Manufacturing sector in India
• Contribution of manufacturing sector in GDP is 15-17%
• Key products manufactured in India - Adhesive and films, tobacco products, chemicals, electronic, explosives, machineries and tools, plastic products, leather products, household, food, etc.
• ‘Make in India’ initiative taken by government of India to:
facilitate investment
foster innovation
enhance skill development
protect intellectual property
build best in class manufacturing infrastructure
turning labour intensive manufacturing industry to capital intensive
Slide 2
Transfer Pricing Jigsaw
FAR analysis Selecting the tested party
Comparability
Analysis
Transfer
Pricing
Methods
Industry
Overview
Slide 4
Typical manufacturing models
Parameters Full Fledge
Manufacturer Licensed
Manufacturer Contract
Manufacturer
Toll Manufacturer
Produces on Own behalf Own behalf Principal Principal
Intellectual Property Owns the IP Licenses the IP Does not own Does not own
Materials Owns Owns Owns Does not own
Raw materials
Principal
Contract manufacturer
Production Schedule
Finished Goods
Production Schedule
Principal
Toll manufacturer
Raw materials
Finished Goods
Physical Flow
Legal Ownership
Information Flow
Slide 7
Functions, Assets and Risk Analysis
FAR Manufacturer
Full fledge License Contract Toll
FUNCTIONS
Owns non-routine technology i.e. IP
(Research & Development) Y N N N
Owns Material Y Y Y N
Manufactures for himself Y Y
Manufactures on behalf of others Y Y
Marketing Y Y N N
Sales & Distribution Y Y N N
RISKS Normal Less than
normal Limited Minimal
Market Risk Y Y N (Minimal) N (Minimal)
Price Risk Y Y N N
Inventory Risk Y Y Y N
Capacity Risk Y Y Limited N
Product Liability Risk Y Y N N
Warranty Risk Y Y Limited to re-work
Technology R&D Risk Y N N N
Slide 8
Compensation Structure – Manufacturing Models
Functions Typical Compensation model
Contract / Toll manufacturing operations
Full cost plus mark up (or)
Return for value added services plus appropriate return on capital investments in material and finished goods inventory
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
Slide 9
Typical TP issues for Indian manufacturers
Slide 11
Payment of know-how royalty vs brand royalty (in
loss scenarios) Marketing intangibles
Comparability analysis for contract manufacturers
Risk adjustments – depreciation, capacity
utilisation, working capital and risk adjustments for
captive entities
Local vs export profits
Manufacture (Use of CUP over TNMM –
considerations for quality, shelf life etc.)
Hybrid models – segmental accounts and profitability
Location savings
Conversion of overseas contract manufacturers to toll manufacturers (Exit
charge and business restructuring implications)
1. Payment of know-how royalty vs brand royalty (in loss scenarios)
Slide 13
IP Owner
India
ICO
Issues instrument • Licensed
manufacturing
• Distribution
• ICo is the Entrepreneur for the local market
• AE imports & exports, royalty payments and management fee could be challenged
• Losses would be borne by Indian company unless losses are a result of incorrect transfer price
1. Payment of know-how royalty vs brand royalty (in loss scenarios)
Slide 14
• Payment of royalty can be challenged aggressively in case of loss making companies
• Business and Commercial reasons for loss (capacity underutilization, start up / market penetration, competition / pricing pressures etc.)
• Company to substantiate benefits received –comprehensive documentation demonstrating business & commercial rationale
• Assess the royalty on the touchstone of third party scenario (risk and reward analysis)
• Projections, budgets / forecasts indicating profit potential
• Group Policy
2. Comparability analysis
Adjustment for differences in risks between comparables and tested party necessary to be included in the TP Study Report
Approach Full
Fledged Licensed Contract Toll
Comparable Set Manufacturing Set Services Set
Parameters for selection of comparable companies
Broad product comparability Keywords such as contract, custom, job work, processing, as per specifications / requirements, on behalf of
Absence of distribution facilities, sales personnel, marketing of products
No raw material content, only consumables (Notes to Accounts is key)
Ratios to be analysed Manuf. / Sales Manuf. / Sales R&D / Sales
R&D / Sales, Adv & Marketing / Sales, Royalty expense
RM / TC
Slide 16
3. Adjustment for Capacity Utilisation
• To account for differences in capacity utilization (fixed costs) between the tested party and the uncontrolled comparable transaction
• The low profitability of tested party may not always be attributable to pricing of international transaction
• One needs to consider effects of under-absorption of overheads due to under-utilisation of capacities
Slide 18
Need for adjustment for differences in capacity utilisation
3. Adjustment for Capacity Utilisation
Types of capacity utilization adjustment
• By hypothetically calculating sales/ revenue at optimum utilization level:
- Corresponding increase in variable cost
- Fixed cost assumed to be at same levels
Or
• By reducing fixed cost to the extent not utilized:
- Sales and variable cost remains unchanged
Slide 19
3. Adjustment for Capacity Utilisation
Capacity Utilization Adjustment On Comparable vs Tested party
• In accordance with Indian regulations such adjustment will have to be performed on financial data of comparable companies
- Impossible/Difficult to identify fixed costs of comparable companies
- Difficulty in finding gross margins of comparable companies
• Therefore, adjustment will have to done on tested party (Fiat India Pvt. Ltd.)
- Fixed costs/overheads can be easily identified for tested party
- Gross margin data can be derived for tested party
Slide 20
3. Adjustment for Capacity Utilisation Illustration…
Capacity Utilisation of ComparablesCapacity Utilisation of
Tested Party
Tested Party
40%
Company
XYZ
90%
Company
ABC
50%
Average
70%
Slide 21
Adjustment to Tested Party
Under Utilised Capacity: 100 – 40 % = 60 %
or
70 – 40 % = 30%
+ =
3. Adjustment for Capacity Utilisation Illustration…
Slide 22
1Underutilised capacity = 40/70*100=57% (approx)
Particulars Actual Data
Variable Cost Fixed Cost Adjusted
Fixed Cost
Adjusted Financial
Data
A B C = B x 57%1 D = A + C
Sales 1000 1000
Operating Expenses
Material 600 600 - - 600.00
Salary 100 25 75 42.75 67.75
Depreciation 200 - 200 114.00 114.00
Other Expenses 100 50 50 28.50 78.50
Total Cost 1000 860.25
Operating Profit 0 139.75
OP / Sales 0% 13.98%
3. Adjustment for Capacity Utilisation
• Document basis and method of calculation of underutilized capacity
- business reason for under utilization of capacity
- rationale for setting up excess capacity
- business plans, capacity utilisation data and profitability for future years
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3. Adjustment for Capacity Utilisation
Fiat India • Assessee was under utilized due to low sales/production volume
• Made several adjustments on account of depreciation and other fixed overhead
• Tribunal ruled in favor stating that the Assessee had sufficiently explained and demonstrated (with relevant facts/figures/supporting evidence) that there were material differences
Brintons Carpets Asia Pvt. Ltd.
• Adjustment on account of labour unrest carried out • Tribunal ruled in favor by allowing economic adjustment
which was restricted to fixed cost/ overhead • Ruling supported adjustment to tested party
Slide 24
Legal Precedence
4. Location Savings
• Location savings is generally defined as the net cost savings realized by a party in a high cost location through outsourcing a certain activity to a low cost location
• In addition, Location specific benefits/advantages such as proximity to local market, regulations also increase profitability
• Net Location savings + Location specific benefits = Location specific advantages (LSAs)
• Location rent is the incremental profit derived from the exploitation of the LSAs
Slide 26
GAP Ruling
• Generally, the advantage of location savings is passed on to the end customer via a competitive sales strategy
• The arm’s length principle requires benchmarking to be done with comparables in the jurisdiction of the tested party and the location savings, if any would be reflected in the profitability earned by comparables.
• No separate/additional allocation is called for location savings
4. Location Savings
Slide 27
Watson Pharma Ruling
• The taxpayer as well as AEs operated in a perfectly competitive market, and the taxpayer did not have exclusive / unique access to factors leading to location-specific advantages and therefore there was no super profit arising
• Where local market comparables were available and used, specific adjustment for location savings was not required. Any benefit/ advantage to the AE was irrelevant if the profit level indicator of the taxpayer was within the range of comparables.
• The India chapter of the United Nations Transfer Pricing Manual (which, among other issues, also discusses location savings) represented a view of the Indian tax
administration and was not binding on appellate authorities.
5. Marketing Intangibles
• Advertising and promotional activities - Focus area of TP authorities in India
• Promotional spends considered a service to the parent
• Possible adjustment scenarios:
Slide 29
Prices of imported goods Imputed as cost reimbursement
Disallowance of excessive
marketing spend
Disallowance / reduction of
brand royalty paid
5. Marketing Intangibles
• In relation to the AMP issue faced by manufacturing entities, the Delhi high court in case of Maruti Suzuki has seen the concerned issue in new light:
- Once the ‘Bright line test’ had been negated, there was no basis on which it could be said that there was an international transaction;
- It is essential to show the existence of an ‘agreement’, an ‘understanding’, an ‘agreement’ or ‘action’ in concert between the Indian company and the AE as regards to AMP spend for brand promotion; and
- Any incidental benefit to the AE on account of AMP expenses incurred by the taxpayers should not lead to an automatic interference of a service being rendered by the taxpayer of the AE; and
- The said manufacture’s ruling is in line with the fundamentals of ‘TP international guidelines including the OECD TP guidelines’
Slide 30
Key issues
Key Clauses in a contract / toll manufacturing scenario
• Compensation clause
- True up / true down
• Minimum commitment
• Idle capacity costs
• Product liability risk
• Early termination
setting up of asset with no alternative use
asset capable of alternative use
• Termination after initial period
• Inventory on termination
• Right to subcontract
Slide 32
Indian Pharma – Big picture
• Highly regulated – from innovation till sale
• Trend towards new drug discovery
- In-house research (Generic as well as branded)
- Collaboration
• Overseas acquisitions
• Hub for Pharma Manufacturing (‘CRAMS’)
- Low cost
- Easier process
- Infrastructure – Good Manufacturing Practice
• FDI in pharma – Greenfield / Brownfield
Slide 35
• Licensed manufacturer vs. value added distributor
• Import of APIs vs. local procurement
Inbound models
Slide 36
Sale of formulations
Principal Co API Manufacturer (Legal owner of IP)
Indian Sub Co
(Secondary Manufacturer)
Imports of
original
APIs
Indian Customer
India
Outside India
Distribution
Principal Co (Legal owner of IP)
Distributor
Imports of
branded
finished goods
Indian Customer
India
Outside India
• Routine vs. super distributor
• Return for local value addition
• Basket of product approach - product launch/ start-up issue
• Product wise profitability analysis
• Various Distribution models – Consistency TP models
• Bill to Ship to model using Marketing Companies
Outbound models
Sale of formulations Distributor / MSS
IP Owner – Manufacturer
Exports of
original
APIs
Foreign Customer
India
Outside India
Legal owner of IP & Distribution
Contract Manufacturing /
Contract Research Companies
(Flag ship Group Co)
Cost plus
markup India
Outside India
• Low-Risk / Low Return models for Indian Flag ship companies scrutinized by tax authorities
• FA related challenges
Sale of formulations Foreign
Customer
Slide 50
Principal Co API Manufacturer (Legal owner of IP)
Indian Sub Co (Secondary
Manufacturer)
Imports of
original APIs
Indian Customer
Sale of formulations
Issue: • Comparison of import price of
branded APIs with price of generic APIs (Serdia Ruling)
• Customs database (TIPS)
India
Outside India
Slide 38
Import of API
Import of API - Key points
• Adjustments in view of quality, purity etc. and their quantification
• Relevance of SVB Order
Serdia Fulford
CUP most appropriate method for import of API transaction
Before applying CUP it is important to understand characterization of the entity importing API
Comparison of import price of off-patented API with generic API
Comparison with generic API not sustained, product accompanied with IP rights will fetch premium price
Is CUP the right method
after ruling in case of
Fulford India Limited
Slide 39
Issue: • Product-wise profitability analysis • New product launches (initial
losses)
ABC Inc. (Legal owner of IP)
DEF (Distributor)
Imports of branded
finished goods
Indian Customer Distribution to customers
India
Outside India
Slide 40
Import of Finished Goods
Import of Finished Goods – Key points
• Routine v/s marketer distributor
• Low operating margins – product launch/ start-up issue
• Harmonization with Custom positions
• Value addition at India: Reward
• Aggregation
• Basket of products
Slide 41
Exports to AEs
India
Outside India
Export of goods for
resale
Issue: • Comparison of sales to AEs
with third party (domestic/ export) sales
• Tested Party selection
Third Party Sale of
goods
ABC India
XYZ Inc. JKL GmbH
Slide 42
Exports to AEs – Key Points
• Generally non-comparable transactions – functional, risk and market differences
• Robust FAR analysis and characterizing operations of AEs
• Evaluate whether AEs can be selected as tested party
Slide 43
Contract Manufacturing
Slide 44
India
DEF (Contract
Manufacturing
ABC
Sale of goods
Outside India
Issue: • High markup expected for Contract
Manufacturing activity (location savings)
• Difficulty in identifying appropriate comparable companies
Key points: • Agreement • Prior purchase orders / Volume
Commitment • Operating cost definition, ROA • Capacity Utilisation • Early termination • Comparables
Issue: • High markup expected for R&D
activity (location savings) • Difficulty in identifying appropriate
comparable companies
Key points: • R&D risk • IP Ownership • Comparables • Circular 6 of CBDT / Action Plan 8-
10 of BEPS • Safe Harbor margin - 29%
Slide 45
India
DEF (Contract Research)
ABC
R&D Service
Outside India
Contract Research Services
ABC India Indian CRO/
Hospitals
Facilitation
Issue: • Treatment of third party costs as
pass-through denied • Comparison with full fledged
Contract Research Organizations (CROs) for determination of mark-ups by Revenue authorities
India
Outside India
Clinical trial facilitation
service
Slide 46
ABC Inc.
Clinical Trials Facilitation Services
Clinical Trials Facilitation Services – Key points
• Key points:
- Agreement
- Comparables
- Support services v/s clinical trials
- Robust FAR
Slide 47