TRANSFER PRICING Case Studies Navigating the Indian & Singapore waters!

1. TRANSFER PRICING Case Studies Navigating the Indian & Singapore waters! Narayan Mehta Partner, Sudit K. Parekh & Co. 25th May 2005

2. Agenda • Practical applicability of the regulations & case studies • Case 1: ODC / ITES operations in India • Case 2: Manufacturing & indenting model • Case 3: Intra group services • Case 4: Benchmarking royalty payments Transfer Pricing

3. Opening Remarks • Bilateral & not unilateral exercise • Need for balancing the Indian & Singapore tax regulations • An effective tax planning tool! • Integrated approach • May involve International tax, exchange control, Service Tax / VAT, STPI, issues • Could be used to: • Justify pricing policy • Formulate pricing policy

4. CASE I Indian Company Singapore Owned

5. Singapore Owned Indian Co Contract for software development Marketing intangible Brand creation Trade intangible Entrepreneurial risk • Off-shore software • Development • No risks undertaken Singapore Co Singapore Client Consideration Outsourcing Arrangement @S $ 35 per hour Equity Contract for software development Indian subsidiary UK Client @ S $ 45 per hour

6. Singapore Owned Indian Co • CUP Method • Internal comparables • Adjustment for differences for • Volume difference • No marketing required and assured market • Credit terms • External comparables • May not be always reliable!

7. Singapore Owned Indian Co • Internal comparables • Constructing transactional profit and loss account to ascertain the margins separately for sales to AE and sales to 3P • Allocation of certain expenses to AE and / or 3P P/L A/c • Marketing expenses – 3P • Apportionment of other expenses to both on certain basis • No of employees • Sales value • Costs, etc

8. Transactional Trading & P & L A/c 3P = 3rd Party (comparable transactions)AE = Associated Enterprise

9. Singapore Owned Indian Co • Cost Plus / TNMM – external comparables • Step 1: Functional analysis • Objectives • Assessing the functions performed, risk undertaken and intangibles owned by associated parties to the transaction • Identifying the simpler entity • Margins of the simpler company generally examined

10. Functional Analysis - Relevance Understanding of where and how value is added Assist in identification of simpler entity Compliance with documentation requirements Criteria for Comparability Platform for Economic Analysis

11. FunctionalProfiling Income distribution within the MNC must reflect economic value and activities Each activity or enterprise receives a share of total profits that reflects the contribution of that activity or enterprise to earning those profits. R&D Processing Marketing Finance Sales & Distribution

12. Functional Analysis • Analyzing risks associated in relation to various business operations • Strategic Planning • Production Scheduling & Production Activities • Quality Control • Research & Development • Marketing • Sales & Distribution • Idle Capacity • Foreign Exchange

13. Functional Analysis The following categories need to be taken into account for intangibles analysis: • Technical / Trade Intangibles • Marketing Intangibles

14. Functional Analysis- Summary XYZ Group of Companies Country A Country B Functions Assets Risks Profits $$$$$$$$$$$ $$$ Profit = f (F + A + R)

15. Procedure Market Analysis Industry Background Description of Activities Organisation Chart Analysis of Risks Description of Inter-company Transactions Terms of Trade

16. Step 2: Economic characterisation of simpler entity Determining the nature of the entities Characterisation in the instant case: Contract service provider / production center for the Singapore parent Step 3: Selection of the most appropriate method Service provider- cost plus / TNMM Singapore Owned Indian Co

17. Singapore Owned Indian Co • Step 4: Search and analysis for comparables • Running queries on Indian TP databases • Search for companies in the same line of business • Contract service providers • Short listing the initial sample of companies identified by: • Applying quantitative and qualitative filters • Reviewing short business descriptions of each of the companies found • Examining public documents (ex Annual reports of companies) • Further search on company’s website, interviews etc • Selection of appropriate PLI • Identifying the margins of each of the companies based on PLI selected

18. Singapore Owned Indian Co • Step 5: Computing the arm’s length price • Adjustments to comparable companies • By taking the arithmetic mean of each of the companies selected in the final sample • Balancing the Indian and the Singapore regulations!!

19. Computing the Arm’s Length Price • Generally- 5% to 20% margin on costs depending upon the nature of activities • Entrepreneurial manufacturer v/s contract manufacturer • Idle capacity risk - who bears? R E V E N U E V O L U M E V A L U E

20. Transfer Pricing- a Tax Planning Tool! Total Profit • Above-normal profit: • Goes to developer(s) of intangible assets [R&D marketing] • May be zero or negative! Return to risk-taker Return to service providers / suppliers of labor and capital Normal profit: Paid out for performance of normal tasks [ mfg. , sales, distrib., service, support] or for normal risks using comparables to benchmark

21. Transfer Pricing Study Process STEP 1 Undertaking a functional analysis & economic characterization STEP 2 Selecting the most appropriate transfer pricing methodology STEP 3 Applying the most appropriate method & determining the arm’s length outcome Step 4 Implement support processes.Install review process to ensure adjustment for material changes Maintaining necessary documentary evidence to support each of the above steps!

22. Running search on database- key features • Exact comparables may not be available • Use of lateral comparables • Sample size – should not be too small? • US v/s Canadian practice

23. Quantitative Filters 3 Year Track Record Ratios Any Other Parameters Revenue No. of Employees Applying Filters • Qualitative Filters • Companies Incorporated In Foreign Countries • Positive Word Search • Negative Word Search • Independent Companies

24. Use of PLI’s under TNMM • The three financial ratios generally considered as acceptable in the US context are: • Rate of Return on Capital Employed • Berry Ratio (GP / Op exp) • Operating Margin (Op profit / Sales or Cost) • Selection of appropriate PLI depends upon: • Nature of the activities of the tested party, • The reliability of the available data with respect to comparable uncontrolled taxpayers, and • The extent to which a particular profit level indicator is likely to produce a reasonable determination of the income that the tested party would have earned had it dealt with the controlled taxpayer at arm’s length.

25. Adjustment to Ratios • Useful when feasible to increase ratio’s comparability to the tested party • Three standard adjustments • Inventory Differences • Inv. Adj. = (Inv./Sales taxpayer – Inv./Sales comparable) * Sales comparable * Prime Lending Rate • Receivables Differences • Rec. Adj. = (Receivables/Sales Taxpayer – Receivables/Sales Comparable) * Sales Comparable * Prime Lending Rate • Payable Differences • Pay. Adj. = (Payables/COGS or Sales Taxpayer – Payables/COGS or Sales Comparable) * COGS or Sales Comparable * Prime Lending Rate

26. CASE II & Indenting Model Manufacturing

27. Manufacturing & Indenting Model X Pte Ltd Singapore 100% Shares Outside India Receipt of Commission / consideration & sale of raw materials In India Direct sale of chemicals Payments Payments Customers Customers X Ltd India Marketing Manufacturing & Sales

28. Transactional P&L A/c

29. Functional Analysis- Services • Services – Indenting • Functions performed • Liaisoning with clients in India • Sales support and after sales services • Assets Used • Employee Skills / Network / Customer list • Risks Assumed • Depends on the commercial / contractual terms

30. Volume Market Share Product Mix Pricing Currency exposure Obsolescence Warranty Credit risk Marketing Costs Duties Sales Expense REWARD Admin & Accountancy RISK Commissionaire Stripped Distributor Distributor Instant Buy/Sell Risk Factors in Distribution

31. Functional Analysis- Manufacturing • Manufacturing • Functions performed • Purchasing, mfg, distribution, sales, etc. • Assets used • Intangibles and plants • Risks assumed • Inventory holding risks, bad debts risks, etc.

32. Risk Factors in Manufacturing R&D Volume Pricing REWARD Quality Raw Material Costs Long Term Contracts Labour Costs Down time Fixed overhead Manufacturing services RISK Toll Manufacturer Contract Manufacturer Full Manufacturer

33. Search for Comparables • Re services / indenting • Traders / agents in Chemicals • Re manufacturing • TNMM with ROA or Operating margins as the PLI

34. TP Methodologies • CUP • Industry benchmark for commission rates • Resale price • NA in the instant case • Cost plus • Rejected for want of adequate disclosure requirement • Profit split • NA in the instant case

35. TP Methodologies • TNMM • Re indenting • Berry Ratio (GP/ Operating exp) • Operating margin (NPBIT / Indenting income) • Re manufacturing • TNMM with ROA or Operating margins as the PLI

36. CASE III Intra-Group Services

37. Intra-group Services • No clear cut guidelines under the Indian regulations • OECD Guidelines- Intra group services • Whether the activity provides economic or commercial value to enhance commercial position? • Whether an independent enterprise in comparable circumstances would have been willing to pay for the activity if performed for it by an independent enterprise or would have performed the activity in-house for itself

38. Central Services Examples Administrative Services Planning/coordination Budget Control Financial Advice Book Keeping Internal Auditing of the Books Legal Matter Financial Treasury Services Cash Management Attracting Capital Concluding Loan Agreements Trading in Derivatives Refinancing Factoring Operational Logistics Services Manufacturing Warehousing Transport

39. Central Services Examples Information Technology Services Software / Hardware Systems Training Specific Services Technical Advice with regard to Production Central Purchasing, distribution or marketing Personnel Services Recruitment and Selection Training & Education Secondment of Personnel

40. OECD Guidelines • Shareholder activities • Such activities should not be charged to group companies • Expenses relating to judicial structure of the parent company • Shareholder meetings, the issue of shares in parent company and the costs of its supervisory board • Reporting reqt of the parent company including consolidation of reports • Raising funds for acquisition of new company to be held by parent company • Central services that duplicate activities

41. Management Fees • Management fees could be based on cost plus 5 /15% mark-up • Need for contractual agreement 10.2% service tax / VAT applicability? W /tax under India-Singapore tax treaty?

42. CASE IV Royalty Payments

43. Royalty Payments • Relevant factors: • Description of implicit rights, geographical coverage, time horizon, exclusivity, level of capital investments needed, the possibility of sub-licensing, etc. Any specific industry norms? Similar comparable transactions? TNMM analysis to benchmark the operating margin of the Indian sub

44. Royalty Payments • A 5 yr profitability projections of the sub could be helpful • Reference to historical level of R&D expenses • The use of DCF Method to corroborate the findings • Relevance of Industrial Policy norms? • 5% / 8% on local sales / exports • Lumpsum payments of US$ 2 million

45. Establishing Most Appropriate Method Methods Functions CUP: Comparable Uncontrolled Price TNMM: Transactional Net Margin Method

46. SKP Transfer Pricing Division • Exposure to accounting, international tax and transfer pricing issues required for a TP analysis • Associates in UK and US • Have provided assistance to many of the fortune 500 companies • Have been specifically trained in the US and the UK • Appointed by the Gem and Jewellery Export Promotion Council of India to study the applicability of the transfer pricing regulations to the Gem / Jewellery and the diamond industry and make a representation to the Government

47. SKP Transfer Pricing Division • SKP in co-ordination with its associates helps in balancing the Indian and overseas transfer pricing / tax regulations • Personalized service

48. Transfer Pricing Industries covered……… • Software, ITES, BPO opn • Engineering • Diamonds, Gem and Jewellery • Textiles and garment • Poultry • Auto ancillary and road equipment • Construction • Entertainment • Pharmaceuticals • Recruitment agencies • EPC Contractors • Water Polymers

49. Transfer Pricing- Scope of Services • Developing appropriate methodology • Alignment with client’s global business objectives • Assisting in implementing optimal transfer pricing policy • Developing strategies that meet the Indian and international transfer pricing requirements • Assisting in maintenance of documentation • Issuance of CPA certification • Tax compliance and representation services

50. Thank You • Contact Narayan Mehta • Tel: +91 22 22821141 • Fax: +91 22 22024193 • Mobile: +91 9820544495 • E-Mail: narayan.mehta@skparekh.com • Queries ?