This article was first published in the May 2010 edition of Accounting and Business magazine.

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The growing importance of transfer pricing can be seen by the actions of tax authorities around the world. Vietnam introduced transfer pricing regulations in 2006, and the tax authorities have now carried out several transfer pricing audits involving automotive companies.

China also issued new transfer pricing regulations last year, and the tax authorities are now aiming to establish a transfer pricing team with several hundred specialists.

The Indian tax authorities have substantially increased the size of their transfer pricing team over the last two years. The UK tax authorities established a transfer pricing group in 2008 with about 70 specialists, and there are currently about 1,000 ongoing transfer pricing enquiries.

The figures involved can be substantial. In 2006, UK-based group GlaxoSmithKline made an out-of-court transfer pricing settlement to the US tax authorities of $3.1bn. This dispute centred on the price paid by the group's US subsidiary company to the UK parent company for Zantac, a drug used to treat ulcers. In China, recent transfer pricing cases have resulted in more than RMB100m (£10m) of additional taxes being paid.

Transfer pricing is the term used for the price that associated enterprises charge each other for goods or services. Although such enterprises may be situated in the same country, tax authorities are more concerned with transfer pricing where enterprises are situated in different countries. Without transfer pricing legislation it would be easy for a multinational enterprise to shift profits to any country. The reason for moving profits from one country to another is to benefit from a difference in tax rates.

Transfer pricing can also be used to repatriate profits from a country where it might otherwise be difficult to do so because of, for example, exchange controls.

Transfer pricing does not just apply to goods, but also to transactions involving services, management charges, intangible property and financing. Intra-group financing is an area of increasing concern to tax authorities because the value of such transactions can be significant, and their pricing is very subjective.

Arm's length principle

The transfer pricing regulations adopted by most countries are based on the arm's length principle as defined by the Organisation for Economic Co-operation and Development (OECD). There are three methods of calculating a transfer price.

Comparable uncontrolled price: this method provides the best evidence of an arm's length price. Ideally a comparison is made to the price of a similar product sold or purchased by an unconnected enterprise (an external comparable). Alternatively, a comparison can be made if the product in question is sold or purchased outside the group to an unconnected enterprise (an internal comparable).

Cost plus method: this method is typically used to calculate the transfer price for finished goods where a mark-up is added to the production cost of the goods.

The cost is based on cost accounting records and, ideally, the relevant mark-up should be determined by a comparison with the profit earned on a similar product by an unconnected enterprise. Although this method would appear to be an accurate method of establishing a transfer price, in reality it is easy for companies to manipulate the costs used. Cost can be based on the actual cost, standard costs or marginal costs.

Then there are various ways of dealing with fixed assets and research and development costs.

Resale price method: this method is similar to the cost plus method, but is instead found by subtracting a gross margin from the ultimate selling price to an unconnected enterprise. Once again, the relevant gross margin should ideally be determined by a comparison with the profit earned on a similar product by an unconnected enterprise.

This method is typically used where very little value is added by the company that sells the product outside the group. The more value added by the seller, the more difficult it will be to establish a gross margin.

It is also useful when it is difficult to determine actual cost figures, such as where technological know-how is concerned. A transfer price for the payment of royalties can be based on the profit made from using the know-how. This was the method used by the Canadian subsidiary of GlaxoSmithKline. The price was set so that the subsidiary earned a gross margin of 60%, which was comparable to that earned by European distributors of Zantac.

Establishing price

All three traditional methods have one overriding problem in that external data may not be available for a product. This is particularly the case for companies operating in smaller countries. The OECD guidelines mention two non-traditional methods of establishing a transfer price, although there are more.

Profit split method: this looks at the overall profit made on a transaction by the group, and then divides it between each group company according to the relative values of their contributions. This split will take into account the functions performed, assets used and risks taken by each company.

This method is useful where the companies involved in a transaction are too integrated for it to be looked at from the viewpoint of just one company. It is also useful where the transaction makes use of unique intangible assets where it would be impossible to make an unconnected comparison.

Due to the complexity of transactions, the profit split may often be in two stages. The first stage will allocate the profit related to routine functions such as manufacturing and distribution, and may be calculated using one of the three traditional methods. The second stage will then allocate the profit attributable to intangible property based on the contribution of each company; for example, according to the number of employees provided.

Transactional net margin method: although requiring an unconnected net profit (or operating profit) margin, such a figure will often be available when a gross profit margin is not. The unconnected net profit margin is then applied to an appropriate base such as costs, sales or assets employed.

Although not one of the three traditional methods, the transactional net margin method is one of the most widely used transfer pricing methods because it is relatively accurate and easy to apply. For example, it is widely used by Dutch companies because of the unavailability of the comparable data needed for other methods.


If a multinational group is undertaking the same transactions around the world, it would seem sensible to adopt one common transfer pricing policy. However, such an approach will be problematic as different countries permit different methods. China and India permit any of the five methods discussed.

Malaysia and the Slovak Republic prefer the traditional (particularly the comparable uncontrolled price method) over the non-traditional methods. Russia does not recognise the profit split method, whilst Brazil does not approve either of the non-traditional methods.
If these problems were not enough, companies may find that a transaction is subject to transfer pricing rules in one country, but not in another. Take, for example, a UK company with a 30% shareholding in a Polish company.

The UK transfer pricing regulations generally only apply if there is control, so a 30% shareholding would be outside the scope of UK transfer pricing legislation. It is also worth noting that most transactions carried out by small or medium-sized UK companies are exempt from the transfer pricing rules, even where there is control. By contrast, the Polish transfer pricing rules can apply where there is just a 5% shareholding.

Another problem can arise due to the conflict of interests between the different tax departments within the same country. Transfer pricing regulations have traditionally been focused on direct taxation, but governments are aware that transfer pricing is also relevant to indirect taxes such as customs duty and value-added tax.

The conflict arises because customs authorities will be concerned that the value of imports is not underestimated. The higher the transfer price, the higher the amount of indirect tax. In contrast, direct taxation authorities will be concerned that the value of imports is not overestimated. A lower transfer price will lead to higher profits and hence more tax being paid.

In many countries, such as Singapore and Poland, the different tax departments will work together and normally a common transfer price will be used. In other countries, such as Russia, Malaysia and Vietnam, the tax departments do not share information, and it is possible to use one transfer price for indirect tax purposes and another for direct taxes.

The cost of falling foul of a country's transfer pricing rules can be severe. There will be additional tax to pay, and this is likely to be double taxation. It may be possible to get relief for this double taxation if there is a double taxation treaty between the two relevant countries (or if they are EU members). If profits are increased in one country, there should be a corresponding reduction in profits taxed in the other country.

This is what will happen in most cases, but relief is not guaranteed, as the two tax authorities may not be able to reach an agreement. If there is no double taxation agreement, then relief will not be available. However, even when double taxation relief is available, it will often be the case that profits are increased in a high tax rate country and reduced in a low tax rate country. The overall amount of tax payable increases.

Secondly, many tax authorities have introduced hard-hitting penalties in the event of a transfer pricing adjustment. Finally, there is the cost of the dispute itself, in terms of time and accountants' fees. Complex transfer pricing disputes in the UK can take up to three years to resolve.

Minimising risk

So what actions can companies take to minimise risk? It is crucial to have a transfer pricing policy and be able to provide appropriate documentary evidence. Such documentary evidence would typically consist of:

  • description of the transaction
  • details of the functions performed by each party, assets used and risks borne by each party
  • the method used to establish an arm's length price.

Many countries allow companies to agree their basis of transfer pricing in advance by the use of advance pricing agreements. Provided a company adheres to the prices set in the agreement, it will then not have to worry about a dispute arising and will, therefore, avoid penalties and double taxation.

Ideally, an advance pricing agreement should be a multilateral one involving the tax authorities of both countries in which a transaction is to take place. If an agreement is made unilaterally with one tax authority, there is still the risk that the other country's tax authority will dispute the arm's length price. Of course, multilateral agreements involve a lengthier application process. In Singapore, for example, it typically takes six to 12 months for a unilateral agreement, but two years for a multilateral one.


Given the need for countries to protect their tax base in the current economic climate, a continuing aggressive approach to transfer pricing can be expected.

This is going to be a problem for companies as they increasingly globalise and optimise their supply chains. A move into transfer pricing would therefore be a good career move for accountants looking for an interesting challenge and the chance to work with senior management.

Online references

  • The Wikipedia transfer pricing page has several useful links
  • Ernst & Young provides an up-to-date survey of transfer pricing practices in nearly 50 countries
  • An article looking at the conflict between direct taxation and customs duties as regards transfer pricing
  • The OECD website contains comprehensive transfer pricing resources

David Harrowven runs a tax consultancy business and is an ACCA tax examiner