Practical Experiences

Transcription

1 Practical Experiences Presented by: Dinesh Supekar PwC

2 Snapshot of assessment issues covered 1. Marketing intangibles FMCG Industry 2. Selection of comparables Automobile Industry 3. Commission income received from Group Companies 4. Issues for India-centric software companies 5. Loss situations 6. Royalty Payments 7. Procurement Services 8. Issues for captive software companies of MNCs

3 General Background of TP in India Audit Statistics S.N. Charge Number of TP audits completed Number of adjustment cases % of adjustment cases For FY Amount of adjustment INR crore For FY New Delhi ,730 2 Mumbai ,794 3 Bangalore ,451 4 Chennai Kolkata Ahmedabad Pune Total ,010 Five rounds of audit completed - adjustment approx. INR 30,000 cr. Slide 3

4 What do transfer pricing assessments involve?

5 Copy of a typical notice (Sample 1) To, Continued... Slide 5

6 Copy of a typical notice (Sample 1) Continued... Slide 6

7 Copy of a typical notice (Sample 1) Slide 7

8 Copy of a typical notice (Sample 2) To, Slide 8

9 Copy of a typical notice (Sample 3) To, Slide 9

10 Copy of a typical notice (Sample 3) Slide 10

11 Copy of a typical notice (Sample 3) Slide 11

12 Marketing Intangibles

13 Marketing Intangibles General Concept Principal Co Manufacturer Brand Distribution Rights India Sub Co Distributor To what extent should the distributor bear marketing and advertising expenses? Flow of legal title of goods Physical movement of goods INDIA Indian customer Slide 13

14 Marketing Intangibles Disputes in India Principal Co Legal owner of IP Tech/ Brand Royalty Supplier India Sub Co Licensed manufacturer India Sub Co operates as licensed manufacturer No royalty pay-out/ minimal royalty for mere license of tech/ brand India Sub co takes all key decisions on A&M/ distribution, etc Bears all A&M/ distribution expenses Revenue makes addition in hands of India Sub Co to the extent the advertising expenses exceed that of comparables INDIA Indian customer Flow of legal title of goods Physical movement of goods Slide 14

15 Marketing Intangibles Relevant considerations Evaluate contribution (& related benefits) of each entity in developing marketing intangibles Who undertakes key decision making activities Significance of local marketing in taxpayer s industry Business/ commercial expediency of marketing efforts Who is the economic owner of the marketing intangible? Are the profits arising from the marketing / brand building activity sitting in the P&L account of the Indian subsidiary? If yes, how can this be demonstrated? Robust FAR analysis, documentation and transactional price analysis Slide 15

16 Assessment issues for automobile OEMs

17 Issues in the automobile industry Tendency to benchmark Indian Sub Co (licensed manufacturer/ entrepreneur) against local entrepreneurs under overall TNMM Could sail through in years of profits; major issue during losses entire third party turnover exposed, as compared to just AE transactions Example I Co's turnover for manufacturing segment Rs crores; Components imported from global AEs Rs. 200 crores [supplied at say "cost plus" margin (low/ moderate) by foreign AE suppliers]; Royalty payable by I Co to P 3% of turnover Rs. 30 crores; I Co has a small return on sales (ROS) of say 2%; If under overall TNMM, average comparable ROS is 5% TP adjustment works out to 3% of total turnover of I Co Rs crores i.e. an adjustment for Rs. 30 crores Slide 17

18 Issues in the automobile industry Profitability of one car manufacturer can vary from that of the other on account of various reasons: Differences in brand and technology Some car models may or may not be successful Advertising and selling expenses Capacity utilisation Development or otherwise of local vendors Varying impact of customs duties Quality related issues Slide 18

19 Issues in the automobile industry Does varying profitability necessarily mean inappropriateness of transfer prices? If no, should a better methodology be adopted rather than an overall TNMM? Subjective adjustments for transactional differences to what extent acceptable on the ground? Are other car manufacturers really comparables? Slide 19

20 Issues in the automobile industry Characterization of India Sub Co and selection of tested party: Principle of tested party as least complex of two entities, upheld by Kolkata Tax Tribunal (argued by PwC) Determination of primary risk taker Who is the entrepreneur, Ind Co or Principal Co? Ind Co always characterised as licensed manufacturer if products manufactured & sold in India? If localisation/ value-addition is insignificant, should Ind Co be characterized as a full fledged manufacturer? In case significant value addition at a local level, then can Ind Co be a tested party in the first place? Slide 20

21 Issues in the automobile industry Significant import of materials from foreign principal Value Added Distributor Principal Co Low tax rate Entrepreneurial profits embedded in import price Import of materials Flow of legal title of goods Physical movement of goods INDIA India Sub Co (Value added distributor) Tax rate 42.73% Assembly division Say 15% on VAE [or 6% ROCE] Sales division Say ROS 3 to 4% VAE = value added expenses ROCE = return on capital employed Slide 21

22 Issues in the automobile industry Significant localisation / value addition [Indian entrepreneurial model] Principal Co Low tax rate Tech & Brand Royalty Significant localisation in India; also, significant peoples functions for manufacturing, performed in India Difficult to segregate manufacturing & distribution functions India Sub Co entrepreneur, though licensed manufacturer Not proper to benchmark combined results of India Sub Co against Indian OEMs If significant intangibles not embedded in imported components, price to be tested in hands of Principal Co on cost plus/ TNMM If significant intangibles embedded in imported components, price may be tested with residual profit split analysis Royalty needs to be justified on stand alone basis, as per CUP analysis from global royalty databases, e.g. RoyaltyStat India Sub Co (License Mfg) Tax rate 42.73% INDIA Supplier Mfg division Sales division Flow of legal title of goods Physical movement of goods Indian customer Slide 22

23 Issues in the automobile industry Key Learnings An entrepreneur should never be the tested party Where the AE as well as Ind Co are entrepreneurs, a TNMM may not give appropriate results! Careful choice of comparables essential! Slide 23

24 Commission received from Group Companies

25 Commission received from Group Companies Assessee (Ind Co) is in the business of marketing in India the products manufactured by the overseas Principal Total direct sales effected in India = Rs.100 crores Commission 5 percent on sales = Rs. 5 crores Operating costs = Rs 3 crores OP / TC margins of 66 % against comparable OP/TC margins of 20 percent of that of comparables Assessee contends that given its high operating margins, the commission earned satisfies the arms length test Slide 25

26 Commission received from the Group companies Contention of the TPO Ind Co is functionally comparable to a distributor of goods Based on a search for traders of comparable products, arms length return on sales should be 3 percent Accordingly arms length commission determined at Rs. 6 crores (Rs. 3 crores operating costs + Rs. 3 crores of return i.e. Profit on account of trading function) Transfer Pricing adjustment of Rs. 1 crore made Slide 26

27 Commission received from the Group companies Key issues to be considered When can a sales agent be regarded as functionally comparable to distributor? Adjustment for working capital? Difference on account of inventory risks? Importance of robust documentation and functional analysis Slide 27

28 Commission received from the Group companies Key issues to be considered Other related issues: If the Ind Co is performing significant functions on be half of the overseas Principal Is a PE for the overseas Principal created? If yes, then what would be the income attributable to the PE? Would the PE be comparable to a distributor in terms of its functional profile? Slide 28

29 Key issues to be considered Routine services provided by the Ind Co Unlikely to continue a PE Arms length remuneration computed on operating costs (which will not include cost of goods) say 15 to 20 percent on operating costs Significant functions performed by the Ind Co on be half of the foreign Principal Could create a PE for the overseas principal but by itself the agent may not have the FAR profile of a distributor since it may not bear / have the ability to bear risks associated with such functional profile Income attributable to PE (Gross margins of a distributor) minus (payment made to sales agent) Would the payment of a distributor return to the agent extinguish risk of income attribution in the hands of the PE? Slide 29

30 Issues for India-centric software companies

31 Issues for India-centric software companies 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 Slide 31

32 Issues for India-centric software companies 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 Strength of employees with (X) as on April 1st: 3,000 Allocation as under: 100 employees deputed to Germany; 500 employees deputed to USA; 400 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) Slide 32

33 Issues for India-centric software companies 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 Slide 33

34 Issues for India-centric software companies Suggested approach to assist (X)... 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 Study 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 Slide 34

35 Issues for India-centric software companies...suggested approach to assist (X) Assist (X) in creating 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 enhances the solution delivery skills and thereby helps in execution of offshore work with great efficiency Explain the operating model to Revenue Demonstrate benefits received by (X) from deputation, by providing business case studies (which can be sourced from (X) s business) Submit third party data available in public domain Slide 35

36 Loss Situations

37 Loss Situations Business Model and Structure XYZ Singapore Low Risk Manufacturer Import of premium FMCG products ABC India (Manufacturer & distributor) Sales Third party customers in India Basic Facts of the Case ABC India is primarily a manufacturer of FMCG products and sells the products in India to third party customers ABC India also imports some premium FMCG 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 Slide 37

38 Loss Situations Other critical facts of the case During FY , ABC India introduced new hygiene products to supplement the already existing regular hygiene product market 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 in FY 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 Slide 38

39 Loss Situations Revenue s contentions and approach Revenue compared the operating margin (loss) suffered by ABC India in relation to import of hygiene products with the arithmetic mean of the operating margin earned by third party FMCG 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 Slide 39

40 Loss Situations Suggested approach to assist ABC India Conduct critical interviews with business heads who have taken the conscious decision to launch these products Conduct other functional interviews with key personnel in Finance, Import department and Marketing department Review the market research study report Peruse the budget prepared by ABC India in relation to product launched To identify the year when ABC India would break-even To verify the assumptions made Identify the contributors to operating loss Most critical part of analysis in any operating loss situation Review and confirm the accuracy of the spreadsheets prepared Identify if there are any errors in allocation of expenses Slide 40

41 Loss Situations...Suggested approach to assist ABC India Explain the following to Revenue: Nature of operations carried out by ABC India and its role being more like entrepreneur distributor for imported products Importance of market research study undertaken and the data considered by market research company before suggesting the launch price Target customers are not different than served prior to imports Break-even point and the year after which operating profits would be generated Slide 41

42 Loss Situations...Suggested approach to assist ABC India Explain the following to the Revenue: Contributors to losses Penetration strategy; Low volumes; and High advertising spend Consistency of pricing policy followed in group for same / similar transactions Above exercise to be backed by a foreign search demonstrating the reasonableness of the margins earned by the overseas Group entity Slide 42

43 Royalty Payments

44 Royalty Payments Business Model and Structure FCO US Parent Royalty flow 100% USA India Sub 1 Sub 2 Sub 3 Basic Facts of the Case FCO, a US parent, is engaged in engineering activities and operates globally through several subsidiaries including three 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 and technology Present royalty arrangement: Royalties are 1% of sales, based on turnover threshold Currently only Sub 2 pays royalty fee as its turnover exceeds the threshold limit Slide 44

45 Royalty Payments 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 No royalty on account of exports to FCO can be paid Slide 45

46 Royalty Payments Suggested approach to assist Sub 2 Interview the FCO s head responsible for royalty arrangement: Identify the benefits perceived by FCO, which shall accrue to subsidiaries in India on exploiting the right to use the trade name and the technology Identify the group pricing policy to ensure consistency Enquire, if tax authorities in other countries where FCO operated, had accepted the royalty charge mechanism Prepare robust documentation capturing the benefits received Review the global benchmarking analysis Royalty on exports to AE What is the pricing policy for such exports What are the functions of the AE Whether the AE gets only a return for sales function Whether the return for the technology is captured in the P&L account of the Indian entity Slide 46

47 Procurement Services

48 Procurement Functions Typical Scenario Principal Co Manufacturer/ Retailer Flow of goods Service fee India Sub Co Procuring Services India Sub Co carries out co-ordination functions for Principal Co Key decision on procurement taken by Principal Co India Sub Co maintains day-to-day relationship with vendors Vendors sell products directly to Principal Co Principal Co remunerates India Sub Co at Cost Plus Say, operating costs of India sub Co INR 70 crores Mark-up on operating 20% INR 14 crores Products sourced by Principal Co from Indian vendors INR 9,200 crores INDIA Indian vendor Flow of legal title of goods Physical movement of goods Slide 48

49 Procurement Functions Disputes in India Principal Co Manufacturer/ Retailer Service fee Flow of goods India Sub Co Procuring Services Revenue - India Sub Co to receive of value of goods sourced Say, 5% rate (on INR 9200 crores) - Commission imputed at INR 460 crores Adjusted profits of India Sub Co - INR 390 crores [460-70] TP adjustment in hands of India Sub Co - INR 376 crores [390 14] Imputed profits/ margin - 550% on operating cost INDIA Indian vendor Flow of legal title of goods Physical movement of goods Slide 49

50 Procurement Functions Procurement Functions option of models Principal Co Manufacturer/ Retailer Option 1 Buy-Sell Margin Procurement Service Co Option 2 Agency of value of goods Option 3 Services Service Cost Plus Mark Up Indian vendor Flow of legal title of goods Physical movement of goods Slide 50

51 Procurement Functions Considerations Choice of model to be backed by substance FAR profile to determine model Documentation & inter-company agreement extremely important - substance is key Rulings of Tribunal (Nike Inc) & Authority of Advance Ruling (Ikea Trading) - Indian liaison office of Foreign Co, facilitating procurement of goods held not to constitute PE of Foreign Co Slide 51

52 Issues for Captive Software companies of MNCs

53 Issues for captive software companies of MNCs Background a 100% subsidiary of a US entity registered under the STPI a captive software service provider to the US parent remunerated on an hourly rate basis The TP report: characterized the assessee as a low risk service provider benchmarking assessee s hourly rate remuneration, using industry averages During the year, the assessee made an operating loss Slide 53

54 Issues for captive software companies of MNCs TPO s contention Assessee is captive service provider for group entities. Hence, losses not justified Assessee s contention Company can also service third party customers, hence bears associated risks. Revenues are hourly recoveries, not based on cost plus model. Losses attributable to extraneous factors (under utilization due to absence of requisite orders, competition etc.) not related to international transactions. Third party customers actually not serviced TPO s conclusions No documentation to suggest and substantiate that assessee made effort to service third parties to utilize its idle capacity No marketing functions performed, no marketing/sales promotion expenses incurred Hence, Assessee is a risk mitigated service provider and should not incur operating losses Slide 54

55 Issues for captive software companies of MNCs Best Practices Operational realities to reflect in documents evidencing the arrangements (e.g. TP Study and Agreements) Periodic review of the appropriateness of the hourly rates Slide 55

56 Key takeaways Transfer pricing disputes are increasing manifold Significant additional efforts called for from the assessee on: Awareness of how transfer prices are set Backups supporting the setting of transfer prices Assessing the appropriateness of transfer prices at the stage of price setting Periodic review of the transfer prices in the course of the year Year end transfer pricing study to be a culmination of all the above Slide 56

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