Intangibles: OECD vs India View

At the 68th Congress of The International Fiscal Association in Mumbai, CBC-TV18’s Payaswini Upadhyay spoke to Sanjay Puri, Director, CBDT on the OECD’s work on Transfer Pricing principle of intangibles and India’s position on it and the kinds of transactions that the Department is looking at in the intangibles space.

Upadhyay: You were on the IFA panel with the some of the OECD members who have worked on the BEPS Action plan related to intangibles. Were you happy to see the definition that came out of the OECD and the approach towards it?

Puri: OECD has at least attempted a definition. Whether it is good or whether it is bad, what implications it will have that time will tell. At least a beginning has been made. The term intangible has been sought to be defined by the OECD. There are couple of concerns which we expressed in the panel concerning the definition itself. But yes it is a good beginning. So far as India is concerned, we have also explained the term intangible property in our Act. In Finance Act 2012, we explained intangible property in our Act and identified dozens of intangibles which can be transacted and for transfer pricing purposes there can be taxation angle involved.

Upadhyay: I’ll come to the domestic law in a bit. When you said that you had some concerns regarding what the OECD and how the OECD has approached to define intangibles. Could you help me understand some of those concerns?

Puri: The definition starts with saying these are those assets which are neither financial assets nor physical assets and then they go on to say capable of being owned. Capability of ownership is a right, a law that confers right to someone to own something. Now there can be intangibles for which no right can be exercised, they cannot be protected. If I have a contract with my employee and that employee is a valuable employee, he may be doing very valuable work. Whatever he produces that will belong to the company that will belong to me. Now intangible is created but can I protect that intangible through any law; perhaps not. That’s why they have used the term capable of being owned, not owned but capable of being owned or controlled. Customer list – now this another kind of intangible which has been identified. Is it a list of customers which I have I own it but can I exercise a right that I can protect this right as an owner. Can somebody else not take it away? It is like telephone directory. These days nobody gives you telephone directories. For telecom companies, customer list is their telephone directory. Now that directory is not publicly available. It is being controlled and capable of being owned but the moment they put it in public domain it becomes everybodies property. So these are the kind of concerns which the definition has but I will say in absence of any other, this is as good a definition as it can be.

Upadhyay: Let us come to the domestic law and how the transfer pricing with regards to intangibles has developed. Could you help me understand the definition that we saw in the 2012 Finance Act- what sort of problems is that likely to create?

Puri: I will not say that it will create some problems; I will say that it has brought more certainty to the law. Now the tax payers are aware what all can be treated as an intangible. It is a long list. Is it not better that we have a long list and leave something for something else also. As I said the last expression is any similar item of same nature of having commercial right. So it is a long list that gives tax payer the idea that if these things happen in your company, in your transactions, first of all we will treat it as a transaction and then we will go on to see whether transfer pricing rules apply.

Upadhyay: You also made the point that there could be transactions that may emerge out of transfer of these intangibles. The tax payer may transfer inadvertently and may not even realize it and then have the tax department tell them that you transferred an intangible and we will impute a demand on it.

Puri: That is precisely the reason why the law has been made more clear that these are the transactions which will be treated – these are the happenings which may be treated as transactions. In the matters of intangibles, you must understand that it is a 3-4 step process. First of all we have to indentify the intangible, which intangible are we talking about? Secondly who owns the intangible. Thirdly whether there is a transaction involving intangible. These steps have been outlined in the law itself. Finally whether that transaction involves income arising in India and lastly we go to the transfer pricing valuation part of that particular intangible. These steps are to be followed only then we will be able to reach some kind of numerical solutions otherwise we will be simply talking words and no number will appear which can be taxed.

Upadhyay: Within the intangible space, some of the headline grabbing demands have been on corporate guarantees, on marketing intangibles, on location savings. How does the Department view or what the departments view has been on these sit with what the OECD is proposing?

Puri: On location savings, OECDs view is that it is not an intangible. It is a market condition. It can be part of comparability analysis. UN manual also which came last year – that also spoke about the same thing. It also included location saving in comparability chapter. The major difference between OECD and our approach is that, I will include China also, is that OECD says locational advantages cannot be owned by anybody. So, there can be no extra profit that can be attributed to a firm which is based in some low cost jurisdiction. The profit which can be given to them should be based on arms length principle only. India and China’s approach which has been specifically outlined in UN manual also in a country specific Chapter- we are saying that whenever two unrelated parties will transact, one party in low cost jurisdiction and another party in high cost jurisdiction- they are unrelated to each other- when they will have a transaction, the low cost jurisdiction party will always have it in mind that this transaction is resulting in substantial saving to other party and they will bargain for more profit. That is all we are saying that this extra profit should also be attributed when related parties are transacting.

There is an example given in UN manual by China. It is an excellent example. It simplifies the things. India’s stand is no different. India has not numerically identified the numbers but they have said the same thing. Location saving can be zero, can be substantial and that location saving the number should be something in between. You can’t say that there will be no extra profit that can be attributed to a firm in low cost jurisdiction and at the same time it cannot be more than the total savings. So, the number has to be somewhere in between.

Upadhyay: The tax department lost round one on location saving so far and probably we will see more clarity..(Interrupted by guest)

Puri: Yes, in one of the cases the Delhi Tribunal, I forgot which tribunal it was, they have held that location saving is passed on to the ultimate customer. I think that they were more guided by the OECDs discussion draft than our own position in UN manual which came later.

Upadhyay: So, we will see what shapes up in the higher courts then. On marketing intangibles where do you think OECD stands versus what the department is saying?

Puri: OECD’s earlier manual in their Chapter VI which they are revising completely they had identified trade intangibles and market intangibles separately. They had delineated these two types of intangibles. Trade intangibles are the ones like patents, know-how, secret processes, trade secrets – they are trade intangibles. Marketing intangibles would be brand trademarks and things like that. Goodwill is separate anyway. So they were delineated. Our stance till now also has been we see them differently because trade intangibles take time, money and energy in getting created, whereas marketing intangible creation is simple maintaining, enhancing is expensive. The value marketing intangible gets is from ad spend, the product itself and it takes longer time to gain in value. They were being treated differently. In the latest discussion draft which will become Chapter VI of OECD manual, OECD is saying we will not delineate intangibles in this manner. They have listed out a couple of intangibles, they have left sufficient space through their definition for other kind of intangibles, they have created a negative list of two or three types of location savings they say it is not intangible. So a negative list has been created. They are not delineating them as trade intangible, soft intangible, hard intangibles, routine intangibles, non-routine intangibles – they have specifically said that we are not doing it.

Upadhyay: How much of this stance or the approach that OECD is taking and what comes out of it do you think will weigh on the courts in India?

Puri: The courts do take OECD’s work very seriously and they should. OECD has done quite a good work in the field of taxation and even the UN manual which has come out it says in its foreword itself that it seeks to achieve consistency with OECD work. So, it is not that we are working at some kind of cross purpose.

Upadhyay: But on some of the areas that you mentioned where the department seems to have a different approach from what the OECD thins- if that comes before a court of law and the court of law is giving that much weightage to the OECD or the UN work, where does it leave the tax department’s point of view?

Puri: Tax department has a view. In our country, courts and government are two different entities. The department can have a view and courts may not agree and that is what has happened in location savings case which we were fighting. We had a view, we took a view before the court, court saw a couple of other arguments which appealed to them more and they decided accordingly.

Upadhyay: On IP -OECDs work is in progress on that front; on transfer of intellectual property, what is the Department’s view?

Puri: It is still work in progress. A lot of shaded portions are there in their discussion drafts which are still to be agreed. Next – as that representative from OECD was telling us- that they expect to complete it next year some time.

Upadhyay: On valuation of intangibles, could you help me understand where the OECD work is going and what is the department’s approach?

Puri: On valuation of intangibles, OECD at some point has talked about Discounted Cash Flow method but they have put a question mark also in front of that. Business people are comfortable and accountants are also comfortable with discounted cash flow method. I have no problem with this method of valuing any intangible. That is not a problem. It is a good starting point. You have some figure, you have some number to begin with. The only problem as a tax authority I see is that these numbers are based upon the method which uses the numbers. These numbers are based upon estimates and forecasts of the tax payer himself or he gets another valuation company, pays to that valuation company which uses this method using their own forecast and estimates to come to a particular number. It can be self serving sometimes and that is the concern which any tax authority, not only Indian tax authority, any tax authority in the world will have that kind of a concern.

Upadhyay: Which brings us to if not DCF, then what; profit split?

Puri: That is what we have expressed our preference for. In the manual we have expressed our preference for profit split. Profit split has its own problems. We have not reached that stage where we start valuing these intangibles. We start using profit split method; it will take some time for our tax administration to reach that stage. As I said, first we have to identify the intangible. That identification, then transaction all these steps are to be followed. Jumping straight to valuation, holding out some kind of a judgment on that probably will not be the right thing.

Upadhyay: The industry then tells me that if the department is going to use profit split, then would you give me credit when there is a loss?

Puri: For the sake of consistency why not? That is what ourpoint is that whatever method is employed to determine income has to be consistent – that is what Section 145 says. So whatever method we will employ to determine income of the taxpayer that will remain consistent. The department has to remain consistent. If the department doesn’t remain consistent, courts will force them to be consistent.

Upadhyay: In the area of intangibles what is the new set of transactions, new set of disputes you anticipate that might come forth in the next couple of years?

Puri: One you have already seen in case of company, which was having massive ad spend and the department sought to attribute some income or rather wanted some income to be imputed on that company because we felt that they are enhancing the intangible for their parent company; so that is one case which is presently being argued in the High Court.

Upadhyay: For the reference of our viewers, I will say the name, it is the LG Case.

Puri: Yes, I suppose that is the one. Let me just think aloud in the sense that couple of new intangibles which have been identified, the employee contract is one of the intangible that has been identified. Union contracts, they have been identified as intangibles. For employee contract, if I give you an example, if I am a company in India and I have a very important key employee with a lot of expertise in a particular field and I open a subsidiary in some country- in Africa- and I depute this person to that company, have I passed some intangible to that subsidiary of mine? Yes. Would I have done the same thing to an unrelated party? Maybe yes, I would have but then I would have charged something. So that is the kind of transaction which I am now looking at. As a tax authority, I will be looking at your transfer posting orders also.

Upadhyay: What are the some of the challenges that the department faces because this is also a new area of law for the tax department to deal with?

Puri: As I said, following those steps – the first step of identification itself is a big challenge. How do I find that some intangible property has actually been transferred? First thing is – a company is owning a list of customers in India- that customer list is passed on to another country; another company in the same group. Now how do I come to know of it that is a first challenge.

Once I have identified this customer list is an intangible property, next is whether the transaction has taken place. If the transaction has taken place, what will be the valuation of that transaction, whether the income arises as a result of that transaction. So all these questions are going to be answered in the coming days. I will say they are very difficult questions, not easy to answer.