2. PHARMACEUTICAL INDUSTRY CASE STUDY Presentation by Alpana Saksena CIT(A) International Tax MUMBAI

3. Facts of the case ABC India is engaged in the manufacture and marketing of formulations Main transactions were – Payment of Commission to AE Rs 12.86 crores – Import of Actives transaction Rs 113.8 crores

4. Method of Computing ALP Operating Profit Margins of ABC India 13.87% ABC India aggregated all transactions  Applied the TNMM method  Used a set of external comparables  to benchmark profits Operating Profit Margins of Comparable companies 7.53%

5. Commission transaction

6. Commission transaction Payment of Commission @12.5% of Sales Marketing & Canvasser services for exports as per agreement ABC India ABC AE Assessee's Contention

7. ABC India compares its OPM with the OPM of external comparables by aggregating all transactions Commission transaction Taxpayer’s Contention Which were Imports of actives Commission Sundry Reimbursements Export of formulations

8. Comparisons of Operating Profit margins Operating Profit Margins of ABC India 13.87% So, So, ABC India stated that its transactions Operating Profit Margins of Comparable companies 7.53% are at arms length

9. Justification for commission payment  For establishing close contacts with customers  For employing marketing personnel for marketing these products  For participating in exhibitions, fairs, buyer/seller meets, seminar, conferences  To promote products through doctor’s meets, & conferences Taxpayer's contention  To distribute information material,leaflets, pattern cards etc.

10.  Copy of Agreement called “Export Canvasser agreement ”  Some advertisements of overseas AEs  Letters from overseas AEs to assessee  CA Certificate / Bank Realization Certificates To support payments Documents produced

11. Documentation Rules Prescribed by rule 10D of the I.T. Rules Lays down 13 different types of information which should be maintained  Enterprise –wise documents  Transaction specific documents  Computation related documents They are (broadly speaking)

12. Documentation Rules The Rule 10D(3) states that information in sub- rule (1) shall be supported by f) letters & other correspondence relating to terms of contract (g) documents required to be kept under the accounting practices followed. authentic documents which include

13. Documents which should have been produced  Reports of contacts with customers  List of marketing personnel hired for the purpose  Details of participation in exhibitions, fairs, buyer/seller meets, conferences,seminars  List of doctors approached for using product  Copies of information material,leaflets, pattern cards distributed

14. As no such documents were produced Commission payment was not authenticated In the opinion of revenue

15. Objected to aggregation of all transactions for benchmarking them Insisted for commission was not closely linked to other transactions if imports, reimbursements No justification given for rate of 12 % paid Revenue's Contention Separate set of required for benchmarking Commission Payment similar independent comparables separate evaluation of commission

16. Similar comparables would mean Who had paid commission or any other expense to any foreign party All such cases To promote their sales So we needed to look at foreign expenses be it marketing Advertisement Sales promotion As a percentage of sales Commission

17. Which means Foreign expense to sales ratio We needed to look at the

18. 'Result' based Export Canvasser Agreement not 'effort' based Results showed 15% increase in sales as compared to previous year Taxpayer’s counter plea Commission transaction Hence, transaction is at Arms Length

19. Taxpayer took another plea Domestic sales Domestic Selling expenses ratio Export sales Foreign Selling expenses (Commission) ratio 480 Crores 16.14% 103.08 Crores 12%

20. Assessee pleaded that………  costs in India would be lower than the costs of promoting products in an overseas market  As the export selling expenses of 12% were less than the domestic selling expenses of 16.14%  So the commission payment to AE was at arms length

21. So dept asked assessee to do the analysis first ABC India carried out an analysis of computing the ‘Foreign exchange expense’ to ‘Sales’ ratio for the pharma companies (comparable in size to ABC India).

22. Sl No Company Total forex outflow (in crores) Total export sales Forex outflow as % of export sales 1 A Co 3.1866.785 2 B Co 2.795.4251 3 C Co 2.0022.339 4 D Co 0.481.583 5 E Co 7.7213.0359% Average forex outflow on sales 25.40% Analysis given by assessee

23. Defects in assessee’s analysis  huge variations in the outflow  Some companies have a outflow as high as 59% and some as low as 3%.  Extraordinary reasons would exist for such heavy outflows…not explained by assessee  Most of the companies had paid Royalty for brand…hence not comparable

24. Department rejects assessee’s contentions Dept carried out analysis on the same set of comparables originally used for TNMM analysis by the taxpayer, for benchmarking its profits instead of the new 5 companies selected by ABC India

25. Basic criteria for selection  Only those independent companies were short listed who  Matched the Export sales to Gross sales ratio  The taxpayer had a ratio 25% of export sales / Gross sales

26. Analysis of forex outflow / export sales of Independent comparables Company Name Export sales / Gross sales ratio Forex expense / Export Sales ratio F Co27.28%2% G Co27.20%2% H Co16.88%6.8% I Co13.73%2% J Co10.35%13% K Co19.70%4% Average4.96%

27. F.Y. 2002-03 - 5 % allowed (claimed 12.5%) F.Y. 2003-04 - 7 % allowed (claimed 12.5%) Adjustment was made to the ALP by taking rate of 5% instead of 12% as claimed by assessee Commission transaction evaluated separately Final Outcome:

28. Thank you