Introduction To Transfer Pricing

Introduction To Transfer Pricing


Transfer pricing is a profit allocation method used to attribute a corporation’s net profit or loss before tax to tax jurisdictions. Sections 92 to 92F of the Income Tax Act, 1961 deal with a transfer pricing. Due to the increasing participation of multinational groups in India, there have been new complex issues emerging from transactions between two or more enterprises belonging to the same group. The price at which the goods and services are transferred between independent units of an organization is termed as “transfer price”. Such a price can be arbitrary and not in accordance of the market forces. This leads to the parent company or subsidiary incurring huge losses or producing insufficient taxable income. Hence these sections were framed, in order to provide guidelines for the computation of transfer price and documentation procedures. These are broadly based on the OECD guidelines (organization for economic co operation and development).

This legislation mainly deals with cross border transactions, “international transactions” are defined as transaction between two or more associated enterprises involving the sale, purchase or lease of tangible or intangible property; provision of services; cost sharing arrangements; lending/ borrowing of money; or any other transaction having a bearing on the profits, income, losses or assets of such enterprises.

The various methods of computing arm’s length price are:
(a) Comparable uncontrolled price method
(b) Resale price method
(c) Cost plus method
(d) Profit split method
(e) Transactional net margin method
(f) Any other method prescribed by the board

If price is determined by more than one method, the arms length will be determined as the arithmetic mean of the prices so determined.

Various Methods In Brief

Comparable Uncontrolled Pricing: This is the most direct way of determining arms length price. Uncontrolled price is the price agreed between unrelated parties for the transfer of goods and services. It is of two types:


i) Internal CUP
The taxpayer enters into transactions with unrelated parties, and similar transaction is entered with related parties as well. Therefore in this case similar product is sold to a third party and the same is also transferred to an associated enterprise.


ii) External CUP
A transaction takes place between two independent enterprises under comparable conditions and comparable goods and services.


CUP is the most reliable method in case of internal CUP, but in this case also its has to be made sure that the following are thoroughly checked:
a) Type, quality and quantity of good sold and the good transferred to the associated enterprise.
b) Geographic market
c) Foreign currency risks
d) Intangible property

Transactional net margin method (TNMM)
Under this method the net margin realized by the enterprise from an international transaction with regard to an appropriate base, along with this net profit margin from an uncontrolled transaction is identified. The differences between the two are adjusted with respect to the changes in the open market. The net profit so established is used to establish the Arm’s length price.

Resale Price Method
This method reduces relevant gross profit mark-up from the sale price charged to free entity to reach the arm’s length price, primarily used when vendor adds little value to goods owned from associated enterprises.

Profit split method


Three steps under this method that are applied in order to reach the ALP:
1. Net profit of the AE is computed
2. Compute relative contribution made by each of the AE to the earning of the combined Net Profit.
3. Split the combined net profit in proportion to their contributions.
This method is applied in cases where the international transactions are so inter related that they cannot be evaluated separately.

Cost plus method
The cost incurred by the assessee in transfer is measured and sum of gross profit of other comparables is determined. The sum of gross spot arrived is used to take into account functional and other variation to determine ALP.
It is very difficult to find a similarly placed situation which can be compared to a transaction between two independent enterprises, even small variations in the two transactions may lead to a huge difference in the price estimated. Thus authorities should be cognizant of such differences even though the business activities are of a similar nature, suitable adjustments should be made in order to ensure necessary comparability.

In order to determine the arm’s length price of the tested company, an individual identical company has to be found as a comparable in case of non associated parties .The various information that is required in case of comparable companies are company activity, business description, ownership holding patterns, year of available financials and financials themselves. It has to be ensured that there are no differences in the situation of the comparables so as to affect the condition used in the method applied or in case of any differences, adjustments can be in such a manner that the differences get eliminated. 

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