transfer pricing in m&e for nadt 30.07.2009

Presented By, Romesh S A Sankhe

Transfer Pricing in Media & Entertainment IndustryPresentation in ‘National Academy of Direct Taxes (NADT)’ on July 30, 2009

Transfer pricing in Media & Entertainment IndustryJuly 30, 2009 For Presentation in NADT

► Importance of the M&E Sector in India and key happenings

► Key transfer pricing issues in M&E

► Recent important judicial decisions of transfer pricing in India

► Recent global developments & emerging concepts

► Key takeaways

ROAD MAP


Importance of M&E sector in India and key happenings


M&E Sector - Key Segments

► The Indian Media and Entertainment (M&E) Industry can be categorized as follows;� Television

� Print (Primarily Newspaper and Magazines)

� Filmed Entertainment (Movies)

� Radio

� Music

� Animation

� Gaming

� Outdoor Advertisement such as Concerts etc


Sector Performance in IndiaRs. BillionChange %

2005 2006 2007 2008 CAGR(05-08)

Television 163.3 182.5

12%

211.3

16%

240.5

14% 14%

Print Media 117.1 138.6

18%

160.4

16%

172.6

8% 14%

Filmed

Entertainment

66.9 81.7

22%

96.4

28%

109.3

13% 18%

Radio 4.9 6.0

22%

7.4

23%

8.4

14% 20%

Music 8.3 7.8

-6%

7.4

-5%

7.3

-1% -4%

Animation , Gaming & VFX, Out-of-home advertising & Online Advertising

24.5 28.4

16%

37.1

31%

45.9

24%

19%

Total M & E Industry 385.0 445.016%

520.017%

584.012% 15%

Source :- FICCI FRAMES 2009 by FICCI-KPMG


Recent Key Changes► Indian M & E Industry has grown at a rate of 12.4% p.a. during 2008

with an size of Rs.584 billion, over the next five years the industry is projected to grow at CAGR of 12.5% p.a. to reach the size of Rs.1052 billion by 2013;► The segments with highest rates of growth were online advertising, out-of-home

advertising and the radio industry► followed by Animation, Gaming & VFX, and Television Industry

► In 2008, number of M&E deals grown from 59(2007) to 85, valued at USD 1.7 billion. The inflows in the form of investments are; ► Disney’s acquisition of 15% stake in UTV Global broadcasting► NBC universal’s acquisition of 26% stake in NDTV Network Plc► Morgan Stanley and India Infrastructure Holding Fund’s USD 60 mn in Hathway

Cable and Datacom ► DE Shaw’s acquisition of additional stake in Amar Ujala► Goldeman Sachs & Lehman brother’s investment of USD 50 mn in out-of-home

(OOH) advertising subsidiary ENIL► Warbugr Pincus’s USD 75 mn investment in Laqshya Media


Recent Key Changes

► Indian Film Industry declared as ‘Industry’ in 2000 under IDBI Act

► Corportisation of the Film Industry lead to more organized & transparent business model

► Liberalized FDI norms► 100% in Film, Advertisement, non-news broadcast & magazines, ► 49% in cable► 26% in news, print etc

► Availability of finance from banks compare to old source of financing from private lenders,

► Indo-foreign collaborations for Media, film ventures, etc such TOI-Reuters, IBN-CNN, TV18-CNBC, ADAG-Spielberg, YRF-Walt Disney, Sippy-Warner Bros, etc

► Foreign countries such as Switzerland, UK, Germany, Italy, Brazil entered into co-production bilateral agreements with India offering incentive to the Indian Media Companies


Key Transfer Pricing Issues in M&E


Key Transfer Pricing Issues

► Certain key cross border transactions in the Indian M&E sector are as under :� Overseas Film Distribution

� Payment of Royalty

� Setting up of subsidiary for business support, marketing etc.

� Availing services of professionals employed by the overseas company

� Financing of the subsidiary company

� Reimbursement of expenses

� Use of loss making comparables in the benchmarking study

Some of the above issues are discussed herewith through case

studies


Film Distribution – a case study

► Facts of the caseABC Ltd who acquired the overseas rights of a Hindi Film, distributes it through its subsidiaries in USA, UK & South Africa and through third party agents in rest of the world. The terms of the arrangement with various entities are as follows;

Country Terms of Film Distribution Terms regarding th e reimbursement of advt. and

other related expenses

USA No Minimum Guarantee & 10% Commission on net revenues1 On actual without any markup

UK No Minimum Guarantee & 10% Commission on net revenues1 On actual without any markup

South Africa No Minimum Guarantee & 10% Commission on net revenues1 On actual without any markup

UAE No Minimum Guarantee & 5% Commission on Grossrevenues

On actual without any markup

Nepal No Minimum Guarantee & 15% Commission on net revenues1 On actual without any markup

Malaysia Certain Minimum Guarantee & 30% Commission On actual without any markup

Germany No Minimum Guarantee & 5% Commission on net revenues1 On actual without any markup

Russia No Minimum Guarantee & 5% Commission on net revenues1 On actual without any markup

France Outright Purchase Not Applicable

Canada Outright Purchase Not Applicable

Australia Outright Purchase Not Applicable1. Net revenues = Gross revenue – exhibitors share – taxes – cost of print



► Step 1 – Business Study & FAR► Understanding of business model

► Outright sale – Business risk fully born by licensee► Minimum guarantee (MG) basis – Business risk depends upon MG &

commission ratio ► Pure commission basis – Business risk fully born by licensor

Vital considerations- MG & commission may vary from film to film such as YRF, KJ, SRK, AK may fetch a higher MG-Higher the MG , higher the risk hence higher commission share of licensee from the balance trade proceeds -Each business model is distinctively different from each other hence may not be compared with each other



► Step 2 – Selection of Method► CUP method could be ‘Most Appropriate Method’ (MAM) over the

other methods because;► Comparable Uncontrolled Price – Required degree of comparability is higher

and availability of existing CUP► Cost Plus – No uniform formula to compute gross margins in India, hence

could not be relied upon ► Resale Price – Generally used in distribution of manufacturing good hence

may not be MAM► Profit Spilt – Only used in complex, interdependent & interlinked transactions,

hence may not be MAM► Transaction Net Margin – Segmental data may not be available due to

upcoming segment, also termed as residual method

Vital considerations-Generally CUP is preferred as MAM, due to high level of comparability-First preference should be given to Internal cups, as degree of comparability could be measured appropriately



► Step 3 – Selection of Comparables► Internal CUP should be preferred

► Analysis of terms with the third parties through whom distribution was done in the same region prior to opening of an subsidiary i.e. US, UK & South Africa in the instant case

► If above not available, then analysis of existing third party comparables on the following grounds;► Comparable business model & terms

► Comparable geographic, local business environment such as NRI & PIO population in the instant case

► External CUP may not be used, due to lack of availability of detailed information due to which conclusive comparative analysis could not be undertaken

Vital considerationsHigher the level of comparability, higher the accuracy of

benchmarking study



Country Population of NRI & PIO’s ‘Accept / Reject an alysis’ with reasons thereon

USA 3,000,000 N.A.

UK 1,600,000 N.A.

South Africa 1,160,000 N.A.

UAE 1,400,000 Accepted , because of comparable business model due tosimilar geographical conditions

Nepal 4,000,000 Accepted , because of comparable business model due tosimilar geographical conditions

Malaysia Certain Minimum Guarantee &30% Commission

Rejected , because of different business model

Germany 80,000 Rejected , because of different geographical conditions

Russia 16,000 Rejected , because of different geographical conditions

France Outright Purchase Rejected , because of different business model

Canada Outright Purchase Rejected , because of different business model

Australia Outright Purchase Rejected , because of different business model

► Step 3 – Selection of Comparables► Accept / Reject Matrix

Facts



► Step 4 – Analysis of Comparables► Comparison on identical grounds

Particulars AssociatedEnterprises

Third Party inUAE

Third Party in Nepal

Terms of Arrangement 10% on net revenues

5% on Gross revenues

15% on net revenues

Gross Collections of the movies (net of taxes) 100 100 100

Less: Theatre Share on the above 45 45 45

Less: Cost of prints 10 10 10

Net Collection from Film distribution 45 45 45

Less: Share of trade proceeds to on netcollections

4.5 N. A. 6.75

Less: Share of trade proceeds to on GrossCollections

N. A 5 N. A

Net Collection received by ABC, India 40.5 40 38.25

Percentage share of trade profits given toOverseas Exhibitor

10% 11.11% 15%

Arithmetic mean is (15+11.11)/2 = 13.05%, hence the existing transaction is comparable in the Indian context.


Royalty – An analysis

► Problems faced in benchmarking analysis► Maintenance of documentation of ‘benefits received’ from use of

intangible such as trademark, brand name, patent, designs, marketing intangibles etc.

► Difficult to demonstrate the economic value of the intangible, however sometimes a report of an independent valuer could be considered

► Application of TNMM and exchange control approvals are not widely accepted by authorities in India

► Internal CUPs are only available, that to in rare cases

► Due to secrecy norms & sensitive business information, external CUPs are not available in public domain in India► In foreign countries , the public databases are used for comparable search

such as; Asia-pacific franchise directory, International Franchise Association (IFA)’s franchise opportunities directory, Franchise-Euro edition, RoyaltyStat compiled from US SEC archieve, RoyaltySource based on media reports etc.



► Indian Regulatory Scenario for Royalty payment► In the past, reference for comparable royalty rates used to be made to the

website (www.siadipp.nic.in) of the Secretariat of Industrial Assistance (SIA) constituted under the Ministry of Industry and Commerce of the Government of India

► Through this website, SIA used to publish information on a monthly basis on royalty rates approved by the Government, in various technical collaboration proposals put forth by the industry for the Government's approval

► However, SIA has discontinued publishing data relating to approved royalty rates from September 2004

► Currently prescribed ‘automatic approval route’ for Royalty payment by Department of Industrial Policy & Promotion (DIPP) is as under;► Use of trademark - 1% on domestic sales & 2% on exports► Use of trademark along with technology transfer - 5% on domestic sales & 8%

on exports or lump sum payment up to USD 2 million► However, there exists an ambiguity on availability of automatic approval route to

service industry► However, recently it is proposed to allow all payments for trademark,

know-how, technology transfer under the ‘automatic route’ without any restrictions of DIPP



► Suggested way forward► Detailed documentation of ‘benefit received’ along with various business &

commercial justifications for the payment► Internal CUP’s & its consistency should be carefully analyzed► ‘Holistic approach’ needs to be adopted such as consideration of;

► Tenure of the agreement► Various benefits available to Indian company which may not be utilized by the

Indian company due to its limited business capabilities► Practice followed by its peers► Prevailing business conditions of the industry segment

► Use of intangibles may not always/every year results into super profits► Regulatory approvals such as DIPP, RBI should be considered especially

approvals obtained other than under automatic route with specific representations before these authorities

Transfer pricing incase of ‘payments for use of intangibles’ needs a special consideration both from revenue

authorities as well as tax payers


Captive Service Provider – a case study

► Facts of the caseWDV Inc a US based company engaged in media & entertainment business has set up a company in India for carrying out its business support function exclusively for its parent, which is remunerated at ‘Cost plus’

► Step 1 – Business Study & FARAssets employed

Type of Assets WDV India WDV USA

Employees Yes Yes

Property, Plant & Equipment Limited Yes

Intangible such as Trade Licenses, KnowHow etc.

No Yes



► Step 1 – Business Study & FARRisk assumed

Type of Risk WDV India WDV USA

Entrepreneurship Risk No Yes

Market Risk No Yes

Manpower Risk Yes Yes

Credit & Collection Risk No Yes

General business risks Limited Yes

Foreign Exchange Risk No Yes

Legal Risk No Yes

Vital considerationsAccordingly, WDV USA should be characterized as the

‘Entrepreneur’ and WDV India as the ‘Limited Risk Bearing enterprise’



► Step 2 – Selection of method► TNMM method could be ‘Most Appropriate Method’ (MAM) over other methods because;

► Comparable Uncontrolled Price – Required degree of comparability is higher and no availability of CUP due to closely held industry► Cost Plus – No uniform formula to compute gross margins in India, hence could not be relied upon ► Resale Price – Generally use in distribution of manufacturing good hence may not be MAM► Profit Spilt – Only used in complex, interdependent & interlinked transactions, hence may not be MAM► Transaction Net Margin – Comparable data is available in the public database, and also termed as residual method



► Step 3 – Selection of comparables► After conducting the search on public database on the basis of various parameters such as turnover, availability of data, related party transactions, elimination of companies with abnormal results. The following are the final comparables;

Sr.No.

Company NameEBIT ofFY 20XX-XX

EBIT ofFY 20XX-XX

Averageof 2 years

1 AL XX% XX% XX%

2 IOL XX% XX% XX%

3 TCL XX% XX% XX%

Average (Arithmetic mean) XX% XX% XX%

Vital considerationsThe prime factors distinguishing WDV from the set of comparables is that it do not undertake following risks;-Marketing functions & risk-Credit Risk



► Step 4 – Analysis of comparables► Hence appropriate ‘discounting’ has to be done to the arithmetic mean in the absence of ‘marketing activity’ function by WDV India.► Till date, only 3 judicial precedents has computed margins attributable to marketing activities, hence same may be used for discounting as under;

Vital considerationsHence, arms length price could be arrived as follows;XX% - (XX*26.67%) = XX%

Sr.No.

Particulars of Judicial decisionMargin attributable marketingActivities by judicial authorities

1 Ahmad Bhai Umar Bhai (SC), 18 ITR 472 35.00%

2 Carborandum Co. Vs CIT (SC), 108 ITR 335 10.00%

3 M/s Rolls Royce Plc, Delhi Tribunal, M.A. Nos.55 to66/Del/2008, ITA Nos.1496 to 1501/Del of 2007

35.00%

Simple Average (Arithmetic mean) 26.67%


Key Indian Judicial decisions


Litigation Update…

► Skoda Auto India – Pune ITAT► Transactions between Associated Enterprises (‘AEs’) cannot be

considered for determining the existence of an internal Comparable Uncontrolled Price (‘CUP’)

► The external CUP is not the correct method when the product is unique

► Assessee cannot be expected to get details and particulars, which are not available in public domain

► Honeywell Automation – Pune ITAT► Only current year data to be used, if the Appellant is not be able to reveal

any facts to bring the case to the proviso to Rule10B(4)

► Gujarat Guardian – Delhi High Court► The judgment tacitly endorses that companies may follow “prudent”

business strategies that may result in current losses if such losses are less than the losses to be incurred had the company gone out of business



► Coca Cola India – Punjab & Haryana High Court► For invoking Transfer Pricing (‘TP’) regulations, there is no requirement to

establish transfer of profits outside India or evasion of tax

► Permission granted by the Reserve Bank of India (‘RBI’) under the Foreign Exchange Regulation Act (‘FERA’) cannot control the provisions of the Income-tax Act, 1961 (‘the Act’)

► UCB India – Mumbai ITAT► CUP method requires a high degree of comparability , even a minor

change in the properties of the products, circumstances of trade (billing period, amount of credit therein, geographical market conditions etc.) may have a significant effect on the price

► Detailed Functions, Assets & Risks (‘FAR’) analysis required for application of CUP method



► Sony India – Delhi ITAT► Loss making companies cannot be excluded from the list of comparables,

as incurrence of loss is a normal part of business. However, incase of consistent losses and other peculiar company specific factors, the company may not be a comparable.

► Not an easy job to evaluate the differences for each of the factors and held that the “Ad-Hoc” adjustment of 20% granted by TPO for these factors was fair and reasonable

► Schefenacker Motherson Ltd – Delhi ITAT► Cash profit on sale or cash profits on total cost excluding depreciation can

be adopted as an appropriate profit level indicator (PLI) under TNMM

► No standard concept existed for ‘operating income’, hence it would depend on facts of each case



► The Karnataka High Court stayed the ITAT decision i ncase of Aztec Software & Philips Software, and admitted the appeal on the following substantial question of law :► Whether the TP regulations cannot be invoked and applied in the case

where the provisions of section 10A of the Act where income is exempt, is availed of by the Appellant?

► Whether the Appellant was justified in using earlier year data in comparability analysis?

► Whether section 92C(2) of the Act provides for a standard deduction of 5% in all TP cases?

► Whether a flat comparability adjustment for working capital and risk can be made ignoring the quality, data, purpose and reliability of adjustment?

► Whether companies with even a single rupee related party transaction should not be selected as comparables?

Post the decisions of Karnataka High Court in the case of Philips Software and Aztec Software, most of the TP issues

are now open for interpretation


Recent global developments & emerging issues


Recent global developments

► AustraliaAustralian Tax Office (ATO) working on draft discussion paper on transfer pricing implications on ‘financing group companies’

► ChinaChina’s State Administration of Taxation (SAT) issued detailed guidelines on transfer pricing covering various issues such as APAs, Cost sharing arrangement, Safe harbor etc

► SingaporeInland Revenue Authority of Singapore (IRAS) issued detailed draft discussion paper on transfer pricing implication on ‘related party loans’ & ‘related party services & cost sharing arrangements’

► United StatesUS Treasury department and Internal Revenue Services (IRS) published regulations on ‘Cost sharing arrangement (CSA)’


Overview and need for an APA

► The comparability of the taxpayer with uncontrolled third parties is subjective and fraught with number of assumptions

► Given the subjectivity or lack of quality data for a perfect analysis the potential risk of double taxation in case of TP adjustment, TP is an area of concern for the taxpayers

► There is a genuine desire amongst for taxpayers to comply with TP provisions of both jurisdictions that are involved in each transaction

► Therefore APAs are desired to achieve certainty in TP valuation and to avoid litigation

► Countries who have introduced concept of APA have made provision for unilateral, bilateral or multilateral APA in domestic law. They have also set up a separate authority to execute APA. Bilateral or Multilateral APA are attended by the Competent Authority under article on mutual agreement procedure in DTAA


Countries with APA … so far

► Mexico► Netherlands► New Zealand► Peru► Poland► Singapore► Spain► Switzerland► Taiwan► Thailand► Turkey► UK► USA► Venezuela

► Australia► Belgium► Canada► China► Colombia► Denmark► France► Germany► Hungary► Ireland► Israel► Italy► Japan► Kazakhstan► Korea


Is APA successful ?

► This can be known from the status of number of APA applications filed and disposed off by the tax authorities. Given below is select country wise summary of status of APA application

Name of country

Introduced since

No of APAs pronounced/ operating

Information available as of

Australia 1995 1314 30.06.2005

Canada 1994 55 From 94’ to 2003

China 1998 180 Until 2007

France 1999 30* 2004

Japan 1987 303 Till year 2004

Korea 2006 5 As per latest information available

Mexico 1995 1300 As per latest information available

United Kingdom 1999 300 Till 2006

USA 1991 692 Till year 2005

* Applications receivedThe details mentioned in the table are gathered from the information available in internet.


APA - Conclusion

► APA definitely a tool to resolve transfer pricing, especially by use of BAPA ► Time period to conclude (normally 2-3 years) does not act as constraint, as

both taxpayer as well as revenue sure of certainty in tax and APA covers several years

► Gives both taxpayer and revenue a perspective / experience on transactions where APA has not been obtained

► Transactions which are complex and difficult can be analysed more carefully during APA process, thereby giving both taxpayer and revenue to showcase their case

► Renewal of APA becomes less time consuming and definitely reduces cost and time

► Taxpayer obtaining APA lives in more certain environment then taxpayers who have not obtained APA (No hefty tax provisioning required)

► Annual Documentation cost can be substantially reduced and TP audit and penalty fear almost becomes negligible

► Lastly reduces double taxation and promotes international business


Is it a time to introduce APA in India ?

► Currently we are in eighth year since introduction of TP in 2001► Information as per newspaper indicates total quantum of adjustment in 3

years of audit - approx US$ 1.5B ► A large number of cases pending at first level of appeal, indicates difficulty to

adjudicate a ruling on TP matters► Only in few cases Tribunal has pronounced its judgment► Even in US, Courts has not been able to pronounce more than 30 cases vs

500 or more APAs► Resolution through APA seems to have more success in countries where

APAs are available – see table in previous slides► India’s case is no different, APAs definitely helps in resolving pricing matters

upfront

Indian revenue authorities as well as the taxpayers are prepared for the APA regime


Key takeaways


Key takeaways

► Certain key points for transfer pricing audits :� Detailed comparability analysis of the data is a must� Peculiarity of business and prevalent business conditions should be

considered� Exceptional situation needs exceptional actions such as recent global

downturn etc.� Emphasis on detailed & in-depth FAR analysis and documentation� Internal CUPs should be preferred over the external CUPs� Cost-benefit analysis needs to be undertaken incase of payment of

management fees, royalty & reimbursement of expenses� Revenue authorities needs to come out with guidelines/safe harbor on

certain key issues such as� Group support services� Reimbursement of expenses� Cost sharing arrangement etc.

� Indian government should introduce APA’s which would result into� Comfort to the non-resident coming into India & taxpayers� Less burden on the assessing officers


Key takeaways

► Certain key points for transfer pricing audits :� Start up losses or initial low margins may be considered for ‘Full fledge

manufacturer’� Multiple year data may be considered as per business cycle� Use of loss making comparables may be allowed in selected cases

Transfer pricing is about understanding the business & its mechanism ….. It’s the way you would have carried on your own business !!!


Q&A


For any further clarifications;Mr. Romesh S A Sankhe, E-mail - [email protected], (Cell) - +91 9892 892504.

Thank You

DisclaimerThe views expressed in this presentation are solely that of the speaker and do not constitute any kind of professional advice. These views or opinion expressed in this presentation should not be directly applied or used without a professional advice as the review of the facts and the existing judicial position is of utmost importance in the transfer pricing analysis.

transfer pricing in m&e for nadt 30.07.2009

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