TRANSFER

PRICING
RAJ KUMAR CHAKRABORTY;
PHD-2018 (PT), ROLL -11

INDIAN INSTITUTE OF FOREIGN TRADE

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INTRODUCTION

About Transfer Price:

Transfer pricing is a term used to describe inter-company pricing arrangements relating to

transactions between related business entities. These can include transfers of intellectual
property, tangible goods, services, and loans or other financing transactions.

Context of Transfer Price for Policy makers & MNC:

As the global economy expands into every corner of the world, many national fiscal
authorities are seeking more effective ways to protect their tax bases. This has translated
into increased challenges for multinational organizations.

From detailed transfer pricing regulations to strict documentation requirements, sophisticated

audit practices to significant penalties for non-compliance, global companies are looking for
advice in dealing with the increased regulation and higher scrutiny.

Transfer pricing has been attracting considerable attention in recent years, especially after
the opening up of the Indian economy in 1990-91. Changes in manufacturing processes,
increased data communication, ever enhancing contribution of intangibles and various
services have facilitated businesses to operate effectively across nations. While on the one
hand, a large number of multinational corporations (MNCs) have come into existence in the
Indian shores, many of the Indian companies have also expanded their worldwide
operations. As a result, related party trade has grown both in volume and in scope.
International transfer pricing is now considered as an important factor in corporate strategic
planning and decision making. This is a shift from the past, when transfer pricing was only a
subject of interest for the accounting department. The corporate sector now realizes that
transfer pricing should be viewed from a company’s perspective – this approach could
enhance operational performance, minimize overall tax burden, improve cash flows, reduce
legal exposures, and increase earnings.

The study of transfer prices in an economy is of significance to corporate policy makers,

economic policy makers, tax authorities, and regulatory authorities. “From a business
perspective, there are many dimensions in deciding what to charge for the inter-company
exchange of goods or services. Compensation and performance measurement may push in
one direction; the demand for simplicity may push in another; and tax considerations may
push in a third. Other factors may come into play as well. Governments, through their tax
systems, have a vested interest in ensuring that appropriate profits are reported in their
jurisdiction. Government concerns are heightened when one of the parties to a related-party
transaction is subject to tax at a rate that is considerably less than that applying in the other
related party’s country. In addition to tax-rate pressures, other government pressures can be
brought to bear on the transfer-pricing decision, including heavy penalties or restrictive
measures dealing with related-party transactions” (Turner, 1996).

Transfer price and Taxation:

Deciding intra-group transfer prices is a complex and difficult process. For deciding transfer
prices, MNCs have to take into account a wide range of factors, of which tax and tariff are
the most important ones. Although, through various tax and economic reforms, countries
across the globe have generally reduced corporate tax rates, differences in international tax
rates still persist in international fiscal environment. Multinational organizations are inclined
to reduce their total tax burden, by practising shift of income from highly taxed countries to
lightly taxed countries. Shifting of reported income can be attained by manipulation of
transfer prices for international transactions.
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The use of transfer pricing tax strategies has recently attracted a high level of international
attention, due in part to the rapid rise of multinational trade, the opening of several significant
developing economies and transfer pricing’s increased impact on corporate income taxation.
As multinational corporations evolve into true global enterprises compliance with the differing
requirements of multiple overlapping tax jurisdictions has become a complicated and
expensive task.

In response to these factors, tax authorities around the world have become more aggressive
in the transfer pricing arena, introducing stricter penalties, new documentation requirements,
increased information exchange, improved audit staff training and increased audit and
inspection activity and specialization.

When two entities are selling goods or services, one entity sets the price, the second entity
has the luxury to negotiate or substitute the product or service.

If the same force controls or owns two or more entities, the price set forth can be the correct
or not the truly correct price, in other words the price of the product or service is controlled.

Many times, the accounting or tax department will adjust the price of items or services for the
benefit of their employer with the objective of minimizing tax obligation.

Controlled price

The controlled price should be comparable to the uncontrolled price. Uncontrolled price
occurs when two parties can freely negotiate the price of goods or services. The result in
comparing the controlled and uncontrolled price is similar if relatively similar income is
recorded.

Arm’s length standards are the basis to determine if a controlled transaction is properly
recorded.

Arm’s length transaction

There is no single method that is correct all the time, it is not that simple. The underlying
principle is based on the arm’s length transaction. This principle can be defined as a
transaction in which the buyers and seller of a product act independently and have no
connection to each other. Often the arm’s length price is sometimes stated as a range rather
than a single price. In addition, there is no one best method to determine the “correct” price
exists; different types of transactions will follow different rules for arm’s length transactions.
Extremely aggressive tax planning drives the problem. There are specific methods for
calculating an arm’s length transaction. The taxing authorities will review the forms submitted
and even compare the previous year submitted tax returns to determine if consistent
methodology was used. These forms should be prepared by experienced tax professionals
before, attaching to the tax returns. A common procedure used in auditing is called analytical
review or another tool known in financial statement analysis, is trend analysis or horizontal
analysis that can be used to analyze consistency in reporting.

In order to calculate or test the arm’s length nature of prices or profits, use is made of
transfer pricing methods or methodologies. Transfer pricing methods are ways of calculating
the profit margin of transactions or an entire enterprise or of calculating a transfer price that
qualifies as being at arm’s length. The application of transfer pricing methods is required to
assure that transactions between associated enterprises conform to the arm’s length
standard. Please note that although the term “profit margin” is used, companies may also
have legitimate reasons to report losses at arm’s length. Furthermore, transfer pricing
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methods are not determinative in and of themselves. If an associated enterprise reports an

arm’s length amount of income, without the explicit use of one of the transfer pricing methods
recognized in the OECD Transfer Pricing Guidelines, this does not mean that its pricing is
automatically not at arm’s length and there may be no reason to impose adjustments.

Some methods are more appropriate and indicative to provide for an arm’s length result for
certain transactions than others. For example, a cost-based method is usually deemed more
useful for determining an arm’s length price for services and manufacturing, and a resale
price-based method is usually deemed more useful for determining an arm’s length price for
distribution/selling functions.

The starting point to select a method is the functional analysis which is necessary regardless
of what transfer pricing method is selected. Each method may require a deeper analysis
focussing on aspects in relation with the method. The functional analysis helps to identify
and understand the intra-group transactions: first, to have a basis for comparability; second,
to determine any necessary adjustments to the comparables; third, to check the accuracy of
the method selected; and fourth, there exists a need to consider adaptation of the policy if
the functions, risks, or assets have been modified.

Documentation

The key to minimize the potential problem is documentation, starting with the forms supplied
to the taxing authorities. It is very important to follow the instructions of the forms and clearly
document all numbers, calculations, and schedules, before the tax return is submitted to the
government agencies. The burden of proof of notice received by the taxpayer is on the
taxpayer, not the IRS, because of this; the cost of litigation is extremely expensive. One of
the ways to minimize such cost is through the use of advanced pricing agreements.

APA

The APA program is designed to resolve actual or potential transfer pricing disputes in a
principled, cooperative manner, as an alternative to the traditional adversarial process. An
APA is a binding contract between the IRS and a taxpayer. By which the IRS agrees not to
seek a transfer pricing adjustment for a covered transaction if the taxpayer files its tax return
for a covered year consistent with the agreed transfer pricing method. This contract is an
opportunity to reach agreement in advance of filing a tax return on the appropriate transfer
pricing method to be applied to related party transactions. The prospective nature of APAs
lessens the burden of compliance by giving taxpayers greater certainty regarding their
transfer pricing methods (IRS, 2013).

Penalties

Penalties are used as a way to deter inappropriate behavior. The IRS makes no exceptions;
various penalties can be assessing for not filing the correctly completed forms. These
penalties can start at $10,000 per form per year, where an entity might be required to file
more than one copy of such form.

State and local taxes

The issue of transfer pricing also occurs when an entity needs to allocate or apportion, gross
income, deductions, credits, or other allowance between one or more organization(s) in two
or more states. Each state may or may not follow the IRS rules and regulations. One needs
to examine the individual state or local tax laws and regulations.

Managerial accounting
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Many decentralized organizations, should determine the profitability of each subunit. Pricing
of services or product need to be calculated between such related entities as appropriate.
Does the accounting department charge their direct and indirect expenses to the appropriate
subunit that is required? Therefore the accounting department can show either a breakeven
or even a profit depending upon management goals and objectives.

TRANSFER PRICING: MEANING, DEFINITION, AND REGULATIONS IN INDIA

Transfer prices are the prices at which an enterprise transfers physical goods and intangible
property or provides services to an associated enterprise. Transfer Pricing Guidelines issued
by Organization for Economic Cooperation and Development (OECD) defines transfer
pricing as “payment from one part of a multinational enterprise for goods or services
provided by another…”(Williamson 2003). This definition stresses on multinationals, which
looks appropriate as more than one-third of the cross-border sale of goods and services
worldwide occurs between related enterprises of MNCs. The internationally agreed standard
for setting prices is the “arm’s length principle”. According to this principle, intra-group
(related party) transfer prices should be equivalent to those which would be charged
between independent persons dealing at arm’s length in otherwise similar circumstances.
This principle has been incorporated in Article 9 of OECD’s Model Tax Convention on
Income and on Capital. Section 92 of the Income Tax Act 1961 also provides that any
income arising from an international transaction or where the international transaction
comprises of only an outgoing, the allowance for such expenses or interest arising from the
international transaction shall be determined having regard to the arm’s length price.
Transfer pricing has become a matter of great concern for the tax authorities and MNCs in
India due to increasing participation of multinational groups in economic activities in the
country. Realizing its importance, in November 1999, the government set up an Expert
Group under the chairmanship of Mr. Raj Narain to examine the issues relating to transfer
pricing. To provide a detailed statutory framework for computation of reasonable, fair, and
equitable profits and tax of MNCs in India, the Finance Act, 2001 substituted section 92 with
a new section and introduced new sections 92A to 92F in the Incometax Act. The new
provisions relate to computation of income from an international transaction having regard to
the arm’s length price; meaning of associated enterprise; meaning of information and
documents; and definitions of certain expressions occurring in these sections.

Basic Methods Used to Calculate a Transfer Price

There are several methods that companies use to set transfer prices. The most commonly
used methods are described below.
Market rate transfer price (or comparable uncontrolled price)
Market rate is generally the most straightforward method of calculating a transfer price. Put
simply, it means the transfer price is the same as the current market price for the goods or
services in question.
With market rate transfer price, the upstream unit can sell its goods or services either by
conducting its sale internally or externally. Under both methods, the profit for the unit remains
the same.
Adjusted market rate transfer price
The adjusting market rate method is often used to derive a transfer price when the market
rate method is unavailable. This method accounts for an adjustment to current market price
to some stated degree.
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For example, a company may choose to use a reduced price to eliminate the risk of late
payments. In most cases, this stills falls within the arm’s length principle.
Negotiated transfer pricing
With negotiated transfer pricing, specific corporate units negotiate a price regardless of the
market baseline price. In fact, it can be quite different than the prevailing market price.
Companies often opt for this method in situations where the market price is difficult to
calculate; the market for the goods or service is limited; or the item in question is highly
customized.
Contribution margin transfer price
Companies tend to use the contribution margin transfer price method in cases where no set
market price for the goods or services being sold exists. Under this method, companies
calculate a market price “alternative” based on the unit’s contribution margin.
Cost-plus transfer price methodology
Cost-plus transfer price methodology is another method that’s used when no valid market
price exists. This method is often used in cases where the item in question is a manufactured
good.
When calculating the cost-plus transfer price, companies tend to add a margin on the cost of
the good by adding the standard cost onto a standard profit margin.
Cost-based transfer pricing
Some companies choose to sell their goods or services to other units by simply using the
production cost as the price point. If that product or service is then sold to a third party, that
unit can add its own costs to the final price.
Under the cost-based transfer pricing method, the company that makes the final sale
receives the entire profit of the goods or service. This method is often used as a tax
avoidance strategy.
REVIEW OF LITERATURE

Transfer pricing as a corporate stratagem, is of relatively recent origin. A limited literature

has flowed on the issue of transfer pricing over the last two decades. Few researchers have
touched the issue of transfer pricing and their impact on taxes and tariffs but there is no
consensus on the magnitude of transfer pricing. Some researchers have conducted primary
data surveys to find out the importance of transfer pricing and related issues. Ernst & Young
Global Survey of Multinational Corporations (1995) clearly established that transfer pricing
was vitally important for MNCs in all surveyed countries and most MNCs were familiar with
the concept of Advance Pricing Agreements (APAs), and expected their use to increase in
future. The Ernst & Young survey of transfer pricing documentation (1996) concluded that
there were lack of documentation requirements and/or lack of meaningful penalties in most
countries other than the US. Turner (1996) summarized the transfer pricing guidelines issued
by OECD in 1995, provided an overview of the tax rules applying to related party
transactions in various countries, and compared those approaches to the ones found in
Canada — the alternative approaches for the Canadian tax system for protecting the
Canadian tax base, and simplifying and enhancing fairness by ensuring that all businesses
shared the cost of providing government services.

Dawson and Miller (2000) studied how the multinational corporations’ transfer prices
responded to changes in international corporate effective tax rates and confirmed that profit-
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maximizing multinational corporations used transfer price to shift profit to the relatively lower-
tax country in order to maximize their global after-tax profit, all else equal. Swenson (2000) is
an econometric study that found that reported prices increased when the combined effect of
taxes and tariffs provided an incentive for firms to overstate their prices. He found that while
the results were statistically significant, they were economically small, implying that a 5 per
cent decline in foreign tax rates caused the reported price of affiliated firm imports to rise by
0.024 per cent.

Shah (2001) examined transfer pricing regulations in India introduced by The Finance Act
2001. The study stated that the objective of the introduction of transfer pricing regulations in
India was to check the manipulation in prices charged and paid in intra-group transactions. It
was felt that the assessee would have to review the methods for negotiations in respect of
import-export transactions and collect basic data about market prices and other evidence to
justify that the prices paid or received in the transactions with associated enterprises are on
arm’s length basis. The study concluded that onerous responsibilities have been put on the
persons entering into international transactions.

Reeb and Hansen (2003) explored whether income shifting had decreased with increased
governmental regulations in recent years and found that international firms continued to shift
income during the 1990s to minimize taxes. They also found evidence to suggest that tax
minimization schemes were more aggressively pursued in small firms; and firms based in
low tax countries were more likely to shift income home than firms in high tax countries were
to shift income abroad.

Srivatsan (2004) theoretically examined some economic aspects such as extension of Value
Added Tax (VAT) in transfer pricing; bridging of fiscal vs economic tax base; and the
multiplier effect of transfer pricing. The study stated that by adopting tax/profit shifts from
higher tax jurisdictions to lower tax jurisdictions, the firm could go on building the profits and
multiplier concept would hold true for transfer pricing. Further, the multiplier would be limited
and dependent on tax rates prevailing in each shift; and the quantum of corpus that is shifted
each time. The study concluded that despite all issues and propositions, transfer pricing, no
doubt, is a welcome legislation given the winds of change blowing all across nations to
protect their tax share in global tax wealth.

Bernard, Jensen and Schott (2006) established that export prices for intra-firm transactions
were significantly lower than the prices for the same good sent to an arm’s length customer.
Their study found that the price wedge between arm’s-length and intra-firm prices responds
to differences in market structure, taxes, and tariffs.

DISCUSSION:

Multinational tax challenges are among the most complex and potentially expensive issues
facing companies with international operations. At the same time, this complexity provides
ample opportunities to optimize profits, increase cash flows, and moderate taxes. Transfer
pricing policies should be developed with the assistance of tax professionals that are
defensible, flexible, and congruent with your company’s overall tax planning, so that you can
focus on other operational business objectives.

The control of foreign subsidiaries is crucial for MNCs. The high number of studies on
management control (MC in MNCs indicates that this subject represents a research focus.
Martina Sageder and Birgit Feldbauer Durstmuller in 2018 examined a broad spectrum of
control mechanisms to provide a common knowledge base for future research, depicting and
categorizing numerous influencing factors, their interrelations and effects on several control
mechanisms. This research contribution discusses conflicting findings and limitations of
certain mechanisms and presents research designs, applied theoretical frames and a
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summary of the development of control mechanisms as well as of the examined influencing

factors over time. There is consensus that output controls particularly in form of financial
measures are prevalent and widely accepted. Nonfinancial measures complement financial
output controls with regard to complex environments. Process controls ensure that
employees at subsidiaries comply with guidelines and act in line with the MNC’s goals.
Social controls are the trailblazer for other mechanisms of control, particularly in emerging
countries, where certain standards need to be established. MNCs apply combined control
mechanisms depending on various influencing factors, such as the company environment
that affects the management control strategies (MCS) (Granlund and Lukka 1998), as well as
internal factors like size or strategy (Otley 2016). Some of these, such as corporate strategy,
are associated with headquarters; others are attributed to the subsidiary or to the relationship
between headquarters and subsidiaries. Most studies investigate more than one influencing
factor and identify interactions between these factors. Hence it is safe to say that a
combination of factors shape MC at MNCs. The findings of this paper are of high practical
relevance for MNCs. Output controls, especially financial figures, are widely understood and
accepted across countries and sectors, which enables benchmarking. Non-financial
measures allow adjustment to local requirements and increase the significance of PMS
under environmental uncertainty. A broad measurement focus, comprising financial and non-
financial indicators can prevent a loss of control over a subsidiary. Nevertheless, PMS that
are too complex lose influence due to their incomprehensibility. MC should be adapted to the
environment of a subsidiary; especially market requirements, culture, legal frameworks, and
languages should be taken into account when implementing MCS. Otherwise, MNCs risk
that control mechanisms are ineffective or even cause additional costs. Social controls tend
to be neglected, although they smooth the way for process and output controls. Training
serves to transfer both knowledge and corporate culture to subsidiaries and ensures that
MCSs are, on the one hand, applied correctly and, on the other hand, accepted by
subsidiaries—both requirements for effective control. Frequent communication between
subsidiaries helps to develop social relationships, which support introducing MC and
resolving conflict situations. Expatriates provide control over subsidiaries, which is
particularly important when setting-up new subsidiaries if expatriates are familiar with host
country conditions. Process controls are useful mechanisms to control the behaviour of
employees and align it with company objectives. However, the extensive use of such
controls limits flexibility and adaptions to local requirements. Culture is a critical factor for the
effective control of subsidiaries. The nationality of the headquarters shapes the control
exerted over subsidiaries. Managers at headquarters should realize that these control
mechanisms might not be fully understood or accepted in other countries and their
respective cultural backgrounds or business traditions.

The activity-based costing approach justifies the transfer prices a multinational corporation
uses to transfer unique company parts or services among its divisions located in different
countries. How this approach reduces the probability of costly tax audits and assists in
obtaining an advanced pricing agreement is also assessed.

Prior to 1994, there were essentially four approaches in which transfer prices could be
determined to meet the Basic Arms Length Standard, the international standard for transfer
price determination accepted by tax authorities around the world. The first approach was the
comparable/uncontrollable method, which required the seller to compare its transfer price to
that of an independent seller selling a similar good to an independent buyer. The second
approach was the resale price or gross margin method, which required the seller to compare
its gross profit margin to that attained by independent sellers selling to independent buyers
(i.e., comparable uncontrolled transactions). The third approach was the cost-plus or gross
markup method, which required the seller to add a gross profit to product costs that was
comparable to that earned by companies performing similar functions. If none of these three
methods applied, an alternate method could be used. Multinational enterprises were required
to apply these approaches in a hierarchical fashion; that is, the comparable/uncontrollable
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resale method was to be used unless the MNE rejected it as unsuitable for its circumstances.
The MNE could then try the resale price method; if it was also unsuitable, the cost-plus
method could be tried. If none of these approaches suited the unique requirements of the
MNE, another approach could be used. However, alternate approaches were rarely used
because of the potential for closer scrutiny by taxing authorities.

These approaches were augmented in 1994 by two additional transfer approaches: the
comparable profits method and the profit-split method. The comparable profits method
required the seller to compare its profits to those of similar MNEs. The profit-split method
allocated profits between business units on the basis of the functions performed, assets
used, and risks assumed by each unit. The profit-split method then compared relative profits
with those of uncontrolled MNEs in similar situations.

In addition to offering two new transfer pricing options, the 1994 regulations dropped the
strict hierarchical approach to selection of a transfer pricing procedure and instead adopted
a “best-method” rule. This rule allowed an MNE to select the transfer pricing procedure that
provided the most accurate price for its unique situation.

Nevertheless, this flexibility was not a panacea because the common theme in each of these
pricing methods is a comparison to similar companies supplying similar products to
independent buyers. However, in the case of companies transferring business services or
component parts, it is frequently difficult to identify similar products and services in unrelated
companies. This is especially true in the case of components, because the policy of having
each subsidiary specialize in its most efficient activity means that many services and
components are unique to that subsidiary. To meet the taxing authorities’ rule that prices of
products and services be comparable requires that labor, materials, overhead, and profits
associated with a given product or service be compared with those provided by independent
suppliers. Such comparisons are problematic for MNEs because even if comparable
suppliers exist for “work in progress” items or services, it is unlikely that costs would be
comparable because of different methods or rates of depreciation, labor and material costs,
labor/automation mixes, and overhead bases. Furthermore, even if information on material
and labor costs was obtainable on a comparable basis, data on overhead and indirect costs
would be extremely difficult to obtain and even more difficult to compare across components
or services. Thus, the existence of a comparable situation to meet taxing requirements is
problematic.

Further, Modern manufacturing entities often operate in capital groups, and their role is
sometimes limited to the function of cost centers. From the legal point of view, however, they
are separate entities obliged to apply transfer pricing regulations. Meeting the requirements
of the arm's length principle can be very difficult at this time, given the relationships and
conflicts of interest in the capital group. Complexity increases in capital groups operating in
different countries, due to differences in tax regulations. The need to valuate the sale of
finished goods to a manufacturing entity, which is a subject to a different tax jurisdiction, may
lead to a problem of compliance with the arm's length principle. It has also been noted that
there are differences in transfer pricing regulations in different countries, for example by
analyzing Polish and Czech regulations. The lack of uniform benchmarking legislation can
cause inconsistencies in the selection of comparable data, resulting in differences in transfer
pricing.

Capital groups have various relationships. From the perspective of the dominant entity, the
individual subsidiaries can be treated simply as the responsibility centers. This is particularly
evident in vertically organized capital groups where the manufacturing entities act as toll
manufacturers or contract manufactures. The dominant position of a parent company usually
manifests in the imposition of prices in purchase or sale transactions. On the other hand,
subsidiaries are separate legal entities that are governed by the laws of the country in which
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they are located. It is clear from the case study that the problem of valuing transactions
between related entities can often be the cause of an unsolvable conflict and give rise to tax
risks for those entities in which transfer pricing is more rigorously regulated.

MARKETING IMPLICATIONS/SIGNIFICANCE

Transfer pricing is portrayed as a technique for optimal allocation of cost and revenues
amongst divisions, subsidiaries and joint ventures within a group of related entities such
practice of transfer pricing simultaneously acknowledge and include how it is deeply
implicated in process of wealth retentiveness that enable the companies to avoid taxes and
facilitate the flight of capital. Transfer pricing practices are responsive to opportunities for
determining values in way that are consequential for enhancing private gains and thereby
contributing to relative social impoverishment, by avoiding the payment of public taxes.
Transfer pricing policies are highly related to the organizational structure of the company,
characterized by degree of autonomy of divisions. There are four main reason company use
transfer pricing: Saving on taxes, Facilitating performance measurement, providing relevant
information for trade off decisions, inducing goal congruent decision. The price at which two
unrelated 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 arm’s length price, to prevent the loss of tax revenue. There are
different methods to determine the arm’s length price. They are-Resale price method, Cost
plus method, Profit split method, Transactional net margin method and any other basis
approved by the central govt. which has the effect of valuing such transaction at arm’s length
price.

As importance of the transfer pricing is increasing, it is generally considered as a major

international taxation issue faced by MNCs today. The tools is particular attractive because it
is largely invisible to the public and is difficult and expensive for regulatory authority to
detect. Transfer pricing is important to corporations because its affect calculation of
divisional, segmental, product and global profits. The reported price matter to stock markets
because they effect earning, dividend, share price and return on capital. They matter to co.
executive because there financial rewards are frequently linked to corporate earnings.
Transfer pricing matter to the state because they affect the taxes that it can levy upon
corporate profit to finance public goal to secure its legitimacy.

Transfer pricing, like science and technology, is a neutral phenomenon. It is its use or abuse
which makes it an innocuous commercial practice or a cognizable offence. Transfer pricing is
not an immoral or illegal act. It can be purely for business considerations without any
intentional or unintentional endeavor to defraud government or any concerned party.
Therefore transfer pricing is generally conceived as a permissible practice like other
administrative or commercial practices of business entities. So transfer pricing should be
treated as normal routine practice and not a tool to evade tax.

Transfer pricing is the setting of the price for goods and services sold between controlled (or
related) legal entities within an enterprise. For example, if a subsidiary company sells goods
to a parent company, the cost of those goods paid by the parent to the subsidiary is the
transfer price. Legal entities considered under the control of a single corporation include
branches and companies that are wholly or majority owned ultimately by the parent
corporation. Certain jurisdictions consider entities to be under common control if they share
family members on their boards of directors. Transfer pricing can be used as a profit
allocation method to attribute a multinational corporation's net profit (or loss) before tax to
countries where it does business. Transfer pricing results in the setting of prices among
divisions within an enterprise.
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Transfer pricing multi-nationally has tax advantages, but regulatory authorities frown upon
using transfer pricing for tax avoidance. When transfer pricing occurs, companies can book
profits of goods and services in a different country that may have a lower tax rate. In some
cases, the transfer of goods and services from one country to another within an interrelated
company transaction can allow a company to avoid tariffs on goods and services exchanged
internationally. The international tax laws are regulated by the Organization for Economic
Cooperation and Development (OECD), and auditing firms within each international
location audit financial statements accordingly.

For income tax purposes, MNCs must assign worldwide profits amid the various nations in
which they function. The ideal allocation would authorize each country to tax a correct range
of the taxpayer's whole profit while evading taxation of the equivalent income by more than
one nation. When tax rates differ across nations, transfer pricing can have a noteworthy
effect on the taxpayer's overall tax costs.

How companies used transfer pricing to its advantage:

Google

The regional headquarter of Google is in Singapore and it has a subsidiary in Australia. The
sales and marketing support services are provided by the Australian subsidiary to users and
Australian businesses and also provides research services to Google worldwide. The billing
for Australian activities is done in Singapore and the payment is received from the Google
entities.

In 2012-13 Google Australia earned $46 million as profit on revenues of $ 358 million. The
corporate tax payment was A$7.1 million, more so, as they had claimed a tax credit of $ 4.5
million.

Ms. Maile Carnegie, the Managing Director of Google Australia was asked to respond on
why Google Australia did not pay more corporate tax in Australia. She Replied by saying that
the lion’s share of the taxes was paid to the country where they were headquartered. She
was talking about the intellectual capital that Google owns which drives their business and it
was owned outside of Australia.

Google declared that it paid US$ 3.3 billion as tax globally in 2014 on revenues of US$ 66
billion. The effective tax rate came up as 19%, while the statutory federal rate of 35% applied
on Google in the US. Had Google been paying most of the tax in US, it would follow that it
was not paying much taxes on the revenues that is generated from other countries.
In 2013, in Singapore US$ 4 million was paid by Google in corporate tax on undisclosed
revenues from the Asia – Pacific countries as well as Australia. Compared to this, Google
Australia made a payment of A$7.1 million as tax, and they did not account for most of that
revenue that was booked in Singapore.

Moreover, the details of the sources of revenue that was generated from Australia was not
provided by Google.

It was seen that some of the multinational companies were involved in tax minimisation using
the tax incentives that were offered in accordance with the overseas jurisdiction to them
which led to the evasion of tax in Australia.
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Microsoft

The internal revenue system has investigated that Microsoft is using transfer pricing , among
other things or method of booking prices and sales between subsidiaries that lends to the
opportunity to report earning in lower tax jurisdiction.

Companies routinely and legally book profit overseas to avail lower tax rate and avoid hefty
35% levy on profit in the US.

Microsoft accumulated $44.8 billion non-US earning and reinvested aboard, accounting in
deferred taxes of about $14.5 billion.

Microsoft did not specify how did they employ cash earned aboard but reinvestment could be
anything from buying an office or parking money in the bank. While storing money overseas
prevented them from repatriation tax.

Microsoft stated that "primarily due to a higher mix of earnings taxed at lower rates in foreign
jurisdictions resulting from producing and distributing our products and services through our
foreign regional operations centers in Ireland, Singapore and Puerto Rico, which are subject
to lower income tax rates."

Forty-six percent (about $ 32 billion) of the total sales came from overseas in the year 2011 ,
however, pre-tax profit tripled over the past six years to $19.2 billion. In contrast, its US
earning have dropped from $11.9 billion to $8.9 billion in the same period. Thereby now 68%
of the total earning are made by from foreign earning.

Risks and benefits

However, some of the risks and benefits associated with transfer pricing are as follows:

Benefits:

1. Transfer pricing helps in reducing the duty costs by shipping goods into high tariff
countries at minimal transfer prices so that duty base associated with these
transactions are low.

2. Reducing income taxes in high tax countries by overpricing goods that are
transferred to units in those countries where the tax rate is comparatively lower
thereby giving them a higher profit margin.

Risks:

1. There can be a disagreement among the organizational division managers as what

the policies should be regarding the transfer policies.

2. There are a lot of additional costs that are linked with the required time and
manpower which is required to execute transfer pricing and help in designing the
accounting system.

3. It gets difficult to estimate the right amount of pricing policy for intangibles such as
services, as transfer pricing does not work well as these departments do not provide
measurable benefits.
 TRANSFER PRICING

4. The issue of transfer pricing may give rise to dysfunctional behavior among
managers of organizational units. Another matter of concern is the process of
transfer pricing is highly complicated and time-consuming in large multi-nationals.

5. Buyer and seller perform different functions from each other that undertakes different
types of risks. For instance, the seller may or may not provide the warranty for the
product. But the price a buyer would pay would be affected by the difference. The
risks that impact prices are as follows

 Financial & currency risk

 Collection risk
 Market and entrepreneurial risk
 Product obsolescence risk
 Credit risk

REFERENCES

1. International Revenue Service (IRS) (2013), “Development of IRC section 482

cases”, available at: www.irs.gov (accessed June 12, 2013).

2. Organization for Economic Co-Operation and Development (OECD) (2013), Serves

as a reference for multinational executives not covered by the IRS, available at:
www.oecd.org (accessed June 2013).

3. Transfer Pricing: Conceptual Thoughts on the Nature of the Multinational Firm;

Markus Brem and Thomas Tucha, VIKALPA • VOLUME 31 • NO 2 • APRIL - JUNE
2006

4. Transfer Pricing: Impact of Taxes and Tariffs in India, VIKALPA • VOLUME 37 •

NUMBER 4 • OCTOBER - DECEMBER 2012

5. Journal of Management Development, An introduction to transfer pricing, Yair

Holtzman & Paul Nagel, 2014

6. Management control in multinational companies: a systematic literature review

Martina Sageder & Birgit Feldbauer Durstmuller, Springer, 2018

7. Integrating Transfer Pricing Policy and Activity-Based Costing Thomas H. Stevenson

and David W.E. Cabell, Journal of International Marketing Vol. 10, No. 4, 2002, pp.
77–88

8. Conflicting Transfer Pricing Incentives and the Role of Coordination, JENNIFER L.

BLOUIN, LESLIE A. ROBINSON, JERI K. SEIDMAN, Contemporary Accounting
Research Vol. 35 No. 1 (Spring 2018) pp. 87–116

9. Knocking on Tax Haven’s Door: Multinational Firms and Transfer Pricing, Ronald B
Davies, Julien Martin, Mathieu Parenti, Farid Touba, Econstor, Working Paper Series,
No. 14/21

10. Dilemmas of transfer pricing comparability analysis in manufacturing entities. Polish-

czech case study, aleksandra sulik-górecka, Management Systems in Production
Engineering, 2018, Volume 26, Issue 2, pp 76-82