Although transfer pricing is not a new issue and has been much discussed, doubts and misinterpretations about it have been very common, to the point that the idea has proliferated that they represent a negative practice. As we know, these prices are simply transfer prices agreed within an organization for the transfer of assets, and services both tangible and intangible. We must remind that at the time, companies were focused on their core activities as well as to external customers and little attention was paid to their areas of support. These areas were considered cost centers and not being part of the main business, and were expected only to recover the costs incurred. When various management concepts evolved, and developing information technology was expected to recover additional costs, these units also started generating income, beginning to be treated as profit centers. In this regard, Horngren, Foster and Datar (1996) in their book “Cost Accounting: A Managerial Approach” define transfer pricing as a price that a unit, segment, department, division, etc. charge for a product or service provided to another subunit of the same organization.
From a tax point of view, the above dynamics and fragmentation of these business units into separate legal entities, often located in different jurisdictions as a result of globalization has meant that the profits generated by these units are taxed at different jurisdictions, and as a result, the transfer prices agreed within these business groups became very important for the tax authorities where these groups operate.
In the end, business groups could transfer, voluntarily or involuntarily, profits between tax jurisdictions. It is worth mentioning that the existence of different income tax rates in different jurisdictions, product of the sovereignty of nations, and tax competition, create an incentive for the accumulation of such profits in the jurisdiction or jurisdictions with lower tax rates. In this regard, the United Nations Practical Manual on Transfer Pricing for Developing Countries, hereinafter UN Handbook, defines transfer pricing in paragraph B.1.1 .6, as follows:
“Transfer pricing is the general term for fixing cross-border prices of intra-firm transactions between related parties. The transfer pricing, thus refers to the pricing for transactions between associated companies involving the transfer of property or services.”
Given the impact, from a tax point of view, that the prices agreed between companies in a multinational group transfer might have in each jurisdiction as a result of the various transactions of a taxpayer with other companies in the same corporate group that are not domiciled in the same territory, the different countries have developed regulations to prevent a decrease in tax revenue as a key element, establishing the principle of market value, of independent operator and the arm´s length principle.
Concerning the arm´s length principle, the OECD Guidelines applicable to the transfer pricing for multinational enterprises and tax administrations (OECD Guidelines) in paragraph 1.2 underlines the following:
“When independent companies negotiate between themselves, market forces usually determine the conditions of their commercial and financial relations (for example, the price of the transferred goods or services provided, and the conditions of the transmission or delivery). When associated companies interoperate, external market forces cannot affect in the same way their commercial and financial relations, although it happens often that associated companies intend to reproduce in their operations the dynamics of market forces.”
In essence, this means that the transactions between related parties or partner companies should be conducted under terms consistent with those which would have agreed with independent parts or in independent conditions.
Although, as mentioned above, the arm´s length principle has become the key element in the transfer pricing regulations in different jurisdictions, the OECD Guidelines recognize the difficulties that their application could present. In this regard, paragraph 1.2 of the guidelines also states that:
“Tax administrations should not automatically consider that associated companies seek to manipulate their profits. There may be real difficulties in the accurate determination of a fair market value in the absence of market forces or because of the adoption of a specific business strategy. It is important to note that the need to make adjustments to approximate the arm´s length conditions arises irrespective of any contractual obligation to pay a particular price assumed by the parties, or any attempt to minimize the tax burden. Therefore, the adjustments guided by the arm´s length principle would not affect contractual obligations without tax purpose assumed by associated companies and may be appropriate even when there is no intention to minimize or avoid taxes. The transfer pricing analysis should clearly disassociate itself from consideration of the problems of fraud or tax avoidance, even if the decisions adopted on transfer pricing could be used for such purposes”
Meanwhile, both the model tax convention on income and capital of the OECD (OECD Model) and the United Nations (UN Model) in the first paragraph of Article 9 mention the following with respect to the determination of transfer pricing adjustments:
“When … conditions are imposed between two enterprises in their commercial or financial relations that differ from those which would be made between independent parties, the benefits that would have accrued to one of the companies in the absence of such conditions, and in fact not been performed because of them, may be included in the profits of that enterprise and taxed accordingly.”
The Arm’s Length principle has been commonly adopted in several jurisdictions in Latin America as well as in the rest of the world, as a reference to ensure that as a result of transactions between companies, and their respective transfer pricing, the taxable income of taxpayers in their territories is not affected negatively.