FORUMULATING A TRANSFER PRICING STRATEGY Navigating the Indian & Overseas waters!

1. FORUMULATING A TRANSFER PRICING STRATEGY Navigating the Indian & Overseas waters! Narayan Mehta Partner, Sudit K Parekh & Co 3rd February 2006

2. Agenda • Importance of Compliance • A case study • Indian owned UK, US and Canadian software subsidiaries • Transfer Pricing considerations • Related issues under other laws

3. Importance of Compliance • Any related party transaction undertaken from 1st April 2001 onwards covered • Currently 60% of world’s cross-border trade is between related parties – Indian tax authorities have taken the cue! • UK –every £1 spent on TP investigation has fetched £120 to UK Inland Revenue! • 1/3 rd of audits globally end up with TP adjustments! • India - FY 01-02 assessments complete • Incremental revenue collection - in excess of INR 600 Cr • Around 25% to 30% of the case show adjustments!

4. Importance of Compliance • Transactions exceeding INR 50 mn to attract compulsory TP audit • Onus of proof- tax payer primarily liable • S.10A / 10B units- thin margin for error • No deduction under section 10A / 10B on enhanced income! • More than ordinary profits taxable & may not be tax exempt! • Double taxation for the Group in respect of enhanced income

5. Penalties are High • Failure to maintain documentation • 2% of value of transaction • Failure to furnish documentation • 2% of value of transaction • Addition to Income • 100% to 300% of tax on addition • Failure to furnish Accountant’s Report • Rs. 100,000 Penalties are not tax deductible! Most TP penalties are not appealable! Penal regulations in many overseas jurisdictions as well!

6. A Bilateral Exercise • At least 9 out of 25 EU / accession countries have specific TP documentation requirements: Denmark Hungary Portugal France Netherlands Spain Germany Poland UK • Upward of 20 other countries have specific TP documentation requirements Japan Australia Korea China Canada Mexico • TP documentation may be required in other countries under general anti-avoidance provisions Israel Singapore, etc. Need for balancing the Indian & overseas transfer pricing regulations!

7. Dual Advantage! • An effective tax planning & risk management tool to establish the appropriateness of transfer prices

8. Integrated & Holistic Approach Also involves • Commercial considerations • International tax • Section 10A optimization • Withholding tax • Expatriate taxation • Immigration issues • Exchange control • Service Tax / VAT • STPI issues

9. Documentation- Why Necessary? • To be better prepared for transfer pricing audit • To support your arm’s length price in future • Self review Effective communication of TP policy is critical for IRS to appreciate & approve transfer pricing documentation!

10. Onerous Documentation Retention Reqt Beginning of tax year End of tax year Deadline for maintaining documentation Filing Accountant’s Report & ROI Limitation for initiation of assessment Limitation for completion of assessment Date till which docn. is required to be maintained

11. Legislative Framework Legislative Framework Associated Enterprise Associated Enterprise International Transaction Arm’s length computation & maintenance of necessary documentation

12. Indian Transfer Pricing Regulations Indian Income-tax Act, 1961 Arm’s length price Documentation Accountant’s Report

13. UK, US & Canadian subsidiaries CASE STUDY: Indian Owned

14. Indian tax rate=0 / 33% UK tax rate= 10/30% Transfer Pricing issues! Indian Co UK WOS Contract for outsourcing • Software • development • Brand creation • Entrepreneurial • risk Principal contract for software development Deputation / secondment of personnel for onsite execution Contract value UK £ 100 Ultimate UK client Similar fact pattern for the US / Canadian subs. UK Subsidiary Consideration ? • Marketing in UK • Payroll / work permit • Dely mgt. & sales support

15. Step 1- Functional Analysis Compliance with documentation requirements Understanding of where and how value is added Criteria for Comparability Assist in identification of simpler entity Platform for Economic Analysis

16. Functions Performed Income distribution within the MNC to be based on economic value and activities Each activity / enterprise receives a share of total profits that reflects the contribution of that activity / enterprise to earning those profits. R&D Software Development Finance Marketing Sales & Distribution

17. Risks undertaken Income distribution within the MNC to be based on risks undertaken Strategic Planning Foreign Exchange Project Scheduling & Dvlpt Activities Idle Capacity Quality Control Sales & Distribution Research & Development Marketing

18. Assets employed Income distribution within the MNC to be based on assets employed Technical/ Trade Intangibles Marketing Intangibles

19. Step 2: Economic Characterization of simpler entity • UK subsidiary – the simpler entity! • Economic characterization • Ring fenced, risk mitigated contract service provider

20. India UK Functions Assets Risks Profits £,£ £ £, £ £ £, £ £ ££, £ £ £ Functional & Economic analysis- significance XYZ Group of Companies Profit = f (F + A + R)

21. Step 3: Selecting the most appropriate method Most Appropriate Method ??? ??? ? Cost Plus Profit Split TNMM Resale Price Method Comparable uncontrolled price Other Yet to be prescribed Most appropriate method - service provider - cost plus / TNMM

22. External comparables- running queries on UK databases for searching functionally comparable companies preferably in the same line of business Fame database Global Vantage Kompass Amadeus Marketing / commission agents for software / ITES services . Step 4: Search and assessment of comparables

23. Sample record of benchmarks used as comparable data

24. An alternative analysis • Constructing an alternate broad base sample • Use of lateral comparables to broad-base final sample size! • What should be the sample size? • US / UK vs. Canadian practice

25. Sample record of benchmarks used as comparable data (extended sample)

26. Arithmetic mean and median of extended sample

27. UK Subsidiary- SKP experience

28. Rest of the profits! Cost plus 11% only! Consideration ? Indian tax rate=0 / 33% UK tax rate= 10/30% Transfer Pricing issues! Indian Co UK WOS Contract for outsourcing • Software • development • Brand creation • Entrepreneurial • risk Principal contract for software development Deputation / secondment of personnel for onsite execution Contract value UK £ 100 Ultimate UK client UK Subsidiary • Marketing in UK • Payroll / work permit • Dely mgt. & sales support Mark up for US & Canadian subs – cost plus 7 / 8%!

29. Transfer pricing – a tax planning tool! Total Profit • Above-normal profit: • Goes to economic owner(s) & developer(s) of intangible assets • May also be zero or negative! Return to entrepreneurial risk-taker Return to routine service providers / suppliers of labor and capital • Normal profit: • Paid out for performance of normal tasks [software development, sales, distribution, marketing support, etc]

30. Compliance with Indian TP Regulations • UK entity remunerated on cost plus 11% mark up • Onsite cost – regarded as flow through costs and no mark up thereon! • Rest of the profits belong to Indian entity! • Undertaking supplementary search on Indian database to corroborate findings

31. India Concept of arithmetic mean - 5% variation allowed but range not permitted Past data of only 2 years UK / US / Canada Use of (inter-quartile) range generally allowed Use of past data of even more than 2 years generally allowed Balancing Indian / UK / US / Canadian Regulations

32. India/OverseasDocumentationRequirements- Fixing the jigsaw puzzle! Accountant’s Report Industry Analysis Agreements Benchmarking Functional Analysis Other Docn

33. Other Issues Encountered • Even if PE, whether arm’s length mark-up would eliminate further tax incidence? • Employees on dual payroll or overseas payroll? • Compliances under STPI & FEMA regulations for export billing • W/ tax issues and remittances under FEMA • Drafting the contractual agreement • Consistent allocation of F / A / R • Treatment of flow through costs • Re % mark-up • Whether UK Co. is a PE of the Indian company?

34. Transfer Pricing Study - end results • Global documentation- killing many birds with one stone! • Compliance with the UK / US / Canadian transfer pricing regulations! • Compliance with the Indian transfer pricing regulations! • Minimum corporate tax incidence in UK / US / Canada! • Optimization of section 10A benefits & complete tax exemption in India! • Compliance with exchange control regulations, STPI norms & formulation of expatriate secondment policy

35. Concluding Remarks • An effective tax planning & risk management tool • Need for a holistic approach • Harmonizing the Indian & overseas transfer pricing requirements • Contemporaneous documentation • Regular review & update • Tailored to the needs of the IRS in India & overseas • Global / centralized / regional documentation • Relaxation if value of all international transaction < 1 Cr • Benchmarking analysis may yet be reqd in absence of CUPs

36. Thank You • Contact • Narayan Mehta • Tel: +91 22 2282 1141 • Mobile: +91 98205 44495 • E-Mail: narayan.mehta@skparekh.com