This article explains the difference between domestic and international transfer pricing. For understanding, we first need to look at domestic vs international controlled transactions.
Domestic vs international controlled transactions
A domestic controlled transaction is a transaction between associated enterprises that are resident in the same tax jurisdiction. For example: Iris Technology sells IT equipment to associated enterprise Yuri Technology, and the tax jurisdiction of both enterprises is the United Kingdom.
An international controlled transaction is a transaction between associated enterprises in different tax jurisdictions. For example: Iris Technology sells IT equipment to associated enterprise Yuri Technology US. The tax jurisdiction of Iris Technology is the United Kingdom, and the tax jurisdiction of Yuri Technology US is the United States.
You now understand that the tax jurisdiction is the relevant criterion to determine whether you’re dealing with a domestic controlled transaction, or an international controlled transaction. This can be confusing when there are multiple tax jurisdictions within the same country. Take for example Labuan, which is a federal territory with its own tax jurisdiction, yet, part of Malaysia. A transaction between associated enterprises in Kuala Lumpur and Labuan could therefore be categorized as an international controlled transaction.
Difference between international and domestic controlled transactions
We have made clear now the difference between domestic and international controlled transactions. But what is the relevance of that difference? Well, mainly the following three points:
Risk of challenges
Tax authorities are far less likely to scrutinize the transfer pricing of a domestic controlled transaction. The reason is that an adjustment to the terms and conditions of such transaction at the level of one associated enterprise, will be mirrored by a corresponding adjustment at the level of the other associated enterprise. And since both enterprises are resident in the same tax jurisdiction and pay taxes there, in most cases a correction will have a neutral result for the tax authorities in terms of tax revenues.
In international transfer pricing however, a correction can result in additional tax revenues. Let’s make this clearer let us go back to our example:
Iris Technology sells IT equipment to associated enterprise Yuri Technology and the tax jurisdiction of both enterprises is the United Kingdom. The price for the sale is GBP 100,000 and both enterprises book this amount as revenue respectively costs of goods sold in their books. The HRMS, the tax authority of the United Kingdom, takes the position that the price is not at arm’s length and should be increased with GBP 50,000. This means that the revenue of Iris Technology increases with GBP 50,000 and normally corporate tax revenue also increases. However, the position of the HRMS has the consequences that the costs of goods sold for Yuri Technology increases with GBP 50,000 and normally corporate tax revenue decreases. Non-acceptance of the latter would be inconsistent of the HRMS! So, in most cases on balance there is not much to win. There are cases that this doesn’t apply, for example where one of the associated enterprises has tax losses to be utilized.
Now Iris Technology sells IT equipment to associated enterprise Yuri Technology US. The tax jurisdiction of Iris Technology is the United Kingdom and the tax jurisdiction of Yuri Technology US is the United States. The price for the sale is GBP 100,000 and both enterprises book this amount as revenue respectively costs of goods sold in their books. The HRMS takes the position that the price is not at arm’s length, and should be increased with GBP 50,000. This means that the revenue of Iris Technology increases with GBP 50,000 and normally corporate tax revenue also increase. This is a real gain for the HRMS. And contrary to the above example, the correction of the HRMS does not necessarily mean that the costs of goods sold for Yuri Technology US increase with the same amount. The IRS, the United States tax authorities, may have a different view on such an increase. In the worst-case scenario this correction is not followed by the IRS and a new dispute is born. Solving such disputes takes a lot of time and costs.
Compliance
There can be a difference in the compliance requirements such as reporting of transactions in tax filings and transfer pricing documentation. For domestic controlled transactions the compliance burden is usually more relaxed. In some countries there is no documentation requirement for domestic transfer pricing at all!
Withholding taxes
There can be a difference in withholding taxes. Domestic transactions normally do not attract withholding tax. International transfer pricing can attract withholding taxes based on domestic legislation and subject to application of double tax treaties. Withholding taxes may apply on payment of royalty fees, services fees, interest payments and dividends. If the recipient of such payments cannot claim a credit for the withholding tax paid, this is a real cost for the company.
We hope you have enjoyed reading this article. If you want to learn more about transfer pricing, feel free to look at our course.
