Transfer Pricing

• Transfer pricing is the determination of an exchange

price for intra-organizational transfers of goods or
services (e.g., Division A “sells” subassemblies to
Division B)
• Products can be final products sold to outside
customers (e.g., batteries for automobiles) or
intermediate products (e.g., components or
subassemblies)
• Transfers of products and services between business
units is most common in firms with a high degree of
vertical integration
 Objectives of Transfer Pricing
• The objectives of transfer pricing are the same as those
for evaluating the performance of profit and
investment centers:
– To motivate managers
– To provide an incentive for managers to make decisions
consistent with the firm’s goals
– To provide a basis for fairly rewarding managers

• Specific international issues include:

– Minimization of customs charges
– Minimize total (i.e., worldwide) income taxes
– Currency restrictions
– Risk of expropriation (government seizure)
 General Transfer Pricing
Methods
• Variable cost (standard or actual), with or without a
mark-up for “profit”

• Full cost (standard or actual), with or without a

markup for “profit”

• Market price (perhaps reduced by any internal cost

savings realized by the selling division)

• Negotiated price between buyer and selling units,

perhaps with a provision for arbitration
 Choosing a Transfer
Pricing Method
• Firms can use two or more methods, called dual
pricing, one method for the buying unit and a
different one for the selling unit
• From top management’s (i.e., a firm-wide)
perspective, there are three considerations in setting
the most advantageous transfer price:
– Is there an outside supplier?
– Is the seller’s variable cost less than the market price?
– Is the selling unit operating at full capacity?
 Comparing Transfer Pricing
Methods―Variable Cost:
(Exhibit 19.9, partial)
Advantage Limitation
The relatively low transfer “Unfair” to the seller unit
price encourages buying (profit or investment
internally (the correct center) because no “profit”
decision from the overall on the transfer is
firm’s standpoint when there
is excess capacity) recognized
 Comparing Transfer Pricing
Methods―Full Cost:
(Exhibit 19.9, partial)
Advantages Limitations
 Easy to implement—data  Irrelevance of fixed cost in
already exist for financial short-term decision making;
reporting purposes fixed costs should be ignored
 Intuitive and easily in the buyer’s choice of
understood whether to buy inside or
 Preferred by tax outside the firm
authorities over variable  If used, should be standard
cost rather than actual cost
 Comparing Transfer Pricing
Methods―Market Price:
(Exhibit 19.9, partial)
Advantages Limitations
 Helps preserve subunit  Often intermediate products
autonomy have no market price
 Provide for the selling unit  Should be adjusted for cost
to be competitive with savings such as reduced
outside suppliers
selling costs, no
 Has arm’s-length standard commissions, etc.
desired by international
taxing authorities  Can lead to short-term sub-
optimization
 Comparing Transfer Pricing
Methods―Negotiated Price:
(Exhibit 19.9, partial)
Advantages Limitations
 May be the most  Need negotiation rule
practical approach when and/or arbitrations
significant conflict exists procedure, which can reduce
 Is consistent with the autonomy
theory of decentralization  Potential tax problems; may
not be considered “arm’s
length”
 Potential sub-optimization
(dysfunctional decisions)
 Transfer Pricing Context:
High Value Computer (Exhibit 19.8)

Note: “Internal to the firm” refers to interdivisional transfers of goods and/or services. In the HVC example, internal units include
both domestic and nondomestic units/divisions.
 Transfer Pricing―Example: High Value
Computer Company (Exhibit 19.11, partial)
Key assumptions:
– Manufacturing unit can buy the x-chip inside or outside
– x-chip can sell inside or outside
– x-chip unit is at full capacity (150,000 units)
– One x-chip is needed for each computer manufactured
Other Information:
– Unit selling price of computer = $850
– Variable manufacturing costs (excluding x-chip) = $650
– Variable unit manufacturing cost of x-chip = $60
– Price of x-chip sold to outside supplier = $95
– Outside supplier price of x-chip = $85
– Variable cost to make the outside chips compatible = $5
– Variable selling cost for HVC to sell its chip = $2
 Option 1
X-Chip Production Division Sells Outside:
High Value Computer (Exhibit 19.11, partial)

Contribution Income Statement (000s omitted)

150,000 computers
Computer X-Chip
Mfg. Unit Unit Total
Sales ($850, $95) $127,500 $14,250 $141,750
Less: Variable costs
X-chip ($85 + $5) $13,500 $13,500
Other ($650, $60 + $2) $97,500 $9,300 $106,800
CM $16,500 $4,950 $21,450
 Option 2
X-Chip Production Division Sells Inside:
High Value Computer (Exhibit 19.11, partial)
Contribution Income Statement with Pricing at Variable Cost
(000s omitted) 150,000 computers
Computer X-Chip
Mfg. Unit Unit Total
Sales ($850, $60) $127,500 $9,000 $136,500
Less: Variable costs
x-chip ($60) $9,000 $9,000
Other ($650, $60) $97,500 $9,000 $106,500
CM $21,000 $21,000

∴ The firm benefits more from Option 1

Pp. 847 CHOOSING THE RIGHT TRANSFER PRICE
 HVC Transfer Pricing Example:
Summary Analysis (1 of 2)

 Is there an outside supplier?

– HVC has an outside supplier, so we must compare the
inside seller’s variable costs to the outside seller’s price

 Is the seller’s variable cost less than the market

price?
– For HVC, it is, so we must consider the utilization of
capacity in the inside selling unit
 HVC Transfer Pricing Example:
Summary Analysis (2 of 2)
 Is the selling unit operating at full capacity?
– For HVC, it is, so we must consider the contribution of the
selling unit’s outside sales relative to the savings from
selling inside. Again, for HVC, the contribution of the
selling unit’s outside sales is $33 per unit, which is higher
than the savings of selling inside ($30), so from the
standpoint of the company as a whole, the selling unit
should choose outside sales and make no internal transfers.
 Total Operating Income
Under Alternative Transfer Prices:
High Value Computer (Exhibit 19.12)
(000s omitted)
 General Transfer Pricing Rule (to
maximize firmwide financial results)
From Chapter 11, we know that “relevant cost” for
decision-making purposes
= out-of-pocket costs + opportunity cost

Based on the above, we can develop a General Transfer

Pricing Rule, as follows:

Minimum Transfer Price = incremental (i.e., out-of-pocket)

cost of the producing division + opportunity cost to the
organization as a whole, if any, for an internal transfer
 General Transfer Pricing Rule (1 of 3)

The preceding rule establishes a minimum transfer price

from the standpoint of the selling division, but generally
ensures that from a firmwide standpoint the correct
economic decision is made.
 General Transfer Pricing Rule (2 of 3)

The opportunity cost in the preceding formula

represents the amount of contribution margin given up
to make the sale internally. In other words, if a sale
could be made to an outside buyer, the difference
between the outside buyer's price and the additional
outlay costs per unit equals the opportunity cost.
Obviously, the opportunity cost of selling internally
depends on whether the selling division has excess
capacity or not.
 General Transfer Pricing Rule (3 of 3)

Though conceptually appealing, the preceding

general transfer pricing rule may be difficult to
implement in practice because of a lack of required
data (inputs to the formula).
 International
Issues in Transfer Pricing

• Survey evidence: more than 80% of multinational

firms see transfer pricing as a major international tax
issue, and more than half of these firms said it was the
most important issue
• Because of international tax treaties, an “arm’s-length
standard” is the general rule
• The arm’s-length standard calls for setting transfer
prices to reflect the price that unrelated parties acting
independently would have set for the transaction
 Methods for Applying the “Arm’s-Length”
Standard for International Transfer Pricing
(1 of 2)

• The comparable-price method is the most commonly

used and most preferred method by tax authorities
– This method establishes an arm’s-length price by using the
sales prices of similar products made by unrelated parties

• The resale-price method is used when little value is

added and no significant manufacturing operations
exist
– This method based on an appropriate markup using gross
profits of unrelated firms selling similar products
 Methods for Applying the “Arm’s-Length”
Standard for International Transfer Pricing
(2 of 2)
• The cost-plus method determines the transfer
price based on the seller’s costs plus a gross
profit % determined by comparing the seller’s
sales to those of unrelated parties or comparing
unrelated parties’ sales to other unrelated parties
• Advance pricing agreements (APAs) are
agreements between the IRS and the firm using
transfer prices that establish an agreed-upon
transfer price (to save time and avoid costly
litigation)
 Other International Considerations

• Risk of Expropriation (of assets)

• Minimization of Customs Charges

• Currency Restrictions
 Transfer Pricing in Indian Context
• The Finance Act, 2001 introduced Transfer Pricing Regulations for
curbing tax avoidance and manipulation of intra-group transactions
by abusing transfer pricing.
• Specifically, the memorandum to the Finance Act, 2001 stated that:
• “The increasing participation of multinational groups in economic
activities in the country has given rise to new and complex issues
emerging from transactions entered into between two or more
enterprises belonging to the same multinational group. The profits
derived by such enterprises carrying on business in India can be
controlled by the multinational group, by manipulating the prices
charged and paid in such intra-group transactions, thereby, leading to
erosion of tax revenues. With a view to provide a statutory framework
which can lead to computation of reasonable, fair and equitable
profits and tax in India, in the case of such multinational enterprises,
new provisions are proposed to be introduced in the Income-tax Act.”
 Section 92

• Section 92 deals with Transfer Pricing

regulations
• Any income, expenditure, interest and
allocation of cost in relation of international
transaction or specified domestic transaction
shall be computed having regard to Arm’s
length price.
• If due to ALP there is reduction in the income
or increase in the losses then TP provisions
shall not apply
 Section 92A
• Section 92A defines Associated Enterprises
• Section 92A(1): An ENTERPRISE which participates
DIRECTLY OR INDIRECTLY or through intermediaries
in:
• a) Management
• b) Control
• c) Capital of other enterprise

• Enterprise means person engaged in activity relating to

production, supply etc. of goods, know-how, patents etc.
of which the other enterprise is the owner or in respect
of which the other enterprise has exclusive
rights/provision of service/carrying out
work/investment/loan/ business of dealing in shares etc
 Section 92A(2)
• Capital Based Relationships
1. ENTERPRISE OWNERSHIP: Any enterprise
having direct or indirect ownership in shares
having ≥ 26% of voting power. (since the term
voting power is used, preference shareholders
are not covered).
2. MUTUAL HOLDING: Any person has direct
or indirect ownership of shares having ≥ 26%
of voting power, in two or more enterprises.
 Capital Based Relationships

3. SUBSTANTIAL LENDER:
Loan advanced by an enterprise constitutes ≥
51% of the BOOK VALUE of the ASSETS of
the borrower.
 CONTROL BASED RELATIONSHIPS
5.GUARANTOR FOR BORROWINGS:
An enterprise guarantees ≥ 10% of the total
borrowings of the other enterprise.

6. DEPENDENCY ON INTANGIBLES:
a) An enterprise which is wholly dependent for its
business on the use of intangible assets like
patents, copyrights, etc.
b) Such intangible asset is owned by another
enterprise or the other enterprise has exclusive
right to use or exploit the intangible asset
 CONTROL BASED RELATIONSHIPS
7. SUPPLY DEPENDENCY: One enterprise is engaged
in manufacturing or processing of goods/articles and
≥ 90% of the raw materials or consumables: a) Are
supplied by the other enterprise, or b) Are supplied by
persons specified by the other enterprise. c) Prices and
other conditions of supply are specified by the other
enterprise.
Example: BPCL India is an oil marketing company.
The company predominantly deals with Shell
Petroleum of Dubai. Shell Dubai supplies almost 100%
of the crude oil required by BPCL either directly or
from its subsidiaries in India. Both Shell and BPCL
shall be considered as AE.
 CONTROL BASED RELATIONSHIPS

8. SALE DEPENDENCY:
Where one enterprise is engaged in
manufacturing or processing of goods/articles
and such goods/ articles:
a) Are sold to the other enterprise, or b) Are
sold to persons specified by the other
enterprise;
AND c) Prices & other Conditions of Sale are
specified by the other Enterprise.
CONTROL BASED RELATIONSHIPS

• INDIVIDUAL – CONTROL: When same

INDIVIDUAL/HIS RELATIVE CONTROLS
TWO ENTERPRISES
• HUF-CONTROL: Where one enterprise is
CONTROLLED BY A HUF, the other
enterprise is CONTROLLED BY A MEMBER
OF SUCH HUF OR BY A RELATIVE of a
member
MANAGEMENT BASED RELATIONSHIPS
11. APPOINTMENT OF BOARD:
If one enterprise has following powers in relation
to other enterprise: a) appoints > HALF of BoD
members; or b) appoint 1 or more Executive
Director
12. APPOINTMENT OF BOARD IN TWO OR
MORE ENTITIES:
Where a person has the following powers with
respect to two or more enterprises: a) appoints >
HALF of BoD members; or b) appoint 1 or more
Executive Director
 Section 92B
• International Transaction
• between 2 or more Associated Enterprises [Sec.92A]
• One or both AE should be Non-resident

The transaction between two AE’s (one or both of them should be

non-resident), if relating to say purchase of goods, would get
covered under the definition of international transaction.
TRANSACTION BETWEEN FOREIGN HEAD OFFICE AND
INDIAN BRANCH OR PERMANENT ESTABLISHMENT SHALL
BE INTERNATIONAL TRANSACTION.
Further, if a transaction has effect on profits/losses/assets of
enterprise, such transaction shall be classified under international
transaction. However, it is pertinent to note that business
restructuring transaction would get classified as international
transaction even if does not have any bearing on
profits/losses/assets of enterprise.
Deemed to be International Transaction
• It is pertinent to note that transfer pricing
adjustment to SDT is not required if it has
the effect of increasing the loss or reducing
the income. As transfer pricing mechanism
is for preventing avoidance of tax and in
such casesthere is no avoidance of tax.
 ALP Computation
COMPARABLE UNCONTROLLED PRICE
(CUP) METHOD
• Step 1: Identify the price charged for similar
goods/services provided in comparable
uncontrolled transaction
• Step 2: Adjust Price for following:
• Quantity discount • Insurance charges •
Freight cost • Warranty charges etc.
• PP Ltd. supplies 50,000 engines to its
holding company PP Inc @ Rs. 3,000 per
engine. It also supplies 15,000 engines to XY
Ltd. (unrelated party) @ Rs. 4,000 per
engine. The company claims to give a
volume discount of 10% for the bulk
purchase by the parent company.
 RESALE PRICE METHOD (RPM)
Identify property purchased or services
obtained by the enterprise from an AE
Identify price at which such property/services is
resold or are provided to an unrelated enterprise
Deduct normal GP margin earned from
uncontrolled transaction from Step 2.
Reduce the expenses incurred in connection
with purchase of property or obtaining services
Adjust for various factors like Qty
disc/Insurance/ Freight
• PP Ltd. imports Ford cars @ Rs. 12 Lakhs
from its parent PP Inc for sale in India. PP
Ltd resells the imported car in India @ Rs.
13.5 Lakhs and incurs expense of Rs. 1.2
Lakhs on import. XY Ltd. an Indian
unrelated party, imports similar cars
(Hyundai) @ Rs. 11.5 Lakhs and sells at Rs.
14 Lakhs.
• Cost plus method
• Determine the total direct & indirect costs
of production of goods/services
• Determine normal gross profit mark-up to
such costs in comparable uncontrolled
transaction
• PP Ltd. provides support services to its
parent AP Inc @ USD 25/hr. PP Ltd. also
provides similar service to XY Ltd. an
unrelated party @ USD 36/hr. PP Inc makes
immediate payment while credit period is
allowed to XY Ltd of 45 days. The total
direct & indirect cost of PP Ltd. is USD 15/hr
and it incurs finance charges of USD 2 p.m.
Further, assume cost of manpower to PP Ltd
is 40% more
• TRANSACTION NET MARGIN METHOD
(TNMM)
• Identify the net margin to the enterprise
from international transaction.
• Identify net margin from comparable
uncontrolled transaction
• Adjust with factors
• ALP will be computed with adjusted net
margin computed in last step
• PP Ltd. procures antivirus software from its
parent AP Inc in US @ Rs. 650 per pack. PP
Ltd. incurs additional expense of Rs. 200
per pack on labelling. The product is sold
for Rs. 1000 per pack. It also procures
similar antivirus software from Windows @
Rs. 3,000 per pack and incurs an additional
expense of Rs. 400 per pack and sells the
product at Rs. 5,000 in India.
 PROFIT SPLIT METHOD (PSM)

• PP Inc. provided R&D services to its three

AEs i.e. AP Ltd (India), PP Plc (UK), AP
Korea. The cost incurred is Rs. 2 crores. The
relative effort put in by group companies are
10%, 40% and 50% respectively. PP billed to
AP Ltd. Rs. 31 Lakhs.
 Rule 10CA: Range Concept
>1 ALP

Yes No
Which Method Price
Applied? Determined

CUP/RPM/CPM/ PSM/ Other

TP = ALP
If TNMM methods

Yes
Apply Variation of 3% of TP
If Comparable Arithmetic
(1% in case of
Range Companies >6 Mean wholesalers) between TP
& ALP allowed
Concept
 Steps in Range method
• Calculate Weighted Average Margins or Prices for all comparables using 3 years
data (including CY data) *
• Arrange the prices given in ASCENDING ORDER
• Obtain 35th Percentile = Total No of comparables * 35%
• Obtain 65th Percentile = Total No of comparables * 65%
• Find 35th& 65th percentile in data arranged in ascending order. THIS WILL BE
ARM’S LENGTH RANGE. If TP is within range, TP is at ALP
• If TP is not within range, obtain MEDIAN (50th Percentile) = Total No of
comparables * 50%. Find the 50th percentile in data arranged in ascending order
• If DECIMALS ROUND OFF TO NEXT HIGHER VALUE
• If WHOLE Number AVERAGE of PERCENTILE & NEXT HIGHER VALUE

*
•
 Safe Harbour Rules

• Section 92CB was inserted in Finance Act

2009 w.r.e.f. 1st April 2009. The said
section gave powers to Central Board of
Direct Taxes (CBDT) to make Safe
Harbour Rules.
• “safe harbour” means circumstances in
which the income-tax authorities shall
accept the transfer price declared by the
assessee.
 Advance Pricing Agreement
• An Advance Pricing Agreement (APA) is AN AGREEMENT ENTERED BETWEEN A
TAXPAYER AND A TAXING AUTHORITY to determine ALP or specifying the manner
in which ALP shall be determined, in relation to such INTERNATIONAL
TRANSACTION.
• It is pertinent to note that the provisions of APA shall override the normal
provisions of determination of arm’s length price.

• Section 92CC
• Applicable for maximum consecutive 5
years
 https://www.india-
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advance-pricing-agreements-complex-transfer-
pricing-environment-23555.html/
 Penalties
Section Nature of Default Penalty
270A(9) Failure to report any 200% of the tax payable on
International transaction under- reported income
or ‘misreporting of income’
271BA Failure to furnish a report 1 lakh
from an accountant as
required under section 92E
271G Failure to furnish info or 2% of the value of the
doc as required by International transaction
Assessing Officer for each failure
271AA Failure to keep and 2% of the value of each
maintain any such such International
document and information transaction
as required or
Failure to report such
International transaction
which is required to be
• The penalty u/s 271AA shall be in addition
and not in substitution of penalty u/s 271BA.
• If the assessee proves that there was
reasonable cause for the failure, no penalty
would be leviable under section 271BA, 271G
and 271AA.
•
Transfer Pricing Assessment
Through Dispute Resolution Panel

ITAT: Income Tax Appellate Tribunal

 Notified Jurisdictional Area [Section 94A]

• The Central Government (CG) is empowered to notify any

country or territory outside India as a notified
jurisdictional area in relation to transactions entered into
by any assessee, if such country lack effective exchange of
information with India. Cyprus was notified as NJA by CG.
• If a taxpayer from India pursues any transaction with a
person located in the NJA, it will result in the following
implications, which qualifies it for transfer pricing
regulations:

– The parties to the concerned transactions would be

considered as associated enterprises
– The concerned transactions would be categorized as
international transactions