* Original Question “We need to hire a Director
of Transfer Pricing…”
* The Correct Question - “You need to
understand the downside impact of incorrect
transfer pricing. It can kill a company. Its not
just about saving taxes.”
And The Philosophy Behind The Answer
Transfer Pricing is a fundamental principle used in assigning value and
revenue attribution to the various business units. Essentially, transfer
pricing in banking is the method of assigning the interest rate risk of the
bank to the various funding sources and uses of the enterprise.
Thus, the bank's corporate treasury department will assign funding
charges to the business units for their use of the bank's resources when
they make loans to clients. The treasury department will also assign
funding credit to business units who bring in deposits (resources) to the
Although the funds transfer pricing process is primarily applicable to the
loans and deposits of the various banking units, this proactive is applied to
all assets and liabilities of the business segment. Once transfer pricing is
applied and any other management accounting entries or adjustments are
posted to the ledger (which are usually memo accounts and are not
included in the legal entity results), the business units are able to produce
segment financial results which are used by both internal and external
users to evaluate performance.
* Formulary apportionment is a method of allocating profit
earned (or loss incurred) by a corporation or corporate group
to a particular tax jurisdiction in which the corporation or
group has a taxable presence.
* It is an alternative to separate entity accounting, under
which a branch or subsidiary within the jurisdiction is
accounted for as a separate entity, requiring prices for
transactions with other parts of the corporation or group to
be assigned according to the arm's length standard commonly
used in transfer pricing.
* In contrast, formulary apportionment attributes the
corporation's total worldwide profit (or loss) to each
jurisdiction, based on factors such as the proportion of sales,
assets or payroll in that jurisdiction.
The Arms Length Principle
The Organization for Economic Co-operation and Development (OECD) has adopted the
principle in Article 9 of the OECD Model Tax Convention, to ensure that transfer prices
between companies of multinational enterprises are established on a market value
basis. In this context, the principle means that prices should be the same as they
would have been, had the parties to the transaction not been related to each other.
This is often seen as being aimed at preventing profits being systematically deviated to
lowest tax countries, although most countries are also concerned about prices that fail
to meet the arm's length test due to inattention rather than by design and that shifts
profits to any other country (whether it has low or high tax rates). It provides the legal
framework for governments to have their fair share of taxes, and for enterprises to
avoid double taxation on their profits.
A simple example of not at arm's length is the sale of real property from parents to
children. The parents might wish to sell the property to their children at a price below
market value, but such a transaction might later be classified by a court as a gift
rather than a bona fide sale, which could have tax and other legal consequences. To
avoid such a classification, the parties need to show that the transaction was
conducted no differently than it would have been for an arbitrary third party. This can
be done, for example, by hiring a disinterested third party such as an appraiser or
broker, who can offer a professional opinion that the sale price is appropriate and
reflects the true value of the property.
* Governments will try to maximize the Tax in
their Local Jurisdiction (ref: Arms Length)
* Firms will try to move Allocations to the
country with the lowest tax amongst all the
countries it does business in
* We will be looking at the problem from
Multiple Perspectives (i) The Firm and (ii) The
* The problem is
* Σ mpi >> MPend-product
* i.e. Sum of all Fair market prices of all inputs
put together is grossly greater than the Fair
market price of the End Product
* The arm’s length principle has Gross
Deficiencies and renders Firms uncompetitive
Step 1) It is in an organizations best interest to use pure Cost’s upstream
and book all profits at the Country(s) of Sale. Each Org. will have multiple
country’s of sale.
This allows the most efficient and competitive delivery of Value and
Step 2) Do one of the following
For each country of sale allocate its profit to the country with the lowest
tax in the chain
Or else use a Formulary approach to allocate actual profits in the chain e.g.
proportion of Costs is a good measure to allocate profits in proportion…
The Biggest Question To Ask: Why do governments tax Firms (at that level
or at all) when its clear that the Financial Firms never pay any taxes by
using Liquid Synthetic Instruments. Are we saying that Firms should better
manage their treasury’s the same way. Or are we promoting tax avoidance
by a privileged few and putting the rest of the non-financial firms which
contribute immensely to the economy at a disadvantage?
It is in the best interest of the Government that the firms are as competitive as possible
For the Firms its best if they don’t use Transfer Pricing to measure the Efficiency and Performance of its Groups. It
leads to Immense Conflicts and renders the Firm Uncompetitive
The best Law would be to set the Corporate Tax rate using a Formulary approach at…
The best option would be a 0% Corporate Tax Rate but that would again lead to exploitation by firms who would
register in the country and allocate profits to it while not doing any business in the country and hence not helping
If the base rate is 2% then if proportion is 2% (use minimum of 2% in calculations if proportion < 2%) then
Applicable Corporate Tax will be 100% of all allocated profits.
If the base rate is 2% then if proportion is 30% then Applicable Corporate Tax will be 6.67%
If the base rate is 2% then if proportion is 70% then Applicable Corporate Tax will be 2.86%
But this by itself will deter Globalization and hence we need to put in another Tax Scaling Factor based on Levels
of Economic Contributions e.g. = 0.3 if Sales or Production > $1Bn, = 0.2 if > $2Bn etc. in absolute terms
Governments shouldn’t impose the Arm’s Length Rule as it is in direct conflict with the Economic Viability of the
Rule: Government’s make nothing from Direct Corporate Tax compared to the benefit (direct & indirect) it derives
from the multiplier effects Firms create in the economy.
And that’s exactly what the Governments should focus on.