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Transfer Pricing - An Overview
[Submitted by Ms. Priyanka Garg,
CA Final Student,
Delhi]
September 9, 2008
1 Introduction
1.1 The lopsided distribution of economic resources between
different countries is the basis of international trade. With increasing
globalization, related party transactions between Multinational
Enterprises (MNEs), which account for almost 60 per cent of all
international transactions, necessitated the concept of Transfer Pricing (TP).
TP is typically used in situations where MNEs seek to cut their tax base
by artificially shifting the profits from higher tax jurisdictions to
lower tax jurisdictions without a considerable change in business
operations. The TP regime may even be manipulated by small organizations
engaging in cross border transactions with affiliated entities. A less
developed country is more likely to suffer due to TP manipulation than a
developed country because of the lack of adequate resources and the
inability to monitor transactions.
1.2 In this paper, I shall discuss briefly the concept of
transfer pricing, the implications of its manipulation, and attempt to
give recommendations for improving the Indian TP regime.
2 The Concept
2.1 TP relates to the pricing of transactions (such as transfer
of goods, services, intangibles and funds) that take place within
affiliate segments of a group company in different tax jurisdictions. To
illustrate this, let us suppose a subsidiary company, resident in country
'A' (which has a tax rate of, say, 40%) manufactures goods and transfers
them to its parent company in country 'B' (which has a tax rate of 20%)
for trading. In order to increase the overall profits of the group
company, it will seek to supply the goods at prices which are lower than
the market price. So, in effect, the subsidiary company in country 'A'
will have lower profits and [therefore,] a lower tax incidence whereas the
parent company in country 'B' is affected in the opposite manner - higher
profits due to low costs, but lower taxes because of the tax rate - which
illustrates the importance of TP from a taxation perspective. However, TP
transactions can be much more complex than the example above and usually
involve deliberations on inter related variables and the weighing of
regulatory and other constraints.
2.2 Nowadays, tax revenue authorities have become more vigilant
about TP issues as TP transactions form a considerable part of the tax
base of all countries. Compared to other countries, India is a late
entrant in the field of regulating TP. The Finance Act, 2001 introduced
provisions regulating TP in the Income Tax Act, 1961 with effect from 1
April, 2001. Prior to this amendment, a limited provision regulating
transfer pricing did exist in section 92 of the Act. However, this was
very often not strictly complied with by businesses as there were no rules
or guidance available regarding its implementation. However, the 2001
amendment, which defined 'associated enterprise' and 'international
transaction' for the first time, has brought much needed clarity to the
law. There is greater respect among businesses (including MNEs) for the
expertise of the Indian tax authorities in handling the complexities
involved in TP transactions.
2.3 MNEs have to keep in mind multiple factors in deciding their
TP strategies. Some of them are:
2.3.1 Tax jurisdiction: Profit is a function of
price. As a result, charging higher prices in a higher tax jurisdiction
results in a low tax base and relatively higher profits in a lower tax
jurisdiction.
2.3.2 Import duties: Usually, low prices of
commodities attract low import duties in countries where custom duties
form a major part of tax revenues.
2.3.3 Thin Capitalization: MNEs also have the
option of thinly capitalizing some of its constituent entities by making
investments as loans instead of equity to avail tax benefits. This
mechanism would usually involve a foreign affiliate of a group company
making an investment in a domestic affiliate of the company in the form of
loans. As a result, the company's debt-equity ratio increases, i.e. it
becomes thinly capitalized. Thin capitalization can be part of a larger TP
strategy. MNEs make iniquitous use of this method to avail of tax benefits
since interest on loans is deductible while calculating taxable income. In
India, there is no formalized provision regulating thin capitalization
under the law, but there are some related provisions regarding permissible
debt in the Foreign Exchange Management Act, 1999 (FEMA), which act as
alternative mechanisms to reduce such practices.
2.3.4 Others: Other methods include the
exploitation of fluctuations in foreign exchange rates to derive maximum
benefit. For instance, a company can reduce the expected currency
devaluation risk by transferring funds to its affiliates in other
countries and varying the cash flow requirements of the companies within
MNEs. The MNE group may be pressurised by shareholders to show high
profitability at the parent company level, particularly if financial
reporting is not carried out on a consolidated basis.
3 Methods for calculating arm's length price
3.1 To counter TP manipulations, the Organization of Economic
Cooperation & Development (OECD) introduced the Transfer Pricing
Guidelines for Multinational Enterprises and Tax Administrations in 1995.
These guidelines are respected worldwide and the Indian TP regime is
primarily based on them, though with a few customized features. Under the
TP regime, the transfer price has to be determined on the basis of the
arm's length principle and the price so determined is the Arm's Length
Price (ALP). According to the arm's length principle, there are two sets
of methods for arriving at the ALP:
3.1.1 Transactional methods: These methods
emphasize each transaction specifically rather than considering the
overall profit figure of related entities to arrive at the ALP. These are:
- Comparable Uncontrolled Prices method (CUP): Under
this method, price charged in an uncontrolled transaction between
comparable entities is identified and compared with the tested entity
price (after making due adjustments in relation to terms and
conditions and risk involved) to determine the ALP.
- Cost Plus Method (CPM): Here, the total cost of
production incurred by the tested enterprise in transferring goods and
services to Associated Enterprises (AEs) is calculated and the total
gross profit mark up used by comparable entities in similar
transactions with independent enterprises is determined. The total
gross mark-up arrived at is adjusted to take into account functional
and other differences to determine ALP.
- Resale Price Method (RPM): This method is similar to
CPM and is used where the seller adds relatively little or no value to
products acquired from AEs. Here, ALP is determined by subtracting the
appropriate gross profit mark-up from the sale price charged to an
independent entity. The appropriate gross margin is determined by
comparing the gross margin of comparable entities with the tested
enterprise, after making necessary adjustments regarding functional
and other differences.
3.1.2 Non transactional methods: In non
transactional methods, related parties income figures are considered and
adjusted according to their share. These are:
- Profit Split Method (PSM): PSM is used when AEs'
transactions are so integrated that it becomes impossible to conduct a
TP analysis on a transactional basis. First, the combined net profit
incurring to related enterprises from a transaction is determined.
Then, the combined net profit is allocated between related enterprises
with reference to market returns achieved by independent entities in
similar transactions. The relative contribution of related parties is
then evaluated on the basis of assets employed, functions performed or
to be performed and risk assumed.
- Transactional Net Margin Method (TNMM): TNMM is
normally adopted in cases of transfer of semi-finished goods,
distribution of finished products (where resale price method (RPM)
cannot be adequately applied) and transactions involving the provision
of services. TNMM compares the net profit margin relative to an
appropriate base (sales, assets or costs incurred) of the tested party
with net profit margin of the independent enterprises in similar
transactions after making adjustments regarding functional differences
and risk involved.
3.2 Under the Indian TP regime, there is no hierarchy in terms
of preferred methods of determining ALP. Indeed, as per section 92C (2) of
the Income Tax 1961, the most appropriate method has to be applied for
determining ALP in the manner prescribed under Rules 10 A to 10C notified
vide S.O. 808 E dated 21.8.2001.
4 Procedural aspects of determining ALP:
An example would be useful in understanding the procedure for
calculating ALP. Let us suppose a subsidiary company 'A' in India is
importing manufactured goods from parent company 'B' in France for the
purpose of trading the goods in India. There is no public information
available regarding prices charged by companies engaged in similar
activities. To calculate ALP, we will have to select most appropriate
method after taking into consideration the various aspects described
below:
4.1 Finding uncontrolled comparable data:
4.1.1 The first step would be to access databases like Prowess
and Capitaline Plus, two commercial databases available in India which
contain financial and non-financial information gathered from audited
annual accounts, stock exchanges, company announcements, etc of over
10,000 small and mid-sized companies. Let us suppose that to find
comparable companies, a search for companies engaged in similar business
is first run in Prowess which shows say 200 companies with comparable
transactions. Then say the same procedure is followed in Capitaline Plus
database from where we get 100 companies. We would now have to compare the
results from the two electronic databases to exclude companies which form
part of both searches and say we get 110 comparable companies.
4.1.2 These comparable companies would then be screened on a
qualitative basis (for instance on the basis of the exclusion of sick
units, related party transactions and functionally different units) and
quantitative basis (for instance, transaction thresholds, turnover
thresholds etc.) and say, finally we get 15 companies for comparison with
company A.
4.2 Selection of most appropriate method:
4.2.1 Cost plus method (CPM): Since the CPM method
is usually used where semi finished goods are transferred, it will not be
applicable to our example.
4.2.2 Comparable Uncontrolled Prices Method (CUP):
The CUP is not applicable as no public information is available regarding
prices charged by independent companies in import of similar goods.
4.2.3 Resale Price Method (RPM): RPM is used where
the seller adds relatively little or no value to products acquired from
AEs. In the present case RPM may be taken as the most appropriate method
as comparable data of similar transactions by independent entities is
available.
4.2.4 Profit Split method (PSM): This method is
used when AEs transactions are so integrated that it becomes impossible to
make TP analysis on transactional basis, which is not the case in our
example.
4.2.5 Transactional Net Margin Method (TNMM): TNMM
is normally adopted in the case of transfer of semi finished goods,
distribution of finished products and where resale price method (RPM)
cannot be adequately applied. However, since RPM can be more appropriately
applied in this case, TNMM is also not appropriate.
4.3 Calculation of ALP: Now the most appropriate
method, which is RPM in this case, is applied to calculate the ALP. Since
data is available for 15 comparable companies, we would take arithmetic
mean of prices of charged by such companies for similar goods and this
arithmetic mean, or a price which differs from arithmetic mean by +-5%,
will be taken as the ALP for company 'A'.
5 Significant factors while calculating ALP:
5.1 Risk Analysis: In India, tax authorities often
err on the side of caution and transfer pricing officers (TPOs) have
largely ignored the importance of risk in TP analysis in many cases. It is
a fundamental principle of economics that enterprises which undertake low
risk can expect only to yield low profits. This was also acknowledged by
Delhi Income Tax Appellate Tribunal (ITAT) in its recent landmark decision
of Mentor Graphics (Noida) Private Limited v. Dy. CIT ITA, NO. 1969/D/2006
which has revived the hopes of taxpayers. Mentor Graphics Private Limited
(Noida) was engaged in the business of software development and rendering
marketing systems services to its parent company, IKOS Systems Inc. in
USA. It charged for its software development services by using TNMM as the
most appropriate method and used Net Cost Profit (NCP) as the price level
indicator to its US parent company (in this case, NCP of 6.99%). However,
placing reliance on the TPO's order, the Assessing Officer accepted the
revised NCP at 23.53% and accordingly made an adjustment of Rs.14.5
million to the company's taxable income which was upheld by the
Commissioner (Appeals). However, ITAT, in its decision, concluded that
search conducted by the TPO had serious defects affecting the ALP and
ruled that the decision was incorrect. Therefore the price disclosed by
the assessee was considered as the ALP and the addition of Rs.14.5 million
was rejected. ITAT emphasized that appropriate adjustments relating to
functional, asset and risk differences are necessary while choosing
comparable enterprises in TP analyses.
5.2 Use of secret data: In many developed
countries, use of secret data while carrying out assessments is
prohibited. However in India, this information may be used by tax
authorities against tax payers.
5.3 Transactions involving intangibles: At present
TP regulations have no specific provisions for transfer of intangibles and
the five prescribed methods are often found inadequate to deal with TP
issues relating to intangibles.
6 Recommendations:
6.1 Advance Pricing Agreement (APA): In some
jurisdictions, in order to resolve complex TP issues, taxpayers may agree
with the appropriate tax authority that future transactions will be
conducted at an agreed price which will be deemed as the ALP for those
transactions. For instance, UK legislation provides that a UK business may
agree the ALP with Her Majesty's Revenue & Customs (HMRC) but it will run
the risk of being assessed by foreign tax authorities relating to the
method of calculation of the ALP. Bilateral or multilateral agreements,
which eliminate risk of double taxation are also in existence in certain
other developed countries, but there is no provision for such agreements
in India as of now. APA places a company in a better position by
predicting costs and expenses including tax liabilities. It limits the
prospect of potentially costly and time consuming examination of major TP
issues that would arise in TP audit and also substantially reduces or
eliminates the possibility of double taxation. By promulgation of the
amendment regarding APA, government can reduce TP problems to a great
extent.
6.2 Databases: In India, as mentioned earlier, two
commercial databases (Prowess and Capitaline Plus) are available which
contain financial information of about 10,000 public and private
companies. However, these databases are not primarily designed for TP
analyses. If these databases are made suitable for TP analysis in terms of
improvement of search parameters, increase in the size of the databases
etc., finding comparable transactions for determination of ALP would
become much easier.
6.3 Risk differences: While the ruling laid in Mentor Graphics case (as
discussed above) acknowledges the risk differences to be considered for TP
analysis, no guidance has been provided on the correct approach for making
risk adjustments. If appropriate guidance for making such adjustments is
provided, key TP issues can be resolved.
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