A transfer pricing audit is an examination carried out by tax authorities to verify whether transactions between related entities of a multinational enterprise (MNE) comply with the arm’s length principle. This principle requires intercompany transactions—such as the transfer of goods, services, or intellectual property—to be priced as if they were conducted between independent, unrelated parties under comparable conditions.
In India, the Income Tax Department conducts these audits to prevent profit shifting and ensure that taxable income is appropriately reported within the country. Given the scale and complexity of intercompany transactions, transfer pricing audits can be detailed, time-consuming, and financially impactful if not handled correctly.
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What is transfer pricing?
Transfer pricing is the method of setting prices for goods, services, or intellectual property shared between associated enterprises of a multinational corporation (MNC). For example, when a manufacturing unit in India sells products to its distribution subsidiary abroad, the price set is called the transfer price.
The primary goal is to ensure fair allocation of income and expenses across countries so that profits are taxed where actual economic activity occurs. To prevent companies from shifting profits to low-tax nations, global tax authorities—including India under the Income Tax Act, 1961—apply the Arm’s Length Principle (ALP). This ensures that intra-group transactions are priced just like they would be between independent entities.
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Examples of transfer pricing
Transfer pricing is commonly applied in cross-border transactions within multinational corporations. Below are some practical examples:
1. Sale of goods between subsidiaries
A multinational company has a manufacturing unit in India and a distribution subsidiary in Singapore. The manufacturing unit produces smartphones at Rs. 10,000 per unit and sells them to the Singaporean subsidiary. The price at which the goods are transferred between these entities is called the transfer price. If the price is set at Rs. 12,000, the Indian subsidiary books a profit of Rs. 2,000 per unit, taxable in India.
2. Transfer of intellectual property
An Indian software company develops a proprietary software and licenses it to its subsidiary in the UK. The royalty charged for using the software must be set at an arm’s length price. If the Indian company undercharges, the tax authorities may adjust the royalty to reflect fair market value.
3. Financial transactions
A US-based parent company provides a loan to its Indian subsidiary at an interest rate of 4% per annum. If similar independent loans in the market carry an interest rate of 6%, tax authorities may challenge the lower rate as non-compliant with the arm’s length principle.
Transfer pricing examples show how companies must price intercompany transactions fairly to comply with global tax regulations.
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Also Read: What Is taxable income
How transfer pricing works
Transfer pricing regulations rely on the Arm’s Length Principle (ALP). Companies must compare related-party transactions with those between independent parties.
1. Comparability analysis
- Examines similar transactions between unrelated companies.
- Factors include product type, risks involved, market conditions, and business functions.
2. Transfer pricing methods
Five globally accepted methods help ensure fairness:
- Comparable Uncontrolled Price (CUP): Compares with similar independent transactions.
- Resale Price Method (RPM): Deducts resale margin from selling price.
- Cost Plus Method (CPM): Adds a fair profit margin to cost.
- Profit Split Method (PSM): Splits profits based on each entity’s contribution.
- Transactional Net Margin Method (TNMM): Compares net margins with similar independent companies.
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Also Read: What is a taxable benefit
