Transfer Pricing | Concept, Purpose and Importance

What is Transfer Pricing?

Transfer Pricing can be defined as the determination of the cost of transactions of goods and services between two related companies owned and/or operated by the same parent company, often across international borders. Companies often use transfer pricing to avail themselves of tax benefits. Multinational companies avail the benefits of different tax regimes by practising transfer pricing. The main objective of transfer pricing is deciding the transaction costs of these intra-group transactions. Transfer Pricing undertakes the concept of the Arm’s Length Principle.

Geeky Takeaways:

• Transfer Pricing matters because it directly affects the allocation of profits, tax liabilities, and revenue collection.
• Companies avail benefits by using different tax regimes when they practice transfer pricing.
• Transfer Pricing ensures the applicability of the Arm’s Length Principle.

What is Arm’s Length Principle?

Arm’s Length Principle is the principle practised under transfer pricing, which ensures that the cost of transactions between the related entities is determined with the assumption that they are unrelated entities, to ensure the fair profit allocation between entities. The Arm’s Length Principle is defined by the United Nations and the Organisation of Economic Co-operation and Development (OECD).

Purpose of Transfer Pricing

1. Determination of Transaction Costs: The main purpose of transfer pricing is to determine the transaction costs of goods, services, rights, intellectual property, etc., between different entities of the same parent company, generally across borders, to avail tax benefits.

2. Reduction of Overall Tax Burden: MNCs try to reduce the overall tax burden by dividing the profits between their subsidiary companies. Profit shifting happens from the highly taxed countries to the comparatively lower-taxed countries.

3. Consideration of Market Price: Transaction costs are determined in accordance with the market price to avoid confusion between entities.

4. Financial Reporting: Transfer Pricing is also helpful for true and fair financial reporting of transactions between entities of the same parent company.

Importance of Transfer Pricing

1. Profit Optimisation: Proper transfer pricing allows MNCs to allocate their profits efficiently among their various subsidiaries. By setting fair practices for intra-group transactions they can optimise their global tax liabilities, avoiding overpayment and underpayment of taxes.

2. Risk Mitigation: Complying with transfer pricing regulations helps businesses avoid costly disputes with tax authorities. This in turn reduces the risk of penalties, interest charges, and reputational damage.

3. Global Expansion: Transfer Pricing considerations are crucial when expanding into new markets. Businesses need to follow local tax regulations and transfer pricing rules to ensure a smooth entry and avoid tax-related obstacles.

4. Internals Performance Evaluation: Transfer Pricing serves as an internal performance evaluation tool. It enables MNCs to assess the profitability and performance of individual business units, which can give information about every aspect of performance.

5. Transfer of Intellectual Property: Many MNCs held valuable intellectual property, such as patents and trademarks. Proper Transfer Pricing ensures that the entity is getting benefits from intellectual property and tax benefits from the same.

Issues Related to Transfer Pricing

Although transfer pricing helps in an overall reduction of tax reduction, it comes with certain issues. Issues related to transfer pricing are majorly divided into three subcategories namely, Jurisdiction issues, Allocation issues, and Valuation issues. These three are explained below:

1. Jurisdictional Issues: Transfer Pricing helps in the determination of the tax base of the respective countries of different entities that are involved in cross-border transactions. The multinational company as a whole, along with both the governments (say government of country A and country B) are included while considering the cross-border tax. When the government of one country (say country A) taxes the transactions of the MNC, it will affect the tax base of another country (say country B) as well. Basic jurisdictional issues involve the decisions,

• Which government should tax the transactions? and what if the government of both countries claims the same?
• If the tax base of one country rises, should the government of another country give relief to transactions to reduce the tax burden?
• What is the effect of imputation tax benefits in the parent company’s country of residence?

2. Allocation Issues: Government demands an optimal and clear allocation of resources among various entities of an MNC to calculate tax. These entities may enter into a tug-of-war situation to get the resources to increase the tax base of the respective country. Intangible and service-related should not be just allocated to save tax, as these items are a source of competitive advantage and need a proper watch.

3. Valuation Issues: Valuation issues undertake the methods and rules of valuing the revenues and expenses within the entities of MNCs, where there is a conflict of interest from the side of the government. Sometimes, there arises a tension between the goals of MNC and the overall economic and social goals of the country. The entities try to maximise their profits and minimise their tax burden by staying within the boundaries only which have been set by the government of the respective nation. These lead to clashes between the goals of MNCs, and the overall social, economic, and political goals of the nation.