Guest Speaker : Ashutosh Mohan Rastogi, Founder Partner of Amicus (law firm) and Tax Counsel/advisor, highly experienced in Transfer Pricing and International Taxation.
Host: Abhyuday Agarwal, Co-Founder, LawSikho.
Transfer Pricing Policy: Concept and Rationale
Before we undertake a transaction, we need to design the price or the profitability on the basis of which the parties to the transaction will deal with each other. Whenever there is a related party transaction, the finance or the corporate professional need to give some thought, ahead of the transaction on the pricing for the transaction. There are two related parties dealing with each other. The pricing is completely controlled by the MNCs.
By designing a proper transfer pricing policy, you can limit your tax exposure, and later on, a transfer policy documentation would be required and maintained which will leverage on your transfer pricing policy. It is extremely important for all corporate lawyers, tax, and finance professionals responsible for inter-company transactions. They must discuss the transfer pricing policy for a transaction.
Table of Contents
At the group level the head office (principal) situated in one country, having its manufacturing and distribution unit in other countries, will try to give high-level guidance, lay down the principles of transfer pricing policy and for similar and repeating transactions, these principles are compiled in a particular document which can be called as Transfer pricing policy Manual for the group as a whole. That manual may be referred to by the different units of the Multi-national company from time to time for specific transactions.
At the transactional level, we get into the specifics where the role of the consultants may also come. Once you have a given transaction, let suppose you are doing manufacturing in a low-cost country, you need to first decide the way to determine the price for the manufacturing unit, either by price testing or by profitability testing . Then the question arises what will be the profitability measure which is Profit Level Indicator (PLI) , whether we should take Gross Profit or Net Profit or if we take the base for PLI, what should that be, Sales or costs?
So, this is the determination of the Transfer Pricing Policy.
There are a number of factors that are needed to be considered when looking at the Transfer Pricing Policy for any Multinational Company.
In commercial terms, “what do you want to achieve” is basically a business objective. For instance, you may want your Transfer Pricing Policy should be framed in such a way that it maximizes the profit in the head office jurisdiction.
Supply Chain analysis refers to the study of the supply chain which basically shows how different operations are spread into different countries. It is to be noticed in a supply chain that where the transaction lie.
Taking into account the position and the function in a supply chain which is the most appropriate Transfer Pricing model, you have to consider the choice of tested party and decided your Transfer Pricing Policy Model.
We cannot benchmark the entrepreneurial returns because these are highly fluctuating, volatile.
Once you have decided your Transfer Pricing Policy Model, then you have to capture your Transfer Pricing Policy in the form of an Inter-company agreement which is the written manifestation of Transfer Pricing Policy at a transactional level.
While drafting the inter-company agreement, your form must reconcile with the substance. A Substance is basically the actual conduct of the party.
The in-house personnel in a corporate firm or in any company, should be alert when the transfer Pricing regulations will kick in. They should be aware that:
One another aspect linked with Transfer Pricing Policy formulation is the choice of tested party. What is the tested party and when you are having a transaction between two related parties A and B, how do you decide whether you should be testing the profitability of A or you should be testing the profitability of B.? There is guidance available from OECD and Indian Case Law that you have to opt for the least complex entity as the tested party.
Least Complex Entity can be determined by breaking it down into three parts:
This is the substance in the Transfer Pricing Context. This tells ‘what is actually happening on the ground?’ if there is a variation between your contractual document and what is actually happening on the ground level, so for the purpose of transfer policy, we have to be guided by these Significant People Functions that are being carried out.
These have had a history in Transfer Pricing Jurisprudence:
Transfer pricing agreement is a manifestation of the Transfer Pricing Policy. Before fixing a transfer pricing policy, you have to do a lot of fact-finding, functional analysis, & determining the characterization type. Once the Transfer Pricing Policy is framed, you need to capture it in the form of Transfer Pricing Policy agreement.
The tax authorities always ask for the Inter-company agreement to understand the distribution of the functions, assets, and risks between the two parties.
Periodical review of Inter-company agreements is necessary and it should be ensured that the inter-company agreements should match with the on the ground reality happening at the unit level or the factory level.
In any inter-company agreements, it is important that the functions, which are being performed by the respective parties, have to be delineated correctly.
There should be appropriate clauses in the agreement which ensures that the legal ownership of Intellectual Property.
All the risks associated with the specific functions; will also align with the respective parties.
In the Transfer Pricing Agreements, it is important to lay down the transfer policy model which is being followed for the transaction. So, if you are having a cost-plus model, your transfer pricing agreement will stipulate clearly that you are opting cost-plus model to remunerate the contract manufacturing entity.
Payment term embodied in a Transfer Pricing Agreement
– include expenses such as office expenses, communication charges, salaries, employee benefit, depreciation, amortization, and the appropriate share of common expenses.
Interest for late payment.
Adjustments (in case of shortfall)
Maintaining Mark up for the entire year.
LawSikho has created a telegram group for exchanging legal knowledge, referrals and various opportunities. You can click on this link and join:
Follow us on Instagram and subscribe to our YouTube channel for more amazing legal content.
