INTM431010 - What is transfer pricing all about?

What is the transfer pricing problem?

For every item sold, and every service provided, a price is charged by the seller and paid by the buyer. And it is the sum total of prices charged and paid that determines the commercial profits (or losses) of any business. In the most straightforward cases things are offered for sale at a fixed price: the buyer has the choice of buying at the advertised price or not buying at all. But for transactions that are more complex, prices are negotiated between buyers and sellers.

Where goods are sold on the open market, it is fairly easy to fix on a price that buyers are prepared to pay (although the prices set will determine the volume of sales made). The size and nature of the market, the quality of the goods, the extent of the competition, cost and desired profit margin are all factors which bear on the selling price.

But where the parties to the transaction are connected, the conditions of their commercial relations will not be determined solely by market forces. The price will not necessarily correspond to what would have been charged if they had not been connected. And where both the seller and the purchaser are companies owned by the same person the price charged will not of itself make their common owner any richer or poorer; it will merely serve to determine the extent to which the common owner's funds/profits/financial resources are transferred/shifted from one company to the other.

So a transfer price is the price charged in a transaction. And where connected parties transact with each other there is not always the need or the incentive to charge prices that precisely replicate what would have happened had they been dealing at arm's length. As a result the level of their commercial profits may differ - sometimes by accident and, on occasions, by design - from what would have arisen if they had done the same transactions with unconnected parties.

The transfer pricing issue mainly arises in cross border transactions between two companies who are part of the same group. However, transfer pricing problems are not limited to company to company transactions; for example a transaction between an individual and an overseas company he controls can be manipulated through the transfer price.

Large multinational enterprises and their advisors are well aware of the opportunities to manipulate transfer prices. From the point of view of a large multinational group, it is better to structure the business so that profits are earned in a territory that taxes them at 10%, rather than a territory that taxes them at 35%. Tax planning to help bring about such a result is now very sophisticated.

Tax authorities around the world are increasingly aware that the transfer pricing of transactions between connected parties can affect their tax yield. Moreover, this is particularly so where the parties to a transaction are subject to different tax rules and rates.