Transfer pricing – definition and methods

Abstract: Transfer prices refer to the terms and conditions which so called “associated enterprises” agree for their “controlled transactions.” Examples of such transactions are the provision of management services, the supply of goods and the provision of loans. According to this widely used OECD definition, enterprises are associated if: (a) an enterprise participates directly or indirectly in the management, control or capital of another enterprise or (b) the same persons participate directly or indirectly in the management, control or capital of two enterprises. Transfer prices are very important, because of the following: there are large differences in tax rates between countries. If left unchecked, the practice could lead to the shifting of profits from high-tax countries to lower tax countries. Even though less likely, it can also be the case that the pricing policy leads to multinationals reporting too much taxes in high tax countries and too little in low tax countries. The main goal of transfer pricing regulation is to prevent both situations and ensure that profits are taxed at the place where value is actually created. Transfer pricing rules provide that the terms and conditions of controlled transactions may not differ from those which would be made for uncontrolled transactions. The main goal of these rules is to prevent profit shifting from high-tax countries to low-tax countries (and the other way around, although less likely). The aim of this paper is to investigate the importance of transfer pricing, and to examine what are the methods of transfer pricing available. Most countries have transfer pricing rules in their domestic tax legislation. In a nutshell, these rules provide that the terms and conditions of controlled transactions may not differ from those which would be made for uncontrolled transaction ( transactions between independent enterprises). This is referred to as the arm’s length principle. There are several methods that multinational enterprises and tax administrations can use to determine accurate arm’s length transfer pricing for transactions between associated enterprises. The Organization for Economic Cooperation and Development (OECD) outlines five main transfer pricing methods that these enterprises and tax administrations can use. We explore the five methods, giving examples for each, to help organizations decide which is most appropriate for their needs: 1. Comparable uncontrolled price (CUP) method; 2. Resale price method; 3. Cost plus method; 4. Transactional net margin method (TNMM); 5. Transactional profit split method. These are the five transfer pricing methods, and the ones favored by the OECD. The option that an organization chooses to use depends on the particular situation. It should take into account the amount of relevant comparables data that is available, the level of comparability of the uncontrolled and controlled transactions in question, and whether a method is appropriate for the nature of a particular transaction (determined through a functional analysis). The OECD states that it is not necessary to use more than one transfer pricing method when determining the arm’s length price for a particular transaction. Key words: transfer, pricing, associated entities, controlled transactions, method