What Is Transfer Pricing And Why Should Your Business Care About It?

What is Transfer Pricing and Why Should Your Business Care About it?

Okay so transfer pricing. Sounds like one of those heavy CA terms that only big multinational companies need to worry about na?

But honestly if you have a business that does any kind of buying or selling with a related company — a subsidiary, a sister concern, a branch in another country — then this is something you really should know about. Because not knowing can cost you a lot of money later.

So lets just get into it simply.

Okay First — What is Transfer Pricing?

So when two companies that are connected to each other — like a parent company and its subsidiary — buy or sell things between themselves, the price they charge each other is called the Transfer Price.

Pretty simple so far right?

But here's the thing. Because these two companies are related they can technically charge each other whatever price they want. And some businesses use this to move profits from a country where tax is high to a country where tax is low. End result — the whole group pays less tax overall.

Now the Income Tax department of India — and honestly tax departments all over the world — they know this trick very well. And they have a whole separate team just to catch this kind of thing.

Meet Raj — A Business Owner Who Learnt This the Hard Way

Raj has a manufacturing business in Pune. Few years back he also set up a small subsidiary in Singapore — lets just call it Raj Trading Pte Ltd.

So what was happening was — Raj's Pune company was making products and selling them to the Singapore company. And then the Singapore company was selling those same products to international customers at a much higher price and making big profits there.

Now Singapore has a much lower tax rate compared to India. So Raj thought — why not sell the goods from Pune to Singapore at a very low price? That way Pune shows less profit, pays less tax in India. And the big profit sits in Singapore where the tax is anyway low.

Sounded like a very smart plan honestly.

But it wasnt.

What Happened Next

The Income Tax department looked at Raj's transactions and noticed something. He was selling goods to his own Singapore company at ?500 per unit. But those same goods were being sold to outside customers in the market at ?900 per unit.

So they asked a simple question — why are you charging your own company ?400 less than what you charge everyone else?

This is what they call the Arm's Length Price. Basically it means — what would two completely unrelated people charge each other for the same transaction? Thats the price you should be using even with your own related companies.

Since Raj was charging ?500 instead of ?900 the department added that ?400 difference back as income in India and taxed the whole thing here. Plus interest. Plus penalties on top of that.

What looked like a clever tax saving idea ended up costing Raj way more than whatever he thought he was saving. And the audit process itself took months and was a huge headache.

So What Should You Actually Do if You Have Related Party Transactions?

Few simple things to keep in mind —

• Write everything down — keep proper records and documentation of why you charged a particular price between related companies. This is the most important thing honestly.
• Check your prices against the market — whatever price you charge your related company should be close to what you'd charge an outsider for the same thing.
• Get a Transfer Pricing report done — if your international related party transactions are more than ?1 crore in a year you need to get a proper transfer pricing audit done by a CA and file a report with the tax department.
• Dont get too clever with it — the department has seen every possible arrangement. If something looks like its only purpose is to avoid tax they will find it.

The Simple Takeaway

Transfer pricing is not some illegal thing. Doing business with your own subsidiaries or sister companies is completely fine and very normal.

The only thing is — charge a fair price. A price that makes sense. A price you would charge even if that company had nothing to do with you.

Do that, keep your paperwork in order and you really have nothing to stress about.

But if your using related party transactions just to move profits around without any real business reason behind it — thats when things get complicated. And the penalties that come with a transfer pricing addition are not small at all.

So its always better to do it right from the beginning itself.

Have related party transactions in your business and not sure if everything is in order? Our team at CA Dhiraj Ostwal and Co. can sit down with you and help you sort it out — feel free to reach out anytime.