Industry Trend & Transfer Price

Background

The scope of transfer price as a subject is much beyond the boundaries of Income Tax law, as the pricing of tangible & intangible goods is not always undertaken with a motive for tax saving / planning. There are many external factors which play a major role which influences the pricing.

In this article we are trying to analyse the impact from transfer pricing perspective of the industry downtrend. How to capture & demonstrate them that your company has been impacted by the industry cycle keeping in mind the rule 10D of the income tax rules.

For the purposes of the article we have considered "Automobile Industry" which is off late having a downtrend.

Facts of Industry

The automotive industry is a chief component of economic growth, connecting the Industrial and cultural framework. It contributes towards employment generation, facilitates rapid movement of goods and services and contributes to the overall economic growth.

The importance of automotive industry to the Indian economy can be well understood from the fact that it contributes to 7.5% of the Indian GDP (i.e. nearly 49% of the total manufacturing sector's share of 17%). The Automobile Mission Plan 2016 – 2026 envisages creating India as one of the top three automobile manufacturing centres in the world with gross revenue of US $ 300 bn by 2026. India being the fourth biggest automobile market¹ highlights the potential that the Indian market holds, and the presence automobile makers in India have around the world.

Recent Developments of the Industry :

The automotive industry functions in a dynamic environment. Each player is making belligerent efforts towards technological upgrades to improve fuel efficiency, offer more comfort and utility to end users and to prepare for the vision of green energy future. Bracing for the future, Indian oil refiner Hindustan Petroleum Corp might roll out a pilot programme for swapping batteries of electric two and three – wheelers at its outlets this December². The government is also making conscious efforts to reduce the consumption of eco-destructive fuels and induce the consumption of more environment-friendly sources of energy. Recently, Niti Aayog had suggested transition to full electric vehicles (EVs) for three-wheelers by 2023 and two-wheelers with an engine capacity of less than 150cc by 2025³ As of now, no deadline has been prescribed by the government amid dissent from manufactures sighting the major slowdown. Further, the industry leaders like Mahindra and Mahindra, Maruti Suzuki and even global EV manufacturers like Tesla have sighted and shown confidence in India's potential to be a Global EV Hub.

The Slowdown:

The slowdown in the automobile sector has been ongoing for about 9 months through July 2019. The five biggest automobile makers in the Indian market namely – Maruti Suzuki Limited, Hyundai Motor India, Mahindra and Mahindra, Tata Motors and Honda Cars India have all experienced significant decline in sales and profitability. Multiple carmakers like Mahindra, Toyota, Maruti and Hyundai are halting productions and cutting jobs at plants to combat slumping sales (Reuters earlier this month reported automakers, component manufacturers and dealers had already cut 3,50,000 jobs).

a: Financial Results:

(Figures in Crores)

Particulars	Maruti Suzuki		Tata Motors
	June' 18	June' 19	June' 18	June' 19
Revenue	22,459.4	19,719.80	16,803.11	13,351.91
Net Profit/(Loss)	1,975.30	1,435.50	1,187.65	(97.50)

Besides, Mahindra & Mahindra Ltd has reported a drop of 15% in its total vehicle sales with 40,142 units registered in July 2019 compared to 47,199 units in the same month last year. Honda Cars India Ltd. (HCIL), reported domestic sales of 10,314 units in June 2019. Sales decline is down 41.4% from 17,602 units sold in June 2018. Even as 2019 started on a positive note for HCIL (unlike other manufacturers in the industry), quarter ending June'19 has been unkind. HCIL sales for Q1 FY2019-20 (April-June 2019) is reported at 33,028 units. Sales decline stands at 22.48 percent, down from 42,609 units sold in Q1 FY2018-19.

b: What is driving the slowdown? 

Mirroring the weak consumer sentiment and slowdown in the sector, S&P BSE auto sector index has fallen 35% during the last one year, with home-grown Tata Motors falling 55% in the same period. The slowdown is happening due to four major reasons:

1. Declining GDP Growth Rate: The 5-year low GDP growth rate coming from weak industrial growth and muted investment has resulted in slowing consumption, especially private consumption.
2. Liquidity Crunch and Scepticism from Lenders: The recent events revolving the NBFCs crisis has created a Liquidity crunch in the market. Further, the banking companies are more sceptical and stricter with their lending terms making it difficult to access finance by Auto makers, dealers, suppliers, component makers and consumers alike. (Source: HW News English YouTube Channel)
3. Regulatory and Policy Changes: As a measure to control pollution levels, the government skipped BS-V emission norms entirely and opted for BS-VI standards making it costlier and trickier for the automakers. Further, Supreme Court (SC) has given instructions to ban sale of vehicles conforming to BS-IV standards from April 1, 2020 (four years earlier from the original plan)
4. Possible changes in consumer behaviour: Slowdown in the auto sector has been a global phenomenon. But with cross-border trade issues impacting many countries, India seems to have been hit harder than most others. There is a growing body of opinion that suggests that millennials don't like owning cars, especially in the US and Europe. Similarly, in India, millennials are using car-ride services such as Ola and Uber more than ever and consequently, an answer to declining sales might emanate from here.

c: Impact on other than OEM manufacturers

The automotive component industry contributes 2.3 per cent to India's gross domestic product (GDP), 25 per cent to its manufacturing GDP and provides employment to 50 lakh people. 

The decline in growth in the auto industry over the past 11 months has affected the components industry as well. It has resulted in the laying off 8-10 lakh contract employees in recent months in the auto parts sector.

New incentive – as way Ahead:

To help the auto sector tide over stress, the country's largest lender State Bank of India (SBI) has extended the credit period of automobile dealers that are facing demand slowdown and inventory build-up.

Further, Production correction and reduced wholesale dispatches by passenger vehicles manufacturers brought respite for dealers amidst the ongoing sales slowdown as inventory stockpiles with them reduced thereby reducing associated fixed and variable costs.

Also, to fight the slowdown, the transport ministry wrote to the finance ministry asking for the goods and services tax on hybrid vehicles to be reduced from 28%. Even as Finance Minister has not conceded the pressing demand of the industry to bring down the GST rate to 18 percent, some reliefs have been given such as:

1. Accelerated depreciation of 15 percent (making it a total of 30 percent) for vehicles acquired till March'20 and deferment of proposed increase in registration fees for new vehicles to June'20.
2. Clarified that all the BS-IV vehicles purchased until March'20 will be operational for the entire period of registration.
3. Public Sector Banks (PSBs) will be given an upfront funding of Rs 70,000 crore through recapitalisation.
4. Assurance on the 'Scrappage Policy'.

Transfer Pricing Impact:

This downturn in the industry will have a significant impact in the transfer price both in the internal pricing policy as well to adhering to the compliance, as discussed below some of them;

• Royalty Rate - Vendors to the OEM would be the most impacted. Usually such vendors have long term relationship with the OEM and based on the forecast there is quite investment is made in the dies & tools. Also, it is true that for some of the vendors the dependency with few / even sole OEM is too highly concentrated, keeping in mind long term relationship there would be lot of push back from the OEM to honour the commitment. Resulting such vendors may not be profitable or lower than usual with high working capital.With this above fact, I clearly believe the TP methodology followed earlier to defend the covered transaction may not continue to sustain particularly where profit-based methods have been used. For example – most of the vendors will have either an overseas joint venture partner for technology – hence there is payment of royalty triggers. Typically, royalty is based percentage of sales, in order to benchmark the royalty, rate the company choose either sophisticated database such "royalty stat", etc. or use over aggregate approach using some profit-based method. In case of transaction-based approach, it may be difficult to rely on such global database, as there may not be significant change in the royalty rates, also it is not possible for the companies renegotiating the royalty rates for such inverted growth which is potentially temporary. Here is a challenge… Of course, in profit-based method, one may argue that it would apply to the comparable sets and hence the "tested party" can be aligned with market profit. In order to sustain such argument – (a) selection of right comparable is an very important , apart from the routine selection process one must carefully compare the right business model (b) after screening the right set - the importance of various financial ratio's including selection of profit level indicator plays a crucial role (c) apply the permissible economic adjustment . Having said this , based on our experience after applying above you may have set of comparable's below threshold number for application of range plus practical challenge during the time when the return needs to filed the local Indian data based may not have financials of the relevant year, multiple year may throw up wrong number.
• Tangible transaction – here in this article, we are only dealing with purchase of goods including raw materials (may be in SKD / CKD) from its associated enterprises. These purchases are made in order to supply to their domestic customers in India. The challenges will be more severe as it would significantly impact their profitability and it may be very difficult for the local subsidiary to renegotiate with their group companies. Once it impacts on profitability, the issues would be the same as described in the previous paragraph under "Royalty rate". How do we overcome the challenges;Here we would like to illustrate some of the adjustments which is possible;
• It is very important to demonstrate to the revenue officers that the downfall of profit is purely an industry issue. In order to demonstrate it is important documenting every day the industry outlook as has been described above facts of the industry. Create a robust transfer price document with sustainable economic adjustments.
• Impact on ECB's from Associated Enterprises (AE's) - State Bank of India (SBI) has recently relaxed the credit terms for automobile dealers in order to help the auto sector tide over stress. Given this, it may be anticipated that such relaxations are provided to OEMs in the automobile sector. If this happens, Companies shall repay the loans from AEs which have relatively stricter credit terms (credit period, interest rates etc). This may reduce Transfer Pricing compliance including the arm's length price analysis for the interest paid to AEs by these companies.
• Profitability (Profit Level Indicator) - Looking at the ongoing slowdown in the automobile industry, one can easily reckon the ineffectual profitability. It will be important to analyse how these incidents will impact the profit level indicator (PLI) of manufacturers and traders from the Transfer Pricing Perspective.
  • Capacity Utilisation: Taxpayers and revenue authorities resort to making capacity utilisation adjustments to moderate the profitability of comparable companies where there exists significant disparity between the capacity utilised by the assessee and the comparable companies. Where companies like Hyundai and Mahindra and Mahindra have listed no production days, whether capacity utilisation adjustment can be made or not will require an intricate analysis. Such adjustment may neutralize the impact on profit margins of the assessee and the comparable companies arising on account of working capital involved and the funds blocked therein.
  • Blockage of Inventory and resulting adjustment: Even as production correction brought relief to manufacturers on account of stockpiles and reduced wholesale dispatches by manufacturers to dealers/traders reduced the investment blockage, relevance of working capital and its applicability will differ from entity to entity. Duration of working capital cycle substantially affects the additional cost incurred by a business by way of interest on borrowing from the open market.
  • Profitability analysis from TP perspective: Whether an income/expense be treated as operating or non-operating item in determining the PLI has always been a subject matter of discourse. To fight the decline in revenues, certain companies have laid off a considerable number of employees since they are not operating in full scale. However, this may have increased the employee benefit expenses in terms of leave encashments, PF, gratuity etc. which wouldn't have been incurred in normal circumstances. Further, in order to boost sales, any measures taken by OEMs / Vendors /Dealers and their foreign counterparts in the form of high discounts or additional benefits.Such factors should also be considered appropriately while calculating profit margins from transfer pricing analysis. Additionally, there should also be a careful analysis while selecting the comparables for comparing the profitability of the assessee keeping in mind the judicial pronouncements supporting the impact of industry slowdown / stress on the profitability of companies operating in that sector.

Conclusion

Hence, it is very important to have robustness of the Transfer price document and apply various acceptable economic adjustments possible and well can be demonstrated. Having close eye on the various industry reports to substantiate the ground of lower profitability and economic adjustments.

Here above we have provided some of the examples of the adjustments, depending upon the facts for each of the tested party there are many more industry adjustments possible.

Source: https://tp.taxmann.com/fileopennew.aspx?id=105010000000016847&mode=home&page=ts