“What is transfer pricing?”
If you have this question please read this article carefully. Because neglecting transfer pricing rules can result in financial risk for your firm.
After reading this article, you understand the concept of transfer pricing. First, we define transfer pricing. Next, you will discover the potential financial risks you face when not taking the right steps. Lastly, you learn which requirements your firm needs to meet.
Transfer Prices Defined
Transfer prices refer to the terms and conditions which so-called “associated enterprises” agree for their “controlled transactions.” Examples of such transactions are the provision of management services, the supply of goods and the provision of loans.
According to this widely used OECD definition, enterprises are associated if:
(a) an enterprise participates directly or indirectly in the management, control or capital of another enterprise or (b) the same persons participate directly or indirectly in the management, control or capital of two enterprises.
Now we know the concept of associated enterprises. The following example shows this practice in a graph:
In the picture you see that Enterprise X manufactures pianos in Malaysia. Enterprise Y distributes these from Hong Kong. Both X and Y are 100% owned by Enterprise Z. Because Z participates directly in the capital of both X and Y, they are all associated enterprises.
When selling pianos on the market, Z has no control on the price at which one piano is sold. Reason is that prices are set by supply and demand. Currently, the market price for one piano is USD 5,000. However, Z does control any transactions between X and Y.
Therefore, the internal sale of a piano by X to Y is called a “controlled transaction.” The price charged for this transaction is what is called a “transfer price.”
Why Are Transfer Prices Important?
We now understand what a transfer price is. But why is this relevant?
Let’s go back to our example.
The price at which one piano is sold by X to Y affects their individual financial results (remember: this is the controlled transaction). If X charges a high price, X makes more profit. If X charges a low price, Y makes more profit.
From a commercial perspective, the price doesn’t matter. The financial results of X and Y are consolidated. For shareholder Z, it doesn’t matter which of the two companies makes the profit. However, from a tax perspective it does matter.
X is taxed in Malaysia and Y is taxed in Hong Kong. The corporate tax rate in Hong Kong is 16.5%. In Malaysia, it is 25%. Z wants to see as much profit after tax as possible. Z can use its influence as a shareholder to set the prices in such a way that the profits are highest where taxes are lowest.
Some numbers to explain this example:
Say that the direct / indirect costs of manufacturing one piano are USD 1,000. And say that the average third party piano manufacturer similar to Y realizes a profit before tax of USD 3,000 when selling one piano to a distributor. We already know that the market price for one piano is USD 5,000.
Now, we will show 2 scenarios. Scenario 1 shows the profit if the price X charges to Y for the supply of one piano is similar to the market price (USD 4,000 as this ensures a profit of USD 3,000). The 2nd scenario shows the potential profit when X charges a non-market price of USD 2,000.
But what if the transfer price for the sale of one piano is lower? In that case, the following results can be shown:
In scenario 1, most of the profit is made by X in Malaysia at 25% tax. In scenario 2, most of the profit shifts to Y in Hong Kong. There, it is taxed at 16.5%. You understand that scenario 2 is preferred by Z. The result is an extra profit after tax of USD 170 per piano sold.
What Is The Goal Of Transfer Pricing Rules?
There are large differences in tax rates between countries. If left unchecked, the practice could lead to the shifting of profits from high-tax countries to low(er)-tax countries, as shown in the example.
Even though less likely, it can also be the case that the pricing policy leads to multinationals reporting too much taxes in high-tax countries and too little in low-tax countries.
The main goal of transfer pricing regulation is to prevent both situations and ensure that profits are taxed at the place where value is actually created.
The Arm’s Length Principle
Most countries have transfer pricing rules in their domestic tax legislation. In a nutshell, these rules provide that the terms and conditions of controlled transactions may not differ from those which would be made for uncontrolled transaction (remember: transactions between independent enterprises). This is referred to as the arm’s length principle.
Let’s go back again to our example.
The price for the sale of one piano should be similar to the price for a sale of a similar piano between independent enterprises. The below chart illustrates this: (green shows independence, red association).
What Actions Can Tax Authorities Take?
What can happen when the terms and conditions of a particular controlled transaction do not satisfy the arm’s length principle? In such case, tax authorities can make an adjustment to the profit(s) of the associated enterprise(s) involved in the transaction.
In our example under scenario 2, the Malaysian tax authorities have an interest that X sells the piano against the market price: that would result in a higher profit for X and more tax.
The Malaysian authorities may therefore make a correction to the profits of X in line with their transfer pricing rules. The Hong Kong authorities will not automatically follow such a correction. That will, among other things, depend on whether there is double tax treaty in place between Hong Kong and Malaysia.
More Focus On Transfer Pricing Rules
Recently, there has been a wide international focus on tp practices. Various international developments, such as political pressure at the level of G20/G8 and OECD, make that transfer pricing guidelines are becoming more strict and complex. To understand this development better, read our article what is BEPS.
Governments consider unrealistic profit shifting a major problem and have taken it head on. If you don’t follow the rules you take a substantial risk. And it is important to note that the rules apply even if you’re not trying to avoid taxes.
Transfer pricing disputes between taxpayers and tax authorities generally cover multiple financial years and can therefore substantially affect the financial position of a company.
An example is the ‘deal’ that pharma giant AstraZeneca concluded with the UK tax authorities (HRMC) and the IRD. This considered a transfer pricing dispute covering a period of 13 years. Eventually AstraZeneca paid an amount of USD 1.1bn to settle the dispute (more on Reuters).
Obviously, not all enterprises have such these big exposures. But for small and medium enterprises doing business internationally a transfer pricing dispute can become quite costly as well!
What Are The Requirements For Your Firm?
Transfer pricing rules around the globe are quite similar. At the same time, there are different focus areas in specific countries. Generally speaking, pricing regulations impose a number of obligations on your firm if it has controlled transactions (sometimes revenue thresholds apply):
- Your firm should be able to proof that the terms and conditions of internal transactions are comparable to those which would have been agreed in the free market when concluding comparable transactions (referred to as “arm’s length”).
- Your firm should keep documentation on record which shows:
- (a) how the transfer pricing has been established and
- (b) whether the transfer pricing is in line with the arm’s length principle.
- Your firm should file annual (corporate) tax returns on the basis of arm’s length terms and conditions of controlled transactions.
The obligations may seem straight forward. But in practice, taxpayers often spend a lot of time and effort in making sure these are met. For example, a transfer pricing analysis which aims to meet the second obligation mentioned above can span more than 100 pages!
How Can Your Firm Meet These Requirements?
You first have to ask yourself the question: What are we doing now?
As a first step it is good to look at what internal transactions your firm has and which associated enterprises are involved. This does not only include the “visible transactions” such as supply of goods and provision of services. It also includes “invisible transactions” such as group guarantees provided to external banks.
As a next step you would need to verify whether the terms and conditions of internal transactions are in accordance with the arm’s length principle and whether this can be substantiated.
In a lot of cases, the conditions of internal transactions are equally applied to external comparable transactions (example: a firm sells a product at the same price to both associated entities and third parties). That is in itself a sound basis to take the position that the transfer pricing is at arm’s length.
The last step would be to determine whether transfer pricing documentation needs to be prepared. This depends on steps 1 and 2, but also on local legislation. For example, in Vietnam a company is exempted from preparing transfer pricing documentation if the revenue is below VND 50bn (approx. USD 2.2m) and when transactions with related parties are below VND 30bn (approx. USD 1.3m).
Based on this article, we can highlight a number of conclusions:
Transfer pricing refers to the terms and conditions which associated enterprises agree for their controlled transactions. These prices are important. They affect the individual results of associated enterprises and therefore the amount of taxes they pay.
Transfer pricing rules provide that the terms and conditions of controlled transactions may not differ from those which would be made for uncontrolled transactions. The main goal of these rules is to prevent profit shifting from high-tax countries to low-tax countries (and the other way around, although less likely).
Authorities of many countries focus on compliance with TP rules. Not paying sufficient attention can result in big financial exposures. The rules impose a number of obligations to firms doing international business. Proper compliance of these rules can be ensured by following a three step approach.
What is transfer pricing? We trust we answered this question!
Want to learn more? Take a look at our transfer pricing course.
Or read our most popular article on the calculation methods used in transfer pricing.
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