INTRODUCTION

An essential feature of decentralized firms is responsibility centers (e.g.,cost-, profit-, revenue-,

or investment-centers). The performance of these responsibility centers is evaluated on the basis

of various accounting numbers, such as standard cost, divisional profit, or return on investment

(as well as on the basis of other non-accounting measures, like market share). One function of

the management accounting system therefore is to attach a dollar figure to transactions between

different responsibility centers.

The transfer price is the price that one division of a company charges another division of the

same company for a product transferred between the two divisions. The basic purpose of transfer

pricing is to induce optimal decision making in a decentralized organization (i.e., in most cases,

to maximize the profit of the organization as a whole).

Profit Center: Any sub-unit of an organization that is assigned both revenues and expenses. In

a profit center, a manager is treated as an entrepreneur. Typically, a profit center manager is

given decision-making power and is held responsible for the profits generated by her center.

Transfer pricing refers to the setting, analysis, documentation, and adjustment of charges made

between related parties for goods, services, or use of property (including intangible property).

Transfer prices among components of an enterprise may be used to reflect allocation of resources

among such components, or for other purposes. OECD Transfer Pricing Guidelines[dead link] state,

“Transfer prices are significant for both taxpayers and tax administrations because they

determine in large part the income and expenses, and therefore taxable profits, of associated

enterprises in different tax jurisdictions.”

Many governments have adopted transfer pricing rules that apply in determining or adjusting

income taxes of domestic and multinational taxpayers. The OECD has adopted guidelines

followed, in whole or in part, by many of its member countries in adopting rules. United States

and Canadian rules are similar in many respects to OECD guidelines, with certain points of

material difference. A few countries follow rules that are materially different overall.

1

 HISTORY

Transfer pricing adjustments have been a feature of many tax systems since the 1930s. Both the

U.S. and the Organization for Economic Cooperation and Development (OECD, of which the

U.S. and most major industrial countries are members) had some guidelines by 1979. The United

States led the development of detailed, comprehensive transfer pricing guidelines with a White

Paper in 1988 and proposals in 1990-1992, which ultimately became regulations in 1994.[2] In

1995, the OECD issued the first draft of current guidelines, which it expanded in 1996 and 1996.[3] The two sets of guidelines are broadly similar and contain certain principles followed by many

countries. The OECD guidelines have been formally adopted by many European Union countries

with little or no modification.

The OECD[4] and U.S.[5] systems provide that prices may be set by the component members of an

enterprise in any manner, but may be adjusted to conform to anarm's length standard. Each

system provides for several approved methods of testing prices, and allows the government to

adjust prices to the mid-point of an arm's length range. Both systems provide for standards for

comparing third party transactions or other measures to tested prices, based on comparability and

reliability criteria. Significant exceptions are noted below.

2

OBJECTIVES OF TRANSFER PRICING

Companies with dispersed production facilities, usually in different countries, use transfer

pricing. It involves over- or undercharging for goods sold between branches at a price

determined by the company. The main objective is to take advantage of different tax rates

between countries. Transfer pricing also is used to evaluate performance of divisions within a

company.

Tax Savings

Imagine a company with two branches, where one makes semi-finished goods in a low-tax

country and exports them to a branch in a high-tax country, where they are finished and sold. By

increasing the transfer price and declaring more of its profits in the low-tax country, the company

can reduce its global tax bill.

Boost Profits

By undercharging for goods crossing national borders, a company can save money on customs

duties paid by the branch in the importing country. Conversely, by overcharging, a company can

extract more money from a country with tighter currency outflow restrictions.

Measure Performance

Companies need to know how their individual divisions are performing. A way of measuring that

is through transfer pricing. By setting a price for goods in each stage of the production process, a

company can measure the profitability of each division and decide where to make organizational

adjustments.

Arm's Length Standard

The basic principle of this standard used by most developed countries is that for transactions

between branches a company should use market prices. However, enforcement of this rule is

complicated, especially when a company has branches in numerous countries.

3

Transfer pricing serves the following purposes.

1.      When product is transferred between profit centers or investment centers within a

decentralized firm, transfer prices are necessary to calculate divisional profits, which then affect

divisional performance evaluation.

2.      When divisional managers have the authority to decide whether to buy or sell internally or

on the external market, the transfer price can determine whether managers’ incentives align with

the incentives of the overall company and its owners. The objective is to achieve goal

congruence, in which divisional managers will want to transfer product when doing so

maximizes consolidated corporate profits, and at least one manager will refuse the transfer when

transferring product is not the profit-maximizing strategy for the company.

3.      When 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 and regulatory issues.  

The transfer generates journal entries on the books of both divisions, but usually no money

changes hands. The transfer price becomes an expense for the downstream division and revenue

for the upstream division.

4

CRITERIA FOR EVALUATING TRANSFER PRICING

Many enterprises today have a decentralized structure with some variation of vertical integration

in which the result of one unit (center) becomes the input of another unit . Transfer price is the

financial basis used to quantify the transfer of products and services from one unit to another . It

enables to determine if the participation of each participant (unit) in the internal transfer is

adequate and correct, as well as to measure its efficiency. Transfer pricing has become a very

influential factor of efficient managementand one of the most important elements in

performance measurement of decentralized enterprise and its parts. The internal transfer of

products or services can impact positively or negatively the performance measures used for

organizational units (centers) just the same as the external transfer of products and services. It

should be obvious that a conflict is likely to arise in an enterprise between its center managers

because the "buyer" center wants the transfer price to be as low as possible while the "seller"

center wants the transfer price to be as high as possible. Therefore, when an exchange of

products or services takes place between a center and an external party, the forces of demand and

supply on market determine the price in external transactions. An exchange of products or

services between a center and an internal party, however, poses a potentially more serious and

complex problem than the external exchange.

What transfer price should be set so that buying and selling centers, acting in their own best

interests, will at the same time act in the best interests of the enterprise as a whole? This is a

serious question because sub optimal decision making will result if either

(1) the buying center manager goes to an external supplier to satisfy his needs when he

should have gone to the selling center manager or

(2) the buying center manager goes to the selling center manager to satisfy his needs when he

should have gone to an external supplier. Consequently, upper-level management may insist that

the buying and selling centers, although they are theoretically autonomous units, always take

only those actions that are in the best interests of the enterprise as a whole, which may result in

undesirable behavior of centers and their managers and pseudo decentralization.

5

The solution of the problem of inadequate decision-making on different managerial levels in the

enterprise could be a reliable information basis for transfer prices, as they should be the

significant informational input for managers on all levels and express real performance of each

center. There are several different methods for determining transfer prices The transfer pricing

method used must be the one most beneficial to the enterprise. The following four interrelated

criteria should be used to evaluate adequacy of the transfer pricing methods that are currently

being used by profit or investment centers

1. Goal Congruence

The transfer prices that are set should enable a harmonization of goals of enterprise as a

whole and its parties (centers) as well as to avoid sub optimal decision-making.

2. Motivation

Transfer prices should not interfere with the process wherein the buying center manager

rationally strives to minimize his costs and the selling center manager rationally strives to

maximize his revenues.

3. Autonomy

Each center manager should be free to satisfy his own needs either internally or

externally at the best possible price. This also means a higher autonomy of profit or

investment centers in the enterprise.

4. Performance Evaluation

Transfer prices should enable objective evaluation of profit center results giving the

information for optimal decision-making and real appraisal of managerial performance

and economic value of particular parties of the enterprise.

6

Advantages and Disadvantages of Decentralization

Advantages

• Decisions are better and more timely because of the manager’s proximity to local conditions.

• Top managers are not distracted by routine, local decision problems.

• Managers’ motivation increases because they have more control over results.

• Increased decision making provides better training for managers for higher level positions in the

future.

Disadvantages

• Lack of goal congruence among managers in different parts of the organization.

• Insufficient information available to top management; increased costs of obtaining detailed

information.

• Lack of coordination among managers in different parts of the organization.

7

Transfer Pricing and Corporate Policies

Introduction and operation of an effective system of transfer pricing in an organizations is

entangled with atleast major aspects of corporate policy. They are:

1) Divisional Autonomy

2) Transfer Pricing and

3) Performance Evaluation

The first two aspects are specific ingredients of general areas of corporate control. Most large

organizations may be divisionalized. The divisional managers freedom of action is not complete.

Divisional managers are to make periodic reports to the headquarters. The corporate policy on

this may include;

a) the level of details in this report,

b) the accountability of decisions and actions,

c) the frequency of over-ruling of the divisional managers decisions and so on.

The headquarters closely controls those aspects which affect the operations of other divisions.

This includes quantities of output transferred among the divisions as also the price at which the

transfer price takes place (the transfer price)

Apart from control control considerations the headquarters must also be concerned with policy

regarding evaluation of performance of the divisions. The valuation of performance of the

divisions is necessary for the ‘rewards’ and ‘punishments’ to be decided for the divisional

managers. The rewards and punishments of the divisional managers have to be based on some

observable objective measures such as sales, profits, cost reductions, innovation, improvements

and growth.

The corporate policy determination in the context of divisionalized firms involves two decision

making levels. First the headquarters which sets overall performance and secondly by the which

set the enterprise level policies relating to discretionary controls such as physical outputs, prices

and the like.

8

The divisional managers who control enterprise level variable would like to maximize their

benefits. The benefits depend on the evaluation criteria set by the headquarters. The outcomes

depend on the corporate control policies and environment factors. The environment factors such

as market conditions, competition price, taxation and so on are exogenous for any enterprises.

Most of this environmental variable may be uncertain and will force the divisional manager to

take decisions under uncertainity.

In accordance with the criteria, the transfer pricing method should be chosen in the way to be

the most beneficial for the enterprise as a whole as well as for its organizational parties.

Frequently, the choice of the method is connected with the motivation and autonomy of profit (or

investment) center managers and their maximum coordination. Each of the various transfer

pricing methods currently in use will be discussed only in relation to profit centers for two

reasons: First, transfer prices impact on profit and investment centers in an identical manner;

and second, the analysis will be more efficient and comprehensive by being restricted to a single

type of responsibility center

9

REASONS FOR INSTITUTING A TRANSFER PRICING

SCHEME

Following are the main reasons for instituting a transfer pricing scheme:

• Generate separate profit figures for each division and thereby evaluate the performance of each

division separately.

• Help coordinate production, sales and pricing decisions of the different divisions (via an

appropriate choice of transfer prices). Transfer prices make managers aware of the value that

goods and services have for other segments of the firm.

• Transfer pricing allows the company to generate profit (or cost) figures for each division

separately.

• The transfer price will affect not only the reported profit of each center,but will also affect the

allocation of an organization’s resources.

10

TRANSFER PRICING METHODS

Best Method Rule of Transfer Pricing

The best method rule is intended to avoid the rigidity of the priority of methods that formerly had

been required. The rule guides taxpayers and the IRS as to which method is most appropriate in a

particular case. The temporary regulations no longer provided for an ordering rule to select the

method that provides for an arm’s-length result. Rather, in choosing a method, the arm’s-length

result must be determined under the method which provides “the most accurate measure of an

arm’s-length result.”

The best method rule appears to be somewhat subjective and, because of its technical nature,

may require special expertise. Certainly, the rule does not appear to eliminate the potential for

controversy between the IRS and taxpayers. The rule will likely require taxpayers to expend

more energy developing intercompany transfer prices and reviewing data.

The best method rule had three limitations:

1. Tangible property rules normally do not adequately consider the effect of nonroutine

intangibles in determining which method is the best method. In these cases, adjustments

may be required under the intangible property rules.

2. Tangible property comparable methods may be superseded, especially as they effect

significant nonroutine intangibles that are not defined.

3. A taxpayer can request an “advance pricing agreement” to determine its best method.

11

Multiple Methods of Transfer Pricing

The temporary regulations encouraged the taxpayer to use more than one transfer pricing

method. When two or more methods produce inconsistent results, the best method rule should be

applied to determine which method produces the most accurate measure. Presumably, if the

results are consistent, it may not be necessary to invoke the best method rule.

If the best method rule does not clearly indicate the most accurate method, consistency between

results should be considered as an additional factor. Using this approach, the taxpayer should

ascertain whether any of the methods, or separate applications of a method, yields a result

consistent with any other method.

Comparable Uncontrolled Price Method

The CUP method provides the best evidence of an arm's length price. A CUP may arise where:

the taxpayer or another member of the group sells the particular product, in similar

quantities and under similar terms to arm's length parties in similar markets (an internal

comparable);

an arm's length party sells the particular product, in similar quantities and under similar

terms to another arm's length party in similar markets (an external comparable);

the taxpayer or another member of the group buys the particular product, in similar

quantities and under similar terms from arm's length parties in similar markets (an

internal comparable); or

an arm's length party buys the particular product, in similar quantities and under similar

terms from another arm's length party in similar markets (an external comparable).

Incidental sales of a product by a taxpayer to arm's length parties may not be indicative of an

arm's length price for the same product transferred between non-arm's length parties, unless the

non-arm's length sales are also incidental.

12

Transactions may serve as comparables despite the existence of differences between those

transactions and non-arm's length transactions, if:

the differences can be measured on a reasonable basis; and

appropriate adjustments can be made to eliminate the effects of those differences.

Where differences exist between controlled and uncontrolled transactions, it may be difficult to

determine the adjustments necessary to eliminate the effect on transfer prices. However, the

difficulties that arise in making adjustments should not routinely preclude the potential

application of the CUP method. Therefore, taxpayers should make reasonable efforts to adjust

for differences.

The use of the CUP method precludes an additional allocation of related product development costs or

overhead unless such charges are also made to arm's length parties. This prevents the double deduction

of those costs-once as an element of the transfer price and once as an allocation.

Resale price method of Transfer Pricing

The resale price method begins with the resale price to arm's length parties (of a product

purchased from an non-arm's length enterprise), reduced by a comparable gross margin. This

comparable gross margin is determined by reference to either:

the resale price margin earned by a member of the group in comparable uncontrolled transactions

(internal comparable); or the resale price margin earned by an arm's length enterprise in

comparable uncontrolled transactions (external comparable).

Under this method, the arm's length price of goods acquired by a taxpayer in a non-arm's length

transaction is determined by reducing the price realized on the resale of the goods by the

taxpayer to an arm's length party, by an appropriate gross margin. This gross margin, the resale

margin, should allow the seller to:

13

recover its operating costs; and earn an arm's length profit based on the functions performed,

assets used, and the risks assumed.

Where the transactions are not comparable in all ways and the differences have a material effect

on price, the taxpayer must make adjustments to eliminate the effect of those differences. The

more comparable the functions, risks and assets, the more likely that the resale price method will

produce an appropriate estimate of an arm's length result.

An exclusive right to resell goods will usually be reflected in the resale margin.

The resale price method is most appropriate in a situation where the seller adds relatively little

value to the goods. The greater the value-added to the goods by the functions performed by the

seller, the more difficult it will be to determine an appropriate resale margin. This is especially

true in a situation where the seller contributes to the creation or maintenance of an intangible

property, such as a marketing intangible, in its activities.

Cost plus method of Transfer Pricing

The cost plus method begins with the costs incurred by a supplier of a product or service

provided to an non-arm's length enterprise, and a comparable gross mark-up is then added to

those costs. This comparable gross mark-up is determined in two ways, by reference to:

the cost plus mark-up earned by a member of the group in comparable uncontrolled transactions

(internal comparable); or the cost plus mark-up earned by an arm's length enterprise in

comparable uncontrolled transactions (external comparable).

In either case, the returns used to determine an arm's length mark-up must be those earned by

persons performing similar functions and preferably selling similar goods to arm's length parties.

Where the transactions are not comparable in all ways and the differences have a material effect

on price, taxpayers must make adjustments to eliminate the effect of those differences, such as

differences in: the relative efficiency of the supplier; and any advantage that the activity creates

for the group.

14

The more comparable the functions, risks and assets, the more likely it is that the cost plus

method will produce an appropriate estimate of an arm's length result.

In general, for purposes of applying a cost-based method, costs are divided into three categories:

(1) direct costs such as raw materials;

(2) indirect costs such as repair and maintenance which may be allocated among several products; and

(3) operating expenses such as selling, general, and administrative expenses.

The cost plus method uses margins calculated after direct and indirect costs of production. In

comparison, net margin methods-such as the transactional net margin method (TNMM)

discussed in Section B of this Part-use margins calculated after direct, indirect, and operating

expenses. For purposes of calculating the cost base for the net margin methods, operating

expenses usually exclude interest expense and taxes.

Properly determining cost under the cost plus method is important. Cost is usually calculated in

accordance with accounting principles that are generally accepted for that particular industry in

the country where the goods are produced.

However, it is most important that the cost base of the transaction of the tested party to which a

mark-up is to be applied be calculated in the same manner as-and reflects similar functions, risks,

and assets as-the cost base of the comparable transactions. Where cost is not accurately

determined in the same manner, both the mark-up (which is a percentage of cost) and the transfer

price (which is the total of the cost and the mark-up) will be misstated.

For example, if the comparable party includes a particular item as an operating expense, while

the tested party includes the item in its cost of goods sold, the cost base of the comparable must

be adjusted to include the item.

15

Transactional Profit Methods of Transfer Pricing

Traditional transaction methods are the most reliable means of establishing arm's length prices or

allocations. However, the complexity of modern business situations may make it difficult to

apply these methods. Where the information available on comparable transactions is not detailed

enough to allow for adjustments necessary to achieve comparability in the application of a

traditional transaction method, taxpayers may have to consider transactional profit methods.

However, the transactional profit methods should not be applied simply because of the

difficulties in obtaining or adjusting information on comparable transactions, for purposes of

applying the traditional transaction methods. The same factors that led to the conclusion that it is

not possible to apply a traditional transaction method must be considered when evaluating the

reliability of a transactional profit method.

The OECD Guidelines endorse the use of two transactional profit methods: the profit split

method; and transactional net margin method (TNMM).

The key difference between the profit split method and the TNMM is that the profit split method

is applied to all members involved in the controlled transaction, whereas the TNMM is applied to

only one member.

The more uncertainty associated with the comparability analysis, the more likely it is that a one-

sided analysis, such as the TNMM, will produce an inappropriate result. As with the cost plus

and resale price methods, the TNMM is less likely to produce reliable results where the tested

party contributes to valuable or unique intangible assets. Where uncertainty exists with

comparability, it may be appropriate to use a profit split method to confirm the results obtained.

16

Profit split method of Transfer Pricing

Under the profit split method:

The first step is to determine the total profit earned by the parties from a controlled

transaction. The profit split method allocates the total integrated profits related to a controlled

transaction, not the total profits of the group as a whole. The profit to be split is generally the

operating profit, before the deduction of interest and taxes. In some cases, it may be appropriate

to split the gross profit.

The second step is to split the profit between the parties based on the relative value of their

contributions to the non-arm's length transactions, considering the functions performed, the

assets used, and the risks assumed by each non-arm's length party, in relation to what arm's

length parties would have received.

The profit split method may be applied where:

the operations of two or more non-arm's length parties are highly integrated, making it difficult

to evaluate their transactions on an individual basis; and the existence of valuable and unique

intangibles makes it impossible to establish the proper level of comparability with uncontrolled

transactions to apply a one-sided method.

Due to the complexity of multinational operations, one member of the multinational group is

seldom entitled to the total return attributable to the valuable or unique assets, such as

intangibles.

Also, arm's length parties would not usually incur additional costs and risks to obtain the rights

to use intangible properties unless they expected to share in the potential profits. When

intangibles are present and no quality comparable data are available to apply the one-sided

methods (i.e., cost plus method, resale price method, the TNMM), taxpayers should consider the

use of a profit split method.

The second step of the profit split method can be applied in numerous ways, including: splitting

profits based on a residual analysis; and relying entirely on a contribution analysis.

17

Following the determination of the total profit to be split in the first step of the profit split, a

residual profit split is performed in two stages. The stages can be applied in numerous ways, for

example:

Stage 1: The allocation of a return to each party for the readily identifiable functions (e.g.,

manufacturing or distribution) is based on routine returns established from comparable data. The

returns to these functions will, generally, not account for the return attributable to valuable or

unique intangible property used or developed by the parties. The calculation of these routine

returns is usually calculated by applying the traditional transaction methods, although it may also

involve the application of the TNMM.

Stage 2: The return attributable to the intangible property is established by allocating the residual

profit (or loss) between the parties based on the relative contributions of the parties, giving

consideration to any information available that indicates how arm's length parties would divide

the profit or loss in similar circumstances.

Transactional net margin method (TNMM) of Transfer Pricing

The TNMM: compares the net profit margin of a taxpayer arising from a non-arm's length

transaction with the net profit margins realized by arm's length parties from similar transactions;

and examines the net profit margin relative to an appropriate base such as costs, sales or assets.

This differs from the cost plus and resale price methods that compare gross profit margins.

However, the TNMM requires a level of comparability similar to that required for the application

of the cost plus and resale price methods. Where the relevant information exists at the gross

margin level, taxpayers should apply the cost plus or resale price method.Because the TNMM is

a one-sided method, it is usually applied to the least complex party that does not contribute to

valuable or unique intangible assets. Since TNMM measures the relationship between net profit

and an appropriate base such as sales, costs, or assets employed, it is important to choose the

appropriate base taking into account the nature of the business activity.The appropriate base that

profits should be measured against will depend on the facts and circumstances of each case.

18

A transfer pricing policy defines rules for calculating the transfer price.In addition, a transfer

price policy has to specify sourcing rules (i.e.,either mandate internal transactions or allow

divisions discretion in choosing whether to buy/sell externally). The most common transfer

pricing methods are described below.

Market-based Transfer Pricing

When the outside market for the good is well-defined, competitive, and stable, firms often use

the market price as an upper bound for the transfer price. Concerns with market-based Transfer

Pricing When the outside market is neither competitive nor stable, internal decision making may

be distorted by reliance on market-based transfer prices if competitors are selling at distress

prices or are engaged in any of a variety of “special” pricing strategies (e.g., price discrimination,

product tie-ins, or entry deterrence). Also, reliance on market prices makes it difficult to protect

“infant” segments.

Negotiated Transfer Pricing

Here, the firm does not specify rules for the determination of transfer prices. Divisional

managers are encouraged to negotiate a mutually agreeable transfer price. Negotiated transfer

pricing is typically combined with free sourcing. In some companies, though, headquarters

reserves the right to mediate the negotiation process and impose an “arbitrated” solution. In the

absence of an established market price many companies base the transfer price on the production

cost of the supplying division. The most common methods are:

• Full Cost

• Cost-plus

• Variable Cost plus Lump Sum charge

• Variable Cost plus Opportunity cost

• Dual Transfer Prices

19

Each of these methods is outlined below.

Full Cost

A popular transfer price because of its clarity and convenience and because it is often viewed as

a satisfactory approximation of outside market prices.

(i) Full actual costs can include inefficiencies; thus its usage for transfer pricing often fails to

provide an incentive to control such inefficiencies.

(ii) Use of full standard costs may minimize the inefficiencies mentioned above.

Cost-plus

When transfers are made at full cost, the buying division takes all the gains from trade while the

supplying division receives none. To overcome this problem the supplying division is frequently

allowed to add a mark-up in order to make a “reasonable” profit. The transfer price may then be

viewed as an approximate market price.

Variable Cost plus a Lump Sum Charge

In order to motivate the buying division to make appropriate purchasing decisions, the transfer

price could be set equal to (standard) variable cost plus a lump-sum periodical charge covering

the supplying division’s related fixed costs.

Variable Cost plus Opportunity Cost

Also know as the Minimum Transfer Price:

Minimum Transfer Price = Incremental Cost + Opportunity Cost.

20

For internal decision making purposes, a transfer price should be at least as large as

the sum of:

• cash outflows that are directly associated with the production of the transferred goods; and,

• the contribution margin foregone by the firm as a whole if the goods are transferred internally.

Sub-optimal decisions can result from the natural inclination of the manager of an autonomous

buying division to view a mix of variable and fixed costs of a selling division plus, possibly, a

mark-up as variable costs of his buying division. Dual transfer pricing can address this problem,

although it introduces the complexity of using different prices for different managers.

Dual Transfer Prices

To avoid some of the problems associated with the above schemes, some companies adopt a dual

transfer pricing system.

For example:

• Charge the buyer for the variable cost. The objective is to motivate the manager of the buying

division to make optimal (short-term) decisions.

• Credit the seller at a price that allows for a normal profit margin. This facilitates a “fair”

evaluation of the selling division’s performance.

21

TRANSFER PRICING PRACTICES

There is a large amount of documented sources on the transfer pricing policies used by the

companies all over the world. These studies have documented various aspects of transfer pricing

policies such as

a) its role as an overall component of reporting and control system in companies

b) the effect of transfer pricing on intra-corporate conflicts.

c) variations in transfer pricing policies across the world, and

d) environment constraints on use of transfer prices.

A brief summary of transfer pricing practices is as following:-

1) Companies tend to look at transfer pricing not just the mere accounting exercise, but also as an

important tool in policy formulation towards achievement of corporate objectives.

2) Transfer pricing acts as a major source of political conflict within the organization and this

takes place irrespective of the method used for this purpose. Different methods may, however

increase or decrease the possibility of conflict.

3) Companies tend to use a variety of transfer pricing methods. However the dominant among

them are the market prices or the methods based on modifications of the market prices.

4) Even though many companies use transfer prices as a policy variable, it is not the major or

principal policy variable.

5) International companies use conscious manipulation of transfer prices as an instrument of

maximizing achievement of corporate goals. An explicit example is the transfer of profits from

subsidiaries to parent companies or other companies in the group through transfer pricing

policies relation to supply of capital equipment or inputs by multinational companies.

22

THE TRANSFER PRICING PROCESS

Transfer Pricing Associates has developed the “Transfer Pricing Process”, a methodology that

allows you to manage your transfer pricing system yourself in a more focused and cost efficient

way. The Transfer Pricing Process also allows you to make an assessment of your transfer

pricing risks.

Although a large number of multinationals have devoted considerable time and efforts to transfer

pricing documentation and dispute resolution strategies, few have made an explicit connection

between their business and operational model and the transfer pricing system they apply. Making

such a connection allows a multinational – based on sound economic arguments – to align its

transfer pricing system with its (new) business model and at the same time develop the

arguments needed to justify and defend the transfer pricing policy towards internal and external

stakeholders, e.g. subsidiary companies, internal and external auditors, potential investors, and

the tax authorities in all the countries where they operate their business.

The Transfer Pricing Process enables you to make a complete transfer pricing risk assessment. It

will assess your current and/or future transfer pricing system against ‘best practices’ of

designing, documenting and defending a transfer pricing system in multiple countries.

The Transfer Pricing Process is all about treating transfer pricing and corresponding business

risks as a business process.The input in this process is the way you run your business and the

output is a manageable and defensible transfer pricing system. The system allows you to link

how you operate your business to a transfer pricing system that works from an operational

perspective and that is in compliance with the local tax rules.

The steps in this process are:

23

• Identify business context:

Identify where your company makes money in your industry. For example, is it through the

production activity itself or the brand you have developed?

• Design and implementation:

Design an appropriate transfer pricing system and allocate an appropriate operating margin to

the contributors in your value chain.

• Documentation:

Capture the information (Step 1) and system you have designed (Step 2) on paper. Apart from

the obvious purpose of meeting documentation requirements in a certain tax jurisdiction and

helping yousupport your transfer pricing policy, capturing this information also allows you to

have a point of reference when there are changes in your business that may create a need to

review and perhaps change the transfer pricing system.

• Transfer pricing controversy/dispute resolution:

Defending your transfer pricing system to all stakeholders, e.g. management, external auditors

and the tax authorities. Avoiding disputes through the use of Advanced Pricing Arrangements

(APAs) might be a good alternative to dispute resolution when a taxpayer is already under a tax

audit.

LAW OF TRANSFER PRICING IN INDIA

24

1. INTRODUCTION

Increasing participation of multi-national groups in economic activities in India has given rise

to new and complex issues emerging from transactions entered into between two or more

enterprises belonging to the same group. Hence, their was a need to introduce a uniform and

internationally accepted mechanism of determining reasonable, fair and equitable profits and

tax in India in the case of such multinational enterprises. Accordingly, the Finance Act, 2001

introduced law of transfer pricing in India through sections 92A to 92F of the Indian Incometax

Act, 1961 which guides computation of the transfer price and suggests detailed

documentation procedures. This article aims to provide a brief overview on the applicability of

transfer pricing regulations in India, methods of determining the transfer price and the

documentation procedures.

2. SCOPE & APPLICABILITY

Transfer Pricing Regulations ("TPR") are applicable to the all enterprises that enter into an

'International Transaction' with an 'Associated Enterprise'. Therefore, generally it applies to all

cross border transactions entered into between associated enterprises. It even applies to

transactions involving a mere book entry having no apparent financial impact. The aim is to

arrive at the comparable price as available to any unrelated party in open market conditions

and is known as the Arm's Length Price ('ALP').

2.1. Associated Enterprises ('AEs')- How Identified?

25

The basic criterion to determine an AE is the participation in management, control or capital

(ownership) of one enterprise by another enterprise. The participation may be direct or

indirect or through one or more intermediaries.

The concept of control adopted in the legislation extends not only to control through holding

shares or voting power or the power to appoint the management of an enterprise, but also

through debt, blood relationships, and control over various components of the business

activity performed by the taxpayer such as control over raw materials, sales and intangibles.

It appears that one may go to any layer of management, control or ownership in order to find

out association

(a) Direct Control

(b) Through Intermediary

2.2. What is an International Transaction?

An international transaction is essentially a cross border transaction between AEs in any sort

of property, whether tangible or intangible, or in the provision of services, lending of money

etc. At least one of the parties to the transaction must be a non-resident entering into one or

more of the following transactions

(a) Purchase, sale or lease of Tangible or Intangible Property

(b) Provision of services

(c) Lending or borrowing of money

(d) Any transaction having a bearing on profits, income, losses or assets

(e) Mutual agreement between AEs for allocation/apportionment of any cost, contribution or

expense.

26

3. METHODS OF DETERMINING THE ALP

In accordance with internationally accepted principles, the TPR have provided that any

income arising from an international transaction between AEs shall be computed having

regard to the ALP, which is the price that would be charged in the transaction if it had been

entered into by unrelated parties in similar conditions.

The ALP is to be determined by any one or more of the prescribed methods. The taxpayer

can select the most appropriate method to be applied to any given transaction, but such

selection has to be made taking into account the factors prescribed in the TPR. With a view to

allow a degree of flexibility in adopting the ALP, a variance allowance of 5 percent has been

provided under the TPR. The prescribed methods have been listed below

(a) Comparable Uncontrolled Price Method ('CUPM')

(b) Resale Price Method ("RPM')

(c) Cost plus method ('CPM')

(d) Profit Split Method ('PSM')

(e) Transactional Net Margin Method ('TNMM')

4. DOCUMENTATION

27

The provisions contained in the TPR are exhaustive as far as the maintenance of

documentation is concerned. This includes background information on the commercial

environment in which the transaction has been entered into, information regarding the

international transaction entered into, the analysis carried out to select the most appropriate

method and to identify comparable transactions, and the actual working out of the ALP of the

transaction. This also includes report of an accountant certifying that the ALP has been

determined in accordance with the TPR and that prescribed documentation has been

maintained. This documentation should be retained for a minimum period of 8 years.

However, it may be noted that in case the value of the international transaction is below INR

10 million, it would be sufficient for the taxpayer to maintain documentation and information

which substantiates his claim for the ALP adopted by him. In effect, they need not maintain

the prescribed documentation.

5. BURDEN OF PROOF - TAXPAYER OR TAX OFFICER?

The primary onus is on the taxpayer to determine an ALP in accordance with the TPR and to

substantiate the same with the prescribed documentation. Where such onus is discharged by

the taxpayer and the data used for determining the ALP is reliable and correct there can be

no intervention by the tax officer.

In other cases, where the tax officer is of the view that the

(a) price charged in the international transaction has not been determined in accordance with

the methods prescribed,

(b) or information and documents relating to the international transaction have not been kept

and maintained by the assessee in accordance with the TPR,

(c) or the information or data used in computation of the ALP is not reliable or correct,

28

(d) or the assessee has failed to furnish any information or document which he was required to furnish under the TPRthe tax officer may reject the ALP adopted by the assessee and determine the ALP in accordance with the TPR. For this purpose, he would then refer the matter to a Transfer Pricing Officer ('TPO') (a special post created for valuation of ALP) who would determine the ALP after hearing the arguments of the taxpayer.

6. EFFECTS OF ADJUSTMENT TO THE ALP

In case the ALP determined by the TPO indicates understatement of income by the taxpayer,

it could result into the following

(a) Adjustment to reported income of the taxpayer

(b) Levy of penalty

6.1. Adjustment to the Reported Income

The tax officer is bound to adjust the reported income of the taxpayer with the amount of

adjustment proposed by the TPO. This would have an effect of increasing the assessed

income or alternatively decreasing the assessed loss. Furthermore, the eligible deductions

available to the taxpayer under section 80 could not be availed on the enhanced income.

However, those taxpayers who are eligible for deductions under section 10A and 10B remain

unaffected as these deductions remain available on the enhanced income.

6.2. Penalties

29

Penalties have been provided as a disincentive for non-compliance with procedural

requirements are as follows.

(a) Penalty for Concealment of Income - 100 to 300 percent on tax evaded

(b) Failure to Maintain/Furnish Prescribed Documentation - 2 percent of the value of the

international transaction

c) Penalty for non-furnishing of accountants report - INR 100,000 (fixed)

(The above penalties can be avoided if the taxpayer proves that there was reasonable cause for such failures.)

30

CONCLUSION

Transfer pricing is inherent in the way the global economy is structured with sourcing

and consuming destinations being different, with numerous organizations operating in

multiple countries and most importantly due to varying tax and other laws in different

nations.

Also nations have to achieve a fine balance between loss of revenues in the form of

outflow of tax and making their country an attractive investment destination by giving

flexibility in Transfer Pricing. One can choose to go to extremes like Singapore would be

doing especially when it is the low tax country. Given that countries are not integrated

into a global system, each of them want increase in total inflow through tax or FDI and

something like VAT is not expected to remove this non-competitive method of attracting

investment, countries will need to enact legislations on their own. Thus, achieving the

mentioned balance, suiting their conditions and pattern of international transactions,

according to the stage of economic development they are in, are some of the challenges

companies are facing as they become a global economic community.

31