In March, the Central Board of Direct Taxes (CBDT) signed India’s second batch of unilateral advance pricing agreements (APA) with taxpayers, bringing advance certainty on transfer pricing matters to those cases. While a large number of the 570-plus applications filed until date remain under discussion, the addition of industries such as financial services to the concluded set is a precursor to several APAs likely to be signed across industries.
The financial services industry—which broadly comprises banking and capital markets, asset management, and insurance—has seen its fair share of transfer pricing litigation over the years. Unsurprisingly, after a cautious outlook, players in this industry have begun to venture into applying for APAs. Thus, it is worth analysing some of the key areas in financial services that have progressed so far, and others that could be the subject of APAs in the near future, along with practical considerations that taxpayers could bear in mind to support successful outcomes.
On the asset management side, India has several private equity and institutional investors with advisory arms in the country. Such advisory entities need to be remunerated by their parents on an arm’s-length basis factoring in the functional and risk profiles. A mark-up on cost is often the pricing model that is applied by the industry in such cases, recognising their risk-insulated and service-driven profile. The government’s APA team has gained significant experience analysing such models and concluding APAs. This is, therefore, an area where taxpayers can expect APAs to progress on a fast track. Advance preparation and groundwork to respond within a defined timeframe to the APA team’s information requests around investment processes and documentation would go a long way towards a seamless and timely closure of APAs in this space.
On the banking side, there are several areas such as offshore loan booking, funding, derivatives and cost recharges that have witnessed transfer pricing litigation, and therefore are candidates for tax certainty through APAs.
Offshore loan booking involves foreign currency loans by offshore branches of foreign banks, where the Indian branch is remunerated on an arm’s-length basis for its support with origination and relationship management.
Evolving appropriate pricing policies based on functional and factual analysis that mirror individual fact patterns is key.
Funding may involve overnight, short-term and long-term financing arrangements between bank branches and their head office or offshore affiliates. Intricacies such as costs of funding and managing funds, liquidity, credit standing and appropriate benchmarks in relevant markets have a significant bearing on the pricing, which could be a composite of interest and the cost of managing funds.
Derivative transactions such as forward contracts, interest rate and currency swaps are complex instruments undertaken by banks as market makers on behalf of their customers, for their own risk management and hedging, or simply as originating entities for offshore booked trades. An associated entity is often the counter-party for such deals. Defining the income flows and relative contributions of the associated entities involved, in terms of key functions and risks including market and credit risk, is fundamental to the transfer pricing framework of derivative transactions. Additionally, there is a need for factoring in individual country regulatory dynamics that may necessitate exceptions to global policies, and aligning of documentation with the bank’s trading systems in view of the real time, voluminous nature of these transactions.
On the capital markets side, businesses such as equity broking and investment banking have been the subject of transfer pricing challenges. In fact, the challenges in broking have been around mapping and quantifying the impact of functional differences between related-party and third-party arrangements. Investment banking transfer pricing policies can be more intricate where integrated origination and execution of advisory and capital market deals is often not easily appreciated by tax authorities, leading to apportionment mechanisms and documentation being challenged.
As is evident, the niche transactions in the financial services domain, while carried out in line with industry practices, have several nuances and complexities that are potentially sensitive to transfer pricing litigation. A handful of industry players have now chosen to move forward and address the issues through the APA mechanism, with several others watching the developments closely.
Certain critical factors that should contribute to the success of these APAs are a careful mapping of global policies where relevant, customisation of the model that is the subject of the APA to individual fact patterns, alignment of documentation with the implemented model, and evolving a framework that sustains generation of robust data and documentation to support the critical assumptions, functional profile and business conduct on an ongoing basis. In summary, the path of the APAs, with the necessary preparation and implementation, is very much a direction that the financial services industry can take towards certainty on its niche transfer pricing issues.