Industry Specific Transfer Pricing Issues –
Manufacturing Sector
The Chamber of Tax Consultants
International Fiscal Association – India Branch
23 April 2010
Rohan Phatarphekar
Global Transfer Pricing Services
National Leader, KPMG India
Discussion Points
1
Economic Characterization and
Compensation Models
2
Transfer pricing issues – Manufacturing
industry
3
4
5
Focus Sectors – Auto and Pharma
Guidance from judicial analysis
Way Forward
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and
risks
Intangibles
Intangibles
Sales
Sales
Inventory
Intangibles
Intangibles
Sales
Sales
Inventory
Inventory
Manufacturing
Manufacturing
Licensed
Manufacturer
Entrepreneur
Manufacturer
Functions
Principal
Manufacturing Functions
Inventory
Manufacturing
Toll
Manufacturer
Manufacturing
Contract
Manufacturer
Profits
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3
Compensation Model
Functions
Typical Compensation model
Contract / Toll manufacturing
operations
Full cost plus mark up (or)
Routine manufacture / assembly
activity with licensed technology
from Group.
Risk free assured return in line with industry benchmarks
As a variant of the above with
significant local marketing efforts
Receipt of compensation for marketing intangible in addition
to the above
Full fledged manufacturer and
contributing to the R&D effort of
the Group
Profit Split Method (PSM) to determine the contribution
towards routine functions and towards intangibles
Return for value added services plus appropriate return on
capital investments in material and finished goods inventory
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Typical Transfer Pricing Issues- Manufacturing Industry
 Start up phase challenges
 Application of the TNMM method –
Dealing with losses
 Application of CUP – Comparability
issues
 Aggregation of transactions – Trading,
Sourcing, Product bundling
 Payment towards technical know how
 IPR valuation
 TP Vs. Customs
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5
Specific Transfer Pricing Issues – Manufacturing Industry
Business Restructuring
Challenges for Contract Manufacturers
Comparability Adjustments – Specific focus working capital
Payouts - Specific focus on Royalty
Imports Vs Local
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6
OECD on business restructuring and practical To Do’s
 OECD
– Working Party No 6 – Transfer Pricing
aspects of business restructurings – Discussion draft
issued:
To-Dos
–Issue
Note 1 – Allocation of Risk – Contractual
allocation
respected only to the extent of
economic substance
–Issue Note 2 – Applying the arm’s length principle
to business
restructuring
•
•
Reallocation of profit or loss;
•
Arm’s length remuneration for detriment /
loss??
Arm’s length
property;
remuneration for transfer of a
Necessary changes in the
contractual terms and intercompany agreements as per the
new arrangement
To defend any tax scrutiny which
are likely in case of business
restructuring with robust transfer
pricing policies and
documentation.
Review inter-company pricing
policies periodically
–Issue
Note 3 – Applying arm’s length principle
post restructuring – Should not apply differently
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Supply Chain Planning
Illustrative Sample – Existing Supply Chain
Local
Suppliers
Inputs, raw
materials
Indian Manufacturer
Global sales subsidiaries
(local market IP)
Global
Customers
Global
Suppliers
Foreign Manufacturers
Global sales subsidiaries
(local market IP)
Customer service
primarily local;
support centers
Global sales subsidiaries
(local market IP)
Local
Customers
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Tax Efficient Supply Chain Model
- Illustrative Sample
Corporate
Headquarter
Research
Centers
Management
Services.
Suppliers
Delivery of
materials
Shared
Services
Services
R&D
services
Sales &
Marketing
(Limited Risk
Distributor]
Service
s
Sale 1
(flash title)
Sale 2
Key Entrepreneurial Risk Taker
Intangibles
Trading Risks
Purchase of
materials
Manufacturing
services
Manufacturing
(consignment)
Delivery
of
goods
Legal title
Distribution and
logistics services
Customers
Delivery of
goods
Distribution
Centers
Physical flow
Services
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Case Study
•
A foreign-based, Tier 1 automotive supplier has manufacturing and distribution operations
around the world, including India
•
The global business was slightly profitable (0.5 percent to 2.5 percent operating margin) in each
of the past five years
•
The India business has recorded losses in four of the past five years, and the forecast (under the
current structure) suggests losses will continue to mount
What can be done to help mitigate transfer pricing audit risk in India
and restructure the supply chain to be more tax efficient?
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Current Business Model
Parts,
Tooling,
Know-How
Royalty
Parts
Indian-Sub
(Licensed
Manufacturer)
China-Sub
(Manufacture)
Third-Party Vendor
OEM Customer
overseas
High Tax Parent
(R&D;
Manufacture)
Raw Materials &
Components
• India Sub COGS by source / value
• Parent: 10 percent
• Third-Parties: 90 percent
• Royalty rate: 3%
• Parts transfer price: net cost plus 10%
• India -Sub Operating Margin %
• Y1 (2%), Y2 +3%, Y3 (1%), Y 4
(7%), Y5 (4%)
India -Sub P&L (USD million)
Revenue
1,100
Less: COGS
(1,000)
Less: Royalty
(33)
Less: SG&A Expense
(111)
Operating Loss
(44)
Operating Margin %
- 4%
• Parent Operating Margin %
• Y1 +3%, Y2 +1%, Y3 +4%, Y4
+6%, Y5 +5%
• China-Sub Operating Margin %
• Net Cost Plus 6% in all years
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Issues Raised by Losses
•
Apparent transfer pricing risk
•
Global effective tax rate high
•
Potential need for ongoing capital contributions
Transfer Pricing alone won’t solve the issues
Consider Business restructuring options
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Possible Business Model
Parts, Tooling,
Know-How
High Tax Parent
(R&D; Manufacture)
OEM Customer
overseas
Parts
Lower Tax
Indian-Sub
(Contract Manufacturer)
China-Sub
(Manufacture)
Parts
Third-Party Vendor
Raw Materials &
Components
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13
Challenge for contract manufacturers
 Functional profile of Contract Manufacturers - Risk-free operations
Determination of remuneration level Contract Manufacturers
 Remuneration model - remunerated with a Cost Plus Mark-up with
reference to third party manufacturers
Challenge
 Third parties available as benchmarks are Entrepreneurial manufacturers
– Undertake full gamut of risks
– Not remunerated on “Cost Plus” basis
Solutions
 Adjustments for better comparability
– Possible adjustments for working capital and Risk differential
 Alternate PLIs
– Use of Return on Assets (ROA) as PLI
– Use of Return on Capital Employed (ROCE) as PLI
 Safe Harbours
– Example - Maquiladora in Mexico
– As a percent of return on value of assets employed / return on total
costs
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Comparability adjustments
•
Typical adjustments: Working Capital, Risk adjustment, Depreciation adjustment, Idle capacity
adjustment, Accounting adjustments
Working Capital Adjustments
•
Purpose: Adjust for the differences between the tested party and potential comparables in interest
expenses, with an assumption that the difference should be reflected in profits.
•
The underlying reasoning is that:
•
A company will need funding to cover the time gap between the time it invests money (i.e.
pays money to supplier) and the time it collects the investment (i.e. collects money from
customers)
•
This time gap is calculated as: the period needed to sell inventories to customers + (plus) the
period needed to collect money from customers – (less) the period granted to pay debts to
suppliers.
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OECD Example…
TESTCO
Sales
Year 1
$179.5m
Year 2
$182.5m
Year 3
$187m
Year 4
$195m
Year 5
$198m
Earnings Before Interest & Tax (EBIT)
$1.5m
$1.83m
$2.43m
$2.54m
$1.78m
EBIT/Sales (%)
0.8%
1%
1.3%
1.3%
0.9%
Trade Receivables (R)
$30m
$32m
$33m
$35m
$37m
Inventories (I)
$36m
$36m
$38m
$40m
$45m
Trade Payables (P)
$20m
$21m
$26m
$23m
$24m
Receivables (R) + Inventory (I) – Payables
(P)
$46m
$47m
$45m
$52m
$58m
(R + I – P) / Sales
25.6%
25.8%
24.1%
26.7%
29.3%
Working Capital (at end of year)
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OECD Example…
COMPCO
Sales
Year 1
$120.4m
Year 2
$121.2m
Year 3
$121.8m
Year 4
$126.3m
Year 5
$130.2m
Earnings Before Interest & Tax (EBIT)
$1.59m
$3.59m
$3.15m
$4.18m
$6.44m
EBIT/Sales (%)
1.32%
2.96%
2.59%
3.31%
4.95%
Trade Receivables (R)
$17m
$18m
$20m
$22m
$23m
Inventories (I)
$18m
$20m
$26m
$24m
$25m
Trade Payables (P)
$11m
$13m
$11m
$15m
$16m
Receivables (R) + Inventory (I) – Payables
(P)
$24m
$25m
$35m
$31m
$32m
(R + I – P) / Sales
19.9%
20.6%
28.7%
24.5%
24.6%
Working Capital (at end of year)
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OECD Example
WORKING CAPITAL
ADJUSTMENT
TestCo’s (R + I – P) / Sales
YEAR 1
YEAR 2
YEAR 3
YEAR 4
YEAR 5
25.6%
25.8%
24.1%
26.7%
29.3%
CompCo’s (R + I – P) / Sales
19.9%
20.6%
28.7%
24.5%
24.6%
Difference (D)
5.7%
5.1%
-4.7%
2.1%
4.7%
Interest Rate (i)
4.8%
5.4%
5.0%
5.5%
4.5%
Adjustment (D*i)
0.27%
0.28%
-0.23%
0.12%
0.21%
CompCo’s EBIT/Sales (%)
1.32%
2.96%
2.59%
3.31%
4.95%
Working Capital Adjusted
EBIT / Sales for CompCo
1.59%
3.24%
2.35%
3.43%
5.16%
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18
Points to Note
•
At what point in time should the Receivables, Inventory and Payables compared? – Averages can
be applied
•
Which interest rate to use? – Typically borrowing rate, In case tested parties working capital is
negative – lending rate may be considered
•
When to do a working capital adjustment? – Need based not as a routine
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Management Payouts in the Manufacturing Sector
 Typical forms of payouts: Royalty, Technical fee, Management fee, Guarantee fee
 Primary challenge – Payouts through having economic substance are challenged in the start up phase due to
existing losses
 Benchmarking - Is a challenge due to inadequate comparable data in public domain
 Documentation - Under the transaction specific approach it is necessary to anlayse potential “cost-benefit” and
maintain appropriate documentation to substantiate arm’s length nature of payouts
– Costs - Benchmarking payouts of comparable companies, Basis of arriving at the value of payouts ( Direct
/ Indirect Method) by the Group
– Potential Benefits - Need for obtaining service from the Group, Analysis of potential benefit obtained by
the Company and value attributable to the service
 Other Regulatory Considerations: The recent relaxation of the statutory RBI / FEMA limits on royalty and
technical fee payouts increases the challenge of defending the arm’s length nature of such transactions.
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Case Study – Royalty payment
Is royalty payment justified in loss making companies?
Background & Issues
A
Company – Earning losses even
though in business for over 5 years
 Company
procured technical know how
from Parent - To improve its
manufacturing process and quality of
product - anticipating future benefits
Solutions
 Defend the royalty payment on a stand alone
basis, rather than aggregating with other
transactions
– Benchmark
royalty payouts of other
comparable companies
 Detailed
business and commercial rationale
for the transaction should be documented.
 However,
the Company did not earn
profits immediately.
 Commercial
reasons for losses should be
detailed
 The royalty payment had been approved
by the Government of India
 Anticipated
benefits to be documented using
forecasts
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Auto Industry –Typical issues…
Industry factors

Pricing pressures on automobiles results in push back
on component suppliers – cost pressure

Extremely competitive industry – Extreme market and
price risk

Capital intensive and high fixed cost
Other issues

Dealing with low profits/losses – Are losses attributable
to transfer prices - TNMM

Remuneration for routine functions – Distribution
function, Contract manufacturing


Bundled goods
Research and Development
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22
…Auto Industry –Typical issues
Differences between foreign companies and Indian
MNCs
 High initial import content with steady localisation
 Unutilized capacity
 Dependent on technical support from Group: High tech
fee / royalty payouts
 Local documentation preferred to Group global
documentation by revenue authorities
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Benchmarking Issues
Profit margin (%)
Auto - Foreign / New players
Auto Ancillary
10
5
0
2006
-5
2007
2008 s
2009
Hyundai Motors 1996
General Motors 1994
Honda Siel - 1995
10
Profit
Margin
(%)
9
All
Engine parts
8
-10
Ford India - 1995
-15
7
2006
Years
2007
2008
2009
Years
Impact on Transfer Pricing
Auto - Established / Domestic Players
Profit margin (%)
15
Tata Motors 1945
10
5
0
-5
2006
2007
2008
2009
Mahindra and
Mahindra 1945
Hindustan
Motors - 1942
Maruti Suzuki
-10
Years
India Ltd. -
1984
 Well established players (primarily Indian
players) earning higher margins vs-a-vis foreign
players most of whom are new entrants
 New entrants incur initial year losses due to high
import content, forex issues, start up costs and
idle capacity
 New units shall be benchmarked with Indian
players without cognizance of years of presence or
industry / economic dynamics
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Case Study – Auto Industry – Start up unit
Background & Issues
Solution
 Indian subsidiary of foreign entity engaged in
Adjustment to be made for
the business of manufacturing and selling cars
 International transactions - Purchase of RM,
Payment of Royalty and Technical know-how
 Being in start-up stage, capacity utilisation at
37.19 percent
 Import content at 98.55 percent of total
purchases
 Non-cenvatable import cost

Higher cost during set-up stage

Lower capacity utilisation
To consider effect of product cycle on multiple
year data
 Issue - Significant losses due to the above
 Multiple year data used
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25
Pharma Industry
Government pricing regulations – NPPA, DPCA
Imports vs. Locals – Application of CUP method
Basic / Applied Research
Cost contribution and buy in arrangements for R&D
Valuation of IPRs
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26
Guidelines from judicial analysis
Industry
Ruling
Key principles / Takeaways
Auto
Skoda Auto India P Ltd, Pune
ITAT
Schefenacker Motherson Ltd,
Delhi ITAT
 Acceptance of adjustments for better comparability
 Reasonable assumptions while performing adjustments
 Acceptance of Cash Profits as PLI
Pharma
Hoescht, Mumbai ITAT
Ranbaxy Laboratories Ltd,
Delhi ITAT
UCB India Pvt Ltd, Mumbai
ITAT
Gharda Chemicals Ltd,
Mumbai ITAT
 Indian government’s price regulations to be factored
 Overseas comparables acceptable only if tested party is overseas
Sony India P Ltd, Delhi ITAT
Il Jin, Delhi ITAT
 Adjustment towards markets risk, R&D risks and working
Consumer
Electronics




and data should be available in public domain
High degree of comparability required under the CUP method –
Purity, potency and characteristics
capital risks
Impact of idle capacity - Challenge
Guidance on marketing fee
Restrict adjustment to quantum of International transaction
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27
Way Forward …
 Operational Transfer Pricing
– Present focus is on tax documentation
– Harmonious approach between transfer pricing for operational
and regulatory purposes
 Unspecified Methods
– Presently no clear recognition in Indian Regs
– More reflective of actual process than TNMM approach
– Increased application in US IRS-approved APAs
 Advance Pricing Arrangements (APAs)
– Provides upfront clarity and reduces litigation
 Safe Harbours
– Useful for Contract Manufacturing etc.
 Mutual Agreement Procedure (MAP)
– Alternate to Litigation in Indian courts
– Suspension of tax payment demand subject to MAP
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28
in.kpmg.com
Contact details
Name
Thank You
: Rohan Phatarphekar
Designation : National Leader – Transfer Pricing
Email
: rohankp@kpmg.com
Tel
: +919820036156
Mumbai
New Delhi
Bangalore
Hyderabad
Lodha Excelus, 1st Floor,
Apollo Mills Compound,
N.M. Joshi Marg, Mahalakshmi,
Mumbai 400 011
Tel +9122 39896000
Fax +91 22 39836000
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8th Floor, DLF Cyber City,
Phase – II
Gurgaon 122002 Haryana
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Inner Ring Road
Bangalore 560 071
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8-2-618/2
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Road No. 11, Banjara Hills
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Kolkata
Pune
Kochi
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Chennai 600 034
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Sector - V, Salt Lake City
Kolkata 700091
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