INTRODUCTION
A transfer price is the rate at which one party buys and sells supplies or services or shares funds with a related associate in its supply chain. It rules in most nations stands on arms length principle that is to set up TP based on study of price in comparable transactions between two or more unrelated parties trading at arms length.
Transfer price rules commonly provide companies with the flexibility to set the situation surrounding intercompany transactions.
OECD Transfer Pricing Guidelines state, Transfer prices are significant for both taxpayers and tax administrations because they determine in large part the income and expenses, and therefore taxable profits, of associated enterprises in different tax jurisdictions.
Uses of Transfer Pricing
TRANSFER PRICING MANIPULATION
1. Reduce Taxes
MNCs can reduce tax liability by TP
Eg. Parent Co. - A Subsidiary co. B
B buys goods at $100 each from A, packages it and exports back to A at $200 each. Profit= $100 each A getting each good at $200 & sells it at $300 thereby making profit = $100 each The overall profit is $100 in host country & $100 in home country.
Suppose Bs tax rate is 20% and As tax rate is 60% Subsidiary co. B pays tax of $100*20%= $20 whereas A pays $100* 60%= $60. Total tax = $80. This saved tax of $40 and generates after tax profits equal to $120(200-80) instead of $80(200-120).
2. REDUCE TARIFF COSTS Tariffs are additional costs imposed on goods and services imported to a country. Management can minimize import duties paid by setting transfer prices as low as possible. Tariffs are levied on the transfer prices selected and are deductible expenses in figuring the branches income taxes.2.
3. CONFLICTS IN JOINT VENTURE Conflicts over TP arise when one of the affiliates involved is owned jointly by one or more partners. The outside partners are suspicious that that TP is used to shift profits from JV, where they must be shared, to a wholly owned subsidiary. Continuing disputes may still arise over the pricing of new products introduced to an existing venture.
4. DISGUISING PROFITABILITY Many less-developed countries(LDCs) erect high tariff barriers to bring focus to local industries. In such situation,MNCs can use TP (buying goods from sister affiliates at a higher price) to disguise the true profitability of its local affiliate, enabling it to justify higher local prices. Lower reported profits also may improve a subsidiarys position in wage negotiations. To avoid this, several international unions ask for full disclosure of accounts of MNCs worldwide.
5. EVALUATION & CONTROL TP adjustment distorts the profits of reporting units & creates potential difficulties in evaluating managerial performance. Also, managers evaluated on the basis of these reported profits may have an incentive to behave in ways that are sub optimal for the corporation as a whole.
TRANSFER PRICING PROCESS
The Transfer Pricing Process is all about treating transfer pricing and corresponding business risks as a business process. The input in this process is the way you run your business The output is a manageable and defensible transfer pricing system. The system allows you to link how you operate your business to a transfer pricing system that works from an operational perspective and that is in compliance with the local tax rules.
The steps of the Transfer Pricing Process:
Identify business context: Identify where your company makes money in your industry. For example, is it through the production activity itself or the brand you have developed? Design and implementation: Design an appropriate transfer pricing system and allocate an appropriate operating margin to the contributors in your value chain. Documentation: Capture the information (Step 1) and system you have designed (Step 2) on paper. - Helps in meeting documentation requirements in a certain tax jurisdiction - Support transfer pricing policy, capturing this information also allows you to have a point of reference when there are changes in your business that may create a need to review and perhaps change the transfer pricing system. Transfer pricing controversy/dispute resolution: Defending your transfer pricing system to all stakeholders, e.g. management, external auditors and the tax authorities. Avoiding disputes through the use of Advanced Pricing Arrangements (APAs) might be a good alternative to dispute resolution when a taxpayer is already under a tax audit.
OECD Specific Tax Rules regarding Transfer Pricing
ORGANISATION FOR ECONOMIC COOPERATION AND DEVELOPMENT (OECD)
Its an International Economic Organisation of 34 countries. founded in 1961 It is a forum of countries committed to democracy and the market economy providing a platform to compare policy experiences, seek answers to common problems, identify good practices, and co-ordinate domestic and international policies of its members.
AIM OF OECD
Its AIM is to cover covers economic, environmental, and social issues. It acts by peer pressure to improve policy and implement "soft law"non-binding instruments that can occasionally lead to binding treaties.
Impact of the OECD Tax Co-operation with India
The OECD engagement with India in the tax field had a humble beginning in 1990s. The co-operation between the OECD and India in addition to tax covers diverse fields such as trade, development, investment, energy, money laundering and other areas. India is working with the OECD in other projects like Forum on Tax Administration, Oslo Dialogue on Tax and Other Crimes, Network on Fiscal Relations across Levels of Government and Advisory Group for Cooperation with Non-OECD Economies.
India has recently signed and ratified the Convention on Mutual Administrative Assistance in Tax Matters which was developed by the OECD and Council of Europe. This is done with a broader multilateral approach to improve tax cooperation between the countries.
Since 2000, the OECD has delivered around 30 bilateral and multilateral technical events in India. These have provided a platform for Indian tax administrators to learn and discuss practical solutions to challenges faced by them.
The OECD has been very active in building capacity of tax administration in India, particularly in the fields of transfer pricing and international taxation.
COST PLUS METHOD
In this method, first the cost incurred by the supplier of goods or service is determined. An appropriate cost plus mark-up is then added to the cost so as to arrive at an appropriate profit in the light of the functions performed and market conditions. Thus, the result would yield the arms length price. This method relies upon two mark ups- one, achieved by the controlled supplier on its cost, and the other, by uncontrolled entities on their costs with respect to comparable transactions. Adjustments need to be accordingly made with regard to costs and expenses (operating and non-operating inclusive of financial expenditures).Thus, CPM involves the comparability of gross margins earned by suppliers in uncontrolled transactions.
COMPARABLE UNCONTROLLED PRICE METHOD
This method compares the price charged for property or services transferred in a controlled transaction to the price charged for property or services transferred in a comparable uncontrolled transaction in comparable circumstances. CUP method is the most direct and reliable way to apply the arms length principle, and hence, the same is preferable over all other methods wherever it is possible to locate comparable uncontrolled transactions.
RESALE PRICE METHOD
The price at which property purchased or services obtained by the enterprise from an associated enterprise is resold or are provided to an unrelated enterprise, is identified; The resale price is reduced by the amount of a normal gross profit margin accruing to the enterprise; The price so arrived at is further reduced by the expenses incurred by the enterprise in connection with the purchase of property or obtaining of services; The price so arrived at is adjusted to take into account the functional and other differences, including differences in accounting practices, if any, between the international transaction and the comparable uncontrolled transactions; The adjusted price arrived at under sub-clause (iv) is taken to be an arms length price in respect of the purchase of the property or obtaining of the services by the enterprise from the associated enterprise;
PROFIT-SPLIT METHOD
This method applies where there are multiple transactions which are inter-related and cannot be evaluated separately for the purpose of determining arms length price of any one transaction.
This method identifies the profit to be split between the associated enterprises on the basis of functions performed, assets employed or to be employed and risks assumed by each enterprise. Such contribution is valued to the extent possible by any available external data which may include profits split percentages or returns observed among independent enterprises with comparable functions.
TRANSACTIONAL NET MARGIN METHOD
It compares the net profit margin of a taxpayer arising from a non-arm's length transaction with the net profit margins realized by arm's length parties from similar transactions; and examines the net profit margin relative to an appropriate base such as costs, sales or assets.
Advance Pricing Agreements (APA)
WHAT IS APA?
APAs are arrangements that determine appropriate set of criteria for determination of the transfer price for related transactions over a fixed period of time. Generally, they are based on transfer pricing documentation prepared by the taxpayer and presented to the government(s) Under an APA, the taxpayer and one or more governments agree on the methodology used to test prices
Contd.
APA covers many different types of international dealings like: - Between Related parties - Including transfers of tangible or intangible property - Services - Cost contribution - Global trading - Profit attribution - Global manufacturing
APA programs are designed so that taxpayers can willingly determine real or possible TP disputes in an honourable, supportive manner, as an option to the traditional assessment process. The potential nature of APAs supply taxpayers greater confidence concerning their TP methods, and support ethical resolution of transfer pricing issues before positions become well-established.
While "advance" agreements, APAs frequently engage declaration of pending transfer pricing issues from previous years.
In some cases, APAs can give a successful means for settle existing transfer pricing audits or adjustments.
As an effect, they ease the possibility of risk and assist the financial reporting of possible tax liabilities.
TYPES OF APAs
BI- OR MULTILATERAL APA: includes agreements between the taxpayer and one or more foreign tax administrations, thereby specified in income tax treaties. It is binding on the tax authorities and the tax administration of another countries. It is general policy to "encourage" taxpayers to seek bilateral or multilateral APAs where competent authority provisions exist.
Contd.
Bilateral agreements are more preferred by major countries as they: - reduce the risk of double taxation - Equitable to all tax administrations and taxpayers - Provides greater certainty to the taxpayers
Contd.
UNILATERAL APA: Concluded between the tax authorities and a taxpayer, but does not guarantee the agreement of the other tax administration. They are not recognised by a foreign tax authority, so the risk of double taxation still exists. Therefore, bilateral and multilateral APAs substantially reduce or eliminate the possibility of juridical or economic double or non-taxation.
Transfer PricingLAWS
NEED FOR RULES
Increasing participation of multi-national groups in economic activities in India has given rise to new and complex issues emerging from transactions entered into between two or more enterprises belonging to the same group.
Need to introduce a uniform and internationally accepted mechanism of determining reasonable, fair and equitable profits and tax in India in the case of such multinational enterprises.
INTRODUCTION TO LAW
The Finance Act, 2001 introduced law of transfer pricing in India through sections 92A to 92F of the Indian Income-tax Act, 1961 which guides computation of the transfer price and suggests detailed documentation procedures.
This law aims to provide an overview on the applicability of transfer pricing regulations in India, methods of determining the transfer price and the documentation procedures.
SCOPE & APPLICABILITY OF THE LAW
Transfer Pricing Regulations (TPR) are applicable to the all enterprises that enter into an 'International Transaction' with an 'Associated Enterprise'. Associated Enterprise- means an enterprise (a) which participates, directly or indirectly, or through one or more intermediaries, in the management or control or capital of the other enterprise; or (b) in respect of which one or more persons who participate, directly or indirectly, or through one or more intermediaries, in its management or control or capital, are the same persons who participate, directly or indirectly, or through one or more intermediaries, in the management or control or capital of the other enterprise.
DETERMINING ALP
The price at which two parties would agree to a transaction is known as ARMS LENGTH PRICE. All income acquired by the company by means of any international transaction shall be calculated at arms length price. There are various methods to calculate the arms length price, depending on the nature and type of the transaction, the nature of the group or the association involved, or any other features of the transactions involved.
DOCUMENTATION
A description of the ownership structure of the enterprise and details of shares or other ownership interest held therein by other enterprises; A profile of the multinational group of which the taxpayer is a part and the name, address, legal status and country of tax residence of each of the enterprises comprised in the group with whom international transactions have been made by the taxpayer and the ownership linkages among them; A description of the functions performed, risks assumed and assets employed or to be employed by the taxpayer and by the associated enterprise involved in the international transaction;
Cont
A description of the methods considered for determining the arm's length price in relation to each international transaction or class of transaction, the method selected as the most appropriate method along with explanations as to why such method was so selected, and how such method was applied in each case; The assumptions, policies and price negotiations if any which have critically affected the determination of the arm's length price ; Published accounts and financial statements relating to the business of the associated enterprises; Letters and other correspondence documenting terms negotiated between the taxpayer and associated enterprise;
BURDEN OF PROOF
The primary burden is on the taxpayer to determine an ALP in accordance with the TPR and to substantiate the same with the prescribed documentation. One of the conditions to be fulfilled for discharging this burden by the taxpayer is maintenance of prescribed information and documents in respect of an international transaction entered into with a associated enterprise. The tax officer may reject the ALP adopted by the assesse and determine the ALP in accordance with the TPR.
PENALTIES
Penalties have been provided as a disincentive for non compliance with procedural requirements are as follows: (a) Penalty for Concealment of Income - 100 to 300 percent on tax evaded (b) Failure to Maintain/Furnish Prescribed Documentation - 2 percent of the value of the international transaction (c) Penalty for non-furnishing of accountants report - INR 100,000 (fixed)
