At its core, transfer pricing refers to the pricing of goods, services, and intangible assets transferred between related entities within the same corporate group. While it may sound straightforward, transfer pricing has significant implications for tax liability, regulatory compliance, and financial reporting.

Different countries offer different income tax rates. These differences in tax rates create an arbitrage opportunity for the multinational enterprise (MNE) to set their transfer price in such a manner that the profit shifts to low-tax countries and thus reduces their group tax liability.

The strategy involves a multinational enterprise selling itself goods or services at an artificially high price to a subsidiary in a tax haven. For example, buying a pen from a tax haven subsidiary for $150 per paper, the MNE moves its profits out of the country to the tax haven and saves itself from paying high taxes in the country where it is actually doing business.

This practice resulted in a huge tax loss (approx. USD 100–200 billion annually) for governments even though the primary economic activity is taking place in their countries.

To counter such tax avoidance mechanisms and ensure fair tax practices, where the income generated in a country is taxed in the same country, the OECD introduced the Base Erosion and Profit Shifting (BEPS) initiative. This seeks to close gaps in international taxation for companies that allegedly avoid taxation by engaging in tax inversions or by migrating intangibles to lower-tax jurisdictions.

The OECD has issued 15 Action Items to tackle areas where multinational companies most aggressively shift profits to low-tax jurisdictions. These cover concerns such as the digital economy, treaty abuse, and transfer pricing documentation.

The Act requires the enterprise to price international transactions between associated enterprises at Arm's Length Price.

Let's take a detailed example:

Stylora Inc. is a U.S.-based fashion brand that designs and markets premium clothing globally. It owns a wholly owned manufacturing subsidiary in India, Stylora India Pvt. Ltd., which produces garments exclusively for the U.S. parent.

Cost and Sales Details (per shirt):

• Stylora India manufactures a shirt for $5 (including fabric, labor, overheads).
• These shirts are sold by Stylora Inc. in the U.S. market for $40 each.
• Stylora Inc. incurs an additional $10 per shirt on marketing, warehousing, and retail operations in the U.S.

Total Group Profit (per shirt):

• $40 (U.S. sales price) - $5 (India cost) - $10 (U.S. costs) = $25 total profit

Stylora must decide the transfer price at which Stylora India sells the shirts to the U.S. parent. This price determines how much profit is taxed in India and how much is taxed in the U.S.

Option A: Low Transfer Price – $6 per shirt

• Profit in India = $6 - $5 = $1 per shirt
• U.S. cost of goods sold = $6
• U.S. profit = $40 - $6 - $10 = $24 per shirt

Most profit is taxed in the U.S., where the tax rate is 21%.

Option B: High Transfer Price – $20 per shirt

• Profit in India = $20 - $5 = $15 per shirt
• U.S. cost of goods sold = $20
• U.S. profit = $40 - $20 - $10 = $10 per shirt

More profit is taxed in India, where the corporate tax rate is 25% (assuming no special tax incentives).

Under Indian transfer pricing regulations (Section 92 of the Income Tax Act), Stylora must justify that the $6 or $20 transfer price aligns with the arm’s length principle — i.e., what an unrelated buyer would pay an independent Indian manufacturer for similar shirts under similar terms.

Methods for determining Arm’s Length Price:

There are several accepted methods for determining arm’s length prices, including:

1. Comparable Uncontrolled Price (CUP) Method
2. Resale Price Method
3. Cost Plus Method
4. Transactional Net Margin Method (TNMM)
5. Profit Split Method

Each method has its strengths and is suitable for different types of transactions, depending on the availability of reliable data and the nature of the goods or services.

Transfer pricing is a complex and often contentious issue. Common challenges include:

• Valuing intangible assets, like intellectual property
• Finding comparable market data to support the transfer price determined
• Doing cumbersome computations and having all the variables and assumptions in place
• Dealing with differing tax rules and documentation requirements across jurisdictions
• Huge penalties for non-compliance