DOMESTIC TRANSFER PRICING CONFERENCE Importance of FAR & Comparability; Selection of the Most Appropriate Method and Issues in disclosure in new Form 3CEB from SDT perspective 19 October 2013 Pramod Joshi
Importance of FAR & Comparability
What is a FAR analysis? Analysis of the functions performed, assets employed and risks assumed in the normal course of business by related parties involved in the intercompany transactions being analyzed This comparison is based on a functional analysis that identifies and compares the economically significant activities undertaken, or to be undertaken, by the taxpayers in both controlled and uncontrolled transactions In order to determine the degree of comparability between controlled and uncontrolled transactions, we need to compare the functions performed and assets employed, by the taxpayers in each transaction along with associated risks
Why Functional analysis? Why a functional analysis is essential to transfer-pricing analysis Understanding functions performed and risks assumed by related parties is crucial to identifying an appropriate level of profit that related parties should earn with respect to intercompany transactions under review The functions, risks and assets associated with a related party's operations usually have a significant effect on its profitability Arm's length transfer pricing is determined by a review of the relevant data (e.g., transactional or financial) for the transactions with unrelated companies with functions, risks, and assets sufficiently similar to those of a related party transactions
Some Examples Functions Performed R&D Entity A markets and distributes drug; Entity B funded all development; clinical development performed by Entity A on a fee-for-service basis. Significant number of lawsuits alleging injuries from the drug. Should Entity A bear some of these costs because it designed, in part, and performed analysis of the data on clinical trials? Manufacturing / Processing Taxpayer that employs an injection molding process to manufacture plastic components would be sufficiently different from a company using a casting process to manufacture engine components. Casting is capital intensive and energy intensive. Useful to distinguish whether entity performs heavy-duty manufacturing or light assembly
Some Examples Assumption of Risks Marketing Risk Taxpayer performs most of the marketing activities under the guidance of its related party. The related party will compensate taxpayer s marketing expenses if taxpayer would not have enough orders to cover its cost incurred. Which party bears marketing risk under this arrangement? Inventory Risk Taxpayer purchases raw materials from its related party but does not need to pay for the materials. Instead, it receives the difference between the sales amount and material costs after finished products are shipped to the related party. Which party bears the inventory risk under this arrangement? Product Liability Risk Entity A performs detailing of drugs and Entity B owns all the patents and other knowhow related to the drug. If detailing activity did not adequately address adverse side effects of drug, should product liability risk be shared between Entity A and Entity B?
Functional and Risk Analysis Principles Understanding the business model More Functions Less Functions
Functional and Risk Analysis Principles Manufacturing reward profile Profit R & D Volume Pricing Quality Raw material costs Long term contracts Labour costs Down time Fixed overhead Manufacturing services Risk Toll Manufacturer Contract Manufacturer Full-fledged Manufacturer Note: This graph only shows the relationship between profit and functions/risks. It is worth noting that more functions/risks also associate with larger potential losses.
Functional and Risk Analysis Principles Distributor reward profile Profit Volume Market share Product mix Pricing Currency exposure Obsolescence Warranty Credit risk Marketing costs Duties Sales Expense Admin & Accountancy Risk Commissionaire Instant Buy/Sell Distributor Note: This graph only shows the relationship between profit and functions/risks. It is worth noting that more functions/risks also associate with larger potential losses.
Comparability Analysis The comparability of property transferred in a controlled transaction and an uncontrolled transaction is most decisive for the application. Functional analysis enables comparison of controlled transactions with uncontrolled transactions Extent of comparability required changes according to the method selected for benchmarking traditional methods comparing prices require high degree of comparability Transactions cannot be compared if there are significant differences affecting prices in the open market and if suitable adjustments cannot be made to mitigate such differences
Comparability Analysis Factors to Consider Very important for traditional methods Product similarity (similar type, quality, quantity, features, etc) Same stage in supply chain (wholesales, retail, etc.) Geographic market in which transaction takes place Embedded intangibles Contractual terms (e.g., warranty, discount policy, credit terms, shipping liability, etc.)
Selection of the Most Appropriate Method
Transfer Pricing Methods Overview Methods Traditional Transaction Methods Transactional Profit Methods Comparable Uncontrolled Price (CUP) Resale price method (RPM) Cost Plus Profit Split Transactional Net Margin Method ( TNMM) Contribution Analysis Residual Analysis
Transfer Pricing Methods TP Methods OECD Guidelines Indian Regulations CUP Methods CUP Methods Resale Price Method Resale Price Method Cost Plus Method Profit Split Method Cost Plus Method Profit Split Method Transactional Net Margin Method Transactional Net Margin Method Other Method
..Transfer Pricing Methods.. In general CUP Method compare prices Resale Price Method compares gross margins Cost Plus Method compares profit mark-up on total cost Profit Split Method refers to the (total) profit from transactions and splits them among the parties based on the level of contribution Transactional Net Margin Method analyses net profit in relation to an appropriate base, such as costs, sales or assets
..Transfer Pricing Methods.. Applicability depends on the characteristics of property or services functions performed (including asset and risk assumed) contractual terms economic circumstances business strategies also depends upon the availability of information and reliability of assumptions
..Transfer Pricing Methods.. Priority among methods Indian Regulations does not prescribe any priority Earlier OECD Guidelines issues in 1995 traditional transaction methods are given priority over residuary method However, draft OECD guideline on related issue d for comments has done away with preferential status of traditional transactional methods remove The Most Appropriate Method which is best suited to the facts and circumstances of each particular controlled transaction, and which provides the most reliable measure of an arm s length price in relation to the controlled transaction.
..Transfer Pricing Methods.. Typical applicability criteria for each method CUP when price of exact comparable uncontrolled transaction is available RPM when goods are purchased for resale CPM when goods are manufactured & data related to cost of production is available, particularly in cases of toll or contract manufacturing, services of purchasing agents, contract research etc. PSM when transaction are complex & involve transfer of intangibles TNMM normally when none of the other methods are applicable & comparison with uncontrolled transaction is possible only at net profit level
Issues in disclosure of Form 3CEB from SDT perspective
Accountant s Report in Form 3CEB Clauses relevant to SDT Part A to Form 3CEB Clause 9 Aggregate Value of specified domestic transactions as per books of account Part C to Form 3CEB Clause 21 disclosure of PAN of the AE in addition to other disclosures Clause 22 - disclosure of expenditure for payment made / to be made to person referred to in Sec 40A(2)(b) Clause 23A disclosure of inter-unit transactions (in the nature of sale by the eligible business/ unit of the taxpayer) as referred to in S. 80A(6), 80-IA(8) or 10AA Clause 23B disclosure of inter-unit transactions (in the nature of purchase by the eligible business/ unit of the taxpayer) as referred to in S. 80A(6), 80-IA(8) or 10AA Clause 24 disclosure of business transacted with closely connected person (which has resulted in more than ordinary profits to an eligible business/ unit of the taxpayer) as referred to in S. 80-IA(10) or 10AA Clause 25 disclosure of any other transaction not covered in the above clauses [residual clause]
Aggregate value of SDT under clause 9 Important keeping in mind threshold of Rs. 5 crores Amount recorded in the books of account as per the Companies Act to be considered Only the amount 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. Values of loans & guarantees as well as outstanding balances not to be included in the aggregate value 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.
Other expected concerns Identification of transactions relating to allocation of cost amongst eligible & non eligible units & consequently the amount of disclosure in Form 3CEB Differences in transactions covered under section 40A(2)(b) as per Tax Audit Report & as per Form 3CEB Identification of transactions covered under section 80IA(10) owing to the close connection between assessee s eligible business & other person
Other administrative aspects Regulations require maintaining one Transfer Pricing Documentation & one Form 3CEB for International Transactions as well as Specified Domestic Transactions However, two different sets / annexures of functional & economic analysis can be maintained in respect of International Transactions and Specified Domestic Transactions There is no provision for joint signing of Form No. 3CEB. Also the online Form No. 3CEB has to be signed by one chartered accountant using his or her digital signature
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