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Transfer pricing practices

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  • 1. Chapter 1 : Rationale of the Study Transfer pricing is the process that a multinational company undergoes when transferring goods from one division to another. This is required for the distribution of taxable profit in multiple countries, and to allocate profits and losses for each individual division of the company. Three problems with transfer pricing:• Divisional autonomy - transfer prices are particularly appropriate for profit centers because if one profit center does work for another the size of the transfer price will affect the costs of one profit center and the revenues of another. However, a danger with profit center accounting is that the business organization will divide into a number of self-interested segments, each acting at times against the wishes and interest of other segments. A balance ought to be kept between divisional autonomy to provide incentives and motivation, and retaining centralized authority to ensure that the organizations profit centers are all working towards the same target, the benefit of the organization as a whole.• Divisional performance measurement - profit centers managers tend to put their own profit performance above every this else. Since profit centers performance is measured according to the profit they earn, no profit center will want to do work for another an incur cost without being paid for it. Consequently, profit center managers are likely to dispute the size of transfer prices with each other, or disagree about whether one profit center should do work for another or not.• Corporate profit maximization - When there are disagreements about how much work should be transferred between divisions, and how many sales the division should make to the external market, there is presumably a profit- maximizing level of output and sales for the organization as a whole. However, unless each profit center also maximizes its own profit at this same level of output, there will be inter divisional disagreements about output levels and the profit maximizing output will not be achieved. 1
  • 2. The ideal solution: Ideally a transfer price should be set at a level that overcomes these problems.• The transfer price should provide an artificial selling price that enables the transferring division to earn a return for its efforts. And the receiving division to incur a cost for benefits received.• The transfer price should be set at a level that enables profit center performance to be measured commercially. This means that the transfer price should be a fit commercial price.• The transfer price, if possible, should encourage profit center managers to agree on the amount of goods and services to be transferred, which will also be at a level that is consistent with aims of the organization as a whole such as maximizing company profits.Process of Transfer Pricing : Globalization Increased cross border inter-company transactions Decision on transfer prices in order to minimize the tax burden Tax authorities forced to regulate transfer prices Arm’s length principle (The prices in inter-company transactions should not differ from the prices determined by unrelated parties and the profit or income accrued from inter-company transactions should not differ from the profit or income earned from transactions between unrelated parties.) Provisions of services between associated enterprises Suitable Transfer Pricing Method (Cost plus Method) Multinational companies are elevating the importance of transfer pricing and dedicating more resources to understanding, planning and documenting their inter-company pricing. 2
  • 3. Not long ago, transfer pricing was a subject for tax administrators and one or two otherspecialists. But recently, politicians, economists and businesspeople, as well as NGOs,have been waking up to the importance of who pays tax on what in international businesstransactions between different arms of the same corporation. Globalization is one reasonfor this interest, the rise of the multinational corporation is another. Once you take onboard the fact that more than 60% of world trade takes place within multinationalenterprises, the importance of transfer pricing becomes clear. Transfer prices are useful inseveral ways. They can help an MNE identify those parts of the enterprise that areperforming well and not so well.In contrast to a purely tax-driven mechanism, Principle underlying use of internationaltransfer pricing is to accomplish corporate objectives and thus create strategicconsequences. Multinationals could employ transfer pricing to assist in achievingcompetitive advantage and other corporate objectives as well. We need to understand theinfluence of transfer pricing on corporate performance and the link involving theeffectiveness of transfer pricing in accomplishing objectives. 3
  • 4. Chapter 2 : Objective of the Study Title of the project: With the rise of Globalization and Multinational Corporations has increased the importance of Transfer pricing and this project is an endeavor to study the transfer pricing regime in different countries , studied at KPMG India has been titled as : “Study of International practices for Transfer Pricing” Objective of the Study: This project has been divided into four parts to understand the transfer pricing regimes and study its application.1) To study the prevalent practices for Transfer Pricing in selected countries.2) To compare the Transfer Pricing practices in other countries with India.3) To analyze the application of Arm’s length principle in Transfer Pricing.4) To study Cost plus method application under Transfer Pricing. Scope of the Study: In this project I have covered the different aspects of Transfer Pricing, to show how it can benefit the organization and at times it could be reason to levy penalties. Under the transfer pricing implementation MNE’s have to abide by the government consideration and how they have to satisfy the Arm’s Length Standard with the application of various transfer pricing method to set their prices for the various services rendered or goods transferred.• Transfer pricing has assumed enormous significance in the modern economic context. The practice of transfer pricing refers to the application of prices to transactions that are conducted within the structure of an enterprise. In this project I have tried to incorporate different regimes followed in 4 selected countries. 4
  • 5. • However, an interesting dimension is thrown open when one considers the ability of a firm to drastically reduce its tax incidence by using transfer pricing. As the prices for intra-firm transactions are fixed in such a manner that low profits are reflected in jurisdictions having a high tax rate while higher profits are shown in those jurisdictions having a low tax rate.• It is now being recognized that international exchange of goods and services, like equivalent domestic exchange, takes place both through hierarchies and on markets.• The growth of management contracts, technical assistance agreements, licensing arrangements, etc. probably implies the expansion of non-market hierarchical influences even upon `arms length market transactions.• The problematic role of the market as the main instrument in the allocation of resources is due to increased mechanization and has been responsible in creating opportunities for the pursuit of `restrictive business practices within intra-firm trade.• The transfer pricing when undertaken within transnational corporate hierarchical systems are considered the basics of good transnational corporate management now a days.• The issue of transfer pricing arises because of the existence of intra-firm trade across national borders; but direct foreign investment, licensing agreements, joint ventures (both technical and financial), often also provide ample scope for transfer pricing not only to circumvent adverse government policies, but also as a part of the corporate strategy and organizational structure of transnational entities.• TNC’s combine centralized control and integrated corporate functioning with a geographical dispersal of their production and investment activities. Their multinational character is an attempt to `internalize market imperfections so as to maximize current global profits or minimize future risks and uncertainties in order to ensure long-term gains for the corporation as a whole. 5
  • 6. Chapter 3 : Company ProfileKPMG is one of the largest professional services firms in the world and one of the Big Fourauditors, along with PricewaterhouseCoopers (PwC), Deloitte and Ernst & Young (EY).COMPANY NAME: KPMG (Klynveld Peat Marwick Goerdeler)HEADQUATERS : Amsterdam Area, Netherlands.FOUNDED : 1987; in merger of Peat Marwick International and Klynveld Main Goerdeler.TYPE : Swiss cooperative.INDUSTRY : Professional Services.AREA SERVED : World Wide.KEY PEOPLE : Timothy P. Flynn (CHAIRMAN).SERVICES : Audit Tax AdvisoryREVENUE : ▲US$20.1 billion (2009)EMPLOYEES : 136000 6
  • 7. HISTORY1897: James Marwick and Roger Mitchell founded Marwick, Mitchell & Company in NewYork City.1925: Company established alliance with British accounting firm W.B. Peat & Co. andformed Peat, Marwick, Mitchell & Company.1978: Company changed its name to Peat Marwick International.1987: Peat Marwick International merged with Klynveld, Main, Goerdeler to form KlynveldPeat Marwick Goerdeler, based in the Netherlands; the U.S. arm was named Peat, Marwick,Main & Company.1989: U.S. branch was renamed KPMG Peat Marwick.1999: KPMG Peat Marwick shortened its name to KPMG LLP, a branch of KPMGInternational.The firm was established in 1870 when William Barclay Peat formed an accounting firm inLondon. In 1877 accountancy firm Thomson McLintock opened an office in Glasgow and in1911 William Barclay Peat & Co. and Marwick Mitchell & Co. merged to form PeatMarwick Mitchell & Co, later known as Peat Marwick. Meanwhile in 1917 Piet Klynveldopened his accounting-firm in Amsterdam. Later he merged with Kraayenhof to formKlynveld Kraayenhof & Co.In 1979 Klynveld Kraayenhof & Co. (Netherlands), Thomson McLintock (United States) andDeutsche Treuhandgesellschaft (Germany) formed KMG (Klynveld Main Goerdeler) as agrouping of independent national practices to create a strong European-based internationalfirm. Then in 1987 KMG and Peat Marwick joined forces in the first mega-merger of largeaccounting firms and formed a firm called KPMG in the US, and most of the rest of theworld, and Peat Marwick McLintock in the UK. In 1990 the two firms settled on the commonname of KPMG Peat Marwick McLintock but in 1991 the firm was renamed KPMG PeatMarwick and in 1999 the name was reduced again to KPMG. 7
  • 8. GLOBAL STRUCTURE Each national KPMG firm is an independent legal entity and is a member of KPMG International Cooperative, a Swiss entity registered in the Swiss Canton of Zug. KPMG International changed its legal structure from a SwissVerein to a co-operative under Swiss law in 2003. KPMG International is led by:• Timothy P. Flynn, Chairman, KPMG International• Michael Wareing, CEO, KPMG International• John Griffith-Jones, Chairman, Europe, Middle East, Africa and India Region• John B. Harrison, Deputy Chairman, KPMG International• John Veihmeyer, Chairman, Americas Region• Carlson Tong, Chairman, Asia Pacific Region. VALUES & CULTURE Values : Our commitment to our communities is set out clearly in our values and encourages us to act responsibly and do the right thing at all times. People :An overwhelming majority of our people view us as environmentally and socially responsible, and welcome a clear opportunity to volunteer. By putting our people’s time and skills to work in our communities, we are able to focus their passion towards sustainable community development. Living Green:Our Living Green program is driven by our commitment to the environment, and by our belief that the threats posed by climate change need to be tackled immediately. 8
  • 9. KPMG Services Support Advisory Audit Tax Performance & Risk & Compliance Finance Risk Technology Accounting Business Advisory Perform Services ance Financial Risk Services Managemen IT Advisory t Forensic Internal Audit, Risk & Compliance Research Human Services Resource Transaction & Restructuring Corporate Finance Restructuring Transaction Services T&R Sector Administration T&R Services Markets T&R CountryCompliance Knowledge Management 9
  • 10. KPMG In IndiaKPMG in India is one of the leading providers of risk, financial and business advisory, internalaudit, corporate governance, and tax and regulatory services. With a global approach to servicedelivery, KPMG responds to clients complex business challenges with a broad range of servicesacross industry sectors and national boundaries.HISTORYKPMG was established in India in September 1993, and has rapidly built a significantcompetitive presence in the country. The firm operates from its offices in Mumbai, Pune, Delhi,Kolkata, Chennai, Bangalore, Hyderabad, Kochi and Chandigarh, and offers its clients a fullrange of services, including financial and business advisory, tax and regulatory, and risk advisoryservices.In India, KPMG has a client base of over 2000 companies. The firms global approach to servicedelivery helps provide value-added services to clients. The firm serves leading informationtechnology companies and has a strong presence in the financial services sector in India whileserving a number of market leaders in other industry segments. Our differentiation is derivedfrom rapid performance-based, industry-tailored and technology-enabled business advisoryservices delivered by some of the leading talented professionals in the country. Our internalinformation technology and knowledge management systems enable the delivery of informed andtimely business advice to clients.STRUCTUREKPMG International is a Swiss cooperative. KPMG member firms in more than 140 countrieswork with clients drawn from the corporate, government and not-for-profit sectors. It is thecoordinating entity for a global network of independent firms. Their structure is designed tosupport consistency of service quality and adherence to agreed values wherever in the world ourmember firms operate. The member firms commit themselves to a common set of KPMG values.Firms must abide quality standards governing how they operate and how they provide services toclients. Other firms, licensed by member firms to use the KPMG name, must also abide by these 10
  • 11. standards. Each KPMG member firm takes responsibility for its management and the quality ofits work. Partners and professionals within those firms undertake to act with integrity at all times.CORPORATE CITIZENSHIP‘Commitment to our communities’ is not a mere statement. It is a defining value of our corporateculture, and the factor that gives us a great sense of pride. KPMG not only look at what they cando locally, but also at contributing towards global commitments such as the MillenniumDevelopment Goals and the ‘Living Green’ initiative.The very fact that their strategy focuses onthe core requirements of their local communities and also aligns their efforts with key globalissues like climate change and the Millennium Development Goals speaks volumes for theircommitment. This is India at its best - a place of innovation and leadership, and the Foundationmanifests the same creativity and passion. Their latest initiative ‘Partner school program’highlights the natural evolution process in their strategy and their aim to harness the strong coreskills of our people in implementing initiatives that provide a very promising future for ourpeople and their communities.”GLOBAL GREEN INITIATIVEIn April 2008, Timothy P. Flynn, Chairman, KPMG International Cooperative, announcedKPMG’s Global Green Initiative (GGI) – a three tiered global approach to help address thechallenges of climate change. This initiative incorporates a global commitment from memberfirms to reduce carbon emissions and constantly looking out for ways to reduce consumption of 11
  • 12. electricity and natural resources as well as air and vehicular travel. Including Tree plantingactivities, setting up of solar units for use of solar energy and Rainwater harvestingprojects. Chapter 4 : Review of LiteratureTransfer pricing has been defined by Pass and Christopher as: “A transfer price is theinternal price charged by a selling department, division or subsidiary of a company for a rawmaterial, component or finished good or service which is supplied to a buying department,division or subsidiary of the same company.” The transfer price charged may be set byreference to the prices ruling in outside markets for inputs and products (arms lengthpricing).It is basically a practice that multinational enterprises adopt of organizing their accountingpractices so as to declare high incomes and profits in geographical areas with low taxationrates. In todays international market, a large share of world trade consists of transfer ofgoods, intangibles and services within multinational enterprises (associated companies withbusiness establishments in 2 or more countries). To determine the international tax liabilityin each jurisdiction, the right transfer pricing principle has to be applied. To ensure that thetax base of a multinational enterprise is divided fairly, it is important that transfer pricingwithin a group should approximate those, which would be negotiated between independentfirms. For the purpose of transferring profits, revenues or money out of a country in order toevade taxes under transfer pricing, overpricing of imports and/or under-pricing of exportsbetween affiliated companies in different countries.According to the OECD (2007), more than 60% of world trade takes place withinmultinational enterprises, so the importance of transfer pricing becomes clear and itsimportant to understand why multinational enterprises practice transfer pricing. Pass andChristopher has identified the objectives of transfer pricing as follows:a) Taxation: Minimization of the MNCs global tax liability by using transfer pricing to move products at cost out of countries with high corporate taxes and the generation of profits in countries with low corporate taxes. 12
  • 13. b) Tariffs: Minimization of the MNCs exposure to tariffs by using transfer pricing to lower product prices sold to countries with high import tariffs. Transfer pricing objectives could be further differentiated as domestic and international objectives and International Aspects of Transfer pricing study gives a brief distinction between considerations for adopting transfer pricing domestically or internationally : Domestic Objectives International Objectives • Greater divisional autonomy • Less taxes, duties and tariffs • Greater motivation for managers • Less foreign exchange risks • Better performance evaluation • Better competitive position • Better goal congruence • Better governmental relations • Risk ManagementThe objective of international transfer pricing focus on minimizing taxes, duties, and foreignexchange risks, along with enhancing a companys competitive position and improving itsrelations with foreign governments. Although domestic objectives such as managerialmotivation and divisional autonomy are always important, they often become secondarywhen international transfers are involved. Companies will focus instead on charging atransfer price that will slash its total tax bill or that will strengthen a foreign subsidiary.For example, charging a low transfer price for parts shipped to a foreign subsidiary mayreduce customs duty payments as the parts cross international borders or it may help thesubsidiary to compete in foreign markets by keeping the subsidiarys costs low. On the otherhand, charging a high transfer price may help a multinational corporation draw profits out ofa country that has stringent controls on foreign remittances, or it may allow a multinationalcorporation to shift income from a country that has high income tax rates to a country that haslow rates.But most of the enterprises prefer international transfer pricing as compared to the domestictransfer pricing and the key drivers underlying this preferences are : 1 Market Conditions 2 Competition 13
  • 14. 3 Profit for the affiliate 4 Tax Rates 5 Economic conditions 6 Import Restrictions 7 Customs Duties 8 Price Controls 9 Exchange ControlSetting up the transfer prices for transaction of goods and services between associatedcompanies in a manner such that its objectives are met , the process would reap benefits tothe multinational enterprises. Based on the study of general concepts of transfer pricingconducted by Khurram khan enumerated the following benefits of transfer pricing : 1. To Reduce Tax 2. To Reduce Tariffs 3. For Avoiding Exchange Controls 4. To Optimize global profits by reducing tariffs and taxes to minimum or nil levels.On one hand the multinational enterprises are trying to seek advantages from transferpricing practices at the same time the management of transfer pricing risk has become one ofthe key challenges for the respective enterprises .They have to focus towards reducing theuncertainty from the risks, the various risks which are associated with transfer pricing are , • Double taxation, • Unexpected cash calls, • Interest on tax, and • Penalties for non-compliance. • Advisor Defense Costs • Revenue Authority Information Sharing • Internal Defense Costs • Income AdjustmentHence reviews of existing transfer pricing policies, intercompany arrangements, and/ordocumentation to assess any potential transfer pricing risks and the subsequent provision ofrecommendations could help enterprises to reduce these risks and to identify anyopportunities for further growth. 14
  • 15. This past year had been tough for the world economy and while there are signs of a recovery, troubles may still lie ahead. Several major territories, for instance, are now adopting new, or revised, transfer pricing requirements, and there is a discernible increase in disputes globally. Documenting — and sustaining — transfer pricing in this economic setting can also create difficult issues for tax departments. The continuously uncertain tax positions generated by the transfer pricing process means that multinational companies must now satisfy the ever-increasing demands of tax authorities and stakeholders. The present economic situation has only intensified this situation.Transfer pricing is of relevance to international transactions where inappropriate transfers could result in the loss of tax revenue to one country or another and the firm need to be more vigilant pertaining to their transactions and the rates they quote for transfer pricing, hence there are many challenges that a firm counters while practicing transfer pricing as stated by Govind Sankaranarayanan who considers transfer pricing as a fiscal challenge. Countries across the world, including India, appear to be bound for severe fiscal deficits in the coming years, and tax authorities will be induced to close all possible loopholes in the fiscal regimes that they govern. At the Organisation for Economic Co-operation and Development (OECD), economists have indicated that nearly 60% of world trade occurs between different arms of multinational companies. In today’s fiscal situation, it would be unthinkable for revenue authorities to pass up such a large fiscal opportunity.At the same time, there are two other critical factors that come into play. First, a large numberof multinational companies, faced with slowing growth in their core markets, will use themanagement of taxes to offset reductions in their profits elsewhere. Second, there is ingeneral a greater awareness created, in many countries, due to the emergence of a commonbody of knowledge on transfer pricing, which can now be used for the evolution ofmeaningful tax opinions and judgment.Companies should be spending resources to establish a robust documentation process,persuading tax authorities to look at substance over form while assessing transfer pricingstructures, and so on. Perhaps in the interim, a period of two-three years, some form of safeharbor provision could be provided to give an element of certainty to companies 15
  • 16. To study the trend of transfer pricing practices globally in December 2007 Ernst & Younghad undertaken a survey of 850 MNEs in 24 countries and examined how transfer pricingaffects the way that MNEs conducted business. The results showed the following:1. Forty percent (40%) of all respondents identified transfer pricing as their most importanttax issue.2. Over half (52%) of all respondents had undergone a transfer pricing examination since2003, with 27% resulting in adjustments by tax authorities.3. Eighty-seven (87%) percent of all respondents consider transfer pricing a risk issue inrelation to managing financial statement risk.4. Sixty-five percent of respondents from parent MNEs believe transfer pricingdocumentation is more important today than two years ago. However, only one-third ofMNEs prepare transfer pricing documentation on a concurrent, globally coordinated basis. According to John Smullen based on his study of transfer pricing in financial institutions the Uses of transfer pricing could be divided under four headings which are as follows : Government Relationship Organizational Risk Based with other Management Management Motivation organizations Management Ensuring Sensible Pricing For Strategy Isolating Risk, Response to Services, Formulation , Motivation of Regulation , Decision On Establishing risk management Requirement for Outsourcing , Financial Impact Competition Evaluation On of entity, Regulations M&A, Motivation, Benchmarking Pricing Decision Evaluation, Planning and Budgeting 16
  • 17. Transfer pricing is one of the key factors of a management control system, which helps acompany to achieve its goals, including profit maximization and tax minimization.There are several methods of setting transfer prices among profit centers within the sameorganization. Each profit center tries to set transfer prices which maximize their own profit.The buying and selling profit centers’ profits are largely affected by transfer prices. Forexample, when a high transfer price is charged, the selling division’s profits increase, whilethe buying division’s costs increase. So, transfer pricing should be established on areasonable and objective basis, which should maximize the companywide profit, rather thanbeing based on an individual division’s profit. The company can choose market-basedtransfer pricing, cost-based transfer pricing, or negotiated transfer pricing. AccordingTomas Buus from University of Economics, Prague the cost based transfer pricing i.e.average cost of the supplying division plus economic profit of the multi-business enterprise,independent on the market conditions at the market of either intermediate or final productsets the most optimal transfer price as compared to market-based and negotiation basedtransfer pricing methods because the latter two price base their arguments on marketimperfections like information asymmetry, motivation of managers and hence lead to loss ofmulti - business enterprises ability to compete its rivals as supported by“ Economics of Transfer Pricing: A Review” .Cross country differences in corporate income tax rates lead multinationals to find strategiesin order to diminish their tax liabilities. The manipulation of transfer prices represents acommon way to minimize the fiscal burden. But at the same time the widespread practice ofabusive transfer pricing is suspected to lead to a fiscal loss of a large magnitude. The startingpoint to encourage transfer pricing abuse has been the tax differentials, and that some firmshave a greater ability to manipulate transfer prices. Celine Azemar and Gregory Corcosrevealed that the ability of multinational firms to manipulate transfer prices affects the taxsensitivity of foreign direct investment (FDI and as per their findings the unobservable abilityto manipulate transfer prices is correlated with whole ownership of affiliates and R&Dexpenditure. Because interest is tax-deductible, multinationals may bias the capital structureof their affiliates towards debt financing in high-tax countries. R&D-intensive parent firmsare expected to invest in wholly-owned affiliates to have a greater ability to manipulatetransfer prices. The detection of abusive transfer pricing begins with more investment in low-tax countries. Multinationals engaging in abusive transfer pricing will try to maintainstandard profit-to assets ratios in order to minimize the risk of detection and punishment..It 17
  • 18. interprets the results as indirect evidence that abusive transfer pricing is one of thedeterminants of FDI activity.With the understanding as to how firms indulge into abusive transfer pricing by manipulatingtheir transfer price , now shifting the focus to repercussions of practicing inconsistenttransfer pricing rules. On study of a strategic tax compliance model by Waegenaere ;Sansing ; Wielhouwer revealed that an increase in transfer price rule inconsistency couldeither increase or decrease the taxpayers expected tax liability and could either increase ordecrease the deadweight loss from auditing. The prospect of double taxation due to transferprice rule inconsistency increases a firms expected tax liability and governments expectedaudit costs.Whereas some companies are practicing abusive transfer pricing and or inconsistent transferpricing rules there is a bright aspect for companies through transfer pricing as it offersremedy to tackle gray market trading , Romana Autrey from Harvard Business School andFrancesco Bova from University of Toronto found a method for the MNC’s to combat graymarkets by increasing internal transfer prices to foreign subsidiaries in order to increase thegray market’s cost base. Gray markets arise when a manufacturer’s products are sold outsideof its authorized channels, for instance when goods designated for a foreign market are resolddomestically. When a gray market competitor is present, the optimal price for internaltransfers not only exceeds marginal cost, but is also a function of the competitiveness of theupstream economy. Moreover, the presence of a gray market competitor may causeunintended social welfare consequences when domestic governments mandate the use ofarm’s length transfer prices between international subsidiaries. When markets are sealed,arm’s length transfer pricing strictly increases domestic social welfare. In contrast, wedemonstrate that when a gray market competitor is present, mandating the use of arm’s lengthtransfer pricing decreases domestic social welfare when the domestic market is sufficientlylarge relative to the foreign market. Specifically, a shift to arm’s length transfer pricingerodes domestic consumer surplus by making the gray market less competitive domestically,which in turn may offset any domestic welfare gains that accompany a shift to arm’s lengthtransfer pricing. Transfer pricing can deprive governments of their fair share of taxes from global corporations and expose multinationals to possible double taxation. No country – poor, emerging or wealthy – 18
  • 19. wants its tax base to suffer because of transfer pricing. The arm’s length principle can help. Thetransfers are not subject to the full play of market forces. Factors other than tax considerationsmay distort the conditions of commercial and financial relations established between associatedenterprises for example, such enterprises may be subject to conflicting governmental pressuresrelating to customs valuations, anti-dumping duties, and exchange or price controls. In addition,transfer price distortions may be caused by the cash flow requirements of enterprises within anMNE group. In a bid to avoid such problems, current OECD international guidelines are basedon the Arm’s length principle – that a transfer price should be the same as if the two companiesinvolved were indeed two independents, not part of the same corporate structure. As stated byJohn Neighbour in - OECD Centre for Tax Policy and Administration explains the need forthe application of Arm’s Length PrincipleAccording to the OECD guidelines, Article 9 of the OECD Model Tax Convention providesthe Statement of the arms length principle, which is as follows: “When conditions are made or imposed between ... two enterprises in their commercial orfinancial relations which differ from those which would be made between independententerprises, then any profits which would, but for those conditions, have accrued to one of theenterprises, but, by reason of those conditions, have not so accrued, may be included in theprofits of that enterprise and taxed accordingly."The separate entity approach treats the members of an MNE group as if they were independententities; attention is focused on the nature of the dealings between those members. TheOrganization for Economic Co-operation and Development (OECD) set forth Transfer PricingGuidelines for Multinational Enterprises in 1995 instructing that the pricing of intra-grouptransactions should be based on the arm’s-length standard. The arm’s-length standard states that:“A controlled transaction meets the arm’s-length standard if the results of the transaction areconsistent with the results that would have been realized if uncontrolled taxpayers had engagedin the same transaction under the same circumstances (arm’s-length result).”The OECD Guidelines and other transfer pricing legislation urge taxpayers to employ the best(or most appropriate) transfer pricing method rule, which states: 19
  • 20. “The arm’s-length result of a controlled transaction must be determined under the method that, under the facts and circumstances, provides the most reliable measure of an arm’s-length result.” There are five methods highlighted in the OECD Guidelines that are appropriate for setting and evaluating transfer prices. There are three applicable “transactional methods” specified in the OECD Guidelines. They are:• Comparable Uncontrolled Price (CUP) : Most systems consider a third party price for identical goods, services, or property under identical conditions, called a comparable uncontrolled price (CUP), to be the most reliable indicator of an arms length price. CUPs are based on actual transactions.• Resale Price Method (RPM): It compares the gross profit margin earned in the controlled (related) transaction to the gross profit margin realized in comparable uncontrolled transactions.• Cost Plus Method (CPLM): Goods or services provided to unrelated parties are consistently priced at actual cost plus a fixed markup. There are two specified “profit-based” methods. These methods of testing prices do not rely on actual transactions. Use of these methods may be necessary due to the lack of reliable data for transactional methods. These methods may include:• Transactional Net Margin Method: which evaluates the arm’s-length character of a controlled transaction based upon objective measures of profitability of one of the participants to the transaction (tested party) derived from uncontrolled taxpayers who engage in similar business activities under similar circumstances.• Profit Split Method: which determines an arm’s-length division of the combined operating profits/losses from one or more controlled transactions based on the relative value of each controlled taxpayer’s contribution to that combined operating profit or loss. To prevent profit shifting by manipulation of transfer prices, tax authorities typically apply the arm’s length principle in corporate taxation and use comparable market prices to ‘correctly’ assess the value of intra-company trade and royalty income of multinationals. The arm’s length prices systematically differ from independent party prices. Application of the principle thus distorts multinational activity by reducing debt capacity and investment of foreign affiliates, and by distorting organizational choice between direct investment and 20
  • 21. outsourcing. Although it raises tax revenue and welfare in the headquarter country, welfare losses are larger in the subsidiary location, leading to a first order loss in world welfare. This exemplifies the distorting aspect of arm’s length principle as per Devereux and Keuschnigg It is important acquaint ourselves with the importance of adopting arms length principle by the OECD Member countries and other countries under transfer pricing. It shed lights on as to how arm’s length standard make transfer pricing a fair play as it provides the following benefits to the firm such as,• A major reason is that the arms length principle provides broad parity of tax treatment for MNEs and independent enterprises.• The arms length principle puts associated and independent enterprises on a more equal footing for tax purposes, it avoids the creation of tax advantages or disadvantages that would otherwise distort the relative competitive positions of either type of entity.• The arms length principle promotes the growth of international trade and investment. But there are difficulties faced by the MNE’s under the application of Arm’s length principle. It is not a simple statement that a firm has to abide by it levies a complete set of regulations which has to be followed by the firm and such difficulties in practical application of the principle could be as follows :• The arms length principle is viewed by some as inherently flawed because the separate entity approach may not always account for the economies of scale and interrelation of diverse activities created by integrated businesses.• A practical difficulty in applying the arms length principle is that associated enterprises may engage in transactions that independent enterprises would not undertake as there is no direct evidence of what conditions would have been established by independent enterprises.• In certain cases, the arms length principle may result in an administrative burden for both the taxpayer and the tax administrations of evaluating significant numbers and types of cross-border transactions. At some point the enterprise may be required to demonstrate that these are consistent with the arms length principle. The tax administration may also have to engage in this verification process perhaps some years after the transactions have taken place. 21
  • 22. OECD Member countries continue to support strongly the arms length principle. In fact, nolegitimate or realistic alternative to the arms length principle has emerged as yet.International Consensus of the arm’s length principle in view of OECD Member countriescontinues to be that the arms length principle should govern the evaluation of transfer pricesamong associated enterprises. The arms length principle is sound in theory since it providesthe closest approximation of the workings of the open market in cases where goods andservices are transferred between associated enterprises. It reflects the economic realities ofthe controlled taxpayers particular facts and circumstances and adopts as a benchmark thenormal operation of the market. A move away from the arms length principle would increasethe risk of double taxation.Application of the arms length principle is generally based on a comparison of the conditionsin a controlled transaction with the conditions in transactions between independententerprises This part of the chapter would serve as a guide to the application of the armslength principle i) Comparability analysisMost rules provide standards for when unrelated party prices, transactions, profitability or otheritems are considered sufficiently comparable in testing related party items. Among the factorsthat must be considered in determining comparability are:1) The Nature of the property or services provided between the parties2) Functional analysis of the transactions and parties, buyers and sellers may perform differentfunctions related to the exchange and undertake different risks.3) Comparison of Contractual Terms , that may impact price include payment timing, warranty,volume discounts, duration of rights to use of the product, form of consideration, etc.4) Comparison of significant economic conditions that could affect prices, including the effectsof different market levels and geographic marketsii.Use of an arms length rangeAs transfer pricing is not an exact science, there will also be many occasions when theapplication of the most appropriate method or methods produces a range of figures all of whichare relatively equally reliable. In these cases, differences in the figures that comprise the range 22
  • 23. may be caused by the fact that in general the application of the arms length principle onlyproduces an approximation of conditions that would have been established between independententerprises.iii) Use of multiple year data :In order to obtain a complete understanding of the facts and circumstances surrounding thecontrolled transaction, it generally might be useful to examine data from both the year underexamination and prior years. The analysis of such information might disclose facts that mayhave influenced the determination of the transfer price.iv) The effect of government policies :There are some circumstances in which a taxpayer will claim that an arms length price must beadjusted to account for government interventions such as price controls (even price cuts),interest rate controls, and controls over payments for services or management fees, controls overthe payment of royalties, subsidies to particular sectors, exchange control, anti-dumping duties,or exchange rate policy. As a general rule, these government interventions should be treated asconditions of the market in the particular country, and in the ordinary course they should betaken into account in evaluating the taxpayers transfer price in that market.v) Intentional set-offs :An intentional set-off is one that associated enterprises incorporate knowingly into the terms ofthe controlled transactions. These enterprises may claim that the benefit each has receivedshould be set off against the benefit each has provided as full or part payment for those benefitsso that only the net gain or loss on the transactions needs to be considered for purpose ofassessing tax liabilities.vi) Use of customs valuations :The arms length principle is applied by many customs administrations as a principle ofcomparison between the value attributable to goods imported by associated enterprises and thevalue for similar goods imported by independent enterprises. In particular, customs officials mayhave contemporaneous documentation regarding the transaction that could be relevant fortransfer pricing purposes, especially if prepared by the taxpayer and, may be useful to taxadministrations in evaluating the arms length character of a controlled transaction transfer price.vii) Use of transfer pricing methods : 23
  • 24. There are various methods set forth to establish whether the conditions imposed in thecommercial or financial relations between associated enterprises are consistent with the armslength principle. No one method is suitable in every possible situation and the applicability ofany particular method need not be disproved. Moreover, MNE groups retain the freedom toapply methods to establish prices provided those prices satisfy the arms length principle.However, a taxpayer should maintain and be prepared to provide documentation regarding howits transfer prices were established. For difficult cases, where no one approach is conclusive, aflexible approach would allow the evidence of various methods to be used in conjunction. Insuch cases, an attempt should be made to reach a conclusion consistent with the arms lengthprinciple that is satisfactory from a practical viewpoint to all the parties involved, taking intoaccount the facts and circumstances of the case, the mix of evidence available, and the relativereliability of the various methods under consideration.Although there are discrepancies in the specifics of each countrys laws concerning theapplication of the arms length principle, most countries have based their transfer pricing lawsand regulations on the OECD Guidelines. Further, most double-tax treaties contain provisionsthat force both taxing authorities to resolve transfer pricing disputes on the basis of the armslength principle. Thus, multi-national companies should be able to devise global transferpricing policies that can be effectively used to determine appropriate ranges representing thearms length prices for transactions carried out across a global enterprise without necessarilyrunning afoul of local laws and regulations.Different countries may accept different methods of calculating the transfer prices so caremust be taken in such circumstances. In addition, some countries may have immature transferpricing regimes or apply the arms length principle in different ways. Traditional transactionmethods are the most direct means of establishing whether conditions in the commercial andfinancial relations between associated enterprises are arms length. As a result, traditionaltransaction methods are preferable to other methods. However, the complexities of real lifebusiness situations may put practical difficulties in the way of the application of thetraditional transaction methods. In those exceptional situations, where there are no dataavailable or the available data are not of sufficient quality to rely solely or at all on thetraditional transaction methods, it may become necessary to address whether and under whatconditions other methods may be used. 24
  • 25. Type of Transaction Possible method Manufacturing of goods CUP, C+, Profit split Sale of goods CUP, Resale price, Profit split, TNM Provision of services CUP, C+, TNM Financing (loans, deposits, guarantees) CUP, Profit split, TNM Transfer of intangibles (technology, brand) CUP, C+The above table shows which transfer pricing methods would be the most appropriate way toset prices for intra-firm transaction. As already stated traditional methods are the first choiceas compared to the profit-based methods. Amongst these traditional methods one importantmethod is Cost plus method this method probably is most useful where the transaction is theprovision of services. For international transfer pricing for services cost plus method is thefirst preference. This is considered a practical approach to the problem of divergent profitcenter and corporate interests. In some cases the profit center manager may want to basetransfer prices on variable costs plus profit whereas in other cases that manager may wantfixed costs also to be included. Even though the transfer price will be higher than full cost, itmay still be in the best interests of the buying responsibility center and the company as awhole to transfer the product within the company.The Cost Plus Method is defined as the simplest method for pricing products or servicesrendered. The cost plus method begins with the costs incurred by the supplier of property orservice provider in a transaction for property transferred or services provided to a relatedpurchaser. An appropriate cost plus mark up is then added to this cost, to make an appropriateprofit in light of the functions performed and the market conditions. What is arrived at afteradding the cost plus mark up to the above costs may be regarded as an arms length price of theoriginal transaction. This method probably is most useful where the transaction is the provision ofservices. The cost-plus method is used as an approximation of market price. Often this isconsidered a practical approach to the problem of divergent profit center and corporate interestsas per “Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations”by OECD. 25
  • 26. In situations where a division cannot derive its transfer prices from the outside market , the cost-plus approach may be a reasonable alternative as stated by Mr Putra based on his study of Transfer Pricing Best Practice. This method is based on its name—just accumulate a product’s full cost, add a standard margin percentage to the cost, and this becomes the transfer price. It has the singular advantage of being very easy to understand and calculate, and can convert a cost center into a profit center, which may be useful for evaluating the performance of a division manager. Applying cost plus method : P = (AVC + FC%) * (1 + MK%) • P = price • AVC = average variable cost • FC% = percentage allocation of fixed costs • MK% = percentage markup Nearly every MNE group must arrange for a wide scope of services to be available to its members, in particular administrative, technical, financial and commercial services. Such services may include management, coordination and control functions for the whole group. The cost of providing such services may be borne initially by the parent, by a specially designated group member ("a group service centre"), or by another group member. Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations published by OECD has mentioned about what all considerations should be taken into account under the cost plus approach :• The cost plus mark up of the supplier in the controlled transaction should ideally be established by reference to the cost plus mark up that the same supplier earns in comparable uncontrolled transactions. In addition, the cost plus mark up that would have been earned in comparable transactions by an independent enterprise may serve as a guide.• In addition, when applying the cost plus method one should pay attention to apply a comparable mark up to a comparable cost basis. The cost plus method relies upon a comparison of the mark up on costs achieved by the controlled supplier of goods or services and the mark up achieved by one or more uncontrolled entities on their costs with respect to comparable transactions. 26
  • 27. • The differences between the controlled and uncontrolled transactions that have an effect on the size of the mark up must be analyzed to determine what adjustments should be made to the uncontrolled transactions respective mark up. So it is particularly important to consider differences in the level and types of expenses -- operating expenses and non-operating expenses including financing expenditures - associated with functions performed and risks assumed by the parties or transactions being compared.• In general the costs and expenses of an enterprise are understood to be divisible into three broad categories. First, there are the direct costs of producing a product or service, such as the cost of raw materials. Second, there are indirect costs of production, which although closely related to the production process may be common to several products or services (e.g. the costs of a repair department that services equipment used to produce different products). Finally, there are the operating expenses of the enterprise as a whole, such as supervisory, general, and administrative expenses.• In principle historical costs should be attributed to individual units of production, although admittedly the cost plus method may over-emphasize historical costs. Some costs, for example costs of materials, labor, and transport will vary over a period and in such a case it may be appropriate to average the costs over the period. Costs such as replacement costs and marginal costs also may need to be considered where these can be measured and they result in a more accurate estimate of the appropriate profit margin.• The costs that may be considered in applying the cost plus method are limited to those of the supplier of goods or services. There is a possibility that some costs will be borne by the purchaser in order to diminish the suppliers cost base on which the mark up will be calculated. In practice, this may be achieved by not allocating to the supplier an appropriate share of overheads and other costs borne by the purchaser (often the parent company) for the benefit of the supplier (often a subsidiary). The allocation should be undertaken based on an analysis of functions performed by the respective parties. Advantages of cost-plus pricing: • Easy to calculate • Minimal information requirements 27
  • 28. • Easy to administer• Tends to stabilize markets - insulated from demand variations and competitive factors• Simplicity• It offers the illusion that profit can somehow be guaranteedDisadvantages of cost-plus pricing:• Provides no incentive for efficiency• Tends to ignore the role of consumers• Tends to ignore the role of competitors• Uses historical rather than replacement value• Uses “normal” or “standard” output level to allocate fixed costs• Includes sunk costs rather than just using incremental costs• Ignores opportunity costs• It takes no account of demand• It does not maximize the revenue from a product or service where the company should be charging considerably more than the cost plus approach would justify. For example a premium product which faces little 28
  • 29. Chapter 5: Research MethodologyResearch Design:This study is a Exploratory research, which is an attempt to provide insights into andcomprehension of practices followed under transfer pricing .The study is basically acomparison between the transfer pricing practices in selected countries. In this study threecountries have been selected from 3 different continents and compared them with the Indiantransfer pricing regime. KRCPL is one of the entity KPMG, which is a joint venture betweenKPMG India and KPMG UK. This entity is involved in transfer pricing by rendering servicesto its subsidiaries in United States and Philippines. KPMG India also offers its services toKPMG UK. This project covers the aspect as to how the tax authorities regulations vary inthese four countries and how do the companies set their transfer prices for provision ofservices. This project is based on data of secondary nature. Case studies have been includedto show the threats and opportunities offered by Transfer Pricing . MIS reports have beenused to show application of Transfer Pricing Method-Cost Plus Method for Services.Data Collection Methods:The study relies on secondary research i.e. reviewing available literature and/or data, casestudies and as formal discussions with employees. Internet has played a major role in findingfacts related to transfer pricing. Study on Transfer pricing conducted by KPMG and theirarticle on the Global Transfer Pricing Services has provided information in order to reviewthe transfer pricing regimes followed in the selected countries.Central Board of Direct Taxes (CBDT), Internal Revenue Services (IRS), Bureau of InternalRevenue (BIR), Her Majestys Revenue and Customs (HMRC) are the Tax authorities forIndia , United States , Philippines and United Kingdom respectively. These authorities givesthe outlines for documentation requirements and penalties information in relevance totransfer pricing practices.Employees of KPMG who are involved in preparing MIS reports have given information asto how KPMG India is related to transfer Pricing. 29
  • 30. Data Analysis :To compare the transfer pricing regimes in different countries have been depicted in a tabularform Pie charts and Bar graphs have been used to understand the data transfer pricingregulations such as to demonstrate the statute of limitations, penalties and documentationrequirements. Cost plus method has been used to identify the budget, forecast and actual costfigures of the MI report at 7% margin.Sampling Plan:This project is based on convenience sampling .In this project the Transfer Pricing regime offour countries has been compared i.e. India, Philippines, United Kingdom and United States. • KRCPL is one of the entity under the KPMG head which is a joint venture between KPMG India and KPMG UK. This entity indulges into transfer pricing by rendering services to its subsidiaries in United States, Philippines and United Kingdom . • This project would provide insights into how the transfer pricing regimes vary in these four countries. How does the tax authorities regulations vary and requirements to abide by government rules. • Philippines and India covers the Asia Pacific Region , United States Cover the American Region and United Kingdom covers the European region. • MI report have been used to show the application of Cost plus module under the transfer pricing for provision of services to satisfy arm’s length standard. 30
  • 31. Chapter 6: Data Analysis and InterpretationAfter understanding the basics of transfer pricing and arm’s length principle, this part ofproject presents the facts as to how the transfer pricing methodology differs in the fourselected countries. Comparison of Transfer pricing practices between India, Philippines,United Kingdom and United StatesTable 6.1 - Basic Information: Features India Philippines United United States KingdomTax Authority Central Board of Bureau of Her Majestys Internal RevenueName Direct Taxes Internal Revenue Revenue and Services ( IRS) (CBDT) (BIR) Customs (HMRC)Requirement of Accountants No specific No specific Related Partytransfer pricing Report in form of disclosures are disclosure transactions,related disclosure Form 3CEB to required. required. Form filed within or with their be filed along- Tax returntax returns with Tax Return ; form to be certified by Chartered Accountant The relationship Direct/indirect Under common Ownership Under commonthreshold for participation in control ; share between 40-50 Controltransfer pricing management, capital % ; based onrules to apply 26% equity voting power ;between parties participation, 13 share capital ; criteria’s for are under associated common enterprise control . relationship to be satisfied. 31
  • 32. The statute of 45 Months from No existing law Six years from Three years fromlimitations on the end of the tax on statute of tax year-end filing dateassessment of year limitation ontransfer pricing transfer pricingadjustments assessment.The above table provides the basic information about which all tax authorities are involved inregulating the transfer pricing in the selected countries. These tax authorities require thecompanies to file their tax returns but in India companies involved in transfer pricing has toprovide Form 3CEB which contains details of all the related party international transactionsand methods to use to justify arms length standard. All the tax authorities describe that theminimum requirment for the companies to enter into transfer pricing is that they should beunder common control but the associated enterprise conditions vary from country to country . Figure 1 : The graphs represents the period after which legal actions would proceed after the event at issue i.e. transfer pricing takes place.United Kingdom provides 6 years period for Statute of limiations , 4.7 years in India and 3years in United States and Philippines tax authority has not prescribed the statute oflimitations. Statute of limitation represents the period after which the legal actiona takes placeafter the events has ocurred. 32
  • 33. Table 6.2 - Transfer Pricing Documentation Review: Features India Philippines United United States KingdomDocumentation Statutory No specific Statutory Documentationrequirements for requirement: requirements. requirement: is required fortransfer pricing Documentation, BIR requests Documentation penalty Form 3CEB, and documents to support protection Tax return relating to entries on a taxpayers taxpayers tax transfer pricing return , including during conduct transfer pricing of audit documentation. investigation.Deadlines for Preparation Preparation and HRMC will set Preparationdocumentation along-with Tax submission the deadline on a deadline within 9preparations and return , deadline - Not case-by-case months of fiscalsubmission Submission applicable basis , typically year-end , within 30days of ;Documents to be 45 to 90 days. Submission request. submitted within deadline is 45 days upon within 30 days request.What purpose Penalty Penalty Penalty Penaltydoes elimination elimination and elimination ; eliminationdocumentation shift burden of penalty reductionserve ? proof ; shift of burden of proof 33
  • 34. Features India Philippines United United States KingdomSpecific Business Business Organizational Businesscategories of overview , overview , structure, description ,documenation organizational organizational functional organizationalrequired structure, structure, analysis , risk structure, functional functional analysis, functional analysis , Risk analysis , Risk industry analysis analysis , Risk analysis, Industry analysis, Industry , financial analysis, analysis , analysis , performance , Intercompany financial financial intercompany analysis performance performance agreements, ,intercompany ,intercompany ,intercompany description of agreements, agreements, agreements, controlled description of description of description of transactions, controlled controlled controlled method selection transaction, transaction, transaction, , rejection of method method selection, method selection, alternate selection, rejection of rejection of methods, rejection of alternate alternate identification of alternate methods, methods, comparables, methods, identification of identification of economic identification of comparables, comparables, analysis. comparables, economic economic economic analysis, Profile analysis. analysis. Certain of multinational Intercompany group, record of agreements and actual work documentation carried out for are required, determining the including cost arms length price share and adjustments arrangements. made.This Table covers transfer pricing requirement, what purpose does the transfer pricingdocumentation serves to the companies and what all documents do the companies need toprepare for penalty elimination or to shift burden of proof, also the deadlines set by the 34
  • 35. authorities for submission of the documentations. The requirements and the deadlines varyfrom country to country.The compulsory elements of transfer pricing documentation: • Information about the parties involved in the transaction; • Information about intercompany transactions: – Characteristics of the subject of transaction; – Functional analysis; – Terms and conditions of the transaction; – Economic circumstances of the transaction; – Business strategy. • Information about transfer pricing method used; • Other information that reveals the important circumstances of transfer pricing. Figure 2 : This Graph depicts the deadline for documentation submission. 35
  • 36. United Kingdom and Philippines provide the maximum period of 45 days for the submissionof transfer pricing documentation after the tax authorities request whereas In India andUnited States it is only 30 days. 1. Represents its statutory to submit transfer pricing documentation) 2. Represents transfer pricing documentation is required) 3. Represents transfer pricing documentation may not be required) Figure 3 : This Chart depicts documentation RequirementsIn India and United Kingdom the tax authorities have mentioned transfer pricingdocumentations to be of statutory importance as they prove to evidences concerning thetransfer pricing transactions and the prices charged under the practices, hence helping thefirm in penalty elimination while paying the tax and as a burden of proof is shifted becausethese documents would prove to be a great help to show the status of the firm under transferpricing in case of audit investigations and legal actions against the firm. In United States thefirm have to submit the transfer pricing documentation only when requested by the taxauthorities to do so and in Philippines it is required in rare case when undergoing auditinvestigation etc. 36
  • 37. Table 6.3 - Transfer Pricing Methods : Features India Philippines United United States KingdomAcceptable Transaction Transaction Transaction Transactiontransfer pricing method : method : methods : method :methods comparable comparable comparable comparable uncontrolled uncontrolled uncontrolled uncontrolled price ,cost plus price ,cost plus price ;resale price ,cost plus method and resale method and price ; cost plus. method and price , Profit resale price , Profit based resale price ; based method Profit based methods : profit Profit based :Profit split , method :Profit split , method :Profit transactional net split , transactional net split , margin method. transactional net margin method. comparable margin method. profits method .Priority among None Yes , transaction Yes, It follows Nonethe acceptable based method is OECDs transfermethods preferred. If not pricing then profit-based guidelines for method determining the most appropriate method.Existence of best Yes Most appropriate Not applicable Yesrule method method ruleAll the five types of transfer pricing methods are applied in all the four countries and thenature of transaction determines the most appropriate method for setting the prices while 37
  • 38. transferring goods or for provision of services. In Philippines and United Kingdom thetransaction based methods are given priority over profit based methods and the best methodrule is applicable in all countries except United Kingdom. The below table describes the mostappropriate methods for different types of transactions that takes place between thesubsidiaries.Table 6.4 - Transfer Pricing Penalties: Features India Philippines United United States KingdomRates and 100-300% tax General tax General tax Complianceconditions apply due on transfer penalties only penalties, For Penalties . 20%for transfer pricing incorrect of additional taxpricing penalties adjustments; 2% returns , a due if income of aggregate transfer pricing adjustment is value of adjustment may more than USD international lead to a penalty 5 million or 10 transactions for based on a % of gross % or failure to percentage of more or to 50 % maintain potential tax or less. 40% of prescribed lost . Penalties additional tax documentation ; up to 30 % for due if income 2% of aggregate failure to take adjusted more value of reasonable care; than USD 20 international up to 70% for a million or 20 % transactions for deliberate of gross failure to furnish understatement receipts ; or price prescribed or over claim is adjusted to documentation ; and up to 100% 400% or more or Fixed penalty for for a deliberate to 25 or less. failure to furnish understatement Accountants aggravated by report in Form concealment . 3CEB ( appox. USD 2,200 )Extent of Often Often Very Strict Very Strictenforcingtransfer pricingpenaltiesCan transfer No No Yes, the Nopricing penalties penalties can bebe reduced or mitigated forremoved for reasons, such asreason other than cooperation withdocumentation ? HMRC 38
  • 39. Some jurisdictions impose significant penalties relating to transfer pricing adjustments by taxauthorities. The rules of many countries require taxpayers to document that prices charged arewithin the prices permitted under the transfer pricing rules. Where such documentation is nottimely prepared, penalties may be imposed.United States and United Kingdom are very strict in enforcing transfer pricing penalties ascompared to Philippines and India which often apply the penalties on the tax payers.TransferPricing penalties are applied when the companies are not able to furnish the prescribeddocumentation as and when demanded by the tax authority and also in case of adjustmentsmade in the transfer pricing procedures. It is only United Kingdom which at times providechances for the penalty reduction but not by the other three countries.The tax authoritieshave prescribed their transfer pricing penalties for adjustments and failure in providingdocumentation and it varies from country to country. ( 1. Represents the countries where transfer pricing penalties cannot be reduced) ( 2. Represents the countries where trnsfer pricing penalties can be reduced) Figure 4 : This chart shows the percentage if transfer pricng penalties reduction chances.Under the transfer pricing penalties enforcement only United Kingdom has a provision forreduction of trnasfer pricing penalties if the company cooperates with their tax authority andnone of the other three countries remove the penalties. 39
  • 40. Table 6.5 - Special Consideration : Features India Philippines United United States KingdomUse secret No guidance on No, tax No, Secret Nocomparables by use of secret authorities use comparablestax authorities comparables, the secret may be used by tax authority uses comparables in HMRC to select secret practice to companies for comparables for benchmark a audit. concluding audits taxpayers return in relation to its peersLevel of Low, joint low Historically low, Highinteraction tax working groups but seeking moreauthorities have have been formed coordinatedwith customs in order to approach withauthorities ? increase the the merger of the interaction level. Inland Revenue and Customs & excise.Other unique Provides testing None None Noneattributes of the controlled transactions with the arithmetical mean of the comparable companies. • The respective tax authorities uses the secret comparables as tools for various purposes such as India and United Kingdom uses it for Auditing purpose and in Philippines it is used for benchmarking tax returns by the companies but none these authorities have provided any guidance as to how secret comparables are used by them. 40
  • 41. • On comparing the interaction levels of tax and custom authorities in concern to transfer pricing , it is low in India , Philippine and United States but in Unites States the interaction level is high . custom authorities come into role as there is transfer of good between the subsidiaries which are geographically distributed. India and United Kingdom have taken steps to strengthen the interaction level as both tax and custom have established joint working groups . • In just India the tax authorities are involved in testing of the controlled transaction between the subsidiaries which does not take place in the other three countries. ( 1. Represents Low interaction between Tax and Custom Authorities) (2. Represents High interaction between Tax and Custom Authorities) Figure 5 : This chart depicts the interaction level between tax and custom authorities in the Selected countries.As shown in this chart maximum countries i.e. 3 out of the 4 sampled countries have low interactionlevels between tax and custom authorities. Amongst the low interaction level countries India andUnited Kingdom have taken steps to strengthen the interaction by setting up joint working groups . 41
  • 42. Table 6.6 - Advance Pricing Agreements Features India Philippines United United States KingdomAny advance No provision for Unilateral , Unilateral, Unilateralpricing APAs bilateral and Bilateral APAs ;Bilateral ;agreement multilateral Multilateraloptions available APAs APAsFiling fees for Not Applicable Submission of Not applicable Yes ,APAs proposal - EUR USD50,000 for 30000-35000 large txpayers ; depending on the USD 22,500 for revenue of the small taxpayers. taxpayer ; USD 35,000 for Renewal or renewals review of APAs require filing fees but with a 50% discount on the initial fees.Advance pricing agreements:• Advance Pricing Agreement (APA) is an agreement between a taxpayer and a taxing authority on an appropriate transfer pricing methodology (TPM) for some set of transactions at issue (called "Covered Transactions").• Under an APA, the taxpayer and one or more governments agree on the methodology used to test prices. APAs are generally based on transfer pricing documentation prepared by the taxpayer and presented to the government(s).• Types of Advance pricing Agreements :1) Bilateral and multilateral Advance pricing agreements : 42
  • 43. APAs are generally bi- or multilateral--i.e., they also include agreements between the taxpayer and one or more foreign tax administrations under the authority of the mutual agreement procedure specified in income tax treaties. The taxpayer benefits from such agreements since it is assured that income associated with Covered Transactions is not subject to double taxation by the relevant foreign tax authorities. MAP i.e. a mutual agreement procedure is an instrument used for relieving international tax grievances, including double taxation2) Unilateral Advance pricing agreements : Its possible, however, that a taxpayer may negotiate a unilateral APA involving only the taxpayer and the concerned tax authority. In this case, the two parties negotiate an appropriate TPM for the concerned tax purposes only.While there is no provision for APA’s in India , United Kingdom has both Unilateral andBilateral APA’s provided. Whereas Philippines and United States have provision for allunilateral, bilateral as well as Multilateral APA’s.So when the tax authority and the taxpayer get into the APA’s there is filing fees that is to besubmitted by the taxpayer at initiation of the agreement which is required to be paid underPhilippines and United States transfer pricing regimes only as in United Kingdom no suchfees is required at initiation and India has no APA’s provision and hence no filing fees. Figure 6 : The above graph depicts the amount charged by the respective tax authorities for filing fees. 43
  • 44. The maximum filing fees is charged by United States i.e. $ 50,000 and then followed byPhillipines that charges $ 44480 (approx), but United Kingdom doest not charge this fees . inIndia there is no provision for APA’s so no filing fees is charged. Figure 7 : This graphs Represents the amount charged by respective tax authorities for renewal of the Advance Pricing Agreements.The maximum renewal fees is charged in United States i.e. $ 35,000 and in Philippines it isaround $ 19,060(approx), whereas United Kingdom does not ask for renewal fees and inIndia there is no Advance Pricing Agreement facility. 1. Represents Provision of Advance Pricing Agreements 2. Represents No provision of Advance Pricing Agreements Figure 8 : This pie-chart depicts the provision of APA’s in the respective companies. 44
  • 45. In the 4 countries , 75% i.e. 3 countries which include United States, United Kingdom andPhilippines have provision for APA’s but only one country does not have the APA provisionwhich is India.Table 6.7 - Recent Developments Features India Philippines United United States KingdomRecent Higher mark-ups None In addition to Nonedevelopments for service APA, introduced companies , non- Advance Thin tolerance of Capitalization losses in case of Agreement routine (ATCA). distributors ,benefit test for cross chargesUnder transfer pricing regulation there has been no change in Philippines and United states inthe respective practices followed. India and United Kingdom have taken step to improve thetransfer pricing practices such as facilitating higher mark-ups to be charged by servicesrendering firms under transfer pricing as in India. Along-with the provision of AdvancePricing Agreements and Advance Thin Capitalization Agreement which included a non-compulsory model ATCA to set out the financial conditions and the consequences whenthese conditions of transfer pricing are breached. 45
  • 46. Table 6.8 - Competent Authority Features India Philippines United United States KingdomSubmission of No formal rules After an After an After anadjustment to adjustment is adjustment is adjustment iscompetent proposed to the proposed to the proposed to theauthority taxpayer taxpayer taxpayerMay a taxpayer No formal rules Permitted Permitted Permittedgo to competentauthority beforepaying tax ?Toughest Tax 6 Not in first 10 10 3AuthoritiesRankingGovernment authority to adjust prices :Most governments have granted authorization to their tax authorities to adjust prices chargedbetween related parties. Many such authorizations, including those of the United States, UnitedKingdom, Canada, and Germany, allow domestic as well as international adjustments. Someauthorizations apply only internationally. Most, if not all, governments permit adjustments by thetax authority even where there is no intent to avoid or evade tax.Adjustment of prices is generally made by adjusting taxable income of all involved related partieswithin the jurisdiction, as well as adjusting any withholding or other taxes imposed on partiesoutside the jurisdiction. Such adjustments generally are made after filing of tax returns. Most 46
  • 47. rules require that the tax authorities consider actual transactions between parties, and permitadjustment only to actual transactions.Testing of prices :Tax authorities generally examine prices actually charged between related parties to determinewhether adjustments are appropriate. Such examination is by comparison (testing) of such pricesto comparable prices charged among unrelated parties. Such testing may occur only onexamination of tax returns by the tax authority, or taxpayers may be required to conduct suchtesting themselves in advance or filing tax returns.In UK , US and Philippines the companies are allowed to interact with the competentauthority which deal with the transfer pricing functioning of the respective territories beforepaying of tax and there is formal description of rules as to how to submit adjustments undertransfer pricing in order to satisfy arm’s length standard. In India there is no mention of anykind of rules to guide companies on interacting with the competent authority and how shouldthe adjustments be submitted to the concerned party.Table 6.9 - Language Features India Philippines United United States KingdomIn which English English English Englishlanguage orlanguages candocumentation befiled?All the documentation required for the Transfer Pricing methodology in all the fourcontinents should be in English . In India and Philippines they have not given an option ofusage of their national language for the sake of documentation as nor hindi and norportuguese can be used for documentation. 47
  • 48. MI ReportsThe MI report consolidates the budget, forecast and the actual costs made by the differentbusiness units of the company. They help in determining the variance between the budget and theactual cost and the variance between forecast and the actual cost. The MI report preparation isbased on Cost Plus Method. MI report form a part of MIS which is prepared to show the costborne by the company which is providing the services to its subsidiary under transfer pricing andit also depicts the application of coat plus method to satisfy Arm’s Length Standard.Budget Preparation :The values for different cost elements for budget of the present year is determined by keepingcertain percentage amount as standard and adding some margin of previous years actual costs areused in order to determine the budget for the present year. Consideration is also given toheadcounts which is responsible for the variability in the budget figures.Budget = Standard Amount + certain margin of Previous year actual costs + Charges variable with the headcountForecast Preparation :Basically forecast is determined using the previous month costs and the previous year last monthactual cost are matched up for determining the forecast figures for all the months. Otherconstraints are also taken into consideration such as the factors of expense for example, In theauditing department the refreshment and travel charges increase in the month of March which isconsidered to be the peak time of activities in the audit department. Recruitment costs variablewith the employment trend , Effect of recession , Offsite charges , Variable headcounts alsohave an impact on determining the forecast for the various months .Actual Cost and the Cost Plus module :With reference to the actual transactions made by the business units .The cost plus module comesinto role after determination of the various cost and then markup is calculated at a particularpercentage on these costs and the charges are further forwarded to the related party as theirtransfer prices with reference to the cost plus method satisfying the Arm’s Length Principle. 48
  • 49. The mark – up is also calculated for the budget and the forecast figures for the various costelements at the same percentage as with the actual cost.Division of the total cost under the following heads as a prerequisite of the cost plus method:Staff Cost is inclusive of: Salaries, Bonus and Gratuity.Direct Cost is inclusive of: Staff welfare, Recruitment cost, Attrition cost, Travel, Food andtransport, Subsistence cost and Communication cost.Overhead is inclusive of: Facilities and seat cost, IGDC cost and shares service cost.The Mark-up is calculated on the Staff Cost, Direct Cost and the Overhead Expenses. Additionalcost elements which can be taken into consideration are stewardship cost and the sharedmanagement service cost management.Mark Up has been calculated at 7% in the setting up the Transfer Price for provision of servicesby KPMG India to KPMG United Kingdom.Preparation of the MI report: 1. The budget and the forecast figures are calculated according to the formula stated above. The figures under the various cost element heads of the budget sheet are mapped on to the MI sheet .The forecast figures are then mapped onto the MI report from the forecast sheet. 2. After the budget and forecast figures are mapped from the respective sheets, then the actual are added. The actual cost is obtained from the data dump sheet. The data dump sheet consists of the description of all the cost that are made under the project , full details about the expenses are prepared , which are further summarized in to annexure by summating all the cost under common cost element heads depending on the nature of the expense. 3. Along-with the actual even the out of pocket expenses are also allocated on the MI report. 4. After all the figures have been mapped, the delta is determined i.e. the variance in the budget and the actual cost and the variance in the forecast and the actual cost. These delta figure would further effect the decision made with respect to forecast preparation for the next month and actual cost allocation under the various cost element heads. 49
  • 50. 5. The MI reports are prepared on the monthly basis, to expense made by the company under different projects and comparing it with their allocation strategy. 50
  • 51. Current Month YTD Full Year Actual Excl BudVsAct ForVsAct Actual excl BudVsAct ForVsAct BudVsForCost Element Budget Forecast OPE OPE Actual Delta Delta Budget Forecast OPE OPE Actual Delta Delta Budget Forecast DeltaSalaries 100.00 110.00 85.00 - 85.00 15.00 25.00 300.00 390.00 238.00 - 238.00 62.00 152.00 1,200.00 990.00 210Bonus 25.00 27.50 21.25 - 21.25 3.75 6.25 75.00 97.50 59.50 - 59.50 15.50 38.00 300.00 247.50 53Gratuity and Leave Encashment 12.50 13.75 10.63 - 10.63 1.88 3.13 37.50 48.75 29.75 - 29.75 7.75 19.00 150.00 123.75 26Mark Up-Staff Cost 9.63 10.59 8.18 - 8.18 1.44 2.41 28.88 37.54 22.91 - 22.91 5.97 14.63 115.50 95.29 20.21Staff Cost Total(A) 147.13 161.84 125.06 - 125.06 22.07 36.78 441.38 573.79 350.16 - 350.16 91.22 223.63 1,765.50 123.75 1,641.75Staff Welfare 2.00 2.20 1.70 - 1.70 0.30 0.50 6.00 7.80 4.76 - 4.76 1.24 3.04 24.00 19.80 4Recruitment Cost 1.12 1.23 0.95 - 0.95 0.17 0.28 3.36 4.36 2.66 - 2.66 0.69 1.70 13.43 11.08 2Training 0.20 0.22 0.17 0.09 0.26 0.03 0.05 0.60 0.78 0.48 0.26 0.74 0.12 0.30 2.40 1.98 0Database 0.10 0.11 0.09 - 0.09 0.02 0.03 0.30 0.39 0.24 - 0.24 0.06 0.15 1.20 0.99 0Miscellaneous 0.02 0.02 0.02 0.01 0.03 0.00 0.01 0.06 0.08 0.05 0.03 0.07 0.01 0.03 0.24 0.20 0Company Transport 15.00 22.00 17.00 - 17.00 (2.00) 5.00 45.00 58.50 47.60 - 47.60 (2.60) 10.90 180.00 198.00 (18)Subsistence and Travel Cost 20.00 22.00 17.00 12.75 29.75 3.00 5.00 60.00 78.00 47.60 39.53 87.13 12.40 30.40 240.00 198.00 42Communication Cost 0.02 0.02 0.02 - 0.02 0.00 0.01 0.06 0.08 0.05 - 0.05 0.01 0.03 0.24 0.20 0Mark Up-Direct Function Cost 2.69 3.35 2.59 0.90 3.48 0.11 0.76 8.08 10.50 7.24 2.79 10.03 0.84 3.26 32.31 30.12 2.19Direct Function Cost Total(B) 41.15 51.15 39.53 13.74 53.27 1.63 11.63 123.45 160.49 110.67 42.60 153.27 12.78 49.82 493.81 460.36 33.45Shared Management Cost/Funding Cost 0.70 0.77 0.60 - 0.60 0.11 0.18 2.10 2.73 1.67 - 1.67 0.43 1.06 8.40 6.93 1Mark Up-CMT Allocation Cost 0.05 0.05 0.04 - 0.04 0.01 0.01 0.15 0.19 0.12 - 0.12 0.03 0.07 0.59 0.49 0.10Allocation Cost Total(C) 0.75 0.82 0.64 - 0.64 0.11 0.19 2.25 2.92 1.78 - 1.78 0.46 1.14 8.99 7.42 1.57Accomodation Cost 20.00 22.00 17.00 - 17.00 3.00 5.00 60.00 78.00 47.60 - 47.60 12.40 30.40 240.00 198.00 42Mark Up- Accomodation Cost 1.40 1.54 1.19 - 1.19 0.21 0.35 4.20 5.46 3.33 - 3.33 0.87 2.13 16.80 13.86 2.94Rental Cost Total(D) 21.40 23.54 18.19 - 18.19 3.21 5.35 64.20 83.46 50.93 - 50.93 13.27 32.53 256.80 211.86 44.94Facilities and Seat cost 25.00 27.50 21.25 - 21.25 3.75 6.25 75.00 97.50 59.50 - 59.50 15.50 38.00 300.00 247.50 53Shared Service Cost 6.25 6.88 5.31 - 5.31 0.94 1.56 18.75 24.38 14.88 - 14.88 3.88 9.50 75.00 61.88 13IGDC Service Cost 1.56 1.72 1.33 - 1.33 0.23 0.39 4.69 6.09 3.72 - 3.72 0.97 2.38 18.75 15.47 3 Mark Up-Overheads 2.30 2.53 1.95 - 1.95 0.34 0.57 6.89 8.96 5.47 - 5.47 1.42 3.49 27.56 22.74 4.82Overheads CosTS US Total(E) 35.11 38.62 29.84 - 29.84 5.27 8.78 105.33 136.93 83.56 - 83.56 21.77 53.37 421.31 347.58 73.73Stewardship Cost 4.00 4.40 3.40 - 3.40 0.60 1.00 12.00 15.60 9.52 - 9.52 2.48 6.08 48.00 39.60 8Mark Up-Overheads 0.28 0.31 0.24 - 0.24 0.04 0.07 0.84 1.09 0.67 - 0.67 0.17 0.43 3.36 2.77 0.59Stewardship Cost Total(F) 4.28 4.71 3.64 - 3.64 0.64 1.07 12.84 16.69 10.19 - 10.19 2.65 6.51 51.36 42.37 8.99Total Cost (A+B+C+D+E+F) 249.81 280.68 216.89 13.74 230.63 32.92 63.79 749.44 974.28 607.29 42.60 649.89 142.15 366.99 2,997.77 2,526.13 471.65Head Count 112 135 98 98 145 112 86 - 86 156 146Total Cost/FTE 2.23 2.08 2.21 2.35 5.17 8.70 7.06 - 7.56 26.77 18.71 51
  • 52. Example to show the application of the cost plus method:The Lie Dharma Putra Inc has a large number of profit centers, including b (representing thebuying profit center) and s (representing the selling profit center). Profit center b needs 20,000units of component 12. Component 12 is an integral part of product z, which is manufactured inprofit center b and sold for $24. Component 12 can be purchased by profit center b eitherexternally at $19 per unit from the Thompson Company or internally from profit center s. inaddition to component 12, profit center s regularly manufactures between 80,000 and 100,000units of component 13, which is sold at a 60% markup on full cost ($21.60 = 160% × $13.50).Component 13 is slightly different from component 12 because of the use of more costly directmaterials; so it cannot be substituted for component 12 in the manufacture of product Z.The standard and actual controllable costs of profit centers S and B for production and saleof components 12 and 13 and product z are shown on below table: 52
  • 53. The transfer price will be set equal to full cost plus normal markup. Full cost for profit center s is$12.70 per unit and the normal markup is 60% so that the transfer price equals $20.32 per unit($12.70 × 160%). The relevant incomes for profit center b and the company are:A transfer price set equal to full cost plus markup will not lead to goal congruence. With anoutside price of $ 19 per unit, which is less than the transfer price of $20.32 per unit, the managerof profit center b will be sent an erroneous signal to buy 20,000 units of component 12 from theThompson Company instead of from profit center s. As a result, the company as a whole ispenalized $8.30 per unit, the difference between Thompson Company’s purchase price of $19 perunit and the relevant variable costs of $10.70 per unit to make and sell component 12 in profitcenter s. With respect to the three remaining criteria—motivation, autonomy, and performanceevaluation—a cost-plus transfer price leads to their satisfaction from the perspective of both thebuying and the selling profit centers. 53
  • 54. Chapter 7 : FindingsA brief analysis has been presented on transfer pricing regulations across jurisdictions. Theprimary purpose of these regulations is to cut down on evasion of tax and subsequentlyincrease revenue reserves. It is true that transfer pricing is often considered by tax authoritiesas a soft target with huge potential to produce large increases in revenue. From 1995 towardsthis end, various countries evolved regulations to govern transfer pricing in their respectivejurisdictions. • The application of Transfer Pricing by KPMG India in rendering services to its subsidiary i.e. KPMG UK has been shown by the MI reports which are based on Cost Plus Method of Transfer Pricing to satisfy Arm’s Length Standard as they have been charging 7% markup on the actual costs made by the firm and both the firms are considered as two separate legal firms. • On comparing the Transfer pricing regimes followed in the four selected countries i.e. India , Philippines, United States and United Kingdom. There is a lot of difference in regulations which the respective tax authorities have imposed on the transfer pricing practices in the selected countries. Amongst them United Kingdom is expected to have the toughest Tax regulation, followed by India and then United States, the Philippines tax authorities are expected to be very lenient as compared to the other three. • Philippines and United States transfer pricing regulations are quite similar to the OECD guidelines for transfer pricing , but India and United Kingdom show dissimilarities in this respect , hence they should get in synchronization with the OECD guidelines such that there would be more uniformity in the transfer pricing regulations for the firms. The United Kingdom have more specified regulations given by the tax authorities and the custom authorities. Indian Tax authorities have to be more elaborate on its transfer Pricing Regulations. • The case study attached in the Appendix-B helps in realizing the what opportunities and threats are offered by Transfer Pricing. It is a great avenue for companies to go 54
  • 55. global and transfer profits to the country with low tax regimes, they also gain operational efficiency with goal congruence and avoid double taxation. But it could be a great loss for the company to indulge into transfer pricing if they do not follow the regulations of the tax authorities and the custom authorities under transfer pricing. As they would have to pay penalties and would bear losses .The case studies prove that rather indulging into market-driven mechanisms, buying andselling within firm would be more beneficial and with application of arm’s length standard itwould be safe also as proved in the case study attached in chapter 6. • Most legal dispensations identify associated enterprises, transactions between associated enterprises and then seek to determine whether these transactions have been conducted at the ALP. It is suggested that analysis begin from international transactions for the sole reason that the ambit of transfer pricing regulations would be widened. • Further, under a cross-jurisdictional comparison, the meaning of associated enterprises or related parties may vary. With a view to ensure consistency, it would help if transfer pricing analysis began from the stage of international transactions. • Additionally, APA’s should be favored for firms so as to further strengthen the objects of consistency and certainty. The Indian law should get in sync with the OECD Guidelines. • Finally, it should be endorsed for the need of greater clarity in the realm of comparability i.e. in determining how adjustments between an international transaction and an uncontrolled transaction are to be made. 55
  • 56. Chapter 8 : Limitation Of the Study• The project is prepared on the basis of the secondary data but there could be chances when the secondary would not be reliable.• This project gives a overall picture of the Transfer Pricing regime but intricate details could not be mentioned as they were confidential to the firm.• Lack of awareness in concern to the topic amongst the people.• The study was conducted for a short period , so the project gives a brief idea about the Transfer Pricing practices followed in the selected countries. 56
  • 57. Chapter 9 : Recommendation• There is a fundamental need for co-operation among tax administrations in order to remove the obstacles that international double taxation presents to the free movement of goods, services and capital under transfer pricing.• Considering that the prices of such transactions between associated enterprises (usually referred to as transfer pricing) should, nevertheless, for tax purposes be in conformity with those which would be charged between independent enterprises (usually referred to as arm’s length pricing).• Considering the need to achieve consistency in the approaches of tax administrations, on the one hand, and of associated enterprises, on the other hand, in the determination of the income and expenses of a company that is part of a Multinational Enterprise Group that should be taken in to account within a jurisdiction.• More awareness about transfer pricing is required by the companies.• Companies should be prepared with the documentation as described under the tax authorities regulations for transfer pricing to avoid penalties.• In case of queries companies have the benefit to consult the competent authorities.• Companies should not indulge into any unfair trade practices. 57
  • 58. Appendix – A Current month : Budget , Forecast and Actual mapped Current Month Actual Excl BudVsAct ForVsActCost Element Budget Forecast OPE OPE Actual Delta Delta 100 110. 8 8 15.0 25.0Salaries .00 00 5.00 - 5.00 0 0 25. 27. 2 2 3.7 6.2Bonus 00 50 1.25 - 1.25 5 5Gratuity and Leave 12. 13. 1 1 1.8 3.1Encashment 50 75 0.63 - 0.63 8 3 9. 10. 1.4 2.4Mark Up-Staff Cost 63 59 8.18 - 8.18 4 1 147 161. 12 12 22.0 36.7Staff Cost Total(A) .13 84 5.06 - 5.06 7 8 2. 2. 0.3 0.5Staff Welfare 00 20 1.70 - 1.70 0 0 1. 1. 0.1 0.2Recruitment Cost 12 23 0.95 - 0.95 7 8 0. 0. 0.0 0.0Training 20 22 0.17 0.09 0.26 3 5 0. 0. 0.0 0.0Database 10 11 0.09 - 0.09 2 3 0. 0. 0.0 0.0Miscellaneous 02 02 0.02 0.01 0.03 0 1 15. 22. 1 1 (2.0 5.0Company Transport 00 00 7.00 - 7.00 0) 0Subsistence and Travel 20. 22. 1 1 2 3.0 5.0Cost 00 00 7.00 2.75 9.75 0 0 0. 0. 0.0 0.0Communication Cost 02 02 0.02 - 0.02 0 1Mark Up-Direct Function 2. 3. 0.1 0.7Cost 69 35 2.59 0.90 3.48 1 6Direct Function Cost 41. 51. 3 1 5 1.6 11.6Total(B) 15 15 9.53 3.74 3.27 3 3Shared Management 0. 0. 0.1 0.1Cost/Funding Cost 70 77 0.60 - 0.60 1 8Mark Up-CMT Allocation 0. 0. 0.0 0.0Cost 05 05 0.04 - 0.04 1 1 0. 0. 0.1 0.1Allocation Cost Total(C) 75 82 0.64 - 0.64 1 9 58
  • 59. 20. 22. 1 1 3.0 5.0Accomodation Cost 00 00 7.00 - 7.00 0 0Mark Up- Accomodation 1. 0.2 0.3Cost 1.40 54 1.19 - 1.19 1 5 21. 23. 1 1 3.2 5.3Rental Cost Total(D) 40 54 8.19 - 8.19 1 5 25. 27. 2 2 3.7 6.2Facilities and Seat cost 00 50 1.25 - 1.25 5 5 6. 6. 0.9 1.5Shared Service Cost 25 88 5.31 - 5.31 4 6 1. 1. 0.2 0.3IGDC Service Cost 56 72 1.33 - 1.33 3 9 2. 2. 0.3 0.5Mark Up-Overheads 30 53 1.95 - 1.95 4 7 35. 38. 2 2 5.2 8.7Overheads Cost Total(E) 11 62 9.84 - 9.84 7 8 4. 4. 0.6 1.0Stewardship Cost 00 40 3.40 - 3.40 0 0 0. 0. 0.0 0.0Mark Up-Overheads 28 31 0.24 - 0.24 4 7 4. 4. 0.6 1.0Stewardship Cost Total(F) 28 71 3.64 - 3.64 4 7 249 280. 21 1 23 32.9 63.7Total Cost (A+B+C+D+E+F) .81 68 6.89 3.74 0.63 2 9 1Head Count 112 35 98 98 2. 2.Total Cost/FTE 23 08 2.21 2.35 59
  • 60. Year To Date : Budget, Forecast and Actual mapped YTD Actual excl BudVsAct ForVsActBudget Forecast OPE OPE Actual Delta Delta 300.00 390.00 238.00 - 238.00 62.00 152.00 75.00 97.50 59.50 - 59.50 15.50 38.00 37.50 48.75 29.75 - 29.75 7.75 19.00 28.88 37.54 22.91 - 22.91 5.97 14.63 441.38 573.79 350.16 - 350.16 91.22 223.63 6.00 7.80 4.76 - 4.76 1.24 3.04 3.36 4.36 2.66 - 2.66 0.69 1.70 0.60 0.78 0.48 0.26 0.74 0.12 0.30 0.30 0.39 0.24 - 0.24 0.06 0.15 0.06 0.08 0.05 0.03 0.07 0.01 0.03 45.00 58.50 47.60 - 47.60 (2.60) 10.90 60.00 78.00 47.60 39.53 87.13 12.40 30.40 0.06 0.08 0.05 - 0.05 0.01 0.03 8.08 10.50 7.24 2.79 10.03 0.84 3.26 123.45 160.49 110.67 42.60 153.27 12.78 49.82 2.10 2.73 1.67 - 1.67 0.43 1.06 0.15 0.19 0.12 - 0.12 0.03 0.07 2.25 2.92 1.78 - 1.78 0.46 1.14 60.00 78.00 47.60 - 47.60 12.40 30.40 4.20 5.46 3.33 - 3.33 0.87 2.13 64.20 83.46 50.93 - 50.93 13.27 32.53 75.00 97.50 59.50 - 59.50 15.50 38.00 18.75 24.38 14.88 - 14.88 3.88 9.50 4.69 6.09 3.72 - 3.72 0.97 2.38 6.89 8.96 5.47 - 5.47 1.42 3.49 105.33 136.93 83.56 - 83.56 21.77 53.37 12.00 15.60 9.52 - 9.52 2.48 6.08 0.84 1.09 0.67 - 0.67 0.17 0.43 12.84 16.69 10.19 - 10.19 2.65 6.51 749.44 974.28 607.29 42.60 649.89 142.15 366.99 145 112 86 - 86 5.17 8.70 7.06 - 7.56 60
  • 61. Full Year : Budget , Forecast mapped Full Year BudVsForBudget Forecast Delta1,200.00 990.00 210 300.00 247.50 53 150.00 123.75 26 115.50 95.29 20.211,765.50 123.75 1,641.75 24.00 19.80 4 13.43 11.08 2 2.40 1.98 0 1.20 0.99 0 0.24 0.20 0 180.00 198.00 (18) 240.00 198.00 42 0.24 0.20 0 32.31 30.12 2.19 493.81 460.36 33.45 8.40 6.93 1 0.59 0.49 0.10 8.99 7.42 1.57 240.00 198.00 42 16.80 13.86 2.94 256.80 211.86 44.94 300.00 247.50 53 75.00 61.88 13 18.75 15.47 3 27.56 22.74 4.82 421.31 347.58 73.73 48.00 39.60 8 3.36 2.77 0.59 51.36 42.37 8.992,997.77 2,526.13 471.65 156 146 26.77 18.71 61
  • 62. Appendix –B Case StudyThe Transfer Pricing Threat… or Opportunity?It is spring 2005 and Canadian company has just received a reassessment from Canada RevenueAgency (“CRA”) after a lengthy and painful audit process. This was not the first CRA auditCanadian company had undergone, yet this was the first time that CRA performed an in-depthanalysis on the prices charged by Canadian company to its US subsidiary, US Co. The wholesituation took Canadian company management quite by surprise – they had believed that theirtransfer prices for the goods manufactured in Canada and sold to its US subsidiary fordistribution in the US was an appropriate transfer price.According to the CRA reassessment, however, an additional $3,000,000 over a three year periodshould have been charged to US Co. In addition to this adjustment, CRA’s reassessment proposedthat an additional $500,000 should have been charged to US Co. for services provided by theCanadian head office to US Co. To top it off, a penalty of 10% of the adjustment was also appliedbecause Canadian company was “deemed not to have made reasonable efforts” to document andsupport its transfer prices and the interest was also charged .After the initial shock of the reassessment, Canadian company management sat down to quantifythe impact of these adjustments and found, much to its surprise, that it would be better off from apure tax cost perspective, to apply CRA’s transfer pricing methodology! US Co was paying about40% tax on its earnings in the U.S. whereas with the reduced Canadian tax rates, it would havepaid between 33% - 35% on profits in Canada. A 5% - 7% spread on $3,500,000 translated into atax savings of up to $245,000. In addition to that, there was an additional 5% withholding tax thatcould have been avoided on the repatriation of these earnings to Canada.However, the potential benefits were quickly overshadowed by the prospect of hefty penaltiesand interest arising from the reassessment, in addition to the uncertainty of obtaining equivalentrelief from the US tax authorities. According to Canadian company’s tax advisors, the only wayto get a corresponding deduction from US Co’s taxable income in the US was to apply to the“competent authorities” of Canada and the US for the IRS to accept the proposed adjustments.Apparently this was a lengthy process which was expected to last between 2 to 3 years. 62
  • 63. Canadian company first entered the US market about 10 years ago and like many othercompanies, started out as a branch of the Canadian company to get a “feel” for the Americanmarket and its potential. After two years, things started to look promising and so a separate legalentity was formed. At that time, while Canadian company management had some knowledge oftransfer pricing as a tax compliance issue, it felt that Canadian company and US Co. were muchtoo small to attract any attention from either revenue authority. Besides, US sales were notsufficient to warrant any in-depth study into establishing the appropriate transfer price. A mark-up of 15% on the manufactured cost sounded right – even at that, it barely left any operatingprofit in US Co - and it wasn’t too high a price for duty purposes. Several years later, US Co saleswere rising and along with it, huge profits were being realized. Canadian company managementdecided that it was time to revisit its transfer pricing policy. A review revealed several things:• First, the current transfer pricing methodology to apply a 15% mark-up on manufactured costwould result in much larger gross margins for US Co. The gross margin on Canadian company’sproducts had increased significantly over the last few years because of a number of factors;Canadian company’s continued development to improve its products and its branding effortsallowed it to increase its price point in the market. In addition, its ability to improvemanufacturing efficiency along with the weaker Canadian dollar vis-à-vis the US dollarsignificantly reduced production costs. The transfer pricing methodology was transferring all ofthe additional profits from these efforts to US Co while Canadian company was left with a fixed15% return.• While the 15% mark-up seemed appropriate at the time when gross margins on Canadian saleswere only 20%, now that gross margins were averaging 35%, the additional 15% was beingtrapped in the U.S.• Back when USCo was first established, there was little difference in the Canadian and Americancorporate tax rates. By 2004, however, the federal Canadian tax rate decreased by 7%. Thisresulted in a rate differential between Canada and the US of up to 9%.• “Transfer price” for customs and income tax purposes were not necessarily the same.Furthermore, most of Canadian company’s products were now no longer subject to duty andtherefore, the issue from a customs perspective was largely irrelevant.• Recognizing that gross margins were increasing because of its marketing and branding efforts,Canadian company management had contemplate charging US Co a royalty for use of Canadiancompany’s brand name. The transfer pricing review revealed that a royalty would have attracted a 63
  • 64. further 10% withholding tax, whereas a different transfer pricing model would achieve the same result with a lower tax cost. • The transfer pricing documentation and required financial analysis provided management with an opportunity to examine its business in a way that it hadn’t previously. Reports and analysis that were originally developed for transfer pricing purposes also allowed management to improve certain business decisions and operational processes. • Finally, the Company was also considering expansion outside of the North American market and the review revealed a number of ways to structure the international expansion such that worldwide taxes could be minimized. There were opportunities to centralize certain functions or operations to maximize business process efficiency and at the same time minimize or defer worldwide taxes. As a result of the review, the Company realized that what started out as a tax compliance exercise turned into a tax minimization strategy and a business process improvement. The transfer pricing review benefited the Company in the following ways:1. Management gained a heightened awareness of the implications of business process changes to its overall tax cost and its ability to remain in compliance with transfer pricing rules. Likewise, management also understood that any attempts to change the transfer pricing business model had to be operationally practical. As a result, management was able to make better overall decisions for the Company, recognizing the tax cost/savings of business model changes and the impacts to its transfer pricing risks.2. The Company was better prepared for a transfer pricing audit. Although this did not guarantee that an adjustment would not be made, it reduced the time it took for CRA to conduct an audit, it reduced the time and efforts management had to devote to the audit, it removed the risks of transfer pricing penalties and it set out the Company’s reasons and support for the chosen transfer pricing methodology. This shifted the burden of proof to CRA to challenge the transfer price that was used and avoided “fishing expeditions” and diversions by CRA.3. Most importantly, the Company was in a better position to manage its global tax costs, its transfer pricing risks and manage the uncertainties that transfer pricing adjustments can pose for businesses. 64
  • 65. Bibliography Books:• Organisation for Economic Co-operation and Development (2008), “OECD Transfer Pricing Guidelines for Multinational Enterprises and tax administration” Oecd Publishing.• John Smullen(2001), “Transfer pricing for financial institutions” Woodhead Publishing Limited, England.• Robert Newton Anthony, John Dearden, Richard F. Vancil (2007) “Management control systems” Tata McGraw Hill, New Delhi. Websites :• www.Wikipedia.com• www.Scribd.com• www.Kpmg.com• http://hubpages.com/hub/Managerial-Accounting-Investment-Centers-Transfer- Pricing• http://accounting-financial-tax.com/2010/01/how-to-make-transfer-pricing-tax- reduction-strategy-work/• www.Livemint.com Articles :• “Global Transfer pricing services” by KPMG International• “TP Global Reference Guide” 2009 by Ernst & Young 65