It is probably not news anymore that around the world, tax jurisdictions are facing budgetary crises and are doing everything in their powers to generate additional tax revenues. Transfer pricing is seen, by most tax jurisdictions, as an effective way to increase said tax revenues. As such, more and more tax jurisdictions are tightening or implementing transfer pricing regulations and strengthening enforcement thereof.
On the other hand multinational enterprises (“MNEs”) are under pressure by shareholders to become more profitable which in current economic times is a tough task. Many MNEs look at transfer pricing in order to structure their tax affairs in the most efficient, yet legal, way. A correctly applied transfer pricing policy can save MNEs millions of dollars in taxes whereas a wrong strategy or implementation may result in taxes and penalties which are far greater than any tax estimates which may render a profitable transaction loss making.
So what is transfer pricing? A colleague of mine once described transfer pricing as the art of splitting a pie which has been created by friends (or otherwise related people) residing in different jurisdictions into fair pieces for each tax jurisdiction involved. This sounds much easier than it really is. To give you some food for thought, how do you determine who gets how much? I mean, who is to say that the base of the pie is more important than its filling and therefore the person who made the base should get a greater share of the pie. What if the different jurisdictions provide different ingredients to make the pie, which is more important, the eggs or the flour? Again, I cannot stress enough that this is merely a very simplified example but I am just trying to get the point across that transfer pricing is tricky, to say the least.
Let’s get into the theoretical stuff. Transfer pricing is defined by the Tax Foundation (2008) as follows:
“The price that is assumed to have been charged by one part of a company for products and services it provides to another part of the same company, in order to calculate each division’s profit and loss separately. Generally, transfer pricing rules indicate that one affiliate must charge another affiliate the same price as would be demanded in an ’arm’s length transaction’ [,a] transaction between two related or affiliated parties that is conducted as if they were unrelated, so that there is no question of a conflict of interest.”
One of the reasons why a company would sell products more cheaply or more expensively than the prevailing market price to a related part of its enterprise may be for the purpose of “earnings stripping” Please note there are other legitimate reasons but earnings stripping or also known as profit stripping is a tax authority’s main concern.
“Earnings stripping is a process by which a firm reduces its overall tax liability by moving earnings from one taxing jurisdiction, typically a relatively high-tax jurisdiction, to another jurisdiction, typically a low-tax jurisdiction. Often, earnings stripping arrangements involve the extension of debt from one affiliate to another. Debt is accumulated in a high-tax jurisdiction that allows a company to deduct interest payments from their taxable income. “
An example of earnings stripping would be where a company resident in country X sells semi-finished goods to a related party resident in a tax haven (country Y) at a lower selling price when compared to the same product being sold to an independent party. This is to ensure that there will be no or a very small profit in country X. When the product is sold in country Y, at a market related price, the profit will be higher when compared to the same product being sold by an independent party. This is due to the fact that the independent party would have had to buy the semi-finished good at a higher market related input price whereas the related company in country Y did not. The higher profit that is achieved in country Y will be taxed at a much lower tax rate as it is situated in a tax haven compared to country X. This will lead to a tax saving for the group as a whole.