Issues in Domestic Transfer Pricing including various methods for determining ALP Rakesh Alshi, Anand Thacker - 6 th October 2014 2014 Deloitte Haskins & Sells LLP 1
Contents 1. Specified Domestic Transactions The intent of law 2. Implications of SDT provisions 3. New Accountants Report i.e. Form 3CEB 4. Practical Issues in SDT 5. Best Practices for SDT 6. Selection of the Most Appropriate Method 7. Most Appropriate Method General Applicability 2014 Deloitte Haskins & Sells LLP 2
Specified Domestic Transactions The intent of law 2014 Deloitte Haskins & Sells LLP 3
Specified Domestic Transactions Intent of the Law Bringing in objectivity in the interpretation and governance introduction of ALP mechanism Doing away with tax arbitrage abuse that stems from differential tax rate, tax holiday/benefits availed by undertaking and presence of accumulated losses Protecting the revenue of the Indian government 2014 Deloitte Haskins & Sells LLP 4
Specified Domestic Transactions Introduction Transfer Pricing was earlier limited to International Transactions The issue of applying transfer pricing provisions to SDT was first discussed by the Supreme Court of India while delivering it s judgment in the case of Glaxo Smithkline Asia (P) Ltd. The Supreme Court of India suggested that the Ministry of Finance should consider appropriate provisions in law to make transfer pricing provisions applicable to the Domestic RPT. The Finance Act 2012, extended the scope of Transfer Pricing provision to Specified Domestic Transactions The Specified Domestic Transactions would include the following: Expenditure for which payment is made or to be made to domestic related parties Tax Holiday/ Deductions claimed by the taxpayer Transfer of goods or services between various businesses of same taxpayer Transfer Pricing provisions to apply to the Specified Domestic Transactions if the aggregate value exceeds five crores 2014 Deloitte Haskins & Sells LLP 5
Specified Domestic Transactions Intent of the Law Shifting of expenses Shifting of expenses Loss making company Profit making company Tax Holiday Unit Taxable unit / company Shifting of Income Shifting of Income SDT is introduced to avoid loss to Indian revenue due such arrangements 2014 Deloitte Haskins & Sells LLP 6
Specified Domestic Transactions What it includes? Specified domestic transaction in case of an assessee means any of the following transactions, not being an international transaction, namely: What is a specified domestic transaction? Explanation Expenditure incurred between related parties defined u/s 40A(2)(b) Payment made or to be made for expenditure incurred with domestic related parties Undertaking to which profit linked deductions are provided, covering: Inter Unit transfer of goods and services 80 IA(8); and Transactions between entities having close connection and generating more than ordinary profits 80 IA(10) Aggregate transaction value exceed INR 50 million in a financial year Section 80IA(8) Any transfer of goods / services between various undertakings or units of the assessee. Transfer at market value. Onus on tax payer. Section 80IA(10) More than ordinary profits derived from closely connected persons for claiming deduction to be brought down to reasonable profits. Primary onus on tax payer. Onus on tax authorities as well Any allowance for an expenditure or interest or allocation of any cost or expense or any income in relation to the Specified Domestic Transaction shall be computed having regard to the arm s length price Member Firms and DTTL: Insert appropriate copyright (Go Header & Footer to edit this text) 7
40A(2)(b) Expenditure between related parties Expenditure paid or to be paid to related parties will require to be at arm s length Examples of related parties under section 40A(2)(b) Payer Receiver of Payment Individual Relative of individual Company Director of company or relative of the director AoP/ HUF Member of AoP / HUF or relative of such member Any taxpayer Payment to a person who has substantial interest in me Payment to a director / partner / member / relatives of a person who has substantial interest in me Payment to a company in which my parent (more than 20% holding) has substantial interest Payment to a person whose director/ partner/ member has substantial interest in me Payment to a director/ partner/ member/ relatives of a person whose director/ partner/ member has substantial interest in me Payment to a person in which I have substantial interest Payment to a person in which my director/ partner/ member/ relatives have substantial interest Payment to any of my director/ partner/ member/ relatives Substantial Interest means beneficial ownership of shares with at least 20% voting right or 20% of the profits for other than company at any time during the year 2014 Deloitte Haskins & Sells LLP 8
Implications of SDT provisions 2014 Deloitte Haskins & Sells LLP 9
Implications of the Amendments Particulars Compliance Requirement Expenses Companies enjoying tax holiday Assessment Penalty Impact The taxpayers will now have to maintain the mandatory transfer pricing documentation for specified domestic related party transactions by specified timeline. Taxpayers will have to file Form 3CEB along with their tax return Expenses paid by domestic parties to related parties will be questioned in audit cases Need for benchmarking Corresponding adjustment not permitted for disallowed expenses which will lead to double taxation Owing to close connection, companies declaring More than ordinary Profits for tax holiday units will loose excessive incometax benefits Inter undertaking transfers would be covered Close connection not defined Assessment of specified domestic transaction would be done by TPOs and not AOs. Stringent Penalty - For failure to report a transaction in accountants report a penalty of 2% of the value of transaction 2014 Deloitte Haskins & Sells LLP 10
Implications of the Amendments - Penalty implications Penalty Impact Sec 271AA Failure to keep and maintain Transfer Pricing documentation Failure to report such transaction which is required to do so Maintaining or furnishing incorrect information or documents Section 271G Failure to furnish / submit any information / document to the transfer pricing officer Section 271BA Failure to furnish accountant s report in Form No. 3CEB Section 271(1)(c) Transfer pricing adjustment Concealment of income or furnishing inaccurate particulars of income Quantum of Penalty 2% of value of each international transaction 2% of value of international transaction for each such failure INR 100,000 100-300% of amount of tax sought to be evaded on concealment of particulars of income or furnishing inaccurate particulars of such income 2014 Deloitte Haskins & Sells LLP 11
Implications of the Amendments Move from FMV to ALP Fair Market Value Arm s Length Price No method prescribed for computing fair market value Six methods prescribed for computing Arm s Length Price No documentation required to be maintained Contemporaneous documentation required to be maintained Other than reporting in tax audit report, no statutory compliance Accountant s report signed by a Chartered Accountant to be filed Assessment done by the Assessing Officer Assessment done by the Transfer Pricing Officer 2014 Deloitte Haskins & Sells LLP 12
Arm s Length Price What has changed? Business Purpose Test Real Income Principle Burden of Proof 2014 Deloitte Haskins & Sells LLP 13
Concept of Arm s Length Price Arm s length price means a price which is applied or proposed to be applied in a transaction in uncontrolled conditions Arm s Length price is determined using the Most Appropriate Method out of the six transfer pricing methods prescribed by the Income Tax Rules: Comparable Uncontrolled Price Method Resale Price Method Cost Plus Method Profit Split Method Transactional Net Margin Method Other Method If more than one comparable price is obtained using above methods, then the arm s length price would be Arithmetic Mean of comparable prices Deviation of plus/ minus three percent is permitted from arm s length price 2014 Deloitte Haskins & Sells LLP 14
New Accountants Report i.e. Form 3CEB 2014 Deloitte Haskins & Sells LLP 15
New Accountants Report Form 3CEB The new Form 3CEB ( the Form ) contains 25 clauses requiring disclosure of the details of the various international transactions and specified domestic transactions. The Form is broadly divided into 3 parts. Part A deals with general information about the taxpayer Part B is in relation to International transactions and Part C deals with Specified domestic transactions This new Accountants Report has to be signed by a Chartered Accountant and submitted to the Tax Department before the due date of filing return of income Issuance of Accountants Report in Form 3CEB : Timeline is before 30 November 2014 2014 Deloitte Haskins & Sells LLP 16
Amended Form no. 3CEB certificate: Accountant to certify Specified Domestic Transactions as well 2014 Deloitte Haskins & Sells LLP 17
Clauses for Specified Domestic Transactions 2014 Deloitte Haskins & Sells LLP 18
Clauses for Specified Domestic Transactions Clause 21: List of Associated enterprises with whom the Taxpayer has entered into specified domestic transactions Clause 22: Transaction of any expenditure in respect of which payment has been made to a person referred to in section 40A(2)(b) Clause 23A: If an undertaking or unit or enterprise or eligible business of the Taxpayer [as referred to in section 80A(6), 80IA(8) or section 10AA)] transferred any goods or services to any other business carried on by the Taxpayer Clause 23B: If an undertaking or unit or enterprise or eligible business of the Taxpayer [as referred to in section 80A(6), 80IA(8) or section 10AA)] acquired any goods or services from any other business carried on by the Taxpayer Clause 24: Transactions with any AE which has resulted in more than ordinary profits to an eligible business to which section 80IA(10) or section 10AA Clause 25: Any other SDT not specifically covered in other clauses 2014 Deloitte Haskins & Sells LLP 19
Practical Issues in SDT - Applicability of SDT - Transactions covered under SDT 2014 Deloitte Haskins & Sells LLP 20
Issues Applicability of SDT 2014 Deloitte Haskins & Sells LLP 21
Whether under SDT? Issue 1 - Whether indirect holding is covered by section 40A(2)(b) of the Act? Section 40A(2)(b)(iv) - a company, firm, association of persons or Hindu undivided family having a substantial interest in the business or profession of the assessee or any director, partner or member of such company, firm, association or family, or any relative of such director, partner or member or any other company carrying on business or profession in which the first mentioned company has substantial interest Explanation. For the purposes of this sub-section, a person shall be deemed to have a substantial interest in a business or profession, if, (a) in a case where the business or profession is carried on by a company, such person is, at any time during the previous year, the beneficial owner of shares (not being shares entitled to a fixed rate of dividend whether with or without a right to participate in profits) carrying not less than twenty per cent of the voting power; Company A 100% 100% 2014 Deloitte Haskins & Sells LLP Company B 100% Company D Whether under SDT? Company C 100% Company E 22
Issue 1 - Whether indirect holding is covered by section 40A(2)(b) of the Act? (contd) Reference to Memorandum to the Finance Bill 2012 (Page 24): However, extending the transfer pricing requirement to all domestic transactions will lead to increase in compliance burden on all assesses which may not be desirable. In view of the circumstances which were present in the case before the Supreme Court, there is a need to expand the definition of related parties for purpose of section 40A to cover cases of companies which have the same parent company. It is further proposed to amend the meaning of related persons as provided in section 40A to include companies having the same holding company. Revised Guidance Note issued by ICAI (Para 4A. 16) Hence, the emphasis is on covering the real owner of the shares and not the nominal owner. This proposition is also supported by legal jurisprudence which states that in a multi-tier structure, a parent cannot be regarded as the beneficial owner of shares in a downstream subsidiary merely because it owns the shares of the intermediate subsidiary companies. Consequently, in a situation where A Ltd. holds 50% in B Ltd. and B Ltd. holds 50% in C Ltd., under ordinary circumstances, A Ltd. cannot be regarded as having beneficial interest in C Ltd. In other words, for purposes of Section 40A(2)(b), it may be appropriate to consider only direct shareholding and not derivative or indirect shareholding. Support also from certain Supreme Court decisions as well as various international guidance 2014 Deloitte Haskins & Sells LLP 23
Illustration Expenditure u/s 40A Transactions covered? A 20% 20% A & B A & C Yes Yes B C A & D A & E No No 20% 20% D E B & C Yes* D & E No * Post Budget 2012 amendment under section 40A Requirement to justify that expenditure not excessive or unreasonable and meets the arm s length criteria 2014 Deloitte Haskins & Sells LLP 24
Issue 2 - Whether shareholding needs to be aggregated for section 40A(2)(b) of the Act? Mr. X Relative of Mr. X Director X Company A Director Y Whether under SDT? Company A (Assessee) Company B Assessee 8% Relative Z of Y SDT not applicable in any of these examples However, once any one director of a company holds shares more than 20% in other company, all other directors of that company will be considered as related parties irrespective of their shareholdings 2014 Deloitte Haskins & Sells LLP 25
Issue 3 Inter unit transactions between two eligible units is covered? S. 80IA(8) states as follows :- Where any goods or services held for the purposes of the eligible business are transferred to any other business carried on by the assessee, or where any goods or services held for the purposes of any other business carried on by the assessee are transferred to the eligible business and, in either case, the consideration, if any, for such transfer as recorded in the accounts of the eligible business does not correspond to the market value of such goods or services as on the date of the transfer, Reference to Memorandum to the Finance Bill 2012 (Page 24): Therefore, the transfer pricing regulations need to be extended to the transactions entered into by domestic related parties or by an undertaking with other undertakings of the same entity for the purposes of section 40A, Chapter VI-A and section 10AA. Accordingly, Sec. 80IA(8) requires that transfer of goods and services between the eligible business and any other business (which includes eligible or noneligible business) of the taxpayer shall be at market value / Arm s Length Price. 2014 Deloitte Haskins & Sells LLP 26
Issue 4 Whether SDT applicable where percentage holding is more than or equal to 20% but less than 26%? Section 92BA For the purposes of this section, "specified domestic transaction" in case of an assessee means any of the following transactions, not being an international transaction, namely: (i) any expenditure in respect of which payment has been made or is to be made to a person referred to in clause (b) of sub-section (2) of section 40A;. Explicit mention in Revised Guidance Note issued by ICAI (Para 4A. 14) For example, where an Indian company purchases goods from a US company in which it has a 23% equity stake (substantial interest), such an expenditure transaction will not qualify as an international transaction amongst associated enterprises, but will qualify as a specified domestic transaction and thus subjected to arms length price requirements, transfer pricing documentation, accountant s report, etc. Section 40A (2) of the Act does not make distinction between resident and non-resident related parties and the section is applicable once the payment is made to a related party with holding more than 20%, resident or non-resident. Transaction between the taxpayer and a non-resident related party (where percentage holding is more than or equal to 20% but not more than 26%) would be covered within the ambit of SDT provisions and hence is required to be disclosed in Form 3CEB. 2014 Deloitte Haskins & Sells LLP 27
Issues Transactions covered under SDT 2014 Deloitte Haskins & Sells LLP 28
Issue 5 Whether capital expenditure including purchase of fixed assets is covered under SDT? Section 92(2A) states as follows: (2A) Any allowance for an expenditure or interest or allocation of any cost or expense or any income in relation to the specified domestic transaction shall be computed having regard to the arm's length price. Section 92BA(i) defines SDT as (along with other clauses): any expenditure in respect of which payment has been made or is to be made to a person referred to in clause (b) of sub-section (2) of section 40A Two prerequisite conditions for application of SDT under section 92BA(i) there should be an expenditure payment has been made or to be made Revised Guidance Note issued by ICAI (Para 4A. 7) The transactions included in the ambit of this section would include expenditure transactions like (illustrative only): Expenditure on purchase of tangible and intangible property... Entire value of purchase of fixed asset needs to be disclosed in the year of purchase and not only depreciation year on year 2014 Deloitte Haskins & Sells LLP 29
Issue 6 Whether SDT is applicable to purchase of capital asset and claimed as deduction under section 35AD of the Act? Two prerequisite conditions for application of SDT under section 92BA(i) 1. there should be an expenditure 2. payment has been made or to be made Purchase of capital asset from a domestic related party claimed as deduction u/s 35AD is similar to other capital expenditures as explicitly mentioned in Para 4A.11 of the Guidance Note issued by ICAI (August 2013 revision) These provisions are also applicable to expenditures which are in capital in nature and fully claimed as deduction under other provisions(eg Sec 35(2AB), 35 or 35AD) since any expenditure is covered under the scope of sec 40A (2)(b). SDT is applicable to purchase of capital asset from a Domestic Associated Enterprise even if it is claimed as deduction under section 35AD of the Act and is required to be disclosed in Form 3CEB. 2014 Deloitte Haskins & Sells LLP 30
Issue 7 Whether allocation of common overheads & costs like interest, administrative cost etc. to unit eligible for deduction under section 80IA or any other relevant section of the Act is covered under the purview of SDT provisions? Reference can be made to section 92(2A) as well as proviso to Section 80-IA(8) of the Act: 92(2A) Any allowance for an expenditure or interest or allocation of any cost or expense or any income in relation to the specified domestic transaction shall be computed having regard to the arm's length price. 80IA(8)- Where any goods or services held for the purposes of the eligible business are transferred to any other business carried on by the assessee, or where any goods or services held for the purposes of any other business carried on by the assessee are transferred to the eligible business and, in either case, the consideration, if any, for such transfer as recorded in the accounts of the eligible business does not correspond to the market value of such goods or services as on the date of the transfer, then, for the purposes of the deduction under this section, the profits and gains of such eligible business shall be computed as if the transfer, in either case, had been made at the market value of such goods or services as on that date Based on the combined reading of section 92(2A), the charging section and provisions of section 80IA(8), it is clear that the allocation of costs to unit eligible for deduction under section 80IA is covered under the purview of SDT 2014 Deloitte Haskins & Sells LLP 31
Issue 7 Whether allocation of common overheads & costs like interest, administrative cost etc. to unit eligible for deduction under section 80IA or any other relevant section of the Act is covered under the purview of SDT provisions? (contd) The necessity of allocation of common overhead costs and the value at which the same should be allocated is summarized below: Above mentioned allocation of common overheads & costs to unit eligible for deduction under section 80IA is covered under the purview of SDT provisions and accordingly needs to be disclosed in Form 3CEB and appropriately benchmarked to show the arm s length nature of the same. 2014 Deloitte Haskins & Sells LLP 32
Issue 8 Issue Whether reimbursement of expenses is covered under SDT? Section 92BA(i) of the Act is applicable to any expenditure in respect of which payment has been made or is to be made to a person referred to in clause (b) of subsection (2) of section 40A of the Act Additionally, reference can be drawn from the para 4A.7 (on page no 35) of the Guidance note on report under section 92E of the Act (Transfer Pricing) [Based on Law as amended by the Finance Act, 2012]. This para provide an illustrative list of transaction included in the ambit of section 92BA of the Act which read as under: The transactions included in the ambit of this section would include expenditure transactions like (illustrative only):.. Group charges Reimbursement expenditure Guarantee fee expenditure Thus it can be concluded that reimbursement expenditure transaction is also covered within the ambit of section 92BA of the Act. Since the underlying transaction would be in the nature of reimbursement of expenses on cost to cost basis, no separate benchmarking analysis would be required however adequate documentation needs to be maintained 2014 Deloitte Haskins & Sells LLP 33
Issue 9 What amounts have to be considered in calculating the applicability limit of 5 crores for SDT? Amounts recorded in the books of account as per the Companies Act to be considered Only the amounts of transactions recorded in the books of account of the taxpayer need to be considered for computing the limit of Rs. 5 crores (e.g. non charging of guarantee fees) Suo moto adjustments offered by the assessee in its return of income should be appropriately disclosed under relevant clauses of Form No. 3CEB but need not be considered for disclosure in clause 9 of Form 3CEB. Transactions between two eligible units need to be disclosed in both clauses 23A & 23B of Form 3CEB, however, need to be counted only once for the purpose of computing aggregate value of SDT under clause 9. Value of all SDT should be considered, whether or not expenses are deductible or not Threshold limit for SDT can be computed either on net basis (i.e. without including indirect tax levies like service tax, VAT, etc.) or on gross basis, depending upon the method of accounting regularly followed. 2014 Deloitte Haskins & Sells LLP 34
Best Practices for SDT 2014 Deloitte Haskins & Sells LLP 35
Best Practices for SDT To Identify and map the relationship between domestic related parties specified u/s 40A(2)(b) Identify and map the Specified Domestic Transactions Revisit the pricing mechanism applied by the company for SDT applying the most appropriate prescribed methods Develop a pricing policy Determine arm s length price to be charged Identify documentation to be collated to substantiate the arms length nature of transaction To note that year on year variations in profits of tax holiday units may raise concerns from tax officers Now the Transfer pricing will not be limited to just the large groups any more. Many mid-sized groups, partnership firms, Hindu Undivided Families ( HUFs ) and even individuals in smaller cities will now have to adhere to the TP rules. This amendment will largely increase the compliance burden for taxpayers having substantial domestic related party transactions. The onus of proving SDT at ALP is on the tax payer 2014 Deloitte Haskins & Sells LLP 36
Best Practices for SDT (contd) Impact Analysis Identify transactions with related parties and tax holiday units Desktop analysis to determine whether the current way of carrying on transactions will comply with arm s length standard Identify major transactions which need correction Planning (Forward Looking) FAR analysis of proposed specified domestic transaction Benchmarking the proposed transaction Recommend the pricing to be followed for specified domestic transaction Documentation (Historic) Roll forward the planning study with the actual FAR Benchmark the actual transactions carried out during previous year Maintain documents to be produced before the tax authorities during assessment 2014 Deloitte Haskins & Sells LLP 37
Selection of the Most Appropriate Method 2014 Deloitte Haskins & Sells LLP 38
Selecting the Most Appropriate Method Rule 10C(1) Method which best suits to the facts and circumstances Provides the most reliable measures of an ALP Transaction wise Rule 10C(2) Due regard to Nature and class of transaction Class or classes of AEs entering into transaction and their FAR analysis Availability, coverage and reliability of data Degree of comparability between controlled and uncontrolled transactions Extent and reliability / accuracy of adjustments Nature, extent and reliability of the assumptions required 2014 Deloitte Haskins & Sells LLP 39
ALP Computation - Overview of Methods Prescribed Methods Transaction based Methods Profit based Methods CUP Method RPM Method CPM Method PSM Method TNMM Method Other Method - Price Charged or paid / would have charged or paid No hierarchy or preference of methods prescribed under the Act The methods applicable for determining ALP for SDT transactions are same as those for international transactions 2014 Deloitte Haskins & Sells LLP 40
Comparable Uncontrolled Price Method 2014 Deloitte Haskins & Sells LLP 41
Comparable Uncontrolled Price Method ( CUP ) Comparison of controlled transaction with the uncontrolled transaction(s) High degree of comparability of products or services Direct and reliable Comparability Factors Strong similarity of products and services Geography of markets Functions and Risks Business strategy Contractual terms Timing of the transaction Volume 2014 Deloitte Haskins & Sells LLP 42
CUP Method - Examples Internal CUP External CUP A Ltd Sale of goods Sub. Co. A Subsidiary A Ltd Sale of goods Independent Co. Sale of goods Sale of goods Independent Co. Sub. Co. A ltd Independent Co. Similarity of Functions, Asset and Risks? Internal CUP is preferable 2014 Deloitte Haskins & Sells LLP 43
CUP Method Practical Perspective Due to the increased market volatility and increased complexity in related party transactions it is often difficult to obtain identical transactions under similar facts and circumstances Indirect evidences of CUP Can Industry average data / commodity / exchanges / quotations be used? 2014 Deloitte Haskins & Sells LLP 44
Resale Price Method 2014 Deloitte Haskins & Sells LLP 45
Resale Price Method ( RPM ) Measures the value of functions performed Ordinarily used in cases involving the purchase and resale of tangible property Reseller has not added substantial value Packaging, labeling, or minor assembly are acceptable Reseller does not apply intangible assets to add substantial value More reliable if internal comparables are present 2014 Deloitte Haskins & Sells LLP 46
RPM How to arrive at ALP? Steps 1 Determine the gross profit margin earned in comparable uncontrolled transactions 2 Subtract the appropriate gross margin and expenses from the applicable resale price 3 The remainder will be the arm s length price with the controlled entity 2014 Deloitte Haskins & Sells LLP 47
RPM Practical Perspective How to determine Gross Profit margin when no internal comparables are available? Tolerant to minor product difference. However, high degree of functional comparability required Impact of intangibles to be duly considered 2014 Deloitte Haskins & Sells LLP 48
Cost Plus Method 2014 Deloitte Haskins & Sells LLP 49
Cost Plus Method ( CPM ) Similarity of products/services transferred not a prerequisite Similarity of functions is a prerequisite for applying CPM Gross margins are more sensitive to difference in functions and risks Most useful method where, interalia, related parties undertake transaction in respect of: Sale of semi-finished goods Joint facility agreements Long term buy and supply arrangements Provisions of services on contract basis 2014 Deloitte Haskins & Sells LLP 50
CPM Example A Ltd Contract R&D services Sub Co. A A Ltd Provides directions for the manner in which research has to be carried out A Ltd assumes all risks associated with Research A Ltd also owns all intangibles developed through Research Sub Co. A agrees to carry-out Contract Research All costs for Research is compensated alongwith mark up 2014 Deloitte Haskins & Sells LLP 51
CPM Practical Perspective Inadequate data to compute gross margins accurately. As under Indian GAAP, companies reporting financial statements are not required to compute gross margin separately Using total cost plus as PLI under TNMM may be a better approach Better applied for comparison with internal comparable, due to lack of reliable data 2014 Deloitte Haskins & Sells LLP 52
Profit Split Method 2014 Deloitte Haskins & Sells LLP 53
Profit Split Method ( PSM ) - Applicability The PSM is typically applied in complex situations when other available methods (such as the CUP or the TNMM) are not sufficient to price the functions performed Profit split methods are usually appropriate when: Transactions are very interrelated it might be that they cannot be evaluated on a separate basis Valuable, non-routine intangibles exist in transactions and profit arising to the group cannot be assigned to one of the entities of the group Significant differences between controlled and uncontrolled transactions are attributable to economies of horizontal/vertical integration Adequate comparables are unavailable to set margins for all the entities PSM is contribution analysis, rather than comparability analysis 2014 Deloitte Haskins & Sells LLP 54
How to apply Residual Profit Split Method? Particulars Rs. Rs. Combined Group Profits 100 Assign basic return to each entity Entity A 30 Entity B 20 Entity C 10 60 Residual profit 40 Contribution analysis (based on relative contribution of the entities) Entity A 30 Entity B 10 Contribution Analysis Element of subjectivity 2014 Deloitte Haskins & Sells LLP 55
PSM Practical Perspective Typical example of Industries, where PSM can be applied: Telecommunications Pharmaceuticals Courier/logistic Implementation Issues: External market data Identification of value drivers Measurement of value drivers contributed by each entities in the group Assignment of weight to value drivers 2014 Deloitte Haskins & Sells LLP 56
Transactional Net Margin Method 2014 Deloitte Haskins & Sells LLP 57
Transactional Net Margin Method ( TNMM ) Most practical and widely used method Broad level of similarity of Functions, Assets and Risks TNMM can be applied as internal TNMM as well as external TNMM Comparison is at net operating margin with the application of appropriate Profit Level Indicators (PLIs) 2014 Deloitte Haskins & Sells LLP 58
TNMM - Example PLI of OP / Sales I Co. A PLI of OP / Cost I Co. A Purchase of goods I Co. B Distributor I Co. B Service Provider Business Support services Particulars Rs. Purchase from I Co. A (A) 800 Sales to 3rd party (B) 1000 Profit (C = B A) 200 OP / Sales 20% Particulars Rs. Services provided to I Co. A (A) 1100 Operating Exps. (B) 1000 Profit (C = B A) 100 OP / TC 10% 2014 Deloitte Haskins & Sells LLP 59
TNMM Example Segmental AE and Non AE business Particulars AE Non AE Total Sales 110 100 210 Purchases 85 80 165 Other Administrative Expenses 12 10 22 Operating Profit 13 10 23 OP/Sales 11.81% 10% 10.95% Comparability when: Internal comparability exists - Internal TNMM No internal comparability exists - External TNMM 2014 Deloitte Haskins & Sells LLP 60
TNMM Practical Experience Net profit margins may be influenced by some factors that have less or no effect on the price or gross margins Net profit margins may be affected by varying cost structures, business experience, management efficiency, etc. Net margins are less affected by the transactional differences e.g. difference in contractual terms, credit period, etc. In absence of applicability of CUP, RPM, CPM and PSM, TNMM is applied Potential comparable companies performing similar functions have to be searched on publicly available databases Various quantitative and qualitative filters should be applied and final comparable companies should be selected Currently, Prowess and CapitalinePlus databases are used for search of comparable companies 2014 Deloitte Haskins & Sells LLP 61
Other Method 2014 Deloitte Haskins & Sells LLP 62
Other Method Rule 10AB For the purposes of clause (f) of sub-section (1) of section 92C, the other method for determination of the arms' length price in relation to an international transaction shall be any method which takes into account the price which has been charged or paid, or would have been charged or paid, for the same or similar uncontrolled transaction, with or between non associated enterprises, under similar circumstances, considering all the relevant facts. Other Method can be used for following transactions Valuation of intangible property Valuation of shares Cost allocation Reimbursements Notification No. 18 of 2012 dated 23 rd May 2012 effective AY 2012-13 2014 Deloitte Haskins & Sells LLP 63
Transfer Pricing Method A comparative statement Method Measurement Focus Comparability Requirements CUP Price Similar products Similar conditions RPM Gross Income Similar functions Risk Contractual terms Similar product group CPM Gross Income Similar functions Risk Contractual terms Similar product group Indicative difference requiring adjustments Product quality Contractual terms Level of market Intangible property Transaction date Foreign Exchange Inventory levels Turnover rates Operating expenses Foreign currency risks Accounting differences Operating Complexity Operating expenses Foreign currency risks Accounting differences 2014 Deloitte Haskins & Sells LLP 64
Transfer Pricing Method A comparative statement 2014 Deloitte Haskins & Sells LLP 65
Most Appropriate Method General Applicability 2014 Deloitte Haskins & Sells LLP 66
Most Appropriate Method General applicability Method Transaction Type CUP Sale and Purchase of goods and services Guarantee fees Loans Royalties Commission RPM Distributor CPM PSM Sale of finished / semi-finished goods or services Transactions which are interrelated and involve more than one enterprise or involves valuable intangibles Joint Research and Development Development of joint Intellectual Property Rights Certain Financial Transactions TNMM Manufacture / distribution of finished goods Provision of services 2014 Deloitte Haskins & Sells LLP 67
Any Questions? 2014 Deloitte Haskins & Sells LLP 68
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