Transfer Pricing – Purpose & Methodologies
The value ascribed to the commodities or services that are supplied or sold between related parties is known as transfer pricing. To put it another way, transfer pricing is the price paid for goods or services that are transferred from one unit of an organisation to other units belonging to the same organization in different nations or otherwise with exceptions.
Transactions which will Subject to Transfer Pricing
Some of the international transactions which are ruled by the laws or rules pertaining to transfer pricing would include the following:
- Purchase of raw material
- Purchase of fixed assets
- Sale or purchase of machinery etc.
- Management fees
- Loan received or paid
- Sale of finished goods
- Sale or purchase of intangibles
- Reimbursement of expenses paid/received
- IT enabled services
- Support services
- Software development services
- Technical Service fees
- Royalty fees
- Corporate Guarantee fees.
What is the Purpose of Transfer Pricing?
The major objectives of transfer pricing would include the following:
- Transfer prices would have an impact on not only the reported and furnished earnings of each centre or unit of the organization, but also on how a company is allocating its available resources among these units or centres.One thing to be noted here would be that the cost that is incurred or expended by one centre or unit of the organization would account to the resource that is utilized by another unit or centre.
- Creating a separate profit for each division and allowing each division’s performance to be evaluated on an individual basis providing clarity.
What is the Importance of Transfer Pricing?
Multinational corporations (MNCs) have some sort of arrangement for determining how to distribute revenues and expenses to subsidiaries in various countries for the purposes of management accounting and reporting.
A subsidiary of a firm may be separated into segments or accounted for as a separate entity at times. In these situations, transfer pricing aids in the proper allocation of revenue and expenses to such subsidiaries.
The pricing at which inter-company transactions take place determine a subsidiary’s profitability. Governments are increasingly scrutinising inter-company transactions these days.
When transfer pricing is used, it can have an impact on shareholders’ wealth since it affects the company’s taxable income and after-tax free cash flow.
It is critical for a firm that conducts cross-border or international intercompany transactions to grasp or get hold of the transfer pricing idea, particularly in order to meet legal compliance requirements and avoid the risk of non-compliance.
Methodologies of Transfer Pricing
The transfer pricing methodologies that could be used to examine the arms-length price of controlled transactions are discussed in the Organisation for Economic Co-operation and Development (OECD) recommendations.
The price that is imposed, offered, or charged when unrelated parties engage in similar transactions in an uncontrolled situation is referred to as an arms-length pricing. Three of the most widely utilised transfer pricing approaches are listed below.
For the sake of clarity, linked enterprises are businesses that participate directly or indirectly in the management, capital, or control of another business.
Comparable Uncontrolled Price (CUP) Method
The CUP methodology or technique of transfer pricing recognises and evaluates a price charged in an uncontrolled transaction between comparable firms with a verified entity price to determine the Arm’s Length Price. Example:
X Ltd. buys 20,000 metric tonnes of metal from Y Ltd.’s subsidiary for INR 40,000 per metric tonne. It also bought 2,500 MT from Z Ltd. for INR 50,000 per MT.
Y Ltd. provided X Ltd. with a quantity discount of INR 500 per MT. Y Ltd. offers a one-month credit at 1.25% per month. The transaction with Y Ltd. is FOB (free on board), whereas the deal with Z Ltd. is CIF (cost-in-freight) (Cost, Insurance, and Freight). The freight and insurance costs are INR 2,000.
The terms of transactions are not the same here, and this has influenced the price of crude metal. As a result, changes are required. Differences in necessitate adjustments.
- Quantity discount: If Z Ltd. had offered a similar discount, the price charged by Z Ltd. would have been INR 500/MT lower.
- Freight & Insurance (FOB vs. CIF): If the purchase from C Ltd. was similarly FOB, then C Ltd. would have charged a lower price. As a result, the freight and insurance costs must be deducted from the purchase price.
- Credit period: If C Ltd. had extended equivalent credit, the price charged by them would have been higher after such costs were included in. As a result, the purchase price must be increased by 1.25% per month.
Computation to be made on an Arm’s Length Price basis:
|Price Per MT (In INR)
|Price per MT
|Adjustments to be Made:
|Less: Discount per Quantity
|Less: Freight and Insurance
|Add: Credit for Interest
|Arm’s Length Price
This method is the most dependable, consistent and is regarded as a straightforward means of applying the arms-length principle and establishing prices for related party transactions. However, extreme caution must be exercised when determining whether controlled and uncontrolled transactions are comparable. As a result, unless items or services meet the severe criterion of high comparability, this method of determining transfer price is not used.
Resale Minus or Resale Price Method
The prices at which the associated business entities sells its goods to a third party are used in this manner. The resale price is the name given to this pricing.
This resale price is then decreased by the gross margin, which is calculated by comparing gross margins in comparable unregulated transactions. Following that, all charges linked with the acquisition of such a commodity, such as customs duty, are subtracted. What’s left is an arm’s length pricing for a managed transaction between the related businesses.
For example, A Ltd. is dealing with the sales of electronics. For this purpose, it has purchased laptops and desktops from R Ltd. and NR Ltd. Here, R Ltd. Is a related party while NR Ltd. being a non-related party?
|Purchase Price for A Ltd.
|Sales Price for A Ltd.
|Miscellaneous Expenses incurred by A Ltd.
Computation of Arm’s Length Price
|Purchase Price for A Ltd.
|Less: Expenses Incurred with regard to R Ltd.
|Less: Resale Margin @ 15%
|Arm’s Length Price
|Price Paid to R Ltd.
Cost Plus Method
The Cost-Plus Method focuses on the costs of the goods or services supplier in the controlled transaction. After you’ve determined the costs, you’ll need to factor in a markup. On the basis of risks and functions performed, this markup must reflect the profit for the linked firm. As a result, the price is set at arm’s length.
In the cost-plus approach, the markup is usually determined after the direct and indirect costs of manufacturing or supply which have been taken into account. However, an enterprise’s running expenses which also includes the overhead expenses are not included in this markup.
For example, X and Y are two associated entities. And X has asked Y to manufacture 5 laptops for X with certain quality. Say the cost to be incurred by Y for manufacturing laptops would be INR 30,000 and the markup % which the company charges at Arm’s Length Price would be 40%.
So, the resulting price at which transaction should occur between X and Y would be INR 42,000 [30,000*(1+0.40)].
Problems that are Associated with Transfer Pricing
There are certain problems which are associated with the transfer prices and these are listed below:
- There may be disagreements among organisational divisional managers over how the transfer price should be determined.
- Executing the transfer prices and building the accounting system to meet the criteria of transfer pricing standards would take more time, money, and labour.
- Managers of organisational units may engage in dysfunctional behaviour as a result of arm’s length pricing.
- Arm’s length prices don’t work as well for other divisions or departments, such as a service department, because such departments don’t provide measurable advantages.
- In a multinational setting, the transfer price issue is quite complicated.
- Until March 2013, transfer pricing provisions in the United States were limited to overseas transactions only. Transfer Pricing regulations have been extended to SDTs (Specified Domestic Transactions) since April 2013, and they are effective for the assessment year 2013-14. The following transactions are covered by the Specified Domestic Transactions:
Payments have been paid or will be made to a director, a relative of a director, or an entity in which a director or the firm has a voting stake of more than 20%.
- Transactions involving the transfer of goods or services under Section 80-IA (8) and (10) i.e., deductions which are related to gains and profits earned from enterprises engaged in industrial undertakings or the infrastructure development, or the producers and distributors of power or Telecommunication Service Providers.
- Section 80-IA (8) and (10) transactions relating to the transfer of goods or services (i.e., deductions which are related to profits and gains from enterprises engaged in infrastructure development or industrial undertakings, distributors and also the manufacturers or producers of power or Telecommunication Service Providers.
- SDT also applies to transactions involving entity located in a tax holiday area and one located in a non-tax holiday area if both entities are managed by the same person.
- For enterprises based in SEZs (special economic zones), EOUs (export-oriented units), or the FTZs (free trade zones), that include the non-market price orthe non-market transfer of products or the goods and services to another unit under the same management.
It shall be noted that, it is only if the total value of the transactions surpasses INR 5 crore in total will they be classified as Specified Domestic Transactions or SDTs.