Transfer pricing refers to the determination of prices at which goods, services and intangible properties are transacted between related parties. When unrelated parties deal with each other, independent market forces shape the commercial pricing of such transactions. However, in transactions involving related parties, their commercial and financial relations may lead to the setting of prices that deviate from independent commercial prices. This results in distortion of the profits derived by each related entity to the transactions as well as in the tax liabilities of each.
The distorting effects of non-arm’s length transfer pricing is of greater concern to tax authorities where related parties engaged in the transactions are located in different tax jurisdictions. This is because the varying taxation levels in different tax jurisdictions may lead to entities concerned not paying their fair share of tax in one or more jurisdictions, and the related entities as a group enjoying a tax advantage.
Increasingly, tax authorities worldwide are stepping up their audit efforts to verify that transfer pricing of cross-border related party transactions comply with the arm’s length principle. Where related party transactions are found not to have complied with the arm’s length principle and where the profits and tax liabilities of the related parties have been reduced, adjustments to the profits and tax liabilities would be made by tax authorities. Such unilateral adjustments increase the total taxable profits arising from the related parties’ transactions and hence result in double taxation.
This is an overview of transfer pricing mechanisms, providing guidelines to follow arm’s length principle and documentation to be maintained for the purpose of audits.