Unfolding the transfer pricing complexities in Indian financial services

Since its introduction, India's transfer pricing regime has emerged as a key challenge for multinational enterprises doing business in the country. Over the past few years, the Indian transfer pricing litigation environment has been continuously evolving, with the intensity of audits and tax adjustments increasing year after year. It has been estimated that the total value of adjustments for transfer pricing audits undertaken during the financial year (FY) 2013-14 was about $9 billion, resulting in adjustments in almost 53% of the cases audited by field level officers, according to the Indian Ministry of Finance's Annual Report FY 2013-14.

The effect of aggressive transfer pricing audits has been felt across industries, and the financial services sector is no exception. Transfer pricing issues faced by the financial services firms have increased in significance and scope. This may be attributable to the experience gained by field officers in scrutinising financial services transactions, the near absence of guidance in the Indian regulations, and limited judicial precedents on the application of transfer pricing methodology to complex financial services transactions.

This article provides insights into some of the recent transfer pricing challenges faced by multinational banks, asset managers, and alternative investment firms that have a presence in India.

Over the last decade, India has witnessed a sizable increase in the number of foreign bank branches dealing in structured finance products, primarily focused on the Indian market. These products include structured derivative products, corporate banking products, commodities trading and foreign currency loans, etcetera.

Before delving into the issues faced by Indian branches, it is important to understand the key activities undertaken by the parties to the transaction and the compensation model generally adopted by the banks. Typically, Indian branches are responsible for dissemination of local market information, opportunity/target identification, liaising with potential customers, origination of the deal, and assistance in structuring and maintaining client relationships. The overseas branch/head office is engaged in product development, approving the structuring performed by the Indian branch, credit approval, pricing and booking the deal on its balance sheet, and subsequent management of the positions.

With respect to the compensation model, many foreign banks have global policies for determining the compensation for such origination and marketing activities. For such derivative transactions, Indian branches are generally compensated as per the foreign bank's global policy, using a benchmark that may be a percentage of the client value, a portion of the value added on a transaction, a percentage of day one profit/loss, or a proportion of the commercial markup of each transaction. This compensation model typically results in a split of the initial dealer spread – the difference between final price quoted to the client by the marketing team of the Indian branch and the price quoted by the trading desk – in a specified ratio between the Indian branch and the foreign bank.

During audit, the Indian Revenue has tended to take a position that the Indian branch should be entitled to the larger initial dealer spread, contending that the spread is earned due to the efforts of the Indian branch's marketing/sales team. Further, the Indian Revenue has put forth that the default credit risk is also borne by the Indian branches when such branches enter into swaps and options on their own account, effectively resulting in the capital of the Indian branch getting blocked, and warranting additional compensation to be attributed to the Indian branch. As a consequence, we have often seen the Indian Revenue propose adjustments equal to almost 100% of the initial dealer spread.

With respect to other banking products, Indian branches have developed key capabilities over the last few years, resulting in an increase in their level of involvement in origination activities. Because of the enhanced role, there has been a gradual shift in the remuneration model from a cost-plus approach to a more sophisticated profit/fee-split model. The Indian Revenue, during audits, tends to take a position that because the Indian branches are undertaking certain key entrepreneurial risk-taking (KERT) functions, revenue splits should be applied to test the arm's-length nature of such origination activities undertaken by the Indian branches. To support its case, the Indian Revenue has resorted to the use of outside comparables by finding support in the global transfer pricing policies of other banks and proposing adjustments on that basis. Overall, the Indian Revenue tends to assign a higher weightage to the origination activity undertaken by Indian branches, effectively resulting in a significant portion of the revenue/profits being attributed to the Indian branch.

Although partial relief has been granted by the appellate authority in a few cases, the matter is still being litigated at the Income Tax Appellate Tribunal (ITAT) and has yet to reach any finality.

Transactions involving the provision of investment advisory services have also been the subject of scrutiny by the Indian Revenue, and substantial tax adjustments have been proposed over the last few years.

The advisory model being followed in India is similar to the model followed across the globe, wherein an adviser provides nonbinding recommendations on potential investment/divestment opportunities to their investment adviser/manager abroad. The investment manager is responsible for selecting and managing the investments, and makes all the key decisions with regard to such investments/divestments.

The remuneration model for Indian advisers is generally a recharge of the local operating costs incurred by the advisers, along with a mark-up on such costs, which is generally low. In our experience, the Indian Revenue has, in the past, proposed high mark-ups in the range of 40% to 50% over operating costs which has been the subject of litigation.

In proposing such adjustments, the Indian Revenue has generally held that the advisers add substantial value to the activities undertaken by the investment manager, primarily based on the observation that the Indian advisers have highly skilled and qualified professionals on their payrolls and that they play an important role in assisting the investment manager while making investment/divestment decisions. In some cases, they are also present on the board of the portfolio companies. Based on all these factors, the Indian Revenue surmises that the Indian advisers should receive higher mark-ups. In terms of the benchmarking analysis, the Indian Revenue has often rejected the comparable companies selected by the investment advisers and has selected companies primarily engaged in investment/merchant banking activities. In many cases, this has failed on a functional comparability basis, and the ITAT has provided substantial relief, but the authorities at the field level tend to continue with their approach, waiting for a higher court ruling and not agreeing with the ITAT rulings.

Accordingly, it is of paramount importance for investment advisers to support the limited-risk nature of their advisory activities with a detailed functional and risk analysis backed by internal documentation in the nature of research reports/deal-related papers to demonstrate that they are not involved in any decision-making activities and merely render their services under the directions of the overseas investment manager.

To seek relief from onerous litigation, many private equity players have taken recourse to advance pricing agreements (APAs). This is an area in which the tax authorities have gained significant experience, and an investment adviser can expect an APA application to progress on a fast track. With the thrust provided by the first batch of unilateral APAs concluded in the investment advisory space, which stipulated cost-plus mark-ups in the 20% to25% range, many more private equity firms have lined up to seek relief under the newly introduced APA regime.

Foreign banks operating in India are generally involved in investment banking activities such as advisory activities in relation to mergers and acquisitions, securities issue management, underwriting, and distribution of securities. Typically, the operating model of a global investment bank would involve interplay between group companies spanning jurisdictions, often leading to complex and challenging transfer pricing issues. Coming to the operating model, many investment banks operating in India follow the hub-spoke model, whereby the Indian entity, acting as the spoke, is generally responsible for performing research, marketing/origination, and assistance in structuring a deal. The hub (the head office/overseas entity) performs execution, structuring, and arranging capital. These activities involve regular interaction between various participating group companies and, in some cases, are highly integrated so that a part of the execution is undertaken by the Indian entity itself, leading to a mix of execution and origination functions spread across jurisdictions.

In the past, many Indian entities were remunerated on a cost-plus model because India was considered a support location and not much of a trading or booking location. Lately, some of the investment banking firms have developed a few capabilities and have started performing part of the KERT functions on global deals in India. Consequently, there has been a shift to a fee/ profit-split approach, depending on the functional and risk profile of the Indian entity. Such application of profit-split may be either under the residual method or under contribution analysis, depending on the facts and circumstances of the case.

Often, investment banking activities include a mix of routine functions and significant intangibles contributions for a particular transaction type. In such a situation, the routine functions may be compensated at an appropriate rate of return and the residual combined profit may be allocated on the basis of relative value of intangibles contributed by the entities involved in the transaction. In situations when there are no major routine functions and all entities possess unique and valuable intangibles, then contribution analysis becomes essential and is often applied to price the related-party transaction.

The Indian Revenue, while basing audits on the changing business scenario, has taken the position that the services rendered by the Indian entity are high value-driving activities, and require attribution of a higher percentage of the fee earned on a transaction. In line with that approach, we have seen the Indian Revenue in some cases allocate 50% to 60% of the total fees to the Indian entity during the audit stage. The Indian Revenue also undertakes an analysis using the transactional net margin method (TNMM) to corroborate the global pricing policy of profit/fee-split adopted by the taxpayer.

Though partial relief has been granted to a few banks during appellate proceedings, the matter is still being litigated at the ITAT level and has yet to reach any finality. However, with the advent of the APA regime, it is expected that a few cases on investment banking, where the pricing is based on the application of global transfer pricing policy across multiple jurisdictions, are likely to get settled in the coming years.

For this segment of the financial services sector, the issue often relates to the selection of the transfer pricing method, wherein the Indian Revenue has demonstrated a preference for the use of the comparable uncontrolled price (CUP) method rather than the TNMM generally selected by taxpayers. The dispute arises primarily because of the difference in brokerage rates charged to overseas affiliates vis-à-vis the rates charged to third-party institutions.

Many foreign brokerage houses operating in India cater to their overseas affiliates, foreign institutional investors (FIIs), and domestic institutional investors. Thus, the brokerage rate charged to third-party FIIs can be considered an internal comparable for benchmarking the brokerage rate charged to overseas affiliates. In the case of trades with overseas affiliates, generally a lower brokerage fee is charged, because the volume of business from affiliates is generally high compared to third-party trades, and because the Indian entity does not have to undertake marketing and research activities and assumes lower risks while rendering brokerage services to its affiliates.

Although the services rendered under both types of trades are broadly similar, there are numerous differences in the two trades, such as volume of business, level of marketing activity, and the level of risks involved that influence the brokerage rates. Indian entities prefer selection of TNMM in many cases, owing to the fact that quantifying and making appropriate adjustments for the above differences is often a challenge. The Indian Revenue, however, often reject the TNMM approach followed by the Indian entities, and frequently selects the CUP as the most appropriate method by comparing third-party trades to trades with affiliates, without making all the adjustments for the various differences discussed above.

Considering the Revenue's preference for the CUP method, it is often advisable to maintain robust documentation to substantiate key differences between the two types of trades and to make appropriate adjustments when the CUP is selected as a corroborative method.

Many foreign banks have set up subsidiaries in India to render centralised back office services to their group companies. This transaction has been under close review by the Indian Revenue for almost a decade and is often the first transaction to be scrutinised during audit proceedings.

Back office support services are generally in the form of accounting, human resources, legal, regulatory, processing of contracts, information technology, product-specific accounting, and finance support and administrative assistance. The remuneration model is generally a recharge of the local operating costs incurred by the Indian entity, along with a low mark-up on such costs. However, the mark-up charged by the Indian entities has been a subject of intense litigation, where we have seen that the Indian Revenue proposes mark-ups in the range of 25% to 30% over operating costs. Disputes also arise regarding the characterisation of the Indian entity, that is, whether the activities are in the nature of a back office service or knowledge process outsourcing services. In a few cases, the Indian Revenue has also taken the position that the activities being rendered by the Indian entity are in the nature of knowledge process outsourcing services warranting a higher mark-up.

There a few favourable rulings at the ITAT level providing relief to the Indian entities on the level of mark-up proposed by field officers. However, field officers continue to charge high mark-ups on this transaction during the audit stage. As a long-term solution to protracted litigation, many entities have chosen to address this issue through the APA/Mutual Agreement Procedure (MAP) route. It can be said, without any doubt, that APAs are a good option to offer much-needed clarity and certainty to taxpayers rendering back office support services. Many APAs pertaining to back office support services are at an advanced stage of negotiation. In addition, there has been a favourable development with respect to MAP cases relating to provision of low-end/back office support services, with many cases having already been successfully resolved and the pending cases being fast-tracked.

As the Indian tax authorities' approach to analysing financial services transactions has evolved, it has become imperative for taxpayers to undertake a detailed and careful evaluation of their existing transfer pricing arrangements to ensure that those arrangements are mapped to the group's global policy, and are consistent with their functional and risk profile. Further, with BEPS around the corner, it becomes essential for the financial services industry to focus on the transparency of information relating to global value chain of the multinational enterprise.

Consequently, the financial services industry must deploy a risk management framework for mitigating transfer pricing risks by maintaining robust and effective documentation.

Anis Chakravarty Senior Director, Transfer Pricing Deloitte Touche Tohmatsu India Private Limited Mumbai, India Tel: +91 22 6185 4265 anchakravarty@deloitte.com Anis Chakravarty is a financial services transfer pricing partner in Deloitte India. He brings significant experience in advising companies in the European Union, India and the United States on a number of issues related to economics, finance and transfer pricing. Anis is the co-leader of Deloitte's Global Economists Network. He specialises in advance pricing agreements (APA), transfer pricing risk management and implementation of cost allocation systems. He has assisted a number of financial services institutions including foreign and domestic commercial and investment banks, private equity players and asset management firms with their transfer pricing needs including filing and negotiation of APAs. Anis is involved with the firm's practice and knowledge development initiatives in India and the Asia Pacific region. He is a guest faculty at IBFD Asia Pacific, IFA and other forums, lecturing on various transfer pricing issues. Before joining Deloitte India, Anis was based in Brussels, Belgium, advising European inbound as well as outbound clients on a number of transfer pricing and supply chain issues. Anis is a regular contributor to the print and electronic media on various macroeconomic issues and trade, monetary and fiscal policies. His views have been quoted by Bloomberg, and the Wall Street Journal amongst others. He is a speaker at seminars on topics related to economics, transfer pricing and business and has appeared in various publications.

Vineet Chhabra Director Deloitte Touch Tohmatsu India Private Limited Mumbai, India Tel: +91 22 6185 6803 vchhabra@deloitte.com Vineet is part of Deloitte India's Financial Services Transfer Pricing group and is based out of Mumbai. Vineet has about 14 years of tax and transfer pricing experience in consulting and industry. He has experience across diverse industries with a specific focus on the FSI sector, including banks, private equity, investment management, equity broking and insurance companies. Vineet has recently completed his two years' deputation to Deloitte UK's financial services transfer pricing group. During his deputation to Deloitte UK, he gained significant experience in banking and other FS clients and has assisted in bringing strategic best practices to India. Since the introduction of the APA programme in India, Vineet has been actively involved in more than six FS-focused APAs and has been instrumental in recently concluding the first APA relating to investment advisory. Vineet has also contributed several articles on transfer pricing in tax journals, leading newspapers, etcetera. Vineet holds a Bachelor's degree in Commerce, Diploma in Business Finance from ICFAI and is also Associate Member of the Institute of Chartered Accountants of India.

Neha Bang Manager Deloitte India Mumbai, India Tel: +91 22 6185 6736 nehabang@deloitte.com Neha is part of Deloitte India's financial services transfer pricing group and is based out of Mumbai. Neha has about six years of transfer pricing experience across diverse industries with a specific focus on the FSI sector. She has advised foreign and Indian multinationals in developing their transfer pricing strategies and is involved in implementing transfer pricing policies for them. She has been actively engaged in transfer pricing compliance, audit and litigation process. Her assignments include assisting multinational companies with their documentation requirements, planning and defending their pricing arrangements from an Indian perspective. Neha is a qualified Chartered Accountant from the Institute of Chartered Accountants of India.