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Transfer pricing is the exchange price of goods and services between the companies under the parent company's control.Transfer pricing provisions ensure that transactions between associate enterprises and related parties should be at a rate comparable to fair market rate or at arm's length price . It might be that Companies may use transfer pricing practices as a tool for saving taxes.
How does transfer pricing work, what are the best practices and different methods for transfer pricing, and how do companies save taxes using this practice? Learn everything you need to know about transfer pricing.
Transfer pricing determines the price of goods and services exchanged between related parties, such as subsidiaries of the same parent company. Transfer pricing is important for tax purposes, as it affects the allocation of income and expenses among different jurisdictions. In India, transfer pricing rules are based on the arm's length principle, which means that the price of a transaction between related parties should be comparable to the price of a similar transaction between independent parties. Transfer pricing in India is regulated by the Income Tax Act 1961, the Income Tax Rules, 1962, and various guidelines and circulars issued by the Central Board of Direct Taxes (CBDT). The CBDT has also prescribed various methods for determining the arm's length price. Transfer pricing in India is subject to documentation requirements, reporting obligations, and audits by the tax authorities.
Transfer pricing is a way of setting prices for transactions within a company or a group of companies under the same management or ownership. This applies to both international and domestic transactions. A transfer price is the amount that one division or subsidiary charges from another for a product or service they provide. Transfer prices are usually based on the market price for the product or service. Transfer pricing can also be used for research, patents, or royalties. Multinational companies can legally use transfer pricing to allocate their profits among their parent and subsidiary entities.
However, some companies may also use (or abuse) this method to manipulate their corporate income and lower their overall taxes. Transfer pricing helps companies to shift tax liabilities to low-tax jurisdictions.
Example of Transfer Pricing: ABC and CBD are both subsidiaries of XYZ's company. ABC manufactures cars and imports the engine from CBD. The price that ABC pays to CBD for the engine is the transfer price. Transfer pricing can affect the profitability and tax liability of each subsidiary and the parent company. If CBD charges a lower price, then the revenue of CBD will be lower; on the other hand, the cost of the car for ABC is lower, increasing the company’s profit. In short, Company CBD’s revenues are lower by the same amount as Company ABC’s cost savings—so there's no financial impact on the parent company.
Suppose company CBD operates in a higher tax rate country; XYZ can save taxes by making CBD less profitable and ABC more profitable. In other words, company CBD’s decision not to charge market pricing to company ABC allows the parent company to save taxes.
The arm's length principle is a business deal in which buyers and sellers act independently without one party influencing the other. It is a key concept in international taxation that ensures that transactions between related parties are conducted at fair market prices. The principle aims to prevent tax avoidance and ensure a level playing field for taxpayers. The arm's length principle is based on the idea that unrelated parties would negotiate the terms and conditions of a transaction in a way that reflects their respective economic interests and risks. By applying the arm's length principle, The arm’s length price can be determined by various transfer pricing methods under section 92C(1) using the best applicable methods suited to parties involved in particular transactions.
Section 92C(1) prescribed the methods of arm’s length, which are the followings:
Organizations can reduce the appropriate costing using transfer pricing practices. Companies are required to export goods and services at a lower price to countries with higher tax rates; therefore, their tax liability will become low.
Companies can gain more profit margins using transfer pricing. Companies require to export the goods and services at an over price to countries where the tax rate is lower. They would have the leverage of lower tax rates in such countries. Transfer Pricing provisions aim to avoid such kinds of activities or manipulations.
Transfer pricing documentation is a set of documents that multinational enterprises (MNEs) must prepare and submit to tax authorities to demonstrate their intercompany transactions' regularity with the arm's length principle. The arm's length principle states that the prices charged by related parties for services, goods, or intangible assets should be comparable to those charged by independent parties under similar circumstances. Transfer pricing documentation helps MNEs to comply with tax regulations and mitigate transfer pricing risks.
According to the transfer pricing regulations in India, every taxpayer who has entered into an international transaction or a specified domestic transaction with an associated enterprise must maintain proper documentation and records to substantiate the arm's length nature of such transactions. The taxpayer must also file a report in Form 3CEB along with the income tax return, disclosing the details of such transactions and the methods used to determine the arm's length prices.
An Advance Pricing Agreement (APA) is an agreement between an assessee and tax authorities on an applicable TPM (transfer pricing methodology) for a set of transactions at issue over a specified period of time (called “Covered Transactions”). The agreement is made ahead of time and is based on an appropriate transfer pricing methodology (TPM) for a set number of transactions over a period of time.
The Income Tax Authority regulates the transfer pricing under the income tax act 1961 and regulations enforced by the central board of direct taxes in India.
