Functional and Comparability Analysis February 16, 2013, Mumbai Grant Thornton India LLP Ms. Vaishali Mane Director Transfer Pricing Services
Agenda Function, Assets and Risk Analysis Tested Party Concept Comparability Factors General Documentation Principles Challenges Key Takeaways
Function, Assets and Risk Analysis Tested Party Concept Comparability Factors General Documentation Principles Challenges Key Takeaways
What is Function, Assets and Risk (FAR) Analysis FAR analysis - exercise to determine and document significant economic activities performed by the enterprise and its AEs in an International Transaction The allocation of these activities between those entities involved in the transaction so each entity can be fully characterised Price charged in any transaction reflects the functions performed (taking into account the risks assumed and assets used) FAR analysis essential to determine comparability Functional analysis identifies and compares Economically significant activities Assets used Risks assumed Functions Assets Risks
Purpose of FAR Gathering and organizing facts needed to analyze intercompany prices To identify an appropriate level of profit that related parties should earn with respect to intercompany transactions under review To identify effects of functions, risks and assets on its profitability To determine the economic characterization of the entities in the international transaction To determine the most appropriate method for benchmarking the international transaction To identify any uncontrolled transaction involving one of the controlled parties
Why do a functional analysis? The arm s length principle is based on comparability: [When] conditions are made or imposed between two [associated] enterprises in their commercial or financial relations which differ from those which would be made between independent enterprises, then any profits which would, but for those conditions, have accrued to one of the enterprises, but, by reason of those conditions, have not so accrued, may be included in the profits of that enterprise and taxed accordingly. * *Paragraph 1 of Article 9 of the OECD Model Tax Convention
What goes into a Functional Analysis? Transactions Functions Risks Entities Assets Products Markets / Competition Business Processes FAR Analysis Forecasts / Business Plans Organisation / Staff Agreements / Terms Financial Results
What comes out of Functional Analysis? Internal Comparables Understanding of the Business Basis to search for external comparables FAR Analysis Documentation Characterization of entities Risk and opportunity assessment Determination of the MAP Method
Components of FAR Analysis Functions performed Activities carried out by each of the parties to the transaction Focus should be on identification of critical functions which add value to the international transactions Principal functions performed by the entities in a controlled transaction are compared with the functions performed in uncontrolled transactions
Components of FAR Analysis (contd ) Assets employed 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 the International transaction Knowledge of assets owned and employed by the entities facilitates determination of the profit margin to be earned by them
Components of FAR Analysis (contd ) Risks Assumed Probable variability of future outcomes or returns As the risk increases, the expected return should increase as well The 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 one bears as per the economic substance of the transaction
Components of FAR Analysis (contd ) Functions Assets Risks Manufacturing / Processing Research & Development Quality control Advertising / Marketing Sales Ordering and distribution Invoicing and collection Inventory Service, Warranty and Spare Parts Administrative, Financial and Legal Matters - Tangible Assets (e.g Building, Plant & Machinery, etc) - Intangible Assets (e.g Patents, Trade Marks, Copyrights etc) Market risk Product liability risk Inventory risk Technology risk Research and development risk Credit risk Foreign exchange risk Manpower risk
Importance of FAR Analysis Contract IT/ITE Services Contract Manufacturer Sales Agent Low Function & Low Risk Full fledged service provider Manufacturer/ Developer Marketing/ Distribution High Function & High Risk Comprehensive FAR leads to in-depth understanding of the business and related commercial considerations Allows correct characterization of the business Helps setting up of an appropriate pricing model for inter company transactions Robust FAR analysis - foundation of a sound economic analysis
Trading Industry Facts PQR Group, USA develops, manufactures and markets cancer related products PQR India is engaged in the business of import and resale of these products in India
Trading Industry Functions Entities Involved Functions Outside India PQR Group Trading of products - Manufacture - Research & Development - Quality Control - Sales & Distribution India PQR India Distribution Customers - Distribution - Warehousing / Inventory
Trading Industry Assets Employed Type of Assets PQR India PQR Group Employees Yes Yes Property, Plant & Equipment Yes Yes Intangible such as Trade Licenses, Know-How etc No Yes
Trading Industry Risk Assumed Type of Risk PQR India PQR Group Product Development Risk No Yes Market Risk Yes (Limited) Yes Manpower Risk Yes Yes Credit & Collection Risk Yes Yes General business Risk Yes (Limited) Yes Foreign Exchange Risk Yes No Vital Consideration Accordingly, PQR USA should be characterised as the 'Entrepreneur' and WDV India as 'Limited Risk distributor'
Service Industry Facts ABC India is a is a software development company. Engaged in the development of IT solutions and software products ABC India provides software development and related services to ABC Group ABC India is remunerated by ABC Group on full cost plus mark up basis All the IPRs developed and owned by ABC Group
Service Industry Functions Outside India Entities Involved ABC Group Software Development Services Functions - Contracting, Billing & Collection - Services Delivery - Development of new products - Credit, Market, Service Liability Risk India ABC India - Development of software - No Credit Risk - Limited Manpower Risk
Service Industry Assets Employed Type of Assets ABC India ABC Group Employees Yes Yes Property, Plant & Equipment Yes (Limited) Yes Intangible such as Trade Licenses, Know- How etc No Yes
Service Industry Risk Assumed Type of Risk ABC India ABC Group Entrepreneur Risk No Yes Market Risk No Yes Manpower Risk Yes Yes Credit & Collection Risk No Yes General business Risk Limited Yes Foreign Exchange Risk No Yes Legal Risk No Yes Vital Consideration Accordingly, ABC Group should be characterised as the 'Entrepreneur' and ABC India as 'Limited Risk Bearing enterprise'
Value Drivers Profitability ROI (=Risk) High Profit Examples: High Assets Brand Tradenames Know How Risks Doubtful Debtor Foreign Exchange Market Functions Manufacturing Sales Distribution R&D Low Low
Function, Assets and Risk Analysis Tested Party Concept Comparability Factors General Documentation Principles Challenges Key Takeaways
Selection of Tested Party Participant in an international transaction with whose reference the international transaction is tested The selection of the tested party influences the selection of the most appropriate method to benchmark the international transaction and consequently on the comparables selected The comparables performing similar functions as the AE in the territory in which the AE operates will have to be selected as comparables The term tested party has not been defined in the Indian transfer pricing regulations.
Selection of Tested Party Entity performing simpler functions and not owning any valuable intangibles is normally selected as the tested party Availability of the reliable financial information of the comparable companies Normally least complex entity selected as the tested party as testing the margin of such entity would require least adjustments
Selection of Tested Party ABC Inc Parent Ownership of IP Contract Risk R&D Marketing & Sales USA India Provision of Services Payment for Services ABC India Subsidiary Back Office, accounting Least Complex entity No ownership of IP Tested Party
Selection of Tested Party Selection of comparables based on Economic Characterization of Tested Party Quantitative Analysis Qualitative Analysis Financial Analysis
Function, Assets and Risk Analysis Tested Party Concept Comparability Factors General Documentation Principles Challenges Key Takeaways
Comparability Analysis Arm s length principle is generally applied in practice by establishing comparability between the conditions in a controlled transaction and the conditions in uncontrolled transactions Used in the selection of the most appropriate transfer pricing method as well as in arriving at the correct arm s length prices Plays a central role in the overall application of the arm s length principle Corner stone of transfer pricing analysis
Approach towards performing comparability analysis Analysis of controlled transactions Identifying potential comparable transactions internal and external Selection of most appropriate transfer pricing method Documentation of comparability analysis Attributes or comparability factors Comparability adjustments Determination of the arm's length price or profit
Analysis of the controlled transaction Broad analysis of the controlled transaction(s)under examination and understanding the taxpayer business:- Gathering of basic information about the taxpayer Transaction analysis Evaluation of separate and combined transactions Selection of the tested party
Factors Determining Comparability Rule 10B(2) of Rules & OECD TP Guidelines - FIVE KEY FACTORS Characteristics of Property or services Functional Analysis Contractual Terms Economic Circumstances Business Strategies
Rejection of Potential Comparables Independence and related party transactions Related party transactions distortion in comparables profits Small related party transactions may allow potential comparable to be accepted e.g. small sample size due to specialised industry Conclusion: generally reject if non-independent Failure to check for independence will be costly during audit
Rejection of Potential Comparables Function Function is an important measure of comparability Comparable must perform similar function or processes If function is incomparable to tested party then reject Product Comparable must sell/manufacture a broadly similar product Product comparability sometimes less important than function; profit margins are more related to functions than product
Rejection of Potential Comparables Financial data Several years of data for comparable should be available to allow for financial analysis In certain instances, can be difficult to get data, e.g. small companies or specific countries If financial data is unavailable then reject
Other important issues in judging comparability Start-ups o Different risks from established companies o Initially invest heavily reflected in costs o Start-up period depends on industry (in absence of industry data, 3-year period often used) Persistent loss-making companies: o Although, may be good reasons behind losses (e.g. business cycles) should reject companies that make persistent losses, unless the tested party is not: a start-up company following a market penetration strategy at the bottom of its business cycle Diversification o Many publicly held companies are diversified o Companies may offer different products in fundamentally different markets o Best comparability most easily achieved with no diversification One-off events o Major events disrupt company earnings; - e.g. sale/purchase of major division, major legal suit o May be difficult to adjust for such events o When assessing comparability, check for one-off events
Comparables Database Searches Commercial databases Databases of publicly available information Contain activity descriptions, financial and ownership information Facility for searching for potential comparables Searching for comparable companies specify search criteria Independence Applicable industry codes Keywords Geographic - country specific vs. pan-european Finalising search strategy Checking business descriptions Altering search strategy
Comparables Exclusion Steps Excluding companies Financial screening Minimum turnover screens Timeframe for application Net worth Business descriptions Internet Company Annual Reports
Reviewing Business Descriptions Required descriptive information for potential comparables will usually include Functions performed Property or services transferred Risks assumed In most cases cannot obtain all above information Try to make judgement on information available If information is not sufficient then should reject
Judging comparability: Summary Good descriptive and financial data is paramount to identifying a good comparable Function is most important measure of comparability Comparables should be independent check this carefully Other issues affecting comparability are also important, in particular you should consider carefully: Persistent loss makers Dormant companies Companies with diversified activities Companies affected by one-off events.
Function, Assets and Risk Analysis Tested Party Concept Comparability Factors General Documentation Principles Challenges Key Takeaways
Key Transfer Pricing Principles - Documentation Financial Information Economic Models Extensive Functional Analysis: Risk-Function Matrix Lengthy Documentation Packages Global Transfer Pricing Policy Segmental Profit & Loss A/C Jurisdictions and Parties of Principal Interest Intangible Property Development History, Financing and Facilities Internet Downloads
Key Transfer Pricing Principles - Documentation Transfer Pricing Methodologies Defending Crucial Transactions Collectivity and Consistency Country Specific Documentation Packages Published market prices (Exchanges) Published accounts & financial statements Agreements & contracts with AE & others for similar transactions Letters & other correspondence on negotiations
Function, Assets and Risk Analysis Tested Party Concept Comparability Factors General Documentation Principles Challenges Key Takeaways
Functional Challenges 1 2 3 Extensive Functional Analysis: Risk-Function Matrix Unavailability of adequate data for conducting robust analysis TP Reports of two AE's would have conflicting conclusion Detailed FAR analysis for tested party and comparable companies is crucial Some international transactions are so unique that can not be compared Corporates and Group Companies hesitant to disclose information of manufacturing process, any developed IP, etc.
Characterization / Restructuring of operations Limited Risk Service provider Characterization and business restructuring imperative in this dynamic economic environment
Comparability Challenges Comparability Dearth of comparables Due to emerging economies Use of new technologies, products & services Consolidation &Vertical Integration Non availability of data Cherry picking of comparables Losses Intentional set offs Failure to check for independence will be costly during audit Use of custom valuations Use of secret comparables Overall process complexity
Benchmarking Challenges Benchmarking Calculation of Debtors Aging in case of comparable No Recommended method for benchmarking Arm's Length Range Vs Arithmetic Mean Pricing of Intangibles Difficulties in justifying adjustments for factors having a bearing on prices Insufficient information available for calculation of gross margin in case of comparables Benchmarking Rapidly fluctuating prices, which prices to compare with Transfers at cost Capital transaction Cost Allocation & Cost Sharing Arrangements
Function, Assets and Risk Analysis Tested Party Concept Comparability Factors General Documentation Principles Challenges Key Takeaways
To Summarize FAR Analysis Important to characterize value added and non valued added activities for tested party; Also important for PE attribution analysis and appropriate economic analysis Comparability Analysis Accept-reject needs to be extremely detailed and not casual; Companies with RPT to be excluded; Functional comparability of comparables important Adjustments Important to quantify and document risk, working capital, idle capacity adjustment upfront Selection of PLI and MAM Important to go through the process of MAM selection in detail Financial analysis of tested party and comparables consistency and in-depth analysis
To Summarize Selection of Tested Party Nexus with FAR; Critical for implementing global TP policy. Financial Transactions Just because assessee is shareholder, cannot assume nature of transaction to be quasi-equity Documentation Must and Mandatory not only TP study but also supporting agreements / documents should be in sync with defense Benefit test for services essential to be qualified Evaluate that documentation does not have negative repercussions from other regulatory and tax perspective
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