When a Start-up expands internationally, they need to manage both domestic tax matters as well as international tax matters. Apart from navigating the business and operational challenges, there are various questions that hover around international taxation
The world is experiencing unprecedented times, innovative surges in technology, new business models, and completely new ways of experiencing the internet. One of the world’s largest online cab-booking companies owns no vehicles. The biggest and most popular social media platform creates no content by itself. One of the most common household names for online shopping does not hold any inventory. And the world’s large accommodation providers do not own real estate.
With each passing moment, the integration of the digital economy into the global economy is accelerating. Technology has moved well beyond a niche for geeks and gamers – it has now become the driving force which is propelling our society from the Industrial Age into the Information Age. As a result of these societal and economic shifts, technology start-ups are cashing in and coming up in a big way.
A start-up can be any nascent company that develops a unique business idea, aims to make an instant impact, and take over the market. Several of the world’s most valuable companies we see today had humble beginnings as Start-ups and were founded by influential entrepreneurs with an incredible idea. In fact, every start-up is launched with an anticipation of evolution of an idea with the potential for significant business opportunities and impact. Sometimes the idea is a flash of insight, but more often it begins with the extensive development of an antidote or a solution to a prevalent problem area that has a recognisable market.
The evolution of a start-up, from an idea to exit, is a continuous process. It is often difficult to precisely identify exactly where you are in the start-up lifecycle because it involves many factors. The length of each start-up stage will vary depending on the business execution, the industry, and the fund raising abilities of the start-up.
The last two decades have witnessed a momentous change in the entrepreneurial landscape globally, from the founding of new start-ups to development of global investors’ interests, to start-ups becoming some of the most valuable companies.
Imperatives of Transfer Pricing for Start-Ups
The rapid and incessant growth momentum of start-ups means their financial and tax systems can quickly be astonished. When a Start-up expands internationally, they need to manage both domestic tax matters as well as international tax matters. Apart from navigating the business and operational challenges, there are various questions that hover around international taxation.
In fact, one common question which generally comes up in any discussion with Start-ups is ‘Why should Transfer Pricing be a priority discussion area, given its unified ownership where the founder(s) own all the companies of the group?'
The reality is: Transfer Pricing does matter. Start-ups should care because the Regulators across the globe do not see the group as one Company. Instead, it is the opposite; Transfer Pricing is about pricing the transactions among group companies, based on the market prices assuming that such group companies are independent. More frequent than one thinks, we come across businesses that are facing challenges on these aspects when the Regulators or even the Auditors raise questions on related party transactions and their pricing.
Some examples of such challenges include mismatches of income and expenses resulting in losses in one entity and disproportionate profit in the other entity, incorrect pricing of services transactions and profit mark-ups, implementation of incorrect royalty rates for Intellectual Property (IP), incorrect management of cost centres entities, etc. Not considering Transfer Pricing aspects in a proactive manner can impact business’ income and expenses, and result in incorrect assessment of tax liabilities in different countries or even double taxation.
These are concerns which could have been either prevented or the Start-ups would have been in a better position to deal with such concerns, in case they had focussed on pricing the related party transactions in the right manner with a robust Transfer Pricing policy in place. In fact, developing such a policy not just helps in preventing tax-related contingencies, but also helps Start-ups in achieving greater efficiency.
The focus of this article has been on exhibiting the criticality of having a robust Transfer Pricing Policy for the Start-up group, and to allude to Transfer Pricing challenges that are relevant for the Start-ups, from the establishment stages through to the later stages of an enterprise, which should be a top priority for enterprises looking to gain an international presence.
Transfer Pricing due diligence – At The Seed Investment Phase
Considered as pivotal for the future, the seed investment phase is the initial phase when Start-ups pitch for corporate investors. While Start-ups must meet multiple criteria to attract investment from investors, a vital norm is a successful completion of due diligence of their Transfer Pricing policies amongst other taxation matters. This presents the opportunity for an investor to look at the intra-group pricing policies and identify any potential risks that should be accounted for while making the investment decisions. A typical checklist for Transfer Pricing review would include the following documents to ensure adherence to the Transfer Pricing norms.
- Transfer Pricing Policy – helps evaluate whether any formal intra-group arrangement exists as a supporting document that can be referred at the time of fixing the price for related party transactions.
- Transfer Pricing compliance documents – helps demonstrate company’s adherence to local regulatory compliances.
- Inter-company agreements – helps in documenting the intra-company arrangement for any specific related party transaction.
- Review of Transfer Pricing litigation history – helps identify any future contingencies and risks due to any past litigations pertaining to related party transactions.
- Supporting documents – such as need-benefit documentation, copies of e-mail communications, invoices, workings, employee details, note on any commercial rationale relied upon, etc.
Identifying and addressing risks early on in the process allows for sufficient planning, and by anticipating future Transfer Pricing challenges, the investors can consider such contingencies leading to any financial implications down the line, including garnering unwelcome attention from Tax Authorities.
Intellectual Property (IP) – Development, Ownership and Monetisation
For any technology start-ups contemplating on expanding into new territories, IP-related aspects are likely to pose Transfer Pricing challenges. These would typically start from assigning the weights to IP as a key business driver, and branch out to areas such as identification of routine versus non-routine IP development functions, characterisation of entity engaged in IP development versus IP ownership, legal versus economic IP ownership, determining appropriate remuneration for usage of such IP, etc.
While these may appear as challenges in the first look, one can address such issues by appropriately bifurcating and understanding the on-ground functions and associated risks involved in the complete value chain of IP development. A robust documentation covering such aspects in a formal Transfer Pricing Policy further helps in responding to any potential query from either the Regulators or any other stakeholders. A robust documentation with respect to IP would typically include some of the following key aspects:
- A macro level objective of the group behind creation of IP.
- Details of functions performed, assets utilised, and risks assumed by the transacting entities in connection with the complete lifecycle of IP.
- Focus on Development, Enhancement, Maintenance, Protection, and Exploitation of IP.
- Contributions made by transacting entities for developing the IP in terms of concept, design, resources, expertise, intent, knowledge, market inputs, legal rights, etc as possessed by the transacting entities.
- Valuation of IP using different valuation methodologies as well as determination of fee in case of potential externalization of IP among the group.
It is extremely critical for any tech-enabled Start-up to focus on the IP-related aspects, especially where multiple entities are involved. Identification of value-added contributions made by different group entities and a return that, commensurate with the contributions made, is extremely critical for adopting right Transfer Pricing model for the IP.
Losses In Early Years
Post getting recognition, a Start-up may apply for tax exemption under section 80 IAC of the Income Tax Act, 1961; and post getting clearance for tax exemption, the Start-up can avail tax holiday for three consecutive financial years out of its first ten years since incorporation. However, the Regulators may scrutinise the negative profitability/ loss situation of any Start-up while reviewing its international related party transaction, from the perspective of verifying its genuineness vis-a-vis any conscious effort of shifting the taxable income outside the country. It is even more concerning when a Start-up consistently realises losses while the overseas related parties earn profits.
While the losses in a Start-up may result from several factors such as high expenditure on conceptualisation and product development, employee cost, debt interest rates, marketing and promotional events, etc. – the Revenue Authorities may try to allege that the loss occurs due to non arm’s length pricing of related party transactions. It is, therefore, necessary to understand the reasons behind losses on a case-by-case basis; and document the business rationale for losses in addition to appropriately justifying the arm’s length pricing of the related party transactions in the Transfer Pricing documentation.
A careful approach along with a well-documented Transfer Pricing document helps in preparing any company in responding to any potential questioning on the losses of a Start-up. While a Start-up may focus on value creation, but a well-drafted policy for pricing its related party transactions with due focus on the contributions made by such group entities is the need of the hour for Start-ups to justify the transfer prices in a loss situation.
Significant People Function
While we analyse the intra-group transactions of any Start-up, another critical issue which arises is the issue of alignment of group’s ‘Key Management Personnel’ or ‘Significant People Function’ with the legal entity they technically work for. By Key Management Personnel or Significant People Function, we mean the Founders or the Chief Executive Officer or the Chief Technology Officer or Marketing Heads.
Start-ups are established with a very few and effective people such as a closed group of people working on the idea and technology; and the number of employees increases in direct proportion to the transaction volume. Although the number of employees increases according to the development of the company, the number of Key Management Personnel remains at a certain number. And these continue to play a key role in all the group companies, creating Transfer Pricing challenges of categorising the specific significant people function for specific group companies.
The solution lies in creating a robust mechanism of tracking the efforts put in by such Key Management Personnel and allocating the appropriate costs after determining the arm’s length price among all such beneficiary companies, treating all such group entities as if they are independent third parties.
For any start-up, it is always recommended to develop an appropriate Transfer Pricing structure of capturing the costs of significant people function; and appropriately cross charging these costs as per arm’s length principles to the beneficiary companies.
Source: Outlook Startup