X

Sign up for Equitymaster's free daily newsletter, The 5 Minute WrapUp and get access to our latest Multibagger guide (2017 Edition) on picking money-making stocks.

This is an entirely free service. No payments are to be made.


Download Now Subscribe to our free daily e-letter, The 5 Minute WrapUp and get this complimentary report.
We hate spam as much as you do. Check out our Privacy Policy and Terms Of Use.
Transfer pricing: Emerging issues - Views on News from Equitymaster
 
 
  • PRINT
  • E-MAIL
  • FEEDBACK
  • A  A  A
  • Aug 24, 2001

    Transfer pricing: Emerging issues

    Corporates the world over are expanding their wings in an effort to gain a share of the global pie. There is talk of the world fast turning into a global village with economies increasingly becoming inter-connected. But with cross-border trade comes a whole new set of problems. Transfer pricing is one of them.

    When a company opens a branch in another country, gets its products manufactured there and then imports it, there is a question mark over what price should the parent pay for buying the product from the subsidiary. This price till now has been subject to the parentís discretion and has been used by many corporates the world over to control the tax outgo to their Government. In effect, the price at which goods are transferred from one arm of the company to another is known as transfer pricing.

    The question arises that how the transfer price can be used as a mechanism to evade tax, especially between countries that have a treaty against double taxation. To explain this letís take an example. Suppose there is an MNC shoe corporation with a subsidiary in India. The Indian subsidiary manufactures shoes at a cost price of Rs 50 per unit and supplies it to the MNC. The MNC sells the same shoes in its own country at Rs 200. To be fair, the transfer price, which the Indian subsidiary should get, is cost plus a reasonable rate of return (i.e. Rs 50 plus). This is where the MNC company calls the shots.

    In India, the corporate tax on profits is at 35%. Suppose for the MNC country the rate of tax is 45%.

    Case 1.

    The MNC decides that Rs 100 is the correct transfer price. Then the scenario looks like this:

    Transfer Price at Rs 100
    Indian subsidiary MNC Grand Total
    Cost price 50 100
    Selling price 100 200
    Profit 50 100 150
    Tax 17.5 45 62.5
    Net Profit 32.5 55 87.5

    The transfer price becomes the cost price for the MNC and thus it earns a profit of Rs 100 per unit. Post tax, its profit is whittled down to Rs 55. Overall, the total profit after tax earned by the MNC (including the subsidiaryís profit) is Rs 87.5 per unit.

    Case 2.

    The MNC decides that Rs 150 is the correct transfer price. Then the scenario looks like this:

    Transfer Price at Rs 150
    Indian subsidiary MNC Grand Total
    Cost price 50 150
    Selling price 150 200
    Profit 100 50 150
    Tax 35 22.5 57.5
    Net Profit 65 27.5 92.5

    The MNCís profits post tax in its own country comes down to Rs 27.5. But overall the profit surges to Rs 92.5 per unit.

    Case 3.

    The MNC decides that Rs 200 is the correct transfer price. In such a case, the MNC earns zero profits in its own country, but its subsidiary pays a 35% tax on its profit of Rs 150 and thus overall net profit surges to Rs 97.5.

    Transfer Price at Rs 200
    Indian subsidiary MNC Grand Total
    Cost price 50 200
    Selling price 200 200
    Profit 150 0 150
    Tax 52.5 0 52.5
    Net Profit 97.5 0 97.5

    Case 4.

    The MNC decides that Rs 300 is the correct transfer price. In this case, the MNC earns a loss of Rs 100 per unit of shoe sold in the home country. Meanwhile, its subsidiary earns Rs 162.5 as profit, after paying Rs 87.5 as tax. But the clever MNC gets a tax write off at home worth Rs 45 m.

    Transfer Price at Rs 300
    Indian subsidiary MNC Grand Total
    Cost price 50 300
    Selling price 300 200
    Profit 250 -100 150
    Tax 87.5 -45 42.5
    Net Profit 162.5 0 192.5

    Please remember, these are just a few hypothetical simple situations. In reality, these dealings are much more complex with conglomerates having more than 50 subsidiaries in just as many countries. Transfer pricing became a subject of much debate in the western countries as governmentís felt that corporates are down paying their fair share of tax. As a result, these countries spearheaded awareness regarding transfer pricing.

    To find out a reasonable price for products and technologies transferred, leading accountancy and legal firms propagate Ďarmís lengthí methodologies. Armís length, as the term indicates, means keeping a neutral balance between inter-corporate arms. The idea is that companies should treat each subsidiary as a separate entity and deal with them on purely commercial terms, as they would have if they transacted with any other market player.

    Armís length methodologies are of two types.

    • Transactional Methods Ė Where focus is on the product or the technology to ascertain the correct transfer price.

    • Profit Methods Ė Where profitability is the cornerstone for analyzing the correct transfer price.

    Transaction methods can be further divided into two broad sub-groups.

    • Comparable uncontrolled price : In this method, the focus is on ascertaining the correct price of the property or service. This maybe done by finding out the price of such services or products prevailing in that market. However, it is difficult to implement because it requires similarity of products and also of markets.

    • Resale price method : Here the accountants look at ascertaining the resale price of the product or service under question. The focus is on the margins earned. However, this method is only useful for subsidiaries that add little value. For example, this method is useful when the subsidiary is just a manufacturing base for the parent and thus adds little economic value to the product or service. However, where a technology transfer is involved, the resale price is subjective.

    Profit method has been further sub-divided into two sub-groups.

    • Profit split method : In this method, the conglomerates entire profits are consolidated and then this profit is split between various subsidiaries depending on their perceived contribution to profits. But this method is also not without its share of criticism. For one, some experts argue that the allocation of profits to subsidiaries is subjective and hence, open to manipulation.

    • Net margin method : As the name suggests, this method focuses on ascertaining the appropriate net margins for the transactions. The net margin earned is benchmarked to a relative base like sales or assets employed.

    While going through each of these methods, it becomes clear that all these methods are not definitive methods for ascertaining transfer prices. Being a complex subject, more fine-tuning is needed to finally get a definitive benchmark method for calculating the transfer price.

    As business between countries is likely to only increase in future, transfer-pricing issues would be subject of even more scrutiny not only by governmentís and legal bodies, but also the companiesí respective shareholders. But there is a lot of ground still to be done in this area.

     

     

    Equitymaster requests your view! Post a comment on "Transfer pricing: Emerging issues". Click here!

      
     

    More Views on News

    How to Ride Alongside India's Best Fund Managers (The 5 Minute Wrapup)

    Jun 10, 2017

    Forty Indian investing gurus, as worthy of imitation as the legendary Peter Lynch, can help you get rich in the stock market.

    Why NOW Is the WORST Time for Index Investing (The 5 Minute Wrapup)

    Aug 18, 2017

    Buying the index now will hardly help make money in stocks even in ten years.

    Trump Takes a Beating (Vivek Kaul's Diary)

    Aug 18, 2017

    Donald J Trump, a wrasslin' fan, took a 'Holy Sh*t!' blow on Tuesday.

    How To Read Your Mutual Fund Account Statement Correctly (Outside View)

    Aug 17, 2017

    PersonalFN simplifies the mutual fund account statement for you.

    This Small Cap Can Drive Chinese Players Out of India (and Make a Fortune in the Process) (The 5 Minute Wrapup)

    Aug 17, 2017

    A small-cap Indian company with high-return potential and blue-chip-like stability is set to supplant the Chinese players in this niche segment.

    More Views on News

    Most Popular

    Demonetisation Barely Made Any Difference to Tax Collections(Vivek Kaul's Diary)

    Aug 7, 2017

    The data tells us quite a different story from the one the government is trying to project.

    A 'Backdoor' to Multibaggers: It's Like Investing in Asian Paints Ten Years Ago(The 5 Minute Wrapup)

    Aug 10, 2017

    Don't miss these proxy bets on growing companies or in a few years you will be looking back with regret.

    Should You Invest In Bharat-22 ETF? Know Here...(Outside View)

    Aug 8, 2017

    Bharat-22 is one of the most diverse ETFs offered so far by the Government. Know here if you should invest...

    Signs of Life in the India VIX(Daily Profit Hunter)

    Aug 12, 2017

    The India VIX is up 36% in the last week. Fear has gone up but is still low by historical standards.

    7 Financial Gifts For Your Sister This Raksha Bandhan(Outside View)

    Aug 7, 2017

    Raksha Bandhan signifies the brother-sister bond. Here are 7 thoughtful financial gifts for sisters...

    More
    Copyright © Equitymaster Agora Research Private Limited. All rights reserved.
    Any act of copying, reproducing or distributing this newsletter whether wholly or in part, for any purpose without the permission of Equitymaster is strictly prohibited and shall be deemed to be copyright infringement.

    LEGAL DISCLAIMER: Equitymaster Agora Research Private Limited (hereinafter referred as 'Equitymaster') is an independent equity research Company. Equitymaster is not an Investment Adviser. Information herein should be regarded as a resource only and should be used at one's own risk. This is not an offer to sell or solicitation to buy any securities and Equitymaster will not be liable for any losses incurred or investment(s) made or decisions taken/or not taken based on the information provided herein. Information contained herein does not constitute investment advice or a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual subscribers. Before acting on any recommendation, subscribers should consider whether it is suitable for their particular circumstances and, if necessary, seek an independent professional advice. This is not directed for access or use by anyone in a country, especially, USA or Canada, where such use or access is unlawful or which may subject Equitymaster or its affiliates to any registration or licensing requirement. All content and information is provided on an 'As Is' basis by Equitymaster. Information herein is believed to be reliable but Equitymaster does not warrant its completeness or accuracy and expressly disclaims all warranties and conditions of any kind, whether express or implied. Equitymaster may hold shares in the company/ies discussed herein. As a condition to accessing Equitymaster content and website, you agree to our Terms and Conditions of Use, available here. The performance data quoted represents past performance and does not guarantee future results.

    SEBI (Research Analysts) Regulations 2014, Registration No. INH000000537.

    Equitymaster Agora Research Private Limited. 103, Regent Chambers, Above Status Restaurant, Nariman Point, Mumbai - 400 021. India.
    Telephone: +91-22-61434055. Fax: +91-22-22028550. Email: info@equitymaster.com. Website: www.equitymaster.com. CIN:U74999MH2007PTC175407
     

    Become A Smarter Investor In
    Just 5 Minutes

    Multibagger Stocks Guide 2017
    Get our special report, Multibagger Stocks Guide (2017 Edition) Now!
    We will never sell or rent your email id.
    Please read our Terms

    S&P BSE SENSEX


    Aug 18, 2017 03:37 PM

    MARKET STATS