Transfer pricing — the global phenomenon

THE world appears to be getting much smaller. Rapid technological advances, increased people mobility, and changes in the international political climate have all helped to break down many of the traditional barriers to global and regional trade.

For dynamic, fast-growing businesses, this increased globalisation represents an excellent opportunity for businesses in our Caribbean region. However, regardless of the business you are in, it is essential to understand the various legislations that will affect your business, especially the tax legislation. One increasingly important issue facing businesses expanding into new geographical markets is transfer pricing.

Transfer pricing, simply put, refers to the pricing of transactions between related or connected parties. Related or connected parties include not only relatives, but also separate legal entities where either one controls the other, or both are controlled by a common shareholder. In most countries, transfer pricing is mainly relevant for taxpayers if the transaction is cross-border, but it also

covers branch operations. Various studies indicate that intercompany trade accounts for as much as 50 per cent of all global trade today, so as Jamaican companies expand their operations into new geographical markets, transfer pricing will become increasingly important.

In every company with overseas operations, goods and services pass between the different operating units very frequently. All of these movements between countries or legal entities are treated as a sale for transfer pricing purposes. These sales not only include the transfer of partly finished or finished goods for resale, but also intellectual property, including the company’s brand, the provision of administrative, strategic or managerial services, plus loans and other forms of finance.

The charge for the transfer of these goods and services is known as the transfer price. In essence, transfer pricing rules and legislation are designed to ensure these transactions result in a fair allocation of profits between the various countries in which the company does business.

The arm’s length principle

Most countries adopt the approach set out in Article 9 of the Organisation for Economic Cooperation and Development’s (OECD) Model Tax convention on income and capital. This approach which is promoted by the OECD

as the international standard for determining transfer prices for tax purposes is the arm’s length principle. In accordance with the arm’s length principle, the price of goods and services between related parties should be comparable to the price that would be charged between independent parties.

Calculating the arm’s length price can be a challenge because differences in product types, characteristics and transactional conditions, as well as varying management objectives often make it difficult for a company to work out what it might have charged to an independent customer. Moreover, in many cases the transactions may be unique and there is often very little data available to make comparisons. Therefore, it is common for a company to carry out an economic analysis and not find comparable arm’s length transactions and prices. However, while the basic principle of arm’s length pricing is relatively simple, there are a number of different ways to apply it, depending upon the type of goods or services involved. It can be a complex challenge to determine which method to use and how to apply it.

The traditional arm’s length methods include:

Cost Plus method

For this method the gross profit earned on an intercompany sale is compared to similar independent transactions. This approach is typically used where goods are manufactured or assembled and then sold within the group. In this instance, the goods compared don’t have to be identical, but must perform similar functions.

Profit Split method

For this method, the relative contribution of each tax-paying entity is determined within the group to the combined profit or loss of the group, and then compares this contribution with what would have resulted from a similar arrangement between independent taxpayers. This methodology is used in situations where two parties contribute valuable assets or services to a transaction.

Comparable Uncontrolled Price method (CUP)

This method compares the internal transfer price directly with the similar products sold in an independent, uncontrolled transaction.

There are also the Transactional profit methods that include the Profit Split and the Transactional Net Margin methods (TNMM). The TNMM effectively deduces the right transfer price by comparing the level of profitability of the tested, related party to similar independent companies. Indeed, I am sure we could find many other ways to value an arm’s length transaction.

Therefore, although most jurisdictions follow the arm’s length principle in regulating transfer prices, tax authorities apply the principle in different ways in different countries.

Well over 60 countries currently have transfer pricing rules, and the increasing complexity in this area can be gauged from a recent Global Transfer Pricing Survey, conducted by Ernst & Young, where more than 74 per cent of the multinational enterprises (MNEs), believed that transfer pricing will be absolutely critical to their organisations during the next two years.

Furthermore, one-third of the MNEs surveyed identified transfer pricing as one of the most important tax challenges facing their group. Therefore, when you expand your business overseas you can’t focus only on the income tax rates because you need to make sure you understand the transfer pricing rules since transfer pricing applies to more situations than you might think. So before you assume that it won’t affect you, I want you to consider the following queries:

Does your business:

1) Have operations in different jurisdictions (sales, manufacturing, management services, and call centres)?

2) Have an acquisition strategy involving new companies internationally?

3) Have operations in countries where the tax rate is substantially lower than in your primary country of operation?

4) Provide goods and services to your international operations?

5) Provide technology, applications or systems to your international operations?

6) Utilise your brand while conducting international operations?

7) Provide management services strategic advice or guidance to your operations?

8) Provide financial support (intercompany loans) to your operations?

9) Anticipate going through a period of considerable change domestically or internationally?

10) Have any sales reps internationally?

11) Have transactions with legal entities that do not have employees?

If you answered yes, or think you will answer yes in the near future, you need to start to think of a robust approach to pricing your intercompany transactions so that you are compliant with transfer pricing legislation, if or when it comes to the Caribbean, and if you intend to operate outside of the region, such as in Canada,

the US, UK, where transfer pricing legislation currently exists.

Global spread of transfer pricing legislation

Tax authorities around the world are increasingly focused on making companies compliant with transfer pricing legislation. Therefore, if you don’t have a robust transfer pricing policy and you operate in a country with transfer pricing rules, you could find that you face a transfer price adjustment by tax authorities in one jurisdiction that you can’t deduct in another, so double taxation can occur and it can become very expensive.

Currently in the Caribbean, only the island of Aruba has enacted transfer pricing rules. However, Trinidad in its 2011 budget, and Jamaica in a recent budget, announced the intent to introduce transfer pricing legislation. Transfer pricing is also a big component of the recent OECD Base Erosion and Profit Shifting Initiative so there is a high probability that more islands in the Caribbean will be adopting Transfer Pricing legislation in the near future. Therefore, transfer pricing appears to be spreading to Jamaica and the rest of the Caribbean.

Most Caribbean countries, including Jamaica, have general anti-avoidance rules that require arm’s length pricing amongst related or connected parties, but no rules are set out to govern exactly what that pricing should be so the transfer pricing laws, in essence, will codify how to determine arm’s length and what documentation is needed and how to report these transactions to the tax authorities.

If you are a Jamaican company that operates overseas or vice versa, getting your transfer pricing wrong can be costly. However, get your approach right, and not only will you remain compliant with the tax legislation, but it is also likely that you will save both money and management time in the long run.

The ideal approach is to adopt a consistent, global transfer pricing policy that is aligned to your business, allocates profitability in accordance to the value that is provided by legal entities, and complies with the tax laws in each country in which you operate. This transfer pricing policy will need to have a degree of flexibility to be compliant with the nuances of each individual country’s specific transfer pricing requirements and ensure appropriate arm’s length documentation is in place in each country.

If you have a dynamic, fast-moving business, you can’t afford to ignore transfer pricing because it is becoming a global phenomenon, but if your transfer pricing policies and documentation are in order, you can avoid unwelcome surprises and be confident when you expand globally. This will allow you to approach international and regional opportunities with confidence, and you can be focused on your company’s growth instead of on tax issues.