Transfer Pricing: Issues, Risks & Opportunities for Multinationals 8-9 May 2013 Chair: Mukesh Butani – Taxand India Panelists: Shiv Mahalingham – Taxand

Transfer Pricing: Issues, Risks & Opportunities for Multinationals

8-9 May 2013

Chair: Mukesh Butani – Taxand IndiaPanelists:

Shiv Mahalingham – Taxand UK Clemens Thym – Standard and Poor Sam Sim – Standard Chartered Steven Carey – Quantera Global

1. UN Manual & the Acceptance of Arm’s Length Principle – an OECD Comparison

2. Intangibles: Tax Controversies, Enforcement & Litigation in Asia

3. The OECD BEPS Study & the “Grey Area” Definition

4. Valuation in Business Restructurings: the Different Approaches of Tax Authorities

5. Developments in Policy on Advance Pricing Agreements

6. Intercompany Loans Focus

7. Managing TP In-House Across Asia-Pacific

8. Taxand’s Take

9. Key Contacts & About Taxand

Contents

UN Manual & the Acceptance of Arm’s Length Principle & OECD

8-9 May 2013

UN Manual was prepared by the Subcommittee on Transfer Pricing, constituted in 2009

Developed with a purpose to provide a practical manual on transfer pricing for developing countries

Manual covers aspects starting from methodologies to documentation to dispute resolution. It also covers country specific chapters on Brazil, China, India and South Africa

UN Manual, Arm’s Length Principle & OECD41 UN Manual & the Acceptance of Arm’s Length Principle – an OECD Comparison

Issues to be debated:

Discussions on important aspects covered in India and China chapter

Comparison with OECD Guidelines

Implications on non-OECD member countries

UN Manual, Arm’s Length Principle & OECD51 UN Manual & the Acceptance of Arm’s Length Principle – an OECD Comparison

Key topics covered in the India Chapter of UN Manual include:

Location savings

India provides ‘Location Specific Advantages’ (LSA) in addition to location savings

LSAs include access to market, skilled manpower, large customer base, information and distribution networks

Quantification and allocation of location savings and location rent (in case of LSA) to be an important area of concern

Use of Profit Split Method endorsed by Indian Revenue (in case of absence of Comparable Uncontrolled transactions)

UN Manual - India Chapter61 UN Manual & the Acceptance of Arm’s Length Principle – an OECD Comparison

Intangibles

Marketing intangibles and co-branding activities - particularly relevant for India owing to unique market characteristics

Enhancement of brand, creation of efficient supply chain, conducting market research identified as factors relevant to creation of marketing intangible

Ways of compensation for creation of marketing intangibles eg: Reimbursement of extra-ordinary expenses, with a mark-up; or share of profits in relation to marketing intangible


R&D related intangibles

Remuneration received by captive providers should commensurate to functions performed and risks assumed

Routine and low cost plus mark up perceived to be insufficient – day to day decision making and operational risks lie in India

Additional compensation on account of creation of intangibles and ‘more than’ routine functions / risks required


Intra-group services

Categorised as high risk area

Nature of allocation keys is a grey area

Non-receipt of mark-up on provision of services considered as a ‘pain-point’ by Indian Revenue

Use of contemporaneous data – relevance of current year data re-emphasised


Allocation of risks between taxpayer and AEs – contingent on core functions, responsibility and decision making

Comparability adjustments

Burden to proof on taxpayers

Difficulty in undertaking risk adjustment

highlighted, however no guidance / solutions

provided in Manual


Lack of reliable local comparables

Location specific advantages (LSAs)

Location savings

Market premium

Very structured approach to defining and calculating

UN Manual - China Chapter11UN Manual & the Acceptance of Arm’s Length Principle – an OECD Comparison1

Intangibles

General position that Chinese intangibles under-

compensated

Confidence in effectiveness of documentation and audits to achieve compliance

UN Manual - China Chapter12UN Manual & the Acceptance of Arm’s Length Principle – an OECD Comparison1

Intangibles: Tax Controversies, Enforcement & Litigation in Asia

8-9 May 2013

Increased interest of tax authorities regarding:

Economic ownership vs legal ownership of intangible

Attribution of benefits of intangibles to parties

OECD’s draft guidelines on intangibles (released in June 2012) - emphasis on FAR for intangible related returns

Intangibles142 Intangibles: Tax Controversies, Enforcement & Litigation in Asia

Issues to be debated

Views of tax administrators and taxpayers on intangibles and transfer pricing in relevant jurisdiction

Recent tax controversies

Intangibles152 Intangibles: Tax Controversies, Enforcement & Litigation in Asia

Legislative developments

Definition of intangibles introduced vide Finance Bill 2012

New definition includes marketing, human capital, customer related intangibles

Definition introduced retrospectively

Intangibles - India Perspective162 Intangibles: Tax Controversies, Enforcement & Litigation in Asia

Disputes in India primarily focus on:

Creation of marketing intangibles by Indian entities manufacturing / distributing branded products

Contribution of Indian contract software service providers to the overall product development lifecycle

Recent Special Bench ruling in case of LG

Electronics

Intangibles - India Perspective172 Intangibles: Tax Controversies, Enforcement & Litigation in Asia

The OECD BEPS Study & the “Grey Area” Definition

8-9 May 2013

BEPS – a debate gaining recognition across BRICS and G20 nations

Meeting of G20 leaders in July 2012 and November 2012 emphasised on “the need to prevent base erosion and profit shifting”

OECD highlights the ‘grey area’ between tax planning and tax evasion

The OECD BEPS Study - An Overview193 The OECD BEPS Study & the “Grey Area” Definition

Joint Communiqué issued by BRICS identified the following as primary reasons leading to erosion of the tax base:

Abuse of tax treaty benefits

Incomplete disclosure of information between tax administrations


Primary ways of cross-border profit shifting:

Pricing of international transactions between two associated enterprises

Capital structuring / financing between associated enterprises

Development of international standards, improving access to data and information and capacity building is ‘need of the hour’


Issues to be debated:

How to draw the line between tax planning and tax evasion

Impact of BEPS on emerging economies

Learning from international best practices

Suggest improvements that may be made to transfer pricing rules

Other ways to resolve BEPS (areas such as GAAR, thin capitalization to be discussed)

The OECD BEPS Study223 The OECD BEPS Study & the “Grey Area” Definition

Valuation in Business restructurings & Tax Authorities

8-9 May 2013

Historical stand - transfer pricing provisions do not apply to cross-border business restructuring if there is no bearing on taxable income

Important amendment introduced (with retrospective effect) in Budget 2012 – ‘business restructuring’ to be considered an international transaction irrespective of its bearing on taxable income (at the time of transaction or in future years)

Valuation in Business Restructurings - India244 Valuation in Business Restructurings: the Different Approaches of Tax Authorities

Transactions such as issuance, conversion, buy-back of shares targeted

Discounted cash flow (DCF) preferred by Indian Revenue

Valuation reports and methods such as DCF and NAV likely to gain acceptance with introduction of ‘Other Method’

Highly litigative area at present

Valuation in Business Restructurings - India 254 Valuation in Business Restructurings: the Different Approaches of Tax Authorities

Developments in Policy on Advance Pricing Agreements

8-9 May 2013

Developments in APAs - India Perspective275 Developments in Policy on Advance Pricing Agreements

Guidelines notified on August 31, 2012

Taxpayer community reposing faith in the APA regime

Encouraging response – about 150 pre-filings in 8 months

Approx 80% of the pre-filings are for unilateral APA

Developments in APAs - India Perspective285

Relationship between Indian – US Competent Authority cause of concern

In absence of Art 9(2), bilateral APAs not available

Transactions targeted – Royalty, Contract R&D, software, management fees, contract manufacturing, cost allocations

Developments in Policy on Advance Pricing Agreements

Proliferation of countries now with APA rules

Various countries such as HK growing DTA network partly to support APAs

Indonesia and Vietnam now on steep learning curve

HK IRD enthusiastic but only limited cases underway so far

China focus on bilateral/multilateral due to severe limitations on resources

29

Developments in APAs - Asia PerspectiveDevelopments in Policy on Advance Pricing Agreements5

Intercompany Loans Focus

8-9 May 2013

Intercompany Loans Focus - India Perspective316 Intercompany Loans Focus

Financial transactions such as loans and guarantees – highly litigative area in Indian TP arena

Expressly introduced in definition of international transaction vide Finance Act 2012

CUP mostly relied upon as the most appropriate method – PLR, LIBOR typically used for benchmarking

More sophisticated quantification techniques gaining importance: Credit rating comparison of borrower & its AEs

Managing TP In-House Across Asia-Pacific

8-9 May 2013

337 Managing TP In-House Across Asia-Pacific

Transfer Pricing is the Number One Challenge

Increasingly sophisticated tax authorities are utilising commercial databases for risk- based audit selection, increasing the number of audit and calculated adjustmentsLack of consistency from country to country pose added difficultiesDispute resolution on undocumented cases is a very challenging and potentially expensive problemBusiness continues to change as a result of globalisation, M&A and reorganisationImportance of business aligned tax planning is rising

Response to a Taxand survey of tax professionals

Transfer Pricing – Managing the Challenge34

Considerations in establishing best practice

Market rates for interest

Credit premium reflecting credit risk?

Quantifiable? (spreads, historical default information)

Comparables? (bonds, credit default swap spreads, liquidity issues)

Challenges in emerging markets

Sovereign intervention

Country risk

Resulting risk / pricing impact

Managing TP In-House Across Asia-Pacific7

How do issues of ‘Transfer Pricing’ originate?The process of producing a ‘Coke’

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Example: How do Intercompany Loan Issues Originate?

• CDS are good proxy for actual risk premium• Most responsive market to changes in risk perception• Very liquid market for parent company’s funding• High credit quality, high liquidity => low spreads


Example: Credit Default Spreads at the Parent Level

Source: S&P Capital IQ, Standard & Poor’s Ratings

=*

* … broadly the same credit quality; within +/- 1 notch

Source: S&P Capital IQ, Standard & Poor’s Ratings

Standard & Poor’s Ratings

S&P Capital IQ – Credit Model

CMS - CDS Prices

?


Example: Using an Objective Model to Score Where no Risk Indicators are Available

The reliance on empirical basedapproaches assures transparencyand trustworthiness of the pricingapproach• Build custom empirical yield curves

based on actual historical data only,utilizing typical polynomial or moreadvanced approaches

• Pre-generated templates allow you toinstantly review relevant statistic onthe a custom yield curve

Note: Graph contains hypothetical data.

Building Robust Market Based Reference PricingCalculate Yield Curves for Custom Pool of Comparables

Empirical Term Structure

0

1

2

3

4

5

6

7

0 5 10 15 20 25 30

Term (years)

Yie

ld (

%)

Median

Upper Quartile

Lower Quartile

Exposure Weighted Average

Establishing a market based comparable requires:

Transparent methodologyAppropriate segmentation (geography, industry, credit rating, duration, etc.)Cover all risk factors (sovereign risk, T&C)Strong grounding on empirical data

Credit Spread Models

7 Managing TP In-House Across Asia-Pacific

Alternatives in Establishing Effective Reference Prices

Sovereign Default Risk

(LC / FC)

Transfer & Convertibility Risk

“Country risk is the risk that economic, social, and political conditions and events in a foreign country will adversely affect an

institution’s financial interests. […] Country risk includes the possibility of nationalization or expropriation of assets, government

repudiation of external indebtedness, exchange controls, and currency depreciation or devaluation.

Risk associated with the non-repaymentof a sovereign’s financial obligations

issued in local or foreign currency

Country Risk

Likelihood of sovereign interference in the exchange rate market to prevent non-sovereign entities to repay their financial obligations in

foreign currency

The risk that a government will discriminatorily change the laws, regulations, or contracts governing an investment—or will fail to

enforce them—in a way that reduces an investor’s financial returns is what we call “policy risk.”

Policy Risk


Emerging Markets – Look Beyond Sovereign Risk

Incongruity Between Country Risk Scores & Sovereign Ratings

Source: S&P Capital IQ Country Risk Framework and Rating information from Global Credit Portal (R) as of September 30, 2011 and provided for illustrative purposes.

Concentrating on Country Risk - Its Impact on Corporations


Malaysia Thailand China Cambodia

Country Risk Score

a a- bb+ b

Standalone Score

bbb- bb+ bb- b+

* FC… Foreign Currency* FC… Foreign Currency

Country risk impacts the standalone score significantly and across a number of countries with different risk, that leads to 4 notches difference

Country risk impacts the standalone score significantly and across a number of countries with different risk, that leads to 4 notches difference

Sovereign Rating FC*(as at 21 Jun 2012)

A- BBB+ AA- B

Credit Score bbb- bb+ bb- b

Where the sovereign rating is low (Cambodia), it would limit the company’s ability to get a higher rating, even if the standalone score is strongerThe range of scores, depending on industry and country selection is from bbb- to b (5 notches)!

Where the sovereign rating is low (Cambodia), it would limit the company’s ability to get a higher rating, even if the standalone score is strongerThe range of scores, depending on industry and country selection is from bbb- to b (5 notches)!

Scoring the same financial profile across different countries… Scoring the same financial profile across different countries…


Impact of Sovereign & Country Risk Scores to Individual Co.s

Global consistency vs local customisation

Adapting Master-file to local circumstances

Preference for local methods, comparables

Reconciling different local studies

Optimal TP team structure & infrastructure

Governance

Engagement of key stakeholders (business, tax, finance, legal/compliance) and local teams

Operational: embedding TP into BAU

Managing TP Risk In-house Across Asia-Pacific42Managing TP In-House Across Asia-Pacific7

Taxand’s Take

8-9 May 2013

Financial transactions, intangibles gaining focus globally

Need for “glocal” documentation - MNEs should tailor their global documentation to manage risks in complex jurisdictions

Involvement of in-house tax department in operational changes critical

Proactive approach towards controversy management

Convergence of global tax policies with local risks

Increased transparency and sharing of information - need of the hour

Exploring alternate dispute resolution mechanisms

Taxand’s Take44Managing TP In-House Across Asia-Pacific8

Key Contacts Key Contacts 456

Mukesh ButaniTaxand IndiaE. [email protected]. +91 124 339 5011

Clemens ThymStandard and PoorsE. [email protected]

Shiv MahalinghamTaxand UKE. [email protected]. +44 207 715 5234

Steven CareyQuantera GlobalE. [email protected]

http://www.taxand.com/events

Understanding and managing the tax consequences of cross-border tax transactions

Considering organisational (re)structuring options in full awareness of the tax implications

Realising tax, supply chain and overall operational efficiencies

Interpreting technical tax provisions

Our Global Service Commitment469 Key Contacts & About Taxand

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Why Taxand?489 Key Contacts & About Taxand

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Documents

Transfer Pricing: Issues, Risks & Opportunities for Multinationals 8-9 May 2013 Chair: Mukesh Butani – Taxand India Panelists: Shiv Mahalingham – Taxand