This site uses cookies to provide you with a more responsive and personalised service. By using this site you agree to our use of cookies. Please read our PRIVACY POLICY for more information on the cookies we use and how to delete or block them.

Changing Business Dynamics amidst COVID-19 - Is Cost Plus Model Sustainable?

Taxsutra |
Partho Dasgupta, Partner
Tax and Regulatory Services
|

07 July 2020

Background

There is no doubt that globally the Business Dynamics of the companies has undergone a significant change , which is more towards southward due to this unexpected business risk called “COVID-19”, it is quite natural and obvious it could not have factored in their business plan. There is empirical evidence available which indicates that global economy has already contracted further. The June outlook as published by OECD where the projections for some of the large economies shows significant negative growth as depicted below.

 

2019

YOY 2020

YOY 2021

World

2.7

(6.02)

5.2

G-20 countries

2.9

(5.7)

5.5

Australia

1.8

(5.5)

4.1

Canada

1.7

(8.8)

3.9

Germany

0.6

(6.6)

5.88

France

1.5

(11.4)

7.77

Italy

0.3

(11.3)

7.77

Japan

0.7

(6)

2.9

UK

1.4

(11.25)

9

USA

2.7

(7.3)

4.1

GDP growth % Year on Year basis

Source: OECD projection on single hit covid

As per the projections, subject to control of the Pandemic the recovery will be quite slow, and it would take minimum two years to recovery with an assumption that there will be no second hit of COVID.

India is no exception as compared to global economy; GDP is projected to fall by 7.3% as compared to 3.7% in single hit scenario.

Keeping in mind of the above, at this stage it is pertinent to think whether from the business perspective ,the present cost plus model essentially for captive IT industry will survive with the current mark which they have been charging in the past. As per my experience, currently the range of mark up would be from 13% - 20%, however revised safe harbor continue to be at 17%.

It is important to mull over our practical challenge going forward which one may have to cross in case we wish to want straight away to make any changes or changes without any strategy.

Practical challenges

Database

While undertaking the comparable search for the FY 20-21 normally done around July ’21 within the purview of routine compliance service, the financial data of the comparable companies will be that for FY19-20 as the latest data. It is obvious that data in no way can be comparable, FY20-21 being an exceptional year (probably in recent history).

Further, multiple year concept also may be difficult to apply, one of the economic reasons behind the multiple year is to take care of normal business fluctuation. Again, last three-year data will provide a quite wrong indicator as this being an abnormal business fluctuation.

This being one of the challenges for comparability analysis.

Safe harbour

As per the latest notification issued by the CBDT, the safe harbor regime is the same to that previous year. New notification for assessment year 2012-22 will come next year, which may be very difficult to predict.

Future Year

Assuming the economy (including global) comes back to normal, though there are many articles available where the predictions have been made that it will take at least 2 years for the economic to revive and start back to normal. In this situation, even if we consider in lowering the mark up in FY 20-21 the challenge can we move back to normal rate as we have been applying in pre COVID time or under normal circumstances.

Importantly, how the revenue officer is going to accept the lower mark as we embark to the normalcy in the economy. Especially in India, the audit process in India starts after couple of years gone by and hence the revenue will have more realistic business numbers.

Current Documentation

Most of the IT companies operating as subsidiary in India is either acting as pure development centre or support service centre with very low financial and market risk. So to justify the current cost-plus model along with the mark-up which may be on lower side of the range in absence of defined economic adjustment.

Further, most of the inter-company agreement that has been entered supports the above view as stated being part of current documentation.

Now the challenge is how to reflect the change in the business, if we are risk free so one can argue, that we why you want to change the current model. Though the business reality is different now because of the circumstances

So, what is the way forward?

Yes, it is very much challenging time for the economy so also without any doubt will have severe impact in the way we use to do business earlier. On the top setting the transfer price with this dynamic and uncertain future is also equally challenging.

Though I have tried to highlight some of the apparent challenges which we may face in future if we do not act now in the right way.

Potentially a way can be considering an option to move away from the current loaded cost plus to another suitable method, while we approach any new method, it should be enough flexible to take care when the economy returns to normalcy. In other word’s a short-term view may not be advisable.

Even though OECD has released some draft recommendation for transfer price methods, apart from other tax related initiatives following pandemic.

Secondly, one can think of Mutual Agreement Procedure (MAP) / Advance Price agreement (APA) is one of such tools which can be used extensively. We have witnessed, there are substantial number unilateral APA has been concluded by the revenue and one can safely presume it has lots of experience now to resort to. It may be worth examining the assumptions made during the negotiation, which may have some room for exceptional business cycle, how to invoke such paragraphs with the new Pandemic situation which has created havoc in world economic health.

APA may have its own limitation as many of the midsize companies in today’s environment may find challenging to pay the fees, even if they reach the threshold and while for some companies fees and efforts need to commensurate with the size of business / transaction.

Alternatively, it is important to understand how to tide over the current situation apart from APA understanding the limitation.

Before we step into the forthcoming discussion;

· Self awareness - we need to introspect and ask certain questions to ourselves whether the COVID has really impacted our business, if yes try & understand the impact and measure them. In the following paragraph am discussing the importance to document the why & how it has impacted.

· Industry- Fact-finding exercise is required not only for Indian sub but also need to assess the impact of the market (geography) and industries in which it operates.

It must be continuously evaluated and the same should be factored. Hence, the global industry analysis becomes very important from the overall perspective.

· Quantification – It is important at the end the above two bullets that it should be transformed into a quantifiable , for example In order to quantify try and evaluate the extraordinary expense due to such COVID and identify the same, for example many companies had to incur wages for the staff but there is no corresponding revenue etc. This should not be confused with capacity adjustment. Secondly, the impact of downtrend of the industry into your financial situation, so on and so forth. Also important to evaluate the current intercompany agreement and if there is scope for negotiation, while doing so it is important to see the impact of foreign exchange fluctuation as well because it is believed that currency market is not going to behave in an unpredictable manner.

These are some of the baby steps, hence it is highly important & recommendatory that the process to think and act to be initiated at earliest. Such as fact finding, gathering relevant information and start factoring them in your business. While factoring them into pricing it is also necessary to build in an economic adjustment.

The entire process will not only help for the current year 2020-21, it will also help us to undertake a better negotiation with tax authorities both during audit as well for APA/ MAP.

So, in order to sustain the cost plus model a COVID adjustment whether possible or not needs to looked at first and its application. It is important to constantly gather the facts and that would help us in navigating the temporary (as I believe) crisis phase in our economy much better. Thus, robust documentation is key to the analysis.

Source: https://tp.taxsutra.com/experts/column?sid=603