PHARMACEUTICAL INDUSTRY CASE STUDY

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PHARMACEUTICAL INDUSTRY CASE STUDY
Presentation by Alpana Saksena CIT(A)
International Tax MUMBAI
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Facts of the case

• ABC India is engaged in the manufacture and
  marketing of formulations

• Main transactions were

• Payment of Commission to AE Rs 12.86 crores

• Import of Actives transaction Rs 113.8 crores

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Method of Computing ALP

• ABC India aggregated all transactions

• Applied the TNMM method

• Used a set of external comparables
• to benchmark profits

Operating Profit Margins of Comparable companies 7.53
Operating Profit Margins of ABC India 13.87
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Commission transaction
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Commission transaction
Assessee's Contention
ABC AE
Marketing Canvasser services for exports as per
agreement
Payment of Commission _at_12.5 of Sales
ABC India
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Commission transaction
Taxpayers Contention

• ABC India compares its OPM with the OPM of
  external comparables

• by aggregating all transactions

• Which were

• Imports of actives

• Export of formulations

• Commission

• Sundry Reimbursements

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Comparisons of Operating Profit margins
Operating Profit Margins of ABC India 13.87
Operating Profit Margins of Comparable companies 7.53
So, ABC India stated that its transactions
are at arms length
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Justification for commissionpayment
Taxpayer's contention

• For establishing close contacts with customers

• For employing marketing personnel for marketing
  these products

• For participating in exhibitions, fairs,
  buyer/seller meets, seminar , conferences

• To promote products through doctors meets,
  conferences

• To distribute information material ,leaflets,
  pattern cards etc.

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Documents produced
To support payments

• Copy of Agreement called Export Canvasser
  agreement

• Some advertisements of overseas AEs

• Letters from overseas AEs to assessee

• CA Certificate / Bank Realization Certificates

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Documentation Rules
Prescribed by rule 10D of the I.T. Rules
Lays down 13 different types of information which
should be maintained
They are (broadly speaking)

• Enterprise wise documents

• Transaction specific documents

• Computation related documents

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Documentation Rules
The Rule 10D(3) states that information in
sub-rule (1) shall be supported by
authentic documents
which include
f) letters other correspondence relating to
terms of contract
(g) documents required to be kept under the
accounting practices followed.
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Documents which should have been produced

• Reports of contacts with customers

• List of marketing personnel hired for the purpose

• Details of participation in exhibitions, fairs,
  buyer/seller meets, conferences,seminars

• List of doctors approached for using product

• Copies of information material ,leaflets,
  pattern cards distributed

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As no such documents were produced
Commission payment was not authenticated
In the opinion of revenue
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Commission Payment
Revenue's Contention
Objected to aggregation of all transactions for
benchmarking them
Insisted for
separate evaluation of commission
commission was not closely linked to other
transactions if imports, reimbursements
No justification given for rate of 12 paid
similar independent comparables
Separate set of
required for benchmarking
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Similar comparables would mean

• All such cases

• Who had paid commission or any other expense to
  any foreign party

• To promote their sales

• So we needed to look at foreign expenses be it

• marketing

• Advertisement

• Commission

• Sales promotion

As a percentage of sales
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Which means
We needed to look at the
Foreign expense to sales ratio
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Commission transaction
Taxpayers counter plea
'Result' based Export Canvasser Agreement not
'effort' based
Results showed 15 increase in sales as compared
to previous year
Hence, transaction is at Arms Length
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Taxpayer took another plea
Domestic sales
480 Crores
Domestic Selling expenses ratio
16.14
103.08 Crores
Export sales
Foreign Selling expenses (Commission) ratio
12
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Assessee pleaded that

• costs in India would be lower than the costs of
  promoting products in an overseas market

• As the export selling expenses of 12 were less
  than the domestic selling expenses of 16.14

• So the commission payment to AE was at arms length

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So dept asked assessee to do the analysis first
ABC India carried out an analysis of computing
the Foreign exchange expense to Sales ratio
for the pharma companies (comparable in size to
ABC India).
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Analysis given by assessee
Sl No Company Total forex outflow (in crores) Total export sales Forex outflow as of export sales
1 A Co 3.18 66.78 5
2 B Co 2.79 5.42 51
3 C Co 2.00 22.33 9
4 D Co 0.48 1.58 3
5 E Co 7.72 13.03 59
Average forex outflow on sales Average forex outflow on sales Average forex outflow on sales 25.40
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Defects in assessees analysis

• huge variations in the outflow

• Some companies have a outflow as high as 59 and
  some as low as 3.

• Extraordinary reasons would exist for such heavy
  outflowsnot explained by assessee

• Most of the companies had paid Royalty for
  brandhence not comparable

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Department rejects assessees contentions
Dept carried out analysis on the same set of
comparables originally used for TNMM analysis by
the taxpayer, for benchmarking its profits
instead of the new 5 companies selected by ABC
India
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Basic criteria for selection

• Only those independent companies were short
  listed who

• Matched the Export sales to Gross sales ratio

• The taxpayer had a ratio 25 of export sales /
  Gross sales

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Analysis of forex outflow / export sales of
Independent comparables
Company Name Export sales / Gross sales ratio Forex expense / Export Sales ratio
F Co 27.28 2
G Co 27.20 2
H Co 16.88 6.8
I Co 13.73 2
J Co 10.35 13
K Co 19.70 4
Average Average 4.96
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Commission transaction evaluated separately
Final Outcome
Adjustment was made to the ALP by taking rate of
5 instead of 12 as claimed by assessee

• F.Y. 2002-03 - 5 allowed (claimed 12.5)

F.Y. 2003-04 - 7 allowed (claimed 12.5)
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Thank you