Transfer Pricing in Pharma / IT industry - Case Studies

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1 Transfer Pricing in Pharma / IT industry - Case Studies Presented by: Munjal Almoula Prasad Pardiwala August

2 Snapshot of Case Studies Case Study 1 Deputation of employees Case Study 2 Operational losses Case Study 3 Royalties by software entity Case Study 3 Import of APIs Case Study 4 Cross Charges PwC 2

3 Case Study 1 Deputation of employees PwC 3

4 Business Model and Structure Parent Company (X) Entrepreneur Owns Intellectual Property Assumes significant business risks Engaged in software development services Parent Company (X) 100% INDIA SUB 1 SUB 2 SUB 3 Customers Customers Customers Germany USA France Subsidiaries Limited risk marketing service providers Guaranteed return on such services Also provides onsite software development services with support from (X) Ownership Deputation Services PwC 4

5 Other Critical Facts of the Case Human Resource Department of (X) recruits software engineers / programmers - Direct recruits - Assistance from third party recruitment agencies (X) provides 3 months training to all new joiners after which it decides to depute them either on offshore or onsite activities depending on project requirements Total employees 3,000 Allocation as under: PwC employees deputed to Germany; employees deputed to USA; employees deputed to France - Balance continues to work with (X) in India On deputation, payroll would shift to respective associated enterprises - After completion of onsite job, payroll shifts back to (X) 5

6 Revenue s contentions and approach Revenue alleged that deputation of employees abroad is akin to providing recruitment services Accordingly: - Form 3CEB should have recorded this transaction; - Contemporaneous documentation should have been in place before filing tax return; - (X) should have received arm s length compensation for providing recruitment services Revenue compared this alleged transaction with third party recruitment service providers and proposed adjustment to income of (X) In addition, Revenue exposed (X) to penalties: - Concealment penalty on the income adjusted; - Documentation penalty for non-maintenance of contemporaneous documentation PwC 6

7 Defence mechanism Conduct detailed functional interviews with key personnel in Finance, Human Resource and also with few software engineers / programmers Study information provided on website, promotional materials and business cards Peruse legal agreements in great detail Studied employee deputation letters and understand the impact of social security benefits (pre and post deputation) Carry out a detailed industry research to understand the practice followed by other software professionals Understand the compensation mechanism of third party recruitment service providers PwC 7

8 Defence mechanism Create a robust documentation substantiating the following business rationale - Increase in offshore revenues for (X); and - Employees returning with upgraded skills, enormous experience and business domain enhanced the solution delivery skills and thereby helped in execution of offshore work with great efficiency Explain the operating model to Revenue Support with third party data available in public domain PwC 8

9 Case Study 2 Operational Losses PwC 9

10 Business Model and Structure XYZ Singapore Low Risk Manufacturer Import of premium Formulations ABC India (Manufacturer & distributor) Sales Third party customers in India Basic Facts of the Case ABC India is primarily a manufacturer of Pharma products and sells the products in India to third party customers ABC India also imports some premium Pharma products from associated enterprises and acts as an entrepreneur distributor for such products in Indian market ABC India retains the entrepreneurial profits on distribution and compensates XYZ Singapore on cost plus 8% for imports XYZ Singapore acts as a low risk manufacturer for exports made to India PwC 10

11 Other Critical Facts of the Case ABC India introduced new products to complement the already existing regular product portfolio in India Imports were currently made under test market stage Import pricing was consistent with Group s transfer pricing policy Cost plus mark-up for exports made by low-risk manufacturer Incurred huge advertising and other marketing costs Launch pricing was based on inputs received from market research company Huge operating expenses resulted in negative operating margin (OM) for the specific import transaction ABC India had no written transfer pricing policy document or legal agreements to support the nature of transaction and its pricing policy PwC 11

12 Revenue s contentions and approach Revenue compared the operating margin (loss) suffered by ABC India in relation to import of specific product with the arithmetic mean of the operating margin earned by third party Pharma distributors engaged in similar distribution activity Disregarded the aggregation approach adopted by ABC India to justify the arm s length nature for its import transaction Concluded that the import prices were high which contributed to operating loss for ABC India Proposed transfer pricing adjustment PwC 12

13 Defence mechanism Detailed functional analysis taking in inputs from the operational personnel explaining the necessity for new product, launch expenses, etc Support through market research study report Analyse budget prepared in relation to product launched - To identify the year when ABC India would break-even Identification of contributors to operating loss - Most critical part of analysis in any operating loss situation Analyse the cost plus margins of the overseas supplier and benchmark these with comparables to showcase the appropriateness of the pricing arrangements vis-à-vis inports PwC 13

14 Case Study 3 Royalties by software entity PwC 14

15 Business Model and Structure FCO US Parent Royalty flow 100% USA India Sub Basic Facts of the Case FCO, a US parent, is engaged in software services and operates globally through subsidiaries including subsidiary in India Indian subsidiaries use the trade name of FCO for carrying out their businesses Indian subsidiaries are required to pay royalties to FCO for usage of trade name Present royalty arrangement: Royalties are 1% of sales, based on turnover PwC 15

16 Revenue s contentions and approach No substantive documentation provided to demonstrate benefits received by Sub 2 from exploiting the right to use FCO s trade name Compliance with Indian Foreign Direct Investment policy would not be sufficient compliance with Transfer Pricing laws of India No pricing policy written document provided to substantiate the payments Disallowed the entire royalty charge penalty implications PwC 16

17 Defence mechanism Put in place robust documentation to showcase the benefits derived from us of tradename based on interviews of operational personnel key to substantiating the appropriateness of the royalty payouts Benchmark the royalty rate using licensed databases Put in place legal agreement PwC 17

18 Case Study 4 Import of APIs PwC 18

19 Business Model and Structure (including Revenue s approach) ABC s business model and structure Revenue s approach on secret comparables ABC UK Import of Formulations Import of API (original research) ABC USA ABC Indonesia XYZ China Import of API, similar to Swiss API Outside India Re-selling of Imported formulations Third Party, India ABC, India Export of Formulations Manufacture Domestic Sales Third Party, India PQR India Third Party India Manufacturing - Domestic Sales India PwC 19

20 Facts of the Case International Transaction Import of Active Pharmaceutical Ingredient (API) from an associated enterprise (AE) Why Imported from associated enterprise? Information asked by Revenue on Product Imported External CUP Comparability Show Cause Notice to Company Owner / Developer of the API R&D activity undertaken by Parent Risk assumed by Parent Application Therapeutic Segment Formulations Competitors Use of Customs Database Import price of competitors is lower Justify why company s price is higher PwC 20

21 Defence mechanism Rebuttal of CUP strict product comparability Import of products of original research - supported by research data which brings greater conviction to medical professionals Highly sophisticated manufacturing operations of the foreign parent processes are different impacting quality of finished products Comparison of prices at which same APIs sold by US parent to third party overseas PwC 21

22 Case Study 5 Cross Charges PwC 22

23 Business Model and Structure PARENT COMPANY (X) Entrepreneur performing Group roles INDIA 100% OUTSIDE INDIA ASSOCIATED ASSOCIATED ASSOCIATED ENTERPRISE ENTERPRISE ENTERPRISE (A) (B) (C) Country A Customers Customers Country B Customers Country C Basic Facts of the Case (X) acts as an entrepreneur and performs Group roles (X) provides following services to various associated enterprises: Group Human Resource Group Finance Group IT and Admin support Ownership Group services PwC 23

24 Revenue s contentions and approach Revenue alleged that Group roles performed by (X) are in the nature of intra group services Such services should be cross charged along with an arm s length mark up Exposed (X) to concealment penalties PwC 24

25 Defense mechanism The overseas subsidiaries act as limited risk distributors or limited risk service providers In either case subsidiaries earn either routine margin on sales or on cost Entrepreneur profits flown back to India In case a cost plus charge out is introduced, this would increase the cost base of the overseas entities In any case, the Indian parent would need to support this through intercompany pricing Finally the cost would come back to the Indian entity hence the charge out for the support services would not be warranted PwC 25

26 Key Points discussed through case studies Case Study 1: Importance of business and commercial rationale Case Study 2: Identifying contributors to loss is critical Case Study 3: Importance of satisfying Benefit Test Case Study 4: Importance of Industry analysis and requirements for CUP comparability Case Study 5: Operating model governs the transfer pricing Remember: Facts are King and Transfer Pricing is an Art and not Science PwC 26

27 Thank You This publication has been prepared for general guidance on matters of interest only, and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is given as to the accuracy or completeness of the information contained in this publication, and, to the extent permitted by law, [insert legal name of the PwC firm], its members, employees and agents do not accept or assume any liability, responsibility or duty of care for any consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it PricewaterhouseCoopers Private Ltd. All rights reserved. PwC, a registered trademark, refers to PricewaterhouseCoopers Private Limited (a limited company in India) or, as the context requires, other member firms of PwC International Limited, each of which is a separate and independent legal entity.

Practical Experiences

Practical Experiences Presented by: Dinesh Supekar PwC Snapshot of assessment issues covered 1. Marketing intangibles FMCG Industry 2. Selection of comparables Automobile Industry 3. Commission income