Principal Techniques of Transfer Pricing - Essay Example

Transfer Pricing Part A: Principal Techniques of Transfer Pricing Introduction Large organizations face significant issues when deciding on the methods to use in transfer pricing when selling goods and services. Different factors influence the transfer prices including internal, external, legal and political factors (Dogan, Deran, & Koksal, 2013, p.734). Transfer pricing refers to prices in transactions between associated enterprises. It is one of the principal problems in the global tax law (Wittendorff ,2011, p. 1). Arm’s length principle is the major technique that assists in transfer pricing. When applying the arms length principle to evaluate the transfer prices that has been put in business dealings between the related firms it is necessary to compare the price with other prices of identical traansactions between interdependent firms in analogous situations. The comparison helps to determine whether there is need to change the transfer price during the computation of the chargeable proceeds any of the allied companies. Comparison plays a significant role when it comes to transfer pricing. However, the quality and the accessibility of monetary dealings used to make major comparisons from unrelated parties alarms the members and non-members countries of OECD. Importance of transfer pricing Transfer pricing is important because it reduces the incidences of double taxation and mispricing resulting from transfer pricing adjustments. Transfer pricing ensures that enterprises prepare and maintain contemporaneous documentation, failure to which penalties follow. It also helps in lowering the effective tax rate (Whitmer & Hazard, 2012, p. 4). Most companies in OECD countries generally use arm’s length principle in performing transfer pricing. Applying the Arm’s Length Principle The implementation of arm’s length principle uses the following ways (IRD, 2009, p. 12). Characterize and document the transactions between the associated enterprises Select the most appropriate transfer piecing method and document it Apply the most suitable transfer pricing method, determine the outcome of the arm’s length and document the process Implement the support processes and include a review process to ensure adjustment for material changes and then document the processes The principal techniques of transfer pricing The arms length principle The UK’s transfer pricing legislation details how to handle transactions between related parties and in common with many other countries based on the internationally recognized arm’s length principle. The legislation allows a transfer pricing adjustment only either to reduce a tax loss or to increase the taxable profit. The transfer pricing legislation in UK also applies to transactions between any connected UK entities. To achieve fair division of tax profits and to address the issue of double taxation, OECD member countries have agreed to treat the transaction between the connected parties by reference to the amount of profit that would have arose. Such occurs if unconnected parties for tax purposes had executed similar operations. According to Mohapatra (2012, p. 161), transfer pricing techniques falls into three categories namely cost price based, market price based and negotiated price based. Under the cost based pricing, the selling division of the firm prices its transfers to the selling division at a cost plus a margin. The cost can either be the actual, budgeted or full cost. The advantage of cost-based method is that it ensures better control and evaluation of divisional control easier. The method is very practical in situations where the market price of same products is not available. In market-based pricing, the selling division prices its transfers to the buying department at a price prevalent in the market (Saudagaran, 2009, p. 125). The key benefit of using this method is that it makes it easier to distinguish between the profitable and the non-profitable group. Organization for Economic Co-operation Development (OECD) Transfer Pricing Guidelines Chapter two of the OECD transfer pricing procedure for large firms and tax management discusses a number of transfer pricing methods that an organization can use to find out if the conditions of regulated transactions are in line with the arms length principle (OECD, 2010, p.2). Some of these methods are the traditional profit methods namely, the cost plus method, the resale price method and the comparable uncontrolled pricing (CUP) method. Other methods are transactional profit methods, which are transactional profit split, and the transactional net margin methods. These methods act as the global agreement on the approach in which firms should use to apply the principle of arm’s length. It is advisable for countries to apply the transfer pricing methods in the stipulated rules in accordance with TPG in order to reduce or eliminate the incidences of double taxation. The diagram below illustrates all the methods. The Comparable Uncontrolled Pricing Method (CUP) Comparable uncontrolled method of pricing is the most ideal technique in determining the arm’s length price of a transaction (Petruzzi & Spies, 2014, 303).The technique makes a comparison between the cost of commodities and the services in a restricted operation and the cost of similar services and commodities transferred in similar uncontrolled transactions within the same conditions. The occurrence of variation in the prices is an indicator that the situations of the financial and commercial affairs of the associate firm are not at arms length. In addition, presense of a difference means that uncontrolled transaction price may require to be substituted with a price in the restricted transaction. According to OECD, 2012, p.2, the comparison of controlled and uncontrolled transactions using the CUP method aims at finding out whether transactions have adhered to any of the two conditions. The foremost condition demands absence of material influence on inherent pricing within the free market and amongst the interacting firms. In addition, the transacting companies must establish explicit and sound modifications that warrant mitigation of the aforementioned material influence within the open market. In cases where frequent fluctuation of the prices of the product occurs, timing of the transaction is relevant. CUP’s falls under two categories either as in-house dealings or as exterior dealings as described below. Source: (Kanthakrishnan & Vasan, 2015, p. 1) Comparable uncontrolled pricing (CUP) is applicable in bench marking on the basis of price methodology. The practical difficulty experienced under the comparable uncontrolled pricing is the inability to find the right CUP for direct price comparison. The accuracy of the adjustment is always questionable. The number of adjustments in this method reduces the integrity of transaction. Finally, the method requires close similarity between products which becomes difficult under external comparison (Mehta, 2013, p. 28) Resale Price The other traditional method used in applying the Arm’s length principleis the resale price technique. The method pays much attention on the associate sales firm that conducts the promotional roles like other entity when analyzing the transfer price. The method is more important when it applies to the sales and marketing operations such those of intermediaries. Under certain circumstances, the resale value margin of the reseller in the restricted transaction is established through reference to the resale value margin that the same seller gets after selling and buying goods in similar unrestricted transactions. In case of unavailability of the domestic reliable comparables, firms can establish the resale price margin by referring to the resale price margin gained by self-governing enterprises in similar unrestricted transactions. The Cost plus Method The method commences with costs from the seller of goods or services in restricted operation for the goods or services offered to a related business partner . The next process involves adding the mark up price to this cost to add to the right amount of profit according to the work done, the resources used the nature of market and the risks involved. This method is essential in analyzing transfer-pricing problems concerning tangible property or services under the OECD regulations. The method is most useful when applied to manufacturing or assembling activities and relatively simple service providers. The process focuses on the related party manufacturer as the tested party in the transfer price analysis. It evaluates the arm’s length nature of an intercompany charge by reference to the gross profit markup on costs incurred by suppliers of property for tangible property transferred. The method compares the total markup earned by the experienced party for the production of goods or services with profit markups gained by the similar companies in the same industry. Transactional Net Margin Method OECD introduced the transactional net margin as a method of last resort. It is only applicable in cases where the use of the other three principle methods is available. The method involves the examination of net profit indicator that taxpayer realizes from a controlled transaction with the net profit gained in comparable uncontrolled transactions. The arms length profit indicator of the taxpayer from the controlled transaction may be determined by referring to the net profit indicator that the same taxpayer earns in comparable uncontrolled transactions. Otherwise it remains a possibility by referring to the net profit indicator gained in similar dealings by an self-governing venture. where the profit is measured to costs, TNMM functions in an approach like the one of resale price and cost plus techniques respectively (King, 2009, p. 14). However the exception is that it compares the profit from controlled and uncontrolled transactions instead of contrasting gross markup on costs or gross profit on resale. In TNMM, the net profit indicator is the operating profit. The Transactional Profit Split Method The method first identifies the combined profits that require splitting for associated enterprises from controlled transactions in which they have an engagement. Depending on the case, the combined profit will be the total profit from controlled transaction. Otherwise, it would symbolize a residual profit representing profit that cannot readily be allocated either of the parties from submission of another transfer pricing method like the profit arising from valuable and unique intangibles. The combined profits may be a loss or in some cases. When applying the transactional profit split method, the multinational enterprise presupposes that there are no true comparables. The guidelines recognize that the method enables the taxpayer to take into account the associated enterprises specific and possibly unique facts and circumstances that are not present in the independent enterprises. Nevertheless, the OECD views the transactional profit split method as being an arm’s length approach (OECD, 2010, p. 93). Such approach treats the transactional profit split method by reflecting what individual independent enterprises would have done if faced with the same circumstances (Kent & Feinschreiber, 2013, p. 23). In applying the profit split method, the enterprise should follow the steps below (Petruzzi & Spies, 2014, p. 301). Identify the profit to be split for the associated enterprise from the controlled transaction in which the associated enterprises have an engagement Split those profits between the associated enterprises on a basis that is economically valid by approximating the division of profits that would have reflected in an agreement made at arm’s length. Part B: Developments in Transfer Pricing In an Era of Globalization According to Lechner, 2009, globalization relates an international integration process through which people remain connected in various ways across large geographical distances. Globalization encompasses development of various disciplines including communication and infrastructure. Most evidently, globalization era resulted into revolution in business especially the trade off goods and services amongst companies across the globe. It is crucial to note that the introduction of globalization era caused revolution in understanding transfer pricing amongst companies. Moreover, globalization has remained fundamental in business expansion through advancement of world trade. Development of international trade during the start of globalization era resulted into developments of various implications. The most significant implications related to international trading includes transfer pricing that inherently defines prices or rates used during sale of services and goods amongst parent organizations, subsidiaries or departments. Though transfer pricing defines a simple technique of moving services and goods within the corporate family, it has resulted into different problems for tax authorities and multinational corporations. Due to globalization era, transfer pricing has become more vital amongst industrial organizations dealing in goods and services. However, as aforementioned transfer pricing has also become more complex with globalization era. It is essential to note that the era of globalization has caused expansion of companies and their worldwide operations. Expansion of global operations demands that the aforementioned companies should develop defensible and robust policies and structures. Such changes in global operations consequently resulted into development in transfer pricing requiring involved companies to deal with advancing numbers of jurisdictions. Companies have adjusted by adopting rigorous transfer pricing policies that would rely mostly on the inconsistent inter-organization transfer pricing standards and laws. Transfer pricing laws developments is imperative for a company that aims at adjusting towards globalization of business operations (Heimert, 2010, p.10). Such developments in transfer pricing includes need for multinational companies to deal with aggressive enforcements placed by tax authorities. Moreover, development in transfer pricing assists the aforementioned companies to in dealing with exploitations by taxpayers and increased imposition of revenues. Consequently, the companies would reduce potential deficits through adjustments in transfer pricing policies. It is imperious to note that the aforementioned developments in transfer pricing occurs both in emerging and developed countries. Based on recent data Organization for economic cooperation development (OECD) has shifted its focus to transfer pricing development through creation of base erosion and profit shifting (BEPS) (OBrien & Oates, 2013, p. 8). Major multinational companies developed BEPS as a strategy to address the existing perception about tax remittances (PWC, 2015, p. 1). The perceptions indicate that the major economies do not submit fair shares of taxes. The development fostered by OECD remains achievable by through use of transfer pricing. It is indispensable to note that BEPS remains as the development on transfer pricing relating to inherent negative effects of multinational organizations strategies of tax avoidance. The inherent developments indicate why specific multinationals struggles to remain in compliance with inherent variation in transfer pricing rules across jurisdictions. For instance, certain countries including Brazil have their companies adopting transfer-pricing strategies that have no adherence to arm’s-length principle (Bea & Gaudio, 2013, p.50). The introduction of transfer pricing regime in Brazil acts as a form of formulary-based system. Such system explains how maximum price ceiling affects intercompany import transactions as deductible expenses. The inherent regime challenges Brazilian companies mainly due to two irreconcilable distinct model requirements in using transfer pricing (Borkowski & Gaffney, 2014, p 50). Such cases of transfer pricing due to globalization requires adoption of double taxation. Developments of global economic crisis have caused transfer pricing to remain as an activity of allocating losses instead of income amongst involved companies. In the midst of such developments, governments that carry out audit for the organizations aims at increasing tax revenues to offset eminent economic crisis. Emergence of interests of both governments and companies results into development of tax controversy environment even within transfer pricing policies. Most multinationals have opposed government intervention in manipulating tax revenues with the objective of managing increasing expenditures (Kepoglu, 2013, p. 476). Consequently, multinationals has remained in constant confrontation by governments over compliance with the enhanced taxation systems. The observed developments implicates challenges in using transfer pricing mainly to multinationals that aims at managing many stakeholders in various regions within the new economy. In conclusion, though globalization has resulted into enormous expansion of businesses through accessibility of goods and services worldwide, various transaction policies have changed. Expansion of business though globalization influenced changes in business policies including pricing strategies. Despite OECD, aims to maintain fair sale of goods and services amongst parent companies though enactment of transfer pricing rules, globalization has caused a change in the policies. Such regional changes due to globalization consequently caused development in transfer pricing including introduction of BEPS to overcome mispricing. References Bea, C, & Gaudio, B. 2013, Transfer Pricing and Arms-Length Standard, American Journal Of Business Research, 6, 1, pp. 49-62, Business Source Complete, EBSCOhost, viewed 11 February 2015. Borkowski, S, & Gaffney, M. 2014, Proactive Transfer Pricing Risk Management in PATA Countries, Journal Of International Accounting Research, 13, 2, pp. 25-55, Business Source Complete, EBSCOhost, viewed 11 February 2015. Dogan, Z., Deran A. & Koksal, G. A. (2013). Factors influencing the selection methods and the determination of transfer pricing in multinational: a case study of the United Kingdom. International journal of economics and financial issues. 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