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Transfer pricing can be defined as the value which is attached to the goods or services transferred between related parties. In other words, transfer pricing is the price that is paid for goods or services transferred from one unit of an organization to its other units situated in different countries (with exceptions).
The following are some of the typical international transactions which are governed by the transfer pricing rules:
The key objectives behind having transfer pricing are:
For the purpose of management accounting and reporting, multinational companies (MNCs) have some amount of discretion while defining how to distribute the profits and expenses to the subsidiaries located in various countries.
Sometimes a subsidiary of a company might be divided into segments or might be accounted for as a standalone business. In these cases, transfer pricing helps in allocating revenue and expenses to such subsidiaries in the right manner.
The profitability of a subsidiary depends on the prices at which the inter-company transactions occur. These days the inter-company transactions are facing increased scrutiny by the governments. Here, when transfer pricing is applied, it could impact shareholders wealth as this influences company’s taxable income and its after-tax, free cash flow.
It is important that a business having cross-border intercompany transactions should understand the transfer pricing concept, particularly for the compliance requirements as per law and to eliminate the risks of non-compliance.
The Organisation for Economic Co-operation and Development (OECD) guidelines discuss the transfer pricing methods which could be used for examining the arms-length price of the controlled transactions.
Here, arms-length price refers to the price which is applied or proposed or charged when unrelated parties enter into similar transactions in an uncontrolled condition. The following are three of the most commonly used transfer pricing methodologies.
For the purpose of understanding, associated enterprises refer to an enterprise that directly or indirectly participates in the management or capital or control of another enterprise.
Under the CUP method, a price that is charged in an uncontrolled transaction between the comparable firms is recognized and evaluated with a verified entity price for determining the Arm’s Length Price. Example:
A Ltd. purchases 10,000 MT metal from B Ltd. its subsidiary @INR 30,000 /MT. Also purchase from C Ltd. 2,500 MT @ INR 40,000/MT.
A Ltd. received a discount of INR 500 /MT as a quantity discount from B Ltd. B Ltd. allows credit of one month at 1.25% pm. The transaction with B Ltd. is at FOB (Free on board) whereas with C Ltd. is at CIF (Cost, Insurance, and Freight). The cost of freight and Insurance is INR 1,000.
Here, the terms of transactions are not the same and hence, it has affected the cost of the crude metal. Hence, adjustments are needed. Adjustments required for differences in;
1. Quantity discount: In case a similar discount is offered by C Ltd., the price that was charged by C Ltd. would have been lower by INR 500/MT.
2. Freight & Insurance (FOB Vs CIF): In case the purchase from C Ltd. was also on FOB, then the price charged by C Ltd. would have been lesser. Hence, the cost of freight & insurance must be reduced from the purchase price.
3. Credit period: In case similar credit was offered by C Ltd., then the price charged by them would have been more after factoring in such cost. Hence, 1.25% pm must be added to the purchase price.
Computation of Arm’s length price:
|Particulars||Price per MT|
|Less: Quantity discount||-500|
|Less: Freight & Insurance Cost||-1000|
|Add: Interest Interest for credit||500 (40,000 *1.25%)|
|Arm’s length price/MT||INR 39,000|
This method is most reliable and is considered as a direct way of applying the arms-length principle and for determining the prices for related party transactions. However, while considering whether the controlled and uncontrolled transactions are comparable, high care has to be taken. Hence, this way of arriving at transfer price isn’t applied unless products or services meet the stringent requirements of the high comparability.
In this method, it takes the prices at which the associated enterprise sells its product to the third party. This price is referred to as the resale price.
The gross margin which is determined by comparing the gross margins in a comparable uncontrolled transaction is then reduced from this resale price. After this, costs which are associated with the purchase of such product such as the customs duty are deducted. What remains is considered as arm’s length price for a controlled transaction between the associated enterprises.
Example: An Ltd is a deal in IT products. An Ltd had purchased desktops from a related party, B Ltd and also from a non-related party B Ltd.
|Particulars||B Ltd. (AE)||C Ltd. (Non-AE)|
|Purchase price of A Ltd.||INR 30,0000||INR 44,000|
|Sales Price of A Ltd.||INR 36,000||INR 52,000|
|Other Expenses incurred by A Ltd||INR 500||INR 800|
Calculation of Arm’s length price
With the Cost Plus Method, you emphasize on costs of the supplier of goods or services in the controlled transaction. Once you’re aware of the costs, you need to add a markup. This markup must reflect the profit for the associated enterprise on basis of risks and functions performed. The result is the arm’s length price.
Generally, the markup in the cost plus method would be calculated after the direct and indirect cost related to production or supply is considered. But, the operating expenses of an enterprise (like overhead expenses) aren’t part of this markup.
Example: Associated Enterprise-A, a computer manufacturer in Thailand, manufactures under a contract for Associated Enterprise B. Associated Enterprise B would instruct Associated Enterprise-A about the quantity and quality of computers to be manufactured.
The Associated Enterprise-A would be guaranteed of its sales to Associated Enterprise B and would have little or no risk.
Let’s assume that the Cost of goods sold is INR 50,000. Also, assume that the arm’s length markup which Associated Enterprise-A should earn is 40%.
The resulting arm’s length price between Associated Enterprise-A and Associated Enterprise B is INR 70,000 (i.e. INR 50,000 x (1 + 0.40)).
There are quite a few problems associated with the transfer prices. Some of these issues include:
The above transactions would be treated as Specified Domestic Transactions only if the aggregate value of such transactions exceeds INR 5 crore.