Sanjeev Sharma
Commissioner, Income Tax
Advance Pricing Agreement,
New Delhi
sanjeev.sharma63@nic.in
Sanjeev Sharma belongs to 1989 batch of the Indian Revenue Service (IRS) and has been working in the international taxation and transfer pricing set up of the department for the last 20 years. He worked as an adviser with the OECD, Paris for 39 months and was responsible for issues of tax transparency, exchange of information and banking secrecy. He is on the roster of the UNDP/OECD’s “Tax Inspector Without Border” programme and IMF as an international tax expert.
Executive Summary
Two issues are important for determining the arm’s length price of the services provided to foreign affiliate by an Indian service provider. These are proper determination of cost base on which arm’s lengthy mark- up will apply and the mark-up. The article deals with the issue of constituents of cost base. Hopefully, the proper determination of cost base by the assessee and in the transfer pricing audit will help in collection of due taxes in India.
India is an excellent location for service providers of MNE groups due to easy availability of qualified and skilled resources, low cost of operations, benefits of time difference, and tax benefits. The service providers could be captive (also called insourcing centres) providing services for use in the business of foreign entities or an offshore location of the service provider in India which provides services to customers of its parent. These services could be of software development, IT infrastructure support services, various types of other services like accounting, medical transcription,1financial services, engineering design, and other BPO services, knowledge-based services, and research and development services.
Over the years, the nature of services provided from India has moved in the value chain from the call centre services to services involving machine learning and artificial intelligence. Digital services are the buzzword these days in the services industry.
The economic Times citing a NASSCOM Report has reported on 26th September 2019 that the number of insourcing centres providing software development services in India has increased to over 1,250 in FY19 from about 1,000 in FY15, with market size rising to $28.3 billion from $19.4 billion over the same period.
Most of these captive service providers get remuneration based on cost plus margin. The remuneration methodology is different from that of domestic big four software services exporters namely TCS, Infosys, HCL Technologies, and Wipro. These local services exporters get competition from the captive centres as contracts move to them after a customer decides to open a centre of its own. The process also involves the movement of trained and skilled employees.
The profits earned by the insourcing centres should be comparable to those made by domestic service providers. Otherwise, lower profits would require less tax payment by the MNE Group operating a captive centre and such lesser tax cost distorts competition in the market.
Only in a few cases revenue split or profit split method can be applied to arrive at remuneration for service providers in India. These cases would be those involving major activities resulting in profit being carried out in India. Cases involving significant decisions taken in India or on-shore locations only performing marketing and sales functions. The transactional net margin method (TNMM) selecting the Indian centre as a tested party and applying operating profit/operating expenses as profit indicator is used in most of such cases.
Operating profit is the difference in operating revenue and operating expenses. The ratio of operating profit to operating expenses (termed as operating profit margin) is multiplied by operating expenses to arrive at the operating profit of the service provider.
The operating profit margin (or mark-up) is determined based on the mark-up earned by comparable entities operating in similar circumstances. In simple terms a comparable entity would be one engaged in similar business and working in the same business environment and under similar conditions. The identification of a suitable comparable entity is a subject in itself and not dealt with here.
There are two fundamental issues in the application of TNMM in the cases of service providers. The determination of a proper mark-up and arriving at an appropriate cost base. Our efforts in the transfer pricing audits were centered around the determination of a mark-up only and not on cost base on which mark-up is applied to arrive at a profit.
The employees of the service provider provide services by using IT systems, databases, IT platforms, software, tools, and office, etc. The comparable entity will use all these assets for proving the services and cost of these assets is included in its cost base. It has been our experience that service providers also use all these assets (tangible and intangible) in the provision of services, but some of the assets are provided by the affiliates free of cost, and cost of these assets or the effect of depreciation on such assets is not included in the operating expenses.
In the process of identification of a comparable entity, the FAR of the tested party and comparable entity should be similar. The comparison of FAR (functions performed, assets used, and risks assumed) suggests that assets used should also be similar. The cost of every item that is used to provide the services should be taken into account in computing the operating expenses.
The taxpayers sometimes argue that third-party service providers also use some of the assets provided by the customers, and they are not charged for the same. It may be noted that in the case of the third-party service provider the remuneration methodology would be different. Companies like TCS, Infosys, Wipro or Tech Mahindra do not provide services based on cost- plus. No third party works on the cost-plus pricing methodology. It may determine a price based on likely expenses incurred, but a high mark-up is applied.
Keeping in mind the fact, that depending on the quantum of operating expenses, the profit chargeable to tax will vary. Therefore, our efforts should be to work out the correct operating expenses/operating cost while applying the TNMM, and we should ensure that no item of expenses is left out in computing the operating costs.
Some MNEs do not charge their captive service providers for various expenses incurred on their behalf because that will lead to increased profit in the country of the service provider and that ultimately will be required to be invoiced to the service recipient by the service provider.
The inter-company agreement will require to be studied, and the service provider may be asked to specify which costs are included in the operating expenses.
Based on the principle discussed above, some of the common items of expenses have been identified below and require to be considered in each case of a service provider providing services to their affiliates or customers of affiliates.
(A) Definition of Operating Expenses
The expression “operating expenses” is defined below:
“Operating expense” means the costs incurred in the previous year by the taxpayer in relation to the provision of services during the course of its normal operations including depreciation and amortization expenses relating to the assets used by the taxpayer. Operating expense includes:
1. Original cost incurred by the AE and/or depreciation cost in regard to third party software licenses, and databases and other tangible and intangible assets/tools used by the taxpayer in the course its normal operations, including depreciation and amortization and provided by its AEs free of cost or on loan basis or at a price less than cost to its AE or at a notional value. The information on these assets, databases should be obtained. It may be noted that laws governing the SEZ units and STPI units where these service providers are generally located allow the service provider to import and use free of cost assets (sometimes even large servers, testing equipment, test materials, etc.).
The SEZ/STPI regulations oblige these entities to maintain a register/records of such assets.
2. Reimbursement of expenses by the service provider to the AEs (which the AEs have incurred on behalf of the service provider). This reimbursement may be of any type, for example, hotel expenses, traveling expenses, Visa expenses, etc. Instead of taxpayer spending, the payment is made by the AE but reimbursed. The cost is incurred in the business of providing services; hence, it should be included in the operating expenses.
3. The cost of Stock Incentive Plan (“SIP”)/ Employee Stock Option Plan (“ESOP”)/ restricted stock units (RSU) and/or similar plan granted by the AEs to the employees of the service provider, the amount pertaining to the employees of the service provider, whether or not cross charged to it. This cost is incurred as an incentive to the employee of the service provider, and instead of the taxpayer bearing the cost, it is borne by the AE as it issues its shares. But, the award of such stocks is to give incentive to the employee and retain them in employment as valuable employees and forms part of their salary, this cost is required to be treated as salary.
4. Any recovery of expenses by the service provider from the AEs, which are integral to its business operations. However, recovery of costs by the service provider from the AE or any other group entity (which relate to shareholder activity of the AE) will not form part of the operating expense;
5. cost of communication/connectivity network that enables the service provider to connect/communicate with the AEs whether borne by the service provider or the AE and whether or not cross charged to the service provider;
6. cost if any, incurred by the AE towards the salary of the employees of the AE, who are seconded/transferred to the service provider, whether or not cross-charged to the service provider;
7. the cost incurred by the service provider towards salary, social security contributions, and travel expenses, any of its employees transferred/seconded to the AE or any other entity of the Group;
8. The cost incurred by the service provider towards salary, social security contributions, and travel expenses, if any, on any of its employees during their presence at onsite locations of the AEs or their customers, irrespective of their period of stay on onsite locations, if they are not transferred or seconded to the AEs;
9. Cost of travel and other expenses incurred by the taxpayer in regards to travel outside India of employees of the taxpayer for work or training or any other business purpose of the taxpayer;
10. Management fees and other intra-group services including expenses in relation to technology-related services (as per technology services agreement) charged to the Applicant by the AEs. It may be noted that the management fee charged in case of a captive service provider working on cost plus should not be disputed as this would otherwise result in the reduction of cost base and loss to the Revenue.
11. Payment made to the third party vendors engaged by the taxpayer in connection with the provision of services;
However, operating expense does not include the following, namely:
- interest expense;
- provision for unascertained liabilities;
- pre-operating expenses;
- Extraordinary expenses (for example expenditures incurred as a consequence of Act of God (viz. floods, earthquakes, natural disasters, etc.); However, these extraordinary expenses net of insurance claims shall be recovered on cost-to-cost basis.
- Loss on the transfer of assets or investments, other than for assets whose depreciation has been included in operating expenses;
- Corporate Social Responsibility expenses;
- Costs incurred for the issue of shares;
- payment on account of income-tax; or
- Other expenses not relating to normal business operations of the Applicant.
It may be noted that parity should be maintained in the case of identified comparable entities regarding these expenses.
(B) Definition of Operating Revenue
The determination of operating revenue also is a very import aspect in the computation of operating profit. Operating revenue is defined below:
“Operating revenue” means the revenue earned by the taxpayer in the previous year concerning the covered transaction during the course of its normal operations but does not include the following, namely:
1. interest income;
2. gain on transfer/sale of assets or investments, other than assets whose depreciation has been included in operating expenses;
3. refunds relating to income-tax;
4. provisions for unascertained liability written back;
5. extraordinary incomes (for example, receipts in relation to insurance claims received for damages resulting as a consequence of Act of God viz. floods, earthquakes, natural disasters, etc.;
6. benefits received under the Service Export from India Scheme (SEIS); and
7. Other incomes not relating to the normal operations of the service provider.
It may be noted that the working of operating revenue in the case of a comparable entity should be consistent with the taxpayer methodology.
(C) Treatment of Gain/loss on Account of Foreign Exchange Fluctuation
The service providers generally compute cost is INR and raise an invoice in foreign currency based on the prevailing exchange rate of foreign currency on the date of raising the invoice. On the day of receipt of remittance, the INR may have appreciated or depreciated depending on the forex market. In case, the INR depreciates, the service provider, will be receiving more INR than accounted earlier and will result in a gain on account of fluctuation in the foreign currency exchange rate. It will lose INR if the INR becomes strong (appreciates).
It is seen that in the economic analysis for TP purposes some taxpayers change methodology on year to year bases depending on whether they have earned net gain or suffered net loss. They know the results in hindsight and may change treatment of gain/loss in the transfer pricing documentation while computing OP/OC for testing the arm’s length nature of the transaction.
If they have gained, then such a gain is added in the revenue, and it improves its OP/OC and may avoid TP adjustments. In case, the service provider has suffered a net loss; such a loss is not included in the operating expenses because it will increase the cost base and OP/OC will reduce. In this situation, they seek double benefits. The net loss is further deducted from the operating profit to report reduced taxable income.
In case, the gains or loss are included in the computation of operating profit then this methodology is termed as consideration of gain/ loss as operating and the risks relating to foreign exchange fluctuation are considered to have borne by the AE. In case, the loss/gain is borne by the taxpayer, and it may do hedging also then it is called treatment of loss/gain on account of foreign exchange fluctuation as non-operating.
In the TP assessment, the above treatment should be consistent by the taxpayer on year to year basis and the same treatment for loss or gain and must be consistent with the FAR which mentions who is bearing the foreign exchange gain or loss.
The determination of the correct cost base is an essential aspect of TP assessment. Experience shows that some MNE groups generally do not include significant costs like ESOP cost, reimbursements, third party vendor costs, and cost of assets provided for use by the AEs without any charge.
A similar methodology will apply in case of manufacturers working for MNE groups in the capacity of a contract manufacturer.
Hope proper determination of profit of service provides will help in the right payment of corporation tax and avoids creation of a non- competitive environment between domestic entities and service provider entities of the MNE groups.
Notes:
1 Article is written by Sanjeev Sharma, Commissioner Advance Pricing Agreement, New Delhi
