Transfer Pricing (#376)
/The Nature of Transfer Pricing
Transfer pricing refers to the prices at which assets are transferred between related businesses within a multi-national business. So for example, let’s say that you have a cell phone manufacturer that produces computer chips in South Korea, and then inserts the chips into phones that are assembled in Vietnam, with the phones then being sold in India. Which, in case you’re curious, is exactly what Samsung does.
The manufacturer has to set a transfer price at which it sells the chips made by its South Korean subsidiary to its Vietnam subsidiary. When setting this price, the number one decision is how you want to allocate profits between the subsidiaries. If South Korea has a higher corporate tax rate, then it makes sense to set a low price for its chips, so that the South Korean subsidiary reports a very low profit, and maybe no profit at all. That way, the income tax paid will be very low.
Meanwhile, the Vietnam subsidiary, which is subject to a lower tax rate, is buying chips for a low price, and so reports much higher profits. The result of this price setting is that the parent company, overall, is paying a lower tax rate.
Now, of course, if companies did this all the time, then the countries that impose higher corporate tax rates would never collect any money from their multi-nationals, since reported profits are all being shifted elsewhere. Which is why the national tax authorities impose what’s called the arm’s length principle, which states that a transfer price should be similar to what unrelated parties would agree upon in a free market. Well, that’s nice, but how does a government prove that a company is following the arm’s length principle? There are a bunch of ways.
Transfer Pricing Documents
First, most countries requires businesses to submit a set of transfer pricing documents. The names of these documents may differ by country, but there’s usually a master file, which contains the organizational structure and operations of the business, as well as its transfer pricing policies, and how it allocates income across jurisdictions. The master file helps tax authorities get a big picture view of an organization’s operations.
Next, there’s the local file. This contains country-specific details on intercompany transactions, and how the business justifies its transfer pricing.
It contains information about the nature and value of related-party transactions, and identifies who those parties are. It also identifies the transfer pricing methodology used, and why it was used. We’ll get into transfer pricing methodologies in a minute. The reason for this report is to give tax authorities a clear view of how profits are being allocated within their jurisdictions.
And finally, there’s the country-by-country report. This contains a breakdown of revenues, profits, taxes paid, and economic activity by country. Its useful for comparing recognized profit to the activity level in each jurisdiction; if there’s a high activity level but a low recognized profit, there’s a good chance that the government will be asking some questions.
All three of these reports are usually issued annually.
Advance Pricing Agreements
So far, this reporting is fairly passive. The business prepares it and sends it to the government in which it has operations. What does the government do with it? One option is the advance pricing agreement, or APA. This is a formal agreement between the business and the government that states in advance the transfer pricing methodology that the business is going to use, so that there are no surprises. In essence, both parties agree on what’s going to be a fair approach, and which transactions it’s going to apply to. These agreements are usually good for somewhere in the range of three to five years, and may be rolled forward without too much additional discussion.
A business might enter into an APA with just one government, which is called a unilateral APA, or it could enter into the agreement with several countries at once, which is called a multilateral APA. The advantage of having a multilateral one is that all parties agree on the pricing arrangement, which helps to avoid any disputes between the parties.
A further benefit of an APA is that a business is at less risk of being targeted by a government audit. These audits examine whether a company’s transfer prices are reasonable. If the government finds any evidence of accounting inconsistencies or manipulation, then the business is going to be hit with penalties and interest. Some countries impose double taxation on these adjustments, so they can be a really big deal.
General Anti-Avoidance Rules
Now, some organizations can get into some serious tax avoidance strategies that are technically legal, but which go against the nature of the underlying transactions. Governments deal with these situations using what are called general anti-avoidance rules. These rules give tax authorities the power to override tax arrangements that are primarily designed to avoid taxes, and which lack genuine economic substance.
For example, let’s get back to that cell phone manufacturer. Let’s say that it sets up a subsidiary in a zero-tax jurisdiction with no employees or assets, and it routes most of its profits there through some complicated transfer pricing arrangements. Even if those prices seem justifiable on paper, tax authorities could say that the structure has no real business purpose other than avoiding taxes. Therefore, the tax people can ignore it and tax the company as if the income was earned elsewhere.
Transfer Pricing Methods
And, as I mentioned earlier, there are different approaches to transfer pricing – I’ll give you a quick summary of the main methods. There is the cost plus method, in which a subsidiary is allowed to add a markup to the costs that it has incurred, which results in a transfer price. Next up is the profit split method, which allocates the combined profits from the entire value chain to each subsidiary, based on each entity’s contribution to the final product. And then there’s the resale price method, which starts with the resale price at which a product could be resold to an independent third party, and then subtracts the gross margin that an independent reseller would earn to arrive at the transfer price.
Another option is the comparable uncontrolled price method, which compares the price charged between subsidiaries to the price charged to an outside party, to see if it’s reasonable. And finally, we have the transactional net margin method, which sets up a net profit margin relative to the most appropriate base, such as revenues, expenses, or assets related to an inter-company transfer.
I’m not going to explain the details for each of these methods – the point is merely to point out that there are a lot of ways to develop transfer prices, all of which are legitimate, and which can result in differing amounts of profits being recognized in each subsidiary of a multi-national company. So, given the number of options available, it should be no surprise that accountants pay a lot of attention to transfer pricing, and negotiating with governments to get their favored approaches accepted. Which could result in millions of dollars of tax savings.
The Transfer Pricing Career Path
One last item - the career path for an accountant working in this area. First, it’s a good niche to be in, both from the perspective of the company accountant and the government auditor, because both of them can positively impact the cash flows of their employers.
A company accountant can get into this profession by concentrating on cost accounting, while the path for a government auditor also includes cost accounting, but in addition, spending some time as either an internal auditor or as a public accountant, in order to gain experience with auditing work.
And one word of warning; this is a niche area, so you may have trouble getting promoted out of this field, on the grounds that you’re too valuable within it.