Transfer Price

Transfer price refers to the amount used in accounting for transfer of goods or services from one responsibility centre to another or from one company to another which belongs to the same group. y A transfer price is the price one subunit charges for a product or service supplied to another subunit of the same organization. y The price at which divisions of a company transact with each other
y

Transfer Price
TP means the value or price at which transactions take place amongst related parties. y Transactions may include the trade of supplies or labor between departments. y Transfer prices are used when individual entities of a larger multi-entity firm are treated and measured as separately run entities. y Companies with dispersed production facilities, usually in different countries, use transfer pricing.
y

Fundamental decisions
Should the company produce the product inside the company or purchase from out side vendor ? This is sourcing decision. If produced inside at what price should the product be transferred between profit centers? This is transfer pricing decision.

Why Transfer Pricing?

Approximately 60% of the total transactions across the world are between related parties. y If the transactions are across different tax jurisdictions, where tax rates are different, shifting is beneficial.
y

Objectives of Transfer Pricing

Facilitates goal congruence y Tax savings y Boost profits y Measure performance
y

T natios rasc n

In rnl te a
(W inth cutry ith e on )

Ete a x rnl
(ots eth cutry u id e on )

In rCmay te o pn

In Cmay tra o pn

In rCmpy te o an

In Cmay tra o pn

RvneP fit eeu ro Cp l Gin aita a Rylty oa

Cn lSs m otro yte Nn e te: o-Rla d Rla d e te c s cn s ot etre P fit/Didn/Rylty P fit/Didn/Rylty ro iv ed oa ro iv ed oa reeu cn s vne etre Fre F c a n o x lututios T nfe Pic g ras r r in p fit/Inetmncn ro v s et etre Acutin con g Fre/Ac utin o x con g

Cn lSs m otro yte s Fre F c a n o x lututios Acutin con g T nfeP in ras r ric g

Transfer Pricing Mechanisms

Market-based transfer pricing y Cost-based transfer pricing
y

Factors Affecting Transfer Pricing

Internal factors: Performance Measurement and Evaluation y External Factors:
y

Accounting Standard Income Tax Custom Duty Currency Fluctuations Risk of Expropriation

Uses of TP
1. Price setting for services performed by business unit. 2. A mean of evaluating financial performance of business unit. 3. Determining the contribution to net profit by profit centers in org. 4. Reduce in corporate taxes paid. 5. Reduce in VAT , excise, tariff

Transfer Price Regulations

y

International OECD formulated Guidelines on transfer pricing. They serve as generally accepted practices by the tax authorities

y y y

India The Finance Act 2001 introduced the detailed TPR w.e.f. 1st April 2001 The Income Tax Act AS-18 Other Relevant Acts

Transfer pricing documentation (1)

The transfer pricing documentation should be prepared by:
1. Each tax payer whose turnover exceeds LTL 10 million (~EUR 2,9 million) during the tax year before the controllable transaction takes place; 2. Financial companies and credit institutions; 3. Insurance companies.

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Transfer pricing documentation (2)

The compulsory elements of transfer pricing documentation:
Information about the parties involved in the transaction; Information about intercompany transactions:
Characteristics of the subject of transaction; Functional analysis; Terms and conditions of the transaction; Economic circumstances of the transaction; Business strategy.

Information about transfer pricing method used; Other information that reveals the important circumstances of transfer pricing.

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Transfer pricing documentation (3)

Based on international experience, we structure the documentation as follows:
1. Industry analysis: analyses of market trends, critical success
factors;

2. Company analysis: business overview and financial results of

the parties involved in the transaction, description of their business strategy;

3. Functional analysis: description of functions performed, risk

assumed and assets engaged by related parties;

4. Description of intercompany transactions: characteristics of

the subject of transaction, analysis of costs borne by related parties; determination of benefits derived from intercompany transactions;

5. Economic analysis: description of the pricing methodology,

selection of transfer pricing method, benchmarking study, financial analysis.

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Main issues (1)

1. The accessibility of information; 2. Comparability of transactions; 3. Management services; 4. Transfers of intangibles.

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Main issues (2)

Accessibility of information:
Public available information is limited; Some information may be not reliable; The access to the commercial data bases is fairly expensive; Third parties often are not willing to reveal the information.

Complications determining the arms length range and justifying the transfer prices.

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Main issues (3)

Comparability of transactions:
Application of arms length principle involves a comparison of the terms and conditions in a controlled transaction between related parties with the terms and conditions in transactions between independent parties. The degree of comparability depends on various factors: characteristics of goods, property or services, contractual terms, economical circumstances, functions performed, risk assumed, business strategies, etc.

Difficulties to find highly comparable transactions.

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Main issues (4)

Management services:
Service agreements lack information on service specification, costs arising in the parent company and calculation of the charge (fee) for service rendered. The costs of parent company (shareholders costs) are transferred to its subsidiaries. Duplication of services. Mark-up is too high or not added at all.

The fee for management services is not justified.

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Main issues (5)

Transfers of intangibles:
There is generally not an active market for intangibles. Transactions involving intangibles often include other assets and liabilities, disguising the value of the subject of intangible. Transaction prices are often not disclosed.

Limited comparability and complications determining the arms length range.

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Main issues (6)

The main issue the Lithuanian Tax Authorities have not yet started reviewing intercompany transactions

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Accounting Standard 18
Requires disclosure of any elements of the related party transactions necessary for an understanding of the financial statements.

Related Parties
y y y

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

ASAS-18 and Transactions

y y y y y y y y y

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. y These sections are the backbone of Indian TPR. y These sections define the meaning of related parties, international transactions, pricing methodologies etc.
y

TPR: Some Important Concepts

y

Income/Expenses/Cost arising from an international transaction shall be computed having regard to arms

length price (ALP). y ALP provisions can be applied if it leads to decrease in taxable income or increase in losses.

Arms Length Price

Price which two independent firms would agree on. y Price which is generally charged in a transaction between persons other than associated enterprises.
y

Methods of Transfer Pricing

Comparable Uncontrolled Price Method (CUP Method) y Resale Price Method (RPM) y Cost plus method (CPM) y Transactional Profit Method (TPM) y Profit split method (PSM) y Transactional net margin method (TNMM)
y

Comparable uncontrolled price method

CUP method compares the price transferred in a controlled transaction to the price charged in a comparable uncontrolled transaction. y CUP method is the most direct and reliable way to apply the arms length principle.
y

Resale price method

y

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
x (profit of Rs. 500 for relevant IE)

Arms length price = 2000 - 500 = 1500

Profit Split Method

PSM is used when transactions are interrelated and is not possible to evaluate separately. y 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
y

Cost Plus Method

y

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.

Transfer Pricing Methods

Type of Transaction Manufacturing of goods Sale of goods Provision of services Financing (loans, deposits, guarantees) Transfer of intangibles (technology, brand, know how) Possible method CUP, C+, Profit split CUP, Resale price, Profit split, TNM CUP, C+, TNM CUP, Profit split, TNM CUP, C+

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Some Transactions subject to ALP

Purchase at little or no cost. Payment for services never rendered. Sales below MP/ Purchase above MP Interest free borrowings Exchanging property Selling of real estate at a price different from MP Use of trade names or patents at exorbitant rates even after their expiry.

Example
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