For the purpose of the subject under consideration, it is also assumed that the subsidiary company in the aforementioned group structure is a foreign company and the Parent is a local company. When the companies in the group structures are involved in transactions with each other, they put a price on the transaction. This price is termed as the ‘transfer price’. This can further be illustrated with the help of the following example: Company A, the parent company, is situated in USA and its subsidiary company, Company B is situated in UK. Suppose that Company A has outsourced its financial activities to its subsidiary company, which means that Company A does not have any staff which are performing finance related activities (such as preparing financial statement, filing tax return, involved in budgeting etc.) instead the finance department of Company B is performing these activities for Company A and in return is charging a fee. Although the owners of both Company A and Company B are the same, but still one company is charging a fee for performing a particular service to another company in the capital structure. Transfer pricing is not a legal activity in its substance, but its misuse can label it as abusive. Transfer mispricing is quite common in manufacturing concern all across the globe where the transfer of services are involved rather than the transfer of services. A safe estimate made by the economists and financial analyst presents the fact that around 60% of the international trade that place globally, is between the countries under the same corporate structure. In addition to this figure, the economists also put forward the fact that due to transfer mispricing, billions of dollars is lost for tax revenue. The tax authorities argue the fact that transaction between associated companies within a group should take place on arms length basis. The arms length price is the price at which two unrelated parties in the market would agree to proceed with the transaction. The arms length pricing is a result of genuine negotiation in the market. But usually what happens in the global market is that companies usually distort the transfer prices at which the transaction is recorded. This usually assists the companies in avoiding tax and report higher profit for the financial year. Illustrative Example No. 1 (all figures in USD) Subsidiary Company (fully owned and controlled by the parent company) Parent Company (Head Office of the Multinational) Host Country (China) Home Country (USA) Price of good bought Transfer Price Selling price Total Case 1 100 200 300 Profit Before Tax 100 100 200 Tax Rate (%)[Ey.com 2013] 25% 40% Tax paid 25 40 65 Profit after tax 75 60 135 Case 2 100 280 300 Profit Before Tax 180 20 200 Tax Rate (%) 25% 40% Tax paid 45 8 53 Profit after tax 135 12 147 Case 3 100 300 300 Profit Before Tax 200 0 200 Tax Rate (%) 25% 40% Tax paid 50 0 50 Profit after tax 150 0 150 In the first illustrative example, we are considering two companies situated in USA and China. The company situated in the USA is the parent company whereas the company situated in China is the wholly owned subsidiary company of the Parent. The Parent company is involved in the trading of FMCGs. The items that the company A sale to the general public is manufactured by the subsidiary
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