FORUMULATING A TRANSFER PRICING STRATEGY

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FORUMULATING A TRANSFER PRICING
STRATEGY Navigating the Indian Overseas waters!
Narayan Mehta, Partner Sudit K Parekh Co
8th October 2005
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Agenda

• Compliance
• A case study
• Indian owned UK, US and Canadian software
  subsidiaries
• Transfer pricing a planning tool
• Other related issues under other laws

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Importance of Compliance

• Any related party transaction undertaken from
• 1st April 2001 onwards covered
• Currently 60 of worlds cross-border trade is
  between
• related parties Indian tax authorities have
  taken the cue!
• UK every 1 spent on TP investigation has
  fetched
• 120 to UK Inland Revenue!
• Japan transfer pricing has been a major revenue
  churner-
• individual cases exceeds 100 m!
• 1/3 rd of audits globally end up with TP
  adjustments!
• India - FY 01-02 assessments complete
• Incremental revenue collection - in excess of INR
  600 Cr
• Around 25 to 30 of the case show adjustments!

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Importance of Compliance

• Transactions exceeding INR 50 mn to attract
  compulsory transfer pricing audit
• Onus of proof- tax payer primarily liable
• S.10A / 10B units- thin margin for error
• No deduction under section 10A / 10B on enhanced
  income!
• More than ordinary profits taxable may not be
  tax exempt!
• Double taxation for the Group in respect of
  enhanced income

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Penalties are High

• Failure to maintain documentation
• 2 of value of transaction
• Failure to furnish documentation
• 2 of value of transaction
• Addition to Income
• 100 to 300 of tax on addition
• Failure to furnish Accountants Report
• Rs. 100,000

Penalties are not tax deductible! Most TP
penalties are not appealable! Penal
regulations in many overseas jurisdictions
as well!
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A bilateral exercise

• At least 9 out of 25 EU / accession countries
  have specific TP documentation requirements
• Denmark Hungary Portugal
• France Netherlands Spain
• Germany Poland UK
• Upward of 20 other countries have specific TP
  documentation requirements
• Japan Australia Korea
• China Canada Mexico
• TP documentation may be required in other
  countries under general anti-avoidance provisions
• Israel, Singapore, etc.

Need for balancing the Indian overseas
transfer pricing regulations!0
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Dual advantage!

• An effective tax planning risk management tool
  to establish the appropriateness of transfer
  prices

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Integrated holistic approach

• Also involves
• Commercial considerations
• International tax
• Section 10A optimization
• Withholding tax
• Expatriate taxation
• Immigration issues
• Exchange control
• Service Tax / VAT
• STPI issues

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CASE STUDY
Indian Owned

• UK, US Canadian subsidiaries

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UK Subsidiary
Consideration ?

• Marketing in UK
• Payroll / work permit
• Dely mgt. sales support

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Step 1- Functional Analysis
Compliance with documentation requirements
Understanding of where and how value is added
Criteria for Comparability
Assist in identification of simpler entity
Platform for Economic Analysis
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Functions performed
Income distribution within the MNC to be based on
economic value and activities
Each activity / enterprise receives a share of
total profits that reflects the contribution of
that activity / enterprise to earning those
profits.
RD
Software Development
Finance
Marketing
Sales Distribution
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Risks undertaken
Strategic Planning
Foreign Exchange
Project Scheduling Dvlpt Activities
Idle Capacity
Quality Control
Sales Distribution
Research Development
Marketing
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Assets employed
Technical/ Trade Intangibles
Marketing Intangibles
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Step 2 Economic Characterization of simpler
entity

• UK subsidiary the simpler entity!
• Economic characterization
• Ring fenced, risk mitigated contract service
  provider

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Functional Economic analysis- significance
XYZ Group of Companies
Profit f (F A R)
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Step 3 Selecting the most appropriate method
Most Appropriate Method ??? ??? ?
Cost Plus
Profit Split
TNMM
Resale Price Method
Comparable uncontrolled price
Other Yet to be prescribed
Most appropriate method - service provider - cost
plus / TNMM
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Step 4 Search and assessment of comparables

• External comparables- running queries on UK
  databases for searching functionally comparable
  companies preferably in the same line of business
• Fame database
• Global Vantage
• Kompass
• Amadeus
• Marketing / commission agents for
• software / ITES services
• .

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Sample record of benchmarks used as comparable
data
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An alternative analysis

• What should be the sample size?
• US / UK vs. Canadian practice

• Constructing an alternate broad base sample
• Use of lateral comparables to broad-base final
  sample size!

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Sample record of benchmarks used as comparable
data (extended sample)
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Arithmetic mean and median of extended sample
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UK Subsidiary- SKP experience
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UK Subsidiary

• Marketing in UK
• Payroll / work permit
• Dely mgt. sales support

Mark up for US Canadian subs cost plus 7 / 8!
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Transfer pricing a tax planning tool!
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Transfer pricing a tax planning tool!
Total Profit

• Above-normal profit
• Goes to economic owner(s) developer(s) of
  intangible assets
• May also be zero or negative!

Return to entrepreneurial risk-taker
Return to routine service providers / suppliers
of labor and capital

• Normal profit
• Paid out for performance of normal tasks
  software development, sales, distribution,
  marketing support, etc

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Compliance with Indian TP Regulations

• UK entity remunerated on cost plus 11 mark up
• Onsite cost regarded as flow through costs and
  no mark up thereon!
• Rest of the profits belong to Indian entity!
• Undertaking supplementary search on Indian
  database to corroborate findings

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Balancing Indian / UK / US / Canadian Regulations

• UK / US / Canada
• Use of (inter-quartile) range generally allowed
• Use of past data of even more than 2 years
  generally allowed

• India
• Concept of arithmetic mean - 5 variation allowed
  but range not permitted
• Past data of only 2 years

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Other Issues encountered

• Drafting the contractual agreement
• Consistent allocation of F / A / R
• Treatment of flow through costs
• Re mark-up
• Whether UK Co. is a PE of the Indian company?

• Even if PE, whether arms length mark-up would
  eliminate further tax incidence?
• Employees on dual payroll or overseas payroll?
• Compliances under STPI FEMA regulations for
  export billing
• W/ tax issues and remittances under FEMA

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Transfer pricing study - end results

• Global documentation- killing many birds with one
  stone!
• Compliance with the UK / US / Canadian transfer
  pricing regulations!
• Compliance with the Indian transfer pricing
  regulations!
• Minimum corporate tax incidence in UK / US /
  Canada!
• Optimization of section 10A benefits
• complete tax exemption in India!
• Compliance with exchange control
• regulations, STPI norms formulation
• of expatriate pricing policy

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Concluding remarks

• An effective tax planning risk management tool
• Need for a holistic approach
• Harmonizing the Indian overseas transfer
  pricing requirements
• Contemporaneous documentation
• Regular review update
• Tailored to the needs of the IRS in India
  overseas
• Global / centralized / regional documentation
• Relaxation if value of all international
  transaction
• Benchmarking analysis may yet be reqd in
• absence of CUPs

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Thank You
Contact Narayan Mehta Tel [phone]
1141 Mob 91 98205 44495 E-Mail
narayan.mehta_at_skparekh.com