International Taxation Emerging Jurisprudence

Dr. SHAKUNTALA MISRA NATIONAL REHABILITATION UNIVERSITY

Lucknow

Faculty of Law

PROJECT ON

“TRANSFER PRICINGS ANS ITS METHODS”

For

Course On‘International Taxation: Emerging Jurisprudence’

Submitted by

Mrinalini Pal

B.Com LL.B/15-16/18

Academic Session: 2018-19

Under the Guidance of

Dr.VijetaDuaTondon
Asst. Prof. in Law & Faculty for International Taxation: Emerging Jurisprudence
Faculty of Law
Dr. ShakuntalaMisra National Rehabilitation University
International Taxation Emerging Jurisprudence

DRAFT TABLE OF CONTENTS

1. ACKNOWLEDGEMENT

2. INTRODUCTION OF INTERNATIONAL TAX

3. HISTORICAL BACKGROUND OF TRANSFR PRICING

4. MEANING OF TRANSFER PRICING

5. PURPOSE OF TRANSFER PRICING

6. FUNCTION OF TRANSFER PRICING

7. SIGNIFICANCE OF TRANSFER PRICING

8. BASIC ISSUES OF TRANSFER PRICING

9. AIMS AND OBJECTIVE OF TANSFER PRICING

10. METHODS OF TRANSFER PRICING

11. ARM’S LENGTH PRINCIPLE

12. ARM’S LENGTH IN TRANSFER PRINCING

13. ASSOCIATED ENTERPRISES

14. CONCLUSION
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ACKNOWLEDGEMENT

I am highly indebted to our Mam, Dr.VijetaDuaTondonfor her guidance and constant

supervision as well as for providing necessary information regarding the assignment and also
for her support in completing the assignment on “Transfer Pricing and its Methods”.

My thanks and appreciation also goes to my colleague in developing the project and people
who have willingly helped me out with their abilities.

Thank you!
International Taxation Emerging Jurisprudence

Introduction of International Tax

International Tax is best regarded as the body of legal provisions of different countries that
covers the tax aspects of cross - border transactions. It is concerned with Direct Taxes and
Indirect Taxes - Kevin Holmes.

International taxation in a simple language means the study of Taxation beyond the National
Level. Though we all are very much aware about our Indian Taxation Laws but as time is
demanding something more so, there is a need to study the taxation at another level.

International taxation is the study or determination of tax on a person or business subject to

the tax laws of different countries or the international aspects of an individual country’s tax
laws as the case may be.

It is well known that international tax law has many loopholes, and in the past three decades,
multinational corporations (MNC) have exploited them. On 30 August 2016 the European
Commission sent shockwaves throughout the entire investment community when it imposed
a massive $14.5. billion in penalties on Apple, Inc., USA, for receiving illegal tax subsidies
from the Irish government. Further, on 24 December 2016, the Organization of Economic and
Cooperation Development (OECD) announced a universal agreement to address these issues.
The tax loophole misuses have become too serious to neglect anymore. This section reviews
some of the literature to see what has been done and what lies ahead. Morgan (2016)
investigated the root of international taxation problems, arguing profits ought to be reported
as to the place where they are created. Presently, MNCs derive profits from many places
around the world, which can confuse the origin of their profits. The current law cannot keep
pace with the current business environment, as it leads to abuses. Morgan states, “ . . . The
underlying issues are rooted in the capacity of a multinational corporation to construct
organizational circuits that shift where sales, revenue and profit are reported. The capacity in
turn becomes a focus because of the way MNC are treated as a series of separate entities,
subject to the arm’s length principle.” This means contemporary international tax problems
arise from the obsolescence of current law. Thus, reform is required.

Arel-Bundock (2017) indicated international tax treaties among countries give rise to treaty
shopping. This is where the problem of tax loopholes begins. Arel-Bundock claims, “The
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international tax system is a complex regime composed of thousands of bilateral tax treaties.
These agreements coordinate policies between countries to avoid double taxation and
encourage international investment . This implies that multilateral tax treaties cause double
taxation. In order to alleviate the ill-effect, the solution is more treaties. As a result, it
provides the MNC with an opportunity for treaty shopping. Olbert and Spengel (2017)
demonstrated that current international law has been out of touch with what is done in
practice and in fact is not up to speed with advances in technology. They state, “The
phenomenon of digitalization is considered the most important development of the economy
since the industrial revolution and one of the major drivers of growth and innovation. At the
same time, the digital economy is associated with major challenges for the international tax
system. Traditional tax laws are governing new ways of conducting business, but current
international tax law and its underlying principles may not have kept pace with changes in
global business practices.” As a result, international tax law as it stands is inadequate and
does not address current business practices, which tends toward abuse. Transfer pricing is
probably the most serious problem in international taxation. Riley (2014) pointed out that: It
is a general maxim that taxpayers want to minimize their tax liability to the greatest extent
possible. However, taxpayers who overzealously pursue this aim risk crossing the line
separating permissible tax avoidance from impermissible tax evasion. In the realm of
international business tax law, nowhere is this issue more pressing than in the arena of
transfer pricing, in cases where the taxpayer is a multi-national enterprise (MNE) comprised
of corporate entities located in several tax jurisdictions worldwide.This means that the
multinational enterprises increasingly abuse ‘transfer pricing’ between the parent company
and its controlled foreign corporation as a vehicle to shift its profit from a lower-tax country
to a higher one. The only purpose is to minimize its overall tax liability.

Meaning of Transfer Pricing

Transfer price is the price at which transactions are carried out between companies’ part of
the same group .The transactions carried out between related companies must comply with
the arm’s length principle, which is at the heart of any transfer pricing analysis. This means
that the prices applied in transactions between companies from the same group must be the
same with the prices charged by independent companies in comparable economic conditions.
Otherwise, profits will not be correctly reflected in the jurisdiction of each related company
involved in the transaction.
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Transfer pricing is a system of laws and practices used by countries to ensure that goods,
services, intellectual property and resources transferred or shared between affiliated
companies are appropriately priced based on market conditions. This is important as transfer
pricing may inflate profits in low tax jurisdictions and decrease profits in high tax countries –
the so called “base erosion and profit shifting” concept.

Purpose of Transfer Pricing1

Transfer pricing involves the assignment of costs to transactions for goods and services
between related parties. Transfer pricing is typically used for purposes of financial reporting
and reporting income to taxing authorities.
Function
Transfer pricing is used to assign a cost to either tangible goods, intangibles or service
transactions within an organization or related parties. For example, a business that
manufactures clothing may have one business entity that produces the fabric. Since the
business entity that produces the fabric does not formally sell it to the organization that cuts
and assembles the fabric, transfer pricing is used to assign a sales price.

Significance

While transfer pricing is used to create financial statements and report income for tax
purposes, it receives the most scrutiny from taxing authorities. Often, when products are
produced in different countries or tax jurisdictions, organizations may utilize transfer pricing
to assign the greatest profit to tax jurisdictions with the lowest tax rates.

Basic issues of Transfer Pricing2

Transfer prices serve to determine the income of both parties involved in the cross border
Transaction. The transfer price therefore tends to shape the tax base of the countries Involved
in cross‐border transaction.In any cross‐border tax scenario, the three parties involved are the
multinational group, taken as a whole, along with the tax authorities of the two countries
involved in the transaction. When one country’s tax authority taxes a unit of the MNE group,
it has an effect on the tax base of the other country. In other words, cross‐border tax
situations involve issues related to jurisdiction, allocation and valuation.
Jurisdictional issues:-

1Michael Dreiser, Purpose of Transfer Pricing,2017,Bizfluent,https://bizfluent.com, last seen 11/11/18

2ShivangiAgarwal,Transfer pricing:-Meaning ,Risk and Benefits,2015,available at https://www.linkedin.com last seen
12/11/18
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Which government should tax the MNE’s income and what if both claim the same right?
If we consider the case where the tax base arises in more than one country, should one of the
governments give tax relief to prevent double taxation of the MNE’s income, and if so, which
one?
These are some of the jurisdictional issues which arise with cross‐border transactions.-
1. An added dimension to the jurisdictional issue is the spectre of transfer pricing
manipulation as some MNEs engage in practices that seek to reduce their overall tax
bills. This may involve profit shifting through transfer pricing in order to reduce the
aggregate tax burden of a multinational group. It must be noted that the aim of
reducing taxation may be a key motive influencing an international enterprise in the
setting of transfer prices for intra‐group transactions, but it is not the only factor
contributing to the transfer pricing policies and practices of an international
enterprise.
2. The aim in such cases is to usually reduce a multinational group’s worldwide taxation
byshifting profits from associated entities in higher tax countries to associated entities
in relativelylower tax countries through either under‐charging or over‐charging the
associated entity forintra‐group trade. The net result is to maximise an international
enterprise’s after tax profits.For example, if an international enterprise has a tax rate
in the residence country of the parentcompany of 30% and it has a subsidiary entity
resident in another country with a tax rate of20%, the parent has an incentive to shift
profits to its subsidiary to reduce its tax rate on theseamounts from 30% to 20%. If the
parent company shifts $100 million of taxable profits to itssubsidiary, it will make a
tax saving of $10 million. This may be achieved by the parent beingover‐charged for
the acquisition of property and services from its subsidiary.
3. While the most obvious motivation maybe to reduce an international
enterprise’sworldwide taxation, other factors may create an inducement for transfer
pricing manipulation,such as imputation tax benefits in the parent company’s country
of residence.
4. Another motivation for an international enterprise to engage in such practices is to use
a tax benefit, such as a tax loss, in a jurisdiction in which it operates. This may be
either a current year loss or a loss that has been carried forward from a prior year by
an associated company. In some cases an international enterprise may wish to take
advantage of an associated company’s tax losses before they expire, in situations
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where losses can only be carried forward for a certain number of years. Even if there
are no restrictions on carrying forward tax losses by an associated company, the
international enterprise has an incentive to use the losses as quickly as possible. In
other words profits may sometimes be shifted to certain countries in order to obtain
specific tax benefits.In short, international taxation, especially transfer pricing related
issues, throws open a host of issues, the complexity and magnitude of which are often
especially daunting for smalleradministrations.
(ii) Allocation issues
1. MNEs are global entities which share common resources and overheads. From the
perspective of the MNE, these resources need to be allocated with maximum
efficiency in the most optimal manner.
2. From the governments’ perspective, the allocation of costs and income from the
MNE resources needs to be addressed to calculate the tax. There sometimes tends to
be a “tug‐ofwar” between countries in the allocation of costs and resources aimed
towards maximising the tax base in their respective nation states.
3. From the MNE’s perspective, any trade or taxation barriers in the countries in which
it operates raise the MNE’s transaction costs while distorting the allocation of
resources. Furthermore, many of the common resources which are a source of
competitive advantage for the MNEs cannot be disentangled from the global income
of the MNEs for tax purposes – this is especially true in the case of intangibles and
service‐related intra‐group transactions.
(iii) Valuation issues
1. Mere allocation of income and expenses to one or more members of the MNE group
is not sufficient; the income and expenses must also be valued. This directly leads us
to a key issue of transfer pricing, the valuation of intra‐firm transfers.
2. With the MNE being an integrated entity with the ability to exploit international
differentials and utilise economies of integration not available to domestic firms,
transfer prices within the group are unlikely to be the same prices unrelated parties
would negotiate.
3. More generally speaking there sometimes seems to be an underlying tension between
the common goals of the MNEs and the overall economic and social goals of
countries. This is because the perceived responsibility of business is often seen as
using its resources to increase its profits as much as possible while staying within the
rules. This seems to be in contrast at times with the social, economic and political
International Taxation Emerging Jurisprudence

consideration of countries. With so many complex forces at play, it is clear why

international taxation is an open‐ended problem with transfer pricing at its heart.
4. In short, transfer pricing regulations are essential for countries in order to protect their
tax base, to eliminate double taxation and to enhance cross border trade. For
developing countries, to provide a climate of certainty and environment for increased
cross‐border trade while at the same time not losing out on critical tax revenue is of
paramount importance and hence detailed transfer pricing regulations are a must.

Aims & Objective Of Transfer Pricing3:

1. Transfer pricing minimizes the tax burden or arranging direction of cash flow:
Transfer price, as aforesaid, refers to the value attached to transfer of goods, services, and
technology between related entities such as parent and subsidiary corporations and also
between the parties which are controlled by a common entity. Its essence being that the
pricing is not set by an independent transferor and transferee in an arm’s length transaction.
Transaction between them is not governed by open market considerations.

2. Transfer pricing results in shifting profits:

Whatever the reason for fixing a transfer price which is not arm’s length, the result is the shift
of profit. The effect is that the profit appropriately attributable to one jurisdiction is shifted to
another jurisdiction. The main object is to avoid tax as also to withdraw profits leaving very
little for the local participation to share. Other object is avoidance of foreign exchange
restrictions.

3. Shifting of Profits- Tax avoiding not the only object:

Transfer between the enterprises under the same control and management, of goods,
commodities, merchandise, raw material, stock, or services is made at a price which is not
dictated by the market but controlled by such considerations such as:

• To reduce profits artificially so that tax effect is reduced in a specific country;

• To facilitate decentralization of production so that efforts are directed to concentrate profits

in the State of production where there is no or least competition;

• To remit profits more than the ceilings imposed for repatriation.

3Transfer Pricing :-Meaning and Objective,2018, Taxman, Tax and Corporate ,Laws of India .
International Taxation Emerging Jurisprudence

Five Transfer Pricing Methods With Examples4

What Transfer Pricing Methods Are There?

The OECD Transfer Pricing Guidelines provide 5 common transfer pricing methods that are
accepted by nearly all tax authorities.The five transfer pricing methods are divided in
“traditional transaction methods” and “transactional profit methods.”

Traditional Transaction Methods

Traditional transaction methods measure terms and conditions of actual transactions between
independent enterprises and compare these with those of a controlled transaction.This
comparison can be made on the basis of direct measures such as the price of a transaction but
also on the basis of indirect measures such as gross margins realized on particular
transactions.

Transactional Profit Methods

The transactional profit methods don’t measure the terms and conditions of actual
transactions. In fact, these methods measure the net operating profits realized from controlled
transactions and compare that profit level to the profit level realized by independent
enterprises that are engaged in comparable transactions.The transactional profit methods are
less precise than the traditional transaction methods, but much more often applied. The
reason is that application of the traditional transaction methods, which is preferred, requires
detailed information and in practice this information is not easy to find. In short Traditional
transaction methods rely on actual transactions.Traditional profits method rely on profit
levels.

4Methods of Transfer Pricing ,2017 Transfer Pricing Asia, https://transferpricingasia.com Last Seen 13/11/18.
International Taxation Emerging Jurisprudence

The Five Transfer Pricing Methods

As mentioned, the OECD Guidelines discuss five transfer pricing methods that may be used
to examine the arm’s-length nature of controlled transactions. Three of these methods are
traditional transaction methods, while the remaining two are transactional profit methods.

Traditional transaction methods

1. CUP method
2. Resale price method
3. Cost plus method

Transactional profit methods

1. Transactional net margin method (TNMM)

2. Transactional profit split method.

The OECD Guidelines provide that you as a taxpayer should select the most appropriate
transfer pricing method. However, if a traditional transaction method and a transactional
profit method are equally reliable, the traditional transaction method is preferred.In addition,
if the CUP method and any other transfer pricing method can be applied in an equally reliable
manner, the CUP method is to be preferred.

Explanation of the methods

Transfer Pricing Method 1: The Cup Method

The CUP Method compares the terms and conditions (including the price) of a controlled
transaction to those of a third party transaction. There are two kinds of third party
transactions.

 Firstly, a transaction between the taxpayer and an independent enterprise (Internal

Cup).
 Secondly, a transaction between two independent enterprises (External Cup).
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The below example shows the difference between the two types of CUP Methods:

Transfer Pricing Method 2: The Resale Price Method

The Resale Price Method is also known as the “Resale Minus Method.”As a starting position,
it takes the price at which an associated enterprise sells a product to a third party. This price
is called a “resale price.”Then, the resale price is reduced with a gross margin (the “resale
price margin”), determined by comparing gross margins in comparable uncontrolled
transactions. After this, the costs associated with the purchase of the product, like custom
duties, are deducted.What is left, can be regarded as an arm’s length price for the controlled
transaction between associated enterprises. Example of the Resale Price Method:
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Transfer Pricing Method 3: The Cost Plus Method

The Cost Plus Method compares gross profits to the cost of sales. The first step is to
determine the costs incurred by the supplier in a controlled transaction for products
transferred to an associated purchaser. Secondly, an appropriate mark-up has to be added to
this cost, to make an appropriate profit in light of the functions performed. After adding this
(market-based) mark-up to these costs, a price can be considered at arm’s length.The
application of the Cost Plus Method requires the identification of a mark-up on costs applied
for comparable transactions between independent enterprises. An arm’s length mark-up can
be determined based on the mark-up applied on comparable transactions among independent
enterprises.Eg
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Transfer Pricing Method 4: The Transactional Net Margin Method

With the Transactional Net Margin Method (TNMM), you need to determine the net profit of
a controlled transaction of an associated enterprise (tested party). This net profit is then
compared to the net profit realized by comparable uncontrolled transactions of independent
enterprises.As opposed to other transfer pricing methods, the TNMM requires transactions to
be “broadly similar” to qualify as comparable. “Broadly similar” in this context means that
the compared transactions don’t have to be exactly like the controlled transaction. This
increases the amount of situations where the TNMM can be used.A comparable uncontrolled
transaction can be between an associated enterprise and an independent enterprise (internal
comparable) and between two independent enterprises (external comparables).Example:
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Transfer Pricing Method 5: The Profit Split Method

Associated enterprises sometimes engage in transactions that are very interrelated. Therefore,
they cannot be examined on a separate basis. For these types of transactions, associated
enterprises normally agree to split the profits.The Profit Split Method examines the terms and
conditions of these types of controlled transactions by determining the division of profits that
independent enterprises would have realized from engaging in those transactions.

An example of this method is shown in this image:

In the above example, we see two comparable joint ventures. Joint Venture I is owned by
associated enterprises Y and X. Opposite to that, Joint Venture II is owned by independent
enterprises A and B. we need to determine the transfer prices to be charged for the
transactions related to Joint Venture I. For that, we can compare the terms and conditions of
the controlled transactions by determining the division of profits of comparable uncontrolled
transactions. In this example, this means that we can compare Profit Split I with Profit Split
II.

Arm’s Length Prnciples

In order to tackle the issues that arise in the transfer pricing area, the OECD has issued
guidelines which contain recommendations for multinational companies and tax authorities;
OECD international guidelines are based on the arm’s length principle.A transfer price
should be the same as if the two companies involved were indeed two independents, not part
of the same corporate structure. The arm’s length principle (ALP), despite its informal
International Taxation Emerging Jurisprudence

sounding name, is found in Article 9 of the OECD Model Tax Convention and is the
framework for bilateral treaties between OECD countries, and many non-OECD .

The arm’s length principle is a condition in which the parties to a transaction have no prior
relationship with each other, and that they are equal parties to the transaction.
In consideration of the arm’s length principle, parties are considered independent of each
other when they are not related to each other in the familial sense, nor have they engaged in
any prior deals with each other, and have no side deals with each other. The arm’s length
principle also helps guide transactions insofar as appropriate taxation is concerned.

An example of the arm’s length principle at work involves a supervisor’s use of the
company’s human resources department to fire an employee. While the employer and the
employee do have a prior relationship with each other, the termination itself is conducted by a
neutral third party who is not a party to that relationship. This is done to protect the employer
from any lawsuits that the employee may be able to bring upon being terminated, should he
be terminated in a way that deviates from the labor laws within that jurisdiction. The arm’s
length principle here ensures that the employer and the employee each have an unbiased and
qualified advocate on his side.

Arm’s Length in Transfer Pricing

The arm’s length in transfer pricing principle states that the amount that is charged by one
party to the other party in the transaction must be the same as if the parties were not related.
For example, the arm’s length price must be the same as what the price would be on the open
market.When dealing in commodities, arm’s length in transfer pricing is rather
straightforward, and can be as easy as researching comparable transactions. However, if the
transaction deals with trademarked goods or services, then settling on an arm’s length price
can be more complicated.Parties engaged in arm’s length in transfer pricing transactions in
the United States are guided by the best method rule when determining the appropriate arm’s
length price for the transaction. The Best Method Rule requires that the method used to arrive
at the best transfer price be the one that offers the best precision in matching the price of a
comparable transaction. IRS regulations can guide parties insofar as helping them with
determining the best possible method for their transaction.
International Taxation Emerging Jurisprudence

Conclusion

Transfer price is the price at which divisions of a company transact with each other, such as
the trade of supplies or labor between departments. Transfer prices are used when individual
entities of a larger multi-entity firm are treated and measured as separately run entities
Transfer pricing methods are quite similar all around the world. The OECD Guidelines
provide five transfer pricing methods that are accepted by nearly all tax authorities. These
include 3 traditional transaction methods and 2 transactional profit methods.A taxpayer
should select the most appropriate method. In general, the traditional transaction methods is
preferred over the transactional profit methods and the CUP method over any other method.In
practice, the TNMM is the most used of all five transfer pricing methods, followed by the
CUP method and Profit Split method. Cost Plus Method and Resale Margin Method are
barely used.