Transfer pricing is the area of taxation that deals with the pricing of transactions between enterprises under common ownership or control (associated enterprises). Transactions are for example the sale of goods, the provision of services, the use of intellectual property or the provision of financial transactions. The price for such transactions between associated enterprises must be comparable to what independent enterprises would agree upon.

Transfer pricing is relevant for transactions between associated enterprises. In general, enterprises can be associated for two reasons:

• An enterprise participates directly or indirectly in the management, control, or capital of another enterprise; or
• The same person participates directly or indirectly in the management, control or capital of both enterprises.

The arm’s length principle focuses on pricing the transaction between associated enterprises on market conditions. It says that transactions should be priced as if they had been carried out by independent enterprises under comparable circumstances. Market forces ensure that the price between independent enterprises is an arm’s length price.

The arm’s length principle forms the basis of international transfer pricing rules and is incorporated in most bilateral tax treaties.

Transfer pricing is relevant for each transaction between associated enterprises. In most countries substantiation of the arm’s length conditions of these transactions is required by law. In general, this relates to both domestic and cross-border transactions. The relevance of transfer pricing however increases in case of cross-border transactions with a certain materiality. This should be analysed on a case-by-case basis.

Incorrect transfer prices can lead to tax disputes and can be corrected by tax authorities. These corrections can create a risk of double taxation when they are not followed by tax authorities in other jurisdictions.

Moreover, transfer pricing should support the business of a company. Incorrect transfer prices may however lead to distortions or inefficiencies of the business. This can be prevented by a careful consideration of transfer prices.

If the transfer price is set incorrect on purpose, penalties may be imposed. This is also the case if insufficient or none transfer pricing documentation is prepared were required by law. In addition, non-compliance may also result in a reversal of the burden of proof.

The OECD Transfer Pricing Guidelines are the internationally accepted standard for transfer pricing. The OECD Transfer Pricing Guidelines provide guidance for taxpayers and tax authorities on the application of the arm’s length principle. Most countries follow the OECD Transfer Pricing Guidelines in their interpretation of transfer pricing rules. Some variations between countries may however exist.

As transfer pricing is not an exact science there is no one size fits all approach for determining a transfer price. The basis of transfer pricing is to make a comparison with transactions between independent enterprises in comparable circumstances. In practice, this comparison can be a challenge.

A typical process for determining a transfer price can be summarized as follows:

1. Broad-based analysis of the taxpayer’s circumstances;
2. Review of available intercompany agreements;
3. Understanding the intercompany transactions based on an analysis of the functions performed, risks assumed and assets used (functional analysis);
4. Review of internal comparables and/or external comparables (if available);
5. Selection of the transfer pricing method;
6. Identification of potential comparables;
7. Determination of comparability adjustments (if needed); and
8. Interpretation of data to determine the arm’s length transfer price.

Intercompany agreements are the starting point of the transfer pricing analysis. Intercompany agreements might however not always cover all the relevant aspects for a transfer pricing analysis. Transfer pricing analyses focus on the actual conduct of the respective associated enterprises. If the actual conduct of these enterprises deviates from what was agreed upon in the agreements, the actual conduct will be the subject of the transfer pricing analysis. For the burden of proof, it is recommendable to have an intercompany agreement in place and to align this agreement with the actual conduct of the respective associated enterprises.

Transfer pricing methods are used to establish an arm’s length transfer price for intercompany transactions. The methods are used to examine whether the conditions imposed in the commercial or financial relations between group enterprises are consistent with the arm’s length principle. The following five transfer pricing methods can be distinguished:

• Comparable uncontrolled price method (CUP)

The CUP method compares the price charged for property or services transferred in a controlled transaction to the price charged for property or services transferred in a comparable uncontrolled transaction in comparable circumstances. A comparable uncontrolled transaction may either be internal (between an associated enterprise and an independent enterprise) or external (between two independent enterprises).

• Resale price method

The Resale price method starts with the price at which a product that has been purchased from a related party is resold to an unrelated party. This price is then reduced by an appropriate gross margin representing the amount out of which the reseller would seek to cover its selling and other operating expenses and make an appropriate profit.

• Cost plus method

The Cost plus method starts with the costs incurred by the supplier of property (or services) in a controlled transaction. An appropriate cost plus mark-up is added to this cost, to make an appropriate profit in light of the functions performed (taking into account assets used and risks assumed) and the market conditions. What is arrived at after adding the cost plus mark up to the above costs may be regarded as an arm’s length price of the original controlled transaction.

• Transactional net margin method (TNMM)

The TNMM examines the net profit margin relative to an appropriate base (e.g. costs, sales, assets) that a taxpayer realises from a controlled transaction.

• Transactional profit split method

The Profit split method determines the division of profits that independent enterprises would have expected to realize from engaging in the transaction or transactions. It first identifies the profit to be split for the associated enterprises from the transactions in which the associated enterprises are engaged. It then splits those profits between the associated enterprises on an economically valid basis.

A comparability analysis is a comparison of a transaction between associated enterprises with a transaction or transactions between independent enterprises. These transactions are comparable if there are no differences between the two transactions that could materially affect the pricing. If adjustments can be made to eliminate these material differences, the transaction may also be considered comparable.

• Comparable uncontrolled price method (CUP)

The CUP method compares the price charged for property or services transferred in a controlled transaction to the price charged for property or services transferred in a comparable uncontrolled transaction in comparable circumstances. A comparable uncontrolled transaction may either be internal (between an associated enterprise and an independent enterprise) or external (between two independent enterprises).

• Resale price method

The Resale price method starts with the price at which a product that has been purchased from a related party is resold to an unrelated party. This price is then reduced by an appropriate gross margin representing the amount out of which the reseller would seek to cover its selling and other operating expenses and make an appropriate profit.

• Cost plus method

The Cost plus method starts with the costs incurred by the supplier of property (or services) in a controlled transaction. An appropriate cost plus mark-up is added to this cost, to make an appropriate profit in light of the functions performed (taking into account assets used and risks assumed) and the market conditions. What is arrived at after adding the cost plus mark up to the above costs may be regarded as an arm’s length price of the original controlled transaction.

• Transactional net margin method (TNMM)

The TNMM examines the net profit margin relative to an appropriate base (e.g. costs, sales, assets) that a taxpayer realises from a controlled transaction.

• Transactional profit split method

The Profit split method determines the division of profits that independent enterprises would have expected to realize from engaging in the transaction or transactions. It first identifies the profit to be split for the associated enterprises from the transactions in which the associated enterprises are engaged. It then splits those profits between the associated enterprises on an economically valid basis.

Based on an assessment of the information available, tax authorities make an informed decision about whether to start an audit. During an audit, tax authorities perform a transfer pricing analysis to determine whether the transfer pricing applied by the associated enterprises is at arm’s length. If the tax authorities are of the opinion that the transfer price applied is not at arm’s length,  transfer pricing adjustments can be made to correct the price.

Transfer pricing adjustments are corrections of the transfer price applied between associated enterprises to comply with the arm’s length principle. In general, there are three types of adjustments:

• Primary adjustment: an adjustment that a tax authority in a tax jurisdiction makes to a taxpayer’s transfer price (i.e. taxable profit) as a result of applying the arm’s length principle to transactions involving an associated enterprise in another tax jurisdiction.
• Corresponding adjustment: an adjustment to the tax liability of an enterprise by the tax authority of that jurisdiction, corresponding to the primary adjustment made by the tax authority in another jurisdiction. This ensures that the allocation of profits by the two jurisdictions is consistent.
• Secondary adjustment: an adjustment that arises from imposing tax on a secondary transaction.

In order to mitigate the risk for transfer pricing disputes, taxpayers can agree with tax authorities upfront on the transfer price. This provides taxpayers with certainty in advance on the transfer pricing consequences in future years. Such an agreement between a taxpayer and tax authorities is called Advance Pricing Agreement (APA). APAs are concluded for multiple years and can be unilateral, bilateral or multilateral. The procedures for obtaining an APA may differ per country.