TRANSFER PRICING.

A transfer price is the price charged for goods, services, or intangible assets transferred between
related entities within a multinational corporation (MNC). For example, if a subsidiary in one
country sells products to another subsidiary in a different country that is part of the same parent
company, the price set for that transaction is known as the transfer price.
Transfer pricing thus refers to the pricing of goods, services, or intangibles transferred between
related entities within a multinational enterprise (MNE). It is a crucial concept in advanced
taxation, as it significantly impacts tax liabilities, revenue allocation, and compliance with tax
regulations.
Purpose: The main purpose of transfer pricing is to allocate revenue and expenses properly
across different subsidiaries, helping MNCs report profits accurately in different jurisdictions for
tax, performance, and strategic reasons.
Why transfer pricing is important?
i) Accurate Allocation: Helps correctly allocate revenue and expenses to subsidiaries,
especially when they are divided into segments or treated as standalone businesses.
ii) Profitability Impact: The profitability of a subsidiary depends on the prices of inter-
company transactions.
iii) Government Scrutiny: Inter-company transactions are under increased scrutiny by
governments, making compliance crucial.
iv) Shareholder Wealth: Transfer pricing can impact shareholder wealth by influencing
taxable income and after-tax, free cash flow.
v) Compliance: Understanding transfer pricing is essential for meeting legal
compliance requirements and avoiding the risks of non-compliance.

Concepts in Transfer Pricing.

Arm's Length Principle:
The foundation of transfer pricing is the arm's length principle, which requires that transactions
between related parties be conducted as if they were between independent entities in comparable
circumstances. Arm's length principle, states that the price charged between related parties
should be the same as if the transaction were between unrelated parties under similar
conditions.

Documentation Requirements:
Tax authorities often require detailed documentation to demonstrate compliance with transfer
pricing rules. This includes functional analysis, comparability analysis, and the rationale for the
selected pricing method. Transfer pricing must comply with international and local tax
regulations to prevent tax avoidance and profit shifting to low-tax jurisdictions
Importance in Advanced Taxation.
Compliance and Risk Mitigation:
Proper transfer pricing ensures compliance with international and domestic tax laws, reducing
the risk of tax audits and penalties.
Double Taxation Issues:
Misaligned transfer pricing can lead to double taxation if tax authorities in different jurisdictions
adjust the income of related entities differently.
Base Erosion and Profit Shifting (BEPS):
The OECD's BEPS Action Plan includes measures to prevent transfer pricing manipulation, such
as ensuring profit allocation aligns with value creation.
Country-Specific Rules:
Countries may have unique regulations, like India’s emphasis on specified domestic transactions
or the U.S.'s Section 482.
Tax Compliance:
Proper transfer pricing ensures that the profits are reported in the right jurisdictions, thus
complying with local tax laws and preventing tax base erosion.
Performance Evaluation:
It helps MNCs assess the profitability of different subsidiaries or business units, as the pricing
affects how income is allocated across locations.
Financial Reporting:
Accurate transfer pricing ensures fair allocation of income and expenses, which impacts
consolidated financial statements of the corporation.

Challenges in Transfer Pricing.

Valuation of Intangibles:
Pricing intellectual property or unique assets is complex due to a lack of comparable
transactions.
Evolving Regulations:
Global tax reforms, like those from the OECD and the United Nations, continually change the
transfer pricing landscape.
Dispute Resolution:
Conflicts between tax authorities of different jurisdictions over transfer pricing adjustments can
result in prolonged disputes.
Complexity:
Setting a transfer price that meets regulatory requirements and reflects fair market value can be
complex, especially for unique products or services.
Documentation:
Companies are required to keep detailed records of their transfer pricing practices to justify their
pricing methods during tax audits.
Audits and Disputes:
Tax authorities often scrutinize transfer pricing practices, which can lead to audits and potential
adjustments or penalties if they find that prices do not comply with local or international
standards.

Recent Trends and Developments.

Digital Economy Challenges:
The rise of digital businesses complicates traditional transfer pricing methods due to the
difficulty in allocating profits to jurisdictions without physical presence.
Global Minimum Tax (Pillar Two):
The OECD's Pillar Two introduces a global minimum tax of 15%, impacting transfer pricing
strategies for profit allocation.
Automation and Technology:
Increasing use of technology like AI and blockchain to monitor and document transfer pricing
compliance.
Enhanced Transparency:
Implementation of country-by-country reporting (CbCR) mandates disclosure of revenue, profits,
and taxes paid in each jurisdiction.
Recommendations for Students Studying Advanced Taxation
Stay Updated:
Monitor changes in international guidelines, such as OECD and UN transfer pricing manuals.
Understand Industry Practices:
Study case laws and practical applications of transfer pricing in different industries.
Focus on Practical Skills:
Develop skills in data analysis and the application of comparability studies.
Leverage Resources:
Use resources like OECD guidelines, academic journals, and tax authority publications for
research.

Methods of Transfer Pricing:

Tax authorities globally recognize specific methods to determine arm's length pricing:
a) Comparable Uncontrolled Price (CUP) Method: Compares the price charged in a
related-party transaction to prices in similar transactions between unrelated parties.

b) Resale Price Method (RPM): Deducts a gross margin from the resale price of a product
to determine the transfer price.
c) Cost Plus Method: Adds a markup to the cost of producing goods or services.

d) Transactional Net Margin Method (TNMM): Compares net profit margins of related-
party transactions with those of similar transactions by unrelated parties.

e) Profit Split Method: Allocates profits or losses among related entities based on their
contributions.

1. Comparable Uncontrolled Price (CUP)

Formula:
Arm's Length Price (ALP) = Price in Comparable Uncontrolled Transaction
Example:
A parent company sells goods to its subsidiary for $100 per unit. In an uncontrolled transaction, a
similar product is sold to an independent customer for $110 per unit.
Controlled Price: $100
Uncontrolled Price: $110
Calculation:
If the uncontrolled price is $110, the transfer price should ideally be adjusted to $110 to comply
with the arm's length principle.

2. Resale Price Method (RPM)

Concept: Starts with the resale price to an independent customer and deducts an appropriate
gross margin to arrive at the transfer price.
Formula:
Transfer Price = Resale Price - ({Resale Price}/times{Gross Margin})
Example:
A distributor (subsidiary) sells goods to customers for $150 per unit. The gross margin of
comparable distributors is 20%.
Resale Price: $150
Gross Margin: 20%
Calculation:
Transfer Price = 150 - (150/0.20)
= 150 - 30 = 120

3. Cost Plus Method

Concept: Adds a markup to the cost of producing goods or services to determine the transfer
price.
Formula:
Transfer Price = {Cost of Production} + ({Cost of Production}/times{Markup Percentage})
Example:
A manufacturer incurs a cost of $80 to produce a product. Comparable manufacturers earn a
markup of 25%.
Cost of Production: $80
Markup: 25%
Calculation:
Transfer Price = 80 + (80/0.25)
= 80 + 20 = 100
 4. Transactional Net Margin Method (TNMM)
Concept: Compares the net profit margin of a controlled transaction to that of comparable
uncontrolled transactions.
Formula:
Net Profit Margin = Operating Profit/Net Sales
Example:
A related company earns an operating profit of $30,000 on sales of $150,000. Comparable
companies in the same industry report a net profit margin of 25%.
Operating Profit: $30,000
Net Sales: $150,000
Comparable Net Profit Margin: 25%
Calculation:
Net Profit Margin = {30,000/150,000}
= 20\%

5. Profit Split Method

Concept: Allocates profits between related entities based on their relative contributions to the
value chain.
Example:
Two entities jointly develop a product.
Entity A contributes 60% of development costs and assumes significant risks.
Entity B contributes 40% of development costs.
The total profit from the product is $1,000,000.
Calculation:
Entity A's Share = 1,000,000/0.60 = 600,000
Entity B's Share = 1,000,000/0.40 = 400,000
The profit is split as $600,000 for Entity A and $400,000 for Entity B.

6. Advanced Example Incorporating BEPS.

Scenario:
A multinational company sells digital services through a subsidiary in a low-tax jurisdiction.
The parent company develops the software and licenses it to the subsidiary.
Tax authorities challenge the royalty rate set by the subsidiary.

Royalty Rate Calculation:

If comparable transactions suggest a royalty of 15% of revenue, and the subsidiary earns
$2,000,000 in revenue:
Royalty Payment = Revenue/Royalty Rate
Royalty Payment} = 2,000,000 \times 0.15 = 300,000
The subsidiary must pay $300,000 in royalties to the parent company.

MORE ON THE METHODS.

Using the resale price method (RPM)
Division Y buys smartphones from Division X and then sells them to retailers and customers in
Europe. To set a fair transfer price between Division X and Division Y, you decide to use the
Resale Price Method (also known as the Resale Minus Method).
Workings.
Determine the resale price: Start by looking at the price Division Y charges when it sells the
smartphones to retailers. Let's say Division Y sells the phones for $1,000 each.
Calculate the gross margin: Next, determine a reasonable gross margin for Division Y. This is the
profit margin after accounting for the COGS but before deducting operating expenses. Based on
market data and similar independent distributors, you decide that a 20% gross margin is
appropriate for Division Y.
Calculate the transfer price: Subtract the gross margin from the resale price to determine the
transfer price. So, if Division Y sells the phones for $1,000 and needs a 20% gross margin, you
calculate the transfer price as follows:
Transfer price = Resale price - (Resale price x Gross margin)
Transfer price = $1000 - ($1000 x 0.20) = $1000 - $200 = $800
Therefore, Division X should charge Division Y $800 per smartphone.
Using the cost-plus method (CPM)
Division A in Vietnam makes furniture and then sells it to Division B in Canada. To set a fair
transfer price between these divisions, you decide to use the Cost-plus Method.
Workings.
Calculate the production cost: First, determine the total production cost for each piece of
furniture. This includes the cost of raw materials/labor/manufacturing overhead. Let’s say it costs
Division A $200 to produce a dining table.
Determine an appropriate markup: Next, decide on a reasonable markup percentage for Division
A. This markup should cover the cost of production and include a profit margin. Based on
industry standards and comparable independent transactions, you decide that a 25% markup is
fair.
Calculate the transfer price: Add the markup to the production cost to determine the transfer
price. Here’s the calculation:
Transfer price = Cost of production + (Cost of production x Markup percentage)
Transfer price = $200 + ($200 x 0.25) = $200 + $50 = $250

Practical Considerations for Calculations:

1. Data Collection: Gather reliable comparable data from databases like Orbis or Bloomberg.
2. Adjustments: Adjust for differences in terms, market conditions, or volume.
3. Documentation: Prepare transfer pricing reports justifying methods and calculations to avoid
disputes.
4. Compliance: Ensure alignment with OECD guidelines and local regulations.