Chapter 1:An Introduction to Transfer Pricing 1.1Whatis Transfer Pricing? 1.1.1 This introductory chapter gives a brief outline of the subject of transfer pricing and addresses the practical issues and concerns surrounding it, especially issues faced by, and approaches taken by, developing countries. Many of the issues discussed in the introduction are dealt with in greater detail in later chapters. 1.1.2 Rapid advances in technology, transportation and communication have given rise to a large number of multinational enterprises (MNEs) which have the flexibility to place their enterprises and activities anywhere in the world. 1.1.3 A significant volume of global trade nowadays consists of international transfers of goods and services, capital (such as money) and intangibles (such as intellectual property) within an MNE group; such transfers are called “intra‐group” transactions. There is evidence that intra‐group trade is growing steadily and arguably accountsformore than 30 per cent of all internationaltransactions. 1.1.4 In addition, transactions involving intangibles and multi‐tiered services constitute a rapidly growing proportion of an MNE’s commercialtransactions and have greatly increased the complexitiesinvolved in analysing and understanding such transactions. 1.1.5 The structure of transactions within an MNE group1 is determined by a combination of the market and group driven forces which can differ from the open market conditions operating between independent entities. Thus, a large and growing number of international transactions are no longer governed entirely bymarketforces, but by forces which are driven by the common interests ofthe entities of a group. 1.1.6 In such a situation, it becomesimportant to establish the appropriate price, called the “transfer price”, forintra‐group, cross‐bordertransfers of goods, intangibles and services. Transfer pricing isthe general term for the pricing of cross‐border, intra‐firm transactions between related parties. “Transfer pricing” therefore refersto the setting of prices2 for transactions between associated enterprisesthe transfer of property or services. These transactions are also referred to as “controlled” transactions, as distinct from “uncontrolled” transactions between companies that are not associated and can be assumed to operate independently (“on an arm’slength basis”) in reaching termsforsuch transactions. 1.1.7 “Transfer pricing” thus does not necessarily involve tax avoidance as the need to set such prices is a normal aspect of how MNEs must operate. Where the pricing does not accord with internationally applicable norms or with the arm’s length principle under domestic law, the tax administration may 1 The component parts of an MNE group, such as companies, are also called “associated enterprises” in the language of transfer pricing. 2 However, in most cases the transfer pricing analysis will end after an appropriate profit margin has been determined. See Chapter [5] on transfer pricing methods 2 considerthisto be “mispricing”, “incorrect pricing”, “unjustified pricing” or non arm’slength pricing, and issues oftax avoidance and evasionmay potentially arise. A few examplesillustrate these points: ‐ Consider a profitable computer group in country A that buys “flash‐memory drives” from its own subsidiary in country B: how much the parent company in country A pays its subsidiary company in country B (the “transfer price”) will determine how much profit the country B unit reports and how much local tax it pays. If the parent paysthe subsidiary a price that islowerthan the appropriate arm’s length price, the country B unit may appear to be in financial difficulty, even if the group as a whole shows a reasonable profitmargin when the completed computerissold. ‐ From the perspective of the tax authorities, country A’s tax authorities might agree with the profit reported at their end by the computer group in country A, but their country B counterparts may not agree ‐ they may not have the expected profit to tax on their side of the operation. If the computer company in country A boughtitsflash‐memory drivesfroman independent company in country B under comparable circumstances it would pay the market price, and the supplier would pay taxes on its own profitsin the normal way. This approach givesscope for the parent orsubsidiary, whichever isin a low‐ tax jurisdiction,to be shownmaking a higher profit by fixing the transfer price appropriately and thereby minimising itstax incidence. ‐ So, when the various parts of the organisation are under some form of common control, it may mean thattransfer prices are notsubjectto the full play ofmarketforces and the correct arm’slength price, or atleast an “arm’slength range” of prices(an issue discussed further below) needsto be arrived at. ‐ Consider next the example of a high‐end watch manufacturer in country A that distributes its watches through a subsidiary in country B. Let ussay the watch costs $1400 to make and it coststhe country B subsidiary $100 to distribute it. The company in country A sets a transfer price of $1500 and the subsidiary unitin country B retailsthe watch at $1600 in country B.Overall,the company hasthus made $100 in profit, on which itis expected to pay tax. ‐ However, when the company in country B is audited by country B’stax administration they notice that the distributor itself is not showing any profit: the $1500 transfer price plus the country B unit’s $100 distribution costs are exactly equal to the $1600 retail price. Country B’s tax administration considers that the transfer price should be shown as $1400 so that country B’s unitshowsthe group’s $100 profit that would be liable fortax. ‐ However this poses a problem for the parent company, as it is already paying tax in country A on the $100 profit per watch shown in its accounts. Since it is a multinational group it is liable for tax in the countries where it operates and in dealing with two different tax authoritiesit is generally not possible to just cancel one out against the other. So the MNE can end up suffering double taxation on the same profits where there are differences about what constitutesthe appropriate transfer pricing. 1.1.8 A possible reason for associated entities charging transfer pricesfor intra‐group trade isto measure the performance of the individual entities in a multinational group. The individual entities within a multinational group may be separate profit centres and transfer prices are required to determine the profitability of the entities. However not every entity would necessarily make a profit or loss in arm’s length conditions. Rationally, an entity having a view to its own interests as a distinct legal entity would only acquire products or services from an associated entity if the purchase price was equal to, or cheaper than, prices being charged by unrelated suppliers. This principle applies, conversely, in relation3 to an entity providing a product or service; it would rationally only sell products or services to an associated entity if the sale price was equal to, or higher than, prices paid by unrelated purchasers. Pricesshould on this basis gravitate towardsthe so‐called “arm’slength price”, the transaction price to which two unrelated parties would agree. 1.1.9 Though the above explanation of transfer pricing sounds logical and innocuous, arriving at an appropriate transfer price may be a complex task particularly because of the potential difficulties in identifying and valuing intangibles transferred and / or services provided. For example, intangibles could be of various different types such as: industrial assets like patents, trade types, trade names, designs or models, literary and artistic property rights, know‐how or trade secrets. Sometimes such intangibles are reflected in the accounts and sometimes not. Thus, there are many complexities involved which have to be taken into account while dealing with transfer pricing in cross‐border transactions between MNE entities. 1.1.10 Transfer pricing is a term used in economicsso it is useful to see how economists define it. In business economics a transfer price is considered as the amount that is charged by a part or segment of an organisation for a product, asset or service that it supplies to another part or segment of the same organisation
Posted on: Tue, 13 Aug 2013 22:06:24 +0000
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