Transfer Pricing Is Not An Accounting Tool

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Mar 20, 2007
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“Transfer Pricing is not an accounting tool” comment with an illustration
If a group has subsidiaries that operate in different countries with different tax rates, manipulating the transfer prices between the subsidiaries can scale down the overall tax bill of the group. For example the tax rate in Country A is 20% and is 50% in Country B. In the larger interest of the group, it would be advisable to show lower profits in Country B and higher profits in Country A. For this, the group can adjust the transfer price in such a way that the profits in Country A increase and that in Country B get reduced. For this the group should fix a very high transfer price if the Division in Country A provides goods to the Division in Country B. This will maximize the profits in Country A and minimize the profits in Country B. The reverse will be true if the Division in Country A acquires goods from the Division in Country B.

There is also a temptation to set up marketing subsidiaries in countries with low tax rates and transfer products to them at a relatively low transfer price.

Transfer price is viewed as a major international tax issue. While companies indulge in all types of activities to lower their tax liability, the tax authorities monitor transfer prices closely in an attempt to collect the full amount of tax due. For this they enter into agreements whereby tax is paid on specific transactions in one country only.But if companies set unrealistic transfer price to minimize their tax liabilities and the same is spotted by the tax authority, then the company is forced to pay tax in both countries leading to double taxation.

There have been instances where companies have fixed unrealistic transfer prices. The first case relates to Hoffman La Roche that imported two drugs Librium and Valium into UK at prices of 437 pounds and 979 pounds per kilo respectively. While the tax authorities in UK accepted the price, the Monopolies Commission did not accept the company's argument, since the same drugs were available from an Italian firm for 9 pounds and 28 pounds per kilo.

The company's lawyers argued the case before the Commission on two grounds viz.
1. The price was not set on cost but on what the market would bear and
2. The company had incurred an R&D cost that was included in the price.

These arguments did not go well with the Commission and the company was fined 1.85 million pounds for the manipulative practices adopted while fixing the transfer price.

The second case is of Nissan. The company had falsely inflated freight charges by 40-60% to reduce the profits.The manipulation helped the company to hide tax to the tune of 237 million dollars. The next year Nissan was made to pay 106 million dollars in unpaid tax in the USA because the authorities felt that part of their US marketing profits were being transferred to Japan, as transfer prices on import of cars and trucks were too high.Interestingly the Japanese tax authorities took a different view and returned the double tax.

With a view to avoid such cases from recurring, Organisation for Economic Cooperation and Development issued some guidelines in 1995. These guidelines aim at encouraging world trade. They evolved what came to be known as the arm's length price. The principle states that the transfer price would be arrived at on the basis as if the two . companies are independent and unrelated. The price is determined through:

•Comparable Price Method where the price is fixed on the basis of prices of similar products or an approximation to one.

•Gross Margin Method where a gross margin is established and applied to the seller's manufacturing cost.

In spite of all these efforts, it has to be admitted that setting a fair transfer price is not easy. So the onus of proving the price has been put on the taxpayer who is required to produce supporting documents. If the taxpayer fails to do this he is required to pay heavy penalty. For example, in USA, failure to provide documentary evidence results in a 40% penalty on the arm's length price. In UK the penalty is to the tune of 100% of any tax adjustment. Other countries are also in the process of evolving tight norms for the same.Countries across the globe also allow the taxpayer to enter into an Advance Pricing Agreement whereby dispute can be avoided and so also the costly penalty of double taxation and penalty.
 
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