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Interplay between IND AS and Transfer Pricing

February 6, 2018 7151 Views
Hasnain Shroff
CA and Specialists in Transfer Pricing laws in India
.Poonam Ghelani
CA and Specialists in Transfer Pricing Laws in India

One of the cornerstones of transfer pricing is the 'arm's length price' and this concept has today become ubiquitous finding its way into various legislations such as the Companies Act, GST, GAAR, etc. However, the one development which impacts the determination of the arm's length price is the convergence of the Indian Accounting Standards ('AS') with the International Financial Reporting Standards ('IFRS')resulting in the introduction of a new set of Accounting Standards ('Ind AS') by the Ministry of Corporate Affairs ('MCA') on 16 February 2015.

The MCA has laid down a road map in phases for companies (other than banks, insurance companies and NBFCs) based on net worth for applicability of Ind AS tabulated below:

Applicability of Ind AS

Phase

Effective date

Applicability

I

1 April 2016 (with 1 April 2015 as the transition date1)

Applicable if networth > = Rs 500 crores2

II

1 April 2017 (with 1 April 2016 as the transition date)

Applicable if networth > = Rs 250 crores3

Applicable to all listed companies4

Separate road maps have been issued for banks, insurance companies and Non-Banking Financial Companies ('NBFCs') with the first cycle of applicability from 1 April 2018 onwards (transition date 1 April 2017).

Based on the road map for corporates, companies with a net worth of INR 500 crores or more wererequired to report their results for the year ended 31 March 2017 as per the requirements of Ind AS.

As a result, from the financial year 2016-17 onwards companies in India were split into two groups from a financial reporting perspective -companies with a net worth more than or equal to Rs 500 crores who prepared financial statements per the requirements of Ind AS and other companies which continue to prepare their financial statements per requirements of AS.

Since determination of the arm's length price depends to a large extent upon the data points in the Annual Reports, the introduction of Ind AS has resulted in an impact in several areas within transfer pricingthe key issues revolving around benchmarking and reporting of transactions undertaken with related parties.

There are totally 40 Ind AS which have been issued by the MCA so far. Of the 40 there are 14 Accounting Standards which impact the operating income / expense thereby impacting determination of arm's length price. Based on our analysis of disclosures made by a few listed companies in their financial statements, we have, in this article tried to explain the impact from a transfer pricing perspective.

1. Benchmarking and reporting

In determining the arm's length price from a transfer pricing perspective a taxpayer is required to employ the methods as prescribed in Section 92C of the Income-tax Act, 1961 ('Act'). These methods are Comparable Uncontrolled Price Method ('CUP'), Resale Price Method ('RPM'), Cost Plus Method ('CPM'), Profit Split Method ('PSM'), Transactional Net Margin Method ('TNMM') and Other Method.

For companies that use the comparable uncontrolled price (CUP) method to determine their transfer pricing, essentially there was no impact, because the CUP method uses market prices todetermine the appropriate price that should be charged between related entities. Market prices are typically not affected byaccounting standards.

For companies that use the RPM or CPM or TNMM, the calculation of gross profits / net margins is essential todetermining the arm's length price. In calculating the margins/markups or the base to which thosemargins/markups are applied, financial earnings (revenues, costs and profits numbers) generally form the basis of these calculations, which are directly affected bythe accounting standards used. It is possible that a company's overall taxable results using the RPM or CPM or TNMM may change, solely because of the conversion to Ind AS even though there has been no change in the underlying economicsof the transactions.

This can be explained through the following illustrations:

Illustration 1

As per the previous Accounting Standard (AS) on Revenue ie AS 9 excise duty is presented as a reduction from the revenue whereas as per Ind AS 18 on Revenue excise duty is presented as an expenditure in the Profit and Loss Account.

Further, cash discounts and incentives are presented as an expenditure under AS 9 whereas all discounts and incentives (which are linked to the volume of sales) are required to be presented as a reduction from revenue (other sales promotion expenses such as advertisement expense etc. are shown separately as expenses) under Ind AS 18.

The impact of the above can be explained based on the following disclosure made in relation to adoption of Ind AS in the financial statements of a listed company which is into manufacture of paints.

Rs in Crores

Particulars Previous GAAP (AS) Effect of transition to Ind AS Ind AS
Revenue from sale of products (including excise duty) 12,446.02 686.30 13,132.32

As can be seen there is a 5.51 percent increase in revenue as reported under Ind AS vis-à-vis the revenue reported under AS. The above impact is due the following differences between AS and Ind AS

Reason for increase / decrease in revenues reported under Ind AS Whether increase / decrease in the amount of revenues reported under Ind AS Amount (Rs in crores)
Revenues reported including excise duty under Ind AS Increase 1,533.50
Discounts and sales promotional expenses reduced from revenue under Ind AS Decrease (870.85)
Sale of raw materials to be reported as sale of products under Ind AS which were netted off against cost of materials consumed Increase 23.65
Net impact 686.30

In a case where the above company is a comparable to be used for benchmarking,the impact of the transition to Ind AS would be as follows.

  •  If the tested party prepares accounts under AS, based on the above, it is evident that an adjustment would need to be made for the abovementioned differences to make revenues comparable as this would impact the denominator where the PLI used is Net Profit Margin.

  •  Further, if a majority of the companies in the comparable set follow AS an adjustment would need to be made to these companies as well. Alternatively, if the number of companies following Ind AS are few one may consider excluding these companies on the basis of 'following a different accounting framework'. However, in such case the number of comparables may reduce below six and consequently the range concept may not apply.

In a case where the above company following Ind AS is the tested party, similar issues would arise and hence adjustments would need to be made to the tested party as well as the comparablepreparing their financial statements under Ind AS as the denominator would undergo a change where the PLI used is Net Profit Margin (NPM).

Illustration 2

Under the AS 16, Property, Plant and Equipment are measured at historical costs. However, under Ind AS 10 read with Ind AS 6 companies may on the date of transition recognize existing property, plant and equipment either in accordance with the current AS with carrying value as the deemed cost or with fair value as the deemed cost. In a case where a company chooses to fair value the property, plant and equipment the depreciation amount debited to the profit and loss account would be impacted to the extent of the revaluation and adjustment for such a difference between the depreciation under AS and Ind AS would be merited. The same is explained below by way of an illustration.

In case of a listed company into manufacture of steel the company when applying Ind AS adopted a revaluation of the property, plant and equipment resulting in a corresponding impact on depreciation. The disclosures made by the company are as follows:

"Fair value as deemed cost for items of property, plant and equipment

The Company has elected to treat fair value as deemed cost for certain items of its property, plant and equipment. The aggregate fair value of property, plant and equipment where the exemption was availed amounted to ₹ X crore with an aggregate adjustment of ₹Y crore being recognised to the carrying value reported under the Previous GAAP.

Property, plant and equipment

On transition to Ind AS, the Company has treated fair value as deemed cost for certain items of property, plant and equipment resulting in an uplift in carrying value as compared to the Previous GAAP. The consequential impact of additional depreciation on fair value uplift is recognised in the statement of profit and loss."

A review of the reconciliation provided in the financial statements for FY 2015-16 indicates that the additional depreciation due to revaluation of expenses resulted in a reduction in net profit by approximately 19 percent.

Illustration 3

A contract may include multiple components (for example,when goods are sold with subsequent support ormaintenance services). Under AS the entire contract value is recognized as revenue. However, as per Ind ASwhen an arrangementincludes more than one component, it is necessary toaccount for the revenue attributable to each componentseparately. This maybe explained by way of an illustration:

X Ltd sells a machine witha two year maintenance service for INR 1,000,000 to acustomer. A two year maintenance service is provided toother customers at a consideration of INR 200,000. In thiscase, the sale of the machine and the maintenance serviceswould be regarded as separate components under Ind AS. Revenue fromthe sale of machine INR 800,000 (INR 1,000,000 lessINR 200,000) will be recognised when the machineis delivered.Revenues of INR 200,000 from the rendering ofmaintenance services will be recognised on a straight linebasis over the two years.

In a case where the above transaction is with a related party an issue arises as to what should be amount to be reported in the Form 3CEB of X Ltd, Rs 900,000 (ie revenue from sale of goods of Rs 800,000 plus revenue from maintenance service Rs 100,000) in Year 1 and Rs 100,000 being the revenue from maintenance service in Year 2 OR the transaction value of Rs 1,000,000 in Year 1?

Based on the above, it is evident that the transition to Ind AS has an impact on the PLI computation of the comparable companies as well as the tested party. It may so happen that due to the conversion to Ind AS the arm's length range may change even though the economics of the comparable companies do not change. This is because in a set of comparable companies certain companies may follow AS whereas certain companies may follow Ind AS. Further, for the same comparable when using a multiple year analysis in the first year of adoption say FY 2016-17 the accounts for FY 2014-15 would be in AS wheras for FY 2015-16 and FY 2016-17 would be in Ind AS.

In light of the above, it would be ideal to make adjustments for each of the differences between the AS and Ind AS comparables. However, it may not be possible to make these adjustments due to dearth of information. The companies are required to provide a reconciliation between the AS and Ind AS financial statements only in the year of adoption of Ind AS. Hence, even if the adjustments required are identifiable based on disclosures made in Year 1, it may not be possible to identify the quantum of the adjustments in subsequent years. The adjustments would in such case entail making assumptions which may not necessarily be accurate enough.

A review of the differences between AS and Ind AS reveals that the differences between AS and Ind AS maybe classified as follows:

  •  Differences which are a reclassification and do not impact the operating margins.

  •  Differences which impact the operating margins.

  •  Differences which are only a timing issue ie differences which only result in the income / expense being recognized in different years under AS vs Ind AS.

Hence, the need for adjustments should be determined based on an understanding of the impact of the differences and the materiality of the same.

Further, it maybe noted that the differences in accounting framework would not only impact the PLI computation but also impact applicability of filters such as sales filter, employee costs to total costs filter, advertising marketing and promotional expenses to total cost filters, etc. Further, working capital is typically computed with reference to the Net Cost Plus or Net Profit Margin as the case maybe. Hence, the change in accounting framework would impact the computation of working capital adjustment.

It should be noted that during the selection of comparable companies, including the financial data analysis stageof a transfer pricing study, the effects of business combinations, goodwill, and intangibles when converting from AS to Ind AS are expected to have limited impact on the transfer pricing analysis. Those line items will typically either be removedfrom the financial data, or the potentially comparable company with these attributes will be excluded from the set ofcomparable companies altogether.

2. Financial transactions

As per Ind AS 109 all financial instruments including guarantees / loans etc are required to be recognized at their fair value.

a) Guarantees

Hence, if an Indian parent issues a corporate guarantee on behalf of a subsidiary/associate/joint venture at a Nil guarantee fee, the parent is required to report a notional guarantee income with a corresponding impact on the investment in the respective entity. The notional guarantee income is determined with reference to the guarantee commission which a third party would have charged in an arm's length arrangement.

Illustration 4

To illustrate, in case of an Indianheadquartered company listed on the stock exchange operating in the the following disclosure has been made:

"Under Ind AS the company has recognized fair value of financial guarantee provided to its subsidiary companies. The fair value of such guarantee as at 1 April 2015 an has been recognized as additional investment in its subsidiaries and amortised over the tenure of the loan…………..The impact of such amortization of such fair value of guarantee has been recognized in the statement of profit and loss as interest income."

The amount of this guarantee fee is recognized under 'Other income' in the Profit and Loss account and the same is also reflected in the reconciliation statement of the net profit under AS and Ind AS. It maybe noted that the company has not actually charged a guarantee fee to its subsidiary based on the premise that the provision of guarantee is a shareholder activity. This position has been upheld by the courts in many other cases on the premise that there is no impact on profits, income, losses or assets of the parent.

Considering that the notional guarantee fee has now been recognized in the profit and loss account the following issues merit consideration.

  •  Does the amount of guarantee fee recognized in the profit and loss account need to be reported in Form 3CEB?

  •  Whether the tax authorities can now reject the position adopted by the courts on the basis that the guarantee fee is recognized as an income in the profit and loss account?

  •  Would the guarantee fee amount need to be offered to tax in the return of income?

In ourview, since there is no change in the facts and the commercial aspects of the transaction there should be no need to change the position adopted under transfer pricing as the guarantee still continues to be a shareholder activity and there is no change in the economic substance of the transaction. However, the basis of adopting this position should be adequately supported by documentation.

b) Interest

A similar issue would also arise in case of loans provided by an India parent to its overseas subsidiary or vice-versa.

Illustration 5

To illustrate, in case of another listed company the following disclosure has been made.

"Under previous GAAP, interest free loans given by a parent to its subsidiaries are not required to be fair valued on initial recognition and hence these were recognized at the amount of loan given. Under Ind AS, such loans are measured at fair value on initial recognition basis discounting as market interest rates and the difference is accounted as investment in respective subsidiary. The consequent unwinding of discounted fair value is recognized as interest income in the statement of profit and loss with the corresponding increases in the loans."

3. Change in the definition of 'control'

Currently, 'control' over a company is established (and thecompany is consolidated as a subsidiary) if the investorowns more than half of the voting power or the investorcontrols the composition of the Board of Directors. UnderInd AS, the definition of a subsidiary is not solely basedon the majority voting interest or ability to control thecomposition of the Board of Directors, but is also influencedby the rights of the investors. For example, majority votinginterest in a company may not result in consolidation of thecompany as a subsidiary if the minority shareholders of thecompany have substantive participative rights.As a result of this change, previously consolidatedsubsidiaries may now need to be treated as jointlycontrolled entities / joint ventures under Ind AS. This would be relevant in determining whether an entity is a constituent entity from a BEPS reporting perspective. This is because as per Section 286 of the Income-tax Act, 1961 'constituent entity' means "any separate entity of an international group that is included in the consolidated financial statement of the said group for financial reporting purposes,……." Hence, if an entity is not required to be included in the consolidated financial statements due to the above change in definition, it may not form part of the BEPS reporting.

4. Conclusion

To sum up, there are various areas of differences arising due to companies using different accounting framework ie AS and Ind AS. The abovementioned issues are only illustrative and there maybe a larger universe of issues that need to addressed.

The differences between AS and Ind AS have an impact on the determination of the benchmarks, require a deliberation of the numbers to be reported in the Form 3CEB and review of the positions adopted in transfer pricing vis-à-vis the disclosures made in the financial statements.

The process of converting from AS to Ind AS framework could take a long time to complete (takinginto consideration the threshold for applicability of Ind AS), and there may be a long period during which different accounting standards maybe in vogue affecting the transfer pricing analysis. Companies may see the range of arm's length profits shift due to the use of Ind AS, eventhough there is no change in the economics of the companies and the economics of the comparable companies. It may be thecase that a company whose transfer pricing was within the arm's length range of profitability under AS falls outside of the arm's length range of profitability under Ind AS.

Hence, taxpayers would need to review their transfer pricing to ascertain whether the change in accountingstandards results in a change their overall transfer pricing results. The tax authorities may also require an explanation for any change in results / reporting. Hence, the taxpayers would need to be prepared for the possible areas of discussion with tax authorities.

Further, the changes in accounting framework would also need to be factored in when the taxpayers are negotiating an Advance Pricing Agreement ('APA') with the tax authorities agreeing on a specific cost plus mark up or a targeted net / gross margin, especially where the APA covers years where the taxpayer is required to follow the AS in some years and Ind AS in other years.

Considering the complexities around identification of the differences between AS and Ind AS and the difficulties that may arise in making adjustments, guidance from the Finance Ministry in the Union Budget 2018 would have be most welcome especially considering that this issue has impacted / would have an impact on the transfer pricing filings to be made for FY 2016-17 onwards. However, in any case, even though not covered in the Budget, it would be good if the CBDT could issue some guidelines around the manner in which the differences arising due to launch of Ind AS maybe addressed.

The views and opinions expressed above are the views and opinions of the authors.

___________________________

  1. The transition date denotes that comparative Ind AS numbers for FY 15-16 would be provided in the Ind AS financials for FY 16-17

  2. Holding, subsidiary, joint venture or associate companies of companies covered

  3. Ibid

  4 Ibid

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