Transfer Principle Use - Essay Example

1023404 Draft Transfer principle is a common notion that is used in business studies referring to a process through which related trading entities define prices by which goods and services will be transferred from one entity to another. Nevertheless, it carries another definition, which alludes to systematic price manipulations for artificial reduction or increment of profits for malice such as avoiding taxation in a country of operation. Transfer price is involved in business transaction where a taxpayer sets the price to use while buying from, selling to as well as sharing resources together with other related trading person(s)1. In contrast, a market price is not determined by an individual but prevails to any participant within a market set-up involving exchange of goods and services between unrelated persons. We note that the market price cannot be tampered with and every person strives to maximize on own gains. Prices within the conventional market scene are determined by forces of market while the transfer prices are determined and set by an individual and thus are not negotiated freely or openly. This implies that transfer prices would often deviate from the conventional market prices within the same or alike market circumstances. It is worth to note that subsidiaries to one enterprise operating within one country face similar operational environment and hence the transfer prices poses similar problems of tax avoidance while compared to subsidiaries operating within different countries. With multinationals running various subsidiaries in different countries, which have different regulatory frameworks, taxation problems through transfer prices are very pronounced. The most prevalent problem with price transfers with multinationals is the tendency of subsidiaries stating inaccurate prices in order to lower profit margins to avoid high taxation. Beside, multinationals manipulate transfer prices through the internal payment networks with the goods they share between one to another. Therefore, the channels adopted within trading transactions by multinational subsidiaries, some price distortions are possible which may not be possible within the uncontrolled trading transactions by unrelated/unaffiliated trading companies. There are a number of principles techniques, which are applied in transfer pricing and which determine the overall outcome in price transfers. The methods of transfer pricing involve ways of calculation of margins of profits of business transactions within an entire business enterprise. However, it is worth noting that enterprises may not only quote profits for the margins but also may quote losses dependent on the interest of quoting it. Variations may also be notable in the quotations of transfer prices when different techniques of pricing are applied and this is not taken by itself to imply errors and thus necessitating adjustments. Distinctions are made in application of cost-based techniques in transfer pricing and the price-based transfer pricing techniques as they are applied. For instance, traditional transaction techniques are often preferred within certain countries while the modernized techniques are higher in preference within other countries. The traditional techniques referred to in this paper are such as comparable uncontrolled price technique, cost price techniques as well as resale price technique2. Comparable Uncontrolled Price technique The CUP (comparable uncontrolled technique) technique adopts comparison in setting prices where prices of goods and or services within a controlled transaction are subjected to the comparison with such other prices of goods of goods and or services in uncontrolled transaction circumstances. It is a method that is equally applied in pricing of royalties and thus applied to controlled transactions involving both goods and service. Moreover, the technique applies to both internal as well as external trading transactions. While applying the CUP methods based on internal comparables detailed transactional comparison comparing controlled as well as uncontrolled transactions I involved. Bench marking with such other companies of comparable nature being sought for comparison purposes. The basis of comparison in CUP technique is dependent on the capacity of the transactions being compared having no observable differences that would affect commodity prices in any way as well as having the capacity for transactional adjustments to the books of account. Comparison of the transaction is wholly dependent on comparative factors, economic conditions as well as contractual terms. There are two main types of CUPs, which are close and inexact, and they apply reliable adjustments in the following circumstances: where there are differences in product sources, differences in terms of delivery, application of volume discounts, modifications of products as well as in instances where risks are incurred. However, the reliability of CUP methods decreases in the event that it is hard to perform reasonable adjustments. There are basic advantages that are associated with the CUP method which include but are not limited to: that the analysis is not single sided, as both parties to a transaction are involved in setting the price. The process also involves the comparison of very detailed transactions for clarity and reliability of the process. However, the technique suffers two main shortcomings, which are that the strict comparability standards that are basic to comparison are limited to only finding very close comparable uncontrolled transactions. Besides it is not likely that internal comparables are found and that getting external comparables is equally hard thus limiting the application of the technique of CUP. Resale Price Method This is another technique that is classified as traditional and equally applies the ‘arm’s length’ principle. This method relies on focusing on related company whose responsibilities are those of marketing and selling to represent the tested party as a necessity in the analysis of transfer pricing. Accounting consistency is important in applying the resale price method. Gross profit margins will not be comparable if accounting principles and/or practices differ between the controlled transaction and the uncontrolled transaction. For example, the comparable distributors may differ from the related sales company in reporting certain costs (e.g., discounts, transportation costs, insurance and costs of performing the warranty function) as operating expenses or as cost of goods sold. Differences in inventory valuation methods will also affect the gross margins. It is thus important that the analysis does not compare “apples with bananas” but rather, “apples with apples”. Therefore, appropriate adjustments should be performed to the data used in computing the gross margin to make sure that ‘similar’ gross margins are compared. In practice the application of the resale price method is often based on a functional comparison. The benchmarking analysis under functional comparison is performed usingcomparable data. Those date may be available via publicly available databases. Based on the benchmarking and financial analyses, an arm’s length range of gross margins earned by comparable independent distributors is established and fall between x% and y%. If the gross margin earned by Associated Enterprise 2 is within this range, then its transfer price will be considered arm’s length. Under the resale price method, functional comparability is important, while product comparability is less important. Product differences are less critical for the resale price method than for the CUP method, because it is less probable that product differences have a material effect on profit margins than on price. One would expect a similar level of compensation for performing similar functions across different activities. Cost Plus Method In a controlled transaction involving tangible property, the cost plus method focuses on the related manufacturing company as the tested party in the transfer pricing analysis. The cost plus method may also be used in the case of services rendered. The cost plus method ‘begins with the costs incurred by the supplier of property (or services) in a controlled transaction for property transferred or services provided to a related purchaser. An appropriate cost plus mark up is then added to this cost, to make an ppropriate profit in light of the functions performed, risks assumed, assets used and market conditions. The cost plus method is used to analyse transfer pricing issues involving tangible property or services both under the OECD Transfer Pricing Guidelines and the US transfer pricing regulations. It is most useful where it is applied to manufacturing or assembling activities and relatively simple service providers. The cost plus method focuses on the related party manufacturer or service provider as the tested party in the transfer pricing analysis. The method evaluates the arm’s‐length nature of an intercompany charge by reference to the gross profit mark up on costs incurred by suppliers of property (or services) for tangible property transferred (or services provided). It compares the gross profit mark up earned by the tested party for manufacturing the product or for providing the service to the gross profit mark‐ups earned by comparable companies. Read More