Transfer pricing means pricing transactions between companies belonging to the same group i.e. related parties.
Pricing of intra-group transactions are not usually determined by normal market behaviour. Therefore, pricing is often different than what it would have been if an equivalent transaction had been made between unrelated parties in the equivalent circumstances. Pricing transactions rightly is central when ensuring that the income is collected by the right companies and hence also to the right countries. Especially in intra-group cross-border transactions the meaning of transfer pricing is significant because countries want to protect their tax revenue. Because of the mentioned reasons authorities throughout the world have started to pay more attention to transfer pricing. Therefore, it’s advisable to review transfer pricing questions from early stage on, such as choosing tax efficient and reasonable operations model and transfer pricing method, defining and testing prices and reviewing documentation requirements.
Arm’s length principle
To ensure that transactions are priced rightly transfer pricing needs to be at arm’s length i.e. based on the arm’s length principle. Arm’s length principle means in practice that the terms and conditions of intra-group transactions need to be equivalent to what independent parties would have agreed on. If transfer pricing isn’t at arm’s length, the tax authorities may adjust tax assessment. Arm’s length principle and generally transfer pricing rules are mainly based on OECD Transfer Pricing Guidelines, which means that similar principles are applied nearly worldwide.
The aim of the arm’s length principle is to ensure that income and costs are accumulated to the right companies and especially that the income is accumulated to the right country and taxes are paid in the right country. The arm’s length principle applies also to cross-border dealings between a company and its permanent establishment. To control the application of the arm’s length principle the tax payer may be subject to transfer pricing documentation requirements concerning transactions where the other party is foreign if certain thresholds are exceeded.
Transfer pricing in practice
In practice for transfer pricing to be at arm’s length the most appropriate transfer pricing method for the group’s business should be selected. Selecting the appropriate transfer pricing method requires understanding the value chain, business model and the circumstances where the transactions take place. The OECD Transfer Pricing Guidelines include transfer pricing methods applicable in different situations. It needs to be taken into account that pricing of intra-group transactions doesn’t have to follow any of the methods in the OECD Transfer Pricing Guidelines. Then again, if the pricing of transactions is challenged in taxation, taxpayer needs to show why the chosen method is better compared to the methods in the OECD Transfer Pricing Guidelines.
Transfer pricing starts with identifying and recognizing the intra-group transactions and carrying out functional analysis. In functional analysis the following questions are reviewed: the circumstances where the business is carried on, the nature of the business, the way how it’s carried on and by which company the value is created. The focus is on the functions performed, risks assumed and assets used by the parties of the transactions. When the functions are recognized and the functional analysis is ready, the transactions still need to be compared to the equivalent transactions made by independent parties. This process is called the comparability analysis.
Our tax experts help with questions related to transfer pricing
We help our clients to build a tax effective transfer pricing model for the group, changing the model, evaluating the risks of the current model, going through the intra-group agreements, evaluating if the transactions are at arm’s length, drafting the transfer pricing documentation, pre-emptive discussions concerning transfer pricing, Advance Pricing Agreements (APA), appeals and rejoinders needed in transfer pricing disputes, Mutual Agreement Procedures (MAP) following transfer pricing tax audits or disputes and in other situations where adjusting transfer pricing is needed. Because of our Nexia network our customers have a worldwide group of experts, with the help of whom we can also review transfer pricing questions related to other countries and to compile searches for comparables.