Transfer pricing can be defined simply
As we kick-off training this week for our recent new hires at Aspect Advisory, we are starting from the start – by answering the question: what is transfer pricing? Although transfer pricing can be a complex discipline, its base definition is not complicated:
Transfer pricing is the pricing of transactions between related parties.
When transactions occur between unrelated, independent parties, prices are determined based on market forces and the natural inclination of the bargaining parties to act with their own self-interest in mind – that is, to obtain the lowest price as the buyer, or the highest price as the seller. The final negotiated price represents an uncontrolled market price.
Transactions between related parties do not usually occur under similar external market forces. Two legal entities in a corporate group are instead likely to consider pricing transactions between them based on the interest of the consolidated group position. In this case, setting the prices for transactions between related parties could be manipulated to allocate profits associated with the transactions in a way that achieves the lowest overall tax outcome for the corporate group.
Since most transfer prices impact two or more taxing jurisdictions, tax authorities have an interest in ensuring the “right” prices are paid on intercompany transactions so that their tax base is not eroded by manipulating these prices. On this basis, the majority of tax authorities around the world have developed stringent (and often complex) rules, regulations and guidance on how transfer prices are to be determined.
In the vast majority of cases, tax authorities base their transfer pricing rules on the “arm’s length standard” or the arm’s length principle.” Applying the arm’s length principle means that the price paid for a transaction between related parties is equal to the price that would be paid between two independent entities operating under similar conditions. And this my friends, is why transfer pricing is an art, rather than a science (if I had a penny for every time I heard this phrase…).
Example – Roller-skate multinational (we’re done with “widgets”)
For example, assume a corporate group that produces roller skates in Ireland (tax rate 12.5%) at a cost to manufacture of EUR 100, can sell them to a final customer in France (tax rate 34ish%) for EUR 250 (top-of-the-line quads!). The Irish company sells the skates to its sister company in France (controlled transfer price), which on-sells to the end-customer in Paris (uncontrolled market price).
The corporate group must determine the sales price from the Irish company to the French sister company.
So let’s say our roller-skate multinational decides to sell a pair of skates from Ireland to France at an artificially high price of EUR 220 – the total group taxes paid would be as follows:
But if instead, a transfer pricing benchmarking analysis taking into account the economic contributions made by the Irish and French companies determines that an arm’s length price for the sale of the skates is actually closer to EUR 150, the total group taxes paid would instead look quite different:
You can see in this over-simplified example that the impact of being able to manipulate the sales price is to ultimately shift taxable operating profits of the group to the lower tax jurisdiction, paying less overall tax on a global basis.
Obviously, as a result of transfer prices having such a significant impact on the determination of a country’s tax base, tax authorities globally have a keen interest in ensuring compliance with transfer pricing rules and guidelines – as artful as they are.