What is Transfer Pricing in India?

Transfer pricing refers to value attached to transfer of goods or services between related parties.

Thus, transfer pricing can be defined as the price paid for goods transferred from one economic unit
to another, assuming that the two units involved are situated in different countries, but belong to the
same multinational firm.
Arm’s Length Principle Applied to Transfer Pricing And Attribution of Profits to PE:
The arm’s length principle is applied both in the context of transfer pricing and attribution of profits.
Such an application makes no distinction between a branch or a subsidiary through which an MNE
carries on business in a country. A functionally separate entity approach as a working hypothesis
underlying the application of the arm’s length principle, is found in almost all tax treaties.

Transfer Price is Not Arm’s Length Price:

Transfer price is the price charged in a transaction. The term ‘transfer price’ is used to describe the
actual price charged between the associated enterprises in an international transaction. Transfer
pricing issues arise when entities of multinational corporations resident in different jurisdictions
transfer property or provide services to one another. These entities do not deal at arm’s length and,
thus, transactions between these entities may not be subject to ordinary market forces. Where the
transfer price is different from the price which would have been charged if the enterprises were not
associated and the difference gives rise the tax advantage, the tax is calculated on the basis of arm’s
length price.

Aims & Objective Of Transfer Pricing:

1. Transfer pricing minimizes the tax burden or arranging direction of cash flow:
Transfer price, as aforesaid, refers to the value attached to transfer of goods, services, and technology
between related entities such as parent and subsidiary corporations and also between the parties
which are controlled by a common entity. Its essence being that the pricing is not set by an
independent transferor and transferee in an arm’s length transaction. Transaction between them is
not governed by open market considerations.
2. Transfer pricing results in shifting profits:
Whatever the reason for fixing a transfer price which is not arm’s length, the result is the shift of
profit. The effect is that the profit appropriately attributable to one jurisdiction is shifted to another
jurisdiction. The main object is to avoid tax as also to withdraw profits leaving very little for the local
participation to share. Other object is avoidance of foreign exchange restrictions.
3. Shifting of Profits- Tax avoiding not the only object:
Transfer between the enterprises under the same control and management, of goods, commodities,
merchandise, raw material, stock, or services is made at a price which is not dictated by the market
but controlled by such considerations such as:
• To reduce profits artificially so that tax effect is reduced in a specific country;
• To facilitate decentralization of production so that efforts are directed to concentrate profits in the
State of production where there is no or least competition;
• To remit profits more than the ceilings imposed for repatriation;
• To use it as an effective tool to exploit the fluctuation in foreign exchange to advantage.
 The Five Transfer Pricing Methods

As mentioned, the OECD Guidelines discuss five transfer pricing methods that
may be used to examine the arm’s-length nature of controlled transactions.
Three of these methods are traditional transaction methods, while the remaining
two are transactional profit methods.We list the methods below:

Traditional transaction methods:

1. CUP method
2. Resale price method
3. Cost plus method

Transactional profit methods:

4. Transactional net margin method (TNMM)

5. Transactional profit split method.

Intercompany loans

Intercompany loans are loans made from one business unit of a company to another,
usually for one of the following reasons:

 To shift cash to a business unit that would otherwise experience a cash shortfall
 To shift cash into a business unit (usually corporate) where the funds are aggregated for
investment purposes
 To shift cash within business units that use a common currency, rather than sending in
funds from a foreign location that will be subject to exchange rate fluctuations

The use of intercompany loans can cause tax problems, since the issuing business unit
should record interest income on the loan, while the receiving unit should record interest
expense - both of which are subject to tax rules. Also, the interest rate associated with such
a loan should be one that would be derived in an arm's-length transaction with a third
party.
 When an intercompany loan is created, it should be fully documented, including the amount of the interest
rate to be charged and principalrepayment terms. Otherwise, the loan might instead be considered an
investment by the issuing business unit in the receiving unit, which can create other tax problems.

Given the extent of these tax concerns, a company using intercompany loans should be prepared to undergo a
tax audit that focuses on the underlying reasons for and documentation of these loans.

Intercompany loans are recorded in the financial statements of individual business units, but they are
eliminated from the consolidated financial statements of a group of companies of which the business units are
a part, using intercompany elimination transactions.

Despite the issues just noted, intercompany loans are extremely useful for the following reasons:

 No credit application is required

 The cash can be made available on short notice
 Repayment terms may be much longer than would be required by a commercial lender