Tax avoidance/Transfer pricing

General principle

It is widely accepted by legislatures, implicitly or explictly, that transactions should be taxed as if they are undertaken at prevailing market prices and on ordinary commercial terms.

Where the parties are operating at arm's length, their actual transaction is evidence of prevailing market conditions, and so there is no need to impose any special rules. The transaction can be taxed as-is.

However, where the parties are not operating at arm's length -- e.g. a company dealing with a wholly-owned subsidiary company, or an individual dealing with their spouse -- there is a need for some independent evidence of the proper market conditions. Obtaining this evidence consumes vast resources when it is litigated (in terms of payment of expert witnesses and court time, and associated lawyers' fees) and, depending on the extent to which the terms of the transaction need to be 'reconstructed' and the likelihood that a pair of arm's-length parties would have ever entered into such a transaction, the exercise can approach 'valuing a unicorn that nobody wants' (author of quote unknown, please attribute if known).

Transfer pricing in (internal) management accounting

Within any business with a vertically-integrated supply chain (that is, the outputs of one part of the business are the inputs of another, such as where coffee beans are roasted by a company which then uses those beans to make coffee for sale to individuals on the street), it is necessary to know how profitable each part of the business is. Therefore, it is necessary (for reasons completely unrelated to tax) to attempt to superimpose an arm's-length price on transactions for which actual payment may or may not be necessary (since the parties are related or are one and the same).

Legislation giving effect to the general principle in its purest form

There is no legislation in existence which provides that, in all cases,

(Note, until a comprehensive comparative survey of all tax legislation in the world is undertaken, this statement is subject to being proven wrong. Please edit it with evidence if it is in fact wrong.)

Instead, there are specific rules for various types of transactions, such as the sale of trading stock, transactions with counterparties outside of the jurisdiction (cross-border transactions) or transactions with a tax avoidance purpose.

Domestic transfer pricing rules

In Australia's income tax system, the following types of transactions are subject to 'market value substitution' rules:

• acquisition or sale of trading stock
• acquisition or sale of assets subject to capital gains tax
• transactions where one party is a resident and the other is not (with 'party' read as including a 'branch'): see 'Cross-border transfer pricing rules'

Cross-border transfer pricing rules

There are two types of cross-border transfer pricing rules:

• price only - the only thing the tax authority can 'change' is the price paid for a goods or services;
• reconstruction - the tax authority can make up a 'counterfactual' which represents the transaction which a pair of arm's-length parties would have entered into instead of the actual transaction.

Methods for deriving an arm's-length price include:

• traditional transactional methods
  • comparable uncontrolled transaction
  • 'cost plus'
  • 'resale price minus'
• transactional profit methods
  • profit split
  • transactional net margin method

One of the objectives of cross-border transfer pricing rules -- ensuring that an appropriate level of profit is taxed in each jurisdiction -- can instead be pursued through unitary taxation. Unitary taxation takes a group of associated entities and ignores transactions within the group to derive a consolidated figure for sales, expenses, etc. The group's profit is then apportioned to each jurisdiction using a formula based on factors such as the number of employees or the value of property, plant and equipment in each jurisdiction. The key difference between transfer pricing rules and unitary taxation, in terms of policy, is that transfer pricing rules attempt to estimate the profits actually generated in each jurisdiction, whereas unitary taxation instead decides which jurisdictions should get what share of the group's tax liability based on the group's presence in each jurisdiction. The weakness of transfer pricing rules is that the required estimates are difficult or impossible (and therefore results may be arbitrary), and the weakness of unitary taxation is that the result is, because of the imposition of an arbitrary formula, arbitrary.

Particular types of transactions for which transfer pricing rules are important

TODO

Funding of a subsidiary e.g. loan, equity injection, guarantee

TODO

See also 'thin capitalisation'