This refers to tangible and intangible assets, services, and funds that are transferred within an organization, that is, goods from the parent company may be sold to a branch of the parent company in a foreign country, or goods from the production department may be sold to the sales or marketing division just within the organization. (Charles, 2005)
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Mechanisms that set prices for such transactions within the organization and between third parties may not apply in this case because the prices are set within the organization hence they are controlled. The allocation of the total profit between the different parts of the company is affected by the choice of the transfer price. This has been a major headache or problem for the authorities concerned with fiscal matters because they have been worried that the entities that are multi-national may set their own transfer prices on cross-border transactions in order to reduce profits that are taxable and which are within their jurisdiction.
As a result transfer pricing regulations and enforcements have been established and due to this transfer pricing has become one of the major tax compliance which is practiced by multinational companies. The economic theory behind optimal transfer pricing explains that optimal refers to the transfer pricing that increases the firm’s overall profits in a situation where there are no taxes. (Andy, 2006)
There are many factors that influence the transfer prices that are made use of by the multinationals and this includes import quotas, VAT, performance measurement, custom duties, the accounting systems capabilities, taxes on profits, and in many scenarios transfer pricing is also influenced by not having attention to the pricing. From the theory of marginal price determination, it is well known that the output optimum level is the point where the marginal revenue of the firm is equal to the marginal cost.
In this perspective, a firm can continue with its production activities as long as the marginal revenue experienced from additional sales remains higher than the marginal costs. However, when a firm decides to sell its products to itself, the external market for that type of good is absent and the scenario becomes more complex but the final results remain the same.
The optimum quantity and price as well as the demand curve remain the same. The total marginal costs can however be separated from the marginal costs of production. In the same perspective, the marginal revenue for the total firm can also be separated from the marginal revenue which s associated with the production division and this is what is called the Net Marginal Revenue (NMR) and it is calculated by subtracting the marginal costs of distribution from the marginal revenue.
If the division responsible for production is able to sell in a competitive market the transfer goods as well as sell its goods internally then both must operate where their marginal revenue is equal to marginal cost in order to realize profit maximization. Then it means that the firm must accept the transfer price that is determined by market forces and therefore becoming a price taker and in this regard, the demand for transfer products and the marginal revenue becomes the transfer price. If the firm is able to sell its products in a market that is imperfect then the firm does not necessarily have to be a price taker.
Transfer pricing becomes advantageous in that in terms of bookkeeping the in-country with low taxes most of the profit is made there which enables the multinationals to shift their profits in order to reduce the overall taxes that they pay. As a result, most countries have adopted the arm’s law principle of enforcing tax laws as stated in the Organisation for Economic Co-operation and Development guidelines for transfer pricing for multinationals companies and tax administrators which ensures that every country taxes its fair share.
There are several elements of transfer pricing. The general principle is expenses and taxable incomes are to be computed using the arm’s length terms for transactions with enterprises that are connected. The second element of transfer pricing is the rules pertaining to transfer pricing that apply within the United Kingdom and also across border transactions.
The third element is that any transfer pricing adjustments for purposes of taxation for a business enterprise outside the United Kingdom and which has a subsidiary in the United Kingdom requires that the corresponding adjustments to its taxable profits be made to the subsidiary in the United Kingdom. Another element of transfer pricing is in the definition of medium and small-sized enterprises and this is based on the European Union rules relating to small micro-enterprises. (Larry and Lucien, 2004)
The items to be considered in the determination of whether an enterprise is small or medium is in the number of staff, balance sheet, and the turnover which should be 50, $10 million, $ 10 million for a small enterprise and 250, $50 million, $43 million for a medium enterprise. Hence the point to be considered in this perspective is that a business is medium or small if its staff is below the staff limit and it is either below the balance sheet or the turnover limits.
The staff mentioned above should include the owner-managers, employees, individuals seconded to work in the business or the partners. Where the staff does not work full time in the period they should be counted as an appropriate fraction. A business is also small or medium when its balance sheet totals are gross instead of the net asset value. The other element related to transfer pricing is in the group aspects.
The business will be a company but the tax rules will also cover limited liability partnerships, partnerships, and other legal forms and the rules will apply to the corporations well as the income taxes. The other element of transfer pricing is in the treatment of dormant companies. The company that has been dormant for three months before 1st April 2004 should be considered outside the bracket of transfer pricing and should not be covered by the transfer pricing rules for the period it remains dormant.
However, any company that becomes dormant after 1st April 2004 should be considered to be within the transfer pricing rules. The other element of transfer pricing is in the exemptions that apply to small-medium enterprises. The first element is that small-medium enterprises should be exempted from the rules that pertain to the United Kingdom transactions.
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The small and medium enterprises found in the countries with which the United Kingdom has a double tax treaty are exempted from the rules that concern the cross-border transactions in their connected enterprises. The HMRC retains the power to ensure that the transfer pricing rules are observed within the medium-sized groups. Other elements considered in transfer pricing include the industrial analysis which includes the analysis of critical success factors as well as market trends.
The other element is the company analysis which includes the overview of the business and the financial results of the parties involved in the various business transaction as well as their business strategies. The next element is the functional analysis and this involves the description of the performed functions, assets engaged by the parties to the functions as well as the risks assumed by the parties.
Description of the inter-company transactions is another element that is considered in transfer pricing. Included here are the analysis of the costs that parties to the transaction bore, the payback that is expected by the parties to the transaction, and the description of the characteristics of the subject of the transaction. The other element is an economic analysis which involves the selection of the transfer pricing method, financial analysis, benchmarking study, and the description of the pricing methodology.
There are several illegalities as well as legalities associated with the transfer pricing practice. The first is the declaration of lower values of profits as well as lower turnover values in order to get reduced taxes. The second illegality is the declaration of higher purchase prices than those in the market as services or equipment from related companies. Thirdly, manipulation of debt cash flows in order to transfer money to a parent or a subsidiary company and is done through inflating repayment of debts with the objective of avoiding taxes on profits. Fourthly, undervaluing, under measuring, under grading, and lack of proper classification of species for the local market as well as for exports. (Roland, 2004)
Legalities that exist in the transfer pricing include the declaration of the correct values of profits as well as the correct figures or volumes of turnover in order to pay the correct amounts of taxes as required. The second legality is the declaration of the correct figures that relate to purchase prices and these prices should be in line with those that are in the market.
The third legality that concerns transfer pricing is availing the correct amounts of debt cash flows without inflating the repayments of debts. The fourth legality in transfer pricing is providing the correct values, correct measurements, correct grading, and proper classification of the species for the local market and for exports. The pertinent accounting concepts used in transfer pricing include the cost recognition concepts and the revenue recognition concepts in order to adequately compute the amount of tax to be paid by the multinational companies.
GlaxoSmithKline v. The Queen
The taxpayer was served with a notice requiring him to avail all documents and studies that compared a certain drug component to the same constituent used by its generic drug companies. In this case, Glaxo availed only one document and stated that it was not to its advantage to produce all the documents. The court restricted the use utilization of the information by the company. But the court did not issue a complete ban on the use of the documents covered by the requirement.
Canada Safeway v. The queen
The CRA relied on subsection 69(2) in pre1998 case that involved transfer pricing regime and it did this to deny a Canadian company from getting a reduction for particular charges which were paid to a no- arm’s length resident in the United States in calculating income for the taxation year 1996. The CRA held that the charges were not reasonable and that no party to the arm’s length would have agreed to pay the figures at issue. The ruling, in this case, imposed a standard of arm’s length that was consistent with the one embodied in section 247 of the act.
Andy, P. Wrestling with issues surrounding Transfer Pricing, Oxford: Oxford University Press, 20064.
Andy, P. The Paradoxes of Transfer Pricing, New York: New York Press, 20055.
Larry, A. and Lucien J. International Business Law: A transactional approach to Transfer Pricing, New York: New York Press, 20046.
Roland, N. Transfer Pricing and related issues, South Wales: South Wales publishers, 20047.