Managing Recession

from a Transfer Pricing Perspective

Vispi T. Patel

October 2009
 Glossary and Abbreviations

” BEP Break Even Point

” CPM Cost Plus Method

” CUP Comparable Uncontrolled Price Method

” GDP Gross Domestic Product

” OECD Organisation for Economic Co-operation and Development

” TNMM Transactional Net Margin Method

” TP Transfer Pricing
 Contents
DBackground of Recession

DTransfer Pricing in Recessionary

Conditions

DDocumentation Requirements

DTransfer Pricing Policy Review

DCase Study
Background of Recession
 Recession!
DWhat is Recession??
D It is the economy shrinking for two consecutive quarters with a
decrease in the GDP
D It may be preceded by several quarters of slow down
D 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!
DThe shock of the current recession was sudden. All
thanks to abundance of cheap credit for many years

DThis 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

DA single trigger point of default of home credit payments

was enough for global economic crisis

DBefore 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! Upward Spiral – when all
is well!

5 Country
becomes favoured 4 With feel good
destination for factor and increase
investment in demand, stock
markets rise overall
3 Increased
employment and
spending by
industry amounts 2 In response to rise
to further in demand, industry
consumption produces more,
which means
increase in
1 Consumers employment levels
feel confident in and more
the future of the consumption of
economy so resources
7 they spend
more
 Downward Spiral – when
Recession! the economy has
suffered major setbacks

1 Consumers lose
confidence in the 2 In response to
future of the fall in demand,
economy so they industry lays off
spend less employees and
reduces
production
3 Now people have amounting to
less money to spend less consumption
and debts mounting of raw material
so they further
reduce spending 4 Stock markets
take a hit due to
poor earnings of
the industry
5 Country loses
creditworthiness hence
lower investments
8
 A Look at the Global Financial Indicators
– Outcome of the Downward Spiral

9
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

DTransfer Pricing policy of the multinational is

generally based on the underlying presumption of

stability
DIt is also based on the reasonable predictions or

certainty of the future events

DTherefore, sudden uncertainty caused by the recession

throws light on the loopholes in the Transfer Pricing

policy of the Multinational Group. For Example:
D It becomes difficult to split losses as compared to

splitting of profits in the good times

D Pre-recession methodologies may not hold good in

recession
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 Transfer Pricing issues specific to Recession

DPre-recession benchmarking analysis may become

ineffective for the following reasons:

D CUP Method: change in the economic circumstances and

business exigencies makes pre-recession CUPs unreasonable

D 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
D Presents difficulties with profit-targeting for entities
on CPM/TNMM benchmarking policies

D Some jurisdictions may have losses while others have

taxable profits, deteriorating cash tax position

D Increasing transfer pricing audit risks

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 Transfer Pricing issues specific to Recession

DRecession creates business issues such as:

DOperating Losses

DReduction in force and plant closures

DCash flow and debt service constraints

DExcess/obsolete inventory

DCredit crunch

DAnalyses prepared in these circumstances will require careful

consideration of attribution of risk and splitting of the losses
DThese 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
DIndia, 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

DThe 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
DConsider whether any other method can now be more

appropriate in the changed scenario

DComparable set to take into consideration the companies that

are equally impacted by the recession in the same period

DAdjust the financial results of the comparables to take into

consideration the current economic conditions – industry

specific analysis
DDocument in a robust way the impact of recession

DConsider Year-end adjustments (True-ups)

DKeep 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
Is the
Did recession Are the
No No company open to
force a company business conditions
restructuring its
to change its business affecting company’s
economic
model? profitability?
substance?

Yes
Yes

Formulate new TP Review existing TP Formulate new TP

policy policy policy

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Case Study
 Case Study
D Utility Vehicles India Ltd (‘UV India’) is a well established
leading utility vehicle manufacturer in the Indian market

D 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

D 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

D Engines supplied by UV India form a major portion of the

production cost of UV Korea

D 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
D 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

D 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

D Therefore, now the question before UV India is:

DWould 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…

Strategic plan
Identification of Determination of should dovetail into
constraints and various alternatives a ‘Benefit Test’
their effect on available under achievement from an
the profitability arm’s length scenario Arm’s Length
perspective

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:

DThe Benefit Test (taking into consideration the

future strategy of the Group),

DHow the strategy dovetails into the long term vision

of UV India, and

DProfitability analysis (taking into consideration the

financial data of the comparable companies)

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 Profitability Analysis

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 Profitability Analysis
D The comparable data on the public domain shows the following results:

Sr. Particulars Arithmeti Arm’s +/- 5% Price

No. c Mean Length range
(%) Price
1 Comparable's results – using 8% 108 102.60 -
data pertaining to FY 2008- (i.e. 100 + 113.40
09 8%)
2 Latest available quarterly 5% 105 (i.e. 99.75 – 110.25
results data (April 2009 – 100 +5%
June 2009)

D 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
D 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 / 2009-10 2010-11 2011-12 2012-13 2013-14 2014-15 2015-16 2016-17 Life
Year Cycle
2009-10
to 2016-17

Contribution 15,500 34,500 38,000 47,900 51,000 51000 51,000 51,000 44,500
per unit

PBIT per unit (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 2014- 2015-16 2016-17 Life Cycle
15 2009-10 to
2016-17

2% 31,000 49,900 53,400 63,100 66,600 66,600 66,600 66,600 59,500

3% 29,000 48,000 51,500 61,200 64,700 64,700 64,700 64,700 57,600

4% 27,000 46,000 49,600 59,300 62,800 62,800 62,800 62,800 55,700

Projected PBIT per unit (in SKW)

2009-10 2010-11 2011-12 2012-13 2013-14 2014-15 2015-16 2016-17 Life Cycle
2009-10 to 2016-17
2% (75,000) (38,100) 1,200 21,000 24,500 24,500 24,500 24,500 5,300

3% (82,300) (40,000) (600) 19,100 22,600 22,600 22,600 22,600 3,500

4% (89,000) (41,900) (2,000) 17,200 20,700 20,700 20,700 20,700 1,600

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 Future Projections of UV Korea Business
D 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

D 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

D 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
D 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 2009-10 2010-11 2011-12 2012-13 2013-14 2014-15 2015-16 2016-17

/ Year
@10% 32,366 16,519 15,531 12,850 11,925 11,925 11,925 11,925
@2% 16,165 11,461 11,089 9,739 9,234 9,234 9,234 9,234
@3% 17,244 11,917 11,500 10,043 9,502 9,502 9,502 9,502
@4% 18,478 12,411 11,942 10,366 9,786 9,786 9,786 9,786
Projected Sales 3,980 6,500 11,350 14,620 14,620 14,620 14,620 14,620
D 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
DAll 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

DThe reduction in profitability has to be supported by a robust

documentation which should be able to demonstrate that the re-
engineering business strategy is in-fact the need of an hour and reflects
mirror image of the market conditions

DThe 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
DTransfer Pricing law gives due importance to the
changes in the economic conditions - OECD

DTransfer Pricing is flexible enough to take into

consideration the changes in the economic conditions
if structured appropriately - OECD

DHowever, 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