TRANSFER PRICING – INTRODUCTION, ALP, METHODS

AND INTRICACIES INVOLVED

11-11-2013By

D. Prabhakar Reddy, IRS

INTRODUCTION What is transfer pricing? When independent enterprises deal with

each other, the conditions of their commercial and financial relations are determined by market forces.

When related enterprise deal with each other, their commercial and financial relations may not be directly affected by external market forces in the same way as those of independent enterprises.

INTRODUCTION (CONTD…) Related enterprise transactions may lead

to erosion of tax base even though their transfer pricing policies may not be necessarily with that intention

Transfer pricing refers to pricing of transactions between associated enterprises or related parties.

When transfer pricing does not reflect market forces, the tax revenues of either or both of the tax jurisdictions could be distorted.

IMPORTANCE OF TP The role of MNEs in world trade increased over

the last 20 years The increased volume of transactions within MNEs Taxing rights of each country would be affected

by the price charged by MNEs within the group and across the borders

Transfer prices are significant for both taxpayers and tax administrations because they determine in large part the income and expenses, and therefore taxable profits, of associated enterprises in different tax jurisdictions.

WHAT ARE THE TRANSACTIONS?

Physical goods/ tangible property Intangible property Providing services Financial Transactions – Lending /

borrowing / guarantees

OUR LEGISLATION Finance Act, 2001 introduced detailed

provisions relating to transfer pricing, requiring all ‘international transactions’ between ‘associated enterprises’ to be at arm’s length.

These provisions are applicable to the transactions with effect from 1st April, 2002.

The law with respect to transfer pricing in India is to a great extent in lines with that prescribed by the Organization for Economic Cooperation and Development (‘OECD’).

OUR LEGISLATION (CONTD.)

India is not a member nation of OECD (it now has an "Observer Status"); however, there has been an increasing and greater reliance being placed by the tax authorities in India on the OECD Model.

Even the Courts / Tribunals held that reliance can be placed on OECD TP Guidelines in so far as they are not inconsistent with the domestic legislation.

ARM’S LENGTH PRICE A price which is applied or proposed

to be applied in a transaction between persons

other than associated enterprises, in uncontrolled conditions Controlled transactions are by way

of Control / Capital /Management

ARM’S LENGTH PRICE Any income/expense arising from an

international transaction with an associated enterprise must be computed having regard to the arm’s length price.

Also, costs or expenses allocated or apportioned between two or more associated enterprises based on mutual agreement or arrangement, should be determined having regard to arm’s length prices.

The transfer pricing provisions are wide enough to cover transactions between a foreign entity and its permanent establishment in India.

ARM’S LENGTH PRICE (CONTD..)

The transfer pricing provisions would not however apply in cases wherein the application of the arm’s length price results in a downward revision in the income chargeable to tax in India or results in an increase in the loss.

ARM’S LENGTH PRINCPLE Conditions are made or imposed between

the two enterprises in their commercial or financial relations

which differ from those which would be made between independent enterprises,

then any profits which would, but for those conditions, have accrued to one of the enterprises, but, by reason of those conditions, have not so accrued,

may be included in the profits of that enterprise and taxed accordingly

TESTED PARTY When applying CUP, cost plus, resale price or

transactional net margin method, it is necessary to choose the party to the transaction for which most appropriate method is applied. Such party is called tested party.

As a general rule, the tested party is the one to which a transfer pricing method can be applied in the most reliable manner and for which the most reliable comparables can be found.

It will most often be the one that has the less complex functional analysis.

MOST APPROPRIATE METHOD

The arm’s length price in relation to an international transaction shall be determined by any of the methods prescribed, being the most appropriate method

Having regard to the nature of transaction or class of transactions or class of associated persons or functions performed by such persons or such other relevant factors as the Board may prescribe.

TRANSFER PRICING METHODS

Comparable uncontrolled price (CUP) method;

Resale price method (RPM); Cost plus method (CPM); Profit split method (PSM); Transactional net margin method

(TNMM); Such other method as may be prescribed

by the Board – Rule 10BA

MAIN FACTORS IN APPLYING A METHOD

None of the differences (if any) between the transactions being compared or between the enterprises undertaking those transactions could materially affect the price / margins in the open market. (OR)

Reasonably accurate adjustments can be made to eliminate the material effects of such differences.

MAIN FACTORS IN APPLYING A METHOD (CONTD..)

All methods that apply the arm’s length principle can be tied to the concept that independent enterprises consider the options available to them and in comparing one option to another they consider any differences between the options that would significantly affect their value.

Internal and External

CIRCUMSTANCES – RULE 10B(2) The specific characteristics of the property

transferred or services provided in either transaction; The functions performed, taking into account assets

employed or to be employed and the risks assumed, by the respective parties to the transactions; (FAR Analysis)

The contractual terms (whether or not such terms are formal or in writing) of the transactions which lay down explicitly or implicitly how the responsibilities, risks and benefits are to be divided between the respective parties to the transactions;

Economic circumstances Business strategy?

CHARACTERISTIC OF PROPERTY OR SERVICES

In the case of transfer of tangible property, the physical features of the property, its quality and reliability, and the availability and volume of supply;

In the case of the provision of services, the nature and extent of the services; and

In the case of intangible property, the form of transaction (e.g. licensing or sale), the type of property (e.g. patent, trademark, or knowhow), the duration and degree of protection, and the anticipated benefits from the use of the property.

FAR ANALYSIS The functional analysis seeks to identify

and compare the economically significant activities and responsibilities undertaken, assets used and risks assumed by the parties to the transactions.

The functions that might need to identify and compare include, e.g. design, manufacturing, assembling, research and development, servicing, purchasing, distribution, marketing, advertising, transportation, financing and management.

FAR ANALYSIS (CONTD…) The functional analysis should consider

the type of assets used, such as plant and equipment, the use of valuable intangibles, financial assets, etc., and the nature of the assets used, such as the age, market value, location, property right protections available, etc.

FAR ANALYSIS (CONTD…) The types of risks to consider include

market risks, such as input cost and output price fluctuations; risks of loss associated with the investment in and use of property, plant, and equipment; risks of the success or failure of investment in research and development; financial risks such as those caused by currency exchange rate and interest rate variability; credit risks; and so forth.

ECONOMIC CIRCUMSTANCES – RULE 10B(2)

Conditions prevailing in the markets in which the respective parties to the transactions operate,

including the geographical location and size of the markets,

the laws and Government orders in force, costs of labour and capital in the markets, overall economic development and level of

competition and whether the markets are wholesale or retail.

CUP METHOD It is one of the transaction based

methods A transfer pricing method that compares

the price for property or services transferred in a controlled transaction to the price charged for property or services transferred in a comparable uncontrolled transaction in comparable circumstances.

The most direct method

CUP METHOD (CONTD…) The CUP method is a particularly reliable

method where an independent enterprise sells the same product as is sold between two associated enterprises.

Transportation and insurance (FOB / CIF) Volumes / volume discount Agri goods / crude oil / vegetable oils /

metals / mineral oils / fuels

RESALE PRICE METHOD - RPM

A transfer pricing method based on the price at which a product that has been purchased from an associated enterprise is resold to an independent enterprise.

The resale price is reduced by the resale price margin.

What is left after subtracting the resale price margin can be regarded, after adjustment for other costs associated with the purchase of the product (e.g. custom duties), as an arm’s length price of the original transfer of property between the associated enterprises.

RPM (CONTD…) Gross Margin – Marketing, warranty, discount Cost of goods sold Minor product differences are less likely to have

as material an effect on profit margins as they do on price.

Branded vs unbranded Intangibles involved – market intangible The level of inventory / inventory period Warranty on sales / payment terms Wholesale / retail Exclusive right to resell

RPM (CONTD…) The amount of the resale price margin will be

influenced by the level of activities performed by the reseller. This level of activities can range widely from the case where the reseller performs only minimal services as a forwarding agent to the case where the reseller takes on the full risk of ownership together with the full responsibility for and the risks involved in advertising, marketing, distributing and guaranteeing the goods, financing stocks, and other connected services.

COST PLUS METHOD - CPM A transfer pricing method using the costs

incurred by the supplier of property (or services) in a controlled transaction.

An appropriate cost plus mark up is added to this cost, to make an appropriate profit in light of the functions performed (taking into account assets used and risks assumed) and the market conditions.

What is arrived at after adding the cost plus mark up to the above costs may be regarded as an arm’s length price of the original controlled transaction.

COST PLUS METHOD - CPM First, there are the direct costs of producing a product

or service, such as the cost of raw materials. Second, there are indirect costs of production, which

although closely related to the production process may be common to several products or services (e.g. the costs of a repair department that services equipment used to produce different products). Finally, there are the operating expenses of the enterprise as a whole, such as supervisory, general, and administrative expenses.

In general, the cost plus method will use mark ups computed after direct and indirect costs of production, while a net profit method will use profits computed after operating expenses of the enterprise as well.

TRANSACTIONAL NET MARGIN METHOD - TNMM

A transactional profit method that examines the net profit margin

relative to an appropriate base (e.g. costs, sales, assets)

that a taxpayer realizes from a controlled transaction (or transactions that it is appropriate to aggregate)

with that of an uncontrolled transaction(s) of an uncontrolled enterprise.

TNMM – CONTD… One strength of the transactional net

margin method is that net profit indicators (e.g. return on assets, operating income to sales, and possibly other measures of net profit) are less affected by transactional differences than is the case with price, as used in the CUP method.

Net profit indicators also may be more tolerant to some functional differences between the controlled and uncontrolled transactions than gross profit margins.

TNMM – CONTD… TNMM is more tolerant for differences in

characteristic of property or services It is one sided method i.e. applied on one

of the AE. Can be applied on least complex entity. The main disadvantage is that this

method cannot be applied if the Indian entity is also contributing to unique intangibles or its functions are so intricately linked with that of its AEs

TNMM – CONTD… Lack of comparables like in Medical

Equipment industry, ATM machines. Adjustments – Marketing, depreciation,

under-utilisation of assets / infrastructure, under-utilisation of human resources, working capital, risk

Branded vs unbranded

TNMM – SEARCH PROCESS Two widely used databases – Prowess and

Capitaline Industry / Product / NIC / Segment keyword

search These databases are used to search for suitable

comparable companies for applying TNMM Annual Reports / Financial information

contained in these databases Diagnostic ratios / filters / criteria applied Qualitative analysis to find final comparables Computation of PLIs of comparable companies

PROFIT LEVEL INDICATOR - TNMM

Net margin in relation to cost, sales, assets or any other appropriate base

As a matter of principle, only those items that (a) directly or indirectly relate to the controlled transaction at hand and (b) are of an operating nature should be taken into account in the determination of the net profit indicator for the application of the transactional net margin method.

PROFIT LEVEL INDICATOR - TNMM

Non-operating items such as interest income and expenses and income taxes should be excluded from the determination of the net profit level indicator (PLI).

Loss / gain on sale of assets / investments, dividends etc

Foreign exchange gain / loss? Exceptional and extraordinary items of a

non-recurring nature should generally also be excluded.

PROFIT LEVEL INDICATOR - TNMM

Start-up costs / pre-operative expenses Provisions for doubtful debts Contingent provisions Provisions for future losses Liabilities no longer required written back Prior period expenses The denominator should be reasonably

independent from controlled transactions.

OTHER ISSUES - TNMM Aggregation Vs segregation Segmentation vs entity level TNMM vs other methods Adjustments – Working capital Risk adjustment PLI / Cost / Sale / Asset / RoCE / OP/TC Rate of depreciation / other accounting

differences

OTHER ISSUES - TNMM Loss making comparables Quality vs quantity Diagnostic ratios / filters / search criteria Multiple year data vs single year data Earlier year data Foreign comparables Tested party

DIAGNOSTIC RATIOS Significant activity / function filter

(>75%) Related party transactions < 25% of the

revenues Export earnings > 75% of the revenues Marketing expenses > 3% of revenues R&D Expenses > 3% or 5% of revenues Onsite revenues > 75% of revenues Consistently loss making companies (3

yrs) Declining revenues for three years

DIAGNOSTIC RATIOS Different accounting year ending filter Consolidated results vs Standalone

results

PROFIT SPLIT METHOD - PSM

A transactional profit method that identifies the combined profit to be split for the associated enterprises from a controlled transaction (or controlled transactions that it is appropriate to aggregate) and

then splits those profits between the associated enterprises based upon an economically valid basis that approximates the division of profits that would have been anticipated and reflected in an agreement made at arm’s length.

Allocation keys

PSM - STRENGTH In cases where both parties to a transaction

make unique and valuable contributions (e.g. contribute unique intangibles) to the transaction, because in such a case independent parties might wish to share the profits of the transaction in proportion to their respective contributions and a two-sided method might be more appropriate in these circumstances than a one-sided method.

The transactions between AEs are so inter-linked that other methods cannot be applied reliably.

PSM - WEAKNESS A weakness of the transactional profit split method

relates to difficulties in its application. Associated enterprises and tax administrations alike

may have difficulty accessing information from foreign affiliates.

In addition, it may be difficult to measure combined revenue and costs for all the associated enterprises participating in the controlled transactions, which would require stating books and records on a common basis and making adjustments in accounting practices and currencies.

Further, when the transactional profit split method is applied to operating profit, it may be difficult to identify the appropriate operating expenses associated with the transactions and to allocate costs between the transactions and the associated enterprises' other activities.

RESIDUARY PSM Applied when comparable data for PSM is not

available. A residual analysis divides the combined profits from

the controlled transactions under examination in two stages.

In the first stage, each participant is allocated an arm’s length remuneration for its non-unique contributions in relation to the controlled transactions in which it is engaged.

In the second stage, any residual profit (or loss) remaining after the first stage division would be allocated among the parties based on an analysis of the unique contributions of respective parties.

FACTORS AMONG THE METHODS Depending on the transfer pricing method, the characteristic of property

or services must be given more or less weight. Among the methods described earlier, the requirement for

comparability of property or services is the strictest for the comparable uncontrolled price method. Under the CUP method, any material difference in the characteristics of property or services can have an effect on the price and would require an appropriate adjustment to be.

Under the resale price method and cost plus method, some differences in the characteristics of property or services are less likely to have a material effect on the gross profit margin or mark-up on costs.

Differences in the characteristics of property or services are also less sensitive in the case of the transactional profit methods than in the case of traditional transaction methods.

This however does not mean that the question of comparability in characteristics of property or services can be ignored when applying these methods, because it may be that product differences entail or reflect different functions performed, assets used and/or risks assumed by the AEs

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