What are the key principles of transfer pricing?

Arm's length principle is the key principle for transfer pricing. It means that the international transactions between 2 or more related parties are conducted at the same commercial terms as independent/third parties conduct their business under similar circumstances and economic conditions. This ensures that tax base of a country is intact and avoids tax evasion.

One thing i have realised is that transfer pricing provisions aim to adjust prices in order to reflect an arm’s length price which would have applied had the transaction been concluded on normal commercial grounds between unrelated parties. There are several reasons why affiliated enterprises may charge each other prices that are different from those charged between independent willing buyers and willing sellers, some of which are: Low prices charged because sale is made internally, i.e. the seller will not bear advertising costs or costs of securing the market. It may be part of the pricing strategy to kill off competition or to win a market share.

The key principles of transfer pricing are essential guidelines that govern the determination and implementation of transfer prices for intercompany transactions within multinational corporations. These principles ensure that transfer pricing arrangements are conducted in accordance with the arm's length principle and comply with relevant tax regulations. Here are the important key principles of transfer pricing: 1. Arm's Length Principle; 2. Comparable Uncontrolled Price (CUP); 3. Transactional Net Margin Method (TNMM); 4. Cost Plus Method (CPM); 5. Resale Price Method (RPM); 6. Best Method Rule; 7. Documentation and Compliance; and 8. Consistency and Rationality.

An "arm's length price" is the fair and reasonable price at which goods, services, or assets are bought or sold between two parties who are not related to each other and have no special relationship. It's like the price you would expect to pay or receive if you were buying or selling something to a stranger in an open market, without any special deals or influence. The idea is to ensure that transactions are fair and not influenced by any personal or business relationships that could skew the price.

Income Tax Officer: “Ensuring arm’s length pricing with parties?” Taxpayer: “Yes, I am not shaking hands with them. And, hugging is out of question.” Arm’s length principle, the foundation of transfer pricing assures fair price and fair profits. The buyer and seller assume they’re not related. And agree to a price that they would’ve agreed to in open market. But, consider this scenario. A subsidiary company manufactures goods in country A where tax rate is 30%. It transfers these goods. for trade, at a price lower than market price to parent company in country B, where tax rate is 20%. The subsidiary company and paren company are both taxed less. Had arm's length principle been followed, what would everyone have had? Squeaky clean hands.

Substance over form means that the facts are more important than the legal structure and that the facts should conform to the legal form. Say a transaction is legally called a contract manufacturing, however it is in reality a full fledged manufacturing activity. This will give rise to a completely different entity characterisation, remuneration, IP issues etc. Therefore, there is an increased emphasis on substance over form over the past many years and tax authorities are trying to understand the true substance of a transaction and not just go by the legal form.

"Substance over form" is a principle used in transfer pricing to make sure that transactions between related companies reflect the actual economic reality, rather than just the way they are legally structured on paper. Imagine 2 Cos owned by same parent company. One company makes a product and sells it to the other, which then sells it to customers. Now, on paper, these transactions might look like separate sales. But if, in reality, the second company is just acting as a middleman and not adding much value, the transactions might not reflect the true nature of the business. So, look beyond the legal structure of transactions and focus on what's really happening economically. This helps ensure that transfer prices are fair.

One wicked magician used to show a mirror to the king, where everything in the realm was hunky-dory. The complacent king lost his kingdom. Mirror is a mirage. In transfer pricing too, substance must always prevail over form. Conduct of parties must be seen, not contracts. Is the buyer an agent? Study a document, not in parts, but as a whole. In Rolls Royce v DCIT (ITAT 1310/ Delhi/2007), it was found that Rolls Royce Pcl, incorporated in UK, was selling aeronautical engines and spare parts to wholly owned subsidiary Rolls Royce India. But, the Tribunal taxed Rolls Royce Pcl. Why? Because it’s employees. sent on business visits were sleeping in building, with the name plate of Rolls Royce, India. The substance got precedence over form.

“Inconsistency is the only thing in which men are consistent,” once, remarked English poet, Horace Smith, in a light vein.. But, transfer pricing requires consistency principle, which states that when the facts & circumstances continue to remain the same, there should not be any variation in the treatment from earlier year. In JCIT Vs M/s Super House Leather Ltd. (ITAT Lucknow) : Income Tax (Appeal) No. 127 of 2012 case, the assessee had adopted cost plus method, which was rejected by Transfer Pricing Officer. No reasons were given. The Tribunal held that one cannot brush aside the “Principle of Consistency.” Forex loss claimed as non-operating cost in one year and operating cost earlier is against consistency and may attract tax.

In international transfer pricing, transparency extends beyond mere regulatory compliance to become a strategic asset. Effective transparency involves not only meticulous documentation and open disclosure but also the strategic use of technology. Leveraging advanced data analytics and real-time reporting tools can significantly enhance visibility and accuracy in transfer pricing practices. Proactively engaging with tax authorities and adopting technological solutions can mitigate disputes and provide valuable strategic insights, ultimately supporting more robust global operations and decision-making. #TransferPricing #InternationalTaxation #Compliance #DataAnalytics #TaxTransparency #TechnologyInFinance