Benefits we offer
Our services
Diagnose yourself
About transfer pricing
Contact Us
Designed by AdesDesign
Text © Transfer Pricing
Solutions Limited 2004-7
Learn 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 rules needed?

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 chain.

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 been used.

Applying the arm's length test

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.

Compliance requirements

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:
  • 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 to comply.
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 themselves in 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.

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'

The comments on this page and elsewhere on this website are of a general nature.  It is not practicable in a general review such as this 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 website 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.

Neither TPS nor its affiliates and employees make any representation regarding the 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.
BNA International has published Transfer Pricing Manual, a major new global reference work on the topic.  Gareth Green is the Technical Editor and three chapters have been written by TPS. 

Click on the book to purchase a copy from BNAI:

BNAI Transfer Pricing Manual cover