Basics of Transfer Pricing

What are transfer prices?

 Transfer prices (TP) refers to the terms and conditions which so-called “associated enterprises agree for their “controlled transactions”.

According to this widely used Organization of Economic Cooperation and Development (OECD) Model Tax Convention (MTC) definition, enterprises are associated if:

A.   An enterprise participates directly or indirectly in the management, control or capital of another enterprise or

B.   the same persons participate directly or indirectly in the management, control or capital of two enterprises.

Let us look at some examples to link those concepts together and make this clearer:

Example 1: Company A sells apples to Company B. Company A owns 100% of the shares in Company B. Company A and B are associated enterprises – see part (A) of the OECD definition.

The sale of apples is a controlled transaction.

Example 2: Company A sells apples to Company B. Company A and B are both 100% owned by Company C. Company A, B and C are associated enterprises – see part (A) of the OECD definition.

The sale of apples is a controlled transaction.

Example 3: Company A sells apples to Company B. Mr X is the only director of both Company A and Company B. Company A and B are associated enterprises – see part (B) of the OECD definition.

The sale of apples is a controlled transaction.

It follows from the above that an uncontrolled transaction is a transaction between two (or more) enterprises that are not ‘associated enterprises’ with respect to each other.

Example 4: Company A sells apples to Company B. Company A and B are not related in any way via management, control or capital. They do not have the same owner or people Company A and B are not associated enterprises.

The sale of apples is not a controlled transaction.

Examples of controlled transactions

There are many different types of controlled transactions. Besides ‘visible’ controlled transactions such as the supply of goods and provision of services, there can also be ‘invisible’ ones such as a guarantee provided to a bank for a group credit facility.

Below we list the most common types controlled transactions.

• Supply of goods
• Provision of management services
• Provision of support services
• Granting of license
• Provision of guarantee
• Financing
• Transfer of business / assets

Now we understand the concepts of associated enterprises and controlled transactions.

The following example shows this practice as illustrated below:

In the above illustration, you see that Enterprise X manufactures PCs in Saudi Arabia. Enterprise Y distributes these PCs from Bahrain. Both X and Y are 100% owned by Enterprise Z in Germany. Because Z participates directly in the capital of both X and Y, they are all associated enterprises.

When selling PCs in the market, Z has no control on the price at which one PC is sold. Reason is that prices are set by supply and demand. Currently, the market price for one PC is USD 5,000. However, Z does control any transactions between X and Y.

Therefore, the internal sale of a PC by X to Y is called a “controlled transaction.” The price charged for this transaction is what is called a “transfer price.”

Why are TP important?

We now understand what a TP is. But why is this relevant?

Let us have another look to the above illustration.

The price at which one PC is sold by X to Y affects their individual financial results (remember: this is the controlled transaction). If X charges a high price, X makes more profit. If X charges a low price, Y makes more profit.

From a commercial perspective, the price does not matter. The financial results of X and Y are consolidated. For shareholder Z, it does not matter which of the two companies makes the profit. However, from a tax perspective it does matter.

X is taxed in Saudi Arabia and Y is taxed in Bahrain. The corporate tax rate in Saudi Arabia is 20%. In Bahrain, it is 0%. Z wants to see as much profit after tax as possible. Z can use its influence as a shareholder to set the prices in such a way that the profits are highest where taxes are lowest.

Some numbers to explain this example:

Say that the direct / indirect costs of manufacturing one PC is USD 1,000. In addition, let us say that the average third party PC manufacturer similar to Y realizes a profit before tax of USD 10,000 when selling one PC to a distributor. We already know that the market price for one PC is USD 5,000.

Now, we will show 2 scenarios. Scenario 1 shows the profit if the price X charges to Y for the supply of one PC is similar to the market price (USD 4,000 as this ensures a profit of USD 3,000). Scenario 2 shows the potential profit when X charges a non-market price of USD 2,000.

Scenario 1: controlled transaction @ market price of USD 4,000

Nevertheless, what if the TP for the sale of one PC is lower? In that case, the following results can be shown:

Scenario 2: controlled transaction @ non-market price of USD 2,000

 In scenario 1, most of the profit is made by X in Saudi Arabia at 20% tax. In scenario 2, most of the profit shifts to Y in Bahrain. There, it is taxed at 0%. You understand that scenario 2 is preferred by Z. The result is an extra profit after tax of USD 400 per PC sold.

 What is the goal of TP rules?

 There are large differences in tax rates between countries. If left unchecked, the practice could lead to the shifting of profits from high-tax countries to low(er)-tax countries, as shown in the previous example.

Even though less likely, it can also be the case that the pricing policy leads to multinationals reporting too much taxes in high-tax countries and too little in low-tax countries.

The main goal of TP regulation is to prevent both situations and ensure that profits are taxed at the place where value is actually created.

The Arm’s Length Principle (ALP)

 Most countries have TP rules in their domestic tax legislation. Briefly, these rules provide that the terms and conditions of controlled transactions may not differ from those, which would be made for uncontrolled transaction (remember: transactions between independent enterprises). This is referred to as the ALP.

Rationale of the ALP

When you look at countries around the world, you can see huge differences in tax rates. If left unchecked, Multinational Enterprises (MNEs) could shift profits from high-tax countries to low-tax countries. How?

Well, MNEs always have internal transactions. A regional headquarter invoicing management and service fees. A holding company providing financing to an operational company. A manufacturing branch supplying finished product to a distributing branch. MNEs are able to control the terms and conditions of these transactions. They can set the price, so to speak. This way, they can influence taxable profit and the amount of tax due.

To prevent this from happening, tax administrations (organized in the OECD) have invented the ALP. This principle requires that controlled transactions should be conducted at market rates.

Definition of the ALP

The ALP means that:

‘Entities that are related via management, control or capital in their controlled transactions should agree the same terms and conditions which would have been agreed between non-related entities for comparable uncontrolled transactions’.

If this principle is met, we can say that the terms and conditions of the particular transaction are ‘at arm’s length’.

Let us go back again to our example.

The price for the sale of one PC should be similar to the price for a sale of a similar pc between independent enterprises. The below chart illustrates this: (red shows independence, green association).

What actions can tax authorities take?

What can happen when the terms and conditions of a particular controlled transaction do not satisfy the ALP? In such case, tax authorities can adjust the profit(s) of the associated enterprise(s) involved in the transaction.

In our previous example under scenario 2, the Saudi Arabian tax authorities have an interest that X sells the PC against the market price: that would result in a higher profit for X and more tax.

The Saudi Arabian tax authorities may therefore make a correction to the profits of X in line with their transfer pricing rules. The Bahraini tax authorities will not automatically follow such a correction. That will, among other things, depend on whether there is double tax treaty in place between Saudi Arabia and Bahrain.

More focus on TP rules

Recently, there has been a wide international focus on TP practices. Various international developments, such as political pressure at the level of G20/G8 and OECD, make that regulations become more strict and complex.

Governments consider unrealistic profit shifting a major problem and have taken it head on. If you do not follow the rules, you take a substantial risk. Moreover, it is important to note that the rules apply even if you are not trying to avoid taxes.

TP disputes between taxpayers and tax authorities generally cover multiple financial years and can therefore substantially affect the financial position of a company.

An example is the ‘deal’ that pharma giant AstraZeneca concluded with the UK tax authorities (HRMC) and the IRD. This considered a TP dispute covering a period of 13 years. Eventually AstraZeneca paid an amount of USD 1.1bn to settle this dispute.

Obviously, not all enterprises have such these big exposures. However, for small and medium enterprises doing business internationally a TP dispute can become quite costly as well!

What are the requirements for your firm?

TP rules around the globe are quite similar. At the same time, there are different focus areas in specific countries. TP regulations impose a number of obligations on your firm if it has controlled transactions (sometimes revenue thresholds apply):

1.    Your firm should be able to proof that the terms and conditions of internal transactions are comparable to those, which would have been agreed in the free market when concluding comparable transactions.

2.    Your firm should keep documentation on record which shows:

a.    how the TP has been established and;

b.    Whether the TP is in line with the ALP.

3.    Your firm should file annual corporate tax returns on the basis of arm’s length terms and conditions of controlled transactions.

The obligations may seem straightforward. However, in practice, taxpayers often spend a lot of time and effort in making sure these are met. For example, a TP analysis which aims to meet the second obligation mentioned above can span more than 100 pages!

How can your firm meet these requirements?

You first have to ask yourself the question: What are we doing now?

As a first step it is good to look at what internal transactions your firm has and which associated enterprises are involved. This does not only include the “visible transactions” such as supply of goods and provision of services. It also includes “invisible transactions” such as group guarantees provided to external banks.

As a next step you would need to verify whether the terms and conditions of internal transactions are in accordance with the ALP and whether this can be substantiated.

In many cases, the conditions of internal transactions are equally applied to external comparable transactions (example: a firm sells a product at the same price to both associated entities and third parties). That is in itself a sound basis to take the position that the TP is at arm’s length.

The last step would be to determine whether TP documentation (TPD) needs to be prepared. This depends on steps 1 and 2, but also on local legislation.

What is TPD?

 First, we explain why TPD exists. After that, we look at the goals of the current documentation requirements. Finally, we explain the three different reports that together form a full set of transfer pricing documentation.

Why do you need TPD?

 TP has been a relatively new focus-area for tax authorities. Only as recent as 1995, the OECD wrote a first recommendation concerning transfer pricing documentation.

This first recommendation was very general. It aimed on finding a balance between the interest of the taxpayer and the tax authorities. It did not presented a specific framework for transfer pricing documentation.

The result of this approach was that there were large differences in approach in countries around the world. At the same time, international corporate structures and flows of value become more complex. This led to uncertainty on both ends of the spectrum. Moreover, the tax authorities reported that the documentation provided was not good enough for their tax enforcement and risk assessment needs.

What was needed was a set of standardized documents. In addition to that, standardization on the documentation process, the administration of penalties and the burden of proof.

In the recent BEPS initiative, this became one of the Action Points (Action point 13). Moreover, on 16 Sep 2014, the OECD issued the “Guidance on Transfer Pricing Documentation and Country-by-Country Reporting” to tackle this issue.

The goals of TPD

According to the OECD, there are three main objectives of TPD:

1.    “To ensure that taxpayers give appropriate consideration to transfer pricing requirements in establishing prices and other conditions for transactions between associated enterprises and in reporting the income derived from such transactions in their tax returns.”

Documentation requirements create awareness and a culture of compliance. Taxpayers are forced to take in a position, about TP rules.

2.    “To provide tax administrations with the information necessary to conduct an informed transfer pricing risk assessment.”

The documentation provides tax-authorities with a clear overview of the activities of a multinational enterprise. It tells them where there are risks.

3.    “To provide tax administrations with useful information to employ in conducting an appropriately thorough audit of the transfer pricing practices of entities subject to tax in their jurisdiction, although it may be necessary to supplement the documentation with additional information as the audit progresses.”

 If tax-authorities think that there is a risk, the documentation provides them with a good indication of where else to look.

 TPD requirements

In order to reach the objectives mentioned above, there are three types of documentation that taxpayers need to provide as follows:

1.    The Master File:

The master file is intended to provide a high-level overview. It explains the dealings of a Multinational Enterprise on a global scale. With this information, governments have a high-level overview of the economic, legal, financial and tax arrangements of the MNE. This gives them a good idea if any risks exist.

2.    The Local File:

The local file is where you go into detail. Here, you look at specific inter-company transactions that are relevant for the tax authority involved. The local file contains relevant financial data, like the transfer prices used and the transfer pricing method chosen to calculate them. Where the Master File provides the general overview, the Local File explains how the inter-company transactions happen at “Arm’s Length.”

3.    The Country-by-Country Report

The Country-by-Country Report is an additional high-level report required from large Multinational Enterprises with a turnover of 750 Million USD or more per year. It requires details of the global allocation of income, taxes paid, and the location of economic activity among the jurisdictions in which the MNE group operates.

In addition, a list of the legal entities that together form the group has to be added, as well as information about their jurisdiction or incorporation and residence status.

Time frame of preparing TPD

Unfortunately, the time frame for preparing the documentation differ among countries. Some countries require information to be ready at the time a tax return is filed. Other countries want to see it ready at the time of audit.

However, the entire logic of the TP regulation is to actively apply the ALP. You do this, by calculating the correct transfer price before the actual transactions take place. What this means is that you build TPD during the year when doing the business. Not at the end of the year.

Conclusion

Based on the above, we can highlight a number of conclusions:

TP refers to the terms and conditions, which associated enterprises agree for their controlled transactions. These prices are important. They affect the individual results of associated enterprises and therefore the amount of taxes they pay.

TP rules provide that the terms and conditions of controlled transactions may not differ from those, which would be made for uncontrolled transactions. The main goal of these rules is to prevent profit shifting from high-tax countries to low-tax countries.

Tax authorities of many countries focus on compliance with TP rules. Not paying sufficient attention can result in big financial exposures. The rules impose a number of obligations to firms doing international business. Proper compliance of these rules can be ensured by following a three-step approach.

There are three reports that need to be provided. The Master File, the Local File and the Country-by-Country report. The Country-by-Country report is only for large Multi-National Enterprises with a turnover of 750 Million USD or more.