Pricing. Selection of Methods / Comparables Examples/ Case studies. Sanjay Kapadia

Transcription

1 WIRC Intensive Study Course on Transfer Pricing Selection of Methods / Comparables Examples/ Case studies Sanjay Kapadia 05 August 2011

2 Index Indian Transfer Pricing - Concept Most Appropriate Method: Suggestive Approach on selection of Most Appropriate Method Characteristics and requirements of methods used in the process of identifying ALP Economic adjustments allowed under various methods Selection of comparables Case studies Judicial precedents on methods and comparables Page 2

3 Concept of Transfer Pricing Indian TPR requires that an international transaction between two Associated enterprises (AEs) should be at an Arm s Length Price (ALP) - ALP refers to a price between two unrelated parties Based on such analysis, it is determined whether the international transaction of the assessee is at ALP or not! Determination of ALP requires an analysis of the functions performed, assets employed and risks assumed by the company with respect to the subject transaction Necessary economic/ accounting adjustments must be carried out to even out the differences between the international transaction and the comparable transaction Different methods have been prescribed under the Act for determining the ALP Based on various factors which includes availability of comparable information, the most appropriate method (MAM) is selected and probable comparables are identified Page 3

4 Most Appropriate Method ( MAM ) The arm s length price in relation to an international transaction shall be determined by any of the following methods, being the MAM, having regard to the nature/class of the transactions or class of AE or functions performed, namely Comparable Uncontrolled Price ( CUP ) method Resale Price Method ( RPM ) Cost Plus Method ( CPM ) Profit Split Method ( PSM) Transactional Net Margin Method ( TNMM ) Such other method as may be prescribed by the Board (None as of now) Page 4

5 Most appropriate method (MAM) Unlike under the OECD guidelines, no preference for methods is prescribed under the Act Availability of comparables is the key factor in determining MAM CUP being a direct method, will always qualify as MAM. However, CUP applicability is dependent on availability of accurate comparable information RPM is applicable in case of specific transactions such as distribution of goods etc - however Indian GAAP poses difficulty in computing comparables gross margins CPM is ideal for routine/ low risk manufacturing/ services - however Indian GAAP poses difficulty in computing comparables gross margins Profit Split Method is applicable where multiple inter-related transactions are involved and is rarely used TNMM is the method of last resort - most frequently used, including by the tax department Page 5

6 MAM - Characteristics and requirements Method Measurement Focus Comparability CUP Price Similar products Similar conditions Indicative differences requiring adjustment * Product quality Contractual terms Level of market Intangible property Transaction rate Foreign exchange RPM Gross Income Similar functions Inventory levels performed Turnover rates Risk Operating expenses Contractual terms Foreign currency risks Similar product group Accounting differences CPM Gross income Similar functions performed Risk Contractual terms Similar product group Operating complexity Operating expenses Foreign currency risks Accounting differences Page 6

7 MAM - Characteristics and requirements Method Measurement Focus Comparability PSM Profit Functions performed (routine & non routine) Value drivers Industry value indicators Multiple Transactions TNMM Operating income Functionally similar but cannot necessarily have exact product comparability Resources employed Risks Indicative differences requiring adjustment * NA Asset intensity adjustments Economic risk adjustments Accounting differences Foreign currency risks *Above factors are illustrative and need to be applied considering facts of each case Page 7

8 Suggestive Approach on selection of MAM Factors CUP RPM CPM PSM TNMM Methods Nature and class of the international transaction X X Class of AEs entering into the transaction and functions performed by them taking in to account the FAR analysis of such enterprises Availability, coverage and reliability of data necessary for application of the method Degree of comparability between the international transaction and the uncontrolled transaction and between the enterprises entering into such transactions NA NA X X NA NA NA NA NA NA Page 8

9 Suggestive Approach on selection of MAM Factors CUP RPM CPM PSM TNMM Extent to which reliable and accurate adjustments can be made to account for differences, if any, between the international transaction and the uncontrolled transaction and between the enterprises entering into such transactions Nature, extent and reliability of assumptions required to be made in application of a method NA NA NA NA NA NA NA NA TNMM can be considered as the MAM Page 9

10 Identification of comparables Internal as well as external comparable should be analysed Comparable should be independent and at least of the same industry of the assessee Following factors are generally used in judging comparability: nature of transactions undertaken (i.e type of good, service etc.) company functions risks assumed contractual terms (i.e similar credit terms) economic and market conditions Assuming all other methods fails and TNMM is being tested as MAM Page 10

11 Comparability Generate a list of probable comparable companies by using key words and industry classifications in the publicly available databases (Prowess and Capitaline) Apply various qualitative and quantitative filters on the list of companies generated from step 1 above (Discussed in the subsequent slide) Review the annual reports and other qualitative information. eg: websites for all the probable comparable companies Final set of comparables are identified TNMM is the MAM and comparables are identified for ALP determination Page 11

12 Criteria for selection of comparables Analysis of the list of probable comparable companies generated by the databases is undertaken based on the following criterion: Insufficient financial data; No operations/ Sick companies/ persistent loss makers; Functionally different; Companies having significant related party transactions; Companies with exceptional year(s) of operations; and Other specific filter such as turnover, trading income etc Page 12

13 ALP Determination Once the final set of comparables are arrived at, their operating margin should be computed Multiple year data may also be used to capture market cycles and reduce the likelihood of financial results of an anomalous year distorting the arm s length margin If required, any accounting differences should be adjusted The Average operating margin of identified comparables are computed (in case of multiple ALP margins are arrived at) and based on the same, the ALP would be determined Page 13

14 Case Study 1 - TP Method X Inc USA Provision of software development services to X Inc Compensation on basis of costs incurred Outside India India X Ltd India The company does not provide service to third parties Pricing policy of companies are more or less influenced by competition but not any industry benchmark Page 14

15 Case study 2 - Economic Analysis Provision of software developme nt services ABC Inc Value of services provided by ABC India to its AE, ABC Inc - Rs 50 crore Benchmarking is done using External TNMM 100% subsidiary Outside India In India Assessee conducted a search for comparables (as tabulated in the next slide) with the objective of identifying Independent companies that perform similar functions and ABC India Operate in broadly similar Markets to that of ABC India s business profile Page 15

16 Case study 2 - Economic Analysis Name of potential comparable Description A Ltd Financial data available prior to March, 2008 B Ltd C Ltd D Ltd Sick company Turnover less than Rs 1 crore Turnover more than Rs 1000 crore E Ltd Revenue from manufacturing activity more than 25% F Ltd G Ltd X Ltd Y Ltd Z Ltd R&D to sales > 5% - significant intangibles Marketing to sales > 5% - significant marketing activity Controlled transactions more than 25% of turnover Engaged in ITES/BPO/software products Engaged in varied activities and segmental data not available Can the above companies be accepted as comparable to ABC India? Page 16

17 Case Study 3 Accounting adjustments Provision of Software development services X Inc USA X Ltd India Outside India X Ltd India is engaged in provision of software development service to its X Inc USA. To benchmark the said international transaction, TNMM has been chosen as MAM India The comparables found functionally similar follows different accounting policy with respect to accounts receivables Q. Would it be possible to consider the identified comparables for ALP determination by X Ltd, irrespective of different accounting policies followed? Page 17

18 Case Study 4 TP adjustment XYZ Inc Purchase of Raw material from AE (40%) ABC Co Sales Third parties Purchase of Raw material from third party (60%) Outside India Third party customer India ABC Co is engaged in manufacturing activities and it sources 60% of the raw materials from third parties and 40% from AEs. ABC Co has earned an operating margin of 10% from this activity whereas the comparable s margin is 18% thereby requiring a transfer pricing adjustment to be made Q. How the transfer pricing adjustment should be made in respect of the above transaction? Page 18

19 Judicial precedents on methods and comparables Issues covered Judgments Key takeaway Adjustment on account of differences in accounting practices Single year vs. Multi-year data CUP is the most preferred method Schefenacker Motherson Ltd, Delhi E-Gain Communications Pvt Ltd, Pune Aztec Software and Technology, Bangalore Honeywell Automation India Ltd, Pune Customer Services India (P) Ltd, Delhi Skoda Auto India Ltd, Pune Panasonic India Pvt Ltd, Delhi (use of multiple year data allowed) Clearplus India Pvt Ltd, Delhi Serdia Pharmaceuticals, Mumbai Upfront evaluation of various comparability criteria is recommended Mandatory requirement of law for use of current FY data, cannot be dispensed with, unless if use of multiple year data adds value to the TP analysis CUP is the most direct method for determining ALP, provided product comparability is established Page 19

20 Judicial precedents on methods and comparables Issues covered Judgments Key takeaway Applicability of +/-5% range in case of one price Whether +/-5% range is a standard deduction Perot Systems TSI, Delhi Essar Steel Ltd, Visakhapatnam Development Consultants Pvt Ltd, Calcutta Skoda Auto India Pvt Ltd, Pune Sony India Pvt Ltd, Delhi Philips Software Centre P. Ltd, Bangalore Schefenacker Motherson Ltd, Delhi Toshiba India Ltd, Delhi UE Trade Corporation (India) Pvt Ltd, Delhi Cummins India Ltd, Pune SAP Labs India Pvt Ltd, Bangalore BASF India Ltd, Mumbai Technimount Icb Pvt Ltd, Mumbai Marubeni India Pvt Ltd, Delhi (not allowed) Global Vantedge Pvt Ltd, Delhi (not allowed) Relief of +/-5% is available only when more than one price is determined by the most appropriate method Diverse views on the subject Page 20

21 Judicial precedents on methods and comparables Issues covered Judgments Key takeaway Whether +/-5% benefit is applicable in case ALP is determined using only one method ADP Pvt Ltd, Hyderabad (+/-5% benefit not allowed if ALP determined using one method) Electrobug Technologies Ltd, Delhi (+/-5% benefit allowed even if ALP determined using one method) Diverse views on the subject Use of foreign tested Development Consultants Pvt Diverse views on the subject party / comparables Ltd, Calcutta (allowed use of further development to be seen foreign tested party) Globally accepted view Tested Ranbaxy Laboratories Ltd, Delhi party should be the lesser (not allowed) complex entity Global Vantedge Pvt Ltd, Delhi (not allowed) Start-up / Idle capacity and working capital adjustment Global Vantedge Pvt. Ltd, Delhi Vertex Customer Services, Delhi Sony India Pvt Ltd, Delhi Fiat India Pvt Ltd, Mumbai All judgments in favour of taxpayers. Upfront evaluation of such adjustments is recommended Page 21

22 Judicial precedents on methods and comparables Issues covered Judgments Key takeaway Applicability of turnover filter Abnormal/ supernormal profitability of comparables E-Gain Communications Pvt Ltd, Pune Indo American Jewellery, Mumbai Symantec Software Solutions Private Ltd, Mumbai (rejected use of turnover filter) DHL express (India) Pvt Ltd, Mumbai (rejection of companies with turnover < 20% of assessee s turnover) Agnity India Technologies Pvt Ltd, Delhi Adobe Systems India Pvt Ltd, Delhi Quark Systems Pvt Ltd, Punjab and Haryana HC Sapient Corporation Pvt Ltd, Delhi Diverse views on the subject Companies earning abnormal profits should not be treated as comparables Page 22

23 Thank you The discussions in this presentation are personal views of the speaker and are intended to provide only a general outline of the subjects covered. The presentation should not be regarded as comprehensive or sufficient for making decisions, nor should it be used in place of professional advice, which should always have regard for the particular commercial facts and circumstances. Accordingly, Ernst & Young Private Ltd accepts no responsibility for loss arising from any action taken or not taken by anyone by relying on this presentation. Page 23