Explain the concept of transfer pricing with suitable examples and related regulatory framework in Indian context.

What is Transfer Pricing?

Transfer pricing arises when goods, services, or intangible property are transferred between related parties (e.g., parent company and subsidiary) across national borders. The price charged for these transactions is known as the transfer price. Multinational enterprises (MNEs) can manipulate these prices to shift profits from high-tax countries to low-tax countries, thereby reducing their overall tax liability. This manipulation is often achieved by inflating the price of goods sold by a subsidiary in a high-tax country to its parent company in a low-tax country, or vice versa.

Illustrative Examples

Let's consider a few examples:

• Example 1: Pharmaceutical Company: An Indian subsidiary of a US pharmaceutical company manufactures a drug and sells it to its parent company at a price significantly lower than the market price. The parent company then sells the drug in the US at a higher price, effectively shifting profits to the US.
• Example 2: IT Services: An Indian IT services company provides services to its parent company in a tax haven. The price charged for these services is inflated, allowing the parent company to claim higher expenses and reduce its taxable income.
• Example 3: Royalty Payments: An Indian company uses a trademark owned by its foreign parent company and pays a substantial royalty fee. This royalty payment reduces the Indian company’s profits and shifts income to the foreign parent.

Regulatory Framework in India

The Indian transfer pricing regulations are primarily governed by Chapter XII-B of the Income Tax Act, 1961, introduced in 2001. Key aspects of the framework include:

• Arm’s Length Principle (ALP): Transactions between associated enterprises must be priced as if they were conducted between independent parties. This is the cornerstone of transfer pricing regulations.
• Section 92C: This section empowers the tax authorities to disregard transactions that are not at arm’s length and re-determine the taxable income.
• Section 92D: This section outlines the methods for determining the arm’s length price.
• Rules 10A to 10H: These rules provide detailed guidance on the application of the arm’s length principle and the documentation requirements.
• Safe Harbour Rules: These rules provide a simplified approach for determining the arm’s length price for certain routine transactions, reducing the compliance burden for taxpayers.
• Advance Pricing Agreement (APA): An agreement between a taxpayer and the tax authorities on the transfer pricing methodology to be applied to specific transactions.

Methods for Determining Arm’s Length Price

Section 92C(2) of the Income Tax Act, 1961, specifies the following methods for determining the arm’s length price:

Method	Description
Comparable Uncontrolled Price (CUP)	Compares the price charged in a controlled transaction to the price charged in a comparable uncontrolled transaction.
Resale Price Method (RPM)	Determines the arm’s length price by subtracting a gross profit margin from the resale price of the goods.
Cost Plus Method (CPM)	Determines the arm’s length price by adding a gross profit margin to the cost of production.
Profit Split Method (PSM)	Splits the combined profits of the associated enterprises based on their relative contributions.
Transactional Net Margin Method (TNMM)	Compares the net profit margin of the controlled transaction to the net profit margin of comparable uncontrolled transactions.

Challenges in Transfer Pricing Regulations

Despite the comprehensive regulatory framework, several challenges remain:

• Data Availability: Obtaining comparable data for determining the arm’s length price can be difficult, especially for unique or specialized transactions.
• Complexity: Transfer pricing regulations are complex and require specialized expertise.
• Litigation: Transfer pricing disputes are often litigated, leading to lengthy and costly legal battles.
• BEPS Action Plan: The implementation of the Base Erosion and Profit Shifting (BEPS) Action Plan by the OECD has introduced new challenges and complexities in transfer pricing regulations.
• Digital Economy: Valuing intangible assets and determining the arm’s length price for transactions in the digital economy pose significant challenges.