Transfer pricing is a process where prices or rates used when selling products or services between parent companies, divisions, departments, or subsidiary (SMULLEN, 2001). It exists when two related companies (the parent company and a subsidiary) trade amongst each other. For example, a US based subsidiary of Coca-cola trading with an African subsidiary of Coca-cola. When such subsidiaries engage in price establishments for a transaction the results are transfer pricing.
WITTENDORFF (2010) provides that in transfer pricing the prices set for the exchange may be the original prices set for the products or the original purchase price or a rate reduced to cater for internal depreciation. In situations where the goods transacted are transported, the rated used include both the fixed prices per unit of commodity transferred plus the transportation or shipping charges considered as additional charges (ABDALLAH, 2004). The parent company may arrange for such charges through a discounted plan with the smaller entity.
In management accounting, transfer pricing is used as a tool of managing the profit and loss ratios within a company (BRAGG, 2013). The process makes it possible for companies to move goods and services with the smallest amounts of expenditures possible, and this adds on the value of profit and loss statements. It is also an effective way to move goods within a company’s divisions without generating a lot of postings on the accounts payables and receivables. It eliminates the necessity for internal bills of lading, invoices, tariffs and documents that accompany transactions with outside vendors.
While the main aim of transfer pricing is enhancing the overall value and quality of the corporate world, there are some instances when it can be misused. This mostly happens when international transfers are conducted leading to product mispricing. An example of transfer mispricing is hen transfer pricing occurs between unrelated parties or un-invoicing.
It is approximated that at least 60% of international trade happens between multinationals or across international subsidiaries within the same corporate group. To minimize cases of transfer mismanagement or manipulation, most countries have regulations that control international pricing strategies by use of transfer pricing method so that unethical acts that lead to transfer mispricing, such as tax evasion are eliminated.
THE PRINCIPLE OF TRANSFER PRICING.
In all transactions be it local or international, the facts about all costs must be established for proper identification and accounting of the service. The functions and costs related to the supply of a commodity or service, and the extent to the recipient benefits must also be established (SMULLEN, 2001). Such costs would affect the prices charged, levels of tax, and profit levels of the subsidiaries.
When two unrelated companies transact, the results are the generation of a market price. This is referred as arms-length trading. The resulted price is a product of negotiation in a market (OECD, 2009). The arms length price is considered as internationally acceptable for taxable purposes by the Organization for Economic Co-operation and Development (OECD).
The OECD has developed the arms-length principle of transfer pricing. The principle states that the amount charged by transacting parties should be equivalent whether the parties are related or not related. The principle states that the arms-length price is the price charged for a commodity as if the transaction happened in an open market (HEIMERT, 2010).
The arms-length principle (ALP) was introduced by OECD in 1995 for multinational enter[rises and tax management. According to ALP a transfer price is internationally acceptable if all transactions between the parties are done at arm’s-length price. In applying the principle, to the international domain, attention should remain on the scope and nature of the transaction (ABDALLAH, 2004). Each party should be treated as a unit entity rather than an inseparable part of a single or unified business. This minimizes the risk of tax evasion and double taxing. According to the OECD guidelines, the ALP takes two forms; traditional transaction method and the transactional profit method or non-transactional method (BENKE and EDWARDS, 1980).
The OECD provides that the most appropriate method of determination of the arm’s length price should be used in the manner and way described. The method should be ascertained having regard to the class and nature of transaction, or the associated persons (OECD, 2009). The method should also be applied as prescribed by the board of determination of the arm’s length price. OECD admits that not every method is applicable in every situation and that the applicability of a method needs not to be disapproved. It is the duty of the tax administrators to desist from making marginal adjustments (BRAGG, 2013). Additionally, multi-national enterprises should retain their freedom in applying methods of price determination provided such methods satisfy the rule of the arm’s length principle.
The traditional transaction method highlights each transaction relative to the view of overall profits of the connected entities. The OECD recognizes the Comparable Uncontrolled Price method (CPU), Resale Price method (RPM), and the Cost Plus Method (CPM) as the internationally acceptable transaction methods under traditional transaction method.
CUP recognizes the prices charged in an uncontrolled deal between comparable parties, and evaluates such prices with the verified entity in the determination of the arm’s-length price (ROXAS, STONEBACK and ROXAS, 2011). Under CUP, the arm’s length price arises in four different conditions: Firstly where an ALP entity sells similar products in similar quantities and comparable conditions to the other arm’s length parties in similar markets (internal comparable). The second condition applies where a tax payer, or any other associate member, sells the product in comparable terms, sizes, and in a similar market (internal comparable) (OECD, 2009).
The third instance is when the tax payer buys similar quantities in similar terms and comparable quantities from associated parties, in a comparable market (internal comparable). The fourth condition applies where an ALP party transacts a commodity in comparable quantities and similar terms from another arm’s length associate party in a similar market (external comparable).
The CPM involves measuring the total price of transferring the products, and the sum of gross spot arrived at using similar enterprises and comparable transactions with self determining associate enterprises determined. The gross spot is used to account for functional and other variations in determining the ALP (BRAGG, 2013). Costs under CPM are classified into direct, indirect, and operating costs. The cost base of the transaction to which the mark-up is to be applied is calculated the same way as the cost base of a similar transaction. Where costs do not resolute the same way, both the transfer and mark-up are used.
The RPM relates to CPM, and applied in cases where the vendor adds similar value to the commodities owned from the associate enterprise. The arm’s length price is determined by reducing the gross profit mark-up from the selling price charged in a free entity (BENKE and EDWARDS, 1980). The gross margin and resale margin allows the vendor to recover the operating costs, and earn an arm’s length profit that supports properties used and risks covered.
The transactional profit method relates the profits statistics of the parties, measures and adjusts them relevant to their share. The Profit Split method (PSM) and Transactional Net Margin Method (TNMM) are the methods used in the determination of the arm’s length price under this method. PSM is used when parties are relatively intertwined; when it is difficult to make a transfer pricing analysis on a transactional method basis (ROXAS, STONEBACK and ROXAS, 2011). The priority function is to decide on a combination of the net profit acquired, and allocating it between the parties in comparison to the market income gained by free markets in a comparable transaction. The TNNM applies in cases of transfer of incomplete or partially completed products, distribution of commodities, and where RPM is insufficient (BENKE and EDWARDS, 1980).
THE CONCEPT OF COMPARABILITY IN TRANSFER PRICING.
For all pricing transfer methodologies, the concept of comparability is a pre-requisite so that the prices adapted conform to the arm’s length principle. The concept of comparability refers to a comparison of conditions in a controlled transaction with transactions in the free market or between independent parties (ABDALLAH, 2004). A transaction is deemed comparable if the transactions being compared do not have any material difference. It is also comparable when it is possible to eliminate material differences in the transaction by reasonably and accurately making adjustments.
In conducting a comparability analysis, focus is directed to circumstances that surround a transaction’s financial and commercial relation between associated enterprises, and the economic performance factors, such as margins and profits (MARKHAM, 2005). The comparability factor is determined by a consideration of the characteristics of commodities transacted. The similarity or differences of products is more relevant when comparing prices rather than margins between controlled or uncontrolled transactions. The characteristics that are compared include the commodity’s physical features such as quality and volume, the nature and extent or provision of the service or commodity, and in case of intangibles, the form of the transaction and property. Such comparisons are useful when applying the Comparable Uncontrolled Price (CUP) method of arms’ price determination.
The functions performed by a commodity or service being transacted are also relevant in comparability analysis. A functional analysis on product design, research and development, marketing, advertising, and manufacturing is conducted in determining how the functions, assets and risks are to be divided up between the transacting enterprises (SMULLEN, 2001). A functional analysis, however, does not determine the result of arm’s length of a controlled transaction but forms a basis of identifying comparables.
An analysis of contractual terms complements the functional analysis in coming up with the arm’s length price. This includes the allocation of responsibilities, benefits and risks between enterprises in a contract agreement (MARKHAM, 2005). Such terms may influence the price margin, payment terms, terms of warranties, and volume of transactions, which are critical in transfer pricing.
Other factors considered in comparability analysis of transfer pricing include the economic circumstances that have influence on prices such as market size, substitutability of commodities, geographical regions of transacting enterprises, and government intervention. The business strategies may also be used as comparable factors. Such strategies as market penetration schemes, extent of diversification, product development, market allocation, innovation levels, and channels of distribution contribute to business pricing strategies (MARKHAM, 2005). In comparability analysis, it is crucial to determine the extent that such strategies would have on the levels of tax expected from the enterprises.
LIKELY DEVELOPMENTS IN TRANSFER PRICING IN AN ERA OF GLOBALIZATION.
Transfer pricing involves determining the price at which transactions between units of multinational enterprises take place, including inter-company transfer of property, loans and leases, and services. Most multinational companies have elevated the need for transfer pricing, and dedicated additional resources to understand, plan, and document their inter-company pricing strategies. More often than not multinational companies think globally but most of them act locally. This is as a result of improper implementation of price transfer policies, and lack of management of the process. The increased importance of globalization, however, has driven most international enterprises to recognize the need for transfer pricing, and the need to elevate their profiles to fit in the process.
Transfer pricing is of importance to corporations intending to participate in globalization. The process is, however, challenged with the diversities and complexities in the tax regimes of different economies. This creates a favorable environment for some corporations to allocate and design strategies for allocating costs, enabling them to minimize on their tax payments (NAKADA, 2004). Experts argue that transfer pricing is the best strategy for minimizing tax evasion and double taxation, but also opens tax abuse.
The mobilization of transfer pricing policies for tax avoidance and evasion is significantly invisible in some economies, and also an expensive and difficult task for most regulatory authorities to detect. For purposes of globalization, there is the need to involve authorities such as tax regulatory authorities, lawyers, auditors, government consultants, multinational agencies such as OECD, and accountants (HEIMERT, 2010). Such authorities will engage in revising and establishing new rules of transfer pricing that will assist in calculating acceptable prices, and develop ways to detect manipulation, tax avoidance and evasion.
The malleability of transfer pricing and its role in tax avoidance, and’ knock on effect’ on public legitimacy have led to some economies such as US to take considerable powers that challenge corporate calculations. For example, the US tax authorities have powers to allocate deductions, credits, incomes, or other allowances between controlled enterprises if such a process is considered necessary to prevent tax evasion. Other transnational agencies have also developed joint frameworks such as the formation of treaties, and guidelines that control transfer pricing. In the era of globalization, every economy should establish measures and policies that authorize the tax authorities to collect all relevant information related to a transaction (NAKADA, 2004). There is the need to show greater interest in scrutinizing the effect of transfer pricing on corporate taxes.
Economies should also be encouraged to enter into bilateral or multilateral agreements to improve on transfer pricing regulations (BROOMHALL, 2007). Such agreements should adopt variants of the arm’s length principal as the economies seek to simultaneously support international trade. A possible challenge in such agreements is that, in the absence of active markets, a suitable transfer price may not be ascertainable. This may be the case in economies where companies use brands, logos, trademarks, and other intangible assets for identification (BATEMAN, 2007). Multinational companies need to be encouraged to provide information on countries of operation, names and performance of all subsidiaries, and details of gross and net assets.
The unitary taxation approach may also be a solution to support globalization and transfer pricing. Unitary taxation involves taxing various parts of a multinational enterprise based on its activities. It involves setting up jurisdiction of how international corporations should be taxed in their places of operations. The corporation groups should be treated as units them the group’s income apportioned out the participating states according to an agreed formula (BROOMHALL, 2007). Each state should then apply its tax rates to the overall income of the unit apportioned. Such a strategy may boost international trade and globalization in that it would allocate profits based upon third party factors such as employment levels, total sales, and the total value of physical and intangible assets. The states also have the capacity to set the tax rates that they want.
The conventional solution to dealing with transfer mispricing, however, lies in the principle of arm’s length pricing. Globalization will be enhanced by the fact that the transfer price remains the same as if the trading enterprises were unrelated or negotiating in a free market (BATEMAN, 2007). This would boost the basis of formation if bilateral treaties among governments in trading enterprises. There is the need for increased awareness of the determination of transfer prices, and the need to collect taxes from the corporate world if economies are to benefit from globalization.
With its best intentions, most economies find it difficult to implement the ALP. The resulting damage of arm’s length has been the inability of governments to collect revenues from the corporate tax systems. Billions of dollars are wasted due to lack of governments’ enforcements, and lack of resources to meet the expensive compliance of transfer pricing. However, incorporating different authorities such as lawyers, government, accountants, auditors, tax authorities, and other multinational agencies such as OECD will guarantee successful implementation of transfer pricing, and globalization (BROOMHALL, 2007). With proper implementation of the Arm’s Length Principal of price determination, the problems of tax evasion and double taxing will be resolved. Additionally, corporate companies will participate in their corporate social responsibilities such as local employment, which also marks a successful globalization.
BIBLIOGRAPHY.
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