June 21, 2023
Durga Prasad

Transfer Pricing: A Key Factor in Tax Compliance

In the fast-expanding global economy of the twenty-first century, India's remarkable growth in commerce and investment, coupled with the establishment of international supply chains, has revolutionized the way businesses operate. This shift has led to an increase in intra-group transactions, commonly known as related party transactions, on a global scale. One significant aspect of these transactions is transfer pricing, which plays a crucial role in determining taxable income distribution among different jurisdictions. 

Transfer Pricing:

In intercompany transactions, transfer pricing refers to the price charged for goods, services, or technology transferred between linked parties. These linked parties can include a parent company and its controlled foreign firm, subsidiaries, or other associated enterprises. The transfer prices set in these transactions have a direct impact on the allocation of taxable income across different tax jurisdictions. As tax rates vary between countries, transfer pricing strategies can significantly affect a company's after-tax income.

Importance of Transfer Pricing:

Transfer pricing holds several key goals and importance for multinational corporations (MNCs) and tax authorities. Let's explore some of them:

1. Profit Allocation: Transfer pricing allows MNCs to allocate profits and costs to their subsidiaries located in different countries for management accounting and financial reporting purposes. This ensures proper evaluation of each division's performance and facilitates resource allocation within the company.
2. Compliance and Risk Mitigation:
With increased scrutiny from tax authorities, complying with transfer pricing regulations is crucial to avoid the risk of non-compliance. Understanding transfer pricing concepts helps businesses meet legal obligations and ensure accurate reporting, thereby minimizing the risk of penalties or audits.
3. Shareholders' Wealth:
Transfer pricing can directly impact a company's taxable income and, consequently, its after-tax free cash flow. By managing transfer pricing effectively, companies can optimize their tax liability and enhance shareholders' wealth.

Arm's Length Principle:

To prevent profit shifting and ensure fairness in intercompany transactions, tax administrators worldwide have established the Arm's Length Principle (ALP). The ALP dictates that controlled transactions between associated enterprises should be conducted at market prices similar to those between unrelated parties. This principle ensures that entities with common ownership or control agree on terms and conditions similar to those observed in independent transactions.

Transfer Pricing Methods:

In India, the Transfer Pricing Regulations provide six primary methods for calculating an appropriate arm's length price (ALP) for international transactions or specified domestic transactions. These methods include:

1. Comparable Uncontrolled Price (CUP) Method:

The CUP method compares the price charged in a controlled transaction with the price charged in a comparable uncontrolled transaction between unrelated parties. This method relies on identifying similar transactions involving similar products or services under comparable circumstances. It aims to determine an arm's length price by ensuring that the controlled transaction is priced similarly to transactions between unrelated parties. Commercial databases and market research are often utilized to gather data and support the analysis.

2. Resale Price Method (RPM):

The RPM evaluates the resale price of a product or service purchased by a controlled entity from a related party and then resold to an independent customer. This method applies a suitable gross profit margin to the resale price to establish an arm's length price. It is commonly used when the controlled entity primarily performs basic functions such as sales, marketing, and distribution, without significant value-adding activities.

3. Cost Plus Method (CPM):

The CPM determines an arm's length price by adding an appropriate markup to the production cost incurred by the supplier of goods, services, or intangibles to the controlled entity. This method is often applied when the controlled entity engages in the purchase of semi-finished goods, components, or services from a related party. The markup represents the expected profit that an independent supplier would seek to earn in a comparable transaction.

4. Profit Split Method (PSM):

The PSM allocates profits between related parties based on a comparison of profits earned in analogous uncontrolled transactions. This method is suitable when the controlled entity and the related party contribute unique and valuable intangibles, resources, or services to a transaction, and it is challenging to determine a comparable price using other methods. The allocation of profits is based on the relative contributions of each party to the overall profitability of the transaction.

5. Transactional Net Margin Method (TNMM):

The TNMM compares the net profit margin realized in a controlled transaction with the net profit margin realized in a comparable uncontrolled transaction or a set of comparable uncontrolled transactions. It takes into account various factors such as costs, sales, or assets employed to calculate the net profit margin. The TNMM is commonly used when analyzing transactions involving the provision of services, the transfer of unique intangibles, or the use of complex business models.

6. Other Method:

The "Other Method" allows for flexibility in selecting alternative procedures to determine an arm's length price. It considers hypothetical third-party transactions and follows the guidelines provided by the Organization for Economic Cooperation and Development (OECD). This method can be applied when none of the other five prescribed methods are suitable or when adjustments are required to account for unique circumstances in the controlled transaction.


Transfer pricing has become a critical aspect of global commerce and tax compliance in the twenty-first century. As businesses expand across borders, understanding and adhering to transfer pricing regulations is essential for multinational corporations. By ensuring proper profit allocation, complying with legal obligations, and optimizing tax liability, companies can navigate the complex world of transfer pricing effectively. As transfer pricing regulations continue to evolve, staying updated and implementing robust transfer pricing strategies will remain vital for businesses operating in a globalized economy.


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