WHAT IS TRANSFER WHAT IS TRANSFER PRICING?PRICING?

TRANSFER PRICINGTRANSFER PRICING

Transfer pricing refers to the pricing of Transfer pricing refers to the pricing of cross-cross-border transactionsborder transactions between two between two related entitiesrelated entities

When two related entities enter into any cross-When two related entities enter into any cross-border transaction, the price at which they border transaction, the price at which they undertake their transaction is called transfer priceundertake their transaction is called transfer price

Due to the special relationship between related Due to the special relationship between related companies, the transfer price may be different than companies, the transfer price may be different than the price that would have been agreed between the the price that would have been agreed between the unrelated companiesunrelated companies

Price between Price between unrelated partiesunrelated parties in in uncontrolled uncontrolled conditionsconditions is known as the “arm’s length” price is known as the “arm’s length” price (ALP)(ALP)

WHY TRANSFER PRICING LEGISLATION?WHY TRANSFER PRICING LEGISLATION?

COMPANY

A

COMPANY

B

India Overseas

To prevent shifting of profits from India

TRANSFER PRICING – INDIAN LEGISLATIONTRANSFER PRICING – INDIAN LEGISLATION

Introduced in 2001, the Indian Transfer Pricing regulations Introduced in 2001, the Indian Transfer Pricing regulations detailed in the Income Tax Act, 1961 are largely based on the detailed in the Income Tax Act, 1961 are largely based on the OECD (Organisation for Economic Co-operation and OECD (Organisation for Economic Co-operation and Development) Transfer Pricing Guidelines:Development) Transfer Pricing Guidelines: Contains transfer pricing documentation requirements and Contains transfer pricing documentation requirements and

penaltiespenalties No automatic correlative relief for transfer pricing No automatic correlative relief for transfer pricing

adjustmentsadjustments

IMPORTANT LEGISLATIONSIMPORTANT LEGISLATIONS

Section 92 to 92F of the Income Tax Act, 1961 (Act)Section 92 to 92F of the Income Tax Act, 1961 (Act) Rules 10A to 10D of the Income Tax Rules, 1962 (Rules)Rules 10A to 10D of the Income Tax Rules, 1962 (Rules) Section 271AA of the Act Section 271AA of the Act Section 271BA of the Act Section 271BA of the Act Section 271G of the ActSection 271G of the Act OECD guidelines on Transfer Pricing , July 1995OECD guidelines on Transfer Pricing , July 1995 Article 9 of DTAAArticle 9 of DTAA

INDIAN TP LEGISLATIONINDIAN TP LEGISLATION

BROAD OVERVIEWBROAD OVERVIEW

Clearly lays down the scope and purview of Indian Transfer Clearly lays down the scope and purview of Indian Transfer Pricing legislation Pricing legislation

Defines basic terms like Defines basic terms like associated enterprisesassociated enterprises and and international transactions international transactions

One of the five prescribed methods to be considered for One of the five prescribed methods to be considered for determination of the arm’s length pricedetermination of the arm’s length price

Mandatory to maintain and furnish prescribed documentationMandatory to maintain and furnish prescribed documentation Independent accountant’s certificate to be furnishedIndependent accountant’s certificate to be furnished Stringent penalties prescribed for non-complianceStringent penalties prescribed for non-compliance

INDIAN TRANSFER PRICING REQUIREMENTSINDIAN TRANSFER PRICING REQUIREMENTS

International transactions with International transactions with related entities to be at Arm’s related entities to be at Arm’s Length PriceLength Price

Arm’s length price

If required, representation before If required, representation before Indian Tax/Transfer Pricing Indian Tax/Transfer Pricing authorities to justify arm’s length authorities to justify arm’s length nature of international transactionsnature of international transactions

Representation

Documentation

Maintenance of specified documentation Maintenance of specified documentation to justify the arm’s length nature of to justify the arm’s length nature of international transactionsinternational transactions

BASICSBASICS

Any incomeAny income arising from an arising from an international transactioninternational transaction shall shall be computed having regard to the be computed having regard to the arm’s length price arm’s length price (Section 92)(Section 92)

The provisions of section 92 shall not apply in a case where The provisions of section 92 shall not apply in a case where the computation of income or allowance for any expense the computation of income or allowance for any expense has the effect of reducing the income chargeable to tax or has the effect of reducing the income chargeable to tax or increasing the lossincreasing the loss

ASSOCIATED ENTERPRISESASSOCIATED ENTERPRISES

Associated enterprises have Associated enterprises have direct or indirect participation direct or indirect participation (through one or more entities) in (through one or more entities) in management or in control or in management or in control or in capital. For examplecapital. For example

Shareholding with voting Shareholding with voting

power (26% or more); orpower (26% or more); or

Appointment of majority Appointment of majority

directors of the board or directors of the board or

majority members of majority members of

governing boardgoverning board

Definition

B

>=26%

>=26%

B and C are associated enterprises since they have a common parent A

A

C

DEEMED ASSOCIATED ENTERPRISESDEEMED ASSOCIATED ENTERPRISES

Deemed Associated Enterprises

Common executive director(s)

Loans in excess of

51% of total assets

Guarantees in excess of 10% of total borrowings

Relationships of mutual interest

Complete dependence

on IPRs

Existence of common control

Supply of raw materials (90%

or more)

Power to appoint more than half of directors

INTERNATIONAL TRANSACTIONINTERNATIONAL TRANSACTION

Transaction between two or more associated enterprisesTransaction between two or more associated enterprises At least one of the associated enterprise must be a non-At least one of the associated enterprise must be a non-

residentresident Scope of transactions coveredScope of transactions covered

Purchase, sale, lease of tangibles or intangiblesPurchase, sale, lease of tangibles or intangibles Provision of servicesProvision of services FinancingFinancing Cost apportionments, allocations, contributionsCost apportionments, allocations, contributions Any other transactions having a bearing on profits, Any other transactions having a bearing on profits,

income, losses or assets of an enterpriseincome, losses or assets of an enterprise

Transaction between A and Transaction between A and 3rd party is also subject to 3rd party is also subject to transfer pricing norms, iftransfer pricing norms, if::

TRANSACTIONS BETWEEN UNRELATED PARTIESTRANSACTIONS BETWEEN UNRELATED PARTIES

A’s parent

3rd party

Prior agreement

Service

s

Aa prior agreement exists between A’s parent and 3rd party; and

3rd party

Service

s

Determination of terms

A

A’s parent

terms of transaction are determined in substance by A’s parent and 3rd party

TRANSFER PRICING TRANSFER PRICING METHODOLOGIESMETHODOLOGIES

MOST APPROPRIATE METHODMOST APPROPRIATE METHOD

Most appropriate method shall be the method best suited to Most appropriate method shall be the method best suited to the facts and circumstances of each particular international the facts and circumstances of each particular international transaction and which provides the most reliable measure transaction and which provides the most reliable measure of an arm’s length price in relation to the international of an arm’s length price in relation to the international transactiontransaction

Factors considered for selection of the most appropriate Factors considered for selection of the most appropriate method:method: Nature and class of international transactionNature and class of international transaction Class of associated enterprise and functions performedClass of associated enterprise and functions performed Availability, coverage and reliability of dataAvailability, coverage and reliability of data Degree of comparability between the International Degree of comparability between the International

transactiontransaction Extent to which reliable and accurate adjustments can Extent to which reliable and accurate adjustments can

be madebe made The nature, extent and reliability of assumptions for The nature, extent and reliability of assumptions for

application of the method application of the method

COMPARABLE UNCONTROLLED PRICE METHOD (CUP)COMPARABLE UNCONTROLLED PRICE METHOD (CUP)

The CUP Method seeks to The CUP Method seeks to determine the arms’ length determine the arms’ length price by comparing the price by comparing the controlled transaction with the controlled transaction with the uncontrolled transactionuncontrolled transaction

Method used in case of strong Method used in case of strong similarity of products or similarity of products or servicesservices

Most direct and reliable Most direct and reliable method – preferred by OECDmethod – preferred by OECD

Generally produces the most Generally produces the most reliable resultsreliable results

Comparability based on: Comparability based on: FunctionsFunctions Contractual termsContractual terms Risks Risks Economic conditionsEconomic conditions Strong similarity of products Strong similarity of products

and services is criticaland services is critical

Manufacturer

in US

AE in IndiaUnrelated

Party in India

Manufacturer in US,

manufactures

electronic chips which are sold

to both AE,

a related party in India,

and unrelated Indian customersCUP

Sale price to unrelated party may be used to benchmark sale to group entity in India

Method used in case of Method used in case of purchase of goods or services purchase of goods or services from related parties for resale from related parties for resale to unrelated parties without to unrelated parties without substantial value additionsubstantial value addition

The price is reduced by the The price is reduced by the normal gross margins earned normal gross margins earned by unrelated party for same or by unrelated party for same or similar products or services; similar products or services; andand

Need for similarity of functions Need for similarity of functions performed and risks performed and risks undertakenundertaken

Gross margins used as the Gross margins used as the profit level indicatorprofit level indicator

Group Manufacturer

in US

Distributor

in India

Unrelated

Wholesaler

An Indian distributor purchases

watches from its US manufacturer

for resale to unrelated wholesalers

in India.

Indian distributor earns a

gross margin of 25%

Price paid by Indian distributor to Group manufacturer in US is the arm’s length if the 25% resale margin earned by Indian distributor lies within arm’s length range of margins earned by similar Indian distributors

$ 75

$ 100

RESALE PRICE METHOD (RPM)RESALE PRICE METHOD (RPM)

Method used in cases Method used in cases involving manufacture, involving manufacture, assembly or production of assembly or production of tangible products or services tangible products or services that are sold / provided to that are sold / provided to related partiesrelated parties

The mark up on direct and The mark up on direct and indirect costs incurred to be indirect costs incurred to be based on unrelated based on unrelated comparablescomparables

Need for similarity in functions Need for similarity in functions performed and risks borneperformed and risks borne

Gross margins used as the Gross margins used as the profit level indicatorprofit level indicator

External Market in US

AE in USManufacturer

In India

Margin earned by Indian manufacturer on sales to Group manufacturer to be benchmarked against margin on total costs (direct and indirect) earned by similar manufacturers in India

$ 140

$ 100

COST PLUS METHOD (CPLM)COST PLUS METHOD (CPLM)

Indian manufacturer makes

electronic components and sells

these at fully absorbed cost plus

40% to a US manufacturer which

uses those components in

manufacture of electric power tools

Method used in cases involving transfer of unique Method used in cases involving transfer of unique intangibles or in multiple international transactions that intangibles or in multiple international transactions that cannot be evaluated separatelycannot be evaluated separately

Evaluates allocation of combined profit/loss in controlled Evaluates allocation of combined profit/loss in controlled integrated transactionsintegrated transactions

Reference to relative value of each controlled taxpayer’s Reference to relative value of each controlled taxpayer’s contribution (functions performed, risks assumed and contribution (functions performed, risks assumed and resources employed)resources employed)

Complex Method/ Sparingly usedComplex Method/ Sparingly used

PROFIT-SPLIT METHOD (PSM)PROFIT-SPLIT METHOD (PSM)

Examines operating profit Examines operating profit from transactions as a from transactions as a percentage of appropriate percentage of appropriate base (can use different bases base (can use different bases i.e. costs, turnover etc.) in i.e. costs, turnover etc.) in respect of similar partiesrespect of similar parties

Broad level of similarity of Broad level of similarity of resources employed, functions resources employed, functions and risks and risks

Operating margin of Indian Operating margin of Indian company to be compared with company to be compared with operating margin earned by operating margin earned by similar enterprises in similar enterprises in uncontrolled transactionsuncontrolled transactions

Most preferred and practical Most preferred and practical method vis-à-vis the assesses.method vis-à-vis the assesses.

TRANSACTION NET MARGIN METHOD (TNMM)TRANSACTION NET MARGIN METHOD (TNMM)

Subsidiary

in India

Unrelated

Subsidiary in

India

AE in USUnrelated

Company

SUMMARY OF METHODSSUMMARY OF METHODS

MethodsMethods Comparability Comparability RequirementsRequirements ApproachApproach RemarksRemarks

CUPCUP Very HighVery High Prices are Prices are benchmarkedbenchmarked

Very difficult to apply Very difficult to apply as very high degree of as very high degree of comparability requiredcomparability required

RPMRPM HighHigh Gross Profit margins Gross Profit margins are benchmarkedare benchmarked

Difficult to apply as Difficult to apply as high degree of high degree of comparability requiredcomparability required

CPLMCPLM HighHigh Gross Profit margins Gross Profit margins are benchmarkedare benchmarked

Difficult to apply as Difficult to apply as high degree of high degree of comparability requiredcomparability required

PSMPSM MediumMediumNet Operating Profit Net Operating Profit margins are margins are benchmarkedbenchmarked

Complex Method, Complex Method, sparingly usedsparingly used

TNMMTNMM MediumMediumNet Operating Profit Net Operating Profit margins are margins are benchmarkedbenchmarked

Most commonly used Most commonly used methodmethod

COMMON APPLICABILITY OF METHODSCOMMON APPLICABILITY OF METHODS

MethodsMethods Applicability Applicability

CUPCUP IntangiblesIntangibles Transfer of commoditiesTransfer of commodities Loans, provision of financingLoans, provision of financing

Distribution of finished productsDistribution of finished products

Provision of servicesProvision of services Transfer of semi finished goodsTransfer of semi finished goods Distribution of finished productsDistribution of finished products

Transactions involving integrated services provided by more Transactions involving integrated services provided by more than one enterprisethan one enterprise

Provision of servicesProvision of services Distribution of finished products where the RPM cannot be Distribution of finished products where the RPM cannot be

adequately appliedadequately applied Transfer of semi finished goodsTransfer of semi finished goods

RPMRPM

CPLMCPLM

PSMPSM

TNMMTNMM