Transfer Pricing - Purpose & Methodologies

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).

Transactions Subject to Transfer Pricing

The following are some of the typical international transactions which are governed by the transfer pricing rules:

• Sale of finished goods
• Purchase of raw material
• Purchase of fixed assets
• Sale or purchase of machinery etc.
• Sale or purchase of intangibles
• Reimbursement of expenses paid/received
• IT enabled services
• Support services
• Software development services
• Technical Service fees
• Management fees
• Royalty fees
• Corporate Guarantee fees
• Loan received or paid

Purposes of Transfer Pricing

The key objectives behind having transfer pricing are:

• Generating separate profit for each of the divisions and enabling performance evaluation of each division separately.
• Transfer prices would affect not just the reported profits of every centre, but would also affect the allocation of a company’s resources (Cost incurred by one centre will be considered as the resources utilized by them).

Importance of Transfer Pricing

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.
 

Transfer Pricing Methodologies

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.
 

Comparable Uncontrolled Price (CUP) Method

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:
 

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.

Resale Price Method or Resale Minus Method

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.

Calculation of Arm’s length price

Cost Plus Method

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)).

Problems Associated With Transfer Pricing

There are quite a few problems associated with the transfer prices.  Some of these issues include:

• There could be differences in opinions among organizational divisional managers with respect to how to transfer price needs to be set.
• Additional time, costs and manpower would be required for executing the transfer prices and designing the accounting system to match the requirements of transfer pricing rules.
• Arm’s length prices might cause dysfunctional behaviour among the managers of organizational units.
• For some of the divisions or departments, for instance, a service department, arm’s length prices don’t work equally well as such departments don’t offer measurable benefits.
• The transfer pricing issue in a multinational setup is very complicated.
• Domestic transfer pricing till March 2013, the transfer pricing provisions were limited to international transactions alone. From April 2013 Transfer Pricing provisions have been extended to SDTs (Specified Domestic Transactions) and are applicable from the assessment year 2013-14. Transactions that are covered under the Specified Domestic Transactions include:
  • Expenditures in which payment has been made or would be made to a director, a relative of the director, or an entity where a director or the company has the voting interest exceeding 20%.
• Transactions which relates to transfer of goods or services provided in Section 80-IA (8) & (10) (i.e. deductions which are related to profits and gains from enterprises engaged in infrastructure development or industrial undertakings, producers and distributors of power or Telecommunication Service Providers).
• SDT is also applicable to the transactions between the entity located in a tax holiday area, and the one which is situated in a non-tax holiday area in case both are under the same management structure.
• For undertakings which are established in SEZs (special economic zones), free trade zone or EOUs (export-oriented units) involving the transfer of goods and services to another unit under same management at the non-market prices.

The above transactions would be treated as Specified Domestic Transactions only if the aggregate value of such transactions exceeds INR 5 crore.

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