Taxation has remained an ever-green subject for business groups and continues to remain so. Its interactions with the legal systems are also intriguing. The incorporation of tax principles and concepts (which are basically economics-driven) and rules (which include a lot of procedural safeguards) in the legal system is baffling for a number of exceptions and special provisions are carved taking into account the intricacies and needs of a tax system. Here I discuss about Transfer Pricing as a distinctive concept of 'International Taxation', its meanings and attributes (in 'What'), its significance and need (in 'Why'); and its implementation and other related issues (in 'How').
Placing International Taxation in context
Transfer Pricing is essentially an outcome of globalization. A distinctive part of International Taxation, it has come to mark the legal responses to business' profit maximizing tendencies. To give a prelude to Transfer Pricing, International Taxation is to be understood. This is one specific branch of taxation which taxes the profits arising from Inbound Investment (i.e. taxation of income earned by a foreign company in a host country) and Outbound Investment (i.e. taxation of income earned by a domestic country abroad). The purpose of International Taxation is to ensure that the earnings of a company from a foreign company neither go tax free nor are doubly taxed.
To illustrate, let us suppose a premises that an Indian Company has a branch in Singapore Singapore Singapore Singapore Singapore Singapore
This would lead to a double taxation in the hands of the company in so much of the profits earned in one country is being subjected to taxation in two countries. In order to mitigate this wasteful costs (because ultimately taxes are costs of doing business), countries are obliged to enter into double taxation avoidance agreements ( DTAAs, also called DTCs or Double Tax Conventions) wherein under one of the countries forgoes its right to tax and therefore tax is effectively levied only in one jurisdiction, which would be determined under the DTAA.
Now why this leads to transfer pricing is obvious. Under the DTAA, generally one only country can tax. However what is not determined here is the rate at which the country would tax. Therefore despite the DTAA, countries remain free to charge the rate of tax which they generally would be charging in other than international tax situations. For illustration, the rate of tax in
What is Transfer Pricing?
Transfer Pricing is an offshoot of this tendency of business to install a base in both the countries and try to carry out its operations in a manner which would render most profitable activities in the country with low tax rate. An illustration would clarify the matter.
In the diagram below, we have the case of two countries which have different tax rates i.e. X and Y with 30% and 50% respectively. In this scenario, a group company has two associate companies operating in X and Y. While Company A is engaged in manufacturing, Company B is engaged in trading. A sells its manufactured products to B whereupon B sells it to third parties.
(click on the diagram to enlarge)
In the above diagram, we have two situations. In the first situation, the A sells to B at a mark-up of 50 (upon its manufacturing cost of 50) and therefore that 50 of profit are chargeable to tax in X, which is a lower tax jurisdiction. B sells at a profit of 40, which are chargeable to tax in Y at a rate higher than in country X. In this situation, the tax payable by A and B together in X and Y comes out to be 35 units.
Ceteris paribus, the group finds that it can save a bit on those taxes by just changing the price at which A and B transact. Thus now A sells the same product at a price of 120 and thus earns a profit of 70 which results into a reduction in B's profits (considering that it does not change its price charged to third parties) to 20 and consequently also reduced the tax liability of B in Y. The net impact of this change is that in situation 2, A and B together pay only 31 units of tax in X and Y. Thus by a mere change in the pricing, the company has reduced its overall tax liability by shifting the profits legitimately earned in Y to X.
This shifting of profits from a higher tax jurisdictions to lower tax jurisdictions by related entities (or affiliate enterprises) by changing the pricing policy at which the transactions between these related entities take place is described as transfer pricing.
Why does a country need Transfer Pricing Rules?
Once we know what transfer pricing is, it is clear for us to identify its impact. It has a significant effect on the revenue collection of the various countries. Because of the manipulations under the transfer pricing policies, countries lose out their genuine share of the tax they are entitled to collect on the transactions which take place in the country. In our original illustration, Y country is losing out on a tax of 10 units (20-10). Given the size of operations which take place between these affiliate parties, these figures grow in size to give a considerable set-back to the revenue collection targets of the countries.
Each country would expect a fair share of taxes to be paid by companies operating in their territory as they exploit the resources made available to them by the country and thus they are entitled to collect taxes to reflect the cost of the resources being made available. Further, the change of tax collected in the case of these affiliate enterprises is not because of a significant change in the way business has been operating but only because conditions for dealing have been imposed between these companies, which would not have been existing has the transaction been undertaken between independent parties.
While the companies' tax payments get reduced and thus their overall profits increase, this is only because of an adjustment in prices and transfer of profits (artificially) from one country to the other. This is not tolerated by the countries which provide infrastructure and support for the countries to operate and thus they seek to disregard the prices which are adopted between the affiliate parties. What is sought to be done by these countries is an adoption of 'Transfer Pricing Rules' whereby they seek to determine the actual prices that would have been charged that the parties been independent and on that basis come to arrive at the correct figure of profits due to be taxed in their country.
What are Transfer Pricing techniques?
Once we have established a need to have rules in place to check the transfer pricing policies of related parties, one has to arrive at an understanding as to how this would be done. Primarily countries adopt the 'Arm's length standard'. This basically implies that prices are considered to be acceptable if the transactions are at a arm's length distance (i.e. at a distance which is considered to be acting independently and not being influenced by the other). If the transactions are not at an arm's length, in that case the prices are recasted to determine the arm's length price value.
There are essentially two ways of negating Transfer Pricing i.e. for determining the arm's length price. These are; (i) transactional methods, (ii) non-transactional methods. These are further divided into three and two parts respective (thus total five different techniques for transfer pricing). These can be briefly (briefly because an exhaustive discussion of each can fill volumes of treatises) described as under;
(I) Transactional Methods: These are called so as they generally intend to work out the transactions in specific detail to arrive at the arm's length value for each transaction in question and thus arrive at the overall recasted profits figure when the transactions undertaken by the company have been brought at a fair value terms. There are three methods collated in this transactional approach;
(a) Comparable Uncontrollable Price Method (or CUP method): In this method, the essence is essentially to find out a similar transaction to the one in review which takes place between independent parties and adopt the value which exists in that similar transaction to determine the profits under the transaction in review. For example, in our original illustration, if Company A was selling steel of particular grade to Company B and was charging 120 units of currency for each unit of steel, what was the price being charged by other companies to independent companies around the same time at which this transaction took place. If independent parties were charging 100 units of currency, that price of 100 units would be adopted and the company B's profit redetermined in accordance with these changed prices.
(b) Cost Plus Method: In this method, the arm's length prices are sought to be arrived at by starting with the cost of inputs in the hands of a company and adding a proportionate mix of manufacturing and other expenses of production, marketing and selling expenses and a reasonable level of profits and thus arriving out at a constructed arm's length price. This method is generally adopted wherein the entity in question is engaged in manufacturing and thus it is easier in their case to come out with a constructed arm's length price.
(c) Resale Price Method: This method is quiet the converse of the Cost Plus Method. In this method the profit-margins are fixed first (depending upon the industry average of profits being charged) and these are then deducted from the sale price to come out with the costs that would have been imputable to the company in an arm's length transaction scenario. Once this arm's length price is arrived it, profits are recomputed and taxes levied thereon.
(II) Non-Transactional methods: As the name suggests, unlike the transactional methods (wherein each transaction is looked into specific detail), these methods apply in a broader perspective wherein the overall figures of related entities are taken into account and adjusted to arrive at arm's length terms. There are two essential methods for this approach:
(a) Profit Split Method: Under this method, the profits of related parties are collated and them split up between the two in a manner which in the opinion of the national authorities is a right allocation of profits on the basis of commercial and productive activity carried out within their territory. This would, therefore, taken into account factors such as level of risk undertaken by an enterprise, the level of productive activity undertaken, etc. and on this basis divide the profits.
(b) Transactional Net Margin Method (or TNMM method): This method generally taken into account the margin that is earned by a related entity in question. For example, in our original illustration the margin in first situation is 40 wherein in second situation is 20. TNMM takes into account the margin figures and seeks to adjust them on the basis of the real nature and depth of the operations in question. So the first step is to arrive at a margin to be charged in the dealings between related parties at a level which would have been a case had the transaction been between independent parties. Once the margins are set, the profit levels are recomputed on an aggregate basis (unlike on a transaction-to-transaction basis as in transactional methods case) and thus taxable amounts determined accordingly.
There are essentially two ways of negating Transfer Pricing i.e. for determining the arm's length price. These are; (i) transactional methods, (ii) non-transactional methods. These are further divided into three and two parts respective (thus total five different techniques for transfer pricing). These can be briefly (briefly because an exhaustive discussion of each can fill volumes of treatises) described as under;
(I) Transactional Methods: These are called so as they generally intend to work out the transactions in specific detail to arrive at the arm's length value for each transaction in question and thus arrive at the overall recasted profits figure when the transactions undertaken by the company have been brought at a fair value terms. There are three methods collated in this transactional approach;
(a) Comparable Uncontrollable Price Method (or CUP method): In this method, the essence is essentially to find out a similar transaction to the one in review which takes place between independent parties and adopt the value which exists in that similar transaction to determine the profits under the transaction in review. For example, in our original illustration, if Company A was selling steel of particular grade to Company B and was charging 120 units of currency for each unit of steel, what was the price being charged by other companies to independent companies around the same time at which this transaction took place. If independent parties were charging 100 units of currency, that price of 100 units would be adopted and the company B's profit redetermined in accordance with these changed prices.
(b) Cost Plus Method: In this method, the arm's length prices are sought to be arrived at by starting with the cost of inputs in the hands of a company and adding a proportionate mix of manufacturing and other expenses of production, marketing and selling expenses and a reasonable level of profits and thus arriving out at a constructed arm's length price. This method is generally adopted wherein the entity in question is engaged in manufacturing and thus it is easier in their case to come out with a constructed arm's length price.
(c) Resale Price Method: This method is quiet the converse of the Cost Plus Method. In this method the profit-margins are fixed first (depending upon the industry average of profits being charged) and these are then deducted from the sale price to come out with the costs that would have been imputable to the company in an arm's length transaction scenario. Once this arm's length price is arrived it, profits are recomputed and taxes levied thereon.
(II) Non-Transactional methods: As the name suggests, unlike the transactional methods (wherein each transaction is looked into specific detail), these methods apply in a broader perspective wherein the overall figures of related entities are taken into account and adjusted to arrive at arm's length terms. There are two essential methods for this approach:
(a) Profit Split Method: Under this method, the profits of related parties are collated and them split up between the two in a manner which in the opinion of the national authorities is a right allocation of profits on the basis of commercial and productive activity carried out within their territory. This would, therefore, taken into account factors such as level of risk undertaken by an enterprise, the level of productive activity undertaken, etc. and on this basis divide the profits.
(b) Transactional Net Margin Method (or TNMM method): This method generally taken into account the margin that is earned by a related entity in question. For example, in our original illustration the margin in first situation is 40 wherein in second situation is 20. TNMM takes into account the margin figures and seeks to adjust them on the basis of the real nature and depth of the operations in question. So the first step is to arrive at a margin to be charged in the dealings between related parties at a level which would have been a case had the transaction been between independent parties. Once the margins are set, the profit levels are recomputed on an aggregate basis (unlike on a transaction-to-transaction basis as in transactional methods case) and thus taxable amounts determined accordingly.
How are Transfer Pricing Rules implemented?
This part, it seems to me, serves as an appropriate conclusion for this post. The above discussion of transfer pricing; what, why and hows etc. are sufficient to deter a first-time reader on the level of complexity involved therein. But then to just relax the things a bit, I surely assure you that this transfer pricing is a daily routine matter for those involved therein and has got no involvement for those not affected by it. For companies which undertake transactions with related parties, there certainly are mechanisms designed in place to record the details of transaction to precise details to prove before the taxation authorities that the prices charged reflect a fair value.
Even otherwise, these transfer pricing rules are integrated in the tax systems in a precise detail as the non-integration would imply losing out on prospective revenues and therefore the tax authorities tax due care to ensure that things relating to transfer pricing are in order. In fact most countries offer an 'Advanced Transfer Pricing' (APA ) agreement which the companies operating in their territory can enter into. This saves the re-computation of figures in future as the companies agree to follow a particular methodology for dealing with related parties, as the host country would tell them to under the APA .
Even otherwise, these transfer pricing rules are integrated in the tax systems in a precise detail as the non-integration would imply losing out on prospective revenues and therefore the tax authorities tax due care to ensure that things relating to transfer pricing are in order. In fact most countries offer an 'Advanced Transfer Pricing' (
Further Readings;
1. HMRC (UK
2. Wikipedia on Transfer Pricing
3. OCED Transfer Pricing Country profiles
4. Government ofAustralia
5. Links from Transfer Pricing Network
2. Wikipedia on Transfer Pricing
3. OCED Transfer Pricing Country profiles
4. Government of
5. Links from Transfer Pricing Network
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