Transfer pricing

Introduction

Today’s organizational thinking is oriented towards decentralization. One of

the principal challenges in operating a decentralized system is to devise a
satisfactory method of accounting for the transfer of goods and services from
one profit center to another in companies that have a significant amount of
these transactions. When two or more profit centers are jointly responsible
for product development, manufacturing, and marketing each should share
in the revenue that is generated when the product is finally sold. The
Transfer price is the mechanism for distributing this revenue. The transfer
price is not primarily an accounting tool; rather, it is a behavioral tool that
motivates managers to make the right decisions. Decentralization means the
freedom to make decisions. Decentralization can transform a profit center
into an investment center. Centralization can transform an investment
center into a profit center or transform a profit center into a cost center.

Research objectives

 To understand the concepts of Transfer Pricing

 To understand the need & importance of Transfer Pricing

 To deeply understand various Transfer Pricing Methods & their

application

 To be able to successfully prepare a Transfer Pricing Memorandum.

Research analysis

Transfer Prices

A transfer price refers to the price used for intra-company transfers, i.e.,
transfers between segments of a company. The term transfer pricing
normally means pricing transfers between divisions, but could be used in any
situation where the output of one segment (e.g., department, operation,
process) becomes the input for another segment within the same company.

Three Decisions

A transfer pricing situation usually involves three questions or decisions.

 1. Should the transfer take place? This is essentially a (Make or Buy)
question. Should the company make the item or outsource, i.e.,
purchase it on the outside market? This is a relevant cost problem
(also referred to a differential or incremental cost). The key is which
costs will be different under the two alternatives, i.e., make inside
and transfer, or buy from outside the company?

2. If the answer to question one is yes, then what transfer price should
be used?

3. Should the central office interfere in establishing the transfer price?

Objectives of Transfer Prices

The overall objective is to establish a transfer price that will motivate effort
and goal congruence. There are at least three underlying objectives.

1. To aid in Evaluating Division Performance, i.e., investment centers or

profit centers. If the divisions are treated as investment centers, then
Return on Investment (ROI) and Residual Income (RI) are the relevant
measurements. For profit centers, contribution margin, segment
margin, or net income would be a more appropriate measurement.

2. To maintain Division Autonomy. Since autonomy means

decentralization and freedom to make decisions, it is also an ingredient
in motivating effort. Remember, however, that effort and goal
congruence are different. Managers may exert considerable effort in
pursuing their own goals that conflict with the goals of the firm. Central
office interference in a transfer pricing dispute will affect autonomy and
effort. The dilemma is that goal congruent behavior may not be
obtained with or without interference.

3. To provide the buying segment with the information necessary for the
make or buy question. Intra-company profits included in a transfer price
make it impossible for the buying division to answer the make or buy
question.

Possible Transfer Prices

1. Market prices: A market price is considered best if the market is perfectly

competitive, i.e., if a single buyer or seller cannot affect the price. Generally
intra-company transfers at market prices accomplish objectives 1 and 2, but
not 3. Unfortunately, several problems occur when trying to use market
prices:

a. Most markets are not perfectly competitive. In other words, the demand
curve and price structure may shift if the firm buys outside.

b. Market prices may not exist for some products.

c. A market price may not be comparable because of differences in quality,

credit terms, or extra services provided.

d. Price quotations may not be reliable because they are based on temporary
distress or dumping conditions.

e. A market price may not be relevant because the selling division would not
have the same transportation cost, accounting cost for A/R, credit etc. as an
outside supplier.

f. Information for the make or buy decision would not be available to the
buying division.

2. Full cost: All manufacturing, selling and administrative costs are included.
The problems that occur when full cost is used as a transfer price include:

a. Transfer prices based on full cost do not accomplish any of the objectives
stated above. The selling division could not be evaluated as a profit center or
investment center since it is treated as a cost center.

b. The seller would be motivated to over allocate cost to the product

transferred.

c. If actual costs are transferred, the cost of inefficiency will be passed along
to the buying division. Thus, standard costs make better transfer prices
although standards may be rigged.

d. The buyer would not have the differential cost information needed for the
overall firm make or buy decision. The irrelevant (mostly common fixed cost)
of the seller become relevant cost to the buyer.

3. Full Cost Plus: All manufacturing, selling and administrative costs plus a
markup for profit. Standard cost plus would be better than actual cost plus to
motivate the seller to be an efficient cost producer. The same problems in 2
are applicable here. Motivation for over allocation is still present. Transfers at
standard could motivate the seller to rig the standard.
4. Variable cost: All variable manufacturing, selling and administrative costs.
This may come close to accomplishing objective 3, since variable cost may
approximate differential cost. It should be noted however, that variable cost
and differential cost are not the same since some fixed cost may also be
relevant, i.e., change if the product is purchased outside rather than
produced inside. Objectives 1 and 2 would not be obtained since the other
problems listed under 2 and 3 are applicable here, lack of motivation for
profits, potential for cost over allocation etc.

5. Variable cost plus: This may be a little better than 4, but the plus should
be kept separate to allow for a ball park make or buy decision. Objectives 1
and 2 would not be fully obtained.

6. Negotiated price: Negotiated prices may be best if:

a. An imperfect market exists for the product making it difficult, if not

impossible, to determine the appropriate market price.

b. The seller has excess capacity), thus the transfer becomes a differential
cost problem to the seller. Any transfer price above the seller's differential
cost would benefit the seller.

c. There is no external market) for the product, thus no market price.

In these cases the buyer and seller may negotiate a price that allows both
parties to share in the benefits of the transfer. This may accomplish
objectives 1 and 2, but not 3. A problem with this approach is that managers
may spend a substantial amount of time and effort negotiating transfer
prices.

7. Dual Price: Use two transfer prices. Give the seller credit for selling at
market price or full cost plus a reasonable markup, but charge the buyer
with variable cost (i.e., approximate differential or additional outlay cost).
Charge the difference to a central account. This approach may not motivate
either the seller or the buyer to be efficient.

Very General Rule:

Optimum Price = Additional Outlay Cost + Opportunity Cost

Opportunity Cost = Market Price - Additional Outlay Cost

Opportunity Cost is the contribution margin that the seller would earn if the
product could be sold on the outside market.
If the seller has excess capacity, i.e., cannot sell additional units on the
outside market, then the seller's opportunity cost is zero. Thus, it is argued
that the seller should transfer the product at cost. A problem may arise
however, since the seller has no incentive to produce the extra product.

Maximum Price = Market Price

Minimum Price = Additional outlay cost, i.e., differential cost.

Transfer pricing is a classic catch-22 situation, a problem without a definitive

answer.

Transfer Pricing Mechanism in Banks

Of late, there has been a marked shift in the measures used for evaluating
the bank branches. From deposit mobilization criterion the emphasis is now
being turned on to the profits made by the bank branches. When the concept
of ‘profit centre’ is being applied the significance of the methodology
involved in ascertaining the profits gains prominence for the management
control system. Transfer price, in the context of banking sector, is the
interest charged by the surplus funds branch to the deficit funds branch on
the transferred funds. Though branches are identified to be of deposit
intensive, advances intensive and ancillary business intensive for
administrative convenience there are other material factors like the location,
size, and the nature of clientele that impinges on the performance of the
branches.

Profit is the most commonly acceptable measure for evaluation of Branch

performance. To what extent profit is a good indicator of viability of the
branches depends upon how independent the branches are in the
commercial sense. As the branches of a Bank, in reality, are not truly and
entirely independent commercial units, it is difficult to determine the real
profitability of such branches with the help of existing systems that are less
transparent, less accurate and having weak linkage with the overall costing
and pricing structure of business/products.

In the light of the above, the present study probes into various modalities of
Transfer Pricing Systems and suggests a suitable mechanism so as to reflect
the true profitability, productivity and efficiency of the Branches.
The bank branches are identified into two:

1. Deposit oriented

Majority of bank branches comes under this category. Though 80% of

branches are acting as deposit-pooling centers all branches are not uniform
in terms of deposit mix. It is a fact that the deposit mix is favorable (low cost
deposits) with respect to Metro/Urban branches where as depositors of Rural
and Semi-urban branches tend to keep their deposits in Term deposits. This
has effect on branch profitability.

2. Advance oriented

Though the branches are independent units in terms of accepting deposits

and lending funds, the CD ratio is below 25% in many of the bank branches.
It speaks that the lending activity is considered as centralized activity and
the lending of top 10% branches constitutes 80% of lending. However, all
lending branches are not uniform in terms of yield on advances since it
depends on sectoral deployment and quality of lending. Obviously, the yield
on advances at Metro/Urban branches is higher when compared to rural and
Semi-Urban branches.

Fund Transfer Pricing (FTP)

In the banking industry, the deposits are collected by one branch and used
by another to fund loans. This process is usually handled using an FTP
system.

When a bank makes a loan to a customer, the funding for this loan has to
come from one source or another. Typically, the funding in a financial
institution will come from deposits collected by the bank. This type of
funding is normally the cheapest and most desirable; however, when
deposits are not sufficient to fund all the needs for cash that the bank has,
the bank will have to get additional funding in the wholesale market.
Therefore, each deposit brought in to the bank has a value to the financial
institution for funding purposes, and, by the same token, a loan also has an
underlying cost of funds and is not just interest income for the bank, as it
would look in a typical income statement analysis. The purpose of FTP is to
place a value on each deposit and assign a cost to each loan that a bank has.
When implementing an FTP system, banks' must determine a "funding
curve" that most reflects their source or use of funds on the wholesale
market. Many banks in the past used United States Treasuries as their
funding curve. But recently, the government has dropped some buckets from
its information. Therefore, many banks have switched to the LIBOR/Swap
curve. The funding curve for a financial instrument shows the relationship
between time to maturity and interest rate. Many banks make adjustments
to these curves to customize the curve to fit the banks unique lending
environment.

Next, each loan or deposit that the bank has is assigned a rate based upon
this adjusted funding curve. The rate that is assigned to these customer
relationships will vary based upon the characteristics of the relationship. One
characteristic that will cause a rate to change is time to maturity. For
instance, a 5 year fixed rate note will be assigned a different rate than a 5
year variable rate note. Also, for loans, the longer the term is to maturity, the
higher the rate to fund that loan. By the same principle, a deposit that has a
longer maturity would be assigned a higher funding rate credit because the
bank is guaranteed the use of these funds for a longer period of time.

Other unique characteristics of a loan will cause the rate assigned to it to

vary. One such characteristic is a prepayment option on a loan. A
prepayment option will change the average expected life of the loan. This is
an assumption that is based on looking at historical trends in the bank.

Once all the data is input into the FTP system, management will have to
decide how often the rates will be assigned. This may be done monthly,
weekly or sooner depending on the capabilities of the system and the needs
of management for decision making. Large amounts of data must be stored
and many calculations must be made for an FTP system to provide useful
information for management. In the past, the technological hardware and
software used within banks were not of sufficient power or flexibility to
handle the data volumes involved or provided the analytical capabilities
demanded. Today, however, such technology is available, enabling the
appropriate levels of contract-level detail handling and providing the ability
to analyze data across any number of dimensions in ad hoc fashion.

Using FTP to measure Branch Profitability

Financial Institution's income statement is designed to calculate net-interest
income for the entire organization. It is not designed to calculate the net-
interest income of one product. This is also true of calculating the net
interest income of branches for comparative purposes. Branches within a
bank are almost never the same in terms of loans and deposits. Some
branches are heavy on the loan side, while others are heavy on the deposit
side and still others are fairly evenly balanced. Determining the profitability
of individual branches in a traditional accounting sense is extremely difficult.
Looking at an income statement for a branch using a typical accounting
analysis, interest collected from loan payments are shown as interest income
and interest paid out on deposits are shown as interest expense. But this
does not take into account that deposits have a positive value to the bank by
providing cheap funding for its loan purposes. Conversely, it also does not
take into account that a loan has an underlying funding cost associated with
the process of making the loan. Therefore, using a typical income statement
format, a branch that is heavy on the deposit side will look like it is losing
money, while a branch that is heavy on the loan side will look like it is highly
profitable.

International Transfer Pricing:

International transfer pricing is concerned with the prices that an

organisation uses to transfer products between divisions in different
countries. The rise of multinational organisation introduces additional issues
that must be considered when setting transfer prices.

When the supplying and the receiving divisions are located in different
countries with different taxation rates, and the taxation rates in one country
are much lower than those in the other, it would be in the company’s interest
if most of the profits were allocated to the division operating in the low
taxation country.

Additional Problems with Multinational Transfer Pricing

1. Taxes rates in different countries.

The firm's strategy is to shift income from the high tax country to the low tax
country. If the buying division is in a low tax country, then transfers would be
made at the lowest cost possible. If the seller is in a low tax country transfers
would be made at high prices.

2. Foreign Laws preventing income and dividend repatriations.

If there are restrictions on the buying division payments of dividends and
transfers of income to the central office, then transfers of products to the
buyer would be made at high prices. Transfers from the foreign division
would be made at low prices.

Transfer Pricing Law in India

Increasing participation of multi-national groups in economic activities in the

country has given rise to new and complex issues emerging from
transactions entered into between two or more enterprises belonging to the
same multi-national group. With a view to provide a detailed statutory
framework which can lead to computation of reasonable, fair and equitable
profits and tax in India, in the case of such multinational enterprises, the
Finance Act, 2001 substituted section 92 with a new section and introduced
new sections 92A to 92F in the Income-tax Act, relating to computation of
income from an international transaction having regard to the arm’s length
price, meaning of associated enterprise, meaning of information and
documents by persons entering into international transactions and
definitions of certain expressions occurring in the said section.

Section 92: As substituted by the Finance Act, 2002 provides that any
income arising from an international transaction or where the international
transaction comprise of only an outgoing, the allowance for such expenses or
interest arising from the international transaction shall be determined having
regard to the arm’s length price. The provisions, however, would not be
applicable in a case where the application of arm’s length price results in
decrease in the overall tax incidence in India in respect of the parties
involved in the international transaction.

Arm’s length price: In accordance with internationally accepted principles,

it has been provided that any income arising from an international
transaction or an outgoing like expenses or interest from the international
transaction between associated enterprises shall be computed having regard
to the arm’s length price, which is the price that would be charged in the
transaction if it had been entered into by unrelated parties in similar
conditions. The arm’s length price shall be determined by one of the
methods specified in Section 92C in the manner prescribed in Rules 10A to
10C that have been notified vide S.O. 808 E dated 21.8.2001.

Specified methods are as

follows:

Comparable uncontrolled price

a.
method;

b Resale price method;

c. Cost plus method;

d. Profit split method or

Transactional net margin

e.
method.

The taxpayer can select the most appropriate method to be applied to any
given transaction, but such selection has to be made taking into account the
factors prescribed in the Rules. With a view to allow a degree of flexibility in
adopting an arm’s length price the provision to sub-section (2) of section 92C
provides that where the most appropriate method results in more than one
price, a price which differs from the arithmetical mean by an amount not
exceeding five percent of such mean may be taken to be the arm’s length
price, at the option of the assessee.

Associated Enterprises: Section 92A provides meaning of the expression

associated enterprises. The enterprises will be taken to be associated
enterprises if one enterprise is controlled by the other, or both enterprises
are controlled by a common third person. 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.

International Transaction: Section 92B provides a broad definition of an

international transaction, which is to be read with the definition of
transactions given in section 92F. An international transaction is essentially a
cross border transaction between associated enterprises in any sort of
property, whether tangible or intangible, or in the provision of services,
lending of money etc. At least one of the parties to the transaction must be a
non-resident. The definition also covers a transaction between two non-
residents where for example, one of them has a permanent establishment
whose income is taxable in India.
Sub-section (2), of section 92B extends the scope of the definition of
international transaction by providing that a transaction entered into with an
unrelated person shall be deemed to be a transaction with an associated
enterprise, if there exists a prior agreement in relation to the transaction
between such other person and the associated enterprise, or the terms of
the relevant transaction are determined by the associated enterprise.

Documentation: Section 92D provides that every person who has

undertaken an international taxation shall keep and maintain such
information and documents as specified by rules made by the Board. The
Board has also been empowered to specify by rules the period for which the
information and documents are required to be retained. The documentation
has been prescribed under Rule 10D. The documentation should be available
with the assessee by the specified date defined in section 92F and should be
retained for a period of 8 years.

Further, Section 92E provides that every person who has entered into an
international transaction during a previous year shall obtain a report from an
accountant and furnish such report on or before the specified date in the
prescribed form and manner. Rule 10E and form No. 3CEB have been notified
in this regard. The accountants report only requires furnishing of factual
information relating to the international transaction entered into, the arm’ s
length price determined by the assessee and the method applied in such
determination. It also requires an opinion as to whether the prescribed
documentation has been maintained.

Section 92CA provides that where an assessee has entered into an

international transaction in any previous year, the AO may, with the prior
approval of the Commissioner, refer the computation of arm’s length price in
relation to the said international transaction to a Transfer Pricing Officer. The
Transfer Pricing Officer, after giving the assessee an opportunity of being
heard and after making enquiries, shall determine the arm’s length price in
relation to the international transaction in accordance with sub-section (3) of
section 92C. The AO shall then compute the total income of the assessee
under sub-section (4) of section 92C having regard to the arm’s length price
determined by the Transfer Pricing Officer.

The Transfer Pricing Officer means a Joint Commissioner/Deputy

Commissioner/Assistant Commissioner authorized by the Board to perform
functions of an AO specified in section 92C & 92D.
The first provision to section 92 C(4) recognizes the commercial reality that
even when a transfer pricing adjustment is made under that sub-section the
amount represented by the adjustment would not actually have been
received in India or would have actually gone out of the country. Therefore
no deductions u/s 10A or 10B or under chapter VI-A shall be allowed in
respect of the amount of adjustment.

The second provision to section 92C(4) provides that where the total income
of an enterprise is computed by the AO on the basis of the arm’s length price
as computed by him, the income of the other associated enterprise shall not
be recomputed by reason of such determination of arm’s length price in the
case of the first mentioned enterprise, where the tax has been deducted or
such tax was deductible, even if not actually deducted under the provision of
chapter VIIB on the amount paid by the first enterprise to the other associate
enterprise.

Understanding Transfer Pricing Mechanism through the example of

a ABCIPL India

ABC Investment Private Limited(‘ABCIPL India’) engaged the services of the

firm to prepare the transfer pricing review memorandum (‘the
memorandum’) documenting the review of the arm’s length nature of its
international transactions with its AEs during FY 2009-10, from an Indian
transfer pricing perspective.

The firm prepared the memorandum in accordance with the Indian transfer
pricing provisions contained in sections 92 and 92A to 92F of the Act, read
with Rules 10A to 10E of the Rules. In reviewing the international
transactions useful inferences have been made from the OECD Guidelines
and Guidance Note.

ABC Investment Management Inc. (‘ABCIM Inc’), established in 1975, is a

wholly owned subsidiary of ABC & Co. It is an asset management company in
the mutual funds and funds management industry in the United States of
America. It provides customized asset management services and products to
governments, corporations, pension funds, non-profit organizations, high net
worth individuals and retail investors worldwide.

Section 92 of the Act requires that the income arising from an international
transaction shall be computed having regard to the arm’s length price. 1 To
prepare the memorandum, the firm interviewed ABCIM’s personnel and
1
reviewed various documents2 and financial data provided by the ABCIM. We
present below, the relevant details of the international transactions
undertaken between ABCIM and its AEs and the transfer pricing method
identified as the most appropriate method.

In the above example we find the detailed analysis of how transfer pricing
mechanism works in the company after comparing the arm’s length price
through the transactions it performs all throughout the world.

The basic transfer pricing mechanism is followed everywhere whereby the

selection of the appropriate method is of the utmost importance right at the
beginning.

The research process consisted of comparison of multiple year data. The

purpose of using multiple-year data is to ensure that the outcomes for the
relevant year are not unduly influenced by abnormal factors. In attempting
to determine an arm’s length outcome for international dealings between
associated enterprises, the results of any one-year may be distorted by
differences in economic or market conditions and the features and
operations of the enterprise affecting the controlled or uncontrolled dealings.
Participants in an industry may not be uniformly affected by business and
product cycles, and therefore differences between dealings may reflect
differences in circumstances, not the effects of non-arm’s length dealings.

The data of the two immediately preceding years gives a clear indication of
the business and economic conditions prevailing at the beginning of the
relevant financial year i.e. the time when the transfer prices were set up.

In applying multiple-year data, inferences have been drawn from the OECD
Guidelines on Transfer Pricing [Paras 1.49 to 1.51].

In view of the aforesaid, in our view, the use of a three-year comparable data
would assist in minimizing the impact of abnormal factors on the outcomes
of the comparable data so far as relevant because of their influence on the
determination of transfer prices.

The audited financial data for financial year 2008-09 in the case of several
comparables is not available in the public domain at the time of conducting
the comparables search. Thus, we have considered financial data for both
the earlier year’s i.e. financial years 2006-2007 and 2007-2008 as well
results for financial year 2008-09 where available.

2
In view of the above, we used the comparable data for FY 2008-09 and the
two previous years as it assist in minimizing the impact of abnormal factors
on the determination of the arm’s length prices. Moreover, for certain
comparable companies, their data for FY 2008-09 was not available in public
domain at the time of preparing the memorandum; therefore the usage of
comparable data only for the FY 2008-09 would have rendered the analysis
less reliable.

Conclusion

We compared the NCP that ABCP derived from its provision of investment
advisory services function to the arm’s-length results achieved by
independent companies that perform functions similar to those of ABCP. The
three-year weighted average NCP earned by broadly comparable
independent companies range from (-) 1.28 percent to 81.84 percent with an
arithmetical mean of 31.54 percent.

For the year ended FY 2008-09, ABCP earned an NCP of 40 percent, (Refer
Appendix B) which falls above the arithmetical mean of the NCPs of the
comparable companies.

Based thereon, ABCP’s international transaction with AEs related to the

provision of investment advisory services is consistent with the arm’s length
standard from an Indian transfer pricing regulations perspective.

Application of Research

The research process performed in this project is essential to understand the

transfer pricing mechanism and the selection and use of the appropriate
techniques for different companies across different sectors of the economy.

Documents of to be kept

Rule 10D has prescribed an illustrative list of information and documents and
the supporting documents required to be kept and maintained by the
assessee entering into an international transaction. However this mandatory
documentation requirement is applicable only in a case where the aggregate
value of the international transactions entered into by the assessee as
recorded in the books of account exceed one crore rupees. The information
and documents specified, should, as far as possible, be contemporaneous
and should exist latest by the specified date. The information and documents
specified shall be kept and maintained for a period of nine years from the
end of the relevant financial year.
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