Surana & Surana National Corporate Law Moot Court Competition JSS Law College, Mysore 7 9 February 2014

4 ___________________________________________________________________________________ This problem pertains to the law relating to Transfer Pricing under Chapter X of the Income-tax Act, 1961 and the Advance Pricing Agreement scheme introduced by the Government of India. _________________________________________________________________________________ BEFORE THE INCOME TAX APPELLATE TRIBUNAL SPECIAL BENCH AT BANGALORE ITA No. 250/Blr/ 2014 Assessment Year: 2013-14 Giggle India Ltd. Co. Vs The DCIT Company Circle, Bangalore & CBDT

1. Giggle India Ltd. Co. (Giggle India) is a company incorporated in Bangalore as per the Companies Act, 1956. The company is into pharmaceutical business which manufactures drugs based on the traditional knowledge in India for treating different types of diseases. The company has huge market for these drugs outside India and the company is very keen to make huge profits on its offshore sales. 2. Giggle India has a wholly owned subsidiary in Ireland namely, Giggle Ireland Holdings which is very suitable for holding intellectual property (IP) assets due to the favorable Irish tax regimes for IP holding companies. Though Giggle Ireland Holdings is incorporated in Ireland, the company is wholly managed and controlled from Bermuda. Therefore, for tax purpose in Ireland, the company is treated as a Bermudian company. 3. Giggle India has been in operation for several years in India and it was interested in shifting its profits (legitimately) outside India preferably to a relatively low tax jurisdiction so that it can save its Indian taxes. In this exercise it was involved in excessive transfer pricing mechanisms which all ended up in disputes with the Indian Tax Department (ITD) with huge transfer pricing adjustments. The company was about to exit India mainly to avoid transfer pricing disputes with the ITD and stop getting its money stuck up with the ITD. The exit thought arose mainly due to the fact that the company wanted to venture in formulating a new kind of drug to combat cancer disease and did not want to lock its horns with ITD on its new business. Luckily, for the company the Indian Government came up with the Advance Pricing Agreement (APA) scheme 1

in 2012 which was believed to be a boon to Indian companies having international transactions to avoid future disputes with the ITD on transfer pricing matters. 4. Giggle India made a detailed study of the APA scheme in India from the Finance Act, 2012, the corresponding Income-tax Rules, notifications, press releases, circulars, etc. The company was convinced that the Indian APA is by all means similar to the international standards of APA as in the US, Canada, the UK, etc. and therefore, it was worth giving it a shot with the ITD. Post the Notification No. 36 of 2012 dated August 30, 2012 issued by the Indian Govt., there was much clarity on APA process and Giggle India entered into a unilateral APA with the Central Board of Direct Taxes (CBDT) as per all the procedures laid down by the Government. (The copy of the actual APA is appended to this case study as an Annexure). The APA has to be read before proceeding further to better appreciate the facts. 5. The APA was concluded on November 1, 2012. The method that was adopted to determine the Arms Length Price (ALP) for the creation and transfer of the intangibles in relation to the new cancer medicine was Cost Plus Method (CPM). The gross profit ratio was arrived at 50% on the total costs for the creation of the intangibles. The ITD was happy in arriving at the gross profit ratio as it was relatively a high mark up comparing to the uncontrolled transactions. Giggle India too was happy for arriving at this ratio for its own reasons. Also, the Government was mainly concerned to portray to the commercial world that India is a suitable place to do business and transfer pricing litigations will in no way impede in achieving this purpose. Therefore, the ITD concluded the APA with Giggle India at a gross profit ratio of 50%. 6. This APA was a boon to Giggle India and it immediately started to formulate the new medicine. As mentioned in the APA, Giggle Ireland Holdings deputed a team of top experts in the field of biomolecules to Giggle India for R&D purpose. The arrangement was that the employees will stay in India for more than six months and their salary will be paid by Giggle India as if they were its employees. Significant contribution was actually made by the Giggle Indias experts to the R&D. The entire R&D was conducted in India under the supervision of Giggle India. 7. As a major breakthrough, the Indian company formulated the new medicine in just less than two months i.e. by the end of January 2013 since it was all game for this venture. The Indian company held the patents for the medicine. As agreed between Giggle India and Giggle Ireland Holdings, all the intellectual properties relating to the medicine were transferred to Giggle Ireland Holdings which became the owner of the IPRs. The Irish company was only required 2

to manufacture the medicines based on the formulae and sell it to the consumers at huge profits. 8. Interestingly, instead of Giggle Ireland Holdings directly manufacturing and selling the medicines to the consumers, it created a subsidiary in Netherlands namely, Giggle Netherlands Holdings BV (Giggle Netherlands) which in turn created another subsidiary in Ireland namely, Giggle Ireland Sales Ltd. (Giggle Ireland Sales). Giggle Ireland Holdings licensed the IPRs of the medicine to Giggle Netherlands. Giggle Netherlands on the other hand, sub-licensed these IPRs to Giggle Ireland Sales. It was Giggle Ireland Sales which exploited the IPRs and manufactured large volumes of the newly formulated cancer medicine and sold them at super profits. 9. Giggle Ireland Sales was the hub of the newly formulated life saving drug and several Governments and private healthcare companies were willing to pay any price for the medicine and paid several billion dollars as advance for the medicine. This led to sky rocketing profits to the Irish Sales Company in just few weeks of the release of the medicine. The Irish Sales company made several billion dollars of profits by the end of March 2013. However, since the IPR for the medicine was sub-licensed by the Dutch Company to the Irish Sales Company, almost 99% of the profits of the sales were paid as royalty to the Dutch Company by the Irish Sales Company. Again, since the Dutch Company had obtained the IPRs on license from the Irish Holding company in the first place, the Dutch company had to pay 99% of its receipts as royalty to the Irish Holding company. This was the arrangement within the group. 10. The above arrangement led to unimaginable tax savings to the entire group. In the sense, to avoid the corporate tax at the rate of 12.5% in Ireland by Giggle Ireland Holdings on the royalties it received from the Dutch company, it had its (Giggle Ireland Holdings) control and management in Bermuda. It therefore, became a Bermudian company for Irish tax purposes because a company is said to be an Irish company only if its control and management is situated in Ireland. Secondly, the Dutch company again sub-licensed the IPRs to another Irish Sales company and this was to avoid 20% withholding tax (WHT) on the royalties paid by the Irish Sales company if it had to directly license from the Irish Holding company (because for tax purpose the Irish Holding company is deemed to be Bermudian company and therefore, royalties paid to offshore company by an Irish company will attract 20% WHT in Ireland). Since the tax treaty between Ireland and Netherlands does not impose any WHT on royalties, the Irish Sales company paid 99% of its sales profits to the Dutch company at 0% WHT. Again, the entire royalty payments received by the Dutch company was paid to the Irish Holding company (which is actually treated as a Bermudian company) at 0% WHT because there is no WHT on royalty payments as per Dutch domestic tax laws. Further, no corporate 3

tax was paid either by the Irish Sales company in Ireland or the Dutch company in the Netherlands since the entire income these companies earned was paid as royalty (which is a deductible expense). Finally, since the entire sales profits is booked in Giggle Irish Holdings (Bermudian) company, no corporate tax is being paid since Bermuda does not impose any corporate income tax on its companies and, also, the entire money is kept clandestine! Needless to say, the motto of the Giggle Group is Dont be devil. 11. The entire arrangement of the transfer, licensing and royalty payments, diagrammatically, is as below:

Giggle India Ltd. Co. (India) Transfer of IPRs Consideration for transfer of IPRs (As per APA) Giggle Ireland Holdings (Bermuda)

Licensing of IPRs Giggle Netherlands BV (Netherlands)

Royalty payments

Sub-licensing of IPRs Giggle Ireland Sales (Ireland)

Royalty payments

Sales to ultimate consumers (i.e. Governments and Private Healthcare Companies) 12. The Indian company as per the terms of the APA and the conditions mentioned in the above said Notification, filed its compliance report in Form 3CEF and the return of income for the AY 201314 (i.e. FY 2012-13) within the prescribed due dates. Being one of the first APAs entered by the 4

ITD, it was keenly watching the activities of Giggle India. On filing the return of income and the compliance report, the ITD was extremely disappointed that the Indian company had reported only the profits on the transfer of the IPRs of the medicine and had reported nothing on the super profits on the sale of those life saving drugs. The ITD was of the view that the Indian company should have a huge share in the profits of the ultimate sale of the drugs to the end consumers as it was the creator of the IPRs based on which the medicines were manufactured and sold. 13. The Assessing Officer (AO) i.e. the Deputy Commissioner of Income-tax (DCIT) referred the matter to the Transfer Pricing Officer (TPO) under section 92CA of the Income-tax Act, 1961 (the Act) for determination of ALP on any other international transaction that may have been entered by the Indian company along with the compliance report filed by the company. The TPO, as per Rule 10P of the Income-tax Rules, 1962 (the Rules), scrutinized the compliance report (Form 3CEF), Form 3CEB and the return of income and also called for certain documents and gave personal hearing to the Indian company. After the inquiry, as per Rule 10P of the Rules, the TPO gave a compliance audit report to the Director General of Income-tax (International Taxation) [DGIT] stating that the price at which the IPR was transferred to Giggle Ireland Holdings by the Indian company is as per the APA and is therefore, at ALP. He, however, added in his report that the ideal method for such globally interconnected transactions would be the Profit Split Method (PSM) where the ultimate profit earned by the group should be split based on the contributions made by each company of the group. Since the main R&D, head & brain of the IPR for the medicine (especially since the medicine is based on Indian traditional knowledge), functions performed, assets employed and significant risks assumed was by Giggle India, he mentioned in the report that 70% of the global profits should be attributed to the Indian company and should be liable to tax in India. The report further added that the APA does not mention about the transactions to be undertaken by the group post transfer of the IPR by the Indian company to Giggle Ireland Holdings and therefore, there was a serious violation of the critical assumptions and suppression of material facts and therefore, the APA should be treated as void ab initio. The TPO while submitting the report, orally explained to the DGIT that had these subsequent transactions (post transfer of the IPRs) be known to the ITD, he believed, such an APA would not have been entered in the first place. 14. The DGIT wrote a letter to the CBDT that gargantuan tax has been evaded by the Indian company and therefore, the CBDT should immediately cancel the APA with the Indian company. The CBDT immediately under Rule 10R of the Rules issued a Show Cause Notice (SCN) to the Indian company requiring as to why the APA should not be canceled from the date of its entering since the critical assumptions have been violated by the Indian company and material facts have been suppressed leading to misrepresentation. 5

15. The Indian company quickly reacted by submitting a detailed submission to the Board (CBDT) that the APA was only confined to the transfer of the IPR of the medicine to the Irish Holding company and that it was the only international transaction within the limits of the Indian tax authorities. Also, the gross profit margin accepted at the rate of 50% on cost was much beyond the market ALP and therefore, the CBDT should not complain now on any matters. On critical assumptions violation remark, the Indian company submitted that only those critical assumptions pertaining to the transfer of IPR should be considered by the Board and not on transactions happening subsequent to the transfer of the IPRs. On misrepresentation allegation, the Indian company submitted that all the required documents and details were given to the ITD as per law and the Board entered into the APA with its eyes wide open and therefore, there is neither misrepresentation nor fraud on the part of the Indian company. The Indian company therefore, requested the Board not to unilaterally renege the agreement as the Indian company was willing to perform its duties as per the APA. It further cautioned that any act of unilateral measure by the Board could be construed by the commercial world that doing business in India is always unreliable as the goal posts are constantly moved when the game is on! 16. The Board on receipt of the submission passed an order (with the prior approval of the Central Government) unilaterally canceling the agreement inter alia stating that the Board entered into the APA with the Indian company on the premise that it was a mere transfer of IPR and therefore, the methodology adopted i.e. CPM was the most appropriate method only pertaining to the price at which the IPRs were transferred. Had the Board known about the subsequent arrangements by the Indian companys group, either the APA would not have been entertained or PSM would have been adopted at the most appropriate method on the global profits. Further, failure to mention about the subsequent mode of licensing and sale by the group was a clear misrepresentation which renders the APA void ab initio. The Board added that one of the key assumptions by the Board was that the Indian company has approached the CBDT with clean hands and the transfer of the IPR was the only international transaction that will be undertaken by the Indian company. Since such key assumption has been violated, the Board held under Rule 10R(1)(i) read with Rule 10M(2) of the Rules that the assessee (the Indian company) has failed to comply with the terms of the agreement by violating the critical assumptions and therefore, the APA was not binding on the Board from the date of its entering. The Board further directed the DGIT to take appropriate steps. 17. The DGIT immediately instructed the concerned AO and the TPO to disregard the APA entered with the Indian company and to make necessary adjustments to the income of the Indian company for AY 2013-14 as per the Act. The TPO attributed 70% of the global profits to the Indian 6

company and made upward adjustments accordingly and sent the report to the AO. The AO issued a draft assessment order under section 144C of the Act to the Indian company. The Indian company received the draft assessment order and preferred to approach the Dispute Resolution Panel (DRP) under section 144C stating that while it participates in the proceedings it strongly believes that the cancelation of the APA was against the law and the ITD is bound to honor the terms of the APA and therefore, no upward adjustment whatsoever should be made to the income of the Indian company. 18. The DRP heard the matter almost on daily basis keeping in mind the importance of the matter and the image of the Indian business environment. However, the DRP simply confirmed the draft assessment order and rejected the claims of the Indian company. The DRP directed the AO to pass the final assessment order as per section 144C. The AO passed the final assessment order which was just the same as the draft assessment order. The Indian company preferred an appeal to the Bangalore Income-tax Appellate Tribunal (ITAT) against the assessment order. The ITAT appreciating the urge and the sensitivity involved in the matter requested the President of the ITAT to constitute a Special Bench (SB) to decide the matter. The SB was constituted and the matter has been posted for final hearing before the SB of the ITAT. 19. The following are the broad arguments to be made by both the parties before the SB: By the Assessee/ Appellant/ Giggle India Ltd. Co. i. The unilateral cancelation of the APA by the Board was in violation of law, breach of trust and breach of promissory estoppel. The Income-tax Act being a self contained code and the nature of the agreement being very specific to tax issues, this Tribunal has jurisdiction to entertain the appeal. ii. There has been no change in the critical assumptions as the critical assumption contemplated by both the parties at the time of the APA was only the creation of the IPR for the medicine and transferring the same to the Irish Holding company. This assumption has in no way been violated. iii. The methodology already adopted i.e. the CPM was the most appropriate method and change in the methodology to PSM after the APA was entered and inclusion of other international transactions which were not contemplated under the APA is unacceptable. iv. Even assuming (though not conceding) PSM has to be adopted on the global profits, the income earned by the appellant on the global transaction is at arms length since the gross profit margin accepted by the Indian company at 50% is much higher than the arms length price even between any unrelated parties. 7

v.

The appellant relied on various circulars (including issued, withdrawn and amended ones), reports of certain committees constituted by the Government of India (even though it was pertaining to IT and ITES sectors), Safe Harbor Rules and such other materials to support its case on applicability of most appropriate method. It also laid a line of argument that the Indian company was just a contract R&D center.

vi.

The Indian tax department does not have jurisdiction to include income of other group companies situated outside India having offshore transactions to the income of the Indian company under the guise of PSM.

vii.

The tribunal gave liberty to raise any other arguments by the appellant.

By the Revenue/ Respondent i. The unilateral cancelation of the APA by the Board is as per law and does not violate anyones trust or promissory estoppel. In any case, for violation of the agreement, if any, the appellant should have approached only a civil court and cannot raise such issues before this Tribunal. ii. There has been significant change in the critical assumptions i.e. the Board believed that the only international transaction involved was transfer of the IPR by the Indian company to the Irish Holding company. Since many other transactions have been linked with such transfer, there is a violation of the critical assumptions. Further, there has been suppression of facts and misrepresentation by the appellant. iii. The most appropriate method is the PSM because much of R&D work, functions, assets employed, the risks assumed and major contributions are in/ from India and therefore, much of the global profits has to be attributed to the Indian company and be liable to tax in India. iv. The respondent relied on various circulars (including issued, withdrawn and amended ones), reports of certain committees constituted by the Government of India (even though it was pertaining to IT and ITES sectors), Safe Harbor Rules and such other materials to support its case on applicability of most appropriate method. It vehemently opposed to the line of argument that the Indian company was just a contract R&D center. v. Though the Revenue admits that the gross profit margin arrived at 50% on costs is higher than the usual ALP that was only pertaining to the transfer of the IPR and not in case if PSM is applied on global profits. vi. By applying the PSM, the Indian tax department has jurisdiction to take stock of all the international transactions of the Indian companys group and a formulary apportionment of the profits of the group to the Indian company based on its contribution is an accepted international transfer pricing practice. vii. The tribunal gave liberty to raise any other arguments by the respondent.

Annexure ADVANCE PRICING AGREEMENT BETWEEN THE CENTRAL BOARD OF DIRECT TAXES AND GIGGLE INDIA LTD. CO. This Advance Pricing Agreement (APA) entered on the 1st day of November 2012 between: The Central Board of Direct Taxes (CBDT) of the FIRST PART; AND Giggle India Ltd. Co., a company incorporated under the Indian Companies Act, 1956 having its registered office in Bangalore which expression shall include its successors, of the SECOND PART. WHEREAS Giggle India is willing to enter into an APA with the CBDT with regard to a proposed international transaction with its subsidiary in Ireland namely Giggle Ireland Holdings. WHEREAS the CBDT has accepted the willingness expressed by Giggle India and has entered into this APA. NOW THIS AGREEMENT WITNESSETH AS FOLLOWS: 1. Giggle India is a pharmaceutical company and is interested in formulating new drug to combat

cancer disease. In order to achieve this objective, Giggle India will request its subsidiary situated in Ireland i.e. Giggle Ireland Holdings to send some of its high end top level and mid level employees who are experts with the knowhow and well trained in formulating the required drug. The international transaction involved in this agreement is the formulation of the cancer drug by the Indian company with the help of the technical support (deputation of its employees) provided by the Irish company and to transfer the intellectual properties pertaining to the drug to the Irish Holding company. 2. The seconded (deputed) employees will stay in India for more than six months and will be paid

by the Indian company for the services rendered by them. The Indian company is also having its array of experts in this field especially having knowledge about the Indian traditional medicines which is the main component for formulating this medicine. The research and development (R&D) will happen in India at the cost, risks, assets and functions of the Indian company.

3.

The Indian company post the formulation of the medicine will transfer the R&D along with the The Irish subsidiary will

connected intellectual property rights (IPRs) to its Irish subsidiary.

compensate the Indian company for such transfer. There may be improvisation of the medicines by the Indian company on year-to-year basis and the connected IPRs will also be transferred to the Irish subsidiary for such consideration. 4. The agreed transfer pricing methodology (TPM) for the consideration at which the IPRs will be

transferred by the Indian company will be the Cost Plus Method (CPM). The profit ratio will be calculated based on the Gross Profit over the Total Cost (including the huge salaries paid to the seconded employees) incurred by the Indian company for creating the intangibles in relation to the medicine which will be transferred to the Irish company. In other words, the gross profit that the Indian company is expected to earn on the transfer of the intangibles to its subsidiary in Ireland will be determined based on the costs actually incurred by the Indian company in creating such intangibles. 5. For the purpose of this agreement the gross profit ratio in applying the CPM method will be at

least 50% i.e. the Indian company will have a markup (gross profit) of at least 50% on the total cost involved in creating the intangibles. For example, If the cost incurred for creating such intangibles is Then the gross profit markup has to be at least 50% of the cost which is Therefore, the sale price (at which the intangibles is sold to the Irish company) less that 35%. 6. The critical assumptions are that the Indian company will create the intangibles in relation to 100 50 150 (100 +50)

It is also admitted by the parties that gross profit ratio at 50% will lead to a net operating profit of not

the medicine in India and transfer it only to its subsidiary in Ireland i.e. Giggle Ireland Holdings. The functions performed by the Indian company, assets employed and the risks assumed for the creation of the intangibles will remain the same throughout the tenure of this APA. 7. This agreement shall be in force for a period of five years. The other requirements and

conditions as mentioned in the Notification No. 36 of 2012 dated August 30, 2012 issued by the Ministry of Finance, Government of India shall mutatis mutandis apply to this APA. Signed this the 1st day of November, 2012 at Bangalore. For CBDT For Giggle India Ltd. Co.

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