Today I discuss transfer pricing and why it is a tax issue.
Investopedia defines transfer pricing as: In managerial accounting, when different divisions of a multi-entity company are in charge of their own profits, they are also responsible for their own "return on invested capital".
Therefore, when divisions are required to transact with each other, a transfer price is used to determine costs. Transfer prices tend not to differ much from the price in the market because one of the entities in such a transaction will lose out: they will either be buying for more than the prevailing market price or selling below the market price, and this will affect their performance.
Transfer pricing becomes a tax issue when members of a multinational company group allocate prices to manipulate income and taxes. That is, profits are increased in low or no tax countries and reduced in higher tax countries. The following example illustrates the concept: Bananas are grown in a plantation in Honduras;
The bananas are harvested and transported to a packing house;
The bananas are packaged and brand labels attached;
The bananas are transported to the dock and loaded on a freighter;
The bananas are shipped to a New Zealand port and unloaded;
The bananas are sent to a central warehouse and then delivered to your local supermarket or fruit shop where you buy the bananas.
In addition to each of these steps, there are other costs:
A fee is paid for use of the trade name (royalty on intellectual property);
Insurance cover is provided for the growing and transportation of the bananas;
Loans are obtained for the purchase of the plantation land, trucks, packing house and freighter.
There would not be a tax issue if all the producers and service providers at each stage were independent. If, however, members of a multinational group are the producers or service providers for each of the above steps (though probably not step 6), there is considerable scope for manipulation through "transfer mispricing".
Much of the current debate about large multinational companies such as Amazon and Google not paying tax in mature (high tax) economies relates to transfer pricing. Typically, intellectual property such as formula and patents is transferred to an entity in a low or no tax jurisdiction.
The manufacturing of products such as medicines is undertaken, under licence, in developing countries. Given that much of international trade occurs between multinational company groups, there is considerable scope for transferring tax liabilities.
New Zealand and many other countries have rules to mitigate transfer pricing abuse.
Transfer pricing will remain an issue unless there is international agreement on the application of transfer pricing rules.
* Murray McClennan is director of Tax Central Ltd, a specialist tax consulting firm.
The above comments are of a general nature only and are not a substitute for specific advice.
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