Contents at a glance Acknowledgement. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . vii About the author. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ix Technical reviewer’s profile . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . x Preface . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xi Table of contents. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xvii Chapter 1
Introduction. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Chapter 2
Types of Intangibles. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
Chapter 3
Ownership of intangibles. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39
Chapter 4
Transfer Pricing of Intangibles. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47
Chapter 5
Valuing the Intangibles: Transfer Pricing Approaches. . . . . . . . . . . . . . 59
Chapter 6
Tax planning & Intangibles. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 151
Chapter 7
Digital Economy and Intangibles. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 199
Chapter 8
Base Erosion and Profit Shifting (BEPS). . . . . . . . . . . . . . . . . . . . . . . 219
Chapter 9
Cost Contribution Arrangement (CCA). . . . . . . . . . . . . . . . . . . . . . . . 285
Chapter 10
Intra group services. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 307
Chapter 11
Business restructuring (BR). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 323
Chapter 12
Global Judicial Experience and Marketing Intangibles. . . . . . . . . . . . 345
Chapter 13
General Anti Avoidance Rules (GAAR) . . . . . . . . . . . . . . . . . . . . . . . 393
Chapter 14
The next steps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 413
Annexures Annexure 1
Income-tax (16th Amendment), Rules, 2015 . . . . . . . . . . . . . . . . . . . 425
Annexure 2
Guidelines for implementation of transfer pricing provisions. . . . . 435
Annexure 3
Equalisation Levy Rules, 2016. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 443
Annexure 4
Guiding Principles for determination of Place of Effective Management. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 455
Annexure 5
Clarification on functional profile of development centers engaged in contract R&D services with insignificant risk. . . . . . . . 465
Annexure 6
Income-tax (19th Amendment), Rules, 2016 . . . . . . . . . . . . . . . . . . . 469
Annexure 7
Clarifications on Indirect Transfer provisions under the Income Tax Act, 1961. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 483
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Annexure 8
Action on Decision. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 491
Annexure 9
Clarifications on implementation of GAAR provisions under the Income Tax Act, 1961. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 497
Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 503
Note: The views expressed by the author in this book solely represent his personal views and do not represent views of the Government. xvi
Table of contents Acknowledgement. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . vii About the author. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ix Technical reviewer’s profile . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . x Preface . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xi Contents at a glance. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xv Introduction 1 Chapter 1 1.1 Unique and opaque world of intangibles. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 1.1.1 What, Why and How?. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 1.1.1.1 What are intangible assets?. . . . . . . . . . . . . . . . . . . . . . . . . 2 1.1.1.2 Characteristics of intangibles: Value Drivers vs Value Detractors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 1.1.1.3 Why we need to study intangible assets? . . . . . . . . . . . . . . 4 1.1.1.4 How do we identify or value intangible assets? . . . . . . . . . 6 1.2 Intangible assets and the challenge of transfer pricing. . . . . . . . . . . . . . . . . . . . 11 1.2.1 Intra-firm Trade. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11 1.2.2 Race to the bottom. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12 1.2.3 Tax Planning or Tax avoidance or Tax evasion? . . . . . . . . . . . . . . . . 13 1.2.4 Use of Intangibles for tax planning through innovative transfer pricing. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15 1.2.5 Perspective of MNEs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16 Types of Intangibles 19 Chapter 2 2.1 Introduction. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19 2.2 Types of Intangibles. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20 2.2.1 Marketing related intangibles assets. . . . . . . . . . . . . . . . . . . . . . . . . . 22 2.2.2 Technology related intangibles assets. . . . . . . . . . . . . . . . . . . . . . . . . 24 2.2.3 Artistic related intangible assets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26 2.2.4 Data processing related intangible assets. . . . . . . . . . . . . . . . . . . . . . 27 2.2.5 Engineering related intangible assets. . . . . . . . . . . . . . . . . . . . . . . . . 29 2.2.6 Customer related intangible assets. . . . . . . . . . . . . . . . . . . . . . . . . . . 31 2.2.7 Contract related intangible assets. . . . . . . . . . . . . . . . . . . . . . . . . . . . 32 Human capital related intangible assets. . . . . . . . . . . . . . . . . . . . . . . 33 2.2.8 2.2.9 Location related intangible assets. . . . . . . . . . . . . . . . . . . . . . . . . . . . 34 2.2.10 Goodwill related intangible assets. . . . . . . . . . . . . . . . . . . . . . . . . . . 35
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2.2.11
2.3
Methods, programmes, systems, procedures, campaigns, surveys, studies, forecasts, estimates, customer lists, or technical data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37 2.2.12 Any other similar item that derives its value from its intellectual content rather than its physical attributes.. . . . . . . . . . . . 38 Hard To Value Intangibles. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38
Ownership of intangibles 39 Chapter 3 3.1 Introduction. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39 3.2 Legal vs Economic Ownership. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40 3.3 Transfer Pricing Controversy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41 3.4 How to determine the ownership. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42 Transfer Pricing of Intangibles 47 Chapter 4 4.1 International transfer pricing regime. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47 4.2 Why value the invaluable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49 4.3 Issues in transfer pricing of intangibles. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51 Valuing the Intangibles: Transfer Pricing Approaches 59 Chapter 5 5.1 Introduction. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59 5.2 The ALP Approach . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59 5.2.1 ALP Approach - a market based approach. . . . . . . . . . . . . . . . . . . . . 60 5.2.1.1 Applying ALP approach to intangibles: Issues. . . . . . . . . 60 5.3 Factors influencing the value of Intangible. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62 5.4 Modes of transfer of intangibles. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65 5.5 Valuation Approaches . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 68 5.6 The Indian Income Tax Act, 1961, Chapter X. . . . . . . . . . . . . . . . . . . . . . . . . . . 69 5.6.1 The legal provisions as per Income Tax Act, 1961. . . . . . . . . . . . . . . 69 5.7 Pre-Conditions for Applicability of Chapter X. . . . . . . . . . . . . . . . . . . . . . . . . . 70 5.8 What is an International Transaction. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71 5.8.1 International Transaction vs Cross Border Transaction. . . . . . . . . . . 73 5.8.2 Transaction between two non-residents. . . . . . . . . . . . . . . . . . . . . . . 73 5.8.3 Deemed International Transaction. . . . . . . . . . . . . . . . . . . . . . . . . . . 77 5.9 Associated Enterprises. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78 5.9.1 Associated enterprises and deemed associated enterprises . . . . . . . . 79 5.10 Arm’s Length Price (ALP) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83 Uncontrolled Vs Controlled Transaction. . . . . . . . . . . . . . . . . . . . . . 83 5.10.1 5.11 Determination of ALP. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 84 5.11.1 Analysis of intangible international transactions. . . . . . . . . . . . . . . . 87 5.11.1.1 Identifying commercial relations and defining ownership amongst AEs . . . . . . . . . . . . . . . . . . . . . . . . . . 87 xviii
Table of contents
5.11.2
5.12
5.13 5.14 5.15
5.16
5.17 5.18 5.19
Characterisation of intangibles. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89 5.11.2.1 Transactions involving transfers of intangibles or rights in intangibles. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89 5.11.2.2 Transactions involving the use of intangibles in connection with sales of goods or performance of services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90 Comparability Analysis. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90 5.12.1 Specific Characteristics of the Property & Services. . . . . . . . . . . . . . 91 5.12.2 Functional (FAR) analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 91 5.12.2.1 Functions: Performance & Control. . . . . . . . . . . . . . . . . . 92 5.12.3 Analysis of assets employed. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 93 5.12.3.1 Analysis of risks assumed. . . . . . . . . . . . . . . . . . . . . . . . . 94 5.12.3.2 Contractual terms. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97 5.12.3.3 Market conditions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 98 5.12.3.4 Other important considerations like business strategies, commercial considerations and economic principles. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 98 5.12.3.5 Application of different criterion. . . . . . . . . . . . . . . . . . . . 99 5.12.4 Adjustments post the comparability analysis. . . . . . . . . . . . . . . . . . . 99 5.12.4.1 Use of public databases. . . . . . . . . . . . . . . . . . . . . . . . . . 101 Role of the Assessing Officer (Transfer Pricing Officer) . . . . . . . . . . . . . . . . . 102 Primary adjustment vs secondary adjustment. . . . . . . . . . . . . . . . . . . . . . . . . . 103 ALP determination - Methods. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106 5.15.1 Comparable Uncontrolled Price Method (CUP Method) [Rule 10B(1)(a)]. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106 5.15.2 Resale Price Method (RPM) [Rule 10B (1)(b)]. . . . . . . . . . . . . . . . 110 Cost Plus Method (CPM) [Rule 10B(1)(c)]. . . . . . . . . . . . . . . . . . . . 111 5.15.3 5.15.4 Profit Split Method (PSM) [Rule 10B(1)(d)] [H2]. . . . . . . . . . . . . . 112 5.15.4.1 Total profit split method . . . . . . . . . . . . . . . . . . . . . . . . . 115 5.15.4.2 Residual profit split method. . . . . . . . . . . . . . . . . . . . . . . 116 5.15.5 Transactional Net Margin Method (TNMM) [Rule 10B(1)(e)]. . . . 118 Other Method (OM). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 121 5.15.6 Economic approaches to value the intangibles (Under other method). . . . . . . 122 5.16.1 Cost based approach. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 123 5.16.2 The Market Approach. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 126 5.16.3 The Income Approach . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 129 A mixed approach. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 132 5.16.4 Most appropriate method (MAM). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 133 Case study. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 134 Special factors for determining MAM for intangible property. . . . . . . . . . . . . 137 xix
Recent Trends in Transfer Pricing - Intangibles, GAAR and BEPS
5.20 Valuing highly uncertain & hard to value intangibles. . . . . . . . . . . . . . . . . . . . 140 5.20.1 Highly uncertain intangibles. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141 5.20.2 Hard to value Intangibles (HTVI) . . . . . . . . . . . . . . . . . . . . . . . . . . 142 Tax planning & Intangibles 151 Chapter 6 6.1 Introduction. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 151 6.1.1 Economic principles of tax avoidance. . . . . . . . . . . . . . . . . . . . . . . 151 6.1.1.1 Consequences . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 153 6.1.2 Tax planning vs tax avoidance vs tax evasion. . . . . . . . . . . . . . . . . 154 6.1.3 Characteristics of tax planning. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 155 6.1.4 Scale of taxes forgone. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 156 6.2 Tax Havens . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 158 6.2.1 Scale & Impact. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 161 6.3 Techniques of Tax Planning through use of IP . . . . . . . . . . . . . . . . . . . . . . . . . 162 6.4 Double Irish & Dutch sandwich strategy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 175 6.5 Case studies. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 178 6.5.1 Microsoft . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 178 6.5.2 HP. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 178 6.5.3 Glencore. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 179 6.5.4 SAB Miller. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 180 6.5.5 IKEA. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 180 6.5.6 Adobe. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 180 6.5.7 Apple . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 181 6.5.8 Diageo. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 192 6.5.9 McDonald’s . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 194 6.5.10 Starbucks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 195 6.5.11 Fiat . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 196 6.5.12 Google . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 196 Digital Economy and Intangibles 199 Chapter 7 7.1 What’s thy zeitgeist. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 199 7.2 Digital Economy – Entrepreneur World . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 199 7.3 Digital Capital & Intangible Assets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 202 7.4 Importance of identification of Intangible Assets. . . . . . . . . . . . . . . . . . . . . . . 203 7.5 Features of Digital Economy. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 204 7.6 Challenges for taxation in Digital Economy. . . . . . . . . . . . . . . . . . . . . . . . . . . 212 Base Erosion and Profit Shifting (BEPS) 219 Chapter 8 8.1 Introduction. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 219 8.2 The Need for BEPS Project. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 220 8.2.1 Taxation Issues. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 221 xx
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8.3 8.4 8.5
8.6 8.7
8.8
8.9
8.10
8.11
8.12 8.13 8.14 8.15
8.2.2 Indian Context . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 222 Impact of BEPS. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 223 Aims and Focus areas of BEPS Project. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 224 Action 1: Addressing the tax challenges of the digital economy . . . . . . . . . . . 225 8.5.1 Key features. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 225 8.5.2 Action 1 deliverables in the Indian context . . . . . . . . . . . . . . . . . . . 226 8.5.3 Impact. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 229 8.5.4 Criticism. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 229 8.5.5 Analysis of the criticism. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 230 8.5.6 Global Steps to tax digital economy. . . . . . . . . . . . . . . . . . . . . . . . . 231 Action 2: Neutralising the Effects of Hybrid Mismatch Arrangements (HMA). . . 231 Action 3: Designing Effective Controlled Foreign Company Rules. . . . . . . . . 232 8.7.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 232 8.7.2 Scope . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 233 8.7.3 Impact. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 234 8.7.4 Indian Context . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 234 8.7.5 PoEM . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 234 Action 4: Limiting Base Erosion Involving Interest Deductions and other Financial Payments. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 241 8.8.1 Recommendation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 243 8.8.2 Indian Context . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 243 Action 5: Countering harmful tax practices more effectively, taking into account transparency and substance. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 246 8.9.1 Nexus Approach. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 247 8.9.2 Global IP regimes. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 248 8.9.3 Indian Context . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 249 Action 6: Preventing the Granting of Treaty Benefits in Inappropriate Circumstances. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 252 8.10.1 Indian Context . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 253 Action 7: Preventing the Artificial Avoidance of Permanent Establishment Status. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 258 8.11.1 Indian Context . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 258 Actions 8, 9, 10: Aligning Transfer Pricing Outcomes with Value Creation. . . 260 8.12.1 Indian context. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 270 Action 11: Measuring and Monitoring BEPS. . . . . . . . . . . . . . . . . . . . . . . . . . 271 Action 12: Mandatory Disclosure Rules. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 272 8.14.1 India’s outlook on exchange of information. . . . . . . . . . . . . . . . . . . 274 Action 13: Transfer Pricing Documentation and Country-by-Country Reporting. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 274 8.15.1 Indian Context . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 276 xxi
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8.15.2 Issues of confidentiality of data disclosed in CbCR. . . . . . . . . . . . . 279 8.16 Action 14: Make dispute resolution mechanisms more effective. . . . . . . . . . . 279 8.16.1 Indian context. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 281 8.17 Action 15: Developing a Multilateral Instrument to Modify Bilateral Tax Treaties. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 282 Cost Contribution Arrangement (CCA) 285 Chapter 9 9.1 Introduction. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 285 9.2 What is a CCA?. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 285 9.2.1 CCA vs CSA. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 286 9.2.2 Specific Characteristics of the CCA. . . . . . . . . . . . . . . . . . . . . . . . . 287 9.3 Purpose of a CCA . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 288 9.4 Types of CCAs. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 289 9.5 Structure of CCAs. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 290 9.5.1 Applying ALP Principle to a CCA. . . . . . . . . . . . . . . . . . . . . . . . . . 292 9.5.2 Determining the participants . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 294 9.5.3 Measuring the contribution and risks undertaken. . . . . . . . . . . . . . . 295 9.5.3.1 Current Contributions and Contributions of Preexisting Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 295 9.5.4 Calculation of the Expected Benefit. . . . . . . . . . . . . . . . . . . . . . . . . 296 9.6 Balancing payments. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 299 9.7 Accurate delineation of the actual transaction. . . . . . . . . . . . . . . . . . . . . . . . . . 299 9.7.1 The tax treatment of contributions and balancing payments. . . . . . 300 9.8 Restructuring a CCA. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300 9.8.1 Buy-in Payment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 301 9.8.2 Buy out-payment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 301 9.8.3 Termination of CCA. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 302 9.9 Tax Planning through CCA. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 302 9.10 Adjustments by Tax Authorities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 303 9.11 Relevant Documentation for CCAs. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 304 307 Chapter 10 Intra group services 10.1 Introduction. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 307 10.1.1 Intra Group Services vs CCA. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 309 10.2 Transfer Pricing Methodology for Intra Group Services. . . . . . . . . . . . . . . . . . 310 10.2.1 Has an intra-group service been provided? . . . . . . . . . . . . . . . . . . . 311 10.2.1.1 Shareholder activities . . . . . . . . . . . . . . . . . . . . . . . . . . . 311 10.2.1.2 Duplicate activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 312 10.2.1.3 On call services. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 313 10.2.1.4 Incidental benefits. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 313 xxii
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10.2.2
Determining the ALP remuneration for intra-group services. . . . . . 314 10.2.2.1 Direct-charge method . . . . . . . . . . . . . . . . . . . . . . . . . . . 314 10.2.2.2 Indirect-charge method. . . . . . . . . . . . . . . . . . . . . . . . . . 315 10.2.3 Choosing the MAM . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 316 10.3 OECD BEPS Project Report on Action 8-10 (2015). . . . . . . . . . . . . . . . . . . . . 317 10.3.1 Low value-adding intra-group services (LVAIS). . . . . . . . . . . . . . . 317 10.3.1.1 Approach to be followed for determining the ALP of such LVAIS. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 319 10.3.1.2 Determination of the costs incurred. . . . . . . . . . . . . . . . . 320 10.3.1.3 Allocation of low value-adding service costs. . . . . . . . . 320 10.3.1.4 Profit mark-up. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 321 10.3.1.5 Total charge for low value-adding services. . . . . . . . . . . 321 10.3.1.6 A simplified benefit test. . . . . . . . . . . . . . . . . . . . . . . . . . 321 10.3.1.7 Threshold (Safe harbour). . . . . . . . . . . . . . . . . . . . . . . . . 322 10.3.1.8 Levy of Withholding Taxes. . . . . . . . . . . . . . . . . . . . . . . 322 323 Chapter 11 Business restructuring (BR) 11.1 Introduction. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 323 11.2 Definition. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 324 11.3 Types of BR. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 325 11.3.1 Purpose of BR. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 326 11.3.2 Scope &theoretical framework. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 326 11.4 Application of the ALP principle. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 327 11.4.1 Understanding the BR process &transactions . . . . . . . . . . . . . . . . . 327 11.4.1.1 Accurate delineation of actual transaction. . . . . . . . . . . . 328 11.4.1.2 Risk analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 330 11.4.2 Reallocation of profit potential. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 330 11.4.2.1 Tangible assets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 331 11.4.2.2 Intangible assets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 331 11.4.3 Centralization of intangibles. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 332 11.4.4 Local intangibles. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 333 11.4.5 Contractual rights. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 333 11.5 Transfer of activity (ongoing concern) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 334 11.5.1 Direct transfer. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 334 11.5.2 Indirect transfer. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 334 11.6 Termination or substantial renegotiation of existing arrangements. . . . . . . . . . 337 345 Chapter 12 Global Judicial Experience and Marketing Intangibles 12.1 Global case laws . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 345 12.1.1 Royalty income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 345
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12.1.1.1 Ciba-Geigy [CIBA-GEIGY Corporation v Commissioner, 85 T.C. 172 (1985)] . . . . . . . . . . . . . . . . 345 12.1.2 Transfer of IP to low tax jurisdiction. . . . . . . . . . . . . . . . . . . . . . . . 347 12.1.2.1 Eli Lilly [Eli Lilly v Commissioner, 84 T.C. 996 (1985):856 F.2d. 855 (1988)]. . . . . . . . . . . . . . . . . . . . . . 347 12.1.2.2 G.D. Searle [G.D. Searle & Co. v Commissioner, 88 T.C. 252 (1987)]. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 348 12.1.2.3 Bausch & Lomb [Bausch & Lomb Inc. v Commissioner, 92 T.C. 525 (1989)] . . . . . . . . . . . . . . . . 349 12.1.2.4 Sundstrand [Sundstrand Corp. v Commissioner, 96 T.C. 226 (1991)]. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 351 12.1.3 Valuation of intangibles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 352 12.1.3.1 DHL [DHL Corp. v Commissioner, 76 T.C.M. (CCH) 1122 (1998)] . . . . . . . . . . . . . . . . . . . . . . . . . . . . 352 12.1.3.2 Nestle [United States Court of Appeals, Second Circuit, Nestlé Holdings, Inc. v Commissioner of Internal Revenue, July 31, 1998], [Nestlé Holdings, Inc. v Commissioner, 70 T.C.M. (CCH) 682, 1995 WL 544886, 1995 Tax Ct. Memo Lexis 439 (1995)]. . . . . . . . . . . . . . . . . . . . . . . . . 354 12.1.4 Cost sharing agreement/cost contribution arrangement. . . . . . . . . . 355 12.1.4.1 Veritas [Veritas Software Corporation v Commissioner, 2009 U.S. Tax Ct. Lexis 34, 133 T.C. No. 14 (Dec. 10, 2009), nonacq., AOD 2010-005, 2010-49 I.R.B. (Dec. 6, 2010)] . . . . . . . . . . . 355 12.1.5 Transfer of IP to low tax jurisdiction. . . . . . . . . . . . . . . . . . . . . . . . 357 12.1.5.1 Amazon [Amazon.com, Inc. & Subsidiaries v Commissioner, Docket No. 31197-12 (28 December 2012)]. . . . . . . . . . . . . . . . . . . . . . . . . . . . 357 12.1.6 Inversion. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 359 12.1.6.1 Medtronic [Medtronic, Inc. et al v Commissioner, T.C. Memo 2016-112 (9 June 2016)]. . . 359 12.1.7 Location Savings as a part of ALP. . . . . . . . . . . . . . . . . . . . . . . . . . 361 12.1.7.1 Compaq Computer Corporation & Subsidiaries v Commissioner of Internal Revenue 113 T.C. No. 17. . . . 361 12.1.8 Guarantee Fee. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 364 12.1.8.1 Her Majesty The Queen v General Electric Capital Canada Inc [2009 TCC 563 : 2010 D.T.C. 1007]. . . . . . 364 12.1.9 Marketing Intangibles: Advertisement, Marketing and Promotion Expenses (AMP). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 366
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12.1.9.1 Glaxo Case (Glaxo Smith Kline Holding (Americas) Inc. v Commissioner, T.C. No.575004 : Glaxo Smith Kline Holding (Americas) Inc v Commissioner : T.C. No 6959-05). . . . . . . . . . . . . . . . 368 12.1.9.2 Maruti Suzuki India Ltd v Additional CIT/TPO (2010) 328 ITR 210 (Del.) (Delhi High Court). . . . . . . . 371 12.1.9.3 LG Electronics (ITA No.5140/Del/2011 Special Bench, ITAT, New Delhi) . . . . . . . . . . . . . . . . . . . . . . . . 376 12.1.9.4 Bausch& Lomb[Bausch & Lomb Eyecare (India) Pvt Ltd v Additional Commissioner of Income Tax (ITA No:3861/Del/2010 : 4924/Del/2011 : 6382/Del/2012 : 6580/Del/2013). . . . . . . . . . . . . . . . . . . 380 12.1.9.5 BMW India (P) Ltd v Additional Commissioner of Income Tax (ITA No 5354/Del/2012). . . . . . . . . . . . . 382 12.1.9.6 Sony Ericsson Mobile Communications India Pvt Ltd (ITA No. 16/2014 [2015] 55 taxmann.com 240). . . . . 385 12.1.9.7 Maruti Suzuki India Limited (MS-II) (ITA 110/2014 Delhi High Court) (AY 2005-06) (December 2015). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 388 12.1.9.8 Whirlpool of India Limited (Jan 2016, ITA Nos. 610/2014:228/2015). . . . . . . . . . . . . . . . . . . . . . . . . . . . . 392 12.2 Conclusion. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 392 393 Chapter 13 General Anti Avoidance Rules (GAAR) 13.1 Introduction. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 393 13.2 Rationale, Features& Concerns. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 394 13.2.1 Two Stage Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 395 13.3 GAAR in Indian Income Tax Act, 1961 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 399 13.4 GAAR Provisions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 401 13.4.1 Impermissible Avoidance Arrangement (IAA). . . . . . . . . . . . . . . . . 401 13.4.2 Consequences of IAA. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 405 13.4.3 Exempted categories of Persons [Rule 10U (1)] . . . . . . . . . . . . . . . 406 13.4.4 Implementation Procedure. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 408 13.4.5 CBDT Circular no 7/2017 dated 27.01.2017. . . . . . . . . . . . . . . . . . 410 13.5 Concluding Remarks. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 411 413 Chapter 14 The next steps 14.1 Intangibles. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 413 14.1.1 Identification & Recognition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 414 14.1.2 Valuation of Intangibles. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 415 14.2 Marketing Intangibles. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 416 xxv
Recent Trends in Transfer Pricing - Intangibles, GAAR and BEPS
14.3 Digital Economy. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 417 14.4 Taxation in the BEPS Era . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 419 14.5 Conclusion. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 422 Annexures Annexure 1
Income-tax (16th Amendment), Rules, 2015 . . . . . . . . . . . . . . . . . . . 425
Annexure 2
Guidelines for implementation of transfer pricing provisions. . . . . 435
Annexure 3
Equalisation Levy Rules, 2016. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 443
Annexure 4
Guiding Principles for determination of Place of Effective Management. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 455
Annexure 5
Clarification on functional profile of development centers engaged in contract R&D services with insignificant risk. . . . . . . . 465
Annexure 6
Income-tax (19th Amendment), Rules, 2016 . . . . . . . . . . . . . . . . . . . 469
Annexure 7
Clarifications on Indirect Transfer provisions under the Income Tax Act, 1961. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 483
Annexure 8
Action on Decision. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 491
Annexure 9
Clarifications on implementation of GAAR provisions under the Income Tax Act, 1961. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 497
Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 503
Note: The views expressed by the author in this book solely represent his personal views and do not represent views of the Government. xxvi
Chapter 1
Introduction
“Not everything that counts can be counted and not everything that can be counted counts�
1.1
Albert Einstein
UNIQUE AND OPAQUE WORLD OF INTANGIBLES
We used to live in a wired & a materialistic world dominated by assets of traditional capitalist economy. The market consumed various forms of assets to churn out goods and services for the end consumption by consumers in exchange of money, which was further invested to create more assets and produce more goods and services. This virtuous cyclical nature of economy employed as well as created all sorts of assets. Such traditional economy was dominated by tangible assets like plant, machinery, stock, land etc which we could see, touch and value with relative ease. In the last century, especially in the last quarter, the unprecedented growth of intangible assets has toppled the erstwhile dominance of traditional tangible assets. Intangibles are the nuclei of the current digital economy. Welcome to the world of intangibles. It is unique, invisible, eerie, wireless, opaque, fascinating yet crucial. It is what counts the most; yet goes unaccounted. It is what gives worth to companies yet considered unworthy of being reported in financial statements. It is what gives the steady supernormal profits yet considered too fickle to be relied upon for valuation. Its success decides the future yet is ignored based on the past failures. It is what enhances the existence yet its existence is only a guesstimate. It is what gives sky rocketing valuations to the businesses yet is never valued itself. Thus, it is there and it is what matters. We just need to believe in it! To break the stupor and to clarify, we are not talking here about the Almighty God, just the humble intangible assets.
1.1.1
What, Why and How?
What exactly are these intangible assets? Why do we need to bother so much about studying them? How do we recognize them if we cannot feel them? How do we value them if they are so opaque? These are the fascinating questions that intangibles arouse in the minds of those who wish to know more about reality. In this chapter and the forthcoming chapters, we shall make an attempt to learn, understand and thereby enhancing a unique intangible asset i.e. our knowledge to sharpen our other valuable intangible asset ie mind and finally illuminate our 1
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intangible basis of existence ie our soul. Higher knowledge, ignited mind and illuminated soul, are the crucial human assets that has made us the most intelligent and successful species on the planet. Yet even after dissecting cadavers for thousands of years & conducting most sophisticated PET/MRI/CT scans, scientists have neither been able to locate such vital human assets nor confirm or deny their existence. What soul, mind and knowledge are to Homo Sapiens, the intangible assets are to the Homo Commerciens 1. Try to write down whatever characteristics come to your mind regarding metaphysical assets like mind or soul and then try comparing the same with characteristics of commercial intangible assets. Isn’t it uncanny?
1.1.1.1
What are intangible assets?
Intangible assets are commercial but non-physical assets like patents and copyrights which are the bedrocks of the capitalist world around us. They are the keystones to the economic growth and wealth creation across the globe. However, their precise identification, accounting treatment and valuation remains highly opaque even till now. Intangible assets, though invisible, are the most crucial determinants of any organization’s market value in the modern economy. Such assets are mostly selfcreated/generated through years and years of heavy investments in the research & development or through consistent and creative sales and marketing efforts. In alternative, one could acquire or purchase such intangible assets. Further, most of these assets can be licensed and sub-licensed to other enterprises (related or unrelated) and thus, the latter can exploit such asset without self-creating or purchasing. Though, there are wide varieties and aspects of intangibles (including metaphysical like mind or soul), we shall keep our focus limited to commercial intangible assets and that too which are capable of being transferred either individually or bundled together with other tangible or intangible assets. We shall understand the different types and meanings of such intangible assets in the next chapter. The most prominent examples of such intangible assets would be patents copyrights, trademarks, brands etc and we all would have heard of them at some point of time. The little less known commercial intangible assets would be Air rights, Water rights, Easements, Masks &Markers of Integrated Circuits etc. It can be disheartening for few to understand and know, how humans have commercialized and created rights over universal and natural assets like air, water
1
2
The word homo commerciens has been used just as an epithet for commercial business world of human beings.
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Introduction
etc; but as we study more about them in next chapter, we shall realize that most of such rights have been delineated to avoid abuses and disputes. What can be the examples of such intangible assets which cannot be transferred?
1.1.1.2
Characteristics of intangibles: Value Drivers vs Value Detractors
The intangibles assets are considered as value drivers as well as value detractors for any organization because of their unique characteristics. In his book, Baruch Lev (2000), a pioneer in the field of intangible accounting, accounts non-rivalry and network effects as primary value driving factors arising out of intangibles. Further he simultaneously identified partial excludability, inherent risk and non-tradability to be the three main value detractors. Value Drivers: The intangibles are highly scalable and easily transferable assets. Multiple users can simultaneously utilize them in a non-mutually exclusive manner. This is not the case with tangible assets as there are costs involved in scalability wherein plant and machinery needs to be set up, while intangibles can be transferred and operations can be globally scaled with much ease. Further, use of tangible assets is a mutually exclusive phenomenon as in if one person is using a tangible asset like a personal computer; it excludes others from using the same computer at the same time. On the other hand, millions of users can simultaneously work on the intangible software. Once a patent is developed and registered, it is very easy to duplicate the process and easily license/sub-license the same to multiple subsidiaries without any extra cost. Thus, intangibles are highly scalable and easily transferable. This creates a lot of value proposition and enormous future profit potential in case of the intangibles which is not matched by the tangible assets. This also is the primary reason that most of profit shifting and tax avoidance happens through the mechanism of intangibles. Since intangibles can be scaled up quickly and without incurring much cost, it creates sort of what Lev (2000) referred to as “network effects”. As the size of the market increases, the profit potential too increases exponentially as the size and scale of operations attract much higher valuations by creating further intangibles like brands, customer loyalty etc. Value Detractors: As identified by Lev (2000), “partial excludability” is one of the primary value detractors. Though the intangibles are legally protected and the owners go to maximum extent to exclude any unauthorized users from benefitting, the fact that intangibles are easily transferable and use is not mutually exclusive, the excludability is at best partial only. There are millions of pirated and copied illegal versions of almost every software, music albums, movies etc. Even in case of highly protected intangibles like a patent, there is no absolute protection. Many a times, the patented products are reverse engineered to understand the process and 3
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thus, cloned products are introduced in the markets at much cheaper costs. A company like Nike, benefits a lot by selling the branded products but at the same time, many similarly sounding names (like ‘Nikes’ etc) or with same “tick” sign, also sell which cannibalize the original product sales. This increases the legal costs of companies engaged in protecting their turfs against an all-surrounding competition. It also increases the inherent risks involved in creation of intangibles as there could be lot of devaluation in case there are significant unauthorized users or versions of the intangibles. Intangibles are highly risky proposition anyway as it takes a lot of money, effort and innovation to build a valued intangible, which even then may or may not succeed finally. Even if the product is successful, there is always a real risk of a better product being launched by the competitor leading to sudden value erosion. Another of the value detractors is the lack of markets for the intangibles and thus leading to “non-tradability” and also lack of quality and worthy information about the intangibles. As I mentioned right in the beginning, the world of intangibles is highly opaque and one of the main reasons for that is the lack of any open markets where such intangibles could be freely traded. Thus, intangible assets have unique value drivers as well as a few value detractors too. All such criterion may not be applicable to all intangibles assets but would depend upon the nature of intangible and how one decides to exploit it.
1.1.1.3
Why we need to study intangible assets?
After a brief philosophical and commercial introduction of the nature and importance of intangible assets, we need to define our scope of studying them. Why do we need to bother about valuing them? The precise reason of need to study them has already been answered in a way when we say that they are the most crucial determinants of the economic growth. Issues of such vital importance deserve deeper insights into them. One may actually ponder, how come such assets which are very difficult to develop and even riskier to hold have become so crucial to the economic growth and net worth of the companies. There can be many reasons attributed for this enormous importance being attached to intangibles. Primary reason would be what Darwin referred to in his “natural selection theory” of “evolution” ie “survival of the fittest”. There is neck throat competition in the commercial world and only those who are able to constantly adapt, adopt, evolve, innovate and invest in future are able to survive or grow; others simply perish. As we shall see later in the chapter, one time blue-eyed boy of the digital world, Yahoo!, lost its way and has met a tragic end. There are multiple cases like this eg Nokia & Blackberry used to be the market leaders in the mobile phone market just a decade back and in a decade, both have almost stopped selling phones. Thus, there is no option for the companies but to invest in newer technologies, newer products and create intangibles to protect their long term interests. We shall 4
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discuss in the chapter on digital economy, how the current era has changed everything. The entry barriers have collapsed, the monopoly of traditional giants has been rattled by new comer start-up companies with virtually no fixed assets or even own capital. Firms like Uber, Air BnB, Amazon, Flipkart, Ola etc have taken the world by storm just on the basis of an “idea” and “execution” backed by “sound technology”, everything being virtually intangible. Intangibles matter and thus need to be understood in as much detail as possible, as they have disrupted the past, are dictating the present and will decide the future. Unfortunately, however, the statutory financial statements filed by companies, usually neither account for nature or number of intangibles they hold nor provide any indication of true market-worth of such assets. In reality, however, as we discussed, the intrinsic value of such assets may be much higher than the value of all the tangible assets put together. Thus, it becomes imperative to understand the nature of such intangible assets as well as the valuation of such assets, so as to know the real worth of any organization. This is necessary from the point of the view of any investor, shareholder, company executive, public policy-maker or any other stakeholder having a keen interest in the growth and real valuation of any firm or the overall GDP of the national economy. It assumes still greater importance when such assets are transferred either individually or as a bundle of assets and also, when such assets piggyback on the transfer of tangible assets. Globally, all multinational enterprises (MNEs) having complex operations across multiple nations, regularly transfer such assets between the group enterprises and thus, from a transfer pricing perspective too, it is of paramount importance to ensure that such transfer takes place at arm’s length ie as if the transfer was happening between two unrelated independent enterprises. MNEs have engaged themselves in very creative tax planning measures employing intangible assets leading to allegations of huge Base Erosion & Profit Shifting (BEPS) into tax-havens or the low tax jurisdictions. Most of such strategies involve international transactions between the group entities situated across various jurisdictions and piggybacking on invisible and high worth of intangible assets. In the forthcoming chapters, we shall gather deeper understanding of kind and nature of intangibles, the types of strategies employed, methods of valuation, steps taken by international organizations like OECD to reduce the uncertainties and various judicial insights into these complex matters. Go to the web and try to read what tax-havens are? What is tax planning? How do we distinguish between tax planning, tax avoidance and tax evasion? What is OECD and what is its mandate? What do we mean by BEPS?
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You will notice that most of the terms are self-explanatory. Relate to what a place would be heaven for taxes. What do terms like planning, avoidance or evasion signify? What is income base whose erosion can lead to loss of profits? Which are the nations that constitute the core OECD members. Are they different from G8? What about G20?
1.1.1.4
How do we identify or value intangible assets?
Now that we have got a brief snapshot of what and why of the world of intangibles, the next obvious question in any curious mind would be to how to move ahead on this opaque path. First let me begin by admitting that it is indeed an arduous task to identify the intangibles in many cases. Further, it is even more difficult to arrive at a definite valuation for the intangibles in most of the cases. Fortunately though, over the years many economists, accountants and tax practitioners have developed various methodologies to value the intangibles to a significant extent. Let us first understand the aspects involved in the identification and valuation of intangibles. Identification As we know that intangible assets are non-physical and sort of invisible in nature; it becomes very difficult to identify them as compared to traditional tangible assets. Such tangible assets such as capital, labor etc which are physical factors of production, are employed over a long period of time to create, inter-alia intangible assets such as patents, trademarks, brand etc. These intangible assets are then further utilized and exploited in the future to achieve super normal growth in revenues and thus, resulting in increased net-worth of the organization. However, since it is very difficult to determine the exact amount of money invested to create a particular intangible asset or to precisely calculate the contribution to the overall business of the company, it becomes tedious to assign specific values to such intangible assets or to measure precise rates of return on the capital employed for creating such assets. Since more often than not, intangible assets are never explicitly mentioned or recorded in the balance sheet, it becomes difficult to identify such assets. Moreover, besides the registered intangible assets like patents, copyrights or trademarks etc there are many intangible assets which are never formally registered or recognized, hence it is far more tedious to recognize what sort of intangibles exist. There is lot of subjectivity and litigation involved as to whether a particular non-physical advantage should be treated as intangible asset or not. For example, whether group synergies or local market conditions are commercial intangibles or not, is a much contested issue. Most of the time the stand of any party would depend upon the
6
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Introduction
side of table the party is sitting on ie whether it is beneficial to recognize it as an intangible or not. Further, in any going concern, there happens a lot of intangible value creation on a very regular basis. The companies do not overtly identify measure or value it as it is neither feasible nor desirable for any company to commit significant resources to identify measure or account for the same. Ranging from the novel solutions for the daily mundane problems to coming up with altogether innovative ideas in the line of business, such value creation can lead to a lot of cost savings, increased efficiencies as well as significant returns at times. One could actually reward the employee concerned or pass on the cost-savings to the customers or just book higher profits arising out of such solutions. Let us call this knowledge capital. However, it would be very difficult to actually quantify the exact amount of revenues earned or costs saved. Thus, these intangibles, though very invaluable, are in essence quite tricky to identify and tedious to account for and far more difficult to put an exact value on. How significant this knowledge capital to the overall worth of the company or how much intangible capital intensive (as compared to traditional monetary capital) the enterprises have turned, can be gauged through a study published in CFO, a sister publication of The Economist, which attempted to estimate the “knowledge capital” of 27 large chemical and 20 large pharmaceutical firms of that time 2. The study was itself referred to in the June 1999 issue of The Economist in an aptly titled article “A price on the priceless”. The study utilized a technique devised by Lev, whom we have referred earlier too as being one of the pioneers of the field of intangible valuation. For every firm, the expected income from its tangible and financial assets was calculated and then the same was subtracted from an estimate of past and expected earnings. The difference was termed as “knowledge earnings” ie the earnings beyond what is expected out of mere tangible and financial assets. Then, a suitable discount rate derived from the average post-tax return for three knowledge-intensive industries - computer software, biotechnology and pharmaceuticals was applied to arrive at the Net Present Value (NPV) of such “knowledge earnings” and the resultant figure was termed as company’s “knowledge capital”. As a result, Merck, with its “knowledge-intensive” pipeline of new medicines, had sales of $24 billion in 1997 but knowledge capital worth $48 billion. DuPont, with its capital-intensive chemical and plastics businesses, had sales of $40 billion but knowledge capital of $26 billion. A chart derived from the same study is replicated below, and the same shows that even two decades back, the intangible capital was contributing one third of the market value and the proportion has only exponentially increased since then. 2
Measuring intangible assets - A price on the priceless - Jun 10th 1999 available at http://www.economist.com/node/322532
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Figure 1.1: Knowledge Capital for selected companies (Sources: Lev, CFO) and crop the title and source at base
The study thus emphasized the importance of identifying and unlocking the knowledge capital for companies. The article referred to Mr. Bill Gates, the then CEO of Microsoft and richest man globally at present, who quipped that – “our most valuable assets are software and software-development skills, which do not even show up in the balance sheet�. A lack of proper identification and accounting for these intangible assets would therefore lead to a yawning gap between the market value and the book value of the publicly listed companies. The problem is more acute in highly knowledge intensive technology companies of the digital economy like Google, Microsoft etc where the balance sheet assets are absolutely insignificant when compared to the intangible assets. We shall be studying the issues of the digital economy in much greater details in chapter 7. Think over few questions like what is a digital economy? Who are the main players in such economy? How is it different from traditional industrial economy? Are the assets employed and functions performed similar or drastically different? What is virtual world? Do such companies need physical presence to do business in any third country? How do they recognize and apportion profits then? Who gets the right to tax them? Thus, intangible assets remain crucial, yet elusive resource for any modern organization, which should be identified and accounted for, despite the challenges discussed in the preceding paragraphs, in order to truly measure the worth of an organization. 8
Chapter 1
Introduction
Valuation Methodologies for intangible assets and inherent challenges The valuation of the intangible assets is by far the most tedious of aspects here. There have been many methodologies proposed, which are utilized depending upon the purpose of valuation and nature of intangible assets. The purpose can be standalone valuation by the investors, stakeholders, market analysts etc to understand the real worth of any organization. The other purpose can be for calculating the value of intangible assets, if they are transferred either individually (say a patent) or bundled together with other intangible or tangible assets (say complete enterprise is put on block). Further, the transfer can be between two unrelated parties or between the related group entities. In the former case, mostly one of three approaches ie cost, market or income based is used. In the later case, especially when such transfer is a part of an international transaction, the specified methods are recommended failing which any suitable approach can be used to calculate the arm’s length price. A simple valuation approach would be to use the market prices of the shares for the companies listed on the stock exchanges. It involves calculation of the firm’s market capitalization by multiplying the available price per share by number of issued shares and then subtracting the net value of tangible fixed and current assets as derived from the balance sheet. The resulting figure shall be an approximate value of all the intangible assets bundled together as held by the firm. The assumption here is that financial markets automatically take into account the value and the future earning potential of such intangible assets that the company is purported to own. However, the methodology is plagued with the practical challenges of an inefficient market and further, it is not possible to assign any value to a particular individual asset, and hence, the inherent shortcomings of the approach. The market valuation can fluctuate very widely due to many exogenous reasons as the listed prices can be based on market sentiments which are perception based. Hence valuing intangible assets relying only on the market valuation would give varying results and thus would be quite unstable. For example, in the year 2000, at the peak of dotcom bubble, Yahoo! was valued at more than $100 billion which sharply fell to its third by the year 2003. This spiral downfall may have been attributed to the reduced investor confidence in the future earning potential of the firm, or due to multiple extraneous, macro-economic factors such as the bubble that dominated the dot com boom till 2000. The valuations rose again and Yahoo! was offered excess of $44billion for an outright purchase by Microsoft, which was rejected by the Yahoo! shareholders. The erstwhile tech giant was finally sold for a measly $4.4billion to American telecom company Verizon in 2016 3.The following chart depicts the fluctuating valuation of Yahoo!:
3
As sourced from the July 25, 2016 article on www.ukbusinessinsider.com, available at http://uk.businessinsider.com/yahoo-market-cap-over-time-2016-7
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Figure 1.2: Fluctuating Fortunes of Yahoo!
[Source: http://uk.businessinsider.com/yahoo-market-cap-over-time-2016-7 (Bloomberg Data)]
Thus, how the market perceives the value and revenue earning potential of the intangibles held by a company, drastically changes the net worth of the shares. Think of any other tech-firm like Google and compare how its earnings and market valuation has fluctuated in almost two decades of its existence. You may use Google itself for finding the same. Further can you find out any other tech giant like Yahoo! that has met similar fate? Do you know about Alta-vista, Netscape? What was Napster famous for? Yahoo is being acquired by Verizon, which had acquired AOL some time back. What was AOL’s story? Though, the market is supposed to be efficient in itself, all characteristics of an efficient market are not fulfilled perfectly anywhere in the world. Specifically, the efficiency with which information is processed by a market varies greatly, thereby causing temporary variations that deter reflection of true value. Another, oft-used and widely accepted methodology for valuing the individual intangible assets would be to determine the Net Present value (NPV) of cash flows expected to be generated by such assets by using the Discounted Cash Flow (DCF) method. Here, depending on the present and past growth rates, kind of revenues being generated, nature and number of intangibles the firm holds, the analysts predict the future earnings expected from the intangibles, taking into account the 10
Chapter 1
Introduction
industry growth as well. Further, a terminal value is taken at 1-2% beyond 5-7 years and then a discount rate is applied to calculate the NPV. Here, it is assumed that the intangibles are the main contributors to the future earnings and growth of the company. The main shortcomings of the approach are the assumptions and the growth forecasting that the analysts do and also the use of an arbitrary discount rate, which is very subjective and can lead to wide variations in the NPV of the firm. There are many other methods for valuing the intangibles which shall be discussed in the chapter on valuation. However, the moot point is that all such methods are riddled with assumptions, subjectivities and uncertainties. Infact, when applied to the same transaction, no two methods would yield a similar figure, forget the same figure. Similarly, two analysts applying the same method to the same transaction would also often fail to arrive at similar valuation. However, given the vital importance that the intangible valuations carry, a combination of various methods is employed along with the mutual negotiations to finalise the price for any transferred intangible especially between the unrelated parties. In the next section, we shall focus on the various issues and challenges faced in transfer pricing cases involving the intangibles. These are the cases where one group entity enters into an international transaction with another associated enterprise and the transaction involves intangibles explicitly or implicitly. As mentioned earlier, most of the tax planning and so called BEPS happens through such intra-group transactions by the MNEs. Many new terms have suddenly been introduced here. What is transfer pricing? What is an international transaction? Is it same as cross-border transaction? What is an associated enterprise? How would any group entity qualify to be called an associated enterprise?
1.2
INTANGIBLE ASSETS AND THE CHALLENGE OF TRANSFER PRICING
1.2.1
Intra-firm Trade
The emergence of “global value chains” and increasing specialization of value chain activities being conducted across different jurisdictions to capitalize on “economies of scale”, has led to a situation where global trade is being dominated by “intra-firm trade”. There are very few statistics on the overall global picture as no such data is explicitly collected, many estimates put the figure of intra-firm trade as high as 40-60% of the global trade. As per the OECD (trade policy working paper no. 114), in USA where such data is indeed collected, intra-firm trade accounted for 48% of US goods imports and about 30% of US goods exports in
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2009 4. In Australia alone, the value of related-party business transactions was estimated at $76 billion in 1998, excluding cross-border related party loans 5. Though the definition of a related party or an AE varies from country to country, the sheer volume of such transactions reflects the amount of attention that the global transfer pricing deserves.
1.2.2
Race to the bottom
All the countries across the globe have sovereign governments which are fully entitled to legislate on any taxation law in their jurisdiction. Hence all countries vary in what sort of income is taxed, who are the kind of persons who need to pay tax and at what rate the taxes would be levied. Until specified otherwise in this book, we shall be referring to direct taxes (like corporate income tax) as simply taxes. There are countries that have very high tax rates like USA or UK (the highest rate of tax applicable in any country is called maximum marginal rate). There are countries with moderate rate of taxation like India. Further, there are countries with very low rates of taxation like Ireland, Netherland etc. Finally, there are countries which are practically heavens on earth ie they do not levy any taxes (hence the term tax havens). The MNEs have obvious incentives to run the business operations from the jurisdictions which give them maximum flexibility and do not levy high taxes. To encash this, many countries lower their tax rates in order to attract the companies to set up offices and industries. Though this strategy provides growth and employment for the citizens of the country and saves taxes for the MNE, it also kicks off a sort of unhealthy competition amongst the sovereign nations; aptly termed as “tax wars” or “race to the bottom” 6. Hypothetically such a blind race can eventually lead to zero direct taxes and progressive taxes being replaced gradually by regressive indirect taxes or unmanageable fiscal deficits. Again, a barrage of jargons. What is a MNE actually? What do we mean by tax wars or race to bottom? What are direct and indirect taxes? What do we mean by progressive and regressive taxation? What is fiscal deficit? Are there any other deficits? What is a revenue deficit? Are such deficits desirable or have become unnecessary evil? Draw a list of world’s top 20 countries by size of their economy. What are
4
5
6
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Intra-firm trade: patterns, determinants and policy implications OECD Trade Policy Working Paper No. 114 dated 24/05/2011 available at http://www.oecd.org/officialdocuments/ publicdisplaydocumentpdf/?cote=TAD/TC/WP(2010)27/FINAL&docLanguage=En Page 6. See Jim Killaly, Australian Taxation Office, Presentation at the Transnational Crime Conference: Transfer Pricing Compliance Issues and Insights in the Context of Global Profit Allocation 2 (Mar. 9– 10, 2000), available at http://www.aic.gov.au/media_library/conferences/transnational/killaly.pdf The interested reader may refer to http://www.taxjustice.net/topics/race-to-the-bottom/tax-wars/ for brief discussion on this topic. You may use your discretion in adhering to the views posted there.
Chapter 1
Introduction
the rates of taxes in such countries? Why do not all companies shift to countries with zero or low taxation rates?
1.2.3
Tax Planning or Tax avoidance or Tax evasion?
Russ (2004) mentioned three types of strategies that MNEs can employ to minimize their tax burden: •
tactical (profit shifting activities),
•
operational (financial restructuring), and
•
tax planning (MNE Group structure reorganization).
All such strategies are made possible due to the varying tax rates and tax laws across different countries. Taking advantages of “tax-wars” amongst countries, the global MNEs tend to resort to innovative techniques in order to save on paying the taxes. This is termed as tax planning by tax payers and their accounting firms. However, revenue authorities of the affected countries refer to these strategies as nothing but tax avoidance or even tax evasion by use of shell or zero capital subsidiaries that exist only on paper. Most of these methods involve transfer of intangible assets between the group entities and are carefully designed using all the available legal options present in the statutes of various countries and accompanied by detailed legal agreements. The shifting of the very income, on which ultimately taxes are to be levied, to the low tax jurisdictions thus leads to the erosion of very base and resulting shifting of accompanied profits as well, hence the term BEPS. Thus, transfer price ie, the price at which goods, services or assets (tangible/intangible) are transferred in an international transaction between the associated enterprises (AEs) of the same group, assumes critical importance. Infact, transfer pricing though itself a very neutral term, has in common newspaper parlance become the sobriquet for tax avoidance and tax evasion , due to its alleged rampant abuse. For instance, let us assume that ABC Inc is a large pharmaceutical company based out of USA. Further, it has amongst multiple other subsidiaries, two subsidiaries, one based out of India (taxed at say 35%) and other based out of Singapore (10% tax rate). ABC decided to maximize its profits by resorting to creative tax planning through transfer of an intangible asset. ABC India develops a new drug molecule by incurring a cost of $100 million and gets it patented. Further, it transfers all the rights of the patent to ABC Singapore at $100 million, which was the actual cost incurred by the Indian company to develop the molecule. Thus, there arises no taxation in India as there is no profit generation in India, however, ABC Singapore generates international sales of $1 billion, from the sale of the drug and all the profits arising therein are then taxed at a low rate in Singapore. As per the Indian tax authorities, it is a copy book case of base erosion and profit shifting (BEPS), since ABC India would have never sold the same patent to any 13
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third party at the cost. Hence, during the transfer pricing audit, the Transfer Pricing Officer does a fresh valuation of the transferred intangible and values the same at $1.2billion and hence the profits of ABC India would be adjusted upwards to the tune of $1.1 billion. In this case, the transfer pricing audit has effectively managed to thwart the plans of ABC Inc to indulge in BEPS and thus, keeping the global tax pay-out at the minimum. However, in most cases, the companies indulging in such creative tax planning strategies are able to get away with their practices as it is often impossible to track the international transactions involving intangibles and value them properly. Infact, there is lot of information asymmetry and imbalance of resources between MNEs and the tax authorities. This is because the authorities have no inside knowledge of how any deal has been structured, what was the purpose, what sort of documentation exists and hence the MNEs supply only the information asked for. This creates a lot of information asymmetry which works to the advantage of the companies. Further, there is no level playing field when it comes to people handling the TP audits. Companies are able to afford highly professional accountants and lawyers to buttress their claim while tax authorities globally are overburdened, undertrained and understaffed. Hence, these companies are effectively able to save a lot of taxes and as we shall note in the chapter on “Tax Planning using IP”, biggest and wealthiest of MNEs like Apple, Google, Adobe etc pay taxes at very low effective tax rates. Seeing the magnitude of the transactions and the stakes involved for both the MNEs as well as the tax authorities, transfer pricing has become one of the biggest taxrelated concerns globally. This is as valid for developed countries as much for the developing economies like China. A news item in China Daily revealed that “tax evasion by multinational companies is costing China more than 30 billion Yuan (US$3.6 billion) in lost tax revenues annually (2004) and that tax evasion through transfer pricing accounted for 60 percent of such total tax evasion” (25 November 2004) 7. In addition to the scale, the complexity of the “global value chain” operations is also multiplying. For Example, XYZ de, a German MNE may develop a new patent in Canada with R&D assistance from employees in its subsidiaries in various other countries, obtain international rights, design the prototype in California, and assemble the final products in China, distributing the products world-wide from its Irish subsidiary while utilizing all the intra-group administrative services from parent in the Germany and generating still most of its revenues from sales to consumers in the United States. In the current era of virtual world, MNEs practically pick and choose various locations for various purposes depending upon availability of cheap capital, skilled HR or favorable tax rates. The adoption of such suave tax planning practices further help generate higher retained profits for the 7
14
Available at http://www.chinadaily.com.cn/english/doc/2004-11/25/content_394744.htm as accessed on 28/10/2016
Chapter 1
Introduction
shareholders. At the same time, it is virtually a nightmare for tax authorities of any single jurisdiction to fully understand and fathom the complex web of international transactions and to unravel the real tax liability within the limited framework of law.
1.2.4
Use of Intangibles for tax planning through innovative transfer pricing
Though, such innovative tax planning can be effected through tangible assets as well, such as over-invoicing or under-invoicing of sale and purchase of goods and services; high value income reallocations are implemented quicker and better through the intangibles. Intangibles are, in general, highly sensitive and malleable to such transfer pricing strategies. For example, transferring ownership of an “intangible income base” like brand or know-how or patent to a subsidiary based out of tax haven, would effectively mean “the shifting of complete royalty and technical fee income (or profits)”resulting from such base erosion. It should have ideally been taxed in the country where all such R&D took place and the subsidiary employed the necessary assets and assumed risks to develop such intangible. These techniques are feasible due to the fact that though intangibles are highly valuable assets with strong “future economic potential” yet are very complex and hard to distinguish or to be precisely valued. Therein lays the critical need to understand, distinguish and value such transactions, so that no nation is robbed of its deserved share of revenues. The view points of the tax authorities and the industry differ on these aspects. The tax authorities claim that many companies carry out their R&D activity in a country with low cost of capital and human resources and all the expenses along with the risks are allocated to such subsidiary, while the benefits received from a resultant IP in the form of say patent, is often inadequate to compensate for the risk taken by such subsidiary in carrying out such unpredictable research. Further, due to the global presence, the MNEs are able to load higher or lesser costs, depending on the tax incidence in a specific jurisdiction and also the setting up of regional or global hubs, in order to achieve efficient operations; MNEs are able to shift the profits in the name of charging for providing such intra-group services. Studies conducted by some non-governmental organizations have argued that such transfer pricing practices are very harmful for the revenues growth in developing countries, effectively robbing them of opportunities to fund the welfare for the poor and needy. A study by Christian Aid, a UK based NGO estimated that every year developing countries lose almost $160 billion of tax revenues on accounts of such flight of capital. Further the report estimated that from 2005 to 2007 if the due taxes were raised on such shifted profits, China would have got an additional £20.2
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Recent Trends in Transfer Pricing - Intangibles, GAAR and BEPS
Chapter 1
billion and India would have been able to raise an additional ÂŁ3.6billion for higher public spending 8. Amidst all this global hue and cry about low tax payments by MNEs and the whole outrage over the BEPS issue, what is the perspective of such companies about all this? How are they able to justify and rationalize such tax planning practices? The industry perspective on this entirely different as they see the whole value chain as means of achieving economies of scale at lowest possible costs and the subsidiaries carrying virtual zero risk in operations as all activities are finances by the parent entities at cost plus basis. Let us try to understand a bit more what a MNE is and why it operates the way it does.
1.2.5
Perspective of MNEs
What is a multinational enterprise? Technically any enterprise having operations in more than two countries should qualify as a MNE. However, to be termed as a true global MNE, the enterprise should be operating across three or more continents having significant earnings from all of them. There can be regionally focused MNEs too having presence across many nations in the same continent. The global scale of operations allows MNEs to gain significant economies of scale and competitive advantages as compared to the domestic companies. How do MNEs originate? Most of them start as very low scale operations and gradually expand across the globe as the business grows. To understand such enterprises, one needs to really study the growth and challenges that a company faces when it starts from a small office or garage and goes on to become a global multinational corporation with offices across the world. There is inherent uniqueness in the whole structure of being a global entity. While all the nations are sovereign and protect their geographical and maritime boundaries, this is not so in the case of a MNE. For them, the whole globe or the countries they operate in, represents one area of doing business and profit making. MNEs make possible international trade and inspite of so many territorial hurdles and absolutely varied laws and work cultures, they are able to spread their wings and establish businesses. Expansion across various countries has its own set of costs involved, including capital expenses of setting up, administrative, monitoring and huge compliance costs along with abundant failure risks. Further many companies have to make many kinds of informal expenses in order to grease the local machinery and generate goodwill for creating a workable atmosphere. Amidst all this, wherever an opportunity of saving; be it in the form of costs or taxes; is perceived as possible within the given legal interpretations of the statutes, more often than not the MNEs act to save the taxes and employ tax planning strategies. More than half of the 8
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Interested readers may go through detailed reports available at http://www.christianaid.org.uk/images/ deathandtaxes.pdf&http://www.christianaid.org.uk/Images/false-profits.pdf. You may adhere to these views as per your discretion and understanding.
Chapter 1
Introduction
global trade happens within the MNEs ie from one entity to another associated enterprise and this doesn’t even take into account the nature, volume and value of the intangibles transferred across the group entities. This intra-group trade is actually quite cost-effective and safe mode of operation as the parent entity is able to have a control over the operations, costs, standards, and profits as well as is exposed to less risk of IP transgressions. The parent entity, through its single entity hierarchical nature, is able to efficiently run the business inspite of so much varying nature of working environment in various countries. Therefore, the inherent need, advantage and importance of these intra group transactions, make the process of transfer pricing a very critical one for both the entity as well for the local government, and intangibles are the most important tools in the hands of the MNEs. Intangibles Assets not only are difficult to identify, track or value but also generate significant income and the ease of their transfer to low tax jurisdictions, makes them a very attractive option for MNEs to resort in order to save payment of taxes as legally possible.
1.3
THE CHAPTERS AHEAD
After this brief introductory chapter on various aspects of intangible assets, we shall have a further detailed discussion on these issues in forthcoming chapters. We shall learn about different types of intangible assets; especially focusing on the comprehensive definition provided in the Indian Income Tax Act. Then we discuss the concepts of legal and economic ownership of intangible assets. Further ahead I shall be enumerating the kinds of challenges faced in transfer pricing cases involving intangibles and then go on to discuss various relevant methods of valuation. We will also cover the highly relevant topics of digital economy with respect to intangibles and the changes brought by BEPS reports of OECD as released in 2015. Along with these reports, I shall also be mentioning corresponding amendments done in the Indian IT Act as brought by Finance Act 2016 and Finance Bill 2017. Further, a discussion on GAAR would be very appropriate at this juncture as these rules would in operation from 01/04/2017 onwards in India. Finally, we shall go through the important international and Indian judicial pronouncements on the relevant topics and I shall be closing the discussion with a few recommendations as the next steps for legislation in future.
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