Industry Benchmarking for select Industries CA.Bhupendra Kothari

croatiandestructiveΒιοτεχνολογία

9 Δεκ 2012 (πριν από 4 χρόνια και 4 μήνες)

331 εμφανίσεις

Transfer Pricing

Industry
Benchmarking
for
select
Industries

Bhupendra Kothari

Villy Dhabhar

28 October 2012

Contents


Sector Based Transfer
Pricing
Policy




Manufacturing Sector


Distribution Sector


Services Sector


Transfer Pricing Methods


Industry Specific Issues


Case Study


Specified Dome
stic Transaction


2

Sector Based Transfer
Pricing
Policy

-

Manufacturing Sector

-

Distribution Sector

-

Services Sector

Transfer Pricing Policy
-

Manufacturing Activity


Transfer pricing policy
for manufacturing is complex and has to take into
consideration possibility of internal comparable


Typical manufacturing structures may include a) few subsidiaries focused on
manufacturing and rest distribution b) one overseas entity in manufacturing
(mother plant) rest all distribution entities


In the below structure, AE manufacturing entity imports raw materials from parent
and manufactures component for domestic and export consumption


Gross level comparison of sales to AE
vis
-
à
-
vis 3rd party sales can be made to
review the profitability

Indian parent
(exports raw
materials)

AE
manufacturing
entity (country X)

Export sales to
AE (country Y)

Sales to 3
rd

parties

(
country X)

Manufacturing Functions

Manufacturing

Toll Manufacturer

Inventory

Contract Manufacturer

Sales

Licensed Manufacturer

Intangible

Full Fledged
Manufacturer

+

+

+


Functions and Risks


Transfer Pricing Policy
-

Distribution Activity


Transfer pricing
policy for distribution has to take into consideration the
positioning of the distributor i.e., low
-
risk distributor, full fledged distributor or
somewhere in between


In the below structure, AE distribution entity imports finished goods from parent
and sells it in its domestic market


Under a low risk distribution model the transfer pricing method should be such
that it results in a consistent margin over a period of time


Return for low risk distributors in developing markets are generally higher than
corresponding margins in developed
economies

Indian parent
(exports finished
goods)

AE distribution
entity

(
country X)

Sales to 3rd
parties

(
country X)

Distribution Functions

Sales


disclosed
Principal

Commission Agent

Undisclosed
Principal

Commissionaire

Inventory

Buy
-
Sell Distributor /
Reseller

Marketing
Intangible

Full Fledged
Distributor

+

+

+


Functions and Risks


Transfer Pricing Policy
-

Services


Indian MNCs provide a variety of IT and ITeS to global multinationals, including
engineering design, back office, procurement, financial and analytical services


In the below structure, Indian parent has a central development center in country
Y and an onsite delivery entity in country X to provide the final product


Most development centers are set
-
up as risk free service providers which are
guaranteed return on a time
-
cost basis or a cost plus mark
-
up basis


The intellectual property rights for the software they develop vests with the Indian
parent


The onsite entity is primarily engaged in marketing, understanding client
requirements and implementation of the software developed

Indian parent
(service
company)

AE onsite entity
(country X)

Service to 3rd
parties

(
country X)

AE development
center

(
country Y)

Service Providers

Provision of
Services

Contract Service
Provider

Varied Functions

Shared Service Center

Sophisticated
Work
-
force

Routine Service
Provider

Non Routine
Intangible

Sophisticated Service
Provider

+

+

+


Functions and Risks


Transfer
Pricing Methods

Overview of Transfer Pricing Methods

The
arm’s length price in relation to an international transaction is to be determined
by any of the following methods, being the most appropriate method, namely
:


Comparable
uncontrolled price
(CUP) method
;


Resale price
method (RPM);


Cost plus
method (CPM);


Profit split
method (PSM);


Transactional net margin
method (TNMM);
and


Any other method that may be considered appropriate in determining the arm’s
length
price

as per
Rule
10AB of the Income
-
tax Rules, 1962

11

Summary of Methods

Methods

Product
Comparability

Functional
Comparability

Approach

Remarks

CUP
Method

Very High

Medium

Prices are
benchmarked

Very difficult to apply as very
high degree of product
comparability required

RPM

High

Medium

GPM (on sales)
benchmarked

Difficult to apply as high
degree of product
comparability required

CPM

High

High

GPM (on costs)
benchmarked

Difficult to apply as high
degree of product
comparability required

PSM

Medium

Very High

Profit Margins

Complex Method, sparingly
used

TNMM

Medium

Very High

Net Profit Margins

Most commonly used
Method

Pharmaceuticals,
Telecommunications

and
Entertainment
& Media
Industry

Characteristics of
the Pharmaceutical Industry


Long
product
lifecycle


Exclusive patents can ensure premium pricing for 10
-
15 years, given no product recalls


Costly
R&D investments, along with significant risk of R&D failure


Of 5,000 newly
-
discovered compounds, only one, on average, makes it to
market


R&D
, manufacturing and distribution, and pricing are highly regulated by
governments


Approval from regulatory bodies are required to market a drug in a
market


Co
-
marketing
and/or
co
-
promotion


Requires
very high level of spending


E.g., Pfizer spent approx. 32% of total revenues on selling, informational and administrative
expenses.


Contract
Research


Clinical Trials


Contract Manufacturing

Segments Within Pharmaceuticals Industry

Traditional
Research
-
Based Pharma Manufacturers


Such as Pfizer, GSK, Sanofi
-
Aventis


Incur high level of R&D/Marketing costs to launch branded blockbusters


Continued emphasis on partnering and licensing

Generic Pharma Manufacturers


Such as Teva, Forest Labs,
Mylan, Dr.
R
eddy’s


Lower R&D costs and overall profits, and easier regulatory approval

Biotechnology Firms


Such as Amgen, Genentech


Younger versions of traditional pharma, less of a distinction than before

Medical Device Manufacturers


Such as Medtronic, Boston Scientific, but very diverse set of product offerings


Unique after
-
sales process, shorter economic life of products

Some Key TP Issues in the Product Lifecycle

Research

Discovery

In
-
License

Development

Trial
Manufacturing

Patent
Expiry

Prod. Launch

Regulatory
Approval

Detailing and

Co
-
Promotion

Phase IV
R&D

Do detailing & marketing create
intangibles?

What
is the impact of co
-
marketing/promo
deals?

Is “manufacturing” intangibles
creating
?

Out
-
License to:

Principal in MNC, or
Third Party

What are the right terms of the
license, and how do you
implement them to a low tax
jurisdiction?

Why do generics make so much
money?

Characteristics of
the Telecommunication Industry


High capital intensive industry


Government regulated





Approval
from regulatory bodies are required to enter a market


Common
network and resources
used globally


Large number of integrated transactions
offered
in the telecommunications
services

Telecommunication
-

Reach

22
countries
, thousands of customers, with large variety of products and services

18

Segments Within
Telecommunication



Voice
Services


International
Long Distance Telecommunications
Services


Domestic Long Distance Telecommunications
Services



Data Services


Corporate
Internet Service


Voice Over IP Service


Internet
Data Center


Internet
& Broadband Service


Video Conferencing
Service



Other Value Added
Services


Data Center and Media
Services

Characteristics of the Entertainment and
Media Industry


Entertainment and
media company are responsible for broadcasting
content through various multimedia channels


Typical transactions in transfer
pricing


Payment of licence fees for distribution of
channels


Receipt of advertising sales
commission


Receipt from the export of
content


Payment of royalty for wireless content


Impact of transfer pricing issues on the industry


“Age of a Channel” is no longer a value driver


Constant enlargement of the value chain


Widespread

use of market penetration strategies by media conglomerates


Pricing
issues due to movement from analogue technology to digital technology

BENCHMARKING ?

Methods

Applicability

Reasons

CUP
Method

Normally

c
annot be
applied


䕡捨⁣c慮湥氠桡猠楴猠潷渠畮楱略湥獳


乯⁰ 扬楣i楮景牭慴楯n

剐R

䍡湮潴o扥⁡ 灬楥d


䑵e

瑯ti
湶n汶l浥m琠潦⁩o瑡t杩扬敳

䍐C

䝥G敲e汬y 湯琠慮
慰灲p灲p慴a 浥瑨潤


䍐䴠楳潲C⁳畩瑡扬攠景爠
浡m畦u捴畲楮朮g


䱩捥c捩cg

晥f猠捡s 琠扥 扥湣n浡牫m搠
畳u湧 䍐C

偓P

䵡M 扥⁣潮獩s敲ed


䥦 敡捨c杲g異

敮瑩瑩敳t
灥牦潲洠刦R
浵m瑩浥t楡 牥r慴a搠慲a慳

慮搠敡捨c扥慲a
物獫映慰灲p灲p慴a 捯c瑥tt

慮搠
摥汩癥特

T乍N

䵯獴⁷楤敬e 畳u搠


副畴楮攠晵f捴楯c猠捡c⁢ 扥湣n浡牫m搠
畳u湧 T乍N

Most Appropriate Method

Rationale for RPSM


Other methods fail in the context of globally integrated companies with large
number of intercompany transactions


RPSM is the industry standard for large global telecommunication companies
(most large telecommunication companies in the U.S., Europe and Asia has
adopted this method)


Acceptable method in all
jurisdictions

23

Implementation RPSM


The choice and applicability of the RPSM is
intimately tied to the identification and
valuation of Routine & Non routine functions


This leads to the questions:


FAR of each entities for routine return


What is non routine intangible?


How do we detect the presence of non
routine intangibles?


How can we value contribution of non
routine intangibles?

24

Overview of RPSM


Treats the related parties’ profits as being composed of two parts


profits arising from “routine” activities and profits arising from
“intangible” activities


First reward a market return to each related party for the “routine”
activities.


F
ind
service comparables and measure profits based on cost plus
returns


Pool of intangible profits is the difference between total revenue
and the cost plus profit attributable to routine activities.


Residual profit is split between the related parties based on keys that
reflect relative value in contributing to the pool of intangible profit.

Case Study

4. Calculating Residual Profit


case study


Assume that there exists a multimedia company which is responsible for
broadcasting content through various multimedia channels all over the world.


This company through its subsidiaries provide television network feeds to
various broadcasters around the world. These broadcasters may be 3
rd

parties.


Each subsidiary company is responsible for content development and
transmission to broadcaster.


To ensure appropriate content development, each subsidiary perform research
and development on multimedia related areas.


These subsidiaries bear the risk of appropriate content, delivery and standard
routine transfer pricing risks.

What is the transfer pricing mechanism through which these subsidiaries may be
remunerated?

Steps in Applying
the
RPSM


To apply the RPSM one must

1.
Define the correct pool of global profit to perform the analysis

2.
Identify “routine” activities

3.
Determine the functional returns for the routine activities performed

4.
Determine the residual profit pool as equal to global revenues minus the
routine net cost plus returns


5.
Determine the value drivers or objective key(s) to apportion the residual
profit to Parent and Full Branches

1. What Pool of Profits?


Key areas to discuss/review include


“Flow
-
through” expenses and whether these expenses should attract a
profit


Some third party contracts (e.g., installation and maintenance) are not
value
-
added by
participants


The
treatment of interest expense


As non
-
operating, interest expense would not be included in cost plus
returns for routine activities


Participants cover
this with their profit reward

2
. Determining Routine Returns


Use
Net cost plus
in major regions of the
world


Standard comparable sets used given the FAR


Returns commensurate with what 3
rd

parties in the local market are expected
to earn


In India research can be performed on Prowess and Capitaline


Multiyear data vs single year data


Routine costs receive a routine markup


3. Calculating Residual Profit

Residual profit is equal to global revenue minus routine costs plus the profit
markup on these costs

Total Revenue

Mark
-
up

Routine Costs

Residual Profit

5. Determining Value Drivers


Assume there are significant “intangible income” to be allocated


How should the allocation work?


The
key value drivers appear
ed

to be


Research &
Development (a
portion is
routine)


Multimedia (mostly
the TV and
Radio)


The
Network (not
the hardware
-

alone this is
routine)



Non
-
routine
EBT
80
%

Routine EBT
20
%

5. Determining Value Driver Weights

Residual Profit

How to Weigh
Intangibles?

Residual Profit Pools

R&D

Multimedia

Network

Key question
-

How to weight the relative importance of these value drivers?

5. Determining Value Driver Weights


Possible weighting value driver weighting factors
include


A
n
internal variable that objectively allows for comparison of relative
contribution


For example,
bonuses to employees
are awarded across functions,
although this does not appear to be
objective


Can sales and marketing be used?


If it indeed contributes non
-
routine
profits


What about the price of
content?


No as it is tainted.

5. Determining Value Driver Weights

Regression analysis


Estimates the relative contribution of the value drivers in increasing
revenue/profits


For example, estimates how a $1 increase in R&D, Multimedia, and Network
spending contributed to an increase in global revenues/profits


Since the relative contribution of each value driver is determined, this gives us
the weighting factors


In applying regression analysis, need to determine how to specify the
variables/model (1)


For example, should the variables be
lagged?


e.g., should past R&D spending be used to estimate the contribution to
current profit or does current spending contribute to current profit?


What is the correct “dependent” variable
-

global revenues, total operating
profits, residual operating profits?

5. Determining Value Driver Weights

How does regression work?


In this simple example, regression predicts the value for the coefficient “
b” in
the equation of a line:

Y =
a + b X



b is the slope of a line and it indicates how much Y will change for a 1 unit
change in X


For example, assume Y is global revenue (Rev) and X is R&D spending. If we
estimate the regression to be:

Rev = 5 + 2 (R&D)


we have determined that a $1 increase in R&D spending will increase Rev by
$2


We determined
three value drivers
-

R&D, Multimedia, and Sales
Expense
(proxy for value of network)


Therefore
, the specification of this model is:

Rev = a + b (R&D) + c (Multimedia) + d (Sales)



b, c, and d represent the weights on each value driver


5. Determining Value Driver Weights
-

Alternate


Conduct interviews to gauge the relative contribution that each variable have


Interviews should be unbiased and held through formalized questionnaire
targeted towards operational and management personnel


Objective is to gauge the relative contribution as perceived by the business


This provides an approximate proxy of how 3
rd

parties would also view this


The contribution interviews can be utilized in the value driver equation to arrive
at a, b, c and d.

-
Rev = a + b (R&D) + c (Multimedia) + d (Sales)



Exercise


Assumed that the routine returns for the functions based on market benchmarks
are as follows:


Assets deployment: ROA 6%


Selling & marketing: Total Cost Plus 6%


Network maintenance: Total Cost Plus 8%


G
& A: Total Cost Plus 5%


Value added drivers


Multimedia (Content cost / Total content cost)


Research & Development (R&D personnel per entity/total R&D personnel)


Network (Sales expense / Total sales expense)


VAD weight


Network
50
%


Multimedia 33
%


R&D 17
%

38

Standalone Financials


Key Entities

Particulars

India

Singapore

US

Canada

Thailand

B.V.

Gross Revenue (a)

264.82

8.47

20.51

166.00

2.50

4.20

3
rd

Party Costs (b)

216.50

0.34

13.30

66.00

5.11

4.33

Net Revenue (c) = (a)


(b)

48.32

8.13

7.21

100.00

(2.61)

(0.13)


Selling & Marketing
Expenses (d)



Network Maintenance
expenses (e)



General Administration
Expenses (f)



Depreciation (g)

3.77



2.36



15.34



19.11

1.93




0.35



0.91



0.96


0.82



12.15



5.67



1.14

4.09



7.78



18.71



3.63

0.00



0.00



0.28



5.98

0.00



0.00



0.01



0.24

39

Financials Post TP


Key Entities

40

Particulars
India
Singapore
US
Canada
Thailand
B.V.
Net Revenue (c) = (a) –
(b)
48.32
8.13
7.21
100
-2.61
-0.13
Routine Returns
43.01
4.40
20.97
36.26
6.64
0.27
–Total Cost
40.58
4.15
19.78
34.21
6.26
0.25
–Markup
2.43
0.25
1.19
2.05
0.38
0.02
Residual Profit/Loss for
pool
5.31
3.73
-13.76
63.74
-9.25
-0.40
–Allocation Ratio
(as per value driver
equation)
0.2
0.03
0.01
0.7
0.05
0.01
–Allocation Amount
(transfer pricing
adjustment)
9.88
1.48
0.49
34.56
2.47
0.49
PBIT After TP Adjustment
52.89
5.88
21.46
70.83
9.10
0.76
Key Issues


Gross revenue or net profit after expenses?


Return on third party cost


Book value of the assets or fair value of the assets


Currency of transactions


Need of TPA

41

Specified Domestic
Transactions (“SDT”)

Inclusion
of
SDT within
the ambit of Transfer Pricing

Definition of international transaction has been extended to include “Specified
Domestic Transactions” with
a threshold limit of Rs.5 crores

Specific
domestic transactions that would now fall within the ambit include:


Expenditure

in respect of which payment has been made or is to be made
between domestic related parties under clause (b) of sub
-
sec. (2) of sec. 40A;


Transfer of goods or services
between entities claiming deduction under section
80
-
IA(8);


More than ordinary profits
earned by entities claiming deduction under section
80
-
IA(10); and


Any transaction, referred to in any other
section under Chapter VI
-
A or Section
10AA,

to which the provisions of sub section (8) or (10) of section 80
-
IA are
applicable



43

Value of SDT

Value more than 5 crs


Arm’s
Length Price

Value less than 5 crs


Fair
Market Value

Implication post
-
budget 2012 for
SDT

44

Fair Market Value

Arm’s Length Price

No method prescribed for
computing fair market value

Five methods prescribed for
computing Arm’s Length Price

No documentation required to be
maintained

Contemporaneous documentation
required to be maintained

Other than reporting in tax audit
report, no statutory compliance

Accountant’s report signed by a
Chartered Accountant to be filed

Assessment done by the Assessing
Officer

Assessment done by the Transfer
Pricing Officer

Questions
?

This material has been prepared by Deloitte
on
a specific request from


FIT
(‘
you’) and contains general information only. This information is not
intended to constitute professional advice or services or is to be relied upon as the sole basis for any decision which may a
ffe
ct you or your
business. Before making any decision or taking any action that might affect your personal finances or business, you should co
nsu
lt a qualified
professional adviser. The information contained in this material is intended solely for you thereby, any disclosure, copy or
fur
ther distribution of this
material or the contents thereof may be unlawful and is strictly prohibited.

None of DHS or its affiliates shall be responsible for any loss whatsoever sustained by any person who relies on this materia
l.



©
2012
Deloitte


Touche Tohmatsu