Transfer Pricing in Pharma / IT industry -Case Studies

Presented by: Munjal AlmoulaPrasad Pardiwala Prasad Pardiwala August 2011

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Snapshot of Case Studies

• Case Study 1 – Deputation of employees

• Case Study 2 – Operational losses

• Case Study 3 – Royalties by software entity

• Case Study 3 – Import of APIs

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• Case Study 3 – Import of APIs

• Case Study 4 – Cross Charges

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Case Study 1 – Deputation of employees

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Business Model and Structure

Parent Company (X)

INDIA

Parent Company (X)

• Entrepreneur – Owns Intellectual

Property

• Assumes significant business risks

• Engaged in software development

services

100%

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SUB 1 SUB 2 SUB 3

FranceUSAGermany

Subsidiaries

• Limited risk marketing service providers – Guaranteed return on such

services

• Also provides onsite software development services with support from (X)

Customers Customers Customers

Ownership

Deputation

Services

Other Critical Facts of the Case

• Human Resource Department of (X) recruits software engineers / programmers

- Direct recruits

- Assistance from third party recruitment agencies

• (X) provides 3 months training to all new joiners after which it decides to depute them either on offshore or onsite activities depending on project requirements

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requirements

• Total employees – 3,000

• Allocation as under:

- 100 employees deputed to Germany;

- 500 employees deputed to USA;

- 400 employees deputed to France

- Balance continues to work with (X) in India

• On deputation, payroll would shift to respective associated enterprises

- After completion of onsite job, payroll shifts back to (X)5

Revenue’s contentions and approach

• Revenue alleged that deputation of employees abroad is akin to providing

recruitment services

• Accordingly:

- Form 3CEB should have recorded this transaction;

- Contemporaneous documentation should have been in place before filing tax return;

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filing tax return;

- (X) should have received arm’s length compensation for providing recruitment services

• Revenue compared this alleged transaction with third party recruitment

service providers and proposed adjustment to income of (X)

• In addition, Revenue exposed (X) to penalties:

- Concealment penalty on the income adjusted;

- Documentation penalty for non-maintenance of contemporaneous documentation

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Defence mechanism

• Conduct detailed functional interviews with key personnel in Finance,

Human Resource and also with few software engineers / programmers

• Study information provided on website, promotional materials and business

cards

• Peruse legal agreements in great detail

• Studied employee deputation letters and understand the impact of social

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• Studied employee deputation letters and understand the impact of social

security benefits (pre and post deputation)

• Carry out a detailed industry research to understand the practice followed

by other software professionals

• Understand the compensation mechanism of third party recruitment service

providers

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Defence mechanism

• Create a robust documentation substantiating the following business

rationale

- Increase in offshore revenues for (X); and

- Employees returning with upgraded skills, enormous experience and business domain enhanced the solution delivery skills and thereby helped in execution of offshore work with great efficiency

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helped in execution of offshore work with great efficiency

• Explain the operating model to Revenue

• Support with third party data available in public domain

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Case Study 2 – Operational Losses

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Business Model and Structure

XYZ SingaporeLow Risk Manufacturer

ABC India(Manufacturer &

distributor)

Import of premium Formulations

Third party customers in

India

Sales

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• ABC India is primarily a manufacturer of Pharma products and sells the products in

India to third party customers

• ABC India also imports some premium Pharma products from associated enterprises

and acts as an entrepreneur distributor for such products in Indian market

• ABC India retains the entrepreneurial profits on distribution and compensates XYZ

Singapore on cost plus 8% for imports

• XYZ Singapore acts as a low risk manufacturer for exports made to India

distributor)

Basic Facts of the Case

Other Critical Facts of the Case

• ABC India introduced new products to complement the already existing regular product portfolio in India

• Imports were currently made under test market stage

• Import pricing was consistent with Group’s transfer pricing policy

• Cost plus mark-up for exports made by low-risk manufacturer

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• Cost plus mark-up for exports made by low-risk manufacturer

• Incurred huge advertising and other marketing costs

• Launch pricing was based on inputs received from market research company

• Huge operating expenses resulted in negative operating margin (OM) for the specific import transaction

• ABC India had no written transfer pricing policy document or legal agreements to support the nature of transaction and its pricing policy

Revenue’s contentions and approach

• Revenue compared the operating margin (loss) suffered by ABC India in relation to import of specific product with the arithmetic mean of the operating margin earned by third party Pharma distributors engaged in similar distribution activity

• Disregarded the aggregation approach adopted by ABC India to justify the arm’s length nature for its import transaction

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• Concluded that the import prices were high which contributed to operating loss for ABC India

• Proposed transfer pricing adjustment

Defence mechanism

• Detailed functional analysis taking in inputs from the operational personnel

– explaining the necessity for new product, launch expenses, etc

• Support through market research study report

• Analyse budget prepared in relation to product launched

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- To identify the year when ABC India would break-even

• Identification of contributors to operating loss

- Most critical part of analysis in any operating loss situation

• Analyse the cost plus margins of the overseas supplier and benchmark these

with comparables to showcase the appropriateness of the pricing

arrangements vis-à-vis inports

Case Study 3 – Royalties by software entity

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Business Model and Structure

FCOUS Parent

Sub

India

USARoyalty flow 100%

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Sub

Basic Facts of the Case

• FCO, a US parent, is engaged in software services and operates globally through

subsidiaries including subsidiary in India

• Indian subsidiaries use the trade name of FCO for carrying out their businesses

• Indian subsidiaries are required to pay royalties to FCO for usage of trade name

• Present royalty arrangement: Royalties are charged @ 1% of sales, based on turnover

Revenue’s contentions and approach

• No substantive documentation provided to demonstrate benefits received by Sub 2 from exploiting the right to use FCO’s trade name

• Compliance with Indian Foreign Direct Investment policy would not be sufficient compliance with Transfer Pricing laws of India

• No pricing policy written document provided to substantiate the payments

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• No pricing policy written document provided to substantiate the payments

• Disallowed the entire royalty charge – penalty implications

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Defence mechanism

• Put in place robust documentation to showcase the benefits derived from us of tradename – based on interviews of operational personnel – key to substantiating the appropriateness of the royalty payouts

• Benchmark the royalty rate – using licensed databases

• Put in place legal agreement

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• Put in place legal agreement

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Case Study 4 – Import of APIs

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Business Model and Structure (including Revenue’s approach)

ABC UK

ABC Indonesia

ABC USA

Import of API

XYZ China

Import of API, similar

Revenue’s approach on secret comparables

ABC’s business model and structure

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Outside India

India

ABC, India

Third Party, India

Third Party, India

API (original

research)

Export of Formulations

Re-selling of Imported formulations

Manufacture –Domestic Sales

PQR India

Third Party India

Import of API, similar to Swiss API

Manufacturing -Domestic Sales

Import of Formulations

Facts of the Case

Why Imported from associated enterprise?

• Application

• Owner / Developer of the API

• R&D activity undertaken by Parent

• Risk assumed by Parent

Import of Active Pharmaceutical Ingredient (API) from an associated enterprise (AE)

International Transaction

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Show Cause Notice to Company

External CUP Comparability

Information asked by Revenue on Product Imported

• Import price of competitors is lower

• Justify why company’s price is higher

Use of Customs Database

• Application

• Therapeutic Segment

• Formulations

• Competitors

Defence mechanism

• Rebuttal of CUP – strict product comparability

• Import of products of original research - supported by research data which brings greater conviction to medical professionals

• Highly sophisticated manufacturing operations of the foreign parent –processes are different impacting quality of finished products

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processes are different impacting quality of finished products

• Comparison of prices at which same APIs sold by US parent to third party overseas

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Case Study 5 – Cross Charges

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Business Model and Structure

PARENT COMPANY (X)Entrepreneur performing Group

roles

ASSOCIATED ENTERPRISE

ASSOCIATED ASSOCIATED

INDIA

OUTSIDE INDIA

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• (X) acts as an entrepreneur and performs Group roles

• (X) provides following services to various associated enterprises:

– Group Human Resource

– Group Finance

– Group IT and Admin support

Basic Facts of theCase

ENTERPRISE (A)

ASSOCIATED ENTERPRISE

(B)

ENTERPRISE (C)

Country CCountry BCountry ACustomers Customers Customers

Ownership

Group services

Revenue’s contentions and approach

• Revenue alleged that Group roles performed by (X) are in the nature of intra

group services

• Such services should be cross charged along with an arm’s length mark up

• Exposed (X) to concealment penalties

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Defense mechanism

• The overseas subsidiaries act as limited risk distributors or limited risk service

providers

• In either case – subsidiaries earn either routine margin on sales or on cost

• Entrepreneur profits flown back to India

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• In case a cost plus charge out is introduced, this would increase the cost base

of the overseas entities

• In any case, the Indian parent would need to support this through inter-

company pricing

• Finally the cost would come back to the Indian entity – hence the charge out

for the support services would not be warranted

Key Points discussed through case studies

• Case Study 1: Importance of business and commercial rationale

• Case Study 2: Identifying contributors to loss is critical

• Case Study 3: Importance of satisfying “Benefit Test”

• Case Study 4: Importance of Industry analysis and requirements for CUP

comparability

• Case Study 5: Operating model governs the transfer pricing

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• Case Study 5: Operating model governs the transfer pricing

Remember: Facts are King and Transfer Pricing is an Art and not Science

Thank You

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