Transfer Pricing – The International Practice and the Indian Scenario

ABSTRACT:

Transfer pricing has become a hot topic in the current global economic scenario. The globalization of business organizations has been the pick of events in the recent decades and they have truly and effectively become the world players. Transfer pricing is one the consequence of their worldwide extension. Adding to this, the increased scrutiny by revenue authorities throughout the world and their respective inconsistencies in their approaches and views regarding different concepts have furthermore increased the need to give more attention to this area. This report gives a brief outlook of the meaning and the evolution of the concept of TP, its measurement, the laws related to it and the current Indian scenario.

MEANING AND EVOLUTION:

he transfer price is the price that one division of a company charges another division of the same company for a product transferred between the two divisions. The basic economic reasoning behind this is to induce optical decision-making in a decentralized organization, i.e. to increase the profits of the organization as a whole.

Transfer pricing is almost invariably needed when a business is divided into more than one department or division and especially if based in different nations or a different set of jurisdictions. The basis on which these fixed overheads are apportioned into the production process can radically change the perceived profitability of the business.

One of the basic purposes behind the transfer pricing mechanism is to generate separate profit figures for each division and thereby evaluate the performance of each division separately; it gives a proper idea about the profitability and efficiency of each sub division to the parent company. It also allows the company to generate profit figures for each segment and it is also bound to effect the allocation of an organization’s resources to its different sectors depending upon their respective profitability and efficiency.

The product being transferred is treated in the same way as it is done with an outside customer; it comes as revenue to the selling unit and as a cost to the buying unit. Transfer pricing gains significance because it can be used by the controlling party as a tool to their advantage to minimize their tax incidence. Its significance is evident from the fact that approximately 60% of the total transactions across the world are between related parties.

The practice of transfer pricing evolved as the with the advent of globalization and liberalization, the MNC’s grew in their size and power, and set up their businesses in multiple nations, they basically exploited this practice of transfer pricing to their own advantage in channeling their profits in low tax destinations and further swell their growing profits.

Significant amendments were made in the transfer pricing regulations in India by the finance act 2001 by way of insertion of section 92 to section 92F in the Income Tax Act, 1961.

An important trend highlighted in the Indian and across country comparisons shows an interesting trend that import duty rates in India have shown a declining trend substantially reducing from 30.4 per cent in 2001 to 21.8 per cent in 2005 and further to 11 per cent in 2008. This declining trend of import duty rates in India furthermore highlight the importance and attention to this issue of transfer pricing, because if not addressed, it can have serious repercussions on the economy.

The following table gives a list trend of corporate tax rates in some important economies over a period of time.

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UNDERSTANDING TRANSFER PRICING:

Say if there are two divisions A and B of some big MNC and if division A supplies some product to division B, then for every $1 increase in the Transfer Price, division A will make $1 more profit and division B will make $1 less. Although logically, the group as a whole will make the same amount of profit, but these changing profits can result in each division making different decisions and as a result of these divisions, the group might be affected.

No money needs to change hands between the two divisions; the transfer price might only be used for internal record keeping.

(Transfer price * quantity of goods exchanged) is an expense for the purchasing division and a revenue for the selling division.

For the transfer in division, the transfer in price plus its own marginal cost must be no greater than the marginal revenue earned from outside sales. This allows that division to also make a significant amount of contribution…

Transfer pricing applies to most inter-company transactions, including services, leases, sales of tangible property or leases for them and financing arrangements.

The pricing mechanism is often complex, taking into regard many aspects like functional analysis, finance, economies, industry practcses etc. OECD formulated “Guidelines on transfer pricing” serve as generally accepted practices by the tax authorities around the world and especially in developed economies.

Some of the important external factors that are taken into regard while considering transfer pricing are:

1. Accounting standard
2. Custom duty.
3. Risk of expropriation
4. Currency fluctuations
5. Income tax.

MEASUREMENT OF TRANSFER PRICING:

Although several acceptable transfer pricing methods exist, some abstract and calculative ways for the effective determination of the arm’s length price must be provided. However, no single method is considered to be suitable in each and every situation and the taxpayer must select the method that provides the best estimate of an arm’s length price for the transaction that is being considered.

According to the generally and widely accepted norms, the value of this transfer price calculated should be in line with what it would have been had the same transaction taken place between two unrelated parties under similar circumstances.

Although there are discrepancies in the specifics of each country’s laws concerning the application of the arm’s length principle, most countries rely on the methods and mechanisms that are based on transfer pricing laws and regulations as have been developed in the OECD Guidelines.

The rules of nearly all countries have been set up in a way that they permit related parties to set prices in any manner, but at the same time they also permit the tax authorities to adjust those prices where the prices charged are outside an arm’s length range. Generally, rules are provided for determining what constitutes such arm’s length prices, and how any analysis should proceed, but things do vary slightly from country to country.

The generally prescribed methods for computing this Arm’s length price are described below:

(a) Comparable Uncontrolled Price Method (‘CUPM’):

It is the most direct and reliable way to apply the Arm length’s principle. It tends to compare the price transferred in a controlled transaction to the price charged in a comparable uncontrolled transaction. It is generally used in transactions which involve the transfer of goods, intangibles, interest payments on loans, services etc.

CUPs are based on actual transactions. It is particularly suitable for transaction in commodities as actual transactions of other parties may be reported in a reliable manner.  However, for other items i.e., transactions of one of the considered parties with the third parties, it may be the only available and worth-considering reliable data.

The mechanism works as follows:

Identification of an identical international transaction with some other unrelated entity –> Sorting out the price differential due to the unrelated scenarios –> Finally the adjusted price is compared with the related party transaction.

(b)  Resale Price Method (RPM):

This method is typically adopted in transactions where the distribution of goods requires little or virtually no value additions.

The mechanism for this process is described below:

Identification of the products purchased from a related party –> Calculate the price at which the product was sold to the unrelated party –> Deduct the industry margin for similar products from the sale price –> Work back to find out the actual cost price of the product –> Compare the worked out price with the related party-purchase price.

(c) Profit Split Method (PSM):

This method is generally used when the transactions are so much inter-connected that it is not possible to evaluate them separately.

It involves transactions involving integrated services provided by more than one enterprise and transfer of unique intangibles.

The entire mechanism for the method is described below:

The combined net profit of the entire group is evaluated –> Profits are split among the enterprises on the basis of assets employed, functions undertaken and risks assumed –> The profit figures thus calculated are compared with the actual profits.

(d) Cost Plus Method (CPM):

In this method, first the cost incurred is determined, then an appropriate price markup is added to it and an appropriate profit level is determined. This figure gives the ALP for that particular product.

This method is generally used for the transfer of semi-finished goods, joint facility agreements, provision of services and sometimes for long-term buying and selling arrangements.

The working mechanism for this method is described below:

The direct and indirect costs of the product and the industry margin for similar products, are determined –> The industry margin for the specific related party transaction is adjusted –> This calculated price is compared with the actual related party transaction price.

(e) Transactional Net Margin Method :

Both TNMM and CPM have a practical advantage in the ease of implementation, as both methods rely on macroeconomic analysis rather than specific transactions.

But in this method, it becomes particularly important to determine which of the two related parties should be tested. The parties must be selected in a way that it is made sure that the testing parties produce the most reliable results.

This method is often used in transactions involving provision of services where the RPM method can’t be used effectively, or in cases of transfers of semi finished goods where the CPM can’t be applied effectively.

The working mechanism for this method is described below:

Evaluate industry averages of two independent firms and compare them –> Compute the net profits of the concerned entities –> Compute the net profits of two other comparable firms in the same business –> Adjust these numbers for the economic differences –> Finally compare the net profits of the concerned and the comparable entities.

LAWS ON TRANSFER PRICING:

The government is required to frame a mechanism to determine reasonable and fair profits and tax in India in the case of such multinational enterprises. Accordingly, the Finance Act, 2001 introduced law of transfer pricing in India through sections 92A to 92F of the Indian Income Tax Act, 1961 which gives a detailed procedure for the assessment of the transfer price and also suggests some detailed documentation procedures.

In India, rules on this issue have been formed in accordance with internationally accepted principles. The TPR have provided that any income arising from an international transaction between AEs shall be computed having regard to the ALP.

Usually, the taxpayer is allowed to choose the most suitable method for computing the ALP in any specific transaction, but the government prescribed the above explained five methods for the computation of ALP in accordance with the internationally accepted principles.

In India, the provision of TPR is exhaustive as far as the maintenance of documentation is concerned. The law gives complete provisions for the analysis of the selection of the most appropriate method and identifying of the comparable transactions, and also the background information of the commercial and economic environment in which the transaction is taking place.[3]

The tax officer in India has been given the authority to reject the ALP method adopted by the assessee if he seems to have adopted an unsuitable or a wrong method for ALP. Thereafter, he can determine the ALP with accordance to the TPR. For this purpose, he can take the help of the Transfer Pricing Officer (TPO), who would then finally decide the ALP after hearing the arguments of both the sides.

If the ALP worked out by the TPO indicates the under-reporting of profits or income by the taxpayer then it may very well result in the adjustment to the reported income or in penalty.

TRANSFER PRICING: THE INDIAN SCENARIO:

India contributes a significant volume of Transfer pricing litigation globally at the level of Tribunal/ tax contributions or above

For a developing economy like India, it is not surprising to know that transfer pricing regulations and litigations are widely practised in India and India completed 7 rounds of TP audits in 2001.

There are two broad categories of TP litigations in India :

• Pure comparability issues
• Complex transactions on fundamentals of Transfer Pricing

The aggregate TP adjustments in the 2001 audit cycle have amounted to rupees 45,000 crores, and the Cummulative TP adjustments in the first six audit cycles have amounted to rupees 50,000 crores.[4]

The assessment procedure in India involves mainly the following steps :

Scrutiny by the assessing officer –> Referencing to the Transfer Pricing Officer –> Order of the TPO after the assessment –> Passing of the final verdict of the assessing officer.

RECENT AMENDMENTS AS PER THE FINANCE ACT, 2012

The Finance Act of 2012 brought in many changes to the Indian TP scenario. The major amendments brought in by this Act are explained below:

1. Introduction of the Advanced Pricing Agreements (APAs) which came into effect only after July, 2012.
2. Clarification of the powers of the TPO.
3. Clarification of the terms like ‘International Transactions’ and ‘intangibles’.
4. The compliance of TP has been extended to include certain domestic transactions as well.
5. Clarification of the 5% range around the Arithmetic Mean for ALP.

Now, the entire procedure contains vivid information about the setting of the pricing policy, requirement of robust documentation and capturing of FAR, economic analysis by the concerned firms, information about inter-company agreements. It also shares information about Foreign AE’s etc.

By: Ansh Gandhi

References:

1. International Transfer Pricing by Brenda Humphreys.
2. Transfer Pricing: impact of taxes and tariffs in India, by Pradeep Gupta.
3. The Impact of Transfer Pricing on Financial reporting, by PwC.
4. Transfer Pricing, Tata McGraw Hill, 2011.
5. Transfer Pricing: Evolution, concept, audit and tax aspects in India, by V.V. Srinath Sharma