A Study On Transfer Pricing Accounting Essay

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The report is the documentation of the Course of Independent Study undertaken on Transfer Pricing. Transfer pricing is the mechanism of valuing goods and services traded between related companies so as to reduce the tax burden for the related companies taken together. The various goods and services which are covered under transfer pricing have been discussed through the course of the report. All the goods and services traded are supposed to be transferred at arm's length price. Almost all countries follow OECD norms in case of international taxation which deals with transfer pricing. OECD norms prescribe five major methods for arriving at a transfer price for a particular good or services being traded. Transfer pricing is of importance not only for income tax related purposes but also from the point of view of corporate governance where a publicly listed company trades with one of its related companies. The Income Tax Act, 1961 discusses transfer pricing under Section 92 to Section 92F where it has defined the concept of arm's length price, associate company and international transaction. It also specifies dispute resolution methodologies and penalties, in case of default. Additionally, there is a need for reconciliation between Income Tax Act, 1961 and Customs Act, 1962 which prescribe different methods to arrive at arm's length price for a related party transaction as it hampers trade which could be carried on smoothly instead.


Transfer Pricing is the mechanism adopted by multinational enterprises for valuing the goods and services traded with their Subsidiary or Associate Companies abroad so as to lower taxes and maximize profit (Government of India). As the pace of international trade has increased on account of globalization, it has become imperative to keep a close watch on inter-company (between subsidiary and associate companies) transactions. Inter-company transactions can be easily used to maximize profits in one country and reduce in the other by using artificial price for the goods and services transferred between the companies. There are a number of countries which can be considered as tax havens or tax shelters, and it would benefit a company to have maximum profits in those countries as against the country of operations. This would put considerable strain on the national treasury of the country with higher tax rates as all companies will route the transactions through tax havens or tax shelters.

A simple example below can show how transactions between two associate companies can inflate the profits in one country and reduce it in the other.

Consider a company A (operating in country X), which has two subsidiary companies B & C, operating in countries X and Y respectively. The tax rates in countries X and Y are considerably different from each other. The tax rate in country X is 35% of the profits, while that in country Y is 5% of the profits. Also, there is a dividend distribution tax of 14% in country X and 2% in country Y. Country X and Y have a tax avoidance agreement, such that a company can claim exemption from double taxation. Company A earns all its revenues from the dividends that the companies B and C. There is transfer of goods from company C to company B and the same goods are sold thereafter to the public. Let the goods be sold to the public in country X by company B at Rs. 500. Let the cost of goods in country Y for company C be Rs. 100. Now, company A would like to earn the maximum profit from this transaction after both income and dividend distribution tax. The figure on the next page will explain how the total profit for company A can be varied by changing the cost of goods that are transferred between company B and C. By varying the cost of goods and thus, profits for company B and C, the profits earned by company A change considerably.

Company B

Sales: Rs 500

Cost of Goods: Rs 500

Profits: Rs 0

Tax @ 35%: Rs 0

Dividend: Rs 0

Dividend tax @ 14%: Rs 0

Effective Dividend: Rs 0

Company C

Sales: Rs 500

Cost of Goods: Rs 100

Profits: Rs 400

Tax @ 5%: Rs 20

Dividend: Rs 380

Dividend tax @ 2%: Rs 7.6

Effective Dividend: Rs 372.4

Transfer Price: Rs 500

Company A

Total Profits in Rs



Company B

Sales: Rs 500

Cost of Goods: Rs 200

Profits: Rs 300

Tax @ 35%: Rs 105

Dividend: Rs 195

Dividend tax @ 14%: Rs 27.3

Effective Dividend: Rs 167.7

Company C

Sales: Rs 200

Cost of Goods: Rs 100

Profits: Rs 100

Tax @ 5%: Rs 5

Dividend: Rs 95

Dividend tax @ 2%: Rs 1.9

Effective Dividend: Rs 93.1

Transfer Price: Rs 200

Scenario 1

Scenario 2

Thus, we see that by changing the transfer price for the transfer of goods between company B and C, the profits for company A change from Rs. 260.8 to Rs. 372.4. By the economic philosophy that more is always better than less, company A would always prefer to have scenario 1 over scenario 2. The price of Rs. 500 for transfer of goods between company B and C is 'arbitrary' and 'dictated' as opposed to free market price which would have existed had the companies been unrelated.

To avoid this, the income tax legislations in various countries specify rules for international transactions between subsidiary and associate companies. Almost all countries which have adopted the transfer pricing rules specify that transactions between subsidiary or associate companies should take place at 'arm's length price'. Arm's length price is the price at which two totally unrelated parties will carry out a transaction for transfer of goods or services. In the example cited previously, had company B and C been unrelated companies, the transaction would have closely replicated scenario 2 and Rs. 200 could be called as the arm's length price. Income tax legislations across countries will specify that the transaction has to go through at Rs. 200 as opposed to Rs. 500 as Rs. 200 signifies the arm's length price for the transaction.

Throughout the discussion above, the focus of transfer pricing has mainly been on transfer of goods, but a number of aspects of business services between subsidiary companies attract transfer pricing provisions. These aspects may go ignored by the companies and attract penalties from the income tax authorities during assessment. They include, but not restricted to matters related to intellectual property rights, treasury management, sale of existing machinery and equipment, provision of services provided by employees of a particular subsidiary to the parent company, shareholder services, marketing related payments, etc. A detailed discussion regarding the aspects mentioned above will be done in the next section.

Applicability of Transfer Pricing [1] 

Transfer pricing is applicable for any transaction that takes place between subsidiary or associate company. The definition of subsidiary and associate company varies across countries depending on the legislation in that particular country. Transactions between subsidiaries and associate companies can take place through transfer of tangible and intangible property, provision of services from one subsidiary through other through human capital exchange, financing, rental and leasing arrangements, etc. For instance, a company might receive management services through an e-mail from an employee in the subsidiary company. Ideally, a service has been performed by the subsidiary company and a transaction has taken place for transfer pricing purposes but in the real world situations, such services might be ignored for transfer pricing purposes. As opposed, if an employee is deputed to work in an associate company, the associate company is expected to compensate the other company for the services provided through the employee. Again, the compensation will be determined in accordance to the principal of 'arm's length pricing'. The various aspects which might invite transfer pricing provisions are discussed below.

Sale of Tangible Goods

Sale or transfer of tangible goods is mostly in terms of machinery, equipment or inventory. A parent company may transfer machinery and equipment to its affiliates, which it has bought from unrelated parties or is used and no longer necessary for the parent company. Tax rules specify that the transfer of this machinery should be at arm's length price, which would translate to a fair market price of the equipment. Sale of machinery and equipment might arise also due to restructuring process, where assets are relocated across subsidiaries. Aspects such as tax implications arising out of bundling assets, related liabilities and goodwill or intangibles as against piecewise transfer of plant and machinery have to be given due consideration during transfer of fixed assets. Sale of inventory would include sale of raw materials, work in progress and finished goods. In these cases, arm's length pricing would reflect the cost of comparable goods in free market conditions. It is easy for the company to foresee an applicability of transfer pricing provisions for sale or transfer of tangible goods given the nature of goods.

Sale of Intangible Goods

In transfer pricing, transfer of services or rights from a company to its subsidiary or an associate would constitute as sale of intangible goods. Taking Hindustan Unilever as an example, it would be easy to explain sale or transfer of intangible rights. Hindustan Unilever has to pay royalty for using Unilever plc's trademark license, technology license and central service agreement. Unilever plc is transferring an intangible in form of licenses and service agreements to its subsidiary company, Hindustan Unilever. Thus, the agreement is likely to attract transfer pricing provisions, both in India as well as United Kingdom, where its parent company is located. Intangibles can be transferred in the following four ways from a company to its subsidiary or its associate:

Outright sale

Transfer without remuneration (Not considered by tax authorities as a legal transaction expect in special circumstances)

Transfer of license with royalty as a consideration

Royalty free transfer of license (Again, not considered by tax authorities)

Intangible transfer can also be broadly classified into manufacturing intangibles and marketing intangibles. Patents and technical know-how form the bulk of manufacturing intangibles that would attract transfer pricing regulations. A company may transfer its patent to one of its subsidiary or associate companies, thereby giving them the right to manufacture a particular good in other country. Patents form a barrier for entry for the manufacture of the particular product, and thus, more often than not a monopolistic situation. The degree of monopoly power which is transferred to the affiliated company is used to determine the arm's length price for transfer of this manufacturing intangible in form of patents. Technical know-how, when transferred between unrelated parties attracts consultation charges or royalty fees. It is difficult to detect and then value transfer of technical know-how from a company to one of its affiliates in business operations. Unilever plc's transfer of technology license to Hindustan Unilever would constitute transfer of manufacturing intangibles between subsidiary & associate companies.

Marketing intangibles will constitute, but not restricted to permission for the use of trademarks and logos, etc. As discussed previously in the same section, Hindustan Unilever uses the same logo as Unilever plc, its parent company. Thus, a subsidiary or an affiliate company has the right to use the parent company's logo, resulting in a transfer of marketing intangible. Also, the central services agreement between Hindustan Unilever and Unilever constitutes a transfer of marketing intangible. It is difficult to find the arm's length price for marketing intangibles as a trademark or a logo might have no value when the product is first introduced in a market. In addition to transfer of trademark and logo, existence of developed sales force and ability to provide service and training to customers would also entail transfer of marketing intangibles between associate and subsidiary companies.

Manufacturing and marketing intangible transfers cannot into as two isolated transfers between associate companies. A case of Apple Inc, could easily explain why the two cannot be looked as isolated transfers. Apple's corporate reputation is a result of the company historically producing high quality products such as Macintosh. Thus, corporate reputation i.e. marketing intangible has risen out of Apple manufacturing products which were "leading edge" in the industry, which forms a part of manufacturing intangible. Another case could be that of software developed by a parent company being used by one of its subsidiaries. Arm's length price should be paid by the subsidiary to its parent company so that transfer pricing regulations are satisfied in both the countries of operation.

Thus, we have seen that transfer of intangibles could include a wide range of transfers like trademark and logo to corporate reputation arising out of superior products. The arm's length price to be associated with such transactions is a relatively tricky art. The arm's length price associated with such transactions is more likely to be contested by tax authorities as opposed to transfer of tangible goods.

Transfer of Services

A number of services in form of human capital exchange are provided by related to each other. Services provided range from accounting to taxation, or technical assistance on a complex operation undertaken. Generally, the parent company pools services like legal assistance and treasury for all the subsidiary companies, even if they are operating in different countries. The company that avails the services, the subsidiary in this case has to pay a service fee to the parent company. As the services have been transferred between related companies, it attracts transfer pricing regulations and the service fee should closely reflect the arm's length price for that particular service. In the country where the service has been availed, the company can deduct the expense for tax benefit only if it can prove that the service was directly beneficial for the company. There are 5 types of services defined under PwC's International transfer pricing 2012:

Routine services such as tax, legal and accounting aid are included in this type of transfer of service. There is no intangible transfer in such cases. The arm's length price is computed by cost plus methodology, the plus element varying with the type of service and the value added by the same. While some countries allow the reimbursement of the 'plus' component, certain others do not allow profits to be included to get tax deductions.

When technical assistance is provided in addition to the transfer of an intangible between related companies, a service is said to be transferred between them. Typically, a certain amount of assistance is allowed to be provided in case of intangible transfer, but if the service is in excess of the same, it has to be done at an extra cost in accordance to the arm's length philosophy.

The transfer of technical service, which is independent of any transfer of intangibles between related companies have to be paid for on an arm's length basis.

When certain employees are deputed from the parent company to work at a new facility (subsidiary in a different country), the tax authorities might consider it as a transfer of intangibles between the parent company and the subsidiary. The tax authorities might force the parent company to add royalty in accordance to the arm's length principle for the transfer of intangibles between the companies. The intangibles in this case as defined by tax authorities would be knowledge and technical know-how.

The tax authorities while assessing a parent company might force it to lower the profits of its offshore affiliates by claiming that offshore affiliates require service in form of expertise to manage its affairs, including determining its strategy up to an certain extent.

In case of transfer of services, it is imperative to categorize services as stewardship services or beneficial services. As a parent company, if the company undertakes certain activities for its benefit as a shareholder of the subsidiary, then no service charge can be invoked for the same. Duplicate reviews or activities already undertaken by the subsidiary, general review of subsidiary's performance, report and meeting requirements as majority shareholder, cost of financing or refinancing ownership of subsidiary, etc. are services which can be categorized as stewardship services and no charge can be invoked on the subsidiary company by the parent company. In contrast, services like preparing operations plans, providing legal aid for compliance with legal and tax norms of subsidiary's home country, conducting internal audit of subsidiary are beneficial services provided to the subsidiary. These beneficial services ought to be charged in accordance to the arm's length principle by the parent company.

Financing Transactions

The concept of transfer pricing arises when a particular company funds long or short term fund requirements for any of its related companies in form of a loan or other funding techniques. If a related company pumps in additional equity into a company, transfer pricing provisions would not be invoked. Tax authorities in different countries will treat the transaction differently. While the tax authorities in the country of the borrower company will reason for a lower rate of interest, the tax authorities in the company funding the debt will argue for a higher interest rate. The factors which can be considered relevant to related party debt are:

Rate of interest for the issued debt

The capital amount of debt

Currency in which debt is issued

The credit worthiness of the borrower

The tax authorities would consider the debt to equity ratio, interest rate prevailing in the country due to monetary guidelines and if an unrelated party will be willing to fund the entity or not to fix the arm's length price i.e. interest rate for the transaction. Financing transactions can be broadly categorized as shown below:

Financing of short term capital needs

Financing of long term capital needs

Mortgages: Purchase of land through payment spread over a period of time

Lease financing: Leasing of capital goods like machinery

Capital Stock: The parent company might purchase capital stock for the subsidiary company

Inter-company loans

Guarantying of bank loans: The parent guarantees the bank loan undertaken by the subsidiary operating in another country

Additionally, intercompany payables and receivables due for a long duration will also get categorized as loans depending on the legislation prevalent in the country. Cost sharing of R&D activities undertaken by related company will also come under the purview of financing transactions.

The discussion above focused on the application of transfer pricing legislations to various transactions that are undertaken by related companies. In all the above cases, the focus of discussion was that the transaction should take place at arm's length price as determined by the company and tax authorities. The Organization for Economic Co-operation and Development (OECD) has published guidelines with regards to arriving at an arm's length price in related party transactions which are discussed in the next chapter.

OECD Guidelines on Arm's Length Pricing

Organization for Economic Co-operation and Development was established in 1961 to establish policies within member countries which would maintain high and sound economic growth and contribute to world trade through multilateral, non-discriminatory basis. OECD provides a general guidance on transfer pricing. These guidelines were first issued in 1979 and subsequently reviewed in 1995 and 2010. The concept of arm's length price is explained in article 9 of OECD Model Tax Convention. The OECD Guidelines provide various methods which can be used to arrive at an arm's length price for a related party transaction. The methods are discussed below.

Comparable Uncontrolled Price Method

This is the most direct way of determining the arm's length price. In this method the price charged for goods and services in a comparable uncontrolled transaction or a few transactions identified will be used as the arm's length price after adjusting for any differences. The adjustment shall take into account any difference between the related party transaction and the comparable uncontrolled transaction or the enterprises entering into such transactions which can affect the price in the open market.

The uncontrolled transaction should be a transaction between independent enterprises and should have goods or services of a similar type, quality and quantity as of the transaction between the associated enterprises. The circumstance of the sale and the terms and conditions should also be similar.

If the differences between the transactions can be valued and has a reasonably small effect on the transaction, then the adjustments can be easily made. Adjustments can be made on differences like terms of transaction, volume of sales and timing of transaction. It is difficult to make adjustments if there are differences in the quality of product, geographical market, level of the market and the amount and type of intangible property involved in the sale.

Resale Price Method

In this method the arm's length price is determined by discounting the actual resale price for the activities of the reseller. The discount made will include the gross profit margin accruing to the enterprise or to an unrelated enterprise from the purchase and resale of same or similar goods or services in a comparable uncontrolled transaction in the relevant market. This price shall be reduced further by the expenses incurred in the purchase of goods or services. Further adjustments would be made to take into account any differences between the related party transaction and the comparable uncontrolled transactions or between the enterprises entering into such transactions, which could affect the gross profit margin in the open market.

This method is usually used when there is little or no value addition before the resale of the finished products or the other goods acquired from related parties. There can be problems in obtaining comparable data especially when there is a time gap between the comparable transaction and the one reviewed as economic factors like interest rates, exchange rates etc can cause significant distortions.

Cost Plus Method

In this method the arm's length price is determined by adding a suitable mark up to the cost of producing the goods or service. The amount of mark up is determined from similar transactions made by the enterprise or an unrelated enterprise in a comparable uncontrolled transaction. It should be ensures that the total cost base of the comparable transaction should be similar to the cost base of the transaction to which the mark up is applied. A comparison of the accounting policies of both the enterprises should be performed to identify any mismatches in expense classification between the cost of goods sold and administrative expenses.

While determining the mark up to be applied for a contract manufacturer, the goods transferred under the transactions compared need not be physically similar as the contract manufacturer is compensated for the service provided by him. But for full fledged manufacturers the mark ups vary considerably from one product to another.

This method is mainly used when uncontrolled price for a transaction is not available or where there are long term buy and supply arrangements. This is also used in case of provision of services or contract manufacturing.

Profit Split Method

In this method arm's length price is arrived at by splitting the combined net profits of the related parties arising from the transaction. This combined net profit will be allocated to each related party on the basis of returns comparable transactions by independent enterprises. As this data is rarely available, the profit split is done on the basis of their relative contribution to the combined net profit. This relative contribution will be evaluated on the basis of the functions performed, tangible and intangible assets employed or to be employed and risks assumed by each enterprise.

Here it is necessary to compute the costs and revenues of each related party in this transaction. It should also be noted that the profit split analysis is usually performed at the operating income level and non-operating income should be excluded from the analysis.

This method is used in transactions where both related parties make unique and valuable contributions to the transaction. It is also used in transactions where integrated services are provided by more than one enterprise and in the case of multiple inter-related transactions which cannot be evaluated separately.

Transactional Net Margin Method

In this method the net profit margin of the related party transaction is calculated relative to a base such as cost incurred or sales or assets employed or to be employed by the enterprise or any other relevant base. The net profit margin from a comparable uncontrolled transaction is computed to a relevant base and it is adjusted to account the differences, between the transactions or the enterprises entering into transaction, which can affect the profit margin in open market. This profit markup is added to the cost of production to get the arm's length price.

This method is used in the case of transfer of semi furnished goods or distribution of finished products where resale price method cannot be used.

Berry ratio compared to return on sales

ROS is the primary profit level indicator applied to distribution operations to evaluate the transfer pricing mechanism. Berry ratio looks at the gross profitability of an activity and the operating expenses needed to carry out the activity. It is the ratio between gross profit and operating expenses.

When a company has done the R&D and manufacturing of a product and a related entity is doing the sales. Here the mark up the distributor earns on selling, and general and administrative expenses which it incurs while providing sales has to be determined. The berry ratio is used to mark up the general and administrative costs the distributor incurs in the related party transaction.

Berry ratio can be easily used as the size of the distributor used as comparable is not an issue. It is used when the distribution activity is a provision of service to the manufacturer and consists of a limited range of functions and risks. But ROS can be used to better evaluate distributors that operate with a higher degree of independence or that perform value addition activities along with resale of the goods.

Return on Assets

As return on equity is difficult to use in an inter-company pricing framework, return on assets is used as a substitute. ROA is usually used as a profit level indicator as part of transactional net margin and cost plus method analysis. This is mainly used in manufacturing activities and when the assets used in the manufacturing activity is difficult to define, return on net book value of all assets is used. Usually operating income before interest and tax is used as numerator and net book value of all assets on the balance sheet which are utilized in the manufacturing activity, excluding financial and non-operating assets is used as denominator.

The age of the plant and equipment should also be considered while comparing the ROA in a related party transaction with that of an independent company transaction.

Corporate Governance

Corporate Governance is defined by OECD as "The system by which business corporations are directed and controlled. The corporate governance structure specifies the distribution of rights and responsibilities among different participants in the corporation, such as the board, managers, shareholders and other stakeholders, and spells out the rules and procedures for making decisions on corporate affairs" In transfer pricing corporate governance has a significant social and economic impact in ensuring accountability in equitable distribution of wealth. It is implemented not only at the corporate level of an enterprise, but also at the divisional level, determining the interaction between divisions, and at the level of individual managers who are the decision makers.

Transfer pricing will influence the manner in which the profits of a multinational are distributed across the various countries in which they are operating. Tax compliance in this regard will also increase the shareholder value as it avoids double taxation and penalties.

Transfer pricing can help in aligning the interests of the various business units involved as well as the interests of the people who work for the units with that of the corporate goals. Divisional profits will be influenced by transfer pricing and this can help in performing a better evaluation of the divisions involved as well as the performance evaluation of the mangers. If the pricing decision is moved to the corporate level, the control of the divisional manager on the divisional profit is lost and this will reflect on his performance measure as well.

While designing the transfer pricing policy an organization must align the interests of the various stakeholders involved like the internal stakeholders of the organization and the external stakeholders such as shareholders and tax authorities.

Legislation in India [2] 

The sections 92 to 92F of the Indian Income Tax Act, 1961 provides a separate code on transfer pricing and covers intra group cross border transactions. The code describes the various transfer pricing methods, enforces requirements for annual transfer pricing documentation, and also mentions the penalty for noncompliance. These regulations which are applicable from April 1st, 2001 are broadly based on the OECD guidelines. After the introduction of this code, transfer pricing has become the most important international tax issue affecting multinational companies operating in India.

A summary of these legal provisions is given below: [3] 


What it provides


Computation of Income from International transactions involving transfer pricing having regard to ''Arm's length price'' 


Meaning of ''Associated Enterprise''


Meaning of ''International Transaction''


Computation of ''Arm's Length Price''


Reference to Transfer Pricing Officer


Maintenance of Documents and Information


Requirement of Audit Report


Important Definitions.


Adjustment to income on account of Transfer Pricing Provisions to be regarded as concealed Income.


Penalty for failure to keep and maintain information and documents


Penalty for failure to furnish Audit Report


Penalty for failure to furnish information or documents


What it Provides 


Meaning of expression used in computation of ''Arm's Length Price''


Determination of ''Arm's Length Price' under section 92C


Most Appropriate Method


Information and Documents to be kept and maintained under section 92D


Report from an Accountant to be furnished under section 92E

According to the Indian Transfer Pricing Code the income arising from the "international transactions" between "associated enterprises" should be computed at "arm's-length price". The allowance for any expense or interest arising from an international transaction will also be determined having regard to the arm's-length price.

Arm's Length Price

Arm's length price is defined as a price, which is applied in a transaction between persons other than associated enterprises, in uncontrolled conditions. The arm's length price is determined by any of the following methods based on the nature of transaction or class of transaction or class of associated persons or functions performed by such persons or other relevant factors.

comparable uncontrolled price method;

resale price method;

cost plus method;

profit split method;

transactional net margin method;

Any other method prescribed by the Board.

Associate Enterprises

Associated Enterprises have been defined to cover those having direct/indirect participation in the management, control or capital of one enterprise by another enterprise. Two enterprises shall be deemed to be associated enterprises if, at any time during the previous year there is

Direct or Indirect holding of shares carrying not less than 26% of voting power in one enterprise by the other.

Direct or Indirect holding of shares carrying not less than 26% of voting power by one person or enterprise in each of such enterprise.

Advancement of loan by an enterprise to the other enterprise constitutes not less than 51% of the book value of the assets of the borrowing enterprise.

Guarantee for not less than 10% of the total borrowings of one enterprise by the other

Appointment of more than half of the board of directors or members of the governing board, or one or more executive directors or executive members of the governing board of one enterprise is done by the other enterprise.

Appointment of more than half of the board of directors or members of the governing board, or one or more executive directors or executive members of the governing board of both the enterprises are done by the same person.

Complete dependence on the use of know-how, patents, copyrights, trade-marks, licenses, franchises or any other business or commercial rights of similar nature, or any data, documentation, drawing or specification relating to any patent, invention, model, design, secret formula or process of one enterprise for the manufacture or processing of goods or articles or business carried out by the other enterprise.

Purchase of 90% or more of the raw materials and consumables required for the manufacture or processing of goods or articles carried out by one enterprise, are supplied by the other enterprise, or by persons specified by the other enterprise, and the prices and other conditions relating to the supply are influenced by the other enterprise.

Sale of goods or articles manufactured or processed by one enterprise to the other enterprise or to persons specified by the other enterprise, and the prices and other conditions relating thereto are influenced by the other enterprise.

Control of one enterprise by an individual and the other enterprise is also controlled by such individual or his relative or jointly by such individual and relative of such individual.

Control of one enterprise by a Hindu undivided family and the other enterprise is also controlled by a member of such Hindu undivided family or by a relative of a member of such Hindu undivided family or jointly by such member and his relative.

Holding of not less than 10% interest by one enterprise in the other enterprise which is a firm, association of persons or body of individuals.

Existence of mutual interest between the two enterprises.

A transaction between an enterprise and a third party can also be considered as a transaction between associated enterprises if there is a prior agreement between the two parties or if the terms of such transactions are determined in substance between them. This clause will counter any move to avoid transfer pricing regulation by using a third party during transactions between two associated enterprises.

International Transactions

International transaction is defined to mean a transaction between two (or more) associated enterprises, either or both of whom are non-residents, which has a bearing on the profits, income, losses or assets of such enterprises. The transaction can involve sale, purchase or lease of tangible or intangible property, provision of services, lending or borrowing money etc.

Documentation regarding the international transactions between associated enterprises has to be maintained by the taxpayer on an annual basis. The documentation requirements has two parts

The mandatory documents/information that a taxpayer must maintain comes under the first part. This list includes information on the ownership structure of the taxpayer, group profile, business overview of the taxpayer and AEs, prescribed details of international transactions and relevant financial forecasts/estimates of the taxpayer. A comprehensive transfer pricing study including the functions performed, risks assumed, assets employed, details of relevant uncontrolled transactions, comparability analysis, benchmarking studies, assumptions, policies, details of adjustments and explanations as to the selection of the most appropriate transfer pricing method should also be documented.

The second part requires the maintenance of adequate documentation to substantiate the information/analysis documented under the first part of the rule. It also contains a list of recommended supporting documents like government publications, reports, studies, technical publications/market research studies undertaken by reputable institutions, price publications, relevant agreements, contracts, and correspondence.

If the aggregate international transaction of a taxpayer is less than Rs.10 million, then the taxpayer is relieved from maintaining the documentation. But adequate documents to substantiate the arm's length price of the international transactions have to be maintained.


Stringent penalties have been laid down for violating the transfer pricing code.

2% of transaction value for failure to maintain the prescribed information/documentation.

2% of transaction value for failure to furnish information/documentation during the audit.

100% to 300% of the total tax on the adjustment amount for adjustment to taxpayer's income.

Rs.100,000 for failure to furnish an accountant's report.

Advance Pricing Agreement

With a view to reduce transfer pricing tax disputes, the government of India has introduced the Advance Pricing Agreement (APA) rule through the Finance Act 2012. This rule will allow companies to seek guidance on the pricing of the goods and services in advance for a set of international transactions on a suitable transfer pricing technique. The taxpayer can enter into an agreement for multiple years with the tax authority (Central Board of Direct Taxes in India).

By entering into an agreement the Associated enterprises can be certain about the tax risks and can organize the risk exposure in a better way. Through APA, the tax authority agrees not to look for transfer pricing adjustments for the transactions covered under the agreement as long as the taxpayers abides by the terms and conditions in the APA. APAs can be unilateral, bilateral or multilateral based on the number of taxpayers and tax authorities joined by the agreement.

APA will not be binding on the Board or the taxpayer. If there is any change in the factors and assumptions that are critical to the APA, neither party entering into the agreement will be bound by the agreement. Revision of the APA is possible if there is a change in law or a change in critical assumption or a request from a competent authority of another country in case of bilateral and multilateral agreements. The Board can also cancel the APA if the annual compliance report is not filed on time or if the report filed contains material error.

To enter into and APA, the tax payer has to pay Rs.10 lakh for international transactions up to Rs.100 crore, Rs.15 lakhs for transactions up to Rs.200 crore and Rs.20 lakh for transactions above Rs.200 crore. APA can also provide various profits as they reduce the possibility of risks and assists reporting of possible tax liabilities. It can also decrease the cases of double taxation, the cost involved in transfer pricing documentation and audit defense.

As APA is an excellent controversy management tool, many countries with specific transfer pricing regulations provide an option for APA.

Transfer pricing and Customs valuation: Need for Rationalization

Any international transaction is subjected to indirect tax through customs, sales or value added tax to determine the duty payable on the goods imported. If the goods are transferred between related parties, then the transfer price should be determined giving consideration to both: corporate income tax-recompressions and customs implications. The conflicting objectives of the income tax and customs departments leads to the need for rationalization of laws under which arm's length price is arrived at for customs and income tax valuation. To increase the revenues of their departments, custom officials would like the arm's length price of good to be as high as possible while it is the vice versa for income tax officials.

Customs Valuation

In India, customs are governed under Customs Act, 1962. The value of a good is discussed under Section 14 of Chapter 5 (Levy of and exemption from Custom Duties) in Customs Act, 1962. Section 14 of Customs Act, 1962 defines the value of good to be the transactional value, such that the transaction has taken place between unrelated parties i.e. arm's length price. The provisions of Section 14 apply for valuation and the rules under which valuation has to take place are defined by The Customs Valuation (Determination of Price of Imported Goods) Rules, 1988. The Customs Valuation Rules are an outcome of the Tokyo Round, 1973-79 of GATT (presently WTO) discussions which developed the Agreement on Customs Valuation (ACV). [4] The WTO mandates the use of ACV for all its members and as India is a member of WTO, the valuation under The Customs Valuation Rules, 1988 follow the same principle of valuation as the ACV.

Income Tax Valuation

The sections 92 to 92F of the Indian Income Tax Act, 1961 provides a separate code on transfer pricing and covers intra group cross border transactions. The code describes the various transfer pricing methods, enforces requirements for annual transfer pricing documentation, and also mentions the penalty for noncompliance. These regulations which are applicable from April 1st, 2001 are broadly based on the OECD guidelines. After the introduction of this code, transfer pricing has become the most important international tax issue affecting multinational companies operating in India. [5] 

Similarities and Dissimilarities between Income Tax and Customs Valuation

The founding principle for income tax and customs valuation in determining the transfer price is the same: the price established for the goods should be the same had the transaction taken place between unrelated parties but there are certain differences which stand out when we compare arm's length valuation of the good under Income Tax Act and Customs Act. The Income Tax Act prescribes determination of the arm's length price by first determining the most appropriate method between the following: comparable uncontrolled price method, resale price method, cost plus method, profit split method, transactional net margin method or any such other method as may be prescribed by the Board. If more than one method can be considered appropriate, then the arithmetic sum of the price found by each method will be chosen to be the arm's length price. The Customs Act contrastingly follows a sequential process in determining the arm's length price. Under Customs Act, the arm's length is determined by the method which is appropriate in the following sequence: transaction value of identical goods, transaction value of similar goods, deductive value, computed value and residual value. So, if the arm's length price of goods is determined under transaction value of identical goods, it will not be subjected to deductive, computed and residual valuation. Under Income Tax Act, even if the price of good is identified under comparable uncontrolled price method (which is identical to transaction value of identical goods), if a different valuation is found under cost plus or profit split method, then the arithmetic mean of the prices will be determined as the transaction price. Additionally, under Income Tax Act, if the arm's length price so determined is within 5% of the actual international transaction price, then the transaction value will be used to determine the taxable income. There is no such provision under Customs Act. Also, owing to the above factors, the valuation of the imported good by custom officials and income tax officials might vary significantly. To increase the revenues of their departments, while custom officials would like the arm's length price to be as high as possible, income tax officials would prefer it to be as low as possible. Also, companies are put at a significant risk as custom valuation takes place when goods are imported while income tax officials asses the company around 2-3 years after the end of a financial year. If on account of transfer pricing adjustments, the value of the imported good is altered, then there is likely hood of proceedings from the customs special valuation or special investigation branch proceedings being triggered. [6] Recently, in September 2012, the Finance Ministry notified the "Advance Pricing Agreement (APA) Scheme" under which any party could get into an agreement with Central Board of Direct Taxes (CBDT) which would fix the transfer price well in advance. So, the problem of customs special valuation and special investigation branch proceedings being triggered may well be a thing of the past.

Furthermore, the database used for zeroing in on arm's length price differs for both the Boards, though they come under the same ministry. Directorate General of Valuation, under the Central Board of Excise & Customs has developed its own database: National Imports Database (NIDB), Export Community Database (ECB) and Central Excise Database (CEDB). Income tax officials use 'Prowess' or 'CapitalLine' database to arrive at an arm's length price. [7] Though, fundamentally the values obtained via both the databases should be same, more often than not there is a likelihood of discrepancies between the two values.

Income Tax Act, 1961

Customs Act, 1962

Comparable Uncontrolled Price Method

Transaction Value of Similar / Identical Goods

Resale Price Method

Deductive Value Method

Cost Plus Method

Computed Value Method

Profit Split Method


Transaction Net Margin Method


Table: Similarity of methods for valuation as prescribed under Income Tax and Customs Act

Comparable Uncontrolled Price Method

Transaction Value of Similar / Identical Goods


This method compares the amount charged by uncontrolled transactions between unrelated companies with that of transactions within related companies

This method compares the FOB of the importer with of similar or identical goods with FOB of import by unrelated parties.


The country of origin need not be the same.

The country of origin should be the same.

The adjustments to price allowed are liberal.

The adjustments allowed need to be precise and accurate, clearly establishing reasonableness and accuracy of the adjustment.

Table: Comparison between CUP and TVS/TVI [8] 

Resale Price Method

Deductive Value Method


The cost incurred from import to sale is allowed to be deducted as expense.

Loading value is arrived at by deducting profits, general expenses, duties and taxes.

The method focuses on comparability of functions involved as the emphasis on comparability of goods has reduced.

The emphasis is on the costs incurred in carrying out similar functions for goods produced by a particular industry sector.


Costs which are not included in operating costs are not allowed for income tax deductions.

There is no stipulation on deducting costs which do not form a part of operating expense.

There is no stipulated comparison time validity for data.

The time for comparable data is 90 days from the date of import.

There is no clarity on addition of intangibles and is left to the discretion of the assessing officer.

There is clarity on addition of intangibles. If intangibles are payable as 'condition for sale', then it can be added as an expense.

Table: Comparison between RSM and DVM [9] 

Cost Plus Method

Computed Value Method


Transfer Price includes all cost of production with an addition of gross profit.

Costs are determined on the basis of accounting practices

Gross Profit percentage is determined using comparable data

Table: Comparison between CPM and CVM [10] 

Problems Faced by Trade

Companies have internal transfer pricing policies which help in establishing arm's length pricing in related party transactions. For goods that attract custom duties, companies have to actively set policies which will result in meeting the requirements of custom authorities in the country of import and create an opportunity for tax and custom officials to accept their arm's length price without prejudice to each other. Companies also face problem due to exchange rate fluctuations while determining the arm's length price for custom and income tax valuation. Customs valuation takes place at the time of import while for income tax purposes, the valuation will take place at a later stage, and generally around 2-3 years after the returns have been filed. A retrospective price adjustment might involve re-assessment by customs officials and subsequent proceedings being initiated against the company. Also, as transfer price has to be established for both, customs and income tax separately, a company ends up spending additional money to achieve the same goal of setting an arm's length price which would be acceptable. There is no clarity with regards to the difference in documentation required to establish an arm's length price but since the focus of custom officials is per unit price of imported goods, while that of income tax department is overall taxable income of importer or exporter, it is bound to be different.

Government Action

The Government of India, through an order in May, 2007 implemented a recommendation of a Joint Working Group which was formed for better co-ordination between customs and income tax officials while arriving at an arm's length price. The committee was of the opinion that co-operation and co-ordination between the two departments on transfer pricing is extremely essential. They proposed that there be bi-monthly meetings at regional level in metro cities between income tax and customs departments. In addition, there will be a meeting every 6 months between Director General of Transfer Pricing, Director General of Valuation and the Chief Commissioners of Customs. In these meetings, the two departments will exchange of information in specific cases. In addition, the Joint Working Committee proposed that National Academy of Direct Taxes (NADT) and National Academy of Customs, Excise and Narcotics (NACEN) shall develop and organize training programmes on transfer pricing. This can be considered as the first step towards addressing transfer pricing issues between the two departments in a harmonious manner. Even though the two departments have agreed for joint meetings and have shown intent to arrive at a consensus for transfer pricing, they are no legally bound to co-operate with each other and fix on a particular arm's length price. Transfer pricing officers, in past have expressed a view that price accepted by other officers may not be conclusive in determining the arm's length price for a particular transaction. [11] 

Suggestions for Harmonisation

As we have seen that customs and income tax officers differ on their valuation guidelines for determining the arm's length price. In order to counter the same, Indian entities have to undertake separate paperwork for customs and income tax to determine the transfer price. In case there is difference between the same, the entity might end up paying either additional income tax or customs duty on importing a particular good. The first level of harmonisation could include thawing out the dissimilarities that exist in prescribed valuation methods.

Comparable Uncontrolled Pricing Method and Transaction Value of Similar / Identical Goods

The dissimilarity can be reduced by making requirements for adjustments more stringent under income tax law. While adjustments are arbitrary and liberally applied in CUP, in TVS/TVI, adjustments can only be made on the basis of demonstrable evidence. Also, for customs valuation for similar or identical goods, the country of origin of comparable goods should be same. This clause, we believe can be done away with as countries are converging towards a single global price of products.

Resale Price Method and Deductive Value Method

Treatment to intangibles is the main difference between valuation using the above two methods. Since, there is clarity of 'condition for sale' for intangibles to be addable using deductive value method (customs valuation), while in resale price method (income tax valuation) the treatment to intangibles is arbitrary, we suggest that valuation using resale price method adopt 'condition for sale' principles to add intangibles.

Cost Plus Method and Computed Value Method

These are the easiest to harmonise as there exist very little dissimilarities between the two methods of valuation to arrive at arm's length price.

Harmonisation through APAs

The newly introduced APAs have legal validation only for income tax officials and the customs officers may only use it as a guideline to determine the appropriate transfer price. Since, both the bodies report to the revenue department, we propose that there be a central body for valuation under the revenue department which consists of officers from Special Valuation Branch (SVB), Customs and Directorate of Transfer Pricing (DTP) to establish the arm's length price. Instead of APAs with CBDT, there could be APAs with this central body for valuation which would be legally binding on the income tax officials as well as customs officials. The streamlining of process will be a big benefit for the companies towards a single window to fix the transfer price.


We would like to thank our guide, Prof. V. Gopal for helping us through the course of our Course of Independent Study. His invaluable suggestions, giving us directions at every step were of great help, particularly in the need for rationalization in Customs and Income Tax Acts on transfer pricing. We would also like to thank IIM Trichy for providing us with resources for this study, without which this study would not have been possible.