Transfer Pricing: The Good, The Bad, and the The Confusing

“Transfer Pricing” refers to a business “transferring” some or all of it's profits or losses to another entity that is usually controlled by the business either as an outright subsidiary or as an affiliate relationship of some sort. This other entity is often located in another jurisdiction which sometimes results in beneficial tax treatment.

I suspect every global company practices “Transfer Pricing” to one degree or another, if only to insure that their subsidiaries are complying with local tax rules, regulations and agreements. In execution “Transfer Pricing” involves one company buying a product or service from or selling a product or service to another company that is either a subsidiary or an affiliate of the parent company. If a factory in Canada, owned by a Canadian subsidiary of the parent company, makes parts which are used to produce a finished product in a factory in Mexico, owned by a Mexican subsidiary of the same parent company, which is then sold in the USA by the parent company, it is only reasonable that the Canadian company makes a reasonable profit on the sale of the parts to the Mexican company, and that the Mexican company makes a reasonable profit when the finished goods are sold to the parent company. I would suspect anything else would result in severe tax problems with the Canadian and Mexican governments respectively since these government will expect the profits made by the subsidiaries to be taxed by those governments in which the subsidiaries are located. So the Canadian subsidiary pays Canadian taxes on the profits it made, the Mexican subsidiary pay Mexican taxes on its profits, and the parent company in the USA will only have to pay taxes to the USA on the profits earned as defined by the difference between the price the parent company paid the Mexican subsidiary and the final sales price in the USA.

Of course this example is a gross over-simplification. If you read anything technical about “Transfer Pricing” you are going to see some very confusing discussions about how to define “reasonable” profits. In the end the US taxing authority may still get its snout in the trough when the after-tax profits of the subsidiaries are repatriated or attributed to the parent company. All the same I believe it is a reasonable initial explanation of how “Transfer Pricing” can work. The subsidiaries are not necessarily set up to avoid or even reduce taxes, but merely to help clarify where and how to apportion profits in order to facilitate tax payments to the respective taxing authorities, and to avoid the possibility of double taxation of profits.

Now I am sure everyone who is reading this is already thinking of dozens of ways in which this simple mechanism designed only to apportion profits in order to more efficiently pay taxes on multinational transactions could be used to do more than just apportion taxes. “Transfer Pricing” can be and is used to significantly reduce the tax burden on multinational companies that do business globally. This is because taxation across national borders is not equal. Where to locate various transactions depends upon a number of factors, tax treatment being a significant consideration. The factory making the parts in Canada may have been located there because of a number of reasons: a reliable well educated workforce, access to raw materials, easy access to transportation networks, etc. But if the Canadian government offered tax incentives that resulted in significant tax savings, that must be considered as well.

Every country has its own rules regarding the taxation of business activities inside its borders. Some countries desire to lure businesses by offering tax incentives and other benefits. Other countries simply offer competitive advantages that are simply part of their regulatory structure. The companies themselves must take advantage of any benefit available since the competition will clearly do so. So there you have it. Governments competing with other governments to attract businesses that in turn compete with other businesses. A country or a company that ignores this global aspect of business competition is at a real disadvantage.

“Transfer Pricing” inevitably covers every aspect of the supply chain from sourcing of raw materials to final delivery of a finished good or service. Included within this structure is financing. Many large multinationals establish their own banking/finance operations in friendly jurisdiction which inevitably provide loans and/or factoring services to the various entities along the supply chain. The financing operations are almost always established in jurisdictions which either do not tax these types of transactions or tax them at a significantly reduced rate. And don't think for a minute that this involves only small “tax havens” in odd locations. Virtually every country on earth with a healthy financial sector competes for this business by offering tax loopholes to foreign companies that choose to park their money in its banks.

There are many myths associated with “Transfer Pricing”. One is that only large multinational firms can take advantage of this strategy. This is not true. There are many costs associated with establishing an effective and legal “Transfer Pricing” strategy from legal fees to added accounting burdens. For smaller firms the benefits may simply not justify the added costs. But for many small businesses the benefits do justify the costs, and failing to take advantage of them can prove even more costly since the competition will most likely take advantage and thereby reduce overhead and costs.

The best examples of smaller companies that can benefit from “Transfer Pricing” are businesses that are already involved in global transactions, sometimes without fully realizing the significance. The Internet has accelerated the growth of such situations dramatically.

Let us take as an example a small business I came across a few years ago in Arizona which hired software engineers located outside the USA to write programs which were then sold to end customers in the USA and in other countries. The business was structured as a US corporation and paid US taxes on 100% of the profits from all sales of the company. Under US tax rules, it was totally appropriate for the US company to establish a wholly owned subsidiary to manage the day to day issues regarding the production of the software by the non-US workers and the sales of the software to other countries. This wholly owned subsidiary was ideally located in a jurisdiction which did not tax these transactions, and the US company bought the product at a reasonable fair market wholesale price for resale inside the USA. The US company only had to pay taxes on income that was earned from sales inside the USA. The profits from the sale of software of the foreign subsidiary outside the USA was not taxed by the USA.

The USA can also serve as an ideal location to establish your subsidiary operation. I have represented a number of mid-size non-US companies that have used the USA as a jurisdiction for “Transfer Pricing”. The examples vary accordingly to the nature of the businesses, but not in the basic nature of the transactions. There are essentially two strategies that are employed: 1. The companies buy or sell a good or service for resale in their home market or abroad and use a US based company as a middle man, or 2. The companies finance their operations in their home country through loans issued by a US based company. If properly structured, the US companies pay no taxes on income that is not derived from “US Source Income”, and the foreign companies do not pay income in their home countries on the income that was earned by the US companies. All legal and ethical (I have had some people argue that these strategies are not ethical even though they are legal; I simply cannot understand this reasoning. How can it be unethical to structure your business in a way that legally reduces your overhead, in this case taxes. Would it be unethical to come up with a legal method of reducing your rent, or your cost of raw materials, labor costs, energy, etc.?)

On the one hand “Transfer Pricing” is as simple as simple can be, you attribute profits or losses to another company in another jurisdiction and reduce your own profit accordingly, but on the other hand the actual execution can be complicated if only because of the fact that every business is a little different, and each strategy must be tailored to fit the particular needs of the business. Ultimately it depends upon the business. Some businesses are very easy to structure, and for others it is simply not worth the effort.

I encourage those businesses that might benefit from legal and ethical business planning to contact me so that we can further discuss your options.