Transfer pricing is the price paid in transactions between related parties
The main types of intercompany transactions involve:
Transfer pricing is also an issue for global operations involving the execution of customer transactions (including marketing, sales, pricing, and risk management activities) in a particular financial product or line of financial products, in multiple tax jurisdictions and/or through multiple participants.
Most countries require multinational enterprises (MNEs) to demonstrate that their intercompany transactions are arm’s length.Their primary concern is whether the taxable entities operating in the country are recognizing their fair share of income. Transfer pricing is a significant international tax issue as it impacts where MNEs recognize taxable income.
The arm's length principle, as set out in Article 9 of the OECD Model Tax Convention (referred to as the arm’s length standard in the U.S. tax code), is the underlying international standard most MNEs and tax administrations use to establish the pricing between affiliated entities. The arm´s length principle is satisfied when the price paid between related parties is the same as the price (e.g., within an arm’s length range of prices established by a transfer pricing study) that would have been paid between unrelated parties under the same or similar economic circumstances.
The OECD has published ´Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations´ (OECD Guidelines) based on the arm's length principle. The OECD Guidelines provides guidance on the pricing of cross-border transactions between associated enterprises for tax purposes.
The importance of transfer pricing for MNEs
Transfer pricing represents a major international tax planning opportunity and risk for many MNEs. With a global increase in the volume and complexity of transactions among related parties and with countries looking to increase in tax revenue, tax authorities around the world have increased their scrutiny of transfer prices. The OECD has stated that “In a global economy where MNEs play a prominent role; governments need to ensure that the MNEs are not artificially shifting taxable profits out of their jurisdiction; the taxable income reported by MNEs should reflects the economic activity undertaken in the countries in which they operate." Today, MNEs are encountering an increase in the number of transfer pricing related tax audits and tax adjustments. This has brought transfer pricing to the forefront of attention for MNEs.
MNEs often get into trouble when they don’t take tax and transfer pricing into account when restructuring their supply chains. For instance:
MNEs can create sustainable tax efficient structures by layering transfer pricing and tax planning with their supply chain initiatives. As MNEs expand or streamline their supply chains, they can make tax smart decisions about where to locate the value drivers and the important functions within their supply chains. For instance, if it makes sense to create a regional headquarters or centralized services such as a strategic sourcing group, MNEs should consider the tax rates that their cash flows would be subjected to in the various jurisdictions. MNEs should keep in mind that there are significant differences in the tax rates levied by countries they are operating in. As they decide on locations of important supply chain functions, they should perform their cost benefit analyses on an after tax basis.
Differences in transfer pricing documentation and approaches can vary significantly even among countries adhering to the arm’s length principle and the OECD Guidelines. Consequently, taxable income reported from cross-border transactions may result in disagreements between tax authorities as well as disputes between tax authorities. In addition to risks of double taxation, MNEs face risks of penalties and interest by countries. Depending on the jurisdictions involved, penalties triggered by transfer pricing adjustments and lack of documentation can be considerable and are typically considered non-deductible. As a result, MNEs must concurrently take both a global and a local approach to transfer pricing planning, risk management and compliance.