by Countries around the world have huge differences in tax rates. These differences give incentive to the multinational enterprises to shift profits from high tax countries to ones with lower tax rates. This shifting of profits can be easily achieved via internal transactions, a holding company providing financing or consultancy services to its subsidiaries, a manufacturing branch supplying finished product to a distributing branch, one associated enterprise supplying provision of services to another. The MNEs can set the price and control the terms and conditions of these transactions and thereby influence the amount of profit and resultant amount of tax due. To prevent this from happening, tax administrations (organized in the OECD) invented the arm’s length principle (Article 9 of the OECD Model Convention) which requires that controlled transactions are done at market rates.
Objective of Transfer Pricing
“Associated Enterprise” means an enterprise that participates or in respect of which one or more persons who participate, directly or indirectly, or through one or more intermediaries, in the management, control, or capital of the other enterprise.
“Arm’s Length Price” refers to the price that should have been charged between related parties had those parties been not related to each other.
“Constituent Entity” means:
- Any entity of the international group that is included in consolidated financial statements for financial reporting purpose or included if equity share of any entity of the group were to be listed; or
- Any entity of the group which is excluded from consolidated financial statements on the basis of size or materiality; or
- Any permanent establishment of an entity of the group if separate financial statements are prepared for financial reporting, regulatory, tax reporting, or internal management control purposes.
Risks
- There can be disagreements within the divisions of an organization regarding the policies on pricing and transfer.
- Lots of additional costs are incurred in terms of time and manpower required in executing transfer prices and maintaining a proper accounting system to support them. Transfer pricing is a very complicated and time-consuming methodology.
- It gets difficult to establish prices for intangible items such as services rendered, which are not sold externally.
- Sellers and buyers perform different functions and, thus, assume different types of risks. For instance, the seller may refuse to provide a warranty for the product. But the price paid by the buyer would be affected by the difference.
