If you are looking to expand your business across borders, you cannot afford to make a move without a foolproof tax strategy in place. That’s why matters like transfer pricing have become a focal point for multinational enterprises.
Keeping up with international tax regulations is a complex issue and non-compliance can prove costly. Particularly in international business operations, setting a transfer pricing is crucial between two related legal entities within an organization for exchanging products or services.
WHAT IS TRANSFER PRICING?
The following example explains what transfer pricing is.
Enterprise A provides insurance services in Singapore. Enterprise B provides accounting services in Malaysia. Both A and B are 100% owned by Enterprise C, making A and B associated enterprises.
Now, A wants to hire accounting services from B. Since their parent company is same, but they have separate profit systems, they need to use a transfer price for selling the services. Here C has no control over the selling price. The prices are set by supply and demand. So, C can only control the transactions between A and B.
In turn, the internal sale of services by B to A is called a controlled transaction. The price charged for this transaction is called a transfer price.
HOW TRANSFER PRICING WORKS
CONTROLLED AND UNCONTROLLED TRANSACTIONS
Controlled transactions take place between two legal entities that are associated. In short, these are associated enterprises. Transactions that happen between two independent entities are called uncontrolled transactions.
According to the definition by the Organization for Economic Co-operation and Development (OECD), enterprises are associated if:
- They participate directly or indirectly in the management, control or capital of another enterprise or,
- The same persons or entities directly or indirectly participate in the management, control or capital of two enterprises.
Some common types of controlled transactions are listed.
- Supply of materials/goods
- Transfer of business / assets
- Provision of guarantee
- Provision of support services
- Provision of management services
- Granting of license
Other than ‘visible’ controlled transactions such as the supply of materials/goods, there can also be ‘invisible’ transactions like a guarantee provided to a bank for a credit facility.
WHAT IS THE OBJECTIVE?
Implementing a comprehensive transfer pricing strategy helps multinational corporations optimize their business operations and expansion efforts. Moreover, it ensures tax compliance, as tax rates vary drastically between countries. Not setting an appropriate transfer pricing may lead to the shift of profits from high-tax countries to lower-tax countries. It can also result in multinationals reporting much higher taxes in high-tax countries and much lower taxes in low-tax countries.
Often, countries have transfer pricing rules in their domestic tax legislation. These rules can outline that the terms and conditions of controlled transactions may not be different from uncontrolled transactions. This is called the “Arm’s Length Principle.”
Thus, the main objective of an effective transfer pricing strategy is to prevent either of these situations.