PROVISION OF GOODS AND SERVICES FREE OF COST TRANSFER PRICING IMPLICATIONS By Mr. Neeraj Jain, FCA, Vaish Associates

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1 PROVISION OF GOODS AND SERVICES FREE OF COST TRANSFER PRICING IMPLICATIONS By Mr. Neeraj Jain, FCA, Vaish Associates With the proliferation in intra-group cross-border transactions, Transfer Pricing has emerged as one of the significant tax issues for multinational enterprises (MNEs) and also for the Revenue. For Revenue, it is an area for prevention of erosion of tax base and revenue generation. For businesses, it is an area of caution and is about maintaining the thin line of distinction between permissible tax planning and non permissible tax evasion Transfer Pricing in substance enshrines the arm s length principle, i.e., entities entering into business transactions, should expect to make appropriate profits from those transactions, commensurate with the functions performed, risks assumed and assets utilized. An arm s length transaction is understood as a transaction negotiated by unrelated parties each acting in his or her own self interest or a transaction in good faith in the ordinary course of business by parties with independent interests. Arm s length price has also been defined in the Income-tax Act, 1961 ( the Act ) to mean a price which is applied or proposed to be applied in a transaction between persons other than associated enterprises in uncontrolled conditions [section 92F(ii)]. The issue, that arises, is as to whether the enterprise is expected to earn income in every transaction undertaken with an associated enterprise. In other words, can an associated enterprise validly undertake transaction which may not have any element of income Section 92 of the Act provides for computation of income arising from an international transaction having regard to the arm s length price. The essential elements that should exist for application of provisions of section 92 of the Act are income and international transaction. In terms of section 4 of the Act, which is the charging section, the charge of tax is on the total income of an appellant. All receipts may not necessarily constitute income taxable under the Act, and only those receipts could be taxed in the hands of an assessee if the same are in the nature of income as defined in section 2(24) of the Act. In terms of section 2(24) read with section 4 of the Act, the word income given its ordinary and natural meaning would take in any monetary return coming in which is connected or

2 2 linked with any office, vocation or occupation. The Supreme Court in the case of Emil Webber vs. CIT : 200 ITR 483, held that the definition of "income" in clause (24) of section 2 of the Act is an inclusive definition. It adds several artificial categories to the concept of income but on that account the expression "income" does not lose its natural connotation. The various clauses of section 2(24) of the Act, include receipts which are in the nature of income in as much as the same arise on account of one s work, business or profession, land or investment, etc. Under the scheme of taxation, voluntary and gratuitous payment(s) which are not connected nor a necessary incident of carrying on of a business, vocation or occupation, are not sought to be included within the ken of section 2(24) of the Act, so as to be characterized as income. The meaning of the term international transaction is provided in section 92B of the Act as under: 92B. Meaning of international transaction. (1) For the purposes of this section and sections 92, 92C, 92D and 92E, international transaction means a transaction between two or more associated enterprises, either or both of whom are non-residents, in the nature of purchase, sale or lease of tangible or intangible property, or provision of services, or lending or borrowing money, or any other transaction having a bearing on the profits, income, losses or assets of such enterprises and shall include a mutual agreement or arrangement between two or more associated enterprises for the allocation or apportionment of, or any contribution to, any cost or expense incurred or to be incurred in connection with a benefit, service or facility provided or to be provided to any one or more of such enterprises. (2) A transaction entered into by an enterprise with a person other than an associated enterprise shall, for the purposes of sub-section (1), be deemed to be a transaction entered into between two associated enterprises, if there exists a prior agreement in relation to the relevant transaction between such other person and the associated enterprise; or the terms of the relevant transaction are determined in substance between such other person and the associated enterprise. International transaction as defined in section 92B of the Act, is a term of wide amplitude. The essential requirement for a transaction to be covered within the ambit of section 92B of the Act is that it should be between two or more 'associated enterprises', either of whom is a non-resident. Clause (v) of section 92F of the Act defines the term transaction to include an arrangement, understanding or action in concert (A) whether or not such arrangement, understanding or action is formal or in writing; or

3 3 (B) whether or not such arrangement, understanding or action is intended to be enforceable by legal proceeding. From the conjoint reading of provisions of clause (v) of section 92F and sub-section (1) of section 92B of the Act it could be inferred that Transfer Pricing regulation would be applicable to any transaction, being an arrangement, understanding or action in concert, inter alia, in the nature of purchase, sale or lease of tangible or intangible property or any other transaction having bearing on profits, income, losses or assets of such enterprises. Therefore, in order to be characterized as an international transaction, it would have to be demonstrated that the same arises pursuant to an arrangement, understanding or action in concert. Meaning of term arrangement, understanding or action in concert, as provided in the dictionary / Court rulings are extracted as follows: Arrangement: Compromise. [K.J. Aiyar s - Judicial Dictionary (12 th Edition) at page 125] An arrangement that you make with somebody that you can both accept: [Oxford Advanced Learners Dictionary: (New 7 th Edn.) at Page 70] Settlement; adjustment by agreement. [Word Definition.com] Understanding: Use to introduce a condition that must be agreed before something else can happen. [Oxford Advanced Learners Dictionary: (New 7 th Edn.) at page 1667] An agreement, especially of an employed or tacit nature. [Black s Law Dictionary: (8 th Edn.) at page 1562] A mutual agreement, esp. of a private, unannounced or tacit kind. [Disctionary.com Unabridged (v 1.1] Acting in Concert: An action that has been planned, arranged and agreed on by parties acting together to further some scheme or cause, so that all involved are liable for the actions of one another also termed concert of action. [Black s Law Dictionary: (8 th Edn.) at page 307] Common intention would be action in consort in pre-arranged plan [Pradeep Kumar vs. Union Administration, Chandigarh : AIR 2006 SC 2992]. Agreement in design or plan: In concert Together <acting in concert with others>[merriam-webster Online]

4 4 A transaction, per se, involves a bilateral arrangement or contract between the parties and unilateral action by one of the parties without any binding obligation in absence of a mutual understanding or contract, could not be termed as a transaction. A unilateral action, therefore, cannot be characterized as an international transaction so as to invoke the provisions of section 92 of the Act. In the background of the aforesaid discussion, the applicability of Transfer Pricing provisions is examined with respect to the following situations of unpaid / uncharged goods or services: Situation - I: Use of brand name, transfer of goods or provision of services free of cost: MNEs operating in India may be permitted by the overseas parent company to use their brand name free of cost or without payment of any royalty. MNEs may also receive or provide services or transfer goods, free of cost, from/to the overseas parent company. Under FEMA regulations, 1% can be paid for use of brand name under automatic route without any specific approval. The arrangement between parent company and MNE for use of brand name without payment of consideration is a transaction entered into (in the course of the business) and has bearing on the profits, income or losses, etc., of the two enterprises. The transaction being international transaction entered into between the two associated enterprises, one of which is a non resident, would be covered under the Transfer Pricing regulations and would have to satisfy the arm s length test as provided in section 92(1) of the Act. Formatted: Highlight In other words, it may be possible to impute the arm s length price to the transaction of use of brand, and subject to tax the same in the hands of the overseas parent company under section 9(1)(vi) of the Act or the provisions of relevant Double Taxation Avoidance Agreement, whichever is more beneficial to the overseas parent company. [Instrumentarium Corpn. : 272 ITR 499 (AAR)] The transaction of transfer of goods or provision of services free of cost by the overseas parent company to the MNEs assessable to tax in India would have no Transfer Pricing implication in the latter s hands in as much as under Transfer Pricing regulations downward adjustment to the income of the assessee is not permitted. Such transaction, however, may have relevance in determining the arm s length income in case of MNEs operating on a cost Formatted: Highlight

5 5 plus basis, where by virtue of such services / goods being provided by the foreign parent company free of cost, consequent mark up to be received by the MNE may be considered to be lower to that extent. The transaction of transfer of goods or provisions of services free of cost by a MNE may attract adjustment considering the arm s length test under the Transfer Pricing regulations. [ref. Mozagaon Dock Ltd. vs. CIT : 34 ITR 368 (SC).. The MNE may, however, demonstrate on the basis of FAR analysis that such transaction were not liable to be undertaken at a price. Paragraph 1.42 of the OECD guidelines provide for evaluation of combined transactions where such transactions are closely linked or continuous and cannot be evaluated separately. As per the OECD guidelines, examples may include, (a) long-term contracts for the supply of commodities or services, (b) rights to use intangible property, (c) pricing a range of closelylinked products (e.g., in a product line) when it is impractical to determine pricing for each individual product or transaction. Another example would be the licensing of manufacturing know-how and the supply of vital components to an associated manufacturer; it may be more reasonable to assess the arm's length terms for the two items together rather than individually. As per the OECD guidelines combining more than one transactions becomes all the more necessary where there exists an intentional set-off - one associated enterprise provides a benefit to another associated enterprise which is balanced to some extent by different benefits received from that enterprise in return. In such situation the enterprises may claim that the benefit received by the respective enterprises should be set-off against the benefit each enterprise has provided as full or part payment of those benefits and only net gain or loss of the transactions needs to be considered. The combined analysis and/or an intentional set off between more than one interlinked international transactions is also permissible under the US Transfer Pricing regulations as well as Australian Transfer Pricing regulations. The Indian Transfer Pricing regulations, too, provide for the evaluation of combined transactions. The term transaction has been defined in clause (v) of section 92F of the Act to include the arrangement, understanding or action in concert whether or not such arrangement, understanding or action is formal or in writing. Similar transactions include a number of closely linked transactions.

6 6 It would, therefore, be possible to contend that all the international transactions including the transactions for use of brand name, transfer of goods or provisions of services free of cost need to be evaluated together for determining the arm s length price. In other words, the MNE may contend that the entire gamut of international transactions including the transaction undertaken free of cost be evaluated applying TNMM on an entity-wise basis. However, the onus would be on the MNE / overseas parent company to establish that the transactions are closely inter-linked. It would, however, be advisable that MNE / overseas parent company declare such nexus at the time of undertaking such transactions free of cost. Situation - II : Gift: The term transaction has been defined in section 92F(v) of the Act to include arrangement, understanding or action in concert. The inclusive definition enlarges the meaning of the words to take in the ordinary, popular and natural sense of words and is to be construed broadly. The word transaction, is defined to include an arrangement or understanding which would take within its fold any agreement or settlement. Transfer of shares by way of gift, being an arrangement or settlement would be construed as a transaction as defined in section 92F(v) of the Act. Further, emphasis is invited to the words or any other transaction having bearing on profits, income, losses or assets of such enterprise in the definition of international transaction as provided in section 92B(1) of the Act. A transaction of gift having bearing on the assets of the associated enterprise would be regarded as international transaction within the meaning of section 92B(1) of the Act. Section 92(1) of the Act, however, provides for computation of income arising from an international transaction having regard to the arm s length price. Section 2(24) of the Act provides an inclusive definition of the term income for purposes of the Act. The Finance (No.2) Act, 2004, w.e.f., inserted clause (xiii) in section 2(24) of the Act to include as income any sum referred to in clause (v) of sub-section (2) of section 56 of the Act. Clause (v) of section 56(1) of the Act provides that a sum of money exceeding Rs.25,000/- received without consideration by an individual or HUF from any person after first day of September, 2004 is, in certain cases, liable to be taxed as income from other sources. There is no provision under section 2(24), other than as provided in section 56(2)(v) of the Act, to specifically deem gift as income liable to tax. A gift would, thus, ordinarily, be outside the purview of Income-tax Act.

7 7 The arm s length principle as provided in section 92(1) of the Act would have application only when there is an income arising from an international transaction which is required to be computed having regard to the arm s length price. In other words, provision of section 92(1) of the Act would have no application to an international transaction which is capital receipt per se and does not result in any income. Further, in the hands of the donor also the transaction does not result in any income per se for the purposes of the Act as no consideration is receivable. A valid gift, subject to section 56(2)(v), which has specifically been brought certain gifts within the definition of income under section 2(24)(xiii) of the Act, does not result in any income liable to tax. Provisions of section 92(1) of the Act, therefore, in our opinion, would not apply to an international transaction by way of gift (other than referred to under section 56(2)(v) of the Act) in as much as there is no income which arises from such transaction. In case an asset could validly and lawfully be transferred by way of a gift, having regard to the laws governing such gift, in the country of residence of the donor, the transaction would not result in income within the meaning of section 2(24) of the Act. Therefore, it should be possible to argue that such transaction of gift would not be covered within the mischief of section 92(1) of the Act. The transfer by way of a gift, therefore, would not have to satisfy the arm s length test laid down in section 92(1) of the Act, not withstanding that such transaction is an international transaction. However, if the asset is transferred by way of gift with the purpose of transferring income to non resident and thereby avoid tax or is not a bona fide commercial transaction, provision of section 93 of the Act may apply and the income from the transferred asset may be considered as income of the transferee. Further, it needs to be borne in mind that for making a valid gift, the presumption is that the transfer is made without consideration out of natural love and affection. It would be a moot issue as to whether there could in law be a valid gift to by one non-resident corporate entity to another entity. Subject to the aforesaid Transfer Pricing transactions should not apply to transaction of gift. Situation III : Brand Promotion Expenses: MNEs in India incur substantial expenditure on advertisement and brand promotion. The Revenue, in some cases, has taken a position that benefit of such expenses on advertisement

8 8 enures to the foreign parent company in as much as such expenses promote the brand name owned by the foreign parent company. The Revenue has sought to impute a value to the benefit alleged to have been received by the foreign parent company by virtue of expenses on brand promotion and advertisement so as to make adjustment to the income of the MNEs. The advertising expenditure incurred by an MNE in India is for promotion of products dealt in by the MNE in India and is incurred in the course of carrying on its business in India. The expenditure incurred by the MNE may not have any reach outside India. It is highly improbable that such expenditure incurred by the MNE results in any benefit to the overseas parent company. The apex Court in the case of Sassoon J. David and Co. P. Ltd. v. CIT: 118 ITR 261 (SC), in which the Supreme Court while defining the meaning of the expression wholly and exclusively used in section 37 (1) of the Act held that the expression `wholly and exclusively does not mean `necessarily. The Apex Court further observed that the fact that somebody, other than the assessee, is also benefited by the expenditure should not come in the way of an expenditure being allowed by way of deduction under section 10(2)(xv) of the Act, if it satisfies otherwise the tests laid down by law. The apex Court in that case relied upon observations made earlier in CIT v. Chandulal Keshavlal & Co. [1960] 3 SCR 38 at page 48: 38 ITR 601 (SC). In the case of Star India (P) Ltd. : 103 ITD 73 (TM) the Tribunal by a majority judgment applying the aforesaid principal held that where expenditure incurred by the assessee on advertisement had direct nexus with earning of income by the Indian entity, the expenditure, could not be disallowed on the ground that the foreign principal also benefited by the incurring of the expenditure. The overseas parent company may have incurred much large expenditure on advertisement and brand promotion to promote its brand. The MNE does not incur the advertisement and brand promotion expenses in India at the instance of the overseas parent company but to cater to local requirements. It would in such circumstances, not be possible to contend that the benefit which allegedly results to the overseas parent company is pursuant to an arrangement, understanding or action in concert so as to be termed as a transaction. A transaction, per se, involves a bilateral arrangement or contract between the parties and unilateral action by one of the parties without any binding obligation in absence of a mutual

9 9 understanding or contract, could not be termed as a transaction. The alleged benefit from the expenditure on advertisement and brand promotion can it best be said to unilaterally flow from the action of the MNE and could not, therefore, be characterized as an international transaction so as to invoke the provisions of section 92 of the Act. Situation IV : Reimbursement of Expenses: Several MNEs operating in India are reimbursed a part of expenditure incurred on brand promotion and/or advertising by their overseas parent company, who is the owner of the brand name. The MNEs account for net expenditure on brand promotion and advertising in their profit and loss account. The Revenue / TPOs have held the expenses reimbursed by the overseas parent company as operating expenses of the MNEs and computed the operating margins of the MNEs notionally treating the reimbursement of expenses as operating expenses, for applying TNMM for bench marking the international transactions. The TPO while calculating the operating profit as aforesaid, also did not treat the reimbursement of expenses as operational income of the querist. The aforesaid resulted in notional reduction of operating profits leading to the transfer pricing adjustment made by the TPO in his order, while applying the TNMM method. TNMM involves comparison of net profit, i.e., operating profit margin, being the ratio of operating profit to sales as an indicator of the total return of the business activity of the tested party, and the comparable uncontrolled entities. This term has not been defined anywhere in the Act. The same, therefore, have to be construed as understood in accounting parlance. The Institute of Chartered Accountants of India ( ICAI ) has issued a Guidance Note on terms used in Financial Statements. Para of the said Guidance Note defines the term operating profit in the following words: Operating Profit The net profit arising from the normal operations and activities of an enterprise without taking account of extraneous transactions and expenses of purely financial nature. Black s Law Dictionary explains net profit, operating profit and operating expenses in the following words: Operating profit. Deducting the cost of goods sold from sales gives gross profit. Deducting the operating expense (overhead) from the gross profit gives the operating profit.

10 10 Operating expenses. Those expenses required to keep the business running, e.g. rent, electricity, heat. Expenses incurred in the course of ordinary activities of an entity. It will be seen from the above definition that the term operating profit includes within its scope all the normal operational activities of an enterprise while it excludes extraneous transactions and expenses of purely financial nature. As per US Regulation (d), too, operating profit means gross profit less operating expenses. Gross profit means sales revenue less cost of goods sold. Sales revenue is net of discount and returns and is calculated using general accepted principles of accounting.. Operating expenses include all expenses not included in costs of goods sold except for interest expenses and income-tax. The issue, that arises, is whether part of the expenses on brand promotion and advertisement, which is reimbursed by the overseas parent company, would be construed as operating expenditure of the MNE. The term reimbursement has the following meaning/connotations as provided in the Black s Law Dictionary: Reimburse. To pay back, to make restoration to repay that expended; to indemnify, or make whole. Los Angeles County v. Frisbie, 19 Cal.2d 634, 122 P.2d 526, See also Restitution. Reimbursement. With respect to surety, the common law right to get indemnity, or otherwise recoup, from the principal debtor the value of the surety s performance in satisfying the principal debtor s duty. Also refers to the right of an issuer of a letter of credit to recoup from its customer upon duly honoring the credit. The reimbursement is to recoup advertisement and brand promotion expenses. To the extent of such reimbursement, the expenses ceases to be expenditure of MNE. The Courts have consistently held that amount of income received is to be netted from the corresponding expenditure where there exists direct nexus between the two. [Ref: Karnal Cooperative Sugar Mills Ltd. vs. CIT : 243 ITR, 2 (SC); Bokaro Sales Ltd. Vs. CIT 236 ITR 96 (SC) and Lalsons Enterprises 89 ITD 25 (SB) (Del)] For the purpose of application of TNMM the operating profit is to be determined as per the basic principles of commercial accounting. Considering that the amount received from the overseas parent company by way of reimbursement, is connected with the expenditure on

11 11 marketing / sale promotion, the same is to be netted from the corresponding expenditure and only net expenditure is to be taken to the Profit & Loss account. It would not be possible for the Revenue to contend that the expenditure incurred by the MNE and reimbursed by the overseas parent company to remain the operating expenditure of the MNE. It would also be possible to contend that, (i) the reimbursement of actual expenses do not have any element of income embedded therein which could be brought to tax, (ii) the amount of reimbursement received may be treated as payment made by the overseas parent company as an adjustment towards the price of the various international transactions. Transfer Pricing regulations in India are at a nascent stage. Matters are yet to reach the Courts. The jurisprudence in this regard is evolving. Such kind of complex issues would have to be addressed by the Courts in the years to come, to clear the clouds and impart certainty..