Transfer Pricing - VAT implications: background
Profits for the purposes of UK Income Tax and Corporation Tax are calculated according to generally accepted accountancy principles except where there is a specific provision to the contrary. Transfer pricing rules are such an exception.
Trading organisations will decide the price that they charge for their goods or services in a variety of ways. For goods, the price may be based on the cost of raw materials, direct labour, a share of the overhead cost and a mark up. More simply the price may be based on a judgement of what the market will stand, depending of the nature of the market and the goods. The total prices charged will help to determine the commercial profits (or losses) of the business.
If parties to the transaction are connected, the price charged for the transaction may not be the same as that charged between unconnected parties, as many other influences and factors come in to play. If the parties are wholly owned by a third party then the price charged in the transaction will not make the third party any richer or poorer, it will merely move funds / profits from one entity to another.
The price charged between ‘connected parties’ is termed the ‘transfer price’. The transfer price may be the same as that which would be charged if the parties were unconnected (i.e. they were dealing with each other at ‘arms length’). In the case of wholly owned connected parties there is not the need or incentive to charge an “arm’s length” price.
One way that a multinational corporation can calculate the transfer price is to ensure the profits of the multinational were maximised in the tax jurisdiction where they would wish them to be maximised. Therefore profits may be concentrated within that territory which taxes corporate profits at 10% rather than the territory which taxes profits at 40%. Clearly if an unadjusted transfer price was used in tax calculations the effect on tax revenues in differing jurisdictions would be dramatic.
The taxation effect of transfer prices is often quoted, but it is just one of many motives, influences and factors impacting on a multinational in setting the transfer price between its connected parties. Differing national laws and regulations, degree of control from the parent, unstable local political situation, high inflation or exchange controls in some countries may all influence the decision.
Due to the potentially dramatic effect of transfer pricing on taxation revenue, there is a general international consensus that, to achieve a fair distribution of taxing profit, and to address international double taxation, transactions between connected parties should be treated for tax purposes by reference to the profit that would have arisen had the parties been unconnected. In other words, the arms length provision is used rather than the transfer price charged.