Rules and methods for pricing transactions between enterprises under common ownership
Transfer pricing refers to the rules and methods for pricing transactions within and between enterprises under common ownership or control. Because of the potential for cross-border controlled transactions to distort taxable income, tax authorities in many countries can adjust intragroup transfer prices that differ from what would have been charged by unrelated enterprises dealing at arm’s length (the arm’s-length principle). The OECD and World Bank recommend intragroup pricing rules based on the arm’s-length principle, and 19 of the 20 members of the G20 have adopted similar measures through bilateral treaties and domestic legislation, regulations, or administrative practice. Countries with transfer pricing legislation generally follow the "OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations" in most respects, although their rules can differ on some important details.
Where adopted, transfer pricing rules allow tax authorities to adjust prices for most cross-border intragroup transactions, including transfers of tangible or intangible property, services, and loans. For example, a tax authority may increase a company’s taxable income by reducing the price of goods purchased from an affiliated foreign manufacturer or raising the royalty the company must charge its foreign subsidiaries for rights to use a proprietary technology or brand name. These adjustments are generally calculated using one or more of the transfer pricing methods specified in the OECD guidelines and are subject to judicial review or other dispute resolution mechanisms.
Although transfer pricing is sometimes inaccurately presented by commentators as a tax avoidance practice or technique (transfer mispricing), the term refers to a set of substantive and administrative regulatory requirements imposed by governments on certain taxpayers. However, aggressive intragroup pricing – especially for debt and intangibles – has played a major role in corporate tax avoidance, and it was one of the issues identified when the OECD released its base erosion and profit shifting (BEPS) action plan in 2013. The OECD’s 2015 final BEPS reports called for country-by-country reporting and stricter rules for transfers of risk and intangibles but recommended continued adherence to the arm’s-length principle. These recommendations have been criticized by many taxpayers and professional service firms for departing from established principles and by some academics and advocacy groups for failing to make adequate changes.
Transfer pricing should not be conflated with fraudulent trade mis-invoicing, which is a technique for concealing illicit transfers by reporting falsified prices on invoices submitted to customs officials. “Because they often both involve mispricing, many aggressive tax avoidance schemes by multinational corporations can easily be confused with trade misinvoicing. However, they should be regarded as separate policy problems with separate solutions,” according to Global Financial Integrity, a non-profit research and advocacy group focused on countering illicit financial flows.
In general.
Over sixty governments have adopted transfer pricing rules, which in almost all cases (with the notable exception of Kazakhstan) are based on the arm's-length principle. The rules of nearly all countries permit related parties to set prices in any manner, but permit the tax authorities to adjust those prices (for purposes of computing tax liability) where the prices charged are outside an arm's length range. Most, if not all, governments permit adjustments by the tax authority even where there is no intent to avoid or evade tax. The rules generally require that market level, functions, risks, and terms of sale of unrelated party transactions or activities be reasonably comparable to such items with respect to the related party transactions or profitability being tested.
Adjustment of prices is generally made by adjusting taxable income of all involved related parties within the jurisdiction, as well as adjusting any withholding or other taxes imposed on parties outside the jurisdiction. Such adjustments are generally made after filing of tax returns. For example, if Bigco US charges Bigco Germany for a machine, either the U.S. or German tax authorities may adjust the price upon examination of the respective tax return. Following an adjustment, the taxpayer generally is allowed (at least by the adjusting government) to make payments to reflect the adjusted prices.
Most systems allow use of transfer pricing multiple methods, where such methods are appropriate and are supported by reliable data, to test related party prices. Among the commonly used methods are comparable uncontrolled prices, cost-plus, resale price or markup, and profitability based methods. Many systems differentiate methods of testing goods from those for services or use of property due to inherent differences in business aspects of such broad types of transactions. Some systems provide mechanisms for sharing or allocation of costs of acquiring assets (including intangible assets) among related parties in a manner designed to reduce tax controversy. Most governments have granted authorization to their tax authorities to adjust prices charged between related parties. Many such authorizations, including those of the United States, United Kingdom, Canada, and Germany, allow domestic as well as international adjustments. Some authorizations apply only internationally.
In addition, most systems recognize that an arm's length price may not be a particular price point but rather a range of prices. Some systems provide measures for evaluating whether a price within such range is considered arm's length, such as the "interquartile range" used in U.S. regulations. Significant deviation among points in the range may indicate lack of reliability of data. Reliability is generally considered to be improved by use of multiple year data.
Most rules require that the tax authorities consider actual transactions between parties, and permit adjustment only to actual transactions. Multiple transactions may be aggregated or tested separately, and testing may use multiple year data. In addition, transactions whose economic substance differs materially from their form may be recharacterized under the laws of many systems to follow the economic substance.
Transfer pricing adjustments have been a feature of many tax systems since the 1930s. The United States led the development of detailed, comprehensive transfer pricing guidelines with a White Paper in 1988 and proposals in 1990–1992, which ultimately became regulations in 1994. In 1995, the OECD issued its transfer pricing guidelines which it expanded in 1996 and 2010. The two sets of guidelines are broadly similar and contain certain principles followed by many countries. The OECD guidelines have been formally adopted by many European Union countries with little or no modification.
Comparability.
Most rules provide standards for when unrelated party prices, transactions, profitability or other items are considered sufficiently comparable in testing related party items. Such standards typically require that data used in comparisons be reliable and that the means used to compare produce a reliable result. The U.S. and OECD rules require that reliable adjustments must be made for all differences (if any) between related party items and purported comparables that could materially affect the condition being examined. Where such reliable adjustments cannot be made, the reliability of the comparison is in doubt. Comparability of tested prices with uncontrolled prices is generally considered enhanced by use of multiple data. Transactions not undertaken in the ordinary course of business generally are not considered to be comparable to those taken in the ordinary course of business. Among the factors that must be considered in determining comparability are:
Nature of property or services.
Comparability is best achieved where identical items are compared. However, in some cases it is possible to make reliable adjustments for differences in the particular items, such as differences in features or quality. For example, gold prices might be adjusted based on the weight of the actual gold (one ounce of 10 carat gold would be half the price of one ounce of 20 carat gold).
Functions and risks.
Buyers and sellers may perform different functions related to the exchange and undertake different risks. For example, a seller of a machine may or may not provide a warranty. The price a buyer would pay will be affected by this difference. Among the functions and risks that may impact prices are:
Terms of sale.
Manner and terms of sale may have a material impact on price. For example, buyers will pay more if they can defer payment and buy in smaller quantities. Terms that may impact price include payment timing, warranty, volume discounts, duration of rights to use of the product, form of consideration, etc.
Market level, economic conditions and geography.
Goods, services, or property may be provided to different levels of buyers or users: producer to wholesaler, wholesaler to wholesaler, wholesaler to retailer, or for ultimate consumption. Market conditions, and thus prices, vary greatly at these levels. In addition, prices may vary greatly between different economies or geographies. For example, a head of cauliflower at a retail market will command a vastly different price in unelectrified rural India than in Tokyo. Buyers or sellers may have different market shares that allow them to achieve volume discounts or exert sufficient pressure on the other party to lower prices. Where prices are to be compared, the putative comparables must be at the same market level, within the same or similar economic and geographic environments, and under the same or similar conditions.
Testing of prices.
Tax authorities generally examine prices actually charged between related parties to determine whether adjustments are appropriate. Such examination is by comparison (testing) of such prices to comparable prices charged among unrelated parties. Such testing may occur only on examination of tax returns by the tax authority, or taxpayers may be required to conduct such testing themselves in advance of filing tax returns. Such testing requires a determination of how the testing must be conducted, referred to as a transfer pricing method.
Best method rule.
Some systems give preference to a specific method of testing prices. OECD and U.S. systems, however, provide that the method used to test the appropriateness of related party prices should be that method that produces the most reliable measure of arm's length results. This is often known as a "best method" rule. Factors to be considered include comparability of tested and independent items, reliability of available data and assumptions under the method, and validation of the results of the method by other methods.
Comparable uncontrolled price (CUP) method.
The comparable uncontrolled price (CUP) method is a transactional method that determines the arm's-length price using the prices charged in comparable transactions between unrelated parties. In principle, the OECD and most countries that follow the OECD guidelines consider the CUP method to be the most direct method, provided that any differences between the controlled and uncontrolled transactions have no material effect on price or their effects can be estimated and corresponding price adjustments can be made. Adjustments may be appropriate where the controlled and uncontrolled transactions differ only in volume or terms; for example, an interest adjustment could be applied where the only difference is time for payment (e.g., 30 days vs. 60 days). For undifferentiated products such as commodities, price data for arm's-length transactions ("external comparables") between two or more other unrelated parties may be available. For other transactions, it may be possible to use comparable transactions ("internal comparables") between the controlled party and unrelated parties.
The criteria for reliably applying the CUP method are often impossible to satisfy for licenses and other transactions involving unique intangible property, requiring use of valuation methods based on profit projections.
Other transactional methods.
Among other methods relying on actual transactions (generally between one tested party and third parties) and not indices, aggregates, or market surveys are:
Profit-based methods.
Some methods of testing prices do not rely on actual transactions. Use of these methods may be necessary due to the lack of reliable data for transactional methods. In some cases, non-transactional methods may be more reliable than transactional methods because market and economic adjustments to transactions may not be reliable. These methods may include:
CPM and TNMM have a practical advantage in ease of implementation. Both methods rely on microeconomic analysis of data rather than specific transactions. These methods are discussed further with respect to the U.S. and OECD systems.
Two methods are often provided for splitting profits: comparable profit split and residual profit split. The former requires that profit split be derived from the combined operating profit of uncontrolled taxpayers whose transactions and activities are comparable to the transactions and activities being tested. The residual profit split method requires a two step process: first profits are allocated to routine operations, then the residual profit is allocated based on nonroutine contributions of the parties. The residual allocation may be based on external market benchmarks or estimation based on capitalised costs.
Tested party and profit level indicator.
Where testing of prices occurs on other than a purely transactional