What is transfer pricing?
Transfer pricing is the price that the related entities under common ownership decide upon for the internal exchange of goods, intangibles, resources or services. The term ‘transfer pricing’ is generally used in relation to multinational enterprises (MNEs) with multiple subsidiaries or divisions that can transfer tangible or intangible assets internally. To give an example, an MNE like Chevron Corporation has many subsidiaries – Texaco, Saudi Arabian Chevron Inc and Chevron Australia Pty Ltd, to name a few – all of which are able to transact with each other. In short, transfer pricing refers to the amount of money that is exchanged when two or more related company entities transact with each other.
If transfer pricing regulations were not in place, it would be possible for MNE groups to shift profits into no- or low-tax jurisdictions and artificially reduce the tax burden for their internal transactions. To stop this from happening and to help MNE groups determine reasonable transfer pricing, there are certain transfer pricing regulations and guidelines in place that companies can use for advice.
Transfer pricing regulations and guidelines
MNEs need to be sure that they are complying with international regulations on transfer pricing, such as the Organisation for Economic Co-operation and Development (OECD) base erosion and profit shifting (BEPS) initiative. The 2017 edition of the OECD Transfer Pricing Guidelines provides the latest practical advice about what MNEs must do in order to comply – for example, adhering to the arm’s length principle (outlined below). There are also official guidelines to help developing countries (e.g. South Africa, Brazil and Mexico) overcome the challenges associated with the lack of comparables data available for transfer pricing purposes and the accurate valuation of intangibles. They include: A Toolkit for Addressing Difficulties in Accessing Comparables Data for Transfer Pricing Analyses (released in 2017 by the Platform for Collaboration on Tax); and the United Nations Practical Manual on Transfer Pricing for Developing Countries (released in 2017).
The arm’s length principle
In order for MNEs to comply with international regulations and standards like the OECD BEPS, they need to meet the arm’s length principle when it comes to transfer pricing. The arm’s length principle is the condition that the price charged for a transaction between two related parties (e.g. Texaco and Chevron Australia Pty Ltd) must be equal to what it would have been should the transaction have occurred on the open market between two independent, unrelated parties. The arm’s length principle ensures that an MNE’s tax obligations cannot be lessened or avoided through strategic internal trading. With the rise of globalization, the implementation of the arm’s length principle to stop unjust transfer pricing practices is being recognized as essential by economists, politicians and the business community alike.
The concept of the development, enhancement, maintenance, protection and exploitation of intangibles (DEMPE) was introduced in the final Actions 8-10 report of the Transfer Pricing Aspects of Intangibles on October 5th 2015. It means that any parties within an MNE group that contribute to the value of intangibles by performing DEMPE functions, using assets or assuming risks should be fairly compensated. DEMPE is now an essential component of transfer pricing.
Transfer pricing example
In the below infographic, we outline how transfer pricing works for a corporation that is exchanging goods, intangibles, resources or services between itself and its Saudi Arabian and Australian entity. The MNE group needs to ensure that the prices it sets for the internal exchange of these goods, intangibles, resources or services between each of its entities is the same as it would have been had the transaction occurred between unrelated parties. It also needs to take into consider the parties that performed functions related to DEMPE. In order to achieve arm’s length transfer pricing, these parties should be compensated appropriately for their contributions.
Transfer pricing methods
There are two main categories of method to choose from for your transfer pricing analysis: 1) traditional transaction methods; and 2) transactional profit methods. Traditional transaction methods include the comparable uncontrolled price (CUP) method, the resale price method and the cost plus method. Transactional profit methods include the transactional net margin method and the transactional profit split method. According to the 2017 Transfer Pricing Guidelines, the selection of a transfer pricing method always aims at finding the most appropriate method for a particular case. For this purpose, the selection process should take account of the respective strengths and weaknesses of the OECD recognized methods; the appropriateness of the method considered in view of the nature of the controlled transaction, determined in particular through a functional analysis; the availability of reliable information (in particular on uncontrolled comparables) needed to apply the selected method and/or other methods; and the degree of comparability between controlled and uncontrolled transactions, including the reliability of comparability adjustments that may be needed to eliminate material differences between them.
A comparability analysis is a core component of the arm’s length principle. You must find high-quality comparables data that enables you to compare the conditions of your controlled transaction with those of a comparable transaction between independent parties under comparable circumstances. This includes identifying the commercial or financial relations between the associated enterprises and the conditions and economically relevant circumstances attaching to those relations in order that the controlled transaction is accurately delineated and comparing the conditions and economically relevant circumstances of the controlled transactions as accurately delineated with the conditions and the economically relevant circumstances of comparable transactions between independent enterprises. You can find the high-quality comparables data you need for your analysis within the RoyaltyRange database.
Transfer pricing benchmarking
RoyaltyRange can prepare you a Benchmarking Study that analyzes comparable agreements, including royalty rates, service fees and loans interest rates, to help you identify whether your internal company transactions adhere to the arm’s length principle. Our data is fully compliant with OECD BEPS guidelines.
Visit our page about Benchmarking Studies to find out more.
Transfer pricing documentation
We can prepare a full OECD-compliant transfer pricing documentation package for licensing transactions, which you can use for transfer pricing compliance and reporting. Our transfer pricing documentation includes an industry analysis, group and company analysis, description of the transaction, functional analysis, selection of method, Benchmarking Study and financial analysis.
In our insights section you can find out more about our transfer pricing documentation services and what analyses it includes.
We hope that this article sheds some light on what transfer pricing is and how you can comply with the regulations and guidelines. If you have any questions about how we can help with the data you need for your transfer pricing analysis, please contact us at RoyaltyRange today.
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