How Transfer Pricing Works
The business world is becoming increasingly global and multinational companies are the norm today. In fact, large, multinational corporations are becoming so common that some suggest 60% of all international trade happens within multinational companies rather than between different multinational corporations.
One of the aspects closely related to multinational trading is transfer pricing. This guide will look at 1) what transfer pricing is all about, 2) how it has evolved and 3) how the transfer pricing works. The guide will also look at 4) rules and regulations surrounding transfer pricing and its issues with tax avoidance.
WHAT IS TRANSFER PRICING?
Transfer pricing can be quite a complex system to understand. Before we look at the system in action, it is a good idea to delve deeper into the definition of transfer pricing.
Transfer price is essentially the price at which different parts of the company transact with each other. For example, this could include transactions such as trading supplies between departments. They are therefore used by multi-entity firms in situations where the firm’s individual units are treated as separate.
The situation where units are treated as separate deals with units that are in charge of their own profit, or the return on invested capital. If a multi-entity firm has units that are in charge of their own profits and these divisions transact with each other, a transfer price will be used.
In general, transfer prices don’t differ much from the market price. This is because one of the units would always lose out if a different price were to be set. In the long term, this could affect the unit’s performance and therefore the overall financial health of the multi-entity company.
The reason transfer prices shouldn’t differ too much from market price is down to the principle of arm’s length pricing. This is a system, which means the transfer price shouldn’t be too different to the current market price, i.e. it should be within reach.
The below video is a more detailed look into the arm’s length principle:
Basic issues underlying transfer pricing
Because the transfer price determines the income of the two parties involved in the cross-border transaction, the price also deals with the tax base of the countries involved. This means that transfer pricing has three underlying issues to solve.
These three issues are related to jurisdiction, allocation and valuation and below is a quick look at each point.
Countries often try to avoid double taxation of corporate income, but transfer pricing makes this a bit trickier. Defining which country has the right to tax the transaction can be difficult and in some cases are used as a tax avoidance tool by the companies.
The multi-national entities (MNEs) still share common resources and overheads; therefore, allocation of these resources is especially important. But efficient allocation is also a concern for countries in terms of taxation and there can be, again, huge differences in how to best solve this allocation dilemma in deciding transfer pricing.
Finally, the income and expenses regarding transfer pricing must be correctly valued, which is the key issue for most companies. Since there aren’t too many international rules regarding corporate taxation, for example, the valuation becomes a tool companies sometimes use to exploit these differences.
The evolution and history of transfer pricing
The first transfer pricing adjustments were used in the 1930s. The Organisation for Economic Cooperation and Development (OECD) together with the US had developed some guidelines by 1979 which many corporations began using.
But the first proper regulations were published in 1995, when the OECD published its first transfer pricing principles. The guidelines have now been adopted by a majority of the member countries and other smaller nations use them as a starting point to their specific regulatory framework.
While the OECD and United Nations guidelines have been accepted in principle in many parts of the world, their enforcement is not always easy. Countries with smaller and less developed economies are finding it especially hard to enforce some of the regulations.
The organizations are therefore continuously trying to improve the guidelines and to improve the system. The European Council together with business experts, for instance, has continued to work on resolving some remaining issues relating to transfer pricing and ensuring a global set of regulations could be used.
KEY METHODS USED TO CALCULATE A TRANSFER PRICE
When it comes to setting a transfer price, companies can use a wide variety of different methods. The plethora of different calculation points reflects well some of the above difficulties underlying the current system.
The main methods used to calculate a transfer price are as follows.
Market rate transfer price
This is the most straightforward method of calculating a transfer price. It is also often referred to as the most elegant method. It simply means the transfer price is the same to the current market price for the goods or service.
Under this method, the upstream unit has two options for selling the goods or services, either by conducting the sale internally or externally. The profit for the unit will be the same under both methods.
Adjusted market rate transfer price
If the above method is unavailable, the adjusting market rate is often used to deriving the transfer price. This method simply includes some adjustment to current market price.
For example, companies may choose to use a reduced price to ensure there is no risk of late payments. In most instances, this stills falls well within the arm’s length principle.
Negotiated transfer pricing
In some instances, the different units negotiate a specific price, without considering the market price as a baseline. The price will be decided by the units and it can be significantly different to the market price.
Companies choose to use this method if the market for the goods or service is very limited or the sold item is highly customized. Essentially, it often arises in situations where the market price is hard to calculate or is insufficient in terms of what is being sold.
If the market price is non-existent, then analyzing the proper valuation with the arm’s length principle will be difficult.
Contribution margin transfer price
In certain instances, there might not be a set market price for the goods or services being sold. Companies then tend to use the contribution margin transfer price method, which means they calculate a market price alternative based on the unit’s contribution margin.
Cost-plus transfer pricing
Another option in instances of no valid market price is to calculate the transfer price based on the cost of components. This method is especially useful if the sold item is a manufactured good.
When calculating a cost-plus transfer pricing, most companies add a margin on the cost of the good by compiling the standard cost together with a standard profit margin. The resulting price is then used as the transfer price.
Cost-based transfer pricing
Finally, companies often sell the goods or service to the other unit by simply using the production cost as the price point. If the product or service is then sold further to a third party, the unit can add their own costs to the final price.
Under this method, the company, which makes the final sale, receives the entire profit of the goods or service. This final method is often considered to be used for tax avoidance purposes. You can read more on the reasons in the coming section.
An example of transfer price in action
To fully understand how transfer pricing works, it is a good idea to see it in action through an example.
Consider there is a company called A, which creates batteries for a variety of different uses. Company A is purchased by company C. C also owns a company B, which makes low-emission motorboats.
Company B now wants to purchase batteries from company A. Since they share a parent company, but have separate profit systems, they need to use a transfer price for selling the goods.
The companies can use any of the above methods to calculate the transfer price. If they wish to use the most straightforward method, they’d go with the current market price for the batteries.
But it might be that company C wants to boost company B’s profits more, and asks them to negotiate a cost-based transfer pricing. Under this, B only has to pay for the cost A encounters manufacturing the products. B can then add its own costs to the price before it sells the batteries along with the motors.
The problem with this method could be that A’s profits decline and the business might end up making a loss. Therefore, finding the right transfer price can be quite a balancing act.
GLOBAL TRANSFER PRICING REGULATIONS
As mentioned briefly above, there aren’t yet any unified standards to how legislation deals with transfer price. Although there is a set of guidelines companies and countries follow, more work is required to truly unify the regulation and to ensure companies don’t take advantage of existing loopholes.
Country specific rules
All countries tend to have certain country-specific rules regarding transfer pricing. This is especially true when it comes to the key global economies such as the US and China.
Country-specific transfer pricing rules are especially important to know for companies that operate around the world. You can find much more information at a country’s tax or trade authority.
Here are some of the key points to note when it comes to the US and China. First, some of the main points from the US transfer pricing rules include:
- The US uses the principle of comparable profits method (CPM). Under the model, the transfer price’s validity is tested by comparing the unit’s overall results with another similar business, instead of simply focusing on the transaction.
- The US permits shared services agreements.
- The US considers the conduct of the parties more important than the contractual terms if the case is being reviewed.
- The tax authorities cannot adjust prices that are found to be within the arm’s length range in the US.
Key points for China:
- China used the OECD guidelines until 2009, when it announced its own guidelines.
- The guidelines give specific information for the country’s tax administration on how to test transfer-pricing agreements.
- The rules apply to transactions between a Chinese business and either a domestic or foreign related unit. The related party must pass one of eight tests conducted to see the relation is close enough with the parties.
The OECD specific transfer pricing rules
While the OECD guidelines are voluntary for each member nation, most countries have adopted them almost unchanged. There are some terminology changes in how countries might interpret some of the rules, but understanding the OECD rules can help understand most countries’ approach to transfer pricing.
Here are some of the key things to understand from the OECD guidelines:
- The priority in the OECD guidelines is given to the transactional methods.
- The rules permit consideration of business strategies in coming up with transfer pricing in instances of comparable transactions. These include: market penetration, expansion of market share, and cost of locations savings, for instance.
- The transactional net margin method is often used to compare the net profitability of a transaction.
- Contractual terms between parties are given a lot of value in the OECD guidelines.
- Tax authorities cannot generally adjust the prices if the arm’s length range is achieved.
- There are no specific documentation rules, as these are left to the individual countries to decide.
EU specific transfer pricing rules
The European Union has also created its own set of guidelines. The EU Joint Transfer Pricing Forum provided a set of guidelines and suggestions for creating more unified rules across member states.
Much of EU’s guidelines are similar to the OECD guidelines, but it also looks more in detail to how individual countries could unify taxation. The EU is still looking into transfer pricing and the systems to improve it.
PROBLEM WITH TAX AVOIDANCE
As mentioned above, transfer pricing has often been accused of enabling the use of tax avoidance practices. Because companies are relatively free to negotiate the prices, they can often sell goods and services that might somehow distort the global competition, not to mention use the method for transferring income from one company to another in order to pay less tax.
It is important to note transfer pricing itself is not illegal nor is it necessarily abusive. But illegalities and tax avoidance calls do arise when companies abuse transfer pricing, through a method known as transfer mispricing. This means that companies knowingly manipulate the transfer price, often to avoid tax.
There are no clear figures as to how much countries lose on tax revenues due to transfer mispricing. According to a Christian Aid report from 2009, the trade mispricing into the EU and the US from non-EU countries stood at $1.1 trillion from 2005 to 2007.
An example of transfer mispricing
To better understand what accounts transfer mispricing, below is an example of a very common situation.
Company A provides harvested goods in Africa to sell in the US. Company A also has three different subsidiaries, which are located in different countries: company B in Africa, company C in a tax haven, and company D in the US.
Company B sells the products it produces in Africa to company C at an artificially low price. This means company B’s tax bill is artificially low, as it hardly makes a profit.
On the other hand, company C sells the product forward to company D at a very high price. Since it doesn’t need to pay corporation tax, it can generate as much profit as possible.
Finally, the company D sells the product in the US almost at the retail price, meaning its profits also remain low. This means the US tax authority also loses out, as the profits of the company D are kept low.
The arm’s length principle
To counter the above situation, countries often use the arm’s length principle to see whether companies are transfer mispricing. This is endorsed by both the OECD guidelines and the United Nations Tax Committee’s guidelines. It’s also often used in bilateral trade agreements between countries.
The problem is the principle isn’t always easy to implement. This is because figuring out the correct market price can be impossible or extremely difficult. As the different calculation methods highlighted, there are situations where the goods or products being sold don’t have a proper market price due to their nature.
To encounter the limitations of arm’s length principle, many experts have suggested a method called Unitary Taxation. Under this principle, the economic substance of a multinational company and its transactions would be prioritized instead of the legal form in which the company organizes itself and its transactions. This would essentially mean the company is taxed on a unitary basis, instead of allowing the shifting of profits. There are also other ideas to encounter the issues, such as the Country by Country reporting system.
Transfer pricing is one of the most important aspects a multinational business needs to know about. It is a crucial part of taxation strategies, not just for the company but also for the country it operates in.
While the principle of transfer pricing doesn’t mean companies should abuse its opportunities, there are clear problems that need to be resolved as multinational trade within corporations increases. Nonetheless, transfer pricing offers companies different options for maximizing their incomes and benefitting from mutual trade.