Transfer Pricing Methods

1. Transfer Pricing Methods Seminar on Transfer Pricing The Northern India Regional Council of the ICAI 8th February 2014 By: CA. Gaurav Garg

2. Agenda JGarg Economic Advisors • Meaning of Transfer Pricing • Arm’s Length Principle • Applicability on Specified Domestic Transaction • Compliance • Transfer Pricing Documentation • Transfer Pricing Methods • Accountants Report

3. Meaning of Transfer Pricing JGarg Economic Advisors • Mechanism or exercise • through which • price for transfer or say transfer price, of, • tangibles, intangibles, services, capital financing etc. • is computed.

4. Arm’s Length Principle JGarg Economic Advisors • Principle • Prices set for a transaction • between related parties • should • for tax purposes • be derived from prices • which would have been applied by unrelated parties • in similar transactions under similar conditions in the open market.

5. Compliance… Transfer pricing provision on specified domestic transactions are applicable from FY 2012-13 / AY 2013-14. Taxpayer must compute an arm’s length price of specified domestic transaction and/or international transaction as per the methods prescribed under section 92C. Burden of proof is on the taxpayer to establish the arm’s length price and to maintain related documents. Must obtain a report under Form 3CEB from a Chartered Accountant and file it before tax authorities within due date of filing of return of income. Due date for filing tax return would be 30 November for a taxpayer on whom transfer pricing provisions are applicable. Tax payer must submit the transfer pricing document to the tax authorities, within 30 days of the receipt of notice from the department. JGarg Economic Advisors

6. …Compliance • Penalties • Non maintenance of documents, fail to report transaction, maintain or furnishes an incorrect information or document – 2% of the value of controlled transaction – Section 271AA • Non filing of Form 3CEB – Rs.100,000/ - Section 271BA • Failure to furnish information or document to tax authorities – 2% of the value of controlled transaction – Section 271G JGarg Economic Advisors

7. Arm’s Length Price 5 specific and 1 general method In case more than one price determined, ALP shall be mean of such prices Variation of 1% in case of whole sale trader and 3% in other cases allowed from ALP In case variation is more than the percentage specified, addition would be from mean Data to be used for analysing of ALP shall be of financial year in which transaction has been entered Prior 2 years data for the purpose of computation could only be used if such data could have influence on determination of ALP JGarg Economic Advisors

8. Transfer Pricing Methods… + Rule 10AB TP Methods Indian Regulations CUP Methods CUP Methods Resale Price Method Resale Price Method Cost Plus Method Cost Plus Method Profit Split Method Profit Split Method Transactional Net Margin Method Transactional Net Margin Method OECD Guidelines JGarg Economic Advisors

9. …Transfer Pricing Methods • In general • Comparable Uncontrolled Price (“CUP”) Method compare prices. • Resale Price Method (“RPM”) compares gross margins. • Cost Plus Method (“CPM”) compares profit mark-ups on costs. • Profit Split Method (“PSM”) refers to the (total) profits from transactions and splits them among the parties based on the level of contribution. • Transactional Net Margin Method (“TNMM”) analyses net profit in relation to an appropriate base, such as costs, sales or assets. • Other Method (Rule 10AB) takes into account the price which has been charged or paid, or would have been charged or paid, for the same or similar uncontrolled transaction. JGarg Economic Advisors

10. TP Methods – CUP… • CUP Method • Most direct way of determining an ALP • It compares the price charged for goods or services transferred in SDT to the price charged for property or services transferred in a comparable uncontrolled transaction. • Price is adjusted to account for differences, if any, between the SDT and the comparable uncontrolled transactions or between the enterprises entering into such transactions, which could materially affect the price in the open market. JGarg Economic Advisors

11. ..TP Methods – CUP.. SDT Seller (RP) Buyer (RP) Seller Uncontrolled Transaction • Types of comparison • Internal comparison • External comparison Internal Comparison JGarg Economic Advisors

12. ..TP Methods – CUP.. Buyer (RP) SDT Seller (RP) Uncontrolled Transaction Buyer Seller (RP) SDT Buyer (RP) Seller Uncontrolled Transaction Buyer Internal Comparison External Comparable JGarg Economic Advisors

13. …TP Methods – CUP • Comparability • The comparability of property transferred in SDT and an uncontrolled transaction is most decisive for the application. • Intended purpose of use, branding or customer perception and preference would impact applicability. • Market comparability is another important factor to be considered. • Contractual term including quantity of property sold or acquired, volume discounts, applicable currency, marketing, advertising, after sale support, duration of contract, terms of delivery, terms of payment etc can not be ignored. JGarg Economic Advisors

14. CUP – Case Study 1 AB India Ltd. 200 customers A Ltd. XY India Ltd. 210 customers JGarg Economic Advisors

15. CUP – Case Study 1 FAR JGarg Economic Advisors

16. CUP – Case Study 1 FAR JGarg Economic Advisors

17. CUP – Case Study 1 Other information JGarg Economic Advisors

18. CUP – Case Study 1 • Conclusion • Transaction between A Ltd. & AB Ltd. (‘Controlled transaction’) and A Ltd. & XY India Ltd (‘Uncontrolled transaction’) are comparable. • However, difference for adjustments in delivery terms need to be carry out. • Hence, CUP is the most appropriate method. JGarg Economic Advisors

19. CUP – Case Study 1 • Steps to follow • Identify controlled transaction • Identify uncontrolled transaction • Is price data or data for calculating profit margin available for each transaction? • Are the physical characteristics of inventories and nature of services involved in controlled transactions and uncontrolled transaction are same or similar? • Is market level same – retail, wholesaler, OEM, secondary etc.? • Do the transactions differ in volume or timing? • Are there any differences in the terms of trade, payment terms, conditions for returns, or conditions regarding contract renewal? • Are there any differences in the functions of the seller or buyer (e.g. in terms of R&D, marketing, and after-sales service)? JGarg Economic Advisors

20. CUP – Case Study 1 • Steps to follow • Are there any differences in the terms of trade, payment terms, conditions for returns, or conditions regarding contract renewal? • Are there any differences in the functions of the seller or buyer (e.g. in terms of R&D, marketing, and after-sales service)? • Are intangible properties used by the seller or buyer in transactions? • Are there any differences in terms of business strategy (e.g., policy toward market development and penetration) or timing of market entry? • Are there any differences in government regulation (e.g. price regulation), market size, or competition, etc. affecting prices and profit margins? • Are there any special circumstances dictating that transactions may not reasonably be regarded as comparable (e.g. bankruptcy situations)? JGarg Economic Advisors

21. TP Methods – RPM… • Resale Price Method (‘RPM’) • The resale price method measures an arm's length price by subtracting the appropriate gross profit from the applicable resale price for the property involved in the controlled transaction under review. • The price is adjusted to take into account the functional and other differences, including differences in accounting practices, if any, between the SDT and the comparable uncontrolled transactions, or between the enterprises entering into such transactions, which could materially affect the amount of gross profit margin in the open market. JGarg Economic Advisors

22. RPM – Case Study 2 A Ltd. AB India Ltd. Third party customers • - AB India Ltd. is a distributor of product A in India. • AB India does not engage in unique or original advertising or sales promotion activities, and makes no use of its own trademarks or other such properties in its distribution activities. • No internal comparable available • Financial data in respect of distributor of comparable product available JGarg Economic Advisors

23. RPM – Case Study 2 FAR JGarg Economic Advisors

24. RPM – Case Study 2 FAR JGarg Economic Advisors

25. RPM – Case Study 2 FAR JGarg Economic Advisors

26. RPM – Case Study 2 • Conclusion • Transaction between A Ltd. & AB Ltd. (‘Controlled transaction’) and Comparable 1 transactions are comparable. • Though Comparable 2 is distributor but cannot be considered comparable on account of different FAR, for which it might be tough to carry out reasonable adjustments. JGarg Economic Advisors

27. …TP Methods – RPM • Applicability • Reseller should not make any material alterations to the product traded. • Comparability • Product comparability not very important, however better the product comparability better would be the results • More functions and asset, higher risk would require higher gross margin • Accounting variations should be taken care • Other factors like geographical differences, volume, high operating cost may effect comparison JGarg Economic Advisors

28. TP Methods –CPM… • Cost Plus Method (‘CPM’) • The cost plus method tests whether a profit mark-up charged in a SDT is at arm’s length by reference to the mark-up charged in uncontrolled transactions. • Transfer pricing is calculated by adding a mark-up, earned in uncontrolled transactions, to a direct and indirect cost of production/ services relating to SDT. JGarg Economic Advisors

29. ..TP Methods –CPM.. Buyer (RP) 100 + 20 Seller (RP) 100 + 25 Buyer Example SDT Uncontrolled Transaction JGarg Economic Advisors

30. CPM – Case Study 3 AB India Ltd. A Ltd. Distributors & Agents Third party manufacturer • AB India Ltd is a manufacturer • A India Ltd. is a distributor of product “A100” manufactured by AB India Ltd. • A Ltd. also procures another product “A200” from third party contract manufacturer and distributes the same • - A India ltd owns all intangibles JGarg Economic Advisors

31. CPM – Case Study 3 FAR JGarg Economic Advisors

32. CPM – Case Study 3 FAR JGarg Economic Advisors

33. CPM – Case Study 3 FAR JGarg Economic Advisors

34. CPM – Case Study 3 • Conclusion • AB India Ltd. being simpler entity should be considered as the ‘tested party’ • As financial data would be available for the tested party and third party, gross margin earned by the third party would be considered as arm’s length mark-up • If tested party would be earning less, it can be concluded that the transaction is at arm’s length. • However, if financial data for third party contract manufacturer is not available, it may be tough to apply CPM. JGarg Economic Advisors

35. ...TP Methods - CPM • Applicability • CPM is useful in case of long-term buy-and-supply agreements, pricing of semi-finished goods, toll or contract manufacturing, services of purchasing agents, contract research etc. • Comparability • Product comparability not very important, however better the product comparability better would be the results • More functions and asset, higher risk would require higher gross margin • Accounting variations should be taken care • Other factors like geographical differences, volume, high operating cost may effect comparison JGarg Economic Advisors

36. TP Methods –PSM… • Profit Split Method (‘PSM’) • This method aims to determine what division of total profits independent enterprise would expect in relation to the relevant transactions. • The profits should be split on an economically valid basis that reflects the functions and risks of each of the parties. • In order to apply this method, it is necessary to identify the total profit arising from the related party transactions and split that profit between the parties according to their respective contributions. JGarg Economic Advisors

37. ..TP Methods –PSM.. • Applicability • In certain very complex trading relationships involving very interrelated transactions, it is sometimes genuinely difficult to evaluate those transactions on a separate basis. • Approaches • There are two approaches to this method; • Total profits split, and • Residual profit split JGarg Economic Advisors

38. ..TP Methods –PSM • Total Profit Split • Total profits from the controlled transactions made by all the enterprises involved in earning those profits are split between those enterprises based on the relative value of the functions that each carries out. • Residual Profit Split • Total profit of the overall trade made by the associated enterprises is considered. • Firstly, each participant is allocated sufficient profit to provide it with a basic return appropriate to the functions carried out. • Secondly, any profit (or loss) left after the allocation of basic returns would be split as appropriate between the parties – based on an analysis of how this residual would have been split between third parties. JGarg Economic Advisors

39. TP Methods –TNMM… • Transactional Net Margin Method (‘TNMM’) • The TNMM examines the net profit margin relative to an appropriate base that a tax payer realizes from SDT vis-à-vis comparable uncontrolled transactions. • Thus, the TNMM operates in a manner similar to the cost plus and resale price methods. • The TNMM is based on the economic theory that returns earned by an enterprise operating under similar conditions, in the same market and industry, tend to become more equal after some time. JGarg Economic Advisors

40. TP Methods –Rule 10AB • Other method of determination of arm's length price. For the purposes of clause (f) of sub-section (1) of section 92C, the other method for determination of the arms' length price in relation to an international transaction or a specified domestic transaction shall be any method which takes into account the price which has been charged or paid, or would have been charged or paid, for the same or similar uncontrolled transaction, with or between non-associated enterprises, under similar circumstances, considering all the relevant facts. JGarg Economic Advisors

41. Thank You CA. Gaurav Garg JGarg Economic Advisors Pvt. Ltd. Email: gaurav@jgarg.com Mobile: +91 98999 94934 Landline: 011 – 47094934 :011 - 65394934 www.jgarg.com JGarg Economic Advisors