Transfer pricing practices

Chapter 1 : Rationale of the Study

Transfer pricing is the process that a multinational company undergoes when
transferring goods from one division to another. This is required for the distribution of
taxable profit in multiple countries, and to allocate profits and losses for each individual
division of the company.

Three problems with transfer pricing:

• Divisional autonomy - transfer prices are particularly appropriate for profit centers because
if one profit center does work for another the size of the transfer price will affect the costs of
one profit center and the revenues of another. However, a danger with profit center
accounting is that the business organization will divide into a number of self-interested
segments, each acting at times against the wishes and interest of other segments. A balance
ought to be kept between divisional autonomy to provide incentives and motivation, and
retaining centralized authority to ensure that the organization's profit centers are all working
towards the same target, the benefit of the organization as a whole.
• Divisional performance measurement - profit centers managers tend to put their own profit
performance above every this else. Since profit centers performance is measured according to
the profit they earn, no profit center will want to do work for another an incur cost without
being paid for it. Consequently, profit center managers are likely to dispute the size of
transfer prices with each other, or disagree about whether one profit center should do work
for another or not.

• Corporate profit maximization - When there are disagreements about how much work
should be transferred between divisions, and how many sales the division should make to the
external market, there is presumably a profit- maximizing level of output and sales for the
organization as a whole. However, unless each profit center also maximizes its own profit at
this same level of output, there will be inter divisional disagreements about output levels and
the profit maximizing output will not be achieved.

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The ideal solution:

Ideally a transfer price should be set at a level that overcomes these problems.

• The transfer price should provide an 'artificial' selling price that enables the transferring
division to earn a return for its efforts. And the receiving division to incur a cost for benefits
received.
• The transfer price should be set at a level that enables profit center performance to be
measured 'commercially'. This means that the transfer price should be a fit commercial price.

• The transfer price, if possible, should encourage profit center managers to agree on the
amount of goods and services to be transferred, which will also be at a level that is consistent
with aims of the organization as a whole such as maximizing company profits.

Process of Transfer Pricing :

Globalization

Increased cross border inter-company transactions

Decision on transfer prices in order to minimize the tax burden

Tax authorities forced to regulate transfer prices

Arm’s length principle
(The prices in inter-company transactions should not differ from the prices determined by
unrelated parties and the profit or income accrued from inter-company transactions should not
differ from the profit or income earned from transactions between unrelated parties.)

Provisions of services between associated enterprises

Suitable Transfer Pricing Method (Cost plus Method)

Multinational companies are elevating the importance of transfer pricing and dedicating
more resources to understanding, planning and documenting their inter-company pricing.
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Not long ago, transfer pricing was a subject for tax administrators and one or two other
specialists. But recently, politicians, economists and businesspeople, as well as NGOs,
have been waking up to the importance of who pays tax on what in international business
transactions between different arms of the same corporation. Globalization is one reason
for this interest, the rise of the multinational corporation is another. Once you take on
board the fact that more than 60% of world trade takes place within multinational
enterprises, the importance of transfer pricing becomes clear. Transfer prices are useful in
several ways. They can help an MNE identify those parts of the enterprise that are
performing well and not so well.

In contrast to a purely tax-driven mechanism, Principle underlying use of international
transfer pricing is to accomplish corporate objectives and thus create strategic
consequences. Multinationals could employ transfer pricing to assist in achieving
competitive advantage and other corporate objectives as well. We need to understand the
influence of transfer pricing on corporate performance and the link involving the
effectiveness of transfer pricing in accomplishing objectives.

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Chapter 2 : Objective of the Study

Title of the project:

With the rise of Globalization and Multinational Corporations has increased the
importance of Transfer pricing and this project is an endeavor to study the transfer pricing
regime in different countries , studied at KPMG India has been titled as :

“Study of International practices for Transfer Pricing”

Objective of the Study:
This project has been divided into four parts to understand the transfer pricing regimes
and study its application.

1) To study the prevalent practices for Transfer Pricing in selected countries.

2) To compare the Transfer Pricing practices in other countries with India.

3) To analyze the application of Arm’s length principle in Transfer Pricing.

4) To study Cost plus method application under Transfer Pricing.

Scope of the Study:
In this project I have covered the different aspects of Transfer Pricing, to show how it can
benefit the organization and at times it could be reason to levy penalties. Under the transfer
pricing implementation MNE’s have to abide by the government consideration and how they
have to satisfy the Arm’s Length Standard with the application of various transfer pricing
method to set their prices for the various services rendered or goods transferred.

• Transfer pricing has assumed enormous significance in the modern economic context. The
practice of transfer pricing refers to the application of prices to transactions that are
conducted within the structure of an enterprise. In this project I have tried to incorporate
different regimes followed in 4 selected countries.

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• However, an interesting dimension is thrown open when one considers the ability of a firm to
drastically reduce its tax incidence by using transfer pricing. As the prices for intra-firm
transactions are fixed in such a manner that low profits are reflected in jurisdictions having a
high tax rate while higher profits are shown in those jurisdictions having a low tax rate.

• It is now being recognized that international exchange of goods and services, like equivalent
domestic exchange, takes place both through hierarchies and on markets.

• The growth of management contracts, technical assistance agreements, licensing
arrangements, etc. probably implies the expansion of non-market hierarchical influences even
upon `arms length' market transactions.

• The problematic role of the market as the main instrument in the allocation of resources is
due to increased mechanization and has been responsible in creating opportunities for the
pursuit of `restrictive business practices' within intra-firm trade.

• The transfer pricing when undertaken within transnational corporate hierarchical systems are
considered the basics of good transnational corporate management now a days.

• The issue of transfer pricing arises because of the existence of intra-firm trade across national
borders; but direct foreign investment, licensing agreements, joint ventures (both technical
and financial), often also provide ample scope for transfer pricing not only to circumvent
adverse government policies, but also as a part of the corporate strategy and organizational
structure of transnational entities.

• TNC’s combine centralized control and integrated corporate functioning with a geographical
dispersal of their production and investment activities. Their multinational character is an
attempt to `internalize' market imperfections so as to maximize current global profits or
minimize future risks and uncertainties in order to ensure long-term gains for the corporation
as a whole.

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Chapter 3 : Company Profile

KPMG is one of the largest professional services firms in the world and one of the Big Four
auditors, along with PricewaterhouseCoopers (PwC), Deloitte and Ernst & Young (EY).

COMPANY NAME: KPMG (Klynveld Peat Marwick Goerdeler)

HEADQUATERS : Amsterdam Area, Netherlands.

FOUNDED : 1987; in merger of Peat Marwick International and Klynveld

Main Goerdeler.

TYPE : Swiss cooperative.

INDUSTRY : Professional Services.

AREA SERVED : World Wide.

KEY PEOPLE : Timothy P. Flynn (CHAIRMAN).

SERVICES : Audit

Tax

Advisory

REVENUE : ▲US$20.1 billion (2009)

EMPLOYEES : 136000

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HISTORY
1897: James Marwick and Roger Mitchell founded Marwick, Mitchell & Company in New
York City.
1925: Company established alliance with British accounting firm W.B. Peat & Co. and
formed Peat, Marwick, Mitchell & Company.
1978: Company changed its name to Peat Marwick International.
1987: Peat Marwick International merged with Klynveld, Main, Goerdeler to form Klynveld
Peat Marwick Goerdeler, based in the Netherlands; the U.S. arm was named Peat, Marwick,
Main & Company.
1989: U.S. branch was renamed KPMG Peat Marwick.
1999: KPMG Peat Marwick shortened its name to KPMG LLP, a branch of KPMG
International.

The firm was established in 1870 when William Barclay Peat formed an accounting firm in
London. In 1877 accountancy firm Thomson McLintock opened an office in Glasgow and in
1911 William Barclay Peat & Co. and Marwick Mitchell & Co. merged to form Peat
Marwick Mitchell & Co, later known as Peat Marwick. Meanwhile in 1917 Piet Klynveld
opened his accounting-firm in Amsterdam. Later he merged with Kraayenhof to form
Klynveld Kraayenhof & Co.

In 1979 Klynveld Kraayenhof & Co. (Netherlands), Thomson McLintock (United States) and
Deutsche Treuhandgesellschaft (Germany) formed KMG (Klynveld Main Goerdeler) as a
grouping of independent national practices to create a strong European-based international
firm. Then in 1987 KMG and Peat Marwick joined forces in the first mega-merger of large
accounting firms and formed a firm called KPMG in the US, and most of the rest of the
world, and Peat Marwick McLintock in the UK. In 1990 the two firms settled on the common
name of KPMG Peat Marwick McLintock but in 1991 the firm was renamed KPMG Peat
Marwick and in 1999 the name was reduced again to KPMG.

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GLOBAL STRUCTURE
Each national KPMG firm is an independent legal entity and is a member of KPMG
International Cooperative, a Swiss entity registered in the Swiss Canton of Zug. KPMG
International changed its legal structure from a SwissVerein to a co-operative under Swiss
law in 2003.

KPMG International is led by:

• Timothy P. Flynn, Chairman, KPMG International
• Michael Wareing, CEO, KPMG International
• John Griffith-Jones, Chairman, Europe, Middle East, Africa and India Region
• John B. Harrison, Deputy Chairman, KPMG International
• John Veihmeyer, Chairman, Americas Region
• Carlson Tong, Chairman, Asia Pacific Region.

VALUES & CULTURE
Values : Our commitment to our communities is set out clearly in our values and
encourages us to act responsibly and do the right thing at all times.

People :An overwhelming majority of our people view us as environmentally and socially
responsible, and welcome a clear opportunity to volunteer. By putting our people’s time and
skills to work in our communities, we are able to focus their passion towards sustainable
community development.

Living Green:Our Living Green program is driven by our commitment to the environment,
and by our belief that the threats posed by climate change need to be tackled immediately.

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KPMG Services

Support Advisory Audit Tax

Performance & Risk & Compliance
Finance Risk Technology Accounting
Business Advisory
Perform Services
ance Financial Risk
Services Managemen
IT Advisory t
Forensic
Internal Audit,
Risk &
Compliance
Research Human Services
Resource Transaction &
Restructuring
Corporate
Finance
Restructuring
Transaction
Services
T&R Sector
Administration T&R Services
Markets T&R Country

Compliance Knowledge
Management

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KPMG In India
KPMG in India is one of the leading providers of risk, financial and business advisory, internal
audit, corporate governance, and tax and regulatory services. With a global approach to service
delivery, KPMG responds to clients' complex business challenges with a broad range of services
across industry sectors and national boundaries.

HISTORY

KPMG was established in India in September 1993, and has rapidly built a significant
competitive presence in the country. The firm operates from its offices in Mumbai, Pune, Delhi,
Kolkata, Chennai, Bangalore, Hyderabad, Kochi and Chandigarh, and offers its clients a full
range of services, including financial and business advisory, tax and regulatory, and risk advisory
services.

In India, KPMG has a client base of over 2000 companies. The firm's global approach to service
delivery helps provide value-added services to clients. The firm serves leading information
technology companies and has a strong presence in the financial services sector in India while
serving a number of market leaders in other industry segments. Our differentiation is derived
from rapid performance-based, industry-tailored and technology-enabled business advisory
services delivered by some of the leading talented professionals in the country. Our internal
information technology and knowledge management systems enable the delivery of informed and
timely business advice to clients.

STRUCTURE

KPMG International is a Swiss cooperative. KPMG member firms in more than 140 countries
work with clients drawn from the corporate, government and not-for-profit sectors. It is the
coordinating entity for a global network of independent firms. Their structure is designed to
support consistency of service quality and adherence to agreed values wherever in the world our
member firms operate. The member firms commit themselves to a common set of KPMG values.

Firms must abide quality standards governing how they operate and how they provide services to
clients. Other firms, licensed by member firms to use the KPMG name, must also abide by these

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standards. Each KPMG member firm takes responsibility for its management and the quality of
its work. Partners and professionals within those firms undertake to act with integrity at all times.

CORPORATE CITIZENSHIP

‘Commitment to our communities’ is not a mere statement. It is a defining value of our corporate
culture, and the factor that gives us a great sense of pride. KPMG not only look at what they can
do locally, but also at contributing towards global commitments such as the Millennium
Development Goals and the ‘Living Green’ initiative.The very fact that their strategy focuses on
the core requirements of their local communities and also aligns their efforts with key global
issues like climate change and the Millennium Development Goals speaks volumes for their
commitment. This is India at its best - a place of innovation and leadership, and the Foundation
manifests the same creativity and passion. Their latest initiative ‘Partner school program’
highlights the natural evolution process in their strategy and their aim to harness the strong core
skills of our people in implementing initiatives that provide a very promising future for our
people and their communities.”

GLOBAL GREEN INITIATIVE

In April 2008, Timothy P. Flynn, Chairman, KPMG International Cooperative, announced
KPMG’s Global Green Initiative (GGI) – a three tiered global approach to help address the
challenges of climate change. This initiative incorporates a global commitment from member
firms to reduce carbon emissions and constantly looking out for ways to reduce consumption of

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electricity and natural resources as well as air and vehicular travel. Including Tree planting
activities, setting up of solar units for use of solar energy and Rainwater harvesting
projects.

Chapter 4 : Review of Literature

Transfer pricing has been defined by Pass and Christopher as: “A transfer price is the
internal price charged by a selling department, division or subsidiary of a company for a raw
material, component or finished good or service which is supplied to a buying department,
division or subsidiary of the same company.” The transfer price charged may be set by
reference to the prices ruling in outside markets for inputs and products (arm's length
pricing).

It is basically a practice that multinational enterprises adopt of organizing their accounting
practices so as to declare high incomes and profits in geographical areas with low taxation
rates. In today's international market, a large share of world trade consists of transfer of
goods, intangibles and services within multinational enterprises (associated companies with
business establishments in 2 or more countries). To determine the international tax liability
in each jurisdiction, the right transfer pricing principle has to be applied. To ensure that the
tax base of a multinational enterprise is divided fairly, it is important that transfer pricing
within a group should approximate those, which would be negotiated between independent
firms. For the purpose of transferring profits, revenues or money out of a country in order to
evade taxes under transfer pricing, overpricing of imports and/or under-pricing of exports
between affiliated companies in different countries.

According to the OECD (2007), more than 60% of world trade takes place within
multinational enterprises, so the importance of transfer pricing becomes clear and its
important to understand why multinational enterprises practice transfer pricing. Pass and
Christopher has identified the objectives of transfer pricing as follows:

a) Taxation: Minimization of the MNC's global tax liability by using transfer pricing to
move products at cost out of countries with high corporate taxes and the generation of
profits in countries with low corporate taxes.

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b) Tariffs: Minimization of the MNC's exposure to tariffs by using transfer pricing to lower
product prices sold to countries with high import tariffs.

Transfer pricing objectives could be further differentiated as domestic and international
objectives and International Aspects of Transfer pricing study gives a brief distinction
between considerations for adopting transfer pricing domestically or internationally :

Domestic Objectives International Objectives
• Greater divisional autonomy • Less taxes, duties and tariffs
• Greater motivation for managers • Less foreign exchange risks
• Better performance evaluation • Better competitive position
• Better goal congruence • Better governmental relations

• Risk Management

The objective of international transfer pricing focus on minimizing taxes, duties, and foreign
exchange risks, along with enhancing a company's competitive position and improving its
relations with foreign governments. Although domestic objectives such as managerial
motivation and divisional autonomy are always important, they often become secondary
when international transfers are involved. Companies will focus instead on charging a
transfer price that will slash its total tax bill or that will strengthen a foreign subsidiary.

For example, charging a low transfer price for parts shipped to a foreign subsidiary may
reduce customs duty payments as the parts cross international borders or it may help the
subsidiary to compete in foreign markets by keeping the subsidiary's costs low. On the other
hand, charging a high transfer price may help a multinational corporation draw profits out of
a country that has stringent controls on foreign remittances, or it may allow a multinational
corporation to shift income from a country that has high income tax rates to a country that has
low rates.

But most of the enterprises prefer international transfer pricing as compared to the domestic
transfer pricing and the key drivers underlying this preferences are :

1 Market Conditions
2 Competition

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3 Profit for the affiliate
4 Tax Rates
5 Economic conditions
6 Import Restrictions
7 Customs Duties
8 Price Controls
9 Exchange Control

Setting up the transfer prices for transaction of goods and services between associated
companies in a manner such that its objectives are met , the process would reap benefits to
the multinational enterprises. Based on the study of general concepts of transfer pricing
conducted by Khurram khan enumerated the following benefits of transfer pricing :

1. To Reduce Tax
2. To Reduce Tariffs
3. For Avoiding Exchange Controls
4. To Optimize global profits by reducing tariffs and taxes to minimum or nil levels.

On one hand the multinational enterprises are trying to seek advantages from transfer
pricing practices at the same time the management of transfer pricing risk has become one of
the key challenges for the respective enterprises .They have to focus towards reducing the
uncertainty from the risks, the various risks which are associated with transfer pricing are ,
• Double taxation,
• Unexpected cash calls,
• Interest on tax, and
• Penalties for non-compliance.
• Advisor Defense Costs
• Revenue Authority Information Sharing
• Internal Defense Costs
• Income Adjustment

Hence reviews of existing transfer pricing policies, intercompany arrangements, and/or
documentation to assess any potential transfer pricing risks and the subsequent provision of
recommendations could help enterprises to reduce these risks and to identify any
opportunities for further growth.

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This past year had been tough for the world economy and while there are signs of a recovery,
troubles may still lie ahead. Several major territories, for instance, are now adopting
new, or revised, transfer pricing requirements, and there is a discernible increase in
disputes globally. Documenting — and sustaining — transfer pricing in this economic
setting can also create difficult issues for tax departments. The continuously uncertain
tax positions generated by the transfer pricing process means that multinational
companies must now satisfy the ever-increasing demands of tax authorities and
stakeholders. The present economic situation has only intensified this situation.

Transfer pricing is of relevance to international transactions where inappropriate transfers
could result in the loss of tax revenue to one country or another and the firm need to
be more vigilant pertaining to their transactions and the rates they quote for transfer
pricing, hence there are many challenges that a firm counters while practicing transfer
pricing as stated by Govind Sankaranarayanan who considers transfer pricing as a
fiscal challenge. Countries across the world, including India, appear to be bound for
severe fiscal deficits in the coming years, and tax authorities will be induced to close
all possible loopholes in the fiscal regimes that they govern. At the Organisation for
Economic Co-operation and Development (OECD), economists have indicated that
nearly 60% of world trade occurs between different arms of multinational companies.
In today’s fiscal situation, it would be unthinkable for revenue authorities to pass up
such a large fiscal opportunity.

At the same time, there are two other critical factors that come into play. First, a large number
of multinational companies, faced with slowing growth in their core markets, will use the
management of taxes to offset reductions in their profits elsewhere. Second, there is in
general a greater awareness created, in many countries, due to the emergence of a common
body of knowledge on transfer pricing, which can now be used for the evolution of
meaningful tax opinions and judgment.

Companies should be spending resources to establish a robust documentation process,
persuading tax authorities to look at substance over form while assessing transfer pricing
structures, and so on. Perhaps in the interim, a period of two-three years, some form of safe
harbor provision could be provided to give an element of certainty to companies

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To study the trend of transfer pricing practices globally in December 2007 Ernst & Young
had undertaken a survey of 850 MNEs in 24 countries and examined how transfer pricing
affects the way that MNEs conducted business. The results showed the following:

1. Forty percent (40%) of all respondents identified transfer pricing as their most important
tax issue.

2. Over half (52%) of all respondents had undergone a transfer pricing examination since
2003, with 27% resulting in adjustments by tax authorities.

3. Eighty-seven (87%) percent of all respondents consider transfer pricing a risk issue in
relation to managing financial statement risk.

4. Sixty-five percent of respondents from parent MNEs believe transfer pricing
documentation is more important today than two years ago. However, only one-third of
MNEs prepare transfer pricing documentation on a concurrent, globally coordinated basis.

According to John Smullen based on his study of transfer pricing in financial institutions the
Uses of transfer pricing could be divided under four headings which are as follows :

Government Relationship Organizational Risk
Based with other Management Management
Motivation organizations
Management

Ensuring Sensible Pricing For Strategy Isolating Risk,
Response to Services, Formulation , Motivation of
Regulation , Decision On Establishing risk management
Requirement for Outsourcing , Financial Impact
Competition Evaluation On of entity,
Regulations M&A, Motivation,
Benchmarking Pricing
Decision
Evaluation,
Planning and
Budgeting

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Transfer pricing is one of the key factors of a management control system, which helps a
company to achieve its goals, including profit maximization and tax minimization.
There are several methods of setting transfer prices among profit centers within the same
organization. Each profit center tries to set transfer prices which maximize their own profit.
The buying and selling profit centers’ profits are largely affected by transfer prices. For
example, when a high transfer price is charged, the selling division’s profits increase, while
the buying division’s costs increase. So, transfer pricing should be established on a
reasonable and objective basis, which should maximize the companywide profit, rather than
being based on an individual division’s profit. The company can choose market-based
transfer pricing, cost-based transfer pricing, or negotiated transfer pricing. According
Tomas Buus from University of Economics, Prague the cost based transfer pricing i.e.
average cost of the supplying division plus economic profit of the multi-business enterprise,
independent on the market conditions at the market of either intermediate or final product
sets the most optimal transfer price as compared to market-based and negotiation based
transfer pricing methods because the latter two price base their arguments on market
imperfections like information asymmetry, motivation of managers and hence lead to loss of
multi - business enterprise's ability to compete its rivals as supported by
“ Economics of Transfer Pricing: A Review” .
Cross country differences in corporate income tax rates lead multinationals to find strategies
in order to diminish their tax liabilities. The manipulation of transfer prices represents a
common way to minimize the fiscal burden. But at the same time the widespread practice of
abusive transfer pricing is suspected to lead to a fiscal loss of a large magnitude. The starting
point to encourage transfer pricing abuse has been the tax differentials, and that some firms
have a greater ability to manipulate transfer prices. Celine Azemar and Gregory Corcos
revealed that the ability of multinational firms to manipulate transfer prices affects the tax
sensitivity of foreign direct investment (FDI and as per their findings the unobservable ability
to manipulate transfer prices is correlated with whole ownership of affiliates and R&D
expenditure. Because interest is tax-deductible, multinationals may bias the capital structure
of their affiliates towards debt financing in high-tax countries. R&D-intensive parent firms
are expected to invest in wholly-owned affiliates to have a greater ability to manipulate
transfer prices. The detection of abusive transfer pricing begins with more investment in low-
tax countries. Multinationals engaging in abusive transfer pricing will try to maintain
standard profit-to assets ratios in order to minimize the risk of detection and punishment..It

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interprets the results as indirect evidence that abusive transfer pricing is one of the
determinants of FDI activity.

With the understanding as to how firms indulge into abusive transfer pricing by manipulating
their transfer price , now shifting the focus to repercussions of practicing inconsistent
transfer pricing rules. On study of a strategic tax compliance model by Waegenaere ;
Sansing ; Wielhouwer revealed that an increase in transfer price rule inconsistency could
either increase or decrease the taxpayer's expected tax liability and could either increase or
decrease the deadweight loss from auditing. The prospect of double taxation due to transfer
price rule inconsistency increases a firm's expected tax liability and governments' expected
audit costs.

Whereas some companies are practicing abusive transfer pricing and or inconsistent transfer
pricing rules there is a bright aspect for companies through transfer pricing as it offers
remedy to tackle gray market trading , Romana Autrey from Harvard Business School and
Francesco Bova from University of Toronto found a method for the MNC’s to combat gray
markets by increasing internal transfer prices to foreign subsidiaries in order to increase the
gray market’s cost base. Gray markets arise when a manufacturer’s products are sold outside
of its authorized channels, for instance when goods designated for a foreign market are resold
domestically. When a gray market competitor is present, the optimal price for internal
transfers not only exceeds marginal cost, but is also a function of the competitiveness of the
upstream economy. Moreover, the presence of a gray market competitor may cause
unintended social welfare consequences when domestic governments mandate the use of
arm’s length transfer prices between international subsidiaries. When markets are sealed,
arm’s length transfer pricing strictly increases domestic social welfare. In contrast, we
demonstrate that when a gray market competitor is present, mandating the use of arm’s length
transfer pricing decreases domestic social welfare when the domestic market is sufficiently
large relative to the foreign market. Specifically, a shift to arm’s length transfer pricing
erodes domestic consumer surplus by making the gray market less competitive domestically,
which in turn may offset any domestic welfare gains that accompany a shift to arm’s length
transfer pricing.

Transfer pricing can deprive governments of their fair share of taxes from global corporations
and expose multinationals to possible double taxation. No country – poor, emerging or wealthy –

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wants its tax base to suffer because of transfer pricing. The arm’s length principle can help. The
transfers are not subject to the full play of market forces. Factors other than tax considerations
may distort the conditions of commercial and financial relations established between associated
enterprises for example, such enterprises may be subject to conflicting governmental pressures
relating to customs valuations, anti-dumping duties, and exchange or price controls. In addition,
transfer price distortions may be caused by the cash flow requirements of enterprises within an
MNE group. In a bid to avoid such problems, current OECD international guidelines are based
on the Arm’s length principle – that a transfer price should be the same as if the two companies
involved were indeed two independents, not part of the same corporate structure. As stated by
John Neighbour in - OECD Centre for Tax Policy and Administration explains the need for
the application of Arm’s Length Principle

According to the OECD guidelines, Article 9 of the OECD Model Tax Convention provides
the Statement of the arm's length principle, which is as follows:

“When conditions are made or imposed between ... two enterprises in their commercial or
financial relations which differ from those which would be made between independent
enterprises, then any profits which would, but for those conditions, have accrued to one of the
enterprises, but, by reason of those conditions, have not so accrued, may be included in the
profits of that enterprise and taxed accordingly."

The separate entity approach treats the members of an MNE group as if they were independent
entities; attention is focused on the nature of the dealings between those members. The
Organization for Economic Co-operation and Development (OECD) set forth Transfer Pricing
Guidelines for Multinational Enterprises in 1995 instructing that the pricing of intra-group
transactions should be based on the arm’s-length standard. The arm’s-length standard states that:

“A controlled transaction meets the arm’s-length standard if the results of the transaction are
consistent with the results that would have been realized if uncontrolled taxpayers had engaged
in the same transaction under the same circumstances (arm’s-length result).”

The OECD Guidelines and other transfer pricing legislation urge taxpayers to employ the best
(or most appropriate) transfer pricing method rule, which states:

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“The arm’s-length result of a controlled transaction must be determined under the method that,
under the facts and circumstances, provides the most reliable measure of an arm’s-length result.”

There are five methods highlighted in the OECD Guidelines that are appropriate for setting and
evaluating transfer prices. There are three applicable “transactional methods” specified in the
OECD Guidelines. They are:

• Comparable Uncontrolled Price (CUP) : Most systems consider a third party price for identical
goods, services, or property under identical conditions, called a comparable uncontrolled price
(CUP), to be the most reliable indicator of an arm's length price. CUPs are based on actual
transactions.

• Resale Price Method (RPM): It compares the gross profit margin earned in the controlled
(related) transaction to the gross profit margin realized in comparable uncontrolled transactions.

• Cost Plus Method (CPLM): Goods or services provided to unrelated parties are consistently priced
at actual cost plus a fixed markup.

There are two specified “profit-based” methods. These methods of testing prices do not rely on
actual transactions. Use of these methods may be necessary due to the lack of reliable data for
transactional methods. These methods may include:

• Transactional Net Margin Method: which evaluates the arm’s-length character of a controlled
transaction based upon objective measures of profitability of one of the participants to the
transaction (tested party) derived from uncontrolled taxpayers who engage in similar business
activities under similar circumstances.

• Profit Split Method: which determines an arm’s-length division of the combined operating
profits/losses from one or more controlled transactions based on the relative value of each
controlled taxpayer’s contribution to that combined operating profit or loss.

To prevent profit shifting by manipulation of transfer prices, tax authorities typically apply
the arm’s length principle in corporate taxation and use comparable market prices to
‘correctly’ assess the value of intra-company trade and royalty income of multinationals.
The arm’s length prices systematically differ from independent party prices. Application of
the principle thus distorts multinational activity by reducing debt capacity and investment of
foreign affiliates, and by distorting organizational choice between direct investment and

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outsourcing. Although it raises tax revenue and welfare in the headquarter country, welfare
losses are larger in the subsidiary location, leading to a first order loss in world welfare. This
exemplifies the distorting aspect of arm’s length principle as per Devereux and Keuschnigg

It is important acquaint ourselves with the importance of adopting arm's length principle by
the OECD Member countries and other countries under transfer pricing. It shed lights on as
to how arm’s length standard make transfer pricing a fair play as it provides the following
benefits to the firm such as,

• A major reason is that the arm's length principle provides broad parity of tax treatment for MNEs
and independent enterprises.
• The arm's length principle puts associated and independent enterprises on a more equal footing
for tax purposes, it avoids the creation of tax advantages or disadvantages that would otherwise
distort the relative competitive positions of either type of entity.
• The arm's length principle promotes the growth of international trade and investment.

But there are difficulties faced by the MNE’s under the application of Arm’s length
principle. It is not a simple statement that a firm has to abide by it levies a complete set of
regulations which has to be followed by the firm and such difficulties in practical application
of the principle could be as follows :

• The arm's length principle is viewed by some as inherently flawed because the separate entity
approach may not always account for the economies of scale and interrelation of diverse
activities created by integrated businesses.
• A practical difficulty in applying the arm's length principle is that associated enterprises may
engage in transactions that independent enterprises would not undertake as there is no direct
evidence of what conditions would have been established by independent enterprises.
• In certain cases, the arm's length principle may result in an administrative burden for both the
taxpayer and the tax administrations of evaluating significant numbers and types of cross-border
transactions. At some point the enterprise may be required to demonstrate that these are
consistent with the arm's length principle. The tax administration may also have to engage in this
verification process perhaps some years after the transactions have taken place.

21

OECD Member countries continue to support strongly the arm's length principle. In fact, no
legitimate or realistic alternative to the arm's length principle has emerged as yet
.International Consensus of the arm’s length principle in view of OECD Member countries
continues to be that the arm's length principle should govern the evaluation of transfer prices
among associated enterprises. The arm's length principle is sound in theory since it provides
the closest approximation of the workings of the open market in cases where goods and
services are transferred between associated enterprises. It reflects the economic realities of
the controlled taxpayer's particular facts and circumstances and adopts as a benchmark the
normal operation of the market. A move away from the arm's length principle would increase
the risk of double taxation.

Application of the arm's length principle is generally based on a comparison of the conditions
in a controlled transaction with the conditions in transactions between independent
enterprises This part of the chapter would serve as a guide to the application of the arm's
length principle

i) Comparability analysis

Most rules provide standards for when unrelated party prices, transactions, profitability or other
items are considered sufficiently comparable in testing related party items. Among the factors
that must be considered in determining comparability are:

1) The Nature of the property or services provided between the parties

2) Functional analysis of the transactions and parties, buyers and sellers may perform different
functions related to the exchange and undertake different risks.

3) Comparison of Contractual Terms , that may impact price include payment timing, warranty,
volume discounts, duration of rights to use of the product, form of consideration, etc.

4) Comparison of significant economic conditions that could affect prices, including the effects
of different market levels and geographic markets

ii.Use of an arm's length range

As transfer pricing is not an exact science, there will also be many occasions when the
application of the most appropriate method or methods produces a range of figures all of which
are relatively equally reliable. In these cases, differences in the figures that comprise the range

22

may be caused by the fact that in general the application of the arm's length principle only
produces an approximation of conditions that would have been established between independent
enterprises.

iii) Use of multiple year data :

In order to obtain a complete understanding of the facts and circumstances surrounding the
controlled transaction, it generally might be useful to examine data from both the year under
examination and prior years. The analysis of such information might disclose facts that may
have influenced the determination of the transfer price.

iv) The effect of government policies :

There are some circumstances in which a taxpayer will claim that an arm's length price must be
adjusted to account for government interventions such as price controls (even price cuts),
interest rate controls, and controls over payments for services or management fees, controls over
the payment of royalties, subsidies to particular sectors, exchange control, anti-dumping duties,
or exchange rate policy. As a general rule, these government interventions should be treated as
conditions of the market in the particular country, and in the ordinary course they should be
taken into account in evaluating the taxpayer's transfer price in that market.

v) Intentional set-offs :

An intentional set-off is one that associated enterprises incorporate knowingly into the terms of
the controlled transactions. These enterprises may claim that the benefit each has received
should be set off against the benefit each has provided as full or part payment for those benefits
so that only the net gain or loss on the transactions needs to be considered for purpose of
assessing tax liabilities.

vi) Use of customs valuations :

The arm's length principle is applied by many customs administrations as a principle of
comparison between the value attributable to goods imported by associated enterprises and the
value for similar goods imported by independent enterprises. In particular, customs officials may
have contemporaneous documentation regarding the transaction that could be relevant for
transfer pricing purposes, especially if prepared by the taxpayer and, may be useful to tax
administrations in evaluating the arm's length character of a controlled transaction transfer price.

vii) Use of transfer pricing methods :

23

There are various methods set forth to establish whether the conditions imposed in the
commercial or financial relations between associated enterprises are consistent with the arm's
length principle. No one method is suitable in every possible situation and the applicability of
any particular method need not be disproved. Moreover, MNE groups retain the freedom to
apply methods to establish prices provided those prices satisfy the arm's length principle.
However, a taxpayer should maintain and be prepared to provide documentation regarding how
its transfer prices were established. For difficult cases, where no one approach is conclusive, a
flexible approach would allow the evidence of various methods to be used in conjunction. In
such cases, an attempt should be made to reach a conclusion consistent with the arm's length
principle that is satisfactory from a practical viewpoint to all the parties involved, taking into
account the facts and circumstances of the case, the mix of evidence available, and the relative
reliability of the various methods under consideration.

Although there are discrepancies in the specifics of each country's laws concerning the
application of the arm's length principle, most countries have based their transfer pricing laws
and regulations on the OECD Guidelines. Further, most double-tax treaties contain provisions
that force both taxing authorities to resolve transfer pricing disputes on the basis of the arm's
length principle. Thus, multi-national companies should be able to devise global transfer
pricing policies that can be effectively used to determine appropriate ranges representing the
arm's length prices for transactions carried out across a global enterprise without necessarily
running afoul of local laws and regulations.

Different countries may accept different methods of calculating the transfer prices so care
must be taken in such circumstances. In addition, some countries may have immature transfer
pricing regimes or apply the arm's length principle in different ways. Traditional transaction
methods are the most direct means of establishing whether conditions in the commercial and
financial relations between associated enterprises are arm's length. As a result, traditional
transaction methods are preferable to other methods. However, the complexities of real life
business situations may put practical difficulties in the way of the application of the
traditional transaction methods. In those exceptional situations, where there are no data
available or the available data are not of sufficient quality to rely solely or at all on the
traditional transaction methods, it may become necessary to address whether and under what
conditions other methods may be used.

24

Type of Transaction Possible method

Manufacturing of goods CUP, C+, Profit split

Sale of goods CUP, Resale price, Profit split, TNM

Provision of services CUP, C+, TNM

Financing (loans, deposits, guarantees) CUP, Profit split, TNM

Transfer of intangibles (technology, brand) CUP, C+

The above table shows which transfer pricing methods would be the most appropriate way to
set prices for intra-firm transaction. As already stated traditional methods are the first choice
as compared to the profit-based methods. Amongst these traditional methods one important
method is Cost plus method this method probably is most useful where the transaction is the
provision of services. For international transfer pricing for services cost plus method is the
first preference. This is considered a practical approach to the problem of divergent profit
center and corporate interests. In some cases the profit center manager may want to base
transfer prices on variable costs plus profit whereas in other cases that manager may want
fixed costs also to be included. Even though the transfer price will be higher than full cost, it
may still be in the best interests of the buying responsibility center and the company as a
whole to transfer the product within the company.

The Cost Plus Method is defined as the simplest method for pricing products or services
rendered. The cost plus method begins with the costs incurred by the supplier of property or
service provider in a transaction for property transferred or services provided to a related
purchaser. An appropriate cost plus mark up is then added to this cost, to make an appropriate
profit in light of the functions performed and the market conditions. What is arrived at after
adding the cost plus mark up to the above costs may be regarded as an arm's length price of the
original transaction. This method probably is most useful where the transaction is the provision of
services. The cost-plus method is used as an approximation of market price. Often this is
considered a practical approach to the problem of divergent profit center and corporate interests
as per “Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations”
by OECD.

25

In situations where a division cannot derive its transfer prices from the outside market , the
cost-plus approach may be a reasonable alternative as stated by Mr Putra based on his study
of Transfer Pricing Best Practice. This method is based on its name—just accumulate a
product’s full cost, add a standard margin percentage to the cost, and this becomes the
transfer price. It has the singular advantage of being very easy to understand and calculate,
and can convert a cost center into a profit center, which may be useful for evaluating the
performance of a division manager.

Applying cost plus method :

P = (AVC + FC%) * (1 + MK%)

• P = price
• AVC = average variable cost
• FC% = percentage allocation of fixed costs
• MK% = percentage markup

Nearly every MNE group must arrange for a wide scope of services to be available to its
members, in particular administrative, technical, financial and commercial services. Such
services may include management, coordination and control functions for the whole group.
The cost of providing such services may be borne initially by the parent, by a specially
designated group member ("a group service centre"), or by another group member. Transfer
Pricing Guidelines for Multinational Enterprises and Tax Administrations published by
OECD has mentioned about what all considerations should be taken into account under the
cost plus approach :

• The cost plus mark up of the supplier in the controlled transaction should ideally be
established by reference to the cost plus mark up that the same supplier earns in comparable
uncontrolled transactions. In addition, the cost plus mark up that would have been earned in
comparable transactions by an independent enterprise may serve as a guide.
• In addition, when applying the cost plus method one should pay attention to apply a
comparable mark up to a comparable cost basis. The cost plus method relies upon a
comparison of the mark up on costs achieved by the controlled supplier of goods or services
and the mark up achieved by one or more uncontrolled entities on their costs with respect to
comparable transactions.

26

• The differences between the controlled and uncontrolled transactions that have an effect on
the size of the mark up must be analyzed to determine what adjustments should be made to
the uncontrolled transactions' respective mark up. So it is particularly important to consider
differences in the level and types of expenses -- operating expenses and non-operating
expenses including financing expenditures - associated with functions performed and risks
assumed by the parties or transactions being compared.

• In general the costs and expenses of an enterprise are understood to be divisible into three
broad categories. First, there are the direct costs of producing a product or service, such as
the cost of raw materials. Second, there are indirect costs of production, which although
closely related to the production process may be common to several products or services
(e.g. the costs of a repair department that services equipment used to produce different
products). Finally, there are the operating expenses of the enterprise as a whole, such as
supervisory, general, and administrative expenses.

• In principle historical costs should be attributed to individual units of production, although
admittedly the cost plus method may over-emphasize historical costs. Some costs, for
example costs of materials, labor, and transport will vary over a period and in such a case it
may be appropriate to average the costs over the period. Costs such as replacement costs and
marginal costs also may need to be considered where these can be measured and they result
in a more accurate estimate of the appropriate profit margin.

• The costs that may be considered in applying the cost plus method are limited to those of the
supplier of goods or services. There is a possibility that some costs will be borne by the
purchaser in order to diminish the supplier's cost base on which the mark up will be
calculated. In practice, this may be achieved by not allocating to the supplier an appropriate
share of overheads and other costs borne by the purchaser (often the parent company) for the
benefit of the supplier (often a subsidiary). The allocation should be undertaken based on an
analysis of functions performed by the respective parties.

Advantages of cost-plus pricing:
• Easy to calculate
• Minimal information requirements

27

• Easy to administer
• Tends to stabilize markets - insulated from demand variations and competitive factors
• Simplicity
• It offers the illusion that profit can somehow be guaranteed

Disadvantages of cost-plus pricing:

• Provides no incentive for efficiency
• Tends to ignore the role of consumers
• Tends to ignore the role of competitors
• Uses historical rather than replacement value
• Uses “normal” or “standard” output level to allocate fixed costs
• Includes sunk costs rather than just using incremental costs
• Ignores opportunity costs
• It takes no account of demand
• It does not maximize the revenue from a product or service where the company should
be charging considerably more than the cost plus approach would justify. For example
a premium product which faces little

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Chapter 5: Research Methodology

Research Design:
This study is a Exploratory research, which is an attempt to provide insights into and
comprehension of practices followed under transfer pricing .The study is basically a
comparison between the transfer pricing practices in selected countries. In this study three
countries have been selected from 3 different continents and compared them with the Indian
transfer pricing regime. KRCPL is one of the entity KPMG, which is a joint venture between
KPMG India and KPMG UK. This entity is involved in transfer pricing by rendering services
to its subsidiaries in United States and Philippines. KPMG India also offers its services to
KPMG UK. This project covers the aspect as to how the tax authorities regulations vary in
these four countries and how do the companies set their transfer prices for provision of
services. This project is based on data of secondary nature. Case studies have been included
to show the threats and opportunities offered by Transfer Pricing . MIS reports have been
used to show application of Transfer Pricing Method-Cost Plus Method for Services.

Data Collection Methods:

The study relies on secondary research i.e. reviewing available literature and/or data, case
studies and as formal discussions with employees. Internet has played a major role in finding
facts related to transfer pricing. Study on Transfer pricing conducted by KPMG and their
article on the Global Transfer Pricing Services has provided information in order to review
the transfer pricing regimes followed in the selected countries.
Central Board of Direct Taxes (CBDT), Internal Revenue Services (IRS), Bureau of Internal
Revenue (BIR), Her Majesty's Revenue and Customs (HMRC) are the Tax authorities for
India , United States , Philippines and United Kingdom respectively. These authorities gives
the outlines for documentation requirements and penalties information in relevance to
transfer pricing practices.
Employees of KPMG who are involved in preparing MIS reports have given information as
to how KPMG India is related to transfer Pricing.

29

Data Analysis :

To compare the transfer pricing regimes in different countries have been depicted in a tabular
form Pie charts and Bar graphs have been used to understand the data transfer pricing
regulations such as to demonstrate the statute of limitations, penalties and documentation
requirements. Cost plus method has been used to identify the budget, forecast and actual cost
figures of the MI report at 7% margin.

Sampling Plan:

This project is based on convenience sampling .In this project the Transfer Pricing regime of
four countries has been compared i.e. India, Philippines, United Kingdom and United States.

• KRCPL is one of the entity under the KPMG head which is a joint venture between
KPMG India and KPMG UK. This entity indulges into transfer pricing by rendering
services to its subsidiaries in United States, Philippines and United Kingdom .

• This project would provide insights into how the transfer pricing regimes vary in
these four countries. How does the tax authorities regulations vary and requirements
to abide by government rules.

• Philippines and India covers the Asia Pacific Region , United States Cover the
American Region and United Kingdom covers the European region.

• MI report have been used to show the application of Cost plus module under the
transfer pricing for provision of services to satisfy arm’s length standard.

30

Chapter 6: Data Analysis and Interpretation
After understanding the basics of transfer pricing and arm’s length principle, this part of
project presents the facts as to how the transfer pricing methodology differs in the four
selected countries. Comparison of Transfer pricing practices between India, Philippines,
United Kingdom and United States

Table 6.1 - Basic Information:
Features India Philippines United United States
Kingdom
Tax Authority Central Board of Bureau of Her Majesty's Internal Revenue
Name Direct Taxes Internal Revenue Revenue and Services ( IRS)
(CBDT) (BIR) Customs
(HMRC)

Requirement of Accountant's No specific No specific Related Party
transfer pricing Report in form of disclosures are disclosure transactions,
related disclosure Form 3CEB to required. required. Form filed with
in or with their be filed along- Tax return
tax returns with Tax Return ;
form to be
certified by
Chartered
Accountant
The relationship Direct/indirect Under common Ownership Under common
threshold for participation in control ; share between 40-50 Control
transfer pricing management, capital % ; based on
rules to apply 26% equity voting power ;
between parties participation, 13 share capital ;
criteria’s for are under
associated common
enterprise control .
relationship to be
satisfied.

31

The statute of 45 Months from No existing law Six years from Three years from
limitations on the end of the tax on statute of tax year-end filing date
assessment of year limitation on
transfer pricing transfer pricing
adjustments assessment.

The above table provides the basic information about which all tax authorities are involved in
regulating the transfer pricing in the selected countries. These tax authorities require the
companies to file their tax returns but in India companies involved in transfer pricing has to
provide Form 3CEB which contains details of all the related party international transactions
and methods to use to justify arm's length standard. All the tax authorities describe that the
minimum requirment for the companies to enter into transfer pricing is that they should be
under common control but the associated enterprise conditions vary from country to country .

Figure 1 : The graphs represents the period after which legal actions
would proceed after the event at issue i.e. transfer pricing takes place.

United Kingdom provides 6 years period for Statute of limiations , 4.7 years in India and 3
years in United States and Philippines tax authority has not prescribed the statute of
limitations. Statute of limitation represents the period after which the legal actiona takes place
after the events has ocurred.

32

Table 6.2 - Transfer Pricing Documentation Review:

Kingdom

Documentation Statutory No specific Statutory Documentation
requirements for requirement: requirements. requirement: is required for
transfer pricing Documentation, BIR requests Documentation penalty
Form 3CEB, and documents to support protection
Tax return relating to entries on a
taxpayer's taxpayer's tax
transfer pricing return , including
during conduct transfer pricing
of audit documentation.
investigation.

Deadlines for Preparation Preparation and HRMC will set Preparation
documentation along-with Tax submission the deadline on a deadline within 9
preparations and return , deadline - Not case-by-case months of fiscal
submission Submission applicable basis , typically year-end ,
within 30days of ;Documents to be 45 to 90 days. Submission
request. submitted within deadline is
45 days upon within 30 days
request.

What purpose Penalty Penalty Penalty Penalty
does elimination elimination and elimination ; elimination
documentation shift burden of penalty reduction
serve ? proof ; shift of burden
of proof

33

Kingdom

Specific Business Business Organizational Business
categories of overview , overview , structure, description ,
documenation organizational organizational functional organizational
required structure, structure, analysis , risk structure,
functional functional analysis, functional
analysis , Risk analysis , Risk industry analysis analysis , Risk
analysis, Industry analysis, Industry , financial analysis,
analysis , analysis , performance , Intercompany
financial financial intercompany analysis
performance performance agreements, ,intercompany
,intercompany ,intercompany description of agreements,
agreements, agreements, controlled description of
description of description of transactions, controlled
controlled controlled method selection transaction,
transaction, transaction, , rejection of method
method selection, method selection, alternate selection,
rejection of rejection of methods, rejection of
alternate alternate identification of alternate
methods, methods, comparables, methods,
identification of identification of economic identification of
comparables, comparables, analysis. comparables,
economic economic economic
analysis, Profile analysis. analysis. Certain
of multinational Intercompany
group, record of agreements and
actual work documentation
carried out for are required,
determining the including cost
arm's length price share
and adjustments arrangements.
made.

This Table covers transfer pricing requirement, what purpose does the transfer pricing
documentation serves to the companies and what all documents do the companies need to
prepare for penalty elimination or to shift burden of proof, also the deadlines set by the

34

authorities for submission of the documentations. The requirements and the deadlines vary
from country to country.

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.

Figure 2 : This Graph depicts the deadline for documentation submission.

35

United Kingdom and Philippines provide the maximum period of 45 days for the submission
of transfer pricing documentation after the tax authorities request whereas In India and
United States it is only 30 days.

1. Represents its statutory to submit transfer pricing documentation)
2. Represents transfer pricing documentation is required)
3. Represents transfer pricing documentation may not be required)

Figure 3 : This Chart depicts documentation Requirements

In India and United Kingdom the tax authorities have mentioned transfer pricing
documentations to be of statutory importance as they prove to evidences concerning the
transfer pricing transactions and the prices charged under the practices, hence helping the
firm in penalty elimination while paying the tax and as a burden of proof is shifted because
these documents would prove to be a great help to show the status of the firm under transfer
pricing in case of audit investigations and legal actions against the firm. In United States the
firm have to submit the transfer pricing documentation only when requested by the tax
authorities to do so and in Philippines it is required in rare case when undergoing audit
investigation etc.

36

Table 6.3 - Transfer Pricing Methods :

Kingdom

Acceptable Transaction Transaction Transaction Transaction
transfer pricing method : method : methods : method :
methods comparable comparable comparable comparable
uncontrolled uncontrolled uncontrolled uncontrolled
price ,cost plus price ,cost plus price ;resale price ,cost plus
method and resale method and price ; cost plus. method and
price , Profit resale price , Profit based resale price ;
based method Profit based methods : profit Profit based
:Profit split , method :Profit split , method :Profit
transactional net split , transactional net split ,
margin method. transactional net margin method. comparable
margin method. profits method .

Priority among None Yes , transaction Yes, It follows None
the acceptable based method is OECD's transfer
methods preferred. If not pricing
then profit-based guidelines for
method determining the
most appropriate
method.

Existence of best Yes Most appropriate Not applicable Yes
rule method method rule

All the five types of transfer pricing methods are applied in all the four countries and the
nature of transaction determines the most appropriate method for setting the prices while

37

transferring goods or for provision of services. In Philippines and United Kingdom the
transaction based methods are given priority over profit based methods and the best method
rule is applicable in all countries except United Kingdom. The below table describes the most
appropriate methods for different types of transactions that takes place between the
subsidiaries.

Table 6.4 - Transfer Pricing Penalties:

Kingdom
Rates and 100-300% tax General tax General tax Compliance
conditions apply due on transfer penalties only penalties, For Penalties . 20%
for transfer pricing incorrect of additional tax
pricing penalties adjustments; 2% returns , a due if income
of aggregate transfer pricing adjustment is
value of adjustment may more than USD
international lead to a penalty 5 million or 10
transactions for based on a % of gross % or
failure to percentage of more or to 50 %
maintain potential tax or less. 40% of
prescribed lost . Penalties additional tax
documentation ; up to 30 % for due if income
2% of aggregate failure to take adjusted more
value of reasonable care; than USD 20
international up to 70% for a million or 20 %
transactions for deliberate of gross
failure to furnish understatement receipts ; or price
prescribed or over claim is adjusted to
documentation ; and up to 100% 400% or more or
Fixed penalty for for a deliberate to 25 or less.
failure to furnish understatement
Accountant's aggravated by
report in Form concealment .
3CEB ( appox.
USD 2,200 )

Extent of Often Often Very Strict Very Strict
enforcing
transfer pricing
penalties
Can transfer No No Yes, the No
pricing penalties penalties can be
be reduced or mitigated for
removed for reasons, such as
reason other than cooperation with
documentation ? HMRC

38

Some jurisdictions impose significant penalties relating to transfer pricing adjustments by tax
authorities. The rules of many countries require taxpayers to document that prices charged are
within the prices permitted under the transfer pricing rules. Where such documentation is not
timely prepared, penalties may be imposed.

United States and United Kingdom are very strict in enforcing transfer pricing penalties as
compared to Philippines and India which often apply the penalties on the tax payers.Transfer
Pricing penalties are applied when the companies are not able to furnish the prescribed
documentation as and when demanded by the tax authority and also in case of adjustments
made in the transfer pricing procedures. It is only United Kingdom which at times provide
chances for the penalty reduction but not by the other three countries.The tax authorities
have prescribed their transfer pricing penalties for adjustments and failure in providing
documentation and it varies from country to country.

( 1. Represents the countries where transfer pricing penalties cannot be reduced)
( 2. Represents the countries where trnsfer pricing penalties can be reduced)
Figure 4 : This chart shows the percentage if transfer pricng penalties reduction chances.

Under the transfer pricing penalties enforcement only United Kingdom has a provision for
reduction of trnasfer pricing penalties if the company cooperates with their tax authority and
none of the other three countries remove the penalties.

39

Table 6.5 - Special Consideration :

Kingdom

Use secret No guidance on No, tax No, Secret No
comparables by use of secret authorities use comparables
tax authorities comparables, the secret may be used by
tax authority uses comparables in HMRC to select
secret practice to companies for
comparables for benchmark a audit.
concluding audits taxpayer's return
in relation to its
peers

Level of Low, joint low Historically low, High
interaction tax working groups but seeking more
authorities have have been formed coordinated
with customs in order to approach with
authorities ? increase the the merger of the
interaction level. Inland Revenue
and Customs &
excise.

Other unique Provides testing None None None
attributes of the controlled
transactions with
the arithmetical
mean of the
comparable
companies.

• The respective tax authorities uses the secret comparables as tools for various
purposes such as India and United Kingdom uses it for Auditing purpose and in
Philippines it is used for benchmarking tax returns by the companies but none these
authorities have provided any guidance as to how secret comparables are used by
them.

40

• On comparing the interaction levels of tax and custom authorities in concern to
transfer pricing , it is low in India , Philippine and United States but in Unites States
the interaction level is high . custom authorities come into role as there is transfer of
good between the subsidiaries which are geographically distributed. India and United
Kingdom have taken steps to strengthen the interaction level as both tax and custom
have established joint working groups .

• In just India the tax authorities are involved in testing of the controlled transaction
between the subsidiaries which does not take place in the other three countries.

( 1. Represents Low interaction between Tax and Custom Authorities)
(2. Represents High interaction between Tax and Custom Authorities)

Figure 5 : This chart depicts the interaction level between tax and custom
authorities in the Selected countries.

As shown in this chart maximum countries i.e. 3 out of the 4 sampled countries have low interaction
levels between tax and custom authorities. Amongst the low interaction level countries India and
United Kingdom have taken steps to strengthen the interaction by setting up joint working groups .

41

Table 6.6 - Advance Pricing Agreements

Kingdom

Any advance No provision for Unilateral , Unilateral, Unilateral
pricing APA's bilateral and Bilateral APA's ;Bilateral ;
agreement multilateral Multilateral
options available APA's APA's

Filing fees for Not Applicable Submission of Not applicable Yes ,
APA's proposal - EUR USD50,000 for
30000-35000 large txpayers ;
depending on the USD 22,500 for
revenue of the small taxpayers.
taxpayer ; USD 35,000 for
Renewal or renewals
review of APA's
require filing
fees but with a
50% discount on
the initial fees.

Advance pricing agreements:

• Advance Pricing Agreement (APA) is an agreement between a taxpayer and a taxing
authority on an appropriate transfer pricing methodology (TPM) for some set of transactions
at issue (called "Covered Transactions").

• Under an APA, the taxpayer and one or more governments agree on the methodology used
to test prices. APAs are generally based on transfer pricing documentation prepared by the
taxpayer and presented to the government(s).

• Types of Advance pricing Agreements :

1) Bilateral and multilateral Advance pricing agreements :

42

APAs are generally bi- or multilateral--i.e., they also include agreements between the
taxpayer and one or more foreign tax administrations under the authority of the mutual
agreement procedure specified in income tax treaties. The taxpayer benefits from such
agreements since it is assured that income associated with Covered Transactions is not
subject to double taxation by the relevant foreign tax authorities. MAP i.e.
a mutual agreement procedure is an instrument used for relieving
international tax grievances, including double taxation

2) Unilateral Advance pricing agreements :

It's possible, however, that a taxpayer may negotiate a unilateral APA involving only the
taxpayer and the concerned tax authority. In this case, the two parties negotiate an
appropriate TPM for the concerned tax purposes only.

While there is no provision for APA’s in India , United Kingdom has both Unilateral and
Bilateral APA’s provided. Whereas Philippines and United States have provision for all
unilateral, bilateral as well as Multilateral APA’s.
So when the tax authority and the taxpayer get into the APA’s there is filing fees that is to be
submitted by the taxpayer at initiation of the agreement which is required to be paid under
Philippines and United States transfer pricing regimes only as in United Kingdom no such
fees is required at initiation and India has no APA’s provision and hence no filing fees.

Figure 6 : The above graph depicts the amount charged by the respective
tax authorities for filing fees.
43

The maximum filing fees is charged by United States i.e. $ 50,000 and then followed by
Phillipines that charges $ 44480 (approx), but United Kingdom doest not charge this fees . in
India there is no provision for APA’s so no filing fees is charged.

Figure 7 : This graphs Represents the amount charged by respective tax authorities
for renewal of the Advance Pricing Agreements.
The maximum renewal fees is charged in United States i.e. $ 35,000 and in Philippines it is
around $ 19,060(approx), whereas United Kingdom does not ask for renewal fees and in
India there is no Advance Pricing Agreement facility.

1. Represents Provision of Advance Pricing Agreements
2. Represents No provision of Advance Pricing Agreements
Figure 8 : This pie-chart depicts the provision of APA’s in the respective
companies.

44

In the 4 countries , 75% i.e. 3 countries which include United States, United Kingdom and
Philippines have provision for APA’s but only one country does not have the APA provision
which is India.

Table 6.7 - Recent Developments

Kingdom

Recent Higher mark-ups None In addition to None
developments for service APA, introduced
companies , non- Advance Thin
tolerance of Capitalization
losses in case of Agreement
routine (ATCA).
distributors
,benefit test for
cross charges

Under transfer pricing regulation there has been no change in Philippines and United states in
the respective practices followed. India and United Kingdom have taken step to improve the
transfer pricing practices such as facilitating higher mark-ups to be charged by services
rendering firms under transfer pricing as in India. Along-with the provision of Advance
Pricing Agreements and Advance Thin Capitalization Agreement which included a non-
compulsory model ATCA to set out the financial conditions and the consequences when
these conditions of transfer pricing are breached.

45

Table 6.8 - Competent Authority

Kingdom

Submission of No formal rules After an After an After an
adjustment to adjustment is adjustment is adjustment is
competent proposed to the proposed to the proposed to the
authority taxpayer taxpayer taxpayer

May a taxpayer No formal rules Permitted Permitted Permitted
go to competent
authority before
paying tax ?

Toughest Tax 6 Not in first 10 10 3
Authorities
Ranking

Government authority to adjust prices :

Most governments have granted authorization to their tax authorities to adjust prices charged
between related parties. Many such authorizations, including those of the United States, United
Kingdom, Canada, and Germany, allow domestic as well as international adjustments. Some
authorizations apply only internationally. Most, if not all, governments permit adjustments by the
tax authority even where there is no intent to avoid or evade tax.

Adjustment of prices is generally made by adjusting taxable income of all involved related parties
within the jurisdiction, as well as adjusting any withholding or other taxes imposed on parties
outside the jurisdiction. Such adjustments generally are made after filing of tax returns. Most

46

rules require that the tax authorities consider actual transactions between parties, and permit
adjustment only to actual transactions.

Testing of prices :

Tax authorities generally examine prices actually charged between related parties to determine
whether adjustments are appropriate. Such examination is by comparison (testing) of such prices
to comparable prices charged among unrelated parties. Such testing may occur only on
examination of tax returns by the tax authority, or taxpayers may be required to conduct such
testing themselves in advance or filing tax returns.

In UK , US and Philippines the companies are allowed to interact with the competent
authority which deal with the transfer pricing functioning of the respective territories before
paying of tax and there is formal description of rules as to how to submit adjustments under
transfer pricing in order to satisfy arm’s length standard. In India there is no mention of any
kind of rules to guide companies on interacting with the competent authority and how should
the adjustments be submitted to the concerned party.

Table 6.9 - Language

Kingdom

In which English English English English
language or
languages can
documentation be
filed?

All the documentation required for the Transfer Pricing methodology in all the four
continents should be in English . In India and Philippines they have not given an option of
usage of their national language for the sake of documentation as nor hindi and nor
portuguese can be used for documentation.

47

MI Reports

The MI report consolidates the budget, forecast and the actual costs made by the different
business units of the company. They help in determining the variance between the budget and the
actual cost and the variance between forecast and the actual cost. The MI report preparation is
based on Cost Plus Method. MI report form a part of MIS which is prepared to show the cost
borne by the company which is providing the services to its subsidiary under transfer pricing and
it also depicts the application of coat plus method to satisfy Arm’s Length Standard.

Budget Preparation :
The values for different cost elements for budget of the present year is determined by keeping
certain percentage amount as standard and adding some margin of previous years actual costs are
used in order to determine the budget for the present year. Consideration is also given to
headcounts which is responsible for the variability in the budget figures.

Budget = Standard Amount + certain margin of Previous year actual costs + Charges
variable with the headcount

Forecast Preparation :
Basically forecast is determined using the previous month costs and the previous year last month
actual cost are matched up for determining the forecast figures for all the months. Other
constraints are also taken into consideration such as the factors of expense for example, In the
auditing department the refreshment and travel charges increase in the month of March which is
considered to be the peak time of activities in the audit department. Recruitment costs variable
with the employment trend , Effect of recession , Offsite charges , Variable headcounts also
have an impact on determining the forecast for the various months .

Actual Cost and the Cost Plus module :
With reference to the actual transactions made by the business units .The cost plus module comes
into role after determination of the various cost and then markup is calculated at a particular
percentage on these costs and the charges are further forwarded to the related party as their
transfer prices with reference to the cost plus method satisfying the Arm’s Length Principle.

48

The mark – up is also calculated for the budget and the forecast figures for the various cost
elements at the same percentage as with the actual cost.

Division of the total cost under the following heads as a prerequisite of the cost plus method:

Staff Cost is inclusive of: Salaries, Bonus and Gratuity.

Direct Cost is inclusive of: Staff welfare, Recruitment cost, Attrition cost, Travel, Food and
transport, Subsistence cost and Communication cost.

Overhead is inclusive of: Facilities and seat cost, IGDC cost and shares service cost.

The Mark-up is calculated on the Staff Cost, Direct Cost and the Overhead Expenses. Additional
cost elements which can be taken into consideration are stewardship cost and the shared
management service cost management.

Mark Up has been calculated at 7% in the setting up the Transfer Price for provision of services
by KPMG India to KPMG United Kingdom.

Preparation of the MI report:
1. The budget and the forecast figures are calculated according to the formula stated
above. The figures under the various cost element heads of the budget sheet are
mapped on to the MI sheet .The forecast figures are then mapped onto the MI report
from the forecast sheet.

2. After the budget and forecast figures are mapped from the respective sheets, then the
actual are added. The actual cost is obtained from the data dump sheet. The data dump
sheet consists of the description of all the cost that are made under the project , full
details about the expenses are prepared , which are further summarized in to annexure
by summating all the cost under common cost element heads depending on the nature
of the expense.

3. Along-with the actual even the out of pocket expenses are also allocated on the MI
report.

4. After all the figures have been mapped, the delta is determined i.e. the variance in the
budget and the actual cost and the variance in the forecast and the actual cost. These
delta figure would further effect the decision made with respect to forecast
preparation for the next month and actual cost allocation under the various cost
element heads.

49

5. The MI reports are prepared on the monthly basis, to expense made by the company
under different projects and comparing it with their allocation strategy.

50

Current Month YTD Full Year
Actual Excl BudVsAct ForVsAct Actual excl BudVsAct ForVsAct BudVsFor
Cost Element Budget Forecast OPE OPE Actual Delta Delta Budget Forecast OPE OPE Actual Delta Delta Budget Forecast Delta

Salaries 100.00 110.00 85.00 - 85.00 15.00 25.00 300.00 390.00 238.00 - 238.00 62.00 152.00 1,200.00 990.00 210
Bonus 25.00 27.50 21.25 - 21.25 3.75 6.25 75.00 97.50 59.50 - 59.50 15.50 38.00 300.00 247.50 53
Gratuity and Leave Encashment 12.50 13.75 10.63 - 10.63 1.88 3.13 37.50 48.75 29.75 - 29.75 7.75 19.00 150.00 123.75 26
Mark Up-Staff Cost 9.63 10.59 8.18 - 8.18 1.44 2.41 28.88 37.54 22.91 - 22.91 5.97 14.63 115.50 95.29 20.21

Staff Cost Total(A) 147.13 161.84 125.06 - 125.06 22.07 36.78 441.38 573.79 350.16 - 350.16 91.22 223.63 1,765.50 123.75 1,641.75

Staff Welfare 2.00 2.20 1.70 - 1.70 0.30 0.50 6.00 7.80 4.76 - 4.76 1.24 3.04 24.00 19.80 4
Recruitment Cost 1.12 1.23 0.95 - 0.95 0.17 0.28 3.36 4.36 2.66 - 2.66 0.69 1.70 13.43 11.08 2
Training 0.20 0.22 0.17 0.09 0.26 0.03 0.05 0.60 0.78 0.48 0.26 0.74 0.12 0.30 2.40 1.98 0
Database 0.10 0.11 0.09 - 0.09 0.02 0.03 0.30 0.39 0.24 - 0.24 0.06 0.15 1.20 0.99 0
Miscellaneous 0.02 0.02 0.02 0.01 0.03 0.00 0.01 0.06 0.08 0.05 0.03 0.07 0.01 0.03 0.24 0.20 0
Company Transport 15.00 22.00 17.00 - 17.00 (2.00) 5.00 45.00 58.50 47.60 - 47.60 (2.60) 10.90 180.00 198.00 (18)
Subsistence and Travel Cost 20.00 22.00 17.00 12.75 29.75 3.00 5.00 60.00 78.00 47.60 39.53 87.13 12.40 30.40 240.00 198.00 42
Communication Cost 0.02 0.02 0.02 - 0.02 0.00 0.01 0.06 0.08 0.05 - 0.05 0.01 0.03 0.24 0.20 0
Mark Up-Direct Function Cost 2.69 3.35 2.59 0.90 3.48 0.11 0.76 8.08 10.50 7.24 2.79 10.03 0.84 3.26 32.31 30.12 2.19

Direct Function Cost Total(B) 41.15 51.15 39.53 13.74 53.27 1.63 11.63 123.45 160.49 110.67 42.60 153.27 12.78 49.82 493.81 460.36 33.45

Shared Management Cost/Funding Cost 0.70 0.77 0.60 - 0.60 0.11 0.18 2.10 2.73 1.67 - 1.67 0.43 1.06 8.40 6.93 1
Mark Up-CMT Allocation Cost 0.05 0.05 0.04 - 0.04 0.01 0.01 0.15 0.19 0.12 - 0.12 0.03 0.07 0.59 0.49 0.10

Allocation Cost Total(C) 0.75 0.82 0.64 - 0.64 0.11 0.19 2.25 2.92 1.78 - 1.78 0.46 1.14 8.99 7.42 1.57

Accomodation Cost 20.00 22.00 17.00 - 17.00 3.00 5.00 60.00 78.00 47.60 - 47.60 12.40 30.40 240.00 198.00 42
Mark Up- Accomodation Cost 1.40 1.54 1.19 - 1.19 0.21 0.35 4.20 5.46 3.33 - 3.33 0.87 2.13 16.80 13.86 2.94

Rental Cost Total(D) 21.40 23.54 18.19 - 18.19 3.21 5.35 64.20 83.46 50.93 - 50.93 13.27 32.53 256.80 211.86 44.94

Facilities and Seat cost 25.00 27.50 21.25 - 21.25 3.75 6.25 75.00 97.50 59.50 - 59.50 15.50 38.00 300.00 247.50 53
Shared Service Cost 6.25 6.88 5.31 - 5.31 0.94 1.56 18.75 24.38 14.88 - 14.88 3.88 9.50 75.00 61.88 13
IGDC Service Cost 1.56 1.72 1.33 - 1.33 0.23 0.39 4.69 6.09 3.72 - 3.72 0.97 2.38 18.75 15.47 3
Mark Up-Overheads 2.30 2.53 1.95 - 1.95 0.34 0.57 6.89 8.96 5.47 - 5.47 1.42 3.49 27.56 22.74 4.82

Overheads CosTS US Total(E) 35.11 38.62 29.84 - 29.84 5.27 8.78 105.33 136.93 83.56 - 83.56 21.77 53.37 421.31 347.58 73.73

Stewardship Cost 4.00 4.40 3.40 - 3.40 0.60 1.00 12.00 15.60 9.52 - 9.52 2.48 6.08 48.00 39.60 8
Mark Up-Overheads 0.28 0.31 0.24 - 0.24 0.04 0.07 0.84 1.09 0.67 - 0.67 0.17 0.43 3.36 2.77 0.59

Stewardship Cost Total(F) 4.28 4.71 3.64 - 3.64 0.64 1.07 12.84 16.69 10.19 - 10.19 2.65 6.51 51.36 42.37 8.99

Total Cost (A+B+C+D+E+F) 249.81 280.68 216.89 13.74 230.63 32.92 63.79 749.44 974.28 607.29 42.60 649.89 142.15 366.99 2,997.77 2,526.13 471.65

Head Count 112 135 98 98 145 112 86 - 86 156 146
Total Cost/FTE 2.23 2.08 2.21 2.35 5.17 8.70 7.06 - 7.56 26.77 18.71

51

Example to show the application of the cost plus method:

The Lie Dharma Putra Inc has a large number of profit centers, including b (representing the
buying profit center) and s (representing the selling profit center). Profit center b needs 20,000
units of component 12. Component 12 is an integral part of product z, which is manufactured in
profit center b and sold for $24. Component 12 can be purchased by profit center b either
externally at $19 per unit from the Thompson Company or internally from profit center s. in
addition to component 12, profit center s regularly manufactures between 80,000 and 100,000
units of component 13, which is sold at a 60% markup on full cost ($21.60 = 160% × $13.50).
Component 13 is slightly different from component 12 because of the use of more costly direct
materials; so it cannot be substituted for component 12 in the manufacture of product Z.

The standard and actual controllable costs of profit centers S and B for production and sale
of components 12 and 13 and product z are shown on below table:

52

The transfer price will be set equal to full cost plus normal markup. Full cost for profit center s is
$12.70 per unit and the normal markup is 60% so that the transfer price equals $20.32 per unit
($12.70 × 160%). The relevant incomes for profit center b and the company are:

A transfer price set equal to full cost plus markup will not lead to goal congruence. With an
outside price of $ 19 per unit, which is less than the transfer price of $20.32 per unit, the manager
of profit center b will be sent an erroneous signal to buy 20,000 units of component 12 from the
Thompson Company instead of from profit center s. As a result, the company as a whole is
penalized $8.30 per unit, the difference between Thompson Company’s purchase price of $19 per
unit and the relevant variable costs of $10.70 per unit to make and sell component 12 in profit
center s. With respect to the three remaining criteria—motivation, autonomy, and performance
evaluation—a cost-plus transfer price leads to their satisfaction from the perspective of both the
buying and the selling profit centers.

53

Chapter 7 : Findings

A brief analysis has been presented on transfer pricing regulations across jurisdictions. The
primary purpose of these regulations is to cut down on evasion of tax and subsequently
increase revenue reserves. It is true that transfer pricing is often considered by tax authorities
as a soft target with huge potential to produce large increases in revenue. From 1995 towards
this end, various countries evolved regulations to govern transfer pricing in their respective
jurisdictions.

• The application of Transfer Pricing by KPMG India in rendering services to its
subsidiary i.e. KPMG UK has been shown by the MI reports which are based on Cost
Plus Method of Transfer Pricing to satisfy Arm’s Length Standard as they have been
charging 7% markup on the actual costs made by the firm and both the firms are
considered as two separate legal firms.

• On comparing the Transfer pricing regimes followed in the four selected countries i.e.
India , Philippines, United States and United Kingdom. There is a lot of difference in
regulations which the respective tax authorities have imposed on the transfer pricing
practices in the selected countries. Amongst them United Kingdom is expected to
have the toughest Tax regulation, followed by India and then United States, the
Philippines tax authorities are expected to be very lenient as compared to the other
three.

• Philippines and United States transfer pricing regulations are quite similar to the
OECD guidelines for transfer pricing , but India and United Kingdom show
dissimilarities in this respect , hence they should get in synchronization with the
OECD guidelines such that there would be more uniformity in the transfer pricing
regulations for the firms. The United Kingdom have more specified regulations given
by the tax authorities and the custom authorities. Indian Tax authorities have to be
more elaborate on its transfer Pricing Regulations.

• The case study attached in the Appendix-B helps in realizing the what opportunities
and threats are offered by Transfer Pricing. It is a great avenue for companies to go

54

global and transfer profits to the country with low tax regimes, they also gain
operational efficiency with goal congruence and avoid double taxation. But it could
be a great loss for the company to indulge into transfer pricing if they do not follow
the regulations of the tax authorities and the custom authorities under transfer pricing.
As they would have to pay penalties and would bear losses .

The case studies prove that rather indulging into market-driven mechanisms, buying and
selling within firm would be more beneficial and with application of arm’s length standard it
would be safe also as proved in the case study attached in chapter 6.

• Most legal dispensations identify associated enterprises, transactions between
associated enterprises and then seek to determine whether these transactions have
been conducted at the ALP. It is suggested that analysis begin from international
transactions for the sole reason that the ambit of transfer pricing regulations would be
widened.

• Further, under a cross-jurisdictional comparison, the meaning of associated
enterprises or related parties may vary. With a view to ensure consistency, it would
help if transfer pricing analysis began from the stage of international transactions.

• Additionally, APA’s should be favored for firms so as to further strengthen the
objects of consistency and certainty. The Indian law should get in sync with the
OECD Guidelines.

• Finally, it should be endorsed for the need of greater clarity in the realm of
comparability i.e. in determining how adjustments between an international
transaction and an uncontrolled transaction are to be made.

55

Chapter 8 : Limitation Of the Study

• The project is prepared on the basis of the secondary data but there could be chances
when the secondary would not be reliable.

• This project gives a overall picture of the Transfer Pricing regime but intricate details
could not be mentioned as they were confidential to the firm.

• Lack of awareness in concern to the topic amongst the people.

• The study was conducted for a short period , so the project gives a brief idea about
the Transfer Pricing practices followed in the selected countries.

56

Chapter 9 : Recommendation

• There is a fundamental need for co-operation among tax administrations in order to
remove the obstacles that international double taxation presents to the free movement
of goods, services and capital under transfer pricing.

• Considering that the prices of such transactions between associated enterprises
(usually referred to as transfer pricing) should, nevertheless, for tax purposes be in
conformity with those which would be charged between independent enterprises
(usually referred to as arm’s length pricing).

• Considering the need to achieve consistency in the approaches of tax administrations,
on the one hand, and of associated enterprises, on the other hand, in the determination
of the income and expenses of a company that is part of a Multinational Enterprise
Group that should be taken in to account within a jurisdiction.

• More awareness about transfer pricing is required by the companies.

• Companies should be prepared with the documentation as described under the tax
authorities regulations for transfer pricing to avoid penalties.

• In case of queries companies have the benefit to consult the competent authorities.

• Companies should not indulge into any unfair trade practices.

57

Appendix – A
Current month : Budget , Forecast and Actual mapped
Current Month
Actual
Excl BudVsAct ForVsAct
Cost Element Budget Forecast OPE OPE Actual Delta Delta

100 110. 8 8 15.0 25.0
Salaries .00 00 5.00 - 5.00 0 0
25. 27. 2 2 3.7 6.2
Bonus 00 50 1.25 - 1.25 5 5
Gratuity and Leave 12. 13. 1 1 1.8 3.1
Encashment 50 75 0.63 - 0.63 8 3
9. 10. 1.4 2.4
Mark Up-Staff Cost 63 59 8.18 - 8.18 4 1

147 161. 12 12 22.0 36.7
Staff Cost Total(A) .13 84 5.06 - 5.06 7 8

2. 2. 0.3 0.5
Staff Welfare 00 20 1.70 - 1.70 0 0
1. 1. 0.1 0.2
Recruitment Cost 12 23 0.95 - 0.95 7 8
0. 0. 0.0 0.0
Training 20 22 0.17 0.09 0.26 3 5
0. 0. 0.0 0.0
Database 10 11 0.09 - 0.09 2 3
0. 0. 0.0 0.0
Miscellaneous 02 02 0.02 0.01 0.03 0 1
15. 22. 1 1 (2.0 5.0
Company Transport 00 00 7.00 - 7.00 0) 0
Subsistence and Travel 20. 22. 1 1 2 3.0 5.0
Cost 00 00 7.00 2.75 9.75 0 0
0. 0. 0.0 0.0
Communication Cost 02 02 0.02 - 0.02 0 1
Mark Up-Direct Function 2. 3. 0.1 0.7
Cost 69 35 2.59 0.90 3.48 1 6

Direct Function Cost 41. 51. 3 1 5 1.6 11.6
Total(B) 15 15 9.53 3.74 3.27 3 3

Shared Management 0. 0. 0.1 0.1
Cost/Funding Cost 70 77 0.60 - 0.60 1 8
Mark Up-CMT Allocation 0. 0. 0.0 0.0
Cost 05 05 0.04 - 0.04 1 1

0. 0. 0.1 0.1
Allocation Cost Total(C) 75 82 0.64 - 0.64 1 9

58

20. 22. 1 1 3.0 5.0
Accomodation Cost 00 00 7.00 - 7.00 0 0
Mark Up- Accomodation 1. 0.2 0.3
Cost 1.40 54 1.19 - 1.19 1 5
21. 23. 1 1 3.2 5.3
Rental Cost Total(D) 40 54 8.19 - 8.19 1 5

25. 27. 2 2 3.7 6.2
Facilities and Seat cost 00 50 1.25 - 1.25 5 5
6. 6. 0.9 1.5
Shared Service Cost 25 88 5.31 - 5.31 4 6
1. 1. 0.2 0.3
IGDC Service Cost 56 72 1.33 - 1.33 3 9
2. 2. 0.3 0.5
Mark Up-Overheads 30 53 1.95 - 1.95 4 7

35. 38. 2 2 5.2 8.7
Overheads Cost Total(E) 11 62 9.84 - 9.84 7 8

4. 4. 0.6 1.0
Stewardship Cost 00 40 3.40 - 3.40 0 0
0. 0. 0.0 0.0
Mark Up-Overheads 28 31 0.24 - 0.24 4 7

4. 4. 0.6 1.0
Stewardship Cost Total(F) 28 71 3.64 - 3.64 4 7

249 280. 21 1 23 32.9 63.7
Total Cost (A+B+C+D+E+F) .81 68 6.89 3.74 0.63 2 9

1
Head Count 112 35 98 98

2. 2.
Total Cost/FTE 23 08 2.21 2.35

59

Year To Date : Budget, Forecast and Actual mapped
YTD
Actual excl BudVsAct ForVsAct
Budget Forecast OPE OPE Actual Delta Delta

300.00 390.00 238.00 - 238.00 62.00 152.00
75.00 97.50 59.50 - 59.50 15.50 38.00
37.50 48.75 29.75 - 29.75 7.75 19.00
28.88 37.54 22.91 - 22.91 5.97 14.63

441.38 573.79 350.16 - 350.16 91.22 223.63

6.00 7.80 4.76 - 4.76 1.24 3.04
3.36 4.36 2.66 - 2.66 0.69 1.70
0.60 0.78 0.48 0.26 0.74 0.12 0.30
0.30 0.39 0.24 - 0.24 0.06 0.15
0.06 0.08 0.05 0.03 0.07 0.01 0.03
45.00 58.50 47.60 - 47.60 (2.60) 10.90
60.00 78.00 47.60 39.53 87.13 12.40 30.40
0.06 0.08 0.05 - 0.05 0.01 0.03
8.08 10.50 7.24 2.79 10.03 0.84 3.26

123.45 160.49 110.67 42.60 153.27 12.78 49.82

2.10 2.73 1.67 - 1.67 0.43 1.06
0.15 0.19 0.12 - 0.12 0.03 0.07

2.25 2.92 1.78 - 1.78 0.46 1.14
60.00 78.00 47.60 - 47.60 12.40 30.40
4.20 5.46 3.33 - 3.33 0.87 2.13
64.20 83.46 50.93 - 50.93 13.27 32.53

75.00 97.50 59.50 - 59.50 15.50 38.00
18.75 24.38 14.88 - 14.88 3.88 9.50
4.69 6.09 3.72 - 3.72 0.97 2.38
6.89 8.96 5.47 - 5.47 1.42 3.49

105.33 136.93 83.56 - 83.56 21.77 53.37

12.00 15.60 9.52 - 9.52 2.48 6.08
0.84 1.09 0.67 - 0.67 0.17 0.43

12.84 16.69 10.19 - 10.19 2.65 6.51

749.44 974.28 607.29 42.60 649.89 142.15 366.99

145 112 86 - 86

5.17 8.70 7.06 - 7.56

60

Full Year : Budget , Forecast mapped
Full Year
BudVsFor
Budget Forecast Delta

1,200.00 990.00 210
300.00 247.50 53
150.00 123.75 26
115.50 95.29 20.21

1,765.50 123.75 1,641.75

24.00 19.80 4
13.43 11.08 2
2.40 1.98 0
1.20 0.99 0
0.24 0.20 0
180.00 198.00 (18)
240.00 198.00 42
0.24 0.20 0
32.31 30.12 2.19

493.81 460.36 33.45

8.40 6.93 1
0.59 0.49 0.10

8.99 7.42 1.57

240.00 198.00 42
16.80 13.86 2.94
256.80 211.86 44.94

300.00 247.50 53
75.00 61.88 13
18.75 15.47 3
27.56 22.74 4.82

421.31 347.58 73.73

48.00 39.60 8
3.36 2.77 0.59

51.36 42.37 8.99

2,997.77 2,526.13 471.65

156 146

26.77 18.71

61

Appendix –B

Case Study

The Transfer Pricing Threat… or Opportunity?

It is spring 2005 and Canadian company has just received a reassessment from Canada Revenue
Agency (“CRA”) after a lengthy and painful audit process. This was not the first CRA audit
Canadian company had undergone, yet this was the first time that CRA performed an in-depth
analysis on the prices charged by Canadian company to its US subsidiary, US Co. The whole
situation took Canadian company management quite by surprise – they had believed that their
transfer prices for the goods manufactured in Canada and sold to its US subsidiary for
distribution in the US was an appropriate transfer price.

According to the CRA reassessment, however, an additional $3,000,000 over a three year period
should have been charged to US Co. In addition to this adjustment, CRA’s reassessment proposed
that an additional $500,000 should have been charged to US Co. for services provided by the
Canadian head office to US Co. To top it off, a penalty of 10% of the adjustment was also applied
because Canadian company was “deemed not to have made reasonable efforts” to document and
support its transfer prices and the interest was also charged .

After the initial shock of the reassessment, Canadian company management sat down to quantify
the impact of these adjustments and found, much to its surprise, that it would be better off from a
pure tax cost perspective, to apply CRA’s transfer pricing methodology! US Co was paying about
40% tax on its earnings in the U.S. whereas with the reduced Canadian tax rates, it would have
paid between 33% - 35% on profits in Canada. A 5% - 7% spread on $3,500,000 translated into a
tax savings of up to $245,000. In addition to that, there was an additional 5% withholding tax that
could have been avoided on the repatriation of these earnings to Canada.

However, the potential benefits were quickly overshadowed by the prospect of hefty penalties
and interest arising from the reassessment, in addition to the uncertainty of obtaining equivalent
relief from the US tax authorities. According to Canadian company’s tax advisors, the only way
to get a corresponding deduction from US Co’s taxable income in the US was to apply to the
“competent authorities” of Canada and the US for the IRS to accept the proposed adjustments.
Apparently this was a lengthy process which was expected to last between 2 to 3 years.

62

Canadian company first entered the US market about 10 years ago and like many other
companies, started out as a branch of the Canadian company to get a “feel” for the American
market and its potential. After two years, things started to look promising and so a separate legal
entity was formed. At that time, while Canadian company management had some knowledge of
transfer pricing as a tax compliance issue, it felt that Canadian company and US Co. were much
too small to attract any attention from either revenue authority. Besides, US sales were not
sufficient to warrant any in-depth study into establishing the appropriate transfer price. A mark-
up of 15% on the manufactured cost sounded right – even at that, it barely left any operating
profit in US Co - and it wasn’t too high a price for duty purposes. Several years later, US Co sales
were rising and along with it, huge profits were being realized. Canadian company management
decided that it was time to revisit its transfer pricing policy. A review revealed several things:

• First, the current transfer pricing methodology to apply a 15% mark-up on manufactured cost
would result in much larger gross margins for US Co. The gross margin on Canadian company’s
products had increased significantly over the last few years because of a number of factors;
Canadian company’s continued development to improve its products and its branding efforts
allowed it to increase its price point in the market. In addition, its ability to improve
manufacturing efficiency along with the weaker Canadian dollar vis-à-vis the US dollar
significantly reduced production costs. The transfer pricing methodology was transferring all of
the additional profits from these efforts to US Co while Canadian company was left with a fixed
15% return.
• While the 15% mark-up seemed appropriate at the time when gross margins on Canadian sales
were only 20%, now that gross margins were averaging 35%, the additional 15% was being
trapped in the U.S.
• Back when USCo was first established, there was little difference in the Canadian and American
corporate tax rates. By 2004, however, the federal Canadian tax rate decreased by 7%. This
resulted in a rate differential between Canada and the US of up to 9%.
• “Transfer price” for customs and income tax purposes were not necessarily the same.
Furthermore, most of Canadian company’s products were now no longer subject to duty and
therefore, the issue from a customs perspective was largely irrelevant.
• Recognizing that gross margins were increasing because of its marketing and branding efforts,
Canadian company management had contemplate charging US Co a royalty for use of Canadian
company’s brand name. The transfer pricing review revealed that a royalty would have attracted a

63

further 10% withholding tax, whereas a different transfer pricing model would achieve the same
result with a lower tax cost.
• The transfer pricing documentation and required financial analysis provided management with
an opportunity to examine its business in a way that it hadn’t previously. Reports and analysis
that were originally developed for transfer pricing purposes also allowed management to improve
certain business decisions and operational processes.
• Finally, the Company was also considering expansion outside of the North American
market and the review revealed a number of ways to structure the international expansion
such that worldwide taxes could be minimized. There were opportunities to centralize certain
functions or operations to maximize business process efficiency and at the same time
minimize or defer worldwide taxes.

As a result of the review, the Company realized that what started out as a tax compliance
exercise turned into a tax minimization strategy and a business process improvement. The
transfer pricing review benefited the Company in the following ways:
1. Management gained a heightened awareness of the implications of business process changes to
its overall tax cost and its ability to remain in compliance with transfer pricing rules. Likewise,
management also understood that any attempts to change the transfer pricing business model had
to be operationally practical. As a result, management was able to make better overall decisions
for the Company, recognizing the tax cost/savings of business model changes and the impacts to
its transfer pricing risks.
2. The Company was better prepared for a transfer pricing audit. Although this did not guarantee
that an adjustment would not be made, it reduced the time it took for CRA to conduct an audit, it
reduced the time and efforts management had to devote to the audit, it removed the risks of
transfer pricing penalties and it set out the Company’s reasons and support for the chosen transfer
pricing methodology. This shifted the burden of proof to CRA to challenge the transfer price that
was used and avoided “fishing expeditions” and diversions by CRA.
3. Most importantly, the Company was in a better position to manage its global tax costs, its transfer
pricing risks and manage the uncertainties that transfer pricing adjustments can pose for
businesses.

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Bibliography

Books:

• Organisation for Economic Co-operation and Development (2008), “OECD Transfer
Pricing Guidelines for Multinational Enterprises and tax administration” Oecd
Publishing.

• John Smullen(2001), “Transfer pricing for financial institutions” Woodhead
Publishing Limited, England.

• Robert Newton Anthony, John Dearden, Richard F. Vancil (2007) “Management
control systems” Tata McGraw Hill, New Delhi.

Websites :

• www.Wikipedia.com

• www.Scribd.com

• www.Kpmg.com

• http://hubpages.com/hub/Managerial-Accounting-Investment-Centers-Transfer-
Pricing

• http://accounting-financial-tax.com/2010/01/how-to-make-transfer-pricing-tax-
reduction-strategy-work/

• www.Livemint.com

Articles :

• “Global Transfer pricing services” by KPMG International

• “TP Global Reference Guide” 2009 by Ernst & Young

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