TRANSFER PRICING DOCUMENTATION Navigating the Indian & Overseas waters!

1. TRANSFER PRICING DOCUMENTATION Navigating the Indian & Overseas waters! Narayan Mehta Sudit K Parekh & Co, 19th November 2005, Pune Branch of WIRC (ICAI)

2. Agenda • An overview of Indian documentation requirements • Practical case study • Indian owned US & Canadian software subsidiaries

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

4. 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 • Japan –transfer pricing has been a major revenue churner- individual cases exceeds $100 m! • India - FY 01-02 assessments complete - Press has reported incremental tax revenues in excess of INR 600 Cr based on the first year of TP audit adjustments • Around 25% to 30% of the case show adjustments!

5. Enhanced audit exposure • Percentage of completed scrutiny assessments resulting in an adjustment (E & Y Survey)

6. E&Y Transfer Pricing Survey 2003- Key findings • 86% of parent and 93% of subsidiary respondents identified TP as most important international tax issue • 1/3 rd of audits concluded in TP adjustments • Penalty actually imposed in 50% of cases in which penalty threatened by TP authorities • 40% of TP adjustments have resulted in double taxation

7. 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!

8. Importance of Compliance • No exemption from compliance • Transactions exceeding INR 50 million to attract compulsory transfer pricing audit • Onus of proof- tax payer primarily liable • Nestle India Ruling • 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 • DHL Corp. & Subsidiaries Ruling

9. 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! Penal regulations in many overseas jurisdictions as well

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

11. Integrated & holistic approach May involve • International tax • Expatriate tax • Exchange control • Service Tax / VAT • STPI issues

12. 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!

13. Documentation – when most critical? • Continuous loss situation • GP / Operating margin is very volatile & fluctuating • Market penetration strategy is adopted • Changes in transfer pricing policy • Unutilized / idle capacity • Monopolistic situation • Start up phase • Transactions involving • Royalties and / or intangibles • Intra group services • Cost sharing arrangements

14. 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

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

16. Key definitions • “Document” [Section 2(22AA) of the Income tax Act, 1961] • includes electronic record as defined in sec 2(1)(1) of the Information Technology Act, 2000 • “Electronic record” [Section 2(1)(l) of the Information Technology Act, 2000] • means data, record or data generated image or sound stored, received or sent in an electronic form or micro film or computer generated micro fiche

17. Indian statutory provisions • kept and maintained in prescribed manner by every person [Section 92(D)(1)] • kept and maintained for a prescribed time [Section 92(D)(2)] • furnished within 30 / 60 days of Revenue’s request [Section 92(D)(3)] Information / documents in relation to an international transaction needs to be:

18. Documentation- fixing the jigsaw puzzle! Accountant’s Report Industry Analysis Agreements Benchmarking Functional Analysis Other Docn

19. Primary Documentation required under Indian Regulations • Associated Enterprise related documents • Transaction related documents • Description of functions performed, risks assumed and assets utilised • ALP computation related documents • Record of transactions considered for determining price of international transactions • Analysis performed to evaluate comparability • Description of all methods considered and reasons for selection of the most appropriate method • Record of actual working for determining arm’s length price • Details of comparable data used in applying most appropriate method

20. Additional Documentation required under Indian Regulations • Government publications, reports, studies, databases • Market research studies and technical publications of recognized national or international institutions • Price publications including stock exchange and commodity market quotations Relevant agreements and contracts entered into with associated enterprises or with unrelated enterprises Letters and correspondence documenting terms negotiated with the associated enterprise

21. Documentation- guiding principles Taxpayers’ standpoint • Principles of prudent business management to be followed for maintaining documentation Revenue authorities’ standpoint • Documentation examined should be that which exists at the time of determining the transfer price • Not burden the taxpayer to produce documentation which are not in its possession or over which it has no legal control • No public disclosure of trade / scientific secrets

22. US and Canadian subsidiaries CASE STUDY Indian Owned

23. US / Canadian subsidiaries Consideration ? Indian tax Rate = 0 / 35% US / Canadian federal tax rate= 35% / 39% Transfer Pricing issues! • Marketing in US / Canada • On site services and • support Indian Co US/ Canadian WOS Contract for outsourcing • Software • development • Brand creation • Entrepreneurial • risk Principal contract for software development Contract value $ 100 Deputation / secondment of personnel at site & execution of the contract offshore & onsite Ultimate US/Canadian client

24. 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

25. 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

26. Risks undertaken Analysing risks associated in relation to various business operations Strategic Planning Foreign Exchange Project Scheduling & Dvlpt Activities Idle Capacity Quality Control Sales & Distribution Research & Development Marketing

27. Assets employed Analysing various assets & intangibles employed Technical/ Trade Intangibles Marketing Intangibles

28. Functional Analysis- findings in instant case • Indian Co: • performs most of the functions • owns most of the intangibles • undertakes most of the risks • Consequently, • Indian Co relatively more complex entity • US / Canadian Cos relatively simpler entities

29. India US/Canada Functions Assets Risks Profits $,$$$,$$$,$$$ $,$$$ Functional Analysis- significance XYZ Group of Companies Profit = f (F + A + R)

30. Procedure followed in practice Site visits Background information Review client documents Client interviews Tax & audit files Written questionnaire Financial statements

31. Step 2: Economic Characterization of simpler entity • Assists in determining the search parameters for comparables • Determining the nature of the entities • Re onsite contract support - ring fenced, risk mitigated contract service providers • Re marketing support- routine market service providers

32. Step 3: Selecting the most appropriate method Most Appropriate Method ??? ??? ? Cost Plus Profit Split TNMM Resale Price Method Comparable uncontrolled price Others Yet to be prescribed Most appropriate method - service provider - cost plus / TNMM Document reasons for selection / rejection of TP methods

33. Step 4: Search and assessment of comparables • External comparables- running queries on North American TP databases for searching functionally comparable companies preferably in the same line of business • Compustat • Disclosure . In practice, Indian IRS more comfortable with searches on Indian databases!

34. Search for initial comparables • Re Onsite support services • Information Technology / Software service providers (based on Industry key words / SIC Codes) • Re Marketing support services • Marketing / advertising / commission agents

35. Identifying initial rejection criteria • Company undertakes different function • Company involved in different product • Company operates in different industry • Company is not independent • Company is dormant / inactive • Company has no financial data • Other reasons

36. Quantitative Filters 3 Year Track Record Ratios Any Other Parameters Revenue No. of Employees Applying Filters • Qualitative Filters • Companies Incorporated In Foreign Countries • Positive Word Search • Negative Word Search • Independent Companies

37. Short listing final comparables: • Review business descriptions and other details • Background information, Directors’ Report, Websites, Trend in sales, News Abstracts, Mgt discussion & Analysis, Related Party Disclosures, SEC disclosures, etc • Examine public documents (eg annual reports) • Telephone interview / company contacts • Select comparable companies

38. Ascertaining margins of final selected comparables • Needed to benchmark the margins of the tested party • Need for selection of the appropriate PLI to ascertain the margins of comparables

39. Selection of PLI • The three financial ratios generally considered as acceptable in the US context are: • Rate of Return on Capital Employed • Berry Ratio (GP / Op exp) • Operating Margin (Op profit / Sales or Cost) • Selection of appropriate PLI depends upon: • Nature of the activities of the tested party, • The reliability of the available data with respect to comparable uncontrolled taxpayers, and • The extent to which a particular profit level indicator is likely to produce a reasonable determination of the income that the tested party would have earned had it dealt with the controlled taxpayer at arm’s length • PLI in instant case - Operating Margin (Op profit / Total Cost) • - Also preferred in practice by the Indian & the US IRS

40. Sample record of benchmarks used as comparable data

41. An alternative analysis • What should be the sample size? • US v/s Canadian practice • Constructing an alternate broad base sample • Use of lateral comparables to broad-base final sample size! • US IRS prefers an alternate sensitivity analysis in practice

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

43. Arithmetic mean and median of extended sample

44. Adjustment to Ratios • Useful when feasible to increase ratio’s comparability to the tested party • Three standard adjustments • Inventory Differences • Inv. Adj. = (Inv./Sales taxpayer – Inv./Sales comparable) * Sales comparable * Prime Lending Rate • Receivables Differences • Rec. Adj. = (Receivables/Sales Taxpayer – Receivables/Sales Comparable) * Sales Comparable * Prime Lending Rate • Payable Differences • Pay. Adj. = (Payables/COGS or Sales Taxpayer – Payables/COGS or Sales Comparable) * COGS or Sales Comparable * Prime Lending Rate Not used in practice generally by Indian / European IRS- however, US & Canadian IRS prefers this adjustment in practice

45. US Subsidiary- SKP experience

46. Profit sharing based on TP policy Rest of the profits! Cost plus 8% only! Consideration ? Indian tax Rate = 0 / 35% US / Canadian federal tax rate= 35% / 39% Transfer Pricing issues! • Marketing in US / Canada • On site services and • support Indian Co US/ Canadian WOS Contract for outsourcing • Software • development • Brand creation • Entrepreneurial • risk Principal contract for software development Contract value $ 100 Deputation / secondment of personnel at site & execution of the contract offshore & onsite Ultimate US/Canadian client

47. 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]

48. Compliance with Indian TP Regulations • US / Canadian entites remunerated on cost plus 8% mark up • Rest of the profits belongs to Indian entity! • Undertaking supplementary search on Indian database to corroborate findings • In practice, Indian IRS prefers Indian entity to be the tested entity

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

50. Taking advantage of Global Documentation • Taking advantages of tax planning opportunities • Consistency & uniformity in documentation • Cost savings – killing two birds with one stone!