The first thing you have to ask yourself when looking at a potential transfer pricing issue is …are there controlled transactions?
Because transfer pricing refers to the terms and conditions which so-called ‘associated enterprises’ agree for their ‘controlled transactions’. Transfer pricing rules do not apply to ‘uncontrolled transactions’.
It is therefore very important to understand the differences between ‘controlled’ and ‘uncontrolled’ transactions. This short article explains just that.
Controlled transaction vs. uncontrolled transaction
Remember, the aim of transfer pricing rules is to prevent Multinational Enterprises from shifting profits between entities and as a result not paying the correct amount of taxes. Such a practice is only possible when there is a level of control that can be exercised across the different entities. This level of control can only exist when enterprises are associated.
In short: a controlled transaction is a transaction between two (or more) enterprises that are ‘associated enterprises’ with respect to each other. According to the 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.
Let’s look at some examples to make this clearer:
Example 1: Company A sells apples to Company B. Company A owns 100% of the shares in Company B. Company A and B are associated enterprises – see part (A) of the OECD definition.
The sale of apples is a controlled transaction.
Example 2: Company A sells apples to Company B. Company A and B are both 100% owned by Company C. Company A, B and C are associated enterprises – see part (A) of the OECD definition.
The sale of apples is a controlled transaction.
Example 3: Company A sells apples to Company B. Mr X is the only director of both Company A and Company B. Company A and B are associated enterprises – see part (B) of the OECD definition.
The sale of apples is a controlled transaction.
It follows from the above that an uncontrolled transaction is a transaction between two (or more) enterprises that are not ‘associated enterprises’ with respect to each other.
Example 4: Company A sells apples to Company B. Company A and B are not related in any way via management, control or capital. They do not have the same owner or people Company A and B are not associated enterprises.
The sale of apples is not a controlled transaction.
What level of participation is required?
You may wonder whether any participation in the management, control or capital is sufficient for being qualified as associated enterprises. In spite of the OECD definition, the answer is no.
As mentioned, the relevant criterion is whether one enterprise (or person) can exercise ‘control’ over another enterprise and thus determine the terms and conditions of transactions between these two enterprises.
Say that in Example 1 Company A owns just 5% of the shares in Company B. A third party owns the other 95%. It is very unlikely for Company A to individually determine the terms and conditions of a sale of apples to Company B. The third party owning 95% would of course not accept non-market terms and conditions if it is not in their interest to do so.
To deal with this issue, transfer pricing legislation often includes thresholds that need to be met before enterprises are being qualified as associated. For example in China, enterprises are only associated if there is a direct or indirect capital participation of at least 25 percent.
Examples of controlled transactions
There are many different types of controlled transactions. Besides ‘visible’ controlled transactions such as the supply of goods and provision of services, there can also be ‘invisible’ ones such as a guarantee provided to a bank for a group credit facility.
Below we list the most common types controlled transactions.
- Supply of goods
- Provision of management services
- Provision of support services
- Granting of license
- Provision of guarantee
- Financing
- Transfer of business / assets
We hope that you have enjoyed reading this article.
Learn more about transfer pricing in the far east.
