Adoption of Transfer Pricing Rules
More than 60 governments have adopted transfer pricing rules. In almost all countries, these rules are based on the Arm’s-Length Principle. Kazakhstan is mentioned as a notable exception to this general approach.
Transfer pricing rules generally allow related enterprises to determine the prices of transactions between themselves. However, tax authorities have the power to adjust these prices for the purpose of calculating tax liability when the prices charged fall outside an arm’s-length range.
In most tax systems, tax authorities can make transfer pricing adjustments even when there is no intention to avoid or evade tax. Therefore, the main consideration is whether the price of a related-party transaction satisfies the arm’s-length requirement rather than whether the taxpayer intended to reduce tax liability.
Comparability of Related and Unrelated Party Transactions
The application of the arm’s-length principle requires comparison between related-party transactions and unrelated-party transactions or activities.
For a reliable comparison, factors such as the market level, functions performed, risks assumed, and terms of sale should be reasonably comparable. These factors are examined to determine whether the price or profitability of a related-party transaction is consistent with conditions that would exist between independent parties.
Transfer Pricing Adjustments
Transfer pricing adjustments are generally made by adjusting the taxable income of related parties within the jurisdiction. Tax authorities may also adjust withholding taxes or other taxes imposed on parties located outside the jurisdiction.
Such adjustments are generally made after the taxpayer has filed the tax return and the tax authority examines the reported transactions.
For example, suppose Bigco US sells a machine to Bigco Germany. If the U.S. or German tax authority examines the relevant tax return and finds that the transaction price is not at arm’s length, the authority may adjust the price for tax purposes.
After a transfer pricing adjustment, the taxpayer is generally permitted, at least by the government making the adjustment, to make payments that reflect the adjusted transfer price.
Transfer Pricing Methods
Most transfer pricing systems permit the use of multiple transfer pricing methods, provided the selected method is appropriate and supported by reliable information.
Common methods include the Comparable Uncontrolled Price Method, Cost-Plus Method, Resale Price or Mark-up Method, and profitability-based methods.
Different methods may be used for different types of transactions. Many transfer pricing systems distinguish between methods used for goods, services, and the use of property because these transactions have different business and economic characteristics.
Some systems also provide mechanisms for the sharing or allocation of the costs of acquiring assets, including intangible assets, among related parties. Such arrangements are designed to reduce disputes relating to the allocation of costs and transfer pricing.
Authority of Tax Authorities to Adjust Prices
Most governments have authorized their tax authorities to adjust prices charged between related parties when the prices do not satisfy transfer pricing requirements.
In countries such as the United States, United Kingdom, Canada, and Germany, tax authorities may make adjustments to both domestic and international related-party transactions. In some other systems, transfer pricing adjustment powers apply only to international transactions.
Arm’s-Length Range
Transfer pricing rules generally recognize that an arm’s-length price may not always be a single specific price. Instead, a range of acceptable prices may satisfy the arm’s-length principle.
Some tax systems provide specific methods for determining whether a price falls within the arm’s-length range. For example, U.S. transfer pricing regulations use the interquartile range for evaluating related-party prices.
A significant difference between the price points within a range may indicate that the underlying data is not sufficiently reliable. The reliability of transfer pricing analysis is generally considered to improve when multiple-year data is used.
Examination of Actual Transactions and Economic Substance
Most transfer pricing rules require tax authorities to examine the actual transactions carried out between related parties. Adjustments are generally permitted only in relation to transactions that have actually taken place.
Multiple transactions may be combined and tested together or examined separately. Transfer pricing analysis may also use financial and transactional data covering multiple years.
In many tax systems, the economic substance of a transaction is important. If the actual economic substance of a transaction is materially different from its legal or formal structure, tax authorities may recharacterize the transaction according to its economic substance.
Development of Transfer Pricing Guidelines
Transfer pricing adjustments have been part of many tax systems since the 1930s.
The United States played an important role in developing detailed transfer pricing guidelines. It issued a White Paper in 1988, followed by transfer pricing proposals between 1990 and 1992. These proposals ultimately became formal transfer pricing regulations in 1994.
The OECD issued its Transfer Pricing Guidelines in 1995. These guidelines were expanded in 1996 and 2010.
The U.S. and OECD transfer pricing guidelines are broadly similar and contain several common principles followed by many countries. Many countries in the European Union have formally adopted the OECD Transfer Pricing Guidelines with little or no modification.
Key Exam Points
More than 60 governments have adopted transfer pricing rules, and almost all are based on the Arm’s-Length Principle.
Tax authorities may adjust related-party prices that fall outside the arm’s-length range, even when there is no intention to avoid or evade tax.
Comparability analysis generally considers the market level, functions, risks, and terms of sale.
Common transfer pricing methods include the Comparable Uncontrolled Price Method, Cost-Plus Method, Resale Price or Mark-up Method, and profitability-based methods.
An arm’s-length price may be a range of prices rather than a single price. The interquartile range is used under U.S. regulations to evaluate the arm’s-length range.
Transfer pricing rules generally examine actual transactions and their economic substance.
The United States issued comprehensive transfer pricing regulations in 1994, while the OECD issued its Transfer Pricing Guidelines in 1995, which were expanded in 1996 and 2010.