What is Transfer Pricing?

The world is becoming more complex and more connected than ever and, due to this interconnection, transfer pricing is taking on a more significant role. There are more entrepreneurs in the marketplace nowadays, and the definition of control is becoming more stretched than ever. Who is truly operating independently on the market, especially with so many giant corporations in the business of linking businesses to other businesses? And with this growth, it is only a matter of time before affiliated transactions take place, with or without them realising it.

In this context, I feel this is a good time for us to think about transfer pricing. The rules are slightly different in various jurisdictions, but essentially any controlled transactions (be they directly or indirectly, through ownership, family ties or simply operational structures) are subject to transfer pricing rules. Which brings us to the question: what is transfer pricing?

The basic definition of transfer pricing is, in practice, an argumentation showing that the prices between controlled entities are similar to some1 of the independent entities on the market, and the business behaviour between those entities is fair and based on normal market forces and business decisions. The declared intent of transfer pricing, from the point of view of the authorities, is to force entities to pay fair taxes in the jurisdictions they are owed, essentially avoiding both taxable base erosion and profit shifting (you may have heard of the BEPS initiative).

The actual intent of transfer pricing is slightly different however, and while it stems from the desire to collect fair taxes, it focuses on a few important concepts:

1. Groups must always pay at least the minimum average (1st quartile) amount of corporate tax in every jurisdiction, regardless of actual local profitability
2. Groups must always support all their entities to obtain that minimum amount of profit, even if normal business relations would not result in it
3. Groups must bear the entirety of the financial burden of this process, both the costs of compliance and the costs of an unfair decision from the authorities, until it is overturned
4. It is assumed that all controlled transactions are fraudulent, unless proven arm's length, and the burden of proof is on the affiliated entities
5. It is an acceptable side effect that loss-making affiliated but functionally independent entities are penalised
6. It is acceptable for tax authorities to be the judge of what constitutes acceptable business behaviour, and even to contradict themselves in similar situations if the result is a gain for them
7. Intangibles are only a method of tax evasion, and may not be leveraged at perceived value, even though estimating value is almost impossible considering the digital economy

Sometimes, this reasoning is correct, as the largest groups have the ability and the interest to siphon legitimate tax revenues out of poor jurisdictions, without considering the impact this has on those communities. All of the above are fair assumptions in some cases, and corporations need to consider their impact on communities beyond where the best offer is.

However, the result of this kind of reasoning is simple: transfer pricing is a retroactive tax2, based on the principle that groups have enough resources to pay it, even if the reality contradicts this assumption. It is a protectionist measure, that aims to ensure fair taxation, but steamrolls struggling SMEs. More so, the assumption of guilt means that their defenses, even if they respect the methodology set in place by the OECD, can be simply contradicted by the tax authorities, and gigantic fines levied against them (not just additional income tax, but interest, penalties, double taxation, and so on, going as far back as the law allows it). Even if eventually reversed by courts of law, this has a huge impact on the cash flow of those companies, and can severely cripple their ability to grow or even survive. SMEs may not even have the resources to, after paying the fines, hire lawyers and carry these decisions through lawsuits, appeals and entertain the possibility of not even recovering their money.

The largest criticism to the authorities is that they never take into account the net result of their decisions. Frequently, you see authorities adjusting the income of entities that are part of loss-making groups where it is obviously no foul play is involved. Also, many groups that don't even have any cross-border transactions are adjusted, leading to the absurd decision to adjust profits between entities that pay taxes to the authorities of the same country. Sometimes, the decision to adjust certain groups, even if they are non-compliant, leads to thousands of jobs lost, because the group doesn't feel the hassle is worth it.

A simple solution would be global taxation of groups based on the location of their headquarters, but this requires a level of international cooperation that is currently impossible. As such, the only solution that exists at the moment is to try to respect the principles of transfer pricing as well as possible, and to prepare every transfer pricing file with the expectation of a lawsuit, since tax authorities are sadly not obligated to accept sound business reasoning and the absence of foul play as sufficient proof that no transfer pricing adjustment is warranted.

1 Transfer pricing requires the usage of central tendency methods to gauge the appropriate third party prices to compare the tested company to, reasoning that extreme results should be excluded. However, if we are to express that an affiliated company is behaving like an independent company, these extremes should not be excluded, as they represent normal, if not average, results. It is our opinion that a correct approach must take into account primarily the business reasoning and only optionally the price, as we are dealing with a free market, and it is not uncommon for prices to be set very far off from average.

2 Of course, this is not an actual tax, but the net result for the company is an additional burden from the state, that is impossible to forecast and very frequently results in double taxation. This can technically be avoided through an APA, but it is not always the case that it applies retroactively in various jurisdictions, and it generally requires a large amount of money and time to complete.