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MBA (Finance specialisation)

&
MBA Banking and Finance
(Trimester)
Term VI
Module : International Financial Management
Unit VI: Country Risk Analysis and International Taxation
Lesson 4.2
(Transfer pricing methods and Double taxation Avoidance agreements, etc.)

Methods of Transfer pricing
Arms length price means a price which is applied or
proposed to be applied in a transaction between persons
other than associated enterprises, in uncontrolled
conditions.
Methods of Computing Arms Length price
Comparable uncontrolled price method
Resale price method
Cost plus method
Profit split method
However, among these, the methods generally used are
Comparable uncontrolled price method and Resale price
method, which have been briefly explained below
alongwith brief description of other methods.



Comparable uncontrolled price method

Under this method , following steps are taken
Identify the price charged or paid for goods
transferred in comparable uncontrolled
transactions.
Adjust such price to account for the difference ,
if any, between the international transaction and
comparable uncontrolled transaction .
The adjusted price is taken to be the arms
length price.


Comparable Uncontrolled price method

Example: Sony Japan (MNC) and A Ltd. (in India) are related companies. A Ltd.
(in India) manufactures mobile covers and supply to Sony Japan (related
company) and LG Korea (unrelated company) at price of Rs 2000 per unit and Rs
3200 per unit respectively. The difference in price charged was attributed to
following reasons:

Sale to Sony does not include freight and insurance charge amount to
Rs300. The cost is borne by Sony itself.

One year warranty provided to LG whose estimated cost is Rs 350 per
unit. No such warranty given to Sony.

Since Sony has purchased in bulk quantity, a discount of Rs 50 per
unit has been provided.

Compute arms length price using Comparable uncontrolled pricing method.





Comparable Uncontrolled price method


Solution
Price charged from non related entity (LG Korea): Rs 3200
Less : Adjustment of difference on account of :
Freight and insurance charges 300
Estimated cost of warranty 350
Bulk quantity discount 50
Arms length price 2500

A Ltd. (Indian Subsidiary ) should have supplied the products to Sony Japan at a
price of Rs 2500 per unit instead to Rs 2000 per unit.




Resale Price Method
Under this method , the arms length price is computed by
deducting the gross profit margin (charged on resale to non
related company) and other material differences, as
explained in the example given below:
Example: Sony Japan and A Ltd.(India) are related companies.
A Ltd. purchases Air conditioners from Sony Japan at price
of Rs 15000 per unit and sells the same in India at Rs 17000
per unit. In the past, A Ltd. had purchased similar kind of
Air conditioners from Samsung and sold in India at a gross
profit margin of 10%. A Ltd. had incurred freight of Rs 400
and custom duty of Rs 1500 per unit in case of purchase
from Sony Japan whereas it has incurred only Rs 200 per
unit freight charges while purchasing from Samsung.
Compute arms length price using resale price method.
Resale Price Method
Solution
Resale price of goods purchased from Sony Japan : Rs 17000
Less: Normal Gross Profit Margin @ 10% : Rs 1700
Less: Difference in the expenses ( 1900-200) : Rs 1700
Arms Length Price: Rs13600
Cost Plus Method
In Cost Plus method, first the direct and indirect cost incurred is
determined and adjustment is done using the gross mark up profit
margin to arrive at arms length price.

For example, A Ltd. ( Indian Subsidiary) transferred goods to US MNC at
a price of Rs 200 per unit. The direct and indirect cost involved in
the manufacturing is Rs 80 and Rs 30 per unit .

Gross profit margin in such cases is 25% and the direct and indirect cost
involved in other such transactions is Rs 60 and Rs 20 respectively.

Arm length price in this case shall be
Rs ( 60+ 20) + 25% of ( 60+20)
= Rs 80 + 25% of Rs 80 = Rs 100
Profit Split Method
PSM is used when transactions are inter-related and is not possible
to evaluate separately.
PSM first identifies the profit to be split for the associated
enterprises. The profit so determined is split between the
associated enterprises on the basis of the functions performed by
them.
Forexample, a software is designed by Indian Subsidiary and
Japanese Subsidiary for US parent MNC , by using 60% services
from Indian subsidiary and 40% from Japanese Subsidiary whereas
the entire remuneration is paid to Indian Subsidiary and total profit
of Rs 5 lacs is shown in their account. Now, using profit split
method, only 60% of Rs 5 lakhs i.e. Rs 3 lakhs is eligible to be shown
as profit in the books of Indian subsidiary whereas remaining Rs 2
lakhs in the books of Japanese subsidiary.
Double Taxation Avoidance Agreements
Introduction
Double taxation means taxation of same income of a person in
more than one country. This results due to countries following
different rules for income taxation. There are two main rules of
income taxation:
i) Source of income rule
ii) Residence rule.

Double Taxation Avoidance Agreements
As per the source of income rule, the income
may be subject to tax in the country where the
source of income exists( i.e. where the business
establishment is located)

On the other hand, residence rule stipulates
that the power to tax should rest with the
country in which tax payee resides.
Double Taxation Avoidance Agreements
Some countries may follow a mixture of the above two
rules. As a result of this , the problem of double taxation
arises.
For example, if a resident of India has generated any
income in US , he will be required to pay tax in US as well as
India. Thus , same income has been doubly taxed.
Relief against such hardship can be provided mainly in two
ways:
a)Bilateral relief
b)Unilateral relief.

Bilateral relief
The Government of two countries can enter into
Double Taxation Avoidance Agreements so that
the same income may not be taxed twice.

Bilateral relief may be granted in either one of the
following two methods:
Exemption method
Tax credit method

Bilateral relief
Exemption method: Under this method, the
incomes which are likely to be taxed in two
different countries are taxed only in one country
whereas the other country allows tax exemption
on the same. For example, an Indian resident has
maintained his bank account in some other
country say U.S.. The interest accruing on that
account if taxed in U.S. would not be taxed in
India.

Bilateral relief
Tax credit method: Under this method, the assessee
is liable to have his income taxed in both the
countries but is given a deduction , from the tax
payable by him in the country of residence. The
amount of deduction is lower of the tax amount paid
by the assessee.
For example: Mr. X, a resident, has earned Rs 100000
in US and paid Rs 10000 to US Govt. In India , again he
is taxable on the same income and he is required to
pay Rs 25000 as tax. Then , according to tax credit
method , his actual tax liability in India will be
Rs 25000 Rs 10000 (tax paid in U.S.) = Rs 15000

Bilateral relief
Various models of treaties: Although treaties
entered into by various countries cannot be
exactly identical, a certain amount of uniformity is
desirable in its framework. Keeping in view this
fact, tax treaties have been based on models such
as :
OECD (Organisation of Economic Co-operation
and Development)
U.N. models double taxation Convention
between developed and developing countries.
Unilateral relief
Unilateral relief means one sided relief. This is
used when a person earns any income in country
with which India has not signed any tax treaty. The
assessee pay tax in the foreign country where the
income has been generated but when the same
income is included in his taxable income, at the
time of tax calculation in India, he is provided relief
by reducing his tax liability. The amount of relief is
calculated using the formula:
Amount of relief = (Lower rate of tax) X (Doubly taxed income)

Unilateral relief
Example: A musician ,Mr. X (resident in India), earns Rs 100000 in U.S.. He paid
Rs 20000 as tax in U.S. on the same income. In India, his income from Salary ,
capital gain and other sources including foreign income is Rs 8,00,000 on which
total tax liability amounted to Rs 2,00,000. Find the amount of tax payable by
Mr. X to the Government of India.

Solution: Tax payable : Rs 200000
Less tax relief u/s 91
(Foreign rate = 20% i.e. 20000/100000)
(Indian average rate of tax = 25% i.e. 200000/800000)
Doubly taxed income = Rs 1,00,000
Amount of Relief = Lower rate X doubly taxed income
Amount of Relief = 20% x 100000 = Rs 20000

Therefore, tax payable = 1,80,000


Unilateral relief
Example: A musician ,Mr. X (resident in India), earns Rs 100000 in U.S.. He paid
Rs 20000 as tax in U.S. on the same income. In India, his income from Salary ,
capital gain and other sources including foreign income is Rs 8,00,000 on which
total tax liability amounted to Rs 2,00,000. Find the amount of tax payable by
Mr. X to the Government of India.

Solution: Tax payable : Rs 2000000
Less tax relief u/s 91
(Foreign rate = 20% i.e. 20000/100000)
(Indian average rate of tax = 25% i.e. 200000/800000)
Doubly taxed income = Rs 1,00,000
Amount of Relief = Lower rate X doubly taxed income
Amount of Relief = 20% x 100000 = Rs 20000

Therefore, tax payable = 1,80,000

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