Presentation Compiled By. Akshay Kenkre Gaurav Garg Tejas Dharwadkar

Transcription

1 FAR Analysis 1

2 Presentation Compiled By Akshay Kenkre Gaurav Garg Tejas Dharwadkar

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4 Maintenance of documentation Under Section 92D of the Act every person entering into an international transaction is required to maintain information and documentation to support their international transactions The information / documentation to be maintained is prescribed in Rule 10D of the Rules 4

5 Mandatory documentation Entity Related Profile of the Group Profile of the Indian entity Profile of AE Profile of Industry Price Related Transaction terms Functional Analysis (Functions, Assets, Risks) Economic Analysis (Method selected, Benchmarking analysis) Forecasts, budgets, estimates, etc. Transaction Related Agreement, MoU Invoices Price related correspondence Policy Documentation News articles Press releases 5

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7 Group Overview Group s business activities / operations / division Products and Services Geographical presence Any significant development during the year 7

8 Company Overview Evolution Shareholding structure Overview of operations Key business areas, customers, products / services etc Any significant events during the year 8

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10 Why do we need Industry Overview ( IO ) Assists in understanding the clients relative positioning in the industry visà-vis other players Helps in screening factors when undertaking a comparables search qualitative analysis Provides overall justification of clients financial results 10

11 Suggested Steps Detailed IO to be prepared after understanding the functions precise activities, products of the client; Determine client s position within the industry; Information about the market share of the client; Establish linkage of IO with Functional and Economic Analysis; Key to successful industry research is to connect the research to the subject analysis; 10 11

12 Sources of Research The source should be a publicly available and a reliable source; Assess the validity and reliability of the source; Few sources that one can consider in preparing an IO (not exhaustive): Annual report of client company Management Discussion & Analysis (MD&A), Annual reports of clients competitors (names of competitors not to be mentioned) Ask the client to provide industry information / presentations etc. Client website, Internet Google, Material published in the trade journals and magazines etc. Newspaper articles, Specific subscriptions to magazines, trade journals, NASSCOM publications etc. Indian Brand Equity Foundation (IBEF) website 12

13 Structure of IO About the industry (Introduction, Background) Size and Structure Industry drivers Competitive landscape Regulatory environment Key trends Key challenges Way forward or Outlook Summary 12 13

14 Do s and Don ts... Do s Understand the clients products, their nature i.e. if they are complimentary on other products etc., and decide on the industry/industries that need to be analyzed and documented; Always mention the source in the report such that we can easily locate the same in future; Customize the IO to your specific client in case of using the standard IO s; Use of Pie charts / Diagrams / Bar charts will be helpful; Keep the IO as specific, crisp/short as possible; Take a look at last years IO to keep in line with long term statements, sources mentioned in last years IO etc

15 ...Do s and Don ts Don ts Copy-paste previous years IO as it is; Copy-paste standard IO s blindly; Include statements in the IO which can be contradictory to our study; Leave the IO for the end of the assignment; Use too many technical jargons and figures; Document prices or price trends without being doubly sure of its consequences

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17 Transfer Pricing Jigsaw Tested Party Functional Analysis Comparability Analysis Transfer Pricing Methods Industry Overview 17

18 Functional Analysis Introduction Critical part in establishing ALP Gathering information and analyzing controlled transactions to ensure the parties and transactions are understood Understanding of Economically Significant Factors Helps appropriate assessment of comparability Important role in selection of TP Method and tested party Fixation of price by facilitating comparability Testing: One sided view; Functional Analysis: Two sided view 18

19 Functional Analysis Economically Significant Factors The profits a company makes are dependent on: The business environment it operates in The strategy it pursues in that environment The functions they engage in The assets they employ The risks they undertake E (P) = ƒ (F,A,R) 19

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21 Preparing for FAR Introduction Focus on practical aspects of FAR Aim is to build documentation highlighting key functions, Assets and Risks FAR is one of the most important aspects of TP as it involves meetings with employees at all levels We will understand practical background work and front end work that goes in preparation of FAR 21

22 Preparing for FAR Step 1: Utility and Purpose Uncontroversial Tax compliance? In Dispute: Defense Document? Cost? Benefit Policy Documentation? Restructuring/ Structuring the transaction? The length and style of the functional analysis needs to reflect the complexity and materiality of the arrangement. For e.g.: Generic Pharma Basic Tabular FAR; Policy for entire specialized pharma group Detailed and explained 22

23 Preparing for FAR Step 2: Navigator Navigator: One who arranges interviews and acts as a bridge between the interviewer and interviewee Traits of Navigator: Good understanding of overall business Understands Transfer Pricing and its importance Well connected in the organization Well Respected in the organization Knows internal processes Could also highlight business weakness and failures Helps to identify risk Is responsible for Transfer Pricing E.g.: Tax Heads, Managers, CFOs, Business Controllers, Operational heads 23

24 Preparing for FAR Step 3: Fact gathering Obtain relevant agreements and other documentation- Agreements with related companies and third parties Business plans and Budgets Review and document the review in a summary form Use organization charts to plan the interviewing process Send questionnaires to people not being interviewed Interview key personnel Financials and management accounts 24

25 Preparing for FAR Step 4: Interview Team Ideally 3 participants from Interview team 1. Interview Leader 2. Note Taker 3. Navigator One can follow a break up approach or a big bang approach for an interview Introduction of the interview team Purpose of interview Either by leader or Navigator Flexibility in questioning Bringing back on track Spot issues, guide note taker Clarify issues, give back ground Capturing of details by note taker Keep track of to-do 25

26 Preparing for FAR Step 4: The Interview Taking interview is an art than science Communication and Clarity Planning is the key Identify the persons to be interviewed prior hand Understand the basic business model from the Navigator Preparation and circulation of questionnaire / agenda Explain importance of documentation and confidentiality Ask open ended questions: what is the process involved in.. Let the speaker share experiences and instances If technical jargons are not understood, ask for a simpler explanation Stick to timeliness Post interview- Summarize the understanding and ask for verbal confirmation Document the interview and ask for written confirmation In case of recording INFORM and TAKE PERMISSION!!! 26

27 Preparing for FAR Interview key personnel to identify: Inter- company transactions Products, processes, divisions that can be grouped or segregated Background of business Competitors to get idea on comparables Product life cycle, history of company etc. Identify key decision makers Identification of internal comparables Business drivers 27

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29 Structuring FAR Guess Central (USA) HO/ Pricing/ Logistics/ Marketing/ Design selection/ Trademarks ABC Ltd- 3 rd Party (Italy 80%) Contract Manufacturer Guess Design (France) Develops Design Guess India (India 20%) Manufacturer Guess Retail (U.K, USA, INDIA, CHINA) Retail 29

30 Typical Supply Chain Research and Development Manufacturin g Marketing After Sale Support Procuremen t Warehousin g Sales and Distribution Invoicing and corporate services 30

31 Typical Business functions Research and Development R&D strategy Intellectual property (IP) for development Product design and research Recruitment Lab equipment's and supplies Analysis and testing Documentation Review of test results Creation of IP Registration of IP Commercialization of IP Procurement Procurement Strategy Purchase of materials and supplies Developing cost budgets Evaluating Quotations Pricing Quality testing of inward or raw materials Warehousing Stock Strategy JIT/1 month stock Controlling of stock Location of warehouse Inward and outward logistics Quality checks Security 31

32 Typical Business functions Marketing Strategic marketing Market Surveys Assess market demand Advertisement Trade shows and exhibitions Samples Product brochures, information and designing Creation, maintenance, protection of brand (IPmarketing intangible) Manufacturing Equipment Procurement Scheduling Maintenance Process control Production of Finished goods Packaging and Labelling Sampling Quality control Storage Logistics Compliances and administration Managing Idle time, Shifts, Safety 32

33 Typical Business functions Sales and Distribution Sales Distribution network Managing distributors Pricing Discounts Shipping of products/ logistics Controlling stocks Managing returns Corporate services Invoicing Receivable and payable management HR, Accounting, Tax, Legal, IT Pricing policy General Administration After Sale Support Customer complaints Service requirement Call centers and data collection Feedbacks 33

34 Typical Business Assets Tangible assets Production Equipment & Machinery Buildings Office equipment Cars, trucks, etc Receivables, Inventory Intangible assets Patents Unpatented technical know-how Formulae, trade marks and brand names Licences & Copyrights Technical data Customer lists Goodwill 34

35 Typical Business Risks Market risk: volume, mix, price Inventory risks: raw materials, work in progress and finished goods Defective products and warranty Credit risk Product liability risk Foreign exchange risk Environmental risk 35

36 Typical Business Risks Risk Explanation Market Risk Market risk arises for a business due to increased competition and relative pricing pressures, change in demand patterns and needs of customers, inability to develop / penetrate in a market, etc Utilisation Risk: Credit Risk: Inventory Risk: Foreign Exchange Risk: Utilisation risk relates to the possibility of non-recovery of fixed costs being incurred. This may happen due to circumstances such as, lack of production, to lack of demand, inability to recover prices etc This is the risk arising from default in payment of receivables by customers This risk is linked with management of inventory in case of overstocking or slow/ non-moving inventory resulting from a rapidly changing and technology/ price sensitive market. As a result the enterprise may be forced to bear a loss of margin on the inventory, or incur additional costs to dispose the same This risk relates to the potential impact on profits that may arise because of changes in foreign exchange rates. 36

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38 Summary - Functions Functions R&D (Design) Design Selection Trademark & Design registration Guess USA XXX XXX Guess France Guess India Guess Retail XXX Procurement XX X Warehousing XX X XX Manufacturing X (20%) Marketing XXX Sales After Sale XXX XXX Corporate Services XX XX XX XX 38

39 Summary - Assets Assets Guess USA Guess France Guess India Guess Retail Trade Receivables XX X Inventory XX Property X X XX Plant & Equipment XX Trademark XXX Manufacturing knowhow XX Designs XXX XX X Customer list XXX 39

40 Summary - Risks Risk Guess USA Guess France Guess India Guess Retail Business XX X X X Market XX XX Inventory XXX Credit X X Foreign Exchange Product Liability X X X X XXX Service Failure XXX XX 40

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42 A comparative analysis Guidelines for identification of low risk Contract R&D service provider Criteria Circular 6 Functions Principal or AEs perform economically significant functions. Guidance provided on what is economically significant Assets Control and supervision Principal or AEs provides funds/capital and economically significant assets DC works under the direct supervision of principal or AEs who control and monitor the research and provide strategic inputs Risks DC does not bear any significant risk Remuneration Remuneration to DC required. AO/TPO to refer to the TP provisions for applicability of Most appropriate method 42

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44 Functional Analysis- Conclusion Business never sleeps and hence important to review functional analysis periodically Review by the interviewees of relevant sections If business undergoes significant change- Critical to document such change and changes in the FAR Functional analysis has to highlight the company reality Once FAR is established, it helps in CHARACTERIZATION that is a bridge between Functional analysis and economic analysis (Comparability) 44

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46 Entity Categorization Introduction Most important outcome of FAR : Classification of entities Transactional approach not entity approach Principle of : Higher complexity leads to higher return Simple entities Routine tasks with lower risks ; Complex entity Specialized tasks with higher risks along with assets like intangibles Categorization helps to find like functional entities to ease comparability FAR Categorization Comparability 46

47 Complex v. Simple entity Pharma Co Functions: Development of new drugs Owns and managed IP Manufactures the API Formulates the drug Establishes Distribution network Takes onus on sales Functions: Does not develop drugs Does not own or manage IP Functions on parent s instructions Simple formulation, no API No distribution network No sales force Complex Simple 47

48 Profit Potential and Profit Potential Functions, Risks and Assets No Risk Limited Risk Full Risk Entrepreneur Functions, Risks and Assets 48

49 Profit Potential and Typical Distribution function Functions, Risks and Assets Sales Support Sales Agent LRD Licensed Distributor Full Risk Functions, Risks and Assets 49

50 Sales Support Provides market information Common link between principal and customer No title to product or stock No substantial risk Facilitation of distribution but has no control over distribution Value Driver is : Cost 50

51 Sales Agent Acts on behalf of principal Customer negotiations based on guidance from principal No legal title of goods Takes decision on pricing based on guidance from principal Performs all function of sales support + additional responsibility to acts as a principal itself May lead to PE exposure, if appropriate care not taken Value Driver: Commission as a percentage of sales 51

52 Limited Risk Distributor Enters in contract on its own behalf Makes sales inn its own name Has a distribution network Risk if inventory, losses, warranty, currency, bad debts would be restricted Value Driver: Limited LRD profits 52

53 Licensed Distributor Brand and know how IP through franchisee model Market strategy, pricing, inventory risks are with the distributor Risks of inventory, warranty, currency, debts lies with distributor No much contribution to marketing and advertising as the same is performed by the licensor of the brand If marketing and advertising done by distributor excessively marketing intangibles Value Driver: Profits 53

54 Full Risk Distributor Similar to Licensed Distributor Own significant intangibles All risks assumed Value Drivers: profits 54

55 Profit Potential and Typical Manufacturing function Functions, Risks and Assets Toller Contract Mfg Licensed Mfg Full Risk Functions, Risks and Assets 55

56 Toller Bears no risk Functions of conversion as per principals instructions Does not own any raw material or even the finished stock Responsible for only processing Value driver: Tolling fees 56

57 Contract manufacturer Own plant, raw material, skilled labor Does not own design, know how or title to end product Order based manufacturing No marketing in tangibles Limited risks Value driver: Limited profits 57

58 Licensed manufacturer Almost a full risk manufacturer, however does develop or manage IP Licenses IP All other functions undertaken by manufacturer himself Value driver: Full profits 58

59 Full risk manufacturer Owns, develops and manages intangibles Licenses out intangibles Production on own account Supply chain from procurement till after-sales Assumes all risks Value Driver: entrepreneur profits 59

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61 Question 1 Facts ABC Ltd in India is organized into three business segments as under: Segments Contract Mfg of Chemical A Distributor of Chemical B Multiplication of Seeds International Transaction Import of RM Export of FG Import of FG Mgmt fee Import of Seeds Export of seeds Mgmt fees Benchmarking 1 Benchmarking 2 Benchmarking 3 61

62 Question 1 How would you prepare the Group Overview? What industry overview would you prepare? How will you write the functional analysis? Each international transaction wise or business segment wise? Would the characterization be determined for each segment or entity as a whole? 62

63 Question 2 Facts XYZ in USA markets the products manufactured by ABC in India ABC owns the trademark and technology to manufacture the product Benchmarking has been carried out considering comparables providing similar marketing service providers in USA TP Report of ABC Ltd has to be prepared ABC Ltd XYZ Ltd Marketing Support Services in USA 63

64 Question 2 How would you prepare the Group Overview? Industry overview? Which geographical location would you consider India or USA? Which activity would you consider manufacturing in India or marketing in USA What will you capture in the functional analysis? What would be the characterization of ABC and XYZ? Who should be considered as the tested party? 64

65 Question 3 Which department of a manufacturing client is likely to provide greater insights into the functional analysis? Finance department Marketing / Sales department Manufacturing and Operations department Administration department 65

66 Question 4 Functional analysis has to be written for the Indian entity alone or for both Indian entity and the Associated Enterprise? 66

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68 Verifone Sales Ind P. Ltd Del ITAT Verifone India engaged in distribution and marketing of hi-tech products Trading company Imports from AE ( AY ) ALP : NPM is 1.22% as against 3.49% achieved by the taxpayer TPO accepted 4 companies and accordingly made adjustments ITAT held Working capital adjustments to give due recognition Companies with consistent loss making, transaction of sales of FA and lack of segmental data to be rejected 68

69 Symphony Services Pune P. Ltd. Taxpayer engaged in business of software development for its AEs Selling of Software products not comparable to the service provided by the taxpayer for software development; hence Kals Information as a comparable rejected Companies in KPO business cannot be considered comparable to software development service. Hence functionally different. E-Zest Solutions Limited as a company rejected. 69

70 Thank You