about transfer pricing
For those who have not yet had to deal with transfer pricing, here is a
brief high level summary of what it is all about.
Why are transfer pricing
Related entities (such as companies or individuals) often interact with
one another: for instance, they may transfer goods between themselves,
perform services for one another, provide funding to one another, or
share resources. The transfer price is the price that the
provider charges to the recipient for whatever is supplied.
If the parties to a transaction are not related (ie, they are “at arm’s
length”), then they will naturally bargain with one another to reach
what they both regard as a fair price for the transaction. One
will want as high a price as possible, while the other will seek to
minimise the price. It is generally considered that this pricing
mechanism ensures the appropriate allocation of profits in a supply
For instance, a machine manufacturer will want to buy its steel as
cheaply as possible, whereas its steel supplier will push for as high a
price for the steel as it can. If a taxpayer only transacts with
unrelated parties, then the Inland Revenue can rely on the fact that it
is unlikely to have overpaid any suppliers or accepted less than it
could have obtained for any supplies it made.
Although related parties may bargain just as hard as arm’s length
parties (sometimes harder!), tax authorities cannot be sure that this
has happened. If the related parties have different effective tax
rates (or some other difference in tax attributes), there is a risk
that because they are related they might manipulate the transfer price
to move profit to whichever of them has the lower tax rate, and so
reduce the tax that they jointly pay. There is also a risk (far
more common in practice), that they may simply not be as assiduous in
bargaining on the price, given that it is “all in the family”.
The purpose of the UK transfer pricing rules (and the equivalents
around the world), then, is to ensure that the taxable profits of UK
taxpayers are not understated as a result of using transfer prices that
are (whether inadvertently or by design) higher or lower than the price
(known as “the arm’s length price”) that would have applied between
unrelated parties, all other factors being the same. The process
of checking whether the actual price meets this requirement is known as
“the arm’s length test”. If the test is not met then the profits
are increased to what they would have been had the arm’s length price
Applying the arm's length
In practice, applying this test can be extremely tricky, because it
involves hypothesis about what would have happened at arm’s
length. Usually, this is highly subjective. The process is
not helped by the fact that related parties often interact in ways that
they would be highly unlikely to use, were they unrelated.
This analysis is generally accepted as requiring some specialist input,
either internal (some major multinationals have transfer pricing teams
with staff numbers in double figures) or external, although a lot of
the work can often be done by non-specialists.
Most big (and many small) economies now have transfer pricing rules
that require that taxable profits of multinationals must not be
understated by the use of transfer prices that do not meet the arm's
length test. Increasingly, these rules are backed up by:
In the UK, for instance, there is a general requirement that a taxpayer
keeps proper records to support its self-assessment tax return.
The Inland Revenue have released various guidance about what this means
in the context of transfer pricing (see here), though they tie
knots by the need to require what is, from their perspective, a
reasonable level of documentation, whilst simultaneously playing down
any impression that the compliance burden is onerous.
- A requirement that the taxpayer documents its
analysis of why it believes it has complied with the arm's length test,
- Penalties that are imposed if the taxpayer has failed
The UK penalty rules are tough. If an understatement of UK tax is
found to have been caused by negligence (or fraud) on the part of the
taxpayer in meeting the arm's length test, the penalty is up to 100% of
the tax. In practice, there are mitigating factors that are taken
into account, which typically reduce the penalty to around 40% of the
tax. On top of this, there is also a penalty of £3000 per
tax return for failure to keep proper records.
The 'small print'
comments on this page and elsewhere on this website are of a
general nature. It is not practicable in a general review such as
to consider every convolution of the UK transfer pricing rules or of
any other tax law that may be relevant. Moreover, these pages
naturally do not take into account the specific facts relating to any
particular taxpayer. Therefore, although the guidance in this
should give a good indication of the likely position under the transfer
pricing rules, taxpayers should obtain professional advice to verify
the position, or carry out their own analysis.
TPS nor its affiliates and employees make any representation regarding
completeness or accuracy thereof and they accept no responsibility for
any loss or damage incurred as a result of any user acting or
refraining from acting upon anything contained on these pages or upon
its omission therefrom.