Transfer Pricing

Transfer Pricing

By Admin March 6, 2017

What Business Leaders Need to know about Transfer Pricing

What is Transfer Pricing

Transfer pricing is the process used to determine a price at which to sell assets between two companies that are owned by the same larger multinational group. Setting this price is necessary in order for each company to determine both the amount of revenue they will receive and the amount of taxes each company will have to pay. For example, consider a large multinational corporation that sells smartphones. They have one company in Asia that manufactures the devices, another company that does accounting work in the Cayman Islands, and a US-based company that sells the devices to local stores.

In this example the Asian company would sell the devices to the accounting firm, which turns and sells them to the US-based company for delivery to the local stores. The value that each company gives in exchange for the smartphones reflects how much revenue that company makes and how much each is required to pay in taxes.

The tax benefits and subjectivity associated with transfer pricing seem to incentivize businesses to look for a pricing option that minimizes tax expense; however, transfer pricing manipulation in order to avoid paying taxes is illegal. In our example above, the Asian company could attempt to say the phones are worth very little when they sell them to the company in the Cayman Islands, which will reflect low profits – and thus incur low taxes. The company in the Cayman Islands then attempts to sell the devices to the US-based company at a price that is very close to the price the US company will get from the local stores, meaning almost all of the profits go to the company in the Cayman Islands and very little to local US stores. In the end, the company will pay almost all of its taxes in the Cayman Islands, which has the lowest tax rate of the three locations.

How to Perform Transfer Pricing Appropriately

The “arm’s-length” rule states that when two unrelated companies do business, where neither is forced to sell or buy, a fair market value is negotiated for the assets being sold. For transfer pricing, companies try to estimate this same price. In the US, it is stated to use the “best method rule.” In general, the arm’s length result of a controlled transaction must be determined under the method that, given the facts and circumstances, provides the most reliable measure of an arm’s length result. Thus, there is no strict priority of methods and no method will invariably be considered to be more reliable than others.

Leading methods to generate a value from the “arm’s-length” rule are the comparable uncontrolled, cost-plus, and resale price or markup methods.

  • Comparable uncontrolled pricing is a simple way to determine the arm’s-length price when what is being sold is standard enough to be sold on the open market. With this approach, the company makes assumptions based on comparable transactions in the open market and utilizes those assumptions to conclude a fair market value for the asset being priced. This approach doesn’t work when the asset is more complex or has unique characteristics such as intellectual property, both of which make finding comparable precedent transactions nearly impossible.
  • Cost-plus approach takes the product’s unit cost and adds a percent markup. This method is more flexible to adjust to what the additional markup should be. Between two unrelated companies, the markup is generally agreed upon beforehand and results in a fair market value based on an arm’s length transaction. Determining this markup with a company doing business with itself leaves more room for discretion.
  • Resale price or markup is similar to cost-plus but instead of starting with the base cost of producing one unit, the markup starts with the market price of one unit and adds a price markup from that point. This method doesn’t work well with unique assets that are not traded often in the open market, and thus do not have a clear market price.

An alternative that is starting to become more prevalent in the US to the arm’s-length rule is the unitary tax. The unitary tax approach involves taxing the various parts of a multinational company based on what each is doing in the real world. In this approach, companies aggregate all of their business incomes and apportionment factors (generally an average of factors such as property, payroll and sales for the whole company), and compare the resulting data with the same factor inside the state itself to find how much economic activity is being produced independently by the company

Fees for Transfer Pricing Manipulation

US rule for transfer pricing remains arguably the toughest and most comprehensive in the world. It is stated that the burden of proof of valuation lies on the taxpayer; so, if questioned on transfer price, appropriate data will need to reflect reasonable valuation standards and care. If the transfer price is found to be undervalued by 50% or overvalued by 200% there is a 20% non-deductible transaction penalty.  If the transfer price is found to be undervalued by 75% or overvalued by 400% the fine rises to 40%.

For this reason, it is often advised that companies engage a valuation firm to perform a transfer pricing study as an independent third party. If you have more questions about Transfer Pricing or complying with US regulation, seek additional help from tax advisors and valuation specialists.

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