Transfer Pricing

Transfer pricing is the setting of prices for goods, services, loans and intellectual property traded between companies in the same corporate group, and the body of tax rules that governs those prices. Because a multinational corporation controls both sides of such a deal, it could choose prices that move profit into low-tax countries, so tax authorities require intra-group prices to match what independent parties would agree. That standard is called the arm's length principle.

Transfer pricing works alongside permanent establishment rules, which decide where a business is taxable, and controlled foreign company rules, which catch profit that ends up offshore anyway. In management accounting the term also describes internal prices used to judge how divisions perform.

Imagine two sisters who each run a shop, one in a town with high local taxes and one in a town with low taxes. If the high-tax sister sells her stock to the other at a giveaway price, and the low-tax sister then sells it on at full price, the family's profit lands where taxes are lowest, even though nothing about the goods or the customers has changed.

Transfer pricing rules ask one question: what would two strangers have charged each other? If the answer is very different from what the sisters charged, the tax office in the high-tax town can replace their price with a fair one and tax the profit it thinks should have stayed there. The same test applies to a brand licensed, a loan made or a service provided inside the family.

The principle is set out in Article 9 of the OECD Model Tax Convention, which lets a country adjust the profits of associated enterprises whose dealings differ from those of independent parties. Detailed guidance is in the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, first issued in 1995 and last consolidated in January 2022. In the United States the equivalent power is section 482 of the Internal Revenue Code, and the United Nations publishes a practical manual aimed at developing countries.

Applying the principle means comparing the controlled transaction with similar deals between unrelated parties, after a "functional analysis" of which entity performs the work, owns the assets and bears the risks. Contracts are the starting point, but tax authorities look at how the parties actually behave.

The Guidelines recognise five main methods and ask taxpayers to use the most appropriate one for the facts:

• Comparable uncontrolled price (CUP). The intra-group price is compared directly with the price charged in a comparable deal between independent parties.
• Resale price method. A distributor's resale price is reduced by an arm's length gross margin.
• Cost plus method. A supplier's costs are increased by an arm's length markup.
• Transactional net margin method (TNMM). The net profit earned relative to a base such as costs or sales is compared with that of comparable independent companies; it is the most widely used method in practice.
• Transactional profit split. Combined profit from highly integrated operations or unique intangibles is divided according to each party's contribution.

Under the cost plus method, the arm's length price is calculated as:

• $P$ is the arm's length transfer price.
• $C$ is the supplier's relevant cost of producing the goods or service.
• $m$ is the markup earned by comparable independent companies, written as a decimal.

Suppose a group's manufacturing subsidiary incurs costs of $2,000,000 making goods for a sister company, and a benchmarking study shows comparable contract manufacturers earn a markup of 8 percent. The price is $2{,}000{,}000 \times 1.08 = 2{,}160{,}000$, so the manufacturer should report $160,000 of profit. If the group charged only $2,050,000, the manufacturer's tax authority could raise its taxable profit by $110,000.

The OECD/G20 base erosion and profit shifting (BEPS) project revised the Guidelines under Actions 8 to 10 so that profits follow real value creation, with stricter rules for intangibles, risk and capital. Action 13 introduced three-tier documentation: a master file, a local file and a country-by-country report for groups with consolidated revenue of at least €750 million, which tax authorities exchange with each other. In February 2024 the OECD added "Amount B", a simplified approach to pricing baseline marketing and distribution activities.

Because an adjustment in one country is not automatically matched in the other, transfer pricing disputes are a leading cause of double taxation. Groups use the mutual agreement procedure in double taxation treaties and advance pricing agreements to resolve or prevent them. Intra-group loans raise their own questions about arm's length interest rates, and payments for brands and know-how may also attract withholding tax.

Critics say the arm's length principle is hard to apply to unique intangibles with no true comparables, giving groups room to place valuable rights in a holding company or shell company in a tax haven with little economic substance. High-profile cases, including the EU Court of Justice's September 2024 ruling that Ireland must recover €13 billion from Apple under state aid rules, have kept the topic in the news. Some economists favour formulary apportionment, which would divide a group's total profit by sales, staff or assets. The 15 percent Pillar Two minimum tax narrows the gains from shifting but leaves the arm's length principle in place, and the border between legitimate pricing and tax avoidance or evasion remains contested.

• OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations 2022
• OECD: Transfer pricing