Principles of Transfer pricing.

 Given below the major principles of transfer pricing.

1.     Arm's length principle

The arm's length principle is the cornerstone of transfer pricing. It states that the prices of transactions between related parties should be comparable to those of transactions between independent parties under similar circumstances. This principle aims to prevent artificial shifting of profits and ensure a fair allocation of taxable income among countries. To apply the arm's length principle, you need to identify comparable transactions, select appropriate transfer pricing methods, and document your analysis and assumptions.

An "arm's length price" is the fair and reasonable price at which goods, services, or assets are bought or sold between two parties who are not related to each other and have no special relationship. It's like the price you would expect to pay or receive if you were buying or selling something to a stranger in an open market, without any special deals or influence. The idea is to ensure that transactions are fair and not influenced by any personal or business relationships that could skew the price.

2.     Value creation principle

The value creation principle is another important concept of transfer pricing. It states that the profits of a multinational group should reflect the economic activities and functions performed by each entity, rather than the legal form or contractual arrangements. This principle requires you to analyze the value chain of your business and identify the key drivers of value and risk. You also need to consider the intangible assets, such as patents, trademarks, or know-how, that contribute to your competitive advantage and profitability.

3.     Substance over form principle

The substance over form principle is a general principle of tax law that applies to transfer pricing as well. It states that the tax consequences of a transaction should follow its economic substance, rather than its legal form or appearance. This principle aims to prevent tax avoidance schemes that exploit loopholes or inconsistencies in the tax rules. To comply with the substance over form principle, you need to ensure that your transfer pricing policies and practices are consistent with your business reality and objectives.

Substance over form means that the facts are more important than the legal structure and that the facts should conform to the legal form. Say a transaction is legally called a contract manufacturing, however it is in reality a full fledged manufacturing activity. This will give rise to a completely different entity characterisation, remuneration, IP issues etc. Therefore, there is an increased emphasis on substance over form over the past many years and tax authorities are trying to understand the true substance of a transaction and not just go by the legal form.

 

4.     Consistency principle

The consistency principle is a practical principle of transfer pricing that helps you avoid double taxation and disputes with tax authorities. It states that you should use the same transfer pricing method and assumptions for both sides of a transaction, unless there is a valid reason to do otherwise. This principle also implies that you should apply the same transfer pricing policy across your group, unless there are specific factors that justify different approaches. To adhere to the consistency principle, you need to communicate and coordinate with your related parties and document any deviations or adjustments.

“Inconsistency is the only thing in which men are consistent,” once, remarked English poet, Horace Smith, in a light vein.. But, transfer pricing requires consistency principle, which states that when the facts & circumstances continue to remain the same, there should not be any variation in the treatment from earlier year. In JCIT Vs M/s Super House Leather Ltd. (ITAT Lucknow) : Income Tax (Appeal) No. 127 of 2012 case, the assessee had adopted cost plus method, which was rejected by Transfer Pricing Officer. No reasons were given. The Tribunal held that one cannot brush aside the “Principle of Consistency.” Forex loss claimed as non-operating cost in one year and operating cost earlier is against consistency and may attract tax.

5.     Transparency principle

The transparency principle is a compliance principle of transfer pricing that helps you demonstrate your good faith and cooperation with the tax authorities. It states that you should disclose relevant information about your transfer pricing policies and transactions in a timely and accurate manner. This principle also involves complying with the reporting and documentation requirements of the countries where you operate and participate in the exchange of information agreements. To follow the transparency principle, you need to prepare and maintain transfer pricing documentation, such as master file, local file, and country-by-country report, and respond to any inquiries or audits from the tax authorities.

 

Transfer pricing is a complex and dynamic area of financial management that requires careful planning and analysis. By understanding and applying the key principles of transfer pricing, you can optimize your tax position and align your business model with your strategic goals