What is Transfer Pricing?

Transfer pricing is an accounting practice followed to establish an agreed price at Arm’s length during a transaction between associated enterprises. The transactions can be in terms of goods and services.

There are five methods which can be used to get to the agreed price where the profits are divided fairly among the divisions of the given enterprise. They are:

1) Comparable Uncontrolled Price (CUP) method.

2) Resale Price Method (RPM)

3) Cost Plus Method (CPM)

4) Profit Split method (PSM)

5) Transaction Net Margin Method (TNMM)

Working Capital Adjustments In Transfer Pricing

What is Arm’s length Principle?

Arm’s Length principle states ‘entities that are related via management, control or capital in their controlled transactions should agree the same terms and conditions which would have been agreed between non-related entities for comparable uncontrolled transactions’.

For example, a company making fertilizers should charge the same price to the farm it owns to that of the farms it does not own.

Determination of Arm’s length price

The arm’s length price can be determined using:

1) Comparable Uncontrolled Price (CUP) method – In this method, the prices are benchmarked with the profits not referred. It compares the charged prices in controlled transaction to that of the uncontrolled transaction.

2) Resale Price Method (RPM) – In this method, transfer of almost finished goods is made between associated enterprises. The resale gross profit margin is compared in this method between the controlled and uncontrolled transaction.

3) Cost Plus Method (CPM) – This method includes comparison and identification of mark-up earned on direct and indirect costs of production incurred with comparable external company. The determination of price in this method follows: cost + margin + mark-up (on Gross profit). Generally applicable for semi- finished goods transaction between related parties, contract manufacturing agreement and services.

4) Profit Split Method (PSM) – This method is generally applicable in the transfer of unique intangibles or multiple international transactions which cannot be evaluated separately. Here net profits of the associated enterprises are compared and not the gross profit which is generally harder to procure.

5) Transaction Net Margin Method (TNMM) – In this method, the net margin and the adjustments to minimize material effect is taken into account while calculation the arm’s length price. The net margin is calculated taking a base value (total costs or total sales). [Operating profit/base value =Profit Level Indiacator]. The TNMM is widely used to calculate the price.

So, using TNMM a transfer price set which can cover operating expenses with a significant amount of profit margin can be formulated as:

Transfer price = Independent price – operating expenses – profit margin

What is Working Capital Adjustments/ Comparability adjustments?

Working capital can be expressed in two forms:

Working capital= Current assets – Current liabilities

Or

Working Capital= {Accounts Receivable + Inventory} – Accounts payable.These shows whether a company has enough short-term assets to cover its short- term debts.

A comparability adjustment is an adjustment made to the conditions of uncontrolled transactions with the view of eliminating the effects of material differences between them and the controlled transaction being examined. Comparability adjustments also include accountability adjustments caused due to different accounting practices followed in different enterprise; segmentation of financial data to eliminate significant non- comparable transactions and adjustments for significantly different level of relative working capital between uncontrolled and uncontrolled transactions, functions, assets and also risks.

For example, if a tax payer sells the same product to an associated enterprise and to an external enterprise, assuming the two sales are comparable. The exception being that in the controlled transaction, the import duty is borne by the tax payer and in the uncontrolled transaction, the duty is borne by the customer. Assume this different allocation of payments materially affects the comparison. In this case, the uncontrolled transaction can be used as a comparable to the controlled transaction if adjustments are made to eliminate the material effect.

When to do a comparability adjustment?

Comparability adjustments are to be made only if the results are known to be more reliable after. They are only appropriate for differences that has material effect on the comparison. If there arises the need to perform multiple adjustments to main comparability factors then that indicates that the third party is actually not sufficiently comparable.

Working capital adjustments may be warranted when applying the transactional net margin method. In practice they are usually found when applying a transactional net margin method, although they might also be applicable in cost plus or resale price methods. Working capital adjustments should only be considered when the reliability of the comparables will be improved and reasonably accurate adjustments can be made. They should not be automatically made and would not be automatically accepted by tax administrations.

Why to do such adjustments?

Money has time value in a cut throat competitive environment.

For example, if a company provides 80 days trade terms for payment of accounts, the price of the good should be equal to the price plus 80 days interest. The company is allowing its customers a longer period to pay their accounts by carrying high accounts receivable. So, the company will require to borrow funds to cover the credits thus leading to a reduction in its available funds to invest.

If the situation is the opposite, and a company carries a high account payable, it is getting a longer time period to pay up to its suppliers. This leads to the position to borrow less and increase in cash surplus thus leading to an increase in investment.

Similarly, a company with high inventory will need to borrow funds for purchasing which will lead to reduction in investment. The interest rate also gets affected by the funding structure.

Working Capital Adjustments are made to cover up for the time gap between the tested party and the comparable party. The time gap can be calculated as:

Period needed to sell to customers + period required to collect money from customers – period granted to pay debtors.

Other factors affecting comparability:

  • Characteristics of property or services
  • Functional analysis
  • Contractual terms
  • Economic circumstances
  • Business strategies

 Calculation of Working Capital Adjustments

There can be two ways to calculate the working capital adjustments.

First, to identify the differences in level of working capital mainly trade receivables, inventory and trade payables and then adjust the results. (The time value of money using an appropriate interest rate has to be shown).

Second, to adjust the tested party’s results to reflect the comparable levels of working capital or to adjust both the tested party and the comparable’s result to reflect “zero” working capital.

The second method can be illustrated as follows.

The capital adjustments can be calculated using the formulation presented in the work of Miesel and Verma (2001). The formulation is derived from the following fundamental expressions:

Where:
DR = Days receivable;
AR = Accounts receivable;
OP = Operating profit; and
i = Interest rates for short-term loan;
the subscript A and T means Actual or, respectively, Target.

Subsequently, the relation between the accounts receivable adjustment and change in Operating profit (OP) is obtained by applying the following formulas:

The numerator approximates implicit interest embedded in sales over one year. The denominator calculates the present value of the implicit interest.

Analogically, the adjustment computation will be identical for accounts payables and inventory:

Where:
AP = Accounts payable;
COGS = Costs of goods sold
INV = Inventory;
i = Interest rates for short-term loan.

Based on the working capital adjustment to zero, the operating profit margin (“OM”) to “zero” is obtained by applying the following formula:

Where, SG&A= Selling, General Expenses and Amortization.

The first method can be illustrated using a practical example given in the table below:

T.Co. Reference Y1 Y2 Y3 Y4 Y5 Y6
Sales A 110 114 119 124 150 165
Earning before interest and taxes (EBIT) B 1.2 1.5 2 2.6 3.1 4
EBIT/SALES C = A / B 1.09% 1.32% 1.68% 2.10% 2.07% 2.42%
Working capital at the end of the year
Trade Receivables (R) D 17 19 24 28 30 34
Inventory (I) E 17 20 20 23 26 30
Trade Payables (P) F 11 14 15 12 16 14
R+I-P G = D + E – F 23 25 29 39 40 50
R + I-P/SALES (%) H = G / A 20.91% 21.93% 24.37% 31.45% 26.67% 30.30%
C.Co. Reference Y1 Y2 Y3 Y4 Y5 Y6
Sales I 180 190 200 210 220 230
Earning before interest and taxes (EBIT) J 2 2.5 3 3.5 4 4.5
EBIT/SALES (%) K = J / I 1.11% 1.32% 1.50% 1.67% 1.82% 1.96%
Working capital at the end of the year
Trade Receivables L 20 25 30 35 40 45
Inventory M 25 25 32 32 35 44
Trade Payables N 10 12 15 17 20 30
R+I-P O = L + M – N 35 38 47 50 55 59
R+I-P/SALES (%) P = O / I 19.44% 20.00% 23.50% 23.81% 25.00% 25.65%
Working Capital Adjustment Reference Y1 Y2 Y3 Y4 Y5 Y6
T.Co. (R+I+P)/Sales (%) Q 20.91% 21.93% 24.37% 31.45% 26.67% 30.30%
C.Co. (R+I+P)/Sales (%) R 19.44% 20.00% 23.50% 23.81% 25.00% 25.65%
Difference (%) S = Q – R 1.46% 1.93% 0.87% 7.64% 1.67% 4.65%
Interest Rate (%) T 4.50% 4.90% 5.40% 5.80% 6.00% 6.50%
Adjustment (%) U = S * T 0.07% 0.09% 0.05% 0.44% 0.10% 0.30%
C.Co. EBIT/Sales V 1.11% 1.32% 1.50% 1.67% 1.82% 1.96%
Working Capital Adjusted W = U + V 1.18% 1.41% 1.55% 2.11% 1.92% 2.26%

Hypothetically, we have assumed the tested party to be (T.Co.) and the comparable party (C.Co.).

Observations

Some issues with the working capital adjustments:

  • It is difficult to determine the point at which the working capital is to be compared between the tested party ad the comparable party. In the above example, it is compared at the end of the year which might not be a feasible option in other scenarios.
  • It is also an issue to select an appropriate interest rate. In most of the cases the commercial loan rate is used. In case payables<receivables + inventories, a borrowing rate is generally used because the company has to invest in R and I.

In the opposite case, lending rate is considered.

  • The question whether working capital adjustments should be made or not to improve the reliability of the comparable is also a matter to be looked into cause some results can be reliable and some might not be.

*****

(This article is co-authored by Ankita Saha and Piyush Pratik from BDO India LLP)

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