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Transfer Pricing-A Case Study of Vodafone

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DOI 10.4010/2016.1499
ISSN 2321 3361 2016 IJESC

Research Article Volume 6 Issue No. 5

Transfer Pricing- A Case Study of Vodafone

Dr.G.V.Satya Sekhar

A goal of transfer pricing may be to maximize after tax revenue besides reduction in the total tax paid. It is known fact
that the most of the corporate entities are using the method of Window dressing, as a technique used in financial reporting
system. Financial experts say that the abuse of transfer prices is a key tool used by the corporate entities to think that they have
virtually no profit; hence, they shouldn't pay any taxes. In this context this case study is divided into two parts. This study intends
to focus on the strategies adopted by corporate entities in general and Vodafone Company in particular.

1. To understand the process of transfer pricing technique used in corporate entities.
2. To examine the impact of transfer pricing on tax policy.
3. To analyze the pros and cons of Vodafone company and its transfer pricing strategy.
First part of the paper focuses on conceptual approach and second part deals with the case study.

Keywords: Transnational companies, Corporate strategy, transfer pricing policy, tax policy, Government reuglations

PART-I: TRANSFER PRICING: WAYS AND MEANS corporate entities documented transfer-pricing policies for
INTRODUCTION: administrative or managerial services. With no or minimal
Transfer-pricing is a way of window dressing financial documentation, these transactions appear to be the 'weakest
reports by adjusting or manipulating the transnational and/or link' in transfer pricing armor. The rapid growth in off
trans-corporate entities regarding their accounting shoring business services should therefore exacerbate
transactions to minimize tax liabilities. The prices of already high tensions in this area of transfer-pricing
transactions between associated enterprises, which are regulation.
referred to as transfer-pricing, for tax purposes are in In order to curtail irregularities of corporate
conformity with those which would be charged among entities, most Governments have adopted transfer-pricing
independent enterprises. The increasing concern of regulations based on the Organization for Economic
international taxation, especially in terms of a transfer- Cooperation and Development (OECD) guidelines. These
pricing mechanism, is certain to become a part of the guidelines require corporate entities to follow the arm's
economic life of all developing countries as major length principle, i.e. firms must price each intra-company
transactions are tossed into the world of global taxation. transaction as if it had occurred between two unrelated
Transfer Pricing generally being the first tax consideration of parties negotiating for the same product under the same
any cross border transaction between related parties, circumstances as the related party firms. Transfer pricing is,
developed countries such as USA and UK have had transfer and has been for many years, the most contentious issue in
pricing law for decades.1 Transfer Pricing is also called as international taxation due to the difficulties involved in
Transfer Pricing Manipulation (TPM), which is fixing setting arm's length prices acceptable to both tax authorities
transfer price on non-market basis which generally results in and transnational companies. Comparable transactions
saving total quantum of organizations tax by shifting between unrelated parties are often not available for intra-
accounting profits from high tax to low tax jurisdiction.2 firm transactions in goods, much less for intangibles and
Ernst & Young (2003) found that 43% of parent services. Thus, transfer pricing is an area fraught with
transnational companies believed their transfer-pricing difficulties and pitfalls for the unwary.
policies for administrative/managerial services were
vulnerable to Government audit; 30% believed their pricing TRANSFER PRICING MECHANISM
of technical services were also vulnerable. Ernst & Young Of course, no company should have to pay more tax
argued that audits of services were increasing as a share of than they are legally obligated to, and they are entitled to
all transfer-pricing audits, partly because few transnational locate to any low-tax jurisdiction. The problem starts when
they use fraudulent transfer pricing and other tricks to
Waman Y Kale, Transfer Pricing- Practical Issues and artificially shift their income from other countries to a tax-
Controversies, The Chartered Accountant, October, 2005, haven. According to OECD guidelines transfer prices should
pp570-579 be the same as if the two companies involved were indeed
Mayank K Agarwal, Transfer Pricing A beginners two independents, not part of the same corporate structure.
Perspective, www.indiainfoline.com Over the last decade, major barriers to trade among
countries have decreased due to the galloping growth in
International Journal of Engineering Science and Computing, May 2016 6207 http://ijesc.org/
information technology. This increase of information has complicated rules that limit the extent to which companies
seen many companies significantly expanding their cross- can shift income out of the United States.
border trade. A result of this globalization of world trade is
that transactions can be executed effortlessly and at lowering REVIEW OF LITERATURE:
marginal costs. Increasing technology and decreasing Transfer Prices have been described as: the net
transaction costs have meant quicker clearing markets and value per unit that records the transaction for the purposes of
hence profit opportunities in products, services and operating statements. While many studies have addressed
geographic areas that may have been unattainable earlier. transfer pricing in transnational corporations, none to date
With such comprehensive and timely data, international have addressed transfer pricing specifically in the context of
businesses are now able to take decisions more effectively Transnational Financial Institutions (TFI).
and quicker than ever before. From the perspective of tax Yoon K. Choi (1998) 3 examines the relation
authorities around the world, transfer-pricing is fast gaining between transfer pricing and production incentives using a
importance, necessitating change in legislation to protect tax model of a vertically integrated firm with divisions located
revenue bases. In major industrial countries, such legislation in different tax jurisdictions. His study shows that if
has primarily been driven by developments in the US and divisional profits are taxed at the same marginal rate, the
other OECD member-states. transfer price should be set to minimize the compensation
risk faced by the manager of the buying division. As
Transfer Pricing and Multinational tax system: transnational companies move business services offshore,
When divisions transfer product across tax jurisdictions, they must develop transfer-pricing policies for pricing these
transfer prices play a role in the calculation of the companys intra-company transactions. Transfer-pricing regulations for
income tax liability. In this situation, the companys transfer services are much less developed than for goods and raw
pricing policy can become a tax planning tool. For instance, materials (Feinschreiber, 2004). Transnational companies are
the United States has agreements with most other nations expected to follow the benefit-cost principle, with little
that determine how multinational companies are taxed. explicit guidance as to acceptable methodologies compared
These agreements, called bilateral tax treaties, establish to the detailed guidelines available for goods transactions.
rules for apportioning multinational corporate income among In terms of tax planning, Tang4 finds that all five MNEs he
the nations in which the companies conduct business. These has selected used a variety of methods to reduce their overall
rules attempt to tax all multinational corporate income once tax rates, including setting up holding companies in tax
and only once which excludes the double-taxation that havens, taking full advantage of tax incentives such as the
occurs at the Federal and state levels. In other words, the tax US foreign Sales Corporation export incentive programme,
treaties attempt to avoid the double-taxation that would and shifting income to low-tax and expenses to high-tax
occur if two nations taxed the same income. Since transfer locations. In the light of recent corporate tax scandals, these
prices represent revenue to the upstream division and an practices would be a useful spring board for a class
expense to the downstream division, the transfer price affects discussion of the ethical aspects of tax planning.
the calculation of divisional profits that represent taxable Nicole Bastian Johnson (2006) 5 explains the
income in the nations where the divisions are based. divisional performance measurement and transfer pricing.
For example, if a U.S.-based pharmaceutical company He describes three methods of transfer pricing viz., i)
manufactures a drug in a factory that it operates in Ireland Royalty Based system ii) Negotiated Transfer Pricing and
and transfers the drug to the U.S. for sale, a high transfer iii) Renegotiated Royalty based pricing. It was mentioned
price increases divisional income to the Irish division of the that, a royalty-based transfer price that can be re-negotiated
company, and hence, increases the companys tax liability in provides better investment incentives than either a non-
Ireland. At the same time, the high transfer price increases negotiable royalty based transfer price or a purely negotiated
the cost of product to the U.S. marketing division, lowers transfer price. Negotiated transfer pricing provides efficient
U.S. income, and lowers U.S. taxes. The companys investment incentives for the buyer, but creates a hold-up
incentives with regard to the transfer price depend on
whether the marginal tax rate is higher in the U.S. or in
Ireland. If the marginal tax rate is higher in the U.S., the Yoon K. Choi and Theodore R. Day (1998), Transfer
company prefers a high transfer price, whereas if the pricing, incentive compensation and tax avoidance
marginal tax rate is higher in Ireland, the company prefers a in a multi-division firm, Review of Quantitative
low transfer price. The situation reverses if the drug is finance and accounting, 1998, pp 139-164.
manufactured in the U.S. and sold in Ireland. The general 4
rule is that the company wants to shift income from the high Roger Y.W. Tang, Current Trends and Corporate Cases in
tax jurisdiction to the low tax jurisdiction. There are limits Transfer Pricing, Reviewed by Prof. Lorraine Eden, Journal
to the extent to which companies can shift income in this of International Business Studies, March, 2003.
manner. When a market price is available for the goods Nicole Bastian Johnson (2006), Divisional
transferred, the taxing authorities will usually impose the performance measurement and transfer pricing for
market-based transfer price. When a market-based transfer intangible assets, published on line, Springer Science,
price is not feasible, U.S. tax law specifies detailed and New York, 17 May, 2006.

International Journal of Engineering Science and Computing, May 2016 6208 http://ijesc.org/
problem for the seller, leading to underinvestment. The third depends on the prices at which intermediate goods are
method, royalty-based transfer pricing with renegotiation, transferred between the producer (the upstream firm) and the
combines features of both royalty-based and negotiated user (downstream firm) of the intermediate goods. When the
transfer pricing, protecting the developer of the intangible entities operate in different countries, the transfer price
from a hold-up problem and providing efficient investment determines how much of the income earned by the joint
incentives for the buyer. This method improves efficiency efforts of the two entities is taxed in each country.
relative to pure royalty- or negotiation-based transfer pricing
and provides first-best investment incentives for some types PART-II: TRANSFERPRICING-VODAFONE CASE:
of investments. Transfer pricing is referred to the setting of the price for
Tim Baldenius, Stefan Reichestein and Savita A goods and services sold between related legal entities within
Sahay (1999)6, studied an incomplete contracting model to an enterprise. This is to ensure fair pricing of the asset
compare the effectiveness of alternative transfer pricing transferred. For example, if a subsidiary company sells
mechanisms. Transfer pricing serves the dual purpose of goods to a parent company, the cost of those goods is the
guiding intra-company transfers and providing incentives for transfer price. The case dates back to financial year 2007-8
upfront investments at the divisional level. Their analysis involving the sale of Vodafone India Services Private Ltd.,
shows that negotiation frequently performs better than a the call centre business of Vodafone, to Hutchison, and the
cost-based pricing system, though identified circumstances tax authorities demanded capital gain tax for this transaction.
under which cost-based transfer pricing emerges as the The Income Tax department had demanded that Rs.8,500
superior alternative. In their study a performance comparison crore be added to the companys taxable income.
of two commonly used schemes: negotiated and cost-based Vodafone has repeatedly clashed with the authorities over
transfer pricing, is analyzed. Transfer pricing serves two taxes since it bought Hutchisons mobile business in 2007.
major purposes in their model: to guide intra-firm transfers Vodafone acquired the telecom business of Hutchison in
of an intermediate product and to create incentives for India to enter the Indian market. And the British company is
divisional managers to make relationship specific also fighting another case with the tax authorities relating to
investments. Such investments can take different forms, e.g., this transaction.
research and development (R&D), machinery and In this current transfer pricing case, Vodafone argued in the
equipment, or personnel training. In one-period model, High Court that the Income Tax Department had no
investments entail an upfront fixed cost and a subsequent jurisdiction in this case because the transaction was not an
reduction in the unit variable cost incurred by the supplying international one and did not attract any tax.
division. Alternatively, investments by the buying division The dispute on transfer pricing surfaced after the Income
may enhance net revenues obtained from internal Tax Department issued a draft transfer pricing order in
transactions. December 2011 and added Rs. 8,500 crore to Vodafones
Richard Sansing (1999)7 used a model in which differences taxable income for the sale of the call centre business. In
in organization structure induce different investment choices, 2013, the Income Tax Department issued a tax demand of
shows that transfer pricing methods based on the price Rs. 3,700 crore to Vodafone India. However, the IT tribunal
charged by independent firms results in controlled foreign stayed the demand during the proceeding of the case and
subsidiaries being allocated a greater amount of income than asked Vodafone to deposit Rs. 200 crore by February 15,
its domestic parent. The model implies that the current 2014. It complied with the order.
dispute between the Internal Revenue Service (IRS) and its However, Vodafone argued that the sale of the call centre
foreign counterparts regarding the acceptability of the business was between two domestic companies and the
comparable profit method of determining transfer prices is transfer pricing officer had no jurisdiction over the deal. On
consistent with the desire of each tax authority to maximize Thursday, Vodafone India did not issue any elaborate
its own tax revenues in transfer pricing disputes involving statement. It said: Vodafone welcomes todays decision by
U.S. parents and foreign subsidiaries. The allocation of the Bombay High Court. The tax authorities are likely to
income between a parent corporation and its subsidiary challenge the decision in the Supreme Court.
In October 2015, Vodafone won a transfer pricing case
Tim Baldenius, Stefan Reichestein and Savita A Sahay having an additional demand of Rs.3,200 crore from the tax
(1999), Negotiated versus Cost-Based Transfer Pricing, authorities in the Bombay High Court. The High Court has
Review Accounting Studies 4, 67-91, 1999, Kluwer reversed the decision of the tax tribunal that the recasting of
Academic Publishers, Boston. (Manufactured in The the framework agreement between taxpayer and Indian
Netherlands). business partners was to be regarded as a transfer of call
options by assesse to its Parent entity merely because the
latter was a confirming party. The tribunal, in so holding had
Richard Sansing (1999), Relationship-Specific rejected taxpayers contention that Supreme Court in its own
Investments and the Transfer Pricing Paradox, Review case had already settled the issue in its favor, Arun
Accounting Studies 4, 119-134, 1999. Kluwer Academic Chhabra, Director, Grant Thornton Advisory said while
Publishers, Boston. Manufactured in The Netherlands commenting on the case.

International Journal of Engineering Science and Computing, May 2016 6209 http://ijesc.org/
In a major relief to British telecom major Vodafone in the Tim Baldenius, Stefan Reichestein and Savita A
transfer pricing case, the Bombay High Court on Thursday Sahay (1999), Negotiated versus Cost-Based
ruled in its favour, setting aside a tax demand of Rs. 3,700 Transfer Pricing, Review Accounting Studies 4, 67-
crore imposed on Vodafone India by the income tax 91, 1999, Kluwer Academic Publishers, Boston.
authorities. This is likely to benefit multinational companies (Manufactured in The Netherlands).
such as IBM, Royal Dutch Shell and Nokia that face similar
tax demands. Yoon K. Choi and Theodore R. Day (1998),
The division bench comprising SC Dharmadhikari and AK Transfer pricing, incentive compensation and tax
Menon said in an oral order that relying upon the earlier avoidance in a multi-division firm, Review of
Supreme Court judgment, the court is of the view that there Quantitative finance and accounting, 1998, pp 139-
is no transfer of the 'call options' and hence the transaction is 164.
not falling within the purview of transfer pricing.
Waman Y Kale, Transfer Pricing- Practical Issues
and Controversies, The Chartered Accountant,
QUESTION FOR DISCUSSION; October, 2005, pp570-579
The court decision came as Vodafone challenged the order
of the Income Tax Appellate Tribunal which held last year Mayank K Agarwal, Transfer Pricing A
that it structured the deal with Hutchison Whampoa beginners Perspective, www.indiainfoline.com
Properties, a company based in India, to circumvent transfer
pricing norms, though it was an international transaction
wherein there was no arms length dealing between the
related entities.
Discuss whether the court decision will favour Vodafone
companys reputation?




Ernst & Young 2003 Survey on Transfer Pricing


Feinschreiber, Robert (2004). Transfer Pricing

Methods: An Applications Guide (Hoboken, NJ:
John Wiley & Sons, Inc.).

Nicole Bastian Johnson (2006), Divisional

performance measurement and transfer pricing for
intangible assets, published on line, Springer
Science, New York, 17 May, 2006.

Roger Y.W. Tang, Current Trends and Corporate

Cases in Transfer Pricing, Reviewed by Prof.
Lorraine Eden, Journal of International Business
Studies, March, 2003.

Richard Sansing (1999), Relationship-Specific

Investments and the Transfer Pricing Paradox,
Review Accounting Studies 4, 119-134, 1999.
Kluwer Academic Publishers, Boston.
Manufactured in The Netherlands

International Journal of Engineering Science and Computing, May 2016 6210 http://ijesc.org/

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