I intend for this page to be as comprehensive as possible and welcome any comments that anyone has on a topic that seems always to have been controversial.

Definition of Transfer pricing

I have seen a number of definitions of transfer pricing and offer the following as a decent one:

A transfer price is the amount of money that one unit of an organisation charges for goods and services to another unit of an organisation.

Despite the fact that transfer pricing arrangements can exist in the humblest of organisations, many people get stressed about them and immediately launch into tirades against multi national corporations!

Why do I say this?

Well, there has been a huge amount of research into transfer pricing over the last thirty years or so and a lot of it is aimed at multi nationals.

The Organisation for Economic Cooperation and Development (OECD) issued transfer pricing guidelines in 1979 and it defines transfer prices as:

... payments from one part of a multi national enterprise for goods or services provided by another ...
Source: http://www.oecd.org/document/47/0,2340,en_2649_33753_2508655_1_1_1_1,00.html

... this is a click through link

The Inland Revenue says that

Transfer pricing concerns the terms that connected parties use when they conduct business with each other. The issue is of most importance for multinational groups that conduct business across international boundaries.
Source: http://www.inlandrevenue.gov.uk/international/technical2.htm

Again, note the stress on multinationals; but not everyone is so obsessed with the multi national angle.

Transferpricing.ca Limited, an Ontario incorporated private company that promotes understanding of Canadian transfer pricing rules and regulations defines a transfer price as:

... an amount paid or payable or an amount received or receivable, as the case may be, by a participant in the transaction as a price, a rental, a royalty, a premium or other payment for, or for the use, production or reproduction of, property or as consideration for services (including services provided as an employee and the insurance or reinsurance of risks) as part of the transaction.
Source: http://www.transferpricing.ca/downloads/ita247.pdf

This latter definition is incomprehensible, unless it is appreciated what context it has been written in. However, it does not mention multinational corporations.

Accounting and Consulting firm Grant Thornton define transfer pricing as:

Transfer pricing is the process by which related parties set the prices at which they pass goods, services, finance and intangible assets between each other
Source: http://www.grant-thornton.co.uk/pages/Services/

Again, Grant Thornton provide us with a rational definition in that it related to related parties and doesn’t get hung up on multinational corporations although their work is at least partly aimed at working with TNCs.

Calculating a Transfer Price

Given that a transfer price is the “selling price” that department or division A sells at to department or division B of the same organisation, the basis of that transfer price is ably demonstrated by SJ Challinor in his Power Point Presentation: this is hosted on this web site and you can download a ZIPped version of it from here now http://www.duncanwil.co.uk/TransPricing.zip Note that this presentation contains a lot more than just transfer pricing and thanks to Stuart Challinor for making this presentation available to us. Please note, Stuart advises that he put this presentation together a while ago so you may need to review some of the messages it contains.

Challinor distinguishes between artificial and natural profit centres in an organisation and illustrates this with the following diagram:

One of the key aspects here is that a transfer price is equivalent to an ordinary selling price and that any department or division that sets a transfer price is effectively selling its goods and services at a profit or a loss to another department or division within its organisation. Any part of an organisation using transfer pricing will be classed as a profit centre: since it is operating with a view to making a profit (whether positive, profit, or negative, loss).

If goods and services are transferred between departments and divisions at cost, then no profit or loss arises and the issue of transfer pricing does not, or should not, arise.

Organisations have a system of transfer pricing, therefore, in order to assess the efficiency and effectiveness of its department and divisional managers. This maybe in spite of the fact that transfer prices may be artificial in the sense that it is felt that there is no rationale for “selling” between departments and divisions.

What does Challinor mean by artificial and natural profit centres, then?

Natural Profit Centres

Occur only at that stage in a vertically integrated business where revenue and costs coincide ie when products are sold: known as the rolled through profit.

Artificial Profit Centres

Many vertically integrated businesses are broken down into artificial profit centres at the various operational levels.

The profit Centre principle is used to show the relative contribution to total profit made at each stage of the operation.

The system requires that output be valued at each stage of the operation: the internal transfer price.

The transfer represents an estimate of the market value of output at intermediate stages in the value chain.

Again, Challinor has a very useful illustration of how all of this comes together:

NOTE: Challinor has simplified his arguments: there is no mention in this diagram of anything other than production or factory costs. After, all only production costs can be classified as direct and indirect.

What’s All the Fuss About?

So what’s all of the fuss about? There is a problem with transfer pricing that has spurned Manfred Davidmann to write:

One of the most controversial and often least understood operations of multinationals, transfer pricing, is clearly described and defined.

Source: http://www.solbaram.org/articles/clm503.html

Firstly, I find Davidmann’s style to be rather emotional but at least he does take us through a set of examples that illustrate some of the worries that people have with multinational corporations and their supposed tax shenanigans.

Davidmann’s discussion begins with:

When one part of a multinational organisation in one country transfers (that is, sells) goods, services or know how to another part in another country, the price charged for these goods or services is called 'transfer price'. This may be a purely arbitrary figure, meaning by this that it may be unrelated to costs incurred, may be unrelated to operations carried out or to added value. We will see here that the transfer price can be set at a level which reduces or even cancels out the total tax which has to be paid by the multinational.

Davidmann then takes us step by step through the examples he has devised:

Paying Some Tax

Paying no Tax

Getting Tax Rebates

Tax Avoidance

Increases Profits

Transfers the Tax Obligation

All of the examples that follow are illustrated in the table that follows them

Paying Some Tax

In all of the cases that follow, the ultimate selling price to the final consumer is £300.

Case 1

The subsidiary company buys goods at £100 each. They repack them and then export them from their country to our country, selling them to us at a price of £200 each. They are transferring them to us for a transfer price of £200.

So they have made a profit of £200-100 = £100 and we are getting them at a price of £200. This case is illustrated in the table at the end of this section (Case 1).

Case 2

Consider Case 2 (see table). The transfer price is now £280 (compared with the previous £200). This has the effect of shifting before-tax profits from the parent company's home country (corporation tax 60%) to the subsidiary's host country (corporation tax 20%).

Overall, we now pay less tax (£36 + 12 = £48) and as the before-tax profit is unchanged (£200), the after-tax profit becomes £200 - 48 = £152 and that is much more than the corresponding profit of £120 we made with a transfer price of £200.

The subsidiary contributes £144 to this while our own contribution is £8.

Our overall after-tax profit is now 51% of the selling price.

Merely by changing the transfer price to an arbitrary higher figure of £280 we have increased our overall after-tax profit from £120 to £152, increased it by a staggering 27%.

Paying No Tax

Case 3

As the transfer price is arbitrary, it can be £300 (see table, Case 3). This means that we are buying and selling at the same price of £300.

Overall tax paid is now £40 and our after-tax profit becomes £160.

The subsidiary contributes £160 to this while our own contribution is £0.

So what we have done is to shift all our profits to the subsidiary and do not need to pay tax in the home country.

But we need not stop there. The parent company can shift even more of its profits to the subsidiary. It can make a loss and this is illustrated by Case 4.

Getting Tax Rebates

At this stage I would say that Davidmann goes into flights of fantasy and angst. However, his examples are useful in the academic sense that they do demonstrate what might happen if it were possible. The table at the end of this section shows Davidmann’s calculations and I have left in the details of his examples below. Go to Davidmann’s web page if you wish to see the examples in full.

Case 4: in brief

This case shows what happens if the transfer price is increased to £400. The subsidiary makes a profit of £300 and we make a loss of £100 on each item.

Case 5: in brief

The subsidiary now makes a profit of £400 and we make a loss of £200.

Tax Avoidance

Tax Avoidance Increases Profits

So by increasing the purely arbitrary transfer price we doubled our after-tax profit, increasing it by 100%. This was done without any change to our procedures, operations or added value, was done by merely changing book entries.

So where do these additional profits come from? They arise from tax avoidance. In other words it is possible for a multinational company to minimise its liability for corporation tax by transfer pricing. This is legal until governments legislate to prevent this practice ... see the section on UK Tax Law below

But note that in the cases we discussed, the tax paid to the host-country government increased, while the tax paid to the home-country government decreased, case by case. In other words, one government's loss is the other government's gain.

So one government can be expected to want to legislate against unfair transfer pricing practices, while the other government can be expected to object to, and to resist, such legislation.

Tax Avoidance Transfers The Tax Obligation

The parent company operates in the home country. The government of that country or state spend money on behalf of its citizens - providing education, health care, social security, protection against crime and security against attack from outside ...

Say a multinational has increased its profits by tax avoidance. As the government's expenses have not changed it must make up this shortfall elsewhere. ...

It seems that at times some top companies pay no [corporation or] income tax or obtain an overall rebate. Tax allowances appear to add well over $100bn each year to the accounts of US corporations, and are thus given to owners and directors.

UK Tax Law

One of the reasons I say that Davidmann is emotional is that whilst he has presented some clear and concise examples of how it is possible to set transfer prices that can mean that not only will a TNC not pay taxes; but that they can even get a tax rebate, it is out of touch with some of the reality that TNCs face.

The UK, along with other countries, now has a Transfer Pricing Tax Regime that attempts to control and eradicate the excesses that Davidmann demonstrates.

A starting point of a discussion of UK Transfer Pricing tax law is http://www.inlandrevenue.gov.uk/international/technical2.htm where they briefly introduce the ideas behind current legislation. From this page, there is a link to Transfer Pricing and Corporation Tax Self Assessment at http://www.inlandrevenue.gov.uk/international/technical2a.htm.

This page also points us to further information on transfer pricing that is available from The 1995 OECD Guidelines on Transfer Pricing for Multinational Enterprises and Taxation Administrations. Available from HMSO in the UK or from the OECD at 2 rue Andre-Pascall, 75775 Paris Cedex, France.

Writing in 1999, Jonathan Schwarz has provided a very comprehensive guide to Transfer Pricing. Schwarz has prepared separate papers on his site under these headings

Current Issues in Transfer Pricing
Transfer Pricing and Electronic Commerce
What do the New UK Transfer Pricing Rules Mean?
How Far do the Rules Go?
Transfer Pricing Self Assessment and Dispute Resolution
Advance Pricing Agreements
Transfer Pricing and Investment in UK Property

The Arm’s Length Principle

Perhaps the most important aspect of legislation in this area is the Arm’s Length Principle: this is a common principle in International Accounting Standards and it means that the Inland Revenue will need to see that a transfer price has been established fairly by the parties to any agreement in which a transfer price is involved.

Arm’s length, then, means that no one has imposed a transfer price on anyone: it has been calculated and agreed according to normal, fair, equitable, business principles.

The point here is that even within organisations in the same building, let alone on different continents, it has always been the case that one manager has more power than another; and the exercise of that power can lead to distorted decisions and, in this case, taxation positions.

The Key Transfer Pricing Tax Rules

Since this page was only intended to be a review of transfer pricing and not a detailed expose, let me just review the key points of UK tax legislation in the area of transfer pricing:

The enactment of the principle transfer pricing rules and supporting administrative provisions are now to be found in three different sets of legislation:

• The Taxes Act 1988, s770A which gives effect to The Taxes Act 1988, Schedule 28AA,
• The Finance Act 1998 ss109 to 111
• The statutory framework for Advance Pricing Agreements (APAs) in Finance Bill 1999 Clauses 76-77
• The Inland Revenue’s Tax Bulletin Issue 37 October 1998 Page 579 and Issue 39 February 1999 Page 623 deal with record-keeping requirements, penalties and cross-border funding.

We’ll look at the following issues in this section

• Transfer Pricing And Self-Assessment
• The Arm’s Length Standard
• Documentation
• Penalties
• Advance Pricing Agreements

Transfer Pricing And Self-Assessment

One of the most profound changes introduced by Finance Act 1998 is that the arm’s length principle is now mandatory for all taxpayers. Taxpayers must now self-assess the application of the arm’s length principle even if the issue is not raised by the Inland Revenue. It is regarded as implicit when a return is signed that the arm’s length standard has been complied with in relation to every affected transaction.

The Arm’s Length Standard

The new legislation specifically requires the transfer pricing rules to be applied in a manner which is consistent with the OECD Transfer Pricing Guidelines. These guidelines can be downloaded from http://www1.oecd.org/daf/fa/material/mat_07.htm#material_Model articles as a PDF file: it’s a small file!

Documentation

The Taxes Management Act 1970, s12B (income tax) and

The Finance Act 1998, Sch 18 para 21 (corporation tax) require taxpayers to keep and preserve records needed to make and deliver a correct and complete return for any chargeable period.

Nothing new here for TNCs or anyone else: we all have a duty to prepare and maintain adequate records for taxation purposes.

Penalties

Since transfer pricing is not an exact science, the concept of fraud and negligence, as well as the criteria for mitigating penalties do not fit easily with transfer pricing given the nature of the rule. The Revenue will take into account the "size and gravity" of any misdemeanours:

• the absolute size of the problem
• the size of the problem relative to the turnover and profitability of the business
• where this is possible, the size of the adjustment in relation to the volume and value of the related party transactions giving rise to the adjustment.

The Revenue have reaffirmed that where taxpayers can show that they have made an honest and reasonable attempt to comply with the legislation, there will be no penalty even if there is an adjustment. The onus will be on the Revenue to show that there has been fraudulent or negligent conduct. Each case must be judged on its own facts and merits, based on what a reasonable person would do. Examples of this given by the Revenue include:

• using commercial knowledge and judgment to make arrangements and set prices which conform to the arm’s length standard or to make computational adjustments where they do not
• being able to show (for example by means of good quality documentation) that they made an honest and reasonable attempt to comply with the arm’s length standard and the legislation
• seeking professional help where they know they need it.

Advance Pricing Agreements

In principle, the procedure for an APA is simple. Taxpayers may make an application for an APA: in essence this is the making of an offer in contractual terms. The APA includes setting up taxpayers’ understanding as to how the transaction in question ought to be taxed, those aspects that require agreement and the manner in which it is proposed that they should be agreed. This is then followed by negotiation that should lead to a binding agreement.

The legislation specifically contemplates an informal consultation process to explore the possibility of an APA. Although the draft statement of practice indicates that the Inland Revenue encourages applications for APAs, it may decline to accept certain applications. It regards the process as designed to offer assistance in resolving complex issues.

P Previously, APAs have been available on an informal basis and were made pursuant to the mutual agreement procedure in tax treaties. Any domestic agreements were made under administrative law principles such as those in Regina v IRC, ex parte MFK Underwriting Agencies Ltd [1989] STC 873 (QBD) and Regina v IRC, ex parte Matrix Securities Ltd [1994] STC 292 (HL).

Globalisation Viewpoints

I have included Davidmann’s discussion in detail to illustrate the ways in which the transfer pricing issue within TNCs is often viewed. I have pointed out that I think that Davidmann’s views are rather emotionally presented.

At the time of writing, the World Economic forum is meeting in New York. One of the key issues that many of the protesters against globalisation are concerned about is the power of the TNC, including its apparent ability to use, misuse and abuse its transfer pricing arrangements.

From a businessman’s point of view, the consultancy Accenture is represented at the World Economic Forum in New York and they have prepared a document entitled 01.01.12 Business in a Fragile World. To whet your appetite, the major section headings of this document are:

• The rise of the anti-globalization movement
• The global economic slowdown
• The terrorist attacks of September 11 and the subsequent war against terrorism

This document can be accessed from http://www.accenture.com/xdoc/sv/locations/sweden/pdf/fragileworld.pdf but beware, it is a 2Mb beastie that will take a while to download.

To provide further balance to this argument, I recommend a visit to at least one page of the World Development Movement’s (WDM) site. The WDM is a pressure group that is bound to be active in New York at the moment and their page Briefing on regulating TNCsis at http://www.wdm.org.uk/cambriefs/Wto/TNCs.htm. Whilst the WDM may be seen by many as an extreme, anti business, pressure group, by some, this page on TNCs is well written, it is instructive and it is written without the vitriol that is the hallmark of many anti globalists. Let me stress, WDM doesn’t necessarily concern itself only with transfer pricing!

On my TNC page (http://www.duncanwil.co.uk/tnc.html), I listed The Nine UN Principles that the UN ‘challenged world business leaders to "embrace and enact"’. Similarly, I am giving here the annex to the WDM page on TNCs since I think it helps us to see the balance of the WDM’s arguments: we don’t need to agree with all of them; but we ought to consider them at least to understand the balance of the arguments. We should notice, in particular, that WDM has referenced each of their core standards to The Universal Declaration of Human Rights, ILO Conventions, UN Guidelines for Consumer Protection and more.

World Development Movement’s Annex

Core Standards
The World Development Movement (WDM) believes multinational companies should abide by basic standards in all their operations and ensure that their subsidiaries and sub-contractors also comply. Such standards would give the business community a stable, agreed international framework for their operations, and enable countries and their people to maximise the benefits and minimise the costs of multinational companies’ operations.

Basic human rights
Multinational companies should respect the right of everyone to life and liberty; no-one should be subjected to torture, cruel treatment or arbitrary arrest. Companies should promote basic human rights, ensuring they are universally and effectively observed. Companies must ensure any security forces working for them abide by basic standards.
The Universal Declaration of Human Rights: Articles 3 and 5 and Preamble. The UN Code of Conduct for Law Enforcement Officials

Working conditions
Multinational companies should uphold the rights of workers to form and join trades unions andP  bargain collectively and to a safe working environment. Multinational companies must not use child or forced labour.P 
ILO Conventions 29, 87, 98, 155, 105 and 138.

Multinational companies should offer the best possible wages, benefits and conditions, and when applicable, no less favourable than those offered by other comparable firms.
ILO Tripartite Declaration 34, 33

Multinational companies should maintain the highest health and safety standards, bearing in mind their experience within the whole company, including knowledge of special hazards. They should inform representatives of the workers and the government about health and safety standards they observe in other countries.
ILO Tripartite Declaration 37

Equality
Multinational companies should uphold the right of women and men have to equal pay.P  Companies should not discriminate in employment on the grounds of sex, race, beliefs or origin.
ILO Conventions 100 and 111.

Consumer protection
Multinational companies should uphold the right of Consumer to; accurate marketing and information on products, safe goods, instructions on their proper use and information on all risks.
UN Guidelines for Consumer Protection; WHO Codes on breast milk substitutes and on promoting pharmaceuticals, FAO convention on pesticides, Food standards of Codex Alimentarius.

The environment
Multinational companies have responsibilities to undertake environmental impact assessments, to prevent and clean up pollution and meet their responsibilities on climate change, biodiversity, the sea, and ozone-depleting substances. Prior informed consent is needed for the export of toxic waste or banned pesticides.P 
Rio Declaration, Agenda 21, Conventions on Climate Change, Biodiversity and the Law of the Sea, the Basle agreement, the Montreal Protocol, the Rotterdam Convention.

Local communities
Multinational companies should uphold indigenous people’s rights to control their own development. They should respect their rights over lands, the environment and natural and mineral resources. Companies should act to compensate people relocated with their consent and ensure effective protection at work.
ILO Convention 169 on Indigenous and Tribal Peoples 7,14, 15, 16, 20.

Business practices
MultinationalP  companies should not abuseP  market power or limit competition, such as through price fixing, predatory take-overs or collusive deals, and should provide the authorities with all necessary information.
UNCTAD Rules for the Control of Restrictive Business Practices (D 1-4)

Sovereignty and development strategies
Multinational companies should respect every state’s right to choose its own economic system and to regulate foreign investment and the activities of transnational corporations within its jurisdiction.
UN Charter of Economic Rights and Duties of States, Articles 1 & 2.

Multinational companies should take account of countries’ policy objectives including development and social priorities.  They should pay due regard to using technologies which generate employment and consider giving contracts to national companies, using local materials and promoting local processing.
ILO Tripartite Declaration of Principles concerning Enterprises and Social Policy 10, 19, 20.”

Conclusions

This page has had the purpose of introducing several aspects of transfer pricing as they relate to ordinary businesses as well as to TNCs. I have tried to show that much of the transfer pricing world is normal and that it is regulated to some extent, even though one of the major concerns that people have about it is that it concerns global issues that no single government can control.

The transfer pricing issue, then, becomes embroiled in globalisation politics and the issues are then clouded because emotion gets in the way of rational argument.

I have given examples and references that show how it is possible to exploit the transfer pricing regime of an organisation to ensure that any efforts on the behalf of one or more governments to optimise its own tax regime can be foiled. I have also tried to bring some balance to the debate by providing examples and materials from management consultancies and globalisation pressure groups.

The transfer pricing debate has gone on for some time and I don’t doubt it isn’t finished yet!