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How to Calculate Transfer Pricing?

Transfer pricing is the setting of the price for goods and services sold between controlled or related legal entities inside an enterprise or between two countries. For example, if a subsidiary company sells goods to a parent company, the cost of goods paid by the parent to the subsidiary is the transfer price. In this article, we review the benefits of transfer pricing and various methods of calculating transfer pricing.

Related Entities for Transfer Pricing

Legal entities under the control of a single corporation inclusive of branches and companies that are wholly or majority-owned eventually by the parent corporation. Certain jurisdictions consider entities to be under common control if they share family members on their boards of directors.

Benefits of Transfer Pricing

• Transfer pricing for profit allocation method attributes a multinational corporation’s net profit (or loss) before tax to countries where it conducts business.
• Transfer pricing results in the setting of prices among divisions within an enterprise. In principle, a transfer price should be equivalent with either what the seller would charge an independent, arm’s length customer, or what the buyer will pay an independent, arm’s length supplier.
• At the same time as unrealistic transfer prices do not affect the overall enterprise directly. They turn out to be a concern for government taxing authorities when transfer pricing utilizes lower profits in a division of an enterprise that is located in a country that levies high-income taxes and increases profits in a country that is a tax haven that levies no or low-income taxes.

Methods of Calculating Transfer Pricing

The following are methods of calculating transfer pricing:

General Method

Determine the price chargeable for the property transferred or service that is provided in a ‘comparable uncontrolled transaction’. Such price is then adjusted to account for the practical difference between the international transaction and the comparable uncontrolled transaction that could materially affect the price in the open market. Such an adjusted price is the arm’s length price.

Resale Price Method

Decide the price at which the property purchased or service attained by the enterprise from an associated enterprise is re-sold or supplied to an unrelated enterprise. Such a resale price is reduced by normal gross profit margin accruing to the enterprise to the enterprise from the purchase and resale of similar goods in a comparable uncontrolled transaction; if there is no comparable uncontrolled transaction then consider the gross profit of an unrelated person from the purchase and resale of comparable goods. Then decrease the expenses incurred by the enterprise in connection with the purchase of the property. The price so obtained is adjusted to account for the functional difference in the international transaction which may perhaps materially affect the gross profit margin in the open market. The adjusted price is considered the ‘arms-length price’.

Profit Split Method

Decide the combined net profit of the related enterprise’s from the international transaction. Assess the contribution made by each party taking into consideration the functions, responsibility, assets utilized and external market data. Divide the combined net profit in the ratio of the contribution as above determined. Take the profit to arrive at the arm’s length price (ALP).

Cost-plus Method

Decide the direct and indirect costs of production with reference to property or service transferred to the associated enterprise. Determine normal gross profit from uncontrolled transactions. Adjust normal gross profit for the functional and other differences observed in the international transaction. Costs plus adjusted gross profit mark up will be arm’s length price (ALP).

Transaction Net Margin Method

Decide the net profit margin from the international transaction with an associated enterprise. Net Profit Margin from the comparable uncontrolled transaction is computed. Adjust the net profit of uncontrolled transactions for the difference between the transactions. The net profit margin so obtained is utilized to get the arm’s length price (ALP).

Know more about the documentation requirement for transfer pricing in India.