INTERNATIONAL

TRANSFER PRICE
Tax Evasion Vs. Tax Planning
What is Transfer Price
• Transfer price is the price at which an MNC sells goods to an
associate concern.
• It can be used as a tool to allocate profit amongst the
associated firms, so as to minimise the incidence of the tax.
• Tax structures in different countries are different which
include
– the rates of tax on the profits earned,
– benefits of tax holidays,
– rebates and concessions,
– permissible/ deductible expenditure,
– recognition of income etc.
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MNCs Vs Domestic Firms
• MNCs usually have a control of supply chain in
the manufacture of a product where the output
of one becomes the input for another
enterprise.
• MNCs have extra leverage to adjust the profits
of each firm in the group to a certain extent,
through the mechanism of transfer price which
domestic firms do not have.

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How Transfer Price Works
1. Country A supplies material at cost lower than fair price
reducing its profit being taxed at higher rate.
2. Country B receives material from Country A at lower cost
increasing profit, and therefore paying taxes at lower rate.
Firm in Associated Firm in
Country A Country B

• High Tax Rate • Low Tax Rate

• Transfer Profit • Transfer Profit
from High Tax to Low Tax
Jurisdiction Jurisdiction

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How Transfer Price Enriches
Shareholder
Savings in tax will increase the cash flows to the MNC in
aggregate and hence increase valuation.
These savings in tax would accrue to shareholders of the
parent, at the cost of revenue lost by the government.
• If Country B also happens to impose lower tariff
there is added advantage in reducing the price.
• Besides tax evasion (planning) the tool of transfer
pricing can also be used for money laundering too.

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OECD and Transfer Price
• At what price the firm supplies to its associate in
another country is the prerogative of the parent firm,
and perhaps cannot be challenged.
• The fairness of the price is difficult to establish
• This is a global concern and more so for developed
economies where MNCs belong to.
• OECD has done some pioneering work related to
fairness of the transfer price, and has provided a
framework to establish fairness of price, referred as
“Arm’s Length Price”.
• OECD does not have any jurisdiction over any country
and hence each member country must pass the
relevant laws conforming to the OECD guidelines.
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India and Transfer Price
• Section 92 of Income Tax Act dealt with the issue of transfer
pricing. It empowered the department to determine
“reasonable profit” and the “connected enterprises”. Both
the issues remained undefined.
• Finance Act 2001 clarified the issue in detail.
• A need was felt for a detailed and separate regulation for
administering transfer pricing with globalisation of Indian
economy. Absence of such regulations
– results in litigation and loss of revenue to the exchequer.
– India was losing its legitimate share of revenue.

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Issues in Transfer Price
There are three issues in the transfer pricing:
1. What kind of transactions need to be covered by transfer
pricing regulation.
Transaction in revenue account and capital account.
2. How to determine/establish the connection (related
party)?
Parameter to establish who influenced the price?
3. How to determine the fair price of the goods traded
amongst the related parties?
If the transfer price is inappropriate how to replace it
with true price and tax profits on that basis.

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Transaction Covered
Section 92 D
• Sale/purchase of goods and services
• Sale/purchase of fixed assets
• Agency arrangements
• Leasing arrangements
• Licence arrangements
• Loans/Guarantees
• Management contracts
• Deputation of personnel
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Establish Relationship of Firms
Section 92 A (directly or indirectly)
a) By management control
b) By holding shares > 26%
c) By lending/borrowing > 90% of total borrowed amount
d) By control of board of directors > 50% appointment
e) By control of supply chain
> 90% of raw materials and consumables
> 90% of sales
f) By control through relatives

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Arm’s Length Price (ALP)
• The term "arm’s length price" is defined as price applied
in uncontrolled conditions. In other words it refers to the
market value of a particular transaction ignoring the
impact on pricing due to existence of special relationship
between associated enterprises.
• Arm’s length principle would avoid the creation of tax
advantages or disadvantages that would otherwise distort
the relative competitive position of either type of entity.
• By separating tax considerations from economic decisions
the arm’s length principle promotes the growth of
international trade and investment.
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Methods to Determine ALP
• Not applied to individual transactions; they
can be accumulated/clubbed together for a
period.
Five methods:
• Comparable Uncontrolled Price (CUP) Method
• Resale Price Method
• Cost Plus Method
• Profit Split Method
• Transactional Net Margin Method

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Comparable Uncontrolled Price (CUP)
• Compare price of the related party with that of the
uncontrolled transaction.
• Most direct and most reliable.
• Need obtain comparable uncontrolled transaction.
• Differences in products are minor and reliable method
exists to account for differences
• Adjustments allowed:
Differences in terms of trade
Differences in volume of trade
Differences in the credit period

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CUP Method - Example
LNM – Trinidad supplies ingots to Arcelor in France as well as to its
subsidiary LNM - France. The price paid by Arcelor is US $ 150 per MT
in June with credit period of 45 days and volumes aggregating 100
MT. LNM France gets 90 days credit and the volume is 500 MT in
December. What would be the Arm’s Length Price for LNM Trinidad.
Comparable Uncontrolled Price : 150.00
Add: Differences in timing of trade 7.50
(Assuming price in Dec was 5% higher)
Less: Quantity Discount 3% 4.50
Add: Differences in the credit period 2.25
(@1% pm as interest for 45 days)
Arm’s Length Price 155.25
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Cost Plus Method
• Find out the cost of production
• Add appropriate margin as % of cost of
production, determined by sale to unrelated
parties.
• Need to have gross margin in uncontrolled
transactions
• Applicable for contract manufacturing
• Useful for semi finished goods

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Cost Plus Method - Illustration
Production (Tons) - CHIPS 44,000
Rs. in Lacs Rs. Per Kg.

Raw Material Consumption 24,579.26 55.86

Manufacturing Expenses 3,645.16 8.28
(Power, Repairing & Maintenance,
Consumables, Packaging & Job Works
Wages 940.32 2.14
Depreciation 2,726.52 6.20

Cost of Production 31,891.26 72.48

Add : Gross Profit Margin 24.68% 17.89
ARM'S LENGTH PRICE (Rs. per Kg) 90.37
Less : DEPB availed for export 1,187.84 11.52
Quantity for DEPB Availment (Tons) 10,314

ARM'S LENGT H PRICE (Rs. per Kg) 78.85

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Resale Price Method
• Find out the resale price
• Deduct the appropriate margin of the reseller
• Margin should be consistent with the activities performed
by the reseller
• Use gross margin of the competing reseller
• Need to consider level of costs, value addition at each
stage, time of sale etc.
Gucci supplies shoes to its subsidiary in Brazil. Sale made by the
subsidiary are US $ 100 M. On an average the traders in shoe earn
a margin of 15% in Brazil. The Arm’s Length Price for Gucci would
be 100 – 15 = $ 85 M.

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Profit Split Method
• Determine aggregate profit of the two associated
enterprises
• Split the profit for the two in ratio of the jobs/functions
performed.
• Ratio of profit sharing could also be in terms of capital
employed or cost incurred.
• Dependent upon availability of reliable external data.

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Profit Split Method - Illustration
• ‘A’ sell goods to its subsidiary ‘B’ for a price of 100
A B Total
Sales 100 155 155
Cost of sales 70 100 70
Gross Profit 30 55 85
Other Cost 10 35 45
Operating Profit 20 20 40
Capital Employed 80 20
Profit Apportionment 32 8
Transfer Price 112

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Transactional Net Margin Method
• Net profit realised by the firm in an international
transaction is computed on a base like cost, sales,
capital employed.
• Net profit realised by the firm in domestic transaction
(comparable uncontrolled transaction)
• This is adjusted for the differences in the international
transaction and comparable uncontrolled transaction.

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Choice of Method
• Each method may be deployed with data from
internal or external sources.
• External sources are always preferred over
internal sources of data.
• Any method can be used by the firm and
• IT department too can ask for application of any
method.

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Pre-requisites
• Records need to be maintained.
• Results in an administrative burden for both the tax
administrations and firms.
• Also verification of such transactions takes place for
some years later at the time of assessment and
therefore, it becomes all the more difficult to assess
conditions prevailed at the time the transactions.
• Far placed geographical locations and confidentiality
cause difficulty in obtaining comparable data.

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Avoiding Litigation
• Determination of the ALP has sufficient scope for
controversies in terms of method chosen, non-availability of
accurate/reliable information, subjectivity in the data, etc.
• This may lead to an expensive and lengthy litigation with no
advantage to the tax payer as well as tax collector.
• To avoid unnecessary litigations there exist following
guidelines (may vary from country to country).
– No Adjustment
– Advance Pricing Agreements
– Safe Harbour Rules
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Need for Recalculating the Profit
• No Adjustment: No adjustment to the ALP computed
by the taxpayer would be made if the price computed
by the tax department is within ± 5%.

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Advanced Pricing Agreements (APAs)
Advance Pricing Agreements (APAs) introduced in Finance Act,
2012,
• An agreement in advance between the tax authority and
taxpayer is reached for determining the transfer price/ALP.
• It is binding of both parties for specified transactions.
• APAs are likely to
– provide certainty to the pricing in advance,
– eliminate tax leakages arising due to double taxation,
– proactively avoid transfer pricing controversies, and
– eliminate/reduce risk of economic double taxation.
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Advanced Pricing Agreement (APA)
• The maximum period for which advance pricing agreements
can be entered is five years.
• There is no threshold minimum either for duration or
monetary value for APAs.
• These APAs can be unilateral (agreement between taxpayer
and tax authority in India), bilateral, (agreement between
tax authorities in two countries where associated
enterprises are located) or multilateral (agreement
involving several tax authorities and associated
enterprises).

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Safe Harbour Rules
Safe Harbour Rules
• Introduced in September 2013 to reduce transfer pricing
audits and prolonged disputes.
• They intend to provide certain standards for profitability.
• If the profit is within specified standards the transfer pricing
as determined by the taxpayer would remain valid and
unchallenged.
• These rules would a) increase transparency, b) help improve
investment climate, and c) make revenue authorities
business friendly.
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