Summary

As more and more startups go global, they will need to handle transfer pricing. This involves pricing for goods or services between related parties across borders. While most startups will engage experts to actually handle transfer pricing, founders should grasp how organisational structure impacts it. A proper policy will help a business hold the right amount of cash balances and cash flows in each geography.

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Indian companies are breaking barriers and setting up global businesses. In our last piece, we spoke about how founders should decide where they want to establish their base. Once you’ve made that choice and have decided you want to be based in a foreign country, how do you manage your tax reporting and treasury/cash flows between India and another geography? Transfer pricing can be a very handy tool to achieve these objectives and using it requires some degree of sophistication. In this article, we’ll take you through how your business operations can impact transfer pricing, and how important it is for managing your cash flows properly. 

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What is transfer pricing?

Very simply speaking, transfer pricing refers to the price of transactions made for goods or services executed between related parties, especially in a cross-border context. Take, for example, a US parent company that sells software to its customers in the US, and uses its Indian subsidiary to provide engineering services, customer care, and other back-office services. Transfer pricing in this case refers to the price charged by the Indian subsidiary for providing these services to its US parent. 

In transfer pricing, according to Indian law, a transaction between related parties has to be made as per the arm’s length principle. How to determine arm’s length transfer price is a technical topic and the most common practice is to bring in a tax expert who will perform a functions and risk analysis for your business. This expert can also help identify the most appropriate method to test or advise on the price of your intercompany transactions. However, you should know that the most important factor that impacts your transfer pricing is the way your business is structured.

Why is it important to have an arm’s length transfer pricing?

Tax principles require you to have an arm’s length transfer price or a fair price charged between related parties. This fair price ensures that the service provider is not overcharging or under-charging its related party to manage a desired tax outcome. Consider Singapore-India group companies for instance. Tax rates in Singapore are around 18%, whereas in India they are around 35%. Without an arm’s length basis for transfer pricing for goods or services being transacted within their group between Singapore and India, companies can potentially leave larger profits in the hands of the Singapore group company, which is taxed at a lower rate than India. To avoid such situations, tax rules require us to have a fair price of exchange between group companies so that fair profits are reported in each jurisdiction.

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How does transfer pricing impact the treasury/cash flows for startups?

After you have set up an international parent company, say in the US, which has a subsidiary in India where a large portion of costs are incurred, a right transfer pricing policy will ensure holding the right amount of cash balances and cash flows in each of the countries. 

In this structure, shareholder or investor capital will be infused in the parent company in the form of share capital. The parent company does not need to transfer all this cash to India, even if the majority of operations are being done from India. In fact, it can initially capitalise the Indian subsidiary with a limited amount of seed capital to start operations. The rest of the funds can be retained in the US in USD, which is a stronger currency compared to INR.

Subsequently, once the Indian entity begins operations, in simpler structures/business models, the Indian entity can invoice the US company for the services provided by it to support the running of the US company. This can include functions such as software development, finance and HR, operations, marketing, and other sales support activities. Therefore, all subsequent operations can be funded by a recharge of costs between India and the US, which the US pays promptly and, in some cases, even in advance. As long as this recharge meets the transfer pricing arm’s length standard, it will continue to work. Overall, this will allow you to bring only as much cash in India as is needed to sustain Indian operations, while retaining all surplus cash in the US in USD.

How do my business operations impact transfer pricing ? 

The way the business operations are conducted has a significant impact on how transfer pricing is determined. Few questions worth considering here are:

• Where are the CEO and other business heads located? Are they based in the foreign parent company or in the India subsidiary?
• Where are the customers located? Who bills the customers and takes the risk for defaults - the foreign parent or Indian subsidiary?
• Who owns and develops the IP of the business?
• Where are the capital allocation decisions taken from?

These questions help answer which entity is playing what role in value creation for the company. The transfer prices are to be set in a manner that fairly rewards the functions and risks undertaken by each entity. There can’t be a scenario where a US entity is performing minimalistic functions or undertaking low risks, but is retaining the bulk of profits from operations in the company. This will very likely be challenged by tax authorities in India.

“There can’t be a scenario where a US entity is performing minimalistic functions or undertaking low risks, but is retaining the bulk of profits from operations in the company.”

We hear most commonly that companies prefer to use cost plus markup as the transfer pricing model. In this model, they will charge costs incurred in India over to the parent company, at a cost plus 15-20% markup. While it is relatively easy to implement, it is important to know that this method works best for routine and low risk activities. In cases where services performed in India have a higher value-add compared to services performed from the foreign parent, cost plus markup may not pass the arm’s length test unless a materially higher rate of markup is applied. 

It is best to engage a tax expert to help assess other methods. We are also seeing an increasing trend of early stage companies adopting profit split or revenue split methods. In such cases, a share of profits or revenues earned from transactions with customers is determined as a fair arm’s length price for underlying intercompany transactions. These methods work dynamically and the profit or revenue share can vary over the years, as the business evolves, and functions and risk adoption shifts with relocation of key personnel to overseas entities. 

“While cost plus markup is relatively easy to implement, it is important to know that this method works best for routine and low risk activities.”

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How do IP rights impact transfer pricing?

IP rights are the rights over intangible properties of the company. For example, copyright, patents over software, trademarks, confidential information, brand, databases, etc. These rights are considered to accrue a large part of value, especially in tech-enabled businesses, SaaS companies, IT companies and so on. The owner of IP rights can claim a larger share of profits of a transaction in an intercompany situation. To illustrate, think of a company where the US parent owns the IP rights to the software IT licences to the customers and its India subsidiary provides development support for this software. In this case, a larger value from the sale of such software is allocable to the US parent and a lesser share of such profits can be allocated to the India entity as a remuneration for development support. 

However, this allocation is not always straightforward. IP ownership between the parent and Indian subsidiary is less clear in situations where senior people and decision-making leaders are spread between the parent and Indian entities. For example, in cases where the parent is responsible for all the costs in building a software, but the key decisions to build the software and developing its sales strategy are taken by leaders based in India, it will be difficult to argue that the parent owns all the IP. Such cases can create an IP which is co-owned by both entities and a suitable transfer pricing mechanism may need to be applied to reward each entity for the value added.

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#transferpricing #armslengthprinciple #crossborderoperations #crossborderstartups #taxation #companydomicile

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Disclaimer: This is not legal or accounting advice. This is only intended for educational purposes.