Transfer Pricing 101

Every few years (or months as of late), the area of “transfer pricing” surfaces itself, even if the term never (or rarely) appears anywhere, as was the case with last week’s 60 Minutes segment on the world’s “new tax havens”. Part of it is the skewed taxonomy of the word itself, evoking implications of price structuring (i.e., determining how much a product is worth (albeit partially true)) versus its actual practice, determining the internal market cost of services rendered between company subsidiaries.

But a large part of it is the complexity of the practice itself, despite a very simple and innately intuitive objective — companies should compensate its internal business units for services rendered the same way they would with any external service. In this way, according to theory, companies would be prevented from shifting profits to lower tax jurisdictions.

As an example, Apple, which makes its famed iPods and iPhones predominantly in its Shenzhen, China factories, managed by third-party FoxConn and its own Apple-owned site.  Apple pays FoxConn the equivalent of a cost plus 5% margin but could choose to “charge” its own privately held subsidiary a cost plus 15% amount. Because Apple only has to pay a 25% tax rate in China, versus the 35% in the US, Apple would automatically gain a 10% cost savings for all business expenses incurred in China.  (all numbers, except for the corporate tax rates, are made up)

Transfer pricing tries to prevent this through a principle known as “arm’s length”, and while each tax jurisdiction has its own definition of what is considered arm’s length, it’s generally accepted that companies may compensate their internal business units at a margin that is roughly equal to those realized by third party companies.

While most reports like the recent 60 Minutes special are quick to tack onto the $60 billion of tax dollars that flow overseas every year, and the questionable practices that surround it, this fundamental principle remains largely untouched and unspoken for.  Rather than calling for this practice to be done away with (which is not possible; if anything, the number of countries that have enacted transfer pricing in recent years is steadily on the rise), emphasis should be placed on creating less ambiguity. What entails a sales and marketing service? What third-party companies should be considered as comparable in determining arm’s length? Are public companies, which are often the only companies with publicly available financial statements, even the right benchmarks to use?

And perhaps the foremost challenge and threat governments, particularly the US, should consider is the question of intellectual property transfer.  Especially among Silicon Valley companies, the ongoing trend has been to shift valuable technical IP developed in the heart of California’s Silicon Valley to the corporate-friendly business environment of Dublin, Ireland (tax rates range between 10% and 12.5%), where English is also the lingua franca.   According to an article by BusinessWeek, Google has been able to save more than $3 billion in taxes by housing the company’s search advertising IP in Dublin.

More than just profits, however, what happens when a paper-based transfer of IP translates into talent-based IP transfer?  Then, while the numbers won’t be as quantifiable or seem as impactful as $60 billion in tax savings, the implications will be far more substantial. Rather than asking the question of how we need to crack down on corporations to retain tax savings, the more pivotal question will be what we can do to ensure that IP developed within the borders of any one country need not move simply based on tax merits.

views expressed are only my own, and are by no means comprehensive. i am not a transfer pricing practitioner or expert, just a passerby thinking aloud on two years in the field

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