Introduction to Transfer Price
It is the price, or the consideration exchanged between the related parties belonging to the same parent (unit or division or subsidiary or associate or affiliate), established in different countries. The main purpose of undertaking transactions of transfer pricing is to avail the benefits associated with the entities established in tax havens or no-tax countries.
Transfer pricing is significant from both performance and tax perspective.
- Management evaluates the performance of the department or unit with the other units of the organization, which would require the transfer pricing.
- Income Tax Department would require that tax is being paid on the actual income earned by the assessee and not on manipulated prices.
The main foundation of TP is the Arm’s Length Principle (ALP).
ALP simple means that prices, royalties or other fees that are being charged by the associated enterprises (related parties) between themselves should be the same as being charged by the independent parties.
Purpose of Transfer Price
As the pricing is set between the related parties, so there are high chances of profit getting shifted to the entities established in tax haven countries from the high tax nation establishments, resulting in shifting of the profits plus reduction in the tax liability of the company as a whole.
Before Transfer Pricing norms, entities used to undertake such transactions with the motive of tax evasion, which resulted in the loss to the nation manufacturing goods. To prevent this, TP norms have been introduced which talks about ALP and unrelated parties.
Methods of Transfer Pricing
Organization for Economic Co-operation and Development (OECD) has framed the following main TP methods, which can be used by the organization depending upon their business deals.
1. Comparable Uncontrolled Price Method (CUP): As the name suggests, the price that should be charged in the uncontrolled transaction is compared with the actual price charged to arrive at the ALP.
2. Resale Price Method: This method focuses on the price of a product that an associated enterprise would charge to an unrelated party, which would help to determine an arm’s length gross margin. The residual would be regarded as the ALP which would be compared with the pricing charged between the related parties.
3. Cost Plus Method: This method is primarily used for manufacturing concerns, wherein the cost incurred by the seller associated enterprise is taken into account, and then a reasonable mark-up on the cost is being added to derive the ALP.
4. Transactional Profit Method: This is different from the above methods in the sense that the analysis is based on the net returns earned by the comparable companies engaged in the particular line of business.
There are two categories through which one can use this method –
- Transaction Net Margin Method (TNMM)
- Profit Split Method (PSM)
Example of Transfer Price
A software technology service provider company, based out of the US, with operations in Canada and India, intends to outsource the client support functions to its subsidiary, located in the respective countries.
Now the company needs to plan its strategy in such a way that it results in savings of tax and ultimately bringing the profits to the company. The tax rate is lower in India and the labour is also not very dear.
In the absence of transfer pricing norms, the company would pay to the Indian counterpart arbitrary price, which would result in a loss in the revenue of the US Tax Department.
But due to TP norms, now company need to determine the ALP and thereby compute its income tax liability.
Why TP is Important?
Following are the importance given below:
- For Companies: Non-compliance of the legal provisions can result in high penal consequences, which is not good for the entity, in terms of finance and reputation.
- For Tax Authorities: This will help them to assess the transactions on a fair and equitable basis which will lead to increased compliance from the companies.
- For Investors: When the dealings are occurring as per the laws, then it boosts the confidence of the investors that the company is ethically strong and they can look at it as their prospective investment.
Transfer Pricing vs Standard Cost
Basis of Comparison
|Meaning||The price that has been charged from one unit by another.||It is the budgeted cost that is being planned at the time of framing of the budget of the company as a whole.|
|Type||It is the actual cost that is being incurred.||It is the notional cost.|
|Reporting||They appear in the financial statements which are presented to the investors.||They appear in the budgeted financial statements which are presented to the management only.|
Benefits are given below:
- Safeguarding from High Litigation Expenses: Complying with the TP laws would help the company to avoid litigation with the income tax departments.
- Simplifying the Transactions: Accounting the transactions that would have occurred with the independent seller/buyer saves the company from extra efforts of how to avoid taxes.
- Separate Department: For TP, the entity needs expert and need a separate budget for properly complying with the laws. The cost incurred for this would be huge and the company has no option, even if the cost due to this department is more than the benefits that arise due to this.
- Disputes: There are five methods of determining Transfer Pricing and there can be disagreement between the company units of which method to choose for complying with the norms.
Transfer Pricing was introduced to curb the unhealthy practices that arose due to tax evasive practices being followed by the MNCs. From its introduction, there have been remarkable changes that have come in the world but still today, it is not away from debates and ambiguity. With the changes that are occurring, the ambiguity that is being around us would resolve.
This is a guide to Transfer Price. Here we discuss the introduction to Transfer Price along with the methods, benefits, and limitations of TP. You may also look at the following articles to learn more –