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RESEARCH PROJECT
ON
TRANSFER PRICING
SUBMITTED BY

ASHISH SINGH

ROLL NO-18

B.COM. LL.B
7TH SEMESTER

OF

FACULTY OF LAW

DR. SHAKUNTALA MISRA NATIONAL REHABILITATION

UNIVERSITY, LUCKNOW
IN

NOVEMBER, 2018

UNDER THE GUIDANCE OF

ASST. PROF. VIJEETA DUA

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TABLE OF CONTENTS

ACKNOWLEDGEMENT........................................................................................................ 3

INTRODUCTION.....................................................................................................................4

OBJECTIVES OF TRANSFER PRICES..................................................................................5

TRANSFER PRICING MECHANISM IN BANKS...............................................................8

FUND TRANSFER PRICING (FTP).......................................................................................9
TRANSFER PRICING LAW IN INDIA................................................................................12

CONCLUSION.......................................................................................................................18

BIBLIOGRAPHY................................................................................................................... 19
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ACKNOWLEDGEMENT

Any project completed or done in isolation is unthinkable. This project, although prepared
by me, is a culmination of efforts of a lot of people. Firstly, I would like to thank our
teacher, Vijeeta Dua Maa'm for her valuable suggestions towards the making of this
project.

The contributions made by my classmates and friends are, definitely, worth

mentioning. I would like to express my gratitude towards the library staff for their help
also.

Last, but far from the least, I would express my gratitude towards the Almighty for
obvious reasons.

Thanking You
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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.
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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.
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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.
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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
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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.
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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.
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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.
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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.
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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
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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:

a. Comparable uncontrolled price method;

b Resale price method;

c. Cost plus method;

d. Profit split method or

e. Transactional net margin 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,
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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
 INTERNATIONAL TAXATION15

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
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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
1
computed having regard to the arm’s length price. To prepare the memorandum, the firm
interviewed ABCIM’s personnel and reviewed various documents 2 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

2
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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.

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.
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For the year ended FY 2008-09, ABCP earned an NCP of 40 percent, 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.
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