Introduction:Determination of exchange price when different businessunits within a firm exchange the products and servicesDefinition:As per section 92 (1) of the Income Tax Act, 1961 –Income from an international transaction shall becomputed having regard to the Arm’s length Price(correct market price).Commercial transactions between the different parts of themultinational groups may not be subject to the same market forcesshaping relations between the two independent firms. One partytransfers to another goods or services, for a price. That price is knownas “transfer price”.
Uses of Transfer Pricing:When product is transferred between profit centers or investment centerswithin a decentralized firm, transfer prices are necessary to calculatedivisional profits, which then affect divisional performance evaluationThe objective is to achieve goal congruence, in which divisional managerswill want to transfer product when doing so maximizes consolidated corporateprofits, and at lest one managers will refuse the transfer when transferringproduct is not the profit-maximizing strategy for the companyWhen multinational firms transfer product across international borders,transfer prices are relevant in the calculation of income taxes,and are sometimes relevant in connection with other international trade andregulatory issues.
Transfer pricing is the process of setting transfer prices between associatedenterprises or related parties where at least one of the related parties is anon-resident. Transfer Price is the price at which an enterprise transfersgoods and services, intangible and intangible assets, services or lending/borrowing money to associated enterprises. Transfer prices are generallydecided prior to entering the transaction and they are audited/ reviewedby the auditor after the year finalization.Example:In the example, we see that ABC (India)and ABC (UK) are related parties orassociated enterprises while XYZ is anindependent enterprise. It is expected thatthe prices at which ABC (India) deals withABC (UK) are expected to be at par withthe price at which it deals with XYZ i.e.the fact that ABC(India) and ABC(UK) arerelated parties should not have anyinfluence on the price at which transferstake place between them.Explanation of Transfer Pricing
Transfer Pricing Model In IndiaEvery country is following its own TP model but most of the countriesare following OECD model of convention on Transfer PricingIndia is following its own model of Transfer Pricing under the Income-tax Act and IT Rules and India is an observer of OECD Model ofconvention on Transfer Pricing. India is a non-member in OECD(Organization for Economic Cooperation and Development).India is successful in implementing the Transfer Pricing laws in thecountry achieving its targets.There are so many new concepts have come up in treating the“ Reimbursements , Interest income, deemed international transactions ,sale of shares, loans received/ paid , corporate guarantees etc., at Arm’sLength Standard.India is rapidly growing using its own model of TP rules and alsoobserving the OECD TP Guidelines.In fact, OECD is also agreed that India is fast developing country ontransfer pricing and OECD itself learning the rules/concepts framed byIndian Revenue Authorities.
Some Transactions subject toALP(Arm’s Length Price)• Exchanging property• Selling of real estate at a price different from MP• Use of trade names or patents at exorbitant rateseven after their expiry.• Purchase at little or no cost.• Payment for services never rendered.• Sales below MP/ Purchase above MP• Interest free borrowings
Income Tax Act 1961Section 92: 92.Computation of income from international transactionhaving regard to arm’s length price. (ALP)Section 92 A: Meaning of associated enterpriseSection 92 B: Meaning of international transactionSection 92 C: Computation of arm’s length priceSection 92 D: keeping of information and document by persons enteringinto an international transactionSection 92 E: Report from an accountant to be furnished by persons enter-inginto international transactionSection 92 F: Definitions of certain terms relevant to computation of arm’slength price, etc
Penal Provisionso Non Maintenance of Records :2% of the transaction value (u/s 271AA)o Non submission of information/Records :2% of the transaction value (u/s 271G)o Non submission of Report u/s 92E :Rs. 1 lakh (u/s 271BA)Above penalty need not be levied if reasonable cause forfailure is proved u/s 273Bo Addition / Disallowance u/s 92C(4) is deemed to be income concealed u/s271(1)(c)o Penalty 100% to 300% of the tax on disputed income
Methods of Transfer Pricing:Comparable uncontrolled price method CUP method compares the price transferred in a controlled transaction to theprice charged in a comparable un-controlled transaction. CUP method is the most direct and reliable way to apply the arm’s lengthprinciple.Resale price method The resale price method begins with the price at which a product is resold toan independent enterprise (IE)by an associate enterprise. X sold to AE at Rs. 1000 (profit: 300) AE sold to an IE at Rs. 2000 (profit of Rs. 500 for relevant IE) Arms length price = 2000 - 500 = 1500
Profit Split Method PSM is used when transactions are inter-related and is not possible toevaluate separately. PSM first identifies the profit to be split for the AE. The profit sodetermined is split between the AE on the basis of the functionsperformed/assets/CECost Plus Method In CP method, first the cost incurred is determined. An appropriate costplus mark-up is then added to the cost to arrive at an appropriate profit.The resultant figure is the arm’s length price.
Methods of Transfer Pricing:• Variable Cost MethodTransfer price = variable cost of selling unit + markup• Full Cost MethodTransfer price = Variable Cost + allocated fixed cost• Market Price MethodTransfer price = current price for the selling unit’s in the market• Negotiated Price Method
Why Did TEVA Introduce Transfer Pricing Teva, a multinational pharmaceutical company, solved its transfer pricingproblems by using activity-based costing Teva reorganized its pharmaceutical operations into 1 operation division (with 4manufacturing plants) and 3 marketing divisions Marketing divisions are organized into the US marketing and the local market, andthe rest of the world Responsible for decisions about sales, product mix, pricingand customer relationships Marketing were evaluated on sales, not profit Manufacturing plants were measured how meeting expense budgets and delivered theright orders on time Cost system emphasized variable costs: materials expenses and direct labor. Allother costs were considered fixed Decided to introduce transfer pricing system that would enhance profitconsciousness and improve coordination between operations and marketing
Why Traditional Transfer Pricing Method not workVariable Cost MethodCovering only ingredients and packaging materials which was inadequate for theirpurposesMarketing divisions would report extremely high profits because they were beingcharged for materials onlyOperations divisions would get credit only for expenses of purchased materials•No motivation to control labor or other fixed expensesMarginal cost transfer price would give the marketing divisions no incentive to shifttheir source of supplyMeasuring profits as price less materials cost would continue to allow marketing andsales decisions to be make without regard to their implications for production capacityand long-run costs and overall company profitabilityFull cost MethodOverhead did not capture the actual cost structure in Teva’s plantMarket Price MethodNo market existed for manufactured and packaged products that had not beendistributed or marketed to customersNegotiated price methodWould lead to endless arguments
Strategic Factors of Transfer Pricing1. International Transfer Pricing Consideration Tax Rate- minimize taxes locally as wellinternationally Exchange Rate Custom Charges Risk of expropriation Currency Restriction2. Strategic relationship Assist bayside division to grow Gain entrance in the new country Supplier’s quality or name
Case Study 1: Transfer Pricing Restructuring(India/Europe)WTPA Client wished toestablish a single globalproduction facility inIndiaTPThe global nature of this transferpricing project required us todevelop solutions formanufacturing, distribution andmargin changes among threeseparately-managed regions.