Countering transfer pricing

In the late 1990s, a series of incidents started taking place in the Indian corporate sector, probably beginning with the erstwhile Smithkline Beecham Consumer Healthcare (SBCH, now GSK Consumer), a processed foods company. The British parent company, with a turnover of Rs. 6483 million in 1997-98, decided that it was time to extract royalty from SBCH for its “efforts to build the brand in India.” This is a common form of transfer pricing.

Transfer pricing is a process by which companies transfer payments between group companies and subsidiaries at adjusted prices to improve profits. Royalty is one of many forms of transfer pricing; other forms include consultancy charges, commissions and technical fees.

Nothing apparently wrong with SBCH’s decision to extract royalty, except that it rang hollow – the main SBCH brands, including the iconic Horlicks, is home-grown and hardly exists in other parts of the world where the parent operates.  Horlicks serves as a milk substitute in India more than as a malted drink. So though the basic technology of creating a powder-form drink was developed abroad, the market for Horlicks was developed in India; it was here that SBCH learned about, and built, the brand.

Then in the early 2000s, two similar episodes took place. The U.S.-based Citigroup took an approximately 30% stake in the Indian-owned software company Polaris.  Citigroup was also Polaris’ largest customer globally for IT services. Polaris soon slashed billing rates by as much as 20% – another transfer pricing trick.

A few months later, the U.S. company Hewlett Packard globally acquired Compaq, also an American company, and Digital Globalsoft, Compaq’s publicly-listed Indian subsidiary. After the acquisition, Digital Globalsoft was merged with HP’s India operations at a valuation beneficial to HP. A year later, in late 2003, for undisclosed reasons, HP compensated for the merger by buying out Digital’s minority shareholders at a nearly 50% premium to the prevailing share price. [1] Subsequently, HP delisted the company from Indian stock exchanges and became the sole owner of Digital.

We may not have had the need to revisit these incidents were it not for the fact that they have started recurring. In 2012, there was a resurgent trend of royalty payments. For example, the decision of Holcim, a multinational company and majority-owner of listed cement companies ACC and Ambuja Cements, to charge royalty from ACC and Ambuja, is remarkably similar to SBCH’s move in the 1990s.

How can there be a royalty for entirely indigenous brands like ACC and Ambuja? These companies were owned and operated by Indian business houses before being sold to Holcim. Besides, in the cement industry, manufacturing technology has not changed for several decades. This is unlike, say, the case of Suzuki that can justify a royalty on technology transfer for cars to Maruti.

The lesson from these situations is twofold.

First, keeping subsidiaries of multinational corporations (MNCs) publicly-listed in India, especially those subsidiaries which have minority shareholders, potentially leaves the door open for transfer pricing tactics. Not only does this expose minority shareholders to the risk of unfair treatment by favouring the majority shareholders, but, more importantly, it hurts the country through a loss of revenue.

Aggregate losses on this account have been estimated at $75-100 billion annually. A recent research piece by Espirito Santo analysing 25 listed MNCs indicates that since December 2009, royalties have increased 140%, whereas profitability has trended downwards.

Yes, these means can be adopted by MNCs even if the subsidiaries are not listed, but clearly the incentive is higher in case of listed entities, because the parent MNC wants to avoid sharing the profits with other shareholders. A more radical suggestion would be to encourage MNCs to delist. This is indeed permitted by regulations of the Securities and Exchange Board of India (SEBI), but delistings have been few.

Second, delisting helps to bring in foreign direct investment (FDI) as the MNC buys out the minority shareholders, or actually puts in money into the local subsidiary to increase its stake. So delisting is in India’s interest, considering how critical the current account (CA) management has become. India’s CA management is heavily dependent on portfolio flows and external commercial borrowings. For example, India’s recent efforts to invite FDI in aviation and retailing have been mired in controversies, and these are now recognised as areas which may not contribute much to FDI after all.

In one way, it is common sense. If MNCs do not need to be listed, they better not be. They were forced to reduce their stakes at the height of socialism in 1978, and times have changed after that. Most of them have never raised any capital from the markets, and have huge cash hoards, and MNCs in the consumer goods sector, such as the U.S.-based toothpaste company Colgate, report high returns on invested capital in excess of 400%.

Let us be clear that delisting is not the silver bullet to eliminate transfer pricing/ royalty controversies. But it is important to take such steps to curtail transfer pricing, and at the same time delisting is an important source of FDI that helps plug current account deficit.

But the government has tied itself up in knots trying in addressing these situations. First there was the overly-restrictive Press Note 18 and then the overly- liberal Press Note 8. [2]

The time has come for a well thought through and bold response.  SEBI and the Reserve Bank of India have indeed done their bit over the years. Now a greater and proactive role must be played by the government, notably the finance and commerce ministries, and by the MNC in question and its minority shareholders themselves.

The government can provide outright incentives to the MNCs to delist by bringing down the cost of acquisition of the subsidiary. The apparent reason for the slow uptake of delistings is that most MNCs find the valuations of their listed entities forbidding. MNC managers should be more persuasive with their Boards on this issue, since the subsidiaries are a lot more profitable. A rough cross-country comparison of valuations of various MNCs shows that returns in their industries in India are typically ten times that in developed countries.

On the other side, minority investors should shed their ambivalence on selling their stakes to MNCs because of the perception that the price is not good enough. Minority investors should realise that by not subscribing to these offers, they are becoming vulnerable in the future to transfer pricing pressures.

Dipankar Choudhury has been a senior research analyst at various investment banks and is currently an independent consultant and columnist.