Introduction to Transfer Pricing
Territorial expansion of businesses that followed after globalization, has led to an increase in intra company transactions and cross border transactions between related companies. For instance, while manufacturing activities are managed by an entity of a larger group in one country, marketing of the manufactured products in another country are being handled by a different subsidiary belonging to the same group. In such cases, Transfer Pricing mechanism determines the price of the goods, services, funds, rights or intangible assets that are thus transferred for sale or consumption to a related entity. Transfer pricing is not limited to just pricing but also includes terms and conditions of such transactions between related parties.
It is important to understand the transfer pricing mechanism because it largely determines the revenue of related entities and therefore their taxable profits under their respective tax jurisdiction. The fundamental guideline for transfer pricing is “Arm’s Length Principle”, that is, the pricing of cross-border transactions between related entities must be market based, and similar to the pricing that would have been charged if the parties were unrelated.
In the case of unrelated entities the market forces such as demand and supply largely determine the commercial pricing of such cross border transactions, but in the case of related entities, because of the element of association and relationship, there is a propensity to set prices that are deviant from the actual market price. The selling entity may undercut the price, or the buying party may set a higher cost in order to lower their profits thereby affecting their taxable income. Such distortion of prices will impact the tax liability of the entities in their respective jurisdiction.
With businesses rapidly expanding beyond their domestic borders, leading to a spike in cross border transaction between related parties, tax authorities around the globe are stepping up their scrutiny on such transactions. Where a related party transaction is identified to be not in compliance with the arm’s length principle, tax authorities would make adjustments to the profits and tax liabilities. Such adjustments along with interest and in some cases penalty will always amount to increased tax liability of the entity. Therefore it is of utmost importance to familiarize with the transfer pricing regulations of the local tax jurisdiction as well as that of the related party’s jurisdiction.
Due to the nature of relationship that exists between related companies there is a potential for artificially shifting profits from an entity in higher tax jurisdiction to a related entity in lower tax jurisdiction, in order to reduce the overall tax liability. To prevent the practice of such tax reduction strategies by related entities engaging in cross border transactions, tax authorities of various countries required a regulatory framework. Following the initial efforts by United Nations, the Organization for Economic Cooperation and Development (OECD) Council originally approved the Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations in 1995. The OECD transfer pricing guidelines, is widely acknowledged by tax authorities around the globe to determine transfer pricing. It is a powerful tool for the tax authorities to attribute taxable profits to their jurisdiction.
The OECD guidelines recommend several methods that taxpayers may use to derive an arm’s length price or allocation, for the valuation, for tax purposes, of cross-border transactions between associated enterprises. In 2010 there were some elaborate additions to the guidelines on the selection of the most appropriate transfer pricing method, on how to apply transactional profit methods and on how to perform a comparability analysis. Many OECD member countries and non-member countries follow the OECD guidelines on transfer pricing, it must be noted that although the OECD guidelines are widely adopted, its interpretation, application and emphasis may vary between jurisdictions.
The OECD guidelines are based on arm’s length principle defined in Article 9 of the OECD Model Tax Convention, which also forms the basis of many bilateral tax treaties involving OECD member countries and non-member countries. The application of the arm’s length principle is generally based on a comparison of the prices or margins used by related parties with those used by arm’s length parties engaged in similar transactions.