Transfer Pricing –International Transaction and Methods of Arm’s Length Price
Introduction : In current scenario it is possible that entity is operating not only in multiple state but also in multiple country; for said purpose it is important to understand whether entity is required to comply any additional law; how income tax will be levied if one of the branches of entity which is operating in tax free zone makes transfer of goods or service to another branch who is operating in taxable zone or vice-versa. In this article we will cover all compliance and related interpretation of transfer pricing.
In previous part we have discussed the widely used method, (i.e., Comparable Uncontrolled Price method). In this part we will discuss other method along with its illustrations.
Other method is Resale Price method, this method is likely to be used when the one associate enterprise is selling the goods as obtained from other associate enterprise to external party. In such case the if transaction is not at arm’s length price than price at which it has been sold to external party will be arm’s length price, however from said price normal gross profit margin and expenditure incurred with respect to purchase from such associate enterprise and expense incurred for selling the product shall be adjusted accordingly.
Illustration : Hari & Co. has associated enterprise in Dubai, he has sold good worth Rs. 30,00,000/- to them quoting Rs. 30 per kg. the same goods have been sold by associate enterprise by quoting Rs. 50 per kg. Industry operating margin is 20% on sales value, the said associate enterprise is spending Rs. 5 per kg. as packing cost. What will be arm’s length price and whether such transaction will be acceptable as it is?
It has been prescribed if transaction is International Transaction and the said has been entered between associate enterprise, it is required to be entered at arm’s length price. If the said transaction is not at arm’s length price than entity is required to calculate arm’s length price by using the prescribed method. In this situation as associate enterprise is selling the goods without carrying any further manufacturing process, Resale price method will be best suited for calculation of arm’s length price.
If the industry is operating at margin of 20% on sales price than the cost at which transfer should has been incurred is Rs. 40, however Rs. 5 has been specifically incurred as per kg packing cost. Therefore, packing cost for the purpose of calculation will be Rs. 35 per kg. Transaction has been entered by Hari & Co. at Rs. 30 per kg. which is required to be revised and the new sales value of entire transaction will be Rs. 35,00,000/- (30,00,000/30*35).
The third method by which arm’s length price can be calculated is Cost-Plus Method, this method is widely used when entity is selling semi-finished goods to its associate enterprise.
In such case if transaction is not at arm’s length price than such transaction is required to be identified and shall be recorded at arm’s length price. For determining arm’s length price, entity will be required to identify direct& indirect Cost of Production incurred for property transferred or services provided to associate enterprise, on such cost normal industry gross profit margin will be required to be added. The price which is arrived after such calculation will be treated as arm’s length price.
Another method that can be used for determination of arm’s length price is Profit Split Method.
The method can be used where there is transfer of unique intangibles or in multiple International transaction.
For determining Arm’s Length price through this method associate enterprises are required to combine net profits arising out of international transaction.
Now the said profit is required to be segregated or distributed amongst both the associate enterprise on basis of percentage of market return on contribution made by both associate enterprises.
Illustration: Shiva and Company has associate enterprise in America, during the previous year it has transferred unique patent rights to said associate enterprise. The assessing office is of the opinion that consideration charge by Shiva and Company from its associate enterprise is not at arm’s length price. Associate enterprise has earned the revenue of Rs. 10,00,000/- from use of said patent rights. Shiva and Company has charged Rs. 4,00,000/- as use of such patent rights, total of expense side for them in relation to said transaction was Rs. 2,00,000/-, except consideration paid to Shiva and Company Rs. 1,00,000 has been incurred as expenses by associate enterprise. What will be arm’s length price of said transaction.
According to the guidelines provided for using various method for determining Arm’s length price, in case where transaction is of transfer which is relating to unique intangibles or there is multiple International transaction than in said case profit-split method shall be used by entity.
Profit earned by Shiva and Company from said transaction is Rs. 2,00,000/- and profit earned by its associated enterprise from said transaction is Rs. 5,00,000/-. The said profit will be required to be distributed on basis of contribution done by each enterprise for earning such profit.
Total combined profit earned by the entity is Rs. 7,00,000/-, if is distributed on the basis of expenses incurred by each organisation than the profit earned by Shiva and Company should have been Rs. 4,66,667/- and profit earned by associate enterprise should have been Rs. 2,33,333/-. It is apparent that transaction is not been carried at arm’s length price and therefore, addition of Rs. 2,66,667/- shall be made to total income of Shiva and Company.
The residuary method is Transactional Net Margin Method (TNMM), In this method for determination of Arm’s length price entity will be required to compute net profit margin from International Transaction with associate enterprise after taking into consideration cost incurred, sales affected and asset employed in that regard. Also, entity will be required to compute net profit margin realised from unrelated enterprise in comparable uncontrolled transaction. The said net margin is required to be adjusted in reference to cost/sales/assets employed by the entity for transaction entered with associated enterprise. The revised net margin will be considered for calculation of Arm’s Length price.
In next part we will cover what is advance pricing agreement, and what are the questions that may arise in relation to it.