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: narayan.mehta@skparekh.com

Queries?

Thank You