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Transfer Pricing

US Ltd. a US based MNC has a subsidiary, IND Ltd. in India. US Ltd. sells computer monitors to CMI Ltd., another computer reseller. It sells 50,000 computer monitors to IND Ltd. at Rs. 11,000 per unit. The price fixed for CMI Ltd. is Rs. 10,000 per unit. The warranty in the case of sale of monitors by IND Ltd. is handled by IND Ltd. However, for sale of monitors by CMI Ltd., US Ltd. is responsible for the warranty for 3 months. Both US Ltd and IND Ltd. offer extended warranty at a standard rate of Rs. 1,000 per annum. On these facts, how the assessment of IND Ltd. is going to be affected?

Transfer Pricing
Price charged by US Ltd. to CMI Ltd.
Less: Cost of warranty included in price charged to CMI Ltd. (1000X3/12)

10,000
250

Adjusted price (ALP)


Price per unit charged to IND Ltd.

9,750
11,000 1,250

Difference per unit


No. of units supplied Addition required to be made in the computation of total income of IND Ltd. (50,000 x 1,250) 50,000 6.25 crore

Transfer Pricing
Price charged by US Ltd. to CMI Ltd. Less: Cost of warranty included in price charged to CMI Ltd. (1000X3/12) Adjusted price (ALP)

Price per unit charged to IND Ltd.


Difference per unit No. of units supplied Addition required to be made in the computation of total income of IND Ltd. (50,000 x 1,250)

Transfer Pricing
Transfer pricing refers to policy for pricing goods sent by either the parent or a subsidiary to a subsidiary of an MNC. It is a device used by MNCs to price intra-corporate exchange of goods and services in a manner designed to maximize overall after-tax profit. It allows the parent company to control the amount and direction of intra-corporate transfers towards the attainment of a number of vital but often conflicting objectives. in recent years opportunities in this direction are being severely restricted by legal constraints placed by many governments on the practice of transfer pricing.

Transfer Pricing
Essentially, transfer pricing involves charging prices for intra-corporate transactions which are different from those used for identical goods and services in transactions with third parties. The latter are called arms length prices. Transfer Pricing Mechanism By charging high prices higher than arms length prices for the inputs supplied to the subsidiary, the reported taxable profit of the subsidiary is reduced while that of the parent is increased, thus reducing the overall tax liability.

Objectives of Transfer Pricing

Tax saving
Reducing exchange exposure and circumventing exchange controls, restrictions on remittance so that transfers from affiliates to the parent can be maximized.

Reducing customs duty payments and overcoming quota restrictions on imports

Impact of Transfer Pricing Adjustment on Pro Forma Earnings and Taxes: Oakland Corporation Original Estimates (Figures in thousands) Hitax Sub Lotax Sub Consolidated

Sales Less: cost of goods sold Gross profit


Less: operating expenses EBIT

$100,000 $150,000 50,000 100,000 50,000 50,000


20,000 30,000 20,000 30,000

$250,000 150,000 100,000


40,000 60,000

Interest expense Earnings before taxes Taxes (50% & 20% res.) Earning after tax

5,000 25,000 12,500 12,500

5,000 25,000 5,000 20,000

10,000 50,000 17,500 32,500

Revised Estimates Based on Adjusting Transfer Pricing Policy

Hitax Sub Lotax Sub


Sales Less: cost of goods sold $80,000 50,000 $150,000 80,000

Consolidated

$230,000 130,000

Gross profit
Less: operating expenses EBIT Interest expense Earnings before taxes Taxes (50% & 20% res.) Earning after tax

30,000
20,000 10,000 5,000 5,000 2,500 2,500

70,000
20,000 50,000 5,000 45,000 9,000 36,000

100,000
40,000 60,000 10,000 50,000 11,500 38,500

Computation of Arms Length Price

Comparable Uncontrolled Price Method Resale Price method Cost Plus Method Profit Split Method Transactional Net Margin Method