Transfer Pricing: Meaning, Methods, and Importance
Introduction
Transfer pricing has emerged as a vital area in international taxation due to the growing presence of multinational enterprises (MNEs) operating across various tax jurisdictions. Since these MNEs often transact within their own group entities—such as buying raw materials, providing services, or transferring technology—it’s essential to determine a fair price for these internal transactions.
This is where Transfer Pricing comes in. By ensuring a fair market-based pricing mechanism, it helps prevent profit shifting to low-tax jurisdictions and protects a country’s tax base.
What is Transfer Pricing?
Transfer pricing is the price charged for goods, services, or intangible property exchanged between divisions, subsidiaries, or affiliated companies under the same corporate ownership.
For example, imagine a software developed in India is sold to the US branch of the same MNC. The price at which the Indian office charges the US branch is the “transfer price.”
This becomes important because if the transfer price is set artificially low or high, it can impact the taxable income in each country—leading to tax avoidance or double taxation.
The golden rule in transfer pricing is the Arm’s Length Principle, which says:
The price for intra-group transactions should be the same as if the transaction were between unrelated parties in a free market.
Objectives of Transfer Pricing
1. Fair Allocation of Income
To ensure that each country involved in a cross-border transaction receives a fair share of the tax revenue, transfer pricing prevents artificial shifting of profits to tax havens.
2. Prevent Tax Base Erosion
When prices are manipulated to shift profits to low or no-tax jurisdictions, it results in Base Erosion and Profit Shifting (BEPS). Proper transfer pricing ensures such erosion is minimized.
3. Ensure Legal Compliance
Tax authorities in almost every country require companies to follow transfer pricing rules. Non-compliance can lead to heavy penalties and legal battles.
4. Performance Evaluation
Internal divisions of a company can be assessed fairly using accurate transfer prices, helping in better strategic planning and managerial decisions.
Transfer Pricing Methods
Tax authorities around the world—including India—permit the following methods to compute the Arm’s Length Price (ALP):
1. Comparable Uncontrolled Price (CUP) Method
This method compares the price charged in a controlled transaction (between related parties) to the price charged in a comparable uncontrolled transaction.
Example:
If Company A sells phones to its sister company for ₹10,000 but sells the same phone to an independent buyer at ₹12,000, the transfer price might be considered too low.
Best Used When:
- Identical goods or services are involved
- Market conditions are comparable
2. Resale Price Method (RPM)
Here, the resale price to an independent party is reduced by an appropriate gross margin to arrive at the transfer price.
Formula:
Transfer Price = Resale Price – Gross Margin
Example:
A company imports electronics from its parent and resells them. If the resale price is ₹20,000 and the industry gross margin is 25%, the arm’s length price would be ₹15,000.
Best Used When:
- The reseller does not add significant value
- The final sale price is known
3. Cost Plus Method (CPM)
Adds a standard markup to the cost incurred by the supplier in a controlled transaction.
Formula:
Transfer Price = Cost + Markup
Example:
If it costs ₹1,000 to produce a part and the markup is 20%, the transfer price should be ₹1,200.
Best Used When:
- Goods are semi-finished
- Internal services or contracts exist within the group
4. Profit Split Method (PSM)
Used when two or more entities jointly develop or contribute to a product or service. The combined profits are split based on their contribution.
Example:
If Company A in India and Company B in the US co-develop a software, and the total profit is ₹10 crore, then based on their contribution (say 60%-40%), profits are split accordingly.
Best Used When:
- Joint IP development
- Complex, highly integrated operations
5. Transactional Net Margin Method (TNMM)
Examines the net profit margin relative to a base (like costs, sales, assets) of a controlled transaction and compares it with that of independent companies.
Example:
If an Indian subsidiary earns a 10% profit margin on its sales, and independent companies earn between 9%-12%, the transaction is considered at arm’s length.
Best Used When:
- No close external comparable exists
- Operational data is available for benchmarking
Transfer Pricing in India
India has robust transfer pricing laws under the Income Tax Act, 1961, primarily governed by Sections 92 to 92F and Rules 10A to 10E.
✅ Applicability:
- International Transactions: Between two or more associated enterprises (AEs), where at least one is non-resident
- Specified Domestic Transactions: If aggregate exceeds ₹20 crore
✅ Documentation Requirements:
Companies must maintain extensive documentation including:
- Nature and terms of transactions
- Functional and risk analysis
- Benchmarking study
- Transfer pricing report
- Form 3CEB certified by a Chartered Accountant
✅ Penalties for Non-Compliance:
| Non-Compliance | Penalty |
|---|---|
| Failure to maintain documents | 2% of transaction value |
| Failure to furnish Form 3CEB | ₹1,00,000 |
| Concealment of income | 100% to 300% of tax evaded |
Example of Transfer Pricing
Let’s say:
- Indian subsidiary of a pharma company manufactures medicines for $10 and sells them to its US parent for $12.
- The market price of such medicine in India is $20.
Here, the Indian company may be undervaluing its sale (transfer price), thus reducing its taxable income in India. This could raise a red flag for Indian tax authorities.
Importance of Transfer Pricing
- Protects Government Revenue: Ensures that profits are taxed where economic activity takes place.
- Improves Corporate Governance: Fair pricing leads to better internal decision-making.
- Reduces Legal Risks: Staying compliant avoids litigation and penalties.
- International Fairness: Maintains transparency between countries in cross-border trade.
- Reduces Double Taxation: Transfer pricing adjustments help resolve tax disputes through APA or MAP mechanisms.
Common Transfer Pricing Risks
- Use of Incorrect Comparables: Choosing inappropriate industry benchmarks can lead to faulty conclusions.
- Weak Documentation: Missing data or incomplete reports attract penalties and adjustments.
- Ignoring Local Guidelines: Not aligning with Indian tax rules despite OECD compliance can still lead to issues.
- Overuse of TNMM: Relying only on TNMM when other methods may be more appropriate may signal manipulation.
- Inadequate Functional Analysis: Misjudging roles, assets, and risks of each entity can skew results.
Conclusion
In an increasingly global business environment, transfer pricing ensures transparency, tax fairness, and economic accountability. For businesses, getting it right means avoiding legal troubles, protecting reputation, and ensuring that value creation is fairly rewarded across borders.
