Comparability Adjustments - 1.
Comparability Adjustments
August 17, 2010
All rights reserved
CA Darpan Mehta
Tax
PE & PROFIT ATTRIBUTION
Disclaimer
All rights reserved
This presentation provides general information existing at the time of its preparation. The presentation is meant for general guidance and no responsibility for loss arising to any person acting or refraining from acting as a result of any material contained in this publication will be accepted by the Presenter. It is recommended that professional advice be taken based on the specific facts and circumstances. This presentation does not substitute the need to refer to the original pronouncements.
Tax
Contents Comparability adjustments – An overview Working Capital Adjustments
Approach
Illustration
Risk Adjustments
Approach
Illustration
Judicial precedents
All rights reserved
Q&A
Tax
All rights reserved
Comparability Adjustments - An overview
Tax
PE & PROFIT ATTRIBUTION
Comparability adjustments – An overview
1/2
A FAR analysis is essential to establish comparability of transactions or entities
Functions performed Assets employed Risks assumed
The need to adjust comparables is asserted in:
Rules 10B(2), 10B(3), 10C and 10C(3) under the Indian Transfer Pricing Regulations Paras 1.17, 1.23, 1.24, 1.25, 3.34, 3.39 of the OECD Guidelines published in 2009; and Section A.6 of revised Chapter III of the OECD Guidelines published in 2010
The need to perform numerous or substantial adjustments to key comparability factors may indicate that the third party transactions are in fact not sufficiently comparable
Tax
All rights reserved
Comparability adjustments should be considered if and only if they increase the reliability of the results
Comparability adjustments – An overview
2/2
Types of comparability adjustments
Risk adjustments Working capital adjustments Market conditions Adjustments for intangibles Country risk adjustments Capacity utilization adjustment Difference in accounting standards
Whether comparability adjustments should be performed and if so, what adjustments should be performed is a matter of judgment
All rights reserved
Is it mandatory to carry out comparability adjustments ?
Tax
All rights reserved
Working Capital Adjustments
Tax
PE & PROFIT ATTRIBUTION
Overview
1/4
Working capital denotes the operating liquidity available to a business Working capital adjustments are designed to reflect two key areas of Working Capital: • •
Inventory and accounts receivable Accounts payable
Purpose - to adjust for the differences in time value of money between the tested party and potential comparables with an assumption that the difference should be reflected in profits Need - when the tested party exhibits differing level of Working Capital intensities relative to the comparable
All rights reserved
Basis - An adjustment must be accompanied by an explanation of why, making the adjustment improves comparability
Tax
Typical Approach
2/4
Steps in undertaking the working capital adjustments: Identification of the appropriate base ie costs, sales etc depending upon the profit level indicator applied Identification of the parameters that require adjustments. This is done as per the business profile of the company viz working capital investment of a service company for maintaining inventory is minimal. Thus, undertaking an adjustment for inventory is not relevant in such a case Calculating the average level of inventories, accounts receivable and accounts payable for the tested party and the comparable companies Determining the difference between the tested party’s ratio of accounts receivable to total cost (ie the appropriate base) and the corresponding ratio of accounts receivable to total cost (ie the appropriate base) of each comparable Multiplying the above difference by an interest rate factor in order to arrive at a figure representing the implicit interest expense or benefit to the comparable due to its different accounts receivable carrying costs Adjustments on account of difference in levels of accounts receivable are added to the unadjusted operating revenue of the comparable companies and adjustments on account of difference in levels of accounts payable and inventory are added to the operating costs
Tax
All rights reserved
Similar workings for accounts payable and inventory needs to be undertaken
All rights reserved
Illustration
Tax
3/4
Key issues for discussions
4/4
OECD in its latest ‘Transfer Pricing Guidelines’ has illustrated the procedure to be adopted for undertaking the working capital adjustments. The OECD approach is similar to the procedure discussed earlier, except for the following:
Follows a net working capital approach No concept of interest rate factor
Selection of the appropriate interest rate (or rates) - the rate should be determined by reference to the rate applicable to an enterprise operating in the same market as the tested party; possibility to apply different rates for different elements ? Relevant point in time the Receivables, Inventory and Payables of the tested party and the comparables should be compared ?
All rights reserved
Whether working capital adjustments should be made when the results of some comparables can be reliably adjusted while the results of some others cannot ?
Tax
All rights reserved
Risk Adjustments
Tax
PE & PROFIT ATTRIBUTION
Overview
1/6
A full fledged entrepreneur bears considerable business risk such as credit risk, market risk and foreign exchange risk Para 1.23 of the OECD guidelines provides “controlled and uncontrolled transactions and entities are not comparable if there are significant differences in the risks assumed for which appropriate adjustments cannot be made. Functional analysis is incomplete unless the material risks assumed by each party have been considered since the assumption or allocation of risks would influence the conditions of transactions between the associated enterprises”. A full fledged entrepreneur is expected to achieve higher return in the form of a ‘risk premium’ for bearing business risk
All rights reserved
Where the tested party is a low-risk bearing enterprise, risk adjustments has to be made to comparable companies in order to extract the risk premium associated with their returns
Tax
Possible Approaches
2/6
Given lack of guidance in the Indian transfer pricing regulations (or the OECD, USA, Australia) regarding the procedures to be followed for undertaking risk adjustments, the Capital Asset Pricing Model (‘CAPM’) Model could be applied CAPM demonstrates that the expected return of a security or a portfolio equals the rate of return on a risk-free security plus a risk premium; the components of CAPM are Risk free rate of return, Beta of security, Equity Risk Premium and Expected Stock Market return
An alternate approach is to use Sharpe ratio which compares the operating profit margin earned by the comparable companies over and above the risk free interest rate with the risk assumed by the comparable companies (‘standard deviation’) and computes the additional return earned on account of risk assumed; however, even this approach has its weaknesses
Tax
All rights reserved
Since the CAPM is based on the assumption that the investor has a well diversified portfolio and only the systemic risk is adjusted (ie the firm specific risk is not adjusted), it may be difficult to apply in transfer pricing analysis
An alternate approach
3/6
First step in the risk adjustment procedure is to calculate the risk premium. In general terms, risk premium is the expected excess of the aggregate return in the stock market over and above the risk-free rate i.e.
Risk Premium = Total Stock Market Return – Return on risk-free investments
For calculation of the risk premium, the following stock market indices may be used:
S&P CNX Nifty; and CNX Nifty Junior etc
All rights reserved
The next step in the approach is to identify the risk free rate prevalent in the open market. In general, the yield on government bonds are considered to be the prevalent risk free rate of return.
Tax
An alternate approach
4/6
Further steps in undertaking the risk adjustments: Computation of return on costs (Operating profit/Total Cost) for comparable companies (OP/TC)
Computation of average capital employed (CE) for year under consideration for comparable companies.
Calculate the super normal profit earned owing to the risk premium earned on Capital Employed
Reduce the super normal profit from the reported operating profit of the company to arrive at the risk adjusted profit
Divide the above with the total costs incurred by the company to arrive at the risk adjusted margins
The same has been illustrated in the next slide
All rights reserved
Tax
All rights reserved
Illustration
Tax
5/6
Key issues for discussions
6/6
As mentioned, there is no regulatory guidelines available for risk adjustments. These can often lead to litigations Risk premium used for calculating the returns are averages of returns from the stock indices. These may not be appropriate representative of the actual risk premium witnessed by the companies.
All rights reserved
Further, this procedure assumes that all the companies in the comparable set are in the similar phase of business cycles, that may not be the actual scenario
Tax
All rights reserved
Summary of judicial precedents
Tax
PE & PROFIT ATTRIBUTION
Summary of judicial precedents Case Law Aztec Software & Technology Services Limited
1/2
Principles
Functions, Assets and Risk analysis (“FAR analysis”) essential
Adjustments should be such that the differences or variations are ironed out
Philips Software Centre Pvt Ltd
Working capital adjustment accepted
Risk adjustment accepted being a captive service provider
[Bangalore Tribunal ]
Adjustment towards difference in depreciation rates also considered
Egain Communications Pvt
Adjustments should be made for material differences in functions performed and risks assumed
[Bangalore Tribunal]
All rights reserved
[Pune Tribunal]
Tax
Summary of judicial precedents Case Law Sony India Private Ltd
Principles
Adjustments to minimise differences on account of intangibles and R&D
Working capital adjustment was also accepted
FAR analysis had to be undertaken
Company characteristics, presence of intangible assets, assets employed and risks carried assume significance
Company size, fixed to operating asset ratio and variation in the profit level indicators also noteworthy
Adjustments for differences in working capital, Research and development should be made
Comparables to be rejected where differences are substantial
[Delhi Tribunal]
Mentor Graphics (Noida) Pvt Ltd
2/2
All rights reserved
[Delhi Tribunal]
Tax
All rights reserved
THANK YOU
Tax
Tax PE & PROFIT ATTRIBUTION
| 22
August 17, 2010
All rights reserved
CA Darpan Mehta
Tax
PE & PROFIT ATTRIBUTION
Disclaimer
All rights reserved
This presentation provides general information existing at the time of its preparation. The presentation is meant for general guidance and no responsibility for loss arising to any person acting or refraining from acting as a result of any material contained in this publication will be accepted by the Presenter. It is recommended that professional advice be taken based on the specific facts and circumstances. This presentation does not substitute the need to refer to the original pronouncements.
Tax
Contents Comparability adjustments – An overview Working Capital Adjustments
Approach
Illustration
Risk Adjustments
Approach
Illustration
Judicial precedents
All rights reserved
Q&A
Tax
All rights reserved
Comparability Adjustments - An overview
Tax
PE & PROFIT ATTRIBUTION
Comparability adjustments – An overview
1/2
A FAR analysis is essential to establish comparability of transactions or entities
Functions performed Assets employed Risks assumed
The need to adjust comparables is asserted in:
Rules 10B(2), 10B(3), 10C and 10C(3) under the Indian Transfer Pricing Regulations Paras 1.17, 1.23, 1.24, 1.25, 3.34, 3.39 of the OECD Guidelines published in 2009; and Section A.6 of revised Chapter III of the OECD Guidelines published in 2010
The need to perform numerous or substantial adjustments to key comparability factors may indicate that the third party transactions are in fact not sufficiently comparable
Tax
All rights reserved
Comparability adjustments should be considered if and only if they increase the reliability of the results
Comparability adjustments – An overview
2/2
Types of comparability adjustments
Risk adjustments Working capital adjustments Market conditions Adjustments for intangibles Country risk adjustments Capacity utilization adjustment Difference in accounting standards
Whether comparability adjustments should be performed and if so, what adjustments should be performed is a matter of judgment
All rights reserved
Is it mandatory to carry out comparability adjustments ?
Tax
All rights reserved
Working Capital Adjustments
Tax
PE & PROFIT ATTRIBUTION
Overview
1/4
Working capital denotes the operating liquidity available to a business Working capital adjustments are designed to reflect two key areas of Working Capital: • •
Inventory and accounts receivable Accounts payable
Purpose - to adjust for the differences in time value of money between the tested party and potential comparables with an assumption that the difference should be reflected in profits Need - when the tested party exhibits differing level of Working Capital intensities relative to the comparable
All rights reserved
Basis - An adjustment must be accompanied by an explanation of why, making the adjustment improves comparability
Tax
Typical Approach
2/4
Steps in undertaking the working capital adjustments: Identification of the appropriate base ie costs, sales etc depending upon the profit level indicator applied Identification of the parameters that require adjustments. This is done as per the business profile of the company viz working capital investment of a service company for maintaining inventory is minimal. Thus, undertaking an adjustment for inventory is not relevant in such a case Calculating the average level of inventories, accounts receivable and accounts payable for the tested party and the comparable companies Determining the difference between the tested party’s ratio of accounts receivable to total cost (ie the appropriate base) and the corresponding ratio of accounts receivable to total cost (ie the appropriate base) of each comparable Multiplying the above difference by an interest rate factor in order to arrive at a figure representing the implicit interest expense or benefit to the comparable due to its different accounts receivable carrying costs Adjustments on account of difference in levels of accounts receivable are added to the unadjusted operating revenue of the comparable companies and adjustments on account of difference in levels of accounts payable and inventory are added to the operating costs
Tax
All rights reserved
Similar workings for accounts payable and inventory needs to be undertaken
All rights reserved
Illustration
Tax
3/4
Key issues for discussions
4/4
OECD in its latest ‘Transfer Pricing Guidelines’ has illustrated the procedure to be adopted for undertaking the working capital adjustments. The OECD approach is similar to the procedure discussed earlier, except for the following:
Follows a net working capital approach No concept of interest rate factor
Selection of the appropriate interest rate (or rates) - the rate should be determined by reference to the rate applicable to an enterprise operating in the same market as the tested party; possibility to apply different rates for different elements ? Relevant point in time the Receivables, Inventory and Payables of the tested party and the comparables should be compared ?
All rights reserved
Whether working capital adjustments should be made when the results of some comparables can be reliably adjusted while the results of some others cannot ?
Tax
All rights reserved
Risk Adjustments
Tax
PE & PROFIT ATTRIBUTION
Overview
1/6
A full fledged entrepreneur bears considerable business risk such as credit risk, market risk and foreign exchange risk Para 1.23 of the OECD guidelines provides “controlled and uncontrolled transactions and entities are not comparable if there are significant differences in the risks assumed for which appropriate adjustments cannot be made. Functional analysis is incomplete unless the material risks assumed by each party have been considered since the assumption or allocation of risks would influence the conditions of transactions between the associated enterprises”. A full fledged entrepreneur is expected to achieve higher return in the form of a ‘risk premium’ for bearing business risk
All rights reserved
Where the tested party is a low-risk bearing enterprise, risk adjustments has to be made to comparable companies in order to extract the risk premium associated with their returns
Tax
Possible Approaches
2/6
Given lack of guidance in the Indian transfer pricing regulations (or the OECD, USA, Australia) regarding the procedures to be followed for undertaking risk adjustments, the Capital Asset Pricing Model (‘CAPM’) Model could be applied CAPM demonstrates that the expected return of a security or a portfolio equals the rate of return on a risk-free security plus a risk premium; the components of CAPM are Risk free rate of return, Beta of security, Equity Risk Premium and Expected Stock Market return
An alternate approach is to use Sharpe ratio which compares the operating profit margin earned by the comparable companies over and above the risk free interest rate with the risk assumed by the comparable companies (‘standard deviation’) and computes the additional return earned on account of risk assumed; however, even this approach has its weaknesses
Tax
All rights reserved
Since the CAPM is based on the assumption that the investor has a well diversified portfolio and only the systemic risk is adjusted (ie the firm specific risk is not adjusted), it may be difficult to apply in transfer pricing analysis
An alternate approach
3/6
First step in the risk adjustment procedure is to calculate the risk premium. In general terms, risk premium is the expected excess of the aggregate return in the stock market over and above the risk-free rate i.e.
Risk Premium = Total Stock Market Return – Return on risk-free investments
For calculation of the risk premium, the following stock market indices may be used:
S&P CNX Nifty; and CNX Nifty Junior etc
All rights reserved
The next step in the approach is to identify the risk free rate prevalent in the open market. In general, the yield on government bonds are considered to be the prevalent risk free rate of return.
Tax
An alternate approach
4/6
Further steps in undertaking the risk adjustments: Computation of return on costs (Operating profit/Total Cost) for comparable companies (OP/TC)
Computation of average capital employed (CE) for year under consideration for comparable companies.
Calculate the super normal profit earned owing to the risk premium earned on Capital Employed
Reduce the super normal profit from the reported operating profit of the company to arrive at the risk adjusted profit
Divide the above with the total costs incurred by the company to arrive at the risk adjusted margins
The same has been illustrated in the next slide
All rights reserved
Tax
All rights reserved
Illustration
Tax
5/6
Key issues for discussions
6/6
As mentioned, there is no regulatory guidelines available for risk adjustments. These can often lead to litigations Risk premium used for calculating the returns are averages of returns from the stock indices. These may not be appropriate representative of the actual risk premium witnessed by the companies.
All rights reserved
Further, this procedure assumes that all the companies in the comparable set are in the similar phase of business cycles, that may not be the actual scenario
Tax
All rights reserved
Summary of judicial precedents
Tax
PE & PROFIT ATTRIBUTION
Summary of judicial precedents Case Law Aztec Software & Technology Services Limited
1/2
Principles
Functions, Assets and Risk analysis (“FAR analysis”) essential
Adjustments should be such that the differences or variations are ironed out
Philips Software Centre Pvt Ltd
Working capital adjustment accepted
Risk adjustment accepted being a captive service provider
[Bangalore Tribunal ]
Adjustment towards difference in depreciation rates also considered
Egain Communications Pvt
Adjustments should be made for material differences in functions performed and risks assumed
[Bangalore Tribunal]
All rights reserved
[Pune Tribunal]
Tax
Summary of judicial precedents Case Law Sony India Private Ltd
Principles
Adjustments to minimise differences on account of intangibles and R&D
Working capital adjustment was also accepted
FAR analysis had to be undertaken
Company characteristics, presence of intangible assets, assets employed and risks carried assume significance
Company size, fixed to operating asset ratio and variation in the profit level indicators also noteworthy
Adjustments for differences in working capital, Research and development should be made
Comparables to be rejected where differences are substantial
[Delhi Tribunal]
Mentor Graphics (Noida) Pvt Ltd
2/2
All rights reserved
[Delhi Tribunal]
Tax
All rights reserved
THANK YOU
Tax
Tax PE & PROFIT ATTRIBUTION
| 22
