Transfer Pricing Methods and Globalisation - Essay Example

TRANSFER PRICING METHODS AND GLOBALISATION Introduction 1 Background There are a number of multinational enterprises (MNEs) and intra-group transaction between different countries, a phenomenon that can be attributed to globalisation. In this era of globalisation it is therefore very important to develop transfer pricing techniques to make the more accommodative. In today’s world transfer pricing has become one of the fundamental issues in regards to international tax, which have become problematic and complicated in tax administration as far as MNEs are concerned. Transfer pricing can be defined as ‘pricing of transactions between group members’ in simple definition. In an era of globalisation the members can be countries. Globalisation can subject a business enterprise such as MNE to comply with different transfer pricing regulations, which in turn can end up creating uncertainty, double taxation, and increased administrative burden for MNEs (Wolters, 2011). Due to such circumstance transfer pricing can be described as the most critical issue in international tax as a result of globalisation. There is an upsurge in electro commerce and intensified globalisation, this will make transfer pricing a key issue in international taxation. Tax authorities in various jurisdiction should make sure that compliance rules are not applied unduly, but are applied responsibly. Business activities and international trade should not be affected by actions of tax authority in various jurisdiction.1 1.2 Definitions OECD is an exceptional forum where governments work in unity to address social, economic and environmental challenges of globalisation. The European communities’ commission is involved in the works of OECD. According to the glossary of International Tax, transfer pricing is “the area of tax law and economics that is concerned with ensuring that prices charged between associated enterprises for the transfer of goods, services and intangible property accord with the arm’s length principle.”2 Arm’s length principle: this is an international standard that OECD member countries have agreed to use for the purpose of determining transfer prices, especially tax issues. 1.3 OECD transfer guidelines These are very important guidelines especially in this era of globalisation. The guidelines are intended to assist tax administrators (members and non-members of OECD countries) and MNEs to come up with a satisfactory remedies to transfer pricing cases, which enhances that conflict is avoided by MNEs and tax administrators hence reducing or avoiding litigation. Financial relations and commercial conditions within an MNE are analysed by the guidelines to evaluate whether arm’s length principle are satisfied as well as discourse the application of those techniques (Wittendorff, 2009, p. 179). It doesn’t matter whether a country adheres to arm’s length principle, they are highly encouraged to follow this guidelines. 2. Arm’s length principle As stated earlier the arm’s length principle is the international standard, which is agreed upon by members of OECD. It is a principle that ensures that transactions taking place between companies that are related should be priced as if the companies were unrelated parties. This principle thus the general idea behind this principle is that every part of the value chain in a MNE, is apportioned with profit according to the value, which is being formed. As a result, any country that is involved is able to acquire a tax base that matches the actual value created in that particular country. A company that fails to adhere to arm’s length principle, wit will be able to shift profits among countries, in order to have low margins in high tax jurisdictions and higher margins in low tax jurisdiction. (Hansen & Andersen, 2008, p. 20). Evaluation of arm’s length principle involves the circumstances under which the transactions are taking place (characteristics of the transaction) and price of the transaction has to be taken into consideration. It begins by first identifying features of the transaction, functions performed, risk assumed and asset employed, which will help in determination of the market price. 2.1 its relation to transfer pricing method 2.2 comparability analysis It can therefore be established that the Arm’s length price compares the conditions and terms under which the controlled transaction takes place against related transactions between independent unrelated parties. As a result, none of the characteristics in the tested transactions should digress meaningfully from those transactions used as comparable. The only way this is relevant is when the characteristics have an effect on the price, or if it is not possible to accurately do an adjustment. Independent unrelated enterprises takes into account various options available and compares one option to another, any differences that will upset their value is taken into consideration. It is on this note that Arm’s length principle justifies a price of related parties. There are five factors that OECD has established as very crucial when determining comparability as discussed below. It should be however noted that the list is not complete nor comprehensive, it is not either the minimum factors that determine comparability, as a particular transaction may be unique. (Bundgaard & wittendorff, 2001, pp. 112-113). 2.2.1 Characteristics The value of a transaction will be affected by the difference in the characteristic of the transferred good or service. Depending on the transfer technique applied the, the significance of this comparability factor can be considered more or less important. Key factors are the traded services or goods functionality, availability in supply, quality and quantity transferred. Some factors such as trademark are immaterial, but can affect the price significantly (OECD Guidelines section 1.39-1.41). Economical advantage is taken into account in matters relating services, which determines whether the receiver of the service dos or doesn’t attain the economic advantage (Bundgaard & Wittendorff, 2001, p. 113). 2.2.2 functional analysis Functional analysis as defined in OECD Guidelines section 1.42 states: “This functional analysis seeks to identify and compare the economically significant activities and responsibilities undertaken, assets used, and risks assumed by the parties to the transaction” It is therefore a framework established to ascertain the functions that each entity perform in order to identify the level of compensation for a particular good or service. The term “economic significant” helps to determine which assets and risks are to be considered. 2.2.2.2 Assets Any asset that is used to create or support a transaction should be listed, which means it is anything that has a significant economic value. Financial assets, plants and equipment, valuable intangible etc., and the nature of the asset used such as age, location and market value are mentioned in OECD guidelines. There is a distinction between marketing intangible and trade intangible, trade intangibles are created through research and development. A company that that owns trade intangible should be compensated for the expenses related to their development either through increase transfer prices or royalty. Marketing intangible are the same, but are more connected to a significant risk and cost in their development. 2.2.2.3 Risks If one party has the affinity of higher risk, then higher compensation should be conferred. This therefore ascertains that the level of risk should be a crucial factor in determining the price. According to OESD Guidelines, uncontrolled and controlled transactions can’t be compared if the assumed risk is different, since appropriate adjustment can’t be made. 2.2.3 business strategies Business strategy can be used a as a comparability factor, this is the same manner in which an independent enterprise can price products according to a business strategy. In relation to globalisation business enterprise can lower a price when entering a new market in another country, this is for the purpose of penetrating the market of that foreign country. Transfer pricing methods can make some factors to be relevant such as innovation, assessment of political changes, the labour laws of a particular country, duration of arrangement, development of a new product, and degree of diversification (OECD guidelines section 1.59). It is therefore very important for a business enterprise to document any strategy it uses in its quest of globalisation. 2.2.4 economic circumstances Globalisation will make a commodity to be traded around the globe, this means that Arm’s length price on the same commodity is traded across various markets and may vary as a result of difference in industry and market factors. It is therefore very important to include the economical circumstance of the location where the commodity is traded. If these differences are identified, it becomes possible to make appropriate adjustment to cater for the adjustments, hence complying with Arm’s length principle. In regard to globalisation, a country can have an economically circumstances that greatly affect the pricing of a good or service. 2.2.5 contractual terms Contractual terms among the unrelated independent parties defines how benefits and risks are divided among them. It is very important for local tax authorities to possess any intercompany agreement, for the purpose of functional analysis. Contractual terms can also help determine terms that affect the price, which can include volume of the transaction or the number of units bought that affect a price downward. 3.0 Transfer Pricing Methods (OECD) There are various transfer methods that are used for different transactions. The selection of any particular method is important for international businesses in order to identify the most appropriate method to be used for intercompany transactions and at which businesses can determine an arm’s length price. It is therefore important to conduct a review of the different methods by analysing their strengths and weaknesses as well as the appropriateness of the pricing method with regards to the transaction under taking into perspective the functional analysis. Moreover, all the available information and materials should be assessed for comparability analysis with a view of eliminating any differences that may be exhibited. The selection of the most appropriate transfer pricing method to use depends on the method that will lead to the generation of the most accurate arm’s length price. This is dependent on the level of information available and the individual transaction to be carried out. While the Comparable uncontrolled prices method is the most widely used method for pricing interest rates on loans, there are other methods which can be used given different circumstances and individual situations (Breggen, 2006). Such methods include: 3.1 Comparable Uncontrolled Price (CUP) This method is considered the most direct method and is popularised for application in cases where the information available is utmost and reliable. This is widely used for interest rates on loans whereby a benchmark on loans is conducted with similar loan characteristics. When there are other third party arrangements in the transaction, this method is preferred as the strong one to use as such arrangements can be used as price basis. The procedure is to conduct a benchmark analysis in order to identify the appropriate location of the transfer price (Berning, 2008). 3.2 Cost-Plus When applying this method to price intercompany loans depends on the actual costs expenditure on the part of the company providing the loan. The mark-up added should be adequate to add mark-up which any other company would have earned if it were unrelated to the actual company. This pricing method have approaches in two folds. First, the company can pass the loan to an associated party after sourcing it from a third party. As such, the company only adds mark-up to the cost so as to cater for the cost of administering the loan. Furthermore, the mark-up added is supposed to be a reflection of the actual risk that is associated with such a transaction. Since the mark-up added to the transaction will have to be benchmarked against other loans, there arises some technical challenges which can make it difficult to distinguish the mark-up associated with the risk of the transaction and that associated with administration of the loan. This is because the two mark-ups are different depending on the companies they are sourced from (PwC, 2011). The second approach to applying this method is by having the company offering the loan to calculate the actual cost of capital. This will help in determining the cost base after which a suitable mark-up which reflects the cost which fits the one that would have been appropriate for the open market is then added to the actual cost of the loan. The resulting price is identified as an arm’s length price of the loan. Although this pricing method has proved to be very difficult for practical application, it is one of the most suitable methods to use when pricing loans. A benchmark can be used to identify the mark-up to be added in the actual cost. However, the administration costs may prove to be problematic if excluded from the interest rate as it was earlier included in the benchmark. 3.3 Resale Minus Price Method This method is not considered as the most appropriate in conducting transactions global transactions involving loans. This is because the loan is not directed through the loan taker. However, this method is preferred for application in cases where the functions conducted are standard in nature. This method is not appropriate for loans pricing due to the fat that the risk undertaken in the transaction is the major value driver in the loan arrangement. 3.4 Profit Splits This pricing method is only suitable if the transfer of a particular good or service will yield some revenue in terms of profit when sold in the open market. The produced profit is then divided such that the involved parties get their equivalent share in terms of the assets and risks which have been put forward for the completion of the transaction by every party. It is imperative to note that the profit generated and shared in this case does not emanate from the transaction itself and the parties involved do not provide their unique and valuable contribution towards the generation of the profit. As such, there is no profit to be shared between the two parties as the profit made is not generated from the loan. Nevertheless, the loan can generate profit if it is offered at a lower rate such that the borrowing party can generate some profit when selling the loan in the open market (PwC, 2011). 3.5 Transactional Net Margin Method This method focuses on the profit to be made by the selling party. As such, its emphasis is on the return of a function and value addition to the goods being transferred. As such, the party of focus is the company offering the loan. The whole concept of this pricing method is similar to that of the cost plus method. However, this method is slightly different in that it is mostly used in determining transactions involving low risk arrangements. This is because it recognises a product’s fixed margin and therefore, not preferred as suitable. The major motivation for the return on loan is the risk and the different levels of profit which are typical of the loan arrangement due to the differences identified in the varied loan arrangements and their characteristics. The most appropriate scenario for applying this pricing method is when a number of transactions which are made up of the same type of products are bundled up and priced as a unit (Breggen, 2011). Bibliography Ana Maria Janschek, Danny Oosterhoff, (2002). “Transfer Pricing Trends and Perceptions in Europe” International Transfer Pricing Journal 46 Berning, J. (2008, 1144). Koncernlån og Rentefastsættelse. Tidskrift for skatter og afgifter. Breggen, M. E. (2006). Intercompany Loans: Observations from a Transfer Pricing Perspective. International Transfer Pricing Journal, November/December, 295-299. Breggen, M. v., & Twigt, J. (2011). Financial Transactions in a Changing World. Transfer Pricing Forum (p. 38). Copenhagen: PwC. Bundgaard, J., &Wittendorff, J. (2001). Armslængdeprincippet & Transfer Pricing (1st ed.). Copenhagen: Magnus Informatik. 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(2011). Transfer pricing perspectives: sustainable transfer pricing in an era of growth and business transformation. PwC. Read More