Industry Specific Transfer Pricing Issues – Manufacturing Sector The Chamber of Tax Consultants International Fiscal Association – India Branch 23 April

Industry Specific Transfer Pricing Issues – Industry Specific Transfer Pricing Issues –

Manufacturing SectorManufacturing Sector

The Chamber of Tax Consultants The Chamber of Tax Consultants

International Fiscal Association – India BranchInternational Fiscal Association – India Branch 23 April 2010

Rohan PhatarphekarRohan PhatarphekarGlobal Transfer Pricing Global Transfer Pricing Services Services National Leader, KPMG National Leader, KPMG IndiaIndia

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© 2010 KPMG India Pvt. Ltd., the Indian member firm of KPMG International, a Swiss cooperative. All rights reserved. KPMG and the KPMG logo are registered trademarks of KPMG International, a Swiss cooperative.

Discussion Points

Economic Characterization and Compensation Models

Transfer pricing issues – Manufacturing industry

Focus Sectors – Auto and Pharma

Guidance from judicial analysis

Way Forward

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2222

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Manufacturing Functions

Toll Manufacturer

Contract Manufacturer

Licensed Manufacturer

Profits

Functions

and

risks

Intangibles

Sales

Inventory

Manufacturing

Pri

ncip

al

Intangibles

Sales

Inventory

Manufacturing

Intangibles

Sales

Inventory

Manufacturing

Man

ufac

ture

rIntangibles

Sales

Inventory

Manufacturing

Entrepreneur

4


Compensation Model

Functions Typical Compensation model

Contract / Toll manufacturing operations

Full cost plus mark up (or)

Return for value added services plus appropriate return on capital investments in material and finished goods inventory

Routine manufacture / assembly activity with licensed technology from Group.

Risk free assured return in line with industry benchmarks

As a variant of the above with significant local marketing efforts

Receipt of compensation for marketing intangible in addition to the above

Full fledged manufacturer and contributing to the R&D effort of the Group

Profit Split Method (PSM) to determine the contribution towards routine functions and towards intangibles

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Typical Transfer Pricing Issues- Manufacturing Industry

Start up phase challenges

Application of the TNMM method – Dealing with losses

Application of CUP – Comparability issues

Aggregation of transactions – Trading, Sourcing, Product bundling

Payment towards technical know how

IPR valuation

TP Vs. Customs

6


Specific Transfer Pricing Issues – Manufacturing Industry

Business Restructuring

Challenges for Contract Manufacturers

Payouts - Specific focus on Royalty

Imports Vs Local

Comparability Adjustments – Specific focus working capital

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OECD on business restructuring and practical To Do’s

OECD – Working Party No 6 – Transfer Pricing aspects of business restructurings – Discussion draft issued:

–Issue Note 1 – Allocation of Risk – Contractual allocation respected only to the extent of economic substance

–Issue Note 2 – Applying the arm’s length principle to business restructuring

• Reallocation of profit or loss;

• Arm’s length remuneration for transfer of a property;

• Arm’s length remuneration for detriment / loss??

–Issue Note 3 – Applying arm’s length principle post restructuring – Should not apply differently

Necessary changes in the contractual terms and inter-company agreements as per the new arrangement

To defend any tax scrutiny which are likely in case of business restructuring with robust transfer pricing policies and documentation.

Review inter-company pricing policies periodically

To-Dos

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Supply Chain PlanningIllustrative Sample – Existing Supply Chain

Inputs, rawmaterials

Global sales Global sales subsidiariessubsidiaries(local market (local market

IP)IP)

Global Global CustomeCustome

rsrs

Global Global SupplieSupplie

rsrs

Customer serviceprimarily local; support centers

Indian Indian ManufacturerManufacturer

Foreign Foreign ManufacturerManufacturer

ss


IP)IP)


IP)IP)

Local Local CustomeCustome

rsrs

Local Local SupplieSupplie

rsrs

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Tax Efficient Supply Chain Model - Illustrative Sample Tax Efficient Supply Chain Model - Illustrative Sample

Research Centers

Shared Shared Services

Services

Purchase ofPurchase ofmaterialsmaterials

ServicesR&Dservices

Distribution andlogistics services

Delivery ofgoods

Delivery ofmaterials

Sale 1(flash title)

Sale 2

Distribution Centers

Delivery ofgoods

Legal title Physical flow Services

CustomersKey Entrepreneurial Risk Taker

IntangiblesTrading Risks

Manufacturing(consignment)

Sales & Marketing

(Limited Risk Distributor]

Manufacturingservices

CorporateHeadquarter

ManagementServices.

Suppliers

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Case Study

• A foreign-based, Tier 1 automotive supplier has manufacturing and distribution operations around the world, including India

• The global business was slightly profitable (0.5 percent to 2.5 percent operating margin) in each of the past five years

• The India business has recorded losses in four of the past five years, and the forecast (under the current structure) suggests losses will continue to mount

What can be done to help mitigate transfer pricing audit risk in India and restructure the supply chain to be more tax efficient?

What can be done to help mitigate transfer pricing audit risk in India and restructure the supply chain to be more tax efficient?

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Current Business Model

High Tax Parent(R&D;

Manufacture)

High Tax Parent(R&D;

Manufacture)

Indian-Sub(Licensed

Manufacturer)

Indian-Sub(Licensed

Manufacturer)

China-Sub(Manufacture)


Third-Party VendorThird-Party Vendor Raw Materials & Components

Parts, Tooling,

Know-How

Royalty• India Sub COGS by source / value

• Parent: 10 percent

• Third-Parties: 90 percent

• Royalty rate: 3%

• Parts transfer price: net cost plus 10%

• India -Sub Operating Margin %

• Y1 (2%), Y2 +3%, Y3 (1%), Y 4 (7%), Y5 (4%)

• Parent Operating Margin %

• Y1 +3%, Y2 +1%, Y3 +4%, Y4 +6%, Y5 +5%

• China-Sub Operating Margin %

• Net Cost Plus 6% in all years

Parts

OE

M C

ust

omer

over

seas

India -Sub P&L (USD million)

Revenue 1,100

Less: COGS (1,000)

Less: Royalty (33)

Less: SG&A Expense (111)

Operating Loss (44)

Operating Margin % - 4%

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Issues Raised by Losses

• Apparent transfer pricing risk

• Global effective tax rate high

• Potential need for ongoing capital contributions

Transfer Pricing alone won’t solve the issuesConsider Business restructuring options

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Possible Business Model

High Tax Parent(R&D; Manufacture)

High Tax Parent(R&D; Manufacture)

Lower TaxIndian-Sub

(Contract Manufacturer)

Lower TaxIndian-Sub

(Contract Manufacturer)



Third-Party VendorThird-Party Vendor Raw Materials & Components

Parts, Tooling, Know-How

Parts

OEM Customeroverseas

Parts

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Challenge for contract manufacturers

Functional profile of Contract Manufacturers - Risk-free operations

Remuneration model - remunerated with a Cost Plus Mark-up with reference to third party manufacturers

Challenge

Third parties available as benchmarks are Entrepreneurial manufacturers– Undertake full gamut of risks– Not remunerated on “Cost Plus” basis

Solutions Adjustments for better comparability

– Possible adjustments for working capital and Risk differential

Alternate PLIs– Use of Return on Assets (ROA) as PLI– Use of Return on Capital Employed (ROCE) as PLI

Safe Harbours – Example - Maquiladora in Mexico– As a percent of return on value of assets employed / return on total costs

Determination of remuneration level - Contract Manufacturers

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Comparability adjustments

• Typical adjustments: Working Capital, Risk adjustment, Depreciation adjustment, Idle capacity adjustment, Accounting adjustments

Working Capital Adjustments

• Purpose: Adjust for the differences between the tested party and potential comparables in interest expenses, with an assumption that the difference should be reflected in profits.

• The underlying reasoning is that:

• A company will need funding to cover the time gap between the time it invests money (i.e. pays money to supplier) and the time it collects the investment (i.e. collects money from customers)

• This time gap is calculated as: the period needed to sell inventories to customers + (plus) the period needed to collect money from customers – (less) the period granted to pay debts to suppliers.

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TESTCO Year 1 Year 2 Year 3 Year 4 Year 5

Sales $179.5m $182.5m $187m $195m $198m

Earnings Before Interest & Tax (EBIT) $1.5m $1.83m $2.43m $2.54m $1.78m

EBIT/Sales (%) 0.8% 1% 1.3% 1.3% 0.9%

Working Capital (at end of year)

Trade Receivables (R) $30m $32m $33m $35m $37m

Inventories (I) $36m $36m $38m $40m $45m

Trade Payables (P) $20m $21m $26m $23m $24m

Receivables (R) + Inventory (I) – Payables (P)

$46m $47m $45m $52m $58m

(R + I – P) / Sales 25.6% 25.8% 24.1% 26.7% 29.3%

OECD Example…

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COMPCO Year 1 Year 2 Year 3 Year 4 Year 5

Sales $120.4m $121.2m $121.8m $126.3m $130.2m

Earnings Before Interest & Tax (EBIT) $1.59m $3.59m $3.15m $4.18m $6.44m

EBIT/Sales (%) 1.32% 2.96% 2.59% 3.31% 4.95%

Working Capital (at end of year)

Trade Receivables (R) $17m $18m $20m $22m $23m

Inventories (I) $18m $20m $26m $24m $25m

Trade Payables (P) $11m $13m $11m $15m $16m

Receivables (R) + Inventory (I) – Payables (P)

$24m $25m $35m $31m $32m

(R + I – P) / Sales 19.9% 20.6% 28.7% 24.5% 24.6%

OECD Example…

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WORKING CAPITAL

ADJUSTMENT

YEAR 1 YEAR 2 YEAR 3 YEAR 4 YEAR 5

TestCo’s (R + I – P) / Sales 25.6% 25.8% 24.1% 26.7% 29.3%

CompCo’s (R + I – P) / Sales 19.9% 20.6% 28.7% 24.5% 24.6%

Difference (D) 5.7% 5.1% -4.7% 2.1% 4.7%

Interest Rate (i) 4.8% 5.4% 5.0% 5.5% 4.5%

Adjustment (D*i) 0.27% 0.28% -0.23% 0.12% 0.21%

CompCo’s EBIT/Sales (%) 1.32% 2.96% 2.59% 3.31% 4.95%

Working Capital AdjustedEBIT / Sales for CompCo 1.59% 3.24% 2.35% 3.43% 5.16%

OECD Example

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Points to Note

• At what point in time should the Receivables, Inventory and Payables compared? – Averages can be applied

• Which interest rate to use? – Typically borrowing rate, In case tested parties working capital is negative – lending rate may be considered

• When to do a working capital adjustment? – Need based not as a routine

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Management Payouts in the Manufacturing Sector

Typical forms of payouts: Royalty, Technical fee, Management fee, Guarantee fee

Primary challenge – Payouts through having economic substance are challenged in the start up phase due to existing losses

Benchmarking - Is a challenge due to inadequate comparable data in public domain

Documentation - Under the transaction specific approach it is necessary to anlayse potential “cost-benefit” and maintain appropriate documentation to substantiate arm’s length nature of payouts

– Costs - Benchmarking payouts of comparable companies, Basis of arriving at the value of payouts ( Direct / Indirect Method) by the Group

– Potential Benefits - Need for obtaining service from the Group, Analysis of potential benefit obtained by the Company and value attributable to the service

Other Regulatory Considerations: The recent relaxation of the statutory RBI / FEMA limits on royalty and technical fee payouts increases the challenge of defending the arm’s length nature of such transactions.

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Case Study – Royalty payment

Background & Issues

A Company – Earning losses even though in business for over 5 years

Company procured technical know how from Parent - To improve its manufacturing process and quality of product - anticipating future benefits

However, the Company did not earn profits immediately.

The royalty payment had been approved by the Government of India

Solutions

Defend the royalty payment on a stand alone basis, rather than aggregating with other transactions

– Benchmark royalty payouts of other comparable companies

Detailed business and commercial rationale for the transaction should be documented.

Commercial reasons for losses should be detailed

Anticipated benefits to be documented using forecasts

Is royalty payment justified in loss making companies?

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Auto Industry –Typical issues…

Industry factors

Pricing pressures on automobiles results in push back on component suppliers – cost pressure

Extremely competitive industry – Extreme market and price risk

Capital intensive and high fixed cost

Other issues

Dealing with low profits/losses – Are losses attributable to transfer prices - TNMM

Remuneration for routine functions – Distribution function, Contract manufacturing

Bundled goods

Research and Development

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…Auto Industry –Typical issues

Differences between foreign companies and Indian MNCs

High initial import content with steady localisation

Unutilized capacity

Dependent on technical support from Group: High tech fee / royalty payouts

Local documentation preferred to Group global documentation by revenue authorities

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Benchmarking Issues

Well established players (primarily Indian players) earning higher margins vs-a-vis foreign players most of whom are new entrants

New entrants incur initial year losses due to high import content, forex issues, start up costs and idle capacity

New units shall be benchmarked with Indian players without cognizance of years of presence or industry / economic dynamics

Impact on Transfer Pricing

Auto - Foreign / New players

-15

-10

-5

0

5

10

2006 2007 2008 2009

Years

Pro

fit

mar

gin

(%

)

Hyundai Motors -1996

General Motors -1994

Honda Siel - 1995

Ford India - 1995

s

Auto - Established / Domestic Players

-10

-5

0

5

10

15

2006 2007 2008 2009

Years

Pro

fit

mar

gin

(%

) Tata Motors -1945

Mahindra andMahindra -1945HindustanMotors - 1942

Maruti SuzukiIndia Ltd. -

1984

Auto Ancillary

10

7

8

9Profit Margin

(%)

2006 2007 2008 2009

Years

All

Engine parts

KPMG

see if you can change these colours

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Case Study – Auto Industry – Start up unit

Background & Issues

Indian subsidiary of foreign entity engaged in the business of manufacturing and selling cars

International transactions - Purchase of RM, Payment of Royalty and Technical know-how

Being in start-up stage, capacity utilisation at 37.19 percent

Import content at 98.55 percent of total purchases

Issue - Significant losses due to the above

Multiple year data used

Solution

Adjustment to be made for

Non-cenvatable import cost

Higher cost during set-up stage

Lower capacity utilisation

To consider effect of product cycle on multiple year data

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Pharma Industry

Cost contribution and buy in arrangements for R&D

Imports vs. Locals – Application of CUP method

Basic / Applied Research

Government pricing regulations – NPPA, DPCA

Valuation of IPRs

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Guidelines from judicial analysis

Industry Ruling Key principles / Takeaways

Auto Skoda Auto India P Ltd, Pune ITAT

Schefenacker Motherson Ltd, Delhi ITAT

Acceptance of adjustments for better comparability

Reasonable assumptions while performing adjustments

Acceptance of Cash Profits as PLI

Pharma Hoescht, Mumbai ITAT

Ranbaxy Laboratories Ltd, Delhi ITAT

UCB India Pvt Ltd, Mumbai ITAT

Gharda Chemicals Ltd, Mumbai ITAT

Indian government’s price regulations to be factored

Overseas comparables acceptable only if tested party is overseas and data should be available in public domain

High degree of comparability required under the CUP method – Purity, potency and characteristics

Consumer Electronics

Sony India P Ltd, Delhi ITAT

Il Jin, Delhi ITAT

Adjustment towards markets risk, R&D risks and working

capital risks

Impact of idle capacity - Challenge

Guidance on marketing fee

Restrict adjustment to quantum of International transaction

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Way Forward …

Operational Transfer Pricing

– Present focus is on tax documentation

– Harmonious approach between transfer pricing for operational and regulatory purposes

Unspecified Methods

– Presently no clear recognition in Indian Regs

– More reflective of actual process than TNMM approach

– Increased application in US IRS-approved APAs

Advance Pricing Arrangements (APAs)

– Provides upfront clarity and reduces litigation

Safe Harbours

– Useful for Contract Manufacturing etc.

Mutual Agreement Procedure (MAP)

– Alternate to Litigation in Indian courts

– Suspension of tax payment demand subject to MAP

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Contact details

Name : Rohan Phatarphekar

Designation : National Leader – Transfer Pricing

Email : [email protected]

Tel : +919820036156

Documents

Industry Specific Transfer Pricing Issues – Manufacturing Sector The Chamber of Tax Consultants International Fiscal Association – India Branch 23 April