The Government of India (GOI) recently announced “Atmanirbhar Bharat Scheme” in order to bring various structural reforms for making India a ‘Self-reliant nation’. While GOI has been taking various measures for attracting Foreign Direct Investment (FDI) in India, recently it has made various announcements for opening new horizons of growth such as changing the definition of Micro, Small and Medium Enterprises (MSMEs), boosting scope of private participation in numerous sectors, increasing FDI in defence sector, etc. With such reforms introduced by GOI, the coming years are expected to see increased cross-border transactions from a different set of players. There are various tax and regulatory frameworks that provide governance with respect to cross-border transactions, which needs to be taken into consideration. In this two-series article, we have tried to present an overview of certain inter-company transactions between Multinational Group (MNE Group) entities and area of consideration having regard to Indian Transfer Pricing regulations (ITPR) and Indian Exchange Control Regulations (IECR).
The GOI introduced ‘Foreign Exchange Management Act, 1999’ (FEMA) in June
2001, replacing the old regulations, to facilitate Globalisation and
cross-border transactions and promoting orderly development and maintenance of
foreign exchange in India. FEMA governs ‘transactions’ which impacts the
foreign exchange reserves of the country.
During the year 2001, Indian
Income Tax Act, 1961 (IT Act) introduced ITPR for ‘cross-border transactions’ between related parties, under Chapter X, as a measure against
tax avoidance for cross border
transactions between related parties.
The ITPR mainly focus on the arm’s length nature of the transaction from
Indian income-tax perspective, i.e. the arrangement of intercompany
transaction, including terms, pricing terms, etc., with a view to address the
assertion: “whether pricing arrangements between related parties are in
accordance with what would have been agreed between unrelated parties”. On
other hand, IECR provides an environment
and/ or framework including the procedures, compliances and documentation
required to be maintained in cross- border transactions, whether between
related parties or otherwise. Accordingly, while entering into any cross-border
transactions with a related party (referred to as an Associated Enterprise (AE)
under ITPR, due regard also needs to be given to the provisions of IECR.
In this part, we have covered certain operating
business transactions and interplay between ITPR and IECR.
1.
Export
of goods / services:
Pricing:
Under ITPR, the important aspects to be considered
for export of goods / services include evaluation of pricing terms agreed with
the AE and confirming that they are not prejudicial from India income-tax
perspective (e.g. in case similar
goods/ services are exported to third party
customers then the pricing terms are similar in both cases). The
selection of method for computation of Arm’s Length Price (ALP) and the
selection of tested party would depend upon the functional analysis of
respective parties. The IECR only provides that the full value of export should
be recovered with prescribed timeframe - there are certain restrictions in terms of country and the currency
in which transaction to be undertaken.
Recovery:
From a TP perspective, in case the export proceeds are
not realised from AE within arm’s length credit period, then the Indian
Revenue Authorities (IRA) may consider the same as a finance
arrangement by
deferring the receivables and impute an arm’s length
interest income on the same. While such arm’s length credit period could be identified
based on the credit terms agreed by the taxpayer with a third-party customer or
by two third parties, a due reference may also be sought to the credit period
allowed under IECR.
The IECR provides that export proceeds should be realised within the
period of 9 months
from export date. After expiry
of nine months, if the exporters are unable to realise the export proceeds,
approval from the Authorised Dealer (‘AD’) can be obtained on a case to case
basis for a maximum period of further 6 months. In case export proceeds are not realised
within said period,
approval of the RBI could be required.
Funding:
While the funding functions are outside the purview
of application of Transactional Net
Margin Method (TNMM) and hence the interest income / expense needs to be
ignored while computing the operating profit to apply TNMM, the intercompany
interest transactions need to comply with the arm’s length principle under
ITPR.
To fund the working capital requirements, exporter could explore certain
options such as advance against export or avail factoring facility from Banker/
Group treasury entity, subject to satisfaction of the terms and conditions.
If exporter receives advance against exports, the exporter shall be under
obligation to ensure that shipment of goods or services are rendered within 1
year from date of receipt of advance payment. Higher duration is permitted
subject to satisfaction of prescribed conditions for execution of long-term supply
contracts for export of goods. Additionally, subject to commercial arrangement
between the parties, IECR permits interest pay-out on such advance upto LIBOR+100
bp. From a TP perspective, such interest rate should be ideally benchmarked and
capped to the limit under IECR. However, in the absence of any benchmarking
exercise, one may consider this interest rate as a benchmark rate since the
same is prescribed by the RBI. Moreover, the advance against exports may need
to be considered while computing the working capital adjustment, while ironing
out the differences between the working capital levels of the taxpayers and
third-party comparables.
ECB could also be explored to fund working capital subject to certain
conditions prescribed under the tax and regulatory framework - we have covered
this in detail in part II of this article.
Aggregation / set-off:
While the ITPR require evaluation of each international transaction
separately on a transaction-by-transaction basis, it allows aggregation of
certain closely linked transaction
under the combined transaction approach for evaluation of arm’s length nature
of such aggregated transactions together. There are no such aggregation norms
that are set-out under IECR and each transaction needs to be demonstrated to be
compliant with the provisions of IECR. Separately,
where Indian entity import goods from its AE and also exports goods to such AE,
set-off of ‘export receivables’ against ‘import payables’ is permitted subject
to satisfactions of prescribed conditions. However, in case of services, there
is ambiguity with respect to permissibility of set-off, on account of which
prior approval/ clarification should be obtained from the RBI. Since such a
set-off is at a balance sheet stage, i.e. involves receivable / payable stage,
the ITPR provisions are not specifically triggered, as the original transactions
of such receivable / payable, i.e. export / import are already tested under ITPR.
Conversion
of receivables into equity
The IECR permits Indian exporter to capitalise the exports subject to
certain ceilings and compliance of certain conditions including pricing
guidelines. Capitalisation of export receivables that are not realised within the limits prescribed above, could require
prior RBI approval.
Further, guidelines in case of issue of shares have been discussed in detail in Part II of the article.
Write-off:
In case where exporter is not able to realize
outstanding export dues despite best efforts, the exporter can either itself or approach AD Banker for write off upto a particular
limit, subject to satisfactions of the prescribed conditions. However, from a TP perspective, the bad debt from an AE may be viewed as a non-
arm’s length behaviour and may undergo a stringent scrutiny
under the TP audit.
Discounts:
In certain
circumstances, reduction in outstanding invoice value for cash discount is
permitted under IECR
upto a certain ceiling. Such a cash discount may need to pass the arm’s length
test on a transactional basis or
under the combined
transactions approach (i.e. aggregation).
Year-end true-up / true-down:
In TP landscape, especially where the Indian entity is a captive
manufacturer / service provider, it is awarded with an assured annual arm’s
length profit margin on goods / services exported. The difference between
budgeted costs versus actual costs, budget utilisation versus actual
utilisation, year-end audit entries may lead to a need for revision of the
invoices raised to ensure that the Indian entity earns the target arm’s length
profits. Such an adjustment may result in debit note (in case of a need for
increase in invoice price) or a credit
note (in case of reduction in invoice price). However, one will have to also keep in mind provisions of section 92(3)
of the IT Act which prescribes that the provisions of ITPR shall not apply in
case where the computation of income has effect of reducing the income
chargeable to tax or increasing the loss, as the case may be, computed on the
basis of entries made in the books of accounts in respect of the year to which
the international transaction pertains.
IECR does not provide for any specific
guidance on such adjustments. Thus, one needs to look into the general
provisions which permits increase/ decrease in the value of export invoice [for
instance, reduction in outstanding invoice is permitted upto 25% of invoice
value, subject to satisfaction of prescribed conditions]. If such adjustments
are not covered within the framework, prior approval of the RBI may be
required.
2.
Import
of goods / services:
Pricing:
The important aspect to be considered for import of
goods / services under ITPR include pricing terms which should not be
prejudicial from Indian income-tax perspective (i.e. pricing terms for similar
goods/ services imported/ availed from third party suppliers by Indian company,
or similar goods/ services sold/ rendered by AE to third party customers should
be comparable with underlying transaction). The selection of method for
computation of ALP and the selection of tested party would depend upon the
Functional analysis by the respective parties. There are no specific
restrictions on the pricing of such transactions from IECR perspective.
Remittances:
The IECR have prescribed remittance time limit upto
6 months from the date of shipment for
import payments in relation to raw materials and 3 years for capital goods. In
case the importer is facing some financial difficulty or there is any dispute with
regard to quality or quantity or contractual terms, the AD Banker can permit
delay in remittance for period upto 3 years from date of shipment, subject to
satisfaction of prescribed conditions. One of the key conditions, for
considering extension beyond 1 year is that the total amount of outstanding of
importer shall not exceed USD 1 million or 10% of average import remittances
during preceding two financial years. Delay, which is not covered with the
permissible framework, may be referred to the concerned Regional Office of RBI.
The payables against import of goods / services may need to be considered for
working capital interest to iron out differences in working capital levels of
the taxpayers and the third party comparables.
Funding:
The ICER provide that AD banker can allow advance remittance for import of goods and
services subject to certain conditions which include receipt of goods and
services within one year/ three years (for capital goods) from the date of payment.
The IECR also provide that importer could pay interest on overdue delayed
payments for a period of less than three years from the date of subject to
ceiling provided under the regulations. Such interest rate would need to be compliant with the arm’s length test under the ITPR.
Where the contract involves deferred
consideration for making the payment for import, such arrangement shall be
required to adhere to Trade credit regulations.
Conversion
of payables into equity:
IECR also provide flexibility to convert the import
payables into equity, subject to satisfaction of the prescribed conditions,
adherence to pricing guidelines and the underlying nature of the transaction.
The compliance with the IECR provisions itself could be considered as
compliance with the arm’s length test under ITPR under certain circumstances.
Year-end true-up / true-down:
TP policies may need awarding a certain margin
to the Indian entity for the distribution functions (where the imports are for resale)
and such a policy may result in a need for year-end
true-up debit note by the AE (to increase the import price)
or a true-down credit note (to reduce
the import price)
with a view to achieve
the target arm’s length operating margin by the Indian entity. However,
as mentioned above, the provisions of section 92(3) of the IT Act should
also be kept in mind.
In case of import of goods/ services, for true-down
adjustment, there are no provisions that are available as in case of export of
goods/ services. Hence, case to case discussion is required with the AD/ RBI
before permitting such adjustments.
3.
Payment
of royalty:
Till May 2010, under IECR, there were upper caps on
royalty payment. In 2010, the GOI had liberalized the regulations by removing
these caps.
Under IECR, the provisions with respect to import of goods/ services as
discussed above are equally applicable for payment of royalty transaction.
While traditionally the Indian entities were paying fixed royalty for use
of Intellectual Property (IP), with this liberalization of IECR, “variable
royalty” arrangements, i.e. royalty linked to
profits earned by the Indian entity also have been implemented. The same are
also tested by Advance Pricing Agreement (APA)
authorities in certain
cases, based on certain methodology.
Nonetheless, in Indian TP landscape, IRA scrutinise the payment of
royalty by Indian entity requiring justification of the legitimacy of charge in
terms of demonstrating commercial necessity/ need for payment of royalty,
demonstrating that technology/ know-how is actually being made available,
benefits derived by India entity like increase in sales, newly added customers,
newly introduced products using the technology/ know- how, etc. Accordingly,
taxpayers are required to maintain robust documentation to justify payment of
royalty charge, apart from the benchmarking analysis to demonstrate the arm’s
length nature of the royalty rate. Similar considerations would also apply to
trademark / brand royalty.
Further, based on Country-by-Country Reporting and Master File
regulations, IRA will now have access to information in relation to intangibles
and license arrangements within the Group. Accordingly, it is necessary to
ensure that similar royalty (in case of fixed royalty arrangement) is being
charged by the IP owner to all affiliates that are using similar technology/
know-how or justification for variation, if any, is appropriately available
based on arm’s length principles.
GOI is reportedly considering a proposal to once
again introduce limits on the amount of royalty payable by Indian subsidiaries
to Non-resident. A report published in Economic Times in December 2018 suggests
that the Department of Industrial Policy and
Promotion (DIPP), under the Ministry of Commerce, is preparing a note for
consideration by the Union Cabinet along these lines, however, nothing has been
notified formally till now.
Recently, in news report, it was reported that Government has urged the
automakers to find ways to reduce royalty payments to foreign parent companies for use of technology or brand names.
From standpoint of AE, in case where royalty arrangement allows a
moratorium period for Indian entity (for legitimate reasons like its initial
years of operations), still this arrangement could be questioned by IRA in
respect of the AE (royalty being taxable income of AE in India).
4.
Intra-group
service charges:
Many MNEs have created centralised service centres for providing a range
of administrative, management services within the Group in order to have better
synergies for efficiency reasons, economies of scale and for confidentiality
purpose.
The ITPR and the IRA, while analysing
such transaction, usually
look into commercial necessity of availing
the services, benefits derived and documentary evidences against the
same. Further, under Indian Safe Harbour Rules,
‘receipt of low-value added intra-group services’ has been covered which
is largely in line with guidance issued by Organisation for Economic
Co-operation and Development (OECD) under BEPS (Base Erosion and Profit
Shifting) Action Plan10. Further, maximum safe harbour margin of 5% (mark-up on
cost) has been prescribed for the same.
Under IECR, the provisions with respect to import of goods/ services
as discussed above are equally
applicable for payment of inter-group transaction
also.
Further, from AE standpoint, moratorium arrangement allowed by AE to
Indian entity could be questioned by IRA.
5.
Reimbursement
and recovery of expenses:
In case of transactions in the nature
of reimbursement/ recovery
of expenses, from ITPR perspective, one needs to check
if there is mere facilitation of a particular third-party transaction by a group
company, and in that case back-to-back copies of third
party invoices in support of the reimbursement charge should be documented and
reimbursement/ recovery can be on a cost-to-cost basis. Further, the OECD TP guidelines
mention that where a Group company is acting only as an agent/ intermediary in provision of services, then the
mark-up shall be charged only on costs incurred by Group company
in performing agency function. In respect of ‘expense recovery’ by the Indian entity, IRA inquire
into the nature
of activities and where they assert that a service
element is involved
from Indian entity,
they expect the Indian entity
to earn an arm’s length mark-up
on such costs. For ‘expense reimbursement’, especially where the Indian entity
is a captive manufacturer / service
provider, IRA expect that such costs
have been considered as operating costs
eligible for mark-up. In view of this position, IRA enquire
into accounting aspects
of such transactions during TP audit proceedings i.e. whether the same are routed through
statement of profit and loss (P&L) or balance sheet. Since, where these transactions are routed through
P&L, the same would have impact on operating profit margin (%) of the Taxpayer.
Under IECR, AD banker
treats ‘expenses reimbursement’ as a permissible current account transaction, and the provisions with respect to import of goods/ services as
discussed above are equally applicable for ‘expense reimbursement’ also. However, where the Indian
entity makes
any payment on behalf of AE, which is subsequently recovered from AEs, such transaction may not be permissible under IECR, except
in certain permissible scenarios
– hence one need to look transaction on a case-to-case basis.
Concluding thoughts
While we have covered certain key aspects in relation to
certain operating business
inter-company transactions from
IECR and ITPR perspective, we shall delve
into various funding
arrangements between MNE Group
entities in Part II of the article.
From the above discussion, it is amply clear that the two regulations do have
their interplay on the international transactions between AEs and the
transacting parties are expected to align their arrangements by appropriately
complying with the interplay between the two regulations. While the focus of
this article is on ITPR vis-à-vis ICER, one cannot
ignore the specific
implications on such transactions under Indian Income- tax and under the indirect tax
laws, such as Customs and GST. All
in all, the taxpayers need to manage a tight rope walk by complying with the
varied regulations applicable to the international transactions and therefore,
due evaluation of all the applicable regulations before entering into such
transactions and laying down the roadmap
for compliances becomes
an inevitable step for the MNE Group.
[Note: The views and opinions expressed in this
Article are those of the Authors]
Notes:
1 . Transactions captured in the note has
implications under Income Tax Act,
1961, GST law and corporate law etc., which one needs to take into considerations.
2 . Under the IECR, various compliances (monthly, quarterly,
semi-annually or annually) need to be
complied with.
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