TRANSFER PRICING

INTRODUCTION
Within the past 5 to 10 years, transfer pricing has become a significant issue to the broader business audience. The popular press often portrays transfer pricing as a practice whereby multinational firms distort profit flows and corporate tax payments. In response to these fears, governments around the world follow the lead of the United States in making transfer pricing audits a strategic priority. Under a high level of scrutiny, establishing appropriate transfer pricing policies is a difficult task. What Is Transfer Pricing? The price that is assumed to have been charged by one part of a company for products and services it provides to another part of the same company, in order to calculate each division's profit and loss separately.
Transfer pricing refers to the price charged for goods and services sold within a

company. Transfer pricing is common among multinational corporations or corporations with multiple subsidiaries. Transfer pricing, or intra company pricing, is the pricing of goods (and sometimes services) to a firm's own subsidiaries and affiliates. Transfer pricing can occur with both domestic and international members of the corporate family

Transfer pricing involves the assignment of costs to transactions for goods and services between related parties. Transfer pricing is typically used for purposes of financial reporting and reporting income to taxing authorities. Transfer pricing is used to set the internal price of goods and services that move between the divisions or business units of a corporation. Transfer pricing is used throughout the corporate world and impacts performance management, cost management and taxation.When multinational firms transfer product across international borders, transfer prices are relevant in the calculation of income taxes, and are sometimes relevant in connection with other international trade and regulatory issues. In today's international market, a large share of world trade consists of transfer of goods, intangibles and services within multinational enterprises (MNEs) - associated companies with bussiness establishments in 2 or more countries. To determine the international tax liability in each jurisdiction, the right
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transfer pricing principle has to be applied. Transfer pricing - payments from one part of a multinational enterprise for goods or services provided by another - may diverge from market prices for reasons of marketing or financial policy, or to minimise tax.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.

HISORTY
Transfer pricing: early Italian contributions This paper aims at reviewing the early contributions made by Italian scholars to the field of transfer pricing, from the works of Francesco Villa (1840, 1853) to the birth of Economia Aziendale (in the first half of the twentieth century). Although this topic has been traditionally overlooked in the Italian accounting literature, this study shows how Italian accountants were familiar with different methods of transfer pricing and elaborated certain original solutions. The intensive, mainly theoretic discussion for attaching a value to goods exchanged amongst segments of the same company indicates an early recognition of the potential influence of organizational structure, intermediate markets, coordination and differentiation that may have laid the platform for a greater integration between financial and cost accounting. Unfortunately this genuine debate suddenly stopped: the diffusion of Zappa's theories partly explains this phenomenon.

LAW OF TRANSFER PRICING IN INDIA

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1. INTRODUCTION Increasing participation of multi-national groups in economic activities in India has given rise to new and complex issues emerging from transactions entered into between two or more enterprises belonging to the same group. Hence, their was a need to introduce a uniform and internationally accepted mechanism of determining reasonable, fair and equitable profits and tax in India in the case of such multinational enterprises. Accordingly, the Finance Act, 2001 introduced law of transfer pricing in India through sections 92A to 92F of the Indian Incometax Act, 1961 which guides computation of the transfer price and suggests detailed documentation procedures. This article aims to provide a brief overview on the applicability of transfer pricing regulations in India, methods of determining the transfer price and the documentation procedures. 2. SCOPE & APPLICABILITY Transfer Pricing Regulations ("TPR") are applicable to the all enterprises that enter into an 'International Transaction' with an 'Associated Enterprise'. Therefore, generally it applies to all cross border transactions entered into between associated enterprises. It even applies to transactions involving a mere book entry having no apparent financial impact. The aim is to arrive at the comparable price as available to any unrelated party in open market conditions and is known as the Arm's Length Price ('ALP'). 2.1. Associated Enterprises ('AEs')- How Identified? The basic criterion to determine an AE is the participation in management, control or capital(ownership) of one enterprise by another enterprise. The participation may be direct or indirect or through one or more intermediaries.The concept of control adopted in the legislation extends not only to control through holding shares or voting power or the power to appoint the management of an enterprise, but also through debt, blood relationships, and control over various components of the business activity performed by the taxpayer such as control over raw materials, sales and intangibles. It appears that one may go to any layer of management, control or ownership in order to find out association (a) Direct Control (b) Through Intermediary For instance, if enterprise B is managed, controlled or owned either directly or through an intermediary, then Enterprise B is said to be an AE of enterprise A. Further, if Mr A and Mr B control both Enterprise A and Enterprise B then both Enterprise A and Enterprise B AEs.

3. FUNCTION Transfer pricing serves an internal function, because when the divisions and business units of a corporation combine their financial statements the internal costs and revenues cancel each other out. Transfer pricing's function is to establish agreed upon costs and revenues for the interaction that occurs within a company. Transfer pricing is used to assign a cost to tangible goods, intangibles or service transactions within an organization or related parties. For example, a business that manufactures clothing may have one business entity that produces the fabric. Since the business entity that produces the fabric does not formally sell it to the organization that cuts and assembles the fabric, transfer pricing is used to assign a sales price.

TRANSFER PRICING POLICIES

Transfer pricing represents the price paid from one company to another for a product or service when both are owned and report to the same parent company. Transfer pricing policy dictates the approach taken by the two companies when determining the price for the product or service. Companies incorporate different transfer pricing policies to achieve different objectives. External Market Price Some companies employ a transfer pricing policy that incorporates the external market price for all inter-company transactions. The shipping facility charges the receiving facility the same price it charges customers outside of the organization. If the receiving company is able to obtain the same product or service at a cheaper price outside of the organization, it is encouraged to do so. The advantage of this policy is that all transactions occur at the higher market price, allowing the company to maximize profits. The disadvantage of this policy is that the company loses control over quality when purchasing from outside the company. Contribution Margin Approach Companies who encourage a contribution margin approach to their transfer pricing policy split the contribution margin of the final product with all contributing facilities. When the company sells the final product to a customer, the company determines the contribution margin percentage of that product. Each contributing facility determines the cost of the component and applies the same contribution margin percentage to that component. The cost plus the contribution margin equals the transfer price of the component. The advantage of this policy is that the contribution margin is shared equally among all facilities. The disadvantage is that the transfer price may not be known until the product is eventually sold to the final customer. Cost-plus Approach Companies who incorporate a transfer pricing policy using a cost-plus approach provide for shipping facilities to recoup the costs and an additional amount to contribute to that site's profits. The shipping facility calculates its costs and adds a predetermined percentage to that cost. The advantage of this policy is that the calculation is simple to do. The disadvantage is that the shipping facility has no incentive to manage its costs. Negotiated Transfer Price Using a negotiated transfer pricing policy gives each facility some latitude in determining the price to use for inter-company transfers. The shipping facility determines the lowest price by calculating its product cost. The receiving facility determines the highest price by researching what it can pay for a similar product outside

of the company. Managers from the two companies meet and negotiate a price in the middle. The advantage of this policy is that both companies feel ownership over the pricing decision. The disadvantage is that the control lies with the two managers, not with the parent company.

OBJECTIVES OF TRANSFER PRICING

Companies with dispersed production facilities, usually in different countries, use transfer pricing. It involves over- or undercharging for goods sold between branches at a price determined by the company. The main objective is to take advantage of different tax rates between countries. Transfer pricing also is used to evaluate performance of divisions within a company. 1. Tax Savings Imagine a company with two branches, where one makes semi-finished goods in a lowtax country and exports them to a branch in a high-tax country, where they are finished and sold. By increasing the transfer price and declaring more of its profits in the low-tax country, the company can reduce its global tax bill. 2. Boost Profits By undercharging for goods crossing national borders, a company can save money on customs duties paid by the branch in the importing country. Conversely, by overcharging, a company can extract more money from a country with tighter currency outflow restrictions. 3. Measure Performance Companies need to know how their individual divisions are performing. A way of measuring that is through transfer pricing. By setting a price for goods in each stage of the production process, a company can measure the profitability of each division and decide where to make organizational adjustments. When divisional managers have the authority to decide whether to buy or sell internally or on the external market, the transfer price can determine whether managers incentives align with the incentives of the overall company and its owners. 4. Arm's Length Standard The basic principle of this standard used by most developed countries is that for transactions between branches a company should use market prices. However, enforcement of this rule is complicated, especially when a company has branches in numerous countries.

FACTORS AFFECTING TRANSFER POLICY

There are several factors that affect a company's transfer pricing policies: organization's goals, marketing objectives pricing objectives cost competition

Effective transfer prices are ideally set equal to or lower than those charged by a provider from outside the organization.

BENEFITS OF TRANSFER PRICING POLICY An ideal transfer pricing policy will benefits the organization in the following ways: Divisional performance evaluation is made easier.
It will develop healthy inter- divisional competitive spirit. Management by exception is possible.

It helps in co-ordination of divisional objectives in achieving organisational goals. It provides useful information to the top management in making policy decisions like expansion, subcontracting closing down of a division make or buy decisions etc.

Transfer price will act as a check on supplier's prices. It fosters economic entity and free enterprise system. It helps in self- advancement generates high productivity and encouragement to meet the competitive economy.

It optimises the allocation of company's financial resources based of the relations performance of various profit center which in turn are influenced by transfer pricing policies.

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METHODS
There are different methods of transfer pricing: 1.Actual full cost In this method, the transfer cost is calculated by dividing all fixed and variable expenses for the production period by the actual number of units produced. 2.Direct Cost Plus Additional Expenses It is also referred to as cost-plus investment. This method entails computing the direct cost, but also includes a portion of assets, such as specialized equipment used for production. 3. End-Market Prices. This method calculates transfer prices based on the price an end user would pay, but includes a small discount meant to reflect the lack of sales effort and other promotional expenses. 4.Arm's-Length Pricing. The arm's-length price is the price at which the company would have sold the product to an unrelated party.

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MOST APPROPRIATE METHOD

Factors prescribed for selecting most appropriate method: Nature of transaction Functions performed Availability, reliability of data necessary for applying a particular method Degree of comparability Extent to which reliable adjustments can be made to account for differences Reliability and extent of assumptions required to be made in applying a method

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LEGAL AND GOVERNMENTAL POLICIES GOVERNING PROFIT AND TAXES.

The extensive use of transfer pricing has management, financial and tax implications for corporations. For example, low transfer pricing can make a division's financial performance look better than it might be if it had to pay open market prices for its inputs. Unusually high transfer pricing can cause a purchasing division's taxable income to be lower than it might ordinarily be, while the selling division will have inflated profits. Often, when products are produced in different countries or tax jurisdictions, organizations may utilize transfer pricing to assign the greatest profit to tax jurisdictions with the lowest tax rates. Prevention/Solution To prevent businesses from assigning all profit to the lowest tax rate jurisdictions, most countries have stringent transfer pricing review processes. Most countries follow guidelines put forth by the Organisation for Economic Co-operation and Development (OECD). These guidelines allow a wide variety of methods to be used for setting transfer prices. Legal/Regulatory Issues Transfer pricing makes it possible for an organization to manipulate tax and financial outcomes. Dishonest companies can use transfer pricing to hide subsidiary profits and taxable income, and to avoid paying foreign taxes. Companies often manage transfer pricing in such a way that profits and taxable income are taken in the country with the lowest tax rate. This is especially common when customs and income taxes are high. Repercussions According to The Japan Times, Nippon Roche, a Japanese-based pharmaceutical company, did not report 14 billion yen in taxable income between 1992 and 1995. The unreported income was transferred to the firm's parent company, Switzerland-based Roche Holding, via transfer pricing. Nippon Roche paid artificially inflated prices for medicines and raw materials for cancer drugs purchased from Roche Holding in order to reduce taxable income in Japan. When Japanese tax authorities discovered the discrepancy, Nippon Roche was ordered to pay 5.5 billion yen in penalty fines.

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TAX IMPLICATIONS OF TRANSFER PRICING

Multinational corporations can face serious tax implications if transfer pricing is not executed properly. Transfer pricing has tax implications that should be discussed with a tax adviser. Double Taxation Corporations will be taxed by both the host country and the home country for the revenue generated by the good sold. The transfer pricing method chosen by the company may result in the company paying more taxes overall. Government Preferences Transfer pricing methods impact whether the home or host government receives the lion's share of the tax revenue. If the host country offers lower tax rates, specific transfer pricing methods can result in lower taxation rates overall. Speak with your tax adviser to determine methods that are best for your company. Tariffs and Duty Taxes Goods transferred from one country to another can incur tariffs and duty taxes depending on the country of origin. Tariffs and duties are applied to goods sold within a company as well. However, import tariffs are tax deductible in the United States.

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. Such testing requires a determination of how the testing must be conducted, referred to as a transfer pricing method.

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DOCUMENTATION OF TRANSFER PRICING

The Indian Transfer Pricing Regulations came into force in 2001 with the transfer pricing audits effectively beginning from 2003. The Central Board of Taxes in India introduced a special cell of trained officers which is responsible for all transfer pricing audits. Over the past four years, there has been a significant increase in the number of transfer pricing audit officers (TPOs). The TPOs in this short time have clearly been successful in positioning Indias transfer pricing administration as an aggressive one. The Indian process of selecting cases for a transfer pricing audit is procedural and apparently does not deal with the qualitative aspects of the case. The Board of Taxes has, vide an instruction, notified that should the value of its transaction exceeds $1.25 million (now stands revised at $3.75 million) the case should be compulsorily audited. This process has led to a large number of cases having selected, which does not leave the TPOs with adequate time to scrutinise the case. In the past couple of years, the TPOs have made significant adjustments. The fact pattern of adjustments indicates that one in every four cases picked-up for audit, is adjusted. The typical scenarios which would attract the attention of the TPOs for a transfer pricing audit would be: Consistent losses of the taxpayer attributable to inter-company transactions; Significant changes in the profitability of the taxpayer and its associated enterprises; Unjustifiably large payment of management charges not passing the benefit test; Losses incurred by routine distributors; and Low mark-ups for services. It is important that a taxpayer regularly monitors and regulates its transfer prices to survive a transfer pricing audit in India. The Indian transfer pricing regulations mandate a taxpayer entering into international transactions with its overseas affiliates, to maintain specified transfer pricing documentation and information. The list of prescribed documentation in India is an exhaustive one with details relating to the profile of the group, the industry in which the taxpayer operates, a description of the functional profile of the taxpayer, etc. The documentation maintained by the taxpayer must also include a detailed economic analysis which would be the basis to conclude that the taxpayers transactions are at arms length. The economic analysis is
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the critical part of a transfer pricing documentation which would be the basis of defending the transfer pricing policy of a taxpayer. It also becomes imperative for a taxpayer to regularly update the information and documentation so that the true and accurate business reality of the taxpayer is reflected in the documentation, including their future business plans, strategies and market positioning. It is also crucial for a taxpayer to not deviate from global policies for pricing of goods and services unless the pricing is not feasible from a business perspective. Further, all reasons for any deviations must be clearly documented and recorded as the same may support the taxpayer during the audit process.

Establishing control of the audit process

The Indian transfer pricing audit process may become tedious and lengthy at times; however it is crucial for the taxpayer to take control of the audit process. To take control of the situation, the taxpayer must take a firm stance and must clearly put his case forward to the TPO. When a taxpayer provides timely and appropriate responses to the TPO with a clear focus on (i) the business reality and (ii) the economic analysis, the former can really take control of the audit process. Further, the taxpayer must deploy the right resources for a transfer pricing audit, which can drive the audit in the right direction. A clear approach in a transfer pricing audit is very important because the Indian TPOs tend to categorise taxpayers under certain classifications (e.g. IT service providers, contract manufacturers, routine distributors, etc.). Thus there is a need for highlighting the factual peculiarities of the taxpayers case and distinguishing oneself from others.

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CONCLUSION
Transfer pricing is of relevance to international transactions where inappropriate transfers could result in the loss of tax revenue to one country or another. Any company will always have unique characteristics, which, if ignored, could place it at a disadvantage compared with others. Consequently, we have to ensure that a simplistic approach to transfer pricing does not create the unintended consequence of taking away a level playing field in some industries. Given that it is going to take time for all parties to reach the necessary level of maturity in this area, the challenge is to ensure that in the interim, neither revenue nor companies are affected adversely. This may involve companies 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 Almost all large Indian companies either have substantial multinational operations or are themselves associates of foreign multinationals or of their subsidiaries. The implications of transfer pricing can have a substantial impact on the net profits of such companies. It is, therefore, worthwhile for audit committees to dedicate sufficient time to assess the transfer pricing mechanics of the companies they audit.

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BIBLIOGRAPHY
o o o o o o o o o http://www.cci.in/upload%5CArticle%5Cfile%5CFileKCKXXZHlaw_transfer_pricing.pdf http://www.investorwords.com/5051/transfer_pricing.html http://law.incometaxindia.gov.in/DIT/inttpcont.aspx http://en.wikipedia.org/wiki/Transfer_pricing http://www.itinet.org/transferpricing/methods.htm http://www.ehow.com/list_6874545_objectives-transfer-pricing.html http://www.iimahd.ernet.in/~jrvarma/reports/Transfer_Price/expert_group_report.htm www.sars.co.za www.fitindia.org/

OTHER REFERENCES
o Ben Gurion University: Transfer Pricing "International Political Economy"; Goddard, Cronin & Dash; 2003 o Organisation for Economic Co-operation and Development

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