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CA Hiren D [email protected]
Specific Specific Domestic Domestic TransactionsTransactions
Technical Analysis
4
Manage theprocess
Accountant’s Report
Benchmarking
Gathering Background Information
Documentation
1 5
23
Functional Analysis
6
Ownership Structure
Profile of the company
Overview of industry
Competition faced by the company
Selection of Method
Analysis of activities of the Tested Party
Search for Comparable Companies
Profitability Measure
Arm’s Length Range
Profitability Analysis of the Company
Tested Party
In order to determine the most appropriate method for determining ALP, it is the first necessary to select the “Tested Party”.
The Transfer pricing legislation in India does not provide any discussion or mention of the concept of “Tested Party”.
Tested Party means a participant in an international transaction with reference to which the international transactions is tested.
The tested party would have a lesser risk as compared to the other transacting party.
The selection of tested party must be borne in mind while applying the CPM, RPM or TNMM.
The selection of the tested party would have an influence on the selection of the most appropriate method to benchmark the international transaction and consequently on the comparables selected.
In case Indian taxpayer is selected as the tested party, then ◦ Companies having functional profile similar to the
Indian company and operating in India will have to be selected as comparables.
In case the foreign AE is selected as the tested party, then◦ Comparables performing similar functions as the
AE in the territory in which the AE operates will have to be selected as comparables.
Section 1.482-5 of the US Transfer Pricing regulations state that “The tested party will be the participant in the controlled transactions whose operating profit attributable to the controlled transactions can be verified using the most reliable data and requiring the fewest and most reliable adjustments and for which reliable data regarding uncontrolled comparables can be located.”
Generally, the entity which performs simpler functions and which does not own any valuable non-routine intangibles is selected as the tested party.
Tribunal held that under the Transfer Pricing Mechanism, out of two parties of a multinational involved in the transaction, the least complex party not owning intangible assets is to be taken as a tested party.
The Delhi tribunal upheld that the decision of CIT(A) by accepting fact that the least complex entity should be chosen as the tested party. However, due to lack of availability of adequate data, the tribunal treated the Indian entity as tested party.
The assesse had chosen foreign AEs from whom components were imported as tested parties and had computed profit of AEs with comparable chosen from Indian and other data base. Since all international transactions were claimed at ALP, AO referred the question of determination of ALP to TPO. TPO agreed that TNMM was rightly applied, however, he did not agree that foreign AE could be taken as tested parties while determining ALP of imported electronic components and finished goods.
When applying a cost plus, resale price or TNMM, it is necessary to choose the party to the transaction for which a financial indicator ( mark-up on cost, gross margin, or net profit indicator) is tested. The choice of tested party should be consistent with the functional analysis of the transaction. As a general rule, the tested party is the one to which a transfer pricing method can be applied in the most reliable manner and for which the most reliable comparables can be found i.e. it will most often be the one that has the least complex functional analysis.
It is clear from these decisions that though foreign party can be tested party but due to lack of the availability of required data about foreign party, practically in almost all decisions, Indian party is preferred as tested party.
Profit Level Indicator Analysis
Comparative analysis of the functions and risks of the tested party
PLIs can be measured in five different ways• Operating margin• Return of Assets• Net Cost Plus• Berry Ratio• Gross Margin
PLI Sectors
Manufacturer
Distributor Service Provider
Operating margin
___
Return on Assets
___
Net Cost Plus ___
Berry Ratio
Gross Margin ___
Operating Margin = Operating Profit Net Revenue
Return on Asset = Operating Profit Operating Asset
Net Cost Plus = Gross Profits COGS
Berry Ratio = Gross Profits Operating Expenses Gross Margin = Gross Profit Revenue
100
Revenue Based Analysis:
Average Mean = Total of OPBIT Total of Revenue
Cost Based Analysis :
Average Mean = Total OPBIT Total Operating Cost
This Average Mean should be the Benchmark for the tested party to compare its profitability.
v 100
100
Selection Of Most
Appropriate Method
Traditional Transaction method:
Comparable Uncontrolled Method (CUP)Resale Price method (RPM)Cost Plus Method (CPM)
Transactional Profit Method
Profit Split Method (PSM)Transactional Net Margin Method (TNMM)
Traditional transaction methods are the most reliable means of establishing arm’s length prices or allocations.
However, the complexity of modern business situations may make it difficult to apply these methods.
Where the information available on comparable transactions is not detailed enough to allow for adjustments necessary to achieve comparability in the application of a traditional transaction method, taxpayers may have to consider transactional profit methods.
However, the transactional profit methods should not be applied simply because of the difficulties in obtaining or adjusting information on comparable transactions, for purposes of applying the traditional transaction methods.
The same factors that led to the conclusion that it is not possible to apply a traditional transaction method must be considered when evaluating the reliability of a transactional profit method.
Manufacturer
Distributor Service Provider
CUP ----- -----
RPM -----
CPM ----- -----
PSM ----- -----
TNMM
Data Strategy
Data Strategy
Use of Data base
Data Search Strategy
To identify a group of independent companies with publicly available data that performed broadly similar functions operate in broadly in similar markets and bear broadly similar risk to that of tested party.
In India two financial database are available to search for comparable companies.1. Capital line plus 2. Prowess
Using the above databases, one can arrive at a set of comparable which are closest to the tested parties.
The next step is Accept/Reject analysis.
Database
Industry
Database ADatabase A Database BDatabase B Database CDatabase C
Core Manufacturing
Elimination of companies with insufficient data
40 Companies
Accept Reject
Analysis
Analysis of annual reports, information available on database / website and other publicly available information on the internet.
Manual Selection Process
Data are comparable but on technical assessment, they are not comparable.
The Accept / Reject matrix is prepared in practice to provide the list of all the companies that have passed through the final qualitative filtration process and the manner in which each company was dealt with in this process.
41
Database
Industry
Database A
Core Manufacturing
Elimination of companies with insufficient data
1. Segment Analysis2. Must not engage in significant related party transactions3. Must not own valuable IPRs
1. Data – Non Availability,2. Continuous Loss making,3. Companies not engaged into R&D 4. Sales Filter 5. Government Ownership
QuantitativeCriteria
QualitativeCriteria
Database B Database C
40 Companies
25 Companies
15 Companies
8 Acceptable Companies for Comparison
The Accept/Reject matrix is particularly useful while rejecting companies that are facing extreme economic circumstances.
It has been held by the Indian courts that any conclusion reached for a particular company should be based on an analysis of all the relevant factors and not just on the economic outcome of a company.
The reasons for rejecting the companies should be probed in to adequately documented to justify the exclusions of such company. This has been witnessed in the ITAT Ruling in the case of Quark Systems India Pvt. Ltd.( Supra).
FAR Analysi
s
FAR Analysi
s
Functions performed are the activities that are carried out by each of the parties to thetransaction.
Important and significant functions are considered.
Some of the important functions that are generally observed and examined in a transaction are:◦ Research and Development ;◦ Process engineering and designing work ;◦ Purchasing and materials management ;◦ Manufacturing, production or assembly work ;◦ Warehousing and inventory ;◦ Marketing and distribution ;
One needs to identify the assets ( tangible as well as intangible) used in the course of international as well as Domestic transaction.
Identification of the type of capital assets used, as well as the capital assets left idle and the nature of assets used, such as the age, market value, location etc.
Assessment of risk is important aspect of the FAR Analysis process
Identification of various risks that are assumed by
each of the parties to the transaction.
More risk, More Returns are expected.
Different Risk undertaken by the companies
Typical transaction where CUP can be adopted are:◦ Transfer of goods◦ Provision of Services◦ Intangibles◦ Loans. Provision of finance
Examples : ◦ Royalty payment◦ Transaction dependent on publicly available market
quotation (e.g.: gold whose prices are available at the commodity exchange) etc
RPM can be adopted when transactions are of distribution of Finished products or other goods involving no or Little value addition.
Illustration:
Sells Sells
@ Rs 10 @ Rs 12Foreign co. Indian Co Indian Co
(AE) (Tested Party) (Unrelated Party)
Fire US LtdFire US Ltd Fire India LtdFire India Ltd Water India Ltd
Water India Ltd
RPM Applicable?
RPM Applicable? YESYES
Typical Transaction when CPM can be adopted
◦ Provision of services◦ Joint facility arrangements◦ Transfer of semi finished goods◦ Long term buying & selling arrangements
Typical transactions where PSM can be adopted◦ transfer of unique intangibles◦ multiple inter-related international transactions which
cannot be evaluated separately.
However PSM is not widely used in practice since it is difficult to apply.
TNMM is generally considered as a method of last resort and is applied when it is not possible to apply any other method to determine ALP.
Benchmarking Analysis
Benchmark means to find out the Average mean of companies that are accepted in Accept / Reject matrix.
For e.g. Suppose through Accept / Reject matrix, 8 companies are accepted after
passing Qualitative and Quantitative Filtration Process. Calculation of their Average mean is as follows:
Transfer Pricing regulations provides for computation of the notified controlled transactions to be at arm’s length price (ALP).
ALP shall mean that the price charged for a transaction between AE’s shall be the same that would be charged had the transaction been between two unrelated parties.
Six methods have been prescribed by the Act for the determination of ALP.
The transaction is then benchmarked against the ALP. The process of finding transaction/data comparable to the controlled transaction to determine the ALP of the transaction is referred to as the “Benchmarking ProcessBenchmarking Process”
Revenue Based Analysis:
Average Mean = Total of OPBIT Total of Revenue
Cost Based Analysis :
Average Mean = Total OPBIT Total Operating Cost
This Average Mean should be the Benchmark for the tested party to compare its profitability.
v 100
100
Arm’s Length
Determination
Arm’s Length should be determined by comparing Benchmark vis-à-vis PLI of tested party.
If it falls within the range of 3% +/-, then transactions of Tested Party with its AE are at Arm’s Length.
Thank You