Year: 2021

The authors of the earlier articles in the MLI Series have covered various facets of the Multilateral Instrument (‘MLI’) such as the background and application of the MLI and various other specific articles in the MLI relating to dual resident entities, treaty abuse, transparent entities and method of elimination of double taxation. In this two-part article, the authors attempt to analyse Article 10 of the MLI relating to the anti-abuse rule for Permanent Establishments (‘PEs’) situated in third jurisdictions and some of the intricacies related therein. The first part of this article lays down the background for the introduction of this anti-avoidance rule, the broad structure of the rule, some of the issues arising in its interpretation and the interplay of this rule with the other articles of the MLI and other anti-avoidance measures.

1. BACKGROUND
At the outset, one admits that very limited literature is available in respect of this anti-abuse rule as most discussions on the MLI, at least in the Indian context, focus on the Principal Purpose Test (‘PPT’) and the amendments to the rules relating to the constitution of a PE. However, the anti-abuse rule for PEs situated in third jurisdictions can have significant implications, especially for an Indian payer undertaking compliance u/s 195 of the Income-tax Act, 1961 (‘the Act’), given the amount of information required to apply this rule.

Under this rule, the Source State can deny treaty benefits to taxpayers on certain conditions being triggered. Such treaty benefits can be in the form of a lower rate of tax (as in the case of dividends, royalty, fees for technical services) or in the form of narrower scope (such as the narrower definition of royalty under the treaty or the make-available clause). Therefore, when one is undertaking compliance u/s 195, one would need to evaluate the impact of this rule.

While a detailed evaluation of the impact on India has been provided subsequently in this article, before one undertakes an analysis of the anti-abuse rule it is important to understand how the taxation works in the case of a PE in a third state, i.e., in triangular situations and the abuse of treaty provisions that this rule seeks to address.

1.1 Basic structure and taxation before application of the said rule
For the purpose of this article, let us take a base example of interest income earned by A Co, a resident of State R, from money lent to an entity in State S and such income earned is attributable to the PE (say a branch) of A Co in the State PE as it is effectively connected with the activities of the PE. A diagrammatic example of the said structure is provided below:

 

In this particular fact pattern, State S being the country of source would have a right to tax the interest. However, such right may be restricted by the application of the R-S DTAA, particularly the article dealing with interest. If the article on interest in the R-S DTAA is similar to that in the OECD Model Convention1, interest arising in State S payable to a resident of State R, who is the beneficial owner of the income, can be taxed in State S but not at a rate exceeding 15% of the gross amount of the interest.

1   Unless specifically
provided, the OECD Model Tax Convention and Commentary referred to in this
article is the 2017 version

Now, State PE, being the country in which the PE of A Co is constituted, will have the right to tax the income of the PE in accordance with the domestic tax laws and in the manner provided in the article dealing with business profits of the R-PE DTAA.

Further, while State PE would tax the profits of the PE, one would apply the non-discrimination article in the R-PE DTAA which generally provides that the taxation of a PE in a particular jurisdiction (State PE in this case) shall not be less favourable than that of a resident of that jurisdiction (State PE). This particular clause in the article would enable one to treat the PE as akin to a resident of State PE and therefore would be eligible to claim the foreign tax credit in State PE for taxes paid in State S2. The OECD Model is silent on whether State PE shall provide credit under domestic tax law or whether it would restrict the credit under the DTAA between State PE and State S. This issue of tax credit, not being directly related to the subject matter of this article, has not been dealt with in detail.

State R being the country of residence, would tax the income of the residence and provide credit for the taxes paid in State S as well as State PE in accordance with the R-S and the R-PE DTAAs.

1.2 Use of structure for aggressive tax planning
Many multinationals use the triangular structure to transfer assets to a jurisdiction which has a low tax rate for PEs and where the residence state provides an exemption for profits of the PE. These structures were typically common in European jurisdictions such as Belgium, Luxembourg, Switzerland and the Netherlands.

A common example is of the finance branch set up by a Luxembourg entity in Switzerland3. In this fact pattern, a Luxembourg entity would set up a branch in Switzerland for providing finance to all the group entities all over the world. Given the fact that a finance branch only required movement of the funds, it was fairly easy to set up the structure wherein the funds obtained by the Luxembourg entity (A Co) would be lent to its branch in Switzerland. This finance branch would then lend funds to all the operating group entities around the world acting as the bank of the group and earning interest. Interest paid by the operating entities would be deductible in the hands of the paying entity and taxed in the country of source in accordance with the DTAA between that jurisdiction and Luxembourg. Further, the Swiss branch, constituting a PE in Switzerland, would be subject to very low taxation in accordance with the domestic tax law in Switzerland.

2   Refer para 67 of the OECD
Model Commentary on Article 24

3   J-P. Van West, Chapter 1:
Introduction to PE Triangular Cases and Article 29(8) of the OECD Model in The
Anti-Abuse Rule for Permanent Establishments Situated in Third States: A Legal
Analysis of Article 29(8) OECD Model (IBFD 2020), Books IBFD (accessed 16^th
November, 2021)

Moreover, the Luxembourg-Swiss DTAA provides that in the case of a PE in a Contracting State, the Resident State (State R) will relieve double taxation by using the exemption method (and not the tax credit method as is generally prevalent in the Indian tax treaties), i.e., the Resident State (State R) would not tax the profits attributable to a PE in the other State. Therefore, the profits attributable to the Swiss branch of A Co would be exempt from tax in Luxembourg.

This would result in the interest being taxed in the country of source (with a deduction for the interest paid in the hands of the payer in the country of source) at a concessional treaty rate, very low tax in the country where the PE is constituted, i.e., Switzerland and no tax in the country of residence, i.e., Luxembourg by virtue of the exemption method followed in the Luxembourg-Swiss DTAA.

Like interest, one could also transfer other assets which resulted in passive income such as shares and intangible assets, resulting in a low tax incidence on the dividend and royalty income, respectively.

Let’s take the example of India, where a resident of Luxembourg invests in the shares of an Indian company through a PE situated in Switzerland. In such a scenario, India would tax the dividend at the rate of 10% due to the India-Luxembourg DTAA (as against 20% under the Act), Switzerland may tax the income attributable to the PE at a low rate and Luxembourg would not tax the income in accordance with the Luxembourg-Switzerland DTAA.

The OECD, recognising the use of PE to artificially apply lower tax rates, attempted to tackle this in the OECD Model Convention by providing further guidance on what would be considered as income effectively connected in the PE. For example, para 32 of the 2014 OECD Model Commentary on Article 10, dealing with taxation of dividends, provides,

‘It has been suggested that the paragraph could give rise to abuses through the transfer of shares to permanent establishments set up solely for that purpose in countries that offer preferential treatment to dividend income. Apart from the fact that such abusive transactions might trigger the application of domestic anti-abuse rules, it must be recognised that a particular location can only constitute a permanent establishment if a business is carried on therein and, as explained below, that the requirement that a shareholding be “effectively connected” to such a location requires more than merely recording the shareholding in the books of the permanent establishment for accounting purposes.’

Similar provisions were also provided in the Commentary on Article 11 and Article 12, dealing with interest and royalty, respectively.

However, the above provisions may not necessarily always tackle all forms of tax avoidance. Thanks to the nature of tax treaties applying only in bilateral situations, it may not apply in case of a PE constituted in a third state (State PE). Similarly, one may still achieve an overall low rate of tax by moving the functions related to the activities in the State PE. For example, in the case of a finance branch, one can consider moving the treasury team to State PE with an office, which would constitute a fixed place of business and therefore, the interest income earned from the group financing activities may still be effectively connected to the PE in the State PE.

The OECD Model recognised this limitation and para 71 of the 2014 OECD Model Commentary on Article 24 provides that a provision can be included in the bilateral treaty between the State R and the State S to provide that an enterprise can claim the benefits of the treaty only if the income obtained by the PE situated in the other State is taxed normally in the State of the PE.

1.3 BEPS Action 6
The US was one of the few countries which had provisions similar to the Article in the MLI in its tax treaties even before the OECD BEPS Project. In fact, even though the US is not a signatory to the MLI, the provisions as released by the US were used as a base for further discussion in the BEPS Project. The anti-abuse rule was covered in the OECD BEPS Action Plan 6 dealing with Preventing the Granting of Treaty Benefits in Inappropriate Circumstances.

The objective of the anti-abuse provision is provided in para 51 of the BEPS Action 6 report, which is reproduced below,

‘It was concluded that a specific anti-abuse provision should be included in the Model Tax Convention to deal with that and similar triangular cases where income attributable to the permanent establishment in a third State is subject to low taxation.’

While the language in the MLI is similar to the suggested draft in the final report of the BEPS Action Plan 6, there are certain differences – mainly certain deletions, in the MLI, which have been discussed in detail in the second part of this article.

It is important to note that while Article 10(1) is included in the MLI as a specific anti-avoidance rule, MLI also contains a general anti-avoidance rule under Article 7 through the PPT. Further, in the Indian context, the domestic law also contains anti-avoidance provisions in the form of general anti-avoidance rules. An interplay between all three is discussed in para 3.5 below.

2. STRUCTURE AND LANGUAGE OF ARTICLE 1
2.1 Introduction to Article 10
The language contained in this Article refers to various terminologies that have been defined under Article 2 of the MLI [e.g., Contracting Jurisdiction (‘CJ’), Covered Tax Agreement (‘CTA’)]. Those terminologies referred to in Article 10, which have not been defined under Article 2 of the MLI, have to be interpreted as per Action 6 of Base Erosion and Profit Shifting (‘BEPS’).

Article 10 of the MLI seeks to deny treaty benefits in certain circumstances.

2.2 Structure
Article 10 of the MLI is structured in six paragraphs wherein each paragraph addresses a different aspect related to the anti-abuse provision. The flow of the Article is structured in such a way that the conditions for attracting the provisions of the article are laid down first, followed by the exceptions and finally the reservation and notification which are in line with the overall scheme of the MLI.

To better understand Article 10, it would be beneficial to understand each paragraph individually. Let us proceed as per the order of the article.

Paragraph 1:
Paragraph 1 brings out the conditions for the applicability of Article 10 in certain circumstances:

‘Where:

a) an enterprise of a Contracting Jurisdiction to a Covered Tax Agreement derives income from the other Contracting Jurisdiction and the first-mentioned Contracting Jurisdiction treats such income as attributable to a permanent establishment of the enterprise situated in a third jurisdiction; and

b) the profits attributable to that permanent establishment are exempt from tax in the first-mentioned Contracting Jurisdiction,

the benefits of the Covered Tax Agreement shall not apply to any item of income on which the tax in the third jurisdiction is less than 60 per cent of the tax that would be imposed in the first-mentioned Contracting Jurisdiction on that item of income if that permanent establishment were situated in the first-mentioned Contracting Jurisdiction. In such a case, any income to which the provisions of this Paragraph apply shall remain taxable according to the domestic law of the other Contracting Jurisdiction, notwithstanding any other provisions of the Covered Tax Agreement.’

Each underlined word is a condition for the applicability of the article and has its own significance.

An enterprise – The question as to how to interpret the term ‘an enterprise’ and what comes under the purview of the same is covered in the later part of this article.

derives income from the other Contracting Jurisdiction – This emphasises on the aspect that the income earned by the Resident State should be derived from the State S for the Article to get triggered.

income as attributable to a permanent establishment of the enterprise situated in a third jurisdiction – In addition to the condition as mentioned above, the income derived by the State PE from State S should be treated as attributable to the PE in State PE by State R.

exempt from tax in the first-mentioned Contracting Jurisdiction – This covers the point regarding the taxability of the profits attributable to the PE in the State R. It focuses on the point that Article 10 would be applicable if the profits attributable to the PE are exempt from tax in State R.

tax in the third jurisdiction is less than 60 per cent – This sentence points out the 60% test which states that the tax in the State PE is less than 60% of the tax that would be payable in the State R on that item of income if that PE was situated in the State R.

In case all the above conditions are satisfied, the benefits of the CTA between the State R and the State S shall not apply to such item of income.

The second part of paragraph 1 gives power to the State S to tax the item of income as per its domestic laws notwithstanding any other provisions of the CTA in cases where the provisions of Article 10(1) are satisfied.

Thus, it can be understood that the provisions of Article 10(1) emphasise on the denial of treaty benefits in order to prevent complete non-taxation or lower taxation of an item of income.

Paragraph 2:
Paragraph 2 states the exceptions where the provisions as set out in paragraph 1 of the Article 10 will not be applicable.

The exception covers the income derived from the State S in connection with or is incidental to active conduct of the business carried on by the PE. However, the business of making, managing or simply holding investments for the enterprise’s own account such as activities of banking carried on by banks, insurance activities carried on by insurance enterprises and securities activities carried on by registered securities dealers will not come under the purview of paragraph 1 of the Article. The business of making, managing or simply holding investments for the enterprise’s own account carried on by other than the above-mentioned enterprises shall come under the purview of paragraph 1 of the Article. A detailed discussion on what is considered as active conduct of business is covered in the second part of this article.

Paragraph 3:
Paragraph 3 of Article 10 provides that even if treaty relief is denied due to the trigger of the provisions of
Article 10(1), the competent authority of State S has the authority to grant the treaty relief as a response to a request by the taxpayer in the State R on the basis of justified reasons for not satisfying the requirements of Article 10(1).

In such situations, the competent authority of the State S shall consult with the competent authority of the State R before arriving at a decision.

Paragraph 4:
Paragraph 4 is the compatibility clause between paragraph 1 through paragraph 3 which mentions ‘in place of or in the absence of’.

This means that if there is an existing provision in a CTA which denies / limits treaty relief in instances of triangular cases (‘Existing Provision’), then such a provision would be modified (i.e. in place of) to the extent paragraph 1 through 3 are inconsistent with the existing provisions (subject to notification requirements analysed below).

However, if there is no existing provision then paragraph 1 through 3 would be added to the CTAs (i.e., in absence of).

Paragraph 5:
Article 10(5) covers the reservation aspect to be in line with the overall scheme of the MLI.

This reservation clause is applicable because Article 10 is not covered under minimum standard and hence the scope for reservation is wide. There are three options available to each signatory:
a) Article to not be applicable to all CTA’s in entirety, or
b) Article to not be applicable in case where the CTA already contains the provision as mentioned in paragraph 4, or
c) Article to only be applicable in case of CTA’s that already contain the provisions as mentioned under paragraph 4 (i.e., the existing provisions to be modified to the extent that they are inconsistent with the provisions of Article 10).

Paragraph 6:
Article 10(6) provides the notification mechanism to assess the impact of the reservations and position adopted by the signatories on the provisions of the CTAs.

In cases where the parties decide to go as per sub-paragraph (a) or (b) of Article 10(5), then they need to notify the depository whether each of its CTA contains the provisions as per Article 10(4) along with the article and paragraph number. In case where all contracting jurisdictions have made such a notification, then the existing provisions shall be replaced by the provisions of Article 10. In other cases, such as in the case of a notification mismatch (i.e., one signatory to the CTA does not notify the provisions of Article 10 whereas the other signatory to the same CTA notifies them), the existing provisions shall ONLY be modified to the extent that they are inconsistent with the provisions of Article 10.

India has not made any reservation. Further, India has not notified any DTAAs which have a provision similar to that in para 4 of Article 10. Therefore, the provisions of Article 10 of the MLI shall supersede the existing provisions of the DTAAs to the extent they are incompatible with the existing provisions.

2.3 Reason as to why the Source Country should not grant DTAA benefits
The main policy consideration for implementation of Article 10 of the MLI is to plug the structure wherein one can artificially reduce the overall tax simply by interposing a PE in a low-tax jurisdiction, which is a major BEPS concern.

Tax treaties allocate the taxing rights between the jurisdictions. A Source State giving up its taxing rights is a result of bilateral negotiation with the Residence State. However, if such Residence State decides to treat such income as attributable to a third state and therefore not taxing such income by virtue of another treaty of which the Source State is a not a party, would be against the intention of the countries who have negotiated the treaty in good faith.

Therefore, if State R gives up its right of taxation of income earned from State S due to the artificial imposition of a PE in a third State, Article 10 of the MLI gives the entire taxing right back to State S.

3. SOME ISSUES RELATED TO INTERPRETATION OF PARA 1 OF ARTICLE 10 OF MLI
Having analysed the broad provisions of Article 10 of the MLI, the ensuing paragraphs seek to raise (and analyse) some of the issues in relation to para 1 of Article 10.

3.1 Definition of PE – Which DTAA to Apply
While considering the situation of denial of treaty benefits laid out in the treaty between State R and State S with regard to the income earned by the PE of an entity of the State R in a State PE, there are two DTAA’s that come under this purview, namely:
i. Treaty between the State R and the State S, and
ii. Treaty between the State R and the third state (PE State).

For the purpose of referring to the definition of PE, the first question that arises is which of the two DTAAs has to be referred to? This issue arises mainly because the term ‘Permanent Establishment’ is not a general term but is a specific term which is defined in the DTAA (generally in Article 5 of the relevant DTAA).

A view could be that since the acceptability or denial of benefits under the DTAA between the State R and State S is evaluated and State S is the jurisdiction denying the treaty benefit, one should look at the DTAA between the State R and State S to determine the PE status. However, the objective of the anti-abuse provision is to target transactions wherein income is not taxed in State R due to a PE in State PE. Further, MLI 10(1) applies only if the Residence State treats the income of an enterprise derived from the Source State as attributable to the PE of a third State. This decision of Residence State is obviously on the basis of its treaty with the PE State as it is a bilateral decision. As the Source State is not a party to this decision, the treaty between Residence State and Source State cannot be applied. Therefore, a better view would be to consider the provisions of the DTAA between the State R and the third state (State PE) for the definition of PE.

It is also important to note that prior to introduction of MLI, Article 5 of the DTAA was referred to in order to establish the PE status. However, post introduction of the MLI, one would also need to evaluate the impact of Article 12 to Article 15 of the MLI which covers the PE status based on Action 7 of Base Erosion and Profit Shifting (BEPS). This, of course, is subject to the CTA between Residence State and PE State not reserving the above articles.

3.2 Whether PE jurisdiction needs to be a signatory to MLI
Article 10 of the MLI merely provides that State S should deny benefit of the DTAA between State R and State S if certain conditions are triggered. One of the conditions is that the income is treated by Residence State as attributable to the PE of the taxpayer in State PE. Having concluded the above, that the PE definition under the DTAA between State R and State PE should be considered, it is not necessary that such DTAA is impacted by the MLI. If the DTAA between State R and State PE is impacted by the MLI, one would need to consider the modified definition of PE in such a situation.

Here, it would be important to look at Article 34 of the Vienna Convention on the Law of Treaties, 1969. The same is reproduced below:

Article 34 – General Rule Regarding Third States
A treaty does not create either obligations or rights for a third state without its consent.

In this particular scenario, it is clear that there is no right or obligation granted to the State PE under the DTAA between State R and State S. State PE can continue to tax the profits of the PE.

Further, by signing MLI Article 10, State S and State R should be deemed to have consented their rights and obligations under the State R-State S treaty as amended by MLI Article 10. Consequently, State PE would not be required to be a signatory to the MLI.

3.3 No taxation in country of residence
Another issue which arises is what if the country of residence does not tax the income irrespective of whether the income is attributable to a PE or not. For example, if dividend income is earned by a resident of Singapore and such income is attributable to the PE of the shareholder in a third jurisdiction, such dividend would not be taxable irrespective of whether the dividend is attributable to a PE in a third state or not.

In such a scenario, Article 10 of the MLI should not apply as the tax rate in State PE is not less than 60% of the tax rate in State R. In any case, as the Source State had given up its right of taxation even when the Residence State did not tax such income and imposing a third jurisdiction in the transaction, would not result in a reduction of taxes in the Residence State.

3.4 Interplay of Article 10 with Article 5
Article 5 of the MLI provides for the elimination of double taxation using the credit method as against the exemption method. It refers to three options for preventing double non-taxation situations arising due to the State R providing relief under the exemption method for income not taxed in the State S.

The interplay between Article 5 and Article 10 comes into play because Article 10 is applicable only in cases where the income is exempt in the State R. So, in order to determine whether or not the income is exempt in the State R, Article 5 will have to be referred to. If the DTAA between State R and State PE provides for the exemption method for elimination of double taxation, but State R has opted to apply Article 5 of the MLI, the credit method would apply and in such a situation, in the absence of exemption granted in State R, the provisions of Article 10(1) shall not apply.

India has opted for Option C under Article 5 which allows a country to apply the credit method to all its treaties where the exemption method was applicable earlier. Therefore, with respect to India only credit method will be applicable as a method to eliminate double taxation.

Given that India’s tax treaties apply the credit method for providing relief from double taxation, the situation contemplated under Article 5 may not be relevant in the Indian context.

3.5 Interplay of Article 10 with PPT / GAAR
The Principle Purpose Test (‘PPT’) rule under Article 7 is the minimum standard and applies to all DTAAs covered under MLI. A question could therefore arise as to which provision would override the other. It is pertinent to note that provisions of Article 29 of the OECD Model clearly specify that Article 29 would apply where the PPT has been met. However, Article 10 of the MLI does not lay down any preference of application of PPT or otherwise. Consequently, it could be possible to take a view that if the specific conditions of Article 10 are met, PPT rule should not apply to deny the treaty benefits.

However, a better and sensible view could be that even if the special anti-abuse provision contained in Article 10 is satisfied, the general anti-abuse provision under Article 7(1) also needs to be satisfied to avail treaty benefits. In other words, where the main purpose to set up or constitute the PE in the third state (State PE) was to obtain tax benefit, such an arrangement should be covered under the mandatory provisions of Article 7(1) of the MLI so as to deny the treaty benefits. In a case where the provisions of MLI Article 10 are applicable, the treaty benefits can be denied based on the applicability of MLI Article 10 itself. In other words, MLI article 7(1) and MLI Article 10 both can co-exist and an assessee needs to satisfy both the tests to avail treaty benefits.

Further, in a case where India is the State S, one will also have to see the applicability of GAAR provisions and its interplay with the provisions of Article 10. Typically, GAAR applies where the main purpose of the arrangement is to obtain tax benefit and the GAAR provisions can kick in to deny the treaty benefits as well. Here it is important to note that both Indian domestic law and OECD recognise that the provisions of GAAR / PPT and SAAR / MLI 10 can co-exist. FAQ 1 under Circular 7 of 2017 states that the provisions of GAAR and SAAR can co-exist and are applicable, as may be necessary, in the facts and circumstances of the case. The same has also been recognised under para 2 of the OECD commentary on Article 29.

4. CONCLUSION
In the second part of this article, the authors will attempt to analyse some practical challenges arising on account of the difference in the tax rates of the jurisdictions involved and the impact of the anti-avoidance rule on India. The second part will also cover the difference between Article 10 of the MLI and the BEPS Action Plan 6 Report on the basis of which the rule was incorporated in the MLI and Article 29 of the OECD Model.  

 

The recently introduced new tax reporting obligations under the three-tier documentation [that is, country-by-country report (CbCR), master file and local file] pursuant to implementation of Action 13 of the action plans on Base Erosion and Profit Shifting (BEPS1) for companies having cross-border operations, requires maintenance and sharing of the transfer pricing documentation with tax authorities across the globe. While the CbCR will give tax authorities much more information on the global tax footprint of the group, the master file requires it to produce a global ‘overview’ of a multinational entity’s business including its supply chain, allocation of income and transfer pricing policies, and this may include sharing of critical and sensitive information about its business operations. The documentation required has become more robust and in sync with the actual conduct of the operations as against the contractual obligations. Hence, the existing requirement of documentation, which historically has been the cornerstone for supporting the arm’s length standard, needs to be aligned with the new reporting framework. The discrepancy between the two documentation frameworks, if not reconciled, can lead to misinterpretations and ineffective discussions between the taxpayers and tax authorities. This has led to the taxpayers relooking at the way the businesses have been conducted and requiring a much closer alignment between a company’s value chain, operating model and the tax structure.

1   BEPS
relates chiefly to instances where the interaction of different tax rules leads
to double non-taxation or less than single taxation. It also relates to
arrangements that achieve no or low taxation by shifting profits away from the
jurisdictions where the activities creating those profits take place – OECD’s
publication on ‘Action Plan on Base Erosion and Profit Shifting’

In line with the above and with the advent of the new framework of documentation, the arm’s length principle (ALP) which was considered to be transaction-based and at most entity-based, has evolved from the entity approach to mapping of the position of the group entities and reconciling the profits allocated according to arm’s length with ‘value creation’. This shift is more so as ALP is seen as being vulnerable to manipulation as it lays emphasis on contractual allocations of functions, assets and risks and this results in outcomes which do not correspond to the value created through the economic activity carried out by the members of the group. Some of the instances of current ALP mismatches are given below:

(a) Benchmarking analysis currently undertaken which considers only one part of the transaction without taking into consideration the holistic analysis of the parties involved in the intercompany transaction.
(b) Commissionaire model wherein the significant people functions contribute highly to the group but draw only a cost plus or fixed return to the entity with the people function.
(c) IP structures without the people function charging royalty to the group entities by claiming to be the legal owner of intangibles while no value creation happens in the said entities.

Hence, for the sustainability of the group’s transfer pricing policy, it becomes necessary to conduct a value chain analysis in order to bridge the gap between the requirements of the existing documentation requirement and the BEPS-driven documentation.

Value chain analysis in simple terms means a systematic way of examining all the activities performed by the business and determining the sources of the competitive advantage which translate into profit for the group. In short, a value chain analysis projects the value creation story of the group by bringing out how and where the value is created and by which entities within the group. This analysis is crucial as it will assist the group to test and corroborate the alignment of the transfer pricing policies with the value creation.

The OECD in its BEPS projects has also recognised value chain analysis as being useful in determining the value drivers and the relevant factors necessary for splitting the profits to the entities creating the value. Further, Actions 8-102: 2015 Final Reports on ‘Aligning transfer pricing outcomes with value creation’ states that the value chain analysis should consider where and how value is created in the operations by considering the following:
(a) Economically significant functions, assets and risks and the key personnel contributing to the same;
(b) The economic circumstances that add to the creation of opportunities to increase profits;
(c) The substance in the value creation and whether the same is sustainable or short-term.

Effectively conducted value chain analysis can lead to transformation in the supply chain in order to align with the value drivers. A value chain analysis thus provides companies with a means to defend their transfer pricing policies, i.e., to prove that the arm’s length price is in sync with the actual functions performed, assets employed and risks assumed.

ORIGIN AND CONCEPT OF VALUE CHAIN
The concept of ‘value chain’ was introduced by Micheal Porter in his book The Competitive Advantage: Creating and Sustaining Superior Performance, back in 1985. In simple terms, it refers to the chain of activities performed by a business to transform an input for a product or service into an output that is of value in the market for the customer. Such activities could range from design and development, procurement, production, marketing, logistics, distribution, to after-sales support to the final customer. These activities may be performed by a single entity or a group of entities which are based in different locations that contribute to the overall profitability of the business.

With increasing globalisation, international trade and advent of technology, the value chains of MNEs are dispersed across multiple geographies and entities which have resulted in the evolution of the concept of global value chain (‘GVC’). GVCs are organisational systems that operate across multiple nations and are highly integrated. GVCs help the MNEs to achieve enhanced productivity, efficiency and economies of scale at a global level in this dynamic business environment. Typically, a GVC would involve vertical integration of economic activities which at the same time are divided across countries, specialisation in tasks and business-related functions and reliance on the integrated networks of buyers and suppliers.

2   Actions
8 to 10 – Action 8 relates to TP framework for intangibles and cost
contribution agreements, Action 9 relates to TP framework for risks and
capital, and Action 10 relates to TP methods for other high-risk transactions

POST-BEPS – GUIDANCE PROVIDED ON VALUE CHAIN
BEPS is an initiative by the OECD which seeks to ensure that each country gets its fair share of taxes by setting up effective domestic and international tax systems which curb base erosion and profit shifting by multinational corporations by misusing the gaps and mismatches in the present tax systems. As a part of this project, 15 detailed Action Plans were laid down by the OECD across the themes of coherence, economic substance and transparency.

The concept of value chain analysis, though well-known, has gained more significance with the BEPS initiative. From a transfer pricing perspective, the important areas of change lie within the ‘economic substance’ and ‘transparency’ themes. The need for value chain analysis is rooted under both the said themes and is the heart of the BEPS from a transfer pricing perspective.

The OECD3 recognised that there is a need to address the issues arising due to mismatch of economic substance in corporate structures, where the income is parked in low tax jurisdictions under legal entities which lack substance, thus leading to erosion of the tax base of the other high tax jurisdictions.

Some of the guidance available emphasising on the relevance of value chain are reproduced below:

– OECD’s publication on ‘Action Plan on Base Erosion and Profit Shifting’ 2013 has highlighted the importance of value chain analysis:
Action 54 – Point (ii) on ‘Restoring the full effects and benefits of international standards’ states that ‘Current rules work in many cases, but they need to be adapted to prevent BEPS that results from the interactions among more than two countries and to fully account for global value chains’.

– BEPS Action Plan 8-10’s final reports, ‘Aligning Transfer Pricing Outcomes with Value Creation’ released in 2015 lays emphasis on value chain in determining the arm’s length price for transactions with related parties. This was also included in the OECD Transfer Pricing Guidelines, 2017 (‘TPG’), in para 1.51 – Functional analysis, which reads as under:
‘… it is important to understand how value is generated by the group as a whole, the interdependencies of the functions performed by the associated enterprises with the rest of the group, and the contribution that the associated enterprises make to that value creation. It will also be relevant to determine the legal rights and obligations of each of the parties in performing their functions…
Determining the economic significance of risk and how risk may affect the pricing of a transaction between associated enterprises is part of the broader functional analysis of how value is created by the MNE group and the activities that allow the MNE group to sustain profits, and the economically relevant characteristics of the transaction…” para 1.73

3   OECD
– Organization for Economic Co-operation and Development

4   Action
5 relates to countering harmful tax practices more effectively, taking into
account transparency and substance

– The TPG lays emphasis on the principle of substance over form in para 1.66 which reads as under –
‘The capability to perform decision-making functions and the actual performance of such decision-making functions relating to a specific risk involve an understanding of the risk based on a relevant analysis of the information required for assessing the foreseeable downside and upside risk outcomes of such decisions and the consequences for the business of the enterprise…’

– The public discussion draft of revised guidance on Profit Splits of 20165, contained a section on value chain analysis, which emphasised the following –
• A value chain analysis can be used as a ‘tool to assist in delineating the controlled transactions, in particular in respect of the functional analysis, and thereby determining the most appropriate transfer pricing methodology.’
• A value chain analysis ‘does not, of itself, indicate that the transactional profit split is the most appropriate method, even where the value chain analysis shows that there are factors which contribute to the creation of value in multiple places, since all parties to a transaction can be expected to make some contributions to value creation’.

However, this section was eliminated from the final Guidance as it was thought that overemphasis could unduly uplift the significance of profit splits even in cases where this would not be the best method.

5   https://www.oecd.org/tax/transfer-pricing/BEPS-discussion-draft-on-the-revised-guidance-on-profit-splits.pdf

– In relation to analysis of intangibles, the TPG lays focus on identifying the factors that contribute to value creation and entities that perform economically significant functions in relation to the intangibles which are used by the MNE to create value for the business. The relevant paras are given below:

‘…In cases involving the use or transfer of intangibles, it is especially important to ground the functional analysis on an understanding of the MNE’s global business and the manner in which intangibles are used by the MNE to add or create value across the entire supply chain…’ para 6.3

‘In a transfer pricing analysis of a matter involving intangibles, it is important to identify the relevant intangibles with specificity. The functional analysis should identify the relevant intangibles at issue, the manner in which they contribute to the creation of value in the transactions under review, the important functions performed and specific risks assumed in connection with the development, enhancement, maintenance, protection and exploitation of the intangibles and the manner in which they interact with other intangibles, with tangible assets and with business operations to create value…’ para 6.12.

– BEPS Action Plan 13 on three-tier documentation requires disclosure of certain information in the master file for the MNE group such as key value drivers of
the business, details on intangibles, transfer pricing policies, contribution of the key group entities, etc., which will enable tax administrations access to global documentation leading to enhanced transparency
and thereby provide a mechanism to tackle BEPS problems.

– Both the local documentation and the CbCR could reveal the key data points in relation to the MNCs’ IP activities highlighting the low substance entities generating lower taxable income.

– Also, there are certain countries (such as China, Germany, Spain, Austria, Ecuador, South Africa, etc.) where the tax administrations lay emphasis on documentation of the VCA in the local TP documentation.

WHAT IS VALUE CHAIN ANALYSIS (‘VCA’)
VCA can be said to be a blueprint of the MNE’s group operations. The analysis involves a detailed investigation into the functions, assets and risks of the MNE as a whole and thereby evaluating the contribution of each of the activities involved in the value chain to the overall value created by the group. A VCA is a deep-dive analysis of understanding where and how the economic value is created and by which parties within a multinational group.

A VCA reflects the key value drivers for an MNE’s business, sector, or line of activity and identifies the relative contributions to the value-creation process. Value driver is something that contributes to the generation of income for an MNE’s business. Value drivers could also be defined as the performance variables that will actually create the value of the business.

The value drivers may vary across different businesses, industries and sectors. It is important to note that the nature of the business or industry generally defines whether it has more of tangible or intangible value. Most of the service industry players will have greater intangible value while an asset intensive industry will have higher tangible value. For instance:
(a) For Apple, which is one of the leading companies which sells computers, mobile phones and such other electronic devices, their key value drivers would be continuous innovation, unique technology which differentiates their products from the other competitors in the market, brand, customer loyalty, geographic reach, etc.
(b) For an IT company like Infosys which is a multinational company engaged in providing services in the area of information technology, business consultancy, outsourcing and managed services, their key value drivers would be employee productivity, a skilled and trained workforce, a global delivery model, latest technology, acquisitions, etc.
(c) For a company like McDonalds which falls under the fast-food industry, the value drivers would be product quality and customer health, human capital, environment footprint, brand management, sustainable supply chain and packaging waste, etc.
(d) For a company like Paytm which is a leading digital financial services platform, the value drivers would be technology, customer experience, availability of frictionless payment options, etc.

The VCA highlights the economically significant functions performed and risks assumed by the MNE group and also by the individual entities within the group which leads to value creation for the group. Further, by understanding whether an entity is really controlling the function / risk, it becomes easier to understand whether such an entity is adequately remunerated for these activities in line with its value contribution and whether it would need to be remunerated if there is a transfer of such function or risk from that entity to any other group entity. The VCA helps in identifying the commercial or financial relations between the parties and thereby assists in accurately delineating the controlled transactions based on the actual conduct of the parties in the entire value chain. A VCA is therefore a critical and important step for the purpose of drawing conclusions from a tax and transfer pricing perspective to align the value drivers with the functions performed and risks borne by the respective entities in the global value chain.

STEPS FOR UNDERTAKING VCA
There is no ‘right’ way of conducting a value chain analysis because every business will have its own value drivers and value creation story. Further, there are various techniques that can be applied while conducting a VCA to map the activities against the value creation. We explain below some of the steps which need to be considered in performing a VCA:

Step 1: Identification of the value drivers for the business
Value drivers in principle are common for a business operating in a particular industry or sector; however, its importance will vary from business to business. These drivers can be linked to the tangible assets or intangible assets of the business that are created or used for conducting the business, the various processes / systems adopted, customer relationships developed, the skilled workforce, or even the culture of the organisation which leads to value creation. Also, not all the value drivers would draw equal weightage when their contributions in the value chain are analysed. Hence, it is important to evaluate their relative value in the entire value chain by assigning a numerical weightage to them.

Step 2: Mapping the contribution by the legal entities / territories
The next step is to determine and map the contribution to the value generated by the value drivers with the legal entities that are part of the value chain. This will involve conducting a detailed functions, asset and risk analysis for the legal entities, analysing the key tangible and intangible assets employed and the risks assumed by the entities while contributing to the value chain. The OECD guidelines provide a detailed framework on risk analysis – control and management of risks, which would play a vital role in determining their weightage in value creation. Para D.1.2.1.1 of the TPG.

Step 3: Allocate the profits to the legal entities
Based on the results of Steps 1 and 2, the overall profit of the group is calculated and then appropriately allocated to the respective legal entities in line with the weightage assigned to the relative contributions of the entities in the value chain.

Step 4: Alignment with the transfer pricing outcomes
The results of Step 3 can be compared with the existing or proposed transfer pricing for controlled transactions across the group and in alignment with the value created by each of the entities in the value chain. VCA is a corroborative analysis which would help identify the mismatches in the pricing for the individual entities by providing a holistic picture of the allocation of profit results at a group level.

We have illustrated below a case study evaluating the value chain for an MNE group:

 

In relation to the above case study:
• F Co. is the parent company of I Co., S Co. and D Co.
• F Co. is engaged in full-fledged manufacturing activities.
• I Co. and S. Co. are R&D centres of the group.
• I Co. supervises the R&D services performed by S Co.
• D Co. is a full-fledged distributor engaged in distribution of goods in the local jurisdiction.

Value chain – Analysis of the value contribution of each of the parties

Functions of F Co.	Functions of I Co.	Functions of S Co.	Functions of D Co.
• Manufacture and sale of products • Legal owner of the IP developed by I Co. and S Co. • Provides funding to I Co. and S Co.	• Manages the R&D projects by hiring own R&D workforce • Frames its own research budgets, decides on the termination /	• Designs and develops R&D programme under the supervision and control of I Co. • Performs the contract R&D services	• Imports (procures) finished goods from F Co. and sells to local customers • Performs local marketing and sales functions
(continued)   for the R &D activities	(continued)   modification to the R&D projects • Controls and supervises the R&D activities performed by S Co. • Takes all the relevant decisions related to R&D of S Co.	(continued)   under supervision and control of I Co.	• After sales support activities
Risks borne by F Co.	Risks borne by I Co.	Risks borne by S Co.	Risks borne by D Co.
• Financial risk of failure of R&D projects • Operates as a full-fledged manufacturer bearing all the related risks	Responsible for key development activities and risk management functions of I Co. and S Co. both in relation to the IP developed through the R&D activities	Limited risks service provider – attrition risk, foreign currency fluctuation risk, technology risk, etc.	Takes title to the goods and bears the related risks such as market risks, inventory risk, credit risk, foreign currency fluctuation risk, etc.

In order to perform an analysis of the value contribution of each of the entities it is essential to understand the functions performed and risks assumed by each of the entities in the value chain. From the above tabulation of the functional and risk analysis of all the entities participating in the value chain of the group, it is evident that the primary functions in the value chain are research and development, procurement, manufacturing, sales and marketing and after sales services. Various entities of the group based in different geographies are engaged in performing the said activities in relation to these functions which leads to creation of value for the group and thereby results in generating profits. The key value drivers for this business are people, technology, marketing intangible (brand), customer base, innovation through R&D, location savings, etc.

In the above case study, from a transfer pricing perspective the following are the key points for consideration:
a) F Co. being the IP owner contractually assumes the financial risk and has the financial capacity to assume the risk in relation to the IP developed as a result of the R&D activities performed by I Co. and S Co. However, it does not exercise any control over these risks. Accordingly, in addition to the return on the manufacturing function, F Co. may only be entitled to a risk-free return on the funding activities.
b) I Co. is entitled to returns derived from the exploitation of the intangibles developed as a result of the R&D efforts of I Co. and S. Co., as it performs both the development and risk management functions in relation to the intangibles developed.
c) S Co. needs to be remunerated for its contract R&D services rendered to F Co. based on the function, asset and risk analysis in relation to these activities performed by F Co. In determining the remuneration for S Co., it will be critical to consider the comparability factors such as the skill sets of the employees employed for performing the R&D services, the nature of research being undertaken, etc.
d) D Co. is a full-fledged distributor and needs to be remunerated adequately for the distribution functions performed by it.

In the above case study, based on the steps for conducting the VCA (explained before the case study), the controlled transactions were accurately delineated from the value chain and the key functions performed and risks assumed by the respective group entities in the value chain have been identified and evaluated. On the basis of the evaluation of the contribution of each of the parties, the remuneration in line with the conduct has been discussed in the above section.

In practical scenarios, the value chain analysis could be more complex for large MNEs where the supply chain is fragmented across various geographies with multiple group entities involved in the value chain performing various integrated functions. Accordingly, it is necessary to follow a methodical and step-by-step process while conducting the value chain analysis which forms the basis of tax and transfer pricing analysis for the group at a global level.

Purpose of conducting a value chain analysis in the current environment
a) Supply chain analysis vis-à-vis traditional FAR analysis vis-à-vis value chain analysis
A value chain as a concept is different from a supply chain. A supply chain typically focuses on the ‘flow of goods and services’, while value chain addresses the question of what value the business has created by analysing what it is able to sell in the market and what is the cost of creating that.

Supply chain can be described as a business transformation tool which helps in minimising the costs, maximising the customer satisfaction by ensuring that the products are provided to the customers at the right time and place; whereas value chain provides the competitive advantage which ensures that the competition is taken care of by fulfilling customer satisfaction by adding value. Supply chain is only a component of the value chain.

The value chain analysis supplements the traditional functional analysis and establishes the connection on how the FAR and value drivers contribute value to the MNC. The value chain analysis strengthens the documentation as it evaluates both sides of the contracting parties and provides a justification of the arm’s length principle by highlighting the alignment of the transfer pricing policy with the actual conduct of the parties. The robust documentation will serve as back-up to defend the pricing policy during transfer pricing audits. This will also be relevant during negotiations with the APA / competent authority on the allocation of profits among the parties in the value chain as the documentation clearly highlights the robust functional profile.

b) Globalisation and decentralisation of functions, digitalisation
With the emergence of MNEs across different jurisdictions, the competitiveness of the companies is influenced by the efficiency of the supply chain and the corresponding value created by each of the functions in the value chain. Given the current dynamics, not only the supply chain but also the value chain is shifting towards becoming more sustainable, globalised and digitalised.

Digitalisation is bringing about a change by introducing new operating models and revolutionising the existing models. With this there is bound to be a change in the value drivers of the companies and a shift in the functional profile. Corresponding alignment of the pricing policy with the value creation / contribution of each entity in the value chain is going to be critical in order to ensure appropriate allocation of the profits to the entities.

6   In
transfer pricing cases involving intangibles, the determination of the entity
or entities within an MNE group which are ultimately entitled to share in the
returns derived by the group from exploiting intangibles is crucial. A related
issue is which entity or entities within the group should ultimately bear the
costs, investments and other burdens associated with the Development of
intangible asset, Enhancement of the value of intangible asset, Maintenance
of intangible asset, Protection of intangible asset against infringement
and Exploitation of intangibles

c) Assessing the value in the value chain for intangibles
For the purpose of assessing the value, the strong focus is on DEMPE function6. It is important that the profit allocation is based on the functional substance-based contribution towards the DEMPE of the intangibles. The value drivers in the case of intangibles go beyond the legal definition of the intangible. In the case of intangibles, factors such as risks borne, specific market characteristics, location, business strategies and group synergies could contribute to value creation. All the entities performing functions, using assets or assuming risks for contributing to the value of the intangible, must be adequately remunerated for their contribution under the arm’s length principle.

d) Application of profit split method (PSM) for value chain analysis
The main objective of BEPS is that the transfer pricing outcomes are in sync with the economic value created. Hence, it becomes necessary to accurately delineate the actual transaction and its pricing in accordance with the most appropriate method selected to justify the arm’s length principle. The transfer pricing regulations requires selection of the most appropriate method to justify the arm’s length principle. PSM7 could be considered as the most appropriate method as it advocates alignment of profits with the relative values / contribution of the functions, assets and risks.

7   PSM
– is applied in cases involving transfer of unique intangibles or highly
integrated operations that cannot be evaluated on an individual basis, i.e.,
they are intrinsically linked

EFFECT OF COVID ON VALUE CHAIN AND NEED TO CONDUCT THE ANALYSIS TO ANALYSE ITS IMPACT FROM A TAX PERSPECTIVE – RISKS OF NOT CONDUCTING A VCA

The Covid-19 pandemic has hit the international trade hard thereby causing concerns of serious disruptions to the global value chains (GVCs). The pandemic has impacted the way companies conduct their operations – consequential changes to the value chains as a stop-gap arrangement or a permanent modification to how the business was undertaken.

Some of the instances of disruption in the value chain are given below:
(a) Lockdowns changed the dynamics of how products were sourced. There was a sudden shift from brick-and-mortar retail chains to digital marketplaces / e-commerce platforms. Unlike historically where the physical stores, sales personnel, advertising, etc., which were value drivers in the value chain, now the value contribution of digital / ecommerce platforms has increased significantly.
(b) MNCs having centralised sourcing for their manufacturing / trading activities, faced challenges due to supply chain disruptions. Many resorted to decentralised sourcing from alternate locations / suppliers.
(c) The pandemic influenced work from home for employees which disrupted the provision of services. Example – employees responsible for performing significant DEMPE functions had to work from remote locations thereby disrupting the significance of the location base.

Both the business operations and the financial markets got disrupted due to the pandemic. For the companies that reorganised their operations to adapt to the evolving economic and business environment, the existing transfer pricing policies may no longer apply in line with the transformation of the value chain. In order to sustain their business operations, some companies moved parts of their supply chains as a result of the pandemic, thereby making existing transfer pricing policies obsolete. Due to the impact on the profitability or disruptions to cash flows, the existing transfer pricing policies may not be complied with due to the inability to compensate the entities in line with the functions they performed. Hence, it would be critical for taxpayers to evaluate whether changes in a value chain result in transfer of value or alteration of the profit potential of group entities in their jurisdiction. Thus, taxpayers need to be alert about such eventualities.

Since the pandemic has impacted the economic conditions significantly, this would have an effect on the APAs entered into covering the pandemic year onwards. Most APAs include specific assumptions about the operational and economic conditions that will affect transactions covered in the APA. Hence, it is critical to determine to what extent the changes will affect the application of existing APAs. Since the pandemic has not affected all companies equally, the individual cases of each taxpayer should be evaluated.

JUDICIAL PRECEDENCE – INDIAN AND GLOBAL
With the above detailed discussion on the concept of value chain and the need for conducting the same, let us look at how value chain analysis has gained significance from the Indian perspective. The transfer pricing provisions in India were enacted in the Income-tax Act in 2001 and since then the transfer pricing law in India has evolved with substantial developments. Though the Indian provisions do not provide detailed guidance on various transfer pricing issues, the Indian tax authorities including the dispute resolution forums and Tax Courts place reliance on international guidelines such as the OECD TP guidelines, the United Nations’ TP Manual and guidelines published by various countries while conducting TP audits and deciding on the complex issues related to transfer pricing.

India has also adopted the BEPS Action Plan 13 – three-tier documentation (country-by-country report, master file and local file) in the local regulations in 2016 with additional requirements for master file compliance, wherein it requires the MNC’s to provide the drivers of profits for the business, the transfer pricing policies and strategies in relation to intangibles and R&D facilities and the detailed functional analysis for principal entities contributing to the profits, revenue or assets of the group as per the specified threshold. Pursuant to the BEPS Action Plans released in 2015, the concept of substance over form, i.e., actual conduct of the parties vis-à-vis the legal form plays a vital role in determination of the arm’s length price for a controlled transaction. The Indian tax authorities during the course of TP investigations attempt to re-characterise the transaction to determine the arm’s length price based on the actual conduct of the parties rather than the contractual arrangements, which is in line with OECD guidelines.

Some of these case laws where emphasis is laid on the value chain analysis are summarised below:
a) In the case of L’Oreal India Pvt. Ltd. [TS-829-ITAT-2019 (Mum)-TP], the Mumbai Income Tax Appellate Tribunal (ITAT) referred to the Development Enhancement Maintenance Protection and Exploitation (DEMPE) framework while analysing the issue of marketing intangibles arising due to the significant incurrence of Advertising, Marketing and Promotion (AMP) expenses. The ITAT held as follows:
• the sine qua non for commencing the TP exercise is to show the existence of an international transaction and the same had not been shown to have been fulfilled in the instant case, therefore, the issue of traversing to the aspect of determining the validity of the method for determining the ALP of such transaction does not arise at all.
• The assessee had never admitted that the incurring of AMP expenses was an international transaction and had, in fact, since inception canvassed that the said expenses were incurred in the normal course of its own business and not for rendering any DEMPE functions for brand building of its AE.
• Accordingly, the ITAT held that no part of the AMP expenses incurred by the assessee are attributable to rendering of any DEMPE functions for the brands owned by the AE and deleted the adjustment proposed by the Indian Revenue Authorities with respect to the AMP expenses incurred by the assessee.
• The ITAT distinguished the decision of the High Court in the case of Sony Ericsson India Pvt. Ltd. by recording the finding that the presence of AMP as a transaction was accepted by the assessee itself in case of the High Court decision, whereas in the current case the assessee had never made any such admissions.
• The ITAT further remarked that de hors any ‘understanding’ or an ‘arrangement’ or ‘action in concert’, as per which the assessee had agreed for incurring of AMP expenses for brand building of its AE, the provisions of Chapter X could not have been invoked for undertaking a TP adjustment exercise.

From the above case it is evident that the ITAT has laid emphasis on evaluation of the DEMPE functions performed by the entities in the group for determining whether incurring of AMP expenses alone leads to brand-building for the AE for which the assessee needs to be remunerated separately as an international transaction. Accordingly, a detailed value chain analysis for an MNE group which also includes analysis of the DEMPE functions in relation to the intangibles would help in strongly defending its position before the tax authorities.

b) In the case of Infogain India Pvt. Ltd. [TS-392-ITAT-2015 (Del)-TP], the Delhi ITAT upheld the application of the Profit Split Method (PSM) adopted by the assessee on the ground that the activities of the assessee and its associated enterprise were intrinsically linked and both the entities were significantly contributing to the value chain of provision of software services to the end customers. The ITAT, based on the examination of the functions performed by both the parties and weights assigned to each activity, observed that – ‘In the present case, both the parties, i.e., Infogain India (assessee) and Infogain US are making contribution. Therefore, the Profit Split Method is the most appropriate method for determination of ALP.’

c) In the Coca-Cola USA case8, the US Tax Court confirmed an adjustment made by the Internal Revenue Service (‘IRS’) to the income of the company. The issue under examination was that Coca Cola was not adequately compensated (i.e., with royalty) by its group entities for the use of intangibles. While deciding this issue, the IRS laid emphasis on the functions performed by the respective entities in the supply chain, risks control and allocation, DEMPE functions in relation to the intangibles, costs incurred by the different entities on the Advertising, Marketing and Promotion expenses, and contractual arrangements between the group entities. Upon in-depth analysis, the IRS proposed to benchmark the transaction in question using the Comparable Profits Method (CPM) treating unrelated bottlers as comparable parties wherein ‘Return on Assets’ (ROA) was taken as the appropriate Profit Level Indicator. The US Tax Court upheld the contentions of the IRS based on the above economic analysis conducted to derive an approximate royalty payment to Coca Cola Company by the group entities.

8   155
T.C. 10 Docket No. 31183-15, US Tax Court, Coca Cola Company & Subsidiaries
vs. Commissioner of Internal Revenue

d) In the case of Dutch taxpayer Zinc Smelters BV9, the taxpayer was engaged in the business of zinc smelting. The zinc smelting process involved conversion of zinc ore and the related raw materials into pure zinc and the same was distributed in the market. The value chain of this activity comprised of key functions, namely, procurement of raw materials, planning and scheduling of production, undertaking the production activity, planning the logistics and distribution in the market, undertaking support functions such as finance, IT, marketing, etc. Globally, the business of the group was sold, pursuant to which all the functions except the production activity were transferred to a new entity. The question was regarding the remuneration of the taxpayer post the business restructuring. The Dutch Court of Appeals agreed with the ruling of the Dutch tax authority that the key functions of sourcing raw material and thereby conversion of the ore (raw material) into finished product were critical functions in the value chain and were inter-linked. Accordingly, both the taxpayer and the new entity were performing non-routine functions. Hence, profit split was considered as the most appropriate method to determine the arm’s length remuneration for both the entities. For the purpose of profit split, the profit achieved from joint smelting activities of the taxpayer and the new entity were to be determined and then split between both the entities based on their contributions to the revenue generated.

9   Case
number ECLI:NL:GHSHE:2020:968  – 17/00714
Zinc Smelter B.V. vs. Dutch Tax Authority

REPORTING REQUIREMENTS
The taxpayer is required to appropriately report under Clause 18 of Form No. 3CEB10 any transactions arising out of or by being a part of business restructuring11 or reorganisation.

Some of the instances of business restructuring or reorganisation are as follows:
(a) Reallocation of functions, assets and risks within the group.
(b) Transfer of valuable intangibles within the group.
(c) Termination or renegotiation of the existing contractual arrangements.
(d) Shift of responsibility of specific functions from one entity to another entity within the group.

The taxpayers must maintain robust documentation such as agreements, valuation reports (if any), post-restructuring FAR analysis, etc., to substantiate the arm’s length principle. In the changing dynamics of business, it is imperative that taxpayers monitor business operations more closely for any changes.

DOCUMENTATION
As we all know, documentation forms the core of the entire transfer pricing analysis; accordingly, in a post-BEPS world it is even more critical to ensure that the MNE group has adequately documented its transfer pricing policies which are in line with the value contributions by the respective group entities in the value chain, economic functions performed and risks assumed while dealing with controlled transactions.

In order to manage the risks, the MNCs will have to ensure that the documentation is more elaborate and thorough both in the factual description of the functional profile in the value chain and in the related transfer pricing analysis. A well-documented VCA would serve as a foundation for the MNE’s tax and transfer pricing analysis and help achieve consistency across various facets of regulatory compliances.

Some of the key back-up documentation that can be maintained by an MNE group to support the VCA analysis are listed below:
a. Industry reports, management discussions, financial reports – sources to ascertain the key value drivers for business;
b. Functional interview notes / recordings with key business personnel at management level, operational division personnel, process flowcharts, asset evaluation records, organisation structure, responsibility matrix, etc. – to support the functional analysis documented as part of the VCA;
c. Contractual arrangements within the group entities which are in line with the actual conduct and substance of the parties to the arrangements;
d. Back-up documents to justify the rationale adopted by the management in assigning specific weightages to the value drivers in the value chain while determining the value contribution of the respective group entities;
e. Risk analysis assessment in light of the framework of the guidelines provided by OECD for the group entities – documents which demonstrate key decisions made by entities such as board approvals, internal email correspondences, important call minutes, etc.;
f. Documents which support the legal ownership of intangibles with the group entities such as IP registrations in certain jurisdictions, accounting of these assets in the financial reporting as per local requirements, etc.;
g. Documentary evidences to support the DEMPE functions and the value contribution of each of the entities in the value chain;
h. Analysis of the key financial ratios for the group entities such as costs incurred in production, gross level margins, net profit margins, FTE count, net worth, etc.

The above list is illustrative considering that each business would have a different value chain story and hence one would need to maintain robust back-up documentation to support its VCA for the entire MNE group.

10 Form
No. 3CEB is a report from an accountant to be furnished under section 92E
relating to international transactions and specified domestic transactions

11           Explanation
to Section 92B of the Income-Tax Act 1961, clarifies the expression
‘international transaction’ to include – ‘….. (e) a transaction of business
restructuring or reorganisation, entered into by an enterprise with an
associated enterprise, irrespective of the fact that it has bearing on the
profit, income, losses or assets of such enterprise at the time of the
transaction or at any future date’

In the post-BEPS era it is apparent that one will have to substantiate any tax planning with adequate substance. The profit allocated to different group entities will have to be aligned with value contributed by those entities across the value chain of the MNC. The companies are expected to be transparent with their global operational and tax payment structure in order to be compliant with the BEPS requirement. Therefore, the companies will have to improve the way they explain their operating model and tax approach to the stakeholders.

The BEPS project has changed the dynamics of the international tax landscape in an unprecedented manner. The advanced work on addressing the tax challenges arising from the digitalisation of the economy will further change the status quo. Both globalisation and trade frictions in certain countries coupled with the severe impact of the Covid-19 pandemic have forced the MNEs to evaluate their global operations and the value chain distribution. This will create even more challenges in the transfer pricing areas which will have to be dealt with by both the MNEs and the tax administrations of the developing countries. It would be critical for the MNEs to effectively focus on their value chain to achieve the desired business and tax objectives in order to sustain themselves in this evolving business environment.