What Is Transfer Pricing?
Transfer pricing is an accounting practice that represents the price that one division in a company charges another division for goods and services provided.
Transfer pricing allows for the establishment of prices for the goods and services exchanged between subsidiaries, affiliates, or commonly controlled companies that are part of the same larger enterprise. Transfer pricing can lead to tax savings for corporations, though tax authorities may contest their claims.
How Transfer Pricing Works
Transfer pricing is an accounting and taxation practice that allows for pricing transactions internally within businesses and between subsidiaries that operate under common control or ownership. The transfer pricing practice extends to cross-border transactions as well as domestic ones.
A transfer price is used to determine the cost to charge another division, subsidiary, or holding company for services rendered. Typically, transfer prices are reflective of the going market price for that good or service. Transfer pricing can also be applied to intellectual property such as research, patents, and royalties.
Multinational corporations (MNC) are legally allowed to use the transfer pricing method for allocating earnings among their various subsidiary and affiliate companies that are part of the parent organization. However, companies at times can also use (or misuse) this practice by altering their taxable income, thus reducing their overall taxes. The transfer pricing mechanism is a way that companies can shift tax liabilities to low-cost tax jurisdictions.
What Are The Requirements For Your Firm?
Transfer pricing rules around the globe are quite similar. At the same time, there are different focus areas in specific countries. Generally speaking, pricing regulations impose a number of obligations on your firm if it has controlled transactions (sometimes revenue thresholds apply):
- Your firm should be able to proof that the terms and conditions of internal transactions are comparable to those which would have been agreed in the free market when concluding comparable transactions (referred to as “arm’s length”).
- Your firm should keep documentation on record which shows:
- (a) how the transfer pricing has been established and
- (b) whether the transfer pricing is in line with the arm’s length principle.
- Your firm should file annual (corporate) tax returns on the basis of arm’s length terms and conditions of controlled transactions.
How Can Your Firm Meet These Requirements?
You first have to ask yourself the question: What are we doing now?
As a first step it is good to look at what internal transactions your firm has and which associated enterprises are involved. This does not only include the “visible transactions” such as supply of goods and provision of services. It also includes “invisible transactions” such as group guarantees provided to external banks.
As a next step you would need to verify whether the terms and conditions of internal transactions are in accordance with the arm’s length principle and whether this can be substantiated.
In a lot of cases, the conditions of internal transactions are equally applied to external comparable transactions (example: a firm sells a product at the same price to both associated entities and third parties). That is in itself a sound basis to take the position that the transfer pricing is at arm’s length.
The last step would be to determine whether transfer pricing documentation needs to be prepared. This depends on steps 1 and 2, but also on local legislation.
What Transfer Pricing Methods Are There?
The good thing about transfer pricing is that the principles and practices are quite similar all around the world. The OECD Transfer Pricing Guidelines (OECD Guidelines) provide 5 common transfer pricing methods that are accepted by nearly all tax authorities.
The five transfer pricing methods are divided in “traditional transaction methods” and “transactional profit methods.”
The Arm’s Length Principle
Most countries have transfer pricing rules in their domestic tax legislation. In a nutshell, these rules provide that the terms and conditions of controlled transactions may not differ from those which would be made for uncontrolled transaction (remember: transactions between independent enterprises). This is referred to as the arm’s length principle.
The Five Transfer Pricing Methods
As mentioned, the OECD Guidelines discuss five transfer pricing methods that may be used to examine the arm’s-length nature of controlled transactions. Three of these methods are traditional transaction methods, while the remaining two are transactional profit methods.
We list the methods here, and provide a handy graph we created:
Traditional transaction methods:
- CUP method
- Resale price method
- Cost plus method
Transactional profit methods:
- Transactional net margin method (TNMM)
- Transactional profit split method.
Our publication about transfer pricing here!