Ultimate guide to Transfer Pricing

The term Transfer Pricing refers to the pricing of goods or services which are exchanged between two or more related parties of the same multinational group. Sometimes, related parties are also called associated enterprises or depending companies. As a definition, business transaction parties are related to each other if certain criteria of ownership, management, rights, or economic dependency are met. Such criteria are usually defined by local law, primarily by tax law and corporate law.

The subject area Transfer Pricing is construed of, and linked to, three areas of law: the law of obligations, the corporate law, and the tax law.

Referring to the law of obligations, the Transfer Price is the reward on the exchange of a good or product, the delivery of a service, the right to use assets of other owners, or a guarantee received, if such exchanges occur between related parties. Transfer Pricing, actually, is a matter of subject for legal entities and/or permanent establishments, belonging to the same group of companies. Hence, the corporate law and the corporate setting of companies practically provide for the statutory framework affecting shareholding, management, and rights and duties of decision makers of such entities.

Transfer Pricing has become so prominent and controversial due to the scope of globalization and the inherent income taxation issues regarding the fair allocation of the tax base. If such related-party transactions are cross-border, both/all tax jurisdictions involved may have a stake in taxing the profit allocated in the course of such business. Therefore, corporate tax law and income tax law are the third legal framework affecting Transfer Pricing decision makers and both the tax base allocation and the effective tax rate determine the tax burden on such cross-border business. From a tax policy perspective, the challenge is to attempt the avoidance of double taxation, non-taxation, and discrimination of cross-border business vs. domestic business.

Today, it is said that about two third of cross-border business is governed within multinational firms. Though no governmental institution maintains statistics on exact figures, specific information on the scale of such cross-border business at stake can be drawn from the webpages of the Organization of Economic and Co-operative Development (OECD), the successor organization of the former Marshall Plan which was setup in Europe for recovery after the Second World War (WWII). The OECD provides for a large volume of information and guidance on transfer pricing (comp. http://www.oecd.org/tax/transfer-pricing/ for Transfer Pricing and http://www.oecd.org/tax/beps/ for the so-called BEPS Project).

Worldwide, the total volume of such cross-border business between related parties is huge, estimated to a two-digit figure of trillions of US Dollar or so – exact figures are not present as of today. Such business generates a large bulk of thousands of billions of cost and profit dollars which are in search of being accounted for with an appropriate allocation into jurisdictions. In many countries around the world, including the vast majority of industrialized and emerging countries, the default measure of “appropriateness” is the so-called “Arm’s Length Principle”, as defined by the OECD Model Tax Treaty, the OECD Transfer Pricing Guidelines, the United Nations Transfer Pricing Manual, and many countries’ tax provisions.

Transfer Pricing makes many experts curious and sometimes even dizzy: not only for the purpose to allocate the tax base right, often zillions of big money in a given case of a multinational group of companies, but also to master the compliance requirements in many jurisdictions and within the multinational company organizations. The development of the last three decades was primarily triggered by the opening of economies in the wake of the fall of the Berlin Wall (Iron Wall) in the 1990s and was accelerated in the first and second decade of this 21st century by free-trade treaties and digitalization. Nowadays, Transfer Pricing engages a legion of experts within the multinational groups and their related-party taxpayer units (entities, permanent establishments, shareholders), their tax consulting teams and auditors in the jurisdictions of related-party entities, tax authorities, tax courts, international organizations (e.g. OECD UN, PATA, European Commission) and so on. In addition, providers of services, data, and IT solutions (e.g. Bureau van Dijk, Moody’s, OneSource, ktMine, and the like) are increasingly posing themselves in the market on Transfer Pricing expertise. And within the jurisdictions, the governmental ministries and their governmental bodies such as national tax agencies, national training units of the tax organization, the local and regional tax offices, the competent authorities for mutual agreement procedures, and the respective parliament and advisors of policy makers are involved. Transfer Pricing has become big business in the tax and compliance industry.

In practice, Transfer Pricing requires so-called transfer pricing documentation, which, subject to the given country, refers to the package of information and documents on the transfer pricing fact pattern of the taxpaying unit and its related parties. Such package is aligned to financial years of the companies. The documentation is either to submit at the time in advance (advance pricing agreements), in the course of tax filing, or ex post along certain deadlines or upon request of tax authorities (then, usually in the course of a tax audit). Nowadays, defined by the G20/OECD BEPS Action Plan 13, transfer pricing documentation comes with the so-called Master File (or Masterfile), Local File (or Local file) and, if applicable, the Country-by-Country Reporting (CbCR). Each of these documentation components are defined by the OECD BEPS Action Plan and many countries have taken over such principles in their domestic corporate tax code.

In addition, and following the nature of the Arm’s Length Principle, Transfer Pricing needs to be aligned to the perspective of whether the business transaction considered is, was, or would have dealt with in the same manner and with the same pricing as third parties do, did, or would have done, i.e. under the conditions of at arm’s length. For that, the G20/OECD BEPS Action Plan 8 to 10 was composed and, again, many tax jurisdictions have implemented such logic of arm’s length transfer pricing in their domestic tax code and the practice of reviewing transfer pricing for tax purpose.

Transfer Pricing appears complex, yet it is based on same basic principals. Within the arena of tax law, the predominant principle in most jurisdictions of the world has been the so-called separate entity approach. Here, the legal entity is the taxpayer unit and its tax base is identified by cost and profits behind individual business transactions between one separate entity with another one.

With digital business models and the increasing role of intangible assets for the overall business success or failure, this basic principle is questioned and challenged by the way globalization has evolved and is expected to further develop. Just a few years back, the OECD experts and the global tax community were re-addressing the idea of the so-called unitary entity approach. Here, the multinational group, more precisely, a defined conglomerate of actors of the business model, constitute the tax base which, in turn, is allocated into jurisdictions by models of allocation factors and formulary apportionment. Not the individual business transaction is analyzed, but the allocation model.

It should be noted that, while much is talked about the arm’s length transfer price, little is defined in the provisions of the law of obligations which, however, is the fundamental legal basis for business transactions. Not one single country around the world, which maintains a civil code and the specific provisions on the law of obligations, does define how a price is set between transaction partners – no figure is provided for in such code, no model is defined. Also, usually no monetary price information can be found in the tax codes. Nevertheless, many representatives of the “Transfer Pricing Industry” are continuously blabbering on the right transfer price regime and predominance of the so-called transfer pricing methods.

In practice, and with a few exceptions of the arm’s length analysis, Transfer Pricing of a multinational group is analyzed by means of contractual terms, the functions and risks allocated to the related-party transaction partners, and appropriate application of test models called OECD Transfer Pricing Methods, and financial ratios deployed for arm’s length test.

The next blog entry will closer elaborate on the price setting and the arm’s length test, referring to the OECD Transfer Pricing Guidelines and the transfer pricing methods.

For more information, contact us at info@GlobalTransferPricing.com 

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