International Transfer Pricing: Alarming Challenges and Methods of Tax Administration

KEY CONCEPTS

Transfer pricing. OECD Model Tax Convention. History of taxation.

CONCEPT OF TRANSFER PRICING

One of the most complex issues faced by multinational enterprises in tax calculation is determining the appropriate price in accordance with tax principles.

Transfer price is defined as the price established in transactions between associated (dependent) companies within a group, and the process of determining such price is referred to as transfer pricing (TP). This can include both domestic transactions between companies within the same jurisdiction and cross-border transactions between group companies located in different countries. It is the taxation of the latter that presents particular challenges and receives primary attention in international tax conventions and approaches.

In its Model Tax Convention, the OECD defines the conditions under which two companies are considered associated and the transactions between them are deemed controlled. These conditions include:^[1]

• One of these companies participates directly or indirectly in the management, control, or capital of the other company; or
• The same person(s) participate(s) directly or indirectly in the management, control, or capital of both of these companies.

For companies that do not meet the above definition, they are considered independent and transactions between them are deemed uncontrolled for transfer pricing (TP) purposes.

While prices between independent companies are typically determined based on market demand and supply for goods, services, and labor, it is difficult to determine purely market-based prices in transactions between dependent companies due to the unique nature of their relationship. Consequently, tax authorities see risks in transfer prices, such as the understatement of taxable profits.

One of the main risks associated with transfer pricing is the possibility of using dependent transactions to reallocate profits within a group of companies. Companies may intentionally understate prices in internal transactions to shift a portion of profits to companies with lower tax burdens. This allows them to reduce their tax obligations in countries with higher tax rates. Such behavior may be deemed inconsistent with tax principles by tax authorities and can lead to tax risks and potential penalties.

To prevent these risks, tax authorities develop special rules and methods for determining appropriate transfer prices between dependent companies. They aim to identify and regulate situations where prices in internal transactions may be non-market and distort taxable profits.

It is important to note that the taxpayer is responsible for proving the “marketability” of the transfer price. In the course of their activities, the taxpayer is required to analyze prices in transactions between associated companies, record any price deviations, reflect them in tax accounting, perform calculations, and gather supporting evidence. All this information must be documented in transfer pricing documentation, which tax authorities use to verify the completeness and timeliness of profit tax payments related to intra-group transactions. Companies often seek assistance from consulting firms specializing in transfer pricing and having access to databases of market prices and transaction conditions.

PRINCIPLES OF INTERNATIONAL TRANSFER PRICING

There is a set of international principles that companies must adhere to when determining transfer prices. The main principles include:

Arm’s Length Principle

Profits that have been understated due to special commercial or financial conditions in transactions between dependent companies can be included in the taxable profits of the company and subject to the corresponding tax. The main goal of this principle is to compare controlled and uncontrolled transactions in terms of the tax benefits and disadvantages they create.

Comparability Principle

Transactions to be compared must be comparable in terms of sales conditions and the characteristics of goods or services. Factors such as geography and market size, market competition, and the existence of homogeneous goods or services are taken into account when determining comparability. It is also important to consider contract terms, functions of the parties involved, risks, and commercial strategies. A comparability analysis is necessary for selecting the appropriate transfer pricing method and conducting further research.

Substance Over Form Principle

This principle implies that each controlled transaction should have a positive economic effect. This means that the transaction should result in an increase in the value of assets or create conditions that contribute to future value enhancement.

If a transaction lacks a reasonable economic purpose and is solely undertaken for tax optimization purposes, it cannot be considered a genuine and corresponding controlled transaction. In such cases, the transaction may receive special attention from tax authorities as its purpose is solely to reduce tax obligations without sufficient economic justification. This can lead to additional scrutiny and analysis to identify potential violations of tax legislation.

METHODS FOR DETERMINING TRANSFER PRICES USED IN INTERNATIONAL PRACTICE

In international practice, there are various methods and approaches for determining the arm’s length nature of commercial and financial relationships between associated companies, depending on the type and conditions of the transaction. The Organization for Economic Cooperation and Development (OECD) identifies two main categories of methods used in taxation: traditional transaction methods and profitability analysis methods. Let’s examine each of them in more detail.

Traditional Transaction Methods

These methods are direct tools for assessing the comparability of prices to the arm’s length principle. They are based on comparing the conditions of controlled and uncontrolled transactions based on price and gross margin. However, information on prices of comparable transactions is not always available.

Data on completed transactions and the conditions under which they were conducted are usually found in international databases such as CP Catalyst, ORBIS, AMADEUS of Bureau van Dijk, Thomson Reuters Transfer Pricing Database, Bloomberg, as well as in industry journals, stock quotes, customs reports, and publicly available sources of company accounting and statistical reporting information.

1. Comparable Uncontrolled Price Method (CUP)

The CUP method is based on comparing prices of comparable products or services sold in an open market. To apply this method, publicly available information on prices during a specific period is necessary, as well as comparability of the conditions of these transactions with the conditions of the analyzed transaction.

The CUP method is considered the most reliable for evaluating transactions involving goods to comply with the arm’s length principle. However, its application can be challenging, especially for goods with constantly fluctuating prices, such as oil.

2. Resale Price Method:

The Resale Price Method is more commonly used by distributors, wholesalers, and trading intermediaries rather than manufacturing companies. This method is like the CUP method, but instead of comparing prices, the analysis focuses on the margin – the difference between the price at which the product is acquired from the associated company and the price at which it is resold to an independent party. If the gross profitability aligns with the market, then the purchase price of the product from the associated company complies with the arm’s length principle. When using this method, it is still important to maintain comparability between the goods in controlled and uncontrolled transactions. However, some differences in the comparability of functions between the parties are allowed during the comparison.

3. Cost Plus Method:

The Cost Plus Method is based on analyzing the costs incurred by the supplier of goods or services in a controlled transaction when supplying them to the associated buyer company. These costs are then added with a certain profit percentage that corresponds to the functions performed by the parties and market conditions. The resulting value is considered in compliance with the arm’s length principle and compared to the indicator in the controlled transaction.

This method is usually applied in the sale of semi-finished products, joint ventures, or long-term supply of goods and services. It is also convenient when there is a lack of market information on transactions involving similar goods or services, allowing for the use of a transaction involving a comparable product or service for comparison.

Transactional Profit Methods

Transactional profit methods measure the net operating profit obtained from controlled transactions and compare it to the profit level of comparable companies engaging in similar transactions. Although these methods may be less precise compared to traditional transactional methods, they are widely used due to the availability of data required for their application.

For example, indicators of operating profit, such as gross profit or profit before taxation, can be extracted from the financial statements of companies or other publicly available sources of information.

1. Transactional Net Margin Method (TNMM)

This method is based on comparing the profitability of costs, sales, and assets of the controlled party in the controlled transaction with the corresponding profitability indicators assuming independence and applying market prices. This method is applicable when one party bears a unique functional burden in the transaction, while the other party does not contribute to the operation, incur costs, or make decisions. In this case, the second company is the tested party.

When selecting a specific profitability indicator, the nature of the business activity, functions performed, assets used, and economic risks assumed are considered. It is also important to ensure the completeness, reliability, and comparability of data for calculating the corresponding profitability and justify the economic rationale for the chosen indicator.

2. Profit Split Method

This method is based on the allocation of the total profit between the associated parties to the controlled transaction according to their unique contributions in terms of functions and assets. In this method, the total profit of all parties derived from the transaction is considered as the sum of the operating profit for the analyzed period. When using this method, if the unique contribution cannot be compared to the contribution of independent parties under comparable conditions (e.g., in the case of transfer of developed intangible assets and rights thereto) and it is a key factor related to the generation of economic profit in business operations, such contribution is considered unique.

The objective of the profit split method is to ensure that the profits of associated companies correspond to the value of their contributions and the compensation they would receive under comparable conditions if they were independent parties. This method helps establish a fair distribution of profits between associated parties and prevent potential distortions in profit resulting from controlled transactions.

SOME ASPECTS OF TRANSFER PRICING METHODS APPLICATION

When choosing a transfer pricing analysis method, a key factor is the availability of reliable information and the ability to compare the conditions of the controlled transaction with those of a comparable transaction between independent parties. In complex situations where no single method can be sufficiently persuasive, companies may apply a combination of methods.

Countries can establish a mandatory order of priority for methods at the legislative level. This helps ensure consistency and fairness in assessing pricing between related parties.

Transfer pricing is an important component of the global economy and requires strict compliance with international principles and rules. Companies must exercise caution when determining the transfer price to avoid violating legislation and international standards. Adhering to transfer pricing principles allows for a fair distribution of income and tax obligations among related parties in different jurisdictions.

[1] OECD. Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, January 2022. URL: https://read.oecd-ilibrary.org/taxation/oecd-transfer-pricing-guidelines-for-multinational-enterprises-and-tax-administrations-2022_0e655865-en#page1. Accessed: July 19, 2023.