The term "transfer pricing" frequently arises among multinational corporations engaged in cross-border dealings. But what exactly is it? 

Essentially, it’s a set of methods and policies a multinational employs to set prices for transactions between its associated enterprises, such as subsidiaries, branches, or holding companies. It doesn’t only apply to cross-border dealings; it can also apply to domestic transactions.

This concept is crucial for organizations and tax authorities alike, and it has been a hot topic in the news in recent years. Transfer pricing rules are set by national tax authorities and exist to provide a level playing field. Companies operating in those tax jurisdictions must abide by those rules to prevent them from avoiding tax. 

This latest article in our “What is…” series aims to demystify the concept, discuss its implications, and explore why it’s crucial for any multinational to master it.

The Basics

When a company has all its business dealings in a single country, it can operate from a single, legally registered organization — a single legal entity. If the company wants to start trading in multiple countries — perhaps either selling into or sourcing goods from another country — depending on the countries involved and the nature of the activity, it might need to set up a legally registered organization in that country. In doing so, it becomes a multi-entity organization.

Let’s look at the fictional organizations we came across in our guide to intercompany vs. intracompany accounting: when ACME Inc. decided to open a sales office in the UK, it created a new legal entity registered with the UK authorities called ACME Sales UK Ltd. Whenever ACME Sales UK Ltd. makes a sale, it gets paid by the customer but, because it does not manufacture the goods, it has to make a payment to the US-based ACME Inc., which does. The amount at which that payment is made is called transfer pricing.

Put simply, any financial activity that occurs between different legal entities of a larger group is called intercompany accounting and the value at which the transaction occurs is called transfer pricing.

These intra-group transactions pertain to the exchange of goods or services between different divisions of the same parent company. So it’s not just physical items; it can also apply to transactions involving intellectual property, such as royalties.

Unlike open-market transactions, where prices are determined by market forces, intra-group prices are controlled by the organization. Given free reign, many organizations would want to set their transfer pricing to help them achieve strategic goals, including tax optimization. However, there are rules governing what strategies and prices can be used — we’ll discuss in more detail later. First, it’s important to be aware of the "arm's length principle". The purpose of this principle is to ensure that transfer prices reflect market conditions; it states that the prices set in intra-group transactions should be consistent with those that would have been set between independent parties under similar circumstances.

Why Transfer Pricing Matters

The implications of transfer pricing are significant; the values used for these intra-group trades have the potential to lower or raise the global tax burden of the group. That means companies that can recognize profits in low-tax jurisdictions will reduce their overall tax liability.

But, as we mentioned previously, it’s not a free-for-all, and compliance with transfer pricing regulations is the other vital part of the puzzle. The US IRS, UK HMRC, and other tax authorities have stringent reporting rules for transfer pricing and require comprehensive documentation. Failing to adhere to these rules can result in severe penalties and tax adjustments. Not to mention the reputational risk from this featuring in the press.

Internationally, the OECD has put much time and effort into providing guidelines that attempt to level the playing field through their two-pillar solution. These guidelines are intended to heavily influence national laws concerning transfer pricing. Pillar 2 of the guidelines is recommended for implementation in 2024 and includes policies such as a global minimum Effective Tax Rate (ETR).

Being able to comply — and, more importantly, provide evidence of the compliance — is increasingly critical to a multinational’s ability operate an effective transfer pricing scheme and avoid crippling penalties.

Transfer Pricing Methods

There are several well-recognized methods to determine transfer pricing. Let’s have a look at some of them.

The Comparable Uncontrolled Price Method (CUP)

The CUP method is among the most straightforward. It compares the price of goods or services in a controlled transaction (a transaction between related parties) to the price charged in an uncontrolled transaction (a transaction between independent enterprises, i.e., an open-market transaction). Of course, it considers factors such as the contractual terms, market conditions, and geographic location.

If there’s a difference to the extent that the price of the uncontrolled transaction falls outside the range considered to be "arm’s length," it may need "reasonably accurate adjustment" so that it’s in the range.

The CUP method is commonly used for tangible goods transactions because of the relative ease of finding comparable market prices. It can also be applied to financial transactions, such as loans or guarantees, where market interest rates can serve as comparables.

The Resale Price Method

The Resale Price Method (RPM) is often used for transactions involving the purchase and resale of goods; especially when a parent company sells products to a subsidiary, which then resells these products to independent third parties. It’s best used when gross margin data is available and when the reseller does not add substantial value to the product.

This method focuses on the resale margin that a distributor earns when purchasing products from a related party and then resells them to an independent party. The method begins with the resale price to an independent third party and works backward to deduce an arm's length price for the intra-group transaction.

The first step is to identify the price at which the product is resold to an independent third party. From this resale price, an appropriate gross margin is subtracted that would allow the reseller (i.e., the subsidiary) to cover its selling and operating expenses and earn a reasonable profit given the functions performed and market conditions.

The remaining amount after subtracting the gross margin represents the arm's length price for the initial transfer of goods between the related entities.

The Cost-Plus Method

This method focuses on the costs incurred by the supplier of goods or services in a controlled transaction. A mark-up is then added to these costs to arrive at an arm's length price for the transaction between the associated enterprises. (The mark-up should be determined based on what independent entities earn in similar transactions, which calls for a thorough analysis of comparable transactions in the market.)

The method is commonly applied in situations where one entity provides manufacturing, assembly, or service functions to a related party. It’s useful when the services or products are not sold to independent parties, making other methods like the CUP method less applicable.

The Profit Split Method

This approach is relevant in complex intercompany transactions, such as those involving the transfer of intangible assets or in cases where business operations are highly integrated. 

The method involves identifying the total profit earned from controlled transactions between entities, and then splitting these profits in a way that reflects the value that each entity has contributed. This is determined based on various factors, such as assets used, costs incurred, or risks assumed.

Transactional Net Margin Method (TNMM)

The TNMM is widely used where transactions involve the transfer of goods, services, or intangible assets. It’s helpful when it’s difficult to find comparable uncontrolled transactions for methods (such as CUP), and for routine transactions where one party earns a stable return for performing less complex functions.

The first step is to select an appropriate net profit indicator (NPI), such as the net profit margin on costs, sales, or assets. Next, a functional analysis is performed to assess the functions performed, assets used, and risks assumed by the parties involved. This helps in determining which party’s profitability should be tested using TNMM.

The net profit margin of the tested party is then compared to that of comparable independent enterprises engaged in similar transactions to determine an arm’s length range of profitability.

Challenges in Transfer Pricing

As you have probably already discovered, transfer pricing is not straightforward, and there are many challenges associated with both defining an appropriate methodology and with enacting it. They include the following:

• Finding comparable transactions: Identifying truly comparable transactions between independent parties can be difficult, especially for unique or specialized goods and services.
• Valuing intangibles: Accurately valuing intangible assets like intellectual property, brand value, or unique business processes is often subjective and complex.
• Complexity of transactions: Transactions involving intangible assets or services can be highly complex, making it challenging to apply transfer pricing methods accurately.
• Compliance: Keeping up with the diverse and evolving transfer pricing regulations across different jurisdictions can be a significant challenge.
• Risk of double taxation: Inconsistencies in transfer pricing rules across countries may lead to the same income being taxed twice.
• Documentation requirements: As mentioned, it’s necessary to maintain extensive and detailed documentation for reporting purposes — a burdensome undertaking. In addition, drafting and managing intercompany agreements that reflect the arm's length principle and are compliant with local laws can be challenging.
• Adjustments and penalties: There is a risk of significant penalties and adjustments during tax audits if the authorities deem that arm's length requirements are not met.
• Market changes: Fluctuations in market conditions, exchange rates, and economic environments can impact transfer pricing strategies and their justification.
• Conflict resolution: Resolving disputes, either between tax authorities and the company or between different tax jurisdictions, can be time-consuming and costly.

Transfer Pricing in the Modern Global Economy

In recent years, initiatives have been developed to target Base Erosion and Profit Shifting (BEPS). BEPS practices exploit gaps in tax rules to shift profits to low-tax locations, causing countries to lose revenues. The OECD/G20 Inclusive Framework on BEPS is being implemented in 140 jurisdictions to tackle this issue.

The digital economy also poses new challenges for traditional transfer pricing models because value creation often transcends physical borders. Essentially, the question is whether tax rules developed long ago for brick-and-mortar businesses are still appropriate for today’s economy. According to the OECD, digitization enables scale without mass, reliance on intangible assets, and the centrality of data; all of these factors challenge the existing system.  

One answer to this challenge has been the introduction of country-by-country reporting, which has become an important tool for national tax authorities and, therefore, a significant requirement for multinationals. Organizations must report various metrics for each jurisdiction they operate in, enhancing transparency and compliance — and increasing the administrative burden involved.

Best Practices in Transfer Pricing

Given the complexity of transfer pricing, many organizations are left wondering how they can navigate this path in a way that allows them to see the benefits while still staying compliant.

Firstly, regular reviews and adjustments of intercompany policies are a must in order to ensure alignment with current laws and market conditions. This article is purely an informative guide; seeking advice from qualified, transfer pricing experts is crucial, especially for complex transactions.

Secondly, comprehensive documentation and transparency with tax authorities cannot be overstated. Documentation that supports not just the numbers but the rationale behind transfer pricing policies is crucial in the event of audits or disputes.

Finally, enacting these business policies — often during the time-sensitive accounting close — in a way that avoids human error is not an easy task. That’s where automation using intercompany accounting software comes in. Software processes data quicker than any accountant and improves the accuracy of IC processes. The days of relying on spreadsheets and manual entries are over; it’s just too risky as there are so many ways that errors can occur.

Virtual Trader automates the whole process, from data gathering to calculation and journal entry postings. The system handles complex agreements with ease and provides comprehensive documentation that explains the narrative behind the numbers.

In Conclusion

Transfer pricing is an intricate aspect of multinational business operations, and its importance is only set to grow in an increasingly interconnected global economy. Organizations must stay informed, consult experts, and continuously evaluate the implications of transfer pricing for their operations.

There are a whole host of challenges in implementing a robust transfer pricing policy, but don’t let the final piece of the jigsaw let you down. Request a demo of Virtual Trader today to see how you can solve the operational transfer pricing conundrum.