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                    TRANSFER PRICING

Amit Daga






Table Of Content




Introduction. 1

Definations. 6

Methods Of Computation Of Arm’s Length Price……….........5

Exceptions. 6

















Transfer pricing


        “Transfer pricing can deprive governments of their fair share of taxes from global corporations and expose multinationals to possible double taxation. No country – poor, emerging or wealthy – wants its tax base to suffer because of transfer pricing. The arm’s length principle can help.”


John Neighbour

OECD Centre for Tax Policy and Administration


         "Transfer pricing" is an increasingly important and contentious area of the tax law in the U.S. and around the world. It deals with the pricing for "intercompany" transactions, that is, transactions between commonly controlled parties such as a parent corporation and its subsidiaries, or "brother-sister" corporations. The U.S. and all its major trading partners have tax laws designed to prevent multinational groups from reducing taxes inappropriately by entering into transactions among related parties on terms that would not occur in a comparable "arm's length" situation.

         Transfer pricing typically involves international transactional flows among the members of a multinational corporate group, such as licensing of intellectual property, sales of components for use in manufacturing products, and intercompany financings and loans. Non-U.S. tax administrators have followed the lead of the U.S. Internal Revenue Service in requiring extensive contemporaneous documentation of the tax justification for such related party transactions and aggressively auditing those transactions to ensure arm's length pricing. Multinational taxpayers are often caught between jurisdictions making inconsistent tax claims as to the same cross-border transactions, which can result in "international double taxation." As tax administrators become more aggressive in seeking revenues, transfer pricing examinations and litigation have increased in number and scope, and taxpayers have become increasingly vulnerable to double (or even triple) taxation.

         The large-scale tax avoidance practices used by transnational corporations (TNCs) came into public notice recently when the giant drug TNC, GlaxoSmithKline, agreed to pay the US government $3.4 billion to settle a long-running dispute over its tax dealings between the UK parent company and its American subsidiary. This was the largest settlement of a tax dispute in the US. The investigations carried out by Internal Revenue Service found that the American subsidiary of GlaxoSmithKline overpaid its UK parent company for drug supplies during 1989-2005 periods, mainly its blockbuster drug, Zantac. These overpayments were meant to reduce the company's profit in the US and thereby its tax bill. The IRS charged the Europe’s largest drugs company for engaging in manipulative “transfer pricing.”



         Transfer pricing, one of the most controversial and complex issues, requires closer scrutiny not only by the critics of TNCs but also by the tax authorities in the poor and the developing world. Transfer pricing is a strategy frequently used by TNCs to book huge profits through illegal means. The transfer price could be purely arbitrary or fictitious, therefore different from the price that unrelated firms would have had to pay. By manipulating a few entries in the account books, TNCs are able to reap obscene profits with no actual change in the physical capital. For instance, a Korean firm manufactures a MP3 player for $100, but its US subsidiary buys it for $199, and then sells it for $200. By doing this, the firm’s bottom line does not change but the taxable profit in the US is drastically reduced. At a 30 per cent tax rate, the firm’s tax liability in the US would be just 30 cents instead of $30.

         A multinational company in country A produces shoes for $50. They sell the shoes to another part of the corporation in country B for $150, which is the transfer price. They are then retailed for $350 in country B. Gross profit to the corporation is $300 ($350 – $50): $100 of the profit ($150 – $50) is earned in country A, and $200 ($350 – $150) is earned in country B. Assuming tax rates are 20% in country A, and 50% in country B, the taxes paid by the corporation are $20 ($100 * 20%) in country A and $100 ($200 * 50%) in country B for a total tax liability of $120. The profit after-tax is $180 ($300 - $120).

         If the multinational corporation changes the transfer price from country A to country B from $150 to $300, the gross profit remains the same at $300. But, profit in country A is now $250 ($300 – $50) and in country B $50 ($350 – $300). Taxes paid in country A are $50 ($250 * 20%), and in country B are $25 ($50 * 50%) for a total tax liability of $75. The after-tax profit has now increased to $225 ($300 – $75), although production costs have not changed.

         Transfer pricing refers to the pricing of contributions (assets, tangible and intangible, services, and funds) transferred within an organization. For example, goods from the production division may be sold to the marketing division, or goods from a parent company may be sold to a foreign subsidiary. Since the prices are set within an organization (i.e. controlled), the typical market mechanisms that establish prices for such transactions between third parties may not apply. The choice of the transfer price will affect the allocation of the total profit among the parts of the company. This is a major concern for fiscal authorities who worry that multi-national entities may set transfer prices on cross-border transactions to reduce taxable profits in their jurisdiction. This has led to the rise of transfer pricing regulations and enforcement, making transfer pricing a major tax compliance issue for multi-national companies










               Transfer Pricing:



  • Transfer pricing provisions primarily require any income arising from an international transaction between two or more Associated Enterprises (‘AE’) to be at arm’s length price and comparable to similar transactions between unrelated enterprises.



Associated Enterprises:


  • The enterprises will be taken to be associated enterprises if one enterprise is controlled by the other, or both enterprises are controlled by a common third person. 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.


International Transaction:


  • An international transaction is essentially a cross border transaction between associated enterprises 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. The definition also covers a transaction between two non-residents where for example, one of them has a permanent establishment whose income is taxable in India.


Arm’s length price:

·       The price at which two unrelated and non-desperate parties would agree to a transaction. This is most often an issue in the case of companies with international operations whose international subsidiaries trade with each other. For such companies, there is often an incentive to reduce overall tax burden by manipulation of inter-company prices. Tax authorities want to insure that the inter-company price is equivalent to an arm's length price, to prevent the loss of tax revenue


          Application of the Arm's Length Principle


         Although there are discrepancies in the specifics of each country's laws concerning the application of the arm's length principle, the fact that they are primarily based in the OECD (Organization for Economic Co-operation and Development) Guidelines means that, although such a strategy carries a greater taxation risk than solutions tailored to each country, global transfer pricing policies can be effectively used to determine an appropriate range representing the arm's length price for transactions carried out across a global enterprise.

         However, different countries may accept different methods of calculating the transfer price (i.e. Japan requires that the three "traditional" methods, outlined below, be systematically discounted before allowing the use of alternative methods, while the United States accepts the most appropriate method regardless), so care must be taken in such circumstances. In addition, some countries may have immature transfer pricing regimes or apply the arm's length principle in different ways—Brazil, for example, does not apply the arm's length principle despite the existence of transfer pricing legislation.


Methods Of Computation Of Arm’s Length Price


         The arm’s length price shall be determined by any of the following methods, being the most appropriate method, having regard to the nature of transaction or class of transaction, namely :- 

(1)   Comparable Uncontrolled Price Method

(2)   Resale Price Method

(3)   Cost plus Method

(4)   Profit Split Method

(5)   Transactional Net Margin Method

(6) Such other method as may be prescribed by the Board.



1.      Comparable Uncontrolled Price method


         This compares the transfer price to a comparable transaction between unrelated parties. The key is comparability. The two transactions being compared might not be the same in all respects. Adjustments must be made for any differences between the transactions. If the differences are not material, or if the effect of any material differences can be quantified, then this method often results in the best estimation of an arm’s-length price.



           The regulations list eight factors that often cause differences between transactions.


(1) Quality of the product;

(2) Contractual terms, (e.g., scope and terms of warranties provided, sales or purchase volume, credit terms, transport terms);

(3) Level of the market (i.e., wholesale, retail, etc.);

(4) Geographic market in which the transaction takes place;

(5) Date of the transaction;

(6) Intangible property associated with the sale;

(7) Foreign currency risks; and

(8) Alternatives realistically available to the buyer and seller

         Company A is the U.S. distribution subsidiary of Company B, a foreign manufacturer of consumer electrical appliances. Company A purchases toaster ovens from Company B for resale in the U.S. market. To exploit other outlets for its toaster ovens, Company B also sells its toaster ovens to Company C, an unrelated U.S. distributor of toaster ovens. The products sold to Company A and Company C are identical in every respect and there are no material differences between the transactions. If there is any material differences arise its mean it’s attracting transfer pricing.


2. Cost Plus method


         The Cost plus (CP) method, generally used for the trade of finished goods, is determined by adding an appropriate markup to the costs incurred by the selling party in manufacturing/purchasing the goods or services provided, with the appropriate markup being based on the profits of other companies comparable to the tested party.


         Example. Amcan, a U.S. company, produces unique vessels for storing and transporting toxic waste, toxicans, at its U.S. production facility. Amcan agrees by contract to supply its Canadian subsidiary, Cancan, with 4000 toxicans per year to serve the Canadian market for toxicans. Prior to entering into the contract with Cancan, Amcan had received a bona fide offer from an independent Canadian waste disposal company, Cando, to serve as the Canadian distributor for toxicans and to purchase a similar number of toxicans at a price of $5,000 each. If the circumstances and terms of the Cancan supply contract are sufficiently similar to those of the Cando offer, or sufficiently reliable adjustments can be made for differences between them, then the Cando offer price of $5,000 may provide reliable information indicating that an arm's length consideration under the Cancan contract will not be less than $5,000 per toxican.


3. Resale Price method


         This uses the gross profit margin on the transaction to determine if the transfer price is an accurate estimation of an arm’s-length price. The method compares the gross profit earned on the transfer with the gross profit that would be earned on a comparable transaction between unrelated parties. This method is most useful for companies that buy and resell identical tangible products. Changes in packaging or labeling do not constitute changes to the product. This method should not be used by taxpayers who use intangibles to add value to a product

         A controlled taxpayer sells property to another member of its controlled group that resells the property in uncontrolled sales. There are no changes in the beginning and ending inventory for the year under review. Information regarding an uncontrolled comparable is sufficiently complete to conclude that it is likely that all material differences between the controlled and uncontrolled transactions have been identified and adjusted for. If the applicable resale price of the property involved in the controlled sale is $100 and the appropriate gross profit margin is 20%, then an arm's length result of the controlled sale is a price of $80 ($100 minus (20% x $100)).


     4. Profit split method

         This method assesses the relative value contributed by each member of a controlled group to the combined profit or loss resulting from controlled transactions. A taxpayer must use the most “narrowly identifiable business activity” that includes the controlled transactions. In assessing the control member’s contribution to the success of the activity, a taxpayer should consider several factors—including functions performed, risks assumed, and resources employed by the individual members of the controlled group—compared with the combined totals for the activity. This method can be applied via the comparable profit split and the residual profit split.

         The residual profit approach can be explained by the following example, based on an example in the regulations. A U.S. manufacturer (USCo) obtained a patent on a new invention that was produced and sold within the United States. The manufacturer also licensed its European subsidiary (EUCo) to use the patent to produce products in Europe. USCo incurred no additional expenses as a result of EUCo’s use of the patent. EUCo had sales of $500 and expenses (other than patent royalties) of $300, resulting in a profit of $200, before considering its royalty expense. It used operating assets costing $200. Assuming that a 10% return on investment is appropriate, EUCo’s normal profit should be $20 (10% of $200). This would result in a residual profit of $180 ($200 profit minus $20). USCo performed the research and development resulting in the patent. Its patent amortization as a percent of worldwide sales of products using the patent was 20%. EUCo also did research and development to get a patent to produce additional products. Its patent amortization rate was 40% of sales, and the total for the two companies was 60% of sales. EUCo’s rate was two-thirds of the total, and USCo’s rate was one-third of the total. The amount of royalty income that USCo should receive from EUCo should be $60 (one-third of the $180 residual profit).

      5. Transactional net margin method


         The Transactional net margin method

  • 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





 Exceptions to arm’s length transfer price


         In exceptional cases, the company may decide to use a non-arm’s length transfer price provided:

·        The Board of Directors as well as the audit committee of the Board are satisfied for reasons to be recorded in writing that it is in the interest of the company to do so, and

·        The use of a non-arms length transfer price, the reasons therefore, and the profit impact thereof are disclosed in the annual report




  Advance Pricing Agreement/Arrangement


      An Advance Pricing Agreement/Arrangement (the specific terminology varies by country), or APA, is an agreement between the taxpayer and the competent taxation authorities that a future transaction will be conducted at the agreed-upon price, which is recognized as the arm's length price for the period designated. Although retroactive APAs can be used to reduce tax exposure in past years, APAs are primarily used to avoid the risk of future income assessment adjustments which, as in the case of GlaxoSmithKline, could lead to hefty payments in the future.

         There are two types of APAs: unilateral and bilateral/multilateral APAs. A unilateral APA is, as its name suggests, an agreement between a corporation and the authority of the country where it is subject to taxation. Although simpler to implement than a bilateral/multilateral APA, a unilateral APA will not be recognized by a foreign tax authority, meaning that a U.S. company securing a unilateral APA for trade with its British subsidiary would still run the risk of being assessed should the foreign tax authorities not agree with the method of calculating the arm's length price, resulting in double taxation.

           Bilateral/multilateral APAs, however, do provide such coverage, although their implementation requires a more lengthy application process, including consultation between and the agreement of all competent authorities involved.




  Mutual agreement procedures


            A mutual agreement procedure is an instrument used for relieving international tax grievances, including double taxation. Although the specifics vary based on the laws of each country, they are only carried out between authorities of countries or principalities with existing tax treaties--for example, it is impossible to relieve double taxation by holding mutual agreement procedures between the authorities of China and Taiwan.


          Although most conventions require that each party to put forth all reasonable effort to resolve such disputes, they are generally not required to come to any sort of agreement. This means that although mutual agreement procedures can be an effective tool for the relief of taxation grievances, they are not fail-safes.



                              THANKING YOU

                               Amit Daga



Category Income Tax, Other Articles by - CA. Amit Daga