How can company A implement an appropriate Transfer pricing method for Bulgarian and Dutch entities?
The two related entities are a Bulgarian and a Dutch entity, in which the Bulgarian entity sells goods to the Dutch company on a drop-shipping basis. The entities are related because the Bulgarian entity owns the Dutch entity with headquarters located in Bulgaria. The drop model shipping refers to a retail fulfilment method where a store or a seller does not keep the products in stocks but buys the stock from a third party when a customer needs them. The stock is shipped to the customer directly and the seller does not handle the product directly (Ferreira, 2020). In this model, the seller does not stock the inventories because products are shipped to the buyer directly only when an order is placed by the buyer. This first sale is termed as a “sale for resale “as per the vendor’s perspective. Drop shipping offers a very large number of sales tax difficulties which states have the will to make capital out of when it is possible to ensure taxes are covered by an individual on the business.
Related companies should ensure fair pricing by avoiding transfer pricing manipulation that leads to transaction abuse risks. Transfer pricing guidelines are offered by Organisation for Economic Co‐operation and Development (OECD). When the same person directly or indirectly participates in the management of capital in two different companies, it makes these companies related (OECD, 2011). Related companies’ transactions can take different forms, such as sales and purchases of goods, services and assets, receipt of services, and intangible item transfer (OECD & Union of Arab Securities Authorities, 2014). OECD is a platform in which 36 member states and 70 non-member economies come together to enhance economic growth, success and sustainable development (European Commission, 2020). OECD offers a platform on which governments can establish different domestic and international policies find solutions to economic problems.
Description of the problem
This thesis addresses a transfer pricing problem involving two related entities. This transfer pricing problem arises when the entities fail to follow the OECD guidelines on transfer price documentation. The failure to document transfer prices means that the entities can charge rates that do not indicate a fair market value by manipulating the pricing figures to avoid taxation. The entities do not have a documentation that shows their transfer prices are at Arm’s length. According to (Clempner, and Poznyak, 2017. p2), ” Transfer pricing suggests the setting of the price at which a firm transfers goods and services between its collaborating (or not) divisions. It is employed as a profit allocation strategy to attribute a multinational corporation’s net profit before tax when crossing international borders”.
Two types of taxes are supposed to be paid by companies in drop shipping model. These taxes are income tax and sales tax. Income tax refers to tax that a business pays from the profit it makes or rather its income. Sales tax refers to tax paid on goods sold in a certain state by a company. Sales tax is as a result of imposition by governing bodies within their area of jurisdiction on goods and services sold in a certain country. It is a requirement for each business to possess nexus in a state prior to paying taxes in the country it operates. Nexus is a lawful phrase referring to a situation where a company has great physical presence in a state to the extent of paying sale taxes (Stolarzyk, Scaffidi, Milwaukee; and Polson, 2019). The OECD’s initiatives are anticipated to draw tax revenues to jurisdictions where income is earned, and this relates to nexus concept.
Transfer pricing occurs when a couple of companies belong to one multinational group trade. Transfer pricing describes pricing arrangements between companies in relation to their transaction entities. This involves transfer of tangible and intangible inventories and services across borders (PWC, 2017). Transfer pricing is a legal act and transfer mispricing or transfer manipulation is illegal and abusive. Transfer pricing documentation is one of the requirements in profit tax auditing and related companies may manipulate prices and profit figures to evade high taxation. Unrelated companies for instance can trade together and whenever these companies trade, there a market price for the transactions called the arms-length trading authentic. The arm’s length price is admissible for the intent of taxes. Whenever two same companies conduct business with each other, there is a desire to change the price in trade records to reduce the tax bill enabling the companies accumulate profit with little taxation.
Arm’s length range refers to the indicators of related financial figures; such as profit share. The principle of Arm’s Length is expected to confirm that market prices on record appear as if the trade was carried out at ‘arm’s length. Arm’s-length principle is an international standard in establishing suitable transfer price (OECD, 2011). Transactions of two related parties are expected to produce results not contradicting transactions of independent organisations under the same circumstances (PWC, 2017). According to Arm’s length principle, when related or dependent entities are involved in financial transactions, they must determine the taxable income as if such transactions’ conditions are the same for transactions between independent entities.
Companies’ tax systems are based on self-assessment, where a company will choose a transfer pricing method of its choice and with such freedom, the tax authorities are keen on detecting opportunistic behaviors of tax evasion. It is argued by (PwC, 2015. p 3) that, “A key incentive for challenging taxpayers on their transfer prices is that the authorities see transfer pricing as a soft target with the potential to produce substantial increases in tax revenues.” Transfer pricing is applicable to a variety of inter-company transactions. These include transactions dealing with: tangible goods such as manufacturing and distribution, services dealing with management , sales support, contract R&D services, financing example; inter-company loans, accounts receivable, guarantees, debt capacity and intangible property (e.g., licenses, royalties, cost sharing transactions, platform contribution transactions, sales of intangibles) (PWC, 2017). Preparing documents for transfer pricing is not mandatory but it is recommended that tax payers prepare transfer pricing documentation to curb arising administrative fines in case assessments are requested by the tax authorities. Business documents and records such as contracts and invoices are not included in transfer pricing documentation. Business records can prove or support amount of income and deductible expenses. Only specified items are presented during audit assessments. The rest of information, tax payers are expected to keep it as a requirement by tax administrations. There are legislation outlining how long the taxpayers should keep records of such information.
Why failure to follow the OECD guidelines on transfer price documentation is a problem
Failure to document transfer prices is problematic as it may result to compliance cost
associated with transfer pricing rules to the taxpayers. Transfer pricing could result to income tax implications for the holding company. Some of the key issues include: first, Revenue basis where the manager of a subsidiary negotiates price of a product in the same way for products sold in and out of the company. A part of revenue for the subsidiary is formed making it vital on his judgment in regards to his financial performance. Second issue revolves around the, preferred customers where Given alternatives on who to sell to between downstream subsidiary and outside consumers, management goes for outside customers because of extremely low transfer price. Third issue is about the preferred suppliers because whenever a down stream subsidiary is given an alternative of buying supplies from an upstream subsidiary or an outside supplier the manager opts to buy from outside suppliers because of excessively high transfer price. This results to upstream subsidiary cutting on expenses to maintain profitability due to lots of unused capacity. Entities can face upstream pricing compliance issues resulting from non compliance. These upstream pricing compliance issues include the following according to (OECD, 2014);
- Contemporaneous documentation
All taxpayers are supposed to identify transfer prices for the purpose of taxes in line with arms length principle. This should be based on reasonable information present during transactions. A taxpayer ordinarily should give consideration to whether its transfer pricing is appropriate for tax purposes before the pricing is established and should confirm the arm’s length.
- Time frame.
Practices concerning time for documentation preparation are different among countries. In some countries information should be finalized before filing tax returns. In other countries documentation must be completed by the beginning of auditing period. There is variation in practice regarding time available for taxpayers to give feedback to certain tax administration requests about documentation and other requests related to audit. The variation in time of providing information leads to compliance issues that taxpayers face when setting their priorities and giving correct information to tax administrators. The most efficient practice is ensuring local files are finalized before filing date of returns for a particular year. Reviewing and necessary updating of the master file should be complete by the due date of tax returns for final parent MNE group.
Transactions occurring between associate enterprises do not require complete documentation in the local file. Tax administrations are interested in looking at vital information and that MNE are not oppressed by compliance demands which they have not considered or documented. Materiality measures can be deliberated Measures of materiality may be considered in absolute terms such as transactions not surpassing a percentage of revenue or a cost percentage measure or in relevant amount terms transactions not surpassing a certain fixed amount. Each country come up with individual materiality standards for the purpose of local files. These standards ought to be real, understandable and acceptable in business.
- Frequency of documentation updates
Documentation of transfer pricing should be reviewed after a certain period to decide if functional and economic analysis have relevance and accuracy. Documentation should be done to confirm how valid the transfer pricing method used is. These files, both general and master and country by country report must be reviewed and updated yearly. An update should be done annually on financial data of the comparable to effectively use arms length principle.
Penalties related to transfer pricing documentation are embraced by countries to make sure there is proper functioning of requirements of transfer pricing documentation. These penalties are formulated to make the cost of non-compliance expensive than compliance cost. Penalties related to documentation are called civil monetary penalties. Penalties relating to documentation are founded on a constant value reviewed for every missing document or each financial year or calculated as percentage relating to income, tax or cross border transactions that are not documented. Other penalties result from the failure to to follow all the requirements of documentation leading to higher penalties. Currently, transfer misconduct penalty stands at 20% of the tax adjustment amount which can go up to 40% in cases where transfer pricing documentation do not exist during the filing of corporate income tax returns (Brigham Young University, 2020). Depending on the penalty category, some penalties that result from failure to comply with transfer pricing principles can total to millions of dollars (Van Stappen, 2010. p3). Availability of diverse country penalty regimes affects value of taxpayer compliance and the taxpayers may be pushed in favor of a country because of compliance practices.
- Negative impacts on Managerial Decisions
Despite the effects on taxes, managerial accounting of a company is affected if it happens between departments where each department is required to account for its profit. Whenever downstream sale occurs and goods or services are sold to lower division by upper division, an in increase in income of upper division results from higher transfer price that pushes lower division to incur higher cost and lower profits. The effect on profitability for both upper and lower divisions could cause bias performance evaluations. In this case improper transfer of pricing policy could result to internal disputes and poor business planning. Differences between transfer prices and market value favors one entity causing increase in cost of operations for the entity and this may potentially mask real results. This misalignment can occur for transactions between domestic entities or between departments within one entity. Whenever transactions are not correctly priced to conceal true value, an effective shift of profits to no-tax or low tax power is observed (United Nations, 2020). This can notably reduce tax revenue of a country and reduction of resources necessary for funding development. This leads to undermining of investments because of double taxation.
For whom it is a problem?
Compliance to transfer pricing is handled by senior tax executives. Other responsibilities to conducting the company transactions are distributed among a broad member’s chain either related or not related to internal affairs of the company. Several price transfers issues are involved in the processes between tax, regional controllership, shared services and external advisers. With lack of unity in management improper financial issues can arise at all transaction points. Some of these improper financial issues results from: equivocality in responsibility, inadequate reconciliation mechanism, accounting policy, over-dependence on personal relationships and interpretations which are not documented of equivocal terms in company agreements (PWC, 2020). Multinationals find themselves in between improper financial management issues which leads to tax and compliance risks, inefficiencies and improver chain of execution.
What do you want to achieve with your project?
This study main objective is to determine the most appropriate method of documenting transfer prices between Dutch and Bulgarian entities and advise on its implementation to meet tax reporting standards.
- Determining an appropriate process of managing transfer pricing by collecting, analyzing, and reporting transfer pricing data to determine actual transfer prices for inventories.
- Illustrating how to implement a suitable method of transfer pricing because the company itself can select any method according to the OECD.
Which is the most appropriate transfer pricing method to implement for the Dutch and Bulgarian entities?
- What is the appropriate process of managing transfer pricing that can help collect, analyze, and report transfer pricing data to determine actual transfer prices for inventories?
- How can the company implement a suitable method of transfer pricing according to the OECD?
Importance of the research and its relevance
The majority of global transactions consist of the global transfer of goods or services, intangibles, and capital within Multinational Enterprises (MNEs) in intra-group transactions.
Intra-group transactions are growing because they account for about 30% of international transactions (UN, 2014). When done correctly, transfer pricing is used not only for taxation purposes but for managing risks (Pwc, 2015). Currently, there is no transfer pricing documentation available to show that the company has priced at Arm’s length between the two entities, and this means that the company is in danger of being being penalized by tax authorities. Transfer pricing is a critical item to consider during this pandemic because companies may be forced to enter into transactions they had not forecasted (Berry, Chadderton, and Sporken, 2020; Bose, 2020; Paruthi, and Noronha, 2020). This research has managerial applications because transfer pricing is an excellent indication of the price one entity should sell its inventories to a related entity. This research is essential in literature because no other study has been conducted on the topic addressed in this paper, which complements the available studies on transfer pricing.
The implementation of the recommended method will help the entities in the following ways according to (OECD, 2014);
- Transparency in assuring that the tax payer transfer pricing in consistent with arms length principle.
Documents that are properly assembled offer tax administrators with an easy analysis of the taxpayer of tax report. Proper documentation offers tax administrators with comparable data that attains dependable transfer pricing positions. Contemporaneous documentation requirement aids in guaranteeing honesty among tax payer positions. Compliance goals can be supported in two critical techniques: Tax administrations should expect transfer pricing documentation be fulfilled on contemporaneity where readiness of records should be prior to completion of the fiscal year. Second compliance should be encouraged through formulation of penalty terms whose intention is timely rewards, effective preparation of transfer pricing documents and proper consideration of transfer pricing positions of the tax payer.
- To give information required by tax administration for purposes of planning, risk assessments, auditing and assessing legality and suitability of transfer prices formulated by tax payers.
Successful recognition an evaluation of risks helps in the process of choosing suitable situations for transfer pricing audits. Appropriate transfer pricing evaluation by tax administrators needs access to enough, applicable and secure data and in this case transfer pricing documentation is a major source of secure data. Other sources of secure data include: transfer pricing forms and documents that show agreement of taxpayers with arm’s length principle. Secure sources of data are important as they enable correct and informed evaluation of transfer pricing risks. Assurance that a reliable and effective transfer pricing risk evaluation is conducted must be a vital inclusion when preparing transfer pricing documentation.
- To achieve tax administrations’ data requirement and implement the guidelines of transfer pricing and to prevent imposing extreme requirements of documentation on taxpayers.
Cases of transfer pricing audit are fully based on facts. These case mostly include complex assessments of similarities and differences between a number of transactions and markets. Consideration of data based on finances, facts and the industry is required. There should be enough data from varying sources in audit process. This helps tax administrators to assess a taxpayer’s business implement relevant guidelines of transfer pricing. Documents of transfer pricing are essential in showing the taxpayers agreement with transfer pricing guidelines.
This study shall only investigate and recommend the implementation of a transfer pricing method. For the reason that transfer pricing is one of the significant tax compliance concerns for multinationals the OECD guidelines on transfer pricing will guide this research because it focuses on practical solutions to determining the Arm’s length (John McKinley, C.P.A. and CGMA, 2013; Talab, Flayhh, & Yassir, 2017). OECD advises that, to be successful in implementing a transfer pricing method the businesses should consider these factors; the nature of the transaction, availability of information and the degree of comparability between uncontrolled and controlled transactions (OECD, 2017). There are two transfer pricing methods; traditional methods (resale price method, comparable uncontrolled price method, cost plus method) and Transaction net margin methods (Transactional net margin method and Transactional profit split method). The arms length principle does not recommend the application of more than one method for a particular transaction. Some cases may require the selection of more than one method but arms length principle advises selection of a method that yields best estimation of arms length price. This study will select the traditional methods- resale price method as an appropriate model for transfer pricing because in drop shipping model, the first sale takes place between the company and the vendor in a sale for resale transaction.
CHAPTER 2: EXPLORATION
In a MNEs, the member companies collaborate to share a financial benefit. In many cases, this collaboration leads to transfer pricing issues when companies fail document transfer prices. This study addresses transfer pricing from a tax perspective. The problem analyzed in this study involves how well and fairly MNEs should conduct transfer pricing for a drop shipping. According to (Leng & Parlar, 2012 p.366), “The transfer pricing problem is of significant importance to multidivisional firms which need to consider the allocation of firm-wide profit between an upstream division and multiple downstream division.” The power to determine how much transfer prices depends on the MNEs which may lead to transfer pricing manipulation. The following situations lead to transfer pricing issues.
- Failure to document transfer prices
The company fails to keep information on transfer pricing. The company risk being fined by the tax authorities is 2% of each transaction’s value completed across borders as dictated by the Finance Act 2016 (Agrawal, 2020). The entities are supposed to enter, keep, and furnish information about all the transactions they completed across borders.
- Transfer prices do not indicate actual market value.
In perfect market competition, there should be one market piece for a given commodity. Competitions make the sellers sell at a relative price that does not reflect the commodity’s market value. Valuation in transfer pricing is guided by Article 9 (1) of OECD arm’s length for MNEs’ price transactions (Jens, 2011). The Arm’s length requests for a subjective and entity-specific valuation. According to (Stephen p 228), transfer pricing standards and valuation standards come into play when determining transfer prices. It is argued by (Lorraine p 593) that transfer pricing manipulation and failing to document transfer prices becomes an issue with tax authorities. The entities may choose to charge prices that do not reflect an accurate market value of inventories to avoid taxation.
- Headquarter and service transactions.
The entities have a centralized headquarter that manage businesses activities. According to (EY 2018. P4), companies should expect scrutiny of the headquarters to identify service transactions. The tax authorizes at the headquarter location expect that the business will charge out costs related to the services benefiting the foreign services or goods recipient. The entities may deny deducting the costs incurred for the benefit of the recipient. An issue arises if the foreign recipient’s tax authority does not allow such tax deductions. Another issue arise because of duplicate activities which is defined by OECD as “activities undertaken by one group member that merely duplicate a service that another group member is performing for itself, or that is being performed for such other group member by a third party.” The mandate to determine activities are duplicate depends on the tax authority and this leads to tension between the tax authority and the taxpayer (MNE) if no documentation is available (Vilaseca, 2020). A standard documentation could contain identification of duplicative activities and services; expected benefits from the service; agreements; description of all services received and reasons no to consider duplicative services.
Related companies are required to charge prices similar to the prices indicated in the Arm’s length transaction guidelines. It is the business owners’ duty or the management team to obtain certainty concerning transfer prices by negotiating a pricing agreement with the tax authorities.
When managing financial and functional analyses manager fails to determine transfer pricing implications of supply chain decisions, deals and acquisitions. The entities in this study, trade products among themselves. They trade with each other without keeping sold goods in stock and market exchange not taking place. Transfer prices exhibit natural prices that are used in the transfer of goods and services from entity A to entity B within the MNE. Internal accounting is usually not correctly done as cash does not get transferred between segments.
Profitability is a measure of evaluation among entities. Trading entities are usually affected by transfer price as it affects profitability of these entities. Sellers benefit from high transfer price while buyers get relieve from low transfer price. Practically, organizations have a deficiency of transfer pricing methods which brings failure of the methods based on market price, product cost and failure to outline a worked out quota by entities’ managers. Since entities do not have methods of transfer pricing, supervisors of different sections receive inaccurate stimulus for decision making for both the interests of the company and their own interests. For instance, whenever a company can make all its sales of their production at 100 dollars per unit the buying entity should pay a market price of 100 dollars per unit. Retailers with very high capability needs to convey goods to the buying entity at any agreed price which is above production cost and product transfer to buying segment.
The major challenge in planning and recording a transfer pricing policy is selecting appropriate methods. This process includes high levels of management judgment. The IRS and OECD guidelines advises organizations to two major factors while selecting suitable methods of transfer pricing (Brigham Young University, 2020). First, the transfer pricing involves comparing internal transaction to alike market transactions. Alikeness in controlled and uncontrolled business is measured through comparability. Companies should stand responsible for all undertakings including, operation similarity structural cost of products, risks and terms of contract in comparability determination. Second, a company must ascertain dependability levels of information and assumptions used in determining a transfer price. Consideration should be accurate to avoid errors in the data.
Lack of accurate records is the second challenge. To efficiently support the tax position of a company, proper records and decision making is vital as transfer pricing puts balance between tax regulations and economics. Only a third of companies have existing records, 11% showing satisfaction in current global documentation process in transfer pricing (Brigham Young University, 2020). Lack of proper documents results to inadequate transfer pricing policy support.
The third challenge is political scrutiny. There is notable increase in investigation of transfer price issues by the media. Locating the owner of a business in tax havens and using licensing in product selling and earning income across the world is a transfer strategy companies have adapted presently. This strategy is undergoing acute investigations with the release of new rules by tax authorities. These rules minimize the ability of a company to transfer their revenue to low tax jurisdiction. The United states through Tax cuts and Job Cuts (TCJA) 2017 formed a global intangible low tax income (GILTI) that demoralizes businesses away from moving profits outside US through intellectual property. Earnings that a company gets from its foreign assets are subjected to taxing by GILTI whenever they are above 10%. The rate of taxation ranges between 10.5% to 13.125% per annum (Brigham Young University, 2020). That same year, 2017, the UK formulated DPT (Diverted Profit Tax) that taxes profits the authority determines as diverted out of UK by 25%. Other countries such as China and Australia have mapped such laws and other countries are considering the same (Brigham Young University, 2020). The rules reduce undermining of the tax base where the company headquarters are located.
Drop shipping model
Whenever goods are directly delivered to a customer by the distributor who then sends bills to the company in regards to purchases the company has made, is regarded as a drop-shipment relationship. In this kind of transaction different sales happen at the same time when goods are shipped to the customer (Lenhart, 2017). Sales happen between the vendor and the company before proceeding to customer. This kind of sale is referred as “Sale for resale”. Bills are forwarded to the company by the sales person for the sake of purchase price of products the company bought and delivered to consumers (Lenhart, 2017). A second sale happens after delivery which is between the company and customer. Documentation of this sale is done for what the company receives upon purchase by the customer. The second sale can be termed as a retail sale with the assumption that the customer is the end user. This sale is taxable as per dictations of laws in the area of customer’s residence.
Drop shipping model is appropriate for the purpose of meeting consumer needs on time and ease in the management of inventory. A number of sales tax challenges are presented in the drop ship model because of transactions across borders. Two independent sale tax decisions are made in drop shipment transactions as there is occurrence of two separate sales. These tax decisions require the MNE to answer two questions: do either of the sellers (vendor and the company) have connection in the destination state? and is the sale to either customer a “sale for resale”? (Lenhart, 2017). When a company develops connections in a state, it becomes liable for the collection of sales tax in a particular state. Calculations must be carried out and sales tax imposed on all customers in the state despite the sale method and shippment. Upon registration, it is vital to file tax returns and dispatch sales tax gathered and maintaining a tax calendar becomes inevitable.
Sales tax nexus is common in drop ship model which shows a connection between a state and an organisation in terms of tax compliance (Sales Tax Institute, 2020). Taxing jurisdiction does not have mandate to foist its sale taxes on a company without any established connection. Determination of Nexus due process clause should have a firm connection linking a state and the organisation being taxed. Commerce Clause on the other hand should have fundamental existence. Some definitions of Nexus within states according to (Sales Tax Institute, 2020) are; Maintaining, occupying, or using permanently or temporarily, directly or indirectly or through a subsidiary, an office, place of distribution, sales or sample room or place, warehouse or storage place or other place of business. Having a representative, agent, salesman, canvasser, or solicitor operating in this state under the authority of the retailer or its subsidiary on a temporary or permanent basis. Any seller who does not have a physical presence in this state shall remit sales or use tax, if the seller meets either a gross sales from the sale of taxable items delivered exceed $100,000 or the seller sold taxable items for delivery in 200 or more separate transactions”.
Nexus is a major concern in drop shipping sales tax because it is essential to find out what role is played by all parts in a destination state for sales tax. This is because the first transaction includes the sale of the property from sales person to the company. Whenever a sales agent has nexus in a state where the goods are delivered to consumers, provision of resale certificate to the agent by the company is vital to avoid being taxed on the wholesale cost of products (Lenhart, 2017). When a company holds nexus in a state where drop shipment takes place, the entity must have an exemption certificate from the customer to avoid further charges on customer sales tax on the retail price of goods together with delivery charges that are taxable (Lenhart, 2017).When a company fails to produce a resale certificate, resale business converts to a taxable retail business.Companies without nexus in the drop ship state for example California could face real difficult situations.
Resale Price transfer pricing method
The Resale Price Method (RPM) is based on the gross margin or difference between the price at which a product is purchased and the price at which it is on-sold to a third party (Hughes, & Nicholls, 2010). The resale price less the arm’s-length gross margin (and after adjusting for other costs eg, customs duty) is considered to be the arm’s-length transfer price for the goods. The RPM is typically most appropriate to distributors and resellers. The figure below shows a resale price transfer pricing model.
The resale price transfer pricing method takes the price at which an associated enterprise sells a product to a third party. This price is called a “resale price.” The resale price is reduced with a gross margin (the “resale price margin”), determined by comparing gross margins in comparable uncontrolled transactions. After this, the costs associated with the purchase of the product, like custom duties, are deducted. What is left, can be regarded as an arm’s length price for the controlled transaction between associated enterprises. The Resale Price Method requires that third party transactions are comparable with the controlled transaction. As a result, there can be no differences that have a material effect on the resale price margin. Because each transaction is unique, it is quite difficult to meet this requirement. The Resale Price Method is not often used and in case sufficient comparable transactions are available the Resale Price Method can be useful to determine transfer prices. The reason is that in such a case, third party sales prices are easily found.
Advantages and disadvantages of the RPM
One of the disadvantages of the RPM is that it is very difficult to identify whether the comparable businesses do (or do not) employ valuable marketing intangibles in their business. Arguably the presence of such intangibles may allow the comparable entity to enjoy a higher level of profitability compared with those marketing/selling companies without such an intangible. Without the ability to undertake a functional analysis of the comparable, the business is uncertain (Hughes, & Nicholls, 2010). Small product differences can make a large difference to the gross margin that a company earns. For example, some products ‘sell themselves’, whilst for others the marketing company has to make significant efforts to make even a low level of sales. In the latter case one might expect that the distributor should receive a higher gross margin to cover its additional selling costs.
Lessons from theories, best practices
- Additional income tax, interest and penalties are some of the risks ready to be faced by entities who don’t charge arms-length cost. This makes transfer pricing a major tax issue that multinationals face.
Adjustments in transfer pricing can be a way of increasing tax revenues. This ensures that taxes companies pay are fair. Double taxation is also a major hiccups companies face. In order to resolve transfer pricing audits, it frequently requires more than ten years of management, time and resources (Clayton & McKervey, 2019). Audits in transfer pricing are usually factual and circumstancial. Critical areas such as, finance, marketing and sales should be ready for interviews and information requests with contingency.
- In transfer pricing, companies must satisfy two or more tax authorities.
Transfer pricing dilemma is a problem faced by all multinational companies. High price charges on inter company business stirs up questions on multinationals in relations to taxes they pay locally. With low price charges entities are blamed of shifting their profits offshore. Despite most countries following the arm’s length principle, there is variation in how they choose to interpret and apply it in transactions (Clayton & McKervey, 2019). Taxpayers are expected to display the pricing of their transactions in the inter companies that are conducted as if the two were not related. This should happen during audit and record keeping.
- Profits earned by subsidiaries should be steady as it a regular starting point of the auditor.
Foreign companies who conduct sales in the US are expected by tax authorities to pay a level of operating profits to subsidiaries. Such expectations demoralize companies trying to cope with the unfavorable market. In several occasions transfer pricing auditors advise that the mother company should carry any losses incurred (Clayton & McKervey, 2019). IRS advises that any subsidiary distributions by foreign companies in the US should be ready for unique investigation as an element in transfer pricing audit campaign.
- Transfer Pricing documentation should assist in the avoidance of transfer pricing audit.
Entities should assemble contemporaneous transfer pricing documents to avoid any fines that could arise from any noticeable adjustments. Contemporaneous refers to documents that have been assembled recently through filing tax returns of the company. These are the various requirements in the preparation of a transfer pricing documentation report. (1) An explanation of all company’s functions, its assets and risks by including the functional analysis. (2) An industrial analysis where an explanation is given on how the business is affected by industry developments. (3) Financial analysis. Relevant Information concerning pricing and financing of inter company transactions is described. (4) A selection of the most appropriate bench-marking method for transactions is done. A demonstration on how pricing is arms length is conducted. (Financial/Economic Analysis) (Clayton & McKervey, 2019). Despite knowing how sound the transfer policies of a company are, regulators are interested in controls put in place to make sure policies are respected in all operations of the company to mitigate financial risks. Apart from individual transactions, Tax authorities assess broader risks that could arise. They find out how strong a company’s transfer pricing governance is as a pointer of tax responsibility to bring down risks of non-compliance. Firm transfer pricing processes in a company enable a business to stand visible over transfer pricing data and overall engagement of the company. These pricing processes should touch many internal stakeholders in different units; finance, business and legal (2020 KPMG LLP). Companies will realize benefits arising from visibility and engagement which improve decision making, understanding financial threats and coming up with new and strategic prospects. Control of transfer pricing is essential which determines performance and management of crucial economic aspects of a company. Control of transfer pricing involves liaising with domestic and foreign subsidiaries, foreign associates across the globe and bodies regulating transfer pricing and international tax planning.
COMBINING SITUATIONAL ANALYSIS AND THEORETICAL BACKGROUND
When a company implements transfer pricing and fails to document each cross-border transaction concerning Arm’s length, tax authorities have the right to ask for a transfer pricing audit. Transfer pricing can accelerate MNE’s success and value if implements and documentation are correct (Dean, Feucht, and Smith, 2008). It can impact profits, and the management must set appropriate transfer prices that mark correct market values. Other than compliance with tax policies, transfer pricing documentation maintains transparency with the investors, stakeholders, and tax authorities (Dean et al., 2008). All cross-border transactions must be priced at Arm’s length principle to avoid corporate tax issues. OECD performs audits on MNEs to determine if they follow the Arm’s length principle and if not, the tax authority assigns a new transfer price, computes new tax liabilities, and determines possible penalties (Dean et al., 2008; Florence, 2016). Documentation in transfer pricing must indicate the transfer pricing process and the Arm’s length methodologies that a MNE follows. Once an MNE has identified an appropriate transfer pricing method, the method is applied to the independent parties’ transaction data to determine the Arm’s length price. An excellent transfer pricing documentation requires data sufficiency in compliance with the Arm’s length principle (Inland Revenue Authority of Singapore, 2015). According to (Dogan, Deran, and Koksal, 2013), the transfer pricing method should be a footnote in financial reports despite the presence of many factors such as economic, legal, internal and external, and political that impact the selection of an effective transfer pricing method. Market volatility and complex cross border transactions place new challenges when determining Arm’s length prices.
Soution1- determining a suitable transfer pricing method
The total amount of income taxes paid affect the general level of profitability by MNE. Companies with subsidiaries in areas with various tax jurisdictions can adjust the profitability level of each subordinate by using transfer prices. The lowering of the transfer prices of components of the subsidiaries located in various tax jurisdiction can help the company parent/founding company identify the tax jurisdictions with the most taxable income and the lowest corporate income taxes. The adoption of the transfer prices by the MNE provide the highest profit in total to the entire entity’s consolidated results (UN, 2014). As such, it is important to set the transfer price of the company as the market price of the product while bearing in mind the issue involving the recognition of income taxes. Market price is the value charged for selling or buying an asset. Setting the transfer price as the market price helps subsidiaries sell to an outside and in-house target market thus, attain finances for the company entirely allowing subsidiaries chances to expand their businesses due to the increase in the capacity of production.
The arm’s length nature of prices/profits has its testing or calculation done using transfer pricing methods. The establishing of arm’s length prices or profits from transactions between the involved enterprises depend on the use of transfer pricing methods. A “controlled transaction” is one which involves various enterprises focusing on the establishment of an arm’s length (UN, 2014). Applying transfer pricing methods helps in the conformation of transactions to the arm’s length standard. The use of “profit margin” by companies does not eradicate chances and reasons that the company can report losses incurred at arm’s length. If there is a report of an arm’s length income value without the use of a transfer pricing method in the process, the pricing is not at an arm’s length thus, there is no need for adjustment since transfer pricing methods are not influential. The selection of the most suitable transfer pricing method for use in a case depends on the controlled transaction’s nature, each method’s strengths and weaknesses, the uncontrolled and controlled comparability degree, together with the presence of reliable data on an uncontrolled comparable for the application of the best method.
Before selecting a transfer pricing method, it is crucial for one to understand whether the controlled transaction is inbound or outbound while looking at the functional analysis which is necessary for use with each method. The functional analysis has a massive impact in choosing the correct transfer pricing method when dealing with a particular case. The functional analysis helps identify whether a method’s modification applies due to the advancement of the function, transaction, assets allocation, or risks allocation, identifying and understanding intra-group transactions, identifying necessary adjustments to the comparable, finding out traits structuring a function/transaction as a comparable, and checking the comparative dependability of the transfer pricing method of choice. Analyzing functions, assets, and risks sum up the major components of a functional analysis.
The description of activities including inventory management, design, marketing and sales activities, inbound logistics, manufacturing, research and development (R&D), assembling, after sale services, outbound logistics, supporting activities, services, advertising, financing and management, together with purchasing is by functional analysis. During the description of activities there is need to specify the activities performed by each party and in case two parties share an activity, they require distinctive differences. For example, if both companies have inventories, they need a difference in time such that, Company A keeps inventories for two years whereas Company B keeps inventories for a month. The activities of the highest value which are the period of time that each company held inventories require a more detailed discussion (OECD, 2010). Operational risk (systems failure risk), financial risk (currency, interest rate, funding risks etc.) credit and collection risk (trading credit risk, commercial credit risk), product risk (product liability risk, warranty risk and costs and contract enforceability), commodity price risk, inventory risk and carrying costs, environmental and other regulatory risks, market risk (country political risk, reliability of customers, fluctuation in demand and prices) and R&D risks require identification using functional analysis.
The identification between intangible and tangible assets must be a successful work done by functional analysis. Financing a plant, an equipment, and a property or investing in capital assets thus, attain a return for given period depending on the investment’s risk and use is a function is a must for tangible assets. The use of intangible assets helps in the creation of a significant competitive gain identifying the vitality of intangible assets (OECD, 2020). All intangibles are important including those with legal protection such as trademarks, trade names, and patents or those with less protection legally such as trade secrets, know-how, and marketing intangibles. The interplay of factors requires identification by the functional analysis due to the integration of operations in a transnational group across jurisdictional boundaries while there is the sharing of risks, functions, and assets between units of various jurisdictions thus, functional analysis becomes more challenging and more essential. Attributable functions, assets, and risks to different related parties are identifiable using functional analysis. For example, using functional analysis can help identify that the performance of a company in satisfying a given function although the other company bears its cost during the transaction. The terms of contract of the current transaction, the employed business strategies, a discussion of the tested party’s operation industry, and the parties’ economic circumstances are parts of the functional analysis. With the use of the functional analysis, it is possible to recognize operations in need of an arm’s length return and add a profit to a related party.
The completion of the process of the functional analysis leads to the use of a transfer pricing method and evaluating comparable transactions distinguishes the importance of selecting a transfer pricing method after the functional analysis. It is significant for there to be the use of data on comparable when using transfer pricing methods since without comparable in the methods, a method can become inapplicable while the other method highly reliable. Since the parties involved in comparable transactions are independent of one another, it is correct to call the transactions “uncontrolled transactions.” There are challenges in identifying reliable information that is comparable in the same market as that of uncontrolled transactions independent companies that are not related to the comparable of the transfer pricing tenacity (OECD, 2020). It is a requirement for a company to seek practical solutions through the tax administration and being in a good agreement with the taxpayers.
Looking for comparable in other industries whereby tracking down comparable in geographical regions sharing definite basic resemblances with the country situating a business’s operations, using analysis of an industry to recognize the levels of profit attainable for various routine functions including distribution, production, and services, and the comparable companies have comparable functions, risks, and assets are applicable solutions in a case with vast difficulty to attain a comparable (OECD, 2020). When considering various factors while in the process of selecting the suitable method it is vital to identify the party with the development/acquisition of used intangibles with a specific capacity, the party receiving the intangibles’ profit, and the party that owns the company legally since intangibles are a great factor. There is the provision of benefits to the party that developed intangibles through Selling or licensing intangibles to another exploitative party that abuse it, or exploiting the intangible by increasing the cost value of the products and services provided by particular intangibles.
Traditional Transaction Methods and Transactional Profit Methods are the two categories of methods. Traditional Transaction Methods involve the Cost Plus, the Resale Price Method and the Comparable Uncontrolled Price. The Profit Split Method and the Transactional Net Margin Method are categorized as “Transactional Profit Methods.” When selecting a method, the method must align with the arm’s length principle. For example, there is need for the taxpayer to consider the functional analysis, the type of transaction, adjusting information for better comparability, ensuring the presence of comparable transactions and looking into factors affecting comparability (OECD, 2020). After the selecting and application of a method, the taxpayers use and apply the method consistently. Changes in a method apply when there is limited data, issues with functionalities, or issues with facts when applying the suitable transfer pricing method.
Proactively designing a suitable transfer pricing policy and preparing enough documentation by using one of the five methods of transfer pricing is the most suitable solution for use when facing transfer pricing challenges. Some transactions are crucial and require consistent updating and high maintenance including accounting data, contracts and invoices. The placement and use of global policies that provide data about documentation and setting of transfer pricing cannot be ignored. The use of the global policies helps a company have enough preparations to avoid conflict with tax authorities incase need arises for an audit for transfer pricing. Transparency and consistency in financial documentation eases the entire process of determining an appropriate transfer pricing method.
Solution 2- Recommendation for resale price method transfer pricing method.
Through the use of the Resale Price Method, there is the determination of the profit ratios since, the method sells tangible goods to an unrelated party using comparable profits. The comparison between the realized gross profit during the re-selling of goods to related party by an entity and the realized gross profits in transactions that are uncontrolled by comparable entities. With the help of the Resale Price Method, it is possible to identify whether the charges during a controlled transaction are arm’s length when referring to the realized gross profit margin in uncontrolled transactions that are comparable (OECD, 2017). The ratio of the initial buying price of comparable tangible goods to the selling/resale price when selling to an unrelated party is the comparable profitability. The ratio is in percentage and helps calculate the value of goods during a transaction with a related-party.
Measuring the value of performed functions together with adding substantial value to tangible good by altering their physical structure before reselling is a success by the use of the Resale Price Method. Alterations including repackaging, labelling, packaging and minor assembly are not part of physical alteration. When a controlled taxpayer adds substantial value to tangible goods by using of intangible property one cannot use the Resale Price Method. The subtraction of the suitable gross profit from the applicable resale price of the property within the controlled transaction under review helps in the measuring of the arm’s length price using the resale price method. The applicable resale price is comparable with either the price of the contemporaneous resale of the created property or the resale price of the involved good. The applicable resale price is the value of reselling a property in an uncontrolled party or the price of the contemporaneous resale of the property if a property bought in a controlled sale is resold to one/more related parties in controlled sells before its resale in an uncontrolled sale (OECD, 2017). Determining the suitable gross profit accounts important factors and the functions of each group member participating in many controlled sales and finalizing uncontrolled resale. Multiplying the applicable resale price to the gross profit margin which is the percentage of the total revenue acquired from sales attained during uncontrolled transactions that are comparable helps identify the suitable gross profit.
Solution 3- Advance Pricing Arrangement (APA) and Mutual Agreement Procedure (MAP)
When compared to other areas in an organization, transfer pricing faces strict examination by the tax authorities creating an issue facing a company. As such, the best way to solve the issue of being watched by tax authorities involves the use of an Advance Pricing Arrangement (APA) or a Mutual Agreement Procedure (MAP). Through APA, the tax authority agrees to allow a company recognize viable transfer pricing policy applicable in the future. The ability of 57% of individuals in EY’s survey respond with distinct answers of being very satisfied or satisfied with the use of APA whereas, only 37% of organizations use APA. MAP, on the other hand, is an agreement between a company and the tax authorities to help solve issues that can rise over time dealing with double taxation. The use of both APA and MAP ensure the presence of early business solutions for transfer pricing while companies attain further control in transfer pricing planning. Startup companies with limited resources should not use APA or MAP in finding solutions due to the tremendous expense for use.
Solution 4- Equal Splitting of Profits
Setting the transfer price for a split profit by the two entities is a huge challenge since, a purchasing division incurs a large profit percentage when dealing with lower price whereas, a selling division acquires a greater profit when the price is high. There are some approaches that can help solve the issue of unequal splitting of profits including negotiation by letter as the first method to ensure that the side selling and the one purchasing settle on a given agreement of the price of a product (Holtzman, 2013). Cost-based transfer price is the second method that involves ensuring that the variable/total cost of the selling division is similar to the transfer price, thus, equal splitting of profits. The third method is the market-based transfer pricing whereby the individual in charge makes sure that the market value of the goods is equal to the transfer price in that, when selling the products to outside customers, the selling division attains a similar profit to that of the boss. Centralization is the fourth and last method whereby the boss of a company sets martial law as one legitimate for use. In the process, there is the eradication of all transfer pricing arrangements and a system that supports the earning of separate profit by each division. Therefore, for the equal splitting of profits, the boss uses the total expense value to evaluate the selling division and total sales to analyze the purchasing division thus, identifying each division as a business on its own net income (Holtzman, 2013). For that reason, when the divisions conduct business through the buying and selling of products, the set transfer prices help determine the percentage of profit shared between the parties. The higher transfer prices shift their income from the purchasing division to the selling division and can result to a case of disagreement when the splitting of profits is unequal between the two divisions.
Solution 5- Avoiding Taxation of the “Resale Transaction”
There are various ways when implemented help avoid the charging of taxes for resale transactions when dealing with drop ship businesses. The registration of the company with the ship-to state help an organization acquire a resale certificate. The company follows the law by registering for taxes and can collect them when dealing with ‘drop shipment’ despite the absence of nexus within a state. Second, one can break the structure of the drop-shipment especially when the additional shipping costs incurred while shipping the goods to one’s company within their “home state” then re-shipping the goods to the customer’s state destination is lower than the tax cost. Lastly, to avoid taxation, one can pay the vendor’s tax as an additional 8% value to the company’s cost-of-sales (Lenhart, 2017). According to the State of California (2020), the issuing of resale certificates when buying items is only allowed for carrying out by purchasers who sell tangible personal goods sold during their time in the business. A seller has no tax charges on a sale if he/she accepts an original resale certificate on time and through legal channels. CDTFA-230 is a General Resale Certificate that purchasers can issue when procuring goods for resell in the unvarying sequence of their business. The application of resale certificates is when purchasing materials included as part of a physical good held for resale, when buying goods for display/demonstration while the goods are under sale in the daily business projects, and when acquiring finished items for resale.
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