Transfer pricing simply refers to the price that is charged in a transaction between two parties. However, aside from commercial considerations, transfer pricing is usually only of issue in respect of transactions between connected parties.
In the absence of tax rules to the contrary, groups would be able to organise their affairs via intercompany pricing so that, say, profits were made in low tax jurisdictions and losses were made in high tax jurisdictions even if this was not in accordance with economic reality. This is set out in the following example.
A and B are companies and are both members of the same multinational group. A makes household electrical goods which it sells to B which then sells the goods to the public. The cost to manufacture a single unit is £100 and the selling price to the public is £200 per unit. A is in a country in which profits are taxed at 35% whereas B is in a country where profits are taxed at 10%.
In the absence of transfer pricing rules, A could, for instance, sell to B at cost making no profit on the sale. B would then make a profit per unit sold of £100 and tax thereon to the group would be £10.
Transfer pricing rules act to prevent the artificial manipulation of profits. In essence, the rules state that connected parties should undertake transactions between themselves at “arm’s length”; being the price that would be charged for the same transaction between unconnected parties. This is demonstrated in the following example in which arm’s length transfer pricing is adopted.
The facts are the same as in example 1, with the exception that the arm’s length price for the sale of an electrical unit from A to B is determined to be £180 (for instance, A sells to a third-party distributor in the same country as B for this price). A and B apply arm’s length pricing in respect of transactions between themselves.
A therefore makes a profit of £80 per unit and B makes a profit of £20 per unit. Overall tax payable by the group per unit increases to £30 (£80 at 35% plus £20 at 10%).
In example 2, the transfer pricing rules have acted to prevent the potential artificial manipulation of profits between connected parties and this is all the rules seek to do. However, the way in which arm’s length pricing is determined in order to conform with the rules can be difficult to arrive at and is often subjective in nature – possible methodologies for setting acceptable transfer prices will be the subject of a future blog .