Transfer Pricing In M&E For Nadt 30.07.2009

Transfer Pricing in Media
& Entertainment Industry
Presentation in ‘National Academy of Direct
Taxes (NADT)’ on July 30, 2009

Presented By,
Romesh S A Sankhe

ROAD MAP
► Importance of the M&E Sector in India and key
happenings

► Key transfer pricing issues in M&E

► Recent important judicial decisions of transfer
pricing in India

► Recent global developments & emerging concepts

► Key takeaways

July 30, 2009 Page 2 Transfer pricing in Media & Entertainment Industry For Presentation in NADT

Importance of M&E
sector in India and key
happenings


M&E Sector - Key Segments
► The Indian Media and Entertainment (M&E) Industry can
be categorized as follows;
Television
Print (Primarily Newspaper and Magazines)
Filmed Entertainment (Movies)
Radio
Music
Animation
Gaming
Outdoor Advertisement such as Concerts etc


Sector Performance in India
Rs. Billion 2005 2006 2007 2008 CAGR
Change % (05-08)
Television 163.3 182.5 211.3 240.5
12% 16% 14% 14%
Print Media 117.1 138.6 160.4 172.6
18% 16% 8% 14%
Filmed 66.9 81.7 96.4 109.3
Entertainment 22% 28% 13% 18%
Radio 4.9 6.0 7.4 8.4
22% 23% 14% 20%
Music 8.3 7.8 7.4 7.3
-6% -5% -1% -4%
Animation , Gaming 24.5 28.4 37.1 45.9 19%
& VFX, Out-of-home 16% 31% 24%
advertising & Online
Advertising
Total M & E Industry 385.0 445.0 520.0 584.0
16% 17% 12% 15%
Source :- FICCI FRAMES 2009 by FICCI-KPMG


Recent Key Changes
► Indian M & E Industry has grown at a rate of 12.4% p.a. during 2008
with an size of Rs.584 billion, over the next five years the industry is
projected to grow at CAGR of 12.5% p.a. to reach the size of Rs.1052
billion by 2013;
► The segments with highest rates of growth were online advertising, out-of-home
advertising and the radio industry
► followed by Animation, Gaming & VFX, and Television Industry

► In 2008, number of M&E deals grown from 59(2007) to 85, valued at
USD 1.7 billion. The inflows in the form of investments are;
► Disney’s acquisition of 15% stake in UTV Global broadcasting
► NBC universal’s acquisition of 26% stake in NDTV Network Plc
► Morgan Stanley and India Infrastructure Holding Fund’s USD 60 mn in Hathway
Cable and Datacom
► DE Shaw’s acquisition of additional stake in Amar Ujala
► Goldeman Sachs & Lehman brother’s investment of USD 50 mn in out-of-home
(OOH) advertising subsidiary ENIL
► Warbugr Pincus’s USD 75 mn investment in Laqshya Media


Recent Key Changes
► Indian Film Industry declared as ‘Industry’ in 2000 under IDBI Act
► Corportisation of the Film Industry lead to more organized &
transparent business model
► Liberalized FDI norms
► 100% in Film, Advertisement, non-news broadcast & magazines,
► 49% in cable
► 26% in news, print etc
► Availability of finance from banks compare to old source of financing
from private lenders,
► Indo-foreign collaborations for Media, film ventures, etc such TOI-
Reuters, IBN-CNN, TV18-CNBC, ADAG-Spielberg, YRF-Walt Disney,
Sippy-Warner Bros, etc
► Foreign countries such as Switzerland, UK, Germany, Italy, Brazil
entered into co-production bilateral agreements with India offering
incentive to the Indian Media Companies


Key Transfer Pricing
Issues in M&E


Key Transfer Pricing Issues
► Certain key cross border transactions in the Indian M&E
sector are as under :
Overseas Film Distribution
Payment of Royalty
Setting up of subsidiary for business support, marketing etc.
Availing services of professionals employed by the overseas
company
Financing of the subsidiary company
Reimbursement of expenses
Use of loss making comparables in the benchmarking study

Some of the above issues are discussed herewith through case
studies


Film Distribution – a case study
► Facts of the case
ABC Ltd who acquired the overseas rights of a Hindi Film, distributes it through its
subsidiaries in USA, UK & South Africa and through third party agents in rest of the
world. The terms of the arrangement with various entities are as follows;
Country Terms of Film Distribution Terms regarding the
reimbursement of advt. and
other related expenses
USA No Minimum Guarantee & 10% Commission on net revenues1 On actual without any markup

UK No Minimum Guarantee & 10% Commission on net revenues1 On actual without any markup
South Africa No Minimum Guarantee & 10% Commission on net revenues1 On actual without any markup

UAE No Minimum Guarantee & 5% Commission on Gross On actual without any markup
revenues
Nepal No Minimum Guarantee & 15% Commission on net revenues1 On actual without any markup
Malaysia Certain Minimum Guarantee & 30% Commission On actual without any markup
Germany No Minimum Guarantee & 5% Commission on net revenues1 On actual without any markup
Russia No Minimum Guarantee & 5% Commission on net revenues1 On actual without any markup
France Outright Purchase Not Applicable
Canada Outright Purchase Not Applicable
Australia Outright Purchase Not Applicable
1. Net revenues = Gross revenue – exhibitors share – taxes – cost of print


► Step 1 – Business Study & FAR
► Understanding of business model
► Outright sale – Business risk fully born by licensee
► Minimum guarantee (MG) basis – Business risk depends upon MG &
commission ratio
► Pure commission basis – Business risk fully born by licensor

Vital considerations
- MG & commission may vary from film to film such as YRF,
KJ, SRK, AK may fetch a higher MG
-Higher the MG , higher the risk hence higher commission
share of licensee from the balance trade proceeds
-Each business model is distinctively different from each
other hence may not be compared with each other


► Step 2 – Selection of Method
► CUP method could be ‘Most Appropriate Method’ (MAM) over the
other methods because;
► Comparable Uncontrolled Price – Required degree of comparability is higher
and availability of existing CUP
► Cost Plus – No uniform formula to compute gross margins in India, hence
could not be relied upon
► Resale Price – Generally used in distribution of manufacturing good hence
may not be MAM
► Profit Spilt – Only used in complex, interdependent & interlinked transactions,
hence may not be MAM
► Transaction Net Margin – Segmental data may not be available due to
upcoming segment, also termed as residual method
-Generally CUP is preferred as MAM, due to high level of
comparability
-First preference should be given to Internal cups, as degree
of comparability could be measured appropriately


► Step 3 – Selection of Comparables
► Internal CUP should be preferred
► Analysis of terms with the third parties through whom distribution was done in
the same region prior to opening of an subsidiary i.e. US, UK & South Africa in
the instant case
► If above not available, then analysis of existing third party comparables on the
following grounds;
► Comparable business model & terms
► Comparable geographic, local business environment such as NRI & PIO population in
the instant case
► External CUP may not be used, due to lack of availability of detailed
information due to which conclusive comparative analysis could not be
undertaken

Higher the level of comparability, higher the accuracy of
benchmarking study


► Step 3 – Selection of Comparables
► Accept / Reject Matrix
Country Population of NRI & PIO’s ‘Accept / Reject analysis’ with reasons thereon
USA 3,000,000 N.A.

UK 1,600,000 N.A.
South Africa 1,160,000 N.A.

UAE 1,400,000 Accepted, because of comparable business model due to
similar geographical conditions
Nepal 4,000,000 Accepted, because of comparable business model due to
similar geographical conditions
Malaysia Certain Minimum Guarantee & Rejected, because of different business model
30% Commission
Germany 80,000 Rejected, because of different geographical conditions
Russia 16,000 Rejected, because of different geographical conditions
France Outright Purchase Rejected, because of different business model
Canada Outright Purchase Rejected, because of different business model
Australia Outright Purchase Rejected, because of different business model

Facts


► Step 4 – Analysis of Comparables
► Comparison on identical grounds
Particulars Associated Third Party in Third Party in Nepal
Enterprises UAE
Terms of Arrangement 10% on net 5% on Gross 15% on net
revenues revenues revenues
Gross Collections of the movies (net of taxes) 100 100 100
Less: Theatre Share on the above 45 45 45
Less: Cost of prints 10 10 10
Net Collection from Film distribution 45 45 45
Less: Share of trade proceeds to on net 4.5 N. A. 6.75
collections
Less: Share of trade proceeds to on Gross N. A 5 N. A
Collections
Net Collection received by ABC, India 40.5 40 38.25
Percentage share of trade profits given to 10% 11.11% 15%
Overseas Exhibitor

Arithmetic mean is (15+11.11)/2 = 13.05%, hence
the existing transaction is comparable in the Indian context.


Royalty – An analysis
► Problems faced in benchmarking analysis
► Maintenance of documentation of ‘benefits received’ from use of
intangible such as trademark, brand name, patent, designs,
marketing intangibles etc.
► Difficult to demonstrate the economic value of the intangible,
however sometimes a report of an independent valuer could be
considered
► Application of TNMM and exchange control approvals are not
widely accepted by authorities in India
► Internal CUPs are only available, that to in rare cases
► Due to secrecy norms & sensitive business information, external
CUPs are not available in public domain in India
► In foreign countries, the public databases are used for comparable search
such as; Asia-pacific franchise directory, International Franchise Association
(IFA)’s franchise opportunities directory, Franchise-Euro edition, RoyaltyStat
compiled from US SEC archieve, RoyaltySource based on media reports etc.


► Indian Regulatory Scenario for Royalty payment
► In the past, reference for comparable royalty rates used to be made to the
website (www.siadipp.nic.in) of the Secretariat of Industrial Assistance
(SIA) constituted under the Ministry of Industry and Commerce of the
Government of India
► Through this website, SIA used to publish information on a monthly basis
on royalty rates approved by the Government, in various technical
collaboration proposals put forth by the industry for the Government's
approval
► However, SIA has discontinued publishing data relating to approved
royalty rates from September 2004
► Currently prescribed ‘automatic approval route’ for Royalty payment by
Department of Industrial Policy & Promotion (DIPP) is as under;
► Use of trademark - 1% on domestic sales & 2% on exports
► Use of trademark along with technology transfer - 5% on domestic sales & 8%
on exports or lump sum payment up to USD 2 million
► However, there exists an ambiguity on availability of automatic approval route to
service industry
► However, recently it is proposed to allow all payments for trademark,
know-how, technology transfer under the ‘automatic route’ without any
restrictions of DIPP


► Suggested way forward
► Detailed documentation of ‘benefit received’ along with various business &
commercial justifications for the payment
► Internal CUP’s & its consistency should be carefully analyzed
► ‘Holistic approach’ needs to be adopted such as consideration of;
► Tenure of the agreement
► Various benefits available to Indian company which may not be utilized by the
Indian company due to its limited business capabilities
► Practice followed by its peers
► Prevailing business conditions of the industry segment
► Use of intangibles may not always/every year results into super profits
► Regulatory approvals such as DIPP, RBI should be considered especially
approvals obtained other than under automatic route with specific
representations before these authorities
Transfer pricing incase of ‘payments for use of
intangibles’ needs a special consideration both from revenue
authorities as well as tax payers


Captive Service Provider – a case study
► Facts of the case
WDV Inc a US based company engaged in media & entertainment business
has set up a company in India for carrying out its business support function
exclusively for its parent, which is remunerated at ‘Cost plus’

Assets employed
Type of Assets WDV India WDV USA
Employees Yes Yes
Property, Plant & Equipment Limited Yes
Intangible such as Trade Licenses, Know No Yes
How etc.



Risk assumed
Type of Risk WDV India WDV USA
Entrepreneurship Risk No Yes
Market Risk No Yes
Manpower Risk Yes Yes
Credit & Collection Risk No Yes
General business risks Limited Yes
Foreign Exchange Risk No Yes
Legal Risk No Yes

Accordingly, WDV USA should be characterized as the
‘Entrepreneur’ and WDV India as the ‘Limited Risk Bearing
enterprise’



► Step 2 – Selection of method
► TNMM method could be ‘Most Appropriate Method’ (MAM) over
other methods because;
► Comparable Uncontrolled Price – Required degree of comparability is
higher and no availability of CUP due to closely held industry
► Cost Plus – No uniform formula to compute gross margins in India, hence
could not be relied upon
► Resale Price – Generally use in distribution of manufacturing good hence
may not be MAM
► Profit Spilt – Only used in complex, interdependent & interlinked
transactions, hence may not be MAM
► Transaction Net Margin – Comparable data is available in the public
database, and also termed as residual method



► Step 3 – Selection of comparables
► After conducting the search on public database on the basis of various
parameters such as turnover, availability of data, related party transactions,
elimination of companies with abnormal results. The following are the final
comparables;

Sr. EBIT of EBIT of Average
Company Name
No. FY 20XX-XX FY 20XX-XX of 2 years
1 AL XX% XX% XX%
2 IOL XX% XX% XX%
3 TCL XX% XX% XX%
Average (Arithmetic mean) XX% XX% XX%

The prime factors distinguishing WDV from the set of
comparables is that it do not undertake following risks;
-Marketing functions & risk
-Credit Risk



► Step 4 – Analysis of comparables
► Hence appropriate ‘discounting’ has to be done to the arithmetic mean in
the absence of ‘marketing activity’ function by WDV India.
► Till date, only 3 judicial precedents has computed margins attributable to
marketing activities, hence same may be used for discounting as under;
Sr. Margin attributable marketing
Particulars of Judicial decision
No. Activities by judicial authorities
1 Ahmad Bhai Umar Bhai (SC), 18 ITR 472 35.00%
2 Carborandum Co. Vs CIT (SC), 108 ITR 335 10.00%
3 M/s Rolls Royce Plc, Delhi Tribunal, M.A. Nos.55 to 35.00%
66/Del/2008, ITA Nos.1496 to 1501/Del of 2007
Simple Average (Arithmetic mean) 26.67%

Hence, arms length price could be arrived as follows;
XX% - (XX*26.67%) = XX%


Key Indian Judicial decisions


Litigation Update…

► Skoda Auto India – Pune ITAT
► Transactions between Associated Enterprises (‘AEs’) cannot be
considered for determining the existence of an internal Comparable
Uncontrolled Price (‘CUP’)
► The external CUP is not the correct method when the product is unique
► Assessee cannot be expected to get details and particulars, which are not
available in public domain
► Honeywell Automation – Pune ITAT
► Only current year data to be used, if the Appellant is not be able to reveal
any facts to bring the case to the proviso to Rule10B(4)
► Gujarat Guardian – Delhi High Court
► The judgment tacitly endorses that companies may follow “prudent”
business strategies that may result in current losses if such losses are
less than the losses to be incurred had the company gone out of business



► Coca Cola India – Punjab & Haryana High Court
► For invoking Transfer Pricing (‘TP’) regulations, there is no requirement to
establish transfer of profits outside India or evasion of tax
► Permission granted by the Reserve Bank of India (‘RBI’) under the
Foreign Exchange Regulation Act (‘FERA’) cannot control the provisions
of the Income-tax Act, 1961 (‘the Act’)
► UCB India – Mumbai ITAT
► CUP method requires a high degree of comparability , even a minor
change in the properties of the products, circumstances of trade (billing
period, amount of credit therein, geographical market conditions etc.) may
have a significant effect on the price
► Detailed Functions, Assets & Risks (‘FAR’) analysis required for
application of CUP method



► Sony India – Delhi ITAT
► Loss making companies cannot be excluded from the list of comparables,
as incurrence of loss is a normal part of business. However, incase of
consistent losses and other peculiar company specific factors, the
company may not be a comparable.
► Not an easy job to evaluate the differences for each of the factors and
held that the “Ad-Hoc” adjustment of 20% granted by TPO for these
factors was fair and reasonable
► Schefenacker Motherson Ltd – Delhi ITAT
► Cash profit on sale or cash profits on total cost excluding depreciation can
be adopted as an appropriate profit level indicator (PLI) under TNMM
► No standard concept existed for ‘operating income’, hence it would
depend on facts of each case



► The Karnataka High Court stayed the ITAT decision incase of
Aztec Software & Philips Software, and admitted the appeal on
the following substantial question of law :
► Whether the TP regulations cannot be invoked and applied in the case
where the provisions of section 10A of the Act where income is exempt, is
availed of by the Appellant?
► Whether the Appellant was justified in using earlier year data in
comparability analysis?
► Whether section 92C(2) of the Act provides for a standard deduction of
5% in all TP cases?
► Whether a flat comparability adjustment for working capital and risk can
be made ignoring the quality, data, purpose and reliability of adjustment?
► Whether companies with even a single rupee related party transaction
should not be selected as comparables?

Post the decisions of Karnataka High Court in the case of
Philips Software and Aztec Software, most of the TP issues
are now open for interpretation


Recent global developments
& emerging issues


Recent global developments
► Australia
Australian Tax Office (ATO) working on draft discussion paper on
transfer pricing implications on ‘financing group companies’
► China
China’s State Administration of Taxation (SAT) issued detailed
guidelines on transfer pricing covering various issues such as APAs,
Cost sharing arrangement, Safe harbor etc
► Singapore
Inland Revenue Authority of Singapore (IRAS) issued detailed draft
discussion paper on transfer pricing implication on ‘related party
loans’ & ‘related party services & cost sharing arrangements’
► United States
US Treasury department and Internal Revenue Services (IRS)
published regulations on ‘Cost sharing arrangement (CSA)’


Overview and need for an APA
► The comparability of the taxpayer with uncontrolled third parties is
subjective and fraught with number of assumptions
► Given the subjectivity or lack of quality data for a perfect analysis the
potential risk of double taxation in case of TP adjustment, TP is an
area of concern for the taxpayers
► There is a genuine desire amongst for taxpayers to comply with TP
provisions of both jurisdictions that are involved in each transaction
► Therefore APAs are desired to achieve certainty in TP valuation and
to avoid litigation
► Countries who have introduced concept of APA have made provision
for unilateral, bilateral or multilateral APA in domestic law. They have
also set up a separate authority to execute APA. Bilateral or
Multilateral APA are attended by the Competent Authority under
article on mutual agreement procedure in DTAA


Countries with APA … so far
► Australia ► Mexico
► Belgium ► Netherlands
► Canada ► New Zealand
► China ► Peru
► Colombia ► Poland
► Denmark ► Singapore
► France ► Spain
► Germany ► Switzerland
► Hungary ► Taiwan
► Ireland ► Thailand
► Israel ► Turkey
► Italy ► UK
► Japan ► USA
► Kazakhstan ► Venezuela
► Korea


Is APA successful ?
► This can be known from the status of number of APA applications filed and
disposed off by the tax authorities. Given below is select country wise
summary of status of APA application
Name of Introduced No of APAs
Information available as of
country since pronounced/ operating
Australia 1995 1314 30.06.2005
Canada 1994 55 From 94’ to 2003
China 1998 180 Until 2007
France 1999 30* 2004
Japan 1987 303 Till year 2004
Korea 2006 5 As per latest information
available
Mexico 1995 1300 As per latest information
available
United Kingdom 1999 300 Till 2006
USA 1991 692 Till year 2005
* Applications received
The details mentioned in the table are gathered from the information available in internet.


APA - Conclusion
► APA definitely a tool to resolve transfer pricing, especially by use of BAPA
► Time period to conclude (normally 2-3 years) does not act as constraint, as
both taxpayer as well as revenue sure of certainty in tax and APA covers
several years
► Gives both taxpayer and revenue a perspective / experience on transactions
where APA has not been obtained
► Transactions which are complex and difficult can be analysed more carefully
during APA process, thereby giving both taxpayer and revenue to showcase
their case
► Renewal of APA becomes less time consuming and definitely reduces cost
and time
► Taxpayer obtaining APA lives in more certain environment then taxpayers
who have not obtained APA (No hefty tax provisioning required)
► Annual Documentation cost can be substantially reduced and TP audit and
penalty fear almost becomes negligible
► Lastly reduces double taxation and promotes international business


Is it a time to introduce APA in India ?
► Currently we are in eighth year since introduction of TP in 2001
► Information as per newspaper indicates total quantum of adjustment in 3
years of audit - approx US$ 1.5B
► A large number of cases pending at first level of appeal, indicates difficulty to
adjudicate a ruling on TP matters
► Only in few cases Tribunal has pronounced its judgment
► Even in US, Courts has not been able to pronounce more than 30 cases vs
500 or more APAs
► Resolution through APA seems to have more success in countries where
APAs are available – see table in previous slides
► India’s case is no different, APAs definitely helps in resolving pricing matters
upfront

Indian revenue authorities as well as the taxpayers
are prepared for the APA regime


Key takeaways


Key takeaways
► Certain key points for transfer pricing audits :
Detailed comparability analysis of the data is a must
Peculiarity of business and prevalent business conditions should be
considered
Exceptional situation needs exceptional actions such as recent global
downturn etc.
Emphasis on detailed & in-depth FAR analysis and documentation
Internal CUPs should be preferred over the external CUPs
Cost-benefit analysis needs to be undertaken incase of payment of
management fees, royalty & reimbursement of expenses
Revenue authorities needs to come out with guidelines/safe harbor on
certain key issues such as
Group support services
Reimbursement of expenses
Cost sharing arrangement etc.
Indian government should introduce APA’s which would result into
Comfort to the non-resident coming into India & taxpayers
Less burden on the assessing officers


Key takeaways
► Certain key points for transfer pricing audits :
Start up losses or initial low margins may be considered for ‘Full fledge
manufacturer’
Multiple year data may be considered as per business cycle
Use of loss making comparables may be allowed in selected cases

Transfer pricing is about
understanding the business & its mechanism ….. It’s the
way you would have carried on your own business !!!


Q&A


Thank You
For any further clarifications;
Mr. Romesh S A Sankhe,
E-mail - romesh.sankhe@rediffmail.com, (Cell) - +91 9892 892504.

Disclaimer
The views expressed in this presentation are solely that of the speaker and
do not constitute any kind of professional advice. These views or opinion
expressed in this presentation should not be directly applied or used without
a professional advice as the review of the facts and the existing judicial
position is of utmost importance in the transfer pricing analysis.


Transfer Pricing In M&E For Nadt 30.07.2009

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