; however the same might not be accepted by the Customs authorities
Royalty payments, Cost Contribution Agreements, payment of Management Service Fees
- Payments such as royalty, management service fees may be justified to be at arms length by maintaining rigorous transfer
pricing documentation to support the same
- However, Customs Authorities may treat such payments as compensation for lower import value of goods and may thus levy
additional duty by adding the value of such payments to import value of goods
Advance Pricing Agreements (APAs)
- APAs obtained by taxpayers to achieve certainty in TP matters may not include Customs Authorities in discussions,
- Therefore, though the transfer prices agreed in an APA might provide certainty from a transfer pricing/income tax point of
view, the uncertainty regarding customs valuation may still persist.

Issues and Impact
Issue Trigger Points
Page 22
Double taxation
- No provision for tax refunds under either laws in case of adjustments made in the other law
- Corresponding adjustments to associated enterprise/related party not available
- Results in additional global tax cost to the Group
Hardship to the taxpayer on account of differences in
- Methodologies
- Documentation requirements
- Use of comparables
- Asymmetrical information availability
- Timing of valuation/audit
- Assessment and audit provisions
Due to differences in compliance requirements under the two laws, maintenance of records increases the cost of
administration of the taxpayer.
No provision for joint price setting/evaluation for transfer pricing and customs purposes

Issues and Impact
Impact on Taxpayer
12 April 2014
ACHIEVING PRICE CERTAINTY

Page 24
APAs are agreements entered into between the taxpayer and the income tax authorities for pre-determining transfer
prices to be applied for transactions to be entered with associated enterprises. APAs are generally seen by taxpayers as
the ultimate achievement of certainty around the acceptability of their transfer prices from an income tax perspective.
Similarly, Indian Custom Authorities issue Advanced Rulings for determining the customs valuation in advance, providing
certainty to taxpayers.
However, the prices agreed in an APA from an income tax perspective may not be acceptable to the customs authorities
and vice-versa. Thus, there is a need to have a mechanism wherein both the income tax as well as custom authorities
can be jointly approached in negotiations for setting prices for transactions involving cross-border movement of goods.

Achieving Price Certainty
Advanced Pricing Arrangement (APA) vs. Advanced Rulings
12 April 2014
INDIAN JURISPRUDENCE

Page 26
Panasonic India Pvt. Ltd. vs. ITO [[2011] 43 SOT 68(DELHI)]
The Tribunal rejected taxpayers reliance on valuation done by SVB for customs valuation by observing that customs
valuation and determination of ALP for income tax purposes serve different purposes and rules under the respective laws
need to be followed
Serdia Pharmaceuticals (India) Pvt. Ltd. vs. ACIT [[2011] 44 SOT 391 (Mumbai)]
The Tribunal rejected taxpayers contention that import prices being accepted by customs authorities, ought to be
considered as arms length for transfer pricing purposes as well. It observed that the onus of the taxpayer is discharged
only when the ALP is determined in accordance with the transfer pricing regulations
Fuchs Lubricants (India) Pvt. Ltd. vs. DCIT [ITA NO. 6339/Mum/2011]
The Tribunal observed that value of raw material imports accepted by custom authorities cannot be considered as arms
length price under the provisions of Income Tax Act.

Transfer Pricing Rulings for use of / reliance on customs data
Page 27
Mobis India Ltd. vs. DCIT [ITA No. 2112/Mds/2011]
The Tribunal held that the valuations made by customs authorities on import of raw material for purpose of levy of
customs duty cannot be considered as a comparable. The purpose of valuation by the customs authorities is to determine
undervaluation, which by its very nature, would not fit with the scheme of transfer pricing analysis under the Income Tax
Act.
Tilda Riceland Pvt. Ltd. vs. ACIT [[2014] 42 taxmann.com 400 (Delhi - Trib.)]
The Tribunal upheld taxpayers reliance on database maintained by Tips software for comparison of prices of basmati
rice as it consisted of information publicly available with the customs department.
Coastal Energy Pvt. Ltd. vs. ACIT [[2011] 12 ITR(T) 347 (Chennai)]
The Tribunal held that the taxpayer has no locus standi to question the credibility of customs data relied upon by TPO.
Customs authorities assign values to imported goods on the basis of scientifically formulated methods and is not an
arbitrary exercise.

Transfer Pricing Rulings for use of / reliance on customs data
12 April 2014
RECENT CONVERGENCE INITIATIVES

Page 29
Many countries have initiated processes to increase interaction between the Customs and Transfer Pricing authorities

Various governments have issued guidelines to resolve the Customs / TP conflicts USA, Australia, Canada, Chile, France,
etc.

Review of TP Studies, Advance Pricing Arrangements and other TP documentation for determining customs value

World Customs Organization/OECD Conference on TP and Customs Valuation in Brussels May 2007 followed by meeting
of the Focus Group on Transfer Pricing , 26 October 2007
Global Initiatives
Page 30
Australia
The Australian Customs authorities have published Practice Statements to provide guidance for Customs staff and
industry stakeholders on Customs policies on valuation of imported goods that involve transfer pricing arrangements.
Further, legislative changes are being recommended to facilitate transfer pricing arrangements to allow refund of
overpaid duty by reason of any downward adjustments.

USA
Recently, the US customs authorities have shown some willingness in certain circumstances to consider a multinational
importers Internal Revenue Service(IRS) approved Advance Pricing Agreements (APAs), transfer pricing studies, and
other tax-related pricing practices in establishing the customs valuation of imported goods.
Further, in a policy change proposed by the customs authorities, importers ought to report any post-importation price
adjustments (either upward or downward) made pursuant to a documented transfer pricing policy. Depending upon the
circumstances, an upward adjustment may require an additional customs payment and a downward adjustment may
permit a refund.
Global Initiatives Select Jurisdictions
Page 31
A Joint Working Group comprising senior officers from Income Tax and Customs Departments was constituted to study
the subject of Transfer Pricing (Price adjusted in Related Party Transactions) in the context of Income Tax and Customs
laws, and to suggest measures on co-operation between the two Departments. The Group was co-chaired by Member
(IT), CBDT and Member (Customs), CBEC.
Vide Customs Circular No. 20/2007 dated. 8 May, 07, it was decided to implement the following recommendations of the
Joint Working Group:
- Two Tier co-operation through recommended Bi-monthly and Six-monthly joint meetings
- Training programs for officers of both Departments
- Sharing of Related Party information on a Need to Know basis
- Exchange of information on specific-cases

Indian Initiatives
12 April 2014
APPLICATION OF TRANSFER PRICING TO SECTION 10AA

Page 33
Tax holiday Units covered under sections 10AA
No tax holiday on more than ordinary profits i.e. excessive profits
Application of ALP principle prescribed under Indian TP Regulations
Impact of introduction of Domestic TP
- Fine balance required between transfer pricing and tax holiday provisions
- Suo-motu reporting of inter-unit and inter-entity transfers/transactions implies better availability of relevant data and information with
the revenue authorities

Applicability of Transfer Pricing to Section 10AA
12 April 2014
TRANSFER PRICING & CORPORATE GOVERNANCE

Page 35
Increasing trend of Transfer Pricing Adjustments from INR 45,000 Crore in FY 2011-12 to INR 70,000 crore in FY 2012-13
and INR 60,000 crore in FY 2013-14
Uncertainty - Limited guidelines and contradictory rulings by Indian courts
Significant value adjustments by TPOs on account of share valuations, corporate guarantees, marketing intangibles, etc.
Corporate Governance pressure points:
- Being aware of legal positions and ensuring their alignment with other Indian laws
- Understanding of Pricing Methods being followed for various transactions and appropriateness thereof
- Ensuring Documentation requirements are strictly and completely met with
- Updation with judicial and legislative developments in India and overseas, on a real-time basis
- Ensuring timeliness and completeness in compliances
- Being aware of penal consequences

Transfer Pricing & Corporate Governance
Page 36
Governing Boards should increasingly take responsibility for identification, quantification and management of transfer
pricing risks from a corporate governance perspective:
- Identify material intra-group transactions, especially off-balance sheet items
- Ensure co-ordination among cross-functions such as operations and finance so that pricing adjustments are appropriately
documented in intercompany agreements
- Conduct an impact analysis of potential transfer pricing risks that could lead to double taxation, increase in effective rate of
tax at the Group level
- Reporting and justifying transactions not at ALP in Board Report
- Recourse to TP documentation for statutory disclosures i.e. Alignment with Cost Audit Rules 2011, Companies Act 2013, AS-18
issued by ICAI, tax audit report disclosures
- Pro-active approach for amendments in the legislation or introduction of new legislation; for instance, proposed DTC 2013
- Use of APAs and safe harbours for better certainty
Transfer Pricing & Corporate Governance
12 April 2014
THANK YOU

CA Milind Kothari

Contact details
e: milindkothari@bdo.in
t: +91-22-24393601

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Application of Transfer Pricing to Section 10AA,

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