cost contribution arrangements, intra group services & intangibles – issues and way forward...

Cost Contribution Arrangements, Intra Group Services & Intangibles – Issues and Way Forward

Intensive Workshop on Transfer Pricing

28 October 2012

© 2011 KPMG, an Indian Partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.

Agenda

• Intra-group Services

• Intangibles

• Cost Contribution Arrangements (CCAs)

2•2

Intra Group Services


Definition of Intra Group Services

• Services performed by one member of a MNE for the benefit of one or more related members (located in different tax jurisdiction) of the same group

• Per the OECD Guidelines - An activity (e.g. administrative, technical, financial, commercial, etc.) for which an independent enterprise would have been willing to pay or perform for itself.

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Intra Group Services generally include…

• Planning

• Coordination

• Budgetary Control

• Financial advice

• Accounting

• Auditing

• Legal services

• Computer services

• Financial services

• Management and administrative services

• Purchasing, marketing and distribution

• Human resource services

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The Indian Approach

No specific provisions governing intra-group services are contained in Chapter X of the Income Tax Act, 1961

Indian tax authorities tend to follow the principles set forth in the OECD Guidelines

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The Indian Approach – Documentation

• Maintenance of service contracts including:

nature and extent of services to be provided;

basis for determining the fees to be charged; etc

• Maintenance of relevant documents to confirm rendering of services for the benefit of the recipient

• Maintenance of a detailed narrative of benefits received and supporting documents to identify services and prove non duplication of services, etc.


8

The Indian Approach – Illustrative Documentation

• Contract/ Agreement

• This would serve as a supportive document, highlighting the understanding and arrangement agreed between the related parties. Board authorization should be obtained

• Supporting Basis of charge

• This may either form part of the agreement or may be in the nature of mails, etc. determining the basis of charge. Certificate from an independent accountant certifying the basis of charge should be obtained.

• Evidencing receipt of services by the Indian entity

• This may be in the nature of emails, presentations, write-ups, etc. The write-ups may be made by management, say each department availing the services and should provide for the benefits, tangible or intangible, accrued as a result of availing such services

• Functional analysis of the respective parties

• This is basically to document functions performed, assets employed and risks assumed by the service provider and the service recipient.

• Supporting the Benchmarking analysis

• This will ideally form part of the Transfer Pricing Study Report


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The Indian Approach – Basis of Charge

Outbound Services• Cost plus Model– Determining cost base

Direct / indirect cost Management overheads Notional Cost

– Determining a mark-up

Comparison of captive unit with independent companies

Possibility of risk adjustment

• Hourly / Man Day Rate Model– Comparison of hourly rate charged in related and unrelated

transactions

– Adjustment on account of idle capacity/under-utilization of capacity


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The Indian Approach – Basis of Charge

Inbound Services

Benefit Analysis

Global transfer pricing policy

Documents evidencing services availed

Recovery

Pass through costsCosts for trial runs and initial setting up of business without

mark-up

Reimbursement

Documents evidencing benefits received by Indian entityBasis of cost allocation – hourly/personnel/ actual


The OECD Approach

• Whether intra-group services have in fact been provided?

• What should be the arm’s length price for the above services?

• Key considerations Would an independent enterprise pay for such activity?

Would an independent enterprise perform the activity in-house by itself?

Should the service be charged “at cost”?

Should an arm’s length mark-up be added?

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The U.S. Approach

• The Final Services Regulations (‘FSR’) are effective for taxable years beginning after July 31, 2009

• Taxpayers may elect to apply the FSR to taxable years beginning after September 10, 2003 :If election is made, all provisions of the Temporary Regulations will apply, i.e., no cherry picking of

provisions

Election applies to first year specified and all subsequent taxable years, e.g., if elected for 2004, also applies to 2005 and 2006

• The regulations are relevant to ‘activities’, broadly defined“includes the performance of functions, assumption of risks, or use by a renderer of tangible or

intangible property or other resources, capabilities or knowledge . . . .”

• A service renderer must charge for activities that provide a direct benefit to a controlled party (a “controlled services transaction”)


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The U.S. Approach

• Beneficial services do not include:Duplicative activities

Activities that only provide an indirect or remote benefit

Passive association

Shareholder activities

• Controlled services transactions must be charged at:An arm’s length price, orAt cost, under the Services Cost Method if the services qualify and if the taxpayer so elects

• Transfer Pricing Methods (TPM) for intercompany services:Services Cost Method

Comparable Uncontrolled Services Price Method (CUSP)Gross Service Margin Method (GSM)Cost Of Services Plus Method Comparable Profits Method (CPM)Profit Split MethodUnspecified Methods


Chargeable and Non-Chargeable Intra Group services

Chargeable services are those which provide a respective group member with economic or

commercial value to enhance its commercial position in the market that it operates

Non-Chargeable services include Shareholder activities and Duplicative services

• Shareholder activities - Activity that a group member performs solely because of its ownership interest in one or more of the group members. Examples could include:

Costs of visits and reviewing subsidiary performance on a regular basis

Costs relating to reporting and legal requirements of the parent company e.g. consolidation of financial accounts

• Duplicative services - If a group member duplicates a service already being performed by another group member. Examples of duplicative services could include:

Costs incurred by the parent on review of financial analysis made by subsidiary

Audit conducted by the parent to avoid risky or erroneous business decision

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Issues in Intra Group Services

• Determination of actual nature of intra group services and benefits received

• Determination of arm’s length charge based on the benefit received

• Maintenance of cost benefit documentation, cost base, cost apportionment, allocation methodology, allocation keys, etc.

• Substantiation of mark up, if any Based on mark-ups earned by comparable independent companies

Examination by revenue authorities whether basis of determination of mark-up is appropriate. Benchmarking analysis required.

• Recovery of costs without mark-up No significant value is added by intra-group services

Market value of the intra-group service is not greater than the costs incurred by the service provider in rendering this service

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Intra-Group Services – Basis of Charge

• Determination of mark-up for intra-group services Based on mark-ups earned by comparable independent companies Examination by revenue authorities. Basis of determination of mark-up appropriate

benchmarking analysis required.

• Recovery of costs without mark-up No significant value is added by intra-group services Market value of the intra-group service is not greater than the costs incurred by the service provider in

rendering this service.


Issues relating to Management Fee Payouts - An Illustration

Justification of the following aspects:

• Was there service received from Group

• Why not from third party

• Would there be same payment if rendered by third party

• Services rendered by group are not in the nature of stewardship, duplicative services

• Services in nature of back-office like accounting / payroll etc., being questioned that while others are off-shoring to India why taxpayer has to receive from Group

Challenge: Inadequate comparable data in the

public domain

Documentary evidence to substantiate management fees• Business reports

• Training manuals

• Marketing brochures

• Time sheets / logs

• Copies of emails

• Minutes of meeting confirming receipt of services

• HR Schemes

• IT network / e-mail systems

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Judicial Rulings - Gemplus (1/3)

• Taxpayer is a WOS of Gemplus, SA France

• Taxpayer entered Management Services Agreement with Regional HQ (AE)

• Marketing & Sales support

• Customer service support

• Finance, Accounting & Admin support

• Legal support

• As per taxpayer, billed on basis of time spent, subject to cap of $300K (Rs. 1.44 Crore)

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Judicial Rulings - Gemplus (2/3)

• Benefits for taxpayer: (i) commendable sales growth; and (ii) only employed handful of technical personnel

• TPO’s findings

(i) none of the comparables have paid management fee

(ii) taxpayer not established necessity of availing such services from AE – already has qualified personnel

(iii) Cost apportioned on mutually agreed basis, not on basis of actual services;

(iv) payments were excessive

• ITAT observed that taxpayer needs to establish that payments made against Management Services Agreement are commensurate to the volume and quality of services

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Judicial Rulings – Gemplus (3/3)

• Terms in Agreement are independent of the nature and volume of services rendered by Singapore AE

• ITAT upheld adjustment

• Expenses were allocations and not charged on basis of the actual services

• No details available as to nature of services rendered by AE

• Taxpayer not proved the commensurate benefits received for the service fees paid

Need to review arrangements w.r.t. intra-group services and strengthen documentation to

demonstrate compliance with ALP

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Judicial Rulings – Cheil Communications

Case Law Key Contentions of TPO / Taxpayer Ruling

Cheil Communications India Pvt Ltd

Delhi ITAT (I.T.A. No. 712/ Del / 2010)

The taxpayer rendered advertising and related services to its AEs. Its revenue comprised of advertising commission and service fees from jobs completed on behalf of its customers / AEs, as also the corresponding costs were disclosed ‘net’ of pass-through costs in the books of account.

The TPO rejected that approach of the taxpayer and held that the gross revenue and gross costs (including the pass through costs) should have been taken into account to compute the taxpayer’s net profit margin.

The Tribunal affirmed that it is appropriate to pass on the cost of renting advertising space, etc. to the customers / AEs without a mark-up, as the taxpayer has not performed any activity which added value to such costs and to apply a mark-up only to the costs incurred by the intermediary in performing its agency function.

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Judicial Rulings - McCann Erickson (1/2)

• Delhi Tribunal’s Ruling – Management services received from AE

The taxpayer had placed substantial evidence in respect of the management service charges and client coordination fee on record and had been able to establish the nature and benefits of services provided by the Associated Enterprise (AE). The tax department had not brought out anything to negate such evidence.

The taxpayer is engaged in only one class of business. There are no segments which can be said to be independent of each other. Entity level benchmarking using the Transactional Net Margin Method (TNMM) shall be most appropriate .

Considering the business environment of the taxpayer, it would be difficult to operate successfully without receipt of services which carry huge intrinsic and creative value. Only a business expert can evaluate the true intrinsic and creative value of such services.

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Judicial Rulings - McCann Erickson (2/2)

The Tribunal relied on the High Court judgment in the case of Hive Communication Pvt. Ltd. wherein it was held that the legitimate business needs of the company must be judged from the perspective of the company. It is not for the AO to dictate what the business needs of the company should be.

The term “benefit” to a company in relation to its business has a very wide connotation. It is difficult to accurately measure these benefits in terms of money value separately.

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Summary

Group Service Centre

Intra-group services / Beneficial Services

Non-beneficial Services

Chargeable

ServicesNon –

Chargeable

ServicesArm’s length mark-up determined based on:• Functional and

Economic analysis

• Availability of internal / external data

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Key Audit Issues – Services

• Management / Stewardship / Technical Services Benefits Test

Cost allocation / cost base working

Inbound / outbound services – No set off

Justification of mark-up – Routine services vs. value added services

Documentation


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Key Audit Issues – Services

• IT/ITES

Determining remuneration level for Captive Units Functional profile of Captive Units Captive services providers remunerated with a Cost Plus Mark-up, operating

in a risk-free environment Cost base an issue

Quantum of “Cost Plus Mark-up” Reference to profitability of third party service providers

• Third parties are Entrepreneurial enterprises Undertake full gamut of risks Entrepreneurial and economic risk adjustment not yet accepted

• Adjustments in Audits range from mark-up of 20% - 40%

• Concept of locational savings


Intangibles

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What Are Intangibles?

• Non-physical in nature

• Capable of producing future economic benefits (profit potential)

• Legally protected (brand name, patented formulae/processes etc.) or De Facto rights (know-how)

• Limited relationship with cost

• Generally need a long term evaluation

• Routine vs. Non Routine Intangibles

Generally, enterprises possessing non-routine intangibles are expected to earn above-average profits over a period of time

However, enterprises earning above-average profits may not necessarily possess

valuable intangibles

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Intangibles Categories

• Technology Intangibles

Patented processes/ Formulae/ Designs/ Models

Unpatented processes

Know-how

• Marketing Intangibles generally associated with

Brand name

Trade name / Trademarks

Copyrights

• Others (Customer lists/ Customer relationships, Supplier relationships, Contractual relationships)

• Goodwill

• Workforce in place

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How are Intangibles created and who owns them?

30


Indian Tax Regulations• Finance Act 2012 amendment the definition of the

term ‘international transaction’ to include “purchase, sale, lease or use of intangibles (wref from April 2001)

• Definition of the term ‘intangible’ specifically inserted – coverage significantly wide

• Under transfer pricing related rules, the definition of 'property' includes 'intangible property'. In clause 9 of the Form No. 3CEB, transactions in intangible property (IP) are described as those which relate to 'know-how, patents, copyrights, licenses etc'.

Intangibles under Indian Transfer Pricing

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OECD Guidelines (1/2)

Chapter VI of the OECD Guidelines defines intangibles as the assets that may have considerable value and risks (book value not essential).

• Trade Intangible

An intangible used in commercial activities such as the production of a good or the provision of a service, as well as an intangible right that is itself a business asset transferred to customers or used in the operation of business.

• Marketing Intangible

An intangible that is concerned with marketing activities, which aids in the commercial exploitation of a product or service and/or has an important promotional value for the product concerned.

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OECD Guidelines (2/2)

OECD Discussion Draft on intangibles

•OECD released a discussion draft on July 2012 in respect of revisions to be made to the existing commentary on transfer pricing aspects relating to intangibles

•Significant changes proposed to the existing commentary

•Comments received by the OECD from various stakeholders worldwide – comments published and released by the OECD in September 2012

•Comments being presently discussed by the OECD – final commentary expected shortly

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Why value Intangibles ??

• Buy-in to an existing cost contribution arrangement

• Royalty for a licensing transaction

• Tax restructuring (IP base shifting, acquired IP shifting etc.)

• Exit cost

• Other purposes

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Valuing Intangibles

Factors influencing Valuation• Strength and enforceability of legal protection

• Risk of future litigation

• Specified legal life

• Life cycle

• Expected remaining useful life

• External commercialization opportunities

OECD TP Guidelines • consider usefulness of intangible property to

associate enterprise (AE)

• consider perspective of transferor and transferee.

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Valuing Intangibles

As per - OECD TP Guidelines –• Examine price at which comparable independent enterprise would be willing to

transfer property.

• From transferor’s perspective – highest price

• From transferee’s perspective, whether comparable independent enterprise would be prepared to pay such a price, depending on the value and usefulness of the intangible property to the transferee in its business.

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Discussion draft on revision guidelines issued – in the process of being finalised


Valuing Intangibles – various approaches

Market Approach• Estimates the value based on current purchases and sales of similar

assets.

• At what price would independent parties buy/sell comparable intangibles?

• Generally, absolute price measure is not used for comparability reasons and lack of information.

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Income Approach• Estimates value by calculating present worth of future benefits expected to be

derived from use /ownership of asset;

• Future benefits can include earnings, cost savings, tax deductions, proceeds from disposition etc.

• Generally uses Discounted Cash Flow (DCF) analysis.

• Under DCF analysis, expected cash flows are discounted to their present value equivalents - at a rate of return that is commensurate with the underlying risk of the cash flows.

• How much additional income or cost savings would a comparable intangible generate?

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Cost Approach• Based on principle of substitution -assumes a prudent investor would pay no

more than cost to replace an asset with one of similar utility.

• Requires restatement of historical cost incurred in development of the asset to fair market value, along with revision of cost assumptions (if necessary).

• Generally least preferred method, as cost do not necessarily correlate with expected benefits.

• What would it cost to replace the intangible being valued?

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Marketing Intangibles – General Concept (1/2)

Principal Co

Entrepreneur

Indian Sub Co

DistributorIndian

Customer

INDIA

Distrib

utio

n R

igh

ts

Bra

nd

Flow of Legal title of Goods

Physical movement of Goods

Regional intangible created if Indian Sub Co. incurs non routine AMP

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Economic concept – no legal ownership or legal protection

Derived from valuable marketing activities performed for developing / maintaining a brand or brand

Created by the entity that invests to give the brand or trademark its value

High marketing expenditure by a subsidiary is increasingly being scrutinized by revenue authorities – The authorities are either

a) Disallowing AMP expenditure of distributor

b) Deeming a service fee for the marketing effort

c) Expect higher marketing margins as return for investment

Marketing Intangibles – General Concept (2/2)

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Three Cheese Examples in U.S. 482 Regs

FP a well known cheese manufacturer (but unknown in U.S.) enters the U.S. market and incorporates a U.S. Sub for developing the U.S. market:

Example 1 – U.S. Distributor Sub incurs normal marketing expenditure

Example 2 – U.S. Distributor Sub incurs higher than normal marketing expenditure

Example 3 – U.S. Distributor Sub enters long term agreement with Parent and acquires exclusive right to distribute cheese in the U.S. under FP trademark

Does U.S. Distributor Sub need to be compensated?

Similar Guidance from Australian Tax Office (ATO)

Marketing Intangibles – International Guidance

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Illustration 1A

USCo

IndCo

Facts

•USCo is a U.S. manufacturer of goods and is the registered owner of the trade name

•IndCo, a wholly-owned distributor in India, incurs AMP consistent with that incurred by independent distributors

•IndCo does not pay any royalty to USCo

•USCo does not reimburse IndCo for AMP expenditure

Question

•Is any TP adjustment warranted in India in relation to IndCo’s marketing efforts?

Supply of luxury goods

Payment for imports

IndCo incurs AMP

locally

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Illustration 1B

USCo

IndCo

Facts

•USCo is a U.S. manufacturer of goods and is the registered owner of the trade name

•IndCo, a wholly-owned distributor in India, incurs AMP significantly higher than those incurred by independent distributors

•IndCo does not pay any royalty to USCo

•USCo does not reimburse IndCo for AMP expenditure

Question



Payment for imports

IndCo incurs significant

AMP locally

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Illustration 1C

USCo

IndCo

Facts

•Same as 1B, except as below

•IndCo and USCo enter into a long-term agreement wherein:

IndCo receives an exclusive distribution right for India region using USCo’s tradename

IndCo to incur AMP expenses locally with no reimbursement from USCo

Question



Payment for imports

IndCo incurs significant AMP

locally

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•Suzuki Motor Corporation, Japan

•Maruti Suzuki India Limited, India

The taxpayer is a joint venture company in India of Suzuki Motor Corporation (‘SMC’), Japan

Engaged in manufacture of automobiles and its spares and components

SMC granted composite license in 1992 for technical-know how and use of Suzuki (“S”) trade-mark under an agreement

The taxpayer paid a recurring royalty besides lump-sum payment

Taxpayer started using the logo “S” in new cars after 1993, instead of the logo “M” initially used

The TPO allocated 50 percent of royalty amount as being paid for use of trade-mark and ALP of the same to be NIL

‘Bright Line Test’ – TPO contended that taxpayer incurred advertisement expenses for SMC and not been compensated on ALP for developing “Suzuki” brand name in India

Maruti Suzuki (Delhi High Court and Supreme Court) – (1/3)

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Delhi High Court’s (HC) ruling – Marketing Intangibles Principles:

• Transaction relating to marketing intangibles to be viewed in context of market conditions

• If use of foreign trade mark is mandatory, compensation for marketing intangibles to be paid by foreign AE to domestic entity

• A domestic company is entitled to receive compensation for value creation and incremental mileage for foreign brand

• Bright-line test for AMP expenditure to be viewed in conjunction with benefits-n-burden test

• To determine the adequacy of AMP expenditure, it is necessary to identify appropriate comparables

• The HC set aside the order and directed the TPO to determine the appropriate ALP based on the above

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The Supreme Court:

• Observed that the High Court has not merely set aside the original show-cause notice but has made certain observations on the merits of the case and has given directions to the TPO in the nature of guiding principles

• Directed the TPO to decide the matter in accordance with law and uninfluenced by the above observations/ directions given by the High Court

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Dispute involved sale of GSK heritage products (mainly ulcer drug “Zantac”) in U.S.

U.S. IRS view

Glaxo U.S. (distributor in the U.S.) should have retained a larger share of the profits attributable to the U.S.

Glaxo U.S. had made significant contributions to develop valuable sales and marketing intangibles in the U.S.

Medical Detailing performed by Glaxo U.S. had created values in the U.S. market

Glaxo U.S.’ payment to Glaxo UK for product intangibles and trademarks too high

Settlement

Dispute settled before it could go to trial

GSK agreed to settle the case with the U.S. IRS be paying $3.4 billion in back taxes (in effect conceding to 60% of the U.S. IRS’ claim)

Glaxo Smithkline – U.S. Dispute

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Compensation by brand owner for the entity developing the same

Should the marketing subsidiary be compensated as a service provider, i.e. for providing promotional services?

Should the marketing subsidiary share in any additional return attributable to the marketing intangible? How should the return attributable to the marketing intangibles be identified?

If the marketing activities are successful, how should the resulting profit be divided between the subsidiary and the trademark legal owner ? If unsuccessful, who should bear losses ?

Economic / Legal ownership – compensation due to legal owner?

Bifurcation of AMP expenditure between routine and non routine expenditure

Bright-line test - While every licensee or distributor is expected to expend a certain amount of cost to exploit the items of intangible property to which it is provided, it is when the investment crosses the ‘bright line’ of routine expenditures into the realm of non-routine that, economic ownership likely in the form of a marketing intangible, is created.

Points to Evaluate

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Royalty payouts

Issues relating to Royalty pay-outs:

Royalty is widely adopted appropriate mechanism to compensate for use of manufacturing intangible

Benchmarking Issues:

• Limits specified by RBI and FEMA not considered as external CUP.

• Aggregation approach under TNMM – Challenged and general lack of availability of comparables

• Transaction specific approach has been adopted by revenue – examine the ‘cost – benefit’ analysis

Is Royalty Payment justified in case of loss situation?

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Royalty payouts – Points to Ponder

• Documentary evidence

• Benefits received / receivable by the taxpayer and quantification of the benefit

• Unique nature of the intangible, market where it is used and strategic advantage achieved

• Rights of the taxpayer to receive upgrades

• Comparative profits before and after use of the intangible

• Whether there are any geographic restrictions such as to export based on the licensed technology

• Rates at which the royalty is paid for use of similar intangibles by any other concern / subsidiary of the AE / Group

• Benchmarking royalty payouts based on global databases

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Judicial Rulings - EKL Appliances Ltd. (1/2)

Delhi High Court’s Ruling – Payment of Royalty to AE

• It is not for the Revenue authorities to dictate to the taxpayer how he or she should conduct his business and what expenditure should be incurred.

• It is not necessary for the taxpayer to show that any legitimate expenditure incurred by him or her :

was also incurred out of necessity or

that the expenditure incurred by him or her for the purpose of business has actually resulted in profit or income.

• The taxpayer only needs to show that the expenditure should have been incurred “wholly and exclusively” for the purpose of business.

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Judicial Rulings - EKL Appliances Ltd. (2/2)

• The amount of expenditure can be examined by the TPO but he or she has no authority to disallow the expenditure on the basis that the taxpayer has suffered continuous losses.

• The High Court also relied on the OECD Guidelines: Tax administrations should not disregard and restructure the transactions as actually undertaken by the taxpayer except

where the economic substance of a transaction differs from its form; and

where the form and substance of the transaction are the same but arrangements made in relation to the transaction differ from those which would have been adopted by independent enterprises behaving in a commercially rational manner

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Judicial Rulings - Sona Okegawa Precision Forging (1/2)

• Taxpayer paid royalty and technical service fee to AE

• Justified using CUP Method, relying on ceiling under erstwhile FEMA regulations

• Royalty paid on total sales (i.e. sales to AEs and third parties)

• TPO made adjustment

• (i) no actual third party transaction so there is no CUP as such

• (ii) as royalty is also paid on sales to AE, it is not compliant with ALP

• (iii) disallowed technical service fee

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Judicial Rulings - Sona Okegawa Precision Forging (2/2)

• ITAT ruled in favour of the taxpayer

• Royalty computed based on sales made to AE is at arm’s length as the taxpayer is a full Entrepreneur and not a Contract Manufacturer

• Royalty was recovered by the taxpayer from the AE as part of the sale price and thus the transaction was revenue neutral

• Technical service fee justifiable since it is payable under the know-how license agreement and is not the responsibility of the AE under the royalty agreement

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Judicial Rulings - Abhishek Auto Industries (1/2)

• Taxpayer is a manufacturer of car seat belts – International transactions with AE include imports of RM; and availing of know-how from AE

• Taxpayer contention - since the payment for royalty & technical fees was made in accordance with the agreements approved by regulatory agencies, the question of arm’s length consideration does not arise

• Taxpayer undertook a gross level comparison of AE and non-AE operations to demonstrate compliance with arm’s length

• TPO rejected the taxpayer’s analysis:

(i) Applied TNMM and made adjustment to taxpayer’s margins on a company-wide basis

(ii) Contended that there was no transfer of technology, accordingly treated ALP of the royalty and technical know transaction as Nil

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Judicial Rulings - Abhishek Auto Industries (2/2)

• CIT(A) enhanced based on updated margins of comparables

• Tribunal ruled in favor of the taxpayer

(i) Tax authorities erroneously disregarded royalty & technical knowhow agreement merely by pleading absence of commercial need

(ii)Commercial expediency is the domain of the taxpayer

(iii) Legally binding agreements which are also approved by regulatory agencies cannot be disregarded without assigning cogent reasons

(iv) Not alleged by the Revenue that the agreements were non-genuine or sham

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Cost Contribution Arrangements


Cost Contribution Arrangement – An Introduction

• A Cost Contribution Arrangement (CCA) is a contractual agreement among business enterprises to share costs and risks for

Developing, producing or obtaining assets,

Providing services or rights, and

For determination of nature & extent of the interests of participants in those assets.

Definition :

“A CCA is a framework agreed among business enterprises to share the costs and risks of developing, producing or obtaining assets, services, or rights, and to determine the nature and extent of the interests of each participant in those assets, services, or rights.”

-OECD Transfer Pricing Guidelines (Para 8.03)

• Commonly observed for joint development of intangibles and management fees ,it can also exist for any joint funding or sharing of costs and risks, for developing or acquiring property or for obtaining services.

• Many countries broadly follow the OECD approach to CCAs, but there are also many countries that treat CCA’s in the same way as they do any inter-company recharge of costs.

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Cost Contribution Arrangement – An Introduction

Wherein :

• XYZ Ltd. is a R&D centre

• A,B,C,D & E are participant entities at various geographical locations

• A,B,C,D&E bring in consideration in return for the Technical know how they get from XYZ Ltd.

• A,B,C,D & E share the cost & risk of XYZ Ltd.

• On entering a contractual framework it becomes a CCA.

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Two principal types of CCAs

R&D CCA Pure Services CCA

Example • Pharmaceutical industry • Procurement service

Commercial rationale

• Spread and share risk of commercial failure/financial loss

• Share costs with view to saving money

Type benefit • IP • Receipt of services e.g. centralised management services

Expectation of benefit

• Mid-long term

• Benefits from successful CCA activity e.g. future sales

• Immediate-short term

• Normally realised in period that service performed (costs incurred)

Degree of risk involved

• Significant risk of commercial failure • Low risk of commercial failure

Types of CCA

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Transfer Pricing Implications

• Determination of Participants

• Buy-in / Buy-out Adjustments

• Balancing Payments

• Determination of cost base

• Appropriateness of allocation & contribution

• Consequences of a non-ALP CCA

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Determination of Participants

Who is a Participant?

A Participant: • Must be assigned a beneficial Interest in the results of CCA

• Have a reasonable expectation to exploit the interest assigned either directly or indirectly

• Must share the Profit & Loss arising on account of a CCA

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Buy-In adjustments

What is a buy-in payment?

Payment to already existing CCA by other new participants for the use of intangibles developed or acquired outside the CCA

Definition :

“The term “buy-in payment” is limited to payments made by new entrants to an already active CCA for obtaining an interest in any results of prior CCA activity.”


Treatment of Buy- in Payments / Receipts:• In the hands of payer -Treated for tax purpose as if payments were made outside the CCA framework for

acquiring the interest

• In the hands of payer - Buy –in payment will not constitute as Royalty except where participant obtains right

to use the IP and doesn’t get the beneficial interest in such IP

• In the hands of Recipient – Buy –in payment received will be treated as taxable income

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• Transfer previous knowledge / IP to the new entrant

• Bring their own existing IP / interests into the CCA – Netting is permitted

• Transfers should be rewarded at arm’s length

• Where the CCA is for the provision of services, a Buy-Out / Buy-In payments may not be needed

• Absence of express terms does not prevent a CCA from being considered to exist

• Payment can be

• Lump sum or

• Installment payments on lump sum, with arm’s length interest

Buy-In adjustments – Key Features

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What is a buy-out payment?

Payment made to/by participant at the time of disposal of interest in past activity of CCA is known as buy-out payment.

Definition :

“If there is an effective transfer of property rights at the time of a participant’s withdrawal, the transfer should be compensated according to the arm’s length principle. This compensation is called a “buy-out” payment.”


Treatment of Buy- out Payments / Receipts:

• In the hands of Recipient – it will be treated in same manner as consideration received on disposal of rights in IP

• In the hands of payer – as if payment were made outside the framework of a CCA for purchase of rights in IP

Buy-out adjustments

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• Transfer of interest in the expected results of the CCA

• Compensation should consider the impact on the remaining CCA participants

• Payment must be commensurate with the increase in value of the remaining participant’s consequent to withdrawal

• At termination, CCA members should receive an interest in the benefits gained from the CCA that is consistent with their contributions throughout the life of the CCA

• No Buy-out payment in the following cases:

When the results of the prior CCA activity do not have any value

Where the participants withdrawal results in an identifiable & quantifiable reduction in the value of IP/Assets.

Buy-out adjustments – Key Features

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Balancing Payments

What is Balancing Payments?

When a participant’s share of expense is reduced as a part of the review or when a CCA receives a payment from participant when his share increases its called as Balancing Payment /Receipt.

Need for Balancing Payments

• Economic life of the intangibles extend into future & estimation of the accrued benefit is uncertain

• Periodic review of the expected benefits (based on changed circumstances)

• Comparison of the actual results to the Ex-Ante expectation of benefits

Treatment of Balancing Payments :

• Treated as an addition to the costs of the payer and as a reimbursement (and therefore a reduction) of costs to the recipient.

• When Balancing Payment > Recipient’s allowable expenditure /cost, then the excess over the allowable expenditure will be treated as taxable profit.

• US regulation requires truing up of expected benefits from the projected benefits to the actual outcome – where actual outcome is 20 percent > projected benefit.

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Determination of cost base

Definition of Cost:• Costs associated with advertising, promotion, sales, marketing, warehousing, distribution and general

administration, but excluding depreciation or amortization expense, plus the charge for the use of any tangible property made available to the qualified CCA.

• All stock-based compensation that is granted to the employees of CCA during the term and which is related at date of grant to the development of intangibles covered by the CCA arrangement is included as part of cost.

As per OECD Guidelines • Any contribution into the CCA activity (except cash) must be at market value

• Applying normal Transfer pricing principles

• Must consider the rational that 3rd party cannot be expected to contribute to CCA activity on a non-arm’s length basis.

Passing on R&D credits/other fiscal incentives by reducing the cost contribution depends on whether independent entities in comparable circumstances would have passed on such savings

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Appropriateness of allocation & contribution

• Allocation of intangible development expense among participants is based on the Allocation Key.

• Allocation key should be devised in line with the share of benefits to be obtained by each participant

Direct Method

Estimated additional income to be generated or costs to be saved by each participant as a result of the arrangement (using projected figures)

Indirect Method

Sales

Units used/produced/sold

Gross or Operating Profits

Number of employees

Capital invested

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Appropriateness of allocation & contribution

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• Determination of cost allocation is an uncertain exercise as there is a possibility that the taxable profits in some countries might be over stated and vice versa. Hence taxpayer must be prepared to substantiate the basis of allocation key.

• Whatever is the allocation method , adjustments must be made for differences in the expected benefits to be received by the participants. e.g. in the timing of their expected benefits


Consequences of a non-ALP CCA

• The tax authorities may disregard part or all of the terms of a CCA or adjust the participant’s contribution by the technique of Balancing Payments under the following circumstances:

Facts and circumstances indicate that the reality differs from the terms purportedly agreed by participants

Substantial discrepancy or disproportion between purported contribution and benefits over time

CCA is not based on a sharing of costs, i.e. in service situations

Non-commerciality - CCA designed just for tax purposes

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Glossary

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Abbreviations Full Name

AE Associated Enterprise

A&M Advertisement and Marketing

CCA Cost Contribution Arrangement

DCF Discounted Cash Flow

HC High Court

IP Intangible Property

SCM Supply Chain Management

LRD Limited Risk Distributor

TESCM Tax Efficient Supply Chain Management

OECD Organization for Economic Cooperation and Development

RBI Reserve Bank of India

Abbreviations Full Name

TNMM Transactional Net Margin Method

R&D Research and Development

MNE Multinational Enterprise

FEMA Foreign Exchange Management Act, 1999

HR Human Resources

IT Information Technology

TPO Transfer Pricing Officer

AO Assessing Officer


Questions

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&

cost contribution arrangements, intra group services & intangibles – issues and way forward...

Documents

administrative services

intra group services

extent of services

rendering of services

duplication of services

indian partnership

swiss entity

indian tax authorities