Transfer pricing controversies in the TMT sector in India

Over the years, India has gained a special position and made significant advances in the technology sector, with the advantages of a strong labour supply and growing demand. Businesses are investing increasingly in new technologies to stay competitive and provide innovative value propositions to customers.

The first thing that comes to mind when India and technology are mentioned together are the vast software service centres located in India. According to a report jointly prepared by the Boston Consulting Group and the Confederation of Indian Industry: "The Indian IT Industry has been a key driver in the new knowledge economy and [is] expected to touch $100 billion in fiscal year 2013, approximately 7.5% of GDP." The information technology/information technology enabled services (IT/ITeS) sectors in India lead the economic growth in terms of employment, export promotion, revenue generation, and standards of living. The market size of the IT/ITeS industry is expected to rise to $225 billion by 2020.

On the demand side, technology adoption in India has not been the same across industries. Certain industries such as banking, insurance, and telecom have embraced technology to efficiently carry out revenue-generating functions, back-end support functions, customer interface, and billing functions. Conversely, technology penetration has not been significant in other sectors, including healthcare, education, government, and retail.

The media industry in India is multidimensional, and predominantly follows the global trends of digitisation and convergence. India has been a developer of content and media technology, while becoming a growing consumer of global content.

The media and entertainment industry in India grew at approximately a 12.6% rate in 2012, and is expected to grow at an 11.8% rate in 2013, driven by digitissation and growth in new media. In spite of being the most prolific movie making country in the world, television production dominates the media and entertainment landscape in India, growing at a 12.5% rate in 2012 and accounting for $6.37 billion of total revenue in this industry. Films were ranked third behind the print industry in terms of revenue, accounting for $1.9 billion.

In terms of content development, animation is an emerging industry. The current sise of the Indian animation industry is estimated at $247 million, and it is expected to grow at a rate of 15% to 20% per annum. The Indian animation industry employs over 80,000 people, and there are over 650 animation studios in India located in cities such as Mumbai, Hyderabad, Chennai, and Bangalore.

The telecommunications sector in India has been one of the fastest growing industries since the last decade, and it is likely to continue to be on a growth path in the coming years. According to a report prepared by Telecom Regulatory Authority of India, the total wireless subscriber base in India through January 2013 was 863 million, of which 708 million (approximately 82%) were active mobile users. While the mobile subscriber base is growing exponentially, the number of landline users in the country is gradually decreasing.

Taxpayers in the TMT sector inherently have high intellectual property content, and the time gap between investment and returns can be long, subjecting companies in these industries to fluctuating returns. Moreover, in India, this industry continues to evolve, leading to more unpredictable returns. For instance, one major player within the telecoms industry – Reliance Communication Limited – was barely able to break even last year, whereas another major company – Bharti Hexacom – earned an operating margin of approximately 30%. As a result, this industry has been increasingly under the lens of the Indian tax authorities from a transfer pricing perspective.

The TMT sector has been facing audits on various issues, most of which relate to basic transfer pricing analysis such as the type of comparable companies selected, use of single-year data, and application of a turnover filter. For instance, in the recent case Vodafone India Services Private Limited (Vodafone India), the Mumbai bench of the Income Tax Appellate Tribunal (ITAT) disagreed that Vodafone India was providing low-end activities, and allowed the selection of companies providing high-end services to be used as comparable. ITAT further held that arguments such as high turnover and super normal profits were not sufficient basis to consider a company as not comparable. In a contrasting decision, the Bangalore bench of ITAT ruled in favor of Autodesk India Private Limited, which is engaged in rendering technical services for the development of entertainment products including 3D animation, and accepted the taxpayer's argument for exclusion of companies with significantly high turnovers.

Factors relating to turnover filter and super normal profits are significant because rather than relying on the interquartile range, which excludes outliers, the arithmetic mean of comparable companies' return is used to calculate the arm's-length price.

Other recent issues affecting the TMT industry include the treatment of research and development (R&D) centres, marketing intangibles, locationa savings, and intragroup services.

Generally, MNEs maintain that the Indian affiliate is a captive R&D centre, involved in less complex functions and bearing insignificant risks in the overall value chain, however, the tax officers have argued that these entities perform significant functions, and therefore should be considered to bear significant risks. This notion has been the subject of litigation, was outlined in India's submission to the United Nations Transfer Pricing Manual for Developing Countries, and was reinforced in a recent circular released by the Indian government. For instance, in the case of GE India Technology Centre Private Limited, the ITAT emphasised that an R&D centre cannot be completely risk free, if core R&D activities are carried out in India.

Because of the increasing number of audit controversies, the Indian tax authorities recently released a circular to provide clarification on the issue of R&D centres. The circular lays down guidelines to identify a contract R&D service provider assuming insignificant risk. The circular requires that the foreign principal perform economically significant functions, provide capital and other economically significant assets (including intangibles), provide direct supervision, assume economically significant realised risks, and have ownership rights (legal or economic) on the outcome of the research, for the Indian R&D centre to be classified as a contract R&D service provider.

In the last few years, a highly debated issue in transfer pricing audits and litigation has been the existence of marketing intangibles, when the Indian affiliates of MNE groups incur significant advertising, marketing, and promotion (AMP) expenses.

In the case of LG Electronics India Private Limited, the special bench of ITAT in its detailed order held that incurring AMP expenses by the taxpayer toward building a brand legally owned by the foreign affiliate constituted a "transaction" and the foreign entity should pay for the AMP expenses above the bright line. Bright Line test was laid down by the US Tax Court in the case of DHL Incorporated, wherein it was held that the expenditure on advertisement and brand promotion expenses which exceeded the average of AMP expenses incurred by the comparable companies, created marketing IP. Haier Telecom Private Limited, from the telecom industry, and Star India Private Limited, a prominent media company in India, were also part of this litigation as interveners. The ITAT's decision will have far reaching effect and will impact a large number of Indian taxpayers that are incurring significant AMP expenditures in respect of global brands in India.

In our view, the issue is far from being resolved, and more litigation is expected.

The tax authorities have argued that due to easy access to low-cost skilled manpower, MNEs enjoy substantial cost savings in India. In addition to location savings, MNEs also obtain certain location-specific advantages, such as access and proximity to growing local/regional markets, superior information and distribution networks, and a large customer base with spending ability. However, thus far, there has not been a successful effort to quantify the impact of location-specific advantages.

Payments of royalties for brand names, trade-marks, and technical know-how by the Indian affiliate to the overseas MNE are often challenged by the Indian tax authorities. It is important to note that until a few years ago, India's Central Bank (the Reserve Bank of India) imposed a cap on the amount of royalties that could be paid out of India. After this cap was removed, the amount of royalties paid out has crept up, and often caused suspicion in the minds of Indian tax officers.

In the case of Samsung India Electronics Private Limited, the tax officer challenged the payment of royalties to Samsung Korea for technical know-how on sales made to the MNE group, arguing that those sales tantamount to sales to itself. The Delhi ITAT held that sales made to another company within the MNE group do not amount to sales to itself, and the tax officer had wrongly endeavored to reach the so-called economic substance, ignoring the legal substance accepted and admitted in separate jurisdictions. The tax officer also contended that the taxpayer had not demonstrated the benefit derived from the payment of such a royalty. Although ITAT in this case compared the royalty payment with third-party royalty payments and considered it at arm's length, there are a number of other cases in which the importance of the "benefit test" has been emphasised.

Passing the benefit test in connection with allowing the payment of royalties has been discussed and upheld by the appellate authorities. The benefit test evaluates the transaction according to the following parameters:

• Do taxpayers require such intangible assets?

• Have the intangible assets actually been received?

• Has the use of intangible assets resulted in any benefit?

• Has appropriate documentation been maintained to demonstrate the receipt of intangible and direct or indirect benefit derived therefrom?

Passing the benefit test will be an important factor in scrutinising royalty payments in the future.

The Indian transfer pricing regulations do not specify the manner in which an arm's length price must be determined for payment for intragroup services. The key to determine the price is whether the services have actually been provided and whether the benefit test has been met.

In a recent case, McCann Erickson India Private Limited paid management service fees and coordination costs, and applied the transactional net margin method (TNMM) to substantiate the arm's length price. The tax officer rejected the TNMM and contended that the taxpayer had failed to demonstrate the benefit derived from such services. The Delhi ITAT upheld the application of TNMM, because the various businesses were interrelated and constituted a single business. Regarding benefit derived, the ITAT held that the benefit derived and occurring to the company must be considered from the angle of a prudent businessman. The term "benefit" to a company in relation to its business has a very wide connotation. It is difficult to accurately measure these benefits in terms of monetary value.

Similar issues were discussed and decided in a number of other cases, which held that payments for intragroup services must satisfy the key attributes similar to the benefit test discussed above.

For sustainable growth in the TMT industry, it is critical that companies operating in multiple jurisdictions have a well laid out transfer pricing policy, and that intragroup transactions satisfy the arm's-length standard supported by robust documentation.

Tax authorities have introduced an advance pricing agreement regime in India effective July 1, 2012, which is likely to provide reasonable certainty to taxpayers in connection with transfer pricing matters. On the other hand, domestic transactions have been brought into the ambit of Indian transfer pricing regulations with effect from April 01, 2012, which reaffirm the Indian tax authorities' aggressive stance. Therefore, both MNE group and Indian TMT companies must be well-prepared, from the initial transfer pricing planning to maintaining comprehensive documentation, and implementing a robust strategy for transfer pricing audits.

Biography
		Rahul Tomar Senior Director Deloitte India Tel: +91 124 679 2909; +91 98114 34269 Email: rtomar@deloitte.com Experience Rahul is currently a senior director of transfer pricing in Deloitte's Delhi office. He led the Philadelphia transfer pricing group of Deloitte US before moving to India in October 2012. He has more than 11 years of experience in transfer pricing, mostly in the US, and for another four years he has been involved in valuation, pricing analysis, and negotiation work. Rahul has managed and led transfer pricing engagements involving planning, documentation, and controversy work, across more than a dozen industries, including healthcare, industrial products, technology and telecom. His specialisation is in assisting clients with transfer pricing planning, often covering complex transfer pricing structures involving intellectual property analysis, restructuring, and entity conversions. Rahul has also led global documentation projects coordinating with Deloitte colleagues in over a dozen countries. He has co-authored a number of transfer pricing related articles published in international trade journals such as the Transfer Pricing Report and the International Transfer Pricing Journal, and has spoken in a number of seminars and forums. Education M.B.A. from the Wharton School; PGDM from IIM Bangalore; and Bachelor of Technology from IIT Kanpur. Rahul is also a CFA charter holder.

Biography
		Kulvinder Makkar Senior Manager Deloitte India Tel: +91 124 679 2222 Email: kmakkar@deloitte.com Experience Kulvinder Makkar is a senior manager with the transfer pricing practice of Deloitte Haskins & Sells and is based out of the New Delhi office. Kulvinder has over 10 years of experience in transfer pricing. Kulvinder has served transfer pricing clients of Deloitte and another Big 4 accounting firm in Canada and has worked as an in-house transfer pricing expert with the 3rd largest insurance company and the largest bank in Canada in their capital markets division. His experience includes specialisation in conducting transfer pricing studies and documentation for clients, expertise in representations at the tax office for TP audits, expertise in preparing and filing TP appeals with the appellate authorities and experience in reviewing and planning international agreements. Kulvinder has been a regular speaker at various industry and professional associations on topics relating to domestic and international transfer pricing subject. Qualification and Professional Affiliations Bachelor of Commerce PG Diploma in Business Management Chartered Accountant – ICAI, India Certified Public Accountant – AICPA, USA