A Tutelage in Transfer Pricing

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Benchmarking is a key concept that allows companies and businesses to adapt, grow and thrive. Important metrics pertaining to the business are compared to understand where the business/company needs to change in order to be on par with the best in the field.

Benchmarking is also a crucial subset within Transfer Pricing.

What is Transfer pricing benchmarking?

Transfer pricing enters the stage when one division of the company charges another division of the same company, or a holding company, for goods and services provided. It establishes prices for commonly controlled companies i.e. those that may come under the same parent company. It also works for cross-border establishments when one division is in the US, and the other in India. It reduces the tax burden of such companies as well.

A critical part of transfer pricing documentation and policy is benchmarking. It is used to test the arm’s length range and price of the transactions. It is a legal requirement and failure to produce such documentation will result in fines and penalties.

Transfer pricing benchmarking is one of the most important issues that companies with a cross-border presence face. The whole procedure involves gathering data regarding the company, industry, and transaction information. The benchmarking analysis is done to finally reach a suitable comparable set. The final report includes the analysis and the financials of the comparable companies.

Transfer pricing in India– Transfer Pricing was introduced in India by inserting Sections 92A-F in the Income Tax Act, 1961 in line with Article 9 of OECD guidelines.

The provisions dictate that any income arising from international transactions should be computed at an arm’s length price. The application of such transfer pricing provisions should not result in reducing the income computed on the basis of books of account.

Section 92B defines the aforementioned ‘international transactions as a transaction between two or more associated enterprises, wherein either one or both the enterprises are non-residents. The nature of transactions should be recorded through a mutual agreement. It could be a purchase, sale/lease of assets, provision of services, borrowing and lending of money, etc.

‘Associated enterprises’ is an enterprise that participates in the control or management of the other enterprise, directly or indirectly.

Some such situations in which two enterprises are called ‘associated enterprises’ are if :

  • one enterprise has a shareholding of not less than 26% of the voting power in the other enterprise
  • a loan advanced by one enterprise to another constitutes not less than 51% of the book value of the total assets
  • more than half of the board of directors are appointed by the other enterprise.
  • 90% or more of the raw materials or consumables are supplied by the other enterprise

Transfer pricing in the US– According to the Transfer Pricing statute in the Internal Revenue Code Section 482, the transfer pricing between intercompany transactions should be the same as the pricing between the company and an external party. The regulations are based on the arm’s length principle and are consistent with OECD guidelines (but do not explicitly contain the OECD guidelines). It applies to all taxpayers including US branches of overseas companies. Transfer Pricing documentation is not specifically required. But, if asked for, they must be submitted to the IRS within 30 days of request.

Determination of Arm’s Length Price

Since countries sometimes have huge differences in tax rates, MNCs try to shift profits from high-tax countries to low-tax countries. To prevent this, the OECD invented the Arm’s length principle which necessitates that controlled transactions be done at market rates. As of date, there are 5 methods to determine the arm’s length price.

  1. Comparable Uncontrolled Price (CUP) method – It compares the price charged in a controlled transaction with the price charged in an uncontrolled transaction between comparable independent parties in similar circumstances.
  2. Resale Price method – This method is based on Gross Margins earned by a distributor. It is then used to determine the appropriate gross margin that should be earned by the distributor that purchases finished goods from a related entity.
  3. Cost Plus method – This is a transaction-based method and is less direct than the other methods. The manufacturing costs incurred by the supplier are determined. A market-based markup is then added to that cost to account for appropriate profits. The markup is compared to the markups realized in comparable transactions between unrelated organizations.
  4. Profit split method – It is applied in complex industries with high profits like the pharmaceutical industry. There are different types of profit split methods, but they are all based on the division of profits that independent enterprises would have realized from engaging in controlled transactions.
  5. Transactional Net Margin Method – This method uses the net profits of a controlled transaction and an uncontrolled transaction and compares them to determine transfer prices.

The OECD introduced “Other methods” in 2012. It can be any method that considers the price which has been charged or paid or would have been charged or paid, for the same or similar uncontrolled transaction with or between unrelated parties under similar circumstances, considering all the relevant facts.

For transfer pricing of tangible property, the comparable uncontrolled price, resale price, cost plus, comparable profits method, and profit split methods can be used.

For transfer pricing of intangible property, the comparable uncontrolled transactions, comparable profits method, and profit split methods can be used.

For controlled services transactions, the comparable uncontrolled services price, gross services margin method, services cost-plus method, comparable profits method, services cost method, and profit split methods can be used.

In India, in case there is a price variation, it should not exceed 1% of the wholesale price and 3% in all other cases.

In the US, no adjustment is made to a company’s transfer pricing results if those results are within an arm’s-length range derived from two or more comparable uncontrolled transactions. This is what makes the US regulation flexible.

Transfer Pricing Documentation required in India

TP documentation in India happens at three levels-

  1. A local file that needs to be maintained by the company itself
  2. A master file that needs to be filed with the Income Tax Department- The master file is applicable when the Consolidated revenue of International Group for the Accounting Year exceeds INR 500 crore and one out of the following two conditions-
  • The aggregate value of the international transaction exceeds INR 50 crore
  • The aggregate value of international transactions pertaining to intangible property exceeds INR 10 crore

Form 3CEAA should be filed before the due date of furnishing ITR. It has two parts, A and B.

Information required in Form 3CEAA(Part A) includes basic details like name, address, and PAN of the assessee, accounting year, number of constituent entities, and details of constituent entities.

Information required in Form 3CEAA(Part B) includes a list of entities of the international group, ownership structure of all the entities, TP Policy for transactions made between members entities of the group, list of functions, assets, and risk analysis of the constituent entities, list of all intangible property of the group, etc.

Form 3CEAB should be filed 30 days before filing the Master File

  1. Country by Country report that also needs to be filed with the IT Department- This is applicable when the Consolidated revenue of International Group is more than INR 5500 crore.

Form 3CEAC contains details of the Parent entity (if it is not in India) and should be filed at least 2 months before filing ITR

Form 3CEAD is the Country by CountryReport by a parent entity or an alternate reporting entity or any other constituent entity, resident in India and needs to be filed within 12 months following the end of reporting accounting year.

Transfer pricing documentation required in the US

Unlike India, the US does not require local files and master files.

Documentation is annual and two categories need to be maintained- principal documents and background documents.

Principal documents include-

  • Analysis of economic and legal factors affecting pricing
  • description of the company’s organizational structure covering all related parties engaged in transactions
  • description of the method selected and an explanation of why that method was selected
  • description of the comparables that were used, and how comparability was evaluated

All principal documents must be submitted to the IRS within 30 days of a request.

Background documents must support the assumptions and conclusions in the principal documents. They include original entry books and records, profit and loss statements, and other documents. They need not be provided to the IRS until requested.

The determining of transfer prices, benchmarking, and their documentation is a process that must be done with utmost diligence with the help of a CFO consultancy service.

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