Transfer pricing is the price paid for goods or services transferred from one party to another. Transfer pricing is an accounting and taxation practice, and it refers to the rules and procedures used for pricing transactions within and between enterprises that operate under common control. Introduced in India in 2001, the transfer pricing rules and regulations are followed in cross-border and domestic transactions.
Purpose of Transfer Pricing
Some of the main objectives behind implementing transfer pricing are:
To generate separate profit for separate divisions of an enterprise
To enable performance evaluation of each division separately
To ensure that the profits are taxed in such a place where value is created.
Transfer Pricing Procedures
The OECD (Organisation for Economic Co-operation and Development) Guidelines has laid out the transfer pricing methodologies used for examining the arm’s length price of the controlled transactions.
An arm’s length transaction refers to a transaction in which both the parties in the business deal act independently without any party influencing the other. It is crucial to know the arm’s length transaction of an entity to ensure that both the parties in the deal are acting in their self-interest and no party is subject to any pressure or constraint from the other party.
The procedures for transfer pricing are divided into Traditional Transaction Methods and Transactional Profit Methods.
Traditional Transaction Methods include Comparable Uncontrolled Price, Cost Plus, and Resale Price Methods. On the other hand, Transactional Profit Methods include Transactional Net Margin Method and the Profit Split Method.
There are also other methods used by several jurisdictions, considered to provide arm’s length results. However, it should be made sure that such practices are consistent with the arm’s length principle.
Traditional Transaction Methods
Comparable Uncontrolled Price Method
In the Comparable Uncontrolled Price (CUP) Method, the price of a product/service transferred in a controlled transaction is compared to the price of a product/service transferred in a comparable uncontrolled transaction in comparable circumstances. CUP Method is the most preferred method and is used for deciding the arm’s length royalty for the use of an intangible asset.
Resale Price Method
The Resale Price Method examines the product price that a related sales company charges to an unrelated customer. It helps to calculate the arm’s length gross margin. The sales company uses the arm’s length price determined with this method to cover all its expenses and make a reasonable profit.
Cost Plus Method
Generally, the Cost-Plus Method is applied to manufacturing or assembling activities and relatively simple service providers, and is used to analyze transfer pricing issues that involve tangible product/service. The gross profit mark-up earned by the tested party is compared to the gross profit mark‐ups earned by comparable companies.
Transactional Profit Methods
Transactional Net Margin Method
In the Transactional Net Margin Method, the tested party’s net profit margin in the controlled transactions is compared to the same net profit margins earned by the tested party in comparable uncontrolled transactions.
Profit Split Method
The Profit Split Method is used when both parties of the controlled transaction contribute significant intangible property. The profit is divided in a way that is expected in a joint venture relationship. Suppose, two related entities might work together on a separate joint venture to develop or launch a new brand. In such situations, the Profit Split Method is used to determine a way for dividing profits that is beneficial to both entities.
Different entities follow different procedures of transfer pricing in India. So, there is no one “right” procedure for transfer pricing. What might be the right procedure for one entity is not relevant to the other entity. Also, choosing the correct method for transfer pricing depends on several factors. The transaction type, functional analysis, comparability factors, availableness of comparable transactions, and the possibility of making some adjustments to the data should be taken into account by the taxpayer. Select the method for transfer pricing that is the most suitable for your entity after considering all the above factors.