Transfer Pricing

Vinay Nichani

November 2, 2009

1 Transfer Pricing - The Tax Side

What is Transfer Pricing?

• Transfer pricing is used to justify the arm’s length nature of

inter-company pricing arrangements between related parties
operating in different tax jurisdictions

• Cross border transactions between related entities: applies to

transactions relating to goods, services, assets and financing

• Arm’s length principle  related parties should undertake

transactions under the same terms and conditions as unrelated
parties

• Principle is universal  countries enact laws to implement

principles

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Why is Transfer Pricing relevant?

• Objective of Tax Authorities  Maximize tax payments in their

jurisdictions

• Objective of Tax Payers  Rationalise global tax costs / Avoid

double taxation / Avoid Disputes with Tax Authorities

• Strong focus of MNEs and Tax Authorities globally

• Most countries have transfer pricing regulations and adhere to

the arm’s length principle - most countries have
documentation requirements

• Transfer pricing audits are becoming more common – high

stakes for MNEs / Increasingly stringent penalties for failure to
comply

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Relevance of OECD in Transfer Pricing

• Organization for Economic Co-operation and Development

(“OECD”) is an organization of more than 30 countries

• OECD has published Transfer Pricing Guidelines for

Multinational Enterprises

• Provides guidance for application of the arm’s length principle

 remuneration to be commensurate with functions, risks and
assets (Functional Analysis)

• Provides framework for determination of the arm’s length price

for the transactions between two related parties

• Prescribes methods to determine the arm’s length price

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Arm’s Length Principle
• Internationally accepted yardstick to ensure correct and fair
transfer prices in each jurisdiction

• Arm’s Length Price  price at which two independent /

unrelated parties enter into business transactions

• Arm’s Length Range  range of results that are acceptable for

establishing whether the terms & conditions (price / profit) of
a controlled transaction are arm's length

• Controlled transaction  transaction between related parties

• Uncontrolled transaction  transaction between two

independent / unrelated parties

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Associated Enterprises / Related Parties

• Association / relation through management / control / capital
of other enterprise

• Management  one enterprise or person having right to

nominate persons to manage the affairs of the other enterprise

• Control  one enterprise being economically dependent on the

other enterprise or person e.g. provision of technical know
how, purchase of majority of finished goods, use of trade
mark, etc.

• Capital  an enterprise or person subscribes to the share

capital or provides loans to the other enterprise

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What should a Transfer Pricing study include?

• Understanding of the tax payers overall business, group

structure, transactions with related and unrelated parties,
intercompany agreements etc.

• Functional analysis  description of functions undertaken,

risks assumed and assets owned by each party to the
transaction

• Industry analysis  analysis of industry of the tax payer

(markets, drivers, competitors, customers etc.)

• Economic analysis  Choice (incl. rationale) of transfer pricing

methodology & evidence that the chosen method results in an
arm’s length outcome (e.g. benchmarking study)

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Functional Analysis - an introduction

• Functional analysis is an exercise to determine and document /

map the significant economic activities performed by the tax
payer and its related parties in a particular transaction or set of
transactions

• Significant economic activities have a bearing on the price

charged by an enterprise

• A functional analysis is not limited to functions only, risks and

assets also play a crucial role  referred to as Functions, Risks,
Assets (FAR) analysis

• Based on the FAR analysis, different related parties to the

transaction are characterised  selection of tested party, choice
of transfer pricing method & remuneration model, comparability
with external companies etc.

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What goes into a functional analysis?

Transactions Risks Functions

Entities Assets

Agreements/terms
Products FAR
Analysis
Markets/competition Financial results

Business processes Organisation/staff

Forecasts/business plan

• Interviews with responsible people within the tax payer

• Analysis of financial statements and websites

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What comes out of FAR analysis?

Internal
comparables
Basis to search
Understanding for external
the business comparables

FAR Risk and

Documentation opportunity
Analysis assessment

Characterising Transfer Pricing

entities methods

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Transfer Pricing methods

Traditional Methods

– Comparable Uncontrolled Price Method (CUP)

– Resale Price Method (RPM)

– Cost Plus Method (COST+)

Transaction based methods

– Profit Split Method (PSM)

– Transactional Net Margin Method (TNMM) / Comparable Profit

Method (CPM)

Unspecified Methods

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Comparable Uncontrolled Price (“CUP”) Method

• Arm’s length price is measured directly by comparison to one
or more comparable uncontrolled transactions

• Comparable only if high degree of comparability exists

between products / services and circumstances or if reliable
adjustments can be made

• Comparability factors  quality, volume, market (level and

geography), time, alternatives available, and associated
intangible property

• Arm’s length price is measured directly by comparison to one

or more comparable uncontrolled transactions  best
method if applicable (rarely used in practice in case of
tangible goods)

• May be internal or external

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Comparable Uncontrolled Price (“CUP”) Method

Related Party Sales

Model ABC
Unrelated Party Sales
Phone
(INR X)
Related Retailer
Company A Distributor Unrelated

Model ABC
Phone Unrelated Retailer
Distributor Unrelated
(INR 500)

Other terms and

conditions highly
comparable

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Resale Price Method

• Used for testing transfer of a distributor who adds no value to
the products

• Arm’s length price = Controlled taxpayer’s resale price minus

arm’s length gross profit percentage for tax payer

• Arm’s length gross profit should cover the selling, other

operating expenses [in light of the functions performed, assets
employed and risk assumed] and an appropriate profit

• Comparability depends on functions performed and economic

circumstances – broad product comparability

• May be internal or external

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Resale Price Method Illustrated

Model ABC
X% Distribution
Gross Margin
Model ABC

Distributor
Company A
related
Retailer
to Company A Unrelated

Model XYZ
40% Distribution
Gross Margin
Company X Model XYZ Related Party Sales
Unrelated
Unrelated Party Sales

The Distributor purchases and resells similar products from Company A and Company X, performs
the same distribution functions and bears the same risks under similar market conditions –
Internal Comparable

15 Transfer Pricing - The Tax Side

Cost Plus Method

• Used for testing transfer prices of manufacturers, assemblers,

or others that add value

• Arms Length Price = Cost of production (direct and indirect

cost of production) + arm's length mark-up on such costs

• Arm’s length mark-up determined with reference to internal /

external comparables (uncontrolled)

• Comparability in functions (manufacturing process and

complexity, degree of processing / assembly, level of research
and development etc.)

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Cost Plus Method Illustrated

Related Party Sales

Cost + X% Company B
related
Unrelated Sales to Company A
Model ABC
Keyboard

Company A
(Manufacturer)

Model XYZ
Keyboard
Company X
Unrelated
Cost + 7%

Company A sells similar products to an Company B and Company X, performs the same functions
and bears the same risks under similar market conditions – Internal Comparable

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Profit Split Method (“PSM”)

• Used in case of interdependent and integrated transactions
involving valuable intangibles or high-value services

• Involves evaluation of arm’s length allocation of the combined

operating profit or loss attributable to one or more controlled
transaction based on relative value of each controlled
taxpayer’s contribution to that combined operating profit or
loss

• Each taxpayer’s relative contribution should reflect the

functions performed, risks assumed, and resources employed
by each participant

• Complex method – involves subjectivity

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Transactional Net Margin / Comparable Profit Method
• Used for testing the net profit margin of the tax payer from a
controlled transactions relative to an appropriate base
(benchmarking of profits earned by uncontrolled parties
engaged in similar business activities)

• In practice, this is the most commonly used method (although

sometimes viewed as last resort – change in OECD view)

• Functional comparability important – always external

• Similar transactions may be aggregated - Not advisable to be

applied on company level data if company is involved in a
variety of transactions

• Profitability compared using Profit Level Indicators (“PLIs”) -

ratios that measure relationships between profits and costs
incurred or resources employed (e.g. OM, FCMU etc.)
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Types of business models:

 Manufacturer:

– Principal manufacturer
- Contract manufacturer
- Toll manufacturer

 Distributor:

- Full-fledged / Marketer distributor

- Limited risk distributor
- Commission agent

 Service provider:
- Risk taking service provider
- Limited risk service provider
- Captive service provider

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Types of Transfer Pricing Studies
• Benchmarking study
– Undertaken to determine the arm’s length price in case of newly
set-up entities having international transactions or new
international transactions
• A full scope study
– Undertaken to determine whether the values of the existing
international transactions meet the arm’s length test
– It involves undertaking:
– Industry analysis
– Functional analysis
– Economic analysis
• Updation study
– Undertaken to determine whether the values of the existing
international transactions meet the arm’s length test
– It involves undertaking only an economic analysis (i.e., the
functional analysis of the existing international transactions have
remained unchanged from the previous year) and updating
industry overview
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