Transfer pricing is the setting of the price for goods and services sold between related legal entities within an enterprise. For example, if a subsidiary company sells goods to a parent company, the cost of those goods paid by the parent to the subsidiary is the transfer price. Transfer pricing is probably the most important consideration for all multinational companies related to international coporate taxation because it impacts the purchasing behavior of subsidiaries and has tax implications for the company as a whole. Governments around the world are cracking down on transfer pricing regulations because of the rise of budget deficits and companies’ use of transfer pricing to avoid taxes. There is a thin, often blurry line, between the legal benefits of transfer pricing and tax avoidance, so it is more important than ever to understand the benefits, implications, and consequences of transfer pricing. Keep reading to learn more about international taxation and transfer pricing.
Globig recently spoke with Jason Fritts, a senior manager specializing in Transfer Pricing at Eide Bailly, about transfer pricing. Mr. Fritts described what transfer pricing is, why it matters, how to set up transfer pricing documentation, and the different expectations in different countries. Here is an overview of the conversation.
Since transfer pricing is the price of goods (or services or financing) sold between two subsidiaries of the same corporation, these transactions are subject to regulation and are treated as such by governing bodies. Although it doesn't have to involve international expansion, businesses about to expand abroad should start thinking about transfer pricing and getting their sales between parent and branch companies in compliance.
Why is transfer pricing regulated?
Transfer pricing is regulated because there are different tax rates in different countries that companies could avoid or take advantage of. Without these regulations, companies would use transfer pricing to get the best rates for their separate entities. For example, transfer pricing without this principle could be used to lower profits in one division of an entity located in a country with high income taxes and raise profits in a country that is a tax haven, that is with no or low income taxes.
Most governments with transfer pricing regulations have given their tax authorities the authority to adjust the prices charged between entities, even if there was no intent to avoid taxes.
Transfer pricing regulations generally require that the transfer price be appropriate. To determine the appropriateness of a transaction, almost all countries with transfer pricing regulations use the arm’s length principle, which the OECD provides guidance on. So, what is this arm’s length principle?
What is the arm’s length principle?
The arm’s length principle is a universal (global) standard that ensures intercompany transactions are appropriate, which is to say, similar to that of transactions with a third party. A price will be considered appropriate if it is the same price (or range) that an independent buyer would pay an independent seller for an identical item, under identical terms and conditions, and without any compulsion to act.
A good way to check the pricing for accuracy (or “fairness”) is to back away from the sale and consider it from a third party’s point of view. If it wasn’t a related company, would the transaction still occur? Would company A sell services to company B at the same margin if company B were not a subsidiary? The best way to determine whether the company has complied with the arm’s length requirement is to compare the transaction to another similar company. Using this similar company as a guide for pricing is called benchmarking and is useful for avoiding tax penalties.
How do you determine the appropriate transfer price?
Companies and governments have several different methods available to them to determined the appropriate transfer price, but the most common method is comparability (in the US, “comparable profits method” (CPM) and outside the US, “transactional net margin method” (TNMM)). Comparability is what it sounds like it is, when transactions are compared for similarities. In the context of transfer pricing, a transaction is appropriate when it is comparable to another similar transaction.
Comparability is best when identical items (including terms and conditions) are compared. However, because identical items are not always available, those different factors are taken into consideration in determining the appropriate price.
Transfer pricing can be complicated, particularly if you are new to the concept. Because violations can result in taxation issues in multiple jurisdictions, it is important to comply with all applicable transfer pricing regulations. Most accounting and tax firms can help you with your transfer pricing questions and concerns.
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