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Li & Fung’s TP Victory!

Published on Sat, Jan 04,2014 | 16:00, Updated at Sat, Jan 04 at 16:00Source : 

By: Richa Gupta, Director, Deloitte Haskins & Sells

The whole edifice of transfer pricing regulation depends upon comparing transactions between group companies (related party transactions) with transactions that take place amongst unrelated enterprises (uncontrolled transactions). This comparison can only be made if the differences between the transactions are minimised through appropriate adjustments. In common parlance, apples have to be compared with apples. To ensure appropriate level of comparability, correct characterisation of the enterprise and transaction being compared is very important. Characterisation, to a large extent, depends on the analysis around ownership of intangibles and assumption of significant functions and risks. It is accepted logic that companies with intangibles or companies that carry out valuable economic activities should be compensated at a higher level.

During the last few rounds of transfer pricing assessments, characterisation of the Indian enterprise involved in international transaction has been a contentious issue. This was also an issue in the case of Li & Fung India Pvt Ltd (“LIF India”), where the Transfer Pricing Officer (“TPO”) held that the Indian entity had created several intangibles and proceeded to make an adjustment. This was a significant departure from the facts presented by LIF India in its submissions. The TPO had not provided material or basis to negate the facts presented by the taxpayer.

LIF India had transactions with its associate company, Li& Fung (Trading), Hong Kong (“AE”), wherein it rendered captive sourcing services to its AE. The AE entered into contracts with independent customers and in turn subcontracted with LIF India for sourcing products from Indian suppliers. The AE is paid an agreed fee by the end customer. LIF India submitted detailed transfer pricing documentation. As a captive, the company held itself to be a limited risk service provider. It justified its margin of 5% on operating cost based on external comparable analysis.

The TPO re-characterised the business model in as much he held that the principal risks and significant intangibles were borne by LIF India. But he did not provide any specific material to negate the functional analysis provided LIF India when he opined that LIF India had developed several unique intangibles such as supply chain, human intangible and has locational advantage in India. The TPO then made an adjustment wherein he said that LIF India should earn a margin of 5% on the value of goods exported by Indian vendors (that were sourced by LIF India), rather than LIF India’s operating expense. The next levels i.e. the DRP and the ITAT agreed with the TPO’s approach.

But when the Delhi High Court took up the appeal, the Court, in its decision dated Dec 16, 2013 upheld the approach adopted by the taxpayer and disagreed with the lower authorities that any valuable intangibles were created or owned by the Indian entity or it had assumed significant risks. The Court, in the process, laid out more widely applicable TP principles.

The decision reinforces traditional transfer pricing principles in as much as it requires appropriate understanding of facts through functional and risk analysis and appropriate application of the method selected, e.g., the base on which profitability is to be computed has to be consistent and another party’s cost may not be used as the cost base. The Court has, once again, reiterated that the authorities cannot arrive at unsubstantiated conclusions without any evidence or material and also the authorities cannot supplant taxpayers’ analysis without providing a detailed reasoning or analysis.

Apart from the above aspects, there are a few crucial areas that were thrown up by the TPO’s order which are open for debate. For example while the decision mentions that the TPO may not construe a different allocation of risk without factual basis, it has not discussed whether risks only follow contractual arrangements or are also influenced by which entity is the decision maker and/or which entity has substance. Some of these aspects were addressed in the Tribunal ruling in the case of GAP International Sourcing (I) P. Ltd wherein the taxpayer was able to demonstrate that all the significant functions were actually undertaken by the overseas associated enterprises.

Typically, tax laws are evolved through judicial interpretation and this applies for transfer pricing as well. Hence this decision, as a speaking order on a specific issue of re-characterisation of business, which sets aside the orders of all the lower authorities, has provided important lessons for taxpayers as well as tax authorities. It again highlights the importance of comprehensive analysis of functions, assets and risks associated with international transactions.


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