Transfer pricing and arm’s length principle
The dramatic expansion of international trade and development of new business strategies due to globalisation, converted the world into a large global market. In connection with that, companies have been using complex networks of subsidiaries and branches (e.g. permanent establishments) in order to continue most of their operations.
The Multinational Enterprises (MNEs) pose special problems. Under an economic language MNEs can be defined as a single firm operating in a unified direction. In legal terms, they consist of many (sometimes thousands) affiliates constituting a corporate group. Some estimates suggest that 30 per cent or more of world trade takes place among affiliates of the same global MNE group. In today’s globalized economy and technological integration, it is typical that components for an MNE’s products are produced in one country and final assembling of products are done in another country. Sales and marketing functions may well take place in local markets, far away from the place of production. Rapidly spreading internet in remote locations has helped efficient outsourcing and decentralization of management of productions and sales in different parts of the world.
Sometimes, related entities of an MNE show artificially high prices for an imported product or service in an attempt to deflate profits and evade taxes. The practice is known as transfer mispricing, a way of price manipulation or fraudulence. MNE can shift profits and minimise the tax burden in high tax countries by overpricing imports from foreign subsidiaries, or underpricing the exports. This is usually leading to substantial losses in tax revenue for some countries.
Such transfers can be of intermediate goods, produced by one company within the multinational group and sold to another, or they can include a licence or royalty fee paid for the right to produce and to use intellectual property owned by another part of the group.
Accordingly, companies and tax administrations have a lively interest in transfer pricing determinations related to all types of cross-border transactions. Moreover, the growth of international commerce has led more and more countries to have an active interest in transfer pricing as developing economies have become important participants in the international flow of goods and services and have accordingly found it necessary to protect their local tax bases with well enforced transfer pricing rules.
Arm´s length (AL) principle is the universal method used for tax purposes in order to allocate profits between related enterprises operating in different countries. The AL principle of transfer pricing states that the amount charged by one related party on another for a given product must be the same as if the parties were not related. An arm’s-length price for a transaction is therefore the same as the price of the transaction would be in the open market.
It has become a major tax issue to legislators, tax authorities and taxpayers especially for MNEs. Bangladesh lost $1.4 billion a year between 2001 and 2010 due to illicit capital flight, according to a Washington-based Global Financial Integrity. A Transfer Price (TP) occurs when two related companies-such as a parent company and a subsidiary, or two subsidiaries controlled by a common parent-engage in international trade with each other for goods and services. According to a study of Centre for Policy Dialogue (CPD), Bangladesh is fourth among 29 countries that lost US$359 million in taxes in 2005-2007 period due to transfer mispricing.
To prevent profit shifting by manipulation of transfer prices, tax authorities typically apply the arm’s length principle (AL) in corporate taxation and use comparable market prices to ‘correctly’ assess the value of intra-company trade and royalty income of multinationals.
For commodities, determining the arm’s-length price can sometimes be as simple a matter as looking up at comparable pricing from non-related party transactions, but while dealing with proprietary goods and services or intangibles, arriving at an arm’s length price can be a much more complicated affair.
The principle is set out in Article 9 of the OECD Model Tax Convention and governs the prices at which transfers within a multinational company are set for the purposes of taxes.
Many countries use three types of methods: the comparable uncontrolled price method (CUP), the resale price method (RPM) and the cost plus method (C+) to detect TP. According to the OECD, these methods provide the most direct way to establish whether a transfer pricing has been used.
The most frequently advocated alternative is some kind of formulary apportionment that would split the entire profits of an MNE among all its subsidiaries, regardless of their location. But proponents of such alternatives not only have to show that their proposals are theoretically “better” but also that they are capable of winning international agreement.
Applying transfer pricing rules based on the arm’s length principle is not easy, even with the help of the OECD’s guidelines. It is not always possible – and certainly takes valuable time – to find comparable market transactions to set an acceptable transfer price. A computer chip subsidiary in a developing country might be the only one of its kind locally. But replacement systems suggested so far would be extremely complex to administer.
The National Board of Revenue (NBR) is the taxing authority and the tax laws have been introduced as: Section 107A to 107J of the Income Tax Ordinance, 1984 (the Ordinance) and Rule 70 to 75A of the Income Tax Rules, 1984. The transfer pricing regulations in Bangladesh have been made effective from 1 July 2014 by the Finance Act, 2014 and transfer pricing legislation prescribes the following methods for the determination of arm’s length price: (1) Comparable Uncontrolled Price Method (CUP), (2) Resale Price Method (RPM), (3) Cost Plus Method (CPM), (4) Profit Split Method (PSM), (5) Transactional Net Margin Method (TNMM) and (6) Any other method.
Transfer pricing officers (TPOs) will be appointed to audit and determine arm’s length prices. A TP cell will coordinate efforts to build awareness and train stakeholders on TP, a mechanism practiced in around 70 countries, including India and Sri Lanka in South Asia.
There will be a TP cell in NBR. It will also assist the tax policy wing of NBR to make TP administrative guidelines for taxmen, and establish contacts with tax authorities in other countries to exchange information on TP. The cell will also collect data and build database on the issue. But dealing with such transfer pricing issues is a big challenge and risk factor for NBR because of its complex nature, adding that with transfer pricing issue, many challenges emerged like limited resources, complexity and tax recovery rates vary, likely difficulties in obtaining information-access and quality issues, managing international relationship and the use of double taxation matters and building stocks of incomplete cases, etc.
NBR required building and strengthening its administrative capacity for optimizing management of transfer pricing programme. To meet the challenges, NBR needs to establish overall tax policy, determine the functions and responsibilities, devise compliance strategy, establish working relationship with stakeholders, prepare transfer pricing plan, set-up a dispute resolutions mechanism, secure the resources to implement the transfer pricing plan, implement quality assurance process, apply risk assessment to identify the audit risk and to conduct audit.