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Transfer Pricing

Regulations
T ra n s a c tio n s

In te rn a l E x te rn a l
(W i t h i n th e c o u n try ) (o u ts i d e th e c o u n try )

In te r C o m p a n y In tra C o m p a n y In te r C o m a p n y In tra C o m p a n y

R e v e n u e P ro fit C o n tro l S y s te m N o n -R e l a te d : R e la te d C o n tro l S y s te m s


C a p ita l G a in c o s t c e n tre s P ro fit/D i v id e n d /R o y a lty P ro fit/D i v id e n d /R o y a lty F o re x F l u c tu a tio n s
R o y a lt y re v e n u e c e n tre s F o re x F lu c tu a tio n s T r a n s fe r P r ic in g A c c o u n ti n g
p ro fit/In v e s tm e n t c e n tre A c c o u n tin g F o re x /A c c o u n tin g T ra n s fe r P ric i n g
Transfer Price: What and
Why?
TP means the value or price at which
transactions take place amongst related
parties.
TP are the prices at which an enterprise
transfers physical goods and intangible
property and provides services to
associated enterprises
TP gain significance because these can be
used by the controlling party to their
advantage to minimise tax incidence.
Transfer Price: What and
Why?
Approximately 60% of the total
transactions across the world are
between related parties.
If the transactions are across
different tax jurisdictions, where tax
rates are different, shifting is
beneficial.
Factors Affecting Transfer
Pricing
Internal factors: Performance
Measurement and Evaluation
External Factors:
Accounting Standard
Income Tax
Custom Duty
Currency Fluctuations
Risk of Expropriation
Transfer Price Regulations
International India
OECD formulated The Finance Act
Guidelines on 2001 introduced
transfer pricing. the detailed TPR
They serve as w.e.f. 1st April 2001
generally accepted The Income Tax Act
practices by the AS-18
tax authorities
Other Relevant
Acts
Accounting Standard 18
Requires disclosure of any elements
of the related party transactions
necessary for an understanding of
the financial statements.
Related Parties

Control by ownership
50% of the voting right
Control over composition of board of
directors
Power to appoint or remove the directors
Control of substantial interest
20% or more interest in the voting power
AS-18 and Transactions

Purchase and sale of goods;


Rendering or receiving services;
Agency arrangements;
Leasing arrangements;
Transfer of research and development;
Licence aggrements;
Finance
Guarantees and collaterals;
Management contracts.
Income Tax Act and TP
Finance Act 2001 substituted the old
section of 92 of the ITA by sections
92,92A to 92 F.
These sections are the backbone of
Indian TPR.
These sections define the meaning
of related parties, international
transactions, pricing methodologies
etc.
TPR: Some Important
Concepts
Income/Expenses/Cost arising from
an international transaction shall be
computed having regard to arms
length price (ALP).
ALP provisions can be applied if
it leads to decrease in taxable
income or increase in losses.
Associate Enterprise: 92A
Direct Control/Control through
intermediary
Holding 26% of voting power
Advance of not less than 51% of the total
assets of borrowing company.
Guarantees not less than 10% on behalf of
borrower
Appointment of more than 50% of the BoD
Dependence for 90% or more of the total
raw material or other consumables
International Transactions:
92B
Transaction between two or more AE
of which either both or anyone is a
non-resident.
Transactions:
Purchase/Sale/Lease
Provision of service
Lending or borrowing
Arms Length Price
Price which two independent firms
would agree on.
Price which is generally charged in a
transaction between persons other
than associated enterprises.
Arms Length Price: 92C
Comparable uncontrolled price
method
Resale price method
Cost plus method
Profit split method
Comparable uncontrolled price
method
CUP method compares the price
transferred in a controlled
transaction to the price charged in a
comparable un-controlled
transaction.
CUP method is the most direct and
reliable way to apply the arms
length principle.
Resale price method
The resale price method begins with
the price at which a product is resold
to an independent enterprise (IE)by
an associate enterprise.
X sold to AE at Rs. 1000 (profit: 300)
AE sold to an IE at Rs. 2000
(profit of Rs. 500 for relevant IE)
Arms length price = 2000 - 500 = 1500
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 AE. The profit so
determined is split between the AE
on the basis of the functions
performed/assets/CE
Cost Plus Method
In CP method, first the cost incurred
is determined. An appropriate cost
plus mark-up is then added to the
cost to arrive at an appropriate
profit. The resultant figure is the
arms length price.
Some Transactions subject to ALP
Purchase at little or no Exchanging property
cost. Selling of real estate at
Payment for services a price different from
never rendered. MP
Sales below MP/ Use of trade names or
Purchase above MP patents at exorbitant
Interest free rates even after their
borrowings expiry.
Some Cases
Kinetic Honda Motors
Collaborator: Honda Motor Co. Ltd Japan and
their Subsidiary Honda Trading Corpn. Japan
Hero Honda Motors Ltd.
Parent: Honda Motor Co. Ltd Japan and their
Subsidiary Honda Trading Corpn. Japan
Some Cases
Peico Electronics & Electricals Ltd.
Parent: Phillips Netherlands and its subsidiaries
Asea Brown Boveri
Parent: ABB Switzerland and its subsidiaries
Videocon Group
Collaborators: Toshiba Co., Mitsubishi Co
Learning Objective 4

Calculate transfer prices using


three different methods.
Transfer-Pricing Methods

Market-based transfer prices

Cost-based transfer prices

Negotiated transfer prices


Transfer-Pricing
Methods Example

Lomas & Co. has two divisions:


Transportation and Refining.

Transportation purchases Refining processes


crude oil in Alaska and crude oil
sends it to Seattle. into gasoline.
Transfer-Pricing
Methods Example

External market price for supplying


crude oil per barrel: $13
Transportation Division:
Variable cost per barrel of crude oil $ 2
Fixed cost per barrel of crude oil 3
Total $ 5
The pipeline can carry 35,000 barrels per day.
Transfer-Pricing
Methods Example

External purchase price for


crude oil per barrel: $23
Refining Division:
Variable cost per barrel of gasoline $ 8
Fixed cost per barrel of gasoline 4
Total $12
The division is buying 20,000 barrels per day.
Transfer-Pricing
Methods Example

The external market price to outside


parties is $60 per barrel.
The Refining Division is operating
at 30,000 barrels capacity per day.
Transfer-Pricing
Methods Example

What is the market-based transfer price


from Transportation to Refining?

$23 per barrel

What is the cost-based transfer price


at 112% of full costs?
Transfer-Pricing
Methods Example

Purchase price of crude oil $13


Variable costs per barrel of crude oil 2
Fixed costs per barrel of crude oil 3
Total $18
1.12 $18 = $20.16
What is the negotiated price?
Between $20.16 and $23.00 per barrel.
Transfer-Pricing
Methods Example

Assume that the Refining Division buys


1,000 barrels of crude oil from the
Transportation Division.
The Refining Division converts these 1,000
barrels of crude oil into 500 gallons of
gasoline and sells them.
What is the Transportation Division operating
income using the market-based price?
Transfer-Pricing
Methods Example

Transportation Division:
Revenues: ($23 1,000) $23,000
Deduct costs: ($18 1,000) 18,000
Operating income $ 5,000
What is the Refining Divisions operating
income using the market-based price?
Transfer-Pricing
Methods Example

Transportation Division:
Revenues: ($23 1,000) $23,000
Deduct costs: ($18 1,000) 18,000
Operating income $ 5,000
What is the Refining Divisions operating
income using the market-based price?
Transfer-Pricing
Methods Example

Refining Division:
Revenues: ($60 500) $30,000
Deduct costs:
Transferred-in ($23 1,000) 23,000
Division variable ($8 500) 4,000
Division fixed ($4 500) 2,000
Operating income $ 1,000
Transfer-Pricing
Methods Example

What is the operating income of both


divisions together?
Transportation Division $5,000
Refining Division 1,000
Total $6,000
Transfer-Pricing
Methods Example

What is the Transportation Divisions operating


income using the 112% of full cost price?
Transportation Division:
Revenues: ($20.16 1,000) $20,160
Deduct costs: ($18.00 1,000) 18,000
Operating income $ 2,160
What is the Refining Division operating
income using the full cost price?
Transfer-Pricing
Methods Example

Refining Division:
Revenues ($60 500) $30,000
Deduct costs:
Transferred-in ($20.16 1,000) 20,160
Division variable ($8.00 500) 4,000
Division fixed ($4.00 500) 2,000
Operating income $ 3,840
Transfer-Pricing
Methods Example

What is the operating income of both


divisions together?

Transportation Division $2,160


Refining Division 3,840
Total $6,000
Learning Objective 5

Illustrate how market-based


transfer prices promote goal
congruence in perfectly
competitive markets.
Market-Based Transfer
Prices

By using market-based transfer prices


in a perfectly competitive market, a
company can achieve the following:

Goal congruence

Management effort

Subunit performance evaluation

Subunit autonomy
Market-Based Transfer
Prices

Market prices also serve to evaluate the


economic viability and profitability
of divisions individually.