Transfer pricing is the general term for the pricing of cross-border, intra-firm transactions between related parties. It refers to setting of prices for transactions between associated enterprises involving the transfer of property or services. These transactions are also called ‘Controlled Transactions’.
‘Controlled Transactions’ are different from ‘Uncontrolled Transactions’. ‘Uncontrolled transactions’ are the transactions involving the independent parties which are not related to each other.
All controlled transactions does not necessarily involve tax avoidance. Where the pricing does not accord with internationally applicable norms or with the arm’s length principle under domestic tax law, the tax administrators will consider this to be ‘mis-pricing’, ‘incorrect pricing’ or non-arms length price. This would lead to issues of tax avoidance and evasion.
The arms length principle by itself is not new; it has its origins in contract law to arrange an equitable agreement that will stand up to legal scrutiny, even though the parties involved may have shared interests. Under the arms length principle, transactions within a group are compared to transactions between unrelated entities under comparable circumstances to determine acceptable transfer prices. Thus, the market place comprising independent entities is the measure or benchmark for verifying the transfer prices for intra-entity or intra group transactions and their acceptability for taxation purposes.
The rationale for the arms length principle itself is that because the market governs most of the transactions in an economy it is appropriate to treat intra group transactions as equivalent to those independent entities. Arms length principle is favoured because it is geographically neutral; as it treats profits from investments in different places ina similar manner. However this claim of neutrality is conditional on consistent rules and administration of the arms length principle throughout the jurisdictions in which an international enterprise operates.
An alternative to the arms length principle might be a Global formulary Apportionment Method which would allocate the global profits of an MNE group amongst the associated enterprises on the basis of a multi factor weighted formula (using factors such as property, payroll and sales or such other factors as may be defined when adopting the formula). A formulary apportionment approach is currently used by some states of the USA, cantons of Switzerland and provinces of Canada.
Process to arrive at the appropriate arms length price typically involves the following processes or steps:
- Comparability analysis
- Evaluation of transactions
- Evaluation of separate and combined transactions
- Use of an arms length range or a central point in the range
- Use of multiple year data
- Location savings and location rents
- Intentional set offs
- Use of customs valuation
Transfer Pricing Methods:
Several acceptable transfer pricing methods exist, providing a conceptual framework for the determination of the arms length price. No single method is considered suitable in every situation and the tax payer must select the method that provides the best estimate of an arms length price for the transaction in question. All these methods rely directly or indirectly on the comparable profit, price or margin information of similar transactions. This information may be an “internal comparable” based on similar uncontrolled transactions between the entity and a third party or an “external comparable” involving independent enterprises in the same market or industry.
- Transaction Based Methods:
- Comparable Uncontrolled Price (CUP)
The CUP method compares the price charged for a property or service transferred in a controlled transaction to the price charges for a comparable property or services transferred in a comparable uncontrolled transaction in comparable circumstances.
- Resale Price Method (RPM)
The Resale price method is used to determine the price to be paid by a reseller for a product purchased from an associated enterprise and resold to an independent enterprise. The purchase price is set so that the margin earned by the reseller is sufficient to allow it to cover its selling and operating expenses and make an appropriate profit.
- Cost Plus (C+ or CP)
The Cost Plus Method is used to determine the appropriate price to be charged by a supplier of property or services to a related purchaser. The price is determined by adding to costs incurred by the supplier an appropriate gross margin so that the supplier will make an appropriate profit in the light of market conditions and functions performed.
- Profit Based Methods
- Profit comparison methods (Transactional Net Margin Method [TNMM]/ Comparable Profits Method [CPM] )
These methods seek to determine the levels of profits that would have resulted from controlled transactions by reference to the return realised by the comparable independent enterprises. The TNMM determines the net profit margin relative to an appropriate base realised from the controlled transactions by reference to the net profit margin relative to the same appropriate base realised from uncontrolled transactions.
- Profit – split method
Profit – split methods take the combined profits earned by two related parties from one or a series of transactions and then divide those profits using an economically valid defined basis that aims at replicating the division of profits that would have been anticipated in an agreement made at arms length. Arms length pricing is therefore derived for both parties by working back from profit to price.
It must be noted that the USA regulations provide for the use of additional methods applicable to global dealing operations like the Comparable Uncontrolled Transaction (CUT) Method. This method is similar to the CUP in that it determines an arms length royalty rate for an intangible by comparison to uncontrolled transfers of comparable intangible property in comparable circumstances.