Transfer Pricing is Complex: Play it Straight to Avoid Financial and Reputational Risk
By Gianluca Queiroli, Director, Advisory Services
As businesses expand, they must sort out the complexities of transactions between divisions, subsidiaries and companies that are under the same ownership but operate in different tax jurisdictions. As entity make-ups become more complex and businesses span ever more jurisdictions, transfer pricing, determining the price charged for goods and services exchanged between these smaller entities, becomes more difficult. Here are a couple of simple lessons to orient yourself for this complicated task:
The ‘Arm’s Length’ Principle
In setting transfer prices, you will have to take into account several factors, including the rules in the jurisdictions involved and prevailing industry norms for marking up given goods or services. Over 60 governments have adopted transfer pricing rules, but most are based on a single standard, the “arm’s length” principle. In short, the principle means that you should price the transaction at the prevailing market rate, as if the two entities were two independent companies, under completely separate ownership. You should hold the other part of your enterprise at arm’s length or risk looking as thick as thieves.
Avoid the Dual Risks of Noncompliance
In recent years some firms have exploited the complexity of transfer pricing to pay fewer taxes, making it look on paper as if most of the value has been added in jurisdictions with low rates. For example the Caymanian subsidiary of Rip Van Auto, a hypothetical Dutch multinational, might buy automobiles manufactured by its Canadian subsidiary for a penny over cost. The Caymanian subsidiary could then sell the cars at a high markup to American automotive dealers. The cars would go straight to the U.S., but the books would show that much of the added value was created, and would therefore be taxed, in the Caymans, at a low(er) or no tax rate.
But tax authorities in many jurisdictions, including the U.S., Germany and India, have wised up and are cracking down on transfer pricing that eschews the arms-length principle in order to favorably shift tax burdens. And such tinkering can land you in financial trouble: many jurisdictions impose penalties when tax authorities have to step in and correct manipulated transfer pricing.
It also can carry a significant reputational risk. If U.S. companies shirk tax obligations at home, they risk earning the wrath of American taxpayers at a time when anemic growth and rising inequality make the subject of overseas tax havens especially sensitive. If they shirk tax obligations abroad, they risk charges of economic imperialism and exploiting host countries.
So, in most cases, you’ll want to stick with the arm’s length principle. And when in doubt, seek outside expertise.
See a graphic of the hypothetical distribution of tax liability for a global enterprise here
Want to learn more? You can read three important tips for avoiding common transfer pricing pitfalls here