Transfer Pricing Explained: How it Impacts Global Businesses
Modern globalized economy means multinational companies (MNCs) operating in different jurisdictions. MNCs transfer goods and services and even intellectual property rights across subsidiaries. Although this boosts innovation and economic growth, it also poses several tax complexities.
An important aspect of international transactions is transfer pricing (TP). Let us explore the importance of TP, its significance to ensure fair taxation, and impact on global businesses.
What is Transfer Pricing?
It refers to the pricing of goods, services, and intangibles transferred between related entities of an MNC. The core principle is that transactions between related entities must be maintained at an arm’s length ensuring pricing is consistent with that charged to an unrelated party. This ensures fair allocation of profits across different jurisdictions, preventing tax evasion, and ensuring each country receives the due tax liability.
How Transfer Pricing Works?
Comparability Analysis: It examines similar transactions between unrelated entities and is impacted by factors like product type, market conditions, risks, and business functions.
Transfer Pricing Methods
• Comparable Uncontrolled Price: Analyze similar independent transactions
• Resale Price Method: Decrease resale price from the selling price
• Cost Plus Method: Increase price with a fair profit margin
• Profit Split Method: Split profits between entities based on their contributions
• Transactional Net Margin Method: Compare net margins with similar unrelated entities
Importance of Transfer Pricing
• Prevent Tax Evasion and Base Erosion
Profit shifting is a common practice between MNCs. Companies may manipulate transfer prices to shift profits to jurisdictions with lower tax rates. TP regulations ensure profits are reported in the jurisdiction where the economic activity generates these profits to combat base erosion and profit shifting.
• Ensuring Fair Allocation of Taxable Income
TP ensures every country receives its fair share of the tax income. Ensuring arm’s length principles, MNCs allocate profits to reflect value created in each jurisdiction, which is important for developing nations that largely depend on tax revenues for economic growth.
• Promoting Compliance and Transparency
Stringent TP regulations ensure companies maintain detailed documentation for intercompany transactions, which boosts transparency and assist tax authorities to ensure transactions are conducted at an arm’s length.
• Support Global Trade and Investments
Consistent and clear TP regulations ensure certainty and encourage cross-border investments and trade. When MNCs confidently navigate TP rules, it encourages them to increase their global expansion driving growth.
Examples of Transfer Pricing
• Sale of Goods between Subsidiaries
An MNC operates a manufacturing unit in India and a distribution unit in Malaysia. The Indian manufacturing unit produces products at INR 100,000 and sells these to the Malaysian entity. The price at which the products are transferred between the two entities is referred to as the transfer price. If the selling price is INR 125,000 the Indian entity will pay tax on its profit of INR 25,000.
• Transfer of Intellectual Property
An Indian software subsidiary develops proprietary software for its parents based in the United States. The royalty charged for using this software should adhere to the arm’s length principle. If the Indian entity undercharges, the tax authorities may adjust the royalty to be in line with the fair market value.
• Financial Transactions
A parent company based in Australia offers a loan to its Indian subsidiary at an interest rate of 6% per year. If similar loans from independent lenders in the market are available at a higher rate of interest, the regulators may challenge the lower rate as not complying with the arm’s length rule.
TP is a crucial component for global businesses and may have certain challenges. But as global economy evolves, TP regulations will also adapt. Ensuring an in-depth understanding and adhering the TP regulations, MNCs can contribute to a fair and sustainable global tax system.
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