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Transfer Pricing : Meaning, examples, risks and benefits
Introduction:
Transfer pricing is the setting of the price for goods and services sold between controlled (or related) legal entities within an enterprise. For example, if a subsidiary company sells goods to a parent company, the cost of those goods paid by the parent to the subsidiary is the transfer price. Legal entities considered under the control of a single corporation include branches and companies that are wholly or majority owned ultimately by the parent corporation. Certain jurisdictions consider entities to be under common control if they share family members on their boards of directors. Transfer pricing can be used as a profit allocation method to attribute a multinational corporation's net profit (or loss) before tax to countries where it does business. Transfer pricing results in the setting of prices among divisions within an enterprise.
Transfer pricing multi-nationally has tax advantages, but regulatory authorities frown upon using transfer pricing for tax avoidance. When transfer pricing occurs, companies can book profits of goods and services in a different country that may have a lower tax rate. In some cases, the transfer of goods and services from one country to another within an interrelated company transaction can allow a company to avoid tariffs on goods and services exchanged internationally. The international tax laws are regulated by the Organization for Economic Cooperation and Development (OECD), and auditing firms within each international location audit financial statements accordingly.
Arm’s Length Transaction:
Article 9 of the OECD Model Tax Convention is dedicated to the Arms Length Principle (ALP). It says that the transfer prices set between the corporate entities should be in such a way as if they were two independent entities.
A framework has been provided by the OCED in the Transfer Pricing Guidelines issued by it which provides details regarding the arm’s length price.
ALP is based on real markets and provides the MNE’s and the governments a single international standard for the contracts that allows various different government entities to collect their share of tax at the same time creating enough room for the MNE’s to avoid the double taxation.
Example:
USAco, a local company, makes small engines available to be purchased both in the United States and abroad. Outside deals are made through FORco, a wholly owned foreign company. USAco's engines cost $600 to make and $100 to market, and offer for $1,000 abroad. Notwithstanding the transfer prize utilized for deals by USAco to FORco, the consolidated income from a remote deal is $300 per engine [$1,000 final sales price -$600 manufacturing cost -$100 selling expense]. Be that as it may, transfer prices do influence the designation of that joined profit amongst USAco and FORco.
At one end, a transfer price of $600 would designate the consolidated profit of $300 totally to FORco, as takes after:
At the other extreme, a transfer price of $900 would designate the combined benefit of $300 totally to USAco, as follows.
For income tax purposes, MNCs must assign worldwide profits amid the various nations in which they function. The ideal allocation would authorize each country to tax a correct range of the taxpayer's whole profit while evading taxation of the equivalent income by more than one nation. When tax rates differ across nations, transfer pricing can have a noteworthy effect on the taxpayer's overall tax costs.
For example, the foreign tax credit restriction prevents U.S. companies operational in high-tax external jurisdictions from demanding a credit for those additional foreign taxes. These non-creditable foreign taxes upsurge the worldwide tax rate on distant earnings above the U.S. company rate of 35%. A local corporation may be able to circumvent these greater foreign taxes by changing its transfer prices to shift income out of these high-tax dominions. For example, a U.S. producer may be able to decrease a foreign marketing subsidiary share of universal profits by exercising higher prices for measured inventory sales.
Now, assume that the U.S. tax rate is 35% and the appropriate foreign tax rate is 45%. Given this rate differential, the USAco. group can decrease its worldwide taxes by using superior transfer prices for its controlled sale. For example, if a transfer price of $600 is applied for sale by USAco to FORco, the $300 gross profit is assigned entirely to FORco, and the entire tax on that profit equals the overseas tax of $135 [$300 of income X 45% external tax rate]. If a transfer price of $900 is applied for the controlled sale, the $300 gross profit is billed entirely to USAco, and the total tax on that profit parallels the U.S. tax of $105 [$300 of income x 35% U.S. tax rate].
Likewise, transfer pricing also is a pertinent issue for U.S. companies with operations in low-tax foreign jurisdictions. In these circumstances, a U.S. parent company has an incentive to move income to its low-tax foreign ancillary, for example, using lesser transfer prices on controlled inventory sales. Though shifting income to a low-tax foreign subsidiary does not everlastingly avoid the outstanding U.S tax on those low-taxed foreign earnings,what it does is defer that tax till the foreign subsidiary repatriates those profits through a dividend distribution.
A true example that shows how Google used transfer pricing to its advantage:
The regional headquarter of Google is in Singapore and it has a subsidiary in Australia. The sales and marketing support services are provided by the Australian subsidiary to users and Australian businesses and also provides research services to Google worldwide. The billing for Australian activities is done in Singapore and the payment is received from the Google entities.
In 2012-13 Google Australia earned $46 million as profit on revenues of $ 358 million. The corporate tax payment was A$7.1 million, more so, as they had claimed a tax credit of $ 4.5 million.
Ms. Maile Carnegie, the Managing Director of Google Australia was asked to respond on why Google Australia did not pay more corporate tax in Australia. She Replied by saying that the lion’s share of the taxes was paid to the country where they were headquartered. She was talking about the intellectual capital that Google owns which drives their business and it was owned outside of Australia.
Google declared that it paid US$ 3.3 billion as tax globally in 2014 on revenues of US$ 66 billion. The effective tax rate came up as 19%, while the statutory federal rate of 35% applied on Google in the US. Had Google been paying most of the tax in US, it would follow that it was not paying much taxes on the revenues that is generated from other countries.
In 2013, in Singapore US$ 4 million was paid by Google in corporate tax on undisclosed revenues from the Asia – Pacific countries as well as Australia. Compared to this, Google Australia made a payment of A$7.1 million as tax, and they did not account for most of that revenue that was booked in Singapore.
Moreover, the details of the sources of revenue that was generated from Australia was not provided by Google.
It was seen that some of the multinational companies were involved in tax minimisation using the tax incentives that were offered in accordance with the overseas jurisdiction to them which led to the evasion of tax in Australia.
MICROSOFT
The internal revenue system has investigated that Microsoft is using transfer pricing , among other things or method of booking prices and sales between subsidiaries that lends to the opportunity to report earning in lower tax jurisdiction.
Companies routinely and legally book profit overseas to avail lower tax rate and avoid hefty 35% levy on profit in the US.
Microsoft accumulated $44.8 billion non-US earning and reinvested aboard, accounting in deferred taxes of about $14.5 billion.
Microsoft did not specify how did they employ cash earned aboard but reinvestment could be anything from buying an office or parking money in the bank. While storing money overseas prevented them from repatriation tax.
Microsoft stated that "primarily due to a higher mix of earnings taxed at lower rates in foreign jurisdictions resulting from producing and distributing our products and services through our foreign regional operations centers in Ireland, Singapore and Puerto Rico, which are subject to lower income tax rates."
Forty-six percent (about $ 32 billion) of the total sales came from overseas in the year 2011 , however, pre-tax profit tripled over the past six years to $19.2 billion. In contrast, its US earning have dropped from $11.9 billion to $8.9 billion in the same period. Thereby now 68% of the total earning are made by from foreign earning.
Risks and benefits
However, some of the risks and benefits associated with transfer pricing are as follows:
Benefits:
1. Transfer pricing helps in reducing the duty costs by shipping goods into high tariff countries at minimal transfer prices so that duty base associated with these transactions are low.
2. Reducing income taxes in high tax countries by overpricing goods that are transferred to units in those countries where the tax rate is comparatively lower thereby giving them a higher profit margin.
Risks:
1. There can be a disagreement among the organizational division managers as what the policies should be regarding the transfer policies.
2. There are a lot of additional costs that are linked with the required time and manpower which is required to execute transfer pricing and help in designing the accounting system.
3. It gets difficult to estimate the right amount of pricing policy for intangibles such as services, as transfer pricing does not work well as these departments do not provide measurable benefits.
4. The issue of transfer pricing may give rise to dysfunctional behavior among managers of organizational units. Another matter of concern is the process of transfer pricing is highly complicated and time-consuming in large multi-nationals.
5. Buyer and seller perform different functions from each other that undertakes different types of risks. For instance, the seller may or may not provide the warranty for the product. But the price a buyer would pay would be affected by the difference. The risks that impact prices are as follows
· Financial & currency risk
· Collection risk
· Market and entrepreneurial risk
· Product obsolescence risk
· Credit risk
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