Transfer Pricing Insight FAR Analysis & Most Appropriate Method

1. Transfer Pricing Insight FAR Analysis & Most Appropriate Method Manas Rindani Workshop on SDT - Raipur 14th November’13

2. Functions Assets & Risk Analysis (FAR)

3. Contents

4. Why FAR required? • Prices charged between two independent enterprises usually reflects functions performed, risk assumed and assets employed by each enterprise • FAR analysis forms the basis and framework for • Undertaking comparability study • determining comparability between controlled and uncontrolled transactions, comparison of functions, assets and risks necessary • Determining the most appropriate method • Assessment of the arm’s length price • Reference in Statute • Computation of arm’s length price (Section 92C) • Most appropriate method (Rule 10C) • Documentation requirement (Rule 10D) • Authorities lay emphasis on FAR • E.g. PE attribution

5. Reference to the Statute Section 92C - Computation of arm’s length price “The arm’s length price in relation to an international transaction shall be determined by any of the following methods, being the most appropriate method, having regard to the nature of transaction or class of transaction or class of associated persons or functions performedby such persons or such other relevant factors …” Rule 10C(2) – Most appropriate method “In selecting the most appropriate method…..the following factors shall be taken into account, namely: (b) ………and the functions performedby them taking into account assets employedor to be employed and risks assumed by such enterprises;

6. Reference to the Statute (…Conti.) Rule 10D - Documents to be maintained under section 92D “(e) a description of the functions performed, risks assumed and assets employed or to be employed by the assessee and by the associated enterprises involved in the international transaction…” FAR Analysis Determination of most appropriate method and arm’s length price Maintenance of documentation

7. Steps followed in preparing Reports Step 1 Step 2 Step 3 Step 4 FAR Analysis Economic Analysis (Benchmarking Study) Determination of ALP Conclusion and documenting the process

8. Understanding Overall business and fact finding • Process of finding and organizing facts about a business in terms of its FAR in order to identify how these are divided between the parties involved in the transaction • Collecting basic information: • Background information of the enterprise • Ownership structure • Understand business operations and activities • Manufacturer, wholesaler, distributor • Product profile (Single product, Multiple products, Proprietary product, etc.) • Marketing penetration strategies • Manufacturing facilities; R&D centers; Warehouses • Understand the Industry to which the enterprise belongs to • Market segments • Market share of an enterprise • Specific industry regulations - Pharmaceuticals; IT/ ITES; Oil and Natural Gas

9. Understanding Overall business and fact finding • Collecting specific information: • Identification of associated enterprises • Identification of international transactions • Details of international transactions • Product / Services • Value • Pricing • Terms and conditions, etc. • Functions generally performed; assets employed and risks assumed by each party to the transaction for each class of the transaction • To bear in mind that underlying aim is also to identify comparable transactions / comparative information • Search for comparables can begin with review of the business operations • Internal / external comparables • Information on competitors

10. Undertaking FAR analysis • Study of functions, assets and risks • Analysis to determine nature of functions performed, degree of risks undertaken and type of assets used • For example

11. Functions Performed • Activities that are carried out by each of the parties to the transaction • Transaction level analysis • Value chain • Functions that add more value to the transaction and fetch higher returns • Focus should be not only to identify maximum number of functions but to identify critical functions performed by related parties • E.g. R&D, engineering & design work, material management, manufacturing and assembly work, warehousing and inventory, marketing and distribution, software development, etc.

12. Functions Performed (...conti.) Different functions for different business activities

13. Risks Assumed • Risk and returns go hand-in-hand – Higher the risk, higher the return • Risks assumed in respect of each function • Identification of various risks that are assumed by each of the parties to the transaction • Study facilitates adjustments based on differences in risks that are undertaken in a controlled transaction as compared to uncontrolled transactions • Also analyze how risk is mitigated / any steps taken to reduce risk • E.g. Foreign exchange risk – Hedging

14. Risks assumed (...conti.) • Significant risks involved in the transaction • Market / Industry risk Market risk arises when an enterprise faces adverse sales conditions resulting from either increased competition, declines in demand, inability to market or position products for targeted customers, etc. • Manufacturing risk Manufacturing risk is associated with losses incurred due to errors in the manufacturing process, More complex process, more risk • Product Liability Risk Product liability risk arises when a product fails to perform at accepted or advertised standards • Inventory Risk Inventory risk results from spoiled, stolen or obsolete inventory • Credit Risk An enterprise faces customer credit risk when it supplies products to a customer and the customer fails to make payment or the payment is deferred

15. Risks assumed (...conti.) • Financial risks • Method of funding – Equity Vs Debt • Funding for losses – Subvention payments to subsidiaries • Foreign exchange risk - Risk relates to the potential impact on profits that may arise because of changes in foreign exchange rates; • Contract risk • Terms of the contract not fulfilled • Manpower attrition risk • High turnover of employees • Availability of highly experienced employee • Human intensive industry like IT/ITES • Risk of loss of data / data security

16. Assets employed • Assets used in the course of international transaction • Analysis to be done considering the industry • Capital intensive industry – Property, Plant and Equipment • Labour intensive industry – Human resource • Assets employed for each party and for each function need to be identified • Significant tangible / Intangible assets • Routine / Non routine intangibles • Who has developed intangibles? • Legal and Economic owner of intangibles • Intangibles earning super profits • Any idle capacity?

17. How to get information? • Annual Report • Website • Standard questionnaire • Functional interview • Interview with Business Heads / Operational level staff • Pre interview preparation – Domain Knowledge, Competitors • Information that can be gathered • Corporate background • Group entities and holding pattern • Geographical spread • Product profile and end use of the products • Industry verticals and end customers • Business model • International transactions • Future projections / upcoming projects • Factory setup, number of plants and locations • Major suppliers • Supply chain • Statistical data such as proportion of domestic and export sales • Tax holiday / any other tax benefits

18. How to get information? (...conti.) • Inter-company agreements • Projections • Product brochure • Due diligence reports • Market strategy reports • Internal reports (MIS) • Prospectus • Industry reports

19. Shared services centre R&D centre Sales Headquarters admin services research services after sales service management services arrange sales purchase materials sale of finished goods Supplier Principal Trading Company Customer deliver materials processing services deliver goods legal title physical flow services Factory An example – FAR Functions, risks and profits are shifted to the Principal Trading Company with an efficient tax rate The amount of the benefit depends on the size of the business, the total net returns, the degree of shifting of functions and risks and the conversion costs

20. To Summarize…

21. Functional and Risk Analysis Principles Identifying the business • Licensed manufacturer • Toll manufacturer • Strippeddistributor • Commission agent • Service Recipient More Functions Less Functions • Service Provider • Commissionaire Contract manufacturer Full-fledged manufacturer • Full-fledgedDistributor

22. Functional and Risk Analysis Principles Manufacturing reward profile Profit R & D Volume Pricing Quality Raw material costs Long term contracts Labour costs Down time Fixed overhead Manufacturing services Risk Toll Manufacturer Contract Manufacturer Full Manufacturer Note: This graph only shows the relationship between profit and functions/risks. It is worth noting that more functions/risks also associate with larger potential losses.

23. Functional and Risk Analysis Principles Distributor reward profile Profit Volume Market share Product mix Pricing Currency exposure Obsolescence Warranty Credit risk Marketing costs Duties Sales Expense Admin & Accountancy Risk Commissionaire Instant Buy/Sell Distributor Note: This graph only shows the relationship between profit and functions/risks. It is worth noting that more functions/risks also associate with larger potential losses.

24. Most Appropriate Method (MAM)

25. Transfer Pricing Methods OECD Guidelines 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

26. Transfer Pricing Methods • In general • CUP Method compare prices • Resale Price Method compares gross margins • Cost Plus Method compares profit mark-ups on costs • Profit Split Method refers to the (total) profits from transactions and splits them among the parties based on the level of contribution • Transactional Net Margin Method analyses net profit in relation to an appropriate base, such as costs, sales or assets

27. Transfer Pricing Methods • Applicability • Not every method can be applied to each taxpayer and business transaction • Applicability depends on • the characteristics of property or services • functions performed (including asset and risk assumed) • contractual terms • economic circumstances • business strategies • also depends upon the availability of information and reliability of assumptions • Most Appropriate Method • which is best suited to the facts and circumstances of each particular international transaction, and • which provides the most reliable measure of an arm’s length price in relation to the international transaction.

28. Transfer Pricing Methods – CUP • CUP Method • Most direct way of determining an ALP • It compares the price charged for goods or services transferred in an international transaction 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 international transaction and the comparable uncontrolled transactions or between the enterprises entering into such transactions, which could materially affect the price in the open market.

29. Transfer Pricing Methods – CUP • Comparability • The comparability of property transferred in an international transaction 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.

30. Transfer Pricing Methods – CUP • Factors to Consider • Product/Service similarity (similar type, quality, quantity, features, etc) • Seasonality (e.g., air conditioner, ski) • Same stage in supply chain (wholesales, retail, etc.) • Geographic market in which transaction takes place • Embedded intangibles • Contractual terms (e.g., warranty, discount policy, credit terms, shipping liability, etc.) • Other factors that might affect comparability

31. Example #1 Comparable Uncontrolled Price Method The CUP method compares prices charged between related properties with those charged between non-related parties for the same property or service. Colombian Coffee vendor B Brazilian Coffee vendor A Independent Parties Relatad Parties Coffee Buyer B Coffee Buyer A • Requirements for CUP Implementation • Coffee beans of same (similar) quality, type, and quantity • Both Producers in same (similar) markets • Both Buyers in same (similar) markets • Transactions occur during the same time frame • Transactions occur during same stage of production/distribution chain • Transactions occur under same (similar) conditions

32. Comparable Uncontrolled Price Method Example #1 • Accuracy and Possible Adjustments • Certain adjustments should be made to improve model accuracy whenever slight differences with the tested party occur. For example: • What if coffee beans are of different (branded vs. unbranded) quality? • What if the coffee buyers belong to similar, but not exact, geographic markets? • If any of these differences have a material effect on price then adjustments are in order. • However, if there is no information available to make these adjustments OR if the differences are significant, then the reliability of the CUP method would be reduced and a less direct method may be preferred.

33. Example #2 Comparable Uncontrolled Price Method Identical circumstances for both related and independent party transactions except... Manufacturar RelatedParty IndependentParty Distributor A Distributor B • Sales price is FOB factory price •Sales price is delivery (CIF) price

34. Comparable Uncontrolled Price Method Example #2 • Adjustments • Only difference between related and independent transactions are the terms in which the prices are listed. • Deviations from Distributor B´s price may be due to: • Cost of delivery to Distributor A. • Cost of insurance for delivery to Distributor A. • If a break-down of Distributor A´s price can be obtained which states the applicable delivery and insurance costs then pricing terms can be equalized allowing for reliable implementation of the CUP method.

35. Comparable Uncontrolled Price Method Example #3 Identical conditions for both related and independent party transactions except... Seller RelatedParty IndependentParty Buyer A Buyer B • 500 tons of product • 1,000 tons of product • $80.00 per ton • $100.00 per ton

36. Comparable Uncontrolled Price Method Example #3 • Arm’s Length Pricing? • At first glance it seems that the seller is giving its related buyer preferential treatment. • However, this pricing discrepancy may be due to: • Price discount due to larger volume purchase. • Analysis should focus around independent party transactions in the same (similar) markets to identify typical market discounts.

37. Transfer Pricing 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 international transaction 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.

38. Transfer Pricing 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

39. Resale Price Method Example #1 Arm’slengthprice = resale price - resale pricemargin (pricereseller (costs distributor mustcover charges) plus a reasonableprofit) • Same product • Same brand name • Same market Distributor B Distributor A • Offers warranty • Charges higher price • Reaps higher gross margin • Does not offer warranty • Charges lower price • Obtains lower gross margin

40. Resale Price Method Example #1 Are Gross Margins comparable? Although Distributor A’s gross margin is higher, it does not take into consideration the cost of servicing its warranties. Before the margins can be compared, adjustments must be made to ascertain the cost Distributor A incurs by servicing its warranties.

41. Resale Price Method Example #2 Supplier Lower Price Higher Price Distributor C Distributor D • Sends warrantied products back to the supplier. • Performswarrantyfunction

42. Resale Price Method Example #2 • Are Gross Margins comparable? • If Distributor C accounts the cost of performing the warranty service under COGS then its gross profit margin is automatically adjusted. • However, if Distributor C accounts the cost of performing the warranty service as an operating expense, its gross profit margin will be higher due to its lower supply price. • Reasoning is that if Distributor D incurred the cost of performing the warranty service, the supplier would compensate it with a lower (equal to Distributor C’s) price.

43. Resale Price Method Example #3 Supplier Country A Country B Country C Country D Distributor D Distributor A Distributor B Distributor C • Non-exclusive distributor • Only markets product • Non-exclusive distributor • Only markets product • Non-exclusive distributor • Only markets product • Non-exclusive distributor • Only markets product • Non-exclusive distributor • Only markets product Country E Country F Distributor E Subsidiary • Exclusive distributor • Perform technical applications • Non-exclusive distributor • Only markets product

44. Resale Price Method Example #3 • Are Gross Margins comparable? • Even if all other circumstances are identical, adjustments should be made for: • Exclusive vs. non-exclusive selling agreement • Value-adding services such as technical applications for customers

45. Transfer Pricing Methods –CPM • Cost Plus Method (‘CPM’) • The cost plus method tests whether a profit mark-up charged in a international transaction 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 international transaction.

46. Transfer Pricing 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

47. Transfer Pricing Methods - CPM • Factors to Consider • Cost should include all costs associated with the process (manufacturing, provision of services) • Direct Costs- materials, labor • Indirect Costs – Overhead, SG&A • Mark up applied to the total cost is set or tested having regard to the third party comparable mark ups. • (Profile of the parties involved, functions/risks/assets, accounting differences , etc. should be considered)

48. Cost Plus Method Example #1 Sale of intermediate goods Arm’s length price = Cost incurred by supplier of + Cost plus mark up for property or service reasonable profit Unrelated Party Transactions Related Party Transactions Manufacturer X Manufacturer Y Manufacturer A Manufacturer Z Same country gross profit markup 5% 3% 4% 5% Foreign countries Subsidiary B Buyer Q Buyer R Buyer S • SG&A costs accounted as operating expenses • SG&A costs accounted as COGS

49. Cost Plus Method Example #1 • Necessary Adjustments • Differences in accounting standards can have an effect on comparative margins. • Since the unrelated transactions include the SG&A expenses as part of the COGS, the gross profit markup reflects this. • The related transaction includes the SG&A expenses as part of the Operating Expenses, this makes the gross profit margin seem higher than it actually is. • Before the margins can be compared accountancy adjustments must be made to the independent party transactions for uniformity.

50. Cost Plus Method Example #2 Risks • Guarantees purchases Functions • Provides components, know-how, etc Country F Company E 100% Subsidiary Risks • Eventual differences in agreed quality & quantity Functions • Assembly of electronic goods. Company C Low wage Country Country D The basis for application of the method will be formed by all the costs connected to assembling activities (e.g. net cost plus)