What is transfer pricing?

Transfer prices are the charges made when a company supplies goods, services or finance to another company to which it is related. It is an internationally accepted principle that transactions between related parties should be based upon the same terms as between unrelated parties. Thus both tax treaties entered into between countries and domestic tax legislation of various countries have adopted the arm's length principle.

Why is transfer pricing required?

Price charged by one company in Country A to another company in Country B is reflected in the profit and loss account of both companies, either as an income or an expenditure. Thus prices charged impact the tax paid by the two related companies.

By resorting to transfer pricing, related entities can reduce the global incidence of tax by transferring higher income to low-tax jurisdictions or greater expenditure to those jurisdictions where the tax rate is very high.

For example, the current tax rate on domestic companies in India is 35 per cent. Company A is located in India and Company B in Country XYZ. Both belong to the same group. If tax rate in Country XYZ is 15 per cent, then Company B will transfer raw material to Company A at slightly higher prices. This will enable Company A to show a higher expenditure and reduce its taxable profits. On the other hand, slightly higher income will not harm Company B much as the tax rate in its country is very low. Thus the global group as a whole will benefit from tax savings.

How do tax authorities detect transfer pricing?

Globally several methods of detecting transfer pricing have been set out to check whether transactions between related parties have been at arm's length.

The transaction method relies directly or indirectly on information of prices at which similar transactions have been entered into by unrelated parties. This method is further divided into the comparable uncontrolled price (CUP) method and the cost plus (C+) method.

Prices charged in similar business transactions between two independent parties is the yardstick adopted under the CUP method. Whereas under the C+ method, an arm's length price is determined by applying an appropriate mark-up on the costs incurred.

The transactional profit method, as the name indicates, is transaction-specific: it examines whether or not profits from a particular deal are reasonable.

Why do transfer pricing regulations gain importance in a developing country like India?

Import of raw material, semi-finished goods for assembling and most important of all, intellectual property such as know-how and technology are areas prone to transfer pricing. Such goods or services can be sent to associate companies in India either at a higher or lower rate than prices charged to unrelated parties to secure a global tax advantage.

In a high-tech age, Indian companies often rely on technology and know-how from their foreign joint venture partners: thus strict regulations are very important.

Are the regulations in India adequate to curb transfer pricing abuse?

Transfer pricing regulations are extremely stringent in developed countries such as the United States of America, United Kingdom, Canada, Australia and Germany.

In these countries, the tax payer has to maintain extensive records of all transactions with related parties.

In the UK, such disclosures have to be made in the self assessment returns filed with tax authorities. In India, though provisions relating to transfer pricing regulations are there in the Income Tax Act, 1961, they are not very effective as tax payers are not required to maintain detailed documents or voluntarily disclose information of related party transactions.