MCS Session 8 - Transfer Pricing - Nov 2020

Transfer Pricing
Concept of Transfer Pricing

• Factors Influencing Transfer Pricing
• Methods of Calculating Transfer Prices
• Administration of Transfer Prices
• The Indian Perspective
Reading: Chapter 8 of Text Book

Concept of Transfer Pricing
A transfer price is the price one subunit charges for a product
or service supplied to another subunit of same organization
Intermediate products are products transferred between

subunits of an organization
Transfer pricing should help achieve a company’s strategies

and goals
• Fit Organization’s structure
• Promote Goal Congruence
• Promote a sustained high level of management effort
Objectives that a Transfer Pricing Policy should meet
• Goal congruence: Interests of individual profit centers should not
supersede those of organization as a whole. (Divisional
optimisation vs. Organisational optimisation of profits)
• Performance appraisal: Should aid in reliable and objective
assessment of activities of profit centers
– Transfer prices should provide relevant information to guide
decision-making, assess performance of divisional managers, also
assess value added by Profit Centers toward organization as a whole
• Divisional Autonomy: Should aim at providing Optimum Divisional
Autonomy, thereby retaining benefits of decentralization
• Each divisional manager should be free to satisfy requirements of

his/her profit center from internal or external sources
• Should be no interference in process, by which buying center
manager rationally strives to minimize costs, and selling center
manager strives to maximize revenues
Methods for Calculating Transfer Price
Methods of Calculating Transfer Prices
• Market-based Pricing Method or Comparable Uncontrolled
Price (CUP) Method
• Cost-based Pricing Method or Cost Plus (CP) Method
– Costs
– Profit Mark-up
• Negotiated Pricing Method
• Resale Price (RP) Method
Alternative Methods for Transfer Price Calculation

• Two-Step Pricing
• Profit Sharing or Profit Split (PS) Method
• Two Sets of Prices
Conditions necessary for development of a proper
Transfer Pricing Mechanism
• Role definition
• Competent managers
• Equity and Fairness
• Information on prevailing market prices
• Proper investment
• Consideration for Internal Constraints
External Constraints that can influence Transfer Prices

• Limited markets
• Excess or shortage of industry capacity
Implementing Transfer Pricing
• Articulation and communication of the transfer pricing strategy
• Documentation of Transfer pricing process and inter-divisional
agreements
• Involvement of multi-disciplinary team
• Negotiation and conflict resolution
• Transfer pricing – potential for misuse (Tax avoidance ?)

• Transfer prices that differ from market value, will be
advantageous for one entity, while lowering profits of other
entity
Illustration
Assembly Division of a Company has offered to purchase 90,000
batteries from Electrical Division (ED) for Rs.104 per unit
At a normal volume of 250,000 batteries per year, production costs
per battery are:
Direct materials 40
Direct labor 20
Variable factory overhead 12
Fixed factory overhead 42
Total 114
• Electrical Division has been selling 250,000 batteries per year to
outside buyers for Rs.136 each. Capacity is 350,000 batteries/year
• Assembly Division has been buying batteries from outside
suppliers for Rs.130 each.
Should Electrical Division manager accept the Offer? Will an
internal transfer be of any benefit to the company ?
Solution
• ED manager should accept. There is surplus capacity of 100,000
units
– So relevant costs to ED is the Variable Cost = Rs.72 / battery
• Increased Cash Margin to ED would be 90,000*Rs.(104 – 72) =
Rs.28,80,000
• Company would be better off with an internal transfer:

– Currently paying Rs.130 for batteries that could be made
internally for incremental cost of Rs.72
• Company would save 90,000 * (130 – 72) = Rs.52,20,000 per year
• Transfer Price negotiation range =

Max. of Rs.130 to Min of Rs.72
Transfer Pricing Objectives in International Business
• Manage exchange rate fluctuations
• Handle competitive pressures
• Reduce impact of taxes and tariffs
• Movement of funds between countries
Transfer Pricing Issues in International Business
• A large part of international commerce is actually done within
companies as opposed to between unrelated companies
• Transfer prices are used when divisions sell goods in
intracompany transactions to divisions in other international
jurisdictions
• Multinational companies can manipulate transfer prices in order
to shift profits to low tax regions
– Companies can manipulate profits of goods & services, in order
to book higher profits in another country that may have a lower
tax rate
• Intercompany transfers done internationally have tax
advantages, which has led regulatory authorities to frown upon
using transfer pricing for tax avoidance
• To remedy this, regulations enforce an arm's length transaction
rule that requires pricing to be based on similar transactions
done between unrelated parties
Indian Perspective
• Transfer Pricing Guidelines designed along those issued by
Organization for Economic Cooperation & Development (OECD)
Organizations in India can adopt any of following methods of

transfer pricing:
• Comparable Uncontrolled Price method (CUP)
• Resale Price Method (RPM)
• Cost Plus method (CPLM), and
• Profit Split method (PSM), depending on situation
OECD Transfer Pricing Methods
Documentation Guidelines for firms operating in India
Section 92D of the Income Tax Act: Maintaining of information &

documents specified by Central Board of Direct taxes (CBDT), for
International Taxation:
• Background information on commercial environment in which the
transaction has been entered into
• Information regarding international transaction entered into
• Analysis carried out to select the most appropriate method
• Identification of comparable transactions
• Actual working out of arm's length price of the transaction

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Transfer Pricing

Concept of Transfer Pricing

Reading: Chapter 8 of Text Book

Intermediate products are products transferred between

Transfer pricing should help achieve a company’s strategies

• Each divisional manager should be free to satisfy requirements of

Alternative Methods for Transfer Price Calculation

External Constraints that can influence Transfer Prices

• Transfer pricing – potential for misuse (Tax avoidance ?)

• Company would be better off with an internal transfer:

• Transfer Price negotiation range =

Organizations in India can adopt any of following methods of

Section 92D of the Income Tax Act: Maintaining of information &

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