C Satapathy - Transfer Pricing - Impact on Taxation and Profits

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Transfer Pricing: Impact on Trade and Profit TaxationAuthor(s): C. SatapathySource: Economic and Political Weekly, Vol. 36, No. 20 (May 19-25, 2001), pp. 1689-1692Published by: Economic and Political WeeklyStable URL: http://www.jstor.org/stable/4410629 .

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PerspectivesTransfer Pricing: Impact o nT r a d e a n d P r o f i t TaxationIt is not enoughto adoptinglaws to regulatetransferpricingforwhich several models exist. The test in implementinghe laws liesin developingpractical skills and meetingthe resource needswithinthe administration.Theadministrativeregime or regulatingtransferpricingshould be specialised but also developmentfriendly.Duties and taxes should not be allowed to be evaded,butat the same time the mannerof regulating transferpricing shouldnot act as a disincentiveto theflow offoreign investment.C SATAPATHY

he World Development Report1999/2000 [World Bank 1999]notes that fragmentation of pro-duction processes across internationalborders s animportantnew trend,particu-larly for developing economies. This"slicing up the value chain" involvesseparatestages of production being con-ductedin different countries. The reasonsarenotfarto seek. Global trade rules havelowered trade barriers and uncertainties,and have consequently given a boost toglobal productionnetworks. Phenomenalprogress n global transportation nd com-municationhas also made managementofsuch global productionnetworks easy.These developments have also resultedin an increase in intra-firm trade. TheWorld Development Report notes thatabout one-third of the world trade takesplace within global productionnetworks.The following figures indicate the recenttrend in global trade:- About 40 percent of US importsandexports are between US firms and theirforeign affiliates or parents.- About 40 percent of US-Europe tradeis betweenparent irms andtheir affiliates.- About 55 per cent of EC-Japantradeis betweenparent irms andtheiraffiliates.- About80percentofUS-Japan tradeisbetween parentfirms and their affiliates.Transferpricing is one of the mecha-nisms for inter-companyfund flows, theothers being fee and royalty adjustments,dividendadjustments,nter-companyoans,

etc. Transfer rice s thepricechargedbytheparent irm o itsaffiliate, heaffiliateto its parent irm,one affiliate o anotherorbyonedivisionoanotherdivisionithinthesame irmorgoodsorservices rovided.Transfer ricescanbe arbitrarilyet to:- reduce taxes,- reducetariffs based on ad valoremduties,- avoid exchange controls.Hines(1996)andClausing 1998)pro-vide evidence of transfer ricingsignifi-cantly influencedby taxation.Tax au-thoritiesaround heworldareincreasingtheir crutiny f inter-companyransfer fgoods andservices withinmultinationalcorporations. heconcerns nmostdevel-opedcountries elate o theareaof directtaxation, ie, income tax on corporateprofits.Thedeveloping ountries aveanadditionalconcernrelatingto customsvaluationn view of theirgreaterdepen-denceon trade axes as a major ourceofrevenue.Left oitself,amultinationalirmwouldobviously choose a price that wouldoptimise tsglobalprofits. nhis seminalpaper,Horst 1971)haddeviseda globalafter-tax arning unctionE as follows:

E= (1-t,)(Rl- C1)+(1-t2)(R2-C2)+[(t2- tl) - (- t2)T2]PM,where R1, C1, tI and R2, C2, t2 arerevenue rom ales,cost ofproductionndtax onprofitsn theexporting nd mport-ing countriesrespectivelyand M is thequantity exported from Country 1 toCountry , P the transfer riceandT2the

tariff in Country 2. His conclusion wasthat if the relative tax rate between the twocountries (t2- tl)/(1- t2) is less than thetariff rate T2, the multinational firm willalways choose the lowest transferprice tosave on tariffs. While choosing a lowtransferpricethatoptimises global profits,a multinational irmhas,however,to ensurethat such a price meets the legal require-ment of the arm's length principle. Theborderline between criminally fraudulentover- and under-invoicing and lawfultransferpricingcanbe thin attimes. Trans-actionsthrough ax-havensshowing lowerprofitsinboth theexportingandimportingcountries as well as evading tariffs in theimporting countries further complicatethings for the tax administrators.Arm's Length Principle

The transferpricing laws in most devel-oped countries have been influenced bythe Organisationfor Economic Coopera-tion andDevelopment (OECD) guidelinesand US law on the subject, which in turnare based on the arm's length principle.The arm's length principle means thattransactions should be valued at priceswhich a company would have chargedanother unrelatedcompany based purelyon marketconsiderations. Article 9 of theModel Tax Convention on Income and onCapital formulated by OECD applies theconcept of arm's length principle to taxa-tion as follows:

[When] conditionsare made or imposedbetween two [associated]enterprisesintheir commercial or financial relationswhich differ from those which would bemade between independententerprises,thenany profitswhichwould,but or thoseconditions, have accrued to one of theenterprises,but, by reason of those con-ditions, have not so accrued, may beincluded in the profits of thatenterpriseand taxedaccordingly.Thearm's engthprinciple asnot,how-ever,resulted n a singlemethodof trans-ferpricing. thasgivenrise to thefollow-ing transferpricingmethods:- Comparable Uncontrolled Price(CUP)Methodor MarketPriceMethod,- Resale PriceMethod(RPM)or Re-sale MinusMethod,- Cost Plus Method (C+),- Comparable rofitsMethod CPM),

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- Profit Split Method (PSM),- Transactional Net Margin Method(TNMM), and- other unspecified methods.ComparableUncontrolledPrice Methodis also known as the MarketPrice Methodunder which the price of a transferredproduct is compared with the prices ofsimilarproductssold by or to uncontrolledand unconnectedentities. This methodcanbe used if productsare similar. Identifyinganexactly similarproduct s often difficultunless the multinational firm itself sellsthe same product to both controlled anduncontrolled customers At times, an ad-justed or inexact comparablemarketpriceis also used.The Resale Price Method uses the resaleprice at which a product bought from anassociated multinationalfirm is resold toanindependentcustomer.The resale priceis reduced by the resale gross margin,customs duties, etc, to arrive at the arm'slength price.The Cost Plus Methodon the other handuses the cost incurredby the supplier firmwith anappropriatemarkuptowardsprofit.The idea is similar to cost plus governmentcontracts.The Comparable Profits Method deter-mines the amount of profit the multina-tional firm would have earned by using acomparable profit level derived from itsuncontrolled transactions with indepen-dent buyers. Under this method, profit ofone party to the transaction is analysed.The Profit Split Method on the otherhand measures the combined profit fromintrafirm transactions and then the sameis split or allocated according to contribu-tion of each affiliate ordivision of the firm.In this method, profits of both parties tothe transactionhave to be analysed.The Transactional Net Margin Method(TNMM) examines the net profit marginrelative to appropriatebase such as costs,sales, assetsetc, andis similarto Cost Plus.and Resale Price Methods.Other unspecified methods also existwhich are not frequently used. Engineer-ing Cost StudyMethod estimates at whatcost the purchasingfirm can manufacturea productand decides to pay that amountto its related supplier. Under the Formu-lary ApportionmentMethod, the globalprofits are allocated between all affiliatesand divisions in a predeterminedmanner.Similarly, a Cost and Risk Arrangementmay exist between affiliates primarily inrelation to development and research fora new productor a new intangible prop-

erty. While, the multinational firms mayuse these methods in a way that is mosttax-efficient, the tax-administrators haveto ensure that these methods are not usedas means of tax avoidance. Advance Pric-ingArrangementsaresometimes concludedbetween the multinational firms and thetax authorities of home/host countries toavoid future uncertainties and conflicts.

As far as intangible services and prop-ertiesareconcerned,theyalso pose similarproblems in transferpricing as in the caseof tangibles in the form of goods includingfinished products, components and rawmaterials. The UNCTAD publication on'Transfer Pricing' lists the following in-tangibles:- patents, inventions, formulas, pro-cesses, designs or patterns;- copyrights, literarymusicalorartisticcompositions;- trade marks, trade names or brandnames;

- franchises, licences or contracts;- methods, programmes, systems, pro-cedures,campaigns, surveys, studies,fore-casts, estimates, customer lists or technicaldata; and- other intellectual property not listedabove.Comparable Uncontrolled Transaction

(CUT) method of valuing intangibles issimilar to the CUP Method for tangibles.Comparable Profit Method (CPM) andProfit Split Method (PSM) also apply tointangibles. On the otherhand, the ResalePrice Method and the Cost Plus Methodare not applicable to intangibles as intan-gibles are not resold separately.A super royalty provision in the US lawmakes an advance in this regardrequiringthat income on transferor licence of intan-gibles should be commensurate with in-come attributableto the intangible. Withthis provision, if income from intangibleschange significantly in thefuture,thepricedetermined arliercanbechanged.Attimes,therearearangeofpricesavailable ochoosefrom n respectof intangiblesuch as interestrates on intra-firmloans, managerial ser-vices provided at cost, etc. Multinationalfirms can set suitable prices for such in-tangible to minimise their totaltax burden.Changes in Finance Bill 2001

The armslength principle is reflected inthe tax legislations of several countries:- Section 482 of the Internal RevenueCode of the US,- Sections 770-773 of the Income and;

CorporationTaxes Act of the UK.- Articles 66-5 of the Special TaxationMeasures Law and the Special TaxationLaw relating to Tax Treaty of Japan.- Section 69 of the Income Tax Act ofCanada.- Section 92 of the Income Tax Act ofIndia.The Finance Bill, 2001 (Clause 44) hasintroduced legislative changes in the In-come Tax Act for substitutingthe existingSection 92 by new Sections 92 and 92Athrough 92F with effect from April 1,2002. These changes are based on thereportof anexpertgroupset upin Novem-ber 1999 to examine issues relating totransferpricing.Existing Section 92 of theIncome Tax Act reads as under:

92 Income from transactions with non-residents, how computed in certain cases:

Where a business is carriedon between aresidentand non-residentand it appearstotheincome-taxofficerthat,owingto theclose connection between them, thecourse of business is so arrangedthatthebusiness transacted etween hempro-duces to the resident either no profitsorless thantheordinaryprofitswhichmightbe expected to arise in thatbusiness,theincome-tax officer shall determine theamount of profits which may reasonablybedeemedtohave been derived herefromand include such amountin the total in-come of the resident.The text of the existing Section 92 isquite general and is based on the conceptof 'ordinary profits' which in a way is notdifferent from the arm's length principle.However, the proposed Section 92 explic-itly refers to the arm's length principle:92 Computationof Income from Interna-tional transactionhaving regardto arm'slength price:(1) Any income arising from an inter-national ransactionhallbecomputedhav-ing regardto the arm's length price.(2) In computingincome under sub-sec-tion (1), the allowance for any expenseorinterest shall also be determinedhavingregardto the arm's length price.(3) Wherein an internationalransaction,two or more associatedenterprisesenterinto a mutualagreementor arrangementfor the allocationor apportionment f, orany contribution o, any cost or expenseincurredor to be incurred n connectionwith a benefit,service of facilityprovidedor to be providedto any one or more ofsuch enterprises,the cost or expense al-located or apportioned o or, as the casemaybe,contributedy, anysuchenterpriseshall be determinedhaving regardto the

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arm's engthpriceof suchbenefit,serviceor facility, as the case may be.The proposed Sections 92A and 92Brespectively define the meaning of 'asso-ciated enterprise'and 'international trans-action'. The definition of associated en-terpriseproposedin the Finance Bill 2001is very broad and goes far beyond theconcept of 'mutuality of interest in thebusiness of each other' strictly interpretedby thejudicial authorities in India in sev-eral customs and central excise valuationcases. For example, under the proposedSection 92A(2)(a), one enterpriseholdingshares carrying voting powers of 26 percent or more in another is sufficient tomake them associated enterprises,even ifthelatterhasnoshareholdingin the former.Similarly, one enterpriseappointingmorethan half the board of directors or one ormoreof the executive directorsof theotheror supplying know-how, patents etc, tothe otherwill now be treated as associatedenterprises.Even purchaseof 90 per centor more of raw materials and sale of fin-ishedgoods with theprices influenced willhave to be treated as associated enter-prises.These provisions provide acontrastto the earlier decision of the customs tri-bunal upheld by the Supreme Court inCollector of Customs v Maruti Udyog,[1989(22) ECR482(SC)] to the effect thatSuzuki and Maruti cannot be held to berelated or to have interest in the businessof each otherdespite Suzuki having 26 percent share in Maruti since Marutihad nosharein Suzuki.This decision is still goodlaw and has been followed in other cases.To ensure similar treatment to the sameinternational ransactionbetween two en-terprisesunderboth the Income Tax Actandthe Customs Act, the legal provisionsunder the latter need to be changed andmade asbroadbasedas has now been doneunder the proposed Section 92A of theIncome Tax Act.The proposed Section 92B defines aninternationaltransaction as a transactionbetween two or more associated enter-prises, either or both of whom are non-residents. It appears to intentionally orotherwise exclude from its ambit cases ofinternational transfer of goods betweentwo domestic firms. A domestic firm maysupply to another affiliated domestic firmgoods from its depot abroad which willconstitute an international mporttransac-tion and is so treated from customs valu-ation point of view.The proposed Section 92C stipulatesthat the.arm's length price in relation to

an international transaction is to be deter-mined by one of the five methods listed(CUP, RPM, C+, PSM andTNMM) or bysuch other method as may be prescribed,being the most appropriatemethod. Arm'slength price has been defined in the pro-posed Section 92F as the "price which isapplied or proposed to be applied in atransaction between persons other thanassociated enterprises, in uncontrolledconditions". A provision has also beenintroduced by way of proposed Section92C(3) which enables as assessing officerto redetermine the arm's length price onthe basis of material,information or docu-ment with him if he is of the opinion ithas not correctly determined, or if theinformationor data used is not reliable orcorrect, or if the necessary information,documents etc, have not been maintainedor furnished.The proposed Section 92D requirespersonsentering ntoaninternational rans-action to keep and maintain informationand document in respect thereof and tofurnish thesame on demand.TheproposedSection 92E requires obtaining and fur-nishing a reportfrom an accountant.Theproposed Sections 271AA and 271G pro-vide for a penaltyof 2 percent of the valueof international transaction for whichrequired information and documents arenot maintained or furnishedunderSection92D and the proposed Section 271BAprovides for a penalty of Rs 1 lakh for notfurnishing a report under Section 92E.Penal provisions under Section 271 forconcealment of income (up to three timesthe amount of tax on concealed income)has also been extended to transferpricing cases.There has been some criticism in thepress (The Economic Times, March 8,2001) thatoverpolicing of transferpricingwill keep FDI away and that the penalprovisions areexcessive. Some apprehen-sions have also been expressed that "theelegance of transfer pricing norms endswhen the tough business of implementa-tion begins".Customs Valuation

While the income tax authorities mayseek to assess a lower transfer price onimportsto avoid diversion of profitsto theexporting country,the customs authoritiesmay seek to determine a higher transferprice to avoid undervaluationand conse-quent loss of customs duty. The tradeministryn an mporting ountryncharge

of administering anti-dumping andcounter-vailing duty laws would also likethat the transfer price of imports is sethigherso thatthereis no dumpingor unfairtrade.Understandably,the WTO measures oncustoms valuation, being mostly reitera-tion of Tokyo Round measures agreed in1979,are silentabout ransferpricing ssueswhich had not assumed prominence 22years ago. Article VII of GATT, 1994 doesnot refer to transfer pricing, but clearlymakes a case for arm's length price forcustoms valuation. Similarly, the imple-menting WTO Agreement on CustomsValuation (ACV) does not mention abouttransferpricing, but in the case of relatedparty transactions, it favours an arm's

length price comparable to test valuesarrived from sale of identical or similargoods. If there is no sale, as would be thesituation in respect of transfer of goodsbetween divisions of the same company,arm's length price for sale of identical orsimilargoods provides the basis. In otherwords, ACV provides a method ofvaluation akin to the CUP method. In acase where transaction values are notavailableeven foridenticalor similargoods,ACV provides for Deductive ahd Com-puted Value Methods which are akin toResale Price Method and Cost PlusMethod respectively.In a recentcase, the US court of appealsfor the federal circuit has delivered a sig-nificantjudgmenton April27, 1999 (VWPof America Inc v United States) seekingto harmonise the valuation methods usedfor purposes of customs valuation and thefederal income tax laws [Millerand Cheva-lier 1999]. It reversed a long-standing UScustoms service policy under which cus-toms duties for intra-firm transfers werecommonly based on price to the subse-quent third-partyUS customers. As perthe courtruling,thecustoms valuationwillnow be equal to the price that would bepaid, by unrelatedcompanies buying andselling at arm's length.With the intra-firm trade growing inleaps and bounds, the customs adminis-trations as well as the income tax authori-ties have a difficult job in hand in tacklingtransferpricing issues. They need to havenotonly informationsharing arrangementswithin their own countries, but also haveto take recourse to mutual administrativeassistance from the exportingcountries.Inthe case of developing countries like Indiahighercustoms duty rates than the incometaxratesoncorporateprofitsinduces lower

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transferprices to save on importtariffseven if incometax may have to be paidon resultant igherprofits.Let us assumea productmportedby an affiliate of anMNC oIndia romacountrywith ncometax rate 30 percent has an arm'slengthpriceof Rs 100. If the product s over-valuedby Rs 20, the MNChasto payRs6 of extra income tax in the exportingcountryon extraprofits,whereas he af-filiate n IndiawillpayRs 6.12less incometax(calculated@ 30.6 percentincluding2 percent surcharge) n reducedprofitsbut increased ustomsduty of Rs 12.57(calculated@35 percent basic customsduty+ 16percentadditionalustomsduty+ 4 per cent special additional ustomsdutywhichequals62.86 percent on theimportprice).This would reflecta globalloss of profit o theextentof Rs 12.45forthe MNCand ts affiliate. t is inconceiv-able,therefore,hat he transfer ricewillbesethigher oevade ncome axin India.Onthe otherhand, f theproducts under-valuedby Rs 20, the tax liabilityin theexporting ountrywill reduceby Rs 6 onreducedprofits,whereas the affiliate inIndiawill have to pay increased ncometaxof Rs 6.12on increased rofitsbutwillsaveRs 12.57oncustomsduties.Thiswillbe a betteroptionas theglobal profitsofthe MNC and its affiliatewill go up byRs 12.45 despitehavingto pay Rs 6.12more towards ncome tax in India. Thisexampleillustrates hat transferpricingmanipulationncountriesikeIndia s notmuch of a threat or the income tax au-thorities s t is forthecustomsauthorities.There s, therefore, case forstrengthen-ing the legal provisionsandthe admini-strativemachinery n the customsside.There an,ofcourse,bea fewexceptionstothe abovescenario. f thetaxrate n theexporting ountry s low and theproductis eitherexempt from customs duty inIndiaorattracts ery ow duty,over-valu-ationcanberesortedoreduce ncome axliability n India.Nevertheless,giventhecurrent atesof income tax and customsduties nIndia, hereare ikelyto bemuchgreater ncentives or importing irmstoset lower ransfer rices o evadecustomsduty andactually aya littlemore ncometax) than to set highertransferpricestoevade income tax (as this would entailmuchhighercustomsduty liability).Therecan also be cases where for thesametransaction, lowerimportvalue isindicated o customs o payless dutyanda higher mportvalue is indicated o in-come axforpaying esstaxonprofits.To

detect such cases, it would require greatercooperation between the customs andincome tax authorities as well as legalprovisions of the kind incorporated inSection 1059A of the Internal RevenueCode in the US which provides that valuefor importedgoods cannot be greaterthanthe customs value. In enacting Section1059A, the US Congress had taken intoaccount he possibilities hat some importerscould claim a transferprice for income taxpurposes thatwas higherthanthe transferprice claimed for customs purposes andthe Congress was particularlyconcernedthatsuchpracticesbetweencommonlycon-trolled%ntitiesould improperlyavoid USincome tax or customs duties [Cole 2000].It is not known what recommendations,if any, the expertgroupon transferpricinghasgivenin itsreport orlegislative changesin this regard and what steps it has sug-gested for increased cooperation betweenthe customs and income tax authorities fordetecting transfer pricing manipulations.OECD has done a lot of work in the areaof transfer pricing and has this to say inthis context:

Cooperation between income tax andcustomsadministrationswithin a countryin evaluatingtransferprices is becomingmore common and this should help toreduce henumberof caseswherecustomsvaluationsare foundunacceptable or taxpurposesor vice versa. Greatercoopera-tionintheareaof exchangeof informationwould be particularlyuseful, and shouldnot be difficultto achieve in countries hatalreadyhave ntegrated dministrationsorincome taxes and customs duties. Coun-tries hathaveseparate dministrations aywish to considermodifyingthe exchangeof information ulessothat he nformationcan flow more easily between differentadministrations OECD 1999].OECD recommendationsas above havea greater significance in the developingcountry scenario. Apart from mutual co-operationand setting up a formal networkfor exchange of information on transferpricing, the same criteriaas adoptedunderthe Income Tax Act for defining associ-

atedenterprisescanperhapsbe adoptedforcustoms valuation purposes and uniformdocumentation an alsobeprescribedunderthe income tax and customs laws so thatthe assessees do not have to maintainseparaterecords. Even acommon audit forincome tax and,customs purposes can bethoughtof as it would increase greatertaxcompliance while reducing the compli-ance cost forthe assessees. Very often datato provea transferprice manipulationhave

to be obtained either from customs database of contemporaneousimportsor fromabroad through the customs and tax au-thorities of exporting countries undermutual assistance treaties. It may, there-fore, be desirable to channel such requeststogether for both customs and income taxpurposesrather han sendmultiple requestsfor assistance for the same transactiontorevenue authorities abroad.UNCTAD (1999) has highlighted thedevelopment dimensions of the transferpricing issues. It is not merely enough toadopt laws regulating transferpricing forwhich several models exist. The test inimplementingsuch laws lies indevelopingpractical skills and meeting the resourceneedswithin he administration. headmini-strativeregime for regulatingtransferpri-cing shouldbespecialisedbutalsodevelop-mentfriendly. Duties and taxes should notbe allowed to be evaded, but at the sametime, the manner of regulating transferpricing should not act as a disincentive tothe flow of foreign investment. 3il[Theviews expressedhereare thepersonalviewsof the author. Parts of this paperwere used bytheauthor slecturenotes attheCustomsValuationCourse or CommonwealthCountries nMay2000and at a similarcourse for SAARC countries inMarch 2001. The author is grateful for usefulcomments made by the participants at thesecourses.]ReferencesClausing K A (1998): 'The Impactof TransferPricingon Intra-firmTrade',NBERWorkingPaperNo 6688.Cole, R T (ed)(2000): 'PracticalGuide To USTransferPricing',TaxAnalysis,Arlington,US.Hines,J R (1996): 'Tax Policy and the Activitiesof Multinational Corporations', NBERWorking PaperNo 5589.Horst,T (1971):'TheTheoryof the MultinationalFirm:OptimalBehaviourunderdifferentTariffandTaxRates',Journalof PoliticalEconomy,79(5), p 1059.Miller and Chevalier(1999): 'HarmonisationofInteraffiliateTransferPricing', InternationalAlert, May 13.UNCTAD (1999): 'TransferPricing',UNCTADSeries on Issues in International nvestment

Agreements, United Nations, Geneva.World Bank (1999): Enteringthe 21st Century:World Development Report 1999-2000,Oxford UniversityPress, Oxford.

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C Satapathy - Transfer Pricing - Impact on Taxation and Profits

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