Transfer Pricing: Impact on Trade and Profit Taxation Author(s): C. Satapathy Source: Economic and Political Weekly, Vol.

36, No. 20 (May 19-25, 2001), pp. 1689-1692 Published by: Economic and Political Weekly Stable URL: http://www.jstor.org/stable/4410629 . Accessed: 07/08/2011 05:54
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Perspectives

Transfer Pricing: Trade and Profit

Impact on Taxation

It is not enough to adopting laws to regulate transferpricingfor which several models exist. The test in implementingthe laws lies in developingpractical skills and meeting the resource needs within the administration.The administrativeregimefor regulating transferpricing should be specialised but also development friendly. Duties and taxes should not be allowed to be evaded, but at the same time the mannerof regulating transferpricing should not act as a disincentiveto theflow offoreign investment.
C SATAPATHY he World Development Report 1999/2000 [World Bank 1999] notes that fragmentation of production processes across international bordersis an importantnew trend,particularly for developing economies. This "slicing up the value chain" involves separate stages of production being conducted in different countries. The reasons are not far to seek. Global trade rules have lowered trade barriers and uncertainties, and have consequently given a boost to global production networks. Phenomenal and progressin global transportation communicationhas also made management of such global production networks easy. These developments have also resulted in an increase in intra-firm trade. The World Development Report notes that about one-third of the world trade takes place within global production networks. The following figures indicate the recent trend in global trade: - About 40 per cent of US imports and exports are between US firms and their foreign affiliates or parents. - About 40 per cent of US-Europe trade is between parentfirms and their affiliates. - About 55 per cent of EC-Japantrade is between parentfirms and their affiliates. - About 80percentofUS-Japan trade is between parent firms and their affiliates. Transfer pricing is one of the mechanisms for inter-company fund flows, the others being fee and royalty adjustments, dividendadjustments, inter-companyloans,

etc. Transfer priceis the pricechargedby firmto its affiliate,the affiliate Arm's Length Principle theparent to its parent firm,one affiliateto another to within The transferpricing laws in most develorbyonedivision anotherdivision thesamefirm goodsorservices for provided. oped countries have been influenced by Transfer set the Organisation for Economic Cooperapricescan be arbitrarily to:
- reduce taxes,

tariff in Country 2. His conclusion was that if the relative tax rate between the two countries (t2- tl)/(1- t2) is less than the tariff rate T2, the multinational firm will always choose the lowest transferprice to save on tariffs. While choosing a low transferprice thatoptimises global profits, a multinational firmhas, however, to ensure that such a price meets the legal requirement of the arm's length principle. The borderline between criminally fraudulent over- and under-invoicing and lawful transferpricing can be thin at times. Transactions throughtax-havens showing lower profits in both the exporting and importing countries as well as evading tariffs in the importing countries further complicate things for the tax administrators.

tion and Development (OECD) guidelines and US law on the subject, which in turn are based on the arm's length principle. - avoid exchange controls. The arm's length principle means that Hines (1996) andClausing(1998) pro- transactions should be valued at prices vide evidenceof transfer pricingsignifi- which a company would have charged cantly influencedby taxation.Tax au- another unrelated company based purely thoritiesaroundthe worldare increasing on market considerations. Article 9 of the theirscrutiny inter-company of transfer of Model Tax Convention on Income and on goods and services within multinational Capital formulated by OECD applies the The in corporations. concerns mostdevel- concept of arm's length principle to taxarelateto the areaof direct tion as follows: oped countries taxation, ie, income tax on corporate [When] conditions are made or imposed between two [associated] enterprises in havean profits.Thedevelopingcountries their commercial or financial relations additionalconcern relating to customs which differ from those which would be valuationin view of theirgreater depenmade between independent enterprises, denceon tradetaxes as a majorsourceof thenanyprofitswhich would,butforthose revenue. conditions, have accrued to one of the Leftto itself,a multinational would firm enterprises,but, by reason of those conditions, have not so accrued, may be obviously choose a price that would included in the profits of that enterprise optimiseits globalprofits.In his seminal

- reduce tariffs based on ad valorem duties,

and taxedaccordingly. Thearm'slengthprinciple not,howhas ever,resultedin a single methodof transE= (1-t,)(Rl- C1)+(1- t2)(R2-C2)+ ferpricing.It hasgiven rise to the follow[(t2 - tl) - (- t2)T2]PM, ing transferpricingmethods: where R1, C1, tI and R2, C2, t2 are - Comparable Uncontrolled Price revenue fromsales,costof production and (CUP) Methodor MarketPriceMethod, - Resale Price Method(RPM)or Retaxon profitsin theexporting importand ing countriesrespectivelyand M is the sale Minus Method, - Cost Plus Method (C+), quantity exported from Country 1 to - Comparable ProfitsMethod(CPM), 2, Country P the transfer priceandT2the paper,Horst(1971) haddeviseda global after-taxearningfunctionE as follows:

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- Profit Split Method (PSM), - Transactional Net Margin Method (TNMM), and - other unspecified methods. ComparableUncontrolledPrice Method is also known as the Market Price Method under which the price of a transferred product is compared with the prices of similar productssold by or to uncontrolled and unconnected entities. This method can be used if products are similar. Identifying an exactly similar productis often difficult unless the multinational firm itself sells the same product to both controlled and uncontrolled customers At times, an adjusted or inexact comparable market price is also used. The Resale Price Method uses the resale price at which a product bought from an associated multinational firm is resold to an independentcustomer. The resale price is reduced by the resale gross margin, customs duties, etc, to arrive at the arm's length price. The Cost Plus Method on the other hand uses the cost incurredby the supplier firm markup towardsprofit. with an appropriate The idea is similar to cost plus government contracts. The Comparable Profits Method determines the amount of profit the multinational firm would have earned by using a comparable profit level derived from its uncontrolled transactions with independent buyers. Under this method, profit of one party to the transaction is analysed. The Profit Split Method on the other hand measures the combined profit from intrafirm transactions and then the same is split or allocated according to contribution of each affiliate or division of the firm. In this method, profits of both parties to the transaction have to be analysed. The Transactional Net Margin Method (TNMM) examines the net profit margin relative to appropriatebase such as costs, sales, assetsetc, and is similar to Cost Plus. and Resale Price Methods. Other unspecified methods also exist which are not frequently used. Engineering Cost Study Method estimates at what cost the purchasing firm can manufacture a product and decides to pay that amount to its related supplier. Under the Formulary Apportionment Method, the global profits are allocated between all affiliates and divisions in a predetermined manner. Similarly, a Cost and Risk Arrangement may exist between affiliates primarily in relation to development and research for a new product or a new intangible prop-

erty. While, the multinational firms may use these methods in a way that is most tax-efficient, the tax-administratorshave to ensure that these methods are not used as means of tax avoidance. Advance PricingArrangementsaresometimesconcluded between the multinational firms and the tax authorities of home/host countries to avoid future uncertainties and conflicts. As far as intangible services and properties are concerned, they also pose similar problems in transferpricing as in the case of tangibles in the form of goods including finished products, components and raw materials. The UNCTAD publication on 'Transfer Pricing' lists the following intangibles: - patents, inventions, formulas, processes, designs or patterns; - copyrights, literarymusical or artistic compositions; - trade marks, trade names or brand names; - franchises, licences or contracts; - methods, programmes, systems, procedures, campaigns, surveys, studies, forecasts, estimates, customer lists or technical data; and - other intellectual property not listed above. Comparable Uncontrolled Transaction (CUT) method of valuing intangibles is similar to the CUP Method for tangibles. Comparable Profit Method (CPM) and Profit Split Method (PSM) also apply to intangibles. On the other hand, the Resale Price Method and the Cost Plus Method are not applicable to intangibles as intangibles are not resold separately. A super royalty provision in the US law makes an advance in this regardrequiring that income on transferor licence of intangibles should be commensurate with income attributableto the intangible. With this provision, if income from intangibles change significantly in the future,the price determinedearliercan be changed.At times, therearea rangeof pricesavailableto choose from in respectof intangibles such as interest rates on intra-firm loans, managerial services provided at cost, etc. Multinational firms can set suitable prices for such intangible to minimise their total tax burden.

Corporation Taxes Act of the UK. - Articles 66-5 of the Special Taxation Measures Law and the Special Taxation Law relating to Tax Treaty of Japan. - Section 69 of the Income Tax Act of Canada. - Section 92 of the Income Tax Act of India. The Finance Bill, 2001 (Clause 44) has introduced legislative changes in the Income Tax Act for substituting the existing Section 92 by new Sections 92 and 92A through 92F with effect from April 1, 2002. These changes are based on the reportof an expert group set up in November 1999 to examine issues relating to transferpricing. Existing Section 92 of the Income Tax Act reads as under: 92 Income from transactions with nonresidents, how computed in certain cases: Where a business is carriedon between a resident and non-residentand it appears to the income-taxofficer that,owing to the close connection between them, the course of business is so arranged that the business transacted betweenthemproduces to the resident either no profits or less thanthe ordinaryprofitswhich might be expected to arise in that business, the income-tax officer shall determine the amount of profits which may reasonably be deemedto have been derivedtherefrom and include such amount in the total income of the resident.

The text of the existing Section 92 is quite general and is based on the concept of 'ordinary profits' which in a way is not different from the arm's length principle. However, the proposed Section 92 explicitly refers to the arm's length principle: 92 Computationof Income from International transactionhaving regardto arm's length price: (1) Any income arising from an intershallbe computedhavnationaltransaction ing regard to the arm's length price. (2) In computing income under sub-section (1), the allowance for any expense or interest shall also be determinedhaving regard to the arm's length price. transaction, (3) Where in an international two or more associated enterprisesenter into a mutual agreementor arrangement for the allocation or apportionment or of, any contributionto, any cost or expense Changes in Finance Bill 2001 incurredor to be incurredin connection with a benefit, service of facility provided The arms length principle is reflected in or to be provided to any one or more of the tax legislations of several countries: such enterprises,the cost or expense al- Section 482 of the Internal Revenue located or apportionedto or, as the case Code of the US, maybe, contributed any suchenterprise by, - Sections 770-773 of the Income and; shall be determinedhaving regardto the

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arm's lengthpriceof such benefit, service or facility, as the case may be. The proposed Sections 92A and 92B respectively define the meaning of 'associated enterprise' and 'internationaltransaction'. The definition of associated enterpriseproposed in the Finance Bill 2001 is very broad and goes far beyond the concept of 'mutuality of interest in the business of each other' strictly interpreted by the judicial authorities in India in several customs and central excise valuation cases. For example, under the proposed Section 92A(2)(a), one enterprise holding shares carrying voting powers of 26 per cent or more in another is sufficient to make them associated enterprises, even if the latterhas no shareholding in the former. Similarly, one enterprise appointing more than half the board of directors or one or more of the executive directorsof the other or supplying know-how, patents etc, to the other will now be treated as associated enterprises. Even purchase of 90 per cent or more of raw materials and sale of finished goods with the prices influenced will have to be treated as associated enterprises. These provisions provide a contrast to the earlier decision of the customs tribunal upheld by the Supreme Court in Collector of Customs v Maruti Udyog, [1989(22) ECR 482(SC)] to the effect that Suzuki and Maruti cannot be held to be related or to have interest in the business of each otherdespite Suzuki having 26 per cent share in Maruti since Maruti had no share in Suzuki. This decision is still good law and has been followed in other cases. To ensure similar treatment to the same internationaltransaction between two enterprises under both the Income Tax Act and the Customs Act, the legal provisions under the latter need to be changed and made as broadbased as has now been done under the proposed Section 92A of the Income Tax Act. The proposed Section 92B defines an international transaction as a transaction between two or more associated enterprises, either or both of whom are nonresidents. It appears to intentionally or otherwise exclude from its ambit cases of international transfer of goods between two domestic firms. A domestic firm may supply to another affiliated domestic firm goods from its depot abroad which will constitute an internationalimport transaction and is so treated from customs valuation point of view. The proposed Section 92C stipulates that the.arm's length price in relation to

an international transaction is to be determined by one of the five methods listed (CUP, RPM, C+, PSM and TNMM) or by such other method as may be prescribed, being the most appropriatemethod. Arm's length price has been defined in the proposed Section 92F as the "price which is applied or proposed to be applied in a transaction between persons other than associated enterprises, in uncontrolled conditions". A provision has also been introduced by way of proposed Section 92C(3) which enables as assessing officer to redetermine the arm's length price on the basis of material, information or document with him if he is of the opinion it has not correctly determined, or if the information or data used is not reliable or correct, or if the necessary information, documents etc, have not been maintained or furnished. The proposed Section 92D requires transpersons enteringinto an international action to keep and maintain information and document in respect thereof and to furnish the same on demand.The proposed Section 92E requires obtaining and furnishing a report from an accountant. The proposed Sections 271AA and 271G provide for a penalty of 2 per cent of the value of international transaction for which required information and documents are not maintained or furnished under Section 92D and the proposed Section 271BA provides for a penalty of Rs 1 lakh for not furnishing a report under Section 92E. Penal provisions under Section 271 for concealment of income (up to three times the amount of tax on concealed income) has also been extended to transfer pricing cases. There has been some criticism in the press (The Economic Times, March 8, 2001) that overpolicing of transferpricing will keep FDI away and that the penal provisions are excessive. Some apprehensions have also been expressed that "the elegance of transfer pricing norms ends when the tough business of implementation begins".

of administering anti-dumping and counter-vailing duty laws would also like that the transfer price of imports is set higher so thatthere is no dumping or unfair trade. Understandably, the WTO measures on customs valuation, being mostly reiteration of Tokyo Round measures agreed in 1979, aresilent abouttransferpricingissues which had not assumed prominence 22 years ago. Article VII of GATT, 1994 does not refer to transfer pricing, but clearly makes a case for arm's length price for customs valuation. Similarly, the implementing WTO Agreement on Customs Valuation (ACV) does not mention about transfer pricing, but in the case of related party transactions, it favours an arm's length price comparable to test values arrived from sale of identical or similar goods. If there is no sale, as would be the situation in respect of transfer of goods between divisions of the same company, arm's length price for sale of identical or similar goods provides the basis. In other words, ACV provides a method of valuation akin to the CUP method. In a case where transaction values are not availableeven for identicalor similargoods, ACV provides for Deductive ahd Computed Value Methods which are akin to Resale Price Method and Cost Plus Method respectively. In a recent case, the US court of appeals for the federal circuit has delivered a significantjudgment on April 27, 1999 (VWP of America Inc v United States) seeking to harmonise the valuation methods used for purposes of customs valuation and the federal income tax laws [Miller andChevalier 1999]. It reversed a long-standing US customs service policy under which customs duties for intra-firm transfers were commonly based on price to the subsequent third-party US customers. As per the court ruling, the customs valuation will now be equal to the price that would be paid, by unrelated companies buying and selling at arm's length. With the intra-firm trade growing in leaps and bounds, the customs adminisCustoms Valuation trations as well as the income tax authorities have a difficult job in hand in tackling While the income tax authorities may transfer pricing issues. They need to have seek to assess a lower transfer price on not only informationsharing arrangements imports to avoid diversion of profits to the within their own countries, but also have exporting country, the customs authorities to take recourse to mutual administrative may seek to determine a higher transfer assistance from the exporting countries. In price to avoid undervaluation and conse- the case of developing countries like India quent loss of customs duty. The trade higher customs duty rates than the income in in ministry animporting country charge tax rateson corporateprofits induces lower

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transferprices to save on importtariffs even if income tax may have to be paid on resultant higherprofits.Let us assume a productimportedby an affiliate of an withincome MNCto Indiafroma country tax rate 30 per cent has an arm's length price of Rs 100. If the productis overvaluedby Rs 20, the MNC has to pay Rs 6 of extra income tax in the exporting countryon extraprofits,whereasthe affiliateinIndiawill payRs6.12 less income @ tax (calculated 30.6 percent including on 2 per cent surcharge) reducedprofits but increasedcustoms duty of Rs 12.57 (calculated@35 per cent basic customs customsduty duty+ 16percentadditional + 4 per cent special additionalcustoms duty which equals62.86 per cent on the importprice).This wouldreflecta global loss of profitto the extentof Rs 12.45 for the MNCandits affiliate.It is inconceivthat able,therefore, the transfer pricewill be set higherto evadeincometax in India. is Ontheotherhand,if theproduct undervaluedby Rs 20, the tax liability in the countrywill reduceby Rs 6 on exporting reducedprofits, whereasthe affiliate in Indiawill have to pay increasedincome taxof Rs 6.12 on increased profitsbutwill saveRs 12.57on customsduties.Thiswill be a betteroptionas the global profitsof the MNC and its affiliate will go up by Rs 12.45 despite having to pay Rs 6.12 more towardsincome tax in India. This example illustratesthat transferpricing in manipulation countrieslike Indiais not much of a threatfor the income tax authorities it is forthecustomsauthorities. as a Thereis, therefore, case for strengthening the legal provisionsand the adminion strativemachinery the customs side. There of course,be a few exceptions can, If to the abovescenario. the tax ratein the exportingcountryis low and the product is either exempt from customs duty in Indiaor attracts verylow duty,over-valuto ationcanbe resorted reduceincometax in India.Nevertheless,given the liability ratesof income tax and customs current dutiesin India,therearelikely to be much greaterincentivesfor importingfirms to set lowertransfer pricesto evadecustoms pay duty(andactually a littlemoreincome tax) than to set highertransferprices to evade income tax (as this would entail much highercustomsduty liability). Therecan also be cases where for the a same transaction, lower importvalue is indicated customsto pay less dutyand to a higherimportvalue is indicatedto incometaxforpayingless taxon profits.To

detect such cases, it would require greater cooperation between the customs and income tax authorities as well as legal provisions of the kind incorporated in Section 1059A of the Internal Revenue Code in the US which provides that value for imported goods cannot be greater than the customs value. In enacting Section 1059A, the US Congress had taken into accountthe possibilitiesthatsome importers could claim a transferprice for income tax purposes that was higher than the transfer price claimed for customs purposes and the Congress was particularly concerned thatsuch practicesbetween commonly concould improperly avoid US trolled %ntities income tax or customs duties [Cole 2000]. It is not known what recommendations, if any, the expert group on transferpricing has given in its reportfor legislative changes in this regard and what steps it has suggested for increased cooperation between the customs and income tax authoritiesfor detecting transfer pricing manipulations. OECD has done a lot of work in the area of transfer pricing and has this to say in this context: Cooperation between income tax and within a country customs administrations in evaluating transferprices is becoming more common and this should help to reducethe numberof cases wherecustoms valuationsare found unacceptablefor tax purposes or vice versa. Greatercooperation in the areaof exchangeof information would be particularlyuseful, and should not be difficult to achieve in countriesthat for administrations alreadyhaveintegrated income taxes and customs duties. Counadministrations triesthathaveseparate may wish to consider modifying the exchange rulesso thatthe information of information can flow more easily between different administrations[OECD 1999]. OECD recommendations as above have a greater significance in the developing country scenario. Apart from mutual cooperation and setting up a formal network for exchange of information on transfer pricing, the same criteriaas adopted under the Income Tax Act for defining associated enterprisescan perhapsbe adoptedfor customs valuation purposes and uniform documentationcan also be prescribedunder the income tax and customs laws so that the assessees do not have to maintain separaterecords. Even a common audit for income tax and,customs purposes can be thought of as it would increase greater tax compliance while reducing the compliance cost for the assessees. Very often data to prove a transferprice manipulationhave

to be obtained either from customs data base of contemporaneous imports or from abroad through the customs and tax authorities of exporting countries under mutual assistance treaties. It may, therefore, be desirable to channel such requests together for both customs and income tax purposes ratherthansend multiple requests for assistance for the same transaction to revenue authorities abroad. UNCTAD (1999) has highlighted the development dimensions of the transfer pricing issues. It is not merely enough to adopt laws regulating transfer pricing for which several models exist. The test in implementing such laws lies in developing practical skills and meeting the resource The needs withintheadministration. administrative regime for regulating transferpricing should be specialised but also development friendly. Duties and taxes should not be allowed to be evaded, but at the same time, the manner of regulating transfer pricing should not act as a disincentive to the flow of foreign investment. 3il
[The views expressed here are the personalviews of the author. Parts of this paper were used by as theauthor lecturenotesattheCustomsValuation Countries May2000 in CourseforCommonwealth and at a similar course for SAARC countries in March 2001. The author is grateful for useful comments made by the participants at these courses.]

References
Clausing K A (1998): 'The Impact of Transfer Trade', NBER Working Pricingon Intra-firm Paper No 6688. Cole, R T (ed)(2000): 'PracticalGuide To US US. Transfer Pricing',Tax Analysis,Arlington, Hines, J R (1996): 'Tax Policy and the Activities of Multinational Corporations', NBER Working Paper No 5589. Horst,T ( 1971): 'The Theoryof the Multinational Firm:OptimalBehaviourunderdifferentTariff andTax Rates', Journalof Political Economy, 79(5), p 1059. Miller and Chevalier (1999): 'Harmonisationof InteraffiliateTransferPricing', International Alert, May 13. UNCTAD (1999): 'TransferPricing', UNCTAD Series on Issues in InternationalInvestment Agreements, United Nations, Geneva. World Bank (1999): Entering the 21st Century: World Development Report 1999-2000, Oxford University Press, Oxford.

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