Transfer Pricing Documentation in India CA. Vijay Iyer and CA. Nitin Narang

1. Transfer Pricing Documentation in India CA. Vijay Iyer and CA. Nitin Narang September 8, 2007

2. Contents • Transfer Pricing Documentation • Fact gathering • Functional Analysis • Economic Analysis • Transfer Pricing Study Report and Accountant’s Report

3. Transfer Pricing Documentation

4. Transfer Pricing Documentation - Overview • Transfer Pricing (“TP”) regulations were introduced in India w.e.f. financial years beginning from April 1, 2001. • The regulations require extensive TP documentation to be maintained by taxpayer undertaking international transactions with overseas group affiliates (“AEs”). • The contemporaneous TP documentation is required to be maintained on or before the due date of filing the corporate income tax return, i.e. on or before October 31 every year in respect of the tax year. • The detailed list of documents to be maintained as a part of TP documentation is provided in Rule 10D of the Income Tax Rules, 1962 (“Rules”)

5. Rule 10D Documentation Transaction related Price related Entity related • Profile of industry • Profile of group • Profile of Indian entity • Profile of AEs • Transaction terms • Functional analysis (functions, assets and risks) • Economic analysis (method selection, comparable benchmarking) • Forecasts, budgets, estimates • Agreements • Invoices • Pricing related correspondence (letters, emails, fax, etc)

6. Documentation – Rule 10D The approach for TP documentation may be summarised in the following phases of work: Documentation/ Accountants report 4 TP Study Report and Accountant’s Report Economic analysis Calculation of arm’s length result 3 Selection of Most Appropriate Method Selection of Comparables Functional analysis 2 Analysis of Functions, Risks, Assets and Intangibles Fact gathering 1 Mapping of international transaction Industry Analysis

7. Fact gathering

8. Mapping of international transaction • Applicability of TP regulations to the entity and its international transactions with its AEs. • Keeping the legislative provisions in perspective, the following details about the AEs need to be documented: • Name and address of AEs. • Legal status. • Country of tax residence. • Ownership linkages. • Broad description of the business of the AEs.

9. Industry analysis • Understand industry dynamics in which entity operates • Industry analysis examines industry trends, risks and overall environment, in which the entity/ the group operates. • Generally, the following information should be documented about the industry: • Industry structure (including the Legal environment of the industry); • Key players; • Key value drivers/ inhibitors of the industry; • Trends in profitability, turnover, market share, etc.; • Future outlook; and • Other important details, if any.

10. Functional analysis

11. Functional analysis • The functional analysis includes: • Overview of the entity and the group to which it belongs. • Analysis of functions performed by the entity and its AEs. • Analysis of risks assumed by the entity and its AEs. • Analysis of the intangibles owned by the entity and its AEs. • Description of the assets utilised by the entity. • The functional analysis is primarily based on the interviews with the entity’s personnel. • Information can also be gathered from portals of the entity, internet, intranet, entity brochures and audit documents.

12. Functional analysis • Interview with the entity’s personnel, would generally include: • Discussing the organisation structure and operating procedures. • Identifying all international transactions including deemed international transactions. • Functions performed, risks assumed and assets utilised by each entity involved in the transaction. • Identifying pricing strategies. • TP methodology adopted by the group and its implementation in the entity’s operations. • Identifying internal / external comparable data. • If losses are incurred, then reasons for the same.

13. Functional analysis

14. Economic analysis

15. Economic Analysis • Economic Analysis involves: • Determination of method to be applied and reasons for rejection of other methods. • Description of the databases used in the analysis (e.g., Prowess, CapitaLine, etc) and search methodology used. • Description of the financial analysis undertaken including descriptions of the comparables and adjustments to data. • Determination of the arm’s-length price. • Adjustment to the arm’s length price / tested party price to make them comparable: • Capacity utilisation • Working capital • Marketing • Conclusion on whether the transaction meets the arm’s length test.

16. Economic analysis – Selection of Most Appropriate Method

17. Transfer Pricing Methods OECD Transfer Pricing Methods Traditional Transaction Methods Transactional Profit Methods Profit Split Method Transactional Net Margin Method Comparable Uncontrolled Price Resale Price Method Cost Plus Method • 1. OECD: traditional methods preferred to transactional methods • Indian rules confirm OECD approach • Any other method prescribed by the Central Board of Direct Taxes- None as of now

18. Comparables • All methods require comparables. • Transfer price is set/ defended using data from comparable companies. • Comparable company should be independent and similar to the entity. • Following factors are generally used in judging comparability (Rule 10C(2)): • nature of transactions undertaken (i.e type of good, service etc.) • company functions • risks assumed • contractual terms (i.e similar credit terms) • economic and market conditions

19. Comparable Uncontrolled Price Method -Rule 10B(1)(a) • Comparable Uncontrolled Price (“CUP”) method is considered as the most appropriate method, for all transactions, if information is available. • CUP method compares the price charged in a controlled transaction with the price in an uncontrolled transaction. • It requires strict comparability in products, contractual terms, economic terms, etc.

20. Identification of price charged or paid in comparable transaction(s) Such price adjusted to account for differences if any between international transaction and uncontrolled transaction(s) Adjusted price arrived above taken to be arm’s length price Comparable Uncontrolled Price Method

21. Comparable Uncontrolled Price Method • Internal CUP Related party - Manufacturer B Manufacturer A Non-related party • External CUP Non-related party A Non-related party B

22. Resale Price Method- Rule 10B(1)(b) • Resale Price Method (“RPM”) compares the resale gross margin earned by AEs with the resale gross margin earned by comparable independent distributors. • An arms’ length gross margin should be sufficient for a reseller to cover its operating expenses and make an appropriate operating profit (in light of its functions and risks). • Preferred method for a distributor buying purely finished goods from a group entity (if no CUP available). Unrelated Wholesalers Group Manufacturer (Outside India) Related Distributor (India) $100 $75

23. Identification of resale price by tested party Resale price reduced by normal gross profit with reference to uncontrolled transaction(s) Such price reduced by expenses incurred (customs duty etc.) in purchase of the product/ services. This price may be adjusted to account for functional and other differences if any Resale Price Method

24. Adjusted price arrived above taken to be arm’s length price Resale Price Method

25. Cost Plus Method Rule 10B(1)(c) • Cost Plus Method (“CPM”) compares the gross profit on costs the AEs earns with the gross profit on costs earned by comparable independent companies. • Preferred method for: • manufacturer supplying semi-finished goods • entity providing services Manufacturer A (Indian) US Market Related Manufacturer B (Outside India, say US) Cost + 40%

26. Identification of direct and indirect costs of production incurred in tested party transactions Identification of normal gross profit with reference to uncontrolled transaction(s) Normal gross profit adjusted to account for functional and other differences if any Adjusted gross profit added to total costs identified in step 1 Cost Plus Method

27. Sum arrived above is taken to be arm’s length price Cost Plus Method

28. Profit Split Method-Rule 10B(1)(d) • Profit Split Method (“PSM”) is appropriate for transactions which are not capable of being evaluated separately. • Calculates the combined operating profit resulting from the whole inter-company transaction based on the relative value of each AE's contribution to the operating profit. • The contribution made by each party is determined on the basis of a division of functions performed, valued, if possible using external comparable data. • Applicable for analysing tangible, intangible or services issues.

29. Determination of combined net profit of the AEs arising out of international transaction Evaluation of relative contributions by each enterprise on the basis of functions performed, risks assumed and assets employed Splitting of combined net profit amongst enterprises in proportion to their relative contributions Profit thus apportioned to the tested party is used to arrive at the arm’s length price Profit Split Method

30. Transactional Net Margin Method-Rule 10B(1)(e) • Transactional Net Margin Method (“TNMM”) examines net operating profit from transactions as a percentage of a certain base (can use different bases i.e. costs, turnover, etc) in respect of similar parties, as the profit level indicator. • Ideally, operating margin should be compared to operating margin earned by same enterprise on uncontrolled transaction – Internal TNMM • TNMM can also be used to compare the “comparable transactions” between independent parties – External TNMM. • It is applicable for any type of transaction and can also be used to supplement analysis under other methods. • It is the most frequently used method in India, due to: • lack of availability of data to apply other methods. • evens out business cycles, product dissimilarities.

31. Net profit from uncontrolled transaction adjusted to account for differences if any Computation of net profit as a percentage of a certain base realised from theinternational transaction. Computation of net profit realised by the tested party or an unrelated enterprise in a comparable uncontrolled transaction The net profit thus established is taken into account to arrive at an arm’s length price for the international transaction Transactional Net Margin Method

32. Cost reimbursements / allocations • Cost reimbursements • In this case, pure third party costs borne by an Indian entity on behalf of its overseas AEs or borne by an overseas AE on behalf of the Indian entity in received / paid by the Indian entity • Since, these expenses are in the nature of costs, without mark-up, margin based analysis for determination of arm’s length price is not required • Necessary to prove that the Indian entity has not provided any service to the overseas AE • Cost allocations • Certain expenses incurred by the parent such as HO expenses, network expenses are allocated to all its subsidiaries worldwide (including India) • These expenses are in the nature of allocation of costs, without mark-up. • Necessary to demonstrate benefit-rule test.

33. Economic analysis – Selection of Comparables

34. Business Process Analysis TP Method Project Constraints Search Strategy Comparable Search and Analysis Process Database Search Workpaper (WP) Detailed Comparability Review & Elimination Additional Data Sources & Telephone Interviews Final Comparability Review & Elimination Financial Review & Analysis Final Comparables Set Application to the Tested Party

35. Search for comparables: Steps • Select an appropriate database based on geographical considerations, nature of the transaction etc. • Select the appropriate search criteria on the chosen database • Screen potential comparables • Qualitative screening by review of short business description; • Review public documents such as annual reports, company websites, etc. for selected companies • Document search process

36. Search for comparables: Database selection • The following databases are most widely used to identify Indian comparables: • Caplitaline Plus • Prowess

37. Search for comparables: Selection of search criteria (Indian databases) • A preliminary list of companies is identified from Prowess using a keyword filter, generally searching by the products/raw materials filter. • Similarly a preliminary list of companies is obtained from Capitaline Plus using the screener module and then generally searching by Industry/product name/product code. • The list of companies obtained on Prowess and Capitaline Plus is then merged to account for duplication.

38. Search Process: Screening of potential comparables • A set of filters applied to the initial list of companies (obtained from the database) can be used to eliminate companies at the first stage. • In addition, the Directors Report, Auditors Report, Notes to Accounts, Profit and Loss Account, Product details, Segmental information and Other company reports available on the database may be studied to eliminate companies that do not meet certain criteria. • Finally, for the companies that appear to be comparable from the information available, other publically available information such as Annual Reports, company websites, etc. are reviewed.

39. Broad criteria for rejection of companies The following filter are generally applied and are also accepted by the tax authorities: • Insufficient descriptive/ financial/ segmental information to perform analysis. • Functionally different. • No operations. • Significant related party transactions. • Persistent operating losses. • Sick company. • Other filters (e.g. turnover criteria, exceptional year of operations, etc.)

40. Documentation of the Search process • Summary of search process, including which databases were searched, search criteria and reasons for rejection • Short business descriptions of accepted companies • Completed Accept-Reject matrix • Prepare a margin analysis summary sheet

41. Arm’s length price Price applied or proposed to be applied in a transaction between persons other than AEs, in uncontrolled conditions Determination of arm’s length prices using one of the Prescribed methods Whether you arrive at a single price ? Yes No The arithmetic mean of such prices or a price which varies from such arithmetic mean by +/-5% is the arm’s length price (92C(2)) The price thus determined is the arm’s length price

42. The Arm’s Length Range - How it works • In most cases, it is not possible to identify a single price that can be considered to be an uncontrolled price. • It may be that a number of different comparables are equally comparable. Several comparable transactions can therefore define an arm’s length range of possible transfer prices. • Overall range may contain extremes. Indian TP legislation recognizes only arithmetic mean (with a +/-5% variation) though statistically and internationally an inter-quartile range may be more appropriate. • If transfer price falls within a +/- 5% range, pricing should be defendable as arm’s length from tax authority audit perspective.

43. TP Study Report and Accountant’s Report

44. TP Study Report • As discussed above, the contemporaneous TP documentation is required to be maintained on or before the due date of filing the corporate income tax return, i.e. on or before October 31 every year in respect of the tax year.

45. Accountant’s report • The Indian TP legislation also requires that tax payers having international transactions with AEs to file Accountant’s report (in Form 3CEB) with the revenue authorities. • The Accountant’s report should be filed on or before the due date for filing the corporate income tax return, i.e on or before October 31 every year in respect of the tax year. (The Indian tax year is from April to March)

46. Accountant’s report • The Accountant’s report essentially comments on the following: • Whether the tax payer has maintained the prescribed TP documentation as required by the legislation; • Whether as per the TP documentation the prices of international transactions are at arm’s length; and • Certifies the value of the international transactions as per the books of account and as per the TP documentation are “true and correct”.

47. Thank You