The Right Markup: A study on Transfer Pricing in Private Equity
Private Equity (PE) funds have been a part of India’s emerging story for more than a decade where many investments have now moulded the investment climate in India. In this article we will look at some of the issues faced by the Indian affiliates of global PE funds with respect to Transfer Pricing regulations in India.
Global fund houses provide financial resources in form of investments through a number of separate funds managed by the same private equity house. Such fund houses operate in India through their Indian affiliates.
The Indian affiliates of the foreign fund houses typically follow an advisory model, wherein the Indian affiliate provides non-binding advisory services for evaluating potential investment/ divestment opportunities to the foreign fund houses. The remuneration paid to the Indian affiliates for such services is generally a recharge of its operating costs together with a mark-up on such costs. The mark-up on the operating costs is calculated by applying the arm’s length principle.
The arm’s length principle prescribes that a transaction between related/ associated enterprises be conducted in the same manner as that between unrelated parties.
India has become a leading jurisdiction in terms of transfer pricing litigation due to detailed scrutiny by the tax authorities and tax adjustments increasing year after year.
Here’s some data on recently concluded cases and the relevant amount in dispute with respect to transfer pricing.
It is interesting to know that in none of the above cases, the tax authorities disputed the method (also known as the most appropriate method or MAM) adopted by the Indian affiliates for benchmarking the arms’ length price. Thus tangible net margin method (TNMM) emerge as the MAM in all these cases.
Litigation, apart from a few other issues, primarily comprised of disputes based on the comparable companies used by the parties for pricing or benchmarking of advisory services. Many of the comparables used by the Indian affiliates have been rejected by the tax department without providing a reason. Simultaneously, the department, on its own, went on to include a number of entities as comparables. The exercise by the tax department of including new comparables in almost in all cases was carried without providing detailed justification of choosing the new comparables. The comparables included by the revenue at times have been companies that are primarily engaged in merchant banking, securities broking or investment banking activities and may not be precisely relevant. Based on the analysis carried out by the tax department, the assessing officers have subsequently proposed to make upward adjustments (applying higher mark-ups over the operating costs based on the comparables used by them) in the range of 30% to 60% resulting in tax adjustments as high as INR 37 Crs.
Have a look at the Venn diagram below to understand the approach adopted by ITATs in respect of comparable entities for the Indian affiliates of the global fund houses:
The legend below describes the various areas of the diagram
- A – Comparables proposed by Indian affiliates and accepted by AO (Assessing Officer)
- B – Comparables proposed by Indian affiliates and accepted ITAT although rejected by the AO
- C – Comparables proposed by Indian affiliates, rejected by AO, and not discussed by ITAT
- D – Comparables proposed by AOs and rejected by ITAT
- E – Comparables suggested for use by the ITAT
- F – Comparables suggested for use by the AOs and accepted by ITAT
The question to ask is that by not providing a reason for rejecting a comparable company used for benchmarking the price are Assessing Officers not abiding by the principles of natural justing. The ITAT does seem to concur, and in fact mentions it in a few cases.
A series of bends
From the data at hand, we thought of sharing the path that many cases have traversed.
As depicted above, the fund houses are probably going through much hassle and ultimately are being given relief and this is an oft repeated scenario.
Judicial Trend at the ITAT Level
The trouble of the fund houses could be greatly mitigated if the tax department follows certain principles recognised by the ITAT as given below:
- The practice of blindly rejecting or including a comparable is bad in law. The approach of the tax authorities must conform to the functional benchmarking principle (i.e. comparison of taxpayers’ business functions to function of other companies having similar or identical practices within same or similar functions).
- Mere classification of function as ‘advisory services’ by the tax authority will not put any company in a comparable basket in the absence of functionality similarity and transactional analysis.
- There is no estoppel against the assesse from demonstrating that a particular comparable was wrongly included in earlier year and therefore, it should be excluded in subsequent year.
- The companies engaged in merchant banking, stock broking or issue management functions of investment banking cannot be considered for benchmarking analysis of a company providing pure investment advisory services.
Opportunity before High Courts
The recurrent practice of the tax department to dispute position on comparable companies adopted by Indian affiliates of fund houses can be addressed by a detailed pronouncement of law by superior courts.
Case of General Atlantic Private Limited
Bombay High Court, 2016
In 2016, the Bombay High Court was presented with an opportunity, to address the dispute on comparable companies adopted. The tax department had appealed against the order of ITAT Mumbai passed in 2013 in the case of General Atlantic Private Limited. The question before the court was whether Carlyle India Advisors Pvt Ltd is a good comparable for General Atlantic Private Limited. The Bombay High Court however steered clear of the contentious issues stating that the appeal raised questions of fact and not substantial questions of law. Given the volumes of pages that have been written by ITAT judges on the applicable legal principles for selecting comparables, the judgement of the Bombay High Court in General Atlantic (2016) can be viewed as a missed opportunity for an authoritative pronouncement on law.
Case of Avenue Asia Advisors
Delhi High Court, 2016
A similar opportunity was presented before the Delhi High Court where Avenue Asia Advisors preferred an appeal against a 2016 decision of ITAT Delhi upholding inclusion by the tax department of Brescon Corporate Advisors Ltd, Ladderup Corporation Limited, and subject to certain conditions, inclusion of Sumedha Fiscal Services Ltd. Interestingly, this is the only case among the cases reviewed for this article, where the ITAT substantially examined the contents of the advisory agreement between the Indian affiliate of Avenue Capital and its international associated enterprise.
Upon examination, ITAT held that services offered by Avenue Capital’s Indian affiliate cannot be termed as a mere non-binding investment advisory service but such services also include advice on financing, restructuring and execution support akin to those provided by a merchant banker. By an order dated 18 September 2017, the Delhi High Court partly allowed appeal of the Indian affiliate of Avenue Capital and held that broad functionality test is not sufficient to find comparable entities under TNMM.
The High Court went as far as to note that where ITAT finds a line of activity which is not offered by a comparable (in this case advice in connection with rights issue), then it should not send that matter back to the tax department for a fresh consideration. It should simply reject that comparable. The High Court did not approve ITAT’s exercise of finding similarity based on presence of common terms like ‘debt syndication’, ‘ debt financing’, ‘restructuring’, ‘mergers’, ‘acquisition’, etc in the annual reports of disputed comparables and the advisory agreement between Avenue Capital and its Indian affiliate. It held that non binding advisory provided in connection with any of the above will not render Avenue Capital’s India affiliate as a merchant banker who actually undertake activities like syndication of debt.
However, the High Court still sent the matter back to CIT (Appeal) to take a final decision on whether advisory services offered by Sumedha, Brescon and Ladderup could be similar to the advisory services referred in the agreement of Avenue Capital.
A path to certainty
The big question in your mind would be, is there a way out of litigation. Here are a few steps that our data reveals, that might help.
- Documentation: A well-defined strategy, supporting pricing policies for transfer pricing analysis, would offer PE Fund and its Indian Associates, a first line of defence in the event of a tax audit, minimizing the harm to reputations, risk of costly adjustments and penalties that can be imposed in most jurisdictions absent such documentation. It appears that presence of certain terms in the advisory agreements between Indian affiliates and global fund houses may be giving rise to protracted litigation. The agreements can be suitably modified to bring them within the fold of advisory services as described by the Delhi High Court in Avenue Capital’s case.
- Research: Use of data mining through an advanced easy-to-use research database will help in deciding the tax strategies, pricing policies more efficiently by deriving substantial value from large litigation data.
- Advanced Pricing Agreements: To seek certainty and relief from strenuous litigation, few foreign fund houses have taken recourse to agreements called as the Advance Pricing Agreements or APAs between the taxpayer and the tax authorities for agreeing on substantive items like:
- Choosing a Transfer Pricing Method
- Selecting comparable uncontrolled companies or transactions
- Deciding on the years over which comparable companies’ results are analysed.
APAs will help the taxpayers to resolve their transfer pricing issues with the tax authority in a cooperative and mutually beneficial manner and provide certainty on its niche transfer pricing issues. Indeed, some of the large fund houses have been reported to have entered into bilateral APAs with the Government to address the uncertainties around transfer pricing.
(Article written by Saili Kulkarni, Product Manager – Tax @ Riverus)