Transfer Pricing
Industry Benchmarking for select
Industries
Bhupendra Kothari
Villy Dhabhar
28 October 2012
Contents
• Sector Based Transfer Pricing Policy –
‒ Manufacturing Sector
‒ Distribution Sector
‒ Services Sector
• Transfer Pricing Methods
• Industry Specific Issues
• Case Study
• Specified Domestic Transaction
2
Sector Based Transfer Pricing Policy
- Manufacturing Sector
- Distribution Sector
- Services Sector
Transfer Pricing Policy - Manufacturing Activity
• Transfer pricing policy for manufacturing is complex and has to take into
consideration possibility of internal comparable
• Typical manufacturing structures may include a) few subsidiaries focused on
manufacturing and rest distribution b) one overseas entity in manufacturing
(mother plant) rest all distribution entities
• In the below structure, AE manufacturing entity imports raw materials from parent
and manufactures component for domestic and export consumption
• Gross level comparison of sales to AE vis-à-vis 3rd party sales can be made to
review the profitability
Export sales to
AE (country Y)
Indian parent
(exports raw
materials)
AE
manufacturing
entity (country X)
Sales to 3rd
parties
(country X)
Manufacturing Functions
Manufacturing
+
Inventory
+
Sales
+
Intangible
Toll Manufacturer
Contract Manufacturer
Licensed Manufacturer
Full Fledged
Manufacturer
Functions and Risks
Transfer Pricing Policy - Distribution Activity
• Transfer pricing policy for distribution has to take into consideration the
positioning of the distributor i.e., low-risk distributor, full fledged distributor or
somewhere in between
• In the below structure, AE distribution entity imports finished goods from parent
and sells it in its domestic market
• Under a low risk distribution model the transfer pricing method should be such
that it results in a consistent margin over a period of time
• Return for low risk distributors in developing markets are generally higher than
corresponding margins in developed economies
Indian parent
(exports finished
goods)
AE distribution
entity
(country X)
Sales to 3rd
parties
(country X)
Distribution Functions
Sales – disclosed
Principal
+
Undisclosed
Principal
+
Inventory
+
Marketing
Intangible
Commission Agent
Commissionaire
Buy-Sell Distributor /
Reseller
Full Fledged
Distributor
Functions and Risks
Transfer Pricing Policy - Services
• Indian MNCs provide a variety of IT and ITeS to global multinationals, including
engineering design, back office, procurement, financial and analytical services
• In the below structure, Indian parent has a central development center in country
Y and an onsite delivery entity in country X to provide the final product
• Most development centers are set-up as risk free service providers which are
guaranteed return on a time-cost basis or a cost plus mark-up basis
• The intellectual property rights for the software they develop vests with the Indian
parent
• The onsite entity is primarily engaged in marketing, understanding client
requirements and implementation of the software developed
AE development
center
(country Y)
Indian parent
(service
company)
AE onsite entity
(country X)
Service to 3rd
parties
(country X)
Service Providers
Provision of
Services
+
Varied Functions
+
Sophisticated
Work-force
+
Non Routine
Intangible
Contract Service
Provider
Shared Service Center
Routine Service
Provider
Sophisticated Service
Provider
Functions and Risks
Transfer Pricing Methods
Overview of Transfer Pricing Methods
The arm’s length price in relation to an international transaction is to be determined
by any of the following methods, being the most appropriate method, namely:
‒ Comparable uncontrolled price (CUP) method;
‒ Resale price method (RPM);
‒ Cost plus method (CPM);
‒ Profit split method (PSM);
‒ Transactional net margin method (TNMM); and
‒ Any other method that may be considered appropriate in determining the arm’s
length price as per Rule 10AB of the Income-tax Rules, 1962
11
Summary of Methods
Methods
CUP
Method
RPM
Product
Comparability
Very High
High
Functional
Comparability
Approach
Remarks
Medium
Prices are
benchmarked
Very difficult to apply as very
high degree of product
comparability required
Medium
GPM (on sales)
benchmarked
Difficult to apply as high
degree of product
comparability required
Difficult to apply as high
degree of product
comparability required
CPM
High
High
GPM (on costs)
benchmarked
PSM
Medium
Very High
Profit Margins
TNMM
Medium
Very High
Net Profit Margins
Complex Method, sparingly
used
Most commonly used
Method
Pharmaceuticals,
Telecommunications and
Entertainment & Media
Industry
Characteristics of the Pharmaceutical Industry
• Long product lifecycle
‒
Exclusive patents can ensure premium pricing for 10-15 years, given no product recalls
• Costly R&D investments, along with significant risk of R&D failure
‒
Of 5,000 newly-discovered compounds, only one, on average, makes it to market
• R&D, manufacturing and distribution, and pricing are highly regulated by
governments
‒
Approval from regulatory bodies are required to market a drug in a market
• Co-marketing and/or co-promotion
• Requires very high level of spending
‒
E.g., Pfizer spent approx. 32% of total revenues on selling, informational and administrative
expenses.
• Contract Research
• Clinical Trials
• Contract Manufacturing
Segments Within Pharmaceuticals Industry
Traditional Research-Based Pharma Manufacturers
• Such as Pfizer, GSK, Sanofi-Aventis
• Incur high level of R&D/Marketing costs to launch branded blockbusters
• Continued emphasis on partnering and licensing
Generic Pharma Manufacturers
• Such as Teva, Forest Labs, Mylan, Dr. Reddy’s
• Lower R&D costs and overall profits, and easier regulatory approval
Biotechnology Firms
• Such as Amgen, Genentech
• Younger versions of traditional pharma, less of a distinction than before
Medical Device Manufacturers
• Such as Medtronic, Boston Scientific, but very diverse set of product offerings
• Unique after-sales process, shorter economic life of products
Some Key TP Issues in the Product Lifecycle
Is “manufacturing” intangibles
creating?
Discovery
Research
In-License
Why do generics make so much
money?
Trial
Manufacturing
Phase IV
R&D
Patent
Expiry
Prod. Launch
Development
Out-License to:
Principal in MNC, or
Third Party
What are the right terms of the
license, and how do you
implement them to a low tax
jurisdiction?
Regulatory
Approval
Detailing and
Co-Promotion
Do detailing & marketing create
intangibles?
What is the impact of co-marketing/promo
deals?
Characteristics of the Telecommunication Industry
• High capital intensive industry
• Government regulated
–
Approval from regulatory bodies are required to enter a market
• Common network and resources used globally
• Large number of integrated transactions offered in the telecommunications
services
Telecommunication - Reach
22 countries, thousands of customers, with large variety of products and services
18
Segments Within Telecommunication
• Voice Services
‒
International Long Distance Telecommunications Services
‒
Domestic Long Distance Telecommunications Services
• Data Services
‒
Corporate Internet Service
‒
Voice Over IP Service
‒
Internet Data Center
‒
Internet & Broadband Service
‒
Video Conferencing Service
• Other Value Added Services
‒
Data Center and Media Services
Characteristics of the Entertainment and Media Industry
• Entertainment and media company are responsible for broadcasting
content through various multimedia channels
• Typical transactions in transfer pricing

Payment of licence fees for distribution of channels

Receipt of advertising sales commission

Receipt from the export of content

Payment of royalty for wireless content
• Impact of transfer pricing issues on the industry

“Age of a Channel” is no longer a value driver

Constant enlargement of the value chain

Widespread use of market penetration strategies by media conglomerates

Pricing issues due to movement from analogue technology to digital technology
BENCHMARKING ?
Methods
Applicability
Reasons
CUP
Method
Normally cannot be
applied
 Each channel has its own uniqueness
RPM
Cannot be applied
 Due to involvement of intangibles
CPM
Generally not an
appropriate method
 CPM is more suitable for
manufacturing.
 Licencing fees can not be benchmarked
using CPM
PSM
May be considered
 If each group entities perform R&D on
multimedia related areas and each bear
risk of appropriate content and delivery
TNMM
Most widely used
 Routine functions can be benchmarked
using TNMM
 No public information
Most Appropriate Method
Rationale for RPSM
• Other methods fail in the context of globally integrated companies with large
number of intercompany transactions
• RPSM is the industry standard for large global telecommunication companies
(most large telecommunication companies in the U.S., Europe and Asia has
adopted this method)
• Acceptable method in all jurisdictions
23
Implementation RPSM
• The choice and applicability of the RPSM is
intimately tied to the identification and
valuation of Routine & Non routine functions
• This leads to the questions:
− FAR of each entities for routine return
− What is non routine intangible?
− How do we detect the presence of non
routine intangibles?
− How can we value contribution of non
routine intangibles?
24
Overview of RPSM
• Treats the related parties’ profits as being composed of two parts –
profits arising from “routine” activities and profits arising from
“intangible” activities
− First reward a market return to each related party for the “routine”
activities.
− Find service comparables and measure profits based on cost plus
returns
 Pool of intangible profits is the difference between total revenue
and the cost plus profit attributable to routine activities.
− Residual profit is split between the related parties based on keys that
reflect relative value in contributing to the pool of intangible profit.
Case Study
4. Calculating Residual Profit – case study
•
Assume that there exists a multimedia company which is responsible for
broadcasting content through various multimedia channels all over the world.
•
This company through its subsidiaries provide television network feeds to
various broadcasters around the world. These broadcasters may be 3rd parties.
•
Each subsidiary company is responsible for content development and
transmission to broadcaster.
•
To ensure appropriate content development, each subsidiary perform research
and development on multimedia related areas.
•
These subsidiaries bear the risk of appropriate content, delivery and standard
routine transfer pricing risks.
What is the transfer pricing mechanism through which these subsidiaries may be
remunerated?
Steps in Applying the RPSM
• To apply the RPSM one must
1. Define the correct pool of global profit to perform the analysis
2. Identify “routine” activities
3. Determine the functional returns for the routine activities performed
4. Determine the residual profit pool as equal to global revenues minus the
routine net cost plus returns
5. Determine the value drivers or objective key(s) to apportion the residual
profit to Parent and Full Branches
1. What Pool of Profits?
• Key areas to discuss/review include
− “Flow-through” expenses and whether these expenses should attract a
profit
 Some third party contracts (e.g., installation and maintenance) are not
value-added by participants
− The treatment of interest expense
 As non-operating, interest expense would not be included in cost plus
returns for routine activities
 Participants cover this with their profit reward
2. Determining Routine Returns
•
Use Net cost plus in major regions of the world
•
Standard comparable sets used given the FAR
•
Returns commensurate with what 3rd parties in the local market are expected
to earn
•
In India research can be performed on Prowess and Capitaline
•
Multiyear data vs single year data
•
Routine costs receive a routine markup
3. Calculating Residual Profit
Residual profit is equal to global revenue minus routine costs plus the profit
markup on these costs
Total Revenue
Routine Costs
Mark-up
Residual Profit
5. Determining Value Drivers
•
Assume there are significant “intangible income” to be allocated
•
How should the allocation work?
•
The key value drivers appeared to be
− Research & Development (a portion is routine)
− Multimedia (mostly the TV and Radio)
− The Network (not the hardware - alone this is routine)
Non-routine
EBT 80%
Routine EBT
20%
5. Determining Value Driver Weights
Key question - How to weight the relative importance of these value drivers?
R&D
How to Weigh
Intangibles?
Multimedia
Network
Residual Profit
Residual Profit Pools
5. Determining Value Driver Weights
• Possible weighting value driver weighting factors include
− An internal variable that objectively allows for comparison of relative
contribution
 For example, bonuses to employees are awarded across functions,
although this does not appear to be objective
− Can sales and marketing be used?
 If it indeed contributes non-routine profits
− What about the price of content?
 No as it is tainted.
5. Determining Value Driver Weights
Regression analysis
 Estimates the relative contribution of the value drivers in increasing
revenue/profits
 For example, estimates how a $1 increase in R&D, Multimedia, and Network
spending contributed to an increase in global revenues/profits
 Since the relative contribution of each value driver is determined, this gives us
the weighting factors
 In applying regression analysis, need to determine how to specify the
variables/model (1)
 For example, should the variables be lagged?
 e.g., should past R&D spending be used to estimate the contribution to
current profit or does current spending contribute to current profit?
 What is the correct “dependent” variable - global revenues, total operating
profits, residual operating profits?
5. Determining Value Driver Weights
How does regression work?
• In this simple example, regression predicts the value for the coefficient “b” in
the equation of a line:
Y=a+bX
‒ b is the slope of a line and it indicates how much Y will change for a 1 unit
change in X
• For example, assume Y is global revenue (Rev) and X is R&D spending. If we
estimate the regression to be:
Rev = 5 + 2 (R&D)
‒ we have determined that a $1 increase in R&D spending will increase Rev by
$2
• We determined three value drivers - R&D, Multimedia, and Sales Expense
(proxy for value of network)
• Therefore, the specification of this model is:
Rev = a + b (R&D) + c (Multimedia) + d (Sales)
• b, c, and d represent the weights on each value driver
5. Determining Value Driver Weights - Alternate
 Conduct interviews to gauge the relative contribution that each variable have
 Interviews should be unbiased and held through formalized questionnaire
targeted towards operational and management personnel
 Objective is to gauge the relative contribution as perceived by the business
 This provides an approximate proxy of how 3rd parties would also view this
 The contribution interviews can be utilized in the value driver equation to arrive
at a, b, c and d.
- Rev = a + b (R&D) + c (Multimedia) + d (Sales)
Exercise
• Assumed that the routine returns for the functions based on market benchmarks
are as follows:
− Assets deployment: ROA 6%
− Selling & marketing: Total Cost Plus 6%
− Network maintenance: Total Cost Plus 8%
− G & A: Total Cost Plus 5%
• Value added drivers
− Multimedia (Content cost / Total content cost)
− Research & Development (R&D personnel per entity/total R&D personnel)
− Network (Sales expense / Total sales expense)
• VAD weight
− Network 50%
− Multimedia 33%
− R&D 17%
38
Standalone Financials – Key Entities
Particulars
India
Gross Revenue (a)
264.82
8.47
20.51
166.00
2.50
4.20
3rd Party Costs (b)
216.50
0.34
13.30
66.00
5.11
4.33
48.32
8.13
7.21
100.00
(2.61)
(0.13)
• Selling & Marketing
Expenses (d)
3.77
1.93
0.82
4.09
0.00
0.00
• Network Maintenance
expenses (e)
2.36
0.35
12.15
7.78
0.00
0.00
• General Administration
Expenses (f)
15.34
0.91
5.67
18.71
0.28
0.01
19.11
0.96
1.14
3.63
5.98
0.24
Net Revenue (c) = (a) –
(b)
• Depreciation (g)
39
Singapore
US
Canada
Thailand
B.V.
Financials Post TP – Key Entities
Particulars
Net Revenue (c) = (a) –
(b)
India
Singapore
US
Canada
Thailand
B.V.
48.32
8.13
7.21
100
-2.61
-0.13
Routine Returns
43.01
4.40
20.97
36.26
6.64
0.27
–Total Cost
40.58
4.15
19.78
34.21
6.26
0.25
2.43
0.25
1.19
2.05
0.38
0.02
5.31
3.73 -13.76
63.74
-9.25
-0.40
–Markup
Residual Profit/Loss for
pool
–Allocation Ratio
(as per value driver
equation)
–Allocation Amount
(transfer pricing
adjustment)
PBIT After TP Adjustment
40
0.2
0.03
0.01
0.7
0.05
0.01
9.88
1.48
0.49
34.56
2.47
0.49
52.89
5.88
21.46
70.83
9.10
0.76
Key Issues
• Gross revenue or net profit after expenses?
• Return on third party cost
• Book value of the assets or fair value of the assets
• Currency of transactions
• Need of TPA
41
Specified Domestic
Transactions (“SDT”)
Inclusion of SDT within the ambit of Transfer Pricing
Definition of international transaction has been extended to include “Specified
Domestic Transactions” with a threshold limit of Rs.5 crores
Specific domestic transactions that would now fall within the ambit include:
• Expenditure in respect of which payment has been made or is to be made
between domestic related parties under clause (b) of sub-sec. (2) of sec. 40A;
• Transfer of goods or services between entities claiming deduction under section
80-IA(8);
• More than ordinary profits earned by entities claiming deduction under section
80-IA(10); and
Value of SDT
• Any transaction, referred to in any other section under Chapter VI-A or Section
10AA, to which the provisions of sub section (8) or (10) of section 80-IA are
applicable
43
Value more than 5 crs – Arm’s
Length Price
Value less than 5 crs – Fair
Market Value
Implication post-budget 2012 for SDT
Fair Market Value
Arm’s Length Price
No method prescribed for
computing fair market value
Five methods prescribed for
computing Arm’s Length Price
No documentation required to be
maintained
Contemporaneous documentation
required to be maintained
Other than reporting in tax audit
report, no statutory compliance
Accountant’s report signed by a
Chartered Accountant to be filed
Assessment done by the Assessing
Officer
Assessment done by the Transfer
Pricing Officer
44
Questions?
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