Transfer Pricing for Tax Planning: Objectives of Transfer Pricing

Increasing participation of multinational groups in economic activities in India has given rise to new and complex issues emerging from transactions entered into between two or more enterprises belonging to the same group. Hence, there was a need to introduce a uniform and internationally accepted mechanism of determining reasonable, fair and equitable profits and tax in India in the case of such multinational enterprises. Accordingly, the Finance Act, 2001 introduced law of transfer pricing in India through Section 92 A to 92 F of the Indian Income-tax Act, 1961 which guides computation of the transfer price and suggests detailed documentation procedures.

Objectives of Transfer Pricing

  1. Profitability: To foster a commercial attitude in those who are responsible for the performance of profit centres. The main emphasis here is on profitability. This objective forces the units to improve their profit position.
  2. Maximum Utilization of Plant Capacity: To optimize the profit of the company over a given short period of time. Here the stress is on maximum utilization of plant capacity.
  3. Optimize Financial Resources: this is a long-term objective. The allocation of resources is based on relative performance of various profit centres, which in turn are influenced by transfer pricing policies.
  4. Performance Evaluation: To enable the performance of a division to be evaluated by compensating it for benefits providing for other divisions and charging it for benefits received.
  5. Minimize Tax: international groups may try to manipulate transfer prices between countries in order to minimize overall tax burden.

Transfer Pricing Methods

1. Comparable Uncontrolled Price Method

  1. The price charged or paid for property transferred or services provided in a comparable n, or a number of such transactions, is identified.
  2. Such price is adjusted to account for differences, if any, between the international transaction and the comparable uncontrolled transactions or between the enterprises entering into such transactions, which could materially affect the price in the open market.
  3. The adjusted price arrived at under sub-clause (ii) is taken to be an arm’s length price in respect of the property transferred or services provided in the international transaction.

2. Re-Sale Price Method

  1. The price at which property purchased or services obtained by the enterprise from an associated enterprise are resold or are provided to an unrelated enterprise, is identified.
  2. The price arrived at is further reduced by the expenses incurred by the enterprise in connection with the purchase of property or obtaining or services.
  3. The adjusted price arrived at under sub-clause (IV) is taken to be an arm’s length price in respect of the puchase of the property or obtaining of the services by the enterprise from the associated enterprise.

3. Cost Plus Method

  1. That mark-up should reflects the profit for the associated enterprise on the basis of functions and risks performed. The result is an arms’ length price.
  2. In general, the mark-up in a cost plus method will be computed after direct and indirect costs of production or supply. However, operating expenses of the enterprise such as overhead expenses are not part of the mark up.
  3. The mark-up can be determined in two ways. The first, it can be compared to the mark-up applied by the associated supplier of property or services for comparable transactions with third parties (internal cost-plus method). If such transactions do not take place, the alternative is to look at the cost plus mark-up applied in transactions between third parties.
  4. The costs referred to in sub-clause (i) are increased by the adjusted profit mark-up arrived at under sub-clause (iii).
  5. The sum so arrived at is taken to an arm’s length price in relation to the supply of the property or provision of services by the enterprise.

4. Profit Split Method

  1. The Profit Split Method examines the terms and conditions of these types of controlled transactions by determining the division of profits that independent enterprises would have realized from engaging in those transactions.
  2. The combined net profit is then split amongst the enterprises in proportion to their relative contributions, as evaluated under sub-clause (ii).
  3. The profit thus apportioned to the assessee is taken into account to proportion to arrive at an arm’s length price in relation to the international transaction.

5. Transactional net margin method

  1. The transactional net margin method (“TNMM”) compares the tested party’s net profitability on a controlled transaction to the net profit obtained by broadly similar uncontrolled companies on similar transactions. The OECD Guidelines state that the TNMM may be a practical solution to otherwise insolvable transfer pricing problems when used sensibly with appropriate adjustments to account for any material differences between transactions. Also, the degree of comparability required to apply the TNMM is less stringent than what is necessary under other methods. A primary benefit of the less stringent comparability standards is a significant increase in the number of arms-length observations available to establish the arm’s-length remuneration of the entities tested.
  2. The profitability margins used for the comparison are often referred to as profit level indicators (“PLIs”). PLIs are ratios that capture relationships between profits and costs incurred, revenues generated, or resources employed. Below, a few commonly applied PLIs are described.