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What Is Transfer Pricing?

by James Green on 27/10/09 at 9:00 pm

“Transfer pricing” is an increasingly important and contentious area of international tax law. This is because so much of modern world trade involves the transfer of goods, intangibles or services within multinational enterprises (MNEs) – groups of companies or related businesses based in 2 or more countries.

Such international trade offers scope for an MNE to keep or move most of its profits in a low or no tax jurisdiction.

An Example

A widget manufacturer (company “A”) is based in a country where labour costs are low but corporate tax is 40%. Widgets sell in the “developed” world at 100 units (let’s call them “cents”) each. It costs A just 20 cents to make each widget, including overheads. If A sold the widgets directly it would need to pay tax of 32 cents on each widget (40% of 80 cents).

Instead A sells its widgets to a related wholesale company (“B”) for 25 cents resulting in a tax bill of just 2 cents per widget for company A. Now B is located in a low tax country, such as Bulgaria (10%) or Ireland (12.5%) and so when B sells the widgets making a 75 cents profit it could pay as little as 7.5 cents in tax.

What this means is that this MNE has reduced its tax from 32 cents to less than 10 cents on each widget.

There could even be a third company inserted between A and B, located in an offshore jurisdiction with a zero tax rate. This would enable the MNE to strip out even more of the profit, say buying widgets at 25 cents and selling them at 90 cents easily reducing the total tax for the three jurisdictions to just 3 cents.

Arms Length Principle

It’s obvious when you look at the above example that the prices at which the widgets were transferred were not commercially driven but a method of tax avoidance. In technical terms they were not carried out “with reference to the arms length principle”.

The arm’s length principle states “the amount charged by one related party to another for a given product [service, etc] must be the same as if the parties were not related”. An arm’s length transaction is therefore what the price of the transaction would be on the open market. So although the above example of tax avoidance is not illegal – no-one will go to jail (if they do it carefully) it will fall foul of what is called “anti avoidance legislation” and if the tax authorities where company A is located decide that an arms length price should be 70 cents rather than 25 then A will have to pay 20 cents tax (40% of a notional 70 cents less 20 cents cost). The danger is of course that B are is showing a purchase price of 25 cents and so would be taxed in Bulgaria (for example) another 7.5 cents. So the total tax bill is now 27.5 cents, still less than the original 32 cents but not nearly so good for the MNE.

If we were to add the offshore jurisdiction into the equation there is even the possibility that B might be held to have bought the widgets for less than the amount A has been deemed to have charged and so the eventual tax bill could be more than 32 cents. In fact if A and B are located in countries which do not have a double taxation treaty that could happen anyway as the country where A is located will want to claim that the arms length selling price was as high as possible whilst the tax authorities where B is located will want to claim the purchase price was as low as possible – that way each gets the maximum tax take even if it is more than it should be?

International Cooperation

As explained above multinational taxpayers are often caught between jurisdictions making inconsistent tax claims as to the same cross-border transactions. This can and does result in “international double taxation.”

To counter this and bring some degree of fairness to both MNEs and tax authorities, several organisations such as the OECD (Organisation for Economic Cooperation & Development) and the European Union (EU) have established agreed methods of establishing arms length pricing. Note though that not all countries have signed up to one or more of the international agreements and in many cases full protection against international double taxation may only be available where the parties are located in countries that have a double taxation treaty dealing with transfer pricing.

How to Deal with Transfer Pricing

In most countries all MNEs are required to establish a transfer pricing policy and produce a Transfer Pricing Manual to document the processes they have used to ensure that intra-group and related party transactions are carried out at arms length. This is not a simple task and should only be undertaken by or with a specialist tax advisor. Despite what is shown in the example of our widget manufacturer there is in fact scope to argue that an acceptable price between A and B should be lower than a normal arms length price perhaps by arguing that as A is taking no risk (it only manufactures for B with a guaranteed market) it doesn’t deserve to make as much profit as another widget manufacturer supplying a variety of wholesalers. Indeed there are hundreds of permutations and arguments that can be tested to see which is best. Hence, use an expert.

Note that transfer pricing legislation doesn’t just affect groups of companies it also catches “associated parties” which definition is extended to include control rather than ownership so that a company with loans or guarantees above a certain figure or with the power to appoint board directors are related parties as are those with common directors or close relations as owners or directors.

James Green & Co provide Transfer Pricing advice and are able to assist businesses in many jurisdictions to develop a Transfer Pricing Policy and Manual. Email us to discuss.

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Category: Taxation