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1 Rahul K Mitra* Amitava Sen** Rajneesh Verma*** Global Procurement Companies in India - Transfer Pricing Challenges & The Way Ahead INTRODUCTION T he Indian procurement industry is oriented towards exporting a variety of goods and services across the globe. While traditionally not being in the limelight, global procurement operations have been the focus of much attention over the past few years in India, both for the Multinational Enterprises (MNEs) running these operations as well as the Indian Revenue, but obviously due to dichotomous reasons. While MNEs are trying to maximise global supply chain efficiency by tapping into the strengths of the Indian economy, the Indian Revenue has been trying to claim a greater share of taxes from these entities through transfer pricing (TP) and permanent establishment (PE) challenges. 2. PE implications for procurement companies From PE perspective, the initial issue which arises is whether procurement operations can create a source state taxing right in India? For evaluating this issue, if one refers to the existing guidance provided in the Income-tax Act, 1961 (ITA), the Indian Tax Treaties and the OECD Model Tax Convention (MTC), it appears that traditionally procurement operations have not been regarded as an business activity creating sufficient economic nexus for source based taxation. This is because: (a) as per article 5 of the OECD MTC and most Indian Tax Treaties, any fixed place of business maintained solely for the purpose of purchasing goods or merchandise or for collecting information are considered to be of preparatory or auxiliary character, hence not creating a PE; (b) as per section 9 of ITA, no income shall be deemed to accrue or arise in India to the PE through or from operations which are confined to the purchase of goods in India for the purpose of export; (c) as per article 7 of the pre-2010 OECD MTC and most Indian Tax Treaties, no profits shall be attributed to a PE by reason of the mere purchase by that PE of goods or merchandise for the enterprise. However, in the 2010 revised OECD MTC, the aforesaid clause of article 7 was deleted with an intention that such blanket exemption was not * Rahul K Mitra, National Leader, Transfer Pricing Practice, PwC, India, rahul.k.mitra@in.pwc.com ** Amitava Sen, Associate Director, Transfer Pricing Practice, PwC, India, amitava.sen@in.pwc.com *** Rajneesh Verma, Manager, Transfer Pricing Practice, PwC, India, rajneesh.k.verma@in.pwc.com INTERNATIONAL TAXATION n VOL. 7 n AUGUST 2012 n 13 91

2 consistent with the arm s length principle, as in similar circumstances an independent enterprise purchasing goods or merchandise for a third party while performing ancillary services as well, would be remunerated at arm s length for its functions. Nevertheless, the exemption for purchasing activities (as preparatory and auxiliary functions) as per article 5 still remains in the 2010 OECD MTC 1 and this possibly creates a conflicting perspective on the issue. At one hand, if a PE is performing purchasing activities, as per the new article 7, it would not necessarily be outside the scope of source country taxation - and thus can be taxed on arm s length basis. On the other hand, a fixed place of business performing purchasing activities per se would not create a PE. In the view of the authors, one may try to align these two clauses by interpreting that local operations for pure purchasing/procurement activities will still get the protection of article 5 and in the Indian context, also the protection of section 9 as aforesaid but the current article 7 in OECD MTC, unlike the past, will not provide any protection to PEs which perform purchasing functions along with other business activities. But the debate on this apparent conflict will remain unless article 5 of OECD MTC is also suitably modified in the days to come. As a matter of fact, there are conflicting views coming out even from certain Indian Rulings where the Tribunal decisions in cases such as Nike Inc. v. Asstt. CIT 2 and Addl. DIT v. M. Fabrikant & Sons Ltd. 3 conclude that the Liaison Office (LO) does not create any taxable presence through sourcing activities performed for its head office. Whereas, in cases like Linmark International (Hong Kong) Ltd. v. Dy. DIT 4, the Tribunal held that the LO was liable to be taxed in India. The above discussion on OECD MTC and the Indian Rulings in cases of LOs is to only bring out the relevance of sourcing activities in the Indian context, otherwise, whether and in what circumstances an LO creates a PE is a subject of in-depth deliberation, which is beyond the scope of this article. In the context of procurement functions, realistically speaking, the perspectives have changed today not only at the Revenue s end but also for MNEs. Globally, MNEs have recognised that to survive against highly competitive market place or challenging consumer behaviour, the global supply chain cannot be optimised or sustained only through sales related efforts, but also requires greater focus on purchase effectiveness too. Due to this reason, countries like India and China have become global sourcing hubs which offer MNEs an opportunity to buy quality products at extremely competitive prices. Thus, with the removal of the relevant clause in the 2010 OECD model tax convention, unlike the past, it is not possible to draw a blanket conclusion that procurement does not create taxing rights in the source country. With this context, this article analyses the various TP challenges for procurement companies, and the possible way ahead. 3. Global sourcing from India - Recent statistics Today, the Indian procurement industry is not only confined to export of software or back office services but it has expanded across various industry segments. As per the recent statistics from Economic Survey , cumulative exports from India were at around US $148 billion (during April to September 2011). The following figures exhibit exports by industry and regions during the said period: Although, there is no concrete data available in the Economic Survey to identify how much of the above exports are a result of global procurement activities of MNEs, however, one would tend to believe that industries such as readymade garments, textile, cotton fabrics, jewellery, 92 INTERNATIONAL TAXATION n VOL. 7 n AUGUST 2012 n 14

3 electronics etc. would be the major contributors in the global procurement arena. 4. Key determinants in a global supply chain strategy 5 In today s competitive world, global supply chain strategies have become more complex and crossfunctional. Along with the traditional logistical drivers of supply chain performance like facilities, inventory and transportation; the importance of cross-functional drivers of sourcing (procurement), pricing and information technology have grown over the years. Further, MNEs are recognizing that in a highly competitive market, supply chain surplus can be generated more effectively through lower purchase costs rather than higher sales realization. The following diagram depicts how effective procurement strategies can add greater value: Decrease Increase purchase Sales by cost by 5% 50% Income Material cost Other costs Net Profit The above diagram indicates that a 5% reduction in material cost can result in 50% increase in profit margin. Whereas, on the sales side, in order to obtain an equivalent impact, a firm would need to increase its sales by 50% and significantly reduce staff cost. Procurement includes the entire gamut of business processes required to purchase goods and services. For any supply chain function, the most significant decision is whether to outsource (or offshore) the function or perform it in-house. The decision is an outcome of two factors (a) the additional supply chain surplus (or system profit) generated through the outsourcing and (b) the level of additional risks from outsourcing. The sourcing process typically encompasses critical functions, as depicted in the chart below: When designing a sourcing strategy, it is important for the MNE to identify the functional elements that have greatest influence on performance, supply chain surplus as well as the incremental risks. It is obvious that any multinational would decide to outsource only if incremental supply chain surplus (or system profit) is generated without significantly affecting existing risks or creating new ones. Supply chain surplus can be generated through aggregation (centralisation) of critical supply chain factors, such as capacity, inventory, transportation, warehousing, procurement, information, receivables, relationship etc. On the other hand, there are various incremental risks which may arise from third party outsourcing, such as loss of control on process, higher costs from lack of coordination, reduced supplier contact, loss of internal capability (lower bargaining power), information/know-how security, ineffective contractual terms etc. Another critical element is the vendor contract (or supplier contract) which can be designed to increase product availability, coordinate supply chain costs, and induce performance improvement for the supplier. From a TP perspective, arm s length principle would also imply that a procurement intermediaries share in the system profit is correlated to the extent it generates the incremental supply chain surplus or manages the additional supply chain risks or maintains the contractual relationships. Thus, greater the role and responsibilities of the intermediary, greater is the arm s length return attributable to it. INTERNATIONAL TAXATION n VOL. 7 n AUGUST 2012 n 15 93

4 Therefore, for evaluating the correct TP structure and remuneration model for any Indian procurement company, one must look at the level of involvement the Indian company has in executing the critical supply chain functions or managing the critical supply chain risks or even managing the contractual framework with vendors. Or in other words, the function-assetrisk (FAR) profile of the procurement company in the context of the MNEs global operations is the key determinant of its ideal TP structure. With the increasing complexity of supply chain strategies, having the classical LO structure with a thin FAR profile may not always be conducive from a business perspective. In such cases, the TP model of the Indian company would also require alignment with the true operational structure. 5. Typical operating models for procurement companies Procurement intermediaries are the entities which connect the global buyers to the local vendors or suppliers. They typically assist MNEs with a wide spectrum of services viz. locating and selecting vendors/suppliers, price negotiations, quality inspection, coordinating logistics etc. The extent of involvement or value addition of these entities would naturally depend on the industry, competitive forces and business environment. As mentioned earlier, not all procurement entities can be structured as LOs with a thin FAR profile. In terms of their increasing FAR profile and corresponding earning potential, operating models or TP structures for procurement intermediaries can be broadly categorised in 3 types: u Procurement services company, which merely performs coordination and liaising functions for its Principal with vendors being identified by the Principal, thus earning a service fee based upon reimbursement of full costs of operation and an arm s length mark-up thereon which would again be the result of its FAR profile 6 ; u Procurement agent, which identifies third party vendors, may participate in negotiation of the pricing and contract terms with the vendors on behalf of the Principal, thus earning remuneration in the form of commission as a percentage of value of goods procured for the Principal, again depending on its level of FAR; and u Buy-sell procurement company, which buys products from third party vendors and sells the same to Principals, thus retaining a gross margin commensurate with its level of FAR; What emanates from the above discussion is that level of functions performed, assets employed and risks assumed are the key determinants of the appropriate TP structure. These factors need to be considered in light of the MNE s global supply chain model. 6. FAR profile and arm s length remuneration As mentioned earlier, the advent of MNEs in the Indian procurement industry drew focus of the Indian Revenue which raised numerous TP issues surrounding one key question - how should such procurement intermediaries in India be remunerated? Many MNEs have set up low risk procurement support companies working on cost plus model. However, the Indian Revenue has become more watchful in assessing the role of such intermediaries in the global supply chain and even claiming that the companies should earn a commission based income on the notion that its FAR profile is not commensurate with a cost plus return. This, following the earlier discussions, procurement service entities are being recharacterised as procurement agents. Another trend that has been observed in India is that MNEs have set up regional procurement hubs (in key locations like Hong Kong or Singapore) with a support arm in India. Typically, the hubs act as centralized buying agents and have more complex FAR profile while the Indian company has a simpler role to play. The hub may earn a commission income while the Indian support company earns a cost plus service fee. The Indian Revenue can challenge such structures if the differential FAR profile of the procurement hub and Indian support arm is not clearly demonstrated. 94 INTERNATIONAL TAXATION n VOL. 7 n AUGUST 2012 n 16

5 One interesting factor to be considered here is that in case one were to remunerate a procurement intermediary through a commission, in the authors experience, it is very difficult to directly identify arm s length commission rates based on comparable Uncontrolled Price Method. This is due to two primary reasons: (a) firstly, third commission rates are not available in the public domain as these are confidential business information, (b) further, even if these are available, the commission rate will be a function of the agent s FAR profile, cost structure, competitive advantage, experience and such other qualitative factors, which cannot be easily gauged from publicly available information. Alternatively, the indirect method to arrive at presumptive commission rates is to adopt the working capital cost adjusted gross margin earned by distributors with intensity of functions 7 similar to that of the agent. In this method, the commission rate would be a resultant of the intensity of functions and the return on value added costs (i.e. return on operating expenses) earned by such distributors. Evaluation of functional intensity while remunerating a service provider or limited risk distributor is a globally accepted norm and is normally assessed by examining the Berry Ratio 8 of the low risk distributors. Berry Ratio as an important quantitative measure has been shown to be successfully used as an indicator of economic performance for routine or limited risk distributors, as it indicates the level of margin earned for low value added functions. A simple application of the Berry Ratio to derive buying agent s commission rate is explained below 9 : Total value of good procured A 2,000 by agent Total value added expenses B 200 (operating expenses) Intensity of functions (IOF) C=B/A 10% IOF range used to identify 5%-15% comparable distributors Berry ratio of such D 120% comparable distributors (arm s length margin) Effective arm s length E=B * D 240 earning for the agent Thus, derived arm s length F=E/A 12% commission rate As mentioned earlier, the above illustration proves that the commission rate is a resultant of the intensity of functions (i.e. 10%) and the Berry ratio (i.e. 120%). It has also been observed by the authors that a multi-year regression analysis may also act as a more robust analytical tool to arrive at an arm s length commission rate based on the intensity of functions. 7. Case of Li & Fung The recent Ruling by Delhi Tribunal in case of Li & Fung (India) Pvt. Ltd. v. Dy. CIT 10 is an example of the interplay of intensity of functions and resultant operating returns. The taxpayer, Li & Fung India provided sourcing services to its related party, Li & Fung HK. The Revenue challenged the cost plus model of the taxpayer and held that the taxpayer should receive a commission on the value of products sourced from India in view of critical functions performed, unique intangibles and locational advantages available to the taxpayer. The Tribunal upheld the Revenue s view primarily because the taxpayer could not refute that it had actually performed all critical functions, assumed significant risks and also developed significant supply chain intangibles in India and Li & Fung HK did not have either any technical expertise or manpower to carry out the sourcing activities in HK. The Tribunal held that Li & Fung India should receive 80% of what Li & Fung HK was earning from its customers, which was a 5% commission income. In other words, Li & Fung India should receive 4% commission rather than a cost plus remuneration. In this case, even if the entire commission income of 5% is attributed to Li & Fung India, it results in a Berry ratio of 132%, due to Li & Fung India s relatively high intensity of functions. Thus, though the taxpayer s remuneration model was attacked, it may not have resulted in a very INTERNATIONAL TAXATION n VOL. 7 n AUGUST 2012 n 17 95

6 high Berry Ratio effect as compared to what third party distributors tend to earn. 8. Location savings arising from global procurement Another key TP issue that may be raised in this context is whether the Indian procurement entity is entitled to any local savings or supply chain surplus arising from the procurement operations in India. It is important to note that all location savings do not always result in location rent. Location rent is the additional profit (if any) associated with location savings, however, location may not be solely responsible for additional profit. Sharing of local savings between the ultimate customer and the supply chain participants depends on various factors like, relative bargaining power profile, economic circumstances, competitive forces etc. While the location saving concept requires significant deliberation beyond the scope of this article, some of the possible scenarios related to sharing of location rent are briefly illustrated below: Highly competitive market and perfect competition: In such a scenario, the ultimate customers demand lower prices and there are multiple suppliers to serve that demand. Hence, advantage of location savings would generally flow to the end-customer because low cost of sourcing is set off through low sales price. In such cases, no supply chain surplus may arise. Supplier or Buyer having greater bargaining power: Bargaining power arise from various factors like competitive advantage, high entry barriers, availability of asymmetrical alternatives, higher strategic patience, greater financial strength etc. In such cases, one would assume that a location rent arises due to the advantageous position of the supplier or the buyer, as compared to the ultimate customer. In case one of the parties has greater bargaining power, it can possibly retain the location rent. Intermediary having greater bargaining power: This scenario can only arise if the intermediary has the aforesaid bargaining power advantages, instead of the supplier or the buyer. Normally, such situations may not be found since intermediaries tend to provide routine support to the buyer, which holds the strategic advantage. At the same time, there may be large scale procurement agents who wield significant competitive advantage and may also retain location savings to its advantage. 9. Using APAs to address transfer pricing issues Finance Act, 2012 has introduced Advanced Pricing Agreements (APA) in India. APAs may prove to be very welcoming step in achieving certainty for MNEs who have procurement operations in India or are envisaging to establish one in future. Compared to a protracted litigation or uncertainty, it may be much more viable to apply for APA wherein the proposed TP method and pricing model will be blessed by the authorities. Further, a bilateral APA can assist MNEs to address global TP challenges and offer efficiencies along the way. 10. Conclusion All of the above discussions bring the whole emphasis on the need to carry out an in-depth analysis of the intensity of FAR before drawing any inferences regarding the remuneration model, as different procurement designs would undoubtedly warrant different remuneration models. In a nutshell, the decision of where to locate a procurement set-up may be driven by nontax business considerations but the remuneration for such set-ups from a TP perspective should solely be based upon the extent and nature of the activities being performed (extent of valueaddition) and the risks assumed, which possibly an APA programme would strengthen. 96 INTERNATIONAL TAXATION n VOL. 7 n AUGUST 2012 n 18

7 1 OECD s paper on attribution of profits to PEs was only focused on amending and improving the context and implications of article 7 and not amending article 5 itself 2. [2010] 125 ITD 35 (Bang.) 3. [2011] 9 taxmann.com 286 (Mum.) 4. [2011] 10 taxmann.com 184 (Delhi - Trib.) 5. Inputs from Supply Chain Management - Strategy, Planning and Operation, 4th edition, by Sunil Chopra, Peter Meindl, DV Kalra 6. LOs will also be a variant of this structure, with the exception that no arm s length mark-up is paid 7. Measured as the ratio of value added expenses to value of goods sourced 8. This ratio was propounded by Dr. Charles Berry and is measured as the ratio of gross profit to value added (operating) expenses. 9. All numbers in this explanation are assumed for illustrative purpose only 10. [2011] 16 taxmann.com 192 INTERNATIONAL TAXATION n VOL. 7 n AUGUST 2012 n 19 97

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