Restructuring is routine for multinational enterprises (MNEs) as they widen the scope of their businesses and seek efficiency improvements through synergies and scale economies. Due account has to be taken of transfer pricing (TP) issues during restructuring. When restructuring takes place there are some typical transfers that can arise, which in turn attract transfer pricing regulations. The same can be transfer of assets i.e. tangible or intangible and transfer of activities or functions to capture various synergies envisaged and also to minimize tax and cost aspects both and future

There are also business restructurings whereby intangibles and/or risks are reallocated to operational entities (e.g. to manufacturers or distributors). Business restructurings can also consist of the rationalization, specialization or de-specialization of operations (manufacturing sites and / or processes, research and development activities, sales, services), including the downsizing or closing of operations. In the example of Tata Steel, the major production activity of Corus(UK) was shifted to India to rationalize production cost.

After applying various strategies and developing detailed plans to capture value for all stakeholders, if issues arise due to transfer pricing regulations
of various countries , substantial savings achieved may not get captured. So in any internal restructuring, one must look at transfer pricing provisions
with a view to

  • Optimize the effective tax rate for the group in a way that the group pays tax on real income only and not on derived income under the provisions
  • Optimize future tax liabilities by placing various functions in the country where the cost of development/execution is lowest and tax-friendly
  • Minimize various risks including currencies, regulatory and compliance, for future growth

In a nutshell, one needs to get a highest possible return on investments and under the new scenarios if transfer pricing issues are ignored, one may not capture desired value. Thus to attain these objectives following points have to be considered

  • Special considerations for risks during restructuring
  • Arms Length Price during restructuring
  • Methods to be used for determining the transfer price

Part I: Special Considerations for risk

Risks are of critical importance in the context of business restructurings. An examination of the allocation of risks between associated enterprises is an essential part of the functional analysis. The following points should be considered for evaluating risk.

Contractual terms:

The examination of risks starts from an examination of the contractual terms between the parties, as those generally define how risks are to be divided between the parties. Contractual arrangements are the starting point for determining which party to a transaction bears the risk associated with it. Accordingly, it would be a good practice for associated enterprises to document in writing their decisions to allocate or transfer significant risks before the transactions with respect to which the risks will be borne or transferred occur, and to document the evaluation of the consequences on the profit potential of significant risk reallocations. One needs to consider pricing at the time of reallocation of risks and if the compensation awarded in future is in line with risks assumed by each enterprise. Lets take a example: Assume that the tax administration finds that the taxpayer’s arrangements made in relation to its controlled transactions, and in particular the allocation of excess inventory risk to the manufacturer, differ from those which would have been adopted by independent enterprises behaving in a commercially rational manner and that in comparable circumstances, a manufacturer would not agree at arm’s length to take on substantial excess inventory risk by, for example, agreeing to repurchase from the distributors at full price any unsold inventory. In such a case, the tax administration would seek to arrive at a reasonable solution through a pricing adjustment.

Therefore the risk taken should be compensated adequately so as to satisfy the tax administrators. Thus while assessing the risk and compensation awarded three questions that need to be answered are:

  • Whether the conduct of the associated enterprises conforms to the contractual allocation of risks
    Compensation or price depends on level and type of risks each enterprise is supposed to assume as per the agreement. However one needs to look at the actual behavior of associated enterprises and risks actually bear by each of them, If risk sharing is not in accordance with the contract but the compensation paid is as per the contract then there can be a major issue under transfer pricing.

    Example:
    Suppose a manufacturer sells property to an associated distributor in another country and the distributor is claimed to assume all exchange rate risks, but the transfer price appears in fact to be adjusted so as to insulate the distributor from the effects of exchange rate movements. In such a case, the tax administrations may wish to challenge the purported allocation exchange rate risk.

  • Whether the allocation of risks in the controlled transaction is arm’s length , and
    • Evaluating with the help of comparables
      <br\>Where data evidence a similar allocation of risk in comparable uncontrolled transactions, then the contractual risk allocation between the associated enterprises is regarded as arm’s length. In this respect, comparables data may be found either in a transaction between one party to the controlled transaction and an independent party (“internal comparable”) or in a transaction between two independent enterprises, neither of which is a party to the controlled transaction (“external comparable”)
    • Cases where comparables are not found
      Just because an arrangement between associated enterprises is one not seen between independent parties should not by itself mean the arrangement is non-arm’s length. However, where no comparables are found to support a contractual allocation of risk between associated enterprises, it becomes necessary to determine whether that allocation of risk is one that might be expected to have been agreed between independent parties in similar circumstances.
  • What the consequences of the risk allocation are
    In general, the consequence for one party being allocated the risk associated with a controlled transaction, where such a risk allocation is found to be consistent with the arm’s length principle, is that such party should:

    1. Bear the costs, if any, of managing (whether internally or by using associated or independent service providers) or mitigating the risk (e.g. costs of hedging, or insurance premium),
    2. Bear the costs that may arise from the realization of the risk. This also includes, where relevant, the anticipated effects on asset valuation ( e.g. inventory valuation) and / or the booking of provisions, subject to the application of the relevant domestic accounting and tax rules; and
    3. Generally, be compensated by an increase in the expected return.
      For instance, where a buy-sell distributor which is converted into a commissionaire transfers the ownership of inventory to an overseas principal and where this transfer leads to a transfer of inventory risk, the questions that needed to be answered are:<br\>

      • What the level of investment in inventory is,
      • What the history of stock obsolescence is,
      • What the cost of insuring it is, and
      • What the history of loss in transit (if uninsured) is.

Part II: Arm’s length compensation for the restructuring itself

A business restructuring may involve cross-border transfers of something of value, e.g. of valuable intangibles, although this is not always the case. It may also or alternatively involve the termination or substantial renegotiation of existing arrangements, e.g. manufacturing arrangements, distribution arrangements, licenses, service agreements, etc.

The determination of whether the conditions made or imposed in a business restructuring transaction at arm’s length will generally be informed by a comparability analysis, and in particular by an examination of the functions performed, assets used and risks assumed by the parties, as well as of the contractual terms, economic circumstances and business strategies.

Example:Daiichi’s acquisition of Ranbaxy
The main objective of combination was to give Ranbaxy access to Daiichi’s expertise in research while the Japanese company would benefit from the low cost of production. Also the major objective of acquisition was to help Daiichi to add generic low cost medicines to its portfolios and help Ranbaxy to enter into the much coveted Japanese market.

Now let’s evaluate this deal with regards to transfer pricing issues post-acquisition taking this example in consideration

Transfer pricing issues when transfer of assets take place

Tangible Assets

Suppose Ranbaxy transfers finished generics medicines to Daichi in Japan for sale in Japan. Now how is the valuation to be done so as to optimize tax and avoid complex transfer pricing issues? Transfer pricing regulations of both the countries i.e. India and Japan should be taken into consideration. How can the valuation of finished goods be done

  • One possibility could be to determine the arm’s length price finished products by reference to comparable uncontrolled prices, to the extent the comparability factors can be met by such comparable uncontrolled prices, i.e. that the conditions of the uncontrolled transaction are comparable to the conditions of the transfer that takes place in the context of the restructuring
  • Another possibility could be to determine the transfer price for the finished products as the resale price to customers minus an arm’s length remuneration for the marketing and distribution functions that still remain to be performed.
  • A further possibility would be to start from the manufacturing costs and add an arm’s length markup to remunerate the manufacturer for the functions it performed, assets it used and risks it assumed with respect to these inventories. There are however cases where the market value of the inventories is too low for a profit element to be added to costs at arm’s length.

The transfer price should be set so that the profitability of a group as a whole is increased, tax authorities of India are satisfied and also the authorities in Japan are satisfied. Proper pricing is, therefore, important so as to save the time and resources and to avoid complexities of transfer pricing regulations.

Intangible assets

Suppose the Ranbaxy acquire rights of some patents and trademarks of Daiichi to produce drugs in India and sale in India. In this case, the determination of the arm’s length price for a transfer of patents and trademarks should take account of both the perspective of the transferor i.e. Daiichi and of the transferee i.e Ranbaxy. It will be affected by a number of factors among which are the amount, duration and riskiness of the expected benefits from the exploitation of the intangible property, the nature of the property right and the restrictions that may be attached to it (restrictions in the way it can be used or exploited, geographical restrictions, time limitations), the extent and remaining duration of its legal protection (if any), and any exclusivity clause that might be attached to the right. Valuation of intangibles can be complex and uncertain.

Transfer of activity (ongoing concern)

Business restructurings sometimes involve the transfer of an ongoing concern, i.e. a functioning, economically integrated business unit. The transfer of an ongoing concern in this context means the transfer of assets, bundled with the ability to perform certain functions and bear certain risks.

Example:
An example is the case where a manufacturing activity that used to be performed by Daiichi, is re-located to another entity, Ranbaxy (e.g. to benefit from location savings). Assume Daiichi transfers to Ranbaxy its machinery and equipment, inventories, patents, manufacturing processes and know-how, and key contracts with suppliers and clients. Assume that some of the employees of Daiichi are relocated to Ranbaxy in order to assist it in the start of the manufacturing activity so relocated. Assume such a transfer would be regarded as a transfer of an ongoing concern, should it take place between independent parties. In order to determine the arm’s length remuneration, if any, of such a transfer between associated enterprises, it should be compared with a transfer of an ongoing concern between independent parties rather than with a transfer of isolated assets.

Part III: Methods to be used for determining the transfer price

The arm’s length price is to be determined by adopting any one of the following methods, being the most appropriate method:

  • Comparable Uncontrolled Price method (CUP method)
  • Resale Price Method (RPM)
  • Cost Plus Method (CPM)
  • Profit Split Method (PSM)
  • Transactional Net Margin Method (TNMM)
  • Any other method prescribed by the Board

The Rule states that the method to be selected shall be the one best suited to the facts and circumstances of each international transaction and that provides the most reliable measure of the arm’s length price.

Specific factors that should be taken into account in the process of selecting the most appropriate method are as under:

  1. nature and class of international transactions;
  2. class or classes of associated enterprises and the functions performed by them taking into account the assets employed or to be employed and risks assumed by such enterprises;
  3. availability, coverage and reliability of data. For instance, data relating to transactions entered into by the enterprise itself would be more reliable than the data relating to transactions entered into by third parties;
  4. the degree of comparability and
  5. the extent to which reliable and accurate adjustments can be made to account for the difference between the transactions.

Let's take a example about how we can arrive at a transfer price which optimizes taxes

Conclusion

Thus TP issues should be on both pre- and post-restructuring checklists of priorities because such issues contain both opportunities and risks. Early TP analysis can allow the restructured business to integrate TP into its business plans and anticipate local difficulties. Very importantly, the early documentation of TP policy is an essential basis for effective TP risk management. TP is perhaps the most subtle yet an integral aspect of any restructuring deal that clearly demonstrates the intended synergies in a transparent and accurate manner. It’s both compensatory i.e. rewarding and de-risking.

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