Meaning of Transfer Pricing
Transfer pricing refers to the rules and methods used for determining the price of transactions carried out within or between enterprises that are under common ownership or control. Such transactions are generally known as intragroup or controlled transactions.
Transfer pricing becomes particularly important when transactions take place between related enterprises located in different countries. Cross-border transactions between associated enterprises may affect the amount of taxable income reported in a particular country. Therefore, tax authorities may examine and adjust the prices charged in such transactions.
Arm’s-Length Principle
The basic principle of transfer pricing is the Arm’s-Length Principle. According to this principle, the price charged in a transaction between related enterprises should be similar to the price that would have been charged between independent or unrelated enterprises under comparable circumstances.
If an intragroup transfer price differs from the price that unrelated enterprises would have agreed upon, tax authorities may adjust the transfer price for taxation purposes. The objective is to ensure that taxable income is not distorted because of the relationship between the enterprises.
The Organisation for Economic Co-operation and Development (OECD) and the World Bank recommend transfer pricing rules based on the arm’s-length principle. Similar measures have been adopted by 19 of the 20 G20 members through bilateral treaties, domestic laws, regulations, or administrative practices.
Countries having transfer pricing legislation generally follow the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations. However, specific transfer pricing rules may differ between countries in certain important areas.
Scope of Transfer Pricing Rules
Transfer pricing rules generally allow tax authorities to examine and adjust the prices of most cross-border intragroup transactions. These transactions may involve the transfer of tangible property, intangible property, services, and loans between related enterprises.
For example, a tax authority may increase the taxable income of a company by reducing the price recognized for goods purchased from an affiliated foreign manufacturer. Similarly, the tax authority may increase the royalty that a company is required to charge its foreign subsidiary for the right to use proprietary technology or a brand name.
Such adjustments are generally calculated by applying one or more transfer pricing methods specified in the OECD Guidelines. Transfer pricing adjustments may also be subject to judicial review or other dispute resolution mechanisms.
Transfer Pricing and Tax Avoidance
Transfer pricing itself should not be considered a tax avoidance practice or technique. The term transfer pricing refers to the substantive and administrative regulatory requirements imposed by governments on certain taxpayers for pricing transactions between related enterprises.
However, aggressive intragroup pricing, particularly in transactions involving debt and intangible assets, has played an important role in corporate tax avoidance. Companies may structure intragroup transactions in a manner that affects the location and amount of taxable profits.
This issue became an important concern under the Base Erosion and Profit Shifting (BEPS) Action Plan, released by the OECD in 2013.
Transfer Pricing and the BEPS Action Plan
The OECD’s 2015 final BEPS reports recommended stronger measures relating to international taxation and transfer pricing. The reports called for country-by-country reporting and stricter rules relating to the transfer of risks and intangible assets between related enterprises.
However, the OECD continued to recommend the use of the Arm’s-Length Principle as the basic principle for transfer pricing.
These recommendations received criticism from different groups. Some taxpayers and professional service firms argued that the recommendations departed from established transfer pricing principles. On the other hand, some academics and advocacy groups argued that the reforms did not introduce sufficient changes.
Transfer Pricing and Trade Mis-Invoicing
Transfer pricing should not be confused with fraudulent trade mis-invoicing. Although both may involve issues relating to the pricing of transactions, they are separate concepts and represent different policy problems.
Trade mis-invoicing is a technique used to conceal illicit financial transfers by reporting false or falsified prices on invoices submitted to customs authorities.
In contrast, transfer pricing deals with the pricing of transactions between enterprises under common ownership or control and the regulatory requirements applicable to such transactions.
Aggressive tax avoidance schemes of multinational corporations may sometimes be confused with trade mis-invoicing because both may involve incorrect or manipulated prices. However, transfer pricing issues and trade mis-invoicing should be treated as separate policy problems requiring separate solutions.
Key Points
Transfer pricing deals with pricing transactions between enterprises under common ownership or control. The basic principle of transfer pricing is the Arm’s-Length Principle, under which related-party transactions should be priced as if they were carried out between independent enterprises.
The OECD and World Bank recommend transfer pricing rules based on the Arm’s-Length Principle. Countries with transfer pricing legislation generally follow the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations.
Transfer pricing rules may apply to cross-border transfers of tangible property, intangible property, services, and loans.
The OECD introduced the BEPS Action Plan in 2013, and the 2015 final BEPS reports recommended country-by-country reporting and stricter rules for risks and intangible assets.
Transfer pricing is not itself a tax avoidance technique. However, aggressive intragroup pricing may contribute to corporate tax avoidance.
Transfer pricing and fraudulent trade mis-invoicing are separate concepts and should not be treated as the same policy problem.