Transfer pricing for Indian software distribution affiliates

By Dr. J. Harold McClure, New York City economist

The Supreme Court of India, on March 2, ruled on a long-standing issue of international tax in favor of foreign-based software providers. The case involves the tax treatment of intercompany payments between Indian affiliates selling shrink-wrapped software designed by their foreign parents.

While the multinational prefers to treat the Indian affiliate as a distributor of goods, the Indian tax authority characterized the Indian affiliate as a licensee that pays intercompany royalties to its parent corporation. Royalty treatment allows the Indian tax authorities to impose withholding taxes. As discussed in detail by Ritu Shaktawat and Krutika Chitre in their MNE Tax article, the Indian Supreme Court ruled that these transactions represent the payment for goods, which implies that no taxation should be imposed.

Now that the Indian tax authorities no longer have a claim on the intercompany payments through withholding taxes, they may take more aggressive transfer pricing positions with respect to the size of intercompany payments in other types of transfer pricing cases involving shrink-wrapped software.

For example, consider the case of Adobe, which earns operating margins in excess of 30 percent of revenue on sales of products and prepackaged software. Its worldwide sales exceeded $12.8 billion in 2020. Also, the US parent incurs ongoing R&D expenses and other operating costs, while its foreign affiliates generally incur selling expenses and certain servicing costs.

If Adobe’s India affiliate, Adobe Systems India, performs all selling and service functions as well as any upfront marketing activities, the arm’s length gross margin must compensate this affiliate for the value of these activities.

The following table considers the financials for the Indian affiliate under two transfer pricing policies under the assumptions that:

• annual sales = $500 million;
• expenses incurred by the Indian affiliate = 35 percent of sales; and
• expenses incurred by the US parent = 35 percent of sales.

Here, operating profits represent 30 percent of sales or $150 million.

The first transfer pricing policy sets the intercompany payment to the US parent equal to 50 percent of sales or $250 million. Under this policy, the Indian affiliate retains a 15 percent operating margin or $75 million, with the US parent earning $75 million on Indian operations.

Income Statement Under Two Intercompany Pricing Policies

The IRS, however, might assert that this payment should be increased to 60 percent of sales or $300 million. Under this policy, the US parent receives $125 million in profits leaving the Indian affiliate with only $25 million, or 5 percent of sales.

Transfer pricing practitioners often defend this alternative allocation of income by treating the Indian affiliate as a mere distributor entitled to only a routine return as established by some application of the comparable profits method (CPM).

The Indian tax authority, however, may not agree with any such application of CPM. Over a generation ago, I was asked to advise on certain transfer pricing issues for a competitor of Adobe and review the transfer pricing for a US-based developer of educational software. In both cases, their European operations had distribution affiliates receiving 50 percent gross margins even though their operating expenses were only 35 percent of sales.

The European affiliates for both multinationals had originally been third-party distributors of their products and services. In the early years when these products were introduced to European customers, the European distributor agreed to a long-term arrangement to incur upfront marketing expenses to develop the European customer base. While the 50 percent gross margin did not fully cover operating expenses relative to sales when sales were low but growing, the forecast was such that the European distributors would eventually be profitable as operating expenses relative to sales would decline over time.

These third-party contracts were real-world illustrations of the market share strategy noted in the US regulations under section 1.482-1(d)(4)(i). Marc M. Levey illustrated this market share strategy in an example of a foreign-based software multinational relying on a US distribution affiliate with high marketing expenses relative to sales (“US Distribution Companies of Foreign Multinationals Can Present Difficult Transfer Pricing Issues”, Journal of International Taxation, December 1997).

After the European operations turned profitable, both US parents acquired these European distributors. As affiliates, these European entities were still afforded a 50 percent gross margin. The arm’s length nature of the higher gross margin can be seen as both an affirmation of the market share strategy as well as an application of the resale price method.

Whether this application of the resale price method or an application of CPM represents the more appropriate transfer pricing methodology for Adobe Systems India or any other Indian distribution affiliate of foreign-based software multinational depends on the history of how the Indian market was established.

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Dr. Harold McClure

Independent consultant at James Harold McClure

Dr. J. Harold McClure is a New York City-based independent economist with 26 years of transfer pricing and valuation experience. He began his transfer pricing career at the Internal Revenue Service and has worked for some of the Big Four accounting firms as well as a litigation support entity. His most recent employer was Thomson Tax and Accounting.

Dr. McClure has assisted multinational firms with both U.S. and foreign documentation requirements, IRS audit defense work, and preparing the economic analyzes for bilateral and unilateral Advanced Pricing Agreements.

Dr. McClure has written several articles on various aspects of transfer pricing including the determination of arm’s length interest rates, arm’s length royalty rate, and the transfer pricing economics for mining.

Dr. McClure taught economics at the graduate and undergraduate level before his transfer pricing and valuation career. He had published several academic and transfer pricing papers.

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