Transfer Pricing in India

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Transfer Pricing

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Transfer pricing refers to the value of the goods exchanged in conjunction with each other between the two parties. The sum thus attached may be equally correlated with both goods and services. When products are moved from one unit to another, the idea of transfer pricing comes into play, especially when the two units are located in separate countries.

The transfer of goods and services between the two units of a multinational or multi-state company should take place. There are several branches in larger entities, and this is done to maintain efficient management control over the activities in the corporation as a whole. The transfer price is the price paid to the other unit by one unit of the company for the goods or services provided.

This transition happens between the two divisions of the same company and thus represents an internal transfer rather than a sale. It can be one of the important factors for determining the movement of goods and services between a company’s various divisions.

This will allow you to assess the success of various divisions and units. When there are a considerable number of internal transfers, it becomes necessary and therefore needs to be carefully handled.It is important to set prices with a fair amount of thought in relation to the final market price. You will end up with a preferred selling center if the transfer price is set high, while the purchasing center will be favored if it is set too low.

Transfer pricing is a method of accounting and taxation that enables transactions to be priced internally within companies and between subsidiaries operating under common control or ownership. The practice of transfer pricing includes cross-border transactions as well as domestic ones.

A transfer price is used to calculate the amount to be paid for the services provided by another division, subsidiary, or holding company. Transfer rates are usually priced based on the prevailing selling price for that product or service. It is also possible to apply transfer pricing to intellectual property, such as research, patents, and royalties.

The transfer pricing approach is legally permissible to be used by multinational companies (MNC) to divide earnings between their different subsidiaries and associate companies that are part of the parent organization. However, by altering their taxable revenue, businesses may sometimes also use (or misuse) this practice, thus reducing their total taxes. The system of transfer pricing is a way for businesses to move tax obligations to low-cost tax jurisdictions.

  • Your business should be able to show that the terms and conditions of internal contracts are equal to those negotiated at the end of comparable transactions in the free market (referred to as ‘arm’s length’).

  • Your organization should have on record paperwork that shows:

    • how the transfer pricing was defined and how the transfer pricing was calculated and
    • if transfer pricing is in accordance with the concept of arms length.
  • On the basis of arm’s length terms and conditions of regulated transactions, your company can file annual (corporate) tax returns.

Multinational companies (MNCs) have some flexibility for managerial accounting and reporting purposes when defining how to allocate revenues and expenditures to subsidiaries based in different countries. A company subsidiary can often be split into divisions or may be accounted for as a standalone company. In such situations, transfer pricing allows assigning revenue and expenditure in the correct way to such subsidiaries.

A subsidiary’s profitability depends on the rates at which inter-company transactions take place. Inter-company transactions are facing heightened regulatory scrutiny these days. Here, it could affect shareholder capital when transfer pricing is applied, as this affects the taxable profits of the company and its free cash flow after tax.

It is essential for an organization with cross-border intercompany transactions to understand the definition of transfer pricing, especially with regard to compliance requirements as required by law, and to eliminate the risks of non-compliance.

Profitability


The price of the transfer should pay careful attention to the viability of both organizations’ divisions. In both cases, the divisions belong to the same organization. Thus, at any arbitrary price, objects, products, and services may be configured. But, if you want the profit margins of both divisions to remain unaffected, holding rates as close to consumer prices as possible will be a smart idea.

Taxation


Taxation would also have an effect on the transfer price. A proper transfer price will allow you to cover one division’s tax burden with an equal one on the other. The maximization of your organization’s net taxable income is one of the key goals of transfer pricing. Open market considerations do not regulate transactions. This helps you boost the options for taxes.

Performance evaluation of individual units


Transfer pricing can be one of the better choices for the individual divisions to arrive at the best possible assessment. This can help direct decision making that is successful. Any of the ways where transfer pricing can help performance evaluation, and performance management involves evaluating the divisions’ administrative performance, assessing the individual entities’ contributions to the company’s overall income, and assessing the importance of each division as an individual entity.

Taking a good look at international trade


Measuring the foreign trade situation is another prime goal that transfer pricing seeks to achieve. Pricing should be in accordance with the norms of import and export and should be measured precisely. A price too low will distort the statistics for foreign trade to a greater degree. The rates for transfer prices should be such that they would not distort the statistics for foreign trade.

  • Transfer pricing helps to minimize the cost of duty by exporting goods to high tariff countries at minimum transfer rates so that the basis of duty associated with such transactions is minimal.

  • Decreasing income taxes in high-tax countries by overpricing of products shifted to units in countries where the tax rate is relatively lower gives them a higher profit margin.

  • Gaining separate benefits for each of the divisions and allowing each division to independently assess output.

  • Transfer rates would not only impact the reported income of each center, but would also affect the distribution of resources of a corporation (Cost incurred by one centre will be considered as the resources utilized by them).

  • Benefit transfer is meant to reduce the tax liabilities that can be minimized in a specific country. This can be done by artificially cutting profits. It is also intended to decentralize production in such a way that profits are adequately concentrated in the area where the production of products takes place.

In the OECD Guidelines, 5 main methods for setting transfer prices are outlined:

The Comparable Uncontrolled Price, or CUP, Method


It is the most common form and, in most instances, the OECD prefers it. In an intercompany trade, the CUP Approach compares the price of products or services to the price adjusted between separate parties. It is essential that goods and services are measured under comparable conditions in order to achieve an accurate price that will be approved by the tax authorities.
This can also be referred to as market-set pricing, since the CUP approach is focused on fair market rates, unlike other approaches that rely on margins. If a company makes a product, by selling it to the “outside world,” they have to weigh what they will gain. The corporation needs to optimize profit margins, so it can certainly exercise good habits, like charging fair market rates for products or services provided inside the organization.

Cost-Plus-Percent Method


It is an approach favored by some manufacturers and is popular with the aerospace industry. It’s a transaction method that compares gross profit to costs of sales. The division supplying goods or services determines the cost of the transaction, then adds a markup for profit on the goods or services delivered. The markup should be equal to what a third party would earn for transactions in a comparable situation, including similar risks and market conditions.

The Resale Price Method


It explores the gross profit or the difference between the price at which the product or service is bought and the price at which the product or service is sold to a third party. Although similar to the Cost-Plus-Percent System, only the margin (minus related costs such as customs duty) is considered as the transfer price in the resale price method. It is most suitable for distributors and resellers, as opposed to manufacturers, for this reason.

Transaction Net Margin Method, or TNMM


It has recently emerged as a preferred model for many multinationals because, as opposed to comparable external market pricing, transfer pricing is focused on net profit. The CUP, Cost-Plus-Percentage, and Resale Price Strategies are all focused on the real cost for external sales of equivalent products or services. Instead, TNMM contrasts the net profit margin earned from a regulated intercompany transaction with the net profit margin earned from a similar third-party transaction. It can also look at the net margin gained on a similar deal with another third party by a third party.
This measures the profit margin versus real costs, which is particularly attractive in the absence of external pricing data to assess the market price. Organizations may calculate net profit against revenue, expenditures, or assets with TNMM. Usually, it is implemented to a defined range by targeting an operating margin. Although the CUP approach has been favored by the tax authorities, TNMM is emerging as a new standard.

The Profit-Split Method


Like TNMM, it is based on benefit, not a market price, which is comparable. For this process, transfer pricing is calculated by the determination of the division between the separate undertakings engaged in the transaction of the benefit resulting from a specific transaction. This is focused on the relative contribution of each of the relevant business parties to the transaction, as calculated by the functional profile, and the external market data as applicable.
Each approach has pros and cons, and each company can decide what works best with its specific requirements. In certain cases, with particular kinds of transactions, an entity may also use different approaches.

  • As an initial step, it is good to look at what internal transactions the company has and what related firms are interested in. This encompasses not just obvious transactions, such as the supply of goods and the supply of services. “Invisible transactions” are also included, such as community guarantees given to external banks.

  • As a next step, it will be appropriate to check if the terms and conditions of internal contracts comply with the concept of arm’s length and whether this can be justified.

  • In certain instances, the terms of internal transactions apply similarly to equivalent external transactions (for example a firm sells a product at the same price to both associated entities and third parties). That is in itself a sound foundation for taking the view that the price of the transfer is at arm’s length

  • The last step will be to decide whether there is a need to plan transfer pricing paperwork. This is based on steps 1 and 2, but also on local guidelines.

  • The OCED’s Updated Transfer Pricing Documentation and Reporting Standards would raise the MNE’s enforcement burden substantially over the coming years.

  • Since transfer pricing is no longer a compliance exercise, it requires compliance with strategic tax risk management.

  • The OCED approach will be followed by the tax authorities, which will be a crucial mechanism to ensure that the data regularly submitted to the tax authorities are harmonized and incorporated.

  • The global documentation would also appear to increase the globally burdensome process, which will place pressure on multinationals to maintain efficient and reliable documentation of transfer pricing.

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Transfer Pricing

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