Transfer Pricing - International Taxation

Transfer pricing is a technique used by multinational corporations to shift profits out of the countries where they operate and into tax havens. The technique involves a multinational selling itself goods and services at an artificially high price. By using its subsidiary in a tax haven to charge an inflated cost from its subsidiary in another country, eg buying boxes of pens from the tax haven-based subsidiary for $200 for a pen, the multinational corporation “moves” its profits out of the country where it genuinely does business and into a tax haven where it has to pay very little or no tax on profit.

Another example: let’s say it costs a multinational corporation $100 to produce a crate of bananas in Ecuador. It then sells that crate to an affiliate located in a tax haven for $100, leaving no profits in Ecuador. The tax haven affiliate immediately sells that crate on to an affiliate in Poland for $300, leaving $200 profit in the tax haven. That Polish affiliate sells the crate at the genuine market price of $300 to a supermarket, leaving no profits in Poland.

As a result, the multinational pays no tax in Ecuador and no tax in Poland, and the $200 in profits shifted to the tax haven do not get taxed.

In this way, multinational corporations avoid their responsibility to pay tax and fail to contribute to the societies in which they operate.

For the purpose of management accounting and reporting, multinational companies (MNCs) have some amount of discretion while defining how to distribute the profits and expenses to the subsidiaries located in various countries.

Sometimes a subsidiary of a company might be divided into segments or might be accounted for as a standalone business. In these cases, transfer pricing helps in allocating revenue and expenses to such subsidiaries in the right manner.

The profitability of a subsidiary depends on the prices at which the inter-company transactions occur. These days the inter-company transactions are facing increased scrutiny by the governments. Here, when transfer pricing is applied, it could impact shareholders wealth as this influences company’s taxable income and its after-tax, free cash flow.

It is important that a business having cross-border intercompany transactions should understand the transfer pricing concept, particularly for the compliance requirements as per law and to eliminate the risks of non-compliance.

Article 9 of the OECD Model Tax Convention describes the rules for the Arm’s Length Principle. It states that transfer prices between two commonly controlled entities must be treated as if they are two independent entities, and therefore negotiate at arm’s length. The Arm’s Length Principle is based on real markets and provides a single international standard of tax computation, which enables various governments to collect their share of taxes and at the same time creates enough provisions for MNCs to avoid double taxation.

The Organisation for Economic Co-operation and Development (OECD) guidelines discuss the transfer pricing methods which could be used for examining the arms-length price of the controlled transactions.

Here, arms-length price refers to the price which is applied or proposed or charged when unrelated parties enter into similar transactions in an uncontrolled condition. The following are three of the most commonly used transfer pricing methodologies.

For the purpose of understanding,  associated enterprises refer to an enterprise that directly or indirectly participates in the management or capital or control of another enterprise.

1. Transfer pricing helps in reducing duty costs by shipping goods into countries with high tariff rates by using low transfer prices so that the duty base of such transactions is lowered.
2. Reducing income and corporate taxes in high tax countries by overpricing goods that are transferred to countries with lower tax rates helps companies obtain higher profit margins.

1. There can be disagreements within the divisions of an organization regarding the policies on pricing and transfer.
2. Lots of additional costs are incurred in terms of time and manpower required in executing transfer prices and maintaining a proper accounting system to support them. Transfer pricing is a very complicated and time-consuming methodology.
3. It gets difficult to establish prices for intangible items such as services rendered, which are not sold externally.
4. Sellers and buyers perform different functions and, thus, assume different types of risks. For instance, the seller may refuse to provide a warranty for the product. But the price paid by the buyer would be affected by the difference.