Captive outsourcing models

India TP hygiene workshop

Presenter: Vishnu Bagri
October 23, 2013

© 2013 Transfer Pricing Associates Holding B.V.

BACKDROP

+ India has evolved as a premier outsourcing hub for IT, ITES, engineering and
other R&D activities
+ MNEs have typically adopted the cost-plus mark-up pricing model for
remunerating their captive centres in India
o Mark-ups ranged between 5%-10 during the 1990s and early 2000s;
o MNEs have increased mark-ups to 15-20% to reduce India transfer pricing risks

+ Transfer pricing is one of the most important issues for tax heads in light of the
aggressive enforcements by Indian tax authorities
o 8 cycles of TP audits and transfer pricing adjustments to the tune of approx. USD 27 billion.

+ Captive centres have attracted considerable attention from Indian tax

authorities on account of alleged disparity between their functional and risk
profile in form vis-à-vis substance
+ In this presentation, we look at the emerging landscape for these captive
centres from an Indian transfer pricing perspective

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STATED VIEWPOINTS OF INDIAN TAX
ADMINISTRATION

+ Scope of intangible property widened

o 2012 : Retrospective amendment (effective 2001-2002) to define intangible
property to cover technology-related, marketing-related, customer-related,
contract-related, human-capital related intangibles, location-based intangibles,
etc.
+ Captive centres are not necessarily risk mitigated
o March and June 2013: Administrative circular issued to provide parameters for
identifying risk-mitigated captive R&D centres.
+ Inclination towards Profit split method
o March and June 2013: Administrative circular encourages use of the Profit Split
Method to benchmark transactions involving use /transfer of intangibles; The
circular was withdrawn in June 2013.
+ Emphasises higher returns for captive centres (particularly engaged in R&D
activities); trend emphasised through the safe harbour rules which are based
on above principles.

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STATED VIEWPOINTS OF INDIAN TAX
ADMINISTRATION

+ Indian tax authorities skewed towards higher returns for captive centres
– following views provided in 2013 United Nations Practice Manual for Developing
Countries:
o Allocation of routine and low cost-plus return for captive centres may not
reflect ALP. Decision making by skilled manpower of captive centre reflects
the risks are controlled by the captive centre in conduct.
o Location savings should be split between the participating parties.
Comparability with local comparables determine only the price of the
transaction and not allocation of location savings.
o Compensation attributable for transfer of intangibles in addition to the arm’s
length compensation for R&D activities. The captive centre creates unique
intangibles, transfers legal ownership in the intangibles under agreement
without appropriate compensation.

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INDIA TP MANAGEMENT: THE EMERGING
DECISION VARIABLES ….

+ How to demonstrate the lower risk characterization of captive centres?

+ Have the outsourcing models resulted in any location (dis)savings? Who
should benefit/absorb the same?
+ What intangibles are created in supply chain and what is the role of the
captive centres vis-à-vis these intangibles? Should the captive centres be
remunerated for any intangible related returns?
+ Is the current cost-plus compensation technique appropriate? Should
alternative techniques, such as revenue share or hourly charge out rates,
be considered?
+ Which is the most appropriate transfer pricing method for testing
compliance with ALP appropriate? Is there a case for the application of the
Profit Split Method vis-à-vis the Transactional Net Margin Method?

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 THE VALUE CHAIN CONTEXT

Tertiary Primary
Non-core Core support Customer Core
Functions support facing business
X1 X2 X3 X4
Highest value Profit
Judgmental Centre; High risks,
Y3
Location Savings and
Intangibles

Y2
Also factor:
• Key decision makers;
employee profile
Lowest value
Cost Centre; • Business case
Y1 minimal risk,
• Stage in business cycle
Location • Alternatives to captive
Routine Savings and
Intangibles
outsourcing

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LOCATION SAVINGS

+ Net cost savings that an MNE realises as a result of relocation of

operations from a high-cost jurisdiction to a low-cost jurisdiction.
+ Review of following parameters to demonstrate existence / non-existence
of location savings
o Cost-benefit / opportunity cost analysis performed prior to outsourcing
o Cost of capital and transition costs associated with outsourcing
o Actual benefit vis-à-vis anticipated benefit
o Industry / economic environment vis-à-vis efficiency
o Bargaining power of captive centre : the value chain context
o Trend in location savings over a period of time
o Independent intangible transaction vis-à-vis factor of pricing

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INTANGIBLES : VALUE RELEVANCY
Kind of intangibles Routine
Intellectual Property Easily transferable
Rights Not a Critical Success
Protected by law Factor (typically value not
dependent on mechanics
of adaptability)
Competitive Can be easily duplicated
Intangibles Not a Critical Success
Generate a Factor (however value
competitive advantage could be dependent on
but do not have legal mechanics of adaptability –
protection e.g. methodology to use
technology in non-tech
savvy environment)
Premium
Easily transferable
Critical Success Factor – control
exercised through contracts
and legislation
Can be duplicated only through
transition of Human Capital
Critical Success Factor
• Competency based
• Relational based
• May be protected through
non-compete arrangements
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INTANGIBLES : VALUE RELEVANCY

+ Need to distinguish between:

o Unique intangibles transforming revenue earning potential of the entity vis-à-
vis intangibles resulting in business efficiencies.
o Impact of efficiency related intangibles can be demonstrated through
productivity increases based on management information reports.

+ Need to identify the entity that makes decisions on the intangibles and
bears intangibles-development risks.

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COMPENSATION TECHNIQUES

+ Is a cost-plus model appropriate to remunerate highly-skilled talent and

services?
+ Does compensation technique determine risk allocation?
+ Would third party service providers provide similar services on a cost-plus
pricing model?
+ Alternative pricing models
o Revenue share or charge-out rates

Value chain context influences choice of compensation technique

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METHOD OF TRANSFER PRICING

+ TNMM is a single-sided approach and does not throw light on

entrepreneurial margins / losses earned by MNE group on specific
transactions.
+ Value chain context can influence choice of method :
o Profit split method more suitable to captive centres which are profit centres
(by performing customer front-ending activities).
o TNMM still appropriate for non-core support functions (such as payroll
support).
+ Use of a contribution based approach in the value chain framework can be
a strong defense strategy

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CONCLUDING REMARKS – HYGIENE CHECK

+ India operational profile – review transfer pricing or/and permanent

establishment risks
+ Document the value chain framework for risk assessment
+ Perform a mock assessment to not only test model and documentation
but also spread transfer pricing awareness with decision makers.
+ Review policy and aim alignment with business dynamics.
+ Proactive collation of evidence for use in TP audit defense

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THANK YOU!

“An organization’s ability to learn, and translate that learning

into action rapidly, is the ultimate competitive advantage.”

- Jack Welch

Vishnu Bagri
Presenter Coordinates
T: 91 80 22261371
E: vishnu@sduca.com

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inbound and outbound investments, tax optimization strategies, transfer pricing strategies and representation services.
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All Rights Reserved.

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