1. Industry Specific Transfer Pricing Issues – Manufacturing Sector The Chamber of Tax Consultants International Fiscal Association – India Branch
23 April 2010
Rohan Phatarphekar Global Transfer Pricing Services National Leader, KPMG India

2. Discussion Points Economic Characterization and Compensation Models 1
Transfer pricing issues – Manufacturing industry
Focus Sectors – Auto and Pharma
Guidance from judicial analysis
Way Forward 1 2 3 4 5

3. Manufacturing Functions
Intangibles
Sales
Inventory
Manufacturing
Intangibles
Sales
Inventory
Manufacturing
Intangibles
Sales
Inventory
Manufacturing
Intangibles
Sales
Inventory
Manufacturing
Functions
and
risks
Principal
Manufacturer
Toll Manufacturer
Contract Manufacturer
Licensed Manufacturer
Profits
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

5. 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
Comparability Adjustments – Specific focus working capital
Payouts - Specific focus on Royalty
Imports Vs Local

7. 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
To-Dos
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

8. Supply Chain Planning Illustrative Sample – Existing Supply Chain
Inputs, raw
materials
Global Suppliers
Local Suppliers
Indian Manufacturer
Foreign Manufacturers
Global sales subsidiaries (local market IP)
Global sales subsidiaries
(local market IP)
Global sales subsidiaries (local market IP)
The chart on this slide depicts the existing value chain. The following points from this structure should be noted –
Multiple IP owners (potential problem in IP management and protection)
Multiple point of contact and duplicative functions across several entities (example, procurement)
Competition internally
Lack of control
Overall, from an operational standpoint, there seems to be lot synergies of window for cost reduction, process optimization and leveraging the global size of the group. And from a tax perspective, the existing structure results in high effective tax rates and potential tax assessment challenges.
This kind of a centralized structure can be approached over a period of time, it doesn't have to be done all at a time. In other words full-scale transformation of the whole supply chain is not the only solution that TESCM offers. Discrete projects in respect of sourcing, manufacturing, support and IP can also be done.
Global Customers
Local Customers
Customer service primarily local; support centers

9. Tax Efficient Supply Chain Model - Illustrative Sample
Corporate
Headquarter
Research
Centers
Shared
Services
Services
Sales &
Marketing
(Limited Risk Distributor]
Services
Sale 1
(flash title)
R&D
services
Management
Services.
Sale 2
Key Entrepreneurial Risk Taker
Intangibles
Trading Risks
Customers
Suppliers
Purchase of
materials
Delivery of
materials
Manufacturing
services
Distribution and logistics services
Delivery of
goods
Manufacturing
(consignment)
Delivery of
goods
Distribution Centers
Legal title
Physical flow
Services

10. 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?

11. Current Business Model
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
High Tax Parent
(R&D; Manufacture)
Royalty
Parts, Tooling, Know-How
Parts
Indian-Sub
(Licensed Manufacturer)
OEM Customer
overseas
China-Sub
(Manufacture)
Third-Party Vendor
Raw Materials & Components
India -Sub P&L (USD million)
Revenue ,100
Less: COGS (1,000)
Less: Royalty (33)
Less: SG&A Expense (111)
Operating Loss (44)
Operating Margin % %

12. 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 issues
Consider Business restructuring options

13. Possible Business Model
High Tax Parent
(R&D; Manufacture)
Lower Tax
Indian-Sub
(Contract Manufacturer)
China-Sub
(Manufacture)
Third-Party Vendor
Raw Materials & Components
Parts, Tooling, Know-How
Parts
OEM Customer
overseas

14. 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
Possible risk adjustment
Removal of outliers - extremes inconsistent with ‘captive’ profile
Use of statistical measure such as inter-quartile range to eliminate outliers
Target arithmetic mean of remaining companies

15. 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.

16. OECD Example… TESTCO Year 1 Year 2 Year 3 Year 4 Year 5 Sales $179.5m
Earnings Before Interest & Tax (EBIT)
$1.5m
$1.83m
$2.43m
$2.54m
$1.78m
EBIT/Sales (%)
0.8% 1%
1.3%
0.9%
Working Capital (at end of year)
Trade Receivables (R)
$30m
$32m
$33m
$35m
$37m
Inventories (I)
$36m
$38m
$40m
$45m
Trade Payables (P)
$20m
$21m
$26m
$23m
$24m
Receivables (R) + Inventory (I) – Payables (P)
$46m
$47m
$52m
$58m
(R + I – P) / Sales
25.6%
25.8%
24.1%
26.7%
29.3%

17. OECD Example… COMPCO Year 1 Year 2 Year 3 Year 4 Year 5 Sales $120.4m
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)
$26m
$24m
$25m
Trade Payables (P)
$11m
$13m
$15m
$16m
Receivables (R) + Inventory (I) – Payables (P)
$35m
$31m
$32m
(R + I – P) / Sales
19.9%
20.6%
28.7%
24.5%
24.6%

18. OECD Example WORKING CAPITAL ADJUSTMENT YEAR 1 YEAR 2 YEAR 3 YEAR 4
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 Adjusted EBIT / Sales for CompCo
1.59%
3.24%
2.35%
3.43%
5.16%

19. 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

20. 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.

21. Case Study – Royalty payment
Is royalty payment justified in loss making companies?
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

22. 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

23. …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

24. Benchmarking Issues Impact on Transfer Pricing Tata Motors - 1945
Auto - Foreign / New players
Auto Ancillary
-15
-10 -5 5 10
2006
2007
2008
2009
Years
Profit margin (%)
Hyundai Motors -
1996
General Motors -
1994
Honda Siel
Ford India s 10 7 8 9
Profit
Margin
(%)
2006
2007
2008
2009
Years
All
Engine parts
Impact on Transfer Pricing
Auto - Established / Domestic Players
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
-10 -5 5 10 15
2006
2007
2008
2009
Years
Profit margin (%)
Tata Motors -
1945
Mahindra and
Mahindra -
Hindustan
Motors
Maruti Suzuki
India Ltd. -
1984

25. 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 percent
Import content at 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

26. Government pricing regulations – NPPA, DPCA
Pharma Industry
Government pricing regulations – NPPA, DPCA
Imports vs. Locals – Application of CUP method
Basic / Applied Research
Cost contribution and buy in arrangements for R&D
Valuation of IPRs

27. 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

28. 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

29. Thank You in.kpmg.com Contact details Name : Rohan Phatarphekar
Designation : National Leader – Transfer Pricing
Tel :
Thank You
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Mumbai
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Kolkata
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