Significance of International Transfer Pricing

Some importance of international transfer pricing include:

Tax Optimization

Generally, transfer pricing affects the distribution of income between countries, and this usually impact the global tax burden of the multinationals. However, complying with the transfer pricing regulations can help companies to minimize the risk of double taxation and optimize tax burden.

Regulatory Compliance

To prevent tax base erosion and profit shifting (BEPS), including the need to ensure that transfer pricing is fairly determined to reflect the market price, regulatory authorities around the world and Organisation for Economic Co-operation and Development (OECD) have specific rules and regulations in which multinationals must complied with. Complying with these specific rules and regulations can make companies avoid compliance risk.

Profit Allocation

Transfer pricing is used for resource allocation between connected entities involving international transactions. This usually determines the profit attributable to the multinational, and in effect, its financial performance.

Key Components of International Transfer Pricing

Basically, the international transfer pricing usually involves:

Goods

This represents transfer of physical products between connected parties having a common control i.e., within an organization.

Services

This involves managerial, technical, and administrative services exchanged between the parent and its subsidiaries, or affiliates.

Intercompany Loans and Advances

This relates to financial arrangements between the parent company and its subsidiaries.

Intangibles

These include intellectual property, trademarks, patents, franchise, and brand values exchanged between the parent and its subsidiaries.

Methods of Transfer Pricing

Consistent with the dictate of (OECD), the following are major transfer pricing methods, including:

Comparable Uncontrolled Price (CUP) Method

This represents one of the most popular transfer pricing methods in the determination of arm’s length prices to be used between connected parties. This method compares the price charged between related parties for goods or services in a comparable uncontrolled transaction. The CUP method is generally used in arm’s length principle where sufficient data is available. It is easy to apply and mostly preferred by many tax authorities.

Resale Price Method

Under this method, the transfer price to be used between related parties is the resale price to an independent entity less gross profit margin for the goods purchased from a connected party for resale.

Cost Plus Method

Consistent with the arm’s length principle, transfer price is determined by adding an appropriate markup to the total cost incurred on the supply of goods or service in a related party transaction.

Transactional Net Margin Method

This involves comparing the net profit margin in a controllable transaction with the net profit margin in comparable uncontrolled transaction. It examines the net profit margin relative to an appropriate base involving assets, sales, and costs, that a taxpayer earns from a controlled transaction.

Profit Split Method

This method identifies the combined operating profit or loss to be allocated between related parties in a controlled transaction, by referencing the value contributed by each participant to earn the profit.

Regulatory Framework

The Organisation for Economic Co-operation and Development (OECD) provides detailed guidelines on transfer pricing. The guidelines emphasized the need to utilize the principle of arm’s length transaction between connected parties. This principle ensures that transactions between related companies are valued at market prices.

OECD also provides initiative through BEPS to address the tax avoidance scheme usually adopted by entities to exploit loopholes and mismatches in tax regulations between countries. This ensures that transfer pricing aligns with the value creation system, and that there is transparency in country-by-country reporting (CbCR).

In addition, local tax authorities have specific rules and regulations that govern transfer pricing. In Nigeria, transfer pricing is regulated by the existing tax laws, including Income Tax (Transfer Pricing) Regulations 2018.

Challenges and Considerations

There are plethora of issues facing transfer pricing practices, and some of which include:

Documentation: Transfer pricing transactions requires detailed documentation to support the judgment and policies adopted, especially during tax audits. These documents are usually subjected to thorough investigation to ensure that the right tax is paid.

Complexity: Generally, transfer pricing involves multiple jurisdictions with specific rules, regulations, and interpretations. Therefore, the ability to navigate through all these can pose a daunting task.

Disputes: Oftentimes, transfer pricing can lead to disputes between tax authorities of different jurisdictions, resulting to double taxation or litigation.

Risk Management: Having the right expertise to develop robust transfer pricing policies to manage compliance, financial, and reputational risks can be challenging.

Economic Changes: The prevailing market conditions, exchange gyrations, and unstable economic environments can have far-reaching effect on the transfer pricing strategies.

Best Practices

The following are some of the transfer pricing best practices that can be adopted by companies:

Documentation: Companies should maintain up to date and detailed documentation to support transfer pricing policies and practices.

Review: The transfer pricing policies should be regularly reviewed to reflect the prevailing market conditions and regulatory changes.

Benchmarking: The transfer pricing policies and decisions should be consistent with the industry standard and that of the comparable companies.

Professional Expertise: Companies should engage professionals endowed with transfer pricing expertise to help navigate tax intricacies and international regulations.

Advanced Pricing Agreement: Align or enter into agreement with the relevant tax authorities to obtain certainty on transfer pricing methods to avoid future disputes.

Ethical Issues in Transfer Pricing

Transfer pricing often involves ethical issues that bother around abuse and manipulation of records by multinational enterprises (MNEs), and which can negatively impact the economic and social welfare of a country. Some of the key ethical issues include:

• Tax Avoidance and Evasion
• Economic Inequality
• Fairness and Equity
• Transparency and Accountability
• Corporate Social Responsibility
• Legal and Regulatory Challenges

Tax Avoidance and Evasion

Companies can manipulate transfer prices to achieve a targeted goal. For instance, multinationals can use transfer pricing to shift profits from countries with high tax rate to jurisdictions with lower tax rate to reduce their overall tax burden. This practice may seem legal, but it deprives countries of their benefits from tax revenue. In addition, when multinationals allocate profits to jurisdictions with favourable tax rates (i.e., tax havens), there will be tax base erosion in the countries where significant economic activities occur, thereby limiting their ability to fund public projects.

Economic Inequality

Shifting profits from countries with higher tax rates to tax havens can worsen economic inequality of the countries because resources available to fund social programs, infrastructure, and public services may be inadequate. Also, developing countries who often rely heavily on tax revenues can be disproportionately impacted by aggressive transfer pricing practices, impairing their ability to reduce poverty and develop as a nation.

Fairness and Equity

There is huge disparity between SMEs and MNEs, since the SMEs do not have the requisite resources to engage in sophisticated transfer pricing strategies, resulting in an uneven playing ground. Also, local businesses may face higher effective tax rates relative to companies that engage in international transfer pricing, which give undue advantage to MNEs over the local companies.

Transparency and Accountability

Companies can intentionally make transfer pricing practices to be opaque and complex in order to make it difficult for relevant tax authorities to understand and scrutinize the financial records of the MNEs. At times, lack of, or inadequate disclosures in financial reporting and intercompany transactions can limit the ability of the tax authorities to hold MNEs accountable for their transfer pricing practices.

Corporate Social Responsibility (CSR)

In addition to legal compliance, ethical business practices encompass honesty, fairness, and positive contribution towards to the society. Engaging in aggressive transfer pricing practices can undermine the CSR efforts of MNEs and impair their reputation.

Legal and Regulatory Challenges

MNEs usually exploit gaps and mismatches in different tax jurisdictions in relation to transfer pricing. As a result, enforcing compliance may be challenging. Also, ethical issue can occur when MNEs encounter double taxation due to tax disputes between tax authorities of different jurisdictions, resulting in lawsuits and strained international relations.