Tax advisory is primarily the province of the Big Four: Deloitte, PwC, EY and KPMG. A major specialisation of the tax departments of all four of these special services firms is transfer pricing, making it worthy of a closer look if you are considering entering this field.
Transfer pricing comes into the picture when the forces of market competition are wiped out. This happens in situations where economic transactions are not happening between independent parties who are each seeking to pursue their individual self-interest. The most prevalent case is when goods or services are being exchanged between different departments of the same corporation, or subsidiaries belonging to the same holding company. Under such circumstances, supply and demand do not directly determine the price, since both entities have the same shareholders. If that is the case, why would anyone care what transfer prices are used? If the owners are the same, transfer prices could theoretically be zero.
The level at which transfer prices are set is indeed irrelevant from the government’s perspective as long as both the selling and buying party is subject to the same tax rate. For multinational corporations operating in multiple jurisdictions and tax regimes, however, transfer pricing offers an opportunity for tax-optimisation.
Corporations with multiple subsidiaries are incentivised to arbitrarily set transfer prices in order to maximise profits for the subsidiary residing in the most advantageous tax regime. The key factor that drives this phenomenon is goal congruence between the different entities. That is, the profits of both companies should benefit the same owners, thereby making it irrelevant which subsidiary has higher profits, as long as aggregate profits are maximized.
In order to tackle this issue, state authorities have created regulations that address transfer pricing. The most widely applied practice is the so called “arm’s length principle”, meaning that goods and services transferred between related companies should be valued using market prices, which unrelated parties would agree on.
Determining the appropriate price is straightforward when the two subsidiaries trade not only with each other but also have other customers. In that case, they only need to apply the same prices as they do for their other customers. If the parties trade exclusively with each other, however, the correct transfer price is much less obvious, and microeconomic theory only gives a broad range of prices that might prevail in the market. For instance, the minimum selling price should not be lower than the variable cost, even if there is excess capacity on the supply side.
In order to make sure that transfer prices comply with the “arm’s length principle” and thereby tax regulations, multinationals often seek advice from the Big Four.
The primary task of transfer pricing units is to ensure that there is a legally defensible case for using of a certain transfer price if it were to be scrutinised by tax authorities. Firms do this mainly by searching for companies with similar profiles, and benchmarking prices against those used in the broader market. However, this is often difficult to do since there may be no comparable companies selling similar types of products.
Multinational corporations like to take advantage of any ambiguity. A showcase example are royalties paid for patents and other intellectual property. How can we assess the market value of a new innovation if there are no competitors? This is the strategy followed by Apple. Most of Apple’s intellectual property and patents are owned by a subsidiary located in Ireland, where the corporate tax rate is only 12.5%. In fact, Apple is taxed substantially less than that, as it enjoys substantial tax breaks from the Irish government. This led to a perverse situation where the European Commission ordered Apple to pay €13 billion in back taxes to Dublin, which Ireland itself refused to collect. Litigation between Ireland and the European Commission continues up to this day at the highest judicial level, the European Court of Justice.
Although tax optimization is definitely an important bread and butter service provided by the tax departments of the Big Four, the lion’s share of their work simply involves helping companies comply with regulations. Services such as Advance Pricing Agreements and Mutual Agreement Procedures serve as platforms that help multinational corporations find common ground with tax authorities more easily.
Bence Borbély is a Hungarian first-year History and Politics student at the University of Cambridge whose professional fields of interest are management consultancy, public policy-making, politics and international relations.
Image: Unsplash
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