Transfer pricing: New focus in India

Towards the beginning of November 1999, the Finance Ministry

decided to take a serious look at the existing regulations, which
deal with transfer pricing. It also asked the Central Board of
Direct Taxes (CBDT) to set up a committee to recommend
changes, if necessary, in the provisions of the Income Tax Act
so that transfer pricing in respect of cross-border transactions
does not lead to an adverse impact on revenue. By the end of
November 1999, the CBDT had set up the committee. The
committees report is awaited.
Transfer pricing is fast developing into one of the most important and
complex tax issues that modern businesses are faced with today.
With transfer pricing being seen more and more as an essential part
of business planning and strategy, taxation authorities worldwide are
investigating transfer-pricing arrangements with increased vigour.
Similar imperatives seem to be on their way in India as well.
Transfer Pricing Concept:
The price charged between related parties for goods, services,
intangibles, loans as well as cost sharing agreements are considered
to fall within the broad purview of transfer pricing.
For tax purposes, revenue authorities would expect arms length
pricing on all transactions whether they are between related (i.e.,
having a common thread of ownership or control) or unrelated
parties. An arms length price is the price that would be charged
between two parties acting independently, each trying to get the best
deal. While this is a simple statement of principle, its implication has
been a subject of considerable interpretation.
Application of the Arms Length Principle:
The application of the arms length principle is generally based on a
comparison of conditions in a controlled transaction (i.e., transaction
between related parties) with the conditions in transactions between
unrelated parties. The economically relevant characteristics of the
situations being compared ought to be sufficiently comparable for the
results of such an exercise to be useful. The key factors for

evaluating comparability are functions, risks, contractual terms,

business strategies, etc. Some general principles to be followed in
transactions between related parties would be as follows:

the greater the risk taken by one party, the greater is the reward
to be allocated to them. For example, if a group manufacturing
company has been given a long-term supply agreement by the
group export/sales company then the latter may be entitled to a
greater share of the total profits;

the payment for individual functions should be quantifiable

based on comparable prices charged by third parties;

a value should be attributable to the intangibles owned by each

party;

location of manufacture or sale may affect prices to be charged

between related parties; and,

strategic considerations such as opening new markets, loss,

leaders, promotions, etc. may affect prices of goods or services.

Methods for determining arms length price:

There are a variety of ways in which arms length prices could be
determined. Certain pricing methodologies are appropriate in certain
types of transactions. The Transfer Pricing Guidelines issued by the
Organisation for Economic Co-operation and Development (OECD)
contain the description of specific methods, so do US regulations.
Many countries do not prescribe or recommend any specific method
for determining transfer prices. However, on the whole, they agree
with the principles of the OECD Guidelines.
Global trends in transfer pricing:
Having understood and examined the impact that transfer pricing
policies of multinational corporations can have on their share of tax
revenues, numerous countries (such as the United States of America,
United Kingdom, Australia, Mexico, Brazil, South Africa, Ukraine, etc.)
have:

introduced detailed transfer pricing laws, or

tightened existing transfer pricing laws, or

are investigating the need for the process of formulating such

laws.

In the United States, for instance, transfer pricing is a top priority

issue for the Internal Revenue Services in International Taxation.
The OECD has issued revised Transfer Pricing Guidelines between
1995 and 1998; these have been well appreciated by the Asia-Pacific
Economic Co-operation (APEC) countries.
Faced with severe reductions in tax revenue and at the same time, an
ever-increasing demand for public spending to support individuals
and businesses, several governments are seeking to increase their
tax take through increased focus on transfer prices.
The Indian scenario:
Post-liberalised India has witnessed numerous transactions by
multinational corporations in India with their overseas members that
relate to the purchase/sale of products/services, licensing of
technology, loan grants, etc.
Unlike the income tax laws of other countries (such as those
mentioned above) describing detailed provisions to deal with the
complex issues of transfer pricing, the Indian Income Tax Law does
not have adequate provisions. Section 92 of the Indian Income Tax
Act, 1962, which is related to transfer pricing remains unchanged
since then. Obviously, it is not equipped to address these issues.
Neither are other related sections such as 40A(2), 80IA(6).
The tax authorities have at times questioned issues of transfer pricing
between related entities. However, having made it known that transfer
pricing is now an area that needs to be tackled on a top priority basis,
one can expect the government to amend the income tax law in line
with those in other countries and empower the tax authorities to deal
with transfer pricingfirmly.

It is also pertinent to note that under the Companies Act, 1956, the
statutory auditors are required to confirm whether certain transactions
with connected parties are at arms length. For such purpose,
auditors generally apply broad level tests. As transfer pricing
legislation in India matures, auditors would be in a position to take a
closer look at Transfer Pricing issues.
Though it was also reported that it could take a couple of years
before the final transfer pricing regulations are in place in India, it may
not be unrealistic to expect the government to move quicker in this
respect. In view of the global trends and the possible favourable
impact on fiscal collections, transfer pricing could prove to be one of
the top issues for Indian Revenue in the new millennium.
It is imperative that companies have streamlined procedures that will
help them substantiate their transfer prices when audited by tax
authorities. It is equally important that companies should, through
proper transfer pricing studies, adopt strategies that will achieve
significant minimisation of the overall tax burden.
Decentralization means the freedom to make decisions.
Decentralization can transform a profit center into an investment
center. Centralization can transform an investment center into a profit
center or transform a profit center into a cost center.
Potential Benefits from Decentralization
1. Better decisions can be made at the local level.
2. Provides more incentives to segment managers.
3. Encourages internal competition.
4. Provides top management with more time for strategic planning
and other policy decisions.
Cost of Decentralization
1. Lack of Goal congruence.
2. Conflicts between divisions.
3. Redundant activities.

The greater the interdependence between divisions, the greater the

likelihood that the costs of decentralization will be greater than the
benefits.
Transfer Prices
A transfer price refers to the price used for intra-company transfers,
i.e., transfers between segments of a company. The term transfer
pricing normally means pricing transfers between divisions, but could
be used in any situation where the output of one segment (e.g.,
department, operation, process) becomes the input for another
segment within the same company.
Three Decisions
A transfer pricing situation usually involves three questions or
decisions.
1. Should the transfer take place? This is essentially a (Make or
Buy) question.
Should the company make the item or outsource, i.e., purchase
it on the outside market?
This is a relevant cost problem (also referred to a differential or
incremental cost).
The key is which costs will be different under the two alternatives, i.e.,
make inside and transfer, or buy from outside the company?
2. If the answer to question one is yes, then what transfer price
should be used?
3. Should the central office interfere in establishing the transfer
price?
Objectives of Transfer Prices
The overall objective is to establish a transfer price that will motivate
effort and goal congruence. There are at least three underlying
objectives.
1. To aid in Evaluating Division Performance, i.e., investment
centers or profit centers.
If the divisions are treated as investment centers, then Return on

Investment (ROI) and Residual Income (RI) are the relevant

measurements. For profit centers, contribution margin, segment
margin, or net income would be a more appropriate measurement.
2. To maintain Division Autonomy. Since autonomy means
decentralization and freedom to make decisions, it is also an
ingredient in motivating effort. Remember, however, that effort and
goal congruence are different. Managers may exert considerable
effort in pursuing their own goals that conflict with the goals of the
firm. Central office interference in a transfer-pricing dispute will affect
autonomy and effort. The dilemma is that goal congruent behavior
may not be obtained with or without interference.
3. To provide the buying segment with the information necessary
for the make or buy question. Intra-company profits included in a
transfer price make it impossible for the buying division to answer the
make or buy question.
Possible Transfer Prices
1. Market prices. A market price is considered best if the market is
perfectly competitive, i.e., if a single buyer or seller cannot affect the
price. Generally intra-company transfers at market prices accomplish
objectives 1 and 2, but not 3. Unfortunately, several problems occur
when trying to use market prices: a. Most markets are not perfectly
competitive. In other words, the demand curve and price structure
may shift if the firm buys outside.
b. Market prices may not exist for some products.
c. A market price may not be comparable because of differences in
quality, credit terms, or extra services provided.
d. Price quotations may not be reliable because they are based on
temporary distress or dumping conditions.
e. A market price may not be relevant because the selling division
would not have the same transportation cost, accounting cost for A/R,
credit etc. as an outside supplier.
f. Information for the make or buy decision would not be available
to the buying division.
2. Full cost. All manufacturing, selling and administrative cost are
included.

The problems that occur when full cost is used as a transfer price
include:
a. Transfer prices based on full cost do not accomplish any of the
objectives stated above.
The selling division could not be evaluated as a profit center or
investment center since it is treated as a cost center.
b. The seller would be motivated to over allocate cost to the
product transferred.
c. If actual cost are transferred, the cost of inefficiency will be
passed along to the buying division. Thus, standard cost make better
transfer prices although standards may be rigged.
d. The buyer would not have the differential cost information
needed for the overall firm make or buy decision. The irrelevant
(mostly common fixed cost) of the seller become relevant cost to the
buyer.
3. Full Cost Plus. All manufacturing, selling and administrative cost
plus a markup for profit. Standard cost plus would be better than
actual cost plus to motivate the seller to be an efficient cost producer.
The same problems in 2 are applicable here. Motivation for over
allocation is still present. Transfers at standard could motivate the
seller to rig the standard.
4. Variable cost. All variable manufacturing, selling and administrative
cost. This may come close to accomplishing objective 3, since
variable cost may approximate differential cost. It should be noted
however, that variable cost and differential cost are not the same
since some fixed cost may also be relevant, i.e., change if the product
is purchased outside rather than produced inside. Objectives 1 and 2
would not be obtained since the other problems listed under 2 and 3
are applicable here, lack of motivation for profits, potential for cost
over allocation etc.
5. Variable cost plus. This may be a little better than 4, but the plus
should be kept separate to allow for a ballpark make or buy decision.
Objectives 1 and 2 would not be fully obtained.
6. Negotiated price. Negotiated prices may be best if: a. An imperfect
market exist) for the product making it difficult, if not impossible, to
determine the appropriate market price.

b. The seller has excess capacity), thus the transfer becomes a

differential cost problem to the seller. Any transfer price above the
seller's differential cost would benefit the seller.
c. There is no external market) for the product, thus no market
price.
In these cases the buyer and seller may negotiate a price that allows
both parties to share in the benefits of the transfer. This may
accomplish objectives 1 and 2, but not 3. A problem with this
approach is that managers may spend a substantial amount of time
and effort negotiating transfer prices.
7. Dual Price. Use two transfer prices. Give the seller credit for selling
at market price or full cost plus a reasonable markup, but charge the
buyer with variable cost (i.e., approximate differential or additional
outlay cost). Charge the difference to a central account. This
approach may not motivate either the seller or the buyer to be
efficient.
Very General Rule:
Optimum Price = Additional Outlay Cost + Opportunity Cost
Opportunity Cost = Market Price - Additional Outlay Cost
Opportunity Cost is the contribution margin that the seller would earn
if the product could be sold on the outside market.
If the seller has excess capacity, i.e., cannot sell additional units on
the outside market, then the seller's opportunity cost is zero. Thus, it
is argued that the seller should transfer the product at cost. A problem
may arise however, since the seller has no incentive to produce the
extra product.
Maximum Price = Market Price
Minimum Price = Additional outlay cost, i.e., differential cost.
Transfer pricing is a classic catch-22 situation, a problem without a
definitive answer.