What Is Transfer Pricing in International Trade?
Transfer pricing governs how related companies within a group price transactions between themselves. Relevant for any business with overseas subsidiaries.
Key Takeaways
- Transfer pricing applies when related companies trade with each other across borders
- The arm's length principle requires prices to mirror what unrelated parties would pay
- HMRC requires large businesses to document their transfer pricing methodology
- Getting it wrong can result in significant tax adjustments and penalties
What transfer pricing means
Transfer pricing refers to the prices charged between related entities within the same corporate group for goods, services, or intellectual property transferred across borders. Because these transactions are between controlled parties, tax authorities scrutinise them to ensure they are not being used to shift profits to lower-tax jurisdictions.
The arm's length principle
The global standard, enshrined in OECD guidelines and UK law, is the arm's length principle: transactions between related parties should be priced as if they were between independent, unrelated companies in comparable circumstances. Artificially low or high prices that shift profits to a tax haven violate this principle.
Methods for setting arm's length prices
Accepted methods include: the Comparable Uncontrolled Price (CUP) method (comparing to a similar transaction between unrelated parties), the Cost Plus method (adding a reasonable markup to the supplier's cost), the Resale Price method (working backwards from the buyer's selling price), and the Transactional Net Margin Method (TNMM).
Documentation requirements
HMRC requires businesses above certain thresholds to maintain contemporaneous documentation demonstrating their transfer prices comply with the arm's length principle. This includes a master file describing the group's structure, a local file detailing specific transactions, and a country-by-country report for very large groups.
Risk for growing businesses
Transfer pricing becomes relevant when you structure separate legal entities in different countries. At this stage, a tax adviser with transfer pricing expertise should review the structure before implementation. Retrospective HMRC adjustments are costly and can negate the tax benefits the structure was designed to achieve.