What is Transfer Pricing?
Transfer pricing, also known as transfer cost, is the price at which related parties transact with each other, such as during the trade of supplies or labour between departments. In other words, transfer pricing is the price that is paid for goods or services transferred from one unit of an organization to its other units situated in different countries (with exceptions).
Transactions subject to Transfer Pricing
- Sale of finished goods
- Purchase of raw material
- Purchase of fixed assets
- Sale or purchase of machinery etc.
- Sale or purchase of intangibles
- Reimbursement of expenses paid/received
- IT enabled services
- Support services
- Software development services
- Technical service fees
- Management fees
- Royaltee fees
- Corporate guarantee fees
- Loan received or paid
Purposes of Transfer Pricing
- Generating separate profit for each of the divisions and enabling performance evaluation of each division separately
- Transfer prices would affect not just the report profits of every centre, but would also affect the allocation of a company’s resources (cost incurred by one centre will be considered as the resources utilized by them)
Importance of Transfer Pricing
Multinational companies have some amount of discretion while defining how to distribute the profits and expenses to the subsidiaries located in various countries.
Sometimes a subsidiary of a company might be divided into segments or might be accounted for as a standalone business. Here, in this case, transfer pricing helps in allocating revenue and expenses to such subsidiaries in the right manner.
Such profitability of a subsidiary depends on the prices at which the inter-company transactions occur. When transfer pricing is applied, it could impact shareholders wealth as this influences company’s taxable income and its after-tax, free cash flow.
It is therefore vital that a business having cross-border intercompany transactions should understand the transfer pricing concept, particularly for the compliance requirements as per law and to eliminate the risks of non-compliance.
Problems Associated with Transfer Pricing
Some issues that are associated with Transfer Pricing are:
- Differences in opinions among organizational divisional managers with respect to how to transfer price needs to be set
- Additional time, costs and manpower would be required for executing the transfer prices and designing the accounting system to match the requirements of transfer pricing rules
- Arm’s length prices might cause dysfunctional behaviour among the managers of organizational units
- For some of the divisions or departments, for instance, a service department, arm’s length prices don’t work equally well as such departments don’t offer measurable benefits
- The transfer pricing issue in a multinational set up is very complicated
What does the OECD Financial Transaction Report (FT Report) say for Mauritius?
The FT Report provides specific guidance on the Transfer Pricing aspects of financial transactions which is a common area of conflict between taxpayers and tax authorities. Mauritius is no exception; this is an area of high scrutiny by the tax authority. The FT report covers various topics such as the Transfer Pricing framework to analyse risk guidance for performing functional analysis and pricing guidance for intra-group loans and so on. In Mauritius, group companies often enter into inter-group loan agreements which is quite a common practice.
The intra-group debt transactions must, at first instance, be accurately delineated. In other words, the terms and conditions of the intra-group debt must be considered for Transfer Pricing purposes before evaluating correct arm’s length prices for those transactions. As in practice, such loans should reflect conditions that make commercial sense from both the perspective of a hypothetical third-party lender as well as from that of a third-party borrower, considering their specific economic circumstances and business strategies.
The Tax Authority in Mauritius applies the arm’s length test under Section 75 of the Income Tax Act 1995 to ensure that related party transactions are conducted on a commercial basis. The Government has, in prior year’s national budget, announced its intention of formalising the Transfer Pricing framework in Mauritius. In the Finance Act 2021, Section 75 was amended to specifically apply to Global Business Licence Companies. ‘
This is why the International Tax Laws are regulated by the Organisation for Economic Cooperation and Development (OECD) and auditing firms within each international local audit the financial statements accordingly.
Transfer Pricing legislation in South Africa requires a South African taxpayer to follow arm’s length principles in transactions with connected persons outside South Africa. The taxpayer has the responsibility for adjusting pricing to arm’s length. Transfer Pricing documentation essentially is mandatory for all South African taxpayers with ‘potentially affected transactions’ (i.e., transfer pricing transactions). Additional Transfer Pricing record-keeping requirements apply if certain thresholds are met.
If the aggregate of potentially affected transactions for the year exceeds ZAR 100million, the South African taxpayer is required to keep certain general records (some of which overlap with a master file requirement). For each category of transactions (e.g., sale of goods) with potentially affected transactions exceeding ZAR 5million, significant additional records must be kept supporting the pricing of the transactions. If the prescribed thresholds above are not met, a South African taxpayer with transfer pricing transactions is still required to keep sufficient records to support the arm’s length nature of the transactions. It is understood that such records include transfer pricing documentation.
To clarify, where there are 2 independent parties, where one party exclusively sells to another, that could be seen to be under the control of the buyer if the buyer is able to control the price charged. Another concern with the associated enterprise definition is that certain countries may interpret the definition different, especially around control, and this could lead to double taxation. Due to the way the transfer pricing legislation is currently worded, a head office and its branch or permanent establishment are not caught by the South African pricing regulations. Therefore, this type of transaction would be dealt with under the relevant double tax treaty (DTA) and without a DTA this may result in double taxation. This has been a concern for SARS (South African Revenue Service) for a while, as this also means that the related compliance requirements are not triggered.
Other aspects to look at for South Africa are the following:
- Interest deduction limitations
- Controlled foreign companies
- Economic substance requirements
- Disclosure requirements
- Exit tax
- Taxable transactions
- Filing and payment
Example of a Case Study to understand more
We have Entity A and Entity B which are 2 segments of the Company ABC. Entity A builds and sells wheels while Entity B assembles and sells bicycles.
Entity A may also sell wheels to Entity B through an intracompany transaction. If Entity A offers Entity B a rate lower than market value, Entity B will have a lower cost of goods sold (COGS) and higher earnings than it otherwise would have. By doing so, Entity’s A sales revenue would be impacted.
On the other hand, if Entity A offers Entity B a rate higher than market value, then Entity A would have higher sales revenue than it would have if it sold to an external customer. Entity B would have higher COGS and lower profits. In either situation, one entity benefits while the other is impacted by a Transfer Price that varies from market value.
Now let’s take the above example and look at it from a tax perspective.
Let’s say Entity A is in a high tax country, while Entity B is in a low tax country. What would happen is that it would benefit the organization as a whole for more of Company ABC’s profits to appear in Entity B’s division, where the company will pay lower taxes.
In the above case, Company ABC may attempt to have Entity A offer a Transfer Price lower than market value to Entity B when selling them wheels needed to build the bicycles. As mentioned above, Entity B would then have a lower COGS and higher earnings and Entity A would have a reduced sales revenue and lower total earnings.
Companies then to attempt to shift a major part of such economic activity to low-cost destinations to save on taxes.