Transfer Pricing
Transfer Pricing
Meaning:-
Transfer pricing is an accounting practice that represents the price that one
division in a company charges another division for goods and services
provided. For example, for a company ABC, entity A manufactures and sells
wheels, and entity B assembles and sells bicycles. A may, through intra
company transactions, sell wheels to entity B. the price at which A sells to B is
called transfer price.
Transfer pricing allows for the establishment of prices for the goods and
services exchanged between a subsidiary, an affiliate, or commonly controlled
companies that are part of the same larger enterprise. Transfer pricing can
lead to tax savings for corporations, though tax authorities may contest their
claims.
In the above example, if entity A offers entity B a rate lower than market value,
entity B will have a lower cost of goods sold (COGS) and higher earnings than it
otherwise would have. However, doing so would also hurt entity A's sales
revenue.
If, on the other hand, entity A offers entity B a rate higher than market value,
then entity A would have higher sales revenue than it would have if it sold to
an external customer. Entity B would have higher COGS and lower profits. In
either situation, one entity benefits while the other is hurt by a transfer price
that varies from market value.
Transfer price effect on taxation:-
o better understand the effect of transfer pricing on taxation, let's take the
example above with entity A and entity B. Assume entity A is in a high tax
country, while entity B is in a low tax country. It would benefit the organization
as a whole for more of the Company ABC's profits to appear in entity B's
division, where the company will pay lower taxes.
In that case, the Company ABC may attempt to have entity A offer a transfer
price lower than market value to entity B when selling them the wheels
needed to build the bicycles. As explained above, entity B would then have a
lower cost of goods sold (COGS) and higher earnings, and entity A would have
reduced sales revenue and lower total earnings.
Thus, Companies will attempt to shift a major part of such economic activity
to low-cost destinations to save on taxes.
Transfer Pricing and the IRS:-
The IRS states that transfer pricing should be the same between intercompany
transactions that would have otherwise occurred, had the company done the
transaction with a party or customer outside the company. the financial
reporting of transfer pricing has strict guidelines and is closely watched by tax
authorities. Extensive documentation is often required by auditors and
regulators. If the transfer value is done incorrectly or inappropriately, the
financial statements may need to be restated, and fees or penalties could be
applied.
Real World Examples:-
Coca-Cola
Due to the production, marketing, and sale of Coca-Cola Co.’s (KO)
concentrating in various overseas markets, the company continues to defend
its $3.3 billion transfer pricing of a royalty agreement. The company
transferred IP value to subsidiaries in Africa, Europe, and South America
between 2007 and 2009. In 2020, the UST Tax Court upheld two tax
adjustments that the IRS had issued to increase Coca-Cola’s taxable US income
from 2007-2009 by more than $9 billion. After the US Tax Court ruled against
it, Coca-Cola is preparing for the next round of battle with the Internal
Revenue Service (IRS).
Facebook Inc.
In another high-stakes case, the IRS alleges that Facebook Inc. (FB) transferred
$6.5 billion of intangible assets to Ireland in 2010, thereby cutting its tax bill
significantly. If the IRS wins the case, Facebook may be required to pay up to
$9 billion in addition to interest and penalties.3 The trial, which was set for
August 2019 at the U.S. Tax Court, has been delayed allowing Facebook to
possibly work out a settlement with the IRS. A special trial that was
subsequently scheduled to take place in June 2020 was cancelled due to the
coronavirus pandemic.
Vodafone and Cairn
The Indian government is appealing The Hague decision in the Vodafone case
and planning to do the same in the Cairn case. The Permanent Court of
Arbitration in The Hague ruled on September 25 2020 in favour of Vodafone
against the Income Tax Department.
The Hague court unanimously rejected the tax authority’s retrospective
demand of back taxes. The decision was welcomed as ‘good news’ for
investors doing business in India. The court reached a similar conclusion in the
case of Cairn in December and rejected the Indian tax authority’s position.
Vodafone has been fighting the case for more than a decade and won its
appeal at the Supreme Court in 2012. However, the Indian government
continued its bid to claim a retrospective tax payment and has refused to
amend tax laws in line with court decisions and expert reviews.
The Vodafone case has become infamous among Indian taxpayers and
investors looking at the Indian market. There may be more twists and turns
before this case is finally closed and it will continue to influence business
decisions on whether to invest in India.
Transfer Pricing Methods:-
The following are the generally accepted methods of calculating transfer
pricing:
1. Comparable uncontrolled price (CUP) method.
2. Resale price method. ...
3. Cost plus method. ...
4. Transactional net margin method (TNMM) ...
5. Transactional profit split method.