Transfer pricing involves the pricing of goods and services exchanged between companies that are under common control. For instance, when a subsidiary sells products or provides services to its parent company or another sister company, the price charged for these transactions is known as the transfer price.
What is Transfer Pricing?
Entities under common control are those ultimately managed by a single parent corporation. Multinational corporations often utilize transfer pricing to allocate profits (earnings before interest and taxes) among their various subsidiaries within the organization.
Transfer pricing strategies can provide numerous tax advantages for companies, although regulatory authorities generally disapprove of manipulating transfer prices for tax avoidance. When executed effectively and legally, transfer pricing leverages the varying tax regimes across countries by increasing transfer prices for consumer goods and services produced in jurisdictions with lower tax rates.
Key Takeaways:
- Transfer prices that differ from market value can benefit one entity while reducing the profits of the other entity.
- Multinational companies may manipulate transfer prices to shift profits to regions with lower tax rates.
- Regulations enforce an arm’s length transaction rule, requiring pricing to reflect values established in similar transactions between unrelated parties.
- Transfer pricing carries significant compliance risks for multinational corporations, impacting tax planning and financial reporting.
In certain instances, companies may also reduce their costs associated with interrelated transactions by circumventing tariffs on internationally exchanged goods and services. The Organization for Economic Cooperation and Development (OECD) governs international tax laws, and auditing firms operating under OECD guidelines review and audit the financial statements of multinational corporations (MNCs) accordingly.
International Transfer Pricing
Transfer prices are established when divisions engage in intracompany transactions by selling goods to other divisions located in different international jurisdictions. A significant portion of international trade occurs within companies rather than between unrelated entities.
Through transfer pricing, companies can manipulate their profits from goods and services to report higher earnings in countries with lower tax rates. Additionally, transferring goods and services within intracompany transactions can help companies avoid tariffs associated with international exchanges.
However, tax authorities around the world are increasingly tightening regulations and increasing scrutiny on transfer pricing practices to prevent profit shifting and ensure compliance with international tax laws. The Organisation for Economic Cooperation and Development (OECD) oversees these international tax regulations, while local auditing firms review the financial statements of companies to ensure adherence.
How Transfer Pricing Impacts Taxation
Consider a scenario involving Entity A and Entity B, where Entity A operates in a high-tax country and Entity B in a low-tax country. To optimize overall profits, Company ABC would benefit from having a greater share of its earnings reported in Entity B, where the tax burden is lower.
In this situation, Company ABC might set a transfer price for the wheels sold by Entity A to Entity B that is below the market value. As a result, Entity B would record a lower cost of goods sold (COGS) and consequently higher earnings, while Entity A would show reduced sales revenue and lower overall profits.
Companies often seek to shift substantial economic activities to low-cost jurisdictions to minimize tax liabilities. This practice has led to ongoing disputes between multinational corporations and tax authorities, such as the Internal Revenue Service (IRS). To combat potential tax avoidance, the IRS has established stringent documentation requirements for transfer pricing. Taxpayers must maintain comprehensive pricing documentation to ensure compliance and avoid penalties.
Arm’s Length Principle
Article 9 of the OECD Model Tax Convention outlines the rules for the Arm’s Length Principle. This principle stipulates that transfer prices between two entities under common control should be determined as if they were independent entities negotiating with each other.
The Arm’s Length Principle is grounded in real market conditions and establishes a unified international standard for tax computation. This approach allows governments to collect their fair share of taxes while providing multinational corporations (MNCs) with mechanisms to avoid double taxation.
Case Study: How Google Uses Transfer Pricing
Google operates a regional headquarters in Singapore and a subsidiary in Australia, which provides sales and marketing support services to users and Australian businesses, as well as research services for Google globally. In the fiscal year 2012-2013, Google Australia reported a profit of approximately $46 million on revenues of $358 million, with corporate tax payments estimated at AU$7.1 million after claiming a tax credit of AU$4.5 million.
When questioned about the relatively low taxes paid in Australia, Ms. Maile Carnegie, the former chief of Google Australia, explained that taxes for Singapore had already been settled in the country where the company is headquartered. Overall, Google reported total tax payments of US $3.3 billion against revenues of $66 billion, resulting in an effective tax rate of 19%, which is significantly lower than the statutory corporate tax rate of 35% in the United States.
Benefits of Transfer Pricing
- Reduction of Duty Costs: Transfer pricing allows companies to minimize duty costs by exporting goods to countries with high tariff rates at lower transfer prices, thereby reducing the duty base for these transactions.
- Tax Optimization: Companies can lower their income and corporate taxes in high-tax jurisdictions by overpricing goods transferred to subsidiaries in countries with lower tax rates, which helps them achieve higher profit margins.
Risks of Transfer Pricing
- Internal Disagreements: Disputes may arise within different divisions of an organization regarding transfer pricing policies, leading to conflicts and inefficiencies.
- Increased Administrative Costs: Implementing transfer pricing involves significant time and manpower costs to execute and maintain a proper accounting system, making the process complex and resource-intensive.
- Challenges with Intangibles: Establishing prices for intangible items, such as services rendered, can be particularly challenging since these items are not sold externally and lack a clear market price.
- Differential Risk Assumption: Sellers and buyers may perform different functions and assume various types of risks. For instance, if the seller refuses to provide a warranty for a product, the buyer may factor this risk into the price they are willing to pay, complicating the transfer pricing process.
