The term transfer pricing refers to the rules and methods for determining the price at which the different divisions of a multi-entity firm transact with each other. And as nearly 60% of all international trade happens within multinational companies, as a transfer of services and goods from one divisions to another abroad, rather than between different multinational corporations, transfer prices, commonly regulated by international jurisdictions, often pose problems of double taxation, or more likely, of business practices aimed at tax avoidance.
As multinational transfer pricing gives companies the right to account profits in the country with lower taxation rate, as well as to avoid tariffs on goods and services exchanged internationally; it is often viewed as a tool which enables multinational corporations to shift profits to tax havens or developing countries.
In order to decrease the likelihood of international corporations using transfer pricing to minimize their taxable profits, the regulatory authorities in many countries have adopted the Organization of Economic Co-operation and Development (OECD) Transfer Pricing Guidelines. The OECD guidelines are based on one of the key elements in international taxation, the arm’s length principle that a transfer price should be the same as if the two parties involved were indeed two independent companies, thus the transfer price should be similar to the market price.
And while in generally, transfer prices don’t differ much from the market price, as otherways would threaten the overall financial health of the multi-entity company, the methods for determining the arm’s length pricing do vary, divided into three traditional transaction methods: the comparable uncontrolled price method (CUP method), the resale price method, and the cost plus method; and two transactional profit methods: the transactional net margin method and the transactional profit split method. And furthermore, the OECD Guidelines do not give a preference for any particular method, but instead leave it to national tax authorities to determine whether the method employed is the one that most directly and reliably reflects arm’s-length conditions in a particular transaction.
National tax authorities, however, may have a preference, or in cases of fraud suspicion may require the restatement of income under an alternative method, leading to a higher taxes due plus penalties. Transfer pricing rules allow national tax authorities to adjust prices for most cross-border intragroup transactions, and to increase a company’s taxable income by reducing the price of goods purchased from an affiliated foreign manufacturer or by raising the royalty the company must charge its foreign divisions for rights to use IP.
In an attempt to answer the call for harmonisation of jurisdictions and in the light of more governments facing budget shortfalls while many multinational companies not paying their fair share of taxes, the OECD, backed up by the G20 governments, has executed a multi-step Action Plan on Base Erosion and Profit Shifting (BEPS) for countries to implement.
Some governments have already changed their tax laws to incorporate the BEPS Action Plans into local country legislation, and others will do so in the next several years, and as the countries directly involved in the OECD BEPS project make up over 84% of the total world economy, most multinational companies need to begin assessing the impact on their business, and the substantial growth of financial and compliance reporting in the markets where they operate.
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