What is Transfer Pricing? Understanding Rules, Methods, Benefits and Risk
Updated: Oct 1
Transfer pricing refers to the price at which goods, services, or intellectual property are exchanged between subsidiaries, divisions, or affiliated companies that are part of the same parent organization. The purpose of transfer pricing regulations is to ensure that transactions between related parties occur at an arm's length price, meaning the price would be comparable to what independent entities would charge in a similar market transaction.
Without proper oversight, companies may use transfer pricing to shift profits to low-tax jurisdictions, thereby reducing their overall tax liability. This is why governments implement strict transfer pricing rules to prevent tax avoidance and ensure fairness.
In this article, we’ll dive into how transfer pricing works, the various methods used to calculate it, and ensure compliance. We’ll also explore how businesses can comply with these regulations effectively and even potentially optimize their tax strategies while staying within legal boundaries. Keep reading to discover everything you need to know about transfer pricing.
Table of Contents
What is Transfer Pricing?
The price of goods and services traded between linked parties, like subsidiaries of the same parent firm, is determined by transfer pricing. Because transfer pricing influences how revenue and expenses are distributed among several countries, it is significant from a tax perspective. The arm's length concept, which states that the cost of a transaction between related parties should be equivalent to the cost of a similar transaction between independent parties, is the foundation for transfer pricing regulations in India. The Income Tax Act of 1961, the Income Tax Rules of 1962, and several directives and circulars issued by the Central Board of Direct Taxes (CBDT) govern transfer pricing in India. Additionally, the CBDT has recommended a number of techniques for figuring out the arm's length price. In India, transfer pricing is subject to reporting requirements, documentation requirements, and tax authority audits.
Understanding Arm’s Length Principle
In a business transaction, buyers and sellers behave independently without any influence from the other, according to the arm's length principle. Ensuring related party transactions are executed at fair market value is a cornerstone principle of international taxation. Protecting taxpayers from tax evasion and upholding market justice are the two main objectives of the proposal. The arm's length principle is based on the idea that unaffiliated parties will negotiate terms and conditions of a transaction based on their disparate risk profiles and financial interests. Applying the arm's length principle, different transfer pricing techniques under section 92C(1) can be used to calculate the arm's length price, with the techniques chosen based on which ones are most appropriate for the parties engaged in a given transaction.
Working of Transfer Pricing
Setting rates for transactions inside a business or a collection of businesses run by the same people or with similar ownership is known as transfer pricing. This holds true for both domestic and foreign transactions. The amount that one division or subsidiary charges another for a good or service that they both provide is known as a transfer price. The market price for the good or service is typically the basis for transfer prices. Transfer price is also applicable to royalties, patents, and research. Transfer pricing is a legitimate tool that multinational corporations can use to divide their revenues between their parent and subsidiary companies. Some common examples of foreign transactions covered by the transfer pricing regulations are as follows:
Selling finished goods
Purchasing raw materials
Purchase or sale of equipment, etc.
Acquisition of fixed assets
Buying or selling intangibles
Software development services
IT enabled services
Support services
Technical service fees
Management fees
Reimbursement of expenses paid/received
Royalty fees
Loan paid or received
Corporate Guarantee fees
Nevertheless, some businesses might also take advantage of (or misuse) this technique to manipulate their corporate income and reduce their total tax burden. Transfer pricing enables businesses to transfer tax obligations to low-tax jurisdictions.
Illustration: X corporation has two subsidiaries: A and B. A imports engines from B and makes automobiles. The transfer price is what A pays B for the engine. The parent company and each subsidiary's tax obligations and profitability may be impacted by transfer pricing. decreased prices for B will result in decreased revenue for the corporation; however, A will make more money because their car costs are lower. In other words, there is no financial impact on the parent firm because firm B's revenues are reduced by the same amount as Company A’s cost savings. Assuming that company B operates in a nation with a higher tax rate, X can reduce taxes by increasing A's profitability and decreasing B's. Put otherwise, firm B's choice to spare company A from market pricing results in tax savings for the parent company.
Objective of Transfer Pricing
The following are the primary goals of transfer pricing:
Allowing for the independent performance assessment of every division and producing distinct profits for every division.
Transfer pricing would have an impact on a company's resource allocation in addition to the reported earnings of each centre. A centre’s costs are taken into account when allocating resources.
Multinational corporations (MNCs) are able to allocate income and expenses to their subsidiaries across different nations with some degree of freedom when it comes to management accounting and reporting. Occasionally, a company's subsidiary may be reported as a separate entity or split into different business sectors. Transfer pricing aids in appropriately distributing income and costs to these subsidiaries in these situations. A subsidiary's profitability is contingent upon the pricing at which intercompany transactions take place. Governments are now paying more attention to the transactions between companies. Applying transfer pricing in this case may have an effect on shareholders' wealth because it affects the company's taxable income and free cash flow after taxes.
Transfer Pricing Methodologies
The transfer pricing techniques that could be applied to determine the arm's-length price of the controlled transactions are covered in the Organisation for Economic Co-operation and Development (OECD) standards. The price that is applied, suggested, or charged when unrelated parties engage in comparable transactions under uncontrolled circumstances is referred to as the "arm's-length price" in this context. Here are a few approaches for transfer pricing.
Comparable Uncontrolled Price Method (CUP)
The Comparable Uncontrolled Price Method, or CUP method, contrasts the price paid in a related parties-controlled transaction with the price paid in an independent party comparable uncontrolled transaction under similar conditions. It is the exchange price for nearly equal or identical property made by two independent parties in a situation that is either the same or comparable. When there is a high level of comparability between the markets and the transactions, this strategy is preferred.
Scenario:
P Ltd. (India) purchases 8,000 MT of copper from its subsidiary Q Ltd. (Canada) at the rate of INR 25,000 per MT. Additionally, P Ltd. purchases 3,000 MT of copper from an independent third-party R Ltd. (Canada) at the rate of INR 35,000 per MT.
Q Ltd. offers a quantity discount of INR 400 per MT on the purchase.
Q Ltd. allows a credit period of 1.5 months at 1.5% per month.
The transaction with Q Ltd. is done on FOB (Free on Board) terms, whereas the transaction with R Ltd. is done on CIF (Cost, Insurance, and Freight) terms, with a freight and insurance cost of INR 1,200 per MT.
Purchase Details:
From Q Ltd. (Canada, AE):
Quantity: 8,000 MT
Price: INR 25,000 per MT
Discount: INR 400 per MT
Credit Period: 1.5 months @ 1.5% per month
Terms: FOB
From R Ltd. (Canada, Non-AE):
Quantity: 3,000 MT
Price: INR 35,000 per MT
No Discount
Terms: CIF
Freight and Insurance: INR 1,200 per MT
Adjustments Required for Arm’s Length Price: The terms of the transactions with Q Ltd. and R Ltd. are not comparable due to differences in quantity discount, freight & insurance costs, and credit period. Adjustments are made as follows:
Quantity Discount: If R Ltd. had offered a similar discount as Q Ltd., the price from R Ltd. would have been INR 500 less per MT. This adjustment ensures fair pricing for volume purchases.
Freight & Insurance (FOB vs. CIF): If R Ltd. had sold the goods on FOB terms, the price charged would have been lower by the amount of freight and insurance, i.e., INR 1,200 per MT.
Credit Period Adjustment: If R Ltd. had offered the same credit terms as Q Ltd., the price would have increased by 1.5% per month for 1.5 months, or INR 525 per MT.
Computation of Arm’s Length Price:
Conclusion:
The adjusted Arm's Length Price after considering quantity discount, freight & insurance adjustments, and credit period differences amounts to INR 33,825 per MT for the transaction with R Ltd. This adjustment brings the price closer to fair market value by aligning it with the terms and conditions of the transaction with the associated enterprise Q Ltd.
This method is reliable for applying the arm’s length principle to related party transactions. However, careful consideration must be given to the comparability of controlled and uncontrolled transactions to ensure accuracy.
Resale Price Method
In this technique, the gross margin received by a comparable reseller in an uncontrolled transaction (between independent parties) under similar circumstances is compared to the gross margin obtained by the reseller in a controlled transaction (between related parties). When the reseller/distributor only serves as an intermediary and does not significantly enhance the product, this approach is appropriate. This approach determines the price at which the good or service is resold or rendered to an unaffiliated third party. The amount that remains after deducting other costs and the gross profit margin from the resale value is referred to as the arm length price.
Scenario:P Ltd. (India) deals in mobile phones and purchases mobile phones from a related party Q Ltd. (Associated Enterprise, AE) and a non-related party R Ltd. (Non-AE).
Calculation of Arm’s Length Price (ALP):
To calculate the Arm's Length Price, we compare the gross margin of transactions with the associated enterprise (AE) Q Ltd. and the non-associated enterprise (Non-AE) R Ltd..
Transaction with Q Ltd. (AE):
Purchase price: INR 25,000
Sales price: INR 30,000
Other expenses: INR 600
Gross margin:
Transaction with R Ltd. (Non-AE):
Purchase price: INR 35,000
Sales price: INR 42,000
Other expenses: INR 900
Gross margin:
Cost Plus Method
The Cost Plus Method compares the markup on costs received by a supplier in a connected parties controlled transaction with the markup on costs received by a comparable supplier in an unrelated parties independent parties transaction under similar conditions. This approach is suitable when the provider offers non-complex, highly customised goods or services and doesn't take on a lot of risks.
Transactional Net Margin Method (TRMM)
The Transactional Net Margin Method compares, under similar conditions, the net profit margin obtained by a comparable party in an uncontrolled transaction (between independent parties) and the net profit margin realised in a regulated transaction by a tested party (between related parties). This approach can be useful when a number of transactions need to be combined or when comparability at the transaction level is necessary.
Profit Split Method
The profit split technique divides up the whole profit or loss from a regulated transaction (including related parties) among the participants according to how much each person contributed to the production of value. When there is a high level of player integration, interdependence, shared risk, and ownership of intangible assets, this strategy can be applied.
Documentation for Transfer Pricing
Multinational corporations (MNEs) are required to compile and present transfer pricing documentation to tax authorities to prove that their intercompany transactions adhere to the arm's length principle. The arm's length principle states that related parties' prices for goods, services, or intangible assets ought to be fair and comparable to what independent parties charge. With the use of transfer price documentation, MNEs can lower the risks associated with transfer pricing and comply with tax regulations
Problems Related to Transfer Pricing
The transfer prices are connected to a number of issues. For example, regarding how to transfer price needs to be determined, organisational divisional managers may have different perspectives. It would take more time, money, and labour to implement the transfer prices and create an accounting system that complies with transfer pricing regulations. Arm's length pricing may lead to dysfunctional behaviour in organisational unit managers. Arm's length pricing doesn’t function as well for other divisions or departments, like a service department, because these departments don't provide quantifiable advantages. In a multinational setting, the transfer pricing problem is quite intricate.
Prior to March 2013, only overseas transactions were covered by the transfer price provisions. The Transfer Pricing regulations have been extended to SDTs (Specified Domestic Transactions) as of April 2013, and they will be in effect for the 2013–2014 assessment year. The following transactions fall under the purview of the Specified Domestic Transactions:
Expenses for which a director, a director's family, or an organisation in which a director or the firm has a voting stake greater than 20% has received or will receive remuneration.
Transfers of goods or services covered by Sections 80-IA (8) and (10) (i.e., deductions for profits and gains from businesses developing infrastructure or carrying out industrial projects, power producers and distributors, or telecom service providers).
For projects formed in export-oriented units (EOUs), free trade zones, or special economic zones (SEZs) that involve the transfer of goods and services to another unit under the same management at rates below the market.
If both entities are under the same management structure, SDT also applies to transactions between the entity situated in a tax holiday area and the one situated in a non-tax holiday area.
The aforementioned transactions would only be classified as Specified Domestic Transactions if their combined value surpassed INR 5 crore.
Benefits and Risks of Transfer Pricing
By adopting transfer pricing procedures, organisations can lower the appropriate cost. Businesses will have a smaller tax burden since they must export goods and services to nations with higher tax rates at a lower cost. Businesses that use transfer pricing can increase their profit margins. Businesses must export their products and services to nations with lower tax rates at a premium price. They would be able to take advantage of lower tax rates in these nations. Transfer pricing regulations are designed to prevent these kinds of actions or tampering.
Conversely, there are several risks associated with transfer pricing. These include:
Risk of fines, litigation with income tax authorities, or double taxation.
Possibility of disputes between different businesses and departments within a group.
A control framework is necessary for transfer pricing risk management in order to effectively organise, classify, and manage risks and controls.
Strong tax governance and a proper strategy based on transfer pricing procedures and controls, aligned with internal tax policy, are also essential to manage transfer pricing risks.
Financial controls and tech tools should be used in transfer pricing risk management to automate procedures and track results.
Conclusion
Every taxpayer who has engaged in a designated domestic transaction or an overseas transaction with an affiliated firm is required under the transfer pricing legislation in India to keep accurate records and documentation attesting to the arm's length nature of those transactions. Together with the income tax return, the taxpayer is required to produce a report in Form 3CEB that includes information on the specifics of these transactions as well as the techniques utilised to calculate arm's length prices.
FAQ
Q1. Who regulates transfer pricing in India?
Under the Income Tax Act of 1961 and rules upheld by India's Central Board of Direct Taxes, the Income Tax Authority controls transfer pricing.
Q2. What is an advanced pricing agreement (APA)?
An agreement on the appropriate transfer pricing methodology (TPM) for a group of transactions at issue over a predetermined time period (referred to as "Covered Transactions") is known as an Advance Pricing Agreement (APA) between tax authorities and assessees. A proper transfer pricing mechanism (TPM) for a set number of transactions spaced over a predetermined period of time is the basis for the planned agreement.
Q3. Who is liable for the transfer pricing audit?
It is mandatory for all taxpayers to submit an accountant's report, prepared by an independent professional, using Form No. 3CEB for all international transactions, regardless of their value. Additionally, for specific domestic transactions, if the value exceeds INR 20 crore in a financial year, an accountant's report must be filed.
Q4. Is a transfer pricing audit mandatory?
A transfer pricing audit is mandated for entities by Section 92E of the Indian Income Tax Act. This entails going over and recording the related party transactions and transfer pricing policies.
Q5. What are the penalties for non-compliance with transfer pricing regulations?
Businesses may face penalties and unfavourable outcomes if they violate India's transfer pricing laws. Penalties ranging from 100% to 300% of the underreported income related to the transfer pricing adjustment may be levied by the Income Tax Department. Therefore, to avoid fines and reduce potential hazards, firms must abide by the requirements.
Q6. What is the limit for transfer pricing audits?
Specified domestic transactions are those that fall under the definition of Section 92BA and for which the taxpayer enters into an aggregate value of more than INR 20 crores in a single year. Transfer pricing laws are therefore only relevant to domestic transactions totalling more than INR 20 crores.
Q7. What is the arm’s length principle in transfer pricing?
The arm’s length principle requires that the price charged in a transaction between two related parties should be the same as if the transaction were conducted between unrelated parties under similar conditions. This principle ensures that taxable profits are not manipulated through controlled transactions.
Q8. How is the arm’s length price (ALP) determined in transfer pricing?
The arm’s length price (ALP) can be determined using various methods, such as the Comparable Uncontrolled Price (CUP) method, Resale Price method, Cost Plus method, Transactional Net Margin method (TNMM), and Profit Split method. The appropriate method depends on the nature of the transaction and available data.
Q9. What is the purpose of transfer pricing documentation?
Transfer pricing documentation is prepared to demonstrate that related-party transactions are in compliance with the arm’s length principle. This documentation helps tax authorities verify that the prices of transactions are consistent with market rates and supports the taxpayer’s transfer pricing policy.
Q10. What are the consequences of failing to maintain transfer pricing documentation?
Failure to maintain or submit transfer pricing documentation can lead to penalties, adjustments to taxable income, and disputes with tax authorities. In India, the penalty for not maintaining proper transfer pricing documentation can be up to 2% of the value of the international transaction.
Q11. How does transfer pricing affect multinational companies (MNCs)?
Transfer pricing regulations primarily impact multinational companies (MNCs) as they are involved in cross-border transactions with related entities. Transfer pricing ensures that MNCs do not shift profits to low-tax jurisdictions and that all jurisdictions involved receive their fair share of taxes.
Q12. What is secondary adjustment in transfer pricing?
A secondary adjustment is an additional adjustment made to ensure that the economic benefits of a transfer pricing adjustment are reflected in the accounts of the associated enterprises. In India, a secondary adjustment is required if the primary adjustment exceeds INR 1 crore, and it ensures that the excess money is repatriated to India.
Q13. What is the role of the Comparable Uncontrolled Price (CUP) method in transfer pricing?
The CUP method compares the price charged for a controlled transaction (between related parties) to the price charged for a similar uncontrolled transaction (between unrelated parties) to determine the arm’s length price. This method is often preferred when comparable transactions are available.
Q14. Can transfer pricing rules apply to domestic transactions?
Yes, in India, transfer pricing rules also apply to Specified Domestic Transactions (SDT), which include transactions between related parties within the country. However, the applicability is limited to cases where the value of such transactions exceeds INR 20 crore in a financial year.
Q15. What is the role of the Central Board of Direct Taxes (CBDT) in transfer pricing?
The Central Board of Direct Taxes (CBDT) in India is responsible for overseeing the administration of transfer pricing regulations, including prescribing rules for determining the arm’s length price, conducting audits, and providing guidance on compliance.
Q16. What are the key challenges faced in transfer pricing compliance?
Some key challenges in transfer pricing compliance include the difficulty in finding comparable transactions, changes in tax regulations across different jurisdictions, disputes with tax authorities over pricing methods, and the complexity of maintaining accurate documentation.
Q17. How do transfer pricing regulations prevent profit shifting and base erosion?
Transfer pricing regulations ensure that profits are not shifted to low-tax or no-tax jurisdictions through manipulation of intra-group transactions. By enforcing the arm’s length principle, tax authorities can prevent base erosion and profit shifting (BEPS), ensuring fair tax collection in all jurisdictions where economic activity occurs.
Q18. Can a company enter into an Advance Pricing Agreement (APA) for future transactions?
Yes, a company can enter into an Advance Pricing Agreement (APA) with tax authorities to pre-determine the transfer pricing methodology for specific future transactions. This helps avoid disputes and ensures certainty in the tax treatment of transactions over a fixed period.
Q19. What is the statute of limitations for transfer pricing audits in India?
In India, the statute of limitations for initiating transfer pricing audits is 8 years from the end of the relevant assessment year. This gives the Income Tax Department sufficient time to review related-party transactions and determine whether they comply with the arm’s length principle.
Q20. What is the safe harbor rule in transfer pricing?
The safe harbor rule in transfer pricing provides specific benchmarks that, if met, assure taxpayers that their transfer pricing will be accepted without further scrutiny by the tax authorities. This simplifies compliance for certain transactions and industries, reducing the likelihood of audits.
Related Posts
See AllThe Ministry of Corporate Affairs (MCA) has details about every company that has been established in India. It has a website that...
The taxes imposed on the sale of inherited property differ significantly from those imposed on the sale of property acquired through the...
The Post Office is one of the oldest institutions in India. It was founded in October 1854 during British rule, initially concentrating...
Comments