Reproduced with permission from Transfer Pricing Forum, null, 10/16/2012.

Copyright 2012 by The Bureau of

National Affairs, Inc. (800-372-1033) http://www.bna.com
India
Sanjay Tolia, Tarun Arora, Ruhi Mehta and Shikha Gupta,
Price Waterhouse & Co., India
Cheil India Private Limited
1.
W
ith regard to the Delhi Tribunal ruling in
the case of Cheil India on pass-through
costs of agents/ intermediaries:
a. How would non value-adding/ pass through costs
be dealt with for the purpose of computing operat-
ing protability, e.g. costs related to advertisement
placement/ obtaining advertising space on behalf
of customers incurred by advertising agencies, or
payments made to clinical research organisations/
external agencies by pharmaceutical companies,
or third party vendor costs incurred for facilitating
logistics, etc ?
b. How would aspects such as risks, level of func-
tions, etc. carried out by the taxpayer in order to
conclude which activity/ cost could qualify as non
value-adding or pass through in nature, be
determined?
Non value-adding expenses/ pass-through costs are
those expenses/ costs which are incidental or ancillary
to the primary business activity of a taxpayer and in
respect of which the taxpayer typically neither per-
forms any signicant functions nor assume any risks
thereof. Accordingly, pass-through costs do not
qualify to be considered as a part of operating costs by
taxpayers, while computing the operating protabil-
ity, since these costs are incidental or ancillary to the
primary business activity of a taxpayer. In such situa-
tions, dealings with AEs should be tested by using the
PLI of OP/ VAE.
Under the Indian transfer pricing (TP) regulations,
the determination of an arms length price in relation
to an international transaction under the TNMM is
determined with reference to the net prot margin re-
alised by the enterprise computed in relation to costs in-
curred or sales effected or assets employed or to be
employed by the enterprise or having regard to any other
relevant base. Though the Indian TP regulations do
not specically provide any guidance on denition of
costs/ relevant base while computing the operating
protability of the taxpayer, the Guidance note on
transfer pricing issued by the Institute of Chartered
Accountants of India (ICAI) species certain ratios
that may be used to determine the arms length price
while applying the TNMM; viz the Berry ratio being
one of them. Thus, OP/ VAE being a variant of the
Berry ratio to this extent does nd a place in the
Indian legislative framework on transfer pricing.
The OECD guidelines 2010 contain clear directions
on the treatment of pass-through costs and the ruling
in the case of Cheil India is the rst ruling in India
which deals with the issue of pass through/ non-value-
adding costs. This ruling extensively relies on the
OECD guidelines and establishes the fundamental
principle that while applying a cost based remunera-
tion model, a return or mark-up is appropriate only
for value-adding services/ costs.
The issue is whether a taxpayer entity which is not
involved in undertaking a particular activity/ service
on its own and does not assume any risks on account
of such service/ activity/ cost should be expected to
earn a mark-up/ return on such costs. The Delhi Tribu-
nal in the case of Cheil India (which is an advertising
agency) noted that Cheil India facilitates the place-
ment of advertisements for its customers/ AE for
which it makes payments to third parties for renting
advertising space on behalf of customers/ AEs and it
recovers all the payments made to the third party
vendors/ media agencies from the customer/ AE and
also does not assume any risk of non-payment by the
customer/ AE.
Based on the detailed factual representations made
before the Tribunal, the Tribunal noted that the adver-
tising space is let out by the third party vendors di-
rectly in the names of customers/ AEs, who only
nalise the terms of advertising. Such third party pay-
ments do not represent value-adding functions of the
Indian taxpayer and therefore should not be consid-
ered for the purpose of determining the operating
protability of the Indian taxpayer entity. The Tribu-
nal accepted that in Cheil Indias case, a mark-up is to
be applied on the costs incurred by the taxpayer in
performing the agency functions and not on the gross
media expenditure.
The Tribunal endorsed the OECDs view that while
applying the TNMM, the costs to be considered
should be the costs incurred in relation to the value-
adding activity, i.e., the costs related to the agency
function in Cheil Indias case (i.e. advertising ser-
vices). As per the OECD, in applying the TNMM, the
costs to be considered for the purpose of applying a
mark-up should be determined on the basis of the
value added to the business operations by the tax-
payer entity. It is appropriate for a company to pass on
the costs of renting advertising space on behalf of its
AE (which it would have incurred directly had it been
independent) to the AE without a mark-up, and to
apply a mark-up only on the costs incurred by the in-
termediary in performing its agency function. The
principle has also been accepted by the renowned
economist, the late Dr. Charles H Berry, while formu-
lating the concept of the Berry ratio. In one of his ar-
10/12 Transfer Pricing Forum BNA ISSN 2043-0760
1
ticles, the case of advertising agencies has been
deliberated wherein it has been concluded that the
cost related to advertisement placement (purchase of
advertising space) is a measure of service(s) provided
by the media agencies and not by the advertising
agency.
The Cheil India ruling therefore lays down an im-
portant transfer pricing principle that keeping in view
the functions assets and risks (FAR) prole, a tax-
payer should not be expected or entitled to earn a
mark-up on pass-through costs, which would have a
favourable impact for taxpayers in other industries as
well. For example, in the pharmaceutical industry
R&D and clinical trial companies typically outsource
the actual research/ trial activity to third party clinical
research organisations (CROs) involving substantial
costs. The role of the taxpayer entity is generally lim-
ited to providing support/ facilitation services for the
clinical research activities conducted by such third
party CROs/ institutions, etc. In such cases, the com-
pany does not have the capability to perform clinical
trials itself but only procures these services from third
parties. Since these are essentially non value-adding
costs for a pharmaceutical company, such costs may
be treated as a pass-through cost and not included in
the operating prots of the taxpayer.
While evaluating whether a cost qualies as pass-
through or not, the taxpayers answer lies in distin-
guishing its FAR vis-a` -vis that of the AE in respect of
these costs. The differences that are critical to demon-
strate include the following:
s the taxpayer does not add any value and only plays
the role of a facilitator while the other transacting
party is the entrepreneurial risk taker in relation
to such costs;
s the taxpayer simply performs the role of an agent
who acts on behalf of and under the control of the
other party, who is the real beneciary and ap-
prover of such third party costs; and
s the taxpayer assumes no risks in relation to such
pass through costs and activities (including results
of performance, and success/ failure of such activ-
ity)
Therefore it is advisable for the taxpayers to main-
tain robust documentation to substantiate the above.
A comprehensive inter-company agreement with the
AE along with any other internal correspondence,
which clearly brings out the nature of the costs, the
precise role of the taxpayer, and the rationale for such
an arrangement should be maintained. Further, where
possible, market data/ information corroborating the
practice followed by the taxpayer to be in line with
that followed by other players in the industry should
be collated.
Moving to question 1.b., while representing the
case, the FAR prole of Cheil India was clearly
brought out before the Tribunal which was well ap-
preciated by the Tribunal. Some of the critical factual
representations made in the matter were:
s Cheil India operates as an agent of the customer/
AE and the relationship does not constitute a Prin-
cipal to Principal relationship. As part of its busi-
ness operations, Cheil India facilitates the
placement of advertisements (for its customers/
AEs) in the print, electronic etc., media.
s To this end, it is required to make payments to third
parties like advertisement agencies, printing
presses, etc., for the renting of advertising space on
behalf of its customers. Such payments are fully re-
covered from the respective customers/ AEs.
s Cheil Indias business is the provision of advertising
and related services and not the sale of advertising
slots to customers.
s Advertising agencies/ companies simply act as in-
termediaries between the ultimate customer and
the third party vendors in order to facilitate the
placement of advertisements. The advertising com-
panies are compensated for their efforts and costs
relating to the provision of advertisement services
on the basis of an agreed commission xed as a per-
centage of the gross media spend for the release of
a particular advertisement.
s Cheil India submitted all relevant documents like
invoices and agreements supporting the above
claims. The Tribunal made a note of the contentions
and documentation and based on the same decided
the case in favour of Cheil India.
From the above it can be seen that aspects such as
risks, level of functions, etc. carried out by the tax-
payer in order to conclude which activity/ cost could
qualify as non value-adding or pass-through in nature
were demonstrated and evaluated in detail by the tax-
payer and considered by the Tribunal in framing their
conclusion. It is therefore imperative for taxpayers to
demonstrate their level of functions and risks with re-
spect to the costs being claimed to be non value-
adding. As an example, in the pharmaceutical
industry, the following functions/ risks are generally
performed by a company acting as a facilitator for
clinical research activities:
s the taxpayer acts as a low risk service provider
merely performing the function of a facilitator;
s such services are typically procured from a third
party, central research organisation (CRO);
s the taxpayer does not assume responsibility for the
quality/ success or failure of the services performed
by a third party CRO;
s the taxpayer does not assume the risk of drug
failure/ adverse side effects, this risk being borne by
an overseas AE which is the ultimate sponsor of the
trial;
s taxpayer does not have the required assets, infra-
structure or technical personnel to perform clinical
trials itself; and
s as per the job description of the employees of the
company, they are expected to perform merely a su-
pervisory role.
In such a situation:
s The taxpayer may be acting as a mere facilitator for
the clinical research activities carried out by the
third party CROs.
s The taxpayer is liable to pay any amount to such
third parties when the same is recovered from the
relevant customer/ principal and does not assume
any risk on this account (for example by taking ad-
vance payment).
This is a suitable example of the globally accepted
term/ concept of pass-through costs.
Thus, if the acceptability of application of OP/ VAE
as a PLI is challenged, it is imperative for the taxpayer
to demonstrate (by way of a robust, well documented
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transfer pricing policy) a thorough and comprehen-
sive FAR analysis of the taxpayer vis a vis its AEs
which takes into account critical considerations like
risks assumed and level of functions of the taxpayer.
Wrigley India Private Limited
2. With regard to the Delhi Tribunal ruling in the case of
Wrigley, which compared licensed manufacturing
margins for domestic business with contract manu-
facturing margins for export business:
a. For the purpose of comparability, how would tax
authorities of your country deal with the evalua-
tion of different business segments of a taxpayer
wherein the FAR proles and business models of
the segments have differences in the level of func-
tions performed and risks assumed by companies
in relation to end customer facing businesses,
where they act as entrepreneurs (exploiting trade
and marketing intangibles), as opposed to when
they deal with related parties, say in the capacity of
contract manufacturers ?
b. In the situation referred to in Question 2.a. above,
would tax authorities of your country compare
the margins of the two business segments by
making rule of thumb adjustments for differences
in FAR proles or refrain from comparing the
margins of the licensed manufacturing or domes-
tic business with those of the contract manufac-
turing business?
The basic requirement of any transfer pricing (TP)
analysis is to select uncontrolled transactions after
undertaking a detailed FAR analysis. Needless to add,
undertaking a comparison of the functional prole of
the tested party with that of the comparable
companies/ transactions is the bedrock of a
benchmarking/ economic analysis.
The Indian TP regulations contain guidance on the
importance of a FAR analysis while undertaking the
TP analysis. Rule 10C(2) of the Income-tax Rules,
1962 (the Act) provides that in selecting the most ap-
propriate method, factors like the class or classes of as-
sociated enterprises entering into the transaction and
the functions performed by them, taking into account
assets employed or to be employed and risks assumed by
such enterprises should be taken into account. How-
ever, the guidance provided in the Indian TP legisla-
tion is constrained/ limited in sphere and depth.
The Delhi Tribunal in the case of Wrigley India has
compared the margins earned by the company from
its licensed manufacturing domestic business with
those of the contract manufacturing margins for
export business. However, while doing so the Tribunal
did not truly appreciate the differences in the FAR
prole of the company while operating in these two
segments correctly and thus concluded them to be the
same.
The issue for deliberation in this case was whether
the margins expected to be earned by a company from
its export business wherein it deals with its AEs and
practically operates as a contract manufacturer can
be compared with the margins it earns when it oper-
ates as a customer-facing licensed manufacturer as-
suming related business risks. It may be worthwhile
to examine the FARassumed by companies in relation
to end customer-facing businesses, where they acts as
entrepreneurs, albeit licensed manufacturers, as op-
posed to when they deal with related parties, say in
the capacity of contract manufacturers in light of the
above case, demonstrated in Table 1:
In the case of a contract manufacturer, the AEs
transact directly with the third parties and therefore
the above mentioned functions and risks, in the case
of the domestic segment, are actually being
undertaken/ assumed by AEs, who are thus entitled to
the corresponding returns. For the same reason, in re-
spect of the domestic segment, the above mentioned
functions and risks are being undertaken/assumed by
the taxpayer, which also earns the resulting prots.
Based on the above analysis, the differences in func-
tions and risks between the segments are apparent.
Further, owing to the said differences in the FAR, Wri-
gley Indias characterisation itself transformed from a
regular risk-taking licensed manufacturer in respect
of the domestic segment to a limited risk contract
manufacturer in respect of the export segment. Thus,
the conclusion regarding the similarity in FARproles
of both the segments appears to be incorrect.
Further, another important dimension which is
critical is the advertising and marketing spends usu-
ally made by the taxpayer in the case of a licensed
manufacturing set-up. The comparison of both seg-
ments would not be fair as both segments serve sig-
nicantly different markets and the cost structures of
the segments are different as the taxpayer typically
incurs a huge amount of advertising and marketing
expenditure in a licensed manufacturing set-up,
which is reected in the operating expenses of the tax-
payer and in the case of the export segment, most of
the sales are made to an AE and the taxpayer needs
not incur any amount on marketing the products. The
operating expenses essentially reect the intensity and
Table 1
Domestic segment: Licensed manufacturer Export segment: Contract manufacturer
Functions
performed
Caters to third parties
Manufacturing, business development,
marketing and advertising, inventory
management, maintaining a distribution
network and relationships, debtor follow-
ups
Exploits both the trade and marketing
intangibles of its AEs
Manufacturing products only for AEs
Virtually acts as a contract manufacturer in
supplying the products to the owner of the
intangibles or licensees of the intangibles
for the foreign markets
AEs responsible for marketing efforts in
their respective territories
Risks Bears credit risk, market risk, contractual
risk, price risk etc.
Not assuming or assuming limited risks
such as market risks, contractual risks,
credit risks, inventory risks, etc
10/12 Transfer Pricing Forum BNA ISSN 2043-0760
nature of functions performed, and gross margins are
a measure of whether an enterprise earns enough to
cover the costs of its various functions, including ad-
vertising and marketing expenses. The Tribunal in this
case had not considered the said expenses to be rel-
evant as according to it, they impacted only net mar-
gins rather than gross prots. However, this is not
true, since gross margins typically include the return
on advertising and marketing expenses, just as they
include the return on other expenses, with net prots
being an arithmetical derivative. Therefore, gross
margins and operating expenses, including advertis-
ing and marketing expenses, share a high correlation
and can certainly not be considered in isolation.
Moving to question 2.b., the Indian regulations do
provide that reliable and accurate adjustments can be
made to account for differences, if any, between the
international transaction and the comparable uncon-
trolled transaction or between the enterprises enter-
ing into such transactions. Further, there have been
several landmark judicial rulings in India
1
which
mandate various comparability adjustments while un-
dertaking the transfer pricing analysis. However, they
clearly provide that comparability adjustments can be
made provided data is available and adjustments can
be quantied and appropriately backed by sound eco-
nomic and statistical principles and robust documen-
tation.
The Tribunal in the above case did allow a rule of
thumb relief of four percent to bridge the differences
between the segments on account of the differential in
the market and credit risk assumed by both the seg-
ments. Thus, it can be inferred that the Tribunal in
effect admitted some differences in FAR proles be-
tween the two segments, and so somewhat deviated
from its own assertion of the FAR proles of both seg-
ments being the same.
As mentioned above, the two segments were com-
pletely incomparable. Moreover, with such signicant
diversity in geographic markets, functions performed
and risks assumed, even economic adjustments
cannot bridge the gap. Therefore, the ad hoc relief
granted by the Tribunal with respect to the differences
in market and credit risks, besides being unsupported
in terms of basis and calculation, seems fairly incon-
sequential.
Agility Logistics Private Limited
3. With regard to the Mumbai Tribunal ruling in the
case of Agility, where a split of net revenue (50:50)
has been accepted as a CUP:
a. Would a sharing of net revenue between two re-
lated parties be accepted for the purposes of apply-
ing the CUP method on the basis that this was the
industry norm?
b. Could the CUP method be held to be inapplicable
in the circumstances referred to in question 3.a.
on the ground that the said method can only apply
for comparing absolute prices and not net revenue
sharing arrangements?
The CUP method prescribed under the Indian trans-
fer pricing regulations for benchmarking interna-
tional transactions provides for determination of a
price of a transaction in an uncontrolled situation
which can be compared with the price of a taxpayers
transactions with its AEs. Accordingly, based on a lit-
eral reading of the Indian regulations, it is the out-
come i.e. the price which can be compared. Further,
on the issue of identifying comparables based on a
prevalent industry norm, Rule 10 B(2) of the Act pro-
vides that comparability of an international transac-
tion shall be judged with reference to conditions
prevailing in the markets in which the respective par-
ties to the transaction operate. However, there is lim-
ited guidance available in the Indian regulations on
what could be considered as conditions prevailing in
the market.
In general, the factors evaluated under this criterion
are aspects such as level of competition in the market,
economic development, industry drivers, industry
performance/ growth rates, etc. It may be possible to
evaluate the pricing arrangements in business/
operational models prevalent between parties in the
industry in order to ascertain if the business and pric-
ing arrangements between the taxpayer and its AEs
are in line with and comparable with the model and
pricing arrangements adopted by unrelated parties in
same industry. In the recent one of its kind ruling by
the Tribunal in the case of Agility, the issue considered
was that, in the case of a logistics company, the rev-
enue received by the taxpayer from the end customers
was being split between the taxpayer and the other
transacting entity on a 50:50 basis. The premise on
which the taxpayer adopted the said arrangement was
that this is the typical model/ pricing arrangement fol-
lowed between parties operating in the logistics in-
dustry for sharing revenue between origin and
destination counterparts.
In the present case, based on the detailed argu-
ments and explanations put forth by the taxpayer, the
Tribunal accepted the pricing arrangements prevalent
in the industry between related entities to be consid-
ered as a comparable since such business is generally
carried out between group/ related entities. The Tribu-
nal made a noteworthy observation that in the event
of comparable price/ arrangements for the same/ simi-
lar activity and FAR prole between unrelated parties
not being available in certain situations owing to the
nature of the business/ activity, then it may be prudent
to consider prevalent arrangements/ prices between
related parties, in order to ensure that standards of
comparability are adhered to, since comparability of
FAR is more critical to any transfer pricing analysis.
In arriving at the above decision, the Tribunal ac-
cepted the following key arguments put forth by the
taxpayer:
s the FARprole of the origin company and destina-
tion company is the same;
s the taxpayer followed the same 50:50 split of net
revenue even in cases where it transacted with un-
related third parties;
s the sharing of net revenue in a 50:50 ratio between
origin and destination company is an industry
norm, which was demonstrated by way of back-up
material available in the public domain in this
regard; and
s the economic conditions prevalent for the compa-
nies in the logistics industry are the same in India
and neighbouring countries, where the taxpayer
had transactions in the present case.
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Further, based on the detailed FAR analysis pre-
sented by the taxpayer, the Tribunal appreciated that
the operations in this industry are highly integrated
where both the parties (i.e. the companies in the
origin and destination countries) provide similar ser-
vices, undertakie similar functions, employ the same
level of assets and assume the same level of risks.
Accordingly, the Tribunal in this case has re-
emphasised the importance of a FAR analysis and the
fact that the standard of comparability while applying
the CUP method needs to be very high. To this end, it
may be prudent even to take into account the industry
norm prevalent on the pricing arrangements which
the companies typically follow if exact/ precise data
for unrelated comparables is not available.
The second issue (Question 3.b.) examined by the
Tribunal in the ruling was whether, when applying the
CUP method a pricing basis, per se can be accepted,
instead of the transaction price, as being a compa-
rable when determining whether the basis adopted by
the taxpayer was arms length.
According to the Indian transfer pricing regula-
tions, the ALP shall be determined using a CUP, i.e., it
stipulates that the price of the transaction be
compared/ benchmarked with reference to an uncon-
trolled transaction. In the Agility ruling, the revenue
authorities contended that the pricing mechanism
would not be tantamount to a CUP, as, strictly, it falls
outside the prevailing legal denition of a CUP. How-
ever, the Tribunal has taken a broader viewin the pres-
ent case and accepted pricing mechanism also to be a
valid CUP. By way of the ruling, the Tribunal has
therefore laid down an important TP principle that if
the pricing basis adopted by the taxpayer is itself cor-
rect then it cannot be said that the resultant outcome
(price or prot) of the taxpayer does not comply with
the arms length standard.
Further, in addition to the use of the ve transfer
pricing methods (in line with the OECD Guidelines),
recently, the Central Board of Direct Taxes (CBDT)
has prescribed the use of a sixth method, the Other
method for the determination of the ALP. When com-
pared with the CUP method, the newly prescribed
Other method has a wider purview and would cover
a price which had been charged or paid or would have
been charged or paid. If the Other method is read in
context with the decision in the case of Agility, it can
be inferred that situations where pricing arrange-
ments are compared could be covered under this
method.
Serdia and Fulford
4. With regard to the Mumbai Tribunal rulings in the
cases of Serdia and Fulford, wherein the implications
of the Glaxo Canada ruling were discussed in detail:
a. How is the CUP method applied to the import of
branded products from related parties for resale,
when the products are accompanied by a licence
or right to use intellectual property (IP), and in
particular can the transaction price be compared
with the market price of similar unbranded prod-
ucts, which do not involve the licensing of any
right to use IP?
b. Could the import prices of off-patented or generic
APIs imported from related parties for conversion
into a full dosage form of medicines, and sold
under a trademark or brand licensed fromsuch re-
lated parties, be compared with the market prices
of generic products of the same or similar
formulation?
The Mumbai Tribunal rulings in the cases of Serdia
and Fulford lay down some notable transfer pricing
principles particularly relevant to the pharmaceutical
domain. These principles essentially relate to the ap-
plication of the CUP method to transactions of import
of off-patented APIs by the local taxpayer from AEs,
which are locally converted into FDF or formulation
of medicines and then sold in the open market. These
principles have been analysed below by using ex-
amples to demonstrate their application. However,
before delving into this analysis, it would be worth-
while to rst get an overviewof a typical drug develop-
ment process. This would facilitate abetter
understanding of value generation in the said process,
in turn enabling better comprehension of the func-
tional prole of the AEs vis-a-vis the taxpayer.
A typical drug development process, as is repre-
sented in Chart 1, begins with the generally long-
drawn, complex, time intensive, and intangible
creating functions of research (involving numerous
stages); evaluation and study of the efcacy of the
product (involving several activities); and setting-up
of quality norms. These functions lead to the creation
of an originally developed API, i.e., an API which is
created for the rst time by an original developer
(i.e., with no one having done so before).
An originally developed API is generally patented
by the original developer for protection of the IP im-
bibed in it (i.e., to prevent copying by others). The
originally developed API would therefore be a pat-
ented API. However, there is a limited period for
which the patent applies, and thereafter this origi-
nally developed API goes off-patent and is then re-
ferred to as an off-patented API.
When an API goes off-patent it can be copied by
others to produce a similar formulation. The impact
of off-patenting is that the IP which was earlier pro-
tected or patented is now generically known and
copied by others to produce APIs. Such APIs pro-
duced by others, which are copies of off-patented
APIs, are typically referred to as generic APIs. Nota-
bly, others would leverage on the research, efcacy
tests, and quality standards established by the original
drug developer. They would, therefore, be able to pro-
duce at a lower cost and thus sell at a lower price. Ac-
cordingly, in an off-patented scenario even the
original developer would be compelled to lower its
selling prices in order to remain competitive.
In the typical drug development process, once the
API is created (as discussed above), it is thereafter
converted into formulation. This is the nal stage
and entails the transformation of the API into FDF,
that is the edible form of the API (i.e., making it t for
consumption). For conversion, certain pre-specied
steps are required to be followed. As is evident from
the discussion above and represented in Chart 1, con-
version ranks lower than the other elements in the
value chain of a typical drug development cycle.
Question 4.b., above, contemplates a situation
where the local entity (i.e. the taxpayer) imports off-
patented APIs from AEs, converts them into FDF
10/12 Transfer Pricing Forum BNA ISSN 2043-0760
and then sells the FDF in the open market. Therefore,
the taxpayers role is limited to the last stage of the
drug development process. In this situation, the func-
tional prole of the taxpayer, simply speaking, is thus
that of a converter and a distributor. Conversion,
also commonly referred to as secondary manufactur-
ing, may even be outsourced. Therefore, in effect, the
taxpayer is primarily a distributor of FDF along with
the added function of conversion, and may thus be
best characterised as a value added distributor, who
should earn a return for its distribution function, and
also for the value addition of conversion (either for
converting on its own or for co-ordinating the same
with outsourced entities).
Having concluded on the functional prole of the
taxpayer, let us now assume that the AE compensates
the taxpayer with 10 percent on sales, for its distribu-
tion function, and also for the value addition of con-
version. It should also be presumed that the 10
percent remuneration is at arms length which has
been determined based on a TP analysis and is com-
mensurate with the functions performed by the tax-
payer.
Let us further assume that since the taxpayer oper-
ates in an off-patented scenario, it has been com-
pelled to lower its selling prices in order to remain
competitive, and has thus also lowered its purchase
price of APIs from AEs.
Now, assume that the taxpayers sale price is 100.
Then, as per the arms length pricing policy agreed
with the AE (based on 10 percent prot on sales) the
taxpayer should earn an operating prot (OP) of 10 for
its distribution and conversion functions. Assuming
its operating expenses are a given at 20, then the API
purchase price should be 70, being the balancing
gure (100 20 10). This situation is depicted in Dia-
gram 1.
In the off-patented scenario, others import ge-
neric APIs from their respective suppliers at say 45. If
the CUP method were to be used, and the purchase
price of the taxpayer was to be compared with the
price of generic APIs procured by others, then 70
would be reduced to 45, and the impact on the taxpay-
ers OP would be as follows:
Selling price (market driven) of the taxpayer = 100
Purchase price (based on a comparison with the price
of generic APIs) = 45
Operating expenses (remain unchanged) = 20
The resulting OP would be (100 - 45 - 20) = 35 (i.e., 35
percent on sales).
The taxpayer thus ends up with an OP/ Sales of 35
percent as against the arms length OP/Sales of 10 per-
cent. The application of the CUP method and adop-
tion of the price of generic APIs procured by others
as a valid CUP for the purchase price of the taxpayer
thus leads to the taxpayer earning a return which is in
divergence from the arms length standard (i.e., far
more than is commensurate with its functional pro-
le).
Accordingly, to answer question 4.b., an outright
comparison of the purchase prices of off-patented
APIs imported from AEs cannot be made with prices
of generic APIs without considering the functional
prole of the taxpayer, and the underlying TP policy.
Moreover, a CUP comparison requires extremely
high standards of comparability of the product as well
as other surrounding facts and circumstances. As re-
gards generic APIs, if the pricing data is derived from
customs authorities, then the only known facts about
the generic APIs is that they are products with similar
chemical composition and properties, which have
been purchased by others. However, apart from
these known facts, there are several unknowns. For
example, the functions of others, who are purchas-
ing the generic APIs, is not precisely known. Others
could simply be purchasing and reselling to secondary
manufacturers for conversion and subsequent distri-
bution therefore the level at which others operate
in the supply chain is not known. Such unknown fac-
tors could make it extremely challenging to adhere to
the high standards of comparability required for a
CUP comparison. Hence, for these reasons too, an
outright comparison of purchase prices of off-
patented APIs imported from AEs with prices of ge-
neric APIs could not be sustained.
Moving to question 4.a., it may be noted that, with
other facts largely remaining the same as they were in
question 4.b., question 4.a. simply introduces an
added dimension, i.e., when off-patented APIs im-
ported from AEs are accompanied by a licence or right
to use the brand, and the FDF or formulation is sold
under the said brand. The situation contemplated in
question 4.a. is demonstrated in Diagram 2:
The taxpayer continues to function as a value added
distributor, and continues its pricing policy with the
AE such that it earns an arms length return of 10 per-
cent on sales commensurate with its functions.
As regards the added dimension of a licence or right
to use the brand, it may be noted that when a product
is accompanied by IP rights (for example brand/
trademark), there is a premium value ascribed to the
product. The premium is the return associated with
the intangible, which is embedded in the products
market price, and would generally belong to the
owner (also presumed to be the developer) of the IP.
However, the owner of the IP may not necessarily be
the entity which is selling the product in the market.
Chart 1
Basic Research - Chemical Research
Biological Research
Pharmaceutical research
Clinical Research Phase I (Human Volunteer Studies)
Phase II (Initial Human Efficacy Studies)
Phase III (Full Scale Clinical Evaluation)
Phase IV (Post-Marketing Surveillance)
Post Clinical research - Prep of product monographs
Develop global manufacturing and quality standards
Conversion of API to formulation
The above stages result in an originally developed API
Numerous
stages of
-
efficacy
studies,
clinical
evaluations,
surveillance,
etc.
standards
Research
Testing
Quality
Conversion
6
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In such circumstances, the selling entity can be said to
be collecting the premium from the market on behalf
of the owner. There must then be a mechanism by
which the premium so collected is passed back to its
rightful owner.
If in the above example, the sale price is 100, then
100 would include the premium associated with the
brand (being collected by the taxpayer on behalf of the
AE). The premium so collected must be passed on to
the AE. If the sale price is 100, then the OP based on
the pricing policy of the taxpayer as agreed with the
AE would be 10 (10 percent of 100). The operating ex-
penses would be the actual amount spent by the tax-
payer (say 20). The selling price, the OP and the
operating expenses are thus a given, and hence the
total amount that needs to be paid back to the AE can
be derived as follows: Sale price operating expenses
OP, i.e., 100 20 10 = 70.
70 is the balancing gure, and includes the pre-
mium associated with the brand, which needs to be
passed back to its rightful owner. Since 70 is the cu-
mulative amount that needs to be paid to the AE for
import of APIs and for using the brand, it could be
broken up into two components, i.e., royalty for use of
brand and the purchase price of APIs.
If in the above example, the royalty is determined at
an arms length rate of say ve percent of sales (5 per-
cent of 100 = 5), then the purchase price of APIs from
AEs would be 65 (i.e., 70 5).
Notably, the purchase price of APIs from AEs (65 in
the above example), should be a derived amount com-
puted after applying the taxpayers pricing policy
agreed with the AE, and after deducting an arms
length price
2
for the right to use the brand. The pur-
chase price of APIs from AEs cannot be compared as
it stands with prices of generic APIs (as has been al-
ready discussed in the answer to question 4(b) above).
Although the CUP method entails a direct compari-
son of prices (and not prots which are directly linked
to the FAR analysis), yet before choosing to apply the
CUP method, FAR analysis needs to be undertaken at
the very outset, to rst ascertain whether application
of this method is at all appropriate in the given facts
and circumstances.
To conclude, a vital observation that may be made
from the above examples taken for the purpose of an-
swering questions 4(a) and 4(b) where application of
the CUP method has been questioned, is that the
above analysis hinges on a critical underlying as-
sumption that the 10 percent remuneration earned by
the taxpayer is as per an arms length TP policy agreed
between the taxpayer and the AE, which is consistent
with their FAR prole. Therefore, if the applicability
of the CUP method is to be challenged under similar
facts and circumstances as prevail in the above ex-
amples (being that of a value added distributor in the
pharmaceutical industry), then a well documented TP
policy is an imperative and should form the mainstay
of any taxpayers dispute resolution strategy.
Bayer Material
5. With regard to the Mumbai Tribunal ruling in the
case of Bayer Material, in which companies having
100 percent controlled transactions were accepted as
comparables and also, agency commission rates were
applied on an arguably arbitrary basis:
a. If a company undertakes both distribution and
agency activities for products manufactured by
overseas related parties, would the differences in
the level of functions, assets and risks assumed by
the company for the two categories of activities be
taken into account, and different pricing basis be
used, e.g. a return on value-adding costs or the
Berry Ratio for agency activities, as against a
return on sales for distribution activities?
b. Could companies having 100 percent controlled
transactions with their respective related parties
be accepted as comparables for the purposes of
testing the results of the taxpayer?
c. In the case of marketing agents or procurement
service companies, would the resultant return on
the value added costs (e.g. operating prot divided
by value added cost) in the hands of the taxpayer
be taken into account, when applying third party
commission rates available from different
sources?
The answer to Question 5.a. should be a yes, even
though that was not the direction in which the Bayer
Material ruling proceeded. Nonetheless, if co-
existence of distribution and agency functions is as-
sumed as it was in the case of Bayer Material, also
contemplated in Question 5.a., and if a distributors
and an agents business and corresponding remunera-
tion models are examined, then some worthwhile TP
principles certainly do emerge, and which have been
analysed below.
Conceptually speaking, if one were to delve into the
spectrum of functions undertaken by a distributor
and an agent, two critical differences would generally
Diagram 1
Original drug developer
Purchase of
off-patented
API @ 70
Sale @ 100
(in off-patented
scenario)
Supply
agreement
AE Open market
Conversion
to FDF
Taxpayer
Diagram 2
Original drug developer &
brand developer and owner
Sale under
X brand
License
agreement
AE Open market
Conversion
to FDF
Taxpayer
Supply
agreement
Purchase of
off-patented
API
Right to
use brand X
10/12 Transfer Pricing Forum BNA ISSN 2043-0760
arise. One would be in the context of inventory and
the other credit (debtors) - related functions/ risks.
Generally speaking, an agent would not be respon-
sible for handling or carrying inventory, and would
thus not bear inventory risk. As for credit, if the agent
is paid by its principal irrespective of recovery from
the nal customer, then the agent does not carry sig-
nicant credit risk. However, if the agents remunera-
tion is linked to recoveries from customers, then the
credit risk would be shared by the agent with its prin-
cipal.
On the other hand, generally speaking, a distributor
would be responsible for handling and carrying inven-
tory, and also for collections from customers. It would
thus typically bear both inventory and credit risk.
However, the distributor could be a limited risk dis-
tributor (LRD) taking only ash title of goods, with
limited responsibility towards collections. In such a
model, the inventory and credit risks would vest
largely with the principal.
What emerges is that, there could be different per-
mutations and combinations of the inventory and
credit related functions/ risks which could be
undertaken/ borne by a distributor and an agent. The
intensity of these functions/ risks would vary depend-
ing upon the arrangement that a distributor and an
agent has with its principal, and this would be re-
vealed by means of a detailed examination of the func-
tions, assets and risks of the distributor/ agent and its
principal.
For TP purposes, distribution and agency activities,
both of which are being undertaken by a single tax-
payer, could either be segregated or aggregated, de-
pending upon the outcome of the FAR analysis as
discussed above. If the functions/ risks of the distribu-
tion and agency activities are analogous to each other,
then the agency activity could be aggregated with dis-
tribution, otherwise not. For instance, where the tax-
payer is an LRD, the inventory and credit risks would
vest largely with the principal instead of the taxpayer,
and the LRD would then in fact be akin to an agent.
Therefore, a FAR analysis would be pivotal to the de-
cision of whether to aggregate or segregate. Further,
the pricing basis would also vary depending upon
whether the activities are aggregated or segregated,
and this is discussed in detail below.
Pricing basis for a distributor if distribution activity is
segregated from the agency function
If, based on FAR analysis it is decided to segregate the
distribution activity from the agency function, then in
respect of its distribution activity, if the taxpayer is
considered to be a standalone distributor operating as
a regular distributor (or more) undertaking all the
typical functions (or more) of a distributor, i.e., mar-
keting, securing orders, procurement, supply chain
management, inventory holding and insurance, col-
lection, etc., then the distributor would typically
expect a certain return on sales, to cover its costs and
to earn a return for the distribution risks undertaken
by it.
However, if the FAR analysis of the distributor re-
veals that it is an LRD taking only ash title to goods,
with a negligible role to play in functions related to
the supply chain, inventory, collection, etc., then the
distributor would be operating more like a marketing
support service entity and would expect to essentially
cover its costs, excluding Cost of Goods Sold (COGS),
and earn a routine return thereon. Total costs, less
COGS, would represent the costs which would
embody the value addition by the taxpayer and would
essentially be the expenses incurred in rendering the
marketing service (or the VAE).
Accordingly, the pricing basis would be dependent
upon the FAR analysis of the distributor, i.e., the in-
tensity of functions performed and risks undertaken
by it. Expressed in terms of PLIs (assuming applica-
tion of the TNMM), the PLI for a regular distributor
who would typically expect a return on sales, would
quite evidently be OP/ Sales and the PLI for an LRD
whose operations are akin to that of a marketing sup-
port service provider could be OP/ VAE or a variant
thereof, i.e., the Berry Ratio (Gross Prot/ VAE). In
fact the use of the Berry ratio in similar circumstances
is supported by the OECD, which states as follows in
paragraph 2.101 of its revised Transfer Pricing Guide-
lines of 2010:
In order for a Berry ratio to be appropriate to test the
remuneration of a controlled transaction (e.g. consist-
ing in the distribution of products), it is necessary
that:. . .. . .
The value of the functions performed in the controlled
transaction (taking account of assets used and risks
assumed) is not materially affected by the value of the
products distributed, i.e. it is not proportional to sales,
and. . .. . . (Emphasis supplied)
Pricing basis if distribution activity is aggregated with
the agency function
If, based on a FAR analysis it is decided to aggregate
the distribution and agency activities,
3
then the remu-
neration (pricing) basis cannot be sales or turnover
based, as the top-line for a distributor is characteris-
tically different from that of an agent (who typically
earns a service fee or a commission), and thus cannot
be placed at par. The remuneration (pricing) basis
must then be cost based, i.e., the pricing should be
based on a return (or OP) on costs, whereby the costs
to be considered cannot include COGS, as COGS are
specic only to distribution activity (and if the tax-
payer is only taking ash title to goods, then COGS
would in essence be pass-through and not value-
added costs). Therefore, the only costs which can be
considered for determining the remuneration (pric-
ing) basis are the VAE, also a true measure of intensity
of functions performed. However, VAE would appro-
priately measure the intensity of functions performed
provided that its composition is also carefully
mapped.
Pricing basis for an agent if distribution activity is
segregated from the agency function
If, based on a FAR analysis, it is decided to segregate
the distribution activity from the agency function,
then applying the same principle as was applied in the
case of distribution, the pricing basis would be depen-
dent upon the FARanalysis of the agent, i.e., the inten-
sity of functions performed and risks undertaken by
it. If the functions are of routine or low intensity, the
risks borne by the agent would also not be signicant
8
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and in such circumstances the agent would typically
like to cover all its costs and earn a routine return
thereon (OP/ Total Costs in PLI terms). If, however,
the agent assumes signicant responsibility for effect-
ing sales and undertakes a gamut of functions for its
principal in this regard, then the agent would also
(similar to a regular distributor) expect a remunera-
tion linked to sales.
As also contemplated in question 5.c., when adopt-
ing a remuneration basis which is linked to sales, say
a commission on sales, the commission rate could be
best determined based on comparable uncontrolled
commission rates (using the CUP method). However,
a standalone determination of commission rates may
not yield bona de results. A commission rate repre-
sents remuneration for the agents activities, and thus
cannot be determined independent of an examination
of the nature of and the level at which functions are
performed by the agent vis-a-vis comparables.
If the price for the transaction of provision of
agency services has been set as a commission rate, de-
termined using the CUP method, after adequately
taking into account the nature and level at which
functions are performed by comparables, then the re-
sultant OP/VAE of the taxpayer may not be a relevant
consideration. This is so because the CUP method
does not warrant going beyond the price, whereas
OP/VAE is a prot measure. Moreover, being a prot
measure, OP/VAE may be inuenced by several fac-
tors extraneous to the transaction per se of provision
of agency services, and also to its pricing, i.e., com-
mission. These could be internal business reasons or
industry specic factors and/ or peculiarities.
Moving to Question 5.b., companies having con-
trolled transactions should ideally not be considered
as valid comparables (although they were in the case
of Bayer Material), as the assumption inherent to a
typical TP analysis is that controlled transactions are
not at arms length. Also, practically speaking, there
would be limited or no data available in the public
domain to counter this assumption. Where there are
no uncontrolled comparable transactions, then indus-
try average data from independent reports/ sources
may be used as a reasonable indicator of whether or
not the pricing is at arms length. The industry average
data would generally be a combination of uncon-
trolled and controlled data. Hence, a comparison with
such industry average data would certainly not re-
place a conventional economic analysis undertaken
using uncontrolled comparable transactions, but with
the given data constraints, it may prove to be useful
during dispute resolution. Needless to say, the lack of
uncontrolled comparable transactions would need to
be sufciently demonstrated and documented, and
the sources for industry average data would have to be
reliable.
Sanjay Tolia and TarunArora are Partners, Ruhi Mehta and
Shikha Gupta are Senior Managers inPricewaterhouseCoopers
Indias National Transfer Pricing Team. They may be contacted
by email at:
sanjay.tolia@in.pwc.com
arora.tarun@in.pwc.com
ruhi.mehta@in.pwc.com
shikha.gupta@in.pwc.com
www.pwc.com/tp
NOTES
1
Mentor Graphics (Noida) Pvt. Ltd. v DCIT [112 TTJ 408],
Egain Communication Pvt. Ltd. v Income Tax Ofcer [109
ITD 101]
2
Independently determined under say a CUP analysis.
3
Which would typically be the case when the taxpayer,
with respect to its distribution activity, operates as an
LRD.
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