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Towards Excellence: An Indexed, Refereed & Peer Reviewed Journal of Higher Education / Dr. Pawan Kumar Chugan & Jitendra Nenavani / 08-122

JAN, 2018. VOL.10. SPECIAL ISSUE FOR INTERNATIONAL YOUTH SYMPOSIUM www.ascgujarat.org Page | 108

CHALLENGES AND ISSUES IN TRANSFER PRICING: IN

SPECIFIC CONTEXT OF ADVERTISEMENT, MARKETING

AND PROMOTION

Dr. Pawan Kumar Chugan

&

Mr. Jitendra Nenavani

Abstract Transfer pricing remains an inevitable tool for MNCs to carry out intra-company transactions.

From the literature, misuse of transfer pricing has been observed with respect to advertisement,

marketing and promotion (AMP). This research paper attempts to demonstrate the instances

wherein abuse of transfer pricing was witnessed in transactions dealing with intangibles. Being

difficult to measure and because of certain legality issues, transactions involve AMP have been

exploited for tax-evasion purposes. Apart from the concept, this paper also stresses upon the

mechanism through which the process of transfer pricing in MNCs can be smoothened and

litigations can be avoided.

Keywords: International Transfer Pricings, Advertisement Marketing & Promotion, Advance

Pricing Agreements (APAs), Safe Harbour Rules (SHRs)

Introduction

The survey conducted by Ernst and Young (2016a) concluded that 75% of respondents from

multinational corporations had cited their concerns over ‘tax risk management’. One of the

components of tax risk management is transfer pricing. Transfer pricing becomes an obvious

affair for the companies which have their subsidiaries either located in a domestic country or

foreign countries. These organizations carry the enormous volume of transactions with their

subsidiaries which has considerably high monetary value; hence taxation is attached to them.

These transactions are based on the prices decided by companies under certain notions. In order

to avoid the tax, several companies were found to be violating the regulation with the tactics of

ISSN No. 0974-035X

An Indexed, Refereed & Peer Reviewed Journal of Higher Education

Towards Excellence UGC-HUMAN RESOURCE DEVELOPMENT CENTRE,

GUJARAT UNIVERSITY, AHMEDABAD, INDIA

http://www.ascgujarat.org/

Towards Excellence: An Indexed, Refereed & Peer Reviewed Journal of Higher Education / Dr. Pawan Kumar Chugan & Jitendra Nenavani / Page 108-122


the accounting system. For instance, Income-Tax Appellate Tribunal (ITAT)suggested that

Google India (the assesse) and Google Ireland were found to avoid payment of taxes. On the

other hand, Google India claimed that the amount payable wasn’t under the tag of royalty and

that too under the law of India-Ireland double taxation avoidance agreement (Ghosh, 2017).

Many of such incidents have been reported earlier but the complexity in transfer pricing

regulation is high which gives benefits of doubt to stakeholders. Hence, there’s need for a

standardised mechanism for transfer pricing regulations under which the ambiguity can be

reduced and transparency can be brought. This research paper makes an attempt to bring the

convincing mechanism of transfer pricing to the notice of researchers and industries so that the

transactions of transfer pricing may be operated with less amount of ambiguity by the parties.

Transfer Pricing

Organisation for Economic Co-operation and Development (OECD) defines transfer pricing as

“A price, adopted for book- keeping purposes, which is used to value transactions between

affiliated enterprises integrated under the same management at artificially high or low levels in

order to effect an unspecified income payment or capital transfer between those enterprises

(OECD, 2013).” Transfer pricing can be defined as, in simple terms, the monetary value attached

to the transactions which take place among the divisions of the same organisation. The

transactions are conducted at the lower or higher than the market trading prices. With the help of

transfer pricing, an organisation can shift the taxable income for the purpose of tax avoidance

(Lin and Chang, 2010). Moreover, the calculations for transfer pricing included the ‘percentage

of contingencies’; whereas the percentage of contingencies usually not fixed (Galway, 1990).

From the above arguments,it can be derived that the transfer pricing techniques are more

beneficial to multinational companies than a domestic enterprise. Hence, deciding the objectives

of transfer pricing strategies becomes the challenging issue and needs more deliberated effort

considering the MNCs’ point of view into account. The modern transfer pricing follows the two

categories: the negotiated and administered. In negotiated transfer pricing, as the word itself

suggests, the departments are free to take the decisions regarding the intra-firm transactions and

terms of transfer pricing. On the other hand, administered transfer pricing suggests that the

central authority of an organisation intervenes and prescribes the norms of transfer pricing (Liu,

2015).




Since transfer pricing has been in majority referred in the literature as exploited by firms with

many objectives; Knowles & Mathur (1985) claims that there were categorically five major

objectives of transfer pricing. First was to attain the congruence among the division and

corporate objective. The second objective was to provide divisional managers to make the

decisions to achieve the corporate goal. This objective stood for intra-firm allocation of resources

in such a way that the corporate goal can be achieved. The fourth objective was for meaningful

measurement of divisional performances and last fifth, the objective was to ensure noise-free

communication among departments of firms.

For instance, in Figure 1 the interactions between the departments remain the key issue which

identically signifies the importance of transfer pricing in a typical organisation. Under such

circumstances, the transaction can take place based on the market price and the assumption of

competitiveness can be preserved. However, in situations where in the dependencies of one

organisation increases; and the concept of transfer pricing abuses comes into the picture.

However, in real terms, the multiple transactions creates inter-dependency among firms and

measuring the valuation of goods transferred becomes more complex (Jones, 1981).

Moreover, in the consideration of transfer pricing many components like currency issues,

motives of firms in setting up the transfer pricing and the legal disputes come into the picture.

Common Ownership

International

Frontier




Figure 1 Illustration of transactions in Transfer Pricing (adapted from Jones, 1981)

Advertisement Marketing and Promotion in Transfer Pricing

An interaction between transfer pricing and advertisement, marketing and promotion (AMP) has

remained questionable from the context of taxation. It has been observed in many cases that the

expenses incurred by the country-of-origin companywere benefiting to the associated enterprise

in the foreign country (Oswal T.P., 2015). Technically, that expenses should be compensated by

the parent company. The issue of transfer pricing is challenging, specifically, in the context of

India; and that too in electronic companies. Moreover, the nature of brand promotion and its

effects over the various subsidiaries of parent company remained the most challenging concept

for taxpayers and income tax authorities. One of the methods, Bright Line Test has not been

considered in Indian Transfer Pricing Regulations (BDO, 2017).

Contemporary Example

LG Electronics India Private Limited v/s. Assistance Commissioner of Income Tax case ruling

had attracted the concern of legal department of several companies. Judgement established the

scope under which an inquiry can be undertaken considering the Advertisement, Marketing and

Manufacturing

Company A

Marketing

Company B

Common Ownership by another Group

Manufacturing

Company C

Manufacturing

Company C

Genuine

Sale

Domestics or

Export Sales to

Third Party

Goods

Transfered




Promotion (AMP) expenses incurred by organisations. LG Electronics India Private Limited

(LGI) is an organisation engaged in manufacturing, selling and distribution of electronic

products and appliances. It should be noted that LGI is a subsidiary of LG Electronics Inc.

(LGK), a Korean based company. LGI had entered into the mutual foreign agreement in the year

1997, and in 2001 it obtained the technical assistance and royalty agreements. These agreements

entitled LGI to undergo some statutory activities like manufacturing, designs, and drawings. For

all this LGI was agreed to pay 1% of royalty to LGK, as a part of consideration; and this didn’t

include LGK’s brand name and trademark.

It was found that LGI had received the contribution from LGK in regard to the expenses incurred

by LGI for sponsoring the Global Cricket Events. Transfer Pricing Officer (TPO) observed that

AMP expenses stood at 3.85% of its sales by LGI which was more compared to the amount spent

by similar companies in this regard. The mean percentage of the amount spent by the similar

companies was 1.39% (Nishith Desai associates, 2016). The mentioned issue had several impacts

on the way transactions were carried out on Indian soil since it was found out that Transfer

Pricing remains the buzzing topic in India. This was an alarming situation for global companies

which were abusing transfer pricing for the sake of tax-saving purpose. This paper underscores

the issue related the AMP with transfer pricing.

Objectives

This paper aims to describe the issues, challenges, and controversies involved in transfer pricing

which has been observed by various authors. In addition, this research paper carries following

two objectives:

• To present the context of transfer pricing with respect to the internationalisation effect

• To indicate the appropriate ways in which the the abuse of transfer pricing with respect to

AMP expenses may be minimised and litigation is avoided

Abuse of Transfer Pricing

The interesting phenomenon under the transfer pricing is that the funds remain within the

organisation, generated by the profit centers of organisation. And these transactions are also

recorded within a particulars company’s book which doesn’t have an impact on the whole




enterprise. This indirectly indicates the mechanism of generating the transfer pricing ‘an artificial

accounting system’; the primary stage for abusiveness of transfer pricing (Smallman & Adrien,

1981).The recent developments in transfer pricing have resulted in the considerable amount of

misuse instances. It was widely noted that the transfer pricing methods were used to avoid tax

and accelerate the expenses of a firm. The detection of transfer pricing abuse is expensive affair

for tax regulators to detect (Sikka & Willmott, 2010). Moreover, there are many instances

wherein the steps have been taken in order to reduce the irregularities in transfer pricing by

imposing financial penalties and enforcement (Williamson et al., 2001). The main actors in

global economy – governments, MNCs and non-government actors – share the different

perspective regarding the ethics in transfer pricing. All of them share different perspectives on

transfer pricing which alert the need for congruence on transfer pricing adjustments and

understanding for all the stakeholders (Eden & Smith, 2011). One of the most debatable and

perplexed issues involves in transfer pricing is marketing intangible.

The aspect of over-pricing was found the most noticeable technique in transfer pricing

mechanism. Various industries have adopted different levels of over-pricing slabs. It has been

observed that the percentage of over-pricing was ranged from ten percent to ten thousand percent

(Chugan, 2010). Rubber industry operates with 40 percent, 26 percent is the usual rate for the

chemical industry and 16-60 percent for the electronics equipment.

Marketing Intangibles

Marketing intangibles have been always burning topic for companies in transfer pricing since the

valuation of marketing intangibles is considered one of the complicated matters. OECD had

specifically laid down regulations which govern the way marketing intangibles could be

measured. According to OECD (1996) guidelines, the categorisation of intangibles follows as

under:

• Patent, invention, formula, process, design, or pattern.

• Copyright, literary, musical, or artistic composition.

• Trademark, trade name, or brand name.

• Franchise, license, or contract.




• Method program, system, procedure, campaign, survey, study, forecast, estimate,

customer list, or technical data.

• Other intellectual property not listed above.

Moreover, Indian Revenue Authority indicated that the excess amount spent on Advertising

Marketing and Promotion (AMP) by Indian associate enterprise contributes toward either

development or enhancement of a brand that it owned by parent multinational group; this

perceived enhancement is generally called as ‘Marketing Intangibles’. In addition to that

marketing intangibles are dependent on following aspect of an organisation:

• The reputation of trade name or trade mark

• The quality of goods and services provided under the name or mark in the past

• The quantum of availability of goods and services being marketed

• The quality control and the R&D function in organisation

The valuation part of intangibles remains controversial for many years and businesspersons

usually termed the intangibles for law purpose only. The reason for this negative attitude is the

complexity and analysis this issue carries a sort of uneasiness (Brauner, 2008). There are several

important aspects which fuelled the importance of transfer pricing for intangibles: growing

globalisation and the restructuring of firms, increasing alertness by national tax authorities in

order to protecting the share of tax which is earned by them from multinational organisations and

last the noteworthy growth of e-commerce business and their increasing share in brick-and-

mortar business activities had attracted tax authorities to go for transfer pricing audit (Abdallah

and Murtuza, 2006). In addition to that, the OECD’s stance is more skewed towards the

economic ownership of intangibles compared to the legal ownership; which is contradictory to

the general stance in which the importance is more given to the legal ownership (Przysuski,

2003).

There were several concerns raised by the authors too in regard to the transfer pricing of

intangibles. Notably, some of the questions have tremendously attracted industries and

researchers to look for (Chugan, 2008):

• The origination of software development and how the remuneration of an owner can be

managed?




• Who is the legal owner of a brand?

• What is the value of the brand name?

• Who is the legal and economic owner of the brand?

Interface between Transfer Pricing and AMP

A study by Knowles and Mathur (1985) revealed that goal congruence, evaluation and

motivation augmenting benefits and restricting the costs are the prime objectives which an

organization takes into the considerations. All of these suggest that the importance of transfer

pricing is paramount and considering the globalization it warrants more strategic drive from the

authorities at the board level. Erickson (2012) indicated that the constant transfer price is

included in the objective function for marketing and operations with an aim of maximizing

firm’s profit. Nonetheless, the interface between marketing and transfer pricing has attracted

substantial attention from the lawmakers since the transfer pricing was used as a strategic

instrument to counter the issue of brand proliferation in oligopoly competition. As studied by

Fong-Sheng Wang & Wang (2008), the monopoly model of brand differentiation and exclude

externalities from organizational divisionalization. This indicates that higher transfer price

invites easier collusion among the brand’s division.

In similar fashion, the transfer pricing should be caused by segmenting an organization into

independent profit responsible. Since the transfer pricing should be used to take the strategic

decision at the divisional level, however at the group level the profit and goals shouldn’t be

compromised. More interestingly, the transfer pricing starts with the sources or procurement

decisions in a manufacture organization; indeed this step is often ignored in the majority of

organizations (Ward, 1993). Indeed this interface had attracted many lawsuits carried out by tax

authorities of many countries when found discrepancies in practicing correct method by

organizations.

Safe Harbour

Safe Harbour is one of the ways in which the avoidance of litigations and the afterward

procedures can be forefended and the safe environment for a foreign player and associate

enterprise can be established. Even though this procedure has not been accepted by many of the

countries, but at the same point in time, it also attracts the policy-makers of national tax-




authority to incentivise the transactions between the domestics and foreign organisation. As

OECD’s norms prescribe safe harbour is “A safe harbour in a transfer pricing regime is a

provision that applies to a defined category of taxpayers or transactions and that relieves eligible

taxpayers from certain obligations otherwise imposed by a country’s general transfer pricing

rules” (HEALY Hazel, 2013). One of the chief intentions of applying safe harbour rules is to

reduce the administrative burden of government and supplying the reliability to organisation that

their transactions will be accepted by tax authority with limited audit or in some of the cases

without audits (PWC, 2013).

In 2013, Central Board of Direct Taxes (CBDT) issued the rules of safe harbours for the period

of five years commencing from financial year 2012-13 to 2016-17. CBDT was backed by

Financial Act 2009 which had some provisions for introducing the safe harbour rules under

Indian Tax Law (ILT). Moreover, on April 1, 2017 CBDT issued several amendments in safe

harbour rules. And in addition to that, taxpayers were given options to choose the rules which are

more beneficial to them, in case of rules overlapping with the previous prior law. Moreover, the

applicability of amended rules is for three years: from 2016-17 to 2018-19 (Ernst and Young,

2017). It should be noted that, SHRs introduced in 2013 did not receive much attraction from

Indian taxpayers since the rates were perceived high (Chugan and Agrwal, 2018). Moreover, for

all the taxpayers whose transactions are more than INR 200 crores have no option to go through

SHRs route. Moreover, they can adopt the APAs and the normal route which may attract the

litigation in long run. This also suggests the intentions of CBDT to restrict the applicability of

SHRs to small and medium size services providers like IT, ITeS, KPO, R&D, for IT and generic

pharmaceutical drugs (KPMG, 2017).

Advanced Pricing Agreements

The Government of India amended the Income Tax act 1961 so that APA can be applied by

organisations which were willing to participate in APA method for their transfer pricing process

(Ernst & Young, 2016a). APA is a contract which is usually for multiple years between a

taxpayer and at least one tax authority in which clarity in terms of transfer pricing mechanism is


Towards Excellence: An Indexed, Refereed & Peer Reviewed Journal of Higher Education / Dr. Pawan Kumar Chugan & Jitendra Nenavani / 8-122


mentioned regarding the future transactions is been carried out by the organisation (Chugan,

2007). Indeed, Advance Pricing Agreements can be further divided into three categories:

Unilateral APAs, Bilateral APAs, and Multilateral APAs. Unilateral APAs suggests an

agreement between a taxpayer and tax authority of a country where it is subject to taxation. On

the other hand, Bilateral and Multilateral agreement indicates the involvement of taxpayer, tax

authority of a country where it is subject to taxation and one or more foreign tax authority of

foreign country (Chugan and Panchal, 2016).

Though it is referred as ‘advance’ but incidents are there which indicate that the transfer pricing

cases pending from prior years are also resolved (PricewaterhouseCoopers, 2015). Moreover,

advanced transfer pricing is considered the safest game to resolute the dispute or in simpler

terms, to avoid the chances of litigations. To bring more clarity on this OECD mentioned:

“APAs, including unilateral ones, differ in some ways from more traditional private rulings that

some tax administrations issue to taxpayers. An APA generally deals with factual issues,

whereas more traditional private rulings tend to be limited to addressing questions of a legal

nature based on facts presented by a taxpayer. The facts underlying a private ruling request may

not be questioned by the tax administration, whereas in an APA the facts are likely to be

thoroughly analysed and investigated. In addition, an APA usually covers several transactions,

several types of transactions on a continuing basis, or all of a taxpayer's international transactions

for a given period of time. In contrast, a private ruling request usually is binding only for a

particular transaction. (OECD, 2001)

Ring (1999) argued that the successful APA programme could result in reduction of government

administration, the cost of enforcement and at the large scale provides the generalised benefits.

For the same, this research argues that APA should be the methods to reduce the controversies

held afterword. Since, APA takes the consensus of both, a taxpayer and at least one tax authority

into the consideration, the chances of controversies remain very low by applying this

mechanism. The below-mentioned figure procedurally dictates the several of stages for

companies, in context of India to be taken while applying the APA mechanism.




Figure 2. APA process - An overview (Source: Ernst & Young, 2016b)

The controversies present here, with respect to the various clauses, suggest that there should be

mutual understanding with tax authority and a taxpayer so that both of them can be on the same

page. This is possible when the negotiations process takes place: this is possible with the help of

the advance pricing agreement wherein both the parties arrive at decision regarding the

transactions that are going to take place and their transfer pricing.

The transfer pricing for Indian perspective is presented in figure 2 which suggests the steps that

are taken in accordance with the transfer pricing mechanism for APA procedure. It has been

suggested that through the APAmechanism both the parties can reach the agreement so that the

discrepancies after the transaction can be avoided. Moreover, APAs also help in avoiding

expensive litigation procedures which is a time-consuming process too.

In India APA system was implementation on July 1, 2012 and at time of closing the financial

year, the Govt. had received 14 APA applications in fact the largest response in any country for

the first year of APA implementation. Next year, response was more encouraging with 146

applications. The number further grew and more than 240 companies had filed up their

applications and had sought APAs for the year 2014-15 covering wide range of sectors such as

IT and IT enabled services (ITeS), financial services, pharmaceuticals and chemicals and deals

• Strategy Development

• Unilateral v. bilateral

• Rollback Evaluation

• Optional Pre-filing Meeting

• Business Overview and Proposed international transaction

Pre-filing

• Industry Overview

• supply chain overview

• FAR Analysis

• Economic Analysis

• Proposed Terms

• Processing of Application

APA Request• Field work

• further documents and information

• Government to Government Process

• Critical Assumptions

• Drafting and concluding APAs

Evaluation and Negotiation -agreement

• Annual compliance report

• Compliance audit

• Revision or cancellation

• Renewal

Execution and monitoring




pertaining to issues such as royalties, corporate guarantees, out-sourcing and interest income.

Moreover, in view of the further improvements in APA system - such as the inclusion of roll

back provision, more applications have been filed by the MNCs and number has already crossed

700 (as reported by Srivats 2016).

Conclusion

As per the discussion of this paper, it may be observed that even though a few options are

available for MNCs which indulge in transfer pricing – but due to ignorance or because of the

complexity of laws they still enter into time-consuming litigation. The transactions associated

with the AMP remains in the radar of income tax authority of the respective country. Since, such

transactions are difficult to be noticed by income tax authorities, many organizations were found

to be avoiding payable tax and attract the litigations by authorities. APAs and Safe Harbor Rules

(SHRs) are the relevant approaches through which the litigations may be avoided and the

companies; domestic and foreign players (MNCs) may rest assured for their transactions.

However, these approaches of new transfer pricing regime have also attracted many concerns not

only by MNCs but also from income tax authorities in several countries. On the other hand, the

timely discussion with Transfer Price Office of Income Tax Department, where the taxation is

subject to incur, in line with the utilization of any of these approach, seems more fruitful

approach to avoid the future problems in terms of litigations and objections by the tax

authorities. The application of SHRs, in India, however, is limited only to a selected sectors such

as IT, ITeS, BPOs, KPOs, core and non-core auto components, contract R&D services in

pharmaceutical drugs, corporate guarantees to WOS, advancing of intra-group loans, etc.

Therefore, in the present Indian scenario it may not be applied to the transfer pricing issues in the

areas of AMP. The application of APAs, however, is not limited to the selected sectors and is

open for all sectors. Hence, the MNCs before getting themselves involved in the transfer pricing

related issues for AMP may explore the APA route to avoid any dispute and litigation with the

taxation authorities.

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transfer pricing cases and tax-advantaged transactions. Chicago: Mayer, Brown & Platt.

Dr. Pawan Kumar Chugan

Professor,

Institute of Management Nirma

University, Ahmedabad

Jitendra Nenavani

Doctoral Student

Institute of Management Nirma

University, Ahmedabad


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