Managing Recession from a Transfer Pricing Perspective

Vispi T. Patel
October 2009

Glossary and Abbreviations
BEP
CPM CUP GDP OECD TNMM TP Break Even Point Cost Plus Method Comparable Uncontrolled Price Method Gross Domestic Product Organisation for Economic Co-operation and Development Transactional Net Margin Method Transfer Pricing

Contents
Background of Recession Transfer Pricing in Recessionary Conditions Documentation Requirements Transfer Pricing Policy Review Case Study

Background of Recession

Recession!
What is Recession??
It is the economy shrinking for two consecutive quarters with a decrease in the GDP It may be preceded by several quarters of slow down It is the situation when it is difficult to drive growth with reduced savings, reduced domestic manufacturing capacity and reduced consumption

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Recession!
The shock of the current recession was sudden. All thanks to abundance of cheap credit for many years This so because research suggests that people don’t stop spending when they run out of money. They stop when they run out of credit. With sub-prime crisis, credit crisis, property values decreasing and credit cards at their limits, people were suddenly out of credit. This was the beginning of end of good times A single trigger point of default of home credit payments was enough for global economic crisis Before looking at the recession from a Transfer pricing perspective, let us first study the causes of prosperity and recession, which are nothing but the spiral effects of consumer confidence

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Recession!
5 Country becomes favoured destination for investment 3 Increased employment and spending by industry amounts to further consumption 1 Consumers feel confident in the future of the economy so they spend more

Upward Spiral – when all is well!

4 With feel good factor and increase in demand, stock markets rise overall

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2 In response to rise in demand, industry produces more, which means increase in employment levels and more consumption of resources

Recession!
1 Consumers lose confidence in the future of the economy so they spend less

Downward Spiral – when the economy has suffered major setbacks

3 Now people have less money to spend and debts mounting so they further reduce spending

2 In response to fall in demand, industry lays off employees and reduces production amounting to less consumption of raw material 4 Stock markets take a hit due to poor earnings of the industry

5 Country loses creditworthiness hence lower investments
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A Look at the Global Financial Indicators – Outcome of the Downward Spiral

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Is Transfer Pricing flexible enough to allow multinationals to adjust to the changing winds

How should Multinationals cope with the Transfer Pricing issues faced by them during the downturn

Transfer Pricing in Recessionary Conditions

Transfer Pricing issues specific to Recession
Transfer Pricing policy of the multinational is generally based on the underlying presumption of stability It is also based on the reasonable predictions or certainty of the future events Therefore, sudden uncertainty caused by the recession throws light on the loopholes in the Transfer Pricing policy of the Multinational Group. For Example:
It becomes difficult to split losses as compared to splitting of profits in the good times Pre-recession methodologies may not hold good in recession
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Transfer Pricing issues specific to Recession
Pre-recession benchmarking analysis may become ineffective for the following reasons:
CUP Method: change in the economic circumstances and business exigencies makes pre-recession CUPs unreasonable Cost Plus and TNMM: un-availability of the most recent comparable financial data reflecting current economic situation poses as a major concern for selecting the comparable results

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Transfer Pricing issues specific to Recession
Presents difficulties with profit-targeting for entities on CPM/TNMM benchmarking policies Some jurisdictions may have losses while others have taxable profits, deteriorating cash tax position Increasing transfer pricing audit risks

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Transfer Pricing issues specific to Recession
Recession creates business issues such as:
Operating Losses Reduction in force and plant closures Cash flow and debt service constraints Excess/obsolete inventory Credit crunch Analyses prepared in these circumstances will require careful consideration of attribution of risk and splitting of the losses These business issues impact transfer pricing, finance, and tax objectives, but can also create restructuring opportunities
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Issues specific to Recession – Captive units
India, a global off-shoring centre, has been facing tremendous pressure as the multinationals can not afford to continue to remunerate Indian captive centers at the same cost plus markup while the global system bleeds The recession creates a situation where entities bearing high risks, owning and developing IP, i.e. the valuable entities in the Group suffer huge losses whereas the other affiliates may remain profitable – Is this economically correct or it requires a review?
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Documentation Requirements
Consider whether any other method can now be more appropriate in the changed scenario Comparable set to take into consideration the companies that are equally impacted by the recession in the same period Adjust the financial results of the comparables to take into consideration the current economic conditions – industry specific analysis Document in a robust way the impact of recession Consider Year-end adjustments (True-ups) Keep in mind whether the change in the methodology / comparables can be consistently used for the post recession period
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Can Industry Use Recession to Re-engineer?

Recession – Review of TP Policy
Did recession force a company to change its business model?
No

Are the business conditions affecting company’s profitability?

No

Is the company open to restructuring its economic substance?

Yes

Yes

Formulate new TP policy

Review existing TP policy

Formulate new TP policy

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Case Study

Case Study
Utility Vehicles India Ltd (‘UV India’) is a well established leading utility vehicle manufacturer in the Indian market It has set up a subsidiary in Korea viz. Utility Vehicles Korea Ltd (‘UV Korea’) to target the utility car users and have a footprint outside India UV Korea manufactures, assembles and markets utility vehicles for which UV India supplies engines. To establish itself in the market, UV Korea has incurred a huge marketing cost Engines supplied by UV India form a major portion of the production cost of UV Korea Based on the economic Transfer Pricing analysis conducted by UV India two years back, it has set its TP policy to sell these engines to UV Korea at cost plus 10% . For this purpose, TNMM was considered as a most appropriate method

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Case Study
Due to the overall economic slowdown, the sales volumes dropped and hence UV Korea has suffered huge losses which could affect it’s very existence In view of sustaining this situation, UV India would like to assist its subsidiary i.e. UV Korea by way of restructuring the existing TP Policy in relation to supply of engines to UV Korea Therefore, now the question before UV India is:

Would TP allow it to supply engines at lower prices or at cost or free of charge considering the current economic condition of the subsidiary?

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Revival Plan – UV India’s Perspective
The revival plan envisioned should keep the TP Regulations and the audit experience of the multinationals in mind. It should involve…
Identification of constraints and their effect on the profitability
Strategic plan should dovetail into a ‘Benefit Test’ achievement from an Arm’s Length perspective

Determination of
various alternatives available under arm’s length scenario

New Transfer Pricing Mechanism

The resulting challenge for UV India is in trying to justify the new business strategy. This is where the appropriate and contemporaneous Transfer Pricing documentation comes into play which should clearly demonstrate how external factors have affected the business – production levels, sales volume, etc.
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Case Study
Accordingly, in the instant case, the Transfer Pricing Analysis for the purpose of revival plan should involve: The Benefit Test (taking into consideration the future strategy of the Group), How the strategy dovetails into the long term vision of UV India, and Profitability analysis (taking into consideration the financial data of the comparable companies)

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Profitability Analysis

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Profitability Analysis
The comparable data on the public domain shows the following results:
Sr. No. 1 Particulars Arithmeti Arm’s Length c Mean Price (%) 8% 108 (i.e. 100 + 8%) 105 (i.e. 100 +5% +/- 5% Price range 102.60 113.40 99.75 – 110.25

Comparable's results – using data pertaining to FY 200809 Latest available quarterly results data (April 2009 – June 2009)

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5%

The above analysis shows that the profitability of the comparable companies in India has come down drastically i.e. as low as 5% in the Q1 of the FY 2009-10 whereas yearly data shows the same at 8%
Quarterly results show more realistic picture than the yearly results as the yearly results include pre-recession period as well which is not comparable This analysis also shows that it is possible for UV India to supply engines at a lower markup. However, the same should also be corroborated by the future benefit test
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The Benefit Test

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Future Projections of UV Korea Business
In this regard, future profitability of the UV Korea under various percentage of markups can be analysed. Various scenarios that would arise in this case would be as follows: Scenario 1: If UV India continues to earn a current markup of 10% on cost of the engines supplied (in South Korean Won i.e. SKW) Projected Contribution and PBIT per unit (in SKW)
Particulars / Year 2009-10 2010-11 2011-12 2012-13 2013-14 2014-15 2015-16 2016-17 Life Cycle 2009-10 to 2016-17

Contribution per unit PBIT per unit

15,500

34,500

38,000

47,900

51,000

51000

51,000

51,000

44,500

(90,000)

(53,000)

(14,000)

5,700

9,500

9,500

9,500

9,500

(9,600)

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Future Projections of UV Korea Business
Scenario 2: If UV India reduces the profit markup on cost to say 2% to 4% Projected Contribution per unit (in SKW)
2009-10 2010-11 2011-12 2012-13 2013-14 201415 2015-16 2016-17 Life Cycle 2009-10 to 2016-17 59,500 57,600 55,700

2% 3% 4%

31,000 29,000 27,000

49,900 48,000 46,000

53,400 51,500 49,600

63,100 61,200 59,300

66,600 64,700 62,800

66,600 64,700 62,800

66,600 64,700 62,800

66,600 64,700 62,800

Projected PBIT per unit (in SKW)
2009-10 2% 3% 4% (75,000) (82,300) (89,000) 2010-11 (38,100) (40,000) (41,900) 2011-12 1,200 (600) (2,000) 2012-13 21,000 19,100 17,200 2013-14 24,500 22,600 20,700 2014-15 24,500 22,600 20,700 2015-16 24,500 22,600 20,700 2016-17 24,500 22,600 20,700 Life Cycle 2009-10 to 2016-17 5,300 3,500 1,600

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Future Projections of UV Korea Business
The analysis shows that if UV India continues to charge a markup of 10% on cost, UV Korea would continue to make losses over a life cycle i.e. 2009-10 to 2016-17 It also shows that reduction in profit mark-up at UV India level as contemplated by the management may have some effect on reducing losses at UV Korea level UV Korea subsidiary was set up by UV India mainly to expand its business in overseas territories and was guided by a long term vision of further expansion; hence, it is extremely essential for UV Korea to survive
Naturally, to sustain the situation and to makeup the huge losses already incurred, UV Korea requires support from UV India by way of reduction in the engine costs
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Future Projections of UV Korea Business
Break Even Point (BEP) under different situations Further, it has also been observed that the BEP[i.e. a point where the total costs are equal to revenue and hence there is no profit no loss situation] under different markups would be as follows:

Particulars / Year @10% @2% @3% @4%
Projected Sales

2009-10 32,366 16,165 17,244 18,478 3,980

2010-11 16,519 11,461 11,917 12,411 6,500

2011-12 15,531 11,089 11,500 11,942 11,350

2012-13 12,850 9,739 10,043 10,366 14,620

2013-14 11,925 9,234 9,502 9,786 14,620

2014-15 11,925 9,234 9,502 9,786 14,620

2015-16 11,925 9,234 9,502 9,786 14,620

2016-17 11,925 9,234 9,502 9,786 14,620

The above analysis shows the year wise BEP (units) achievable by UV Korea under different circumstances. However, it may be noted that the BEP can be achieved only in the year 2012-13 as in other cases projected units fall below the BEP
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Sustainability of the Reduction in the Markup
All the above profitability and BEP analysis show that UV India may have a good case to argue for changing the transfer pricing mechanism in relation to the export of engines to UV Korea in view of achieving its long term objective of doing business in Korea The reduction in profitability has to be supported by a robust documentation which should be able to demonstrate that the reengineering business strategy is in-fact the need of an hour and reflects mirror image of the market conditions The documentation should also include the projections of future situations as to how UV India is going to re-coup its investment in future; with a special emphasis on the future inflows of profit in different forms e.g. increase in price of the engines in later years, etc.

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Conclusion
Transfer Pricing law gives due importance to the changes in the economic conditions - OECD Transfer Pricing is flexible enough to take into consideration the changes in the economic conditions if structured appropriately - OECD However, robust documentation which brings out the impact of economic downturn, necessity of adjustment / changes, benefit test, etc. holds the key

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Thank You

Questions?

Contact : Vispi T. Patel +91 9867635555 vispipatel5@gmail.com