Budget 2015: India Inc’s demands on cost sharing and cost allocation arrangements

With increased globalization, the multinational enterprises (“MNEs”) are setting up their subsidiaries in various tax jurisdictions. These MNE group entities enter into various intra-group arrangements for provision and receipt of wide variety of technical, financial, administration and managerial services between its worldwide group entities. Both as a measure of cost-cutting and ensuring quality and efficiency of services, the MNE Head Office or any other centralized entity of an MNE allocates certain common costs for extending a wide range of services to the worldwide subsidiaries engaged in manufacturing, sales support, business support, management activities, and research and development.

Accordingly, tax administrations are showing a significant interest in critiquing MNE groups’ pricing and transaction structures in respect of allocation of common costs.

However, what India Inc really need is: clear guidelines for cost sharing and cost allocation arrangements on the below-mentioned.

Indian Transfer Pricing Regulations
The Indian transfer pricing (“TP”) regulations are still emerging and there is no specific mention of allocation of common cost in the Indian TP regulations (i.e. under sections 92 to 92F of the Income-tax Act, 1961). Thus, the TP law in relation to the intra group allocation of common costs has been interpreted having regard to the international tax practices followed in some other developed countries, along with the OECD Transfer Pricing Guidelines (“OECD TP Guidelines”).

The OECD TP Guidelines
The OECD TP Guidelines inter alia does not specifically cater to the allocation of common expenses. However, a reference of principles laid down therein in relation to intra-group services can broadly be considered for addressing the issues related to the allocation of common costs. The same has been provided as below:
· Have there been any benefits received by the entity paying such allocated cost?
· What should the intra-group charge be?

Firstly, the ‘need’ for allocation of the common costs along with the consequent direct or indirect ‘benefits’ are required to be determined. This need and benefit requirement can be determined by considering whether an independent enterprise in comparable circumstances would have been willing to pay for the activity if performed for it by an independent enterprise or would have performed the activity in-house for itself. For this purpose, the substance of the situation that always determines whether a transaction has taken place, rather than whether any invoice/ documentation have been exchanged. It is thus, important to appreciate that while theoretically the OECD TP Guidelines require the paying entity to demonstrate actual need for an intra-group charge by way of allocation of such common costs, there could be significant practical challenges to demonstrate the actual receipt of services or the tangible benefit directly co-relatable to the allocation of common cost.

For the valuation of services, the OECD TP Guidelines typically require related entities to compensate each other appropriately so as to meet the arm’s-length principle. In this regard, appropriate allocation key should be used for apportioning the common costs. The OECD TP Guidelines are not prescriptive on allocation keys but merely states that the allocation made based on the selected key must lead to a result that is consistent with what comparable independent enterprises would be prepared to accept.

Indian Jurisprudences
In the Indian context, the tax authorities have elementarily been focusing on the ‘need’ and ‘benefit’ of the payment made by the Indian entity to its MNE group members for the allocation of common costs. In the guise of determining the ALP of payments made in respect of allocation of common costs, the Indian tax authorities, on the contrary, are targeting the business and commercial expediencies of the taxpayer.

However, it is a settled principal in the Indian tax law and has been ruled out in various adjudications like EKL Appliances Limited [(2012) 209 Taxman 200]; AWB India Private Limited [ITA No.4454/Del./2011] and Indigene Pharmaceuticals [TS-46-ITAT-2014(HYD)-TP] etc., that the commercial expediency is not be questioned by the tax authorities.

In addition to above, the lower tax authorities also make upward additions on account insufficiency of evidences being produced by taxpayers. The same is an undue hardship to the taxpayer since the demonstration of ALP of allocation of common costs is highly subjective exercise and difficult to be established with certainty.

Documentation requirements
As discussed earlier, for an intra-group transaction, it is important to prove that the benefits are received by the taxpayer from payment of allocated cost to its MNE group members and also to justify the charge for these benefits derived. For this purpose, the companies should maintain adequate documentary evidences comprising of legal contracts, evidence of benefits in form of e-mails, reports, presentations, detailed invoices and/or other detailed worksheets or evidence of costs incurred.

Conclusion
In the context of an aggressive audit and litigation environment like the one that currently prevails in India, it is recommended to introduce the certain guidelines for determining the ALP of intra-group cost allocation of common costs in the Indian TP regulations. This would eventually avoid the hardship on the taxpayers which, at the first instance, have onus to prove the need and benefit analysis in respect of payment made towards allocated expenses. Certain mechanisms (like in case if the apportionment of common cost, based on certain allocation keys, is being verified/ audited, and further certified by an independent consultant) should be introduced in the Indian TP regulations which would ultimately benefit the both the taxpayer and tax administration in concluding the arm’s length nature of the payments made towards allocated costs.

(About the author: The article has been written by Rakesh Nangia, Managing Partner with inputs from Amit Bhalla, Manager, Nangia & Co.)