Transfer Pricing Essay ⋆ Business Essay Examples ⋆ EssayEmpire

As world trade increases, more countries are implementing regulations to ensure they receive a fair share of taxable corporate profits. The universally acceptable approach for setting transfer prices is the “arm’s length standard.” This is a price that would have been reached by two independent parties trading in a free market. However, problems arise in applying this concept across country borders. Regulations and legal interpretations differ from country to country. A price acceptable to authorities on one side of a transaction may not be considered acceptable to those on the other side. Failure to comply with transfer pricing laws can result in significant penalties and fines. Even worse, a country may disallow a transfer price, thus forcing a change in a division’s taxable profit. If the division on the other side of the transaction is not allowed to revise its price in unison, the same corporate profit can be taxed twice.

Transfer pricing regulations were established by the Internal Revenue Service (IRS) in the United States and the Organisation for Economic Co-operation and Development (OECD) for Europe. Most of the world has adopted some form of OECD regulations. The two sets of rules are essentially the same: both agree that transfer prices can be calculated by a number of acceptable alternative methods. All methods look at some element of comparability in the marketplace to determine an arm’s-length transfer price. For example, one of these methods is called comparable uncontrollable price. It estimates transfer price by looking at prices charged by independent sellers of similar products. Another method, called cost plus, derives transfer price by using gross profit earned by independent sellers of similar products. It is up to the corporate entity to choose a method. The main criterion is that the method used should result in the most reliable means to estimate a price that would have been charged in a free-standing market.

After an MNC has selected a method and estimated an arms-length price, it must then determine whether its circumstances differ from those of the independent firm used for comparison. If differences do exist, then the transfer price will have to be adjusted accordingly. Factors to consider include product functionality, contract terms, risks, economic conditions, and differences in products. For example, an MNC division might be a new entrant to an existing market. An arm’s-length price is estimated by looking at comparable prices from independent suppliers. However, outside suppliers normally require that purchase orders consist of larger quantities and longer contractual terms. Because the intracompany transaction provides more lenient terms, the arm’s length transfer price would be adjusted to allow for these differences.

The shared use of intellectual property between company divisions presents particularly difficult transfer pricing problems. Included are such intangible assets as patents, formulas, trademarks, and brand names, among others. It is difficult to determine a market value for intellectual property because such items tend to be unique in nature. It may also be difficult to separate the benefits of one type of intangible asset from others related to products being sold. For example, a division buys a brand name pharmaceutical drug from another division. It introduces the drug in a new geographic market and undertakes an intensive marketing effort. To determine a transfer price for the brand, the corporate entity would have to separate value of brand name from that of marketing. Despite difficulties in estimating value, this type of transaction is receiving increased attention worldwide by tax authorities.

An MNC has two primary ways to alleviate tax conflicts over its transfer prices. The first is to document all aspects of transfer pricing calculations to verify adherence to the arm’s-length standard. The second is to enter into advance pricing agreements with tax authorities. Under this approach, an MNC creates a contract giving it assurance of compliance if it follows agreed-upon procedures for calculating transfer prices.

Bibliography:

Andrew B. Bernard, J. Bradford Jensen, and Peter K. Schott, Transfer Pricing by U.S. Based Multinational Firms (National Bureau of Economic Research, 2006);
Thomas A. Gresik and Petter Osmundesen, “Transfer Pricing in Vertically Integrated Industries,” International Tax and Public Finance (v.15/3, 2008);
Ashok Kumar, Transfer Pricing, Multinationals, and Taxation: Concepts, Mechanisms, and Regulations (New Century Publications, 2006);
Marc M. Levey et al., Transfer Pricing Rules and Compliance Handbook (CCH, 2006);
Victor H. Miesel et al., “International Transfer Pricing: Practical Solutions for Intercompany Pricing,” The International Tax Journal (v.28/4, 2002);
Toshio Miyatake and Robert H. Green, Transfer Pricing and Intangibles (Sdu Fiscale & Financiële Uitgevers, 2007);
Joey W. Styron, “Transfer Pricing and Tax Planning,” The CPA Journal (v.77/11, 2007);
Thomas Tucha, Fuzzy Transfer Pricing World on the Analysis of Transfer Pricing with Fuzzy Logic Techniques (Indian Institute of Management, 2005);
Villegas and J. Ouenniche, “A General Unconstrained Model for Transfer Pricing in Multinational Supply Chains,” European Journal of Operational Research (v.187/3, 2008).

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