The process of selling goods and services between companies with the same or similar ownership or control is called transfer pricing (transfer pricing). This process can take place between sub-divisions of a company, subsidiaries of a company, or between companies that all have management. This process often results in tax benefits.
Why need transfer pricing?
- Revenue – The financial performance of the company is not affected by keeping the prices of all the related companies’ products and services the same.
- preferred customer – If a related company places an order at a lower price to another related company, the company taking the order can sell the product to external customers to earn more profit.
- Preferred Suppliers – If the price is increased by the selling company, the buying company can buy goods from an outside company offering a lower price.
All these affect the profits of the parent company.
Types of transfer pricing
There are 5 methods of transfer pricing. Of these, three are under traditional transaction methods and two are transactional profit methods, which are –
Traditional transaction methods
- Comparable arbitrary value method (Comparable uncontrolled price
method) – Transactions between two related companies are called controlled transactions. In this method the price, terms and conditions of controlled transactions are compared with those of a third party transaction. It can be between two independent third parties or a taxpayer company and an independent company.
- Resale Price Method (The resale price method) – The price at which an affiliated enterprise sells a product to a third party is called the resale price. In this method the resale value is considered the basis for the controlled transaction. The margin of resale value is then calculated based on the uncontrolled transaction and this margin is subtracted from the resale value. After this additional expenses like custom duty are deducted. The remaining balance is then the transfer price for the controlled transaction.
- Cost plus method (Cost plus method) – In this method sales costs are compared to gross profit. The first is to decide on the cost of sales in a controlled transaction. After this a mark up is added to cover the cost and add the profits and the end result is the transfer price.
Transactional profit methods
- Transactional Net Margin Method (Transactional net margin method) – In this method the net profit of the controlled transaction is compared to the uncontrolled transaction. Prices are determined based on this comparison.
- Profit sharing method (The profit split method) – Sometimes transactions are conducted within a company. In this situation it is decided to divide the profits. It is divided on the basis of how the profits have been made.
Advanced pricing agreement
As mentioned above, there are a variety of methods for performing transfer pricing (transfer pricing). Similarly, the Advance Pricing Agreement (Advance Price Agreement – APA) is an agreement between the taxpayer and the tax authority, according to which method will be used to make transfer pricing for future transactions. Advance price agreements can be of the following types –
- Independent APA – It is an agreement between the taxpayer and the tax authority in the taxpayer’s country.
- Bilateral or two-party APA – The agreement includes the taxpayer, the taxpayer’s affiliated group abroad and the tax authorities of the two countries.
- Multilateral APA – It is an agreement between the taxpayer, the taxpayer’s partner groups in many countries, and the tax authorities of all countries.
Transfer pricing in India
The concept of transfer pricing was introduced in 2001 with the objective of availing tax benefits in India. According to the Income Tax Act of 1961, income from any controlled transaction (associated enterprises) is treated as an uncontrolled transaction. Because enterprises are interconnected, tax laws apply only in the case of unrelated enterprises. It is applicable to both international and domestic transactions. The concept of transfer pricing is important for MNCs. Earlier MNC companies used to have two different pricing. One for international trade and the other for taxation. But, due to Income Tax Acts promoting transfer pricing, tax can now be availed.
Objectives for transfer pricing
- The tax burden on monetary transactions can be reduced.
- It is easier to maintain and manage the balance between countries with different tax policies.
- Optimizing the profitability of the business as a whole.
- Effective decisions can be taken for foreign investment.
- Policies can be developed to levy penalties.
Problems in transfer pricing
- The process of transfer pricing in a multinational set up can be complex. This will require proper computation and planning.
- There may be disagreement among managers regarding transfer pricing.
- Transfer pricing is difficult in the service industry.