Transfer pricing

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Transfer pricing refers to the rules and methods for pricing transactions within and between enterprises under common ownership or control. Because these transactions do not occur under market conditions, transfer pricing rules are necessary to ensure that the prices charged reflect the economic reality of the transactions.

Overview

Transfer pricing is a significant issue in international taxation and corporate governance. It involves the pricing of goods, services, and intangibles between related entities, such as subsidiaries of a multinational corporation. The primary objective of transfer pricing regulations is to ensure that transactions between related parties are conducted at arm's length prices, which are the prices that would be charged between independent parties in comparable circumstances.

Arm's Length Principle

The arm's length principle is the foundation of transfer pricing rules. It requires that the terms and conditions of transactions between related parties be consistent with those that would have been agreed upon by unrelated parties in similar circumstances. This principle is endorsed by the Organisation for Economic Co-operation and Development (OECD) and is incorporated into the transfer pricing regulations of many countries.

Methods of Transfer Pricing

Several methods can be used to determine arm's length prices, including:

• Comparable Uncontrolled Price (CUP) Method: Compares the price charged in a controlled transaction to the price charged in a comparable uncontrolled transaction.
• Resale Price Method: Determines the arm's length price by subtracting an appropriate gross margin from the resale price to an independent party.
• Cost Plus Method: Adds an appropriate markup to the costs incurred by the supplier of goods or services in a controlled transaction.
• Transactional Net Margin Method (TNMM): Examines the net profit margin relative to an appropriate base (e.g., costs, sales) that a taxpayer realizes from a controlled transaction.
• Profit Split Method: Divides the combined profits from controlled transactions in a manner that reflects the relative value of each party's contribution.

Compliance and Documentation

To comply with transfer pricing regulations, multinational enterprises must maintain detailed documentation that supports the arm's length nature of their intercompany transactions. This documentation typically includes:

• A description of the organizational structure.
• Details of the intercompany transactions.
• An analysis of the functions performed, risks assumed, and assets used by each party.
• A selection and application of the most appropriate transfer pricing method.
• Financial information and comparables used in the analysis.

Transfer Pricing Adjustments

Tax authorities may review and adjust the transfer prices reported by multinational enterprises if they believe the prices do not reflect arm's length conditions. Such adjustments can result in double taxation, where the same income is taxed in more than one jurisdiction. To mitigate this risk, many countries have entered into tax treaties that include provisions for resolving transfer pricing disputes through mutual agreement procedures.

Related Pages

• International taxation
• Corporate governance
• Subsidiary
• Arm's length principle
• Organisation for Economic Co-operation and Development
• Tax treaty
• Mutual agreement procedure

See Also

• Base erosion and profit shifting (BEPS)
• Tax avoidance
• Tax compliance
• Double taxation

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