Transfer pricing is the process of selling goods and services between associated companies, irrespective of their association. This could be between sub-divisions of a company, between subsidiaries of a company or between companies that have common top management. This method often has tax benefits.
Why Transfer Pricing?
- Revenue: Maintaining the same pricing will not affect the financial performance of the company.
- Preferred customers: If prices are reduced for associated companies, then the manager of the selling company will choose to sell the products to outside customers; rather than taking up low price orders from subsidiaries.
- Preferred suppliers: Now, if the prices are increased by the selling company, a buying associate of the company will look forward to procuring goods from outside suppliers who offer them at a lower price.
All this adversely affects the profits of the parent company.
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What is Transfer Pricing? Importance of Transfer Pricing
Types of transfer pricing:
There are 5 methods of transfer pricing. Three of them are listed under traditional transaction methods and two of them under the transactional profit method. Let's take a detailed look at this:
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Traditional transaction methods:
- Comparable uncontrolled price (cup) method: Transaction between two associated companies is called controlled transactions. In CUP method, the terms and conditions including price of a controlled transaction are compared with a third party transaction. This can be between two independent third parties (external CUP) or between the taxpaying company and an independent company (internal CUP).
- The resale price method: The price at which an associated enterprise sells a product to a third party is called resale price. In this method, resale price is considered as the base for a controlled transaction. Then a resale price margin is calculated based on uncontrolled transactions. This margin is then subtracted from the resale price. Further, additional expenses like custom duties are subtracted. The remaining amount would be the transfer price for this particular controlled transaction.
- Cost plus method: In this method, the costs of sales are compared to gross profits. Here the first step is to decide on the cost of sales in a controlled transaction. Then a mark up is added to cover up the costs and add profits. The final result will serve as the transfer price.
- Transfer pricing methods:
- Transactional net margin method: In this method, the net profit of a controlled transaction is compared to that of an uncontrolled transaction. Based on this comparison, prices will be decided.
- The profit split method: Sometimes, transactions within an enterprise can be interrelated. In this case, they decide to split the profits. Profits are split by comparing how it would have been split; if an independent enterprise was involved in these interrelated transactions.
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Advance pricing agreement (APA)
As mentioned above, there are different types of methodologies to decide transfer pricing. Advance pricing agreement is an agreement between a taxpayer and the tax authority as to which method will be used to decide the Transfer Pricing for future transactions. APAs can be of the following types:
- Independent APA: It is an agreement between the taxpayer and the tax authority located in the taxpayer's country.
- Bilateral / Two-sided APA: it is an agreement that involves taxpayer, taxpayer's associated group in the foreign country and tax authorities of both the countries.
- Multilateral APA: it is an agreement between the taxpayer, taxpayer's associate's groups in multiple countries, tax authorities of all the countries being involved.
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Transfer pricing in India
In India, the concept of transfer pricing was introduced in 2001, for the purpose of availing tax benefits. According to the income-tax Act of 1961, income arising out of any controlled transaction (associated enterprises); must be treated as an uncontrolled transaction. That is, although the enterprises are associated, tax laws will be applied as in the case of unrelated associations. This is applicable on international and domestic transactions.
The concept of transfer pricing is important to MNCs. Earlier; MNCs used to maintain two different pricing. One for international trade and another for taxation. But, with the income tax acts that promote transfer pricing, tax benefits are availed.
Objectives of transfer pricing:
- Tax burden on monetary transactions can be reduced.
- Maintain and manage a balance between countries with different tax policies.
- Optimizing the profit of the business as a whole.
- Effective foreign investment decisions can be made.
- Policies can be developed to manage penalties.
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Problems associated with transfer pricing:
- In a multinational set up, transfer pricing can be complicated. It requires proper computation and planning.
- There could be a disagreement among managers to decide on the transfer price.
- To design an accounting system that matches the transfer price policies and rules, additional manpower, time and cost is required.
- Transfer pricing in the service industry will be difficult to decide upon.
Transfer pricing under the Section 92 of the income tax act
- Under this section of the income tax act, income arising out of any international transactions will be considered at arm's length price. Arm's length price in simple words, means price applied to transactions between unrelated companies. This section is aimed at ensuring the price between associated international transactions would be similar to those transactions in uncontrolled situations.
Transfer pricing with an example:
Let's assume the following example to further understand the concept of transfer pricing.
A multinational company X in Germany has a subdivision Y in India. Company X sells goods worth Rs 2,000 to company Y for Rs 3,000. Company Y sells this in the Indian market for Rs 5,000. Considering market prices, if company X had sold these products to an unrelated company, it would have gained a profit of Rs 2,000.
But, in this case, profit is limited to just Rs 1,000. Here, the prices are deliberately decided by the two companies. As a result the profit of Rs 2,000 is shifted from Germany to India, which leaves space for questioning.
It is in this scenario that transfer pricing was introduced and implemented. Each country must have their fair chances of gaining revenue and profit in international trade. Transfer pricing ensures this.
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