Transfer Pricing Establishing policy for an MNC

1 Transfer PricingEstablishing policy for an MNCS amir Gandhi & Bhupendra Kothari 2015 Deloitte Touche Tohmatsu India Private LimitedContents Structuring a Transfer Pricing policy Key Issues The Optimum Business Model Transfer Pricing as Planning Tool2 Structuring a Transfer Pricing policy3 2015 Deloitte Touche Tohmatsu India Private LimitedKey considerations for Transfer Pricing policyGeneral issuesIssuestobekeptinmindwhilestructuri ngaglobaltransferpricingpolicy: GlobalTransferPricingpolicyshouldclearly defineanddocumenttheglobalsupplychainoft hemultinationalgroup Termsandconditionsofcross-bordertransact ionsbetweenrelatedpartiesshould,asfarasp ossible,besubstantiatedbyanagreement: wouldensuretransparencyininter-companyde alings providecomfortduringauditproceedings Needtostrengtheninternalsystemsandproces sesinordertomaintaintransactionallevelda taandcollatecontemporaneousdocuments TransferPricingdocumentationshouldberobu st,updatedandmonitoredonayearlybasisbase donthejurisdictionsrequirement4 2015 Deloitte Touche Tohmatsu India Private LimitedSupply Chain Management ProcessSupply chain business process starts right from Supply chain planning Forecasting.

2 Sales and marketing Sourcing and procurement Manufacturing Order management & Logistics management Delivery to customerManufacturingStorageDistributorR etailerExternal SupplierCustomerCentral Service Provider5 2015 Deloitte Touche Tohmatsu India Private LimitedManufacturing FunctionsManufacturingToll ManufacturerInventoryContract ManufacturerSalesLicensed ManufacturerIntangibleFull Fledged Manufacturer+++Functions and Risks6 2015 Deloitte Touche Tohmatsu India Private LimitedManufacturing Models7 Traditional / Fully fledged ManufacturingThe manufacturer owns intangibles and manufactures product for its own risk and contract manufacturer produces goods to order for and for the risk of the principal company. A contract manufacturer buys materials and sell finished goods to principal. However, it has less risk and earns a lower profit than a traditional manufacturer.

3 A toll / consignment manufacturer processes goods belonging to the principal company and never takes ownership. It assumes less risk and earns a lower return than a traditional manufacturer. Distributorsellfinished goodssellRisks: Inventory Warranty Intangibles Capital buymaterialsCustomerManufacturersellRisk s Inventory Warranty Intangibles Working capitalsellfinishedgoodsRisks: Capital Working capitalbuymaterialsPrincipalcompanyDistr ibutorManufacturersellCustomerPrincipalc ompanyDistributorManufacturerCustomerbuy materialsservicefeeprocessingServicessel lsellRisks: CapitalRisks Inventory Warranty Intangibles Working capitalContract ManufacturingToll / Consignment Manufacturing 2015 Deloitte Touche Tohmatsu India Private LimitedKey considerations for Transfer Pricing policyManufacturing activity TransferPricingpolicyformanufacturingisc omplexandhastotakeintoconsiderationpossi bilityofinternalcomparable Typicalmanufacturingstructuresmayinclude a)fewsubsidiariesfocusedonmanufacturinga ndrestdistributionb)oneoverseasentityinm anufacturing(motherplant)restalldistribu tionentities Inthebelowstructure,AEmanufacturingentit yimportsrawmaterialsfromparentandmanufac turescomponentfordomesticandexportconsum ption GrosslevelcomparisonofsalestoAEvis- -vis3rdpartysalescanbemadetoreviewthepro fitabilityIndian parent (exports raw materials)AE manufacturing entity (country X)Export sales to AE (country Y)

4 Sales to 3rdparties (country X)8 2015 Deloitte Touche Tohmatsu India Private LimitedKey considerations for Transfer Pricing policyManufacturing activity PricingofimportedrawmaterialsbytheAEisan essentialconsiderationforestablishingaef fectiveTPpolicy: Pricesensitivityofthesalemarketalsoimpor tantconsideration Localregulatoryenvironmentfavoringmanufa cturing( ,specialeconomiczones)alsoimpactscostsan dprice Anotherimportantissueistheextentofvaluea dditionmadebytheAEinmanufacturingprocess Manufacturingset-upcouldrangefromassembl yoperationattheverylowendofthescaletoful lyintegratedmanufacturingactivityandbein ganOEM Theextentofvalueadditionwouldbeakeydeter minantinestablishingtransferpricingallow inganarm slengthcompensationforsuchfunctions TheoverseasAEmaybelicensedtousetechnolog yandknow-howinreturnforroyaltypayments Separatebenchmarkingforroyaltyandbenefit testdocumentation9 2015 Deloitte Touche Tohmatsu India Private LimitedJudicial precedentsSonaOkegawaPrecisionForgings(2 011)

5 TPOdisallowedroyaltypaymentconsideringth attheassesseisacontractmanufacturerandno royaltyneedstobepaidifitisusingthetechni calknowhowtomanufacturegoodsandsellthesa metoitsgroupcompaniesitself. (2013) Assesseepurchasedrawmaterialandothercons umablesonitsownaccountandentireriskofman ufacturingwasbornebytheassesse. TPOhasdisallowedroyaltypaymentconsiderin gthattheassesseisacontractmanufactureran dnoroyaltyneedstobepaid. ITAT wasoftheopinionthattheassesseewasmanufac turinggoodsonlyontheinstructionsofthepri ncipalcompanybuthowever,sellinggoodstoth irdpartiesalsoandthefactsofthecasewereun likeacontractmanufacturer. Thus, 2015 Deloitte Touche Tohmatsu India Private LimitedKey considerations for Transfer Pricing policyDistribution activity ,low-riskdistributor,fullfledgeddistribu tororsomewhereinbetween Inthebelowstructure,AEdistributionentity importsfinishedgoodsfromparentandsellsit initsdomesticmarket Underalowriskdistributionmodelthetransfe rpricingmethodshouldbesuchthatitresultsi naconsistentmarginoveraperiodoftime Returnforlowriskdistributorsindeveloping marketsaregeneralhigherthancorresponding marginsindevelopedeconomiesIndian parent (exports finished goods)AE distribution entity (country X)Sales to 3rd parties (country X)11 2015 Deloitte Touche Tohmatsu India Private LimitedKey considerations for Transfer Pricing policyDistribution activity Incontrast,afullfledgeddistributorwould.

6 Takemarketingandcreditrisk performsignificantbrandbuildingexercises bewillingtodynamicallychangepricingstrat egiestoincreaseitsmarketshare Performvalueaddedservicessuchaspackingan dlabeling,logistics,pre-salespresentatio nandaftersaleservices Accordingly,afullfledgeddistributorhasto haveapolicythatcompensatesforsuchvaluead dedfunctions Thedeterminationofthe mostappropriatemethod willdependonthelevelofvalueadditionalsoc onsideringanymarketingintangiblescreated Profitabilityofadistributoralsodependson thesellingstrategyandchanneladopted Ifdistributorundertakestoestablishitsown distributionnetworkitmayresultininitialy earlossesdotodisproportionatecostsincurr ed Howeverinlateryearsgreaterprofitsareexpe ctedonaccountofimprovedefficiencies12 2015 Deloitte Touche Tohmatsu India Private LimitedDistribution FunctionsSales disclosed PrincipalCommission AgentUndisclosed PrincipalCommissionaireInventoryBuy-sell distributor / ResellerMarketing IntangibleFull Fledged Distributor+++Functions and Risks13 2015 Deloitte Touche Tohmatsu India Private LimitedSales Models14 Fully fledged

7 DistributorA full distributor bears market risk, holds inventory for its own risk and sells to the customer as principal. The distributors profit margin reflects its risks and functions. Limited Risk DistributorA master distributor bears market risk and inventory risk. The local limited risk distributors buy product from the master distributor and resell the product to the customer. The limited risk distributors earn a lower profit than a full distributor, consistent with their reduced functions and civil law concept whereby the commissionaire sells product in its own name but for the account of the principal. The risks and benefits of the sale (and the profit) rest with the principal. The commissionaire receives a commission which provides it with a lower profit than a full distributor, consistent with its reduced functions and goodssellCustomerManufacturer Price risk Volume risk Inventory risk Credit risk Marketing intangiblesPrincipalcompanyCommissionair eCustomersellcommission Price risk Volume risk Inventory risk Credit risk Marketing intangiblessellPrincipalcompanyDistribut orsellCustomer Price risk Volume risk Inventory risk Credit risk Marketing intangiblesThe local sales company acts as a representative that is not directly involved in making sales.

8 It merely provides product information and performs customer service. The principal receives sales orders directly from customers -either in a call centre or electronically. The local representative earns a lower profit than a full distributor, consistent with its reduced functions and fee Price risk Volume risk Inventory risk Credit risk Marketing intangiblesProduct info and customer servicesOrder 2015 Deloitte Touche Tohmatsu India Private LimitedDistributorship and Berry RatioBerry ratio is the ratio of gross profit to operating expenses. It is primarily used in the case of pure/routine distributors; entitled to a return on its operating expenses alone; the return is primarily dependent on the extent of services provided and not on the market value of the products distributed; does not perform any value addition to goods; and does not own non-routine ( ,greateristhegrossprofitneeded,tosustain theoperatingexpenses).

9 15 2015 Deloitte Touche Tohmatsu India Private LimitedJudicial (2014) Assesseewasactingasamediumofcommunicatio nthroughwhichtheycancompetewithitsassoci atedenterprisescompetitorsinIndiaperform ingdistributionactivities. Assesseebelievedsinceitwasonlyfrontendin gthegroupcompaniesoperations,itwasaservi ceprovider. However,ITAT statedthattheassessewasanintermediary(di stributor)performingbuysellactivitiesand notcarryinginventoryriskandsinceallitsex penseswhichanassesseneedstobecompensated for,werecapturedinitsoperatingexpenses, (2011) Theassesseeperformeddistributionservices foritsassociatedenterpriseinUS. Sincedistributorsshouldearnareturncommen suratetoitsservicesandthecostofwhichisco veredinitsoperatingexpenses, 2015 Deloitte Touche Tohmatsu India Private LimitedKey considerations for Transfer Pricing policyServices IndianMNCsprovideavarietyofITandITeStogl obalmultinationals,includingengineeringd esign,backoffice,procurement,financialan danalyticalservices Inthebelowstructure,Indianparenthasacent raldevelopmentcenterincountryYandanonsit edeliveryentityincountryXtoprovidethefin alproduct Mostdevelopmentcentersareset-upasriskfre eserviceproviderswhichareguaranteedretur nonatime-costbasisoracostplusmark-upbasi s Theintellectualpropertyrightsforthesoftw aretheydevelopvestswiththeIndianparent Theonsiteentityisprimarilyengagedinmarke ting.

10 Understandingclientrequirementsandimplem entationofthesoftwaredevelopedIndian parent (service company)AE onsite entity (country X)Service to 3rd parties (country X)AE development center (country Y)17 2015 Deloitte Touche Tohmatsu India Private LimitedService ProvidersProvision of ServicesContract Service ProviderVaried FunctionsShared Service CenterSophisticated Work-force Routine Service ProviderNon Routine IntangibleSophisticated Service Provider+++Functions and Risks18 2015 Deloitte Touche Tohmatsu India Private LimitedKey considerations for Transfer Pricing policyServices Foreignparenttakesdecisiononconceptualiz ationandfunctionalityofthesoftwareandthe developmentcenteroperateinIndiaontheinst ructionsoftheForeignparent Thekeyissueisbetweenadoptingacost-basedm odeloraman-hourratemodelforthedevelopmen tcenter Costbasedmodelwouldensureariskfreereturn withoutregardtoefficienciesandcapacityut ilization Man-hourratemodelisnowincreasinglyusedfo rreasonsthatitaddressesissuesofefficienc yandidletime19 2015 Deloitte Touche