Transfer pricing is the price that one division of a firm charges another division for goods and services offered. It establishes prices for goods and services exchanged between subsidiaries, affiliates, or enterprises under shared management that are all part of the same bigger organization. Corporations can save money on taxes by using transfer pricing, while tax authorities may challenge such claims. In this article, we will study transfer pricing which is important for UPSC examination.

What is Transfer Pricing?

• Increased globalization has also resulted in greater cross-border trading involving various international entities.
• Transfer pricing underlines the mechanism resorted to by firms while charging a price for a good/service purchased from one of its affiliates.
• Therefore, transfer pricing can be defined as setting, analysis, documentation, and adjustment of charges made between related parties for goods, services, or use of the property (including intangible property like IPRs).
• It is undertaken by the companies so as to reduce the overall tax burden; a transfer price is based on market price.
• Transfer Pricing can also be used as a tax avoidance mechanism as companies while dealing with one of their affiliates, decide prices of goods/services artificially in order to avail maximum benefits.

Objectives of Transfer Pricing

• It assists in a separate profit generation in each division of the company which in turn enables performance evaluation of each division separately.
• Along with the generation of separate profits, it also helps in better resource allocation in each division of the company.

Need for Transfer Pricing

• It helps in better management accounting and reporting, as it provides multinational companies (MNCs) with discretion while distributing the profits and expenses to its subsidiaries present in various countries.
• When a subsidiary is further divided into various segments transfer pricing helps in better allocation of revenue and expenses to such subsidiaries.
• It impacts the wealth of shareholders as it has an impact on the company's taxable income and its after-tax, free cash flow.
• It helps reduce risks associated with non-compliance, especially in cross-border intercompany transactions.

International Transactions Done by Transfer Pricing Rules

• Fees for technical services
• Management fees
• Fees for royalty
• Corporate guarantee fees
• Loan paid or received
• Finished goods sales
• Purchase of raw materials
• Purchasing of fixed assets
• Sale or purchase of machinery, intangibles, etc
• Reimbursement of paid or received expenses
• Services such as IT, support services, etc
• Software development services

Various Methods For Transfer Pricing

Comparable Uncontrolled Price (CUP) Method

• In this method, in an uncontrolled transaction, a price charged between the comparable firms is given recognition and is evaluated with the price of a verified entity price for determining the Arm’s Length Price.
• This method of transfer pricing is most accurate and is the best way of applying the arm's-length principle and determining the prices for related party transactions. It can only be used where products or services have high comparability.

Resale Price Method or Resale Minus Method

• In this method of transfer pricing, those prices are considered at which the associated enterprise sells its product to the third party and such a price is called the resale price.
• From this resale price the gross margin which is deciphered by comparison of the gross margins in a comparable uncontrolled transaction is deducted. After reducing other costs such as customs duties we get the arm’s length price for controlled transactions.

Cost Plus Method

• This method of transfer pricing is focused on the costs of the supplier of goods or services in the controlled transaction. After the estimation of costs, a markup price is determined which tells about the profit for the associated enterprise on the basis of risks and functions performed this produces the arm’s length price.
• It is determined after the direct and indirect cost related to production and supply is considered.

Benefits of Transfer Pricing

• Transfer price for a product is mostly lower than the market price of the product, therefore it results in cost savings for various departments.
• It inculcates transparent pricing mechanisms and prevents arbitrary charging of prices.
• It lowers the duty costs by shipping goods into high-tariff countries at minimal transfer prices so that duty base and duty are low.

Policy Measure to address Transfer Pricing

• The government has framed rules regarding the computation of the Foreign Tax Credit (FTC).
• An equalization levy was introduced to tax e-commerce transactions of non-residents.
• Base Erosion and Profit Shifting (BEPS) Action Plan 13 was introduced in the Budget 2016
• A Transfer Pricing Code was introduced by the government in 2001 which is based on OECD guidelines.
• Indian Transfer Pricing Code is discussed below in a comprehensive manner:

Armed Length Principle:

• It states that related party transactions should involve an arm’s length principle and the pricing between related parties should be such as that charged from an independent buyer.
• Arm’s length can be defined by Comparable uncontrolled price (CUP) method; Resale price method (RPM); Cost plus method (CPM), etc.

Use of multiple-year data and Range Concept:

• They increase the authenticity of the analysis undertaken for the computation of arm’s length price (ALP).
• Multiple Data Approach is when data for the previous year is also to be used for calculation of transfer pricing.
• A statistical tool that is used for the computation of ALP using various data to construct a range is the range concept.

Mutual Agreement Procedure (MAP) and Advance Pricing Agreements (APA):

• APAs are used to avoid disputes on transfer pricing. APAs increase transparency, bring tax certainty, reduce litigation etc.
• Mutual Agreement Procedure (MAP) was used as per the agreed double taxation avoidance agreement (DTAA) between the two countries.

Base Erosion Profit Sharing (BEPS) Initiative:

• It is an initiative of the Organization for Economic Cooperation and Development (OECD) that is working to close gaps in international taxation for companies that allegedly avoid taxation or reduce the tax burden in their home country by engaging in tax inversions.

Dispute Resolution Panels:

• It is made of three commissioners or directors of income tax appointed by the Central Board of Direct Taxes (CBDT). It can ve availed by any company with transfer pricing issues.

Limitations of Transfer Pricing

• In order to fulfil the requirements of transfer pricing rules additional work, manpower, costs and time are required.
• Arm’s length prices do not work for various departments uniformly.
• Transfer pricing involving multi-national jurisdictions gets complicated.
• It can cause a rift among various departments because those supplying goods to other departments will feel that they are sacrificing their profit by not selling their products to the market as market rates are higher than transfer price.

Conclusion

Inter-company transactions across borders are growing complex, this method of transfer pricing helps make the international marketplace a competitive environment, helps reduce taxes, and also reduce foreign exchange risks.