Transcript Transfer Pricing

Transfer Pricing Insight
FAR Analysis &
Most Appropriate Method
Manas Rindani
Workshop on SDT - Raipur
14th November’13
Functions Assets & Risk
Analysis (FAR)
Contents
Why FAR required?
Reference to Statute
Steps followed in preparing study report
FAR Analysis – fact finding exercise
FAR Analysis – Study of functions, assets and risks
How to get information?
Learning
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
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 performed by 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 performed by them taking into account
assets employed or to be employed and risks assumed by such
enterprises;
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
Steps followed in preparing Reports
Step 1
FAR
Analysis
Step 2
Economic
Analysis
(Benchmarking
Study)
Step 3
Determination
of ALP
Step 4
Conclusion
and
documenting
the process
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
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
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
Illustration of contribution of FAR in different industries
Manufacturing
(e.g. highly
Automated Industry)
Distribution
Low Risk Service
provider
Functions
40%
60%
60%
Assets
40%
10%
25%
Risk
20%
30%
15%
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.
Functions Performed (...conti.)
Different functions for different business activities
Manufacturing and
Selling
Distribution
Marketing support
services
Non binding
investment advisory
Business decisions
Budgeting
Lead / Opportunity
Data research
Budgeting
Procurement
Identify customers
Statistical analysis
Procurement
Warehousing
Industry trend
Information supply
Production
Marketing
Product survey
Quality check
Selling
Warehousing
Sales collection
Contractual
arrangement
Investment
recommendation
Marketing & selling
After sales service
Sales collection
After sales services
R&D, HR, Admin,
Finance, IT Support
After sales service
NAV calculation
Fund accounting
and reconciliations
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
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
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
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?
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
How to get information? (...conti.)
• Inter-company agreements
• Projections
• Product brochure
• Due diligence reports
• Market strategy reports
• Internal reports (MIS)
• Prospectus
• Industry reports
An example – FAR
Functions, risks and profits are shifted to the Principal Trading Company
with an efficient tax rate
Shared services centre
R&D centre
Headquarters
management
services
Supplier
research
services
Sales
admin
services
arrange sales
purchase materials
after sales
service
sale of finished goods
Principal Trading Company
Customer
deliver
materials
legal title
physical flow
services
processing
services
deliver
goods
Factory
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
To Summarize…
Functional and Risk Analysis Principles
–
Identifying the business
More
Functions
Less
Functions
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
Toll Manufacturer
Contract Manufacturer
Risk
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.
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.
Most Appropriate Method
(MAM)
Transfer Pricing Methods
TP Methods
OECD Guidelines
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
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
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.
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.
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.
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
Comparable Uncontrolled Price
Method
Example #1
The CUP method compares prices charged between related properties with those charged
between non-related parties for the same property or service.
Brazilian
Coffee
vendor
A
Relatad
Parties
Coffee
Buyer
A
Colombian
Coffee
vendor
B
Independent
Parties
Coffee
Buyer
B
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
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.
Comparable Uncontrolled Price
Method
Example #2
Identical circumstances for both related and independent party transactions except...
Manufacturar
Related Party
Distributor A
•Sales price is delivery (CIF) price
Independent Party
Distributor B
• Sales price is FOB
factory price
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.
Comparable Uncontrolled Price
Method
Example #3
Identical conditions for both related and independent party transactions except...
Seller
Related Party
Independent Party
Buyer A
Buyer B
• 1,000 tons of product
• $80.00 per ton
• 500 tons of product
• $100.00 per ton
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.
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.
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
Resale Price Method
Arm’s length price = resale price
(price reseller
charges)
Example #1
-
resale price margin
(costs distributor must cover
plus a reasonable profit)
• Same product
• Same brand name
• Same market
Distributor A
• Offers warranty
• Charges higher price
• Reaps higher gross margin
Distributor B
• Does not offer warranty
• Charges lower price
• Obtains lower gross margin
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.
Resale Price Method
Example #2
Supplier
Lower Price
Distributor C
• Performs warranty function
Higher Price
Distributor D
• Sends warrantied products
back to the supplier.
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.
Resale Price Method
Example #3
Supplier
Country A
Country B
Country C
Country D
Distributor A
Distributor B
Distributor C
Distributor D
Non-exclusivedistributor
distributor • Non-exclusive distributor
•• Non-exclusive
Onlymarkets
marketsproduct
product
•• Only
• Only markets product
Country E
Distributor E
• Non-exclusive distributor
• Only markets product
• Non-exclusive distributor • Non-exclusive distributor
• Only markets product
• Only markets product
Country F
Subsidiary
• Exclusive distributor
• Perform technical applications
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
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.
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
Transfer Pricing Methods - CPM
Factors to Consider

Cost should include all costs associated with the process
(manufacturing, provision of services)
i) Direct Costs- materials, labor
ii) 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)
Cost Plus Method
Example #1
Sale of intermediate goods
Arm’s length price
=
Cost incurred by supplier of
property or service
Manufacturer X
5%
gross
profit
markup
Subsidiary B
• SG&A costs accounted as
operating expenses
Cost plus mark up for
reasonable profit
Unrelated Party Transactions
Related Party Transactions
Manufacturer A
+
Manufacturer Y
Manufacturer Z
Same
country
3%
4%
5%
Buyer Q
Buyer R
Buyer S
• SG&A costs accounted as
COGS
Foreign
countries
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.
Cost Plus Method
Risks
• Guarantees purchases
Functions
• Provides components,
know-how, etc
Example #2
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)
Cost Plus Method
Example #3
Contract to carry out R&D project
• Carries out contract research
Company A
Related Party Transaction
• Owns all intangibles from
research
• Absorbs risk of research
failure
Company B
Method Implementation
• Typical setup for applying the cost plus method
• All costs for the research carried out have to be compensated
plus a profit margin reflecting the complexity and innovation
of the research carried out.
Transfer Pricing Methods – PSM
•
Profit Split Method (‘PSM’)
– This method aims to determine what division of total profits independent
enterprise would expect in relation to the relevant transactions.
– The profits should be split on an economically valid basis that reflects
the functions and risks of each of the parties.
– In order to apply this method, it is necessary to identify the total profit
arising from the related party transactions and split that profit between
the parties according to their respective contributions.
Transfer Pricing Methods – PSM
•
Applicability
– In certain very complex trading relationships involving very interrelated
transactions, it is sometimes genuinely difficult to evaluate those
transactions on a separate basis.
•
Approaches
– There are two approaches to this method;
• Total profits split, and
• Residual profit split
Transfer Pricing Methods – PSM
• Total Profit Split
– Total profits from the controlled transactions made by all the enterprises
involved in earning those profits are split between those enterprises
based on the relative value of the functions that each carries out.
•
Residual Profit Split
– Total profit of the overall trade made by the associated enterprises is
considered.
– Firstly, each participant is allocated sufficient profit to provide it with a
basic return appropriate to the functions carried out.
– Secondly, any profit (or loss) left after the allocation of basic returns
would be split as appropriate between the parties – based on an
analysis of how this residual would have been split between third
parties.
Transfer Pricing Methods – TNMM
•
Transactional Net Margin Method (‘TNMM’)
– The TNMM examines the net profit margin relative to an appropriate
base that a tax payer realizes from an international transactions vis-àvis comparable uncontrolled transactions.
– Thus, the TNMM operates in a manner similar to the cost plus and
resale price methods.
– The TNMM is based on the economic theory that returns earned by an
enterprise operating under similar conditions, in the same market and
industry, tend to become more equal after some time.
Transfer Pricing Methods – TNMM
•
Procedure
– Selection of Tested Party
– Data – Current year vs. Multiple year
– Aggregation of transaction
– Identification of comparables
– Profit level indicator
• Operating Margin = OP/Sales X 100
• Net Cost Plus = OP/ Total Operating Expenses X 100
• Berry Ratio = GP/ Operating Expenses
• Return on Asset = OP/ Operating Asset X 100
Transactional Net Margin Method
Unrelated Party Transactions
Related Party Transactions
Manufacturer X
Manufacturer A
5%
Subsidiary B
• Costs accounted as
operating expenses
profit
markup
Example #1
Manufacturer Y
Manufacturer Z
Same
country
3%
4%
5%
Buyer Q
Buyer R
Buyer S
• Costs accounted as
COGS
Foreign
countries
Transactional Net Margin Method
Example #1
Insufficient Information
What if the information necessary to carry out a gross margin method is
unavailable?
In the first example of the cost plus method we needed to identify the particular
costs associated with SG&A in order to make accountancy adjustments.
If the cost information cannot be obtained, it still might be possible to identify the
net margin arising from the transaction. This information would enable the use
of the TNMM as an alternate method.
Transactional Net Margin Method
Example #2
Supplier
Country A
Country B
Country C
Country D
Distributor A
Distributor B
Distributor C
Distributor D
• Non-exclusive distributor • Non-exclusive distributor • Non-exclusive distributor
• Perform technical
• Perform technical
• Perform technical
applications
applications
applications
• Reports service costs in • Reports service costs in • Reports service costs in
COGS (cannot be
COGS (cannot be
COGS (cannot be
separately identified)
separately identified)
separately identified)
Country E
Distributor E
• Non-exclusive distributor
• Perform technical
applications
• Reports service costs in COGS
(cannot be separately identified)
• Non-exclusive distributor
• Perform technical
applications
• Reports service costs in
COGS (cannot be
separately identified)
Country F
Subsidiary
• Exclusive distributor
• Only markets product
Transactional Net Margin Method
Example #2
Method Selection
Reasons for choosing the TNMM:
− Significant product & market differences for a CUP.
− Since additional service costs cannot be independently identified, gross
margins of independent distributors must be higher invalidating a Resale
method.
Transactional Net Margin Method
Example #3
Supplier
Lower Price
Distributor A
• Performs warranty function
Higer Price
Distributor B
• Sends warrantied products
back to the supplier.
Transactional Net Margin Method
Example #3
Information Unavailable...
Same as example #2 of Resale Price Method.
− What if it is impossible to ascertain Distributor A’s warranty expenses?
• Without the expense information, Distributor A’s gross profit cannot be
adjusted.
− If there are no other functional differences between Distributor A and B and
the net profit of Distributor A relative to its sales is known then…
Apply the TNM method by using A’s net margin relative to its sales with B’s net
margin relative to its sales.
Transfer Pricing Methods – Other Method
– Other method refers to “price which has been
• charged or paid, or
• would have been charged or paid”
– Use of Other method for benchmark using prices rather than margins
– Not fall within the meaning of property or service
– Better benchmarking for transactions of Cost Allocation, reimbursement,
interest on loan
– Other method could be any method – no specific method described
– Could cover transactions such as “valuation” of shares, intangible property
etc.
– Use of Quotations
To Summarize…
Application
Analysis Of Transaction Under TP
Regulation
Analyze Each Method Of Computation
Of Arm’s Length Price
Methods Not Applicable To Be
Rejected With Due Reasoning
Application Of Most Appropriate
Method And Computation Of ALP
Questions ..?