This contrasts with the situation when you are trading between different divisions, business units and group companies. Here the independence and basic desire to trade is impacted by internal procedures and strategy including tax and accounting methods. What governs this type of trade is known as transfer pricing.
Transfer pricing is the accounting practice that helps govern, structure and operationalise transactions between connected companies and agrees the tax implications of such transactions.
The transfer pricing policy will ultimately need to show fair value in the trade and that it is comparable to the market rate. It will be used as part of the groups tax planning and accounting methods, so it is important that companies demonstrate clearly why the values in the trade are appropriate. Tax authorities may review this value to check that the appropriate taxes have been paid and the transfer pricing policy hasn’t been used to avoid the company’s tax burden.
A key principle in how the transaction is priced is the arm’s length principle and most countries broadly follow the OECD definition and related guidance. Simply, the profit generated should result in a similar outcome if the transaction had been completed by unconnected parties.
The OECD lays out 5 main methods of transfer pricing:
Where available, if a similar transaction can be shown between an unconnected party, this is considered a fair comparison and basis on which to form the pricing of a connected party transaction. However, it is acknowledged that this can be very difficult to evidence.
Used predominately for companies where the distribution of a product is separate to the manufacturing of the product. It will therefore consider the recommended retail price minus the costs associated to distribution.
Differing to the resale method, the cost-plus model starts with the cost already realised by the first part of the chain where it is given to a connected company in a semi-finished state.
This method, sometimes referred to as the other method is where it is challenging to identify the gross profit margin and therefore looks to find transactions that are comparable on a net margin basis.
More challenging for companies is when the trade between the entities is based on the sharing of their intellectual property including their know-how, brand, trademarks, patents etc. As an intangible asset, the party must consider the implications of the OECD term DEMPE (development, enhancement, maintenance, protection, and exploitation) of intangibles. DEMPE governs what factors need to be considered when determining the contributing price.
At Source Advisors, we can provide unique insight into how your Intellectual Property can be leveraged to maximise the fiscal benefits you achieve.
By understanding the practical application of inter-company trading and the related IP that is held by the group, we can uncover hidden value in your IP.
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