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Transfer Pricing is a method used to determine the payments between legal entities within a multinational corporation.

Transfer pricing is a contentious issue since it can appear to enable multinationals to artificially allocate profit to low-tax countries, thus reducing its tax bill.

In most Western countries, the directors of a corporation have the fiduciary duty to maximise shareholder returns, through revenue maximisation and cost (including tax) minimisation.

Internationally accepted transfer pricing rules were developed by the Organisation for Economic Cooperation and Development (OECD), in the Transfer Pricing Guidelines.

The Multinational
A multinational’s network of subsidiaries (aka affiliates or legal entities) may undertake manufacturing, distribution, research & development, sales & marketing and management services (such as strategy, recruitment, trademarks, patents) as well as other functions. When a subsidiary’s function benefits another subsidiary ie through services rendered, product supplied or rights granted, the supplying subsidiary should be compensated by the receiving subsidiary.

The price at which products and/or services are supplied (or transferred) from one subsidiary to another is known as the transfer price. Additionally, if a subsidiary exploits a patent or trademark owned by another subsidiary, the owning subsidiary would be compensated in the form of a royalty, which can be embedded within a product transfer price or charged separately.

Subsidiaries are considered in-scope of transfer pricing regulations when they are >50% owned (‘controlled’) by the multinational. Branches of a multinational are also in-scope.

Transfers or sales between subsidiaries are termed interchangeably ‘intercompany’ or ‘intragroup’ sales or ‘controlled transactions’.

Being internal transfers, the value of intercompany sales are eliminated ie ignored from the consolidated results of the multinational. They are sometimes known as ‘wooden dollars’. Nevertheless, they have to be invoiced in order to allow custom duties to be imposed (where applicable) and for a country to calculate an export/import value in its balance of trade figure. Some 80% of world trade is intercompany.

The Rules: The Arm’s Length Principle
From 1918, governments decided that best way to check that transfer prices were reasonable was to insist that they should be similar to those that would be used between independent companies ie if the subsidiaries were trading at ‘arm’s length’.

This resulted in the method called the Comparable Uncontrolled Price (CUP) - the price that independent companies use in similar circumstances.

Since the relationship between the intercompany supplier and recipient or the product/service supplied might be unique, it is often not possible to find a CUP to use. In such cases, the next best method should be used: Comparable Profit Method (CPM).

The CPM applies the profit level, that a similar independent company earns, to the supplying and/or receiving subsidiary (the tested party).

BENCHMARKING

The multinational is obliged to find out the profitability of independent companies, which are functioning in a comparable way to the subsidiary in question, from publicly available sources.

Profitability is typically expressed as Net Margin (aka Return on Sales) which is defined as Net Profit (before tax/dividends/ extraordinary items) / Net Sales x 100. However, in order to determine transfer prices for individual products/services at the comparable profitability, it is more convenient to calculate a profit level indicator such as cost plus (typically for a supplying manufacturer) or resale minus (typically for a receiving distributor).

PROFIT LEVEL INDICATORS

Cost plus is calculated as (Net Sales - Cost of Sales) / Cost of Sales x 100.

Resale minus is calculated as (Net Sales - Cost of Sales) / Net Sales x 100.

The chosen method can have significant impact on the tax paid by the multinational. In the following simplified example, we compare the profit and tax paid resulting from cost plus 5% for a manufacturer (supplier) vs resale minus 15% for a distributor (purchaser).

History
Beps DST

Important Legal Cases
Glaxo

Rosneft