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FORUMULATING A TRANSFER PRICING STRATEGY Navigating the Indian & Overseas waters!. Narayan Mehta Partner, Sudit K Parekh & Co. 3 rd February 2006. Agenda. Importance of Compliance A case study Indian owned UK, US and Canadian software subsidiaries Transfer Pricing considerations

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FORUMULATING A TRANSFER PRICING STRATEGY

Navigating the Indian & Overseas waters!

Narayan Mehta

Partner, Sudit K Parekh & Co

3rd February 2006


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Agenda

  • Importance of Compliance

  • A case study

    • Indian owned UK, US and Canadian software subsidiaries

      • Transfer Pricing considerations

      • Related issues under other laws


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Importance of Compliance

  • Any related party transaction undertaken from

    1st April 2001 onwards covered

    • Currently 60% of world’s cross-border trade is between

      related parties – Indian tax authorities have taken the cue!

      • UK –every £1 spent on TP investigation has fetched

        £120 to UK Inland Revenue!

      • 1/3 rd of audits globally end up with TP adjustments!

    • India - FY 01-02 assessments complete

      • Incremental revenue collection - in excess of INR 600 Cr

      • Around 25% to 30% of the case show adjustments!


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Importance of Compliance

  • Transactions exceeding INR 50 mn to attract compulsory TP audit

  • Onus of proof- tax payer primarily liable

  • S.10A / 10B units- thin margin for error

    • No deduction under section 10A / 10B on enhanced income!

    • More than ordinary profits taxable & may not be tax exempt!

  • Double taxation for the Group in respect of enhanced income


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Penalties are High

  • Failure to maintain documentation

    • 2% of value of transaction

  • Failure to furnish documentation

    • 2% of value of transaction

  • Addition to Income

    • 100% to 300% of tax on addition

  • Failure to furnish Accountant’s Report

    • Rs. 100,000

Penalties are not tax deductible!

Most TP penalties are not appealable!

Penal regulations in many

overseas jurisdictions as well!


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A Bilateral Exercise

  • At least 9 out of 25 EU / accession countries have specific TP documentation requirements:

    Denmark Hungary Portugal

    France Netherlands Spain

    Germany Poland UK

  • Upward of 20 other countries have specific TP documentation requirements

    Japan Australia Korea

    China Canada Mexico

  • TP documentation may be required in other countries under general anti-avoidance provisions

    Israel Singapore, etc.

Need for balancing the Indian &

overseas transfer pricing regulations!


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Dual Advantage!

  • An effective tax planning & risk management tool to establish the appropriateness of transfer prices


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Integrated & Holistic Approach

Also involves

  • Commercial considerations

  • International tax

  • Section 10A optimization

  • Withholding tax

  • Expatriate taxation

  • Immigration issues

  • Exchange control

  • Service Tax / VAT

  • STPI issues


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Documentation- Why Necessary?

  • To be better prepared for transfer pricing audit

  • To support your arm’s length price in future

  • Self review

Effective communication of TP policy is critical for IRS to appreciate & approve transfer pricing documentation!


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Onerous Documentation Retention Reqt

Beginning of tax year

End of tax year

Deadline for maintaining documentation

Filing Accountant’s Report & ROI

Limitation for initiation of assessment

Limitation for completion of assessment

Date till which docn. is required to be maintained


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Legislative Framework

Legislative Framework

Associated

Enterprise

Associated

Enterprise

International

Transaction

Arm’s length computation & maintenance of necessary documentation


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Indian Transfer Pricing Regulations

Indian Income-tax Act, 1961

Arm’s

length price

Documentation

Accountant’s

Report


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UK, US & Canadian subsidiaries

CASE STUDY:

Indian

Owned


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Indian tax

rate=0 / 33%

UK tax

rate= 10/30%

Transfer Pricing issues!

Indian

Co

UK

WOS

Contract for outsourcing

  • Software

  • development

  • Brand creation

  • Entrepreneurial

  • risk

Principal contract

for software development

Deputation / secondment

of personnel

for onsite execution

Contract value UK £ 100

Ultimate

UK

client

Similar fact pattern for the US / Canadian subs.

UK Subsidiary

Consideration ?

  • Marketing in UK

  • Payroll / work permit

  • Dely mgt. & sales support


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Step 1- Functional Analysis

Compliance with documentation requirements

Understanding of where and how value is added

Criteria for Comparability

Assist in identification of simpler entity

Platform for Economic Analysis


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Functions Performed

Income distribution within the MNC to be based on economic value and activities

Each activity / enterprise receives a share of total profits that reflects the contribution of that activity / enterprise to earning those profits.

R&D

Software

Development

Finance

Marketing

Sales &

Distribution


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Risks undertaken

Income distribution within the MNC to be based on risks undertaken

Strategic

Planning

Foreign

Exchange

Project Scheduling &

Dvlpt Activities

Idle

Capacity

Quality Control

Sales &

Distribution

Research &

Development

Marketing


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Assets employed

Income distribution within the MNC to be based on assets employed

Technical/

Trade Intangibles

Marketing Intangibles


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Step 2: Economic Characterization of simpler entity

  • UK subsidiary – the simpler entity!

  • Economic characterization

    • Ring fenced, risk mitigated contract service provider


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India

UK

Functions

Assets

Risks

Profits £,£ £ £, £ £ £, £ £ ££, £ £ £

Functional & Economic analysis- significance

XYZ Group of Companies

Profit = f (F + A + R)


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Step 3: Selecting the most appropriate method

Most Appropriate

Method ???

??? ?

Cost Plus

Profit Split

TNMM

Resale Price

Method

Comparable

uncontrolled price

Other

Yet to be prescribed

Most appropriate method - service provider - cost plus / TNMM


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External comparables- running queries on UK databases for searching functionally comparable companies preferably in the same line of business

Fame database

Global Vantage

Kompass

Amadeus

Marketing / commission agents for

software / ITES services

.

Step 4: Search and assessment of comparables


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Sample record of benchmarks used as comparable data searching functionally comparable companies preferably in the same line of business


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An alternative analysis searching functionally comparable companies preferably in the same line of business

  • Constructing an alternate broad base sample

    • Use of lateral comparables to broad-base final sample size!

  • What should be the sample size?

    • US / UK vs. Canadian practice





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Rest of the profits! (extended sample)

Cost plus 11% only!

Consideration ?

Indian tax

rate=0 / 33%

UK tax

rate= 10/30%

Transfer Pricing issues!

Indian

Co

UK

WOS

Contract for outsourcing

  • Software

  • development

  • Brand creation

  • Entrepreneurial

  • risk

Principal contract

for software development

Deputation / secondment

of personnel

for onsite execution

Contract value UK £ 100

Ultimate

UK

client

UK Subsidiary

  • Marketing in UK

  • Payroll / work permit

  • Dely mgt. & sales support

Mark up for US & Canadian subs – cost plus 7 / 8%!


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Transfer pricing – a tax planning tool! (extended sample)

Total Profit

  • Above-normal profit:

  • Goes to economic owner(s) & developer(s) of intangible assets

  • May also be zero or negative!

Return to

entrepreneurial risk-taker

Return to routine service providers / suppliers of labor and capital

  • Normal profit:

  • Paid out for performance of normal tasks [software development, sales, distribution, marketing support, etc]


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Compliance with Indian TP Regulations (extended sample)

  • UK entity remunerated on cost plus 11% mark up

    • Onsite cost – regarded as flow through costs and no mark up thereon!

  • Rest of the profits belong to Indian entity!

  • Undertaking supplementary search on Indian database to corroborate findings


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India (extended sample)

Concept of arithmetic mean - 5% variation allowed but range not permitted

Past data of only 2 years

UK / US / Canada

Use of (inter-quartile) range generally allowed

Use of past data of even more than 2 years generally allowed

Balancing Indian / UK / US / Canadian Regulations


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I (extended sample)ndia/OverseasDocumentationRequirements- Fixing the jigsaw puzzle!

Accountant’s

Report

Industry

Analysis

Agreements

Benchmarking

Functional

Analysis

Other

Docn


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Other Issues Encountered (extended sample)

  • Even if PE, whether arm’s length mark-up would eliminate further tax incidence?

  • Employees on dual payroll or overseas payroll?

  • Compliances under STPI & FEMA regulations for export billing

  • W/ tax issues and remittances under FEMA

  • Drafting the contractual agreement

    • Consistent allocation of F / A / R

    • Treatment of flow through costs

    • Re % mark-up

  • Whether UK Co. is a PE of the Indian company?


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Transfer Pricing Study - end results (extended sample)

  • Global documentation- killing many birds with one stone!

    • Compliance with the UK / US / Canadian transfer pricing regulations!

    • Compliance with the Indian transfer pricing regulations!

  • Minimum corporate tax incidence in UK / US / Canada!

  • Optimization of section 10A benefits &

    complete tax exemption in India!

  • Compliance with exchange control

    regulations, STPI norms & formulation

    of expatriate secondment policy


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Concluding Remarks (extended sample)

  • An effective tax planning & risk management tool

  • Need for a holistic approach

  • Harmonizing the Indian & overseas transfer pricing requirements

  • Contemporaneous documentation

  • Regular review & update

  • Tailored to the needs of the IRS in India

    & overseas

    • Global / centralized / regional documentation

  • Relaxation if value of all international

    transaction < 1 Cr

    • Benchmarking analysis may yet be reqd in

      absence of CUPs


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Thank You (extended sample)

  • Contact


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