Transfer pricing happens when two related companies, that occupy a similar industry, trade with each other. When a US-based subsidiary of Company A decides to buy something from its UK-based subsidiary and the two entities agree on a price for the transaction, transfer pricing occurs. A principle comparable to transfer pricing is the “arm’s length” doctrine. The arm’s length doctrine states that the amount charged between two related parties for a given transaction must be the same as if the parties were not actually related. In essence pricing between two related companies must be consistent with pricing either entity would charge a third party. The doctrine also states that two companies must act as though they are negotiating in a normal market since the market would provide a guideline for the ‘fair’ price of a particular transaction.
Limitation of Arm’s Length
Since transfer pricing occurs between two related companies there is potential for price distortion to occur. Two companies may wish to distort or manipulate the price of the transaction that occurred to minimize overall tax liability if one or both of the companies is subject to a substantial corporate tax. Price distortion is especially appealing in ‘tax havens’ or countries with low or zero corporate tax rates. Transfer pricing has been under the microscope in recent years for this reason.
Government appointed agencies work to ensure that companies are not abusing it to avoid taxation. In theory, the ‘arm’s length’ approach is supposed to stop misuse by ensuring that transactions between related companies are treated as if the two entities are not related and priced accordingly. However, in practice, implementing ‘arm’s length’ proves to be bothersome if not impossible for highly specialized companies. Imagine, for a moment, that two related companies are trading a tiny component for an MRI machine that is only made for that particular machine and is not manufactured by any other company.
Hardly any market comparison would exist for this transaction, so the appropriate price is not obvious. The problem with this is two-fold. This situation could provide leeway for abuse because with no market comparison the companies could simply set their own price. It could also create undue burden on companies that are law-abiding and follow ‘arm’s length’ but are lacking a market-based guideline. Currently, ‘arm’s length’ is a favored approach to determining transfer prices; however in this case it is problematic. Perhaps other ways of determining transfer prices need to be developed and implemented.