Transfer pricing refers to the amount paid for the transfer of goods, services or both from one unit of a company to its foreign branch. These types of transfers generally include the sale of finished products, the purchase of raw materials, the sale of fixed assets and more. Although transfer pricing in India is largely governed by the income tax laws, it still plays a pivotal role in determining the GST tax liability.
In this blog, we will discuss more about the significance of transfer pricing and its role in GST calculation.
What are related party transactions?
Related party transactions are the transaction that are made to parties who are considered “related parties” under the taxation regulations. As per Section 2(84) of the GST act, the following are considered as the related parties:
- A person serves as an officer or director in more than one business entity.
- Businesses that are legally recognised as partners.
- An employer and their employee.
- A person who directly or indirectly holds 25% or more of the shareholding in another company.
- One single entity exercises direct or indirect control over the other.
- Both entities are subject to common control or management.
- Two or more entities jointly control another entity.
- The promoters or key managerial personnel are members of the same family.
Transfer pricing framework for related party transactions
Transfer pricing was rolled out in India in 2001 to determine the fair value of related-party transactions or the transfer of goods and services to a subsidiary. Further, it ensures that profits are appropriately allocated and taxed in the correct jurisdictions. Below is the breakdown of how the transfer pricing framework works in India.
What is arms length principle?
To determine the fair value of the transaction, the Indian government uses the arm's-length principle (ALP). The ALP refers to the price charged when unrelated parties enter into a similar transaction under uncontrolled conditions. To put it simply, this approach compares the price used in the transaction to the price that independent, unrelated parties would charge each other for the same or similar transaction in normal market conditions.
Let’s understand this more clearly with the help of an example:
Imagine an Indian company has a branch in another country. The Indian company sells a product to its foreign branch for ₹50 per unit.
Now, the government checks the market and finds that unrelated companies usually sell the same product for ₹80 per unit under normal conditions.
According to the arm’s length principle, the fair price should be ₹80, not ₹50.
So, the government will treat the transaction as if it happened at ₹80 per unit, because that’s the price independent parties would charge.
What are the methods to determine the ALP?
Here are the three methods that are used for determining the ALP of the related party transactions:
Comparable uncontrolled price (CUP) method
This approach compares the price charged in a related-party deal with the price charged in a similar deal between unrelated parties. If both transactions are comparable, the independent price is treated as the fair market price. Simple and most reliable when data is available.
Resale price method or resale minus method
Here, the price at which goods are resold to an unrelated party is considered and a reasonable gross margin is reduced. The balance is considered the arm’s length price. It is commonly used for distributors who don’t add much value.
Cost plus method
In this method, the actual cost incurred is identified and a normal profit markup is added. That total becomes the arm’s length price. Mostly used for manufacturing or service arrangements where costs are clearly known.
How transfer pricing affects GST valuation in India
Here is how transfer pricing works in GST:
GST valuation of inter-company and related party transactions
To calculate the tax liability of the inter-company transaction for goods, services or both, tax authorities consider the arm's length price of the transaction. Failing to quote the right arms-length price will attract unnecessary notices and penalties.
GST liability on cross-border related party transactions
Cross-border transactions between associated enterprises, such as the import of services or goods, have direct GST implications. Even if no consideration is charged due to group arrangements, GST may still apply. Transfer pricing determines whether the transaction is at arm’s length, but GST focuses on whether a supply exists and how it should be valued. Import of services between related parties is deemed a supply under GST, triggering tax liability.
Reverse charge mechanism (RCM) in transfer pricing transactions
The Reverse Charge Mechanism plays a major role where services are imported from foreign group entities. In such cases, the Indian entity is required to pay GST under RCM, regardless of whether payment is actually made. Transfer pricing policies often determine the service value, cost allocations or mark-ups, which directly influence the GST payable under RCM.
Conclusion
Transfer pricing and GST are closely connected when it comes to related party transactions, especially in group structures and cross-border arrangements. While transfer pricing ensures transactions are carried out at arm’s length for income tax purposes, the same values often influence GST valuation, tax liability, and compliance under GST law. Any misalignment between transfer pricing policies and GST valuation rules can lead to additional tax exposure, interest, penalties, and prolonged litigation.
Managing these complexities becomes easier with the right GST software. TallyPrime helps businesses accurately track related party transactions, manage GST compliance and maintain clear records.
