Industry Benchmarking for select Industries Bhupendra Kothari Villy Dhabhar 28 October 2012 Contents Sector Based Transfer Pricing Policy Manufacturing Sector Distribution Sector ID: 243200
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Transfer PricingIndustry Benchmarking for select Industries
Bhupendra KothariVilly Dhabhar28 October 2012Slide2
ContentsSector Based Transfer Pricing Policy – Manufacturing Sector
Distribution SectorServices SectorTransfer Pricing MethodsIndustry Specific IssuesCase StudySpecified Domestic Transaction2Slide3
Sector Based Transfer Pricing Policy- Manufacturing Sector- Distribution Sector- Services SectorSlide4
Transfer Pricing Policy - Manufacturing ActivityTransfer pricing policy for manufacturing is complex and has to take into consideration possibility of internal comparableTypical 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 consumptionGross level comparison of sales to AE vis-à-vis 3rd party sales can be made to review the profitabilityIndian parent (exports raw materials)AE manufacturing entity (country X)Export sales to AE (country Y)Sales to 3rd parties (country X)Slide5
Manufacturing Functions
+++Functions and RisksSlide6
Transfer Pricing Policy - Distribution ActivityTransfer 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 betweenIn 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 timeReturn for low risk distributors in developing markets are generally higher than corresponding margins in developed economiesIndian parent (exports finished goods)AE distribution entity (country X)Sales to 3rd parties (country X)Slide7
Distribution Functions
+++Functions and RisksSlide8
Transfer Pricing Policy - ServicesIndian MNCs provide a variety of IT and ITeS to global multinationals, including engineering design, back office, procurement, financial and analytical servicesIn 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 productMost 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 developedIndian parent (service company)AE onsite entity (country X)Service to 3rd parties (country X)
AE development center
(
country Y)Slide9
Service Providers
+++Functions and RisksSlide10
Transfer Pricing MethodsSlide11
Overview of Transfer Pricing MethodsThe 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); andAny other method that may be considered appropriate in determining the arm’s length price as per Rule 10AB of the Income-tax Rules, 1962 11Slide12
Summary of Methods
MethodsProduct ComparabilityFunctional Comparability
Approach
Remarks
CUP Method
Very High
Medium
Prices are benchmarked
Very difficult to apply as very high degree of product comparability required
RPM
High
Medium
GPM (on sales) benchmarked
Difficult to apply as high degree of product comparability required
CPM
High
High
GPM (on costs) benchmarked
Difficult to apply as high degree of product comparability required
PSM
Medium
Very High
Profit Margins
Complex Method, sparingly used
TNMM
Medium
Very High
Net Profit Margins
Most commonly used MethodSlide13
Pharmaceuticals, Telecommunications and Entertainment & Media Industry Slide14
Characteristics of the Pharmaceutical Industry
Long product lifecycleExclusive patents can ensure premium pricing for 10-15 years, given no product recallsCostly R&D investments, along with significant risk of R&D failureOf 5,000 newly-discovered compounds, only one, on average, makes it to marketR&D, manufacturing and distribution, and pricing are highly regulated by governmentsApproval from regulatory bodies are required to market a drug in a marketCo-marketing and/or co-promotionRequires very high level of spendingE.g., Pfizer spent approx. 32% of total revenues on selling, informational and administrative expenses.Contract Research
Clinical Trials
Contract ManufacturingSlide15
Segments Within Pharmaceuticals IndustryTraditional Research-Based Pharma ManufacturersSuch as Pfizer, GSK, Sanofi-AventisIncur high level of R&D/Marketing costs to launch branded blockbusters
Continued emphasis on partnering and licensingGeneric Pharma ManufacturersSuch as Teva, Forest Labs, Mylan, Dr. Reddy’sLower R&D costs and overall profits, and easier regulatory approvalBiotechnology FirmsSuch as Amgen, GenentechYounger versions of traditional pharma, less of a distinction than beforeMedical Device ManufacturersSuch as Medtronic, Boston Scientific, but very diverse set of product offeringsUnique after-sales process, shorter economic life of productsSlide16
Some Key TP Issues in the Product Lifecycle
Research
Discovery
In-License
Development
Trial Manufacturing
Patent Expiry
Prod. Launch
Regulatory Approval
Detailing and
Co-Promotion
Phase IV R&D
Do detailing & marketing create intangibles?
What
is the impact of co-marketing/promo deals?
Is “manufacturing” intangibles creating
?
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?
Why do generics make so much money?Slide17
Characteristics of the Telecommunication Industry
High capital intensive industryGovernment regulated – Approval from regulatory bodies are required to enter a marketCommon network and resources used globallyLarge number of integrated transactions offered in the telecommunications services Slide18
Telecommunication - Reach
22 countries, thousands of customers, with large variety of products and services 18Slide19
Segments Within Telecommunication
Voice ServicesInternational Long Distance Telecommunications ServicesDomestic Long Distance Telecommunications ServicesData ServicesCorporate Internet ServiceVoice Over IP ServiceInternet Data CenterInternet & Broadband ServiceVideo Conferencing ServiceOther Value Added Services
Data Center and Media
ServicesSlide20
Characteristics of the Entertainment and Media Industry
Entertainment and media company are responsible for broadcasting content through various multimedia channels Typical transactions in transfer pricingPayment of licence fees for distribution of channelsReceipt of advertising sales commissionReceipt from the export of contentPayment 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 Slide21
BENCHMARKING ?
MethodsApplicabilityReasonsCUP MethodNormally cannot be appliedEach channel has its own uniquenessNo public informationRPMCannot be appliedDue to involvement of intangiblesCPM
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 TNMMSlide22
Most Appropriate MethodSlide23
Rationale for RPSMOther methods fail in the context of globally integrated companies with large number of intercompany transactionsRPSM 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 jurisdictions23Slide24
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?24Slide25
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 returnsPool 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.Slide26
Case StudySlide27
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?Slide28
Steps in Applying the RPSM
To apply the RPSM one mustDefine the correct pool of global profit to perform the analysisIdentify “routine” activitiesDetermine the functional returns for the routine activities performedDetermine the residual profit pool as equal to global revenues minus the routine net cost plus returns Determine the value drivers or objective key(s) to apportion the residual profit to Parent and Full BranchesSlide29
1. What Pool of Profits?
Key areas to discuss/review include “Flow-through” expenses and whether these expenses should attract a profitSome third party contracts (e.g., installation and maintenance) are not value-added by participantsThe treatment of interest expenseAs non-operating, interest expense would not be included in cost plus returns for routine activitiesParticipants cover this with their profit reward Slide30
2. Determining Routine Returns
Use Net cost plus in major regions of the worldStandard comparable sets used given the FARReturns commensurate with what 3rd parties in the local market are expected to earnIn India research can be performed on Prowess and CapitalineMultiyear data vs single year dataRoutine costs receive a routine markupSlide31
3. Calculating Residual ProfitResidual profit is equal to global revenue minus routine costs plus the profit markup on these costs
Total Revenue
Mark-up
Routine Costs
Residual ProfitSlide32
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
%Slide33
5. Determining Value Driver Weights
Residual ProfitHow to Weigh Intangibles?
Residual Profit Pools
R&D
Multimedia
Network
Key question - How to weight the relative importance of these value drivers? Slide34
5. Determining Value Driver WeightsPossible weighting value driver weighting factors include
An internal variable that objectively allows for comparison of relative contributionFor example, bonuses to employees are awarded across functions, although this does not appear to be objectiveCan sales and marketing be used?If it indeed contributes non-routine profitsWhat about the price of content?No as it is tainted.Slide35
5. Determining Value Driver WeightsRegression 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/profitsSince the relative contribution of each value driver is determined, this gives us the weighting factorsIn 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?Slide36
5. Determining Value Driver WeightsHow does regression work?In this simple example, regression predicts the value for the coefficient “b” in the equation of a line:
Y = a + b X b is the slope of a line and it indicates how much Y will change for a 1 unit change in XFor 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 $2We 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 driverSlide37
5. Determining Value Driver Weights - AlternateConduct interviews to gauge the relative contribution that each variable have
Interviews should be unbiased and held through formalized questionnaire targeted towards operational and management personnelObjective is to gauge the relative contribution as perceived by the businessThis provides an approximate proxy of how 3rd parties would also view thisThe 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) Slide38
ExerciseAssumed 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 driversMultimedia (Content cost / Total content cost)Research & Development (R&D personnel per entity/total R&D personnel)Network (Sales expense / Total sales expense)VAD weightNetwork 50%Multimedia 33%R&D 17%38Slide39
Standalone Financials – Key Entities
ParticularsIndiaSingaporeUSCanada Thailand
B.V.
Gross Revenue (a)
264.82
8.47
20.51
166.00
2.50
4.20
3
rd
Party Costs (b)
216.50
0.34
13.30
66.00
5.11
4.33
Net Revenue (c) = (a) – (b)
48.32
8.13
7.21
100.00
(2.61)
(0.13)
Selling & Marketing Expenses (d)
Network Maintenance expenses (e)
General Administration Expenses (f)
Depreciation (g)
3.77
2.36
15.34
19.11
1.93
0.35
0.91
0.96
0.82
12.15
5.67
1.14
4.09
7.78
18.71
3.63
0.00
0.00
0.28
5.98
0.00
0.00
0.01
0.24
39Slide40
Financials Post TP – Key Entities40Slide41
Key Issues
Gross revenue or net profit after expenses?Return on third party costBook value of the assets or fair value of the assetsCurrency of transactionsNeed of TPA41Slide42
Specified Domestic Transactions (“SDT”)Slide43
Inclusion of SDT within the ambit of Transfer PricingDefinition of international transaction has been extended to include “Specified Domestic Transactions” with a threshold limit of Rs.5 croresSpecific
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); andAny 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 applicable43Value of SDT
Value more than 5 crs –
Arm’s Length Price
Value less than 5 crs –
Fair Market ValueSlide44
Implication post-budget 2012 for SDT44
Fair Market ValueArm’s Length PriceNo method prescribed for computing fair market valueFive methods prescribed for computing Arm’s Length PriceNo documentation required to be maintainedContemporaneous 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 OfficerSlide45
Questions?Slide46
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