What is Transfer Pricing and Why Does it Matter?

Transfer Pricing and the Arm's Length Standard

Multinational groups of companies are the drivers of international trade. These corporate groups operate cross borders by transferring goods, services, and intellectual property between group members. In administering an intra-group transfer, related companies must set a price (i.e., the transfer price) for the transaction because, in our residence- and source-based international tax system, countries generally treat each group member as a separate entity for domestic income tax purposes. Members are then responsible for paying taxes on their respective taxable income, adhering to the legislation of the country or countries in which they have established residency or maintain business operations.

Companies engage in transfer pricing for various reasons. These range from financial reporting and strategic business reasons, including optimizing supply chain operations, to tax optimization, such as seeking to pay lower taxes by allocating profits to low-tax jurisdictions. But, because of the impact that transfer prices have on a group's profit allocation and tax liabilities, intra-group transfers are susceptible to manipulation. Simply put, pricing a transaction higher than an acceptable market price can result in an artificial shifting of profit to the seller's jurisdiction, whereas pricing a transaction below market can result in an artificial shifting of profit to the buyer's jurisdiction.

Recognizing that transfer pricing strategies have a direct impact on their tax base, governments have enacted laws regulating how companies must determine prices, maintain documentation, and report global transfer pricing operations, policies, and transaction details. Notably, most governments have incorporated the arm's length principle into their domestic laws as a standard to ensure prices reflect reality. This fundamental principle is the internationally accepted standard for valuing cross-border transactions between associated enterprises. It requires that prices charged between related parties reflect what would be charged between unrelated parties acting under similar circumstances. That is, the price should reflect a fair market price and result in an approximate profitability that would have been realized by independent enterprises.

An Overly Simplified Example

Let's look at a simplified example illustrating the impact a transfer price can have on a multinational group's overall tax liability. We’ll consider two countries: Jurisdiction X with a corporate income tax rate of 15% and Jurisdiction Y with a corporate income tax rate of 30%.

Transfer Pricing Regulations and International Guidelines

Most countries have enacted some form of oversight to regulate and audit transfer pricing issues. Country-specific approaches generally include requirements that companies employ certain pricing methods to ensure income is reported accurately and an appropriate amount of taxes are paid. Many countries have also adopted a standardized approach to transfer pricing documentation consisting of the following reports:

• Master file: Containing standardized information relevant for all group members, including the multinational enterprise's transfer pricing operations and policy;
• Local file: Containing detailed information specific to material transactions of the local taxpayer; and
• Country-by-Country (CbC) report: Containing aggregate data on the multinational enterprise's global allocation of income, profit, taxes paid together with the locations of economic activity within the multinational enterprise.

Internationally, the Organisation for Economic Cooperation and Development (OECD) provides guidelines for transfer pricing, aiming to standardize practices across countries and reduce the risk of double taxation. The OECD also publishes a model tax convention, which acts as a guide for countries negotiating bilateral income tax treaties. It includes provisions outlining boundaries for application of domestic transfer pricing laws and dispute resolution mechanisms.

United States Federal Guidance

In the United States specifically, federal tax law requires that when two or more organizations, trades, or businesses are owned or controlled by the same interests, they must apportion profits among the parties in a way that reflects an arm's length result in order to clearly reflect the income of each party and prevent evasion of taxes. LINK Internal Revenue Code § 482 is the statutory authority for transfer pricing law at federal level, but is also persuasive, and at time instructional, at the state level. For in depth guidance, taxpayers should also refer to accompanying regulations adopted by the US Treasury Department.

The IRS is vigilant in its oversight of transfer pricing, employing rigorous transfer pricing audits to identify discrepancies and enforce compliance. Accuracy-related penalties can reach as high as 40% of an underpayment due to erroneous pricing. To avoid hefty penalties, taxpayers must maintain thorough documentation, ensure their transfer pricing practices are in line with federal regulations and international standards, and demonstrate that their transfer prices are based on the arm's length principle.

OECD Guidelines

The OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (OECD Guidelines) offers a framework for governments and companies alike to avoid transfer pricing disputes and ensure fair tax practices.

The OECD Guidelines provide in depth commentary on all aspect of transfer pricing, including:

• Application of the arm's length principle,
• Application of common transfer pricing methods,
• Comparability analyses,
• Administrative approaches to avoiding and resolving disputes,
• Documentation requirements; and
• Special considerations that should be taken into account regarding intangible assets, intra-group services, and financial services.

The OECD Guidelines also provide commentary on transfer prices as they relate to certain business arrangements and restructurings.

The OECD Guidelines were most recently updated in 2022 to incorporate revised guidance drafted and agreed to by members of the members of the OECD/G20 Inclusive Framework on Base Erosion and Profit Shifting (BEPS) - international collaboration to end tax avoidance. Updates included revisions to the guidance for tax administrations on the application of the approach to hard-to-value intangibles, as well as the new transfer pricing guidance on financial transactions.

Tax Treaties

The treatment of related party transactions is also informed by bilateral, and at times multilateral, income tax treaties in force between taxing jurisdictions. In particular, the OECD model tax convention, includes two articles that are relevant to addressing intercompany transactions:

Article 9 Associated Enterprises: This article deals with adjustments to profits that treaty countries may make for tax purposes if the price of a transaction between associated enterprises does not reflect an arm's length price.

Article 25 Mutual Agreement Procedure (MAP): This article institutes a MAP between treaty countries for resolving treaty-related disputes, including transfer pricing disputes arising under Article 9. Article 25 also contains a model provision allowing taxpayers to request arbitration of unresolved issues that have prevented competent authorities from reaching a mutual agreement.

Choosing a Transfer Pricing Method

Transfer pricing methods are employed by both multinational corporations and tax authorities worldwide to ensure compliance with transfer pricing regulations. The five most common methods used internationally, including in the United States, comprise of traditional transaction methods and two transactional profit methods.

Each transfer pricing method aims to mirror the profitability of transactions between independent enterprises, ensuring fair tax treatment. Each method has its own benefits and risks and is suitable under different circumstances. But it should be noted that other lesser used methods exist and may be accept by tax authorities if the domestic laws of the country allow.

Traditional Transaction Methods

Traditional transaction methods evaluate the terms and conditions of a controlled transaction (i.e., the intercompany transaction) in comparison to uncontrolled transactions (transactions between unrelated parties).

• Comparable Uncontrolled Price Method (CUP): This approach compares the price charged in a controlled transaction to the price charged in comparable transactions between unrelated parties.
• Resale Price Method: With this approach, the price charged to an external customer is reduced by an appropriate margin based on what the reseller would have earned in comparable transactions with unrelated parties.
• Cost Plus Method: This approach involves adding a markup to the costs incurred by the seller of goods or services in a controlled transaction.

Transactional Profit Methods

Transactional profit methods evaluate whether the amount charged in a controlled transaction is arm's length by comparing the net profits of the transactions to comparable uncontrolled transactions. These method are beneficial when specific transactional data are not available.

• Profit Split Method: This approach divides the total profit from controlled transactions in a manner that reflects the specific contributions of each party. As such, this method is beneficial when each party to the transaction makes unique and valuable contributions.
• Transactional Profit Methods (TNMM): Also called the comparable profits method, this approach evaluates the net profit relative to an appropriate base (e.g., costs, sales, assets) that a taxpayer realizes in a controlled transaction, which is then compared to net profits derived in uncontrolled transactions under the similar circumstances.

The Importance of Transfer Pricing Methods

Understanding transfer pricing methods is crucial for navigating and complying with the complexities of transfer pricing international tax laws. By adhering to established guidelines and standards when choosing and employing a specific method, companies can avoid disputes with tax authorities and ensure fair and accurate financial reporting.

US transfer pricing regulations state that the best method to use under any particular set of facts and circumstances is the method that "provides the most reliable measure of an arm’s-length result." To make a determination, companies should assess:

• the degree of comparability between the controlled transaction and any uncontrolled comparables, and
• the quality of the data and assumptions used in the analysis.

Transfer pricing disputes often arise when tax authorities believe that transfer prices are not aligned with market prices based on application of the most appropriate method. Such disputes can result in adjustments in the prices charged, affecting the companies' profits and tax obligations, as well as possible subsequent to corresponding adjustments and secondary adjustments by the taxing jurisdictions involved.

Choosing the method that best approximates the profits that would have been realized by independent enterprises can help taxpayers avoid a transfer pricing audit and subsequent pricing adjustments by tax authorities.

Resources and More Information

It's important for tax professionals engaged in transfer pricing issues and disputes to be familiar with the following guidance:

• OECD Transfer Pricing Guidelines 2022
• OECD Model Tax Convention Commentary on Article 9 - Associated Enterprises
• OECD Model Tax Convention Commentary on Article 25 - MAP
• IRS Transfer Pricing Frequently Asked Questions

Additionally, IBFD offers a range of products, books, and other resources that provide expert discussion and distillation of transfer pricing guidance, regulations, and current trends:

• Table:
  • IBFD OECD - BEPS Country Monitor
  • Country Key Features (A.3. Specific Issues)
• Newest Webinars:
  • How to Price Intra-Group Financial Transactions
  • Trends in Transfer Pricing of R&D and IP Activities
• Explore IBFD's webinars on transfer pricing link to filtered webshop
• Discover IBFD's books on transfer pricing link to filtered webshop