Methods of determining ALP 3rd Intensive Study Course on Transfer Pricing Methods of determining ALP CA Vishwanath Kane 16 February 2013

Agenda Introduction Transfer Pricing Methods Overview Applicability of Transfer Pricing Methods Transfer Pricing Methods A) Traditional Transaction Methods i) Comparable Uncontrolled Price Method (CUP) ii) Resale Price Method (RPM) iii) Cost Plus Method B) Transactional Profit Methods i) Profit Split Method ii) Transactional Net Margin Method (TNMM) C) Residuary Method – Other Method Summary of Transfer Pricing Methods

Introduction – Transfer Pricing Transfer pricing provisions - To avoid shifting of profits to low tax Jurisdiction countries or tax heavens and India to get its share of tax International Transactions with Associated Enterprise (AE) to be at Arms Length Price (ALP) Computation of ALP using Most Appropriate Method (MAM) Transfer Pricing methods are prescribed in Section 92C Associated Enterprise Corporate Independent Enterprise Price $A Price $B $A = $B * The overarching premise is that, for the purpose of establishing profits for tax purposes, the price between associated enterprises (controlled transaction) should be same as would have been charged between independent enterprises (uncontrolled transaction)

Selection of TP methods Transfer Pricing Methods Overview Traditional Transaction Methods (Preferred methods) Transactional Profit Methods Residuary Method Profit Split Method (PSM) Transactional Net Margin Method (TNMM) Contribution Analysis Residual Analysis Any other method as provided in rule 10AB The slide only shows TNMM, however, CPM (Comparable Profit Method) is a possibility. Comparable Uncontrolled Price (CUP) Resale Price Method (RPM) Cost Plus Method (CPM)

Selection of TP methods Transfer Pricing Methods Overview No order of priority for selection of methods Taxpayer has the option to choose the Most Appropriate Method Methodologies prescribed are in line with OECD Guidelines Rules 10B and 10AB describe the TP methods Where more than one method can be applied the ALP shall be calculated on average mean of all such computations The slide only shows TNMM, however, CPM (Comparable Profit Method) is a possibility.

Selection of TP methods Applicability of Transfer Pricing Methods The applicability of a transfer pricing method depends on the: Comparability of controlled and uncontrolled transactions in terms of: characteristics of property or services, functions performed, risks borne, Contractual terms, economic circumstances, and business strategies Data and information: availability of information reliability of assumptions, sensitivity of deficits in data and assumptions Purpose of its application, i.e. for planning, defending, documenting, reviewing or opposing transfer prices The slide only shows TNMM, however, CPM (Comparable Profit Method) is a possibility.

Traditional Transaction Methods

Controlled transaction Uncontrolled transaction The CUP Method What is CUP Method? Compares the price charged in a controlled transaction to the price charged in a comparable uncontrolled transaction in comparable circumstances. High degree of comparability of products and functions are required. Differences are allowed if 1) they do not materially affect the price in the open market, 2) effect on price can be reliably measured & adjusted. Compare Price $A & $B Associated Enterprise Corporate Independent Enterprise Price $A Price $B Controlled transaction Uncontrolled transaction Factors to Consider Product similarity (similar type, quality, quantity, features, etc) Seasonality (e.g., air conditioner, ski) 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.) Other factors that might affect comparability 34

The CUP Method Continued… Internal CUP Related party Manufacturer Non-related party Internal CUP application Prices in any comparable dealing between the Company and an independent party; or Prices in any comparable dealing between the associate enterprise who is a party to the transactions with the Company and an independent party. Non-related party A Non-related party B 34

The CUP Method Continued… External CUP Sale of Goods ‘Z’ to AE INDCO (India) USCO (USA) Sale of Goods ‘Z’ Independent Company X (China) Company Y (USA) External CUP application Prices in comparable dealings between two independent third parties Permissible adjustments for comparability

The CUP Method Continued… High degree of comparability required Mostly used in Benchmarking of transactions like – Sale / purchase of goods, Interest rate, Rate of Royalty and Guarantee Fee Benchmarking Preferred by Tax Authorities Globally The slide only shows TNMM, however, CPM (Comparable Profit Method) is a possibility.

The CUP Method Continued… Since CUP method requires high degree of comparability, the adjustments proposed to be made to make the controlled and uncontrolled transactions comparable are : Geographic market in which the transaction takes place Quality of the Product or service Volume Foreign Currency Risk Intangible property associated with the sale Level of the market (i.e. wholesale, retail, etc.) Contractual terms (e.g. Scope and terms of warranties provided, sales or purchase volume, credit terms, transport terms) Date of transaction

The CUP Method Continued… CUP has a number of problems: insufficient market transparency for identifying comparable companies difficult to accomplish necessary adjustment calculations which eliminate material differences For some reasonably accurate adjustments can be made, but for products and markets its not feasible some adjustment calculations even seem to be mutually contradictory The slide only shows TNMM, however, CPM (Comparable Profit Method) is a possibility.

The CUP Method – Case Law Sl. No. Case Citation Ruling 1. Serdia Pharmaceuticals (India) Private Limited vs. ACIT 445 SOT 391 (ITA Nos: 2469/Mum/06, 3032/Mum/07 and 2531/Mum/08) The assessee, a pharmaceutical company, imported ‘Active Pharmaceutical Ingredient’ (‘API’s) from its foreign associated enterprises (‘AE’) and used them for manufacture of drugs. For transfer pricing purposes, the assessee adopted the ‘Transactional Net Margin Method’ (“TNMM”) as the most appropriate method and claimed that its transactions with the AE’s were at arms length on the basis that the assessee’s operating profit at 8.76% on net sales was higher than that of its comparable competitors. However, the TPO held that the assessee had purchased the APIs from the AE’s at prices that were higher than that paid for similar APIs by other companies in India. He rejected the contention of the assessee that the higher prices paid by the assessee were justified owing to their superior quality. The TPO held that the TNMM was not a “reliable” method and that the Comparable Uncontrolled Price (‘CUP’) was, on facts, the most appropriate method and computed the arms’ length price (‘ALP’) on that basis. On appeal, the CIT (A) upheld the stand of the TPO. On further appeal by the assessee, the Mumbai Tribunal dismissed the appeal of the assessee on the ground that for generic drugs, CUP is appropriate method despite quality differences. The slide only shows TNMM, however, CPM (Comparable Profit Method) is a possibility.

Resale Price Method (RPM) What is Resale Price Method? Based on the price at which a product that has been purchased from an associated enterprise is resold to an independent enterprise The resale price is reduced by the resale price margin and this result can be regarded, after adjustment for other costs associated with the purchase of the product, as an arm’s length price of the original transfer of property between the associated enterprises. (OECD Guidelines, para 2.14) Factors to Consider Ordinarily used in cases involving the purchase and resale of tangible property Reseller has not physically altered the product or added substantial value Packaging, labeling or minor assembly are acceptable Reseller does not apply intangible assets to add value Functional/ accounting similarity is required 34

1 2 3 Steps Resale Price Method Continued… 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 34

Whether the transaction is at arm’s length? Resale Price Method Continued… Particulars Amount in INR Sale price to uncontrolled entity 1,00,000 Cost of goods sold 85,000 Arms Length Gross Profit Margin – 15% 15,000 Arms Length Price Purchase price from Associated Enterprise 92,000 Whether the transaction is at arm’s length? 34

Resale Price Method Continued… Applicable in buy and sale transaction Benchmarking of distributor adding no value to tangible goods but incurring heavy AMP costs Maruti Suzuki India Limited (Delhi High Court - 328 ITR 210) Tested party margin at Net Level V/s Gross Level 34

Resale Price Method Continued… RPM has a number of problems: identifying identical or similar functional and risk profiles; facing differences in accounting practices, mainly with respect to costs of goods sold; and eliminating influences from different economies of scale. 34

Resale Price Method – Case Law Sl. No. Case Citation Ruling 1. ITO vs. L’Oreal India P. Ltd ITA No. 5423/Mum/2009 The Tribunal upheld the use of Resale Price Method over TNMM where assessee bought products from AE and resold them without further processing; ITAT agreed with the CIT(A)’s observation that there is no order of priority of methods to determine ALP. ITAT noted that OECD Guidelines stated that in case of distribution and marketing activities, when the goods are purchased from AEs which are sold to unrelated parties, RPM is the most appropriate method. The slide only shows TNMM, however, CPM (Comparable Profit Method) is a possibility.

Cost Plus Method What is Cost Plus Method? Costs incurred by the supplier of property/service in a controlled transaction for property transferred or service provided to a related purchaser. An appropriate cost plus markup is added to this cost to make an appropriate profit in light of the functions performed & market condition. This result may be regarded as an arm’s length price of the original controlled transaction (OECD Guidelines, para 2.32) Factors to Consider Cost should include all costs associated with the process (manufacturing, provision of services) upto manufacturing stage like raw materials, labour, electricity, factory rent, etc. Product Comparability required is low Mark up applied to the total cost is set or tested having regard to the third party comparable mark ups. Profile of the parties involved High degree of functional comparability Assets employed Accounting differences, etc. should be considered 34

1 2 3 Steps Cost Plus Method Continued… Compute the direct and indirect cost incurred in controlled transaction 2 Determine the normal gross profit margin earned in similar uncontrolled transaction 3 Apply the margin in step 2 on amount arrived at in step 1 after making the necessary adjustments, if any to arrive at the ALP 34

Cost Plus Method Continued… Particulars Independent Entities Chinese subsidiary (Amount in Rs.) Direct Cost 100,000 300,000 Indirect Cost 50,000 150,000 Total Cost 450,000 Cost plus mark up (%) 8% 10% Mark up 12,000 45,000 Details of Transactions: Since the mark up earned by Indco from its Chinese subsidiary is higher than that of mark up earned from independent parties, the transaction with the Chinese subsidiary is at arm’s length 34

Cost Plus Method Continued… Generally used to benchmarking of service providers and manufacturers Issue of cost base in determination of cost plus mark-up in case of contract manufacturer and contract service provider Pre checks before selecting CPM: Ensure that inefficiencies do not result in higher profits as costs increase Also must be taken into account that there is often no direct link between the amount of the costs incurred and the market price, i.e. arm’s length price it requires extensive information about the cost base used in comparing the mark-ups reasonable adjustments may not be possible when looking at external comparable companies. 34

Cost Plus Method – Case Law Sl. No. Case Citation Ruling 1. L’Oreal India Pvt. Ltd., Mumbai vs Department Of Income Tax ITA No. 6745/M/2008 The assessee company is a subsidiary of L'Oreal SA France engaged in the business of manufacturing and distribution of cosmetics and beauty products (contract manufacturing). The TPO rejected CPM and adopted TNMM as the MAM and proposed an adjustment of Rs. 1.99 crores (approx) on its international transaction of purchase of raw materials. The CIT (A) order stated that “CPM is applied to test the price of goods that are manufactured and then sold or to measure the value of services performed by a service provider and is generally appropriate when the party being examined is not engaged in significant value adding activities”. Accordingly, the Tribunal upheld the categorical finding of the CIT(A) that the Cost Plus Method adopted by the assessee is based on the functions performed and not on the basis of types of product manufactured, as normally the pricing methods get precedence over profit methods. The slide only shows TNMM, however, CPM (Comparable Profit Method) is a possibility.

TNMM – Case Law 1. Dishman Pharmaceuticals & Chemicals Ltd. Sl. No. Case Citation Ruling 1. Dishman Pharmaceuticals & Chemicals Ltd. ITA No.154 & 587/Ahd/2007 & ITA No.2180 & 3213/Ahd/2007 The Tribunal held that given the facts of the case, use of internal CUP was not appropriate for benchmarking international transaction of exports to associated entities due to various differences. The Tribunal observed differences on account of (a) low volume, (b) sales within Indian market and (c) sales to different geographical location having incomparable economic and political risks. Relying on OECD guidelines, the Tribunal also upheld the contention that TNMM is not the method of last resort and accordingly allowed TNMM applied by the assessee. The slide only shows TNMM, however, CPM (Comparable Profit Method) is a possibility.

Summary of Transfer Pricing Methods Traditional Transaction Methods CUP - This method compares the transfer price directly with similar products sold in an independent uncontrolled situation RPM - When a buyer in an intercompany transaction in turn sells to an independent party, the RPM compares the gross profit margin with that achieved in a similar, uncontrolled transaction OECD guideline and LCITA (Law for the Coordination of International Tax Affairs) which is Korean transfer pricing regulation state that traditional methods are preferred method. However, this may not be the case for other jurisdictions. For example, in the US, “best method rule” applies. CPM - For this method, the gross profit earned by the intercompany sale is compared with a similar independent transaction. This approach is typically used where goods are manufactured or assembled and then sold within the group. In this instance the goods compared do not have to be identical, but should perform similar functions.

Other Method The other method evaluates the arm’s-length character of a controlled transaction by comparing the price charged in the controlled transaction to the price charged or would have been charged in a same or similar uncontrolled transaction in comparable circumstances. Under this method, quotations, price list, data referred to in commercial negotiations, data points reflecting market trend and other evidences may be relied upon. One needs to mention the reason for accepting/ rejecting the method based on the functional analysis. Also, reasons for considering Internal or External comparable companies are required to be mentioned. 34

Way forward… Most Appropriate Method to be selected and applied based on facts and circumstances of the case (FAR, Data availability important) Each year is a separate year - Different method can be used in each year - Principle of res-judicata not applicable What happens if the TPO rejects the method applied by assessee in one year and in the next year the method selected by the TPO results in positive result 34

Thank you Vishwanath Kane vkane@deloitte.com Mobile No. 98190 43126 Landline No. 6185 4325