Transfer Pricing Manipulation (TPM) is about setting artificial pricing over the goods and services in a related party transaction. The aim behind this mispricing or fraudulent pricing is to avoid tax incidences and maximize profits for the MNC. Indulging into TPM by the multinationals is a serious menace faced by economies across boundaries.
Transfer Mispricing or fraudulent Transfer Pricing are all taken synonymously with Transfer Pricing Manipulation (TPM). All of them means setting prices artificially in intra-firm transactions to avoid taxes and reap maximum profits. Imagine the scope of this mispricing practice, when 60% of the world’s business happens within an intra-company environment.
Currently, OECD guidelines on Arm’s Length Principle for Transfer Pricing, Advance Pricing Agreements (APA), and Safe Harbour Rules are some of the measures available with tax regimes to control the fraudulent Transfer Pricing. However, it seems the tax regimes need additional measures to plug the loopholes, given the rampant practice of TPM ongoing.
There is more to know about the manipulation involved in Transfer Pricing and, you may please continue to read to explore!
Any Major Need to Dig into Transfer Pricing Manipulation?
It is estimated that 60% of all business transactions happen in an intra- firm environment. Even the biggest of the multinationals of today’s world have been found to be indulged in fraudulent Transfer pricing some way or the other, with google and apple no exception. Imagine the quantum of a problem!!
This evil practice has in the recent past posed some real challenges before tax administrations. The whole process of executing TPM is so cleverly camouflaged under a set of agreements and contracts that, to an untrained eye, this doesn’t seem to be a crafty mess. In the midst of clever documentation, the pricing manipulation is made to look so natural a part of entire transactions that an average tax official could be easily tricked.
The nasty practice rampant in many of the situations has far-reaching adverse implications for developing economies. The manipulations caused by the MNCs have led to capital flights and siphoning of disposable funds leaving the economy in the lurch. Importantly, there are measures in place to check on this financial crime, but the insider views indicate that they are not sufficiently effective.
What Allows Transfer Pricing Manipulation (TPM) Kick in?
In an ideal open market situation, when financial transactions happen, what are the motivation factors? For the seller, it is to gain maximum profit, and to the buyer, it is to save on the purchase cost. The motivation doesn’t work the same way in an intra-company transaction. The pricing set is either on a much higher side or much lower side, and both situations end up benefitting the parent MNC.
Post globalization MNCs operate in many different countries by setting up their affiliates, subsidiaries, etc. As per requirements, all group companies engage in buying and selling the goods, services, or use of a property (including intangible property like IPRs). How do you think they would pay in purchasing these essentials? Do the open market forces ever come into play in these transactions? No! The price setting is accomplished by a process called Transfer Pricing.
Broadly, Transfer Pricing refers to the setting, analysis, documentation, and adjustment of charges made between related parties. When behind the process, there is a similar product or services available on the market to compare with, the Transfer Pricing could be expected to be fair enough.
But, what if the objects under transactions are declared unique by the companies? The matter of fact is that in the majority of the cases, the products and services are reported to be unique, customized, and patented, and this is where Transfer Pricing, in its very essence, fails. The dealing partners do artificially create reasons to enter the negotiated Transfer Pricing and/or cost–based Transfer Pricing, and TPM is born. Incentives of this all are huge and too many, to say the least!
The illegal practice of TPM adopted by many MNCs have the ulterior motives of shifting the tax base from higher Tax regime to a lower Tax regime and as a result allow the MNCs to reap a higher net profit in the process. It is alleged that the top officials of the companies are incentivized for the gains under TPM.
What does Transfer Pricing Ideally Look Like Vis-à-vis TPM?
Transfer Pricing is an act of pricing the goods (Tangible /Intangible) or services for inter-company trades. It is not bad in itself, so long it is market-based Transfer Pricing. Meaning, so long the pricing is kept consistent with the competitive market atmosphere outside, the act of pricing is a natural trade behaviour. Transfer Pricing adopted consistent with market-driven pricing patterns are not bad for Tax regimes.
Unfortunately, in a related trade behaviour, products, services and properties are reported by the trade partners (the taxpayers) to be unique and patented. This declared uniqueness is often highly exaggerated with an intention to keep oneself outside the Market based Transfer Pricing and widening one’s scope of engaging in fraudulent Transfer Pricing.
Transfer Pricing in its very essence refers to the entire mechanism of setting, analysis, documentation, and adjustment of charges made between related business entities for goods, services or the use of property (including intangible). It aims for optimal distribution of revenue between different divisions of a large MNC which jointly develop, manufacture and market products and services. However, the mechanism of TP has been very rampantly used to evade taxes and facilitating capital flights.
Ethically, fair Transfer Pricing can be decided by a number of methods and approaches. The Organization for Economic Co-operation and Development (OECD) stipulates 05 main transfer pricing methods that MNCs and tax administrations can use. Different tax regimes of the word use slight variations of these methods. These all 05 methods of OECD have one concept underlying and that is: Arm’s length Principle of Transactions.
Arm’s Length Principle (ALP) is the Gold Standard to Adjudge a Manipulation in Transfer Pricing
Regardless of how the related companies determine the Transfer Pricing for inter-company flow of goods and services, the tax authorities across the globe use the criteria of arm’s length principle to test if the transfer pricing has been set without any manipulation in the hindsight.
OECD guidelines on Transfer pricing is one of the most comprehensive framework that suggests various methods to test the Transfer Pricing at arm’s length. Most of the economies use these methods either in same form or with slight variations.
India, although not a signatory member of OECD, also uses the methods of OECD guideline with slight variation of the original nomenclatures. CUP (Comparable Uncontrolled Price) method, Resale price method, Cost Plus method, Transactional net margin method (TNMM) & Transactional profit split method are the major methods prescribed under the OECD guidelines on Transfer Pricing.
Manipulators Work Out Backward to Justify Transactions at Arm’s Length
The MNCs intentionally engaging into TPM do not set their transfer pricing on arm’s length principle they instead go for a premeditated pricing and then engage into various kinds of agreements and contracts with suitable clauses therein to camouflage the pricing look like as if, their pricing is based on one of the five methods.
As the burden of proof for justifying transactions at an arm’s length principle lies over the assesses company, the documentations are worked out backwardly. There are instances wherein, economies have been found to suffer billions of dollars in Tax revenues before the manipulation was unearthed. Investigations and News publications reveal that this is usually done by MNCs in connivance with top financial advisors in lieu of considerable share in the Transfer Mispricing game.
Illustrations of TPM with Help of Hypothetical Figures
Let us suppose there is a smartphone MNC with a subsidiary in India. The Indian subsidiary manufactures smartphone at a cost price of Rs. 50 per unit and supplies it to the MNC abroad. The MNC sells the same smartphone in its own country at Rs. 200 to be fair, the transfer price, which the Indian subsidiary should get is cost plus a reasonable rate of return ( i.e, Rs. 50 plus). Also, suppose, in India corporate tax on profits is at 35% while for the MNC country the rate of tax is 45%.
CASE 1- The MNC decides Rs 100 to be transfer price then the scenario look like this:
| Indian Subsidiary (tax 35%) | MNC (Tax 45%) | Total | |
| Cost Price | 50 | 100 | |
| Selling Price | 100 | 200 | |
| Profit | 50 | 100 | 150 |
| Tax | 17.5 | 45 | 62.5 |
| Net Profit | 32.5 | 55 | 87.5 |
The transfer price becomes the cost price for the MNC outside India and then it earns a profit of Rs 100 per unit. Overall total profit after tax earned by MNC (including the subsidiary profit) is Rs 87.5 per unit.
CASE 2- The MNC decides that Rs 150 is the correct transfer price. Then the scenario looks like this:
| Indian Subsidiary (tax 35%) | MNC (Tax 45%) | Total | |
| Cost Price | 50 | 150 | |
| Selling Price | 150 | 200 | |
| Profit | 100 | 50 | 150 |
| Tax | 35 | 22.5 | 57.5 |
| Net Profit | 65 | 27.5 | 92.5 |
The MNC’s profits after tax in its own country comes down to Rs 27.5 but the overall profit has swollen up to Rs 92.5.
CASE 3: The MNC decides that Rs 200 is the correct transfer price, the scenario looks like:
| Indian Subsidiary (tax 35%) | MNC (Tax 45%) | Total | |
| Cost Price | 50 | 200 | |
| Selling Price | 200 | 200 | |
| Profit | 150 | 0 | 150 |
| Tax | 52.5 | 0 | 52.5 |
| Net Profit | 97.5 | 0 | 97.5 |
In such a case, although the MNC earns a zero profit in its own country but as its subsidiary pays only 35% on its profit the overall Total profit of the MNC (including Indian subsidiary) is 97.5.
CASE 4- The MNC decides that Rs 300 is the correct market price on which it would buy from Indian subsidiary. The entire calculation looks like this:
| Indian Subsidiary (tax 35%) | MNC (Tax 45%) | Total | |
| Cost Price | 50 | 300 | |
| Selling Price | 300 | 200 | |
| Profit | 250 | -100 | 150 |
| Tax | 87.5 | -45 | 42.5 |
| Net Profit | 162.5 | 0 | 162.5+0+ 45 |
In this case MNC earns a loss of Rs 100 per unit of smartphone sold in the home country. Meanwhile, its subsidiary earns Rs 162.5 and simultaneously the clever MNC gets a tax write off at home worth Rs 45, so net profit works out to Rs. 207.5.
ALSO CHECK: Equitable Law of Estoppel & Other Defenses
Other Dimensions to Transfer Pricing Manipulation (TPM)
Menace of Transfer pricing manipulation has larger dimensions too, apart from usual tax avoidance. In developing countries, like India, it can have a significant impact on capital flight, as the TP methods make it possible to transfer assets abroad camouflaging the same a part of normal business activity.
Transfer Pricing in the garb of legal mechanisms can be used huge foreign payments to be made as remuneration for intra-group operations. In the guise of legal mechanism, it can be widely used to avoid exchange restrictions, when unchecked. Revelations by ‘Centre of Economy and Finance for Development in Argentina’ pegs the quantum of capital flight in the year 2012 to the tune of $13.22 bn, which surely makes the concern worthy for enforcement agencies.
Countries like Argentina since 2012 have taken tough measures towards payments greater than 100,000 dollars in the calendar year for services and royalties, rent or leasing of buildings located in the country and owned by non- residents when the beneficiary was a related entity and incorporated in countries in the list maintained by Central Bank of Argentina for monitoring purpose.
TPM Arrangements for Tax Avoidance & Capital Flight
Transfer pricing arrangements are not the plain ones, they are usually complex, hybrid and usually difficult to be made out by untrained eyes. An example of a hybrid arrangement could be an agreement or contract that allows an operation to be deductible in one jurisdiction AND not getting recorded as income in another. Imagine an arrangement of giving loan by one Group company to another wherein, interest payments on loan is deductible in one tax regime which is recorded by the other entity as a dividend payment (by way of making additional situations around the loan giving process at the other end).
1. Triangulation, which might involve under-invoicing of exports, over-invoicing of imports, provision of marketing and/or logistical services from abroad, commission agents etc. help execute TPM. Triangulation represents a chain of supplies of goods involving three parties in three different countries. However, instead of the goods physically passing from one to the other, they are arranged to be delivered directly from the first to the last party in the chain.
2. Intra-group Business Services- by one of the group companies, camouflaged as a service expert and Collecting payments from subsidiaries located in different tax regimes. This is one of the most devious arrangements wherein, a number of services for the rest of the group are typically provided from one centre and to which the rest of the group’s subsidiaries send payments to reimburse expenses under ‘cost contribution arrangements’ or as payment for services provided (calculation typically enumerated under agreements as costs plus a margin). To facilitate this in reality, one or more of the group companies are incorporated in low tax regimes e.g, Switzerland and US. The foreign incomes in these countries are charged minimal to zero to rule out double taxation. Difference in tax slabs favours Income shifting from one regime to another and policy against double taxation favours retention at other end without paying to the tax regime. Tax base erosion at both ends eventually allows capital flight from India to Switzerland or say US.
3. Simplification of intangibles: Group companies are seen operating Contract manufacturing service provider and a contract distribution service provider and charge the group company at cost plus margin basis. To achieve this, marketing intangibles (brand, customer portfolio, local entity reputation and so on) or manufacturing intangibles (local know-how) are transferred to another jurisdiction, explicitly or implicitly. Meaning, they may not be made part of the balance sheet entries. In the camouflaging process they might make less but overall tax saving of the group is bigger. A similar objective is under ‘contract research and Development’ sort of arrangements.
4. Huge Share Transfer to abroad entity in the guise of business restructuring also helps executing Transfer Pricing Manipulation. In such instances, all the sales are actualized from abroad but the group company may not receive any income in lieu of that and thereby it enables shifting of the tax base.
5. Excessive/Minimal interest rate on intra-group loans and ‘cash pool’ generation by individual group entities help execute TPM. Yes, loans and financial instruments are commonly used between group entities to transfer income directly from subsidiaries to tax havens or to their parent companies. Many a time, the financial operations only exist on paper and do not mean there has been an actual asset transfer.
A Conclusive Take on Transfer Pricing Manipulation (TPM)
So, in an inter-company set up, TPM is fixing of pricing on the non-market basis which eventually results in saving the total quantum of organization’s tax by shifting accounting profit from high to low tax jurisdictions. This results in moving on one nation’s tax revenue to another and eventually can lead to capital flights.
Sources like Wikipedia are seen stating that a few tax regimes dispute the legality of the process involved but majority agrees about TPM being fraud/Tax evasion. I am with the majority though!
To deal with the menace of TPM, a separate code on transfer pricing under Sections 92 to 92F of the Indian Income Tax Act, 1961 has been introduced. This covers cross border transactions between intra-group companies and is effective from 1 April 2001.
Although, arm’s length Transfer pricing Code imposes extensive requirements of documentation and stipulates harsh penal provisions for manipulators, the offences are going unabated. In fact, the various requirements of disclosure, documentations and penalty provisions under the transfer pricing guidelines will not work until a sufficient number of trained work force is on work to enforce the spirit of Transfer Pricing Code.
FAQs Related to Transfer Pricing Manipulation (TPM)
Ans: Transfer pricing adjustments are essentially, profitability adjustments. The technique is applied by large MNCs or group of companies to adjust the transfer prices in transactions already occurred in an intra- MNC environment. The idea is to bring these transactions between related entities to be at arm’s length which a benchmark of tax- complaint transactions. Transfer pricing adjustments is a way of complying with tax administration in a post facto situation. In some tax regimes like U.S there are secondary adjustments or conforming adjustments too, in order to eliminate any deviation from the arm’s length standard. If these adjustments are not done, it will automatically render a Transfer Pricing Manipulated.
Ans: 1. Comparable uncontrolled price (CUP) method, 2. Resale price method, 3. Cost plus method, 4. Transactional net margin (TNMM) method and 5. Transactional profit split method are the famous 05 Techniques of setting Transfer Price. The methods are recommended by OECD (Organization for Economic Co-operation and Development) and all of them aim to achieve arm’s length Pricing in a related party transaction. Most of the MNCs and tax administrations use these 5 techniques or slight variations of the same. Depending upon the kind of goods and services flow within a Group of associated companies, suitability of the techniques would vary.
Ans: Many Challenges are there with Tax Authorities in ensuring fair reporting of Transfer Pricing in an intra-group business transaction. Revelations suggest that Massive misuse of transfer pricing is done in respect to AMP (advertisement, marketing and promotion). By sheer virtue of AMP being intangible, these business activities have been exploited for tax-evasion purposes. Owing to downturn because of ongoing pandemic, the challenges in transfer pricing calculations have only added surfacing such as: properly attributing losses to group companies, working out on a changed or snapped royalty arrangements, getting comparable data for proper adjustment to reflect current economic scenario.
Ans: Transfer pricing is the methodology of deciding upon the prices to goods and services, capital assets, IPRs etc when they are exchanged from one associated/ related company to another; both being in different tax regimes. The prices so fixed will be a Transfer Price. Because of vested interests the Transfer Pricing is fraught with risks of malpractices to avoid taxes and this is where Transfer Pricing Manipulation arises. Pricing could be fixed in a way so that a common owner of group companies is unduly rewarded.
Ans: Basically, you want to know the Example of Transfer Pricing Manipulation. When the MNCs do not manipulate they use one of the five OECD methods honestly to decide Transfer Prices. But what do they do when indulging into manipulations? Here is an example: Company A is headquartered in Switzerland where Tax slabs are lesser in comparison to India where its subsidiary B is located. While selling anything to subsidiary, A will always price things higher in comparison to the open market so that the Income/profits shifts to Switzerland. This way, A will have more profit under a low tax slab while B will get negligible (or sometimes will show loss too) profit to ultimately pay no tax to India tax regime.
Ans: For any business transaction happening between related companies, open market forces are not there. So, there has to be some mechanism which is agreed by both the tax payer and the Tax authority; this is where Transfer Pricing (in fair sense of course) came into picture. The Tax regimes use a benchmark of arm’s length principle to check the fairness of transactions, which is reflected in all 5 methods of OCED. Hence companies have no options but to employ an arm’s length Transfer Pricing to comply with Tax regimes. Thus, the concept of Transfer Pricing was basically evolved to facilitate Exchange of goods & services in intra- group atmosphere and thereby ensuring optimal utilization of resources belonging to a common owner. However, the MNCs today are using it as a tactics to evade taxes and reap more profit in the process, commonly known as Transfer Pricing Manipulation (TPM).
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