Functions, Assets and Risk Analysis under Transfer Pricing

1 Functions, Assets and Risk Analysis under Transfer Pricing September 23, 2017 Jigna P. Talati What is Functions, Assets and Risk ( FAR ) Analysis Why do a FAR Analysis How to do a FAR Analysis Key Factors in FAR Analysis OECD Guidance Importance of FAR Analysis FAR Analysis of Intangibles Case Studies Economic Analysis Key Takeaways CONTENTS2 What is Functions, Assets and Risk ( FAR ) Analysis 3 What is FAR Analysis FARA nalysisisanexercisetodetermineanddocumen tsignificanteconomicactivitiesperformedb ytheenterpriseanditsassociatedenterprise ( AEs )inanInternationalTransaction Allocationofsignificanteconomicactivitie sbetweenthoseentitiesinvolvedinthetransa ction,soeachentitycanbeappropriatelychar acterised Pricechargedinanytransactionshouldreflec tthefunctionsperformed(takingintoaccount therisksassumedandassetsused)FAR Analysis Characterization Pricing of the transaction 4 Components of Functionsperformed Activitiescarriedoutbyeachofthepartiesto thetransaction Focusshouldbeonidentificationofcriticalf unctionswhichaddvaluetotheinternationalt ransactions of Typeofassetsandtheirnatureneedstobeunder stood Helpsindeterminationoftheircontributiont othebusinessprocess/economicactivity Facilitatesunderstandingofrespectiverole splayedbytheentitiesparticipatingintheIn ternationaltransaction of FAR RisksAssumed Probablevariabilityoffutureoutcomesorret urns Astheriskincreases,thevulnerabilitytoear nprofitincreasesaswell Thepotentialrisksarecompanyandindustrysp ecific Focusshouldbeonimportantrisks Importanttodistinguishbetweenwhichentity bearsrisksasperlegaltermsandwhichonebear saspertheconductofthetransaction7 Why do a FAR Analysis 8 Why do a FAR Analysis Regulations Perspective (2)

2 OftheIncomeTaxRules,1962assertsonImporta nceofFARA nalysis:Comparabilityofaninternationaltr ansactionwithanuncontrolledtransactionsh allbejudgedwithreferenceto(amongothers) ,takingintoaccountassetsemployedandrisks assumed, (whetherornotsuchtermsareformalorinwriti ng)whichlaysdownexplicitlyorimplicitlyho wtheresponsibilities, (Chapter1)ofOECDTPG uidelines,2017listsfunctionalanalysisaso neofthefivefactorsforcomparabilityanalys is Thefunctionsperformedbyeachofthepartiest othetransaction,takingintoaccountassetsu sedandrisksassumed,includinghowthosefunc tionsrelatetothewidergenerationofvalueby theMNEgrouptowhichthepartiesbelong,theci rcumstancessurroundingthetransaction,and industrypractices 9 Toidentifyanappropriaterewardthateachoft herelatedpartiesshouldearnwithrespecttoi ntercompanytransactionsunderreview Todeterminetheeconomiccharacterizationof theentitiesinthetransactionandtoselectat estedparty Todeterminethemostappropriatemethodforbe nchmarkingthetransaction Toidentifyanyuncontrolledtransactioninvo lvingoneofthecontrolledpartiesDetailed FAR Analysis provides in-depth understanding of the business and assists in appropriate characterization of an entity Importance of FAR to do a FAR Analysis 11 Inputs of FAR Analysis FAR Analysis Functions.

3 Assets & RisksAgreements / Terms Financial Results Organization / Staff Forecasts / Business Plans Business Processes Markets / CompetitionEntities / Transactions 12 Outputs of FAR Analysis FAR Analysis Risk and opportunity assessment Determination of most appropriate method Characterization of entities Documentation Pricing Policy Understanding of Business Internal Comparables Basis to search for external comparables13 Process of undertaking FAR Analysis FAR planning process Identifyrelevanttransactionsandtransacti ngentities Industryandgroupbackground Reviewavailableinternal/externaldocument sFAR Interviews PrepareQuestionnaires&identifyinterviewc ontacts CreatedetailedFARquestionnaire ConductInterviewsandmakenotesFAR Documentation Summarizing FAR findings in the documentation report14 Functional Analysis Process FlowOrganization Structure PharmaMNC EntitiesinUS,UK,IndiaandChinaActivities US StrategyandMarketing UK Marketing India R&D China-ManufacturingFunctions US Identifiesproducts,laysbusinessStrategy, Budgetsandforecasts,Getsregulatorycleara nces,marketsandsells UK Getsregulatoryclearances,marketsandsells India ConductsR&D,sells China Manufacturesandsells15 Fact Finding basic information Background information about the enterprise to understand its business operations and activities (Sources: Annual Report, Product brochures, Websites, internal reports) Description of the ownership structure of the enterprise Profile of multinational group of which the enterprise is a part Broad description of the business of the enterprise Broad description of the industry to which the enterprise belongsGathering specific information Functions generally performed by each party to the transaction.

4 Assets generally employed in a transaction Risks generally assumed by each party to the transaction Contractual terms that have effect on Transfer prices are also to be examined (Sources: Written contracts, agreement, correspondence / communication between the parties) Gathering relevant documents Agreements, common group policies etc. Product brochures, marketing materials etc. Documents providing information such as marketing strategies, Pricing strategies etc. Information about major competitors, customers, market, Questionnaire Typical DistributorBelow are certain important questions for FAR Analysis of a Distributor Who is responsible for market surveys? Who monitors market demand? Who is responsible for devising advertising and promotion strategies? Who formulates the budget? Who bears the costs? Who is responsible for scheduling the distribution of the products in the market?

5 Who is responsible for holding the inventories on hand? Who determines the product Pricing ? Do these require approval from the manufacturer/ principal distributor? Is there an existing distribution network or the distributor is engaged in developing of a distribution network for the product? Who owns the intangibles in the products distributed? Who undertakes the DEMPE functions in relation to the brand Is there a need for installation and after-sales services? Who is responsible for providing these services? Who formulates warranty policies? Who bears the warranty costs? Who bears the risk on account of bad debts Who would bear the risk in case the product does not perform as per standards? Who takes title of the merchandise distributed? 17 Key Factors in FAR Analysis 18 Key Factors in FAR Analysis Sheer volume of functions performed is not decisive -What is relevant is the relative importance of each function Functions performed may be few but significant Identify each party s contribution (Taxpayer & AE) to every function performed Functions are the terra firma for identifying and assigning risks to an entity Aggregation of International Transactions -only if FAR Analysis of such transactions is aligned 19 OECD Guidelines Importance of FAR Analysis 20 OECD Guidelines Importance of FAR SectionDofChapterIoftheOECDG uidelines,2017states.

6 Accuratelydelineatetheactualtransactions byanalyzingthecontractualrelationstogeth erwithevidenceoftheactualconductofthepar ties Detailedguidanceonanalyzingrisksasintegr alpartofafunctionalanalysis,includingsix stepanalyticalframework Partyassumingriskshouldcontroltheriskand havethefinancialcapacitytoassumetherisk Capital-richMNEgroupmemberwithoutanyothe rrelevanteconomicactivities( cashboxes )thatprovidesfunding,butcannotcontrolfin ancialrisksinrelationtothefunding,willat tainnomorethanarisk-freereturn,orlessift hetransactioniscommerciallyirrationalShi ft focus from the legal form to the economic reality of a transaction 21 Six-step analytical framework1. Identification of economically significant risks 2. Determination of contractual assumption of the specific risk3. Functional Analysis in relation to risk4. Interpreting steps 1-35. Allocation of risk6. Pricing the transactions taking into account the allocation of risksIf AE (contractually) assuming the risk does not exercise control over the risk or does not have the financial capacity to assume the risk, then risk should be allocated to enterprise exercising control and having financial capacity to assume risk22 FAR Analysis of Intangibles 23 FAR Analysis of Intangibles , (DEMPE Functions, assetsandrisks) (focusonDEMPE functionsandrisks,etc.)

7 Slengthpricesforcontributions Allocation of returns from the exploitation of intangibles should especially be based on which parties perform the DEMPE functions, assume the risks and provide funds or other Assets Legal ownership becomes less important24 ExploitationProtectionMaintenanceEnhance mentDevelopmentDEMPE Functions are the key 25 Case Studies 26 Typical FAR of ManufacturersFAR Types of Manufacturer Functionsand Assets Full FledgeLicensed ContractTollOwns non-routine technology IP (R & D YesNoNoNoOwns Material YesYesYesNoManufactures for himself YesYesManufactures on behalf of others YesYesMarketing YesYesNoNoSales & Distribution YesYesNo NoRisk NormalLess than NormalLimited MinimalMarket RiskYesYesN(Minimal)N(Minimal)Price Risk YesYesNoNoInventory RiskYesYesYesNoCapacity RiskYesYesLimited NoProduct Liability RiskYesYesNo NoWarranty Risk YesYesLimited to re-workLimited to re-workTechnology R & D RiskYesNoNoNo27 Typical FAR of DistributorsFAR Types of Distributor Functionsand Assets MarketerDistributorNormal DistributorLimited Risk DistributorMarketing Yes (Extensive)Yes (withinindustry standards))

8 MinimalAfter Sales ServicesYesYesYesInventory Management YesYesMinimalFurniture / Fixtures / Communication facilities YesYesYesWarehousing facilitiesYesYesYesMarketing Intangibles YesNoNoCustomer List YesYesNoRisk NormalLess thannormalLimited Market RiskYesYesMinimalPrice Risk YesYesNoInventory RiskYesYesMinimalProduct Liability RiskYesNoNoCredit RiskYesYesNo Warranty RiskYesYesNo28 Typical FAR of Service ProvidersFAR Types of Service ProvidersFunctionsand Assets Entrepreneur / Normal risk serviceprovider Low risk service providers Limited risk / Captive serviceproviders R & DYesNoNoSignificant People functions YesNoNoQualityYes assume overall responsibilityLimited to the extent of services performed Limited to the extent of services performed Marketing YesYesNoRisk NormalLess thannormalLimited Man Power recruitment / attrition YesYesYesService liability YesTo the extent of service performed NoCapacity utilization risk YesNoNoRegulatory YesYesYesForeign Exchange YesYesNoCredit RiskYesNo No Advances 29 Case Study 1 ABC USAABC IndiaOutside IndiaIndiaImport of Products Entities InvolvedFunctions Performed-Manufacture-Research & Development -Quality Control -Sales & Distribution -Distribution -Warehousing / Inventory CustomersDistributionFacts ABC USA develops, manufactures and markets cancer related products ABC India is engaged in the business of import and resale of these products in India30 Typesof RiskABC India ABC USAP roduct Development RiskNoYesMarket Risk Yes (limited)YesManpower RiskYesYesCredit & Collection Risk YesYesGeneral Business RiskYes(limited)

9 YesForeign Exchange Risk YesNoTypesof AssetsABC India ABC USAE mployeesYesYesProperty, Plant & Equipment YesYesIntangibles such as trade licenses, know-how, Study 1 ABC USA should be characterized as the 'Entrepreneur ; and ABC India as 'Limited Risk distributor'Economic Characterization Based on the FAR Analysis 32 Case Study 1 Case Study 2 XYZ IndiaXYZUSAP rocurement & Warehousing R & DManufacturingManufacturingDesign and Engineering Marketing & Promotion Quality Assurance Procurement & SalesExport of Finished Goods Invoicing & CollectionXYZ India and XYZ USA performs the following functions:33 Case Study 2 XYZ USAXYZ IndiaOutside IndiaIndiaSale of finished goodsScenario 1: When XYZ India sells components to AE as well as third partiesThird parties Sale of finished goodsThird party supplier Third party supplier Purchase of components Purchase of components 34 Case Study 2 XYZ India: Normal Risk Manufacturer XYZ USA: Normal Risk ManufacturerEconomic Characterization 35 Case Study 2 XYZ USAXYZ IndiaOutside IndiaIndiaSale of finished goodsScenario 2.

10 When XYZ India sells components to only to its AEThird party supplier Third party supplier Purchase of components Purchase of components 36 Case Study 2 XYZI ndia:RighttorighttoselltoAEonly-Characte rizedasacontractmanufacturer XYZUSA:EntrepreneurEconomic Characterization 37 Economic Analysis38 Economic Analysis Process FlowFunctional Analysis -Functions-Risks - Assets Entity Characterization Tested Party Economic Analysis -Selection of Most Appropriate Method -Benchmarking Financial Analysis -Profit Level Indicator-Arms Length Price Determination 39 Key Takeaways 40 Key Takeaways RobustFARanalysisisthefoundationofasound TransferPricingAnalysis ComparabilitystrictlybasedonFAR-intangib les,risksplayimportantrole Adjustmentstocomparablesnecessarytoaccou ntfordifferencesinFAR41 Thank YouJigna P. TalatiMobile: +91 983302119942