Demystifying Transfer Pricing
Transfer pricing is an accounting technique applicable to charging different divisions or segments of a company for goods and services sold (Tax Justice Network, 2021). This principle is usually used when different divisions act as separate profit centers (Bragg, 2021). Transfer pricing is founded on the arm’s length principle, a strong basis for determining prices of goods and services exchanged between controlled parties. According to the arm’s length principle, entities that are associated through management, control, or investment in their controlled transactions should abide by similar terms and conditions that would have been mutually decided between unrelated entities for similar uncontrolled transactions (Transfer Pricing Asia, 2021).
Multinationals operating at a large scale often have complex transactions due to their size, making it rather difficult to use the arm’s length principle in a manner that complies with tax regulations. Tax authorities around the globe are also increasingly concerned about the possibility of multinational companies using transfer pricing and specifically the arm’s length principle to avoid and evade tax by shifting profits to tax havens (Tax Justice Network, 2021).
Tax avoidance and tax evasion is an extremely important issue that is taking center stage at all political and governmental levels. This was partly driven by the infamous leaks of Panama Papers and Paradise Paper, which revealed the extent of tax evasion by corporations and high net worth individuals by using offshore accounts. Now, tax authorities and regulators are implementing concrete measures to curb tax evasion, helping to increase the scrutiny and due diligence by tax authorities regarding transfer pricing.
Findings suggest that around 57% of tax administrators and 48% of corporations consider transfer pricing to be the most significant tax compliance risk (Borkowski and Gaffney, 2014). Business leaders around the world are faced with serious challenges stemming from the risk of non-compliance with transfer pricing regulations. These include violating transfer pricing rules and double taxation by companies (Kanee, 2019). On the other hand, tax regulators are concerned with transfer pricing as they seek to reduce profit shifting, revenue losses, and ultimately counteract any form of tax evasion (Kanee, 2019).