transfer pricing case studies navigating the indian & singapore waters! narayan mehta partner,...
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TRANSFER PRICING TRANSFER PRICING Case StudiesCase Studies
Navigating the Indian & Singapore waters!Navigating the Indian & Singapore waters!
Narayan MehtaPartner, Sudit K. Parekh & Co. 25th May 2005
Agenda
Practical applicability of the regulations & case studies
Case 1: ODC / ITES operations in India
Case 2: Manufacturing & indenting model
Case 3: Intra group services
Case 4: Benchmarking royalty payments
Transfer Pricing
Opening Remarks
Bilateral & not unilateral exerciseNeed for balancing the Indian & Singapore tax regulations
An effective tax planning tool!Integrated approach
May involve International tax, exchange control, Service Tax / VAT, STPI, issues
Could be used to:Justify pricing policyFormulate pricing policy
Indian Company
CASE I
Singapore Owned
Singapore Owned Indian Co
Singapore Co
Singapore Co
Indian subsidiary
Indian subsidiary
Singapore Client
Singapore Client
Contract for software development
OutsourcingArrangement
@S $ 35 per hourEquity
Consideration
UK Client
UK Client
Contract for software development
@ S $ 45 per hour
Off-shore software DevelopmentNo risks undertaken
Marketing intangibleBrand creationTrade intangibleEntrepreneurial risk
Singapore Owned Indian Co
CUP Method
Internal comparablesAdjustment for differences for
Volume difference
No marketing required and assured market
Credit terms
External comparablesMay not be always reliable!
Singapore Owned Indian Co
Internal comparablesConstructing transactional profit and loss account to ascertain the margins separately for sales to AE and sales to 3PAllocation of certain expenses to AE and / or 3P P/L A/c
Marketing expenses – 3P
Apportionment of other expenses to both on certain basisNo of employeesSales valueCosts, etc
3P = 3rd Party (comparable transactions)AE = Associated Enterprise
Particulars Basis 3P AE TotalParticulars Basis 3P AE Total
To Direct Exps. - salary Actuals 205 525 730
By sales Actual 300 700 1000
To Staff welfare exps.
No. of employees
= 3:7 3 7 10
To Office overheads Sales value 27 63 90
To Selling & Marketing exps. 100% - 3P 20 0 20
To Net Profit before interest & tax - 45 105 150
Total - 300 700 1000 Total - 300 700 1000
Operating margin 15% 15% 15%
Transactional Trading & P & L A/c
Singapore Owned Indian Co
Cost Plus / TNMM – external comparablesStep 1: Functional analysis
ObjectivesAssessing the functions performed, risk undertaken and intangibles owned by associated parties to the transaction
Identifying the simpler entity Margins of the simpler company generally examined
Criteria for Comparability
Assist in identification of
simpler entity
Platform for Economic Analysis
Compliance with documentation requirements
Understanding of where and how value is added
Functional Analysis - Relevance
Functional Profiling
R&DR&D
ProcessingProcessing
MarketingMarketingSales
& Distribution
Sales& Distribution
FinanceFinance
Each activity or enterprise receives a share of total profits that reflects the contribution of that activity or enterprise to earning those profits.
Income distribution within the MNC must reflect economic value and activities
Functional Analysis
Analyzing risks associated in relation to various business operations
Strategic PlanningProduction Scheduling & Production ActivitiesQuality ControlResearch & DevelopmentMarketingSales & DistributionIdle CapacityForeign Exchange
Functional Analysis
The following categories need to be taken into account for intangibles analysis:
Technical / Trade Intangibles
Marketing Intangibles
Functional Analysis- Summary
XYZ Group of Companies
Country ACountry A Country BCountry B
Functions
Assets
Risks
Profits $$$$$$$$$$$ $$$
Profit = f (F + A + R)
Procedure
Description of Inter-companyTransactions
Organisation Chart
Industry Background
Market Analysis
Description of Activities
Analysis of Risks
Terms of Trade
Singapore Owned Indian Co
Step 2: Economic characterisation of simpler entity
Determining the nature of the entities
Characterisation in the instant case:Contract service provider / production center for the Singapore parent
Step 3: Selection of the most appropriate methodService provider- cost plus / TNMM
Singapore Owned Indian Co
Step 4: Search and analysis for comparablesRunning queries on Indian TP databases
Search for companies in the same line of business
Contract service providers
Short listing the initial sample of companies identified by:
Applying quantitative and qualitative filters
Reviewing short business descriptions of each of the companies found
Examining public documents (ex Annual reports of companies)
Further search on company’s website, interviews etc
Selection of appropriate PLI
Identifying the margins of each of the companies based on PLI selected
Step 5: Computing the arm’s length priceAdjustments to comparable companies
By taking the arithmetic mean of each of the companies selected in the final sample
Balancing the Indian and the Singapore regulations!!
Singapore Owned Indian Co
Computing the Arm’s Length Price
Generally- 5% to 20% margin on costs depending upon the nature of activities
Entrepreneurial manufacturer v/s contract manufacturer
Idle capacity risk - who bears?
BPO
Software Solutions & Services
Consulting
Products
0
10
20
30
40
50
VV
AA
LL
UU
E E
VV
AA
LL
UU
E E
RR
EE
VV
EE
NN
UU
E E
RR
EE
VV
EE
NN
UU
E E
VV
OO
LL
UU
MM
E E
VV
OO
LL
UU
MM
E E
Transfer Pricing- a Tax Planning Tool!
Entrepreneurial Profit
Sum of Payments to Factors of Production
Total Profit
Return to risk-taker
Above-normal profit:
• Goes to developer(s) of intangible assets [R&D marketing]
• May be zero or negative!Return to service providers / suppliers of labor and capital
Normal profit:
Paid out for performance of normal tasks [ mfg. , sales, distrib., service, support] or for normal risks using comparables to benchmark
Transfer Pricing Study Process
STEP 1Undertaking a functional
analysis & economic characterization
STEP 1Undertaking a functional
analysis & economic characterization
STEP 2Selecting the most
appropriate transfer pricing methodology
STEP 2Selecting the most
appropriate transfer pricing methodology
STEP 3Applying the most appropriate
method & determining the arm’s length
outcome
STEP 3Applying the most appropriate
method & determining the arm’s length
outcome
Step 4Implement support processes.
Install review process to ensure adjustment for material changes
Step 4Implement support processes.
Install review process to ensure adjustment for material changes
Maintaining necessary documentary evidence to support each of the above steps!
Running search on database- key features
Exact comparables may not be availableUse of lateral comparables
Sample size – should not be too small?
US v/s Canadian practice
Applying Filters
Quantitative Filters3 Year Track Record
Ratios
Any Other ParametersRevenue
No. of Employees Qualitative FiltersCompanies Incorporated In Foreign Countries
Positive Word Search
Negative Word Search
Independent Companies
Use of PLI’s under TNMMThe three financial ratios generally considered as acceptable in the US context are:
Rate of Return on Capital Employed
Berry Ratio (GP / Op exp)
Operating Margin (Op profit / Sales or Cost)
Selection of appropriate PLI depends upon:Nature of the activities of the tested party,
The reliability of the available data with respect to comparable uncontrolled taxpayers, and
The extent to which a particular profit level indicator is likely to produce a reasonable determination of the income that the tested party would have earned had it dealt with the controlled taxpayer at arm’s length.
Adjustment to Ratios
Useful when feasible to increase ratio’s comparability to the tested party
Three standard adjustmentsInventory Differences
Inv. Adj. = (Inv./Sales taxpayer – Inv./Sales comparable) * Sales comparable * Prime Lending Rate
Receivables DifferencesRec. Adj. = (Receivables/Sales Taxpayer – Receivables/Sales Comparable) * Sales Comparable * Prime Lending Rate
Payable DifferencesPay. Adj. = (Payables/COGS or Sales Taxpayer – Payables/COGS or Sales Comparable) * COGS or Sales Comparable * Prime Lending Rate
& Indenting Model
CASE II
Manufacturing
Manufacturing & Indenting Model
X Pte LtdSingapore
X Pte LtdSingapore
X LtdIndia
X LtdIndia
CustomersCustomers CustomersCustomers
100%Shares
Direct saleof chemicals
Payments
Payments
Manufacturing & Sales
Outside India
In IndiaReceipt ofCommission /
consideration & sale of raw materials
Marketing
Transactional P&L A/c
Particulars Total Manufacturing Domestic Sales
Services Indent Commission / inc
Sales 100 90 10
Expenditure
Cost of goods sold
45 45 0
Manufacturing Exps. 20 20 0
Administration Exps. 5 3 2
Selling & Distribution 10 6 4
Depreciation 5 5 0
PBIT 15 11 4
Operating margins 15% 12% 40%
Functional Analysis- Services
Services – IndentingFunctions performed
Liaisoning with clients in India
Sales support and after sales services
Assets UsedEmployee Skills / Network / Customer list
Risks AssumedDepends on the commercial / contractual terms
Risk Factors in DistributionR
EW
AR
D
RISK
Admin & Accountancy
Duties
Credit riskWarrantyObsolescence
Currency exposure
Pricing
Product Mix
Market Share
Volume
Commissionaire StrippedDistributor
Instant Buy/Sell
Distributor
Marketing Costs
Sales Expense
Functional Analysis- Manufacturing
ManufacturingFunctions performed
Purchasing, mfg, distribution, sales, etc.
Assets usedIntangibles and plants
Risks assumedInventory holding risks, bad debts risks, etc.
Risk Factors in ManufacturingR
EW
AR
D
RISKManufacturing
services
Fixed overheadDown time
Labour Costs
Long Term Contracts
Raw Material Costs
Quality
Pricing
Volume
R&D
Toll Manufacturer Contract Manufacturer Full Manufacturer
Search for Comparables
Re services / indentingTraders / agents in Chemicals
Re manufacturingTNMM with ROA or Operating margins as the PLI
TP Methodologies
CUPIndustry benchmark for commission rates
Resale priceNA in the instant case
Cost plusRejected for want of adequate disclosure requirement
Profit splitNA in the instant case
TP Methodologies
TNMMRe indenting
Berry Ratio (GP/ Operating exp)
Operating margin (NPBIT / Indenting income)
Re manufacturingTNMM with ROA or Operating margins as the PLI
Intra-Group Services
CASE III
Intra-group Services
No clear cut guidelines under the Indian regulations
OECD Guidelines- Intra group servicesWhether the activity provides economic or commercial value to enhance commercial position?Whether an independent enterprise in comparable circumstances would have been willing to pay for the activity if performed for it by an independent enterprise or would have performed the activity in-house for itself
Central Services Examples
Administrative Services Planning/coordinationBudget ControlFinancial AdviceBook KeepingInternal Auditing of the BooksLegal Matter
Financial Treasury Services Cash ManagementAttracting CapitalConcluding Loan AgreementsTrading in DerivativesRefinancingFactoring
Operational Logistics Services ManufacturingWarehousingTransport
Central Services ExamplesInformation Technology Services Software / Hardware Systems
Training
Specific Services Technical Advice with regard to Production
Central Purchasing, distribution or marketing
Personnel Services Recruitment and Selection Training & Education Secondment of Personnel
OECD Guidelines
Shareholder activitiesSuch activities should not be charged to group companies
Expenses relating to judicial structure of the parent companyShareholder meetings, the issue of shares in parent company and the costs of its supervisory board
Reporting reqt of the parent company including consolidation of reports
Raising funds for acquisition of new company to be held by parent company
Central services that duplicate activities
Management Fees
Management fees could be based on cost plus 5 /15% mark-up
Need for contractual agreement
10.2% service tax / VAT applicability?
W /tax under India-Singapore tax treaty?
Royalty Payments
CASE IV
Royalty Payments
Relevant factors:Description of implicit rights, geographical coverage, time horizon, exclusivity, level of capital investments needed, the possibility of sub-licensing, etc.
Any specific industry norms?Similar comparable transactions?TNMM analysis to benchmark the operating margin of the Indian sub
Royalty Payments
A 5 yr profitability projections of the sub could be helpful
Reference to historical level of R&D expenses
The use of DCF Method to corroborate the findings
Relevance of Industrial Policy norms?
5% / 8% on local sales / exports
Lumpsum payments of US$ 2 million
Establishing Most Appropriate Method
CUP Resale Price
Cost Plus TNMM Profit Split
Distribution Manufacturing Services and routine software dev., ITES, etc
(total cost plus)
Common facilities
(cost sharing)
Joint R&D Class of Transactions
Methods
Functions
CUP: Comparable Uncontrolled Price TNMM: Transactional Net Margin Method
SKP Transfer Pricing Division
Exposure to accounting, international tax and transfer pricing issues required for a TP analysisAssociates in UK and US
Have provided assistance to many of the fortune 500 companies
Have been specifically trained in the US and the UKAppointed by the Gem and Jewellery Export Promotion Council of India to study the applicability of the transfer pricing regulations to the Gem / Jewellery and the diamond industry and make a representation to the Government
SKP Transfer Pricing Division
SKP in co-ordination with its associates helps in balancing the Indian and overseas transfer pricing / tax regulations
Personalized service
Transfer Pricing
Industries covered………
Software, ITES, BPO opnEngineeringDiamonds, Gem and JewelleryTextiles and garmentPoultryAuto ancillary and road equipment
ConstructionEntertainmentPharmaceuticalsRecruitment agenciesEPC ContractorsWater Polymers
Developing appropriate methodology
Alignment with client’s global business objectives
Assisting in implementing optimal transfer pricing policy
Developing strategies that meet the Indian and international transfer pricing requirements
Assisting in maintenance of documentation
Issuance of CPA certification
Tax compliance and representation services
Transfer Pricing- Scope of Services
Contact Narayan MehtaTel: +91 22 22821141Fax: +91 22 22024193Mobile: +91 9820544495E-Mail: [email protected]
Queries?
Thank You