TL;DR Transfer pricing is needed when two connected (same group/ownership) companies transact. E.g. sending money in return for overseas staff, software licenses, or other services. The amount sent has to be as if the companies were unconnected, so you can't use it to avoid tax, and you also can't send just the amount needed. The transfer pricing rules set how you should calculate this mark-up.
When a group of companies (two or more companies who are owned by the same shareholders, or perhaps one company is owned by the other) need to send funds to each other in return for goods or services, the amount of money sent should be set using transfer pricing. Simply, it's a method of calculating a price for those goods or services, when you sell them to yourself.
Where it's just general funding (e.g. cash from a fundraise being moved to the operating company) this is covered by other mechanisms and transfer pricing is not relevant. We wrote about that here.
For many founders, the first thought might be to just transfer the amount of money needed to continue operating or to just cover the costs, however, it's not that straightforward and you have to allocate the correct price, which may result in you generating a taxable profit in that region.
It is often seen in cross-border scenarios, and in the past has been used as a vehicle to move profits to a lower tax country, in order to avoid paying tax (like certain tech giants have been accused of doing). Because of this the international taxation bodies created transfer pricing rules to prevent manipulation in this way.
The underlying concept is that pricing of that transaction should reflect how prices might be determined if the parts of the group were not connected – which can be summarised as the ‘arm’s length’ principle. By doing so, you recognise the profits generated by that country and ensure that appropriate tax is paid.
Most importantly, you also ensure your startup doesn't get caught up in any problems with tax authorities or have to pay any fines.
If your startup has 2 or more companies (one company is owned by another) in a group structure and those entities transact with each other, then this applies to you. Perhaps you created an overseas subsidiary for sales or have an overseas team of developers who are all employees. Depending on your setup you may have multiple agreements and some even may go in two directions. E.g. your HQ charges your overseas office for HR support and your satellite office charges your HQ for tech development.
When you start sending money between these companies, or as soon as possible thereafter. Don't panic if you have been doing it for a while without realising, just talk to an accountant as soon as possible.
It's also not a one-off task and should be reviewed periodically to ensure the appropriate prices are set. All the documentation setting out the transfer pricing and the ongoing reviews should be kept in the event it is needed for review, or even just to show to potential investors to evidence that you are taking your corporate duties seriously and are mitigating any risks.
A review should ideally be performed annually, or sooner if a change in the nature of the transactions, the costs*, the wider economic environment changes, or tax regimes call for it.
*by change in costs we don't mean normal, expected fluctuations as this can be included within the pricing calculation. What should be considered a change would be a significant, incremental change.
There are 5 basic ways of calculating the price, all using the 'arm's length' principle, and some are more suited to industries or processes than others. Of course, it can get complex and you could have hybrid models, but here we will stick with the basics.
For all transfer pricing, you will want to get an accountant to help, as they will also need sight of the documents when completing your end-of-year filings as it is mandatory to report this kind of transaction. They can also help provide a document template for this and assist with the annual review.
Below is a brief overview of each method:
1. The Comparable Uncontrolled Price (CUP) Method
This means you compare to what you could make by selling that good or service to the outside world, and then charge that price. It's important to choose a comparison that has very similar conditions (geography, features, etc.) to ensure it is a price the tax authorities will accept.
2. Cost-Plus-Percent Method
Self-explanatory. You count up all your costs and add a flat-rate percentage on top. The markup should be equal to what a third party would earn for transactions in a comparable situation. Ballpark numbers are between 2-10% depending on services provided. Common in services scenarios like tech development.
3. The Resale Price Method
This process looks at the gross margin or the difference between the cost and the selling price. It assumes the buying company should make the same profit margin, regardless of whether it is bought from a connected company or a third party. As it uses the buying parties' margin to calculate the transfer price, it's more appropriate for distributors and resellers, as opposed to manufacturers, and is almost always only used for tangible items.
4. Transaction Net Margin Method (TNMM)
This method doesn't look at the resale price, but instead compares net profit margin (as in the final profit after all costs), against the net profit margin earned if purchased from a third party, or you can even compare against similar industry net margins. It's sort-of similar to resale price method, but instead looks at net margin, not gross, so takes into account all your other costs. It's gaining popularity and is fast becoming a dominant method.
5. The Profit-Split Method
Also based on net profit, not comparable market price. In this process, pricing is determined by considering how the final profit from the transaction would have been divided between two unconnected businesses involved in the transaction.
Top tip ⭐ Generally, the higher the transaction value per month or per year, the higher the chance of review by a Tax Authority, so as you do scale your business, be prepared for higher bills from an accountant to review these arrangements, as more work is needed to ensure the setup is watertight.
Company A is based in the US and owns 100% of Company B, which is based in Ireland.
Company B has some engineers that work on the core product that Company A sells, so Company A needs to pay for that service. Company B of course, needs to charge so that it can get some cash in and pay its engineers.
(for reference, Ireland has a 12.5% corporate tax rate and the US varies state by state, but let's say approx. 30%)
Company A sends only the exact amount needed to pay the salaries, rent and other costs that Company B incurs.
All the possible profit accumulates in Company A, resulting in much higher tax bills in addition to not being compliant with transfer pricing rules. They could risk fines and penalties.
Company A decides that it wants to avoid tax by inflating the charge for the services from Company B, leaving all the profit in Ireland to be taxed at a much lower rate.
Lower tax bills, but again, not compliant and risks fines and penalties.
Proper transfer pricing is planned, with review against comparable services. The final method is decided as cost plus percentage, using 10%. Documentation is kept and monitored.
Appropriate tax is paid, risk is eliminated, and the company can get on with business.
The easiest way to deal with this is proactively and with all the information. By having a basic knowledge of what it is (at least by reading this article), and in-depth knowledge of how your startup works, you can speed up the process with your accountant and reduce bills. If you can explain the exchange of goods and services clearly to your accountant, and ideally point them at the comparable services to benchmark against (perhaps your competitors?) then that's half of the job done.
Finally, don't overlook the actual sending of funds, ensure you are not paying too much for your bank transfers, and shop around on FX if you need to exchange funds.