Aim, objective and effect of transfer pricing

Commercial transactions between the different parts of the multinational groups may not be subject to the same market forces shaping relations between the two independent firms. One part transfers to another goods or services, for a price. The price is known as “transfer price”. This may be arbitrary and dictated, with no relation to cost and added value, diverge from the market forces. Transfer price is, thus, a price, which represents the value of goods or services between independently operating units of an organization. But, the expression “transfer pricing” generally refers to prices of transactions between associated enterprises which may take place under conditions differing from those taking place between independent enterprises. It refers to the value attached to transfers of goods, services and technology between related entities. It also refers to the value attached to transfers between unrelated parties, which are controlled by a common entity.

It is defined as the price paid for goods transferred from one economic unit to another, assuming that the two units involved are situated in different countries, but belong to the same multinational firm The essence of transfer and transferee in arm’s length negotiations. It is within this discretion of a single enterprise. Transfer prices are widely used in multinational organizations, which typically involve a parent company domiciled in one country and a number of subsidiary companies operating in other countries. When multinational firms conduct business within their group, the concept of market pricing or arm’s length pricing has no relevance. Income or deduction is arbitrary shifted.
Suppose a company A purchases goods for 100 rupees and sells it to its associated company B in another country for 200 rupees, who in turn sells in the open market for 400 rupees. Had a sold it direct, it would have made a profit of 300 rupees. But by routing it through B, it restricted it to 100 rupees, permitting B to appropriate the balance. The transaction between A and B is arranged and not governed by market forces. The profit of 200 rupees is, thereby, shifted to the country of B. The goods is transferred on a price (transfer price) which is arbitrary or dictated (200 hundred rupees), but not on the market price (400 rupees).

Thus, the effect of transfer pricing is that the parent company or a specific subsidiary tends to produce insufficient taxable income or excessive loss on a transaction. For instance, profits accruing to the parent can be increased by setting high transfer prices to siphon profits from subsidiaries domiciled in high tax countries, and low transfer prices to move profits to subsidiaries located in low tax jurisdiction. As an example of this, a group, which manufactures products in a high-tax country, may decide to sell them at a low profit to its affiliate sales company based in a tax haven country. That company would in turn sell the products at an arm’s length price and the resulting (inflated) profit would be subject to little or no tax in that country. The result is revenue loss and also a drain on foreign exchange reserves.

Transfer price, as aforesaid, refers to the value attached to transfer of goods, services, and technology between related entities such as parent and subsidiary corporations and also between the parties which are controlled by a common entity, its essence being that the pricing is not set by an independent transferor and transferee in an arm’s length transaction. Transaction between them in not governed by open market considerations. The price is fixed, which is within the discretion of a single enterprise. This is done in order to meet the convenience of the multinational enterprise or a group as a whole  and may in consequence be fixed in a variety of ways which would not be possible if the parties to the transactions were independent persons acting at arm’s length. The group’s convenience may, for example, be a matter for arranging  the direction of cash flow (a purely commercial convenience) or of minimizing the total tax burden.

Whatever the reason for fixing a transfer price which is not arm’s length, the result is the shift of profit. The effect is that the profit appropriately attributable to one jurisdiction is shifted to another jurisdiction. The expression “transfer pricing” has to late acquired a pejorative meaning. It evokes the idea of systematic manipulation of prices in order to reduce profits artificially, cause losses, avoid taxes or duties in a specific country.

The main object is to avoid tax as also to withdraw profits leaving very little for the local participation to share. Others are, avoidance of foreign exchange restrictions and the effect of political uncertainties. How best and dexterously it could b done depends upon the tax structure of a jurisdiction, its exchange control regulations, its political and economic conditions, or its dependence on the foreign technology, know-how, skill, expertise etc. The incentives to engage in transfer pricing abuses are greater in less developed than those in industrialized countries with risk of detection being less.

Transfer between the enterprises under the same control ad management, of goods, commodities, merchandize, raw material, stock, or services is made at a price which is not dictated by the market but controlled by such considerations such as:-

1. To reduce profits artificially so that tax effect is reduced in a specific country;
2. To facilitate decentralization of production so that efforts are directed to concentrate profits at the State of production where there is no or least competition;
3. To remit profits more than the ceilings imposed for repatriation;
4. To use it an effective tool to exploit the fluctuation in foreign exchange to advantage.

Factors other than the tax considerations are outlined as below in OECD Transfer Pricing Guidelines:-
“ Factors other than the tax considerations may distort the conditions of commercial and financial established between associated enterprises. For example, such enterprises may be subjected to conflicting government pressure (in the domestic as well foreign country) relating to customs valuations, anti-dumping duties, and exchange or price controls. In addition, transfer price distortions may be caused by the cash flow requirements of enterprises within the MNC group. An MNC group that is publicly held may feel pressure from shareholders to show high profitability at the parent company level, particularly if shareholders reporting is not undertaken on a consolidated basis. All of these factors may affect transfer prices and the amount of profits, accruing to associated enterprises within the MNC group.”

The opportunities for international tax manipulation among the associated enterprises not only involve the use of the arbitrary prices, but also involve conversion of returns on equity investment to royalties and interest. Such a device is termed as “thin capitalization.”

Multinational Companies (MNCs) are not the only entities that engage the transfer pricing abuses. There are many instances in which the local individuals or companies use the device to shift artificially profits so as to avoid or evade taxes, circumvent exchange control or reduce the economic exposure arising from political or economic uncertainties