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Transfer pricing: Emerging issues

Aug 24, 2001

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.

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