transfer pricing basics

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TRANSFER PRICING : BASICS

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Why Transfer Pricing ?

Rise of large number of MNEs

Increase in number of cross border transactions

Existence of different tax rates & rules in different jurisdictions

Transactions between group companies – not determined by market forces

Main motive of MNEs - to maximize stakeholder’s wealth


How profits are manipulated ?

Indian Entity Group EntityMakes payment

Provides Services

India Low Tax Jurisdiction


Importance of Transfer Pricing

Transfer Pricing rules are essential for Tax Administration and Tax Payers in order to:

Protect their tax base

Eliminate double taxation

Enhance cross border trade


Indian Regulations

Finance Act, 2001 recognized the need of TP provisions and introduced Chapter X

Chapter X containing section 92 to 92F provides detailed provisions for Transfer Pricing

Finance Act, 2012 extended the scope of TP provision to Specified Domestic Transactions

APA and Rollback provisions introduced to reduce litigation


Associated EnterpriseAssociated Enterprise

Satisfying the “test of participation in mgmt.,

control or capital” Being Deemed AEs


International Transaction

International Transaction means:

A transaction

Between two or more associated enterprise

Either or both of whom are non-residents

Transaction in the nature of:

- Purchase, sale or lease of tangible/intangible property

- Provision of services

- Lending or borrowing of money

- Other transaction having bearing on profits, incomes, losses or assets

- Mutual agreement between AE for allocation/apportionment/contribution to any cost


Specified Domestic Transaction

Transfer Pricing Regulations extended by Finance Act, 2012 to include SDTs.

SDT means following transactions, not being an international transaction:

Expenditure for which payment made to person referred to in section 40A(2)(b)

Transactions referred to in section 80A

Transfer of goods or services referred in section 80-IA (8)

Business transacted between Assessee and other person referred to in section 80-IA (10)

Any transaction, referred to in any other section under Chapter VI-A or section 10AA, to which provision of

section 80-IA (8) or 80-IA (10) are applicable

Any other prescribed transaction

Aggregate of transaction entered in previous year exceeds a sum of Rs. 5 crore rupees.


Arm’s Length Price

Common Parlance :

Price at which independent enterprises deal with each other, where the conditions of their commercial and

financial relations are ordinarily determined by market forces.

Section 92F(ii) of Act:

A price which is applied or proposed to be applied in a transaction between persons other than associated

enterprise, in uncontrolled conditions.


The Heart of Transfer Pricing:

Comparability


Process of Computation of ALP

(i) Analysis of specific features of controlled transaction (i.e. international transaction of SDT in question)

(ii) Search for comparable uncontrolled transactions

(iii) Comparability Analysis in accordance with sub rule (2) to (4) of Rule 10B

(iv) Selection of Most Appropriate Method

(v) Application of MAM to calculate ALP


Background & Industry Overview

Broad - based analysis of the taxpayer’s circumstances

An analysis of the industry, competition, economic and regulatory factors affecting the taxpayer and its

environment

Helps understand the conditions in the controlled transaction as well as those in the uncontrolled transaction

to be compared, in particular the economic circumstances of the transactions.


Analysis of specific features of controlled transaction

Functional Analysis- Functions performed

- R&D, Design & Engineering- Manufacturing, production & Assembly- Warehousing & Transportation, etc.

- Assets Employed- Tangible Assets: Land & Building, Plant & Machinery, etc.- Intangible Assets: Patents, Trademarks, Licences, etc.

- Risks Assumed- Financial Risks- Product & Market Risk- General Business Risks

Characterisation: Necessary to carry search for similar comparables with similar characteristics


Selection of Tested Party

Tested party is the party to the transaction for which comparability is analysed. Such party’s financial indicators

shall be tested against those of uncontrolled transactions

Choice of Tested Party necessary for applying Cost Plus Method, Resale Price Method or Transactional Net

Margin Method

It may be the local or the foreign party

It should be less complex party in respect of which most reliable data for comparability is available and

adjustments could be made easily


Comparables

Comparables

Internal Comparables External Comparables


Identification of External Comparables

Database Screening

Quantitative Screening

Qualitative Screening

Final Set of Comparables


Quantitative Filters


Most Appropriate Method

For determining comparability, MAM should be used

MAM should be the method best suited to the facts and circumstances of each particular IT/ SDT

It should provide the most reliable measure of an arm’s length price in relation to the IT/SDT

For determining the MAM, following factors should be kept in mind

‐ Nature and class of transactions

‐ Class of AEs and the functions performed by them

‐ Degree of comparability between the IT/SDT and CUT

‐ Extent to which reliable and accurate data is available and adjustments can be made


Comparable Uncontrolled Price Method

Most direct method of comparability analysis

Require a relatively high level of comparability to produce reliable results

Price of comparable transaction xxx

+/- Adjustment for material differences between comparable transaction and IT/SDT xxx

+/- Adjustment in respect of material differences between enterprise to both the transactions xxx

Arm’s length Price as per CUP method xxx


Resale Price Method

Used to determine ALP when goods purchased from AE resold without significant value addition

Involves working back from resale price received from unrelated parties to arrive at an arm’s length price

Resale Price charged from unrelated party xxx

Less: Normal Gross profit margin on similar transaction xxx

Less: Expense in connection with purchase xxx

+/- Stock adjustment and other adjustments on account of difference in transactions and enterprises

xxx

Arm’s length Price as per RPM xxx


Cost Plus Method

Used to determine ALP when goods & services are sold to AE

Compares the gross profit mark-up earned by the tested party for the provision of goods and services with

gross profit mark-ups earned by comparable companies.

Direct and Indirect costs incurred in respect of goods and services xxx

Add: Normal gross profit under by comparables on similar transactions xxx

+/- Adjustments on account of difference in transactions and enterprises xxx

Arm’s length Price as per CPM xxx


Profit Split Method

Typically applied when both sides of the controlled transaction contribute significant intangible property

The profit is to be divided such as is expected in a joint venture relationship

PSM starts by identifying the profits to be divided between the Aes

These profits are subsequently divided between the AEs on the basis of value of each AEs‘ contribution, which

should reflect the functions performed, risks undertaken and assets employed by each AE

PSM is of two types

‐ Total Profit Split Method

‐ Residual Profit Split Method


Transactional Net Margin Method

This method is mainly applied in case of:

Provision of services

Distribution of finished goods where RPM can’t be applied

Transfer of semi-finished goods where CPM can’t be applied

Transactions involving intangibles where PSM can’t be employed

This method involves:

Identification of PLI

Identification of net profit margin realised by the enterprise from international transaction

Identifying the net profit margin from CUT having regard to the same base and adjusting it for material

difference in transactions/enterprise

The adjusted net profit margin is used to arrive at the arm’s length price of the IT/SDT


Transactional Net Margin Method - PLI


Other Method

CBDT has notified such other method apart from the five methods already prescribed. It states

“ the Other Method for determination of the arms' length price in relation to an international transaction shall be any

method which takes into account the price which has been charged or paid, or would have been charged or paid, for

the same or similar uncontrolled transaction, with or between non-associated enterprises, under similar

circumstances, considering all the relevant facts.”

This method is typically used where the other methods can not be used (e.g. Managerial Remuneration). The

various data which can be used for comparability purposes are:

Third party quotations

Valuation reports

Documents relating to negotiations,

Standard rate cards


Contemporaneity of Data

Data for current year should be used

Data for previous two years can also be used if such data reveals facts which could have an influence on the

determination of transfer prices in relation to the transactions being compared


Contemporaneity of Data [Contd…]

Current Developments:

Data for current year or FY preceding the current year shall be used for comparability

Where the CUT has been identified on the basis of data relating to the current year and the enterprise

undertaking the said uncontrolled transaction has in either or both of the two financial years immediately

preceding the current year undertaken similar comparable uncontrolled transaction, then the weighted average

of the prices of the CUT undertaken in the current year and in the preceding two years shall be used.

Where the CUT has been identified on the basis of the data relating to the financial year immediately preceding

the current year and the enterprises undertaking the said uncontrolled transaction, has in the financial year

immediately preceding the said financial year undertaken the same or similar comparable uncontrolled

transaction, then the weighted average of the prices of the CUT undertaken in the aforesaid period of two years

shall be used for determining the arm’s length price.


Mean or Range

If the number of comparables is less than 6, then arithmetic mean of the margins should be used

If the number of comparables is greater than or equal to 6, then

‐ A dataset shall be constructed by arranging the weighted average margins in ascending order

‐ The arm’s length range shall begin from the thirty-fifth percentile of the dataset and end on the sixty-fifth

percentile of the dataset. The data place of x percentile shall be computed as :

Data place of x percentile = Total no. of data points in dataset * (x / 100)

‐ If the price at which the international transaction or the specified domestic transaction has actually been

undertaken is outside the arm's length range, the arm's length price shall be taken to be the median of the

dataset


Documentation Areas• Company• Group• Industry

• Covered Entities• Covered

Transactions

• Functions• Assets• Risk

• Comparability • Method

Selection• Benchmarking

Background Information

Transaction Information

Functional Analysis

Economic Analysis


Penalties

Failure to Keep and maintain information & Documents w.r.t IT/ SDT 2% of value of each transaction

Failure to furnish report u/s 92E Rs. 1,00,000

Failure to furnish information and documents u/s 92D 2% of the value of each transaction

Additionally penalties u/s 271 can also be initiated for any such failure


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