MR DINESH SUPEKAR, Senior Manager, PricewaterhouseCoopers Pvt. Ltd

On January 31, Google reported its fourth quarter (Q4) and fiscal year 2006 results. Revenues for the December 31, 2006 quarter (Q4) were $3.21 billion, an increase of 67 per cent compared to the 2005 Q4 and an increase of 19 per cent compared to Q3 of 2006. "Google's partner sites generated revenues, through AdSense programs, of $1.20 billion, or 37 per cent of total revenues, in the fourth quarter of 2006," informs http://investor.google.com.

What should be of interest to tax professionals is the para on how Google could reduce its `effective tax rate' to 13 per cent for Q4; the rate was 23 per cent for the full year.

"Our tax rate was affected by two discrete items," explained George Reyes, the company's CFO at the `earnings call' on January 31, as one learns from the transcript on http://internet.seekingalpha.com. The first was the APA or `advance pricing agreement', between Google and the IRS (Internal Revenue Service, the US taxman), relating to `certain inter-company transfer pricing arrangements'. And the second item was the benefit that Google realised due to the R&D (research and development) tax credit.

More about the December 2006 APA with IRS is in the `Q4 financial summary' on http://investor.google.com. "The APA applies to the taxation years beginning in 2003. As a result of the APA, we reduced certain of our income-tax contingency reserves and recognised an income-tax benefit of $90 million in the fourth quarter."

For the avid, what merits detailed discussion is APA, as much as the giant Internet search engine's revenue strategies, in the context of TP or transfer pricing. Do you know, for instance, that the US and China signed the first bilateral APA last month, involving Wal-Mart? India may be far behind yet on a similar deal with the Bentonville behemoth.

Be that as it may, for starters it helps to know that TP is "a term used to describe all aspects of inter-company pricing arrangements between related business entities, including transfers of intellectual property; transfers of tangible goods; services and loans and other financing transactions," as www.pwc.com explains.

"Inter-company transactions across borders are growing rapidly and are becoming much more complex. Compliance with the differing requirements of multiple overlapping tax jurisdictions is a complicated and time-consuming task. At the same time, tax authorities from each country are imposing stricter penalties, new documentation requirements, increased information exchange and increased audit/inspection activity," elaborates the site of PricewaterhouseCoopers.

"Indian TP regulations are applicable when receipts/expenses, impacting the computation of income taxable in India, arise from an `international transaction' i.e., a transaction between two entities, one or both being `non-residents' as per the Indian tax laws. These regulations require that the taxable income be computed having regard to the `arm's length price' of these receipts/expenses," explains Mr Dinesh Supekar, Senior Manager, PricewaterhouseCoopers Pvt. Ltd, speaking to Business Line about TP in India. `Arm's length price', in simple terms, is what would be charged in a comparable transaction between third parties.

Mr Supekar is a chartered accountant with more than 10 years' experience in international tax and transfer pricing. His experience includes documentation, planning studies, and developing defence strategies in the course of transfer pricing audits. Here are Mr Supekar's answers to a few questions.

How significant are these regulations in the Indian context?

Internationally, surveys have indicated that corporations consider transfer pricing as a key area requiring appropriate attention to manage tax risk.

In the Indian context, economic growth is bound to result in increasing number of cross-border transactions for MNC group companies, especially with more and more MNCs setting shop in India and Indian companies going global as well. With the quantum and type of international transactions increasing, there would be greater focus on transfer pricing not only amongst corporates but within the tax department as well.

What do our TP regulations aim to achieve?

As in other countries, our regulators seek to protect the tax base of the country. For example, let us assume that an MNC (multinational company) sets up a wholly-owned subsidiary (WOS) in India carrying contract manufacturing for the group.

TP regulations require that the taxable income of the WOS is computed having regard to an arm's length export price, i.e., a price charged in a comparable uncontrolled transaction.

The taxpayer has to demonstrate that the pricing is at arm's length, inter alia, by maintaining detailed documentation in the manner prescribed.

How does a taxpayer demonstrate the arm's length nature of international transactions?

This is an extensive process requiring a detailed understanding and documentation of the taxpayer's business, including the manner of price setting for international transactions.

A thorough search for comparable uncontrolled transactions and performing appropriate adjustments to the same to demonstrate the arm's length nature of the pricing, using one of the prescribed methods most appropriate in the given facts and circumstances, is essential.

What are the key challenges faced by taxpayers in TP?

Since the introduction of the regulations, transfer pricing assessments have been completed for three financial years, and based on press reports, the quantum of overall transfer pricing adjustments has increased every year.

In many cases, absence of proper documentation bringing out a proper business perspective has made it difficult to demonstrate the arm's length nature of pricing. However, in some cases, inadequate clarity on certain technical matters coupled with very limited judicial precedents has resulted in transfer pricing adjustments by the department, which the taxpayers in turn have disputed. Therefore, extensive litigation is imminent, unless there is clarity on a number of contentious issues.

Such as?

There are a number of contentious issues. One such is the period for which data for comparables is to be considered. Transfer pricing documentation required under the regulations is prepared based on comparable financial data available at the time of preparing the documentation.

Obtaining data for the same financial year in question is unrealistic. Moreover, the use of multiple year comparable data evens out the effect of business cycles, etc., on comparables. Transfer Pricing Officers (TPOs) however have been using comparable financial data for the same financial year in question. In most of the cases, this data could not have been available to the taxpayer when his accounts were finalised.

In addition, TPOs have also used a new set of comparables, for which no data was originally available. Here, it is essential to interpret the regulations in a manner that does not cause any undue hardship to the taxpayer. On the point of comparables, an important issue is the increasing use by TPOs of `secret comparables' i.e., data for which is not available in the public domain. One way of obtaining such data is issuing notices to competitors. A moot point that arises is whether the use of such private data is appropriate, and whether transfer pricing regulations permit this. Further, cherry-picking profitable companies for margin comparison is detrimental to taxpayers. A company that is otherwise comparable should not be rejected merely because it has incurred losses.

In the context of Indian MNCs, testing the results of the overseas subsidiary may be sometimes more appropriate than testing the Indian entity. However, TPOs have been reluctant to do this, as, unlike the taxpayer, they may not have access to foreign databases.

Do business dynamics and strategies play a role?

Absolutely. Business dynamics and strategies have to be considered in judging the arm's length nature of the pricing. Commercially, even in an arm's length situation, each and every independent enterprise cannot make profits.

Market strategies (such as entry strategy and cross-subsidisation of products) could initially result in losses, but this may be a part of a larger strategy of building market share and reaping subsequent benefits. These should be considered for determining the arm's length nature of prices, and appropriate adjustments allowed. Differences in the risk profile of the tested party vis--vis independent comparables should also be considered by TPOs, especially while benchmarking low-risk captives.

So, what's on the `to do' list for the taxpayers and the taxman with regard to TP?

Taxpayers should lay down well-defined transfer pricing policies which, inter alia, consider the provisions of the transfer pricing regulations. The documentation should bring out the business dynamics, and its impact on the arm's length nature of pricing. Moreover, their internal systems and processes should be strengthened to maintain transactional data and supporting documentation on a real-time basis.

The Department, on the other hand, should be sensitive to business dynamics of the taxpayer. Also, sooner rather than later, the need to introduce APAs (advance pricing agreements) in the regulations should be considered.

D. Murali