Transfer Pricing

Subject : Economy

Section : Fiscal Policy

Concept :

The Income Tax department recently conducted surveys in BBC offices located in Mumbai, Delhi, and in different other cities in the country.
According to the IT Department, the BBC has violated “Transfer Pricing Rules”. Transfer Pricing is a practice where one company charges another (in the same division). The parent company of both companies is the same.

What is transfer pricing?

Transfer pricing is an accounting practice that represents the price that one division in a company charges another division for goods and services provided.
In such transactions, one party transfers to another goods or services, for a price known as transfer price.
This may be arbitrary and dictated, with no relation to cost and added value, diverge from the market forces.
Hence, 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.

Understanding transfer pricing

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).

What effect does transfer pricing have?

The parent company — or a specific subsidiary — tends to produce insufficient taxable income or excessive loss on a transaction.
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.

What is the “arm’s length arrangement” that the BBC has allegedly violated?

Section 92F of the Income Tax Act, 1961 defines arm’s length price as a price which is applied or proposed to be applied in a transaction between persons other than associated enterprises, in uncontrolled conditions.
e., the price a division or subsidiary of a company pays to buy goods or services from another division or subsidiary should be the same as the market rate — as if the two entities were unrelated.
This is the rule the BBC has allegedly violated.