Transfer Pricing Explained

Over the past couple of years, transfer pricing (TP) has become a topic of discussion and interest in the global environment, even more than it was before. Big multinational (MNE) groups that we are all familiar with are handling the news with court cases regarding TP disputes. However, the relevance of TP doesn’t stop at big corporations. Many firms, companies, corporations, and multinational groups are starting to face TP disputes as tax authorities globally increase their efforts to ensure compliance with TP regulations.

So, what is transfer pricing?

Transfer pricing is a subcategory of international taxation, that focuses on profit allocation in transactions between related parties (controlled transactions). Prices between related entities can be easily set in a way that is more tax-beneficial.

Tax authorities set transfer pricing regulations to ensure that multinational groups can’t do aggressive tax planning to shift their profit and pay less taxes. This is done by asking for the prices set in the controlled transaction to be at arm’s length.

The Arm’s Length Principle

The arm’s length principle is the standard that OECD members agreed should be used to set the pricing in controlled transactions for taxation purposes. The principle is set in Article 9 of the OECD Model Tax Convention. It states that if the conditions set in a controlled transaction are different than those that would’ve been set in the same transaction between unrelated parties (uncontrolled transaction), and this caused one of the parties to have less profit than it should’ve, this profit may be included in the profits of this party and taxed.

In simpler terms – the pricing set in a controlled transaction should be the same that would’ve been set in the same uncontrolled transaction.

An example for the need of TP regulations

We mentioned that a multinational group can use aggressive tax strategies to avoid paying taxes, but how does this work?

In short, when a group has companies in a few jurisdictions, it can set its intragroup pricing in a way that puts more profit in jurisdictions with low taxation, and less in those with high taxation rates, thus paying fewer taxes overall.

Let’s look at a simplified example to demonstrate this.

Say you have an entity in Country A that manufactures chocolate (we’ll call it “Entity A”).

A few details:

• Manufacturing cost – 5$
• Consumer price – 30$
• Country A corporate tax – 30%

We can calculate the profit of Entity A as follows:

In this scenario, Entity A paid 7.5$ in taxes, and its profit is 17.5$.

However, you learn that the corporate tax in the neighboring Country B is only 5%, and decide to open a company, Entity B, there. Entity B will buy chocolate from Entity A at a cost and sell it to the consumers at the consumer price of 30$.

Now we can calculate the profit of the group.

In this scenario, Entity A paid 0$ in taxes, and its profit is 0$. Entity B paid 2.5$ in taxes, and its profit is 22.5$.

• Total taxes paid – 2.5$
• Total profit – 22.5$

The group’s profit increased by 5$.

The issue? The tax authority of Country A lost tax revenues. If a lot of taxpayers use this strategy, they will end up losing a lot of tax revenues.

This is of course a gross and simplified example, but similar tax strategies were commonly used to reduce tax burden. Companies would open entities in low-tax jurisdictions, shift their profit there, and reduce the amount of taxes they pay.

Tax authorities caught up with this kind of strategy and realized the high amounts they were losing due to them. In response, and to lessen the use of those tax strategies, they started to introduce transfer pricing regulations.

A brief history of transfer pricing regulations

The first country to have transfer pricing regulations was the UK in 1915, followed by the US in 1918. Since then, most countries have added some form of transfer pricing regulations into their local legislation.

This issue also caught the attention of the OECD, and they published their first report about transfer pricing in 1979. This report was the basis for the 1995 transfer pricing guidelines. Those guidelines are periodically updated, with the last version being published in 2022.

The OECD guidelines serve as the basis for transfer pricing regulation all over the world.

How to determine the arm’s length price?

The price can be determined using transfer pricing methods, the most common ones (and that are mentioned in the OECD transfer pricing guidelines) are:

• Comparable Uncontrolled Price Method
• Resale Price Method
• Cost Plus Method
• Comparable Profits Method
• Profit Split Method

The choice between the methods is usually made case by case to ensure the most accurate representation of the arm’s length pricing. However, some countries have a hierarchy of methods. This means the regulations specify which method they deem to be best and the one they want taxpayers to first try and use. Of course, if the method doesn’t fit the transaction in question, taxpayers are able to use other methods.

Documentation

Documentation requirements vary among the jurisdictions but are usually based on the three-tier approach set by the OECD.

The approach set three types of documentation:

1. Local file – specific information about the transactions of a local taxpayer.
2. Master file – general information at the group level.
3. Country by Country reporting – information regarding the allocation of income and tax payments between the group entities. Usually required if the group has a consolidated revenue of 750 million euros or more.

Some countries require the preparation of those documents, some the summation and some just require some sort of documentation to be in place showing the adherence to the arm’s length principle.

Our firm assists taxpayer globally in their TP compliance needs in a simple and straightforward way. To contact a team member, click here.