Transfer PricingIndustry 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 Domestic 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 3rd 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

MethodsProduct

ComparabilityFunctional

ComparabilityApproach Remarks

CUP Method

Very High MediumPrices are

benchmarked

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

RPM High MediumGPM (on sales) benchmarked

Difficult to apply as high degree of product comparability required

CPM High HighGPM (on costs) benchmarked

Difficult to apply as high degree of product comparability required

PSM Medium Very High Profit MarginsComplex Method, sparingly used

TNMM Medium Very High Net Profit MarginsMost 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. Reddy’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 andCo-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 cannot be applied

Each channel has its own uniqueness

No public information

RPM Cannot be applied Due to involvement of intangibles

CPM Generally not an appropriate method

CPM is more suitable for manufacturing.

Licencing fees can not be benchmarked using CPM

PSM May be considered If each group entities perform R&D on multimedia related areas and each bear risk of appropriate content and delivery

TNMM Most widely used Routine functions can be benchmarked using TNMM

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.

− Find 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 3rd 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 3rd 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 appeared 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

Intangib

les? 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

− An 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 3rd 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%

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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

3rd 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

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Specified Domestic Transactions (“SDT”)

Inclusion of SDT within the ambit of Transfer PricingDefinition 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

Val

ue

of

SD

T

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?

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