PHARMACEUTICAL INDUSTRY PHARMACEUTICAL INDUSTRY CASE STUDYCASE STUDY

Presentation by Alpana SaksenaCIT(A) International Tax MUMBAI

Facts of the caseFacts of the case

ABC India is engaged in the manufacture and marketing of formulations

Main transactions were

– Payment of Commission to AE Rs Payment of Commission to AE Rs 12.86 crores12.86 crores

– Import of Actives transaction Rs Import of Actives transaction Rs 113.8 crores113.8 crores

Method of Computing Method of Computing ALPALP

Operating Profit Margins of Operating Profit Margins of ABC IndiaABC India

13.8713.87%%

ABC India aggregated all transactions

Applied the TNMM methodUsed a set of external comparables to benchmark profitsOperating Profit Margins of Operating Profit Margins of Comparable companiesComparable companies

7.537.53%%

Commission transaction

CommissioCommission n transaction transaction

Payment of Commission @12.5% of Sales

Marketing & Canvasser services for exports as per agreement

ABC India

ABC AE

Assessee'sAssessee's ContentionContention

•ABC India compares its OPM with the OPM of external comparables•by aggregating all transactions

CommissioCommission n transaction transaction

Taxpayer’s Taxpayer’s ContentionContention

•Which were•Imports of

actives •Commission

•Sundry Reimbursements

•Export of formulations

Comparisons of Operating Profit margins

Operating Profit Margins of Operating Profit Margins of ABC IndiaABC India

13.8713.87% %

So, So, ABC India stated that its transactions

Operating Profit Margins of Operating Profit Margins of Comparable companiesComparable companies

7.537.53%%

are at arms length

Justification for Justification for commissioncommissionpaymentpayment

For establishing close contacts with customers

For employing marketing personnel for marketing these products

For participating in exhibitions, fairs, buyer/seller meets, seminar , conferencesTo promote products through doctor’s

meets, & conferences

Taxpayer's Taxpayer's

contentioncontention

To distribute information material ,leaflets, pattern cards etc.

Copy of Agreement called “Export Canvasser agreement”Some advertisements of

overseas AEs Letters from overseas AEs to

assesseeCA Certificate / Bank Realization Certificates

To support To support paymentspayments

Documents Documents producedproduced

Documentation RulesDocumentation RulesPrescribed by rule 10D of the I.T. Rules

Lays down 13 different types of information which should be

maintained

Enterprise –wise documentsTransaction specific documents Computation related documents

They are (broadly speaking)

Documentation RulesDocumentation RulesThe Rule 10D(3) states that information in sub-rule (1) shall be supported by

f) letters & other correspondence relating to terms of contract(g) documents required to be kept under the accounting practices followed.

authentic documents which include

Documents which should Documents which should have been producedhave been produced

Reports of contacts with customers

List of marketing personnel hired for the purpose Details of participation in

exhibitions, fairs, buyer/seller meets, conferences,seminarsList of doctors approached for using

product Copies of information material ,leaflets, pattern cards distributed

As no such documents were As no such documents were producedproduced

Commission payment was not Commission payment was not authenticatedauthenticated

In the opinion of revenueIn the opinion of revenue

Objected to aggregation of all transactions for benchmarking them

Insisted forcommission was not closely linked

to other transactions if imports, reimbursementsNo justification given for rate of 12 %

paid

Revenue's Revenue's ContentionContention

Separate set of required for benchmarking

Commission Commission PaymentPayment

similar independent comparables

separate evaluation of commission

Similar comparables Similar comparables would mean would mean

Who had paid commission or Who had paid commission or any any other expenseother expense to any foreign party to any foreign party

All such casesAll such cases

To promote their salesTo promote their sales

So we needed to look at So we needed to look at foreign expensesforeign expenses be it be it

•marketinmarketingg

•AdvertiseAdvertisementment•Sales Sales

promotionpromotionAs a percentage of salesAs a percentage of sales

•Commission

Which meansWhich means

Foreign expense to Foreign expense to sales ratiosales ratio

We needed to look We needed to look at the at the

'Result' based Export Canvasser Agreement not 'effort' based

Results showed 15% increase in sales as compared to previous year

Taxpayer’s counter Taxpayer’s counter pleaplea

Commission Commission transactiontransaction

Hence, transaction is at Arms Length

Taxpayer took another Taxpayer took another pleaplea

Domestic salesDomestic Selling expenses ratio Export salesForeign Selling expenses (Commission) ratio

480 Crores

16.14%

103.08 Crores

12%

Assessee pleaded that………

costs in India would be lower than the costs of promoting products in an overseas marketAs the export selling expenses of 12% were less than the domestic selling expenses of 16.14%So the commission payment to AE was at arms length

So dept asked assessee So dept asked assessee to do the analysis firstto do the analysis first

ABC India carried out an analysis of computing the ‘Foreign exchange expense’ to ‘Sales’ ratio

for the pharma companies (comparable in size to ABC India).

Sl Sl NoNo

CompaCompanyny

Total forex Total forex outflow (in outflow (in crores)crores)

Total Total export export salessales

Forex Forex outflow as outflow as % of % of export export salessales

11 A CoA Co 3.18 3.18 66.78 66.78 5522 B CoB Co 2.792.79 5.42 5.42 5151

33 C CoC Co 2.002.00 22.33 22.33 99

44 D CoD Co 0.480.48 1.58 1.58 33

55 E CoE Co 7.727.72 13.03 13.03 59%59%

Average forex outflow Average forex outflow on saleson sales

25.40%25.40%

Analysis given by assesseeAnalysis given by assessee

Defects in assessee’s Defects in assessee’s analysisanalysis

huge variations in the outflow Some companies have a outflow as high as 59% and some as low as 3%. Extraordinary reasons would exist for such heavy outflows…not explained by assessee

Most of the companies had paid Royalty for brand…hence not comparable

Department rejects Department rejects assessee’s contentionsassessee’s contentions

Dept carried out analysis on the same set of comparables originally used for TNMM analysis by the taxpayer, for benchmarking its profitsinstead of the new 5 companies selected by ABC India

Basic criteria for Basic criteria for selectionselection

Only those independent companies were short listed who

Matched the Export sales to Gross sales ratio

The taxpayer had a ratio 25% of export sales / Gross sales

Analysis of forex outflow / Analysis of forex outflow / export sales of Independent export sales of Independent

comparablescomparablesCompany

NameExport sales /

Gross sales ratio

Forex expense /

Export Sales ratio

F Co 27.28% 2%G Co 27.20% 2%H Co 16.88% 6.8%I Co 13.73% 2%J Co 10.35% 13%K Co 19.70% 4%

Average 4.96%

F.Y. 2002-03 - 5 % allowed (claimed 12.5%)

F.Y. 2003-04 - 7 % allowed (claimed 12.5%)

Adjustment was made to the ALP by taking rate of 5% instead of 12% as claimed by assessee

Commission transaction evaluated separatelyFinal Outcome:

Thank youThank you