Transfer pricing definition / what is transfer pricing? A beginner’s manual and a kit of useful learning materials

article published on 10 January 2022

Because of growing government budgets deficits, multiple jurisdictions are putting additional pressure on multinational companies in order to secure a larger portion of for their taxable profits.

This approach can result in the risk of tax assessments performed by the tax authorities, double taxation of the same income by two or more jurisdictions, and penalties for failure to properly allocate revenues among jurisdictions in which they operate. Therefore, virtually all multinational companies are mostly affected by transfer pricing and all it means.

1. The transfer pricing definition

In managerial accounting, the transfer pricing concept refers to the price at which divisions of a company transact with each other.

In tax purpose, transfer pricing broadly refers to the prices at which transactions with capital, goods or services between related parties within the same group of companies / under common control (legal persons or individuals) take place.

The definition of a group of companies / control can take various forms depending on the targeted jurisdiction, but in most cases refer to attaining a certain percentage of ownership or degree of control (de jure or de facto).

2. The arm’s length principle

The arm’s length principle states that the prices applied in intra-group transactions should not differ to the ones applied in transactions taking place between companies that are not part of the same group, if similar business terms apply.

In other words, this standard requires that companies which are part of the same group should transact one with another as if those transactions were taking place under exactly the same conditions between unrelated parties on the open market (i.e. between parties not under common control).

In practice, depending on the nature of the transactions, complex methods are applied as to benchmark the transfer prices applied against the market levels for similarly transacted goods or services.

3. Transfer pricing beginners kit of useful learning materials 

Download below the full transfer pricing beginners kit of documents including NACE Rev. 2 Codes classifications as published by the European Union, OECD and UN materials as well as some of the most comprehensive and self explanatory guidelines from tax authorities around the world.

4. Example of application of the principle – the interquartile range

The result of the application of a transfer pricing method upon similar, comparable transactions is often a range of prices (e.g. between 5 – 10 EUR) or a range of mark-ups, margins or other indicators (e.g. between 5 – 10 %).

This is referred to in transfer pricing as the arm’s length range. If the transfer prices applied by the taxpayer fall into the range of results obtained, both the taxpayer and the responsible tax administration can consider the transfer pricing policy applied as following the arm’s length principle and are in line with the market standards.

Moreover, to increase the reliability of results and of the conclusion upon the arm’s length character of the tested transaction, the concept of the interquartile range was introduced in transfer pricing.

Derived from statistics, the interquartile range refers to the observations contained between the 25th to the 75th percentile of the results derived from the open-market, comparable transactions or companies. This excludes outliers (minimum, maximum) who may have obtained results not aligned with the market due to exceptional causes.

To better portray this concept, let’s have the following example:

During the year 202Z, a related party has earned, as a result of an inter-company transaction, an operating margin of 10%. To test the alignment with the arm’s length principle, a transfer pricing method was applied and 6 individual open-market, comparable observations were obtained.

Derived from the 6 observations, utilizing the same indicator (operating margin), observing the prior three years to the transaction, it resulted in an interquartile range spanning between 5.33% and 19.98%.

We can now conclude with accuracy that the tested related party has observed the arm’s length principle, since the 10% earned is contained within the 25th to the 75th percentile of the results.”

In practice, as in this scenario, the companies tend to target the median of the interquartile range, as this offers both a comfortable position from a taxation / transfer pricing point of view, as well as a nice business return.

Although it depends on the local transfer pricing regulations, if the tested related party’s indicator was outside the lower – upper quartile range, the tax authorities would be entitled to perform transfer pricing adjustments as to “bring” the financial results of the related party to the level of the market.

5. Global consideration of transfer pricing

If companies apply transfer prices that do not align to the level of the market, or as seen in the previous chapter, fit into the interquartile range derived from comparable transactions or companies results, an advantage is created for the related counter party.

In other words, through intra-group transactions, one entity can lower the profits of another entity and maximize its own. By doing so, some entities may malevolently try to shift the profits to lower tax regions and thus, paying less overall income tax and eroding the tax base of the source states. This practice of shifting profits can prove itself as being against the arm’s length principle.

Therefore, transfer pricing is a subject of importance for multinational companies firstly because of the necessity to align to global transfer pricing regulations imposed by the tax authorities, but also because of other business reasons such as group performance management and group synergies like supply chain optimization.

This final scenario presented above underlines the global importance of transfer pricing and why transfer pricing has been given rising attention both from tax authorities, as well as multinational companies alike.

In the recent years, the tax authorities around the globe are making increasing efforts to enforce the transfer pricing regulations, through increased tax auditing efforts, as well as increasingly burdensome transfer pricing documentation requirements and penalties for non-compliance with these requirements.

6. Global transfer pricing regulations

Around the globe, over 55 countries have adopted transfer pricing regulations. The majority of these countries’ governments have based their domestic transfer pricing requirements on the arm’s length principle, as presented above and as defined by OECD.

In order to provide objective proof that a taxpayer has followed this principle in the intra-group transactions it was a part of during a selected period of time, the taxpayer has to prepare and present, in most cases, a transfer pricing file documenting the transfer prices applied.

Both to aid in this documentation feat, as well as with other double taxation issues arising from transfer pricing matters, the Organization for Economic Co-operation and Development (OECD) has issued and several times updated the Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations.

This publication is accepted across the globe as the authoritative guidance on transfer pricing matters for both taxpayers and tax authorities both in OECD member countries, as well as many non-OECD members, and is the dominant basis for the creation of global transfer pricing regulations.

7. Content of the transfer pricing file

As mentioned above, the taxpayer must document the arm’s length nature of the intra-group transactions he has taken part of, in order to comply with the domestic transfer pricing requirements.

The timely preparation of adequate documentation will facilitate the discussion with the tax authorities in the context of a tax audit and therefore help resolve any disputes. Imposing the obligation to contemporaneously prepare transfer pricing documentation is at the freedom of each jurisdiction.

But even if we can identify multiple differences arising from the liberty of each government to implement domestic regulations, the overall content of the transfer pricing file is similar among jurisdictions.

First of all, the documentation process by identifying all intercompany transactions with a material value. In order to do this, it is helpful to start by looking at the type of transfer: tangible, intangible, services, financing and insurance, or cost-sharing agreements.

Moreover, information about the group of companies, about the tested taxpayer and about the industry in which it operates is added in the first part of the document. It usually follows on with an analysis on the functions carried, risks undertook and assets utilized by the taxpayer within the intra-group transactions.

Once this functional analysis is completed, the taxpayer and transactions can be characterized and thus better select comparable data, either other transactions or other companies’ results.

The selection of comparable data and applicable transfer pricing method, as well as determining the arm’s length range is part of the last stage within the process of preparing the documentation, the economic analysis.

This marks the conclusion of the document, as the transfer prices applied by the taxpayer are compared to the market level range that was determined and finally evaluate the arm’s length nature of the related party transactions.

8. Potential consequences in case of non-compliance

As transfer pricing is slowly becoming the number one taxation matter due to globalization, the tax authorities around the globe are getting increasingly aggressive at protecting their tax base.

Therefore, a missing, incomplete or inadequate transfer pricing file can have a significant impact on a taxpayer’s financial results, audit history and taxation obligations.

In more detail, non-compliance can have the following potential consequences:

(i) Transfer pricing adjustments – if the arm’s length principle has been found not to be followed by its transfer prices applied, or if the taxpayer had the burden of proof and failed to provide transfer pricing documentation, the tax authorities may have the liberty to perform transfer pricing adjustments that may lead to a net increase in taxable income;

(ii) Fines and penalties – depending on the targeted jurisdiction, the non-compliance fines and penalties may reach significant amounts;

(iii) Financial reporting concerns – some financial reporting standards impose the booking of significant reserves to be included in a company’s financial statements if transfer pricing documentation is missing;

(iv) Litigation costs – if due to non-compliance any disputes arise, a taxpayer’s costs with audit and litigation processes, including legal and transfer pricing support may be significant.

In addition to the above, it has to be taken into account that any transfer pricing adjustments the tax authorities may perform can actually lead to double taxation at the level of the group as a whole.

Even though there are available instruments to be used as to recover additional corporate income tax paid in corresponding jurisdictions to the one where the transfer pricing adjustments are performed (i.e. Mutual Agreement Procedure), the time and financial costs associated with these procedures are too often larger than the loss itself.

To avoid any transfer pricing disputes over a transaction of high importance for the company, an Advance Pricing Agreement, in-short APA, can be issued with the tax authority/ties involved.

The process involves providing the tax authorities with all requested documentation on parties involved, the subject transaction, as well as proof of the alignment of the transfer pricing methodology chosen to the arm’s length principle. Read more about this topic in the most recent article by ATIPIC Solutions team, Transfer pricing in Europe.

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