You would be amazed to read how Microsoft found a loophole in the global market to reduce the tax burden:
Microsoft recruits software experts and web designers available to be recruited both in the United States and abroad, and sells software product everywhere in the world. Outside sales are made through Indian subsidiary, a wholly owned foreign company. USA head entity costs the software $600 to make and $100 to market, and offer for $1,000 abroad. Notwithstanding the transfer price utilized for deals by Microsoft USA to Microsoft India, the consolidated income from the remote deal is $300 per product [$1,000 final sales price -$600 manufacturing cost -$100 selling expense]. Be that as it may, transfer prices do influence the designation of that joined profit among headquarter (USA) and branch (India)
At one end, a transfer price of $600 would designate the consolidated profit of $300 totally to Indian entity, as takes after:
|Transaction||Sale in USA||Sale in India|
|Cost of sales||$700|
At the other extreme, a transfer price of $900 would designate the combined benefit of $300 totally to USA head, as follows:
|Transaction||Sale in USA||Sale in India|
|Cost of sales||$1000|
As evident, if goods are transferred at cost price to branch then entire profit could be accounted by the branch (read India).
The tax would be paid on the profits that are made by Indian entity as USA head office accounts zero profit.
Similarly, if goods are transferred to branch at certain profit margin by the head office then the company shall pay tax on that profit as Indian entity accounts zero profit.
Thus, with the advent of globalization, companies tend to manipulate transfer prices and shift profit to lower tax levy nations in order to reduce/evade taxes.
Hence, a thorough transfer pricing structure was the need of the hour to maintain tax revenue collection by the government.
Wikipedia defines “In taxation and accounting, transfer pricing refers to the rules and methods for pricing transactions within and between enterprises under common ownership or control”.
Transfer between the enterprises under the same control and management, of goods, commodities, merchandise, raw material, stock, or services is made at a price which is not dictated by the market but controlled by such considerations such as:
• To reduce profits artificially so that tax effect is reduced in a specific country;
• To facilitate decentralization of production so that efforts are directed to concentrate profits in the State of production where there is no or least competition;
• To remit profits more than the ceilings imposed for repatriation;
• To use it as an effective tool to exploit the fluctuation in foreign exchange to advantage.
With about 3,500 disputes, India has the third largest number of pending cases related to transfer pricing in the world stated consultancy firm E&Y back in 2014.
In a global economy where MNCs play a significant role in the economy of various countries, governments need to ensure that the taxable profits of MNCs like Microsoft are not artificially shifted out of their jurisdiction. The OECD Guidelines provide guidance on the application of the “arm’s length principle” for the valuation, for tax purposes, of cross-border transactions involving “controlled transaction”.
Similar to the OECD Guidelines and TP Regulations of several other countries, Indian TP Regulations prescribe methods to compute ‘Arm’s Length Price’ for an ‘International Transaction’ or a ‘Specified Domestic Transaction’ entered into by a taxpayer with its ‘Associated Enterprise’.
Section 92 of the Income-tax Act, 1961 gives authority to an assessing officer to determine the profit which may be reasonably be deemed to have been derived from a transaction. This would be applicable where controlled Companies (associated enterprises) transact in a way that either no profit is earned from such transaction or profit earned is lower than what would be expected in a transaction between uncontrolled Companies (unrelated entities).
In future, transfer pricing has a broad scope owing to disputes arising due to ambiguity in rules. It would be good to see how India will resolve these.
Author | Kshitij Chitransh