Presentation on theme: "TRANSFER PRICING Case Studies Navigating the Indian & Singapore waters! Narayan Mehta Partner, Sudit K. Parekh & Co. 25th May 2005."— Presentation transcript:
TRANSFER PRICING Case Studies Navigating the Indian & Singapore waters! Narayan Mehta Partner, 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 exercise Need 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 policy Formulate pricing policy
Singapore Owned Indian Co Singapore Co Singapore Co Indian subsidiary Indian subsidiary Singapore Client Singapore Client Contract for software development Outsourcing Arrangement @S $ 35 per hour Equity Consideration UK Client UK Client Contract for software development @ S $ 45 per hour Off-shore software Development No risks undertaken Marketing intangible Brand creation Trade intangible Entrepreneurial risk
Singapore Owned Indian Co CUP Method Internal comparables Adjustment for differences for Volume difference No marketing required and assured market Credit terms External comparables May not be always reliable!
Singapore Owned Indian Co Internal comparables Constructing transactional profit and loss account to ascertain the margins separately for sales to AE and sales to 3P Allocation of certain expenses to AE and / or 3P P/L A/c Marketing expenses – 3P Apportionment of other expenses to both on certain basis No of employees Sales value Costs, etc
3P = 3 rd Party (comparable transactions) AE = Associated Enterprise ParticularsBasis3PAETotal Partic ularsBasis3PAETotal To Direct Exps. - salaryActuals205525730 By salesActual3007001000 To Staff welfare exps. No. of employees = 3:73710 To Office overheadsSales value276390 To Selling & Marketing exps.100% - 3P200 To Net Profit before interest & tax -45105150 Total -3007001000 Total -3007001000 Operating margin 15% Transactional Trading & P & L A/c
Singapore Owned Indian Co Cost Plus / TNMM – external comparables Step 1: Functional analysis Objectives Assessing 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&D Processing Marketing Sales & Distribution Sales & Distribution Finance 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 Planning Production Scheduling & Production Activities Quality Control Research & Development Marketing Sales & Distribution Idle Capacity Foreign 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 A Country B Functions Assets Risks Profits $$$$$$$$$$$ $$$ Profit = f (F + A + R)
Procedure Description of Inter-company Transactions 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 method Service provider- cost plus / TNMM
Singapore Owned Indian Co Step 4: Search and analysis for comparables Running 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 companys website, interviews etc Selection of appropriate PLI Identifying the margins of each of the companies based on PLI selected
Step 5: Computing the arms length price Adjustments 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 Arms 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? VALUEVALUE REVENUEREVENUE VOLUMEVOLUME
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 1 Undertaking a functional analysis & economic characterization STEP 1 Undertaking a functional analysis & economic characterization STEP 2 Selecting the most appropriate transfer pricing methodology STEP 2 Selecting the most appropriate transfer pricing methodology STEP 3 Applying the most appropriate method & determining the arms length outcome STEP 3 Applying the most appropriate method & determining the arms length outcome Step 4 Implement support processes. Install review process to ensure adjustment for material changes Step 4 Implement 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 available Use of lateral comparables Sample size – should not be too small? US v/s Canadian practice
Applying Filters Quantitative Filters 3 Year Track Record Ratios Any Other Parameters Revenue No. of Employees Qualitative Filters Companies Incorporated In Foreign Countries Positive Word Search Negative Word Search Independent Companies
Use of PLIs under TNMM The 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 arms length.
Adjustment to Ratios Useful when feasible to increase ratios comparability to the tested party Three standard adjustments Inventory Differences Inv. Adj. = (Inv./Sales taxpayer – Inv./Sales comparable) * Sales comparable * Prime Lending Rate Receivables Differences Rec. Adj. = (Receivables/Sales Taxpayer – Receivables/Sales Comparable) * Sales Comparable * Prime Lending Rate Payable Differences Pay. Adj. = (Payables/COGS or Sales Taxpayer – Payables/COGS or Sales Comparable) * COGS or Sales Comparable * Prime Lending Rate
Manufacturing & Indenting Model X Pte Ltd Singapore X Pte Ltd Singapore X Ltd India X Ltd India Customers 100% Shares Direct sale of chemicals Payments Manufacturing & Sales Outside India In India Receipt of Commission / consideration & sale of raw materials Marketing
Functional Analysis- Services Services – Indenting Functions performed Liaisoning with clients in India Sales support and after sales services Assets Used Employee Skills / Network / Customer list Risks Assumed Depends on the commercial / contractual terms
Functional Analysis- Manufacturing Manufacturing Functions performed Purchasing, mfg, distribution, sales, etc. Assets used Intangibles and plants Risks assumed Inventory holding risks, bad debts risks, etc.
Risk Factors in Manufacturing REWARD RISK Manufacturing services Fixed overhead Down 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 / indenting Traders / agents in Chemicals Re manufacturing TNMM with ROA or Operating margins as the PLI
TP Methodologies CUP Industry benchmark for commission rates Resale price NA in the instant case Cost plus Rejected for want of adequate disclosure requirement Profit split NA in the instant case
TP Methodologies TNMM Re indenting Berry Ratio (GP/ Operating exp) Operating margin (NPBIT / Indenting income) Re manufacturing TNMM with ROA or Operating margins as the PLI
Intra-group Services No clear cut guidelines under the Indian regulations OECD Guidelines- Intra group services Whether 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 ServicesExamples Administrative ServicesPlanning/coordination Budget Control Financial Advice Book Keeping Internal Auditing of the Books Legal Matter Financial Treasury ServicesCash Management Attracting Capital Concluding Loan Agreements Trading in Derivatives Refinancing Factoring Operational Logistics ServicesManufacturing Warehousing Transport
Central ServicesExamples Information 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 activities Such activities should not be charged to group companies Expenses relating to judicial structure of the parent company Shareholder 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 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 CUPResale Price Cost PlusTNMMProfit 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 analysis Associates in UK and US Have provided assistance to many of the fortune 500 companies Have been specifically trained in the US and the UK Appointed 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 opn Engineering Diamonds, Gem and Jewellery Textiles and garment Poultry Auto ancillary and road equipment Construction Entertainment Pharmaceuticals Recruitment agencies EPC Contractors Water Polymers
Developing appropriate methodology Alignment with clients 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
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