Transfer pricing basics

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TRANSFER PRICING
: BASICS
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Why Transfer Pricing ?
 Rise of large number of MNEs
 Increase in number of cross border transactions
 Existence of different tax rates & rules in different jurisdictions
 Transactions between group companies – not determined by market forces
 Main motive of MNEs - to maximize stakeholder’s wealth

How profits are manipulated ?
Indian Entity Group Entity
Makes payment
Provides Services
India Low Tax Jurisdiction

Importance of Transfer Pricing
Transfer Pricing rules are essential for Tax Administration and Tax Payers in order to:
 Protect their tax base
 Eliminate double taxation
 Enhance cross border trade

Indian Regulations
 Finance Act, 2001 recognized the need of TP provisions and introduced Chapter X
 Chapter X containing section 92 to 92F provides detailed provisions for Transfer Pricing
 Finance Act, 2012 extended the scope of TP provision to Specified Domestic Transactions
 APA and Rollback provisions introduced to reduce litigation

Associated Enterprise
Associated
Enterprise
Satisfying the “test of
participation in mgmt.,
control or capital”
Being Deemed AEs

International Transaction
International Transaction means:
 A transaction
 Between two or more associated enterprise
 Either or both of whom are non-residents
 Transaction in the nature of:
- Purchase, sale or lease of tangible/intangible property
- Provision of services
- Lending or borrowing of money
- Other transaction having bearing on profits, incomes, losses or assets
- Mutual agreement between AE for allocation/apportionment/contribution to any cost

Specified Domestic Transaction
Transfer Pricing Regulations extended by Finance Act, 2012 to include SDTs.
SDT means following transactions, not being an international transaction:
 Expenditure for which payment made to person referred to in section 40A(2)(b)
 Transactions referred to in section 80A
 Transfer of goods or services referred in section 80-IA (8)
 Business transacted between Assessee and other person referred to in section 80-IA (10)
 Any transaction, referred to in any other section under Chapter VI-A or section 10AA, to which provision of
section 80-IA (8) or 80-IA (10) are applicable
 Any other prescribed transaction
Aggregate of transaction entered in previous year exceeds a sum of Rs. 5 crore rupees.

Arm’s Length Price
Common Parlance :
Price at which independent enterprises deal with each other, where the conditions of their commercial and
financial relations are ordinarily determined by market forces.
Section 92F(ii) of Act:
A price which is applied or proposed to be applied in a transaction between persons other than associated
enterprise, in uncontrolled conditions.

Process of Computation of ALP
(i) Analysis of specific features of controlled transaction (i.e. international transaction of SDT in question)
(ii) Search for comparable uncontrolled transactions
(iii) Comparability Analysis in accordance with sub rule (2) to (4) of Rule 10B
(iv) Selection of Most Appropriate Method
(v) Application of MAM to calculate ALP

Background & Industry Overview
 Broad - based analysis of the taxpayer’s circumstances
 An analysis of the industry, competition, economic and regulatory factors affecting the taxpayer and its
environment
 Helps understand the conditions in the controlled transaction as well as those in the uncontrolled transaction
to be compared, in particular the economic circumstances of the transactions.

Analysis of specific features of controlled transaction
Functional Analysis
- Functions performed
- R&D, Design & Engineering
- Manufacturing, production & Assembly
- Warehousing & Transportation, etc.
- Assets Employed
- Tangible Assets: Land & Building, Plant & Machinery, etc.
- Intangible Assets: Patents, Trademarks, Licences, etc.
- Risks Assumed
- Financial Risks
- Product & Market Risk
- General Business Risks
Characterisation: Necessary to carry search for similar comparables with similar characteristics

Selection of Tested Party
 Tested party is the party to the transaction for which comparability is analysed. Such party’s financial indicators
shall be tested against those of uncontrolled transactions
 Choice of Tested Party necessary for applying Cost Plus Method, Resale Price Method or Transactional Net
Margin Method
 It may be the local or the foreign party
 It should be less complex party in respect of which most reliable data for comparability is available and
adjustments could be made easily

Comparables
Comparables
Internal Comparables External Comparables

Identification of External Comparables
Database Screening
Quantitative Screening
Qualitative Screening
Final Set of Comparables

Quantitative Filters

Most Appropriate Method
 For determining comparability, MAM should be used
 MAM should be the method best suited to the facts and circumstances of each particular IT/ SDT
 It should provide the most reliable measure of an arm’s length price in relation to the IT/SDT
 For determining the MAM, following factors should be kept in mind
‐ Nature and class of transactions
‐ Class of AEs and the functions performed by them
‐ Degree of comparability between the IT/SDT and CUT
‐ Extent to which reliable and accurate data is available and adjustments can be made

Comparable Uncontrolled Price Method
 Most direct method of comparability analysis
 Require a relatively high level of comparability to produce reliable results
Price of comparable transaction xxx
+/- Adjustment for material differences between comparable transaction and IT/SDT xxx
+/- Adjustment in respect of material differences between enterprise to both the transactions xxx
Arm’s length Price as per CUP method xxx

Resale Price Method
 Used to determine ALP when goods purchased from AE resold without significant value addition
 Involves working back from resale price received from unrelated parties to arrive at an arm’s length price
Resale Price charged from unrelated party xxx
Less: Normal Gross profit margin on similar transaction xxx
Less: Expense in connection with purchase xxx
+/- Stock adjustment and other adjustments on account of difference in transactions and
enterprises
xxx
Arm’s length Price as per RPM xxx

Cost Plus Method
 Used to determine ALP when goods & services are sold to AE
 Compares the gross profit mark-up earned by the tested party for the provision of goods and services with
gross profit mark-ups earned by comparable companies.
Direct and Indirect costs incurred in respect of goods and services xxx
Add: Normal gross profit under by comparables on similar transactions xxx
+/- Adjustments on account of difference in transactions and enterprises xxx
Arm’s length Price as per CPM xxx

Profit Split Method
 Typically applied when both sides of the controlled transaction contribute significant intangible property
 The profit is to be divided such as is expected in a joint venture relationship
 PSM starts by identifying the profits to be divided between the Aes
 These profits are subsequently divided between the AEs on the basis of value of each AEs‘ contribution, which
should reflect the functions performed, risks undertaken and assets employed by each AE
 PSM is of two types
‐ Total Profit Split Method
‐ Residual Profit Split Method

Transactional Net Margin Method
This method is mainly applied in case of:
 Provision of services
 Distribution of finished goods where RPM can’t be applied
 Transfer of semi-finished goods where CPM can’t be applied
 Transactions involving intangibles where PSM can’t be employed
This method involves:
 Identification of PLI
 Identification of net profit margin realised by the enterprise from international transaction
 Identifying the net profit margin from CUT having regard to the same base and adjusting it for material
difference in transactions/enterprise
 The adjusted net profit margin is used to arrive at the arm’s length price of the IT/SDT

Transactional Net Margin Method - PLI

Other Method
CBDT has notified such other method apart from the five methods already prescribed. It states
“ the Other Method for determination of the arms' length price in relation to an international transaction shall be
any method which takes into account the price which has been charged or paid, or would have been charged or paid,
for the same or similar uncontrolled transaction, with or between non-associated enterprises, under similar
circumstances, considering all the relevant facts.”
This method is typically used where the other methods can not be used (e.g. Managerial Remuneration). The
various data which can be used for comparability purposes are:
 Third party quotations
 Valuation reports
 Documents relating to negotiations,
 Standard rate cards

Contemporaneity of Data
 Data for current year should be used
 Data for previous two years can also be used if such data reveals facts which could have an influence on the
determination of transfer prices in relation to the transactions being compared

Contemporaneity of Data [Contd…]
Current Developments:
 Data for current year or FY preceding the current year shall be used for comparability
 Where the CUT has been identified on the basis of data relating to the current year and the enterprise
undertaking the said uncontrolled transaction has in either or both of the two financial years immediately
preceding the current year undertaken similar comparable uncontrolled transaction, then the weighted average
of the prices of the CUT undertaken in the current year and in the preceding two years shall be used.
 Where the CUT has been identified on the basis of the data relating to the financial year immediately preceding
the current year and the enterprises undertaking the said uncontrolled transaction, has in the financial year
immediately preceding the said financial year undertaken the same or similar comparable uncontrolled
transaction, then the weighted average of the prices of the CUT undertaken in the aforesaid period of two years
shall be used for determining the arm’s length price.

Mean or Range
 If the number of comparables is less than 6, then arithmetic mean of the margins should be used
 If the number of comparables is greater than or equal to 6, then
‐ A dataset shall be constructed by arranging the weighted average margins in ascending order
‐ The arm’s length range shall begin from the thirty-fifth percentile of the dataset and end on the sixty-fifth
percentile of the dataset. The data place of x percentile shall be computed as :
Data place of x percentile = Total no. of data points in dataset * (x / 100)
‐ If the price at which the international transaction or the specified domestic transaction has actually been
undertaken is outside the arm's length range, the arm's length price shall be taken to be the median of the
dataset

Documentation Areas
•Functions
•Assets
•Risk
•Comparability
•Method
Selection
•Benchmarking
•Covered Entities
•Covered
Transactions
•Company
•Group
•Industry
Background
Information
Transaction
Information
Functional
Analysis
Economic
Analysis

Penalties
Failure to Keep and maintain information & Documents w.r.t IT/ SDT 2% of value of each transaction
Failure to furnish report u/s 92E Rs. 1,00,000
Failure to furnish information and documents u/s 92D 2% of the value of each transaction
Additionally penalties u/s 271 can also be initiated for any such failure

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Transfer pricing basics

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