Transfer pricing refers to the setting of the price for goods and services traded between different units of a multinational corporation, located in different countries. This pricing practice is used by large organizations to allocate profits and expenses among their various units in a way that minimizes tax liability.
Organizations use transfer pricing to reduce their tax liabilities by shifting profits to low-tax jurisdictions, where they have subsidiaries or other affiliated entities while incurring expenses in high-tax jurisdictions. This can be achieved by setting prices for intercompany transactions that are artificially high or low, depending on the desired tax outcome. For example, a subsidiary located in a high-tax jurisdiction may charge an artificially high price for goods or services it sells to a subsidiary in a low-tax jurisdiction, thus transferring profits to the low-tax jurisdiction and reducing its tax bill in the high-tax jurisdiction.
To justify it clearly, I have considered presenting in points.
Shifting profits to low-tax countries: Companies may allocate profits to subsidiaries located in countries with lower tax rates through transfer pricing, which can reduce the overall tax liability of the multinational company.
Overcharging for inter-company transactions: Companies may artificially inflate the prices of goods or services traded between subsidiaries to reduce taxable profits in countries with higher tax rates.
Undercharging for inter-company transactions: Companies may artificially deflate the prices of goods or services traded between subsidiaries to increase taxable profits in countries with lower tax rates.
Misrepresenting the nature of transactions: Companies may misrepresent the nature of transactions between subsidiaries, for example, by describing a loan as a sale, to reduce taxable profits in countries with higher tax rates.
Transferring intangible assets: Companies may transfer ownership of intangible assets, such as trademarks, patents, and copyrights, to subsidiaries located in countries with lower tax rates.
Centralizing business operations: Companies may centralize business operations, such as sales and marketing, in low-tax countries to reduce taxable profits in countries with higher tax rates.
Avoiding permanent establishment: Companies may avoid having a permanent establishment in high-tax countries by having all of their business activities conducted through subsidiaries located in low-tax countries.
Abusing tax treaties: Companies may abuse tax treaties by exploiting loopholes or by misinterpreting the provisions of tax treaties to reduce taxable profits in countries with higher tax rates.
For example, consider a multinational company with subsidiaries in two countries, one with a tax rate of 20% and the other with a tax rate of 40%. If the company wants to reduce its tax liability, it may artificially increase the price of goods or services sold from the subsidiary in the higher tax rate country to the subsidiary in the lower tax rate country. This will result in lower taxable profits for the subsidiary in the higher tax rate country and higher taxable profits for the subsidiary in the lower tax rate country, reducing the overall tax liability of the multinational company.
It is important to note that transfer pricing is not illegal, but tax authorities in many countries are increasingly cracking down on these practices as they consider them abusive and detrimental to the tax base. Governments around the world are implementing measures to prevent transfer pricing abuses, such as transfer pricing rules, documentation requirements, and audits. These measures aim to ensure that transfer prices are set at levels that would be consistent with those that would be charged in an arm's length transaction between independent parties.
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