What is Transfer Pricing?

In the tax laws of most countries is a rule that governs the price of any transfers of goods or services between related companies. It requires that the price of such transfers (i.e. transfer price) be "arm's length". This is referred to as the arm's length condition. Absent the arm's length condition, companies could use arbitrary prices for any transfers of goods and services between group companies.

So what requirement does the arm's length condition impose, specifically? At least in parlance, the requirement is straightforward: the price of any transfer of goods or service between related parties should be at the price that would have been established if the parties were unrelated (the arm's length price).

Could we look to market prices of similar exchanges between arm's length buyers and sellers? Yes we could, in theory. And we do, in practice - when we can. But market-based evidence is not always easy to come by as most transaction terms are private. Furthermore, the nature of some transaction between related parties are truly unique i.e. similar transactions don't occur amongst arm's length companies.

For example, there are a limited number of companies which provide contract R&D services for drug discovery to pharmaceutical companies. When they exist, such services are provided by not-for-profit entities such as large public universities and the underlying terms of the arrangement may not always be available. Even if they are, the terms of exchange are not motivated purely by commercial interests and hence not economically comparable to a purportedly commercial transaction being analyzed between related parties . Yet, contract R&D service arrangements for drug discovery are a fairly common type of intercompany transaction within large pharmaceutical companies.

Much like the famed gordian knot, the arm's length price appears from the distance as a readily solvable problem, but it is in the solving that its underlying complexity often emerges.

Perhaps its easier to determine when the transfer price is not arm's length. An obviously flawed policy would be to set a transfer price below the cost of production as no independent supplier would agree to such an arrangement on a long-term basis. Another would be to pay a related contract manufacturer of steel ingots significantly more than the prevailing market prices as no independent buyer would pay significantly in excess of market prices for a commodity that it could easily procure from unrelated suppliers. We discuss this in more detail in the last two sections.

But here is the great enigma of the arm's length price: it is typically not a single price. It is, in fact, a set of prices each of which could be supported as being arm's length. Hence, a typical transfer pricing study will determine a range of prices that are arm's length (or the arm's length range) and then conclude whether the specific transfer price being analyzed falls within the arm's length range (and serendipitously it usually does).

For example, Company A sells light sabers to a non arm's length company (i.e. related) Company B for distribution to aspiring jedis. The cost of manufacturing light sabers is $10 and is comprised of the cost of plasma blades, assembly and various royalties. Company B generally retails the light sabers for $50 but incurs additional costs of $20 to maintain a retail space and related overheads, including "gratuities" to the storm troopers. Company A hires Yoda Economic Advisors (Yoda Advisors) to divine the arm's length price for the sale of light sabers to Company B.

After several weeks of study and analysis, Yoda Advisors gives the following cryptic advice: "Between $15 and $20 the arm's length price is."

Company A runs a few simulations. If the transfer price is set at $20, the operating profit of Company A is $10 per saber while that of Company B is $10. The corporate rate of income tax of Company A is 20 percent and of Company B is 10 percent. So Company A pays corporate tax of $2 and Company B pays $1 per saber. Collectively Company A and Company B pay $3 on combined economic profit of $20 per saber which equates to an effective rate of tax of 15 percent.

Alternatively, if the transfer price is set at $15 (also arm's length), Company A pays a corporate tax of $1 and Company B pays $1.5. Hence collectively Company A and Company B pay $2.5 in income taxes (lower by 50 cents) which produces an effective rate of tax of 12.5 percent (lower by 2.5 percent).

So a typical MNE group with sufficient financial resources can engage advisors to develop an arm's length range of prices and then select a price within the range that satisfies the statutory transfer pricing requirement. But in so doing, the company is also able to reduce its tax burden if the arm's length range is wide enough to allow a significant shifting of income from one jurisdiction to another. The right of a taxpayer to reduce its overall tax burden legally has been accepted since 1936 when the Duke of Westminster vs Inland Revenue Commissioner (United Kingdom) was decided by the House of Lords.

This creates an interesting question for the Board of a large Multinational: should the company hold itself accountable only to the letter of the tax law (as legislated) or some higher ideal of its obligations to society? But which society? And who defines those ideals?

Because transfer pricing is the most effective mechanism of achieving a desired financial result due to its inherent subjectivity, it has been a highly publicized topic in recent years when companies are increasingly being held to account on their ESG policies. Separately, transfer pricing has also been the target of anti-trust agencies. The European Union (EU) has been vocal in attacking transfer pricing as an enabler of uncompetitive market practices. Large multinational companies can afford to implement and defend aggressive tax structures and reduce their overall operating costs through lower taxes, gaining an unfair advantage over smaller domestic rivals.

Apart from conflicts that arise due to deliberate acts of tax avoidance, one could argue that there is, at times, an honest disconnect between the theoretical view of how transfer pricing laws expect companies to behave and how they actually behave in practice.

In the transfer pricing/tax view of the world, a multinational (MNE) group is seen as a collection of autonomous constituent companies (or branches) seeking to maximize their individual economic profits (as opposed to the group's profits). In this world view, these individual entities situated within a multinational group's supply chain create an economic output (benefit) for the group and then negotiate a fair price for the output from the group (the arm’s length price). The difference between the arm's length price and the costs of production represents economic profit (or value created) of the isolated entity and which is subject to taxation in the country in which the entity is domiciled.

In practice, however, decision-making in MNE Groups is a centralized process involving the executive leadership, and the governing board of directors which represent the interests of the shareholders. While some limited agency may still be available to the leadership of regional subsidiaries, the reality is that a lot of the value that the MNE Group generates is precisely because of its ability to operate as a unified perfectly-coordinated global organization instead of a collection of independent chiefdoms competing for their own interests.

Good transfer pricing policies therefore need to impute a degree of independence and agency between the transacting companies to ensure that each transacting party would be independently willing to participate in the transaction under the proposed terms notwithstanding its existential link to the group.

Why Transfer Pricing Laws Are Needed?

Because market forces do not influence the terms of transactions between affiliated/related companies, intercompany prices can be set arbitrarily to favor one transacting party over another. Consequently, the disadvantaged company will generate a lower level of taxable income than it would have had it been dealing with the affiliate on an arm’s length basis.

Multinational companies, therefore, have a natural incentive to price intercompany transactions across their supply chains in a manner that generates higher profits in low-tax jurisdictions, and lower profits (or losses) in high-tax jurisdictions. This can create inequities in the share of the tax revenues collected by countries with relatively higher rates of corporate tax.

To curb such arbitrary reassignment of profits, transfer pricing laws were introduced from as far back as the 1930s. In a simpler world, all countries would use the same rate of corporate taxation, and this would eliminate incentives for artificially shifting profits through non arm’s length transfer prices. While the rationale for having transfer pricing legislation is straightforward in theory, its application can be challenging – both for the tax authorities and companies.

Companies in technology and life sciences sectors have significant cash flows attached to assets which are both valuable and portable (such as patents and trademarks). Until recently, companies could transfer valuable intangibles such as provisional drug patents from one group company to another for a nominal consideration (development costs), shifting a sizeable portion of their future global income to the transferee with the stroke of a pen. Governments and their tax agencies, on the other hand, armed with transfer pricing laws, have been equally aggressive in clawing back additional taxable income into their jurisdictions to fill depleted coffers, targeting good and bad actors alike.

In a high-profile Canadian transfer pricing case Cameco Corporation vs Her Majesty the Queen the defendant, Cameco, a uranium mining company headquartered in Saskatchewan, stood at the receiving end of the Canada Revenue Agency which presented it with a transfer pricing adjustment and associated penalties of nearly half a billion dollars - sufficient to trigger a bankruptcy or force significant layoffs. The case was eventually dismissed by the Supreme Court of Canada and Cameco lived to tell the tale from atop a throne of legal bills.

Challenges to Developing Transfer Pricing Legislation

Generally, transfer pricing laws are a subsection of the income tax laws of countries and are triggered when certain conditions pertaining to intercompany transactions are met. Some countries, however, prefer to use broad anti-avoidance statutes instead of more specific transfer pricing laws to curb profit shifting.

In the United States, transfer pricing rules are in Section 482 of the US Internal Revenue Code, in Canada in Section 247 of the Income Tax Act, while in the United Arab Emirates, Article 34 of the Federal Decree Law No 47 of 2022 contains the first iteration of transfer pricing laws as part of a broader legislation introducing corporate income tax in the UAE.

When applicable, transfer pricing rules will supersede broad anti-avoidance rules to reassess the terms of the intercompany transactions. In some jurisdictions which don’t have dedicated transfer pricing legislation and their anti-avoidance statues are too narrow in scope to apply on most intercompany transactions, transfer pricing adjustments and penalties may still be triggered through the invocation of tax treaties between countries.

The State of Libya and the Bailiwick of Guernsey (a self-governing territory of the British Commonwealth), for example, have no transfer pricing rules in their domestic tax laws. But as these jurisdictions have signed various international tax treaties with countries that do have transfer pricing legislation, for example the United Kingdom, any cross-border transaction involving a Libyan subsidiary of a British parent, or vice versa, will implicitly pass on the transfer pricing rules of the conforming jurisdiction on the local taxpayer.

Countries have sovereignty over organizing their tax laws and tax rates (including the corporate income tax rate). Each country will individually interpret the arm’s length principle and its overall spirit (or purpose). The general purpose of the transfer pricing law becomes relevant when transfer pricing controversies between a taxpayer and a tax authority need to be resolved by the courts. When the statutory meaning of the laws as written is not clear, arriving at an equitable judgement requires an understanding of the societal goal or purpose of the law’s existence. It also influences the level of scrutiny to which a taxpayer is subjected and whether the burden of proof in challenging a transfer pricing policy falls on the tax authority or the taxpayer.

Transfer pricing laws need to take into account the right balance between the desire of tax authorities to minimize opportunities for tax avoidance and the ability of foreign and local businesses to do business in the country without an undue compliance burden. To minimize the compliance burden, some countries will allow de minimis exemptions to transfer pricing laws below a certain threshold of value (e.g., in Canada, transactions below $ 1 million are not subject to transfer pricing audits).

As with any body of laws, there can be a tension or inconsistencies between laws belonging to different parts of the commercial and civil codes that govern the conduct of companies. Transfer pricing laws also sometimes conflict with other laws. Traditionally, a common area of conflict has been the consideration given to contracts between associated companies when assessing the appropriateness of their transfer pricing policies. Should the terms and conditions implied by commercial contracts be accepted prime facie in determining an arm’s length price? The contractual terms and conditions (other than price) represent legally binding obligations of the parties but may not align with the actual conduct of the parties. For example, a contract between affiliates, Company A and Company B, specifies that Company A will provide Company B with IT, HR, and Marketing support for a fee of €10,000 annually. Upon closer examination it is found that during the current fiscal period Company A only provided HR and Marketing support and no IT support. Should the transfer price of €10,000 be analyzed in the context of all three support functions—which Company A is legally obliged to provide and which Company B can also enforce performance of? Or should it just reflect the two support activities that were actually provided by Company A to Company B?

For several years, tax courts of various countries had differing opinions on whether they should defer to the stipulated terms of bonafide contracts. On the one hand, the legal obligations of the parties need to be respected as a matter of upholding legal contracts. On the other, when companies violate the stated terms of the contract, combined with the remote possibility of either party invoking the performance provisions within the contract, should the underlying purpose of the transfer pricing law (to prevent profit shifting) override the purpose of contract law- in this specific case? Canadian courts have generally respected the language of the contracts unless there was overwhelming evidence of fraud. The US courts, on the other hand, have disregarded the legal terms and conditions in favour of the true terms and conditions as evidenced by the actual conduct of the parties.

These conflicting viewpoints were finally reconciled through intervention by the Organization for Economic Co-operation and Development (OECD) which provides periodic guidance on transfer pricing matters. In its 2017 edition of the OECD Transfer Pricing Guidelines, the OECD affirmed that legal contracts between affiliated parties should be disregarded if they conflict with the economic substance of intercompany transactions.

Role of Policy Think-Tanks

To aid in the development of transfer pricing legislation and to ensure that the laws enacted by countries reconcile with each other, there is a significant amount of continuous guidance on transfer pricing matters provided by policy think-tanks, most prominently by the Organization for Economic Co-operation and Development (OECD), and the United Nations. Other think-tanks that contribute to this area include the European Commission, the World Bank, and the International Monetary Fund (IMF).

These institutions produce guidelines (updated periodically) that represent their views on the appropriate economic framework for determining arm’s length prices. Countries can choose (but are not obligated) to reflect this guidance when developing their transfer pricing laws.

Most countries have chosen to develop their laws in accordance with and with specific reference to the guidelines endorsed by at least one of these institutions, most commonly the OECD Transfer Pricing Guidelines. The rationale for this is two-fold. First, it is efficient: it does not require writing several hundred pages of regulations that provide detailed guidance on how to apply the arm’s length principle in very specific situations. Second, it reduces conflict between two tax authorities challenging the same transaction based on their specific interpretation of an arm’s length price – almost by definition the transfer price needs to satisfy the transfer pricing laws of two or more tax regimes (e.g., the transfer pricing laws governing the buyer and the seller).

The United Kingdom’s Taxation Act (2010) specifically decrees that its transfer pricing statutes be interpreted in accordance with the OECD Transfer Pricing Guidelines and difficulties in legal interpretation of statutory meaning be resolved by reading them in the context of these guidelines. The United States is an exception in that it does not openly endorse any specific set of guidelines, choosing instead to produce very detailed regulations that accompany its transfer pricing laws.

Transfer Pricing Framework

While the guidance offered by the IMF, World Bank and the United Nations is very similar to the OECD, we will discuss the transfer pricing frameworks specifically adopted by the OECD in its most recent guidance released in February 2022. The foundational ideas are common across all frameworks although some differences exist pertaining to applications in specific situations.

The transfer pricing framework involves two sets of analyses:
Step 1. Assessing a transaction in the context of five factors that are deemed to influence an arm’s length price (referred to as Transaction Delineation or Factors of Comparability)
Step 2. Determining the arm’s length price of the transaction (once appropriately delineated) using one of five available transfer pricing methods.

Step 1: Factors of Comparability Analysis

This general framework can feel self-evident and tedious but still serves as an important anchor for the line of inquiry (OECD TP Guidelines 1.36). Specifically, the framework considers five factors that influence prices amongst arm’s length actors.

a. The arm’s length price is influenced by the nature of the underlying product or service being exchanged i.e., the price of a 100-gram bar of chocolate should be referenced against the price of a bar of chocolate of equal quality and not a banana-nut cupcake.

b. It will also depend on the terms and conditions of the intercompany transaction e.g., whether product delivery is included in the terms of sale, the payment terms, and any after-sale support. These terms may be specified in a legal agreement or inferred based on the interactions of the buyer and the seller.

c. The value created by a seller or service provider comes from three primary factors of production: the functions (or activities) it performs, the assets (tangible and intangible) that it contributes and the risks it assumes.

For example, if Company A sells a 100-gram bar of chocolate to an affiliate Company B for distribution to retailers, the activities performed by Company A include (a) procurement of premium cocoa beans, (b) cooking of the ingredients, (c) cutting up the batch of chocolate into nicely cut 100-gram pieces with an impression of the company monogram, (d) wrapping bars into glossy packets with proprietary trademarks and tradenames printed on the sleeve, and (e) transporting finished batches to Company B’s warehouse. The assets contributed in this endeavor include the use of confectionary equipment and preparation facilities, and proprietary marks and names and their associated brand value (intangible assets). The risks assumed by Company A include the operational risks (not being able to successfully produce an edible chocolate batch), legal risks (the potential for being sued by the end consumer), and counterparty risk (the risk of not receiving payment from Company B as promised within 90 days of delivery).

Functions are also performed, assets are also employed, and risks are also assumed by Company B in its capacity as the wholesale purchaser and distributor to the retail chains. However, the general principle is that the more significant the activities performed, the greater the risks assumed, and the more assets employed, the greater should be the relative share of the overall profit generated collectively by Company A and Company B and the transfer price attached to the sale of chocolate bars by Company A to Company B should result in financial outcomes (or profits) that respect this economic logic.

The first three conditions involve an examination of conditions that are objective and generally observable. The remaining conditions involve a degree of subjectivity. The transfer price should also reflect:

d. The economic circumstances of the parties and the market in which the parties operate. For example, staying with the chocolate bar analogy, the price of a 100 gram of chocolate bar will depend, in addition to the first three conditions, the local dynamics of the market in which the transaction takes place. The same bar of chocolate may fetch a higher price in a market where it is perceived as a novelty item and therefore priced at a premium but a lower price in a different market where consumers are more health conscious and prefer healthier alternatives. In addition, the transfer price will also be influenced by the circumstances of the transacting parties. If the seller (Company A) is facing financial distress, its negotiation strength will be compromised, and it would be willing to accept a lower price than another vendor selling an identical product in the same market.

e. The business strategies pursued by the parties. The classic example is that of a seller trying to break into a new market by selling products at a deep discount (known as dumping) to gain a foothold in the market. In such circumstances, the price it would be willing to accept maybe even lower than the cost of production, resulting in short-term losses for the seller. Notwithstanding, the seller is still viewed as a rational agent driven by a motive to generate profits in the long-term (even if they generate losses in the short-term) and the transfer prices should reflect this principle over the longer term.

The last two conditions rely on the intent of the transacting parties (or its management) and can, at times, be highly subjective factors of consideration.

Step 2: Applying Transfer Pricing Methods

Once the transaction is correctly understood in the context of the relevant factors i.e. we have identified all the relevant factors that could influence the price of the underlying good or service, the framework then provides five methods for determining (or testing) the transfer price against the arm’s length standard.

1. CUP Method: This tends to be the easiest to understand and the most intuitive. The arm’s length price of a good or service should be determined based on the prevailing market price of a similar good or service. For example, the price of a 100-gram bar of chocolate should be determined based on prevailing prices of similar bars of the chocolate observable in the market with appropriate adjustments for any differences that may affect price. For example, the observable price of a 200-gram bar of chocolate sold by Company A to an arm’s length buyer or a sale between external arm’s length buyers may be used to determine the transfer price of the 100-gram chocolate bar by adjusting for differences in quantity.

2. Resale Price Method: This method is applied in specific cases involving the purchase of tangible goods for distribution by reference to a Resale Price Margin. For example, if we have available to us the prices at which a distributor buys and sells a similar product, we can deduce the margin earned by that distributor and determine an arm’s length price through some reverse engineering. Let’s assume that we can observe the prices at which an unaffiliated distributor of cupcakes buys and sells cupcakes. Cupcakes are bought from a manufacturer at €1 and sold to retailers at €2, resulting in a resale margin of 50 percent. We can then use this margin to arrive at the transfer price between Company A and Company B for the chocolate bar. If Company B sells the chocolate bar to a retailer at €1/bar we can work back to the arm’s length transfer price of €0.50 between Company A and Company B such that Company B (the distributor) also earns a resale margin of 50 percent.

3. Cost Plus Method (CPM): The Cost-Plus Method (CPM) tries to determine the arm’s length price by targeting a profit margin for the seller over its costs of production. The transfer price can be determined by aggregating the cost of production of Company A (cocoa beans, sugar, butter, labour, rent, depreciation of confectionary equipment) and applying a mark-up over those costs. Let’s assume that the combined cost of production was €20,000 for 80,000 bars which equates to a per unit production cost of €0.25. For simplicity, we will assume that production costs are primarily variable in nature and the average cost per bar reflects the marginal cost of every unit produced. To arrive at the arm’s length price, we need to apply a markup to the per unit production cost of each bar of chocolate (€0.25). The markup is referenced to margins earned on similar activities (based on a comparison of functions, assets, and risks). If we have available to us the production margins earned by a cake-manufacturer over its cost of production, we can use the implied mark-up to arrive at the transfer price for each bar of chocolate. If the cake manufacturer generates sales of €100,000 and its cost of production was €80,000 (excluding SG&A costs), the implied markup would be 25 percent (€20,000 profit over €80,000 of production costs). We apply this mark-up of 25 percent to the cost of production of each bar of chocolate of €0.25 to arrive at an arm’s length price of €0.31 per bar.

4. Transactional Net Margin Method (TNMM): The TNMM is very similar to the Cost-Plus Method except that instead of targeting a markup over costs of production, it targets a net profit margin over all operating costs (including overheads). Typically, the comparable net profit margins are based on the financial statements of public companies that are engaged in a similar type of activity as the transaction being analyzed.

5. Profit Split Methods: These methods are reserved for transaction that involve heavy use of intangibles which contribute significantly to the underlying product or service and the intangibles involved have been developed collectively by two (or more) transacting parties. Furthermore, these intangibles are unique such that the other four methods cannot be applied due to unavailability of sufficiently comparable data.

In our reference case, we could imagine that the chocolate bar now involves proprietary know-how and ingredients (developed by Company A) and is marketed as a gluten-free product with appropriate certifications obtained by the distributor (Company B). The value chain of chocolate bar production process is now more complex-it now contains the use of critical intangibles which contribute significantly to the value that is created (profits earned). A certified gluten-free bar of chocolate would likely fetch a retail price significantly higher than its generic equivalent sold by Company B to retailers at €2. Let’s assume that through intelligent marketing, Company B can sell each bar for €4. If the cost of production and distribution have remained €0.25 per bar, the company has collectively created an additional €2 of value using unique intangibles and successfully targeting a niche market through strategic product development and positioning. This excess value now needs to be shared amongst the contributing agents through an arm’s length transfer price that captures those unique contributions.

The profit split method splits the excess value created through shared intangibles across the contributing members. In our case, the excess value (or supra-normal profit) of €2 can be shared between Company A and Company B by assessing the relative contributions made by each party towards the portfolio of know-how, certifications, and trade intangibles that generates the excess return. The relative contributions can be measured based on costs incurred by each participant or the estimated market value of the intangibles contributed (if that is determinable).

The profit-split method is only applied in very special situations and its application involves a high degree of subjectivity in identifying the appropriate intangibles involved, establishing economic and/or legal ownership of those intangibles, and, most significantly, assessing the relative value of these contributions towards the excess value created.

The United States recommends a different set of methods that are similar in their application to the five methods proposed by the OECD. However, the US regulations provide more granular approaches to testing specific transaction types such as services transactions and transactions involving the use of intangibles.

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