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Transfer pricing

Introduction

Today’s organizational thinking is oriented towards decentralization. One of
the principal challenges in operating a decentralized system is to devise a
satisfactory method of accounting for the transfer of goods and services from
one profit center to another in companies that have a significant amount of
these transactions. When two or more profit centers are jointly responsible
for product development, manufacturing, and marketing each should share
in the revenue that is generated when the product is finally sold. The
Transfer price is the mechanism for distributing this revenue. The transfer
price is not primarily an accounting tool; rather, it is a behavioral tool that
motivates managers to make the right decisions. Decentralization means the
freedom to make decisions. Decentralization can transform a profit center
into an investment center. Centralization can transform an investment
center into a profit center or transform a profit center into a cost center.

Research objectives

 To understand the concepts of Transfer Pricing

 To understand the need & importance of Transfer Pricing

 To deeply understand various Transfer Pricing Methods & their
application

 To be able to successfully prepare a Transfer Pricing Memorandum.

Research analysis

Transfer Prices

A transfer price refers to the price used for intra-company transfers, i.e.,
transfers between segments of a company. The term transfer pricing
normally means pricing transfers between divisions, but could be used in any
situation where the output of one segment (e.g., department, operation,
process) becomes the input for another segment within the same company.

Three Decisions

A transfer pricing situation usually involves three questions or decisions.

Intra-company profits included in a transfer price make it impossible for the buying division to answer the make or buy question. If the answer to question one is yes. Remember.e. The key is which costs will be different under the two alternatives. make inside and transfer. For profit centers. To aid in Evaluating Division Performance. If the divisions are treated as investment centers. it is also an ingredient in motivating effort. i. Should the company make the item or outsource. Should the central office interfere in establishing the transfer price? Objectives of Transfer Prices The overall objective is to establish a transfer price that will motivate effort and goal congruence. investment centers or profit centers. if a single buyer or seller cannot affect the price. then Return on Investment (ROI) and Residual Income (RI) are the relevant measurements. Generally intra-company transfers at market prices accomplish objectives 1 and 2. 2.. i. 1. Market prices: A market price is considered best if the market is perfectly competitive. but . however. contribution margin. To maintain Division Autonomy. 1. Possible Transfer Prices 1. or buy from outside the company? 2.e. i.e. To provide the buying segment with the information necessary for the make or buy question. or net income would be a more appropriate measurement. segment margin. purchase it on the outside market? This is a relevant cost problem (also referred to a differential or incremental cost). Managers may exert considerable effort in pursuing their own goals that conflict with the goals of the firm. that effort and goal congruence are different.. then what transfer price should be used? 3. There are at least three underlying objectives. Central office interference in a transfer pricing dispute will affect autonomy and effort. Should the transfer take place? This is essentially a (Make or Buy) question.. The dilemma is that goal congruent behavior may not be obtained with or without interference.e. Since autonomy means decentralization and freedom to make decisions. i.. 3.

the cost of inefficiency will be passed along to the buying division. selling and administrative costs are included. Standard cost plus would be better than actual cost plus to motivate the seller to be an efficient cost producer. e. Full Cost Plus: All manufacturing. The selling division could not be evaluated as a profit center or investment center since it is treated as a cost center. as an outside supplier. selling and administrative costs plus a markup for profit. c. Motivation for over allocation is still present. credit etc. . Unfortunately. A market price may not be relevant because the selling division would not have the same transportation cost. If actual costs are transferred. 3. c. Thus. Transfers at standard could motivate the seller to rig the standard. Price quotations may not be reliable because they are based on temporary distress or dumping conditions. The buyer would not have the differential cost information needed for the overall firm make or buy decision. accounting cost for A/R. standard costs make better transfer prices although standards may be rigged. Transfer prices based on full cost do not accomplish any of the objectives stated above. The problems that occur when full cost is used as a transfer price include: a. 2. or extra services provided. Most markets are not perfectly competitive. In other words. The same problems in 2 are applicable here. Market prices may not exist for some products. b. several problems occur when trying to use market prices: a. the demand curve and price structure may shift if the firm buys outside. b. A market price may not be comparable because of differences in quality. Information for the make or buy decision would not be available to the buying division.not 3. The seller would be motivated to over allocate cost to the product transferred. d. f. credit terms. d. The irrelevant (mostly common fixed cost) of the seller become relevant cost to the buyer. Full cost: All manufacturing.

There is no external market) for the product. b.e. 6. In these cases the buyer and seller may negotiate a price that allows both parties to share in the benefits of the transfer. but not 3. thus no market price. to determine the appropriate market price.. 5. c. 7. Dual Price: Use two transfer prices. Charge the difference to a central account. Very General Rule: Optimum Price = Additional Outlay Cost + Opportunity Cost Opportunity Cost = Market Price .. since variable cost may approximate differential cost. Objectives 1 and 2 would not be fully obtained. thus the transfer becomes a differential cost problem to the seller. This may come close to accomplishing objective 3. lack of motivation for profits. but charge the buyer with variable cost (i. . approximate differential or additional outlay cost). The seller has excess capacity).e.Additional Outlay Cost Opportunity Cost is the contribution margin that the seller would earn if the product could be sold on the outside market. Variable cost plus: This may be a little better than 4. It should be noted however. Any transfer price above the seller's differential cost would benefit the seller. i. Variable cost: All variable manufacturing. This approach may not motivate either the seller or the buyer to be efficient. but the plus should be kept separate to allow for a ball park make or buy decision. selling and administrative costs. Objectives 1 and 2 would not be obtained since the other problems listed under 2 and 3 are applicable here. potential for cost over allocation etc. A problem with this approach is that managers may spend a substantial amount of time and effort negotiating transfer prices. This may accomplish objectives 1 and 2. An imperfect market exists for the product making it difficult. that variable cost and differential cost are not the same since some fixed cost may also be relevant. if not impossible. change if the product is purchased outside rather than produced inside. Negotiated price: Negotiated prices may be best if: a. Give the seller credit for selling at market price or full cost plus a reasonable markup.4.

Profit is the most commonly acceptable measure for evaluation of Branch performance. it is argued that the seller should transfer the product at cost. productivity and efficiency of the Branches. are not truly and entirely independent commercial units. When the concept of ‘profit centre’ is being applied the significance of the methodology involved in ascertaining the profits gains prominence for the management control system.e. size. there has been a marked shift in the measures used for evaluating the bank branches. Though branches are identified to be of deposit intensive.. As the branches of a Bank. cannot sell additional units on the outside market. Transfer price. then the seller's opportunity cost is zero. differential cost. In the light of the above. in the context of banking sector. Transfer Pricing Mechanism in Banks Of late. Maximum Price = Market Price Minimum Price = Additional outlay cost.e. i. in reality. a problem without a definitive answer. is the interest charged by the surplus funds branch to the deficit funds branch on the transferred funds.. it is difficult to determine the real profitability of such branches with the help of existing systems that are less transparent. A problem may arise however. advances intensive and ancillary business intensive for administrative convenience there are other material factors like the location.If the seller has excess capacity. Thus. and the nature of clientele that impinges on the performance of the branches. since the seller has no incentive to produce the extra product. i. To what extent profit is a good indicator of viability of the branches depends upon how independent the branches are in the commercial sense. From deposit mobilization criterion the emphasis is now being turned on to the profits made by the bank branches. the present study probes into various modalities of Transfer Pricing Systems and suggests a suitable mechanism so as to reflect the true profitability. Transfer pricing is a classic catch-22 situation. . less accurate and having weak linkage with the overall costing and pricing structure of business/products.

the funding for this loan has to come from one source or another. all lending branches are not uniform in terms of yield on advances since it depends on sectoral deployment and quality of lending. . and. It is a fact that the deposit mix is favorable (low cost deposits) with respect to Metro/Urban branches where as depositors of Rural and Semi-urban branches tend to keep their deposits in Term deposits. This has effect on branch profitability. When a bank makes a loan to a customer. the yield on advances at Metro/Urban branches is higher when compared to rural and Semi-Urban branches. as it would look in a typical income statement analysis. Deposit oriented Majority of bank branches comes under this category. 2. This type of funding is normally the cheapest and most desirable. Therefore. when deposits are not sufficient to fund all the needs for cash that the bank has. It speaks that the lending activity is considered as centralized activity and the lending of top 10% branches constitutes 80% of lending. each deposit brought in to the bank has a value to the financial institution for funding purposes. Though 80% of branches are acting as deposit-pooling centers all branches are not uniform in terms of deposit mix. Advance oriented Though the branches are independent units in terms of accepting deposits and lending funds. This process is usually handled using an FTP system. The purpose of FTP is to place a value on each deposit and assign a cost to each loan that a bank has. However. the funding in a financial institution will come from deposits collected by the bank. Typically. however. Obviously. a loan also has an underlying cost of funds and is not just interest income for the bank. Fund Transfer Pricing (FTP) In the banking industry. the deposits are collected by one branch and used by another to fund loans. by the same token. the CD ratio is below 25% in many of the bank branches. the bank will have to get additional funding in the wholesale market.The bank branches are identified into two: 1.

Many banks in the past used United States Treasuries as their funding curve. Once all the data is input into the FTP system. The funding curve for a financial instrument shows the relationship between time to maturity and interest rate. This may be done monthly. many banks have switched to the LIBOR/Swap curve. In the past. for loans. the government has dropped some buckets from its information. Next. a 5 year fixed rate note will be assigned a different rate than a 5 year variable rate note. a deposit that has a longer maturity would be assigned a higher funding rate credit because the bank is guaranteed the use of these funds for a longer period of time. Today. This is an assumption that is based on looking at historical trends in the bank. however. One such characteristic is a prepayment option on a loan. Large amounts of data must be stored and many calculations must be made for an FTP system to provide useful information for management. each loan or deposit that the bank has is assigned a rate based upon this adjusted funding curve. the higher the rate to fund that loan. By the same principle. Other unique characteristics of a loan will cause the rate assigned to it to vary. Using FTP to measure Branch Profitability . One characteristic that will cause a rate to change is time to maturity.When implementing an FTP system. But recently. Therefore. enabling the appropriate levels of contract-level detail handling and providing the ability to analyze data across any number of dimensions in ad hoc fashion. A prepayment option will change the average expected life of the loan. management will have to decide how often the rates will be assigned. banks' must determine a "funding curve" that most reflects their source or use of funds on the wholesale market. For instance. Many banks make adjustments to these curves to customize the curve to fit the banks unique lending environment. such technology is available. the longer the term is to maturity. The rate that is assigned to these customer relationships will vary based upon the characteristics of the relationship. weekly or sooner depending on the capabilities of the system and the needs of management for decision making. Also. the technological hardware and software used within banks were not of sufficient power or flexibility to handle the data volumes involved or provided the analytical capabilities demanded.

it also does not take into account that a loan has an underlying funding cost associated with the process of making the loan. The firm's strategy is to shift income from the high tax country to the low tax country. Therefore. interest collected from loan payments are shown as interest income and interest paid out on deposits are shown as interest expense. while others are heavy on the deposit side and still others are fairly evenly balanced. it would be in the company’s interest if most of the profits were allocated to the division operating in the low taxation country. Some branches are heavy on the loan side. while a branch that is heavy on the loan side will look like it is highly profitable. This is also true of calculating the net interest income of branches for comparative purposes. Additional Problems with Multinational Transfer Pricing 1. Conversely. When the supplying and the receiving divisions are located in different countries with different taxation rates. Foreign Laws preventing income and dividend repatriations. Looking at an income statement for a branch using a typical accounting analysis. then transfers would be made at the lowest cost possible. Determining the profitability of individual branches in a traditional accounting sense is extremely difficult. a branch that is heavy on the deposit side will look like it is losing money. Branches within a bank are almost never the same in terms of loans and deposits. But this does not take into account that deposits have a positive value to the bank by providing cheap funding for its loan purposes. Taxes rates in different countries. 2. .Financial Institution's income statement is designed to calculate net-interest income for the entire organization. International Transfer Pricing: International transfer pricing is concerned with the prices that an organisation uses to transfer products between divisions in different countries. using a typical income statement format. The rise of multinational organisation introduces additional issues that must be considered when setting transfer prices. and the taxation rates in one country are much lower than those in the other. If the buying division is in a low tax country. It is not designed to calculate the net- interest income of one product. If the seller is in a low tax country transfers would be made at high prices.

With a view to provide a detailed statutory framework which can lead to computation of reasonable. 2002 provides that any income arising from an international transaction or where the international transaction comprise of only an outgoing. the Finance Act. Transfer Pricing Law in India Increasing participation of multi-national groups in economic activities in the country has given rise to new and complex issues emerging from transactions entered into between two or more enterprises belonging to the same multi-national group.O. Transfers from the foreign division would be made at low prices. then transfers of products to the buyer would be made at high prices.8. The provisions. relating to computation of income from an international transaction having regard to the arm’s length price. in the case of such multinational enterprises. 2001 substituted section 92 with a new section and introduced new sections 92A to 92F in the Income-tax Act. Specified methods are as . Section 92: As substituted by the Finance Act. however. The arm’s length price shall be determined by one of the methods specified in Section 92C in the manner prescribed in Rules 10A to 10C that have been notified vide S.If there are restrictions on the buying division payments of dividends and transfers of income to the central office. meaning of information and documents by persons entering into international transactions and definitions of certain expressions occurring in the said section. the allowance for such expenses or interest arising from the international transaction shall be determined having regard to the arm’s length price. would not be applicable in a case where the application of arm’s length price results in decrease in the overall tax incidence in India in respect of the parties involved in the international transaction.2001. which is the price that would be charged in the transaction if it had been entered into by unrelated parties in similar conditions. Arm’s length price: In accordance with internationally accepted principles. it has been provided that any income arising from an international transaction or an outgoing like expenses or interest from the international transaction between associated enterprises shall be computed having regard to the arm’s length price. fair and equitable profits and tax in India. 808 E dated 21. meaning of associated enterprise.

and control over various components of the business activity performed by the taxpayer such as control over raw materials. Profit split method or Transactional net margin e. sales and intangibles. method. at the option of the assessee. International Transaction: Section 92B provides a broad definition of an international transaction. The concept of control adopted in the legislation extends not only to control through holding shares or voting power or the power to appoint the management of an enterprise. but also through debt.follows: Comparable uncontrolled price a. but such selection has to be made taking into account the factors prescribed in the Rules. blood relationships. With a view to allow a degree of flexibility in adopting an arm’s length price the provision to sub-section (2) of section 92C provides that where the most appropriate method results in more than one price. . c. At least one of the parties to the transaction must be a non-resident. The enterprises will be taken to be associated enterprises if one enterprise is controlled by the other. Cost plus method. method. or in the provision of services. b Resale price method. a price which differs from the arithmetical mean by an amount not exceeding five percent of such mean may be taken to be the arm’s length price. The definition also covers a transaction between two non- residents where for example. which is to be read with the definition of transactions given in section 92F. one of them has a permanent establishment whose income is taxable in India. or both enterprises are controlled by a common third person. whether tangible or intangible. lending of money etc. An international transaction is essentially a cross border transaction between associated enterprises in any sort of property. The taxpayer can select the most appropriate method to be applied to any given transaction. d. Associated Enterprises: Section 92A provides meaning of the expression associated enterprises.

after giving the assessee an opportunity of being heard and after making enquiries. with the prior approval of the Commissioner. the arm’ s length price determined by the assessee and the method applied in such determination. or the terms of the relevant transaction are determined by the associated enterprise. It also requires an opinion as to whether the prescribed documentation has been maintained. the AO may. Section 92CA provides that where an assessee has entered into an international transaction in any previous year. The Transfer Pricing Officer means a Joint Commissioner/Deputy Commissioner/Assistant Commissioner authorized by the Board to perform functions of an AO specified in section 92C & 92D. of section 92B extends the scope of the definition of international transaction by providing that a transaction entered into with an unrelated person shall be deemed to be a transaction with an associated enterprise. . if there exists a prior agreement in relation to the transaction between such other person and the associated enterprise. The Board has also been empowered to specify by rules the period for which the information and documents are required to be retained. Section 92E provides that every person who has entered into an international transaction during a previous year shall obtain a report from an accountant and furnish such report on or before the specified date in the prescribed form and manner. The Transfer Pricing Officer. refer the computation of arm’s length price in relation to the said international transaction to a Transfer Pricing Officer. The documentation should be available with the assessee by the specified date defined in section 92F and should be retained for a period of 8 years. The AO shall then compute the total income of the assessee under sub-section (4) of section 92C having regard to the arm’s length price determined by the Transfer Pricing Officer. The accountants report only requires furnishing of factual information relating to the international transaction entered into. shall determine the arm’s length price in relation to the international transaction in accordance with sub-section (3) of section 92C. 3CEB have been notified in this regard. Further. Rule 10E and form No.Sub-section (2). Documentation: Section 92D provides that every person who has undertaken an international taxation shall keep and maintain such information and documents as specified by rules made by the Board. The documentation has been prescribed under Rule 10D.

Section 92 of the Act requires that the income arising from an international transaction shall be computed having regard to the arm’s length price. is a wholly owned subsidiary of ABC & Co. Understanding Transfer Pricing Mechanism through the example of a ABCIPL India ABC Investment Private Limited(‘ABCIPL India’) engaged the services of the firm to prepare the transfer pricing review memorandum (‘the memorandum’) documenting the review of the arm’s length nature of its international transactions with its AEs during FY 2009-10. 1 To prepare the memorandum. established in 1975. corporations. the income of the other associated enterprise shall not be recomputed by reason of such determination of arm’s length price in the case of the first mentioned enterprise. It provides customized asset management services and products to governments. The second provision to section 92C(4) provides that where the total income of an enterprise is computed by the AO on the basis of the arm’s length price as computed by him. ABC Investment Management Inc.The first provision to section 92 C(4) recognizes the commercial reality that even when a transfer pricing adjustment is made under that sub-section the amount represented by the adjustment would not actually have been received in India or would have actually gone out of the country. from an Indian transfer pricing perspective. even if not actually deducted under the provision of chapter VIIB on the amount paid by the first enterprise to the other associate enterprise. read with Rules 10A to 10E of the Rules. Therefore no deductions u/s 10A or 10B or under chapter VI-A shall be allowed in respect of the amount of adjustment. high net worth individuals and retail investors worldwide. the firm interviewed ABCIM’s personnel and 1 . (‘ABCIM Inc’). pension funds. non-profit organizations. It is an asset management company in the mutual funds and funds management industry in the United States of America. The firm prepared the memorandum in accordance with the Indian transfer pricing provisions contained in sections 92 and 92A to 92F of the Act. In reviewing the international transactions useful inferences have been made from the OECD Guidelines and Guidance Note. where the tax has been deducted or such tax was deductible.

We present below. the relevant details of the international transactions undertaken between ABCIM and its AEs and the transfer pricing method identified as the most appropriate method. In attempting to determine an arm’s length outcome for international dealings between associated enterprises. 2 . we have considered financial data for both the earlier year’s i. The audited financial data for financial year 2008-09 in the case of several comparables is not available in the public domain at the time of conducting the comparables search. In the above example we find the detailed analysis of how transfer pricing mechanism works in the company after comparing the arm’s length price through the transactions it performs all throughout the world. in our view. the use of a three-year comparable data would assist in minimizing the impact of abnormal factors on the outcomes of the comparable data so far as relevant because of their influence on the determination of transfer prices. The research process consisted of comparison of multiple year data. The data of the two immediately preceding years gives a clear indication of the business and economic conditions prevailing at the beginning of the relevant financial year i.49 to 1. In applying multiple-year data. the time when the transfer prices were set up. inferences have been drawn from the OECD Guidelines on Transfer Pricing [Paras 1.e.51].reviewed various documents2 and financial data provided by the ABCIM. In view of the aforesaid.e. The basic transfer pricing mechanism is followed everywhere whereby the selection of the appropriate method is of the utmost importance right at the beginning. not the effects of non-arm’s length dealings. The purpose of using multiple-year data is to ensure that the outcomes for the relevant year are not unduly influenced by abnormal factors. and therefore differences between dealings may reflect differences in circumstances. the results of any one-year may be distorted by differences in economic or market conditions and the features and operations of the enterprise affecting the controlled or uncontrolled dealings. financial years 2006-2007 and 2007-2008 as well results for financial year 2008-09 where available. Thus. Participants in an industry may not be uniformly affected by business and product cycles.

Conclusion We compared the NCP that ABCP derived from its provision of investment advisory services function to the arm’s-length results achieved by independent companies that perform functions similar to those of ABCP. as far as possible. should.In view of the above. for certain comparable companies.28 percent to 81. ABCP earned an NCP of 40 percent. Documents of to be kept Rule 10D has prescribed an illustrative list of information and documents and the supporting documents required to be kept and maintained by the assessee entering into an international transaction. therefore the usage of comparable data only for the FY 2008-09 would have rendered the analysis less reliable. Based thereon. ABCP’s international transaction with AEs related to the provision of investment advisory services is consistent with the arm’s length standard from an Indian transfer pricing regulations perspective. The three-year weighted average NCP earned by broadly comparable independent companies range from (-) 1. The information and documents specified shall be kept and maintained for a period of nine years from the end of the relevant financial year. . be contemporaneous and should exist latest by the specified date. their data for FY 2008-09 was not available in public domain at the time of preparing the memorandum. Application of Research The research process performed in this project is essential to understand the transfer pricing mechanism and the selection and use of the appropriate techniques for different companies across different sectors of the economy. we used the comparable data for FY 2008-09 and the two previous years as it assist in minimizing the impact of abnormal factors on the determination of the arm’s length prices.54 percent. However this mandatory documentation requirement is applicable only in a case where the aggregate value of the international transactions entered into by the assessee as recorded in the books of account exceed one crore rupees. (Refer Appendix B) which falls above the arithmetical mean of the NCPs of the comparable companies. Moreover. The information and documents specified. For the year ended FY 2008-09.84 percent with an arithmetical mean of 31.

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