When we go out to shop essential items, we usually have a preferred shop, out of convenience or the trustin the quality of products offered. On the flip side, the shopkeeper recognises the importance of having regular customers and therefore, gives us a little preferential treatment, sometimes even discounts, which may not be generally offered to other customers. These discounts become even more obvious when the shop owner is a close relative or a friend. Businesses and corporates also deal in a similar manner. They usually prefer regular suppliers, offer deep discounts to bulk buyers, and regularly deal with companies which are related to them. This is all fine as long as the transactions are happening at fair price, as offered in the markets. However, things get dubious for taxation purposes, when the contrary happens.
Understanding Transfer Pricing
Let’s say, two companies Alpha and Beta, with a same holding company (which makes them related entities under law) enter into an agreement where Alpha sells spare parts to Beta, at a price 10% lower thanthe market rate. Firstly, this agreement is possible because the holding company is the same, and it can exercise its influence on this agreement. Secondly, this transaction results in lesser income for Alpha, which as a result, would pay lesser taxes as well.This might have been acceptable, asBeta would have lesser expense and thereby, the total tax collection remains same. However, ifAlpha is located in Mauritius, a tax haven, where taxes are minimal or not applicable, and Beta, on the other hand, is located in India, paying regular taxes, such a transaction would result in lesser tax collection for Indiathan what it would have been otherwise and also result in a drain of foreign exchange reserves. In another situation, if Alpha and Beta are located in same country, however, Alpha is enjoying a tax holiday, then again, such a transaction would result in tax avoidance.These tax avoidance practices have been adopted by corporates for a long time until the introduction of Transfer Pricingregulations.
Commercialtransactions between the different fragments of a multinational conglomerate may not be subject to the same market forces. When one independent unit of the entity transfers goods or servicesto another independent unit of the same organisation, for a price, the price is known as “transfer price”. This price may have been decided arbitrarilyor may have been dictated by influence, withno relation to the cost or the added value, and deviating from the market forces. Owing to common influence, the prices of transactions between associated enterprises may have been decided under conditions differing from those between independent enterprises. Therefore, an independent evaluation of the same becomes necessary. This is achieved by establishing a fair value of the transactions and pricing the transaction accordingly. This entire process of deciding price for the transfer is called as ‘Transfer Pricing’.
Purpose of Transfer Pricing
Corporates today have complex entity structures and a large number of entities comprising under the same group, related to each other or unrelated, but controlled by the same company. Therefore, Transfer Pricing has become more relevant than it was ever. While the first and foremost purpose of Transfer Pricing is to establish a fair transfer price, to satisfy the legal requirements, there are some ancillary purposes as well, which Transfer Pricing enables.
- It helps in generating separate profitabilitystatement for each division of a company, thereby, enabling performance evaluation of each division separately.
- Not only in evaluating the reported profits of every unit, but Transfer Pricingalso helps in understanding the resource utilisation. The price charged by one unit will be the cost for another unit, which will establish the resources that have been utilised by that unit. Thus, enabling costing of product and services and other cost management practices in that particular unit.
- For financial reporting purposes as it affects the taxable income, after-tax profits and distributable income, free cash flow, thus, in turn, has an impact on the shareholders’ wealth
- For tax, forex and legal reporting purposes, as it may result in tax avoidance, and therefore, faces increased scrutiny by the tax departments of all governments involved
Thus, it is very important for businesses having cross-border intercompany transactions to understand the concept of Transfer Pricing, particularly for the compliance requirements, and thereby, to eliminate the risks of non-compliance.
Transfer Pricing Regulations in India
Transfer Pricing in India is regulated by Section 92 and related rules of the Income Tax Act, 1961. Some salient features of these regulations are as follows:
- Transactions under Transfer Pricing Provisions:Transfer Pricing provisions are applicable on all International Transactions and certain Specified Domestic Transactions between Associated Enterprises.
- Transfer Pricing Methodology: The methods which may be used for calculating transfer price have been specified in the income tax rules. The transfer price must be arrived at using any of the methods prescribed.
- Transfer Pricing Documentation: There are rules which specify the documentation to be maintained by the entity for the purpose of Transfer Pricing which includes ownership structure, group profile, business overview, documents to substantiate the pricing, relevant agreements, and other similar documents.
- Threshold Limit for Transfer Pricing Documentation: Taxpayers having aggregate annual international transactions lesser than INR 1 Crore (10 million) and Specified Domestic Transactions lesser than INR 5 Crore (50 million) are exempted from maintaining the detailedTransfer Pricingdocumentation, as prescribed in the rules. However, even in exempted cases, the taxpayer must maintain adequate documentation to substantiate that the transactions have occurred at arm’s length price.
- Transfer PricingReport: If a company has entered into any International Transaction with an Associated Enterprise, it is liable to obtain a report in prescribed form 3CEB from a Chartered Accountant. Such accountant verifies all documents and records and furnishes a report which contains details about all such transactions, the details, the amount and the method used for calculating the transfer price. While there is no threshold limit for International Transactions, for Specified Domestic Transactions, the threshold limit is set to INR 20 Crores (200 million).
- Advance Pricing Agreement:An entity may enter into an Advance Pricing Agreement whereby it may declare the transfer price or the methodology in advance to the tax authorities and seek approval, even before the transaction has occurred.
- Safe Harbour Rules:There are Safe Harbour Rules under which the transfer price declared by the company is accepted as is, subject to fulfilment of conditions prescribed.
Transfer Pricing Study
Transfer Pricing Study refers to the analysis of the business transactions between the units of the same company or associated enterprises. The purpose of this analysis is to examine the pricing of the transactions covered by the provisions of Transfer Pricing, arrive at the methodology to determine the transfer price and provide documentation to substantiate the Transfer Pricing methodology. The Transfer Pricing Study justifies why a particular method has been used and how the transfer price arrived at thereon, is at arm’s length price. This helps taxpayer survive the scrutiny of the tax departments. Such studies are conducted by Chartered Accountants who specialise in this field.
A typical Transfer Pricing Study report contains:
- Executive Summary
- Overview of the Group
- History and Financial Results
- Legal Structure
- Organisational and Operational Structure
- Description of Related Party Transactions
- Contractual Terms
- Transfer Pricing Methodology
- Advances Pricing Agreements
- Industry Analysis
- Functional Analysis
- Comparable Transactions