Transfer Pricing in uncertain times - considerations for year- end book closure - Private and confidential April 2021 - Deloitte
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Transfer Pricing in uncertain times – considerations for year- end book closure Private and confidential April 2021
Is your business affected by the pandemic - impact compared to your peers in industry? (Select one of the options flashing on the right panel to respond) © 2021 Deloitte Touche Tohmatsu India LLP Transfer Pricing in uncertain times – considerations for year-end book closure 2
Impact of COVID-19 on Transfer Pricing Policies – considerations for book closure
Do Transfer Pricing Policies require a RESET due to supply chain disruptions?
Can limited risk
In Medium to Long term: Intercompany pricing policies would need a reset:
arrangements incur
• to capture change in supply chain due to COVID-19 losses?
• to capture the growing role of digital economy in global value chains
• to plan for a global tax reset - OECD’s pillar one and pillar two proposals
In Short Run: the situation will be more challenging: How can I align my
• as companies need to contemporaneously evaluate how, and to what extent, they have risks?
been impacted by the pandemic
• information to be collated on fixed costs, sales volumes, incremental or exceptional costs,
trends, budget Vs. actual data, change in contractual arrangements, if any, relocation of
control functions viz people movement, etc. Can I reallocate my
pandemic related
exceptional costs?
© 2021 Deloitte Touche Tohmatsu India LLP Transfer Pricing in uncertain times – considerations for year-end book closure 3Summary of OECD Guidance In general, OECD in its COVID-19 guidelines has Four areas of focus: • Comparability analysis • Losses and the allocation of COVID-19 specific costs • Government assistance programs • APAs Traditionally, historical data of comparable companies is used to benchmark company’s remuneration earned from related party(s); The unprecedented change in the economic environment restricts the use of historical data to benchmark the current economic activity How should companies navigate this? © 2021 Deloitte Touche Tohmatsu India LLP Transfer Pricing in uncertain times – considerations for year-end book closure 4
Have you changed your intercompany pricing policies due to impact of the pandemic? (Select one of the options flashing on the right panel to respond) © 2021 Deloitte Touche Tohmatsu India LLP Transfer Pricing in uncertain times – considerations for year-end book closure 5
Ex-ante COVID-19 Impact analysis
Indian economy and its What you can do Why ex-ante analysis is Where can it be applied?
relation to transfer pricing Apply a multi-dimensional required? For general TP setting in the
As the Indian economy analysis to determine, ex ante, Financial results of light of COVID-19 and to
suffers the first ever growth the arm’s length range under comparable companies with defend tested party results
decline, different businesses TNMM using: a time-lag cannot be during compliance and
are likely to be impacted Regression analysis to compared with the tested controversy
differently in the short-term estimate profitability of the party’s present financials due For supporting expected
and long-term comparable companies in line to significant deviations year-end results for statutory
The impact will also depend with macroeconomic Given the scale of the auditors and tax authorities
on the extent of integration outcomes which drive the pandemic, ex-post results During Advance Pricing
with the global demand and market. cannot be reasonably Agreement negotiations to
supply factors Quarterly performance of ascertained by continuing build in appropriate future
listed companies in similar with the traditional approach benchmark results
sector/industry. of multiple year average
Specific adjustments to
revenue/costs of tested party-
but for Covid-19 analysis
© 2021 Deloitte Touche Tohmatsu India LLP Transfer Pricing in uncertain times – considerations for year-end book closure 6Predictive analysis
Deloitte has undertaken a study which examines:
• Impact of macroeconomic indicators on Profit Level Indicators of previously accepted comparable datasets
• If an econometric relationship is established, it would indicate how PLIs are expected to be affected in the future on account of
economic growth cycles
Relationship
• GDP growth was considered as it provides an overall snapshot of the state of the economy between PLI
• Scope of study entailed a period ranging from 2007 through 2019 and GDP
growth rate
• Objective is to help understand how the PLI of comparable companies reacted to the GDP growth
fluctuations
© 2021 Deloitte Touche Tohmatsu India LLP Transfer Pricing in uncertain times – considerations for year-end book closure 7Predictive analysis
How will it help
The arm’s length results will vary as the forecasts for Indian GDP growth rate vary
Insights from the analysis How will the analysis be useful
• Arm’s length profitability based • Comparability needs to factor in economic conditions that
on TNMM benchmarks derived result in lower levels of profitability for its entities
from independent comparable • As the financial results of comparable companies for 2020
company sets may not be available until later in 2021, this analysis
Arm’s length range
• Existing transfer pricing theory supports realised profitability based on ex ante approach
allow for amendments to • Can be included as an ex-ante analysis in the TP
transfer pricing policies in documentation for 2020-21, further supported, if available
response to economic Revised range of comparable by actual results of the comparable companies ex-post
circumstances companies would be computed
• Helps to substantiate lower profits/ losses, if any, with
based on the predicted movement of
financial auditors and tax authorities
the PLI for each of the finally
accepted comparable company • May be used for controversy management including both
litigation and APAs
© 2021 Deloitte Touche Tohmatsu India LLP Transfer Pricing in uncertain times – considerations for year-end book closure 8Predictive analysis
Showing predictive results (OM) on an Indian Manufacturing Showing predictive results (OM) on an Indian Trading
comparable set # # comparable set#
8.0%
6.0%
6.0% 5.0%
4.0% 4.0%
3.0%
2.0%
2.0%
0.0%
1.0%
-2.0%
0.0%
-4.0% -1.0%
Lower 35th Mean Median 65th Upper Lower 35th Mean Median 65th Upper
Quartile Percentile Percentile Quartile Quartile Percentile Percentile Quartile
FY2018 FY2019P FY2019A FY2020P FY2021P FY2018 FY2019P FY2019A FY2020P FY2021P
© 2021 Deloitte Touche Tohmatsu India LLP Transfer Pricing in uncertain times – considerations for year-end book closure 9Analysis based on quarterly trends
This analysis enables comparison across a variety of financial parameters for listed companies- Comparing pre-Covid-19
trajectory with Covid-19 impacted path
QoQ trends in aggregate revenue and OP for consumer automotive companies (listed)
40.00%
20.00%
0.00%
Q1 2017- Q2 2017- Q3 2017- Q4 2017- Q1 2018 - Q2 2018 - Q3 2018 - Q4 2018 - Q1 2019 - Q2 2019 - Q3 2019 - Q4 2019 - Q1 2020 - Q2 2020 - Q3 2020 -
Q1 2018 Q2 2018 Q3 2018 Q4 2018 Q1 2019 Q2 2019 Q3 2019 Q4 2019 Q1 2020 Q2 2020 Q3 2020 Q4 2020 Q1 2021 Q2 2021 Q3 2021
% change
-20.00%
-40.00%
-60.00%
-80.00%
Revenue QoQ from 2017Q1 to 2021Q1
© 2021 Deloitte Touche Tohmatsu India LLP Transfer Pricing in uncertain times – considerations for year-end book closure 10But for Covid analysis Covid-19 impact analysis based on tested party data: • Identifying Covid-19-specific costs - extraordinary costs • Adjustments on the basis of variance in costs/revenues , Covid-19 and pre-Covid-19, for the tested party • Whether to include persistent loss making companies to approximate the pandemic scenario • Whether to consider using multiple year data for the tested party © 2021 Deloitte Touche Tohmatsu India LLP Transfer Pricing in uncertain times – considerations for year-end book closure 11
Comparability adjustment
Degree of operating leverage (DOL): Particulars Company A Company B
• Income-tax Act, 1961 allows taxpayers to carry out reasonable Revenue (R) 1,000 1,000
adjustments to comparables to arrive at the appropriate arm’s Variable Costs (VC) 300 500
length range
Fixed Costs (FC) 500 300
• Operating leverage is an indicator of risk that a company bears on
Contribution margin 700 500
account of its fixed costs
Operating Profit 200 200
• The volatility in business due to the pandemic has increased the
Operating Leverage 3.5 2.5
importance of looking at operating leverage as a relevant
comparability adjustment factor
DOL* = % change in profitability
% change in revenue
*In absence of breakup between fixed cost and variable cost, DOL can also be empirically determined through tracking change in profitability against
change in revenue
© 2021 Deloitte Touche Tohmatsu India LLP Transfer Pricing in uncertain times – considerations for year-end book closure 12Comparability adjustments (illustration)
Step 1 Computation of tested party margin and degree of operating leverage
Tested Party Margin (impacted year) 1.5% Tested Party DOL 3
Step 2 Comparable range analysis
Comparable 1 Comparable 2 Comparable 3 Comparable 4 Lower Quartile Median Upper Quartile
Operating Margin 7.86% 5.22% 2.88% 2.40% 2.76% 5.22% 6.54%
DOL 1.66 1.74 2 2.68
Step 3 Revised range - Adjusting Comparable profitability with Tested Party’s DOL
Comparable 1 Comparable 2 Comparable 3 Comparable 4 Lower Quartile Median Upper Quartile
Revised operating 4.29% 3.68% -0.57% 1.27% 0.81% 3.68% 3.98%
margin
* The above table is only for illustration purposes (Range used per the OECD guidelines). Results will vary based on data of tested party and of comparable(s)
© 2021 Deloitte Touche Tohmatsu India LLP Transfer Pricing in uncertain times – considerations for year-end book closure 13What will be your tax team's priority in short term – in the current economic environment? (Select one of the options flashing on the right panel to respond) © 2021 Deloitte Touche Tohmatsu India LLP Transfer Pricing in uncertain times – considerations for year-end book closure 14
Future Dispute Trend – Reduced Margins / Change in cost base
Scenario 1: Captive units agrees to receive a reduced markup on the entire cost base
Scenario 2: Captive units agrees to remove Idle cost form the cost base
Revenue Service Taxpayer Judicial Precedence
In pre-COVID-19 times, when the group was • Extraordinary/abnormal cost for the Benefit/Advantage accruing to AE is
earning good profits, the Indian entity was period of disruption should be treated as irrelevant
getting a fixed mark-up. Hence in the non operating. • Watson Pharma Ltd. v. DCIT [2015] 54
current situation (Covid-19), Indian entity • The change in characterization if at all taxmann.com 88 (Mumbai - Trib.)
should continue to get the same agreed will be temporary and that cannot be
markup. Abnormal/Extraordinary cost should be
termed as business re-structuring treated as non-operating
Reduced mark-up/ margin would mean requiring a compensation.
pushing the risk to the Indian entity, • Honda Motorcycle & Scooters India (P.)
• On reopening of past years - the Ltd. v. ACIT [2017] 77 taxmann.com 119
thereby changing the characterization characterization remains intact, and the (Punjab & Haryana)
This will be termed as business re- change is only in pricing policy due to
structuring and the AE should compensate unforeseen circumstances. Idle capacity adjustment must be granted
for the change in risk profile. • Reduced markup based on margins • CIT v. Petro Araldite Pvt. Ltd. [2018] 93
Previous years should be re-opened due to earned by comparable companies in taxmann.com 438 (Bombay)
change in characterization imposing similar circumstances – carryout
substance rule rather than the form economic adjustment
© 2021 Deloitte Touche Tohmatsu India LLP Transfer Pricing in uncertain times – considerations for year-end book closure 15Future Dispute Trend – Reduced Margins / Change in cost base
Documentation Evaluate/Renegotiate agreements
• Change in FAR, its intensity and even performance • Definition of cost
• Impact of business disruption on the Industry • Mark up to be worded as being
• Identification of extraordinary/Abnormal Cost commensurate to ALP, rather then a fixed
• Economic Adjustments margin
• Invoicing / Credit period
Behaviour evaluation • Force Majeure clause
• Third party behaviour – eg. reduction in rent
• Company behaviour - eg. salary reduction
• Customer behaviour – eg. customers asking Mitigation of Business restructuring
for a discount • Compensation for business restructuring
Evidence gathering
Evaluate APA Agreements
• Contemporaneous / real time data
• Companies may want to revisit the critical
• Discussion in board meetings
assumptions under the APA since they may
• Disclosure in financial statement in relation to impact of
not be in a position to meet the same;
Covid-19
shelter of provision under Rule 10M(4) and
• Email correspondence with vendors / customers discussing
10M(5) to revise the APA conditions.
impact of Covid -19
• Intimation to PCCIT (Intl tax) within 60 days
• Relief measures / policies announced by the government
of change in facts
© 2021 Deloitte Touche Tohmatsu India LLP Transfer Pricing in uncertain times – considerations for year-end book closure 16In your experience, do customs authority respect the transfer pricing analysis carried out by the assessee? (Select one of the options flashing on the right panel to respond) © 2021 Deloitte Touche Tohmatsu India LLP Transfer Pricing in uncertain times – considerations for year-end book closure 17
Indirect tax implications – Illustrative scenarios*
Function – International transaction COVID -19 impact Year-end transfer pricing scenario because of Indirect tax implication
COVID-19 impact
Manufacturer/ Distributor Manufacturer: Reduction in operating margin Scenario 1: Reduction of import price Scenario 1 and 2:
(i) Purchase of goods from AE due to COVID-19 related disruption paid/ payable to AE (i) Unlikely to result in retroactive re-opening of
(ii) Payment of royalty/ license fees to assessed B/E
AE Distributor: Reduction in operating margin due to Scenario 2: Reduction of payment of royalty/ (ii) No customs duty refund on assessed B/E
COVID-19 related disruption license fees consequent to reduced import price/ royalties
(iii) Going forward, customs is likely to question
Scenario 3: Receipt of aid from AE the reduction in import price/royalties
Scenario 3 & 4:
Scenario 4: Undertaking book tax adjustment (i) IDT position remains unchanged
during return filing (ii) Inflows from AE disregarded from IDT
perspective
(iii) Characterisation of inflow is key- towards
service /goods or is simply financial support
Captive service provider Provision of services by Indian entity to AE at cost Scenario 1: Renegotiation of pricing arrangement Scenario 1: Any inflows from AE on account of
- Provision of services plus markup to predicted arm’s length percentage renegotiation may not be considered towards
exported services and consequently unlikely to
Because of COVID-19 related disruption Group is Scenario 2: Undertaking book tax adjustment count towards any export related
unable to compensate at agreed cost plus during return filing benefit/incentive
markup and seeks reduced markup Scenario 2: IDT position remains unchanged
*There can be other scenarios which would need to be discussed on a case to case basis
© 2021 Deloitte Touche Tohmatsu India LLP Transfer Pricing in uncertain times – considerations for year-end book closure 18Key takeaways
Identify the impact on company’s business, sector, industry and global operations
Compare with trends from quarterly analysis for the relevant industry segment
Determining arm’s
length margins for
Analyse variance in costs and revenues- Undertake “But for Covid Analysis” the Covid-19 period
using multi-
dimensional
Apply predictive modelling to determine year-end defensible TNMM range
ex-ante analysis and
predicting audit risks
Gather evidence of third party and business aspects on real time basis to mitigate TP
audit risks
Quarterly and predictive analysis to be updated in 2021 Q4; document findings in a
memo, consider Indirect tax implications
© 2021 Deloitte Touche Tohmatsu India LLP Transfer Pricing in uncertain times – considerations for year-end book closure 19Thoughtware
Covid-19 Impact: Benchmarking in uncertain times
Articles Dbriefs
This paper attempts to provide a detailed step by step approach for predicting arm’s length
margins to factor in the Covid-19 impact.
Click here to read
© 2021 Deloitte Touche Tohmatsu India LLP Transfer Pricing in uncertain times – considerations for year-end book closure 20Thank you! Kindly spare a minute to help us with your valuable feedback for today’s session… For any queries, please feel free to write to us at intax@deloitte.com © 2021 Deloitte Touche Tohmatsu India LLP 21
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