Transfer price is the price at which two branches of a company transfer goods and services to each other. The United Nations has defined transfer pricing as “the setting of prices for transactions between associated enterprises involving transfer of property and services.” Therefore, transfer pricing is used in relation to multi-entity company. Transfer pricing treats each entity of the same company as separate from each other for the purpose of determining the cost of transacted goods and services between them.
In the era of multi-national corporations that are able to conduct business globally and have branches in various countries, transfer pricing has become a crucial instrument of international taxation. From the point of view of taxation, transfer pricing affects taxable income of a company and thus is crucial in determining the tax base of a country. Another important aspect of transfer pricing is the ability of multi-national corporations to reduce their taxable income by a substantial margin by utilizing different tax rates in different countries.
Therefore, for the purpose of transfer pricing different legal entities of the same company are treated as individual entities, separate from each other, and transacting with each other as in an open market. This is called the ‘arm’s length’ concept based on the principle that each such entity would work towards generating maximum profit for itself.
For computing transfer pricing various instruments, exist. The Organisation for Economic Cooperation and Development (OECD), in its guidelines, divides the methods for determining transfer price into two broad categories—
- Traditional transactional method and
- Transactional profit method.
The first focuses on the prices at which the transaction takes place. This is further broken down into the resale price method, comparable uncontrolled price method and the cost plus method.
The transactional profit methods take from the profitability of the entities that indulge in comparable uncontrolled transactions and is further subdivided into transactional net margin method and profit split method.
Procedurally, determining transfer price involves
- Fact gathering,
- Industry analysis,
- Functional, asset and risk analysis,
- Economic analysis of the entity involved and
- The issue of transfer pricing documentation.
In India, detailed transfer pricing law was introduced under Finance Act 2001 by making amendments to section 92 of the Income Tax Act, 1961. The Finance Act substituted the erstwhile Section 92, which dealt with re-computing the income accruing from a transaction between a resident and non-resident that resulted in less profit owing to the proximity between the two. Section 92 has now been expanded and deals exhaustively with transfer pricing. These provisions fall under section 92 to 92F of the act and define the scope and mechanisms to be employed in computing transfer pricing in great detail.
- Section 92 (1) states ‘any income arising from an international transaction shall be computed having regard to the arm’s length price’, and extensively covers transactions have affect a company’s profits, expenditure etc.
- Section 92 (A) defines the relationship between associated entities and covers the such areas as control over capital by one entity over the other, participation, either direct or indirect, in the management etc.
- Section 92 (B) defines international transaction. According to it, international transaction happens between associated enterprises that can either be two non-residents or a resident and a non-resident. Such transactions involve sale purchase or lease of tangible or intangible property, lending borrowing of money, cost sharing, providing services or any other transaction that affect profit, loss, income or asset of the associated enterprises involved in such transactions.
- Section 92 BA, introduced recently, covers domestic transaction that involve tax holiday units and related entities under Section 40A(2)(b).
- Section 92F defines the concept of ‘arm’s length’ to mean a price that is applicable or proposed to be applied to transactions in uncontrolled conditions between persons other than associated entities.
Further, Rule 10A to 10T of the Income Tax Rules, 1962, also deals with transfer pricing. These also define and elaborate upon the rules to be adhered to while calculating transfer pricing.
- Rule 10A elaborates upon the meaning of expressions used in computation of arm’s length price.
- Rule 10AB, 10B and 10C deal with methods to determine arm’s length price.
- Rule 10D and 10E, deals with information and documentation to be kept under these rules.
- Rule 10F defines the meaning of expressions used in matters in respect of advance pricing agreement.
- Rule 10G to 10T, define the persons eligible to apply, application for advance pricing agreements and other related matters and modalities thereof.
Together with the Income Tax Act, these rules aim at guarding the tax base in India.