Primer: Transfer Pricing

The transfer price is the price of a transaction between two entities that are part of the same group of companies. For example, a South Africa-based company might sell mining equipment and machinery to its Ghana-based subsidiary. The price agreed is the “transfer price.” The process for setting it is referred to as “transfer pricing.” The difficulty in monitoring and taxing such transactions is that they do not take place on an open market. A commercial transaction between two independent companies in a competitive market should reflect the best option for both companies; two affiliated companies are more likely to make transactions in the best interest of their global parent corporation. It can be in the interest of the global corporation to make higher profits in lower-taxed jurisdictions and lower profits in higher-taxed ones, as a means of reducing its overall tax bill.

KEY MESSAGES

• Transfer pricing is a business practice that consists of setting a price for the purchase of a good or service between two “related parties” (e.g., subsidiary companies that are owned or controlled by the same parent company).
• Transfer pricing becomes abusive when the related parties distort the price of a transaction to reduce their taxable income. This is known as transfer mispricing.
• Multinational mining companies rely on complex webs of interrelated subsidiaries. Some of them are domiciled in low-tax and secrecy jurisdictions. These subsidiaries can sell minerals to each other at a discount or purchase goods, services and assets from each other at inflated prices in order to “transfer” profits to lower-tax jurisdictions from higher-tax ones.
• One way governments can address transfer mispricing is by passing laws that require companies to apply the “arm’s length” principle: related parties price transactions as if they were transactions on an open market.
• There are five major transfer pricing methods based on the application of the arm’s length principle. A sixth method overcomes the challenge of lack of comparable transactions by requiring taxpayers selling mineral products to benchmark the sale price to the publicly quoted prices of minerals or metals.
• Alternative tax policy rules—limiting interest deductions on related party loans, for example—help to protect the tax base and simplify implementation of transfer pricing rules.