Simplifying Transfer Pricing and threads of reporting - 2021 Simplifying Transfer Pricing and threads of reporting - 2021
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Agenda
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Concept and Introduction
2
Why is ALP Needed?
3
Economic analysis – Key considerations
4
FAR Analysis
5
Benchmarking analysis / Comparability analysis
6
Effect of Range & Margin
7
TP policy, RPT policy, intercompany agreements and TP study – similarities and differences
8
Threads of Reporting
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Q&A
Simplifying Transfer Pricing and threads of reporting - 2021
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Concept & Introduction
Simplifying Transfer Pricing and threads of reporting - 2021
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Concept
Transfer Pricing refers to the pricing of international transactions / Specified Domestic Transaction (“SDT”) between two Associated Enterprises (“AEs”) (in simple words – related parties fulfilling the relationship conditions specified).
Due to special relationship between related parties, the transfer price may be different than the price that would have been agreed between unrelated parties.
Simplifying Transfer Pricing and threads of reporting - 2021
Provisions require demonstration of “transfer price” is at “arm’s length”
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Flowchart for applying Transfer Pricing Regulations (TPR) for international transaction
Is there a transaction between two enterprises giving rise to income in India?
N
TPR does not apply
Y
Whether two enterprises are Associated with each other out of which at least one is non-resident
Y
N
TPR does not apply
Accountant Report in Form 3CEB is to be filed irrespective of the value of international transaction
TPR applies TP documentation to be maintained if aggregate value of international transactions exceeds 1 Cr
Simplifying Transfer Pricing and threads of reporting - 2021
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Typical Transactions
Manufacturer • Purchase of raw material • Sale of finished goods
Distributor • Purchase/Sale of Finished Goods for resale
Simplifying Transfer Pricing and threads of reporting - 2021
Services • Contract Services Arrangements include: ‒ Enterprises within an MNE often play specific roles according to the operational or cost advantages provided by their locations. ‒ These enterprises are responsible for providing the specific services in which they possess the greatest comparative advantages
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Typical Transactions contd..
Intra-group/Management services include • Administrative services such as planning, coordination, budgetary control, financial advice, accounting, auditing, legal, factoring, computer services; • Financial services such as supervision of cash flows and solvency, capital increases, loan contracts, management of interest and exchange rate risks, and refinancing; • Assistance in the fields of production, buying, distribution and marketing; • Services in staff matters such as recruitment and training; • Research and development or administer and protect intangible property for all or part of the group.
Simplifying Transfer Pricing and threads of reporting - 2021
•
Capital financing arrangements in the nature of lending/borrowing between two Associated Enterprises
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Why is Arm’s length price needed?
Simplifying Transfer Pricing and threads of reporting - 2021
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Illustration for the need of transfer pricing rules
Final Sales Price 500 Cost of production 200
Total Profit 300 Distribution of profits between Countries: Transaction
Transfer Price
Tax rate
Country A
Country B
Country C
23%
40%
15%
100
Transaction 1
400
200
Transaction 2
300
100
Total Profit
300 200
300
•
In each case the profit is 300. However, where Country A has the lower tax rate, more of the profit has been left there to be taxed at 23%. Where the tax rate is lower in Country C most of the profits have been moved there.
•
If we focus on Sales in Country B, by effectively increasing the transfer price, the tax payable by the Group has been reduced.
•
This inherent ability of multinationals to set transfer prices based on tax rate arbitrage is what drives the need for transfer pricing rules
Simplifying Transfer Pricing and threads of reporting - 2021
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Steps to determine Arm’s Length Price (‘ALP’)
Understanding of Business Model
Application of Filters
Effect of Range
FAR Analysis
Identification of Comparable
Computation of Margin
Selection of MAM
Selection of Tested Party
Justification of ALP and Documentation
Simplifying Transfer Pricing and threads of reporting - 2021
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Economic analysis Key considerations
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Economic analysis
Key Considerations • • • • •
Indian company’s margins need not always be tested - “Tested party” should be least complex of two entities in value chain Group’s TP policy – evaluate the policy and test compliance with policy Testing entrepreneurs not appropriate, unless lack of data/ information Availability and reliability of tested party / comparable data vital Route to follow: ‒ Functions, Assets and Risks (“FAR”) / Value Chain analysis and characterization ‒ Selection of Most Appropriate Method – MAM ‒ Identification of tested party ‒ Comparability analysis: Identification and comparison of specific characteristics of the two transactions Finding out whether differences, if any, between the two transactions can be reconciled/resolved Ascertaining the most appropriate method Determination of the arm’s length price by applying the method chosen
Simplifying Transfer Pricing and threads of reporting - 2021
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Functions, Assets and Risk Analysis
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Functional Analysis – Key Points
01
Understand the company and market space
02
Determine inter-company transactions
03
Conducting in-depth analysis of value drivers in industry/company and performing value focussed, end-to-end, functional analysis.
04
Identify potential risks (e.g. projects and engagement risks)
05
Identify profit and characterize functions
06
Identify differences between the company and the rest of the market place
07
Determine other market factors, key value drivers and location issues
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Components of Functional Analysis
Functions performed For example: • Product strategy and design • Purchasing • Product Fabrication and Assembly • Marketing and Distribution • Quality Control
Assets employed Tangible and Intangible Assets • Type of assets and their nature needs to be understood • Helps in determination of their contribution to the business process / economic activity • Facilitates understanding of respective roles played by the entities participating in the international transaction
Risk Assumed For example: • Business risk/ Market risk • Inventory risk • Utilization risk • Product liability risk • Credit and collection risk • Foreign exchange risk
Characterization of Entities
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Why is FAR required in ALP analysis
Importance of FAR Low Function & Low Risk
High Function & High Risk
Comprehensive FAR leads to in-depth understanding of the business and related commercial considerations
To identify any uncontrolled transaction involving one of the controlled parties
Allows appropriate characterization of the business. This is one of the most important objective of a FAR
Helps setting up of an appropriate pricing model for intercompany transactions
Robust FAR analysis - foundation of a sound value chain analysis and thereby a sound economic analysis
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Entity characterization under FAR
1
Entity classification (from ‘simpler’ entities to the more ‘complex’) is one of the main objectives of functional analysis
2
A complex entity might own, manage and develop intellectual property and make key strategic decisions. A simpler entity would normally undertake more routine tasks with lower risk e.g. support service provision
3
Comparing simpler and more complex entities gives an initial understanding of how to direct transfer pricing analysis. This is furthered by precise value contributed by each entity to measure an arm’s length reward
4
The diagram below provides some of the typical business characterisation for each category, the details of which are discussed subsequently
Entity
Manufacturer Toll/ consignment manufacturer Contract manufacturer Licensed manufacturer Full risk manufacturer
Distributor Sales support services Sales Agent/commissionaire Limited Risk Distributor (“LRD”) Full risk distributor
Simplifying Transfer Pricing and threads of reporting - 2021
Service provider Captive service provider Specialist Contract service provider Entrepreneurial service provider
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Benchmarking analysis / Comparability analysis
Simplifying Transfer Pricing and threads of reporting - 2021
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Overview of Transfer Pricing Methods
Selection of the Most Appropriate Method • •
Income Tax Rules prescribes six methods ‘Most appropriate method’ to be used to determine ALP
Prescribed Methods
Traditional Transaction Method
CUP
RPM
CPM
Transactional Profit Method
PSM
TNMM
Other Method
Price charged or paid/ Price would have been charged or paid
No hierarchy or preference of methods prescribed under the Act
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CUP Method • The CUP method requires comparison of the price charged in a controlled transaction vis-à-vis the price charged in a comparable uncontrolled transaction in comparable circumstances. • High degree of comparability of products and functions are required. • Differences are allowed if 1) they do not materially affect the price in the open market; 2) effect on price can be reliably measured & adjusted. • In practice there are two types of comparable uncontrolled transactions 1) Internal Comparable; and 2) External comparable.
RPM Method • The RPM begins with the price at which a product that has been purchased from an AE is resold to an independent enterprise • The resale price (the resale price) is reduced by an appropriate gross margin (the resale price margin) representing the amount out of which the reseller would seek to cover its selling and other operating expenses. The result can be regarded as an arm’s length price of the transfer of goods between the associated enterprises
Simplifying Transfer Pricing and threads of reporting - 2021
Cost Plus Method • The CPM determines the arm’s length price of products manufactured / services rendered in a controlled transaction by comparing the gross profit margin applied to the direct and indirect costs incurred for production or for rendering services by the tested party against the margin earned by the party or by an independent party under uncontrolled similar conditions. This is a preferred method in case of Semi finished goods sold between related parties and Contract/ toll manufacturing agreement.
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Profit Split Method • The PSM is applicable in transactions involving transfer of unique intangibles or in multiple transactions, which are so interrelated that they cannot be evaluated separately for determining the arm’s length price of any one transaction. • Allocates the combined operating profits or losses from controlled transactions in proportion to the relative contributions made by each party in creating the combined profits or losses
Transaction Net Margin Method (TNMM) • The TNMM uses net profitability levels from comparable transactions to establish an arm’s length result against which the profitability of the tested party is compared. The net profit margin in relation to an appropriate base, i.e., cost, sales, assets, etc., from a controlled transaction is compared with the net profit margin on the similar base from an uncontrolled transaction of the taxpayer, or between two independent third parties. When functional analysis of the parties in controlled transaction and uncontrolled transactions result in any differences, necessary adjustments are required to be made to establish reliable results.
Simplifying Transfer Pricing and threads of reporting - 2021
Other Method • With the introduction of Rule 10AB(2) of the Rules, it is possible to use “any method” which takes into account (i) the price which has been charged or paid, or (ii) would have been charged or paid for the same or similar uncontrolled transactions, with or between nonAEs, under similar circumstances, considering all the relevant facts. • It is relevant to note that the text of Rule 10AB of the Rules does not describe any methodology but only provides an enabling provision to use any method that has been used or may be used to arrive at the price of a transaction undertaken between non- AEs. Hence, it provides flexibility to determine the price in complex transactions where third party comparable prices or transactions may not exist.
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Sensitivity of Comparable to Methods
Illustration 1 - from OECD - Effect of a difference in the extent and complexity of the marketing function performed by a distributor
(*) Assume that in this case the difference of 120 in transaction price corresponds to the difference in the extent and complexity of the marketing function performed by the distributor (additional expense of 100 plus remuneration of the function of the distributor)
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Sensitivity of Comparable to Methods
Under the above Illustration,
If a taxpayer is operating with an associated manufacturer as in case 2 while the third party “comparables” are operating as in case 1;
Assuming that the difference in the extent and complexity of the marketing function is not identified because of for instance insufficiently detailed information on the third party “comparables”,
In such case the risk of error when applying a gross margin method could amount to 120 (12% x 1 000), while it would amount to 20 (2% x 1 000) if a net margin method was applied.
This illustrates the fact that, depending on the circumstances of the case and in particular of the effect of the functional differences on the cost structure and on the revenue of the “comparables”, net profit margins can be less sensitive than gross margins to differences in the extent and complexity of functions.
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Selection of Tested Party
The fundamental steps involved in identification of the entity whose margins would be analyzed to determine the arm’s length nature of the controlled transactions are as follows:
1
Whose functions are less complex in nature
2
Which does not own intangibles or owns routine/limited intangibles with respect to the transaction involved (e.g. contract manufacturer); and
3
The result of which can be verified using reliable data that requires the fewest and most reliable adjustments
4
It may be the local or the foreign AE
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Identification of Comparable Companies
Database Screening
Quantitative Screening
Simplifying Transfer Pricing and threads of reporting - 2021
Qualitative Screening
Final Set of Comparable
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Application of Filters
Quantitative Filters
Description
Rationale
Data Sufficiency
Reject Comparables with information prior to two years from current FY
Compliance with Indian TP requirements & to ensure use of current/latest data
No Sales/Opex
Reject companies for which sales and operating expenses details are not available in database.
Sufficient information not available to perform appropriate analysis
Negative Networth
Reject companies with negative net worth in the latest available FY
Eliminate companies with extraordinary operational issue – may not be industry representative
R&D
Reject company with R&D expenses above specified limit
Eliminate companies engaged in development of valuable IP
Turnover
Reject companies with turnover above/below specified limits
Eliminate companies in startup phase or impact economies of scale
Export Earning
Reject companies with export turnover below specified limits
Reject company in different geographical conditions
Mfg/Trading Sale
Reject companies with turnover from relevant activity below specified limit
Eliminate functionally different companies
RPT/Sales
Reject company with Related Party Transaction above specified limit
Identify independent companies
Financial Year
Reject company with FY less than or more than 12 months
Financial numbers of such company may not be true representative
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Effect of Range & Computation of Margin
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Effect of Range (1/3)
Following are some of key features of the Final Rules: •
If the number of comparable is less than 6, then arithmetic mean of the margin should be used.
•
If the number of comparable is greater than or equal to 6, then, 1.
A Dataset shall be construed by arranging the weighted average margins in ascending order
2.
The Arms length range shall begin from the 35th percentile of the dataset and end on the 65th percentile of the dataset. The data place of x percentile = total no. of data point in dataset * (x / 100)
3.
If the price at which the international transaction or the specified domestic transaction has actually been undertaken is outside the arms length range, the arms length price shall be taken to be the median of the dataset.
Simplifying Transfer Pricing and threads of reporting - 2021
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Effect of Range (2/3)
Explanation with an Illustration: Step 1: Computation of weighted average S. No
1
2
3
4
5
6
7
8
Values (OP/OC)%
9.05
- 2.86
5.24
1.65
9.6
6.27
3.5
6.05
Step 2: Arrange the data in ascending order S.No
1
2
3
4
5
6
7
8
Values (OP/OC)%
- 2.86
1.65
3.5
5.24
6.05
6.27
9.05
9.6
Total no. of entries = 8
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Effect of Range (3/3)
Observations
Particulars
Statistical position
Weighted Average (OP/OC)
Remarks
35th Percentile
8* 35/100 = 2.8
3rd position
3.5%
Since this is not a whole number, the number succeeding the above no. is considered as the 35th percentile
65th Percentile
8*65/100 = 5.2
6th position
6.27%
Since this is not a whole number, the number succeeding the above no. is considered as the 65th percentile
Medium
8*50/100 = 4
5.65%
Since this is a whole number, the average of this value and the value succeeding this value has to be calculated. I.e. (5.24+6.05)/2 = 5.65.
Arm’s length range
3.5% to 6.27%
•
So, if the transaction falls within this range, it is deemed to be the arms length price and no adjustment is required.
•
If the transaction falls outside this range, say 7.5, then the necessary adjustment has to be made from the median.
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TP policy, RPT policy, intercompany agreements and TP study – similarities and differences
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TP policy, RPT policy, Intercompany Agreements and TP study – Similarities and Differences (1/2) TP Policy
RPT Policy
Intercompany Agreements
TP Policy provides guidelines on how prices are or will be set for RPT’s within the group entities. Typically the transactions covered under TP policies are provision of management and technical services, secondment of staff, shared services, intercompany loans and guarantees, royalty, sale of goods or transfer of assets and so on.
The listed entity is required to formulate a policy on materiality of related party transactions and on dealing with related party transactions (including clear threshold limits duly approved by the board).
An Intercompany Agreements are commercial agreements for transactions such as sale of goods, financing or intangible property made between companies related through ownership, under common control or part of the same group of companies.
Simplifying Transfer Pricing and threads of reporting - 2021
TP Study
A transfer pricing study examines the pricing of international transactions entered between related two or more associates. By applying and documenting various test methods, it is determined whether the transactions are conducted under market conditions.
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TP policy, RPT policy, Intercompany Agreements and TP study – Similarities and Differences (2/2) TP Policy
RPT Policy
The said policy, if implemented appropriately and being justified to be complied with the income-tax transfer pricing provisions, should serve a great piece of documentation that the GST authorities/MCA authorities can rely upon.
The differing definitions of the term ‘Related Party’ under different accounting standards together with concept of ‘control’ is a matter of judgement. Hence interplay of the policy with TP requires careful consideration and analysis.
Simplifying Transfer Pricing and threads of reporting - 2021
Intercompany Agreements
Intercompany agreement identify the parties and the scope of the services that is being rendered/ availed. The scope mentioned in the agreement therefore should mirror in the RPT Policy, TP Policy and in the TP Study.
TP Study
If a company maintains its documentation on a contemporaneous basis as required in the Indian Income Tax Act and the rules and the ALP for RPT’s are determined accordingly, it appears that the requirement of RPT policy would be met.
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Threads of reporting
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Threads of Reporting • Details of AE’s and RPT disclosure • particulars of contracts or arrangements with related parties referred to in sub-section (1) of section 188 in Form AOC-2; • Foreign exchange earnings and Outgo
Financial Statement
• Disclosure pertaining to RPTs including the nature of AE’s • RPT Policy of the Company (if any)
Board Report
Report from an accountant to be furnished under section 92E relating to international transaction(s) and specified domestic transaction(s)
Audit Report
Any qualification if the auditor has done around the transaction
Simplifying Transfer Pricing and threads of reporting - 2021
Form 3CEB
Basic information relating to the International Group (“IG”) and the constituent entities of the IG operating in India
TP Study
Transfer Pricing study which documents that all international transactions/ business arrangements with group companies are comparable to third parties
Master File
Country by Country Reporting
Large multinationals have to provide an annual return, the CbC report, that breaks down key elements of the financial statements by jurisdiction.
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Threads of Reporting
Form A2 is a FEMA declaration cum application for the purchase of foreign exchange for remittance purposes – which can be used as documentary evidences for TP Purposes
ROI
Suo Moto Adjustment
Form A2
FIRC is a document that acts as a proof of foreign transfers to India, which can be used as documentary evidences for TP Purposes
Tax Audit Report
• Payments made to related party 40a(ii)b • Secondary adjustment
Simplifying Transfer Pricing and threads of reporting - 2021
FIRC
Any company who does IT/ITES exports through Data communication links needs to submit the Softex Form for certification, which can be used as documentary evidences for TP Purposes
Counterparty Financials
Copy of the Financials filed by the AE’s of the Indian Entity, which helps in TP analysis of the Indian Entity
Softex
Form 15CA/CB
15CA is the declaration that the amount has been paid to non resident after TDS, 15CB is the certificate that the CA issues stating that the provisions has been complied, the payments made to the AE’s can be correlated with these forms.
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Threads of Reporting
The bill of Entry under the custom valuations are used for TP Benchmarking while comparing it with a Bill of Entry with a non related enterprise
GST Return
Bill of Entry
The valuation of the domestic supply of goods or services or both and import of services under the GST law provides significant opportunities for application of TP principles
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Q&A
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This material is prepared for the purpose of Webinar on Simplifying transfer pricing and threads of reporting program conducted by Taxmann on 10 November 2021 for the reference of its members. The information contained herein is meant for general purposes and is also not an exhaustive treatment of such subject(s) and accordingly is not intended to constitute any kind of professional advice or services. The information is not intended to be relied upon as the sole basis for any decision which may affect you or your business. Before making any decision or taking any action that might affect you or your business, you should consult a qualified professional adviser. By using any part of the information in this material the user accepts that none of the author, presenter or any organisation with which she or he may be associated, shall be liable to the user for any decisions made or reliance placed on such information.
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