Transfer Pricing - India and Global Perspectives –Advanced Course for BCAS

7 April 2017

2

Agenda

Base Erosion and Profit Shifting (‘BEPS’) (Country by Country Report (‘CbCR’) and intangibles)

Functions, Assets and Risks (‘FAR’) Analysis

Benchmarking methods

Introduction to Transfer Pricing

Introduction to Transfer Pricing

4

What is Transfer Pricing?

• A mechanism for pricing the transfer of goods and services between related entities:

− Tangibles - Raw materials, Components, Spare-parts, Semi-finished / Finished goods, Assets, etc.

− Intangibles - trademarks, trade-names, patents, etc.

− Services - IT/ IT Enabled, Management, Marketing Support, Engineering, After Sales Services, etc.

• A mechanism which provides the conceptual framework for pricing intercompany transactions.

• May or May Not Involve Shifting of Profits to Optimize Taxes

5

Transfer Pricing Regulations for Anti-Avoidance

To Prevent Shifting of profits through Transfer Pricing

Sale to Sub Co. Dubai at INR 80

Parent Co. India

Sub Co. Dubai

3rd Party Customer

Expenses Income

Cost 60 Sales 80

Profit 20

Tax @ 30% = INR 6

Sale by Sub Co. to customer INR 150

Expenses Income

Cost 100 Sales 150

Profit 50

Tax @ NIL = NIL

Overall tax burden of Group is INR 6

Sale to Sub Co. @ ALP = INR 120

Parent Co. India

Sub Co. Dubai

3rd Party Customer

Expenses Income

Cost 60 Sales 120

Profit 60

Tax @ 30% = INR 18

Sale by Sub Co. to customer INR 150

Expenses Income

Cost 140 Sales 150

Profit 10

Tax @ NIL = NIL

Overall tax burden of Group is INR 18

Situation I - Price Situation II - Arm’s Length Price (‘ALP’)

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Concepts of Transfer PricingAny income arising from an international transaction with associated enterprises (‘AEs’) shall

be computed having regard to the ALP

Transfer Pricing

International Transaction AE

Income

Arising?

Also includes Deemed

International Transactions and

Specified Domestic Transactions

ALP

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Scheme of Transfer Pricing Regulations in India…Relevant Provisions under Section 92

Computation of Income

Section 92C + Rule 10B / 10C

Section 92AAEs

Section 92BInternational Transaction

ALP

Section 92D and Section 92EDocumentation and Certificate

Section 92BASpecified Domestic Transaction

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… Scheme of Transfer Pricing Regulations in India

Power of AO and TPO

Scrutiny

Section 92CA

Section 144CDispute Resolution Panel

Section 271 (1) (c), 271AA, 271BA, 271GPenalties

Other relevant provisions

Section 92CC and 92CD + Rules 10F to 10TAdvance Pricing Agreements

Section 92CB + Rules 10TA to 10TGSafe Harbour

BEPS Section 286

BEPS (CbCR)

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Three-tier documentation - Objectives and Approach 5 October 2015, OECD released final guidance on TP Documentation and CbCR. Three-tiered Approachempowers tax authorities with relevant information to assess risk of revenue leakage

Goes Beyond mere Transfer Pricing Risk Assessment

Aid tax authorities perform a transfer

pricing risk assessment

Ensure taxpayers give appropriate consideration

to setting prices consistent with the arm’s-

length principle

Provide information needed for tax authority audit

Objectives

CbCR

Master File (‘MF’)

Local File (‘LF’)

Action Approach

Taxpayer’s key tools for managing transfer pricing risk. Must be consistent

Indian has introduced BEPS documentation norms to align with OECD BEPS guidelines

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CbCR Requirements

CbCR requires aggregate tax jurisdiction wide information relating to the global allocation of:

— Income;

— Taxes paid;

— Location of economic activity;

— Listing of all Constituent Entities including the tax jurisdiction of incorporation, where different from the tax jurisdiction of residence, and also Nature of Main Business Activities carried out by that Constituent Entity

CbCR contains information not previously provided to tax authorities

Tax Jurisdiction

Constituent entities resident in the tax jurisdiction

Tax jurisdiction of organisation or incorporation if different from tax jurisdiction of residence

Activities

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Country A Entity A Country B

Entity B

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Country A

Country B

Not resident in any tax jurisdiction

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MF requirements

MF should provide an overview of the MNE group business - To explain MNE’s transfer pricing policies in thecontext of its global economic, legal, financial and tax profile.

High level Overview

— Organisation structure – Legal and ownership structure and locations of operating entities

— A description of the business including:

- Important drivers of business profit.

- Description of the supply chain (for five largest products / services plus those that represent more than 5%of turnover).

- Description of the main geographic markets for the products / services identified.

- Important intra-group services arrangements, other than R&D services.

- Functional analysis describing principal contributions to value creation by different entities.

- Important business restructurings, acquisitions, divestitures.

— Intangibles including:

- MNE’s strategy for the development of intangibles, ownership and exploitation, location of R&D facilityand its management

- A list of important intangibles

- Agreements relating to intangibles, including CCAs etc.

- Transfer pricing policies related to R&D and intangibles

- Important transfers of intangibles

— Intra-group financial activity including:

- How the MNE is financed

- Identification of central financing companies

- Transfer pricing polices relating to financing.

— Financial and tax positions including:

- Consolidated financial statement.

- Unilateral Advanced Pricing Agreements (APAs); and other tax rulings relating to the allocation of income.

MF contains new info. not previously provided to tax authorities

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LF requirements

Contents must show that taxpayer has complied with arm’s length principle in material intra-group transactions

For each jurisdiction, the LF should contain:

— Description of the management structure, business strategy, business restructurings, keycompetitors.

— For each material category of controlled transactions:

- Description of material controlled transactions and context of transaction.

- Intra group payments for each category by jurisdiction of counter-party, identifyingrelationship between counterparties.

- Copies of material intra group agreements.

- Detailed comparability and two sided functional analysis including any changes to prior years(can be cross-referenced to MF).

- Most appropriate transfer pricing method and tested party.

- Important assumptions in applying the transfer pricing methodology.

- Reasons for performing a multi-year analysis (if relevant).

- List and description of Comparable Uncontrolled Prices (‘CUPS’) if any, search methodologyand financial indicators of comparables.

- Comparability adjustments.

- Reasons for concluding transaction was conducted on arm’s length basis.

- A summary of the financial information used in applying the transfer pricing method.

- A copy of existing APAs and other tax rulings which are related to the controlled transactions(but don’t involve the local entity).

— Financial information for local entities, including local financial accounts and reconciliationbetween information used for transfer pricing, financial statements and financial data forcomparables.

LF is closely aligned with what companies already prepare

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Interaction between elements of documentation

There is now a three tiered approach to transfer pricing documentation - designed to provide tax administration with relevantand reliable information to perform a risk assessment.

LF

• Detailed information relating to specific intra-group transactions

• Assurance that the local entity has complied withthe arm’s length principle for its material intra-group transactions in that jurisdiction.

• Similar to the transfer pricing documentationcurrently prepared

• Similar details required for each legal entity(subject to local law)

To provide a high-level overview of

• the MNC’s group business

• nature of its global business operations

• overall TP policies

• global allocation of income and economicactivity

• organisational structure

• description of intangibles owned

• intra-group financing activities

• financial and tax positions

MF

Strategic split of information

based on local or global

audience

• Aggregate tax jurisdiction wide information relating to the global allocation ofincome, taxes paid, and certain indicators of economic activity among the taxjurisdictions in which MNC's operates

• CbC breakdown of financial and tax data

• List of all entities, branches and PEs, with relevant activity from a tick list

• Assumptions and narrative to support and explain the data

CbCR

MF puts CbCR in global

context

LF puts CbCR in local context

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CbCR Analytics

Understanding the inferences that a tax authority might draw from your CbCR data helps inform the content of the MF and LF

— Total Revenue per Employee.— PBT per Employee.— Unrelated Party Revenue/Total Revenue.— Income Tax Accrued/PBT (ETR).— ETR versus statutory tax rate.— Profit per employee versus ETR.— Revenue per employee versus PBT per

employee.

Ratios

— PBT / Total Revenue – approximation ofoperating margin.

— PBT/(Total Revenue – PBT) – approximation ofnet cost plus.

— PBT/(stated capital plus accumulatedearnings) – approximation of return on capitalemployed.

— PBT / Tangible assets – approximation ofreturn on assets.

Profit level indicators

— Profit per employee versus PBT or ETR isinversely proportional

— Big difference between ETR and statutory tax rate

— A low ratio of unrelated party revenue versus totalrevenue - significant intra-group transactions

— Low ETR

Tax Authorities May Need Explanations for

— How do the profit level indicators compare toyour transfer pricing policy?

— How do the profit level indicators varybetween countries / regions? Are there trendsthat need to be explained?

— Are the returns consistent by function? Whatare the reasons for outliers?

Interpreting your transfer pricing policy

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Alignment of TP Regulations with BEPS Measures

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Alignment of TP Regulations with BEPS Measures

Alignment of TP Regulations with BEPS Measures

Alignment of TP Regulations with BEPS Measures

Finance Act 2016Finance Act 2016

Introduction of CbCReporting Requirements

(BEPS Action Plan 13)

(effective FY 2016-17)

Introduction of CbCReporting Requirements

(BEPS Action Plan 13)

(effective FY 2016-17)

Finance Act 2017Finance Act 2017

Introduction of Thin Capitalization Norms(BEPS Action Plan 4)

(effective FY 2017-18)

Introduction of Thin Capitalization Norms(BEPS Action Plan 4)

(effective FY 2017-18)

India has endorsed BEPS Actions 8-10 on Aligning TP Outcomes with Value Creation

India has not endorsed Guidance on Low Value Adding Intra-Group Services under Action Plan 10

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CbCR Reporting RequirementsCbCR – OECD Objective

To provide information to tax authorities to enable them to undertake TP risk assessment, data may also beused to assess wider BEPS related risks

Section 286 vide Finance Act, 2016

• Indicative Threshold prescribed – CbC reporting to apply only if the consolidated turnover of the MNEgroup in previous year (i.e. FY 2015-16), exceeds EUR 750 million (INR 5,400 crore approx.)

• Indian Parent entity of MNE group or any other designated group entity in India (referred to as alternatereporting entity (‘ARE’))

to file CbCR

for financial year 2016-17

before the due date of filing of Return of Income i.e. 30 November 2017

• Indian subsidiaries of Foreign Parents also obligated to file CbCR, in certain cases -

Country of foreign parent does not have information exchange arrangement with India; or

Such country does not co-operate to provide such information

• Other Indian subsidiaries (of Foreign Parents), required to provide information regarding the country ofresidence of the parent entity.

Detailed Rules / Forms yet to be prescribed

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CbCR – Implications on Outbound / Inbound MNEs

Implications for Indian HQ entity (Outbound)

Implications for Indian entity with Foreign parent (Inbound)

• Indian parent entity obliged to file CbCR in

India, subject to revenue threshold

• Indian parent entity may designate ARE

(resident in India or overseas) to file CbCR

• MF to be maintained by Indian parent

entity – could be subject to threshold,

which is expected to be much lower

• Indian entity with a foreign parent, to

notify Indian prescribed authority on or

before prescribed due date, the details of

parent entity or ARE or whether it is the

ARE

• Indian entity may have to file CbCR if:

• India does not have an agreement for

exchange of CbCR with country of

foreign parent or ARE; or

• Despite having an exchange

agreement, country of foreign parent

or ARE fails to share CbCR

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Stringent Penalties prescribed

Penalty for CbCR: Delay upto one month

Delay beyond one month

Delay in payment of penalty after receipt of

instructions to pay

Failure to furnish CbCR by the due date of filing of return of income

INR 5,000 (USD 75) per day

INR 15,000 (USD 230) per day

INR 50,000 (USD 750) per day

Failure to furnish additional information and documents sought by the Revenue authorities

INR 5,000 (USD 75) per day from the day on which the period for furnishing the information and document expires

INR 50,000 (USD 750) per day

Inaccurate information filed under the CbCR(Penalty to be levied based on certain conditions)

INR 500,000 (USD 7,500)

Failure to furnish MF by due date - Penalty of INR 500,000 (USD 7,500)

BEPS – Illustrative Global Updates

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BEPS – An Illustrative Global perspective

The United States of America

CbCR• MNEs with annual consolidated group revenue => $850 million in the PY• A U.S. territory parent entity may designate a U.S. business entity that it controls to file on its behalf• For fiscal years beginning on or after 30 June 2016• Must be filed on or before the due date (including extensions) for the annual tax return• To be filed in English U.S. has not adopted OECD's XML Schema standardized electronic format yet• Penalties ranging between $10,000 and $50,000 for noncompliance with CbCRMF and LF• No announcements made to date.

United Kingdom…

CbCR• MNEs with annual consolidated group revenue => €750 million in the PY• For fiscal years beginning on or after 1 January 2016.• Must be filed no later than 12 months after the last day of the reporting fiscal year of the MNE group• CbCR language has not been specified yet and adoption of OECD's XML Schema standardized

electronic format is anticipated

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BEPS – An Illustrative Global perspective

…United Kingdom

• Penalties for noncompliance with CbCR and notification requirements ranging from £300 to £3,000with daily penalties for continued failure.

• All U.K. constituent entities are required to file CbCR unless they qualify for an exemption

MF and LF• Intention to implement

Australia…

CbCR• MNEs with annual consolidated group revenue => AUD 1 billion in the PY - Regulations extend to

subsidiary entities• For fiscal years beginning on or after 1 January 2016.• Must be filed no later than 12 months after the last day of the reporting fiscal year of the MNE

group.• The Australian entity will need to disclose in the LF that it is filing CbCR as a surrogate and which

entity will be lodging the CbCR and MF• The Government has introduced draft legislation to increase the maximum penalty for failure to file

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BEPS – An Illustrative Global perspective

…Australia

CbCR to A$525,000 and double the penalties for making false and misleading statements. Criminalpenalties could be due in exceptional cases

MF• MF first filing year, transitional exemption, filing requirements, revenue threshold and penalties are

the same as for CbCR.LF• LF first filing year, revenue threshold and penalties are the same as for CbCR• LF will be in addition to existing Australian transfer pricing documentation requirements, to be

submitted within 12 months after the close of the income year

Belgium…

CbCR• MNEs with annual consolidated group revenue => €750 million in the PY. Regulations extend to

subsidiary entities• For fiscal years beginning on or after 1 January 2016• Must be filed no later than 12 months after the last day of the reporting fiscal year of the MNE

group.• Filing in local language is not required and adoption of OECD's XML Schema standardized

electronic format is anticipated• Penalties ranging from €1,250 to €25,000 will apply for noncompliance with CbCR and notification

requirements

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BEPS – An Illustrative Global perspective

…Belgium

MF• MF applies to a Belgium company or PE of a MNE group exceeding prescribed thresholds• MF applies for financial years ending on 31 December 2016 or later• MF filing deadlines, and penalties are the same as for CbCR. Filling in English will be accepted.LF• LF should be filed together with the Belgian income tax return• LF filing threshold, language and penalties are the same as for MF

Netherlands

CbCR• MNEs with annual consolidated group revenue => €750 million in the PY• For fiscal years beginning on or after 1 January 2016• Must be filed no later than 12 months after the last day of the reporting fiscal year of the MNE group• To be provided in English and the Netherlands have adopted the OECD's XML Schema standardized

electronic format• Penalties to be imposed in instances of intentional non-compliance or “serious misconduct” with

CbCR, with a potential maximum penalty in the amount of €20,250, in addition to possible criminal prosecution

MF• MNEs with annual consolidated group revenue => €50 million.• For fiscal years beginning on or after 1 January 2016.• Non compliance would result in a reversal of the burden of proofLF• LF filing requirements, language and penalties are the same as for MF• Regular TP documentation to be maintained if annual consolidated revenue is < EUR 50 million

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BEPS – An Illustrative Global perspective

Germany

CbCR• MNEs with annual consolidated group revenue => €750 million in the PY Regulations extend to

subsidiary entities• Applies for fiscal years beginning after 31 December 2015• Must be filed no later than 12 months after the last day of the reporting fiscal year of the MNE

group• language in which CbCR to be filed pending determination / adoption of OECD's XML Schema

standardized electronic format is anticipated• Maximum penalty of €10,000 applies.MF• MF required if German taxpayer's sales > €100 million.• MF applies for fiscal years beginning after 31 December 2016.• Submission to the local tax authorities is not required. Typically to be submitted upon request

during a tax audit.• Generally German language required but foreign language (typically English) may be applied

for.• Standard sanctions for non or insufficient MF documentation will apply, including penalties and

reversal of burden of proof.LF• First filing year, filing requirements, penalties and language requirement are the same as for

MF.• No specific threshold currently provided; simplifications apply in case of limited related cross-

border transactions.

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BEPS – An Illustrative Global perspective

China

CbCR

• If enterprise is the UHC of a MNE and the group has consolidated revenue => RMB 5.5 billion inthe PY, or the entity has been designated by the MNE group

• For fiscal years beginning on or after 1 January 2016• CbCR must be filed together with Annual Reporting Forms on RPT on May 31 of the year

following the covered tax year• CbCR will need to be provided in both local language and English and adoption of OECD's XML

Schema standardized electronic format is anticipated• Filing of a substantially incomplete/inaccurate report would be subject to penalties of RMB

10,000 and in serious cases, up to RMB 50,000MF• Must be prepared if (i) the cross-border RPT and the group to which the enterprise’s UHC

belongs has already prepared a MF, or (ii) total annual amount of RPT exceeds RMB 1 billion• MF applies for fiscal years beginning on or after 1 January 2016• MF must be prepared within 12 months of the year end and shall be submitted within 30 natural

days of request• MF must be prepared in Chinese or translated into Chinese• A penalty of RMB 10,000 will apply for noncomplianceLF• LF must be prepared on fulfillment of prescribed conditions• LF effective year, language and penalties are the same as for MF• LF must be prepared by 30 June following the tax year in question and shall be submitted to the

tax authorities within 30 natural days of request

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BEPS – An Illustrative Global perspective

Japan…

CbC reporting• MNEs with annual consolidated group revenue => Yen 100 billion in the PY• For fiscal years beginning on or after 1 April 2016• Must be filed via E-Tax no later than 12 months after the last day of the ultimate parent fiscal

year end• CbCR must be provided in English and Japan has adopted the OECD's XML Schema

standardized electronic format• Maximum penalty of JPY 300,000 will apply for noncomplianceMF• First filing year, revenue threshold, filing dates and penalties are the same as for CbCR.• Virtually the same as MF proposed in the OECD Action 13• MF must be prepared in Japanese or English and submitted electronically via e-Tax.LF• A taxpayer with intercompany transactions < than JPY 5 billion for the prior fiscal year and

intangible transactions of a value of < than JPY 300 million in the prior fiscal year is exemptfrom the LF.

• There is no requirement for the scheduled submission of the LF. However, LF must be preparedon an annual basis by the due date for filing the taxpayer’s tax return and submitted uponrequest within 45 days

• Applies for fiscal years beginning on or after 1 April 2017• A penalty in the form of a “presumptive taxation” may be imposed when a taxpayer fails to

submit the LF upon request

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BEPS – An Illustrative Global perspective

Singapore

CbCR• MNEs with annual consolidated group revenue => SGD 1,125 million.• For fiscal years beginning on or after 1 January 2017.• Must be filed no later than 12 months after the last day of the reporting fiscal year of the MNE

group.• CbCR to be provided in English. Adoption of OECD's XML Schema standardized electronic

format is anticipated.

MF and LF• No announcements made to date

BEPS (Intangibles)

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What is an intangible?

“…Something which is not a physical asset or a financial asset, which is capable of beingowned or controlled for use in commercial activities, and whose use or transfer would becompensated had it occurred in a transaction between independent parties in comparablecircumstances.” (Paragraph 6.6 of Action 8-10 - Final Report)

Examples of Intangibles

• Patents

• Know-how and trade secrets

• Trademarks, trade names, and brands

• Rights under contracts and government licenses

• Licenses and similar limited rights in intangibles

• Goodwill and ongoing concern value:

Items that are not Intangibles

• Group synergies

• Market-specific characteristics / locational advantages

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Intangibles - Who is entitled to return from intangibles?

Entities making the following contributions

The entity(ies) controlling / performing Development,Enhancement, Maintenance, Protection andExploitation (‘DEMPE’) functions in relation to theintangibles

The entity(ies) controlling risks and having thefinancial capacity to assume risks associated with theDEMPE of the intangibles

The entity(ies) providing funding for the intangiblesand relevant DEMPE functions

Function

Risks

Funding

Intangibles - Six step process for analyzing transactions involving intangibles

Identification of economically significant intangibles with specifications1

Analysing contractual arrangement to determine legal ownership, rights & obligations of entities in relation to intangibles2

Undertaking functional analysis to determine actual conduct of parties on ground3

Confirm consistency between contractual arrangement and conduct on ground4

Delineate the controlled transaction based on conduct of parties5

Determination of arm’s length price based on FAR of each entity6

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Transaction involving Intangible – ExampleTransfer pricing outcomes from this example in accordance with Actions 8-10

• B is the legal owner of intangible for which DEMPE and risk management functions are undertaken by A

• B being the legal owner has licensed the IP to C for which it obtains a royalty. However, A is only provided nominal returns for the functions undertaken

• On ground, A is undertaking all DEMPE functions without supervision, control or inputs from B

• If B only funds the IP and assumes no control over A’s DEMPE functions or risks management (including funding risk), B should ideally be entitled only to a risk-free return

• For transfer pricing purposes, A should be entitled to operations return from exploitation of IP

A

B

C

Performs DEMPE

functions and risk

management

Legal owner of IP

IP user / licensee

Nominal return

RoyaltiesIP license

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Intangibles – Challenges for application of arm’s length principle• Lack of comparability between intangibles

• Lack of comparability between intangibles’ related transactions

• Different intangibles owned / used by different AEs

• Difficult to isolate impact of intangibles on group’s income

• Integrated approach of the group for DEMPE – may be absent in an independent scenario

• Timing difference between efforts and corresponding returns

• Group contractual arrangements – Ownership, risk, and / or funding separated fromperformance of functions, control over risk, and decisions making. Difficult to find similarthird party arrangement

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UN TP Manual – Revised India ChapterIntangibles and Royalty Payments

Key Positions of the Indian Revenue Authorities

• Difficult to evaluate transactions involving intangibles – rarely traded, lack of comparable data in public domain, difficult to detect, etc.

• Key issues around determination of ALP of royalty payments, remuneration for development of marketing and R&D intangibles

• Use of Profit Split Method not feasible due to lack of requisite information

• Royalty rate charged by MNE should factor the following:

• Cost borne by subsidiary to promote brand and trademark – subsidiary would require arm’s length compensation for economic ownership and enhancing the value of brand

• Significant R&D expenditure incurred by Indian subsidiaries in customizing technical know-how of parent company to enhance its value

• Co-branding of new foreign brands with popular Indian brand name – expenditure incurred on advertisement, marketing and sales promotion contributes significantly to increasing the value of foreign brand

CBDT Circular 6 of 2013 lays down relevant conditions to identify development centres engaged in contract R&D services with insignificant risk

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Marketing Intangibles – Judicial precedents (Three Different Views)…

Issue Maruti Suzuki ruling(2015 Delhi HC)

Sony Ericsson ruling(2015 Delhi HC)

LG Special bench ruling (2013 Delhi ITAT Special

Bench)

AMP expenseconstitutes aninternationaltransaction

AMP expense not aninternational transactionas application of Brightline test (‘BLT’) is notpermissible undertransfer pricingregulations

AMP expense is aninternational transactionas marketing anddistribution functionperformed towardsrelated party

AMP expense is aninternationaltransaction

Application ofBLT /Bifurcation ofexpense intoroutine versusnon-routine

Relying on the SonyEricsson ruling,application of BLTrejected

Application of BLT andconcept of non-routineAMP expense rejected

Bright line expense is atool to bifurcate AMPexpenses into routineand non-routine

Transfer pricingapproach

If payment of royalty andimport of raw materialstested separately, noadditional benefitflowing by way of AMPexpense

AMP function is closelylinked to and a part ofoverall distributionactivity, can beaggregated for TPanalysis

Purchase of goods andAMP expense areseparate transaction andcannot be Aggregated

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Issue Maruti Suzuki ruling(2015 Delhi HC)

Sony Ericsson ruling(2015 Delhi HC)

LG Special bench ruling (2013 Delhi ITAT Special

Bench)

Set offpermissible /aggregation oftransactions

In consonance withRule 10B, noadjustment warrantedas the margins of thetaxpayer is higher vis-à-vis comparables byapplication of theTNMM

Distribution of goodsand marketing areclosely linkedtransactions. Hence, noadjustment warrantedif taxpayerremuneratedadequately by highermargins on thedistribution of goods

AMP function to beseparately compensatedeven if higherprofitability in thedistribution function

Economicownership onintangibles

Concept of economicownership appreciated

Concept of economicownership appreciated

Concept of economicownership rejected

…Marketing Intangibles – Judicial precedents (Three Different Views)

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Marketing Intangibles – Litigation UpdateMaruti Suzuki / Sony Ericsson - 8 questions raised before Supreme Court*

• AMP Expenses – treated and characterized as international transaction?

• Independent distributor / licensed manufacturers – promotion of brand necessarily be a matter ofnegotiation and not necessarily be reduced to writing as part of an agreement?

• Was HC right in stating – existence of international transaction cannot be arrived at fromintercompany agreement?

• Under Chapter X – can adjustment be made in respect of expenditure treated as AMP expenditure?

• Was HC right in holding that Income -tax Act does not have machinery provision to benchmarkthe international transaction arising from AMP expenses?

• Was HC right in rejecting the BLT?

• Was HC right in holding that the benefit to AE was only incidental and not intentional?

• Was HC right in holding that if TNMM demonstrates that transactions are at ALP – no adjustmentwarranted – ignoring the separate benchmarking of each international transaction?

*Source: Taxsutra article dated 6 October 2016

FAR Analysis

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• PrepareProjectPlan • Search strategy

• Access to local & global database

• Analysis of internal & external comparables

• Judicious identification of arm’s length range

• Understand existing costing mechanism

• Determination of billing methodology

• Benchmarking exercise

Pre – project Planning

Stage 2Stage 3 Stage 4

Functional analysis -Information gathering

Comparable data / Industry Analysis

Economic Analysis

• Interviews• Questionnaires• Management

Discussion• Characterisation

of each entities• Review of

Agreements

Stage 5

• Consultation with Management

• Finalization of Transfer pricing Study Report

Issuance of Transfer Pricing Study Report

Stage 1

Preparation of Transfer Pricing Study Report

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• To have a proper understanding of the business and related commercial considerations

• To analyze intercompany prices

• Appropriate Characterization (e.g. Entrepreneur / Limited Role / Captive, etc.)

• To determine the economic characterization of the entities in the transaction and to select a

tested party

• To determine the most appropriate method for benchmarking the transaction

• To identify any uncontrolled transaction involving one of the controlled parties

Importance of FAR Analysis

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Step 1 Activities

Undertaken

Step 2Financial Attributes /

Assets Employed

Step 3Risk Assumed

• Understand full process flow - Identify and analyze the key functions

performed by parties – from Top level to Operating Level

• Key Performance Indicator (‘KPI’), Significant People function - focus

should be on identification of critical functions which add value to the

transaction

• Assets mapping with functions performed

• Reference to Tangible assets and Intangible assets employed

• Analyze special financial attributes in the financial statements

• Understanding MIS Reporting, TP Policy

• Industry Specific Risk- to be identified

• Contractual Relationship, Key Entrepreneurial Risk

• Business risks such as Currency Risk, Capacity Risk & Market Risk

• Consistency of risks assumed with the functions performed

Documenting FAR analysis

44

• Modes of collecting information:

FAR interviews and discussions with the functional personnel of taxpayer

Relevant agreements / contracts with Group entities

• Other background information that supports the FAR analysis :

Commercial rationale / pertinent facts surrounding the international transaction most

important in special cases like losses, start-ups, market penetration, etc.

Internal comparables (if any), external comparables / competitors of the taxpayer in the

market

Pricing policy of the taxpayer or its international group

• Facts gathered should be documented clearly and unambiguously

• Financial overview of the existing international transactions

Documenting FAR analysis - Other Related Parameters

45

Broad Categories of Business Functions (Illustrative)

Manufacturing

• Purchasing materials, supplies and equipment

• Developing and administering budgets

• Production of finished goods

• Packaging and labelling of products

• Quality control• Shipping of

products to customer

R&D

• Developing R&D strategy

• Funding • Execution of R&D

strategy • Evaluation of test

results • Obtaining

government approvals / registrations

Marketing

• Developing marketing strategy

• Developing and administering marketing budgets

• Execution of marketing strategy

• Monitoring the results and revisiting the marketing strategy, if required

Administration

• Finance and accounts

• Human resource management

• Security

46

Assets Employed

Analysis of the type of assets and their nature needs to be understood

Helps in determination of their contribution to the business process / economic activity

Facilitates understanding of respective roles played by the entities participating in theInternational transaction

Knowledge of assets owned and employed by the entities assists in understandingcomparative analysis

Broad Categories of Assets:

Tangible Assets

• Production Equipment & Machinery

• Buildings

• Office equipment

• Vehicles

Intangible Assets

• Patents

• Unpatented technical know-how

• Formulae, trade marks and brand names

• Licences & Copyrights

• Technical data

• Customer lists

47

Risks Assumed

Analysis of risks undertaken by each transacting entity

As the risk increases, the expected return should increase as well

Potential risks are company and industry specific

Only important risks should be described and quantified

Important to distinguish between which entity bears risks as per legal terms and which onebears as per the economic substance of the transaction

Broad Categories of Risks Assumed

Credit Risk Market Risk Product / service liability risk

Technology risk Foreign Exchange Risk

Employee Turnover related

Risk

48

Key Features – Documenting a FAR

Terms of agreement between the entities

Group transfer pricing policy(ies)

Conduct of the entities

Transfer pricing disputes being faced by the industry / international transactions

Ongoing transfer pricing litigation, if any

Consistency with stands / characterisation taken before other authorities – customs, service taxetc.

49

UN TP Manual – Revised India Chapter

Identification and Allocation of Risks

Key Positions of Indian Revenue Authorities

• It is unfair to give undue importance to risks in determination of the ALP in comparison tofunctions performed and assets employed

• The conduct of the parties is key to determining whether the actual allocation of risksconforms to contractual risk allocation

• Allocation of risks depends upon the ability of parties to the transaction to exercise controlover such risks

• Important factors to identify the party which has control over the risks:• Core functions undertaken and assumption of key responsibilities• Key decision-making and levels of individual responsibility• Financial capability to bear the risk

• The notion that risks can be controlled remotely by the parent company and that the Indiansubsidiary engaging in core functions, is a risk free entity has not found acceptance

• Cases identified wherein Indian subsidiaries exercises control over the operational and otherrisks, undertaking strategic decisions

50

Manufacturing - FAR and Characterisation

Prin

cip

alFunctions

and

risks

Man

ufa

ctu

rer

Toll Manufacturer

Contract Manufacturer

Licensed Manufacturer

Entrepreneur Profits

Possible variations for entity characterization

Intangibles

Sales

Inventory

Manufacturing

Intangibles

Sales

Inventory

Manufacturing

Intangibles

Sales

Inventory

Manufacturing

Intangibles

Sales

Inventory

Manufacturing

Detailed FAR Analysis is useful in characterising a manufacturing entity

51

Manufacturing – Compensation Model

Functions Typical Compensation model

Contract / Toll manufacturing operations

• Full cost plus mark up (or)• Return for value added services plus appropriate

return on capital investments in material and finished goods inventory

Routine manufacture / assembly activity with licensed technology from Group

• Risk free assured return in line with industry benchmarks

As a variant of the above with significant local marketing efforts

• Receipt of compensation for marketing intangible in addition to the above

Full fledged manufacturer and contributing to the R&D effort of the Group

• Profit Split Method (PSM) to determine the contribution towards routine functions and towards intangibles

52

Distributor – FAR and CharacterisationPossible variations for entity characterization

• Takes titles to the goods

• Buys and sells goods in its own name and undertakes all risks including risks of product obsolescence, bad debts, etc.

• Earns a profit or loss from trading activities, based on its ability to sell its products to others and to tap unexplored markets

• Takes title to the goods

• Sells in his own name

• No approval of Principal required for sale / price

• Compensated by resale price

• Low level of risks

• Assured gross profit margin

• Does not take title to goods

• Merely facilitates sale by the foreign Principal

• Principal’s approval required for sale / price

• Compensated by way of operating cost plus fixed mark-up arrangement

• Insignificant level of risks

• Does not take title to goods

• Sells in name of Principal

• Principal’s approval required for sale / price

• Compensated by way of commission

• Low level of risks

• Principal legally bound

Full Fledged Distributor Low Risk Distributor Sales Support ServicesCommission Agent

53

Distributor – Compensation Model

Full Fledged Distributor

Low Risk Distributor

Commission Agent

Sales Support Services

Incr

ease

in F

un

ctio

ns

Incr

ease

in P

rofi

t as

% o

f S

ales

54

Service providerPossible variations for entity characterization

High end functions and Low riskExample: • KPO captive

service provider

Low end functions and Low riskExample: • BPO captive

service provider

High end functions and High riskExample: • KPO entrepreneur

service provider

Low end functions and High riskExample: • BPO entrepreneur

service provider

RiskLow High

Low

Hig

hFu

nct

ion

s

55

Case study

56

Case Study – TP Planning Analysis

An MNE Group proposes intra-group transactions in the nature of -

Supply of manufactured goods

Trade of goods

Provision of services

These transactions are described in the following slides

57

India

Dubai branch

Brazil

Sale of manufactured goodsProposed transaction

Supply of Manufactured Goods

58

International transaction: sale of manufactured products

Payment: Transfer Price

Entities in India and Brazil to manufacture razor blades / other products and supply the same tocentral procurement and sales entity located in Dubai

In this case the Transfer Pricing analysis would involve:

• FAR analysis of international transaction involving sale of manufactured products from anend-to-end perspective

• Determination of transfer price having regard to the FAR analysis and availability ofcomparable data

Flow of international transaction

Manufacturing entity in India /

Brazil

Central procurement and

sales entity in Dubai

Determining an appropriate transfer price for the manufacturing function is crucial from an Indian Transfer Pricing perspective

Supply of Manufactured Goods

59

Trade of Goods

U.K.

Switzerland

USA

Canada

South Africa

Australia

Spain

Russia

Dubai branch

Czech Republic

Trade of goods

60

Sale of product Sale of product

Consideration Consideration

The Central Sales Unit in Dubai to sell products (procured from India and Brazil) to the tradingunits worldwide

These trading units would in turn sell the products to third party customers in their respectivejurisdictions

Flow of international transaction

Central procurement and

sales unit in Dubai

Trading entities worldwide

Third party customer

Determining an appropriate transfer price for purchase of goods by trading entities from the Dubai entity is crucial. Again, FAR analysis is the key to characterise trading entities

Trade of Goods

Benchmarking methods and its impact

62

Prescribed Methods (Sec. 92C(1) r.w. Rule 10AB & 10B)

No hierarchy or preference of methods prescribed under the Act

Prescribed Methods

Traditional

Transaction

Method

Comparable

Uncontrolled Price

Resale

PriceCost Plus

Transactional

Profit Method

Profit Split TransactionalNet Margin

Other Method

Any other method as provided in Rule 10AB

63

Most Appropriate MethodFactors to be considered forselection of the mostappropriate method:

Nature and class ofinternational transaction

Class of AE and functionsperformed

Availability, coverage andreliability of data

Degree of comparabilitybetween the Internationaltransaction

Extent to which reliable andaccurate adjustments can bemade

The nature, extent andreliability of assumptions forapplication of the method

64

Comparables

All methods require comparables

Transfer price is set/ defendedusing data from comparabletransactions / companies

Comparable company should beindependent and similar to thetested party

(a) Characteristics

Depends on type: tangible,intangible or

service

(b) FAR AnalysisConduct of parties, risk

bearing nature and level of

assets

(d) Economic Circumstances

Geography, size of market, level of competition

etc.

(c) Contractual terms

Where not written, deduce from conduct

65

Comparable Uncontrolled Price (‘CUP’) Method

66

…CUP Method… Most Direct Method

Prices are benchmarked without any reference to the profits

Requires strict comparability in products, contractual terms, economic terms, etc.

Volume / quantity of product

Credit terms

Geographic market

Other terms of contract

Two types of CUPs available - Internal CUP & External CUP

Typically Internal CUP is preferred over External CUP due to higher degree of comparability

Sub Co.

Parent Co.

TP

Unrelated Co. X

Unrelated Co. A

Unrelated Co. B

Extern

al C

UP

Unrelated Co. Y

Sub Co.

Parent Co.

TP

67

…Case Study 1: Application of CUP Method…

Ind Co, an Indian Company is engagedin the refining and sale of copper metal

Ind Co purchases crude copper fromboth related and unrelated parties

Critical factors that affect the crudecopper price are:

Volume

Tenure of supply contract (longterms, short term)

Product mix (with or withoutsmall quantities of other metalalloys like gold and silver)

Other terms of contracts (FOB vsCIF)

Ind Co

Related Party C (Country C)

Unrelated Party B (Country B)

Unrelated Party A (Country A)

Purchase of raw material

68

…Case Study 1: Application of CUP Method…

Criteria Related Party C (Country C)Controlled

Supplier A (Country A)

Uncontrolled

Supplier B (Country B)

Uncontrolled

Tenure of Contract Long Term (10 yrs)

Long Term (8 yrs)

Short Term (2 yrs)

Volume during year under consideration

2200 MT 3000 MT 9000 MT

Alloy Mix 0.5% gold, 1% silver

1% gold, 1% silver

None

Price (per MT) INR 29,500 (applicable for

entire year)

INR 32,000 (applicable for

entire year)

INR 28,500 (applicable for

entire year)

Other Terms FOB basis CIF basis FOB basis

69

…Case Study 1: Application of CUP Method

Best Method: Given the availability of required data, CUP is the most appropriate method

Rejection of CUP related to Supplier B: The significant difference in volume render theSupplier B transaction unreliable as suitable adjustments cannot be made to account for thedifference

Acceptance of CUP related to Supplier A: The uncontrolled transaction with Supplier A iscomparable with the controlled transactions with Related Party C (Although, certainadjustments need to be made)

Adjustments

Difference in pricing basis (FOB vs CIF) – add freight and insurance cost

Difference in alloy mix – adjust Supplier A’s price to exclude price for higher content of gold

70

Resale Price Method (‘RPM’)

71

RPM… Compares resale Gross Margin

Preferred method for a trader / distributor- buying purely finished goods from agroup company and selling to thirdparties

Comparability is relatively less dependenton strict product comparability andadditional emphasis is on similarity offunctions performed & risks assumed

Used when reseller does not addsubstantial value to the goods / servicesand does not apply intangible assets toadd value

Difficult to apply where goods / servicesare further processed / modified beforeresale

Sub Co.Sub Co.

Parent Co.Parent Co.

Transfer Price Rs. 75

Resale Price Rs. 100

Outside India

India

Price paid by Sub Co. to AE is at arm’s length if the 25% resale margin earned by Sub Co. is more than margins earned by similar Indian distributors

Price paid by Sub Co. to AE is at arm’s length if the 25% resale margin earned by Sub Co. is more than margins earned by similar Indian distributors

End Customer

End Customer

72

…RPM – Case Study

Independent third party in India

Foreign Manufacturer

Related party in India

COGS = INR 150Resale Price = INR 200

Gross Profit Margin = 50 / 200= 25%

Transfer Price = ?? Resale Price = INR150

ALP = 150 - (150*25%)= 112.50

• Sale to independent third party at INR 150 and sale to end customer by third party at INR 200

• Sale to end customer by related party at INR 150

Particulars Amount (INR)

Gross Profit 50 i.e. (200-150)

Gross Margin 25% i.e. (50/200)

Arm’s Length Purchase Cost 112.50 i.e. [150 – (25% 0f 150)]

End Customer

End Customer

73

Cost Plus Method (‘CPLM’)

74

CPLM… Compares and identifies mark-up earned on

direct and indirect costs of production incurredwith that of comparable internal transactions /independent companies

Preferred method in case

Semi-finished goods sold between relatedparties

Contract manufacturing arrangement

To be applied in cases involving manufacture,assembly or production of tangible products orservices that are sold / provided to AEs

Comparability under this method is relatively notas much dependent on close physical similaritybetween the products

Larger emphasis is on functional comparability

Sub Co.Sub Co.

Parent Co.Parent Co.

Transfer Price Rs. 125

Outside India

India

Direct cost & Indirect cost of Production Rs. 100

Price charged by Sub Co. to AE is at arm’s length if the 25% mark-up on cost is more than that of similar Indian assemblers

Price charged by Sub Co. to AE is at arm’s length if the 25% mark-up on cost is more than that of similar Indian assemblers

75

CPLM – Case Study

A Ltd. (AE)

Total Costs incurred(INR 175,000)

C Ltd.

(Third Party)

B Ltd. – Provision of services to A Ltd. and C Ltd.

GP margin earned oncosts 40 %

B Ltd.

ALP computation for provision of services from B Ltd. to A Ltd.

Direct and Indirect Costs for services to A Ltd.

175,000

GP mark-up in comparable uncontrolled transaction with C Ltd. – i.e. arm’s length mark-up

40 %

ALP for services to A Ltd. 245,000

76

Profit Split Method (‘PSM’)

77

PSM

To be applied in cases involving

• transfer of unique intangibles; or

• in multiple international transactions thatcannot be evaluated separately

Calculates the combined operating profit resultingfrom an inter-company transaction based on therelative value of each AEs contribution to theoperating profit

Evaluates allocation of combined profit / loss incontrolled integrated transactions

The contribution made by each party is basedupon a functional analysis and valued, if possible,using external comparable data

Co A –Technology intangibles

Mfg. Co B

Mkt Co CMarketing intangibles

78

Transactional Net Margin Method (‘TNMM’)

79

TNMM…

Most frequently used method, due to lack ofavailability of data for application of othermethods

Examines net operating profit fromtransactions as a percentage of a certainbase (can use different bases i.e. costs,turnover, etc)

Both internal TNMM and external TNMM arepossible

Broad level of product comparability andhigh level of functional comparability

Applicable for most categories oftransaction and often used to supplementanalysis under other methods

Parent A Co.

Unrelated Cos.

Subsidiary B

Net margin 5%

Unrelated Cos.

Net margin 3%

Outside India

India

80

TNMM…

Grouping of transactions - Relevant controlled transactions require to be aggregated to test whether the controlled transaction earn a reasonable margin as compared to uncontrolled transaction

Selection of tested party - Least complex entity

Selection of Profit Level Indicator such as Operating Margin, Return on Value added expenses, Return on assets – Denominator unaffected by transfer price

Benchmarking exercise (on Databases)

• Entity with similar industry classification to the tested party – through search in Prowess and Capitaline plus databases

• Screen entities by applying appropriate quantitative filters, such as mfg sales <75%, R&D exp >5%, Advertisement exp >5%.

• Review financial and textual information available in the public database of the selected entities – for qualitative filters

• Computation of ALP

Usually regarded as an indirect method, but is most widely adopted

81

Case Study: Application of TNMM…

100% Subsidiary

ABC Korea

ABC India

Engaged in the manufacture of brakes and shock absorbers and distribution of CKD Products

Characterized as Licensed Manufacturer

Engaged in the manufacture and distribution of brakes and shock

absorbersCharacterized as Entrepreneur

InputsInputs ProcessingProcessing OutputOutput

Inputs Received from Output Delivered to

Domestic Parties Domestic Parties

• Purchase of CKD products

• Sale of Brakes and Shock Absorbers

Related Parties Related Parties

• Import of components

• Provision of drawings, technical knowledge, and manufacturing information(R & D Center)

• Sale of CKD Products

82

…Case Study: Application of TNMM…

Particulars Amount

Import of Components 15,000

Payment towards Royalty 5,000

Payment towards Technical fees 5,000

Sale of CKD Products 150,000

Reimbursement 15,000

The following international transactions are inextricably linked with the manufacturing function of ABC India and hence have been aggregated:

• Import of components; and

• Payment towards royalty and technical fees

83

Case Study: Application of TNMM…Particulars Manufacturing Trading Total

Sales 200,000 300,000 500,000

Manufacturing expenses / cost of purchases 90,000 210,000 300,000

Royalty and technical fees 10,000 - 10,000

Employee cost 30,000 24,000 54,000

Administrative expenses 24,000 15,000 39,000

Selling and distribution cost 16,000 24,000 40,000

Depreciation 16,000 12,000 28,000

Total Expenses 186,000 285,000 471,000

Total Profit 14,000 15,000 29,000

Net cost plus Margins (NCP) 5%

Net Profit Margins (NPM) 7%

Results : The NPM earned by the company in the manufacturing segment is 7% and the NPM range of broadly comparable companies operating in the similar segment is between 6% and 9% with a median of 7.5%. The NCP earned by the company in the trading segment is 5% and the arithmetic mean of the comparable companies is 6%

84

…Case Study: Application of TNMM

Name of comparablecompanies

Weighted Avg NPM (%)

A Ltd 4

B Ltd 5

C Ltd 6

D Ltd 7

E Ltd 8

F Ltd 9

G Ltd 10

H Ltd 11

Median 7.5

35th Percentile 6

65th Percentile 9

Name of comparablecompanies

Weighted Avg NCP (%)

I Ltd 4

J Ltd 5

K Ltd 6

L Ltd 7

M Ltd 8

Arithmetical Mean 6

Companies engaged in similar trading activities

Companies engaged in similar manufacturing or assembly activities

85

Other Method

86

Other Method

CBDT has notified the “Other method” vide a Notification with effect from FY 2011-12

ApplicabilityWhere the application of the five specific methods is not possible due to difficulties in

obtaining comparable data or due to uniqueness of transactions Intangibles or business transfers, transfer of unlisted shares, sale of fixed assets,

revenue allocation/splitting, guarantees provided and received, etc.

Possible methods of benchmarkingThird party quotationsValuation reportsCommercial & economic models

Important to maintain proper documentation specifying the rejection reasons for non-application of other five methods and appropriateness of the “other method”

Rule 10AB - “any method which takes into account the price which has been charged or paid, or would have been charged or paid, for the same or similar uncontrolled transaction, with or between non-

AEs, under similar circumstances, considering all the relevant facts."

87

Methods and Comparability

MethodsComparability Requirements

Approach Practical Applicability

CUP Very High Prices are benchmarked Low

RPM HighGross margins are benchmarked

Low

CPM HighGross margins are benchmarked

Low

PSM Medium to HighProfit margins are benchmarked

Low

TNMM MediumNet Profit margins are benchmarked

High

Other Method HighOperating margins are benchmarked

Medium

88

Range Concept and Multiple Year Data (effective FY 14-15)• A minimum of six comparables required in the dataset for applying range - in absence of six

or more comparables, the ALP shall be the arithmetical mean

• Range = starting from 35th percentile and ending on the 65th percentile (Dataset to bearranged in ascending order)

• The ALP = the weighted average of the prices / data points for;

‒ the Current Year and preceding two financial years; or

‒ two financial years immediately preceding the Current Year (but not including the Current Year as the same may not have been available)

MethodsApplicability of

Multiple year data Range Concept

CUP

CPLM

RPM

PSM

TNMM

Other Method

89

Questions and answers

Questions

Answers

90

Thank YouPresenter details:

Hitesh D. Gajariahgajaria@bsraffiliates.comGlobal Transfer Pricing Services

91

Glossary…Abbreviations and Acronyms Full Name

AE Associated Enterprise

ALP Arm's Length Price

AMP Advertisement, Marketing and Sales Promotion

ARE Alternate Reporting Entity

ATO Australian Taxation Office

AUD Australian Dollar

BEPS Base Erosion and Profit Shifting

BLT Bright Line Test

CbCR Country by Country Report

CIF Cost, Insurance and Freight

DEMPE Development, Enhancement, Maintenance, Protection and Exploitation

EUR Euro

FAR Functions, Assets and Risks

92

…Glossary…Abbreviations and Acronyms Full Name

FOB Free on board

HC High Court

HMRC Her Majesty's Revenue and Customs

INR Indian Rupees

IP Intellectual Property

IRAS Inland Revenue Authority of Singapore

JPY Japanese Yen

KPI Key Performance Indicator

LF Local File

MF Master File

MNE Multi National Enterprises

MT Metric tonnes

OECD Organisation for Economic Cooperation and Development

93

…GlossaryAbbreviations and Acronyms Full Name

PE Permanent Establishment

PY Previous Year

R&D Research and Development

RPT Related Party Transactions

SGD Singapore Dollar

U.K. United Kingdom

U.S. United States of America

UHC Ultimate Holding Company

USD United States Dollar