#TaxmannPPT | Simplifying Transfer Pricing and Threads of Reporting | Deloitte India

Simplifying Transfer Pricing and threads of reporting - 2021 Simplifying Transfer Pricing and threads of reporting - 2021

1

Agenda

1

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

9

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”

4

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

Simplifying Transfer Pricing and threads of reporting - 2021

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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

Simplifying Transfer Pricing and threads of reporting - 2021

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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

Simplifying Transfer Pricing and threads of reporting - 2021

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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

Simplifying Transfer Pricing and threads of reporting - 2021

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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

Simplifying Transfer Pricing and threads of reporting - 2021

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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

Simplifying Transfer Pricing and threads of reporting - 2021

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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)

Simplifying Transfer Pricing and threads of reporting - 2021

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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.

Simplifying Transfer Pricing and threads of reporting - 2021

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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

Simplifying Transfer Pricing and threads of reporting - 2021

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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

Simplifying Transfer Pricing and threads of reporting - 2021

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Effect of Range & Computation of Margin

Simplifying Transfer Pricing and threads of reporting - 2021

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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

Simplifying Transfer Pricing and threads of reporting - 2021

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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.

Simplifying Transfer Pricing and threads of reporting - 2021

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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

Simplifying Transfer Pricing and threads of reporting - 2021

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Q&A

Simplifying Transfer Pricing and threads of reporting - 2021

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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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