With the rapid rate at which the technology, transportation and communication have witnessed advancements that it has paved the way for the large number of multinational enterprises or corporations or companies that has the access to the global market as to place their enterprises and carry on their activities. In reality, a considerable portion of global trade today consists of international transfers of commodities and services, capital, and intangible within a multinational enterprise group; these transfers are known as “intragroup” transactions. The pricing that is associated with these kinds of transactions is known as transfer pricing.

Transfer pricing as a concept can be understood as the price that is related to the goods, services and technology between the associated entities that are located at different places or countries where one can be in a high taxed state and the other can be in low taxed state. The prices that are charged for such transactions between the associated entities are validated with a really strong economic reasoning that being the ability of the parent company to assess and evaluate the performance of the individual entities.

Price mechanism in controlled and uncontrolled transaction

The transactions that involve transfer pricing are often known as controlled transactions, reason being that such transactions happen in a controlled environment that is between two or more associated enterprises of the same multinational enterprise group and uncontrolled transactions are quite opposite of such transactions, that is these transactions usually take place between the companies that are not associated and are assumed to be working independently in reaching terms for any such transactions.

Price Mechanism in such transactions is apparently determined by the parent company because of the reason that the parent company wants to derive maximum economic benefits and comparative tax advantage and it is only possible because of the differential tax regulation and economies of scale of operation in different territories or states or nations.

Arm’s length principle

Each territory has their own taxation system and laws which becomes the reason for rate variation at global levels, hence multinational corporations or enterprises are encouraged by such disparities among tax rates, to shift their earnings from high-tax jurisdictions to the jurisdictions that has the low tax rate or no tax at all. To attain the profit shifting, a holding company or the parent company may sell its product or services to its subsidiary company.

The arm’s length price principle is employed which suggests that the transfer pricing for the associated entities in a controlled transactions should be similar to the pricing for the unrelated or independent entities in the uncontrolled transactions.

Methods of transfer pricing

There are majorly five methods through which transfer pricing is carried on are as follows:

1. Comparable uncontrolled price- This method is followed to see that the transfer pricing is done the right way that is the prices that are charged for a good or service by one associated entity to another associated entity in an MNE group is compared to the prices charged by disassociated entities in an uncontrolled transaction for the good or service that is in comparable capacity and the circumstances are also of comparable nature. This approach has been proven to be the most effective and efficient approach.

2. Resale price method- This method helps in determining the price that is paid by a reseller for a product or service that is purchased by the reseller from an associated entity within the same MNE group and then is resold to an independent entity. Through this method, the margin or the difference earned by the reseller can be assessed that can be enough to accommodate the selling and operating expenses and that the reseller is able to make a reasonable and fair profit.
3. Cost plus method- The cost-plus method is employed to analysis the relationship between the supplier and the consumer within a controlled transaction. That is, it helps in determining the price that shall be charged by the supplier of goods or services from the related purchaser. The cost or price that is incurred by the supplier is added to the markup of the product, goods or services in the process of determining the price of that product, goods or services. This helps in determining the profit of the supplier for the role he or she ahs performed in the consideration of the conditions of the market.
4. Profit comparison method- Through this method, the net profit margin that an entity has earned through a regulated or controlled transaction is compared to the net profit margin earned by an independent entity in the uncontrolled transactions in the similar market conditions or similar circumstances and this is how the requirements of Arm Length Price Principle is met.
5. Profit-split methods- The approach that this method follows is that the combined profits that are earned by any two associated parties from one or a series of transaction and then the relative contribution of the associated parties to their earning of such net profit is calculated and then the combined net profit is then split among the entities or parties in accordance to their contribution and this is how arm’s length price is determined for each entity or parties in a MNE group.

In a nutshell

There is always an attempt to increase the profits of the parent company by reducing tax liability by the way of storin funds or by transferring the earnings into related entities situated in the jurisdictions known as tax havens. The way these transactions take place in the multinational enterprise group is determined by a combination of market and group-driven pressures or forces that can differ from open market circumstances that operate between independent firms.

As a result, a huge and growing number of international transactions are no longer dominated just by market forces, but by forces motivated by the common interests of group members. Transfer pricing should be considered as the method of the cross-border transaction or a way to ease the doing and setting up of the business and should not be seen as the way or measure to escape the tax liability by the multinational enterprises.