Further, because Alpha is in a high-tax state, any transfer pricing system that shifts taxable income away from Alpha will probably be challenged almost automatically by the state in which Alpha is situated. In most states, companies compute taxable income using the federal income tax rules as the starting point; however, in determining the portion of their net income subject to tax by each state, companies typically use allocation and apportionment formulaswhich, unfortunately, vary from state to state.
Generally, its to the taxpayers advantage to establish high transfer prices for goods and services provided by a unit in a jurisdiction with low tax rates. The result is to have more revenue subjected to a lower rate and less to a higher rate. If the operating unit receiving the goods and services is in a high-rate jurisdiction, the high transfer price also produces a large expense deduction for that division.
When goods and services must flow in the opposite directionfrom high- to low-tax jurisdiction, its better for the transfer price to be set as low as possible. Of course, tax authorities usually have a different interest: They want to maximize tax revenues. If the U. A similar problem can arise if Example later changes its transfer pricing system. The prospective loss of tax revenue may lead one jurisdiction to reject the new system, while a prospective increase in taxes may lead the other jurisdiction to leave the new system in place.
The key is not simply to set individual transfer prices at the right level but to have a defensible system in place for setting transfer prices and to make sure that that system wins government approval in all tax jurisdictions. CPAs should be aware that some national taxing authorities, including the IRS, will examine and may approve a taxpayers proposed transfer pricing method in advance, thus removing the uncertainty.
A business wishing to reduce the uncertainty concerning IRS approval of its transfer pricing method can participate in the IRS advance pricing agreement APA program, as set out in revenue procedure CB More than businesses have secured protection under this program.
A critical issue is establishing a transfer price for marketing and administration services. Assuming Alpha charges Beta and Gamma a low price in relation to what Alpha incurs to provide those services for marketing and administration services, taxable income effectively would shift away from Alphas high-tax jurisdiction and to Betas and Gammas low-tax jurisdictions. To be sure, the company would have to justify that price.
While cost-plus prices have the appeal of simplicity and ease of calculation, be aware that cost-plus transfer prices can provide exactly the wrong incentive for the producing unit. For example, suppose Betas manager wants to improve profits, including the profits that result from transfer pricing. Using the market-based approach, assume a division producing the transferred goods and services also sells some of the same outputs to unaffiliated entities in arms-length transactions: Those transactions can serve as a starting point in a system of market-based transfer prices.
The latter approach not only avoids the incentive drawbacks of a cost-plus system but in theory it also is the preferred way to value the output of each unit.
Its weakness is that its difficult to defend the system as being truly market-based. For example, a single item may have different prices in different markets, depending on local supply and demand, regulation, shipping costs and many other factors. Transfer prices must reasonably reflect those differences, and when market conditions change significantly, the transfer prices must be revised.
For the transfer pricing system to be defensible, it must be treated consistently throughout the company. A separate chapter, Chapter B. Cost-contribution agreements CCAs may be formulated among group entities to jointly develop, produce or obtain rights, assets or services.
Each participant bears a share of the costs and in return is expected to receive pro rata i. Such arrangements tend to involve research and development or services such as centralized management, advertising campaigns etc. In a CCA there is not always a benefit that ultimately arises; only an expected benefit during the course of the CCA which may or may not ultimately materialize.
The interest of each participant should be agreed upon at the outset. The contributions are required to be consistent with the amount an independent enterprise would have contributed under comparable circumstances, given these expected benefits. The CCA is not a transfer pricing method; it is a contract.
There is often concern expressed by enterprises over aspects of data collection by tax authorities and its confidentiality. Tax authorities need to have access to very sensitive and highly confidential information about taxpayers, such as data relating to margins, profitability, business contacts and contracts.
Using a secret comparable generally means the use of information or data about a taxpayer by the tax authorities to form the basis of risk assessment or a transfer pricing audit of another taxpayer.
Caution should be exercised in permitting the use of secret comparables in the transfer pricing audit unless the tax authorities are able to within limits of confidentiality disclose the data to the taxpayer so as to assist the taxpayer to defend itself against an adjustment. Taxpayers may otherwise contend that the use of such secret information is against the basic principles of equity, as they are required to benchmark controlled transactions with comparables not available to them — without the opportunity to question comparability or argue that adjustments are needed.
It should be recognized that transfer pricing regimes are creatures of domestic law and each country is required to formulate detailed domestic legislation to implement transfer pricing rules. Many countries have passed such domestic transfer pricing legislation which typically tends to limit the application of transfer pricing rules to cross-border related party transactions only.
De minimis criteria for the value of related party transactions may also exist. In other words, some transactions may be considered small enough that the costs of compliance and collection do not justify applying the transfer pricing rules, but this should not allow what are in reality larger transactions to be split into apparently smaller transactions to avoid the operation of the law.
However, it is ultimately for each country to adopt an approach that works in its domestic legal and administrative framework, and is consistent with its treaty obligations. They may only be used by the taxpayers at their option. CFC rules treat this income as though it has been repatriated and it is therefore taxable prior to actual repatriation. After the application of transfer pricing rules, countries can apply the CFC rules on the retained profits of foreign subsidiaries.
This is because it may be sometimes more advantageous from a tax viewpoint to finance a company by way of debt i. To prevent tax avoidance by such excessive leveraging, many countries have introduced rules to prevent thin capitalization, typically by prescribing a maximum debt to equity ratio. From a policy perspective, failure to tackle excessive interest payments to associated enterprises gives MNEs an advantage over purely domestic businesses which are unable to gain such tax advantages.
Another important issue for implementing domestic laws is the documentation requirement associated with transfer pricing. In deciding on the requirements for such documentation there needs to be, as already noted, recognition of the compliance costs imposed on taxpayers required to produce the documentation. A useful principle to bear in mind would be that the widely accepted international approach which takes into account compliance costs for taxpayers should be followed, unless a departure from this approach can be clearly and openly justified because of local conditions which cannot be changed immediately e.
In other cases, there is great benefit for all in taking a widely accepted approach. APAs provide greater certainty for the taxpayer on the taxation of certain cross-border transactions and are considered by the taxpayers as the safest way to avoid double taxation, especially where they are bilateral or multilateral.
Many countries have introduced APA procedures in their domestic laws though these may have different legal forms. For example, in certain countries an APA may be a legally binding engagement between taxpayers and tax authorities, while in other countries it may be a more informal arrangement between the tax authorities and the taxpayer. The possible advantages and disadvantages of APAs for developing country administrations and taxpayers, including some implementation issues, are addressed in Chapter C.
However, too long a period during which adjustment is possible leaves taxpayers in some cases with potentially very large financial risks. Differences in country practices in relation to time limitation should not lead to double taxation. Countries should keep this issue of balance between the interests of the revenue and of taxpayers in mind when setting an extended period during which adjustments can be made. One view is that the associated enterprises article of a tax treaty provides a separate and independent domestic basis for making transfer pricing adjustments.
The detail in such domestic laws will vary from country to country and will often vary depending on how advanced the country is in its transfer pricing journey. A tax treaty is, in this view, a mechanism to allocate the taxing rights to prevent double taxation arising from the overlap of residence and source jurisdiction. Tax treaties operate by altering the operation of domestic tax law; by either excluding the operation of the domestic tax law of a treaty country or by requiring a treaty country to provide a credit against its domestic tax for tax paid in the other treaty country.
The taxing powers of each treaty country are based on their respective domestic taxation law and may be limited but not expanded by the treaty. Also, treaties do not provide the necessary detail on how a transfer pricing regime will work in practice, such as the documentation required. As a consequence of these factors, it is generally considered that a country with tax treaties should enact domestic transfer pricing measures rather than asserting that its treaties provide it with a power to make transfer pricing adjustments.
For transfer pricing measures to be effective, a jurisdiction must enforce them and ensure that taxpayers comply with the rules. If jurisdictions either do not enact transfer pricing measures or do not enforce those measures there is an incentive for taxpayers to ensure that intra-group transfer prices favour jurisdictions that enforce their rules.
This may be described as taking the line of least resistance, but it does provide an incentive for developing jurisdictions to enact and enforce some form of transfer pricing rules to protect their revenue base.
That MNEs might use transfer prices to shift profits from lower tax countries to higher tax countries is a paradox, but happens in practice e. MNEs may also have an incentive to shift profits to jurisdictions in which tax laws, such as transfer pricing rules, are not enforced. Consequently, some international enterprises might set their transfer prices to favour a jurisdiction expected to enforce its transfer pricing rules, in order to minimize the risk of transfer pricing adjustments and penalties in that jurisdiction.
Moreover, transfer pricing disputes are generally time consuming and expensive. A final version was first published in There has historically been a widespread view that the OECD Model was most appropriate for negotiations between developed countries and less suitable for capital importing or developing countries.
In general, it can be said that the UN Model preserves more taxation rights to the source state i. The UN Model has been embraced by many developing states as the basis of their treaty policy. Some developed countries also adopt some UN Model provisions, and at times it has influenced changes to give aspects of the OECD Model a greater source country orientation.
In other words, if one country increases the profit attributed to one side of the transaction, the other country should reduce the profit attributed to the other side of the transaction. The competent authorities of the Contracting States are if necessary to consult with each other in determining the adjustment. However, the UN Model also includes an additional paragraph Article 9 3 which stipulates that a Contracting State is not required to make the corresponding adjustment referred to in Article 9 2 where judicial, administrative or other legal proceedings have resulted in a final ruling that, by the actions giving rise to an adjustment of profits under Article 9 1 , one of the enterprises concerned is liable to a penalty with respect to fraud, or to gross or willful default.
The Model Conventions use the concept to cover relationships between enterprises which are sufficiently close to require the application of transfer pricing rules. Also, sometimes a wider definition including both de jure i. The MAP facilitates the settlement of disputes on corresponding adjustments among competent authorities. It should be noted that the MAP procedure does not guarantee relief as it is voluntary; there is, however, a duty to negotiate in good faith to try to achieve a result consistent with the treaty allocation of taxing rights.
Chapter C. Finally, there are a small number of bilateral treaties which allow for arbitration to resolve transfer pricing disputes. Further, the EU Arbitration Convention establishes a procedure to resolve disputes where double taxation occurs between enterprises of different Member States in the EU as a result of an upward adjustment of profits of an enterprise of one Member State.
Transfer pricing rules have been developed mainly by the members of the OECD i. Many developing countries currently face some of the same conditions as the OECD countries did in the period from the s to the s.
Developing countries often have substantial problems with the availability of comparable transactions. This issue is considered more fully in Chapter B.
Documentation requirements should as far as possible be common between the two Models UN and OECD , because diversity in documentation rules results in excessive compliance costs for MNEs and smaller enterprises. Targeted documentation requirements can be an alternative to full scale documentation where transactions are simple and the tax at issue is not large.
This may be especially important in responding to the needs and capabilities of small and medium-sized enterprises SMEs. The UN and OECD Model Conventions, the OECD Guidelines and domestic legislation of various countries have provided examples for introduction of transfer pricing legislation worldwide, as a response to the increasing globalization of business and the concern that this may be abused to the detriment of countries without such legislation.
Many other countries depend on anti-avoidance rules to deal with the most abusive forms of transfer pricing; see further Part B. Increasing globalization, sophisticated communication systems and information technology allow an MNE to control the operations of its various subsidiaries from one or two locations worldwide.
Trade between associated enterprises often involves intangibles. The nature of the world on which international tax principles are based has changed significantly. It is widely accepted that transfer pricing is not an exact science and that the application of transfer pricing methods requires the application of information, skill and judgement by both taxpayers and tax authorities. The intention of this Manual is to play a part in reducing those gaps.
Some of the specific challenges that many developing countries particularly face in dealing effectively with transfer pricing issues and which will be dealt with in more detail later in this Manual are listed below. Proper comparability is often difficult to achieve in practice, a factor which in the view of many weakens the continued validity of the principle itself.
These comparables have to be close in order to be of use for the transfer pricing analysis. In the worst case, information about an independent enterprise may simply not exist. Databases relied on in transfer pricing analysis tend to focus on developed country data that may not be relevant to developing country markets at least without resource and information-intensive adjustments , and in any event are usually very costly to access; and. Given these issues, critics of the current transfer pricing methods equate finding a satisfactory comparable to finding a needle in a haystack.
Overall, it is quite clear that finding appropriate comparables in developing countries for analysis is quite possibly the biggest practical problem currently faced by enterprises and tax authorities alike, but the aim of this Manual is to assist that process in a practical way.
Transfer pricing methods are complex and time-consuming, often requiring time and attention from some of the most skilled and valuable human resources in both MNEs and tax administrations. Transfer pricing reports often run into hundreds of pages with many legal and accounting experts employed to create them. This kind of complexity and knowledge requirement puts tremendous strain on both the tax authorities and the taxpayers, especially in developing countries where resources tend to be scarce and the appropriate training in such a specialized area is not readily available.
Their transfer pricing regulations have, however, helped some developing countries in creating requisite skill sets and building capacity, while also protecting their tax base. Transfer pricing compliance may involve expensive databases and the associated expertise to handle the data. Transfer pricing audits need to be performed on a case by case basis and are often complex and costly tasks for all parties concerned. Similarly, the tax authorities of many developing countries do not have sufficient resources to examine the facts and circumstances of each and every case so as to determine the acceptable transfer price, especially in cases where there is a lack of comparables.
In case of disputes between the revenue authorities of two countries, the currently available prescribed option is the Mutual Agreement Procedure as noted above. This too can possibly lead to a protracted and involved dialogue, often between unequal economic powers, and may cause strains on the resources of the companies in question and the revenue authorities of the developing countries. The Internet has completely changed the way the world works by changing how information is exchanged and business is transacted.
Physical limitations, which have long defined traditional taxation concepts, no longer apply and the application of international tax concepts to the Internet and related e-commerce transactions is sometimes problematic and unclear. From the viewpoint of many countries, it is essential for them to be able to appropriately exercise taxing rights on these intangible-related transactions, such as e-commerce and web-based business models.
Whether they can do so effectively using the current international taxation models is a matter of considerable debate. Let's say that an automobile manufacturer has two divisions: Division A, which manufactures software, and Division B, which manufactures cars. Division A sells the software to other carmakers as well as its parent company. Division B pays Division A for the software, typically at the prevailing market price that Division A charges other carmakers.
Let's say that Division A decides to charge a lower price to Division B instead of using the market price. As a result, Division A's sales or revenues are lower because of the lower pricing.
In short, Division A's revenues are lower by the same amount as Division B's cost savings—so there's no financial impact on the overall corporation.
However, let's say that Division A is in a higher tax country than Division B. The overall company can save on taxes by making Division A less profitable and Division B more profitable.
In other words, Division A's decision not to charge market pricing to Division B allows the overall company to evade taxes. In short, by charging above or below the market price, companies can use transfer pricing to transfer profits and costs to other divisions internally to reduce their tax burden.
Tax authorities have strict rules regarding transfer pricing to attempt to prevent companies from using it to avoid taxes. The IRS states that transfer pricing should be the same between intercompany transactions that would have otherwise occurred had the company done the transaction with a party or customer outside the company.
According to the IRS website, transfer pricing is defined as follows:. As a result, the financial reporting of transfer pricing has strict guidelines and is closely watched by tax authorities.
Auditors and regulators often require extensive documentation. If the transfer value is done incorrectly or inappropriately, the financial statements may need to be restated, and fees or penalties could be applied. However, there is much debate and ambiguity surrounding how transfer pricing between divisions should be accounted for and which division should take the brunt of the tax burden.
A few prominent cases continue to be a matter of contention between tax authorities and the companies involved. Because the production, marketing, and sales of Coca-Cola Co. The trial, which was set for August at the U. Medtronic is accused of transferring intellectual property to low-tax havens globally. The transfer involves the value of intangible assets between Medtronic and its Puerto Rican manufacturing affiliate for the tax years and The court had originally sided with Medtronic, but the IRS filed an appeal.
Both sides are now awaiting a decision from the Tax Court. Internal Revenue Service. Securities and Exchange Commission.
International Tax Review. Medtronic Investor Relations. Accessed May 6, United States Courts. Commissioner of Internal Revenue. Business Essentials. Investing Essentials.
0コメント