Attribution Principles - is change inevitable?

1. India Branch-Western Region Chapter • Attribution Principles - is change inevitable? • Profit split or formulary apportionment method - a new reality for attribution? • Implementation on Action 8,9,10 - key issues? Chairman Mr. T. P. Ostwal, T. P. Ostwal & Associates, Mumbai Panellist Mr. Sanjay Tolia, PwC India Mr. Paresh Parekh, EY India

3. Vijay Overview BEPS Action 8, 9 and 10 Assure that transfer pricing outcomes are in line with value creation • Action 8: Intangibles • Wider and clearer definition of “intangibles” • Introduction of a six step framework to analyse transfer pricing aspects of intangibles • Legal ownership alone does not generate a right to the return generated by the exploitation of an intangible • Focus on Development, Enhancement, Maintenance, Protection and Exploitation (DEMPE) functions • Hard-to-Value Intangibles (HTVIs) • Cost-Contribution Arrangements (CCAs) • Action 9: Risk and Capital • Focus on conduct of parties and their capability and functionality to manage risks. Assumption of risk without ‘control’ over that risk is likely to be problematic • Separate consideration regarding an appropriate return to any cash investment • Introduction of a six step framework to analyse risks for transfer pricing purposes • Action 10: Other high-risk transactions • Intra-group services / low value-add services • Profit Splits Recognition of transactions • Commodity transactions

4. Third Party customers F Co I Co. IP Co Case study 1 – Attribution of profits and Action 8-10 Intangibles Marketing support services Country A Country Z Payment of royalty Sale of goods License of trademark and know-how • Facts: • F Co is manufacturer of goods and sells goods directly to third party customers in India. • IP Co is the legal owner of the trademark and know-how, for which it receives royalty from F Co. • I Co located in India provides marketing support services to F Co. Such services involve : • Negotiates price and other conditions with third party customers on behalf of F Co. • Provides F Co with the customer list to whom goods are to be sold. • Incurs AMP expenditure in India. • Designs F Cos marketing strategy in India. • I co is also engaged in provision of the contract R&D services to IP Co. for which I Co is remunerated at cost plus mark-up. Such services involve • Designing the R&D blueprint. • Conceptualisation of R&D process. • Taking major R&D decisions • F Co has undertaken seed funding for I Co.’s R&D facility • Key issues and considerations: • I Co would to quality as a Dependent Agent Permanent Establishment (‘DAPE’) of F Co? • Control over risk analysis for the said arrangement? • DEMPE analysis for know-how and trademark? • Economic characterization of F Co, I Co, IP Co and DAPE.? India Payment of cost plus mark-up Provision of contract R&D

5. Third Party customers F Co I Co. IP Co Case study 1 – Attribution of profits and Action 8-10 Intangibles Marketing support services Country A Country Z Payment of royalty Sale of goods Use of trademark and know-how • Whether I Co is correctly remunerated on cost plus basis for its marketing support services function and contract R&D function or a resident return is warranted? • Profit attribution methodology to DAPE? PSM among I Co, IP Co, DAPE and F Co is warranted? • Valuing the relative contribution of entities ? Functions warranting routine return vis-à-vis functions warranting residual return? Remuneration streams warranted for each and every entity? • PSM Methodology for split of profits between IP Co, I Co, F Co and DAPE. India Payment of cost plus mark-up Provision of contract R&D

6. Vijay Profit Split Method

7. IP Co. F Co. I Co. Case study 2 – Profit Split Method Licenses trademark Country Z • Facts: • I Co is a full risk bearing manufacturer, F Co. is full risk bearing distributor • IP Co is the legal owner of the trademark, developed and owns manufacturing know-how • I Co manufactures goods and delivers them to F Co. • Key issues and considerations: • Selection of profit split method (‘PSM’) for benchmarking the arrangement? • Valuing the relative contribution of entities ? Functions warranting routine return vis-à-vis functions warranting residual return? Remuneration streams involved? • Methodology to split the profits earned between I Co, F Co and IP Co? • Separate remuneration to F Co. for incurring AMP expenses or would it be considered as value driver in PSM application? • Application of PSM at gross or net level? • Entire arrangement leads to system loss. To which entity would losses be attributed? • Split of profits at gross level leads to net loss for I Co. How would Indian tax authorities would look at this scenario? Distribution network Licenses know-how Incurs AMP expenditure Country A India Sale of goods Sale of goods

8. TP Ostwal Emerging Issues –Profit Split Method It may be difficult to measure the relevant revenue and costs for all the associated enterprises participating in the controlled transactions, which could require stating books and records on a common basis and making adjustments in accounting practices and currencies. When the transactional profit split method is applied to operating profit, it may be difficult to identify the appropriate operating expenses associated with the transactions and to allocate costs between the transactions and the associated enterprises other activities Depending on the facts of the case, other indicators that the transactional profit split may be the most appropriate method could include a high level of integration in the business operations to which the transactions relate and /or the shared assumption of economically significant risks (or the separate assumption of closely related economically significant risks) by the parties to the transactions. It is important to note that the indicators are not mutually exclusive and on the contrary may often be found together in a single case The Revised Guidance points to employee compensation as an appropriate profit splitting factor for trading profits. The basis for this is that the performance of trading personnel, particularly traders, risk managers, specialised marketers, the so-called "front office" high-value functions, is critical to the profitability of global trading and, as a result, compensation of these functions is generally related to performance and value add. The revised guidance does not provide for the meaning of performance related compensation and relevance of adjustments. How latest development such as master file and local file compliance would help the tax authority in determining profit split factor

9. TP Ostwal Emerging Issues –Profit Split Method Unavailability of comparable data is one of the basic premises of applicability of PSM. However, while applying contribution analysis, the division of profits is to be determined or supported by comparable data (External Data). This appears to be a contradiction. In determining the relevant profits, it is essential to first identify and accurately delineate the transactions to be covered by the transactional profit split method, and from this identify the relevant income and expense amounts for each party in relation to those transactions. This might turn out to be a complex exercise. Further, the availability of information of the financial information What are the factors which one should consider in determining whether the profit to be split should be gross profit or operating profit? The meaning of operating profit and gross profit is not specifically provided and therefore, may be interpreted differently by tax payer and tax authorities. While using assets based profit splitting factors, what all assets should be taken into consideration? What should be the treatment of self-developed intangibles and other intangibles already depreciated which may not be reflected on the balance sheet at all? Whether market would also be an intangible? If no weightage is given to market then it would not be acceptable by the developing countries such as India, China, Brazil etc. While using cost based profit splitting factors, what all costs should be taken into consideration? Guidance on allocation of indirect cost is not available When you split profit, whether losses should also be split. No guidance is available on the same.

10. O Co. N Co. (IP owner) D Co. I Co. Case Study 3 – Benchmarking of intangibles Country Y Royalty of 12% Royalty of 22% • Facts: • All the companies given in the diagram are group companies • N Co. (in Country Y) is group IP owner of manufacturing know how and trademarks • Contract manufacturing of goods is performed by O Co. for N Co. post which the goods are delivered to distributor entities • I Co (in Country Z) and D Co. (in Country X) are distributor entities of the group • Group has performed worldwide benchmarking taking distributor entities as tested parties • Distributor would retain the return of 3% and pass the residual return to N Co. for IP ownership and manufacturing function • Transfer pricing policy is of Variable Royalty • I Co. earned pre-royalty operating margin (OM) of 15% on account of sales in Country Z, while D Co. earned pre-royalty OM of 25% • Both I Co and D Co. paid royalty fee to N Co to leave OM of 3% • N Co. earned the royalty of 12% from I Co. and 22% from D Co • Key issues & considerations: • Whether the benchmarking methodology setting fixed distribution return is correct? • Whether revenue authorities in Country Y would question different return earned for same activity/IP exploitation from different entities? • DEMPE analysis for IP? What are additional factors which need analysis? (e.g. AMP etc) • Potential queries from revenue authorities in Country X and Country Z? Sale of goods Country X Country Z Sale of goods

11. Vijay Significant Economic Presence

12. Significant Economic Presence – SEP Text of the provision relating to SEP – Explanation 2A to Section 9(1)(i) “For the removal of doubts, it is hereby clarified that the significant economic presence of a non-resident in India shall constitute "business connection" in India and "significant economic presence" for this purpose, shall mean— (a)  transaction in respect of any goods, services or property carried out by a non-resident in India including provision of download of data or software in India, if the aggregate of payments arising from such transaction or transactions during the previous year exceeds such amount as may be prescribed; or (b)  systematic and continuous soliciting of business activities or engaging in interaction with such number of users as may be prescribed, in India through digital means: Providedthat the transactions or activities shall constitute significant economic presence in India, whether or not,— (i)  the agreement for such transactions or activities is entered in India; or (ii)  the non-resident has a residence or place of business in India; or (iii) the non-resident renders services in India: Provided further that only so much of income as is attributable to the transactions or activities referred to in clause (a) or clause (b) shall be deemed to accrue or arise in India.”

13. Significant Economic Presence – SEP • Therefore, SEP would be established if a non-resident: • undertakes transactions concerning any goods, services or property, including provision of download of data or software in India, above specified threshold, • OR • through digital means, systematically and continuously solicits business or interacts with users greater than a specified threshold. • In July, 2018, the Indian tax authorities issued a sought comments and suggestions from stakeholders before framing the rules and specifying the revenue thresholds and user thresholds for determining SEP. • Although most non-residents would be able to take shelter under their respective jurisdiction’s DTAA with India, this move makes clear India’s intent with respect to taxation of digital and e-commerce transactions. • Further, India is also likely to (re)negotiate DTAAs pushing for the inclusion of SEP as a means of creating a PE.

14. Thank you!