What Is Transfer Pricing?
entities related to one another. For example, a parent company pricing the sale of goods to a subsidiary or a subsidiary loaning money to its parent would fall under transfer pricing. Transfer prices can include products, services, loans and intellectual property. Governments are very involved with transfer pricing because they want to ensure that taxes are being paid by a corporation in each country where they operate in accordance with the corporation’s profits.
Tax authorities’ guidance on transfer pricing is mainly based on the OECD’s Transfer Pricing Guidelines, which promote the application of the “arm’s-length principle”. This principle means that related parties must set their transfer prices as if they are independent parties and must set their transfer prices so that the terms and conditions are equivalent to the terms and conditions of an uncontrolled transaction between unrelated parties in accordance with the normal market conditions existing at any time.
This principle prevents related companies from shifting their profits to a jurisdiction with lower taxes by allocating the profits of a corporation to the countries in which the respective economic activities occurred.
Why Transfer Pricing Matters for Startups
When companies begin setting up their subsidiaries and hiring expatriate or international intellectual property (IP) employees, they may be surprised by the importance of transfer pricing.
Startups need to be aware of the following transfer pricing issues:
1) Compliance with Regulatory Regulations: Many governments require companies operating internationally to maintain appropriate transfer pricing documentation for auditing purposes (for example, the OECD transfer pricing guidelines).
2) Reduction of Double Taxation: The use of appropriate transfer pricing documentation may assist a business in establishing an appropriate allocation of taxable profits between jurisdictions.
3) Properly Managing Growth: When startups grow internationally, they often create multiple legal entities with varying levels of sales and operating expenses. For example, when a US-based parent corporation employs support/production personnel in several countries around the world to provide services to support its international sales.
4) The Due Diligence Process for Investors and Acquirers: Increasingly, investors and potential acquirers are placing significant emphasis on establishing appropriate compliance with international tax regulations during the due diligence process prior to investing or acquiring a business. Startups that maintain well-documented and established transfer pricing policies will be in a stronger position during any fundraising, merger, or acquisition process.
Common Transfer Pricing Scenarios for Startups
Startups expanding globally often encounter transfer pricing issues in several common situations.
Intellectual Property Licensing
Many startups centralize intellectual property-such as software code or patents-in one jurisdiction and license it to foreign subsidiaries. Transfer pricing rules require that licensing fees reflect market conditions.
Cross-Border Services
A startup may have engineering teams in one country providing services to another group entity. These services must be priced using appropriate transfer pricing methods.
Intercompany Financing
Loans between related entities must also comply with transfer pricing standards. Interest rates should align with market conditions.
Distribution Structures
If a startup sells products globally through local distributors or subsidiaries, transfer pricing rules determine how profits are shared between entities.
Key Transfer Pricing Methods
The OECD guidelines and many government or international organization recommendations discuss different ways to arrive at a “reasonable” transfer price using different methods of evaluating transfer pricing. To establish the “best” method to use:
- Comparable Uncontrolled Price (CUP): This method compares the price paid for a product to the price at an arms-length transaction between unrelated parties selling the same or similar goods/services.
- Cost-Plus: This method begins with the cost of producing or providing a good/service (ex. materials + Labor), then adds a reasonable profit margin (ex. 5%) to that price.
- Resale Price: The resale price method measures a manufacturer’s profit margin from resale in comparison with that of other manufacturers.
- Transactional Net Margin Method (TNM): This method utilizes the profit margins of similarly situated entities to determine an appropriate level of profit for the transaction at issue.
To ensure that related party transactions are as comparable to independent entities as they can be is the cornerstone of all the methods outlined above.
Documentation and Compliance Requirements
Companies will want to follow the guidelines they must meet under the law to create documents proving how prices for goods are determined between companies belonging together. Increasing transparency and fighting against tax avoidance is one way for authorities to make changes and increase their reporting methods.
As part of the OECD BEPS initiative, nations have made efforts to develop standard requirements allowing business to report at a country-by-country basis and creating related documentation that verifies both the location of the business activities and profit creation.
Typical documents that provide evidence of transfer pricing include:
– Descriptions of your company’s worldwide structure
– Analysis on intercompany transactions
– Industry benchmarks
– Reasons for pricing method used
– Financial data relating to the method of pricing selected
When new businesses begin operations, creating good documentation upfront will save them a great deal of time and money during their existence.
Strategic Considerations for Startup Founders
Tax compliance isn’t the only consideration for transfer pricing. When done right, transfer pricing can help support your business strategy as well as operational efficiency.
Start Early: Creating your transfer pricing policies should happen as soon as you begin any international operations.
Connect to Your Business Operations: Ensure that your pricing structures depict actual economic value generated by your entities.
Follow Regulatory Changes Closely: As International Tax Laws are evolving and changing constantly; there will be an impact on international tax rules which are continuously being established by the OECD’s work on the Digital Economy.
Get Your Experts’ Advice: Having specialty tax advisors can help new businesses create a scalable structure that maintains compliance while they are growing.
By proactively addressing transfer pricing, new businesses can avoid costly disputes and establish a strong foundation for sustainable international expansion.
Conclusion
Worldwide tax and financial strategy, as well as a global organization’s tax and regulatory risk at both the government level and the company level, depend significantly on transfer pricing when startups expand internationally. Therefore, as more governments focus on determining whether income generated by cross-border transactions is “real,” the arm’s-length standard will remain a measurement system for appropriately measuring and regulating fair transfer pricing among affiliates, as outlined in the OECD Guidelines.
Recognizing transfer prices early in an international growth strategy will benefit startups’ ability to mitigate regulatory risk; improve investor confidence; and maintain the ability to continue to grow. By having the right planning and documentation in place today, startups can create compliant global organizations and provide for continued growth without incurring disputes with tax authorities that would have been preventable through appropriate planning and documentation.
FAQ
What is transfer pricing?
It is the pricing of transactions between related companies in different countries.
Why is transfer pricing important for startups?
It ensures compliance with international tax rules and prevents double taxation.
What is the arm’s length principle?
It requires related companies to price transactions as if they were independent businesses.
When should startups implement transfer pricing policies?
As soon as they begin operating in more than one country.
Do small startups need transfer pricing documentation?
Yes, if they have cross-border transactions between related entities.