New Managing Recession - VTP Taj

8/7/2019 New Managing Recession - VTP Taj

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Managing Recession

from a Transfer Pricing Perspective

Vispi T. Patel

October 2009


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Glossary and Abbreviations

BEP Break Even Point

CPM Cost Plus Method

CUP Comparable Uncontrolled Price Method

GDP Gross Domestic Product

OECD Organisation for Economic Co-operation and Development

TNMM Transactional Net Margin Method

TP Transfer Pricing


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Contents

Background of Recession

Transfer Pricing in Recessionary

Conditions

Documentation Requirements

Transfer Pricing Policy Review

Case Study


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Background of Recession


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Recession!

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What is Recession?? It is the economy shrinking for two consecutive quarters with a

decrease in the GDP

It may be preceded by several quarters of slow down

It is the situation when it is difficult to drive growth with reducedsavings, reduced domestic manufacturing capacity and reduced

consumption


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Recession!

The shock of the current recession was sudden. Allthanks to abundance of cheap credit for many years

This so because research suggests that people dont stop

spending when they run out of money. They stop whenthey run out of credit. With sub-prime crisis, credit crisis,property values decreasing and credit cards at theirlimits, people were suddenly out of credit. This was the

beginning of end of good times

A single trigger point of default of home credit paymentswas enough for global economic crisis

Before looking at the recession from a Transfer pricingperspective, let us first study the causes of prosperity and

recession, which are nothing but the spiral effects ofconsumer confidence6


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Recession!

1 Consumers

feel confident in

the future of the

economy sothey spend

more

2 In response to rise

in demand, industry

produces more,

which means

increase in

employment levels

and more

consumption of

resources

3 Increased

employment andspending by

industry amounts

to further

consumption

5 Country

becomes favoured

destination forinvestment

4 With feel goodfactor and increase

in demand, stock

markets rise overall

Upward Spiral when all

is well!


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Recession!

1 Consumers lose

confidence in the

future of the

economy so they

spend less

2 In response to

fall in demand,

industry lays off

employees and

reduces

production

amounting toless consumption

of raw material

3 Now people haveless money to spend

and debts mounting

so they further

reduce spending 4 Stock markets

take a hit due topoor earnings of

the industry

5 Country loses

creditworthiness hence

lower investments

Downward Spiral when

the economy has

suffered major setbacks

A L k h Gl b l Fi i l I di


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A Look at the Global Financial Indicators

Outcome of the Downward Spiral


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How should Multinationals cope

with the Transfer Pricing issues

faced by them during thedownturn


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Transfer Pricing issues specific to Recession

Transfer Pricing policy of the multinational is

generally based on the underlying presumption of

stabilityIt is also based on the reasonable predictions or

certainty of the future events

Therefore, sudden uncertainty caused by the recession

throws light on the loopholes in the Transfer Pricing

policy of the Multinational Group. For Example:

It becomes difficult to split losses as compared to

splitting of profits in the good times

Pre-recession methodologies may not hold good in

recession13


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Presents difficulties with profit-targeting for entitieson CPM/TNMM benchmarking policies

Some jurisdictions may have losses while others havetaxable profits, deteriorating cash tax position

Increasing transfer pricing audit risks

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Recession creates business issues such as:

Operating Losses

Reduction in force and plant closures

Cash flow and debt service constraints

Excess/obsolete inventory

Credit crunch

Analyses prepared in these circumstances will require careful

consideration of attribution of risk and splitting of the losses

These business issues impact transfer pricing, finance, and tax

objectives, but can also create restructuring opportunities

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D i R i


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Documentation RequirementsConsider whether any other method can now be more

appropriate in the changed scenario

Comparable set to take into consideration the companies that

are equally impacted by the recession in the same period

Adjust the financial results of the comparables to take into

consideration the current economic conditions industry

specific analysis

Document in a robust way the impact of recession

Consider Year-end adjustments (True-ups)

Keep in mind whether the change in the methodology /

comparables can be consistently used for the post recession

period18


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Can Industry Use Recession to

Re-engineer?

R i n R i f TP P li


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Recession Review of TP Policy

Did recession

force a company

to change its business

model?

Are the

profitability?

business conditions

affecting companys

YesYes

No No

Is the

company open to

restructuring its

economic

substance?

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Formulate new TP

policy

Review existing TP

policy

Formulate new TP

policy


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Case Study

C St d


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Case Study

Utility Vehicles India Ltd (UV India) is a well establishedleading utility vehicle manufacturer in the Indian market

It has set up a subsidiary in Korea viz. Utility Vehicles KoreaLtd (UV Korea) to target the utility car users and have a

footprint outside India

UV Korea manufactures, assembles and markets utility vehiclesfor which UV India supplies engines. To establish itself in themarket, UV Korea has incurred a huge marketing cost

Engines supplied by UV India form a major portion of theproduction cost of UV Korea

Based on the economic Transfer Pricing analysis conducted byUV India two years back, it has set its TP policy to sell theseengines to UV Korea at cost plus 10% . For this purpose,

TNMM was considered as a most appropriate method


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Revival Plan UV Indias Perspective


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Revival Plan UV Indias Perspective

The revival plan envisioned should keep the TP Regulationsand the audit experience of the multinationals in mind. It

should involve

Identification of

constraints and

their effect on

the profitability

Determination ofvarious alternatives

available under

arms length scenario

Strategic planshould dovetail into

a Benefit Test

achievement from an

Arms Length

perspective

New Transfer Pricing Mechanism

The resulting challenge for UV India is in trying to justify the new business

strategy. This is where the appropriate and contemporaneous Transfer Pricing

documentation comes into play which should clearly demonstrate how external

factors have affected the business production levels, sales volume, etc.

Case Study


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Case Study

Accordingly, in the instant case, the Transfer Pricing Analysisfor the purpose of revival plan should involve:

The Benefit Test (taking into consideration the

future strategy of the Group),

How the strategy dovetails into the long term visionof UV India, and

Profitability analysis (taking into consideration thefinancial data of the comparable companies)

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Profitability Analysis

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Profitability Analysis


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Profitability AnalysisThe comparable data on the public domain shows the following results:

The above analysis shows that the profitability of the comparable

companies in India has come down drastically i.e. as low as 5% in the

Q1 of the FY 2009-10 whereas yearly data shows the same at 8%

Sr.No.

Particulars Arithmetic Mean

(%)

ArmsLength

Price

+/- 5% Pricerange

1 Comparable's results usingdata pertaining to FY 2008-09

8% 108

(i.e. 100 +8%)

102.60 -113.40

2 Latest available quarterlyresults data (April 2009

June 2009)

5% 105 (i.e.100 +5%

99.75 110.25

Quarterly results show more realistic picture than the yearly results as the

yearly results include pre-recession period as well which is not comparable

This analysis also shows that it is possible for UV India to supply engines at a

lower markup. However, the same should also be corroborated by the futurebenefit test


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The Benefit Test

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F t P j ti f UV K B i


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In this regard, future profitability of the UV Korea under various percentage

of markups can be analysed. Various scenarios that would arise in this case

would be as follows:

Scenario 1: If UV India continues to earn a current markup of 10% on cost of

the engines supplied

(in South Korean Won i.e. SKW)

Projected Contribution and PBIT per unit (in SKW)

Future Projections of UV Korea Business

Particulars /

Year

2009-10 2010-11 2011-12 2012-13 2013-14 2014-15 2015-16 2016-17 Life

Cycle

2009-10

to 2016-17

Contributionper unit

15,500 34,500 38,000 47,900 51,000 51000 51,000 51,000 44,500

PBIT per unit (90,000) (53,000) (14,000) 5,700 9,500 9,500 9,500 9,500 (9,600)



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Scenario 2: If UV India reduces the profit markup on cost to say 2% to 4%

Projected Contribution per unit (in SKW)

2009-10 2010-11 2011-12 2012-13 2013-14 2014-

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2015-16 2016-17 Life Cycle

2009-10 to

2016-17

2% 31,000 49,900 53,400 63,100 66,600 66,600 66,600 66,600 59,500

3% 29,000 48,000 51,500 61,200 64,700 64,700 64,700 64,700 57,600

4% 27,000 46,000 49,600 59,300 62,800 62,800 62,800 62,800 55,700

2009-10 2010-11 2011-12 2012-13 2013-14 2014-15 2015-16 2016-17 Life Cycle

2009-10 to 2016-17

2% (75,000) (38,100) 1,200 21,000 24,500 24,500 24,500 24,500 5,300

3% (82,300) (40,000) (600) 19,100 22,600 22,600 22,600 22,600 3,500

4% (89,000) (41,900) (2,000) 17,200 20,700 20,700 20,700 20,700 1,600

Projected PBIT per unit (in SKW)



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The analysis shows that if UV India continues to charge amarkup of 10% on cost, UV Korea would continue to make

losses over a life cycle i.e. 2009-10 to 2016-17

It also shows that reduction in profit mark-up at UV Indialevel as contemplated by the management may have some

effect on reducing losses at UV Korea level

UV Korea subsidiary was set up by UV India mainly to

expand its business in overseas territories and was guided by

a long term vision of further expansion; hence, it is extremely

essential for UV Korea to survive


Naturally, to sustain the situation and to makeup the huge losses already

incurred, UV Korea requires support from UV India by way of

reduction in the engine costs



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j

Break Even Point (BEP) under different situations

Further, it has also been observed that the BEP[i.e. apoint where the total costs are equal to revenue and hence

there is no profit no loss situation] under different

markups would be as follows:

The above analysis shows the year wise BEP (units) achievable by UV Korea

under different circumstances. However, it may be noted that the BEP can be

achieved only in the year 2012-13 as in other cases projected units fall below

the BEP

Particulars

/ Year

2009-10 2010-11 2011-12 2012-13 2013-14 2014-15 2015-16 2016-17

@10% 32,366 16,519 15,531 12,850 11,925 11,925 11,925 11,925

@2% 16,165 11,461 11,089 9,739 9,234 9,234 9,234 9,234

@3% 17,244 11,917 11,500 10,043 9,502 9,502 9,502 9,502

@4% 18,478 12,411 11,942 10,366 9,786 9,786 9,786 9,786Projected Sales 3,980 6,500 11,350 14,620 14,620 14,620 14,620 14,620

Sustainability of the Reduction in the Markup


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Sustainability of the Reduction in the Markup

All the above profitability and BEP analysis show that UV India may

have a good case to argue for changing the transfer pricing mechanism in

relation to the export of engines to UV Korea in view of achieving its long

term objective of doing business in Korea

The reduction in profitability has to be supported by a robust

documentation which should be able to demonstrate that the re-

engineering business strategy is in-fact the need of an hour and reflects

mirror image of the market conditions

The documentation should also include the projections of future

situations as to how UV India is going to re-coup its investment in future;

with a special emphasis on the future inflows of profit in different forms

e.g. increase in price of the engines in later years, etc.

Conclusion


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Conclusion

Transfer Pricing law gives due importance to thechanges in the economic conditions - OECD

Transfer Pricing is flexible enough to take intoconsideration the changes in the economic conditions

if structured appropriately - OECD

However, robust documentation which brings out

the impact of economic downturn, necessity of

adjustment / changes, benefit test, etc. holds the key

Thank You


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Thank You

Questions?

Contact :Vispi T. Patel

+91 [email protected]

Documents

New Managing Recession - VTP Taj