INTM431020 - What is transfer pricing all about?: How do companies set their transfer pricing policy?

There are a host of factors that potentially have a bearing on the way transfer prices are set within a group. Some groups plan their transfer pricing with great care in order to shift profit to where it should properly fall - or to where they want it. Others tend to give their transfer pricing relatively little thought. In itself, it would be unlikely to constitute a significant profit generating activity unless it succeeded in lowering a group's global tax bill. Inevitably, motives will vary and there may well be cases where transfer prices are manipulated other than for tax reasons.

Here are some of the factors that could influence the way in which transfer prices are set:-

• Groups want to know, for their own management purposes, where value is being added, and that implies having appropriate transfer pricing policies. Groups tend to be more interested in knowing how value is added between functions than between countries. A distinction between countries can sometimes be relevant only for tax purposes.
• A group's transfer pricing policy will not necessarily be influenced by purely fiscal considerations. Group members may trade in countries which have unstable politics, high rates of inflation, rigid exchange controls or high rates of taxation. Those countries may impose high tariff barriers or otherwise restrict free movement of goods in or out of their territory. Transfer prices may be set in such a way as to extract profit from the country without falling foul of the tax rates or controls.
• Circumstances vary from group to group. Some may be very tightly controlled from the centre so that their subsidiaries are permitted to take no decisions of substance without reference to the parent company. In that situation, the parent's control of transfer prices and trading arrangements might enable it to determine which of its subsidiaries makes commercial profits and how much profit individual subsidiaries are allowed to make. At this point tax is clearly an important consideration and the tendency will be to channel profits into members of the group where it will be taxed at the lowest rate or be eligible for specific exemptions or reliefs.
• Not all groups, however, exercise that degree of control over their members operations. Wars, historical accidents, protective regimes and highly regulated industries have made it politically expedient for the subsidiaries of group companies to assume a distinct local identity. In some countries substantial local minority (or even majority) participation is required, thus weakening the degree of control which the parent can exercise.
• Multinational groups may prefer for nationalistic reasons to pay tax in their home country, even though there may be no saving on their tax bill. There will be cultural considerations to bear in mind.
• Sheer distance sometimes makes it physically impossible for the parent company to do more than exercise general oversight. It is also increasingly common to find that local subsidiaries are expected to operate as cost and profit centres, exercising genuine control over costs and endeavouring to make their operations as profitable as they should be. Directors and employees might be able to earn bonuses and other incentives linked to profits. Price setting may be subject to negotiation but these negotiations are unlikely to replicate what would happen between independent parties.
• Some territories have domestic transfer pricing rules that do not conform to the methods that are generally accepted at an international level for dealing with the transfer pricing problem.