Transfer Pricing Analysis and Benchmarking in Light of ... Vispi... · Transfer Pricing Analysis...
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Transfer Pricing Analysis and Benchmarking in Light of Benchmarking in Light of Recent Experiences and
Judgment
Vi i T P t lBCAS
Vispi T. Patel
BackgroundBackground Presently five rounds of audit have been completed
TNMM is most commonly used by the taxpayers
Precedents set in earlier years – generally followed y g y
Emphasis has been laid on Documentation and Economic Analysis
Legal precedents available on transfer pricing – Mentor Graphics, Morgan Stanley, Development Consultant Engineers Ranbaxy I Gate Sony India Aztec Engineers, Ranbaxy, I-Gate, Sony India, Aztec, Instrumentarium Corporation, Vanenburg etc.
Case StudyABC
International Inc. China
ABC International
GMBHEnd
Customer
Sale of BTS Equipment
Inc. China GMBH
Outside India
Purchase of Mobile Phone Instruments
Sale of BTS Equipment & Providing Installation
& Commissioning services
Installation & Commissioning
of BTS Equipment on Mobile Towers
India
IndiaMobile Towers
End Customer
ABC India Ltd.
Sale of Mobile hPhone
Instruments
Facts ABC India Ltd. is engaged into manufacturing of BTS
Equipment, installation and commissioning of such BTS equipment and trading of Mobile Phone Equipmentsequipment and trading of Mobile Phone Equipments
ABC India sells the BTS Equipment to end customers through its Associated Enterprise (AE) in various countries
ABC India has entered into agreement with its AE for supply ABC India has entered into agreement with its AE for supply of BTS Equipment and installation and commissioning of such BTS Equipment
ABC India sells BTS Equipments to its AE at manufacturing ABC India sells BTS Equipments to its AE at manufacturing cost plus 10 per cent. Installation and commissioning cost is also charged at cost plus 10 per cent
FactsTechnical staff is deputed at the end clients
place for installation and commissioning of BTS Equipment;BTS Equipment;
For deputation of technical staff, following costs are recovered at cost plus 10 per cent p pmark-up:Travel Cost;Lodging and Boarding allowance;Lodging and Boarding allowance;Actual expenses incurred for installation and
commissioning of BTS Equipments;S l t f l b i f M DSalary cost of employees on basis of Man-Days
ABC India also imports Mobile Phone Equipments from ABC International Chinaq p
F ll i th i t ti l t ti Facts
Following are the international transaction entered into by ABC India Ltd. with its AEs
Sr. No. Name of theAE
Nature of Transaction
Amount (`)
(` in 000’s)
AE Transaction1 ABC
International GMBH
Sale of BTS Equipment
104,500
GMBH2 ABC
International GMBH
Commissioning and Installation
8,250
Charges3 ABC
InternationalPurchase of Mobile
48,580
China Ltd. Phone Equipments
Facts
ABC International GMBH sold the BTS Equipments at import cost plus 4 per cent mark-up
ABC International GMBH provided installation and commissioning services at cost plus 4 per cent commissioning services at cost plus 4 per cent mark-up
Consolidated P&L(` in 000’s)
Opening StockBTS Equipment 1,250Mobile Phones 15,250
Sales BTS Equipment 104,500Mobile Phones 68,250
Purchase of Mobile Phone 48,580
Manufacturing Cost 94 750
Installation & Comm. 8,250
Closing StockManufacturing Cost 94,750
Salary, TA, etc. 7,500Other operating
Closing StockBTS Equipment 1,000Mobile Phones 8,200
Expense 4,950
Interest Paid 780
Interest Income 80
N t P fit 17 220Net Profit 17,220
Total 190,280Total 190,280
Economic Analysis ?
BusinessFunction
Intangibles/Risks
ManagementStructure/Processes
Economic Analysis
Economic Profiling
ComparableStrategy
Most Appropriate
Method
FAR Analysis – Manufacturing SegmentFunctions Performed
Activities performed ABC India ABC International
Functions Performed
Development of global strategy / branding for the manufacture and sale of Group’s products
x
productsR&D activities x
Manufacture of BTS Equipment xManufacture of BTS Equipment x
Inventory Management
Selling & Distribution activities
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FAR Analysis – Manufacturing SegmentA t l d
Assets ABC India ABC I i l
Assets employed
International
Manufacturing Facilities x
Technical know-how x
Trademarks x
W h i f iliti Warehousing facilities
Human Resources
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FAR Analysis – Manufacturing SegmentRi k A d
Risks ABC India ABC International
Risks Assumed
Market risk
Legal risk
Inventory risk
Foreign exchange fluctuation risk xForeign exchange fluctuation risk x
Credit risk
ABC India can be characterised as a full fledged entrepreneurial entity owning significant intangibles
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entrepreneurial entity owning significant intangibles pertaining to manufacturing of BTS Equipments
FAR Analysis – Trading SegmentF i P f d
Activities performed ABC India ABC International
Functions Performed
International China
Estimation of demand x
Manufacture of goods x
Customs clearance formalities x
Inventory Management Inventory Management
Marketing activities
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FAR Analysis – Trading SegmentAssets employed
FAR Analysis Trading Segment
Assets ABC India ABC International
ChinaFixed Assets
Human Resources
Trademarks and brand names
x
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Ri k A d
FAR Analysis – Trading Segment
Risks ABC India ABC International
Risks Assumed
ChinaMarket risk
Legal risk Legal risk
Inventory risk
Foreign exchange fluctuation xForeign exchange fluctuation risk
x
Credit risk x
ABC I di b h t i d f ll fl d d T d ABC India can be characterised as a full fledged Trader not owning significant intangibles in respect of trading
of Mobile Phone Equipments
Philips Software Centre Pvt Ltd Vs ACIT (26 SOT226)
18
Philips Software Centre Pvt. Ltd. Vs ACIT (26 SOT226)Mentor Graphics (Noida) Pvt. Ltd. Vs DCIT (109 ITD 101)
Which Way forward……?
M f t iM f t iManufacturingManufacturing
Understanding the Business Model of
the Company
Installation& Commissioning
t e Co pa y
TradingTrading
Operating Operating II
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IncomeIncome
Aggregation vs. Segregation
Manufacturing, Installation and Commissioning: Installation and Commissioning of the BTS Equipment is
inextricably linked to the sale of BTS Equipmentinextricably linked to the sale of BTS Equipment Trading of Mobile Phone Equipment:
Trading of Mobile Phone Equipment is a separate activity d i t i t i bl li k d t th l f BTS and is not inextricably linked to the sale of BTS
Equipment.
Development Consultants (P.) Ltd. vs DCIT (23 SOT 455)Global Vantedge vs. DCIT (37 SOT 1)
UCB I di (P ) Ltd ACIT (121 ITD 131) S litti f UCB India (P.) Ltd. vs. ACIT (121 ITD 131) – Splitting of Consolidated Accounts into Manufacturing & Trading Segments
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Segment Analysis
Based on the business functions of ABC India, the business can be divided into the following segments:g g Manufacturing Segment – This involves manufacturing of BTS
Equipments. The international transactions in this segment include export of BTS Equipments
Installation and commissioning of BTS Equipment Trading Segment – This involves purchase and resale of Mobile
Phone Equipment. The international transactions in this segment include import of Mobile Phone Equipmentsegment include import of Mobile Phone Equipment.
Benchmarking of gInternational Transactions – Which Way
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Forward?
Split P&L AccountTested Party P&L A/c – Manufacturing Segment Tested Party P&L A/c – Trading Segment
(` in 000’s)(` in 000’s)
Opening Stock 1,250
ManufacturingCost 94,750
Sale of BTS 104,500
Installation & Commissioning 8,250
Opening Stock 15,250
Purchases 48,580
Gross Profit 12 620
Sales 68,250
Closing Stock 8,200
,
Salary, TA, etc. 7,500
Net Profit 10,250
g ,
Closing Stock 1,000
Gross Profit 12,620
Total 76,450
Operating Expense
Total 76,450
Gross Profit 12,620
Total 113,750 Total 113,750
4,950
Interest Paid 780
Net Profit 6 970
Interest Income 80
Net Profit 6,970
Total 12,700 Total 12,700
Pricing Method SelectionPricing Method Selection
Transaction Based Methods Comparable Uncontrolled Price
Profit Based Methods TNMM Comparable Uncontrolled Price
(CUP) Resale Price Cost Plus
TNMM Profit Split
-Comparable -Residual
CUP Method
Product/Service Economic Conditions
Lik t Lik i l t i ibl
Contractual terms Like to Like comparison – almost impossible Hence, CUP is rejected as most appropriate
method
Resale Price Method
1Determine the gross profit marginearned in comparable uncontrolled 1 earned in comparable uncontrolled transactions
Steps 2Subtract the appropriate grossmargin from the applicable
l iSteps resale price
3The remainder will be thearm’s length price with thecontrolled entity
Resale Price Method- Trading
XYZ ABC Parent Expenses = 17
India Company
Transfer price Independent
Revenue=20
IndependentDistributor
Transfer price usingRP Method
Independent distributorsmargin-12%
DistributorRevenue –20
Less Cost – 17
Retail
Independent Distributor
Margin = 3PriceUnknown
i.e.3 divided by 20
Cost Plus Method
Transfer Price is determined by adding appropriate fit k t t ll d ll ’ t f gross profit mark-up to controlled seller’s costs of
producing the property or provision of service Indian disclosure norms are not uniform for
classifying expenses that should come before GP and after GP. Hence exact matching of GP with the comparables will not be possible.
Hence, C+ is not selected as the most appropriate method for manufacturing and installation and commissioning of BTS Equipments from an Indian commissioning of BTS Equipments from an Indian perspective
Profit Split Method
Compares allocation of profit (loss) to allocation between uncontrolled parties in similar activitiesbetween uncontrolled parties in similar activities
Applicability-Transfer of unique intangibles Transfer of unique intangibles
- Multiple interrelated International Transactions
Relies on market data
Few taxpayers qualify for this method - difficult to get a comparable
Rejected as the Most Appropriate Method
TNMMTNMM Determine arm’s length price by comparing financial
results of tested party and selected uncontrolled parties
Apply Profit Level Indicators (PLIs)
TNMM is selected as the most appropriate method for benchmarking the international transaction of import f M bil Ph E i tof Mobile Phone Equipments
Selection of Tested Party OCED: The choice of the tested party should be consistent with the
functional analysis of the transaction. As a general rule, the tested party is the one to which a transfer pricing method can be applied in the most reliable manner and for which the most reliable comparables can be found, i.e. it will most often be the one that has the less complex functional analysis.
Based on FAR Analysis following entity are selected as Based on FAR Analysis following entity are selected as tested party Manufacturing, Installation & Commissioning Activity:
ABC International GMBH (AE selected as tested party – being the ABC International GMBH (AE selected as tested party being the simpler entity and reliable internal comparable data available).
Trading of Mobile Phone Equipments: ABC India Ltd (assessee selected as the tested party – being entity with simpler entity and external reliable comparable data is available)
Ranbaxy Laboratories Ltd. vs. ACIT [299 ITR (AT) 175]Development Consultants (P.) Ltd. vs DCIT (23 SOT 455)
Global Vantedge vs. DCIT (37 SOT 1)
Selection of the Most Appropriate Method
Manufacturing Activity:a u actu g ct ty: As discussed earlier, CPM is selected as the
most appropriate method by benchmarking f i AE foreign AE
Trading Activity: T h i ll RPM i li bl Technically RPM is applicable; But in view of lack of availability of data for
computation of gross profit margin;co putat o o g oss p o t a g ; TNMM is selected as the most appropriate
method.
Determination of Arm’s Length Price –Manufacturing Activity
AE has sold BTS System to End Customer at import cost plus 4 percent mark-up
Sale Price to End CustomerParticulars (` in 000’s) (` in 000’s)
Sale Price to End Customer by AE
BTS E i 108 680BTS Equipment 108,680
Installation & Commissioning 8,580 117,260
Import Price to AE
BTS E i t 104 500BTS Equipment 104,500
Installation & Commissioning 8,250 112,750
Variation 4510
V i ti % f i t ti l t ti 4%Variation as % of international transaction 4%
Since the variation between the international transaction and final price to end customer is less than 5 %, international transaction of sale of BTS Equipment is at
’ L tharm’s Length
ACIT vs. MSS India Pvt. Ltd (2009-TIOL-416-ITAT-PUNE)
Determination of Arm’s Length Price –Trading Activity
Search for Comparable Companies D t b U d P Database Used – Prowess
Issues faced in case of the use of Comparable data Comparable contemporaneous data not available Whereas the Tax Department insists on same year data only Limitations of databases such as inadequate information, etc.
Philips Software Pvt. Ltd. vs. ACIT (26 SOT 226) – Use of contemporaneous data
Search Process – Trading Segment
Search criteria No. of companies passing the criteria
Product search Selected companies classified under 15Product search – Selected companies classified under Industry classification “Telephones and Mobile Phones”
15
Companies having Trading Sales / Total Sales > 90% 12
Accept companies ha ing Marketing & Ad ertisement 11Accept companies having Marketing & Advertisement Cost / Sales > 2.5%
11
Rejected companies making losses consistently 1
Qualitative Screening 5Qualitative Screening 5
Select Companies not having significant related party transactions
4
Arithmetic mean of Operating Profit / sales of comparable companies is 8.59%
36Philips Software Centre Pvt Ltd vs ACIT(26 SOT 226)
Determination of the Arm’s Length Price
Selection of PLI
Operating profit margin (on sales) was considered as an appropriate PLI for comparing the operating margin earned by ABC India for Trading activities with that of comparables’ in respecti e businessescomparables’ in respective businesses
Where, Operating Profit Margin (on sales) is computed as = Operating Profits / Operating Income
Operating Profit (EBIT) Operating income Operating Operating Profit (EBIT) = Operating income – Operating cost
Operating income = Total income – Non operating incomes like profit on sale of fixed assets and pinvestments, income from investments, etc.
Operating costs = Total costs- Non operating costs like Preliminary expenses w/off + Loss on sale of assets/investments etc
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assets/investments, etc.
Tested Party P&L A/c – Trading Segment
Determination of the Arm’s Length Price(` in 000’s)
Opening Stock 15,250
Purchases 48,580
Sales 68,250
Closing Stock 8,200
Gross Profit 12,620
Total 76,450 Total 76,450
Operating Expense 4,950
Interest Paid 780
Net Profit 6,970
Gross Profit 12,620
Interest Income 80
Net Profit 6,970
Total 12,700 Total 12,700
Op Profit = NP - Interest Income + Interest O P fit / S l (T t d pPaid = 6,970 – 80 + 780 = 7,670
Op Profit / Sales = 7670 / 68250 * 100 = 11.24%
Op Profit / Sales (Tested Party) = 11.24%Op Profit / Sales
(Comparable Companies) = 8.59%
Since the Operating margin of ABC India is more than the operating margin of comparable companies, the transaction of import of Mobile Phones is at arm’s length