A Logistical and Ethical View of Transfer Pricing in a Global Market

A Logistical and Ethical View of Transfer Pricing in a Global Market

A large share of the world's trade is comprised of the transfer of goods, services, and intangibles within multinational enterprises. As these transactions are not arm's length in nature, the practice and abuse of transfer pricing has become a topic of significant importance. At issue are the methods used by different multinational entities in determining transfer pricing policies, the fair and accurate reporting of profits to the international tax jurisdiction where earned, and the exploitation of tax regulation variances among taxing jurisdictions by certain multinational entities. These issues will now be addressed in further detail.

The term transfer pricing is used to describe the inter-company pricing arrangements pertaining to transactions between related business entities. In transactions between non-related business entities, the cost to the buyer is equal to the price paid to the seller. In transactions between a multinational entity located in one country and its subsidiary entity located in another country, distinguishing actual transfer pricing is not always as clear cut. While this may seem to be of little significance due to consolidated financial reporting, the various countries involved and more specifically their taxing authorities would like to disagree. No country - poor, emerging, or wealthy - wants to watch its tax base erode due to abusive transfer pricing strategies employed by multinational conglomerates. This is one reason why the Organization for Economic Co-operation and Development (OECD) has developed its Transfer Pricing Guidelines. While on one hand, the OECD helps multinational corporations escape double taxation, they also help tax administrations of member countries to receive their fair share of tax revenues for activity transacted within their territories. While the objective of fair transfer pricing is reasonable, applying the principles worldwide is by no means an easy task.

In order to determine the proper tax liability for each jurisdiction, the arm's length principle needs to be applied. An acceptable transfer price would be the price assigned according to the existing price on a free, open market in a comparable transaction between independent subjects. However, even with the OECD's Transfer Pricing Guidelines, determining transfer pricing rules based on arm's length principles can present its own challenges. In addition to requiring valuable time, it is not always possible to find comparable transactions to use in establishing transfer price. This could be the case when either there is a lack of clear competition on which to base the transfer pricing model, or when bounded by an imperfect market.

Aside from the logistical difficulties, there may also exist certain ethical dilemmas faced by management - the temptation to shift profits into low tax jurisdictions as a means of increasing overall after-tax income, even if the entity transacts relatively little activity in that jurisdiction. The manipulation is somewhat of an arbitrage approach where the multinational entity structures their transfer pricing to take unfair advantage of the varying foreign income tax credits and exclusions that differ from one taxing jurisdiction to another. The outcome to this practice is that a disproportionate amount of net income is being allocated to the tax jurisdictions with lower tax ramifications, while net income in jurisdictions with higher taxes is under-allocated. Regardless of motivation, there are definite advantages to fairly and accurately reporting transfer prices for an entity.

With the myriad of production possibilities open to multinational entities today; such as licensing, sub-contracting, outsourcing, and in-house development - it is critical that senior management has the most accurate cost information available. That accurate cost information includes transfer pricing. Accurate and reliable revenue and cost data are critical to the determination of profitability, whether the profitability be for the entity as a whole, or for each and every production unit within the entity. Without accurate transfer pricing, an entity could be foregoing a more viable production venue, thereby hindering the realization of its strategic objectives. Additionally, with governmental budget shortfalls on a global basis, tax authorities around the world are becoming more aggressive in respect to transfer pricing requirements. Stricter penalties, new documentation requirements, increased information exchange (thanks again to the OECD), improved audit staff training and increased audit and inspection activity all add up to change. The question is no longer "if" you should adopt more accurate methods of determining transfer pricing but how soon you can begin.

While the issues of determining transfer pricing, accurate distribution of profits among taxing jurisdictions, and the reduction in exploitation of tax inconsistencies between jurisdictions by multinational entities will by no means be resolved quickly - significant progress toward that end has been made by the OECD and its member nations. Despite the temptation to minimize tax liabilities and given the increased scrutiny of transfer pricing practices, it is evident that multinational corporations need to rethink the motivation for their current transfer pricing policies and adopt a model that will more accurately and fairly reflect the distribution of profits amount the entity's components.

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