Transfer pricing involves the prices of goods and services exchanged between companies under common control, often used by multinational corporations to allocate profits among subsidiaries. It offers benefits like reducing duty costs and corporate taxes, but also presents risks such as internal disagreements and complexities in pricing intangible items. The arm's length principle ensures that related entities agree on terms comparable to those between unrelated entities, though it faces criticism for its interpretative flexibility and potential for facilitating tax avoidance.
Transfer pricing involves the prices of goods and services exchanged between companies under common control, often used by multinational corporations to allocate profits among subsidiaries. It offers benefits like reducing duty costs and corporate taxes, but also presents risks such as internal disagreements and complexities in pricing intangible items. The arm's length principle ensures that related entities agree on terms comparable to those between unrelated entities, though it faces criticism for its interpretative flexibility and potential for facilitating tax avoidance.
Transfer pricing involves the prices of goods and services exchanged between companies under common control, often used by multinational corporations to allocate profits among subsidiaries. It offers benefits like reducing duty costs and corporate taxes, but also presents risks such as internal disagreements and complexities in pricing intangible items. The arm's length principle ensures that related entities agree on terms comparable to those between unrelated entities, though it faces criticism for its interpretative flexibility and potential for facilitating tax avoidance.
Transfer pricing involves the prices of goods and services exchanged between companies under common control, often used by multinational corporations to allocate profits among subsidiaries. It offers benefits like reducing duty costs and corporate taxes, but also presents risks such as internal disagreements and complexities in pricing intangible items. The arm's length principle ensures that related entities agree on terms comparable to those between unrelated entities, though it faces criticism for its interpretative flexibility and potential for facilitating tax avoidance.
Transfer pricing refers to the prices of goods and services that are exchanged between companies under common control. For example, if a subsidiary company sells goods or renders services to its holding company or a sister company, the price charged is referred to as the transfer price.
Entities under common control refer to those that are ultimately controlled by a single parent corporation. Multinational corporations use transfer pricing as a method of allocating profits – earnings before interest and taxes among various subsidiaries within the organization.
Benefits of Transfer Pricing
1. Transfer pricing helps in reducing duty costs by shipping goods into countries with high tariff rates by using low transfer prices so that the duty base of such transactions is lowered. 2. Reducing income and corporate taxes in high tax countries by overpricing goods that are transferred to countries with lower tax rates helps companies obtain higher profit margins. Risks
1. There can be disagreements within the divisions of an organization regarding the policies on pricing and transfer. 2. Lots of additional costs are incurred in terms of time and manpower required in executing transfer prices and maintaining a proper accounting system to support them. Transfer pricing is a very complicated and time-consuming methodology. 3. It gets difficult to establish prices for intangible items such as services rendered, which are not sold externally. 4. Sellers and buyers perform different functions and, thus, assume different types of risks. For instance, the seller may refuse to provide a warranty for the product. But the price paid by the buyer would be affected by the difference.
The arm’s length principle
The arm’s length principle means that:
‘entities that are related via management, control or capital in their controlled transactions should agree the same terms and conditions which would have been agreed between non-related entities for comparable uncontrolled transactions’.
If this principle is met, we can say that the terms and conditions of the particular transaction are ‘at arm’s length’.
Illustration Transaction 1: Company A produces apples and sells these to distributor Company B. Company A and Company B are not related. This is an uncontrolled transaction. The terms and conditions are considered to be ‘at arm’s length’.
Transaction 2: Company X produces the same apples and sells these to distributor Company Y. Company X and Company Y are related. They are both owned by Company Z. This is a controlled transaction and the terms and conditions should satisfy the arm’s length principle to comply with transfer pricing regulation.
If transaction 2 is concluded under the same terms and conditions as transaction 1, we can say that the terms and conditions of Transaction #2 are also ‘at arm’s length’.
The main source of the arm’s length principle is Article 9 of the OECD Model Convention which is adapted in most bilateral tax treaties. The OECD has incorporated the arm’s length principle as part of transfer pricing rules which set forth the guidelines that MNEs should apply to the determination of the terms and conditions of controlled transactions.
Most countries have adapted the arm’s length principle by including an according provision in domestic legislation.
Criticism of the Arm’s Length Principle
The main complaint is that it leaves (too) much room for interpretation, which results in a lot of discussions between taxpayers and tax administrations. This point is even acknowledged by the OECD. Not every product is the same and not every brand has the same value. How do you compare these different products? Therefore, discussions often focus on whether transactions are ‘comparable’ enough or whether all terms and conditions should be same.
Another complaint is voiced by lobby groups like Tax Justine Network and Oxfam. They argue that an ‘arm’s length’ price could still facilitate tax avoidance by Multinational entrprises by shifting profits to low-tax jurisdictions. The standard example used is the allocation of passive income to companies in tax havens with no real activities.
Whether these and other complaints are well-founded or not, the international tax community so far hasn’t been able to come up with a workable alternative in the past few decades.
But the arm’s length principle has deep roots; it is here to stay.
