Transfer Pricing explained ACCOUNTANCY Asish K Bhattacharyya / New Delhi June 30, 2008, 0:39 IST Transfer price refers to the

amount used in accounting for transfer of goods or services from one responsibility centre to another or from one company to another which belongs to the same group. Transfer pricing is a mechanism for distributing revenue between different divisions which jointly develop, manufacture and market products and services. Transfer pricing systems are designed to accomplish the following objectives: to provide each division with relevant information required to make optimal decisions for the organisation as a whole; to promote goal congruence – that is, actions by divisional managers to optimise divisional performance should automatically optimise the firm's performance; and to facilitate measuring divisional performances. The fundamental principle is that the transfer price should be similar to the price that would be charged if the product were sold to outside customers or purchased from outside vendors. Market-based transfer pricing system provides optimal results when the market for the intermediate product is perfectly competitive and the selling division can sell its output either to insiders or outsiders and as long as the buying division can obtain all its requirements from either outsiders or insiders. In such a situation the company as a whole has no additional cost of providing autonomy to divisions. For example, if division A decides to sell its product at the market price of Rs. 100 per unit and division B decides to buy the same product from market at the market price, net cash flow to the firm will be zero. If the market for the intermediate product is imperfect, this system may lead to sub-optimal utilisation of production capacity by the buying division. The transfer price will form an element of the total marginal cost and the buying division will restrict its output at the level where marginal cost = marginal revenue. Thus the firm as a whole will lose an opportunity to improve its profit because actual marginal cost is lower than the transfer price. For instance, the intermediate product that the sub-unit A of the firm uses is produced by the sub-unit B of the firm and another firm. The market price of the product is Rs 100 per unit, while the variable cost of production in division B is Rs 40 per unit. If, the transfer price is fixed at Rs 100 per unit (the market price)

it can sell its total output to outsiders at Rs 100 per unit. that is. It will restrict the output at the level where marginal cost = marginal revenue. Otherwise. transfer price is established with an aim to optimise the group performance. . Although there is sound economic theory behind the selection of transfer pricing methods. Often in family run businesses. thus shifting the profits to reduce overall taxes paid by a multinational group. When group companies produce products that are used within the group.the sub-unit A will consider Rs 100 per unit as a part of its marginal cost. Companies use variations of market-based and cost-based transfer pricing mechanisms to achieve the objective of goal congruence. If competitive prices are not available or it is too costly to obtain market prices. the decision of the sub-unit A is sub-optimal for the firm as a whole. the decision of the sub-unit A to restrict its output at a level lower than its achievable capacity might be sub-optimal for the firm as a whole. For multinational corporations. Even in a situation where the sub-unit B has no excess capacity. An issue that is often ignored is that whether this practice undermines the interest of minority shareholders. transfer prices may be determined based on the cost plus a profit. companies use transfer price methods to achieve certain other objectives even at the cost of goal congruence. it may be advantageous to arbitrarily select prices such that most of the profit is made in a country with low taxes. this is an important issue and need to be addressed by the board of directors of individual companies. The firm loses the opportunity to earn higher profit by using the intermediate product internally in the sub-unit A in stead of selling the same to outsiders. decisions aim to optimise group performance. Therefore. although it may hurt the selling or the buying company within the group. Transfer-pricing system must have in-built mechanisms for smooth negotiation and conflict resolution. The contribution is higher than the contribution of Rs 60 per unit on the intermediate product. Assume that the firm earns a contribution of Rs 100 per unit on the final product. the ethical/corporate governance issue does not arise. the output of the sub-unit A. decisions are taken at the group level. Cost-based transfer prices should be used only as a second option to market-based transfer prices because it involves complex calculations and results are less than satisfactory. If there is no minority shareholder in the company that is hurt. If the sub-unit B has excess capacity.

4. the OECD principle was adopted in 2001. quality and design improvement. The question of ethics cannot be ignored even in tax planning. To promote interaction between the exporting community and the Government both at the Central and State levels 6. most countries enforce tax laws based on the arm's length principle as defined in the OECD (Organisation for Economic Co-operation and Development) Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations. . standards and specifications. To organise visits of delegations of its members abroad to explore overseas market opportunities. To offer professional advice to their members in areas such as technology upgradation. To build a statistical base and provide data on the exports and imports of the country. The revenue authority and the MNCs should work together in good faith to implement regulations effectively. In India. It is not always possible – and certainly takes valuable time – to find comparable market transactions to set an acceptable transfer price. the EPCs encourage and monitor the observance of international standards and specifications by exporters. 5. Applying transfer pricing rules based on the arm's length principle is not easy. 3. exhibitions and buyer-seller meets in India and abroad. product development and innovation etc.However. In particular. The EPCs keep abreast of the trends and opportunities in international markets for goods and services and assist their members in taking advantage of such opportunities in order to expand and diversify exports. To provide commercially useful information and assistance to their members in developing and increasing their exports 2. Functions The major functions of the EPCs are as follows: 1. even with the help of the OECD's guidelines. To organise participation in trade fairs. limiting how transfer prices can be set and ensuring that that country gets to tax its "fair" share. exports and imports of their members. Role The main role of the EPCs is to project India's image abroad as a reliable supplier of high quality goods and services. as well as other relevant international trade data.

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